UNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549

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FORM 10-K/AAMENDMENT NO. 2

|(Mark One)                                                       |                                                                                         
|---------------------------------------------------------------- | ----------------------------------------------------------------------------------------
|ý                                                                | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934    
|For the fiscal year ended December 31, 2004                     
|o                                                                | 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)

|Delaware(State or other jurisdiction of
incorporation or organization)                   |  | 33-0284454(IRS Employer
Identification No.)
|---------------------------------------------------------------------------------------- |  | -------------------------------------------
|412 Creamery Way,
Suite 300,
Exton, Pennsylvania(Address of principal executive offices) |  | 19341(Zip Code)                            

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

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 ý    NO o

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.    o

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

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 o    NO ý

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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EXPLANATORY NOTE

As a result of the routine review of the Daou Systems, Inc. (the "Company") Form 10-K for the year ended December 31, 2004 by the
staff of the Securities and Exchange Commission ("SEC"), the Company examined the classification on its balance sheet of its Series A-1 Preferred Stock. (Note that the initial
Form 10-K for fiscal 2004 referred to this security as Series A Preferred stock. Reference should be made to Note 8Redeemable Preferred Stock, in the
Notes to Financial Statements, for a discussion of this revised designation.) The Company had classified this amount as a component of stockholders' equity in its financial statements for the year
ended December 31, 2004 filed in its Form 10-K with the SEC.

Based
on the staff's comment, the Company reviewed the terms of the Series A-1 Preferred Stock and noted that in the event of an unsolicited tender offer that results
in the Company's stockholders immediately prior to such transaction not holding at least 50% of the voting securities of the surviving entity, the holders of the Series A-1
Preferred Stock would be entitled to receive for each share of such stock an amount per share at least equal to Five Dollars and Fifty Cents ($5.50) plus any accrued but unpaid dividends. Because such
a transaction could result in a cash liquidation of the Series A-1 Preferred Stock that is outside the control of the Company, management, in consultation with the Company's
independent registered public accounting firm, concluded on July 13, 2005 that the Series A-1 Preferred Stock should be classified as a component of mezzanine equity and not
a component of permanent equity on the Company's balance sheet and that the Company should restate its previously issued financial statements. On July 18, 2005, the Audit Committee of the
Company's Board of Directors, in consultation with management and the Company's independent registered public accounting firm, confirmed management's conclusion that a restatement of the previously
issued financial statements is required. The restated financial statements for each of the three years in the periods ended December 31, 2004, 2003 and 2002 are reflected in this Amendment
No. 2 to the Company's Annual Report on Form 10-K. The restatement is a reclassification of Preferred Stock between permanent equity and mezzanine equity on the balance sheet
and has no impact on the Company's historical or future statements of operations or cash flows. In addition to this amended Form 10-K for the year ended December 31, 2004,
the Company has also amended its Form 10-Q for the quarter ended March 31, 2005. The Company did not amend its Annual Report on Form 10-K or Quarterly
Reports on Form 10-Q for periods affected by the restatement that ended prior to December 31, 2004.

Pursuant
to this Form 10-K/AAmendment No. 2, Daou Systems, Inc. amends the following information previously included in the fiscal 2004
Form 10-K filed
on March 30, 2005 and the Form 10-K/AAmendment No. 1 filed on April 29, 2005:



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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

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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.

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.



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:



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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

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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.



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

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

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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.



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:



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 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,

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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.

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.

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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:



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.

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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

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our
revenues and operating results are expected to continue from time to time, due to various factors, including:



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

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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 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

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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.

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

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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.

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.

14

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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.

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.

15

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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-1 redeemable 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:



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.

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:



16

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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-1 redeemable 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 Notes 8 and 9 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.

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    

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17

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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.

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.

18

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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.

19

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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
|---- | ----------- | ------------
|
|2003 |             |             
|     | 1st Quarter |             
|     | 2nd Quarter |             
|     | 3rd Quarter |             
|     | 4th Quarter |             
|2004 |             |             
|     | 1st Quarter |             
|     | 2nd Quarter |             
|     | 3rd Quarter |             
|     | 4th Quarter |             

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 136 holders of record of common
stock.

Dividend Policy

In July 1999, we issued 2,181,818 shares of Series A-1 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-1 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-1 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

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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 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, |                 
|-------------------------------------------------------------------- | ------------------------------- | ------------------------ | ----------------
|
|Revenue before reimbursements (net revenue)                          |                                 | $                        | 63,748          
|Cost of revenue before reimbursable expenses                         |                                 |                          | 58,700          
|                                                                     |                                 |                          |                 
|Gross profit                                                         |                                 |                          | 5,048           
|Operating expenses:                                                  |                                 |                          |                 
|                                                                     | Sales and marketing             |                          |                 
|                                                                     | General and administrative      |                          |                 
|                                                                     | Restructuring (credits) charges |                          |                 
|                                                                     |                                 |                          |                 
|                                                                     |                                 | Total operating expenses |                 
|                                                                     |                                 |                          |                 
|Income (loss) from operations                                        |                                 |                          | (14,883         
|Other income, net                                                    |                                 |                          | 699             
|                                                                     |                                 |                          |                 
|Income (loss) before income taxes                                    |                                 |                          | (14,184         
|Provision for income taxes                                           |                                 |                          |                
|                                                                     |                                 |                          |                 
|Net income (loss)                                                    |                                 |                          | (14,184         
|Dividends on preferred stock                                         |                                 |                          | (4,837          
|Net income (loss) available to common stockholders                   |                                 | $                        | (19,021         
|Net income (loss) available to common stockholders per common share: |                                 |                          |                 
|                                                                     |                                 | Basic                    |                 
|                                                                     |                                 |                          |                 
|                                                                     |                                 | Diluted                  |                 
|Shares used in computing net income (loss) per common share:         |                                 |                          |                 
|                                                                     |                                 | Basic                    |                 
|                                                                     |                                 |                          |                 
|                                                                     |                                 | Diluted                  |                 
|Cash, cash equivalents, restricted cash and short-term investments   |                                 | $                        | 10,586          
|Total assets                                                         |                                 | $                        | 26,832          
|Redeemable preferred stock                                           |                                 | $                        | 13,058          
|Total stockholders' equity (deficit)                                 |                                 | $                        | 7,302           
|Support Center Management Services*Revenue                          |                                 | $                        |                
|                                                                     |                                 |                          | Cost of revenue

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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

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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.

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.

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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 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

23

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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.

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.

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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, |   
|-------------------------------------------- |  | ------------------------ | --
|
|Revenue before reimbursements (net revenue)  |  | 100                      | % 
|Cost of revenue before reimbursable expenses |  | 76                       |   
|                                             |  |                          |   
|Gross profit                                 |  | 24                       |   
|Sales and marketing expense                  |  | 12                       |   
|General and administrative expense           |  | 23                       |   
|Restructuring charges (credit)               |  |                         |   
|                                             |  |                          |   
|Income (loss) from operations                |  | (11                      | ) 
|Other income, net                            |  | 1                        |   
|                                             |  |                          |   
|Income (loss) before income taxes            |  | (10                      | ) 
|Provision for income taxes                   |  |                         |   
|                                             |  |                          |   
|Net income (loss)                            |  | (10                      | )%
|                                             |  |                          |   

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 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.

25

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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 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

26

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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.

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. 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. Additional details are provided in Note 3 of the accompanying Notes to Financial Statements.

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, available-for-sale.

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.

27

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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.

As
previously disclosed, in July 1999 we issued 2,181,818 shares of Series A-1 Redeemable 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-1 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-1 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-1 Redeemable Preferred Stock vote on an as converted to common stock basis with the holders of common stock. The
Series A-1 Preferred stockholders also have a liquidation preference of $5.50 per Series A-1 share, plus any accrued but unpaid dividends. At the option of the
holders, shares of the Series A-1 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-1 Preferred Stock. The holders of Series A-1 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-1 Preferred Stock), thereby entitling the holders of the Series A-1 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-1
Preferred Stock had the right to cause the redemption of their Series A-1 Preferred Stock for approximately $12.9 million. We entered into an agreement with the holders of
the Series A-1 Preferred Stock under which the holders of the Series A-1 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
|--------------------------- |  | ----------------------
|
|Operating lease obligations |  | $                     

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

28

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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 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.



Daou recognizes all of its revenue in accordance with Staff Accounting Bulletin ("SAB") No. 104, Revenue Recognition, and complies with SAB 104
requirements that the following criteria be met in determining whether revenue has been earned:



The
Company records revenue from the following types of transactions: 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, Daou enters into contracts with customers to provide services at a specified fee or rate per hour. Revenue from professional
services contracts is recognized on an hourly basis as work is performed. Contract revenue for the development and implementation of network solutions under fixed-fee contracts is
recognized under a proportionate performance method by determining the level of service performed based upon the amount of labor incurred on the project versus the total labor costs to perform the
project as this is the most readily reliable measure of output (i.e. the amount of the installation complete as of any date) for an installation project. Our policy for recording a provision for a
loss on a fixed fee contract would be made during the period when the loss becomes probable and can be reasonably estimated. The amount of the contract losses recognized was $0, $30,000, and $0 for
the years ended December 31, 2004, 2003, and 2002, respectively. Revenue from technical support, network management and help desk services is recognized on a pro-rata basis over the
performance period. Revenue from the sale of material or goods is recognized upon transfer of title as long as the four elements of revenue recognition discussed above are met.

Daou
was engaged in approximately five (5) outsourcing contracts in 2002, four (4) in 2003 and one (1) in the first quarter of 2004. All contracts had expired by the
end of the first quarter 2004. The Company hired client employees at the inception of one of the five outsourcing contracts that was initiated on January 23, 1998. Daou's revenue recognition
policy on outsourcing contracts is to recognize revenue ratably over the period that these services are provided. One of these contracts

29

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provided
contingency payments (risk/reward) based on meeting service level criteria each month. Daou's policy on recognizing revenue for these contingency payments was to record the revenue in the
period which the contingency was resolved. The contingency revenue was less than 1% of the total revenue earned on this contract.



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.



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.

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.

30

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On December 16, 2004, the Financial Accounting Standards Board (FASB) issued Statement 123 (revised 2004), "Share Based Payment" (FAS 123R). FAS 123R
supersedes APB 25, "Accounting for Stock Issued to Employees," and is effective for public companies at the beginning of the first 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                         |  | 32
|Balance Sheets at December 31, 2004 and 2003                                                       |  | 33
|Statements of Operations for the years ended December 31, 2004, 2003, and 2002                     |  | 34
|Statements of Stockholders' Equity (Deficit) for the years ended December 31, 2004, 2003, and 2002 |  | 35
|Statements of Cash Flows for the years ended December 31, 2004, 2003, and 2002                     |  | 36
|Notes to Financial Statements                                                                      |  | 37
|Financial Statement Schedule                                                                       |  |   
|Schedule IIValuation and Qualifying Accounts                                                      |  | 52

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.

31

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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
(deficit), 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.

As
discussed in Note 8 to the financial statements, the accompanying financial statements for the years ended December 31, 2004, 2003 and 2002 have been restated to
classify the Company's Preferred Stock as mezzanine equity rather than stockholders' equity as previously reported.

|                                                                                                                             |  |  |  | /s/ERNST & YOUNG LLP
|---------------------------------------------------------------------------------------------------------------------------- |  |  |  | --------------------
|Philadelphia, Pennsylvania                                                                                                   |  |  |  |                     
|February 4, 2005, except for
the seventh and eighth paragraphs of
Note 8 and Note 14 as to which the date
is August 11, 2005 |  |  |  |                     

32

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Daou Systems, Inc.  Balance Sheets  (In thousands, except for per share data)

|                                                                                                                                                                                                                                          |                                                                                                                                                                                                                | December 31, |       
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------ | ------
|
|
|ASSETS                                                                                                                                                                                                                                    |                                                                                                                                                                                                                |              |       
|Current assets:                                                                                                                                                                                                                           |                                                                                                                                                                                                                |              |       
|                                                                                                                                                                                                                                          | Cash and cash equivalents                                                                                                                                                                                      |              | $     
|                                                                                                                                                                                                                                          | Investments, available-for-sale                                                                                                                                                                                |              |       
|                                                                                                                                                                                                                                          | Accounts receivable, net of allowance for doubtful accounts of $367 and $789 in 2004 and 2003, respectively                                                                                                    |              |       
|                                                                                                                                                                                                                                          | Contract work in progress                                                                                                                                                                                      |              |       
|                                                                                                                                                                                                                                          | Other current assets                                                                                                                                                                                           |              |       
|                                                                                                                                                                                                                                          |                                                                                                                                                                                                                |              |       
|Total current assets                                                                                                                                                                                                                      |                                                                                                                                                                                                                |              | 17,048
|Due from officers/stockholders                                                                                                                                                                                                            |                                                                                                                                                                                                                |              | 119   
|Equipment, furniture and fixtures, net                                                                                                                                                                                                    |                                                                                                                                                                                                                |              | 885   
|Other assets                                                                                                                                                                                                                              |                                                                                                                                                                                                                |              | 628   
|                                                                                                                                                                                                                                          |                                                                                                                                                                                                                |              |       
|                                                                                                                                                                                                                                          |                                                                                                                                                                                                                | $            | 18,680
|                                                                                                                                                                                                                                          |                                                                                                                                                                                                                |              |       
|LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)                                                                                                                                                                                            |                                                                                                                                                                                                                |              |       
|Current liabilities:                                                                                                                                                                                                                      |                                                                                                                                                                                                                |              |       
|                                                                                                                                                                                                                                          | Trade accounts payable                                                                                                                                                                                         |              | $     
|                                                                                                                                                                                                                                          | Accrued salaries and benefits                                                                                                                                                                                  |              |       
|                                                                                                                                                                                                                                          | Accrued project costs                                                                                                                                                                                          |              |       
|                                                                                                                                                                                                                                          | Other accrued liabilities                                                                                                                                                                                      |              |       
|                                                                                                                                                                                                                                          | Deferred revenue                                                                                                                                                                                               |              |       
|                                                                                                                                                                                                                                          |                                                                                                                                                                                                                |              |       
|Total current liabilities                                                                                                                                                                                                                 |                                                                                                                                                                                                                |              | 4,011 
|Deferred rent, net of current portion                                                                                                                                                                                                     |                                                                                                                                                                                                                |              | 394   
|Other long-term liabilities                                                                                                                                                                                                               |                                                                                                                                                                                                                |              |      
|Commitments and contingencies                                                                                                                                                                                                             |                                                                                                                                                                                                                |              |      
|Redeemable 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 |                                                                                                                                                                                                                |              | 17,827
|Stockholders' equity (deficit):                                                                                                                                                                                                           |                                                                                                                                                                                                                |              |       
|                                                                                                                                                                                                                                          | 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 |              |       
|                                                                                                                                                                                                                                          | Additional paid-in capital                                                                                                                                                                                     |              |       
|                                                                                                                                                                                                                                          | Notes receivable from stockholders                                                                                                                                                                             |              |       
|                                                                                                                                                                                                                                          | Accumulated other comprehensive loss                                                                                                                                                                           |              |       
|                                                                                                                                                                                                                                          | Accumulated deficit                                                                                                                                                                                            |              |       
|                                                                                                                                                                                                                                          |                                                                                                                                                                                                                |              |       
|Total stockholders' equity (deficit)                                                                                                                                                                                                      |                                                                                                                                                                                                                |              | (3,552
|                                                                                                                                                                                                                                          |                                                                                                                                                                                                                |              |       
|                                                                                                                                                                                                                                          |                                                                                                                                                                                                                | $            | 18,680
|                                                                                                                                                                                                                                          |                                                                                                                                                                                                                |              |       

See
accompanying notes to financial statements.

33

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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 |       
|Out-of-pocket reimbursements                               |                                |      | 2,284  |        |   | 3,265  |       
|                                                           |                                |      |        |        |   |        |       
|                                                           | Total revenue                  |      |        | 29,391 |   |        | 45,426
|Cost of revenue before reimbursable expenses               |                                |      | 20,479 |        |   | 28,760 |       
|Out-of-pocket reimbursable expenses                        |                                |      | 2,284  |        |   | 3,265  |       
|                                                           |                                |      |        |        |   |        |       
|                                                           | Total cost of revenue          |      |        | 22,763 |   |        | 32,025
|                                                           |                                |      |        |        |   |        |       
|Gross profit                                               |                                |      | 6,628  |        |   | 13,401 |       
|Operating expenses:                                        |                                |      |        |        |   |        |       
|                                                           | Sales and marketing            |      |        | 3,208  |   |        | 4,550 
|                                                           | General and administrative     |      |        | 6,428  |   |        | 6,670 
|                                                           | Restructuring (credit) charges |      |        |       |   |        | (252  
|                                                           |                                |      |        |        |   |        |       
|                                                           |                                |      | 9,636  |        |   | 10,968 |       
|                                                           |                                |      |        |        |   |        |       
|Income (loss) from operations                              |                                |      | (3,008 | )      |   | 2,433  |       
|Other income, net                                          |                                |      | 209    |        |   | 207    |       
|                                                           |                                |      |        |        |   |        |       
|Income (loss) before income taxes                          |                                |      | (2,799 | )      |   | 2,640  |       
|Provision for income taxes                                 |                                |      | (36    | )      |   | (52    | )     
|                                                           |                                |      |        |        |   |        |       
|Net income (loss)                                          |                                |      | (2,835 | )      |   | 2,588  |       
|Accrued dividends on preferred stock                       |                                |      | (1,571 | )      |   | (1,290 | )     
|                                                           |                                |      |        |        |   |        |       
|Net income (loss) available to common stockholders         |                                | $    | (4,406 | )      | $ | 1,298  |       
|                                                           |                                |      |        |        |   |        |       
|Earnings (loss) per common share:                          |                                |      |        |        |   |        |       
|                                                           | Basic                          |      | $      | (0.20  | ) | $      | 0.06  
|                                                           |                                |      |        |        |   |        |       
|                                                           | Diluted                        |      | $      | (0.20  | ) | $      | 0.05  
|                                                           |                                |      |        |        |   |        |       
|Shares used in computing earnings (loss) per common share: |                                |      |        |        |   |        |       
|                                                           | Basic                          |      |        | 21,656 |   |        | 20,821
|                                                           |                                |      |        |        |   |        |       
|                                                           | Diluted                        |      |        | 21,656 |   |        | 26,513
|                                                           |                                |      |        |        |   |        |       

See
accompanying notes to financial statements.

34

---



Daou Systems, Inc.
Statements of Stockholders' Equity (Deficit)
For the Years Ended December 31, 2004, 2003, and 2002
(In thousands)

|                                                            |                                |        |   |   |    |   |   | Notes
receivable
from
stock-
holders |   |   |        |   |   |     |   
|----------------------------------------------------------- | ------------------------------ | ------ | - | - | -- | - | - | ------------------------------------ | - | - | ------ | - | - | --- | --
|
|
|
|Balance at December 31, 2001                                |                                | 21,556 |   | $ | 22 |   | $ | 39,758                               |   | $ | (1,281 | ) | $ | (72 | ) 
|                                                            |                                |        |   |   |    |   |   |                                      |   |   |        |   |   |     |   
|Issuance of common stock under employee stock purchase plan |                                | 160    |   |   |   |   |   | 81                                   |   |   |       |   |   |    |   
|Accrued dividends on preferred stock                        |                                |       |   |   |   |   |   |                                      |   |   |       |   |   |    |   
|Issuance of common stock upon exercise of stock options     |                                | 21     |   |   |   |   |   | 3                                    |   |   |       |   |   |    |   
|Comprehensive loss:                                         |                                |        |   |   |    |   |   |                                      |   |   |        |   |   |     |   
|                                                            | Unrealized gain on investments |        |  |   |    |  |   |                                      |  |   |        |  |   |     | 16
|                                                            | Net loss                       |        |  |   |    |  |   |                                      |  |   |        |  |   |     |  
|                                                            |                                |        |   |   |    |   |   |                                      |   |   |        |   |   |     |   
|Comprehensive loss:                                         |                                |       |   |   |   |   |   |                                     |   |   |       |   |   |    |   
|                                                            |                                |        |   |   |    |   |   |                                      |   |   |        |   |   |     |   
|Balance at December 31, 2002                                |                                | 21,737 |   |   | 22 |   |   | 39,842                               |   |   | (1,281 | ) |   | (56 | ) 
|                                                            |                                |        |   |   |    |   |   |                                      |   |   |        |   |   |     |   
|Accrued dividends on preferred Stock                        |                                |        |   |   |    |   |   |                                      |   |   |        |   |   |     |   
|Issuance of stock options for Services                      |                                |        |   |   |    |   |   | 10                                   |   |   |        |   |   |     |   
|Issuance of common stock upon exercise of stock options     |                                | 146    |   |   |    |   |   | 26                                   |   |   |        |   |   |     |   
|Purchase of restricted Stock                                |                                | (300   | ) |   |   |   |   | (196                                 | ) |   | 121    |   |   |     |   
|Comprehensive income:                                       |                                |        |   |   |    |   |   |                                      |   |   |        |   |   |     |   
|                                                            | Unrealized gain on investments |        |  |   |    |  |   |                                      |  |   |        |  |   |     | 27
|                                                            | Net income                     |        |  |   |    |  |   |                                      |  |   |        |  |   |     |  
|                                                            |                                |        |   |   |    |   |   |                                      |   |   |        |   |   |     |   
|Comprehensive income:                                       |                                |       |   |   |   |   |   |                                     |   |   |       |   |   |    |   
|                                                            |                                |        |   |   |    |   |   |                                      |   |   |        |   |   |     |   
|Balance at December 31, 2003                                |                                | 21,583 |   |   | 22 |   |   | 39,682                               |   |   | (1,160 | ) |   | (29 | ) 
|                                                            |                                |        |   |   |    |   |   |                                      |   |   |        |   |   |     |   
|Accrued dividends on preferred stock                        |                                |        |   |   |    |   |   |                                      |   |   |        |   |   |     |   
|Issuance of common stock upon exercise of stock options     |                                | 232    |   |   |    |   |   | 39                                   |   |   |        |   |   |     |   
|Comprehensive loss:                                         |                                |        |   |   |   |   |   |                                      |   |   |        |   |   |     |   
|                                                            | Unrealized gain on investments |        |  |   |    |  |   |                                      |  |   |        |  |   |     | 26
|                                                            | Net loss                       |        |  |   |    |  |   |                                      |  |   |        |  |   |     |  
|                                                            |                                |        |   |   |    |   |   |                                      |   |   |        |   |   |     |   
|Comprehensive loss:                                         |                                |       |   |   |   |   |   |                                     |   |   |       |   |   | 26  |   
|                                                            |                                |        |   |   |    |   |   |                                      |   |   |        |   |   |     |   
|Balance at December 31, 2004                                |                                | 21,815 |   | $ | 22 |   | $ | 39,721                               |   | $ | (1,160 | ) | $ | (3  | ) 
|                                                            |                                |        |   |   |    |   |   |                                      |   |   |        |   |   |     |   

See
accompanying notes to financial statements.

35

---





Daou Systems, Inc.  Statements of Cash Flows  (In thousands)

|                                                                                                   |                                                             | Years ended December 31,                 |       
|-------------------------------------------------------------------------------------------------- | ----------------------------------------------------------- | ---------------------------------------- | ------
|
|
|Operating activities                                                                               |                                                             |                                          |       
|Net income (loss)                                                                                  |                                                             | $                                        | (2,835
|Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: |                                                             |                                          |       
|                                                                                                   | Depreciation and amortization                               |                                          |       
|                                                                                                   | Amortization of deferred compensation                       |                                          |       
|                                                                                                   | Provision for uncollectible accounts                        |                                          |       
|                                                                                                   | Issuance of common stock and options for services           |                                          |       
|                                                                                                   | (Gain) loss on retirement of fixed assets                   |                                          |       
|                                                                                                   | Changes in operating assets and liabilities:                |                                          |       
|                                                                                                   |                                                             | Accounts receivable                      |       
|                                                                                                   |                                                             | Contract work in progress                |       
|                                                                                                   |                                                             | Other current assets                     |       
|                                                                                                   |                                                             | Accounts payable and accrued liabilities |       
|                                                                                                   |                                                             | Accrued salaries and benefits            |       
|                                                                                                   |                                                             | Deferred revenue                         |       
|                                                                                                   |                                                             | Other long-term liabilities              |       
|                                                                                                   |                                                             |                                          |       
|Net cash provided by (used in) operating activities                                                |                                                             |                                          | (1,789
|Investing activities                                                                               |                                                             |                                          |       
|Purchase of equipment, furniture and fixtures                                                      |                                                             |                                          | (318  
|Purchase of available-for-sale investments                                                         |                                                             |                                          | (5,009
|Increase in other assets                                                                           |                                                             |                                          | (36   
|                                                                                                   |                                                             |                                          |       
|Net cash used in investing activities                                                              |                                                             |                                          | (5,363
|Financing activities                                                                               |                                                             |                                          |       
|Proceeds from issuance of common stock                                                             |                                                             |                                          | 39    
|Repurchase of restricted stock, net of notes receivable                                            |                                                             |                                          |      
|                                                                                                   |                                                             |                                          |       
|Net cash (used in) provided by financing activities                                                |                                                             |                                          | 39    
|Increase (decrease) in cash and cash equivalents                                                   |                                                             |                                          | (7,113
|Cash and cash equivalents at beginning of year                                                     |                                                             |                                          | 13,045
|                                                                                                   |                                                             |                                          |       
|Cash and cash equivalents at end of year                                                           |                                                             | $                                        | 5,932 
|                                                                                                   |                                                             |                                          |       
|Supplemental disclosure of non-cash investing and financing activities:                            |                                                             |                                          |       
|                                                                                                   | Accrued preferred stock dividends to preferred stockholders |                                          | $     
|                                                                                                   |                                                             |                                          |       
|                                                                                                   | Unrealized gain on investments                              |                                          | $     
|                                                                                                   |                                                             |                                          |       
|                                                                                                   | Property and equipment acquired through tenant allowance    |                                          | $     
|                                                                                                   |                                                             |                                          |       
|                                                                                                   | Income taxes paid                                           |                                          | $     
|                                                                                                   |                                                             |                                          |       

See
accompanying notes to financial statements.

36

---



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

Daou recognizes all of its revenue in accordance with Staff Accounting Bulletin ("SAB") No. 104, Revenue Recognition, and complies with SAB 104
requirements that the following criteria be met in determining whether revenue has been earned:



The
Company records revenue from the following types of transactions: 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, Daou enters into contracts with customers to provide services at a specified fee or rate per hour. Revenue from professional
services contracts is recognized on an hourly basis as work is performed. Contract revenue for the development and implementation of network solutions under fixed-fee contracts is
recognized under a proportionate performance method by determining the level of service performed based upon the amount of labor incurred on the project versus the total labor costs to perform the
project as this is the most readily reliable measure of output (i.e. the amount of the installation complete as of any date) for an installation project. Daou's policy for recording a provision for a
loss on a fixed fee contract would be made during the period when the loss becomes probable and can be reasonably estimated. The amount of the contract losses recognized was $0, $30,000, and $0 for
the years ended December 31, 2004, 2003, and 2002, respectively. Revenue from technical support, network management and help desk services is recognized on a pro-rata basis over the
performance period. Revenue from the sale of material or goods is recognized upon transfer of title as long as the four elements of revenue recognition discussed above are met.

37

---



Daou
was engaged in approximately five (5) outsourcing contracts in 2002, four (4) in 2003 and one (1) in the first quarter of 2004. All contracts had expired by the
end of the first quarter 2004. The Company hired client employees at the inception of one of the five outsourcing contracts that was initiated on January 23, 1998. Daou's revenue recognition
policy on outsourcing contracts is to recognize revenue ratably over the period that these services are provided. One of these contracts provided contingency payments (risk/reward) based on meeting
service level criteria each month. Daou's policy on recognizing revenue for these contingency payments was to record the revenue in the period which the contingency was resolved. The contingency
revenue was less than 1% of the total revenue earned on this contract.

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.

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 and Cash Equivalents

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.

Investments, Available-for-Sale

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.

Restricted Cash

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.

38

---



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 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,

39

---



"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:



|                                                                                                                 |                     | Years Ended December 31, |       
|---------------------------------------------------------------------------------------------------------------- | ------------------- | ------------------------ | ------
|
|Net (loss) income available to common stockholders as reported                                                   |                     | $                        | (4,406
|Add total stock-based employee compensation determined under
APB No. 25                                          |                     |                          |      
|Deduct total stock-based employee compensation determined under the fair value method for all awards, net of tax |                     |                          | (363  
|                                                                                                                 |                     |                          |       
|Pro forma net (loss) income                                                                                      |                     | $                        | (4,769
|                                                                                                                 |                     |                          |       
|(Loss) earnings per share                                                                                        |                     |                          |       
|                                                                                                                 | Basicas reported   |                          | $     
|                                                                                                                 |                     |                          |       
|                                                                                                                 | Dilutedas reported |                          | $     
|                                                                                                                 |                     |                          |       
|                                                                                                                 | Basicpro forma     |                          | $     
|                                                                                                                 |                     |                          |       
|                                                                                                                 | Dilutedpro forma   |                          | $     
|                                                                                                                 |                     |                          |       

40

---



2.    Earnings Per Share

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



|                                                                                                         |  | Years Ended December 31, |       
|-------------------------------------------------------------------------------------------------------- |  | ------------------------ | ------
|
|Numerator:                                                                                               |  |                          |       
|Net (loss) income                                                                                        |  | $                        | (2,835
|Preferred stock dividends                                                                                |  |                          | 1,571 
|                                                                                                         |  |                          |       
|Numerator for basic and diluted (loss) earnings per shareincome (loss) available to common stockholders |  |                          | (4,406
|Denominator:                                                                                             |  |                          |       
|Weighted-average common shares outstanding                                                               |  |                          | 21,742
|Weighted-average unvested common shares subject to repurchase agreements                                 |  |                          | (86   
|                                                                                                         |  |                          |       
|Denominator for basic (loss) earnings per share                                                          |  |                          | 21,656
|Effect of dilutive securities:                                                                           |  |                          |       
|Unvested common shares subject to repurchase agreements                                                  |  |                          |      
|Stock options                                                                                            |  |                          |      
|Warrants                                                                                                 |  |                          |      
|                                                                                                         |  |                          |       
|Dilutive potential common shares                                                                         |  |                          |      
|                                                                                                         |  |                          |       
|Denominator for diluted (loss) earnings per share                                                        |  |                          | 21,656
|                                                                                                         |  |                          |       
|Basic (loss) earnings per share                                                                          |  | $                        | (0.20 
|                                                                                                         |  |                          |       
|Diluted (loss) earnings per share                                                                        |  | $                        | (0.20 
|                                                                                                         |  |                          |       

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-1 Redeemable 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-1 Redeemable 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."

41

---



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 costs for involuntary employee terminations

Costs related to closure and combination of facilities

TotalBalance at December 31, 2001

$
151

$
1,161

$
1,312Year Ended December 31, 2002:Reserve established


1,065


533


1,598Reserve utilized


(222
)

(1,064
)

(1,286
)Balance at December 31, 2002


994


630


1,624Year Ended December 31, 2003:Reserve established








Reserve utilized


(994
)

(309
)

(1,303
)Other adjustments (a)





(252
)

(252
)Balance at December 31, 2003





69


69Year Ended December 31, 2004:Reserve establishedReserve utilized





(31
)

(31
)Balance at December 31, 2004

$


$
38

$
38


---

4. Investments, Available-For-Sale

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

Amortized Cost

Gross Unrealized
Gains

Gross Unrealized
Losses

Estimated Fair
ValueDecember 31, 2004Government debt securities

$
102

$
26

$


$
128Adjustable rate mutual funds


5,009








5,0095,111


26

$


$
5,137December 31, 2003Government debt securities

$
75

$
27

$


$
102


The
government debt securities represent South African bonds which mature in 2007 and 2008.

42

---



5. Selected Balance Sheet Details

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

December 31,2004

2003Equipment and furniture

$
5,084

$
4,826Leasehold improvements


701


6415,785


5,467Less accumulated depreciation and amortization


(4,900
)

(4,323
)$
885

$
1,144


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

December 31,2004

2003Customer prepayments

$
82

$
432Accrued restructuring


38


69Other


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.

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

$
9472006


7072007


7282008


7082009


282Thereafter


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.

43

---



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. Redeemable Preferred Stock

The Series A Preferred Stock described in the Company's Amended and Restated Certificate of Incorporation, filed with the Delaware Secretary of State on
January 6, 1997, relates to shares of Series A Preferred Stock that were issued and outstanding prior to the Company's initial public offering of its common stock in
February 1997. In connection with the Company's initial public offering, all shares of its then outstanding Series A Preferred Stock were converted into common stock. However, the
Certificate of Incorporation was never amended to eliminate this series of preferred stock.

Subsequently,
on July 23, 1999, the Company filed a Certificate of Designations with the Delaware Secretary of State, which authorized and designated a new series of preferred
stock that was also called Series A Preferred Stock (the Certificate of Designations was filed as Exhibit 4.1 to the Company's Form 8-K filed with the SEC on
July 29, 1999). At that time, the Company sold shares of this new Series A Preferred Stock to certain investors. However, because the earlier Series A Preferred Stock was never
eliminated from the Company's Certificate of Incorporation, the new series of preferred stock issued in July 1999 should have been designated as Series A-1 Preferred Stock,
not Series A Preferred Stock. This error was recently discovered and the Certificate of Designations was corrected by a Certificate of Correction filed with the Delaware Secretary of State on
June 14, 2005.

In
July 1999, the Company issued 2,181,818 shares of Series A-1 Redeemable 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-1 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-1 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-1 Redeemable Preferred Stock vote on an as converted to common stock basis with the holders of common stock. The
Series A-1 Preferred stockholders also have a liquidation preference of $5.50 per Series A-1 share, plus any accrued but unpaid dividends. At the option of the
holders, shares of the Series A-1 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-1 Preferred Stock. The holders of Series A-1
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.

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-1
Preferred Stock had the right to cause the redemption of their Series A-1 Preferred Stock for approximately $12.9 million. The Company entered into an agreement with the
holders of the Series A-1 Preferred Stock under which the holders of the Series A-1 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

44

---



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, 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-1 Preferred Stock), thereby entitling the holders of the Series A-1 Preferred Stock to a total liquidation preference of
approximately $17.8 million.

As
a result of the routine review of the Daou Systems, Inc. (the "Company") Form 10-K for the year ended December 31, 2004 by the staff of the Securities
and Exchange Commission ("SEC"), the Company examined the classification on its balance sheet of its Series A-1
Preferred Stock. The Company had classified this amount as a component of stockholders' equity in its financial statements for the years ended December 31, 2004, 2003 and 2002 filed in its 2004
Form 10-K/A with the SEC.

Based
on the staff's comment, the Company reviewed the terms of the Series A-1 Preferred Stock and noted that in the event of an unsolicited tender offer that results
in the Company's stockholders immediately prior to such transaction not holding at least 50% of the voting securities of the surviving entity, the holders of the Series A-1
Preferred Stock would be entitled to receive for each share of such stock an amount per share at least equal to Five Dollars and Fifty Cents ($5.50) plus any accrued but unpaid dividends. Because such
a transaction could result in a cash liquidation of the Series A-1 Preferred Stock that is outside the control of the Company, management, in consultation with the Company's
independent registered public accounting firm, concluded on July 13, 2005 that the Series A-1 Preferred Stock should be classified as a component of mezzanine equity and not
a component of permanent equity on the Company's balance sheet and that the Company should restate its previously issued financial statements. On July 18, 2005, the Audit Committee of the
Company's Board of Directors, in consultation with management and the Company's independent registered public accounting firm, confirmed management's conclusion that a restatement of the previously
issued financial statements was required. The restatement is an adjustment of the Company's balance sheet and will have no impact on the Company's historical or future statements of operations or cash
flows.

9. Stockholders' Equity (Deficit)

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.

45

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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.

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
|-------------------------------------------------------------- | --------- | --------- | ---------- | ---- | ---- | ----
|
|Outstandingbeginning of year                                  |           | 4,471,138 |            | $    | 1.47 |     
|                                                               | Granted   |           | 400,000    |      |      | 0.29
|                                                               | Exercised |           | (232,002   | )    |      | 0.18
|                                                               | Forfeited |           | (1,080,928 | )    |      | 1.96
|                                                               |           |           |            |      |      |     
|Outstandingend of year                                        |           | 3,558,208 |            | $    | 1.28 |     
|                                                               |           |           |            |      |      |     
|Exercisable at end of year                                     |           | 2,341,756 |            | $    | 1.62 |     
|                                                               |           |           |            |      |      |     
|Weighted-average fair value of options granted during the year |           |           |            | $    | 0.24 |     
|                                                               |           |           |            |      |      |     

46

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

|                  |  | Outstanding |  | Exercisable
|----------------- |  | ----------- |  | -----------
|
|$  .00  $    .18 |  | 613,665     |  | 6.2        
|$  .19  $    .33 |  | 710,000     |  | 6.6        
|$  .34  $    .50 |  | 456,777     |  | 8.3        
|$  .51  $    .75 |  | 875,000     |  | 6.6        
|$  .76  $  1.00  |  | 405,500     |  | 7.0        
|$1.01  $  2.00   |  | 177,667     |  | 7.2        
|$2.01  $  3.00   |  | 2,500       |  | 5.3        
|$3.01  $  4.00   |  | 32,234      |  | 4.3        
|$4.01  $  5.00   |  | 79,034      |  | 2.2        
|$5.01  $25.00    |  | 205,831     |  | 3.2        
|                  |  |             |  |            
|                  |  | 3,558,208   |  | 6.5        
|                  |  |             |  |            

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

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 redeemable preferred stock

2,750,000Warrants

3,540,000Stock options

6,243,939Employee stock purchase plan

904,189Total

13,438,128


10.    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.

47

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

December 31,2004

2003Deferred tax liabilities:Depreciation and amortization

$
157

$
60157


60Deferred tax assets:Reserves and allowances


443


696Tax credit carryforwards


35


36Net operating losses


11,930


9,92512,408


10,657Net deferred tax asset before valuation allowance


12,251


10,597Valuation 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 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

2002Tax at federal statutory rate

(35.0
)%
35.0
%
(35.0
)%Nondeductible expenses

0.4

0.9

2.4State taxes, net of federal benefit

(2.2
)
5.6

(5.5
)Valuation allowance

37.6



38.1Use of net operating loss carryforwards



(39.5
)
0.8
%
2.0
%
0.0
%


11.    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.

48

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12.    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.

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

49

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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.

13.    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).

|     |                                                             | Quarter Ended |  
|---- | ----------------------------------------------------------- | ------------- | -
|
|2004 |                                                             |               |  
|     | Net revenue                                                 |               | $
|     | Gross profit                                                |               |  
|     | Net loss available to common stockholders                   |               |  
|     | Net loss available to common stockholders per common share: |               |  
|     |                                                             | Basic         |  
|     |                                                             | Diluted       |  
|     |                                                             |               |  

50

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|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 |   |      

---

14.    Subsequent Event

On August 11, 2005, the Company announced that it had reached a definitive agreement for the acquisition of all the preferred and common stock of Daou by
Proxicom, Inc., a portfolio company of Gores Technology Group, LLC. The transaction has an aggregate value of approximately $21.6 million, less applicable transaction related expenses.
Subject to certain potential pre-closing balance sheet adjustments, each outstanding share of Daou common stock will receive cash equal to approximately $0.305 per share. The holders of
Daou's Series A-1 Preferred Stock will receive an aggregate of $12.2 million in cash. The consummation of the transaction is subject to the approval of Daou's stockholders
and other customary conditions. Either party may terminate the agreement in the event that the common stock per share consideration is less than $0.27. The transaction is expected to close during the
fourth quarter of 2005.

51

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SCHEDULE IIVALUATION AND QUALIFYING ACCOUNTS  (In thousands)

|                              |                                 |  |   | Additions |  |   |      |  
|----------------------------- | ------------------------------- |  | - | --------- |  | - | ---- | -
|
|
|
|
|Year Ended December 31,2004:  |                                 |  |   |           |  |   |      |  
|                              | Allowance for doubtful accounts |  | $ | 789       |  | $ | (405 | )
|Year Ended December 31, 2003: |                                 |  |   |           |  |   |      |  
|                              | Allowance for doubtful accounts |  | $ | 732       |  | $ | 57   |  
|Year Ended December 31, 2002: |                                 |  |   |           |  |   |      |  
|                              | Allowance for doubtful accounts |  | $ | 715       |  | $ | 186  |  

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.

As
discussed in Note 8, a routine review by the SEC staff of our original Form 10-K for the year ended December 31, 2004 resulted in management
evaluating the Company's accounting for the Series A-1 Preferred Stock that was issued in July 1999. Based on guidance from several technical pronouncements and consultations
with the Company's independent registered public accounting firm, the Company concluded on July 13, 2005 that the Series A-1 Preferred Stock should be classified as a
component of mezzanine equity and not a component of permanent equity on the Company's balance sheet and that the Company should restate its previously issued financial statements. On July 18,
2005, the Audit Committee of the Company's Board of Directors, in consultation with management and the Company's independent registered public accounting firm, confirmed management's conclusion that a
restatement of the previously issued financial statements was required. The restatement primarily includes a reclassification of Preferred Stock between permanent equity and mezzanine equity on the
balance sheet and will have no impact on the Company's historical or future income statements or cash flows. Additionally, the Company had previously disclosed the material terms of its preferred
stock in its SEC filings. As such the Company believes that the conclusion to reclassify the preferred stock does not reflect a weakness in the Company's disclosure controls and procedures pursuant to
Exchange Act Rules 13a-15(a) and 15d-15(e). The Company will continue to monitor our internal controls and, if further improvements or enhancements are identified, the
Company will take the necessary steps to implement such improvements or enhancements.

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,

52

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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.

53

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PART III

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

Directors

The following table identifies the directors of the Company, the positions which they hold, their age, and the year in which they began serving in their
respective capacities.

|Name                                 |  | Age |  | Director Since |  | Position                                        
|------------------------------------ |  | --- |  | -------------- |  | ------------------------------------------------
|Vincent K. Roach (1)                 |  | 61  |  | 2001           |  | Chief Executive Officer, President and Director 
|Larry R. Ferguson (2),(4),(5),(6)    |  | 54  |  | 2002           |  | Chairman of the Board                           
|Richard A. Blumenthal (2),(4),(6)    |  | 56  |  | 2004           |  | Director, Chairman of the Nominating Committee  
|Douglas L. Cox (3),(4),(6)           |  | 58  |  | 2004           |  | Director, Chairman of the Audit Committee       
|Robert F. Radin, PhD (3),(4),(5),(6) |  | 51  |  | 2004           |  | Director, Chairman of the Compensation Committee
|Bruce R. Wesson (1),(5)              |  | 62  |  | 2004           |  | Director                                        

---

Mr. Roachhas served as Chief Executive Officer and President of the Company since July 19, 2004, and as a director of the
Company since June 2001. He served as the Company's Executive Vice President from January 2003 through July 2004. Mr. Roach also served as President of the Company's
Application Services business from January 2001 through January 2003 and as a director and President of DAOU-TMI, Inc., a subsidiary of the Company, from
June 1998 through December 2000. He holds a B.A. from Wabash College.

Mr. Fergusonhas been a Director of the Company since November 2002 and the Chairman since February 2003. Since 2000,
Mr. Ferguson has been the President of The Ferguson Group, a private equity investment and consulting firm specializing in information technology companies. An Air Force veteran, competitive
marathon runner, and active Board member of two University of North Carolina foundations, MDEverywhere and ABOVO Marketing Group, Mr. Ferguson is also a frequent speaker at several industry
associations in the healthcare informatics field. Mr. Ferguson has served as President and CEO of both public and privately held IT companies, most recently Avio Corporation from
1999-2000 and First Data Corporation from 1986-1995. He holds a B.A. in business administration from University of North Carolina-Charlotte.

Mr. Blumenthalhas been a Director of the Company since September 9, 2004. Mr. Blumenthal retired as Executive Vice
President, General Counsel and Secretary of Systems & Computer Technology Corporation (SCT), a leading global provider of e-education solutions for colleges and universities, in
April 2004. He held that position from October 2002 until April 2004. Prior to that, Mr. Blumenthal held a variety of executive positions at SCT, serving as Senior Vice
President, General Counsel and

54

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Secretary
from July 1990 to October 2002, Vice President, General Counsel and Secretary from July 1987 to July 1990, Assistant Vice President, General Counsel and Secretary
from May 1986 to July 1987, and Assistant Vice President, General Counsel and Assistant Secretary from December 1985 to May 1986. Mr. Blumenthal holds a B.A. in
Political Science from Temple University and a J.D. from Temple University School of Law.

Mr. Coxhas been a Director of the Company since June 2, 2004. Since 1998, Mr. Cox has been Executive Vice President
and Chief Financial Officer of Opinion Research Corporation. He is responsible for the worldwide financial functions of this NASDAQ-listed professional services company with revenues of
$195 million. From 1988 to 1998, he was the Senior Vice President and Chief Financial Officer of Atofina Chemicals, Inc. (formerly Pennwalt Corporation, a NYSE listed company) a
U.S.-based multinational chemical company operating in 14 countries with revenues of $1.8 billion. Mr. Cox has served as a Director of industry and community organizations. He holds both
a B.S. and a master's degree in business administration from the Wharton School of Business, University of Pennsylvania.

Dr. Radinhas been a Director of the Company since June 2, 2004. Dr. Radin has been an Adjunct Professor at Boston
College since 2003 teaching graduate courses in Corporate Governance, Management and Organizational Behavior and, since 2002 has been an Affiliate of the Boston College Business Institute. From 1996
to 2002, he was a Doctoral Candidate in Board Governance at Boston College, after having served as President of Investor Services Group (ISG), First Data Corporation from 1992 to 1995 and President of
Shareholder Services for American Express Information Services from 1989 to 1992. Dr. Radin worked at The Boston Company/Shearson Lehman Brothers from 1983 to 1989, first as the Senior Vice
President of Operations for the Mutual Fund Division and then as the Executive Vice President of the Transfer Agent Division. He holds a B.S. in Accounting from Northeastern University, a master's
degree in business administration from Babson College and a Ph.D. from Boston College.

Mr. Wessonhas been a Director of the Company since October 26, 2004. Mr. Wesson has been with Galen Associates since
joining them in 1991 after serving as a Managing Director in the Corporate Finance Division at Smith Barney, where he worked for over 23 years. Mr. Wesson joined Smith Barney in 1967,
and in 1976 was promoted to Managing Director, and four years later was elevated to Senior Vice President and Managing Director. During his tenure at Smith Barney, Mr. Wesson directed the Major
Account Group and was Senior Managing Director in charge of the East Coast Region. Mr. Wesson was also Chairman of the Valuation and Opinion Committee for Corporate Finance. In this capacity,
he was ultimately responsible for all of the valuations and opinions given by Smith Barney. He currently serves on the Boards of Qmed, Inc. as Chairman, and Crompton Corporation, Encore
Medical, Inc.,
Acura Pharmaceuticals, Inc., and several privately held companies as a member. He formerly served on the Board of CryoLife, Inc., a publicly traded Galen I portfolio company.
Mr. Wesson serves on the Board of Trustees of Colgate University and is a past President of The Colgate University Alumni Corporation Board of Directors. He also serves as Vice Chairman of the
Board of Trustees and Chairman of the Investment Committee of the Overlook Hospital Foundation. Mr. Wesson holds a Bachelor of Arts from Colgate University and a master's degree in business
administration from Columbia University.

55

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Executive Officers

The following table identifies the executive officers of the Company, their age and the positions which they hold.

Name

Age

PositionVincent K. Roach

61

Chief Executive Officer, President and DirectorJohn A. Roberts

46

Chief Financial Officer and Secretary


Mr. Roachhas served as Chief Executive Officer and President of the Company since July 19, 2004. Please see "Directors" on
page 54 for Mr. Roach's biography.

Mr. Robertswas named Chief Financial Officer of Daou Systems, Inc. in December, 2003. Joining the Company as the Acting CFO
in June 2003, Mr. Roberts was also a partner with the Philadelphia Office of Tatum Partners LLC. Prior to joining Tatum Partners, he served from 2001 to 2002 as the Vice President of
Business Development for MEDecision, Inc., a software products company providing medical management solutions for managed care organizations. From 1999 to 2001, Mr. Roberts held the
position of Senior Vice President of Corporate Development and Chief Financial Officer for HealthOnline, Inc., a provider of web-based community and provider portal and hosting
services. From 1995 to 1999, Mr. Roberts was the Chief Financial Officer for the Center for Health Information, a wholly owned subsidiary of PharMerica, Inc., a pharmaceutical services
company focused in long term care. Mr. Roberts earned a Bachelor of Science and a master's degree in business administration from the University of Maine.

Audit Committee Financial Expert

The Board of Directors has determined that Douglas L. Cox, an independent director serving as the Chairman of the Audit Committee, is qualified and designated as
the "audit committee financial expert" as defined in regulations of the Securities and Exchange Commission (the "SEC") under the Sarbanes-Oxley Act of 2002.

Section 16(a) Beneficial Ownership Reporting Compliance

Section 16(a) of the Securities Exchange Act of 1934 requires the Company's executive officers and directors to file initial reports of ownership and
reports of change of ownership with the SEC. Executive officers and directors and holders of more than 10% of any class of equity securities of the Company are required by SEC regulations to furnish
the Company with copies of all Section 16(a) forms they file. Based solely upon a review of copies of Forms 3 and 4 and amendments thereto furnished to the Company during the fiscal year ended
December 31, 2004 and Form 5 and amendments thereto furnished to the Company with respect to the fiscal year ended December 31, 2004, all executive officers, directors and 10%
holders were in compliance.

Code of Ethics

The Company'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 the Company's website (www.daou.com). This document is also available in print to any person who requests it. Requests should be sent to Investor Relations at Daou
Systems, Inc., 412 Creamery Way, Suite 300, Exton, PA 19341. The Company intends to post all amendments to and waivers from provisions of the Code of Business Conduct and Ethics that apply to
the Company's executive officers on its website to satisfy the disclosure requirements of Item 5.05 of Form 8-K.

56

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Item 11:Executive Compensation.

Summary Compensation Table

The following table shows for the three (3) years ended December 31, 2004 the cash and other compensation awarded to, earned by or paid to
(i) the Company's Chief Executive Officer during 2004, and (ii) each of the executive officers (other than the Chief Executive Officer) who were serving as executive officers at the end
of 2004 (collectively, the "Named Executive Officers"):

Summary Compensation Table

|                                      |                                       |      |      |         |         |           |         | Long-Term
Compensation |   |           |        
|------------------------------------- | ------------------------------------- | ---- | ---- | ------- | ------- | --------- | ------- | ---------------------- | - | --------- | -------
|
|
|Vincent K. Roach(1)                   |                                       | 2004 |      | 639,888 |         | 110,112   | (2)     |                       |   | 444,000(3 | )      
|                                      | Chief Executive Officer and President |      | 2003 |         | 240,000 |           | 970,931 |                        |  |           | 7,200(4
|                                      |                                       | 2002 |      | 240,000 |         | 1,083,984 |         |                       |   | 1,650(4   | )      
|John A. Roberts                       |                                       | 2004 |      | 200,000 |         | 41,961    |         |                       |   |          |        
|                                      | Chief Financial Officer and Secretary |      | 2003 |         | 85,610  |           | 50,000  |                        |  |           |       
|                                      |                                       | 2002 |      |        |         |          |         |                       |   |          |        
|Daniel J Malcolm(8)                   |                                       | 2004 |      | 162,000 |         |          |         |                       |   | 171,562(5 | )      
|Chief Executive Officer and President |                                       | 2003 |      | 300,000 |         | 100,000   |         | 250,000                |   | 18,174(6  | )      
|                                      |                                       | 2002 |      | 240,000 |         | 85,000    |         |                       |   | 5,275(7   | )      

---

Option Grant Table

The Company did not award stock options to any of the Named Executive Officers during 2004.

57

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Aggregated Fiscal Year-End Option Values

There were no option exercises by any of the Named Executive Officers during the twelve months ended December 31, 2004. The following table sets forth
certain information regarding options to purchase shares of Common Stock held as of December 31, 2004 by each of the Named Executive Officers.

|Name              |  | Shares
Acquired on
Exercise(#) |  | Value
Realized($) |  | Number of Securities
Underlying Unexercised
Options at
December 31, 2004
(Exercisable/
Unexercisable) |  | Value of Unexercised
In-the-Money Options
at December 31, 2004
(Exercisable/
Unexercisable)
|----------------- |  | ------------------------------ |  | ----------------- |  | ----------------------------------------------------------------------------------------------------- |  | -------------------------------------------------------------------------------------------
|Daniel J. Malcolm |  |                               |  |                  |  | 811,111/288,889                                                                                       |  | $0/$0                                                                                      
|Vincent K. Roach  |  |                               |  |                  |  | 0/0                                                                                                   |  | $0/$0                                                                                      
|John A. Roberts   |  |                               |  |                  |  | 0/0                                                                                                   |  | $0/$0                                                                                      

Director Compensation

During the Company's 2004 fiscal year, members of the Board were paid according to the following schedule: $1,250 for all Board or committee meetings attended in
person, $1,000 for participation on Audit Committee conference calls and $500 for participation on other conference calls. In addition, the Board approved an annual retainer for each Board member as
follows: $3,000 for each Board member and $15,000 each for the Chairman of the Board and the audit committee chair. In addition, as consideration for serving on the Board, the Company from time to
time grants to each outside director options to purchase shares of Common Stock, in each case vesting over three years from the date of issuance. The Board awarded 100,000 stock options to each of
Mr. Blumenthal, Mr. Cox and Mr. Radin. The Board members are reimbursed for actual out-of-pocket expenses associated with attending Board meetings,
according to the Company's expense reimbursement policy consistent with officers and employees of the Company. On December 2, 2004, the Board voted to modify the fees paid to independent
directors, effective January 1, 2005, to an annual retainer of $25,000, payable quarterly in arrears. In addition, the Chairman of the Board will receive a $15,000 annual retainer as
compensation for his duties as Chairman of the Board; the Chairman of the Audit Committee will receive a $10,000 annual retainer as compensation for his duties as Chairman of the Audit Committee; the
Chairman of the Compensation Committee will receive a $5,000 annual retainer as compensation for his duties as Chairman of the Compensation Committee; and the Chairman of the Nominating Committee will
receive a $5,000 annual retainer as compensation for his duties as Chairman of the Nominating Committee, all payable quarterly in arrears. The Company may elect to change the cash compensation amounts
or grant additional options to directors in the future.

Employment and Other Agreements

Vincent K. Roach.The Company entered into a new employment agreement with Mr. Roach on August 13, 2004, which
provides for base salary through December 31, 2004 at the annualized rate of $750,000, less compensation already paid for calendar year 2004. Mr. Roach was also paid an additional
$444,000 in bi-weekly installments through December 31, 2004 in connection with expanded post-employment non-compete arrangements. Pursuant to the new
employment agreement, commencing January 1, 2005, Mr. Roach will be paid an annualized base salary of $300,000, and certain health and welfare and other benefits. The Board of Directors,
in its sole discretion, may pay Mr. Roach a discretionary bonus in an amount to be determined by the Board of Directors from time to time. Mr. Roach will also be eligible to earn
retention bonuses if the Company completes a strategic transaction while Mr. Roach is President and Chief Executive Officer. The amount of each retention bonus would be based upon the nature of
the transaction and the amount of proceeds received by the Company or its shareholders in each transaction and could range from 5% of the amount of proceeds

58

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received
by the Company or its shareholders in the transaction up to a cumulative maximum of $2,500,000. In the event that Mr. Roach's employment with the Company terminates without cause or
for good reason, or if a calendar year ends prior to the closing of a transaction, the Board of Directors, in its sole discretion, may pay Mr. Roach a discretionary bonus in an amount to be
determined by the Board of Directors.

The
Company may terminate Mr. Roach's employment at any time for cause or because of Mr. Roach's death or disability, provided that the Company will pay Mr. Roach or
his estate within thirty days after the effective date of termination his base salary and any retention bonus earned through the date of termination. In the event the Company terminates
Mr. Roach's employment for a reason other than cause, death or disability or Mr. Roach terminates his employment for good reason, Mr. Roach will receive any earned retention bonus
and a severance payment of $300,000, unless Mr. Roach has already received retention bonuses aggregating at least $300,000. Payments under these provisions are subject to Mr. Roach
executing a release of all claims in favor of the Company.

John A. Roberts.Effective March 9, 2005, the Company entered into an employment agreement with Mr. Roberts.
Pursuant to the agreement, in addition to his annual salary of $200,000, Mr. Roberts receives certain health and welfare and other benefits. Mr. Roberts will also be eligible to earn
retention bonuses if the Company completes one or more strategic transactions while Mr. Roberts is Vice President and Chief Financial Officer. The amount of each retention bonus would be based
upon the nature of the transaction and the amount of proceeds received by the Company or its shareholders in each transaction. The bonus amount could range from 1% of the amount of gross proceeds
received by the Company or its shareholders in the transaction up to a cumulative maximum of $250,000. In the event that Mr. Roberts' employment with the Company terminates without cause or for
good reason, or if a calendar year ends prior to the closing of a transaction, the Company may pay Mr. Roberts a discretionary bonus in an amount to be determined by the Chief Executive
Officer, subject to the approval of the Compensation Committee of the Board of Directors. The Company may terminate Mr. Roberts employment at any time for cause or because of
Mr. Roberts' death or disability, provided that the Company will pay Mr. Roberts or his estate within thirty days after the effective date of termination his base salary and any
retention bonus earned through the date of termination. In the event the Company terminates Mr. Roberts' employment for a reason other than cause, death or disability or if Mr. Roberts
terminates his employment for good reason prior to June 30, 2006,
Mr. Roberts will receive any earned retention bonus and a severance payment of $100,000. Payments under these provisions are subject to Mr. Roberts executing a release of all claims in
favor of the Company. The agreement requires Mr. Roberts to refrain from competing with the Company and soliciting the Company's customers or employees during his employment and for
12 months following termination.

Daniel J. Malcolm.Effective July 24, 2001, the Company entered into an employment agreement with Daniel J. Malcolm
and was amended on February 10, 2003 to adjust for his services as the Company's Chief Executive Officer and President. Under the amended agreement, Mr. Malcolm received an annual base
salary of $300,000 and a bonus at the discretion of the Board in accordance with the Company's Incentive Compensation Plan for senior management.

On
July 19, 2004 ("Separation Date"), the Company entered into a separation and release agreement with Mr. Malcolm. Under the agreement, Mr. Malcolm is eligible to
receive $300,000 as post-employment severance. Severance is paid to Mr. Malcolm on a bi-monthly basis beginning on July 31, 2004 and continuing for twelve months
following the Separation Date. In the event of a change in control of the Company during the twelve month period following the Separation Date, payment of any outstanding portion of the severance will
be paid in a lump sum within five (5) business days following the effective date of the change in control.

59

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Compensation Committee Interlocks and Insider Participation

During fiscal year 2004, Larry R. Ferguson, Robert F. Radin, Bruce R. Wesson, and David W. Jahns served as members of the Compensation Committee of the Company's
Board of Directors. No member of the Compensation Committee is or has been an officer or employee of the Company. No current executive officer of the Company has served as a director or member of the
compensation committee, or other committee serving an equivalent function, of any other entity that has one or more executive officers serving as a director of the Company or as a member of its
Compensation Committee.

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

The following table sets forth certain information regarding beneficial ownership of the Common Stock as of April 20, 2005 by:



Unless
otherwise indicated below, to the knowledge of the Company, all persons listed below have sole voting and investing power with respect to their shares of Common Stock, except to
the extent authority is shared by spouses under applicable community property laws, and their address is 412 Creamery Way, Suite 300, Exton, Pennsylvania 19341.

Shares Beneficially
Owned(1)Name and Address of Beneficial Owner(1)Number

PercentGalen Partners III, L.P.(2)

6,962,510

24.0
%Bruce R. Wesson(3)

7,188,082

24.8Vincent K. Roach

3,199,527

11.0Richard A. Blumenthal(4)

19,444

0.1Douglas L. Cox(4)

27,777

0.1Larry R. Ferguson(4)

86,111

0.3Daniel J. Malcolm(6)

822,222

2.8Robert F. Radin(4)

27,777

0.1James T. Roberto(5)

1,543,400

5.3John A. Roberts



All directors and executive officers as a group (7 persons)(7)

10,548,718

35.4
%


---

60

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Equity Compensation Plan Information

The following table sets forth information as of December 31, 2004 with respect to shares of Common Stock to be issued upon the exercise, and the
weighted-average exercise price, of all outstanding options and rights granted under our equity compensation plans, as well as the number of shares available for issuance under such plans.

|Plan Category                                                 |  | Number of Securities to be
Issued upon Exercise of
Outstanding Options,
Warrants and Rights |  | Weighted-Average
Exercise Price of
Outstanding Options,
Warrants and Rights |      | Number of Securities
Remaining Available for
Future Issuance Under
Equity Compensation Plans
(Excluding Securities
Reflected in Column A)
|------------------------------------------------------------- |  | ------------------------------------------------------------------------------------------- |  | --------------------------------------------------------------------------- | ---- | -----------------------------------------------------------------------------------------------------------------------------------------
|Equity Compensation Plan Approved by Security Holders(1)      |  | 1,579,163                                                                                   |  | $                                                                           | 2.13 |                                                                                                                                          
|Equity Compensation Plans Not Approved by Security Holders(2) |  | 1,979,045                                                                                   |  | $                                                                           | .61  |                                                                                                                                          
|                                                              |  |                                                                                             |  |                                                                             |      |                                                                                                                                          
|Total                                                         |  | 3,558,208                                                                                   |  | $                                                                           | 1.28 |                                                                                                                                          

---

61

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Item 15:Certain Relationships and Related Transactions.



Pursuant to the Sarbanes-Oxley Act of 2002 (the "Act"), the Company will no longer extend credit, or renew an extension of credit, directly or indirectly, to or
for executive officers or directors, except for loans in place when the relevant provisions of the Act became effective, and for other permissible exceptions as provided by the Act.

In
2001, the Company sold 2,500,000 shares of restricted Common Stock in private transactions to Vincent K. Roach, 1,500,000 shares to James T. Roberto, executive officer and former
executive officer respectively of the Company. The per share purchase price in each of these transactions was the closing price on the day the sale was made ($0.29), and the consideration paid by the
executive officers in each case was a full recourse note receivable that accrues interest at a rate of 6.75% and is due five years after the date of the purchase. The Company has a repurchase right on
the unvested portion of the shares which lapses in equal monthly amounts over a thirty-six month period. The following table summarizes the terms of the transactions:

|Name             |  | Date of
Purchase |  | Shares
Purchased |  | Purchase
Price
Per Share |      | Aggregate
Purchase
Price
|---------------- |  | ---------------- |  | ---------------- |  | ------------------------ | ---- | ------------------------
|Vincent K. Roach |  | June 1, 2001     |  | 2,500,000        |  | $                        | 0.29 |                         
|James T. Roberto |  | June 1, 2001     |  | 1,500,000        |  | $                        | 0.29 |                         

In
connection with the transactions, the Company agreed to certain registration rights for each purchaser. The Company received collateral for its promissory notes by entering into stock
pledge agreements with each of the purchasers. Pursuant to the terms of their employment agreements, the Company agreed to pay additional employment compensation to Mr. Roach in an amount equal
to the amount of interest due in accordance with the terms of their notes receivable.



As previously disclosed, in July 1999 we issued 2,181,818 shares of Series A-1 Redeemable 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-1 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-1 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-1 Convertible Preferred Stock vote on an as converted to common stock basis with the holders of common stock. The
Series A-1 Preferred stockholders also have a liquidation preference of $5.50 per Series A-1 share, plus any accrued but unpaid dividends. At the option of the
holders, shares of the Series A-1 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-1 Preferred Stock. The holders of Series A-1 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

62

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Series A-1
Preferred Stock), thereby entitling the holders of the Series A-1 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-1
Preferred Stock had the right to cause the redemption of their Series A-1 Preferred Stock for approximately $12.9 million. We entered into an agreement with the holders of
the Series A-1 Preferred Stock under which the holders of the Series A-1 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.

Additional
information regarding the accounting for this Series A-1 Preferred Stock is contained in Note 8 of the Notes to Financial Statements.

Item 16:Principal Accountant Fees and Services.

Audit Fees.The aggregate fees billed for professional services rendered by Ernst & Young LLP for the audit of the
Company's annual financial statements for 2004 and 2003 and the reviews of the financial statements included in the Company's quarterly reports on Form 10-Q for 2004 and 2003
totaled approximately $209,000 and $190,000, respectively.

Audit Related Fees.None.

Tax Fees.The aggregate fees billed for tax compliance, tax advice and tax planning rendered by Ernst & Young LLP
during 2003 totaled approximately $51,000.

All Other Fees.The aggregate fees billed for professional services rendered by Ernst & Young LLP for other services
not included above for 2003 was $2,000. The services rendered in 2003 related to the review of certain of the Company's contracts.

Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services by Independent Auditors.The
Audit Committee has adopted a policy for, and pre-approves, all audit and non-prohibited, non-audit services provided by the independent auditors. These services
may include audit services, audit-related services, tax services and other services. The Audit Committee has adopted a policy for the pre-approval of services provided by the independent
auditors. Under the policy, pre-approval is generally provided for up to one year and any pre-approval is detailed as to the particular service or category of services and is
subject to a specific budget. In addition, the Audit Committee may also pre-approve particular services on a case-by-case basis. For each proposed service, the
Audit Committee has received detailed information sufficient to enable the Audit Committee to pre-approve and evaluate such service. The Audit Committee may delegate
pre-approval authority to one or more of its members. Any pre-approval decisions made under delegated authority must be communicated to the Audit Committee at or before the
next scheduled meeting. There were no waivers by the Audit Committee of the pre-approval requirement in 2004.

63

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PART IV

Item 17:Exhibits, Financial Statement Schedules, and Reports on Form 8-K.

64

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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:
August 12, 2005

|DAOU SYSTEMS, INC. |                                                                                                       | 
|------------------ | ----------------------------------------------------------------------------------------------------- | 
|By:                | /s/VINCENT K. ROACHVincent K. Roach
Chief Executive Officer
(Principal Executive Officer)             | 
|By:                | /s/JOHN A. ROBERTSJohn 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. ROACHVincent K. Roach           |  | Director, President and Chief Executive Officer |  | August 12, 2005
|/s/LARRY R. FERGUSONLarry R. Ferguson         |  | Chairman of the Board                           |  | August 12, 2005
|/s/BRUCE R. WESSONBruce R. Wesson             |  | Director                                        |  | August 12, 2005
|/s/DOUGLAS L. COXDouglas L. Cox               |  | Director                                        |  | August 12, 2005
|/s/RICHARD A. BLUMENTHALRichard A. Blumenthal |  | Director                                        |  | August 12, 2005
|/s/ROBERT F. RADINRobert F. Radin             |  | Director                                        |  | August 12, 2005

65

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INDEX TO EXHIBITS

|Exhibit
Number |  | Description
|-------------- |  | -----------
|3.1(1)         |  |           
|3.2(1)         |  |           
|4.1            |  |           
|4.2(1)         |  |           
|4.3(3)         |  |           
|4.4(4)         |  |           
|4.5(6)         |  |           
|4.6(6)         |  |           
|4.7(7)         |  |           
|4.8(*)         |  |           
|10.1(1)        |  |           
|10.2(2)        |  |           
|10.3(1)        |  |           
|10.4(1)        |  |           
|10.5(*)        |  |           
|10.6(3)        |  |           
|10.7(3)        |  |           
|10.8(6)        |  |           
|10.9(11)       |  |           
|10.10(6)       |  |           
|10.11(6)       |  |           
|               |  |            

66

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|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.                                                                                                                                                                                   
|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                                                                                                                                                                                                                                                  
|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.                                                                                                                                

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