**UNITEDSTATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON,D.C.  20549**

**FORM 10-K**

**x****ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE**

**SECURITIESEXCHANGE ACT OF 1934**

**For theFiscal Year Ended August 31, 2006**

**or**

**o****TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) of the**

**SECURITIESEXCHANGE ACT OF 1934**

**For thetransition period from                      to                              **

**CommissionFile number 1-13626**

**HORIZON HEALTH CORPORATION**

(Exact name ofregistrant as specified in its charter)

| **Delaware**                     | ** ** | **75-2293354**                        |
|----------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of |       | (I.R.S. Employer  Identification No.) |
| incorporation or  organization)  |       |                                  |

 

**2941 S.Lake Vista DriveLewisville, Texas 75067**(Address of principal executive offices, including zip code)

**(972)420-8200**(Registrant’s telephone number, including area code)

Securitiesregistered pursuant to Section 12(b) of the Act:

Title of eachclass**Common Stock, $.01 par value**

Securitiesregistered pursuant to Section 12(g) of the Act: **None**

Indicate by check markif the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act.Yes  o   No  x

Indicate by check mark if theregistrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act.    Yes  o   No*  *x

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant was requiredto file such reports), and (2) has been subject to such filingrequirements for the past 90 days.     Yes  x*  * No  o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K (229.405of this chapter) is not contained herein, and will not be contained, to thebest of the registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-K orany amendment to this Form 10-K.  o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer” in Rule 12b-of the Exchange Act. (Check one):
|  | Large Accelerated Filer   o | Accelerated Filer  x | Non-Accelerated Filer  o |
|--|---------------------------------------|--------------------------------|------------------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b- of theAct).  Yes  o   No*  *x

The aggregate marketvalue of the voting common stock held by non-affiliates of the registrant(assuming for purposes of this calculation, but without conceding, that allexecutive officers and directors are “affiliates” of the registrant) atFebruary 28, 2006 (the last business day of the most recently completed secondfiscal quarter) was approximately $314,850,000, based on the market price atthe close of business on February 28, 2006.

The number of sharesoutstanding of the registrant’s Common Stock, $.01 par value per share, as ofOctober 23, 2006 was 15,062,113.

DOCUMENTSINCORPORATED BY REFERENCE

There is incorporated byreference in Part III of this Annual Report on Form 10-K portions of theinformation contained in the registrant’s proxy statement for its annualmeeting of stockholders to be held on January 19, 2007.

 

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**TABLE OFCONTENTS**

**HORIZONHEALTH CORPORATION**
| ** **                                                                     | ** ** | **Page** |
|--------------------------------------------------------------------------------|------------|----------|
|                                                                           |       |     |
| **PART I**                                                                     |       |     |
|                                                                           |       |     |
| Item  1.  Business                                                        |       | 5        |
| Disclosures  Regarding Forward Looking Statements                              |       | 5        |
| General Overview                                                               |       | 6        |
| Recent Developments                                                            |       | 6        |
| Services by Service Group                                                      |       | 7        |
| Hospital Services                                                              |       | 7        |
| Contract Management  Services                                                  |       | 8        |
| EAP Services                                                                   |       | 11       |
| Operations                                                                     |       | 11       |
| Behavioral Health  Care Facilities                                             |       | 11       |
| Management Contracts                                                           |       | 12       |
| Program Development                                                            |       | 13       |
| Program Staffing                                                               |       | 14       |
| Program  Education and Community Development                                   |       | 14       |
| Internal Audits                                                                |       | 15       |
| Contract Locations                                                             |       | 15       |
| Client Hospitals                                                               |       | 15       |
| CQI+ Mental  Health Outcomes Measurement                                       |       | 15       |
| Employee Assistance  Programs                                                  |       | 15       |
| Administration                                                                 |       | 15       |
| Sales and Marketing                                                            |       | 16       |
| Competition                                                                    |       | 16       |
| Customers                                                                      |       | 17       |
| Employees                                                                      |       | 17       |
| Government Regulation                                                          |       | 17       |
| Facility Use and  Qualification                                                |       | 17       |
| Licensing and  Certification                                                   |       | 17       |
| Provider-Based Rules                                                           |       | 18       |
| Medicare and  Medicaid: Reimbursement for Services                             |       | 18       |
| Background                                                                     |       | 18       |
| Overview                                                                       |       | 19       |
| Other Reimbursement  Payors                                                    |       | 20       |
| Behavioral  Health Reimbursement Changes/Proposals                             |       | 20       |
| Physical Rehabilitation  Reimbursement Changes/Proposals                       |       | 21       |
| Potential  Adverse Impacts of Changes in Reimbursement                         |       | 21       |
| Patient Referral Laws                                                          |       | 22       |
| Behavioral  Health Care Patient Rights                                         |       | 23       |
|                                                                           |       |     |
| Item 1A. Risk Factors                                                          |       | 24       |
|                                                                           |       |     |
| Item 1B. Unresolved  Staff Comments                                            |       | 32       |
|                                                                           |       |     |
| Item 2.    Properties                                           |       | 32       |
|                                                                           |       |     |
| Item 3.    Legal  Proceedings                                   |       | 33       |
|                                                                           |       |     |
| Item 4.    Submission  of Matters to a Vote of Security Holders |       | 33       |

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| **PART II**                                                                                                           |                                                                             |   |
|-----------------------------------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------|--------|
|                                                                                                                  |                                                                             |   |
| Item 5.   Market for the Company’s Common Equity and  Related Stockholder Matters                      |                                                                             | 33     |
|                                                                                                                  |                                                                             |   |
| Item 6.   Selected Financial Data                                                                           |                                                                             | 35     |
|                                                                                                                  |                                                                             |   |
| Item 7.   Management’s Discussion and Analysis of  Financial Condition and Results of Operations       |                                                                             | 37     |
|                                                                                                                  | General  Overview                                                                |   | 37 |
|                                                                                                                  | Acquisitions                                                                     |   | 38 |
|                                                                                                                  | Segments  (Service Groups)                                                       |   | 38 |
|                                                                                                                  | Revenues                                                                         |   | 38 |
|                                                                                                                  | Operating Expenses                                                               |   | 40 |
|                                                                                                                  | Results of Operations                                                            |   | 41 |
|                                                                                                                  | Fiscal Year  Ended August 31, 2006 Compared to Fiscal Year Ended August 31, 2005 |   | 42 |
|                                                                                                                  | Fiscal Year  Ended August 31, 2005 Compared to Fiscal Year Ended August 31, 2004 |   | 44 |
|                                                                                                                  | Newly Issued  Accounting Standards                                               |   | 46 |
|                                                                                                                  | Sarbanes-Oxley  and Related Compliance                                           |   | 46 |
|                                                                                                                  | Liquidity and  Capital Resources                                                 |   | 47 |
|                                                                                                                  | Inflation and  Economic Trends                                                   |   | 50 |
|                                                                                                                  | Critical  Accounting Policies & Estimates                                    |   | 50 |
|                                                                                                                  |                                                                             |   |
| Item 7A.  Quantitative and Qualitative Disclosures  About Market Risk                                            |                                                                             | 54     |
|                                                                                                                  |                                                                             |   |
| Item 8.     Financial Statements and Supplementary  Data                                          |                                                                             | 55     |
|                                                                                                                  |                                                                             |   |
| Item 9.     Changes in and Disagreements with  Accountants on Accounting and Financial Disclosure |                                                                             | 55     |
|                                                                                                                  |                                                                             |   |
| Item 9A.   Controls and Procedures                                                                               |                                                                             | 55     |
|                                                                                                                  |                                                                             |   |
| **PART III**                                                                                                          |                                                                             |   |
|                                                                                                                  |                                                                             |   |
| Item 10.   Directors and Executive Officers of the  Registrant                                              |                                                                             | 56     |
|                                                                                                                  |                                                                             |   |
| Item 11.   Executive Compensation                                                                           |                                                                             | 57     |
|                                                                                                                  |                                                                             |   |
| Item 12.   Security Ownership of Certain Beneficial  Owners and Management                                  |                                                                             | 58     |
|                                                                                                                  |                                                                             |   |
| Item 13.    Certain Relationships and Related Transactions                                                  |                                                                             | 58     |
| Item 14.    Principal Accounting Fees & Services                                                        |                                                                             | 58     |

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| **PART IV**                                                                            |   |   |
|----------------------------------------------------------------------------------------|--------|--------|
|                                                                                   |   |   |
| Item 15.   Exhibits, Financial Statement Schedules,  and Reports on Form 8-K |   | 59     |
| Index to  Consolidated Financial Statements                                            | F-1    |   |
| Report of  Independent Registered Public Accounting Firm                               | F-2    |   |
| Consolidated Balance  Sheets                                                           | F-4    |   |
| Consolidated  Statements of Operations                                                 | F-6    |   |
| Consolidated  Statements of Changes in Stockholders’ Equity                       | F-7    |   |
| Consolidated  Statements of Cash Flows                                                 | F-8    |   |
| Note 1:   Organization                                                       | F-10   |   |
| Note 2:   Significant  Accounting Policies                                   | F-11   |   |
| Note 3:   Stock-Based  Compensation                                          | F-17   |   |
| Note 4:   Earnings  Per Share                                                | F-20   |   |
| Note 5:   Acquisitions and Entry into a Long-Term  Lease Agreement           | F-21   |   |
| Note 6:   Discontinued Operations                                            | F-25   |   |
| Note 7:   Property and Equipment                                             | F-27   |   |
| Note 8:   Accrued  Expenses and Unearned Revenue                             | F-28   |   |
| Note 9:   Long-Tem  Debt                                                     | F-28   |   |
| Note 10: Shareholders’  Equity                                                    | F-29   |   |
| Note 11:  Goodwill and Other Intangible Assets                                         | F-30   |   |
| Note 12: Retirement Plan                                                               | F-32   |   |
| Note 13: Income Taxes                                                                  | F-32   |   |
| Note 14:  Commitments and Contingencies                                                | F-33   |   |
| Note 15:  Segments (Service Groups) Information                                        | F-35   |   |
| Note 16: EAP  Services Reorganization and Related Impairments                          | F-36   |   |
| Note 17:  Quarterly Financial Information (unaudited)                                  | F-38   |   |
|                                                                                   |   |   |
| Index to Financial Statement Schedules                                                 |   | S-1    |

 

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**PART I**

**ITEM 1.****            BUSINESS**

*Unless the context otherwise requires, wheneverused herein the terms “Company”, “Horizon Health” and “Registrant” refer toHorizon Health Corporation and its subsidiaries.*

**Disclosure Regarding Forward-Looking Statements**

Certainwritten and oral statements made or incorporated by reference from time to timeby the Company or its representatives in this report, other reports, filingswith the Commission, press releases, conferences, or otherwise, are “forwardlooking statements” within the meaning of the Private Securities LitigationReform Act of 1995.  Such statementsinclude, without limitation, any statement that may predict, forecast,indicate, or imply future results, performance or achievements, and may containthe words “believe,” “anticipate,” “expect,” “estimate,” “project,” “will be,” “willcontinue,” “will likely result,” or words or phrases of similar meaning.  Such statements involve risks, uncertaintiesor other factors which may cause actual results to differ materially from thefuture results, performance or achievements expressed or implied by suchforward looking statements.  Certainrisks, uncertainties and other important factors are detailed in this reportand will be detailed from time to time in reports filed by the Company with theCommission, including Forms 8-K, 10-Q, and 10-K, which should be reviewedseparately.  Such risks include, amongothers, the following: general economic and business conditions which are lessfavorable than expected; unanticipated changes in industry trends; decreaseddemand by acute care hospitals for the Company’s management services; theCompany’s inability to retain existing management contracts or to obtainadditional contracts or maintain customer relationships; adverse changes in reimbursementby Medicare or other third-party payers for costs of providing behavioralhealth or physical rehabilitation services; adverse changes to other regulatoryrequirements relating to the provision of behavioral health or physicalrehabilitation services; adverse consequences of investigations by governmentalregulatory agencies; adverse judgments rendered in the qui tam lawsuits pendingagainst the Company; fluctuations and difficulty in forecasting operatingresults; the ability of the Company to sustain, manage or forecast its growth;the ability to obtain capital to fund future acquisitions; the ability toconsummate future acquisitions; the ability of the Company to successfullyintegrate acquired businesses on a cost effective basis; heightenedcompetition, including specifically the intensification of price competition;the entry of new competitors and the development of new products or services bynew and existing competitors; changes in business strategy or developmentplans; inability to carry out marketing and sales plans; business disruptions;liability and other claims asserted against the Company; loss of keyexecutives; the ability to attract and retain qualified personnel; adversepublicity; demographic changes; and other factors referenced or incorporated byreference in this report and other reports or filings with the Commission.  Moreover, the Company operates in a verycompetitive and rapidly changing environment. New risk factors emerge from time to time and it is not possible formanagement to predict all such risk factors, nor can it assess the impact ofall such risk factors on the Company’s business or the extent to which anyfactor may cause actual results to differ materially from those contained inany forward looking statements.  Theseforward-looking statements represent the estimates and assumptions ofmanagement only as of the date of this report. The Company expressly disclaims any obligation or undertaking todisseminate any updates or revisions to any forward looking statement containedherein to reflect any change in its expectations with regard thereto or anychange in events, conditions or circumstances on which any statement isbased.  Given these risks anduncertainties, investors should not place undue reliance on forward-lookingstatements as a prediction of actual results.

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**GeneralOverview**

HorizonHealth is a health care services provider with a focus on its core competencyof behavioral health clinical services. There was one significant change to the structure of the reportableservice groups during the first quarter of fiscal year 2006.  The behavioral health and physicalrehabilitation contract management businesses have been consolidated into oneservice group, contract management services. Therefore, the Company’s reportable service groups are: (1) HospitalServices (2) Contract Management Services, and (3) Employee Assistance ProgramServices (“EAP Services”).  For the yearended August 31, 2006, the revenues of such business service groups constituted58%, 32%, and 10%, respectively, of the total revenues of the Company fromcontinuing operations.  See Note 15 “*Segment (Service Group) Information*” in the notes to theconsolidated financial statements of the Company included elsewhere herein forfinancial information regarding the business segments (service groups) of theCompany.

Duringfiscal year 2005 and prior, the Company offered, on an at risk basis, managedbehavioral health services to self-funded employee groups, insurance companiesand commercial HMO & PPO plans through its EAP Services group.  As of August 31, 2005, all contracts formanaged behavioral healthcare services on an at-risk basis wereterminated.  See Note 16 *“EAP Services Reorganization and Related Impairments”*to the Consolidated Financial Statements of the Company included elsewhereherein this document.

As a result of recent changes in reimbursement underfederal health care programs for both behavioral health and physicalrehabilitation services, the Company may experience adverse consequences in itscontract management business.  At thistime, however, we cannot meaningfully predict the ultimate impact thatreimbursement changes may have on the facilities it owns, the programs itcurrently manages, or on its ability to obtain new management contracts.  See “Government Regulation” – “Medicare andMedicaid; Reimbursement for Services” elsewhere herein regarding Medicarestatutes, hospital reimbursement systems and related recent changes.

The Company wasincorporated in 1989 and is the successor to Horizon Mental Health Management,Inc., incorporated in 1981, which began thedevelopment and contract management of behavioral health treatment programs foracute care hospitals.  The Company’snational support center is located at 2941 S. Lake Vista Drive, Lewisville,Texas, 75067.  The telephone number is(972) 420-8200. The Company’s Form 10-Q’s and Form 10-K can be obtained free ofcharge through the Company’s website at www.horizonhealth.com.

The Company has indicated that it will focusfuture growth, both internal and through acquisitions, primarily in the area ofbehavioral health clinical services.

**RecentDevelopments**

On October 6,2006, the Company announced that it has engaged UBS Securities, LLC to assistthe Board of Directors in evaluating the assets and operations of the Companyin order to review possible alternative strategies to achieve greatershareholder value.  These alternativesmay include a complete or partial sale of the Company, a merger, or a decisionto take no action at this time.  Noassurance can be given that any transaction will be pursued or, if atransaction is pursued, that it will be consummated.

On August 9, 2006,a wholly-owned subsidiary of the Company entered into a long-term leaseagreement with St. David’s Healthcare Partnership, LP, LLP, for the lease ofSt. David’s Pavilion located in Austin, Texas. The Company will operate the facility as a 48 bed free-standingpsychiatric hospital subject to receipt of required governmentalapprovals.  The lease has an initial termof 15 years and can be extended upon the mutual agreement of landlord andtenant.  Total minimum lease paymentsapproximate $13.9 million and are payable over the term of the lease.  Horizon Health Corporation is a guarantor ofthe lease.  The lease term will commenceupon completion of renovations to the facility and upon receipt of allgovernment approvals and licenses required to operate the premises as afree-standing psychiatric hospital.

Effective May 24,2006, the Company entered into a Third Amendment to the Third Amended andRestated Credit Agreement which modified certain fee schedules and certaincovenants of the Company’s existing credit facility.

On February 1, 2006, the Company acquired the behavioral healthfacilities of Lighthouse Care Centers, LLC and Focus Healthcare, LLC.  Lighthouse Care Center, LLC operated fourbehavioral health facilities located in 

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Florida,Georgia and South Carolina.  FocusHealthcare, LLC operated four behavioral health facilities located in Delaware,Florida, Georgia and Ohio.  The Focus& Lighthouse facilities in Florida are operated out of the samefree-standing hospital and will be considered a single operating facility goingforward.  Additionally, the Companyacquired a facility from Lighthouse which is expected to begin operationsduring the 2007 fiscal year.  Thefacilities have a combined total licensed capacity of 512 beds.  The closing of the acquisition for the FocusHealthcare Delaware facility was postponed pending receipt of necessarygovernment approvals and ultimately closed on April 1, 2006.  The net purchase price for the entireLighthouse/Focus transaction, which included the assumption of a HUD loan ofapproximately $7.1 million for the Focus Healthcare Delaware facility, was approximately$91.7 million.

Effective January26, 2006, the Company entered into a Second Amendment to the Third Amended andRestated Credit Agreement which increased the amount of the Company’s revolvingcredit facility to $175.0 million and added Sun Trust Bank as a participatingbank.

Effective January17, 2006, the Company acquired Kingwood Pines Hospital, a 78-bed behavioralhealth facility located in Kingwood, Texas. The transaction was structured as a limited partner interest purchaseagreement and a membership interest purchase agreement by which the Companyacquired all of the partnership interest of the limited partner and all themember interests of the general partner. As a result of the transaction, the Company acquired ownership directlyand indirectly of all the partnership interests in the partnership.  The aggregate purchase price net of cashacquired was approximately $14.1 million.

On January 1, 2006, the Company acquired Kids Behavioral Health ofUtah, Inc., a Utah corporation.  KidsBehavioral Health owned and operated Copper Hills Youth Center, a 126-bedadolescent residential treatment center located in West Jordan, Utah.  The transaction was structured as a stock purchaseagreement.  The aggregate purchase pricewas approximately $9.6 million.

Effective November14, 2005, the Company entered into a Consent and First Amendment to the ThirdAmended and Restated Credit Agreement in connection with the Lighthouse andFocus acquisitions.  This amendmentmodified certain fee schedules and certain covenants of the Company’s existingcredit facility.

***Servicesby Service Group***

***HospitalServices***

The Company’sbehavioral health care facilities offer a wide range of inpatient behavioralhealth care services for children, adolescents and adults.  Our inpatient facilities work closely withmental health professionals, including licensed professional counselors,therapists and social workers; psychiatrists; non-psychiatric physicians;emergency rooms; school systems; insurance and managed care organizations;company-sponsored employee assistance programs; and law enforcement andcommunity agencies that interact with individuals who may need treatment forbehavioral illness or substance abuse. Those clients not meeting the established criteria for inpatient caremay qualify for outpatient care or a less intensive level of care also providedby the facility.

Inpatientpsychiatric treatment is the most intensive level of care, including 24-hourskilled nursing observation and care, daily interventions and oversight by apsychiatrist and intensive, highly coordinated treatment by a physician-ledteam of behavioral health professionals. Every patient admitted to our acute inpatient facilities is assessed bya medical doctor within 24 hours of admission. Patients with non-complex medical conditions are monitored during theirstay by the physician and nursing staff at the inpatient facility.  Patients with more complex medical needs arereferred to more appropriate facilities for diagnosis and stabilization priorto treatment.  Patients admitted to ouracute inpatient facilities also receive comprehensive nursing and psychologicalassessments within 24 to 72 hours of admission. Oversight and management of patients’ medication is performed bylicensed psychiatrists on staff at the facility, and individual, family, andgroup therapy is performed by licensed counselors as appropriate to thepatients’ assessed needs.  Educationregarding their illness is also provided by trained mental healthprofessionals.

Our residential treatment centers offer longer-termtreatment programs primarily for children and adolescents with long-standingacute behavioral health problems.  Ourresidential treatment centers provide physician-led, multi-disciplinarytreatments that address the overall medical, psychiatric, social, and academicneeds of the patient.  Twenty-four hourobservation and care is provided in our residential treatment centers, alongwith 

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individualizedtherapy that usually consists of one-on-one sessions with a licensed counselor,as well as process and rehabilitation group therapy.  Another key component of the treatment ofchildren and adolescents in our inpatient facilities is family therapy.  Participation of the child’s or adolescent’simmediate family is strongly encouraged in order to heighten the chance ofsuccess once the resident is discharged. Medications for residents are managed by licensed psychiatrists whilethey remain at the inpatient facility. Our residential treatment centers also provide academic programs bycertified teachers to children and adolescent residents.  These programs are individualized for eachresident based on analysis by the teacher upon admission.  Upon discharge, academic reports areforwarded to the resident’s school. Specialized programs for children and adolescents in our residentialtreatment centers include programs for sexually reactive children, sexoffenders, reactive attachment disorders, and children and adolescents who aredevelopmentally delayed with a behavioral component.  We also offer specialized programs for adultswhich include a program for adults with eating disorders.

During the last three fiscal years, the Company hasacquired the following facilities:
| Facility                                   | ** ** | **Location**           | ** ** | **Licensed Beds** | ** ** | **Acquisition Date** |
|--------------------------------------------|------------|------------------------|------------|-------------------|------------|----------------------|
| Michiana Behavioral Health  Center         |       | Plymouth, IN           |       | 80                |       | April 1, 2004        |
| Poplar Springs  Hospital                   |       | Petersburg, VA         |       | 184               |       | June 1, 2004         |
| Laurelwood Hospital                        |       | Willoughby, OH         |       | 160               |       | January 1, 2005      |
| Friends Hospital                           |       | Philadelphia, PA       |       | 219               |       | July 1, 2005         |
| River Park Hospital                        |       | Huntington, WV         |       | 187               |       | August 1, 2005       |
| Copper Hills  Youth Center                 |       | West Jordan, UT        |       | 126               |       | January 1, 2006      |
| Kingwood Pines Hospital                    |       | Kingwood, TX           |       | 78                |       | January 17, 2006     |
| Focus Healthcare  of Florida               |       | Cooper City, FL        |       | 78                |       | February 1, 2006     |
| Focus Healthcare of Georgia                |       | St. Simons  Island, GA |       | 101               |       | February 1, 2006     |
| Lighthouse Care  Center of Augusta         |       | Augusta, GA            |       | 106               |       | February 1, 2006     |
| Focus Healthcare of Ohio                   |       | Maumee, OH             |       | 42                |       | February 1, 2006     |
| Lighthouse Care  Center of Conway          |       | Conway, SC             |       | 104               |       | February 1, 2006     |
| Lighthouse Care Center of  Berkeley County |       | Summerville, SC        |       | —            | (a)        | February 1, 2006     |
| Lighthouse Care  Center of Oconee          |       | Tamassee, SC           |       | 28                |       | February 1, 2006     |
| Focus Healthcare of Delaware               |       | New Castle, DE         |       | 53                |       | April 1, 2006        |

 

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(a)   The facility located inSummerville, SC was purchased as a part of the Lighthouse/Focus acquisition,however, it is currently undergoing renovations and is planned to be inoperation in the 2007 fiscal year.

Additionally, the Company has announced that it hasentered into a long-term lease agreement with St. David’s HealthcarePartnership, LP, LLP, for the lease of St. David’s Pavilion.  The Company will operate the facility as a 48bed free-standing psychiatric hospital subject to receipt of requiredgovernmental approvals.  The facility isanticipated to commence operation in the Company’s third fiscal quarter of2007.

***Contract Management Services***

**Behavioral Health Contract Management Services**

The Company believes that there continues to be a viable market forbehavioral health contract management services provided to acute carehospitals.  The Company believes thehospital based clinical service delivery system for the behavioral healthprograms it manages is a cost efficient and effective model competitive withother forms of delivery systems in the marketplace. Acute care hospitals outsourcekey clinical departments to independent contract management companies forseveral reasons, including: (i) the expertise necessary for the development,management and operation of specialized clinical programs differs from thatnecessary for traditional medical/surgical services, (ii) acute care hospitalsoften lack access to the skilled professionals and support staff needed tooperate specialized clinical programs, (iii) acute care hospitals often lackexpertise in community education activities required to support specializedclinical programs, and (iv) acute care hospitals often lack expertise necessaryto design and operate specialized clinical programs that satisfy regulatory,licensing, accreditation and reimbursement requirements.

Afocus of the Company is developing behavioral health programs to accommodatepatients needing different levels of care based on their presentingcondition.  Such levels include inpatienthospitalization as well as alternatives to inpatient hospitalization in orderto ensure that each patient’s treatment regimen utilizes clinical 

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resourceseffectively. The Company believes that acute care hospitals need to be able tooffer a broad array of behavioral health care services in order to develop orparticipate in integrated delivery systems responsive to the changing demandsof governmental payors, managed care companies and other third-party payors.Acute care hospitals are able to provide their mix of behavioral healthpatients (as to age, acuity, comorbidity, etc.) with needed medical andsurgical care on-site. Furthermore, acute care hospitals are eligible toreceive reimbursement under the Medicaid program for behavioral health careprovided to Medicaid-eligible adults, unlike freestanding psychiatrichospitals, which are not presently eligible.

TheCompany believes it is uniquely positioned to capitalize on an increased demandfor behavioral health contract management services as a result of itsdemonstrated industry expertise and its proprietary quality and outcomes measurementsystem. In addition, the Company believes its position as the leading contractmanager (based on market share) of behavioral health programs provides theCompany with a significant advantage in attracting and retaining employees andyields several economies of scale such as the ability to consolidateadministrative functions.

TheCompany has the expertise to manage a broad range of clinical behavioral healthprograms, including geropsychiatric, general adult, substance abuse and childand adolescent programs. The programs use a treatment team concept, with theadmitting physician, team psychologist, social workers, nurses, therapists andcounselors coordinating each phase of therapy. The programs include crisis intervention, individual therapy, group andfamily therapy, recreational therapy, occupational therapy, lifestyleeducation, social services and substance abuse counseling.  Family involvement is encouraged.  Each treatment program is individuallytailored as much as practicable to meet the needs of the patients, the clienthospital, physicians and payor groups.

The Companycontinues to have a focus in the area of behavioral health programs for theelderly (“geropsychiatric programs”).  AtAugust 31, 2006, approximately 59% of the behavioral health treatment programsmanaged by the Company were geropsychiatric programs.  Many elderly patients with short-termbehavioral illness also have physical problems that make the general acute carehospital environment the most appropriate site for their care.  The Medicare program currently reimbursesacute care hospitals at least 85%, in calendar year 2006, of their TEFRA costof providing these services, which includes the Company’s management fee aswell as allocated overhead costs to the program.  The Medicare program also allowsreimbursement for partial hospitalization on a specified fee for service basisthat facilitates the ability to treat patients in the most cost-effectiveenvironment.  The Company has developedparticular expertise in developing specialized psychiatric programs for theelderly, in operating such programs, and in assisting acute care hospitals inreceiving approval for inpatient programs as distinct part units to qualify forreimbursement under Medicare.  Approvalof an inpatient program as a distinct part unit is significant to client acutecare hospitals because services provided in distinct part units are exempt frompredetermined acute care hospital reimbursement rates.  Services provided in such distinct part unitshave been reimbursed by Medicare on an actual cost basis, subject to certainsignificant limitations described below. As discussed below in the “Government Regulations” section, a Medicareprospective payment system was implemented for cost reporting years beginningon January 1, 2005 for inpatient behavioral health services.

The contractmanagement fees received by the Company for its services are paid directly byits client acute care hospitals.  Theclient acute care hospitals receive reimbursement for the clinical servicesprovided to patients of the programs managed by the Company under either theMedicare or Medicaid programs or from insurers, self-funded benefit plans orother third-party payors for the services. As a result, the availability and amount of such reimbursements, whichare subject to change, impacts the decisions of acute care hospitals regardingwhether to offer behavioral health services pursuant to management contractswith the Company, as well as the decisions whether to renew such contracts andthe amount of fees to be paid thereunder. See “Government Regulation” – “Medicare and Medicaid; Reimbursement forServices” elsewhere herein for a further discussion of funding methods, andrecent changes in them.

Elements of the Continuumof Care

The behavioralhealth treatment programs managed by the Company are designed to be part of acontinuum of behavioral health services, consisting of inpatient, partialhospitalization (or day treatment) and outpatient services.

InpatientServices. Inpatient services are generally provided topatients needing the most intensive behavioral health treatment and whofrequently have accompanying medical care needs. The patient is admitted to 

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the clienthospital and remains there on a 24-hour per day basis throughout the course ofthe inpatient treatment, which is continued until the patient can be stabilizedand moved to another level in the continuum of behavioral health services.

PartialHospitalization. Partial hospitalization services areprovided for limited periods per day with the patient returning home at theconclusion of each day’s treatment. Partial hospitalization services aredesigned to be both an alternative to inpatient hospitalization services and akey component of care following inpatient hospitalization.

OutpatientServices. Outpatient services consist generally ofconsultative and therapeutic sessions that can be rendered in a variety ofindividual or group settings at various locations, including acute carehospitals, clinics or the offices of the service provider.  Outpatient service providers can also serve a“gatekeeper” function for persons being evaluated for treatment.  Once an individual is assessed for treatmentin an outpatient environment, the individual is provided the appropriate levelof service in relation to the diagnosis.

CQI+Mental Health Outcomes Measurement

TheCompany began offering its proprietary CQI+ Outcomes Measurement System in1994.  The CQI+ System provides aqualitative and quantitative tool for behavioral health programs to evaluatethe clinical effectiveness of treatment and to make adjustments in the programsin order to improve quality and appropriateness of care.  The CQI+ Outcomes Measurement System providesoutcome information regarding the effectiveness of a hospital’s behavioralhealth programs.  The availability ofsuch information enables a hospital to demonstrate to third-party payorswhether patients are improving as a result of the treatment provided, to refineits clinical treatment programs to improve the effectiveness of care providedand to demonstrate the benefits of its programs to patients and providers.  The CQI+ System also provides the Companywith a valuable tool for demonstrating clinical results of the behavioralhealth programs managed by the Company and for marketing its managementservices to other acute care hospitals. The Company provides outcome measurement services to acute carehospital-based programs as well as freestanding psychiatric hospitals.  The Company’s CQI+ System is included on theJoint Commission on Accreditation of Healthcare Organizations (“JCAHO”) list ofacceptable ORYX outcome measurement systems. The Company is committed to meeting the requirements as established byJCAHO. As of August 31, 2006, 50 of the Company’s behavioral health managementcontracts included the CQI+ System, 8 of the Company’s owned/leased behavioralhealthcare facilities utilize the CQI+ System and there were an additional 43stand-alone contracts.  Since offeringthe CQI+ System, the Company has compiled a proprietary database containingde-identified patient outcome measurement data on approximately 190,000patients.  Sample data is typicallycollected from randomly selected patients at admission, discharge and 90 to 180days after discharge.  Quarterly outcomereports include a summary of patient characteristics and outcome measures.  The Company trains and supervises on-sitepersonnel to ensure the collection of accurate outcome measurement data.  With the continued emphasis on enhancingpatient care, accountability and the JCAHO accreditation requirement, theCompany believes that its CQI+ System is an important component of thebehavioral health services it provides.

**Physical Rehabilitation Contract ManagementServices**

TheCompany’s acquisition of Specialty Healthcare Management, Inc. in August 1997expanded the Company’s operations to include the contract management ofphysical rehabilitation programs.  TheCompany believes that many of the same factors that drive demand for contractmanagement of behavioral health programs are also applicable to physicalrehabilitation programs.  The Companyprovides contract management services for a full range of physicalrehabilitation services.  In addition toacute physical therapy and rehabilitation services, the Company also providescontract management for skilled nursing services and outpatient rehabilitationprograms.

Acuterehabilitation units are specialized programs that incorporate a variety oftreatments and services aimed at improving an individual’s functional levelfollowing a disabling illness or traumatic injury.  The treatment program is led by a physicianand provided by an interdisciplinary team of health care professionalsincluding physical, speech, occupational and recreational therapists,rehabilitation nurses and social workers. The Company tailors an acute rehabilitation program for a health carefacility to satisfy unmet community and medical staff needs, while maximizingutilization of the facility.

Outpatientrehabilitation serves as an adjunct to inpatient physical therapy andrehabilitation programs. Outpatient rehabilitation services are dominated bythe treatment of sports and work related injuries, but also 

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provide the continuum ofrehabilitative care necessary to meet the medical needs of a post-acute carepatient following a disabling illness or traumatic injury.  Pressure from payors to move inpatients tothe lowest-cost appropriate treatment setting has helped stimulate growth inoutpatient rehabilitation services.

***EAPServices***

TheCompany contracts with employers to provide employee assistance programs (“EAPs”)to their employees.  An EAP is a programthat is designed to assist employees and their dependents with resolution ofbehavioral conditions or other personal concerns.  It is considered that having an EAP willresult in more productivity from employees. Employers usually provide an EAP as a benefit at no cost to employees.  Under an EAP, staff or network providersprovide assessment and referral services to employee beneficiaries and theirdependants.  These services consist ofevaluating a beneficiary’s needs and, if indicated, providing limitedcounseling and/or identifying an appropriate provider, treatment facility orother resource for more intensive treatment services.  For its EAP services, the Company is usuallypaid a specified fee per month per employee based on the range and breadth ofservices provided to the employer, which may include work life services, andthe method(s) in which those services are provided.

TheCompany frequently provides training to employer personnel for identifyingtroubled employees.  Often an employerwill refer an employee for consultation after observing a change in workperformance.  The Company believes thatsuch early identification and resolution of productivity problems canfrequently minimize the likelihood that the problem will develop into a seriousdebilitating event requiring extensive treatment.  The Company’s EAP services can include acomprehensive array of work life information and referral sources if desired bythe employer.  Modes of access toservices include internet, phone and face-to-face sessions, all of which focuson providing consultation and resource services to assist employees and theirfamilies in achieving personal and professional success and emotionalwell-being.  Through severalacquisitions, the Company has expanded its service offerings, including theability to conduct EAP business in the State of California, through theacquisition of a limited Knox-Keene license.

Duringthe fiscal year 2005 and prior, the Company also contracted with self-insuredemployers, insurance companies and HMOs to provide the managed behavioralhealth care component of the general health plans offered by such entities.  The contracts were primarily on a full risk,capitated basis under which the Company was paid a set fee per month for eachmember of the respective health plan, however, a small portion of the contractswere structured on a stipulated fee-for-service basis.  As a part of the reorganization of EAPServices, the Company terminated all of the managed behavioral health at-riskcontracts during fiscal year 2005.  TheCompany will continue its administrative services only business in which it isnot at-risk for the cost of treatment services.

EAPservices are provided primarily through a national network of independent EAPproviders that have contracted with the Company to provide such services.  The Company reimburses the independentnetwork professionals and institutions on a negotiated fee-for-servicebasis.  The clinical providers representa broad range of treatment and case management specialties and are qualified torespond to the complete continuum of behavioral health concerns, pediatric togeriatric.  The clinical providersinclude psychiatrists, nurses, psychologists, social workers, and other relatedbehavioral health personnel.  The Companybelieves that its relationships with health care providers and its expertise inthe provision of behavioral health care services provide it with the capabilityto establish, operate and manage the network of health care professionalsnecessary to economically and adequately furnish such services.

**Operations**

***Behavioral Health Care Facilities***

Throughowned and leased behavioral health care facilities, the company offers a widerange of behavioral health care services for children, adolescents andadults.  The facilities**work closely with behavioral health professionals,including licensed professional counselors, therapists and social workers;psychiatrists; non-psychiatric physicians, emergency rooms; law enforcement andcommunity agencies that interact with individuals who may need treatment forbehavioral illness or substance abuse. The facilities have mobile assessment teams who travel to prospectiveclients in order to assess their condition and determine if they meet criteriafor inpatient care.  Those clients notmeeting criteria for inpatient care may qualify for outpatient care or a lessintensive level of care also provided by the facilities.

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Throughthe diversity of programming and levels of care available, the patient canreceive a seamless treatment experience from acute care to residentiallong-term care to group home living to outpatient treatment.  This seamless care system provides thecontinuity of care needed to step the patient down and allow the patient to**develop and use successful coping skills and treatmentinterventions to sustain long-term treatment success.  Treatment modalities include comprehensiveassessment, multidisciplinary treatment planning including the patient andfamily, group, individual and family therapy services, medical and dentalservices, educational services, recreational**services, anddischarge planning services.  Specializedinterventions such as skills training include basic daily living skills, socialskills, work/school adaptation skills and symptom management skills.  Collateral consultations are provided tosignificant others such as family members, teachers, employers and otherprofessionals when needed to help the patient successfully reintegrate backinto his/her world.

Acuteinpatient hospitalization is the most intensive level of care offered andtypically involves 24-hour skilled nursing observation and care, daily interventionsand oversight by a psychiatrist, and intensive, highly coordinated treatment bya physician-led team of behavioral health professionals.  Every patient admitted to acute care isassessed by a medical doctor within 24 hours of admission.  Patients admitted to the acute carefacilities also receive comprehensive nursing and psychosocial assessmentswithin 24 to 72 hours of admission. Oversight and management of patients’ medication is performed bylicensed psychiatrists on staff at the facility, and individual, family, andgroup therapy is performed by licensed counselors as appropriate to thepatients’ assessed needs.  Educationregarding their illness is also provided by trained medical healthprofessionals.

TheCompany’s residential treatment care programs provide longer-term treatmentprograms for children and adolescents with long-standing behavioral healthproblems.  Twenty-four hour observationand care is provided in the residential treatment care programs, along withindividualized therapy that usually consists of one-on-one sessions with alicensed counselor, as well as process and rehabilitation group therapy.  Another key component of the treatment ofchildren and adolescents is family therapy. Participation of the child’s or adolescent’s immediate family isstrongly encouraged in order to heighten the chance of success once theresident is discharged.  Medications forresidents are managed by licensed, often board-certified, psychiatrists whilethey remain at the inpatient facility. The Company’s residential treatment care programs also provide academicprograms by certified teachers to children and adolescent residents.  These programs are individualized for eachresident based on analysis by the teacher upon admission.  Upon discharge of the resident, academicreports are forwarded to the resident’s school. Specialized programs for children and adolescents in the RTCs includeprograms for sexually reactive children, sex offenders, reactive attachmentsdisorders and clients who are developmentally delayed with a behavioralcomponent.  The residential treatmentcare programs often receive out-of-state referrals to their programs due to thelack of specialized programs for these disorders within the referral’s ownstate.

Eachoperating facility has its own administrative team headed by a chief executiveofficer.  The facilities are collectivelysupported by a services group Regional Vice President of Clinical Services anda Regional Vice President of Community Development.  Additional support services such asfinancial, payroll and intellectual property are provided by the nationalsupport center staff of the Company.

***Management Contracts***

TheCompany operates its behavioral health and physical rehabilitation contractmanagement businesses through a regional structure that includes managementpersonnel which office in the regional territory and in the Company’s nationalsupport center (“NSC”) in the Dallas suburb of Lewisville, Texas.  The structure is designed to maintain keyoperating employees of the Company in direct contact with clients.  Each region is under the supervision of avice president who in turn supervises regional directors, each of whom hasdirect responsibility over eight to twelve management contract locations. Otherregional personnel include clinical and other specialists who are available toprovide assistance to the local programs and client hospital personnel. 

TheCompany provides its management services under contracts with client acute carehospitals. Each contract is tailored to address the specific needs of theclient hospital and its community. The Company and the client hospitaldetermine the programs and services to be offered by the hospital and managedby the Company.  At any location, thesemay consist of one or more treatment programs offering inpatient, partialhospitalization, outpatient services, and also other specialized services.Under the management contracts, the hospital is the actual provider of thebehavioral health or physical rehabilitation services and utilizes its ownfacilities (including beds for inpatient programs), its own support services(such as billing, dietary and housekeeping), and frequently its own 

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nursing staff forthe operation of the treatment programs with the Company providing operatingand clinical expertise through its onsite management staff.

Whilethe treatment programs subject to each of the management contracts is tailoredto the specific needs of the client hospital, substantially all of themanagement contracts contain certain non-compete and confidentialityprovisions. In addition, the management contracts typically prohibit the clienthospital from soliciting the employment of the Company’s employees during thecontract term and for a specified period thereafter.

Themanagement contracts generally have a term of 3-5 years although some contractshave shorter or longer terms.  Contractsare frequently renewed or amended prior to their stated expiration date. As ofAugust 31, 2006, 2005 and 2004, the Company had successfully retained 81%, 88%,and 88%, respectively, of the management contracts in existence at thebeginning of the respective fiscal year. Some contracts are terminated prior to their stated expiration date bymutual agreement of the parties or pursuant to early termination provisionsincluded in the contract.  The Company’sexperience is that the most frequent reasons why the client acute carehospitals do not renew a contract is that the hospital desires to manage theprogram itself, the economic viability of the program has changed resulting inthe hospital closing the program, or a change in hospital administration hasoccurred that results in a philosophical change regarding the use of contractmanagers.

Undereach contract, the Company receives a fee for its services paid by the clienthospital. The management fee may be a variable fee related in part to patientvolumes (census, admissions, or discharges) at the program, a fixed fee withreimbursement for specified direct program costs, or a combination of thesestructures.  The management fee isfrequently subject to periodic adjustments as a result of changes in a relevantprice index or other economic factors.  Asignificant number of the Company’s management contracts require the Company torefund some or its entire fee if either Medicare reimbursement for servicesprovided to patients of the programs is denied or the fee paid to the Companyis denied as a reimbursable cost.  Duringthe last three fiscal years the Company has not refunded any significant amountof its fees in relation to such denials.

*Program Development*

TheCompany assists in the development of each clinical program as requested by theclient hospital, including such matters as licensing, accreditation,certificate of need approvals and Medicare certification.  The Company also develops and implementscommunity education awareness plans and development plans for the clinicalprograms to be offered by the hospital. Each program is marketed locally in the name of the client hospital withan emphasis on the hospital addressing the needs of the local community.  The Company’s name is not used and its roleis not publicly emphasized in the operation of the clinical programs offered byits client acute care hospitals. The medical staff of the client hospitaladmits each patient.  Charges fortreatment services provided to the patients of the programs accrue directly toand are billed by the client hospital and/or treating physician.

TheCompany also develops and maintains standardized clinical, operating, andadministrative policy and procedure manuals, conducts initial and ongoing stafftraining and education, and implements quality assurance and ethical andregulatory compliance procedures.  Eachlocal program director receives ongoing support from the regional support staffand the national support center staff in areas including recruiting, finance,reimbursement, referral development, marketing, quality assurance andregulatory compliance.

Eachoperating region is responsible for training new employees, includingformalized instruction and on-the-job training. Continuing education programs are also provided to employees. Inaddition, the Company has a centralized orientation program for new programdirectors and other program management personnel, an annual leadershipconference for all program directors and other program personnel, and anon-going comprehensive Code of Conduct plan.

*Program Staffing*

Behavioral healthprograms managed by the Company generally have a program director that is usuallya psychologist, an advance degreed nurse or a social worker and additionalsocial workers or therapists as needed. Many programs also include a nurse manager, a community educationmanager or a clinical assessment coordinator. Physical rehabilitation programs managed by the Company generally have aprogram director, and additional clinical staff tailored to meet the needs ofthe specific hospital program, which may include physical and occupationaltherapists, speech pathologists, social workers and other appropriatesupporting personnel.

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In addition, formental health and physical rehabilitation programs, the Company generallycontracts with a medical director on an independent contractor basis underwhich on-site administrative services for medical oversight of the program areprovided.  These contracts generallyinclude nondisclosure, non-solicitation and non-competition covenants pursuantto which the medical director agrees not to solicit the Company employees forspecified periods, disclose confidential information of the Company or rendercertain administrative or management services within specified time periods andgeographic areas to any enterprise in competition with the Company or theprograms it manages.

Except for thenursing staff, which is typically provided and employed by the hospital, theother program personnel are usually employees of the Company.  The Company’s management contracts typicallycontain non-solicitation covenants whereby the hospital agrees not to solicitor otherwise employ Company employees for specified periods.

*Program Education and Community Development*

The treatmentprograms managed by the Company are a service provided by the general acutecare hospital client.  Most patients arereferred by the client hospital’s medical staff or result from relationshipsthat the client hospital has in the community. Many contract locations have a community education manager employed bythe company who works with a community awareness and development committeeconsisting of the Company and hospital personnel to educate physicians, otherhealth professionals and nursing homes in the community of the treatmentprograms that are available at the client hospital, to which they can directpatients.  The community educationmanager also designs and offers community educational programs regardingvarious health issues.

*Internal Audits*

The Company hasestablished a clinical internal audit process for its behavioral health andphysical rehabilitation programs.  TheCompany’s regional behavioral health clinical specialists review, as a part ofthe ongoing operations, the services and clinical documentation of thetreatment programs for compliance with client hospital, federal, state andCompany standards.  The clinical auditortypically reviews medical records, clinical and operating procedures, staffing,marketing programs, etc. and conducts interviews with physicians, referralsources and client hospital staff members and frequently patients and/or theirfamilies.

The Company alsohas a compliance audit department that is independent from contract clinicaland operations staff.  The corporatecompliance auditors periodically visit all contract locations.  Results of the compliance audits are reporteddirectly to the senior management of the Company, independent from theoperating organizations.

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*Contract Locations*

At August 31,2006, the Company had a total of 116 behavioral health and physicalrehabilitation management contracts with acute care hospitals located in 36states as shown below:
| State          | ** ** | **Number of  Contracts** | ** ** |
|----------------|------------|-------------------------------|------------|
| Alabama        |       | 3                             |       |
| Arkansas       |       | 9                             |       |
| Arizona        |       | 1                             |       |
| California     |       | 8                             |       |
| Colorado       |       | 1                             |       |
| Connecticut    |       | 1                             |       |
| Florida        |       | 2                             |       |
| Georgia        |       | 1                             |       |
| Idaho          |       | 1                             |       |
| Illinois       |       | 1                             |       |
| Iowa           |       | 1                             |       |
| Kansas         |       | 2                             |       |
| Kentucky       |       | 5                             |       |
| Louisiana      |       | 1                             |       |
| Maryland       |       | 1                             |       |
| Massachusetts  |       | 5                             |       |
| Michigan       |       | 9                             |       |
| Mississippi    |       | 4                             |       |
| Missouri       |       | 4                             |       |
| Montana        |       | 1                             |       |
| Nebraska       |       | 1                             |       |
| Nevada         |       | 1                             |       |
| New Jersey     |       | 2                             |       |
| New York       |       | 7                             |       |
| North Carolina |       | 6                             |       |
| Ohio           |       | 5                             |       |
| Oregon         |       | 3                             |       |
| Pennsylvania   |       | 10                            |       |
| Rhode Island   |       | 1                             |       |
| South Carolina |       | 2                             |       |
| Tennessee      |       | 4                             |       |
| Texas          |       | 6                             |       |
| Virginia       |       | 1                             |       |
| Washington     |       | 3                             |       |
| West Virginia  |       | 1                             |       |
| Wisconsin      |       | 2                             |       |

 

*Client Hospitals*

TheCompany’s management contract clients are primarily small to medium sized acutecare hospitals often located in rural areas, but also include some largetertiary acute care hospitals.  At August31, 2006, approximately 78.4% of the Company’s management contracts were withcommunity or religious based not-for profit acute care hospitals.  The remaining contracts are with for profitacute care hospitals.

*CQI+ Mental Health OutcomesMeasurement*

TheCompany develops and operates its outcomes measurement system primarily out ofits national support center.  Programpersonnel are responsible for the completion of the data input forms concerningthe various treatment programs.  The datais input into the national database using automated technologies from whichreports are developed, reviewed and analyzed.

***Employee Assistance Programs***

The Company’s EAPServices group has positioned itself to compete as a nationally integrated organizationto better service and market to a growing regional and national customer base,for stronger market identification, and to achieve operating efficiencies.  The Company’s service centers are located inthe Dallas, Texas; Denver, Colorado; and San Diego, California metropolitanareas.

EAP Services has anational network of independent EAP providers located in all 50 states.  This service group has employees working inclinical management and administrative positions at its service centers.  EAP Services also has employees performingsales and support services and administrative functions based at the NSC andits various operating locations.

***Administration***

TheCompany’s employees at its national support center provide company-wide supportin finance, human resources, information technology, physician and programdirector recruitment, clinical compliance, risk management, auditing,reimbursement, and other administrative and executive services.

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***Sales and Marketing***

TheCompany conducts direct sales activities for its behavioral health and physicalrehabilitation contract management businesses. The Company compiles information of over 7,000 hospitals in the UnitedStates, with numerous clinical, operating and financial characteristics fromnumerous databases, as well as other sources and referrals, to identifyprospective clients.  Potential clientsinclude acute care hospitals without existing behavioral health, physicalrehabilitation or other programs as well as acute care hospitals with existingprograms of which the Company could assume management.  A select list of high priority candidatesfrom these hospital profiles is systematically targeted based on criteriastrategically formulated to identify acute care hospitals that are the mostlikely to need our services. This strategic approach allows the Company tomaximize its resources in a more focused manner in order to achieve the goal ofincreased sales.  Once identified, aninternal telemarketing system is in place to contact and qualify the potentialclients.  A Vice President ofDevelopment, who typically acts as the point person on the sales team thencontacts the prospective clients and, where appropriate, presents a detailedproposal to key decision-makers. The proposal often contains detailed operatingand financial projections of the proposed programs. The Company works with thepotential client to develop contract terms responsive to the client’s specificneeds. The typical sales cycle for a management contract is approximately sixto nine months.  Operations and clinicalmanagement also participate in and support the sales process.  The Company believes it has opportunity tocross-sell a range of services to client acute care hospitals and is pursuingsuch opportunities as a part of its business strategy.

Thelocal and regional community education and marketing is led by clinical andcommunity development representatives at each of the Company’s behavioralhealth care programs and facilities. These individuals manage relationships among a variety of referralsources and potential referral sources in their respective communities.

TheCompany’s EAP Services group markets employee assistance programs, includingadministrative service only programs, to employers both directly and throughthird party distribution channels.  TheCompany assesses the individualized needs of the employer and its employees tocustomize a program design accordingly.

***Competition***

Thehealth care industry is highly competitive and subject to continual changes inthe method in which services are provided and the types of companies providingsuch services.  The Company competes withseveral national competitors and many regional and local competitors, some ofwhich have greater resources than the Company. In addition, acute care hospitals could elect to manage their ownbehavioral health or physical rehabilitation programs.

Competition amongcontract managers for hospital-based behavioral health and physicalrehabilitation programs is generally based upon reputation for quality, price,the ability to provide financial and other benefits for the hospital, and themanagement, operational and clinical expertise necessary to enable the hospitalto offer behavioral health and physical rehabilitation programs that providethe full continuum of behavioral health and physical rehabilitation services ina quality and cost-effective manner.  Thepressure to reduce health care expenditures has strengthened the need to managethe appropriateness of behavioral health and physical rehabilitation servicesprovided to patients.  As a result,competitors without substantive management experience covering the variouslevels of the continuum of behavioral health and physical rehabilitation servicesmay not be able to compete successfully. The Company believes that its reputation and management expertise willenable it to compete successfully in this rapidly changing market.

Inaddition, acute care hospitals offering behavioral health and physicalrehabilitation programs managed by the Company compete for patients with otherproviders of behavioral health care services, including other acute carehospitals, freestanding psychiatric hospitals, independent psychiatrists andpsychologists, and with other providers of physical rehabilitation services,including other acute care hospitals, freestanding rehabilitation facilitiesand outpatient facilities.

Freestandingbehavioral health hospitals, owned by the Company, compete with otherfor-profit and tax-exempt freestanding providers, as well as behavioral healthunits operated within acute care hospitals. Freestanding behavioral health hospitals generally provide a broaderarray of behavioral health services than those offered in acute care facilities.  Children and adolescent services, inparticular, are more readily available in freestanding behavioral healthfacilities.  Service lines offreestanding behavioral health hospitals include a continuum of care 

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ranging from intensiveinpatient crisis intervention, longer-term residential treatment, group homes,and intensive outpatient services for children, adolescents and adults.

Thedynamics of healthcare, particularly behavioral health care, are as unique asthe local market area in which they are provided.  In addition, the behavioral healthcaremarketplace is somewhat fragmented, and no individual national behavioralhealthcare hospital chain enjoys a significant presence in any specificgeographic market area.

Theemployee assistance marketplace includes six large national providers as wellas a number of mid-size regional and small local providers.  The primary factors affecting competition inthe EAP business are the range and quality of services provided, the ease ofaccess to the services and price.  Asignificant number of employers of all sizes offer employee assistance servicesto their employees as the benefit is designed to proactively address workplaceand personal issues early so as to avoid absenteeism and thereby increaseproductivity. Customers frequently require sophisticated data that providesinformation regarding clinical utilization and outcomes, patient and providersatisfaction, administrative performance, and other performance relatedinformation.

***Customers***

TheCompany has no individual non-governmental customer comprising 10% or more ofits consolidated revenue or on which its overall operations or financialresults are substantially dependent.  Forthe year ended August 31, 2006, revenue from Medicaid comprised approximately 16%of consolidated revenue.  See the “GeneralOverview” section of MD&A included elsewhere herein for the number ofcustomer contracts as of August 31, 2006 and other related information.

***Employees***

AtSeptember 30, 2006, the Company had approximately 2,914 employees.  By operating service group and corporateoffices, the employee counts are as follows:
| Hospital Services             |   | 2,072 |   |
|-------------------------------|--------|-------|--------|
| Contract  Management Services |   | 638   |   |
| EAP Services                  |   | 100   |   |
| National Support Center       |   | 104   |   |

 

AtSeptember 30, 2006, the Company had contracts with 206 physicians asindependent contractors to serve as medical directors providing administrativeservices for hospital clinical programs managed and hospital facilitiesowned/operated by the Company.  TheCompany also leases approximately 573 employees as a result of the acquisitionof the Focus/Lighthouse facilities.  TheCompany has no collective bargaining agreements with any unions and believesthat its overall relations with its employees are good.

**Government Regulation**

The Company’sbusiness is affected by federal, state and local laws and regulationsconcerning, among other matters, behavioral health and physical rehabilitationfacilities and reimbursement for such services. These regulations impact thedevelopment and operation of behavioral health and physical rehabilitationprograms managed by the Company for its client hospitals as well as the Company’sowned behavioral health hospitals. Licensing, certification, reimbursement andother applicable state and local government regulations vary by jurisdictionand are subject to periodic revision. The Company is not able to predict thecontent or impact of future changes in laws or regulations affecting thebehavioral health or physical rehabilitation sectors.

***Facility Use and Qualification***

*Licensing and Certification*

Hospitalfacilities, including those owned by the Company, are subject to variousfederal, state and local regulations, including facilities use, licensure andinspection requirements, and licensing or certification requirements offederal, state and local health agencies. Many states also have certificate ofneed laws intended to avoid the proliferation of unnecessary or under-utilizedhealth care services and facilities. The behavioral health and 

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physical rehabilitationprograms that the Company manages are also subject to licensure andcertification requirements. The Company assists its client hospitals inobtaining required approvals for new programs. Some approval processes maylengthen the time required for programs to commence operations. In granting andrenewing a facility’s licenses, governmental agencies generally consider, amongother factors, community needs, the physical condition of the facility, thequalifications of administrative and professional staff, the quality ofprofessional and other services, and the continuing compliance of such facilitywith the laws and regulations applicable to its operations. The Companybelieves that the behavioral health and physical rehabilitation programs itmanages, the facilities of the client hospitals used in the operation of suchprograms, and the hospitals it owns, comply in all material respects withapplicable licensing and certification requirements.

TheCompany through its owned facilities is a provider reimbursed by Medicareand/or Medicaid.  As such, the Company issubject to federal, state and local regulations governing their operation.   These laws and regulations set forthrequirements for licensure and qualifications to participate in governmentprograms, including the Medicare and Medicaid programs.  These requirements pertain to the adequacy ofmedical care, equipment, personnel, operating policies and procedures, fireprevention, maintenance of adequate records, hospital use, rate-setting, andcompliance with building codes and environmental protection laws.  Additional regulations exist which govern afacilities participation in government programs.  These facilities are subject to periodicinspection by government and other authorities to assure continued compliancewith these regulations.

TheCompany’s owned and operated facilities are properly licensed under theapplicable state, local and federal rules and regulations.  Most of these facilities are also certifiedunder the Medicare and Medicaid programs and most are accredited by the JointCommission on Accreditation of Healthcare Organizations (“JCAHO”).  Should one of the Company’s owned facilitieslose its certification under the Medicare and/or Medicaid program, thatfacility would no longer receive reimbursement from the Medicare and/orMedicaid programs.  The Company believesthat it’s owned facilities are in compliance in all material respects withcurrent federal, state and local regulations governing their operation.

*Provider-BasedRules*

In April 2000, theCenters for Medicare and Medicaid Services, or “CMS” (formerly the Health CareFinancing Administration or “HCFA”) of the U.S. Department of Health and HumanServices (“HHS”) adopted new rules requiring a CMS determination that afacility has provider-based status before a provider can bill Medicare for theservices rendered at the facility.  OnAugust 1, 2002 CMS issued amendments to the provider-based regulations, whichin addition to requirements applicable to all provider based facilities,provide specific requirements for provider based status of “off-campus”locations and additional specific requirements applicable to “off-campus”locations operational under a management contract.  In February 2002, it was clarified by CMS thatinpatient rehabilitation units that are excluded from the inpatient prospectivepayment system for acute hospital services do not have to meet provider-basedstatus in order to bill Medicare for services rendered to patients.

The revised regulations,while still subject to additional clarification as to specific applicability,have affected few of its psychiatric management contracts. The Company believesthat the provider-based regulations will not have a significant impact on itscurrent operations of inpatient psychiatric units located within generalhospitals and will have no material impact on the Company’s owned inpatientpsychiatric hospitals.

***Medicare and Medicaid:Reimbursement for Services***

Background

The Medicareprogram is a federally funded health insurance program for the elderly. Theprogram is divided into Part A and Part B, each of which has separate rules andrequirements. Part A pays for hospital, skilled nursing, home health agency,hospice, and dialysis services determined to be medically necessary for theindividual patient. Part B is a voluntary medical benefits plan in whicheligible individuals can enroll to receive benefits in addition to thoseavailable under Part A and for which they must pay a monthly premium. Part Bcovers non-institutional services, including physician services, outpatienthospital services, durable medical equipment, and laboratory services, amongothers.

The Medicareprogram is administered by CMS, which adopts regulations and issuesinterpretive memoranda and program manuals providing detailed explanation ofthe Medicare program. The payment operations 

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of the Medicare programare handled by fiscal intermediaries (under Part A) and carriers (under Part B)who are insurance companies and Blue Cross/Blue Shield plans which contractwith the Secretary of HHS (the “Secretary”) to make Medicare payments toproviders in a particular geographic region. Individual intermediaries andcarriers issue transmittals, bulletins, notices, and general instructions toproviders and suppliers in their respective areas to facilitate theadministration of the Medicare program, but are required to follow the Medicarestatute, CMS regulations, CMS transmittals, and the program manuals. Withinthese requirements, intermediaries and carriers are granted broad discretion toestablish particular guidelines and procedures for making Medicare coveragedeterminations and payments, including prior approval, utilization limits, andspecific documentation. Some fiscal intermediaries have developed LocalCoverage Determinations (“LCD”).  LCDsare rules established by a fiscal intermediary or carrier, which determineswhether a particular service will be covered on an intermediary-wide orcarrier-wide basis.  This determinationtakes into account whether the service is reasonable and necessary inaccordance with Section 1862(a)(1)(A) of the Social Security Act.  The Company believes that the implementationof LCDs will have no material impact on the Company.

TheMedicaid program is a joint federal-state cooperative arrangement establishedfor the purpose of enabling states to furnish medical assistance on behalf ofaged, blind, or disabled individuals, or members of families with dependentchildren, whose income and resources are insufficient to meet the costs ofnecessary medical services. The federal and state governments share the costs.The Secretary has primary federal responsibility for administering the Medicaidprogram that has been delegated to CMS. States are not required to participatein the Medicaid program. States that choose to participate, however, mustadminister their Medicaid programs in accordance with federal law, theimplementing regulations and policies of the Secretary, and their approvedstate plans. The federal Medicaid statute establishes minimum standards forstate plans but states have significant latitude, within these standards, todetermine the mix of services and structure of their state Medicaid programs.

In order toreceive reimbursement under the Medicare or Medicaid programs, each client orowned hospital or facility must meet applicable requirements promulgated by HHSrelating to the type of facility, personnel, standards of patient care andcompliance with all state and local laws, rules and regulations. The Companyhas a comprehensive code of conduct and regulatory compliance program andbelieves that the programs it manages and its owned hospitals comply in allmaterial respects with applicable Medicare and Medicaid requirements.

Federal lawcontains certain provisions designed to ensure that services rendered byhospitals to Medicare and Medicaid patients are medically necessary and meetprofessionally recognized standards. These provisions include a requirementthat admissions of Medicare and Medicaid patients to hospitals must be reviewedin a timely manner to determine the medical necessity of the admissions. Inaddition, these provisions state that a hospital may be required by the federalgovernment to reimburse the government for the cost of Medicare-reimbursedservices that are determined by a peer review organization to have beenmedically unnecessary. As part of its on-going regulatory and regulatorycompliance program initiatives, the Company for its owned hospitals, and theCompany and its client hospitals for managed programs have developed andimplemented quality assurance programs and procedures for utilization reviewand retrospective patient care evaluation intended to meet these requirements.

*Overview*

Most of theCompany’s client hospitals and its owned hospitals receive reimbursement underone or more of the Medicare or Medicaid programs, private insurers, includingcommercial and managed care plans, as well as reimbursement directly frompatients for behavioral health and physical rehabilitation services provided inprograms managed or owned by the Company. With respect to the managementcontracts, the Company is paid a fee directly by the client hospitals for itsmanagement services. While fees paid to the Company by client hospitals aregenerally not subject to or based upon reimbursement under the Medicare orMedicaid programs or from any other third-party payor, under many of itsmanagement contracts the Company is obligated to refund a portion of its fee ifMedicare denies reimbursement for an individual patient treatment, or its feeif the fee paid to the Company is denied by Medicare as a reimbursable cost.Historically, such reimbursement amounts have been insignificant.  However, since a substantial portion of thepatients of the programs managed by the Company are covered by Medicare,changes which limit or reduce Medicare reimbursement levels could have amaterial adverse effect on the Company’s client hospitals and, in turn, on theCompany

Withrespect to the Company’s owned facilities, all hospital facilitiesparticipating in the Medicare program and some Medicaid programs are requiredto meet certain financial reporting requirements.  These requirements require the submission ofannual cost reports identifying the medical expenses relative to the servicesprovided by a 

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given facility toMedicare beneficiaries and Medicaid dependents. Annual cost reports required under these programs are subject to routinegovernmental audits, which may result in adjustments to the amounts due to the providerunder these reimbursement programs. These audits often require several years to reach the final entitlementearned by the provider under the programs. The Medicare fiscal intermediary issues a Notice of ProgramReimbursement (“NPR”) after audit, and amounts due to or from the provider aredetermined. These amounts are due and payable within 30 days of receipt of theNPR.  Providers have the right to appealand contest issues identified in prior year cost report audits.  As noted below, Medicare has enacted aprospective payment system for inpatient behavioral health services that isbeing phased in over several years.

TheCompany owns hospital facilities and employs individuals who provide medicaland clinical services that are reimbursed by Medicare or Medicaid.  The Company also provides contract managementservices to such providers for which the Company is not reimbursed by Medicareor Medicaid.  Nevertheless, the Companycould be considered subject to federal and state healthcare laws applicable tothe provision of such services. While the Company believes that itsrelationships with its client hospitals, medical directors and other providersand the fee arrangements with its client hospitals are consistent with Medicareand Medicaid criteria, those criteria are often general and ambiguous in natureand subject to interpretation, sometimes differently by different Medicarefiscal intermediaries who administer the programs on behalf of the federalgovernment. In addition, the federal government has been actively investigatinghealth care providers for potential abuses. There can be no assurance thataggressive anti-fraud enforcement actions will not adversely affect thebusiness of the Company.

*Other Reimbursement Payors*

In addition toreimbursement provided by the Medicare and Medicaid programs, the Companiesowned behavioral health hospital facilities receive reimbursement for certainbehavioral health services by private payors including health maintenanceorganizations (“HMO’s), preferred provider organizations (“PPO’s”), commercialinsurance companies, employers and individuals. Generally, patients covered by HMO’s, PPO’s and other private payorswill be responsible for certain co-payments and deductibles, which are paid bythe patient.

*Behavioral Health Reimbursement Changes*

Inthe mid-1980’s, changes in reimbursement rates and procedures included thecreation of the Prospective Payment System (“PPS”) using predeterminedreimbursement rates for diagnosis related groups (“DRGs”). The DRG systemestablished fixed payment amounts per discharge for diagnoses generallyprovided by acute care hospitals. Behavioral health services provided by an acute care hospital mayqualify for an exemption as a distinct part unit (“DPU”). Freestandingpsychiatric hospitals are also exempt from the DRG system.   Psychiatric services provided by DPUs andfreestanding psychiatric hospitals were reimbursed on an actual cost basis,subject to certain limitations for cost reporting periods beginning on orbefore December 31, 2004. The behavioral health programs managed by the Companywhich are eligible for reimbursement by the Medicare program currently meet theapplicable requirements for exemption as DPUs, where desired.  On November 15, 2004, CMS published a finalrule for a prospective payment system for Medicare reimbursement for inpatientbehavioral health services, including those provided by programs managed orfacilities directly owned by the Company as discussed below. A substantialnumber of the behavioral health treatment programs managed by the Company aregeropsychiatric programs for which the majority of the patients are covered byMedicare.  Additionally, approximately15% of the patients treated by the behavioral health hospitals owned by theCompany are Medicare beneficiaries.

TheBalanced Budget Refinement Act of 1999 mandated that PPS for inpatientpsychiatric services be developed.  OnNovember 15, 2004 CMS published final rules in the Federal Register for thepsychiatric inpatient PPS.  The PPS ruleis effective for Medicare cost reporting years that commence on or afterJanuary 1, 2005. The final PPS rules provide for a per diem PPS system phasedin over a four-year period.  The per diemrate has patient specific adjustments based on age, diagnosis, comorbiditiesand electro convulsive therapy treatments. The per diem has facility adjustments based on wage index, ruraldesignation, teaching designation, cost of living adjustments and an adjustmentfor psychiatric facilities with full-service emergency departments.  In addition the per diem rate is increased indays 1 through 8 of the patient’s stay, and incrementally decreases thereafteruntil day 22 of the patients stay.  TheCompany believes that the new PPS rules will affect the hospitals with which ithas management contracts both positively and negatively on a case-by-casebasis.  The new PPS rules have stop lossprotection against significant decreases in reimbursement, during the PPS phasein period, for cost reporting years beginning in calendar year 2005.  The new PPS rules could have an adverseeffect on the contract management business for behavioral health units in the2006 cost reporting year and thereafter.

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TheBalanced Budget Act of 1997 mandated the elimination of cost-based reimbursementof mental health partial hospitalization services (except as stated below). Asa result, PPS for Partial Hospitalization Programs (“PHP”) was implementedgenerally effective August 1, 2000. The resulting reimbursement for partialhospitalization services based on the Medicare outpatient PPS utilizes a fixedreimbursement amount per patient day. These rates lowered Medicarereimbursement levels to many hospitals for partial hospitalization services.This change, in general, adversely affected the ability of the Company tomaintain and/or obtain management contracts for partial hospitalizationservices and the amount of fees paid to the Company under such contracts.  The base reimbursement rate, for partialhospitalization programs operating under PPS, decreased from $287 per day for2004 to $281 effective January 1, 2005. On November 2, 2005, CMS decreased this rate by 15% to $246 effectiveJanuary 1, 2006.  However, the Company atthis time has not ascertained specifically the effect of this change on a facilty-by-faciltybasis and cannot be definitive about its overall effect.  Hospitals that are in a designated rural areaand have less than 100 acute care beds effectively were able to continue costbased reimbursement for PHP services initially until December 31, 2003.However, on December 8, 2003, this was extended to December 31, 2005 with thepassage of the Medicare Prescription Drug Improvement and Modernization Act of2003.  The Deficit Reduction Act of 2005,enacted on February 8, 2006, effectively extends cost based reimbursement for 3additional years, although at 95% of cost for CY 2006, 90% for CY 2007, and 85%for CY 2008.  This change inreimbursement methodology may lower Medicare reimbursement levels for this typeof hospital.

*PhysicalRehabilitation Reimbursement Changes*

Acuterehabilitation units within acute-care hospitals were previously eligible asexempt DPU’s under a cost-based reimbursement system prior to January 1,2002.  Beginning January 1, 2002, acuterehabilitation units began transitioning to PPS.  As of September 1, 2003 all physicalrehabilitation services have been transitioned to the PPS.

On August 1, 2006,CMS published a final rule to change the inpatient rehabilitation facility PPSpayment methodology to be effective October 1, 2006.  The final rule incorporates a market basketincrease of 3.3% and continues the increase in the payment rate adjustment forinpatient rehabilitation facilities in rural areas at 21.30%.  CMS is also incorporating a 2.6%across-the-board reduction in the standard payment amount based on recentevidence indicating that coding increases, rather than actual changes inpatient acuity, have caused increases in payments to inpatient rehabilitationfacilities. The final rule also refined the inpatient rehabilitation facilityclassification system to reflect recent data on case mix groups, relativeweights and the impact of illnesses or conditions other than the admittingdiagnosis on the costs of treating a beneficiary.  For Federal Fiscal Year 2007 the wage indexwill be solely based on Core Based Statistical Areas (CBSA’s) designated wageindices.  The Company does not believethis final rule will have a significant impact on its revenues fromrehabilitation services.

CMS published final rules in the May 7, 2004 FederalRegister to modify the criteria for being classified as an inpatientrehabilitation facility.  The final rule,known as the “75% Rule”, generally required that in order to meet thequalification requirement, 75% of the patients of a physical rehabilitationservices unit must have certain qualifying medical conditions.  The rule provided for a 4-year phase-inperiod for cost reporting periods beginning on or after July 1, 2004.  The August 1, 2006 final rule amends theexisting 75% rule, by delaying the imposition of the full 75% threshold by oneyear.  For providers with cost reportingperiods that start on or after July 1, 2006 and before July 1, 2007, thecompliance threshold will be 60%.  Forproviders with cost reporting periods starting on or after July 1, 2007 andbefore July 1, 2008, the compliance threshold will be 65%.  For all cost reporting periods beginning onor after July 1, 2008, the compliance threshold will be 75%.   The final rules as adopted, unless suspendedor modified, could have an adverse effect on the rehabilitation programsmanaged by the Company.

***Potential Adverse Impacts ofChanges in Reimbursement***

TheMedicare and Medicaid programs are subject to statutory and regulatory changes,retroactive and prospective rate adjustments, administrative rulings andfunding restrictions, any of which could have the effect of limiting orreducing reimbursement levels to general acute care hospitals and freestandingpsychiatric hospitals for behavioral health and physical rehabilitationservices provided by programs managed or facilities owned by the Company. TheCompany cannot predict whether any changes to such government programs will beadopted or, if adopted, the effect, if any, such changes will have on theCompany.

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Also,Medicare retrospectively audits cost reports of client hospitals upon whichMedicare reimbursement for services rendered in the programs managed by theCompany is based. Accordingly, the Company could be contractually obligated tomake refunds to client hospitals for prior year cost reports that have not beenaudited and settled at the date hereof. The cost reports are prepared by the client hospitals independent of theCompany, which does not participate in, nor offer advice on, theirpreparation.  Any significant decrease inMedicare reimbursement levels, the imposition of significant restrictions onparticipation in the Medicare program, or the disallowance by Medicare of anysignificant portion of the client hospital’s costs, including the fee to theCompany, where the Company has a reimbursement denial repayment obligation,could adversely affect the Company.  Inaddition, there can be no assurance that hospitals which offer behavioralhealth or physical rehabilitation programs now or hereafter managed by theCompany will satisfy the requirements for participation in Medicare or Medicaidprograms.

Payors,including Medicare and Medicaid, are attempting to manage costs, resulting indeclining amounts paid or reimbursed to hospitals for the services provided forinpatient services. As a result, the number of patients served by general acutecare and freestanding psychiatric hospitals on a per diem, episodic orcapitated basis may increase in the future. There can be no assurance that ifamounts paid or reimbursed to hospitals decline, it will not adversely affectthe Company.

The target rate limitations, the PPS limitations, andother rules such as the 75% Rule, have resulted, or may result, in some cases,in decreased amounts reimbursed to the Company’s client hospitals.  This decrease in reimbursement has led, ormay lead, in some cases, to the renegotiation of a lower contract managementfee structure for the Company and in other cases has resulted, or may result,in termination or non-renewal of the management contract, or closure of theprogram.  Similarly such limitations andrules to the extent applicable, have resulted or may result, in some cases, tolower reimbursements to the Company’s owned hospital facilities and couldaffect the continued viability of the particular services or of the hospital.

*Patient Referral Laws*

Variousstate and federal laws regulate the relationships between health care providersand referral sources, including federal and state fraud and abuse lawsprohibiting individuals and entities from knowingly and willfully offering,paying, soliciting or receiving remuneration in order to induce referrals forthe furnishing of health care services or items. These federal laws generallyapply only to referrals for items or services reimbursed under the Medicare orMedicaid programs or any state health care program. The objective of these lawsis generally to ensure that the purpose of a referral is quality of needed careand not monetary gain by the referring party. Violations of such laws canresult in felony criminal penalties, civil sanctions and exclusion fromparticipation in the Medicare and Medicaid programs.

TheMedicare and Medicaid anti-kickback statute, 42 U.S.C. d1320a-7b, prohibits the knowing and willful solicitation or receipt of anyremuneration “in return for” referring an individual, or for recommending orarranging for the purchase, lease, or ordering, of any item or service forwhich payment may be made under Medicare or a state health care program.  In addition, the statute prohibits the offeror payment of remuneration “to induce” a person to refer an individual, or torecommend or arrange for the purchase, lease, or ordering of any item orservice for which payment may be made under the Medicare or state health careprograms.  The statute containsexceptions for certain discounts, group purchasing organizations, employmentrelationships, waivers of coinsurance by community health centers, healthplans, and practices defined in regulatory safe harbors.

OnApril 3, 2003 the Office of the Inspector General of the Department of Healthand Human Services (“OIG”) issued an advisory opinion in which it declined toprovide prospective protection from the Medicare Anti-Kickback Statue to aproposed contract to manage rehabilitation services under which thecompensation was based on a variable fee. The OIG opinion was only applicable to the specific situation presentedand did not advise that variable fees were improper in and of themselves.  Under a significant number of its managementcontracts, the Company receives a variable fee related in part to average dailypatient census or number of admissions or discharges in a given period for thebehavioral health or physical rehabilitation program. In addition, the Companyhas entered into agreements with physicians to serve as medical directors atthe behavioral health and physical rehabilitation programs and facilitiesmanaged by the Company, which generally provide for payments to such persons bythe Company as compensation for their administrative services.  These medical directors also generallyprovide professional services at such programs and facilities.  In 1991, regulations were issued underfederal fraud and abuse laws creating certain “safe harbors” for relationshipsbetween health care providers and referral sources.  Any relationship that satisfies the terms ofthe safe harbor is considered permitted. Failure to satisfy a safe harbor, 

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however, does notmean that the relationship is prohibited. Although the contracts and relationships between the Company and itsclient hospitals and medical directors are not within the safe harbors, theCompany believes that such contracts and relationships comply with applicablelaws.  There can be no assurance,however, that the Company’s activities, while not challenged thus far, will notbe challenged by regulatory authorities in the future.

TheOmnibus Budget Reconciliation Act of 1993 contains provisions (“Stark II”)prohibiting physicians from referring Medicare and Medicaid patients to anentity with which the physician has a “financial relationship” for thefurnishing of a list of “designated health services” including physicaltherapy, occupational therapy, home health services, and others.  If a financial relationship exists, the entityis generally prohibited from claiming payment for such services under theMedicare or Medicaid programs. Compensation arrangements are generally exempted from the Starkprovisions if, among other things, the compensation to be paid is set inadvance, does not exceed fair market value and is not determined in a mannerthat takes into account the volume or value of any referrals or other businessgenerated between the parties.

Otherprovisions in the Social Security Act authorize other penalties, includingexclusion from participation in Medicare and Medicaid, for variousbilling-related offenses.  HHS can alsoinitiate permissive exclusion actions for such improper billing practices assubmitting claims “substantially in excess” of the provider’s usual costs orcharges, failure to disclose ownership and officers, or failure to disclosesubcontractors and suppliers.  ExecutiveOrder 12549 prohibits any corporation or facility from participating in federalcontracts if it or its principals have been disbarred, suspended or areineligible, or have been voluntarily excluded, from participating in federalcontracts.  A principal has been definedas an officer, director, owner, partner, key employee or other person with primarymanagement or supervisory responsibilities.

Additionally “HIPAA”granted expanded enforcement authority to HHS and the U.S. Department ofJustice (“DOJ”), and provided enhanced resources to support the activities andresponsibilities of the Office of Inspector General (“OIG”) of HHS and DOJ byauthorizing large increases in funding for investigating fraud and abuseviolations relating to health care delivery and payment.  On January 24, 1997, the OIG issuedguidelines for the Fraud and Abuse Control Program as mandated by the Act, andon February 19, 1997 issued an interim final rule establishing procedures forseeking advisory opinions on the application on the anti-kickback statute andcertain other fraud and abuse laws.  The1997 Balanced Budget Act also includes numerous health fraud provisions,including: new exclusion authority for the transfer of ownership or controlinterest in an entity to an immediate family or household member inanticipation of, or following, a conviction, assessment, or exclusion;increased mandatory exclusion periods for multiple health fraud convictions,including permanent exclusion for those convicted of three health care-relatedcrimes; authority of the Secretary to refuse to enter into Medicare agreementswith convicted felons; new civil money penalties for contracting with anexcluded provider or violating the Medicare and Medicaid anti-kickback statute;new surety bond and information disclosure requirements for certain providersand suppliers; and an expansion of the mandatory and permissive exclusions addedby HIPAA to any federal health care program (other than the Federal EmployeesHealth Benefits Program).

Inaddition, federal and some state laws impose restrictions on referrals forcertain designated health services by physicians and, in a few states,psychologists and other behavioral health care professionals to entities withwhich they have financial relationships. The Company believes that its operations comply with these restrictionsto the extent applicable, although no assurance can be given regardingcompliance in any particular factual situation. Federal legislation has beenconsidered to expand current law from its application to Medicare and Medicaidbusiness to all payors and to additional health services.  Certain states are considering adoptingsimilar restrictions or expanding the scope of existing restrictions.  There can be no assurance that the federalgovernment or other states in which the Company operates will not enact similaror more restrictive legislation or restrictions that could, under certaincircumstances, adversely impact the Company’s operations.

*Behavioral Health Care Patient Rights*

Manystates have adopted “patient bill of rights” regulations, which set forthstandards for least restrictive treatment, patient confidentiality, patientaccess to mail and telephones, patient access to legal counsel and requirementsthat patients be treated with dignity. There are also laws and regulations relating to the civil commitment ofpatients to behavioral health programs, disclosure of information concerningpatient treatments and related matters. The Company believes that its operations comply with the laws andregulations, although no assurance can be given regarding compliance in anyparticular factual situation.

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**ITEM 1A.****               RISK FACTORS**

The business and prospects of the Company are subject to the risksdescribed below and other portions of this report.  If any of the following risks or other risksand uncertainties that are not yet identified or that we currently think areimmaterial actually occur, our business, financial condition and results ofoperations could be materially and adversely affected.

***The Company has announced that it hasretained UBS Securities, LLC as its financial advisor to assist the Company inexploring strategic alternatives to enhance shareholder value.***

OnOctober 6, 2006, the Company announced that it has engaged UBS Securities, LLCto assist the Board of Directors in evaluating the assets and operations of theCompany in order to review possible alternative strategies to achieve greatershareholder value.  These alternativesmay include a complete or partial sale of the Company, a merger, or a decisionto take no action at this time.  Noassurance can be given that a transaction will be pursued or, if a transactionis pursued, that it will be consummated. If a transaction is eventually consummated, no assurance can be givenwith respect to the terms and conditions thereof, including the price.

***If******we fail tocomply with extensive laws and government regulations, we could sufferpenalties or be required to make significant changes to our operations.***

Thehealth care industry is required to comply with extensive and complex laws andregulations at the federal, state and local government levels relating to,among other things:

·      billing for services;

·      relationshipswith physicians and other referral sources;

·      adequacyof medical care;

·      quality of medical equipment and services;

·      qualificationsof medical and support personnel;

·      confidentiality, maintenance and security issues associated withhealth-related information and medical records;

·      licensure;

·      hospitalrate or budget review;

·      operatingpolicies and procedures; and

·      addition of facilities and services.

Among these lawsare the anti-kickback provision of the Social Security Act (the “Anti-kickbackStatute”) and the provision of the Social Security Act commonly known as the “StarkLaw.”  These laws impact therelationships that certain health care providers, including our clienthospitals and the behavioral health facilities we operate, may have withphysicians and other referral sources. The Office of Inspector General (OIG) of the Department of Health andHuman Services (“HHS”) has enacted safe harbor regulations that outlinepractices that are deemed protected from prosecution under the Anti-kickbackStatute.  The current relationships thatour client hospitals or we have with physicians and other referral sources maynot qualify for safe harbor protection under the Anti-kickback Statute.

In order to comply with the Stark Law, the financialrelationships between certain health care providers and physicians and theirimmediate family members must meet an exception.  We structure and believe our client hospitalsstructure our respective relationships to meet an exception to the Stark Law,but the regulations 

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implementing the exceptions, some of which are still under review, aredetailed and complex, and certain of these relationships may not fully complywith the Stark Law.

If we fail to comply with the Anti-kickback Statute,the Stark Law or other applicable laws and regulations, we could be subjectedto penalties, including criminal penalties, civil penalties (including the lossof our licenses to operate one or more inpatient behavioral health facilities),and exclusion of one or more of our inpatient behavioral health facilities fromparticipation in the Medicare, Medicaid and other federal and state health careprograms. In addition, if we do not operate our inpatient facilities inaccordance with applicable law, the facilities may lose their licenses or theability to participate in third party reimbursement programs.  Our client hospitals face similar risks.

Different interpretations or enforcement of theselaws and regulations could subject our current or past practices or our clienthospitals to allegations of impropriety or illegality or could require us orour client hospitals to make changes in our respective facilities, equipment,personnel, services, capital expenditure programs and operating expenses.  A determination that we or our clienthospitals have violated these laws or regulations, or the public announcementthat we or they are being investigated for possible violations of these laws orregulations, could have a material adverse effect on our business, financialcondition, results of operations or prospects and our business reputation couldsuffer significantly. In addition, other similar legislation or regulations atthe federal or state level may be adopted.

***If the availability and amount of reimbursements toour client hospitals or our owned facilities by third party payors decreases,then our revenue and earnings could decrease.***

Insurers, managed care companies and governmentalpayors, including Medicare and Medicaid, have instituted cost containmentmeasures designed to limit payments made to health care providers including ourclient hospitals and owned facilities. The availability and amount of thereimbursements impact the decisions of acute care hospitals regarding whetherto offer behavioral health services pursuant to management contracts with us,as well as their decisions on whether to renew such contracts and the amountspaid to us thereunder.

OnNovember 15, 2004, Centers for Medicare and Medicaid Services (CMS), a federal agencywithin the U.S. Department of Health and Human Services (HHS), published finalregulations adopting a prospective payment system (PPS) for inpatientbehavioral health services, which have historically been reimbursed based onreasonable cost, subject to a discharge ceiling.  CMS has begun phasing in the PPS over afour-year period.  The new system paysinpatient behavioral health facilities a per diem base rate adjusted by factorsthat influence the cost of an individual patient’s care, such as each patient’sdiagnosis related group, certain other medical and psychiatric coexistingconditions that may complicate treatment and age.  The final regulations provide for stop losspayments at 70%, which is calculated on the PPS portion of the transitional ratecompared to what behavioral health facilities and units in general acute carehospitals would have received under the old payment system.  This stop loss provision expires at the endof the transition, i.e. when the facility is paid 100% of the PPS rate.  The prospective payment system rules mayresult in decreased reimbursements to our client hospitals and may lead torenegotiated contract management fees which could have an adverse effect on ourrevenues from behavioral health programs we manage.

On May7, 2004, CMS published a final rule to modify the criteria for being classifiedas an inpatient rehabilitation facility. The final rule, known as the “75% Rule,” generally required that inorder to meet the qualification requirement, 75% of the patients of a physicalrehabilitation services unit must have certain qualifying medicalconditions.  The final rule had afour-year phase-in period and eliminated polyarthritis and other medicalconditions as qualifying medical conditions. On August 1, 2006, CMS published a final rule amending the existing 75%rule by delaying the imposition of the full 75% threshold by one year.  Regardless of the one year delay, the resultis that certain patients that previously satisfied a qualifying medicalcondition do not meet a qualifying medical condition under the new rule. Thefinal rules together with similar prospective payment rules previously adoptedfor physical rehabilitation services have resulted and may continue to resultin decreased reimbursements to our client hospitals which has led and maycontinue to lead to, among other things, renegotiated contract management feeswhich could have an adverse effect on our revenues from rehabilitation programswe manage.

The Medicare and Medicaid programs are subject to additionalstatutory and regulatory changes, retroactive and prospective rate adjustments,administrative rulings and funding restrictions, any of which could have theeffect of limiting or reducing reimbursement levels to general acute carehospitals and freestanding behavioral health facilities for behavioral healthand physical rehabilitation services provided by programs we 

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manage or facilities we own/operate. Other future federal and statelegislation and regulations may also result in reductions in the payments wereceive for our services.

With regard to the prospective payment system forservices provided by inpatient behavioral health care hospitals the per diemamounts are calculated in part based on national averages, but will be adjustedfor specific facility characteristics that increase the cost of patientcare.  The base rate per diem is intendedto compensate a facility for costs incurred to treat a patient with aparticular diagnosis, including nearly all labor and non-labor costs of furnishingcovered inpatient behavioral health care services as well as routine, ancillaryand capital costs.  Payments rates forindividual inpatient facilities will be adjusted to reflect geographicdifference in wages and will allow additional outlier payments for expensesassociated with extraordinary cases. Additionally, rural providers will receive an increased paymentadjustment.  Medicare will pay this perdiem amount, as adjusted, regardless of whether it is more or less than ahospital’s actual costs.  The per diemwill not, however include the costs of bad debt and certain other costs thatare paid separately.

Future federal and state legislation may reduce thepayments we receive for our services.

Insurance and managed care companies and other thirdparties from whom we receive payment in our owned hospitals are increasinglyattempting to control health care costs by requiring that facilities discounttheir fees in exchange for exclusive or preferred participation in theirbenefit plans.  This trend may continueand may reduce the payments received by us for our services.

A significant number of our management contractsrequire us to refund or renegotiate some or all of our management fee if eitherreimbursement for services provided to patients of the program we manage isdenied or the fee paid to us is denied as a reimbursable cost. Medicareretrospectively audits cost reports of client hospitals upon reimbursement forservices rendered.

Some of our management contracts provide forrenegotiation of their terms if the Medicare or Medicaid reimbursement for themental health or physical rehabilitation services provided by the clienthospital drop below a certain level. Any significant decrease in Medicare orMedicaid reimbursement levels, the imposition of significant restrictions onparticipation in the Medicare or Medicaid programs, or the disallowance of anysignificant portion of a hospital’s costs, including the management fee paid tous, may reduce our revenues.

Furthermore,facilities which offer behavioral health or physical rehabilitation programsnow or hereafter managed or owned/operated by us may not satisfy therequirements for participation in the Medicare or Medicaid programs.

***Recently acquired businesses and facilities, and businessesor facilities acquired in the future, will expose us to increased operatingrisks.***

Weacquired two freestanding behavioral health facilities in fiscal 2004, threefreestanding behavioral health facilities in fiscal 2005, and ten freestandingbehavioral health facilities in fiscal 2006. As part of our growth strategy, we intend to continue to pursueadditional acquisitions, leases, joint ventures and similar transactions.

Thisexpansion exposes us to additional business and operating risks anduncertainties, including:

·      theability to effectively assimilate and manage acquired behavioral healthfacilities;

·      the ability to realize our investment in theacquired behavioral health facilities;

·      the diversion of management’s time and attentionfrom other business concerns;

·      the risksof entering markets in which we may have no or limited direct prior experience;

·      thepotential loss of key employees of the acquired behavioral health facilities;

·      the riskthat an acquisition could reduce our future earnings;

·      the exposureto unknown liabilities; and

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·      ourability to meet contractual obligations.

If we are unable to assimilate activities of theacquired behavioral health facilities and manage this expansion efficiently oreffectively, or are unable to attract and retain additional qualifiedmanagement personnel to run the expanded operations, it could result infinancial expenditures and increased demands on management’s time and couldhave a material adverse effect on our business, financial condition and resultsof operations.

Ifwe fail to improve the operations of acquired inpatient facilities, we may beunable to achieve our growth strategy.

Wemay be unable to maintain or increase the profitability of or operating cashflows at, any existing hospital or other acquired inpatient facility,effectively integrate the operations of any acquisition or otherwise achievethe intended benefit of our growth strategy. To the extent that we are unable to enroll in third party payor plans ina timely manner following an acquisition, we may experience a decrease in cashflow or profitability.

***If competition decreases our ability to acquire additionalinpatient behavioral health facilities on favorable terms, we may be unable toexecute our acquisition strategy.***

An important part of our business strategy is toacquire inpatient behavioral health facilities in attractive markets.  Some of our competitors have greaterfinancial resources and a larger, more experienced development stafffocused on identifying and completing acquisitions.  Inaddition, we may compete with not-for-profit entities that operate on atax-exempt basis.

***Regulatory requirements regarding inpatient behavioralhealth facilities could delay or prevent the acquisition of additionalfacilities.***

Some behavioral health facility acquisitions mayrequire a longer period to complete than acquisitions in other industries andmay be subject to additional regulatory uncertainty. Many states have adoptedlegislation restricting the sale or other disposition of facilities operated bynot-for-profit entities. In other states that do not have specific legislation,the attorneys general have demonstrated an interest in these transactions undertheir general obligations to protect charitable assets from waste. Theselegislative and administrative efforts focus primarily on the appropriatevaluation of the assets divested and the use of the proceeds of the sale by thenot-­for-profit seller. In addition, the acquisition of facilities in certainstates requires advance regulatory approval under “certificate of need” orstate licensure regulatory regimes. These state-level procedures couldseriously delay or even prevent us from acquiring inpatient facilities, evenafter significant transaction costs have been incurred.

***Additional financing may be necessary to fund ouracquisition program and capital expenditures, and the financing may not beavailable when needed or may subject us to risks.***

Ouracquisition program requires substantial capital resources.  Likewise, the operation of existing inpatientbehavioral health facilities requires ongoing capital expenditures forrenovation, expansion and the upgrade of equipment and technology.  Our level of indebtedness at any time may restrict our ability to borrow additional funds. If we are notable to obtain financing, we may not be able to consummate acquisitions or undertake capitalexpenditures.

Currently we have approximately $99.0 millionoutstanding on the Company’s $175 million revolving credit facility.  Additionally, we expect to incur additionalindebtedness in the future.

Our borrowed indebtedness could have importantconsequences, including:

·      increasing our vulnerability to general adverse economic andindustry conditions;

·      requiring that an increased portion of our cash flow from operations beused for the payment of interest on our debt, thereby reducing our ability touse this cash flow to fund working capital, capital expenditures, acquisitionsand general corporate requirements;

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·      limiting our ability to sell assets,including capital stock of our restricted subsidiaries, merge or consolidatewith other entities, and engage in transactions with our affiliates;

·      limiting our ability to obtain additionalfinancing to fund future working capital, capital expenditures, acquisitionsand general corporate requirements; 

·      limiting our flexibility in planning for, or reacting to, changes inour business and the health care industry;

·      restricting our ability orthe ability of our restricted subsidiaries to pay dividends or make otherpayments; and

·      placing us at a competitivedisadvantage to our competitors that have less indebtedness.

In addition, our revolving credit facility requiresus to maintain and meet specified financial ratios and tests that may requirethat we take action to reduce our debt or to act in a manner contrary to ourbusiness objectives. Events beyond our control, including changes in generalbusiness and economic conditions, may affect our ability to meet those financialratios and tests.  A breach of any ofthese covenants would result in a default under our revolving creditfacility.  If an event of default underour revolving credit facility occurs, the lenders could elect to declare allamounts outstanding thereunder, together with accrued, but unpaid, interest, tobe immediately due and payable.

***Failure to renew contracts or extend contracts on the sameterms may result in a significant decrease in our revenue.***

Approximately 32% of our revenues for the year endedAugust 31, 2006 were derived from management contracts with general acute carehospitals to manage behavioral health and physical rehabilitation clinicalprograms of those hospitals.  Thecontracts generally have initial terms of three to five years and many haveautomatic renewal terms subject to termination by either party.  The contracts often provide for earlytermination either by the client hospital if specified performance criteria arenot satisfied or by us under various other circumstances.  Although our management contracts arefrequently renewed or extended prior to their stated expiration dates, somecontracts expire without renewal and others are terminated by us or the clienthospital for various reasons prior to their scheduled expiration.  Our continued success is subject to theability to renew or extend existing management contracts and obtain newmanagement contracts.  Contract renewalsand extensions are likely to be subject to competing proposals from othercontract management companies as well as consideration by certain hospitals toconvert from independently managed programs to programs operated internally orto terminate their programs in order to reassign patient beds for other healthcare purposes.  A client hospital may notcontinue to do business with us following expiration or termination of itsmanagement contract.  In addition, anylimitations or reductions in reimbursements for services provided by programsmanaged by us could result in a reduction in the management fees paid to us orthe early termination of existing management contracts and would adverselyaffect our ability to renew or extend existing management contracts and toobtain new management contracts.  Thetermination or non-renewal of a material number of management contracts couldresult in a significant decrease in our net revenues.

***We may be required to spend substantialamounts of capital to comply with legislative and regulatory initiativesrelating to privacy and security of patient health information and standardsfor electronic transactions.***

There are currently numerous legislative andregulatory initiatives at the federal and state levels addressing patientprivacy and security concerns. In particular, federal regulations issued underthe Health Insurance Portability Accountability Act of 1996 (HIPAA) containprovisions that have required, and in the future may require, our facilities toimplement costly new computer systems and to adopt business procedures designedto protect the privacy and security of each of their patients’ individuallyidentifiable health and related financial information.  The privacy regulations have had a financialimpact on the health care industry because they impose extensive newadministrative requirements, restrictions on the use and disclosure ofindividually identifiable patient health and related financial information,provide patients with new rights with respect to their health information andrequire our inpatient facilities to enter into contracts extending many of theprivacy regulation requirements to third parties who perform functions on ourbehalf involving health information.

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On February 20, 2003, HHS issued final securityregulations under HIPAA. Compliance with these security regulations wasrequired by April 21, 2005 for most health care organizations, including ourinpatient facilities. These security regulations require our inpatientfacilities to implement administrative, physical and technical safeguards toprotect the integrity, confidentiality and availability of electronicallyreceived, maintained or transmitted patient individually identifiable healthand related financial information. Compliance with these regulations requires substantial expenditures thatcould negatively impact our financial results. In addition, our management hasspent, and may spend in the future, substantial time and effort on compliancemeasures.

HHS has issued regulations requiring most healthcare organizations, including our behavioral health facilities, to use standarddata formats and code sets when electronically transmitting information inconnection with several types of transactions, including health claims, healthcare payment and remittance advice and health claim status transactions.  Violations of the privacy, security and transactionregulations could subject our inpatient facilities to civil penalties of up to$25,000 per calendar year for each provision contained in the privacy, securityand transaction regulations that is violated and criminal penalties of up to$250,000 per violation for certain other violations.

***We face significant uncertainties associated with healthcare legislation.***

In addition to extensive government health careregulation, there are numerous initiatives on federal and state levels forcomprehensive reforms affecting the payment for and availability of health careservices.  We are not certain whatlegislation on health care reform may ultimately be proposed or enacted orwhether other changes in the administration or interpretation of governmental healthcare programs will occur.  Currentlyproposed or future health care legislation or other changes in theadministration or interpretation of governmental health care programs may havean adverse effect on us.

***Other companies within the health care industrycontinue to be the subject of federal and state investigations, which increasesthe risk that we may become subject to investigations in the future.***

Both federal and state government agencies as wellas private payors have heightened and coordinated civil and criminalenforcement efforts as part of numerous ongoing investigations of health careorganizations. These investigations relate to a wide variety of topics,including:

·      cost reportingand billing practices;

·      quality of care;

·      financial relationships withreferral sources;

·      medicalnecessity of services provided; and

·      treatment of uninsured patients.

The OIG and theU.S. Department of Justice (DOJ) have, from time to time, undertaken nationalenforcement initiatives that focus on specific billing practices or othersuspected areas of abuse. Moreover, health care providers are subject to civiland criminal false claims laws, including the federal False Claims Act, whichallows private parties to bring whistleblower lawsuits against privatecompanies doing business with or receiving reimbursement under federal healthcare programs. Some states have adopted similar state whistleblower and falseclaims provisions. Publicity associated with the substantial amounts paid byother health care providers to settle these lawsuits may encourage our currentand former employees and other health care providers to bring whistleblowerlawsuits. Any investigations of our client hospitals or us could result insignificant liabilities or penalties as well as adverse publicity.

***We may be subject to claims and legal actions for damagesand other expenses that are not covered by insurance.***

We are, and may be in the future, party to litigation arising in thecourse of our business. Our insurance policies may not be adequate tosubstantially cover liabilities arising out of those claims or even cover anyof such claims. Any material claim that is not covered by insurance may have anadverse effect on our business. Claims against us, regardless of their merit oroutcome, may also have an adverse effect on our reputation and business.

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Facilitiesacquired by us may have unknown or contingent liabilities, includingliabilities related to patient care and liabilities for failure to comply withhealth care laws and regulations, which could result in large claims andsignificant defense costs. Although we generally seek indemnification coveringthese matters from prior owners of facilities we acquire, such indemnificationis often limited and material liabilities for past activities of acquiredfacilities may exist and such prior owners may not be able to satisfy theirindemnification obligations.  We are alsosusceptible to being named in claims brought related to patient care and othermatters at inpatient facilities owned by third parties and at which we providecontract management services.

In late 1999, a civil qui tam lawsuit brought underthe Federal False Claims Act was filed under seal naming our psychiatriccontract management subsidiary, Horizon Mental Health Management, Inc., as oneof the defendants in the lawsuit.  InMarch 2001, the relators served the complaint in the lawsuit.  The lawsuit is *United States ex reI Debra Hockett, M.D., Linda Thompson, M.D., andChyrissa Staley, RN, Plaintiffs, v. ColumbialHCA Healthcare Corp., Indian PathHospital, Inc., Horizon Mental Health Management, Inc. and Superior Home Healthof East**Tennessee, Inc.,Defendants,*01-MS-50 (RCL) (Part of Civil No. 99-3311 (RCL)), United States District Court for theDistrict of Columbia.  The DOJ hadpreviously declined to intervene in the lawsuit.  The complaint alleges that certain of ouron-site personnel acted in concert with other non-Company personnel toimproperly inflate certain Medicare reimbursable costs associated withpsychiatric services rendered at a Tennessee hospital prior to August1997.  The complaint also alleges thatthe same actions occurred at other hospitals owned by the owner of theTennessee hospital, a co-defendant in the suit, some of which also hadmanagement contracts with the Company. The parties are in discovery proceedings and no trial date has beenset.  Any judgment in this suit againstus would not be covered by insurance.

***The loss of our key management personnel orour inability to attract and retain qualified clinical management, marketingand other personnel could have a material adverse effect on our businessoperations.***

Our continued success depends upon our executiveofficers and members of our management team, the loss of one or more of whomcould adversely affect our business operations. Our success and growth strategy also depend on our ability to attractand retain qualified clinical, management, marketing and other personnel. Wecompete with general acute care hospitals and other health care providers forthe services of psychiatrists, psychologists, social workers, therapists,physical therapists and other clinical personnel.  Demand for clinical personnel for physicalrehabilitation purposes is high and they are often subject to competing offersof employment. We may not be able to attract and retain the qualified personnelnecessary for our business in the future.

***We operate in a highly competitive environment. If we do notcompete effectively in our markets, then we could lose market share.***

Thehealth care industry is highly competitive and subject to continual changes inthe method in which services are provided and the types of companies providingservices.  We compete with severalnational competitors and many regional and local competitors, some of whichhave greater resources than us.  Inaddition, acute care hospitals could elect to manage their own behavioralhealth or physical rehabilitation programs.

Competition among contract managers forhospital-based behavioral health and physical rehabilitation programs isgenerally based upon reputation for quality, price, the ability to providefinancial and other benefits for the hospital, and the management, operationaland clinical expertise necessary to enable the hospital to offer behavioralhealth and physical rehabilitation programs that provide the full continuum ofbehavioral health and physical rehabilitation services in a quality andcost-effective manner.  The pressure toreduce health care expenditures has strengthened the need to manage theappropriateness of behavioral health and physical rehabilitation servicesprovided to patients.

In addition, acute care hospitals offering behavioralhealth and physical rehabilitation programs managed by us compete for patientswith other providers of behavioral health care services, including other acutecare hospitals, freestanding behavioral health facilities, independentpsychiatrists and psychologists, and with other providers of physicalrehabilitation services, including other acute care hospitals, freestandingrehabilitation facilities and outpatient facilities.

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***There are potential risks associated with our goodwill andother intangible assets.***

AtAugust 31, 2006, goodwill and net intangible assets represented 47.4% of ourtotal assets.  In the event we are sold orliquidated, the value of our intangibleassets may not be realized.  In addition,any significant decrease in the valueof our intangible assets could havea material adverse effect on us.

Under current generally accepted accounting principles, we are required to test impairment of goodwill and intangible assets atleast annually.  Because of thesignificance of goodwill and the identifiedindefinite lived assets to our consolidated balance sheet, impairment analysesare important.  Changes in keyassumptions about our business and its prospects, or changes in marketconditions or other external factors, could result in an impairment charge andsuch a charge could have a material adverse effect on our financial conditionand results of operations.

***As a provider of health careservices, we are subject to claims and legal actions by patients and others.***

Weare subject to medical malpractice and other lawsuits due to the nature of theservices we provide.  Facilities acquiredby us may have unknown or contingent liabilities, including liabilities relatedto patient care and liabilities for failure to comply with health care laws andregulations, which could result in large claims and significant defensecosts.  Although we generally seekindemnification covering these matters from prior owners of facilities weacquire, material liabilities for past activities of acquired facilities mayexist and such prior owners may not be able to satisfy their indemnificationobligations.  We are also susceptible tobeing named in claims brought related to patient care and other matters atinpatient facilities owned by third parties and operated by us.

To protect ourselves from the cost of these claims,professional malpractice liability insurance and general liability insurancecoverage is maintained in amounts and with deductibles common in theindustry.  There are no assurances thatour insurance will cover all claims (e.g., claims for punitive damages) or thatclaims in excess of our insurance coverage will not arise.  A successful lawsuit against us that is notcovered by, or is in excess of, our insurance coverage may have a materialadverse effect on our business, financial condition and results ofoperations.  This insurance coverage maynot continue to be available at a reasonable cost, especially given thesignificant increase in insurance premiums generally experienced in the healthcare industry.

***We depend on our relationships withphysicians who use our inpatient facilities.***

Ourbusiness depends upon the efforts and success of the physicians who providehealth care services at our inpatient facilities and the strength of therelationships with these physicians.

Ourbusiness could be adversely affected if a significant number of physicians or agroup of physicians:

·      terminate their relationship with, or reducetheir use of, our inpatient facilities;

·      fail to maintain acceptable quality of careor to otherwise adhere to professional standards;

·      suffer damage to their reputation; or

·      exit the market entirely.

***Our stock price could be volatile.***

Themarket price of our common stock could fluctuate significantly in response tovarious factors, including:

·      problems achieving revenue enhancements andoperating efficiencies;

·      actual and estimated earnings and cash flows;

·      quarter-to-quarter variations in operatingresults;

·      changes in market conditions in thebehavioral health care industries;

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·      changes in general economic conditions;

·      fluctuations in the securities markets ingeneral;

·      operating results differing from analysts’estimates; and

·      changes in analysts’ earnings estimates.

**ITEM 1B.****             ****UNRESOLVED STAFF COMMENTS**

None.

**ITEM 2.****                 PROPERTIES**

The Company’s National Support Center in the Dallas suburb ofLewisville, Texas, contains approximately 80,000 square feet of office &training facility space and also contains an EAP Services Call Center.  

Forits freestanding behavioral health care facilities, the Company owned/leasedfifteen behavioral health care facilities with approximately 1,546 licensedbeds in 11 states and leases 1,585 square feet of office space in Chester,Virginia with a lease term expiring in February 2010.  The following table sets forth the name,location, number of licensed beds and the acquisition date for each of theCompany’s owned and leased behavioral health care facilities. 
| Facility                                   | ** ** | **Location**          | ** ** | **Sq. Footage** | ** ** | **Licensed Beds** | ** ** | **Acquisition Date** |
|--------------------------------------------|------------|-----------------------|------------|-----------------|------------|-------------------|------------|----------------------|
| Michiana Behavioral Health  Center         |       | Plymouth, IN          |       | 44,000          |       | 80                |       | April 1, 2004        |
| Poplar Springs  Hospital                   |       | Petersburg, VA        |       | 120,390         |       | 184               |       | June 1, 2004         |
| Laurelwood Hospital                        |       | Willoughby, OH        |       | 108,542         |       | 160               |       | January 1, 2005      |
| Friends Hospital                           |       | Philadelphia, PA      |       | 320,287         |       | 219               |       | July 1, 2005         |
| River Park Hospital                        |       | Huntington, WV        |       | 179,232         |       | 165               |       | August 1, 2005       |
| River Park  Hospital                       |       | Barboursville, WV     |       | 31,355          |       | 22                |       | August 1, 2005       |
| Copper Hills Youth Center                  |       | West Jordan, UT       |       | 70,444          |       | 126               |       | January 1, 2006      |
| Kingwood Pines  Hospital                   |       | Kingwood, TX          |       | 56,844          |       | 78                |       | January 17, 2006     |
| Focus Healthcare of Florida                |       | Cooper City, FL       |       | 35,538          |       | 78                |       | February 1, 2006     |
| Focus Healthcare  of Georgia               |       | St. Simons Island, GA |       | 50,113          |       | 101               |       | February 1, 2006     |
| Lighthouse Care Center of  Augusta         |       | Augusta, GA           |       | 48,259          |       | 106               |       | February 1, 2006     |
| Focus Healthcare  of Ohio                  |       | Maumee, OH            |       | 21,068          |       | 42                |       | February 1, 2006     |
| Lighthouse Care Center of  Conway          |       | Conway, SC            |       | 54,000          |       | 104               |       | February 1, 2006     |
| Lighthouse Care  Center of Berkeley County |       | Summerville, SC       |       | 16,000          |       | —            |       | February 1, 2006     |
| Lighthouse Care Center of  Oconee          |       | Tamassee, SC          |       | 6,605           |       | 28                |       | February 1, 2006     |
| Focus Healthcare  of Delaware              |       | New Castle, DE        |       | 45,704          |       | 53                |       | April 1, 2006        |

 

Additionally, theCompany has announced that it has entered into a long-term lease agreement withSt. David’s Healthcare Partnership, LP, LLP, for the lease of St. David’sPavilion.  The Company will operate thefacility as a 48 bed free-standing psychiatric hospital subject to receipt ofrequired governmental approvals.  Thefacility will occupy approximately 28,749 square feet and is anticipated tocommence operation in the Company’s third fiscal quarter of 2007.

The space requiredfor the behavioral health and physical rehabilitation programs managed by theCompany is provided by the client acute care hospitals either within theirexisting facilities or at other locations owned or leased by the acute carehospitals.

For its employeeassistance program and managed behavioral health care businesses, the Companyleases approximately 21,194 square feet of office space primarily in theDallas, Denver, and San Diego metropolitan areas, under lease terms expiringfrom November 2006 to June 2009. The Company also leases approximately 25,000square feet under leases related to offices that the Company has, or will bevacating due to the reorganization and 

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centralization of theCompany’s EAP Services group, under lease terms expiring from October 2006 toApril 2008.  The majority of these leaseswill be expiring in the short term or the Company has subleased or is pursingsublease options.

In addition, theCompany leases approximately 4,507 square feet in the Orlando metropolitan areawith lease terms expiring from March 2007 to June 2007 for its managedbehavioral health care clinical operations that were discontinued at the end offiscal year 2005.  The two former cliniclocations are currently being sublet due to the reorganization andcentralization of the Company’s EAP Services group.

The Company considers that its properties aregenerally in good condition, well maintained, and are generally suitable andadequate to carry on the Company’s business. Use of properties is predicated on existent needs to service customerspursuant to contracts that are subject to termination or non-renewal.  The ability to vacate or sublease propertiesis subject to market conditions and other factors and exposes the Company tocertain financial risks.  Also see Note14 *“Commitments and Contingencies - PropertyLeases”* to the Notes to the Consolidated Financial Statementsincluded elsewhere herein.****

**ITEM 3.****                ****LEGAL PROCEEDINGS**

Fora discussion of the Company’s legal proceedings see the “Legal Proceedings”caption in Note 14 *“Commitments andContingencies”* in the Notes to the Consolidated Financial Statementsincluded elsewhere herein. 

**ITEM 4.****                 SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS**

Nomatters were submitted to a vote of the Company’s stockholders in the fourthfiscal quarter of fiscal 2006.

**PART II**

**ITEM 5.****                 MARKETFOR THE COMPANY’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS**

TheCommon Stock of the Company is traded on the NASDAQ National Market under thesymbol “HORC”.

Thefollowing table sets forth the “intra-day” high and low sale prices per sharefor the Common Stock of the Company as reported by the NASDAQ National Marketfor the periods indicated:
|                                             | ** ** | **High**   | ** ** | **Low**    | ** ** |
|---------------------------------------------|------------|------------|------------|------------|------------|
| **Fiscal  Year Ended August 31, 2006:**     | ** ** | ** ** | ** ** | ** ** | ** ** |
| June 1, 2006 – August 31, 2006         |       | $          | 21.96      |       | $          | 11.93 |   |
| March 1, 2006 – May 31, 2006           |       | 23.96      |       | 19.13      |       |
| December 1, 2005 – February 28, 2006   |       | 25.88      |       | 20.17      |       |
| September 1, 2005 – November 30, 2005  |       | 28.17      |       | 18.48      |       |
| ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Fiscal  Year Ended August 31, 2005 (1):** | ** ** | ** ** | ** ** | ** ** | ** ** |
| June 1, 2005 – August 31, 2005         |       | $          | 27.21      |       | $          | 20.85 |   |
| March 1, 2005 – May 31, 2005           |       | 22.64      |       | 17.50      |       |
| December 1, 2004 – February 28, 2005   |       | 17.50      |       | 11.43      |       |
| September 1, 2004 – November 30, 2004  |       | 12.00      |       | 10.15      |       |

 

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(1) The per share amountshave been restated to reflect the impact of the June 15, 2005 two- for-onestock split.

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As of October 16,2006, there were 308 stockholders of record of the Common Stock of theCompany.  As of October 24, 2006 (themost recent date that data was available to the Company) there were 1,767beneficial owners of 100 or more shares of Common Stock of the Company.

The Company hasnot paid or declared any cash dividends on its capital stock since itsinception.  The Company currently intendsto retain future earnings for use in the expansion and operation of itsbusiness.  The payment of any future cashdividends will be determined by the Board of Directors based on conditions thenexisting, including the Company’s earnings, financial condition and capitalrequirements, restrictions in financing agreements (which currently prohibitany payment of dividends), business opportunities and conditions, and otherfactors.  See “Management’s Discussionand Analysis of Financial Condition and Results of Operations – Liquidity andCapital Resources”, included elsewhere herein.

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**ITEM 6.****                 SELECTEDCONSOLIDATED FINANCIAL INFORMATION AND STATISTICAL DATA**

Theselected historical consolidated financial data presented below for the fiscalyears ended August 31, 2006, 2005 and 2004, and at August 31, 2006 and 2005,are derived from the audited Consolidated Financial Statements of the Companyincluded elsewhere in this Report. The selected historical consolidatedfinancial data presented below for the fiscal years ended August 31, 2003, andat August 31, 2004 and 2003, are derived from the audited consolidatedfinancial statements of the Company not included herein. The selected financialinformation presented below should be read in conjunction with “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” andwith the consolidated financial statements of the Company and notes theretoincluded elsewhere in this Report, including Note 5, *“Acquisitions”* describing the Company’s various acquisitionsin the periods presented. 
| ** **                                                                    | ** ** | **Fiscal Year Ended August 31,**               | ** ** |
|-------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                    | ** ** | **2006**                                                           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                    | ** ** | **(in thousands, except per share data)** | ** ** |
| **Statement  of Operations Data:**                                            | ** ** | ** **                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                                                      |       | $                                                                  | 274,961    |   | $ | 207,392 |   | $ | 161,825 |   | $ | 144,337 |   | $ | 138,402 |   |
|                                                                          |       |                                                               |       |   |   |   |   |   |   |   |   |
| Cost of services                                                              |       | 211,096                                                            |       | 160,032 |   | 121,554 |   | 109,890 |   | 104,957 |   |
| Selling, general  and administrative                                          |       | 26,605                                                             |       | 23,220 |   | 18,835 |   | 18,262 |   | 16,015 |   |
| Provision for  (recovery of) doubtful accounts                                |       | 6,256                                                              |       | 4,382 |   | 869 |   | (910 | ) | 294 |   |
| Impairment loss  on building                                                  |       | —                                                             |       | 1,015 |   | — |   | — |   | — |   |
| Depreciation and  amortization                                                |       | 5,529                                                              |       | 3,387 |   | 2,795 |   | 2,419 |   | 2,752 |   |
|                                                                          |       |                                                               |       |   |   |   |   |   |   |   |   |
| Operating income                                                              |       | 25,475                                                             |       | 15,356 |   | 17,772 |   | 14,676 |   | 14,384 |   |
| Interest and  other income (expense), net                                     |       | (5,196                                                             | )          | (1,298 | ) | (1,307 | ) | (559 | ) | (383 | ) |
|                                                                          |       |                                                               |       |   |   |   |   |   |   |   |   |
| Income before  income taxes, minority interest and discontinued operations    |       | 20,279                                                             |       | 14,058 |   | 16,465 |   | 14,117 |   | 14,001 |   |
| Income tax  provision                                                         |       | 7,976                                                              |       | 5,332 |   | 6,252 |   | 5,395 |   | 5,418 |   |
| Minority  interest, net                                                       |       | 188                                                                |       | (15 | ) | — |   | — |   | — |   |
|                                                                          |       |                                                               |       |   |   |   |   |   |   |   |   |
| Income from  continuing operations                                            |       | 12,115                                                             |       | 8,741 |   | 10,213 |   | 8,722 |   | 8,583 |   |
|                                                                          |       |                                                               |       |   |   |   |   |   |   |   |   |
| Discontinued  operations:                                                     |       |                                                               |       |   |   |   |   |   |   |   |   |
| Income (loss) from discontinued operations, net                               |       | 3                                                                  |       | (488 | ) | 562 |   | 860 |   | 341 |   |
| Income (loss) on disposal of discontinued  operations, net                    |       | 4                                                                  |       | (3,102 | ) | — |   | — |   | — |   |
| Discontinued  operations                                                      |       | 7                                                                  |       | (3,590 | ) | 562 |   | 860 |   | 341 |   |
|                                                                          |       |                                                               |       |   |   |   |   |   |   |   |   |
| Net income                                                                    |       | $                                                                  | 12,122     |   | $ | 5,151 |   | $ | 10,775 |   | $ | 9,582 |   | $ | 8,924 |   |
|                                                                          |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic earnings  per share-continuing operations (a)                           |       | $                                                                  | 0.81       |   | $ | 0.68 |   | $ | 0.94 |   | $ | 0.83 |   | $ | 0.80 |   |
| Basic earnings  per share-discontinued operations (a)                         |       | 0.00                                                               |       | (0.28 | ) | 0.05 |   | 0.08 |   | 0.03 |   |
| Total basic  earnings per share (a)                                           |       | $                                                                  | 0.81       |   | $ | 0.40 |   | $ | 0.99 |   | $ | 0.91 |   | $ | 0.83 |   |
| Weighted average  shares outstanding (a)                                 |       | 14,974                                                             |       | 12,829 |   | 10,849 |   | 10,500 |   | 10,772 |   |
|                                                                          |       |                                                               |       |   |   |   |   |   |   |   |   |
| Diluted earnings  per share-continuing operations (a)                         |       | $                                                                  | 0.79       |   | $ | 0.66 |   | $ | 0.90 |   | $ | 0.77 |   | $ | 0.73 |   |
| Diluted earnings  per share-discontinued operations (a)                       |       | 0.00                                                               |       | (0.27 | ) | 0.05 |   | 0.08 |   | 0.03 |   |
| Total diluted  earnings per share (a)                                    |       | $                                                                  | 0.79       |   | $ | 0.39 |   | $ | 0.95 |   | $ | 0.85 |   | $ | 0.76 |   |
| Weighted average  shares and dilutive potential common shares outstanding (a) |       | 15,408                                                             |       | 13,306 |   | 11,346 |   | 11,283 |   | 11,779 |   |

 

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(a) The number ofshares and per share amounts have been restated to reflect the impact of theJune 15, 2005 two- for-one stock split.

 
| **Balance  Sheet Data (at end of period):** |   |    |   |    |   |    |   |    |   |   |   |
|---------------------------------------------|--------|---------|--------|---------|--------|---------|--------|---------|--------|--------|--------|
| Cash and  short-term investments            |   | $       | 3,043  |    | $      | 8,098   |   | $       | 1,908  |   | $      | 1,973 |   | $ | 4,036 |   |
| Working capital.                            |   | 28,441  |   | 19,490  |   | 5,560   |   | 1,249   |   | 2,899  |   |
| Intangible  assets (net) (1)                |   | 150,600 |   | 81,084  |   | 87,244  |   | 74,882  |   | 68,666 |   |
| Total assets.                               |   | 317,640 |   | 187,218 |   | 145,265 |   | 102,329 |   | 92,585 |   |
| Total debt                                  |   | 106,005 |   | —  |   | 40,000  |   | 14,000  |   | 10,000 |   |
| Stockholders’ equity                   |   | 159,456 |   | 143,121 |   | 75,824  |   | 63,792  |   | 60,733 |   |
|                                             |        |         |        |         |        |         |        |         |        |        |        |  |  |  |  |  |

 

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(1)   Intangible assets consist of goodwill, as wellas service contract valuations, non-compete agreements and trademarks relatedto various acquisitions of the Company.

35

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**SUMMARYSTATISTICAL DATA**
| ** **                                                  | ** ** | **Fiscal Year Ended August 31,** | ** ** |
|-------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                  | ** ** | **2006 (1)**                                    | ** ** | **2005 (2)** | ** ** | **2004 (3)** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                  |       |                                                 |       |   |   |   |   |   |   |   |   |
| **Owned/Leased  Freestanding Behavioral Health Hospitals:** |       |                                                 |       |   |   |   |   |   |   |   |   |
| Total net  revenues (in thousands)                          |       | $                                                    | 158,333    |   | $ | 60,578 |   | $ | 10,069 |   | — |   | — |   |
| Number of  facilities in operation at period end            |       | 14                                                   |       | 5 |   | 2 |   | — |   | — |   |
| Licensed Beds                                               |       | 1,546                                                |       | 833 |   | 267 |   | — |   | — |   |
| Weighted average  available beds                            |       | 1,108                                                |       | 363 |   | 177 |   | — |   | — |   |
| Patient days                                                |       | 299,797                                              |       | 100,396 |   | 19,639 |   | — |   | — |   |
| Admissions                                                  |       | 18,984                                               |       | 6,745 |   | 1,041 |   | — |   | — |   |
| Average length  of stay                                     |       | 15.8                                                 |       | 14.9 |   | 18.9 |   | — |   | — |   |
| Revenue per  patient day                                    |       | $                                                    | 528        |   | $ | 603 |   | $ | 513 |   | — |   | — |   |
| Occupancy based  on weighted average available beds         |       | 74.1                                                 | %          | 75.8 | % | 72.5 | % | — |   | — |   |
| EBITDA Margin  (4)                                          |       | 13.1                                                 | %          | 14.5 | % | 19.4 | % | — |   | — |   |
| EBITDAR Margin  (4)                                         |       | 14.5                                                 | %          | 16.2 | % | 20.4 | % | — |   | — |   |
| ** **                                                  |       |                                                 |       |   |   |   |   |   |   |   |   |
| **Same  Facility Results:**                                 |       |                                                 |       |   |   |   |   |   |   |   |   |
| Net revenues (in  thousands)                                |       | $                                                    | 36,162     |   | $ | 35,347 |   | — |   | — |   | — |   |
| Number of  facilities at period end                         |       | 2                                                    |       | 2 |   | — |   | — |   | — |   |
| Licensed beds                                               |       | 264                                                  |       | 264 |   | — |   | — |   | — |   |
| Weighted average  available beds                            |       | 241                                                  |       | 241 |   | — |   | — |   | — |   |
| Patient days                                                |       | 70,509                                               |       | 70,282 |   | — |   | — |   | — |   |
| Admissions                                                  |       | 3,288                                                |       | 3,231 |   | — |   | — |   | — |   |
| Average length  of stay                                     |       | 21.4                                                 |       | 21.8 |   | — |   | — |   | — |   |
| Revenue per  patient day                                    |       | $                                                    | 513        |   | $ | 503 |   | — |   | — |   | — |   |
| Occupancy based  on weighted average available beds         |       | 80.2                                                 | %          | 79.9 | % | — |   | — |   | — |   |
| EBITDA Margin  (4)                                          |       | 26.1                                                 | %          | 19.7 | % | — |   | — |   | — |   |
| EBITDAR Margin  (4)                                         |       | 26.6                                                 | %          | 20.6 | % | — |   | — |   | — |   |
| ** **                                                  |       |                                                 |       |   |   |   |   |   |   |   |   |
| **EAP  Covered lives (in thousands)**                       |       | 4,464                                                |       | 4,244 |   | 3,569 |   | 3,327 |   | 2,349 |   |
| ** **                                                  |       |                                                 |       |   |   |   |   |   |   |   |   |
| **Number  of Contract Locations (5):**                      |       |                                                 |       |   |   |   |   |   |   |   |   |
| Contract  locations in operation                            |       | 107                                                  |       | 123 |   | 132 |   | 127 |   | 131 |   |
| Contract  locations signed and unopened                     |       | 9                                                    |       | 12 |   | 8 |   | 15 |   | 11 |   |
| Total contract  locations                                   |       | 116                                                  |       | 135 |   | 140 |   | 142 |   | 142 |   |
| ** **                                                  |       |                                                 |       |   |   |   |   |   |   |   |   |
| **Services  Covered by Contracts in Operation (5):**        |       |                                                 |       |   |   |   |   |   |   |   |   |
| Inpatient                                                   |       | 105                                                  |       | 121 |   | 129 |   | 126 |   | 127 |   |
| Partial hospitalization                                     |       | 8                                                    |       | 10 |   | 17 |   | 25 |   | 31 |   |
| Outpatient                                                  |       | 17                                                   |       | 21 |   | 24 |   | 21 |   | 21 |   |
| Home health                                                 |       | 0                                                    |       | 1 |   | 2 |   | 3 |   | 3 |   |
| CQI+                                                        |       | 98                                                   |       | 110 |   | 105 |   | 109 |   | 158 |   |
| ** **                                                  |       |                                                 |       |   |   |   |   |   |   |   |   |
| **Types  of Treatment Programs in Operation (5):**          |       |                                                 |       |   |   |   |   |   |   |   |   |
| Geropsychiatric                                             |       | 63                                                   |       | 79 |   | 85 |   | 87 |   | 106 |   |
| Adult psychiatric                                           |       | 41                                                   |       | 43 |   | 49 |   | 48 |   | 44 |   |
| Substance abuse                                             |       | 2                                                    |       | 2 |   | 4 |   | 4 |   | 2 |   |
| Physical rehabilitation                                     |       | 23                                                   |       | 28 |   | 33 |   | 32 |   | 28 |   |
| Other behavioral  health                                    |       | 2                                                    |       | 4 |   | 4 |   | 8 |   | 2 |   |

 

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(1)  During fiscal year 2006, theCompany operated the Copper Hills Youth Center for eight months, Kingwood PinesHospital for seven and a half months, six Focus/Lighthouse facilities for sevenmonths, and the Focus Healthcare of Delaware facility for five months.  All other facilities were operated for thefull year.

(2)  During fiscal year 2005, theCompany operated Michiana Behavioral Health Center and Poplar Springs Hospitalfor the full year, Laurelwood Hospital for eight months, Friends Hospital fortwo months, and River Park Hospital for one month. 

(3)  During fiscal year 2004, theCompany operated Michiana Behavioral Health Center for five months and PoplarSprings Hospital for three months.

(4)  See Note 11, “*Segment Information”* in the notes to the consolidatedfinancial statements included elsewhere herein for a definition of EBITDA and areconciliation to income before income taxes for the years ended August 31,2006, 2005 and 2004.  EBITDAR is a presentation of “earnings beforeinterest, taxes, depreciation, amortization, and rent” and is an importantfinancial measure that is used by the Company’s operations management tocompare the performance of our owned and leased facilities.  The calculation of EBITDA and EBITDAR for theHospital Services Division presented above does not include an allocation forcorporate overhead expenses.  For thefiscal years ended August 31, 2006, 2005 and 2004, EBITDA and EBITDAR arecalculated as follows:

|                                                      | ** ** | **For the fiscal years ended August 31,** | ** ** |
|------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                                                | ** ** | **2005** | ** ** | **2004** | ** ** |
| Income before  income taxes                          |       | $                                                                       | 9,647      |   | $ | 6,484 |   | $ | 1,598 |   |
| Interest expense  (net of interest and other income) |       | 4,525                                                                   |       | — |   | — |   |
| Depreciation and  amortization                       |       | 3,959                                                                   |       | 1,444 |   | 344 |   |
| EBITDA                                               |       | 18,131                                                                  |       | 7,928 |   | 1,942 |   |
| Hospital  division overhead                          |       | 2,617                                                                   |       | 883 |   | 11 |   |
| Adjusted EBITDA                                      |       | 20,748                                                                  |       | 8,811 |   | 1,953 |   |
| Rent                                                 |       | 2,150                                                                   |       | 1,023 |   | 98 |   |
| EBITDAR                                              |       | $                                                                       | 22,898     |   | $ | 9,834 |   | $ | 2,051 |   |

 

(5)  Includes only the Company’sbehavioral health and physical rehabilitation management contracts.

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**ITEM 7.****                 MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

***General Overview***

HorizonHealth Corporation is a diversified health care services provider.  The Company is (i) an owner/operator offreestanding behavioral health hospitals providing behavioral health care forchildren, adolescents and adults, (ii) a contract manager of behavioral healthand physical rehabilitation clinical programs offered by acute care hospitalsin the United States, and (iii) a provider of employee assistance programs. 

AtAugust 31, 2006, the Company owned/leased fifteen behavioral health care facilitieswith approximately 1,546 licensed beds in 11 states.  The following table sets forth the name,location, licensed beds and acquisition date for each of these facilities:
| Facility                                  | ** ** | **Location**           | ** ** | **Licensed Beds** | ** ** | **Acquisition Date** |
|-------------------------------------------|------------|------------------------|------------|-------------------|------------|----------------------|
| Michiana Behavioral Health  Center   |       | Plymouth, IN           |       | 80                |       | April 1, 2004        |
| Poplar Springs  Hospital                  |       | Petersburg, VA         |       | 184               |       | June 1, 2004         |
| Laurelwood Hospital                       |       | Willoughby, OH         |       | 160               |       | January 1, 2005      |
| Friends Hospital                          |       | Philadelphia, PA       |       | 219               |       | July 1, 2005         |
| River Park Hospital                       |       | Huntington, WV         |       | 187               |       | August 1, 2005       |
| Copper Hills  Youth Center                |       | West Jordan, UT        |       | 126               |       | January 1, 2006      |
| Kingwood Pines Hospital                   |       | Kingwood, TX           |       | 78                |       | January 17, 2006     |
| Focus Healthcare  of Florida              |       | Cooper City, FL        |       | 78                |       | February 1, 2006     |
| Focus Healthcare of Georgia               |       | St. Simons  Island, GA |       | 101               |       | February 1, 2006     |
| Lighthouse Care  Center of Augusta        |       | Augusta, GA            |       | 106               |       | February 1, 2006     |
| Focus Healthcare of Ohio                  |       | Maumee, OH             |       | 42                |       | February 1, 2006     |
| Lighthouse Care  Center of Conway         |       | Conway, SC             |       | 104               |       | February 1, 2006     |
| Lighthouse Care Center of  Berkeley       |       | Summerville, SC        |       | —            |  (a)  | February 1, 2006     |
| Lighthouse Care  Center of Oconee         |       | Tamassee, SC           |       | 28                |       | February 1, 2006     |
| Focus Healthcare of Delaware              |       | New Castle, DE         |       | 53                |       | April 1, 2006        |

 

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(a)   The facility located inSummerville, SC was purchased as a part of the Lighthouse/Focus acquisition,however, it is currently undergoing renovations and is planned to be inoperation in the 2007 fiscal year.

InAugust 2006, the Company announced that it had entered into a long-term leaseagreement with St. David’s Healthcare Partnership, LP, LLP, for the lease ofSt. David’s Pavilion.  The Company willoperate the facility as a 48 bed free-standing psychiatric hospital subject toreceipt of required governmental approvals. The facility will occupy approximately 28,749 square feet and isanticipated to commence operation in the Company’s third fiscal quarter of2007.

Additionally,Horizon had 92 behavioral health program management contracts and 24 physicalrehabilitation program management contracts with acute care hospitals locatedin 36 states; 101 CQI+ mental health outcomes measurement contracts; and 934contracts to provide employee assistance program services covering in excess of4.4 million lives.

TheCompany’s primary growth strategy is to acquire inpatient behavioral healthcare facilities and improve operating results within new and existing inpatientfacilities.  During fiscal year 2004, theCompany acquired two hospital facilities and acquired/leased three additionalfacilities during fiscal year 2005.  Infiscal year 2006, the Company acquired ten hospital facilities and announcedthe leasing of a facility that is anticipated to begin operation in the Company’sthird fiscal quarter of 2007.  TheCompany strives to improve the operating results of new and existing inpatientbehavioral health care operations by providing the highest quality services,the strengthening of referral networks, expanding marketing initiatives and byexpanding and customizing our services to meet the needs of our customers.

37

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TheCompany also plans to enhance its position as the leader (based on marketshare) in the contract management of behavioral health programs and enhance itsposition in the contract management of physical rehabilitation programs byfurther expanding the range of services that it offers to its client acute carehospitals and the continuum of care it provides.  A significant challenge in marketingbehavioral health and physical rehabilitation clinical management contracts isovercoming the initial reservations that many hospital administrators have withoutsourcing key clinical services. The Company believes its expertise inworking with hospital administrators, its reputation in the industry and itsexisting hospital contractual relationships provide it with a significantadvantage in marketing new contracts. The Company also believes it hasopportunities to cross-sell management services of behavioral health andphysical rehabilitation programs to client acute care hospitals.  In addition, the Company capitalizes on itsexpertise in managing the delivery of behavioral health services by directlyoffering employee assistance programs to employers.  The Company believes it is strategicallysized to deliver national programs, while providing local, individualizedservice to employers and to their respective employees.

During fiscal year2005 and prior, the Company offered at risk managed behavioral health servicesto self-funded employee groups, insurance companies and commercial HMO &PPO plans through its EAP Services group. As of August 31, 2005, all contracts for managed behavioral healthcareservices on an at-risk basis had been terminated in connection with thereorganization of the EAP Services group. During fiscal year 2005, the Company offered specialized temporary nursestaffing services to acute care hospitals through ProCare One Nurses.  ProCare One Nurses was sold on August 29,2005 and the company will no longer provide these services.  See Note 6 *“DiscontinuedOperations”* and Note 16 *“EAPServices Reorganization and Related Impairments”* in the Company’sConsolidated Financial Statements included elsewhere herein.

***Acquisitions***

SeeNote 5,*“Acquisitions”*to thenotes to consolidated financial statements included elsewhere herein for adiscussion of the Company’s acquisition activity.

***Segments******(Service Groups)***

Therewas one significant change to the structure of the reportable service groupsduring the first quarter of fiscal year 2006. The behavioral health and physical rehabilitation contract managementbusinesses have been consolidated into one service group, contract managementservices.  Therefore, the Company’sreportable service groups are: (1) Hospital Services (2) Contract ManagementServices, and (3) Employee Assistance Program Services (“EAP Services”).Therewere two significant changes to the structure of the reportable service groupsduring the fourth quarter of fiscal year 2005. See Note 15, *“Segment (Service Group)Information”* to the Notes to the Consolidated Financial Statementsincluded elsewhere herein for a discussion of the Company’s current threereportable business segments (service groups).

***Revenues***

*Hospital Services*

As aresult of a focused growth initiative during the last three fiscal years, theCompany now owns and operates fifteen behavioral health facilities with a totalof 1,546 licensed beds in Delaware, Florida, Georgia, Indiana, Ohio,Pennsylvania, South Carolina, Texas, Utah, Virginia, and West Virginia.  Patient service revenue is reported on theaccrual basis in the period in which services are provided, at establishedrates. Amounts received are generally less than the established billing ratesof the facility and the differences (contractual allowances) are reported asdeductions from patient service revenue at the time the service is rendered.Net patient services revenue includes amounts the Company estimates to bereimbursable by Medicare and Medicaid under provisions of cost or prospectivereimbursement formulas in effect.

Thebehavioral health facilities provide care without charge to patients who arefinancially unable to pay for the behavioral services they receive.  Because the facilities do not pursuecollection of amounts determined to qualify as charity care, they are notreported in revenues.  Settlements undercost reimbursement agreements with third party payors are estimated andrecorded in the period in which the related services are rendered and areadjusted in future periods as final settlements are determined.  Final determination of amounts earned underthe 

38

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Medicare andMedicaid programs often occur in subsequent years because of audits by theprograms, rights of appeal and the application of numerous technicalprovisions.

*Contract Management Services*

Thefees received by the Company for its services under management contracts arepaid directly by its client acute care hospitals.  Generally, contract fees are paid on amonthly basis.  The client acute carehospitals receive reimbursement under Medicare or Medicaid programs or paymentsfrom insurers, self-funded benefit plans or other third-party payors for thebehavioral health and physical rehabilitation services provided to patients ofthe programs managed by the Company.  Asa result, the availability and amount of such reimbursement, which are subjectto change, impacts the decisions of acute care hospitals regarding whether tooffer behavioral health and physical rehabilitation services pursuant tomanagement contracts with the Company, as well as whether to continue suchcontracts (subject to contract termination provisions) and the amount of feesto be paid thereunder.  See “GovernmentRegulation” – “Medicare and Medicaid; Reimbursement for Services” containedelsewhere herein for a discussion of funding factors and recent changes inregulations.  Also see “Operations” – “ManagementContracts” elsewhere herein for a discussion of factors affecting contractscope, operation, and renewal.

Theprimary factors affecting revenues in a period are the number of managementcontracts with treatment programs in operation in the period and the scope ofservices covered by each such management contract.  The Company provides its management servicesunder contracts with terms generally ranging from three to five years. Eachcontract is tailored to address the differing needs of each client hospital andits community. The Company and the client hospital determine the programs andservices to be offered by the hospital and managed by the Company, which mayconsist of one or more behavioral health or physical rehabilitation treatmentprograms offering inpatient, partial hospitalization, and/or outpatientservices. Under the contracts, the hospital is the actual provider of thebehavioral health or physical rehabilitation services and utilizes its ownfacilities (including beds for inpatient programs), nursing staff and supportservices (such as medical ancillaries, billing, dietary and housekeeping) inconnection with the operation of its programs with the Company providingclinical, operating and compliance management staff and expertise. As theCompany expanded the breadth of treatment programs it offers to acute carehospitals, it increased the number of contracts that included management ofmultiple treatment programs.

TheCompany, through its contract management behavioral health services group, alsoprovides behavioral health outcomes measurement services primarily to acutecare hospital-based programs and free standing psychiatric hospitals.  The contracts for outcomes measurementservices are generally for one to two years with an automatic renewalprovision.  The rates for the outcomesmeasurement services are negotiated based on the range of services provided andthe number of patients and are generally paid on a monthly basis.

*Employee Assistance Program Services (EAP Services)*

Throughits EAP Services group, the Company offers an array of behavioral health careproducts to corporate clients, government agencies, and third-partyadministrators.  Revenues are derivedfrom employee assistance program services (“EAP”) and administrative servicesonly services. During fiscal year 2005 and prior, the Company offered at riskmanaged behavioral health services to self-funded employer groups, insurancecompanies and commercial HMO and PPO plans. As of August 31, 2005, all contracts for managed behavioral healthservices on an at-risk basis were terminated as discussed in the previouslymentioned reorganization of the EAP Services group.  Generally fees are paid on a monthly basis pursuantto contracts that typically are renewable annually, although contracts vary asto term and provisions with some being multi-year, some containing automaticrenewal provisions, and some containing termination provisions under specifiedconditions.

Revenues from EAP contracts are typically based on a specified fee permonth per employee based on the range and breadth of services provided to theemployer, which may include work life services (including child and elder careconsultation), referral resource and critical incident debriefings andintervention, and the method(s) in which those services are provided.  Each plan is specifically designed to fulfillthe clients’ needs.

Revenues for administrative services only contractsrelate to the administration of behavioral health benefits and are dependentupon the number of contracts and the services provided.  Fees are usually a case rate or a per memberper month fee applied to the number of eligible members.  The client remains financially liable fordirect cost associated with providing the medical services.  The client is able to benefit from theCompany’s expertise in clinical case management, the behavioral healthprofessionals employed by the Company, the 

39

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independenthealth care providers contracted by the Company at favorably discounted ratesand the administrative efficiencies provided by the Company.

Due to the previously mentioned reorganization of the EAP Services group,the Company-owned clinics operated in the state of Florida were sublet to athird party effective January 1, 2005. These clinics derived income from counseling and therapy servicesrendered, including providing services to patients who were employed bycustomers under various EAP or managed care contracts.

***Operating Expenses***

Inaddition to the respective primary expense factors described below, otheroperating expenses generally incurred by each of the Company’s service groupsinclude items such as training, continuing professional education andcredentialing services, marketing costs and expenses, consulting, accountingand legal fees and expenses, employee recruitment and relocation expenses,rent, utilities, telecommunications costs, and property taxes, as well as baddebt expense.

*Hospital Services*

Operatingexpenses for the Company’s behavioral health facilities are primarily comprisedof the volume and mix of wage rates, including overtime, for clinical staff andnurses, as well as pharmacy and dietary supplies which are affected by thelevels of patient census and acuity.

*Contract Management Services*

Theprimary factors affecting operating expenses for the Company’s contractmanagement business in any period is the number of programs in operation in theperiod and the volume of patients at those locations.  Operating expenses consist primarily ofsalaries and benefits paid to program management, clinicians, therapists andsupporting personnel.  Behavioral healthprograms managed by the Company generally have a program director that isusually a psychologist or a social worker, a community education manager and additionalsocial workers or therapists as needed. Physical rehabilitation programs managed by the Company generally have aprogram director and additional clinical staff tailored to meet the needs ofthe program and the client hospital, which may include physical andoccupational therapists, a speech pathologist, a social worker and otherappropriate supporting personnel. In addition, for both types of programs theCompany contracts with a medical director on an independent contractor basisunder which on-site administrative and clinical oversight services needed toadminister the program are provided. The nursing staff is typically providedand employed by the hospital.

*Employee Assistance Program Services (EAP Services)*

Operatingexpenses for the Company’s employee assistance programs are primarily comprisedof medical claims from clinical providers and salaries and benefits for itsclinical, operations and supporting personnel. Operating expenses are affected by the number of covered lives orcontracts in place.  Medical claimsinclude payments to independent health care professionals providing services tothe covered enrollees under the employee assistance programs offered by theCompany.

40

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***Resultsof Operations***

Thefollowing table sets forth for the fiscal years ended August 31, 2006, 2005 and2004, the percentage relationship to total revenues of certain costs, expensesand income, and the number of management contracts, licensed beds, and coveredlives at the end of each fiscal year.
|                                                                            | ** ** | **Fiscal Year Ended August 31,** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2006**                                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues                                                                   |       | 100.0                                                | %          | 100.0 | % | 100.0 | % |
|                                                                       |       |                                                 |       |   |   |   |   |
| Cost of services                                                           |       | 76.7                                                 |       | 77.2 |   | 75.1 |   |
| Selling, general and  administrative                                       |       | 9.7                                                  |       | 11.2 |   | 11.7 |   |
| Impairment loss on  building                                               |       | —                                               |       | 0.5 |   | — |   |
| Provision for doubtful  accounts                                           |       | 2.3                                                  |       | 2.1 |   | 0.5 |   |
| Depreciation and  amortization                                             |       | 2.0                                                  |       | 1.6 |   | 1.7 |   |
|                                                                       |       |                                                 |       |   |   |   |   |
| Operating income                                                           |       | 9.3                                                  |       | 7.4 |   | 11.0 |   |
|                                                                       |       |                                                 |       |   |   |   |   |
| Interest and other  income (expense), net                                  |       | (1.9                                                 | )          | (0.6 | ) | (0.8 | ) |
|                                                                       |       |                                                 |       |   |   |   |   |
| Income before income  taxes, minority interest and discontinued operations |       | 7.4                                                  |       | 6.8 |   | 10.2 |   |
|                                                                       |       |                                                 |       |   |   |   |   |
| Income tax provision                                                       |       | 2.9                                                  |       | 2.6 |   | 3.9 |   |
|                                                                       |       |                                                 |       |   |   |   |   |
| Minority interest                                                          |       | 0.1                                                  |       | — |   | — |   |
|                                                                       |       |                                                 |       |   |   |   |   |
| Income from continuing  operations                                         |       | 4.4                                                  |       | 4.2 |   | 6.3 |   |
|                                                                       |       |                                                 |       |   |   |   |   |
| Discontinued operations                                                    |       | (0.0                                                 | )          | (1.7 | ) | 0.4 |   |
|                                                                       |       |                                                 |       |   |   |   |   |
| Net income                                                                 |       | 4.4                                                  | %          | 2.5 | % | 6.7 | % |
|                                                                       |       |                                                 |       |   |   |   |   |
| Number of management  contracts, end of year:                              |       |                                                 |       |   |   |   |   |
| Contract  locations in operation                                           |       | 107                                                  |       | 123 |   | 133 |   |
| Contract  locations signed and unopened                                    |       | 9                                                    |       | 12 |   | 7 |   |
|                                                                       |       | 116                                                  |       | 135 |   | 140 |   |
|                                                                       |       |                                                 |       |   |   |   |   |
| Covered lives (000’s),  end of year                                   |       | 4,464                                                |       | 4,244 |   | 3,569 |   |
|                                                                       |       |                                                 |       |   |   |   |   |
| Licensed Beds                                                              |       | 1,546                                                |       | 833 |   | 267 |   |

 

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***Fiscal Year Ended August 31, 2006Compared to Fiscal Year Ended August 31, 2005***

***Revenue.* **Total revenue between the yearsincreased $67.6 million or 32.6%. Revenue associated with hospital services increased by $97.8 million or161.4%, revenue associated with contract management services decreased $9.4million or 9.6% and revenue associated with EAP services decreased $20.5million or 42.5%.

*Hospital Services*

Revenueassociated with the operations of the freestanding behavioral health carefacilities increased by $97.8 million, or 161.4% between the years.  The increase in revenue is primarily theresult of the long-term operating lease associated with Laurelwood Hospitaleffective January 1, 2005, the acquisitions of Friends Behavioral Health Systemand River Park Hospital in the fourth fiscal quarter of 2005, and theacquisitions of Copper Hills Youth Center, Kingwood Pines Hospital, sevenFocus/Lighthouse facilities in the second fiscal quarter, of which six wereoperational, and an eighth Focus/Lighthouse facility in the third fiscalquarter of 2006.

*Contract Management Services*

Revenue associated with contract managementservices decreased $9.4 million, or 9.6% between the years.  This decrease was primarily due to thedecline in the average number of contract management locations in operationfrom 127.1 for the twelve months ended August 31, 2005 to 116.1 for the twelvemonths ended August 31, 2006.  Additionally,$1.2 million of the $9.4 million decrease was primarily attributable to adecrease in revenue related to the restructuring of a behavioral healthmanagement contract effective January 1, 2005, which also resulted in anassociated decrease in expenses (see “Cost of Services”).

*EAP Services*

Revenue associated with EAP Services decreased $20.5 million,or 42.5% between the years.  Thisdecrease was attributable to a decrease in revenue of approximately $21.8million, which related to the termination of the managed behavioral healthat-risk contracts and the discontinuance of the Florida clinic operations onDecember 31, 2004, both of which were implemented as a part of thereorganization of the EAP Services group. This decrease was partially offset by an increase in ongoing EAPcontract revenue, of which $1.6 million is related to a significant increase inthe number of covered lives under one EAP contract.

***Cost of Services.*** Total cost of services provided between the years increased $51.1million, or 31.9%.   Cost of servicesprovided associated with hospital services increased by $84.5 million or173.1%, cost of services provided associated with contract management servicesdecreased $7.9 million or 12.1% and cost of services provided associated withEAP services decreased $25.6 million or 54.7%.

*Hospital Services*

Cost of services associated with the freestandingbehavioral health care facilities increased by $84.5 million, or 173.1%,between the years. The increase was primarily the result of the long-termoperating lease associated with Laurelwood Hospital effective January 1, 2005,the acquisitions of Friends Behavioral Health System and River Park Hospital inthe fourth fiscal quarter of 2005, and the acquisitions of Copper Hills YouthCenter, Kingwood Pines Hospital, seven Focus/Lighthouse facilities in thesecond fiscal quarter, of which six were operational, and an eighthFocus/Lighthouse Facility in the third fiscal quarter of 2006.

*Contract Management Services*

Cost of services provided associated with contractmanagement services decreased $7.9 million, or 12.1%, between the years.  The decrease was primarily due to a declinein the average number of contract management locations in operation from 127.1for the twelve months ended August 31, 2005 to 116.1 for the twelve monthsended August 31, 2006.  Additionally, adecrease of $1.1 million was primarily attributable to the decrease in cost ofservices related to the restructuring of a behavioral health managementcontract effective January 1, 2005, which also resulted in an associated decreasein revenue (see “Revenue”).

*EAPServices*

Cost ofservices provided associated with EAP services decreased $25.6 million, or54.7% between the years.  A decrease ofapproximately $6.6 million in salaries and benefits was primarily due to thedecrease in full-time equivalents related to the reorganization of the EAPServices group completed during the fiscal year ended August 31, 2005, and thediscontinuance of the Florida clinic operations on December 31, 2004.  An additional decrease of $16.7 million inmedical claims related to the termination of the Company’s at-risk managed carecontracts as a part of the fiscal year 2005 reorganization.  As a result of the closure of the Floridaclinic operations 

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and the consolidation ofthe regional call centers to Texas, rent expense decreased approximately $2.8million between the year-to-date periods.

***Selling, General andAdministrative.**** *Total selling, general, andadministrative expenses increased $3.4 million, or 14.6%, between theyears.  Salaries and benefits increasedapproximately $2.0 million due to stock-based compensation expense resultingfrom the adoption of SFAS 123R effective September 1, 2005.  Audit and accounting fees increased $872,000due to the additional costs associated with the FY06 audit and Sarbanes-Oxleycompliance efforts primarily as a result of the new hospital facilitiesacquired.  Rent expense and otherpurchased services increased $839,000 due to the occupation of the new NSCbuilding in April 2006.  Generalinsurance increased $239,000 due to a significant increase in the liabilitypremiums for fiscal year 2006.  Theseincreases were partially offset by a decrease of $861,000 in operations bonusexpense and sales commissions earned during fiscal 2006.

***Provision for Doubtful Accounts.**** *The provision fordoubtful accounts was a net expense of $6.3 million for the twelve months endedAugust 31, 2006, as compared to a net expense of $4.4 million for the twelvemonths ended August 31, 2005, an increase of $1.9 million.  The increase in net expense for the twelvemonths ended August 31, 2006 resulted from an increase of $3.9 million relatedto the acquisitions of 12 free standing behavioral health hospitals, asdetailed in Note 5 – *Acquisitions*inthe notes to the Consolidated Financial Statements included elsewhereherein.  Additionally, an increase of$482,000 was related to reserves recorded for untimely payment of invoices attwo terminated behavioral health contract locations.  These increases were partially offset by adecrease of $1.0 million related to the reversal of bad debt due to receipt ofpayment for outstanding invoices at one behavioral health contract location, adecrease of $605,000 due to the reversal of bad debt for one behavioral healthcontract location as a result of a revision in the location’s existingcontract, a $532,000 decrease due to a change in the reserve estimate for thehospital division as discussed below in *Critical AccountingPolicies and Estimates,*and a decrease of $483,000 due to thereversal of bad debt as a result of receipt of legal settlements at onephysical rehabilitation contract location and one behavioral health contractlocation.

***Depreciation and Amortization.***  Depreciation and amortization expenseincreased approximately $2.1 million or 63.2% between the years.  An increase in depreciation expense of $2.3million is primarily attributable to the addition of the facilities associatedwith Friends Hospital, River Park Hospital, Copper Hills Youth Center, KingwoodPines Hospital and the eight Focus/Lighthouse Hospitals.  This increase was partially offset by adecrease in contract amortization expense of approximately $379,000 associatedwith intangible assets that became fully amortized either during the current orprior fiscal year.

***Interest and Other Income (Expense), Net.* **Interest expense, interest income andother income for the year ended August 31, 2006 resulted in a net expense of$5.2 million as compared to a net expense of $1.3 million for the correspondingperiod in the prior fiscal year.  Thisnet change is primarily the result of an increase in interest expense ofapproximately $3.7 million related to the increase in the weighted averageprincipal balance outstanding under the credit facility between the periods andan increase in the weighted average interest rates between the periods.  The weighted average outstanding creditfacility balance for the year ended August 31, 2006 was approximately $61.5million with an ending balance of $99.0 million.  The weighted average outstanding creditfacility balance for the prior fiscal year was $20.1 million with no debtoutstanding at August 31, 2005.  Theincrease in outstanding balance is a result of the acquisitions during the 2006fiscal year.  The weighted averageinterest rates for the credit facility for the year ended August 31, 2006 and2005 were approximately 7.3% and 4.3%, respectively.  Also included in interest expense wasapproximately $205,000 in interest on the HUD loan that was assumed by theCompany in connection with the Focus – Delaware acquisition in April 2006.  See Note 5, “*Acquisitions*”and Note 9, “*Long-Term Debt*” in the notes tothe consolidated financial statements included elsewhere herein for details ofthe acquisition and a description of the HUD loan.  In addition, the Company recorded a loss onthe sale of the Company’s former National Support Center and related propertyand equipment of approximately $192,000 during the year ended August 31, 2006.

***Income Tax Expense.***  Income tax expense for the twelve monthsended August 31, 2006 was $8.0 million representing an increase of $2.6million, or 49.6%, as compared to income tax expense of $5.3 million for thetwelve months ended August 31, 2005.  Theincrease in income tax expense was largely due to a corresponding increase inpre-tax earnings over the same period last year.  The effective tax rates for the twelve-monthperiods ended August 31, 2006 and 2005 were 39.3% and 37.9%, respectively.

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***Discontinued Operations.*** On August 29, 2005, theCompany sold its membership interests in ProCare One Nurses, LLC, its whollyowned temporary nurse-staffing subsidiary. The results of operations of the disposed assets and the gains (losses)related to this divestiture have been classified as discontinued operations forall periods presented in the accompanying condensed consolidated statements ofoperations.  See Note 6, *“Discontinued Operations”* in the notes tothe consolidated financial statements included elsewhere herein.

***Fiscal Year Ended August 31, 2005Compared to Fiscal Year Ended August 31, 2004***

**Revenue. **Totalrevenue between the years increased $45.6 million or 28.2%.  Revenue associated with hospital servicesincreased by $50.5 million or 501.6%, revenue associated with contractmanagement services decreased $0.6 million or 0.6%, revenue associated with EAPservices decreased $4.1 million or 7.8%, and revenue from other servicesdecreases approximately $0.1 million.

Hospital Services 

### Revenueassociated with the Company’s freestanding behavioral health facilitiesincreased $50.5 million, or 501.6%, between the years.  This increase is a result of the first fullfiscal year of operations for Michiana Behavioral Health Center and PoplarSprings Hospital, both acquired during the last five months of fiscal year 2004and the acquisitions of Friends Behavioral Health System, effective July 1,2005, River Park Hospital, effective August 1, 2005, and the long-termoperating lease agreement associated with Laurelwood Hospital effective January1, 2005.

### Contract Management Services

Revenueassociated with contract management services decreased $621,000, or 0.6%between the years.  Same store salesrelated to behavioral health contract management increased 4.6% resulting in a$3.0 million increase to revenue between the years.  This was partially offset by a decrease of$1.7 million in revenue at one behavioral health contract management locationas a result of the restructuring of that contract with an effective date ofJanuary 1, 2005, which resulted in an associated decrease in expenses (see “Costof Services” below) and the phase out of the Company’s consulting operationsthat contributed $590,000 in revenue in the same period last year.  A decrease of approximately $1.7 million wasprimarily the result of a decrease in the average number of physicalrehabilitation locations in operation from 27.3 for the year ended August 31,2004 to 23.9 for the year ended August 31, 2005.  This decrease was partially offset by anincrease in average revenue per location of 4.2% from year to year.

### EAP Services

Revenueassociated with employee assistance programs and managed behavioral servicesdecreased by $4.1 million, or 7.8% between the years.  A $5.2 million decrease is due to thetermination of three significant managed behavioral health at-risk contractsand discontinuance of the Florida clinic operations on December 31, 2004related to the previously announced reorganization of the EAP Servicesgroup.  These decreases are partiallyoffset by an increase of $1.5 million that is related to the commencement of asignificant new EAP contract on June 1, 2004. Exclusive of the behavioral health at-risk contracts, revenues increased6.9% between the years.

### Other Services

Revenueassociated with other services decreased $115,000 between the years.  This decrease is primarily attributable tothe phase out of the PsychScope Phase IV projects.

***Cost of Services. ***Totalcost of services provided increased $38.5 million, or 31.7% between the years.Cost of services provided associated with hospital services increased by $41.2million or 538.8%, cost of services provided associated with contractmanagement services decreased $1.5 million or 2.3% and cost of servicesprovided associated with EAP services decreased $890,000 or 1.9%.

Hospital Services

Costof services associated with the freestanding behavioral health facilitiesincreased $41.2 million, or 538.8%, between the years.  This increase is the result of the first fullfiscal year of operations for Michiana Behavioral Health Center and PoplarSprings Hospital, both acquired during the last five months of fiscal year 2004and the acquisitions of Friends Behavioral Health System, effective July 1,2005, River Park Hospital, effective 

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August 1, 2005,and the long-term operating lease agreement associated with Laurelwood Hospitaleffective January 1, 2005.

Contract Management Services

Cost of servicesprovided associated with contract management services decreased $1.5 million or2.3%, between the years.  Cost ofservices decreased by approximately $1.7 million primarily due to a decrease inthe average number of physical rehabilitation locations in operation, from 27.3for the year ended August 31, 2004, to 23.9 for the year ended August 31,2005.  Additionally, a $1.8 milliondecrease in costs at one behavioral health contract management location as aresult of the restructuring of a significant contract with an effective date ofJanuary 1, 2005.  These decreases werepartially offset by an increase of $1.6 million primarily due to an increase insalaries and benefits, medical director fees and contributions for clientfacility improvements.  Of this increase(a) $773,000 is attributable to salaries and benefits of which approximately$490,000 relates to one contract management location in which the Company providesall of the psychiatric nursing staff, (b) medical director fees increased$569,000 primarily due to an increase in the number of contracted physiciansfrom 132 as of August 31, 2004, to 144 as of August 31, 2005 and (c)contributions, specifically targeted for client facility improvements,increased $274,000 due to the contractual requirements at two contractlocations.

EAPServices

Costof services provided associated with employee assistance programs and managedbehavioral services decreased by $890,000 or 1.9% between the years.  A decrease of approximately $3.4 million insalaries and benefits was primarily due to a 22.8% decrease in full-timeequivalents related to the previously announced reorganization of the EAPServices group.  An additional decreaseof $2.3 million is related to the discontinuance of the Florida clinicoperations on December 31, 2004. These decreases were offset by an increase of$3.5 million, also associated with the reorganization. Of this $3.5 millionincrease, $1.6 million represents real estate lease expense and terminationcosts, $612,000 represents employee severance and retention bonus costs,$197,000 represents employee relocation costs, $491,000 represents employeetraining and redundant staffing costs, $415,000 represents costs associatedwith the termination of the managed behavioral health at-risk contracts and$182,000 represents miscellaneous other costs associated with thereorganization.  As a result of theattrition of employees related to the reorganization and resulting decrease inability to manage utilization, medical claims expense increased $2.1 milliondue to an 8.7% increase in inpatient days per 1,000 members, a 15.2% increasein the average cost per day and a 29.7% increase in the average outpatient costper member.

OtherServices

Cost of Servicesprovided associated with other services decreased by $347,000 between theyears.  This decrease is primarily due tothe phase out of the PsychScope Phase IV projects.

***Selling, General and Administrative.*****Total selling, general, and administrative expenses, on anet basis, increased $4.4 million, or 23.3%, between the years. Salaries andbenefits increased $1.9 million primarily due to the expansion of severalsupport center departments and the additions of a dedicated acquisitions anddevelopment department and in-house legal counsel.  Consulting fees increased $786,000 due toSarbanes-Oxley compliance efforts and support center related consultingprojects.  Auditing & accounting feesincreased $566,000 due to increased fees related to the company’s annual auditas well as Sarbanes-Oxley compliance efforts. Recruitment advertising increased$221,000 due to increased activity by the company’s internal recruitingfunction.  Workers compensation lossesincreased $238,000 due to favorable adjustments associated with prior yearreserves that were recorded during fiscal year 2004.  Legal fees increased $175,000 primarily dueto costs associated with the long-term operating lease agreement withLaurelwood Hospital, litigation costs associated with six terminated contractlocations, and one contract location still in operation.

***Provision for Doubtful Accounts.**** *The provision fordoubtful accounts was a net expense of $4.4 million for the fiscal year endedAugust 31, 2005, as compared to a net expense of $869,000 for the fiscal yearended August 31, 2004, a difference of $3.5 million.  The net increase for the twelve months endedAugust 31, 2005 was primarily attributable to bad debt provisions totalingapproximately $3.2 million associated with the acquisitions in the Company’shospital services group.  Also includedin this expense are bad debt reserves in the amount of $1.3 million for threeterminated contract locations and two contract locations still in operation forwhich collectibility is uncertain.  Theseexpenses are partially offset by bad debt recoveries of $899,000.

***Impairment Loss on Building. ***Duringthe fourth quarter of fiscal 2005, the Company recorded an asset impairmentcharge of approximately $1.0 million associated with the write-down to fairmarket value of the 

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Company’s NationalSupport Center building. Fair market value was determined by an executed letterof intent to sell the building.  TheCompany plans on consolidating its current National Support Center with the newEAP service center into a new location in Lewisville, Texas during fiscal year2006.

***Depreciation and Amortization.*** Depreciation andamortization expense increased $592,000 or 21.2% between the years.  An increase in depreciation expense of$997,000 is primarily due to the addition of the facilities associated with theacquisitions of Michiana Behavioral Health Center, Poplar Springs Hospital andFriends Behavioral Health System effective April 1, 2004, June 1, 2004, andJuly 1, 2005 respectively.  This increasewas partially offset by a decrease in contract amortization expense ofapproximately $487,000 associated with intangible assets that became fullyamortized either during the current or prior fiscal year.

***Interest and Other Income (Expense), Net.*** Interest expense, interest income and otherincome for the year ended August 31, 2005 was a net expense of $1.3 million ascompared to a net expense of $1.3 million for the prior fiscal year.  Interest expense increased $220,000 as the resultof a $1.7 million increase in the weighted average principal balanceoutstanding under the credit facility and an increase in interest rates betweenthe periods.  The increase in interestexpense was offset by an increase in interest income of approximately $240,000that is a result of higher average cash balances on hand during the period.

***Income Tax Expense****.*Income tax expense for fiscal year 2005 was $5.3 million representing adecrease of $920,000 or 14.7 %, as compared to income tax expense of $6.3million for the prior fiscal year.  Thedecrease in income tax expense was largely due to a corresponding decrease inpre-tax earnings.  The effective tax ratefor fiscal years 2005 and 2004 was 37.9% and 37.9%, respectively.

***Discontinued Operations.*** On August 29, 2005, the Company sold its membership interests inProCare One Nurses, LLC, its wholly owned temporary nurse-staffingsubsidiary.  The results of operations ofthe disposed assets and the gains (losses) related to this divestiture havebeen classified as discontinued operations for all periods presented in theaccompanying consolidated statements of operations.  Revenues decreased $1.5 million, or 8.0%,between the years.  Total cost ofservices decreased $1.1 million, or 6.3%. Total selling, general, and administrative expenses increased $1.4million.  The provision for doubtfulaccounts was a net expense of $136,000 for the year ended August 31, 2005, ascompared to a net recovery of $59,000 for the year ended August 31, 2004.  Depreciation and amortization expensedecreased approximately $32,000, or 24.5% between the years.  Income tax expense decreased $728,000 betweenthe years.

***Newly Issued Accounting Standards***

See Note 2, *“Significant Accounting Policiesand Estimates”*to the notes to the consolidated financial statements includedelsewhere herein for a discussion of newly issued accounting standards.

*Sarbanes-Oxley and RelatedCompliance*

The Sarbanes-OxleyAct of 2002, which became law in July 2002 requires changes in certain of theCompany’s corporate governance practices. In addition, related rules have been made by the Securities and ExchangeCommission and NASDAQ.  These rules andregulations will increase the Company’s legal and financial compliance costs,and make some activities more difficult, time consuming and/or costly.  These rules and regulations are expected tomake it more expensive to obtain director and officer liability insurance.  Additional costs related to compliance withthe requirements of Sarbanes-Oxley Rule Section 404 are expected to continue infuture fiscal years.

The Company’s initiativesto comply with Section 404 of the Sarbanes-Oxley Act and related regulationsregarding management’s required assessment of its internal control overfinancial reporting and the independent auditors’ attestation of thatassessment has required, and continues to require, the commitment ofsignificant financial and managerial resources. In compliance with Section 404, as well as to generally improve itsinternal control environment, the Company has undertaken substantial measures,including among other things, projects to strengthen both its accounting andinformation technology systems, including initiatives related to recentacquisitions.  However, because of thenew and changed laws, regulations and standards are subject to varyinginterpretations in many cases due to their lack of specificity, theirapplication in practice may evolve over time as new guidance is provided byregulatory and governing bodies.  Thisevolution may result in continuing uncertainty regarding compliance matters andadditional costs necessitated by ongoing revisions to disclosure and governance

 

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practices.

***Liquidity and Capital Resources***

Workingcapital increased to $28.4 million at August 31, 2006, as compared to $19.5million at August 31, 2005, primarily due to increases in accounts receivableas a result of the acquisitions during the 2006 fiscal year and at the end ofthe 2005 fiscal year.

TheCompany believes that its future cash flows from operations which wereapproximately $13.1 million for the fiscal year ended August 31, 2006, alongwith cash of approximately $3.0 million at August 31, 2006, and theavailability under its credit facility will be sufficient to cover operatingcash requirements and current debt obligations over the next 12 months.  At August 31, 2006, $70.6 million of the$175.0 million credit facility was available to the Company after letter ofcredit obligations.

Netcash provided by operating activities for the fiscal year ended August 31, 2006was approximately $13.1 million as compared to $12.4 million for the year endedAugust 31, 2005.  Cash used in investingactivities was approximately $121.1 million for the twelve months ended August31, 2006, as compared to $26.6 million for the year ended August 31, 2005.  During the second and third quarters of 2006,the Company acquired ten additional behavioral health care facilities.  The total cash expenditures for theseacquisitions were approximately $115.5 million and the Company’s existingcredit facility was used to fund the transactions.  Additionally, capital expenditures wereapproximately $7.5 million for the fiscal year. These uses of cash were partially offset by approximately $3.5 millionreceived during the third quarter of fiscal 2006 from the sale of the Company’sprior National Support Center in Lewisville, Texas.  The Company moved into its new NationalSupport Center location in April 2006.

Netcash provided by financing activities was approximately $102.9 million for thetwelve months ended August 31, 2006, as compared to $20.4 million in the prioryear and was primarily the result of net borrowings under the Company’sexisting credit facility of approximately $99.0 million.

Cashoutlays for property and equipment purchases in the ordinary course of businesstotaled approximately $7.5 million for the fiscal year ended August 31,2006.  Property and equipmentexpenditures for fiscal year 2005 were approximately $3.1 million.  The Company anticipates its property and equipmentexpenditures for the 2007 fiscal year will be approximately $12 million.

OnJune 1, 2004 the Company acquired the assets of PSH AcquisitionCorporation.  The purchase agreementprovides for additional variable payments in future years based on the futureperformance of the facilities.  Thesecond payment was made during the third quarter of fiscal year 2006 and wasapproximately $422,000.  The thirdpayment was made during the fourth quarter of fiscal year 2006 and wasapproximately $856,000.  The finalvariable payment will be made in the third fiscal quarter of 2007 and theCompany anticipates the amount to be approximately $596,000.  See Note 5, “*Acquisitions*”in the notes to the consolidated financial statements included elsewhereherein.

OnJanuary 1, 2005, the Company entered into a long-term operating lease agreementof Laurelwood Hospital, a 160-bed behavioral health hospital located inWilloughby, Ohio, a suburb of Cleveland. See Note 5, “*Acquisitions*”in the notes to the consolidated financial statements included elsewhereherein.

OnJuly 1, 2005, the Company formed a joint venture with the Thomas ScattergoodBehavioral Health Foundation, a 501(c)(3) charitable organization, and thejoint venture acquired Friends Hospital. Horizon is an 80% member of the joint venture and the Thomas ScattergoodBehavioral Health Foundation is a 20% member of the joint venture.  The Company contributed approximately $15.5million in cash to the joint venture which funds were used for the acquisitionof the hospital by the joint venture. The contribution was paid out of available funds and no debt wasincurred by the Company as a part of the transaction.  The agreement requires the joint venture toexpend at least $5,500,000 in the first five operating years of the jointventure on capital expenditures related to Friends Hospital.  The Company has spent approximately $1.4million on capital expenditures for Friends from the acquisition date throughAugust 31, 2006.  See Note 5, *“Acquisitions”* in the notes to theconsolidated financial statements included elsewhere herein.

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OnAugust 1, 2005, the Company acquired substantially all the assets of River ParkHospital and purchased the stock of an affiliated management company.  The Company paid approximately $11.0 millionin cash, which was paid out of available funds and no debt was incurred by theCompany as a part of the transaction. The agreements provide for additional variable payments in future yearsbased on the future performance of the hospital and the managementcompany.  The first payment was madeduring the first quarter of fiscal year 2007 and was approximately $3.2million.  See Note 5, *“Acquisitions”* in the notes to theconsolidated financial statements included elsewhere herein.

OnAugust 29, 2005, the Company sold its membership interests in ProCare OneNurses, LLC, its wholly owned temporary nurse-staffing subsidiary, toCareerStaff Unlimited, Inc. The transaction consisted of a sale of all themembership interests in ProCare for total consideration of $8.3 million,consisting of $4.2 million in cash and $4.1 million in two promissorynotes.  One promissory note in the amountof $2.1 million was paid during the quarter ended February 28, 2006.  The other promissory note had an originalprincipal balance of $2.0 million and is payable quarterly over three years,bearing interest at the prime rate.  TheCompany has received the first three quarterly payments during the second,third, and fourth quarters of fiscal 2006. See Note 6, *“Discontinued Operations”*in the notes to the consolidated financial statements included elsewhereherein.

On January 1, 2006, the Company acquired Copper Hills Youth Center, a126-bed adolescent residential treatment center located in West Jordan,Utah.  The aggregate purchaseprice was approximately $9.6 million and was financed under the Company’sexisting credit facility.  See Note 5, *“Acquisitions”* in the notes to theconsolidated financial statements included elsewhere herein.

Effective January17, 2006, the Company acquired Kingwood Pines Hospital, a 78-bed behavioralhealth facility located in Kingwood, Texas. The aggregate purchase price net of cash acquired was approximately$14.1 million and was financed under the Company’s existing creditfacility.  See Note 5, *“Acquisitions”* in the notes to theconsolidated financial statements included elsewhere herein.

On February 1, 2006, the Company acquired the behavioral healthfacilities of Lighthouse Care Centers, LLC and Focus Healthcare, LLC.  Lighthouse Care Center, LLC operated fourbehavioral health facilities located in Florida, Georgia and SouthCarolina.  Focus Healthcare, LLC operatedfour behavioral health facilities located in Delaware, Florida, Georgia andOhio.  The facilities have a combinedtotal licensed capacity of 512 beds.  Theclosing of the acquisition for the Focus Healthcare Delaware facility waspostponed pending receipt of necessary government approvals and ultimatelyclosed on April 1, 2006.  The aggregatepurchase price for the entire Lighthouse/Focus transaction, which included theassumption of a HUD loan of approximately $7.1 million for the Focus HealthcareDelaware facility, was approximately $91.7 million and was financed under theCompany’s existing credit facility.  SeeNote 5, *“Acquisitions”* in thenotes to the consolidated financial statements included elsewhere herein.

On August 9, 2006,the Company announced that it had entered into a long-term lease agreement withSt. David’s Healthcare Partnership, LP, LLP, for the lease of St. David’s Pavilion.  The Company will operate the facility as a 48bed free-standing psychiatric hospital subject to receipt of requiredgovernmental approvals.  The facilitywill occupy approximately 28,749 square feet and is anticipated to commenceoperation in the Company’s third fiscal quarter of 2007.

The Companyintends to continue to fund acquisition activity using the balance currentlyavailable under the credit facility. Effective November 14, 2005, the Company entered into a Consent andFirst Amendment to the Third Amended and Restated Credit Agreement inconnection with the Lighthouse and Focus acquisitions mentioned above.  This First Amendment modified certain feeschedules and certain covenants of the Company under the credit facility.  A copy of this agreement was filed as Exhibit10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter endedNovember 30, 2005.  Effective January 26,2006, the Company entered into a Second Amendment to the Third Amended andRestated Credit Agreement which increased the amount of the revolving creditfacility to $175.0 million and added Sun Trust Bank as a participatingbank.  A copy of this agreement was filedas Exhibit 10.1 to the Company’s Current Report on Form 8-K dated January 27,2006.  Effective May 24, 2006, theCompany entered into a Third Amendment to the Third Amended and Restated CreditAgreement which modified certain fee schedules and certain covenants of theCompany’s existing credit facility.  Acopy of this agreement was filed as Exhibit 10.1 to the Company’s QuarterlyReport on Form 10-Q for the quarter ended May 31, 2006.  See Note 9, “*Long-TermDebt*” in the notes to the consolidated financial statements includedelsewhere herein.

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The Company mayacquire additional inpatient psychiatric facilities that fit our corporategrowth strategy. Management continually assesses our capital needs and, shouldthe need arise, we will seek additional financing, including debt or equity, tofund potential acquisitions or for other corporate purposes.  In negotiating such financing, there can beno assurance that we will be able to raise additional capital on termssatisfactory to us.  Failure to obtainadditional financing on reasonable terms could have a negative effect on ourplans to acquire additional inpatient psychiatric facilities.

Thefollowing table provides aggregate information about the Company’s materialcontractual payment obligations and when these payments are due (in thousands):
| ** **                          | ** ** | **Payments due by period** | ** ** |
|-------------------------------------|------------|-------------------------------------------|------------|
| ** **                          | ** ** | **Total**                                 | ** ** | **Less than   1 Year** | ** ** | **1 – 3 Years** | ** ** | **3 – 5 Years** | ** ** | **More than 5   Years** | ** ** | **Other** | ** ** |
|                                |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Long Term Debt  Obligations (1)     |       | $                                         | 106,005    |   | $ | 70 |   | $ | 156 |   | $ | 99,180 |   | $ | 6,599 |   | $ | — |   |
| Interest on Long  Term Debt (2)     |       | 39,290                                    |       | 8,345 |   | 16,675 |   | 6,830 |   | 7,440 |   | — |   |
| Commitment  Fees-Long Term Debt (3) |       | 1,305                                     |       | 348 |   | 696 |   | 261 |   | — |   | — |   |
| Operating Lease  Obligations (4)    |       | 40,679                                    |       | 3,731 |   | 7,029 |   | 6,313 |   | 23,606 |   | — |   |
| Other Contracts  Obligations (5)    |       | 5,076                                     |       | 1,443 |   | 2,367 |   | 1,183 |   | 83 |   | — |   |
| Other Long Term  liabilities (6)    |       | 3,360                                     |       | — |   | — |   | — |   | — |   | 3,360 |   |
|                                |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
|                                |       | $                                         | 195,715    |   | $ | 13,937 |   | $ | 26,923 |   | $ | 113,767 |   | $ | 37,728 |   | $ | 3,360 |   |

 

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(1)   At August 31, 2006, the Companyhad outstanding borrowings of $99.0 million related to its $175.0 millionrevolving credit facility.  The Company’srevolving credit facility expires on May 31, 2010, at which time alloutstanding borrowings will be due.  Theprincipal payments reflected in the table above relating to the revolvingcredit facility assume that the $99.0 million in borrowings outstanding atAugust 31, 2006 remains constant through May 31, 2010.  These payments could change significantlybased on the actual borrowings and payments made by the Company on thisrevolving line of credit.  Additionally,the Company assumed a HUD loan in connection with the Focus – Delawareacquisition which had a principal balance of approximately $7 million at August31, 2006.  Monthly payments of principaland interest are fixed over the term of this loan.  See Note 9 – *“Long-TermDebt”* in the notes to the consolidated financial statements includedelsewhere herein for a further discussion of this loan.

(2)   Projected interest paymentsreported in the table above for the revolving credit facility were calculatedbased on outstanding debt of $99.0 million at an interest rate of 7.94% whichrepresents the weighted average interest rate of Company debt at August 31,2006.  Actual interest payments willdiffer, possibly significantly, as it cannot be guaranteed that outstandingborrowings will remain at $99.0 million. In addition, future interest payments will be affected by changes ininterest rate levels over time, as well as the Company’s basis point spreadover the base rate as affected by its debt leverage.  For the HUD loan, the interest rate is fixedat 6.99% over the term of the loan and this was used to estimate the futureinterest payments under this loan.

(3)   Projected commitment feepayments relate to a 0.5% fee paid on the unused portion of the Company’s$175.0 million revolving credit facility. At August 31, 2006 the Company had approximately $99.0 million inborrowings outstanding under the revolving credit facility.  The unused portion is reduced byapproximately $6.4 million relating to various letters of credit expected to bein place during the periods.  Therevolving credit facility expires on May 31, 2010.

(4)   TheCompany leases various office facilities and equipment under operating leases,as described in Note 14 – *“Commitments andContingencies”* in the notes to the consolidated financial statementsincluded elsewhere herein.  The tableabove reflects payments through the end of the lease terms currently in place.The significant property leases (payments in excess of $100,000 annually)included in the table above have the following terms:

(a)   Barboursville,West Virginia, approximately $19,800 per month, terminates on October 31, 2007

(b)   BlueBell, Pennsylvania , approximately $27,000 per month, terminates on December31, 2007

(c)   Nashville,Tennessee, approximately $12,200 per month, terminates on April 30, 2008

(d)   Denver,Colorado, approximately $11,700 per month, terminates on June 29, 2008

(e)   SanDiego, California, approximately $22,600 per month, terminates on June 30, 2009

(f)    Beachwood,Ohio, approximately $9,800 per month, terminates on August 31, 2013

(g)   Lewisville,Texas, approximately $74,950 per month, terminates on March 31, 2016

(h)   Willoughby,Ohio, approximately $200,400 per quarter, terminates on December 31, 2019

(i)    Austin,Texas, approximately $75,100 per month anticipated to begin in April 2008 andterminate in March 2022

The Company is subleasingthe Blue Bell, PA and Nashville, TN properties mentioned above.

(5)   TheCompany, through its hospital facilities, has entered into the followingcontracts.  A note payable to a MedicalDirector with monthly payments of $4,688 thru August 31, 2007.  A contract for adolescent program serviceswith an annual fee of $10,000 terminating on June 22, 2008.  A pharmaceutical services agreement with amonthly payment of $9,500 that terminates on February 29, 2008.  Clinical Director contracts that terminate onOctober 31, 2006, March 31, 2007 and December 31, 2007 with monthly payments of$12,500, $12,500 and $4,167, respectively. The joint venture with the Thomas Scattergood Behavioral HealthFoundation requires that $5.5 million be expended for capital expenditures forFriends hospital over the first five operating years (2006 – 2010).  The long-term operating lease agreementassociated with Laurelwood hospital requires the Company to contribute $41,666each December 31st beginning December 31, 2007 and endingDecember 31, 2012.

(6)   $3.360,000 of the $4,106,000 inOther Non-Current Liabilities reflected on the Company’s balance sheet isincluded in this table to reflect future payment obligations associated withworkers compensation, professional liability, and the long-term portion of theemployees’ vacation accrual.  The Companyhas reflected these payments under “other”, as the timing of these futurepayments is dependent on the actual processing of the claims and when anemployee takes vacation beyond the amount recorded in the current portion ofthe vacation accrual in our financial statements.  An additional $470,000 is a non-contractualcontingency reserve.

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Contractualobligations represent future cash commitments and liabilities under agreementswith third parties, and exclude contingent liabilities for which the Companycannot reasonably predict the amount(s) or timing of future payments, if any.  See Note 14 *“Commitmentsand Contingencies”* to the Consolidated Financial Statements of theCompany included elsewhere herein.

***Inflation and Economic Trends***

Although inflation has not had amaterial impact on our results of operations, the health care industry is verylabor intensive and salaries and benefits are subject to inflationary pressuresas are rising supply costs that tend to escalate as vendors pass on the risingcosts through price increases.  Some ofour freestanding owned, leased and managed inpatient behavioral health carefacilities we operate are experiencing the effects of the tight labor market,including a shortage of doctors and nurses, which has caused and may continueto cause an increase in our salaries, wages and benefits expense in excess ofthe inflation rate.  Although we cannotpredict our ability to cover future cost increases, management believes thatthrough adherence to cost containment policies, labor management and reasonableprice increases, the effects of inflation on future operating margins should bemanageable.  Our ability to pass onincreased costs associated with providing health care to Medicare and Medicaidpatients is limited due to various federal, state and local laws that have beenenacted which, in certain cases, limit our ability to increase prices.  In addition, as a result of increasingregulatory and competitive pressures and a continuing industry wide shift ofpatients into managed care plans, our ability to maintain margins through priceincreases to non-Medicare patients is limited.

The behavioral health care industryis typically not directly impacted by periods of recession, erosions ofconsumer confidence or other general economic trends as most health careservices are not considered a component of discretionary spending.  However, our inpatient facilities may beindirectly negatively impacted to the extent such economic conditions result indecreased reimbursements by federal or state governments or managed carepayers.  We are not aware of any economictrends that would prevent us from being able to remain in compliance with allof our debt covenants and to meet all required obligations and commitments inthe near future.

***Critical Accounting Policies andEstimates***

This discussionshould be read in conjunction with Note 2 “Significant Accounting Policies andEstimates” in the notes to the consolidated financial statements includedelsewhere herein which describes in more detail the Company’s significantaccounting policies and estimates.

The preparation ofthese financial statements requires the use of estimates, judgments andassumptions that affect the reported amounts of assets and liabilities, and thedisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during therespective reporting periods.  TheCompany’s senior management and independent auditor have discussed the criticalaccounting estimates with the Company’s audit committee.

The Companycontinually evaluates its accounting policies and the estimates it uses toprepare the consolidated financial statements. In general, the estimates are based on historical experience, oninformation from third party professionals and on various other sources andassumptions that are believed to be reasonable under the facts andcircumstances.  Management considers anaccounting estimate to be critical if:

·                  it requiresassumptions to be made that were uncertain at the time the estimate was made,and

·                  changes in the estimate, or theuse of different estimating methods that could have been selected, could have amaterial impact on the Company’s consolidated results of operations orfinancial condition.

The following presents information about theCompany’s most critical accounting estimates.

***Allowances for Doubtful Accounts:***  TheCompany maintains allowances for doubtful accounts for estimated losses thatmay result from the inability of its customers to make required payments.  It is the Company’s policy to record anallowance for doubtful accounts and fully reserve for a customer account if areceivable balance remains outstanding in excess of 90 days for the contractmanagement services and EAP services groups. Discretionary amounts may be reserved prior to aging 90 days and arebased on the likelihood of recoverability of accounts 

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receivableconsidering such factors as past experience and taking into account currentcollection trends that are expected to continue.  Factors taken into consideration inestimating the allowances include amounts past due, in dispute, or a clientwhich the Company believes might be having financial difficulties. If economic,industry, or specific customer business trends worsen beyond earlier estimates,the Company may increase the allowances for doubtful accounts by recordingadditional expense.  Legal fees expendedin the pursuit of the outstanding amounts are considered “recovered” prior tothe reversal of any previously written off bad debt.

Theprimary collection risk with regard to patient receivables associated with theCompany’s hospital services group lies with uninsured patient accounts orpatient accounts whereby the primary insurance carrier has paid the amountscovered by the applicable agreement, but the portion of the amount that is thepatient’s responsibility (primarily deductibles and co-payments) remainsoutstanding.  The Company estimates theallowance for doubtful accounts for these receivables primarily based upon theage of the patient accounts receivable, the patients’ economic ability to payand the effectiveness of historical collection efforts. During the firstquarter of fiscal 2006, the allowance for doubtful accounts for the hospitalservices group was re-evaluated based on the operating experience with our freestanding behavioral healthcare facilities. The Company revised its reserve on bad debt for third-party payordelinquent accounts based on its actual historical collections.  The implementation of this change in estimatein the first quarter of 2006 had a favorable impact of approximately$532,000.  It is currently the Company’spolicy for the hospital services group to record an allowance for doubtfulaccounts and fully reserve for a customer account if a receivable balanceremains outstanding in excess of 180 days from the date of discharge or inexcess of 180 days from the billing date for Medicaid accounts.  Additionally, it is the Company’s policybased on historical experience, to fully reserve for any self-pay balancesoutstanding on the date of discharge. Accounts receivable acquired through an acquisition are recorded at netrealizable value.  The Companycontinually monitors its accounts receivable balances and utilizes cashcollection data to support its estimates of the provision for doubtfulaccounts.  Discretionary amounts may bereserved prior to aging 180 days from discharge upon review of the account andupon determination that the collection of the account or a portion thereof isuncollectible.  Significant changes inpayor mix or business office operations could have a significant impact on theCompany’s results of operations and cash flows.

The Companyemploys a full time business office manager at each of its free-standinghospital facilities who is responsible for billing and collection efforts.  The Company also employs a credit riskmanager whose primary responsibility is the collection of outstandingreceivable balances for the contract management services and EAP servicesgroups.  It is the Company’s policy towrite off receivable balances or portions thereof against the allowance fordoubtful accounts if all collection efforts have been exhausted and the accountis deemed to be uncollectible.

As of August 31,2006, the Company’s days sales outstanding was 52.7 days, an increase of 10.5%from 47.7 days at August 31, 2005.  As ofAugust 31, 2006, the Company owned and operated a total of fifteen freestandingbehavioral facilities, compared to five such facilities at August 31, 2005.

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Shown below is ourpayor mix concentrations and related aging of net accounts receivable for ourhospital services, contract management services, and EAP services groups as ofAugust 31, 2006 and 2005 (in thousands):
| ** **                     | ** ** | **Days outstanding** | ** ** | ** **            | ** ** |
|--------------------------------|------------|---------------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **0 - 30**      | ** ** | **31 - 60** | ** ** | **61 - 90** | ** ** | **91 - 120** | ** ** | **121 - 150** | ** ** | **151 - 180** | ** ** | **Over 180** | ** ** | **Total** | ** ** |
| **As of August 31, 2006:**     | ** ** | ** **                | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Hospital Services              |       |                      |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Medicare                       |       | $                         | 3,739      |                  | $          | 560 |   | $ | 236 |   | $ | 258 |   | $ | 203 |   | $ | 147 |   | $ | — |   | $ | 5,143 |   |
| Medicaid                       |       | 5,202                     |       | 1,418                 |       | 571 |   | 315 |   | 221 |   | 213 |   | — |   | 7,940 |   |
| HMO/PPO/Commercial             |       | 5,301                     |       | 2,102                 |       | 1,244 |   | 875 |   | 825 |   | 696 |   | — |   | 11,043 |   |
| Self-pay                       |       | 270                       |       | —                |       | — |   | — |   | — |   | — |   | — |   | 270 |   |
| Other                          |       | 2,518                     |       | 1,016                 |       | 367 |   | 147 |   | 206 |   | 160 |   | — |   | 4,414 |   |
| Total Hospital Services        |       | 17,030                    |       | 5,096                 |       | 2,418 |   | 1,595 |   | 1,455 |   | 1,216 |   | — |   | 28,810 |   |
|                           |       |                      |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract Mgmt Services (a)     |       | 7,136                     |       | 2,104                 |       | 574 |   | (7 | ) | — |   | (54 | ) | 148 |   | 9,901 |   |
|                           |       |                      |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| EAP Services (b)               |       | 1,064                     |       | 1,009                 |       | 72 |   | — |   | — |   | — |   | — |   | 2,145 |   |
|                           |       |                      |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total Accounts Receivable, net |       | $                         | 25,230     |                  | $          | 8,209 |   | $ | 3,064 |   | $ | 1,588 |   | $ | 1,455 |   | $ | 1,162 |   | $ | 148 |   | $ | 40,856 |   |
|                           |       |                      |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| % of Total A/R                 |       | 61.7                      | %          | 20.1                  | %          | 7.5 | % | 3.9 | % | 3.6 | % | 2.8 | % | 0.4 | % |   |   |
|                           |       |                      |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **As of August 31, 2005:**     | ** ** | ** **                | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Hospital Services              |       |                      |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Medicare                       |       | $                         | 1,421      |                  | $          | 410 |   | $ | 79 |   | $ | 132 |   | $ | — |   | $ | 9 |   | $ | — |   | $ | 2,051 |   |
| Medicaid                       |       | 2,856                     |       | 284                   |       | 273 |   | 204 |   | 168 |   | 188 |   | 151 |   | 4,124 |   |
| HMO/PPO/Commercial             |       | 5,261                     |       | 1,185                 |       | 762 |   | 463 |   | 122 |   | 27 |   | 2 |   | 7,822 |   |
| Self-pay                       |       | 445                       |       | 185                   |       | 245 |   | 123 |   | 97 |   | 50 |   | — |   | 1,145 |   |
| Other                          |       | 692                       |       | 14                    |       | 36 |   | 16 |   | — |   | — |   | — |   | 758 |   |
| Total Hospital Services        |       | 10,675                    |       | 2,078                 |       | 1,395 |   | 938 |   | 387 |   | 274 |   | 153 |   | 15,900 |   |
|                           |       |                      |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract Mgmt Services (a)     |       | 8,100                     |       | 2,292                 |       | 461 |   | 99 |   | — |   | — |   | 78 |   | 11,030 |   |
|                           |       |                      |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| EAP Services (b)               |       | 1,191                     |       | 713                   |       | 40 |   | — |   | — |   | — |   | 2 |   | 1,946 |   |
|                           |       |                      |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total Accounts Receivable, net |       | $                         | 19,966     |                  | $          | 5,083 |   | $ | 1,896 |   | $ | 1,037 |   | $ | 387 |   | $ | 274 |   | $ | 233 |   | $ | 28,876 |   |
|                           |       |                      |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| % of Total A/R                 |       | 69.1                      | %          | 17.6                  | %          | 6.6 | % | 3.6 | % | 1.3 | % | 1.0 | % | 0.8 | % |   |   |

 

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(a)          Payor class consists ofacute-care hospital facilities.

(b)         Payor class consists ofthird-party insurance carriers and commercial organizations.

The Company’sprovision for doubtful accounts increased approximately $1.9 million from $4.4million for the year ended August 31, 2005, to $6.3 million for the year endedAugust 31, 2006, primarily as a result of the acquisitions in the Company’shospital services group.  Our freestandingbehavioral health facilities historically experience higher bad debt expenseand days sales outstanding than the contract management services, and EAPservices groups.  Accordingly, as theCompany acquires additional free-standing behavioral health facilities, baddebt expense and days sales outstanding is expected to increase as thepercentage of consolidated revenues derived from free-standing behavioralhealth facilities increases.  The Companyowned and operated two facilities for the full year and three facilities for aportion of the year ended August 31, 2005. These five facilities were operated by the Company for the entire yearended August 31, 2006, and an additional ten facilities were acquired duringthe year.

Hospital Services – Total receivables grew fromapproximately $15.9 million at August 31, 2005, to $28.8 million at August 31,2006 due to the acquisitions mentioned above. Approximately 77% of the receivable balance at August 31, 2006 waswithin 60 days outstanding.

ContractManagement Services– Total receivables decreased from approximately $11.0 million at August 31,2005 to $9.9 million at August 31, 2006. Approximately 93% of the receivable balance at August 31, 2006 waswithin 60 days outstanding.  At August31, 2006, the balance in the 151 – 180 days column relates to payments receivedsubsequent to year end on past due invoices. The balance in the over 180 days column relates to Medicaid cost reportsettlement payments due from one customer.

EAP Services – Total receivables increased fromapproximately $1.9 million at August 31, 2005 to $2.1 

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million at August 31,2006.  Approximately 97% of thereceivable balance at August 31, 2006 was within 60 days outstanding.

The clients in theCompany’s contract management and EAP services groups are primarily corporateentities and acute-care hospitals whereas, clients for the Company’s hospitalservices group range from governmental agencies, such as Medicare, toindividuals with no insurance (self-pays).

***Allowance for Contractual Discounts:***** **Withregard to the Company’s behavioral health hospitals, the Medicare and Medicaidregulations are complex and various managed care contracts may include multiplereimbursement mechanisms for different types of services provided and costsettlement provisions requiring complex calculations and assumptions subject tointerpretation.  The Company estimatesthe allowance for contractual discounts on a payor-specific basis given itsinterpretation of the applicable regulations or contract terms.  The services authorized and provided andrelated reimbursements are often subject to interpretation that could result inpayments that differ from the Company’s estimates in the near term.  Additionally, updated regulations andcontract renegotiations occur frequently necessitating continual review andassessment of the estimation process by management.  Contractual discounts are reported asdeductions from patient service revenue at the time the service is rendered.  During the year ended August 31, 2005, theCompany recorded a net decrease in the allowance for contractual discounts ofapproximately $19,000 as a result of Medicare cost report settlements for the2004 fiscal year for our Michiana Behavioral Health and Poplar Springsfacilities.  Adjustments related tosettlements during fiscal 2005 for other payor classes were insignificant.  During the year ended August 31, 2006, theCompany recorded a net decrease in the allowance for contractual discounts ofapproximately $451,000 as a result of Medicare cost report settlements for the2005 fiscal year for our Michiana, Poplar Springs, Laurelwood, Friends andRiver Park facilities.  Adjustmentsrelated to settlements during fiscal 2006 for other payor classes wereinsignificant.

***Medical Claims:*** Medical claims payablerepresent the liability for healthcare claims reported but not yet paid andclaims incurred but not yet reported (“IBNR”) related to the Company’s EAPbusiness.  The IBNR portion of medicalclaims payable is estimated based upon past claims payment experience formember groups, enrollment data, utilization statistics and other factors usingaccounting methodologies.  Althoughvariability is inherent in such estimates, management believes the recordedliability for medical claims payable is adequate.  Medical claim payable balances are monitoredand reviewed monthly.  Changes inassumptions for care costs caused by changes in actual or expected experiencecould cause these estimates to change significantly.  Reserves for these liabilities at August 31,2006 and 2005 were $983,000 and $2,838,000, respectively.  During fiscal year 2005 and prior, the Company offeredat risk managed behavioral health services to self-funded employee groups,insurance companies and commercial HMO & PPO plans through its EAP Servicesgroup.  At the end of fiscal year 2005,all contracts for managed behavioral healthcare services on an at-risk basishad been terminated in connection with the reorganization of the EAP Servicesgroup.  Thus, the medical claimsliability related to these services has decreased significantly during fiscalyear 2006 and is the primary reason for the $2 million decrease in thisbalance.

*Stock-BasedCompensation:* Prior to the 2006 fiscal year, the Companyaccounted for its stock-based compensation under the recognition andmeasurement principles of Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees*and related interpretations (“APB 25”). Under APB 25, no stock-based compensation cost was reflected in netincome for grants of stock prior to fiscal year 2006 because the Company grantsstock options with an exercise price equal to or greater than the market valueof the underlying common stock on the date of grant.

Effective September 1, 2005, the Company adopted Statement of FinancialAccounting Standards No. 123 (Revised 2004) *Share-BasedPayment* (“SFAS 123R”), which requires the measurement andrecognition of compensation cost at fair value for all share-based payments,including stock options and restricted share awards.  Stock-based compensation for fiscal year 2006was approximately $2,047,000 and is included in selling, general andadministrative expenses in the consolidated statement of operations.  This expense includes compensation expense,recognized over the applicable vesting periods, for new share-based awards andfor share-based awards granted prior to, but not yet vested, as of August 31,2005.  See Note 3 *“Stock-BasedCompensation”* in the notes to the consolidated financial statementsincluded elsewhere herein.

***Goodwill and Intangible Assets******:***Goodwill representsthe excess of purchase price over the fair value of identifiable assetsacquired, net of liabilities assumed. Intangibles consist of the separately identifiable intangibles, such ascontract valuations, non-competes and trade names.  At August 31, 2006 goodwill and intangibleassets 

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represented 47.4% of total assets. Contract valuations represent the fair value of management contracts andservice contracts purchased and are being amortized using the straight–linemethod over seven years.  Otherintangibles are being amortized over their estimated useful lives.  Per the provisions of SFAS No. 142, theCompany performs an annual goodwill impairment review, for each businessservice group as defined in Note 10 *“Goodwilland Other Intangible Assets”* to the Consolidated FinancialStatements, in the third quarter of each fiscal year or when events or changesin circumstances indicate the carrying value may not be recoverable.  Indicators the Company consider importantwhich could trigger an impairment review include, without limitation, (i)significant under-performance or loss of key contracts acquired in anacquisition relative to expected historical or projected future operatingresults; (ii) significant changes in the manner or use of the acquired assetsor the strategy of the Company’s overall business; (iii) significant negativeindustry or economic trends; (iv) increased competitive pressures; (v) asignificant decline in the Company’s stock price for a sustained period; and(vi) regulatory changes.  In assessingthe recoverability of the Company’s goodwill and intangibles, the Company mustmake assumptions regarding estimated future cash flows and other factors todetermine the fair value of the respective assets.  The fair value of the asset could bedifferent using different estimating methods and assumptions in these valuationtechniques resulting in a possible impairment of the intangible assets and/orgoodwill, or alternatively an acceleration in amortization expense mayresult.  An impairment charge wouldreduce operating income in the period it was determined that the charge wasneeded.  As a result of the May 31, 2006impairment testing, no impairment adjustments were deemed necessary.

***Reserves for Employee Health and WorkersCompensation Benefits***:  These reserves represent accruals forestimated claims incurred, but unpaid or not reported. The accruals are basedon a number of factors including historical experience, industry trends andrecent claims history and are subject to ongoing revision as conditions mightchange and as new data may be presented. In estimating the liability for claims, the Company obtains an estimatefrom a third party actuarial firm, which calculates an estimate using historicalexperiences and estimates of claim costs as well as numerous assumptionsregarding factors relevant to the derivation of an estimate of future claimcosts.  Reserves for employee healthbenefits at August 31, 2006 and 2005 were $910,000 and $1,191,000,respectively.  Reserves for workerscompensation at August 31, 2006 and 2005 were $1,802,000 and $1,214,000,respectively.  The increase in thereserve for workers compensation is primarily due to the increase in theCompany’s employee base and claims experience. Reserve estimates are expected values of the amounts required to payclaims reported or incurred through August 31, 2006 and includes a reasonableadditional reserve to account for a possible adverse deviation from theexpected values estimated.

***Reserves for Professional and GeneralLiability Claims****: *This reserverepresents an accrual for certain general and professional liability claimsfiled and for claims incurred, but not yet reported.  Estimates of the aggregate or portions ofclaims pursuant to the Company’s self-insurance retentions, and liability foruninsured claims incurred are determined by using actuarial assumptionsfollowed in the insurance industry and historical experience.  In estimating the liability for claims, theCompany obtains an estimate from a third party actuarial firm, which calculatesan estimate using historical experiences and estimates of claim costs as wellas numerous assumptions regarding factors relevant to the derivation of anestimate of future claim costs.  TheCompany takes into account those estimates when determining the appropriatereserves.  Reserves for these liabilitiesat August 31, 2006 and 2005 were $1,497,000 and $1,442,000, respectively.   Reserve estimates are expected values of theamounts required to pay claims reported or incurred through August 31, 2006 andinclude a reasonable additional reserve to account for a possible adversedeviation from the expected values estimated.

**ITEM 7A.****                                            QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

In itsnormal operations, the Company has market risk exposure to interest rates dueto its interest bearing debt obligations, which are entered into for purposesother than trading.  To manage itsexposure to changes in interest rates, the Company uses both variable rate debtand fixed rate debt of short duration with maturities ranging from 30 to 180days.  The Company has historicallyestimated its market risk exposure using sensitivity analyses assuming a 10%change in market rates.

Asof August 31, 2006, the Company had approximately $99.0 million outstandingunder its revolving credit facility with a weighted average interest rate ofapproximately 7.99%.  A hypothetical 10%change in the effective interest rate for these borrowings, assuming debtlevels as of August 31, 2006, would change interest expense by approximately$791,000 annually.  This would be fundedout of cash flows from operations, which were approximately $13.1 million forthe twelve months ended August 31, 2006.

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**ITEM 8.****                                                     FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA**

Referenceis made to the Consolidated Financial Statements of the Company and the Notesthereto appearing at page F-1 to F-38 elsewhere herein, which information isincorporated by reference into this Item 8.

**ITEM 9.****                                                     CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

None.

**ITEM 9A.               CONTROLSAND PROCEDURES**

**DisclosureControls and Procedures**

We have establisheddisclosure controls and procedures to ensure that material information relatingto the Company, including its consolidated subsidiaries, is made known to theofficers who certify the Company’s financial reports and to other members ofsenior management and the Board of Directors.

Based on theirevaluation as of August 31, 2006, our principal executive officer and principalfinancial officer have concluded that the Company’s disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act)are effective to ensure that the information required to be disclosed by theCompany in the reports that it files or submits under the Exchange Act isrecorded, processed, summarized, and reported within the time periods specifiedin SEC rules and forms, and information required to be disclosed in the reportsthat it files or submits under the Exchange Act is accumulated and communicatedto the management.

**Management’sReport on Internal Control over Financial Reporting**

Our management isresponsible for establishing and maintaining adequate internal control overfinancial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f)under the Exchange Act. Under the supervision and with the participation of ourmanagement, including our principal executive officer and principal financialofficer, we conducted an evaluation of the effectiveness of our internalcontrol over financial reporting based on the framework in *Internal Control - Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission.

Our internal controlover financial reporting is a process designed to provide reasonable assuranceregarding the reliability of our financial reporting and the preparation offinancial statements for external purposes in accordance with generallyaccepted accounting principles. Because of its inherent limitations, internalcontrol over financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

Pursuant to SECguidance, we have excluded Copper Hills Youth Center, Kingwood Pines Hospital,and the Lighthouse/Focus behavioral health facilities from our assessment ofinternal control over financial reporting as of August 31, 2006 because thehospitals were acquired by the Company in purchase business combinations during2006.  Our independent registered publicaccounting firm has also excluded these entities from their audit.  Copper Hills Youth Center is a wholly ownedsubsidiary of the Company whose total assets and total revenues representapproximately 3.4% and 3.3%, respectively, of the related consolidated financialstatement amounts as of and for the year ended August 31, 2006.  Kingwood Pines Hospital is a wholly ownedsubsidiary of the Company whose total assets and total revenues representapproximately 5.0% and 2.8%, respectively, of the related consolidatedfinancial statement amounts as of and for the year ended August 31, 2006.  The eight Lighthouse/Focus facilities arewholly owned subsidiaries of the Company whose total assets and total revenuesrepresent approximately 33.5% and 9.2%, respectively, of the relatedconsolidated financial statement amounts as of and for the year ended August31, 2006.

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Based on our evaluationunder the framework in *Internal Control -Integrated Framework*, our management concluded that our internalcontrol over financial reporting was effective as of August 31, 2006.

Our management’sassessment of the effectiveness of our internal control over financialreporting as of August 31, 2006, and the effectiveness of our internal controlover financial reporting as of August 31, 2006 have been audited byPricewaterhouseCoopers LLP, an independent registered public accounting firm,who also audited the consolidated financial statements of the Company includedin this report on Form 10-K, as stated in their report which is includedherein.  The report, which expressesunqualified opinions on management’s assessment and on the effectiveness of theCompany’s internal control over financial reporting as of August 31, 2006, isincluded in the “Report of Independent Registered Public Accounting Firm,”elsewhere within this document.

**Changesin Internal Control over Financial Reporting**

There have been nochanges in the Company’s internal control over financial reporting (as definedin Rule 13a-15(f) under the Exchange Act) that occurred during the Company’slast fiscal quarter that have materially affected or are reasonably likely tomaterially affect the Company’s internal control over financial reporting.

**PART III**

**ITEM 10.****                                           DIRECTORSAND EXECUTIVE OFFICERS OF THE REGISTRANT**

*Directors*

TheCompany will file with the Commission a definitive proxy statement with respectto the Annual Meeting of Stockholders of the Company to be held on January 19,2007 (the “Proxy Statement).  Theinformation relating to our directors set forth in the Company’s ProxyStatement under the caption of “Election of Directors” and “CorporateGovernance – Audit Committee” is incorporated herein by reference.

*Audit Committee Financial Experts*

TheCompany has determined that the two members of the Audit Committee of the Boardof Directors, George E. Bello and James E. Buncher each qualify as an “auditcommittee financial expert” as defined in Item 401(h) of Regulation S-K, andthat each of those individuals is “independent” as the term is used in Item7(d)(3)(iv) of Schedule 14A under the Securities Exchange Act.

*ExecutiveOfficers of Registrant*

The ExecutiveOfficers of the Company are as follows:
| Name                  | ** ** | **Age** | ** ** | **Position**                                                   |
|-----------------------|------------|---------|------------|----------------------------------------------------------------|
| James K. Newman       |       | 62      |       | Chairman of the Board, President and Chief Executive  Officer  |
| David K. White, Ph.D. |       | 50      |       | President, Contract Management Services                        |
| Frank J. Baumann      |       | 47      |       | President, Hospital Services                                   |
| John E. Pitts         |       | 41      |       | Executive Vice President, Finance and Chief  Financial Officer |
| David K.  Meyercord   |       | 59      |       | Executive Vice President, Administration and General  Counsel  |
| Donald W. Thayer      |       | 57      |       | Executive Vice President, Acquisitions and  Development        |

 

*James K. Newman* has served asChairman of the Board since February 1992. Currently he also serves as President and Chief Executive Officer of theCompany.  In April 2003, he re-assumedthe position of President and Chief Executive Officer of the Company, aposition he had previously held from July 1989 through August 1997.  He has been Chairman and Chief ExecutiveOfficer since April 2003 and was also President from April 2003 until April2005, a position he re-assumed again in July 2006.  Mr. Newman previously served as a consultantto the Company from September 1997 through April 2003.  Mr. Newman currently serves as a director ofUnited Surgical Partners, Inc., a health care company engaged in the operationof ambulatory surgical centers, and of Telecare Corporation, a privately heldbehavioral health service provider.

*David K.White, Ph.D.* has served as President – Contract ManagementServices of the Company since July 2006. He previously served as President and Chief Operating Officer of theCompany from April 2005 until July 2006, and as President – Behavioral HealthServices from September 2002 until April 2005. He formerly served as 

56

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Senior Vice President –Operations from November 1998 until September 2002 and as Vice President -Operations from February 1998 to October 1998. He was a Regional Vice President from September 1996 to January 1998 anda Regional Director of Operations from April 1995 to August 1996.

*Frank J. Baumann* has beenPresident – Hospital Services of the Company since December 2005.  Previously he served as President – ContractManagement Services from April 2005 to December 2005.  He has also served as Senior Vice President –Operations since March 1999.  He wasPresident – ProCare One Nurses from June 2002 to October 2003 and had oversightresponsibility for that service group until its sale on August 29, 2005.  He was President – Physical RehabilitationServices from March 1999 to April 2005. He formerly served as a Regional Vice President from March 1997 to March1999.  He was also a Regional Director ofOperations from November 1996 to March 1997.

*JohnE. Pitts* has been Executive Vice President – Finance andChief Financial Officer since September 2005. Mr. Pitts was appointed as Chief Financial Officer of the Company inOctober 2004 by the Board of Directors following his appointment as Senior VicePresident - Finance and Principal Financial Officer in September 2004.  He formerly had served as Vice President -Finance and Principal Accounting Officer since October 2003 and had been VicePresident - Controller since November 2001. Mr. Pitts had previously served the Company in various accountingpositions from December 1993 through October 2001.

*DavidK. Meyercord* has been Executive Vice President Administrationand General Counsel since September 2005. Mr. Meyercord joined the company as Senior Vice President and GeneralCounsel in July 2004.  Effective inSeptember 2004, his title was changed to Senior Vice President - Administrationand General Counsel as a result of a change in responsibilities.  Prior to July 2004, Mr. Meyercord had been apartner in the law firm of Strasburger & Price, LLP, a Dallas-based lawfirm.  He had been a member of that lawfirm since 1975 and served as its managing partner from 1990 to 1998. He hadrepresented the Company as outside general counsel since its inception.

*Donald W.Thayer* has been Executive Vice President-Acquisitions andDevelopment since September 2005 and had previously served as Senior VicePresident-Acquisitions and Development since September 2003.  He formerly served as the ManagingDirector-Mergers and Acquisitions for B.C. Ziegler and Company from December2001 to September 2003.  From July 2000to November 2001 he was an independent consultant working under multipleconsulting agreements to provide acquisition and development services.  Mr. Thayer served as VicePresident-Acquisition and Development from July 1978 through July 2000 forTenet Healthcare Corporation.

Officersof the Company are elected by the Board of Directors of the Company and serveat the pleasure of the Board of Directors until their respective successors areelected and qualified.

*Code Of Conduct*

TheCompany has adopted a Code of Conduct applicable to all employees, includingthe principal executive officer, principal financial officer and principalaccounting officer of the Company. A copy of the Code of Conduct is availableon the Company’s Web site at *www.horizonhealth.com.*The Company intends to post on its Web site any amendments to, or waivers from,its Code of Conduct applicable to such senior officers.

*Section 16(a) Compliance*

Theinformation relating to Section 16(a) beneficial ownership reporting compliancethat will be set forth in our Proxy Statement under the caption “StockOwnership by Directors, Executive Officers and 5% Beneficial Owners” isincorporated herein by reference.

**ITEM 11.               EXECUTIVE COMPENSATION**

Theinformation that will be set forth in our Proxy Statement under the caption “ExecutiveCompensation” is incorporated herein by reference.  The Comparative Performance Graph and theCompensation Committee Report on Executive Compensation that also will beincluded in the Proxy Statement are expressly not incorporated herein byreference.

57

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**ITEM 12.****                                              SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT**

The followingtable sets forth a summary of the equity compensation plans offered by theCompany:

**EquityCompensation Plan Information as of September 30, 2006**
| ** **                                                  | ** ** | **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 issue under equity  compensation plans  (excluding securities  reflected in column (a))** | ** ** |
|-------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                  | ** ** | **(a)**                                                                                                                                              | ** ** | **(b)**                                                                                                     | ** ** | **(c)**                                                                                                                                                                                                       | ** ** |
| **Plan  Category**                                          | ** ** | ** **                                                                                                                                           | ** ** | ** **                                                                                                  | ** ** | ** **                                                                                                                                                                                                    | ** ** |
| Equity  compensation plans approved by security holders     |       | 1,177,440                                                                                                                                            |       | $                                                                                                           | 9.11       |                                                                                                                                                                                                          | 390,032    |   |
| Equity  compensation plans not approved by security holders |       | —                                                                                                                                               |       | —                                                                                                      |       | —                                                                                                                                                                                                        |       |
| Total                                                       |       | 1,177,440                                                                                                                                            |       | $                                                                                                           | 9.11       |                                                                                                                                                                                                          | 390,032    |   |

 

The Company herebyincorporates into this Item 12 by reference to the Proxy Statement the otherinformation required by this Item 12 that will appear in the Proxy Statementunder the caption “Security Ownership by Management and Principal Stockholders”.

**ITEM 13.               CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS**

None.

**ITEM 14.               PRINCIPALACCOUNTING FEES AND SERVICES**

Theinformation that will be set forth in our Proxy Statement under the caption “Appointmentof Independent Registered Accounting Firm” is incorporated herein by reference.

58

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**PART IV**

**ITEM 15.****                 EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTSON FORM 8-K**
| (a)    | (1)        | Financial Statements - Reference is made to the  Index to Consolidated Financial Statements appearing at page F-1 of this  report.                                                                                                                                                                                                                                                                          |
|--------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                        |
|   | (2)        | Financial Statement Schedule - Reference is made to  the Index to Financial Statement Schedule appearing at page S-1 of this  report.                                                                                                                                                                                                                                                                       |
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                        |
|   | (3)        | Exhibits.                                                                                                                                                                                                                                                                                                                                                                                                   |
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                        |
| 3.1    | -          | Certificate of Incorporation of the Company, as  amended (incorporated herein by reference to Exhibit 3.1 to the Company’s  Current Report on Form 8-K dated August 11, 1997).                                                                                                                                                                                                                         |
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                        |
| 3.2    | -          | Amended and Restated Bylaws of the Company, as  amended (incorporated herein by reference to Exhibit 3.1 to the Company’s  Current Report on Form 8-K dated April 21, 2005).                                                                                                                                                                                                                           |
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                        |
| 4.1    | -          | Specimen certificate for the Common Stock, $.01 par  value of the Company (incorporated herein by reference to Exhibit 4.1 to the  Company’s Current Report on Form 8-K dated August 11, 1997).                                                                                                                                                                                                        |
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                        |
| 4.2    | **-**      | Rights Agreement, dated February 6, 1997, between  the Company and American Stock Transfer & Trust Company, as Rights Agent  (incorporated by reference to Exhibit 4.1 to the Company’s Registration  Statement on Form 8-A, Registration No. 000-22123, as filed with the  Commission on February 7, 1997).                                                                                       |
|   | ** ** |                                                                                                                                                                                                                                                                                                                                                                                                        |
| 4.3    | -          | First Amendment to Rights Agreement, dated April  22,2005 by and between the Company and American Stock Transfer & Trust  Company, as Rights Agent (incorporated herein by reference to Exhibit 4.1 to  the Company’s Current Report on Form 8-K dated April 21, 2005).                                                                                                                            |
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.1   | -          | Consent and First Amendment to Third Amended and  Restated Credit Agreement dated November 14, 2005, between Horizon Health  Corporation and Horizon Health Management, Inc. as Borrowers and JPMorgan  Chase Bank as Agent, and the banks named therein. (incorporated herein by  reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for  the quarter ended November 30, 2005). |
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.2   | -          | Asset Purchase Agreement dated as of December 9,  2005, by and among Lighthouse Care Centers, LLC, and certain other affiliated  Lighthouse entities as Sellers, and Horizon Health Corporation, as Purchaser  (incorporated herein by reference to Exhibit 10.1 to the Company’s Current  Report on Form 8-K dated December 9, 2005).                                                                 |
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.3   | -          | Asset Purchase Agreement dated as of December 9,  2005, by and among Focus Healthcare, LLC, and certain other affiliated Focus  entities as Sellers, and Horizon Health Corporation, as Purchaser  (incorporated herein by reference to Exhibit 10.2 to the Company’s Current  Report on Form 8-K dated December 9, 2005).                                                                             |
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.4   | -          | Stock Purchase Agreement dated as of December 30,  2005 by and among Kids Behavioral Health, LLC as Shareholder and Kids  Behavioral Health of Utah, Inc., and Horizon Health Hospital Services, Inc.,  as Purchaser (incorporated herein by reference to Exhibit 10.1 to the  Company’s Current Report on Form 8-K dated December 30, 2005).                                                          |
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.5   | -          | Second Amendment to Third Amended and Restated  Credit Agreement dated as of January 26, 2006, between Horizon Health  Corporation and Horizon Mental Health Management, Inc. as Borrowers and  JPMorgan Chase Bank as Agent, and the banks named therein (incorporated by  reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K dated  January 27, 2006).                            |

 

59

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|        |   | reference to Exhibit 10.1 to the Company’s Current  Report on Form 8-K dated January 27, 2006).                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.6   | -      | Amended and Restated Asset Purchase Agreement dated  as of January 30, 2006, by and among Focus Healthcare, LLC, and certain other  affiliated Focus entities as Sellers, and Horizon Health Corporation, as  Purchaser (incorporated herein by reference to Exhibit 10.1 to the Company’s  Current Report on Form 8-K dated February 1, 2006).                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.7   | -      | Agreement and Plan of Merger and Asset Purchase  Agreement dated as of January 30, 2006, by and among Horizon Health  Corporation, HHC Delaware, Inc., HHC Realty Investments, LLC, and Delaware  Investment Associates, LLC, and with respect to the purchase and sale of the  Focus Delaware assets and related transactions by and between HHC Delaware,  Inc. and Focus Healthcare of Delaware, LLC (incorporated herein by reference  to Exhibit 10.2 to the Company’s Current Report on Form 8-K dated February 1,  2006). |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.8   | -      | First Amendment to Asset Purchase Agreement dated as  of January 30, 2006, by and among Lighthouse Care Centers, LLC, and certain  other affiliated Lighthouse entities as Sellers, and Horizon Health Corporation,  as Purchaser (incorporated herein by reference to Exhibit 10.3 to the  Company’s Current Report on Form 8-K dated February 1, 2006).                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.9   | -      | Limited Partner Interest Purchase Agreement dated as  of January 17, 2006, by and among HHC Kingwood Investment, LLC as Purchaser,  Signet Health Corporation as Seller and SHC-KPH, LP (incorporated herein by  reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K dated  February 15, 2006).                                                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.10  | -      | Membership Interest Purchase Agreement dated as of  January 17, 2006, by and among Horizon Health Hospital Services, Inc. as  Purchaser, Jerry G. Browder as Seller and Kingwood Pines Hospital, LLC  (incorporated herein by reference to Exhibit 10.2 to the Company’s Current  Report on Form 8-K dated February 15, 2006).                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.11  | -      | Third Amendment to Third Amended and Restated Credit  Agreement dated as of May 24, 2006, between Horizon Health Corporation and  Horizon Mental Health Management, Inc. as Borrowers and JPMorgan Chase Bank  as Agent, and the banks named therein (incorporated herein by reference to  Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter  ended May 31, 2006).                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.12  | -      | Lease Agreement dated as of August 9, 2006, between  Horizon Mental Health Management, Inc. as Tennant and St. David’s Healthcare  Partnership LP, LLP as Landlord (incorporated herein by reference to Exhibit  10.1 to the Company’s Current Report on Form 8-K dated August 15, 2006).                                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.13  | -      | Executive Agreement, dated September 7, 2006,  between the Company and James Ken Newman (incorporated herein by reference to  Exhibit 10.1 to the Company’s Current Report on Form 8-K dated September 11,  2006).                                                                                                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.14  | -      | Executive Agreement, dated September 7, 2006,  between the Company and David K. White (incorporated herein by reference to  Exhibit 10.2 to the Company’s Current Report on Form 8-K dated September 11,  2006).                                                                                                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.15  | -      | Executive Agreement, dated September 7, 2006,  between the Company and John E. Pitts (incorporated herein by reference to  Exhibit 10.3 to the Company’s Current Report on Form 8-K dated September 11,  2006).                                                                                                                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.16  | -      | Executive Agreement, dated September 7, 2006,  between the Company and Donald W. Thayer (incorporated herein by reference to  Exhibit 10.4 to the Company’s Current Report on Form 8-K dated September 11,  2006).                                                                                                                                                                                                                                                                                                               |

 

60

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| 10.17  | -      | Executive Agreement, dated September 7, 2006,  between the Company and David K. Meyercord (incorporated herein by reference  to Exhibit 10.5 to the Company’s Current Report on Form 8-K dated September  11, 2006).                                                       |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                            |
| 10.18  | -      | Executive Agreement, dated September 7, 2006,  between the Company and Frank J. Baumann (incorporated herein by reference to  Exhibit 10.6 to the Company’s Current Report on Form 8-K dated September 11,  2006).                                                         |
|   |   |                                                                                                                                                                                                                                                                            |
| 10.19  | -      | Horizon Health Corporation Bonus Plans for Executive  Officers for the 2007 Fiscal Year (incorporated herein by reference to  Exhibit 10.1 to the Company’s Current Report on Form 8-K dated October 25,  2006).                                                           |
|   |   |                                                                                                                                                                                                                                                                            |
| 10.20  | -      | Horizon Health Group, Inc. 1989 Stock Option Plan,  as amended (incorporated herein by reference to Exhibit 10.8 to the Company’s  Annual Report on Form 10-K for the fiscal year ended August 31, 2002).                                                                  |
|   |   |                                                                                                                                                                                                                                                                            |
| 10.21  | -      | Horizon Mental Health Management, Inc. 1995 Stock  Option Plan as amended (incorporated herein by reference to Exhibit 10.9 to  the Company’s Annual Report on Form 10-K for the fiscal year ended August 31,  2002).                                                      |
|   |   |                                                                                                                                                                                                                                                                            |
| 10.22  | -      | Horizon Mental Health Management, Inc. Amended and  Restated 1995 Stock Option Plan for Eligible Outside Directors as amended  (incorporated herein by reference to Exhibit 10.10 to the Company’s Annual  Report on Form 10-K for the fiscal year ended August 31, 2002). |
|   |   |                                                                                                                                                                                                                                                                            |
| 10.23  | -      | Horizon Health Corporation 1998 Stock Option Plan as  amended (incorporated herein by reference to Exhibit 10.11 to the Company’s  Annual Report on Form 10-K for the fiscal year ended August 31, 2002).                                                                  |
|   |   |                                                                                                                                                                                                                                                                            |
| 10.24  | -      | Horizon Health Corporation 2005 Omnibus Incentive  Plan (incorporated herein by reference to Exhibit 10.1 to the Company’s  Current Report on Form 8-K dated January 21, 2005).                                                                                            |
|   |   |                                                                                                                                                                                                                                                                            |
| 10.25  | -      | Horizon Health Corporation Bonus Plan Fiscal 2006  (incorporated herein by reference to Exhibit 10.16 to the Company’s Annual  Report on Form 10-K for the fiscal year ended August 31, 2005).                                                                             |
|   |   |                                                                                                                                                                                                                                                                            |
| 21     | -      | List of Subsidiaries of the Company (filed  herewith).                                                                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                            |
| 23     | -      | Consent of PricewaterhouseCoopers LLP (filed  herewith).                                                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                            |
| 31.1   | -      | Certification of Chief Executive Officer required by  Securities and Exchange Commission Rule   13a-14(a) or 15d-14(a) (filed herewith).                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                            |
| 31.2   | -      | Certification of Chief Financial Officer required by  Securities and Exchange Commission Rule   13a-14(a) or 15d-14(a) (filed herewith).                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                            |
| 32     | -      | Certification of Chief Executive Officer and Chief  Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002,  18 U.S.C. Section 1350(filed herewith).                                                                                                       |

 

61

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**SIGNATURES**

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the Company has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.
| **Date: November 9, 2006** |                                                                     |
|----------------------------|--------------------------------------------------------------------------|
| ** **                 | **HORIZON HEALTH CORPORATION**                                           |
| ** **                 | ** **                                                               |
| ** **                 | ** **                                                               |
| ** **                 | **By:**                                                                  | **/s/  JOHN E. PITTS** | ** ** |
| ** **                 | **John E. Pitts**                                                        |
| ** **                 | **Executive  Vice President – Finance and Chief Financial Officer** |
| ** **                 | **(Principal Financial Officer)**                                        |

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, this report has been signed below by the followingpersons on behalf of the Company and in the capacities and on the datesindicated.
| Signature                 | ** ** | **Capacity**                                                               | ** ** | **Date**         |
|---------------------------|------------|----------------------------------------------------------------------------|------------|------------------|
|                      |       |                                                                       |       |             |
| /s/ KEN NEWMAN            |       | Director and Chairman of the Board,                                        |       | November 9, 2006 |
| Ken Newman                |       | President and Chief Executive Officer  (Principal Executive Officer)       |       |             |
|                      |       |                                                                       |       |             |
| /s/ JOHN E.  PITTS        |       | Executive Vice President, Finance                                          |       | November 9, 2006 |
| John E. Pitts             |       | and Chief Financial Officer  (Principal Financial and Accounting  Officer) |       |             |
|                      |       |                                                                       |       |             |
| /s/ GEORGE E.  BELLO      |       | Director                                                                   |       | November 9, 2006 |
| George E. Bello           |       |                                                                       |       |             |
|                      |       |                                                                       |       |             |
| /s/ MIKE R.  BOWLIN       |       | Director                                                                   |       | November 9, 2006 |
| Mike R. Bowlin            |       |                                                                       |       |             |
|                      |       |                                                                       |       |             |
| /s/ JAMES E. BUNCHER      |       | Director                                                                   |       | November 9, 2006 |
| James E. Buncher          |       |                                                                       |       |             |
|                      |       |                                                                       |       |             |
| /s/ ROBERT A.  LEFTON     |       | Director                                                                   |       | November 9, 2006 |
| Robert A. Lefton          |       |                                                                       |       |             |
|                      |       |                                                                       |       |             |
| /s/ WILLIAM H.  LONGFIELD |       | Director                                                                   |       | November 9, 2006 |
| William H.  Longfield     |       |                                                                       |       |             |
|                      |       |                                                                       |       |             |
| /s/ C. THOMAS  SMITH      |       | Director                                                                   |       | November 9, 2006 |
| C. Thomas Smith           |       |                                                                       |       |             |

 

62

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**INDEX TOCONSOLIDATED FINANCIAL STATEMENTS**
| Report of Independent  Registered Public Accounting Firm         |   | F-2    |
|------------------------------------------------------------------|--------|--------|
|                                                             |   |   |
| Consolidated  Balance Sheets at August 31, 2006 and 2005         |   | F-4    |
|                                                             |   |   |
| Consolidated  Statements of Operations                           |   |   |
| For  the Years Ended August 31, 2006, 2005, and 2004             |   | F-6    |
|                                                             |   |   |
| Consolidated  Statements of Changes in Stockholders’ Equity |   |   |
| For  the Years Ended August 31, 2006, 2005, and 2004             |   | F-7    |
|                                                             |   |   |
| Consolidated  Statements of Cash Flows                           |   |   |
| For  the Years Ended August 31, 2006, 2005, and 2004             |   | F-8    |
|                                                             |   |   |
| Notes to Consolidated Financial Statements                       |   | F-10   |

 

F-1

----

**Report of Independent RegisteredPublic Accounting Firm**

To the Board of Directors and Shareholders

ofHorizon Health Corporation:

We have completedintegrated audits of Horizon Health Corporation’s August 31, 2006 and 2005consolidated financial statements and of its internal control over financialreporting as of August 31, 2006, and an audit of its August 31, 2004consolidated financial statements in accordance with the standards of thePublic Company Accounting Oversight Board (United States).  Our opinions, based on our audits, arepresented below.

Consolidatedfinancial statements and financial statement schedule

In our opinion,the consolidated financial statements listed in the index appearing under item15a(1) present fairly, in all material respects the financial position ofHorizon Health Corporation and its subsidiaries at August 31, 2006 and 2005,and the results of their operations and their cash flows for each of the threeyears in the period ended August 31, 2006 in conformity with accountingprinciples general accepted in the United States of America. In addition, in our opinion, the financialstatement schedule listed in the accompanying index appearing under item 15a(2)presents fairly, in all material respects, the information set forth thereinwhen read in conjunction with the related consolidated financial statements. Thesefinancial statements and financial statement schedule are the responsibility ofthe Company’s management. Our responsibility is to express an opinion on thesefinancial statements and financial statement schedule based on our audits. Weconducted our audits of these statements in accordance with the standards ofthe Public Company Accounting Oversight Board (United States). Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement. An audit offinancial statements includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements,, assessing theaccounting principles used and significant estimates made by management, andevaluating the overall financial statements presentation. We believe that ouraudits provide a reasonable basis for our opinion.

As discussed inNote 3 to the financial statements, the Company changed the manner in which itaccounts for share-based compensation in fiscal 2006.

Internal controlover financial reporting

Also, in ouropinion, management’s assessment, included in Management’s Report on InternalControl over Financial Reporting appearing under item 9A, that the Companymaintained effective internal control over financial reporting as of August 31,2006 based on criteria established in *InternalControl - Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO), is fairly stated, in allmaterial respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all materialrespects, effective internal control over financial reporting as of August 31, 2006,based on criteria established in *InternalControl - Integrated Framework* issued by the COSO.  The Company’s management is responsible formaintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financialreporting.  Our responsibility is toexpress opinions on management’s assessment and on the effectiveness of theCompany’s internal control over financial reporting based on our audit.  We conducted our audit of internal controlover financial reporting in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtainreasonable assurance about whether effective internal control over financialreporting was maintained in all material respects.  An audit of internal control over financialreporting includes obtaining an understanding of internal control overfinancial reporting, evaluating management’s assessment, testing and evaluatingthe design and operating effectiveness of internal control, and performing suchother procedures as we consider necessary in the circumstances.  We believe that our audit provides areasonable basis for our opinions.

A company’sinternal control over financial reporting is a process designed to providereasonable assurance regarding the reliability of financial reporting and thepreparation of financial statements for external purposes in accordance withgenerally accepted accounting principles. A company’s internal control over financial reporting includes thosepolicies and procedures that (i) pertain to the maintenance of recordsthat, in reasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (ii) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (iii) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

F-2

----

Because of itsinherent limitations, internal control over financial reporting may not preventor detect misstatements.  Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

As described inManagement’s Report on Internal Control Over Financial Reporting, managementhas excluded Cooper Hills Youth Center, Kingwood Pines Hospital and the eightLighthouse & Focus behavioral health facilities from its assessment ofinternal control over financial reporting as of August 31, 2006 because theywere acquired by the Company in purchase business combinations during 2006.  We have also excluded these entities from ouraudit of internal control over financial reporting. Copper Hills Youth Centeris a wholly owned subsidiary of the Company whose total assets and totalrevenues represent approximately 3.4% and 3.3%, respectively, of the relatedconsolidated financial statement amounts as of and for the year ended August31, 2006.  Kingwood Pines Hospital is awholly owned subsidiary of the Company whose total assets and total revenuesrepresent approximately 5.0% and 2.8%, respectively, of the relatedconsolidated financial statement amounts as of and for the year ended August31, 2006.  The eight Lighthouse/Focusfacilities are wholly owned subsidiaries of the Company whose total assets andtotal revenues represent approximately 33.5% and 9.2%, respectively, of therelated consolidated financial statement amounts as of and for the year endedAugust 31, 2006.

/s/ PricewaterhouseCoopers LLP

Dallas, Texas

November 9, 2006

F-3

----

**HORIZONHEALTH CORPORATION**

**CONSOLIDATEDBALANCE SHEETS**

**(Inthousands)**
| ** **                                                                                                                | ** ** | **August 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|
| ** **                                                                                                                | ** ** | **2006**            | ** ** | **2005** | ** ** |
| CURRENT ASSETS:                                                                                                           |       |                |       |   |   |
| Cash  and cash equivalents                                                                                                |       | $                   | 3,043      |   | $ | 8,098 |   |
| Accounts  receivable less allowance for doubtful accounts of $8,486 and $5,741 at  August 31, 2006 and 2005, respectively |       | 40,856              |       | 28,876 |   |
| Prepaid  expenses and supplies                                                                                            |       | 6,630               |       | 4,822 |   |
| Other  receivables                                                                                                        |       | 4,637               |       | 2,211 |   |
| Other  assets                                                                                                             |       | 1,617               |       | 3,085 |   |
| Income  taxes receivable                                                                                                  |       | 1,619               |       | 204 |   |
| Deferred  taxes                                                                                                           |       | 6,021               |       | 5,388 |   |
|                                                                                                                      |       |                |       |   |   |
| TOTAL CURRENT  ASSETS                                                                                                     |       | 64,423              |       | 52,684 |   |
|                                                                                                                      |       |                |       |   |   |
| Property  and Equipment, net                                                                                              |       | 100,189             |       | 51,698 |   |
|                                                                                                                      |       |                |       |   |   |
| Goodwill                                                                                                                  |       | 106,054             |       | 74,228 |   |
| Other  indefinite life intangibles                                                                                        |       | 42,447              |       | 3,887 |   |
| Contracts,  net of accumulated amortization of $7,756 and $6,946 at August 31, 2006 and  2005, respectively               |       | 2,059               |       | 2,869 |   |
| Other  intangibles, net of accumulated amortization of $402 and $343 at August 31,  2006 and 2005, respectively           |       | 40                  |       | 100 |   |
| Other  non-current assets                                                                                                 |       | 2,428               |       | 1,752 |   |
|                                                                                                                      |       |                |       |   |   |
| TOTAL ASSETS                                                                                                              |       | $                   | 317,640    |   | $ | 187,218 |   |

See accompanying notes toconsolidated financial statements.

F-4

----

**(In thousands, except share andper share amounts)**
| ** **                                                                                                                                                                                                               | ** ** | **August 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|
| ** **                                                                                                                                                                                                               | ** ** | **2006**            | ** ** | **2005** | ** ** |
| CURRENT LIABILITIES:                                                                                                                                                                                                     |       |                |       |   |   |
| Accounts payable                                                                                                                                                                                                         |       | $                   | 7,362      |   | $ | 4,665 |   |
| Employee  compensation and benefits                                                                                                                                                                                      |       | 12,665              |       | 11,985 |   |
| Medical claims  payable                                                                                                                                                                                                  |       | 983                 |       | 2,838 |   |
| Accrued expenses  and unearned revenue                                                                                                                                                                                   |       | 14,902              |       | 13,706 |   |
| Current portion  of long-term debt                                                                                                                                                                                       |       | 70                  |       | — |   |
|                                                                                                                                                                                                                     |       |                |       |   |   |
| TOTAL CURRENT  LIABILITIES                                                                                                                                                                                               |       | 35,982              |       | 33,194 |   |
|                                                                                                                                                                                                                     |       |                |       |   |   |
| Other  non-current liabilities                                                                                                                                                                                           |       | 4,106               |       | 4,002 |   |
| Long-term debt                                                                                                                                                                                                           |       | 105,935             |       | — |   |
| Deferred income  taxes                                                                                                                                                                                                   |       | 8,108               |       | 3,036 |   |
|                                                                                                                                                                                                                     |       |                |       |   |   |
| TOTAL  LIABILITIES                                                                                                                                                                                                       |       | 154,131             |       | 40,232 |   |
|                                                                                                                                                                                                                     |       |                |       |   |   |
| Minority interest                                                                                                                                                                                                        |       | 4,053               |       | 3,865 |   |
|                                                                                                                                                                                                                     |       |                |       |   |   |
| Commitments and  contingencies                                                                                                                                                                                           |       |                |       |   |   |
|                                                                                                                                                                                                                     |       |                |       |   |   |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                                                               |       |                |       |   |   |
| Preferred stock,  $.10 par value, 500,000 shares authorized; none issued or outstanding                                                                                                                                  |       | —              |       | — |   |
| Common stock,  $.01 par value, 40,000,000 shares authorized; 15,048,328 shares issued and  15,033,747 shares outstanding at August 31, 2006, and 14,906,772 shares  issued and 14,899,127 outstanding at August 31, 2005 |       | 151                 |       | 149 |   |
| Additional  paid-in capital                                                                                                                                                                                              |       | 88,375              |       | 84,020 |   |
| Retained  earnings                                                                                                                                                                                                       |       | 71,272              |       | 59,150 |   |
| Treasury stock,  at cost, 14,581 shares at August 31, 2006 and 7,645 shares at August 31, 2005                                                                                                                           |       | (342                | )          | (198 | ) |
|                                                                                                                                                                                                                     |       |                |       |   |   |
| TOTAL  STOCKHOLDERS’ EQUITY                                                                                                                                                                                         |       | 159,456             |       | 143,121 |   |
|                                                                                                                                                                                                                     |       |                |       |   |   |
| TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                                                                         |       | $                   | 317,640    |   | $ | 187,218 |   |

See accompanying notes toconsolidated financial statements.

F-5

----

**HORIZONHEALTH CORPORATION**

# **CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(In thousands, except per share amounts)**
| ** **                                                                            | ** ** | **Years Ended August 31,** | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                            | ** ** | **2006**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                  |       |                                      |       |   |   |   |   |
| Revenue                                                                               |       | $                                         | 274,961    |   | $ | 207,392 |   | $ | 161,825 |   |
|                                                                                  |       |                                      |       |   |   |   |   |
| Cost of services  (exclusive of depreciation and amortization shown separately below) |       | 211,096                                   |       | 160,032 |   | 121,554 |   |
| Selling, general and  administrative                                                  |       | 26,605                                    |       | 23,220 |   | 18,835 |   |
| Provision for doubtful  accounts                                                      |       | 6,256                                     |       | 4,382 |   | 869 |   |
| Impairment loss on  building                                                          |       | —                                    |       | 1,015 |   | — |   |
| Depreciation and  amortization                                                        |       | 5,529                                     |       | 3,387 |   | 2,795 |   |
|                                                                                  |       |                                      |       |   |   |   |   |
| Operating income                                                                      |       | 25,475                                    |       | 15,356 |   | 17,772 |   |
|                                                                                  |       |                                      |       |   |   |   |   |
| Other income (expense):                                                               |       |                                      |       |   |   |   |   |
| Interest expense                                                                      |       | (5,251                                    | )          | (1,573 | ) | (1,354 | ) |
| Interest income  and other                                                            |       | 55                                        |       | 275 |   | 47 |   |
|                                                                                  |       |                                      |       |   |   |   |   |
| Income before income  taxes, minority interest and discontinued operations            |       | 20,279                                    |       | 14,058 |   | 16,465 |   |
|                                                                                  |       |                                      |       |   |   |   |   |
| Income tax provision                                                                  |       | 7,976                                     |       | 5,332 |   | 6,252 |   |
|                                                                                  |       |                                      |       |   |   |   |   |
| Minority interest, net                                                                |       | 188                                       |       | (15 | ) | — |   |
|                                                                                  |       |                                      |       |   |   |   |   |
| Income from continuing  operations                                                    |       | 12,115                                    |       | 8,741 |   | 10,213 |   |
|                                                                                  |       |                                      |       |   |   |   |   |
| Discontinued  operations:                                                             |       |                                      |       |   |   |   |   |
| Income (loss) from  discontinued operations, net                                      |       | 3                                         |       | (488 | ) | 562 |   |
| Income (loss) on  disposal of discontinued operations, net                            |       | 4                                         |       | (3,102 | ) | — |   |
|                                                                                  |       |                                      |       |   |   |   |   |
| Discontinued operations                                                               |       | 7                                         |       | (3,590 | ) | 562 |   |
|                                                                                  |       |                                      |       |   |   |   |   |
| Net Income                                                                            |       | $                                         | 12,122     |   | $ | 5,151 |   | $ | 10,775 |   |
|                                                                                  |       |                                      |       |   |   |   |   |
| Basic earnings per  common share:                                                     |       |                                      |       |   |   |   |   |
| Continuing  operations                                                                |       | $                                         | 0.81       |   | $ | 0.68 |   | $ | 0.94 |   |
| Discontinued  operations                                                              |       | 0.00                                      |       | (0.28 | ) | 0.05 |   |
|                                                                                  |       | $                                         | 0.81       |   | $ | 0.40 |   | $ | 0.99 |   |
|                                                                                  |       |                                      |       |   |   |   |   |
| Diluted earnings per common  share:                                                   |       |                                      |       |   |   |   |   |
| Continuing  operations                                                                |       | $                                         | 0.79       |   | $ | 0.66 |   | $ | 0.90 |   |
| Discontinued  operations                                                              |       | 0.00                                      |       | (0.27 | ) | 0.05 |   |
|                                                                                  |       | $                                         | 0.79       |   | $ | 0.39 |   | $ | 0.95 |   |
|                                                                                  |       |                                      |       |   |   |   |   |
| Weighted average shares  outstanding:                                                 |       |                                      |       |   |   |   |   |
| Basic                                                                                 |       | 14,974                                    |       | 12,829 |   | 10,849 |   |
| Diluted                                                                               |       | 15,408                                    |       | 13,306 |   | 11,346 |   |

See accompanyingnotes to consolidated financial statements.

F-6

----

**HORIZONHEALTH CORPORATION**

** CONSOLIDATED STATEMENTS OF CHANGES INSTOCKHOLDERS’ EQUITY**

**(Inthousands)**
| ** **                                               | ** ** | ** ** | ** ** | **Common   Stock** | ** ** | **Additional  Paid-in** | ** ** | **Retained** | ** ** | **Treasury** | ** ** | **Treasury  Stock,** | ** ** | ** ** | ** ** |
|----------------------------------------------------------|------------|------------|------------|-------------------------|------------|-------------------------|------------|--------------|------------|--------------|------------|----------------------|------------|------------|------------|
| ** **                                               | ** ** | **Shares** | ** ** | **Amount**              | ** ** | **Capital**             | ** ** | **Earnings** | ** ** | **Shares**   | ** ** | **at Cost**     | ** ** | **Total**  | ** ** |
|                                                     |       |       |       |                    |       |                    |       |         |       |         |       |                 |       |       |       |
| Balance at August 31,  2003                              |       | 11,326     |       | $                       | 113        |                    | $          | 20,975       |       | $            | 44,162     |                 | 326        |       | $          | (1,459 | ) | $ | 63,791 |   |
|                                                     |       |       |       |                    |       |                    |       |         |       |         |       |                 |       |       |       |
| Net Income                                               |       | —     |       | —                  |       | —                  |       | 10,775       |       | —       |       | —               |       | 10,775     |       |
| Purchase of  treasury stock                              |       | —     |       | —                  |       | —                  |       | —       |       | 48           |       | (1,177               | )          | (1,177     | )          |
| Tax benefit  associated with stock options exercised     |       | —     |       | —                  |       | 2,109                   |       | —       |       | —       |       | —               |       | 2,109      |       |
| Employee stock  purchases                                |       | —     |       | —                  |       | 99                      |       | —       |       | (14          | )          | 130                  |       | 229        |       |
| Exercise of  stock options:                              |       |       |       |                    |       |                    |       |         |       |         |       |                 |       |       |       |
| Issuance of  treasury stock                              |       | —     |       | —                  |       | (99                     | )          | (772         | )          | (206         | )          | 1,835                |       | 964        |       |
| Employee  surrenders for tax payments                    |       | —     |       | —                  |       | —                  |       | —       |       | 37           |       | (867                 | )          | (867       | )          |
|                                                     |       |       |       |                    |       |                    |       |         |       |         |       |                 |       |       |       |
| Balance at August 31,  2004                              |       | 11,326     |       | $                       | 113        |                    | $          | 23,084       |       | $            | 54,165     |                 | 191        |       | $          | (1,538 | ) | $ | 75,824 |   |
|                                                     |       |       |       |                    |       |                    |       |         |       |         |       |                 |       |       |       |
| Net Income                                               |       | —     |       | —                  |       | —                  |       | 5,151        |       | —       |       | —               |       | 5,151      |       |
| Follow-on public  offering                               |       | 3,450      |       | 35                      |       | 58,398                  |       | (17          | )          | —       |       | —               |       | 58,416     |       |
| Purchase of  treasury stock                              |       | —     |       | —                  |       | —                  |       | —       |       | 10           |       | (292                 | )          | (292       | )          |
| Tax benefit  associated with stock options exercised     |       | —     |       | —                  |       | 1,778                   |       | —       |       | —       |       | —               |       | 1,778      |       |
| Employee stock  purchases                                |       | 23         |       | —                  |       | 377                     |       | —       |       | (9           | )          | 90                   |       | 467        |       |
| Exercise of  stock options:                              |       |       |       |                    |       |                    |       |         |       |         |       |                 |       |       |       |
| Issuance of  shares                                      |       | 108        |       | 1                       |       | 486                     |       | —       |       | —       |       | —               |       | 487        |       |
| Issuance of  treasury stock                              |       | —     |       | —                  |       | (103                    | )          | (149         | )          | (197         | )          | 1,904                |       | 1,652      |       |
| Employee  surrenders for tax payments                    |       | —     |       | —                  |       | —                  |       | —       |       | 13           |       | (362                 | )          | (362       | )          |
|                                                     |       |       |       |                    |       |                    |       |         |       |         |       |                 |       |       |       |
| Balance at August 31,  2005                              |       | 14,907     |       | $                       | 149        |                    | $          | 84,020       |       | $            | 59,150     |                 | 8          |       | $          | (198 | ) | $ | 143,121 |   |
|                                                     |       |       |       |                    |       |                    |       |         |       |         |       |                 |       |       |       |
| Net Income                                               |       | —     |       | —                  |       | —                  |       | 12,122       |       | —       |       | —               |       | 12,122     |       |
| Stock-based  compensation                                |       | —     |       | —                  |       | 1,910                   |       | —       |       | —       |       | —               |       | 1,910      |       |
| Tax benefit  associated with stock options exercised     |       | —     |       | —                  |       | 1,306                   |       | —       |       | —       |       | —               |       | 1,306      |       |
| Exercise of  stock options:                              |       |       |       |                    |       |                    |       |         |       |         |       |                 |       |       |       |
| Issuance of  shares                                      |       | 134        |       | 2                       |       | 1,002                   |       | —       |       | —       |       | —               |       | 1,004      |       |
| Employee  surrenders for tax payments                    |       | —     |       | —                  |       | —                  |       | —       |       | 7            |       | (143                 | )          | (143       | )          |
| Restricted share  awards:                                |       |       |       |                    |       |                    |       |         |       |         |       |                 |       |       |       |
| Issuance of  restricted share awards, net of forfeitures |       | 7          |       | —                  |       | 137                     |       | —       |       | —       |       | —               |       | 137        |       |
| Employee  surrenders for tax payments                    |       | —     |       | —                  |       | —                  |       | —       |       | —       |       | (1                   | )          | (1         | )          |
|                                                     |       |       |       |                    |       |                    |       |         |       |         |       |                 |       |       |       |
| Balance at August 31, 2006                               |       | 15,048     |       | $                       | 151        |                    | $          | 88,375       |       | $            | 71,272     |                 | 15         |       | $          | (342 | ) | $ | 159,456 |   |

 

Treasury shares reported were not affected by thetwo-for-one stock split.  The split inthe form of a 100% stock dividend was only issued on common shares outstandingat the close of business on May 31, 2005.

See accompanying notes to consolidated financialstatements.

F-7

----

**HORIZONHEALTH CORPORATION**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(In thousands)**
| ** **                                                                                                                                    | ** ** | **Years Ended August 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **2006**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Operating activities:                                                                                                                         |       |                                      |       |   |   |   |   |
| Net income                                                                                                                                    |       | $                                         | 12,122     |   | $ | 5,151 |   | $ | 10,775 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:                                                            |       |                                      |       |   |   |   |   |
| Provision for  doubtful accounts                                                                                                              |       | 6,256                                     |       | 4,382 |   | 810 |   |
| Depreciation and  amortization                                                                                                                |       | 5,529                                     |       | 3,387 |   | 2,925 |   |
| Deferred income  taxes                                                                                                                        |       | 4,439                                     |       | (4,567 | ) | 1,168 |   |
| Loss on disposal  of property and equipment                                                                                                   |       | 202                                       |       | 10 |   | — |   |
| Loss on disposal  of discontinued operations                                                                                                  |       | —                                    |       | 4,823 |   | — |   |
| Net loss on  write down of building                                                                                                           |       | —                                    |       | 1,015 |   | — |   |
| Tax benefit  associated with stock options exercised                                                                                          |       | 1,306                                     |       | 1,778 |   | 2,109 |   |
| Stock-based  compensation                                                                                                                     |       | 2,047                                     |       | — |   | — |   |
| Excess tax  benefits associated with stock-based compensation awards                                                                          |       | (516                                      | )          | — |   | — |   |
| Increase  (decrease) in minority interest                                                                                                     |       | 188                                       |       | (15 | ) | — |   |
| Changes in  operating assets and liabilities, net of assets acquired/sold:                                                                    |       |                                      |       |   |   |   |   |
| Increase in  accounts receivable                                                                                                              |       | (9,413                                    | )          | (8,251 | ) | (8,077 | ) |
| (Increase)  decrease in income taxes receivable                                                                                               |       | (1,415                                    | )          | (152 | ) | 576 |   |
| (Increase)  decrease in other receivables                                                                                                     |       | (2,453                                    | )          | (1,402 | ) | 325 |   |
| (Increase)  decrease in prepaid expenses and supplies                                                                                         |       | (1,341                                    | )          | (3,490 | ) | 238 |   |
| Increase in  other assets                                                                                                                     |       | (1,713                                    | )          | (234 | ) | (152 | ) |
| (Decrease)  increase in accounts payable, employee compensation and benefits, medical  claims payable, accrued expenses and unearned revenues |       | (2,165                                    | )          | 7,492 |   | 1,674 |   |
| (Decrease)  increase in income taxes payable                                                                                                  |       | (57                                       | )          | 57 |   | (74 | ) |
| Increase in  other non-current liabilities                                                                                                    |       | 105                                       |       | 2,414 |   | 140 |   |
| Net cash provided by  operating activities                                                                                                    |       | 13,121                                    |       | 12,398 |   | 12,437 |   |
|                                                                                                                                          |       |                                      |       |   |   |   |   |
| Investing activities:                                                                                                                         |       |                                      |       |   |   |   |   |
| Purchases of  property and equipment                                                                                                          |       | (7,490                                    | )          | (3,149 | ) | (1,775 | ) |
| Proceeds from  sale of property and equipment                                                                                                 |       | 3,465                                     |       | 8 |   | — |   |
| Payment for  purchase of Lighthouse/Focus                                                                                                     |       | (91,736                                   | )          | — |   | — |   |
| Payment for  purchase of Kingwood Pines Hospital                                                                                              |       | (14,128                                   | )          | — |   | — |   |
| Payment for  purchase of Copper Hills Youth Center                                                                                            |       | (9,594                                    | )          | — |   | — |   |
| Payment for  Friends Behavioral Health System price adjustment                                                                                |       | (196                                      | )          | — |   | — |   |
| Payment for  River Park Hospital price adjustment                                                                                             |       | (166                                      | )          | — |   | — |   |
| Payment for  Michiana Behavioral Health Center price adjustment                                                                               |       | —                                    |       | (11 | ) | — |   |
| Payment for  Poplar Springs Hospital price adjustment                                                                                         |       | (1,278                                    | )          | (423 | ) | — |   |
| Purchase price  adjustment for Choice Health                                                                                                  |       | —                                    |       | 352 |   | — |   |
| Payment for  purchase of Friends Behavioral Health System                                                                                     |       | —                                    |       | (16,372 | ) | — |   |
| Payment for  purchase of River Park Hospital                                                                                                  |       | —                                    |       | (11,181 | ) | — |   |
| Proceeds from  sale of ProCare One Nurses                                                                                                     |       | —                                    |       | 4,200 |   | — |   |
| Payment for  purchase of Michiana Behavioral Health Center                                                                                    |       | —                                    |       | — |   | (6,198 | ) |
| Payment for  purchase of Poplar Springs Hospital                                                                                              |       | —                                    |       | — |   | (29,651 | ) |
| Payment for  Integrated Insights price adjustment                                                                                             |       | —                                    |       | — |   | (27 | ) |
| Net cash used in  investing activities                                                                                                        |       | (121,123                                  | )          | (26,576 | ) | (37,651 | ) |
|                                                                                                                                          |       |                                      |       |   |   |   |   |
| Financing activities:                                                                                                                         |       |                                      |       |   |   |   |   |
| Payments on  long-term debt                                                                                                                   |       | (212,928                                  | )          | (91,600 | ) | (111,300 | ) |
| Borrowings under  lines of credit                                                                                                             |       | 311,900                                   |       | 51,600 |   | 137,300 |   |
| Proceeds from  follow-on public offering of common stock                                                                                      |       | —                                    |       | 58,416 |   | — |   |
| Cash received  from payment of notes receivable                                                                                               |       | 2,600                                     |       | — |   | — |   |
| Cash provided in  exercise of Options/Employee Stock Purchase Plan                                                                            |       | 1,003                                     |       | 2,606 |   | 1,193 |   |
| Excess tax  benefits associated with stock-based compensation awards                                                                          |       | 516                                       |       | — |   | — |   |
| Tax payments in  connection with treasury stock surrendered                                                                                   |       | (144                                      | )          | (362 | ) | (867 | ) |
| Purchases of  treasury stock                                                                                                                  |       | —                                    |       | (292 | ) | (1,177 | ) |
| Net cash provided by  financing activities                                                                                                    |       | 102,947                                   |       | 20,368 |   | 25,149 |   |
|                                                                                                                                          |       |                                      |       |   |   |   |   |
| Net (decrease) increase  in cash and cash equivalents                                                                                         |       | (5,055                                    | )          | 6,190 |   | (65 | ) |
| Cash and cash  equivalents at beginning of year                                                                                               |       | 8,098                                     |       | 1,908 |   | 1,973 |   |
| Cash and cash equivalents at end of year                                                                                                      |       | $                                         | 3,043      |   | $ | 8,098 |   | $ | 1,908 |   |

F-8

----

 
| ** **                                        | ** ** | **Years ended August 31,** | ** ** |
|---------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                        | ** ** | **2006 (a)**                         | ** ** | **2005 (b)** | ** ** | **2004 (c)** | ** ** |
| Supplemental disclosure  of cash flow information |       |                                      |       |   |   |   |   |
| Net cash paid  during the period for:             |       |                                      |       |   |   |   |   |
| Interest                                          |       | $                                         | 3,273      |   | $ | 1,033 |   | $ | 611 |   |
| Income taxes                                      |       | $                                         | 3,708      |   | $ | 5,883 |   | $ | 2,879 |   |
|                                              |       |                                      |       |   |   |   |   |
| Non-cash investing  activities:                   |       |                                      |       |   |   |   |   |
| Fair value of  assets acquired                    |       | $                                         | 127,974    |   | $ | 34,510 |   | $ | 36,666 |   |
| Cash paid                                         |       | (115,458                                  | )          | (27,553 | ) | (35,849 | ) |
| Liabilities assumed                               |       | $                                         | 12,516     |   | $ | 6,957 |   | $ | 817 |   |

 

----

(a)                                  Non-cashinvesting activity consists of the purchase of Copper Hills Youth Centereffective January 1, 2006, the purchase of Kingwood Pines Hospital effectiveJanuary 17, 2006, and the purchase of the Lighthouse & Focus behavioralhealthcare facilities effective February 1, 2006 and April 1, 2006.  See Note 5 *“Acquisitions”*elsewhere herein this document.

(b)                                 Non-cashinvesting activity consists of the purchase of Friends Behavioral Health Systemeffective July 1, 2005 and the purchase of River Park Hospital effective August1, 2005.  See Note 5 *“Acquisitions”* elsewhere herein thisdocument.

(c)                                  Non-cashinvesting activity consists of the purchase of Michiana Behavioral HealthCenter effective April 1, 2004 and the purchase of Poplar Springs Hospitaleffective June 1, 2004.  See Note 5*”Acquisitions”* elsewhere herein thisdocument.

See accompanyingnotes to the consolidated financial statements.

F-9

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**HORIZON HEALTH CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**AUGUST 31, 2006, 2005 AND 2004**

**1.****                          ORGANIZATION**

Horizon HealthCorporation (“the Company”), d/b/a Horizon Health, is a diversified health careservices provider.  The Companyowns/leases and operates fifteen behavioral health care hospitals and relatedfacilities, which provide behavioral health care programs for children,adolescents, and adults.  Additionally,the Company is a leading contract manager of clinical and related services, primarilyof behavioral health and physical rehabilitation programs, offered by acutecare hospitals in the United States. The management contracts are generally forinitial terms ranging from three to five years, the majority of which haveautomatic renewal provisions.  TheCompany also offers an array of behavioral healthcare products to corporateclients, government agencies and third party administrators through employeeassistance programs.

During fiscal year2005, the Company offered at-risk managed behavioral health services toself-funded employee groups, insurance companies and commercial HMO & PPOplans through its EAP Services group.  Asof August 31, 2005, all contracts for managed behavioral healthcare services onan at-risk basis were terminated as a result of the reorganization of the EAPServices group. See Note 16 *“EAP ServicesReorganization and Related Impairments”* for additional information.

During fiscal year2005, the Company offered specialized temporary nurse staffing services toacute care hospitals through ProCare One Nurses.  ProCare One Nurses was sold on August 29,2005 and the company no longer provides these services.  See Note 6 *“DiscontinuedOperations”* for additional information.

The Companycurrently has regional offices in Denver, Colorado; Richmond, Virginia; and SanDiego, California; and behavioral health care facilities in Delaware, Florida,Georgia, Indiana, Ohio, Pennsylvania, South Carolina, Texas, Utah, Virginia,and West Virginia.  The Company’sNational Support Center and EAP Call Center is in the Dallas suburb ofLewisville, Texas.

The Company wasformed in July 1989 for the purpose of acquiring all the assets of twocompanies.  One of these companies, knownas Horizon Health Management Company, was formed in 1981 and since that timewas engaged in the behavioral health contract management business.  The other company owned a freestandingpsychiatric hospital in California. Effective March 1, 1990, the assets constituting the contract managementbusiness and the psychiatric hospital of the two companies were transferred tothe Company.

Since itsformation, the Company has completed twenty-nine acquisitions, including thefollowing sixteen consummated in the last three fiscal years:

·       On August 9, 2006, awholly-owned subsidiary of the Company entered into a long-term lease agreementwith St. David’s Healthcare Partnership, LP, LLP, for the lease of St. David’sPavilion located in Austin, Texas.  TheCompany will operate the facility as a 48 bed free-standing psychiatrichospital subject to receipt of required governmental approvals. The lease termwill commence upon completion of renovations to the facility and upon receiptof all government approvals and licenses required to operate the premises as afree-standing psychiatric hospital.

·       On February 1, 2006, the Company acquired the behavioral healthfacilities of Lighthouse Care Centers, LLC and Focus Healthcare, LLC.  Lighthouse Care Center, LLC operated fourbehavioral health facilities located in Florida, Georgia and SouthCarolina.  Focus Healthcare, LLC operatedfour behavioral health facilities located in Delaware, Florida, Georgia andOhio.  The Focus & Lighthousefacilities in Florida are operated out of the same free-standing hospital andwill be considered a single operating facility going forward.  Additionally, the Company acquired a facilityfrom Lighthouse which is expected to begin operations during fiscal year2007.  The facilities have a combinedtotal licensed capacity of 512 beds.  Theclosing of the acquisition for the Focus Healthcare Delaware facility waspostponed pending receipt of necessary government approvals and ultimatelyclosed on April 1, 2006.

·       Effective January 17, 2006,the Company acquired Kingwood Pines Hospital, a 78-bed behavioral healthfacility located in Kingwood, Texas.  Thetransaction was structured as a limited partner interest purchase agreement anda membership interest purchase agreement by which the Company acquired all ofthe partnership interest of the limited partner and all the member interests ofthe general partner.

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As a result of thetransaction, the Company acquired ownership directly and indirectly of all thepartnership interests in the partnership.

·       On January 1, 2006, the Company acquired Kids Behavioral Health ofUtah, Inc., a Utah corporation.  KidsBehavioral Health owned and operated Copper Hills Youth Center, a 126-bedadolescent residential treatment center located in West Jordan, Utah.  The transaction was structured as a stock purchaseagreement.

·       Effective August 1, 2005,the Company acquired the assets of River Park Hospital, a 165-bed behavioralhealth facility located in Huntington, West Virginia, and the stock of anaffiliated management company through a stock purchase agreement.  River Park Hospital has been consolidatedwith the Company since August 1, 2005.

·       Effective July 1, 2005, theCompany formed a joint venture with the Thomas Scattergood Behavioral HealthFoundation, a 501(c)(3) charitable organization, and the joint venture acquiredFriends Hospital, a 192-bed behavioral health hospital and a 27-bed adultresidential treatment center located in Philadelphia, Pennsylvania.  Prior to the acquisition, Friends Hospitalwas owned by the Thomas Scattergood Behavioral Health Foundation.  Friends Hospital has been consolidated withthe Company since July 1, 2005.

·       Effective January 1, 2005,the Company entered into a long-term operating lease agreement of LaurelwoodHospital, a 160-bed behavioral health hospital located in Willoughby, Ohio, asuburb of Cleveland.

·       Effective June 1, 2004, theCompany acquired the assets of PSH Acquisition Corporation (“PSH”), whichoperates five behavioral facilities (three owned and two leased) under the nameof Poplar Springs Hospital with a total licensed capacity of 187 beds, in thecentral Virginia region.  The facilitieshave been consolidated with the Company since June 1, 2004.

·       Effective April 1, 2004,the Company acquired the assets of Northern Indiana Hospital, an 80-bedbehavioral health hospital located in Plymouth, Indiana.  The Company operates the facility under thename “Michiana Behavioral Health Center” and it has been consolidated with theCompany since April 1, 2004.

**2.****                          SIGNIFICANTACCOUNTING POLICIES AND ESTIMATES**

The Company continually evaluates its accountingpolicies and the estimates it uses to prepare the consolidated financialstatements.  In general, the estimatesare based on historical experience, on information from third partyprofessionals and on various other assumptions that are believed to bereasonable under the facts and circumstances. In the Company’s opinion, the significant accounting policies mostimportant to aid in understanding its financial results are the following:

**Consolidation: **The consolidated financialstatements include those of the Company and its wholly owned and majority ownedsubsidiaries and one joint venture in which a controlling interest isheld.  The joint venture is included inthe consolidated financial statements of the Company and the 20% minorityinterest component is reflected separately before commitments and contingenciesin the balance sheet.  All significantintercompany accounts and transactions are eliminated in consolidation.

**Cash and Cash Equivalents:** Cashand cash equivalents primarily include highly liquid investments with originalmaturities of three months or less when purchased.  The carrying amount approximates fair valuedue to the short maturity of these instruments. Book overdrafts of approximately $660,000 were included in accountspayable at August 31, 2006.

**Accounts Receivable: **Accounts receivable varyaccording to the type of service being provided.  Accounts receivable for our Hospital Servicessegment is comprised of patient service revenue and is recorded net ofallowances for contractual discounts and estimated allowances for doubtfulaccounts.  Such amounts are owed byvarious governmental agencies, insurance companies and private patients.  Medicare comprised approximately 17.9% and12.9% of net patient receivables for our Hospital Services segment at August31, 2006 and 2005, respectively, and 12.6% and 7.1% of total accountsreceivable (net) of the Company at August 31, 2006 and 2005, respectively.  Medicaid comprised approximately 27.6% and25.9% of net patient receivables for our Hospital Services segment at August31, 2006 and 2005, respectively, and 19.4% and 

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14.3% of total accounts receivable (net) of theCompany at August 31, 2006 and 2005, respectively.  Concentration of credit risk from otherpayors is reduced by the large number of patients and payors.

Accounts receivable from our Contract ManagementServices segment and our EAP Services segment are comprised of contractuallydetermined fees for services rendered. Such amounts are recorded net of estimated allowances for doubtfulaccounts.  Concentration of credit riskis reduced by the large number of customers.

**Allowances for Doubtful Accounts:*** *The Companymaintains allowances for doubtful accounts for estimated losses that may resultfrom the inability of its customers to make required payments.  Allowances are based on the likelihood ofrecoverability of accounts receivable considering such factors as pastexperience and taking into account current collection trends that are expectedto continue.  Factors taken intoconsideration in estimating the allowance are amounts past due, in dispute, ora client which the Company believes might be having financialdifficulties.  If economic, industry, orspecific customer business trends worsen beyond earlier estimates, the Companyincreases the allowances for doubtful accounts by recording additional expense.  Legal fees expended in the pursuit of theoutstanding amounts are considered “recovered” prior to the reversal of anypreviously written off bad debt.

The primary collection risk with regard to patientreceivables associated with the Company’s behavioral health care facilitieslies with uninsured patient accounts or patient accounts whereby the primaryinsurance carrier has paid the amounts covered by the applicable agreement, butthe portion of the amount that is the patient’s responsibility (primarilydeductibles and co-payments) remains outstanding.  The Company estimates the allowance fordoubtful accounts primarily based upon the age of the patients’ accountsreceivable, the patients’ economic ability to pay and the effectiveness ofhistorical collection efforts.  TheCompany continually monitors its accounts receivable balances and utilizes cashcollection data to support its estimates of the provision for doubtfulaccounts.  Significant changes in payormix or business office operations could have a significant impact on theCompany’s results of operations and cash flows.

**Allowances for Contractual Discounts: **With regard to the Company’s owned behavioral healthcare facilities, the Medicare and Medicaid regulations are complex and variousmanaged care contracts may include multiple reimbursement mechanisms fordifferent types of services provided and cost settlement provisions requiringcomplex calculations and assumptions subject to interpretation.  The Company estimates the allowance for contractualdiscounts on a payor-specific basis given its interpretation of the applicableregulations or contract terms.  Theservices authorized and provided and related reimbursements are often subjectto interpretation that could result in payments that differ from the Company’sestimates in the near term. Additionally, updated regulations and contract renegotiations occurfrequently necessitating continual review and assessment of the estimationprocess by management.  Contractualdiscounts are reported as deductions from patient service revenue at the timethe service is rendered.

**Property and Equipment:** Propertyand equipment are recorded at cost. Depreciation expense is recorded on the straight-line basis overestimated useful lives. The useful lives of the buildings are estimated to bebetween twenty-five to forty years. The useful lives of computer hardware andsoftware are estimated to be three years. The useful lives of furniture and fixtures, and transportation equipmentare estimated to be five years. The useful life of office equipment isestimated to be three years.  Buildingimprovements are recorded at cost and amortized over the estimated useful livesof the improvements or the terms of the underlying lease whichever is shorter.  Routine maintenance, repair items, andcustomer facility and site improvements are charged to current operations.

**Accounting for Intangible Assets and Goodwill:**  The cost of acquired companies is allocatedfirst to their identifiable assets based on estimated fair values, and then togoodwill.  Costs allocated toidentifiable intangible assets are generally amortized on a straight-line basisover the remaining estimated useful lives of the assets. The excess of thepurchase price over the fair value of identifiable assets acquired, net ofliabilities assumed, is recorded as goodwill. The Company’s identifiable intangible assets, which are subject toamortization, consist of contracts, consulting agreements and non-competeagreements.  The Company’s indefinitelife intangible assets, which are not subject to amortization, include aKnox-Keene license (to operate as a specialized healthcare plan in California),trade names, and Certificates of Need. The Company 

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follows the requirements of Financial AccountingStandards Board (“FASB”) Statement of Financial Accounting Standards No. (“SFAS”)141 *Business Combinations* (“SFAS 141”) andSFAS 142 *Goodwill and Other Intangible Assets* (“SFAS142”).  SFAS 141 addresses the initialrecognition and measurement of goodwill and other intangible assets acquired ina business combination.  SFAS 142addresses the initial recognition and measurement of intangible assets acquiredoutside of a business combination, whether acquired individually or with agroup of other assets, and the accounting and reporting for goodwill and otherintangibles subsequent to their acquisition. These standards require all future business combinations be accountedfor using the purchase method of accounting and that goodwill and certainindefinite life intangible assets not be amortized, but instead to be subjectto impairment tests at least annually. See Note 11 *“Goodwill and OtherIntangible Assets”* for additional information regarding theseassets.

Accounting for intangible assets and goodwill requires significantestimates and judgment, especially as to: a) the valuation in connection withthe initial purchase price allocation and b) the ongoing evaluation forimpairment.  For each acquisition, avaluation was completed to determine a reasonable purchase priceallocation.  Upon completion of theallocation process an amount was assigned to various identified assetsincluding intangible assets and the remainder was assigned to goodwill.  The purchase price allocation processrequires estimates and judgments as to expectations for the various businessesand business strategies.  For example,certain growth rates were assumed for each business. Additionally, differentoperating margins for each type of service offering were included in theestimates. If actual growth rates or operating margins, among otherassumptions, differ significantly from the estimate and judgments used in thepurchase price allocation, a possible impairment of the intangible assetsand/or goodwill or acceleration in amortization expense may result.

In addition, SFAS 142, *Goodwill and OtherIntangible Assets* (“SFAS 142”), discontinued the amortization ofgoodwill and generally requires that goodwill impairment be tested annuallyusing a two-step process. The first step is to identify a potential impairment.The second step measures the amount of the impairment loss, if any. However,intangible assets with indefinite lives are to be tested for impairment using aone-step process that compares the fair value to the carrying amount of theasset. Because of the significance of the identified intangible assets andgoodwill to the Company’s consolidated balance sheet, annual or interimimpairment analyses are important. Changes in key assumptions about the business and its prospects, orchanges in market conditions or other external factors, could result in animpairment charge and such a charge could have a material adverse effect on theCompany’s financial condition and results of operations.

Contracts represent the fair value of management contracts and servicecontracts purchased and are being amortized using the straight-line method overseven years. Other intangibles primarily include the fair value of trade namesand non-compete agreements, which are being amortized over their expecteduseful lives.

**Accounts Payable:**  Accounts payablerepresent trade payables of the Company. At August 31, 2006, approximately $660,000 of book overdrafts wereincluded in accounts payable.

**TreasuryStock: **The Companyaccounts for treasury stock using the cost method.  Gains on sales of treasury stock are creditedto Additional Paid in Capital (“APIC”), losses are charged to APIC to theextent that previous net gains from sales are included therein, otherwise toretained earnings.

**Medical Claims:**   Medical claims payable represent theliability for healthcare claims reported but not yet paid and claims incurredbut not yet reported (“IBNR”) related to the Company’s managed behavioralhealthcare business.  The IBNR portion ofmedical claims payable is estimated based upon authorized healthcare services, pastclaims payment experience for member groups, enrollment data, utilizationstatistics and other factors using accounting methodologies.  Although variability is inherent in suchestimates, management believes the recorded liability for medical claims payableis adequate.  Medical claim payablebalances are continually monitored and reviewed.  Changes in assumptions for care costs causedby changes in actual or expected utilization experience could cause theseestimates to change significantly.

**Stock-BasedCompensation: **Prior tothe 2006 fiscal year, the Company accounted for its stock-based compensationunder the recognition and measurement principles of Accounting Principles BoardOpinion No. 25, *Accounting for Stock Issuedto Employees* and related interpretations (“APB 25”).  Under APB 25, no 

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stock-basedcompensation cost was reflected in net income for grants of stock prior tofiscal year 2006 because the Company grants stock options with an exerciseprice equal to or greater than the market value of the underlying common stockon the date of grant.

Effective September 1, 2005, the Company adoptedStatement of Financial Accounting Standards No. 123 (Revised 2004) *Share-Based Payment* (“SFAS 123R”), whichrequires the measurement and recognition of compensation cost at fair value forall share-based payments, including stock options and restricted shareawards.  Stock-based compensation forfiscal year 2006 was approximately $2,047,000 and is included in selling, generaland administrative expenses in the consolidated statement of operations.  This expense includes compensation expense,recognized over the applicable vesting periods, for new share-based awards andfor share-based awards granted prior to, but not yet vested, as of August 31,2005.  See Note 3 *“Stock-BasedCompensation”* in the notes to the consolidated financial statementsincluded elsewhere herein.

**Employee Health and Workers Compensation Benefits**: The Company retains a significant amount of self-insurance risk for itsemployee health and workers compensation benefits.  The Company maintains stop-loss insurancesuch that the Company’s liability is subject to certain individual andaggregate limits, as applicable.  Eachmonth end the Company records an accrued expense for estimated benefit claimsincurred but unpaid or not reported at the end of such period.  The Company estimates this accrual based on anumber of factors including historical experience, industry trends and recentclaims history. These accrual estimates are subject to ongoing revision asconditions might change and as new data may be presented. Adjustments toestimated liabilities are recorded in the accounting period in which the changein estimate occurs.  Changes inassumptions for costs caused by changes in actual or expected utilizationexperience could cause these estimates to change significantly. In prior years,estimates of workers compensation claims liability was allocated (based onpayroll dollars) to the operating unit level. Effective September 1, 2003, the Company began recording these estimatesat the general and administrative level with actual paid claims costs beingrecorded to the applicable operating unit.

**Self-Insurance: **Pursuant tovarious deductibles and retentions, the Company is self-insured for certainlosses for general and professional liability claims and up to certainindividual and aggregate stop losses relating to malpractice liabilityclaims.  Self-insurance claims filed andclaims incurred but not reported are accrued based upon management’s estimatesof the aggregate liability for uninsured claims incurred using actuarialassumptions followed in the insurance industry and historical experience.  Although management believes it has theability to adequately estimate losses related to claims, it is possible thatactual results could differ from recorded self-insurance liabilities.  In fiscal year 2006, the Company has switchedto a retrospectively rated policy for professional and general liability inwhich a portion of the premium paid may be refunded in future years based onthe claims experience for that year.  TheCompany has accounted for the minimum premium to be paid as expense and theadditional premium paid as a long-term deposit on the balance sheet.  The deposit amount may be reduced and chargedto expense in future periods based on the loss experience.

**Revenue Recognition:* ***Service revenueis generated by the Company’s three business segments (service groups), whichwere in operation during fiscal year 2006, in the following categories:

(1)                                              Netpatient service revenue, generated by the Company’s Behavioral Health HospitalServices group, is recorded on the accrual basis in the period in whichservices are provided.  Net patientservice revenue includes amounts estimated by management to be reimbursable byMedicare, Medicaid and other payors under provisions of cost or prospectivereimbursement formulas in effect. Amounts received are generally less than the established billing ratesand the differences (contractual discounts) are reported as deductions frompatient service revenue at the time the service is rendered.  The effects of other arrangements forproviding services at less than established rates are also reported asdeductions from patient service revenue.

The behavioral health hospitalsprovide charity care to patients who are financially unable to pay for thebehavioral services they receive. Because the Company does not pursue collection of amounts determined toqualify as charity care, they are not reported in net patient service revenue.

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Settlements under costreimbursement agreements with third-party payors are estimated and recorded inthe period in which the related services are rendered and are adjusted infuture periods as final settlements are determined.  Final determination of amounts earned underthe Medicare and Medicaid and other third-party payor programs often occur insubsequent years because of audits by the programs, rights of appeal, and theapplication of numerous technical provisions. Settlements are considered in the recognition of net patient servicerevenue on an estimated basis in the period the related services are rendered,and such amounts are subsequently adjusted in future periods as adjustmentsbecome known or as years are no longer subject to such audits, review orinvestigations.

Final determination ofamounts earned under prospective payment and cost-reimbursement activities issubject to review by appropriate governmental authorities or their agents.  In the opinion of the Company’s management,adequate provision has been made for adjustments that may result from suchreviews.

(2)                                              Contractmanagement revenue is reported in the period the services are provided at theestimated net realizable amounts from contracted acute care hospitals for contractmanagement services rendered. Adjustments are accrued on an estimated basis in the period they becomeknown and are adjusted in future periods, if and when necessary.

The fees received by the Company for its servicesunder management contracts are paid directly by its client acute carehospitals. Contract management revenue is based on various criteria such as afixed fee and/or variable components and may include per diem calculationsbased on patients per day or for defined periods, the number of admissions ordischarges, direct expenses, or any combination of the preceding, depending onthe specific contract. Generally, contract fees are paid on a monthly basis.

Some management contracts include a clause, whichstates that the Company will indemnify the hospital for any third-party payordenials, including Medicare.  At the timethe charges are denied or anticipated to be denied, the Company records anallowance for 100% of the potential amount. The Company believes it hasadequately provided for potential adjustments that may result from finalsettlement of potential denials, which amounts have historically not beenmaterial.

Client acute care hospitals receive reimbursementunder Medicare or Medicaid programs or payments from insurers, self-funded benefitplans or other third-party payors for the behavioral health and physicalrehabilitation services provided to the patients of the programs managed by theCompany.  As a result, the availabilityand amount of such reimbursements, which are subject to change, may impact thedecision of acute care hospitals regarding whether to offer behavioral healthand physical rehabilitation services pursuant to management contract with theCompany, as well as whether to continue such contracts (subject to contract terminationprovisions) and the amount of fees to be paid thereunder.

(3)                                              Premiumand fees revenue, generated by the Horizon Health EAP Services group, isreported in the period services are provided at the estimated net realizableamounts as defined by client contracts for services rendered.  Adjustments are accrued on an estimated basisin the period they become known and are adjusted in future periods if and whennecessary.

Revenues are derived from EAP services andadministrative service only contracts.  Theat-risk managed behavioral health service contracts were all terminated as ofAugust 31, 2005.  This revenue consistsprimarily of capitation payments, which are calculated on the basis of aper-member/per-month or a per-employee/per-month fee, but also include fee forservice payments.  For the at-riskmanaged behavioral health services contracts, the Company is ‘at-risk’ andbears the economic risk as to the adequacy of capitated revenue versus theactual cost of behavioral health care services provided to covered members bythird parties.

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**Discontinued Operations: **In accordance with the provisions of SFAS No.144, *Accounting for the Impairment or Disposal ofLong-Lived Asset*, the results of operations of the disposed assetsand the losses related to the divestiture of ProCare One Nurses, LLC on August29, 2005, have been classified as discontinued operations for all periodspresented in the accompanying consolidated statements of operations.  See Note 6 *“DiscontinuedOperations”*.

**Earnings Per Share:**Earnings pershare has been computed in accordance with SFAS No. 128, *Earnings PerShare.*  Basic earnings pershare are computed by dividing income available to common stockholders by theweighted-average number of common shares outstanding for the period.  Diluted earnings per share reflect thepotential dilution that may occur if the Company’s in the money stock optionswere exercised.  Such dilutive potentialcommon shares are calculated using the treasury stock method.

**Accounting for Income Taxes:*** *The Company accounts for income taxes inaccordance with SFAS No. 109, *Accounting forIncome Taxes*, which requires that deferred tax assets andliabilities be recognized using enacted tax rates for the effect of temporarydifferences between the book and tax basis of recorded assets andliabilities.  SFAS No. 109 also requiresthat deferred tax assets be reduced by a valuation allowance if it is morelikely than not that some portion or all of the deferred tax assets will not berealized. (See Note 13 *“Income Taxes”.)*

Based upon the Company’s estimates of the sources,nature, and amount of expected future taxable income it determined that it ismore likely than not that its deferred tax assets will be realized, resultingin no valuation allowance.

The Company evaluates quarterly the realizability ofits deferred tax assets and accordingly adjusts its valuation allowance, if anyas necessary.  The factors used to assessthe likelihood of realization include the Company’s estimates of future taxableincome and available tax initiatives that could be reasonably implemented toassure realization of the net deferred tax assets.  The Company has used various appropriate taxinitiatives and alternative tax treatments to realize or to renew net deferredtax assets in order to avoid the potential loss of tax benefits.

Failure to achieve forecasted taxable income amountsmight affect the ultimate realization of all or portions of net deferred taxassets.  Factors that may affect theCompany’s ability to achieve sufficient forecasted taxable income includegeneral business conditions, increased competition, a change in Medicare orMedicare reimbursement, an increase in medical services utilization, etc.,resulting in a decline in sales or margins.

**Use ofEstimates:** The preparation of these financial statementsrequires the use of estimates, judgments and assumptions that affect thereported amounts of assets and liabilities, and the disclosure of contingentassets and liabilities at the date of the financial statements and the amountsof revenues and expenses recorded for the reporting periods in order to preparethe financial statements in conformity with generally accepted accountingprinciples.  Management makes suchestimates, for example, in the allowance for doubtful accounts, allowance forcontractual discounts, medical claims, general and professional liabilityclaims, employee health and workers compensation benefits. Future actualresults experienced by the Company could differ from those estimates.

**Reclassifications:**  Certain prior year amounts have beenreclassified to conform to the current year presentation.

For all periodspresented, “Stockholders’ Equity” reflects a retroactive reclassificationbetween common stock, retained earnings and treasury stock as a result of theJune 15, 2005 two-for-one stock split.

**New Accounting Standards**

In June 2006, the Financial Accounting Standards Board(“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty inIncome Taxes – an interpretation of FASB Statement No. 109” (“FIN 48”).  FIN 48 requires companies to determinewhether it is more likely than not that a tax position will be sustained uponexamination by the appropriate taxing authorities before any part of thebenefit can be recorded in the 

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financial statements. This interpretation also provides guidance on derecognition,classification, accounting in interim periods, and expanded disclosurerequirements.  FIN 48 is effective for fiscalyears beginning after December 15, 2006. We are currently in the process of assessing the impact that FIN 48 willhave on our consolidated financial statements.

**3.****                          STOCK-BASEDCOMPENSATION**

Prior to the 2006fiscal year, the Company accounted for its stock-based compensation under therecognition and measurement principles of Accounting Principles Board OpinionNo. 25, *Accounting for Stock Issued toEmployees* and related interpretations (“APB 25”).  Under APB 25, no stock-based compensationcost was reflected in net income for grants of stock prior to fiscal year 2006because the Company grants stock options with an exercise price equal to orgreater than the market value of the underlying common stock on the date ofgrant.

EffectiveSeptember 1, 2005, the Company adopted Statement of Financial AccountingStandards No. 123 (Revised 2004) *Share-BasedPayment* (“SFAS 123R”), which requires the measurement andrecognition of compensation cost at fair value for all share-based payments,including stock options.  Stock-basedcompensation for fiscal year 2006 includes compensation expense, recognizedover the applicable vesting periods, for new share-based awards and forshare-based awards granted prior to, but not yet vested, as of August 31, 2005(modified prospective application).  Forstock-based compensation awards granted after the adoption of SFAS 123R onSeptember 1, 2005, expense is recognized to the date on which retirementeligibility is achieved, if shorter than the vesting period.  Stock-based compensation for the years endedAugust 31, 2006, 2005 and 2004 totaled approximately $2,047,000, $1,215,000 and$1,341,000, respectively, and is included in selling, general andadministrative expenses in the consolidated statements of operations only forthe period ended August 31, 2006.  Thetotal income tax benefit recognized related to stock-based compensation duringthe years ended August 31, 2006, 2005 and 2004 was approximately $798,000,$480,000 and $515,000, respectively, and is included in the provision forincome taxes in the condensed consolidated statements of operations only forthe period ended August 31, 2006.  Therewere no capitalized stock based compensation costs for any of the periodspresented.

The following table illustrates the effect on netincome and earnings per share of the Company had the Company applied the fairvalue recognition provisions of FASB Statement No. 123,*Accountingfor Stock-Based Compensation*, relating**tostock-based employee compensation for the years ended August 31, 2005 and 2004:
|                                                                                                                                               | ** ** | **Year Ended**                       | ** ** | **Year Ended**                       | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| **(In thousands, except per share amounts)**                                                                         | ** ** | **August 31, 2005  ** | ** ** | **August 31, 2004  ** | ** ** |
|                                                                                                                                          |       |                                      |       |                                      |       |
| Net Income, as  reported                                                                                                                      |       | $                                         | 5,151      |                                      | $          | 10,775 |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |       | 735                                       |       | 826                                       |       |
| Pro forma net  income                                                                                                                         |       | $                                         | 4,416      |                                      | $          | 9,949 |   |
| Earnings per  share:                                                                                                                          |       |                                      |       |                                      |       |
| Basic-as reported                                                                                                                             |       | $                                         | 0.40       |                                      | $          | 0.99 |   |
|                                                                                                                                          |       |                                      |       |                                      |       |
| Basic-pro forma                                                                                                                               |       | $                                         | 0.34       |                                      | $          | 0.92 |   |
|                                                                                                                                          |       |                                      |       |                                      |       |
| Diluted-as reported                                                                                                                           |       | $                                         | 0.39       |                                      | $          | 0.95 |   |
|                                                                                                                                          |       |                                      |       |                                      |       |
| Diluted-pro  forma                                                                                                                            |       | $                                         | 0.33       |                                      | $          | 0.88 |   |

 

On January 21,2005, the stockholders of the Company approved the Horizon Health Corporation2005 Omnibus Incentive Plan (the “Plan”), as detailed in the Form 8-K filedJanuary 21, 2005.  Under the plan,performance based awards, including stock options and restricted stock, may begranted from time to time as approved by the Compensation Committee of theBoard of Directors.  The maximum numberof new shares of Common Stock that can be issued under the Plan is 600,000.  As of August 31, 2006, stock options for 30,000shares had been granted under the Plan and approximately 213,000 shares havebeen awarded as restricted stock.

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The 1989, 1995 and1998 Stock Option Plans for employees and the 1995 Stock Option Plan forEligible Outside Directors are collectively referred to as the “Prior Plans”.  The 1989 Plan has terminated in accordancewith its terms and no further stock options may be granted under thisplan.  Upon approval of the 2005 OmnibusIncentive Plan, the remaining “Prior Plans” were terminated except with respectto stock options previously granted and outstanding under the “Prior Plans” andno further stock options may be granted under those plans. As of August 31,2006, there were outstanding stock options for approximately 1,148,000 sharesthat had been granted under the Prior Plans. Future grants of stock options maybe made only under the 2005 Omnibus Incentive Plan.

**StockOptions**

Stock options generallyvest ratably over five years from the date of grant and terminate ten yearsfrom the date of grant.  The exerciseprice of the options granted equaled or exceeded the market value of the commonstock at the date of the grant. Transactions during the year ended August 31, 2006 were as follows (inthousands, except option prices and years):
|                                                         | ** ** | **Number  of  Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Life (Years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|---------------------------------------------------------|------------|-------------------------|------------|----------------------------------------|------------|------------------------------------------------------------------|------------|---------------------------------|------------|
|                                                    |       |                    |       |                                   |       |                                                             |       |                            |       |
| Options  outstanding at August 31, 2005                 |       | 1,329                   |       | $                                      | 8.73       |                                                             |       |                            |       |   |
| Granted                                                 |       | 15                      |       | 26.76                                  |       |                                                             |       |                            |       |
| Exercised                                               |       | (134                    | )          | 7.48                                   |       |                                                             |       |                            |       |
| Forfeited                                               |       | (32                     | )          | 8.48                                   |       |                                                             |       |                            |       |
| Options  outstanding at August 31, 2006                 |       | 1,178                   |       | $                                      | 9.11       |                                                             | 6.31       |                            | $          | 5,676 |   |
|                                                    |       |                    |       |                                   |       |                                                             |       |                            |       |
| Options  exercisable at August 31, 2006                 |       | 720                     |       | $                                      | 7.81       |                                                             | 5.72       |                            | $          | 4,302 |   |
|                                                    |       |                    |       |                                   |       |                                                             |       |                            |       |
| Options vested and  expected to vest at August 31, 2006 |       | 1,103                   |       | $                                      | 8.93       |                                                             | 6.23       |                            | $          | 5,484 |   |

 

The range of exerciseprices for options outstanding at August 31, 2006 are as follows (in thousandsexcept option prices and years):

| Range or exercise prices | ** ** | **Number   outstanding** | ** ** | **Weighted average   exercise price** | ** ** | **Weighted average   remaining   contractual life** | ** ** |
|-----------------------------------------|------------|-------------------------------|------------|------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| $2.28 to $7.20                          |       | 270                           |       | $                                                    | 4.19       |                                                                    | 3.51       |   |
| $7.20 to $8.56                          |       | 319                           |       | 8.18                                                 |       | 6.44                                                                    |       |
| $8.56 to $11.03                         |       | 132                           |       | 9.93                                                 |       | 7.38                                                                    |       |
| $11.03 to $11.35                        |       | 340                           |       | 11.35                                                |       | 7.58                                                                    |       |
| $11.35 to $26.76                        |       | 116                           |       | 15.66                                                |       | 7.49                                                                    |       |
|                                    |       | 1,177                         |       | $                                                    | 9.11       |                                                                    | 6.31       |   |

 

The total intrinsic valueof stock options exercised during the years ended August 31, 2006, 2005 and2004 totaled approximately $1,913,000, $5,839,000 and $3,737,000,respectively.  The weighted average fairvalues per share of stock option grants were $16.08, $7.43 and $5.93 for theyears ended August 31, 2006, 2005 and 2004, respectively.  As of August 31, 2006, unrecognizedcompensation expense related to stock options totaled approximately $1,918,000,which will be recognized over a weighted average period of 1.6 years.

The fair value of optionsat date of grant was estimated using the Black-Scholes option-pricing modelwith the following weighted average assumptions:

F-18

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|                          | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|----------|------------|
|                     |       |     |       |     |       |     |       |
| Risk free interest  rate |       | 4.31     | %          | 3.91     | %          | 4.09     | %          |
| Expected life  (years)   |       | 6.4      |       | 6.4      |       | 7.3      |       |
| Expected  volatility     |       | 58.4     | %          | 50.7     | %          | 52.0     | %          |
| Expected dividend yield  |       | 0.0      | %          | 0.0      | %          | 0.0      | %          |

 

The risk-freeinterest rate is based on the yield of a seven-year Treasury Note as options havehistorically remained outstanding for six to seven years.  The expected life and expected volatility arebased on the Company’s historical experience.

The Company usesan estimated forfeiture rate of 15% for calculating stock-based compensationexpense related to stock options and this rate is based on the Company’shistorical experience.

**RestrictedShare Awards**

Restricted shareawards issued under the Plan generally vest ratably over five-years from thedate of grant.  The fair value ofrestricted share awards is based on the average of the closing bid and askprices on the date of grant.  The Companyuses an estimated forfeiture rate of 15% for calculating stock-basedcompensation expense related to restricted share awards and this rate is basedon historical experience.  Transactionsduring fiscal 2006 were as follows (in thousands, except fair values):
|                                                                    | ** ** | **Number of  Restricted  Share  Awards** | ** ** | **Weighted  Average  Fair Value  per Award** | ** ** |
|--------------------------------------------------------------------|------------|-----------------------------------------------|------------|--------------------------------------------------------|------------|
|                                                               |       |                                          |       |                                                   |       |
| Non-vested  restricted share awards outstanding at August 31, 2005 |       | 2                                             |       | $                                                      | 25.36      |   |
| Granted                                                            |       | 211                                           |       | 23.63                                                  |       |
| Vested                                                             |       | (7                                            | )          | 20.97                                                  |       |
| Forfeited                                                          |       | (23                                           | )          | 20.83                                                  |       |
| Non-vested restricted  share awards outstanding at August 31, 2006 |       | 181                                           |       | $                                                      | 24.12      |   |

 

There were norestricted shares vested during the year ended August 31, 2005.

As of August 31,2006, unrecognized compensation expense related to restricted share awardstotaled approximately $2,992,000, which will be recognized over a weightedaverage period of 3.9 years.

**2005Deferred Incentive Bonus Plan**

Certain executiveswere awarded deferred incentive bonuses for fiscal year 2005.  These bonuses were based on the attainment ofa corporate performance target for fiscal year 2005 and vest in four equalinstallments.  The performance target wasattained for fiscal year 2005 and these bonuses are payable 50% in restrictedcommon stock and 50% in cash with the four installments payable the firstfiscal quarter of fiscal years 2006 through 2009. The payment of eachinstallment is subject to continued employment with the Company.  Approximately 6,000 in restricted shareawards were vested in the year ended August 31, 2006, related to this deferredincentive bonus plan.  Cash paid in theyear ended August 31, 2006 related to this bonus plan was approximately$149,000 and cash remaining to be paid under this bonus program isapproximately $449,000.

**2006Deferred Incentive Bonus Plan**

Certain executiveswere eligible for deferred incentive bonuses for fiscal year 2006.  All of these bonuses were based on theattainment of a corporate performance target for fiscal year 2006 except forone bonus that was based on a segment performance target.  The corporate performance target was notachieved and no deferred incentive bonuses based on that target wereearned.  The segment performance targetwas achieved

F-19

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and the deferredincentive bonus was earned with respect to the 2006 fiscal year.  This bonus vests in four equal installmentsand is payable 50% in a restricted stock award and 50% in cash with the fourinstallments payable the first fiscal quarter of fiscal years 2007 through2010. The payment of each installment is subject to continued employment withthe Company.

**4.****                         ****EARNINGS PER SHARE**

The following is areconciliation of the numerators and the denominators of the basic and dilutedearnings per share computations for net income for the years ended August 31(in thousands, except per share amounts):
| ** **                                                         | ** ** | **2006**      | ** ** | **2005**        | ** ** | **2004**   | ** ** |
|--------------------------------------------------------------------|------------|---------------|------------|-----------------|------------|------------|------------|
| ** **                                                         | ** ** | **Net**       | ** ** | ** **      | ** ** | **Per**    | ** ** | **Net** | ** ** | ** ** | ** ** | **Per** | ** ** | **Net** | ** ** | ** ** | ** ** | **Per** | ** ** |
| ** **                                                         | ** ** | **Income**    | ** ** | **Shares**      | ** ** | **Share**  | ** ** | **Income** | ** ** | **Shares** | ** ** | **Share** | ** ** | **Income** | ** ** | **Shares** | ** ** | **Share** | ** ** |
| ** **                                                         | ** ** | **Numerator** | ** ** | **Denominator** | ** ** | **Amount** | ** ** | **Numerator** | ** ** | **Denominator** | ** ** | **Amount** | ** ** | **Numerator** | ** ** | **Denominator** | ** ** | **Amount** | ** ** |
| ** **                                                         | ** ** | ** **    | ** ** | ** **      | ** ** | ** ** | ** ** | ** ** | ** ** | **(1)** | ** ** | **(1)** | ** ** | ** ** | ** ** | **(1)** | ** ** | **(1)** | ** ** |
| **Continuing  Operations:**                                        | ** ** | ** **    | ** ** | ** **      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic EPS                                                          |       | $             | 12,115     |            | 14,974     |       | $          | 0.81 |   | $ | 8,741 |   | 12,829 |   | $ | 0.68 |   | $ | 10,213 |   | 10,849 |   | $ | 0.94 |   |
| Effect of dilutive securities options and restricted  share awards |       |          |       | 434             |       |       |       |   |   | 477 |   |   |   |   |   | 497 |   |   |   |
| Diluted EPS                                                        |       | $             | 12,115     |            | 15,408     |       | $          | 0.79 |   | $ | 8,741 |   | 13,306 |   | $ | 0.66 |   | $ | 10,213 |   | 11,346 |   | $ | 0.90 |   |
|                                                               |       |          |       |            |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Discontinued  Operations:**                                      | ** ** | ** **    | ** ** | ** **      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic EPS                                                          |       | $             | 7          |            | 14,974     |       | $          | 0.00 |   | $ | (3,590 | ) | 12,829 |   | $ | (0.28 | ) | $ | 562 |   | 10,849 |   | $ | 0.05 |   |
| Effect of dilutive securities options and restricted  share awards |       |          |       | 434             |       |       |       |   |   | 477 |   |   |   |   |   | 497 |   |   |   |
| Diluted EPS                                                        |       | $             | 7          |            | 15,408     |       | $          | 0.00 |   | $ | (3,590 | ) | 13,306 |   | $ | (0.27 | ) | $ | 562 |   | 11,346 |   | $ | 0.05 |   |
|                                                               |       |          |       |            |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Total:**                                                         | ** ** | ** **    | ** ** | ** **      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic EPS                                                          |       | $             | 12,122     |            | 14,974     |       | $          | 0.81 |   | $ | 5,151 |   | 12,829 |   | $ | 0.40 |   | $ | 10,775 |   | 10,849 |   | $ | 0.99 |   |
| Effect of dilutive securities options and restricted  share awards |       |          |       | 434             |       |       |       |   |   | 477 |   |   |   |   |   | 497 |   |   |   |
| Diluted EPS                                                        |       | $             | 12,122     |            | 15,408     |       | $          | 0.79 |   | $ | 5,151 |   | 13,306 |   | $ | 0.39 |   | $ | 10,775 |   | 11,346 |   | $ | 0.95 |   |

 

----

### (1)           The number of shares and per shareamounts have been restated to reflect the impact of the June 15, 2005two-for-one stock split.

### During 2006, 2005, and 2004 certain options to acquire common stockwere not included in certain computations of EPS because the options exerciseprice was greater than the average market price of the common shares. Theoptions excluded by quarter are as follows:

| Quarter Ended | ** ** | **Options Excluded** | ** ** | **Option Price Range** | ** ** |
|--------------------|------------|---------------------------|------------|----------------------------------|------------|
| August 31, 2006    |       | 75,000                    |       | $14.90 - $26.76                  |       |
| May 31, 2006       |       | 30,000                    |       | $16.10 – $26.76             |       |
| February 28, 2006  |       | 15,000                    |       | $26.76                           |       |
| November 30, 2005  |       | 6,758                     |       | $26.76                           |       |
| August 31, 2005    |       | —                    |       | —                           |       |
| May 31, 2005       |       | —                    |       | —                           |       |
| February 28, 2005  |       | 30,067                    |       | $14.90 - $16.10                  |       |
| November 30, 2004  |       | 416,200                   |       | $11.03 - $12.50                  |       |
| August 31, 2004    |       | 39,134                    |       | $11.65 - $12.50                  |       |
| May 31, 2004       |       | 8,000                     |       | $11.88                           |       |
| February 29, 2004  |       | 12,547                    |       | $11.65 - $11.88                  |       |
| November 30,  2003 |       | 21,000                    |       | $10.50 - $11.88                  |       |

F-20

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**5.        ACQUISITIONS AND ENTRY INTO ALONG-TERM OPERATING LEASE AGREEMENT**

***Lighthouse Care Center, LLC/Focus Healthcare, LLC***

On February 1, 2006, the Company acquired the behavioral healthfacilities of Lighthouse Care Centers, LLC and Focus Healthcare, LLC.  Lighthouse Care Center, LLC operated fourbehavioral health facilities located in Florida, Georgia and SouthCarolina.  Focus Healthcare, LLC operatedfour behavioral health facilities located in Delaware, Florida, Georgia andOhio.  The Focus & Lighthousefacilities in Florida are operated out of the same free-standing hospital andwill be considered a single operating facility going forward.  Additionally, the Company acquired a facilityfrom Lighthouse which is expected to begin operations during the 2007 fiscalyear.  The facilities have a combinedtotal licensed capacity of 512 beds.  Theclosing of the acquisition for the Focus Healthcare Delaware facility waspostponed pending receipt of necessary government approvals and ultimatelyclosed on April 1, 2006.  The results ofoperation for the facilities acquired on February 1, 2006, are included in theCompany’s results of operation for the period February 1, 2006 through August31, 2006.  The results of operation forthe Focus Healthcare Delaware facility are included in the Company’s results ofoperation for the period April 1, 2006 through August 31, 2006.  The aggregate purchase price for the entireLighthouse/Focus transaction, which included the assumption of a HUD loan ofapproximately $7.1 million for the Focus Healthcare Delaware facility, wasapproximately $91.7 million and was financed under the Company’s existingcredit facility.  As of August 31,2006, tangible assets acquired and liabilities assumed totaled approximately$41.7 million and $10.6 million, respectively. The purchase price exceeded the net tangible assets acquired byapproximately $60.7 million of which $22.5 million was recorded as goodwill and$38.2 million is recorded as the value of certain indefinite life intangibleassets.   Goodwill acquired by theCompany is deductible for tax purposes. The Company accounted for the acquisition by the purchase method asrequired by generally accepted accounting principles.

The followingtable summarizes the preliminary allocation of the aggregate purchase price ofthe Lighthouse/Focus acquisition (in thousands):
| Assets acquired:                 |   |    |   |
|----------------------------------|--------|---------|--------|
| Accounts receivable              |   | $       | 4,853  |   |
| Property and equipment           |   | 36,493  |   |
| Other assets                     |   | 312     |   |
| Goodwill                         |   | 22,467  |   |
| Certificates of need             |   | 36,474  |   |
| Trade names                      |   | 1,742   |   |
| Total assets                     |   | 102,341 |   |
| Liabilities  assumed             |   | (10,605 | )      |
|                             |   |    |   |
| Cash paid, net of cash  acquired |   | $       | 91,736 |   |

The purchase price allocation is still preliminary pending the finalvaluation of the assets and liabilities acquired and the receipt of allexpenses related to the acquisition.

F-21

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The following unaudited pro forma financial information gives effect tothe acquisition of Lighthouse Care Center/Focus Healthcare as if they wereowned on September 1, 2005 and 2004, after giving effect to certainadjustments, including the depreciation and amortization of the assets acquiredbased upon their fair value and changes in interest expense resulting fromchanges in consolidated debt (in thousands):
|                             | ** ** | **For the fiscal years ended August 31,** | ** ** |
|-----------------------------|------------|-------------------------------------------------------------------------|------------|
| ** **                  | ** ** | **2006**                                                                | ** ** | **2005** | ** ** |
|                        |       |                                                                    |       |   |   |
| Revenue                     |       | $                                                                       | 295,449    |   | $ | 248,788 |   |
|                        |       |                                                                    |       |   |   |
| Net Income                  |       | $                                                                       | 11,494     |   | $ | 4,578 |   |
|                        |       |                                                                    |       |   |   |
| Earnings per  common share: |       |                                                                    |       |   |   |
| Basic                       |       | $                                                                       | 0.77       |   | $ | 0.36 |   |
|                        |       |                                                                    |       |   |   |
| Diluted                     |       | $                                                                       | 0.75       |   | $ | 0.34 |   |

The unaudited pro forma information presented above does not includenor does it assume any benefits from cost savings or synergies of operations ofthe combined entities.  Additionally, theunaudited pro forma information presented does not purport to be indicative ofwhat our results of operations would have been if the acquisitions had in factoccurred at the beginning of the periods presented, and is not intended to be aprojection of the impact of future results or trends.

***Kingwood Pines Hospital***

Effective January17, 2006, the Company acquired Kingwood Pines Hospital, a 78-bed behavioralhealth facility located in Kingwood, Texas. Kingwood Pines Hospital was owned, operated and managed by SHC-KPH, LP,a Texas limited partnership.  SignetHealth Corporation, a Texas Corporation, owned a 99.9% limited partnershipinterest in SHC-KPH, LP.  Kingwood PinesHospital, LLC, a Texas limited liability company owned a 0.01% generalpartnership interest in SHC-KPH, LP.  Thetransaction was structured as a limited partner interest purchase agreement anda membership interest purchase agreement by which the Company acquired all ofthe partnership interest of the limited partner and all the member interests ofthe general partner.  As a result of thetransaction, the Company acquired ownership directly and indirectly of all thepartnership interests in the partnership. The limited partner interest purchase agreement was by and among SignetHealth Corporation, a Texas corporation, as Seller, HHC Kingwood Investment,LLC, a Delaware limited liability company, as Purchaser, and SHC-KPH, LP, aTexas limited partnership.  Themembership purchase agreement was by and among Jerry G. Browder as Seller,Horizon Health Hospital Services, Inc., a Delaware corporation and wholly-ownedsubsidiary of the Company, as Purchaser, and Kingwood Pines Hospital, LLC, aTexas limited liability company. Simultaneously with the transaction, SHC-KPH, LP acquired ownership ofthe real property and related assets of the hospital.  The aggregate purchase price net of cashacquired was approximately $14.1 million and was financed under the Company’sexisting credit facility.  As of August31, 2006, tangible assets acquired and liabilities assumed totaled $9,102,000and $1,014,000, respectively.  Thepurchase price exceeded the net tangible assets acquired by approximately$6,040,000 of which $5,918,000 was recorded as goodwill and $122,000 isrecorded as the value of certain indefinite life intangible assets.  The indefinite life intangible asset consistsof the assigned value of the trade name. Goodwill acquired by the Company is deductible for tax purposes.  The Company accounted for the acquisition bythe purchase method as required by generally accepted accounting principles andthe results of operation are included in the Company’s results of operation forthe period January 17, 2006 through August 31, 2006.  Pro forma financial data is not presentedbecause the impact of this acquisition is not material to the Company’s resultsof operations for any period presented.

***Copper Hills Youth Center***

On January 1, 2006, the Company acquired Kids Behavioral Health ofUtah, Inc., a Utah corporation.  KidsBehavioral Health owned and operated Copper Hills Youth Center, a 126-bedadolescent residential treatment 

F-22

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center located in West Jordan, Utah. The transaction was structured as a stock purchase agreementdated as of December 30, 2005, whereby Horizon Health Hospital Services, Inc.,a Delaware corporation and wholly-owned subsidiary of the Company, acquired allof the outstanding stock of Kids Behavioral Health of Utah, Inc. from KidsBehavioral Health, LLC, a Nevada limited liability company.  As of August 31, 2006, tangible assetsacquired and liabilities assumed totaled $8,251,000 and $897,000,respectively.  The aggregate purchaseprice of approximately $9.6 million exceeded the fair value of net tangibleassets by approximately $2,240,000 of which $2,024,000 is recorded as goodwilland $216,000 is the value of certain indefinite life intangible assets.  The indefinite life intangible asset consistsof the assigned value of the trade name. The acquisition was financed under the Company’s existing creditfacility.  Goodwill acquired by theCompany is deductible for tax purposes. The Company accounted for the acquisition by the purchase method asrequired by generally accepted accounting principles and the results ofoperation are included in the Company’s results of operation for the periodJanuary 1, 2006 through August 31, 2006. Pro forma financial data is not presented because the impact of thisacquisition is not material to the Company’s results of operations for anyperiod presented.

***River Park Hospital***

On August 1, 2005,the Company acquired substantially all the assets of River Park Hospitallocated in Huntington, West Virginia, pursuant to an Asset Purchase Agreementdated June 9, 2005, and purchased the stock of an affiliated management companythrough a Stock Purchase Agreement of the same date.  The Company paid approximately $11.0 millionin cash, which was paid out of available funds and no debt was incurred by theCompany as a part of the transaction. The agreement also provides for additional variable payments in futureyears based on the future performance of the hospital and goodwill will beadjusted in future years as a result of these payments.  The Company accounted for the acquisition bythe purchase method as required by generally accepted accountingprinciples.  Tangible assets acquired andliabilities assumed totaled $7,037,000 and $391,000, respectively.  As of August 31, 2006, the purchase priceexceeded the fair value of net tangible assets by approximately $4,454,000 ofwhich $890,000 is recorded as goodwill, $1,225,000 is assigned to the value ofthe contracts, and $2,339,000 is recorded as the value of certain indefinitelife assets.  The indefinite life assetsare comprised of a Certificate of Need with an assigned value of $2,185,000 anda trade name with an assigned value of $154,000.  During the 2006 fiscal year, goodwill wasincreased by approximately $166,000 due to purchase price adjustments relatedto legal fees and other costs associated with the acquisition that were paidduring 2006.  River Park Hospital is a187-bed behavioral health facility offering programs for adults, adolescents,children and families.  Pro formafinancial data is not presented because the impact of this acquisition is notmaterial to the Company’s results of operations for any period presented.

***Friends Hospital***

On July 1, 2005,the Company formed a joint venture with the Thomas Scattergood BehavioralHealth Foundation, a 501(c)(3) charitable organization and the joint ventureacquired Friends Hospital located in Philadelphia, Pennsylvania.  Prior to the acquisition, Friends hospitalwas owned by the Thomas Scattergood Behavioral Health Foundation.  Horizon is an 80% member of the joint ventureand the Thomas Scattergood Behavioral Health Foundation is a 20% member of thejoint venture.  The agreement requiresthe joint venture to expend at least $5,500,000 in the first five operatingyears of the joint venture on capital expenditures related to FriendsHospital.  The Company contributedapproximately $15.5 million in cash to the joint venture which funds were usedfor the acquisition of the hospital by the joint venture.  The contribution was paid out of availablefunds and no debt was incurred by the Company as a part of thetransaction.  The Company accounted forthe acquisition by the purchase method as required by generally acceptedaccounting principles.  Tangible assetsacquired and liabilities assumed totaled $21,664,000 and $2,685,000,respectively.  In addition, a certainindefinite life asset, a trade name, in the amount of $423,000 was identifiedand recorded as a result of the transaction. The joint venture is included inthe consolidated financial statements of the Company and the 20% minorityinterest of $4,054,000 is reflected separately at August 31, 2006.  **FriendsHospital consists of a 192-bed behavioral health hospital and a 27-bed adultresidential treatment center.****** Pro forma financialdata is not presented because the impact of this acquisition is not material tothe Company’s results of operations for any period presented.

F-23

----

***Laurelwood Hospital***

On December 30, 2004, the Companyentered into a long-term operating lease agreement of Laurelwood Hospital, a160-bed psychiatric hospital located in Willoughby, Ohio, a suburb ofCleveland.  The hospital was leased fromLake Hospital System, Inc. Lake Hospital System, Inc. is a non-profit healthcare provider operating two hospitals and other health care facilities in LakeCounty, Ohio.  The lease term commencedon January 1, 2005 and has an initial fifteen (15) year term that expires onDecember 31, 2019. The Company also has an option to extend the lease for anadditional fifteen-year term.  Rent underthe lease during the initial lease term consists of quarterly rental paymentsof $200,433 payable in advance on the first day of January, April, July andOctober.  In addition, the Company agreedto make a contribution to the Lake Hospital Foundation in the amount of $41,666on December 31, 2007 and each December 31st thereafter to and includingDecember 31, 2012. Pro forma financial data is not presentedbecause the impact of this acquisition is not material to the Company’s resultsof operations for any period presented.

***PSH Acquisition Corporation***

Effective June 1, 2004, the Company acquired theassets of PSH Acquisition Corporation (“PSH”), which operated five behavioralfacilities with a total licensed capacity of 187 beds, in the central Virginiaregion, for approximately $30.1 million. The agreement also provides for additional variable payments in futureyears based on the future performance of the facilities and goodwill will beadjusted in future years as a result of these payments.  The Company accounted for the acquisition bythe purchase method as required by generally accepted accounting principles.Tangible assets acquired and liabilities assumed totaled $16,507,815 and$626,776, respectively.  As of August 31,2006, the purchase price exceeded the fair value of PSH’s net tangible assetsby $15,471,000 of which $15,142,000 is recorded as goodwill, and $329,000 isrecorded as the value of certain indefinite life assets.  The net increase in goodwill of $1,278,000during the fiscal year ended August 31, 2006, includes additional variablepayments of $422,000 and $856,000 as required by the purchase agreement.  The initial cash purchase price was fundedunder the Company’s revolving credit facility. The three owned and two leased facilities include:

·                 Poplar SpringsHospital - a 132 bed acute adult and adolescent facility that also offersresidential treatment services;

·                 Poplar West – a36-bed Youth Development Center that offers residential treatment care and a60-student special educational program;

·                 Poplar Place ofSutherland – an 8-bed adolescent boys group home;

·                 PoplarTransitions of Shenandoah Valley – a 11-bed female adolescent residential carefacility (leased); and

·                 Recovery Centerof Richmond – an intensive adolescent and adult outpatient service center(leased).

Effective August 31, 2005, the Company did not renewthe lease at the Poplar Transitions of Shenandoah Valley facility and closedthis facility.  During the 2006 fiscalyear, we acquired a group home in Petersburg, Virginia.  In August 2006, we received a license tooperate 8 beds at this group home.  Thefacility will be named Poplar Terrace and it will operate as an 8-bed femaleadolescent residential group home.  Weexpect to begin operations in the first fiscal quarter of 2007.  The new total licensed bed capacity of thePoplar Springs facilities is 184 as of August 31, 2006.

Unaudited pro-forma information is presented forillustrative purposes only and is not necessarily indicative of the financialposition or results of operations that would have actually been reported hadthe acquisition occurred at the beginning of the period presented, nor is itnecessarily indicative of future financial position or results ofoperations.  The unaudited pro-formafinancial information with respect to the PSH Acquisition Corporationacquisition was based upon the respective historical consolidated financialstatements of Horizon Health Corporation and PSH Acquisition Corporation.  This unaudited pro forma information does notinclude nor does it assume any benefits from cost savings or synergies ofoperations of the combined companies.  Proforma financialdata is not presented because the impact of this acquisition is not material tothe Company’s results of operations for any period presented.

F-24

----

The following unauditedpro forma financial information gives effect to the acquisition of PSHAcquisition Corporation by the Company as if the acquisition occurred onSeptember 1, 2003.
|                                                                       | ** ** | **Fiscal Year Ended** | ** ** |
|-----------------------------------------------------------------------|------------|---------------------------------|------------|
| **(In thousands, except per share amounts)** | ** ** | **August 31, 2004**   | ** ** |
|                                                                  |       |                            |       |
| Revenue                                                               |       | $                               | 177,078    |   |
|                                                                  |       |                            |       |
| Net Income                                                            |       | $                               | 11,391     |   |
|                                                                  |       |                            |       |
| Net Income per  common share:                                         |       |                            |       |
| Basic                                                                 |       | $                               | 1.05       |   |
|                                                                  |       |                            |       |
| Diluted                                                               |       | $                               | 1.00       |   |

***MichianaBehavioral Health Center***

Effective April 1, 2004, the Company acquiredthe assets of Northern Indiana Hospital, an 80-bed behavioral health hospitallocated in Plymouth, Indiana for approximately $6.2 million.  The Company operates the facility under thename “Michiana Behavioral Health Center”. The hospital provides behavioral programs for children, adolescents, andadults. The Company accounted for the acquisition by the purchase method asrequired by generally accepted accounting principles.  Tangible assets acquired and liabilities assumedtotaled $6,399,253 and $189,816 respectively. The cash purchase price was funded by the Company’s revolving creditfacility.  Pro forma financial data isnot presented because the impact of this acquisition is not material to theCompany’s results of operations for any period presented.

**6.****                          DISCONTINUEDOPERATIONS**

On August 29, 2005, theCompany sold its membership interests in ProCare One Nurses, LLC, its whollyowned temporary nurse-staffing subsidiary, to CareerStaff Unlimited, Inc. Thetransaction consisted of a sale of all the membership interests in ProCare fortotal consideration of $8.3 million, consisting of $4.2 million in cash and$4.1 million in two promissory notes.  Onepromissory note was non-interest bearing in the amount of $2.1 million payablein six months and the other promissory note was in the amount of $2.0 millionpayable quarterly over three years, bearing interest at the prime rate.  Thetangible assets and assumed liabilities included in the sale were $2,445,338and $45,472 respectively.  The promissorynotes received were recorded by the Company at the estimated net realizablevalue over the term of the instruments, including an initial reserve totaling$666,831 that was based on management’s assessment of ultimatecollectibility.  The Company recognizesinterest income during the period in which the interest is earned and reflectsany unpaid interest due as a receivable. The $2.1 million note was paid during the year and the Company hasreceived 3 quarterly payments on the $2.0 million note.  The balance of the remaining note receivablewas $1,500,000 at August 31, 2006.

In accordance with theprovisions of Statement of Financial Accounting Standard, *Accounting for the Impairment or Disposal ofLong-Lived Assets*(“SFAS No. 144”), the results of operations of thedisposed assets and the losses related to this divestiture have been classifiedas discontinued operations for all periods presented in the accompanyingconsolidated statements of operations.

F-25

----

A summary of the discontinuedoperations for the periods presented is as follows (in thousands, except pershare amounts):
| ** **                                                           | ** ** | **For the years ended August 31,** | ** ** |
|----------------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                                           | ** ** | **2006**                                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                 |       |                                                        |       |   |   |   |   |
| Revenue                                                              |       | $                                                           | —     |   | $ | 17,176 |   | $ | 18,674 |   |
|                                                                 |       |                                                        |       |   |   |   |   |
| Cost of services  (exclusive of depreciation shown separately below) |       | 119                                                         |       | 16,041 |   | 17,121 |   |
| Selling, general  and administrative                                 |       | (124                                                        | )          | 1,636 |   | 278 |   |
| Provision for  (recovery of) doubtful accounts                       |       | —                                                      |       | 136 |   | (59 | ) |
| Depreciation and  amortization                                       |       | —                                                      |       | 98 |   | 130 |   |
|                                                                 |       |                                                        |       |   |   |   |   |
| Operating Income                                                     |       | 5                                                           |       | (735 | ) | 1,204 |   |
|                                                                 |       |                                                        |       |   |   |   |   |
| Interest income  and other                                           |       | —                                                      |       | — |   | — |   |
|                                                                 |       |                                                        |       |   |   |   |   |
| Income before  income taxes                                          |       | 5                                                           |       | (735 | ) | 1,204 |   |
|                                                                 |       |                                                        |       |   |   |   |   |
| Income tax  provision/(benefit)                                      |       | 2                                                           |       | (262 | ) | 466 |   |
|                                                                 |       |                                                        |       |   |   |   |   |
| (Loss) income  from discontinued operations                          |       | 3                                                           |       | (473 | ) | 738 |   |
|                                                                 |       |                                                        |       |   |   |   |   |
| (Loss) on  disposal of discontinued operations, net                  |       | 4                                                           |       | (3,102 | ) | — |   |
|                                                                 |       |                                                        |       |   |   |   |   |
|  Intercompany Revenue                                           |       | —                                                      |       | (15 | ) | (176 | ) |
|                                                                 |       |                                                        |       |   |   |   |   |
| Net (Loss)  income from discontinued operations                      |       | 7                                                           |       | (3,590 | ) | 562 |   |
|                                                                 |       |                                                        |       |   |   |   |   |
| Basic earnings  per common share:                                    |       |                                                        |       |   |   |   |   |
| Discontinued operations                                              |       | $                                                           | 0.00       |   | $ | (0.28 | ) | $ | 0.05 |   |
|                                                                 |       |                                                        |       |   |   |   |   |
| Diluted earnings  per common share:                                  |       |                                                        |       |   |   |   |   |
| Discontinued operations                                              |       | $                                                           | 0.00       |   | $ | (0.27 | ) | $ | 0.05 |   |
|                                                                 |       |                                                        |       |   |   |   |   |
| Weighted average  shares outstanding:                                |       |                                                        |       |   |   |   |   |
| Basic                                                                |       | 14,974                                                      |       | 12,829 |   | 10,849 |   |
| Diluted                                                              |       | 15,408                                                      |       | 13,306 |   | 11,346 |   |

 

The following is areconciliation of the net proceeds received and the loss recorded on sale (inthousands):
| Proceeds:                                       |   |   |   |
|-------------------------------------------------|--------|--------|--------|
| Cash                                            |   | $      | 4,200  |   |
| Promissory notes, net                           |   | 3,366  |   |
| Total proceeds                                  |   | 7,566  |   |
| Less:                                           |   |   |   |
| Tangible assets sold, less liabilities divested |   | (2,400 | )      |
| Write-off of goodwill                           |   | (9,988 | )      |
| Income tax provision                            |   | 1,720  |   |
| Loss on sale                                    |   | $      | (3,102 | ) |

F-26

----

**7.****                                      PROPERTYAND EQUIPMENT**

Property and equipmentconsist of the following at August 31:
|                                | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
|                           |       |     |       |     |       |
| Land                           |       | $        | 16,540     |     | $          | 4,318 |   |
| Buildings                      |       | 74,737   |       | 42,246   |       |
| Computer  Hardware             |       | 3,247    |       | 3,282    |       |
| Computer  Software             |       | 4,843    |       | 2,274    |       |
| Furniture and  Fixtures        |       | 5,835    |       | 4,052    |       |
| Equipment                      |       | 3,122    |       | 2,639    |       |
| Transportation  (Vehicles)     |       | 834      |       | 115      |       |
| Work-in-process  (a)           |       | 2,394    |       | 1,226    |       |
| Leasehold  Improvements        |       | 716      |       | 182      |       |
|                           |       | 112,268  |       | 60,334   |       |
|                           |       |     |       |     |       |
| Less Accumulated  Depreciation |       | 12,079   |       | 8,636    |       |
|                           |       | $        | 100,189    |     | $          | 51,698 |   |

----

(a) At August 31, 2006 the “work-in-process”category primarily represented eight different information technologyinitiatives and building and leasehold improvement projects, which had not beencompleted by year-end.  Of the $2,394,000in work-in-process, $1,606,000 is related to computer software, $357,933 isrelated to computer hardware and $429,277 is related to building and leaseholdimprovements that will be capitalized and depreciated upon the completion ofeach project, which is anticipated to occur during fiscal year 2007.

Effective January1, 2006, the company added approximately $6.0 million in property and equipmentassociated with the acquisition of Copper Hills Hospital in West Jordan,Utah.  Of the $6.0 million in assetsacquired, the hospital facility and land were valued at approximately $4.0million and $1.7 million, respectively.

Effective January17, 2006, the company added approximately $6.8 million in property andequipment associated with the acquisition of Kingwood Pines Hospital inKingwood, Texas.  Of the $6.8 million inassets acquired, the hospital facility and land were valued at approximately$5.1 million and 1.5 million, respectively.

Effective February1, 2006, the company added approximately $29.9 million in property andequipment associated with the acquisition of the seven Focus LighthouseFacilities in Delaware, Florida, Georgia, Ohio and South Carolina.   Of the $29.9 million in assets acquired, thehospital facilities and land were valued at approximately $20.2 million and$9.0 million, respectively.  EffectiveApril 1, 2006, the company added an additional $6.6 million in property andequipment with the purchase of the Focus-Delaware facility in New Castle,Delaware.  Of the $6.6 million in assetsacquired, the hospital facility and land were valued at approximately $5.3million and $1.1 million, respectively.

In May 2006, theCompany sold the prior NSC building for approximately $3.7 million.  The building and related furniture andequipment had a net book value of approximately $3.6 million and the net salesprice received after transaction costs was approximately $3.4 million.  The Company recognized a loss on the sale ofapproximately $192,000.  Additionally,the Company has had capital expenditures for leasehold improvements andfurniture & equipment on the new NSC building of approximately $1.5 millionduring the period ended August 31, 2006.

Depreciation expense for the years ended August 31, 2006, 2005 and 2004totaled approximately $4,659,000, $2,484,000 and $1,412,000, respectively.

F-27

----

** **

### **8.****                                      ACCRUED EXPENSESAND UNEARNED REVENUE**

Accrued expensesconsisted of the following at August 31 (in thousands):
|                                                       | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                  |       |     |       |     |       |
| Due to  Medicare/Medicaid                             |       | $        | 1,322      |     | $          | — |   |
| Interest                                              |       | 1,286    |       | —   |       |
| Employee health  benefits                             |       | 1,076    |       | 1,191    |       |
| Audit and accounting  fees                            |       | 1,139    |       | 702      |       |
| Workers compensation  self-insured liability          |       | 891      |       | 780      |       |
| Legal settlements                                     |       | 808      |       | 1,130    |       |
| Patient credit balances  and third-party overpayments |       | 792      |       | 839      |       |
| Lease obligations                                     |       | 622      |       | 768      |       |
| Deferred revenue and  contract adjustments            |       | 537      |       | 850      |       |
| General and  professional liability claims            |       | 425      |       | 1,387    |       |
| Federal and state  income tax liability               |       | —   |       | 726      |       |
| Other                                                 |       | 4,990    |       | 4,025    |       |
|                                                  |       | $        | 13,888     |     | $          | 12,398 |   |
|                                                  |       |     |       |     |       |
| Unearned Revenue                                      |       | 1,014    |       | 1,308    |       |
|                                                  |       | $        | 14,902     |     | $          | 13,706 |   |

 

**9.****                          LONG-TERMDEBT**

At August 31,2006, the Company had approximately $99.0 million outstanding under itsrevolving credit facility as a result of the acquisitions closed during thecurrent fiscal year as described in Note 5, elsewhere herein.  Additionally, the Company assumed a HUD loanof approximately $7.1 million in connection with the Focus – Delawareacquisition during the third quarter of 2006 and the principal balance atAugust 31, 2006 was approximately $7.0 million. The loan is a fixed rate loan with an interest rate of 6.99%, has aremaining term of approximately 30 years with required monthly payments ofprincipal and interest.  At August 31,2006, the fair value of the HUD loan was approximately $6.4 million based on thediscounted amount of future cash flows. The Company had no long-term debt outstanding as of August 31,2005.  Long-term debt maturities for thefive years following August 31, 2006 are as follows (in thousands):
| Fiscal year | ** ** | ** ** | ** ** |
|------------------|------------|------------|------------|
| 2007             |       | $          | 70         |   |
| 2008             |       | 75         |       |
| 2009             |       | 81         |       |
| 2010             |       | 99,087     |       |
| 2011             |       | 93         |       |
| Thereafter       |       | 6,599      |       |
|             |       | $          | 106,005    |   |

 

On June 10, 2005,the Company entered into a Third Amended and Restated Credit Agreement toextend the term of the agreement by four years and to increase the amount ofthe revolving credit facility to $125.0 million (with an expansion featureunder which the amount of the credit facility can be increased to $175.0million, subject to the satisfaction of certain conditions).  The bank participants under the creditfacility are JPMorgan Chase Bank (which also acts as the agent); Bank ofAmerica, N.A.; Wells Fargo Bank Texas; Key Bank, National Association; WachoviaBank, National Association; and Amegy Bank, National Association.  Effective November 14, 2005, the Companyentered into a Consent and First Amendment to the Third 

F-28

----

Amended andRestated Credit Agreement in connection with the Lighthouse and Focusacquisitions discussed in Note 5 “Acquisitions”.  This amendment modified certain fee schedulesand certain covenants of the Company’s existing credit facility.  Effective January 26, 2006, the Companyentered into a Second Amendment to the Third Amended and Restated CreditAgreement which increased the amount of the revolving credit facility to $175.0million and added Sun Trust Bank as a participating bank.  Effective May 24, 2006, the Company enteredinto a Third Amendment to the Third Amended and Restated Credit Agreement whichmodified certain fee schedules and certain covenants of the Company’s existingcredit facility.  The Company’s mostrestrictive covenant under the revolving credit facility is the ratio ofindebtedness to adjusted EBITDA.  Thiscovenant was amended effective May 24, 2006, as a part of the Third Amended andRestated Credit Agreement which was filed as Exhibit 10.1 to the Company’s Form10-Q for the quarter ended May 31, 2006.

At August 31,2006, approximately $70.6 million of the $175.0 million credit facility wasavailable to the Company after letter of credit obligations.  The revolving credit facility bears interestat (1) the Base Rate plus the Base Rate Margin, as defined or (2) the AdjustedEurodollar Rate, plus the Eurodollar Rate Margin, as defined.  The Eurodollar Rate Margin and Base RateMargin vary depending on the debt coverage ratio of the Company.  The weighted average interest rate on therevolving credit facility for the year ended August 31, 2006 was approximately7.34%.  The revolving credit facility, asamended, is available for acquisitions and working capital purposes and matureson May 31, 2010.

**10.****                   SHAREHOLDERS’EQUITY**

**Common Stock**

Effective March 16, 2005,the Company sold in a public offering 3,450,000 shares of its common stock at aprice of $18.13 per share (shares and share price restated to reflect theimpact of the June 15, 2005 two-for-one stock split).  The aggregate net proceeds to the Company(after deducting underwriters discounts and estimated expenses) were $58.4million.  The Company utilizedapproximately $34.5 million of the proceeds to repay all then outstanding debtunder its revolving credit facility.  Thebalance of the net proceeds was used for the acquisitions of Friends Hospitaland River Park Hospital and for general corporate purposes.

On May 10, 2005,the Company announced that the Board of Directors had approved a two-for-onestock split to be effected in the form of a 100% stock dividend (the “StockSplit”), pursuant to which, on June 15, 2005, the Company distributed to eachholder of record of Common Stock, par value $0.01 per share, of the Company atthe close of business on May 31, 2005 (the “Record Date”), one additional shareof Common Stock for each outstanding share of Common Stock held of record bysuch holder at the Record Date. All references in the financial statements andrelated notes related to the number of shares and per share amounts of thecommon stock have been retroactively restated to reflect the impact of theCompany’s June 15, 2005 two-for-one stock split.

The Board of Directorsadopted in October 1999 the Horizon Health Corporation Employee Stock PurchasePlan (“the Plan”).  The Plan offeredeligible employees the ability to purchase Company stock at a 15% discount tothe current market price at designated periods. Eligible employees were able to contribute up to 10% of their basesalary pursuant to two, six-month offering periods, which were defined asJanuary 1 – June 30 and July 1 – December 31. Pursuant to the Plan, the Company issued 9,352 and 13,887 shares ofCommon Stock from treasury for the fiscal years ended August 31, 2005 and 2004,respectively as well as 22,660 newly issued shares during the fiscal year endedAugust 31, 2005.  On April 21, 2005, theBoard of Directors approved the termination of the Company’s Stock PurchasePlan effective June 30, 2005.  Subsequentto this date, shares were no longer offered under the Company’s Employee StockPurchase Plan.

**Treasury Stock**

During the time period ofSeptember 1998 through February 2001 the Board of Directors of the Companyauthorized the repurchase of up to 2,525,000 shares of its common stock.  As of August 31, 2002, the Company hadrepurchased 2,292,863 shares of its common stock pursuant to suchauthorizations, which had previously expired.

F-29

----

On October 7, 2002 theBoard of Directors authorized the repurchase of up to 800,000 shares of itscommon stock.  As of August 31, 2005, thecompany had repurchased 714,591 shares in total of the 800,000 shareauthorization, which remains in effect.

As of June 15, 2005, all of the treasury shares hadbeen reissued pursuant to the exercise of certain stock options and inconnection with the Employee Stock Purchase Plan that was previously in effect,and in connection with the two-for-one stock split on June 15, 2005.  The above share amounts have not beenadjusted related to the two-for-one stock split on June 15, 2005, as it was notapplicable to treasury shares. Subsequent to that date, 14,581 shares were surrendered to the Companyand were retained in treasury at August 31, 2006.  No treasury stock was issued during thetwelve months ended August 31, 2006.

**11.      GOODWILL AND OTHER INTANGIBLE ASSETS**

The Companyapplies the provisions of SFAS 141, *Business Combinations*and SFAS 142, *Goodwill and Other Intangible Assets*in accounting for its goodwill and otheridentifiable intangible assets. SFAS 141 addresses the initialrecognition and measurement of goodwill and other intangible assets acquired ina business combination. SFAS 142 addresses the initial recognition andmeasurement of intangible assets acquired outside of a business combination,whether acquired individually or with a group of other assets, and theaccounting and reporting for goodwill and other intangibles subsequent to theiracquisition.  See Note 2 *“Accounting for Intangible Assets and Goodwill”*for a discussion regarding SFAS 141 and SFAS 142.

At August 31,2006, the Company had indefinite life intangible assets, which are not subjectto amortization, of approximately $42,447,000. The indefinite life assets were comprised of certificates of need($38,665,000) acquired as part of the acquisition of River Park and theFocus/Lighthouse acquisitions, trade names ($2,986,000) acquired as part of thePoplar Springs, Friends, River Park, Copper Hills, Kingwood Pines andFocus/Lighthouse acquisitions, and the recorded value of the Knox Keene license($796,000), acquired as part of a previous acquisition.  The costs of certain management contracts andother intangible assets acquired by the Company remain subject toamortization.  Amortization of recordedvalues for contracts and non-compete agreements for the years ended August 31,2006 and 2005 were approximately $870,000 and $903,000, respectively.

The following table sets forth the estimatedamortization expense for intangibles subject to amortization for the foursucceeding fiscal years and thereafter (in thousands):
| For the year ending August  31, 2007                 |   | $      | 821    |   |
|------------------------------------------------------|--------|--------|--------|--------|
| For the year  ending August 31, 2008                 |   | 786    |   |
| For the year  ending August 31, 2009                 |   | 333    |   |
| For the year  ending August 31, 2010                 |   | 159    |   |
| For the years  ending August 31, 2011 and thereafter |   | — |   |
|                                                 |   | $      | 2,099  |   |

 

The followingtables set forth by business service group of the Company, as described in Note15 “*Segment Information*” included elsewhereherein, the amounts of goodwill and certain indefinite life intangible assetsas of August 31, 2006 that are subject to impairment tests rather thanamortization and the adjustments, if any, to the amounts of such goodwill andcertain indefinite life intangible assets during the fiscal years ended August31, 2006 and 2005 (in thousands).

F-30

----

** **

**Goodwill**
| ** **                                        | ** ** | ** **   | ** ** | **Contract**   | ** ** | ** **   | ** ** | ** **           | ** ** | ** **       | ** ** |
|---------------------------------------------------|------------|--------------|------------|----------------|------------|--------------|------------|----------------------|------------|------------------|------------|
| ** **                                        | ** ** | **Hospital** | ** ** | **Management** | ** ** | **EAP**      | ** ** | **ProCare One** | ** ** | ** **       | ** ** |
| ** **                                        | ** ** | **Services** | ** ** | **Services**   | ** ** | **Services** | ** ** | **Nurses**           | ** ** | **Consolidated** | ** ** |
|                                              |       |         |       |           |       |         |       |                 |       |             |       |
| Goodwill as of  August 31, 2004                   |       | $            | 13,770     |           | $          | 18,545       |       | $                    | 41,421     |             | $          | 9,988 |   | $ | 83,724 |   |
|                                              |       |         |       |           |       |         |       |                 |       |             |       |
| Goodwill  acquired during the period (1)          |       | 750          |       | —         |       | —       |       | —               |       | 750              |       |
|                                              |       |         |       |           |       |         |       |                 |       |             |       |
| Goodwill  adjusted during the period (1)          |       | 94           |       | —         |       | (352         | )          | —               |       | (258             | )          |
|                                              |       |         |       |           |       |         |       |                 |       |             |       |
| Sale of ProCare  One Nurses during the period (1) |       | —       |       | —         |       | —       |       | (9,988               | )          | (9,988           | )          |
|                                              |       |         |       |           |       |         |       |                 |       |             |       |
| Goodwill as of August  31, 2005                   |       | $            | 14,614     |           | $          | 18,545       |       | $                    | 41,069     |             | $          | — |   | $ | 74,228 |   |
|                                              |       |         |       |           |       |         |       |                 |       |             |       |
| Goodwill acquired  during the period (2)          |       | 30,409       |       | —         |       | —       |       | —               |       | 30,409           |       |
|                                              |       |         |       |           |       |         |       |                 |       |             |       |
| Goodwill adjusted  during the period (3)          |       | 1,417        |       | —         |       | —       |       | —               |       | 1,417            |       |
|                                              |       |         |       |           |       |         |       |                 |       |             |       |
| Goodwill as of August 31, 2006                    |       | $            | 46,440     |           | $          | 18,545       |       | $                    | 41,069     |             | $          | — |   | $ | 106,054 |   |

----

(1)          Goodwillacquired during the twelve months ended August 31, 2005 related to the purchaseof River Park Hospital effective August 1, 2005.  Goodwill for Hospital Services was adjusted anet 94,000 related to purchase price adjustments for the Poplar SpringsHospital that was purchased in 2004 (Variable payment of $381,000, reclass toindefinite life intangibles of $329,000, miscellaneous purchase priceadjustments of $42,000).  Goodwill forEAP Services was adjusted $352,000 during the period due to the reduction of atax reserve associated with the October 1998 acquisition of Choice Health,Inc.  A decrease in goodwill of$9,988,000 related to the sale of ProCare One Nurses effective August 29, 2005.

(2)          Goodwillacquired during the twelve months ended August 31, 2006, is comprised of $2.0million related to the Copper Hills acquisition, $5.9 million related to theKingwood Pines acquisition, and $22.5 million related to the Focus/Lighthouseacquisition.  This is a preliminaryallocation and adjustments may be made in future periods for additional legaland other costs related to the acquisitions.

(3)          Goodwilladjusted during the twelve months ended August 31, 2006, relates to the PoplarSprings and River Park Hospitals.  Thepurchase agreement associated with the acquisition of Poplar Springs Hospitalprovides for additional variable payments in future years based on the futureperformance of the facilities.  Thesecond payment, which was recorded as additional goodwill, was made during thethird quarter ended May 31, 2006 in the amount of $422,000.  The third payment which was recorded asadditional goodwill was made during the fourth quarter ended August 31, 2006 inthe amount of $856,000.  The remaininggoodwill adjusted during the period relates to purchase price adjustments forlegal fees and other costs associated with the purchase of River Park Hospital,which was acquired effective August 1, 2005.

**TradeNames**
| ** **                                  | ** ** | ** **   | ** ** | **Contract**   | ** ** | ** **   | ** ** | ** **       | ** ** |
|---------------------------------------------|------------|--------------|------------|----------------|------------|--------------|------------|------------------|------------|
| ** **                                  | ** ** | **Hospital** | ** ** | **Management** | ** ** | **EAP**      | ** ** | ** **       | ** ** |
| ** **                                  | ** ** | **Services** | ** ** | **Services**   | ** ** | **Services** | ** ** | **Consolidated** | ** ** |
|                                        |       |         |       |           |       |         |       |             |       |
| Trade names as of  August 31, 2004          |       | $            | —     |           | $          | —       |       | $                | 796        |   | $ | 796 |   |
|                                        |       |         |       |           |       |         |       |             |       |
| Trade names  acquired during the period (4) |       | 577          |       | —         |       | —       |       | 577              |       |
|                                        |       |         |       |           |       |         |       |             |       |
| Trade names adjusted  during the period (4) |       | 329          |       | —         |       | —       |       | 329              |       |
|                                        |       |         |       |           |       |         |       |             |       |
| Trade names as of  August 31, 2005          |       | $            | 906        |           | $          | —       |       | $                | 796        |   | $ | 1,702 |   |
|                                        |       |         |       |           |       |         |       |             |       |
| Trade names acquired  during the period (5) |       | 2,080        |       | —         |       | —       |       | 2,080            |       |
|                                        |       |         |       |           |       |         |       |             |       |
| Trade names as of August 31, 2006           |       | $            | 2,986      |           | $          | —       |       | $                | 796        |   | $ | 3,782 |   |

----

(4)          Trade names acquired duringthe twelve months ended August 31, 2005 are comprised $423,000 of related tothe purchase of Friends Hospital effective July 1, 2005 and $154,000 related tothe purchase of River Park Hospital effective August 1, 2005.  Trade names adjusted during the period relateto a reclass from goodwill to trade names related to the Poplar SpringsHospital that was purchased in the 2004 fiscal year.

(5)          Trade names acquiredduring the twelve months ended August 31, 2006 are comprised of $216,000related to the Copper Hills acquisition, $122,000 related to the Kingwood Pinesacquisition and $38.2 million related to the Focus/Lighthouse acquisition.

F-31

----

**Certificates of Need**
| ** **                                           | ** ** | ** **   | ** ** | **Contract**   | ** ** | ** **   | ** ** | ** **       | ** ** |
|------------------------------------------------------|------------|--------------|------------|----------------|------------|--------------|------------|------------------|------------|
| ** **                                           | ** ** | **Hospital** | ** ** | **Management** | ** ** | **EAP**      | ** ** | ** **       | ** ** |
| ** **                                           | ** ** | **Services** | ** ** | **Services**   | ** ** | **Services** | ** ** | **Consolidated** | ** ** |
|                                                 |       |         |       |           |       |         |       |             |       |
| Certificates of need as  of August 31, 2004          |       | $            | —     |           | $          | —       |       | $                | —     |   | $ | — |   |
|                                                 |       |         |       |           |       |         |       |             |       |
| Certificates of need  acquired during the period (6) |       | 2,185        |       | —         |       | —       |       | 2,185            |       |
|                                                 |       |         |       |           |       |         |       |             |       |
| Certificates of need as  of August 31, 2005          |       | $            | 2,185      |           | $          | —       |       | $                | —     |   | $ | 2,185 |   |
|                                                 |       |         |       |           |       |         |       |             |       |
| Certificates of need  acquired during the period (7) |       | 36,480       |       | —         |       | —       |       | 36,480           |       |
|                                                 |       |         |       |           |       |         |       |             |       |
| Certificates of need as of August 31, 2006           |       | $            | 38,665     |           | $          | —       |       | $                | —     |   | $ | 38,665 |   |

----

(6)          Certificates of needacquired during the twelve months ended August 31, 2005 are comprised of$2,185,000 related to the purchase of River Park Hospital effective August 1,2005.

(7)          Certificates of needacquired during the 2006 fiscal year are comprised of $36.5 million related tothe Focus/Lighthouse acquisition.

The Company haselected to conduct the annual impairment testing during its fiscal year thirdquarter.  As a result of the May 31, 2006impairment testing, no impairment adjustments were deemed necessary.

**12.      RETIREMENT PLAN**

The Company sponsors a 401(k) plan that coverssubstantially all employees, subject to certain eligibility requirements.  In fiscal year 2005, the Company began makinga matching contribution equal to 50% of the employees’ contribution up to anamount equal to 3% of the employee’s compensation.  The plan also provides for discretionarymatching contributions, an amount that is to be determined by the Company on anannual basis. Past benefit plan year contributions were on a discretionarybasis only.  For the benefit plan yearsended December 31, 2005, 2004 and 2003 the Company’s contributions wereapproximately $747,000, $714,000, and $646,000 respectively.

**13.      INCOMETAXES**

Deferred taxes areprovided for those items reported in different periods for income tax andfinancial reporting purposes.  Income taxexpense is comprised of the following components (in thousands):
| ** **                                                                   | ** ** | **For the Year Ended August 31,** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Current                                                                      |       |                                                       |       |   |   |   |   |
| Federal                                                                      |       | $                                                          | 2,751      |   | $ | 6,399 |   | $ | 4,858 |   |
| State                                                                        |       | 791                                                        |       | 1,166 |   | 692 |   |
| Total current                                                                |       | 3,542                                                      |       | 7,565 |   | 5,550 |   |
|                                                                         |       |                                                       |       |   |   |   |   |
| Deferred                                                                     |       |                                                       |       |   |   |   |   |
| Federal                                                                      |       | 3,984                                                      |       | (3,783 | ) | 1,048 |   |
| State                                                                        |       | 455                                                        |       | (432 | ) | 120 |   |
| Total deferred                                                               |       | 4,439                                                      |       | (4,215 | ) | 1,168 |   |
|                                                                         |       |                                                       |       |   |   |   |   |
| Income tax expense,  including discontinued operations                       |       | 7,981                                                      |       | 3,350 |   | 6,718 |   |
| Income tax benefit  (expense) related to income from discontinued operations |       | (5                                                         | )          | 262 |   | (466 | ) |
| Income tax benefit  related to the disposal of discontinued operations       |       | —                                                     |       | 1,720 |   | — |   |
|                                                                         |       |                                                       |       |   |   |   |   |
| Income tax expense-continuing operations                                     |       | $                                                          | 7,976      |   | $ | 5,332 |   | $ | 6,252 |   |

 

F-32

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The components ofthe net deferred tax (liability) asset at August 31 are as follows (inthousands):
| ** **                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------------------|------------|----------|------------|----------|------------|
|                                  |       |     |       |     |       |
| Accounts receivable                   |       | $        | 3,765      |     | $          | 2,445 |   |
| Vacation accruals                     |       | 404      |       | 461      |       |
| Management contracts                  |       | 2,082    |       | 2,039    |       |
| Miscellaneous accruals                |       | 4,270    |       | 5,698    |       |
| Net operating loss  carryforward      |       | 134      |       | 174      |       |
|                                  |       |     |       |     |       |
| Deferred tax assets                   |       | 10,655   |       | 10,817   |       |
|                                  |       |     |       |     |       |
| Property &  equipment/intangibles |       | (1,148   | )          | 375      |       |
| Goodwill                              |       | (11,594  | )          | (8,840   | )          |
|                                  |       |     |       |     |       |
| Deferred tax  liabilities             |       | (12,742  | )          | (8,465   | )          |
|                                  |       |     |       |     |       |
| Net deferred tax (liability) asset    |       | $        | (2,087     | )        | $          | 2,352 |   |

 

At August 31, 2006,the Company had available estimated, unused net operating loss carryforwardsfor tax purposes totaling approximately $345,000.  These carryforwards, subject to annualutilization limits, may be utilized to offset future years’ taxable income andwill begin to expire during 2011 if unused prior to that date.

The following is a reconciliation of income taxes atthe U.S. federal income tax rate to the Company’s effective income tax rate forcontinuing operations (in thousands, except tax rate):
| ** **                                                 | ** ** | **Tax Rate  2006** | ** ** | **2006** | ** ** | **Tax Rate  2005** | ** ** | **2005** | ** ** | **Tax Rate  2004** | ** ** | **2004** | ** ** |
|------------------------------------------------------------|------------|-------------------------|------------|----------|------------|-------------------------|------------|----------|------------|-------------------------|------------|----------|------------|
| Federal income taxes  based on 35% of book income          |       | 35.0                    | %          | $        | 7,098      |                    | 35.0       | %        | $          | 4,925                   |       | 35.0     | %          | $ | 5,763 |   |
| State income taxes                                         |       | 4.0                     | %          | 810      |       | 3.7                     | %          | 519      |       | 2.8                     | %          | 464      |       |
| Permanent adjustments:                                     |       |                    |       |     |       |                    |       |     |       |                    |       |     |       |
| Meals & entertainment  and other permanent adjustments |       | 0.6                     | %          | 120      |       | 1.1                     | %          | 150      |       | 0.9                     | %          | 152      |       |
| Other  adjustments                                         |       | (0.3                    | )%         | (52      | )          | (1.9                    | )%         | (262     | )          | (0.8                    | )%         | (127     | )          |
|                                                       |       | 39.3                    | %          | $        | 7,976      |                    | 37.9       | %        | $          | 5,332                   |       | 37.9     | %          | $ | 6,252 |   |

 

**14.      COMMITMENTSAND CONTINGENCIES**

*PropertyLeases*

The Company leasesvarious office facilities and equipment under operating leases.  The following is a schedule of minimum rentalpayments under these leases, which expire at various dates (in thousands):
| For the year ending August  31, 2007 |   | $      | 3,731  |   |
|--------------------------------------|--------|--------|--------|--------|
| For the year ending  August 31, 2008 |   | 3,467  |   |
| For the year ending  August 31, 2009 |   | 3,562  |   |
| For the year ending  August 31, 2010 |   | 3,242  |   |
| For the year ending  August 31, 2011 |   | 3,071  |   |
| Thereafter                           |   | 23,606 |   |
|                                 |   | $      | 40,679 |   |

 

Rent expense forthe years ended August 31, 2006, 2005 and 2004 totaled approximately$3,585,000, $4,695,000 and $2,521,000, respectively.  These amounts exclude rent expense related toProCare One Nurses, which has been reclassified into discontinued operations.

F-33

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The long-termoperating lease associated with Laurelwood Hospital, effective January 1, 2005,increased the total minimum rental payments under the leases by $10.7 million.

The Company beganleasing and occupying their new 80,000 square foot National Support Centerfacility in April 2006.  The term of thelease agreement is ten (10) years with two five year renewal options.  The lease increased the total minimum rentalpayments under the leases by $11.6 million.

On August 9, 2006,the Company entered into a long-term operating lease agreement for the St.David’s Pavilion in Austin, Texas.  TheCompany is planning to operate a 48-bed freestanding behavioral health facilityon 2 floors of the St. David’s Hospital property.  The initial term of the lease is fifteen (15)years and the lease is expected to commence in the Company’s third fiscalquarter of the 2007 fiscal year after renovations are completed at thefacility.  The lease increased the totalminimum rental payments under the leases by $13.9 million.

The above minimumrental payments do not take into account approximately $256,000 of expectedreceipts for two sublet clinic locations in Florida, one sublet office locationin Pennsylvania, and one sublet office location in Tennessee resulting from thereorganization and centralization of the Company’s EAP Services group.

*Insurance Risk Retention*

The Company’s liability and property risk managementprogram involves a balance of insured risks and self-insured retentions.  The Company carries general, professional,and malpractice liability, comprehensive property damage, workers’compensation, directors and officers and other insurance coverages thatmanagement considers cost-effective and reasonable and adequate for theprotection of the Company’s assets, operations and employees.  There can be no assurance, however, that thecoverage limits of such policies will be adequate.  A successful claim against the Company inexcess of its insurance coverage or several claims for which the Company’sself-insurance components are significant in the aggregate could have amaterial adverse effect on the Company.

Estimates of the aggregate or portions of claimspursuant to the Company’s self-insurance retentions, and liability foruninsured claims incurred are determined and accrual reserves and associatedexpenses recorded, by using actuarial assumptions followed in the insuranceindustry and historical experience.  Inestimating the liability for claims, the Company obtains estimates from thirdparty actuarial firms.

*LegalProceedings *

The Company is, and may be in the future, party tolitigation arising in the ordinary course of its business. While the Companyhas no reason to believe that any such pending claims are material, there canbe no assurance that the Company’s insurance coverages will be adequate tosubstantially cover liabilities arising out of such claims or that any suchclaims will be covered by the Company’s insurance. Any material claim that isnot covered by insurance may have an adverse effect on the Company’s business.Claims against the Company, regardless of their merit or outcome, may also havean adverse effect on the Company’s reputation and business.

The Company isparty to a civil qui tam lawsuit styled United States ex rel. Debra Hockett,M.D., Linda Thompson, M.D., and Chyrissa Staley, R.N., Plaintiffs v.Columbia/HCA Healthcare Corp., Indian Path Hospital, Inc., Horizon MentalHealth Management, Inc. and Superior Home Health of East Tennessee, Inc.,Defendants, 01-MS-50 (RCL) (part of Civil Action No. 99-3311 (RCL) pending inthe United States District Court for the District of Columbia. The complaintalleges that certain on-site Company personnel acted in Concert with othernon-company personnel to improperly inflate certain Medicare reimbursable costsassociated with services rendered at Indian Path Hospital prior to 1997.  The complaint seeks to recover amountsallegedly over billed to Medicare as a result. The relators have also alleged that such conduct occurred at otherhospitals owned by the parent corporation of Indian Path.  The parties are in discovery proceedings andno trial date has been set.  As of August31, 2006, there is still uncertainty as to the extent of the damages that canbe asserted by the plaintiffs and the measure of damages that will be assertedby the plaintiffs.  Thus, an estimate ofthe possible loss, if any, cannot be made at this time.

F-34

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The Company isparty to a civil qui tam lawsuit styled United States of America, ex rel.Michael M. Meyer, Patricia J. Szerlip and Vicki Weatherford, Plaintiffs, v.Horizon Health Corporation, Summit Medical Center and Sukhdeep Grewal, M.D.,Defendants, Civil Action No. 00-01-1303 MEJ, pending in the United StatesDistrict court for the Northern District of California.  The relators served the complaint in November2004.  The United States Department ofJustice had previously declined to intervene in the lawsuit.  Thereafter, Vicki Weatherford withdrew as aplaintiff.  The complaint allegesprimarily that certain patients were improperly admitted to a hospitalgero-psychiatry program managed by the Company at the hospital.  The complaint seeks to recover amountsallegedly over billed to Medicare as a result. The case was set for trial in February 2007.  On September 29, 2006, the trial court granted a motion to dismissfiled by the defendants for lack of subject matter jurisdiction.  The lawsuit has been dismissed with prejudicealthough the relators may appeal.

**The Company is party to a lawsuit styled Universityof Utah Neuropsychiatric Institute, Plaintiffs v. Horizon Behavioral Services,Inc., Defendants, pending in the Third Judicial District Court in the County ofSalt Lake, State of Utah.  By agreement,the Company has not been required to file an answer in the proceeding while theparties are having discussions.  Thelawsuit relates to a claim that Horizon improperly denied or underpaid claimssubmitted by UUNI to Horizon for services provided by UUNI to members undermedical plans where Horizon was the mental health provider during the years2000 through 2005. The parties have been engaged in reviewing and discussingthe disputed claims and have agreed to future discussions in a non-bindingarbitration scheduled in December 2006. At this time there is still uncertainty as to the extent of the damagesthat can be asserted by the plaintiffs. The original demand is for $725,000 based on contract rate for theservices although UUNI contends that its normal billing rates apply to theclaims as opposed to the contract rates, in which case the demand is for approximately$2.4 million.  The Company considers thatthe contract rate applies to all the disputed claims.  An estimate of possible loss, if any,can not be made at this time.**

**15.      SEGMENT(SERVICE GROUP) INFORMATION**

The Company hasdetermined that its reportable segments, or service groups, are appropriatelybased on its method of internal reporting, which disaggregates its business byservices category in a manner consistent with how the Company evaluates itsoperations.  During the fourth quarter offiscal year 2005, the freestanding behavioral health hospital services businesswas disaggregated and recognized as a separate service group.  During the first quarter of fiscal year 2006,management determined that it had three reportable service groups: hospitalservices, contract management services and EAP services.  As a result, the behavioral health andphysical rehabilitation contract management businesses have been consolidatedinto one service group.  All prior periodsegment information has been restated to conform to the current segmentpresentation.  See notes (A) through (D)below for a description of the services provided by each of the identifiedservice groups. The Company’s business is conducted solely in the UnitedStates.

F-35

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The following schedulerepresents revenues, operating results and total assets for the years indicatedby operating segment (in thousands):
| ** **            | ** ** | ** **   | ** ** | **(B)**        | ** ** | ** **   | ** ** | ** ** | ** ** | ** **       | ** ** | ** **       | ** ** |
|-----------------------|------------|--------------|------------|----------------|------------|--------------|------------|------------|------------|------------------|------------|------------------|------------|
| ** **            | ** ** | **(A)**      | ** ** | **Contract**   | ** ** | **(C)**      | ** ** | ** ** | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **            | ** ** | **Hospital** | ** ** | **Management** | ** ** | **EAP**      | ** ** | **(D)**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **            | ** ** | **Services** | ** ** | **Services**   | ** ** | **Services** | ** ** | **Other**  | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **2006**              |       |         |       |           |       |         |       |       |       |             |       |             |       |
| Revenues, net         |       | $            | 158,333    |           | $          | 89,040       |       | $          | 27,421     |             | $          | 167              |       | $ | — |   | $ | 274,961 |   |
|                  |       |         |       |           |       |         |       |       |       |             |       |             |       |
| Intercompany Revenues |       | —       |       | 61             |       | 431          |       | —     |       | (492             | )          | —           |       |
|                  |       |         |       |           |       |         |       |       |       |             |       |             |       |
| Cost of Services      |       | 133,380      |       | 57,060         |       | 21,148       |       | —     |       | (492             | )          | 211,096          |       |
|                  |       |         |       |           |       |         |       |       |       |             |       |             |       |
| EBITDA (E)            |       | 18,131       |       | 30,850         |       | 5,234        |       | (23,211    | )          | —           |       | 31,004           |       |
|                  |       |         |       |           |       |         |       |       |       |             |       |             |       |
| Total Assets          |       | 220,868      |       | 132,217        |       | 46,733       |       | 37,833     |       | (120,011         | )          | 317,640          |       |
|                  |       |         |       |           |       |         |       |       |       |             |       |             |       |
| **2005**              |       |         |       |           |       |         |       |       |       |             |       |             |       |
| Revenues, net         |       | $            | 60,577     |           | $          | 98,493       |       | $          | 48,077     |             | $          | 245              |       | $ | — |   | $ | 207,392 |   |
|                  |       |         |       |           |       |         |       |       |       |             |       |             |       |
| Intercompany Revenues |       | —       |       | 34             |       | 324          |       | —     |       | (358             | )          | —           |       |
|                  |       |         |       |           |       |         |       |       |       |             |       |             |       |
| Cost of Services      |       | 48,836       |       | 64,945         |       | 46,709       |       | (85        | )          | (373             | )          | 160,032          |       |
|                  |       |         |       |           |       |         |       |       |       |             |       |             |       |
| EBITDA (E)            |       | 7,928        |       | 29,844         |       | (628         | )          | (17,401    | )          | 15               |       | 19,758           |       |
|                  |       |         |       |           |       |         |       |       |       |             |       |             |       |
| Total Assets          |       | 84,952       |       | 129,124        |       | 47,561       |       | 37,551     |       | (111,970         | )          | 187,218          |       |
|                  |       |         |       |           |       |         |       |       |       |             |       |             |       |
| **2004**              |       |         |       |           |       |         |       |       |       |             |       |             |       |
| Revenues, net         |       | $            | 10,069     |           | $          | 99,147       |       | $          | 52,249     |             | $          | 360              |       | $ | — |   | $ | 161,825 |   |
|                  |       |         |       |           |       |         |       |       |       |             |       |             |       |
| Intercompany Revenues |       | —       |       | 1              |       | 233          |       | —     |       | (234             | )          | —           |       |
|                  |       |         |       |           |       |         |       |       |       |             |       |             |       |
| Cost of Services      |       | 7,645        |       | 66,459         |       | 47,599       |       | 261        |       | (410             | )          | 121,554          |       |
|                  |       |         |       |           |       |         |       |       |       |             |       |             |       |
| EBITDA (E)            |       | 1,942        |       | 29,248         |       | 3,069        |       | (13,868    | )          | 176              |       | 20,567           |       |
|                  |       |         |       |           |       |         |       |       |       |             |       |             |       |
| Total Assets          |       | 43,050       |       | 154,608        |       | 47,586       |       | (5,013     | )          | (95,776          | )          | 144,455          |       |

----

(A)                              HospitalServices provides behavioral health services through the Company’s owned andleased behavioral healthcare facilities.

(B)                             ContractManagement Services provides behavioral health and physical rehabilitationcontract management services to acute care hospitals.

(C)                                EAPServices provides employee assistance programs primarily to employers.

(D)                               Theamounts in the column entitled “Other” represent revenue and expensesassociated with the Company’s primary general and administrative costs, i.e.,expenses associated with the corporate offices and National Support Centerlocated in the Dallas suburb of Lewisville, Texas which provides management,financial, human resources, and information system support for the Company andits subsidiaries.  Also included in Otherare the assets of ProCare One Nurses, which was classified as discontinuedoperations effective with its sale on August 29, 2005.

(E)                                 EBITDAis a presentation of “earnings before interest, taxes, depreciation, andamortization.”  EBITDA is the unit ofmeasure reviewed by the chief operating decision makers in determining segmentoperating performance.  EBITDA may not becomparable to similarly titled measures reported by other companies.  In addition, EBITDA is a non-GAAP measure andshould not be considered an alternative to operating or net income in measuringcompany results.  For the years endedAugust 31, 2006, 2005 and 2004, EBITDA is calculated as follows:
|                                  | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Income before income  taxes      |       | $        | 20,279     |     | $          | 14,058   |       | $ | 16,465 |   |
| Depreciation &  amortization |       | 5,529    |       | 3,387    |       | 2,795    |       |
| Impairment loss on  building     |       | —   |       | 1,015    |       | —   |       |
| Interest, net                    |       | 5,196    |       | 1,298    |       | 1,307    |       |
| EBITDA                           |       | $        | 31,004     |     | $          | 19,758   |       | $ | 20,567 |   |

 

**16.      EAPSERVICES REORGANIZATION AND RELATED IMPAIRMENTS**

Inthe second quarter of 2005, the Company announced that it had commenced areorganization of its EAP Services Group. The reorganization involved thecentralization of most of the business functions of the service group inLewisville, Texas, where the national support center of the Company is located.The reorganization also involved focusing on employee assistance programs andthe termination of the managed behavioral health care at-risk contracts of theservices group.

F-36

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During the year endedAugust 31, 2005, the Company recorded approximately $1,612,000 in real estatelease expense and termination costs primarily associated with the recording ofthe remaining operating lease obligations associated with its Philadelphia andNashville offices.  Also, during the yearended August 31, 2005, the Company recorded an asset impairment charge ofapproximately $1,015,000 related to the write-down to fair market value of theCompany’s National Support Center.  TheCompany consolidated its National Support Center offices with its primary EAPServices call center operations into its new National Support Center buildingin April 2006.  In addition during theyear ended August 31, 2005, the Company incurred approximately $612,000 inemployee costs related to severance and retention bonuses associated with thetermination of employees at its affected locations, $197,000 in employeerelocation costs to its new service center, and approximately $491,000 induplicate salary costs in redundant service center locations during thetraining phase.  At August 31, 2005, thecompany recorded a liability of approximately $504,000 for the remainingadministrative costs associated with the remaining obligations for theterminated managed behavioral health at-risk contracts.  Finally, the Company recorded approximately$182,000 in miscellaneous other costs primarily associated with travel and themoving of company files out of affected locations.  At August 31, 2005, the reorganization wasessentially complete.

The costs incurred inconnection with the reorganization as of August 31, 2005 are presented below(in thousands):
| ** **                                                  | ** ** | **EAP Services** | ** ** | **Other** | ** ** | **Total** | ** ** |
|-------------------------------------------------------------|------------|-----------------------|------------|-----------|------------|-----------|------------|
|                                                        |       |                  |       |      |       |      |       |
| Real estate lease  expense and termination costs            |       | $                     | 1,612      |      | $          | —    |       | $ | 1,612 |   |
| Write-down National  Support Center to FMV                  |       | —                |       | 1,015     |       | 1,015     |       |
| Employee severance and  retention bonus costs               |       | 612                   |       | —    |       | 612       |       |
| Employee relocation  costs                                  |       | 197                   |       | —    |       | 197       |       |
| Employee training and  redundant staffing costs             |       | 491                   |       | —    |       | 491       |       |
| Costs associated with  termination of MBH at-risk contracts |       | 415                   |       | 89        |       | 504       |       |
| Miscellaneous other  costs                                  |       | 182                   |       | —    |       | 182       |       |
| Total                                                       |       | $                     | 3,509      |      | $          | 1,104     |       | $ | 4,613 |   |

 

Areconciliation of the Company’s liability balances for real estate and employeerelocation expenses in connection with the reorganization is as follows(amounts in thousands):
| ** **                                                       | ** ** | **EAP Services** | ** ** | **Other** | ** ** | **Total** | ** ** |
|------------------------------------------------------------------|------------|-----------------------|------------|-----------|------------|-----------|------------|
|                                                             |       |                  |       |      |       |      |       |
| Balance as of August  31, 2005                                   |       | $                     | 2,192      |      | $          | 89        |       | $ | 2,281 |   |
| Change in accruals for  the twelve months ended August 31, 2006: |       |                  |       |      |       |      |       |
| Real estate  lease expense and termination costs                 |       | (72                   | )          | —    |       | (72       | )          |
| Employee  severance and retention bonus costs                    |       | (34                   | )          | —    |       | (34       | )          |
| Employee  relocation costs                                       |       | (43                   | )          | —    |       | (43       | )          |
| Costs associated  with termination of MBH at-risk contracts      |       | (38                   | )          | —    |       | (38       | )          |
| Miscellaneous  other costs                                       |       | (51                   | )          | —    |       | (51       | )          |
|                                                             |       |                  |       |      |       |      |       |
| Cash payments for the  twelve months ended August 31, 2006:      |       |                  |       |      |       |      |       |
| Real estate  lease expense and termination costs                 |       | $                     | (831       | )         | $          | —    |       | $ | (831 | ) |
| Employee  severance and retention bonus costs                    |       | (222                  | )          | —    |       | (222      | )          |
| Employee  relocation costs                                       |       | (84                   | )          | —    |       | (84       | )          |
| Employee  training and redundant staffing costs                  |       | (10                   | )          | —    |       | (10       | )          |
| Costs associated  with termination of MBH at-risk contracts      |       | (315                  | )          | (89       | )          | (404      | )          |
| Miscellaneous  other costs                                       |       | (2                    | )          | —    |       | (2        | )          |
| Total                                                            |       | $                     | (1,702     | )         | $          | (89       | )          | $ | (1,791 | ) |
|                                                             |       |                  |       |      |       |      |       |
| Balance as of August 31, 2006                                    |       | $                     | 490        |      | $          | —    |       | $ | 490 |   |

 

F-37

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**17.****                               QUARTERLYFINANCIAL INFORMATION (unaudited)**

The following is asummary of unaudited quarterly financial data for fiscal 2006 and 2005:
| ** **                    | ** ** | **First Quarter** | ** ** | **Second Quarter** | ** ** | **Third Quarter** | ** ** | **Fourth Quarter** | ** ** |
|-------------------------------|------------|------------------------|------------|-------------------------|------------|------------------------|------------|-------------------------|------------|
| ** **                    | ** ** | **2006**               | ** ** | **2005**                | ** ** | **2006**               | ** ** | **2005**                | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
|                          |       |                   |       |                    |       |                   |       |                    |       |   |   |   |   |   |   |   |   |
| Revenues                      |       | $                      | 58,911     |                    | $          | 47,286                 |       | $                       | 64,123     |   | $ | 49,712 |   | $ | 76,241 |   | $ | 53,805 |   | $ | 75,686 |   | $ | 56,589 |   |
|                          |       |                   |       |                    |       |                   |       |                    |       |   |   |   |   |   |   |   |   |
| Income (Loss) from:           |       |                   |       |                    |       |                   |       |                    |       |   |   |   |   |   |   |   |   |
| Continuing  Operations        |       | 3,241                  |       | 2,747                   |       | 1,635                  |       | 2,894                   |       | 3,733 |   | 3,323 |   | 3,506 |   | (223 | ) |
|                          |       |                   |       |                    |       |                   |       |                    |       |   |   |   |   |   |   |   |   |
| Discontinued  Operations      |       | (47                    | )          | 235                     |       | 29                     |       | 184                     |       | (17 | ) | 170 |   | 42 |   | (4,180 | ) |
|                          |       |                   |       |                    |       |                   |       |                    |       |   |   |   |   |   |   |   |   |
| Net Income (Loss)             |       | $                      | 3,194      |                    | $          | 2,982                  |       | $                       | 1,664      |   | $ | 3,078 |   | $ | 3,716 |   | $ | 3,493 |   | $ | 3,548 |   | $ | (4,403 | ) |
|                          |       |                   |       |                    |       |                   |       |                    |       |   |   |   |   |   |   |   |   |
| Net Income (Loss) Per  Share: |       |                   |       |                    |       |                   |       |                    |       |   |   |   |   |   |   |   |   |
|                          |       |                   |       |                    |       |                   |       |                    |       |   |   |   |   |   |   |   |   |
| Continuing Operations         |       |                   |       |                    |       |                   |       |                    |       |   |   |   |   |   |   |   |   |
|                          |       |                   |       |                    |       |                   |       |                    |       |   |   |   |   |   |   |   |   |
| Basic                         |       | $                      | 0.21       |                    | $          | 0.25                   |       | $                       | 0.11       |   | $ | 0.26 |   | $ | 0.25 |   | $ | 0.24 |   | $ | 0.24 |   | $ | (0.02 | ) |
| Diluted                       |       | $                      | 0.21       |                    | $          | 0.24                   |       | $                       | 0.11       |   | $ | 0.25 |   | $ | 0.24 |   | $ | 0.23 |   | $ | 0.23 |   | $ | (0.01 | ) |
|                          |       |                   |       |                    |       |                   |       |                    |       |   |   |   |   |   |   |   |   |
| Discontinuing  Operations     |       |                   |       |                    |       |                   |       |                    |       |   |   |   |   |   |   |   |   |
|                          |       |                   |       |                    |       |                   |       |                    |       |   |   |   |   |   |   |   |   |
| Basic                         |       | $                      | 0.00       |                    | $          | 0.02                   |       | $                       | 0.00       |   | $ | 0.01 |   | $ | 0.00 |   | $ | 0.01 |   | $ | 0.00 |   | $ | (0.28 | ) |
| Diluted                       |       | $                      | 0.00       |                    | $          | 0.02                   |       | $                       | 0.00       |   | $ | 0.01 |   | $ | 0.00 |   | $ | 0.01 |   | $ | 0.00 |   | $ | (0.27 | ) |
|                          |       |                   |       |                    |       |                   |       |                    |       |   |   |   |   |   |   |   |   |
| Net Income (Loss)             |       |                   |       |                    |       |                   |       |                    |       |   |   |   |   |   |   |   |   |
|                          |       |                   |       |                    |       |                   |       |                    |       |   |   |   |   |   |   |   |   |
| Basic                         |       | $                      | 0.21       |                    | $          | 0.27                   |       | $                       | 0.11       |   | $ | 0.27 |   | $ | 0.25 |   | $ | 0.25 |   | $ | 0.24 |   | $ | (0.30 | ) |
| Diluted                       |       | $                      | 0.21       |                    | $          | 0.26                   |       | $                       | 0.11       |   | $ | 0.26 |   | $ | 0.24 |   | $ | 0.24 |   | $ | 0.23 |   | $ | (0.28 | ) |

 

For 2005, the number of shares and per share amounts have been restatedto reflect the impact of the June 15, 2005 two-for-one stock split.

F-38

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**INDEX TO FINANCIAL STATEMENT SCHEDULE**
| Schedule II Valuation and  Qualifying Accounts |   | S-2 |
|------------------------------------------------|--------|-----|

S-1

----

**HORIZON HEALTH CORPORATION**

**SCHEDULE II: VALUATION AND QUALIFYING ACCOUNTS**
| (In thousands)              | ** ** | **Balance at  Beginning  Of Period** | ** ** | **Net Additions  Charged  (Recoveries  Credited) to  Costs and  Expenses*** | ** ** | **Uncollectible  Accounts  Written off** | ** ** | **Balance  at End  of Period** | ** ** |
|----------------------------------|------------|------------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|------------------------------------------|------------|
|                             |       |                                           |       |                                                                                       |       |                                          |       |                                     |       |
| Year ended August 31,  2006:     |       |                                           |       |                                                                                       |       |                                          |       |                                     |       |
| Allowance for doubtful  accounts |       | $                                              | 5,741      |                                                                                       | $          | 6,427                                         |       | $                                        | (3,682     | ) | $ | 8,486 |   |
|                             |       |                                           |       |                                                                                       |       |                                          |       |                                     |       |
| Year ended August 31,  2005:     |       |                                           |       |                                                                                       |       |                                          |       |                                     |       |
| Allowance for doubtful  accounts |       | $                                              | 2,412      |                                                                                       | $          | 4,246                                         |       | $                                        | (917       | ) | $ | 5,741 |   |
|                             |       |                                           |       |                                                                                       |       |                                          |       |                                     |       |
| Year ended August 31,  2004:     |       |                                           |       |                                                                                       |       |                                          |       |                                     |       |
| Allowance for doubtful accounts  |       | $                                              | 1,512      |                                                                                       | $          | 797                                           |       | $                                        | 103        |   | $ | 2,412 |   |

 

----

*                                         Excludesthe net of recoveries credited and additions charged of approximately$(172,000), $136,000, and $13,000 related to other receivables and accruedliabilities for the fiscal years ending 2006, 2005, and 2004.

S-2

----

**INDEX TO EXHIBITS**
| NUMBER | ** ** | **EXHIBIT**                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|--------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1    |       | -        Certificate of  Incorporation of the Company, as amended (incorporated herein by reference to  Exhibit 3.1 to the Company’s Current Report on Form 8-K dated August 11,  1997).                                                                                                                                                                                                                       |
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 3.2    |       | -        Amended and Restated  Bylaws of the Company, as amended (incorporated herein by reference to  Exhibit 3.1 to the Company’s Current Report on Form 8-K dated April 21,  2005).                                                                                                                                                                                                                         |
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 4.1    |       | -        Specimen certificate for  the Common Stock, $.01 par value of the Company (incorporated herein by  reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K dated  August 11, 1997).                                                                                                                                                                                                      |
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 4.2    | ** ** | -        Rights Agreement, dated  February 6, 1997, between the Company and American Stock Transfer & Trust  Company, as Rights Agent (incorporated by reference to Exhibit 4.1 to the  Company’s Registration Statement on Form 8-A, Registration No. 000-22123, as  filed with the Commission on February 7, 1997).                                                                                      |
|   | ** ** |                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 4.3    |       | -        First Amendment to  Rights Agreement, dated April 22,2005 by and between the Company and American  Stock Transfer & Trust Company, as Rights Agent (incorporated herein by  reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K dated  April 21, 2005).                                                                                                                          |
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 10.1   |       | -        Consent and First  Amendment to Third Amended and Restated Credit Agreement dated November 14,  2005, between Horizon Health Corporation and Horizon Health Management, Inc.  as Borrowers and JPMorgan Chase Bank as Agent, and the banks named therein  (incorporated herein by reference to Exhibit 10.1 to the Company’s Quarterly  Report on Form 10-Q for the quarter ended November 30, 2005). |
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 10.2   |       | -        Asset Purchase Agreement  dated as of December 9, 2005, by and among Lighthouse Care Centers, LLC, and  certain other affiliated Lighthouse entities as Sellers, and Horizon Health  Corporation, as Purchaser (incorporated herein by reference to Exhibit 10.1  to the Company’s Current Report on Form 8-K dated December 9, 2005).                                                                |
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 10.3   |       | -        Asset Purchase Agreement  dated as of December 9, 2005, by and among Focus Healthcare, LLC, and certain  other affiliated Focus entities as Sellers, and Horizon Health Corporation,  as Purchaser (incorporated herein by reference to Exhibit 10.2 to the  Company’s Current Report on Form 8-K dated December 9, 2005).                                                                            |
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 10.4   |       | -        Stock Purchase Agreement  dated as of December 30, 2005 by and among Kids Behavioral Health, LLC as  Shareholder and Kids Behavioral Health of Utah, Inc., and Horizon Health  Hospital Services, Inc., as Purchaser (incorporated herein by reference to  Exhibit 10.1 to the Company’s Current Report on Form 8-K dated December 30,  2005).                                                        |
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 10.5   |       | -        Second Amendment to  Third Amended and Restated Credit Agreement dated as of January 26, 2006,  between Horizon Health Corporation and Horizon Mental Health Management, Inc.  as Borrowers and JPMorgan Chase Bank as Agent, and the banks named therein  (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on  Form 8-K dated January 27, 2006).                           |
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 10.6   |       | -        Amended and Restated  Asset Purchase Agreement dated as of January 30, 2006, by and among Focus  Healthcare, LLC, and certain other affiliated Focus entities as Sellers, and  Horizon Health Corporation, as Purchaser (incorporated herein by reference to  Exhibit 10.1 to the Company’s Current Report on Form 8-K dated February 1,  2006).                                                      |

----

 
| 10.7   |   | -        Agreement and Plan of  Merger and Asset Purchase Agreement dated as of January 30, 2006, by and  among Horizon Health Corporation, HHC Delaware, Inc., HHC Realty Investments,  LLC, and Delaware Investment Associates, LLC, and with respect to the purchase  and sale of the Focus Delaware assets and related transactions by and between  HHC Delaware, Inc. and Focus Healthcare of Delaware, LLC (incorporated herein  by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K  dated February 1, 2006). |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.8   |   | -        First Amendment to Asset  Purchase Agreement dated as of January 30, 2006, by and among Lighthouse Care  Centers, LLC, and certain other affiliated Lighthouse entities as Sellers,  and Horizon Health Corporation, as Purchaser (incorporated herein by  reference to Exhibit 10.3 to the Company’s Current Report on Form 8-K dated  February 1, 2006).                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.9   |   | -        Limited Partner Interest  Purchase Agreement dated as of January 17, 2006, by and among HHC Kingwood  Investment, LLC as Purchaser, Signet Health Corporation as Seller and  SHC-KPH, LP (incorporated herein by reference to Exhibit 10.1 to the  Company’s Current Report on Form 8-K dated February 15, 2006).                                                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.10  |   | -        Membership Interest  Purchase Agreement dated as of January 17, 2006, by and among Horizon Health  Hospital Services, Inc. as Purchaser, Jerry G. Browder as Seller and Kingwood  Pines Hospital, LLC (incorporated herein by reference to Exhibit 10.2 to the  Company’s Current Report on Form 8-K dated February 15, 2006).                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.11  |   | -        Third Amendment to Third  Amended and Restated Credit Agreement dated as of May 24, 2006, between  Horizon Health Corporation and Horizon Mental Health Management, Inc. as  Borrowers and JPMorgan Chase Bank as Agent, and the banks named therein  (incorporated herein by reference to Exhibit 10.1 to the Company’s Quarterly  Report on Form 10-Q for the quarter ended May 31, 2006).                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.12  |   | -        Lease Agreement dated as  of August 9, 2006, between Horizon Mental Health Management, Inc. as Tennant  and St. David’s Healthcare Partnership LP, LLP as Landlord (incorporated  herein by reference to Exhibit 10.1 to the Company’s Current Report on Form  8-K dated August 15, 2006).                                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.13  |   | -        Executive Agreement,  dated September 7, 2006, between the Company and James Ken Newman (incorporated  herein by reference to Exhibit 10.1 to the Company’s Current Report on Form  8-K dated September 11, 2006).                                                                                                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.14  |   | -        Executive Agreement,  dated September 7, 2006, between the Company and David K. White (incorporated  herein by reference to Exhibit 10.2 to the Company’s Current Report on Form  8-K dated September 11, 2006).                                                                                                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.15  |   | -        Executive Agreement,  dated September 7, 2006, between the Company and John E. Pitts (incorporated  herein by reference to Exhibit 10.3 to the Company’s Current Report on Form  8-K dated September 11, 2006).                                                                                                                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.16  |   | -        Executive Agreement,  dated September 7, 2006, between the Company and Donald W. Thayer  (incorporated herein by reference to Exhibit 10.4 to the Company’s Current  Report on Form 8-K dated September 11, 2006).                                                                                                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.17  |   | -        Executive Agreement,  dated September 7, 2006, between the Company and David K. Meyercord  (incorporated herein by reference to Exhibit 10.5 to the Company’s Current  Report on Form 8-K dated September 11, 2006).                                                                                                                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.18  |   | -        Executive Agreement,  dated September 7, 2006, between the Company and Frank J. Baumann  (incorporated herein by reference to Exhibit 10.6 to the Company’s Current  Report on Form 8-K dated September 11, 2006).                                                                                                                                                                                                                                                                                                               |

----

 
| 10.19  |   | -        Horizon Health  Corporation Bonus Plans for Executive Officers for the 2007 Fiscal Year  (incorporated herein by reference to Exhibit 10.1 to the Company’s Current  Report on Form 8-K dated October 25, 2006).                                                            |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.20  |   | -        Horizon Health Group,  Inc. 1989 Stock Option Plan, as amended (incorporated herein by reference to  Exhibit 10.8 to the Company’s Annual Report on Form 10-K for the fiscal year  ended August 31, 2002).                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.21  |   | -        Horizon Mental Health  Management, Inc. 1995 Stock Option Plan as amended (incorporated herein by  reference to Exhibit 10.9 to the Company’s Annual Report on Form 10-K for the  fiscal year ended August 31, 2002).                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.22  |   | -        Horizon Mental Health  Management, Inc. Amended and Restated 1995 Stock Option Plan for Eligible  Outside Directors as amended (incorporated herein by reference to Exhibit  10.10 to the Company’s Annual Report on Form 10-K for the fiscal year ended  August 31, 2002). |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.23  |   | -        Horizon Health  Corporation 1998 Stock Option Plan as amended (incorporated herein by  reference to Exhibit 10.11 to the Company’s Annual Report on Form 10-K for  the fiscal year ended August 31, 2002).                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.24  |   | -        Horizon Health  Corporation 2005 Omnibus Incentive Plan (incorporated herein by reference to  Exhibit 10.1 to the Company’s Current Report on Form 8-K dated January 21,  2005).                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.25  |   | -        Horizon Health  Corporation Bonus Plan Fiscal 2006 (incorporated herein by reference to  Exhibit 10.16 to the Company’s Annual Report on Form 10-K for the fiscal year  ended August 31, 2005).                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 21     |   | -        List of Subsidiaries of  the Company (filed herewith).                                                                                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 23     |   | -        Consent of  PricewaterhouseCoopers LLP (filed herewith).                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 31.1   |   | -        Certification of Chief  Executive Officer required by Securities and Exchange Commission Rule   13a-14(a) or 15d-14(a) (filed herewith).                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 31.2   |   | -        Certification of Chief  Financial Officer required by Securities and Exchange Commission Rule   13a-14(a) or 15d-14(a) (filed herewith).                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 32     |   | -        Certification of Chief  Executive Officer and Chief Financial Officer pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350 (filed herewith).                                                                                                       |

 

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