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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



---



FORM 10-K



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



For the Fiscal Year Ended August 31, 2005



or



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



For the transition period from  to



Commission File number 1-13626



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HORIZON HEALTH CORPORATION

(Exact name of registrant as specified in its charter)



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



1500 Waters Ridge
Drive

Lewisville, Texas 75057-6011

(Address of principal executive offices, including zip code)



(972) 420-8200

(Registrants telephone number, including area code)



---



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



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



|                            
|----------------------------
|Title of each class         
|Common Stock, $.01 par value



---



Indicate by check mark whether the registrant (1) has filed all reports required to be filed by section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90
days.    Yes  x    No ̈



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



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



Indicate
by check mark whether the registrant is a shell Company (as defined in Rule 12b-2 of the Exchange Act).    Yes ̈No  x



The aggregate market value of the voting common stock held by non-affiliates of the registrant (assuming for purposes of this calculation, but without conceding, that all executive officers and directors are affiliates of the
registrant) at February 28, 2005 (the last business day of the most recently completed second fiscal quarter) was $186,607,488, based on the market price at the close of business on February 28, 2005.



The number of shares outstanding of the registrants Common Stock, $.01 par value per
share, as of October 21, 2005 was 14,906,507.



DOCUMENTS
INCORPORATED BY REFERENCE



There is incorporated by reference in Part III of
this Annual Report on Form 10-K portions of the information contained in the registrants proxy statement for its annual meeting of stockholders to be held on January 20, 2006.



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TABLE OF CONTENTS



HORIZON HEALTH
CORPORATION



|
|

|       |  |                                                             |  |     
|------ |  | ----------------------------------------------------------- |  | ----
|       |  |                                                             |  | Page
|PART I |  |                                                            
|       |  |                                                            
|       |  | Item 1.
Business                                            |  | 5   
|       |  | Disclosures Regarding Forward Looking Statements            |  | 5   
|       |  | Risk Factors                                                |  | 6   
|       |  | General Overview                                            |  | 15  
|       |  | Recent Developments                                         |  | 15  
|       |  | Services by Service Group                                   |  | 17  
|       |  |                                                            
|       |  | Behavioral Health Contract Management Services              |  | 17  
|       |  | Behavioral Health Hospital Services                         |  | 20  
|       |  | Physical Rehabilitation Contract Management Services        |  | 21  
|       |  | EAP Services                                                |  | 22  
|       |  | Operations                                                  |  | 22  
|       |  | Management Contracts                                        |  | 22  
|       |  | Program Development                                         |  | 23  
|       |  | Program Staffing                                            |  | 24  
|       |  | Program Education and Referral Development                  |  | 24  
|       |  | Internal Audits                                             |  | 24  
|       |  | Contract Locations                                          |  | 26  
|       |  | Client Hospitals                                            |  | 26  
|       |  | CQI+ Mental Health Outcomes Measurement                     |  | 26  
|       |  | Behavioral Health Care Facilities                           |  | 26  
|       |  | Employee Assistance and Managed Care Contracts              |  | 27  
|       |  | Administration                                              |  | 27  
|       |  | Sales and Marketing                                         |  | 27  
|       |  | Competition                                                 |  | 28  
|       |  | Customers                                                   |  | 29  
|       |  | Employees                                                   |  | 29  
|       |  | Government Regulation                                       |  | 29  
|       |  | Facility Use and Qualification                              |  | 30  
|       |  | Licensing and Certification                                 |  | 30  
|       |  | Provider-Based Rules                                        |  | 30  
|       |  | Medicare and Medicaid: Reimbursement for Services           |  | 31  
|       |  | Background                                                  |  | 31  
|       |  | Overview                                                    |  | 32  
|       |  | Other Reimbursement Payors                                  |  | 33  
|       |  | Behavioral Health Reimbursement Changes/Proposals           |  | 33  
|       |  | Physical Rehabilitation Reimbursement Changes/Proposals     |  | 34  
|       |  | Potential Adverse Impacts of Changes in Reimbursement       |  | 35  
|       |  | Patient Referral Laws                                       |  | 36  
|       |  | Behavioral Health Care Patient Rights                       |  | 37  
|       |  | Executives Officers of the Registrant                       |  | 37  
|       |  | Item 2.
Properties                                          |  | 39  
|       |  |                                                            
|       |  | Item 3.
Legal Proceedings                                   |  | 39  
|       |  |                                                            
|       |  | Item 4.
Submission of Matters to a Vote of Security Holders |  | 40  



2



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##### Index to Financial Statements

|         |  |                                                                                               |  |   
|-------- |  | --------------------------------------------------------------------------------------------- |  | --
|PART II  |  |                                                                                              
|         |  |                                                                                              
|         |  | Item 5.
Market for the Companys Common Equity and Related Stockholder Matters                |  | 41
|         |  |                                                                                              
|         |  | Item 6.
Selected Financial Data                                                               |  | 41
|         |  |                                                                                              
|         |  | Item 7.
Managements Discussion and Analysis of Financial Condition and Results of Operations |  | 44
|         |  | General Overview                                                                              |  | 44
|         |  | Acquisitions                                                                                  |  | 44
|         |  | Segments (Service Groups)                                                                     |  | 45
|         |  | Revenues                                                                                      |  | 45
|         |  | Operating Expenses                                                                            |  | 47
|         |  | Results of Operations                                                                         |  | 48
|         |  | Fiscal Year Ended August 31, 2005 Compared to Fiscal Year Ended August 31, 2004               |  | 49
|         |  | Fiscal Year Ended August 31, 2004 Compared to Fiscal Year Ended August 31, 2003               |  | 52
|         |  | Newly Issued Accounting Standards                                                             |  | 55
|         |  | Sarbanes-Oxley and Related Compliance                                                         |  | 55
|         |  | Liquidity and Capital Resources                                                               |  | 55
|         |  | Inflation and Economic Trends                                                                 |  | 59
|         |  | Critical Accounting Policies & Estimates                                                      |  | 59
|         |  |                                                                                              
|         |  | Item 7A.
Quantitative and Qualitative Disclosures About Market Risk                           |  | 63
|         |  |                                                                                              
|         |  | Item 8.
Financial Statements and Supplementary Data                                           |  | 63
|         |  |                                                                                              
|         |  | Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure  |  | 63
|         |  |                                                                                              
|         |  | Item 9A.
Controls and Procedures                                                              |  | 63
|         | 
|PART III |  |                                                                                              
|         |  |                                                                                              
|         |  | Item 10.
Directors and Executive Officers of the Registrant                                   |  | 64
|         |  |                                                                                              
|         |  | Item 11.
Executive Compensation                                                               |  | 64
|         |  |                                                                                              
|         |  | Item 12.
Security Ownership of Certain Beneficial Owners and Management                       |  | 65
|         |  |                                                                                              
|         |  | Item 13.
Certain Relationships and Related Transactions                                       |  | 65
|         |  |                                                                                              
|         |  | Item 14.
Principal Accounting Fees & Services                                                 |  | 65



3



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|        |  |                                                                           |  |     
|------- |  | ------------------------------------------------------------------------- |  | ----
|PART IV |  |                                                                          
|        |  |                                                                          
|        |  | Item 15.
Exhibits, Financial Statement Schedules, and Reports on Form 8-K |  | 66  
|        |  | Index to Consolidated Financial Statements                                |  | F-1 
|        |  | Report of Independent Registered Public Accounting Firm                   |  | F-2 
|        |  | Consolidated Balance Sheets                                               |  | F-3 
|        |  | Consolidated Statements of Operations                                     |  | F-5 
|        |  | Consolidated Statements of Changes in Stockholders Equity                |  | F-6 
|        |  | Consolidated Statements of Cash Flows                                     |  | F-7 
|        |  | Note 1:
Organization                                                      |  | F-9 
|        |  | Note 2:
Significant Accounting Policies                                   |  | F-10
|        |  | Note 3:
Stock Options and Other Stock Awards                              |  | F-16
|        |  | Note 4:
Earnings Per Share                                                |  | F-18
|        |  | Note 5:
Acquisitions and Entry Into a Long Term Lease Agreement           |  | F-19
|        |  | Note 6:
Discontinued Operations                                           |  | F-22
|        |  | Note 7:
Property and Equipment                                            |  | F-24
|        |  | Note 8:
Accrued Expenses and Unearned Revenue                             |  | F-25
|        |  | Note 9:
Long-Tem Debt                                                     |  | F-25
|        |  | Note 10:
Shareholders Equity                                             |  | F-26
|        |  | Note 11:
Goodwill and Other Intangible Assets                             |  | F-27
|        |  | Note 12:
Retirement Plan                                                  |  | F-28
|        |  | Note 13:
Income Taxes                                                     |  | F-29
|        |  | Note 14:
Commitments and Contingencies                                    |  | F-30
|        |  | Note 15:
Segments (Service Groups) Information                            |  | F-32
|        |  | Note 16:
EAP Services Reorganization and Related Impairments              |  | F-34
|        |  | Note 17:
Quarterly Financial Information (unaudited)                      |  | F-36
|        |  |                                                                          
|        |  | Index to Financial Statement Schedules                                    |  | S-1 



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PART I



ITEM 1. BUSINESS



Unless
the context otherwise requires, whenever used herein the terms Company, Horizon Health and Registrant refer to Horizon Health Corporation and its subsidiaries.



Disclosure Regarding Forward-Looking Statements



Certain written and oral statements made or incorporated by reference from time to time by the Company or its representatives in this report, other reports, filings with the Commission, press releases, conferences, or
otherwise, are forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements include, without limitation, any statement that may predict, forecast, indicate, or imply future
results, performance or achievements, and may contain the words believe, anticipate, expect, estimate, project, will be, will continue, will likely
result, or words or phrases of similar meaning. Such statements involve risks, uncertainties or other factors which may cause actual results to differ materially from the future results, performance or achievements expressed or implied by such
forward looking statements. Certain risks, uncertainties and other important factors are detailed in this report and will be detailed from time to time in reports filed by the Company with the Commission, including Forms 8-K, 10-Q, and 10-K, and
include, among others, the following: general economic and business conditions which are less favorable than expected; unanticipated changes in industry trends; decreased demand by acute care hospitals for the Companys services; the
Companys inability to retain existing management contracts or to obtain additional contracts or maintain customer relationships; adverse changes in reimbursement to by Medicare or other third-party payers for costs of providing behavioral
health or physical rehabilitation or nursing; adverse changes to other regulatory requirements relating to the provision of behavioral health or physical rehabilitation or nursing services; adverse consequences of investigations by governmental
regulatory agencies; adverse judgments rendered in the qui tam lawsuits pending against the Company; fluctuations and difficulty in forecasting operating results; the ability of the Company to sustain, manage or forecast its growth; the ability of
the Company to successfully acquire and integrate facilities or businesses on a cost effective basis; heightened competition, including specifically the intensification of price competition; the entry of new competitors and the development of new
products or services by new and existing competitors; changes in business strategy or development plans; inability to carry out marketing and sales plans; business disruptions; liability and other claims asserted against the Company; loss of key
executives; the ability to attract and retain qualified personnel; adverse publicity; demographic changes; and other factors referenced or incorporated by reference in this report and other reports or filings with the Commission. Moreover, the
Company operates in a very competitive and rapidly changing environment. New risk factors emerge from time to time and it is not possible for management to predict all such risk factors, nor can it assess the impact of all such risk factors on the
Companys business or the extent to which any factor may cause actual results to differ materially from those contained in any forward looking statements. These forward-looking statements represent the estimates and assumptions of management
only as of the date of this report. The Company expressly disclaims any obligation or undertaking to disseminate any updates or revisions to any forward looking statement contained herein to reflect any change in its expectations with regard thereto
or any change in events, conditions or circumstances on which any statement is based. Given these risks and uncertainties, investors should not place undue reliance on forward-looking statements as a prediction of actual results.



5



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Risk Factors



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



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



Insurers, managed care companies and governmental payors, including Medicare
and Medicaid, have instituted cost containment measures designed to limit payments made to health care providers including our client hospitals and owned facilities. The availability and amount of the reimbursements impact the decisions of acute
care hospitals regarding whether to offer behavioral health services pursuant to management contracts with us, as well as their decisions on whether to renew such contracts and the amounts paid to us thereunder.



On November 15, 2004, Centers for Medicare and Medicaid Services (CMS),
a federal agency within the U.S. Department of Health and Human Services (HHS), published final regulations adopting a prospective payment system (PPS) for inpatient behavioral health services, which have historically been reimbursed based on
reasonable cost, subject to a discharge ceiling. CMS has begun phasing in the PPS over a four-year period. The new system will pay inpatient behavioral health facilities a per diem base rate to be adjusted by factors that influence the cost of an
individual patients care, such as each patients diagnosis related group, certain other medical and psychiatric coexisting conditions that may complicate treatment and age. The final regulations only provide for stop loss payments at 70%
of the amount that behavioral health facilities and units in general acute care hospitals would have received under the old payment system. This could have an adverse effect on the reimbursement for the patient services provided in the units in
general acute care hospitals that we manage, which could result in a reduction in revenues that we earn under our management contracts with such client hospitals.



On May 7, 2004, CMS published a final rule to modify the criteria for being classified as an inpatient rehabilitation
facility. The final rule, known as the 75% Rule, generally requires that in order to meet the qualification requirement, 75% of the patients of a physical rehabilitation services unit must have certain qualifying medical conditions. The
final rule has a four-year phase-in period and eliminates polyarthritis and other medical conditions as qualifying medical conditions. As a result, certain patients that previously satisfied a qualifying medical condition do not meet a qualifying
medical condition under the new rule. The final rules together with similar prospective payment rules previously adopted for physical rehabilitation services have resulted and may continue to result in decreased reimbursements to our client
hospitals which has led and may continue to lead to, among other things, renegotiated contract management fees which could have an adverse effect on our revenues from rehabilitation programs we manage.



The Medicare and Medicaid programs are subject to additional statutory and
regulatory changes, retroactive and prospective rate adjustments, administrative rulings and funding restrictions, any of which could have the effect of limiting or reducing reimbursement levels to general acute care hospitals and freestanding
behavioral health facilities for behavioral health and physical rehabilitation services provided by programs we manage or facilities we own/operate. Other future federal and state legislation and regulations may also result in reductions in the
payments we receive for our services.



With regard to the
prospective payment system for services provided by inpatient behavioral health care hospitals the per diem amounts are calculated in part based on national averages, but will be adjusted for specific facility characteristics that increase the cost
of patient care. The base rate per diem is intended to compensate a facility for costs incurred to treat a patient with a particular diagnosis, including nearly all labor and non-labor costs of furnishing covered inpatient behavioral health care
services as well as routine, ancillary and capital costs. Payments rates for individual inpatient facilities will be adjusted to reflect geographic difference in wages and will allow additional outlier payments for expenses associated with
extraordinary cases. Additionally, rural providers will receive an increased payment adjustment. Medicare will pay this per diem amount, as adjusted, regardless of whether it is more or less than a hospitals actual costs. The per diem will
not, however include the costs of bad debt and certain other costs that are paid separately.



6



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##### Index to Financial Statements

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



Insurance and managed care companies and other third parties from whom we
receive payment in our owned hospitals are increasingly attempting to control health care costs by requiring that facilities discount their fees in exchange for exclusive or preferred participation in their benefit plans. This trend may continue and
may reduce the payments received by us for our services.



A
significant number of our management contracts require us to refund or renegotiate some or all of our management fee if either reimbursement for services provided to patients of the program we manage is denied or the fee paid to us is denied as a
reimbursable cost. Medicare retrospectively audits cost reports of client hospitals upon reimbursement for services rendered.



Some of our management contracts provide for renegotiation of their terms if the Medicare or Medicaid reimbursement for the mental health or physical
rehabilitation services provided by the client hospital drop below a certain level. Any significant decrease in Medicare or Medicaid reimbursement levels, the imposition of significant restrictions on participation in the Medicare or Medicaid
programs, or the disallowance of any significant portion of a hospitals costs, including the management fee paid to us, may reduce our revenues.



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



Recently acquired businesses and facilities, and businesses or facilities acquired in the future, will expose us to increased operating risks.



We acquired two freestanding behavioral health facilities in fiscal 2004, and three freestanding behavioral health
facilities in fiscal 2005. As part of our growth strategy, we intend to continue to pursue additional acquisitions, leases, joint ventures and similar transactions.



This expansion exposes us to additional business and operating risks and uncertainties, including:



| |  |  | the ability to effectively assimilate and manage acquired behavioral health facilities;
| | - |  | ---------------------------------------------------------------------------------------



| |  |  | the ability to realize our investment in the acquired behavioral health facilities;
| | - |  | -----------------------------------------------------------------------------------



| |  |  | the diversion of managements time and attention from other business concerns;
| | - |  | ------------------------------------------------------------------------------



| |  |  | the risks of entering markets in which we may have no or limited direct prior experience;
| | - |  | -----------------------------------------------------------------------------------------



| |  |  | the potential loss of key employees of the acquired behavioral health facilities;
| | - |  | ---------------------------------------------------------------------------------



| |  |  | the risk that an acquisition could reduce our future earnings;
| | - |  | --------------------------------------------------------------



| |  |  | the exposure to unknown liabilities; and
| | - |  | ----------------------------------------



| |  |  | our ability to meet contractual obligations.
| | - |  | --------------------------------------------



If we are unable to assimilate activities of the acquired behavioral health facilities and manage this expansion efficiently or effectively, or are unable
to attract and retain additional qualified management personnel to run the expanded operations, it could result in financial expenditures and increased demands on managements time and could have a material adverse effect on our business,
financial condition and results of operations.



If we fail to
improve the operations of acquired inpatient facilities, we may be unable to achieve our growth strategy.



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



If competition decreases our ability to acquire additional inpatient behavioral health facilities on favorable terms, we may be unable to execute our acquisition strategy.



An important part of our business strategy is to acquire inpatient
behavioral health facilities in attractive markets. Some of our competitors have greater financial resources and a larger, more experienced development staff focused on identifying and completing acquisitions. In addition, we may compete with
not-for-profit entities that operate on a tax-exempt basis.



Regulatory
requirements regarding inpatient behavioral health facilities could delay or prevent the acquisition of additional facilities.



Some behavioral health facility acquisitions may require a longer period to complete than acquisitions in other industries and may be subject to
additional regulatory uncertainty. Many states have adopted legislation restricting the sale or other disposition of facilities operated by not-for-profit entities. In other states that do not have specific legislation, the attorneys general have
demonstrated an interest in these transactions under their general obligations to protect charitable assets from waste. These legislative and administrative efforts focus primarily on the appropriate valuation of the assets divested and the use of
the proceeds of the sale by the not-for-profit seller. In addition, the acquisition of facilities in certain states requires advance regulatory approval under certificate of need or state licensure regulatory regimes. These state-level
procedures could seriously delay or even prevent us from acquiring inpatient facilities, even after significant transaction costs have been incurred.



Additional financing may be necessary to fund our acquisition program and capital expenditures, and the financing may not be available when needed or may subject us
to risks.



Our acquisition program requires
substantial capital resources. Likewise, the operation of existing inpatient behavioral health facilities requires ongoing capital expenditures for renovation, 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 not able to obtain financing, we may not be able to consummate acquisitions or undertake capital expenditures.



Although we currently have no outstanding borrowed indebtedness, we expect to incur additional indebtedness in the future.



Our borrowed indebtedness could have important consequences,
including:



| |  |  | increasing our vulnerability to general adverse economic and industry conditions;
| | - |  | ---------------------------------------------------------------------------------



| |  |  | requiring that a portion of our cash flow from operations be used for the payment of interest on our debt, thereby reducing our ability to use our cash flow to fund working capital,
capital expenditures, acquisitions and general corporate requirements;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



| |  |  | limiting our ability to obtain additional financing to fund future working capital, capital expenditures, acquisitions and general corporate requirements;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | limiting our flexibility in planning for, or reacting to, changes in our business and the health care industry;
| | - |  | ---------------------------------------------------------------------------------------------------------------



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##### Index to Financial Statements

| |  |  | restricting our ability or the ability of our restricted subsidiaries to pay dividends or make other payments; and
| | - |  | ------------------------------------------------------------------------------------------------------------------



| |  |  | placing us at a competitive disadvantage to our competitors that have less indebtedness.
| | - |  | ----------------------------------------------------------------------------------------



In addition, our revolving credit facility requires us to maintain and meet specified financial ratios and tests that may
require that we take action to reduce our debt or to act in a manner contrary to our business objectives. Events beyond our control, including changes in general business and economic conditions, may affect our ability to meet those financial ratios
and tests. A breach of any of these covenants would result in a default under our revolving credit facility. If an event of default under our revolving credit facility occurs, the lenders could elect to declare all amounts outstanding thereunder,
together with accrued, but unpaid, interest, to be immediately due and payable.



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



Approximately 47.5% of our revenues for the year ended August 31, 2005 were derived from management contracts with general acute care hospitals to
manage behavioral health and physical rehabilitation clinical programs of those hospitals. The contracts generally have initial terms of three to five years and many have automatic renewal terms subject to termination by either party. The contracts
often provide for early termination either by the client hospital if specified performance criteria are not satisfied or by us under various other circumstances. Although our management contracts are frequently renewed or extended prior to their
stated expiration dates, some contracts expire without renewal and others are terminated by us or the client hospital for various reasons prior to their scheduled expiration. Our continued success is subject to the ability to renew or extend
existing management contracts and obtain new management contracts. Contract renewals and extensions are likely to be subject to competing proposals from other contract management companies as well as consideration by certain hospitals to convert
from independently managed programs to programs operated internally or to terminate their programs in order to reassign patient beds for other health care purposes. A client hospital may not continue to do business with us following expiration or
termination of its management contract. In addition, any limitations or reductions in reimbursements for services provided by programs managed by us could result in a reduction in the management fees paid to us or the early termination of existing
management contracts and would adversely affect our ability to renew or extend existing management contracts and to obtain new management contracts. The termination or non-renewal of a material number of management contracts could result in a
significant decrease in our net revenues.



If we fail to comply with
extensive laws and government regulations, we could suffer penalties or be required to make significant changes to our operations.



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



| |  |  | billing for services;
| | - |  | ---------------------



| |  |  | relationships with physicians and other referral sources;
| | - |  | ---------------------------------------------------------



| |  |  | adequacy of medical care;
| | - |  | -------------------------



| |  |  | quality of medical equipment and services;
| | - |  | ------------------------------------------



| |  |  | qualifications of medical and support personnel;
| | - |  | ------------------------------------------------



| |  |  | confidentiality, maintenance and security issues associated with health-related information and medical records;
| | - |  | ----------------------------------------------------------------------------------------------------------------



| |  |  | licensure;
| | - |  | ----------



| |  |  | hospital rate or budget review;
| | - |  | -------------------------------



9



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##### Index to Financial Statements

| |  |  | operating policies and procedures; and
| | - |  | --------------------------------------



| |  |  | addition of facilities and services.
| | - |  | ------------------------------------



Among these laws are the anti-kickback provision of the Social Security Act (the Anti-kickback Statute) and the provision of the Social Security Act
commonly known as the Stark Law. These laws impact the relationships that certain health care providers, including our client hospitals and the behavioral health facilities we operate, may have with physicians and other referral sources.



The Office of Inspector General (OIG) of HHS has enacted safe
harbor regulations that outline practices that are deemed protected from prosecution under the Anti-kickback Statute. The current relationships that our client hospitals or we have with physicians and other referral sources may not qualify for safe
harbor protection under the Anti-kickback Statute.



In order to
comply with the Stark Law, the financial relationships between certain health care providers and physicians and their immediate family members must meet an exception. We structure and believe our client hospitals structure our respective
relationships to meet an exception to the Stark Law, but the regulations implementing the exceptions, some of which are still under review, are detailed and complex, and certain of these relationships may not fully comply with 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 subjected to penalties, including criminal penalties, civil penalties (including the loss of our licenses to operate one or more inpatient behavioral health facilities), and exclusion of one
or more of our inpatient behavioral health facilities from participation in the Medicare, Medicaid and other federal and state health care programs. In addition, if we do not operate our inpatient facilities in accordance with applicable law, the
facilities may lose their licenses or the ability to participate in third party reimbursement programs. Our client hospitals face similar risks.



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



We may be required to spend substantial amounts of capital to comply with legislative
and regulatory initiatives relating to privacy and security of patient health information and standards for electronic transactions.



There are currently numerous legislative and regulatory initiatives at the federal and state levels addressing patient privacy and security concerns. In
particular, federal regulations issued under the Health Insurance Portability Accountability Act of 1996 (HIPAA) contain provisions that have required, and in the future may require, our facilities to implement costly new computer systems and to
adopt business procedures designed to protect the privacy and security of each of their patients individually identifiable health and related financial information. The privacy regulations have had a financial impact on the health care
industry because they impose extensive new administrative requirements, restrictions on the use and disclosure of individually identifiable patient health and related financial information, provide patients with new rights with respect to their
health information and require our inpatient facilities to enter into contracts extending many of the privacy regulation requirements to third parties who perform functions on our behalf involving health information.



On February 20, 2003, HHS issued final security regulations under HIPAA.
Compliance with these security regulations was required by April 21, 2005 for most health care organizations, including our inpatient facilities. These security regulations require our inpatient facilities to implement administrative, physical
and technical safeguards to protect the integrity, confidentiality and availability of electronically received, maintained or transmitted patient individually identifiable health and related financial information. Compliance with these regulations
requires substantial expenditures that could negatively impact our financial results. In addition, our management has spent, and may spend in the future, substantial time and effort on compliance measures.



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##### Index to Financial Statements

HHS has issued regulations requiring most health care organizations, including our behavioral health
facilities, to use standard data formats and code sets when electronically transmitting information in connection with several types of transactions, including health claims, health care payment and remittance advice and health claim status
transactions. Violations of the privacy, security and transaction regulations could subject our inpatient facilities to civil penalties of up to $25,000 per calendar year for each provision contained in the privacy, security and 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 health care legislation.



In addition to extensive government health care regulation, there are numerous initiatives on federal and state levels for
comprehensive reforms affecting the payment for and availability of health care services. We are not certain what legislation on health care reform may ultimately be proposed or enacted or whether other changes in the administration or
interpretation of governmental health care programs will occur. Currently proposed or future health care legislation or other changes in the administration or interpretation of governmental health care programs may have an adverse effect on us.



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



Both federal and state government agencies as well as private payors have heightened and coordinated civil and criminal enforcement efforts as part of
numerous ongoing investigations of health care organizations. These investigations relate to a wide variety of topics, including:



| |  |  | cost reporting and billing practices;
| | - |  | -------------------------------------



| |  |  | quality of care;
| | - |  | ----------------



| |  |  | financial relationships with referral sources;
| | - |  | ----------------------------------------------



| |  |  | medical necessity of services provided; and
| | - |  | -------------------------------------------



| |  |  | treatment of uninsured patients.
| | - |  | --------------------------------



The OIG and the U.S. Department of Justice (DOJ) have, from time to time, undertaken national enforcement initiatives that focus on specific billing
practices or other suspected areas of abuse. Moreover, health care providers are subject to civil and criminal false claims laws, including the federal False Claims Act, which allows private parties to bring whistleblower lawsuits against private
companies doing business with or receiving reimbursement under federal health care programs. Some states have adopted similar state whistleblower and false claims provisions. Publicity associated with the substantial amounts paid by other health
care providers to settle these lawsuits may encourage our current and former employees and other health care providers to bring whistleblower lawsuits. Any investigations of our client hospitals or us could result in significant liabilities or
penalties as well as adverse publicity.



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



In late 1999, a civil qui tam lawsuit brought under the Federal False Claims Act was filed under seal naming our psychiatric contract management subsidiary, Horizon Mental Health Management, Inc., as one of the
defendants in the lawsuit. In March 2001, the relators served the complaint in the lawsuit. The lawsuit is United States ex reI Debra Hockett, M.D., Linda Thompson, M.D., and Chyrissa Staley, RN, Plaintiffs, v. ColumbialHCA Healthcare Corp.,
Indian Path Hospital, Inc., Horizon Mental Health Management, Inc. and Superior Home Health of East Tennessee, Inc., Defendants,01-MS-50 (RCL) (Part of Civil No. 99-3311 (RCL)), United States District Court for the District of Columbia.
The DOJ had previously declined to intervene in the lawsuit. The complaint alleges that certain of our on-site personnel acted in concert with other non-Company personnel to improperly inflate certain



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##### Index to Financial Statements

Medicare reimbursable costs associated with psychiatric services rendered at a Tennessee hospital prior to August 1997.
The complaint also alleges that the same actions occurred at other hospitals owned by the owner of the Tennessee hospital, a co-defendant in the suit, some of which also had management contracts with the Company. The parties are in discovery
proceedings and there is no trial setting. Any judgment in this suit against us would not be covered by insurance.



In early December 2000, we were served with a DOJ subpoena issued by the U.S. Attorneys Office for the Northern District of California. The subpoena
requested the production of documents related to certain matters such as patient admissions, patient care, patient charting and marketing materials, pertaining to hospital geropsychiatric programs managed by us. We furnished documents relating to
one facility in response to the subpoena in January 2001. After we met with the DOJ in December 2002 and furnished additional information, the DOJ subsequently declined to intervene in the suit. In November 2004, the relators served the complaint.
The lawsuit is United States of America, ex rel. Michael M. Meyer, Patricia J. Szerlip and Vicki Weatherford, Plaintiffs, v. Horizon Health Corporation, a Delaware Corporation, Summit Medical Center, a California Corporation, and Sukhdeep Grewal,
M.D., Defendants,Civil Action No. 00-00-1303 SBA, United States District Court for the Northern District of California. The complaint alleges primarily that patients admitted to two behavioral health programs managed by us did not meet
admission criteria and therefore were inappropriately admitted. No discovery proceedings have been conducted in the case and there is no trial setting. Any judgment in this suit against us would not be covered by insurance.



The Company is a party to a lawsuit styled Jeanine Phillips, on behalf of
herself and all others simultaneously situated v. ProCare One Nurses, LLC, Obstetrical Nurses, Inc. and Horizon Health Corporation, Case Number 030000425, pending in the Superior Court of the State of California for the County of Orange. The
complaint alleges various violations of California wage and hour laws and seeks the recovery of substantial amounts for wages, fines, penalties and attorneys fees. The case is filed as a private attorney general action under Section 17200 of
the California Business and Profession Code. The Company considers that it is entitled to indemnity from Obstetrical Nurses, Inc., a predecessor to ProCare One Nurses, LLC for liability relating to a portion of the claims and has asserted a claim
for indemnity in a separate lawsuit. The parties are engaged in discovery proceedings. The case is filed as a class action, but the court recently denied the motion for class certification. Any judgment in this suit against us would not be covered
by insurance.



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



Facilities acquired by us may have unknown or contingent liabilities, including liabilities related to patient care and liabilities for failure to
comply with health care laws and regulations, which could result in large claims and significant defense costs. Although we generally seek indemnification covering these matters from prior owners of facilities we acquire, such indemnification is
often limited and material liabilities for past activities of acquired facilities may exist and such prior owners may not be able to satisfy their indemnification obligations. We are also susceptible to being named in claims brought related to
patient care and other matters at inpatient facilities owned by third parties and at which we provide contract management services.



The loss of our key management personnel or our inability to attract and retain qualified clinical management, marketing and other personnel could have a material
adverse effect on our business operations.



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



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##### Index to Financial Statements

We operate in a highly competitive environment. If we do not compete effectively in our markets, then we could lose
market share.



The health care industry is highly
competitive and subject to continual changes in the method in which services are provided and the types of companies providing services. We compete with several national competitors and many regional and local competitors, some of which have greater
resources than us. In addition, acute care hospitals could elect to manage their own behavioral health or physical rehabilitation programs.



Competition among contract managers for hospital-based behavioral health and physical rehabilitation programs is generally based upon reputation for
quality, price, the ability to provide financial and other benefits for the hospital, and the management, operational and clinical expertise necessary to enable the hospital to offer behavioral health and physical rehabilitation programs that
provide the full continuum of behavioral health and physical rehabilitation services in a quality and cost-effective manner. The pressure to reduce health care expenditures has strengthened the need to manage the appropriateness of behavioral health
and physical rehabilitation services provided to patients.



In
addition, acute care hospitals offering behavioral health and physical rehabilitation programs managed by us compete for patients with other providers of behavioral health care services, including other acute care hospitals, freestanding behavioral
health facilities, independent psychiatrists and psychologists, and with other providers of physical rehabilitation services, including other acute care hospitals, freestanding rehabilitation facilities and outpatient facilities.



There are potential risks associated with our goodwill and other intangible assets.



At August 31, 2005, goodwill and net intangible
assets represented 43.0% of our total assets. In the event we are sold or liquidated, the value of our intangible assets may not be realized. In addition, any significant decrease in the value of our intangible assets could have a material adverse
effect on us.



Under current generally accepted accounting
principles, we are required to test impairment of goodwill and intangible assets at least annually. Because of the significance of goodwill and the identified indefinite lived assets to our consolidated balance sheet, impairment analyses are
important. Changes in key assumptions about our business and its prospects, or changes in market conditions or other external factors, could result in an impairment charge and such a charge could have a material adverse effect on our financial
condition and results of operations.



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



We are subject to medical malpractice and other lawsuits due to the nature of the services we provide. Facilities acquired by us may have unknown or contingent liabilities, including liabilities related to patient
care and liabilities for failure to comply with health care laws and regulations, which could result in large claims and significant defense costs. Although we generally seek indemnification covering these matters from prior owners of facilities we
acquire, material liabilities for past activities of acquired facilities may exist and such prior owners may not be able to satisfy their indemnification obligations. We are also susceptible to being named in claims brought related to patient care
and other matters at inpatient 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 insurance coverage is maintained in amounts and with deductibles common in the
industry. There are no assurances that our insurance will cover all claims (e.g., claims for punitive damages) or that claims in excess of our insurance coverage will not arise. A successful lawsuit against us that is not covered by, or is in excess
of, our insurance coverage may have a material adverse effect on our business, financial condition and results of operations. This insurance coverage may not continue to be available at a reasonable cost, especially given the significant increase in
insurance premiums generally experienced in the health care industry.



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##### Index to Financial Statements

We depend on our relationships with physicians who use our inpatient facilities.



Our business depends upon the efforts and success of the physicians who
provide health care services at our inpatient facilities and the strength of the relationships with these physicians.



Our business could be adversely affected if a significant number of physicians or a group of physicians:



| |  |  | terminate their relationship with, or reduce their use of, our inpatient facilities;
| | - |  | ------------------------------------------------------------------------------------



| |  |  | fail to maintain acceptable quality of care or to otherwise adhere to professional standards;
| | - |  | ---------------------------------------------------------------------------------------------



| |  |  | suffer damage to their reputation; or
| | - |  | -------------------------------------



| |  |  | exit the market entirely.
| | - |  | -------------------------



Our stock price could be volatile.



| |  |  | The market price of our common stock could fluctuate significantly in response to various factors, including:
| | - |  | -------------------------------------------------------------------------------------------------------------



| |  |  | problems achieving revenue enhancements and operating efficiencies;
| | - |  | -------------------------------------------------------------------



| |  |  | actual and estimated earnings and cash flows;
| | - |  | ---------------------------------------------



| |  |  | quarter-to-quarter variations in operating results;
| | - |  | ---------------------------------------------------



| |  |  | changes in market conditions in the behavioral health care industries;
| | - |  | ----------------------------------------------------------------------



| |  |  | changes in general economic conditions;
| | - |  | ---------------------------------------



| |  |  | fluctuations in the securities markets in general;
| | - |  | --------------------------------------------------



| |  |  | operating results differing from analysts estimates; and
| | - |  | ---------------------------------------------------------



| |  |  | changes in analysts earnings estimates.
| | - |  | ----------------------------------------



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##### Index to Financial Statements

General Overview



Horizon Health is a
health care services provider with focus on its two core competencies of behavioral health and physical rehabilitation clinical services. There were two significant changes to the structure of the reportable service groups during the fourth quarter
of fiscal year 2005. As a result of the growth in the Companys free-standing behavioral health care hospital business, which increased to five during fiscal year 2005 (two of which were acquired in the fourth fiscal quarter), management
determined that it would disaggregate the hospitals and report them as a separate service group. Additionally, as a result of the sale of the Companys temporary nurse staffing business on August 29, 2005, ProCare One Nurses is no longer
reflected as a service group of the Company. Therefore, the Companys reportable service groups are: (1) Behavioral Health Contract Management Services, including psychiatric outcomes measurement services (2) Behavioral Health
Hospital Services, comprised of the Companys owned or leased behavioral health care facilities, (3) Physical Rehabilitation Contract Management Services, and (4) Employee Assistance Program Services (EAP Services). For
the year ended August 31, 2005, the revenues of such business service groups constituted 39%, 29%, 8% and 23%, respectively, of the total revenues of the Company from continuing operations. See Note 15 Segment (Service Group)
Information to the Consolidated Financial Statements of the Company included elsewhere herein for financial information regarding the business segments (service groups) of the Company.



During fiscal year 2005, the Company offered, on an at risk basis, managed
behavioral health services to 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 healthcare services on an at-risk
basis were terminated as discussed in previous filings during the fiscal year. During fiscal year 2005, the Company offered specialized temporary nurse staffing services to acute care hospitals through ProCare One Nurses. In previous filings the
Company indicated that it was evaluating various alternatives to this line of business. ProCare One Nurses was sold on August 29, 2005 and the Company no longer provides these services. See Note 6 Discontinued Operations and
Note 16 EAP Services Reorganization and Related Impairments to the Consolidated Financial Statements of the Company included elsewhere herein this document.



While the Company is generally not experiencing material adverse consequences as a result of recent changes in reimbursement
under federal health care programs, at this time, the Company cannot meaningfully predict the ultimate impact that reimbursement changes may have on the programs it currently manages or the facilities it owns or on its ability to obtain new
management contracts. See Government Regulation  Medicare and Medicaid; Reimbursement for Services elsewhere herein regarding Medicare statutes, hospital reimbursement systems and related recent changes.



The Company was incorporated in 1989 and is the successor to Horizon Mental
Health Management, Inc., incorporated in 1981, which began the development and contract management of behavioral health treatment programs for acute care hospitals. The Companys national support center is located at 1500 Waters Ridge Drive,
Lewisville, Texas, 75057. The telephone number is (972) 420-8200. The Companys Form 10-Qs and Form 10-K can be obtained free of charge through the Companys website at www.horizonhealth.com.



The Company has indicated that it will focus future growth, both internal and
through acquisitions, primarily in the area of behavioral health clinical services.



Recent Developments



On
August 29, 2005, the Company sold its membership interests in ProCare One Nurses, LLC, its wholly owned temporary nurse-staffing subsidiary, to CareerStaff Unlimited, Inc. The transaction consisted of a sale of all the membership interests in
ProCare for total consideration of $8.3 million, consisting of $4.2 million in cash and $4.1 million in two promissory notes. One promissory note is in the amount of $2.1 million payable in six months and the other promissory note is in the amount
of $2.0 million payable quarterly over three years. The sale resulted in a $4.8 million loss to the Company.



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##### Index to Financial Statements

On August 1, 2005, the Company acquired substantially all the assets of River Park Hospital from Mountain State
Behavioral Health Services, LLC and the stock of an affiliated management company located in Huntington, West Virginia for approximately $11.0 million. The hospital is a 165-bed behavioral health facility offering programs for adults, adolescents,
children and families.



On July 21, 2005, the Board of
Directors of the Company at a regular board meeting increased the size of its Board of Directors to eight and elected C. Thomas Smith to fill the one resulting, newly created directorship.



On July 1, 2005, the Company formed a joint venture with the Thomas
Scattergood Behavioral Health Foundation, a 501(c)(3) charitable organization, and the joint venture acquired Friends Hospital, a 192-bed behavioral health hospital and a 27-bed adult residential treatment center located in Philadelphia,
Pennsylvania. Prior to the acquisition, Friends Hospital was owned by the Thomas Scattergood Behavioral Health Foundation. Horizon is an 80% member of the joint venture and the Thomas Scattergood Behavioral Health Foundation is a 20% member of the
joint venture. The Company contributed approximately $15.5 million in cash to the joint venture which funds were used for the acquisition of the hospital by the joint venture.



Construction of a building to serve as the new national support center (NSC), which is in close proximity to the
current NSC facility in Lewisville, Texas, began during June 2005. The Company will lease the 80,000 square foot facility and anticipates completion and occupancy beginning in April 2006. The term of the office lease agreement is ten (10) years
with renewal options of two periods of five years each.



On June 10, 2005, the Company entered into a Third Amended and Restated Credit Agreement to extend the term of its existing credit agreement by four years and to increase the amount of the revolving credit facility to $125.0
million (with an expansion feature under which the amount of the credit facility can be increased to $175.0 million, subject to the satisfaction of certain conditions). The Third Amended and Restated Credit Agreement, as amended, matures on
May 31, 2010.



On May 10, 2005, the Company
announced that the Board of Directors had approved a two-for-one stock split to be effected in the form of a 100% stock dividend (the Stock Split), pursuant to which, on June 15, 2005, the Company distributed to each holder of
record of Common Stock, par value $0.01 per share, of the Company at the close of business on May 31, 2005 (the Record Date), one additional share of Common Stock for each outstanding share of Common Stock held of record by such
holder at the Record Date.



On May 2, 2005, the Company
opened a new EAP Services call center in Lewisville, Texas. As a result, the call center operations in Philadelphia, Orlando, and Nashville were consolidated with the new call center, which was completed as of August 31, 2005.



Effective April 21, 2005, David K. White, Ph.D., was appointed as
President and Chief Operating Officer of the Company. Ken Newman will remain and continue to serve as Chairman and Chief Executive Officer of the Company.



Effective March 16, 2005, the Company sold in a follow-on public offering 3,450,000 shares of its common stock at a price of $18.13 per share (shares
and share price restated to reflect the impact 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 $58.4 million. The Company utilized
approximately $34.5 million of the proceeds to repay all outstanding debt under its revolving credit facility. The balance of the net proceeds was used for the acquisitions of Friends Hospital and River Park Hospital and for general corporate
purposes.



On February 23, 2005, the Company announced
that it had commenced a reorganization of its EAP Services group. The EAP Services group provides employee assistance programs to employers, behavioral



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##### Table of Contents

##### Index to Financial Statements

health administrative services for employer benefit plans and third party payor plans, and managed behavioral health care
at-risk services to managed care companies and employer plans. The reorganization involved the centralization of most of the business functions of the service group to Lewisville, Texas, where the National Support Center of the Company is located.
The reorganization also involved focusing on employee assistance programs and terminating the managed behavioral health care at-risk contracts of the service group. These at-risk contracts had annual revenue of approximately $23.0 million with
little or no margin associated with them. The Company has previously disclosed that it does not consider the at-risk managed behavioral health care business as part of its core competency. The termination of the at-risk managed care contracts is
consistent with the Companys renewed focus on its core competencies. The reorganization was completed August 31, 2005. The reorganization involved personnel changes as well as office location changes. It also involved a reduction in the
total number of employees in the service group.



On
January 21, 2005, the stockholders of the Company approved the Horizon Health Corporation 2005 Omnibus Incentive Plan pursuant to a proposal that was submitted to the stockholders for approval at the Companys 2005 Annual Meeting of
Stockholders.



On December 30, 2004, the Company entered
into a long-term operating lease agreement of Laurelwood Hospital, a 160-bed psychiatric hospital located in Willoughby, Ohio, a suburb of Cleveland. The hospital was leased from Lake Hospital System, Inc. The lease term commenced on January 1,
2005 and has an initial fifteen (15) year term that expires on December 31, 2019. The Company also has an option to extend the lease for an additional fifteen-year term. Rent under the lease during the initial lease term consists of
quarterly rental payments of $200,433 payable in advance on the first day of January, April, July and October. In addition, the Company agreed to make a contribution to the Lake Hospital Foundation in the amount of $41,666 on December 31, 2007
and each December 31st thereafter to and including December 31, 2012.



Services by Service Group



Behavioral Health Contract Management Services



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



A focus of the Company is developing behavioral health
programs to accommodate patients needing different levels of care based on their presenting condition. Such levels include inpatient hospitalization as well as alternatives to inpatient hospitalization in order to ensure that each patients
treatment regimen utilizes clinical resources effectively. The Company believes that acute care hospitals need to be able to offer a broad array of behavioral health care services in order to develop or participate in integrated delivery systems
responsive to the changing demands of governmental payors, managed care companies and other third-party payors. Acute care hospitals are able to provide their mix of behavioral health patients (as to age, acuity, comorbidity, etc.) with needed
medical and surgical care on-site. Furthermore, acute care hospitals are eligible to receive reimbursement under the Medicaid program for behavioral health care provided to Medicaid-eligible adults, unlike freestanding psychiatric hospitals, which
are not presently eligible.



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##### Index to Financial Statements

The Company believes it is uniquely positioned to capitalize on an increased demand for behavioral health
contract management services as a result of its demonstrated industry expertise and its proprietary quality and outcomes measurement system. In addition, the Company believes its position as the leading contract manager (based on market share) of
behavioral health programs provides the Company with a significant advantage in attracting and retaining employees and yields several economies of scale such as the ability to consolidate administrative functions.



The Company has the expertise to manage a broad range of clinical behavioral
health programs, including geropsychiatric, general adult, substance abuse and child and adolescent programs. The programs use a treatment team concept, with the admitting physician, team psychologist, social workers, nurses, therapists and
counselors coordinating each phase of therapy. The programs include crisis intervention, individual therapy, group and family therapy, recreational therapy, occupational therapy, lifestyle education, social services and substance abuse counseling.
Family involvement is encouraged. Each treatment program is individually tailored as much as practicable to meet the needs of the patients, the client hospital, physicians and payor groups.



The Company intends to continue to emphasize the area of behavioral health
programs for the elderly (geropsychiatric programs). At August 31, 2005, approximately 61.7% of the behavioral health treatment programs managed by the Company were geropsychiatric programs. Many elderly patients with short-term
behavioral illness also have physical problems that make the general acute care hospital environment the most appropriate site for their care. The Medicare program currently reimburses acute care hospitals at least 92.5%, in calendar year 2005, of
their cost of providing these services, which includes the Companys management fee as well as allocated overhead costs to the facility. The Medicare program also allows reimbursement for partial hospitalization on a specified fee for service
basis that facilitates the ability to treat patients in the most cost-effective environment. The Company has developed particular expertise in developing specialized psychiatric programs for the elderly, in operating such programs, and in assisting
acute care hospitals in receiving approval for inpatient programs as distinct part units to qualify for reimbursement under Medicare. Approval of an inpatient program as a distinct part unit is significant to client acute care hospitals because
services provided in distinct part units are exempt from predetermined acute care hospital reimbursement rates. Services provided in such distinct part units have been reimbursed by Medicare on an actual cost basis, subject to certain significant
limitations described below. As discussed below in the Government Regulations section, a Medicare prospective payment system was implemented for cost reporting years beginning on January 1, 2005 for inpatient behavioral health
services.



The contract management fees received by the Company
for its services are paid directly by its client acute care hospitals. The client acute care hospitals receive reimbursement for the clinical services provided to patients of the programs managed by the Company under either the Medicare or Medicaid
programs or from insurers, self-funded benefit plans or other third-party payors for the services. As a result, the availability and amount of such reimbursements, which are subject to change, impacts the decisions of acute care hospitals regarding
whether to offer behavioral health services pursuant to management contracts with the Company, as well as the decisions whether to renew such contracts and the amount of fees to be paid thereunder. See Government Regulation 
Medicare and Medicaid; Reimbursement for Services elsewhere herein for a further discussion of funding methods, and recent changes in them.



Elements of the Continuum of Care



The behavioral health treatment programs managed by the Company are designed to be part of a continuum of behavioral health services, consisting of
inpatient, partial hospitalization (or day treatment) and outpatient services.



Inpatient Services. Inpatient services are generally provided to patients needing the most intensive behavioral health treatment and who frequently have accompanying medical care needs. The patient is admitted to the
client hospital and remains there on a 24-hour per day basis throughout the course of the inpatient treatment, which is continued until the patient can be stabilized and moved to another level in the continuum of behavioral health services.



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##### Index to Financial Statements

Partial Hospitalization. Partial hospitalization services are provided for limited periods per day with
the patient returning home at the conclusion of each days treatment. Partial hospitalization services are designed to be both an alternative to inpatient hospitalization services and a key component of care following inpatient hospitalization.



Outpatient Services. Outpatient services consist generally of
consultative and therapeutic sessions that can be rendered in a variety of individual or group settings at various locations, including acute care hospitals, 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 treatment in an outpatient environment, the individual is provided the appropriate level of service in relation to the diagnosis.



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##### Index to Financial Statements

CQI+ Mental Health Outcomes Measurement



The Company began offering its proprietary CQI+ Outcomes Measurement System in 1994. The CQI+ System provides a qualitative
and quantitative tool for behavioral health programs to evaluate the clinical effectiveness of treatment and to make adjustments in the programs in order to improve quality and appropriateness of care. The CQI+ Outcomes Measurement System provides
outcome information regarding the effectiveness of a hospitals behavioral health programs. The availability of such information enables a hospital to demonstrate to third-party payors whether patients are improving as a result of the treatment
provided, to refine its clinical treatment programs to improve the effectiveness of care provided and to demonstrate the benefits of its programs to patients and providers. The CQI+ System also provides the Company with a valuable tool for
demonstrating clinical results of the behavioral health programs managed by the Company and for marketing its management services to other acute care hospitals. The Company provides outcome measurement services to acute care hospital-based programs
as well as freestanding psychiatric hospitals. The Companys CQI+ System is included on the Joint Commission on Accreditation of Healthcare Organizations (JCAHO) list of acceptable ORYX outcome measurement systems. The Company is
committed to meeting the requirements as established by JCAHO. As of August 31, 2005, 52 of the Companys behavioral health management contracts included the CQI+ System and there were an additional 61 stand-alone contracts. Since offering
the CQI+ System, the Company has compiled a proprietary database containing de-identified patient outcome measurement data on approximately 159,000 patients. Sample data is typically collected from randomly selected patients at admission, discharge
and 90 to 180 days after discharge. Quarterly outcome reports include a summary of patient characteristics and outcome measures. The Company trains and supervises on-site personnel to ensure the collection of accurate outcome measurement data. With
the continued emphasis on enhancing patient care, accountability and the JCAHO accreditation requirement, the Company believes that its CQI+ System is an important component of the behavioral health services it provides.



Behavioral Health Hospital Services



The Companys behavioral health care facilities offer a wide range of inpatient behavioral health care services for children, adolescents and adults. Our inpatient facilities work closely with mental 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 and community agencies that interact with individuals who may need treatment for behavioral illness or substance abuse. Those clients not meeting the established criteria for inpatient care may qualify for outpatient
care or a less intensive level of care also provided by the facility.



Inpatient psychiatric treatment is the most intensive level of care, including 24-hour skilled nursing observation and care, daily interventions and oversight by a psychiatrist and intensive, highly coordinated treatment by a physician-led
team of behavioral health professionals. Every patient admitted to our acute inpatient facilities is assessed by a medical doctor within 24 hours of admission. Patients with non-complex medical conditions are monitored during their stay by the
physician and nursing staff at the inpatient facility. Patients with more complex medical needs are referred to more appropriate facilities for diagnosis and stabilization prior to treatment. Patients admitted to our acute inpatient facilities also
receive comprehensive nursing and psychological assessments within 24 to 72 hours of admission. Oversight and management of patients medication is performed by licensed psychiatrists on staff at the facility, and individual, family, and group
therapy is performed by licensed counselors as appropriate to the patients assessed needs. Education regarding their illness is also provided by trained mental health professionals.



Our residential treatment centers offer longer-term treatment programs primarily for children and adolescents with
long-standing acute behavioral health problems. Our residential treatment centers provide physician-led, multi-disciplinary treatments that address the overall medical, psychiatric, social, and academic needs of the patient. Twenty-four hour
observation and care is provided in our residential treatment centers, along with individualized therapy 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



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treatment of children and adolescents in our inpatient facilities is family therapy. Participation of the childs or
adolescents immediate family is strongly encouraged in order to heighten the chance of success once the resident is discharged. Medications for residents are managed by licensed psychiatrists while they remain at the inpatient facility. Our
residential treatment centers also provide academic programs by certified teachers to children and adolescent residents. These programs are individualized for each resident based on analysis by the teacher upon admission. Upon discharge, academic
reports are forwarded to the residents school. Specialized programs for children and adolescents in our residential treatment centers include programs for sexually reactive children, sex offenders, reactive attachment disorders, and children
and adolescents who are developmentally delayed with a behavioral component.



During the last two fiscal years, the Company has acquired the following facilities:



| |  |  | On August 1, 2005, the Company acquired the assets of River Park Hospital, a 165-bed behavioral health facility located in Huntington, West Virginia, and the stock of an
affiliated management company through a stock purchase agreement.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | On July 1, 2005, the Company formed a joint venture with the Thomas Scattergood Behavioral Health Foundation, a 501(c)(3) charitable organization, and the joint venture
acquired Friends Hospital, a 192-bed behavioral health hospital and a 27-bed adult residential treatment center located in Philadelphia, Pennsylvania. Prior to the acquisition, Friends Hospital was owned by the Thomas Scattergood Behavioral Health
Foundation.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Effective January 1, 2005, the Company entered into a long-term operating lease agreement of Laurelwood Hospital, a 160-bed behavioral health hospital located in Willoughby,
Ohio, a suburb of Cleveland.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | On June 1, 2004, the Company acquired the assets of PSH Acquisition Corporation (PSH), which operates five behavioral facilities (three owned and two leased) with a
total licensed capacity of 187 beds, in the central Virginia region.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | On April 1, 2004, the Company acquired the assets of Northern Indiana Hospital, an 80-bed behavioral health hospital located in Plymouth, Indiana. The Company operates the
facility under the name Michiana Behavioral Health Center.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Physical Rehabilitation Contract Management Services



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



Acute rehabilitation units are specialized programs that incorporate a
variety of treatments and services aimed at improving an individuals functional level following a disabling illness or traumatic injury. The treatment program is led by a physician and provided by an interdisciplinary team of health care
professionals including physical, speech, occupational and recreational therapists, rehabilitation nurses and social workers. The Company tailors an acute rehabilitation program for a health care facility to satisfy unmet community and medical staff
needs, while maximizing utilization of the facility.



Outpatient rehabilitation serves as an adjunct to inpatient physical therapy and rehabilitation programs. Outpatient rehabilitation services are dominated by the treatment of sports and work related injuries, but also provide the continuum
of rehabilitative care necessary to meet the medical needs of a post-acute care patient following a disabling illness or traumatic injury. Pressure from payors to move inpatients to the lowest-cost appropriate treatment setting has helped stimulate
growth in outpatient rehabilitation services.



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EAP Services



The Company
contracts with employers to provide employee assistance programs (EAPs) to their employees. An EAP is a program that is designed to assist employees and their dependents with resolution of behavioral conditions or other personal
concerns. It is considered that having an EAP will result in more productivity from employees. Employers usually provide an EAP as a benefit at no cost to employees. Under an EAP, staff or network providers provide assessment and referral services
to employee beneficiaries and their dependants. These services consist of evaluating a beneficiarys needs and, if indicated, providing limited counseling and/or identifying an appropriate provider, treatment facility or other resource for more
intensive treatment services. For its EAP services, the Company is usually paid a specified fee per month per employee based on the range and breadth of services provided to the employer, which may include work life services, and the method(s) in
which those services are provided.



The Company frequently
provides training to employer personnel for identifying troubled employees. Often an employer will refer an employee for consultation after observing a change in work performance. The Company believes that such early identification and resolution of
productivity problems can frequently minimize the likelihood that the problem will develop into a serious debilitating event requiring extensive treatment. The Companys EAP services can include a comprehensive array of work life information
and referral sources if desired by the employer. Modes of access to services include internet, phone and face-to-face sessions, all of which focus on providing consultation and resource services to assist employees and their families in achieving
personal and professional success and emotional well-being. Through several acquisitions, as described in Note 5 Acquisitions in the Notes to Financial Statements included elsewhere herein, the Company has expanded its service
offerings, including the ability to conduct EAP business in the State of California, through the acquisition of a limited Knox-Keene license.



During the fiscal year 2005, the Company also contracted with self-insured employers, insurance companies and HMOs to provide the managed behavioral
health 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 each member of the respective health plan, however, a
small portion of the contracts were structured on a stipulated fee-for-service basis. As a part of the reorganization of EAP Services, the Company terminated all of the managed behavioral health at-risk contracts during fiscal year 2005. The Company
will continue its administrative services only business in which it is not at-risk for the cost of treatment services.



EAP services are provided primarily through a national network of independent EAP providers that have contracted with the Company to provide such
services. The Company reimburses the independent network professionals and institutions on a negotiated fee-for-service basis. The clinical providers represent a broad range of treatment and case management specialties and are qualified to respond
to the complete continuum of behavioral health concerns, pediatric to geriatric. The clinical providers include psychiatrists, nurses, psychologists, social workers, and other related behavioral health personnel. The Company believes that its
relationships with health care providers and its expertise in the provision of behavioral health care services provide it with the capability to establish, operate and manage the network of health care professionals necessary to economically and
adequately furnish such services.



Operations



Management Contracts



The
Company operates its behavioral health and physical rehabilitation contract management businesses through a regional structure that includes management personnel officed in the regional territory and in the Companys national support center
(NSC) in the Dallas suburb of Lewisville, Texas. The structure is designed to maintain key operating employees of the Company in direct contact with clients. Each region is under the supervision of a vice president who in turn supervises
regional directors, each of whom has direct responsibility over eight to twelve management contract locations. Other regional personnel include clinical and other specialists who are available to provide assistance to the local programs and client
hospital personnel.



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The Company provides its management services under contracts with client acute care hospitals. Each
contract is tailored to address the specific needs of the client hospital and its community. The Company and the client hospital determine the programs and services to be offered by the hospital and managed by the Company. At any location, these may
consist of one or more treatment programs offering inpatient, partial hospitalization, outpatient services, and also other specialized services. Under the management contracts, the hospital is the actual provider of the behavioral health or physical
rehabilitation services and utilizes its own facilities (including beds for inpatient programs), its own support services (such as billing, dietary and housekeeping), and frequently its own nursing staff for the operation of the treatment programs
with the Company providing operating and clinical expertise through its onsite management staff.



While the treatment programs subject to each of the management contracts is tailored to the specific needs of the client hospital, substantially all of
the management contracts contain certain non-compete and confidentiality provisions. In addition, the management contracts typically prohibit the client hospital from soliciting the employment of the Companys employees during the contract term
and for a specified period thereafter.



The management
contracts generally have a term of 3-5 years although some contracts have shorter or longer terms. Contracts are frequently renewed or amended prior to their stated expiration date. As of August 31, 2005, 2004 and 2003, the Company had
successfully retained 88%, 88%, and 82%, respectively, of the management contracts in existence at the beginning of the respective fiscal year. Some contracts are terminated prior to their stated expiration date by mutual agreement of the parties or
pursuant to early termination provisions included in the contract. The Companys experience is that the most frequent reasons why the client acute care hospitals do not renew a contract is that the hospital desires to manage the program itself,
the economic viability of the program has changed resulting in the hospital closing the program, or a change in hospital administration has occurred that results in a philosophical change regarding the use of contract managers.



Under each contract, the Company receives a fee for its services paid by the
client hospital. The management fee may be a variable fee related in part to patient volumes (census, admissions, or discharges) at the program, a fixed fee with reimbursement for specified direct program costs, or a combination of these structures.
The management fee is frequently subject to periodic adjustments as a result of changes in a relevant price index or other economic factors. A significant number of the Companys management contracts require the Company to refund some or all of
its fee if either Medicare reimbursement for services provided to patients of the programs is denied or the fee paid to the Company is denied as a reimbursable cost. During the last three fiscal years the Company has not refunded any significant
amount of its fees in relation to such denials.



Program Development



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



The Company also develops and maintains standardized clinical, operating, and administrative policy and procedure manuals, conducts initial and ongoing
staff training and education, and implements



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##### Index to Financial Statements

quality assurance and ethical and regulatory compliance procedures. Each local program director receives ongoing support
from the regional support staff and the national support center staff in areas including recruiting, finance, reimbursement, referral development, marketing, quality assurance and regulatory compliance.



Each operating region is responsible for training new employees, including
formalized instruction and on-the-job training. Continuing education programs are also provided to employees. In addition, the Company has a centralized orientation program for new program directors and other program management personnel, an annual
leadership conference for all program directors and other program personnel, and an on-going comprehensive Code of Conduct plan.



Program Staffing



Behavioral
health programs managed by the Company generally have a program director that is usually a psychologist, an advance degreed nurse or a social worker and additional social workers or therapists as needed. Many programs also include a nurse manager, a
community education manager or a clinical assessment coordinator. Physical rehabilitation programs managed by the Company generally have a program director, and additional clinical staff tailored to meet the needs of the specific hospital program,
which may include physical and occupational therapists, speech pathologists, social workers and other appropriate supporting personnel.



In addition, for mental health and physical rehabilitation programs, the Company generally contracts with a medical director on an independent contractor
basis under which on-site administrative services for medical oversight of the program are provided. These contracts generally include nondisclosure, non-solicitation and non-competition covenants pursuant to which the medical director agrees not to
solicit the Company employees for specified periods, disclose confidential information of the Company or render certain administrative or management services within specified time periods and geographic areas to any enterprise in competition with
the Company or the programs it manages.



Except for the nursing
staff, which is typically provided and employed by the hospital, the other program personnel are usually employees of the Company. The Companys management contracts typically contain non-solicitation covenants whereby the hospital agrees not
to solicit or otherwise employ Company employees for specified periods.



Program Education and Referral Development



The treatment programs managed by the Company are a service provided by the general acute care hospital client. Most patients are referred by the client hospitals medical staff or result from relationships that
the client hospital has in the community. Many contract locations have a community education manager employed by the company who works with a community awareness and referral development committee consisting of the Company and hospital personnel to
educate physicians, other health professionals and nursing homes in the community of the treatment programs that are available at the client hospital, to which they can direct patients. The community education manager also designs and offers
community educational programs regarding various health issues.



Internal Audits



The Company has
established a clinical internal audit process for its behavioral health and physical rehabilitation programs. The Companys regional behavioral health clinical specialists review, as a part of the ongoing operations, the services and clinical
documentation of the treatment programs for compliance with client hospital, federal, state and Company standards. The clinical auditor typically reviews medical records, clinical and operating procedures, staffing, marketing programs, etc. and
conducts interviews with physicians, referral sources and client hospital staff members and frequently patients and/or their families.



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##### Index to Financial Statements

The Company also has a quality audit department that is independent from contract clinical and operations
staff. The corporate auditors periodically visit all contract locations. Results of the quality audits are reported directly to the senior management of the Company, independent from the operating organizations.



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Contract Locations



At
August 31, 2005, the Company had a total of 135 behavioral health and physical rehabilitation management contracts with acute care hospitals located in 36 states and the District of Columbia as shown below:



|                     |  |                     |  |                |  |                    
|-------------------- |  | ------------------- |  | -------------- |  | -------------------
|State                |  | Number of Contracts |  | State          |  | Number of Contracts
|Alabama              |  | 3                   |  | Mississippi    |  | 7                  
|Arkansas             |  | 9                   |  | Missouri       |  | 6                  
|Arizona              |  | 1                   |  | Montana        |  | 2                  
|California           |  | 11                  |  | Nebraska       |  | 1                  
|Colorado             |  | 1                   |  | Nevada         |  | 1                  
|Connecticut          |  | 1                   |  | New Jersey     |  | 2                  
|District of Columbia |  | 1                   |  | New York       |  | 6                  
|Florida              |  | 2                   |  | North Carolina |  | 6                  
|Georgia              |  | 1                   |  | Ohio           |  | 8                  
|Idaho                |  | 1                   |  | Oregon         |  | 3                  
|Illinois             |  | 3                   |  | Pennsylvania   |  | 11                 
|Indiana              |  | 1                   |  | South Carolina |  | 2                  
|Iowa                 |  | 2                   |  | Tennessee      |  | 4                  
|Kansas               |  | 2                   |  | Texas          |  | 8                  
|Kentucky             |  | 4                   |  | Virginia       |  | 1                  
|Louisiana            |  | 3                   |  | Washington     |  | 3                  
|Maryland             |  | 1                   |  | West Virginia  |  | 1                  
|Massachusetts        |  | 4                   |  | Wisconsin      |  | 2                  
|Michigan             |  | 10                  |  |                |  |                    



Client Hospitals



The
Companys management contract clients are primarily small to medium sized acute care hospitals often located in rural areas, but also include some large tertiary acute care hospitals. At August 31, 2005, approximately 77.0% of the
Companys management contracts were with community or religious based not-for profit acute care hospitals. The remaining contracts are with proprietary and nonproprietary for profit acute care hospitals.



CQI+ Mental Health Outcomes Measurement



The Company develops and operates its outcomes measurement system primarily out of its national support center. Program personnel are responsible for the completion of the data input forms concerning the various treatment programs. The data
is input into the national database using automated technologies from which reports are developed, reviewed and analyzed.



Behavioral Health Care Facilities



Through owned and leased behavioral health care facilities, the company offers a wide range of behavioral health care services for children, adolescents and adults. The facilities work closely with behavioral health professionals, including
licensed professional counselors, therapists and social workers; psychiatrists; non-psychiatric physicians, emergency rooms; law enforcement and community agencies that interact with individuals who may need treatment for behavioral illness or
substance abuse. The facilities have mobile assessment teams who travel to prospective clients in order to assess their condition and determine if they meet criteria for inpatient care. Those clients not meeting criteria for inpatient care may
qualify for outpatient care or a less intensive level of care also provided by the facilities.



Through the diversity of programming and levels of care available, the patient can receive a seamless treatment experience from acute care to residential long-term care to group home living to outpatient treatment.
This seamless care system provides the continuity of care needed to step the patient down and allow the patient to develop and use successful coping skills and treatment interventions to sustain long-term treatment success. Treatment modalities
include comprehensive assessment,



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##### Index to Financial Statements

multidisciplinary treatment planning including the patient and family, group, individual and family therapy services,
medical and dental services, educational services, recreational services, and discharge planning services. Specialized interventions such as skills training include basic daily living skills, social skills, work/school adaptation skills and symptom
management skills. Collateral consultations are provided to significant others such as family members, teachers, employers and other professionals when needed to help the patient successfully reintegrate back into his/her world.



Acute inpatient hospitalization is the most intensive level of
care offered and typically involves 24-hour skilled nursing observation and care, daily interventions and oversight by a psychiatrist, and intensive, highly coordinated treatment by a physician-led team of behavioral health professionals. Every
patient admitted to acute care is assessed by a medical doctor within 24 hours of admission. Patients admitted to the acute care facilities also receive comprehensive nursing and psychosocial assessments within 24 to 72 hours of admission. Oversight
and management of patients medication is performed by licensed psychiatrists on staff at the facility, and individual, family, and group therapy is performed by licensed counselors as appropriate to the patients assessed needs. Education
regarding their illness is also provided by trained medical health professionals.



The Companys residential treatment care programs provide longer-term treatment programs for children and adolescents with
long-standing behavioral health problems. Twenty four-hour observation and care is provided in the residential treatment care programs, along with individualized therapy 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 of children and adolescents is family therapy. Participation of the childs or adolescents immediate family is strongly encouraged in order to heighten
the chance of success once the resident is discharged. Medications for residents are managed by licensed, often board-certified, psychiatrists while they remain at the inpatient facility. The Companys residential treatment care programs also
provide academic programs by certified teachers to children and adolescent residents. These programs are individualized for each resident based on analysis by the teacher upon admission. Upon discharge of the resident, academic reports are forwarded
to the residents school. Specialized programs for children and adolescents in the RTCs include programs for sexually reactive children, sex offenders, reactive attachments disorders and clients who are developmentally delayed with a behavioral
component. The residential treatment care programs often receive out-of-state referrals to their programs due to the lack of specialized programs for these disorders within the referrals own state.



Employee Assistance Services



The Companys EAP Services group has positioned itself to compete as a nationally integrated organization to 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 in the Dallas, Texas; Denver, Colorado; and San Diego, California metropolitan areas.



EAP Services has a national network of independent EAP providers located in all 50 states. This service group has employees working in clinical management
and administrative positions at its service centers. EAP Services also has employees performing sales and support services and administrative functions based at the NSC and its various operating locations.



Administration



The
Companys employees at its national support center provide company-wide support in finance, human resources, information technology, physician and program director recruitment, clinical compliance, risk management, auditing, and other
administrative and executive services.



Sales and Marketing



The
Company conducts direct sales activities for its behavioral health and physical rehabilitation contract management businesses. The Company compiles information of over 6,000 hospitals in the United States,



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##### Index to Financial Statements

with numerous clinical, operating and financial characteristics from numerous databases, as well as other sources and
referrals, to identify prospective clients. Potential clients include acute care hospitals without existing behavioral health, physical rehabilitation or other programs as well as acute care hospitals with existing programs of which the Company
could assume management. A select list of high priority candidates from these hospital profiles is systematically targeted based on criteria strategically formulated to identify acute care hospitals that are the most likely to need our services.
This strategic approach allows the Company to maximize its resources in a more focused manner in order to achieve the goal of increased sales. Once identified, an internal telemarketing system is in place to contact and qualify the potential
clients. A Vice President of Development, who typically acts as the point person on the sales team then contacts the prospective clients and, where appropriate, presents a detailed proposal to key decision-makers. The proposal often contains
detailed operating and financial projections of the proposed programs. The Company works with the potential client to develop contract terms responsive to the clients specific needs. The typical sales cycle for a management contract is
approximately six to nine months. Operations and clinical management also participate in and support the sales process. The Company believes it has opportunity to cross-sell a range of services to client acute care hospitals and is pursuing such
opportunities as a part of its business strategy.



The local
and regional community education and marketing is led by clinical and business development representatives at each of the Companys behavioral health care programs and facilities. These individuals manage relationships among a variety of
referral sources and potential referral sources in their respective communities.



The Companys EAP Services group markets employee assistance programs, including administrative service only programs, to employers both directly and through third party distribution channels. The Company
assesses the individualized needs of the employer and its employees and customizes a program design accordingly.



Competition



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



Competition among contract managers for hospital-based behavioral health and
physical rehabilitation programs is generally based upon reputation for quality, price, the ability to provide financial and other benefits for the hospital, and the management, operational and clinical expertise necessary to enable the hospital to
offer behavioral health and physical rehabilitation programs that provide the full continuum of behavioral health and physical rehabilitation services in a quality and cost-effective manner. The pressure to reduce health care expenditures has
strengthened the need to manage the appropriateness of behavioral health and physical rehabilitation services provided to patients. As a result, competitors without substantive management experience covering the various levels of the continuum of
behavioral health and physical rehabilitation services may not be able to compete successfully. The Company believes that its reputation and management expertise will enable it to compete successfully in this rapidly changing market.



In addition, acute care hospitals offering behavioral health and physical
rehabilitation programs managed by the Company compete for patients with other providers of behavioral health care services, including other acute care hospitals, freestanding psychiatric hospitals, independent psychiatrists and psychologists, and
with other providers of physical rehabilitation services, including other acute care hospitals, freestanding rehabilitation facilities and outpatient facilities.



Freestanding behavioral health hospitals, owned by the Company, compete with other for-profit and tax-exempt freestanding
providers, as well as behavioral health units operated within acute care hospitals. Freestanding behavioral health hospitals generally provide a broader array of behavioral health



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##### Index to Financial Statements

services than those offered in acute care facilities. Children and adolescent services, in particular, are more readily
available in freestanding behavioral health facilities. Service lines of freestanding behavioral health hospitals include a continuum of care ranging from intensive inpatient crisis intervention, longer-term residential treatment, group homes, and
intensive outpatient services for children, adolescents and adults.



The dynamics of healthcare, particularly behavioral health care, are as unique as the local market area in which they are provided. In addition, the behavioral healthcare marketplace is somewhat fragmented, and no individual national
behavioral healthcare hospital chain enjoys a significant presence in any specific geographic market area.



The employee assistance marketplace includes six large national providers as well as a number of mid-size regional and small local providers. The primary
factors affecting competition in the EAP business are the range and quality of services provided, the ease of access to the services and price. A significant number of employers of all sizes offer employee assistance services to their employees as
the benefit is designed to proactively address workplace and personal issues early so as to avoid absenteeism and thereby increase productivity. Customers frequently require sophisticated data that provides information regarding clinical utilization
and outcomes, patient and provider satisfaction, administrative performance, and other performance related information.



Customers



The Company has no
individual customer comprising 10% or more of its consolidated revenue or on which its overall operations or financial results are substantially dependent. See the General Overview section of MD&A included elsewhere in for the number
of customer contracts as of August 31, 2005 and other related information.



Employees



At
September 30, 2005, the Company had approximately 2,804 employees. By operating service group and corporate offices, the employee counts are as follows:



|                                                     |  |      
|---------------------------------------------------- |  | -----
|Behavioral Health Contract Management Services       |  | 644  
|Behavioral Health Hospital Services                  |  | 1,740
|Physical Rehabilitation Contract Management Services |  | 167  
|EAP Services                                         |  | 147  
|National Support Center                              |  | 106  



At September 30,
2005, the Company had contracts with 177 physicians as independent contractors to serve as medical directors providing administrative services for hospital clinical programs managed and hospital facilities owned/operated by the Company. The Company
has no collective bargaining agreements with any unions and believes that its overall relations with its employees are good.



Government Regulation



The
Companys business is affected by federal, state and local laws and regulations concerning, among other matters, behavioral health and physical rehabilitation facilities and reimbursement for such services. These regulations impact the
development and operation of behavioral health and physical rehabilitation programs managed by the Company for its client hospitals as well as the Companys owned behavioral health hospitals. Licensing, certification, reimbursement and other
applicable state and local government regulations vary by jurisdiction and are subject to periodic revision. The Company is not able to predict the content or impact of future changes in laws or regulations affecting the behavioral health or
physical rehabilitation sectors.



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Facility Use and Qualification



Licensing and Certification



Hospital facilities, including those owned by the Company, are subject to various federal, state and local regulations, including facilities use, licensure and inspection requirements, and licensing or certification requirements of federal,
state and local health agencies. Many states also have certificate of need laws intended to avoid the proliferation of unnecessary or under-utilized health care services and facilities. The behavioral health and physical rehabilitation programs that
the Company manages are also subject to licensure and certification requirements. The Company assists its client hospitals in obtaining required approvals for new programs. Some approval processes may lengthen the time required for programs to
commence operations. In granting and renewing a facilitys licenses, governmental agencies generally consider, among other factors, community needs, the physical condition of the facility, the qualifications of administrative and professional
staff, the quality of professional and other services, and the continuing compliance of such facility with the laws and regulations applicable to its operations. The Company believes that the behavioral health and physical rehabilitation programs it
manages, the facilities of the client hospitals used in the operation of such programs, and the hospitals it owns, comply in all material respects with applicable licensing and certification requirements.



The Company through its owned facilities is a provider reimbursed by Medicare
and/or Medicaid. As such, the Company is subject to federal, state and local regulations governing their operation. These laws and regulations set forth requirements for licensure and qualifications to participate in government programs, including
the Medicare and Medicaid programs. These requirements pertain to the adequacy of medical care, equipment, personnel, operating policies and procedures, fire prevention, maintenance of adequate records, hospital use, rate-setting, and compliance
with building codes and environmental protection laws. Additional regulations exist which govern a facilities participation in government programs. These facilities are subject to periodic inspection by government and other authorities to assure
continued compliance with these regulations.



The
Companys owned and operated facilities are properly licensed under the applicable state, local and federal rules and regulations. These facilities are also certified under the Medicare and Medicaid programs and are accredited by the Joint
Commission on Accreditation of Healthcare Organizations (JCAHO). Should one of the Companys owned facilities lose its certification under the Medicare and/or Medicaid program, that facility would no longer receive reimbursement
from the Medicare and/or Medicaid programs. The Company believes that its owned facilities are in compliance in all material respects with current federal, state and local regulations governing their operation.



Provider-Based Rules



In
April 2000, the Centers for Medicare and Medicaid Services, or CMS (formerly the Health Care Financing Administration or HCFA) of the U.S. Department of Health and Human Services (HHS) adopted new rules requiring
a CMS determination that a facility has provider-based status before a provider can bill Medicare for the services rendered at the facility. On August 1, 2002 CMS issued amendments to the provider-based regulations, which in 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 that inpatient rehabilitation units that are excluded from the inpatient prospective payment system for acute hospital services do not have to meet provider-based status in order
to bill Medicare for services rendered to patients.



The
Company estimates that the revised regulations, while still subject to additional clarification as to specific applicability, will affect few of its psychiatric management contracts. The Company believes that the provider-based regulations will not
have a significant impact on its current operations of inpatient psychiatric units located within general hospitals and will have no material impact on the Companys owned inpatient psychiatric hospitals.



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Medicare and Medicaid: Reimbursement for Services



Background



The Medicare program
is a federally funded health insurance program for the elderly. The program is divided into Part A and Part B, each of which has separate rules and requirements. Part A pays for hospital, skilled nursing, home health agency, hospice, and dialysis
services determined to be medically necessary for the individual patient. Part B is a voluntary medical benefits plan in which eligible individuals can enroll to receive benefits in addition to those available under Part A and for which they must
pay a monthly premium. Part B covers non-institutional services, including physician services, outpatient hospital services, durable medical equipment, and laboratory services, among others.



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The Medicare program is administered by CMS, which adopts regulations and issues interpretive memoranda
and program manuals providing detailed explanation of the Medicare program. The payment operations of the Medicare program are handled by fiscal intermediaries (under Part A) and carriers (under Part B) who are insurance companies and Blue Cross/
Blue Shield plans which contract with the Secretary of HHS (the Secretary) to make Medicare payments to providers in a particular geographic region. Individual intermediaries and carriers issue transmittals, bulletins, notices, and
general instructions to providers and suppliers in their respective areas to facilitate the administration of the Medicare program, but are required to follow the Medicare statute, CMS regulations, CMS transmittals, and the program manuals. Within
these requirements, intermediaries and carriers are granted broad discretion to establish particular guidelines and procedures for making Medicare coverage determinations and payments, including prior approval, utilization limits, and specific
documentation. Some fiscal intermediaries have developed Local Coverage Determinations (LCD). A LCDs are rules established by a fiscal intermediary or carrier, which determines whether a particular service will be covered on an
intermediary-wide or carrier-wide basis. This determination takes into account whether the service is reasonable and necessary in accordance with Section 1862(a)(1)(A) of the Social Security Act. The Company believes that the implementation of
LCDs will have no material impact on the Company.



The Medicaid
program is a joint federal-state cooperative arrangement established for the purpose of enabling states to furnish medical assistance on behalf of aged, blind, or disabled individuals, or members of families with dependent children, whose income and
resources are insufficient to meet the costs of necessary medical services. The federal and state governments share the costs. The Secretary has primary federal responsibility for administering the Medicaid program that has been delegated to CMS.
States are not required to participate in the Medicaid program. States that choose to participate, however, must administer their Medicaid programs in accordance with federal law, the implementing regulations and policies of the Secretary, and their
approved state plans. The federal Medicaid statute establishes minimum standards for state plans but states have significant latitude, within these standards, to determine the mix of services and structure of their state Medicaid programs.



In order to receive reimbursement under the Medicare or
Medicaid programs, each client or owned hospital or facility must meet applicable requirements promulgated by HHS relating to the type of facility, personnel, standards of patient care and compliance with all state and local laws, rules and
regulations. The Company has a comprehensive code of conduct and regulatory compliance program and believes that the programs it manages and its owned hospitals comply in all material respects with applicable Medicare and Medicaid requirements.



Federal law contains certain provisions designed to ensure
that services rendered by hospitals to Medicare and Medicaid patients are medically necessary and meet professionally recognized standards. These provisions include a requirement that admissions of Medicare and Medicaid patients to hospitals must be
reviewed in a timely manner to determine the medical necessity of the admissions. In addition, these provisions state that a hospital may be required by the federal government to reimburse the government for the cost of Medicare-reimbursed services
that are determined by a peer review organization to have been medically unnecessary. As part of its on-going regulatory and regulatory compliance program initiatives, the Company for its owned hospitals, and the Company and its client hospitals for
managed programs have developed and implemented quality assurance programs and procedures for utilization review and retrospective patient care evaluation intended to meet these requirements.



Overview



Most of the
Companys client hospitals and its owned hospitals receive reimbursement under one or more of the Medicare or Medicaid programs, private insurers, including commercial and managed care plans, as well as reimbursement directly from patients for
behavioral health and physical rehabilitation services provided in programs managed or owned by the Company. With respect to the management contracts, the Company is paid a fee directly by the client hospitals for its management services. While fees
paid to the Company by client hospitals are generally not subject to or based upon reimbursement under the Medicare or Medicaid programs or from any other third-party payor, under many of its management



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##### Index to Financial Statements

contracts the Company is obligated to refund a portion of its fee if Medicare denies reimbursement for an individual
patient treatment, or its fee if 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 the patients of the programs managed
by the Company are covered by Medicare, changes which limit or reduce Medicare reimbursement levels could have a material adverse effect on the Companys client hospitals and, in turn, on the Company



With respect to the Companys owned facilities, all hospital facilities
participating in the Medicare program and some Medicaid programs are required to meet certain financial reporting requirements. These requirements require the submission of annual cost reports identifying the medical expenses relative to the
services provided by a given facility to Medicare beneficiaries and Medicaid dependents. Annual cost reports required under these programs are subject to routine governmental audits, which may result in adjustments to the amounts due to the provider
under these reimbursement programs. These audits often require several years to reach the final entitlement earned by the provider under the programs. The Medicare fiscal intermediary issues a Notice of Program Reimbursement (NPR) after
audit, and amounts due to or from the provider are determined. These amounts are due and payable within 30 days of receipt of the NPR. Providers have the right to appeal and contest issues identified in prior year cost report audits. As noted below,
Medicare has enacted a prospective payment system for inpatient behavioral health services that is being phased in over several years.



The Company owns hospital facilities and employs individuals who provide medical and clinical services that are reimbursed by Medicare or Medicaid. The
Company also provides contract management services to such providers for which the Company is not reimbursed by Medicare or Medicaid. Nevertheless, the Company could be considered subject to federal and state healthcare laws applicable to the
provision of such services. While the Company believes that its relationships with its client hospitals, medical directors and other providers and the fee arrangements with its client hospitals are consistent with Medicare and Medicaid criteria,
those criteria are often general and ambiguous in nature and subject to interpretation, sometimes differently by different Medicare fiscal intermediaries who administer the programs on behalf of the federal government. In addition, the federal
government has been actively investigating health care providers for potential abuses. There can be no assurance that aggressive anti-fraud enforcement actions will not adversely affect the business of the Company.



Other Reimbursement Payors



In addition to reimbursement provided by the Medicare and Medicaid programs, the Companies owned behavioral health hospital facilities receive reimbursement for certain behavioral health services by private payors including health
maintenance organizations (HMOs), preferred provider organizations (PPOs), commercial insurance companies, employers and individuals. Generally, patients covered by HMOs, PPOs and other private payors will
be responsible for certain co-payments and deductibles, which are paid by the patient.



Behavioral Health Reimbursement Changes



In the mid-1980s, changes in reimbursement rates and procedures included the creation of the Prospective Payment System (PPS) using predetermined reimbursement rates for diagnosis related groups
(DRGs). The DRG system established fixed payment amounts per discharge for diagnoses generally provided by acute care hospitals. Behavioral health services provided by an acute care hospital may qualify for an exemption as a distinct
part unit (DPU). Freestanding psychiatric hospitals are also exempt from the DRG system. Psychiatric services provided by DPUs and freestanding psychiatric hospitals were reimbursed on an actual cost basis, subject to certain limitations
for cost reporting periods beginning on or before December 31, 2004. The behavioral health programs managed by the Company which are eligible for reimbursement by the Medicare program currently meet the applicable requirements for exemption as
DPUs, where desired. On November 15, 2004, CMS published a final rule for a prospective payment system for Medicare reimbursement for inpatient behavioral health services, including those provided by programs managed or facilities directly
owned by the Company as discussed below. A substantial number



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##### Index to Financial Statements

of the behavioral health treatment programs managed by the Company are geropsychiatric programs for which the majority of
the patients are covered by Medicare. Additionally, approximately 13% of the patients treated by the behavioral health hospitals owned by the Company are Medicare beneficiaries.



The Balanced Budget Refinement Act of 1999 mandated that PPS for inpatient psychiatric services be developed. On
November 15, 2004 CMS published final rules in the Federal Register for the psychiatric inpatient PPS. The PPS rule is effective for Medicare cost reporting years that commence on or after January 1, 2005. The final PPS rules provide for a
per diem PPS system phased in over a four-year period. The per diem rate has patient specific adjustments based on age, diagnosis, comorbidities and electro convulsive therapy treatments. The per diem has facility adjustments based on wage index,
rural designation, teaching designation, cost of living adjustments and an adjustment for psychiatric facilities with full-service emergency departments. In addition the per diem rate is increased in days 1 through 8 of the patients stay, and
incrementally decreases thereafter until day 22 of the patients stay. The Company believes that the new PPS rules will affect the hospitals with which it has management contracts both positively and negatively on a case-by-case basis. The new PPS
rules have stop loss protection against significant decreases in reimbursement, during the PPS phase in period, for cost reporting years beginning in calendar year 2005. The Company cannot be definitive about the overall effect of the new PPS rules,
which could have an adverse effect on the contract management business for behavioral health units in the 2006 cost reporting year or thereafter.



The Balanced Budget Act of 1997 mandated the elimination of cost-based reimbursement of mental health partial hospitalization services (except as stated
below). As a result, PPS for Partial Hospitalization Programs (PHP) was implemented generally effective August 1, 2000. The resulting reimbursement for partial hospitalization services based on the Medicare outpatient PPS utilizes a
fixed reimbursement amount per patient day. These rates lowered Medicare reimbursement levels to many hospitals for partial hospitalization services. This change, in general, adversely affected the ability of the Company to maintain and/or obtain
management contracts for partial hospitalization services and the amount of fees paid to the Company under such contracts. The base reimbursement rate, for partial hospitalization programs operating under PPS, decreased from $287 per day for 2004 to
$281 effective January 1, 2005. On November 2, 2005, CMS decreased this rate by 15% to $246 effective January 1, 2006. However, the Company at this time has not ascertained specifically the effect of this change on a
facilty-by-facilty basis and cannot be definitive about its overall effect. Hospitals that are in a designated rural area and have less than 100 acute care beds effectively were able to continue cost based reimbursement for PHP services initially
until December 31, 2003. However, on December 8, 2003, this was extended to December 31, 2005 with the passage of the Medicare Prescription Drug Improvement and Modernization Act of 2003. Effective January 1, 2006, they are
scheduled to operate under PPS unless the law is again amended. This change in reimbursement methodology, if made, may lower Medicare reimbursement levels to this type of hospital.



Physical Rehabilitation Reimbursement Changes



Acute rehabilitation units within acute-care hospitals were previously eligible as exempt DPUs under a cost-based reimbursement system prior to January 1, 2002. Beginning January 1, 2002, acute
rehabilitation units began transitioning to PPS. As of September 1, 2003 all physical rehabilitation services have been transitioned to the PPS.



On August 15, 2005, CMS published a final rule to change the inpatient rehabilitation facility PPS to be effective October 1, 2005. The rule
incorporates a market basket increase of 3.6% and an increase in the payment rate adjustment for inpatient rehabilitation facilities in rural areas from 19.14% to 21.30%. CMS is also incorporating a 1.9% across-the-board reduction in the standard
payment amount based on recent evidence indicating that coding increases, rather than actual changes in patient acuity, have caused increases in payments to inpatient rehabilitation facilities. The final rule also refined the inpatient
rehabilitation facility classification system to reflect recent data on case mix groups, relative weights and the impact of illnesses or conditions other than the admitting diagnosis on the costs of treating a beneficiary. In addition, the final
rule adopted the revised Core Based Statistical Area (CBSA) market area definitions as



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##### Index to Financial Statements

announced by the Office of Management and Budget for inpatient rehabilitation facilities; however, the final rule allowed
for a transition to the new CBSA designations. For Federal Fiscal Year 2006 the wage index will be a 50/50 blend of the MSA and CBSA designation wage indices and for Federal Fiscal Year 2007 only the CBSA designation wage index will be utilized. The
Company does not believe this final rule will have a significant impact on its revenues from rehabilitation services.



CMS published final rules in the May 7, 2004 Federal Register to modify the criteria for being classified as an inpatient rehabilitation facility.
The final rule, known as the 75% Rule, generally requires that in order to meet the qualification requirement, 75% of the patients of a physical rehabilitation services unit must have certain qualifying medical conditions. The final rule
has a 4-year phase-in period to allow inpatient rehabilitation facilities time to adjust to the new rule. The first year compliance percentage is 50%; the second year percentage is 60%; the third year percentage is 65% and in the fourth year and
thereafter, the compliance percentage is 75%. The final rule also eliminates polyarthritis as a qualifying medical condition and adds three other arthritis diagnoses that are more restrictive. As a result, patients that previously met the
polyarthritis conditions may no longer meet the specific qualifying medical condition required under the new rule. The final rule also added a new restrictive category for certain knee or hip joint replacements. The effective date for these final
rules is for cost reporting periods beginning on or after July 1, 2004. The final rules as adopted, unless suspended or modified, could have an adverse effect on the rehabilitation programs managed by the Company.



Potential Adverse Impacts of Changes in Reimbursement



The Medicare and Medicaid programs are subject to statutory and regulatory changes, retroactive and prospective rate adjustments, administrative rulings and funding restrictions, any of which could have the effect of
limiting or reducing reimbursement levels to general acute care hospitals and freestanding psychiatric hospitals for behavioral health and physical rehabilitation services provided by programs managed or facilities owned by the Company. The Company
cannot predict whether any changes to such government programs will be adopted or, if adopted, the effect, if any, such changes will have on the Company.



Also, Medicare retrospectively audits cost reports of client hospitals upon which Medicare reimbursement for services rendered in the programs managed by
the Company is based. Accordingly, the Company could be contractually obligated to make refunds to client hospitals for prior year cost reports that have not been audited and settled at the date hereof. The cost reports are prepared by the client
hospitals independent of the Company, which does not participate in, nor offer advice on, their preparation. Any significant decrease in Medicare reimbursement levels, the imposition of significant restrictions on participation in the Medicare
program, or the disallowance by Medicare of any significant portion of the client hospitals costs, including the fee to the Company, where the Company has a reimbursement denial repayment obligation, could adversely affect the Company. In
addition, there can be no assurance that hospitals which offer behavioral health or physical rehabilitation programs now or hereafter managed by the Company will satisfy the requirements for participation in Medicare or Medicaid programs.



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



The target rate limitations, the PPS limitations, and other 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, or may lead, in some cases, to the renegotiation of a lower contract management fee 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 the program. Similarly such limitations and rules to the extent applicable, have resulted or may result, in some cases, to lower
reimbursements to the Companys owned hospital facilities and could affect the continued viability of the particular services or of the hospital.



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##### Index to Financial Statements

Patient Referral Laws



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



The Medicare and Medicaid anti-kickback statute, 42 U.S.C.d1320a-7b, prohibits the knowing and willful solicitation or
receipt of any remuneration in return for referring an individual, or for recommending or arranging for the purchase, lease, or ordering, of any item or service for which payment may be made under Medicare or a state health care program.
In addition, the statute prohibits the offer or payment of remuneration to induce a person to refer an individual, or to recommend or arrange for the purchase, lease, or ordering of any item or service for which payment may be made under
the Medicare or state health care programs. The statute contains exceptions for certain discounts, group purchasing organizations, employment relationships, waivers of coinsurance by community health centers, health plans, and practices defined in
regulatory safe harbors.



On April 3, 2003 the Office of
the Inspector General of the Department of Health and Human Services (OIG) issued an advisory opinion in which it declined to provide prospective protection from the Medicare Anti-Kickback Statue to a proposed contract to manage
rehabilitation services under which the compensation was based on a variable fee. The OIG opinion was only applicable to the specific situation presented and did not advise that variable fees were improper in and of themselves. Under a significant
number of its management contracts, the Company receives a variable fee related in part to average daily patient census or number of admissions or discharges in a given period for the behavioral health or physical rehabilitation program. In
addition, the Company has entered into agreements with physicians to serve as medical directors at the behavioral health and physical rehabilitation programs and facilities managed by the Company, which generally provide for payments to such persons
by the Company as compensation for their administrative services. These medical directors also generally provide professional services at such programs and facilities. In 1991, regulations were issued under federal fraud and abuse laws creating
certain safe harbors for relationships between health care providers and referral sources. Any relationship that satisfies the terms of the safe harbor is considered permitted. Failure to satisfy a safe harbor, however, does not mean
that the relationship is prohibited. Although the contracts and relationships between the Company and its client hospitals and medical directors are not within the safe harbors, the Company believes that such contracts and relationships comply with
applicable laws. There can be no assurance, however, that the Companys activities, while not challenged thus far, will not be challenged by regulatory authorities in the future.



The Omnibus Budget Reconciliation Act of 1993 contains provisions (Stark II) prohibiting physicians from
referring Medicare and Medicaid patients to an entity with which the physician has a financial relationship for the furnishing of a list of designated health services including physical therapy, occupational therapy, home
health services, and others. If a financial relationship exists, the entity is generally prohibited from claiming payment for such services under the Medicare or Medicaid programs. Compensation arrangements are generally exempted from the Stark
provisions if, among other things, the compensation to be paid is set in advance, does not exceed fair market value and is not determined in a manner that takes into account the volume or value of any referrals or other business generated between
the parties.



Other provisions in the Social Security Act
authorize other penalties, including exclusion from participation in Medicare and Medicaid, for various billing-related offenses. HHS can also initiate



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##### Index to Financial Statements

permissive exclusion actions for such improper billing practices as submitting claims substantially in excess
of the providers usual costs or charges, failure to disclose ownership and officers, or failure to disclose subcontractors and suppliers. Executive Order 12549 prohibits any corporation or facility from participating in federal contracts if it
or its principals have been disbarred, suspended or are ineligible, or have been voluntarily excluded, from participating in federal contracts. A principal has been defined as an officer, director, owner, partner, key employee or other person with
primary management or supervisory responsibilities.



Additionally HIPAA granted expanded enforcement authority to HHS and the U.S. Department of Justice (DOJ), and provided enhanced resources to support the activities and responsibilities of the Office of Inspector
General (OIG) of HHS and DOJ by authorizing large increases in funding for investigating fraud and abuse violations relating to health care delivery and payment. On January 24, 1997, the OIG issued guidelines for the Fraud and Abuse
Control Program as mandated by the Act, and on February 19, 1997 issued an interim final rule establishing procedures for seeking advisory opinions on the application on the anti-kickback statute and certain other fraud and abuse laws. The 1997
Balanced Budget Act also includes numerous health fraud provisions, including: new exclusion authority for the transfer of ownership or control interest in an entity to an immediate family or household member in anticipation 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-related crimes; authority of the Secretary to refuse to enter
into Medicare agreements with convicted felons; new civil money penalties for contracting with an excluded provider or violating the Medicare and Medicaid antikickback statute; new surety bond and information disclosure requirements for certain
providers and suppliers; and an expansion of the mandatory and permissive exclusions added by HIPAA to any federal health care program (other than the Federal Employees Health Benefits Program).



In addition, federal and some state laws impose restrictions on referrals for
certain designated health services by physicians and, in a few states, psychologists and other behavioral health care professionals to entities with which they have financial relationships. The Company believes that its operations comply with these
restrictions to the extent applicable, although no assurance can be given regarding compliance in any particular factual situation. Federal legislation has been considered to expand current law from its application to Medicare and Medicaid business
to all payors and to additional health services. Certain states are considering adopting similar restrictions or expanding the scope of existing restrictions. There can be no assurance that the federal government or other states in which the Company
operates will not enact similar or more restrictive legislation or restrictions that could, under certain circumstances, adversely impact the Companys operations.



Behavioral Health Care Patient Rights



Many states have adopted patient bill of rights regulations, which set forth standards for least restrictive treatment, patient confidentiality, patient access to mail and telephones, patient access to legal counsel and
requirements that patients be treated with dignity. There are also laws and regulations relating to the civil commitment of patients to behavioral health programs, disclosure of information concerning patient treatments and related matters. The
Company believes that its operations comply with the laws and regulations, although no assurance can be given regarding compliance in any particular factual situation.



EXECUTIVE OFFICERS OF THE REGISTRANT



|
|

|
|

|                      |  |     |  |                                                              
|--------------------- |  | --- |  | -------------------------------------------------------------
|Name                  |  | Age |  | Position                                                     
|James K. Newman       |  | 61  |  | Chief Executive Officer and Chairman of the Board            
|David K. White, Ph.D. |  | 49  |  | President and Chief Operating Officer                        
|John E. Pitts         |  | 40  |  | Executive Vice President, Finance and Chief Financial Officer
|Donald W. Thayer      |  | 56  |  | Executive Vice President, Acquisitions and Development       
|David K. Meyercord    |  | 58  |  | Executive Vice President, Administration and General Counsel 
|Frank J. Baumann      |  | 46  |  | Senior Vice President, Operations                            



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##### Index to Financial Statements

James K. Newman has served as Chairman of the Board since February 1992. On April 28, 2003 he
re-assumed the position of President and Chief Executive Officer of the Company, a position he held from July 1989 through August 1997. Mr. Newman served as a consultant to the Company from September 1997 through April 2003. Mr. Newman
currently serves as a director of United Surgical Partners, Inc., a health care company engaged in the operation of ambulatory surgical centers, and of Telecare Corporation, a privately held behavioral health service provider.



David K. White, Ph.D. was appointed by the Board of Directors as
President and Chief Operating Officer of the Company effective April 21, 2005. Dr. White had been Senior Vice President - Operations since November 1, 1998. Effective September 28, 2002, he was appointed President 
Behavioral Health Services. He formerly served as Executive Vice President - Operations from February 1998 to October 1998. He was a Regional Vice President from September 1996 to January 1998. He also served as a Regional Director of Operations
from April 1995 to August 1996. He was President and Chief Executive Officer of Charles River Health Management, Inc., a contract behavioral health management company focusing on the public and private sector, from December 1990 to November 1994.



John E. Pitts was promoted to Executive Vice President
on September 20, 2005. Mr. Pitts was appointed as the Chief Financial Officer of the Company at the October 22, 2004 Board of Directors meeting following his appointment as Senior Vice President - Finance and Principal Financial
Officer on September 10, 2004. He was formerly Vice President - Finance and Principal Accounting Officer since October 16, 2003 and had been Vice PresidentController since November 1, 2001. Mr. Pitts had previously served
the Company in various accounting positions from December 9, 1993 through October 31, 2001.



Donald W. Thayer was promoted to Executive Vice President-Acquisitions and Development on September 20, 2005. Mr. Thayer had served as
the Senior Vice President-Acquisitions and Development since September 2003. He formerly served as the Managing Director-Mergers and Acquisitions for B.C. Ziegler and Company from December 2001 to September 2003. From July 2000 to November 2001 he
was an independent consultant working under multiple consulting agreements to provide acquisition and development services. Mr. Thayer served as Vice President-Acquisition and Development from July 1978 through July 2000 for Tenet Healthcare
Corporation.



David K. Meyercord was promoted to
Executive Vice President Administration and General Counsel on September 20, 2005. Mr. Meyercord joined the company as Senior Vice President and General Counsel on July 6, 2004. Effective September 10, 2004, his title was changed
to Senior Vice President - Administration and General Counsel as a result of a change in responsibilities. Prior to July 2004, Mr. Meyercord had been a partner in the law firm of Strasburger & Price, LLP, a Dallas-based law firm. He
had been a member of that law firm since 1975 and served as its managing partner from 1990 to 1998. He had represented the Company as outside general counsel since its inception.



Frank J. Baumann has been Senior Vice President  Operations since March 22, 1999. He was President 
ProCare One Nurses from June 2002 to October 2003 and had oversight responsibility for that service group until its sale on August 29, 2005. He has been President  Physical Rehabilitation Services since March 1999. He formerly served as a
Regional Vice President from March 1997 to March 1999. He was also a Regional Director of Operations from November 1996 to March 1997. He was Chief Executive Officer of Mountain Crest Behavioral Healthcare Systems, a freestanding psychiatric
hospital, from August 1994 to November 1996.



Officers of the
Company are elected by the Board of Directors of the Company and serve at the pleasure of the Board of Directors until their respective successors are elected and qualified.



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ITEM 2. PROPERTIES



The
Companys National Support Center in the Dallas suburb of Lewisville, Texas, contains approximately 40,000 square feet of office and training facility space.



The space required for the behavioral health and physical rehabilitation programs managed by the Company is provided by the
client acute care hospitals either within their existing facilities or at other locations owned or leased by the acute care hospitals.



For its freestanding behavioral health care facilities, the Company operates five owned or leased behavioral health care facilities with approximately 833 licensed beds
in five states and leases 1,585 square feet of office space in Chester, Virginia with a lease term expiring in February 2010. During the fiscal year, Poplar Springs purchased a house with approximately 2,390 square feet that was converted into a
group home. The following table sets forth the name, location, number of licensed beds and the acquisition date for each of the Companys owned and leased behavioral health care facilities.



|                                  |  |                              |  |             |  |               |  |                 
|--------------------------------- |  | ---------------------------- |  | ----------- |  | ------------- |  | ----------------
|Facility                          |  | Location                     |  | Sq. Footage |  | Licensed Beds |  | Acquisition Date
|Michiana Behavioral Health Center |  | Plymouth, Indiana            |  | 44,000      |  | 80            |  | April 1, 2004   
|Poplar Springs Hospital           |  | Petersburg, Virginia         |  | 120,390     |  | 187           |  | June 1, 2004    
|Laurelwood Hospital               |  | Willoughby, Ohio             |  | 93,657      |  | 160           |  | January 1, 2005 
|Friends Hospital                  |  | Philadelphia, Pennsylvania   |  | 330,973     |  | 219           |  | July 1, 2005    
|River Park Hospital               |  | Huntington, West Virginia    |  | 179,232     |  | 165           |  | August 1, 2005  
|River Park Hospital               |  | Barboursville, West Virginia |  | 31,355      |  | 22            |  | August 1, 2005  



For its employee
assistance program and managed behavioral health care businesses, the Company leases approximately 29,920 square feet of office space primarily in the Dallas, Denver, and San Diego metropolitan areas, with smaller offices in various parts of the
country, under lease terms expiring from January 2006 to June 2009. The Company also leases approximately 61,834 square feet under leases related to offices that the Company has, or will be vacating due to the reorganization and centralization of
the Companys EAP Services group, under lease terms expiring from September 2005 to April 2008. The majority of this space will be expiring in the short term or the Company is pursing sublease options.



In addition, the Company leases approximately 13,919 square feet in various
locations throughout central Florida with lease terms expiring from March 2006 to June 2007. These four former clinic locations are currently being sublet due to the reorganization and centralization of the Companys EAP Services group.



The Company considers that its properties are generally in
good condition, are well maintained, and are generally suitable and adequate to carry on the Companys business. Use of properties are predicated on existent needs to service customers pursuant to contracts that are subject to termination or
non-renewal. The ability to vacate or sublease properties is subject to market conditions and other factors and exposes the Company to certain financial risks. Also see Note 14 Commitments and Contingencies - Property Leases to
the Notes to the Consolidated Financial Statements included elsewhere herein.



Construction of a building to serve as the new national support center (NSC), which is in close proximity to the current NSC facility in Lewisville, Texas, began during June 2005. The Company will lease
the 80,000 square foot facility and anticipates completion and occupancy beginning in April 2006.



ITEM 3. LEGAL PROCEEDINGS



For a discussion of the Companys legal proceedings see the Legal Proceedings caption in Note 14 Commitments and Contingencies in the Notes to the Consolidated Financial Statements included elsewhere
herein.



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##### Index to Financial Statements

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



No matters were submitted to a vote of the Companys stockholders in the fourth fiscal quarter in fiscal 2005.



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##### Index to Financial Statements

PART II



ITEM 5. MARKET FOR THE COMPANYS COMMON EQUITY AND RELATED STOCKHOLDER MATTERS



The Common Stock of the Company is traded on the NASDAQ National Market under the symbol HORC.



The following table sets forth the intra-day high and low sale
prices per share for the Common Stock of the Company as reported by the NASDAQ National Market for the periods indicated:



|                                       |  |      |       |     |   |      
|-------------------------------------- |  | ---- | ----- | --- | - | -----
|                                       |  | High |       | Low
|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, 2004   |  |      | 17.50 |     |   | 11.43
|September 1, 2004  November 30, 2004  |  |      | 12.00 |     |   | 10.15
|                                       |  |     
|Fiscal Year Ended August 31, 2004 (1): |  |      |       |     |   |      
|June 1, 2004  August 31, 2004         |  | $    | 13.24 |     | $ | 9.76 
|March 1, 2004  May 31, 2004           |  |      | 13.25 |     |   | 11.02
|December 1, 2003  February 29, 2004   |  |      | 12.50 |     |   | 10.11
|September 1, 2003  November 30, 2003  |  |      | 12.38 |     |   | 8.98 

---

|(1) | The per share amounts have been restated to reflect the impact of the June 15, 2005 two- for-one stock split.
|--- | -------------------------------------------------------------------------------------------------------------



As of October 25, 2005, there were 358 stockholders of record of the
Common Stock of the Company. As of September 30, 2005 (the most recent date that data was available to the Company) there were 1,872 beneficial owners of 100 or more shares of Common Stock of the Company.



The Company has not paid or declared any cash dividends on its capital
stock since its inception. The Company currently intends to retain future earnings for use in the expansion and operation of its business. The payment of any future cash dividends will be determined by the Board of Directors based on conditions then
existing, including the Companys earnings, financial condition and capital requirements, restrictions in financing agreements (which currently prohibit any payment of dividends), business opportunities and conditions, and other factors. See
Managements Discussion and Analysis of Financial Condition and Results of Operations  Liquidity and Capital Resources, included elsewhere herein.



ITEM 6. SELECTED CONSOLIDATED FINANCIAL INFORMATION AND STATISTICAL DATA



The selected historical consolidated financial data presented below for the fiscal years ended August 31, 2005, 2004 and 2003, and at August 31,
2005 and 2004, are derived from the audited Consolidated Financial Statements of the Company included elsewhere in this Report. The selected historical consolidated financial data presented below for the fiscal years ended August 31, 2002 and
2001, and at August 31, 2003, 2002 and 2001, are derived from the audited consolidated financial statements of the Company not included herein. The selected financial information presented below should be read in conjunction with
Managements Discussion and Analysis of Financial Condition and Results of Operations and with the Consolidated Financial Statements of the Company and Notes thereto included elsewhere in this Report, including Note 5,
Acquisitions describing the Companys various acquisitions in the periods presented.



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|                                                                                                                                      |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | - |  | ---- | ------- | - |  | - | ------- | -
|                                                                                                                                      |  | Fiscal Year Ended August 31,          |        
|                                                                                                                                      |  | 2005                                  |         |   | 2004 |   |         | 2003 |  |   | 2002    |   |  | 2001 |        
|                                                                                                                                      |  | (in thousands, except per share data) |        
|Statement of Operations Data:                                                                                                         |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Revenues                                                                                                                              |  | $                                     | 207,392 |   |      | $ | 161,824 |      |  | $ | 144,337 |   |  | $    | 138,402 |   |  | $ | 127,659 |  
|                                                                                                                                      |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Cost of services                                                                                                                      |  |                                       | 160,032 |   |      |   | 121,554 |      |  |   | 109,890 |   |  |      | 104,957 |   |  |   | 92,300  |  
|Selling, general and administrative                                                                                                   |  |                                       | 23,220  |   |      |   | 18,834  |      |  |   | 18,262  |   |  |      | 16,015  |   |  |   | 17,304  |  
|Provision for (recovery of) doubtful accounts                                                                                         |  |                                       | 4,382   |   |      |   | 869     |      |  |   | (910    | ) |  |      | 294     |   |  |   | 1,764   |  
|Impairment loss on building                                                                                                           |  |                                       | 1,015   |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |        |  
|Depreciation and amortization                                                                                                         |  |                                       | 3,387   |   |      |   | 2,795   |      |  |   | 2,419   |   |  |      | 2,752   |   |  |   | 4,510   |  
|                                                                                                                                      |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Operating income                                                                                                                      |  |                                       | 15,356  |   |      |   | 17,772  |      |  |   | 14,676  |   |  |      | 14,384  |   |  |   | 11,781  |  
|Interest and other income (expense), net                                                                                              |  |                                       | (1,298  | ) |      |   | (1,307  | )    |  |   | (559    | ) |  |      | (383    | ) |  |   | (462    | )
|                                                                                                                                      |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Income before income taxes, minority interest and discontinued operations                                                             |  |                                       | 14,058  |   |      |   | 16,465  |      |  |   | 14,117  |   |  |      | 14,001  |   |  |   | 11,319  |  
|Income tax provision                                                                                                                  |  |                                       | 5,332   |   |      |   | 6,252   |      |  |   | 5,395   |   |  |      | 5,418   |   |  |   | 4,529   |  
|Minority interest, net                                                                                                                |  |                                       | (15     | ) |      |   |        |      |  |   |        |   |  |      |        |   |  |   |        |  
|                                                                                                                                      |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Income from continuing operations                                                                                                     |  |                                       | 8,741   |   |      |   | 10,213  |      |  |   | 8,722   |   |  |      | 8,583   |   |  |   | 6,790   |  
|                                                                                                                                      |  |                                       |         |   |     
|Discontinued operations:                                                                                                              |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|(Loss) income from discontinued operations, net                                                                                       |  |                                       | (488    | ) |      |   | 562     |      |  |   | 860     |   |  |      | 341     |   |  |   |        |  
|Loss on disposal of discontinued operations, net                                                                                      |  |                                       | (3,102  | ) |      |   |        |      |  |   |        |   |  |      |        |   |  |   |        |  
|                                                                                                                                      |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Discontinued operations                                                                                                               |  |                                       | (3,590  | ) |      |   | 562     |      |  |   | 860     |   |  |      | 341     |   |  |   |        |  
|                                                                                                                                      |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Net income                                                                                                                            |  | $                                     | 5,151   |   |      | $ | 10,775  |      |  | $ | 9,582   |   |  | $    | 8,924   |   |  | $ | 6,790   |  
|                                                                                                                                      |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Basic earnings per share-continuing operations(a)                                                                                     |  | $                                     | 0.68    |   |      | $ | 0.94    |      |  | $ | 0.83    |   |  | $    | 0.80    |   |  | $ | 0.60    |  
|Basic earnings per share-discontinued operations(a)                                                                                   |  |                                       | (0.28   | ) |      |   | 0.05    |      |  |   | 0.08    |   |  |      | 0.03    |   |  |   |        |  
|                                                                                                                                      |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Total basic earnings per share(a)                                                                                                     |  | $                                     | 0.40    |   |      | $ | 0.99    |      |  | $ | 0.91    |   |  | $    | 0.83    |   |  | $ | 0.60    |  
|                                                                                                                                      |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Weighted average shares outstanding(a)                                                                                                |  |                                       | 12,829  |   |      |   | 10,849  |      |  |   | 10,500  |   |  |      | 10,772  |   |  |   | 11,229  |  
|                                                                                                                                      |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Diluted earnings per share-continuing operations(a)                                                                                   |  | $                                     | 0.66    |   |      | $ | 0.90    |      |  | $ | 0.77    |   |  | $    | 0.73    |   |  | $ | 0.58    |  
|Diluted earnings per share-discontinued operations(a)                                                                                 |  |                                       | (0.27   | ) |      |   | 0.05    |      |  |   | 0.08    |   |  |      | 0.03    |   |  |   |        |  
|                                                                                                                                      |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Total diluted earnings per share(a)                                                                                                   |  | $                                     | 0.39    |   |      | $ | 0.95    |      |  | $ | 0.85    |   |  | $    | 0.76    |   |  | $ | 0.58    |  
|                                                                                                                                      |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Weighted average shares and dilutive potential common shares outstanding(a)                                                           |  |                                       | 13,306  |   |      |   | 11,346  |      |  |   | 11,283  |   |  |      | 11,779  |   |  |   | 11,753  |  
|                                                                                                                                      |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|(a)The number of shares and per share amounts have been restated to reflect the impact of the
June 15, 2005 two- for-one stock split. | 
|                                                                                                                                      |  |                                       |         |   |     
|Balance Sheet Data (at end of period):                                                                                                |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Cash and short-term investments                                                                                                       |  | $                                     | 8,089   |   |      | $ | 1,908   |      |  | $ | 1,973   |   |  | $    | 4,036   |   |  | $ | 1,981   |  
|Working capital                                                                                                                       |  |                                       | 19,490  |   |      |   | 5,560   |      |  |   | 1,249   |   |  |      | 2,899   |   |  |   | 615     |  
|Intangible assets (net) (1)                                                                                                           |  |                                       | 81,084  |   |      |   | 87,244  |      |  |   | 74,882  |   |  |      | 68,666  |   |  |   | 57,260  |  
|Total assets                                                                                                                          |  |                                       | 188,543 |   |      |   | 145,265 |      |  |   | 102,329 |   |  |      | 92,585  |   |  |   | 77,180  |  
|Total debt                                                                                                                            |  |                                       |        |   |      |   | 40,000  |      |  |   | 14,000  |   |  |      | 10,000  |   |  |   | 6,900   |  
|Stockholders equity                                                                                                                  |  |                                       | 143,121 |   |      |   | 75,824  |      |  |   | 63,792  |   |  |      | 60,733  |   |  |   | 50,998  |  



42



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##### Table of Contents

##### Index to Financial Statements

|                                                       |  |               |        |   |              |   |        |               |  |   |               |   |  |               |        |   |              |   |        |               |  |               |       |               |  |       |  |       |  |      
|------------------------------------------------------ |  | ------------- | ------ | - | ------------ | - | ------ | ------------- |  | - | ------------- | - |  | ------------- | ------ | - | ------------ | - | ------ | ------------- |  | ------------- | ----- | ------------- |  | ----- |  | ----- |  | -----
|                                                       |  | Aug. 31, 2005 |        |   | May 31, 2005 |   |        | Feb. 28, 2005 |  |   | Nov. 30, 2004 |   |  | Aug. 31, 2004 |        |   | May 31, 2004 |   |        | Feb. 29, 2004 |  | Nov. 30, 2003 |       | Aug. 31, 2003
|Statistical data:                                      |  |               |        |   |              |   |        |               |  |   |               |   |  |               |        |   |              |   |        |               |  |               |       |               |  |       |  |       |  |      
|Covered lives (000s)                                  |  |               | 4,063  |   |              |   | 3,981  |               |  |   | 3,819         |   |  |               | 3,714  |   |              |   | 3,569  |               |  |               | 3,358 |               |  | 3,331 |  | 3,339 |  | 3,327
|Number of Contract Locations (2):                      |  |               |        |   |              |   |        |               |  |   |               |   |  |               |        |   |              |   |        |               |  |               |       |               |  |       |  |       |  |      
|Contract locations in operation                        |  |               | 123    |   |              |   | 126    |               |  |   | 127           |   |  |               | 128    |   |              |   | 132    |               |  |               | 129   |               |  | 134   |  | 133   |  | 127  
|Contract locations signed and unopened                 |  |               | 12     |   |              |   | 13     |               |  |   | 14            |   |  |               | 11     |   |              |   | 8      |               |  |               | 12    |               |  | 9     |  | 10    |  | 15   
|                                                       |  |               |        |   |              |   |        |               |  |   |               |   |  |               |        |   |              |   |        |               |  |               |       |               |  |       |  |       |  |      
|Total contract locations                               |  |               | 135    |   |              |   | 139    |               |  |   | 141           |   |  |               | 139    |   |              |   | 140    |               |  |               | 141   |               |  | 143   |  | 143   |  | 142  
|                                                       |  |               |        |   |              |   |        |               |  |   |               |   |  |               |        |   |              |   |        |               |  |               |       |               |  |       |  |       |  |      
|Services Covered by Contracts in Operation (2):        |  |               |        |   |              |   |        |               |  |   |               |   |  |               |        |   |              |   |        |               |  |               |       |               |  |       |  |       |  |      
|Inpatient                                              |  |               | 121    |   |              |   | 124    |               |  |   | 125           |   |  |               | 126    |   |              |   | 129    |               |  |               | 126   |               |  | 134   |  | 132   |  | 126  
|Partial hospitalization                                |  |               | 10     |   |              |   | 10     |               |  |   | 11            |   |  |               | 15     |   |              |   | 17     |               |  |               | 19    |               |  | 20    |  | 22    |  | 25   
|Outpatient                                             |  |               | 21     |   |              |   | 21     |               |  |   | 23            |   |  |               | 23     |   |              |   | 24     |               |  |               | 22    |               |  | 21    |  | 21    |  | 21   
|Home health                                            |  |               | 1      |   |              |   | 2      |               |  |   | 2             |   |  |               | 2      |   |              |   | 2      |               |  |               | 2     |               |  | 2     |  | 2     |  | 3    
|CQI+                                                   |  |               | 110    |   |              |   | 111    |               |  |   | 109           |   |  |               | 109    |   |              |   | 105    |               |  |               | 108   |               |  | 107   |  | 106   |  | 109  
|Types of Treatment Programs in Operation (2):          |  |               |        |   |              |   |        |               |  |   |               |   |  |               |        |   |              |   |        |               |  |               |       |               |  |       |  |       |  |      
|Geropsychiatric                                        |  |               | 79     |   |              |   | 80     |               |  |   | 80            |   |  |               | 85     |   |              |   | 85     |               |  |               | 85    |               |  | 87    |  | 85    |  | 87   
|Adult psychiatric                                      |  |               | 43     |   |              |   | 45     |               |  |   | 45            |   |  |               | 44     |   |              |   | 49     |               |  |               | 48    |               |  | 47    |  | 47    |  | 48   
|Substance abuse                                        |  |               | 2      |   |              |   | 2      |               |  |   | 3             |   |  |               | 4      |   |              |   | 4      |               |  |               | 4     |               |  | 4     |  | 4     |  | 4    
|Physical rehabilitation                                |  |               | 28     |   |              |   | 29     |               |  |   | 32            |   |  |               | 32     |   |              |   | 33     |               |  |               | 30    |               |  | 37    |  | 37    |  | 32   
|Other behavioral health                                |  |               | 4      |   |              |   | 4      |               |  |   | 4             |   |  |               | 4      |   |              |   | 4      |               |  |               | 5     |               |  | 5     |  | 8     |  | 8    
|                                                       |  |               |        |   |              |   |        |               | 
|Owned/Leased Freestanding Behavioral Health Hospitals: |  |               |        |   |              |   |        |               |  |   |               |   |  |               |        |   |              |   |        |               |  |               |       |               |  |       |  |       |  |      
|Total net revenues (000s)                             |  | $             | 23,179 |   |              | $ | 16,110 |               |  | $ | 12,175        |   |  | $             | 9,114  |   |              | $ | 10,069 |               |  | $             | 1,789 |               |  |      |  |      |  |     
|Number of facilities at period end                     |  |               | 5      |   |              |   | 3      |               |  |   | 3             |   |  |               | 2      |   |              |   | 2      |               |  |               | 1     |               |  |      |  |      |  |     
|Licensed Beds (3)                                      |  |               | 833    |   |              |   | 427    |               |  |   | 427           |   |  |               | 267    |   |              |   | 267    |               |  |               | 80    |               |  |      |  |      |  |     
|Weighted average available beds                        |  |               | 538    |   |              |   | 357    |               |  |   | 316           |   |  |               | 241    |   |              |   | 177    |               |  |               | 53    |               |  |      |  |      |  |     
|Patient days                                           |  |               | 36,418 |   |              |   | 25,026 |               |  |   | 21,196        |   |  |               | 17,756 |   |              |   | 19,639 |               |  |               | 3,171 |               |  |      |  |      |  |     
|Admissions                                             |  |               | 2,807  |   |              |   | 1,777  |               |  |   | 1,314         |   |  |               | 847    |   |              |   | 1,041  |               |  |               | 215   |               |  |      |  |      |  |     
|Average length of stay                                 |  |               | 13.0   |   |              |   | 14.1   |               |  |   | 16.1          |   |  |               | 21.0   |   |              |   | 18.9   |               |  |               | 14.8  |               |  |      |  |      |  |     
|Revenue per patient day                                |  | $             | 636    |   |              | $ | 644    |               |  | $ | 574           |   |  | $             | 513    |   |              | $ | 513    |               |  | $             | 564   |               |  |      |  |      |  |     
|Occupancy based on weighted average available beds     |  |               | 73.6   | % |              |   | 76.2   | %             |  |   | 74.5          | % |  |               | 81.0   | % |              |   | 72.5   | %             |  |               | 65.0  | %             |  |      |  |      |  |     

---

As of August 31, 2005 the licensed bed mix
consisted of 585 Acute and 248 Residential Treatment Center (RTC) beds.



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

|(2) | Includes only the Companys behavioral health care and physical rehabilitation management contracts.
|--- | ----------------------------------------------------------------------------------------------------

|(3) | Includes only the Companys owned/leased behavioral health facilities of which the first acquisition occurred in April of 2004.
|--- | -------------------------------------------------------------------------------------------------------------------------------



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##### Index to Financial Statements

ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS



General Overview



Horizon
Health Corporation is a health care services provider. The Company is (i) a contract manager of behavioral health and physical rehabilitation clinical programs offered by acute care hospitals in the United States, (ii) an owner/operator of
freestanding behavioral health hospitals providing behavioral health care for children, adolescents and adults, and (iii) a provider of employee assistance programs.



The Company plans to enhance its position as the leader (based on market share) in the contract management of behavioral
health programs and enhance its position in the contract management of physical rehabilitation programs by further expanding the range of services that it offers to its client acute care hospitals and the continuum of care it provides. A significant
challenge in marketing behavioral health and physical rehabilitation clinical management contracts is overcoming the initial reservations that many hospital administrators have with outsourcing key clinical services. The Company believes its
expertise in working with hospital administrators, its reputation in the industry and its existing hospital contractual relationships provide it with a significant advantage in marketing new contracts. The Company also believes it has opportunities
to cross-sell management services of behavioral health and physical rehabilitation programs to client acute care hospitals. In addition, the Company capitalizes on its expertise in managing the delivery of behavioral health services by directly
offering employee assistance programs to employers. The Company believes it is strategically sized to deliver national programs, while providing local, individualized service to employers and to their respective employees.



In conjunction with the Companys growth initiatives, its strategy is to
acquire inpatient behavioral health care facilities and improve operating results within new and existing inpatient facilities. During fiscal year 2004, the Company acquired two hospital facilities and acquired/leased three additional facilities
during fiscal year 2005. The Company strives to improve the operating results of new and existing inpatient behavioral health care operations by providing the highest quality services, the strengthening of referral networks, expanding marketing
initiatives and by expanding and customizing our services to meet the needs of our customers.



At August 31, 2005, the Company owned/operated five behavioral health care facilities with a total of 833 licensed beds in five states. Additionally, the Company had 104 behavioral health management contracts and
31 physical rehabilitation management contracts at acute care hospitals located in 36 states and the District of Columbia; 113 CQI+ mental health outcomes measurement contracts; and 1,097 contracts to provide employee assistance programs and managed
behavioral health services covering in excess of 4.0 million lives.



During fiscal year 2005, the Company offered at risk managed behavioral health services to 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 healthcare services on an at-risk basis had been terminated in connection with the reorganization of the EAP Services group, as discussed in previous filings during the fiscal year. During
fiscal year 2005, the Company offered specialized temporary nurse staffing services to acute care hospitals through ProCare One Nurses. In previous filings the Company indicated that it was evaluating various alternatives to this line of business.
ProCare One Nurses was sold on August 29, 2005 and the company will no longer provide these services. See Note 6 Discontinued Operations and Note 16 EAP Services Reorganization and Related Impairments in
the Companys Consolidated Financial Statements included elsewhere herein this document.



Acquisitions



See Note 5,
Acquisitionsto the Notes to Consolidated Financial Statements included elsewhere herein for a discussion of the Companys acquisition activity.



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##### Index to Financial Statements

Segments (Service Groups)



There were two significant changes to the structure of the reportable service groups during the fourth quarter of fiscal year 2005. As a result of the growth in the Companys free-standing behavioral health hospital business, which
increased to five during fiscal year 2005 (two of which were acquired during the fourth quarter), management determined that it would disaggregate the hospitals and report them as a separate service group. Additionally, as a result of the sale of
the Companys temporary nurse staffing business on August 29, 2005, ProCare One Nurses is no longer reflected as a service group of the Company. See Note 15, Segment (Service Group) Information to the Notes to the
Consolidated Financial Statements included elsewhere herein for a discussion of the Companys current four reportable business segments (service groups).



Revenues



Contract
Management Services (Behavioral Health Services and Physical Rehabilitation Services)



The fees received by the Company for its services under management contracts are paid directly by its client acute care hospitals. Generally, contract fees are paid on a monthly basis. The client acute care hospitals
receive reimbursement under Medicare or Medicaid programs or payments from insurers, self-funded benefit plans or other third-party payors for the behavioral health and physical rehabilitation services provided to patients of the programs managed by
the Company. As a result, the availability and amount of such reimbursement, which are subject to change, impacts the decisions of acute care hospitals regarding whether to offer behavioral health and physical rehabilitation services pursuant to
management contracts with the Company, as well as whether to continue such contracts (subject to contract termination provisions) and the amount of fees to be paid thereunder. See Government Regulation  Medicare and Medicaid;
Reimbursement for Services contained elsewhere herein for a discussion of funding factors and recent changes in regulations. Also see Operations  Management Contracts elsewhere herein for a discussion of factors
affecting contract scope, operation, and renewal.



The primary
factors affecting revenues in a period are the number of management contracts with treatment programs in operation in the period and the scope of services covered by each such management contract. The Company provides its management services under
contracts with terms generally ranging from three to five years. Each contract is tailored to address the differing needs of each client hospital and its community. The Company and the client hospital determine the programs and services to be
offered by the hospital and managed by the Company, which may consist of one or more behavioral health or physical rehabilitation treatment programs offering inpatient, partial hospitalization, and/or outpatient services. Under the contracts, the
hospital is the actual provider of the behavioral health or physical rehabilitation services and utilizes its own facilities (including beds for inpatient programs), nursing staff and support services (such as medical ancillaries, billing, dietary
and housekeeping) in connection with the operation of its programs with the Company providing clinical, operating and compliance management staff and expertise. As the Company expanded the breadth of treatment programs it offers to acute care
hospitals, it increased the number of contracts that included management of multiple treatment programs.



The Company has increased revenues through internal growth, as well as price escalators and increasing volumes at existing contract locations. The
increase in contract revenue has primarily been due to the increased range of services offered per contract. For the Companys behavioral health services group, additional contracts have resulted from the increased demand for geropsychiatric
services as acute care hospitals have sought to enter this market. An additional factor favorably affecting revenues has been the Companys pricing policy of establishing a minimum direct margin threshold for its management contracts.



The Company, through its contract management behavioral health
services group, also provides behavioral health outcomes measurement services primarily to acute care hospital-based programs and free standing psychiatric hospitals. The contracts for outcomes measurement services are generally for one to two years
with an automatic renewal provision. The rates for the outcomes measurement services are negotiated based on the range of services provided and the number of patients and are generally paid on a monthly basis.



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##### Index to Financial Statements

Patient Services (Behavioral Health Hospital Services)



As a result of a focused growth initiative during the last two fiscal years,
the Company now owns and operates multiple behavioral health facilities with a total of 833 licensed beds in Plymouth, Indiana, Willoughby, Ohio; Philadelphia, Pennsylvania; Huntington, West Virginia; and Petersburg, Virginia. Patient service
revenue is reported on the accrual basis in the period in which services are provided, at established rates. Amounts received are generally less than the established billing rates of the facility and the differences (contractual allowances) are
reported as deductions from patient service revenue at the time the service is rendered. Net patient services revenue includes amounts the Company estimates to be reimbursable by Medicare and Medicaid under provisions of cost or prospective
reimbursement formulas in effect.



The behavioral health
facilities provide care without charge to patients who are financially unable to pay for the behavioral services they receive. Because the facilities do not pursue collection of amounts determined to qualify as charity care, they are not reported in
revenues. Settlements under cost reimbursement agreements with third party payors are estimated and recorded in the period in which the related services are rendered and are adjusted in future periods as final settlements are determined. Final
determination of amounts earned under the Medicare and Medicaid programs often occur in subsequent years because of audits by the programs, rights of appeal and the application of numerous technical provisions.



Employee Assistance Programs and Managed Behavioral Health Care Services
(EAP Services)



Through its EAP Services group, the
Company offers an array of behavioral health care products to corporate clients, government agencies, and third-party administrators. Revenues are derived from employee assistance program services (EAP) and administrative services only
services. During fiscal year 2005, the Company offered at risk managed behavioral health services to self-funded employer groups, insurance companies and commercial HMO and PPO plans. As of August 31, 2005, all contracts for managed behavioral
health services on an at-risk basis were terminated as discussed in the previously mentioned reorganization of the EAP Services group. Generally fees are paid on a monthly basis pursuant to contracts that typically are renewable annually, although
contracts vary as to term and provisions with some being multi-year, some containing automatic renewal provisions, and some containing termination provisions under specified conditions.



Revenues from EAP contracts are typically based on a specified fee per month per employee based on the range and breadth of
services provided to the employer, which may include work life services (including child and elder care consultation), referral resource and critical incident debriefings and intervention, and the method(s) in which those services are provided. Each
plan is specifically designed to fulfill the clients needs.



Revenues for administrative services only contracts relate to the administration of behavioral health benefits and are dependent upon the number of contracts and the services provided. Fees are usually a case rate or a per member per month
fee applied to the number of eligible members. The client remains financially liable for direct cost associated with providing the medical services. The client is able to benefit from the Companys expertise in clinical case management, the
behavioral health professionals employed by the Company, the independent health care providers contracted by the Company at favorably discounted rates and the administrative efficiencies provided by the Company.



During fiscal year 2005, revenues derived from at risk managed behavioral
health services were primarily affected by the scope of behavioral health benefits provided and the number and type of members covered. Fees were based on a per member per month fee applied to the number of eligible members. The rate was dependent
upon the benefit designs and actuarially determined anticipated utilization of the customers covered members. The Company was responsible for the cost of the medical services provided to the members under these contracts.



46



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##### Table of Contents

##### Index to Financial Statements

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



Operating Expenses



In
addition to the respective primary expense factors described below, other operating expenses generally incurred by each of the Companys service groups include items such as training, continuing professional education and credentialing
services, marketing costs and expenses, consulting, accounting and legal fees and expenses, employee recruitment and relocation expenses, rent, utilities, telecommunications costs, and property taxes, as well as bad debt expense.



Contract Management Services (Behavioral Health Services and Physical
Rehabilitation Services)



The primary factors affecting
operating expenses for the Companys contract management business in any period is the number of programs in operation in the period and the volume of patients at those locations. Operating expenses consist primarily of salaries and benefits
paid to program management, clinicians, therapists and supporting personnel. Behavioral health programs managed by the Company generally have a program director that is usually a psychologist or a social worker, a community education manager and
additional social workers or therapists as needed. Physical rehabilitation programs managed by the Company generally have a program director and additional clinical staff tailored to meet the needs of the program and the client hospital, which may
include physical and occupational therapists, a speech pathologist, a social worker and other appropriate supporting personnel. In addition, for both types of programs the Company contracts with a medical director on an independent contractor basis
under which on-site administrative and clinical oversight services needed to administer the program are provided. The nursing staff is typically provided and employed by the hospital.



Patient Services (Behavioral Health Hospital Services)



Operating expenses for the Companys behavioral health facilities are primarily comprised of the volume and mix of wage
rates, including overtime, for clinical staff and nurses, as well as pharmacy and dietary supplies which are affected by the levels of patient census and acuity.



Employee Assistance Programs and Managed Behavioral Health Care (EAP Services)



Operating expenses for the Companys employee assistance
programs and managed behavioral health care services are primarily comprised of medical claims from clinical providers and salaries and benefits for its clinical, operations and supporting personnel. Medical claims include payments to independent
health care professionals providing services to the covered enrollees under the employee assistance programs and the managed behavioral healthcare contracts offered by the Company.



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##### Table of Contents

##### Index to Financial Statements

Results of Operations



The
following table sets forth for the fiscal years ended August 31, 2005, 2004 and 2003, the percentage relationship to total revenues of certain costs, expenses and income, and the number of management contracts, licensed beds, and covered lives
at the end of each fiscal year.



|                                                                           |  |                              |   |  |       |   |  |       |  
|-------------------------------------------------------------------------- |  | ---------------------------- | - |  | ----- | - |  | ----- | -
|                                                                           |  | Fiscal Year Ended August 31, |  
|                                                                           |  | 2005                         |   |  | 2004  |   |  | 2003  |  
|Revenues                                                                   |  | 100.0                        | % |  | 100.0 | % |  | 100.0 | %
|                                                                           |  |                              |  
|Cost of services                                                           |  | 77.2                         |   |  | 75.1  |   |  | 76.1  |  
|Selling, general and administrative                                        |  | 11.2                         |   |  | 11.7  |   |  | 12.6  |  
|Impairment loss on building                                                |  | .5                           |   |  |      |   |  |      |  
|Provision for (recovery of) doubtful accounts                              |  | 2.1                          |   |  | 0.5   |   |  | (0.6  | )
|Depreciation and amortization                                              |  | 1.6                          |   |  | 1.7   |   |  | 1.7   |  
|                                                                           |  |                              |   |  |       |   |  |       |  
|Operating income                                                           |  | 7.4                          |   |  | 11.0  |   |  | 10.2  |  
|                                                                           |  |                              |  
|Interest and other income (expense), net                                   |  | (0.6                         | ) |  | (0.8  | ) |  | (0.4  | )
|                                                                           |  |                              |   |  |       |   |  |       |  
|Income before income taxes, minority interest and discontinued operations. |  | 6.8                          |   |  | 10.2  |   |  | 9.8   |  
|                                                                           |  |                              |  
|Income tax provision                                                       |  | 2.6                          |   |  | 3.9   |   |  | 3.8   |  
|                                                                           |  |                              |  
|Minority interest                                                          |  |                             |   |  |      |   |  |      |  
|                                                                           |  |                              |   |  |       |   |  |       |  
|Income from continuing operations                                          |  | 4.2                          |   |  | 6.3   |   |  | 6.0   |  
|                                                                           |  |                              |  
|Discontinued operations:                                                   |  |                              |   |  |       |   |  |       |  
|(Loss) income from discontinued operations, net                            |  | (0.2                         | ) |  | 0.4   |   |  | 0.6   |  
|Loss on disposal of discontinued operations, net                           |  | (1.5                         | ) |  |      |   |  |      |  
|                                                                           |  |                              |   |  |       |   |  |       |  
|Discontinued operations                                                    |  | (1.7                         | ) |  | 0.4   |   |  | 0.6   |  
|                                                                           |  |                              |  
|Net income                                                                 |  | 2.5                          | % |  | 6.7   | % |  | 6.6   | %
|                                                                           |  |                              |   |  |       |   |  |       |  
|Number of management contracts, end of year                                |  | 135                          |   |  | 140   |   |  | 142   |  
|                                                                           |  |                              |  
|Covered lives (000s), end of year                                         |  | 4,063                        |   |  | 3,569 |   |  | 3,327 |  
|                                                                           |  |                              |  
|Licensed Beds                                                              |  | 833                          |   |  | 267   |   |  |      |  





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##### Table of Contents

##### Index to Financial Statements

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



Revenue. Total revenue between the years increased $45.6 million or 28.2%. Revenue for Behavioral Health Contract Management Services
increased as a result of an increase in same store sales. This increase was offset by a decrease associated with the restructuring of one significant behavioral health management contract. Behavioral Health Hospital Services increased primarily as a
result of the first full year of operations for Michiana Behavioral Health Center and Poplar Springs Hospital, both acquired during the last five months of fiscal year 2004 and the acquisitions of Friends Hospital, effective July 1, 2005, River
Park Hospital, effective August 1, 2005 and the long-term operating lease agreement associated with Laurelwood Hospital effective January 1, 2005. Physical Rehabilitation Contract Management Services revenue decreased primarily due to a
decrease in the average number of physical rehabilitation locations in operation. Revenue for EAP Services decreased and is primarily due to the termination of all managed care at-risk contracts, of which three significant managed care contracts
were terminated prior to fiscal year end and the discontinuance of the Florida clinic operations, which was partially offset by the commencement of a significant new EAP contract. Additionally, revenue for Other Services decreased primarily
attributable to the phase out of the Companys PsychScope Phase IV projects.



Behavioral Health Contract Management Services



Revenue associated with behavioral health contract management services increased $1.0 million, or 1.3% between the years. Same store sales related 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 related to the restructuring of one significant behavioral health care management contract retroactive to January 1, 2005,
which resulted in an associated decrease in expenses (see Cost of Services below) and the phase out of the Companys consulting operations that contributed $590,000 in revenue in the same period last year.



Behavioral Health Hospital Services



Revenue associated with the Companys freestanding behavioral health
facilities increased $50.5 million, between the years. This increase is a result of the first full fiscal year of operations for Michiana Behavioral Health Center and Poplar Springs Hospital, both acquired during the last five months of fiscal year
2004 and the acquisitions of Friends Behavioral Health System, effective July 1, 2005, River Park Hospital, effective August 1, 2005, and the long-term operating lease agreement associated with Laurelwood Hospital effective January 1,
2005.



Physical Rehabilitation Contract Management
Services



Revenue associated with the contract management
of physical rehabilitation services decreased by $1.7 million, or 8.8%, between the years. This decrease was primarily attributable to a decrease in the average number of physical rehabilitation 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 an increase in average revenue per location of 4.2% from year to year.



EAP Services



Revenue associated with employee assistance programs and managed behavioral services decreased by $4.1 million, or 7.8% between the years. A $5.2 million
decrease is due to the termination of three significant managed behavioral health at-risk contracts and discontinuance of the Florida clinic operations on December 31, 2004 related to the previously announced reorganization of the EAP Services
group. These decreases are partially offset by an increase of $1.5 million that is related to the commencement of a significant new EAP contract on June 1, 2004. Exclusive of the behavioral health at-risk contracts, revenues increased 6.9%
between the years.



Other Services



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



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##### Index to Financial Statements

Cost of Services. Total cost of services provided increased $38.5 million, or 31.7% between
the years. This increase is primarily attributable to the cost of operations associated with the acquisitions of freestanding behavioral health facilities, as well as the reorganization of the Companys EAP Services group and related increase
in medical claims expense. These increases were partially offset by decreases attributable to the decline in the average number of physical rehabilitation contract locations in operation, the restructuring of a significant behavioral health
management contract, the discontinuance of the Florida clinic operations, and the phase out of the PsychScope Phase IV projects.



Behavioral Health Contract Management Services



Cost of services provided associated with the contract management of behavioral health programs increased $145,000 or 0.3%, between the years. Cost of
services increased $1.6 million primarily due to an increase in salaries and benefits, medical director fees and contributions for client facility 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 provides all of the psychiatric nursing staff, (b) medical director fees increased $569,000 primarily due to an increase in the number of contracted
physicians from 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 contract locations.
This increase was partially offset by a $1.8 million decrease in costs at one behavioral health contract management location as a result of the restructuring of a significant contract with an effective date of January 1, 2005.



Behavioral Health Hospital Services



Cost of services associated with the freestanding behavioral health
facilities increased $41.2 million between the years. This increase is the result of the first full fiscal year of operations for Michiana Behavioral Health Center and Poplar Springs Hospital, both acquired during the last five months of fiscal year
2004 and the acquisitions of Friends Behavioral Health System, effective July 1, 2005, River Park Hospital, effective August 1, 2005, and the long-term operating lease agreement associated with Laurelwood Hospital effective January 1,
2005.



Physical Rehabilitation Contract Management
Services



Cost of services provided associated with the
contract management of physical rehabilitation services decreased by $1.7 million, or 11.6%, between the years. This decrease was primarily due to a decrease in the average number of physical rehabilitation locations in operation, from 27.3 for the
year ended August 31, 2004, to 23.9 for the year ended August 31, 2005.



EAP Services



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



Other Services



Cost of Services provided associated with other services decreased by $347,000 between the years. This decrease is primarily due to the phase out of the
PsychScope Phase IV projects.



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##### Table of Contents

##### Index to Financial Statements

Selling, General and Administrative.Total selling, general, and administrative expenses,
on a net basis, increased $4.4 million, or 23.3%, between the years. Salaries and benefits increased $1.9 million primarily due to the expansion of several support center departments and the additions of a dedicated acquisitions and development
department and in-house legal counsel. Consulting fees increased $786,000 due to Sarbanes-Oxley compliance efforts and support center related consulting projects. Auditing & accounting fees increased $566,000 due to increased fees related
to the companys annual audit as well as Sarbanes-Oxley compliance efforts. Recruitment advertising increased $221,000 due to increased activity by the companys internal recruiting function. Workers compensation losses increased $238,000
due to favorable adjustments associated with prior year reserves that were recorded during fiscal year 2004. Legal fees increased $175,000 primarily due to costs associated with the long-term operating lease agreement with Laurelwood Hospital,
litigation costs associated with six terminated contract locations, and one contract location still in operation.



Provision for Doubtful Accounts.The provision for doubtful accounts was a net expense of $4.4 million for the fiscal year ended
August 31, 2005, as compared to a net expense of $869,000 for the fiscal year ended August 31, 2004, a difference of $3.5 million. The net increase for the twelve months ended August 31, 2005 was primarily attributable to bad debt
provisions totaling approximately $3.2 million associated with the acquisitions in the Companys hospital services group. Also included in this expense are bad debt reserves in the amount of $1.3 million for three terminated contract locations
and two contract locations still in operation for which collectibility is uncertain. These expenses are partially offset by bad debt recoveries of $899,000.



Impairment Loss on Building.During the fourth quarter of fiscal 2005, the Company recorded an asset impairment charge of approximately $1.0
million associated with the write-down to fair market value of the Companys National Support Center building. Fair market value was determined by an executed letter of intent to sell the building. The Company plans on consolidating its current
National Support Center with the new EAP service center into a new location in Lewisville, Texas during fiscal year 2006.



Depreciation and Amortization. Depreciation and amortization expense increased $593,000 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 the acquisitions of Michiana Behavioral Health Center, Poplar Springs Hospital and Friends Behavioral Health System effective April 1,
2004, June 1, 2004, and July 1, 2005 respectively. This increase was partially offset by a decrease in contract amortization expense of approximately $487,000 associated with intangible assets that became fully amortized either during
the current or prior fiscal year.



Interest
and Other Income (Expense), Net.Interest expense, interest income and other income for the year ended August 31, 2005 was a net expense of $1.3 million as compared to a net expense of $1.3 million for the prior fiscal year. Interest
expense increased $220,000 as the result of a $1.7 million increase in the weighted average principal balance outstanding under the credit facility and an increase in interest rates between the periods. The increase in interest expense was offset by
an increase in interest income of approximately $240,000 that 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 a decrease of $920,000 or 14.7 %, as
compared to income tax expense of $6.2 million for the prior fiscal year. The decrease in income tax expense was largely due to a corresponding decrease in pre-tax earnings. The effective tax rate for fiscal years 2005 and 2004 was 37.9% and 38.0%,
respectively.



Discontinued Operations.On
August 29, 2005, the Company sold its membership interests in ProCare One Nurses, LLC, its wholly owned 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 for all periods presented in the accompanying consolidated statements of operations. Revenues decreased $1.5 million, or 8.0%, between the years. Total cost of services decreased $1.1 million, or 6.3%.
Total selling, general, and administrative expenses increased $1.4 million. The provision for doubtful accounts was a net expense of $136,000 for the year ended August 31, 2005, as compared to a net recovery of $59,000 for the year ended
August 31, 2004. Depreciation and amortization expense decreased approximately $32,000, or 24.5% between the years. Income tax expense decreased $728,000 between the years.



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##### Table of Contents

##### Index to Financial Statements

Fiscal Year Ended August 31, 2004 Compared to Fiscal Year Ended August 31, 2003



Revenue.Total revenue between the years increased $17.5 million, or 12.1%. Revenue for Behavioral Health Contract Management
Services increased primarily as a result of an increase in the average revenue per behavioral health care location. The acquisition of two freestanding behavioral health hospitals and their related facilities resulted in the generation of $10.1
million in revenue during fiscal year 2004. Physical Rehabilitation Services revenue increased $1.4 million, primarily due to an increase in the number of average rehabilitation locations in operation. Revenue for EAP Services increased $4.0 million
as a result of additional revenues associated with the acquisitions of Integrated Insights and EAPI. Additionally, revenue for Other Services decreased $1.5 million as a result of the phase out of the Companys PsychScope Phase IV projects.



Behavioral Health Contract Management Services



Revenue associated with behavioral health services
consisting of contract management of behavioral health programs increased $3.7 million, or 4.8% between the years. This increase is a result of a 5.1% increase in average revenue per contract location primarily due to the recognition of
approximately $700,000 in revenue generated by a significant consulting project, and the commencement of two significant behavioral health care contracts.



Behavioral Health Hospital Services



The Companys freestanding behavioral health hospitals generated $10.1 million in revenue during fiscal year 2004. This revenue was attributable to
the acquisitions of Michiana Behavioral Health Center effective April 1, 2004, and Poplar Springs Hospital effective June 1, 2004, which had revenues of approximately $4.3 million and $5.7 million, respectively, during the period.



Physical Rehabilitation Contract Management Services



Revenue associated with the contract management of
physical rehabilitation services increased $1.4 million, or 8.0% between the years. This increase was primarily attributable to an increase in the average number of physical rehabilitation locations in operation from 22.4 for the year ended
August 31, 2003 to 27.3 for the year ended August 31, 2004. This increase was partially offset by a decrease in the average revenue per location of 11.7% from year to year.



EAP Services



Revenue associated with employee assistance programs and managed behavioral services increased by $4.0 million, or 8.1% between the years. This $4.0
million increase was primarily attributable to the acquisitions of EAPI and Integrated Insights, which were consummated in fiscal year 2003 and which had combined revenues of $4.8 million during fiscal 2004. This increase was partially offset by a
decrease of approximately $500,000 as the result of the termination of the at risk portion of a significant managed care contract on August 31, 2003.



Other Services



Revenue associated with other services decreased by $1.5 million, or 81.0% between the years. This decrease is primarily attributable to the phase out of
the PsychScope Phase IV projects.



52



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##### Table of Contents

##### Index to Financial Statements

Cost of Services. Total cost of services provided increased $11.7 million, or 10.6 %
between the years. This increase is primarily attributable to the cost of operations associated with the acquisitions of Michiana Behavioral Health Center, Poplar Springs Hospital, and the inclusion for a full fiscal year for EAPI and Integrated
Insights. In addition increases in the average number of physical rehabilitation contract locations in operation and the commencement of a significant number of new physical rehabilitation programs as well as a new psychiatric contract location
resulted in increases to cost of services. These increases were partially offset by decreases attributable to the termination of one significant managed care contract and the phase out of the PsychScope Phase IV projects.



Behavioral Health Contract Management Services



Cost of services provided associated with the contract management of
behavioral health care programs increased $1.2 million, or 2.3%, between the years. While the average behavioral health care locations in operation remained level between years, significant expenses, related specifically to one new program,
increased the average cost of services per psychiatric location in operation.



Behavioral Health Hospital Services



Cost of services provided associated with the behavioral health care facilities was $7.6 million for the fiscal year ended August 31, 2004 an includes the operations of Michiana Behavioral Health Center, acquired
April 1, 2004, and Poplar Springs Hospital, acquired June 1, 2004.



Physical Rehabilitation Contract Management Services



Cost of services provided associated with the contract management of physical rehabilitation services increased by $1.2 million, or 9.5%, between the years. This increase was primarily due to an increase in the
average number of physical rehabilitation locations in operation, from 22.4 for the year ended August 31, 2003, to 27.3 for the year ended August 31, 2004, as well as a rise in salary and benefits costs per full time equivalent employee
between the periods.



EAP Services



Cost of services provided associated with employee assistance programs and
managed behavioral services increased by $2.9 million or 6.5% between the years. An increase of $3.8 million is the result of the full year inclusion of the EAPI and Integrated Insights acquisitions. This increase is offset by a $1.2 million
decrease in medical claims costs that is attributable to the termination of a significant managed care contract on December 31, 2002.



Other Services



Costs of services provided associated with other services decreased by $1.2 million, or 82.5% between the years. This decrease is primarily attributable
to the phase out of the PsychScope Phase IV projects.



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##### Index to Financial Statements

Selling, General and Administrative.Total selling, general, and administrative
expenses, increased $573,000, or 3.1%, between the years. Salaries and benefits increased $374,000 due to expenses associated with the expansion of several support center departments including the additions of a dedicated acquisitions and
development department and in-house legal counsel. Auditing, accounting and consulting fees increased $259,000 primarily due to the costs associated with Sarbanes-Oxley compliance. An increase of approximately $159,000 was a result of certain
benefit accruals being included in cost of services in prior fiscal periods. An increase of $196,000 is due to increased marketing efforts and corporate identity development. Travel increased $105,000 primarily due to the costs associated with the
acquisition endeavors of the Company, such as the acquisitions of Michiana Behavioral Health Center and Poplar Springs Hospital. These increases are partially offset by a decrease of $389,000 in legal expenses, a portion of which is
attributable to the HIPPA compliance efforts undertaken in the prior fiscal year, and a $162,000 decrease in rent as a result of the Companys purchase of the building used as the National Support Center effective July 31, 2003.



Provision for Doubtful Accounts.The provision
for doubtful accounts was a net expense of $869,000 for the fiscal year ended August 31, 2004, as compared to a net recovery of $910,000 for the fiscal year ended August 31, 2003, a change of $1.8 million. The net expense for the twelve
months ended August 31, 2004 is primarily the result of bad debt associated with the acquisition of Michiana Behavioral Hospital effective April 1, 2004 and Poplar Springs Hospital effective June 1, 2004. An additional increase to
this expense was a result of the Company recording accrued liabilities related to bankruptcy preferential payment claims by two behavioral health contract locations that are currently in bankruptcy proceedings. The liabilities relate to payments
received by the Company within 90 days of the client hospitals filing for bankruptcy. If the Company is not successful in its defense of these claims, the monies will be required to be repaid to the bankruptcy estate. In addition, bad debt
provisions were recorded for contract locations in which collectibility is uncertain. The net recovery for the twelve months ended August 31, 2003 was a result of the recovery of approximately $720,000, of which $601,000 was recorded as bad
debt recovery for a hospital that declared bankruptcy in 1998.



Depreciation and Amortization. Depreciation and amortization expense increased $376,000 or 15.5% between the years. An increase in depreciation expense of $117,000 is primarily related to the purchase of the National Support
Center building in July 2003. A $345,000 increase in depreciation is due to the addition of the facilities associated with the Michiana Behavioral Health Center and Poplar Springs Hospital effective April 1, 2004 and June 1, 2004,
respectively. Contract amortization increased $243,000 as a result of an increase in intangible assets associated with the June 30, 2003 acquisition of Integrated Insights. This increase was partially offset by a decrease in amortization
expense of $300,000 associated with intangible assets that were fully amortized during the prior fiscal year.



Interest and Other Income (Expense), Net.Interest expense, interest income and other income for the year ended August 31, 2004 was a
net expense of $1.3 million as compared to a net expense of $559,000 for the prior fiscal year. Interest expense increased approximately $279,000 as a result of an $8.1 million increase in the weighted average principal balance outstanding under the
credit facility between the periods, as well as a decrease in interest and other income of $56,000 between the periods. The increase in the weighted average principal balance outstanding is due to borrowings related to the acquisition of Michiana
Behavioral Health Center and Poplar Springs Hospital in the amounts of $6.2 million and $29.7 million, respectively.



Income Tax Expense. Income tax expense for fiscal year 2004 was $6.2 million representing an increase of $857,000 or 15.9 %, as
compared to income tax expense of $5.4 million for the prior fiscal year. The increase in income tax expense was largely due to a corresponding increase in pre-tax earnings. The effective tax rate for fiscal years 2004 and 2003 was 38.0% and 38.2%,
respectively.



Discontinued Operations.On
August 29, 2005, the Company sold its membership interests in ProCare One Nurses, LLC, its wholly owned 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 for all periods presented in the accompanying consolidated statements of operations. Revenues



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##### Table of Contents

##### Index to Financial Statements

decreased $3.5 million, or 15.8%, between the years. Total cost of services decreased $2.8 million, or 14.1%. Total
selling, general, and administrative expenses increased $186,000. The provision for doubtful accounts was a net recovery of $59,000 for the year ended August 31, 2004, as compared to a net expense of $295,000 for the year ended August 31,
2003. Depreciation and amortization expense decreased approximately $32,000, or 19.9% between the years. Income tax expense decreased $188,000 between the years.



Newly Issued Accounting Standards



See Note 2, Significant Accounting Policies and Estimatesto the Notes to the Consolidated Financial Statements included elsewhere herein for a discussion of newly issued accounting standards.



Sarbanes-Oxley and Related Compliance



The Sarbanes-Oxley Act of 2002, which became law in July 2002 requires changes in certain of the Companys corporate governance practices. In addition, related rules have been made by the Securities and Exchange Commission and NASDAQ.
These new rules and regulations will increase the Companys legal and financial compliance costs, and make some activities more difficult, time consuming and/or costly. These new rules and regulations are expected to make it more expensive to
obtain director and officer liability insurance. These new rules and regulations could also make it more difficult for the Company to attract and retain qualified members for its board of directors, particularly to serve on its audit committee, and
qualified executive officers. Additional costs related to compliance with the new requirements of Sarbanes-Oxley Rule Section 404 are expected to continue in future fiscal years.



The Companys initiatives to comply with Section 404 of the Sarbanes-Oxley Act and related regulations regarding
managements required assessment of its internal control over financial reporting and the independent auditors attestation of that assessment has required, and continues to require, the commitment of significant financial and managerial
resources. In part to prepare for compliance with Section 404, as well as to generally improve its internal control environment, the Company has undertaken substantial measures, including among other things, projects to strengthen both its
accounting and information technology systems, including initiatives related to recent acquisitions. However, because of the new and changed laws, regulations and standards are subject to varying interpretations in many cases due to their lack of
specificity, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies. This evolution may result in continuing uncertainty regarding compliance matters and additional costs necessitated by
ongoing revisions to disclosure and governance practices.



Liquidity and Capital Resources



The Company believes that its future cash flows from operations, along with cash of $8.1 million at August 31, 2005, and its credit facility of $125.0 million with an accordion feature allowing additional increases to $175.0 million,
subject to satisfaction of certain conditions, will be sufficient to cover operating cash requirements over the next 12 months. The Companys cash flows from operations were $12.4 million for the fiscal year ended August 31, 2005, $12.4
million for the fiscal year ended August 31, 2004, and $13.5 million for the fiscal year ended August 31, 2003. At August 31, 2005, $118.7 million of the $125.0 million credit facility was available to the Company after letter of
credit obligations. As a result of its strong and consistent cash flows generated from operations, its cash balance generated from a follow-on stock offering, its significant amount of available funds under the existing credit facility, and its
relatively low ordinary and customary capital expenditure requirements, including legal and financial compliance costs with new governmental regulatory requirements, the Company expects to be able to continue to fund operating cash requirements.



Cash outlays for property and equipment purchases in the
ordinary course of business totaled approximately $3.1 million for the fiscal year ended August 31, 2005. Property and equipment



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##### Index to Financial Statements

expenditures for fiscal years 2004 and 2003 were approximately $1.8 million and $4.9 million, respectively. Of the $4.9
million related to fiscal year 2003 property and equipment expenditures, $4.4 million was attributable to the purchase of the Companys National Support Center (NSC) located in Lewisville, Texas, which occurred effective
July 31, 2003. The Company anticipates its future annual property and equipment expenditures to be approximately $8.0 million.



On April 1, 2004 the Company expended cash of approximately $6.2 million for the purchase of the assets of Michiana Behavioral Health Center. See
Note 5, Acquisitions in the notes to the consolidated financial statements included elsewhere herein.



On June 1, 2004 the Company acquired the assets of PSH Acquisition Corporation. The purchase price was approximately $30.1 million, which was
financed by borrowings from the Companys credit facility. The purchase agreement also provides for additional variable payments in future years based on the future performance of the facilities. The first payment was made on March 31,
2005 in the amount of $381,000. See Note 5, Acquisitions in the notes to the consolidated financial statements included elsewhere herein.



On January 1, 2005 the Company entered into a long-term operating lease agreement of Laurelwood Hospital, a 160-bed behavioral health hospital
located in Willoughby, Ohio, a suburb of Cleveland. See Note 5, Acquisitions in the notes to the consolidated financial statements included elsewhere herein.



On July 1, 2005, the Company formed a joint venture with the Thomas Scattergood Behavioral Health Foundation, a
501(c)(3) charitable organization, and the joint venture acquired Friends Hospital. Horizon is an 80% member of the joint venture and the Thomas Scattergood Behavioral Health Foundation, is a 20% member of the joint venture. The Company contributed
approximately $15.5 million in cash to the joint venture which funds were used for the acquisition of the hospital by the joint venture. The contribution was paid out of available funds and no debt was incurred by the Company as a part of the
transaction. . The agreement requires the joint venture to expend at least $5,500,000 in the first five operating years of the joint venture on capital expenditures related to Friends Hospital. See Note 5, Acquisitions in the
notes to the consolidated financial statements included elsewhere herein.



On August 1, 2005 the Company acquired substantially all the assets of River Park Hospital and purchased the stock of an affiliated management company. The Company paid approximately $11.0 million in cash, which
was paid out of available funds and no debt was incurred by the Company as a part of the transaction. The agreement also provides for additional variable payments in future years based on the future performance of the hospital. See Note 5,
Acquisitions in the notes to the consolidated financial statements included elsewhere herein.



The Company intends to continue to fund acquisition activity using the balance currently available under the credit facility and if necessary, will seek
to further increase the facility size by exercising the accordion expansion feature.



The Company purchased $653,000 of its common stock during the fiscal year ended August 31, 2005. Under the existing credit facility, the Company may repurchase up to $10.0 million of its common stock per fiscal
year through the end of the agreement, subject to maintaining a debt coverage ratio of less than 1.75 to 1.00. On October 7, 2002 the Board of Directors authorized the repurchase of up to 800,000 shares of its common stock. As of
August 31, 2005, the company had repurchased 714,591 shares of the 800,000 share authorization, which remains in effect.



Effective May 23, 2002, the Company entered into a Second Amended and Restated Credit Agreement. See Note 9, Long -Term Debt to
the Notes to the Consolidated Financial Statements included elsewhere herein for a general discussion including a summary of certain material provisions of the Credit Agreement which does not purport to be complete, and is subject to, and qualified
in its entirety by reference to, the Second Amended Credit Agreement, a copy of which was previously filed as Exhibit 10.1 in the May 2002 Form 10-Q.



56



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##### Index to Financial Statements

Effective May 4, 2004 the Company amended the credit agreement. The amendment increased the facility
size from $60 million to $90 million (including an accordion expansion feature up to $120 million). See Note 9, Long-Term Debt to the Notes to the Consolidated Financial Statements included elsewhere herein.



Effective March 16, 2005, the Company sold in a follow-on public
offering 3,450,000 shares of its common stock at a price of $18.13 per share (shares and share price restated to reflect the impact 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 $58.4 million. The Company utilized approximately $34.5 million of the proceeds to repay all outstanding debt under its revolving credit facility. The balance of the net proceeds will be used for
general corporate purposes including acquisitions.



57



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##### Index to Financial Statements

Effective June 10, 2005, the Company entered into a Third Amended and Restated Credit Agreement. See
Note 9, Long-Term Debt to the Notes to the Consolidated Financial Statements included elsewhere herein for a general discussion including a summary of certain material provisions of the Credit Agreement which does not purport to
be complete, and is subject to, and qualified in its entirety by reference to, the Third Amended Credit Agreement, a copy of is filed as Exhibit 10.1 in this Form 10-Q.



Construction of a building to serve as the new national support center (NSC), which is in close proximity to the
current NSC facility in Lewisville, Texas, began during June 2005. The Company will lease the 80,000 square foot facility and anticipates completion and occupancy beginning in April 2006. The term of the office lease agreement is ten (10) years
with renewal options of two periods of five-years each.



The
following table provides aggregate information about the Companys material contractual payment obligations and the fiscal year in which these payments are due (in thousands):



|                                   |  |                             |        |      |   |       |  |      |       |      |   |                  |  |       |       |  |   |        |  |   |      
|---------------------------------- |  | --------------------------- | ------ | ---- | - | ----- |  | ---- | ----- | ---- | - | ---------------- |  | ----- | ----- |  | - | ------ |  | - | -----
|                                   |  | Payments due in Fiscal Year
|                                   |  | Total                       |        | 2006 |   | 2007  |  | 2008 |       | 2009 |   | 2010 &Thereafter |  | Other
|Long Term Debt Obligations (1)     |  | $                           |       |      | $ |      |  | $    |      |      | $ |                 |  | $     |      |  | $ |       |  | $ |     
|Interest on Long Term Debt (2)     |  |                             |       |      |   |      |  |      |      |      |   |                 |  |       |      |  |   |       |  |   |     
|Commitment Fees-Long Term Debt (3) |  |                             | 1,126  |      |   | 237   |  |      | 237   |      |   | 237              |  |       | 237   |  |   | 178    |  |   |     
|Operating Lease Obligations (4)    |  |                             | 29,990 |      |   | 3,595 |  |      | 3,561 |      |   | 2,969            |  |       | 2,584 |  |   | 17,281 |  |   |     
|Other Contracts Obligations (5)    |  |                             | 6,863  |      |   | 1,824 |  |      | 1,375 |      |   | 1,255            |  |       | 1,142 |  |   | 1,267  |  |   |     
|Other Long Term liabilities (6)    |  |                             | 3,376  |      |   |      |  |      | 425   |      |   | 209              |  |       |      |  |   |       |  |   | 2,742
|                                   |  |                             |        |      |   |       |  |      |       |      |   |                  |  |       |       |  |   |        |  |   |      
|                                   |  | $                           | 41,355 |      | $ | 5,656 |  | $    | 5,598 |      | $ | 4,670            |  | $     | 3,963 |  | $ | 18,726 |  | $ | 2,742
|                                   |  |                             |        |      |   |       |  |      |       |      |   |                  |  |       |       |  |   |        |  |   |      

---

|(1) | At August 31, 2005, the Company had no borrowings outstanding related to its $125.0 million revolving credit facility.
|--- | ----------------------------------------------------------------------------------------------------------------------

|(2) | No interest payments were reported in the table above due to the Company having no borrowings outstanding under its revolving credit facility. Actual interest payments will differ,
possibly significantly, as it cannot be assumed that there will continue to be no outstanding borrowings. In addition, future interest payments will be affected by changes in interest rate levels over time, as well as the Companys basis point
spread over the base rate as affected by its debt leverage.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Projected commitment fee payments relate to a 0.2% fee paid on the unused portion of the Companys $125.0 million revolving credit facility. At August 31, 2005 the Company
had no borrowings outstanding under the revolving credit facility. The unused portion is reduced by approximately $6.3 million relating to various letters of credit expected to be in place during the periods. The revolving credit facility expires on
May 31, 2010.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) | The company leases various office facilities and equipment under operating leases, as described in Note 14 in the notes to the consolidated financial statements. The table above
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) | Lake Mary, Florida, approximately $54,300 per month, terminates on January 31, 2006
| | --- | -----------------------------------------------------------------------------------

| | (b) | Winter Park, Florida, approximately $13,900 per month, terminates on May 31, 2006
| | --- | ---------------------------------------------------------------------------------

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

| | (d) | Blue Bell, Pennsylvania lease, approximately $26,800 per month, terminates on December 31, 2007
| | --- | -----------------------------------------------------------------------------------------------

| | (e) | Nashville, Tennessee, approximately $11,700 per month, terminates on April 30, 2008
| | --- | -----------------------------------------------------------------------------------

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

| | (g) | San Diego, California, approximately $21,100 per month, terminates on June 30, 2009
| | --- | -----------------------------------------------------------------------------------

| | (h) | Beachwood, Ohio approximately $9,100 per month, terminates on August 31, 2013
| | --- | -----------------------------------------------------------------------------

| | (i) | Lewisville, Texas, (occupancy in NSC to begin in April 2006) approximately $74,950 per month, terminates on March 31, 2016
| | --- | --------------------------------------------------------------------------------------------------------------------------

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

The Company is subleasing the clinic in Winter Park (previously discussed in this document).

|(5) | The Company, through its hospital facilities, has entered into the following contracts. A contract for the provision of education services related to its residential treatment
center. This contract terminates on May 31, 2006 and has payments due of $12,004 monthly. A pharmaceutical services agreement with a monthly payment of $14,018 that terminates on July 31, 2006. Clinical
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Index to Financial Statements

Director contracts that terminate on October 31, 2006, March 31, 2007 and
December 31, 2007 with monthly payments of $12,500, $12,500 and $4,167, respectively. A dietary management services contract with a monthly payment of approximately $10,200 that terminates on June 15, 2008. The joint venture with the
Thomas Scattergood Behavioral Health Foundation requires that $5.5 million be expended for capital expenditures for Friends hospital over the first five operating years (2006  2010). The long-term operating lease agreement associated with
Laurelwood hospital requires the Company to contribute $41,666 each December 31stbeginning December 31,
2007 and ending December 31, 2012.

|(6) | $2,742,642 of the $3,873,571 in Other Non-Current Liabilities reflected on the Companys balance sheet is included in this table to reflect future payment obligations
associated with workers compensation, professional liability, and the long-term portion of the employees vacation accrual. The Company has reflected these payments under other, as the timing of these future payments is dependent on
the actual processing of the claims and when an employee takes vacation beyond the amount recorded in the current portion of the vacation accrual in our financial statements. The payments of $424,733 and $209,113 in the fiscal years 2007 and 2008
are for lease obligations related to the EAP Services group reorganization, previously discussed in this document. The remaining $470,000 is a non-contractual contingency reserve.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Contractual obligations represent future cash commitments and liabilities
under agreements with third parties, and exclude contingent liabilities for which the Company cannot reasonably predict the amount(s) or timing of future payments, if any. See Note 14 Commitments and Contingencies to the
Consolidated Financial Statements of the Company included elsewhere herein.



Inflation and Economic Trends



Although inflation has not had a material impact on our results of operations, the health care industry is very labor intensive and salaries and benefits are subject to inflationary pressures as are rising supply costs that tend to escalate
as vendors pass on the rising costs through price increases. Some of our freestanding owned, leased and managed inpatient behavioral health care facilities we operate are experiencing the effects of the tight labor market, including a shortage of
nurses, which has caused and may continue to cause an increase in our salaries, wages and benefits expense in excess of the inflation rate. Although we cannot predict our ability to cover future cost increases, management believes that through
adherence to cost containment policies, labor management and reasonable price increases, the effects of inflation on future operating margins should be manageable. Our ability to pass on increased costs associated with providing health care to
Medicare and Medicaid patients is limited due to various federal, state and local laws that have been enacted which, in certain cases, limit our ability to increase prices. In addition, as a result of increasing regulatory and competitive pressures
and a continuing industry wide shift of patients into managed care plans, our ability to maintain margins through price increases to non-Medicare patients is limited.



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



Critical Accounting Policies and Estimates



This discussion should be read in conjunction with Note 2 Significant Accounting Policies and Estimates in Notes to Consolidated Financial Statements included elsewhere herein which describes in
more detail the Companys significant accounting policies and estimates.



The preparation of these financial statements requires the use of estimates, judgements and assumptions that affect the reported amounts of assets and liabilities, and the disclosure of contingent assets and
liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the respective reporting periods. The Companys senior management and independent auditor have discussed the critical accounting
estimates with the Companys audit committee.



The Company
continually evaluates its accounting policies and the estimates it uses to prepare the consolidated financial statements. In general, the estimates are based on historical experience, on



59



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##### Index to Financial Statements

information from third party professionals and on various other sources and assumptions that are believed to be
reasonable under the facts and circumstances. Management considers an accounting estimate to be critical if:



| |  | it requires assumptions to be made that were uncertain at the time the estimate was made, and
|- |  | ---------------------------------------------------------------------------------------------



| |  | changes in the estimate, or the use of different estimating methods that could have been selected, could have a material impact on the Companys consolidated results of
operations or financial condition.
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The following
presents information about the Companys most critical accounting estimates.



Allowances for Doubtful Accounts:The Company maintains allowances for doubtful accounts for estimated losses that may result from the inability of its customers to make
required payments. Allowances are based on the likelihood of recoverability of accounts receivable considering such factors as past experience and taking into account current collection trends that are expected to continue. Factors taken into
consideration in estimating the allowance are amounts past due, in dispute, or a client which the Company believes might be having financial difficulties. If economic, industry, or specific customer business trends worsen beyond earlier estimates,
the Company increases the allowances for doubtful accounts by recording additional expense. Legal fees expended in the pursuit of the outstanding amounts are considered recovered prior to the reversal of any previously written off bad
debt.



The primary collection risk with regard to patient
receivables associated with the Companys behavioral health hospitals lies with uninsured patient accounts or patient accounts whereby the primary insurance carrier has paid the amounts covered by the applicable agreement, but the portion of
the amount that is the patients responsibility (primarily deductibles and co-payments) remains outstanding. The Company estimates the allowance for doubtful accounts primarily based upon the age of the patients accounts receivable, the
patients economic ability to pay and the effectiveness of historical collection efforts. The Company continually monitors its accounts receivable balances and utilizes cash collection data to support its estimates of the provision for doubtful
accounts. Significant changes in payor mix or business office operations could have a significant impact on the Companys results of operations and cash flows.



Allowance for Contractual Discounts:With regard to the Companys behavioral
health hospitals, the Medicare and Medicaid regulations are complex and various managed care contracts may include multiple reimbursement mechanisms for different types of services provided and cost settlement provisions requiring complex
calculations and assumptions subject to interpretation. The Company estimates the allowance for contractual discounts on a payor-specific basis given its interpretation of the applicable regulations or contract terms. The services authorized and
provided and related reimbursements are often subject to interpretation that could result in payments that differ from the Companys estimates in the near term. Additionally, updated regulations and contract renegotiations occur frequently
necessitating continual review and assessment of the estimation process by management. Contractual discounts are reported as deductions from patient service revenue at the time the service is rendered.



Medical Claims: Medical claims payable represent the
liability for healthcare claims reported but not yet paid and claims incurred but not yet reported (IBNR) related to the Companys managed behavioral healthcare business. The IBNR portion of medical claims payable is estimated based
upon authorized healthcare services, past claims payment experience for member groups, enrollment data, utilization statistics and other factors using both accounting and actuarial methodologies. Although variability is inherent in such estimates,
management believes the recorded liability for medical claims payable is adequate. Medical claim payable balances are monitored and reviewed monthly and actuarially certified, by a third party actuarial firm, on an annual basis. Changes in
assumptions for care costs caused by changes in actual or expected experience could cause these estimates to change significantly. Reserves for these liabilities at August 31, 2005 and 2004 were $2.8 million and $2.5 million, respectively. A
10% increase in the assumed utilization of healthcare services would reduce net income by $1.5 million after tax on an annualized basis. This charge would impact the Companys EAP Services group.



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##### Index to Financial Statements

Goodwill and Intangible Assets: Goodwill represents the excess of
purchase price over the fair value of identifiable assets acquired, net of liabilities assumed. Intangibles consist of the separately identifiable intangibles, such as contract valuations, non-competes and trade names. At August 31, 2005
goodwill and intangible assets represented 43.0% of total assets. Contract valuations represent the fair value of management contracts and service contracts purchased and are being amortized using the straightline method over seven years.
Other intangibles are being amortized over their expected useful lives. Per the provisions of SFAS No. 142, the Company performs an annual goodwill impairment review, for each business service group as defined in Note 10 Goodwill and
Other Intangible Assets to the Consolidated Financial Statements, in the third quarter of each fiscal year or when events or changes in circumstances indicate the carrying value may not be recoverable. Indicators the Company consider
important which could trigger an impairment review include, without limitation, (i) significant under-performance or loss of key contracts acquired in an acquisition relative to expected historical or projected future operating results;
(ii) significant changes in the manner or use of the acquired assets or the strategy of the Companys overall the manner or use of the acquired assets or the strategy of the Companys overall business; (iii) significant negative
industry or economic trends; (iv) increased competitive pressures; (v) a significant decline in the Companys stock price for a sustained period; and (vi) regulatory changes. In assessing the recoverability of the Companys
goodwill and intangibles, the Company must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. The fair value of the asset could be different using different estimating
methods and assumptions in these valuation techniques resulting in a possible impairment of the intangible assets and/or goodwill, or alternatively an acceleration in amortization expense may result. An impairment charge would reduce operating
income in the period it was determined that the charge was needed. As a result of the May 31, 2005 impairment testing, no impairment adjustments were deemed necessary.



SFAS 142 discontinued the amortization of goodwill and generally requires that goodwill impairment be tested annually using
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 a one-step process
that compares the fair value to the carrying amount of the asset. Because of the significance of the identified intangible assets and goodwill to the Companys consolidated balance sheet, annual or interim impairment analyses are important.
Changes in key assumptions about the business and its prospects, or changes in market conditions or other external factors, could result in an impairment charge and such a charge could have a material adverse effect on the Companys financial
condition and results of operations. The Company elected to conduct the annual impairment testing during its fiscal year third quarter. As a result of the May 31, 2005 impairment testing, no impairment adjustments were deemed necessary.



Reserves for Employee Health and Workers Compensation
Benefits: These reserves represent accruals for estimated claims incurred, but unpaid or not reported. The accruals are based on a number of factors including historical experience, industry trends and recent claims history
and are subject to ongoing revision as conditions might change and as new data may be presented. In estimating the liability for claims, the Company obtains an estimate from a third party actuarial firm, which calculates an estimate using historical
experiences and estimates of claim costs as well as numerous assumptions regarding factors relevant to the derivation of an estimate of future claim costs. Reserves for employee health benefits at August 31, 2005 and 2004 were $1,190,911 and
$942,606, respectively. The reserve was higher at August 31, 2005 due to the increase in the Companys employee base. Reserves for workers compensation at August 31, 2005 and 2004 were $1,213,896 and $1,087,730, respectively. The
increase in the reserve is primarily due to the increase in the Companys employee base. Reserve estimates are expected values of the amounts required to pay claims reported or incurred through August 31, 2005 and includes a reasonable
additional reserve to account for a possible adverse deviation from the expected values estimated.



Self-Insurance Reserves:This reserve represents an accrual for certain general and professional liability
claims filed and for claims incurred, but not reported. Estimates of the aggregate or portions of claims pursuant to the Companys self-insurance retentions, and liability for uninsured claims incurred are determined by using actuarial
assumptions followed in the insurance industry and historical experience. In



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##### Index to Financial Statements

estimating the liability for claims, the Company obtains an estimate from a third party actuarial firm, which calculates
an estimate using historical experiences and estimates of claim costs as well as numerous assumptions regarding factors relevant to the derivation of an estimate of future claim costs. The Company takes into account those estimates when determining
the appropriate reserves. Reserves for these liabilities at August 31, 2005 and 2004 were $1,441,879 and $1,433,493, respectively. The third-party actuarial firms analysis resulted in a higher reserve at August 31, 2005 when compared
to the results of the analysis at August 31, 2004. Reserve estimates are expected values of the amounts required to pay claims reported or incurred through August 31, 2005 and include a reasonable additional reserve to account for a
possible adverse deviation from the expected values estimated.



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##### Index to Financial Statements

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



In its normal operations, the Company has market risk exposure to interest rates due to its interest bearing debt obligations, which are entered into for
purposes other than trading. To manage its exposure to changes in interest rates, the Company uses both variable rate debt and fixed rate debt of short duration with maturities ranging from 30 to 180 days. The Company has historically estimated its
market risk exposure using sensitivity analyses assuming a 10% change in market rates. As of August 31, 2005, the Company did not have any debt obligations outstanding under its credit facility and therefore is currently not subject to market
risk exposure.



ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA



Reference is made to the Consolidated Financial Statements of the Company and the Notes thereto appearing at page F-1 to F-36 elsewhere herein, which information is incorporated by reference into this Item 8.



ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE



None.



ITEM 9A. CONTROLS AND PROCEDURES



Disclosure Controls and Procedures



We have
established disclosure controls and procedures to ensure that material information relating to the Company, including its consolidated subsidiaries, is made known to the officers who certify the Companys financial reports and to other members
of senior management and the Board of Directors.



Based on
their evaluation as of August 31, 2005, our principal executive officer and principal financial officer have concluded that the Companys disclosure controls and procedures (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 the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in SEC rules and
forms, and information required to be disclosed in the reports that it files or submits under the Exchange Act is accumulated and communicated to the management.



Managements Report on Internal Control over Financial Reporting



Our management is responsible for establishing and maintaining adequate internal control over financial 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 our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the
effectiveness of our internal control 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 control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Because of its inherent limitations,
internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions,
or that the degree of compliance with the policies or procedures may deteriorate.



We have excluded River Park Hospital, Laurelwood Hospital and Friends Hospital from our assessment of internal control over financial reporting as of August 31, 2005 because the hospitals were acquired by the Company
in purchase business combinations during 2005. Our independent registered public accounting firm has also excluded these entities from their audit. River Park Hospital and Laurelwood Hospital are both wholly-owned subsidiaries whose total assets and
total revenues represent 8.8% and 9.3%, respectively, of the related consolidated financial statement amounts as of and for the year ended August 31, 2005. Friends Hospital is a joint venture of which the Company owns 80%, whose total assets and
total revenues represent 12.2% and 2.9%, respectively, of the related consolidated financial statement amounts as of and for the year ended August 31, 2005.



Based on our evaluation under the framework in Internal Control - Integrated Framework, our management concluded that our internal control over
financial reporting was effective as of August 31, 2005.



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##### Index to Financial Statements

Our managements assessment of the effectiveness of our internal control over financial reporting as
of August 31, 2005, and the effectiveness of our internal control over financial reporting as of August 31, 2005 have been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, who also audited the consolidated
financial statements of the Company included in this report on Form 10-K, as stated in their report which is included herein. The report, which expresses unqualified opinions on managements assessment and on the effectiveness of the
Companys internal control over financial reporting as of August 31, 2005, is included in the Report of Independent Registered Public Accounting Firm, elsewhere within this document.



Changes in Internal Control over Financial Reporting



There have been no changes in the Companys internal control over
financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that occurred during the Companys last fiscal quarter that have materially affected or are reasonably likely to materially affect the Companys internal control
over financial reporting.



PART III



ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT



The Company will file with the Commission a definitive proxy statement with respect to the annual meeting of stockholders of the Company to be held on January 20, 2006 (the Proxy Statement). The
Company hereby incorporates into this Item 10 by reference to the Proxy Statement the information required by this Item 10 that will appear in the Proxy Statement under the caption ELECTION OF DIRECTORS.



Audit Committee Financial Experts



The Company has determined that the three members of the Audit Committee of
the Board of Directors, George E. Bello, James E. Buncher and Donald E. Steen, each qualify as an audit committee financial expert as defined in Item 401(h) of Regulation S-K, and that each of those individuals is
independent as the term is used in Item 7(d)(3)(iv) of Schedule 14A under the Securities Exchange Act.



Code Of Conduct



The Company has adopted a Code of Conduct applicable to all employees, including the principal executive officer, principal financial officer and
principal accounting officer of the Company. A copy of the Code of Conduct is available on 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.



ITEM 11. EXECUTIVE COMPENSATION



The Company hereby incorporates into this Item 11 by reference to the Proxy Statement the information required by this Item 11 that will appear in the Proxy Statement under the caption EXECUTIVE COMPENSATION.



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##### Index to Financial Statements

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT



The following table sets forth a summary of the equity compensation plans offered by the Company:



Equity Compensation Plan Information as of September 30, 2005



|                                                           |  |                                                                                             |  |                                                                             |      |                                                                                                                                          |        
|---------------------------------------------------------- |  | ------------------------------------------------------------------------------------------- |  | --------------------------------------------------------------------------- | ---- | ---------------------------------------------------------------------------------------------------------------------------------------- | -------
|                                                           |  | 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     |  | 1,321,338                                                                                   |  | $                                                                           | 8.75 |                                                                                                                                          | 439,500
|Equity compensation plans not approved by security holders |  |                                                                                            |  |                                                                             |     |                                                                                                                                          |       
|                                                           |  |                                                                                             |  |                                                                             |      |                                                                                                                                          |        
|Total                                                      |  | 1,321,338                                                                                   |  | $                                                                           | 8.75 |                                                                                                                                          | 439,500
|                                                           |  |                                                                                             |  |                                                                             |      |                                                                                                                                          |        



The Company hereby
incorporates into this Item 12 by reference to the Proxy Statement the other information required by this Item 12 that will appear in the Proxy Statement under the caption SECURITY OWNERSHIP BY MANAGEMENT AND PRINCIPAL STOCKHOLDERS.



ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS



None.



ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES



The Company hereby incorporates into this Item 14 by reference to the Proxy Statement the information required by this Item 14 that will appear in the Proxy Statement under the caption APPOINTMENT OF
INDEPENDENT AUDITORS.



65



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##### Index to Financial Statements

PART IV



ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON 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 |  | -   |  | Long-term operating lease agreement of Laurelwood Hospital dated December 30, 2004 between the Company and Lake Hospital System Inc. (incorporated herein by reference to Exhibit 10.1 to
the Companys Quarterly Report on Form 10-Q for the quarter ended February 28, 2005).                                      
|     |  |    
|10.2 |  | -   |  | Asset Purchase Agreement dated June 9, 2005 by and between Mountain State Behavioral Health Services, LLC, as Seller, and HHC River Park, as Purchaser (incorporated herein by reference
to Exhibit 10.1 to the Companys Quarterly Report on Form 10-Q for the quarter ended May 31, 2005).                         
|     |  |    
|10.3 |  | -   |  | Stock Purchase agreement dated June 9, 2005 by and between Scott C. Stamm and Patrick D. Burrows, as Seller, HHC River Park, Inc., as Purchaser and Psychmanagement Group, Inc.
(incorporated herein by reference to Exhibit 10.1 to the Companys Quarterly Report on Form 10-Q for the quarter ended May 31, 2005).
|     |  |    
|10.4 |  | -   |  | Asset Acquisition and Contribution Agreement dated April 22, 2005 by and between Friends Hospital, as Seller, and Friends Behavioral Health System, LP, as Purchaser (incorporated herein
by reference to Exhibit 10.1 to the Companys Current Report on Form 8-K dated July 6, 2005).                              



66



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|      |  |   |  |                                                                                                                                                                                                                                                                                                                                                           
|----- |  | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.5  |  |   |  | Membership Interest Purchase Agreement dated August 22, 2005 by and between Horizon Health Corporation, as Seller, and CareerStaff Unlimited Inc. as Purchaser (incorporated herein by
reference to Exhibit 10.1 to the Companys Current Report on Form 8-K/A dated August 29, 2005).                                                                    
|      |  |  
|10.6  |  | - |  | Office Lease Agreement dated May 6, 2005 between Opus West LP, as Landlord, and Horizon Health Corporation, as Tenant (incorporated herein by reference to Exhibit 10.1 to the
Companys Quarterly Report on Form 10-Q for the quarter ended May 31, 2005).                                                                                               
|      |  |  
|10.7  |  | - |  | Underwriting Agreement dated March 10, 2005, by and between the Company and J.P. Morgan Securities, Inc., as Representative of the Several Underwriters listed on the scheduled 1 thereto
(incorporated herein by reference to Exhibit 1.1 to the Companys Current Report on Form 8-K dated March 10, 2005).                                             
|      |  |  
|10.8  |  | - |  | Third Amended and Restated Credit Agreement dated June 10, 2005 between Horizon Health Corporation and Horizon Health Management, Inc., as Borrowers and J.P Morgan 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, 2005).
|      |  |  
|10.9  |  | - |  | 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).                                                                                                                                                   
|      |  |  
|10.10 |  | - |  | 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).                                                                                                                                        
|      |  |  
|10.11 |  | - |  | 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).                                                                                   
|      |  |  
|10.12 |  | - |  | 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).                                                                                                                                                   
|      |  |  
|10.13 |  | - |  | 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).                                                                                                                                                                             
|      |  |  
|10.14 |  | - |  | Horizon Health Corporation Employee Stock Purchase Plan (incorporated herein by reference to Exhibit 4.3 to the Companys Registration Statement on Form S-8 filed with the Commission on
November 30, 1999, Registration No. 333-91761).                                                                                                                 
|      |  |  
|10.15 |  | - |  | Horizon Health Corporation Bonus Plan Fiscal 2005 (incorporated herein by reference to Exhibit 10.14 to the Companys Annual Report on Form 10-K for the fiscal year ended August 31,
2004).                                                                                                                                                              
|      |  |  
|10.16 |  | - |  | Horizon Health Corporation Bonus Plan Fiscal 2006 (filed herewith).                                                                                                                                                                                                                                                                                       



67



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| | 
| | 

|      |  |   |  |                                                                                                                                                                                                                                                                         
|----- |  | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.17 |  | - |  | Executive Retention Agreement effective May 1,2003 between the Company and James Ken Newman (incorporated herein by reference to Exhibit 10.1 to the Companys Quarterly Report on
Form 10-Q for the quarter ended May 31, 2003).                                       
|      |  |  
|10.18 |  | - |  | Agreement dated July 1, 2004 between Horizon Health Corporation, Inc. and David K. Meyercord regarding severance arrangements (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, 2004).
|      |  |  
|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. (filed herewith)                                                                                                                                      
|      |  |  
|31.2  |  | - |  | Certification of Chief Financial Officer required by Securities and Exchange Commission Rule 13a-14(a) or 15d-14. (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)                                                                                                



68



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##### Index to Financial Statements

SIGNATURES



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



Date:
November 11, 2005



HORIZON HEALTH CORPORATIONBy:

/s/ JOHN E. PITTSJohn E. Pitts Executive Vice President - Finance (Principal Financial Officer)




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



|                                     |  |                                                                                                         |  |                  
|------------------------------------ |  | ------------------------------------------------------------------------------------------------------- |  | -----------------
|Signature                            |  | Capacity                                                                                                |  | Date             
|/s/ JAMES KEN NEWMANJames Ken Newman |  | Director and Chairman of the Board, President and Chief
Executive Officer (Principal Executive Officer) |  | November 11, 2005
|                                     |  |                                                                                                        
|/s/ JOHN E. PITTS                    |  | Executive Vice President  Finance (Principal Financial and Accounting Officer)                         |  | November 11, 2005
|John E. Pitts                        |  |                                                                                                         | 
|                                     |  |                                                                                                        
|/s/ GEORGE E. BELLO                  |  | Director                                                                                                |  | November 11, 2005
|George E. Bello                      |  |                                                                                                         |  |                  
|                                     |  |                                                                                                        
|/s/ MIKE R. BOWLIN                   |  | Director                                                                                                |  | November 11, 2005
|Mike R. Bowlin                       |  |                                                                                                         |  |                  
|                                     |  |                                                                                                        
|/s/ JAMES E. BUNCHER                 |  | Director                                                                                                |  | November 11, 2005
|James E. Buncher                     |  |                                                                                                         |  |                  
|                                     |  |                                                                                                        
|/s/ ROBERT A. LEFTON                 |  | Director                                                                                                |  | November 11, 2005
|Robert A. Lefton                     |  |                                                                                                         |  |                  
|                                     |  |                                                                                                        
|/s/ WILLIAM H. LONGFIELD             |  | Director                                                                                                |  | November 11, 2005
|William H. Longfield                 |  |                                                                                                         |  |                  
|                                     |  |                                                                                                        
|                                     |  | Director                                                                                                |  | November 11, 2005
|C. Thomas Smith                      |  |                                                                                                         |  |                  
|                                     |  |                                                                                                        
|/s/ DONALD E. STEEN                  |  | Director                                                                                                |  | November 11, 2005
|Donald E. Steen                      |  |                                                                                                         |  |                  



69



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##### Index to Financial Statements

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS



|                                                                                                               |  |    
|-------------------------------------------------------------------------------------------------------------- |  | ---
|Report of Independent Registered Public Accounting Firm                                                        |  | F-2
|                                                                                                               | 
|Consolidated Balance Sheets at August 31, 2005 and 2004                                                        |  | F-3
|                                                                                                               | 
|Consolidated Statements of Operations For the Years Ended August 31, 2005, 2004, and 2003                      |  | F-5
|                                                                                                               | 
|Consolidated Statements of Changes in Stockholders Equity For the Years Ended August 31, 2005, 2004, and 2003 |  | F-6
|                                                                                                               | 
|Consolidated Statements of Cash Flows For the Years Ended August 31, 2005, 2004, and 2003                      |  | F-7
|                                                                                                               | 
|Notes to Consolidated Financial Statements                                                                     |  | F-9



F-1



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##### Table of Contents

##### Index to Financial Statements

Report of Independent Registered Public Accounting Firm



To the Board of Directors and Stockholders

of Horizon Health Corporation:



We have completed an integrated audit of Horizon Health Corporations 2005 consolidated financial statements and of its
internal control over financial reporting as of August 31, 2005 and audits of its 2004 and 2003 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based
on our audits are presented below.



Consolidated financial statements



In our opinion, the consolidated financial statement listed in
the accompanying index present fairly, in all material respects, the financial position of Horizon Health Corporation and its subsidiaries at August 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three
years in the period ended August 31, 2005 in conformity with accounting principles general accepted in the United States of America. These financial statements are the responsibility of the Companys management. Our responsibility is to express
an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statement, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.



Internal control over financial reporting



Also, in our opinion, managements assessment, included in
Managements Report on Internal Control over Financial Reporting appearing under item 9A, that the Company maintained effective internal control over financial reporting as of August 31, 2005 based on criteria established in Internal Control
- Integrated Framework issued by the Committee of Sponsoring Organization of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all
material respects, effective internal control over financial reporting as of August 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the COSO. The Companys management is responsible for
maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on managements assessment and on the
effectiveness of the companys internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board
(United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over
financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating managements assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such
other procedures and we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.



A companys internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial
reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A companys internal control over financial reporting includes those policies and procedures that (i)
pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transaction are recorded as necessary to permit
preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and
(iii) provide reasonable assurance regarding prevention of timely detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.



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



As described
in Managements Report on Internal Control over Financial Reporting, management has excluded River Park Hospital, Laurelwood Hospital and Friends Hospital from its assessment of internal control over financial reporting as of August 31, 2005
because they were acquired by the Company in purchase business combinations during 2005. We have also excluded these entities from our audit of internal control over financial reporting. River Park Hospital and Laurelwood Hospital are both
wholly-owned subsidiaries whose total assets and total revenues represent 8.8% and 9.3%, respectively, of the related consolidated financial statement amounts as of and for the year ended August 31, 2005. Friends Hospital is a joint venture of which
the Company owns 80%, whose total assets and total revenues of represent 12.2% and 2.9%, respectively, of the related consolidated financial statement amounts as of and for the year ended August 31, 2005.



/s/ PricewaterhouseCoopers LLP

Dallas, Texas

November 11, 2005



F-2



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##### Index to Financial Statements

HORIZON HEALTH CORPORATION

CONSOLIDATED BALANCE SHEETS



|                                                                                                                                 |  |            |             |      |   |            
|-------------------------------------------------------------------------------------------------------------------------------- |  | ---------- | ----------- | ---- | - | -----------
|                                                                                                                                 |  | August 31,
|                                                                                                                                 |  | 2005       |             | 2004
|CURRENT ASSETS:                                                                                                                  |  |            |             |      |   |            
|                                                                                                                                 |  |           
|Cash and cash equivalents                                                                                                        |  | $          | 8,088,603   |      | $ | 1,907,708  
|Accounts receivable less allowance for doubtful accounts of $5,741,106 and $2,412,152 at August 31, 2005 and 2004,
respectively. |  |            | 28,876,368  |      |   | 22,058,989 
|Prepaid expenses and supplies                                                                                                    |  |            | 4,822,476   |      |   | 573,230    
|Other receivables                                                                                                                |  |            | 2,161,236   |      |   | 964,969    
|Other assets                                                                                                                     |  |            | 3,084,519   |      |   | 806,019    
|Income taxes receivable                                                                                                          |  |            |            |      |   | 51,886     
|Deferred taxes                                                                                                                   |  |            | 4,998,133   |      |   | 2,426,199  
|Residual current assets from divested entity                                                                                     |  |            | 1,322,129   |      |   |           
|                                                                                                                                 |  |            |             |      |   |            
|TOTAL CURRENT ASSETS                                                                                                             |  |            | 53,353,464  |      |   | 28,789,000 
|                                                                                                                                 |  |           
|Property and Equipment, net                                                                                                      |  |            | 51,698,343  |      |   | 28,801,497 
|                                                                                                                                 |  |           
|Goodwill                                                                                                                         |  |            | 74,227,781  |      |   | 83,723,888 
|Other indefinite life intangibles                                                                                                |  |            | 3,886,641   |      |   | 795,988    
|Contracts, net of accumulated amortization of $6,945,723 and $6,184,217 at August 31, 2005 and 2004, respectively                |  |            | 2,869,020   |      |   | 2,405,526  
|Other intangibles, net of accumulated amortization of $342,887 and $458,460 at August 31, 2005 and 2004, respectively            |  |            | 100,127     |      |   | 318,554    
|Other non-current assets                                                                                                         |  |            | 1,751,824   |      |   | 430,434    
|Residual non-current assets from divested entity                                                                                 |  |            | 655,343     |      |   |           
|                                                                                                                                 |  |            |             |      |   |            
|TOTAL ASSETS                                                                                                                     |  | $          | 188,542,543 |      | $ | 145,264,887
|                                                                                                                                 |  |            |             |      |   |            



See accompanying notes
to consolidated financial statements.



F-3



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##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

CONSOLIDATED BALANCE SHEETS



|                                                                                                                                                                                                                      |  |            |             |   |      |   |             |  
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------- | ----------- | - | ---- | - | ----------- | -
|                                                                                                                                                                                                                      |  | August 31, |            
|                                                                                                                                                                                                                      |  | 2005       |             |   | 2004 |  
|CURRENT LIABILITIES:                                                                                                                                                                                                  |  |            |             |   |      |   |             |  
|Accounts payable                                                                                                                                                                                                      |  | $          | 4,656,961   |   |      | $ | 2,772,608   |  
|Employee compensation and benefits                                                                                                                                                                                    |  |            | 11,791,701  |   |      |   | 9,244,235   |  
|Medical claims payable                                                                                                                                                                                                |  |            | 2,837,842   |   |      |   | 2,461,535   |  
|Accrued expenses and unearned revenue                                                                                                                                                                                 |  |            | 12,922,955  |   |      |   | 8,750,459   |  
|Residual current liabilities from divested entity                                                                                                                                                                     |  |            | 1,653,974   |   |      |   |            |  
|                                                                                                                                                                                                                      |  |            |             |   |      |   |             |  
|TOTAL CURRENT LIABILITIES                                                                                                                                                                                             |  |            | 33,863,433  |   |      |   | 23,228,837  |  
|                                                                                                                                                                                                                      |  |           
|Other non-current liabilities                                                                                                                                                                                         |  |            | 3,873,571   |   |      |   | 1,570,386   |  
|Long-term debt                                                                                                                                                                                                        |  |            |            |   |      |   | 40,000,000  |  
|Deferred income taxes                                                                                                                                                                                                 |  |            | 3,691,207   |   |      |   | 4,641,257   |  
|Residual non-current liabilities from divested entity                                                                                                                                                                 |  |            | 127,940     |   |      |   |            |  
|                                                                                                                                                                                                                      |  |            |             |   |      |   |             |  
|TOTAL LIABILITIES                                                                                                                                                                                                     |  |            | 41,556,151  |   |      |   | 69,440,480  |  
|                                                                                                                                                                                                                      |  |           
|Minority interest                                                                                                                                                                                                     |  |            | 3,865,045   |   |      |   |            |  
|                                                                                                                                                                                                                      |  |           
|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; 14,906,772 shares issued and 14,899,127 shares outstanding at August 31,
2005, and 11,326,198 shares issued and 11,134,838 outstanding at August 31, 2004 |  |            | 149,068     |   |      |   | 113,262     |  
|Additional paid-in capital                                                                                                                                                                                            |  |            | 84,020,341  |   |      |   | 23,083,887  |  
|Retained earnings                                                                                                                                                                                                     |  |            | 59,150,173  |   |      |   | 54,165,761  |  
|Treasury stock, at cost, 7,645 shares at August 31, 2005 and 191,360 shares at August 31, 2004                                                                                                                        |  |            | (198,235    | ) |      |   | (1,538,503  | )
|                                                                                                                                                                                                                      |  |            |             |   |      |   |             |  
|TOTAL STOCKHOLDERS EQUITY                                                                                                                                                                                            |  |            | 143,121,347 |   |      |   | 75,824,407  |  
|                                                                                                                                                                                                                      |  |            |             |   |      |   |             |  
|TOTAL LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                                                            |  | $          | 188,542,543 |   |      | $ | 145,264,887 |  
|                                                                                                                                                                                                                      |  |            |             |   |      |   |             |  



See accompanying notes
to consolidated financial statements.



F-4



---

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##### Index to Financial Statements

HORIZON HEALTH CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS



|                                                                          |  |                        |             |   |      |   |             |      |  |   |             |  
|------------------------------------------------------------------------- |  | ---------------------- | ----------- | - | ---- | - | ----------- | ---- |  | - | ----------- | -
|                                                                          |  | Years Ended August 31, |            
|                                                                          |  | 2005                   |             |   | 2004 |   |             | 2003 | 
|Revenue                                                                   |  | $                      | 207,392,327 |   |      | $ | 161,824,612 |      |  | $ | 144,337,311 |  
|                                                                          |  |                        |            
|Cost of services (exclusive of depreciation shown separately below)       |  |                        | 160,032,568 |   |      |   | 121,554,086 |      |  |   | 109,890,095 |  
|Selling, general and administrative                                       |  |                        | 23,219,830  |   |      |   | 18,834,487  |      |  |   | 18,261,990  |  
|Provision for (recovery of) doubtful accounts                             |  |                        | 4,381,681   |   |      |   | 869,079     |      |  |   | (909,518    | )
|Impairment loss on building                                               |  |                        | 1,015,241   |   |      |   |            |      |  |   |            |  
|Depreciation and amortization                                             |  |                        | 3,387,388   |   |      |   | 2,794,832   |      |  |   | 2,419,104   |  
|                                                                          |  |                        |             |   |      |   |             |      |  |   |             |  
|Operating income                                                          |  |                        | 15,355,619  |   |      |   | 17,772,128  |      |  |   | 14,675,640  |  
|                                                                          |  |                        |            
|Other income (expense):                                                   |  |                        |             |   |      |   |             |      |  |   |             |  
|Interest expense                                                          |  |                        | (1,573,082  | ) |      |   | (1,353,528  | )    |  |   | (661,856    | )
|Interest income and other                                                 |  |                        | 275,245     |   |      |   | 46,684      |      |  |   | 103,031     |  
|                                                                          |  |                        |             |   |      |   |             |      |  |   |             |  
|Income before income taxes, minority interest and discontinued operations |  |                        | 14,057,782  |   |      |   | 16,465,284  |      |  |   | 14,116,815  |  
|                                                                          |  |                        |            
|Income tax provision                                                      |  |                        | 5,331,951   |   |      |   | 6,252,038   |      |  |   | 5,395,203   |  
|                                                                          |  |                        |            
|Minority interest, net                                                    |  |                        | (15,262     | ) |      |   |            |      |  |   |            |  
|                                                                          |  |                        |             |   |      |   |             |      |  |   |             |  
|Income from continuing operations                                         |  |                        | 8,741,093   |   |      |   | 10,213,246  |      |  |   | 8,721,612   |  
|                                                                          |  |                        |            
|Discontinued operations:                                                  |  |                        |             |   |      |   |             |      |  |   |             |  
|(Loss) income from discontinued operations, net                           |  |                        | (488,092    | ) |      |   | 561,942     |      |  |   | 860,630     |  
|Loss on disposal of discontinued operations, net                          |  |                        | (3,102,469  | ) |      |   |            |      |  |   |            |  
|                                                                          |  |                        |             |   |      |   |             |      |  |   |             |  
|Discontinued operations                                                   |  |                        | (3,590,561  | ) |      |   | 561,942     |      |  |   | 860,630     |  
|                                                                          |  |                        |             |   |      |   |             |      |  |   |             |  
|Net Income                                                                |  | $                      | 5,150,532   |   |      | $ | 10,775,188  |      |  | $ | 9,582,242   |  
|                                                                          |  |                        |             |   |      |   |             |      |  |   |             |  
|Basic earnings per common share:                                          |  |                        |             |   |      |   |             |      |  |   |             |  
|Continuing operations                                                     |  | $                      | 0.68        |   |      | $ | 0.94        |      |  | $ | 0.83        |  
|Discontinued operations                                                   |  |                        | (0.28       | ) |      |   | 0.05        |      |  |   | 0.08        |  
|                                                                          |  |                        |             |   |      |   |             |      |  |   |             |  
|                                                                          |  | $                      | 0.40        |   |      | $ | 0.99        |      |  | $ | 0.91        |  
|                                                                          |  |                        |             |   |      |   |             |      |  |   |             |  
|Diluted earnings per common share:                                        |  |                        |             |   |      |   |             |      |  |   |             |  
|Continuing operations                                                     |  | $                      | 0.66        |   |      | $ | 0.90        |      |  | $ | 0.77        |  
|Discontinued operations                                                   |  |                        | (0.27       | ) |      |   | 0.05        |      |  |   | 0.08        |  
|                                                                          |  |                        |             |   |      |   |             |      |  |   |             |  
|                                                                          |  | $                      | 0.39        |   |      | $ | 0.95        |      |  | $ | 0.85        |  
|                                                                          |  |                        |             |   |      |   |             |      |  |   |             |  
|Weighted average shares outstanding:                                      |  |                        |             |   |      |   |             |      |  |   |             |  
|Basic                                                                     |  |                        | 12,829,141  |   |      |   | 10,848,866  |      |  |   | 10,499,561  |  
|                                                                          |  |                        |             |   |      |   |             |      |  |   |             |  
|Diluted                                                                   |  |                        | 13,306,444  |   |      |   | 11,346,001  |      |  |   | 11,283,236  |  
|                                                                          |  |                        |             |   |      |   |             |      |  |   |             |  



See accompanying notes
to consolidated financial statements.



F-5



---

##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY



|                                                        |  |            |  |                    |         |                           |   |            |                  |  |   |                |   |  |                         |   |  |       |             |   |  |   |             |  
|------------------------------------------------------- |  | ---------- |  | ------------------ | ------- | ------------------------- | - | ---------- | ---------------- |  | - | -------------- | - |  | ----------------------- | - |  | ----- | ----------- | - |  | - | ----------- | -
|                                                        |  | Shares     |  | Common StockAmount |         | Additional Paid-inCapital |   |            | RetainedEarnings |  |   | TreasuryShares |   |  | Treasury Stock, at Cost |   |  | Total |            
|Balance at August 31, 2002, as reported                 |  | 7,267,750  |  | $                  | 72,678  |                           | $ | 20,278,568 |                  |  | $ | 51,877,878     |   |  | 1,799,203               |   |  | $     | (11,495,637 | ) |  | $ | 60,733,487  |  
|                                                        |  |            |  |                    |         |                           |  
|Retroactive effect of 100% stock dividend June 15, 2005 |  | 4,058,448  |  |                    | 40,584  |                           |   |           |                  |  |   | (15,753,246    | ) |  | (1,604,651              | ) |  |       | 15,712,662  |   |  |   |            |  
|                                                        |  |            |  |                    |         |                           |   |            |                  |  |   |                |   |  |                         |   |  |       |             |   |  |   |             |  
|Balance as of August 31, 2002, as restated              |  | 11,326,198 |  |                    | 113,262 |                           |   | 20,278,568 |                  |  |   | 36,124,632     |   |  | 194,552                 |   |  |       | 4,217,025   |   |  |   | 60,733,487  |  
|                                                        |  |            |  |                    |         |                           |  
|Net Income                                              |  |           |  |                    |        |                           |   |           |                  |  |   | 9,582,242      |   |  |                        |   |  |       |            |   |  |   | 9,582,242   |  
|Purchase of treasury stock                              |  |           |  |                    |        |                           |   |           |                  |  |   |               |   |  | 656,659                 |   |  |       | (9,645,540  | ) |  |   | (9,645,540  | )
|Tax benefit associated with stock options exercised     |  |           |  |                    |        |                           |   | 696,665    |                  |  |   |               |   |  |                        |   |  |       |            |   |  |   | 696,665     |  
|Employee stock purchases                                |  |           |  |                    |        |                           |   | 69,480     |                  |  |   |               |   |  | (10,774                 | ) |  |       | 84,992      |   |  |   | 154,472     |  
|Exercise of stock options:                              |  |            |  |                    |         |                           |   |            |                  |  |   |                |   |  |                         |   |  |       |             |   |  |   |             |  
|Issuance of treasury stock                              |  |           |  |                    |        |                           |   | (69,480    | )                |  |   | (1,544,802     | ) |  | (574,277                | ) |  |       | 4,844,976   |   |  |   | 3,230,694   |  
|Employee surrenders for tax payments                    |  |           |  |                    |        |                           |   |           |                  |  |   |               |   |  | 60,394                  |   |  |       | (960,458    | ) |  |   | (960,458    | )
|                                                        |  |            |  |                    |         |                           |   |            |                  |  |   |                |   |  |                         |   |  |       |             |   |  |   |             |  
|Balance at August 31, 2003                              |  | 11,326,198 |  | $                  | 113,262 |                           | $ | 20,975,233 |                  |  | $ | 44,162,072     |   |  | 326,554                 |   |  | $     | (1,459,005  | ) |  | $ | 63,791,562  |  
|Net Income                                              |  |           |  |                    |        |                           |   |           |                  |  |   | 10,775,188     |   |  |                        |   |  |       |            |   |  |   | 10,775,188  |  
|Purchase of treasury stock                              |  |           |  |                    |        |                           |   |           |                  |  |   |               |   |  | 48,249                  |   |  |       | (1,177,276  | ) |  |   | (1,177,276  | )
|Tax benefit associated with stock options exercised     |  |           |  |                    |        |                           |   | 2,108,654  |                  |  |   |               |   |  |                        |   |  |       |            |   |  |   | 2,108,654   |  
|Employee stock purchases                                |  |           |  |                    |        |                           |   | 99,243     |                  |  |   |               |   |  | (13,887                 | ) |  |       | 129,456     |   |  |   | 228,699     |  
|Exercise of stock options:                              |  |            |  |                    |         |                           |   |            |                  |  |   |                |   |  |                         |   |  |       |             |   |  |   |             |  
|Issuance of treasury stock                              |  |           |  |                    |        |                           |   | (99,243    | )                |  |   | (771,499       | ) |  | (206,181                | ) |  |       | 1,834,870   |   |  |   | 964,128     |  
|Employee surrenders for tax payments                    |  |           |  |                    |        |                           |   |           |                  |  |   |               |   |  | 36,625                  |   |  |       | (866,548    | ) |  |   | (866,548    | )
|                                                        |  |            |  |                    |         |                           |   |            |                  |  |   |                |   |  |                         |   |  |       |             |   |  |   |             |  
|Balance at August 31, 2004                              |  | 11,326,198 |  | $                  | 113,262 |                           | $ | 23,083,887 |                  |  | $ | 54,165,761     |   |  | 191,360                 |   |  | $     | (1,538,503  | ) |  | $ | 75,824,407  |  
|Net Income                                              |  |           |  |                    |        |                           |   |           |                  |  |   | 5,150,532      |   |  |                        |   |  |       |            |   |  |   | 5,150,532   |  
|Follow-on public offering                               |  | 3,450,000  |  |                    | 34,500  |                           |   | 58,397,996 |                  |  |   | (17,250        | ) |  |                        |   |  |       |            |   |  |   | 58,415,246  |  
|Purchase of treasury stock                              |  |           |  |                    |        |                           |   |           |                  |  |   |               |   |  | 9,683                   |   |  |       | (292,523    | ) |  |   | (292,523    | )
|Tax benefit associated with stock options exercised     |  |           |  |                    |        |                           |   | 1,778,325  |                  |  |   |               |   |  |                        |   |  |       |            |   |  |   | 1,778,325   |  
|Employee stock purchases                                |  | 22,660     |  |                    | 227     |                           |   | 376,525    |                  |  |   |               |   |  | (9,352                  | ) |  |       | 89,829      |   |  |   | 466,581     |  
|Exercise of stock options:                              |  |            |  |                    |         |                           |   |            |                  |  |   |                |   |  |                         |   |  |       |             |   |  |   |             |  
|Issuance of shares                                      |  | 107,914    |  |                    | 1,079   |                           |   | 486,468    |                  |  |   |               |   |  |                        |   |  |       |            |   |  |   | 487,547     |  
|Issuance of treasury stock                              |  |           |  |                    |        |                           |   | (102,860   | )                |  |   | (148,871       | ) |  | (197,065                | ) |  |       | 1,903,547   |   |  |   | 1,651,816   |  
|Employee surrenders for tax payments                    |  |           |  |                    |        |                           |   |           |                  |  |   |               |   |  | 13,019                  |   |  |       | (360,585    | ) |  |   | (360,585    | )
|                                                        |  |            |  |                    |         |                           |   |            |                  |  |   |                |   |  |                         |   |  |       |             |   |  |   |             |  
|Balance at August 31, 2005                              |  | 14,906,772 |  | $                  | 149,068 |                           | $ | 84,020,341 |                  |  | $ | 59,150,173     |   |  | 7,645                   |   |  | $     | (198,235    | ) |  | $ | 143,121,347 |  
|                                                        |  |            |  |                    |         |                           |   |            |                  |  |   |                |   |  |                         |   |  |       |             |   |  |   |             |  



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



See accompanying notes to consolidated financial statements.



F-6



---

##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS



|                                                                                                                                 |  |                        |             |   |      |   |              |      |  |   |             |  
|-------------------------------------------------------------------------------------------------------------------------------- |  | ---------------------- | ----------- | - | ---- | - | ------------ | ---- |  | - | ----------- | -
|                                                                                                                                 |  | Years Ended August 31, |            
|                                                                                                                                 |  | 2005                   |             |   | 2004 |   |              | 2003 | 
|Operating activities:                                                                                                            |  |                        |             |   |      |   |              |      |  |   |             |  
|Net income                                                                                                                       |  | $                      | 5,150,532   |   |      | $ | 10,775,188   |      |  | $ | 9,582,242   |  
|Adjustments to reconcile net income to net cash provided by operating activities:                                                |  |                        |             |   |      |   |              |      |  |   |             |  
|Provision for (recovery of) doubtful accounts                                                                                    |  |                        | 4,381,681   |   |      |   | 810,404      |      |  |   | (614,784    | )
|Depreciation and amortization                                                                                                    |  |                        | 3,387,388   |   |      |   | 2,924,667    |      |  |   | 2,581,245   |  
|Deferred income taxes                                                                                                            |  |                        | (4,567,323  | ) |      |   | 1,167,940    |      |  |   | 1,584,896   |  
|Tax benefit associated with stock options exercised                                                                              |  |                        | 1,778,325   |   |      |   | 2,108,654    |      |  |   | 696,665     |  
|Loss on disposal of property and equipment                                                                                       |  |                        | 9,707       |   |      |   |             |      |  |   | (15,250     | )
|Loss on disposal of discontinued operations                                                                                      |  |                        | 4,822,516   |   |      |   |             |      |  |   |            |  
|Net loss on write down of building                                                                                               |  |                        | 1,015,241   |   |      |   |             |      |  |   |            |  
|(Decrease) in minority interest                                                                                                  |  |                        | (15,262     | ) |      |   |             |      |  |   |            |  
|Changes in operating assets and liabilities, net of assets acquired/sold:                                                        |  |                        |             |   |      |   |              |      |  |   |             |  
|(Increase) decrease in accounts receivable                                                                                       |  |                        | (8,250,675  | ) |      |   | (8,077,498   | )    |  |   | 21,883      |  
|(Increase) decrease in income taxes receivable                                                                                   |  |                        | (94,757     | ) |      |   | 502,105      |      |  |   | (327,131    | )
|(Increase) decrease in other receivables                                                                                         |  |                        | (1,401,738  | ) |      |   | 325,591      |      |  |   | (184,220    | )
|(Increase) decrease in prepaid expenses and supplies                                                                             |  |                        | (3,490,229  | ) |      |   | 237,995      |      |  |   | (62,197     | )
|(Increase) in other assets                                                                                                       |  |                        | (243,077    | ) |      |   | (152,334     | )    |  |   | (271,174    | )
|Increase in accounts payable, employee compensation and benefits, medical claims payable, accrued expenses and unearned
revenues |  |                        | 7,492,261   |   |      |   | 1,674,661    |      |  |   | 222,114     |  
|Increase in other non-current liabilities                                                                                        |  |                        | 2,414,344   |   |      |   | 139,718      |      |  |   | 315,040     |  
|                                                                                                                                 |  |                        |             |   |      |   |              |      |  |   |             |  
|Net cash provided by operating activities                                                                                        |  |                        | 12,388,934  |   |      |   | 12,437,091   |      |  |   | 13,529,329  |  
|                                                                                                                                 |  |                        |             |   |      |   |              |      |  |   |             |  
|Investing activities:                                                                                                            |  |                        |             |   |      |   |              |      |  |   |             |  
|Purchases of property and equipment                                                                                              |  |                        | (3,148,685  | ) |      |   | (1,774,529   | )    |  |   | (4,948,302  | )
|Proceeds from sale of property and equipment                                                                                     |  |                        | 8,230       |   |      |   |             |      |  |   | 15,250      |  
|Purchase price adjustment for Choice Health                                                                                      |  |                        | 351,996     |   |      |   |              |      |  |   |             |  
|Payment for Michiana Behavioral Health Center price adjustment                                                                   |  |                        | (11,216     | ) |      |   |             |      |  |   |            |  
|Payment for Poplar Springs Hospital price adjustment                                                                             |  |                        | (423,012    | ) |      |   |             |      |  |   |            |  
|Payment for purchase of Friends Behavioral Health System                                                                         |  |                        | (16,372,198 | ) |      |   |             |      |  |   |            |  
|Payment for purchase of River Park Hospital                                                                                      |  |                        | (11,181,236 | ) |      |   |             |      |  |   |            |  
|Proceeds from sale of ProCare One Nurses                                                                                         |  |                        | 4,200,000   |   |      |   |             |      |  |   |            |  
|Payment for purchase of Michiana Behavioral Health Center                                                                        |  |                        |            |   |      |   | (6,198,221   | )    |  |   |            |  
|Payment for purchase of Poplar Springs Hospital                                                                                  |  |                        |            |   |      |   | (29,650,992  | )    |  |   |            |  
|Payment for purchase of EAP International, net of cash acquired                                                                  |  |                        |            |   |      |   |             |      |  |   | (3,259,870  | )
|Payment for purchase of Integrated Insights, net of cash acquired                                                                |  |                        |            |   |      |   |             |      |  |   | (4,178,489  | )
|Payment for Integrated Insights price adjustment                                                                                 |  |                        |            |   |      |   | (27,290      | )    |  |   |            |  
|                                                                                                                                 |  |                        |             |   |      |   |              |      |  |   |             |  
|Net cash used in investing activities                                                                                            |  |                        | (26,576,121 | ) |      |   | (37,651,032  | )    |  |   | (12,371,411 | )
|                                                                                                                                 |  |                        |             |   |      |   |              |      |  |   |             |  
|Financing activities:                                                                                                            |  |                        |             |   |      |   |              |      |  |   |             |  
|Payments on long-term debt                                                                                                       |  |                        | (91,600,000 | ) |      |   | (111,300,000 | )    |  |   | (72,900,000 | )
|Borrowing under lines of credit                                                                                                  |  |                        | 51,600,000  |   |      |   | 137,300,000  |      |  |   | 76,900,000  |  
|Proceeds from follow-on public offering of common stock                                                                          |  |                        | 58,415,246  |   |      |   |             |      |  |   |            |  
|Cash provided in exercise of Options/Employee Stock Purchase Plan                                                                |  |                        | 2,605,944   |   |      |   | 1,192,827    |      |  |   | 3,385,166   |  
|Purchases of treasury stock                                                                                                      |  |                        | (653,108    | ) |      |   | (2,043,824   | )    |  |   | (10,605,998 | )
|                                                                                                                                 |  |                        |             |   |      |   |              |      |  |   |             |  
|Net cash provided by (used in) financing activities                                                                              |  |                        | 20,368,082  |   |      |   | 25,149,003   |      |  |   | (3,220,832  | )
|                                                                                                                                 |  |                        |             |   |      |   |              |      |  |   |             |  
|Net increase (decrease) in cash and cash equivalents                                                                             |  |                        | 6,180,895   |   |      |   | (64,938      | )    |  |   | (2,062,914  | )
|Cash and cash equivalents at beginning of year                                                                                   |  |                        | 1,907,708   |   |      |   | 1,972,646    |      |  |   | 4,035,560   |  
|                                                                                                                                 |  |                        |             |   |      |   |              |      |  |   |             |  
|Cash and cash equivalents at end of year                                                                                         |  | $                      | 8,088,603   |   |      | $ | 1,907,708    |      |  | $ | 1,972,646   |  
|                                                                                                                                 |  |                        |             |   |      |   |              |      |  |   |             |  
|Supplemental disclosure of cash flow information                                                                                 |  |                        |             |   |      |   |              |      |  |   |             |  
|Net cash paid during the period for:                                                                                             |  |                        |             |   |      |   |              |      |  |   |             |  
|Interest                                                                                                                         |  | $                      | 1,033,257   |   |      | $ | 611,404      |      |  | $ | 397,405     |  
|                                                                                                                                 |  |                        |             |   |      |   |              |      |  |   |             |  
|Income taxes                                                                                                                     |  | $                      | 5,882,619   |   |      | $ | 2,878,691    |      |  | $ | 4,081,932   |  
|                                                                                                                                 |  |                        |             |   |      |   |              |      |  |   |             |  



F-7



---

##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS (Cont.)



|                               |  |          |             |   |          |   |             |          |  |   |            |  
|------------------------------ |  | -------- | ----------- | - | -------- | - | ----------- | -------- |  | - | ---------- | -
|                               |  | 2005 (a) |             |   | 2004 (b) |   |             | 2003 (c) | 
|Non-cash investing activities: |  |          |             |   |          |   |             |          |  |   |            |  
|Fair value of assets acquired  |  | $        | 34,510,410  |   |          | $ | 36,665,805  |          |  | $ | 8,886,432  |  
|Cash paid                      |  |          | (27,553,434 | ) |          |   | (35,849,213 | )        |  |   | (7,641,084 | )
|                               |  |          |             |   |          |   |             |          |  |   |            |  
|Liabilities assumed            |  | $        | 6,956,976   |   |          | $ | 816,592     |          |  | $ | 1,245,348  |  
|                               |  |          |             |   |          |   |             |          |  |   |            |  

---

|(a) | Consists of the purchase of Friends Behavioral Health System effective July 1, 2005 and the purchase of River Park Hospital effective August 1, 2005. See Note 5
Acquisitions elsewhere herein this document.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(b) | Consists of the purchase of Michiana Behavioral Health Center effective April 1, 2004 and the purchase of Poplar Springs Hospital effective June 1, 2004. See Note 5Acquisitions elsewhere herein this document.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(c) | Consists of the purchase of EAP, International effective November 1, 2002 and the purchase of Integrated Insights effective June 30, 2003. See Note 5
Acquisitions elsewhere herein this document.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



See accompanying notes to the consolidated financial statements.



F-8



---

##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

AUGUST 31, 2005, 2004 AND 2003



|1. | ORGANIZATION
|-- | ------------



Horizon Health Corporation (the Company), d/b/a Horizon Health, is a diversified health care services provider. It is a leading contract
manager of clinical and related services, primarily of behavioral health and physical rehabilitation programs, offered by acute care hospitals in the United States. The management contracts are generally for initial terms ranging from three to five
years, the majority of which have automatic renewal provisions. The Company owns/leases and operates five behavioral health care hospitals and related facilities, which provide behavioral health care programs for children, adolescents, and adults.
The Company also offers an array of behavioral healthcare products to corporate clients, government agencies and third party administrators through employee assistance programs.



During fiscal year 2005, the Company offered at-risk managed behavioral health services to 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 healthcare services on an at-risk basis were terminated as a result of the reorganization of
the EAP Services group. See Note 16 EAP Services Reorganization and Related Impairments for additional information.



During fiscal year 2005, the Company offered specialized temporary nurse staffing services to acute care hospitals through ProCare One Nurses. The Company
indicated that it was evaluating various alternatives to this line of business. ProCare One Nurses was sold on August 29, 2005 and the company no longer provides these services. See Note 6 Discontinued Operations for
additional information.



The Company currently has offices in
Denver, Colorado; Richmond, Virginia; and San Diego, California; and behavioral health care facilities in Plymouth, Indiana; Petersburg, Virginia; Willoughby, Ohio; Philadelphia, Pennsylvania; and Huntington, West Virginia. The Companys
National Support Center and EAP Call Center is in the Dallas suburb of Lewisville, Texas.



The Company was formed in July 1989 for the purpose of acquiring all the assets of two companies. One of these companies, known as Horizon Health Management Company, was formed in 1981 and since that time was engaged
in the behavioral health contract management business. The other company owned a freestanding psychiatric hospital in California. Effective March 1, 1990, the assets constituting the contract management business and the psychiatric hospital of
the two companies were transferred to the Company.



Since its
formation, the Company has completed nineteen acquisitions, including the following seven consummated in the last three fiscal years:



| |  |  | Effective August 1, 2005, the Company acquired the assets of River Park Hospital, a 165-bed behavioral health facility located in Huntington, West Virginia, and the stock of an
affiliated management company through a stock purchase agreement. River Park Hospital has been consolidated with the Company since August 1, 2005.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Effective July 1, 2005, the Company formed a joint venture with the Thomas Scattergood Behavioral Health Foundation, a 501(c)(3) charitable organization, and the joint venture
acquired Friends Hospital, a 192-bed behavioral health hospital and a 27-bed adult residential treatment center located in Philadelphia, Pennsylvania. Prior to the acquisition, Friends Hospital was owned by the Thomas Scattergood Behavioral Health
Foundation. Friends Hospital has been consolidated with the Company since July 1, 2005.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Effective January 1, 2005, the Company entered into a long-term operating lease agreement of Laurelwood Hospital, a 160-bed behavioral health hospital located in Willoughby,
Ohio, a suburb of Cleveland.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



F-9



---

##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



| |  |  | Effective June 1, 2004, the Company acquired the assets of PSH Acquisition Corporation (PSH), which operates five behavioral facilities (three owned and two leased)
with a total licensed capacity of 187 beds, in the central Virginia region. The facilities have been consolidated with the Company since June 1, 2004.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Effective April 1, 2004, the Company acquired the assets of Northern Indiana Hospital, an 80-bed behavioral health hospital located in Plymouth, Indiana. The Company operates
the facility under the name Michiana Behavioral Health Center and it has been consolidated with the Company since April 1, 2004.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Effective June 30, 2003, the Company purchased all of the capital stock of privately held Health and Human Resource Center, Inc., d/b/a Integrated Insights. Integrated Insights
has been consolidated with the Company since July 1, 2003.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Effective November 1, 2002, the company purchased all of the capital stock of Employee Assistance Programs International, Inc. (EAP International). EAP
International has been consolidated with the Company since November 1, 2002.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|2. | SIGNIFICANT ACCOUNTING POLICIES AND ESTIMATES
|-- | ---------------------------------------------



The Company continually evaluates its accounting policies and the estimates it uses to prepare the consolidated financial statements. In general, the
estimates are based on historical experience, on information from third party professionals and on various other assumptions that are believed to be reasonable under the facts and circumstances. In the Companys opinion, the significant
accounting policies most important to aid in understanding its financial results are the following:



Consolidation: The consolidated financial statements include those of the Company and its wholly owned and majority owned subsidiaries and one
joint venture in which a controlling interest is held. The joint venture is included in the consolidated financial statements of the Company and the 20% minority interest component is reflected separately before commitments and contingencies in the
balance sheet. Investments in unconsolidated affiliated companies are accounted for on the equity method. All significant intercompany accounts and transactions are eliminated in consolidation.



Cash and Cash Equivalents: Cash and cash equivalents primarily
include highly liquid investments with original maturities of three months or less when purchased. The carrying amount approximates fair value due to the short maturity of these instruments.



Allowances for Doubtful Accounts:The Company maintains
allowances for doubtful accounts for estimated losses that may result from the inability of its customers to make required payments. Allowances are based on the likelihood of recoverability of accounts receivable considering such factors as past
experience and taking into account current collection trends that are expected to continue. Factors taken into consideration in estimating the allowance are amounts past due, in dispute, or a client which the Company believes might be having
financial difficulties. If economic, industry, or specific customer business trends worsen beyond earlier estimates, the Company increases the allowances for doubtful accounts by recording additional expense. Legal fees expended in the pursuit of
the outstanding amounts are considered recovered prior to the reversal of any previously written off bad debt.



The primary collection risk with regard to patient receivables associated with the Companys behavioral health care facilities, lies with uninsured
patient accounts or patient accounts whereby the primary insurance carrier has paid the amounts covered by the applicable agreement, but the portion of the amount that is the patients responsibility (primarily deductibles and co-payments)
remains outstanding. The Company estimates the allowance for doubtful accounts primarily based upon the age of the patients accounts receivable, the patients economic ability to pay and the effectiveness of historical collection efforts. The
Company continually monitors its accounts receivable balances and utilizes cash collection data to support its estimates of the provision for doubtful accounts. Significant changes in payor mix or business office operations could have a significant
impact on the Companys results of operations and cash flows.



F-10



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##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Allowances for Contractual Discounts:With regard to the Companys owned behavioral health care facilities, the Medicare and Medicaid
regulations are complex and various managed care contracts may include multiple reimbursement mechanisms for different types of services provided and cost settlement provisions requiring complex calculations and assumptions subject to
interpretation. The Company estimates the allowance for contractual discounts on a payor-specific basis given its interpretation of the applicable regulations or contract terms. The services authorized and provided and related reimbursements are
often subject to interpretation that could result in payments that differ from the Companys estimates in the near term. Additionally, updated regulations and contract renegotiations occur frequently necessitating continual review and
assessment of the estimation process by management. Contractual discounts are reported as deductions from patient service revenue at the time the service is rendered.



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



Accounting for Intangible Assets and Goodwill: The cost of acquired companies is allocated first to their
identifiable assets based on estimated fair values, and then to goodwill. Costs allocated to identifiable intangible assets are generally amortized on a straight-line basis over the remaining estimated useful lives of the assets. The excess of the
purchase price over the fair value of identifiable assets acquired, net of liabilities assumed, is recorded as goodwill. The Companys identifiable intangible assets, which are subject to amortization, consist of contracts, consulting
agreements and non-compete agreements. The Companys indefinite life intangible assets, which are not subject to amortization, include a Knox-Keene license (to operate as a specialized healthcare plan in California), trade names, and a
Certificate of Need. The Company follows the requirements of Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. (SFAS) 141 Business Combinations (SFAS 141) and SFAS
142 Goodwill and Other Intangible Assets (SFAS 142). SFAS 141 addresses the initial recognition and measurement of goodwill and other intangible assets acquired in a business combination. SFAS 142 addresses the initial recognition
and measurement of intangible assets acquired outside of a business combination, whether acquired individually or with a group of other assets, and the accounting and reporting for goodwill and other intangibles subsequent to their acquisition.
These standards require all future business combinations be accounted for using the purchase method of accounting and that goodwill and certain indefinite life intangible assets not be amortized, but instead to be subject to impairment tests at
least annually. See Note 11 Goodwill and Other Intangible Assets for additional information regarding these assets.



Accounting for intangible assets and goodwill requires significant estimates and judgment, especially as to: a) the valuation in connection with the
initial purchase price allocation and b) the ongoing evaluation for impairment. For each acquisition, a valuation was completed to determine a reasonable purchase price allocation. Upon completion of the allocation process an amount was assigned to
various identified assets including intangible assets and the remainder was assigned to goodwill. The purchase price allocation process requires estimates and judgments as to expectations for the various businesses and business strategies. For
example, certain growth rates were assumed for each business. Additionally, different operating margins for each type of service offering were included in the estimates. If actual growth rates or operating margins, among other assumptions, differ
significantly from the estimate and judgments used in the purchase price allocation, a possible impairment of the intangible assets and/or goodwill or an acceleration in amortization expense may result.



F-11



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##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



In addition, SFAS 142, Goodwill and Other Intangible Assets (SFAS 142), discontinued the amortization of goodwill and generally
requires that goodwill impairment be tested annually using 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 a one-step process that compares the fair value to the carrying amount of the asset. Because of the significance of the identified intangible assets and goodwill to the Companys consolidated balance sheet,
annual or interim impairment analyses are important. Changes in key assumptions about the business and its prospects, or changes in market conditions or other external factors, could result in an impairment charge and such a charge could have a
material adverse effect on the Companys financial condition and results of operations.



Contracts represent the fair value of management contracts and service contracts purchased and are being amortized using the straight-line method over seven years. Other intangibles primarily include the fair value of
trade names and non-compete agreements, which are being amortized over their expected useful lives.



Treasury Stock:The Company accounts for treasury stock using the cost method. Gains on sales of treasury stock are credited to Additional Paid in
Capital (APIC), losses are charged to APIC to the extent that previous net gains from sales are included therein, otherwise to retained earnings.



Medical Claims: Medical claims payable represent the liability for healthcare claims reported but not yet paid and claims incurred but not yet
reported (IBNR) related to the Companys managed behavioral healthcare business. The IBNR portion of medical claims payable is estimated based upon authorized healthcare services, past claims payment experience for member groups,
enrollment data, utilization statistics and other factors using both accounting and actuarial methodologies. Although variability is inherent in such estimates, management believes the recorded liability for medical claims payable is adequate.
Medical claim payable balances are continually monitored and reviewed. Changes in assumptions for care costs caused by changes in actual or expected utilization experience could cause these estimates to change significantly.



Employee Health and Workers Compensation Benefits: The Company
retains a significant amount of self-insurance risk for its employee health and workers compensation benefits. The Company maintains stop-loss insurance such that the Companys liability is subject to certain individual and aggregate limits, as
applicable. Each month end the Company records an accrued expense for estimated benefit claims incurred but unpaid or not reported at the end of such period. The Company estimates this accrual based on a number of factors including historical
experience, industry trends and recent claims history. These accrual estimates are subject to ongoing revision as conditions might change and as new data may be presented. Adjustments to estimated liabilities are recorded in the accounting period in
which the change in estimate occurs. Changes in assumptions for costs caused by changes in actual or expected utilization experience could cause these estimates to change significantly. In prior years, estimates of workers compensation claims
liability was allocated (based on payroll dollars) to the operating unit level. Effective September 1, 2003, the Company began recording these estimates at the general and administrative level with actual paid claims costs being recorded to the
applicable operating unit.



Self-Insurance:Pursuant to
various deductibles and retentions, the Company is self-insured for certain losses for general and professional liability claims and up to certain individual and aggregate stop losses relating to malpractice liability claims. Self-insurance claims
filed and claims incurred but not reported are accrued based upon managements estimates of the aggregate liability for uninsured claims incurred using actuarial assumptions followed in the insurance industry and historical experience. Although
management believes it has the ability to adequately estimate losses related to claims, it is possible that actual results could differ from recorded self-insurance liabilities.



F-12



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##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Revenue Recognition:Service revenue is generated by the Companys four business segments (service groups), which were in
operation during fiscal year 2005, in the following categories:



| | (1) | Contract management revenue, generated by two of Horizon Healths service groups, Behavioral Health Contract Management Services and Physical Rehabilitation Contract Management
Services, is reported in the period the services are provided at the estimated net realizable amounts from contracted acute care hospitals for contract management services rendered. Adjustments are accrued on an estimated basis in the period they
become known and are adjusted in future periods, if and when necessary.
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



Some management
contracts include a clause, which states that the Company will indemnify the hospital for any third-party payor denials, including Medicare. At the time the charges are denied or anticipated to be denied, the Company records an allowance for 100% of
the potential amount. The Company believes it has adequately provided for potential adjustments that may result from final settlement of potential denials, which amounts have historically not been material.



Client acute care hospitals receive reimbursement under Medicare or Medicaid
programs or payments from insurers, self-funded benefit plans or other third-party payors for the behavioral health and physical rehabilitation services provided to the patients of the programs managed by the Company. As a result, the availability
and amount of such reimbursements, which are subject to change, may impact the decision of acute care hospitals regarding whether to offer behavioral health and physical rehabilitation services pursuant to management contract with the Company, as
well as whether to continue such contracts (subject to contract termination provisions) and the amount of fees to be paid thereunder.



| | (2) | Net patient service revenue, generated by the Companys Behavioral Health Hospital Services group, is recorded on the accrual basis in the period in which services are
provided. Net patient service revenue includes amounts estimated by management to be reimbursable by Medicare, Medicaid and other payors under provisions of cost or prospective reimbursement formulas in effect. Amounts received are generally less
than the established billing rates and the differences (contractual discounts) are reported as deductions from patient service revenue at the time the service is rendered. The effects of other arrangements for providing services at less than
established rates are also reported as deductions from patient service revenue.
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



Settlements under cost reimbursement agreements with third-party payors are estimated and recorded in the period in which the related services are rendered and are adjusted in future periods as final settlements are
determined. Final determination of amounts earned under the Medicare and Medicaid and other third-party payor programs often occur in subsequent years because of audits by the programs, rights of appeal, and the application of numerous technical
provisions. Settlements are considered in the recognition of net patient service revenue on an estimated basis



F-13



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##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



in the period the related services are rendered, and such amounts are subsequently adjusted in future periods as adjustments become known or as years are
no longer subject to such audits, review or investigations.



Final determination of amounts earned under prospective payment and cost-reimbursement activities is subject 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 such reviews.



| | (3) | Premium and fees revenue, generated by the Horizon Health EAP Services group, is reported in the period services are provided at the estimated net realizable amounts as defined by
client contracts for services rendered. Adjustments are accrued on an estimated basis in the period they become known and are adjusted in future periods if and when necessary.
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Revenues are derived from EAP services, administrative service only
contracts, and at-risk managed behavioral health services. The at-risk managed behavioral health service contracts were all terminated as of August 31, 2005. This revenue consists primarily of capitation payments, which are calculated on the
basis of a per-member/per-month or a per-employee/per-month fee, but also include fee for service payments. For the at-risk managed behavioral health services contracts, the Company is at-risk and bears the economic risk as to the
adequacy of capitated revenue versus the actual cost of behavioral health care services provided to covered members by third parties.



Discontinued Operations: In accordance with the provisions of SFAS No.144, Accounting for the Impairment or Disposal of Long-Lived Asset,
the results of operations of the disposed assets and the losses related to the divestiture of ProCare One Nurses, LLC on August 29, 2005, have been classified as discontinued operations for all periods presented in the accompanying consolidated
statements of operations. See Note 6 Discontinued Operations.



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



Accounting for Income Taxes:The Company accounts for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes, which requires that deferred tax assets and liabilities be
recognized using enacted tax rates for the effect of temporary differences between the book and tax basis of recorded assets and liabilities. SFAS No. 109 also requires that deferred tax assets be reduced by a valuation allowance if it is more
likely than not that some portion or all of the deferred tax assets will not be realized. (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 is more likely than not
that its deferred tax assets will be realized, resulting in no valuation allowance.



The Company evaluates quarterly the realizability of its deferred tax assets and accordingly adjusts its valuation allowance, if any as necessary. The factors used to assess the likelihood of realization include the
Companys estimates of future taxable income and available tax initiatives that could be reasonably implemented to assure realization of the net deferred tax assets. The Company has used various appropriate tax initiatives and alternative tax
treatments to realize or to renew net deferred tax assets in order to avoid the potential loss of tax benefits.



F-14



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##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Failure to achieve forecasted taxable income amounts might affect the ultimate realization of all or portions of net deferred tax assets. Factors that may
affect the Companys ability to achieve sufficient forecasted taxable income include general business conditions, increased competition, a change in Medicare or Medicare reimbursement, an increase in medical services utilization, etc.,
resulting in a decline in sales or margins.



Use of
Estimates: The preparation of these financial statements requires the use of estimates, judgments and assumptions that affect the reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities at the date of
the financial statements and the amounts of revenues and expenses recorded for the reporting periods in order to prepare the financial statements in conformity with generally accepted accounting principles. Management makes such estimates, for
example, in the allowance for doubtful accounts, allowance for contractual discounts, medical claims, general and professional liability claims, employee health and workers compensation benefits, etc. Future actual results experienced by the Company
could differ from those estimates.



Reclassifications:
Certain prior year amounts have been reclassified to conform to the current year presentation.



For all periods presented, Stockholders Equity reflects a retroactive reclassification between common stock, retained earnings and
treasury stock as a result of the June 15, 2005 two-for-one stock split.



In February 2005, a reclassification was made from selling, general and administrative expense to interest expense for costs related to the Companys existing credit facility. The costs
included the amortization of capitalized costs, unused commitment fees, and the annual administrative fee. For comparative purposes, prior year balances were also reclassified.



In accordance with FASB Statement No.5, Accounting for Contingencies and further, pursuant to FASB Interpretation 39,
Offsetting of Amounts Related to Certain Contracts, the Company records liabilities for estimated losses at the gross amount of expected claims and records corresponding receivables related to amounts expected to be received for claims
exceeding applicable deductible or stop-loss limits. The Company has reclassified the balance sheet at August 31, 2004 related to these expected claims and receivables, which has resulted in an increase in Other Receivables and
Accrued Expenses and Unearned Revenue of approximately $810,000.



New Accounting Standards



In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20, Accounting Changes, and SFAS No. 3, Reporting Accounting Changes in Interim
Financial Statements. The standard changes the requirements for accounting for and reporting of a voluntary change in accounting principle requiring a retrospective application to prior periods financial statements of the change in
principle unless it is impracticable rather than the recording of a cumulative effect of the change in accounting principle in net income in the year of change. The standard is effective for accounting changes and corrections of errors made in
fiscal years beginning after December 15, 2005.



In March
2005, the FASB issued FIN 47, Accounting for Conditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143 (FIN 47), which requires an entity to recognize a liability for the fair value of a
conditional asset retirement obligation when incurred if the liabilitys fair value can be reasonably estimated. FIN 47 is effective for fiscal years ending after December 15, 2005. The Company does not expect the adoption of
FIN 47 to have a material impact on its financial statements.



F-15



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##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



In December 2004, FASB issued revised Financial Accounting Standards No. (SFAS) 123R, Share-Based Payment. This statement amends SFAS
123, Accounting for Stock-Based Compensation. The statement eliminates the alternative to use APB Opinion No. 25, Accounting for Stock Issued to Employees that was provided in SFAS 123 as previously issued. SFAS 123R requires
entities to recognize the cost of employee services received in exchange for awards of equity instruments based on the grant-date fair value of those awards. The statement is effective as of the beginning of the first annual reporting period that
begins after June 15, 2005. This statement will be effective for the Company for its fiscal year ending August 31, 2006.



|3. | STOCK OPTIONS AND OTHER STOCK AWARDS
|-- | ------------------------------------



On January 21, 2005, the stockholders of the Company approved the Horizon Health Corporation 2005 Omnibus Incentive Plan (the Plan), as
detailed in the current report on Form 8-K filed January 21, 2005 and incorporated by reference herein. Under the plan, performance based awards, including stock options and restricted stock, may be granted from time to time as approved by the
Compensation Committee of the Board of Directors. The maximum number of new shares of Common Stock that can be issued under the Plan is 600,000.



As of August 31, 2005, 15,000 shares have been reserved for stock options awarded under the Plan and 1,500 shares have been rewarded as restricted
stock. In addition, certain executives were awarded deferred incentive bonuses for fiscal year 2005. These bonuses are based on the attainment of the corporate performance target for fiscal year 2005 and vest ratably over four years. The performance
target was attained for fiscal year 2005 and these bonuses will be paid 50% in restricted common stock and 50% in cash in four equal installments, in the first fiscal quarter of fiscal years 2006 through 2009. The payment of each installment is
subject to continued employment with the Company.



The 1989,
1995 and 1998 Stock Option Plans for employees and the 1995 Stock Option Plan for Eligible Outside Directors are collectively referred to as the Prior Plans. The 1989 Plan has terminated in accordance with its terms and no further stock
options may be granted under this plan. Upon approval of the 2005 Omnibus Incentive Plan, the remaining Prior Plans were terminated except with respect to stock options previously granted and outstanding under the Prior Plans
and no further stock options may be granted under those plans. As of August 31, 2005, there were outstanding stock options for 1,313,718 shares that had been granted under the prior plans. Future grants of stock options may be made only under
the 2005 Omnibus Incentive Plan.



The exercise prices of the
options granted, equaled or exceeded the market value of the common stock at the date of the grant. The options generally vest ratably over five years from the date of grant and terminate ten years from the date of grant. The restricted stock vests
ratably over five years from the date of grant.



The following
table summarizes the status of the Plans:



|                                   |  |           |   |      |                               |       |         |           |   |                               |   |         |  |            |                               |  |   |     
|---------------------------------- |  | --------- | - | ---- | ----------------------------- | ----- | ------- | --------- | - | ----------------------------- | - | ------- |  | ---------- | ----------------------------- |  | - | ----
|                                   |  | 2005      |   | 2004 |                               | 2003 
|                                   |  | Options   |   |      | WeightedAverageExercise Price |       | Options |           |   | WeightedAverageExercise Price |   | Options |  |            | WeightedAverageExercise Price
|Outstanding at beginning of year   |  | 1,793,162 |   |      | $                             | 7.16  |         | 1,679,524 |   |                               | $ | 4.69    |  | 2,907,098  |                               |  | $ | 3.75
|Granted                            |  | 115,000   |   |      |                               | 13.73 |         | 575,200   |   |                               |   | 10.84   |  | 306,000    |                               |  |   | 8.25
|Exercised                          |  | (502,044  | ) |      |                               | 4.26  |         | (412,362  | ) |                               |   | 2.34    |  | (1,148,554 | )                             |  |   | 2.82
|Expired or canceled                |  | (77,400   | ) |      |                               | 8.68  |         | (49,200   | ) |                               |   | 6.19    |  | (385,020   | )                             |  |   | 5.99
|                                   |  |           |   |      |                               |      
|Outstanding at end of year         |  | 1,328,718 |   |      |                               | 8.73  |         | 1,793,162 |   |                               |   | 7.16    |  | 1,679,524  |                               |  |   | 4.69
|                                   |  |           |   |      |                               |      
|Exercisable at end of year         |  | 592,418   |   |      |                               | 6.88  |         | 787,958   |   |                               |   | 4.91    |  | 827,714    |                               |  |   | 3.18
|                                   |  |           |   |      |                               |      
|Available for grant at end of year |  | 583,500   |   |      |                               |       |         | 240,136   |   |                               |   |         |  | 689,180    |                               |  |   |     



F-16



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##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



The following table summarizes information about options outstanding under the Plans at August 31, 2005:



|                        |  |                     |  |                                         |  |                              |       |                   |         |                              |   |      
|----------------------- |  | ------------------- |  | --------------------------------------- |  | ---------------------------- | ----- | ----------------- | ------- | ---------------------------- | - | -----
|                        |  | Options Outstanding |  | Options Exercisable                    
|Range of Exercise Price |  | NumberOutstanding   |  | WeightedAverageRemainingContractualLife |  | WeightedAverageExercisePrice |       | NumberOutstanding |         | WeightedAverageExercisePrice
|$      2.28  7.20      |  | 342,718             |  | 4.72                                    |  | $                            | 4.35  |                   | 249,418 |                              | $ | 4.07 
|7.26  8.56             |  | 357,600             |  | 7.42                                    |  |                              | 8.13  |                   | 279,920 |                              |   | 8.27 
|9.22  11.03            |  | 168,200             |  | 8.38                                    |  |                              | 9.98  |                   | 19,000  |                              |   | 10.05
|11.35  16.10           |  | 460,200             |  | 8.60                                    |  |                              | 12.01 |                   | 44,080  |                              |   | 12.66



The Company accounts
for these plans under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees and related interpretations. No stock-based employee compensation cost is reflected in net income, as all
options granted under those plans had an exercise price equal to or greater than the market value of the underlying common stock on the date of grant.



FASB Statement No. 123,Accounting for Stock-Based Compensation, as amended by SFAS 123R, requires the expensing of Employee Stock Options
(ESOs) for annual reporting periods beginning after June 15, 2005. Accordingly, the Company will adopt this standard effective with its fiscal year beginning September 1, 2005.



The following table illustrates the effect on net income and earnings per
share of the Company had the Company applied the fair value recognition provisions of FASB Statement No. 123, as amended by SFAS 123R, relating to stock-based employee compensation.



In applying FASB Statement 123, as amended by SFAS 123R, the Company has reviewed various assumptions made within the
Black-Scholes options pricing model, which was designed to value short-term traded options, and determined that the model be adjusted to allow for differences applicable to employee stock options from the attributes of the short-term traded options.
The adjustments reflect a change to the expected life of the employee stock options as opposed to the historical option term of previously issued options, which was utilized in prior period calculations. In addition, the Company is now incorporating
estimated forfeitures in its calculations. The prior year amounts have not been restated for the change in assumptions, however, all number of shares and per share amounts have been changed to reflect the impact of the June 15, 2005 two-for-one
stock split.



|                                                                                                                                            |  |      |           |      |   |            |  |   |          
|------------------------------------------------------------------------------------------------------------------------------------------- |  | ---- | --------- | ---- | - | ---------- |  | - | ---------
|                                                                                                                                            |  | 2005 |           | 2004 |   | 2003      
|Net Income, as reported                                                                                                                     |  | $    | 5,150,532 |      | $ | 10,775,188 |  | $ | 9,582,242
|Deduct: Total Stock-based employee compensation expense determined under fair value based method for all awards, net of related tax
effects |  |      | 735,201   |      |   | 826,341    |  |   | 440,405  
|                                                                                                                                            |  |      |           |      |   |            |  |   |          
|Pro forma net income                                                                                                                        |  | $    | 4,415,331 |      | $ | 9,948,847  |  | $ | 9,141,837
|Earnings per share:                                                                                                                         |  |      |           |      |   |            |  |   |          
|Basic                                                                                                                                       |  |      |           |      |   |            |  |   |          
|As reported                                                                                                                                 |  | $    | 0.40      |      | $ | 0.99       |  | $ | 0.91     
|Pro forma                                                                                                                                   |  | $    | 0.34      |      | $ | 0.92       |  | $ | 0.87     
|Diluted                                                                                                                                     |  |      |           |      |   |            |  |   |          
|As reported                                                                                                                                 |  | $    | 0.39      |      | $ | 0.95       |  | $ | 0.85     
|Pro forma                                                                                                                                   |  | $    | 0.33      |      | $ | 0.88       |  | $ | 0.81     



F-17



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##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



In accordance with SFAS 123, the fair value of options at date of grant was estimated using the Black-Scholes option-pricing model with the following
weighted average assumptions:



|                        |  |      |   |  |      |   |  |      |  
|----------------------- |  | ---- | - |  | ---- | - |  | ---- | -
|                        |  | 2005 |   |  | 2004 |   |  | 2003 |  
|Risk free interest rate |  | 3.91 | % |  | 4.09 | % |  | 2.75 | %
|Expected life (years)   |  | 6.4  |   |  | 7.3  |   |  | 6.4  |  
|Expected volatility     |  | 50.7 | % |  | 52.0 | % |  | 60.0 | %
|Expected dividend yield |  | 0.0  | % |  | 0.0  | % |  | 0.0  | %



In accordance with
SFAS 123, the weighted average fair value of options granted during 2005, 2004, and 2003 was $6.32, $6.39, and $4.88 respectively.



|4. | EARNINGS PER SHARE
|-- | ------------------



The following is a reconciliation of the numerators and the denominators of the basic and diluted earnings per share computations for net income for the
years ended August 31:



|                              |  |                     |            |   |                   |            |                |   |       |                     |  |                      |            |                   |            |                     |   |                      |  |                   |           |  |            |  |   |     
|----------------------------- |  | ------------------- | ---------- | - | ----------------- | ---------- | -------------- | - | ----- | ------------------- |  | -------------------- | ---------- | ----------------- | ---------- | ------------------- | - | -------------------- |  | ----------------- | --------- |  | ---------- |  | - | ----
|                              |  | 2005                |            |   | 2004              |            | 2003          
|                              |  | Net IncomeNumerator |            |   | SharesDenominator |            | PerShareAmount |   |       | Net IncomeNumerator |  | SharesDenominator(1) |            | PerShareAmount(1) |            | Net IncomeNumerator |   | SharesDenominator(1) |  | PerShareAmount(1)
|Continuing Operations:        |  |                     |            |   |                   |            |                |   |       |                     |  |                      |            |                   |            |                     |   |                      |  |                   |           |  |            |  |   |     
|Basic EPS                     |  | $                   | 8,741,093  |   |                   | 12,829,141 |                | $ | 0.68  |                     |  | $                    | 10,213,246 |                   | 10,848,866 |                     | $ | 0.94                 |  | $                 | 8,721,612 |  | 10,499,561 |  | $ | 0.83
|                              |  |                     |            |   |                   |            |                |   |       |                     |  |                      |            |                   |            |                     |   |                      |  |                   |           |  |            |  |   |     
|Effect of dilutive securities |  |                     |            |   |                   |            |                |   |       |                     |  |                      |            |                   |            |                     |   |                      |  |                   |           |  |            |  |   |     
|warrant and options           |  |                     |            |   |                   | 477,303    |                |   |       |                     |  |                      |            |                   | 497,135    |                     |   |                      |  |                   |           |  | 783,675    |  |   |     
|                              |  |                     |            |   |                   |            |                |   |       |                     |  |                      |            |                   |            |                     |   |                      |  |                   |           |  |            |  |   |     
|Diluted EPS                   |  | $                   | 8,741,093  |   |                   | 13,306,444 |                | $ | 0.66  |                     |  | $                    | 10,213,246 |                   | 11,346,001 |                     | $ | 0.90                 |  | $                 | 8,721,612 |  | 11,283,236 |  | $ | 0.77
|                              |  |                     |            |   |                   |            |                |   |       |                     |  |                      |            |                   |            |                     |   |                      |  |                   |           |  |            |  |   |     
|Discontinued Operations:      |  |                     |            |   |                   |            |                |   |       |                     |  |                      |            |                   |            |                     |   |                      |  |                   |           |  |            |  |   |     
|Basic EPS                     |  | $                   | (3,590,561 | ) |                   | 12,829,141 |                | $ | (0.28 | )                   |  | $                    | 561,942    |                   | 10,848,866 |                     | $ | 0.05                 |  | $                 | 860,630   |  | 10,499,561 |  | $ | 0.08
|                              |  |                     |            |   |                   |            |                |   |       |                     |  |                      |            |                   |            |                     |   |                      |  |                   |           |  |            |  |   |     
|Effect of dilutive securities |  |                     |            |   |                   |            |                |   |       |                     |  |                      |            |                   |            |                     |   |                      |  |                   |           |  |            |  |   |     
|warrant and options           |  |                     |            |   |                   | 477,303    |                |   |       |                     |  |                      |            |                   | 497,135    |                     |   |                      |  |                   |           |  | 783,675    |  |   |     
|                              |  |                     |            |   |                   |            |                |   |       |                     |  |                      |            |                   |            |                     |   |                      |  |                   |           |  |            |  |   |     
|Diluted EPS                   |  | $                   | (3,590,561 | ) |                   | 13,306,444 |                | $ | (0.27 | )                   |  | $                    | 561,942    |                   | 11,346,001 |                     | $ | 0.05                 |  | $                 | 860,630   |  | 11,283,236 |  | $ | 0.08
|                              |  |                     |            |   |                   |            |                |   |       |                     |  |                      |            |                   |            |                     |   |                      |  |                   |           |  |            |  |   |     
|Total:                        |  |                     |            |   |                   |            |                |   |       |                     |  |                      |            |                   |            |                     |   |                      |  |                   |           |  |            |  |   |     
|Basic EPS                     |  | $                   | 5,150,532  |   |                   | 12,829,141 |                | $ | 0.40  |                     |  | $                    | 10,775,188 |                   | 10,848,866 |                     | $ | 0.99                 |  | $                 | 9,582,242 |  | 10,499,561 |  | $ | 0.91
|                              |  |                     |            |   |                   |            |                |   |       |                     |  |                      |            |                   |            |                     |   |                      |  |                   |           |  |            |  |   |     
|Effect of dilutive securities |  |                     |            |   |                   |            |                |   |       |                     |  |                      |            |                   |            |                     |   |                      |  |                   |           |  |            |  |   |     
|warrant and options           |  |                     |            |   |                   | 477,303    |                |   |       |                     |  |                      |            |                   | 497,135    |                     |   |                      |  |                   |           |  | 783,675    |  |   |     
|                              |  |                     |            |   |                   |            |                |   |       |                     |  |                      |            |                   |            |                     |   |                      |  |                   |           |  |            |  |   |     
|Diluted EPS                   |  | $                   | 5,150,532  |   |                   | 13,306,444 |                | $ | 0.39  |                     |  | $                    | 10,775,188 |                   | 11,346,001 |                     | $ | 0.95                 |  | $                 | 9,582,242 |  | 11,283,236 |  | $ | 0.85
|                              |  |                     |            |   |                   |            |                |   |       |                     |  |                      |            |                   |            |                     |   |                      |  |                   |           |  |            |  |   |     

---

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



F-18



---

##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



During 2005, 2004, and 2003 certain options to acquire common stock were not included in certain computations of EPS because the options exercise price
was greater than the average market price of the common shares. The options excluded by quarter are as follows:



|                  |  |                  |  |                   
|----------------- |  | ---------------- |  | ------------------
|Quarter Ended     |  | Options Excluded |  | Option Price Range
|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   
|August 31, 2003   |  | 213,000          |  | $8.51 - $11.88    
|May 31, 2003      |  | 110,880          |  | $8.03 - $11.88    
|February 28, 2003 |  | 13,000           |  | $8.18 - $11.88    
|November 30, 2002 |  | 193,400          |  | $7.26 - $11.88    



|5. | ACQUISITIONS AND ENTRY INTO A LONG-TERM OPERATING LEASE AGREEMENT
|-- | -----------------------------------------------------------------



River Park Hospital



On August 1, 2005, the Company acquired substantially all the assets of River Park Hospital located in Huntington, West Virginia, pursuant to an
Asset Purchase Agreement dated June 9, 2005, and purchased the stock of an affiliated management company through a Stock Purchase Agreement of the same date. The Company paid approximately $11.0 million in cash, which was paid out of available
funds and no debt was incurred by the Company as a part of the transaction. The agreement also provides for additional variable payments in future years based on the future performance of the hospital. The Company accounted for the acquisition by
the purchase method as required by generally accepted accounting principles. As of August 31, 2005, tangible assets acquired and liabilities assumed totaled $7,037,000 and $391,347, respectively. The purchase price of approximately $11.0
million exceeded the fair value of net tangible assets by $4,314,472 of which $750,472 is recorded as goodwill, $1,225,000 is assigned to the value of the contracts and $2,339,000 is recorded as the value of certain indefinite life assets. The
indefinite life assets are comprised of a Certificate of Need with an assigned value of $2,185,000 and a trade name with an assigned value of at $154,000. River Park Hospital is a 165-bed behavioral health facility offering programs for adults,
adolescents, children and families. Proforma financial data is not presented because the impact of this acquisition is not material 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 Behavioral Health Foundation, a 501(c)(3) charitable organization and the joint venture acquired Friends Hospital located in Philadelphia, Pennsylvania. Prior to the acquisition, Friends hospital was owned by the Thomas Scattergood
Behavioral Health Foundation. Horizon is an 80% member of the joint venture and the Thomas Scattergood Behavioral Health Foundation, is a 20% member of the joint venture. The agreement requires the joint venture to expend at least $5,500,000 in the
first five operating years of the joint venture on capital expenditures related to Friends Hospital. The Company contributed approximately $15.5 million in cash to the joint venture which funds were used for the acquisition of the hospital by the
joint venture. The contribution was paid out of available funds and no debt was incurred by the Company as a part of the transaction. The Company accounted for the acquisition by the purchase method as required by generally accepted accounting
principles. As of August 31, 2005, the joint ventures tangible assets acquired and liabilities assumed totaled $21,664,204 and $2,685,342, respectively. In addition, a certain indefinite life asset, a trade name, in the amount of $422,651
was identified and recorded as a result of the transaction. The joint venture is included in



F-19



---

##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



the consolidated financial statements of the Company and the 20% minority interest of $3,865,045 is reflected separately at August 31, 2005. Friends
Hospital consists of a 192-bed behavioral health hospital and a 27-bed adult residential treatment center. Proforma financial data is not presented because the impact of this acquisition is not material to the Companys results of operations
for any period presented.



Laurelwood Hospital



On December 30, 2004, the Company entered into a
long-term operating lease agreement of Laurelwood Hospital, a 160-bed psychiatric hospital located in Willoughby, Ohio, a suburb of Cleveland. The hospital was leased from Lake Hospital System, Inc. Lake Hospital System, Inc. is a non-profit health
care provider operating two hospitals and other health care facilities in Lake County, Ohio. The lease term commenced on January 1, 2005 and has an initial fifteen (15) year term that expires on December 31, 2019. The Company also has
an option to extend the lease for an additional fifteen-year term. Rent under the lease during the initial lease term consists of quarterly rental payments of $200,433 payable in advance on the first day of January, April, July and October. In
addition, the Company agreed to make a contribution to the Lake Hospital Foundation in the amount of $41,666 on December 31, 2007 and each December 31st thereafter to and including December 31, 2012. Proforma financial data is not
presented because the impact of this acquisition is not material to the Companys results of operations for any period presented.



PSH Acquisition Corporation



Effective June 1, 2004, the Company acquired the assets of PSH Acquisition Corporation (PSH), which operated five behavioral facilities
with a total licensed capacity of 187 beds, in the central Virginia region, for approximately $30.1 million. The agreement also provides for additional variable payments in future years based on the future performance of the facilities. The Company
accounted for the acquisition by the purchase method as required by generally accepted accounting principles. As of August 31, 2005, tangible assets acquired and liabilities assumed totaled $16,507,815 and $626,776, respectively. The purchase
price of approximately $30.1 million exceeded the fair value of PSHs net tangible assets by $14,192,964 of which $13,863,964 is recorded as goodwill, and $329,000 is recorded as the value of certain indefinite life assets. The net increase in
goodwill of $94,014 during the fiscal year ended August 31, 2005, includes an additional variable payment of $380,841 as required by the purchase agreement, a $329,000 reclassification from goodwill to indefinite life assets and additional
acquisition costs of $42,173 that were capitalized. The cash purchase price was funded under the Companys revolving credit facility. The three owned and two leased facilities include:



| |  |  | Poplar Springs Hospital - a 132 bed acute adult and adolescent facility that also offers residential treatment services;
| | - |  | ------------------------------------------------------------------------------------------------------------------------



| |  |  | Poplar West  a 36-bed Youth Development Center that offers residential treatment care and a 60-student special educational program;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Poplar Place of Sutherland  an 8-bed adolescent boys group home;
| | - |  | -----------------------------------------------------------------



| |  |  | Poplar Transitions of Shenandoah Valley  a 11-bed female adolescent residential care facility (leased); and
| | - |  | ------------------------------------------------------------------------------------------------------------



| |  |  | Recovery Center of Richmond  an intensive adolescent and adult outpatient service center (leased).
| | - |  | ---------------------------------------------------------------------------------------------------



Unaudited pro-forma information is presented for illustrative purposes only and is not necessarily indicative of the
financial position or results of operations that would have actually been reported had the acquisition occurred at the beginning of the periods presented, nor is it necessarily indicative of future financial position or results of operations. The
unaudited pro-forma financial information with respect to the PSH Acquisition Corporation acquisition was based upon the respective historical consolidated financial statements of Horizon Health Corporation and PSH Acquisition Corporation. This
unaudited pro forma information does not include nor does it assume any benefits from cost savings or synergies of operations of the combined companies. Proforma financial data is not presented because the impact of this acquisition is not material
to the Companys results of operations for any period presented.



F-20



---

##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



The following unaudited pro forma financial information gives effect to the acquisition of PSH Acquisition Corporation by the Company as if the
acquisition occurred on September 1, 2003.



|                             |  |                               |            
|---------------------------- |  | ----------------------------- | -----------
|                             |  | The Year EndedAugust 31, 2004
|                             |  |                               |            
|Revenue                      |  | $                             | 177,078,457
|                             |  |                               |            
|Net Income                   |  | $                             | 11,390,611 
|                             |  |                               |            
|Net Income per common share: |  |                               |            
|                             | 
|Basic                        |  | $                             | 1.05       
|                             |  |                               |            
|Diluted                      |  | $                             | 1.00       
|                             |  |                               |            



Michiana
Behavioral Health Center



Effective April 1,
2004, the Company acquired the assets of Northern Indiana Hospital, an 80-bed behavioral health hospital located in Plymouth, Indiana for approximately $6.2 million. The Company operates the facility under the name Michiana Behavioral Health
Center. The hospital provides behavioral programs for children, adolescents, and adults. The Company accounted for the acquisition by the purchase method as required by generally accepted accounting principles. Tangible assets acquired and
liabilities assumed totaled $6,399,253 and $189,816 respectively. The cash purchase price was funded by the Companys revolving credit facility. Proforma financial data is not presented because the impact of this acquisition is not material to
the Companys results of operations for any period presented.



Health and Human Resource Center, Inc., d/b/a Integrated Insights



Effective June 30, 2003 the Company purchased all of the capital stock of privately held Health and Human Resource Center, Inc., d/b/a Integrated Insights for approximately $4.4 million. Integrated Insights,
headquartered in San Diego, California, provides employee assistance programs under contracts directly with employers. It holds a California Knox-Keene License to operate as a specialized health care plan. The Company accounted for the acquisition
of Integrated Insights by the purchase method as required by generally accepted accounting principles. The allocation of the purchase price exceeded the fair value of Integrated Insights tangible net assets by $3,989,880 of which $1,783,864 is
recorded as goodwill, which is fully deductible for tax purposes, $1,213,169 as service contract valuation, $795,988 as a license valuation and $196,859 as non-compete agreements. Tangible assets acquired and liabilities assumed totaled $774,159 and
$407,722, respectively. The cash purchase price of approximately $4.4 million was funded by the Companys revolving credit facility. Proforma financial data is not presented because the impact of this acquisition is not material to the
Companys results of operations for any periods presented.



F-21



---

##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Employee Assistance Programs International



The Company acquired all of the outstanding capital stock of Employee Assistance Programs International, Inc. (EAP International) of Denver,
Colorado, on November 4, 2002, with an effective date of November 1, 2002 for approximately $3.4 million. The Company accounted for the acquisition of EAP International using the purchase method as required by generally accepted accounting
principles. EAP International provides employee assistance programs and other related behavioral services to employers. The purchase price of approximately $3.4 million exceeded the fair value of EAP Internationals tangible net assets by
$3,559,946 of which $2,684,893 is recorded as goodwill, which is fully deductible for tax purposes, and $628,898 as service contract valuation and $246,155 as non-compete agreements. Tangible assets acquired and liabilities assumed totaled $756,697
and $947,392, respectively. Pro forma financial data is not presented because the impact of this acquisition is not material to the Companys results of operation for any period presented.



|6. | DISCONTINUED OPERATIONS
|-- | -----------------------



On August 29, 2005, the Company sold its membership interests in ProCare One Nurses, LLC, its wholly owned temporary nurse-staffing subsidiary, to
CareerStaff Unlimited, Inc. The transaction consisted of a sale of all the membership interests in ProCare for total consideration of $8.3 million, consisting of $4.2 million in cash and $4.1 million in two promissory notes. One promissory note is
non-interest bearing in the amount of $2.1 million payable in six months and the other promissory note is in the amount of $2.0 million payable quarterly over three years, bearing interest at the prime rate. The tangible assets and assumed
liabilities included in the sale were $2,445,338 and $45,472, received were recorded by the Company at the estimated net realizable value over the term of the instruments, including a reserve totaling $666,831 that is based on managements
assessment of ultimate collectibility. The Company recognizes interest income during the period in which the interest is earned and reflects any unpaid interest due as a receivable.



In accordance with the provisions of Statement of Financial Accounting Standard, Accounting for the Impairment or
Disposal of Long-Lived Assets(SFAS No. 144), the results of operations of the disposed assets and the losses related to this divestiture have been classified as discontinued operations for all periods presented in the
accompanying consolidated statements of operations.



F-22



---

##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



A summary of the discontinued operations for the periods presented is as follows:



|                                                                    |  |                        |            |   |      |   |            |      |  |   |            |  
|------------------------------------------------------------------- |  | ---------------------- | ---------- | - | ---- | - | ---------- | ---- |  | - | ---------- | -
|                                                                    |  | Years Ended August 31, |           
|                                                                    |  | 2005                   |            |   | 2004 |   |            | 2003 | 
|Revenue                                                             |  | $                      | 17,176,198 |   |      | $ | 18,674,417 |      |  | $ | 22,178,947 |  
|                                                                    |  |                        |           
|Cost of services (exclusive of depreciation shown separately below) |  |                        | 16,041,371 |   |      |   | 17,121,194 |      |  |   | 19,942,023 |  
|Selling, general and administrative                                 |  |                        | 1,635,485  |   |      |   | 277,858    |      |  |   | 91,922     |  
|Provision for (recovery of) doubtful accounts                       |  |                        | 136,206    |   |      |   | (58,675    | )    |  |   | 294,734    |  
|Depreciation and amortization                                       |  |                        | 97,992     |   |      |   | 129,835    |      |  |   | 162,141    |  
|                                                                    |  |                        |            |   |      |   |            |      |  |   |            |  
|Operating Income                                                    |  |                        | (734,856   | ) |      |   | 1,204,205  |      |  |   | 1,688,127  |  
|                                                                    |  |                        |           
|Interest income and other                                           |  |                        |           |   |      |   |           |      |  |   | (2,582     | )
|                                                                    |  |                        |           
|Income before income taxes                                          |  |                        | (734,856   | ) |      |   | 1,204,205  |      |  |   | 1,690,709  |  
|                                                                    |  |                        |           
|Income tax provision/(benefit)                                      |  |                        | (262,051   | ) |      |   | 465,930    |      |  |   | 654,157    |  
|                                                                    |  |                        |           
|(Loss) income from discontinued operations                          |  |                        | (472,805   | ) |      |   | 738,275    |      |  |   | 1,036,552  |  
|                                                                    |  |                        |           
|(Loss) on disposal of discontinued operations, net                  |  |                        | (3,102,469 | ) |      |   |           |      |  |   |           |  
|                                                                    |  |                        |           
|Intercompany Revenue                                                |  |                        | (15,287    | ) |      |   | (176,333   | )    |  |   | (175,922   | )
|                                                                    |  |                        |            |   |      |   |            |      |  |   |            |  
|Net (Loss) income from discontinued operations                      |  |                        | (3,590,561 | ) |      |   | 561,942    |      |  |   | 860,630    |  
|Basic earnings per common share:                                    |  |                        |            |   |      |   |            |      |  |   |            |  
|Discontinued operations                                             |  |                        | (0.28      | ) |      |   | 0.05       |      |  |   | 0.08       |  
|                                                                    |  |                        |            |   |      |   |            |      |  |   |            |  
|Diluted earnings per common share:                                  |  |                        |            |   |      |   |            |      |  |   |            |  
|Discontinued operations                                             |  |                        | (0.27      | ) |      |   | 0.05       |      |  |   | 0.08       |  
|                                                                    |  |                        |            |   |      |   |            |      |  |   |            |  
|Weighted average shares outstanding:                                |  |                        |            |   |      |   |            |      |  |   |            |  
|Basic                                                               |  |                        | 12,829,141 |   |      |   | 10,848,866 |      |  |   | 10,499,561 |  
|                                                                    |  |                        |            |   |      |   |            |      |  |   |            |  
|Diluted                                                             |  |                        | 13,306,444 |   |      |   | 11,346,001 |      |  |   | 11,283,236 |  
|                                                                    |  |                        |            |   |      |   |            |      |  |   |            |  



F-23



---

##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



A summary of ProCares assets and liabilities retained is reflected as follows:



|                                                                    |  |            |  |           
|------------------------------------------------------------------- |  | ---------- |  | ----------
|                                                                    |  | August 31,
|                                                                    |  | 2005       |  | 2004      
|Current assets, including trade receivables and deferred tax assets |  | 1,322,129  |  | 3,112,506 
|Other non-current assets-deferred taxes                             |  | 655,343    |  |          
|Long term assets, including goodwill                                |  |           |  | 10,065,551
|Current liabilities, including accrued expenses                     |  | 1,653,974  |  | 629,325   
|Long term liabilities                                               |  | 127,940    |  | 491,731   



The
following is a reconciliation of the net proceeds received and the loss recorded on sale:



|                                                |  |   |            |  
|----------------------------------------------- |  | - | ---------- | -
|Proceeds:                                       |  |   |            |  
|Cash                                            |  | $ | 4,200,000  |  
|Promissory notes, net                           |  |   | 3,365,945  |  
|                                                |  |   |            |  
|Total proceeds                                  |  |   | 7,565,945  |  
|Less:                                           |  |   |            |  
|Tangible assets sold, less liabilities divested |  |   | (2,399,866 | )
|Write-off of goodwill                           |  |   | (9,988,595 | )
|Income tax provision                            |  |   | 1,720,047  |  
|                                                |  |   |            |  
|Loss on sale                                    |  | $ | (3,102,469 | )
|                                                |  |   |            |  



|7. | PROPERTY AND EQUIPMENT
|-- | ----------------------



Property and equipment consist of the following at August 31:



|                               |  |             |            |          |   |           
|------------------------------ |  | ----------- | ---------- | -------- | - | ----------
|                               |  | 2005 (a)(b) |            | 2004 (c)
|Land                           |  | $           | 4,317,706  |          | $ | 3,219,011 
|Buildings and improvements (d) |  |             | 42,245,677 |          |   | 23,508,748
|Computer hardware              |  |             | 3,282,079  |          |   | 2,858,717 
|Computer software              |  |             | 2,273,882  |          |   | 1,700,597 
|Furniture and fixtures         |  |             | 4,052,110  |          |   | 2,274,077 
|Equipment                      |  |             | 2,639,480  |          |   | 2,664,184 
|Transportation (vehicles)      |  |             | 115,365    |          |   | 50,445    
|Work-in-process (e)            |  |             | 1,226,265  |          |   |          
|Leasehold improvements         |  |             | 181,596    |          |   | 358,745   
|                               |  |             |            |          |   |           
|                               |  |             | 60,334,160 |          |   | 36,634,524
|Less accumulated depreciation  |  |             | 8,635,817  |          |   | 7,833,027 
|                               |  |             |            |          |   |           
|                               |  | $           | 51,698,343 |          | $ | 28,801,497
|                               |  |             |            |          |   |           



---

|(a) | Effective July 1, 2005, the Company added approximately $15.5 million in property and equipment associated with the acquisition of Friends Hospital in Philadelphia,
Pennsylvania. (See Note 5 Acquisitions) Of the $15.5 million in assets acquired, the hospital facility (approximately 330,990 square feet) was valued at approximately $13.0 million.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(b) | Effective August 1, 2005, the Company added approximately $7.0 million in property and equipment associated with the acquisition of River Park Hospital in Huntington, West
Virginia. (See Note 5 Acquisitions) Of the $7.0 million in assets acquired, a hospital facility (approximately 129,660 square feet) and 4 acres of land were valued at approximately $5.3 million and $1.1million, respectively.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(c) | The 2004 balances above include assets with a net book value of approximately $35,000 that were associated with ProCare One Nurses, which was sold on August 29, 2005.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(d) | During the fourth quarter of fiscal year 2005, the Company recorded an asset impairment charge of $1,015,241. This charge related to the write-down to fair market value of the
Companys national support center building. Fair value was determined by the executed letter of intent to sell the building. This asset is presented in the other service group in the segment disclosure at Note 15.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



F-24



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##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



|(e) | At August 31, 2005, the work-in-process category primarily represented six different information technology initiatives and building and leasehold improvement
projects, which had not been completed by year-end. Of the $1,226,265 in work-in-process, $1,055,322 is related to computer software, $54,875 is related to computer hardware and $116,068 is related to building and leasehold improvements that will be
capitalized and depreciated upon the completion of each project, which is anticipated to occur during fiscal year 2006.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Exclusive of the depreciation expense associated with ProCare One Nurses, which has been retroactively reclassified into discontinued operations,
depreciation expense was $2,484,412, $1,412,202 and $1,018,173 for the years ended August 31, 2005, 2004, and 2003, respectively.



|8. | ACCRUED EXPENSES AND UNEARNED REVENUE
|-- | -------------------------------------



Accrued expenses consisted of the following at August 31:



|                                                     |  |      |            |      |   |          
|---------------------------------------------------- |  | ---- | ---------- | ---- | - | ---------
|                                                     |  | 2005 |            | 2004
|Employee health benefits                             |  | $    | 1,190,911  |      | $ | 942,606  
|General and professional liability claims            |  |      | 1,035,270  |      |   | 1,433,493
|Deferred revenue and contract adjustments            |  |      | 850,434    |      |   | 663,471  
|Workers compensation self-insured liability          |  |      | 779,565    |      |   | 833,717  
|Lease obligations                                    |  |      | 767,720    |      |   | 107,269  
|Federal and state income tax liability               |  |      | 726,348    |      |   |         
|Patient credit balances and third-party overpayments |  |      | 839,418    |      |   | 4,857    
|Employee/physician relocation                        |  |      | 304,555    |      |   | 197,553  
|Audit and accounting fees                            |  |      | 298,430    |      |   | 171,000  
|401 (k) matching funds contributions                 |  |      | 258,911    |      |   | 534,942  
|Other                                                |  |      | 4,562,931  |      |   | 2,969,820
|                                                     |  |      |            |      |   |          
|                                                     |  | $    | 11,614,493 |      | $ | 7,858,728
|Unearned Revenue                                     |  |      | 1,308,462  |      |   | 891,731  
|                                                     |  |      |            |      |   |          
|                                                     |  | $    | 12,922,955 |      | $ | 8,750,459
|                                                     |  |      |            |      |   |          



|9. | LONG-TERM DEBT
|-- | --------------



At August 31, 2005, the Company had no long-term debt outstanding related to its revolving credit facility and had $118.7 million of the current
$125.0 million credit facility available to the Company after letter of credit obligations. At August 31, 2004, the Company had long-term debt of $40.0 million under its then existing $90 million revolving credit facility.



On May 23, 2002, the Company entered into a Second Amended and Restated
Credit Agreement (the Second Amended Credit Agreement), with JPMorgan Chase Bank, as Agent, and Bank of America, NA to fund ongoing working capital requirements, refinance existing debt, finance future acquisitions by the Company, and
for other general corporate purposes. On August 29, 2003, the Company amended the agreement to allow for its expansion to a $60 million facility by adding Wells Fargo Bank Texas as an equal bank participant in the facility. On May 4, 2004,
the Company again amended the agreement to extend the term by one year and to increase the amount of the revolving credit facility to $90 million (with an expansion feature under which the amount of the credit facility could be increased to expand
to $125.0 million, subject to the satisfaction of certain conditions) and to add KeyBank National Association as a participant in the facility. On June 10,



F-25



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##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



2005, the Company entered into a Third Amended and Restated Credit Agreement (the Third Amended Credit Agreement) to extend the term by four
years and to increase the amount of the revolving credit facility to $125.0 million (with an expansion feature under which the amount of the credit facility can be increased to $175.0 million, subject to the satisfaction of certain conditions) and
to add Wachovia Bank, National Association and Amegy Bank, National Association as participants in the facility.



The revolving credit facility bears interest at (1) the Base Rate plus the Base Rate Margin, as defined or (2) the Adjusted Eurodollar Rate,
plus the Eurodollar Rate Margin, as defined. The Eurodollar Margin and Base Rate Margin vary depending on the debt coverage ratio of the Company.



As of October 4, 2002, April 4, 2003, August 29, 2003, and June 10, 2005, the Credit Agreement was amended to allow the
Company to finance the redemption or repurchase of its capital stock, subject to certain conditions. The amendments currently allow the Company to expend up to $10.0 million per fiscal year for the repurchase of shares through the end of the
agreement, subject to maintaining a debt coverage ratio of less than 1.75 to 1.00.



The Third Amended Credit Agreement, as amended, matures on May 31, 2010.



|10. | SHAREHOLDERS EQUITY
|--- | --------------------



Common Stock



Effective March 16, 2005, the Company sold in a follow-on public offering 3,450,000 shares of its common stock at a price of $18.13 per share (shares
and share price restated to reflect the impact 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 $58.4 million. The Company utilized
approximately $34.5 million of the proceeds to repay all outstanding debt under its revolving credit facility. The balance of the net proceeds was used for the acquisitions of Friends Hospital and 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-one stock split to be effected in the form of a 100% stock dividend (the Stock Split), pursuant to which, on June 15, 2005, the Company distributed to each holder of record of Common
Stock, par value $0.01 per share, of the Company at the close of business on May 31, 2005 (the Record Date), one additional share of Common Stock for each outstanding share of Common Stock held of record by such holder at the Record
Date. All references in the financial statements and related notes related to the number of shares and per share amounts of the common stock have been retroactively restated to reflect the impact of the Companys June 15, 2005 two-for-one
stock split.



The Board of Directors adopted in October 1999
the Horizon Health Corporation Employee Stock Purchase Plan (the Plan). The Plan offered eligible employees the ability to purchase Company stock at a 15% discount to the current market price at designated periods. Eligible employees
were able to contribute up to 10% of their base salary pursuant to two, six-month offering periods, which were defined as January 1  June 30 and July 1  December 31. Pursuant to the Plan, the Company issued 9,352,
13,887, and 10,774 shares of Common Stock from treasury for the fiscal years ended August 31, 2005, 2004, and 2003, respectively as well as 22,660 newly issued shares during the fiscal year ended August 31, 2005. On April 21, 2005,
the Board of Directors approved the termination of the Companys Stock Purchase Plan effective June 30, 2005. Subsequent to this date, shares were no longer offered under the Companys Employee Stock Purchase Plan.



F-26



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##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Treasury Stock



During the time period of September 1998 through February 2001 the Board of Directors of the Company authorized the repurchase of up to 2,525,000 shares
of its common stock. As of August 31, 2002 the Company had repurchased 2,292,863 shares of its common stock pursuant to such authorizations, which had previously expired.



On October 7, 2002 the Board of Directors authorized the repurchase of up to 800,000 shares of its common stock. As of
August 31, 2005, the company had repurchased 714,591 shares in total of the 800,000 share authorization, which remains in effect. A total of 1,505,196 and 1,298,779 treasury shares had been reissued pursuant to the exercise of certain stock
options and in connection with the Employee Stock Purchase Plan as of August 31, 2005 and August 31, 2004, respectively.



For the fiscal year ended August 31, 2005 the net difference between the cost price and the option price on the issuance of treasury stock was a loss
of $148,871 that has been charged to retained earnings.



The
above share amounts have not been adjusted related to the 100% share dividend on June 15, 2005 discussed above, as it was not applicable to treasury shares. As of June 15, 2005, the Company utilized all its treasury stock for the payment
of the share dividend. Subsequent to that date, 7,645 shares were surrendered to the Company and were retained in treasury at August 31, 2005.



|11. | GOODWILL AND OTHER INTANGIBLE ASSETS
|--- | ------------------------------------



The Company applies the provisions of SFAS 141, Business Combinations and SFAS 142, Goodwill and Other Intangible Assetsin accounting for
its goodwill and other identifiable intangible assets. SFAS 141 addresses the initial recognition and measurement of goodwill and other intangible assets acquired in a business combination. SFAS 142 addresses the initial recognition and measurement
of intangible assets acquired outside of a business combination, whether acquired individually or with a group of other assets, and the accounting and reporting for goodwill and other intangibles subsequent to their acquisition. See Note 2
Accounting for Intangible Assets and Goodwill for a discussion regarding SFAS 141 and SFAS 142.



The Companys indefinite life intangible assets, which are not subject to amortization, were $3,886,641 and $795,988 at August 31, 2005 and
2004, respectively. The costs of certain management contracts and other intangible assets acquired by the Company remain subject to amortization. Amortization of recorded values for contracts, consulting, and non-compete agreements for the twelve
months ended August 31, 2005 were $761,504, $30,772 and $110,700, respectively, and for the twelve months ended August 31, 2004 were $1,216,682, $30,772 and $135,176, respectively.



The following table sets forth the estimated amortization expense for
intangibles subject to amortization for the four succeeding fiscal years and thereafter.



|                              |  |   |          
|----------------------------- |  | - | ---------
|For the year ended August 31: |  |   |          
|2006                          |  | $ | 869,833  
|2007                          |  |   | 820,860  
|2008                          |  |   | 786,351  
|2009                          |  |   | 332,903  
|Thereafter                    |  |   | 159,200  
|                              |  |   |          
|                              |  | $ | 2,969,147
|                              |  |   |          



F-27



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##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



The following table sets forth by business service group of the Company, as described in Note 15 elsewhere herein, the amount of goodwill and certain
indefinite life intangible assets as of August 31, 2005 that are subject to impairment tests rather than amortization and the adjustments, if any, to the amount of such goodwill and certain indefinite life intangible assets in the twelve months
ended August 31, 2005.



The Company elected to conduct
the annual impairment testing during its fiscal year third quarter. As a result of the May 31, 2005 impairment testing, no impairment adjustments were deemed necessary.



|                                                                                  |  |                                              |            |                                       |   |                                                    |  |                        |           |  |                  |            |   |              |   |            |   |  |   |            |  
|--------------------------------------------------------------------------------- |  | -------------------------------------------- | ---------- | ------------------------------------- | - | -------------------------------------------------- |  | ---------------------- | --------- |  | ---------------- | ---------- | - | ------------ | - | ---------- | - |  | - | ---------- | -
|                                                                                  |  | Behavioral Health ContractManagementServices |            | BehavioralHealth HospitalServices (1) |   | PhysicalRehabilitationContract Management Services |  | ProCare One Nurses (2) |           |  | EAP Services (3) |            |   | Consolidated |  
|Goodwill and certain indefinite life intangible assets as of August 31, 2003      |  | $                                            | 16,841,171 |                                       | $ |                                                   |  | $                      | 1,703,665 |  | $                | 9,988,595  |   |              | $ | 42,236,432 |   |  | $ | 70,769,863 |  
|Goodwill adjusted during the period                                               |  |                                              |           |                                       |   |                                                   |  |                        |          |  |                  |           |   |              |   | (815,926   | ) |  |   | (815,926   | )
|Certain indefinite life intangible assets adjusted during the period              |  |                                              |           |                                       |   |                                                   |  |                        |          |  |                  |           |   |              |   | 795,988    |   |  |   | 795,988    |  
|Goodwill and Certain indefinite life intangible assets acquired during the period |  |                                              |           |                                       |   | 13,769,951                                         |  |                        |          |  |                  |           |   |              |   |           |   |  | $ | 13,769,951 |  
|                                                                                  |  |                                              |            |                                       |   |                                                    |  |                        |           |  |                  |            |   |              |   |            |   |  |   |            |  
|Goodwill and certain indefinite life intangible assets as of August 31, 2004      |  | $                                            | 16,841,171 |                                       | $ | 13,769,951                                         |  | $                      | 1,703,665 |  | $                | 9,988,595  |   |              | $ | 42,216,494 |   |  | $ | 84,519,876 |  
|Goodwill adjusted during the period                                               |  |                                              |           |                                       |   | 94,014                                             |  |                        |          |  |                  |           |   |              |   | (351,996   | ) |  |   | (257,982   | )
|Certain indefinite life intangible assets adjusted during the period              |  |                                              |           |                                       |   | 329,000                                            |  |                        |          |  |                  |           |   |              |   |           |   |  |   | 329,000    |  
|Goodwill and Certain indefinite life intangible assets acquired during the period |  |                                              |           |                                       |   | 3,512,123                                          |  |                        |          |  |                  |           |   |              |   |           |   |  |   | 3,512,123  |  
|Sale of ProCare One Nurses during the period                                      |  |                                              |           |                                       |   |                                                   |  |                        |          |  |                  | (9,988,595 | ) |              |   |           |   |  |   | (9,988,595 | )
|                                                                                  |  |                                              |            |                                       |   |                                                    |  |                        |           |  |                  |            |   |              |   |            |   |  |   |            |  
|Goodwill and certain indefinite life intangible assets as of August 31, 2005      |  | $                                            | 16,841,171 |                                       | $ | 17,705,088                                         |  | $                      | 1,703,665 |  | $                |           |   |              | $ | 41,864,498 |   |  | $ | 78,114,422 |  
|                                                                                  |  |                                              |            |                                       |   |                                                    |  |                        |           |  |                  |            |   |              |   |            |   |  |   |            |  

---

See Note 15, elsewhere herein, for a description of
the Companys business service groups.



|(1) | $13,769,951 of goodwill acquired during the twelve months ended August 31, 2004 related to the purchase of PSH Acquisition Corporation effective June 1, 2004. Goodwill adjustments
during the twelve-month period ended August 31, 2005 include: an additional variable payment of $380,841, a reclassification of $329,000 from goodwill to other indefinite life intangibles and purchase price adjustments of $42,173 all of
which were related to the purchase of Poplar Springs Hospital. The purchase agreement associated with the acquisition of Poplar Springs Hospital provides for additional variable payments in future years based on the future performance of the
facilities. The first payment, which was recorded as additional goodwill, was made during the third quarter ended May 31, 2005 in the amount of $380,841. $422,651 of certain indefinite life intangible assets acquired during the period relates to the
purchase of Friends Hospital effective July 1, 2005. $750,472 of the goodwill and $2,339,000 of certain indefinite life intangible assets acquired during the period relates to the purchase of River Park Hospital effective August 1, 2005. The
indefinite life assets of River Park are comprised of a Certificate of Need with an assigned value of $2,185,000 and a trade name with an assigned value of $154,000.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | A decrease in goodwill of $9,988,595 relates to the sale of ProCare One Nurses effective August 29, 2005. See Note 6 Discontinued Operations.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Goodwill adjusted during the twelve months ended August 31, 2004 relates to reclassifications to other intangibles related to the purchase of Integrated Insights which was acquired
effective June 30, 2003 and purchase price allocations adjustments related to the purchase of EAPI and Integrated Insights. Certain indefinite life intangible assets adjusted during the period relate to reclassifications from goodwill related to the
valuation of the companys Knox Keene License. A decrease in goodwill of $351,966 during the twelve months ended August 31, 2005 relates to a reduction of a tax reserve associated with the October 5, 1998 acquisition of Choice Health, Inc.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|12. | RETIREMENT PLAN
|--- | ---------------



The Company sponsors a 401(k) plan that covers substantially all employees, subject to certain eligibility requirements. New for the benefit plan year
2005, the Company makes a matching contribution equal to 50% of the employees contribution up to an amount equal to 3% of the employees compensation. The plan also provides for discretionary matching contributions, an amount that is to
be determined by the Company on an annual basis. Past benefit plan year contributions were on a discretionary basis only. For the benefit plan years ended December 31, 2004, 2003 and 2002 the Companys contributions were approximately
$714,000, $646,000, and $604,000 respectively.



F-28



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##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



|13. | INCOME TAXES
|--- | ------------



Deferred taxes are provided for those items reported in different periods for income tax and financial reporting purposes. Income tax expense is comprised
of the following components:



|                                                                                |  |                               |            |   |      |   |           |      |  |   |           |  
|------------------------------------------------------------------------------- |  | ----------------------------- | ---------- | - | ---- | - | --------- | ---- |  | - | --------- | -
|                                                                                |  | For the Year Ended August 31, |           
|                                                                                |  | 2005                          |            |   | 2004 |   |           | 2003 | 
|Current                                                                         |  |                               |            |   |      |   |           |      |  |   |           |  
|Federal                                                                         |  | $                             | 6,398,942  |   |      | $ | 4,858,036 |      |  | $ | 3,878,055 |  
|State                                                                           |  |                               | 1,166,239  |   |      |   | 691,993   |      |  |   | 586,409   |  
|                                                                                |  |                               |            |   |      |   |           |      |  |   |           |  
|Total current                                                                   |  | $                             | 7,565,181  |   |      | $ | 5,550,029 |      |  | $ | 4,464,464 |  
|                                                                                |  |                               |            |   |      |   |           |      |  |   |           |  
|Deferred                                                                        |  |                               |            |   |      |   |           |      |  |   |           |  
|Federal                                                                         |  | $                             | (3,782,987 | ) |      |   | 1,048,157 |      |  |   | 1,422,342 |  
|State                                                                           |  |                               | (432,341   | ) |      |   | 119,783   |      |  |   | 162,554   |  
|                                                                                |  |                               |            |   |      |   |           |      |  |   |           |  
|Total deferred                                                                  |  | $                             | (4,215,328 | ) |      | $ | 1,167,940 |      |  | $ | 1,584,896 |  
|                                                                                |  |                               |            |   |      |   |           |      |  |   |           |  
|Income tax expense, including discontinued operations                           |  | $                             | 3,349,853  |   |      | $ | 6,717,969 |      |  | $ | 6,049,360 |  
|Income tax benefit (expense) related to income from discontinued operations     |  | $                             | 262,051    |   |      | $ | (465,931  | )    |  | $ | (654,157  | )
|Income tax benefit (expense) related to the disposal of discontinued operations |  | $                             | 1,720,047  |   |      | $ |          |      |  | $ |          |  
|                                                                                |  |                               |            |   |      |   |           |      |  |   |           |  
|Income tax expense-continuing operations                                        |  | $                             | 5,331,951  |   |      | $ | 6,252,038 |      |  | $ | 5,395,203 |  
|                                                                                |  |                               |            |   |      |   |           |      |  |   |           |  



The components of the
net deferred tax asset at August 31 are as follows:



|                                      |  |      |            |   |      |   |            |  
|------------------------------------- |  | ---- | ---------- | - | ---- | - | ---------- | -
|                                      |  | 2005 |            |   | 2004 |  
|Management contracts                  |  | $    | 2,038,773  |   |      | $ | 1,062,415  |  
|Goodwill                              |  |      | (8,839,319 | ) |      |   | (6,814,697 | )
|                                      |  |      |            |   |      |   |            |  
|Deferred tax liabilities              |  |      | (6,800,546 | ) |      |   | (5,752,282 | )
|                                      |  |      |            |   |      |   |            |  
|Accounts receivable                   |  |      | 2,445,250  |   |      |   | 1,484,252  |  
|Vacation accruals                     |  |      | 460,898    |   |      |   | 620,708    |  
|Miscellaneous accruals                |  |      | 5,698,004  |   |      |   | 916,073    |  
|Property & equipment/intangibles      |  |      | 374,970    |   |      |   | 303,334    |  
|Net operating loss carryforward       |  |      | 173,701    |   |      |   | 212,857    |  
|                                      |  |      |            |   |      |   |            |  
|Deferred tax assets                   |  |      | 9,152,823  |   |      |   | 3,537,224  |  
|                                      |  |      |            |   |      |   |            |  
|Net deferred tax asset (liability)(a) |  | $    | 2,352,277  |   |      | $ | (2,215,058 | )
|                                      |  |      |            |   |      |   |            |  

---

|(a) | $1,045,341 of the $2,352,277 in deferred tax assets as of August 31, 2005 is associated
with ProCare One Nurses. $390,000 is included in the residual current assets from divested entity caption and $655,343 is captioned residual noncurrent assets from divested entity in the August 31, 2005 consolidated
balance sheet included elsewhere herein this document.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



F-29



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##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



At August 31, 2005, the Company had available estimated, unused net operating loss carryforwards for tax purposes totaling approximately $445,386.
These carryforwards, subject to annual utilization limits, may be utilized to offset future years taxable income and will begin to expire during 2011 if unused prior to that date.



The following is a reconciliation of income taxes at the U.S. federal income tax rate to the Companys effective income
tax rate for continuing operations:



|                                                      |  |              |    |  |      |           |   |               |      |    |      |   |           |               |  |      |      |  |   |           |  
|----------------------------------------------------- |  | ------------ | -- |  | ---- | --------- | - | ------------- | ---- | -- | ---- | - | --------- | ------------- |  | ---- | ---- |  | - | --------- | -
|                                                      |  | Tax Rate2005 |    |  | 2005 |           |   | Tax Rate 2004 |      |    | 2004 |   |           | Tax Rate 2003 |  |      | 2003 | 
|Federal income taxes based on 35% of book income      |  | 35.0         | %  |  | $    | 4,925,565 |   |               | 35.0 | %  |      | $ | 5,762,849 |               |  | 35.0 | %    |  | $ | 4,940,885 |  
|Permanent adjustments:                                |  |              |    |  |      |           |   |               |      |    |      |   |           |               |  |      |      |  |   |           |  
|Meals & entertainment and other permanent adjustments |  | 1.1          | %  |  |      | 150,007   |   |               | 0.9  | %  |      |   | 152,189   |               |  | 1.1  | %    |  |   | 149,606   |  
|State income taxes                                    |  | 3.7          | %  |  |      | 518,677   |   |               | 2.8  | %  |      |   | 464,400   |               |  | 3.0  | %    |  |   | 418,023   |  
|Other adjustments                                     |  | (1.9         | )% |  |      | (262,298  | ) |               | (0.8 | )% |      |   | (127,400  | )             |  | (0.8 | )%   |  |   | (113,311  | )
|                                                      |  |              |    |  |      |           |   |               |      |    |      |   |           |               |  |      |      |  |   |           |  
|                                                      |  | 37.9         | %  |  | $    | 5,331,951 |   |               | 37.9 | %  |      | $ | 6,252,038 |               |  | 38.3 | %    |  | $ | 5,395,203 |  
|                                                      |  |              |    |  |      |           |   |               |      |    |      |   |           |               |  |      |      |  |   |           |  



|14. | COMMITMENTS AND CONTINGENCIES
|--- | -----------------------------



Property Leases



The Company leases various facilities and equipment under operating leases. The following is a schedule of minimum rental payments under these leases,
which expire at various dates:



|                               |  |   |           
|------------------------------ |  | - | ----------
|For the year ending August 31, |  |   |           
|2006                           |  | $ | 3,595,163 
|2007                           |  |   | 3,560,972 
|2008                           |  |   | 2,968,879 
|2009                           |  |   | 2,583,944 
|2010 and thereafter            |  |   | 17,281,270
|                               |  |   |           
|                               |  | $ | 29,990,228
|                               |  |   |           



Rent expense for the
years ended August 31, 2005, 2004, and 2003 was $4,694,535, $2,521,362, and $2,394,512, respectively. These amounts exclude rent expense related to ProCare One Nurses, which was reclassed into discontinued operations.



The long-term operating lease associated with Laurelwood Hospital, effective
January 1, 2005, increased the total minimum rental payments by $11.4 million.



Construction of a building to serve as the new national support center (NSC), which is in close proximity to the current NSC facility in Lewisville, Texas, began during June 2005. The Company will lease
the 80,000 square foot facility and anticipates completion and occupancy beginning in April 2006. The term of the office lease agreement is ten (10) years with renewal options of two periods of five-years each. The lease increased the total
minimum rental payments by $12.0 million.



The above minimum
rental payments do not take into account $262,053 of expected receipts for four sublet clinic locations in Florida resulting from the reorganization and centralization of the Companys EAP Services group.



F-30



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##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Insurance Risk Retention



The Companys liability and property risk management program 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 that management considers cost-effective and reasonable and adequate for the protection
of the Companys assets, operations and employees. There can be no assurance, however, that the coverage limits of such policies will be adequate. A successful claim against the Company in excess of its insurance coverage or several claims for
which the Companys self-insurance components are significant in the aggregate could have a material adverse effect on the Company.



Estimates of the aggregate or portions of claims pursuant to the Companys self-insurance retentions, and liability for uninsured claims incurred are
determined and accrual reserves and associated expenses recorded, by using actuarial assumptions followed in the insurance industry and historical experience. In estimating the liability for claims, the Company obtains estimates from third party
actuarial firms.



Legal Proceedings



The Company is, and may be in the future, party to litigation arising in
the ordinary course of its business. While the Company has no reason to believe that any such pending claims are material, there can be no assurance that the Companys insurance coverages will be adequate to substantially cover liabilities
arising out of such claims or that any such claims will be covered by the Companys insurance. Any material claim that is not 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 have an adverse effect on the Companys reputation and business.



The Company is party 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 Mental Health Management, Inc. and Superior Home Health of East Tennessee, Inc., Defendants, 01-MS-50 (RCL) (part of Civil Action No. 99-3311 (RCL) pending in the
United States District Court for the District of Columbia. The complaint alleges that certain on-site Company personnel acted in Concert with other non-company personnel to improperly inflate certain Medicare reimbursable costs associated with
services rendered at Indian Path Hospital prior to 1997. The complaint seeks to recover amounts allegedly over billed to Medicare as a result. The relators have also alleged that such conduct occurred at other hospitals owned by the parent
corporation of Indian Path. The parties are in discovery proceedings and there is no trial setting.



The Company is party 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 States District court for the Northern District of California. The relators served the
complaint in November 2004. The United States Department of Justice had previously declined to intervene in the lawsuit. The complaint alleges primarily that certain patients were improperly admitted to hospital gero-psychiatry program managed by
the Company at the hospitals. The complaint seeks to recover amounts allegedly over billed to Medicare as a result. No discovery proceedings have been conducted in the case and there is no trial setting.



The Company is a party to a lawsuit styled Jeanine Phillips, on behalf of
herself and all others simultaneously situated v. ProCare One Nurses, LLC, Obstetrical Nurses, Inc. and Horizon Health Corporation, Case Number 030000425, pending in the Superior Court of the State of California for the County of Orange. The
complaint alleges various violations of California wage and hour laws and seeks the recovery of substantial amounts for wages, fines, penalties and attorneys fees. The case is filed as a private attorney general action under Section 17200 of
the California Business and Profession Code. The Company considers that it is entitled to indemnity



F-31



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##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



from Obstetrical Nurses, Inc., a predecessor to ProCare One Nurses, LLC for liability relating to a portion of the claims and has asserted a claim for
indemnity in a separate lawsuit. The parties are engaged in discovery proceedings. The case is filed as a class action, but the court recently denied the motion for class certification.



|15. | SEGMENT (SERVICE GROUP) INFORMATION
|--- | -----------------------------------



The Company has determined that its reportable segments, or service groups, are appropriately based on its method of internal reporting which
disaggregates its business by services categories in a manner consistent with the Companys consolidated statements of operations format. There were two significant changes to the structure of the reportable service groups during the fourth
quarter of fiscal year 2005. As a result of the growth in the Companys free-standing behavioral health hospital services business, which increased to five during fiscal year 2005 (two of which were acquired during the fourth quarter),
management determined that it would disaggregate the hospitals and recognize them as a separate service group. Additionally, as a result of the sale of the Companys temporary nurse staffing business on August 29, 2005, ProCare One Nurses
is no longer reflected as a service group of the Company (see Note 6 Discontinued Operations). Therefore, the Companys reportable service groups are Behavioral Health Contract Management Services, Behavioral Health Hospital
Services, Physical Rehabilitation Contract Management Services, and EAP Services. Prior periods have been restated to reflect the new segments. During the fiscal year ended August 31, 2003, the Company discontinued reporting its then smallest
service group Mental Health Outcomes, separately due to its downsizing and integration into Behavioral Health Contract Management Services as a product line. In prior years, estimates of workers compensation claims liability were allocated (based on
payroll dollars) to the operating unit level. Effective September 1, 2003, the Company began recording these estimates at the general and administrative level with actual paid claims costs being recorded to the applicable operating unit.



See notes (A) through (D) below for a description
of the services provided by each of the identified service groups. The Companys business is conducted solely in the United States.



F-32



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##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



The following schedule represents revenues and operating results for the twelve months ended August 31 by operating division/service group:



|                      |  |                                            |             |                                  |   |                                                  |  |                  |            |  |           |            |   |              |   |             |              |  |   |              |   |  |   |            
|--------------------- |  | ------------------------------------------ | ----------- | -------------------------------- | - | ------------------------------------------------ |  | ---------------- | ---------- |  | --------- | ---------- | - | ------------ | - | ----------- | ------------ |  | - | ------------ | - |  | - | -----------
|                      |  | (A)                                        |             | (B)                              |   | (C)                                              |  |                  |            |  |           |            |   |              |   |             |             
|                      |  | BehavioralHealthContractManagementServices |             | BehavioralHealthHospitalServices |   | PhysicalRehabilitationContractManagementServices |  | (D) EAP Services |            |  | (E) Other |            |   | Eliminations |   |             | Consolidated
|2005                  |  |                                            |             |                                  |   |                                                  |  |                  |            |  |           |            |   |              |   |             |              |  |   |              |   |  |   |            
|Revenues              |  | $                                          | 81,387,963  |                                  | $ | 60,577,580                                       |  | $                | 17,104,970 |  | $         | 48,076,719 |   |              | $ | 245,095     |              |  |   |             |   |  | $ | 207,392,327
|Intercompany Revenues |  |                                            | 34,210      |                                  |   |                                                 |  |                  |           |  |           | 324,423    |   |              |   |            |              |  | $ | (358,633     | ) |  |   |           
|                      |  |                                            |             |                                  |   |                                                  | 
|Cost of Services      |  |                                            | 52,364,289  |                                  |   | 48,835,924                                       |  |                  | 12,582,838 |  |           | 46,709,063 |   |              |   | (85,626     | )            |  |   | (373,920     | ) |  |   | 160,032,568
|                      |  |                                            |             |                                  |   |                                                  | 
|EBITDA (F)            |  |                                            | 26,880,334  |                                  |   | 7,928,487                                        |  |                  | 2,963,587  |  |           | (628,506   | ) |              |   | (17,400,838 | )            |  |   | 15,184       |   |  |   | 19,758,248 
|                      |  |                                            |             |                                  |   |                                                  | 
|Total assets (G)      |  |                                            | 111,943,421 |                                  |   | 84,701,264                                       |  |                  | 17,431,724 |  |           | 47,560,971 |   |              |   | 16,337,481  |              |  |   | (91,409,790  | ) |  |   | 186,565,071
|                      |  |                                            |             |                                  |   |                                                  | 
|2004                  |  |                                            |             |                                  |   |                                                  |  |                  |            |  |           |            |   |              |   |             |              |  |   |              |   |  |   |            
|Revenues              |  | $                                          | 80,387,949  |                                  | $ | 10,069,329                                       |  | $                | 18,758,589 |  | $         | 52,249,019 |   |              | $ | 359,726     |              |  |   |             |   |  | $ | 161,824,612
|Intercompany Revenues |  |                                            | 1,136       |                                  |   |                                                 |  |                  |           |  |           | 233,122    |   |              |   |            |              |  | $ | (234,258     | ) |  |   |           
|                      |  |                                            |             |                                  |   |                                                  | 
|Cost of Services      |  |                                            | 52,219,261  |                                  |   | 7,645,487                                        |  |                  | 14,239,741 |  |           | 47,598,774 |   |              |   | 261,414     |              |  |   | (410,591     | ) |  |   | 121,554,086
|                      |  |                                            |             |                                  |   |                                                  | 
|EBITDA (F)            |  |                                            | 25,638,367  |                                  |   | 1,941,896                                        |  |                  | 3,610,121  |  |           | 3,068,545  |   |              |   | (13,868,403 | )            |  |   | 176,434      |   |  |   | 20,566,960 
|                      |  |                                            |             |                                  |   |                                                  | 
|Total assets (G)      |  |                                            | 107,804,272 |                                  |   | 39,668,906                                       |  |                  | 15,146,169 |  |           | 47,586,232 |   |              |   | 33,092,433  |              |  |   | (113,769,567 | ) |  |   | 129,528,445
|                      |  |                                            |             |                                  |   |                                                  | 
|2003                  |  |                                            |             |                                  |   |                                                  |  |                  |            |  |           |            |   |              |   |             |              |  |   |              |   |  |   |            
|Revenues              |  | $                                          | 76,727,730  |                                  |   |                                                 |  | $                | 17,366,592 |  | $         | 48,348,055 |   |              | $ | 1,894,934   |              |  |   |             |   |  | $ | 144,337,311
|Intercompany Revenues |  |                                            |            |                                  |   |                                                 |  |                  |           |  |           | 183,500    |   |              |   |            |              |  | $ | (183,500     | ) |  |   |           
|                      |  |                                            |             |                                  |   |                                                  | 
|Cost of Services      |  |                                            | 51,064,745  |                                  |   |                                                 |  |                  | 13,001,695 |  |           | 44,687,287 |   |              |   | 1,495,790   |              |  |   | (359,422     | ) |  |   | 109,890,095
|                      |  |                                            |             |                                  |   |                                                  | 
|EBITDA (F)            |  |                                            | 23,905,519  |                                  |   |                                                 |  |                  | 3,485,493  |  |           | 1,347,754  |   |              |   | (11,819,944 | )            |  |   | 175,922      |   |  |   | 17,094,744 
|                      |  |                                            |             |                                  |   |                                                  | 
|Total assets (G)      |  |                                            | 106,191,383 |                                  |   |                                                 |  |                  | 12,785,558 |  |           | 49,243,626 |   |              |   | 23,960,879  |              |  |   | (115,358,892 | ) |  |   | 76,822,554 

---

|(A) | Behavioral Health Contract Management services provides behavioral health contract management services to acute care hospitals.
|--- | -------------------------------------------------------------------------------------------------------------------------------

|(B) | Behavioral Health Hospital Services represents the freestanding owned/operated behavioral health care hospitals that provide behavioral health programs for children, adolescents,
and adults.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(C) | Physical Rehabilitation Contract Management Services provides physical rehabilitation contract management services to acute care hospitals.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------

|(D) | EAP Services provides employee assistance programs and managed behavioral health care. EAP Services terminated all its managed behavioral health care contracts effective
August 31, 2005.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(E) | Other represents revenue and expenses associated with residual Phase IV PsychScope agreements and the Companys primary general and administrative costs, i.e.,
expenses associated with the corporate offices and National Support Center located in the Dallas suburb of Lewisville, Texas which provides management, financial, human resources, and information system support for the Company and its service
groups.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(F) | EBITDA is a presentation of earnings before interest, taxes, depreciation, and amortization. EBITDA is the unit of measure reviewed by the chief operating decision
makers in determining service group operating performance. EBITDA may not be comparable to similarly titled measures reported by other companies. In addition, EBITDA is a non-GAAP measure and should not be considered an alternative to operating or
net income in measuring company results. For the year ended August 31, 2005, 2004 and 2003, segment EBITDA is derived by adding depreciation and amortization of $3,387,388, $2,794,832, and $2,419,104, respectively, and other income/expense of
$1,297,387, $1,306,844 and $558,825, respectively, to the Companys income before income taxes, minority interest and discontinued operations for the same periods of $14,057,781, $16,465,284 and $14,116,815, respectively. In addition, for the
year ended August 31, 2005, the impairment loss on building of $1,015,241 is added back to calculate segment EBITDA. Consolidated cash flows from operating, investing, and financing activities for the period ended August 31, 2005 were $12,388,934,
($26,576,121), and $20,368,082 respectively, for the period ended August 31, 2004 were $12,437,091, ($37,651,032), and $25,149,003 respectively, and for the period ended August 31, 2003 were $13,529,329, ($12,371,411) and ($3,220,832),
respectively, and are represented on the Statement of Cash Flows elsewhere herein.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



F-33



---

##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



|(G) | Consolidated assets above do not include assets for ProCare One Nurses, which was sold on August 29, 2005, and is therefore considered a discontinued operation and is no longer
presented as a service group of the Company. Operating results were reclassified as discontinued operations, however, the assets and liabilities of ProCare were not retroactively reclassified into the discontinued assets and liabilities categories
on the balance sheet. To reconcile from this table to total assets presented on the face of the consolidated balance sheet, the assets associated with ProCare One Nurses would need to be added back to the consolidated assets reflected in the table
above as follows:
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|     |  |              |             |                    |   |              |  |   |            
|---- |  | ------------ | ----------- | ------------------ | - | ------------ |  | - | -----------
|     |  | Consolidated |             | ProCare One Nurses |   | Total Assets
|2005 |  | $            | 186,565,071 |                    | $ | 1,977,472    |  | $ | 188,542,543
|2004 |  | $            | 129,528,445 |                    | $ | 15,736,442   |  | $ | 145,264,887
|2003 |  | $            | 76,822,554  |                    | $ | 25,506,154   |  | $ | 102,328,708



|16. | EAP SERVICES REORGANIZATION AND RELATED IMPAIRMENTS
|--- | ---------------------------------------------------



In the second quarter of 2005, the Company announced that it had commenced a reorganization of its EAP Services Group. The reorganization has involved the
centralization of most of the business functions of the service group in Lewisville, Texas, where the national support center of the Company is located. The reorganization has also involved focusing on employee assistance programs and the
termination of the managed behavioral health care at-risk contracts of the services group.



As of August 31, 2005, the Company recorded $1,611,591 in real estate lease expense and termination costs primarily associated with the recording of the remaining operating lease obligations associated with its
Philadelphia and Nashville offices. The Company also recorded an asset impairment charge of $1,015,241 related to the write-down to fair market value of the Companys National Support Center. The Company plans on consolidating its current
National Support Center with the new EAP service center into a new location in fiscal year 2006. In addition, the Company incurred $612,138 in employee costs related to severance and retention bonuses associated with the termination of employees at
its affected locations, $197,084 in employee relocation costs to its new service center, and $490,593 in duplicate salary costs in redundant service center locations during the training phase. At August 31, 2005, the company recorded a
liability of $504,549 for the remaining administrative costs associated with the remaining obligations for the terminated managed behavioral health at-risk contracts. Finally, the Company recorded $181,598 in miscellaneous other costs primarily
associated with travel and the moving of company files out of affected locations. At August 31, 2005, the reorganization was essentially complete.



F-34



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##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



The costs incurred in connection with the reorganization as of August 31, 2005 are presented below. (Amounts presented
in Thousands):



|                                                           |  |              |       |       |   |       |  |   |      
|---------------------------------------------------------- |  | ------------ | ----- | ----- | - | ----- |  | - | -----
|                                                           |  | EAP Services |       | Other |   | Total
|Total amounts expected to be incurred:                     |  |              |       |       |   |       |  |   |      
|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
|                                                           |  |              |      
|Cumulative amount incurred as of August 31, 2005:          |  |              |       |       |   |       |  |   |      
|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



A reconciliation of
the Companys liability balances for real estate and employee relocation expenses in connection with the reorganization is as follows (amounts in thousands):



|                                                           |  |              |       |       |   |       |  |   |      
|---------------------------------------------------------- |  | ------------ | ----- | ----- | - | ----- |  | - | -----
|                                                           |  | EAP Services |       | Other |   | Total
|Balance as of September 1, 2004                            |  | $            |      |       | $ |      |  | $ |     
|Amounts incurred for the year ended August 31, 2005:       |  |              |       |       |   |       |  |   |      
|Real estate lease expense and termination costs            |  |              | 1,612 |       |   |      |  |   | 1,612
|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 |  |              | 353   |       |   | 89    |  |   | 442  
|Miscellaneous other costs                                  |  |              | 182   |       |   |      |  |   | 182  
|                                                           |  |              |       |       |   |       |  |   |      
|Total                                                      |  | $            | 3,447 |       | $ | 89    |  | $ | 3,536
|                                                           |  |              |      
|Cash payments for the year ended August 31, 2005:          |  |              |       |       |   |       |  |   |      
|Real estate lease expense and termination costs            |  | $            | 231   |       | $ |      |  | $ | 231  
|Employee severance and retention bonus costs               |  |              | 343   |       |   |      |  |   | 343  
|Employee relocation costs                                  |  |              | 71    |       |   |      |  |   | 71   
|Employee training and redundant staffing costs             |  |              | 481   |       |   |      |  |   | 481  
|Costs associated with termination of MBH at-risk contracts |  |              |      |       |   |      |  |   |     
|Miscellaneous other costs                                  |  |              | 129   |       |   |       |  |   | 129  
|                                                           |  |              |       |       |   |       |  |   |      
|Total                                                      |  | $            | 1,255 |       | $ |      |  | $ | 1,255
|                                                           |  |              |      
|Balance as of August 31, 2005                              |  | $            | 2,192 |       | $ | 89    |  | $ | 2,281



F-35



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##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



|17. | QUARTERLY FINANCIAL INFORMATION (unaudited)
|--- | -------------------------------------------



The following is a summary of unaudited quarterly financial data for fiscal 2005 and 2004:



|                             |  |               |            |                |   |               |  |                |            |      |   |            |  |      |            |  |      |            |  |   |            |   |  |   |           
|---------------------------- |  | ------------- | ---------- | -------------- | - | ------------- |  | -------------- | ---------- | ---- | - | ---------- |  | ---- | ---------- |  | ---- | ---------- |  | - | ---------- | - |  | - | ----------
|                             |  | First Quarter |            | Second Quarter |   | Third Quarter |  | Fourth Quarter
|                             |  | 2005          |            | 2004           |   | 2005          |  | 2004           |            | 2005 |   | 2004       |  | 2005 |            |  | 2004
|Revenues                     |  | $             | 47,285,573 |                | $ | 37,485,895    |  | $              | 49,712,543 |      | $ | 37,577,124 |  | $    | 53,804,996 |  | $    | 40,233,148 |  | $ | 56,589,215 |   |  | $ | 46,528,445
|Income (Loss) from:          |  |               |            |                |   |               |  |                |            |      |   |            |  |      |            |  |      |            |  |   |            |   |  |   |           
|Continuing Operations        |  |               | 2,747,307  |                |   | 2,346,587     |  |                | 2,893,973  |      |   | 2,664,908  |  |      | 3,322,234  |  |      | 2,560,760  |  |   | (222,421   | ) |  |   | 2,640,991 
|Discontinued Operations      |  |               | 234,972    |                |   | 234,364       |  |                | 184,235    |      |   | 4,478      |  |      | 170,336    |  |      | 169,140    |  |   | (4,180,104 | ) |  |   | 153,960   
|                             |  |               |            |                |   |               |  |                |            |      |   |            |  |      |            |  |      |            |  |   |            |   |  |   |           
|Net Income (Loss)            |  | $             | 2,982,279  |                | $ | 2,580,951     |  | $              | 3,078,208  |      | $ | 2,669,386  |  | $    | 3,492,570  |  | $    | 2,729,900  |  | $ | (4,402,525 | ) |  | $ | 2,794,951 
|                             |  |               |            |                |   |               |  |                |            |      |   |            |  |      |            |  |      |            |  |   |            |   |  |   |           
|Net Income (Loss) Per Share: |  |               |            |                |   |               |  |                |            |      |   |            |  |      |            |  |      |            |  |   |            |   |  |   |           
|                             |  |               |            |                |   |               |  |               
|Continuing Operations        |  |               |            |                |   |               |  |                |            |      |   |            |  |      |            |  |      |            |  |   |            |   |  |   |           
|Basic                        |  | $             | 0.25       |                | $ | 0.22          |  | $              | 0.26       |      | $ | 0.25       |  | $    | 0.23       |  | $    | 0.23       |  | $ | (0.02      | ) |  | $ | 0.24      
|Diluted                      |  | $             | 0.24       |                | $ | 0.21          |  | $              | 0.25       |      | $ | 0.23       |  | $    | 0.23       |  | $    | 0.23       |  | $ | (0.01      | ) |  | $ | 0.23      
|                             |  |               |            |                |   |               |  |               
|Discontinuing Operations     |  |               |            |                |   |               |  |                |            |      |   |            |  |      |            |  |      |            |  |   |            |   |  |   |           
|Basic                        |  | $             | 0.02       |                | $ | 0.02          |  | $              | 0.02       |      | $ | 0.00       |  | $    | 0.01       |  | $    | 0.02       |  | $ | (0.28      | ) |  | $ | 0.02      
|Diluted                      |  | $             | 0.02       |                | $ | 0.02          |  | $              | 0.02       |      | $ | 0.00       |  | $    | 0.01       |  | $    | 0.01       |  | $ | (0.27      | ) |  | $ | 0.01      
|                             |  |               |            |                |   |               |  |               
|Net Income (Loss)            |  |               |            |                |   |               |  |                |            |      |   |            |  |      |            |  |      |            |  |   |            |   |  |   |           
|                             |  |               |            |                |   |               |  |                |            |      |   |            |  |      |            |  |      |            |  |   |            |   |  |   |           
|Basic                        |  | $             | 0.27       |                | $ | 0.24          |  | $              | 0.27       |      | $ | 0.25       |  | $    | 0.25       |  | $    | 0.25       |  | $ | (0.30      | ) |  | $ | 0.26      
|Diluted                      |  | $             | 0.26       |                | $ | 0.23          |  | $              | 0.26       |      | $ | 0.24       |  | $    | 0.24       |  | $    | 0.24       |  | $ | (0.29      | ) |  | $ | 0.25      
|                             |  |               |            |                |   |               |  |                |            |      |   |            |  |      |            |  |      |            |  |   |            |   |  |   |           



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



F-36



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##### Table of Contents

##### Index to Financial Statements

INDEX TO FINANCIAL STATEMENT SCHEDULE



|                                              |  |    
|--------------------------------------------- |  | ---
|Schedule II Valuation and Qualifying Accounts |  | S-2



S-1



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##### Table of Contents

##### Index to Financial Statements

HORIZON HEALTH CORPORATION



SCHEDULE II: VALUATION AND QUALIFYING ACCOUNTS



|                                |  |                              |           |                                                               |   |           |                                  |  |   |                          |   |  |   |          
|------------------------------- |  | ---------------------------- | --------- | ------------------------------------------------------------- | - | --------- | -------------------------------- |  | - | ------------------------ | - |  | - | ---------
|                                |  | Balance atBeginningOf Period |           | Net AdditionsCharged(RecoveriesCredited) toCosts andExpenses* |   |           | UncollectibleAccountsWritten off |  |   | Balance at End of Period
|Year ended August 31, 2005:     |  |                              |           |                                                               |   |           |                                  |  |   |                          |   |  |   |          
|Allowance for doubtful accounts |  | $                            | 2,412,152 |                                                               | $ | 4,245,929 |                                  |  | $ | (916,975                 | ) |  | $ | 5,741,106
|                                |  |                              |           |                                                              
|Year ended August 31, 2004:     |  |                              |           |                                                               |   |           |                                  |  |   |                          |   |  |   |          
|Allowance for doubtful accounts |  | $                            | 1,511,876 |                                                               | $ | 796,949   |                                  |  | $ | 103,327                  |   |  | $ | 2,412,152
|                                |  |                              |           |                                                              
|Year ended August 31, 2003:     |  |                              |           |                                                               |   |           |                                  |  |   |                          |   |  |   |          
|Allowance for doubtful accounts |  | $                            | 1,718,530 |                                                               | $ | (689,410  | )                                |  | $ | 482,756                  |   |  | $ | 1,511,876

---

|* | Excludes the net of recoveries credited and additions charged of $135,751, $13,455, and $74,626 related to other receivables and accrued liabilities for the fiscal years ending
2005, 2004, and 2003.
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



S-2



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##### Table of Contents

##### Index to Financial Statements

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   |  | - |  | Long-term operating lease agreement of Laurelwood Hospital dated December 30, 2004 between the Company and Lake Hospital System Inc. (incorporated herein by reference to Exhibit 10.1 to
the Companys Quarterly Report on Form 10-Q for the quarter ended February 28, 2005).                                      
|       |  |  
|10.2   |  | - |  | Asset Purchase Agreement dated June 9, 2005 by and between Mountain State Behavioral Health Services, LLC, as Seller, and HHC River Park, as Purchaser (incorporated herein by reference
to Exhibit 10.1 to the Companys Quarterly Report on Form 10-Q for the quarter ended May 31, 2005).                         
|       |  |  
|10.3   |  | - |  | Stock Purchase agreement dated June 9, 2005 by and between Scott C. Stamm and Patrick D. Burrows, as Seller, HHC River Park, Inc., as Purchaser and Psychmanagement Group, Inc.
(incorporated herein by reference to Exhibit 10.1 to the Companys Quarterly Report on Form 10-Q for the quarter ended May 31, 2005).
|       |  |  
|10.4   |  | - |  | Asset Acquisition and Contribution Agreement dated April 22, 2005 by and between Friends Hospital, as Seller, and Friends Behavioral Health System, LP, as Purchaser (incorporated herein
by reference to Exhibit 10.1 to the Companys Current Report on Form 8-K dated July 6, 2005).                              
|       |  |  
|10.5   |  | - |  | Membership Interest Purchase Agreement dated August 22, 2005 by and between Horizon Health Corporation, as Seller, and CareerStaff Unlimited Inc. as Purchaser (incorporated herein by
reference to Exhibit 10.1 to the Companys Current Report on Form 8-K/A dated August 29, 2005).                               
|       |  |  
|10.6   |  | - |  | Office Lease Agreement dated May 6, 2005 between Opus West LP, as Landlord, and Horizon Health Corporation, as Tenant (incorporated herein by reference to Exhibit 10.1 to the
Companys Quarterly Report on Form 10-Q for the quarter ended May 31, 2005).                                                          



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##### Table of Contents

##### Index to Financial Statements

|      |  |   |  |                                                                                                                                                                                                                                                                                                                                                           
|----- |  | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.7  |  | - |  | Underwriting Agreement dated March 10, 2005, by and between the Company and J.P. Morgan Securities, Inc., as Representative of the Several Underwriters listed on the scheduled 1 thereto
(incorporated herein by reference to Exhibit 1.1 to the Companys Current Report on Form 8-K dated March 10, 2005).                                             
|      |  |  
|10.8  |  | - |  | Third Amended and Restated Credit Agreement dated June 10, 2005 between Horizon Health Corporation and Horizon Health Management, Inc., as Borrowers and J.P Morgan 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, 2005).
|      |  |  
|10.9  |  | - |  | 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).                                                                                                                                                   
|      |  |  
|10.10 |  | - |  | 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).                                                                                                                                        
|      |  |  
|10.11 |  | - |  | 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).                                                                                   
|      |  |  
|10.12 |  | - |  | 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).                                                                                                                                                   
|      |  |  
|10.13 |  | - |  | 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).                                                                                                                                                                             
|      |  |  
|10.14 |  | - |  | Horizon Health Corporation Employee Stock Purchase Plan (incorporated herein by reference to Exhibit 4.3 to the Companys Registration Statement on Form S-8 filed with the Commission on
November 30, 1999, Registration No. 333-91761).                                                                                                                 
|      |  |  
|10.15 |  | - |  | Horizon Health Corporation Bonus Plan Fiscal 2005 (incorporated herein by reference to Exhibit 10.14 to the Companys Annual Report on Form 10-K for the fiscal year ended August 31,
2004).                                                                                                                                                              
|      |  |  
|10.16 |  | - |  | Horizon Health Corporation Bonus Plan Fiscal 2006 (filed herewith).                                                                                                                                                                                                                                                                                       
|      |  |  
|10.17 |  | - |  | Executive Retention Agreement effective May 1,2003 between the Company and James Ken Newman (incorporated herein by reference to Exhibit 10.1 to the Companys Quarterly Report on
Form 10-Q for the quarter ended May 31, 2003).                                                                                                                         
|      |  |  
|10.18 |  | - |  | Agreement dated July 1, 2004 between Horizon Health Corporation, Inc. and David K. Meyercord regarding severance arrangements (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, 2004).                                                                                  
|      |  |  
|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).                                                                                                                                                                                                                    



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##### Table of Contents

##### Index to Financial Statements

|     |  |   |  |                                                                                                                                                                          
|---- |  | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|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).