The following items were the subject of a Form 12b-25
 and are included herein: Item 6, Item 7, Item 8, Item 9A, Item 15-
 Financial
Statement Schedules and Exhibits 23, 31 and 32.
 
 **UNITED
STATES**
 **SECURITIES
AND EXCHANGE COMMISSION**
 Washington,
D.C. 20549
 **_____________________**
 **FORM
10-K/A**
 **(AMENDMENT
NO. 1)**
 
 ANNUAL
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the
fiscal year ended December 31, 2004
 Commission
File No. 000-26728
 
 **TALK
AMERICA HOLDINGS, INC.**
 (Exact
name of registrant as specified in its charter)
 
 **Delaware**
    **23-2827736**(State
      or other jurisdiction of
    (I.R.S.
      Employerincorporation
      or organization)
    Identification
      Number)**12020
      Sunrise Valley Drive, Suite 250**
    **20191****Reston,
      Virginia**
    (zip
      code)(Address
      of principal executive offices)
 
 **(703)
391-7500**
 (Registrant’s
telephone number, including area code)
 
 **Securities
registered pursuant to Section 12(b) of the Act:**
 **Title
      of each class**
    **Name
      of each exchange on which registered**None
    Not
      applicable
 
 **Securities
registered pursuant to Section 12(g) of the Act:**
 **Common
Stock, Par Value $.01 Per Share**
 **Rights
to Purchase Series A Junior Participating Preferred Stock**
 (Title
of class)
 
 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 of this
Form 10-K. [X]
 
 Indicate
by check mark whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Act). Yes [X] No [ ]
 
 As of
June 30, 2004, the aggregate market value of the voting stock held by
non-affiliates of the registrant, based on the average of the high and low
prices of the common stock on June 30, 2004 of $7.73 per share as reported on
the Nasdaq National Market, was approximately $206,312,664 (calculated by
excluding solely for purposes of this form outstanding shares owned by directors
and executive officers).
 
 As of
March 11, 2005, the registrant had issued and outstanding 27,078,605 shares of
common stock, par value $.01 per share.
  **DOCUMENTS
INCORPORATED BY REFERENCE**
 
 None.
  
 
 **TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**
 
 **INDEX
TO FORM 10-K**
 **FOR
THE YEAR ENDED DECEMBER 31, 2004**
 
 
 **ITEM**
      **NO.**
    **PAGE**
      **NO.**PART
      II6.
      Selected Financial Data
    27.
      Management's Discussion and Analysis of Financial Condition and Results of
      Operations
    38.
      Financial Statements and Supplementary Data
    149A.
      Controls and Procedures
    42PART
      IV15.
      Exhibits, Financial Statement Schedules
    45
 
 
 Unless
the context otherwise requires, references to "us," "we," and "our" or to "Talk
America" refer to Talk America Holdings, Inc. and its subsidiaries.
   
 
 
 
 **PART
II**
 
 **Cautionary
Note Concerning Forward-Looking Statements**
 
 Certain
of the statements contained in this Form 10-K Report may be considered
"forward-looking statements" for purposes of the securities laws. From time to
time, oral or written forward-looking statements may also be included in other
materials released to the public. These forward-looking statements are intended
to provide our management’s current expectations or plans for our future
operating and financial performance, based on our current expectations and
assumptions currently believed to be valid. For these statements, we claim
protection of the safe harbor for forward-looking statements provided by the
Private Securities Litigation Reform Act of 1995. These forward-looking
statements can be identified by the use of forward-looking words or phrases,
including, but not limited to, "believes," "estimates," "expects," "expected,"
"anticipates," "anticipated," "plans," "strategy," "target," "prospects" and
other words of similar meaning in connection with a discussion of future
operating or financial performance. Although we believe that the expectations
reflected in such forward-looking statements are reasonable, there can be no
assurance that such expectations will prove to have been correct.
 
 
 All
forward-looking statements involve risks and uncertainties that may cause our
actual results to differ materially from those expressed or implied in the
forward-looking statements. This Form 10-K Report includes important information
as to risk factors in the "Business" section under the headings “Business
Strategies,” "Business Operations," "Competition" and "Regulation" and in
"Management’s Discussion and Analysis of Financial Condition and Results of
Operations." In addition to those factors discussed in this Form 10-K Report,
you should see our other reports on Forms 10-K, 10-Q and 8-K subsequently filed
with the Securities and Exchange Commission from time to time for information
identifying factors that may cause actual results to differ materially from
those expressed or implied in the forward-looking statements.
 
 ****
 ****
 1
 ****
 **ITEM
6. SELECTED FINANCIAL DATA.**
 
 The
selected consolidated financial data should be read in conjunction with, and are
qualified in their entirety by, "Management's Discussion and Analysis of
Financial Condition and Results of Operations" and our Consolidated Financial
Statements included elsewhere in this Form 10-K. Please note that the selected
financial data below, our Consolidated Financial Statements included elsewhere
in this Form 10-K and the discussion in our “Management’s Discussion and
Analysis of Financial Condition and Results of Operations” reflect the
restatement, discussed in Item 9A of Part II of this Form 10-K, of our
consolidated financial statements for the four quarters and the year ended
December 31, 2003 by our Amendment No. 2 on Form 10-K/A to our Annual Report on
Form 10-K for the year ended December 31, 2003, which Amendment No. 2 was filed
with the Securities and Exchange Commission on March 28, 2005.
 
 
 **Year
      Ended December 31,****2004**
    
    
    **2003**
    
    
    **2002**
    
    
    **2001**
    
    
    **2000******
    
    **(In
      Thousands, Except For Per Share Amounts)****Consolidated
      Statements of Operations Data:**Revenue
    
    $
    471,012
    
    $
    383,693
    
    $
    317,507
    
    $
    488,158
    
    $
    525,712Costs
      and expenses:Network
      and line costs
    
    
    225,244
    
    
    173,349
    
    
    146,911
    
    
    218,964
    
    
    272,208General
      and administrative expenses
    
    
    72,020
    
    
    63,104
    
    
    62,166
    
    
    98,391
    
    
    86,083Provision
      for doubtful accounts
    
    
    21,313
    
    
    11,599
    
    
    9,365
    
    
    92,778
    
    
    53,772Sales
      and marketing expenses
    
    
    70,202
    
    
    51,008
    
    
    27,148
    
    
    73,973
    
    
    152,028Depreciation
      and amortization
    
    
    22,904
    
    
    18,345
    
    
    17,318
    
    
    34,390
    
    
    19,257Impairment
      and restructuring charges
    
    
    --
    
    
    --
    
    
    --
    
    
    170,571
    
    
    --Total
      costs and expenses
    
    
    411,683
    
    
    317,405
    
    
    262,908
    
    
    689,067
    
    
    583,348Operating
      income (loss)
    
    
    59,329
    
    
    66,288
    
    
    54,599
    
    
    (200,909
    )
    
    (57,636
    )Other
      income (expense):Interest
      income
    
    
    290
    
    
    388
    
    
    802
    
    
    1,220
    
    
    4,859Interest
      expense
    
    
    (733
    )
    
    (7,353
    )
    
    (9,087
    )
    
    (6,091
    )
    
    (5,297
    )Other
      income (expense), net
    
    
    1,895
    
    
    2,470
    
    
    28,448
    
    
    17,950
    
    
    (3,822
    )Income
      (loss) before provision (benefit) for incometaxes
    
    
    60,781
    
    
    61,793
    
    
    74,762
    
    
    (187,830
    )
    
    (61,896
    )Provision
      (benefit) for income taxes
    
    
    23,969
    
    
    (20,024
    )
    
    (22,300
    )
    
    --
    
    
    --Income
      (loss) before cumulative effect of anaccounting
      change
    
    
    36,812
    
    
    81,817
    
    
    97,062
    
    
    (187,830
    )
    
    (61,896
    )Cumulative
      effect of an accounting change
    
    
    --
    
    
    --
    
    
    --
    
    
    (36,837
    )
    
    --Net
      income (loss)
    
    $
    36,812
    
    $
    81,817
    
    $
    97,062
    
    $
    (224,667
    )
    $
    (61,896
    )Income
      (loss) per share - Basic:Income
      (loss) before cumulative effect of an accounting change per share
    
    $
    1.37
    
    $
    3.10
    
    $
    3.56
    
    $
    (7.11
    )
    $
    (2.63
    )Cumulative
      effect of an accounting change per share
    
    
    --
    
    
    --
    
    
    --
    
    
    (1.40
    )
    
    --Net
      income (loss) per share
    
    $
    1.37
    
    $
    3.10
    
    $
    3.56
    
    $
    (8.51
    )
    $
    (2.63
    )Weighted
      average common shares outstanding
    
    
    26,847
    
    
    26,376
    
    
    27,253
    
    
    26,414
    
    
    23,509Income
      (loss) per share - Diluted:Income
      (loss) before cumulative effect of an accounting change per
      share
    
    $
    1.32
    
    $
    2.94
    
    $
    3.15
    
    $
    (7.11
    )
    $
    (2.63
    )Cumulative
      effect of an accounting change per share
    
    
    --
    
    
    --
    
    
    --
    
    
    (1.40
    )
    
    --Net
      income (loss) per share
    
    $
    1.32
    
    $
    2.94
    
    $
    3.15
    
    $
    (8.51
    )
    $
    (2.63
    )Weighted
      average common and common equivalent shares outstanding
    
    
    27,854
    
    
    27,806
    
    
    30,798
    
    
    26,414
    
    
    23,509
 
 2
  
 **At
      December 31,****2004**
    
    
    **2003**
    
    
    **2002**
    
    
    **2001**
    
    
    **2000******
    
    **(In
      Thousands)****Consolidated
      Balance Sheet Data:**Cash
      and cash equivalents
    
    $
    47,492
    
    $
    35,242
    
    $
    33,588
    
    $
    22,100
    
    $
    40,604Total
      current assets
    
    
    138,068
    
    
    105,595
    
    
    82,825
    
    
    51,214
    
    
    97,203Goodwill
      and intangibles, net
    
    
    14,979
    
    
    17,769
    
    
    26,882
    
    
    29,672
    
    
    218,639Total
      assets
    
    
    241,728
    
    
    247,178
    
    
    189,075
    
    
    165,737
    
    
    407,749Current
      portion of long-term debt
    
    
    2,529
    
    
    16,806
    
    
    61
    
    
    14,454
    
    
    2,822Total
      current liabilities
    
    
    84,584
    
    
    93,235
    
    
    64,754
    
    
    87,789
    
    
    100,271Long-term
      debt
    
    
    1,717
    
    
    31,791
    
    
    100,855
    
    
    152,370
    
    
    103,695Stockholders'
      equity (deficit)
    
    
    141,521
    
    
    103,143
    
    
    23,466
    
    
    (74,422
    )
    
    82,700
 
 See
“Management’s Discussion and Analysis of Financial Condition and Results of
Operations” for a discussion of items affecting the results of 2002, 2003 and
2004.
 
 **ITEM
7.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.**
 
 The
following discussion should be read in conjunction with the Consolidated
Financial Statements included elsewhere in this Form 10-K.
 
 **Cautionary
Note Concerning Forward-Looking Statements**
 
 Certain
of the statements contained herein may be considered "forward-looking
statements" for purposes of the securities laws. From time to time, oral or
written forward-looking statements may also be included in other materials
released to the public. These forward-looking statements are intended to provide
our management’s current expectations or plans for our future operating and
financial performance, based on our current expectations and assumptions
currently believed to be valid. For these statements, we claim protection of the
safe harbor for forward-looking statements provided by the Private Securities
Litigation Reform Act of 1995. These forward-looking statements can be
identified by the use of forward-looking words or phrases, including, but not
limited to, "believes," "estimates," "expects," "expected," "anticipates,"
"anticipated," "plans," "strategy," "target," "prospects" and other words of
similar meaning in connection with a discussion of future operating or financial
performance. Although we believe that the expectations reflected in such
forward-looking statements are reasonable, there can be no assurance that such
expectations will prove to have been correct.
 
 All
forward-looking statements involve risks and uncertainties that may cause our
actual results to differ materially from those expressed or implied in the
forward-looking statements. In addition to those factors discussed in this Form
10-K Report, you should see our other reports on Forms 10-K, 10-Q and 8-K
subsequently filed with the Securities and Exchange Commission from time to time
for information identifying factors that may cause actual results to differ
materially from those expressed or implied in the forward-looking
statements.
 **OVERVIEW**
 
 We offer
a bundle of local and long distance phone services to residential and small
business customers in the United States. We have built a large, profitable base
of bundled phone service customers using the wholesale operating platforms of
the incumbent local exchange companies, such as the Regional Bell Operating
Companies, and have begun and plan to migrate customers to our own networking
platform in Detroit and Grand Rapids, Michigan, and further increase our
revenues and profitability on those customers by offering new products and
services.
  
 3
 
 In
December 2004, the FCC issued final rules that effectively eliminated the
requirement that incumbent local exchange companies provide us wholesale
services using the unbundled network element platform and established a 12-month
transition plan for implementation. Beginning on March 11, 2005, we are no
longer able to use the unbundled network element platform to provide service to
new customers and 12 months after that date the limitation will extend to all
customers. In addition, during this 12-month period, the wholesale rates that we
are charged will increase by $1 per line per month. At the end of the 12-month
period, we will need to service customers that are not on our own networking
platform through a resale or other wholesale agreement, both of which will have
significantly higher costs than servicing customers through the unbundled
network platform. As a result of (a) significant changes to the FCC rules that
previously required the incumbent local exchange companies to provide on a
wholesale basis the unbundled network elements to us and (b) price increases
established by various state public utility commissions, the rates that we are
to be charged by the incumbent local exchange companies to provide our services
increased significantly in 2004 and will continue to increase over time. These
cost increases have and will continue to lead us to increase our product
pricing, which we believe inhibits our ability to add new customers and to
retain existing customers. Therefore we have reduced our efforts to increase
subscriber growth in the markets other than those areas where we currently have
or plan to deploy network facilities (Detroit and Grand Rapids), which will
significantly reduce our sales and marketing expenditures from past periods. In
addition to the increases discussed above as a result of these regulatory
actions, we plan to further increase our product pricing for our customers
located in those areas where we do not currently have or plan to deploy network
facilities. These cost increases will increase our revenue for such customers;
however, it will likely adversely affect our ability to retain such customers on
our service.
 
 An
integral element of our business strategy is to develop our own local networking
capacity. Local
networking would enhance our operating flexibility and provide us with an
alternative to the wholesale operating platforms of the incumbent local exchange
companies. Beginning in 2003, we deployed networking assets in Michigan and, as
of December 31, 2004, we had approximately 25,000 bundled lines on our Michigan
network. We are continuing the expansion of our network by collocating our
networking equipment in the incumbent local exchange companies’ end offices to
provide service over our own network to a larger existing customer base in
Detroit and Grand Rapids, Michigan. As a result of the significant changes in
the regulatory environment, we have accelerated our networking initiatives and
by December 31, 2005 we expect to have approximately 175,000 bundled lines on
our network in Michigan, although some of the regulatory changes could also
impede this deployment (discussed under “Regulation” above, and "Liquidity and
Capital Resources, Other Matters," below). We have and continue to improve the
automation of the business processes required to provide local network-based
services. In addition, we are actively exploring next generation networking
opportunities with a variety of vendors in order to decrease our cost of
delivering service, reduce our reliance upon the incumbent local exchange
companies and provide local telephone services through new, innovative methods
of delivery.  However, we have not previously developed, deployed or
operated a local network of our own or of this scale and there can be no
assurance that we shall be able successfully to do so and thereafter profitably
provide local telephone services through such a network.
 
 We will
continue to add new services and enhance our existing service and product
offerings, as available. We believe that the addition of these new services and
of enhanced services will increase our revenues and gross margins on those
customers while also meeting their needs and demands and reducing our customer
turnover. We launched a new dial-up internet service in June 2004, and began
testing digital subscriber line, or DSL, service in the third quarter
2004.
 
 Our
future business strategy is to serve medium sized businesses in those areas
where we plan to deploy network facilities. Expansion into this business market
will increase our addressable market in such an area and will permit us to
leverage our investment in our network facilities due to the complementary
telecommunication traffic or usage patterns of these business customers and our
residential and small business customers. We will consider and pursue the
acquisition of customers or networking assets to enter the business market,
complement existing networking plans or to supplement customer density where
there is a potential for deployment of network facilities. As a consequence of
the FCC’s rules regarding access to the incumbent local exchange companies’
networks after March 11, 2005, our acquisition of customers from other companies
who provide service using the unbundled network elements platform must be
consummated in a manner where the transfer of the acquired customer is directly
provisioned to our own network facilities, which, due to the limitations on the
number of phone lines the incumbent local exchange company is required to “hot
cut” over to our network per day, may limit or minimize the potential advantages
of any such acquisition. However, we have not recently made any such
acquisitions of customers, networking assets or businesses and there can be no
assurances that we will be able to do so successfully.
  4
 **RESULTS
OF OPERATIONS**
 
 The
following table sets forth for the periods indicated certain of our financial
data as a percentage of revenue:
 
 **Year
      Ended December 31,****2004**
    
    
    **2003**
    
    
    **2002**Revenue
    
    
    100.0%
    
    
    100.0%
    
    
    100.0%Costs
      and expenses:Network
      and line costs
    
    
    47.8
    
    
    45.2
    
    
    46.3General
      and administrative expenses
    
    
    15.3
    
    
    16.4
    
    
    19.5Provision
      for doubtful accounts
    
    
    4.5
    
    
    3.0
    
    
    2.9Sales
      and marketing expenses
    
    
    14.9
    
    
    13.3
    
    
    8.6Depreciation
      and amortization
    
    
    4.9
    
    
    4.8
    
    
    5.5Total
      costs and expenses
    
    
    87.4
    
    
    82.7
    
    
    82.8Operating
      income
    
    
    12.6
    
    
    17.3
    
    
    17.2Other
      income (expense):Interest
      income
    
    
    0.1
    
    
    0.1
    
    
    0.3Interest
      expense
    
    
    (0.2)
    
    
    (1.9)
    
    
    (2.9)Other,
      net
    
    
    0.4
    
    
    0.6
    
    
    9.0Income
      before income taxes
    
    
    12.9
    
    
    16.1
    
    
    23.6Provision
      (benefit) for income taxes
    
    
    5.1
    
    
    (5.2)
    
    
    (7.0)Net
      income
    
    
    7.8%
    
    
    21.3%
    
    
    30.6%
 
 The
following table sets forth for certain items of our financial data for each year
the percentage increase or (decrease) in such item from the preceding fiscal
year:
 
 **Year
      Ended December 31,****2004**
    
    
    **2003**Revenue
    
    
    22.8%
    
    
    20.8%Costs
      and expenses:Network
      and line costs
    
    
    29.9%
    
    
    18.0%General
      and administrative expenses
    
    
    14.1%
    
    
    1.5%Provision
      for doubtful accounts
    
    
    83.7%
    
    
    23.9%Sales
      and marketing expenses
    
    
    37.6%
    
    
    87.9%Depreciation
      and amortization
    
    
    24.9%
    
    
    5.9%Total
      costs and expenses
    
    
    29.7%
    
    
    (20.7%)Operating
      income
    
    
    (10.5%)
    
    
    21.4%Other
      income (expense):Interest
      income
    
    
    (25.3%)
    
    
    (51.6%)Interest
      expense
    
    
    (90.0%)
    
    
    (19.1%)Other,
      net
    
    
    (23.3%)
    
    
    (91.3%)Income
      before income taxes
    
    
    (1.6%)
    
    
    (17.3%)Provision
      for income taxes
    
    
    219.7%
    
    
    (10.2%)Net
      income
    
    
    (55.0%)
    
    
    (15.7%)
 
 
 5
 **
 *Revenue.* The
increase in revenue in 2004 from 2003 and in 2003 from 2002 was due to an
increase in bundled revenue offset by a decline in long distance revenue. In
2000, we decided to shift our focus to the bundled product and no longer
actively market the long distance product. During 2003 and 2004, we increased
certain fees and rates related to our long distance and bundled products and
such changes in rates adversely affected customer turnover. Additional increases
in fees and rates related to our long distance and bundled products will
adversely affect customer turnover.
 
 Bundled
revenue increased to $407.7 million for 2004 from $282.3 million for 2003 due
primarily to higher average bundled lines in 2004 as compared to 2003. We ended
2004 with 671,000 billed bundled lines, compared to 557,000 at the end of 2003.
Approximately 48.0% of the bundled lines in December 2004 were in Michigan,
compared to 58.6% in December 2003, reflecting our continued efforts to market
into other states. We expect the actions we will take, as a result of the recent
regulatory changes, to focus customer growth on areas where we have our own
local network and increase prices on our services where we do not have or plan
to deploy network facilities will cause the number of bundled lines and revenues
to decline in the future and will significantly increase the percentage of our
bundled lines in Michigan.
 
 The
increase in bundled revenue to $282.3 million in 2003 from $171.2 million in
2002 was due to higher average bundled lines in 2003 as compared to 2002,
partially offset by lower average monthly revenue per customer. We ended 2003
with 557,000 billed bundled lines compared to 333,000 at the end of
2002.
 
 Our long
distance revenue decreased in 2004 to $63.3 million from $101.4 million in 2003,
and from $146.3 million in 2002. Our decision in 2000 to invest in building a
bundled customer base, together with customer turnover, contributed to the
decline in long distance customers and revenue, although the effect on revenue
of the decline in customers was offset partially by an increase in average
monthly revenue per customer due to price increases. We expect this decline in
long distance customers and revenues to continue. Long distance revenues for
2002 included non-cash amortization of deferred revenue of $6.2 million related
to a telecommunications service agreement entered into in 1997. Deferred revenue
relating to this agreement had been amortized over a five-year period. The
agreement and related amortization terminated in October 2002.
 
 *Network
and Line Costs* . The
increase of network and line costs in 2004 from 2003 was primarily due to the
increase in bundled customers, partially offset by the decrease in long distance
customers. Network and line costs as a percentage of revenue increased slightly
in 2004 from 2003 and decreased slightly in 2003 from 2002. To date, we have
been able to increase our prices to offset per line increases in network and
line cost, but these increases may, over time, cause customer attrition. Network
and line costs in 2004 exclude depreciation of $6.2 million for 2004 and $3.4
million for 2003.
 
 We accrue
expenses for network costs that we believe we have incurred pursuant to our
interconnection agreements with a particular supplier or tariffs but for which
we have not yet been billed. This primarily occurs due to errors and omissions
in billing on the part of our principal suppliers, the Regional Bell Operating
Companies. Accrued expenses are eliminated upon the earlier of actual billing
(including billing for charges appropriately recorded in prior periods but not
invoiced, or “backbilling”) by the Regional Bell Operating Companies or the
expiration of the time period for which we are liable for the charges. In
addition, we accrue for network expense not yet billed in a jurisdiction if we
believe there is a prospect that regulatory or other legal changes in the
jurisdiction will retroactively increase the rates we have charged. For example,
in Georgia an appeals court overturned a recent rate reduction by the state
public utility commission and ordered the commission to re-calculate our rates.
This issue is currently being considered by the state commission or remand from
the court and we expect that the issue will be resolved during 2005. We believe
that these rates will be in excess of those previously allowed and have accrued
accordingly.
 
 We seek
to structure and price our products in order to maintain network and line costs
as a percentage of revenue at certain targeted levels. While the control of the
structure and pricing of our products assists us in mitigating risks of
increases in network and line costs, the telecommunications industry is highly
competitive and there can be no assurances that we will be able to effectively
market these higher priced products. In addition, there are several factors that
could cause our network and line costs as a percentage of revenue to increase in
the future, including without limitation:
   6
   
 ·
    As
      a result of significant changes to the FCC rules that required the
      incumbent local exchange companies, such as the Regional Bell Operating
      Companies that are our principal suppliers, to provide us the unbundled
      network elements of their operating platforms on a wholesale basis, the
      wholesale operating platforms of the incumbent local exchange companies is
      effectively not available to us for our new customers after March 11, 2005
      or for all our customers after March 11, 2006.This
      determination and others by the FCC, courts, or state commission(s) that
      make unbundled local switching and/or combinations of unbundled network
      elements effectively unavailable to us in some or all of our geographic
      service areas, will require us either to provide services in these areas
      through other means, including total service resale agreements or
      commercial agreements with incumbent local exchange
      companies, purchase of special access services or network elements
      purchased from the Regional Bell Operating Companies at "just and
      reasonable" rates under Section 271 of the Act, in all cases at
      significantly increased costs, or to provide services over our own
      switching facilities, if we are able to deploy them (see Item 1
      "Regulation," above and "Liquidity and Capital Resources, Other Matters,"
      below);
 
 ·
    Adverse
      changes to the current pricing methodology, TELRIC, mandated by the FCC
      for use in establishing the prices charged to us by incumbent local
      exchange companies for the use of their unbundled network elements for so
      long as we are permitted to continue to use them, and for the use of
      transport and other services in connection with our local network. The
      FCC’s 2003 Triennial Review Order, which was reversed in part and remanded
      to the FCC with instructions to revise the Order in material ways (see
      Item 1, "Regulation," above and "Liquidity and Capital Resources, Other
      Matters," below) clarified several aspects of these pricing principles
      related to depreciation, fill factors (i.e. network utilization) and cost
      of capital, which could enable incumbent local exchange companies to
      increase the prices for unbundled network elements. In addition, the FCC
      released a Notice of Proposed Rulemaking on December 15, 2003, which
      initiated a proceeding to consider making additional changes to its
      unbundled network element pricing methodology, including reforms that
      would base prices more on the actual network costs incurred by incumbent
      local exchange companies than on the hypothetical network costs that would
      be incurred when the most efficient technology is used.The
      TELRIC methodology still governs our pricing for loops purchased from the
      incumbent local exchange companies in connection with our local network.
      We cannot predict if the FCC will order new TELRIC pricing or if Congress
      will amend the 1996 Act, affecting such pricing or availability.These
      changes could result in material increases in prices charged to us for
      unbundled network elements, including those used in our own local network;
      and
 
 ·
    Determinations
      by state commissions to increase prices for unbundled network elements in
      ongoing state cost dockets.
 
 We expect
the actions we will take, as a result of the recent regulatory changes, to focus
customer growth in areas where we have our own local network, currently
Michigan, and increase prices on our services, will cause the number of bundled
lines to decline in the future and reduce network and line costs, although the
amount of the reduction may be offset in part by the increased costs we may be
required to pay. Changes in the pricing of our service plans could also cause
network and line costs as a percentage of revenue to change in the future. See
our discussion under "Liquidity and Capital Resources, Other Matters,"
below.
 
 *General
and Administrative Expenses* . General
and administrative expenses increased in 2004 from 2003 and in 2003 from 2002.
In 2004, the increase was attributable to a new operating lease for information
technology equipment. In 2002, general and administrative expenses were reduced
by a settlement of litigation relating to an obligation with a third party of
$1.7 million. The increases were primarily due to the year-to-year increases in
the number of employees for customer service and information technology to
support our expanding base of bundled customers and our deployment of our local
facilities. General and administrative expense as a percentage of revenue
decreased from 2003 to 2004 and from 2002 to 2003. This decrease resulted from
the efficiencies of a growing base of revenues relative to certain fixed
operating expenses. We expect that as revenues decline in the future, as we
anticipate, general and administrative expense as a percentage of revenues will
increase.
 
 *Provision
for Doubtful Accounts* . The
provision for doubtful accounts increased in 2004 from 2003. The increase was
due to an increase in the number of customers and revenue as well an increase in
bad debt expense as a percentage of revenues. The increase in bad debt as a
percentage of revenue in 2004 was primarily due to:
 
 ·
    Reduced
      employee collection hours as a result of several hurricanes near our
      Florida customer service centers. As a result of the closures and employee
      attendance disruption, our collections personnel were unable to pursue
      payments from delinquent customers. We were unable to make up the lost
      employee time and, as a result, the collection time decreased and aging on
      the accounts deteriorated, therefore, the provision for doubtful accounts
      increased.
 
 ·
    An
      increase in market share outside of Michigan into states where we have
      experienced generally higher levels of bad debt. Our experience is that
      bad debt varies by state. The greater relative proportion of customers in
      states other than Michigan resulted in increased overall bad
      debt.
  ·
    In
      an effort to expand our addressable market during 2004, we experimented
      with a new credit screening vendor and methodology to supplement our
      existing credit screening process. The change was meant to provide a
      credit score for potential customers for whom no score was available under
      our primary scoring methodology. Management believed that, in building the
      parameters for this new method, the bad debt would have been consistent
      with that of our primary method. In actuality, however, customers accepted
      through this new methodology had higher bad debt than customers accepted
      through our primary credit screening method. Thus, the influx of customers
      through the new methodology during the third quarter resulted in increased
      bad debt for the third and fourth quarters. Based on these actual results,
      we ceased utilizing this supplemental screening
    methodology.
 
 7
 
 The
provision for doubtful accounts increased in 2003 from 2002. The increase was
due to an increase in the number of customers and revenue. In addition, in 2002,
the provision for doubtful accounts was reduced by a reversal of the reserve for
doubtful accounts of $1.9 million due to better-than-expected collections
experience on accounts receivable outstanding at year end 2001. The benefits of
our actions taken during the third and fourth quarters of 2001 to reduce bad
debt expense and improve the overall credit quality of our customer base were
reflected in the lower bad debt expense for 2002.
 
 *Sales
and Marketing Expenses* . Sales
and marketing expense increased in 2004 from 2003 and in 2003 from 2002. The
increases are primarily attributable to the increase of sales and marketing
activity for continued growth of our bundled sales. Sales and marketing expense
as a percentage of revenue also increased over the prior year during these
periods, as the cost of acquiring a customer increased. Currently, substantially
all of our sales and marketing expenses relate to the bundled product. Included
in sales and marketing expenses are advertising expenses of $9.8 million for
2004, $6.8 million for 2003, and $1.5 million for 2002. We expect sales and
marketing expenses to decrease in 2005 as we significantly reduce our efforts to
increase subscriber growth and focus only on markets with potential for
networking.
 
 *Interest
Expense* . The
decreases in interest expense for 2004 from 2003 and for 2003 from 2002 are
primarily attributable to the decreases in, and the retirement in 2004 of the
balance of, the outstanding debt balances.
 
 *Depreciation
and Amortization.* Depreciation and amortization increased in 2004 from 2003 and in 2003 from 2002
primarily due to depreciation on costs incurred in 2003 and 2004 related to our
deployment of networking assets (our local switch and collocation equipment) in
Michigan and amortization of capitalized software projects completed during 2003
and 2004 primarily related to the development of customer relations management
software. In December 2004, in connection with a review of our fixed assets, the
estimated remaining useful life of our five long distance switches was shortened
from an average of 8 years to 1.6 years. This change had the effect of
increasing depreciation for 2004 by $1.4 million. In addition, we expect that
depreciation expense will increase by approximately $18 million in 2005 from
2004.
 
 **
 *Other
Income, Net* . Other
income for 2004 consists of income recorded as a result of the statutory
expiration of the liability for certain sales and use taxes reserves. Other
income for 2003 consists of gains from our repurchase of a portion of our 12%
Senior Subordinated Notes at a discount to par. Other income in 2002 included
$28.9 million attributed to the restructuring and repurchase of a portion of our
8% Secured Convertible Notes and $1.6 million attributed to the repurchase of a
portion of our 12% Senior Subordinated Notes, partially offset by a loss of $1.1
million related to the retirement of our senior credit facility.
 
 *Provision
for Income Taxes.* In 2003,
management evaluated the deferred tax asset valuation allowance and determined
that a portion of the allowance should be reversed. The evaluation considered
the profitability of our business, the ability to utilize the deferred tax
assets in the future and possible restrictions on use due to provisions of the
Internal Revenue Code Section 382 "Change in Ownership." After consideration of
each of these factors, we concluded certain deferred tax assets would more
likely than not be utilized, and reversed deferred tax asset valuation
allowances of $50.6 million for 2003, recognized a non-cash deferred income tax
benefit of $44.1 million and reduced the amount of goodwill related to the
August, 2000 acquisition of Access One Communications, Inc. by $6.5 million. In
2003, the tax benefit was partially offset by an income tax expense of $24.1
million.
 
 As a
result of the application of net operating loss carryforwards, or NOLs, we
currently need only pay accrued alternative minimum taxes and certain state
income taxes. As of December 31, 2004, we had approximately $114.7 million of
federal NOLs, which are available to offset future taxable income. A valuation
allowance has been maintained for a $23 million tax deduction, which was taken
in our 1996 federal income tax return and for which we are currently involved in
an administrative proceeding before the Internal Revenue Service. A valuation
allowance has also been maintained for certain state NOLs, which we believe may
not be realized. We will continue to assess the valuation allowance of these
deferred tax assets, and will reverse such allowance if we conclude that it is
more likely than not these deferred tax assets will be utilized. We expect that
our federal NOLs will be substantially utilized by 2007 with the exception of
$2.3 million in NOLs generated by Access One Communications, Inc. and its
subsidiaries, which will be substantially utilized by 2018.
 
 8
 ****
 **LIQUIDITY
AND CAPITAL RESOURCES**
 
 Our
management assesses our liquidity in terms of our ability to generate cash to
fund our operations, our capital expenditures and our debt service obligations.
For 2004 and 2003, our operating activities provided net cash flow of $74.6
million and $73.2 million, respectively, more than half of which in each year
was used by us to reduce our outstanding debt obligations and a significant
portion of the balance of which was used to fund capital expenditures and
capitalized software development costs. As of December 31, 2004, we had $47.5
million in cash and cash equivalents and long-term debt and capital lease
obligations (including current maturities) of $4.2 million, compared to $35.2
million and $48.6 million, respectively, at December 31, 2003.
 
 Our
contractual obligations as of December 31, 2004 are summarized by years to
maturity as follows (in thousands):
 
 Contractual
      Obligations
    
    
    Total
    
    
    1
      year or
      less
    
    
    2 -
      3
      Years
    
    
    4 -
      5
      Years
    
    
    ThereafterTalk
      America Inc. and other subsidiaries:Vendor
      financing agreement (1)
    
    $
    2,057
    
    $
    1,397
    
    $
    660
    
    $
    --
    
    $
    --Capital
      lease obligations
    
    
    2,189
    
    
    1,132
    
    
    1,057
    
    
    --
    
    
    --Vendor
      financed maintenance (1)
    
    
    1,122
    
    
    561
    
    
    561
    
    
    --
    
    
    --Operating
      leases
    
    
    6,003
    
    
    2,922
    
    
    2,447
    
    
    278
    
    
    356Purchase
      commitments (2)
    
    
    4,400
    
    
    4,400
    
    
    --
    
    
    --
    
    
    --Invoice
      printing commitment (3)
    
    
    4,913
    
    
    1,183
    
    
    2,456
    
    
    1,274
    
    
    --Carrier
      commitments (4)
    
    
    97,000
    
    
    33,000
    
    
    64,000
    
    
    --
    
    
    --Total
      Contractual Obligations
    
    $
    117,684
    
    $
    44,595
    
    $
    71,181
    
    $
    1,552
    
    $
    356
 
 (1)  In May
2004, in connection with the purchase of software, we entered into a loan
agreement with the software supplier for $3.1 million payable over 36 months at
a 2.9% annual interest rate. The agreement includes $2.5 million of software and
an annual maintenance contract of $0.6 million. In addition, we agreed to renew
the maintenance agreement for an additional two years at the cost of $1.1
million, which is funded on the anniversary dates. As of December 31, 2004,
there was approximately $2.1 million outstanding under this loan.
 
 (2)  At
December 31, 2004, we had outstanding purchase orders for capital expenditures
related to the build out of our Michigan networking facilities with two vendors
in the aggregate amount of $4.4 million.
 
 (3)  We have a
contract with our invoice printing company that establishes pricing and provides
for annual minimum payments.
 
 (4)  In
December 2003, we entered into a four-year master carrier agreement with
AT&T. The agreement provides us with a variety of services, including
transmission facilities to connect our network switches as well as services for
international calls, local traffic, international calling cards, overflow
traffic and operator assisted calls. The agreement also provides that, subject
to certain terms and conditions, we will purchase these services exclusively
from AT&T during the term of the agreement, provided, however, that we are
not obligated to purchase exclusively in certain cases, including if such
purchases would result in a breach of any contract with another carrier that was
in place when we entered into the AT&T agreement, or if vendor diversity is
required. Our AT&T agreement establishes pricing and provides for annual
minimum revenue commitments based upon usage as follows: 2005 - $32 million,
2006 - $32 million and 2007 - $32 million and obligates us to pay 65 percent of
the revenue shortfall, if any. Despite the anticipated reduction in our local
bundled customer base, we anticipate that we will not be required to make any
shortfall payments under this contract as a result of the restructuring of the
obligations or the growth in network minutes as a result of acquisitions, there
can be no assurances that we will be successful in our efforts. To the extent
that we are unable to meet these minimum commitments, our costs of purchasing
the services under the agreement will correspondingly increase. In addition to
the AT&T commitment, the carrier commitments include a commitment with one
separate carrier of approximate $1.0 million in 2005.
 
  9
 
 Cash
provided by (used for):
 
 Percent
      Change2002
    
    
    2003
    
    
    2004
    
    
    2003
      vs. 2002
    
    
    2004
      vs. 2003Operating
      activities
    
    $
    51,898
    
    $
    73,171
    
    $
    74,595
    
    
    41.0
    %
    
    1.9
    %Investing
      activities
    
    
    (7,332
    )
    
    (14,715
    )
    
    (16,497
    )
    
    (100.7
    %)
    
    (12.1
    %)Financing
      activities
    
    
    (33,078
    )
    
    (56,802
    )
    
    (45,848
    )
    
    (71.7
    %)
    
    19.3
    %
 
 
 *Cash
Provided By Operating Activities.* Cash
generated by operations increased by $1.4 million from 2003 to 2004. The
increase was driven primarily by higher cash flow before changes in working
capital. In the aggregate, the changes in working capital were similar in 2004
and 2003. Net accounts receivable increased by $8.6 million in 2004 down from an
increase of $12.5 million in 2003. The increase in net accounts receivable in
both 2003 and 2004 was due to an increase in revenues during the same periods.
As revenues are expected to decline in 2005, net accounts receivable should also
be expected to decline. Accounts payable increased by $8.1 million in 2004 up
from an increase of $3.1 million in 2003. The increase in accounts payable in
both 2003 and 2004 was due to an increase in operating expenses during the same
periods. As operating expenses are expected to decline in 2005, accounts payable
should also be expected to decline. These items that favorably affected cash
from operations were offset by an increase in other current assets and other
current liabilities. The application of NOL carryforwards has limited our
current payment of income taxes to cash taxes for alternative minimum taxes and
certain state income taxes. We expect that our NOLs will be substantially
utilized during 2007.
 
 Cash
generated by operations increased by $21.3 million from 2002 to 2003. The
increase was driven by both higher cash flow before working capital changes of
$11.7 million and a reduction in working capital. In the aggregate, changes in
working capital used $1.3 million in 2003 down from a use of $10.3 million in
2002. Accounts payable were reduced significantly in 2002 as we improved payment
terms with our vendors. Deferred revenue and net accounts receivable increased
substantially in 2003 as compared to 2002 as our bundled business
grew.
 
 *Net
Cash Used in Investing Activities.* Capital
expenditures increased by $1.1 million during 2004 as compared to 2003 and
capitalized software increased by $0.8 million. In 2004, approximately 37% of
our $13.0 million in capital expenditures consisted of costs related to our
deployment of networking assets (local switch and collocation equipment) in
Michigan, up from 66% of our $5.5 million in 2003. Also in 2003, to support our
customer growth, we opened a new customer service call center. The remaining
2003 capital expenditures consisted primarily of upgrades to
our information technology capabilities to support our customer growth. In
addition, during 2004 we entered into a capital lease valued at $2.5 million for
new database software and during 2003, we entered into a capital lease valued at
$3.4 million for upgrades to our customer data storage equipment.
 
 We expect
to spend between $43 and $47 million in capital expenditures and capitalized
software in 2005, primarily for the build out of the Michigan networking
facilities. We have not, however, previously developed and deployed a local
network of our own or of this scale and there can be no assurance that we
will not encounter unanticipated costs in acquiring the assets necessary for
such networking capability and its operation or in deploying the new network. In
addition, to the extent we identify other markets to deploy networking
facilities, our capital expenditures will increase accordingly.
 
 Capitalized
software development costs consist of direct development costs associated with
internal-use computer software, including payroll costs for employees devoting
time to the software projects. In 2004, capitalized software development costs
totaled $3.5 million and were primarily related to the development of software
related to the deployment of our networking facilities. We expect software
development costs in 2005 to be consistent with 2004 as we continue to develop
the integrated information systems required to provide local switch-based
service.
 
 To the
extent that we are successful in identifying and completing an acquisition of
either customers, networking assets or a business, net cash used in investing
activities may increase.
  10
 **
 *Net
Cash Used in Financing Activities.* Net cash
used in financing activities during 2004 and 2003 was $45.8 million and $56.8
million, respectively, primarily attributable to debt repayments of $46.5
million and $53.0 million in 2004 and 2003, respectively. In addition, during
2003, pursuant to our former share buyback program announced in January 2003, we
purchased 1,315,789 shares for a purchase price of $5.0 million. On June 1,
2004, we announced that our Board of Directors had authorized a share buyback
program for us to purchase up to $50 million of our outstanding shares. The
shares may be purchased from time to time, in the open market and/or private
transactions. Through December 31, 2004, we had not purchased any shares under
this program.
 
 During
2004, we redeemed $40.7 million of our 12% Senior Subordinated Notes, $2.8
million of our 8% Convertible Senior Subordinated Notes and $0.7 million of our
5% Convertible Subordinated Notes, representing the respective entire principal
amounts outstanding as of December 31, 2003.
 
 Net cash
used in financing activities during 2002 was primarily attributable to debt
repayment and purchases of $32.7 million. For 2002, $2.8 million of interest was
recorded as additional principal on the 12% Senior Subordinated Notes and 8%
Secured Convertible Notes for payment of interest in kind rather than in cash.
 
 While we
believe that we may have access to new capital in the public or private markets
to fund our ongoing cash requirements (including any acquisitions), there can be
no assurance as to the timing, amounts, terms or conditions of any such new
capital or whether it could be obtained on terms acceptable to us. We anticipate
that our cash requirements will generally be met from our cash-on-hand and from
cash generated from operations. Based on our current projections for operations,
we believe that our cash-on-hand and our cash flow from operations will be
sufficient to fund our currently contemplated capital expenditures, our debt
service obligations, and the expenses of conducting our operations for at least
the next twelve months. However, there can be no assurance that we will be able
to realize our projected cash flows from operations, which is subject to the
risks and uncertainties discussed in this report, or that we will not be
required to consider capital expenditures in excess of those currently
contemplated, as discussed in this report.
 
 **Other
Matters**
 
 Our
provision of telecommunications services is subject to government
regulation. **** To date,
our local telecommunications services have been provided almost exclusively
through the use of unbundled network elements purchased from incumbent local
exchange companies that were made available to us pursuant to FCC rules. It has
been primarily the availability of these unbundled network elements from
the incumbent local exchange companies' facilities at substantially lower
prices than those available for resale through total service resale agreements
that has enabled us to price our local telecommunications services
competitively.  As a result of the FCC’s final rules, since March 11, 2005,
the unbundled network element platform is no longer available to us for adding
new customers. Further, as of March 11, 2005 there is a $1 increase in the cost
per line, per month for us to continue providing service to our existing
customers that are on the unbundled network element platform. In addition, for
both local loops and dedicated transport, the FCC adopted a twelve-month
transition plan for competitive
local exchange companies, such as us, to
transition away from the use of DS1 and DS3 loops and dedicated transport where
there is no impairment, as defined in the FCC’s final rules, and an
eighteen-month transition plan to transition away from dark fiber. The
transition plans apply only to the customer base as it exists on March 11, 2005,
and do not permit competitive
local exchange companies to add
new dedicated transport unbundled
network elements in the
absence of impairment.
 
 As a
result of the FCC’s final rules, we will be forced by March 11, 2006, to
transition our customers from the unbundled network element platform to our own
network facilities or to service our local customers through resale agreements
or through elements purchased through commercial agreements that we may enter
into with the incumbent local exchange companies. In 2003, we began deploying
networking assets in Michigan and, as of December 31, 2004, we had approximately
25,000 bundled lines on our Michigan network. We are continuing the expansion of
our network by collocating our networking equipment in the incumbent local
exchange companies’ end offices to provide service over our own network to a
larger existing customer base in geographic regions where we have a high density
of customers. We are also considering other ways of expanding our network
capacity and customer base, including by acquisition of capacity and customers
from other companies, both directly and by acquisition of such companies. By
December 31, 2005 we expect to have 175,000 bundled lines on our network in
Michigan, and we are actively exploring network opportunities in areas outside
of Michigan. However, should cost-based transport unbundled network elements
become effectively unavailable to us, our plans to deploy our own network
facilities could be substantially impeded, and we could be forced to use other
means to effect this deployment, including the use of facilities purchased at
higher special access rates or transport services purchased from other
facilities-based competitive local telephone carriers.   In either
event, our cost of service could rise dramatically and our plans for a service
roll-out for use of our own network facilities could be delayed substantially or
derailed entirely.  This would have a material adverse effect on our
business, prospects, operating margins, results of operations, cash flows and
financial condition.
 
 11
 
 **CRITICAL
ACCOUNTING ESTIMATES**
 
 Our
discussion and analysis of our financial condition and results of operations are
based upon our consolidated financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States.
The preparation of these financial statements requires us to make estimates and
judgments that affect the reported amounts of assets, liabilities, revenues and
expenses, and related disclosure of contingent assets and liabilities. On an
on-going basis, we evaluate our estimates, including those related to bad debt,
goodwill and intangible assets, income taxes, contingencies and litigation. We
base our estimates and judgments on historical experience and on various other
assumptions that are believed to be reasonable under the circumstances, the
results of which form the basis for making judgments about the carrying values
of assets and liabilities that are not readily apparent from other sources.
Actual results may differ from these estimates under different assumptions or
conditions.
 
 **Network
and Line Costs**
 
 We accrue
expenses for network costs that we believe we have incurred pursuant to our
interconnection agreements with a particular supplier or tariffs but for which
we have not yet been billed. This primarily occurs due to errors and omissions
in billing on the part of our principal suppliers, the Regional Bell Operating
Companies. In addition, we accrue for network expense not yet billed in a
jurisdiction if we believe there is a prospect that regulators or other legal
changes in the jurisdiction will retroactively increase the rates we have
charged. For example, in Georgia an appeals court overturned a recent rate
reduction by the state public utility commission and ordered the commission to
re-calculate our rates. This issue is currently being considered by the state
commission and we expect that the issue will be resolved during 2005. We believe
that these rates will be in excess of those previously allowed and have accrued
accordingly.
 
 Accrued
expenses are eliminated upon the earlier of actual billing (including billing
for charges appropriately recorded in prior periods but not invoiced, or
“backbilling”) by the Regional Bell Operating Companies or the expiration of the
time period for which we are liable for the charges. The time period is governed
by interconnection agreements or, in the absence of a specific agreement, by the
statute of limitations operative in a given jurisdiction. As the expiration of
the statute of limitations occurred, which began in 2004, we have reduced, and
will reduce in the future, our liability for this exposure as there is no
further legal recourse the supplier can take in collecting these
amounts.
 
 **Allowance
for Uncollectible Accounts**
 
 Allowances
for doubtful accounts are maintained for estimated losses resulting from the
failure of customers to make required payments on their accounts. We review
accounts receivable aging trends, historical bad debt trends, and customer
credit-worthiness through customer credit scores, current economic trends and
changes in customer payment history when evaluating the adequacy of the
allowance for doubtful accounts. In addition, we review the financial condition
of the carriers that pay us access charges to assess their ability to make
payments.
 
 **Valuation
of Long-Lived Assets and Intangible Assets with a Definite
Life**
 
 We review
the recoverability of the carrying value of long-lived assets, including
intangibles with a definite life, for impairment whenever events or changes in
circumstances indicate that the carrying amount of such assets may not be
recoverable. When such events occur, we compare the carrying amount of the
assets to the undiscounted expected future cash flows from them. Factors we
consider important that could trigger an impairment review include the
following:
 
 ·
    Significant
      underperformance relative to historical or projected future operating
      results
 ·
    Significant
      changes in the manner of our use of the acquired assets or expected useful
      lives of the assets or the strategy for our overall business
 ·
    Significant
      negative regulatory, industry or economic trends
 ·
    Significant
      decline in our stock price for a sustained period and market
      capitalization relative to net book value
 
 Long-lived
assets are grouped with other assets and liabilities at the lowest level for
which identifiable cash flows are largely independent of the cash flows of other
assets and liabilities. Since we provide integrated telecommunications services
with our asset groups not being independent of each other, our assets are viewed
as being of a single asset group and impairment testing is conducted at the
entity level. Estimates of future cash flows used to test recoverability are
made for the remaining useful life of the primary asset of the asset group. Cash
flows are estimated using management’s current view of the operating and
financial prospects of the asset group. If this comparison indicates there is
impairment, the amount of the impairment loss to be recorded is calculated by
the excess of the net assets’ carrying value over its fair value and is
typically calculated using discounted expected future cash flows.
  12
 **Goodwill
and Intangible Assets with Indeterminate Lives**
 
 Goodwill
represents the cost in excess of the fair value of the net assets of acquired
companies. Effective January 1, 2002, with the adoption of SFAS No. 142,
goodwill (comprised of goodwill acquired in the Access One acquisition in August
2000) will not be amortized, but rather will be tested for impairment annually,
and will be tested for impairment between annual tests if an event occurs or
circumstances change that would indicate the carrying amount may be impaired.
Impairment testing for goodwill is performed at a reporting unit level; we
determined that we have one reporting unit under the guidance of SFAS No. 142.
An impairment loss would generally be recognized when the carrying amount of the
reporting unit’s net assets exceeds the estimated fair value of the reporting
unit. Fair value for the reporting unit is based on a discounted cash flow
analysis and consideration of the current market value of our common stock. Cash
flows are estimated using management’s current view of the operating and
financial prospects of the business. A discount rate of 18% was used in the
discounted cash flow analysis.
 
 **Income
Taxes**
 
 Income
taxes are accounted for under the asset and liability method. During 2004 and
2003, we recorded income taxes at a rate equal to our combined federal and state
effective rates. Deferred tax assets and liabilities are recognized for the
estimated future tax consequences attributable to the differences between the
financial statement carrying amounts of existing assets and liabilities and
their respective tax bases and operating loss and tax credit carryforwards.
Deferred tax assets and liabilities are measured using enacted tax rates in
effect for the year in which those temporary differences are expected to be
recovered or settled.
 
 We
consider all available evidence, both positive and negative, to determine
whether, based on the weight of that evidence, a valuation allowance is needed
for some portion or all of a net deferred tax asset. Judgment is used in
considering the relative impact of negative and positive evidence. In arriving
at these judgments, the weight given to the potential effect of negative and
positive evidence is commensurate with the extent to which it can be objectively
verified. We record a valuation allowance to reduce our deferred tax assets and
review the amount of such allowance annually. When we determine certain deferred
tax assets are more likely than not to be utilized, we will reduce our valuation
allowance accordingly.
 
 **New
Accounting Pronouncements**
 
 In December
2004, the FASB revised Statement of Financial Accounting Standards No. 123
("SFAS No. 123 (R)"), requiring public companies to recognize the cost resulting
from all share-based payment transactions in their financial statements. SFAS
No. 123(R) supersedes APB Opinion No. 25, "Accounting for Stock Issued to
Employees" and amends SFAS No. 95, "Statement of Cash Flows." Generally, the
approach in SFAS No. 123(R) is similar to the approach described in SFAS No.
123. However, SFAS No. 123(R) requires all share-based payments to employees,
including grants of employee stock options, to be recognized in the income
statement based on their fair values. Pro forma disclosure is no longer an
alternative. The new standard will be effective for us in the first interim or
annual reporting period beginning after June 15, 2005. We are
currently assessing the implications of the transition methods allowed and have
not determined whether the adoption of FAS 123(R) will result in amounts similar
to current pro-forma disclosures under FAS 123. We expect the adoption to have
an adverse impact on future consolidated statements of operations.
 
 In
December 2004, the FASB issued SFAS No. 153 Exchange of Nonmonetary Assets, an
amendment of APB Opinion No. 29 ("SFAS 153"). SFAS 153 amends prior guidance to
eliminate the exception for nonmonetary exchanges of similar productive assets
and replaces it with a general exception for exchanges of nonmonetary assets
that do not have commercial substance. A nonmonetary exchange has commercial
substance if the future cash flows of the entity are expected to change
significantly as a result of the exchange. The provisions of SFAS 153 are
effective for nonmonetary asset exchanges occurring in fiscal periods beginning
after June 15, 2005 and shall be applied prospectively. SFAS 153 is not expected
to have a material impact on our consolidated financial statements at the date
of adoption.
 
 13
 ****
 **ITEM
8.**  **FINANCIAL
STATEMENTS AND SUPPLEMENTARY DATA.**
 
 **TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**
 **INDEX
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **PAGE**Report
      of Independent Registered Public Accounting Firm
    
    15Consolidated
      statements of operations for the years ended December 31, 2004, 2003 and
      2002
    
    18Consolidated
      balance sheets as of December 31, 2004 and 2003
    
    19Consolidated
      statements of cash flows for the years ended December 31, 2004, 2003 and
      2002
    
    20Consolidated
      statements of stockholders' equity (deficit) for the years ended December
      31, 2004, 2003 and 2002
    
    21Notes
      to consolidated financial statements
    
    22
 
 
 
 
 14
  
 **Report
of Independent Registered Public Accounting Firm**
 
 To the
Board of Directors and
 Shareholders
of Talk America Holdings, Inc.:
 
 
 We have
completed an integrated audit of Talk America Holdings, Inc.’s 2004 consolidated
financial statements and of its internal control over financial reporting as of
December 31, 2004 and audits of its 2003 and 2002 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 and financial statements schedule
 
 In our
opinion, the consolidated financial statements listed in the index appearing
under Item 15(a)(1) of this Annual Report on Form 10-K present fairly, in all
material respects, the financial position of Talk America Holdings, Inc. and its
subsidiaries (the “Company”) at December 31, 2004 and 2003, and the results of
their operations and their cash flows for each of the three years in the period
ended December 31, 2004 in conformity with accounting principles generally
accepted in the United States of America. In
addition, in our opinion, the financial statement schedule listed in the index
appearing under Item 15 (a)(2) of this
Annual Report on Form 10-K **** present
fairly, in all material respects, the information set forth therein when read in
conjunction with the related consolidated **** financial
statements. These financial statements and financial statement schedule are the
responsibility of the Company’s management. Our responsibility is to express an
opinion on these financial statements and
financial statement schedule 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
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our
opinion.
 
 Internal
control over financial reporting
 
 Also, we
have audited management’s assessment, included in Management’s Report on
Internal Control over Financial Reporting appearing in Item 9A of this Annual
Report on Form 10-K, that Talk America Holdings, Inc. did not maintain effective
internal control over financial reporting as of December 31, 2004, because the
Company did not maintain effective controls over the application of generally
accepted accounting principles related to the financial reporting process for
complex transactions and did not maintain effective controls over sales, use and
excise tax liability, based on criteria established in Internal Control -
Integrated Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (“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 as 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 transactions 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 or
timely detection of unauthorized acquisition, use, or disposition of the
company’s assets that could have a material effect on the financial
statements.
 
 15
 
 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.
 
 A
material weakness is a control deficiency, or combination of control
deficiencies, that results in more than a remote likelihood that a material
misstatement of the annual or interim financial statements will not be prevented
or detected. The following material weaknesses has been identified and included
in management’s assessment.
 
  *As of
December 31, 2004, the Company did not maintain effective controls over the
application of generally accepted accounting principles related to the financial
reporting process for complex transactions.* Specifically, the Company did not have personnel who possess sufficient depth,
skills and experience in accounting for and review of complex transactions in
the financial reporting process to ensure that complex transactions were
accounted for in accordance with generally accepted accounting principles. This
material weakness resulted in the following adjustments of the Company’s
financial statements:
  a.
    In
      connection with the preparation of the Company’s financial statements for
      the first and second quarters of 2004, management identified errors in the
      computation of deferred tax assets and the release of the valuation
      allowance related thereto that were recorded in the third quarter of 2003
      as follows: (i) failure to deduct state income tax expense from federal
      taxable income and (ii) failure to complete the appropriately detailed
      analysis of the Company’s deferred tax assets relating to state net
      operating loss carryforwards. In addition, in February 2005, management
      determined that they incorrectly applied generally accepted accounting
      principles, which resulted in improper correction of the aforementioned
      errors through an adjustment to the effective tax rate for 2004 rather
      than through the restatement of the Company’s prior period financial
      statements. This resulted in adjustments to deferred tax assets and income
      tax expense in the third and fourth quarter of 2003 and the first, second
      and third quarters of 2004;
  b.
    In
      connection with the preparation of the Company’s financial statements for
      the second quarter of 2004, management identified errors in the
      development and calculation of the effective state income tax rate. This
      resulted in an adjustment of income tax expense in the first and second
      quarters of 2004;
  c.
    Because
      of the Company’s failure to take into account certain applicable tax
      regulations, management did not identify that certain deferred tax assets
      relating to acquired net operating losses were available for and should
      have been recorded in the third quarter of 2003. In February 2005 when
      this error was identified, the correcting entries were not appropriately
      recorded by the Company. This resulted in an audit adjustment of deferred
      tax assets and goodwill in each of the periods beginning in the third
      quarter 2003; and
  d.
    In
      February 2005, during the audit of the Company’s 2004 financial
      statements, it was determined that in the Company’s calculations of
      earnings per share since the third quarter of 2003, the Company had not
      considered or included the tax benefits associated with the assumed
      exercise of employee stock options in the proceeds used to repurchase
      shares in the application of the treasury stock method. As a result, fully
      diluted shares outstanding and earnings per share were adjusted in those
      periods.
  This
control deficiency resulted in the restatement of the Company’s financial
statements for each of the quarters in 2003 and year ended December 31, 2003,
and the first, second and third quarters of 2004 and certain audit adjustments
to the fourth quarter 2004 financial statements. Additionally, this control
deficiency could result in a material misstatement to annual or interim
financial statements that would not be prevented or detected. Accordingly,
management has determined that this control deficiency constitutes a material
weakness.
 
 16
 **
 *As of
December 31, 2004 the Company did not maintain effective controls over sales,
use and excise tax liability.* Specifically,
the Company’s reconciliation and review procedures with respect to the sales,
use and excise tax liability that the Company collect and remit did not identify
that certain customer fee revenue had been incorrectly recorded in the sales,
use and excise tax general ledger account. This control deficiency resulted in
the restatement of the Company’s revenues and sales, use and excise tax
liability for each of the quarters in 2003 and year ended December 31, 2003, and
the first, second and third quarters of 2004 and an adjustment to the fourth
quarter 2004 financial statements. Additionally, this control deficiency could
result in a misstatement of revenues, and sales, use and excise tax liability
that would result in a material misstatement to annual or interim financial
statements that would not be prevented or detected. Accordingly, management has
determined that this control deficiency constitutes a material
weakness.
 
 These
material weaknesses was considered in determining the nature, timing, and extent
of audit tests applied in our audit of the December 31, 2004 Consolidated
Financial Statements, and our opinion regarding the effectiveness of the
Company’s internal control over financial reporting does not affect our opinion
on those consolidated financial statements.
 
 In our
opinion, management’s assessment that Talk America Holding, Inc. did not
maintain effective internal control over financial reporting as of December 31,
2004, is fairly stated, in all material respects, based on criteria established
in *Internal
Control* — *Integrated
Framework* issued by
the COSO. Also, in our opinion, because of the effect of the material weaknesses
described above on the achievement of the objectives of the control criteria,
Talk America Holdings, Inc. has not maintained effective internal control over
financial reporting as of December 31, 2004, based on criteria established in *Internal
Control* — *Integrated
Framework* issued by
the COSO.
 
 **PricewaterhouseCoopers
LLP**
 Philadelphia,
Pennsylvania
 March 29,
2005
 
 17
 
 
 
 **TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**
 **CONSOLIDATED
STATEMENTS OF OPERATIONS**
 **(In
thousands, except for per share data)**
 
 ****
    
    **Year
      Ended December 31,****2004**
    
    
    **2003**
    
    
    **2002**Revenue
    
    $
    471,012
    
    $
    383,693
    
    $
    317,507Costs
      and expenses:Network
      and line costs (excluding depreciation
      shown
      below)
    
    
    225,244
    
    
    173,349
    
    
    146,911General
      and administrative expenses
    
    
    72,020
    
    
    63,104
    
    
    62,166Provision
      for doubtful accounts
    
    
    21,313
    
    
    11,599
    
    
    9,365Sales
      and marketing expenses
    
    
    70,202
    
    
    51,008
    
    
    27,148Depreciation
      and amortization
    
    
    22,904
    
    
    18,345
    
    
    17,318Total
      costs and expenses
    
    
    411,683
    
    
    317,405
    
    
    262,908Operating
      income
    
    
    59,329
    
    
    66,288
    
    
    54,599Other
      income (expense):Interest
      income
    
    
    290
    
    
    388
    
    
    802Interest
      expense
    
    
    (733
    )
    
    (7,353
    )
    
    (9,087
    )Other
      income, net
    
    
    1,895
    
    
    2,470
    
    
    28,448Income
      before provision (benefit) for income taxes
    
    
    60,781
    
    
    61,793
    
    
    74,762Provision
      (benefit) for income taxes
    
    
    23,969
    
    
    (20,024
    )
    
    (22,300
    )Net
      income
    
    $
    36,812
    
    $
    81,817
    
    $
    97,062Income
      per share - Basic:Net
      income per share
    
    $
    1.37
    
    $
    3.10
    
    $
    3.56Weighted
      average common shares outstanding
    
    
    26,847
    
    
    26,376
    
    
    27,253Income
      per share - Diluted:Net
      income per share
    
    $
    1.32
    
    $
    2.94
    
    $
    3.15Weighted
      average common and common equivalentshares
      outstanding
    
    
    27,854
    
    
    27,806
    
    
    30,798
 
 See
accompanying notes to consolidated financial statements.
  
 18
 **TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**
 **CONSOLIDATED
BALANCE SHEETS**
 **(In
thousands, except for share and per share data)**
 
 ****
    
    
    **December
      31,****2004**
    
    
    **December
      31,****2003****Assets**Current
      assets:Cash
      and cash equivalents
    
    $
    47,492
    
    $
    35,242Accounts receivable, trade (net of allowance for uncollectible accounts of
      $17,508 and $9,414 at December 31, 2004 and 2003, respectively)
    
    
    48,873
    
    
    40,321Deferred
      income taxes
    
    
    34,815
    
    
    24,605Prepaid
      expenses and other current assets
    
    
    6,888
    
    
    5,427Total
      current assets
    
    
    138,068
    
    
    105,595Property
      and equipment, net
    
    
    65,823
    
    
    68,069Goodwill
    
    
    13,013
    
    
    13,013Intangible
      assets, net
    
    
    1,966
    
    
    4,666Deferred
      income taxes
    
    
    14,291
    
    
    48,288Capitalized
      software cost and other assets
    
    
    8,567
    
    
    7,547$
    241,728
    
    $
    247,178**Liabilities
      and Stockholders’ Equity**Current
      liabilities:Accounts
      payable
    
    $
    43,439
    
    $
    35,296Sales,
      use and excise taxes
    
    
    11,179
    
    
    13,521Deferred
      revenue
    
    
    15,321
    
    
    10,873Current
      portion of long-term debt and capitalized lease
obligations
    
    
    2,529
    
    
    16,806Accrued
      compensation
    
    
    6,690
    
    
    9,888Other
      current liabilities
    
    
    5,426
    
    
    6,851Total
      current liabilities
    
    
    84,584
    
    
    93,235Long-term
      debt and capitalized lease obligations
    
    
    1,717
    
    
    31,791Deferred
      income taxes
    
    
    13,906
    
    
    19,009Commitments
      and contingenciesStockholders'
      equity:Preferred stock - $.01 par value, 5,000,000 shares authorized; no shares
      outstanding
    
    
    --
    
    
    --Common stock - $.01 par value, 100,000,000 shares authorized; 27,037,096
      and 26,662,952 shares issued and outstanding at December 31, 2004 and
      2003, respectively
    
    
    284
    
    
    280Additional
      paid-in capital
    
    
    356,409
    
    
    354,847Accumulated
      deficit
    
    
    (210,172
    )
    
    (246,984
    )Treasury
      stock - at cost, 1,315,789 shares at December 31, 2004 and
      2003
    
    
    (5,000
    )
    
    (5,000
    )Total
      stockholders' equity
    
    
    141,521
    
    
    103,143$
    241,728
    
    $
    247,178
 
 See
accompanying notes to consolidated financial statements.
  
 19
 
 **TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**
 **CONSOLIDATED
STATEMENTS OF CASH FLOWS**
 **(In
thousands)**
 
 **Year
      Ended December 31,****2004**
    
    
    **2003**
    
    
    **2002**Cash
      flows from operating activities:Net
      income
    
    $
    36,812
    
    $
    81,817
    
    $
    97,062Adjustments
      to reconcile net income to net cash provided by operating
      activities:Provision
      for doubtful accounts
    
    
    21,313
    
    
    11,599
    
    
    9,365Depreciation
      and amortization
    
    
    22,904
    
    
    18,345
    
    
    17,318Other
      non-cash charges
    
    
    9
    
    
    --
    
    
    194Non-cash
      interest and amortization of accrued interest liabilities
    
    
    (956
    )
    
    (260
    )
    
    832Loss
      on sale and retirement of assets
    
    
    4
    
    
    22
    
    
    205Gain
      from restructuring of convertible debt
    
    
    --
    
    
    --
    
    
    (28,909
    )Gain
      from extinguishment of debt
    
    
    --
    
    
    (2,476
    )
    
    (431
    )Gain
      on legal settlement
    
    
    --
    
    
    --
    
    
    (1,681
    )Deferred
      income taxes
    
    
    19,588
    
    
    (23,411
    )
    
    (22,300
    )Changes
      in assets and liabilities:Accounts
      receivable, trade
    
    
    (29,865
    )
    
    (24,077
    )
    
    (10,560
    )Prepaid
      expenses and other current assets
    
    
    (900
    )
    
    (1,533
    )
    
    (1,902
    )Other
      assets
    
    
    60
    
    
    1,410
    
    
    2,211Accounts
      payable
    
    
    8,143
    
    
    3,144
    
    
    (11,462
    )Deferred
      revenue
    
    
    4,448
    
    
    4,393
    
    
    (3,713
    )Sales,
      use and excise taxes
    
    
    (2,342
    )
    
    2,082
    
    
    3,101Accrued
      compensation
    
    
    (3,198
    )
    
    4,279
    
    
    4,501Other
      current liabilities
    
    
    (1,425
    )
    
    (2,163
    )
    
    (1,933
    )Net
      cash provided by operating activities
    
    
    74,595
    
    
    73,171
    
    
    51,898Cash
      flows from investing activities:Acquisition
      of intangibles
    
    
    --
    
    
    (133
    )
    
    (50
    )Capital
      expenditures
    
    
    (12,963
    )
    
    (11,844
    )
    
    (4,781
    )Capitalized
      software development costs
    
    
    (3,534
    )
    
    (2,738
    )
    
    (2,501
    )Net
      cash used in investing activities
    
    
    (16,497
    )
    
    (14,715
    )
    
    (7,332
    )Cash
      flows from financing activities:Payments
      on borrowings
    
    
    (45,273
    )
    
    (52,918
    )
    
    (17,983
    )Payments
      of capital lease obligations
    
    
    (1,228
    )
    
    (61
    )
    
    (1,036
    )Acquisition
      of convertible debt and senior notes
    
    
    --
    
    
    --
    
    
    (14,691
    )Proceeds
      from exercise of options
    
    
    653
    
    
    1,177
    
    
    632Purchase
      of treasury stock
    
    
    --
    
    
    (5,000
    )
    
    --Net
      cash used in financing activities
    
    
    (45,848
    )
    
    (56,802
    )
    
    (33,078
    )Net
      increase in cash and cash equivalents
    
    
    12,250
    
    
    1,654
    
    
    11,488Cash
      and cash equivalents, beginning of year
    
    
    35,242
    
    
    33,588
    
    
    22,100Cash
      and cash equivalents, end of year
    
    $
    47,492
    
    $
    35,242
    
    $
    33,588
 
 
 See
accompanying notes to consolidated financial statements.
 
 20
  **TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**
 **CONSOLIDATED
STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)**
 **(In
thousands)**
 
 Common
      Stock
    
    
    
    
    
    
    
    
    Treasury
      StockShares
    
    
    Amount
    
    
    Additional
      Paid-In Capital
    
    
    Accumulated
      Deficit
    
    
    Shares
    
    
    Amount
    
    
    TotalBalance,
      December 31, 2001
    
    
    27,151
    
    $
    272
    
    $
    351,169
    
    $
    (425,863
    )
    
    --
    
    $
    --
    
    $
    (74,422
    )Net
      income
    
    
    --
    
    
    --
    
    
    --
    
    
    97,062
    
    
    --
    
    
    --
    
    
    97,062Issuance of common stock for services
    
    
    67
    
    
    1
    
    
    82
    
    
    --
    
    
    --
    
    
    --
    
    
    83Exercise of common stock options
    
    
    252
    
    
    2
    
    
    741
    
    
    --
    
    
    --
    
    
    --
    
    
    743Balance,
      December 31, 2002
    
    
    27,470
    
    
    275
    
    
    351,992
    
    
    (328,801
    )
    
    --
    
    
    --
    
    
    23,466Net
      income
    
    
    --
    
    
    --
    
    
    --
    
    
    87,817
    
    
    --
    
    
    --
    
    
    87,817Acquisition of treasury stock
    
    
    --
    
    
    --
    
    
    --
    
    
    --
    
    
    1,136
    
    
    (5,000
    )
    
    (5,000
    )Exercise of common stock options
    
    
    509
    
    
    5
    
    
    1,172
    
    
    --
    
    
    --
    
    
    --
    
    
    1,172Income tax benefit related to exercise of common stock options
    
    
    --
    
    
    --
    
    
    1,683
    
    
    --
    
    
    --
    
    
    --
    
    
    1,683Balance,
      December 31, 2003
    
    
    27,979
    
    
    280
    
    
    354,847
    
    
    (246,984
    )
    
    1,316
    
    
    (5,000
    )
    
    103,143Net
      income
    
    
    --
    
    
    --
    
    
    --
    
    
    36,812
    
    
    --
    
    
    --
    
    
    36,812Exercise of common stock options
    
    
    374
    
    
    4
    
    
    658
    
    
    --
    
    
    --
    
    
    --
    
    
    662Income tax benefit related to exercise of common stock options
    
    
    --
    
    
    --
    
    
    904
    
    
    --
    
    
    --
    
    
    --
    
    
    904Balance,
      December 31, 2004
    
    
    28,353
    
    $
    284
    
    $
    356,409
    
    $
    (210,172
    )
    
    1,316
    
    
    ($5,000
    )
    $
    141,521
  
 See
accompanying notes to consolidated financial statements.
 21
 ****
 **TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **NOTE
1. SUMMARY OF ACCOUNTING POLICIES**
 
 **(a)**  **Business**
 
 Talk
America Holdings, Inc., through its subsidiaries, offers a bundle of local and
long distance phone services and internet access services to residential and
small business customers in the United States. We operate our own nationwide
long distance network and deliver local services on our own local network and
through wholesale operating agreements with the incumbent local exchange
companies. We have developed integrated order processing, provisioning, billing,
payment, collection, customer service and information systems that enable us to
offer and deliver high-quality service, savings through competitively priced
telecommunication products, and simplicity through consolidated billing and
responsive customer service. We operate our own sales and customer service
centers. We manage our business as one reportable operating
segment.
 
 **(b)**  **Basis of
Financial Statements Presentation**
 
 The
consolidated financial statements include the accounts of Talk America Holdings,
Inc. and its wholly owned subsidiaries. All intercompany balances and
transactions have been eliminated.
 
 **(c)**  **Use
of Estimates**
 
 In
preparing financial statements in conformity with generally accepted accounting
principles in the United States, management is required to make estimates and
assumptions that affect the reported amounts of assets and liabilities and the
disclosure of contingent liabilities at the date of the financial statements and
revenues and expenses during the reporting period. Actual results could differ
from those estimates.
 
 **(d)**  **Reclassifications**
 
 Certain
amounts for 2003 and 2002 have been reclassified to conform to the current year
presentation. We have changed the classification of certain expenses, primarily
customer billing expenses, from network and line costs to general and
administrative expenses.
 
 **(e)**  **Risks
and Uncertainties**
 
 Future
results of operations involve a number of risks and uncertainties. Factors that
could affect future operating results and cash flows and cause actual results to
vary materially from historical results include, but are not limited to:
 
 ·
    Changes
      in government policy, regulation and enforcement or adverse judicial or
      administrative interpretations and rulings or legislative action relating
      to regulations, enforcement and pricing, including, but not limited to,
      changes that affect the continued availability until March 11, 2006 and
      thereafter of certain elements of the unbundled network element platform
      of the local exchange carriers network and the costs associated therewith
      and thereafter certain unbundled network element platform elements
      utilized with our network
 ·
    Dependence
      on the availability and functionality of the networks of the incumbent
      local exchange carriers as they relate to the unbundled network element
      platform
 ·
    Increased
      price competition in local and long distance services, including bundled
      services, and overall competition within the telecommunications industry,
      including, but not limited to, in the State of
Michigan
 
 Negative
developments in these areas could have a material effect on our business,
financial condition and results of operations.
 
 22
 **(f)**  **Concentration
of Credit Risk**
 
 We
maintain our cash and cash equivalents in bank deposit accounts, which at times
may exceed federally insured limits. We generally do not have a significant
concentration of credit risk with respect to net trade accounts receivable, due
to the large number of end users comprising our customer base.
 
 **(g)**  **Recognition
of Revenue**
 
 We derive
our revenues from local and long distance phone services, primarily local
services bundled with long distance services. We recognize revenue from voice,
data and other telecommunications-related services in the period in which
subscribers use the related service. Deferred revenue represents the unearned
portion of local service and features that are billed a month in advance.
 
 We also
derive access revenue from long-distance companies for access to our network in
connection with the completion of long-distance telephone calls. We recognize
access revenue based on minutes of traffic captured in a given period. Access
revenue represented less than five percent of total revenue for 2004, 2003 and
2002.
 
 Revenue
for 2002 included amortization of a non-refundable prepayment received in 1997
in connection with an amended telecommunications services agreement with Shared
Technologies Fairchild, Inc. The prepayment was amortized over the five-year
term of the agreement, which expired October 2002. The amount included in
revenue was $6.2 million in 2002.
 
 **(h)**  **Accounts
Receivable and Allowance for Uncollectible Accounts**
 
 Trade
accounts receivable are recorded at the invoice amount. The allowance for
doubtful accounts is our best estimate of the amount of probable credit losses
in our existing accounts receivable. We determine the allowance based on
historical write-off experience. We review our allowance for doubtful accounts
monthly. Account balances are charged off against the allowance when we feel it
is probable the receivable will not be recovered. We do not have any off balance
sheet credit exposure related to our customers.
 
 Receivables
consist of trade accounts receivables of $66,381 million and $49,735 million at
December 31, 2004 and 2003, respectively. Following are the changes in the
allowance for doubtful accounts during the years ended December 31, 2004, 2003
and 2002 (in thousands):
 
 
 ****
    
    
    **Balance
      at Beginning of Year**
    
    
    **Additions**
    
    
    **Write-offs**
      **Net
      of**
      **Recoveries**
    
    
    **Balance**
      **at
      End of**
      **Year**December
      31, 2004
    
    $
    9,414
    
    
    21,313
    
    
    (13,219
    )
    $
    17,508December
      31, 2003
    
    $
    7,821
    
    
    11,599
    
    
    (10,006
    )
    $
    9,414December
      31, 2002
    
    $
    46,404
    
    
    9,365
    
    
    (47,948
    )
    $
    7,821
 
 
 **(i)**  **Cash
and Cash Equivalents**
 
 We
consider all temporary cash investments purchased with an initial maturity of
three months or less to be cash equivalents.
 
 **(j)**  **Property
and Equipment and Depreciation**
 
 Property
and equipment are recorded at historical cost. Depreciation and amortization are
calculated using the straight-line method over the estimated useful lives of the
assets from 1 to 39 years. Leasehold improvements are depreciated over the life
of the related lease or asset, whichever is shorter. Capital leases are included
in property and equipment with corresponding amortization included in
accumulated depreciation. Capital lease assets are amortized over the useful
life of the respective assets, or the lease term, whichever is shorter.
 
 Repair
and maintenance costs are expensed as incurred. Significant improvements
extending the useful life of property are capitalized. When property is retired
or otherwise disposed of, the cost of the property and the related accumulated
depreciation are removed from the accounts, and any resulting gains or losses
are reflected in the consolidated statement of operations.
  23
 **(k)**  **Computer
Software Development Costs**
 
 Direct
development costs associated with internal-use computer software are accounted
for under Statement of Position 98-1 "Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use" and are capitalized including
external direct costs of material and services and payroll costs for employees
devoting time to the software projects. Costs incurred during the preliminary
project stage, as well as for maintenance and training are expensed as incurred.
Amortization is provided on a straight-line basis over the shorter of 3 years or
the estimated useful life of the software.
 
 Computer
software developed or obtained for internal use are included in other assets at
December 31, 2004 and 2003 were $5.7 million and $4.5 million, respectively, net
of accumulated amortization of $4.5 million and $2.1 million, respectively, at
December 31, 2004 and 2003. Amortization expense was $2.4 million and $1.5
million, respectively, for the years ended December 31, 2004 and
2003.
 
 **(l)**  **Goodwill
and Intangible Assets**
 
 Effective
January 1, 2002, we adopted Statement of Financial Accounting Standards No. 142,
"Goodwill and Other Intangible Assets," which establishes the impairment
approach rather than amortization for goodwill and intangible assets with
indeterminate lives. Effective January 1, 2002, we are not required to record
amortization expense on goodwill, but instead are required to evaluate these
assets for potential impairment at least annually and test for impairment
between annual tests, which we conduct in the second quarter, if an event occurs
or circumstances change that would indicate the carrying amount may be impaired.
 
 Based on
recent regulatory changes and the shortening of the remaining useful lives of
our long distance switches, we tested for impairment of our goodwill in the
fourth quarter of 2004 and determined that goodwill is not
impaired.
 
 Intangible
assets consist primarily of purchased customer accounts with a definite life and
are being amortized on a straight-line basis over 5 years. We incurred
amortization expense on intangible assets with a definite life of $2.7 million
for December 31, 2004 and $2.8 million for December 31, 2003 and 2002.
Intangible assets with a definite life amounted to $1.6 million at December 31,
2004, net of accumulated amortization of $11.8 million. Amortization expense on
intangible assets with a definite life is expected to be $1.6 million for the
year ended December 31, 2005.
 
 **(m)**  **Valuation of
Long-Lived Assets**
  Effective
January 1, 2002, we adopted Statement of Financial Accounting Standards No. 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets." SFAS 144
establishes an accounting model for the impairment or disposal of long-lived
assets, including discontinued operations.
 
 We review
the recoverability of the carrying value of long-lived assets, including
intangible assets with a definite life, for impairment using the methodology
prescribed in SFAS 144 whenever events or changes in circumstances indicate that
the carrying amount of such assets may not be recoverable. Based on recent
regulatory changes and the shortening of the remaining useful lives of our long
distance switches, we tested for impairment of our long-lived assets in the
fourth quarter of 2004 and determined long-lived assets are not
impaired.
 
 **(n)**  **Income
Taxes**
 
 Income
taxes are accounted for under the asset and liability method. Accordingly,
deferred tax assets and liabilities are recognized currently for the future tax
consequences attributable to the temporary differences between the financial
statement carrying amounts of assets and liabilities and their respective tax
basis. Deferred tax assets and liabilities are measured using enacted tax rates
in effect for the year in which those temporary differences are expected to be
recovered or settled. A valuation allowance is recorded to reduce the carrying
amounts of deferred tax assets if it is more likely than not that such assets
will not be realized.
 
 24
 **(o)**  **Net
Income Per Share**
 
 Basic
earnings per share for a period computed by dividing income available to common
shareholders by the weighted average number of common shares outstanding during
the period. Diluted earnings per share reflects the effect of common shares
issuable upon exercise of stock options, warrants and conversion of convertible
debt, when such effect is not antidilutive.
 
 **(p)**  **Financial
Instruments**
 
 The
carrying values of accounts receivable, prepaid expenses and other current
assets, accounts payable and accrued expenses approximate their fair values.
Convertible debt is recorded at face amount but such debt has traded in the open
market at discounts to face amount.
 
 **(q)**  **Stock-Based
Compensation**
 
 We
account for our stock option awards under the intrinsic value based method of
accounting prescribed by APB Opinion No. 25, "Accounting for Stock Issued to
Employees," and related interpretations, including FASB Interpretation No. 44
"Accounting for Certain Transactions Including Stock Compensation," an
interpretation of APB Opinion No. 25. Under the intrinsic value based method,
compensation cost is the excess, if any, of the quoted market price of the stock
at grant date or other measurement date over the amount an employee must pay to
acquire the stock. We make pro forma disclosures of net income and earnings per
share as if the fair value based method of accounting had been applied as
required by SFAS No. 123, "Accounting for Stock-Based Compensation" and SFAS
148, “ Accounting
for Stock-Based Compensation - Transition and Disclosure - an amendment of SFAS
123” . The
following disclosure complies with the adoption of this statement and includes
pro forma net income as if the fair value based method of accounting had been
applied:
 
 
 (In
      thousands)
    
    **Year
      Ended December 31,****2004**
    
    
    **2003**
    
    
    **2002**Net
      income as reported
    
    $
    36,812
    
    $
    81,817
    
    $
    97,062Add:
      Stock-based employee compensation expense included in reported net
      income
    
    
    5
    
    
    --
    
    
    110Deduct:
      Total stock-based employee compensation expense determined under fair
      value based method for all options
    
    
    (5,308
    )
    
    (1,348
    )
    
    (5,208
    )Pro
      forma net income
    
    $
    31,509
    
    $
    80,469
    
    $
    91,964
 
 
 **Year
      Ended December 31,****2004**
    
    
    **2003**
    
    
    **2002****Basic
      earnings per share:**As
      reported
    
    $
    1.37
    
    $
    3.10
    
    $
    3.56Pro
      forma
    
    $
    1.17
    
    $
    3.05
    
    $
    3.38**Diluted
      earnings per share:**As
      reported
    
    $
    1.32
    
    $
    2.94
    
    $
    3.15Pro
      forma
    
    $
    1.15
    
    $
    2.94
    
    $
    2.96
  
 25
 For
purposes of pro forma disclosures under SFAS 123, the estimated fair value of
the options is assumed to be amortized to expense over the options' vesting
period. The fair value of the options granted has been estimated at the various
dates of the grants using the Black-Scholes option-pricing model with the
following assumptions:
 
 ·  Fair
market value based on our closing common stock price on the date the option is
granted;
 ·  Risk-free
interest rate based on the weighted averaged 5 year U.S. treasury note strip
rates;
 ·
    Volatility
      based on the historical stock price over the expected term (5
      years);
 ·  No
expected dividend yield based on future dividend payment plans.
 
 **(r)** **Comprehensive
Income**
 
 We have
no items of comprehensive income or expense. Accordingly, our comprehensive
income and net income are equal for all periods presented.
 
 **(s)**  **Advertising**
 
 We
expense advertising costs as they are incurred. Advertising expenses totaled
approximately $9.8 million, $6.8 million, and $1.5 million for the years ended
December 31, 2004, 2003 and 2002, respectively.
 
 **(t)**  **New
Accounting Pronouncements**
 
 In
December 2004, the FASB revised Statement of Financial Accounting Standards No.
123 ("SFAS No. 123 (R)"), requiring public companies to recognize the cost
resulting from all share-based payment transactions in their financial
statements. SFAS No. 123(R) supersedes APB Opinion No. 25, "Accounting for Stock
Issued to Employees" and amends SFAS No. 95, "Statement of Cash Flows."
Generally, the approach in SFAS No. 123(R) is similar to the approach described
in SFAS No. 123. However, SFAS No. 123(R) requires all share-based payments to
employees, including grants of employee stock options, to be recognized in the
income statement based on their fair values. Pro forma disclosure is no longer
an alternative. The new standard will be effective for us in the first interim
or annual reporting period beginning after June 15, 2005. We are
currently assessing the implications of the transition methods allowed and have
not determined whether the adoption of FAS 123(R) will result in amounts similar
to current pro-forma disclosures under FAS 123. We expect the adoption to have
an adverse impact on future consolidated statements of operations.
 
 In
December 2004, the FASB issued SFAS No. 153 Exchange of Nonmonetary Assets, an
amendment of APB Opinion No. 29 ("SFAS 153"). SFAS 153 amends prior guidance to
eliminate the exception for nonmonetary exchanges of similar productive assets
and replaces it with a general exception for exchanges of nonmonetary assets
that do not have commercial substance. A nonmonetary exchange has commercial
substance if the future cash flows of the entity are expected to change
significantly as a result of the exchange. The provisions of SFAS 153 are
effective for nonmonetary asset exchanges occurring in fiscal periods beginning
after June 15, 2005 and shall be applied prospectively. SFAS 153 is not expected
to have a material impact on our consolidated financial statements at the date
of adoption.
  
 26
 **NOTE
2. COMMITMENTS AND
CONTINGENCIES**
 
 **(a)**  **Lease
Agreements**
 
 We lease
office space and equipment under operating and capital lease agreements. Certain
leases contain renewal options and purchase options, and generally provide that
we shall pay for insurance, taxes and maintenance. Total rent expense for all
operating leases for the years ended December 31, 2004, 2003 and 2002 was $3.2
million $1.9 million, and $2.4 million, respectively. As of December 31, 2004,
we had future minimum annual lease obligations under noncancellable leases with
terms in excess of one year as follows (in thousands):
 
 **Year
      Ended December 31,**
    
    
    **Operating
      Leases**
    
    
    **Capital
      Lease**
    
    
    **Total**2005
    
    $
    2,922
    
    $
    1,164
    
    $
    4,0862006
    
    
    2,009
    
    
    1,067
    
    
    3,0762007
    
    
    438
    
    
    --
    
    
    4382008
    
    
    138
    
    
    --
    
    
    1382009
    
    
    140
    
    
    --
    
    
    140Thereafter
    
    
    356
    
    
    --
    
    
    356Total
      minimum lease payments
    
    $
    6,003
    
    $
    2,231
    
    $
    8,234Less:
      interest
    
    
    
    
    
    42Present value of minimum lease payments
    
    
    
    
    $
    2,189Less:
      current installments
    
    
    
    
    
    1,132Long-term
      obligations
    
    
    
    
    $
    1,057
 
 
 **(b)**  **Legal
Proceedings**
 
 In the
third quarter of 2002, we paid $140,000 in connection with the settlement of
litigation relating to an obligation with a third party that had previously been
reflected as a liability, and recorded a non-cash reduction of expense in the
amount of $1.7 million.
 
 On
November 12, 2001, Traffix, Inc. was awarded approximately $6.2 million in an
arbitration concerning the termination of a marketing agreement between us and
Traffix, which was paid in two installments - $3.7 million paid in November 2001
and $2.5 million paid in April 2002.
 
 We are
party to a number of legal actions and proceedings arising from our provision
and marketing of telecommunications services, as well as certain legal actions
and regulatory matters arising in the ordinary course of business. We believe
that the ultimate outcome of the foregoing actions will not result in a
liability that would have a material adverse effect on our financial condition
or results of operations.
 
 27
 **(c)**  **Commitments**
 
 We are
party to various network service agreements, which contain certain minimum usage
commitments. In December 2003, we entered into a four-year master carrier
agreement with AT&T. The agreement provides us with a variety of services,
including transmission facilities to connect our network switches as well as
services for international calls, local traffic, international calling cards,
overflow traffic and operator assisted calls. The agreement also provides that,
subject to certain terms and conditions, we will purchase these services
exclusively from AT&T during the term of the agreement, provided, however,
that we are not obligated to purchase exclusively in certain cases, including if
such purchases would result in a breach of any contract with another carrier
that was in place when we entered into the AT&T agreement or if vendor
diversity is required. Certain of our network service agreements, including the
AT&T agreement contain certain minimum usage commitments. Our contract with
AT&T establishes pricing and provides for annual minimum revenue commitments
based upon usage as follows: 2005 - $32 million, 2006 - $32 million, 2007 - $32
million, and obligates us to pay 65 percent of the revenue shortfall, if any.
Another separate contract with a different network service vendor establishes
pricing and provides for annual minimum payments for 2005 of $1.0 million.
Despite the anticipated reduction in our local bundled customer base, we
anticipate that we will not be required to make any shortfall payments under
this contract as a result of the restructuring of the obligations or the growth
in network minutes as a result of acquisitions, there can be no assurances that
we will be successful in our efforts. To the extent that we are unable to meet
these minimum commitments, our costs of purchasing the services under the
agreement will correspondingly increase.
 
 In
addition, at December 31, 2004, we had outstanding purchase orders for capital
expenditures related to the build out of our Michigan networking facilities with
two vendors in the aggregate amount of $4.4 million. We have a contract with our
invoice printing company that establishes pricing and provides for annual
minimum payments as follows: 2005 - $1.2 million, 2006 - $1.2 million, 2007 -
$1.2 million and 2008 - $1.3 million. We also agreed to renew the
maintenance agreement associated with a vendor financing agreement we entered
into in May 2004 with a software supplier for an additional two years at a cost
of $1.1 million, which is funded on the anniversary dates.
 
 **NOTE
3.   PROPERTY AND EQUIPMENT**
 
 The
following is a summary of property and equipment, at cost, less accumulated
depreciation (in thousands):
 
 **December
      31,******
    
    
    **Lives**
    
    
    **2004**
    
    
    **2003**Land
    
    
    
    
    $
    330
    
    $
    330Buildings
      and building improvements
    
    
    39
      years
    
    
    7,004
    
    
    6,987Leasehold
      improvements
    
    
    3-10
      years
    
    
    2,146
    
    
    1,757Switching
      equipment
    
    
    1-10
      years
    
    
    68,444
    
    
    64,161Software
    
    
    3
      years
    
    
    11,812
    
    
    7,877Equipment
      and other
    
    
    3-10
      years
    
    
    49,152
    
    
    50,830138,888
    
    
    131,942Less:
      Accumulated depreciation
    
    
    
    
    
    (73,065
    )
    
    (63,873
    )$
    65,823
    
    $
    68,069
 
  
 28
 The
following is a summary of property and equipment recorded under capital leases
included above (in thousands):
 
 ****
    
    
    
    
    **December
      31,******
    
    
    **Lives**
    
    
    **2004**
    
    
    **2003**Equipment
      and other
    
    
    3
      years
    
    $
    3,627
    
    $
    3,627Less:
      Accumulated depreciation
    
    
    
    
    
    (1,
      457
    )
    
    (196
    )$
    2,170
    
    $
    3,431
 
 For the
years ended December 31, 2004, 2003 and 2002, depreciation expense amounted to
$17.8 million, $14.1 million and $13.3 million, respectively, this includes
depreciation expense excluded from network and line cost of $6.2 million, $3.4
million and $3.9 million, respectively. During 2004, we reduced our estimate of
useful lives of certain switching equipment to reflect technological changes.
This change had the effect of decreasing net income for 2004 by $1.4 million
($0.05 per share).
 
 **NOTE
4.   DEBT AND CAPITAL LEASE OBLIGATIONS**
 
 The
following is a summary of our debt and capital lease obligations (in
thousands):
 
 ****
    
    **December
      31,****2004**
    
    
    **2003**12%
      Senior Subordinated Notes Due 2007
    
    $
    --
    
    $
    40,7308%
      Convertible Senior Subordinated Notes Due 2007 (1)
    
    
    --
    
    
    3,7785%
      Convertible Subordinated Notes Due 2004
    
    
    --
    
    
    670Vendor
      financing agreement
    
    
    2,057
    
    
    --Capital
      lease obligations
    
    
    2,189
    
    
    3,419Total
      long-term debt and capital lease obligations
    
    
    4,246
    
    
    48,597Less:
      current maturities
    
    
    2,529
    
    
    16,806Total long-term debt and capital lease obligations, excluding current
      maturities
    
    $
    1,717
    
    $
    31,791
 
 (1)
    Includes
      future accrued interest of $1.0 million in
2003.
 
 **(a)**  **Vendor
Financing Agreement**
 
 During
May 2004, we entered into a vendor financing agreement with a software supplier
for $3.1 million payable over 36 months at 2.9% annual interest rate. This
agreement included $2.5 million of software and $0.6 million for an annual
maintenance contract.
 
 **(b)**  **12% Senior
Subordinated Notes Due 2007 and 8% Convertible Senior Subordinated Notes Due
2007**
 
 Effective
April 4, 2002, we completed the exchange of $57.9 million of the $61.8 million
outstanding principal balance of our 4-1/2% Convertible Subordinated Notes due
December 15, 2002 ("4-1/2% Convertible Subordinated Notes") for $53.2 million
principal amount of our new 12% Senior Subordinated PIK Notes due August 2007
("12% Senior Subordinated Notes") and $2.8 million principal amount of our new
8% Convertible Senior Subordinated Notes due August 2007 ("8% Convertible Senior
Subordinated Notes") and cash paid of $0.5 million. In addition, we exchanged
$17.4 million of the $18.1 million outstanding principal balance of our 5%
Convertible Subordinated Notes ("5% Convertible Subordinated Notes") due
December 15, 2004 for $17.4 million principal amount of the 12% Senior
Subordinated Notes.
 
 29
 In
accordance with SFAS No. 15, "Accounting by Debtors and Creditors for Troubled
Debt Restructurings," we accounted for the exchange of the 4-1/2% Convertible
Subordinated Notes for $53.2 million of the 12% Senior Subordinated Notes and
$2.8 million of the 8% Convertible Senior Subordinated Notes as a troubled debt
restructuring. Since the total liability of $57.4 million ($57.9 million of
principal as of the exchange date, less cash payments of $0.5 million) was less
than the future cash flows to holders of 8% Convertible Senior Subordinated
Notes and 12% Senior Subordinated Notes of $91.5 million (representing the $56.0
million of principal and $35.5 million of future interest expense), the
liability remained on our balance sheet at $57.4 million as long-term debt. We
recognized the difference of $1.4 million between principal and the carrying
amount as a reduction of interest expense over the life of the new notes.
 
 In 2003,
we acquired $25.2 million principal amount of 12% Senior Subordinated Notes
during 2003 at a $2.5 million discount from face amount. In 2002, we acquired
$5.7 million principal amount of 12% Senior Subordinated Notes at a $1.6 million
discount from face amount. In accordance with SFAS No. 145, “Rescission of FASB
Statements No. 4, 44, and 64, Amendment of FASB Statements No. 13, and Technical
Corrections as of April 2002,” in 2003 we reported the amount of the discount as
other income in our consolidated statement of operations and its adoption
resulted in a reclassification of this discount from extraordinary gains
(losses) from the extinguishment of debt to other income (expense) in our
consolidated statement of operations for the year ended December 31,
2002.
 
 During
2004, we redeemed $40.7 million and $2.8 million principal amount of 12% Senior
Subordinated Notes and 8% Convertible Senior Subordinated Notes, respectively,
at par, representing the entire outstanding principal balances.
 
 **(c)**  **5%
Convertible Subordinated Notes Due 2004**
 
 As of
December 31, 2003, we had $0.7 million principal amount outstanding of our 5%
Convertible Subordinated Notes that matured on December 15, 2004. Interest on
these notes was due and payable semiannually. The notes were convertible, at the
option of the holder, at a conversion price of $76.14 per share. The 5%
Convertible Subordinated Notes were redeemable, in whole or in part at our
option, at 100.71% of par. The notes were paid at maturity on December 15,
2004.
 
 **(d)**  **8%
Secured Convertible Notes Due 2006**
 
 During
2003, we purchased $30.2 million of the 8% Secured Convertible Notes due 2006
("8% Secured Convertible Notes"), representing the entire outstanding principal
amount.
 
 The 8%
Secured Convertible Notes were convertible into shares of our common stock at
the rate of $15.00 per share and were guaranteed by our principal operating
subsidiaries and were secured by a pledge of our assets. Interest on these notes
was due and payable semiannually.
 
 On
December 23, 2002, we amended certain provisions of the September 2001
restructuring agreement with AOL. As a consequence of the amendment and our
purchase of $4.1 million of the 8% Secured Convertible Notes in the fourth
quarter of 2002, we recorded a gain of $28.9 million from the decrease in the
future accrued interest relating to the 8% Secured Convertible Notes. This gain
was reflected as a $28.9 million reduction in long-term debt. As a further
consequence, we began recording the interest expense associated with the 8%
Secured Convertible Notes in our consolidated statement of
operations.
 
 **(e)**  **Senior
Credit Facility**
 
 On
October 4, 2002, our principal operating subsidiaries retired, prior to
maturity, all of the debt outstanding under the Senior Credit Facility Agreement
between the subsidiaries and MCG Finance Corporation. As a result of the
retirement of the debt under the Senior Credit Facility Agreement, the pledge of
assets and the restrictions and covenants under the Senior Credit Facility
Agreement were terminated and we incurred a non-cash charge to earnings of $1.1
million, reflecting the acceleration of the amortization of certain deferred
finance charges and fees.
 
 **(f)**  **Capital
Leases**
 
 During
2003, we entered into a capital lease agreement for upgrades to our customer
data storage equipment. Approximately $2.2 million was outstanding under this
agreement at December 31, 2004. Total assets under this lease agreement are
approximately $2.2 million as of December 31, 2004. The lease is repayable in 36
monthly installments, which includes interest based on an annual percentage rate
of approximately 2%.
 30
 **(g)**  **Minimum
Annual Payments**
 
 As of
December 31, 2004, the required minimum annual principal payments of long-term
debt obligations, including capital leases, for each of the next five fiscal
years is as follows (in thousands):
 
 **Year
      Ended December 31,**2005
    
    $
      2,5292006
    
    1,3572007
    
    360$
      4,246
 
 
 **NOTE
5.   STOCKHOLDERS' EQUITY**
 
 **(a)**  **Reverse
Stock Split**
 
 Our
stockholders approved a one-for-three reverse stock split of our common stock,
effective October 15, 2002, decreasing the number of common shares authorized
from 300 million to 100 million. All applicable references to the number of
shares of common stock and per share information, stock option data and market
prices have been restated to reflect this reverse stock split.
 
 **(b)**  **Stockholders
Rights Plan**
 
 On August
19, 1999, we adopted a Stockholders Rights Plan designed to deter coercive
takeover tactics and prevent an acquirer from gaining control of us without
offering a fair price to all of our stockholders. Under the terms of the plan,
preferred stock purchase rights were distributed as a dividend at the rate of
one right for each of our shares of Common Stock held as of the close of
business on August 30, 1999. Until the rights become exercisable, Common Stock
issued by us will also have one right attached. Each right will entitle holders
to buy one three-hundredth of a share of our Series A Junior Participating
Preferred Stock at an exercise price of $165. Each right will thereafter entitle
the holder to receive upon exercise Common Stock (or, in certain circumstances,
cash, property or other securities of us) having a value equal to two times the
exercise price of the right. The rights will be exercisable only if a person or
group acquires beneficial ownership of 20% or more of Common Stock or announces
a tender or exchange offer which would result in such person or group owning 20%
or more of Common Stock, or if the Board of Directors declares that a 15% or
more stockholder has become an "adverse person" as defined in the plan.
 
 We,
except as otherwise provided in the plan, will generally be able to redeem the
rights at $0.001 per right at any time during a ten-day period following public
announcement that a 20% position in us has been acquired or after our Board of
Directors declares that a 15% or more stockholder has become an "adverse
person." The rights are not exercisable until the expiration of the redemption
period. The rights will expire on August 19, 2009, subject to extension by the
Board of Directors.
 
 **(c)**  **Treasury
Stock**
 
 In 2003,
we purchased 1,315,789 of our common shares from America Online, Inc. at an
aggregate price of $5.0 million.
 
 31
 **NOTE
6.   STOCK OPTIONS, WARRANTS AND RIGHTS**
 
 **(a)**  **Stock
Based Compensation Plan**
 
 Incentive
stock options, non-qualified stock options and other stock based awards may be
granted by us to employees, directors and consultants under the 2003 Long Term
Incentive Plan (“2003 Plan”), 2000 Long Term Incentive Plan ("2000 Plan"), 1998
Long Term Incentive Plan ("1998 Plan") and otherwise in connection with
employment and to employees under the 2001 Non-Officer Long Term Incentive Plan
("2001 Plan"). Generally, the options vest over a three-year period and expire
ten years from the date of grant. At December 31, 2004: 420,000; 219,155; 541;
and 38,888 shares of common stock were available under the 2003 Plan, 2001 Plan,
2000 Plan, and 1998 Plan, respectively, for possible future issuances.
 
 Stock
options granted in 2004 generally have contractual terms of 10 years. The
options granted to employees have an exercise price equal to the fair market
value of the stock on the grant date. The vast majority of options granted in
2004 vest one-third each year, beginning on the first anniversary of the date of
grant.
 
 Information
with respect to options under our plans is as follows:
 
 **Options**
      **Shares**
    
    **Exercise**
      **Price
      Range**
      **Per
      Share**
    
    **Weighted**
      **Average**
      **Exercise
      Price**Outstanding,
      December 31, 2001
    
    2,476,139
    
    $0.99-$47.64
    
    $12.72Granted
    
    2,248,686
    
    $1.11-$11.91
    
    $1.78Exercised
    
    (250,906)
    
    $0.99-$7.88
    
    $2.50Cancelled
    
    (288,218)
    
    $1.26-$47.64
    
    $21.66Outstanding,
      December 31, 2002
    
    4,185,701
    
    $1.11-$48.54
    
    $6.84Granted
    
    1,873,171
    
    $3.70-$14.35
    
    $10.33Exercised
    
    (509,149)
    
    $0.99-$15.75
    
    $2.34Cancelled
    
    (112,616)
    
    $1.38-$30.18
    
    $12.48Outstanding,
      December 31, 2003
    
    5,437,107
    
    $0.99-$47.63
    
    $8.35Granted
    
    220,833
    
    $5.14-$10.87
    
    $6.83Exercised
    
    (374,144)
    
    $1.05-$6.81
    
    $1.75Cancelled
    
    (401,952)
    
    $1.32-$29.63
    
    $12.86Outstanding,
      December 31, 2004
    
    4,881,844
    
    $0.99-$47.63
    
    $8.41
 
 
 32
 The
following table summarizes options exercisable at December 31, 2004, 2003 and
2002:
 
 **Option
      Shares**
    
    **Exercise
      Price Range**
      **Per
      Share**
    
    **Weighted
      Average Exercise Price**2002
    2,942,999
    
    $0.99-$48.54
    
    $6.842003
    2,939,893
    
    $0.99-$47.63
    
    $7.992004
    3,413,585
    
    $0.99-$47.63
    
    $8.36
 
 
 The
following table summarizes the status of stock options outstanding at December
31, 2004:
 
 
 **Range
      of Exercise Prices**
    
    **Number
      Outstanding at December 31, 2004**
    
    **Weighted
      Average Exercise Price**
    
    **Weighted
      Average Remaining Contractual Life (years)**
    
    **Number
      Exercisable at December 31, 2004**
    
    **Weighted
      Average Exercise Price**$0.99
      to $10.31
    
    2,364,873
    
    $
      3.31
    
    5.6
    
    1,748,121
    
    $
      2.44$10.32
      to $14.35
    
    2,205,328
    
    11.59
    
    7.9
    
    1,353,821
    
    12.27$14.36
      to $21.00
    
    149,868
    
    19.70
    
    4.2
    
    149,868
    
    19.70$21.01
      to $30.00
    
    66,666
    
    26.65
    
    4.1
    
    66,666
    
    26.65$30.01
      to $47.63
    
    95,109
    
    30.94
    
    4.4
    
    95,109
    
    30.94
 
 33
 
 The weighted
average estimated fair values of the stock options granted during the years
ended December 31, 2004, 2003 and 2002 based on the Black-Scholes option pricing
model were $4.99, $7.79, and $2.34, respectively. The fair value of stock
options used to compute pro forma net income (loss) and basic and diluted
earnings (loss) per share disclosures is the estimated fair value at grant date
using the Black-Scholes option-pricing model with the following assumptions:
 
 **Assumption**
    
    **2004**
    
    **2003**
    
    **2002**Expected
      Term
    
    5
      years
    
    5
      years
    
    5
      yearsExpected
      Volatility
    
    93.82%
    
    98.63%
    
    98.13%Expected
      Dividend Yield
    
    --%
    
    --%
    
    --%Risk-Free
      Interest Rate
    
    3.49%
    
    3.15%
    
    4.33%
 
 **(b)**  **Warrants**
 
 Warrants
to purchase an aggregate of 290,472 shares of our common stock at an exercise
price of $6.30 per share and expiring August 2005 were outstanding at December
31, 2004. In connection with a credit facility agreement with a lender and
certain consulting services that the lender was to provide to us, we issued
warrants to the lender as follows: in August 2000, a warrant for 100,000 shares
of our common stock, at an exercise price of $14.19 per share and expiring
August 2007; in October 2000 a warrant for 50,000 shares of our common stock, at
an exercise price of $13.08 per share and expiring March 31, 2007; in August
2001, a warrant for 50,000 shares of our common stock, at an exercise price of
$2.04 per share and expiring August 16, 2006.
 
 **NOTE
7.  INCOME TAXES**
 
 The
provision (benefit) for income taxes is as follows:
 
 Year
      Ended December 31,2004
    
    
    2003
    
    
    2002Current income tax expense:Federal
    
    $
    1,401
    
    $
    1,032
    
    $
    --State
    
    
    2,978
    
    
    2,355
    
    
    --4,379
    
    
    3,387
    
    
    --Deferred
      income tax expense (benefit):Federal
    
    
    18,721
    
    
    (17,206
    )
    
    (22,300
    )State
    
    
    869
    
    
    (6,205
    )
    
    --19,590
    
    
    (23,411
    )
    
    (22,300
    )Total
      provision (benefit) for income taxes
    
    $
    23,969
    
    $
    (20,024
    )
    $
    (22,300
    )
 
  
 34
 Deferred
tax assets and liabilities at December 31, 2004 and 2003 are comprised of the
following elements:
 
 ****
    
    **Year
      Ended December 31,****2004**
    
    
    **2003****Deferred
      Tax Assets**Net
      operating loss carry-forwards
    
    $
    49,546
    
    $
    77,908Amortization
    
    
    198
    
    
    --Allowance
      for uncollectible accounts
    
    
    6,857
    
    
    3,809Warrants
      issued for compensation
    
    
    1,074
    
    
    1,051Accruals
      not currently deductible
    
    
    279
    
    
    562Net
      capital loss carry-forwards
    
    
    --
    
    
    3,119Alternative
      minimum tax credit carryforward
    
    
    2,613
    
    
    1,204Gross
      deferred tax assets
    
    
    60,567
    
    
    87,653Less
      valuation allowance
    
    
    (11,461
    )
    
    (14,760
    )Net
      deferred tax assets
    
    $
    49,106
    
    $
    72,893
 
 
 **Deferred
      Tax Liabilities**Depreciation
      and amortization
    
    $
    12,941
    
    $
    16,881Deductions
      not currently expensed
    
    
    965
    
    
    1,731Revenues
      not currently taxed
    
    
    --
    
    
    397Deferred
      tax liabilities
    
    $
    13,906
    
    $
    19,009
 
 
 A
reconciliation of the Federal statutory rate to our effective tax rate is as
follows:
 
 **Year
      Ended December 31,****2004**
    
    **2003**
    
    **2002**Federal
      income taxes computed at the statutory rate
    
    35.0%
    
    35.0%
    
    35.0%Increase
      (decrease) in income taxes resulting from:State
      income taxes less Federal benefit
    
    4.4
    
    4.0
    
    --Valuation allowance reversals
    
    --
    
    (71.4)
    
    (64.8)Total
      provision (benefit) for income taxes
    
    39.4%
    
    (32.4)%
    
    (29.8)%
 
 During
2003 and 2002, management evaluated the deferred tax asset valuation allowance
and determined that portions of the allowance should be reversed. The
evaluation in 2003 considered the availability of a $23 million tax deduction,
which was taken in our 1996 federal income tax return and for which we are
currently involved in an administrative proceeding before the Internal Revenue
Service. We have
determined the likelihood of our prevailing in this matter is less than probable
and therefore maintain a valuation allowance in the amount of $8 million against
the deferred tax asset generated by the deduction. We maintain valuation
allowances in the amount of $3 million and $4 million against state net
operating losses, or NOLs, in 2004 and 2003, respectively, for NOLs that we
believe will not be used prior to expiration. The 2003
valuation allowances also included a $3 million allowance, for capital loss
carryovers, which expired in 2004 prior to being used.
 
 35
 The 2003
and 2002 evaluations considered the profitability of our business, the ability
to utilize deferred tax assets against future taxable income and possible
restrictions on use due to provisions of the Internal Revenue Code Section 382.
 
 After
consideration of each of these factors, we reversed deferred tax asset valuation
allowances of $50.6 million and $22.3 million for 2003 and 2002,
respectively.
 
 
 
 At December
31, 2004, our federal net operating loss carryforwards are scheduled to expire
as follows:
 
 2018
    
    $
      10,8142019
    
    47,9632020
      and thereafter
    
    55,893$
      114,670
 
 **NOTE
8. AOL AGREEMENTS**
 
 In
September 2001, we restructured our financial obligations with America Online,
Inc., or AOL, that arose under the Investment Agreement entered into on January
5, 1999 and, effective September 30, 2001, also ended our marketing relationship
with AOL. In connection with the AOL restructuring, we entered into a
restructuring and note agreement with AOL pursuant to which we issued to AOL
$54.0 million principal amount of our 8% Secured Convertible Notes due 2006 and
1,026,209 additional shares of our common stock, after which AOL held a total of
2,400,000 shares of common stock. We agreed to provide certain registration
rights to AOL in connection with the shares of common stock issued to it by
us.
 
 In
addition to the restructuring of the financial obligations discussed above, we
agreed with AOL, in a further amendment to our marketing agreement in September
2001, to discontinue, effective as of September 30, 2001, our marketing
relationship under the marketing agreement. AOL, in lieu of any other payment
for the early discontinuance of the marketing relationship, paid us $20 million
by surrender and cancellation of $20 million principal amount of our 8% Secured
Convertible Notes delivered to AOL as discussed above, thereby reducing the
outstanding principal amount of our 8% Secured Convertible Notes to $34 million.
 
 In
accordance with SFAS No. 15, "Accounting by Debtors and Creditors for Troubled
Debt Restructurings," the AOL restructuring transaction was accounted for as a
troubled debt restructuring. We combined all liabilities due AOL at the time of
the restructuring agreement, including the contingent redemption feature of the
warrants with a value of $34.2 million and the contingent redemption feature of
the common stock with a value of $54.0 million. The total liability of $88.2
million was reduced by the fair value of the 1,026,209 incremental shares
provided to AOL of $1.4 million and cash paid in connection with the AOL
restructuring of $3.5 million. Since the remaining value of $83.3 million was
greater than the future cash flows to AOL of $66.4 million, the liability was
written down to the value of the future cash flows due to AOL and an
extraordinary gain of $16.9 million was recorded in the third quarter of 2001.
As a result of this accounting treatment, we recorded no interest expense
associated with these convertible notes during 2001 and 2002 in our statements
of operations.
 
 Under the
terms of the investment agreement, we agreed to reimburse AOL for losses AOL may
incur on the sale of certain shares of our common stock. In addition, AOL also
had the right to require us to repurchase warrants held by AOL. Upon the
occurrence of certain events, including material defaults by us under our AOL
agreements and our "change of control", we could have been required to
repurchase for cash all of the shares held by AOL for $78.3 million ($57 per
share), and the warrants for $36.3 million. We originally recorded the
contingent redemption value of the common stock and warrants at $78.3 and $36.3
million, respectively, with a corresponding reduction in additional paid-in
capital. In connection with the implementation of EITF 00-19, the contingent
redemption feature of the common stock and warrants were recorded as a liability
at their fair values of $53.5 and $32.3 million, respectively, as of June 30,
2001. The increase in the fair value of these contingent redemption instruments
from issuance on January 5, 1999 to June 30, 2001 was $36.8 million, which has
been presented as a cumulative effect of a change in accounting principle in the
statement of operations for the year ended December 31, 2001. For 2001, we
recorded an unrealized loss of $2.4 million on the increase in the fair value of
the contingent redemption instruments, which was reflected in other (income)
expense on the statement of operations. As discussed above, these contingent
redemption instruments were satisfied through the restructuring agreement
entered into with AOL in September 2001.
 
 36
 In
February 2002, by letter agreement, AOL agreed, subject to certain conditions,
to waive certain rights that it had under the restructuring agreement with
respect to the restructuring of our existing 4-1/2% and 5% Convertible
Subordinated Notes. Under the letter agreement, we paid AOL approximately $1.2
million as a prepayment on the 8% Secured Convertible Notes, approximately $0.7
million of which was credited against amounts we owed AOL under the letter
agreement for cash payments in the restructuring of these other notes. We
complied with the various conditions of the letter agreement and did not owe AOL
any additional payments related to this restructuring of our other notes.
 
 In
December 2002, by letter agreement, we amended certain provisions of the
restructuring agreement with AOL. Pursuant to this amendment, the maturity date
for the 8% Secured Convertible Notes issued under the restructuring agreement
was advanced to September 19, 2006 from 2011, and our right to elect to pay a
portion of the interest on the 8% Secured Convertible Notes in kind rather than
in cash was eliminated. This amendment also provided that certain limitations on
the purchase of our outstanding subordinated indebtedness and common stock were
amended to permit us, through September 30, 2003, to: (i) repurchase outstanding
subordinated indebtedness provided we did not pay more than 80% of the face
amount and, for every dollar used to repurchase subordinated indebtedness, we
repurchased $0.50 of principal amount of 8% Secured Convertible Notes from AOL;
and (ii) purchased shares of our common stock, provided we purchased the shares
at or below market value and we concurrently purchase an equal number of shares
of the common stock from AOL. The aggregate amount that we could utilize with
respect to both the repurchase of subordinated indebtedness and of common stock
could not exceed $10 million.
 
 As a
consequence of this amendment in December 2002 and the repurchase of $4.1
million of our 8% Secured Convertible Notes in the fourth quarter of 2002, we
recorded a non-cash gain of $28.9 million from the decrease in the future
accrued interest relating to our 8% Secured Convertible Notes, which was
reflected as a $28.9 million reduction in long-term debt. As a further
consequence, we began recording the interest expense associated with the 8%
Secured Convertible Notes on our statements of operations.
 
 The
restructuring agreement provided that the investment agreement, the security
agreement securing our obligations under the investment agreement and the
existing registration rights agreement with AOL were terminated in their
entirety and the parties were released from any further obligation under these
agreements.
 
 In 2003,
we purchased from AOL the $30.2 million balance of the 8% Secured Convertible
Notes due 2006. In addition, we concurrently purchased from AOL the 1,315,789
shares of our common stock held by AOL for an aggregate price of $5
million.
 
 **NOTE
9.   SUPPLEMENTAL CASH FLOW INFORMATION**
 
 **2004**
    
    
    **2003**
    
    
    **2002**Supplemental
      disclosure of cash flow information:Cash
      paid during the year for interest
    
    $
    3,506
    
    $
    9,930
    
    $
    6,252Cash paid during the year for taxes
    
    
    3,821
    
    
    1,980
    
    
    --Supplemental
      schedule of non-cash investing and financing activities:Acquisition of equipment and software under capital lease obligations and
      vendor financing agreement
    
    $
    2,545
    
    $
    3,392
    
    $
    --Interest expense paid in additional principal
    
    
    --
    
    
    --
    
    
    2,824
 
 
 **NOTE
10.   EMPLOYEE BENEFIT PLANS**
 
 We
sponsor a defined contribution pension plan (the “Plan”). The Plan qualifies as
a deferred salary arrangement under Section 401(k) of the Internal Revenue Code.
Eligible employees may contribute up to 15% of their compensation (subject to
Internal Revenue Code limitations). The Plan allows employees to choose among a
variety of investment alternatives. We are not required to contribute to the
Plan. During the years ended December 31, 2004, 2003 and 2002, we elected to
contribute $125,000, $125,000, and $131,000 to the Plan, respectively.
 
 37
  **NOTE
11. PER SHARE DATA**
 
 Basic
earnings per common share is calculated by dividing net income by the average
number of common shares outstanding during the year. Diluted earnings per common
share is calculated by adjusting the weighted average number of common shares
outstanding and the net income during the fiscal period for the assumed
conversion of all potentially dilutive stock options, warrants and convertible
bonds (and assuming that the proceeds hypothetically received from the exercise
of dilutive stock options are used to repurchase our common stock at the average
share price during the fiscal period). For the diluted earnings calculation, we
also adjust the net income by the interest expense on the convertible bonds
assumed to be converted. Income per share is computed as follows (in thousands
except per share data):
 
 
 **Year
      Ended December 31,****2004**
    
    
    **2003**
    
    
    **2002**Income
      available to common stockholders used to compute basic income per
      share
    
    $
    36,812
    
    $
    81,817
    
    $
    97,062Interest expense on convertible bonds
    
    
    --
    
    
    (1
    )
    
    18Income available for common stockholders after assumed conversion of
      dilutive securities used to   compute diluted income per share
    
    $
    36,812
    
    $
    81,816
    
    $
    97,080Weighted
      average number of common shares outstanding used to compute basic income
      per share
    
    
    26,847
    
    
    26,376
    
    
    27,253Effect
      of dilutive securities*:Stock
      options and warrants
    
    
    1,007
    
    
    1,233
    
    
    1,3478%
      Secured convertible bonds due 2006
    
    
    --
    
    
    --
    
    
    2,0105%
      Convertible subordinated notes due 2004
    
    
    --
    
    
    9
    
    
    --8% Senior convertible subordinated notes due 2007
    
    
    --
    
    
    188
    
    
    188Weighted average number of common and common equivalent shares outstanding
      used to compute    diluted income per share
    
    
    27,854
    
    
    27,806
    
    
    30,798Income
      per share - Basic:Net
      income per share
    
    $
    1.37
    
    $
    3.10
    
    $
    3.56Weighted
      average common shares outstanding
    
    
    26,847
    
    
    26,376
    
    
    27,253Income
      per share - Diluted:Net
      income per share
    
    $
    1.32
    
    $
    2.94
    
    $
    3.15Weighted average common and common equivalent shares outstanding
    
    
    27,854
    
    
    27,806
    
    
    30,798
 
 * The
diluted share basis for the years ended December 31, 2004, 2003 and 2002
excludes options and warrants to purchase 3.1 million, 1.3 million and 1.7
million shares of common stock, respectively, because their exercise prices were
greater than the average market value of the common stock for each year. The
diluted share basis for the year ended December 31, 2002 excludes convertible
bonds that were convertible into 3.3 million shares of common stock, due to
their antidilutive effect.
   38
  ****
 **NOTE
12.   FINANCIAL INSTRUMENTS**
 
 Fair
value estimates, assumptions, and methods used to estimate the fair value of the
Company’s financial instruments are made in accordance with the requirements of
SFAS No. 107, “Disclosures about Fair Value of Financial Instruments”. The
Company has used available market information, where available, to derive its
estimates.
 
 The
carrying values of cash and cash equivalents, accounts receivable, prepaid
expenses and other current assets, accounts payable and accrued expenses
approximate their fair values due to the short-term nature of the instruments.
 
 Debt is
comprised of senior subordinated debt, convertible debt, vendor financing and
capital leases. There was no senior debt or convertible debt outstanding as of
December 31, 2004. The 12% and 8% notes contain provisions that allow the
company to call the notes at par; therefore, fair value approximates carrying
value.  The fair value of the 5% notes and vendor financed debt was
estimated using discounted cash flow calculations, based on borrowing rates
currently available to the company.  Capital
leases are recorded at their net present value, which approximates fair
value.
 
 The
estimated fair value of our financial instruments is as follows:
 
 **December
      31,****2004**
    
    **2003******
    
    
    **Carrying****Amount**
    
    
    **Fair**
      **Value**
    
    
    **Carrying**
      **Amount**
    
    
    **Fair**
      **Value**12%
      Senior Subordinated Notes Due 2007
    
    $
    --
    
    $
    --
    
    $
    40,730
    
    $
    40,7308%
      Convertible Senior Subordinated Notes Due 2007 (1)
    
    
    --
    
    
    --
    
    
    3,778
    
    
    3,7785%
      Convertible Subordinated Notes Due 2004
    
    
    --
    
    
    --
    
    
    670
    
    
    670Vendor
      financing agreement
    
    
    2,057
    
    
    1,999
    
    
    --
    
    
    --Capital
      lease obligations
    
    $
    2,189
    
    $
    2,189
    
    $
    3,419
    
    $
    3,419
 
 
 **NOTE
13. QUARTERLY FINANCIAL DATA (UNAUDITED)**
 
 
 (In
      thousands, except per share data)
    
    
    **First**
      **Quarter**
    
    
    **Second**
      **Quarter**
    
    
    **Third**
      **Quarter**
    
    
    **Fourth**
      **Quarter****2004**Revenue
    
    $
    109,619*
    
    $
    115,213*
    
    
    120,929*
    
    $
    125,251Operating
      income
    
    
    14,401*
    
    
    14,305*
    
    
    14,256*
    
    
    16,367Net
      income
    
    
    8,288*
    
    
    8,422*
    
    
    9,011*
    
    
    11,091Net
      income per share - Basic
    
    
    0.31*
    
    
    0.31*
    
    
    0.33*
    
    
    0.41Net
      income per share - Diluted
    
    
    0.29*
    
    
    0.30*
    
    
    0.32*
    
    
    0.40**2003***Revenue
    
    $
    88,202
    
    $
    93,906
    
    $
    100,178
    
    $
    101,407Operating
      income
    
    
    15,538
    
    
    19,185
    
    
    17,869
    
    
    13,696Net
      income
    
    
    9,343
    
    
    10,771
    
    
    54,102
    
    
    7,601Net
      income per share - Basic
    
    
    0.35
    
    
    0.41
    
    
    2.05
    
    
    0.29Net
      income per share - Diluted
    
    
    0.32
    
    
    0.37
    
    
    1.88
    
    
    0.27
 
 * As
Restated - The
quarterly results for the four quarters of 2003 and for the first three quarters
of 2004 have been adjusted to reflect the restatement of our previously reported
consolidated financial statements for those periods and for the year ended
December 31, 2003 as detailed below.
 
 39
 We have
revised our consolidated financial statements for these periods to correct for
the following errors:
 
 (a)  Due to a
classification error in our general ledger, we incorrectly recorded certain
customer fee revenues as sales, use and excise tax liability to the consolidated
balance sheets for the four quarters of 2003 and for the year ended December 31,
2003 and for the first three quarters of 2004. These customer fee revenues
aggregated $ 1.0 million for the first three quarters of 2004 and $1.0 million
for the full year 2003;
 
 (b) We
determined that in our calculations of earnings per share since the third
quarter of 2003 we had not incorporated the tax benefits associated with the
assumed exercise of employee stock options. As a result, fully diluted shares
outstanding were over-reported and income per fully diluted share was
understated in those periods; and
 
 (c) We
identified errors in the computation of the deferred tax assets recognized in
the third quarter of 2003 as follows: (i) failure to deduct state income tax
expense from federal taxable income resulted in the deferred tax benefit as
originally reported for the year ended December 31, 2003 and the unaudited third
quarter 2003 being understated by $0.9 million and (ii) failure to complete the
appropriately detailed analysis of our deferred tax assets relating to state net
operating loss carryforwards resulted in the deferred tax benefit as originally
reported for the year ended December 31, 2003 and the unaudited third quarter
2003 being understated by $1.7 million. In February 2005, we determined that we
improperly corrected for the errors in the deferred tax computations through an
adjustment to the effective tax rate for the 2004 quarters. As a result, we have
restated the first three quarters of 2004 and the third and fourth quarter of
2003 and year end December 31, 2003.
 
 The
effect of these items on our previously reported consolidated statement of
operations for each of the 2003 quarters and for each of the three quarters
ended September 30, 2004 is summarized in the following table.
 
  40
 (in
      000s, except per share data)
      (Unaudited)
    
    2003
    2004Q1
    
    
    Q2
    
    
    Q3
    
    
    Q4
    
    
    Q1
    
    
    Q2
    
    
    Q3Revenues:Reported
    
    $
    87,843
    
    $
    93,748
    
    $
    99,929
    
    $
    101,143
    
    $
    109,321
    
    $
    114,881
    
    $
    120,537Adjustments
    
    
    359
    
    
    158
    
    
    249
    
    
    264
    
    
    298
    
    
    332
    
    
    392As Restated
    
    $
    88,202
    
    $
    93,906
    
    $
    100,178
    
    $
    101,407
    
    
    109,619
    
    
    115,213
    
    
    120,929Operating
      Income:Reported
    
    $
    15,179
    
    $
    19,027
    
    $
    17,620
    
    $
    13,432
    
    $
    14,103
    
    $
    13,973
    
    $
    13,864Adjustments
    
    
    359
    
    
    158
    
    
    249
    
    
    264
    
    
    298
    
    
    332
    
    
    392As Restated
    
    $
    15,538
    
    $
    19,185
    
    $
    17,869
    
    $
    13,696
    
    
    14,401
    
    
    14,305
    
    
    14,256Pre-Tax
      Income:Reported
    
    $
    14,961
    
    $
    17,500
    
    $
    16,106
    
    $
    12,197
    
    $
    13,387
    
    $
    13,573
    
    $
    14,486Adjustments
    
    
    359
    
    
    158
    
    
    249
    
    
    264
    
    
    298
    
    
    332
    
    
    392As Restated
    
    $
    15,320
    
    $
    17,658
    
    $
    16,355
    
    $
    12,461
    
    
    13,685
    
    
    13,905
    
    
    14,878Income
      Tax Expense:Reported
    
    $
    5,835
    
    $
    6,825
    
    
    ($35,460
    )
    $
    5,103
    
    $
    5,031
    
    $
    5,025
    
    $
    5,339Adjustments
    
    
    141
    
    
    62
    
    
    (2,287
    )
    
    (243
    )
    
    366
    
    
    458
    
    
    528As Restated
    
    $
    5,976
    
    $
    6,887
    
    
    ($37,747
    )
    $
    4,860
    
    
    5,397
    
    
    5,483
    
    
    5,867Net
      Income:Reported
    
    $
    9,126
    
    $
    10,675
    
    $
    51,566
    
    $
    7,094
    
    $
    8,356
    
    $
    8,548
    
    $
    9,147Adjustments
    
    
    217
    
    
    96
    
    
    2,536
    
    
    507
    
    
    (68
    )
    
    (126
    )
    
    (136
    )As Restated
    
    $
    9,343
    
    $
    10,771
    
    $
    54,102
    
    $
    7,601
    
    
    8,288
    
    
    8,422
    
    
    9,011Fully
      Diluted EPS:Reported
    
    $
    0.32
    
    $
    0.37
    
    $
    1.74
    
    $
    0.25
    
    $
    0.29
    
    $
    0.30
    
    $
    0.32Adjustments
    
    
    --
    
    
    --
    
    
    0.14
    
    
    0.02
    
    
    --
    
    
    --
    
    
    --As Restated
    
    $
    0.32
    
    $
    0.37
    
    $
    1.88
    
    $
    0.27
    
    
    0.29
    
    
    0.30
    
    
    0.32Fully
      Diluted Shares:Reported
    
    
    29,940
    
    
    29,563
    
    
    29,761
    
    
    28,884
    
    
    28,862
    
    
    28,694
    
    
    28,212Adjustments
    
    
    --
    
    
    --
    
    
    884
    
    
    777
    
    
    (732
    )
    
    (655
    )
    
    (475
    )As
      Restated
    
    
    29,940
    
    
    29,563
    
    
    28,877
    
    
    28,107
    
    
    28,130
    
    
    28,039
    
    
    27,737
 In
addition, in
connection with the release of the valuation allowance in the third quarter
2003, $6.5 million of deferred tax assets associated with acquired net operating
loss carryforwards were realizable and should have been recorded as a deferred
tax asset. Originally, we believed this deferred tax asset was limited due to
provisions of the Internal Revenue Code Section 382. This error resulted in
deferred tax assets being understated and goodwill being overstated in each of
the periods beginning in the third quarter 2003.
 
 41
 
 The
consolidated balance sheets for the first three quarters of 2004 as originally
reported have been restated as follows:
 
 
 **Quarter
      Ended**(In
      thousands)
    
    
    **March
      31,**
    
    
    **March
      31,**
    
    
    **June
      30,**
    
    
    **June
      30,**
    
    
    **September
      30,**
    
    
    **September
      30,****2004**
    
    
    As
      Originally
      Reported
    
    
    As
      Restated
    
    
    As
      Originally
      Reported
    
    
    As
      Restated
    
    
    As
      Originally
      Reported
    
    
    As
      RestatedDeferred
      tax assets
    
    $
    61,096
    
    $
    69,661
    
    $
    56,957
    
    $
    65,195
    
    $
    52,456
    
    $
    60,321Goodwill
    
    
    19,503
    
    
    13,013
    
    
    19,503
    
    
    13,013
    
    
    19,503
    
    
    13,013Total
      assets
    
    
    236,144
    
    
    238,219
    
    
    239,996
    
    
    241,744
    
    
    235,831
    
    
    237,206Sales,
      use and excise tax
    
    
    14,131
    
    
    12,802
    
    
    14,926
    
    
    13,266
    
    
    14,596
    
    
    12,544Total
      liabilities
    
    
    127,942
    
    
    126,729
    
    
    121,989
    
    
    120,575
    
    
    108,636
    
    
    106,985Total
      stockholders’ equity
    
    
    108,202
    
    
    111,490
    
    
    118,007
    
    
    121,169
    
    
    127,195
    
    
    130,221
 
 
 **ITEM
9A.   CONTROLS AND PROCEDURES.**
 
 *Disclosure
Controls and Procedures* —We
maintain disclosure controls and procedures that are designed to ensure that
information required to be disclosed in our reports under the Securities
Exchange Act of 1934, as amended (the "Exchange Act"), is recorded, processed,
summarized and reported within the time periods specified in the SEC's rules and
forms, and that such information is accumulated and communicated to management,
including our Chief Executive Officer ("CEO") and Chief Financial Officer
("CFO"), as appropriate, to allow timely decisions regarding required
disclosure.
 
 In
connection with the preparation of this Annual Report on Form 10-K, we carried
out an evaluation under the supervision and with the participation of our
management, including the CEO and CFO, of the effectiveness of the design and
operation of our disclosure controls and procedures (as defined in Rule
13a-15(e) under the Exchange Act) as of December 31, 2004. Based upon this
evaluation, our CEO and the CFO concluded that, for the reasons set forth below,
our disclosure controls and procedures were not effective as of December 31,
2004.
 
 In light
of the material weaknesses described below, we performed additional analysis and
other procedures to ensure that our consolidated financial statements were
prepared in accordance with generally accepted accounting principles.
Accordingly, management believes that the financial statements included in this
Annual Report on Form 10-K fairly present in all material respects our financial
condition, results of operations and cash flows for the periods presented.
 
 *Management's
Report on Internal Control over Financial Reporting* —Our
management is responsible for establishing and maintaining adequate internal
control over financial reporting as defined in Rule 13a-15(f) under the Exchange
Act. Our 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.
 
 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.
 
 Our
management assessed the effectiveness of the company’s internal control over
financial reporting as of December 31, 2004. In making this assessment of
internal control over financial reporting, management used the criteria set
forth by the Committee of Sponsoring Organizations of the Treadway Commission in *Internal
Control-Integrated Framework.*
  42
 A
material weakness is a control deficiency, or combination of control
deficiencies, that results in more than a remote likelihood that a material
misstatement of the annual or interim financial statements will not be prevented
or detected. We identified the following material weaknesses in our assessment
of the effectiveness of internal control over financial reporting as of December
31, 2004:
  *As of
December 31, 2004, we did not maintain effective controls over the application
of generally accepted accounting principles related to the financial reporting
process for complex transactions.* Specifically, we did not have personnel who possess sufficient depth, skills and
experience in accounting for and review of complex transactions in the financial
reporting process to ensure that complex transactions were accounted for in
accordance with generally accepted accounting principles. This material weakness
resulted in the following adjustments of our financial statements:
  a.
    In
      connection with the preparation of our financial statements for the first
      and second quarters of 2004, we identified errors in the computation of
      deferred tax assets and the release of the valuation allowance related
      thereto that were recorded in the third quarter of 2003 as follows: (i)
      failure to deduct state income tax expense from federal taxable income and
      (ii) failure to complete the appropriately detailed analysis of our
      deferred tax assets relating to state net operating loss carryforwards. In
      addition, in February 2005, we determined that we incorrectly applied
      generally accepted accounting principles, which resulted in improper
      correction of the aforementioned errors through an adjustment to the
      effective tax rate for 2004 rather than through the restatement of our
      prior period financial statements. This resulted in adjustments to
      deferred tax assets and income tax expense in the third and fourth quarter
      of 2003 and the first, second and third quarters of 2004;
  b.
    In
      connection with the preparation of our financial statements for the second
      quarter of 2004, we identified errors in the development and calculation
      of the effective state income tax rate. This resulted in an adjustment of
      income tax expense in the first and second quarters of 2004;
  c.
    Because
      of our failure to take into account certain applicable tax regulations, we
      did not identify that certain deferred tax assets relating to acquired net
      operating losses were available for and should have been recorded in the
      third quarter of 2003. In February 2005 when this error was identified,
      the correcting entries were not appropriately recorded by us. This
      resulted in an audit adjustment of deferred tax assets and goodwill in
      each of the periods beginning in the third quarter 2003;
    and
  d.
    In
      February 2005, during the audit of our 2004 financial statements, it was
      determined that in our calculations of earnings per share since the third
      quarter of 2003 we had not considered or included the tax benefits
      associated with the assumed exercise of employee stock options in the
      proceeds used to repurchase shares in the application of the treasury
      stock method. As a result, fully diluted shares outstanding and earnings
      per share were adjusted in those periods.
  43
 
 This
control deficiency resulted in the restatement of our financial statements for
each of the quarters in 2003 and year ended December 31, 2003, and the first,
second and third quarters of 2004 and certain audit adjustments to the fourth
quarter 2004 financial statements. Additionally, this control deficiency could
result in a material misstatement to annual or interim financial statements that
would not be prevented or detected. Accordingly, management has determined that
this control deficiency constitutes a material weakness.
 
 *As of
December 31, 2004 we did not maintain effective controls over sales, use and
excise tax liability.* Specifically,
our reconciliation and review procedures with respect to the sales, use and
excise tax liability that we collect and remit did not identify that certain
customer fee revenue had been incorrectly recorded in the sales, use and excise
tax general ledger account. This control deficiency resulted in the restatement
of our revenues and sales, use and excise tax liability for each of the quarters
in 2003 and year ended December 31, 2003, and the first, second and third
quarters of 2004 and an adjustment to the fourth quarter 2004 financial
statements. Additionally, this control deficiency could result in a misstatement
of revenues, and sales, use and excise tax liability that would result in a
material misstatement to annual or interim financial statements that would not
be prevented or detected. Accordingly, management has determined that this
control deficiency constitutes a material weakness.
 
 Because
of these material weaknesses described above, management has concluded that we
did not maintain effective internal control over financial reporting as of
December 31, 2004 based on the criteria in *Internal
Control-Integrated Framework* issued
by the COSO. Management communicated its conclusions to the Audit Committee of
the Company’s Board of Directors.
 
 Management’s
assessment of the effectiveness of our internal control over financial reporting
as of December 31, 2004 has been audited by PricewaterhouseCoopers LLP, an
independent registered public accounting firm, as stated in their report that
appears in Item 8 of this Annual Report.
 
 *Changes
in Internal Control over Financial Reporting* - As of
the end of the period covered by this report, we have not fully remediated the
material weaknesses as of December 31, 2004 identified above. We have taken the
following steps for remediation of the conditions described above that resulted
in our decision to restate certain prior period financial
statements:
  1.
    Engaging
      outside contractors with technical and accounting related expertise to
      assist in the preparation of the income tax provision and related work
      papers. We are also implementing controls to assure accurate data is
      provided to, and that we review and agree with the conclusions of, outside
      contractors.
   2.
    Outside
      contractors with technical accounting capabilities have been and will be
      retained to the extent an issue is sufficiently complex and outside the
      technical accounting capabilities of our
personnel.
   3.
    We
      have redesigned the account reconciliation process for sales, use and
      excise tax liabilities. Our controller will increase the depth of review
      of the account reconciliation and our Chief Accounting Officer will
      confirm that established review processes are being adhered
      to.
  We are in
the process of developing procedures for the testing of these controls to
determine if the material weakness has been remediated. We will continue the
implementation of policies, processes and procedures regarding the review of
complex transactions. Management believes that our controls and procedures will
continue to improve as a result of the further implementation of these measures.
 
 Except
for the changes identified above, there were no changes in our internal control
over financial reporting that occurred during the last fiscal quarter that have
materially affected, or are reasonably likely to materially affect, our internal
control over financial reporting.
 
 44
 
 
 **PART
IV**
 
 **ITEM
15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES.**
 
 (a)  The
following documents are filed as part of this Annual Report on Form
10-K.
 
 1.  Consolidated
Financial Statements:
 
 The
Consolidated Financial Statements filed as part of this Form 10-K are listed in
the "Index to Consolidated Financial Statements" in Item 8.
 
 2.  Consolidated
Financial Statement Schedule:
 
 The
Consolidated Financial Statement Schedule filed as part of this report is listed
in the "Index to S-X Schedule."
 
 Schedules
other than those listed in the accompanying Index to S-X Schedule are omitted
for the reason that they are either not required, not applicable or the required
information is included in the Consolidated Financial Statements or notes
thereto.
  
 45
 **TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**
 
 **INDEX
TO S-X SCHEDULE**
 
 
 
 
 
 **PAGE**Schedule
      II -- Valuation & Qualifying Accounts
    47
 
 
 
 46
 
 **SCHEDULE
II -- VALUATION AND QUALIFYING ACCOUNTS**
 **(In
Thousands)**
 
 **DESCRIPTION
      DEDUCTIONS**
    
    **BALANCE
      AT BEGINNING OF PERIOD**
    
    **ADDITIONS
      CHARGED TO COSTS AND EXPENSES**
    
    **DEDUCTIONS
      FOR WRITE-OFFS**
    
    **BALANCE
      AT END OF PERIOD****Year
      Ended December 31, 2004:**Reserve
      and allowances deducted from asset accounts:Allowance
      for uncollectible accounts
    
    $
    9,414
    
    $
    21,313
    
    $
    (13,219
    )
    $
    17,508**Year
      Ended December 31, 2003:**Reserve
      and allowances deducted from asset accounts:Allowance
      for uncollectible accounts
    
    $
    7,821
    
    $
    11,599
    
    $
    (10,006
    )
    $
    9,414**Year
      Ended December 31, 2002:**Reserve
      and allowances deducted from asset accounts:Allowance
      for uncollectible accounts
    
    $
    46,404
    
    $
    9,365
    
    $
    (47,948
    )
    $
    7,821
  
 47
 
 **(3)
EXHIBITS:**
 
 EXHIBIT
 NUMBER
DESCRIPTION
 
 3.1
    Our
      composite form of Amended and Restated Certificate of Incorporation, as
      amended through October 15, 2002 (incorporated by reference to Exhibit 3.2
      to our Current Report on Form 8-K, dated October 16, 2002).
 
 3.2
    Our
      Bylaws (incorporated by reference to Exhibit 3.2 to our registration
      statement on Form S-1 (File No. 33-94940)).
 
 3.3
    Certificate
      of Designation of Series A Junior Participating Preferred Stock dated
      August 27, 1999 (incorporated by reference to Exhibit A to Exhibit 1 to
      our registration statement on Form 8-A (File No. 000-26728)).
 
 4.1
    Specimen
      of Talk America Holdings, Inc. common stock certificate (incorporated by
      reference to Exhibit 4.1 to our Annual Report on Form 10-K for the year
      ended December 31, 2002).
 
 4.2
    Form
      of Warrant Agreement for Elec Communications, Kenneth Baritz, Joel Dupre,
      Keith Minella, Rafael Scolari, and William Rogers dated August 9, 2000
      (incorporated by reference to Exhibit 4.2 to our Annual Report on Form
      10-K for the year ended December 31, 2000).
 
 4.3
    Form
      of Warrant Agreement for MCG Credit Corporation dated August 9, 2000
      (incorporated by reference to Exhibit 4.3 to our Annual Report on Form
      10-K for the year ended December 31, 2000).
 
 4.4
    Form
      of Warrant Agreement for MCG Credit Corporation dated October 20, 2000
      (incorporated by reference to Exhibit 4.4 to our Annual Report on Form
      10-K for the year ended December 31, 2000).
 
 4.5
    Form
      of Warrant Agreement for MCG Finance Corporation dated October 20, 2000
      (incorporated by reference to Exhibit 4.5 to our Annual Report on Form
      10-K for the year ended December 31, 2000).
 
 10.1
    Employment
      Agreement with Aloysius T. Lawn, IV dated July 30, 2004 (incorporated by
      reference to Exhibit 10.4 to our Quarterly Report on Form 10-Q for the
      quarter ended September 30, 2004).*
 
 10.2
    Employment
      Agreement with Edward B. Meyercord, III dated January 1, 2004
      (incorporated by reference to Exhibit 10.2 to our Annual Report on Form
      10-K for the year ended December 31, 2003).*
 
 10.3
    Tel-Save
      Holdings, Inc. 1995 Employee Stock Option Plan (incorporated by reference
      to Exhibit 10.15 to our registration statement on Form S-1 (File No.
      33-94940)).*
 
 10.4
    Stock
      Option Agreement, dated as of November 13, 1998, with Gabriel Battista
      (incorporated by reference to Exhibit 10.4 to our Current Report on Form
      8-K dated January 20, 1999).*
 
 10.5
    1998
      Long-Term Incentive Plan (incorporated by reference to Exhibit 10.14 to
      our Current Report on Form 8-K dated January 20, 1999).*
 
 48
  10.6
    2000
      Long-Term Incentive Plan (incorporated by reference to Exhibit 10.31 to
      our Registration Statement on Form S-4 (No. 333-40980)). *
 
 10.7
    Form
      of Non-Qualified Stock Option Agreement, dated December 12, 2000, for each
      of Gabriel Battista, Aloysius T. Lawn IV and Edward B. Meyercord, III
      (incorporated by reference to Exhibit 10.40 to our Annual Report on Form
      10-K for the year ended December 31, 2000).*
 
 10.8
    Rights
      Agreement dated as of August 19, 1999 by and between the Talk.com Inc. and
      First City Transfer Company, as Rights Agent (incorporated by reference to
      Exhibit 1 to our registration statement on Form 8-A (File No. 000-26728)).
 
 10.9
    Employment
      Agreement with Thomas M. Walsh dated as of August 7, 2000 (incorporated by
      reference to Exhibit 10.1 to our Quarterly Report on Form 10-Q dated
      November 14, 2000).*
 
 10.10
    Indemnification
      Agreement with Thomas M. Walsh dated as of August 7, 2000 (incorporated by
      reference to Exhibit 10.2 to our Quarterly Report on Form 10-Q dated
      November 14, 2000).*
 
 10.11
    Non-Qualified
      Stock Option Agreement with Thomas M. Walsh dated as of August 7, 2000
      (incorporated by reference to Exhibit 10.3 to our Quarterly Report on Form
      10-Q dated November 14, 2000).*
 
 10.12
    Lease
      by and between Talk.com Holding Corp. and University Science Center, Inc.
      dated April 10, 2000 (incorporated by reference to Exhibit 10.54 to our
      Annual Report on Form 10-K for the year ended December 31, 2000).
 
 10.13
    Lease
      by and between The Other Phone Company, dba Access One Communications and
      University Science Center, Inc. dated December 8, 1999 (incorporated by
      reference to Exhibit 10.55 to our Annual Report on Form 10-K for the year
      ended December 31, 2000).
 
 10.14
    Restated
      Access One Communications Corp. 1997 Stock Option Plan (incorporated by
      reference to Exhibit 4.2 to our registration statement on Form S-8 (File
      No. 333-52166).*
 
 10.15
    Restated
      Access One Communications Corp. 1999 Stock Option Plan (incorporated by
      reference to Exhibit 4.3 to our registration statement on Form S-8 (File
      No. 333-52166).*
 
 10.16
    Employment
      Agreement with Jeffrey Earhart dated July 30, 2004 (incorporated by
      reference to Exhibit 10.3 to our Quarterly Report on Form 10-Q for the
      quarter ended September 30, 2004). *
 
 10.17
    Employment
      Agreement with Warren Brasselle dated July 30, 2004 (incorporated by
      reference to Exhibit 10.2 to our Quarterly Report on Form 10-Q for the
      quarter ended September 30, 2004). *
 
 10.18
    Employment
      Agreement with Timothy Leonard dated March 15, 2005 (filed herewith).*
      (1)
 
 10.19
    Sublease
      Agreement by and between Talk America Inc. and Food Lion, LLC, dated as of
      November 26, 2003 (incorporated by reference to Exhibit 10.23 to our
      annual Report on Form 10-K for the year ended December 31,
      2003).
 
 10.20
    Lease
      by and between Talk America Inc. and BTS Owners LLC, dated as of July 1,
      2003 (incorporated by reference to Exhibit 10.24 to our annual Report on
      Form 10-K for the year ended December 31,
2003).
 
 10.21
    First
      Amendment, dated as of September 19, 2001, to the Rights Agreement dated
      as of August 19, 1999, by and between Talk America Holdings, Inc. and
      First City Transfer Company, as Rights Agent (incorporated by reference to
      Exhibit 10.9 to our Current Report on Form 8-K filed on September 24,
      2001).
 
 10.22      
Employment Agreement with David G. Zahka dated July 30, 2004 (incorporated by
reference to Exhibit 10.1 to our Quarterly Report on Form 10-Q for the quarter
ended    September 30, 2004).*
 
  49
  10.23
    Our
      2001 Non-Officer Long Term Incentive Plan (incorporated by reference to
      Exhibit 4.1 to our registration statement on Form S-8 (File No.
      333-74820).*
 
 10.24
    Second
      Amendment to Office Lease by and between TMT Reston Plaza I and II, Inc.
      and Talk America Inc., dated November 1, 2004 (filed herewith).
      (1)
 
 10.25      
Office Lease by and between Reston Plaza I and II, LLC and Talk.com, Inc. dated
as of April 28, 2000 (incorporated by reference to Exhibit 10.68 to our Annual
Report on Form 10-K for the year ended December 31, 2001).
 
 10.26
    Our
      2003 Long Term Incentive Plan (incorporated by reference to Exhibit B of
      our Definitive Proxy Statement filed on May 6,
2003).*
 
 10.27
    Second
      Amendment to Rights Agreement, dated as of December 13, 2002, to the
      Rights Agreement dated as of August 19, 1999, by and between Talk America
      Holdings, Inc., First City Transfer Company and Stocktrans, Inc.
      (incorporated by reference to Exhibit 10.1 to our Current Report on Form
      8-K filed on December 13, 2002).
 
 10.28
    Lease
      Agreement by and between Jeffrey M. Baumrucker and Monique M. Baumrucker
      and Talk America Inc. dated as of July 7, 2003 (incorporated by reference
      to Exhibit 10.36 to our Annual Report on Form 10-K for the year ended
      December 31, 2003).
 
 10.29
    Summary
      Description of 2004 Supplemental Incentive Compensation Plan (filed
      herewith). * (1)
 
 10.30
    2004
      Bonus Program Summary Description (incorporated by reference to Exhibit
      10.1 to our Current Report on Form 8-K, dated February 23, 2005).
      *
 
 10.31
    Consulting
      Agreement between Talk America Holdings, Inc. and Gabriel Battista, dated
      as of January 1, 2005 (incorporated by reference to Exhibit 10.1 to our
      Current Report on Form 8-K dated January 1, 2005).
 
 10.32
    Office
      Lease by and between TMT Reston I & II, Inc. and Talk America Inc.
      dated as of November 1, 2004 (filed herewith).
(1)
 
 10.33
    Indemnification
      Agreement with Edward B. Meyercord, III dated January 1, 2004
      (incorporated by reference to Exhibit 10.4 to our Annual Report on Form
      10-K for the year ended December 31, 2003).
 
 10.34
    Employment
      Agreement with Gabriel Battista dated January 1, 2004 (incorporated by
      reference to Exhibit 10.6 to our Annual Report on Form 10-K for the year
      ended December 31, 2003).*
 
 14.1
    Code
      of Ethics (incorporated by reference to Exhibit 14.1 to our Annual Report
      on Form 10-K for the year ended December 31,
2003).
 
 21.1
    Our
      Subsidiaries (filed herewith). (1)
 
 23.1 Consent
of PricewaterhouseCoopers LLP (filed herewith).
 
 31.1
    Certification
      of Edward B. Meyercord, III Pursuant to Rule 13a-14(a) (filed
      herewith).
 
 31.2
    Certification
      of David G. Zahka Pursuant to Rule 13a-14(a) (filed
    herewith).
 
 32.1
    Certification
      of Edward B. Meyercord, III Pursuant to Rule 13a-14(b) and 18 U.S.C.
      Section 1350 (furnished herewith).
 
 32.2
    Certification
      of David G. Zahka Pursuant to Rule 13a-14(b) and 18 U.S.C. Section 1350
      (furnished herewith).
 
 *
Management contract or compensatory plan or arrangement.
 
 (1)
Previously filed as an exhibit to our Annual Report on Form 10-K for the year
ended December 31, 2004, filed on March 16, 2005.
 
  
 50
 
 
 
 **SIGNATURES**
 
 Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, the registrant has duly caused this report to be signed on its behalf by
the undersigned thereunto duly authorized.
 
 Date:
March 29, 2005
 
 **TALK
AMERICA HOLDINGS, INC.**
 
 
 
 By:  /s/
Edward B. Meyercord, III
 Edward B. Meyercord,
III
 Chief Executive
Officer