**UNITED
STATES**


**SECURITIES
AND EXCHANGE COMMISSION**


Washington,
D.C. 20549


**_____________________**


**FORM
10-K/A**


**(AMENDMENT
NO. 2)**





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


For the
fiscal year ended December 31, 2003


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. [ ]





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, 2003, 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, 2003 of $10.79 per share as reported on
the Nasdaq National Market, was approximately $280,519,337.15 (calculated by
excluding solely for purposes of this form outstanding shares owned by directors
and executive officers).





As of
March 9, 2004, the registrant had issued and outstanding 26,670,050 shares of
common stock, par value $.01 per share.




**DOCUMENTS
INCORPORATED BY REFERENCE**





Portions
of the Proxy Statement for the 2004 Annual Meeting of Stockholders.    Part
III

















**Explanatory
Note**





Talk
America Holdings, Inc. is filing this Amendment No. 2 on Form 10-K/A (“Amendment
No. 2”) to our Annual Report on Form 10-K originally filed with the Securities
and Exchange Commission on March 12, 2004, as previously amended by Amendment
No. 1 on Form 10-K/A filed with the Securities and Exchange Commission on May 7,
2004 (as so amended, the “Original 10-K”), for the purpose of restating our
consolidated financial statements (as previously restated) for the year ended
December 31, 2003 (including the quarters thereof) to reflect corrections
of the following errors:





Item
# :





1.
    Revenue
      for each of the four quarters of2003and
      the year ended December 31, 2003 was increased to recognize certain
      customer fees previously recorded in sales, use and excise tax
      liabilities, with corresponding increases in operating income, net income,
      net income per share-basic and net income per share-diluted, along with
      corresponding reductions of sales, use and excise tax
      liabilities;




2.
    The
      number of diluted weighted average common and common equivalent shares
      outstanding for each of thethird
      and fourth quarters 2003 and year ended December 31, 2003 was decreased to
      reflect theinclusionofassumedtaxbenefitsin
      theproceeds used torepurchase
      shares in the application ofthe
      treasury stock method of accounting for outstanding options, with a
      corresponding increase in diluted net income per share for each of these
      periods;




3.
    Income
      tax expense for each of the thirdand
      fourthquarters2003and
      year ended December 31, 2003 was reduced to reflect additional deferred
      tax assets relating to net operating loss carryforwards due to (a) a
      correction in the calculation of net operating losses utilized in 2003 to
      reflect the deductibility of state income taxes and (b) a correction to
      thecalculationof
      state deferred tax assets, with corresponding increases in net income, net
      income per share-basic and net income per share-diluted for each of these
      periods; and




4.
    Deferred
      tax assets were increased by $6.5 million and goodwill was decreased by a
      corresponding amount beginning in the third quarter 2003 and for the year
      ended December 31, 2003 to record the deferred taxassetassociated
      withacquirednet
      operating loss carryforwards.




The
effect of these items is reflected in our consolidated financial statements
contained in Item 8 of this Amendment No. 2, with corresponding changes
reflected in  Item 6, Selected Consolidated Financial Data, Item 7,
Management’s Discussion and Analysis of Financial Condition and Results of
Operations and Item 9A, Controls and Procedures. The effect of these items on
our consolidated statement of operations for the year ended December 31, 2003 is
summarized in the following table. Each of the adjustments shown in the table
includes a bracketed reference, by the item numbers set forth above, to the
financial item or items described above giving rise to such adjustment.


1


(in
      000s, except per share data)
    
    2003Q1
      (Unaudited)
    
    
    Q2
      (Unaudited)
    
    
    Q3
      (Unaudited)
    
    
    Q4
      (Unaudited)
    
    
    YearRevenues:Reported
    
    $
    87,843
    
    $
    93,748
    
    $
    99,929
    
    $
    101,143
    
    $
    382,663Adjustments
      [1]
    
    
    359
    
    
    158
    
    
    249
    
    
    264
    
    
    1,030As
      Restated
    
    $
    88,202
    
    $
    93,906
    
    $
    100,178
    
    $
    101,407
    
    $
    383,693Operating
      Income:Reported
    
    $
    15,179
    
    $
    19,027
    
    $
    17,620
    
    $
    13,432
    
    $
    65,258Adjustments
      [1]
    
    
    359
    
    
    158
    
    
    249
    
    
    264
    
    
    1,030As
      Restated
    
    $
    15,538
    
    $
    19,185
    
    $
    17,869
    
    $
    13,696
    
    $
    66,288Pre-Tax
      Income:Reported
    
    $
    14,961
    
    $
    17,500
    
    $
    16,106
    
    $
    12,197
    
    $
    60,763Adjustments
      [1]
    
    
    359
    
    
    158
    
    
    249
    
    
    264
    
    
    1,030As
      Restated
    
    $
    15,320
    
    $
    17,658
    
    $
    16,355
    
    $
    12,461
    
    $
    61,793Income
      Tax Expense(Benefit):Reported
    
    $
    5,835
    
    $
    6,825
    
    $
    (35,460
    )
    $
    5,103
    
    $
    (17,697
    )Adjustments
      [1] [3]
    
    
    141
    
    
    62
    
    
    (2,287
    )
    
    (243
    )
    
    (2,327
    )As
      Restated
    
    $
    5,976
    
    $
    6,887
    
    $
    (37,747
    )
    $
    4,860
    
    $
    (20,024
    )Net
      Income:Reported
    
    $
    9,126
    
    $
    10,675
    
    $
    51,566
    
    $
    7,094
    
    $
    78,461Adjustments
      [1] [3]
    
    
    217
    
    
    96
    
    
    2,536
    
    
    507
    
    
    3,356As
      Restated
    
    $
    9,343
    
    $
    10,771
    
    $
    54,102
    
    $
    7,601
    
    $
    81,817Basic
      EPS:Reported
    
    $
    0.35
    
    $
    0.41
    
    $
    1.96
    
    $
    0.27
    
    $
    2.99Adjustments
      [1] [2] [3]
    
    
    --
    
    
    --
    
    
    0.09
    
    
    0.02
    
    
    0.11As
      Restated
    
    $
    0.35
    
    $
    0.41
    
    $
    2.05
    
    $
    0.29
    
    $
    3.10Fully
      Diluted EPS:Reported
    
    $
    0.32
    
    $
    0.37
    
    $
    1.74
    
    $
    0.25
    
    $
    2.75Adjustments
      [1] [2] [3]
    
    
    --
    
    
    --
    
    
    0.14
    
    
    0.02
    
    
    0.19As
      Restated
    
    $
    0.32
    
    $
    0.37
    
    $
    1.88
    
    $
    0.27
    
    $
    2.94Fully
      Diluted Shares:Reported
    
    
    29,940
    
    
    29,563
    
    
    29,761
    
    
    28,884
    
    
    28,514Adjustments
      [2]
    
    
    --
    
    
    --
    
    
    (884
    )
    
    (777
    )
    
    (708
    )As
      Restated
    
    
    29,940
    
    
    29,563
    
    
    28,877
    
    
    28,107
    
    
    27,806








Unless
otherwise expressly stated (including the restatement reflected in the Amendment No. 1 on Form 10-K/A filed
with the Securities and Exchange Commission on May 7, 2004) , this
Amendment No. 2 does not reflect events occurring after the filing on March 12,
2004 of our Annual Report on Form 10-K for the year ended December 31, 2003, nor
does it modify or update in any way disclosures contained in the Original 10-K
other than to reflect the restatement discussed above.




****


2


****


**ITEM
6.   SELECTED CONSOLIDATED 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.





****
    
    **Year
      Ended December 31,****2003
      (Restated)(1)**
    ****
    ****
    **2002**
    ****
    ****
    **2001**
    ****
    ****
    **2000**
    ****
    ****
    **1999****(In
      Thousands, Except For Per Share Amounts)****Consolidated
      Statements of Operations Data:**Revenue
    
    $
    383,693
    
    $
    317,507
    
    $
    488,158
    
    $
    525,712
    
    $
    516,548Costs
      and expenses:Network
      and line costs
    
    
    181,682
    
    
    155,567
    
    
    235,153
    
    
    292,931
    
    
    289,029General
      and administrative expenses
    
    
    57,503
    
    
    53,510
    
    
    82,202
    
    
    65,360
    
    
    39,954Provision
      for doubtful accounts
    
    
    11,599
    
    
    9,365
    
    
    92,778
    
    
    53,772
    
    
    28,250Sales
      and marketing expenses
    
    
    48,277
    
    
    27,148
    
    
    73,973
    
    
    152,028
    
    
    96,264Depreciation
      and amortization
    
    
    18,344
    
    
    17,318
    
    
    34,390
    
    
    19,257
    
    
    6,214Impairment
      and restructuring charges
    
    
    --
    
    
    --
    
    
    170,571
    
    
    --
    
    
    --Significant
      other charges (income)
    
    
    --
    
    
    --
    
    
    --
    
    
    --
    
    
    (2,718
    )Total
      costs and expenses
    
    
    317,405
    
    
    262,908
    
    
    689,067
    
    
    583,348
    
    
    456,993Operating
      income (loss)
    
    
    66,288
    
    
    54,599
    
    
    (200,909
    )
    
    (57,636
    )
    
    59,555Other
      income (expense):Interest
      income
    
    
    388
    
    
    802
    
    
    1,220
    
    
    4,859
    
    
    3,875Interest
      expense
    
    
    (7,353
    )
    
    (9,087
    )
    
    (6,091
    )
    
    (5,297
    )
    
    (4,616
    )Other
      income (expense), net
    
    
    2,470
    
    
    28,448
    
    
    17,950
    
    
    (3,822
    )
    
    20,115Income
      (loss) before provision for incometaxes
    
    
    61,793
    
    
    74,762
    
    
    (187,830
    )
    
    (61,896
    )
    
    78,929Provision
      (benefit) for income taxes
    
    
    (20,024
    )
    
    (22,300
    )
    
    --
    
    
    --
    
    
    --Income
      (loss) before cumulative effect of anaccounting
      change
    
    
    81,817
    
    
    97,062
    
    
    (187,830
    )
    
    (61,896
    )
    
    78,929Cumulative
      effect of an accounting change
    
    
    --
    
    
    --
    
    
    (36,837
    )
    
    --
    
    
    --Net
      income (loss)
    
    $
    81,817
    
    $
    97,062
    
    $
    (224,667
    )
    $
    (61,896
    )
    $
    78,929Income
      (loss) per share - Basic:Income
      (loss) before cumulative effect of an accounting change per share
    
    $
    3.10
    
    $
    3.56
    
    $
    (7.11
    )
    $
    (2.63
    )
    $
    3.87Cumulative
      effect of an accounting change per share
    
    
    --
    
    
    --
    
    
    (1.40
    )
    
    --
    
    
    --Net
      income (loss) per share
    
    $
    3.10
    
    $
    3.56
    
    $
    (8.51
    )
    $
    (2.63
    )
    $
    3.87Weighted
      average common shares outstanding
    
    
    26,376
    
    
    27,253
    
    
    26,414
    
    
    23,509
    
    
    20,395Income
      (loss) per share - Diluted:Income
      (loss) before cumulative effect of an accounting change per
      share
    
    $
    2.94
    
    $
    3.15
    
    $
    (7.11
    )
    $
    (2.63
    )
    $
    3.68Cumulative
      effect of an accounting change per share
    
    
    --
    
    
    --
    
    
    (1.40
    )
    
    --
    
    
    --Net
      income (loss) per share
    
    $
    2.94
    
    $
    3.15
    
    $
    (8.51
    )
    $
    (2.63
    )
    $
    3.68Weighted
      average common and common equivalent shares outstanding
    
    
    27,806
    
    
    30,798
    
    
    26,414
    
    
    23,509
    
    
    21,471








**At
      December 31,******
    
    
    **2003**
      **(Restated)**
      **(1)**
    
    
    **2002**
    
    
    **2001**
    
    
    **2000**
    
    
    **1999******
    
    **(In
      Thousands)****Consolidated
      Balance Sheet Data:**Cash
      and cash equivalents
    
    $
    35,242
    
    $
    33,588
    
    $
    22,100
    
    $
    40,604
    
    $
    78,937Total
      current assets
    
    
    105,595
    
    
    82,825
    
    
    51,214
    
    
    97,203
    
    
    150,893Goodwill
      and intangibles, net
    
    
    17,769
    
    
    26,882
    
    
    29,672
    
    
    218,639
    
    
    1,068Total
      assets
    
    
    247,178
    
    
    189,075
    
    
    165,737
    
    
    407,749
    
    
    215,008Current
      portion of long-term debt
    
    
    16,806
    
    
    61
    
    
    14,454
    
    
    2,822
    
    
    --Total
      current liabilities
    
    
    93,235
    
    
    64,754
    
    
    87,789
    
    
    100,271
    
    
    71,168Contingent
      obligations
    
    
    --
    
    
    --
    
    
    --
    
    
    114,630
    
    
    114,630Long-term
      debt
    
    
    31,791
    
    
    100,855
    
    
    152,370
    
    
    103,695
    
    
    84,985Stockholders'
      equity (deficit)
    
    
    103,143
    
    
    23,466
    
    
    (74,422
    )
    
    82,700
    
    
    (69,375
    )


________________________________







3







(1)  The
Selected Consolidated Financial Data for 2003 (as previously restated on May 7,
2004) has been restated for matters related to (a) the recognition in revenue in
the four quarters of 2003 and year
ended December 31, 2003 of certain customer fees previously recorded in those
periods as  increase s in sales, use and excise tax liabilities; (b) the calculation
of outstanding diluted weighted average common and common equivalent shares in
the  third and
fourth quarters 2003 and
the year ended December 31, 2003 to
reflect the inclusion
of tax benefits in the proceeds used to repurchase shares in the application of
the treasury method of accounting for outstanding options ; (c) for
the third and
fourth quarter s  2003 and
the year ended December 31, 2003, a correction in the calculation of net
operating losses utilized in 2003 and in the calculation
of state deferred
tax assets; and (d) the recording, beginning in the third quarter 2003 and
for the year ended December 31, 2003, of a deferred tax  asset associated
with acquired net
operating loss carryforwards .  See Note
1 6 to the
Consolidated Financial Statements.





See
“Management’s Discussion and Analysis of Financial Condition and Results of
Operations” for a discussion of items affecting the results of 2001, 2002 and
2003.


****


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





**Restatements
of Previously Issued Consolidated Financial Statements**





Amendment
No. 1





As
discussed in Note 16 to our Consolidated Financial Statements, we revised our
previously issued consolidated sheet as of December 31, 2003 and related
disclosures in Note 5 to reflect the change in classification of $15 million
of  our 12%
Senior Subordinated Notes from long-term debt to current portion of long-term
debt. Refer to Note 16 to our Consolidated Financial Statements for further
information regarding this restatement.





Amendment
No. 2





As
discussed in Note 16 to our Consolidated Financial Statements, we further
restated our previously issued Consolidated Financial Statements for the year
ended December 31, 2003 and the four quarters of 2003 for matters related to:
(a) the recognition in revenue in the four quarters 2003 and year ended December
31, 2003 of certain customer fees previously recorded in those periods as
increases in sales, use and excise tax liabilities; (b) the
calculation of outstanding diluted weighted average common and common equivalent
shares in the third
and fourth quarters of 2003 and the year ended December 31, 2003 to reflect
the  inclusion
of assumed tax benefits in the proceeds used to repurchase shares in the
application of the treasury stock method of accounting for outstanding options;
(c) a correction in the calculation of net operating losses utilized in 2003 and
in the calculation
of state deferred tax assets for the third and fourth quarters 2003 and the year
ended December 31, 2003; and (d) the recording, beginning in the third quarter
of 2003 and for the year ended December 31, 2003, of a deferred tax asset
associated with acquired net operating loss carryforwards.  Refer to
Notes 15 and 16 to the Consolidated Financial Statements for further information
regarding this restatement, including the effect of the restatement for each of
the four quarters 2003 and the year ended December 31, 2003.


The
information in the following discussion reflects these restatements, but is not
otherwise updated.




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 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.








4





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
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 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**





Talk America
Holdings, Inc., through its subsidiaries, offers a bundle of local and long
distance phone services to residential and small business customers in the
United States. Our business strategy is to build a large, profitable base of
bundled phone service customers using the wholesale operating platforms of the
incumbent local exchange companies and then to migrate customers to our own
networking platform and further increase our revenues and profitability by
offering new products and services to these customers. We refer to this strategy
as our “customer first” strategy.





In 2000, we decided
to expand beyond our historical long distance service offerings and utilize the
unbundled network element platform to enter the large local telecommunications
market and diversify our product portfolio through the bundling of local service
with our core long distance service offerings. We encountered a number of
operational and business difficulties during the rollout of our bundled service
offering in 2000 and worked to address the operational issues that we
encountered. We focused on improving the overall efficiency of the bundled
business model in 2001. During 2002, our top operating priorities were to lower
bad debt expense, reduce customer turnover, or “churn,” and lower our customer
acquisition costs. During 2003, our primary focus was increasing sales of our
bundled services within the targets established by management for acquisition
costs, customer turnover and bad debt expense. We ended 2003 with 557,000 billed
bundled lines. We expect our existing base of long distance customers to
continue to decline in 2004 through attrition due to our decision to focus our
marketing efforts on the sale of our bundled product.




An integral
element of our business strategy is our development of our own local networking
capacity. This development, if successful, will enhance our operating
flexibility and provide us with an alternative to the wholesale operating
platforms of the incumbent local exchange companies. As the first step in
enabling us to implement this stage of our business strategy, during 2003, we
deployed networking assets in Michigan and have begun to carry test calls over
our own switching platform. We are in the process of automating the business
processes required to provide local network-based services and to support the
proposed deployment of our own local network. Our objective is to develop a
viable networking opportunity as an alternative to the wholesale operating
platforms of the incumbent local exchange companies to provide us with operating
flexibility. In addition, we will add new services and enhance our existing
service and product offerings, as available, to increase our revenues and
profitability from our customers.





**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,******
      ****
    
    
    **2003**
      **(Restated)**
    ****
    ****
    **2002**
    ****
    ****
    **2001**Revenue
    
    
    100.0
    %
    
    100.0
    %
    
    100.0
    %Costs
      and expenses:Network
      and line costs
    
    
    47.5
    
    
    49.0
    
    
    48.2General
      and administrative expenses
    
    
    15.0
    
    
    16.8
    
    
    16.8Provision
      for doubtful accounts
    
    
    3.0
    
    
    2.9
    
    
    19.0Sales
      and marketing expenses
    
    
    12.6
    
    
    8.6
    
    
    15.2Depreciation
      and amortization
    
    
    4.8
    
    
    5.5
    
    
    7.0Impairment
      and restructuring charges
    
    
    --
    
    
    --
    
    
    34.9Total
      costs and expenses
    
    
    82.9
    
    
    82.8
    
    
    141.2Operating
      income
    
    
    17.1
    
    
    17.2
    
    
    (41.2
    )Other
      income (expense):Interest
      income
    
    
    0.1
    
    
    0.3
    
    
    0.3Interest
      expense
    
    
    (1.9
    )
    
    (2.9
    )
    
    (1.2
    )Other,
      net
    
    
    0.6
    
    
    9.0
    
    
    3.6Income
      (loss) before income taxes
    
    
    15.9
    
    
    23.6
    
    
    (38.5
    )Provision
      (benefit) for income taxes
    
    
    (5.2
    )
    
    (7.0
    )
    
    --Income
      (loss) before cumulative effect of an accounting change
    
    
    21.3
    
    
    30.6
    
    
    (38.5
    )Cumulative
      effect of an accounting change
    
    
    --
    
    
    --
    
    
    (7.5
    )Net
      income (loss)
    
    
    21.3
    %
    
    30.6
    %
    
    (46.0
    )%





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,******
      ****
    
    
    **2003**
      **(Restated)**
    
    
    **2002**Revenue
    
    
    20.8
    %
    
    (35.0
    )%Costs
      and expenses:Network
      and line costs
    
    
    16.8
    
    
    (33.8
    )General
      and administrative expenses
    
    
    7.5
    
    
    (34.9
    )Provision
      for doubtful accounts
    
    
    23.9
    
    
    (89.9
    )Sales
      and marketing expenses
    
    
    77.8
    
    
    (63.3
    )Depreciation
      and amortization
    
    
    5.9
    
    
    (49.6
    )Impairment
      and restructuring charges
    
    
    --
    
    
    (100.0
    )Total
      costs and expenses
    
    
    (20.7
    )
    
    (61.8
    )Operating
      income
    
    
    21.4
    
    
    127.2Other
      income (expense):Interest
      income
    
    
    (51.6
    )
    
    (34.3
    )Interest
      expense
    
    
    (19.1
    )
    
    49.2Other,
      net
    
    
    (91.3
    )
    
    58.5Income
      before income taxes
    
    
    (17.3
    )
    
    139.8Benefit
      for income taxes
    
    
    (10.2
    )
    
    --Income
      before cumulative effect of an accounting change
    
    
    (15.7
    )
    
    151.7Cumulative
      effect of an accounting change
    
    
    --
    
    
    (100.0
    )Net
      income (loss)
    
    
    (15.7
    )%
    
    143.2
    %





*Revenue.* The
increase in revenue in 2003 from 2002 was due to the increase in bundled revenue
offset by a decline in long distance revenue. In 2002 both long distance and
bundled revenue decreased. 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 may adversely impact customer turnover.





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. Approximately 58.6% of the bundled lines in
December 2003 were in Michigan. While we have expanded our marketing efforts in
additional states during 2003, including Georgia, Illinois, New York, New
Jersey, Indiana, Wisconsin, Ohio and Maryland, continued growth in
revenues will depend upon our ability to develop and scale various marketing
programs in additional states or areas and to maintain or reduce the current
level of customer turnover.





The
decrease in bundled revenue to $171.2 million in 2002 from $196.5 million in
2001 was due to lower average revenue per bundled line in 2002 as compared to
2001. Such decrease resulted from our strategy to market lower priced products
to be more competitive with incumbent and other competitive local exchange
carriers. We ended 2002 with 333,000 billed bundled lines compared with
approximately 179,000 billed bundled lines in 2001. Approximately 61.1% of the
bundled lines in December 2002 were in Michigan.







5





Our long
distance revenue decreased in 2003 to $101.4 million from $146.3 million in
2002, and from $291.7 million in 2001. 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 and 2001 included non-cash amortization of deferred revenue of
$6.2 million and $7.4 million, respectively, 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 2003 from 2002 is primarily due to the
increase in bundled customers, partially offset by the decrease in long distance
customers. The lower total network and line costs as a percentage of revenue
were due primarily to lower network costs as a percentage of revenue for both
the bundled and long distance products. This decrease was partially offset by a
shift in our customer base to the higher cost bundled product from the lower
cost long distance product.





Bundled network and
line costs were $141.9 million for 2003, as compared to $96.1 million for 2002
and $107.7 million for 2001. Long distance network and line costs were $39.8
million for 2003, as compared to $59.5 million for 2002 and $127.5 million for
2001. As a percentage of bundled revenue, bundled and network line costs were
50.4% for 2003, as compared to 56.1% for 2002 and 54.8% for 2001. Long distance
network and line costs as a percentage of long distance revenue were 39.2% for
2003, as compared to 40.6% for 2002 and 43.7% for 2001.




The decrease
of network and line costs in 2002 from 2001 was primarily due to the decrease in
long distance customers and a reduction in access and usage rates. Network and
line costs for 2002 benefited from a credit of $1.7 million in connection with a
New York Public Service Commission mandated refund from Verizon New York of
certain unbundled network element platform switching costs. The growth in 2002
of local bundled service as a percentage of total revenue from 2001 and product
mix has contributed to the increase in overall network and line cost as a
percentage of revenues.




We 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. 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:





·  determinations
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, requiring us to provide services
in these areas through total service resale agreements with incumbent local
exchange companies, through network elements purchased from the Regional Bell
Operating Companies at "just and reasonable" rates under Section 271 of the Act
or through the switching facilities of other non-incumbent carriers, in any case
at significantly increased costs, or to provide services over our own switching
facilities, if they have been deployed. The Court of Appeals, on March 2, 2004,
issued an order that reversed the FCC’s Triennial Review Order in part and
remanded to the FCC with instructions to revise the Order in material ways that
may make unbundled local switching and/or combinations of unbundled network
elements effectively unavailable to us in some or all of our geographic service
areas (see Item 1, "Regulation," above and "Liquidity and Capital Resources,
Other Matters," below);




·  adverse
changes to the current pricing methodology mandated by the FCC for use in
establishing the prices charged to us by incumbent local telephone companies for
the use of their unbundled network elements. 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
telephone 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. These changes could result in material
increases in prices charged to us for unbundled network elements;
and




·  determinations
by state commissions to increase prices for unbundled network elements in
ongoing state cost dockets.





6




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 2003 from 2002. 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 increase was also due to
an increase in the number of employees for customer service and information
technology to support our expanding base of bundled customers. As of December
31, 2003, we had 270 and 53 employees within customer service and information
technology, respectively, as compared to 225 and 43 as of December 31, 2002. The
decrease in general and administrative expenses in 2002 from 2001 was due
primarily to significant reductions in workforce and other cost cutting efforts
by us as we pursued improvements in operating efficiencies of our bundled
business model and the litigation settlement.




While we
expect general and administrative expense as a percentage of revenue to continue
to decline as the customer base grows, realization of such efficiencies will be
dependent on the ability of management to continue to control personnel costs in
areas such as customer service and collections. There can be no assurances that
we will be able to realize these efficiencies.




*Provision
for Doubtful Accounts* . The
provision for doubtful accounts increased in 2003 from 2002. 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. In general, bad debt expense
as a percentage of revenue of our long distance customers is lower than that of
our bundled customers because of the relatively greater maturity of the long
distance customer base, however, the impact of this lower bad debt expense is
decreasing as our base of long distance customers continues to
decline.


**


*Sales and
Marketing Expenses* . The
increase in sales and marketing expenses in 2003 from 2002 is primarily
attributable to increased levels of sales and marketing activity to continue our
bundled sales growth. The decrease in sales and marketing costs in 2002 from
2001 was primarily attributable to the reduction in marketing fees paid to AOL
due to the termination of the marketing relationship with AOL effective
September 30, 2001. Currently, substantially all of our sales and marketing
expenses relate to the bundled product. Included in sales and marketing expenses
are advertising expenses of $6.8 million for 2003, $1.5 million for 2002, and
$0.2 million for 2001. We expect sales and marketing expenses to increase in
2004 as we continue to target growth in the bundled product and invest in the
development of our marketing programs.


**


*Impairment
and Restructuring Charges.* Included
in impairment and restructuring charges for 2001 was an impairment charge of
$168.7 million primarily related to the write-down of goodwill associated with
the August 2000 acquisition of Access One Communications Corp. In September
2001, we approved a plan to close one of our call center operations. We incurred
expenses of $1.9 million during 2001 to reflect the elimination of approximately
225 positions and lease exit costs in connection with the call center closure.
There were no impairment or restructuring charges in 2002.


**


*Interest
Expense* . The
decrease in interest expense in 2003 from 2002 is primarily due to lower
outstanding debt balances. As a result of the restructuring agreement with AOL
on December 23, 2002, we recorded interest expense associated with the 8%
Secured Convertible Notes on our consolidated statement of operations for 2003,
partially offsetting the decrease due to lower outstanding debt. The increase in
interest expense in 2002 from 2001 was primarily due to the higher yielding debt
instruments delivered in the exchange of our 4-1/2% and 5% Convertible
Subordinated Notes for 8% Convertible Senior Subordinated Notes and 12% Senior
Subordinated Notes and the restructuring of our senior credit facility. The
issuance in 2001 of the 8% Secured Convertible Notes was initially accounted for
as a troubled debt restructuring. As such, the aggregate interest expense for
these notes was recorded as a liability at such time and the subsequent interest
expense associated with these notes of $2.7 million and $0.8 million for 2002
and 2001, respectively, were not reflected in the statement of operations.





7
 
 **
 *Depreciation and
Amortization.* Amortization expense decreased significantly in 2002 from 2001 due to the
write-down in 2001 of goodwill associated with the acquisition of Access One.
Additionally, we adopted Statement of Financial Accounting Standards No. 142,
"Goodwill and Other Intangible Assets," which established the impairment
approach rather than amortization for goodwill, resulting in reduced
amortization as a result of the elimination of goodwill amortization in 2002.


**


*Other
Income, Net* . 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.




Other income
for 2001 of $20.6 million include a $16.9 million gain on the restructuring of
the AOL contingent redemptions in accordance with SFAS No. 15, "Accounting by
Debtors and Creditors for Troubled Debt Restructurings." In addition, we
reacquired $5.0 million of our 4-1/2% Convertible Subordinated Notes due 2002 at
a $3.8 million discount from the face amount. The amount for 2001 also consisted
of a $2.4 million unrealized loss on the increase in fair value of the AOL
contingent redemptions in accordance with the fair value accounting treatment
under EITF Abstract No. 00-19. This amount did not recur, as the AOL contingent
redemptions had been restructured effective December 2001.





On January 1,
2003, we adopted Statement of Financial Accounting Standards No. 145,
“Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statements
No. 13, and Technical Corrections as of April 2002”, issued in May 2002, by the
Financial Accounting Standards Board, which eliminates the requirement to report
gains and losses from extinguishment of debt as extraordinary items. The
adoption of SFAS 145 resulted in a reclassification from extraordinary gains
(losses) from the extinguishment of debt of $29.3 million and $20.7 million to
other income (expense) for 2002 and 2001, respectively.




*Provision
for Income Taxes* . In both
2003 and 2002, management evaluated the deferred tax asset valuation allowance
and determined that a portion of the allowance should be reversed. The
evaluation considered profitability of the 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
will more likely than not be utilized, and reversed deferred tax asset valuation
allowances of $50.6 million and $22.3 million for 2003 and 2002, respectively,
recognized non-cash deferred income tax benefits of $44.1 million and $22.3
million for 2003 and 2002, respectively, and reduced the amount of goodwill
related to the August 2000 acquisition of Access One Communications, Inc. by
$6.5 million in 2003. 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, 2003, we had approximately $174.4 million of NOLs of which
approximately $151.4 million are estimated to be available to offset taxable
income. A valuation allowance has been recorded to reduce the carrying amounts
of 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 NOLs will be fully utilized by 2007
with the exception of $2.3 million in NOLs generated by Access One
Communications, Inc. and its subsidiaries, which will be fully utilized by
2018.




*Cumulative
Effect of an Accounting Change.* We
adopted Emerging Issues Task Force (EITF) Abstract No. 00-19, "Accounting for
Derivative Financial Instruments Indexed to, and Potentially Settled in, a
Company's Own Stock," in the quarter ended June 30, 2001. The cumulative effect
of the adoption of this change in accounting principle resulted in a non-cash
charge to operations of $36.8 million in the second quarter of 2001,
representing the change in fair value of contingent redemption features of
warrants and common stock held by AOL from issuance on January 5, 1999 through
June 30, 2001. The requirements under EITF 00-19 will not apply to future
changes in the value of these instruments, as the AOL contingent redemptions
have been restructured effective December 2001.




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.
In 2003 and 2002, our operating activities provided net cash flow of $73.2
million and $51.9 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, 2003, we had $35.2
million in cash and cash equivalents and long-term debt (including current
maturities) of $48.6 million, compared to $33.6 million and $100.9 million,
respectively, at December 31, 2002.
 
 Our
contractual obligations as of December 31, 2003 are summarized by years to
maturity as follows (in thousands):
 
 Contractual
      Obligations
    
    
    Total
    
    
    1
      year or
      less
      (as
      restated)
    
    
    2 -
      3
      Years
    
    
    4 -
      5
      Years
      (as
      restated)
    
    
    ThereafterTalk
      America Holdings, Inc.:12%
      Senior Subordinated Notes due 2007 (1)
    
    $
    40,730
    
    $
    15,000
    
    $
    --
    
    $
    25,730
    
    $
    --8%
      Convertible Senior Subordinated Notes due 2007 (2)
    
    
    3,778
    
    
    
    
    
    --
    
    
    3,778
    
    
    --5%
      Convertible Subordinated Notes due 2004
    
    
    670
    
    
    670
    
    
    --
    
    
    --
    
    
    --Talk
      America Inc. and other subsidiaries:Capital
      lease obligations
    
    
    3,419
    
    
    1,136
    
    
    2,283
    
    
    --
    
    
    --$
    48,597
    
    $
    16,806
    
    $
    2,283
    
    $
    29,508
    
    $
    --Operating
      leases
    
    $
    8,248
    
    $
    2,960
    
    $
    4,306
    
    $
    501
    
    $
    481Carrier
      commitments (3)
    
    
    81,650
    
    
    19,250
    
    
    41,600
    
    
    20,800
    
    
    --Total
      Contractual Obligations
    
    $
    138,495
    
    $
    39,016
    
    $
    48,189
    
    $
    50,809
    
    $
    481
 ________
 
 (1)
Reflects our November 5, 2003 notice and commitment to redeem $15 million
principal amount of these 12% Senior Subordinated Notes on January 5, 2004 and
resulting change in the maturity of such principal amount to the noticed
redemption date. Since the end of 2003 and through February 27, 2004, we have
redeemed the $15 million of these 12% Senior Subordinated Notes that we so
noticed for redemption and we have noticed for redemption and committed to
redeem on April 20, 2004 a further $15.0 million principal amount of these 12%
Senior Subordinated Notes.
 
 (2) The
amount of the 8% Convertible Senior Subordinated Notes include $2.8 million of
principal and $1.0 million of future accrued interest.
 
 (3) In
December 2003, we entered into a new 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: 2004 - $25 million, 2005 - $32 million, 2006 - $32
million and 2007 - $32 million and obligates us to pay 65 percent of the revenue
shortfall, if any. A separate contract with a different vendor establishes
pricing and provides for annual minimum payments for 2004 of $3.0 million. While
we believe we will meet these annual minimum revenue commitments, and that we
will not have to pay the shortfalls, there can be no assurances of this, and, if
we are required to pay any of the shortfall amounts under one of these
agreements, our costs of purchasing the services under the agreement will
correspondingly increase.
 
 9
 *Cash
Provided By Operating Activities.* Net cash
provided by operating activities was $73.2 million in 2003 and $51.9 million in
2002. In 2003, the major contributors to the net cash provided by operating
activities were:
 ·  Net
income of $81.8 million;
 ·  Increases
in accounts payable and accrued expenses of $3.1 million, primarily due to
increased levels of sales and marketing activity to continue our bundled sales
growth, and an increase in network and line costs primarily due to the increase
in bundled customers;
 ·  A
decrease in other assets of $1.5 million, primarily from repayment of a related
party loan;
 ·  An
increase in deferred revenue of $4.4 million for advance customer billings,
primarily due to the growth in bundled customers.
 
 Partially
offsetting these contributors to the net cash provided by operating activities
were:
 ·  Non-cash
benefits of $25.9 million, primarily consisting of a net deferred tax asset of
$23.4 million and gain from debt extinguishments of $2.5 million. We recognized
non-cash deferred income tax benefits of $50.6 million because of our outlook
for continued profitability and our ability to more likely than not utilize the
deferred tax assets. The tax benefit was partially offset by income tax expense
of $24.1 million. The application of NOL carryforwards have limited our current
payment of income taxes to cash taxes for alternative minimum taxes and state
income taxes. We expect that our NOLs will be fully utilized by
2007;
 ·  An
increase in accounts receivable of $24.1 million due to the continued shift in
our customer base from long distance customers to local bundled customers with
higher average monthly revenue per customer. 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.
 
 In 2002,
the major contributors to the net cash provided by operating activities were:
 ·  Net
income of $97.1 million; and
 ·  An
increase in other liabilities of $2.6 million, primarily consisting of an
increase in interest payable due to higher yielding debt instruments delivered
in the exchange for our 4-1/2% and 5% Convertible Subordinated Notes for 8%
Convertible Senior Subordinated Notes and 12% Senior Subordinated Notes, and the
restructuring of our senior credit facility.
 
 Partially
offsetting these contributors to the net cash provided by operating activities
were:
 ·  An
increase in accounts receivable of $10.6 million, primarily due to the continued
shift in our customer base from long distance customers to local bundled
customers with higher average monthly revenue per customer;
 ·  A
decrease in accounts payable and accrued expenses of $11.5 million, primarily
due to decreases in 2002 of network and line costs, sales and marketing expenses
and general and administrative expenses from 2001 and due to prompter payment of
vendors; and
 ·  Non-cash
items of $53.3 million, primarily consisting of a gain from restructuring and
redemption of convertible debt of $28.9 million and the deferred income tax
valuation reserve reversal of $22.3 million. On December 23, 2002, we
restructured our 8% Secured Convertible Notes and, accordingly, these notes were
no longer accounted for as a troubled debt restructuring. The $28.9 million gain
from the restructuring and repurchase of these notes was related to the decrease
in future accrued interest, which was reflected as a $28.9 million reduction in
long-term debt. We recognized non-cash deferred income tax benefits because of
our outlook for continued profitability and our ability to utilize the deferred
tax assets.
 
 *Net
Cash Used in Investing Activities.* In 2003,
approximately 42% of our $11.8 million in capital expenditures consisted of
costs related to our deployment of networking assets ( local switch and
colocation equipment) in Michigan. Also in 2003, to support our customer growth,
we opened a new customer service call center. Costs associated with our call
center initiatives were approximately 12% of total capital expenditures. The
remaining 2003 capital expenditures consisted primarily of upgrades to our
information technology capabilities to support our customer growth. In addition,
during 2003, we entered into a capital lease valued at $3.4 million for upgrades
to our customer data storage equipment. In 2004, we plan to add two more
colocations and to start migrating local bundled customers over to our network,
and expect to incur capital expenditures of approximately $12 to $15 million for
both network and non-network assets. As we pursue our "customer first" strategy
of building a large, profitable base of bundled service customers using the
wholesale operating platforms of the incumbent local exchange companies and then
migrate those customers to our own networking platform and offer new products
and services to these customers, our capital expenditures are expected to
increase significantly.
 
 10
 Capitalized
software development costs consist of direct development costs associated with
internal-use computer software including external direct costs of material and
services and payroll costs for employees devoting time to the software projects.
In 2003, capitalized software development costs totaled $2.7 million and were
primarily related to the development of customer relations management software.
In 2004, we expect software development costs to increase moderately as we
continue to develop the integrated information systems required to provide local
switch-based service.
 
 Net cash
used in investing activities was $7.3 million during 2002, consisting of
capitalized software development costs of $2.5 million and capital expenditures
primarily for the purchase of equipment of $4.8 million.
 
 *Net
Cash Used in Financing Activities.* Net cash
used in financing activities for 2003 and 2002 was primarily attributable to
debt repayment and purchases of $52.9 and $32.7 million, respectively. 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. Since December 31, 2003 and through February 27, 2004,
we have purchased $15.0 million principal amount of our 12% Senior Subordinated
Notes at par and committed to redeem an additional $15 million principal amount
in April 2004.
 
 In
addition, in 2003, pursuant to our share buyback program announced in January
2003, we purchased 1,315,789 shares for a purchase price of $5.0 million. Under
the buyback program, we are authorized to spend up to $10.0 million for share
purchases, with a cap of 2.5 million shares.
 
 In 2004,
we will continue to evaluate opportunities to purchase our debt prior to
maturity, as well as to consider acquiring shares under the balance of our share
buyback program. The remaining shares authorized under the program may be
purchased, from time to time, in the open market and/or in private
transactions.
 
 **Note
Obligations**
 
 **8%
Secured Convertible Notes**
 
 In
September 2001, we restructured our financial obligations with America Online,
Inc. that arose under our 1999 investment agreement and, effective September 30,
2001, also ended our marketing relationship with AOL. In connection with the
restructuring, we entered into a Restructuring and Note Agreement with AOL,
pursuant to which we had outstanding as of December 31, 2002, $30.2 million
principal amount of our 8% Secured Convertible Notes. On December 23, 2002, we
restructured these 8% Secured Convertible Notes to provide for: a new maturity
date of September 19, 2006, the elimination of a pay-in-kind interest option and
additional flexibility to purchase subordinated debt and common stock through
September 30, 2003. During 2003, we purchased all of these 8% Secured
Convertible Notes. 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.
 
 **Convertible
Subordinated Notes and Exchange Offers**
 
 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 that
matured on September 15, 2002 for $53.2 million principal amount of new 12%
Senior Subordinated PIK Notes due August 2007 and $2.8 million principal amount
of new 8% Convertible Senior Subordinated Notes due August 2007 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 that
mature on December 15, 2004 for $17.4 million principal amount of the new 12%
Senior Subordinated Notes. In 2003 and 2002, we acquired $25.2 million and $5.7
million principal amount of our 12% Senior Subordinated Notes, respectively, at
respective discounts from face amount of $2.5 million and $1.6 million, which
discounts are reported as other income in our consolidated statement of
operations. We paid at maturity the remaining $3.9 million principal balance of
our outstanding 4-1/2% Convertible Subordinated Notes due September 2002. Since
December 31, 2003 and through February 27, 2004, we have purchased an additional
$15.0 million principal amount of our 12% Senior Subordinated Notes at face
amount and have committed to redeem an additional $15.0 million principal amount
in April 2004.
 
 11
 **Other
Matters**
 
 Our
provision of telecommunication services is subject to government regulation. See
Item 1, "Regulation," above. Changes in existing regulations could have a
material adverse effect on us. Our local telecommunication services are provided
almost exclusively through the use of unbundled network elements purchased from
incumbent local telephone companies, and it is primarily the availability of
cost-based unbundled network element rates that enables us to price our local
telecommunications services competitively. The FCC currently requires incumbent
local telephone companies to provide an unbundled network element platform, that
includes all of the network elements required by a competitor to provide a
retail telecommunications service, in most geographic areas. Through the use of
such unbundled network element platforms we are able to provide retail local
services entirely through the use of the incumbent local telephone company’s
facilities at lower prices than those available for local resale through total
resale service agreements. In its UNE Triennial Review proceeding, the FCC
sought to identify, among other issues, which if any network elements the
incumbent local telephone companies should no longer be required to offer on an
unbundled basis. The FCC also analyzed the issue of which elements must be
unbundled in response to a remand of its previous rules by the U.S. Court of
Appeals for the District of Columbia Circuit. In the FCC’s UNE Triennial Review
Order, released August 21, 2003 and effective as of October 2, 2003, the
Commission determined that certain network elements will no longer be subject to
unbundling, while other elements must continue to be offered subject to further,
more detailed review by the state public utility commissions. The Order was
subject to numerous federal judicial appeals, which were consolidated in the
U.S. Court of Appeals for the District of Columbia Circuit. The Court, on March
2, 2004, issued an order that reversed the FCC’s Order in part and remanded to
the FCC with instructions to revise the Order in material ways. The Court stayed
its decision until the denial of any petitions for rehearing or for a 60-day
period (i.e., until May 1, 2004), whichever is later.
 
 Should
the local circuit switching unbundled network element become effectively
unavailable due to this adverse decision or otherwise, we would be unable to
offer services on an unbundled network element platform basis and would instead
have to serve customers through total service resale agreements with the
incumbent local exchange companies, through network elements purchased from the
Regional Bell Operating Companies at "just and reasonable" rates under Section
271 of the Act or through our own facilities or the switching facilities of
other non-incumbent carriers. Our transition from providing telecommunications
services on an unbundled network element platform basis could delay our service
roll-out in some markets, increase our costs and negatively impact our business,
prospects, operating margins, results of operations, cash flows and financial
condition. See Item 1, "Regulation."
 
 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. During the
second quarter 2003, we were made aware that AOL agreed to settle a class action
case for approximately $10 million; the claims in the case allegedly relate to
marketing activities conducted pursuant to a former telecommunications marketing
agreement, between us and AOL. At the time of the settlement agreement, AOL
asserted that we are required to indemnify AOL in this matter under the terms of
the marketing agreement and advised that it will seek such indemnification from
us. We believe that we do not have an obligation to indemnify AOL in this matter
and that any claim by AOL for this indemnification would be without merit. We
have received no further information regarding this matter and it is our
intention, if AOL initiates a claim for indemnification under the marketing
agreement, to defend against the claim vigorously. We believe that the ultimate
outcome of the foregoing actions will not result in liability that would have a
material adverse effect on our financial condition or results of
operations.
 
 While we
believe that we have access to new capital in the public or private markets to
fund our ongoing cash requirements, 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 above, or that we will not be required to consider capital
expenditures in excess of those currently contemplated, as discussed
above.
 
 Our
business involves risks and uncertainties and our actual results could differ
materially from our expectations. In addition to those factors discussed
elsewhere in this Form 10-K, important factors that could impact our
business include, among others:
 
 12
 ·  changes
in government policy, regulation and enforcement and/or adverse judicial or
administrative interpretations and rulings relating to regulations and
enforcement, including, but not limited to, those that affect the continued
availability to us, on acceptable economic terms, of the unbundled network
element platform of the local exchange carriers network, on which our business,
as now conducted, is substantially dependent;
 ·  our
ability successfully to implement our business strategy, including the
development and deployment of our own local services networking platform and the
migration of our customer base to the new platform, and our ability to finance
the costs of such implementation;
 ·  the
success of such business strategy if and when implemented;
 ·  increased
price competition for long distance and local services;
 ·  our
ability to continue to manage the nonpayment of amounts due us from our
customers from bundled and long distance services;
 ·  attrition
in the number of our customers;
 ·  our
ability to continue to manage our operations, including attracting and retaining
qualified personnel;
 ·  our
ability to continue to expand our active offering of local bundled services to a
greater number of states;
 ·  our
ability to continue to manage our collection management systems and credit
controls for customers;
 ·  interruptions
in our network and information systems; and
 ·  our
ability to continue to provide adequate customer service.
 
 
 **CRITICAL
ACCOUNTING POLICIES**
 
 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.
 
 **Allowance
for Doubtful 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 the strategy
      for our overall business
 ·
    Significant
      negative industry or economic trends
 ·
    Significant
      decline in our stock price for a sustained period and market
      capitalization relative to net book value
 
 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.
 
 13
 **Goodwill**
 
 Goodwill
represents the cost in excess of 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. Prior to January 1,
2002, goodwill and intangibles were amortized on a straight-line basis over
periods ranging from 5 years to 15 years. 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. Prior to January 1, 2002,
goodwill was tested for impairment in a manner consistent with long-lived assets
and intangible assets with a definite life.
 
 **Income
Taxes**
 
 Income
taxes are accounted for under the asset and liability method. During 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**
 
 Effective
January 1, 2002, we adopted Emerging Issues Task Force (EITF) 01-09, "Accounting
for Consideration Given by a Vendor to a Customer or a Reseller of the Vendor's
Products." This issue presumes that consideration from a vendor to a customer or
reseller of the vendor's products is a reduction of the selling prices of the
vendor's products and, therefore, should be characterized as a reduction of
revenue when recognized in the vendor's statement of operations and could lead
to negative revenue under certain circumstances. Revenue reduction is required
unless the consideration relates to a separate, identifiable benefit and the
benefit's fair value can be established. The adoption of this issue resulted in
a reclassification from sales and marketing expenses of $7.3 million to a
reduction of net sales for the year ended December 31, 2001 attributable to
direct marketing promotion check campaigns. The adoption of EITF 01-09 did not
have a material effect on our consolidated financial statements for the years
ended December 31, 2003 and 2002, as we did not have any direct marketing
promotion check campaigns during this period.
 
 In May
2002, the Financial Accounting Standards Board issued Statement of Financial
Accounting Standards No. 145, “Rescission of FASB Statements No. 4, 44, and 64,
Amendment of FASB Statements No. 13, and Technical Corrections as of April
2002.” SFAS 145 eliminates the requirement to report gains and losses from
extinguishment of debt as extraordinary items. Gains and losses from
extinguishment of debt will now be classified as extraordinary items only if
they meet the criteria of APB Opinion No. 30. We adopted SFAS 145 effective
January 1, 2003. The adoption of SFAS 145 resulted in a reclassification from
extraordinary gains (losses) from the extinguishment of debt of $29.3 million
and $20.7 million, respectively, to other income (expense) for the years ended
December 31, 2002 and 2001.
  14
 ****
 **ITEM
8.**  **FINANCIAL
STATEMENTS AND SUPPLEMENTARY DATA**
 
 **TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**
 **INDEX
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **FORM
      10-K/A**
      **PAGE**Report
      of Independent Registered Public Accounting Firm
    
    16Consolidated
      statements of operations for the years ended December 31, 2003 (restated),
      2002 and 2001
    
    17Consolidated
      balance sheets as of December 31, 2003 (restated) and 2002
    
    18Consolidated
      statements of cash flows for the years ended December 31, 2003 (restated),
      2002 and 2001
    
    19Consolidated
      statements of stockholders' equity (deficit) for the years ended December
      31, 2003 (restated), 2002 and 2001
    
    20Notes
      to consolidated financial statements
    
    21
 
  15
  
  **Report
of Independent Registered Public Accounting Firm**
 
 To the
Board of Directors and
 Shareholders
of Talk America Holdings, Inc.:
 
 In our
opinion, the consolidated financial statements listed in the index
appearing under Item 15(a) (1) present fairly, in all material respects, the
financial position of Talk America Holdings, Inc. and its subsidiaries at
December 31, 2003  and 2002,
and the results of their operations and their cash flows for each of the three
years in the period ended
December 31, 2003 **** 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) presents 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.
 
 As
discussed in Note 1 to the consolidated financial statements, the Company
adopted Statement of Financial Accounting Standards No. 145, “Rescission of FASB
Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13 and Technical
Corrections as of April 2002”, effective January 1, 2003 and Statement of
Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets”,
effective January 1, 2002.
 
 As
discussed in Note 16 to the consolidated financial statements, the December 31,
2003 consolidated financial statements have been restated.
 
 **PricewaterhouseCoopers
LLP**
 Philadelphia,
Pennsylvania
 February
3, 2004, except for
 Note 14,
as to which date is
 February
27, 2004, and Note
 16, as to
which date is
 March 25,
2005
 
 16
 
 **TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**
 **CONSOLIDATED
STATEMENTS OF OPERATIONS**
 **(In
thousands, except for per share data)**
 
 ****
    
    **Year
      Ended December 31,******
    ****
    ****
    **2003**
      **(Restated)**
    ****
    ****
    ****
      **2002**
    ****
    ****
    ****
      **2001**Revenue
    
    $
    383,693
    
    $
    317,507
    
    $
    488,158Costs
      and expenses:Network
      and line costs
    
    
    181,682
    
    
    155,567
    
    
    235,153General
      and administrative expenses
    
    
    57,503
    
    
    53,510
    
    
    82,202Provision
      for doubtful accounts
    
    
    11,599
    
    
    9,365
    
    
    92,778Sales
      and marketing expenses
    
    
    48,277
    
    
    27,148
    
    
    73,973Depreciation
      and amortization
    
    
    18,344
    
    
    17,318
    
    
    34,390Impairment
      and restructuring charges
    
    
    --
    
    
    --
    
    
    170,571Total
      costs and expenses
    
    
    317,405
    
    
    262,908
    
    
    689,067Operating
      income (loss)
    
    
    66,288
    
    
    54,599
    
    
    (200,909
    )Other
      income (expense):Interest
      income
    
    
    388
    
    
    802
    
    
    1,220Interest
      expense
    
    
    (7,353
    )
    
    (9,087
    )
    
    (6,091
    )Other
      income (expense), net
    
    
    2,470
    
    
    28,448
    
    
    17,950Income
      (loss) before provision for income taxes
    
    
    61,793
    
    
    74,762
    
    
    (187,830
    )Provision
      (benefit) for income taxes
    
    
    (20,024
    )
    
    (22,300
    )
    
    --Income
      (loss) before cumulative effect of an accounting change
    
    
    81,817
    
    
    97,062
    
    
    (187,830
    )Cumulative
      effect of an accounting change
    
    
    --
    
    
    --
    
    
    (36,837
    )Net
      income (loss)
    
    $
    81,817
    
    $
    97,062
    
    $
    (224,667
    )Income
      (loss) per share - Basic:Income
      (loss) before cumulative effect of an accounting change per share
    
    $
    3.10
    
    $
    3.56
    
    $
    (7.11
    )Cumulative
      effect of an accounting change per share
    
    
    --
    
    
    --
    
    
    (1.40
    )Net
      income (loss) per share
    
    $
    3.10
    
    $
    3.56
    
    $
    (8.51
    )Weighted
      average common shares outstanding
    
    
    26,376
    
    
    27,253
    
    
    26,414Income
      (loss) per share - Diluted:Income
      (loss) before cumulative effect of an accounting change per share
    
    $
    2.94
    
    $
    3.15
    
    $
    (7.11
    )Cumulative
      effect of an accounting change per share
    
    
    --
    
    
    --
    
    
    (1.40
    )Net
      income (loss) per share
    
    $
    2.94
    
    $
    3.15
    
    $
    (8.51
    )Weighted
      average common and common equivalentshares
      outstanding
    
    
    27,806
    
    
    30,798
    
    
    26,414
 
 See
accompanying notes to consolidated financial statements.
  17
  **TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**
 **CONSOLIDATED
BALANCE SHEETS**
 **(In
thousands, except for share and per share data)**
 
 ****
    
    
    **December
      31,**
      **2003**
      **(Restated)**
    
    
    **December
      31,**
      **2002**
      ******Assets**Current
      assets:Cash
      and cash equivalents
    
    $
    35,242
    
    $
    33,588Accounts receivable, trade (net of allowance for uncollectible accounts of
      $9,414 and $7,821 at December 31, 2003 and 2002, respectively)
    
    
    40,321
    
    
    27,843Deferred
      income taxes
    
    
    24,605
    
    
    17,500Prepaid
      expenses and other current assets
    
    
    5,427
    
    
    3,894Total
      current assets
    
    
    105,595
    
    
    82,825Property
      and equipment, net
    
    
    68,069
    
    
    66,915Goodwill
    
    
    13,013
    
    
    19,503Intangibles,
      net
    
    
    4,666
    
    
    7,379Deferred
      income taxes
    
    
    48,288
    
    
    4,800Other
      assets
    
    
    7,547
    
    
    7,653$
    247,178
    
    $
    189,075**Liabilities
      and Stockholders’ Equity**Current
      liabilities:Accounts
      payable
    
    $
    35,296
    
    $
    32,152Sales,
      use and excise taxes
    
    
    13,521
    
    
    11,439Deferred
      revenueLegal settlements
    
    
    10,873
    
    
    6,480Current
      portion of long-term debt
    
    
    16,806
    
    
    61Accrued
      compensation
    
    
    9,888
    
    
    5,609Other
      current liabilities
    
    
    6,851
    
    
    9,013Total
      current liabilities
    
    
    93,235
    
    
    64,754Long-term
      debt
    
    
    31,791
    
    
    100,855Deferred
      income taxes
    
    
    19,009
    
    
    --Commitments
      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; 26,662,952 and
      27,469,593 shares issued and outstanding at December 31, 2003 and 2002,
      respectively
    
    
    280
    
    
    275Additional
      paid-in capital
    
    
    354,847
    
    
    351,992Accumulated
      deficit
    
    
    (246,984
    )
    
    (328,801
    )Treasury
      stock - $.01 par value, 1,315,789 shares at December 31,
    2003
    
    
    (5,000
    )
    
    --Total
      stockholders' equity
    
    
    103,143
    
    
    23,466$
    247,178
    
    $
    189,075
 
 See
accompanying notes to consolidated financial statements.
 18
 
 **TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**
 **CONSOLIDATED
STATEMENTS OF CASH FLOWS**
 **(In
thousands)**
 
 **Year
      Ended December 31,******
    
    
    **2003**
      **(Restated)**
    
    
    **2002**
    
    
    **2001**Cash
      flows from operating activities:Net
      income (loss)
    
    $
    81,817
    
    $
    97,062
    
    $
    (224,667
    )Adjustments
      to reconcile net income (loss) to net cash provided by (used in) operating
      activities:Provision
      for doubtful accounts
    
    
    11,599
    
    
    9,365
    
    
    92,778Depreciation
      and amortization
    
    
    18,344
    
    
    17,318
    
    
    34,390Non-cash
      compensation
    
    
    --
    
    
    194
    
    
    --Non-cash
      interest and amortization of accrued interest liabilities
    
    
    (260
    )
    
    832
    
    
    --Provision
      for uncollectible note
    
    
    --
    
    
    --
    
    
    77Loss
      on sale and retirement of assets
    
    
    23
    
    
    205
    
    
    116Impairment
      of goodwill and intangibles
    
    
    --
    
    
    --
    
    
    168,684Cumulative
      effect of accounting change of contingent redemptions
    
    
    --
    
    
    --
    
    
    36,837Gain
      from restructuring of convertible debt
    
    
    --
    
    
    (28,909
    )
    
    --Gain
      from restructuring of contingent redemptions
    
    
    --
    
    
    --
    
    
    (16,867
    )Gain
      from extinguishment of debt
    
    
    (2,475
    )
    
    (431
    )
    
    (3,781
    )Unrealized
      loss on increase in fair value of contingent redemptions
    
    
    --
    
    
    --
    
    
    2,372Deferred
      income taxes
    
    
    (23,409
    )
    
    (22,300
    )
    
    --Gain
      on legal settlement
    
    
    --
    
    
    (1,681
    )
    
    --Changes
      in assets and liabilities:Accounts
      receivable, trade
    
    
    (24,078
    )
    
    (10,560
    )
    
    (65,788
    )Prepaid
      expenses and other current assets
    
    
    (1,605
    )
    
    (1,902
    )
    
    (527
    )Other
      assets
    
    
    1,475
    
    
    2,211
    
    
    1,142Accounts
      payable
    
    
    3,144
    
    
    (11,462
    )
    
    (27,181
    )Deferred
      revenue
    
    
    4,393
    
    
    (3,713
    )
    
    (9,004
    )Sales,
      use and excise taxes
    
    
    2,082
    
    
    3,101
    
    
    404Other
      current liabilities and accrued compensation
    
    
    2,116
    
    
    2,568
    
    
    5,418Net
      cash provided by (used in) operating activities
    
    
    73,166
    
    
    51,898
    
    
    (5,597
    )Cash
      flows from investing activities:Acquisition
      of intangibles
    
    
    (133
    )
    
    (50
    )
    
    (154
    )Capital
      expenditures
    
    
    (11,842
    )
    
    (4,781
    )
    
    (2,949
    )Capitalized
      software development costs
    
    
    (2,739
    )
    
    (2,501
    )
    
    (1,406
    )Net
      cash used in investing activities
    
    
    (14,714
    )
    
    (7,332
    )
    
    (4,509
    )Cash
      flows from financing activities:Payments
      of borrowings
    
    
    (52,914
    )
    
    (17,983
    )
    
    (2,624
    )Payments
      of capital lease obligations
    
    
    (61
    )
    
    (1,036
    )
    
    (1,022
    )Acquisition
      of convertible debt and senior notes
    
    
    --
    
    
    (14,691
    )
    
    (1,227
    )Proceeds
      from exercise of options and warrants
    
    
    1,177
    
    
    632
    
    
    --Payments
      in connection with restructuring contingent redemptions
    
    
    --
    
    
    --
    
    
    (3,525
    )Purchase
      of treasury stock
    
    
    (5,000
    )
    
    --
    
    
    --Net
      cash used in financing activities
    
    
    (56,798
    )
    
    (33,078
    )
    
    (8,398
    )Net
      increase (decrease) in cash and cash equivalents
    
    
    1,654
    
    
    11,488
    
    
    (18,504
    )Cash
      and cash equivalents, beginning of year
    
    
    33,588
    
    
    22,100
    
    
    40,604Cash
      and cash equivalents, end of year
    
    $
    35,242
    
    $
    33,588
    
    $
    22,100
 
 See
accompanying notes to consolidated financial statements.
  19
 **TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**
 **CONSOLIDATED
STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)**
 **(In
thousands)**
   
 **Common
      Stock**
    
    ****
    
    ****
    
    **Treasury
      Stock**
    
    ********
    
    
    **Shares**
    
    
    **Amount**
    
    
    **Additional
      Paid-In Capital**
    
    
    **Accumulated
      Deficit**
    
    
    **Shares**
    
    
    **Amount**
    
    
    **Total**Balance,
      December 31,
      2000
    
    
    26,148
    
    $
    261
    
    $
    287,486
    
    $
    (201,196)
    
    
    (91)
    
    $
    (3,851)
    
    $
    82,700Net
      (loss)
    
    
    --
    
    
    --
    
    
    --
    
    
    (224,667)
    
    
    --
    
    
    --
    
    
    (224,667)Issuance
      of common stock for compensation
    
    
    --
    
    
    --
    
    
    (2,451)
    
    
    --
    
    
    68
    
    
    2,858
    
    
    407Cumulative
      effect of an accounting change
    
    
    --
    
    
    --
    
    
    65,617
    
    
    --
    
    
    --
    
    
    --
    
    
    65,617Issuance
      of common stock in connection with AOL restructuring
    
    
    1,003
    
    
    11
    
    
    440
    
    
    --
    
    
    24
    
    
    993
    
    
    1,444Acquisition
      of treasury stock
    
    
    --
    
    
    --
    
    
    --
    
    
    --
    
    
    (1)
    
    
    --
    
    
    --Issuance
      of warrants for services
    
    
    --
    
    
    --
    
    
    77
    
    
    --
    
    
    --
    
    
    --
    
    
    77Balance,
      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, restated
    
    
    --
    
    
    --
    
    
    --
    
    
    81,817
    
    
    --
    
    
    --
    
    
    81,817Acquisition
      of treasury stock
    
    
    --
    
    
    --
    
    
    --
    
    
    --
    
    
    1,316
    
    
    (5,000)
    
    
    (5,000)Exercise
      of common stock options
    
    
    509
    
    
    5
    
    
    1,172
    
    
    --
    
    
    --
    
    
    --
    
    
    1,177Income
      tax benefit related to exercise of common stock options
    
    
    --
    
    
    --
    
    
    1,683
    
    
    --
    
    
    --
    
    
    --
    
    
    1,683Balance,
      December 31, 2003 (restated)
    
    
    27,979
    
    $
    280
    
    $
    354,847
    
    $
    (246,984)
    
    
    1,316
    
    $
    (5,000)
    
    $
    103,143
 See
accompanying notes to consolidated financial statements.
 20
 **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 to residential and small business customers in the
United States. We operate our own nationwide long distance network and deliver
local services 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 assets and 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 2002 and 2001 have been reclassified to conform to the current year
presentation.
 
 **(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 of the unbundled network
      element platform of the local exchange carriers network and the costs
      associated therewith
 ·
    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
 ·
    Adverse
      determinations in certain litigation
matters
 
 Negative
developments in these areas could have a material effect on our business,
financial condition and results of operations.
 
 **(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.
 21
 **(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.
 
 Revenue
for 2002 and 2001 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 and $7.4 million in 2001.
 
 **(h)**  **Allowance
for Doubtful 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.
 
 **(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 3 to 39 years. Leasehold improvements are depreciated over the life
of the related lease or asset, if shorter. Amortization of assets acquired under
capital leases is included in depreciation and amortization expense.
 
 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.
 
 **(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, 2003 and 2002 were $6.6 million and $3.9 million, respectively, net
of accumulated amortization of $2.1 million and $0.6 million at December 31,
2003 and 2002. Amortization expense was $1.5 million and $0.6 million,
respectively, for the years ended December 31, 2003 and 2002.
 
 **(l)**  **Goodwill and
Intangibles**
 
 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. 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 if an event occurs or circumstances
change that would indicate the carrying amount may be impaired.
  22
 In order
to complete the transitional assessment of goodwill as required by SFAS 142, we
determined the fair value of the reporting unit associated with the goodwill and
compared it to the reporting unit’s carrying amount, including goodwill. We
determined that we have one reporting unit. The fair value of the reporting unit
was determined primarily using a discounted cash flow approach and quoted market
price of our stock. The amount of goodwill reflected in the balance sheet as of
December 31, 2002 and 2001 was $13.0 and $19.5 million, respectively. We
completed the transitional assessment of goodwill and determined that the fair
value of the reporting unit exceeds its carrying amount, thus goodwill was not
considered impaired at the date of adoption. We tested for impairment during the
second quarter 2003 and determined goodwill is not impaired.
 
 The
following unaudited pro forma summary presents the adoption of SFAS 142 as of
the beginning of the periods presented to eliminate the amortization expense
recognized in those periods related to goodwill that are no longer required to
be amortized. The pro forma amounts for the year ended December 31, 2001 does
not include any write-downs of goodwill that could have resulted had we adopted
SFAS 142 as of the beginning of that year and performed the required impairment
test under this standard.
 
 (In
      thousands, except for per share data)
    
    **Year
      Ended December 31,****2003**
      **(Restated)**
    
    ****
      **2002**
    
    ****
      **2001**Net
      income (loss) as reported
    
    $
    81,817
    
    $
    97,062
    
    $
    (224,667
    )Add
      back: Goodwill amortization
    
    
    --
    
    
    --
    
    
    17,271Adjusted net income (loss)
    
    $
    81,817
    
    $
    97,062
    
    $
    (207,396
    )Basic
      income (loss) per share:Net income (loss) as reported per share
    
    $
    3.10
    
    $
    3.56
    
    $
    (8.51
    )Goodwill amortization per share
    
    
    --
    
    
    --
    
    
    0.66Adjusted
      net income (loss) per share
    
    $
    3.10
    
    $
    3.56
    
    $
    (7.85
    )Diluted
      income (loss) per share:Net
      income (loss) as reported per share
    
    $
    2.94
    
    $
    3.15
    
    $
    (8.51
    )Goodwill
      amortization per share
    
    
    --
    
    
    --
    
    
    0.66Adjusted
      net income (loss) per share
    
    $
    2.94
    
    $
    3.15
    
    $
    (7.85
    )
 
 Intangible
assets consisted 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 $2.8 million,
$2.8 million, and $3.2 million for the years ended December 31, 2003, 2002 and
2001, respectively. Our balance of intangible assets with a definite life was
$4.4 million at December 31, 2003, net of accumulated amortization of $9.0
million. Amortization expense on intangible assets with a definite life for the
next 5 years as of December 31, is as follows: 2004 - $2.8 million, and 2005 -
$1.7 million.
 
 **(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 a single 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
intangibles 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.
 
 **(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.
 
  23
  **(o)**  **Net
Income (Loss) Per Share**
 
 Basic
earnings per share is computed by dividing income (loss) available to common
shareholders by the weighted average number of common shares outstanding for 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. The market value of our public debt
securities was approximately 100% and 75% of face amount at December 31, 2003
and 2002, respectively.
 
 **(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 loss as if the fair value based method of accounting had been
applied:
 
 
 (In
      thousands)
    
    **Year
      Ended December 31,******
    
    
    ****
      **2003**
      **(Restated)**
    ****
    ****
    **2002**
    ****
    ****
    **2001**Net
      income (loss) as reported
    
    $
    81,817
    
    $
    97,062
    
    $
    (224,667
    )Add:
      Stock-based employee compensation expense included in reported net income
      (loss)
    
    
    --
    
    
    110
    
    
    --Deduct:
      Total stock-based employee compensation expense determined under fair
      value based method for all options
    
    
    (1,348
    )
    
    (5,208
    )
    
    (1,380
    )Pro
      forma net income (loss)
    
    $
    80,469
    
    $
    91,964
    
    $
    (226,047
    )
 
 
 **Year
      Ended December 31,******
    
    
    **2003**
      **(Restated)**
    
    
    **2002**
    
    
    **2001****Basic
      earnings (loss) per share:**As
      reported
    
    $
    3.10
    
    $
    3.56
    
    $
    (8.51
    )Pro
      forma
    
    $
    3.05
    
    $
    3.38
    
    $
    (8.56
    )**Diluted
      earnings (loss) per share:**As
      reported
    
    $
    2.94
    
    $
    3.15
    
    $
    (8.51
    )Pro
      forma
    
    $
    2.94
    
    $
    2.96
    
    $
    (8.56
    )
 
 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.
 
 24
 **(r)**  **Comprehensive
Income**
 
 We have
no items of comprehensive income or expense. Accordingly, our comprehensive
income (loss) and net income (loss) are equal for all periods presented.
 
 **(s)**  **New
Accounting Pronouncements**
 
 Effective
January 1, 2002, we adopted Emerging Issues Task Force (EITF) 01-09, "Accounting
for Consideration Given by a Vendor to a Customer or a Reseller of the Vendor's
Products." This issue presumes that consideration from a vendor to a customer or
reseller of the vendor's products is a reduction of the selling prices of the
vendor's products and, therefore, should be characterized as a reduction of
revenue when recognized in the vendor's statement of operations and could lead
to negative revenue under certain circumstances. Revenue reduction is required
unless the consideration relates to a separate, identifiable benefit and the
benefit's fair value can be established. The adoption of this issue resulted in
a reclassification from sales and marketing expenses of $7.3 million to a
reduction of net sales for the year ended December 31, 2001 attributable to
direct marketing promotion check campaigns. The adoption of EITF 01-09 did not
have a material effect on our consolidated financial statements for the years
ended December 31, 2003 and 2002, as we did not have any direct marketing
promotion check campaigns during this period.
 
 In May
2002, the Financial Accounting Standards Board issued Statement of Financial
Accounting Standards No. 145, “Rescission of FASB Statements No. 4, 44, and 64,
Amendment of FASB Statements No. 13, and Technical Corrections as of April
2002.” SFAS 145 eliminates the requirement to report gains and losses from
extinguishment of debt as extraordinary items. Gains and losses from
extinguishment of debt will now be classified as extraordinary items only if
they meet the criteria of APB Opinion No. 30. We have adopted SFAS 145 effective
January 1, 2003. The adoption of SFAS 145 resulted in a reclassification from
extraordinary gains (losses) from the extinguishment of debt of $29.3 million
and $20.7 million, respectively, to other income (expense) for the years ended
December 31, 2002 and 2001.
 
 **(t)**  **Advertising**
 
 We
expense advertising costs as they are incurred. Advertising expenses totaled
approximately $6.8 million, $1.5 million and $0.2 million for the years ended
December 31, 2003, 2002 and 2001, respectively.
 
 **NOTE
2. IMPAIRMENT AND RESTRUCTURING CHARGES**
 
 In 2001,
we recorded an impairment charge of $168.7 million primarily related to the
write-down of goodwill associated with the acquisition of Access One
Communications Corp. in August 2000. SFAS 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed Of," required the
evaluation of impairment of long-lived assets and identifiable intangibles
whenever events or changes in circumstances indicate that the carrying amount of
an asset may not be recoverable. Management determined that goodwill should be
evaluated for impairment in accordance with the provisions of SFAS 121 due to
the increased bad debt rate and increased customer turnover, as well as the
restructuring of our financial obligations with America Online, Inc. and the
concurrent termination of our marketing relationship with AOL that occurred in
the year ended December 30, 2001. The write-down of goodwill was based on an
analysis of projected discounted cash flows using a discount rate of 18%, which
results determined that the fair value of the goodwill was substantially less
than the carrying value.
 
 In
September 2001, we approved a plan to close one of our call center operations
and recorded a charge of $2.5 million to reflect the elimination of
approximately 225 positions amounting to $1.0 million and lease exit costs
amounting to $1.5 million in connection with the call center closure. Actual
restructuring costs were $1.9 million, comprised of $1.2 million of employee
severance costs and $0.7 million of lease termination and other call center
closure costs.
 
 25
 
 **NOTE
3.   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, 2003, 2002 and 2001 was $1.9
million, $2.4 million, and $2.5 million, respectively. As of December 31, 2003,
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**2004
    
    $
    2,960
    
    $
    1,191
    
    $
    4,1512005
    
    
    2,495
    
    
    1,164
    
    
    3,6592006
    
    
    1,811
    
    
    1,164
    
    
    2,9752007
    
    
    363
    
    
    --
    
    
    3632008
    
    
    138
    
    
    --
    
    
    138Thereafter
    
    
    481
    
    
    --
    
    
    481Total
      minimum lease payments
    
    $
    8,248
    
    $
    3,519
    
    $
    11,767Less:
      interest
    
    
    
    
    
    100Present value of minimum lease payments
    
    
    
    
    $
    3,419Less:
      current installments
    
    
    
    
    
    1,136Long-term
      obligations
    
    
    
    
    $
    2,283
 
 **(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 the parties agreed would be paid in two installments - $3.7
million paid in November 2001 and the remaining $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. During the
second quarter of 2003, we were made aware that AOL agreed to settle a class
action case for approximately $10 million; the claims in the case allegedly
relate to marketing activities conducted pursuant to the former
telecommunications marketing agreement, between us and AOL. At the time of the
settlement agreement, AOL asserted that we are required to indemnify AOL in this
matter under the terms of the marketing agreement and advised that it will seek
such indemnification from us. We believe that we do not have an obligation to
indemnify AOL in this matter and that any claim by AOL for this indemnification
would be without merit. We have received no further information regarding this
matter and it is our intention, if AOL initiates a claim for indemnification
under the marketing agreement, to defend against the claim vigorously. 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.
 
 **(c)**  **Network
Commitments**
 
 We are
party to various network service agreements, which contain certain minimum usage
commitments. In December 2003, we entered into a new 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: 2004 - $25 million, 2005 - $32 million, 2006 - $32
million, 2007 - $32 million, and obligates us to pay 65 percent of the revenue
shortfall, if any. A separate contract with a different vendor establishes
pricing and provides for annual minimum payments for 2004 of $3.0 million. While
we believe we will meet these annual minimum revenue commitments and that we
will not have to pay any shortfalls, there can be no assurances of this, and, if
we are required to pay any of the shortfall amounts under one of these
agreements, our costs of purchasing the services under the agreement will
correspondingly increase.
 
 
 26
 **NOTE
4. PROPERTY AND EQUIPMENT**
 
 The
following is a summary of property and equipment, at cost, less accumulated
depreciation (in thousands):
 
 **December
      31,******
    
    
    **Lives**
    
    
    **2003**
    
    
    **2002**Land
    
    
    
    
    $
    330
    
    $
    330Buildings
      and building improvements
    
    
    39
      years
    
    
    6,987
    
    
    6,782Leasehold
      improvements
    
    
    3-10
      years
    
    
    1,757
    
    
    397Switching
      equipment
    
    
    10-15
      years
    
    
    64,161
    
    
    59,289Software
    
    
    3
      years
    
    
    7,877
    
    
    6,366Equipment
      and other
    
    
    3-10
      years
    
    
    50,830
    
    
    44,770131,942
    
    
    117,934Less:
      Accumulated depreciation
    
    
    
    
    
    (63,873
    )
    
    (51,019
    )$
    68,069
    
    $
    66,915
 
 The
following is a summary of property and equipment, at cost, recorded under
capital leases (in thousands):
 
 **December
      31,****Lives**
    
    **2003**
    
    **2002**Equipment
      and other
    
    
    3
      years
    
    $
    3,627
    
    $
    235Less:
      Accumulated depreciation
    
    
    
    
    
    (196
    )
    
    (117
    )$
    3,431
    
    $
    118
 
 For the
years ended December 31, 2003, 2002 and 2001, depreciation expense amounted to
$14.1 million, $13.3 million and $13.6 million, respectively.
 
 **NOTE
5. DEBT AND CAPITAL LEASE OBLIGATIONS**
 
 The
following is a summary of our debt and capital lease obligations (in
thousands):
 
 **December
      31,****2003**
    
    
    **2002**12%
      Senior Subordinated Notes Due 2007
    
    $
    40,730
    
    $
    65,9708%
      Secured Convertible Notes Due 2006
    
    
    --
    
    
    30,1508%
      Convertible Senior Subordinated Notes Due 2007 (1)
    
    
    3,778
    
    
    4,0385%
      Convertible Subordinated Notes Due 2004
    
    
    670
    
    
    670Capital
      lease obligations
    
    
    3,419
    
    
    88Total
      long-term debt and capital lease obligations
    
    $
    48,597
    
    $
    100,916Less:
      current maturities (2)
    
    
    16,806
    
    
    61Total long-term debt and capital lease obligations, excluding current
      maturities
    
    $
    31,791
    
    $
    100,855
 
 (1)
Includes future accrued interest or $1.0 million and $1.2 million in 2003 and
2002, respectively.
 
 (2)
Reflects our November 5, 2003 notice and commitment to redeem $15 million
principal amount of these 12% Senior Subordinated Notes on January 5, 2004 and
resulting change in the maturity of such principal amount to the noticed
redemption date.
 
 27
 **(a)**  **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") that mature
on December 15, 2004 for $17.4 million principal amount of the 12% Senior
Subordinated Notes.
 
 The 12%
Senior Subordinated Notes accrue interest at a rate of 12% per year on the
principal amount, payable semiannually on February 15 and August 15, beginning
on August 15, 2002. Interest is payable in cash, except that we may, at our
option, pay up to one-third of the interest due on any interest payment date
through and including the August 15, 2004 interest payment date in additional
12% Senior Subordinated Notes. The 8% Convertible Senior Subordinated Notes
accrue interest at a rate of 8% per year on the principal amount, also payable
semiannually on February 15 and August 15, and are convertible, at the option of
the holder, into common stock at $15.00 per share. The 12% Senior Subordinated
Notes and 8% Convertible Senior Subordinated Notes are redeemable at any time at
our option at par value plus accrued interest to the redemption date.
 
 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.
 
 **(b)**  **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 mature on December 15, 2004. Interest on
these notes is due and payable semiannually on June 15 and December 15. The
notes are convertible, at the option of the holder, at a conversion price of
$76.14 per share. The 5% Convertible Subordinated Notes are redeemable, in whole
or in part at our option, at 100.71% of par.
 
 **(c)**  **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. The adoption of
SFAS 145 resulted in a reclassification of this gain 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. **** As a
further consequence, we began recording the interest expense associated with the
8% Secured Convertible Notes in our consolidated statement of
operations.
 
 28
 **(d)**  **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. The adoption of SFAS 145 resulted in a
reclassification of this charge 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.
 
 **(e)**  **Capital
Leases**
 
 During
2003, we entered into a non-cancelable capital lease agreement for upgrades to
our customer data storage equipment. Approximately $3.4 million was outstanding
under this agreement at December 31, 2003. Total assets under this lease
agreement are approximately $3.4 million as of December 31, 2003. The lease is
repayable in 36 monthly installments, which includes interest based on an annual
percentage rate of approximately 2%.
 
 **(f)**  **Minimum
Annual Payments**
 
 As of
December 31, 2003, 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,**2004
    
    $
      16,8062005
    
    1,1312006
    
    1,1522007
    
    29,5082008
    
    --$48,597
 
 
 **NOTE
6.   RELATED PARTY TRANSACTION**
 
 We had a
note receivable with one of our officers with a balance of $1.0 million as of
December 31, 2002 for relocation and construction of a new residence in Florida.
The note receivable bore interest at 6.25% and the principal balance together
with unpaid accrued interest was payable to us in November 2004. The note was
collateralized by the new residence. In 2003, the note was paid in
full.
 
 **NOTE
7.   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.
 
 29
 **(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.
 
 **NOTE
8.   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, 2003: 405,000; 14,232; 541;
and 15,556 shares of common stock were available under the 2003 Plan, 2001 Plan,
2000 Plan, and 1998 Plan, respectively, for possible future issuances. The
exercise price of the options is 100% of the market value of the common stock on
the grant date.
 
 Stock
options granted in 2003 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 at grant date. The vast majority of options granted in 2003
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, 2000
    
    5,023,106
    
    $2.64-$51.75
    
    $
      25.80Granted
    
    365,733
    
    $0.99-$5.94
    
    $
      2.58Exercised
    
    --
    
    --
    
    --Cancelled
    
    (2,912,700)
    
    $4.02-$51.75
    
    $34.02Outstanding,
      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
    
    $8.35
 
  
 30
 The
following table summarizes options exercisable at December 31, 2003, 2002 and
2001:
 
 **Option
      Shares**
    
    **Exercise
      Price Range**
      **Per
      Share**
    
    **Weighted
      Average Exercise Price**2001
    1,285,508
    
    $2.64-$47.64
    
    $16.742002
    2,942,999
    
    $0.99-$48.54
    
    $6.842003
    2,939,893
    
    $0.99-$47.63
    
    $7.99
 
 The
following table summarizes the status of stock options outstanding at December
31, 2003:
 
 **Range
      of Exercise Prices**
    
    **Number
      Outstanding at December 31, 2003**
    
    **Weighted
      Average Exercise Price**
    
    **Weighted
      Average Remaining Contractual Life (years)**
    
    **Number
      Exercisable at December 31, 2003**
    
    **Weighted
      Average Exercise Price**$0.99
      to $10.31
    
    2,701,243
    
    $3.12
    
    6.5
    
    1,874,437
    
    $2.20$10.32
      to $14.35
    
    2,355,699
    
    $11.57
    
    9.0
    
    685,291
    
    $14.11$14.36
      to $21.00
    
    150,058
    
    $19.70
    
    5.2
    
    150,058
    
    $19.70$21.01
      to $30.00
    
    134,998
    
    $28.16
    
    2.8
    
    134,998
    
    $28.16$30.01
      to $47.63
    
    95,109
    
    $30.94
    
    5.4
    
    95,109
    
    $30.94
 
 The
weighted average estimated fair values of the stock options granted during the
years ended December 31 2003, 2002 and 2001 based on the Black-Scholes option
pricing model were $7.79, $2.34, and $1.71, 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**
    
    **2003**
    
    **2002**
    
    **2001**Expected
      Term
    
    5
      years
    
    5
      years
    
    5
      yearsExpected
      Volatility
    
    98.63%
    
    98.13%
    
    78.95%Expected
      Dividend Yield
    
    --%
    
    --%
    
    --%Risk-Free
      Interest Rate
    
    3.15%
    
    4.33%
    
    5.92%
 
 **(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, 2003. 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 exercisable 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 October 20, 2005; 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.
 
 31
  **NOTE
9.   INCOME TAXES**
 
 A
reconciliation of the Federal statutory rate to the (benefit) for income taxes
is as follows:
 
   **Year
      Ended December 31,****2003
      (Restated)**
    ****
    **2002**
    ****
    **2001**Current income tax expense:Federal
    
    $
    1,032
    
    $
    --
    
    $
    --State
    
    
    2,355
    
    
    --
    
    
    --3,387
    
    
    --
    
    
    --Deferred income tax expense (benefit):Federal
    
    
    (17,206
    )
    
    (22,300)
    
    
    --State
    
    
    (6,205
    )
    
    --
    
    
    --(23,411
    )
    
    (22,300)
    
    
    --Total (benefit) for income taxes
    
    $
    (20,024)
    
    $
    (22,300)
    
    $
    --
 
 Deferred tax
assets and liabilities at December 31, 2003 and 2002 are comprised of the
following elements:
 
 **Year
      Ended December 31,******
    
    
    **2003**
      **(Restated)**
    
    
    **2002****Deferred
      Tax Assets**Net
      operating loss carry-forwards
    
    $
    77,908
    
    $
    104,032Amortization
    
    
    --
    
    
    1,558Allowance
      for uncollectible accounts
    
    
    3,809
    
    
    3,250Warrants
      issued for compensation
    
    
    1,051
    
    
    1,070Accruals
      not currently deductible
    
    
    562
    
    
    1,317Net
      capital loss carry-forwards
    
    
    3,119
    
    
    8,875Alternative
      minimum tax credit carryforward
    
    
    1,204
    
    
    --Deferred
      tax assets
    
    
    87,653
    
    
    120,102Less
      valuation allowance
    
    
    (14,760
    )
    
    77,591Net
      deferred tax assets
    
    $
    72,893
    
    $
    42,511
 
 
 **Deferred
      Tax Liabilities**Depreciation
      and amortization
    
    $
    16,881
    
    $
    17,386Deductions
      not currently expensed
    
    
    1,731
    
    
    2,825Revenues
      not currently taxed
    
    
    397
    
    
    --Deferred
      tax liabilities
    
    $
    19,009
    
    $
    20,211
 
 32
 A
reconciliation of the Federal statutory rate to our effective tax rate is as
follows:
 
 **Year
      Ended December 31,****2003**
      **(Restated)**
    
    **2002**
    
    **2001**Federal
      income taxes (benefit) computed at the statutory rate
    
    35.0%
    
    35.0%
    
    (35.0)%Increase
      (decrease) in income taxes resulting from:State
      income taxes less Federal benefit
    
    4.0
    
    0.0
    
    0.0Valuation
      allowance changes affecting the provision for income taxes
    
    (71.4)
    
    (64.8)
    
    35.0Total
      provision (benefit) for income taxes
    
    (32.4)%
    
    (29.8)%
    
    --%
 
 At
December 31, 2003 and 2002, management evaluated the deferred tax asset
valuation allowance and determined that portions of the allowance should be
reversed. The 2003 and 2002 evaluations considered profitability of the
business, the ability to utilize these deferred tax assets against future
profitable amounts and possible restrictions on use due to provisions of the
Internal Revenue Code Section 382. Based on information currently available to
us, the change of ownership percentage subject to Section 382 was approximately
25% for the applicable three-year testing period.
 
 We have
not reversed the deferred tax valuation allowance for a $22.9 million deduction
claimed in the 1996 year, which is currently contested by the Internal Revenue
Service, $8.9 million in capital loss carryforwards that are expected to expire,
and $60.2 million in state net operating loss carryforwards that are expected to
expire before realization.
 
 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.
 
 In 2003,
we had federal net operating loss carryforwards which are scheduled to expire as
follows:
 
 2011
    
    $
    --2012
    
    
    --2018
    
    
    91,9542019
    
    
    43,1612020
      and thereafter
    
    
    55,892$
    191,007
 ****
 ****
 **NOTE
10. 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 with AOL a
restructuring and note agreement pursuant to which we issued to AOL $54.0
million principal amount of our 8% Secured Convertible Notes 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.
 
 33
 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.
 
 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 its 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 do not pay more than 80% of
the face amount and, for every dollar used to repurchase subordinated
indebtedness, we repurchase $0.50 of principal amount of 8% Secured Convertible
Notes from AOL; and (ii) purchase shares of our common stock, provided we
purchase 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 may utilize with respect to both the repurchase of subordinated indebtedness
and of common stock cannot 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 repurchased $30.2 million 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.
 
 34
 **NOTE
11. SUPPLEMENTAL CASH FLOW INFORMATION**
 
 **2003**
    
    
    **2002**
    
    
    **2001**Supplemental
      disclosure of cash flow information:Cash
      paid during the year for interest
    
    $
    9,930
    
    $
    6,252
    
    $
    5,620Cash paid during the year for taxes
    
    
    1,980
    
    
    --
    
    
    --Supplemental
      schedule of non-cash investing and financing activities:Acquisition
      of equipment under capital lease obligations
    
    
    3,392
    
    
    --
    
    
    2,145Interest
      expense paid in additional principal
    
    
    --
    
    
    2,824
    
    
    --Issuance
      of warrants for services
    
    
    --
    
    
    --
    
    
    77Contingent
      redemptions exchanged for convertible debt
    
    
    --
    
    
    --
    
    
    32,400Acquisitions:Fair
      value of assets acquired
    
    
    --
    
    
    --
    
    
    835Goodwill
    
    
    --
    
    
    --
    
    
    54Less:
      liabilities assumed
    
    
    --
    
    
    --
    
    
    (889
    )Acquisitions,
      net cash acquired
    
    
    --
    
    
    --
    
    
    --Cumulative
      effect of accounting change attributed to implementation of EITF 00-19 for
      the contingent redemption feature of common stock and
      warrants:Increase
      in additional paid-in capital
    
    
    --
    
    
    --
    
    
    65,617Net change in contingent redemption value of warrants and common
      stock
    
    
    --
    
    
    --
    
    
    (28,780
    )Cumulative
      effect of accounting change
    
    $
    --
    
    $
    --
    
    $
    36,837
 
 
 **NOTE
12. 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, 2003, 2002 and 2001, we elected to
contribute $125,000, $131,000 and $108,000 to the Plan, respectively.
 
 35
 **NOTE
13. 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 outstanding shares, assuming conversion of all
potentially dilutive stock options, warrants and convertible bonds. Earnings per
share are computed as follows (in thousands):
 
 **Year
      Ended December 31,****2003**
      **(Restated)**
    
    **2002**
    
    **2001**Income
      (loss) before cumulative effect of an accounting change
    
    $
    81,817
    
    $
    97,062
    
    $
    (187,830
    )Cumulative effect of an accounting change
    
    
    --
    
    
    --
    
    
    (36,837
    )Income
      available to common stockholders used to compute basic income (loss) per
      share
    
    $
    81,817
    
    $
    97,062
    
    $
    (224,667
    )Interest expense on convertible bonds
    
    
    (1
    )
    
    18
    
    
    --Income
      available for common stockholders after assumed conversion of dilutive
      securities used to    compute diluted income (loss) per
      share
    
    $
    81,816
    
    $
    97,080
    
    $
    (224,667
    )Weighted
      average number of common shares outstanding used to compute basic income
      (loss) per share
    
    
    26,376
    
    
    27,253
    
    
    26,414Effect
      of dilutive securities*:Stock
      options and warrants
    
    
    1,233
    
    
    1,347
    
    
    --8%
      Secured convertible bonds due 2006
    
    
    --
    
    
    2,010
    
    
    --5%
      Convertible subordinated notes due 2004
    
    
    9
    
    
    --
    
    
    --8% Senior convertible subordinated notes due 2007
    
    
    188
    
    
    188
    
    
    --Weighted average number of common and common equivalent shares outstanding
      used to compute diluted income (loss) per share
    
    
    27,806
    
    
    30,798
    
    
    26,414Income
      (loss) per share - Basic:Income
      (loss) before cumulative effect of an accounting change per share
    
    $
    3.10
    
    $
    3.56
    
    $
    (7.11
    )Cumulative effect of an accounting change per share
    
    
    --
    
    
    --
    
    
    (1.40
    )Net income (loss) per share
    
    $
    3.10
    
    $
    3.56
    
    $
    (8.51
    )Weighted average common shares outstanding
    
    
    26,376
    
    
    27,253
    
    
    26,414Income
      (loss) per share - Diluted:Income
      (loss) before cumulative effect of an accounting change per share
    
    $
    2.94
    
    $
    3.15
    
    $
    (7.11
    )Cumulative
      effect of an accounting change per share
    
    
    --
    
    
    --
    
    
    (1.40
    )Net income (loss) per share
    
    $
    2.94
    
    $
    3.15
    
    $
    (8.51
    )Weighted average common and common equivalent shares outstanding
    
    
    27,806
    
    
    30,798
    
    
    26,414
 
 * The
diluted share basis for the years ended December 31, 2003, 2002 and 2001
excludes options and warrants to purchase 1.3 million, 1.7 million and 3.0
million shares of common stock, respectively. The diluted share basis for the
years ended December 31, 2002 and 2001 excludes convertible bonds that are
convertible into 9 thousand and 3.3 million shares of common stock,
respectively, due to their antidilutive effect.
   36
 ****
 **NOTE
14.   SUBSEQUENT EVENTS**
 
 In 2004,
through February 27, 2004, we have (i) acquired an additional $15 million of our
12% Senior Subordinated Notes, leaving $25.7 million principal amount of our 12%
Senior Subordinated Notes outstanding, and (ii) committed to redeem on April 20,
2004, an additional $15 million of our 12% Senior Subordinated
Notes.
 
 **NOTE
15.   QUARTERLY FINANCIAL DATA (UNAUDITED)**
 
 The
consolidated statements of operations for the year ended December 31, 2003 and
each quarter have been restated as follows to reflect these items discussed in
Note 16.
 
 **Quarter
      Ended**(In
      thousands, except per share data)
    
    
    **March
      31,**
    
    
    **March
      31,**
    
    
    **June
      30,**
    
    
    **June
      30,****2003
      (1)**
    
    
    As
      Originally
      Reported
    
    
    As
      Restated
    
    
    As
      Originally
      Reported
    
    
    As
      RestatedRevenues
    
    $
    87,843
    
    $
    88,202
    
    $
    93,748
    
    $
    93,906Operating
      income
    
    
    15,179
    
    
    15,538
    
    
    19,027
    
    
    19,185Net
      income
    
    
    9,126
    
    
    9,343
    
    
    10,675
    
    
    10,771Net
      income per share - Basic
    
    
    0.35
    
    
    0.35
    
    
    0.41
    
    
    0.41Net
      income per share - Diluted
    
    
    0.32
    
    
    0.32
    
    
    0.37
    
    
    0.37
 
 
 **Quarter
      Ended**(In
      thousands, except per share data)
    
    
    **September
      30,**
    
    
    **September
      30,**
    
    
    **December
      31,**
    
    
    **December
      31,****2003
      (1)**
    
    
    As
      Originally Reported
    
    
    As
      Restated
    
    
    As
      Originally Reported
    
    
    As
      RestatedRevenues
    
    $
    99,929
    
    $
    100,178
    
    $
    101,143
    
    $
    101,407Operating
      income
    
    
    17,620
    
    $
    17,869
    
    
    13,432
    
    
    13,696Net
      income
    
    
    51,566
    
    
    54,102
    
    
    7,094
    
    
    7,601Net
      income per share - Basic
    
    
    1.96
    
    
    2.05
    
    
    0.27
    
    
    0.29Net
      income per share - Diluted
    
    
    1.74
    
    
    1.88
    
    
    0.25
    
    
    0.27
 
 
 **Quarter
      Ended**(In
      thousands, except per share data)
    
    
    **March
      31,**
    
    
    **June
      30,**
    
    
    **September
      30,**
    
    
    **December
      31,****2002**Revenues
    
    $
    79,447
    
    $
    77,673
    
    $
    79,133
    
    $
    81,254Operating
      income
    
    
    10,322
    
    
    12,231
    
    
    15,753
    
    
    16,293Net
      income
    
    
    8,130
    
    
    9,417
    
    
    13,378
    
    
    66,137Net
      income per share - Basic
    
    
    0.30
    
    
    0.35
    
    
    0.49
    
    
    2.42Net
      income per share - Diluted
    
    
    0.28
    
    
    0.30
    
    
    0.42
    
    
    2.10
 
 The
consolidated balance sheet at December 31, 2003 and at the end of each quarter
2003 have been restated as follows to reflect these items discussed in Note
16.
 
 
 
 **Quarter
      Ended**(In
      thousands)
    
    **March
      31,**
    
    ****
      **March
      31,**
    
    **June
      30,**
    
    **June
      30,**
    
    ****
      **September
      30,**
    
    ****
      **September
      30,******
      ****
      **2003**
    
    
    As
      Originally
      Reported
    
    
    As
      Restated
    
    
    As
      Originally
      Reported
    
    
    As
      Restated
    
    
    As
      Originally
      Reported
    
    
    As
      RestatedDeferred
      tax assetsCurrent
    
    $
    16,765
    
    $
    16,623
    
    $
    10,653
    
    $
    10,447
    
    $
    20,703
    
    $
    24,605Long-term
    
    
    --
    
    
    --
    
    
    --
    
    
    --
    
    
    44,112
    
    
    51,725Goodwill
    
    
    19,503
    
    
    19,503
    
    
    19,503
    
    
    19,503
    
    
    19,503
    
    
    13,013Total
      assets
    
    
    178,051
    
    
    180,053
    
    
    169,318
    
    
    171,572
    
    
    237,752
    
    
    245,525Sales,
      use and excise tax
    
    
    11,772
    
    
    11,412
    
    
    12,794
    
    
    12,276
    
    
    13,803
    
    
    13,037Total
      liabilities
    
    
    150,448
    
    
    152,233
    
    
    130,554
    
    
    132,495
    
    
    146,476
    
    
    151,400Total
      stockholders’ equity
    
    
    27,603
    
    
    27,820
    
    
    38,764
    
    
    39,077
    
    
    91,276
    
    
    94,125
 
 (1)
Restated as discussed in Note 16.
 
 37
 
 **NOTE
16. RESTATEMENTS**
 
 May 7,
2004 Restatement
 
 On May 7,
2004, we revised our consolidated balance sheet as of December 31, 2003 and
related disclosures in Note 5 to reflect the change in classification of $15
million of our 12% Senior Subordinated Notes from long-term debt to current
portion of long-term debt.  The restatement is the result of our commitment
pursuant to a notice to holders on November 5, 2003 (see Note 5) to redeem $15
million principal amount of our 12% Senior Subordinated Notes on January 5,
2004, which resulted in a change of maturity of such principal amount to the
noticed redemption date.
 
 March
28, 2005 Restatement
 
 On March
28, 2005, we further revised our consolidated financial statements to correct
for the following errors:
 
 (a)
    Due
      to a classification error in our general ledger, we incorrectly recorded
      certain customer fee revenues to the consolidated balance sheets for the
      four quarters of 2003 and for the year ended December 31, 2003 as sales,
      use and excise tax liabilities. These customer fee revenues aggregated
      $1.0 million for the full year 2003. These customer fees have now been
      appropriately recorded to revenues in the consolidated statement of
      operations for the year ended December 31, 2003 and in the unaudited
      quarterly periods for 2003.
 (b)
    In
      connection with the preparation of the financial statements for 2004, we
      determined that in our calculations 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.
 (c)
    In
      connection with the preparation of the financial statements for the first
      and second quarters of 2004, 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 of 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 of 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 2004 rather than through the restatement of our
      prior period financial statements.
 (d)
    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.
 
 As a
result of these restatements, certain originally reported amounts in the
consolidated statements of operations for the year ended December 31, 2003 have
been restated as follows (in thousands, except per share data):
 
 **As
      Originally Reported**
    
    
    **Adjustments**
    
    
    **As**
      **Restated****Year
      Ended December 31, 2003**Revenues
    
    $
    382,663
    
    $
    1,030
    
    $
    383,693Operating
      income
    
    
    65,258
    
    
    1,030
    
    
    66,288Provision
      (benefit) for income taxes
    
    
    (17,697
    )
    
    (2,327
    )
    
    (20,024
    )Net
      income
    
    
    78,461
    
    
    3,356
    
    
    81,817Net
      income per share - Basic
    
    
    2.97
    
    
    0.13
    
    
    3.10Net
      income per share - Diluted
    
    
    2.75
    
    
    0.19
    
    
    2.94Weighted
      average common and common equivalent shares outstanding -
Diluted
    
    
    28,514
    
    
    (708)
    
    
    27,806
 
 
 As a
result of these restatements, certain originally reported amounts in the
consolidated balance sheet at December 31, 2003 has been restated as follows (in
thousands):
 
 ****
    
    
    **As
      Originally Reported**
    
    
    **Adjustments**
    
    
    **As**
      **Restated****At
      December 31, 2003**Deferred
      tax assetsCurrent
    
    $
    24,605
    
    $
    --
    
    $
    24,605Long-term
    
    
    40,543
    
    
    7,745
    
    
    48,288Goodwill
    
    
    19,503
    
    
    (6,490
    )
    
    13,013Total
      assets
    
    
    245,923
    
    
    1,255
    
    
    247,178Sales,
      use and excise tax
    
    
    14,551
    
    
    (1,030
    )
    
    13,521Total
      liabilities
    
    
    146,136
    
    
    (2,101
    )
    
    144,035Total
      stockholders’ equity
    
    
    99,787
    
    
    3,356
    
    
    103,143
  As a result
of these restatements, certain originally reported amounts for cash flows from
operating activities in the consolidated statement of cash flows have been
adjusted as follows (in thousands):
 
 
 **As
      Originally Reported**
    ****
    ****
    **Adjustments**
    ****
    ****
    **As**
      **Restated****At
      December 31, 2003**Cash
      flows from operating activities:Net Income
    
    $
    78,461
    
    $
    3,356
    
    $
    81,817Deferred income taxes
    
    
    (19,740
    )
    
    (3,669
    )
    
    (23,409
    )Changes in assets and liabilities:Sales, use and excise taxes
    
    
    3,112
    
    
    (1,030
    )
    
    2,082Other current liabilities and accrued compensation
    
    
    773
    
    
    1,343
    
    
    2,116Net cash provided by operating activities
    
    
    73,166
    
    
    --
    
    
    73,166
   **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.
 
 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, 2003. Based upon this
evaluation, our CEO and the CFO concluded that, for the reasons described below,
our disclosure controls and procedures were not effective as of December 31,
2003.
 
 We have
restated our previously issued consolidated financial statements for the year
ended December 31, 2003 and the four quarters of 2003 and will restate the first
three quarters of 2004. This restatement was primarily the result of the
following material weaknesses:
 
 1. 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 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.
 
 2. We did
not maintain effective controls over sales, use and excise tax liabilities.
Specifically, our reconciliation and review procedures with respect to 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 the year ended December 31, 2003.
 
 The
restatements, described above, were for matters related to (a) the recognition
in revenue in the four quarters 2003 and year ended December 31, 2003 of certain
customer fees previously recorded in those periods as increases in current
liabilities; (b) the calculation of outstanding diluted weighted average common
and common equivalent shares in the third and fourth quarters 2003 and the year
ended December 31, 2003 to reflect the  inclusion
of assumed tax benefits in the proceeds used to repurchase shares in the
application of the treasury stock method of accounting for outstanding options;
(c) for the third and fourth quarters 2003 and the year ended December 31, 2003,
a correction in the calculation of net operating losses utilized in 2003 and in
the calculation of state deferred tax assets; and (d) the recording, beginning
in the third quarter 2003 and for the year ended December 31, 2003, of a
deferred tax asset associated with acquired net operating loss carryforwards.
Refer to Notes 15 and 16 to the Consolidated Financial Statements for further
information regarding this restatement, including the effect of the restatement
for each of the four quarters of 2003 and the year ended December 31,
2003.
 
 38
 
 To
address these material weaknesses, subsequent to December 31, 2003, we have
taken the following actions:
  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 weaknesses have been remediated. We will continue the
implementation of policies, processes and procedures regarding the review of
complex transactions. Management belives that our controls and procedures will
continue to improve as a result of the further implementation of these
measures.
  The
changes to internal control over financial reporting were implemented subsequent
to the quarter ended December 31, 2003. There were no changes in our internal
control over financial reporting that occurred during the quarter ended December
31, 2003 that have materially affected, or are reasonably likely to materially
affect, our internal control over financial reporting.
 
 39
 
 **ITEM
15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON** **FORM
8-K.**
 
 (a)  The
following documents are filed as part of this report.
 
 1.  Consolidated
Financial Statements:
 
 The
Consolidated Financial Statements filed as part of this report 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.
 
 40
 **TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**
 
 **INDEX
TO S-X SCHEDULE**
 
 
 
 
 
 **PAGE**Schedule
      II -- Valuation & Qualifying Accounts
    42
 
 ****
 ****
 ****
 ****
 41
 ****
 **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, 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**Year
      Ended December 31, 2001:**Reserve
      and allowances deducted from asset accounts:Allowance
      for uncollectible accounts
    
    $
    29,429
    
    $
    92,778
    
    $
    (75,803
    )
    $
    46,404
  42
 
 
 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).
 
 4.6
    Indenture
      dated as of December 10, 1997 between Tel-Save Holdings, Inc. and First
      Trust of New York, N.A. (incorporated by reference to Exhibit 10.34 to our
      Annual Report on Form 10-K for the year ended December 31, 1997).
 
 4.7
    Indenture
      dated as of April 2, 2002, between Talk America Holdings, Inc. and
      Wilmington Trust Company (incorporated by reference to Exhibit 10.69 to
      our Annual Report on Form 10-K for the year ended December 31, 2001).
 
 4.8
    Supplemental
      Indenture No. 1 dated as of April 2, 2002, between Talk America Holdings,
      Inc. and Wilmington Trust Company, to the Indenture dated as of April 2,
      2002, between Talk America Holdings, Inc. and Wilmington Trust Company
      (incorporated by reference to Exhibit 10.70 to our Annual Report on Form
      10-K for the year ended December 31, 2001).
 
 4.9
    Supplemental
      Indenture No. 2 dated as of April 2, 2002, between Talk America Holdings,
      Inc. and Wilmington Trust Company, to the Indenture dated as of April 2,
      2002 (incorporated by reference to Exhibit 10.71 to our Annual Report on
      Form 10-K for the year ended December 31, 2001).
 
 4.10
    First
      Supplemental Indenture dated as of April 2, 2002, between Talk America
      Holdings, Inc. and U.S. Bank Trust National Association, to the Indenture
      dated as of September 9, 1997 (incorporated by reference to Exhibit 10.72
      to our Annual Report on Form 10-K for the year ended December 31, 2001).
 
 4.11
    First
      Supplemental Indenture dated as of April 2, 2002, between Talk America
      Holdings, Inc. and U.S. Bank Trust National Association, to the Indenture
      dated as of December 10, 1997 (incorporated by reference to Exhibit 10.73
      to our Annual Report on Form 10-K for the year ended December 31, 2001).
 
 10.1
    Employment
      Agreement with Aloysius T. Lawn, IV dated March 28, 2001 (incorporated by
      reference to Exhibit 10.1 to our Annual Report on Form 10-K for the year
      ended December 31, 2000).*
 
 10.2
    Employment
      Agreement with Edward B. Meyercord, III dated January 1, 2004 (previously
      filed as an Exhibit to our Annual Report on Form 10-K for the year ended
      December 31, 2003).*
 
 10.3
    Indemnification
      Agreement with Aloysius T. Lawn, IV dated March 28, 2001(incorporated by
      reference to Exhibit 10.3 to our Annual Report on Form 10-K for the year
      ended December 31, 2000). *
 
 10.4
    Indemnification
      Agreement with Edward B. Meyercord, III (previously filed as an Exhibit to
      our Annual Report on Form 10-K for the year ended December 31, 2003). *
 
 10.5
    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)).*
 
 10.6
    Employment
      Agreement with Gabriel Battista dated January 1, 2004 (previously filed as
      an Exhibit to our Annual Report on Form 10-K for the year ended December
      31, 2003).*
 
 10.7
    Indemnification
      Agreement with Gabriel Battista dated as of December 28, 1998
      (incorporated by reference to Exhibit 10.2 to our Current Report on Form
      8-K dated January 20, 1999). *
 
 43
  10.8
    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).*
 
 10.9
    Our
      1998 Long-Term Incentive Plan (incorporated by reference to Exhibit 10.14
      to our Current Report on Form 8-K dated January 20, 1999).*
 
 10.10
    2000
      Long-Term Incentive Plan (incorporated by reference to Exhibit 10.31 to
      our Registration Statement on Form S-4 (No. 333-40980)). *
 
 10.11
    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).*
 
 10.12
    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)).
 
 10.13
    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).*
 
 10.14
    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).*
 
 10.15
    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).*
 
 10.16
    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).
 
 10.17
    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).
 
 10.18
    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).*
 
 10.19
    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).*
 
 10.20
    Employment
      Agreement with Jeffrey Earhart dated October 2, 2001 (incorporated
      by reference to Exhibit 10.1 to our Quarterly Report on Form 10-Q dated
      November 14, 2001).*
 
 10.21
    Employment
      Agreement with Warren Brasselle dated March 8, 2000 (incorporated by
      reference to Exhibit 10.48 to our Annual Report on Form 10-K for the year
      ended December 31, 2001).*
 
 10.22
    Employment
      Agreement with Timothy Leonard dated March 29, 2002 (previously filed as
      an Exhibit to our Annual Report on Form 10-K for the year ended December
      31, 2003).*
 
 10.23
    Sublease
      Agreement by and between Talk America Inc. and Food Lion, LLC, dated as of
      November 26, 2003 (previously filed as an Exhibit to our Annual Report on
      Form 10-K for the year ended December 31,
2003).
 
 10.24
    Lease
      by and between Talk America Inc. and BTS Owners LLC, dated as of July 1,
      2003 (previously filed as an Exhibit to our Annual Report on Form 10-K for
      the year ended December 31, 2003).
 
 10.25
    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).
 
 10.26
    Amendment
      to Employment Agreement for Warren Brasselle dated May 14, 2002
      (incorporated by reference to Exhibit 10.4 to our Quarterly Report on Form
      10-Q dated November 14, 2001).*
 
 10.27
    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).*
 
 10.28
    Indenture
      of Lease by and between Woodruff Properties and Omnicall, Inc. dated
      August 1, 1998 (incorporated by reference to Exhibit 10.64 to our Annual
      Report on Form 10-K for the year ended December 31, 2001).
 
 10.29
    Amendment
      dated February 9, 2001 to the Indenture of Lease by and between Woodruff
      Properties and Omnicall, Inc. dated August 1, 1998 (incorporated by
      reference to Exhibit 10.65 to our Annual Report on Form 10-K for the year
      ended December 31, 2001).
 
 10.30
    Lease
      Agreement by and between Bridge Plaza Partnership and The Furst Group,
      Inc. dated as of November 4, 1998 (incorporated by reference to Exhibit
      10.66 to our Annual Report on Form 10-K for the year ended December 31,
      2001).
 
 10.31
    Option
      dated July __, 2001 to Renew the Lease Agreement by and between Bridge
      Plaza Partnership and The Furst Group, Inc. dates as of November 4, 1998
      (incorporated by reference to Exhibit 10.67 to our Annual Report on Form
      10-K for the year ended December 31, 2001).
 
 10.32
    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).
 
 10.33
    Our
      2003 Long Term Incentive Plan (incorporated by reference to Exhibit B of
      our Definitive Proxy Statement filed on May 6,
2003).
 
 10.34
    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).
 
 10.35
    Lease
      Agreement by and between Jeffrey M. Baumrucker and Monique M. Baumrucker
      and Talk America Inc. dated as of July 7, 2003 (previously filed as an
      Exhibit to our Annual Report on Form 10-K for the year ended December 31,
      2003).
 
 10.36
    Amendment
      dated March 10, 2003 to the Indenture of Lease by and between Woodruff
      Properties and Omnicall, Inc. dated August 1, 1998 (previously filed as an
      Exhibit to our Annual Report on Form 10-K for the year ended December 31,
      2003).
 
 14.1
    Code
      of Ethics (previously filed as an Exhibit to our Annual Report on Form
      10-K for the year ended December 31, 2003).
 
 21.1
    Our
      Subsidiaries (previously filed as an Exhibit to our Annual Report on Form
      10-K for the year ended December 31, 2003).
 
 23.1  Consent
of PricewaterhouseCoopers LLP (filed herewith).
 
 31.1
    Certification
      of Edward B. Meyercord, III Pursuant to 18 U.S.C. Section 1350, as Adopted
      Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed
      herewith).
 
 31.2
    Certification
      of David G. Zahka Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant
      to Section 302 of the Sarbanes-Oxley Act of 2002 (filed
      herewith).
 
 32.1
    Certification
      of Edward B. Meyercord, III Pursuant to 18 U.S.C. Section 1350, as Adopted
      Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (furnished to
      the Commission herewith).
 
 32.2
    Certification
      of David G. Zahka Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant
      to Section 906 of the Sarbanes-Oxley Act of 2002 (furnished to the
      Commission herewith).
 
  
 44
 
 
 **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 28, 2005
 
 **TALK
AMERICA HOLDINGS, INC.**
 
 
 
 By:  /s/
Edward B. Meyercord, III
 Edward B.
Meyercord, III
 Chief
Executive Officer