Table of Contents

  **UNITED STATES SECURITIES AND EXCHANGE COMMISSION****Washington, D.C. 20549****FORM 10-K****(Mark One)**   þ **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934******For the fiscal year ended December 31, 2006******or**   o **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES ACT OF 1934******For the transition period from                      to**                    **.******Commission file number 1-12996****ADVOCAT INC.****(Exact name of registrant as specified in its charter)**   **Delaware** **62-1559667** **(State or other jurisdiction of** **(I.R.S. Employer****incorporation or organization)** **Identification No.)**   **1621 Galleria Boulevard,Brentwood, TN** **37027** **(Address of principal executive offices)** **(Zip Code)****Registrant’s telephone number, including area code: (615) 771-7575****Securities registered pursuant to Section 12(b) of the Act:**   **Title of each class** **Name of each Exchange on which registered**   **Common Stock, $0.01 par value per share** **The NASDAQ Stock Market, LLC****Securities registered pursuant to Section 12(g) of the Act:****None.****Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act. Yes o No þ.****Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 orSection 15(d) of the Act. Yeso No þ.****Indicate by check mark whether the registrant: (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the Registrant was required to file such reports), and (2) has beensubject to the filing requirements for the past 90 days. Yesþ No o.****Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K isnot contained herein, and will not be contained, to the best of Registrant’s knowledge, indefinitive proxy or information statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K.**o**Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer,or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” inRule 12b-2 of the Exchange Act. (Check one):****Large accelerated filer**o            **Accelerated filer**þ            **Non-accelerated filer**o**Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of theAct). Yes o No þ.****The aggregate market value of Common Stock held by non-affiliates on June 30, 2006 (based on theclosing price of such shares on the NASD OTC Market) was $87,784,344. For purposes of theforegoing calculation only, all directors, named executive officers and persons known to theRegistrant to be holders of 5% or more of the Registrant’s Common Stock have been deemed affiliatesof the Registrant.****On March 2, 2007, 5,871,287 shares of the registrant’s $0.01 par value Common Stock wereoutstanding.****Documents Incorporated by Reference:****The following documents are incorporated by reference into Part I, Item 5 and Part III, Items 10,11, 12, 13 and 14 of this Form 10-K: The Registrant’s definitive proxy materials for its 2007annual meeting of shareholders.**  
 

**TABLE OF CONTENTS**
 PART IITEM 1. BUSINESSITEM 1A. RISK FACTORSITEM 1B. UNRESOLVED STAFF COMMENTSITEM 2. PROPERTIESITEM 3. LEGAL PROCEEDINGSITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS PART IIITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIESITEM 6. SELECTED CONSOLIDATED FINANCIAL DATAITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATAITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSUREITEM 9A. CONTROLS AND PROCEDURES.ITEM 9B. OTHER INFORMATION PART IIIITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTITEM 11. EXECUTIVE COMPENSATIONITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER MATTERSITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONSITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES PART IVITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULESSIGNATURESEx-21  Subsidiaries of the RegistrantEx-23.1 BDO Seidman ConsentEx-31.1 Section 302 CertificationEx-31.2 Section 302 CertificationEx-32   Section 906 Certification

Table of Contents
**PART I****ITEM 1. BUSINESS****Introductory Summary.**Advocat Inc. provides long-term care services to nursing home patients in eight states, primarilyin the Southeast. Unless the context indicates otherwise, references herein to “Advocat,” “theCompany,” “we,” “us” and “our” include Advocat Inc. and all of our subsidiaries.The long-term care profession encompasses a broad range of non-institutional and institutionalservices. For those among the elderly requiring temporary or limited special services, a varietyof home care options exist. As needs for assistance in activities of daily living develop,assisted living facilities become the most viable and cost effective option. For those among theelderly requiring much more intensive care, skilled nursing facility care becomes the only viableoption. We have chosen to focus primarily on our skilled nursing centers and to specialize in thisaspect of the long term care continuum.Our objective is to become the provider of choice of health care and related services to theelderly in the communities in which we operate. We will continue to implement our operatingstrategy of (i) providing a broad range of cost-effective elder care services; (ii) increasingoccupancy in our nursing centers through physical plant improvements and an increased emphasis onmarketing efforts; (iii) improving the quality of payor mix; and (iv) clustering our operations ona regional basis.Our principal executive offices are located at 1621 Galleria Boulevard, Brentwood, TN 37027. Ourtelephone number at that address is 615.771.7575, and our facsimile number is 615.771.7409. Ourweb-site is located at www.irinfo.com/AVC. The information on our web-site does not constitutepart of this Annual Report on Form 10-K.**Nursing Centers and Services.**Advocat provides a broad range of long-term care services to the elderly including skilled nursing,ancillary health care services and assisted living. In addition to the nursing and social servicesusually provided in long-term care centers, we offer a variety of rehabilitative, nutritional,respiratory, and other specialized ancillary services. As of December 31, 2006, our continuingoperations include 43 nursing centers containing 4,505 licensed nursing beds and 66 assisted livingunits.Our nursing centers range in size from 48 to 180 licensed nursing beds. The following tablesummarizes certain information with respect to the nursing centers we own or lease as of December31, 2006:                   **Number of** **Licensed Nursing** **Available Nursing** **Assisted**  **Centers** **Beds****(1)** **Beds****(1)** **Living Units****Operating Locations:**                Alabama  6   711   699   52 Arkansas  13   1,411   1,241   12 Florida  5   502   460   0 Kentucky  6   474   470   2 Ohio  1   151   122   0 Tennessee  5   617   586   0 Texas  5   489   442   0 West Virginia  2   150   150   0                     43   4,505   4,170   66                  
2

Table of Contents
                   **Number of** **Licensed Nursing** **Available Nursing** **Assisted Living**  **Centers** **Beds****(1)** **Beds****(1)** **Units****Classification:**                Owned  9   942   870   17 Leased  34   3,563   3,300   49                  Total  43   4,505   4,170   66                   (1) The number of “Licensed beds” is based on the licensed capacity of thefacility. The Company reports its occupancy based on licensed beds. The number of“Available Beds” represents “licensed beds” less beds removed from service. “Availablebeds” is subject to change based upon the needs of the facilities, includingconfiguration of patient rooms and offices, status of beds (private, semi-private,ward, etc.) and renovations.Our nursing centers provide skilled nursing health care services, including room and board,nutrition services, recreational therapy, social services, and housekeeping and laundry services.Our nursing centers dispense medications prescribed by the patients’ physicians, and a plan of careis developed by professional nursing staff for each resident. We also provide for the delivery ofancillary medical services at the nursing centers we operate. These specialty services includerehabilitation therapy services, such as audiology, speech, occupational and physical therapies,which are provided through licensed therapists and registered nurses, and the provision of medicalsupplies, nutritional support, infusion therapies, and related clinical services. The significantmajority of these services are provided using our internal resources and clinicians.Within the framework of a nursing center, we may provide other specialty care, including:*Life Steps Unit.*Six of our nursing centers have units designated as Life Steps Units, ourdesignation for patients requiring short term rehabilitation following an incident such as astroke or bone fracture. These units specialize in short term rehabilitation with the goal ofreturning the patient to their previous level of functionality. These units provide enhancedservices with emphasis on upgraded amenities including electric beds, televisions, phones atbedside and feature a separate entrance for guests and visitors. The design and programming onthe unit appeals to the generally younger resident who intends to return home followingintensive rehabilitation. Specialized therapeutic treatment regimens include orthopedicrehabilitation, neurological rehabilitation and complex medical rehabilitation. While thesepatients generally have a shorter length of stay, the intensive level of rehabilitationgenerally results in higher levels of reimbursement.*Lighthouse Unit.*Thirteen of our nursing centers have Lighthouse Units, our designation foradvanced care for dementia related disorders, including Alzheimer’s disease. The goal of theunits is to provide a safe, homelike and supportive environment for cognitively impairedpatients, utilizing an interdisciplinary team approach. Family and community involvementcompliment structured programming in the secure environment instrumental in fostering as muchresident independence as possible despite diminished capacity.*Assisted Living Units.*Four of our nursing centers have units designated for assisted livingpatients, ranging in size from 2 to 35 units. These units may be a subset of the facility or aseparate freestanding building on the nursing center campus. Services and accommodationsinclude central dining facilities, recreational areas, social programs, housekeeping, laundryand maintenance service, emergency call systems, special features for handicapped persons andtransportation to shopping and special events. Generally, basic care and support services canbe offered more economically in an assisted living facility than either in a nursing home orthrough home health care assistance.
3

Table of Contents
*Other Specialty Programming.*We implement other specialty programming based on a center’sspecific needs. We have developed one adult day care center on the campus of a nursing center.We have developed specialty programming for bariatric patients (generally, patients weighingmore than 350 pounds). These individuals have unique psychosocial and equipment needs.***Continuous Quality Improvement***. We have in place a Continuous Quality Improvement (“CQI”) program,which is focused on identifying opportunities for improvement of all aspects of the care providedin a center, as well as overseeing the initiation and effectiveness of interventions. The CQIprogram was designed to meet accreditation standards and to exceed state and federal governmentregulations. We conduct monthly audits to monitor adherence to the standards of care established bythe CQI program at each center which we operate. The facility administrator, with assistance fromregional nursing personnel, is primarily responsible for adherence to our quality improvementstandards. In that regard, the annual operational objectives established by each facilityadministrator include specific objectives with respect to quality of care. Performance of theseobjectives is evaluated quarterly by the regional vice president or manager, and each facilityadministrator’s incentive compensation is based, in part, on the achievement of the specifiedquality objectives. A major component of our CQI program is employee empowerment initiatives, withparticular emphasis placed on selection, recruitment, retention and recognition programs. Ouradministrators and managers include employee retention and turnover goals in the annual facility,regional and personal objectives. We also have established a quality improvement committeeconsisting of nursing representatives from each region. This committee periodically reviews ourquality improvement programs and conducts facility audits.***Organization*****.**Our long-term care facilities are currently organized into six regions, each ofwhich is supervised by a regional vice president. The regional vice president is generallysupported by specialists in several functions, including nursing, human resources, marketing,receivable management and clerical, all of whom are employed by us. The day-to-day operations ofeach owned or leased nursing center are supervised by an on-site, licensed administrator. Theadministrator of each nursing center is supported by other professional personnel, including amedical director, who assists in the medical management of the facility, and a director of nursing,who supervises a staff of registered nurses, licensed practical nurses, and nurses aides. Otherpersonnel include therapy, dietary, activities and social service, housekeeping, laundry andmaintenance, and a business office staff. All personnel at the leased or owned facilities,including the administrators, are our employees.**Operating and Growth Strategy.**Our operating objective is to be the provider of choice of health care and related services to theelderly in the communities in which we operate. To achieve our objective we:*Provide a broad range of cost-effective services.*Our objective is to provide a variety ofservices in a broad continuum of care which will meet the ever changing needs of the elderly.Our expanded service offering currently includes skilled nursing, comprehensive rehabilitationservices, programming for Life Steps and Lighthouse units, other specialty programming andmedical supply and nutritional support services. By addressing varying levels of acuity, wework to meet the needs of the elderly population we serve for a longer period of time and toestablish a reputation as the provider of choice in a particular market. Furthermore, webelieve we are able to deliver quality services cost-effectively, thereby expanding the elderlypopulation base that can benefit from our services, including those not otherwise able to affordprivate-pay assisted living services.*Increase occupancy through physical plant improvements and emphasis on marketing efforts*. Webelieve we can increase occupancy in our nursing homes through improved physical plants and anincreased emphasis on and an improved program for attracting and retaining patients andresidents. We emphasize strong corporate and regional support for local facility basedmarketing efforts.
4

Table of Contents
*Improve quality of payor mix.*We believe we can improve profitability by improving the payormix of our patients. Quality payor sources include Medicare, HMO, managed care and private pay.These payor sources typically provide a better margin per revenue dollar or patient day.*Cluster operations on a regional basis.*We have developed regional concentrations of operationsin order to achieve operating efficiencies, generate economies of scale and capitalize onmarketing opportunities created by having multiple operations in a regional market area.Key elements of our growth strategy are to:*Increase revenues and profitability at existing facilities.*Our strategy includes increasingcenter revenues and profitability levels through increasing occupancy levels, improving qualitypayor mix, maximizing reimbursement rates and containing costs. In addition to our facilityrenovation program, ongoing initiatives to promote higher occupancy levels and improved payorand case mixes at our nursing centers include programs to improve customer service, newcontracts for insurance and other services, and units for specialized care services developed atcertain centers.*Improve physical plants*. Our nursing centers have an average age of approximately 30 years asof December 31, 2006. After a strategic review, Management determined that renovating certainfacilities offered the opportunity to improve occupancy, quality of care and profitability.Management developed a plan to identify those facilities with the greatest potential forbenefit, and began the renovation program during 2005. We have completed major renovations atfour facilities and have renovations in progress at two facilities as of December 31, 2006. Weexpect to substantially complete two additional renovations in the first quarter of 2007, andplan to complete up to four more renovations in the third and fourth quarters of 2007. Majorrenovations result in significant cosmetic upgrades, including new flooring, wall coverings,lighting, ceilings and furniture throughout the facility. Renovations also usually includecertain external work to improve curb appeal, such as concrete work, landscaping, roof, andsignage enhancements.*Development of additional specialty services*. Our strategy includes the development ofadditional specialty units and programming in facilities that could benefit from these services.The specialty programming will vary depending on the needs of the specific marketplace, and mayinclude Life Steps and Lighthouse Units and other specialty programming. These services allowour facilities to improve census and payor mix. A center specific assessment of the market isconducted related to specialty programming to determine if unmet needs exist as a predictor ofthe success of particular niche offerings.*Acquisition, leasing and development of new homes*. We continue to pursue and investigateopportunities to acquire, lease or develop new facilities, focusing primarily on opportunitieswithin our existing areas of operation. We have entered into an option agreement to purchasecertain assets of a skilled nursing facility in West Virginia. We have made an application tostate regulatory authorities to allow us to operate the facility, and if successful, we intendto arrange financing and construct a new 90 bed replacement facility. The review of stateregulators is expected to take from three to twelve months, and construction of the new facilityis expected to take from eight to fourteen months.**Marketing.**At a local level, our sales and marketing efforts are designed to promote higher occupancy levelsand optimal payor mix. We believe that the long-term care profession is fundamentally a localbusiness in which both patients and residents and the referral sources for them are based in theimmediate geographic area in which the facility is located. Our marketing plan and related supportactivities emphasize the role and performance of administrators, admissions coordinators and socialservices directors of each nursing center, all of whom are responsible for contacting variousreferral sources such as doctors, hospitals, hospital discharge planners, churches, and variouscommunity organizations.
5

Table of Contents
Administrators are evaluated based on their ability to meet specific goals and performancestandards that are tied to compensation incentives. Our regional managers and marketingcoordinators assist local marketing personnel and administrators in establishing relationships andfollow-up procedures with such referral sources.In addition to soliciting admissions from these sources, we emphasize involvement in communityaffairs in order to promote a public awareness of our nursing centers and services. We haveongoing family councils and community based “family night” functions where organizations come tothe facility to educate the public on various topics such as Medicare benefits, powers of attorney,and other matters of interest. We also promote effective customer relations and seek feedbackthrough family surveys. We typically host “open house” events once we complete a major renovationof a facility where people in the community are invited to visit and see the improvements. Inaddition, we have regional marketing coordinators to support the overall marketing program in eachlocal facility, in order to promote higher occupancy levels and improved payor and case mixes atour nursing centers.We have an internally-developed marketing program that focuses on the identification and provisionof services needed by the community. The program assists each facility administrator in analysisof local demographics and competition with a view toward complementary service development. Webelieve that the primary referral area in the long-term care industry generally lies within afive-to-fifteen-mile radius of each facility depending on population density; consequently, localmarketing efforts are more beneficial than broad-based advertising techniques.**Divestitures.**We have undertaken several divestitures through sale of assets and lease terminations. Thedivested operations have generally been poor performing properties. In May 2006, we completed thesale of certain assets of eleven assisted facilities located in North Carolina for a sales price of$11.0 million. Proceeds from this transaction were used to pay transaction costs and repay debt.We closed one remaining North Carolina assisted living facility in April 2006, and are continuingour efforts to sell this facility and land.We sold two nursing centers in Texas effective February 1, 2005. A lease covering three nursingcenters in Texas expired in December 2004 and was not renewed. In November 2004, we sold certainassets of our medical supply business, Advocat Distribution Services. In May 2004, we sold thestock of our Canadian subsidiary, Diversicare Canada Management Services Co., Inc. (“DCMS”).In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting forthe Impairment or Disposal of Long-Lived Assets,” our consolidated financial statements have beenreclassified to reflect these divestitures as discontinued operations.**Nursing Center Profession.**We believe there are a number of significant trends within the long term care industry that willsupport the continued growth of the nursing home segment of the long-term care industry. Thesetrends are also likely to impact our business. These factors include:     *Demographic trends.*The primary market for our long-term health care services is comprisedof persons aged 75 and older. This age group is one of the fastest growing segments of theUnited States population. As the number of persons aged 75 and over continues to grow, webelieve that there will be corresponding increases in the number of persons who need skillednursing.     *Cost containment pressures.*In response to rapidly rising health care costs, governmentaland other third-party payors have adopted cost-containment measures to reduce admissions andencourage reduced lengths of stays in hospitals and other acute care settings. The federal
6

Table of Contents
government had previously acted to curtail increases in health care costs under Medicare bylimiting acute care hospital reimbursement for specific services to pre-established fixedamounts. Other third-party payors have begun to limit reimbursement for medical services ingeneral to predetermined reasonable charges, and managed care organizations (such as healthmaintenance organizations) are attempting to limit hospitalization costs by negotiating fordiscounted rates for hospital and acute care services and by monitoring and reducing hospitaluse. In response, hospitals are discharging patients earlier and referring elderly patients,who may be too sick or frail to manage their lives without assistance, to nursing homes wherethe cost of providing care is typically lower than hospital care. In addition, third-partypayors are increasingly becoming involved in determining the appropriate health care settingsfor their insureds or clients based primarily on cost and quality of care.     *Limited supply of centers.*As the nation’s elderly population continues to grow, lifeexpectancy continues to expand, and there continue to be limitations on granting Certificates ofNeed (“CON’s”) for new skilled nursing centers, so we believe that there will be continueddemand for skilled nursing beds in the markets in which we operate. The majority of states haveadopted CON, or similar statutes, requiring that prior to adding new skilled beds or any newservices, or making certain capital expenditures, a state agency must determine that a needexists for the new beds or proposed activities. We believe that this CON process tends torestrict the supply and availability of licensed skilled nursing center beds. High constructioncosts, limitations on state and federal government reimbursement for the full costs ofconstruction, and start-up expenses also act to restrict growth in the supply for such centers.At the same time, skilled nursing center operators are continuing to focus on improvingoccupancy and expanding services to include high acuity subacute patients, who requiresignificantly higher levels of skilled nursing personnel and care.     *Reduced reliance on family care.*Historically, the family has been the primary provider ofcare for seniors. We believe that the increase in the percentage of women in the work force,the reduction of average family size, and the increased mobility in society will reduce the roleof the family as the traditional care-giver for aging parents. We believe that this trend willmake it necessary for many seniors to look outside the family for assistance as they age.**Competition.**The long-term care business is highly competitive. We face direct competition for additionalcenters, and our centers face competition for employees, patients and residents. Some of ourpresent and potential competitors for acquisitions are significantly larger and have or may obtaingreater financial and marketing resources. Competing companies may offer new or more moderncenters or new or different services that may be more attractive to patients, residents or facilityowners than some of the services we offer.The nursing centers operated by us compete with other facilities in their respective markets,including rehabilitation hospitals, other “skilled” and personal care residential facilities. Inthe few urban markets in which we operate, some of the long-term care providers with which ourfacilities compete are significantly larger and have or may obtain greater financial and marketingresources than our facilities. Some of these providers are not-for-profit organizations withaccess to sources of funds not available to our centers. Construction of new long-term carefacilities near our existing centers could adversely affect our business. We believe that the mostimportant competitive factors in the long-term care business are: a facility’s local reputationwith referral sources, such as acute care hospitals, physicians, religious groups, other communityorganizations, managed care organizations, and a patient’s family and friends; physical plantcondition; the ability to identify and meet particular care needs in the community; theavailability of qualified personnel to provide the requisite care; and the rates charged forservices. There is limited, if any, price competition with respect to Medicaid and Medicarepatients, since revenues for services to such patients are strictly controlled and are based onfixed rates and cost reimbursement principles.
7

Table of Contents
Although the degree of success with which our centers compete varies from location to location, webelieve that our centers generally compete effectively with respect to these factors.**Payor Sources.**We classify our revenues from patients and residents into three major categories: Medicaid,Medicare and private pay. In addition to traditional Medicaid revenues, we include within theMedicaid classification revenues from other programs established to provide benefits to those inneed of financial assistance in the securing of medical services. Medicare revenues includerevenues received under both Part A and Part B of the Medicare program. We classify payments fromindividuals who pay directly for services without government assistance as private pay revenue. Theprivate pay classification also includes revenues from commercial insurers, HMOs, and othercharge-based payment sources. Veterans Administration payments are included in private pay and aremade pursuant to renewable contracts negotiated with these payors.The following table sets forth net patient and resident revenues related to our continuingoperations by payor source for the years presented:                           **Year Ended December 31,**   **(Dollars in thousands)**   **2006**  **2005**  **2004** Medicaid $122,324   56.5% $118,117   58.0% $113,553   59.4%Medicare  66,186   30.5   61,057   30.0   56,018   29.3 Private Pay  28,253   13.0   24,484   12.0   21,653   11.3                    Total $216,763   100.0% $203,658   100.0% $191,224   100.0%                   The following table sets forth average daily census by payor source for our continuing operationsfor the years presented:                           **Year Ended December 31,**  **2006** **2005** **2004**Medicaid  2,508   70.5%  2,493   71.5%  2,524   72.6%Medicare  491   13.8   455   13.0   440   12.7 Private Pay  558   15.7   537   15.5   511   14.7                          Total  3,557   100.0%  3,485   100.0%  3,475   100.0%                         Consistent with the nursing home industry in general, changes in the mix of a facility’s patientpopulation among Medicaid, Medicare, and private pay can significantly affect the profitability ofthe facility’s operations.**Reimbursement.**A significant portion of our revenues is derived from government-sponsored health insuranceprograms. Our nursing centers derive revenues under Medicaid, Medicare and private pay sources.We employ specialists in reimbursement at the corporate level to monitor regulatory developments,to comply with reporting requirements, and to ensure that proper payments are made to our operatednursing centers. It is generally recognized that all government-funded programs have been and willcontinue to be under cost containment pressures, but the extent to which these pressures willaffect our future reimbursement is unknown.The Balanced Budget Act enacted during 1997 (the “BBA”) phased in the prospective payment systemfor nursing centers and contained numerous Medicare and Medicaid cost-saving measures. Asinitially implemented, the BBA negatively impacted the entire long-term care industry. During 1999and 2000,
8

Table of Contents
certain amendments to the BBA were enacted, which helped restore some of the Medicare fundingoriginally eliminated under the BBA. However, certain provisions in the amendments expired onSeptember 30, 2002 and December 31, 2005.In 2005, the Centers for Medicare and Medicaid Services (“CMS”) issued the final rule for therefinement of the Resource Utilization Group (“RUG”) system and provided for the elimination of thereimbursement add-ons for high acuity patients. In addition, Congress implemented a market basketadjustment of approximately 3.1% designed to increase reimbursement for the effects of inflation.The actual amount of the market basket adjustments is adjusted based on various factors. Themarket basket adjustment that became effective October 1, 2006 resulted in an average increase ofapproximately 2.1% for our facilities as a group, and increased our revenue by approximately $0.1million per month.Certain per person annual Medicare Part B reimbursement limits on therapy services became effectiveJanuary 1, 2006. Subject to certain exceptions, the limits impose a $1,740 per patient annualceiling on physical and speech therapy services, and a separate $1,740 per patient annual ceilingon occupational therapy services. CMS established an exception process to permit therapy servicesin certain situations, and the majority of services provided by us are reimbursed under theexceptions. On December 9, 2006, Congress passed the Tax Relief and Health Care Act of 2006(TRHCA), which includes an extension of the existing exceptions process through December 31, 2007.If the exception process is discontinued after 2007, it is expected that the reimbursementlimitations will reduce therapy revenues, and negatively impact our operating results and cashflows.The Federal Deficit Reduction Act of 2005 mandates reducing by 30% the amount that Medicarereimburses nursing centers and other non-hospital providers for bad debts arising fromuncollectible Medicare coinsurance and deductibles for those individuals that are not duallyeligible for Medicare and Medicaid. The reduction is to be phased in over a three year period with10% during fiscal 2006, 20% during fiscal 2007 and 30% thereafter. This provision is not expectedto have a material impact on the Company.The TRHCA passed by Congress on December 9, 2006 reduces the maximum federal matching underMedicare provider assessments to 5.5% of aggregate Medicaid outlays. This reduction in fundingwill become effective for fiscal years beginning after January 1, 2008. The Congressional actioneliminated a regulatory effort proposed by the President’s proposed fiscal year 2007 federal budgetto reduce the allowable federal matching share from 6% to 3%. The new law is expected to have anadverse effect in those states where the tax percentage exceeds 5.5%. The budget proposed byPresident Bush for the government’s 2007 fiscal year includes a number of proposed reductions toMedicare reimbursement for nursing homes and also appears to eliminate certain Federal matchingprograms that benefit many of the state Medicaid programs, including several of the states in whichthe Company operates. In the event the Federal government reduces the amount of state fundingeligible for the Federal matching program, there will be pressure on the states to reduce currentreimbursement levels. If the states reduce the Medicaid reimbursement in response to any Federalaction, it is expected that the reduction in revenues would have a material effect on the Company’soperating results. The Company is unable to quantify the impact that these possible reimbursementcuts would have on it.Reduction in health care spending has become a national priority in the United States, and thefield of health care regulation and reimbursement is a rapidly evolving one. For the fiscal yearended December 31, 2006, we derived 30.5% and 56.5% of our total patient and resident revenuesrelated to continuing operations from the Medicare and Medicaid programs, respectively. Any healthcare reforms that significantly limit rates of reimbursement under these programs could, therefore,have a material adverse effect on our profitability. We are unable to predict which reformproposals or reimbursement limitations will be adopted in the future, or the effect such changeswould have on our operations.
9

Table of Contents
We will attempt to increase revenues from non-governmental sources to the extent capital isavailable to do so, if at all. However, private payors, including managed care payors, areincreasingly demanding that providers accept discounted fees or assume all or a portion of thefinancial risk for the delivery of health care services. Such measures may include capitatedpayments, which can result in significant losses to health care providers if patients requireexpensive treatment not adequately covered by the capitated rate.**Employees.**As of February 1, 2007, we employed a total of approximately 4,716 individuals in connection withour continuing operations. We believe that our employee relations are good. Approximately 151 ofour employees are represented by a labor union.Although we believe we are able to employ sufficient nurses and therapists to provide our services,a shortage of health care professional personnel in any of the geographic areas in which we operatecould affect our ability to recruit and retain qualified employees and could increase our operatingcosts. We compete with other health care providers for both professional and non-professionalemployees and with non-health care providers for non-professional employees. This competitioncontributed to a significant increase in the salaries that we had to pay to hire and retain theseemployees.**Supplies and Equipment.**We purchase drugs, solutions and other materials and lease certain equipment required in connectionwith our business from many suppliers. We have not experienced, and do not anticipate that we willexperience, any significant difficulty in purchasing supplies or leasing equipment from currentsuppliers. In the event that such suppliers are unable or fail to sell us supplies or leaseequipment, we believe that other suppliers are available to adequately meet our needs at comparableprices. National purchasing contracts are in place for all major supplies, such as food, linens,and medical supplies. These contracts assist in maintaining quality, consistency and efficientpricing.**Government Regulation.**The health care industry is subject to numerous laws and regulations of federal, state and localgovernments. These laws and regulations include, but are not necessarily limited to, matters suchas licensure, accreditation, government health care program participation requirements,reimbursement for patient services, quality of resident care and Medicare and Medicaid fraud andabuse. Over the last several years, government activity has increased with respect toinvestigations and allegations concerning possible violations by health care providers of fraud andabuse statutes and regulations as well as laws and regulations governing quality of care issues inthe skilled nursing profession in general. Violations of these laws and regulations could resultin exclusion from government health care programs together with the imposition of significant finesand penalties, as well as significant repayments for patient services previously billed.Compliance with such laws and regulations is subject to ongoing government review andinterpretation, as well as regulatory actions in which government agencies seek to impose fines andpenalties. The Company is involved in regulatory actions of this type from time to time.Additionally, changes in these laws and regulations, such as reimbursement policies of Medicare andMedicaid programs as a result of budget cuts by federal and state governments or other legislativeand regulatory actions, have had a material adverse effect on the industry and our consolidatedfinancial position, results of operations, and cash flows. Future federal budget legislation andfederal and state regulatory changes may further negatively impact us.*Licensure and Certification.*All our nursing centers must be licensed by the state in which theyare located in order to accept patients, regardless of payor source. In most states, nursing homesare subject to certificate of need laws, which require us to obtain government approval for theconstruction of new nursing homes or the addition of new licensed beds to existing homes. Ournursing centers must
10

Table of Contents
comply with detailed statutory and regulatory requirements on an ongoing basis in order to qualifyfor licensure, as well as for certification as a provider eligible to receive payments from theMedicare and Medicaid programs. Generally, the requirements for licensure and Medicare/Medicaidcertification are similar and relate to quality and adequacy of personnel, quality of medical care,record keeping, dietary services, resident rights, and the physical condition of the facility andthe adequacy of the equipment used therein. Each facility is subject to periodic inspections,known as “surveys” by health care regulators, to determine compliance with all applicable licensureand certification standards. Such requirements are both subjective and subject to change. If thesurvey concludes that there are deficiencies in compliance, the facility is subject to varioussanctions, including but not limited to monetary fines and penalties, suspension of new admissions,non-payment for new admissions and loss of licensure or certification. Generally, however, once afacility receives written notice of any compliance deficiencies, it may submit a written plan ofcorrection and is given a reasonable opportunity to correct the deficiencies. There can be noassurance that, in the future, we will be able to maintain such licenses and certifications for ourfacilities or that we will not be required to expend significant sums in order to comply withregulatory requirements.*Medicare and Medicaid.*Medicare is a federally-funded and administered health insurance programfor the aged and for certain chronically disabled individuals. Part A of the Medicare programcovers inpatient hospital services and certain services furnished by other institutional providerssuch as skilled nursing facilities. Part B covers the services of doctors, suppliers of medicalitems, various types of outpatient services, and certain ancillary services of the type provided bylong term and acute care facilities. Medicare payments under Part A and Part B are subject tocertain caps and limitations, as provided in Medicare regulations. Medicare benefits are notavailable for intermediate and custodial levels of nursing home care, or for assisted livingfacility arrangements.Medicaid is a medical assistance program for the indigent, operated by individual states withfinancial participation by the federal government. Criteria for medical indigence and availableMedicaid benefits and rates of payment vary somewhat from state to state, subject to certainfederal requirements. Basic long-term care services are provided to Medicaid beneficiaries,including nursing, dietary, housekeeping and laundry and restorative health care services, room andboard, and medications. Previously, under legislation known as the Boren Amendment, federal lawrequired that Medicaid programs pay to nursing home providers amounts adequate to enable them tomeet government quality and safety standards. However, the BBA repealed the Boren Amendment, andthe BBA requires only that a state Medicaid program must provide for a public process fordetermination of Medicaid rates of payment for nursing facility services. Under this process,proposed rates, the methodologies underlying the establishment of such rates, and the justificationfor the proposed rates are published. This public process gives providers, beneficiaries andconcerned state residents a reasonable opportunity for review and comment. Certain of the statesin which we now operate are actively seeking ways to reduce Medicaid spending for nursing home careby such methods as capitated payments and substantial reductions in reimbursement rates.*HIPAA Compliance*. The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) hasmandated an extensive set of regulations to standardize electronic patient health, administrativeand financial data transactions, and to protect the privacy of individually identifiable healthinformation. We have a HIPAA Compliance Committee and designated privacy and security officers.The HIPAA transaction standards are intended to simplify the electronic claims process and otherhealthcare transactions by encouraging electronic transmission rather than paper submission. Theseregulations provide for uniform standards for data reporting, formatting and coding that we must usein certain transactions with health plans. The HIPAA security regulations establish detailedrequirements for safeguarding protected health information that is electronically transmitted orelectronically stored. Some of the security regulations are technical in nature, while others areaddressed through policies and procedures. We implemented or upgraded computer and informationsystems as we believed necessary to comply with the new regulations.
11

Table of Contents
The HIPAA regulations related to privacy establish comprehensive federal standards relating to theuse and disclosure of individually identifiable health information or protected health information.The privacy regulations establish limits on the use and disclosure of protected healthinformation, provide for patients’ rights, including rights to access, request amendment of, andreceive an accounting of certain disclosures of protected health information, and require certainsafeguards for protected health information. In addition, each covered entity must contractuallybind individuals and entities that furnish services to the covered entity or perform a function onits behalf, and to which the covered entity discloses protected health information, to restrictionson the use and disclosure of that information. In general, the privacy regulations do notsupersede state laws that are more stringent or grant greater privacy rights to individuals. Thus,we must reconcile the privacy regulations and other state privacy laws.Although we believe that we are in material compliance with these HIPAA regulations, the HIPAAregulations are expected to continue to impact us operationally and financially and may poseincreased regulatory risk.*Self-Referral and Anti-Kickback Legislation.*The health care industry is subject to state andfederal laws which regulate the relationships of providers of health care services, physicians, andother clinicians. These self-referral laws impose restrictions on physician referrals to anyentity with which they have a financial relationship, which is a broadly defined term. We believeour relationships with physicians are in compliance with the self-referral laws. Failure to complywith self-referral laws could subject us to a range of sanctions, including civil monetarypenalties and possible exclusion from government reimbursement programs. There are also federaland state laws making it illegal to offer anyone anything of value in return for referral ofpatients. These laws, generally known as “anti-kickback” laws, are broad and subject tointerpretations that are highly fact dependent. Given the lack of clarity of these laws, there canbe no absolute assurance that any health care provider, including us, will not be found inviolation of the anti-kickback laws in any given factual situation. Strict sanctions, includingfines and penalties, exclusion from the Medicare and Medicaid programs and criminal penalties, maybe imposed for violation of the anti-kickback laws.**Available Information.**We file reports with the Securities and Exchange Commission (“SEC”), including annual reports onForm 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K. Copies of our reportsfiled with the SEC may be obtained by the public at the SEC’s Public Reference Room by calling theSEC at 1-800-SEC-0330. We file such reports with the SEC electronically, and the SEC maintains anInternet site at www.sec.gov that contains our reports, proxy and information statements, and otherinformation filed electronically. We also make available, free of charge through our website, ourannual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and othermaterials filed with the SEC as soon as reasonably practicable after such material iselectronically filed with or furnished to the SEC. Our website address is www.irinfo.com/AVC. Theinformation provided on our website is not part of this report, and is therefore not incorporatedby reference unless such information is otherwise specifically referenced elsewhere in this report.**ITEM 1A. RISK FACTORS**There have been a number of material developments both within the Company and the long-term careindustry. These developments have had and are likely to continue to have a material impact on us.This section summarizes these developments, as well as other risks, that should be considered byour shareholders and prospective investors.
12

Table of Contents
*We are substantially self-insured and have significant potential professional liability exposure.*The provision of health care services entails an inherent risk of liability. Participants in thehealth care industry are subject to an increasing number of lawsuits alleging malpractice, productliability, or related legal theories, many of which involve large claims and significant defensecosts. The entire long-term care profession in the United States has experienced a dramaticincrease in claims related to alleged negligence in providing care to its patients and we are noexception in this regard. We have numerous pending liability claims, disputes and legal actionsfor professional liability and other related issues. We expect to continue to be subject to suchsuits as a result of the nature of our business. See “Item 3. Legal Proceedings.” for furtherdescriptions of pending claims, and see “Item 7. Management’s Discussion and Analysis of FinancialCondition – Accounting Policies and Judgments – Professional Liability and Other Self-InsuranceReserves.” for discussion of our reserve for self-insured claims and of our ability to meet ouranticipated cash needs.Due to our past claims experience and increasing cost of claims throughout the long-term careindustry, the premiums we pay for professional liability and other liability insurance to coverfuture periods exceeds the coverage purchased so that it costs more than $1 to purchase $1 ofinsurance coverage. For this reason, effective March 9, 2001, we have purchased professionalliability insurance coverage for our facilities that, based on historical claims experience, islikely to be substantially less than the claims we expect to incur. We have exhausted all of ourinsurance coverage for claims asserted prior to March 7, 2007. For claims made during the periodfrom March 10, 2007 through March 9, 2008, the Company maintains insurance with coverage limits of$100,000 per medical incident and total aggregate policy coverage limits of $500,000. As a result,we are effectively self-insured and expect to remain so for the foreseeable future.*We have significant deferred tax assets which we may not be able to realize.*We have net deferred tax assets of $23.6 million included in our balance sheet as of December 31,2006. Our ability to realize these deferred tax assets depends on our future taxable income. Wereported taxable income for 2004 and 2005. The sale of certain assets during 2006 will result in ataxable loss when our tax returns are filed. We expect future operations will continue to resultin taxable income that will allow these deferred tax assets to be realized. During 2006 wereversed $14.6 million in valuation allowances on our deferred tax assets in anticipation that wewill realize a larger portion of these assets based on our achieved earnings trend and outlook.However, no assurance can be given that we will be able to generate taxable income in futureperiods or realize these deferred tax assets.*We have had substantial downward adjustments to our accrual for professional liability claims whichhas caused significant increases in our net earnings.*In the years ended December 31, 2006, 2005 and 2004, we recorded downward adjustments in ouraccrual for self-insured risks associated with professional liability claims. While theseadjustments to the accrual resulted in reported income, they did not generate cash because theaccrual is not funded. These self-insurance reserves are assessed on a quarterly basis, withchanges in estimated losses being recorded in the consolidated statements of operations in theperiod identified. Any increase in the accrual decreases income in the period, and any reductionin the accrual increases income during the period. Our actual liabilities may vary significantlyfrom the accrual, and the amount of the accrual has and may continue to fluctuate by a materialamount in any given quarter. Each change in the amount of this accrual will directly affect ourreported earnings and financial position for the period in which the change in accrual is made. Noassurance can be given that the accrual will decline during 2007, and it may increase during thisperiod.
13

Table of Contents
*A substantial portion of our outstanding indebtedness is subject to floating rates of interestwhich could be subject to fluctuations based on changing interest rates.*We have $31.5 million of indebtedness at December 31, 2006, with $7.2 million classified as acurrent liability at December 31, 2006 based on payment terms. Approximately 92% of ourindebtedness consists of floating rate debt, which is at variable rates of interest and exposes usto interest rate risk. Interest rate risk is the risk of loss arising from adverse changes ininterest rates associated with variable rate borrowings. If interest rates increase, there ispotential that our debt service obligations would increase even though the amount borrowed woulddecrease or remain the same. In addition, certain of our debt agreements contain various financialcovenants, the most restrictive of which relate to cash flow, net income (loss), liquidity andlimits on the payment of dividends to shareholders. As of December 31, 2006, we were in compliancewith these financial covenants. Our failure to comply with those covenants could result in anevent of default, which, if not cured or waived, could result in the acceleration of some or all ofour debts. Such non-compliance could result in a material adverse impact to our financialposition, results of operations and cash flows. See “Item 7. Management’s Discussion and Analysisof Financial Condition and Results of Operations – Liquidity and Financial Resources.”*We are highly dependent on reimbursement by third-party payors.*Substantially all of our nursing center revenues are directly or indirectly dependent uponreimbursement from third-party payors, including the Medicare and Medicaid programs, and privateinsurers. For the year ended December 31, 2006, our patient revenues from continuing operationsderived from Medicaid, Medicare and private pay (including private insurers) sources wereapproximately 56.5%, 30.5%, and 13.0%, respectively. Changes in the mix of our patients amongMedicare, Medicaid and private pay categories and among different types of private pay sources mayaffect our net revenues and profitability. Our net revenues and profitability are also affected bythe continuing efforts of all payors to contain or reduce the costs of health care. Efforts toimpose reduced payments, greater discounts and more stringent cost controls by government and otherpayors are expected to continue.The federal Government makes frequent changes to the reimbursement provided under the Medicareprogram. These changes could reduce significantly the reimbursement we receive. Also, a number ofstate governments, including several of the states in which we operate, have announced projectedbudget shortfalls and/or deficit spending situations. In addition, the President’s proposed budgetcalls for a significant reduction in the amount of Federal funds provided to the state Medicaidsystems. Possible actions by these states include reductions of Medicaid reimbursement toproviders such as us or the failure to increase Medicaid reimbursements to cover increasedoperating costs.Any changes in reimbursement levels or in the timing of payments under Medicare, Medicaid orprivate pay programs and any changes in applicable government regulations could have a materialadverse effect on our net revenues, net income and cash flows. We are unable to predict whatreform proposals or reimbursement limitations will be adopted in the future or the effect suchchanges will have on our operations. No assurance can be given that such reforms will not have amaterial adverse effect on us. See “Item 1. Business – Government Regulation and Reimbursement.”*We are subject to significant government regulation.*The health care industry is subject to numerous laws and regulations of federal, state and localgovernments. These laws and regulations include, but are not necessarily limited to, matters suchas licensure, accreditation, government health care program participation requirements,reimbursement for patient services, quality of resident care and Medicare and Medicaid fraud andabuse. Various federal and state laws regulate relationships among providers of services,including employment or service contracts and investment relationships. The operation of long-termcare centers and the provision of services are also subject to extensive federal, state, and locallaws relating to, among other things, the adequacy of medical care, distribution ofpharmaceuticals, equipment, personnel, operating policies,
14

Table of Contents
environmental compliance, compliance with the Americans with Disabilities Act, fire prevention andcompliance with building codes.Long-term care facilities are also subject to periodic inspection to assure continued compliancewith various standards and licensing requirements under state law, as well as with Medicare andMedicaid conditions of participation. The failure to obtain or renew any required regulatoryapprovals or licenses could adversely affect our growth and could prevent us from offering ourexisting or additional services. In addition, health care is an area of extensive and frequentregulatory change. Changes in the laws or new interpretations of existing laws can have asignificant effect on methods and costs of doing business and amounts of payments received fromgovernmental and other payors. Our operations could be adversely affected by, among other things,regulatory developments such as mandatory increases in the scope and quality of care to be affordedpatients and revisions in licensing and certification standards. We attempt at all times to complywith all applicable laws; however, there can be no assurance that new legislation or administrativeor judicial interpretation of existing laws or regulations will not have a material adverse effecton our operations or financial condition. Changes in these laws and regulations, such asreimbursement policies of Medicare and Medicaid programs as a result of budget cuts by federal andstate governments or other legislative and regulatory actions, have had a material adverse effecton the profession and our consolidated financial position, results of operations, and cash flows.Future federal budget legislation, federal or state regulatory actions seeking to impose fines andpenalties, and federal and state regulatory changes may negatively impact us. See “Item 1.Business – Government Regulation.” See also “Item 3, Legal Proceedings.”*The health care industry has been the subject of increased regulatory scrutiny recently.*The Office of Inspector General (“OIG”), the enforcement arm of the Medicare program, formulates aformal work plan each year for nursing homes. The OIG’s most recent work plan indicates thataccess to care, quality of care, survey deficiencies, compliance with minimum data set reporting,resident assessment and care planning, and the medical necessity of services billed will be aninvestigative focus in 2007. We cannot predict the likelihood, scope or outcome of any suchinvestigations on our facilities.*We are subject to claims under the self-referral and anti-kickback legislation.*In the United States, various state and federal laws regulate the relationships between providersof health care services, physicians, and other clinicians. These self-referral laws imposerestrictions on physician referrals for designated health services to entities with which they havefinancial relationships. These laws also prohibit the offering, payment, solicitation or receiptof any form of remuneration in return for the referral of Medicare or state health care programpatients or patient care opportunities for the purchase, lease or order of any item or service thatis covered by the Medicare and Medicaid programs. To the extent that we, any of our facilitieswith which we do business, or any of the owners or directors have a financial relationship witheach other or with other health care entities providing services to long-term care patients, suchrelationships could be subject to increased scrutiny. There can be no assurance that ouroperations will not be subject to review, scrutiny, penalties or enforcement actions under theselaws, or that these laws will not change in the future. Violations of these laws may result insubstantial civil or criminal penalties for individuals or entities, including large civil monetarypenalties and exclusion from participation in the Medicare or Medicaid programs. Such exclusion orpenalties, if applied to us, could have a material adverse effect on our profitability.*We operate in an industry that is highly competitive*.The long-term care industry generally, and the nursing home business particularly, is highlycompetitive. We face direct competition for the acquisition of facilities. In turn, our facilitiesface competition for employees, patients and residents. Some of our present and potentialcompetitors are significantly larger and have or may obtain greater financial and marketingresources than we can. Some hospitals that provide long-term care services are also a potentialsource of competition. In addition, we may encounter
15

Table of Contents
substantial competition from new market entrants. Consequently, there can be no assurance that wewill not encounter increased competition in the future, which could limit our ability to attractpatients or residents or expand our business, and could materially and adversely affect ourbusiness or decrease our market share.*We have a number of policies in place that could be considered anti-takeover protections*.We have adopted a Shareholder Rights Plan (the “Plan”). In March 2005, the Board of Directorsamended the Plan to extend the expiration date of the Plan to March 20, 2010 and change theexercise price of the rights under the Plan to $15. The Plan is intended to encourage potentialacquirers to negotiate with our Board of Directors and to discourage coercive, discriminatory andunfair proposals. Our Certificate of Incorporation (the “Certificate”) provides for theclassification of our Board of Directors into three classes, with each class of directors servingstaggered terms of three years. Our Certificate requires the approval of two-thirds of theoutstanding shares to amend certain provisions of the Certificate. Section 203 of the DelawareGeneral Corporate Law restricts the ability of a Delaware corporation to engage in any businesscombination with an interested shareholder. We are also authorized to issue up to 795,000 sharesof preferred stock, the rights of which may be fixed by the Board of Directors without shareholderapproval. Provisions in certain of our executive officers’ employment agreements provide forpost-termination compensation, including payment of amounts up to 2.5 times their annual salary,following certain changes in control. Our stock incentive plans provide for the acceleration ofthe vesting of options in the event of certain changes in control (as defined in such plans).Certain changes in control also constitute an event of default under our bank credit facility. Theforegoing matters may, together or separately, have the effect of discouraging or making moredifficult an acquisition or change of control of us.**ITEM 1B. UNRESOLVED STAFF COMMENTS**None.**ITEM 2. PROPERTIES**We own 9 and lease 34 long-term care facilities. A description of our lease agreements follows.**Description of Lease Agreements.**Our current operations include 34 nursing centers subject to operating leases, including 33 ownedor financed by Omega Healthcare Investors, Inc. (“Omega”) and one owned by another party. In ourrole as lessee, we are responsible for the day-to-day operations of all operated centers. Theseresponsibilities include recruiting, hiring, and training all nursing and other personnel, andproviding resident care, nutrition services, marketing, quality improvement, accounting, and dataprocessing services for each facility. The lease agreements pertaining to our 34 leased facilitiesare “triple net” leases, requiring us to maintain the premises, pay taxes and pay for allutilities. The leases typically provide for an initial term of 4 to 10 years with renewal optionsup to 12 years. The average remaining term of our lease agreements, including renewal options, isapproximately 21 years.*Omega Master Lease.*We lease 29 nursing centers from Omega pursuant to one lease agreement datedOctober 1, 2000 (the “Omega Master Lease”). All of the accounts receivable, equipment, inventoryand other assets of the facilities leased have been pledged as security under the Omega MasterLease. The initial term of the Omega Master Lease was ten years, expiring September 30, 2010.
16

Table of Contents
On October 20, 2006 we entered into a Third Amendment to Consolidated Amended and Restated MasterLease (“Lease Amendment”) with Omega to extend the term of the Omega Master Lease. The amendedmaster lease commenced on October 1, 2006, and extends to September 30, 2018. The Lease Amendmentalso provides for a renewal option of an additional twelve years, assuming no defaults. Consistentwith prior terms, the lease provides for annual increases in lease payments equal to the lesser oftwo times the increase in the consumer price index or 3.0%.Lease payments were $12.9 million for the year ended December 31, 2006. The Omega Master Leaserequires us to fund annual capital expenditures equal to $325 per licensed bed, subject toadjustment for increases in the Consumer Price Index (annual required capital expenditures of $0.7million in 2007). Upon expiration of, or in the event of a default under the Omega Master Lease,we are required to transfer all of the leasehold improvements, equipment, furniture and fixtures ofthe leased facilities to Omega.The 2006 Lease Amendment together with an earlier amendment in 2005 provide for additionalfinancing of up to $10 million to be used to fund renovations to several nursing centers leasedfrom Omega. The renovations will be completed before June 30, 2008. The annual base rent relatedto these facilities will be increased to reflect the amount of capital improvements made to therespective facilities. The amendments also included provisions to amend certain professionalliability insurance requirements in order to cure certain defaults under the Omega Master Lease.The Omega Master Lease prohibits us from operating any additional facilities within a certainradius of each leased facility. We are generally required to maintain comprehensive insurancecovering the facilities we lease as well as personal and real property damage insurance andprofessional liability insurance. The failure to pay rentals within a specified period or tocomply with the required operating and financial covenants, including insurance coverage, generallyconstitutes a default, which default, if uncured, permits Omega to terminate the lease and assumethe property and the contents within the facilities.*Florida Leases.*Effective April 1, 2003, we entered into leases for four nursing centers inFlorida that had previously been managed by us under management contracts. Accordingly, the resultsof operations of these facilities are included in our results of operations beginning April 1,2003. Omega holds mortgages on these properties and we make the lease payments directly to Omega.In December 2005, we extended the term of the leases through February 2010. Lease payments will be$1.6 million during 2007, with increases equal to the lesser of two times the consumer price indexor 3.0% in subsequent years. We are also required to fund annual capital expenditures equal to$350 per licensed bed over the initial lease term, subject to adjustment for increases in theConsumer Price Index.*Other Leases.*We lease approximately 25,000 square feet of office space in Brentwood, Tennessee,that houses our executive offices, centralized management support functions, and the ancillaryservices supply operations. In addition, we lease our regional office with approximately 4,000square feet of office space in Ashland, Kentucky. Lease periods on these facilities generallyrange up to seven years. Regional executives for Alabama, Arkansas, Florida, Tennessee and Texaswork from offices of up to 1,500 square feet each. We believe that our leased properties areadequate for our present needs and that suitable additional or replacement space will be availableas required.**ITEM 3. LEGAL PROCEEDINGS**The provision of health care services entails an inherent risk of liability. Participants in thehealth care industry are subject to an increasing number of lawsuits alleging malpractice, productliability, or related legal theories, many of which involve large claims and significant defensecosts. The entire long-term care profession in the United States has experienced a dramaticincrease in claims related to alleged negligence in providing care to its patients and we are noexception in this regard. We have numerous
17

Table of Contents
pending liability claims, disputes and legal actions for professional liability and other relatedissues. It is expected that we will continue to be subject to such suits as a result of thenature of our business. Further, as with all health care providers, we are periodically subject toregulatory actions seeking fines and penalties for alleged violations of health care laws and arepotentially subject to the increased scrutiny of regulators for issues related to compliance withhealth care fraud and abuse laws.As of December 31, 2006, we are engaged in 18 professional liability lawsuits. Three of thesematters are currently scheduled for trial within the next year. The ultimate results of any of ourprofessional liability claims and disputes cannot be predicted. We have limited, and sometimes no,professional liability insurance with regard to most of these claims. A significant judgmententered against us in one or more of these legal actions could have a material adverse impact onour financial position and cash flows.We cannot currently predict with certainty the ultimate impact of any of the above cases on ourfinancial condition, cash flows or results of operations. An unfavorable outcome in any of thelawsuits, any regulatory action, any investigation or lawsuit alleging violations of fraud andabuse laws or of elderly abuse laws or any state or Federal False Claims Act case could have amaterial adverse impact on our financial condition, cash flows or results of operations and couldalso subject us to fines, penalties and damages. Moreover, we could be excluded from the Medicare,Medicaid or other state or federally-funded health care programs, which would also have a materialadverse impact on our financial condition, cash flows or results of operations.**ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**There were no matters submitted to a vote of security holders during the fourth quarter(October 1, 2006 through December 31, 2006) of the fiscal year covered by this Annual Report onForm 10-K.
18

Table of Contents
**PART II****ITEM 5.** **MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASESOF EQUITY SECURITIES**Our Common Stock was listed on the New York Stock Exchange under the symbol “AVC” through November9, 1999. From that time through September 11, 2006, our Common Stock was traded on NASD’s OTCBulletin Board under the symbol “AVCA.” During the third quarter of 2006, our common stock shareswere approved for listing on the NASDAQ Capital Market and began trading there on September 12,2006 under the symbol “AVCA.” The following table sets forth the high and low bid prices of thecommon stock for each quarter in 2005 and 2006:             Period High Low2005 - 1st Quarter  5.50   4.20 2005 - 2nd Quarter  5.09   3.40 2005 - 3rd Quarter  4.90   3.80 2005 - 4th Quarter  5.77   3.76              2006 - 1st Quarter  9.40   5.25 2006 - 2nd Quarter  17.80   8.85 2006 - 3rd Quarter  20.49   13.50 2006 - 4th Quarter  21.03   15.23 Our Common Stock has been traded since May 10, 1994. On March 2, 2007, the closing price for ourCommon Stock was $12.20, as reported by NASDAQ.com.On March 2, 2007, there were approximately 286 holders of record of the Common Stock. Most of ourshareholders have their holdings in the street name of their broker/dealer.We have not paid cash dividends on our Common Stock and anticipate that, for the foreseeablefuture, any earnings will be retained for use in our business and no cash dividends will be paid.We are currently prohibited from issuing dividends under certain of our debt instruments.We made no purchases of our stock during the fourth quarter of the year ended December 31, 2006.**ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA**The selected financial data of Advocat presented in the following table have been derived from ourfinancial statements, and should be read in conjunction with the annual financial statements andrelated Notes and Management’s Discussion and Analysis of Financial Condition and Results ofOperations. This selected financial data for all periods shown have been reclassified to presentthe effects of certain divestitures as discontinued operations.
19

Table of Contents
                       **Year Ended December 31,**   **2006**  **2005**  **2004**  **2003**  **2002** **Statement of Operations Data** **(in thousands, except per share amounts)** REVENUES:                    Patient revenues, net $216,763  $203,658  $191,224  $172,226  $150,232                 EXPENSES:                    Operating  165,300   155,512   147,842   135,479   114,827 Lease  16,082   15,836   15,283   14,883   13,684 Professional liability  (4,840)  (3,962)  (1,834)  15,154   15,054 General and administrative  15,975   13,311   11,692   10,628   10,705 Stock based compensation  5,184   —   —   —   — Depreciation  3,650   3,493   3,228   3,170   3,077 Asset impairment and othercharges  —   —   219   177   970                    201,351   184,190   176,430   179,491   158,317                 OPERATING INCOME (LOSS)  15,412   19,468   14,794   (7,265)  (8,085)                OTHER INCOME (EXPENSE):                    Foreign currency transactiongain  21   161   784   —   — Other income  207   —   —   —   — Interest income  679   534   286   102   17 Interest expense  (3,707)  (3,382)  (3,069)  (3,091)  (3,717)Debt retirement costs  (194)  —   —   —   —                    (2,994)  (2,687)  (1,999)  (2,989)  (3,700)                INCOME (LOSS) FROM CONTINUINGOPERATIONS BEFORE INCOME TAXES  12,418   16,781   12,795   (10,254)  (11,785)PROVISION (BENEFIT) FORINCOME TAXES  (9,496)  (13,820)  266   —   (387)                NET INCOME (LOSS) FROMCONTINUING OPERATIONS  21,914   30,601   12,529   (10,254)  (11,398)DISCONTINUED OPERATIONS,net of taxes  30   (5,299)  (9,748)  (967)  (1,605)                NET INCOME (LOSS) $21,944  $25,302  $2,781  $(11,221) $(13,003)                                     INCOME (LOSS) PER COMMONSHARE:                    Basic-                    Continuing operations  $3.73  $5.29  $2.16  $(1.92) $(2.12)Discontinued operations   0.01   (0.93)  (1.72)  (0.17)  (0.30)                Net per common share $3.74  $4.36  $0.44  $(2.09) $(2.42)                Diluted-                    Continuing operations  $3.34  $4.69  $1.93  $(1.92) $(2.12)Discontinued operations   0.01   (0.81)  (1.51)  (0.17)  (0.30)                Net per common share $3.35  $3.88  $0.42  $(2.09) $(2.42)                                     WEIGHTED AVERAGECOMMON SHARES:                    Basic  5,784   5,725   5,660   5,493   5,493                 Diluted  6,507   6,498   6,437   5,493   5,493                 
20

Table of Contents
                       **December 31,**  **2006** **2005** **2004** **2003** **2002****Balance Sheet Data**         **(in thousands)**        Working capital (deficit) $8,179  $(39,970) $(45,489) $(54,302) $(58,845)Total assets $96,901  $93,762  $72,392  $94,934  $88,871 Short-term borrowings andlong-term debt includingcurrent portion $31,516  $47,547  $47,024  $52,544  $53,926 Preferred Stock – Series B  —  $4,750  $4,432  $4,135  $3,858 Preferred Stock – Series C(including unamortizedpremium) $11,289   —   —   —   — Shareholders’ Equity (deficit) $3,837  $(16,870) $(41,854) $(42,759) $(33,828)**ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS****Overview**Advocat Inc. provides long-term care services to nursing center patients in eight states, primarilyin the Southeast. Our centers provide a range of health care services to their patients andresidents. In addition to the nursing, personal care and social services usually provided inlong-term care centers, we offer a variety of comprehensive rehabilitation services as well asnutritional support services.As of December 31, 2006, our continuing operations consist of 43 nursing centers with 4,505licensed nursing beds and 66 assisted living units. As of December 31, 2006, our continuingoperations include nine owned nursing centers and 34 leased nursing centers.*Divestitures.*We have undertaken several divestitures through sale of assets and leaseterminations. The divested operations have generally been poor performing properties. In May2006, we completed the sale of certain assets of eleven assisted living facilities located in NorthCarolina for a sales price of $11.0 million. We closed one remaining North Carolina assistedliving facility in April 2006, and are continuing our efforts to sell this facility and land. InFebruary 2005, we sold two nursing centers in Texas. A lease covering three nursing centers inTexas expired in December 2004 and was not renewed. In November 2004, we sold certain assets ofour medical supply business, Advocat Distribution Services. In May 2004, we sold the stock of ourCanadian subsidiary, Diversicare Canada Management Services Co., Inc. (“DCMS”).In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting forthe Impairment or Disposal of Long-Lived Assets,” our consolidated financial statements have beenreclassified to reflect these divestitures as discontinued operations.*Basis of Financial Statements.*Our patient revenues consist of the fees charged for the care ofpatients in the nursing centers we own and lease. Our operating expenses include the costs, otherthan lease, depreciation and amortization expenses, incurred in the operation of the nursingcenters we owned and leased. Our general and administrative expenses consist of the costs of thecorporate office and regional support functions. Our depreciation and interest expenses include allsuch expenses across the range of our operations.
21

Table of Contents
**Selected Financial and Operating Data**The following table summarizes the Advocat statements of continuing operations for the years endedDecember 31, 2006, 2005 and 2004, and sets forth this data as a percentage of revenues for the sameyears.                           **Year Ended December 31,**   **(Dollars in thousands)**   **2006**  **2005**  **2004** Revenues:                        Patient revenues, net $216,763   100.0% $203,658   100.0% $191,224   100.0%                   Expenses:                        Operating  165,300   76.3   155,512   76.4   147,842   77.3 Lease  16,082   7.4   15,836   7.8   15,283   8.0 Professional liability  (4,840)  (2.2)  (3,962)  (2.0)  (1,834)  (0.9)General & administrative  15,975   7.4   13,311   6.5   11,692   6.1 Stock based compensation  5,184   2.4   —   —   —   — Depreciation  3,650   1.6   3,493   1.7   3,228   1.7 Asset impairment andother charges  —   —   —   —   219   0.1                       201,351   92.9   184,190   90.4   176,430   92.3                    Operating income  15,412   7.1   19,468   9.6   14,794   7.7                    Other income (expense):                        Foreign currency transactiongain  21   0.0   161   0.1   784   0.4 Other Income  207   0.1   —   —   —   — Interest income  679   0.3   534   0.2   286   0.2 Interest expense  (3,707)  (1.7)  (3,382)  (1.7)  (3,069)  (1.6)Debt retirement costs  (194)  (0.1)  —   —   —   —                       (2,994)  (1.4)  (2,687)  (1.4)  (1,999)  (1.0)                   Income from continuingoperations before incometaxes  12,418   5.7   16,781   8.2   12,795   6.7 Provision (benefit) for incometaxes  (9,496)  (4.4)  (13,820)  (6.8)  266   0.1                    Net income fromcontinuing operations $21,914   10.1% $30,601   15.0% $12,529   6.6%                   
22

Table of Contents
The following table presents data about the facilities we operated as part of our continuingoperations as of the dates or for the years indicated:               **December 31,**  **2006** **2005** **2004**Licensed Nursing Home Beds:            Owned  942   942   822 Leased  3,563   3,563   3,683              Total  4,505   4,505   4,505              Assisted Living Units:            Owned  17   17   17 Leased  49   61   63              Total  66   78   80              Total Beds/Units:            Owned  959   959   839 Leased  3,612   3,624   3,746              Total  4,571   4,583   4,585              Facilities:            Owned  9   9   8 Leased  34   34   35              Total  43   43   43              Average Occupancy:            Nursing centers  77.9%  76.2%  75.9%Assisted living units  64.1   64.6   69.4              Total  77.7%  76.0%  75.8%             **Critical Accounting Policies and Judgments**A “critical accounting policy” is one which is both important to the understanding of our financialcondition and results of operations and requires management’s most difficult, subjective or complexjudgments often of the need to make estimates about the effect of matters that are inherentlyuncertain. Our accounting policies that fit this definition include the following:Revenues***Patient Revenues***The fees we charge patients in our nursing centers are recorded on an accrual basis. These ratesare contractually adjusted with respect to individuals receiving benefits under federal andstate-funded programs and other third-party payors. Rates under federal and state-funded programsare determined prospectively for each facility and may be based on the acuity of the care andservices provided. These rates may be based on facility’s actual costs subject to programceilings and other limitations or on established rates based on acuity and services provided asdetermined by the federal and state-funded programs. Amounts earned under federal and stateprograms with respect to nursing home patients are subject to review by the third-party payorswhich may result in retroactive adjustments. In the opinion of management, adequate provisionhas been made for any adjustments that may result from such reviews. Retroactive adjustments, ifany, are recorded when objectively determinable, generally within three years of the close of areimbursement year depending upon the timing of appeals and third-party settlement reviews oraudits.
23

Table of Contents
***Allowance for Doubtful Accounts***Our allowance for doubtful accounts is estimated utilizing current agings of accounts receivable,historical collections data and other factors. We monitor these factors and determine theestimated provision for doubtful accounts. Historical bad debts have generally resulted fromuncollectible private balances, some uncollectible coinsurance and deductibles and other factors.Receivables that are deemed to be uncollectible are written off. The allowance for doubtfulaccounts balance is assessed on a quarterly basis, with changes in estimated losses beingrecorded in the consolidated statements of operations in the period identified.Professional Liability and Other Self-Insurance ReservesSelf-insurance reserves primarily represent the accrual for self-insured risks associated withgeneral and professional liability claims, employee health insurance and workers compensation.Our health insurance reserve is based on known claims incurred and an estimate of incurred butunreported claims determined by an analysis of historical claims paid. Our workers compensationreserve relates primarily to periods of self insurance prior to May 1997 and consists of anestimate of the future costs to be incurred for the known claims. Expected insurance coveragesare reflected as a reduction of the reserves. All of our self-insurance reserves are assessedand adjusted on a quarterly basis.*Accrual for Professional and General Liability Claims-*Because our actual liability for existing and anticipated professional liability and generalliability claims will exceed our limited insurance coverage, we have recorded total liabilitiesfor reported professional liability claims and estimates for incurred but unreported claims of$25.7 million as of December 31, 2006. This accrual includes estimates of liability for incurredbut not reported claims, estimates of liability for reported but unresolved claims, actualliabilities related to settlements, including settlements to be paid over time, and estimates ofrelated legal costs incurred and expected to be incurred. All losses are projected on anundiscounted basis.We retain a third-party actuarial firm to estimate the appropriate accrual for incurred generaland professional liability claims. For current periods, the actuary primarily uses historicaldata regarding the frequency and cost of our past claims over a multi-year period and informationregarding our number of occupied beds to develop its estimates of our ultimate professionalliability cost for current periods. The actuary estimates our professional liability accrual forpast periods by using currently-known information to adjust the initial reserve that was createdfor that period.On a quarterly basis, we obtain reports of claims and lawsuits that we have incurred frominsurers and a third party claims administrator. These reports contain information relevant tothe liability actually incurred to date with that claim as well as the third-partyadministrator’s estimate of the anticipated total cost of the claim. This information isreviewed by us and provided to the actuary. The actuary uses this information to determine thetiming of claims reporting and the development of reserves, and compares the information obtainedto its original estimates of liability. Based on the actual claim information obtained and onestimates regarding the number and cost of additional claims anticipated in the future, thereserve estimate for a particular prior period may be revised upward or downward on a quarterlybasis. Final determination of our actual liability for claims incurred in any given period is aprocess that takes years. The following summarizes our accrual for professional liability andother claims for each policy year as of the end of the period:
24

Table of Contents
          **December 31,** Policy Year End March 9, 2006  2005 2007 $6,992,000   — 2006  7,629,000  $10,492,000 2005  6,042,000   12,722,000 2004  3,228,000   6,351,000 2003  1,093,000   3,137,000 2002 and earlier  733,000   1,825,000          $25,717,000  $34,527,000        Although we retain a third-party actuarial firm to assist us, professional and generalliability claims are inherently uncertain, and the liability associated with anticipated claimsis very difficult to estimate. As a result, our actual liabilities may vary significantly fromthe accrual, and the amount of the accrual has and may continue to fluctuate by a material amountin any given quarter. Many factors could result in differences between amounts estimated and theultimate amount of our loss for any period. One of the key assumptions in the actuarial analysisis that historical losses provide an accurate forecast of future losses. This assumption may notprove accurate, as changes in legislation such as tort reform, changes in our financialcondition, changes in our risk management practices and other factors may affect the severity andfrequency of claims incurred in future periods as compared to historical claims. Another keyassumption is the limit of claims to a maximum of $4.5 million. The actuary has selected thislimit based on our historical data. While most of our claims have been for amounts less than the$4.5 million, there have been claims at higher amounts, and there may be claims above this levelin the future. The facts and circumstances of each claim vary significantly, and the amount ofultimate liability for an individual claim may vary due to many factors, including whether thecase can be settled by agreement, the quality of legal representation, the individualjurisdiction in which the claim is pending, and the views of the particular judge or jurydeciding the case. To date, we have not experienced an uninsured loss in excess of this limit.In the event that we believe we have incurred a loss in excess of this limit, an adjustment tothe reserves determined by the actuary would be necessary.We believe that the use of actuarial methods described above provides a valid and reasonablemethod to estimate our liability for professional and general liability claims and that theexpertise of a third- party actuary is required to estimate liabilities using this methodology.Each quarter, we record in our consolidated statement of operations for that period the estimatedaccrual for anticipated liability claims incurred in that period as well as any revisions inestimates and differences between actual settlements and accruals for prior periods. While eachquarterly adjustment to the recorded liability for professional liability claims affects reportedincome, these changes do not directly affect our cash position because the accrual for theseliabilities is not funded. A significant judgment entered against us in one or more of theselegal actions could have a material adverse impact on our financial position and cash flows.Professional liability costs are material to our financial position, and differences betweenestimates and the ultimate amount of loss may cause a material fluctuation in our reportedresults of operations. The liability recorded at December 31, 2006, was $25.7 million, comparedto current assets of $37.8 million and total assets of $96.9 million. For the years endedDecember 31, 2006, 2005 and 2004, our professional liability expense was negative $4.8 million,negative $4.0 million and negative $1.8 million, respectively, with negative amounts representingnet benefits resulting from downward revisions in previous estimates. These amounts are materialin relation to our reported net income from continuing operations for the related periods of$21.9 million, $30.6 million and $12.5 million, respectively.
25

Table of Contents
*Accrual for Other Self-Insured Claim*s**-**With respect to workers’ compensation insurance, substantially all of our employees becamecovered under either an indemnity insurance plan or state-sponsored programs in May 1997. We arecompletely self-insured for workers compensation exposures prior to May 1997. We have been andremain a non-subscriber to the Texas workers’ compensation system and are, therefore, completelyself-insured for employee injuries with respect to our Texas operations. We have providedreserves for the settlement of outstanding self-insured claims at amounts believed to beadequate. The liability we recorded for the self-insured obligations under these plans is $0.5million as of December 31, 2006.Effective June 30, 2003, we entered into workers compensation insurance programs that providecoverage for claims incurred, with premium adjustments depending on incurred losses. We accountfor premium expense under these policies based on our estimate of the level of claims expected tobe incurred. As of December 31, 2006, we have recorded estimated premium refunds due under theseprograms totaling approximately $3.5 million, included in “insurance refunds receivable” in theaccompanying balance sheet. Any adjustments of future premiums for workers compensation policiesand differences between actual settlements and reserves for self-insured obligations are includedin expense in the period finalized.We are self-insured for health insurance benefits for certain employees and dependents foramounts up to $150,000 per individual annually. We provide reserves for the settlement ofoutstanding self-insured health claims at amounts believed to be adequate. The liability forreported claims and estimates for incurred but unreported claims is $0.9 million at December 31,2006. The differences between actual settlements and reserves are included in expense in theperiod finalized.Asset ImpairmentIn accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting forthe Impairment or Disposal of Long-Lived Assets,” we evaluate the recoverability of the carryingvalues of our properties on a property by property basis. On a quarterly basis, we review ourproperties for recoverability when events or circumstances, including significant physical changesin the property, significant adverse changes in general economic conditions, and significantdeteriorations of the underlying cash flows of the property, indicate that the carrying amount ofthe property may not be recoverable. The need to recognize an impairment is based on estimatedfuture cash flows from a property compared to the carrying value of that property. If recognitionof an impairment is necessary, it is measured as the amount by which the carrying amount of theproperty exceeds the fair value of the property.Stock-Based CompensationBeginning January 1, 2006, we adopted SFAS No. 123R, “Share-Based Payment,” using the modifiedprospective method, in which we recognize compensation cost for all share-based payments grantedafter the effective date. We recorded stock-based compensation expense and estimated ourunrecognized stock-based compensation that we will recognize on a straight-line basis over theremaining vesting period. We calculated the recognized and unrecognized stock-based compensationusing the Black-Scholes-Merton option valuation method, which requires us to use certain keyassumptions to develop the fair value estimates. These key assumptions include expectedvolatility, risk-free interest rate, expected dividends and expected term.
26

Table of Contents
Income TaxesWe follow SFAS No. 109, “Accounting for Income Taxes,” which requires an asset and liabilityapproach for financial accounting and reporting of income taxes. Under this method, deferred taxassets and liabilities are determined based upon differences between financial reporting and taxbases of assets and liabilities and are measured using the enacted tax laws that will be in effectwhen the differences are expected to reverse. We assess the need for a valuation allowance toreduce the deferred tax assets by the amount we believe is more likely not to be utilized throughthe turnaround of existing temporary differences, future earnings, or a combination thereof,including certain net operating loss carryforwards we do not expect to realize due to change inownership limitations.**Contractual Obligations and Commercial Commitments**We have certain contractual obligations of continuing operations as of December 31, 2006,summarized by the period in which payment is due, as follows (dollar amounts in thousands):                           **Less than** **2 to 3** **4 to 5** **After****Contractual Obligations** **Total** **1 year** **Years** **Years** **5 Years**Long-term and short-term debtobligations (1) $41,581  $9,847  $6,920  $24,814  $— Settlement promissory notes (2) $129  $129  $—  $—  $— Other settlement obligations $608  $608  $—  $—  $— Series C Preferred Stock (3) $6,209  $344  $689  $5,176  $— Elimination of Preferred StockConversion feature (4) $8,070  $687  $1,374  $1,374  $4,635 Operating leases $495,485  $16,117  $33,957  $32,894  $412,517 Required capital expendituresUnder mortgage loans (5) $1,837  $888  $562  $387  $— Required capital expendituresunder operating leases (6) $22,185  $823  $1,646  $1,485  $18,231 Total $576,104  $29,443  $45,148  $66,130  $435,383  (1) Long-term and short-term debt obligations include scheduled future paymentsof principal and interest of long-term and short-term debt. (2) Settlement promissory note obligations include principal and interest oflong-term debt. (3) Series C Preferred Stock includes quarterly dividend payments and redemptionvalue at preferred shareholder’s earliest redemption date. (4) Payments for the elimination of preferred stock conversion feature – See“Liquidity and Capital Resources.” (5) Includes annual expenditure requirements for capital maintenance under mortgageloan covenants as well as $0.6 million for planned facility renovation in accordance withloan agreement. (6) Includes annual capital expenditure requirements under operating leases.We have employment agreements with certain members of management that provide for the paymentto these members of amounts up to 2.5 times their annual salary in the event of a terminationwithout cause, a constructive discharge (as defined), or upon a change of control of the Company(as defined). The maximum contingent liability under these agreements is approximately $1.8million. The terms of such agreements are from one to three years and automatically renew for oneyear if not terminated by us or the employee. In addition, upon the occurrence of any triggeringevent, certain executives may elect to require that we purchase options granted to them for apurchase price equal to the difference in the fair market value of our common stock at the date oftermination versus the stated option exercise price. Based on the closing price of our stock onDecember 31, 2006, the maximum contingent liability for the repurchase of the currently vestedoptions is approximately $2.9 million. No amounts have been accrued for this contingent liability.
27

Table of Contents
**Asset Impairment and Other Charges**In 2005 and 2004, we recorded asset impairment and other charges as shown below. No assetimpairment charges were recorded in 2006.           **2005**  **2004** Impairment of long-lived assets $4,397,000  $8,419,000 Lease terminations  —   341,000           4,397,000   8,760,000 Less – amount included indiscontinued operations  4,397,000   8,541,000        Asset impairment and other chargesincluded in continuing operations $—  $219,000        In 2005 and 2004, we recorded asset impairment charges of $4,397,000 and $8,419,000, respectively,for the impairment of certain long-lived assets in accordance with the provisions of SFAS 144. Adetail of the impaired asset charges is as follows:         **Description of Impairment** **2005**  **2004** Assisted Living Facilities Impairment Charges –As a result of projected cash flows, impairmentcharges were recorded in 2005 for elevenassisted living facilities and were recorded in2004 for six owned assisted living facilities. $4,397,000  $7,500,000          Nursing Center Impairment charges – As a resultof projected cash flows, impairment chargeswere recorded in 2004 for five nursing centers,including three leased and two ownedfacilities.  —   919,000                 Total impaired asset charges $4,397,000  $8,419,000        We terminated facility leases for three nursing centers in 2004. We incurred lease terminationcharges of approximately $341,000 in 2004 consisting of the remaining net book value of thesefacilities, costs of completing the transactions and settlement charges.**Payor Sources.**We classify our revenues from patients and residents into three major categories: Medicaid,Medicare and private pay. In addition to traditional Medicaid revenues, we include within theMedicaid classification revenues from other programs established to provide benefits to those inneed of financial assistance in the securing of medical services. Medicare revenues includerevenues received under both Part A and Part B of the Medicare program. We classify payments fromindividuals who pay directly for services without government assistance as private pay revenue. Theprivate pay classification also includes revenues from commercial insurers, HMOs, and othercharge-based payment sources. Veterans Administration payments are included in private pay and aremade pursuant to renewable contracts negotiated with these payors.
28

Table of Contents
Medicare represented approximately 30.5%, 30.0%, and 29.3% of our net revenues during 2006, 2005,and 2004, respectively. Approximately 56.5%, 58.0%, and 59.4% of our net revenues were derivedfrom Medicaid during 2006, 2005, and 2004, respectively. Private pay represented approximately13.0%, 12.0% and 11.3% of our net revenues during 2006, 2005, and 2004, respectively.Consistent with the nursing home industry in general, changes in the mix of a facility’s patientpopulation among Medicaid, Medicare, and private pay can significantly affect the profitability ofthe facility’s operations.**Results of Operations**The following tables present interim statements of operations and related data for the years endedDecember 31, 2006, 2005 and 2004:                 **(in thousands)** **Year Ended December 31,**   **2006**  **2005**  **Change**  **%** PATIENT REVENUES, net $216,763  $203,658  $13,105   6.4 EXPENSES:                Operating  165,300   155,512   9,788   6.3 Lease  16,082   15,836   246   1.6 Professional liability  (4,840)  (3,962)  (878)  22.2 General and administrative  15,975   13,311   2,664   20.0 Stock-based compensation  5,184   —   5,184   N/A Depreciation  3,650   3,493   157   4.5              Total expenses  201,351   184,190   17,161   9.3              OPERATING INCOME  15,412   19,468   (4,056)  (20.8)OTHER INCOME (EXPENSE):                Foreign currency transaction gain  21   161   (140)  (87.0)Other income  207   —   207   N/A Interest income  679   534   145   27.2 Interest expense  (3,707)  (3,382)  (325)  9.6 Debt retirement costs  (194)  —   (194)  N/A                 (2,994)  (2,687)  (307)  11.4              INCOME FROM CONTINUING OPERATIONSBEFORE INCOME TAXES  12,418   16,781   (4,363)  (26.0)BENEFIT FOR INCOME TAXES  (9,496)  (13,820)  4,324   (31.3)             NET INCOME FROM CONTINUING OPERATIONS $21,914  $30,601  $(8,687)  (28.4)             
29

Table of Contents
                 **(in thousands)** **Year Ended December 31,**   **2005**  **2004**  **Change**  **%** PATIENT REVENUES, net $203,658  $191,224  $12,434   6.5 EXPENSES:                Operating  155,512   147,842   7,670   5.2 Lease  15,836   15,283   553   3.6 Professional liability  (3,962)  (1,834)  (2,128)  116.0 General and administrative  13,311   11,692   1,619   13.8 Depreciation  3,493   3,228   265   8.2 Asset impairment and other charges  —   219   (219)  (100.0)             Total expenses  184,190   176,430   7,760   4.4              OPERATING INCOME  19,468   14,794   4,674   31.6              OTHER INCOME (EXPENSE):                Foreign currency transaction gain  161   784   (623)  (79.5)Interest income  534   286   248   86.7 Interest expense  (3,382)  (3,069)  (313)  10.2                 (2,687)  (1,999)  (688)  34.4              INCOME FROM CONTINUING OPERATIONSBEFORE INCOME TAXES  16,781   12,795   3,986   31.2 BENEFIT FOR INCOME TAXES  (13,820)  266   (14,086)  (5,295.5)             NET INCOME FROM CONTINUING OPERATIONS $30,601  $12,529  $18,072   144.2              **Year Ended December 31, 2006 Compared With Year Ended December 31, 2005**In 2005 and 2006, we entered into several divestiture transactions, and our consolidated financialstatements have been reclassified to present such transactions as discontinued operations.Accordingly, the related revenue, expenses, assets, liabilities and cash flows have been reportedseparately, and the discussion below addresses principally the results of our continuingoperations.*Patient revenues*. Patient revenues increased to $216.8 million in 2006 from $203.7 million in 2005,an increase of $13.1 million, or 6.4%. The increase in revenues is due to increased Medicaid ratesin certain states, increased Medicare utilization, Medicare rate increases and an increase incensus in 2006 as compared to 2005. The average rate of occupancy at our nursing centers increasedto 77.9% in 2006 from 76.2% in 2005. As a percentage of total census, Medicare days increased to13.8% in 2006 from 13.0% in 2005. Medicare revenues were 30.5% of revenue in 2006 and 30.0% in2005, while Medicaid and similar programs were 56.5% in 2006 compared to 58.0% in 2005.Our average rate per day for Medicare Part A patients increased to $323.97 in 2006 from $311.48 in2005, an increase of 4.0%. We previously expected that our rate would decrease from the 2005 leveldue to the Medicare RUG refinements that were implemented effective January 1, 2006. The acuitylevels of Medicare patients in our nursing centers were higher than expected with a resultingincrease in the average Medicare rate per patient day. Our average rate per day for Medicaidpatients increased to $133.74 in 2006 from $128.71 in 2005, an increase of 3.9%.*Operating expense*. Operating expense increased to $165.3 million in 2006 from $155.5 million in2005, an increase of $9.8 million, or 6.3%. As a percentage of revenues, operating expenses were76.3% in 2006, compared to 76.4% in 2005. The increase in operating expense is primarilyattributable to cost increases related to wages and benefits, partially offset by a reduction inexpense related to workers compensation insurance expense. The decrease in operating costs as apercentage of patient and resident revenues is primarily due to the effects of increases inMedicare and Medicaid rates and increased Medicare utilization, as discussed above.
30

Table of Contents
The largest component of operating expenses is wages, which increased to $98.8 million in 2006 from$92.0 million in 2005, an increase of $6.8 million, or 7.4%. This increase is primarilyattributable to an increase in wages as a result of increased costs of nursing care associated withthe higher Medicare census, competitive labor markets in most of the areas in which we operate, andregular merit and inflationary raises for personnel.Employee health insurance costs were approximately $0.7 million higher in 2006 compared to 2005, anincrease of approximately 18.6%. The Company is self insured for the first $150,000 in claims peremployee each year. Employee health insurance costs can vary significantly from year to year.Costs of workers compensation insurance were approximately $1.4 million lower in 2006 compared to2005. Beginning with the policy year that started in July 2005, our workers compensation insurancepolicies provided us with greater premium decreases resulting from reductions in claims experience.We have had better than expected claims experience, allowing us to reduce the cost of workerscompensation insurance.The remaining increases in operating expense are primarily due to the effects of increases in totalcensus and Medicare utilization.*Lease expense*. Lease expense increased to $16.1 million in 2006 from $15.8 million in 2005, anincrease of $0.3 million, or 1.6%. Effective October 1, 2006, we renewed a master lease covering 29nursing centers. This resulted in an increase in lease expense of $0.7 million during 2006 for theeffects of recording scheduled rent increases on a straight-line basis over the term of the renewalperiod, and will result in increased lease expense of $2.7 million annually in future periods.This increase has no effect on cash rent payments at the start of the lease term, and will onlyresult in additional cash outlay as the 3 percent annual increases take effect each year. Inaddition, there was an increase in lease expense of $0.2 million resulting from rent increases forlessor funded property renovations. Offsetting these increases in rent were reduced rent followingthe purchase of a leased facility in 2005 and the extension of a lease at the beginning of 2006covering four nursing centers that provided for the elimination of certain contingent rent expense.*Professional liability.*Professional liability expense was a net benefit of $4.8 million in 2006,compared to a net benefit of $4.0 million in 2005, an increase in net benefit of $0.8 million, or22.2%. Our cash expenditures for self-insured professional liability costs were $3.4 million and$4.1 million for the twelve month periods ended December 31, 2006 and 2005, respectively. During2006, we reduced our total recorded liabilities for self-insured professional liability risks to$25.7 million, down from $34.5 million at December 31, 2005.*General and administrative expense*. General and administrative expense increased to $16.0 millionin 2006 from $13.3 million in 2005, an increase of $2.7 million or 20.0%. The increase is primarilyattributable to increased compensation costs, and consulting costs related to compliance with therequirements of Section 404 of the Sarbanes-Oxley Act of 2002.Compensation costs were approximately $1.2 million higher in 2006 than in 2005. Salary costsincreased approximately $0.3 million, or 4%, due to normal merit and inflationary increases andapproximately $0.4 million due to new positions added to improve operating and financial controls.In addition, incentive compensation costs were approximately $0.5 million higher in 2006 comparedto 2005 as a result of improved operating performance.We were required to comply with the internal control reporting requirements of the Sarbanes-OxleyAct of 2002 beginning with this annual report on Form 10-K, and compliance costs have resulted inan increase in general and administrative expense of approximately $0.7 million in 2006 compared to2005.
31

Table of Contents
As a percentage of total net revenues, general and administrative expense was approximately 7.4% in2006 and 6.5% in 2005.*Stock-based compensation*. During 2006, we recorded a charge of approximately $5.2 million relatedto stock option grants that were approved by shareholders at our annual meeting on June 1, 2006.Expense related to this grant is being recorded over the vesting period of the options. Mostoptions vested during the second quarter of 2006 and the remaining options vest through December2007.*Depreciation*. Depreciation expense was approximately $3.7 million in 2006 compared to $3.5 millionin 2005, an increase of $0.2 million or 4.5%. The increase was primarily due to the purchase of aleased facility in 2005.*Foreign currency transaction gain*. A foreign currency transaction gain of approximately $21,000 wasrecorded in 2006, compared to $161,000 in 2005. Foreign currency transaction gains and lossesresult from foreign currency translation of a note receivable from the sale of our Canadianoperations in 2004.*Interest expense*. Interest expense increased to $3.7 million in 2006 from $3.4 million in 2005, anincrease of $0.3 million or 9.6%. Interest expense increased as a result of new debt issued inconnection with the acquisition of a facility as well as the interest rate increases on ourvariable rate debt. These increases were partially offset by a reduction in interest as a result ofpayments of debt from proceeds of the sale of discontinued operations, principal payments made inconnection with a refinancing transaction in August 2006, and other principal payments.*Debt retirement costs.*Debt retirement costs of $0.2 million are related to unamortized deferredfinance costs of refinanced loans that were written off following the refinancing transaction wecompleted in August 2006.*Income from continuing operations before income taxes; income from continuing operations per commonshare*. As a result of the above, continuing operations reported income before income taxes of $12.4million in 2006 compared to income before income taxes of $16.8 million in 2005. The benefit forincome taxes was $9.5 million in 2006, compared to $13.8 million in 2005. Our effective tax ratediffers materially from the statutory rate mainly due to changes in our valuation allowance for netdeferred tax assets. In 2006 and 2005, we recorded a deferred tax benefit of approximately $9.7million and $13.9 million, respectively, to reduce deferred tax asset valuation allowances, basedon improvements in our financial position and our updated forecast of income available to supportthe turnaround of existing net operating loss carryforward credits. In future periods, we willcontinue to assess the need for and adequacy of the remaining valuation allowance. The basic anddiluted income per common share from continuing operations were $3.73 and $3.34, respectively, in2006, as compared to a basic and diluted income per common share from continuing operations of$5.29 and $4.69, respectively, in 2005.*Income from discontinued operations*. Operating income of discontinued operations, net of taxes,was approximately $0.1 million in 2006, compared to a loss from discontinued operations of $5.7million in 2005. Losses from the disposition of discontinued operations of $0.1 million, net ofrelated taxes, were recorded in 2006, compared to a gain of $0.4 million recorded in 2005.**Year Ended December 31, 2005 Compared With Year Ended December 31, 2004**In 2004 and 2005 we entered into several divestiture and lease termination transactions and ourconsolidated financial statements have been reclassified to present such transactions asdiscontinued operations. Accordingly, the related revenue, expenses, assets, liabilities and cashflows have been reported separately, and the discussion below addresses principally the results ofour continuing operations.
32

Table of Contents
*Revenues*. Net revenues increased to $203.7 million in 2005 from $191.2 million in 2004, an increaseof $12.5 million, or 6.5%. The increase in revenues is due to Medicare rate increases, increasedMedicare utilization and increased Medicaid rates in certain states. As a percentage of totalcensus, Medicare days increased to 13.0% in 2005 from 12.7% in 2004. Medicare revenues were 30.0%of patient revenue in 2005 and 29.3% in 2004, while Medicaid and similar programs were 58.0% in2005 compared to 59.4% in 2004.Ancillary service revenues, prior to contractual allowances, increased to $42.2 million in 2005from $36.7 million in 2004, an increase of $5.5 million, or 14.9%. The increase is primarilyattributable to increased Medicare census and higher acuity patients.*Operating expense*. Operating expense increased to $155.5 million in 2005 from $147.8 million in2004, an increase of $7.7 million, or 5.2%. As a percentage of patient and resident revenues,operating expense decreased to 76.4% in 2005 from 77.3% in 2004. The increase in operating expenseis primarily attributable to cost increases related to wages and benefits, partially offset by adecrease in employee health insurance costs. The decrease in operating costs as a percent ofpatient and resident revenues is primarily due to the effects of increases in Medicare and Medicaidrates and increased Medicare utilization, as discussed above.The largest component of operating expenses is wages, which increased to $92.0 million in 2005 from$86.2 million in 2004, an increase of $5.8 million, or 6.7%. This increase is primarilyattributable to an increase in wages as a result of competitive labor markets in most of the areasin which we operate and increased Medicare census. This increase was partially offset by areduction in employee health insurance costs, which were $1.4 million lower in 2005 compared to2004. Employee health insurance costs can vary significantly from year to year, and this largedecrease is not expected to continue in 2006.*Lease expense*. Lease expense increased to $15.8 million in 2005 from $15.3 million in 2004. Theincrease in rent expense is primarily due to contingent rent expense incurred in connection withcertain leases, and to increased expense in connection with a lease for one facility that wasrenewed effective April 2005. These increases were partially offset by reduced rent following thepurchase of a leased facility in 2005.*Professional liability.*Professional liability expense in 2005 resulted in a net benefit of $4.0million, compared to a benefit of $1.8 million in 2004, an increase in net benefit of $2.2 million.Our cash expenditures for self-insured professional liability costs were $4.1 million and $3.3 forthe twelve month periods ended December 31, 2005 and 2004, respectively. During 2005, we reducedour total recorded liabilities for self-insured professional liability risks to $34.5 million, downfrom $42.9 million at December 31, 2004.*General and administrative expense*. General and administrative expense increased to $13.3 millionin 2005 from $11.7 million in 2004, an increase of $1.6 million or 13.8%. The increase isprimarily attributable to increased compensation costs, compliance costs and travel expenses. As apercentage of total net revenues, general and administrative expense was approximately 6.5% in 2005and 6.1% and 2004.*Asset impairment and other charges*. During 2005 and 2004, we recorded impairment charges inaccordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 144,“Accounting for the Impairment or Disposal of Long-Lived Assets,” and certain other charges asfollows:
33

Table of Contents
           **2005**  **2004** Impairment of long-lived assets $4,397,000  $8,419,000 Assisted living lease terminations  —   341,000           4,397,000   8,760,000 Less–amount included in discontinuedoperations  4,397,000   8,541,000        Asset impairment and other chargesincluded in continuing operations $—  $219,000        During 2005, an impairment charge of $4.4 million was recorded for eleven assisted livingfacilities to reduce the net book value of these properties to their estimated net realizablevalue. These properties were sold in the second quarter of 2006. As a result of projected cashflows, impairment charges of $8.4 million were recorded in 2004 for five nursing centers, includingthree leased facilities and two owned facilities, and for six owned assisted living facilities.During 2004, we terminated leases covering three nursing centers, and settled a dispute related toan assisted living facility lease termination from 2002. We incurred lease termination charges ofapproximately $341,000 in 2004, consisting of the remaining net book value of the relatedfacilities, costs of completing the transactions and settlement charges. These lease terminationcharges are included in the results of discontinued operations.*Depreciation*. Depreciation expense increased to $3.5 million in 2005 from $3.2 million in 2004, anincrease of $0.3 million or 8.2%. The increase was primarily due to capital expenditures madeduring the periods.*Foreign currency transaction gain*. A foreign currency transaction gain of $161,000 was recorded in2005, compared to a gain of $784,000 in 2004. These gains result from foreign currency translationof a note receivable from the sale of our Canadian operations.*Interest income.*Interest income increased to $534,000 in 2005 from $286,000 in 2004, an increaseof $248,000. The majority of this interest income is non-cash interest income related toamortization of discount on a note receivable recorded in connection with the May 2004 sale of ourCanadian subsidiary.*Interest expense*. Interest expense increased to $3.4 million in 2005 from $3.1 million in 2004, anincrease of $0.3 million or 10.2%. Interest expense increased as a result of new notes issued inconnection with the acquisition of a facility and the settlement of certain professional liabilityclaims and other disputes, and interest rate increases on our variable rate debt. These increaseswere offset by reduction in interest as a result of the payment of debt.*Income from continuing operations before income taxes; income from continuing operations per commonshare*. As a result of the above, continuing operations reported income before income taxes of $16.8million in 2005 compared to income before income taxes of $12.8 million in 2004. The benefit forincome taxes was $13.8 million in 2005, compared to a provision for income taxes of $0.3 million in2004. Our effective tax rate differs materially from the statutory rate mainly due to changes inour valuation allowance for net deferred tax assets. During 2005, we reduced the valuationallowance and recorded a deferred tax benefit of $13.9 million based on the Company’s achievedearnings trend and outlook. The basic and diluted income per share from continuing operations were$5.29 and $4.69, respectively, in 2005, as compared to a basic and diluted income per share fromcontinuing operations of $2.16 and $1.93, respectively, in 2004.*Income from discontinued operations*. Loss from discontinued operations, net of taxes, wasapproximately $5.7 million in 2005 compared to a loss of $10.0 million in 2004. The reduction inthe loss is due primarily to a reduction in the amount of impairment charges recorded related toour assisted living
34

Table of Contents
operations and the sale of nursing centers in Texas in 2004 and 2005. In addition, gains from thedisposition of discontinued operations of $0.4 million and $0.3 million, net of related taxes, wererecorded in 2005 and 2004, respectively.**Liquidity and Capital Resources**On October 20, 2006 we entered into a Restructuring Stock Issuance and Subscription Agreement(“Restructuring Agreement”) to restructure our Series B Redeemable Convertible Preferred Stock heldby Omega Healthcare Investors (together with its subsidiaries, “Omega”), a publicly owned REIT,eliminating the option of Omega to convert the Preferred Stock into shares of Advocat common stock.Advocat and Omega also entered into a Third Amendment to Consolidated Amended and Restated MasterLease (“Lease Amendment”) to extend the term of our lease covering 29 nursing centers we currentlylease from Sterling Acquisition Corp., a wholly-owned subsidiary of Omega. In addition, Omegaagreed to provide up to $5 million to fund capital improvements made to certain nursing centers byJune 30, 2008. Details of these transactions are described below.Under the terms of the Restructuring Agreement, the Series B Redeemable Convertible Preferred Stock(“Series B Preferred Stock”) held by Omega was exchanged for a new Series C Preferred Stock that isnot convertible. At the time of the Restructuring Agreement, the Series B Preferred Stock had arecorded value of approximately $4.9 million, including accrued dividends, at an annual rate of 7%of the stated value, compounded quarterly, and was convertible into approximately 792,000 shares ofcommon stock.The Restructuring Agreement required us to issue to Omega 5,000 shares of Series C Preferred Stockin exchange for the 393,658 shares of Series B Preferred Stock held by Omega. The new Series CPreferred Stock has a stated value of approximately $4.9 million and carries an annual dividendrate of 7% of its stated value. The Series C Preferred Stock will accrue dividends quarterly. TheSeries C Preferred Stock is not convertible, but is redeemable at its stated value at Omega’soption after September 30, 2010, and is redeemable at its stated value at our option afterSeptember 30, 2007, subject to certain limitations. In connection with the termination of theconversion feature, we agreed to pay Omega an additional $687,000 annually under the LeaseAmendment.In connection with the Restructuring Agreement, we also replaced a Subordinated Promissory Notewhich was convertible at our option with a new Subordinated Note, which is not convertible. Thenew Subordinated Note is in the principal amount of approximately $2.5 million, bears interest at7% and matures on September 30, 2007. Except for eliminating the conversion feature, the terms ofthe new Subordinated Note are the same as the original Subordinated Promissory Note.Under the terms of the Lease Amendment, Advocat and Omega also agreed to amend and renew the masterlease covering 29 nursing centers. The initial term of the lease was set to expire in September2010, with a ten year renewal option. The amended master lease commenced on October 1, 2006, andextends to September 30, 2018. The Lease Amendment also provides for a renewal option of anadditional twelve years. Other than the change in rent associated with the restructuring of thepreferred stock described above, there was no change in the base rental amounts as a result of theLease Amendment. Consistent with prior terms, the lease provides for annual increases in leasepayments equal to the lesser of two times the increase in the consumer price index or 3 percent.Under generally accepted accounting principles, we are required to report these scheduled rentincreases on a straight line basis over the 12 year term of the renewal period. As a result ofaccruing the scheduled rent increases, our annual rent expense increased by approximately $2.7million effective October 1, 2006. This increase has no effect on cash rent payments at the startof the lease term, and will only result in additional cash outlay as the 3 percent annual increasestake effect each year.
35

Table of Contents
This lease amendment, together with an earlier amendment in 2005, provides financing of up to $10million to fund capital improvements made to certain nursing centers leased from Omega. The annualbase rent related to these nursing centers will be increased to reflect the amount of capitalimprovements made to the facilities. As of December 31, 2006, we had incurred expenditures of $5.0million for these improvements.On August 7, 2006, we entered into an agreement with our commercial mortgage lender, CapmarkFinance Inc. (“Capmark”), for a comprehensive refinancing of our long term debt. Under the terms ofthe new agreement, Capmark provided mortgage debt of approximately $22.5 million with a five yearmaturity and a term note of approximately $8.1 million with a four year maturity to refinance ourremaining mortgage and bank term debt. The proceeds of these new loans were used to retire theexisting debt and to fund a $1.1 million renovation of a nursing center that is part of thecollateral for the mortgage loans. In connection with this loan, we made a payment ofapproximately $2.6 million to reduce outstanding debt. The new loans include various financialcovenants, the most restrictive of which relate to cash flow, debt service coverage ratios, andliquidity. We are in compliance with these new covenants. We expensed existing deferred financingcosts of $0.2 million related to the debt that was retired and recorded new deferred loan costs of$0.8 million as part of the refinancing transaction.On March 17, 2006, we entered into a two year renewal of our term notes and working capital line ofcredit agreements with our primary bank lender. In addition, the lender agreed to amend certaincovenants of the notes to bring us into compliance with such covenants. These term notes wererepaid with proceeds from the refinance transaction on August 7, 2006, as described above. Theworking capital line of credit remains in place with the bank lender.As of December 31, 2006, we had no borrowings under our working capital line of credit. The maximumoutstanding balance of the working capital line of credit is $2.3 million. There are certainlimitations based on borrowing base restrictions. The working capital line of credit matures inJanuary 2008 with interest at either LIBOR plus 2.5% or the bank’s prime rate plus 0.50% (up to amaximum of 9.5%).We have numerous pending liability claims, disputes and legal actions for professional liabilityand other related issues. Due to our past claim experience and increasing cost of claimsthroughout the long-term care industry, the premiums paid by us for professional liability andother liability insurance to cover future periods exceeds the coverage purchased so that it costsmore than $1 to purchase $1 of insurance coverage. For this reason, effective March 9, 2001, wehave purchased professional liability insurance coverage for our facilities that, based onhistorical claims experience, is likely to be substantially less than the claims that are expectedto be incurred. As a result, we are effectively self-insured and expect to remain so for theforeseeable future.We have essentially exhausted all general and professional liability insurance available for claimsfirst made during the period from March 9, 2001 through March 9, 2007. For claims made during theperiod from March 10, 2007 through March 9, 2008, we maintain insurance coverage limits of $100,000per medical incident and total aggregate policy coverage limits of $500,000.As of December 31, 2006, we have recorded total liabilities for reported and settled professionalliability claims and estimates for incurred but unreported claims of $25.7 million. A significantjudgment entered against us in one or more of these legal actions could have a material adverseimpact on our financial position and cash flows. Future committed settlements total $0.7 million,and are payable over the next three months. Included in that future commitment is approximately$0.6 million that was settled after December 31, 2006 and is fully reserved in our professionalliability claims accrual. Certain of these commitments have been evidenced by promissory noteswhich have been included with debt in the accompanying balance sheet. Settlements of currentlypending claims will require additional cash expenditures.
36

Table of Contents
Net cash provided by operating activities of continuing operations before changes in other assetsand liabilities totaled $14.5 million, $13.2 million and $11.5 million in 2006, 2005 and 2004,respectively. These amounts primarily represent the cash flows from net operations. The effects ofworking capital changes were to provide $0.6 million of cash in 2006 and to use cash of $3.6million and $5.9 million, respectively, in 2005 and 2004, resulting in net cash provided bycontinuing operations of $15.1 million, $9.6 million and $5.6 million in 2006, 2005 and 2004,respectively. Discontinued operations provided cash of $0.2 million and $2.0 million in 2006 and2004, respectively, and used $0.6 million of cash in 2005.Investing activities of continuing operations provided cash of $6.3 million and $2.8 million in2006 and 2004, respectively, and used $8.3 million of cash in 2005. These amounts primarilyrepresent proceeds from the sale of discontinued operations, cash used for the purchase of anursing center in 2005, and cash used for purchases of property, plant and equipment. We have usedbetween $3.0 million and $4.1 million for capital expenditures of continuing operations in each ofthe three calendar years ending December 31, 2006. Such expenditures were primarily for facilityimprovements and equipment, which were financed principally through working capital. For the yearending December 31, 2007, we anticipate that capital expenditures for improvements and equipmentfor our existing facility operations will be higher as we complete facility renovations at certainowned facilities. Investing activities of discontinued operations used no cash in 2006 and used$0.8 million and $1.3 million in 2005 and 2004, respectively.Financing activities of continuing operations used cash of $16.4 million and $8.0 million in 2006and 2004, respectively, and provided $1.4 million of cash of cash in 2005. In 2006 and 2004,proceeds from the sale of discontinued operations were used to repay debt. The cash provided in2005 primarily represents funds from loan proceeds used to acquire a nursing center. There were nocash flows from financing activities of discontinued operations in 2006 or 2005, and discontinuedoperations used cash of $44,000 in 2004. No interest costs or debt were allocated to discontinuedoperations.**Facility Renovations**After a strategic review, we determined that renovating certain facilities offered the opportunityto improve occupancy, quality of care and profitability. We developed a plan to identify thosefacilities with the greatest potential for benefit, and began the renovation program during 2005.Renovation projects on four facilities were completed during 2006. We expect to complete twoadditional projects in the first quarter of 2007, and management is currently developing plans tobegin additional facility renovations.A total of $5.7 million has been spent on these renovation programs to date, with $5.0 millionspent on facilities leased from Omega and $0.7 million spent on owned facilities. The amountsspent on the facilities leased from Omega are financed through increased rent, and are notreflected as capital expenditures.For the three facilities with renovations completed before the beginning of the fourth quarter,fourth quarter occupancy improved from 60.9% in 2005 to 70.6% in 2006, and Medicare census as apercent of total increased from 14.4% in 2005 to 17.9% in 2006. No assurance can be given thatthese facilities will continue to show such occupancy or revenue mix improvement or that the otherrenovated facilities will experience similar improvements.**West Virginia Facility Option Agreement**We have entered into an option agreement to purchase certain assets of a skilled nursing facilityin West Virginia. We recently made an application to state regulatory authorities to allow us tooperate the facility, and construct a new 90 bed replacement facility. In the event ourapplication is approved, we will seek to arrange financing and begin construction of thereplacement facility.
37

Table of Contents
**Receivables**Our operations could be adversely affected if we experience significant delays in reimbursementfrom Medicare, Medicaid and other third-party revenue sources. Our future liquidity will continueto be dependent upon the relative amounts of current assets (principally cash, accounts receivableand inventories) and current liabilities (principally accounts payable and accrued expenses). Inthat regard, accounts receivable can have a significant impact on our liquidity. Continued effortsby governmental and third-party payors to contain or reduce the acceleration of costs by monitoringreimbursement rates, by increasing medical review of bills for services, or by negotiating reducedcontract rates, as well as any delay by us in the processing of our invoices, could adverselyaffect our liquidity and results of operations.Accounts receivable attributable to patient services of continuing operations totaled $18.7 millionat December 31, 2006, compared to $18.6 million at December 31, 2005, representing approximately 31and 33 days in accounts receivable at each period end, respectively.The allowance for bad debt was $2.1 million at December 31, 2006, compared to $1.7 million atDecember 31, 2005. We continually evaluate the adequacy of our bad debt reserves based on patientmix trends, aging of older balances, payment terms and delays with regard to third-party payors,collateral and deposit resources, as well as other factors. We continue to evaluate and implementadditional procedures to strengthen our collection efforts and reduce the incidence ofuncollectible accounts.**Stock Exchange**During 2006, our common stock shares were approved for listing on the NASDAQ Capital Market andbegan trading there on September 12, 2006 under the symbol AVCA. Prior to our listing on theNASDAQ Capital Market our stock was quoted on the NASD’s OTC Bulletin Board under the symbol AVCA.**Inflation**We do not believe that our operations have been materially affected by inflation. We expect salaryand wage increases for our skilled staff to continue to be higher than average salary and wageincreases, as is common in the health care industry.**Recent Accounting Pronouncements**On July 13, 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in IncomeTaxes — An Interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accountingfor uncertainty in income taxes recognized in an enterprise’s financial statements in accordancewith FASB Statement No. 109, “Accounting for Income Taxes.” FIN 48 also prescribes a recognitionthreshold and measurement attribute for the financial statement recognition and measurement of atax position taken or expected to be taken in a tax return. In addition, FIN 48 provides guidanceon derecognition, classification, interest and penalties, accounting in interim periods, disclosureand transition. The provisions of FIN 48 are effective for fiscal years beginning after December15, 2006. Earlier application is permitted as long as the enterprise has not yet issued financialstatements, including interim financial statements, in the period of adoption. The provisions ofFIN 48 are to be applied to all tax positions upon initial adoption of this standard. Only taxpositions that meet the more-likely-than-not recognition threshold at the effective date may berecognized or continue to be recognized upon adoption of FIN 48. The cumulative effect of applyingthe provisions of FIN 48 should be reported as an adjustment to the opening balance of retainedearnings for that fiscal year. We do not expect the adoption of FIN48 to have a material impact onour financial position, results of operations or cash flows.
38

Table of Contents
In September 2006, the FASB issued SFAS No. 157; “Fair Value Measurements” (“SFAS No. 157”). Thisnew standard provides guidance for using fair value to measure assets and liabilities andestablishes a fair value hierarchy that prioritizes the information used to develop themeasurements. Statement 157 applies whenever other standards require (or permit) assets orliabilities to be measured at fair value but does not expand the use of fair value in any newcircumstances. The provisions of Statement 157 are effective for us beginning January 1, 2007.Earlier application is permitted, provided that the reporting entity has not yet issued financialstatements for that fiscal year, including any financial statements for an interim period withinthat fiscal year. We do not expect the adoption of this new standard to have a material impact onour financial position.**Forward-Looking Statements**The foregoing discussion and analysis provides information deemed by Management to be relevant toan assessment and understanding of our consolidated results of operations and financial condition.This discussion and analysis should be read in conjunction with our consolidated financialstatements included herein. Certain statements made by or on behalf of us, including thosecontained in this “Management’s Discussion and Analysis of Financial Condition and Results ofOperations” and elsewhere, are forward-looking statements as defined in the Private SecuritiesLitigation Reform Act of 1995. Actual results could differ materially from those contemplated bythe forward-looking statements made herein. In addition to any assumptions and other factorsreferred to specifically in connection with such statements, other factors could cause our actualresults to differ materially from the results expressed or implied in any forward-lookingstatements including, but not limited to, changes in governmental reimbursement, governmentregulation and health care reforms, the increased cost of borrowing under our credit agreements,ability to control ultimate professional liability costs, the accuracy of our estimate of ouranticipated professional liability expense, the impact of future licensing surveys, the outcome ofregulatory proceedings alleging violations of laws and regulations governing quality of care orviolations of other laws and regulations applicable to our business, our ability to control costs,changes to our valuation of deferred tax assets, changes in occupancy rates in our facilities,changing economic conditions as well as others. Investors also should refer to the risks identifiedin this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” aswell as risks identified in “Part 1. Item 1A. Risk Factors” for a discussion of various riskfactors of the Company and that are inherent in the health care industry. Given these risks anduncertainties, we can give no assurances that these forward-looking statements will, in fact,transpire and, therefore, caution investors not to place undue reliance on them. These assumptionsmay not materialize to the extent assumed, and risks and uncertainties may cause actual results tobe different from anticipated results. These risks and uncertainties also may result in changes tothe Company’s business plans and prospects. Such cautionary statements identify important factorsthat could cause our actual results to materially differ from those projected in forward-lookingstatements. In addition, we disclaim any intent or obligation to update these forward-lookingstatements.
39

Table of Contents
**ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**The chief market risk factor affecting our financial condition and operating results is interestrate risk. As of December 31, 2006, we had outstanding borrowings of approximately $31.5 million,including $2.7 million in fixed-rate borrowings and $28.8 million in variable-rate borrowings. Inthe event that interest rates were to change 1%, the impact on future cash flows would beapproximately $288,000 annually, representing the impact of changed interest expense on variablerate debt.We have a note receivable denominated in Canadian dollars related to the sale of our Canadianoperations. This note is currently recorded on our balance sheet at $5.3 million US based on theoutstanding balance of the note and the exchange rate as of December 31, 2006. The carrying valueof the note in our financial statements will be increased or decreased each period based onfluctuations in the exchange rate between US and Canadian currencies, and the effect of suchchanges will be included as income or loss in our statement of operations in the period of change.In 2006 and 2005, we reported transaction gains of $21,000 and $161,000, respectively, as aresult of the effect of changes in the currency exchange rates on this note. Afurther change of 1% in the exchange rate between US and Canadian currencies would result in acorresponding increase or decrease to earnings of approximately $53,000.**ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA**Auditedfinancial statements are contained on pages F-1 through F-34 of this Annual Report on Form10-K and are incorporated herein by reference. Audited supplemental schedule data is contained onpages S-1 and S-2 of this Annual Report on Form 10-K and is incorporated herein by reference.**ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**None.**ITEM 9A. CONTROLS AND PROCEDURES.****Evaluation of Disclosure Controls and Procedures**Advocat, with the participation of our principal executive and financial officers, has evaluatedthe effectiveness of our disclosure controls and procedures, as such term is defined under Rules13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended, as ofDecember 31, 2006. Based on this evaluation, the principal executive and financial officers havedetermined that such disclosure controls and procedures are effective to ensure that informationrequired to be disclosed in our filings under the Securities Exchange Act of 1934 is recorded,processed, summarized and reported within the time periods specified in the Securities and ExchangeCommission’s rules and forms.**Management’s Report on Internal Control over Financial Reporting**We are responsible for establishing and maintaining adequate internal control over financialreporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, as amended). Weassessed the effectiveness of our internal control over financial reporting as of December 31,2006. In making this assessment, our management used the criteria set forth by the Committee ofSponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control-IntegratedFramework. We have concluded that, as of December 31, 2006, our internal control over financialreporting is effective based on these criteria. Our independent registered public accounting firm,BDO Seidman, LLP, has issued an audit report on our assessment of our internal control overfinancial reporting, which is included herein.
40

Table of Contents
**Changes in Internal Control over Financial Reporting**There has been no change (including corrective actions with regard to significant deficiencies ormaterial weaknesses) in our internal control over financial reporting that has occurred during ourfiscal quarter ended December 31, 2006 that has materially affected, or is reasonably likely tomaterially affect our internal control over financial reporting.Our management does not expect that our disclosure controls and procedures or our internal controlswill prevent all error and all fraud. A control system, no matter how well conceived and operated,can provide only reasonable, not absolute, assurance that the objectives of the control system aremet. Further, the design of a control system must reflect the fact that there are resourceconstraints, and the benefit of controls must be considered relative to their costs. Because ofthe inherent limitations in all control systems, no evaluation of controls can provide absoluteassurance that misstatements due to error or fraud will not occur or that all control issues andinstances of fraud, if any, have been detected. These inherent limitations include the realitiesthat judgments in decision making can be faulty and that breakdowns can occur because of simpleerror or mistake. Controls can also be circumvented by the individual acts of some persons, bycollusion of two or more people, or by management override of the controls. The design of anysystem of controls is based in part on certain assumptions about the likelihood of future eventsand there can be no assurance that any design will succeed in achieving its stated goals under allpotential future conditions.**Report of Independent Registered Public Accounting Firm**Board of Directors and Shareholders