---



U.S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



FORM 10-K



|x | Annual Report under Section 13 or 15(d) of the Securities Exchange Act of 1934
|- | ------------------------------------------------------------------------------



For the fiscal year ended August 31, 2003



| ̈ | Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
|- | ----------------------------------------------------------------------------------------



Commission file number: 000-21574



DYNACQ HEALTHCARE, INC.

(Formerly Dynacq International, Inc.)

(Exact name of registrant as specified in its charter)



|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 76-0375477                          
|(State or Other Jurisdiction of Incorporation or Organization) |  | (I.R.S. Employer Identification No.)



|                                                    |  |           
|--------------------------------------------------- |  | ----------
|10304 Interstate 10 East, Suite 369, Houston, Texas |  | 77029     
|(Address of Principal Executive Office)             |  | (Zip Code)



TELEPHONE NUMBER:
(713) 378-2000

INTERNET WEBSITE: WWW.DYNACQ.COM



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



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



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



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



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



The aggregate market value of the voting and non-voting common equity stock held by non-affiliates of the registrant as of February 27, 2004 was
$33,748,333. As of June 30, 2004, registrant had 14,852,072 shares of common stock outstanding, all of one class.



---



1



---

EXPLANATORY NOTE



We are filing this annual report on Form 10-K in order to reflect the audited consolidated financial statements for the year
ended August 31, 2003, the restatement and re-audit of our financial statements for the fiscal year ended August 31, 2002, the restatement of our 2001 financial statements, and the restatement of our selected financial information for fiscal years
1999 and 2000. All financial data in this report reflects the effects of the restatements. See Recent Developments below as well as Item 7. Managements Discussion and Analysis of Financial Condition and Results of
Operations and Note 2 to the Consolidated Financial Statements included in this report for details relating to these restatements. As a result of these restatements, investors should not rely upon the Companys previously filed financial
statements for the fiscal years ended August 31, 1999 through 2002.



PART I



This annual report on Form 10-K
contains forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as may, will, should, expects, intends, plans,
anticipates, believes, estimates, predicts, potential, or the negative of these terms or other comparable terminology. These statements are only predictions. Actual events or results may
differ materially. Such forward-looking statements relate to future events or future financial performance and involve known and unknown risks, uncertainties and other factors that may cause our industrys actual results, levels of activity,
performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by the forward-looking statements, including the risks and uncertainties described in Risk
Factors below. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance, or achievements. You must read the following discussion
of the results of our business and our operations and financial condition in conjunction with our consolidated financial statements, including the notes, included in this Form 10-K filing.



|Item 1. | Business
|------- | --------



General



Dynacq
Healthcare, Inc., a Delaware corporation, is a holding company which through its subsidiaries develops and manages general acute hospitals that provide specialized general surgeries. The Companys strategy is to develop and operate general
acute hospitals designed to handle specialized general surgeries such as bariatric, orthopedic and neuro spine surgeries. The Companys hospitals include operating rooms, pre- and post-operative space, intensive care units, nursing units, and
modern diagnostic facilities. The Company normally does not participate in any managed care contracts nor does it receive a substantial amount of reimbursement from Medicare or Medicaid. Except for emergency room patients, the surgeries are
typically pre-certified by the insurance carriers. The bulk of the surgeries are either covered by workers compensation insurance or by commercial insurers on an out-of-network health plan basis, and are relatively complex surgeries. The
Company believes that, as a result, the per-procedure revenue generated by the Company is comparatively higher than the per-procedure revenue generated by other hospitals. The Companys facilities are designed to handle complex orthopedic and
general surgeries, such as spine and bariatric surgeries.



During the fiscal year ended August 31, 2003 the Company expanded its hospitals from one to three. Other key events in fiscal year 2003 include:



| |  | The Companys Ambulatory Surgery Center in Pasadena, Texas ceased to operate in November 2002 and consequently surrendered its lease and its license. Vista Hospital in
Pasadena, Texas, near Houston (the Pasadena Facility) was allowed to modify its hospital license and lease the space previously occupied by the Ambulatory Surgery Center, thereby increasing the Pasadena Facilitys surgical suites
from four to eight. The Pasadena Facility contributed 84% of net patient revenues in fiscal year 2003.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | In January 2003, the Company opened its second hospitalVista Surgical Hospital of Baton Rouge (the Baton Rouge Facility), a 49,500 square foot 35-bed facility with
four surgical suites on approximately 20 acres of land. The Baton Rouge Facility contributed 12% of net patient revenues in fiscal year 2003.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



2



---

| |  | In August 2003, the Company acquired the total assets of a 113-bed hospital (which is now licensed for 79 beds), a medical office building and 22.7 acres of land in the Dallas-Fort
Worth area for approximately $8.5 million including the assumption of approximately $2.9 million of liabilities. The Company has completed renovations at that facility, named Vista Hospital of Dallas (the Garland Facility), with six
surgical suites, and started performing surgical procedures in late November 2003.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | The Company bought approximately four acres in The Woodlands, Texas upon which it expects to build a new hospital. At this time, the project is still in the planning stage.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The Company was incorporated in Nevada in June
1989. In November 2003, the Company reincorporated in Delaware and changed its name from Dynacq International, Inc. to Dynacq Healthcare, Inc. The terms Company, Dynacq, our or we as used herein refer
to Dynacq Healthcare, Inc. and its affiliates unless otherwise stated or indicated by context. The term affiliates means direct and indirect subsidiaries of Dynacq Healthcare, Inc. and partnerships and joint ventures in which
subsidiaries are partners, general or limited partners or members.



The Company, through its affiliates, owns or leases 100% of the real estate and owns or leases 100% of the equipment in its facilities. The Company maintains a majority ownership and controlling interest in all of its operating entities. As
of August 31, 2003, the Company owned the following percentages of its facilities:



|                        |  |       |  
|----------------------- |  | ----- | -
|Pasadena Facility(1)    |  | 91.5  | %
|Baton Rouge Facility(2) |  | 97.0  | %
|Garland Facility(3)     |  | 100.0 | %
|West Houston Facility   |  | 100.0 | %

---

|(1) | The Company purchased an additional 3.5% interest on September 15, 2003, thereby increasing its ownership to 95.0%. The Company purchased the remaining 5% interest
in December 2003, thereby increasing its ownership to 100% of this operating entity. The limited partnership was restructured in June 2004 and since then the Company has owned 93% percent of this operating entity. The remaining interests are
primarily owned by physicians and by other healthcare professionals. In November 2002, Vista Healthcare, Inc. ceased to operate and surrendered its license. The Pasadena Facility modified its hospital license and leased the space previously occupied
by the Ambulatory Surgery Center.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(2) | The Company purchased the remaining 3% interest in April 2004, thereby increasing its ownership to 100% of this operating entity. The limited liability company was
restructured in June 2004 and since then the Company has owned 90% percent of this operating entity. The remaining interests are primarily owned by physicians and by other healthcare professionals.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(3) | As of July 2004, the Company owned 92% of this operating entity. The remaining interests are primarily owned by physicians and by other healthcare
professionals.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------



Recent Developments



Change in Independent Auditors



Ernst & Young LLP resigned as the Companys independent auditor
effective December 17, 2003. In conjunction with Ernst & Youngs resignation, Ernst & Young advised us that it had identified material weaknesses relating to our internal controls. Please read Item 9A. Controls and
Procedures for further details. On January 19, 2004, the Audit Committee of the Board of Directors engaged the registered public accounting firm of Killman, Murrell & Company, P.C. as the Companys new independent auditors for the
fiscal year ended August 31, 2003.



SEC Investigation



On December 18, 2003, we received a notice of an informal investigation from
the Fort Worth, Texas District Office of the Securities and Exchange Commission requesting our voluntary assistance in providing information regarding reporting of our financial statements, recognition of costs and revenue, accounts receivable,



3



---

allowances for doubtful accounts and our internal controls. We have been cooperating fully with the continuing informal SEC investigation.



SEC Review



Beginning in October 2003, the Division of Corporation Finance of the SEC has been commenting upon Dynacqs periodic
filings.



Restatement of Financial Statements for the Fiscal Years 1999-2002



On April 6, 2004, we announced that in connection with
the ongoing review by the Securities and Exchange Commissions Division of Corporation Finance of our periodic reports, we would restate our financial statements for the fiscal years ended August 31, 2001 and 2002. We have restated and obtained
a re-audit of our financial statements for the fiscal year ended August 31, 2002, restated our 2001 financial statements, and restated the selected financial information for fiscal years 1999 and 2000. The re-audit and restatements of the financial
statements produced adjustments to previously reported amounts. These adjustments are described in Note 2 to the consolidated financial statements.



The restated financial statements reflect reductions in net income for the fiscal years ended August 31, 2001 and 2002, to approximately $7.7 million and
$14.8 million, respectively, which is 30% and 4% less than the previously reported net income, and increases of approximately 11% and 4%, respectively, in the previously reported stockholders equity. The reductions in previously reported net
income are primarily the result of adjustments for the noncash expensing of stock options issued to non-employees and the related income tax effect.



As part of the audit adjustments, the restated financial statements reflect an increase in stockholders equity at August 31, 2000 of 19% due to the
correction of the over-accrual of income tax liabilities prior to August 31, 2000. Retained earnings reflect an increase at August 31, 2000 of 11%, consisting of a 24% increase related to the overstatement of income tax liabilities offset by a 13%
noncash charge for stock options issued to non-employees prior to August 31, 2000.



None of the restatements has reduced previously reported net revenue, cash flows from operating activities or stockholders equity.



Due to the restatements and re-audit, investors should not rely on the Companys previously issued financial statements
for the fiscal years ended August 31, 1999, 2000, 2001 and 2002. Net revenue and net income for the fiscal year ended August 31, 2003, are approximately $90 million and $21 million, respectively, as we stated on December 1, 2003.



Delisting of Common Stock from Nasdaq National Market



On January 21, 2004, we announced that a hearing had been scheduled for
February 5, 2004 before the Nasdaq Listing Qualifications Panel (the Panel) to review the recent Nasdaq Staff Determination to delist our common stock for failure to comply with certain NASD Marketplace Rules. We requested the hearing in
response to a December 2003 Staff Determination that our securities were subject to delisting from the Nasdaq National Market for failure to comply with the filing requirements for continued listing set forth in NASD Marketplace Rule 4310(c)(14),
due to our failure to file an Annual Report on Form 10-K for the fiscal year ended August 31, 2003. On January 15, 2004, the Company received notice of an additional Staff Determination that due to our failure to timely file periodic reports, as
well as public interest concerns based on the apparent lack of internal controls, we no longer qualified for inclusion in the Nasdaq Stock Market under Nasdaq Marketplace Rules 4300 and 4330(a)(3), which provide broad discretionary authority to deny
continued listing of securities in order to maintain the quality of, and the publics confidence in, the Nasdaq Stock Market.



On April 15, 2004, we announced that the Panel had notified us that our common stock would be delisted from the Nasdaq National Market as of the opening
of business on Friday, April 16, 2004. The Panel acknowledged (a) the reports of the special counsel to the audit committee, which found that there were no questionable, improper/fraudulent actions or practices relating to the potential sale
of account receivables and that there were no internal control and/or accounting weaknesses other than one episode of lack of communication among our officers in connection with a proposed transaction, (b) recently adopted internal
control procedures which limit the chief executive officers authority to enter into contracts in excess of $250,000 and require greater involvement by the



4



---

general counsel in the use of outside counsel and assignment of projects, and (c) resolution to the satisfaction of the Securities and Exchange Commission of
certain concerns with respect to public filings, concluding that public interest considerations did not warrant delisting of our common stock. The Panel also acknowledged the significant amounts of time and resources expended by us in an effort to
complete the audit committee investigation and the 2003 audit so as to remedy the filing delinquencies. However, in a determination delivered to us on April 14, 2004, the Panel indicated that in light of the length of the ongoing delinquency in our
SEC filings and the Panels belief that we had failed to offer a definitive plan to fully remedy the filing delinquency within a reasonable period of time, the Panel had determined to deny our request for a further exception to the filing
requirements and to delist our common stock.



Following the
delisting, our common stock has been quoted on the National Quotation Service Bureau (the Pink Sheets) for unsolicited trading. However, our common stock is not eligible for quotation on the OTC Bulletin Board because we do not have
publicly available financial statements that are as of a date within six months of the possible quote. Once we have released the required financial statements, our common stock could become eligible for quotation on the OTC Bulletin Board if a
market maker makes an application to have the shares quoted and such application is approved by the Nasdaq Compliance Unit. The Company is currently making every effort to file its quarterly reports on Form 10-Q for the first three quarters of
fiscal 2004, as soon as possible.



We are making every effort
to make our remaining late SEC filings as soon as possible, but have not yet filed our quarterly reports on Form 10-Q for the periods ended November 30, 2003, February 29, 2004 and May 31, 2004. Once we have become current in our SEC filings, we
will explore the listing alternatives available to us. However, we cannot assure you that an active trading market will exist for our common stock.



Changes in Directors and Executive Officers



On January 21, 2004, we announced the election of James G. Gerace as a new independent director and a member of our Audit Committee. Mr. Gerace, a
graduate of Texas A&M University, is a Certified Public Accountant and mediator with more than 30 years of professional experience at public accounting firms, performing audits, tax planning and related services. He has served on the board of
directors of several banks and savings and loan associations. Mr. Gerace was appointed Chairman of the Audit Committee in February 2004.



In July 2003, James N. Baxter was appointed an executive vice president for investor relations. In September 2003, Irvin T. Gregory, who had served as the
Companys Executive Vice President and Chief Development Officer since October 2001, resigned but remained with the Company in a market research capacity until January 2004. He subsequently elected to leave the Company at the conclusion of his
employment agreement on January 31, 2004 to pursue his personal investments and business ventures. In December 2003, Tammy Danberg-Farney was appointed Executive Vice President, General Counsel. In January 2004, Richard D. Valentine was appointed
Director of Operations and Development. In February 2004, Sarah C. Garvin resigned from her position as Executive Vice President and Chief Operating Officer of the Company in order to pursue a career as a healthcare management consultant focusing on
project development. She continues to assist the Company on a consulting basis. Chiu M. Chan, Chief Executive Officer of the Company, is serving as acting Chief Operating Officer until a replacement can be secured.



5



---

Loss of Key Physicians



During the period August 2003 to May 2004 six physicians who had accounted for over 54% of our gross revenues in fiscal 2003 departed from the Pasadena
Facility or substantially reduced their surgeries for various reasons. While the Company has added additional physicians in the fourth quarter of fiscal year 2004, the loss of these physicians resulted in a significant reduction in net patient
revenues for the first three quarters of fiscal year 2004. While we believe that we will be able to continue to attract and retain additional physicians, the potential loss of physicians who provide significant net patient revenues for the Company
will adversely affect our results of operations.



During
the fourth quarter of fiscal year 2004, the Pasadena Facility added six physicians to its medical staff: three orthopedic spine surgeons, two general and vascular surgeons and one bariatric surgeon. In addition, one of its bariatric surgeons who had
been out for personal reasons returned in late June of 2004.



Unaudited and
Unreviewed Financial Information



We expect to file
quarterly reports on Form 10-Q for the fiscal quarters ended November 30, 2003, February 29, 2004, and May 31, 2004 as soon as practicable. We expect net income for the quarters ended November 30, 2003, and February 29, 2004, to be approximately
$1.2 million and $700,000, respectively, or 75% and 83% lower than the comparable periods in fiscal 2003. The reduction in net income for the fiscal quarter ended November 30, 2003 includes a non cash charge of approximately $624,000 related to
stock options previously issued to an employee which were amended in the first quarter of fiscal 2004. Based on unaudited financial statements, which have not been reviewed by our independent auditor but which have been prepared based on the same
accounting policies underlying our previously reported and now restated financial statements, we expect a net loss of approximately $2.2 million for the quarter ended May 31, 2004, compared to net income of $6.3 million in the comparable period of
fiscal 2003. We expect net revenues of approximately $47.7 million and a net loss of approximately $300,000 for the nine months ended May 31, 2004, compared to $64.7 million and net income of $15.7 million, respectively, in the comparable period in
fiscal 2003. These lower results were negatively impacted by operating expenses incurred in the start up of our new Garland facility with minimal offsetting revenue, by a lower level of activity in our Pasadena Facility and by increased legal and
auditing fees. Additionally, several long-time members of the physician staff at the Pasadena Facility ceased or reduced their surgeries in that facility at various times during the first three quarters of fiscal 2004. We have been engaged in
efforts to recruit new physicians to the staff. While we have added several new physicians to the staffs of each of the three hospitals, including the return of some who had left earlier, we do not currently expect our financial results to improve
in the near future.



Any failure to attract and retain
physicians on the staff of our hospital could have an adverse impact on our financial situation. We may not be able to improve our financial condition and may incur substantial losses in the future.



Industry Background



The development of proprietary general acute care hospital networks occurred during the 1970s. During the past 20 years,
freestanding outpatient surgery centers were developed to compete with these general hospitals for outpatient procedures. Freestanding outpatient surgery centers allowed surgeons to perform outpatient procedures in specialized facilities, designed
to improve efficiency and enhance patient care. The Company believes that its operational model allows surgeons to perform inpatient procedures at facilities that provide similar efficiencies as those provided at outpatient surgery centers. The
Company believes that the development and acquisition of general acute hospitals focusing on an evolving combination of surgical specialties, such as orthopedics and bariatrics, will continue to aid in the delivery of quality medical care while
resulting in profitable operations.



General acute hospitals
specializing in specific complex surgical procedures are designed with the goal of improving both physician and facility efficiency. The surgeries performed are primarily non-emergency procedures that are electively scheduled and therefore allow for
the full efficiency available through block time/scheduling. Given the opportunity to utilize multiple operating rooms for pre-determined periods of time, the surgeons are able to schedule their time more efficiently and therefore increase the
number of surgeries they can perform within a given amount of time. The facility receives the benefit of consistent staffing patterns and greater facility utilization. In addition, the Company believes that, due to the relatively small size of its
facilities, many surgeons choose to perform surgeries in the Companys facilities because their patients prefer the comfort of a more personal atmosphere and the convenience of simplified admission and discharge procedures.



6



---

Pasadena Facility



At August 31, 2003, the Company owned, through its subsidiaries, 91.5% partnership interest in the Pasadena Facility operating entity, and 8.5% was owned
by Halcyon, L.L.C., a third party physician group. The Company purchased an additional 3.5% interest on September 15, 2003, thereby increasing its ownership to 95.0%. The remaining 5% interest was purchased in December 2003, thereby increasing its
ownership to 100%. The limited partnership was restructured as of June 2004 and since that date the Company has owned 93% percent of this operating entity and the remaining interest is primarily owned by physicians and by other healthcare
professionals. The Pasadena Facilitys primary areas of practice include orthopedic surgery, and general surgery, such as spine and bariatric surgeries, and represents approximately 84% of the Companys fiscal 2003 net patient service
revenues. Through its affiliates, the Company owns 100% of the real estate and owns or leases 100% of the equipment and in turn leases the land, hospital facility and equipment to the operating hospital entity. In November 2002, Vista Healthcare,
Inc. ceased to operate and surrendered its license. The Pasadena Facility modified its hospital license and leased the space previously occupied by the Ambulatory Surgery Center.



Baton Rouge Facility



In January 2003, the Company opened its second hospitalthe Baton Rouge Facility. This facilitys primary areas of practice include bariatric
surgery, orthopedic surgery, general surgery, pain management and cosmetic surgery. At August 31, 2003, the Company owned 97% of the operating hospital entity and a physician group owned the remaining 3%. The Company purchased the remaining 3%
interest in April 2004, thereby increasing its ownership to 100% of this operating entity. The limited liability company was restructured in June 2004 and since that date the Company has owned 90% percent of this operating entity, and physicians and
other healthcare professionals primarily own the remaining 10% interest. The Baton Rouge Facility contributed 12% of net patient revenues in fiscal year 2003. Through its affiliates, the Company owns 100% of the real estate and owns or leases 100%
of the equipment and in turn leases the land, hospital facility and equipment to the operating hospital entity.



Garland Facility



In August 2003, the Company, through its subsidiaries, acquired the total assets of a 113-bed hospital (which is now licensed for 79 beds), a medical
office building and 22.7 acres of land in the Dallas-Fort Worth area for approximately $8.5 million (comprising of approximately $6.7 million for land and building and $1.7 million for medical equipment and furniture and fixtures), including the
assumption of approximately $2.9 million of liabilities. The Company has completed renovations at that facility, with six surgical suites, and started performing surgical procedures in late November 2003. The principal types of surgery to be
performed at this facility are expected to be orthopedic surgery, bariatric surgery, general surgery and pain management. As of July 2004, the Company owned 92% of this operating entity, and the remaining interests are primarily owned by physicians
and by other healthcare professionals. Through its affiliates, the Company owns 100% of the real estate and owns or leases 100% of the equipment and in turn leases the land, hospital facility and equipment to the operating hospital entity.



West Houston Facility



Vista Surgical Center West (the West Houston Facility) was
established in March 2001 and is a satellite ambulatory surgical center to the Pasadena Facility and is located in west Houston. The West Houston Facility houses two operating rooms. This facilitys primary areas of practice include orthopedic
surgery, general surgery and pain management. The facility also houses Vista Fertility Institute which provides invitro fertilization services to couples who have been unable to conceive through other means. The operating entity is a wholly owned
subsidiary of the Company and subleases the premises from a physician who practices there. For fiscal year 2003, the West Houston Facility represented approximately 4% of the Companys net patient service revenues.



Business Growth Strategy



The Company has focused on developing and expanding its surgical services
hospitals. The Companys current business strategy involves:



Creating and maintaining relationships with quality surgeons;



| |  | Attracting and retaining key management, marketing, and operating personnel at the corporate level;
| | - | ---------------------------------------------------------------------------------------------------



7



---

| |  | Further developing and refining its hospital prototype to, among other things, enhance the facility design of its hospitals to provide efficient, effective, and quality patient
care;
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Adding new capabilities to its existing hospital campuses; and
| | - | --------------------------------------------------------------



| |  | Actively seeking and pursuing new opportunities in additional geographic markets.
| | - | ---------------------------------------------------------------------------------



Creating and Maintaining Relationships with Quality Surgeons



Since physicians provide and influence the direction of healthcare, we have developed our operating model to encourage
physicians to affiliate with us and to use our facilities in accordance with their practice needs. Our strategy is to focus on the development of physician partnerships and facilities that will enhance their practices in order to provide high
quality healthcare in a friendly environment for the patient. We seek to attract new physicians to our facilities in order to grow or to replace physicians who retire or otherwise depart from time to time. In order to attract new physicians and
maintain existing physician relationships, the Company affords them the opportunity to purchase interests in the operating entities of the facilities. By doing so, the physician becomes more integrally involved in the quality of patient care and the
overall efficiency of facility operations.



Attracting and Retaining Key
Personnel



We place the utmost importance on attracting
and retaining key personnel to be able to provide quality facilities to attract and retain top quality physicians. Attracting and retaining the appropriate corporate personnel and quality senior executives is also an important goal of management and
essential in expanding our operations.



Further Refining Hospital Design



We believe we attract physicians because we design our
facilities, and adopt staffing, scheduling and clinical systems and protocols to increase physician productivity and promote their professional success. We constantly focus our attention on providing physicians with quality facilities designed to
improve the physicians and their patients satisfaction.



Addition of New Capabilities to Existing Hospitals



Our overall strategy is to develop and operate hospitals designed to handle complex surgeries. Currently, some of our more complex surgeries include spine and bariatric surgeries for which we have added more operating rooms and surgical
equipment. The Company continues to explore the possibility of adding other types of surgical procedures which would fit our business model.



New Opportunities and Market Expansion



An integral part of our future plans is the acquisition and development of additional hospitals. As opportunities are identified, we plan to acquire and
develop additional hospitals using one of three methods: 1) new construction, which generally requires two years to complete; 2) acquisition of assets and renovation, which generally requires four to six months to complete; 3) long-term leases,
which is generally less capital-intensive and requires the least amount of time to commence business operations. Criteria examined when exploring new markets include:



| |  | the potential to attract strong physician partners in the market area;
| | - | ----------------------------------------------------------------------



| |  | the revenue potential associated with those partnerships;
| | - | ---------------------------------------------------------



| |  | current or expected competition in the marketplace;
| | - | ---------------------------------------------------



| |  | size of the market;
| | - | -------------------



| |  | predominate payor groups in the market area; and
| | - | ------------------------------------------------



| |  | licensing and regulatory requirements of the market area.
| | - | ---------------------------------------------------------



8



---

International Development Opportunities



Our Board of Directors has ratified and approved negotiations for the potential long-term lease of land and procurement of a
hospital license for a hospital to be constructed in Shanghai, China. The proposed hospital would be owned by a joint venture company controlled by Dynacq, with several local joint venture partners. While certain approvals from the Beijing and
Shanghai governments have been obtained, other required approvals have not. No assurance can be given that the required approvals will be obtained or that the proposed joint venture hospital project can be achieved at all, or if so, on terms deemed
favorable to us. The Company is currently negotiating the lease and has made an earnest money deposit of $640,000.



Marketing



Our marketing efforts are directed primarily at physicians and other healthcare professionals, who are principally responsible for referring patients to
our facilities. We market our facilities to physicians by emphasizing the high level of patient satisfaction with our hospitals, the quality and responsiveness of our services, and the practice efficiencies provided by our facilities. We believe
that providing quality facilities creates a positive environment for patients and physicians. The Company, through its subsidiaries, also has agreements with outside organizations that offer marketing, pre-authorization and follow up support
services to prospective bariatric and orthopedic patients in areas serviced by the Pasadena, Garland, and Baton Rouge Facilities. These facilities receive bariatric and orthopedic referrals from other sources and the organizations also refer clients
to other area hospitals.



Competition



Presently, the Company operates in the greater Houston, Texas, Baton Rouge,
Louisiana, and Dallas-Fort Worth, Texas metropolitan markets. In each market, the Company competes with other providers, including major acute care hospitals. These hospitals may have various competitive advantages over the Company, including their
community position, capital resources, surgeon partnerships, and proximity to surgeon office buildings. The Company also encounters competition with other companies for acquisition and development of facilities and for strategic relationships with
surgeons.



There are several large publicly-held companies, and
numerous privately-held companies, that acquire and develop freestanding private hospitals and outpatient surgery centers. Many of these competitors have greater financial and other resources than the Company. The principal competitive factors that
affect the Companys ability and the ability of its competitors to acquire or develop private hospitals are experience and reputation, and access to capital. Further, some surgeon groups develop surgical facilities without a corporate partner.
The Company can provide no assurance that it will be able to successfully compete in these markets.



Government Regulation



Overview



All participants in the healthcare industry are required
to comply with extensive government regulation at the federal, state and local levels. Under these laws and regulations, hospitals must meet requirements for licensure and qualify to participate in government programs, including Medicare and
Medicaid. These requirements relate to the adequacy of medical care, equipment, personnel, operating policies and procedures, maintenance of adequate records, hospital use, rate-setting, compliance with building codes and environmental protection
laws. There are also extensive regulations governing a hospitals participation in government programs. These laws and regulations are extremely complex and, in many instances, the industry does not have the benefit of significant regulatory or
judicial interpretation.



In the event of a determination that
we violated applicable laws, rules or regulations or if changes in the regulatory framework occur, we may be subject to criminal penalties and/or civil sanctions and our hospitals could lose their licenses and/or their ability to participate in
government programs. In addition, government regulations frequently change and when regulations change, we may be required to make changes in our facilities, equipment, personnel and services so that our hospitals remain licensed and qualified to
participate in these programs. One or more of these outcomes could be material to our operations. We believe that our hospitals are in substantial compliance with current applicable federal, state and local regulations and standards.



9



---

State Workers Compensation Commissions



A significant amount of our net revenue results from Texas workers compensation claims and to a lesser extent,
currently from Louisiana workers compensation claims. As such, we are subject to the rules and regulations of the Texas and Louisianas Workers Compensation Commissions (TWCC and LWCC, respectively).



The Texas Administrative Code provides the specific
methodology and procedure for the payment and denial of medical bills by third party payers for medical services to injured workers in Texas. Specifically, for inpatient surgical services, reimbursement is predicated upon the Acute Care Hospital
Inpatient Fee Guideline. In April 2004, the TWCC adopted a new Fee Guideline for Ambulatory Surgical Centers which will become effective as of September 1, 2004. Reimbursement for services not identified in an established fee guideline are
reimbursed at a fair and reasonable rate. Fair and reasonable is not a defined term and the only requirement placed upon an outpatient facility is to bill charges at a usual and customary level. Our outpatient and
ambulatory surgical center facilities bill for services provided to its workers compensation patients at its usual and customary level and pursues reimbursement for these services at a fair and reasonable rate. Due to the soon to
be effective Ambulatory Surgical Center guidelines, it is anticipated that the number of medical fee disputes filed with the commission may increase during the first twelve months after implementation of this new guideline. As of now, the new fee
guideline only affects Ambulatory Surgery Centers and therefore only the West Houston Facility will be affected at this time. The TWCC provides the Medical Dispute Resolution process to request proper reimbursement for services pursuant to the Texas
Labor Code and the Texas Administrative Code. For example, if a third party payer does not provide the Company proper reimbursement for a claim, we request reconsideration of that payment amount. After that request, if the third party payer has not
provided proper reimbursement, we file a request for Medical Dispute Resolution with the TWCC.



The TWCC then reviews the claim to determine if additional payment is warranted pursuant to the statutory and regulatory guidelines and/or fee guidelines implemented by the TWCC. The TWCC then issues a finding and
decision, which the non-prevailing party may then appeal to the State Offices of Administrative Hearings. At that point, the parties can pursue an administrative hearing to determine if proper reimbursement was made for services provided to an
injured worker. Although this entire process is lengthy, we request optimal reimbursement for services rendered based upon the utilization of this administrative process. Our Company effectively pursues all avenues of reimbursement allowed under the
law as mandated by the legislature and state administrative agencies.



The Louisiana Administrative Code provides the specific methodology and procedure for the payment and denial of medical bills by third party payers for medical services to injured workers. Specifically, for inpatient surgical services,
reimbursement is predicated upon the hospital reimbursement schedule. In addition, there is also a reimbursement guideline for outpatient services.



We cannot predict the course of future legislation or changes in current administration of the Texas Labor Code and/or Texas Administrative Code or the
Louisiana Administrative Code. We expect that there may be changes in the future, but we are unable to predict their impact on our operations.



Licensure, Certification and Accreditation



Our hospitals are subject to periodic inspection by governmental and other authorities to assure continued compliance with the various standards necessary
for licensing and accreditation. Moreover, in order to participate in the Medicare and Medicaid programs, each of our hospitals must comply with the applicable regulations of the United States Department of Health and Human Services relating to,
among other things, equipment, personnel and standards of medical care, as well as comply with all applicable state and local laws and regulations. We believe that all of our hospitals are in substantial compliance with such regulations and laws
and, as such, are certified for participation in the Medicare and Medicaid programs.



We believe that our hospitals are in substantial compliance with current applicable federal, state and local regulations and standards. However, the requirements for licensure, certification and accreditation are
subject to change. Consequently, in order for our hospitals to remain licensed, certified and accredited, it may be necessary from time-to-time for us to make material changes in our facilities, equipment, personnel and/or services.



10



---

Professional licensure



Healthcare professionals at our hospitals are required to be individually and currently licensed or certified under applicable state law and may be
subject to numerous Medicare and Medicaid participation and reimbursement regulations. We take steps to ensure that all independent physicians and our employees and agents have the necessary licenses and certifications, and we believe that our
employees and agents comply with all applicable state licensure laws.



Corporate practice of medicine and fee-splitting



Some states, including Louisiana and Texas, have laws that prohibit unlicensed persons or business entities, including corporations, from employing physicians. Some states also have adopted laws that prohibit direct or indirect payments or
fee-splitting arrangements between physicians and unlicensed persons or business entities. Possible sanctions for violations of these restrictions include loss of license, civil and criminal penalties, and rescission of the business arrangements.
These laws vary from state to state, are often vague and in most states have seldom been interpreted by the courts or regulatory agencies. We have attempted to structure our arrangements with healthcare providers to avoid the exercise of any
responsibility on behalf of the physicians utilizing our hospitals that could be construed as affecting the practice of medicine and to comply with all such applicable state laws. However, we cannot assure you that governmental officials charged
with responsibility for enforcing these laws will not assert that we, or the transactions in which we are involved, are in violation of these laws. These laws may also be interpreted by the courts in a manner inconsistent with our interpretations.



Healthcare Program Regulations



Participation in any federal or state healthcare program, including the
Medicare and Medicaid programs, is heavily regulated by statute and regulation. If a hospital fails to substantially comply with the numerous conditions of participation in the Medicare and Medicaid programs or performs certain prohibited acts, the
hospitals participation in the federal or state healthcare programs may be terminated, civil or criminal penalties may be imposed under certain provisions of the Social Security Act, or both.



Anti-kickback Statute



Among the provisions of the Social Security Act is a section known as the
Anti-Kickback Statute. The Medicare and Medicaid Anti-Fraud and Abuse Amendments to the Social Security Act, or the Anti-kickback Statute, prohibits providers and others from soliciting, receiving, offering or paying, directly or indirectly, any
remuneration with the intent of generating referrals or orders for services or items covered by a federal healthcare program. Courts have interpreted this statute broadly. Violations of the Anti-kickback Statute may be punished by a criminal fine of
up to $25,000 for each violation, imprisonment up to five years, or both, civil money penalties of up to $50,000 per violation and damages of up to three times the amount of the illegal kickback and/or exclusion from participation in federal
healthcare programs, including Medicare and Medicaid.



The
Office of Inspector General at the Department of Health and Human Services (the OIG), among other regulatory agencies, is responsible for identifying and eliminating fraud, abuse and waste in federal healthcare programs. The OIG carries
out this mission through a nationwide program of audits, investigations and inspections. In order to provide guidance to healthcare providers, the OIG has from time to time issued Special Fraud Alerts that do not have the force of law,
but identify features of arrangements or transactions that may indicate that the arrangements or transactions violate the Anti-kickback Statute or other federal healthcare laws. The OIG has identified several incentive arrangements, which, if
accompanied by inappropriate intent, constitute suspect practices, including: (a) payment of any incentive by the hospital each time a physician refers a patient to the hospital, (b) the use of free or significantly discounted office space or
equipment in facilities usually located close to the hospital, (c) provision of free or significantly discounted billing, nursing or other staff services, (d) free training for a physicians office staff in areas such as management techniques
and laboratory techniques, (e) guarantees which provide that, if the physicians income fails to reach a predetermined level, the hospital will pay any portion of the remainder, (f) low-interest or interest-free loans, or loans which may be
forgiven if a physician refers patients to the hospital, (g) payment of the costs of a physicians travel and expenses for conferences, (h) coverage on the hospitals group health insurance plans at an inappropriately low cost to the
physician, (i) payment for services (which may include consultations at the hospital) which require few, if any, substantive duties by the physician, (j) purchasing goods or services from physicians at prices in excess of their fair market value, or
(k) certain



11



---

gainsharing arrangements, the practice of giving physicians a share of any reduction in a hospitals costs for patient care attributable in
part to the physicians efforts. The OIG has encouraged persons having information about hospitals who offer the above types of incentives to physicians to report such information to the OIG.



As authorized by Congress, the OIG has published final safe harbor
regulations that outline categories of activities that are deemed protected from prosecution under the Anti-kickback Statute. Currently there are statutory exceptions and safe harbors for various activities, including the following: investment
interests, space rental, equipment rental, practitioner recruitment, personal services and management contracts, sale of practice, referral services, warranties, discounts, employees, group purchasing organizations, waiver of beneficiary coinsurance
and deductible amounts, managed care arrangements, obstetrical malpractice insurance subsidies, investments in group practices, freestanding surgery centers, and referral agreements for specialty services. Compliance with a safe harbor is not
mandatory. The fact that a particular conduct or a business arrangement does not fall within a safe harbor does not automatically render the conduct or business arrangement illegal under the Anti-kickback Statute. Such conduct and business
arrangements, however, may lead to increased scrutiny by government enforcement authorities.



The safe harbor regulations with respect to investment interests establish two instances in which payments to an investor in a venture will not be treated as a violation of the Anti-Kickback Statute. The first safe
harbor is for investment interests in public companies that have total assets exceeding $50 million and whose investment securities are registered pursuant to the Securities Exchange Act of 1934, as amended (the Exchange Act). The second
safe harbor or small entity safe harbor is for investments in entities as long as the following criteria are met: (i) no more than 40% of the total investment interests of each class of investment interests are held in the previous
fiscal year or previous 12-month period by investors who are in a position to make or influence referrals to, furnish items or services to, or otherwise generate business for the entity; (ii) the terms on which an investment interest is offered to a
passive investor (e.g., a shareholder or limited partner) who is in a position to make or influence referrals to, furnish items or services to, or otherwise generate business for the entity are no different than the terms offered to other passive
investors; (iii) the terms on which an investment interest is offered to an investor who is in a position to make or influence referrals to, furnish items or services to, or otherwise generate business for the entity are not related to the previous
or expected volume of referrals, items or services furnished or amount of business otherwise generated from that investor to the entity; (iv) there is no requirement that a passive investor, if any, make referrals to, be in a position to make or
influence referrals to, furnish items or services to, or otherwise generate business for the entity as a condition for remaining as an investor; (v) the entity must not market or furnish the entitys items or services to passive investors
differently than to non-investors; (vi) no more than 40% of the gross revenues of the entity in any fiscal year or twelve-month period comes from referrals or business otherwise generated from investors; (vii) the entity or individual acting on
behalf of the entity must not loan funds to or guaranty a loan for an investor who is in a position to make or influence referrals to or otherwise generate business for the entity if the investor uses any part of such loan to obtain the investment
interest; and (viii) the amount of payment to an investor in return for the investment interest is directly proportional to the amount of the capital investment (including the fair market value of any pre-operational services rendered) of that
investor.



We have a variety of financial relationships with
physicians who refer patients to our hospitals. Physicians own interests in certain of our hospitals and may also own our stock. We also have medical directorship agreements with some physicians. Although we believe that our arrangements with
physicians have been structured to comply with the current law and available interpretations, we cannot assure you that regulatory authorities will not determine that these arrangements violate the Anti-kickback Statute or other applicable laws.
Also, the states in which we operate have adopted anti-kickback laws, some of which apply more broadly to all payers, not just to federal healthcare programs. Many of these state laws do not have safe harbor regulations comparable to the federal
Anti-kickback Statute and have only rarely been interpreted by the courts or other government agencies. If our arrangements were found to violate any of these anti-kickback laws we could be subject to criminal and civil penalties and/or possible
exclusion from participating in Medicare, Medicaid, or other governmental healthcare programs such as workers compensation programs.



Stark Law



The Social Security Act also includes certain provisions commonly known as the Stark Law. This law prohibits physicians, absent an exception,
from referring Medicare and Medicaid patients to entities with which they or any of their immediate family members have a financial relationship if these entities provide certain designated health services that are reimbursable by Medicare,
including inpatient and outpatient hospital services. Sanctions for violating the Stark Law include denial of payment, refunding amounts received for services provided pursuant to



12



---

prohibited referrals, civil monetary penalties of up to $15,000 per prohibited service provided, and exclusion from the Medicare and Medicaid programs. The
statute also provides for a penalty of up to $100,000 for a circumvention scheme that has the principal purpose of assuring referrals and that, if directly made, would violate the Stark law. There are exceptions to the self-referral prohibition for
many of the customary financial arrangements between physicians and providers, including employment contracts, leases and recruitment agreements. There is also an exception for a physicians ownership interest in an entire hospital, as opposed
to an ownership interest in a hospital department.



On March
26, 2004, the Centers for Medicare and Medicaid Services (CMS) issued final Phase II regulations to clarify parts of the Stark Law and some of the exceptions thereto. These regulations concluded the second phase of a
two-phase process. The Phase I regulations largely went into effect on January 4, 2002, except for one provision interpreting the requirement in many Stark Law exceptions that a physicians compensation must be set in advance. The
Phase II Regulations became effective on July 26, 2004 and created seven new exceptions. There have been few enforcement actions, and therefore, there is little indication as to how courts will interpret and apply the Stark Law; however, enforcement
is expected to increase.



We believe we have structured our
financial arrangements with physicians to comply with the statutory exceptions included in the Stark Law and the regulatory exceptions. In particular, we believe that our physician ownership arrangements meet the Stark whole hospital exception. On
March 19, 2004, the CMS announced its implementation of a moratorium on physician investment in and referrals to certain specialty hospitals enacted by Congress as part of the Medicare Prescription Drug, Improvement and Modernization Act of 2003.
Congress and CMS define specialty hospitals as primarily or exclusively engaged in the care and treatment of one of the following categories: (i) patients with a cardiac condition, (ii) patients with an orthopedic condition or (iii) patients
receiving a surgical procedure. The moratorium became effective on December 8, 2003 and expires on June 8, 2005. Congress specifically excluded from the moratorium, hospitals that were in operation before or under development as of November 18,
2003. In determining whether a specialty hospital was under development as of November 18, 2003, the CMS considers whether all of the following occurred prior to November 18, 2003: (i) architectural plans were completed, (ii) funding was
received, (iii) zoning requirements were met, and (iv) necessary approvals from appropriate state agencies were received. In cases where all of these steps were not completed prior to November 18, 2003, the CMS will make a case-by-case determination
as to whether the specialty hospital was under development and will consider any other evidence that would indicate the under development status. To request a case-specific determination regarding whether a specialty hospital was under
development as of November 18, 2003, an interested party can request a written opinion from the CMS. During the 18-month moratorium, the Medicare Payment Advisory Commission, in consultation with the Comptroller General of the United States, will
conduct a study to determine, in addition to other things, the financial impact of physician-owned specialty hospitals on local full-service community hospitals. We cannot predict the results of this study or the action that Congress may take in
response to the study.



The Stark Law may also be amended in
ways that we cannot predict at this time, including possible changes to the current physician ownership and compensation exceptions. We cannot predict whether any other law or amendment will be enacted or the effect they might have on us.



State Anti-Kickback and Physician Self-Referral Laws



Many states, including those in which we do or expect to
do business, have laws that prohibit payment of kickbacks or other remuneration in return for the referral of patients. Some of these laws apply only to services reimbursable under state Medicaid programs. However, a number of these laws apply to
all healthcare services in the state, regardless of the source of payment for the service. Based on court and administrative interpretations of the federal Anti-kickback Statute, we believe that the Anti-kickback Statute prohibits payments only if
they are intended to induce referrals. However, the laws in most states regarding kickbacks have been subjected to more limited judicial and regulatory interpretation than federal law. Therefore, we can give you no assurances that our activities
will be found to be in compliance with these laws. Noncompliance with these laws could subject us to penalties and sanctions and have a material adverse effect on us.



A number of states, including those in which we do or expect to do business, have enacted physician self-referral laws that
are similar in purpose to the Stark Law but which impose different restrictions. Some states, for example, only prohibit referrals when the physicians financial relationship with a healthcare provider is based upon an investment interest.
Other state laws apply only to a limited number of designated health services. Some states do



13



---

not prohibit referrals, but require that a patient be informed of the financial relationship before the referral is made. We believe that our operations are
in material compliance with the physician self-referral laws of the states in which our hospitals are located.



HIPAA and The Balanced Budget Act of 1997



The Health Insurance Portability and Accountability Act of 1996 (HIPAA) broadened the scope of certain federal fraud and abuse laws by adding
several criminal provisions for healthcare fraud offenses that apply to all health benefit programs. HIPAA also added a prohibition against incentives intended to influence decisions by Medicare beneficiaries as to the provider from which they will
receive services. In addition, HIPAA created new enforcement mechanisms to combat fraud and abuse, including the Medicare Integrity Program and an incentive program under which individuals can receive up to $1,000 for providing information on
Medicare fraud and abuse that leads to the recovery of at least $100 of Medicare funds. Federal enforcement officials now have the ability to exclude from Medicare and Medicaid any investors, officers and managing employees associated with business
entities that have committed healthcare fraud, even if the officer or managing employee had no knowledge of the fraud. HIPAA was followed by The Balanced Budget Act of 1997, which created additional fraud and abuse provisions, including civil
penalties for contracting with an individual or entity that the provider knows or should know is excluded from a federal healthcare program.



Other Fraud and Abuse Provisions



The Social Security Act also imposes criminal and civil penalties for making false claims and statements to Medicare and Medicaid. False claims include,
but are not limited to, billing for services not rendered or for misrepresenting actual services rendered in order to obtain higher reimbursement, billing for unnecessary goods and services, and cost report fraud. Criminal and civil penalties may be
imposed for a number of other prohibited activities, including failure to return known overpayments, certain gainsharing arrangements, and offering remuneration to influence a Medicare or Medicaid beneficiarys selection of a healthcare
provider. Like the Anti-kickback Statute, these provisions are very broad. Careful and accurate coding of claims for reimbursement, as well as accurately preparing cost reports, must be performed to avoid liability.



The Federal False Claims Act and Similar State Laws



A factor affecting the healthcare industry today is the use of the Federal
False Claims Act and, in particular, actions brought by individuals on the governments behalf under the False Claims Acts qui tam, or whistleblower, provisions. Whistleblower provisions allow private individuals to bring
actions on behalf of the government alleging that the defendant has defrauded the federal government.



When a defendant is determined by a court of law to be liable under the False Claims Act, the defendant may be required to pay three times the actual
damages sustained by the government, plus mandatory civil penalties of between $5,500 and $11,000 for each false claim submitted. There are many potential bases for liability under the False Claims Act. Liability often arises when an entity
knowingly submits a false claim for reimbursement to the federal government. The False Claims Act defines the term knowingly broadly. Thus, although simple negligence will not give rise to liability under the False Claims Act, submitting
a claim with reckless disregard to its truth or falsity constitutes a knowing submission under the False Claims Act and, therefore, will qualify for liability.



In some cases, whistleblowers and the federal government have taken the position that providers who allegedly have violated
other statutes, such as the Anti-kickback Statute and the Stark Law, have thereby submitted false claims under the False Claims Act. Certain states in which we operate have adopted their own false claims provisions as well as their own whistleblower
provisions whereby a private party may file a civil lawsuit in state court.



Health Information Security and Privacy Practices



The Administrative Simplification Provisions of HIPAA also require certain organizations, including us, to implement very significant and potentially expensive new computer systems and business procedures designed to protect each
patients individual healthcare information. HIPAA requires the Department of Health and Human Services to issue rules to define and implement patient privacy and security standards. Among the standards that the Department of Health and Human
Services adopted pursuant to HIPAA are standards for the following:



| |  | electronic transactions and code sets;
| | - | --------------------------------------



14



---

| |  | unique identifiers for providers, employers, health plan and individuals;
| | - | -------------------------------------------------------------------------



| |  | security and electronic signatures;
| | - | -----------------------------------



| |  | privacy; and
| | - | ------------



| |  | enforcement.
| | - | ------------



On August 17, 2000, the Department of Health and Human Services finalized the transaction standards. The Administrative Simplification and Compliance Act extended the date by which we must comply with the transaction
standards to October 16, 2003, provided we submit a compliance plan to the Secretary of Health and Human Services by October 16, 2002. We submitted a compliance plan by October 16, 2002. The transaction standards require us to use standard code sets
established by the rule when transmitting health information in connection with some transactions, including health claims and health payment and remittance advices. We are now in substantial compliance with the standards.



On December 28, 2000, the Department of Health and Human Services published a
final rule establishing standards for the privacy of individually identifiable health information. This rule was amended May 31, 2002 and August 14, 2002. These privacy standards apply to all health plans, all healthcare clearinghouses and many
healthcare providers, including healthcare providers that transmit health information in an electronic form in connection with certain standard transactions. We are a covered entity under the final rule. The privacy standards protect individually
identifiable health information held or disclosed by a covered entity in any form, whether communicated electronically, on paper or orally. These standards not only require our compliance with rules governing the use and disclosure of protected
health information, but they also require us to impose those rules, by contract, on any business associate to whom such information is disclosed. A violation of the privacy standards could result in civil money penalties of $100 per incident, up to
a maximum of $25,000 per person per year per standard. The final rule also provides for criminal penalties of up to $50,000 and one year in prison for knowingly and improperly obtaining or disclosing protected health information, up to $100,000 and
five years in prison for obtaining protected health information under false pretenses, and up to $250,000 and ten years in prison for obtaining or disclosing protected health information with the intent to sell, transfer or use such information for
commercial advantage, personal gain or malicious harm. The compliance date for the privacy rule was April 14, 2003.



On February 20, 2003, the Department of Health and Human Services issued a final rule that establishes, in part, standards for the security of health
information by health plans, healthcare clearinghouses and healthcare providers that maintain or transmit any health information in electronic form, regardless of format. We are an affected entity under the rule. These security standards required
affected entities to establish and maintain reasonable and appropriate administrative, technical and physical safeguards to ensure integrity, confidentiality and the availability of the information. The security standards were designed to protect
the health information against reasonably anticipated threats or hazards to the security or integrity of the information and to protect the information against unauthorized use or disclosure. Although the security standards do not reference or
advocate a specific technology, and affected entities have the flexibility to choose their own technical solutions, we expect that the security standards will require us to implement significant systems and protocols. The compliance date for the
initial implementation of the standards set forth in the security rule is April 20, 2005.



In April 2003, the Department of Health and Human Services published an interim final rule that establishes procedures for the imposition, by the Secretary of Health and Human Services, of civil monetary penalties on
entities that violate the administrative simplification provisions of HIPAA. This was the first installment of the enforcement rule. When issued in complete form, the enforcement rule will set forth procedural and substantive requirements for
imposition of civil monetary penalties. The act also provides for criminal penalties for violations. We have established a plan and committed the resources necessary to comply with the act. At this time, we anticipate that we will be able to fully
comply with the acts regulations that have been issued and with the proposed regulations. Based on the existing and proposed regulations, we believe that the cost of our compliance with the act will not have a material adverse effect on our
results of operations.



15



---

Emergency Medical Treatment and Labor Act



All of our hospitals are subject to the Emergency Medical Treatment and Labor Act (EMTALA). This federal law
requires any hospital that participates in the Medicare program to conduct an appropriate medical screening examination of every person who presents to the hospitals emergency department for treatment and, if the patient is suffering from an
emergency medical condition, to either stabilize that condition or make an appropriate transfer of the patient to a facility that can handle the condition. The obligation to screen and stabilize emergency medical conditions exists regardless of a
patients ability to pay for treatment. There are severe penalties under EMTALA if a hospital fails to screen or appropriately stabilize or transfer a patient or if the hospital delays appropriate treatment in order to first inquire about the
patients ability to pay. Penalties for violations of EMTALA include civil monetary penalties and exclusion from participation in the Medicare program. In addition, an injured patient, the patients family or a medical facility that
suffers a financial loss as a direct result of another hospitals violation of the law can bring a civil suit against the hospital.



Although we believe that we are currently in substantial compliance with the requirements of EMTALA, we cannot predict any modifications that the CMS will
implement in the future. On May 13, 2004, the CMS issued revised interpretive guidelines for surveyors investigating EMTALA complaints. We cannot predict whether we will be in compliance with any new requirements or interpretive guidelines.



In December 2002, the Pasadena Facility was notified by the
CMS that it had allegedly violated EMTALA requirements. The Texas Department of Health (TDH) conducted an investigation and reported to the CMS that appropriate corrective actions had been taken. As a result of TDHs findings, the
CMS notified the facility in January 2003 that its eligibility for Medicare participation remained in effect, but, as required by §1867(d) of the Social Security Act, the matter would be forwarded to the Quality Improvement Organization
(QIO) to review the case and report its findings to the OIG for a possible assessment of a civil monetary penalty. The facility met with the QIO on October 3, 2003. As of this date, there has been no report issued by the QIO or any
response received from the OIG. The Company does not anticipate that it will incur any material liability that would have an adverse effect on the Companys operations, cash flows, or financial condition as a result of this proceeding.



The company is in the process of interviewing individuals with
strong regulatory backgrounds to fill the position of Regulatory Compliance Officer. This individual(s) will be responsible for ensuring that the companys facilities remain in compliance and good standing with both state and federal agencies.
The company expects to fill this position(s) by the end of the fourth quarter of fiscal 2004.



Healthcare Reform



As
one of the largest industries in the United States, healthcare continues to attract significant legislative interest and public attention. In recent years, various legislative proposals have been introduced or proposed in Congress and in some state
legislatures that would affect major changes in the healthcare system, either nationally or at the state level. Many states have enacted or are considering enacting measures designed to reduce their Medicaid expenditures and change private
healthcare insurance. We cannot predict the course of future healthcare legislation or other changes in the administration or interpretation of governmental healthcare programs and the effect that any legislation, interpretation, or change may have
on us.



Certificate of Need



Some states require state approval for construction and expansion of
healthcare facilities, including findings of need for additional or expanded healthcare facilities or services. Certificates of need, which are issued by governmental agencies with jurisdiction over healthcare facilities, are sometimes required for
capital expenditures exceeding a prescribed amount, changes in bed capacity or services and certain other matters. Following a number of years of decline, the number of states requiring certificates of need is once again on the rise as state
legislators are looking at the certificate of need process as a way to contain rising healthcare costs. Currently, we do not operate in any state that requires a certificate of need. Should we desire to expand our operations to any jurisdiction
where a certificate of need will be required, we are unable to predict whether we will be able to obtain any such certificate of need.



Conversion Legislation



Many states have enacted or are considering enacting laws affecting the conversion or sale of not-for-profit hospitals. These laws, in general, include
provisions relating to attorney general approval, advance notification and community involvement. In addition, state attorneys general in states without specific conversion legislation may exercise authority over these transactions based upon
existing law. In many states there has been an increased interest in the oversight of not-for-profit conversions. We may effect a conversion of a not for profit hospital in the future and accordingly, the adoption of conversion legislation and the
increased review of not-for-profit hospital



16



---

conversions may increase the cost and difficulty or prevent our completion of transactions with not-for-profit organizations in certain states in the future.



Environmental Regulation



Our hospital operations generate medical waste that must be disposed of in
compliance with federal, state and local environmental laws, rules and regulations. These operations, as well as our purchases of hospitals, also are subject to compliance with various other environmental laws, rules and regulations. We believe that
the cost of such compliance will not have a material effect on our future capital expenditures, earnings or competitive position.



Insurance



The Company maintains various insurance policies that cover each of its facilities. Specifically, the Company maintains medical malpractice insurance
coverage in Texas. The Company has claims-made malpractice coverage and has purchased tail coverage effective through August 12, 2004. The Company in Louisiana is a member of the Louisiana Patient Compensation Fund and purchases insurance through
the Louisiana Patient Compensation Fund for medical malpractice. In addition, all physicians granted privileges at the Companys facilities are required to maintain medical malpractice insurance coverage. The Company also maintains general
liability and property insurance coverage for each facility and flood coverage for the Baton Rouge Facility. The Company also maintains workers compensation coverage for the Baton Rouge Facility, but does not currently maintain workers
compensation coverage in Texas. In regard to the Employee Health Insurance Plan, the Company is self insured with specific and aggregate re-insurance with stop loss levels appropriate for the companys group size. Coverages are maintained in
amounts management deems adequate.



Employees



As of June 26, 2004, the Company employed approximately 328 full-time
employees and 74 part-time employees, which represents approximately 338 full time equivalent (FTE) employees.



Available Information



We file proxy statements and annual, quarterly and current reports with the U.S. Securities and Exchange Commission (SEC). You may read and copy any
document that we file at the SECs public reference room located at 450 Fifth Street N.W., Washington, D.C. 20549. You may also call the SEC at 1-800-SEC-0330 for information on the operation of the public reference room. Our SEC filings are
also available to you free of charge at the SECs website at http://www.sec.gov. We also maintain a website at http://www.dynacq.com that includes links to our SEC filings, including our annual reports on Form 10-K, quarterly reports on Form
10-Q, current reports on Form 8-K and any amendments to those reports. These reports are available on our website without charge as soon as reasonably practicable after such reports are filed with or furnished to the SEC. Information contained on
our website is not part of this report.



17



---

Risk Factors



The value of an investment in Dynacq Healthcare, Inc. will be subject to significant risks that are inherent in our
business and the industry in which we operate, and some of which are specific to our Company. If any of the matters described in the risk factors listed below were to occur, our business and financial results could be adversely affected in a
material way. This could cause the trading price of our common stock to decline, perhaps significantly. The risks and uncertainties described below are not the only ones facing the Company. Additional risks and uncertainties, including those that
are not presently known or that we currently believe are immaterial, may also adversely affect our business, financial condition or results of operations.



Because we are not current in our periodic SEC filings, we are in default under our reducing revolving line of credit.



We currently have approximately $6.0 million outstanding under our reducing
revolving line of credit, which includes a covenant requiring us to timely file our periodic reports with the Securities and Exchange Commission. Because we did not timely file this annual report on Form 10-K and have not yet filed our quarterly
reports on Form 10-Q for the fiscal quarters ended November 30, 2003, February 29, 2004 and May 31, 2004, we are in default under the terms of the line of credit. On April 16, 2004, the financial institution submitted to us a notice of default.
Since we did not cure the default within 10 days, we are now in default under the line of credit. To this date, the financial institution has not taken any further action. Our indebtedness under our line of credit is secured by substantially all of
our assets. If we are unable to repay all outstanding balances, the financial institution could proceed against our assets to satisfy our obligations under the line of credit.



The cash that we generate from our business may not be sufficient to meet our financial obligations or to fund our capital
requirements. As a result, we may require additional capital for, among other purposes, implementing our business growth strategy, purchasing equipment and establishing new facilities. We may not be able to obtain additional capital on acceptable
terms, if at all. If we are unable to obtain sufficient additional capital in the future, our business could be adversely affected by reducing our ability to increase revenues and profitability. If we are unable to generate sufficient cash flow from
operations in the future to repay our indebtedness and to meet our other commitments, we will be required to adopt one or more alternatives, such as refinancing, selling material assets or operations or seeking to raise additional debt or equity
capital. These actions may not be effected on a timely basis or on satisfactory terms or at all, and these actions may not enable us to continue to satisfy our capital requirements. See Managements Discussion and Analysis of Financial
Condition and Results of OperationsLiquidity and Capital Resources.



Our former and current independent auditors have advised us that they have identified material weaknesses in our internal controls.



In conjunction with Ernst & Youngs resignation, Ernst & Young advised us that it had identified material weaknesses relating to our internal
controls. In a letter dated December 23, 2003, Ernst & Young advised us that a material weakness existed as a result of inadequate communication lines and internal controls relating to the authorization, recognition, capture and review of
transactions, facts, circumstances and events that may have a material impact on the Companys financial reporting process. Ernst & Young has also advised us that a material weakness existed as a result of a lack of supervision, review and
quality control related to the accounting for income taxes, noting errors in the computation of income taxes. Further, our current independent auditors have orally advised the audit committee that they have identified what they consider to be
material weaknesses in our internal controls with respect to:



| |  | the non-compliance by various departments in submitting information in accordance with procedures to ensure proper and timely recording of accounts payable;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | family relationships among certain of our officers and employees;
| | - | -----------------------------------------------------------------



| |  | the failure to properly utilize the inventory software to track and report our inventory quantities on a real time basis;
| | - | -------------------------------------------------------------------------------------------------------------------------



| |  | the failure to properly account for stock options issued to non-employees; and
| | - | ------------------------------------------------------------------------------



| |  | a lack of supervision, review and quality control related to the accounting for income taxes.
| | - | ---------------------------------------------------------------------------------------------



18



---

See Item 9A. Controls and Procedures for a discussion of steps we and our Audit Committee are taking in
response to these communications.



The failure by the Company
to properly and timely address the issues identified by the auditors as material weaknesses could adversely impact the accuracy of future reports and filings and the timeliness of such reports and filings made pursuant to the Securities Exchange Act
of 1934. In addition, for the audit of our financial statements for the fiscal year ended August 31, 2005, we must comply with Section 404(a) of the Sarbanes-Oxley Act, which requires annual management assessments of the effectiveness of our
internal control over financial reporting and a report by the independent auditors addressing those assessments. While the Company is implementing steps to ensure compliance with Section 404(a) of the Sarbanes-Oxley Act, failure to comply with such
requirements could have a material adverse effect on our business.



The
restatement of our financial statements for fiscal years 2001 and 2002 and selected financial information for fiscal years 1999 and 2000 exposes us to risks.



In connection with an ongoing review by the Securities and Exchange Commission of our periodic reports, we have restated and
obtained a re-audit of our financial statements for the fiscal year ended August 31, 2002, restated our 2001 financial statements, and restated the selected financial information for fiscal years 1999 and 2000. The re-audit and restatements of the
financial statements produced adjustments to previously reported amounts. These adjustments are described in Note 2 to the consolidated financial statements. Due to the restatements and re-audit, investors should not rely on the Companys
previously issued financial statements for the fiscal years ended August 31, 1999 through 2002.



The restatement of these financial statements may lead to litigation claims and/or regulatory proceedings against us. The defense of any such claims or
proceedings may divert managements attention and resources away from the business, and we may be required to pay damages if any such claims or proceedings are not resolved in our favor. Any litigation or regulatory proceedings, even if
resolved in our favor, could cause us to incur significant legal and other expenses. In addition, we may be the subject of negative publicity focusing on the financial statement inaccuracies and resulting restatement, which could harm our business
and reputation.



Our former independent accountant has ceased operations
and investors may not be able to recover against them.



KenWood & Associates, P.C., our independent accountants until May 31, 2002, has ceased its audit practice before the Securities and Exchange Commission. KenWood audited our consolidated financial statements as of August 31, 2001, and
for the fiscal year then ended, and issued a report dated November 26, 2001, on such financial statements. KenWood has not reissued its report or consented to the incorporation by reference of such report into this annual report on Form 10-K. In
connection with the restatement of these consolidated financial statements, our current independent accountants, Killman, Murrell & Company, has audited the adjustments that were applied to restate the 2001 consolidated financial statements, but
did not audit or review the 2001 consolidated financial statements other than with respect to such adjustments. Please read Note 2 to the consolidated financial statements for a description of the adjustments applied to restate our financial
statements. Because KenWood has ceased operations before the Securities and Exchange Commission, investors may not be able to recover against KenWood for claims arising from KenWoods provision of auditing services to us, including claims under
federal and state securities laws. Because KenWood has not reissued its report or consented to the incorporation by reference of such report into this annual report on Form 10-K, investors may not be able to recover against KenWood under Section 11
of the Securities Act of 1933 for any untrue statements of a material fact contained in the 2001 financial statements audited by KenWood that are included in this report or any omissions to state a material fact required to be stated therein.



Control by single stockholder



Chiu M. Chan beneficially owns an aggregate of approximately 57.9% of the
Companys issued and outstanding common stock. He also serves as our Chairman, Chief Executive Officer and acting Chief Operational Officer. As majority stockholder, he is able to exert significant influence over all matters requiring
stockholder approval, including the election and removal of any directors and any merger, consolidation or sale of all or substantially all of our assets. In addition, this stockholder may dictate the day-to-day management of our business. This
concentration of ownership could have the effect of delaying, deferring or preventing a change of control, or impeding a merger or consolidation, takeover or other business combination or sale of all or substantially all of our assets. Furthermore,
due to this ownership, our public float is limited and as a result the trading price for our



19



---

common stock may be more volatile than it would be if such concentration did not exist. In the event that this stockholder elects to sell significant amounts
of shares of common stock in the future, such sales could depress the market price of our common stock, further increasing the volatility of our trading market.



Our common stock has been delisted from the Nasdaq National Market, which could have a material adverse impact on our stock price, our ability to raise capital
and increased obligations under state securities laws.



Our common stock was delisted from the Nasdaq National Market as of the opening of business on Friday, April 16, 2004, because we were not able to file our periodic reports with the Securities and Exchange Commission in a timely manner. Our
common stock has continued to be quoted on the National Quotation Service Bureau (the Pink Sheets) for unsolicited trading. As a result, there is currently no regular public trading market for the Companys common stock.



We are making every effort to complete the restatements of our financial
statements and make our SEC filings as soon as possible, but we have not yet filed our quarterly reports on Form 10-Q for the periods ended November 30, 2003, February 29, 2004, or May 31, 2004. Once we have become current in our SEC filings, we
will explore the listing alternatives available to us. However, we cannot assure you that an active trading market will exist for our common stock.



Our failure to relist our common stock on The Nasdaq National Market or a stock exchange could materially adversely affect the liquidity of our common
stock and result in a corresponding material reduction in the price of our common stock. In addition, the continued lack of a public trading market for our common stock could materially adversely affect our ability to raise capital through
alternative financing sources on terms acceptable to us, or at all, which could materially harm our business. In addition, we may no longer qualify for exemptions from state securities registration requirements. Without an exemption, we may need to
file time-consuming and costly registration statements for future securities transactions and issuances and to amend our stock option plans.



We have a limited trading market, which could affect your ability to sell shares of our common stock and the price you may receive for our common stock



Our common stock is currently quoted on the National
Quotation Service Bureau (the Pink Sheets) for unsolicited trading. There is only limited trading activity in our securities. We do not know if a market for our common stock will be reestablished or that, if reestablished, a market will
be sustained. Therefore, investors should realize that they may be unable to sell our common stock if they purchase it. Accordingly, investors must be able to bear the financial risk of losing their entire investment in our common stock.



Even if our common stock were relisted on the Nasdaq National Market
System or on a stock exchange, we would have a relatively small public float compared to our market capitalization. Accordingly, we cannot predict the extent to which investors interest in our common stock will provide an active and liquid
trading market. Due to our limited public float, we may be vulnerable to investors taking a short position in our common stock, which would likely have a depressing effect on the price of our common stock and add increased volatility to
our trading market. Furthermore, we have been, and in the future may be subject to, class action lawsuits which further increase market volatility. The volatility of the market for our common stock could have a materially adverse effect on our
business, results of operations and financial condition.



Future
reductions or changes in reimbursement from government or third party payers could adversely impact our operating results.



During fiscal year 2003, our net revenues were derived approximately 52% from state workers compensation programs, approximately 37% from commercial
payers, and approximately 5% from Medicare and Medicaid programs. In April 2004, the TWCC adopted a new Fee Guideline for Ambulatory Surgical Centers which will become effective as of September 1, 2004. Reimbursement for services not identified in
an established fee guideline are reimbursed at a fair and reasonable rate. Fair and reasonable is not a defined term and the only requirement placed upon an outpatient facility is to bill charges at a usual and
customary level. Our outpatient and ambulatory surgical center facilities bill for services provided to its workers compensation patients at its usual and customary level and pursues reimbursement for these services at a fair and
reasonable rate. Due to the soon to be effective Ambulatory Surgical Center guidelines, it is anticipated that the number of medical fee disputes filed with the commission may increase during the first twelve months after implementation of
this new guideline. As of now, the new fee guideline only affects Ambulatory Surgery Centers and therefore only the West Houston Facility will be affected at this time. In the



20



---

event that additional rule changes are proposed and adopted that revise fee guidelines or reimbursement rates of the current workers compensation
statutes, our operating results may be adversely affected. While to date no proposed legislation impacts inpatient operations, there can be no assurances that future legislation may not be adopted. Likewise, in the event that commercial payers
modify their respective health benefit programs, such changes could have an adverse material affect in our results of operations.



Delayed Reimbursement under Texas Workers Compensation Commission Can Adversely Impact Our Collections Experience and Our Liquidity



With respect to our inpatient surgical services, reimbursement is predicated
upon the Acute Care Inpatient Hospital Fee Guideline established by the Texas Workers Compensation Commission (TWCC). Additionally, with respect to inpatient surgical services having total audited charges exceeding $40,000, the
Acute Care Inpatient Hospital Fee Guideline requires the carrier to reimburse the provider 75% of total audited charges. Our reimbursement experience indicates that carriers often dispute the bill or provide reimbursement less than the amount the
Company believes it is entitled to receive pursuant to the Acute Care Inpatient Hospital Fee Guideline. In such instances, we are relegated to pursuing our claims through the Medical Dispute Resolution (MDR) process. When the Company is required to
pursue reimbursement through the MDR process, any such reimbursement therefrom often involves delays and compromises, due to the subjective nature of the administrative process and the lack of established timeframes in which the reimbursement
disputes are to be resolved. This results in the aging of our receivables which affect our liquidity and, in some instances, actual recoveries. Any modification to current reimbursement guidelines may reduce the amount of our reimbursement for
future services thereby increasing contractual discounts. The fact that our collection process may be longer than other healthcare providers presents inherent risks in ultimate collection.



Limited Operating History of Current Business Strategy



During the last two fiscal years, management has shifted to managing and
operating hospitals rather than the operation of infusion therapy and physician practice management. The Company computes its contractual revenue discount based on its evaluation of historical cash collections and the collectibility of outstanding
receivables based on a number of factors, including the age of the receivables, whether the receivable is subject to the MDR process and other factors. This evaluation is highly subjective and is subject to change in the future based on
managements evaluation of these factors. Any changes in the estimates applied in evaluating the collectibility of outstanding receivables could materially impact the Companys reported revenues and profitability. Due to our limited
operating history in this healthcare segment, we have limited data upon which to base this evaluation. As our business in this healthcare segment matures, additional data with respect to historical cash collections and the collectibility of
outstanding receivables will become available. As the additional collection data becomes available in the future, management may change its estimate of the collectibility of then outstanding receivables which could affect reported net patient
revenues and profitability.



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



We are required to comply with extensive and complex laws and regulations at the federal, state and local government levels. We believe we are in
substantial compliance with current laws and regulations that relate to, among other things:



| |  | licensure, certification and accreditation;
| | - | -------------------------------------------



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



| |  | relationships with physicians and other referral sources, including physician self-referral and fraud and abuse;
| | - | ----------------------------------------------------------------------------------------------------------------



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



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



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



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



| |  | the screening, stabilization and transfer of patients who have emergency medical conditions;
| | - | --------------------------------------------------------------------------------------------



| |  | building codes;
| | - | ---------------



21



---

| |  | environmental protection;
| | - | -------------------------



| |  | clinical research;
| | - | ------------------



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



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



Many of these laws and regulations are expansive, and we do not always have the benefit of significant regulatory or judicial interpretation of them. In
the future, different interpretations or enforcement of these laws and regulations could subject our current or past practices to allegations of impropriety or illegality or could require us to make changes in our facilities, equipment, personnel,
services, capital expenditure programs, operating procedures, and contractual arrangements.



If we fail to comply with applicable laws and regulations, we could be subjected to liabilities, including:



| |  | criminal penalties,
| | - | -------------------



| |  | civil penalties, including monetary penalties and the loss of our licenses to operate one or more of our hospitals, and
| | - | -----------------------------------------------------------------------------------------------------------------------



| |  | exclusion of one or more of our hospitals from participation in the Medicare, Medicaid and other federal and state healthcare programs, such as workers compensation program.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



A determination that we have violated these
laws, or the public announcement that we are being investigated for possible violations of these laws, could have a material adverse effect on our business, financial condition, results of operations or prospects and our business reputation could
suffer significantly. In addition, we are unable to predict whether other legislation or regulations at the federal or state level will be adopted, what form such legislation or regulations may take or their impact.



If the Anti-kickback Statute, physician self-referral or other fraud and abuse laws are
modified, interpreted differently or if other regulatory restrictions are issued, we could incur significant sanctions and loss of reimbursement.



The federal Anti-kickback Statute prohibits the offer, payment, solicitation or receipt of any form of remuneration in return for referring items or
services payable by Medicare, Medicaid or any other federal healthcare program. The Anti-kickback Statute also prohibits any form of remuneration in return for purchasing, leasing, or ordering or arranging for or recommending the purchasing, leasing
or ordering of items or services payable by these programs. The Anti-kickback Statute is very broad in scope and many of its provisions have not been uniformly or definitively interpreted by existing case law, regulations or advisory opinions.
Violations of the Anti-kickback Statute may result in substantial civil or criminal penalties, including criminal fines of up to $25,000 or imprisonment and civil penalties of up to $50,000 for each violation, plus three times the amount claimed and
exclusion from participation in the Medicare, Medicaid, and other federal healthcare reimbursement programs.



The federal physician self-referral law, commonly referred to as the Stark Law, prohibits a physician, absent an exception, from making a referral for a
designated health service to an entity if the physician or a member of the physicians immediate family has a financial relationship with the entity. There are various ownership and compensation arrangement exceptions to the self-referral
prohibition. The exception that in the past permitted physicians to invest in our hospitals and make a referral to the hospital include the requirements that the physician be authorized to perform services at the hospital and own an interest in the
entire hospital, as opposed to an ownership interest in a department or subdivision of the hospital. This exception is currently suspended during an 18-month moratorium on new specialty hospitals while a governmental study is being conducted.



The results of the study may affect ownership and other
investment interests purchased by physicians. This study as well as other possible amendments to the Stark Law could require us, however, to change the manner in which we establish relationships with physicians to develop a hospital. We cannot
predict the results of the study or whether any other amendment to the Stark Law will be enacted or the effect they might have on us. Many states in which we operate also have adopted, or are considering adopting, similar physician self-referral
laws. Some of these laws prohibit referrals of patients by physicians in certain cases and others require disclosure of the physicians interest in the healthcare facility if the physician refers a patient to the facility. Some of these state
laws apply even if the payment for care does not come from the government.



22



---

Federal law also contains provisions imposing civil monetary penalties for various fraudulent and/or
abusive practices, including, among others, hospitals which knowingly make payments to a physician as an inducement to reduce or limit medically necessary care or services provided to Medicare or Medicaid beneficiaries. The OIG issued a Special
Advisory Bulletin on physician incentive compensation, referred to as gainsharing arrangements, that also warns that other joint ventures between hospitals and physicians may implicate this provision as well as the Anti-kickback Statute,
and specifically refers to specialty hospitals. We believe that the ownership distributions paid to physicians by our hospitals do not constitute payments made to physicians under gainsharing arrangements. We cannot assure you, however, that the OIG
or any other federal agency charged with enforcement of the Anti-kickback Statute will agree with this interpretation or that new laws or regulations or future changes in the interpretation of existing laws and regulations will not adversely affect
our business.



The federal Anti-kickback Statute, the Stark Law
and similar federal and state statutes that may also involve private payers are, however, subject to different interpretations with respect to many important provisions. Violations of these laws may result in substantial civil or criminal penalties,
including large civil monetary penalties and exclusion from participation in the Medicare, Medicaid and other healthcare programs. Exclusion of our hospitals from these programs could result in significant loss of revenues and consequently would
have a material adverse effect on us. In addition, we could be forced to expend considerable resources responding to an investigation or enforcement action under these laws and regulations. Further judicial or agency interpretation of existing laws
or further legislative restrictions on physician ownership, investment in, or other financial relationships with healthcare facilities could have a material adverse effect on us.



If we are unable to acquire and develop additional hospitals on favorable terms, we may be unable to execute our acquisition and
development strategy, which could limit our future growth.



Our strategy is to increase our revenues and earnings by continuing to acquire and to develop additional hospitals. Our efforts to execute our acquisition and development strategy may be affected by our ability to identify suitable
candidates and negotiate and close acquisition and development transactions. We are currently evaluating potential acquisitions and development projects and expect to continue to evaluate acquisitions and development projects in the foreseeable
future. The hospitals we develop typically incur losses during the early stages of operation and, unless and until their case loads grow, they generally experience lower total revenues and operating margins than established hospitals. We may not be
successful in acquiring additional hospitals, developing hospitals or achieving satisfactory operating results at acquired or newly developed hospitals. Further, assets we acquire in the future may not ultimately produce returns that justify our
related investment. If we are not able to execute our acquisition and development strategy, our ability to increase revenues and earnings through future growth would be impaired.



If we are unable to manage growth, we may be unable to achieve our growth strategy.



We expect to continue to expand our operations in the future provided that
we have sufficient capital to effect our growth strategy. As a young company, our rapid growth has placed, and will continue to place, increased demands on our management, operational and financial information systems and other resources. Further
expansion of our operations will require substantial financial resources and management attention. To accommodate our past and anticipated future growth, and to compete effectively, we will need to continue to implement and improve our management,
operational and financial information systems and to expand, train, manage and motivate our workforce. Our personnel, systems, procedures or controls may not be adequate to support our operations in the future. Further, focusing our financial
resources and management attention on the expansion of our operations may negatively impact our financial results. Any failure to implement and improve our management, operational and financial information systems, or to expand, train, manage or
motivate our workforce, could reduce or prevent our growth.



Our future
results could be harmed by economic, political, regulatory and other risks associated with our potential expansion into foreign operations.



Our Board of Directors has ratified and approved negotiations for the potential long-term lease of land and procurement of a hospital license for a
hospital to be constructed in Shanghai, China. The proposed hospital would be owned by a joint venture company controlled by Dynacq, with several local joint venture partners. While certain approvals from the Beijing and Shanghai governments have
been obtained, other required approvals have not. No assurance can be given that the required approvals will be obtained or that the proposed joint venture hospital project can be achieved at all, or if so, on terms deemed favorable to us. The
Company is currently negotiating the



23



---

lease and has made an earnest money deposit of $640,000. We cannot assure you that the required approvals will be confirmed or that the proposed joint
venture hospital project can be achieved at all, or if so, that the terms will be favorable to the Company.



There can be no assurance that we will be able to accomplish our expansion plans or successfully conduct our operations in China or in any other future
foreign markets. The failure to do so, including the failure to attract patients and to recruit qualified physicians to this facility, could have a material adverse effect on our business, financial condition, and results of operations. In addition,
there can be no assurance that we will have sufficient capital to complete the construction and development of the facility in China in a timely manner or at all.



The risks associated with international expansion could adversely affect our ability to expand our business. Expansion of
our operations into new markets entails substantial working capital and capital requirements associated with complying with a variety of foreign laws and regulations, complexities related to obtaining agreements from foreign governments and third
parties, foreign taxes, and financial risks, such as those related to foreign currency fluctuations. If we expand internationally, we also will be subject to general geopolitical risks, such as political and economic instability and changes in
diplomatic relationships. In many market areas, other healthcare facilities and companies already have significant presence, the effect of which could be to make it more difficult for us to attract patients and recruit qualified physicians.



New federal and state legislative and regulatory initiatives relating to
patient privacy and electronic data security could require us to expend substantial sums acquiring and implementing new information and transaction systems, which could negatively impact our financial results.



There are currently numerous legislative and regulatory initiatives at the
state and federal levels addressing patient privacy concerns and standards for the exchange of electronic health information. These provisions are intended to enhance patient privacy and the effectiveness and efficiency of healthcare claims and
payment transactions. In particular, the Administrative Simplification Provisions of the Health Insurance Portability and Accountability Act of 1996 may require us to acquire and implement expensive new computer systems and to adopt business
procedures designed to protect the privacy of each of our patients individual health information.



On August 17, 2000, the Department of Health and Human Services issued final regulations establishing electronic data transmission standards that
healthcare providers must use when submitting or receiving certain healthcare data electronically. Compliance with these regulations was initially required by October 16, 2002. However, on December 27, 2001, President Bush signed into law the
Administrative Simplification Compliance Act, which requires that, by October 16, 2002, covered entities must either: (1) be in compliance with the electronic data transmission standards; or (2) submit a summary plan to the Secretary of Health and
Human Services describing how the entity will come into full compliance with the standards by October 16, 2003. As of that date, we believe that we are in substantial compliance with the standards.



The Administrative Simplification Provisions of the Health Insurance
Portability and Accountability Act also require the Department of Health and Human Services to adopt standards to protect the security and privacy of health-related information. Proposed security standards were published on August 12, 1998, but they
have not been finalized. The proposed security standards would require healthcare providers to implement organizational and technical practices to protect the security of patient information. Once the security regulations are finalized, we will have
approximately two years to comply with such regulations.



In
addition, on December 28, 2000, the Department of Health and Human Services released final regulations regarding the privacy of healthcare information. Although these privacy regulations were effective April 14, 2001, compliance with these
regulations was not required until April 14, 2003. The privacy regulations extensively regulate the use and disclosure of individually identifiable healthcare information, whether communicated electronically, on paper or verbally. The regulations
also provide patients with significant new rights related to understanding and controlling how their health information is used or disclosed.



These regulations were expected to have a financial impact on the healthcare industry, because they imposed extensive new requirements and restrictions on
the use and disclosure of identifiable patient information. Because of the nature of the security and privacy regulations, we cannot predict the total financial or other impact of these regulations on our business and compliance with these
regulations could require us to spend substantial sums, which could negatively impact our financial results. We believe that we are in material compliance with existing state and federal regulations relating to patient privacy. However, if we fail
to comply with the recently released



24



---

regulations, we could suffer civil penalties up to $25,000 per calendar year for each violation and criminal penalties with fines up to $250,000 per
violation. In addition, we will continue to remain subject to state laws that may be more restrictive than the federal privacy regulations.



We are dependent upon establishing and maintaining surgeon relationships



Our continued success will depend upon our ability to continue to develop and maintain productive relationships with
surgeons utilizing our facilities. Identifying appropriate surgeons and our surgeon groups and negotiating and implementing affiliations with these groups can be a lengthy process. There can be no assurance that we will be successful in identifying
and establishing relationships with these surgeons, and if relationships are established, there can be no assurance that such relationships will be maintained. None of the surgeons or physicians practicing at our hospitals have a legal commitment,
or any other obligation or arrangement, that requires the physician to refer patients to any of our hospitals. Our revenues and profitability would be reduced if we lost our relationship with one or more key surgeons or group of surgeons or such
surgeons or groups reduce their use of our hospitals.



We are dependent
upon the good reputation of our physicians



The
success of our business is dependent upon quality medical services being rendered by our physicians. Any negative publicity, whether from civil litigation, allegations of criminal misconduct, or forfeiture of medical licenses, with respect to any of
our physicians and/or our facilities could adversely affect our results of operations. This could occur through the loss of a physician who provides significant revenue to the Company, or decisions by patients to use different physicians or
facilities with respect to their healthcare needs. In addition, we have been the subject of negative publicity in news reports focusing on our Pasadena Facility, which has harmed our business and reputation. As the patient-physician relationship
involves inherent trust and confidence, any negative publicity adversely affecting the reputation of our physicians or our facilities would likely adversely affect our results of operations.



A significant percentage of our revenues are generated through relatively few
physicians.



For the fiscal year ended August 31,
2003, approximately 76% of our revenues were generated from 11 surgeons. During the period August 2003 to May 2004 six physicians who had accounted for over 54% of our gross revenues in fiscal 2003, departed from the Pasadena Facility or
substantially reduced their surgeries for various reasons. Among these physicians Dr. Eric Scheffey, who had his medical license suspended in August 2003, accounted for 21% of 2003 gross revenues and Dr. Carlos Ferrari, who departed to practice
elsewhere, accounted for 10.3% of 2003 gross revenues. The Company has been engaged in efforts to recruit new physicians to the staff. While we believe that we will be able to attract and retain additional physicians, the loss of physicians who
provide significant net patient revenues for the Company may adversely affect our results of operations.



Our physicians need to be on the approved doctors list



Since September 2003, the TWCC has required that injured employees in Texas receive healthcare from a doctor on the approved doctors list
(ADL), except in an emergency or for the immediate post-injury medical care. Accordingly, doctors on the ADL, whether licensed in Texas or licensed by another jurisdiction, are required to complete training mandated by the TWCC, apply
for a certificate of registration and disclose any required financial interests. At this time, we believe that all doctors involved in the care and treatment of patients covered by the Texas Workers Compensation Act who maintain medical staff
privileges at the Companys locations have applied to be on the ADL and have either been granted a temporary exception or have been placed on the ADL. The TWCC reserves the right to review a doctor at any time and take action at a later date
for all doctors currently placed on the ADL. The failure of any of our physicians to be listed or maintain listing on the ADL could adversely affect our results of operations.



We are dependent on our hospital facilities for a majority of our revenues



In fiscal year 2003, the majority of our revenues were derived from the
management and operation of the Pasadena Facility. As the Company has executed its business strategy to open additional facilities and recruit more physicians, it has become less dependent upon the net revenues generated by the Pasadena Facility for
its overall financial success. While the departure of several physicians from the Pasadena Facility contributed to its concurrent



25



---

drop in net revenue, our other facilities have increased their net revenue. However, should the results of any one of our current hospital facilities
experience a substantial decline in revenue for any reason, our operating results will be materially adversely affected.



If government laws or regulations change, or the enforcement or interpretation of them change, we may be obligated to purchase some or all of the ownership
interests of the physicians affiliated with us.



Changes in government regulation or changes in the enforcement or interpretation of existing laws or regulations could obligate us to purchase some or all of the ownership interests of the physicians affiliated with us in the limited
partnerships or limited liability companies that own and operate our hospitals. The regulatory changes that could create this obligation include changes that:



| |  | make illegal the referral of Medicare or other patients to our hospitals by physicians affiliated with us;
| | - | ----------------------------------------------------------------------------------------------------------



| |  | create the substantial likelihood that cash distributions from the limited partnerships or limited liability companies through which we operate our hospitals to physicians
affiliated with us would be illegal; or
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | make illegal the ownership by the physicians affiliated with us of interests in the partnerships or limited liability companies through which we own and operate our hospitals.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



At this time, we are not aware of any regulatory
amendments or proposed changes that would trigger this obligation. In the event that we are required to purchase all of the physicians ownership interests we could be required to use our cash resources for such acquisitions. The creation of
these obligations and the possible termination of our affiliation with these physicians could have a material adverse effect on us.



We could be harmed by ongoing Texas Attorney General and SEC investigations.



We have been notified by the Office of the Attorney General of Texas (AGs office) that we are the subject
of an investigation of possible violations of the statutes governing the solicitation of patients. We believe that such investigation stems from the same allegations that have been asserted in a private lawsuit currently pending against us. We have
denied the allegations in that lawsuit and continue to vigorously defend the suit. We had also previously received an inquiry from the AGs office requesting documentation related to any instances of deaths occurring at our facilities between
January 1, 1999 and January 29, 2004. We are cooperating with the AGs office on each of these matters, but believe the complaints received by the AGs office to be without merit. In the event charges are filed against us related to this
investigation, we could be subject to significant sanctions and penalties, which could have a material adverse effect on our business and financial condition. Furthermore, our reputation could suffer and any damage to our reputation could cause us
to lose existing patients and fail to attract new patients and qualified physicians, which would have a material adverse effect on our business and financial condition. While the Company has denied any wrongdoing and intends to vigorously defend
itself, no assurance can be given as to the outcome of this matter or the effect on our business.



On December 18, 2003, we received a notice of an informal investigation from the Fort Worth, Texas District Office of the Securities and Exchange
Commission requesting our voluntary assistance in providing information regarding reporting of our financial statements, recognition of costs and revenue, accounts receivable, allowances for doubtful accounts and our internal controls. We have been
cooperating fully with the continuing informal SEC investigation. We cannot predict the outcome of this matter or the effect that it may have on us.



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



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



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



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



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



| |  | medical necessity of services provided.
| | - | ---------------------------------------



26



---

In addition, the OIG and the Department of Justice have, from time to time, undertaken national
enforcement initiatives that focus on specific billing practices or other suspected areas of abuse. Moreover, another trend impacting healthcare providers is the increased use of the Federal False Claims Act, particularly by individuals who bring
actions under that law. Such qui tam or whistleblower actions allow private individuals to bring actions on behalf of the government alleging that a healthcare provider has defrauded the federal government. If the
government intervenes and prevails in the action, the defendant may be required to pay three times the actual damages sustained by the government, plus mandatory civil monetary penalties of between $5,500 and $11,000 for each false claim submitted
to the government. As part of the resolution of a qui tam case, the party filing the initial complaint may share in a portion of any settlement or judgment. If the government does not intervene in the action, the qui tam plaintiff may
pursue the action independently. Additionally, some states have adopted similar whistleblower and false claims provisions.



Some of our activities could become the subject of governmental investigations or inquiries. For example, a portion of our revenues derive from Medicare
and Medicaid billings, and venture arrangements involving physician investors. Any investigations of us, our executives or physicians practicing at our hospitals could result in significant liabilities or penalties to us, as well as adverse
publicity.



If we become subject to significant legal actions, we could
be subject to substantial uninsured liabilities.



In
recent years, physicians, hospitals and other healthcare providers have become subject to an increasing number of legal actions alleging malpractice, product liability or related legal theories. Many of these actions involve large monetary claims
and significant defense costs. We do not employ any of the physicians who conduct surgical procedures at our hospitals and the governing documents of each of our hospitals require physicians who conduct surgical procedures at our hospitals to
maintain stated amounts of insurance. Additionally, to protect us from the cost of these claims, we maintain professional malpractice liability insurance and general liability insurance coverage in amounts and with deductibles that we believe to be
appropriate for our operations. If we become subject to claims, however, our insurance coverage may not be sufficient or continue to be available at a cost allowing us to maintain adequate levels of insurance. If one or more successful claims
against us were not covered by or exceeded the coverage of our insurance, we could be adversely affected.



We do not presently carry director and officer liability insurance



We do not presently carry director and officer liability insurance, and, pursuant to indemnification agreements with certain of our officers and directors
and our certificate of incorporation and bylaws, we provide for indemnification and advancement of expenses to the full extent permitted by Delaware law. As a result, our assets are at risk in the event of successful claims against us or our
officers and directors. Our assets may not be sufficient to satisfy judgments against us and our officers and directors in the event of such successful claims, or to pay for the costs of defense. In addition, our lack of director and officer
liability insurance may adversely affect our ability to attract and retain highly qualified directors and officers in the future.



Our hospitals face competition for patients from other hospitals and healthcare providers.



The healthcare business is highly competitive and competition among hospitals and other healthcare providers for patients
has intensified in recent years. Generally, other hospitals in the local communities served by most of our hospitals provide services similar to those offered by our hospitals. In addition, the number of freestanding specialty hospitals and surgery
and diagnostic centers in the geographic areas in which we operate has increased significantly. As a result, most of our hospitals operate in an increasingly competitive environment. Some of the hospitals that compete with our hospitals are owned by
governmental agencies or not-for-profit corporations supported by endowments and charitable contributions and can finance capital expenditures and operations on a tax-exempt basis. Increasingly, we are facing competition by physician-owned
freestanding surgery centers that compete for market share in high margin services and for quality physicians and personnel. If our competitors are better able to attract patients, recruit physicians, expand services or obtain favorable managed care
contracts at their healthcare facilities, we may experience a decline in patient volume.



Our hospitals face competition for staffing, which may increase our labor costs and reduce profitability.



Our operations are dependent on the effort, abilities and experience of the management and medical support personnel, such as nurses, pharmacists and lab
technicians, as well as its physicians. We compete with other healthcare providers in recruiting and retaining qualified management and support personnel responsible for the day-to-day operations of each of our hospitals, including nurses and other
non-physician healthcare professionals. In



27



---

some markets, the availability of nurses and other medical support personnel has become a significant operating issue to healthcare providers. This shortage
may require us to continue to enhance wages and benefits to recruit and retain nurses and other medical support personnel or to hire more expensive temporary personnel. We also depend on the available labor pool of semi-skilled and unskilled
employees in each of the markets in which we operate. If our labor costs increase, we may not be able to raise rates to offset these increased costs. Our failure to recruit and retain qualified management, nurses and other medical support personnel,
or to control our labor costs could have a material adverse effect on our results of operations.



Our hospitals are heavily concentrated in Texas and Louisiana, which makes us sensitive to regulatory, economic and competitive changes in those States.



All of our hospitals are currently located in Texas and Louisiana, which
makes us particularly sensitive to regulatory, economic, and competition changes in those states. Any material change in the current regulatory, economic or competitive conditions in these states could have a disproportionate effect on our overall
business results.



If laws governing the corporate practice of medicine
change, we may be required to restructure some of our relationships.



The laws of various states in which we operate or may operate in the future do not permit business corporations to practice medicine, exercise control over physicians who practice medicine or engage in various
business practices, such as fee-splitting with physicians. The interpretation and enforcement of these laws vary significantly from state to state. We are not required to obtain a license to practice medicine in any jurisdiction in which we own or
operate a hospital or other facility because our hospitals are not engaged in the practice of medicine. The physicians who use our hospitals to provide care to their patients are individually licensed to practice medicine. Except for Medical
Directorship Agreements and specialized service agreements, such as anesthesia services, the physicians and physician group practices are not affiliated with us other than through the physicians ownership interests in the ventures that own and
operate our hospitals.



Although we believe that our
arrangements with physicians and physician group practices comply with applicable laws, we cannot assure you that a government agency charged with enforcement of these laws, or a private party, might not assert a contrary position. If our
arrangements with these physicians and physician group practices were deemed to violate state corporate practice of medicine, fee-splitting or similar laws, or if new laws were enacted rendering these arrangements illegal, we may be required to
restructure our relationships with physicians and physician groups which may have a material adverse effect on our business.



The eighteen-month moratorium on physician investment in and referrals to certain specialty hospitals may affect our development of new facilities.



On March 19, 2004, the Centers for Medicare and
Medicaid Services (CMS) announced its implementation of a moratorium on physician investment in and referrals to certain specialty hospitals enacted by Congress as part of the Medicare Prescription Drug, Improvement and Modernization Act of 2003.
Congress and CMS define specialty hospitals as primarily or exclusively engaged in the care and treatment of one of the following categories: (i) patients with a cardiac condition, (ii) patients with an orthopedic condition or (iii) patients
receiving a surgical procedure. The moratorium became effective on December 8, 2003 and expires on June 8, 2005. Congress specifically excluded from the moratorium, hospitals that were in operation before or under development as of November 18,
2003. In determining whether a specialty hospital was under development as of November 18, 2003, the CMS considers whether all of the following occurred prior to November 18, 2003: (i) architectural plans were completed, (ii) funding was
received, (iii) zoning requirements were met, and (iv) necessary approvals from appropriate state agencies were received. In cases where all of these steps were not completed prior to November 18, 2003, the CMS will make a case-by-case determination
as to whether the specialty hospital was under development and will consider any other evidence that would indicate the under development status. To request a case-specific determination regarding whether a specialty hospital was under
development as of November 18, 2003, an interested party can request a written opinion from the CMS. During the 18-month moratorium, the Medicare Payment Advisory Commission, in consultation with the Comptroller General of the United States will
conduct a study to determine, in addition to other things, the financial impact of physician-owned specialty hospitals on local full-service community hospitals. We cannot predict the results of this study, or the action that Congress may take in
response to the study.



28



---

|Item 2. | Properties
|------- | ----------



The Pasadena Facility, the office building adjacent to such facility, and the land upon which the facilities are located are owned by a wholly owned
subsidiary of the Company. The hospital is approximately 45,000 square feet and the office building is approximately 36,000 square feet. Management believes the facility is adequately covered by insurance. The Baton Rouge Facility, the office
building adjacent to such facility, and the approximately 20 acres of land upon which the facilities are located are owned by a wholly owned subsidiary of the Company. The hospital is approximately 49,500 square feet and the office building is
approximately 6,900 square feet. The Garland Facility, including an approximately 90,000 square foot hospital, an approximately 27,000 square foot medical office building and approximately 22.7 acres of land in Garland, Texas, are owned by a
wholly-owned subsidiary of the Company. The total assets were acquired in August 2003 for approximately $8.5 million including the assumption of approximately $2.9 million of liabilities. The Company has completed renovations at that facility, with
six surgical suites, and started performing surgical procedures in late November 2003. In February 2003 a subsidiary of the Company purchased 6.4 acres of land in Slidell, Louisiana for approximately $2.3 million for a possible new hospital. The
Company determined that the proposed Slidell hospital project did not fit its current business plan and sold the land in January 2004 for approximately $2.5 million. This property was classified as an asset held for sale as of August 31, 2003. The
Companys obligations under its reducing revolving line of credit are secured by substantially all of the Companys assets.



During fiscal year 2003, a Company subsidiary purchased approximately four acres of land in The Woodlands, Texas for approximately $3 million with plans
to build a new hospital over the next two years on such property. At this time, the project is still in the planning stage.



The Company leases approximately 7,800 square feet for its West Houston Ambulatory Surgery Center as well as its fertility clinic for approximately
$16,350 per month pursuant to leases that expire in May 2008.



In July 1996, DPMI leased approximately 3,000 square feet of office space from the City of Pasadena pursuant to a lease expiring in June 2006, requiring lease payments of $10,800 annually.



The Company had previously leased 1,000 square feet of office space for its
executive offices on a month-to-month basis for $1,286 per month. As of September 1, 2003, the Company increased its leased space to approximately 7,250 square feet and entered into an 8 year lease for this office space. The Company will pay $1,286
per month for the first year of the lease and $6,525 per month for the remainder of the lease term. The lessor of the office space is Capital Bank, of which Mr. Earl Votaw, one of the Companys directors, is a director. Management believes that
the lease rate being paid is consistent with comparable commercial rates available in the area.



|Item 3. | Legal Proceedings
|------- | -----------------



In January 2002, the Company, two of its officers, and the spouse of one of the officers were named as defendants in a shareholder class action lawsuit,
Hamilton v. Dynacq International, et al., in the United States District Court for the Southern District of Texas alleging violations of federal securities laws and regulations. The suit, in which the plaintiffs sought unspecified damages,
payment of costs and expenses and other equitable or injunctive relief, was brought in early 2002 following a sharp high volume increase in short sales of our common stock. The putative class covered those persons who purchased the Company shares
between November 29, 1999 and January 16, 2002. The various complaints that were consolidated claimed that the Company violated Sections 10(b) and 20(a) and Rule 10b-5 under the Exchange Act by making materially false or misleading statements or
omissions regarding revenues and receivables and regarding whether our operations complied with various federal regulations. The district court consolidated these actions and appointed a lead plaintiff in the matter. The lead plaintiff filed a
consolidated amended complaint on September 6, 2002. The Company and its officers moved to dismiss the complaint on February 25, 2003. On August 26, 2003, the Court dismissed with prejudice and denied plaintiffs leave to amend further. The
plaintiffs thereafter filed a notice of appeal. In May 2004, the plaintiffs dismissed their appeal, thereby concluding the case.



A separate shareholder derivative action alleging breach of fiduciary duty, abuse of control, gross mismanagement and unjust enrichment, Flory v. Chan,
et al., H-02-3123, was also brought in U.S. District Court for the Southern District of Texas in August 2002, but was stayed on November 12, 2002 by the district court pending the outcome of the shareholder class action described above. The
plaintiff in the derivative case, who seeks unspecified



29



---

damages and equitable or injunctive relief, and payment of expenses did not make a demand on the Company or its Board of Directors prior to filing suit. It
remained stayed pending the plaintiffs appeal of the dismissal of the shareholder class action. Given the plaintiffs dismissal of the appeal in the shareholder class action, the Company has moved to dismiss the derivative action. This
derivative matter, if it were to proceed, would not seek to recover any damages from the Company, but could expose the Company to bearing some unknown legal or indemnity costs which we cannot predict at this time.



In March 2002, the Company accepted service of a shareholder derivative
action, Brill v. Chan, et al., filed on or about February 26, 2002 in the 295th District Court of Harris County, Texas brought on behalf of the Company against its officers and directors, outside auditor, investment bank, and two analysts
affiliated with that investment bank. The suit alleges breach of fiduciary duty, aiding and abetting breach of fiduciary duty, negligence and breach of contract. Plaintiff makes general allegations of the defendants alleged misconduct in
(i) causing or allowing the Company to conduct its business in an unsafe, imprudent and unlawful manner; (ii) failing to implement and maintain an adequate internal control system; and (iii) exposing Dynacq to enormous losses, including
allegations that various press releases and/or public statements issued between January 1999 and January 2002 were misleading. Plaintiffs further allege sales by the Companys insiders while in possession of material non-public information. The
plaintiffs made no demand on either the Company or its Board of Directors prior to filing suit. The Companys Board of Directors appointed a Special Litigation Committee to conduct an investigation and make a determination as to how the Company
should proceed on the claims asserted in the state court shareholder derivative case. On February 24, 2003, the Special Litigation Committee adopted a resolution directing the Companys counsel to seek dismissal or settlement of the state court
derivative action. A Stipulation of Settlement was executed by both parties and filed with the Court on September 11, 2003. The final Settlement, which was approved by the Court on November 10, 2003, provided, among other things, that (1) the claims
were dismissed with prejudice and (2) defendants agreed to pay the legal fees and expenses of plaintiffs (shareholders), which the Court set at $500,000. Plaintiffs counsel offered to accept such payment in Dynacq common stock or in cash, and
the payment was made in cash. Among the terms of the Settlement, it was stipulated that, as a result of the prosecution of the lawsuit and/or the work of the Special Litigation Committee of the Board of Directors of Dynacq, Dynacq had implemented
and/or had agreed to implement certain procedures relating to its Audit Committee and its accounting for uncollectible accounts and contractual allowances. The Settlement does not require any change in previously reported financial statements. The
Company had accrued for this settlement at August 31, 2003. The Company made the payment after August 31, 2003 and the matter is now concluded.



Eight lawsuits were filed in the United States District Court for the Southern District of Texas (Houston Division) between December 24, 2003 and January
26, 2004, alleging federal securities law causes of action against the Company and various current and former officers and directors. The cases were filed as class actions brought on behalf of persons who purchased shares of Company common stock in
the open market generally during the period of January 14, 2003 through December 18, 2003. Under the procedures of the Private Securities Litigation Reform Act, certain plaintiffs have filed motions asking to consolidate these actions and be
designated as lead plaintiff. The court consolidated the actions and appointed a lead plaintiff in the matter. An amended complaint was filed on June 30, 2004, asserting a class period of November 27, 2002  December 19, 2003 and naming
additional defendants, including Ernst & Young LLP. The amended complaint seeks certification as a class action and alleges that the defendants violated Sections 10(b), 20(a), 20(A) and Rule 10b-5 under the Exchange Act, by publishing materially
misleading financial statements which did not comply with generally accepted accounting principles, making materially false or misleading statements or omissions regarding revenues and receivables, operations and financial results and engaging in an
intentional fraudulent scheme aimed at inflating the value of Dynacqs stock. The Company intends to vigorously defend the allegations and will file a motion to dismiss all or some of the claims. The Company cannot predict the ultimate outcome
of the lawsuit or whether the lawsuit will have a material adverse effect on the Companys financial condition.



The Company is named as a defendant in the lawsuit Leo Borrell v. Dynacq International, Inc., NeWeigh, Inc., and Diane Crumley, Vital Weight Control,
Inc., d/b/a NeWeigh, and Vista Community Medical Center, L.L.C. (Cause No. 2002-13659) filed in March 2002 in the 281st Judicial District Court of Harris County, Texas. Dr. Borrell is seeking recovery of commissions he alleges are owed pursuant to
an oral agreement with the Company. Dr. Borrell has yet to determine the damages that he is seeking. After a significant amount of discovery has been conducted, we believe this case to be without merit, and intend to continue to vigorously defend
this matter.



Late in fiscal year 2003, a dispute arose between
one of the Companys subsidiaries and Jane Capital, LLC and Sunbelt Medical Corp. related to the purchase of medical equipment for the Companys Baton Rouge Facility.



30



---

Because Jane Capital and Sunbelt each demanded identical full payment for the equipment without providing necessary
supporting documents, the Companys subsidiary filed suit in April 2003 in state district court in Harris County, Texas (165thDistrict) to require Jane Capital, LLC and Sunbelt Medical Corp. to produce the documents, to determine the proper amount owed for the equipment and to whom such amounts were owed and to reimburse the Company for selling it certain
defective products. The lawsuit was settled in May 2004. As a result of the settlement, the amount paid by the Company was approximately $1 million less than the amounts claimed by the defendants.



In September 2003, a contractor who operated the pharmacy at the Baton Rouge
Facility filed suit against the Company, the CEO, and the Baton Rouge Facility in Louisiana. The lawsuit, case number 598-564, was filed in the Twenty Fourth Judicial District Court for the Parish of Jefferson, State of Louisiana, and alleges that
the plaintiff is owed additional fees in excess of $1,000,000 for costs of goods and services rendered. The plaintiff has asserted claims for breach of contract, fraud, negligence, fraudulent misrepresentation, negligent misrepresentation, civil
conspiracy and gross negligence. The Company believes the plaintiffs claims are without merit and intends to continue to vigorously defend the lawsuit. However, we cannot predict the ultimate outcome of the lawsuit or whether the lawsuit will
have a material adverse effect on the Companys financial condition.



In December 2002, the Pasadena Facility was notified by the Centers for Medicare and Medicaid Services (CMS) that the Pasadena Facility had allegedly violated requirements of the Emergency Medical
Treatment and Labor Act (EMTALA). The Texas Department of Health (TDH) conducted an investigation and reported to the CMS that appropriate corrective actions had been taken. As a result of TDHs findings, the CMS
notified the facility in January 2003 that its eligibility for Medicare participation remained in effect, but, as required by §1867(d) of the Social Security Act, the matter would be forwarded to the Quality Improvement Organization
(QIO) to review the case and report its findings to the OIG for a possible assessment of a civil monetary penalty. The facility met with the QIO on October 3, 2003. As of this date, there has been no report issued by the QIO or any
response received from the OIG. The Company does not anticipate that it will incur any material liability that would have a material adverse effect on the Companys operations, cash flows, or financial condition as a result of this proceeding.



On December 18, 2003, we received a notice of an informal
investigation from the Fort Worth, Texas District Office of the Securities and Exchange Commission requesting our voluntary assistance in providing information regarding reporting of our financial statements, recognition of costs and revenue,
accounts receivable, allowances for doubtful accounts and our internal controls. We have been cooperating fully with the continuing informal SEC investigation.



By letter dated December 9, 2003, the Office of the Attorney General of Texas (AGs Office) requested documentation concerning
incidents at Vista Medical Center in Pasadena, Texas, which resulted in death between December 2001 and December 2003. By letter dated January 20, 2004, the AGs office broadened that inquiry to include all Vista facilities, all incidents
resulting in death, and during a broader time period from January 1, 1999 through January 20, 2004. No specific focus or subject of the inquiry was identified and we have received no further correspondence from the AGs office explaining this
request. In February 2004, the Company was notified by the AGs office that it is the subject of an investigation of possible violations of the statutes governing the solicitation of patients. Based on the documents requested by the AGs
office and communications with Company representatives, the Company believes that such investigation stems from the same allegations that have been asserted in the private lawsuit with Dr. Borrell described above. The Company has denied the
allegations in that lawsuit and continues to vigorously defend the suit. The Company is cooperating with the AGs Office on each of these matters, but believes the complaints received by the AGs office to be without merit.



From time to time, the Company is involved in litigation and administrative
proceedings that are incidental to its business. The Company cannot predict whether any litigation to which it is currently a party will have a material adverse effect on the Companys results of operations, cash flows, or financial condition.



|Item 4. | Submission of Matters to a Vote of Security Holders
|------- | ---------------------------------------------------



No matters were submitted to a vote of the stockholders of the Company in the fiscal quarter ended August 31, 2003. However, on October 24, 2003, we sent
a notice and information statement notifying our stockholders that we had received written consents in lieu of a meeting from stockholders representing a majority of our outstanding shares of common stock approving the reincorporation of Dynacq
International, Inc., a Nevada corporation (Dynacq-Nevada or the Company) in Delaware by merger with and into its wholly-owned Delaware



31



---

subsidiary, Dynacq Healthcare, Inc. (Dynacq-Delaware). Prior to the mailing of the notice and information statement, certain of our officers and
directors and their affiliates, who collectively held a majority of our outstanding common stock, signed written consents approving the reincorporation. As a result, the reincorporation was approved, and neither a meeting of our stockholders nor
additional written consents were necessary. The reincorporation was effective at 12:01 a.m., Central Standard Time, on November 14, 2003. As a result of the reincorporation:



| |  | the Company is governed by the laws of the State of Delaware and by a new Certificate of Incorporation and new Bylaws prepared in accordance with Delaware law;
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | the Companys corporate name changed from Dynacq International, Inc. to Dynacq Healthcare, Inc.; and
| | - | ----------------------------------------------------------------------------------------------------



| |  | the Companys authorized capital stock decreased from 300,000,000 shares of common stock and 5,000,000 shares of preferred stock to 100,000,000 shares of common stock and
5,000,000 shares of preferred stock.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



As of the
close of business on September 23, 2003, the record date for shares entitled to notice of and to sign written consents in connection with the reincorporation, there were 14,944,956 shares of our common stock outstanding. The Company received written
consents representing 8,824,964 shares of common stock in favor of the approval of the reincorporation.



32



---

PART II



|Item 5. | Market for Registrants Common Equity and Related Stockholder Matters
|------- | ---------------------------------------------------------------------



The Companys common stock was delisted from the Nasdaq National Market as of the opening of business on Friday, April
16, 2004. Following the delisting, our common stock has been quoted on the National Quotation Service Bureau (the Pink Sheets) for unsolicited trading. As a result, there is no regular public trading market for the Companys common
stock.



The Companys common stock previously traded under
the symbol DYII on the Nasdaq National Market System. The following table sets forth the high and low bid price of the common stock for the past two fiscal years and the interim period prior to the delisting of the Companys common
stock, as reported by the Nasdaq National Market. These prices reflect inter-dealer prices, without retail mark-ups, mark-downs or commissions, and may not necessarily represent actual transactions.



|                 |  |      |       |     |   |      
|---------------- |  | ---- | ----- | --- | - | -----
|                 |  | HIGH |       | LOW
|FISCAL YEAR 2004 |  |      |       |     |   |      
|First quarter    |  | $    | 27.85 |     | $ | 15.71
|Second quarter   |  |      | 18.84 |     |   | 4.11 
|Third quarter    |  |      | 9.51  |     |   | 3.30 
|FISCAL YEAR 2003 |  |      |       |     |   |      
|First quarter    |  | $    | 16.18 |     | $ | 10.40
|Second quarter   |  |      | 15.90 |     |   | 13.08
|Third quarter    |  |      | 14.74 |     |   | 12.00
|Fourth quarter   |  |      | 26.00 |     |   | 12.45
|FISCAL YEAR 2002 |  |      |       |     |   |      
|First quarter    |  | $    | 25.79 |     | $ | 11.00
|Second quarter   |  |      | 29.25 |     |   | 5.70 
|Third quarter    |  |      | 18.00 |     |   | 9.06 
|Fourth quarter   |  |      | 17.25 |     |   | 11.31



As of June 30, 2004,
there were approximately 322 record owners of the Companys common stock. This number does not include stockholders who hold the Companys securities in nominee accounts with broker-dealer firms or depository institutions.



The Company intends to retain all earnings for operations and expansion of
its business and does not anticipate paying cash dividends in the foreseeable future. Any future determination as to the payment of cash dividends will depend upon the Companys results of operations, financial condition and capital
requirements, as well as such other factors as the Companys Board of Directors may consider.



Recent Sales of Unregistered Securities



In January 21, 2003, the Company declared a stock dividend of one Dynacq share of non-transferable Series A Preferred stock for every full block of 100 shares of Dynacq common stock payable to stockholders of record
at the close of business on February 10, 2003. At the option of the holders, the stock dividend could be redeemed by the Company at a price of $14.50 per share, or converted on a 1-to-1 basis to common stock. Pursuant to this stock dividend, during
fiscal year 2003, a total of 129,577 common shares were issued upon conversion and the Company paid approximately $474,000 in cash for shares submitted to us for redemption. No shares of Series A Preferred Stock were outstanding at August 31, 2003.
The Company believes that the transactions were exempt from registration under Section 4(2) of the Securities Act, and all issuances were made by officers of the Company who received no commission or other remuneration.



During fiscal year 2002, the Company issued and sold 3,000 shares of common
stock in a private placement to two accredited investors, for an aggregate consideration of $13,000 in cash. The Company believes that the transactions were exempt from registration under Section 4(2) of the Securities Act. The Company took steps to
ensure that the purchaser was acquiring securities for purposes of investment and not with a view to distribution. All sales of the Companys securities were made by officers of the Company who received no commission or other remuneration for
the solicitation of any person in connection with the respective sales of securities described above.



33



---

Issuer Purchases of Equity Securities



Shares Purchased by the Company During Fiscal Years 2002 and 2003



|                                   |  |         |  |                                |  |                             |  |                                                                        |  |                                                                      
|---------------------------------- |  | ------- |  | ------------------------------ |  | --------------------------- |  | ---------------------------------------------------------------------- |  | ---------------------------------------------------------------------
|                                   |  | Period  |  | Total numberof sharespurchased |  | Average pricepaid per share |  | Total number of sharespurchased as part ofpublicly announcedprogram(1) |  | Maximum number of shares that may yet bepurchased under theprogram(1)
|September 2001 (9/24/01  9/28/01) |  | 6,000   |  | 13.58                          |  | 6,000                       |  | 494,000                                                               
|                                   |  |         |  |                               
|February 2002 (2/1/02  2/5/02)    |  | 80,000  |  | 8.59                           |  | 86,000                      |  | 414,000                                                               
|                                   |  |         |  |                               
|June 2003 (6/10/03  6/30/03)      |  | 189,000 |  | 14.38                          |  | 275,000                     |  | 225,000                                                               
|                                   |  |         |  |                               
|July 2003 (7/1/03  7/10/03)       |  | 72,500  |  | 16.60                          |  | 347,500                     |  | 152,500                                                               

---

|(1) | In January 2002, the Board of Directors of the Company authorized the repurchase of up to 500,000 shares of its common stock from time to time in open market
transactions at prevailing market prices.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



34



---

|Item 6. | Selected Financial Data
|------- | -----------------------



The data that follows should be read in conjunction with our consolidated financial statements and the notes thereto included in Item 8 and Managements
Discussion and Analysis of Financial Condition and Results of Operations.



|                                                                                                     |  |                        |             |   |      |   |            |      |  |   |            |   |  |      |            |   |  |   |            |  
|---------------------------------------------------------------------------------------------------- |  | ---------------------- | ----------- | - | ---- | - | ---------- | ---- |  | - | ---------- | - |  | ---- | ---------- | - |  | - | ---------- | -
|                                                                                                     |  | Years ended August 31, |            
|                                                                                                     |  | 2003                   |             |   | 2002 |   |            | 2001 |  |   | 2000       |   |  | 1999 |           
|Operating Data:                                                                                      |  |                        |             |   |      |   |            |      |  |   |            |   |  |      |            |   |  |   |            |  
|Net patient service revenue                                                                          |  | $                      | 89,976,739  |   |      | $ | 64,883,235 |      |  | $ | 43,803,619 |   |  | $    | 26,032,441 |   |  | $ | 16,212,656 |  
|Cost and expenses                                                                                    |  |                        | 54,509,420  |   |      |   | 38,755,471 |      |  |   | 29,400,119 |   |  |      | 16,881,628 |   |  |   | 12,575,742 |  
|                                                                                                     |  |                        |             |   |      |   |            |      |  |   |            |   |  |      |            |   |  |   |            |  
|Income from operations                                                                               |  |                        | 35,467,319  |   |      |   | 26,127,764 |      |  |   | 14,403,500 |   |  |      | 9,150,813  |   |  |   | 3,636,914  |  
|Other income, net                                                                                    |  |                        | 543,187     |   |      |   | 560,519    |      |  |   | 591,886    |   |  |      | 372,840    |   |  |   | 294,095    |  
|Minority interest in earnings                                                                        |  |                        | (3,306,882  | ) |      |   | (2,203,418 | )    |  |   | (2,476,750 | ) |  |      | (807,452   | ) |  |   | (146,508   | )
|Provision for income tax                                                                             |  |                        | (12,886,335 | ) |      |   | (9,655,378 | )    |  |   | (4,775,000 | ) |  |      | (3,510,000 | ) |  |   | (1,309,000 | )
|Extraordinary gain, net of tax(1)                                                                    |  |                        | 81,317      |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Cumulative effect of a change in accounting principle, net of tax(2)                                 |  |                        | 988,717     |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|                                                                                                     |  |                        |             |   |      |   |            |      |  |   |            |   |  |      |            |   |  |   |            |  
|Net income                                                                                           |  | $                      | 20,887,323  |   |      | $ | 14,829,487 |      |  | $ | 7,743,636  |   |  | $    | 5,206,201  |   |  | $ | 2,475,501  |  
|                                                                                                     |  |                        |             |   |      |   |            |      |  |   |            |   |  |      |            |   |  |   |            |  
|Basic(3):                                                                                            |  |                        |             |   |      |   |            |      |  |   |            |   |  |      |            |   |  |   |            |  
|Income per share before extraordinary gain and cumulative effect of a change in accounting principle |  | $                      | 1.33        |   |      | $ | 1.01       |      |  | $ | 0.55       |   |  | $    | 0.38       |   |  | $ | 0.19       |  
|Extraordinary gain                                                                                   |  | $                      | 0.01        |   |      | $ |           |      |  | $ |           |   |  | $    |           |   |  | $ |           |  
|Effect of a cumulative change in accounting principle                                                |  | $                      | 0.06        |   |      | $ |           |      |  | $ |           |   |  | $    |           |   |  | $ |           |  
|Weighted average common shares                                                                       |  |                        | 14,849,504  |   |      |   | 14,686,236 |      |  |   | 13,997,861 |   |  |      | 13,489,586 |   |  |   | 12,973,442 |  
|Dilutive(3):                                                                                         |  |                        |             |   |      |   |            |      |  |   |            |   |  |      |            |   |  |   |            |  
|Income per share before extraordinary gain and cumulative effect of a change in accounting principle |  | $                      | 1.27        |   |      | $ | 0.96       |      |  | $ | 0.51       |   |  | $    | 0.36       |   |  | $ | 0.18       |  
|Extraordinary gain                                                                                   |  | $                      | 0.01        |   |      | $ |           |      |  | $ |           |   |  | $    |           |   |  | $ |           |  
|Effect of a cumulative change in accounting principle                                                |  | $                      | 0.06        |   |      | $ |           |      |  | $ |           |   |  | $    |           |   |  | $ |           |  
|Weighted average common shares                                                                       |  |                        | 15,564,217  |   |      |   | 15,490,068 |      |  |   | 15,092,433 |   |  |      | 14,268,390 |   |  |   | 13,788,794 |  



|                           |  |                  |            |      |   |            |  |      |            |      |   |            |  |   |           
|-------------------------- |  | ---------------- | ---------- | ---- | - | ---------- |  | ---- | ---------- | ---- | - | ---------- |  | - | ----------
|                           |  | As of August 31,
|                           |  | 2003             |            | 2002 |   | 2001       |  | 2000 |            | 1999
|Balance Sheet Data:        |  |                  |            |      |   |            |  |      |            |      |   |            |  |   |           
|Cash and cash equivalents  |  | $                | 1,883,833  |      | $ | 7,583,756  |  | $    | 5,031,614  |      | $ | 4,301,523  |  | $ | 1,163,535 
|Total assets               |  |                  | 88,136,654 |      |   | 53,926,476 |  |      | 38,207,582 |      |   | 23,046,241 |  |   | 15,512,512
|Long-term debt             |  |                  |           |      |   |           |  |      | 519,075    |      |   | 387,965    |  |   | 685,487   
|Total stockholders equity |  |                  | 64,787,068 |      |   | 46,492,856 |  |      | 30,625,477 |      |   | 17,274,865 |  |   | 11,722,963

---

|(1) | The extraordinary gain relates to purchases of minority interest.
|--- | -----------------------------------------------------------------



|(2) | Represents elimination of negative goodwill in accordance with the provisions of Statement of Financial Accounting Standards No. 142.
|--- | -------------------------------------------------------------------------------------------------------------------------------------



|(3) | Earnings per share have been restated to reflect two-for-one stock splits in March 2001 and in January 2000.
|--- | ------------------------------------------------------------------------------------------------------------



35



---

|Item 7. | Managements Discussion and Analysis of Financial Condition and Results of Operations
|------- | -------------------------------------------------------------------------------------



Executive Summary



Strong Growth in 2003



During the year ended August 31, 2003 the Company greatly expanded its business from two facilities with ten operating rooms to four facilities with 20
operating rooms. In February 2003 the Company began operating a hospital in Baton Rouge, LA (four operating rooms) and in August 2003 the Company acquired a hospital in Garland, TX (six operating rooms), while continuing to expand the activity of
the Pasadena Facility (eight operating rooms) and the West Houston Facility (two operating rooms). Primarily because of increased activity at the Pasadena Facility in 2003, with a contribution from the new Baton Rouge Facility, net patient revenues
rose 39%, compared to 2002, to $90 million and net income increased 41% to $21 million.



Sharp Decline in 2004



During fiscal 2004 a
series of adverse events, as well as the costs of our expansion, has led to a sharp decline in our results.



Decline in 2004 Revenue



| |  | During the period from August 2003 to May 2004 several physicians, including six who accounted for more than 54% of our gross revenues for 2003, left the staff of the Pasadena
Facility for various reasons or temporarily substantially reduced their activity for personal reasons.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Numerous inquiries, reviews, inspections, investigations and litigation and negative media coverage have made recruiting new physicians slow and difficult because of the negative
impact on the Companys reputation. See Item 3 Legal Proceedings.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Revenue contributions from our new Baton Rouge and Garland Facilities have partially offset the physician exodus at the Pasadena Facility, although to date the Garland Facility has
performed below our expectations. We estimate that net revenue for the nine months ended May 31, 2004 will be $47.7 million, 26% lower than that of the comparable period in fiscal 2003.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Decline in 2004 Net Income



We expect a net loss of approximately $300,000 for the nine months ended May
31, 2004 (including a $2.2 million net loss in the quarter ended May 31, 2004), compared to net income of $15.2 million in the 2003 period. There are several causes of this decline.



| |  | The departure of physicians at the Pasadena Facility.
| | - | -----------------------------------------------------



| |  | The expected net losses from the launch of the Garland Facility, which incurred the costs of operation for the full first quarter ended November 30, 2003 without significant
revenues as we renovated the Facility. Although we began inpatient procedures at the end of November 2003 and have been adding physicians, the Garland Facility has continued to be a drag on earnings.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | A $624,000 noncash charge in the first quarter of fiscal 2004 relating to options previously granted to an employee.
| | - | --------------------------------------------------------------------------------------------------------------------



| |  | Increased legal and auditing fees arising from the re-audit and restatement of our financial statements and responding to the numerous inquiries, reviews, inspections,
investigations, de-listing proceedings and class action lawsuits.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Outlook for the Fourth Quarter of Fiscal 2004



During the first half of the current quarter ending August 31, 2004 we have added physicians, including some who had left earlier in the year, to the staff of each of our three hospital facilities. While we are continuing our efforts to
recruit additional physicians, we do not currently expect our financial results to improve in the near future. The full impact of the recently added physicians will probably not be felt until after August 2004 due to scheduling logistics and summer
vacation plans.



36



---

Re-Audit of 2002 and Restatement of 2001 Financial Statements



| |  | Following the resignation of Ernst & Young in December 2003 without completing the audit for fiscal 2003, in January 2004 our Audit Committee engaged Killman, Murrell &
Company, P.C. (KMC) as our new independent auditors.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | As a result of the re-audit of the 2002 financial statements and the restatement of the 2001 financial statements and certain financial information for 1999 and 2000, audit
adjustments primarily related to noncash expensing of stock option grants have reduced previously reported net income for 2001 and 2002 to $7.7 million and $14.8 million, respectively, which is 30% and 4% less than previously reported.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Internal Controls



Both Ernst & Young and KMC have identified material weaknesses and
deficiencies in our internal controls. KMC has conducted a substantive audit of the two fiscal years ended August 31, 2003 and audited the adjustments reflected in the restated financial statements for fiscal year 2001 without substantial reliance
on the effectiveness of our internal controls. Our Audit Committee is in the process of addressing these issues. See Item 9A Controls and Procedures.



Revenue Recognition



Since we are normally not a party to any managed care contracts and do not have significant Medicare/Medicaid cases, we recognize revenue based upon our
estimate of the amount of cash which we will collect for the services delivered. We estimate that we will collect the same percentage of our gross invoices for each facility on a case by case basis in each period as we have actually collecting
during the trailing 12 months. What we term contractual allowance is the amount which must be subtracted from gross billed charges to arrive at the amount of cash which we expect to collect, i.e., net patient service revenue. For
the years ended August 31, 2003, 2002 and 2001, our aggregate contractual allowance, as a percentage of gross billed revenues, was 45%, 43% and 41%, respectively.



Accounts Receivable



Because our business is different from virtually all other healthcare facility companies, our accounts receivable look different from most healthcare
companies. Our accounts receivable are larger and older than those of typical healthcare companies. We are normally not a party to managed care contracts and do not have significant Medicare/Medicaid cases, which assure relatively quick payment of
relatively small amounts of facility reimbursement. The focus of our business is relatively complex cases with corresponding large facility reimbursements. Our 2003 net patient service revenue came 52% from service to injured Texas workers
(Workers Compensation) and 37% from out-of-network commercial insurance. The principal cases involved were orthopedic spine surgeries and bariatric surgeries for the morbidly obese, respectively.



Following our approach to revenue recognition, we initially subtract the
contractual allowance from the gross receivables. Then we subtract an allowance for uncollectible accounts or bad debt reserve, which we estimate at 1% of total outpatient revenue. We believe that this is conservative, since only about 1% of our net
patient service revenue is due from individuals. The great bulk is due from insurance carriers.



Because the normal MDR process (described below) can take more than three years to collect valid receivables, we do not arbitrarily write off MDR
receivables. We evaluate MDR receivables on a case by case basis to estimate the amount which will be collected. If that estimate is less than the gross receivables net of contractual allowance and allowance for uncollectible accounts, then we will
write it down to the estimated collectible amount. To date we have, on average, collected at least the net receivables and have not reduced the net receivables in the last three fiscal years. At each balance sheet date we also separately classify as
long-term receivables all receivables which we expect to collect more than one year from the balance sheet date.



Because the MDR system is not generally understood and is important to understanding our financial statements, we have attempted below to give a more
detailed description of the MDR process, as well as others of our critical accounting policies and estimates.



37



---

Overview



Approximately 84% and 92% of the Companys net patient service revenue for fiscal years 2003 and 2002, respectively, were generated at the
Companys Pasadena Facility. The Baton Rouge Facility contributed 12% in net patient service revenue in fiscal year 2003. We believe that the Baton Rouge Facility and the Garland Facility will constitute a larger percentage of our net patient
revenues in future periods.



Revenues derived from the
Companys hospital and outpatient surgical facilities consist primarily of facility and service fees. These fees do not include charges from the patients physicians, which are billed directly to the patient or the patients insurer
by the physician. The Company no longer engages in the infusion therapy business and physician practice management, consisting of office space and fee-based management services for physicians, a business that represented 6% of net patient revenues
in fiscal year 2001.



An integral part of the Companys
future plans includes the acquisition and development of additional hospitals. As opportunities are identified, the Company plans to acquire or develop additional hospitals using three methods: (1) new construction, which generally requires two
years to complete; (2) acquisition of assets and renovation, which generally requires four to six months to complete; and (3) long-term leases, which is generally the least capital-intensive and requires the least time to commence business
operations. The Company intends to finance such future acquisitions from its available cash funds, equity financing or debt financings.



The Companys facilities are designed to handle specialized general surgeries such as bariatric, orthopedic and neuro spine surgeries. The Company,
unlike many other healthcare providers, does not normally participate in any managed care contracts, nor does it receive a substantial amount of reimbursement from Medicare or Medicaid. The bulk of the surgeries are either covered by workers
compensation insurance or by commercial insurers on an out-of-network health plan basis. Except for emergency room patients, the surgeries are typically pre-certified by the insurance carriers. The Company believes that, as a result, the
per-procedure revenue generated by the Company is comparatively higher than the per-procedure revenue generated by other hospitals.



During fiscal years 2003 and 2002, approximately 52% and 61% of the Companys gross revenues came from surgeries covered by workers
compensation and approximately 37% and 32% came from services covered by commercial and other insurance payers, respectively.



Critical Accounting Policies and Estimates



General



The Consolidated Financial Statements and Notes to Consolidated Financial Statements contain information that is pertinent to the managements discussion and analysis. The preparation of financial statements in
conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of any contingent assets and liabilities.
Management believes these accounting policies involve judgment due to the significant assumptions and estimates necessary in determining the related asset and liability amounts. Management believes it has exercised proper judgment in determining
these estimates based on the facts and circumstances available to its management at the time the estimates were made. The significant accounting policies are described in the Companys financial statements (see Note 1 in Notes to the
Consolidated Financial Statements). Of these policies, management believes the following ones may involve a comparatively higher degree of judgment and complexity. We have discussed the development and selection of the critical accounting policies
and related disclosures with the audit committee of the Board of Directors.



Revenue Recognition



Background



The Companys revenue recognition policy is significant because net
patient service revenue is a primary component of its results of operations. Revenue is recognized as services are delivered. The determination of the amount of revenue to recognize in connection with the Companys services is subject to
significant judgments and estimates, which are discussed below.



38



---

Revenue Recognition Policy



The Company is normally not a party to any managed care contracts. The Company records revenue pursuant to the following
policy. The Company has established billing rates for its medical services which it bills as gross revenue as services are delivered. Gross billed revenues are then reduced by the Companys estimate of the discount (contractual allowance) to
arrive at net patient service revenues. Net patient service revenues represents the Companys estimate of the amounts ultimately expected to be collected for the services it has delivered.



The table below sets forth the percentage of our gross patient service
revenue by financial class for the fiscal years 2003 and 2002:



|                      |  |      |   |  |      |  
|--------------------- |  | ---- | - |  | ---- | -
|                      |  | 2003 |   |  | 2002 |  
|Workers Compensation |  | 52   | % |  | 61   | %
|Commercial            |  | 37   | % |  | 32   | %
|Medicare              |  | 4    | % |  | 4    | %
|Medicaid              |  | 1    | % |  |     | %
|Self-Pay              |  | 1    | % |  | 1    | %
|Other                 |  | 5    | % |  | 2    | %



Contractual Allowance



The Company computes its contractual allowance based on
the ratio of the Companys historical cash collections during the trailing twelve months on a case by case basis to gross billed revenue on a case by case basis by operating facility. This ratio of cash collections to billed services is then
applied to the gross billed services by operating facility. The following table shows gross revenues and contractual allowances for fiscal years 2003, 2002 and 2001:



|                                 |  |            |             |   |      |   |             |      |  |   |            |  
|-------------------------------- |  | ---------- | ----------- | - | ---- | - | ----------- | ---- |  | - | ---------- | -
|                                 |  | August 31, |            
|                                 |  | 2003       |             |   | 2002 |   |             | 2001 | 
|Gross billed charges             |  | $          | 164,343,892 |   |      | $ | 113,760,963 |      |  | $ | 74,097,035 |  
|Contractual allowance            |  |            | 74,367,153  |   |      |   | 48,877,728  |      |  |   | 30,293,416 |  
|                                 |  |            |             |   |      |   |             |      |  |   |            |  
|Net revenue                      |  | $          | 89,976,739  |   |      |   | 64,883,235  |      |  |   | 43,803,619 |  
|                                 |  |            |             |   |      |   |             |      |  |   |            |  
|Contractual allowance percentage |  |            | 45          | % |      |   | 43          | %    |  |   | 41         | %
|                                 |  |            |             |   |      |   |             |      |  |   |            |  



39



---

Accounts Receivable



Accounts receivable represent net receivables for services provided by the Company. The estimated accounts receivable not expected to be collected within
twelve months of the balance sheet date have been shown as long-term receivables and represent receivables in the Medical Dispute Resolution (MDR) and legal third party financial class. The contractual allowance is provided as revenue is
recognized. At each balance sheet date management reviews the accounts receivables for collectibility. If after the review management believes certain receivables would be uncollectible, the receivable would be written down to the expected
collectable amount. Management has not written down any receivables during the three years ended August 31, 2003 as a result of the collectibility test. The following table shows accounts receivable, the contractual allowance, the allowance for
uncollectible accounts, net receivables and the contractual allowance as a percent of receivables at August 31, 2003 and 2002:



|                                                                                                              |  |      |             |   |      |   |             |  
|------------------------------------------------------------------------------------------------------------- |  | ---- | ----------- | - | ---- | - | ----------- | -
|                                                                                                              |  | 2003 |             |   | 2002 |  
|Current portion of gross receivables                                                                          |  | $    | 67,483,780  |   |      | $ | 46,544,023  |  
|Current portion of contractual allowance                                                                      |  |      | (49,602,756 | ) |      |   | (32,958,185 | )
|Current portion of allowance for uncollectible accounts                                                       |  |      | (483,278    | ) |      |   | (248,200    | )
|                                                                                                              |  |      |             |   |      |   |             |  
|Net current portion of accounts receivable                                                                    |  |      | 17,397,746  |   |      |   | 13,337,638  |  
|                                                                                                              |  |      |             |   |      |   |             |  
|Contractual allowance and allowance for uncollectible accounts as a percentage of current gross receivables   |  |      | 74          | % |      |   | 71          | %
|                                                                                                              |  |      |             |   |      |   |             |  
|Long term portion of gross receivables                                                                        |  | $    | 66,064,559  |   |      | $ | 36,624,610  |  
|Long term portion of contractual allowance                                                                    |  |      | (48,559,583 | ) |      |   | (25,934,171 | )
|Long term portion of allowance for uncollectible accounts                                                     |  |      | (473,114    | ) |      |   | (195,305    | )
|                                                                                                              |  |      |             |   |      |   |             |  
|Net long term portion of accounts receivable                                                                  |  |      | 17,031,862  |   |      |   | 10,495,134  |  
|                                                                                                              |  |      |             |   |      |   |             |  
|Contractual allowance and allowance for uncollectible accounts as a percentage of long term gross receivables |  |      | 74          | % |      |   | 71          | %
|                                                                                                              |  |      |             |   |      |   |             |  



The contractual
allowance stated as a percentage of gross receivables at the balance sheet dates is larger than the contractual allowance percentage used to reduce gross billed charges due to the application of cash collections to the outstanding gross receivable
balances without any adjustment being made to the contractual allowance. The contractual allowance amounts netted against gross receivables are not adjusted until such time as the final collections on the gross receivables is recognized.



Collections for services provided are generally settled or written off as
uncollectible against the contractual allowance within six months of the date of service except for services provided to injured workers in Texas. Collections for services provided to injured workers in Texas may take up to three years or longer to
be completely adjudicated. Because the Company has in recent years focused on providing services to injured workers in Texas, accounts receivable in the workers compensation and MDR financial classes have increased.



The MDR process is an established reimbursement resolution process available
to providers of healthcare services under the regulations guiding reimbursement for services provided to injured workers in the State of Texas. Accounts generally do not become subject to the MDR process prior to being outstanding for at least 90
days subsequent to patient discharge. For medical services provided to injured workers in the State of Texas, the MDR process is specifically based upon the administrative and statutory regulations promulgated by the Texas Labor Code and Texas
Administrative Code provisions.



If any reimbursement provided
by a workers compensation carrier is improper pursuant to the statutory or regulatory guidelines administered by the Texas Workers Compensation Commission, our facilities request and pursue additional reimbursement. Following is a brief
discussion on the time-line of a typical workers compensation claim:



| |  | Bills are submitted to a carrier within 21 days of date of service.
| | - | -------------------------------------------------------------------



| |  | A carrier has 45 days to respond to provider with payment or an explanation of benefits (EOB) indicating the rationale of denial or defense to payment.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | The Company forwards a Request for Reconsideration (RFR) to a carriers after the 45th day of the carriers receipt of the bill or after receipt of the explanation of benefits
(EOB).
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | The carrier has 21 days to respond to the RFR.
| | - | ----------------------------------------------



| |  | Should the carrier fail to respond, the Company files a request with the MDR Division of the Texas Workers Compensation Commission (TWCC). This usually occurs at or about six
to eight months after the date of service due to the amount of administrative requirements required before filing the initial request to TWCC.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Usually 30 to 60 days after filing the initial request with the MDR Division, TWCC will review the MDR and determine if additional information is needed. TWCC then will forward an
MR-116 form requesting any additional documentation and rationale for additional reimbursement. The Company has 14 days after the date of receipt of the MR-116 to provide additional documentation.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



40



---

| |  | TWCC is not required by the Texas Labor Code or the Texas Administrative Code to provide a Finding and Decision within a specific timeframe. Based upon the historical actions of the
TWCC, a Finding and Decision is usually received within 3-6 months after the supplemental documentation was forwarded to TWCC. However, this time period has extended in some cases to one year after the initial request for MDR was filed.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | After receipt of the Finding and Decision by the TWCC, the non-prevailing party has the option of appealing the decision with the State Office of Administrative Hearings (SOAH)
within 20 days of receiving the Finding and Decision from TWCC.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | A hearing date with SOAH is assigned generally within 90 days; however, this time period is usually extended 6-9 months depending on discovery requests. After the SOAH contested
case hearing, they will issue a decision within 30-60 days after the hearing or after final closing briefs have been filed.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | The SOAH decision may be appealed to the District Court.
| | - | --------------------------------------------------------



Due to the above-referenced length of the life cycle of a workers compensation account, the accounts subject to the MDR process are generally older
than other accounts receivable. Collection of those accounts can take as many as two to three years past the actual date of service.



Due to a number of factors outside the Companys control, including changes in the Companys reimbursement collection experience associated with
either potential changes in the reimbursement environment in which the Company operates or otherwise, it is possible that managements estimates of patient service revenues could change, which could have a material impact on the Companys
revenue and profitability in the future.



Sources of Revenue and
Reimbursement



The focal point of our business is
providing patient care services, including complex orthopedic and bariatric procedures. The Company pursues optimal reimbursement from third party payers for these services. We do not normally participate in managed care or other contractual
reimbursement agreements, principally because they limit reimbursement for the medical services provided. This business model often results in increased amounts of reimbursement for the same or similar procedure, as compared to other healthcare
providers. However, there are no contractual or administrative requirements for prompt payment of claims by third party payers within a specified time frame. As a result, the Company tends to receive higher amounts of per-procedure
reimbursement than that which may be received by other healthcare providers performing similar services. Conversely, despite the increased reimbursement, we may take additional time to collect the expected reimbursement from third party payers.



In addition to the fact that our collection process may be
longer than other healthcare providers because of our focus on workers compensation and other commercial payers, the collection process can be extended due to our efforts to obtain all optimal reimbursement available to the Company.
Specifically, for medical services provided to injured workers, the Company may initially receive reimbursement that may not be within the fee guidelines or regulatory guidelines mandating reimbursement. For such cases in which third party payers
did not provide appropriate reimbursement pursuant to these guidelines, the Company pursues further reimbursement. The Company reviews and pursues those particular claims that are determined to warrant additional reimbursement pursuant to the fee or
regulatory guidelines. The Companys pursuit of additional reimbursement amounts that it believes are due under fee or regulatory guidelines may be accomplished through established dispute resolution procedures with applicable regulatory
authorities.



Surgeries are typically not scheduled unless they
are pre-authorized by the insurance carrier for medical necessity. After the surgery, the Companys automated computer system generates a statement of billed charges to the third party payer. At that time, the Company also requests payment from
patients for any remaining amounts that are the responsibility of the patient.



Allowance for Uncollectible Accounts



The
Company has estimated uncollectible accounts expense as 1% of gross outpatient revenue. Through August 31, 2003, the Company has made no charge offs against the allowance for uncollectible accounts, as historically all charge offs have been against
the contractual allowance.



41



---

Income Taxes



SFAS 109, Accounting for Income Taxes, establishes financial accounting and reporting standards for the effect of income taxes. The objectives of
accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entitys financial
statements or tax returns. Judgment is required in assessing the future tax consequences of events that have been recognized in our financial statements or tax returns. Fluctuations in the actual outcome of these future tax consequences could
materially impact our financial position or our results of operations.



Results of Operations



|                                                                                                                           |  |                        |            |  |      |   |  |      |            |  |     |   |  |   |            |  |     |  
|-------------------------------------------------------------------------------------------------------------------------- |  | ---------------------- | ---------- |  | ---- | - |  | ---- | ---------- |  | --- | - |  | - | ---------- |  | --- | -
|                                                                                                                           |  | Years ended August 31, |           
|                                                                                                                           |  | 2003                   |            |  | 2002 |   |  | 2001 |           
|Net patient service revenue                                                                                                |  | $                      | 89,976,739 |  | 100  | % |  | $    | 64,883,235 |  | 100 | % |  | $ | 43,803,619 |  | 100 | %
|                                                                                                                           |  |                        |            |  |      |   |  |      |            |  |     |   |  |   |            |  |     |  
|Costs and expenses:                                                                                                        |  |                        |            |  |      |   |  |      |            |  |     |   |  |   |            |  |     |  
|Compensation and benefits                                                                                                  |  |                        | 14,990,675 |  | 17   |   |  |      | 9,349,770  |  | 14  |   |  |   | 5,849,723  |  | 13  |  
|Medical services and supplies                                                                                              |  |                        | 16,505,272 |  | 18   |   |  |      | 15,332,788 |  | 24  |   |  |   | 9,299,835  |  | 21  |  
|Other operating expenses                                                                                                   |  |                        | 20,332,589 |  | 23   |   |  |      | 12,652,455 |  | 20  |   |  |   | 13,379,159 |  | 31  |  
|Provision for uncollectible accounts                                                                                       |  |                        | 512,885    |  | 1    |   |  |      | 250,712    |  |    |   |  |   | 58,259     |  |    |  
|Depreciation and amortization                                                                                              |  |                        | 2,167,999  |  | 2    |   |  |      | 1,169,746  |  | 2   |   |  |   | 813,143    |  | 2   |  
|                                                                                                                           |  |                        |            |  |      |   |  |      |            |  |     |   |  |   |            |  |     |  
|Total costs and expenses                                                                                                   |  |                        | 54,509,420 |  | 61   |   |  |      | 38,755,471 |  | 60  |   |  |   | 29,400,119 |  | 67  |  
|                                                                                                                           |  |                        |            |  |      |   |  |      |            |  |     |   |  |   |            |  |     |  
|Income from operations                                                                                                     |  |                        | 35,467,319 |  | 39   |   |  |      | 26,127,764 |  | 40  |   |  |   | 14,403,500 |  | 33  |  
|Income before income tax, minority interests, extraordinary gain and cumulative effect of a change in accounting principle |  |                        | 36,010,506 |  | 40   |   |  |      | 26,688,283 |  | 41  |   |  |   | 14,995,386 |  | 34  |  
|Provision for income taxes                                                                                                 |  |                        | 12,886,335 |  | 14   |   |  |      | 9,655,378  |  | 15  |   |  |   | 4,775,000  |  | 11  |  
|Minority interest in earnings                                                                                              |  |                        | 3,306,882  |  | 4    |   |  |      | 2,203,418  |  | 3   |   |  |   | 2,476,750  |  | 6   |  
|                                                                                                                           |  |                        |            |  |      |   |  |      |            |  |     |   |  |   |            |  |     |  
|Income before extraordinary gain and cumulative effect of a change in accounting principle                                 |  |                        | 19,817,289 |  | 22   |   |  |      | 14,829,487 |  | 23  |   |  |   | 7,743,636  |  | 18  |  
|                                                                                                                           |  |                        |            |  |      |   |  |      |            |  |     |   |  |   |            |  |     |  
|Net income                                                                                                                 |  | $                      | 20,887,323 |  | 23   | % |  | $    | 14,829,487 |  | 23  | % |  | $ | 7,743,636  |  | 18  |  
|                                                                                                                           |  |                        |            |  |      |   |  |      |            |  |     |   |  |   |            |  |     |  
|Operational statistics (Number of procedures):                                                                             |  |                        |            |  |      |   |  |      |            |  |     |   |  |   |            |  |     |  
|Inpatient:                                                                                                                 |  |                        |            |  |      |   |  |      |            |  |     |   |  |   |            |  |     |  
|Bariatrics                                                                                                                 |  |                        | 676        |  |      |   |  |      | 411        |  |     |   |  |   | 77         |  |     |  
|Orthopedics                                                                                                                |  |                        | 611        |  |      |   |  |      | 473        |  |     |   |  |   | 320        |  |     |  
|Other                                                                                                                      |  |                        | 126        |  |      |   |  |      | 3          |  |     |   |  |   | 9          |  |     |  
|                                                                                                                           |  |                        |            |  |      |   |  |      |            |  |     |   |  |   |            |  |     |  
|Total inpatient procedures                                                                                                 |  |                        | 1,413      |  |      |   |  |      | 887        |  |     |   |  |   | 406        |  |     |  
|                                                                                                                           |  |                        |            |  |      |   |  |      |            |  |     |   |  |   |            |  |     |  
|Outpatient:                                                                                                                |  |                        |            |  |      |   |  |      |            |  |     |   |  |   |            |  |     |  
|Orthopedics                                                                                                                |  |                        | 736        |  |      |   |  |      | 1,621      |  |     |   |  |   | 1,488      |  |     |  
|Other                                                                                                                      |  |                        | 2,535      |  |      |   |  |      | 1,355      |  |     |   |  |   | 1,576      |  |     |  
|                                                                                                                           |  |                        |            |  |      |   |  |      |            |  |     |   |  |   |            |  |     |  
|Total outpatient procedures                                                                                                |  |                        | 3,271      |  |      |   |  |      | 2,976      |  |     |   |  |   | 3,064      |  |     |  
|                                                                                                                           |  |                        |            |  |      |   |  |      |            |  |     |   |  |   |            |  |     |  
|Total procedures                                                                                                           |  |                        | 4,684      |  |      |   |  |      | 3,863      |  |     |   |  |   | 3,470      |  |     |  
|                                                                                                                           |  |                        |            |  |      |   |  |      |            |  |     |   |  |   |            |  |     |  



Comparison of the Fiscal Years
Ended August 31, 2003 and August 31, 2002



Net patient
service revenue increased $25,093,504, to $89,976,739 for fiscal year 2003, compared to $64,883,235 for fiscal year 2002 due to an increase in surgical cases from fiscal year 2002. There was an increase of 59% in inpatient procedures from 887 in
fiscal year 2002 to 1,413 in fiscal year 2003. The increase is partly attributable to the opening of the Companys new Baton Rouge Facility, which began operations in January 2003 and contributed $10,838,134 in net patient service revenues.
This facility added 199 inpatient procedures, including 173 bariatric and 14 orthopedic procedures for the fiscal year 2003. The Pasadena Facility had a net increase of



42



---

$15,430,128 in net patient service revenues due to increase of 327 inpatient procedures from fiscal year 2002, primarily related to the increase in the
bariatric procedures, which increased to 503 in fiscal year 2003 compared to 411 in fiscal year 2002 and orthopedic procedures which increased to 597 in fiscal year 2003 from 473 in fiscal year 2002. The number of outpatient procedures increased by
10% only to 3,271 in fiscal year 2003 from 2,976 in fiscal year 2002, consistent with the Companys focus on the inpatient surgical operations.



The overall increase in revenue in fiscal year 2003 compared to that of previous years is primarily related to the opening of the Companys Baton
Rouge Facility, which added four additional operating rooms in addition to the eight operating rooms at the Pasadena Facility (including four operating rooms that became part of the Pasadena Facility during fiscal year 2003 after the Companys
former ambulatory surgery center in Pasadena, Texas surrendered its lease and license and the Pasadena Facility applied to have its license expanded to include these additional four operating rooms). In addition, an increase in the number of
operating rooms from two to four and the number of special care unit beds from three to five at the Pasadena Facility during fiscal year 2002 were utilized fully for the entire fiscal year 2003. These improvements allowed the existing physicians
practicing at our facilities to perform increased procedures as compared to fiscal year 2002. While the number of procedures increased, the larger percentage of bariatric cases in fiscal year 2003 resulted in a lower average reimbursement per
procedure, compared to fiscal year 2002.



During the period
from August 2003 to May 2004 several physicians, including six who accounted for over 54% of our gross revenues for 2003 left the staff of the Pasadena Facility for various reasons or temporarily reduced their activity for personal reasons. The
Company is adding new physicians to minimize the negative impact on revenue, there is no guarantee that it will be successful in its efforts or the time it may take to compensate for the decrease in revenues. The Companys revenues for fiscal
year 2004 will be adversely affected by these events. However, the Companys Baton Rouge Facility and the newly acquired Garland Facility, is expected to partially offset this decrease in revenues in fiscal year 2004.



For fiscal year 2003, total costs and expenses increased to $54,509,420 from
$38,755,471 in fiscal year 2002. The increase is primarily due to significant increases in the hospital activities. The significant increases in the component expense categories of the operating expenses are as follows:



| |  | Compensation and benefits expense increased by $5,640,905 or 60% from fiscal year 2002. The increase is primarily related to the significant increase in surgical activities at the
Companys Pasadena Facility, combined Full Time Equivalents (FTE) with the opening of the Companys Baton Rouge Facility, which required increased staffing. There was an increase of 160 FTEs from 197 FTEs in fiscal year 2002 to 357 FTEs in
fiscal year 2003, of which increase of 88 FTEs was due to the opening of the Baton Rouge Facility in fiscal year 2003.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Medical services and supplies increased by $1,172,483 or 8% from fiscal year 2002. For the fiscal year 2003, net patient service revenues increased 39%, whereas medical services and
supplies increased by 8%. The Pasadena Facility paid approximately $3.6 million for radiology and laboratory services to a contracted outside agency for the fiscal year 2002 compared to $580,000 paid to them during the fiscal year 2003. The Company
ceased using the outside agency in November 2002 and performed these services in-house. The net savings in medical services and supplies to the Company by performing these services in-house was approximately $3 million. This decrease in medical
services and supplies has been offset by an increase of $2.2 million for the Baton Rouge facility, which became operational in January 2003 and an increase of $2.0 million related to the increased number of inpatient and outpatient procedures
performed. The cession of services rendered by the contracted outside agency also increased the Companys in-house costs for compensation and benefits of approximately $550,000 and other operating expenses of approximately $550,000.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | The supplies inventory on the balance sheet increased by $1,206,308 from $893,727 at August 31, 2002 to $2,100,035 at August 31, 2003. Of the $1,206,308 increase, approximately
$478,000 is due to supplies inventory at the Baton Rouge Facility, which became operational in January 2003, approximately $366,000 if for inventory at the Garland Facility, and approximately $362,000 is primarily due to the increased level of
activity at the Pasadena Facility during the fiscal year 2003.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



43



---

| |  | Other operating expenses, primarily consisting of utilities, insurance, office supplies, lease and rentals, license and other professional fees, increased $7,680,134 or 61% from
fiscal year 2002. Professional fees in fiscal year 2003 increased to $9,625,194 from $3,944,498 in fiscal year 2002, primarily related to the Baton Rouge Facility which added $2,838,890 of other professional fees. The additional increase in
professional fees was related to the increased activities at the Pasadena Facility, which added $974,086 compared to prior year. Legal and accounting fees increased from $941,852 in fiscal year 2002 to $2,693,117 in fiscal year 2003. The increases
in these fees are primarily related to various legal matters and defending lawsuits. Other significant increases relate to utilities and repairs and maintenance, which increased to $839,989 and $745,827, respectively, from $527,972 and $267,179 in
fiscal year 2002. These increases are primarily related to the operations at the Companys Baton Rouge Facility which increased $88,555 in legal fees, $237,215 in utilities and $197,708 in repairs and maintenance.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Depreciation and amortization expense increased to $2,167,999 in fiscal year 2003 from $1,169,746 in fiscal year 2002. The increase is primarily related to the increase in property
and equipment related to the Baton Rouge Facility, which added $3,910,506 in buildings and $5,753,152 in medical equipment and furniture and fixtures during fiscal year 2003.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Provision for income taxes increased to $12,886,335 in fiscal year 2003 from $9,655,378 in
fiscal year 2002, related to the increase in pre-tax income. The effective tax rates were 35.8% and 36.2% in fiscal years 2003 and 2002, respectively. Minority interest in earnings increased to $3,306,882 in fiscal year 2003 from $2,203,418 in
fiscal year 2002, primarily related to increase in earnings at the Pasadena Facility.



Comparison of the Fiscal Years Ended August 31, 2002 and August 31, 2001



Net patient service revenue increased $21,079,616, to $64,883,235 for fiscal year 2002 compared to $43,803,619 for fiscal year 2001 due to an increase in surgical cases from fiscal year 2001. There was an increase of
118% in inpatient procedures from 406 in fiscal year 2001 to 887 in fiscal year 2002. The number of outpatient procedures decreased marginally by 3% to 2,976 in fiscal year 2002 from 3,064 in fiscal year 2002, consistent with the Companys
focus on the inpatient surgical operations. Net patient service revenue from ambulatory infusion therapy services and physician practice management services decreased to $1,374,178 in fiscal year 2002 from $2,677,027 in fiscal year 2001, since the
Company focused on other areas of operations.



The overall
increase in net patient service revenue for fiscal year 2002 was the result of the Companys primary focus on expanding its inpatient hospital operations. During fiscal year 2002, the Company added two physicians to support the bariatric
program, part of hospital operations. In addition, operating rooms at the Pasadena Facility were increased from two to four and the numbers of special care unit beds were increased from three to five during fiscal year 2002. These improvements
allowed the existing physicians practicing at our facilities to perform increased procedures as compared to fiscal year 2001. While the number of procedures increased, the larger percentage of bariatric cases in fiscal year 2002 resulted in a lower
average reimbursement per procedure, compared to fiscal year 2001.



For fiscal year 2002, total costs and expenses increased by $9,355,352 or 32% from fiscal year 2001. The increase is primarily due to significant increases in the hospital activities. The significant increases in the component expense
categories of the operating expenses are as follows:



| |  | Compensation and benefits expense increased by $3,500,047 or 60% from fiscal year 2001. The increase is primarily due to the significant increase in surgical activities compared to
that of fiscal year 2001, which required increased hospital staffing and an increase in the number of Company employees at the corporate level. For fiscal year 2002, there was an increase of 45 FTEs from 152 FTEs in fiscal year 2001 to 197 FTEs in
fiscal year 2002.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Medical services and supplies increased by $6,032,953 or 65% from fiscal year 2001. The increase is primarily due to the significant increase in surgical activities compared to that
of fiscal year 2001.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Other operating expenses decreased by $726,704 or 5% from fiscal year 2001. The decrease is primarily related to a 2001 charge of approximately $3.7 million of
non-cash expensing of stock options issued to non-employees. This decrease is offset by increases in net other operating expenses of approximately $3 million, primarily due to significant increase in operations at the Companys
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



44



---

| | facilities, as well as an increase in general corporate activity compared to such activities in 2001. Contract payments to physicians decreased by $532,679
or 23% from fiscal year 2001, which is attributable to the decrease in activities related to the Companys physician management practice.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Depreciation and amortization expense increased to $1,169,746 in fiscal year 2002 from $813,143 in fiscal year 2001, due to the increase of property and equipment purchases in 2002
of $6,968,932.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Provision for income taxes
increased from $4,775,000 in fiscal year 2001 to $9,655,378 in fiscal year 2002, related to the increase in net income. The effective tax rates were 36.2% and 31.8% for fiscal years 2002 and 2001, respectively. The increase in the effective income
tax rate in 2002 is primarily due to a decrease in minority interest. Minority interest in earnings decreased from $2,476,750 in fiscal year 2001 to $2,203,418 in fiscal year 2002, primarily related to a decrease in minority interest ownership in
Pasadena Facility from 30% to 10% during fiscal year 2002.



Liquidity and
Capital Resources



The Company maintained sufficient
liquidity in fiscal year 2003 to meet its business needs. As of August 31, 2003, its principal source of liquidity included $1,883,833 in cash and cash equivalents. These instruments are short-term, highly liquid instruments and, accordingly, their
fair value approximates cost.



Cash flow from operating activities



Total cash flow provided from operating activities was
$15,670,918 as of August 31, 2003. The $3,889,351 increase in cash flow from operating activities for fiscal year 2003 is related to an increase of $1,999,798 in accounts payable and $2,666,621 in accrued liabilities. These increases in
accounts payable and accrued liabilities are related to the general increase in operating activities, including the opening of the Baton Rouge Facility in fiscal year 2003. The Company had a $500,000 accrual for dismissal or settlement of a state
court derivative action. Other increases in accrued liabilities included property taxes payable of approximately $274,000, and also due to increased wages payable and payroll tax payable by approximately $361,000, of which approximately $211,000
relates to the Baton Rouge Facility. Increases in cash flow from operating activities was offset by decreases in cash flow created by the increase of $11,109,721 in accounts receivable and $840,076 in inventory. The increase in accounts receivable
is primarily related to an overall increase in volume procedures and patient growth. Of the $840,076 increase in inventory, $477,742 is due to the supplies inventory at the Baton Rouge Facility. The remaining increase is primarily due to the
increased level of activity at the Pasadena Facility during the fiscal year 2003. As of August 31, 2003, the Company had $2,000,000 as restricted cash invested in certificate of deposit with a bank, pursuant to the Jane Capital and Sunbelt Medical
lawsuit in which it was required by the Court to post an irrevocable letter of credit to support the issuance of a temporary injunction. This case was subsequently settled in May 2004 and the letter of credit was released.



Cash flow from investing activities



Total cash flow used in investing activities was $22,358,159 as of August
31, 2003. The Company expended approximately $17,282,168 in property and equipment additions, of which $1,002,517 is accrued to be paid in fiscal year 2004. The increase in property and equipment includes additions at Baton Rouge of $3,910,506 in
buildings, $5,753,152 in medical equipment and furniture and fixtures during fiscal year 2003. The Company also used approximately $6,307,000 to purchase land and building and $1,955,000 to purchase medical equipment at the Garland Facility. The
Company used approximately $2,700,000 for building, medical equipment and furniture and fixtures at the Pasadena Facility. The Company purchased land in The Woodlands, Texas and in Slidell, Louisiana for approximately $3,100,000 and $2,300,000,
respectively.



Cash flow from financing activities



Total cash flow provided by financing activities was $987,318 as of August
31, 2003. The Company received proceeds of $1,168,554 from the exercise of stock options and used $3,965,610 cash for treasury stock transactions. The Company redeemed 32,656 preferred shares for cash in the amount of $473,511 and drew $6,413,312
from its line of credit to fund the acquisition of the Garland Facility. Other increases in cash flow from financing activities included contributions from minority interest of approximately $946,000, offset by distributions to and purchases of
minority interests of $3,077,000.



45



---

The Company had working capital of $12,259,123 as of August 31, 2003, and maintained a liquid position
evidenced by a current ratio of approximately 1.6 to 1. During fiscal year 2003, the Company has invested approximately $3,100,000 and $2,300,000 to purchase land in The Woodlands, Texas and in Slidell, Louisiana, respectively. The Company used its
available cash funds to finance these transactions. The Companys management believes that available cash funds and funds generated from operations will be sufficient for the Company to finance working capital requirements for the current
fiscal year. Subsequent to the year ended August 31, 2003, the Company sold the land at Slidell, Louisiana for $2.5 million, resulting in a small profit. The Company had determined that the Slidell hospital project was no longer consistent with its
current business plan. The project at The Woodlands, Texas is in the planning stage.



The Company has a reducing revolving line of credit with an unrelated financial institution. The line is reduced monthly by an amount equal to 1/180th of the original loan amount. The amount available and drawn under
the line of credit at August 31, 2003 is approximately $6.4 million to finance its acquisition of assets in the Garland Facility. The interest rate on the line of credit is a variable rate of 2.3% plus the dealer commercial paper rate.
The effective interest rate as of August 31, 2003 was 3.32%. The balance owed under the line of credit as of June 18, 2004 was $6,002,214. There can be no assurance that the Company will have sufficient funds available to meet all of its capital
needs.



Because we did not timely file this annual
report on Form 10-K and have not yet filed our quarterly reports on Form 10-Q for the fiscal quarters ended November 30, 2003, February 29, 2004 and May 31, 2004, we are in default under the terms of the line of credit. On April 16, 2004, the
financial institution submitted to us a notice of default. Since we did not cure the default within 10 days, we are now in default under the line of credit. To this date, the financial institution has not taken any further action. Our indebtedness
under our line of credit is secured by substantially all of our assets. If we are unable to repay all outstanding balances, the financial institution could proceed against our assets to satisfy our obligations under the line of credit.



Off-Balance Sheet Arrangements and Commitments



The following table summarizes our known contractual obligations at August
31, 2003, and the effect such obligations are expected to have on our liquidity and cash flow in the future periods indicated below:



|                              |  |                        |            |                 |   |           |  |           |            |                  |   |           |  |   |        
|----------------------------- |  | ---------------------- | ---------- | --------------- | - | --------- |  | --------- | ---------- | ---------------- | - | --------- |  | - | -------
|                              |  | Payments due by period
|Contractual obligations       |  | Total                  |            | Less than 1year |   | 1-3 years |  | 3-5 years |            | More than 5years
|Marketing Obligations         |  | $                      | 9,962,000  |                 | $ | 4,525,000 |  | $         | 5,437,000  |                  | $ |          |  | $ |       
|Capital Lease Obligations     |  |                        | 632,014    |                 |   | 161,484   |  |           | 322,968    |                  |   | 147,562   |  |   |       
|Operating Lease Obligations   |  |                        | 6,717,991  |                 |   | 1,899,325 |  |           | 3,012,445  |                  |   | 1,545,764 |  |   | 260,457
|Purchase Obligations          |  |                        | 1,206,000  |                 |   | 1,206,000 |  |           |           |                  |   |          |  |   |       
|Other Contractual Obligations |  |                        | 5,148,000  |                 |   | 2,044,000 |  |           | 2,549,000  |                  |   | 555,000   |  |   |       
|                              |  |                        |            |                 |   |           |  |           |            |                  |   |           |  |   |        
|Total                         |  | $                      | 23,666,005 |                 | $ | 9,835,809 |  | $         | 11,321,413 |                  | $ | 2,248,326 |  | $ | 260,457
|                              |  |                        |            |                 |   |           |  |           |            |                  |   |           |  |   |        



The Company has
operating leases primarily for medical and office equipment. The Company also incurs rental expense for office space and medical equipment. Operating lease and rental expense was approximately $1,394,000, $963,000 and $244,000 in fiscal years 2003,
2002 and 2001, respectively. Future minimum rental commitments under noncancellable leases for the following fiscal years are: 2004, $1,899,325; 2005, $1,532,719; 2006, $1,479,726; 2007, $1,190,916; 2008, $354,848; and thereafter, $260,457.



Commitments for future additions to medical equipment were
approximately $1,206,000 at August 31, 2003, which was guaranteed by the Company on behalf of its subsidiary in the normal course of business. In terms of the guarantee issued, if the Companys subsidiary does not meet its commitment of
purchasing the medical



46



---

equipment and making the related payments, the Company will be liable to purchase the medical equipment for the same amount.



The Company, through its subsidiary, also has agreements with outside
organizations that offer marketing, pre-authorization and follow up support services to prospective bariatric and orthopedic patients in areas serviced by the Pasadena, Garland and Baton Rouge Facilities. These facilities receive bariatric and
orthopedic referrals from other sources and the organizations refers clients to other area hospitals. Payments made under these agreements for the fiscal years 2003, 2002 and 2001 were $6,002,000, $4,802,000 and $4,433,000, respectively. Future
minimum payments under these agreements for the following fiscal years are: for 2004, $4,525,000; for 2005, $4,500,000; and for 2006, $937,000.



The Company has contracts with doctors to manage various areas of the Companys hospitals and other service agreements. Payments made under these
agreements for the fiscal years ending August 31, 2003, 2002 and 2001 were $1,776,000, $741,000 and $495,000, respectively. Future minimum payments under the terms of these contracts and agreements for the following fiscal years are: for 2004,
$2,044,000; for 2005, $1,629,000; for 2006, $920,000; and thereafter $555,000.



Recent Accounting Pronouncements



In November
2002, the FASB issued FASB Interpretation No. 45 (FIN 45), Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, an interpretation of FASB Statements No. 5, 57
and 107 and Rescission of FASB Interpretation No. 34. FIN 45 clarifies the requirements of SFAS 5, Accounting for Contingencies, relating to the guarantors accounting for, and disclosure of, the issuance of certain types of guarantees. The
disclosure provisions of FIN 45 are effective for financial statements of periods that end after December 15, 2002. However, the provisions for initial recognition and measurement are effective on a prospective basis for guarantees that are issued
or modified after December 31, 2002. The Company has adopted the disclosure requirements of FIN 45.



In December 2002, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) 148,
Accounting for Stock-Based CompensationTransition and Disclosure. SFAS 148 amends SFAS 123 to provide alternative methods of transition to the SFAS 123 fair value method of accounting for stock-based employee compensation. In addition,
SFAS 148 requires disclosure of the effects of an entitys accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements. As permitted under SFAS
148, the Company adopted the disclosure only provisions of that accounting standard in the third quarter of fiscal year 2003.



In January 2003, the FASB issued Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities. FIN 46 requires a
variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entitys activities or entitled to receive a majority of the entitys residual returns or
both. A variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights, or (b) has equity investors that do not provide
sufficient financial resources for the entity to support its activities. A variable interest entity often holds financial assets, including loans or receivables, real estate, or other property. A variable interest entity may be essentially passive
or it may engage in research and development or other activities on behalf of another company. The consolidation requirements of FIN 46 apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements
apply to older entities in the first fiscal year or interim period beginning after December 15, 2003. Certain of the disclosure requirements apply to all financial statements issued after January 31, 2003, regardless of when the variable interest
entity was established. As of August 31, 2003, the Company does not have any entities that require disclosure or consolidation as a result of adopting the provisions of FIN 46.



In May 2003, the FASB issued SFAS 150, Accounting for Certain Financial Instruments with Characteristics of both
Liabilities and Equity. The Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument
that is within its scope as a liability (or an asset in some circumstances). It is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning
after June 15, 2003. The adoption of this Statement is not expected to have a significant impact on our financial statements.



47



---

Inflation



Inflation has not significantly impacted the Companys financial position or operations.



|Item 7A. | Quantitative and Qualitative Disclosures About Market Risk
|-------- | ----------------------------------------------------------



Market risks relating to the Companys operations result primarily from changes in interest rates as well as credit risk concentrations. All of the
Companys contracts are denominated in US$ and, therefore, the Company has no foreign currency risk.



Interest Rate Risk



The
Company is exposed to market risk from changes in interest rates on funded debt. This exposure relates to the Companys reducing revolving credit facility. The Company had drawn approximately $6.4 million as of August 31, 2003 from its line of
credit. The balance owed under the line of credit as of June 18, 2004 was approximately $6.0 million. There were no borrowings outstanding under the credit facility as of August 31, 2002. Borrowings under the credit facility bear interest at
variable rates based on the dealer commercial paper rate plus 2.30%. Based on the amount outstanding, a 100 basis point change in the applicable interest rates would not have a material impact on the Companys annual cash flow or
income.



The Companys cash and cash equivalents are
invested in money market accounts. Accordingly, the Company is subject to changes in market interest rates. However, the Company does not believe a change in these rates would have a material adverse effect on the Companys operating results,
financial condition, and cash flows. There is an inherent roll over risk on these funds as they accrue interest at current market rates. The extent of this risk is not quantifiable or predictable due to the variability of future interest rates.



Credit Risks



The Companys financial instruments that are exposed to concentrations
of credit risk consist primarily of trade receivables from various private insurers. The Company monitors its exposure for credit losses and maintains allowances for anticipated losses, but does not require collateral from these parties.



48



---

|Item 8. | Financial Statements and Supplementary Data
|------- | -------------------------------------------



INDEX TO FINANCIAL STATEMENTS



Below is an index to the consolidated financial statements and notes thereto contained in Item 8, Financial Statements and Supplementary Data.



|                                                        |  |     
|------------------------------------------------------- |  | ----
|                                                        |  | PAGE
|Report of Independent Registered Public Accounting Firm |  | 50  
|Consolidated Balance Sheets                             |  | 51  
|Consolidated Statements of Operations                   |  | 53  
|Consolidated Statements of Stockholders Equity         |  | 54  
|Consolidated Statements of Cash Flows                   |  | 55  
|Notes to Consolidated Financial Statements              |  | 57  
|Schedule IIValuation and Qualifying Accounts           |  | 82  



49



---

Report of Independent Registered Public Accounting Firm



To the Stockholders and Board of Directors

Dynacq Healthcare, Inc.

Houston, Texas



We have audited
the accompanying consolidated balance sheets of Dynacq Healthcare, Inc. (formerly Dynacq International, Inc.) (the Company), as of August 31, 2003 and 2002, and the related consolidated statements of operations, stockholders
equity, and cash flows for the years ended August 31, 2003 and 2002. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These consolidated financial statements and schedule are the responsibility of the
Companys management. Our responsibility is to express an opinion on these consolidated financial statements and schedule based on our audits. The consolidated financial statements of Dynacq Healthcare, Inc. (formerly Dynacq International,
Inc.) as of August 31, 2001, and for the year then ended were audited by other auditors who have ceased operations. Those auditors expressed an unqualified opinion on those consolidated financial statements in their report dated November 26, 2001.



We conducted our audits in accordance with the auditing
standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.



In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the
consolidated financial position of Dynacq Healthcare, Inc. (formerly Dynacq International, Inc.) at August 31, 2003 and 2002, and the consolidated results of their operations and their cash flows for the years ended August 31, 2003 and 2002, in
conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents
fairly in all material respects the information set forth therein.



As discussed in Note 1 to the consolidated financial statements, in 2003 the Company changed its method of accounting for negative goodwill.



As discussed above, the consolidated financial statements of Dynacq Healthcare, Inc. (formerly Dynacq International, Inc.) as of August 31, 2001, and for
the year then ended were audited by other auditors who have ceased operations. As described in Note 2, these consolidated financial statements have been restated. We audited the adjustments described in Note 2 that were applied to restate the 2001
consolidated financial statements. In our opinion, such adjustments are appropriate and have been properly applied. However, we were not engaged to audit, review, or apply procedures to the 2001 consolidated financial statements of the Company other
than with respect to such adjustments and, accordingly, we do not express an opinion or any other form of assurance on the 2001 consolidated financial statements taken as a whole.



|                                                                                                    
|----------------------------------------------------------------------------------------------------
|/s/ Killman, Murrell & Company, P. C. Killman, Murrell & Company, P. C. Houston, Texas June 18, 2004



50



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Consolidated Balance Sheets



|                                                                                                                                                                                                                                                |  |            |            |      |   |           
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------- | ---------- | ---- | - | ----------
|                                                                                                                                                                                                                                                |  | August 31,
|                                                                                                                                                                                                                                                |  | 2003       |            | 2002
|Assets                                                                                                                                                                                                                                          |  |            |            |      |   |           
|Current assets:                                                                                                                                                                                                                                 |  |            |            |      |   |           
|Cash and cash equivalents                                                                                                                                                                                                                       |  | $          | 1,883,833  |      | $ | 7,583,756 
|Restricted cash                                                                                                                                                                                                                                 |  |            | 2,000,000  |      |   |          
|Current portion of accounts receivable, net of contractual allowances of approximately $49,603,000 and $32,958,000 and allowances for
uncollectible accounts of approximately $483,000 and $248,000 at August 31, 2003 and 2002, respectively   |  |            | 17,397,746 |      |   | 13,337,638
|Inventories                                                                                                                                                                                                                                     |  |            | 2,100,035  |      |   | 893,728   
|Prepaid expenses                                                                                                                                                                                                                                |  |            | 793,257    |      |   | 222,452   
|Deferred tax assets                                                                                                                                                                                                                             |  |            | 939,655    |      |   | 1,376,522 
|Income taxes receivable                                                                                                                                                                                                                         |  |            | 4,430,485  |      |   | 1,790,370 
|Asset held for sale                                                                                                                                                                                                                             |  |            | 2,315,204  |      |   |          
|                                                                                                                                                                                                                                                |  |            |            |      |   |           
|Total current assets                                                                                                                                                                                                                            |  |            | 31,860,215 |      |   | 25,204,466
|Property and equipment, net                                                                                                                                                                                                                     |  |            | 38,002,399 |      |   | 16,277,167
|Long term portion of accounts receivable, net of contractual allowances of approximately $48,560,000 and $25,934,000 and allowances for
uncollectible accounts of approximately $473,000 and $195,000 at August 31, 2003 and 2002, respectively |  |            | 17,031,862 |      |   | 10,495,134
|Long term deferred tax assets                                                                                                                                                                                                                   |  |            |           |      |   | 748,389   
|Goodwill                                                                                                                                                                                                                                        |  |            | 582,547    |      |   | 582,547   
|Other assets                                                                                                                                                                                                                                    |  |            | 659,631    |      |   | 618,773   
|                                                                                                                                                                                                                                                |  |            |            |      |   |           
|Total assets                                                                                                                                                                                                                                    |  | $          | 88,136,654 |      | $ | 53,926,476
|                                                                                                                                                                                                                                                |  |            |            |      |   |           



The accompanying
notes are an integral part of these consolidated financial statements.



51



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Consolidated Balance Sheets (continued)



|                                                                                                                                                |  |            |            |   |      |   |            |  
|----------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------- | ---------- | - | ---- | - | ---------- | -
|                                                                                                                                                |  | August 31, |           
|                                                                                                                                                |  | 2003       |            |   | 2002 |  
|Liabilities and stockholders equity                                                                                                            |  |            |            |   |      |   |            |  
|Current liabilities:                                                                                                                            |  |            |            |   |      |   |            |  
|Accounts payable                                                                                                                                |  | $          | 3,459,881  |   |      | $ | 1,460,083  |  
|Accrued liabilities                                                                                                                             |  |            | 7,403,850  |   |      |   | 1,552,275  |  
|Notes payable                                                                                                                                   |  |            | 7,083,312  |   |      |   | 39,075     |  
|Current taxes payable                                                                                                                           |  |            | 1,524,244  |   |      |   | 1,307,527  |  
|Current portion of capital lease obligations                                                                                                    |  |            | 129,805    |   |      |   |           |  
|                                                                                                                                                |  |            |            |   |      |   |            |  
|Total current liabilities                                                                                                                       |  |            | 19,601,092 |   |      |   | 4,358,960  |  
|Non-current liabilities:                                                                                                                        |  |            |            |   |      |   |            |  
|Negative goodwill, net                                                                                                                          |  |            |           |   |      |   | 1,550,910  |  
|Deferred tax liabilities                                                                                                                        |  |            | 751,273    |   |      |   |           |  
|Long-term portion of capital lease obligations                                                                                                  |  |            | 428,587    |   |      |   |           |  
|                                                                                                                                                |  |            |            |   |      |   |            |  
|Total liabilities                                                                                                                               |  |            | 20,780,952 |   |      |   | 5,909,870  |  
|                                                                                                                                                |  |            |            |   |      |   |            |  
|Minority interests                                                                                                                              |  |            | 2,568,634  |   |      |   | 1,523,750  |  
|                                                                                                                                                |  |            |            |   |      |   |            |  
|Commitments and contingencies                                                                                                                   |  |            |           |   |      |   |           |  
|Stockholders equity:                                                                                                                           |  |            |            |   |      |   |            |  
|Preferred stock, $.01 par value; 5,000,000 shares authorized, none issued or outstanding                                                        |  |            |           |   |      |   |           |  
|Common stock, $.001 par value; 100,000,000 shares authorized, 16,294,343 and 15,901,430 shares issued at August 31, 2003 and 2002,
respectively |  |            | 16,294     |   |      |   | 15,901     |  
|Treasury stock, 1,445,099 and 1,143,592 shares at August 31, 2003 and 2002, respectively, at cost                                               |  |            | (5,813,284 | ) |      |   | (1,535,934 | )
|Additional paid-in capital                                                                                                                      |  |            | 17,521,843 |   |      |   | 13,695,088 |  
|Accounts receivable Director                                                                                                                    |  |            |            |   |      |   | (28,469    | )
|Retained earnings                                                                                                                               |  |            | 53,721,286 |   |      |   | 35,186,341 |  
|Deferred compensation                                                                                                                           |  |            | (659,071   | ) |      |   | (840,071   | )
|                                                                                                                                                |  |            |            |   |      |   |            |  
|Total stockholders equity                                                                                                                      |  |            | 64,787,068 |   |      |   | 46,492,856 |  
|                                                                                                                                                |  |            |            |   |      |   |            |  
|Total liabilities and stockholders equity                                                                                                      |  | $          | 88,136,654 |   |      | $ | 53,926,476 |  
|                                                                                                                                                |  |            |            |   |      |   |            |  



The accompanying
notes are an integral part of these consolidated financial statements.



52



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Consolidated Statements of Operations



|                                                                                                                           |  |                        |            |   |      |   |            |      |  |   |            |  
|-------------------------------------------------------------------------------------------------------------------------- |  | ---------------------- | ---------- | - | ---- | - | ---------- | ---- |  | - | ---------- | -
|                                                                                                                           |  | Years ended August 31, |           
|                                                                                                                           |  | 2003                   |            |   | 2002 |   |            | 2001 | 
|Net patient service revenue                                                                                                |  | $                      | 89,976,739 |   |      | $ | 64,883,235 |      |  | $ | 43,803,619 |  
|                                                                                                                           |  |                        |            |   |      |   |            |      |  |   |            |  
|Costs and expenses:                                                                                                        |  |                        |            |   |      |   |            |      |  |   |            |  
|Compensation and benefits                                                                                                  |  |                        | 14,990,675 |   |      |   | 9,349,770  |      |  |   | 5,849,723  |  
|Medical services and supplies                                                                                              |  |                        | 16,505,272 |   |      |   | 15,332,788 |      |  |   | 9,299,835  |  
|Other operating expenses                                                                                                   |  |                        | 20,332,589 |   |      |   | 12,652,455 |      |  |   | 13,379,159 |  
|Provision for uncollectible accounts                                                                                       |  |                        | 512,885    |   |      |   | 250,712    |      |  |   | 58,259     |  
|Depreciation and amortization                                                                                              |  |                        | 2,167,999  |   |      |   | 1,169,746  |      |  |   | 813,143    |  
|                                                                                                                           |  |                        |            |   |      |   |            |      |  |   |            |  
|Total costs and expenses                                                                                                   |  |                        | 54,509,420 |   |      |   | 38,755,471 |      |  |   | 29,400,119 |  
|                                                                                                                           |  |                        |            |   |      |   |            |      |  |   |            |  
|Income from operations                                                                                                     |  |                        | 35,467,319 |   |      |   | 26,127,764 |      |  |   | 14,403,500 |  
|Other income (expense):                                                                                                    |  |                        |            |   |      |   |            |      |  |   |            |  
|Rent and other income                                                                                                      |  |                        | 471,778    |   |      |   | 424,472    |      |  |   | 352,114    |  
|Interest income                                                                                                            |  |                        | 73,300     |   |      |   | 163,584    |      |  |   | 299,901    |  
|Interest expense, net of $84,668 capitalized interest in 2003                                                              |  |                        | (1,891     | ) |      |   | (27,537    | )    |  |   | (60,129    | )
|                                                                                                                           |  |                        |            |   |      |   |            |      |  |   |            |  
|Total other income, net                                                                                                    |  |                        | 543,187    |   |      |   | 560,519    |      |  |   | 591,886    |  
|                                                                                                                           |  |                        |            |   |      |   |            |      |  |   |            |  
|Income before income tax, minority interests, extraordinary gain and cumulative effect of a change in accounting principle |  |                        | 36,010,506 |   |      |   | 26,688,283 |      |  |   | 14,995,386 |  
|Provision for income taxes                                                                                                 |  |                        | 12,886,335 |   |      |   | 9,655,378  |      |  |   | 4,775,000  |  
|Minority interest in earnings                                                                                              |  |                        | 3,306,882  |   |      |   | 2,203,418  |      |  |   | 2,476,750  |  
|                                                                                                                           |  |                        |            |   |      |   |            |      |  |   |            |  
|Income before extraordinary gain and cumulative effect of a change in accounting principle                                 |  |                        | 19,817,289 |   |      |   | 14,829,487 |      |  |   | 7,743,636  |  
|Extraordinary gain, net of $49,681 of income tax expense                                                                   |  |                        | 81,317     |   |      |   |           |      |  |   |           |  
|                                                                                                                           |  |                        |            |   |      |   |            |      |  |   |            |  
|Income before cumulative effect of a change in accounting principle                                                        |  |                        | 19,898,606 |   |      |   | 14,829,487 |      |  |   | 7,743,636  |  
|Cumulative effect of a change in accounting principle, net of $562,193 income tax expense                                  |  |                        | 988,717    |   |      |   |           |      |  |   |           |  
|                                                                                                                           |  |                        |            |   |      |   |            |      |  |   |            |  
|Net income                                                                                                                 |  | $                      | 20,887,323 |   |      | $ | 14,829,487 |      |  | $ | 7,743,636  |  
|                                                                                                                           |  |                        |            |   |      |   |            |      |  |   |            |  
|Basic earnings per common share:                                                                                           |  |                        |            |   |      |   |            |      |  |   |            |  
|Income before extraordinary gain and cumulative effect of a change in accounting principle                                 |  | $                      | 1.33       |   |      | $ | 1.01       |      |  | $ | 0.55       |  
|Extraordinary gain, net of tax                                                                                             |  |                        | 0.01       |   |      |   |           |      |  |   |           |  
|Cumulative effect of a change in accounting principle, net of tax                                                          |  |                        | 0.06       |   |      |   |           |      |  |   |           |  
|                                                                                                                           |  |                        |            |   |      |   |            |      |  |   |            |  
|Net income                                                                                                                 |  | $                      | 1.40       |   |      | $ | 1.01       |      |  | $ | 0.55       |  
|                                                                                                                           |  |                        |            |   |      |   |            |      |  |   |            |  
|Diluted earnings per common share:                                                                                         |  |                        |            |   |      |   |            |      |  |   |            |  
|Income before extraordinary gain and cumulative effect of a change in accounting principle                                 |  | $                      | 1.27       |   |      | $ | 0.96       |      |  | $ | 0.51       |  
|Extraordinary gain, net of tax                                                                                             |  |                        | 0.01       |   |      |   |           |      |  |   |           |  
|Cumulative effect of a change in accounting principle, net of tax                                                          |  |                        | 0.06       |   |      |   |           |      |  |   |           |  
|                                                                                                                           |  |                        |            |   |      |   |            |      |  |   |            |  
|Net income                                                                                                                 |  | $                      | 1.34       |   |      | $ | 0.96       |      |  | $ | 0.51       |  
|                                                                                                                           |  |                        |            |   |      |   |            |      |  |   |            |  
|Weighted average common sharesbasic                                                                                       |  |                        | 14,849,504 |   |      |   | 14,686,236 |      |  |   | 13,997,861 |  
|                                                                                                                           |  |                        |            |   |      |   |            |      |  |   |            |  
|Weighted average common sharesdiluted                                                                                     |  |                        | 15,564,217 |   |      |   | 15,490,068 |      |  |   | 15,092,433 |  
|                                                                                                                           |  |                        |            |   |      |   |            |      |  |   |            |  



The accompanying
notes are an integral part of these consolidated financial statements.



53



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Consolidated Statements of Stockholders Equity



|                                                           |  |              |   |  |                |        |   |                          |           |   |                   |   |            |                      |  |   |                         |   |  |       |            |   |  |   |          |   |  |   |         |   |  |   |            |  
|---------------------------------------------------------- |  | ------------ | - |  | -------------- | ------ | - | ------------------------ | --------- | - | ----------------- | - | ---------- | -------------------- |  | - | ----------------------- | - |  | ----- | ---------- | - |  | - | -------- | - |  | - | ------- | - |  | - | ---------- | -
|                                                           |  | Common Stock |   |  | Treasury Stock |        |   | AdditionalPaid-InCapital |           |   | Retained Earnings |   |            | DeferredCompensation |  |   | ReceivableFrom Director |   |  | Total |           
|                                                           |  | Shares       |   |  | Amount         |        |   | Shares                   |           |   | Amount            |   |            |                      |  |   |                        
|Balance, August 31, 2000 as previously reported            |  | 7,658,856    |   |  | $              | 7,659  |   |                          | 794,392   |   |                   | $ | (1,141,546 | )                    |  | $ | 4,309,813               |   |  | $     | 11,392,583 |   |  | $ |         |   |  | $ |        |   |  | $ | 14,568,509 |  
|Cancellation of treasury shares                            |  | (306,868     | ) |  |                | (307   | ) |                          | (306,868  | ) |                   |   | 423,478    |                      |  |   | (423,171                | ) |  |       |           |   |  |   |         |   |  |   |        |   |  |   |           |  
|Stock options issued to non employees                      |  |             |   |  |                |       |   |                          |          |   |                   |   |           |                      |  |   | 1,478,080               |   |  |       | (1,478,080 | ) |  |   |         |   |  |   |        |   |  |   |           |  
|Treasury shares held by subsidiary                         |  |             |   |  |                |       |   |                          | 35,672    |   |                   |   |           |                      |  |   |                        |   |  |       |           |   |  |   |         |   |  |   |        |   |  |   |           |  
|Overstatement of tax liabilities as of August 31, 2000     |  |             |   |  |                |       |   |                          |          |   |                   |   |           |                      |  |   |                        |   |  |       | 2,706,356  |   |  |   |         |   |  |   |        |   |  |   | 2,706,356  |  
|                                                           |  |              |   |  |                |        |   |                          |           |   |                   |   |            |                      |  |   |                         |   |  |       |            |   |  |   |          |   |  |   |         |   |  |   |            |  
|Balance, August 31, 2000 as restated                       |  | 7,351,988    |   |  |                | 7,352  |   |                          | 523,196   |   |                   |   | (718,068   | )                    |  |   | 5,364,722               |   |  |       | 12,620,859 |   |  |   |         |   |  |   |        |   |  |   | 17,274,865 |  
|Stock issued for acquisitions                              |  | 65,751       |   |  |                | 66     |   |                          |          |   |                   |   |           |                      |  |   | 617,152                 |   |  |       |           |   |  |   |         |   |  |   |        |   |  |   | 617,218    |  
|Stock issued for compensation                              |  | 20,620       |   |  |                | 21     |   |                          |          |   |                   |   |           |                      |  |   | 173,042                 |   |  |       |           |   |  |   |         |   |  |   |        |   |  |   | 173,063    |  
|Common stock sales                                         |  | 21,442       |   |  |                | 21     |   |                          |          |   |                   |   |           |                      |  |   | 281,079                 |   |  |       |           |   |  |   |         |   |  |   |        |   |  |   | 281,100    |  
|Stock issued on exercise of stock options                  |  | 551,436      |   |  |                | 551    |   |                          |          |   |                   |   |           |                      |  |   | 788,557                 |   |  |       |           |   |  |   |         |   |  |   |        |   |  |   | 789,108    |  
|Stock options issued to non-employees                      |  |             |   |  |                |       |   |                          |          |   |                   |   |           |                      |  |   | 3,686,510               |   |  |       |           |   |  |   |         |   |  |   |        |   |  |   | 3,686,510  |  
|Income tax benefit from exercise of employee stock options |  |             |   |  |                |       |   |                          |          |   |                   |   |           |                      |  |   | 108,938                 |   |  |       |           |   |  |   |         |   |  |   |        |   |  |   | 108,938    |  
|Stock split                                                |  | 7,641,358    |   |  |                | 7,641  |   |                          | 528,796   |   |                   |   |           |                      |  |   |                        |   |  |       | (7,641     | ) |  |   |         |   |  |   |        |   |  |   |           |  
|Treasury shares acquired                                   |  |             |   |  |                |       |   |                          | 5,600     |   |                   |   | (48,961    | )                    |  |   |                        |   |  |       |           |   |  |   |         |   |  |   |        |   |  |   | (48,961    | )
|Net income                                                 |  |             |   |  |                |       |   |                          |          |   |                   |   |           |                      |  |   |                        |   |  |       | 7,743,636  |   |  |   |         |   |  |   |        |   |  |   | 7,743,636  |  
|                                                           |  |              |   |  |                |        |   |                          |           |   |                   |   |            |                      |  |   |                         |   |  |       |            |   |  |   |          |   |  |   |         |   |  |   |            |  
|Balance, August 31, 2001 as restated                       |  | 15,652,595   |   |  |                | 15,652 |   |                          | 1,057,592 |   |                   |   | (767,029   | )                    |  |   | 11,020,000              |   |  |       | 20,356,854 |   |  |   |         |   |  |   |        |   |  |   | 30,625,477 |  
|Common stock sales                                         |  | 3,000        |   |  |                | 3      |   |                          |          |   |                   |   |           |                      |  |   | 13,309                  |   |  |       |           |   |  |   |         |   |  |   |        |   |  |   | 13,312     |  
|Stock issued on exercise of stock options                  |  | 245,835      |   |  |                | 246    |   |                          |          |   |                   |   |           |                      |  |   | 1,089,050               |   |  |       |           |   |  |   |         |   |  |   |        |   |  |   | 1,089,296  |  
|Stock options issued to non employees                      |  |             |   |  |                |       |   |                          |          |   |                   |   |           |                      |  |   | 385,426                 |   |  |       |           |   |  |   |         |   |  |   |        |   |  |   | 385,426    |  
|Income tax benefit from exercise of employee stock options |  |             |   |  |                |       |   |                          |          |   |                   |   |           |                      |  |   | 245,334                 |   |  |       |           |   |  |   |         |   |  |   |        |   |  |   | 245,334    |  
|Treasury shares acquired                                   |  |             |   |  |                |       |   |                          | 86,000    |   |                   |   | (768,905   | )                    |  |   |                        |   |  |       |           |   |  |   |         |   |  |   |        |   |  |   | (768,905   | )
|Short-term sale by director                                |  |             |   |  |                |       |   |                          |          |   |                   |   |           |                      |  |   | 32,969                  |   |  |       |           |   |  |   |         |   |  |   | (28,469 | ) |  |   | 4,500      |  
|Deferred compensation recognized for options granted       |  |             |   |  |                |       |   |                          |          |   |                   |   |           |                      |  |   | 909,000                 |   |  |       |           |   |  |   | (909,000 | ) |  |   |        |   |  |   |           |  
|Deferred compensation amortization                         |  |             |   |  |                |       |   |                          |          |   |                   |   |           |                      |  |   |                        |   |  |       |           |   |  |   | 68,929   |   |  |   |        |   |  |   | 68,929     |  
|Net income                                                 |  |             |   |  |                |       |   |                          |          |   |                   |   |           |                      |  |   |                        |   |  |       | 14,829,487 |   |  |   |         |   |  |   |        |   |  |   | 14,829,487 |  
|                                                           |  |              |   |  |                |        |   |                          |           |   |                   |   |            |                      |  |   |                         |   |  |       |            |   |  |   |          |   |  |   |         |   |  |   |            |  
|Balance, August 31, 2002 as restated                       |  | 15,901,430   |   |  |                | 15,901 |   |                          | 1,143,592 |   |                   |   | (1,535,934 | )                    |  |   | 13,695,088              |   |  |       | 35,186,341 |   |  |   | (840,071 | ) |  |   | (28,469 | ) |  |   | 46,492,856 |  
|Stock issued on exercise of stock options                  |  | 263,336      |   |  |                | 263    |   |                          |          |   |                   |   |           |                      |  |   | 1,168,291               |   |  |       |           |   |  |   |         |   |  |   |        |   |  |   | 1,168,554  |  
|Income tax benefit from exercise of employee stock options |  |             |   |  |                |       |   |                          |          |   |                   |   |           |                      |  |   | 189,639                 |   |  |       |           |   |  |   |         |   |  |   |        |   |  |   | 189,639    |  
|Stock warrants issued to non employees                     |  |             |   |  |                |       |   |                          |          |   |                   |   |           |                      |  |   | 327,758                 |   |  |       |           |   |  |   |         |   |  |   |        |   |  |   | 327,758    |  
|Sale of residence                                          |  |             |   |  |                |       |   |                          | 25,639    |   |                   |   | (311,740   | )                    |  |   |                        |   |  |       |           |   |  |   |         |   |  |   |        |   |  |   | (311,740   | )
|Stock options issued to non employees                      |  |             |   |  |                |       |   |                          |          |   |                   |   |           |                      |  |   | 262,330                 |   |  |       |           |   |  |   |         |   |  |   |        |   |  |   | 262,330    |  
|Treasury shares acquired                                   |  |             |   |  |                |       |   |                          | 261,500   |   |                   |   | (3,965,610 | )                    |  |   |                        |   |  |       |           |   |  |   |         |   |  |   |        |   |  |   | (3,965,610 | )
|Collections from director                                  |  |             |   |  |                |       |   |                          |          |   |                   |   |           |                      |  |   |                        |   |  |       |           |   |  |   |         |   |  |   | 28,469  |   |  |   | 28,469     |  
|Stock dividend                                             |  | 129,577      |   |  |                | 130    |   |                          | 14,368    |   |                   |   |           |                      |  |   | 1,878,737               |   |  |       | (1,878,867 | ) |  |   |         |   |  |   |        |   |  |   |           |  
|Preferred Stock Redemption                                 |  |             |   |  |                |       |   |                          |          |   |                   |   |           |                      |  |   |                        |   |  |       | (473,511   | ) |  |   |         |   |  |   |        |   |  |   | (473,511   | )
|Amortization of deferred compensation                      |  |             |   |  |                |       |   |                          |          |   |                   |   |           |                      |  |   |                        |   |  |       |           |   |  |   | 181,000  |   |  |   |        |   |  |   | 181,000    |  
|Net income                                                 |  |             |   |  |                |       |   |                          |          |   |                   |   |           |                      |  |   |                        |   |  |       | 20,887,323 |   |  |   |         |   |  |   |        |   |  |   | 20,887,323 |  
|                                                           |  |              |   |  |                |        |   |                          |           |   |                   |   |            |                      |  |   |                         |   |  |       |            |   |  |   |          |   |  |   |         |   |  |   |            |  
|Balance, August 31, 2003                                   |  | 16,294,343   |   |  | $              | 16,294 |   |                          | 1,445,099 |   |                   | $ | (5,813,284 | )                    |  | $ | 17,521,843              |   |  | $     | 53,721,286 |   |  | $ | (659,071 | ) |  | $ |        |   |  | $ | 64,787,068 |  
|                                                           |  |              |   |  |                |        |   |                          |           |   |                   |   |            |                      |  |   |                         |   |  |       |            |   |  |   |          |   |  |   |         |   |  |   |            |  



The accompanying
notes are an integral part of these consolidated financial statements.



54



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Consolidated Statements of Cash Flows



|                                                                                  |  |                       |             |   |      |   |            |      |  |   |             |  
|--------------------------------------------------------------------------------- |  | --------------------- | ----------- | - | ---- | - | ---------- | ---- |  | - | ----------- | -
|                                                                                  |  | Years ended August 31 |            
|                                                                                  |  | 2003                  |             |   | 2002 |   |            | 2001 | 
|Cash flows from operating activities                                              |  |                       |             |   |      |   |            |      |  |   |             |  
|Net income                                                                        |  | $                     | 20,887,323  |   |      | $ | 14,829,487 |      |  | $ | 7,743,636   |  
|Adjustments to reconcile net income to net cash provided by operating activities: |  |                       |             |   |      |   |            |      |  |   |             |  
|Extraordinary gain, net of tax                                                    |  |                       | (81,317     | ) |      |   |           |      |  |   |            |  
|Cumulative effect of a change in accounting principle, net of tax                 |  |                       | (988,717    | ) |      |   |           |      |  |   |            |  
|Depreciation and amortization                                                     |  |                       | 2,167,999   |   |      |   | 1,169,746  |      |  |   | 813,143     |  
|Gain on sale of residential property                                              |  |                       | (145,623    | ) |      |   |           |      |  |   |            |  
|Provision for uncollectible accounts                                              |  |                       | 512,885     |   |      |   | 250,712    |      |  |   | 58,259      |  
|Deferred income taxes                                                             |  |                       | 1,324,656   |   |      |   | (2,978,645 | )    |  |   | (1,078,000  | )
|Minority interests                                                                |  |                       | 3,306,882   |   |      |   | 2,203,418  |      |  |   | 2,476,750   |  
|Expense related to stock options issued to non employees                          |  |                       | 262,330     |   |      |   | 385,426    |      |  |   | 3,686,510   |  
|Stock issued for compensation                                                     |  |                       |            |   |      |   |           |      |  |   | 173,042     |  
|Expense related to issuance of stock warrants                                     |  |                       | 327,758     |   |      |   |           |      |  |   |            |  
|Deferred stock compensation amortization                                          |  |                       | 181,000     |   |      |   | 68,929     |      |  |   |            |  
|Changes in operating assets and liabilities:                                      |  |                       |             |   |      |   |            |      |  |   |             |  
|Restricted cash                                                                   |  |                       | (2,000,000  | ) |      |   |           |      |  |   |            |  
|Accounts receivable                                                               |  |                       | (11,109,721 | ) |      |   | (5,089,837 | )    |  |   | (10,352,299 | )
|Inventories                                                                       |  |                       | (840,076    | ) |      |   | (382,480   | )    |  |   | (139,279    | )
|Prepaid expenses                                                                  |  |                       | (570,805    | ) |      |   | (112,459   | )    |  |   | (109,993    | )
|Income taxes receivable                                                           |  |                       | (2,640,115  | ) |      |   | 622,810    |      |  |   | (2,413,181  | )
|Other assets                                                                      |  |                       | 3,685       |   |      |   | (542,788   | )    |  |   | (66,334     | )
|Accounts payable                                                                  |  |                       | 1,999,798   |   |      |   | 661,296    |      |  |   | (327,283    | )
|Accrued liabilities                                                               |  |                       | 2,666,621   |   |      |   | 826,863    |      |  |   | 43,898      |  
|Income taxes payable                                                              |  |                       | 406,355     |   |      |   | (130,911   | )    |  |   | 2,234,495   |  
|                                                                                  |  |                       |             |   |      |   |            |      |  |   |             |  
|Net cash provided by operating activities                                         |  |                       | 15,670,918  |   |      |   | 11,781,567 |      |  |   | 2,743,364   |  
|                                                                                  |  |                       |             |   |      |   |            |      |  |   |             |  
|Cash flows from investing activities                                              |  |                       |             |   |      |   |            |      |  |   |             |  
|Purchase of property and equipment                                                |  |                       | (17,282,168 | ) |      |   | (3,595,806 | )    |  |   | (1,163,472  | )
|Accrued liabilities related to purchase of property and equipment                 |  |                       | 1,002,517   |   |      |   |           |      |  |   |            |  
|Acquisition of Garland properties, net of assumed liabilities                     |  |                       | (5,607,406  | ) |      |   |           |      |  |   |            |  
|Acquisition of Vista Diagnostic Clinic                                            |  |                       | (471,102    | ) |      |   |           |      |  |   |            |  
|Acquisition of Baton Rouge Facility                                               |  |                       |            |   |      |   | (3,373,126 | )    |  |   |            |  
|Acquisitions of Surgi+Group and Piney Point                                       |  |                       |            |   |      |   |           |      |  |   | (1,008,333  | )
|                                                                                  |  |                       |             |   |      |   |            |      |  |   |             |  
|Net cash used in investing activities                                             |  |                       | (22,358,159 | ) |      |   | (6,968,932 | )    |  |   | (2,171,805  | )
|                                                                                  |  |                       |             |   |      |   |            |      |  |   |             |  



55



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Consolidated Statements of Cash Flows (continued)



|                                                                   |  |                       |            |   |      |   |            |      |  |   |           |  
|------------------------------------------------------------------ |  | --------------------- | ---------- | - | ---- | - | ---------- | ---- |  | - | --------- | -
|                                                                   |  | Years ended August 31 |           
|                                                                   |  | 2003                  |            |   | 2002 |   |            | 2001 | 
|Cash flows from financing activities                               |  |                       |            |   |      |   |            |      |  |   |           |  
|Principal payments on long-term debt                               |  | $                     | (39,075    | ) |      | $ | (708,697   | )    |  | $ | (537,715  | )
|Payments on capital leases                                         |  |                       | (13,821    | ) |      |   |           |      |  |   |          |  
|Proceeds from note payable                                         |  |                       | 6,413,312  |   |      |   |           |      |  |   | 600,000   |  
|Proceeds from exercise of stock options                            |  |                       | 1,168,554  |   |      |   | 1,102,609  |      |  |   | 1,070,208 |  
|Proceeds from short-term sale by director                          |  |                       | 28,469     |   |      |   | 4,500      |      |  |   |          |  
|Acquisition of treasury shares                                     |  |                       | (3,965,610 | ) |      |   | (768,905   | )    |  |   | (48,961   | )
|Preferred stock redemption                                         |  |                       | (473,511   | ) |      |   |           |      |  |   |          |  
|Contributions from minority interest holders                       |  |                       | 946,000    |   |      |   |           |      |  |   |          |  
|Distributions to minority interest holders                         |  |                       | (2,827,000 | ) |      |   | (1,300,000 | )    |  |   | (875,000  | )
|Purchase of minority interests                                     |  |                       | (250,000   | ) |      |   | (590,000   | )    |  |   | (50,000   | )
|                                                                   |  |                       |            |   |      |   |            |      |  |   |           |  
|Net cash provided by (used in) financing activities                |  |                       | 987,318    |   |      |   | (2,260,493 | )    |  |   | 158,532   |  
|                                                                   |  |                       |            |   |      |   |            |      |  |   |           |  
|Net (decrease) increase in cash and cash equivalents               |  |                       | (5,699,923 | ) |      |   | 2,552,142  |      |  |   | 730,091   |  
|Cash and cash equivalents at beginning of year                     |  |                       | 7,583,756  |   |      |   | 5,031,614  |      |  |   | 4,301,523 |  
|                                                                   |  |                       |            |   |      |   |            |      |  |   |           |  
|Cash and cash equivalents at end of year                           |  | $                     | 1,883,833  |   |      | $ | 7,583,756  |      |  | $ | 5,031,614 |  
|                                                                   |  |                       |            |   |      |   |            |      |  |   |           |  
|Supplemental cash flow disclosures                                 |  |                       |            |   |      |   |            |      |  |   |           |  
|Cash paid during year for:                                         |  |                       |            |   |      |   |            |      |  |   |           |  
|Interest                                                           |  | $                     | 48,562     |   |      | $ | 27,539     |      |  | $ | 74,724    |  
|                                                                   |  |                       |            |   |      |   |            |      |  |   |           |  
|Income taxes                                                       |  | $                     | 13,804,485 |   |      | $ | 12,218,229 |      |  | $ | 6,057,347 |  
|                                                                   |  |                       |            |   |      |   |            |      |  |   |           |  
|Non cash investing and financing activities:                       |  |                       |            |   |      |   |            |      |  |   |           |  
|Decrease in minority interest from acquisition                     |  | $                     |           |   |      | $ | (710,437   | )    |  | $ |          |  
|Increase in negative goodwill due to minority interest acquisition |  |                       |           |   |      |   | 710,437    |      |  |   |          |  
|Paid in capital from short-term sale                               |  |                       |           |   |      |   | 32,969     |      |  |   |          |  
|Accounts receivable from director                                  |  |                       |           |   |      |   | (32,969    | )    |  |   |          |  
|Paid in capital from deferred compensation                         |  |                       |           |   |      |   | 909,000    |      |  |   |          |  
|Non cash increase in deferred compensation                         |  |                       |           |   |      |   | (909,000   | )    |  |   |          |  
|Sale of property for treasury stock                                |  |                       | 311,740    |   |      |   |           |      |  |   |          |  
|Treasury stock received for property                               |  |                       | (311,740   | ) |      |   |           |      |  |   |          |  
|Paid in capital from stock dividend                                |  |                       | 1,878,737  |   |      |   |           |      |  |   |          |  
|Common stock increase for stock dividend                           |  |                       | 130        |   |      |   |           |      |  |   | 7,641     |  
|Decrease in retained earnings for stock dividend                   |  |                       | (1,878,867 | ) |      |   |           |      |  |   | (7,641    | )
|Capital lease issued for fixed assets                              |  |                       | 572,212    |   |      |   |           |      |  |   |          |  
|Assets acquired for capital leases                                 |  |                       | (572,212   | ) |      |   |           |      |  |   |          |  
|Reduction in minority interest                                     |  |                       |           |   |      |   |           |      |  |   | (617,218  | )
|Stock issued for acquisition of Surgi+Group                        |  |                       |           |   |      |   |           |      |  |   | 380,000   |  
|Stock issued for acquisition of Piney Point                        |  |                       |           |   |      |   |           |      |  |   | 141,667   |  
|Stock issued for purchase of minority interests                    |  |                       |           |   |      |   |           |      |  |   | 95,551    |  
|                                                                   |  |                       |            |   |      |   |            |      |  |   |           |  
|                                                                   |  | $                     |           |   |      | $ |           |      |  | $ |          |  
|                                                                   |  |                       |            |   |      |   |            |      |  |   |           |  



The accompanying
notes are an integral part of these consolidated financial statements.



56



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Notes to Consolidated Financial Statements



August 31, 2003



|1. | Significant Accounting Policies
|-- | -------------------------------



Business and Organization



Dynacq Healthcare, Inc. is a holding company which through its subsidiaries develops and manages general acute hospitals that provide specialized general
surgeries, such as neurospine, bariatric and orthopedic surgeries. For fiscal year 2003, the surgical hospital and outpatient surgical centers are the predominant revenue generating segments. Hereinafter, the Company will refer to Dynacq
Healthcare, Inc., its wholly or majority owned subsidiaries, unless the context dictates or requires otherwise.



The Company was incorporated under the laws of the State of Utah in September 1983, reincorporated in Colorado in 1987, and reincorporated in Nevada in
1989. The Company was reincorporated in Delaware and its corporate name was changed from Dynacq International, Inc. to Dynacq Healthcare, Inc. in November 2003 to better reflect the Companys business. In connection with the reincorporation in
Delaware, the number of authorized common shares was reduced to 100,000,000.



In May 1998, Doctors Practice Management, Inc. (DPMI), a wholly owned subsidiary of the Company, organized Vista Community Medical Center, L.L.C., a Texas limited liability company, for the purpose of operating a
hospital (the Pasadena Facility). In June 2003, the Pasadena Facility was converted to a limited liability partnership. As of August 31, 2003 and 2002, the Company through its subsidiaries has a 91.5% and 90% ownership interest in the
Pasadena Facility, respectively.



During March 2001, DPMI
organized Vista Surgical Center West, L.L.C., a Texas limited liability company, for the purpose of acquiring and operating Piney Point Surgery Center (the West Houston Facility). The West Houston Facility is a fully operational
ambulatory surgical center in Houston, Texas.



In October 2001,
a wholly owned subsidiary of the Company organized Vista Hospital of Baton Rouge, L.L.C. for the purpose of acquiring and operating a surgical hospital in Baton Rouge, Louisiana (the Baton Rouge Facility). As of August 31, 2003, the
Company has a 97% membership interest in the Baton Rouge Facility.



In July 2003, the Company through its subsidiaries, organized Vista Hospital of Dallas, LP for the purposes of acquiring and operating a surgical hospital in Garland, Texas, (the Garland Facility), and has 100% partnership
interest in it as of August 31, 2003.



Principles of Consolidation



The consolidated financial statements include the
accounts of the Company and its wholly and majority owned subsidiaries. Intercompany accounts and transactions have been eliminated in consolidation.



Basis of Presentation



The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States for
annual financial information and with the instructions to Form 10-K and Article 3 and 3-A of Regulation S-X. The majority of the Companys expenses are cost of revenue items. Costs that could be classified as general and
administrative by the Company would include the corporate office costs, including advertising and marketing expenses, which were approximately $12.6 million, $9.9 million and $6.7 million for the fiscal years 2003, 2002 and 2001, respectively.



The Company operates in one line of business and its strategy
is to develop and manage general acute care hospitals that provide specialized general surgeries. The Company manages these hospitals on an individual basis. The hospitals economic characteristics, nature of their operations, regulatory
environment in which they operate and the way in which they are managed are all similar. Accordingly, the Company aggregates its hospitals into a



57



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Notes to Consolidated Financial Statements (continued)



August 31, 2003



single reportable segment as that term is defined by SFAS No. 131 Disclosures About Segments of an Enterprise and Related Information. The
Company operates one remaining ambulatory surgical center in its West Houston Facility.



Use of Estimates



The preparation of financial
statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. The
most significant of the Companys estimates is the determination of revenue to recognize for the services the Company provides and the determination of the contractual allowance. See Revenue Recognition below for further discussion.
Actual results could differ materially from those estimates used in preparation of these financial statements.



Cash and Cash Equivalents



The Company considers all highly liquid investments with maturities of three months or less on the date of purchase, to be cash equivalents. Cash equivalents are carried at cost, which approximates fair value.



Inventories



Inventories, consisting primarily of medical supplies, are stated at the lower of cost or market, with cost determined by
use of the average cost method.



Property and Equipment



Property and equipment are stated at cost. Maintenance and repairs are
charged to expense as incurred. Expenditures, which extend the physical or economic life of the assets, are capitalized and depreciated.



Depreciation is computed using the straight-line method over the estimated useful lives of the assets ranging from five to 39 years. The Company has
classified its assets into three categories. The categories are listed below, along with the useful life and the weighted average useful life for each category. Interest capitalized in accordance with Statement of Financial Accounting Standards
(SFAS) No. 34, Capitalization of Interest Cost was $84,668 in the fiscal year ended August 31, 2003.



|                                  |  |             |  |                            
|--------------------------------- |  | ----------- |  | ---------------------------
|                                  |  | Useful Life |  | Weighted AverageUseful Life
|Land                              |  | N/A         |  | N/A                        
|Buildings and improvements        |  | 39 years    |  | 39 years                   
|Equipment, furniture and fixtures |  | 5-7 years   |  | 5.2 years                  



The Company also
leases equipment under capital leases. Such assets are amortized on a straight-line basis over the lesser of the term of the lease or the remaining useful life of the assets.



Impairment of Long-lived Assets



The Company routinely evaluates the carrying value of its long-lived assets. The Company would record an impairment loss when events or circumstances
indicate that a long-lived assets carrying value may not be recovered. These events may include changes in the manner in which we intend to use an asset or decisions to sell an asset. To date, the Company has not recognized any impairment
charges.



58



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Notes to Consolidated Financial Statements (continued)



August 31, 2003



Revenue Recognition



Background



The Companys revenue recognition policy is significant because net patient service revenue is a primary component of its results of operations.
Revenue is recognized as services are delivered. The determination of the amount of revenue to be recognized in connection with the Companys services is subject to significant judgments and estimates, which are discussed below.



Revenue Recognition Policy



The Company is normally not a party to any managed care contracts. The
Company records revenue pursuant to the following policy. The Company has established billing rates for its medical services which it bills as gross revenue as services are delivered. Gross billed revenues are then reduced by the Companys
estimate of the discount (contractual allowance) to arrive at net patient service revenues. Net patient service revenues represents the Companys estimate of the amounts ultimately expected to be collected for the services it has delivered.



The table below sets forth the percentage of our gross patient
service revenue by financial class for the fiscal years 2003 and 2002:



|                      |  |      |   |  |      |  
|--------------------- |  | ---- | - |  | ---- | -
|                      |  | 2003 |   |  | 2002 |  
|Workers Compensation |  | 52   | % |  | 61   | %
|Commercial            |  | 37   | % |  | 32   | %
|Medicare              |  | 4    | % |  | 4    | %
|Medicaid              |  | 1    | % |  |     | %
|Self-Pay              |  | 1    | % |  | 1    | %
|Other                 |  | 5    | % |  | 2    | %



Contractual Allowance



The Company computes its contractual allowance based on
the ratio of the Companys historical cash collections during the trailing twelve months on a case by case basis to gross billed revenue on a case by case basis by operating facility. This ratio of cash collections to billed services is then
applied to the gross billed services by operating facility. The following table shows gross revenues and contractual allowances for fiscal years 2003, 2002 and 2001:



|                                 |  |            |             |   |      |   |             |      |  |   |            |  
|-------------------------------- |  | ---------- | ----------- | - | ---- | - | ----------- | ---- |  | - | ---------- | -
|                                 |  | August 31, |            
|                                 |  | 2003       |             |   | 2002 |   |             | 2001 | 
|Gross billed charges             |  | $          | 164,343,892 |   |      | $ | 113,760,963 |      |  | $ | 74,097,035 |  
|Contractual allowance            |  |            | 74,367,153  |   |      |   | 48,877,728  |      |  |   | 30,293,416 |  
|                                 |  |            |             |   |      |   |             |      |  |   |            |  
|Net revenue                      |  | $          | 89,976,739  |   |      | $ | 64,883,235  |      |  | $ | 43,803,619 |  
|                                 |  |            |             |   |      |   |             |      |  |   |            |  
|Contractual allowance percentage |  |            | 45          | % |      |   | 43          | %    |  |   | 41         | %
|                                 |  |            |             |   |      |   |             |      |  |   |            |  



Accounts Receivable



Accounts receivable represent net receivables for services provided by
the Company. The estimated accounts receivable not expected to be collected within twelve months of the balance sheet date have been shown as long-term receivables and represent receivables in the Medical Dispute Resolution (MDR) and
legal third party financial class. The contractual allowance is provided as revenue is recognized. At each balance sheet date management reviews the accounts receivables for collectability. If after the review management believes certain receivables
would be uncollectible, the receivable would be written down to the expected collectable amount. Management has not written down any receivables during the three years ended August 31, 2003 as a result of the collectability test. The following table
shows accounts receivable, the contractual allowance, the allowance for



59



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Notes to Consolidated Financial Statements (continued)



August 31, 2003



uncollectible accounts, net receivables and the contractual allowance as a percent of receivables as August 31, 2003 and 2002:



|                                                                                                              |  |      |             |   |      |   |             |  
|------------------------------------------------------------------------------------------------------------- |  | ---- | ----------- | - | ---- | - | ----------- | -
|                                                                                                              |  | 2003 |             |   | 2002 |  
|Current portion of gross receivables                                                                          |  | $    | 67,483,780  |   |      | $ | 46,544,023  |  
|Current portion of contractual allowance                                                                      |  |      | (49,602,756 | ) |      |   | (32,958,185 | )
|Current portion of allowance for uncollectible accounts                                                       |  |      | (483,278    | ) |      |   | (248,200    | )
|                                                                                                              |  |      |             |   |      |   |             |  
|Net current portion of accounts receivable                                                                    |  | $    | 17,397,746  |   |      | $ | 13,337,638  |  
|                                                                                                              |  |      |             |   |      |   |             |  
|Contractual allowance and allowance for uncollectible accounts as a percentage of current gross receivables   |  |      | 74          | % |      |   | 71          | %
|                                                                                                              |  |      |             |   |      |   |             |  
|Long term portion of gross receivables                                                                        |  | $    | 66,064,559  |   |      | $ | 36,624,610  |  
|Long term portion of contractual allowance                                                                    |  |      | (48,559,583 | ) |      |   | (25,934,171 | )
|Long term portion of allowance for uncollectible accounts                                                     |  |      | (473,114    | ) |      |   | (195,305    | )
|                                                                                                              |  |      |             |   |      |   |             |  
|Net long term portion of accounts receivable                                                                  |  | $    | 17,031,862  |   |      | $ | 10,495,134  |  
|                                                                                                              |  |      |             |   |      |   |             |  
|Contractual allowance and allowance for uncollectible accounts as a percentage of long term gross receivables |  |      | 74          | % |      |   | 71          | %
|                                                                                                              |  |      |             |   |      |   |             |  



The contractual
allowance stated as a percentage of gross receivables at the balance sheet dates is larger than the contractual allowance percentage used to reduce gross billed charges due to the application of cash collections to the outstanding gross receivable
balances without any adjustment being made to the contractual allowance. The contractual allowance amounts netted against gross receivables are not adjusted until such time as the final collections on the receivables is recognized.



Collections for services provided are generally settled or written off as
uncollectible against the contractual allowance within six months of the date of service except for services provided to injured workers in Texas. Collections for services provided to injured workers in Texas may take up to three years or longer to
be completely adjudicated. Because the Company has in recent years focused on providing services to injured workers in Texas, accounts receivable in the workers compensation and MDR financial classes have increased.



The MDR process is an established reimbursement resolution process available
to providers of healthcare services under the regulations guiding reimbursement for services provided to injured workers in the State of Texas. Accounts generally do not become subject to the MDR process prior to being outstanding for at least 90
days subsequent to patient discharge. For medical services provided to injured workers in the state of Texas, the MDR process is specifically based upon the administrative and statutory regulations promulgated by the Texas Labor Code and Texas
Administrative Code provisions.



Due to a number of factors
outside the Companys control, including a change in the Companys reimbursement collection experience associated with potential changes in the reimbursement environment in which the Company operates, it is possible that managements
estimates of patient service revenues could change, which could have a material impact on the Companys revenue and profitability in the future.



Allowance for Uncollectible Accounts



The Company has estimated uncollectible accounts expense as 1% of gross outpatient revenue. Through August 31, 2003, the Company has made no charge offs
against the allowance for uncollectible accounts, as historically all charge offs have been against the contractual allowance.



Stock Based Compensation



The Company accounts for stock-based compensation to employees using the intrinsic value method prescribed in APB Opinion No. 25, Accounting for
Stock Issued to Employees and related interpretations. Compensation cost, if any is measured as the excess of the fair value of the Companys stock at the date of grant



60



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Notes to Consolidated Financial Statements (continued)



August 31, 2003



over the amount an employee must pay to acquire the stock. Statement of Financial Accounting Standards (SFAS) 123, Accounting for Stock-Based
Compensation, amended by SFAS 148, Accounting for Stock-Based Compensation - Transition and Disclosure, established accounting and disclosure requirements using a fair value based method of accounting for stock-based employee
compensation; however, it allows an entity to continue to measure compensation for those plans using the intrinsic value method of accounting prescribed by APB Opinion No. 25. The Company has elected to continue to measure compensation under the APB
Opinion No. 25, and has adopted the disclosure requirements of SFAS No. 123 and SFAS No. 148.



If the fair value of the stock options granted to employees during a fiscal year had been recognized as compensation expense on a straight-line basis over the vesting period of the grants, stock-based compensation
costs would have impacted our net income and earnings per common share for the fiscal years ended August 31 as follows:



|                                                                                  |  |      |            |   |      |   |            |      |  |   |            |  
|--------------------------------------------------------------------------------- |  | ---- | ---------- | - | ---- | - | ---------- | ---- |  | - | ---------- | -
|                                                                                  |  | 2003 |            |   | 2002 |   |            | 2001 | 
|Net income as reported                                                            |  | $    | 20,887,323 |   |      | $ | 14,829,487 |      |  | $ | 7,743,636  |  
|Add: stock-based compensation costs included in reported net income, net of taxes |  |      | 117,650    |   |      |   | 44,804     |      |  |   |           |  
|Deduct: stock based compensation costs, net of taxes under SFAS 123               |  |      | (284,073   | ) |      |   | (95,921    | )    |  |   | (1,213,566 | )
|                                                                                  |  |      |            |   |      |   |            |      |  |   |            |  
|Pro forma net income                                                              |  | $    | 20,720,900 |   |      | $ | 14,778,370 |      |  | $ | 6,530,070  |  
|                                                                                  |  |      |            |   |      |   |            |      |  |   |            |  
|Per share information:                                                            |  |      |            |   |      |   |            |      |  |   |            |  
|Basic, as reported                                                                |  | $    | 1.40       |   |      | $ | 1.01       |      |  | $ | 0.55       |  
|Basic, pro forma                                                                  |  | $    | 1.39       |   |      | $ | 1.00       |      |  | $ | 0.46       |  
|Diluted, as reported                                                              |  | $    | 1.34       |   |      | $ | .96        |      |  | $ | 0.51       |  
|Diluted, pro forma                                                                |  | $    | 1.33       |   |      | $ | 95         |      |  | $ | 0.43       |  



The fair value of the
stock-based awards was estimated using the Black-Scholes model with the following weighted average assumptions for fiscal years ended August 31:



|                        |  |         |      |   |      |   |       |      |  |   |      |  
|----------------------- |  | ------- | ---- | - | ---- | - | ----- | ---- |  | - | ---- | -
|                        |  | Options |     
|                        |  | 2003    |      |   | 2002 |   |       | 2001 | 
|Estimated fair value    |  | $       | 5.59 |   |      | $ | 12.34 |      |  | $ | 1.80 |  
|Expected life (years)   |  |         | 4.53 |   |      |   | 4.29  |      |  |   | 3.00 |  
|Risk free interest rate |  |         | 4.25 | % |      |   | 4.00  | %    |  |   | 6.00 | %
|Volatility              |  |         | 40   | % |      |   | 143   | %    |  |   | 52   | %
|Dividend yield          |  |         |     | % |      |   |      | %    |  |   |     | %



Goodwill and Negative Goodwill



The Company adopted the provisions of SFAS 141,
Business Combinations and SFAS 142, Goodwill and Other Intangible Assets effective September 1, 2002. Upon adoption, the Company discontinued amortization of goodwill and conducted a review for impairment. The Company eliminated negative
goodwill as a cumulative effect of a change in accounting principle. SFAS 142 requires that impairment tests are performed at least annually. The impairment tests done upon adoption of the standard and at the end of the fiscal year indicated no
impairment of goodwill. Amortization of goodwill in the amount of $51,813 and $27,208 was recorded for the years ended 2002 and 2001, respectively. Amortization of negative goodwill in the amount of $126,470 and $78,411 was recorded for the years
ended 2002 and 2001, respectively.



The changes in the carrying
amount of goodwill as of August 31, 2003, are as follows:



|                               |  |          |         |                  |   |            |  
|------------------------------ |  | -------- | ------- | ---------------- | - | ---------- | -
|                               |  | Goodwill |         | NegativeGoodwill |  
|Balance at August 31, 2002     |  | $        | 582,547 |                  | $ | (1,550,910 | )
|Write-off of negative goodwill |  |          |        |                  |   | 1,550,910  |  
|                               |  |          |         |                  |   |            |  
|Balance at August 31, 2003     |  | $        | 582,547 |                  | $ |           |  
|                               |  |          |         |                  |   |            |  



61



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Notes to Consolidated Financial Statements (continued)



August 31, 2003



The following table presents income before extraordinary gain and cumulative effect of a change in
accounting principle, and earnings per common share for the years ended August 31, 2002 and 2001, as if goodwill had not been amortized during those periods, compared with those amounts reported for the year ended August 31, 2003:



|                                                                                                    |  |                        |            |      |   |            |      |  |   |           |  
|--------------------------------------------------------------------------------------------------- |  | ---------------------- | ---------- | ---- | - | ---------- | ---- |  | - | --------- | -
|                                                                                                    |  | Years ended August 31, |           
|                                                                                                    |  | 2003                   |            | 2002 |   |            | 2001 | 
|Income before extraordinary gain and cumulative effect of a change in accounting principle          |  | $                      | 19,817,289 |      | $ | 14,829,487 |      |  | $ | 7,743,636 |  
|Add back: Goodwill amortization                                                                     |  |                        |           |      |   | 51,813     |      |  |   | 27,208    |  
|Less: Tax effect of goodwill amortization                                                           |  |                        |           |      |   | (18,135    | )    |  |   | (9,523    | )
|                                                                                                    |  |                        |            |      |   |            |      |  |   |           |  
|Adjusted income before extraordinary gain and cumulative effect of a change in accounting principle |  | $                      | 19,817,289 |      | $ | 14,863,165 |      |  | $ | 7,761,321 |  
|                                                                                                    |  |                        |            |      |   |            |      |  |   |           |  
|Basic earnings per share:                                                                           |  |                        |            |      |   |            |      |  |   |           |  
|Income before extraordinary gain and cumulative effect of a change in accounting principle          |  | $                      | 1.33       |      | $ | 1.01       |      |  | $ | 0.55      |  
|Add back: Goodwill amortization                                                                     |  |                        |           |      |   |           |      |  |   |          |  
|Less: Tax effect of goodwill amortization                                                           |  |                        |           |      |   |           |      |  |   |          |  
|                                                                                                    |  |                        |            |      |   |            |      |  |   |           |  
|Adjusted income before extraordinary gain and cumulative effect of a change in accounting principle |  | $                      | 1.33       |      | $ | 1.01       |      |  | $ | 0.55      |  
|                                                                                                    |  |                        |            |      |   |            |      |  |   |           |  
|Diluted earnings per share:                                                                         |  |                        |            |      |   |            |      |  |   |           |  
|Income before extraordinary gain and cumulative effect of a change in accounting principle          |  | $                      | 1.27       |      | $ | 0.96       |      |  | $ | 0.51      |  
|Add back: Goodwill amortization                                                                     |  |                        |           |      |   |           |      |  |   |          |  
|Less: Tax effect of goodwill amortization                                                           |  |                        |           |      |   |           |      |  |   |          |  
|                                                                                                    |  |                        |            |      |   |            |      |  |   |           |  
|Adjusted income before extraordinary gain and cumulative effect of a change in accounting principle |  | $                      | 1.27       |      | $ | 0.96       |      |  | $ | 0.51      |  
|                                                                                                    |  |                        |            |      |   |            |      |  |   |           |  



Advertising Costs



Advertising and marketing costs in the amounts of $6,110,000, $5,188,000
and $4,614,000 for the years ending August 31, 2003, 2002 and 2001 respectively were expensed as incurred.



Income Taxes



The
Company uses the liability method in accounting for income taxes. Under this method, deferred tax liabilities or assets are determined based on differences between the income tax basis and the financial reporting basis of assets and liabilities and
are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse.



Minority Interests



The equity of minority investors (minority investors are generally physician groups and other healthcare providers that perform surgeries at the
Companys facilities) in certain subsidiaries of the Company is reported on the consolidated balance sheets as minority interests. Minority interests reported in the consolidated income statements reflect the respective interests in the income
or loss of the limited partnerships or limited liability companies attributable to the minority investors (equity interests ranged from 2.14% to 8.5% at August 31, 2003). During 2002, the Company purchased minority interests from certain minority
interest holders at an amount that was $710,437 less than the net book value of the minority interest liability on the date of purchase. The $710,437 was recorded as negative goodwill on the date of acquisition and was being amortized to income over
a period of 14 years in accordance with the treatment of the excess of fair market value received over cost as promulgated by Accounting Principles Board Opinion 16. This accounting treatment changed on September 1, 2002 when the Company adopted
SFAS 141. During 2003, the Company purchased minority interest from certain minority interest



62



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Notes to Consolidated Financial Statements (continued)



August 31, 2003



holders at an amount that was $130,998 less than the net book value of the minority interest liability on the date of purchase. The $130,998 less applicable
income taxes of $49,681 has been recorded as an extraordinary gain during 2003. The partnership agreement provided a means for the minority interest holders to be cashed out at the net book value. The amounts paid the minority interest holders was
less than the buy out amount that was called for in the partnership agreements. Legal counsel has advised the Company that the acquisitions were negotiated transactions occurring outside the partnership agreement.



The following table sets forth the activity in the minority interest
liability account for the fiscal years ending August 31, 2003 and 2002:



|                                                                                 |  |   |            |  
|-------------------------------------------------------------------------------- |  | - | ---------- | -
|Balance August 31, 2001                                                          |  | $ | (1,920,769 | )
|Earnings allocated to minority interest holders                                  |  |   | (2,203,418 | )
|Distributions to minority interest holders                                       |  |   | 1,300,000  |  
|Acquisition of Vista Surgical Center West minority interest                      |  |   | 406,438    |  
|Acquisition of 20% of Vista Community Medical Center Hospital minority interest  |  |   | 893,999    |  
|                                                                                 |  |   |            |  
|Balance August 31, 2002                                                          |  |   | (1,523,750 | )
|Earnings allocated to minority interest holders                                  |  |   | (3,306,882 | )
|Acquisition of 1.5% of Vista Community Medical Center Hospital minority interest |  |   | 380,998    |  
|Distribution to minority interest holders                                        |  |   | 2,827,000  |  
|Capital contributions received from new partners                                 |  |   | (946,000   | )
|                                                                                 |  |   |            |  
|Balance August 31, 2003                                                          |  | $ | (2,568,634 | )
|                                                                                 |  |   |            |  



Net Income Per Share



Basic net income per share has been computed using the
weighted average number of common shares outstanding during the period. Diluted net income per share has been calculated to give effect to the dilutive effect of common stock equivalents consisting of stock options and warrants. The weighted average
number of basic and diluted shares outstanding for earnings per share calculations has been changed from the number of shares as shown in previously issued financial statements for fiscal year ending 2002 and 2001. The following table presents the
outstanding shares as previously reported and the restated amounts:



|                                                                   |  |            |  |           
|------------------------------------------------------------------ |  | ---------- |  | ----------
|                                                                   |  | 2002       |  | 2001      
|Basic weighted average shares outstanding as previously reported   |  | 14,759,404 |  | 14,614,692
|Basic weighted average shares outstanding as restated              |  | 14,686,236 |  | 13,997,861
|Diluted weighted average shares outstanding as previously reported |  | 15,047,829 |  | 14,673,775
|Diluted weighted average shares outstanding as restated            |  | 15,490,068 |  | 15,092,433



Recent Accounting Pronouncements



In November 2002, the FASB issued FASB Interpretation No.
45 (FIN 45), Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, an interpretation of FASB Statements No. 5, 57 and 107 and Rescission of FASB
Interpretation No. 34. FIN 45 clarifies the requirements of SFAS 5, Accounting for Contingencies, relating to the guarantors accounting for, and disclosure



63



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Notes to Consolidated Financial Statements (continued)



August 31, 2003



of, the issuance of certain types of guarantees. The disclosure provisions of FIN 45 are effective for financial statements of periods that end after
December 15, 2002. However, the provisions for initial recognition and measurement are effective on a prospective basis for guarantees that are issued or modified after December 31, 2002. The Company has adopted the disclosure requirements of FIN
45.



In December 2002, the FASB issued SFAS 148, Accounting
for Stock-Based CompensationTransition and Disclosure. SFAS 148 amends SFAS 123 to provide alternative methods of transition to the SFAS 123 fair value method of accounting for stock-based employee compensation. In addition, SFAS
148 requires disclosure of the effects of an entitys accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements. As permitted under SFAS 148, the
Company adopted the disclosure only provisions of that accounting standard in the third quarter of fiscal year 2003.



In January 2003, the FASB issued Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities. FIN 46 requires a
variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entitys activities or entitled to receive a majority of the entitys residual returns or
both. A variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights, or (b) has equity investors that do not provide
sufficient financial resources for the entity to support its activities. A variable interest entity often holds financial assets, including loans or receivables, real estate, or other property. A variable interest entity may be essentially passive
or it may engage in research and development or other activities on behalf of another company. The consolidation requirements of FIN 46 apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements
apply to older entities in the first fiscal year or interim period beginning after December 15, 2003. Certain of the disclosure requirements apply to all financial statements issued after January 31, 2003, regardless of when the variable interest
entity was established. As of August 31, 2003, the Company does not have any entities that require disclosure or consolidation as a result of adopting the provisions of FIN 46.



In May 2003, the FASB issued SFAS 150, Accounting for Certain Financial Instruments with Characteristics of both
Liabilities and Equity. The Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument
that is within its scope as a liability (or an asset in some circumstances). It is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning
after June 15, 2003. The adoption of this Statement is not expected to have a significant impact on our financial statements.



64



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Notes to Consolidated Financial Statements (continued)



August 31, 2003



|2. | Restatements
|-- | ------------



During the course of the audit of the fiscal year ending August 31, 2003 financial statements, errors were discovered in the previously issued financial
statements. The following table sets forth the capital section as reported and reflects the adjustments to the previously reported amounts:



|                                                                               |  |                     |   |  |                     |        |   |  |    |   |                       |           |   |                       |   |            |   |  |    |                            |  |   |            |   |  |                   |   |  |   |            |   |                          |    |   |                       |   |         |      |  |   |            |   |  |    |  
|------------------------------------------------------------------------------ |  | ------------------- | - |  | ------------------- | ------ | - |  | -- | - | --------------------- | --------- | - | --------------------- | - | ---------- | - |  | -- | -------------------------- |  | - | ---------- | - |  | ----------------- | - |  | - | ---------- | - | ------------------------ | -- | - | --------------------- | - | ------- | ---- |  | - | ---------- | - |  | -- | -
|                                                                               |  | Common Stock Shares |   |  | Common Stock Amount |        |   |  |    |   | Treasury Stock Shares |           |   | Treasury Stock Amount |   |            |   |  |    | Additional Paid-in Capital |  |   |            |   |  | Retained Earnings |   |  |   |            |   | Receivable From Director |    |   | Deferred Compensation |   |         |      | 
|Balance as reported August 31, 2000                                            |  | 7,658,856           |   |  | $                   | 7,659  |   |  |    |   |                       | 794,392   |   |                       | $ | (1,141,546 | ) |  |    |                            |  | $ | 4,309,813  |   |  |                   |   |  | $ | 11,392,583 |   |                          |    |   |                       | $ |        |      |  | $ |           |   |  |    |  
|Cancellation of treasury shares                                                |  | (306,868            | ) |  |                     | (307   | ) |  | (a | ) |                       | (306,868  | ) |                       |   | 423,478    |   |  | (a | )                          |  |   | (423,171   | ) |  | (a                | ) |  |   |           |   |                          |    |   |                       |   |        |      |  |   |           |   |  |    |  
|Addition of treasury shares held by a subsidiary                               |  |                    |   |  |                     |       |   |  |    |   |                       | 35,672    |   |                       |   |           |   |  | (b | )                          |  |   |           |   |  |                   |   |  |   |           |   |                          |    |   |                       |   |        |      |  |   |           |   |  |    |  
|Fair value of stock options issued to non employees                            |  |                    |   |  |                     |       |   |  |    |   |                       |          |   |                       |   |           |   |  |    |                            |  |   | 1,478,080  |   |  | (c                | ) |  |   | (1,478,080 | ) |                          | (c | ) |                       |   |        |      |  |   |           |   |  |    |  
|Over statement of tax liabilities as of August 31, 2000                        |  |                    |   |  |                     |       |   |  |    |   |                       |          |   |                       |   |           |   |  |    |                            |  |   |           |   |  |                   |   |  |   | 2,706,356  |   |                          | (d | ) |                       |   |        |      |  |   |           |   |  |    |  
|                                                                               |  |                     |   |  |                     |        |   |  |    |   |                       |           |   |                       |   |            |   |  |    |                            |  |   |            |   |  |                   |   |  |   |            |   |                          |    |   |                       |   |         |      |  |   |            |   |  |    |  
|Balance as restated August 31, 2000                                            |  | 7,351,988           |   |  | $                   | 7,352  |   |  |    |   |                       | 523,196   |   |                       | $ | (718,068   | ) |  |    |                            |  | $ | 5,364,722  |   |  |                   |   |  | $ | 12,620,859 |   |                          |    |   |                       | $ |        |      |  | $ |           |   |  |    |  
|                                                                               |  |                     |   |  |                     |        |   |  |    |   |                       |           |   |                       |   |            |   |  |    |                            |  |   |            |   |  |                   |   |  |   |            |   |                          |    |   |                       |   |         |      |  |   |            |   |  |    |  
|Balance as reported August 31, 2001                                            |  | 16,266,331          |   |  | $                   | 16,266 |   |  |    |   |                       | 1,599,984 |   |                       | $ | (1,190,507 | ) |  |    |                            |  | $ | 6,690,042  |   |  |                   |   |  | $ | 22,445,443 |   |                          |    |   |                       | $ |        |      |  | $ | (416,061   | ) |  |    |  
|Cumulative effect of changes prior to August 31, 2001                          |  | (306,868            | ) |  |                     | (307   | ) |  |    |   |                       | (271,196  | ) |                       |   | 423,478    |   |  |    |                            |  |   | 1,054,910  |   |  |                   |   |  |   | 1,228,276  |   |                          |    |   |                       |   |        |      |  |   |           |   |  |    |  
|Fair value of stock options issued to non employees                            |  |                    |   |  |                     |       |   |  |    |   |                       |          |   |                       |   |           |   |  |    |                            |  |   | 3,686,510  |   |  | (e                | ) |  |   | (3,686,510 | ) |                          | (e | ) |                       |   |        |      |  |   |           |   |  |    |  
|Elimination of deferred compensation                                           |  |                    |   |  |                     |       |   |  |    |   |                       |          |   |                       |   |           |   |  |    |                            |  |   | (520,400   | ) |  | (f                | ) |  |   | 104,339    |   |                          | (f | ) |                       |   |        |      |  |   | 416,061    |   |  | (f | )
|Change in income tax provision                                                 |  |                    |   |  |                     |       |   |  |    |   |                       |          |   |                       |   |           |   |  |    |                            |  |   |           |   |  |                   |   |  |   | 265,000    |   |                          | (g | ) |                       |   |        |      |  |   |           |   |  |    |  
|Income tax benefit of stock options                                            |  |                    |   |  |                     |       |   |  |    |   |                       |          |   |                       |   |           |   |  |    |                            |  |   | 108,938    |   |  | (h                | ) |  |   |           |   |                          |    |   |                       |   |        |      |  |   |           |   |  |    |  
|Change in stock split in 2000                                                  |  | (306,868            | ) |  |                     | (307   | ) |  | (i | ) |                       | (271,196  | ) |                       |   |           |   |  | (l | )                          |  |   |           |   |  |                   |   |  |   | 306        |   |                          | (i | ) |                       |   |        |      |  |   |           |   |  |    |  
|                                                                               |  |                     |   |  |                     |        |   |  |    |   |                       |           |   |                       |   |            |   |  |    |                            |  |   |            |   |  |                   |   |  |   |            |   |                          |    |   |                       |   |         |      |  |   |            |   |  |    |  
|Balance as restated August 31, 2001                                            |  | 15,652,595          |   |  | $                   | 15,652 |   |  |    |   |                       | 1,057,592 |   |                       | $ | (767,029   | ) |  |    |                            |  | $ | 11,020,000 |   |  |                   |   |  | $ | 20,356,854 |   |                          |    |   |                       | $ |        |      |  | $ |           |   |  |    |  
|                                                                               |  |                     |   |  |                     |        |   |  |    |   |                       |           |   |                       |   |            |   |  |    |                            |  |   |            |   |  |                   |   |  |   |            |   |                          |    |   |                       |   |         |      |  |   |            |   |  |    |  
|Balance as reported August 31, 2002                                            |  | 16,515,166          |   |  | $                   | 16,515 |   |  |    |   |                       | 1,685,984 |   |                       | $ | (1,959,412 | ) |  |    |                            |  | $ | 9,778,701  |   |  |                   |   |  | $ | 37,884,622 |   |                          |    |   |                       | $ |        |      |  | $ | (1,152,053 | ) |  |    |  
|Cumulative effect of changes prior to August 31, 2001                          |  | (613,736            | ) |  |                     | (614   | ) |  |    |   |                       | (542,392  | ) |                       |   | 423,478    |   |  |    |                            |  |   | 4,329,958  |   |  |                   |   |  |   | (2,088,589 | ) |                          |    |   |                       |   |        |      |  |   | 416,062    |   |  |    |  
|Fair value of stock options issued to non employees                            |  |                    |   |  |                     |       |   |  |    |   |                       |          |   |                       |   |           |   |  |    |                            |  |   | 385,426    |   |  | (j                | ) |  |   |           |   |                          |    |   |                       |   |        |      |  |   |           |   |  |    |  
|Change in income tax benefit associated with stock options issued to employees |  |                    |   |  |                     |       |   |  |    |   |                       |          |   |                       |   |           |   |  |    |                            |  |   | (827,466   | ) |  | (k                | ) |  |   |           |   |                          |    |   |                       |   |        |      |  |   |           |   |  |    |  
|Short-term sale gains by director                                              |  |                    |   |  |                     |       |   |  |    |   |                       |          |   |                       |   |           |   |  |    |                            |  |   | 28,469     |   |  | (l                | ) |  |   |           |   |                          |    |   |                       |   | (28,469 | )(l) |  |   |           |   |  |    |  
|Decrease in deferred compensation amortization                                 |  |                    |   |  |                     |       |   |  |    |   |                       |          |   |                       |   |           |   |  |    |                            |  |   |           |   |  |                   |   |  |   |           |   |                          |    |   |                       |   |        |      |  |   | (104,080   | ) |  | (m | )
|Changes in net income:                                                         |  |                     |   |  |                     |        |   |  |    |   |                       |           |   |                       |   |            |   |  |    |                            |  |   |            |   |  |                   |   |  |   |            |   |                          |    |   |                       |   |         |      |  |   |            |   |  |    |  
|Increase in compensation                                                       |  |                    |   |  |                     |       |   |  |    |   |                       |          |   |                       |   |           |   |  |    |                            |  |   |           |   |  |                   |   |  |   | (158,453   | ) |                          | (n | ) |                       |   |        |      |  |   |           |   |  |    |  
|Increase in other operating expenses                                           |  |                    |   |  |                     |       |   |  |    |   |                       |          |   |                       |   |           |   |  |    |                            |  |   |           |   |  |                   |   |  |   | (714,116   | ) |                          | (o | ) |                       |   |        |      |  |   |           |   |  |    |  
|Decrease in depreciation and amortization expense                              |  |                    |   |  |                     |       |   |  |    |   |                       |          |   |                       |   |           |   |  |    |                            |  |   |           |   |  |                   |   |  |   | 43,827     |   |                          | (p | ) |                       |   |        |      |  |   |           |   |  |    |  
|Decrease in provision for income taxes                                         |  |                    |   |  |                     |       |   |  |    |   |                       |          |   |                       |   |           |   |  |    |                            |  |   |           |   |  |                   |   |  |   | 389,081    |   |                          | (q | ) |                       |   |        |      |  |   |           |   |  |    |  
|Increase in minority interest expense                                          |  |                    |   |  |                     |       |   |  |    |   |                       |          |   |                       |   |           |   |  |    |                            |  |   |           |   |  |                   |   |  |   | (170,031   | ) |                          | (r | ) |                       |   |        |      |  |   |           |   |  |    |  
|                                                                               |  |                     |   |  |                     |        |   |  |    |   |                       |           |   |                       |   |            |   |  |    |                            |  |   |            |   |  |                   |   |  |   |            |   |                          |    |   |                       |   |         |      |  |   |            |   |  |    |  
|Balance as restated August 31, 2002                                            |  | 15,901,430          |   |  | $                   | 15,901 |   |  |    |   |                       | 1,143,592 |   |                       | $ | (1,535,934 | ) |  |    |                            |  | $ | 13,695,088 |   |  |                   |   |  | $ | 35,186,341 |   |                          |    |   |                       | $ | (28,469 | )    |  | $ | (840,071   | ) |  |    |  
|                                                                               |  |                     |   |  |                     |        |   |  |    |   |                       |           |   |                       |   |            |   |  |    |                            |  |   |            |   |  |                   |   |  |   |            |   |                          |    |   |                       |   |         |      |  |   |            |   |  |    |  



65



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Notes to Consolidated Financial Statements (continued)



August 31, 2003



(a) The Company was showing as issued 306,868 shares of common stock outstanding that the transfer
agent did not show as outstanding. In addition the Company was showing 306,868 treasury shares which could not be accounted for. This adjusts the number of shares the Company has issued and outstanding and the number of shares the Company holds as
treasury shares. This correction had no effect on the shares shown as issued and outstanding for purposes of earnings per share calculations.



(b) One of the Companys subsidiaries has held shares of the Companys common stock for a number of years. This adjusts the number of treasury
shares held by the Company. The cost of these shares had been included in the cost of treasury shares.



(c) The Company had recorded no compensation cost associated with stock options granted to non employees prior to September 1, 2000. This adjustment
represents the fair value of stock options granted to non employees for all years prior to September 1, 2000. The fair value of the options was estimated using the Black Scholes option pricing model with the following weighted average assumptions:
estimated fair value $3.12; expected life 0.84 years; risk free interest rate 4.25%; volatility 87%.



(d) This represents the overstatement of tax liabilities as of August 31, 2000.



(e) Represents the fair value of stock options granted to non employees during the year ended August 31, 2001. The Company
had recorded deferred compensation expense of $520,400 applicable to 108,000 stock options granted to 13 non employees which was valued on the grant date and was being amortized over a period of 5 years. Upon reexamination the measurement date for
those options should have been the vesting date, which was 6 months after the grant date. The correct expense calculated on the vesting date for this 108,000 shares was $1,798,200. There were another 84,000 additional options granted to non
employees which should have been expensed. The value of these 84,000 options were $1,398,600. The fair value of the 192,000 options has been estimated using the Black Scholes option pricing model with the following weighted average assumptions:
estimated fair value $16.65; expected life six months; risk free interest rate 4.25% volatility 72.8%. An expense charge of $489,710 has been recognized as the intrinsic value of 37,392 shares issued below market value or as gift shares.



(f) Represents the elimination of deferred compensation expense recorded
by the Company for non employees which had been accounted for as if the options were granted to employees. The compensation expenses associated with these options is now included in (c) above.



(g) The provision for income taxes was changed due to the expensing of stock
options for the year ended August 31, 2001, related income tax benefits of those options and other items.



(h) Represents the revised income tax benefit of certain income tax deductions related to employee stock options which are not charged against operations.



(i) Represents an adjustment to the amount of the stock
dividend recorded because of the effective cancellation of treasury shares before the stock split.



(j) Represents the fair value of stock options issued to non employees during the year ended August 31, 2002.



(k) Represents the change in the income tax benefit related to stock option
expense taken in the tax return which is not charged against operations.



(l) Represents a receivable for gains made by a director on the short-term sale of shares of the Companys common stock during the year ending August 31, 2002 for which payments were not received by the Company
until the year ending August 31, 2003.



66



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Notes to Consolidated Financial Statements (continued)



August 31, 2003



(m) Represents the elimination of the amortization of deferred compensation associated with non
employees which had been recorded as applicable to employees.



(n) Represents the expensing of the fair value of 54,000 stock options issued to non employees and other net credit adjustments to compensation of $122,884. The Company had recorded the amortization of deferred compensation associated with
stock options granted to non employees in the amount of $104,080. The $104,080 was based on incorrect assumptions as to the measurement date and the vesting period. Upon reexamination, the expense associated with these 54,000 options was $356,985.
The fair value of the options was estimated using the Black Scholes option pricing model with the following weighted average assumptions: estimated fair value $14.08; expected life 1.52 years; risk free interest rate 4.25%; volatility 130%. An
expense charge of $28,440 was recorded for the sale of stock at below the fair market value on the date of sale.



(o) Represents increases to other operating expenses consisting primarily of the write off of organization costs and other capitalized assets of $213,000,
the recording of expenses found in the search for unrecorded liabilities of $364,000, the recording of estimated tax penalties of $58,000, a net reduction in prepaid expenses of $41,000, a reduction of the accrual for property taxes of $(68,000) and
other changes of $106,000.



(p) Represents a change in
depreciation expense caused by the aggregating of various depreciable costs.



(q) Represents a decrease in the income tax provision as previously reported.



(r) Represents an increase in minority interest expense due to a change in the profits of the Pasadena facility.



(s) The sum of these changes reflect the adjustments set forth in (o) above
plus reclassification and elimination adjustments which have no effect on net income.



67



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Notes to Consolidated Financial Statements (continued)



August 31, 2003



The following sets forth the Statements of Operations for the years ended August 31, 2002 and 2001 as previously
reported and applicable restatement adjustments for those years:



|                                                |  |                            |            |   |                            |   |            |             |  |   |             |   |  |                        |            |   |             |   |            |      |  |   |            |  
|----------------------------------------------- |  | -------------------------- | ---------- | - | -------------------------- | - | ---------- | ----------- |  | - | ----------- | - |  | ---------------------- | ---------- | - | ----------- | - | ---------- | ---- |  | - | ---------- | -
|                                                |  | Year Ended August 31, 2002 |            |   | Year Ended August 31, 2001 |  
|                                                |  | As Reported                |            |   | RestatementAdjustments     |   |            | As Restated |  |   | As Reported |   |  | RestatementAdjustments |            |   | As Restated |  
|Net patient service revenue                     |  | $                          | 64,883,235 |   |                            | $ |           |             |  | $ | 64,883,235  |   |  | $                      | 43,803,619 |   |             | $ |           |      |  | $ | 43,803,619 |  
|Costs and expenses:                             |  |                            |            |   |                            |   |            |             |  |   |             |   |  |                        |            |   |             |   |            |      |  |   |            |  
|Compensation and benefits                       |  |                            | 9,191,317  |   |                            |   | 158,453    | (n)         |  |   | 9,349,770   |   |  |                        | 5,954,061  |   |             |   | (104,338   | )(f) |  |   | 5,849,723  |  
|Medical services and supplies                   |  |                            | 15,332,788 |   |                            |   |            |             |  |   | 15,332,788  |   |  |                        | 9,299,835  |   |             |   |            |      |  |   | 9,299,835  |  
|Other operating expenses                        |  |                            | 11,646,317 |   |                            |   | 1,006,138  | (s)         |  |   | 12,652,455  |   |  |                        | 9,692,649  |   |             |   | 3,686,510  | (e)  |  |   | 13,379,159 |  
|Provision for uncollectible accounts            |  |                            | 350,018    |   |                            |   | (99,306    | )(s)        |  |   | 250,712     |   |  |                        | 58,259     |   |             |   |            |      |  |   | 58,259     |  
|Depreciation and amortization                   |  |                            | 1,213,573  |   |                            |   | (43,827    | )(p)        |  |   | 1,169,746   |   |  |                        | 813,143    |   |             |   |            |      |  |   | 813,143    |  
|                                                |  |                            |            |   |                            |   |            |             |  |   |             |   |  |                        |            |   |             |   |            |      |  |   |            |  
|Total costs and expenses                        |  |                            | 37,734,013 |   |                            |   | 1,021,458  |             |  |   | 38,755,471  |   |  |                        | 25,817,947 |   |             |   | 3,582,172  |      |  |   | 29,400,119 |  
|                                                |  |                            |            |   |                            |   |            |             |  |   |             |   |  |                        |            |   |             |   |            |      |  |   |            |  
|Income from operations                          |  |                            | 27,149,222 |   |                            |   | (1,021,458 | )           |  |   | 26,127,764  |   |  |                        | 17,985,672 |   |             |   | (3,582,172 | )    |  |   | 14,403,500 |  
|Other income (expense):                         |  |                            |            |   |                            |   |            |             |  |   |             |   |  |                        |            |   |             |   |            |      |  |   |            |  
|Rent and other income                           |  |                            | 231,756    |   |                            |   | 192,716    | (s)         |  |   | 424,472     |   |  |                        | 352,114    |   |             |   |            |      |  |   | 352,114    |  
|Interest income                                 |  |                            | 163,584    |   |                            |   |            |             |  |   | 163,584     |   |  |                        | 299,901    |   |             |   |            |      |  |   | 299,901    |  
|Interest expense                                |  |                            | (27,537    | ) |                            |   |            |             |  |   | (27,537     | ) |  |                        | (60,129    | ) |             |   |            |      |  |   | (60,129    | )
|                                                |  |                            |            |   |                            |   |            |             |  |   |             |   |  |                        |            |   |             |   |            |      |  |   |            |  
|Total other income, net                         |  |                            | 367,803    |   |                            |   | 192,716    |             |  |   | 560,519     |   |  |                        | 591,886    |   |             |   |            |      |  |   | 591,886    |  
|                                                |  |                            |            |   |                            |   |            |             |  |   |             |   |  |                        |            |   |             |   |            |      |  |   |            |  
|Income before income tax and minority interests |  |                            | 27,517,025 |   |                            |   | (828,742   | )           |  |   | 26,688,283  |   |  |                        | 18,577,558 |   |             |   | (3,582,172 | )    |  |   | 14,995,386 |  
|Provision for income taxes                      |  |                            | 10,044,459 |   |                            |   | 389,081    | (q)         |  |   | 9,655,378   |   |  |                        | 5,040,000  |   |             |   | 265,000    | (g)  |  |   | 4,775,000  |  
|Minority interest in earnings                   |  |                            | 2,033,387  |   |                            |   | (170,031   | )(r)        |  |   | 2,203,418   |   |  |                        | 2,476,750  |   |             |   |            |      |  |   | 2,476,750  |  
|                                                |  |                            |            |   |                            |   |            |             |  |   |             |   |  |                        |            |   |             |   |            |      |  |   |            |  
|Net income                                      |  | $                          | 15,439,179 |   |                            | $ | (609,692   | )           |  | $ | 14,829,487  |   |  | $                      | 11,060,808 |   |             | $ | (3,317,172 | )    |  | $ | 7,743,636  |  
|                                                |  |                            |            |   |                            |   |            |             |  |   |             |   |  |                        |            |   |             |   |            |      |  |   |            |  
|Basic earnings per common share                 |  | $                          | 1.05       |   |                            | $ | (0.04      | )           |  | $ | 1.01        |   |  | $                      | 0.76       |   |             | $ | (0.21      | )    |  | $ | 0.55       |  
|                                                |  |                            |            |   |                            |   |            |             |  |   |             |   |  |                        |            |   |             |   |            |      |  |   |            |  
|Diluted earnings per common share               |  | $                          | 1.03       |   |                            | $ | (0.07      | )           |  | $ | 0.96        |   |  | $                      | 0.75       |   |             | $ | (0.24      | )    |  | $ | 0.51       |  
|                                                |  |                            |            |   |                            |   |            |             |  |   |             |   |  |                        |            |   |             |   |            |      |  |   |            |  
|Weighted average common sharesbasic            |  |                            | 14,759,404 |   |                            |   | (73,168    | )           |  |   | 14,686,236  |   |  |                        | 14,614,692 |   |             |   | (616,831   | )    |  |   | 13,997,861 |  
|                                                |  |                            |            |   |                            |   |            |             |  |   |             |   |  |                        |            |   |             |   |            |      |  |   |            |  
|Weighted average common sharesdiluted          |  |                            | 15,047,829 |   |                            |   | 442,239    |             |  |   | 15,490,068  |   |  |                        | 14,673,775 |   |             |   | 418,658    |      |  |   | 15,092,433 |  
|                                                |  |                            |            |   |                            |   |            |             |  |   |             |   |  |                        |            |   |             |   |            |      |  |   |            |  



68



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Notes to Consolidated Financial Statements (continued)



August 31, 2003



|3. | Acquisitions
|-- | ------------



The Garland Facility



In August 2003 the Company acquired the assets of a 113-bed hospital (which is now licensed for 79 beds), a medical office building and 22.7 acres of land in the Dallas-Fort Worth area for cash of approximately $5.6 million. The Company has
since completed renovations at that facility, named Vista Hospital of Dallas (the Garland Facility), with six surgical suites, and started performing surgical procedures in late November 2003.



The following table summarizes the estimated fair values of the assets
acquired and liabilities assumed at the date of acquisition.



|                              |  |   |          
|----------------------------- |  | - | ---------
|Current assets                |  | $ | 416,000  
|Property, plant and equipment |  |   | 8,044,000
|                              |  |   |          
|Total assets acquired         |  |   | 8,460,000
|Current liabilities assumed   |  |   | 2,183,000
|Debt assumed                  |  |   | 670,000  
|                              |  |   |          
|Net assets acquired           |  | $ | 5,607,000
|                              |  |   |          



Vista Diagnostic Center



During the year ended August 31, 2003, the Company
acquired assets valued at approximately $471,000 from Vista Diagnostic Center (VDC), an unrelated company which provided laboratory and radiology services to the Pasadena Facility. The Pasadena Facility did not acquire any interest in
VDC, nor did VDC ever have an interest in the Pasadena Facility. The assets included primarily medical and diagnostic equipment as well as furniture and fixtures. The consideration paid for this purchase was equal to the estimated fair value of the
assets at the purchase date. In connection with the asset acquisition, the Company also assumed three operating leases related to medical equipment with required minimum lease payments of $466,000 in 2003, $438,000 in 2004, $89,000 in 2005 and
$59,000 in 2006. The Company has begun using the newly acquired assets to provide laboratory and radiology services at the Pasadena Facility and has discontinued using the services of VDC.



Baton Rouge Facility



During 2002, the Company acquired the land and building located in Baton Rouge, Louisiana known as Charis Hospital for
$3,373,126 in cash. In January 2003, this facility was reopened as the Baton Rouge Facility, as a 35-bed hospital and four operating rooms.



69



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Notes to Consolidated Financial Statements (continued)



August 31, 2003



|4. | Property and Equipment
|-- | ----------------------



At August 31, property and equipment consisted of the following:



|                                               |  |      |            |   |      |   |            |  
|---------------------------------------------- |  | ---- | ---------- | - | ---- | - | ---------- | -
|                                               |  | 2003 |            |   | 2002 |  
|Land                                           |  | $    | 8,608,309  |   |      | $ | 507,113    |  
|Buildings and improvements                     |  |      | 20,266,452 |   |      |   | 8,482,622  |  
|Equipment, furniture and fixtures              |  |      | 16,195,660 |   |      |   | 7,156,190  |  
|                                               |  |      |            |   |      |   |            |  
|                                               |  |      | 45,070,421 |   |      |   | 16,145,925 |  
|Less accumulated depreciation and amortization |  |      | (7,249,485 | ) |      |   | (5,173,001 | )
|Construction in progress                       |  |      | 181,463    |   |      |   | 5,304,243  |  
|                                               |  |      |            |   |      |   |            |  
|Net property and equipment                     |  | $    | 38,002,399 |   |      | $ | 16,277,167 |  
|                                               |  |      |            |   |      |   |            |  



For the years ended
August 31, 2003, 2002, and 2001, depreciation expense was $2,161,166, $1,190,344, and $853,770, respectively.



|5. | Asset held for sale
|-- | -------------------



The Company entered into a letter of intent with a Nevada Limited Liability Company of which a former Executive officer of the Company is a member to sell
land located in Slidell, Louisiana at August 31, 2003. The Company decided not to develop this hospital in Louisiana because it did not fit its current business plan. The carrying value of the land of $2,315,204 is shown as Asset held for
sale on the statement of financial position. On January 23, 2004, the transaction was closed and the Company recognized a gain of $185,000 upon closing.



|6. | Notes payable
|-- | -------------



At August 31, long-term debt consisted of the following:



|                                                                                                                                                                                                                                                                                                                                |  |      |           |      |   |       
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---- | --------- | ---- | - | ------
|                                                                                                                                                                                                                                                                                                                                |  | 2003 |           | 2002
|Note payable to a former shareholder, payable in monthly installments of $10,007, including interest at 11.5%, through December 2002,
uncollateralized                                                                                                                                                                          |  | $    |          |      | $ | 39,075
|Note payable to former owners of the Garland facility, due August 14, 2004 together with interest at the rate of a major banks prime plus 1
%                                                                                                                                                                                   |  |      | 670,000   |      |   |      
|Revolving line of credit with a financial institution payable at variable monthly installments, including variable interest of 2.3% plus the
Dealer Commercial Paper rate, due on demand or July 2011, collateralized by substantially all of the Companys assets. The effective interest rate at August 31, 2003 was 3.32%. |  |      | 6,413,312 |      |   |      
|                                                                                                                                                                                                                                                                                                                                |  |      |           |      |   |       
|                                                                                                                                                                                                                                                                                                                                |  | $    | 7,083,312 |      | $ | 39,075
|                                                                                                                                                                                                                                                                                                                                |  |      |           |      |   |       



The Company has a
revolving line of credit with a financial institution. The amount available and drawn under the line of credit at August 31, 2003 is approximately $6.4 million which was used to finance its acquisition of the Garland Facility. The interest rate on
the line of credit is a variable rate of 2.3% plus the Dealer Commercial Paper rate. The effective interest rate at August 31, 2003 was 3.32%. The balance owed under the line of credit as of June 18, 2004 was approximately $6,002,214.



The Company is in default under the terms of the line of
credit, as the Company has not timely filed this annual report on Form 10-K and have not yet filed its quarterly reports on Form 10-Q for the fiscal quarters ended November 30, 2003, February 29, 2004 and May 31, 2004. On April 16, 2004, the
financial institution submitted to the Company a notice of default. Since the Company did not cure the default within 10 days, the Company is now in default under the line of credit. To this date, the financial institution has not taken any further
action. The Companys indebtedness under its line of credit is secured by substantially all of its assets. If the Company is



70



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Notes to Consolidated Financial Statements (continued)



August 31, 2003



unable to repay all outstanding balances, the financial institution could proceed against the Companys assets to satisfy its obligations under the line
of credit.



|7. | Income Taxes
|-- | ------------



The provision for income tax expense consisted of the following:



|                                |  |                      |            |      |   |            |      |  |   |            |  
|------------------------------- |  | -------------------- | ---------- | ---- | - | ---------- | ---- |  | - | ---------- | -
|                                |  | Year Ended August 31 |           
|                                |  | 2003                 |            | 2002 |   |            | 2001 | 
|Current tax expense:            |  |                      |            |      |   |            |      |  |   |            |  
|Federal                         |  | $                    | 10,262,114 |      | $ | 11,142,485 |      |  | $ | 5,315,000  |  
|State                           |  |                      | 1,299,565  |      |   | 1,491,538  |      |  |   | 538,000    |  
|                                |  |                      |            |      |   |            |      |  |   |            |  
|Total current                   |  |                      | 11,561,679 |      |   | 12,634,023 |      |  |   | 5,853,000  |  
|Deferred tax expense (benefit): |  |                      |            |      |   |            |      |  |   |            |  
|Federal                         |  |                      | 1,167,273  |      |   | (2,653,852 | )    |  |   | (926,000   | )
|State                           |  |                      | 157,383    |      |   | (324,793   | )    |  |   | (152,000   | )
|                                |  |                      |            |      |   |            |      |  |   |            |  
|Total deferred                  |  |                      | 1,324,656  |      |   | (2,978,645 | )    |  |   | (1,078,000 | )
|                                |  |                      |            |      |   |            |      |  |   |            |  
|Total income tax expense        |  | $                    | 12,886,335 |      | $ | 9,655,378  |      |  | $ | 4,775,000  |  
|                                |  |                      |            |      |   |            |      |  |   |            |  



As of August 31, 2003,
2002 and 2001, income tax benefits of $189,639 and $245,334 and $108,938, respectively, resulting from deductions relating to nonqualified stock option exercises and disqualifying dispositions of certain employee incentive stock options were
recorded as increases in stockholders equity.



The
components of the provision for deferred income taxes, at August 31 were as follows:



|                                                                                                             |  |      |           |   |      |   |            |      |  |   |            |  
|------------------------------------------------------------------------------------------------------------ |  | ---- | --------- | - | ---- | - | ---------- | ---- |  | - | ---------- | -
|                                                                                                             |  | 2003 |           |   | 2002 |   |            | 2001 | 
|Applicable to:                                                                                               |  |      |           |   |      |   |            |      |  |   |            |  
|Differences between revenues and expenses recognized for federal income tax and financial reporting purposes |  | $    | 448,327   |   |      | $ | (3,326,701 | )    |  | $ | (435,303   | )
|Stock options                                                                                                |  |      | 127,834   |   |      |   | 683,376    |      |  |   | (673,472   | )
|Allowance for uncollectible accounts                                                                         |  |      | (194,512  | ) |      |   | (95,083    | )    |  |   | (22,095    | )
|Employee deferred compensation                                                                               |  |      | (94,785   | ) |      |   |            |      |  |   |            |  
|Difference in method of computing depreciation for tax and financial reporting purposes                      |  |      | 880,510   |   |      |   | 189,883    |      |  |   | 139,632    |  
|Other                                                                                                        |  |      | 157,282   |   |      |   | (430,120   | )    |  |   | (86,762    | )
|                                                                                                             |  |      |           |   |      |   |            |      |  |   |            |  
|                                                                                                             |  | $    | 1,324,656 |   |      | $ | (2,978,645 | )    |  | $ | (1,078,000 | )
|                                                                                                             |  |      |           |   |      |   |            |      |  |   |            |  



Significant components
of the Companys deferred tax liabilities and assets were as follows at August 31, 2003:



|                                     |  |         |         |   |            |   |            |  
|------------------------------------ |  | ------- | ------- | - | ---------- | - | ---------- | -
|                                     |  | Current |         |   | Noncurrent |  
|Deferred tax liabilities:            |  |         |         |   |            |   |            |  
|Depreciation                         |  | $       |        |   |            | $ | (1,285,346 | )
|Negative goodwill                    |  |         |        |   |            |   | (416,324   | )
|Deferred tax assets:                 |  |         |         |   |            |   |            |  
|Stock options                        |  |         | 298,020 |   |            |   |           |  
|Revenue and expense differences      |  |         | 374,036 |   |            |   |           |  
|Allowance for uncollectible accounts |  |         | 362,712 |   |            |   |           |  
|Other                                |  |         | (95,113 | ) |            |   | 255,400    |  
|Minority interest                    |  |         |        |   |            |   | 694,997    |  
|                                     |  |         |         |   |            |   |            |  
|Net deferred tax asset (liability)   |  | $       | 939,665 |   |            | $ | (751,273   | )
|                                     |  |         |         |   |            |   |            |  



71



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Notes to Consolidated Financial Statements (continued)



August 31, 2003



Significant components of the Companys deferred tax liabilities and assets were as follows at
August 31, 2002:



|                                     |  |         |           |   |            |   |          |  
|------------------------------------ |  | ------- | --------- | - | ---------- | - | -------- | -
|                                     |  | Current |           |   | Noncurrent |  
|Deferred tax liabilities:            |  |         |           |   |            |   |          |  
|Basis in property and equipment      |  | $       |          |   |            | $ | (404,837 | )
|Deferred tax assets:                 |  |         |           |   |            |   |          |  
|Stock options                        |  |         | 425,854   |   |            |   |         |  
|Allowance for uncollectible accounts |  |         | 168,200   |   |            |   |          |  
|Revenue and expense differences      |  |         | 922,363   |   |            |   | 323,068  |  
|Minority interest                    |  |         |           |   |            |   | 462,708  |  
|Other                                |  |         | (139,895  | ) |            |   | 367,450  |  
|                                     |  |         |           |   |            |   |          |  
|Net deferred tax asset               |  | $       | 1,376,522 |   |            | $ | 748,389  |  
|                                     |  |         |           |   |            |   |          |  



The following table
reconciles the federal statutory income tax rate and the Companys effective income tax rate:



|                                                     |  |      |   |  |      |   |  |       |  
|---------------------------------------------------- |  | ---- | - |  | ---- | - |  | ----- | -
|                                                     |  | 2003 |   |  | 2002 |   |  | 2001  |  
|Provision for income taxes at federal statutory rate |  | 35.0 | % |  | 35.0 | % |  | 35.0  | %
|State tax provision, net of federal benefits         |  | 2.2  |   |  | 3.6  |   |  | 3.2   |  
|Minority interest in income of partnership           |  | (5.7 | ) |  | (5.3 | ) |  | (10.6 | )
|Other differences                                    |  | 4.3  |   |  | 2.9  |   |  | 4.2   |  
|                                                     |  |      |   |  |      |   |  |       |  
|Effective tax rate                                   |  | 35.8 | % |  | 36.2 | % |  | 31.8  | %
|                                                     |  |      |   |  |      |   |  |       |  



The Company has
restated its income tax provisions for the fiscal years ended August 31, 2002 and 2001. Those restatements were necessary to give income tax effect to the restatement adjustments for each year and to adjust approximately $2,700,000 over accrual of
the income tax liabilities arising prior to August 31, 2000.



|8. | Related Party Transactions
|-- | --------------------------



The Company leased a residential house to its Chief Executive Officer (CEO), Mr. Chiu M. Chan at a monthly rate of $1,400 per month through April 2003. In
April 2003, the Company consummated the sale of a house to Chiu M. Chan. The house was sold to Mr. Chan in exchange for the transfer of his right to receive 25,639 shares of Dynacq common stock held by Mr. Chan. The contract, which was signed on
April 10, 2003, valued the property at $311,740, which was 10% more than the 2002 appraised value of $283,400. The shares of common stock were valued at 90% of the closing price of Dynacq common stock on April 10, 2003. In addition, the Company paid
the 2003 property taxes. A gain on the sale of the house in the amount of $145,623 was recorded in 2003.



The Company had previously leased 1,000 square feet of office space for its executive offices on a month-to-month basis for $1,286 per month. As of
September 1, 2003, the Company increased its leased space to approximately 7,250 square feet and entered into an 8-year lease for this office space. The Company will pay $1,286 per month for the first year of the lease and $6,525 per month for the
remainder of the lease term. The lessor of the office space is Capital Bank, of which Mr. Earl Votaw, one of the Companys directors, is a director. Management believes that the lease rate being paid is consistent with comparable commercial
rates available in the area.



Since May 2002, when Dr. Ping Chu
became a director, he has paid the Company $26,870 and $17,631 during fiscal years ended August 31, 2003 and 2002, respectively for rent and management fees. As of August 31, 2003 and 2002, the Company had accounts receivable from Dr. Chu of $22,277
and $99,476, respectively. Included in the accounts receivable balance were amounts applicable to Dr. Chus staffs payroll for which he reimburses the Company in the ordinary course of business.



72



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Notes to Consolidated Financial Statements (continued)



August 31, 2003



In January 2004, the Company completed a sale of land (Asset held for sale in 2003)
located in Slidell, Louisiana to HealthGroup Partners, L.L.C. for $2.5 million. An investor in HealthGroup Partners, L.L.C. was previously an executive officer of the Company.



|9. | Stockholders Equity and Stock Option Plans
|-- | -------------------------------------------



Preferred Stock



In January 1992, the board of directors approved an amendment to the Companys articles of incorporation to authorize 5,000,000 shares of
undesignated preferred stock, for which the board of directors is authorized to fix the designation, powers, preferences and rights. There are no shares of preferred stock issued or outstanding as of August 31, 2003.



In February 2003, the Board of Directors designated 200,000 of the
undesignated preferred stock as Series A Preferred Stock and declared a stock dividend equal to one share of Series A Preferred Stock for every full block of 100 shares of common stock. The Series A Preferred Stock could either be
redeemed for cash at $14.50 per share or if not redeemed by June 10, 2003, would be automatically converted into one share of the Companys common stock. As a result of this action the Company redeemed 32,656 shares for cash in the amount of
$473,511 (which has been shown in the accompanying statement of stockholders equity as a preferred stock redemption) and issued 129,577 shares of common stock in conversion of the unredeemed Series A Preferred Stock.



Treasury Stock



Pursuant to the Companys announced 500,000 common stock buy-back program in January 2002, the Company bought back
261,500 and 86,000 shares of its common stock in fiscal year 2003 and 2002, respectively at an average cost of $13.62 for a total purchase of $4,734,515. The Company acquired 103,176 shares of its common stock as treasury shares during December 2003
for $1,611,165 in cash.



Stock Option Plans



The Companys 1995 Non-qualified Plan and the 2000 Incentive Plan (the
Plans) provide for options and other stock-based awards that may be granted to eligible employees, officers, consultants, and non-employee directors of the Company or its subsidiaries. The Company had reserved 6,000,000 shares of common
stock for future issuance under the Plans. As of August 31, 2003, there remains 3,797,146 shares which can be issued under the Plans, after giving effect to stock splits and shares issued under the Plans. All awards previously granted to employees
under the Plans have been stock options, primarily intended to qualify as incentive stock options within the meaning of Section 422 of the Internal Revenue Code (the Code). The Plans also permit stock awards, stock
appreciation rights, performance units, and other stock-based awards, all of which may or may not be subject to the achievement of one or more performance objectives.



The purposes of the Plans generally are to retain and attract persons of training, experience, and ability to serve as
employees of the Company and its subsidiaries and to serve as non employee directors of the Company, to encourage the sense of proprietorship of such persons and to stimulate the active interest of such persons in the development and financial
success of the Company and its subsidiaries.



The Plans are
administered by the Compensation Committee of the board of directors (the Committee). The Committee has the power to determine which eligible employees will receive awards, the timing and manner of the grant of such awards, the exercise
price of stock options (which may not be less than market value on the date of grant), the number of shares, and all of the terms of the awards. The Company may at any time amend or terminate the Plans. However, no amendment that would impair the
rights of any participant, with respect to outstanding grants, can be made without the participants prior consent. Stockholder approval of an amendment to the Plans is necessary only when required by applicable law or stock exchange rules.



73



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Notes to Consolidated Financial Statements (continued)



August 31, 2003



The following summarizes stock option activity and related information:



|                               |  |                              |   |      |                              |       |        |       |   |                              |   |        |  |       |                              |  |   |     
|------------------------------ |  | ---------------------------- | - | ---- | ---------------------------- | ----- | ------ | ----- | - | ---------------------------- | - | ------ |  | ----- | ---------------------------- |  | - | ----
|                               |  | Years ended August 31       
|                               |  | 2003                         |   | 2002 |                              | 2001 
|                               |  | Shares                       |   |      | WeightedAverageExercisePrice |       | Shares |       |   | WeightedAverageExercisePrice |   | Shares |  |       | WeightedAverageExercisePrice
|                               |  | (Share Amounts In Thousands)
|Outstandingbeginning of year: |  | 1,104                        |   |      | $                            | 4.69  |        | 1,469 |   |                              | $ | 3.78   |  | 827   |                              |  | $ | 1.13
|Granted                        |  | 422                          |   |      |                              | 14.67 |        | 174   |   |                              |   | 6.07   |  | 1,229 |                              |  |   | 4.44
|Exercised                      |  | (263                         | ) |      |                              | 4.44  |        | (246  | ) |                              |   | 4.44   |  | (551  | )                            |  |   | 1.43
|Canceled                       |  | (62                          | ) |      |                              | 4.96  |        | (293  | ) |                              |   | 1.15   |  | (36   | )                            |  |   | 1.26
|                               |  |                              |   |      |                              |       |        |       |   |                              |   |        |  |       |                              |  |   |     
|Outstandingend of year        |  | 1,201                        |   |      | $                            | 8.25  |        | 1,104 |   |                              | $ | 4.69   |  | 1,469 |                              |  | $ | 3.78
|                               |  |                              |   |      |                              |       |        |       |   |                              |   |        |  |       |                              |  |   |     
|Exercisableend of year        |  | 687                          |   |      | $                            | 4.65  |        | 956   |   |                              | $ | 4.48   |  | 1,469 |                              |  | $ | 3.78
|                               |  |                              |   |      |                              |       |        |       |   |                              |   |        |  |       |                              |  |   |     



The following
summarizes information related to stock options outstanding at August 31, 2003:



|                         |  |                              |  |                                                 |  |                              |       |        |     |                              |   |      
|------------------------ |  | ---------------------------- |  | ----------------------------------------------- |  | ---------------------------- | ----- | ------ | --- | ---------------------------- | - | -----
|                         |  | Options Outstanding          |  | Options Exercisable                            
|Range of Exercise Prices |  | Shares                       |  | WeightedAverageRemainingContractualLife (Years) |  | WeightedAverageExercisePrice |       | Shares |     | WeightedAverageExercisePrice
|                         |  | (Share Amounts In Thousands)
|$ 4.44                   |  | 625                          |  | 2.3                                             |  | $                            | 4.44  |        | 625 |                              | $ | 4.44 
|$ 6.07                   |  | 154                          |  | 4.2                                             |  |                              | 6.07  |        | 52  |                              |   | 6.07 
|$10.73                   |  | 51                           |  | 4.2                                             |  |                              | 10.73 |        | 10  |                              |   | 10.73
|$12.25                   |  | 171                          |  | 4.7                                             |  |                              | 12.25 |        |    |                              |   |     
|$17.75                   |  | 200                          |  | 5.4                                             |  |                              | 17.75 |        |    |                              |   |     
|                         |  |                              |  |                                                 |  |                              |       |        |     |                              |   |      
|Total                    |  | 1,201                        |  | 3.7                                             |  | $                            | 8.25  |        | 687 |                              | $ | 4.65 
|                         |  |                              |  |                                                 |  |                              |       |        |     |                              |   |      



On April 15, 2002 the
Company granted an employee an option that was in the money on the date of grant. The difference in the market value and the grant price on the grant date was $909,000 which has been recorded as deferred compensation expense in the capital section
and is being amortized to expense over the vesting period of 5 years. Amortization expense of $181,000 and $68,929 has been recorded as compensation expense in the years 2003 and 2002, respectively.



During the three fiscal years ended August 31, 2003, the Company granted
stock options to non-employees. The fair value of such stock options (calculated using the Black Scholes model) has been charged to expense with a corresponding credit to additional paid-in capital. The Company recorded expense associated with stock
options issued to non employees of $262,330, $385,426 and $3,686,510 during the three year period ended August 31, 2003. During October 2002, the Company issued warrants to acquire 61,149 shares of the Companys common stock at a price of
$10.95 per share. The warrants vested immediately and were exercisable through October 2005. The value of the warrants using the Black Scholes pricing model was calculated to be $327,758 which has been charged to expense and credited to additional
paid-in capital. The warrants were subsequently returned to the Company, however, since they vested immediately no reversal of the compensation expense has been recorded.



During the period September 1, 2003 through June 18, 2004, the Company issued 105,500 shares of its common stock upon the
exercise of stock options for cash consideration of $500,806.



74



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Notes to Consolidated Financial Statements (continued)



August 31, 2003



|10. | Employee Benefit Plan
|--- | ---------------------



The Company sponsors a 401(k) defined contribution plan covering substantially all employees of the Company and provides for voluntary contributions by
these employees, subject to certain limits. The plan was effective June 1, 2001. The Company makes discretionary contributions to the plan. The Companys contributions for fiscal years 2003 and 2002 were $54,874 and $43,940, respectively.



|11. | Net Income Per Share
|--- | --------------------



The numerator used in the calculations of both basic and diluted net income per share for all periods presented was net income. The denominator for each
period presented was determined as follows:



|                                                                 |  |                       |  |            |  |           
|---------------------------------------------------------------- |  | --------------------- |  | ---------- |  | ----------
|                                                                 |  | Years ended August 31
|                                                                 |  | 2003                  |  | 2002       |  | 2001      
|Denominator:                                                     |  |                       |  |            |  |           
|Basic net income per shareweighted average shares outstanding   |  | 14,849,504            |  | 14,686,236 |  | 13,997,861
|Effect of dilutive securities:                                   |  |                       |  |            |  |           
|Common stock optionstreasury stock method                       |  | 714,713               |  | 803,832    |  | 1,094,572 
|                                                                 |  |                       |  |            |  |           
|Diluted net income per shareweighted average shares outstanding |  | 15,564,217            |  | 15,490,068 |  | 15,092,433
|                                                                 |  |                       |  |            |  |           



|12. | Accrued Liabilities
|--- | -------------------



Accrued liabilities at August 31 are as follows:



|                                             |  |      |           |      |   |          
|-------------------------------------------- |  | ---- | --------- | ---- | - | ---------
|                                             |  | 2003 |           | 2002
|Accruals for Garland Facility                |  | $    | 2,283,285 |      | $ |         
|Payroll and related taxes                    |  |      | 907,159   |      |   | 545,766  
|Baton Rouge Facility lawsuit settlement      |  |      | 775,000   |      |   |         
|Property taxes                               |  |      | 513,445   |      |   | 239,164  
|Settlement of shareholder derivative lawsuit |  |      | 500,000   |      |   |         
|Accruals for equipment                       |  |      | 127,233   |      |   |         
|Accrued interest                             |  |      | 37,997    |      |   |         
|Franchise taxes payable                      |  |      | 20,000    |      |   |         
|Year-end accruals of expenses and other      |  |      | 2,239,731 |      |   | 767,345  
|                                             |  |      |           |      |   |          
|Total accrued liabilities                    |  | $    | 7,403,850 |      | $ | 1,552,275
|                                             |  |      |           |      |   |          



|13. | Commitments and Contingencies
|--- | -----------------------------



Leases



As of August 31, 2003, the following assets are under capital lease obligations and included in property and equipment for medical:



|                              |  |   |         |  
|----------------------------- |  | - | ------- | -
|Medical equipment             |  | $ | 620,111 |  
|Less accumulated amortization |  |   | (41,341 | )
|                              |  |   |         |  
|                              |  | $ | 578,770 |  
|                              |  |   |         |  



Amortization expense
for assets recorded under capital leases is included in depreciation expense.



75



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Notes to Consolidated Financial Statements (continued)



August 31, 2003



Future minimum payments, by year and in the aggregate, required under capital lease obligations and
noncancellable operating leases for certain facilities and equipment consist of the following at August 31, 2003:



|                                                         |  |              |          |   |                 |   |          
|-------------------------------------------------------- |  | ------------ | -------- | - | --------------- | - | ---------
|Year ending August 31                                    |  | CapitalLease |          |   | OperatingLeases
|2004                                                     |  | $            | 161,484  |   |                 | $ | 1,899,325
|2005                                                     |  |              | 161,484  |   |                 |   | 1,532,719
|2006                                                     |  |              | 161,484  |   |                 |   | 1,479,726
|2007                                                     |  |              | 147,562  |   |                 |   | 1,190,916
|2008                                                     |  |              |         |   |                 |   | 354,848  
|Thereafter                                               |  |              |         |   |                 |   | 260,457  
|                                                         |  |              |          |   |                 |   |          
|                                                         |  |              | 632,014  |   |                 | $ | 6,717,991
|                                                         |  |              |          |   |                 |   |          
|Less imputed interest included in minimum lease payments |  |              | (73,622  | ) |                 |   |          
|                                                         |  |              |          |   |                 |   |          
|Present value of minimum lease payments                  |  |              | 558,392  |   |                 |   |          
|Less current portion                                     |  |              | (129,805 | ) |                 |   |          
|                                                         |  |              |          |   |                 |   |          
|                                                         |  | $            | 428,587  |   |                 |   |          
|                                                         |  |              |          |   |                 |   |          



Total rent and lease
expenses paid by the Company, for the fiscal years 2003, 2002, and 2001, was approximately $1,394,396, $963,000, and $244,000, respectively.



Commitments for future additions to medical equipment were approximately $1,206,000 at August 31, 2003, which was guaranteed by the Company on behalf of
its subsidiary in the normal course of business. In terms of the guarantee issued, if the Companys subsidiary does not meet its commitment of purchasing the medical equipment and making the related payments, the Company will be liable to
purchase the medical equipment for the same amount.



The
Company, through its subsidiary, also has agreements with outside organizations that offer marketing, pre-authorization and follow up support services to prospective bariatric and orthopedic patients in areas serviced by the Pasadena, Garland and
Baton Rouge Facilities. These facilities receive bariatric and orthopedic referrals from these and other sources and the organizations refers clients to other area hospitals. Payments made under these agreements for the fiscal years 2003, 2002 and
2001 were $6,002,000, $4,802,000 and $4,433,000, respectively. Future minimum payments under these agreements for the following fiscal years are: 2004, $4,525,000; 2005, $4,500,000; and 2006, $937,000.



The Company has contracts with Doctors to manage various areas of the
Companys hospitals and other service agreements. Payments made under these agreements for the fiscal years ending August 31, 2003, 2002 and 2001 were $1,776,000, $741,000 and $495,000, respectively. Future minimum payments under the terms of
these contracts and agreements for the following fiscal years are 2004, $2,044,000, 2005, $1,629,000, 2006, $920,000 and thereafter $555,000.



Risks and Uncertainties



The Company maintains various insurance policies that cover each of its facilities. Specifically, the Company maintains medical malpractice insurance
coverage in Texas. The Company has claims-made malpractice coverage and has purchased tail coverage effective through August 12, 2004. The Company in Louisiana is a member of the Louisiana Patient Compensation Fund and purchases insurance through
the Louisiana Patient Compensation Fund for medical malpractice. In addition, all physicians granted privileges at the Companys facilities are required to maintain medical malpractice insurance coverage. The Company also maintains general
liability and property insurance coverage for each facility and flood coverage for the Baton Rouge Facility. The Company also maintains workers compensation coverage for the Baton Rouge Facility, but does not currently maintain workers
compensation coverage in Texas. In regard to the Employee Health Insurance Plan, the Company is self insured with specific and aggregate re-insurance with stop loss levels appropriate for the companys group size. Coverages are maintained in
amounts management deems adequate.



76



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Notes to Consolidated Financial Statements (continued)



August 31, 2003



In January 2002, the Company, two of its officers, and the spouse of one of the officers were named
as defendants in a shareholder class action lawsuit in the United States District Court for the Southern District of Texas alleging violations of federal securities laws and regulations. The putative class covered those persons who purchased the
Company shares between November 29, 1999 and January 16, 2002. The various complaints that were consolidated claimed that the Company violated Sections 10(b) and 20(a) and Rule 10b-5 under the Exchange Act by making materially false or misleading
statements or omissions regarding revenues and receivables and regarding whether our operations complied with various federal regulations. The district court consolidated these actions and appointed a lead plaintiff in the matter. The lead plaintiff
filed a consolidated amended complaint on September 6, 2002. The Company and its officers moved to dismiss the complaint on February 25, 2003. On August 26, 2003, the Court granted the Motion to Dismiss and denied Plaintiffs leave to amend further.
The Plaintiffs thereafter filed a notice of appeal. In May 2004, the Plaintiffs dismissed their appeal, thereby concluding the case.



A separate shareholder derivative action was also brought in federal court, but was stayed pending resolution of the shareholder class action described
above. The Plaintiff in the derivative case did not make a demand on the Company or its Board of Directors prior to filing suit. It remained stayed pending the plaintiffs appeal of the dismissal of the shareholder class action. Given the
Plaintiffs dismissal of the appeal in the shareholder class action, the Company has moved to dismiss the derivative action. This derivative matter, if it were to proceed, would not seek to recover any damages from the Company, but could expose
the Company to bearing some unknown legal or indemnity costs which we cannot predict at this time.



In March 2002, the Company accepted service of a shareholder derivative action filed on or about February 26, 2002 in the 295th District Court of Harris
County, Texas brought on behalf of the Company against its officers and directors, outside auditor, investment bank, and two analysts affiliated with that investment bank. The suit alleges breach of fiduciary duty, aiding and abetting breach of
fiduciary duty, negligence and breach of contract. Plaintiff makes general allegations of the defendants alleged misconduct in (i) causing or allowing the Company to conduct its business in an unsafe, imprudent and unlawful manner; (ii)
failing to implement and maintain an adequate internal control system; and (iii) exposing Dynacq to enormous losses, including allegations that various press releases and/or public statements issued between January 1999 and January 2002 were
misleading. Plaintiffs further allege sales by the Companys insiders while in possession of material non-public information. The plaintiffs made no demand on either the Company or its Board of Directors prior to filing suit. The Companys
Board of Directors appointed a Special Litigation Committee to conduct an investigation and make a determination as to how the Company should proceed on the claims asserted in the state court shareholder derivative case. On February 24, 2003, the
Special Litigation Committee adopted a resolution directing the Companys counsel to seek dismissal or settlement of the state court derivative action. A Stipulation of Settlement was executed by both parties and filed with the Court on
September 11, 2003. The final Settlement, which was approved by the Court on November 10, 2003, provided, among other things, that (1) the claims were dismissed with prejudice and (2) defendants agreed to pay the legal fees and expenses of
plaintiffs (shareholders), which the Court set at $500,000. The Company had accrued for this settlement at August 31, 2003. The Company made the payment and the matter is now concluded.



Eight lawsuits were filed in the United States District Court for the Southern District of Texas (Houston Division) between
December 24, 2003 and January 26, 2004, alleging federal securities law causes of action against the Company and various current and former officers and directors. The cases were filed as class actions brought on behalf of persons who purchased
shares of Companys common stock in the open market generally during the period of January 14, 2003 through December 18, 2003. Under the procedures of the Private Securities Litigation Reform Act, certain plaintiffs have filed motions asking to
consolidate these actions and be designated as lead plaintiff. The district court consolidated the actions and appointed a lead plaintiff in the matter. An amended complaint was filed on June 30, 2004 asserting a class period of November 27, 2002
 December 19, 2003 and naming additional defendants, including Ernst & Young LLP. The amended complaint seeks certification as a class action and alleges that the defendants violated Sections 10(b), 20(a), 20(A) and Rule 10b-5 under the
Exchange Act, by publishing materially misleading financial statements which did not comply with generally accepted accounting principles, making materially false or misleading statements or omissions regarding revenues and receivables, operations
and



77



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Notes to Consolidated Financial Statements (continued)



August 31, 2003



financial results and engaging in an intentional fraudulent scheme aimed at inflating the value of Dynacqs stock. The Company intends to vigorously
defend the allegations and will file a motion to dismiss all or some of the claims. The Company cannot predict the ultimate outcome of the lawsuit or whether the lawsuit will have a material adverse effect on the Companys financial condition.



The Company is named as a defendant in the lawsuit Leo Borrell
v. Dynacq International, Inc., NeWeigh, Inc., and Diane Crumley, Vital Weight Control, Inc., d/b/a NeWeigh, and Vista Community Medical Center, L.L.C. (Cause No. 2002-13659) filed in the 281st Judicial District Court of Harris County, Texas. Dr.
Borrell is seeking recovery of commissions he alleges are owed pursuant to an oral agreement with the Company. Dr. Borrell has yet to determine the damages that he is seeking. After a significant amount of discovery has been conducted, we believe
this case to be without merit, and intend to continue to vigorously defend this matter.



Late in fiscal year 2003, a dispute arose between one of the Companys subsidiaries and Jane Capital, LLC and Sunbelt Medical Corp. related to the purchase of medical equipment for the Companys Baton Rouge
Facility. Because Jane Capital and Sunbelt each demanded identical full payment for the equipment without providing necessary supporting documents, the Companys subsidiary filed suit in Harris County, Texas to require Jane Capital, LLC and
Sunbelt Medical Corp. to produce the documents, to determine the proper amount owed for the equipment and to whom such amounts were owed and to reimburse the Company for selling it certain defective products. The lawsuit was settled in May 2004. As
a result of the settlement, the amount paid by the Company was approximately $1 million less than the amounts claimed by the defendants.



In the first quarter of fiscal 2004, a contractor who operated the pharmacy at the Baton Rouge Facility filed suit against the Company, the CEO, and the
Baton Rouge Facility in Louisiana alleging that it was owed additional fees in excess of $1,000,000 for costs of goods and services. The Plaintiff has asserted claims for breach of contract, fraud, negligence, fraudulent misrepresentation, negligent
misrepresentation, civil conspiracy and gross negligence. The Company believes the Defendants claims are without merit and intends to continue to vigorously dispute the allegations. However, we cannot predict the ultimate outcome of the
lawsuit or whether the lawsuit will have a material adverse effect on the Companys financial condition.



In December 2002, the Pasadena Facility was notified by the CMS that it had allegedly violated EMTALA requirements. The Texas Department of Health
(TDH) conducted an investigation and reported to the CMS that appropriate corrective actions had been taken. As a result of TDHs findings, the CMS notified the facility in January 2003 that its eligibility for Medicare
participation remained in effect, but, as required by §1867(d) of the Social Security Act, the matter would be forwarded to the Quality Improvement Organization (QIO) to review the case and report its findings to the OIG for a
possible assessment of a civil monetary penalty. The facility met with the QIO on October 3, 2003. As of this date, there has been no report issued by the QIO or any response received from the OIG. The Company does not anticipate that it will incur
any material liability that would have an adverse effect on the Companys operations, cash flows, or financial condition as a result of this proceeding.



On December 18, 2003, we received a notice of an informal investigation from the Fort Worth, Texas District Office of the Securities and Exchange
Commission requesting our voluntary assistance in providing information regarding reporting of our financial statements, recognition of costs and revenue, accounts receivable, allowances for doubtful accounts and our internal controls. We have been
cooperating fully with the continuing informal SEC investigation.



By letter dated December 9, 2003, the Office of the Attorney General of Texas (AGs Office) requested documentation concerning incidents at Vista Medical Center in Pasadena, Texas, which resulted in death between December
2001 and December 2003. By letter dated January 20, 2004, the AGs office broadened that inquiry to include all Vista facilities, all incidents resulting in death, and during a broader time period from January 1, 1999 through January 20, 2004.
No specific focus or subject of the inquiry was identified and we have received no further correspondence from the AGs office explaining this request. In February 2004, the Company was notified by the AGs office that it is the subject of
an investigation of possible violations of the statutes governing the solicitation of patients. Based on the documents requested by the AGs office and communications with Company



78



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Notes to Consolidated Financial Statements (continued)



August 31, 2003



representatives, the Company believes that such investigation stems from the same allegations that have been asserted in the private lawsuit with Dr. Borrell
described above. The Company has denied the allegations in that lawsuit and continues to vigorously defend the suit. The Company is cooperating with the AGs Office on each of these matters, but believes the complaints received by the AGs
office to be without merit.



From time to time, the Company is
involved in litigation and administrative proceedings that are incidental to its business. The Company cannot predict whether any litigation to which it is currently a party will have a material adverse effect on the Companys results of
operations, cash flows, or financial condition.



|14. | Concentrations of Credit Risk and Fair Value of Financial Instruments
|--- | ---------------------------------------------------------------------



The Company has financial instruments that are exposed to concentrations of credit risk and consist primarily of cash investments and trade accounts
receivable. The Company routinely maintains cash and temporary cash investments at certain financial institutions in amounts substantially in excess of FDIC and Securities Investor Protection Corporation (SIPC) insurance limits; however,
management believes that these financial institutions are of high quality and the risk of loss is minimal. At August 31, 2003, the Company had cash balances in excess of the FDIC and SIPC limits of $5,035,724.



As is customary in the healthcare business, the Company has accounts
receivable from various third party payers. The Company does not request collateral from its customers and continually monitors its exposure for credit losses and maintains allowances for anticipated losses. Receivables from third party payers are
normally in excess of 90% of the total receivables at any point in time. The mix of gross receivables from self-pay patients and third-party payers at August 31, 2003 and 2002 is as follows:



|                                                                    |  |      |   |  |      |  
|------------------------------------------------------------------- |  | ---- | - |  | ---- | -
|                                                                    |  | 2003 |   |  | 2002 |  
|Workers compensation                                               |  | 14   | % |  | 21   | %
|Workers compensation subject to Medical Dispute Resolution process |  | 55   | % |  | 49   | %
|Commercial                                                          |  | 16   | % |  | 15   | %
|Medicare                                                            |  | 4    | % |  | 4    | %
|Medicaid                                                            |  | 1    | % |  |     | %
|Self-pay                                                            |  | 1    | % |  | 1    | %
|Other                                                               |  | 9    | % |  | 10   | %
|                                                                    |  |      |   |  |      |  
|                                                                    |  | 100  | % |  | 100  | %
|                                                                    |  |      |   |  |      |  



We had no major third
party payers (customers) representing greater than 10% of the Companys revenue or receivables for the years ended August 31, 2003 and 2002.



The carrying amounts of cash and cash equivalents, current receivables, accounts payable and accrued liabilities approximate fair value due to the
short-term nature of these instruments. The carrying amounts of the Companys short-term borrowings, at August 31, 2003 and 2002, approximate their fair value.



79



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Notes to Consolidated Financial Statements (continued)



August 31, 2003



|15. | Quarterly Financial Data (unaudited)
|--- | ------------------------------------



|                                                                                                                           |  |                    |            |             |   |            |  |           |            |  |   |            |    
|-------------------------------------------------------------------------------------------------------------------------- |  | ------------------ | ---------- | ----------- | - | ---------- |  | --------- | ---------- |  | - | ---------- | ---
|                                                                                                                           |  | Three months ended |           
|                                                                                                                           |  | November 30        |            | February 28 |   | May 31     |  | August 31 |           
|Year ended August 31, 2003                                                                                                 |  |                    |            |             |   |            |  |           |            |  |   |            |    
|Revenues                                                                                                                   |  | $                  | 17,933,926 |             | $ | 21,127,507 |  | $         | 25,606,146 |  | $ | 25,309,160 |    
|Income from operations(1)                                                                                                  |  |                    | 7,480,286  |             |   | 7,933,921  |  |           | 11,119,271 |  |   | 8,933,841  | (2)
|Income before extraordinary gain and cumulative effect of a change in accounting principle(1)                              |  |                    | 4,173,100  |             |   | 4,122,741  |  |           | 6,396,834  |  |   | 5,124,614  |    
|Net income(1)                                                                                                              |  |                    | 5,161,817  |             |   | 4,122,741  |  |           | 6,396,834  |  |   | 5,205,931  |    
|Basic net income per common share before extraordinary gain and cumulative effect of a change in accounting principle      |  |                    | 0.28       |             |   | 0.28       |  |           | 0.43       |  |   | 0.34       |    
|Diluted net income per common share before extraordinary gain and cumulative effect of a change in accounting principle(1) |  |                    | 0.27       |             |   | 0.26       |  |           | 0.41       |  |   | 0.33       |    
|Year ended August 31, 2002                                                                                                 |  |                    |            |             |   |            |  |           |            |  |   |            |    
|Revenues                                                                                                                   |  | $                  | 13,854,531 |             | $ | 15,036,293 |  | $         | 19,621,751 |  | $ | 16,370,660 |    
|Income from operations(3)                                                                                                  |  |                    | 6,101,089  |             |   | 6,310,222  |  |           | 7,475,993  |  |   | 6,800,979  |    
|Net income                                                                                                                 |  |                    | 3,377,615  |             |   | 3,542,027  |  |           | 4,127,165  |  |   | 3,782,680  |    
|Basic net income per share(4)                                                                                              |  |                    | 0.23       |             |   | 0.24       |  |           | 0.28       |  |   | 0.26       |    
|Diluted net income per share(4)                                                                                            |  |                    | 0.22       |             |   | 0.23       |  |           | 0.27       |  |   | 0.24       |    

---

|(1) | Income from operations, income before extraordinary gain and cumulative effect of a change in
accounting principle and net income have been restated to reflect audit adjustments for depreciation expense and income taxes for the first three quarters of fiscal year 2003.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(2) | The decrease in the fourth quarter income from operations as compared to the third quarter is the result of the accrual of $500,000 for the settlement of the
shareholder derivative action and the accrual of other legal fees and expenses associated with the Company defending this and other lawsuits.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(3) | In connection with the reaudit of the August 31, 2002 fiscal year, the quarterly income from operations has been restated to reflect the reclassification of
franchise taxes as income taxes for all quarters. All of the year end audit adjustments have been reflected in the fourth quarter.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(4) | Basic net income per share and diluted income per share have been restated to reflect the audit adjustments and the restated number of shares outstanding.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------



Cash flows during the quarters ended February 28, 2003 and
May 31, 2003



Due to a classification error during the
second and third fiscal quarters of 2003, the following amounts of accrued liabilities were included as net cash provided by operating activities. The accrued liabilities for purchase of property and equipment should have been classified
as net cash used in investing activities, and for preferred stock redemption as net cash used in financing activities.



|                                                           |  |                                  |           |                              |   |          
|---------------------------------------------------------- |  | -------------------------------- | --------- | ---------------------------- | - | ---------
|                                                           |  | Six monthsended February 28,2003 |           | Nine monthsended May 31,2003
|Accrued liabilities for purchase of property and equipment |  | $                                | 4,370,727 |                              | $ | 2,494,593
|Accrued liabilities for preferred stock redemption         |  |                                  |          |                              |   | 433,927  



Following is the
summary of net cash changes due to operating, investing and financing activities with the above amounts reclassed properly:



|                                                    |  |                                  |             |   |                              |   |             |  
|--------------------------------------------------- |  | -------------------------------- | ----------- | - | ---------------------------- | - | ----------- | -
|                                                    |  | Six monthsended February 28,2003 |             |   | Nine monthsended May 31,2003 |  
|Net cash provided by operating activities           |  | $                                | 7,496,459   |   |                              | $ | 11,106,866  |  
|Net cash used in investing activities               |  |                                  | (10,734,391 | ) |                              |   | (13,768,382 | )
|Net cash provided by (used in) financing activities |  |                                  | 585,891     |   |                              |   | (780,646    | )



There is no impact of
these reclasses to fiscal year 2003, prior years or prior years quarters.



|16. | Subsequent events
|--- | -----------------



Subsequent to August 31, 2003, the Company entered into an additional management support and marketing services agreement, a physicians assistance
agreement and a consulting agreement which have future minimum payment requirements of $2,613,000 in 2004, $2,565,000 in 2005, $2,510,000 in 2006 and $300,000 in 2007.



The Company has been notified by the Office of the Attorney General of Texas (AGs office) that it is the
subject of an investigation of possible violations of the statutes governing the solicitation of patients. The Company believes that such investigation stems from the same allegations that have been asserted in a private lawsuit currently pending
against the Company. The Company has denied the allegations in that lawsuit and continues to vigorously defend the suit. The Company had also previously received an inquiry from the AGs office



80



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Notes to Consolidated Financial Statements (continued)



August 31, 2003



requesting documentation related to any instances of deaths occurring at the Companys facilities between January 1, 1999 and January 29, 2004. The
Company is cooperating with the AGs office on each of these matters, but believes the complaints received by the AGs office to be without merit. In the event charges are filed against the Company related to this investigation, the
Company could be subject to significant sanctions and penalties, which could have a material adverse effect on the Companys business and financial condition. Furthermore, the Companys reputation could suffer and any damage to the
Companys reputation could cause the Company to lose existing patients and fail to attract new patients and qualified physicians, which would have a material adverse effect on the Companys business and financial condition. While the
Company has denied any wrongdoing and intends to vigorously defend itself, no assurance can be given as to the outcome of this matter or the effect on its business.



On December 18, 2003, the Company received a notice of an informal investigation from the Fort Worth, Texas District Office
of the Securities and Exchange Commission requesting the Companys voluntary assistance in providing information regarding reporting of the Companys financial statements, recognition of costs and revenue, accounts receivable, allowances
for doubtful accounts and the Companys internal controls. The Company has been cooperating fully with the continuing informal SEC investigation. The Company cannot predict the outcome of this matter or the effect that it may have on it.



In April 2004, the Texas Workers Compensation Commission
adopted a new Fee Guideline for Ambulatory Surgical Centers, which will become effective as of September 1, 2004. The new fee guideline only affects Ambulatory Surgical Centers and therefore only the West Houston Facility will be affected at this
time.



Dr. Eric Scheffey, a physician who had accounted for
approximately 21% of the Companys gross patient revenues during each of the fiscal years 2003 and 2002, had his medical license suspended in August 2003 and has not provided medical services at the Companys facilities since that time. In
addition, several physicians, including four physicians who accounted for approximately 28% and 25% of the Companys gross patient revenues during fiscal years 2003 and 2002 respectively, departed to pursue other interests or substantially
reduced their cases at the Pasadena facility, during the fiscal year 2004. While the Company has added additional physicians in the fourth quarter of fiscal year 2004, the loss of these physicians resulted in a significant reduction in net patient
revenues for the first three quarters of fiscal year 2004. While the Company believes that it will be able to continue to attract and retain additional physicians, the potential loss of physicians who provide significant net patient revenues for the
Company will adversely affect its results of operations.



The
Companys common stock was delisted from the Nasdaq National Market as of the opening of business on Friday, April 16, 2004, because of the lateness of its filings of periodic reports with the Securities and Exchange Commission. While the
Companys common stock has continued to be quoted on the National Quotation Service Bureau (the Pink Sheets) for unsolicited trading, there is currently no regular public trading market for the Companys common stock.



In January 2004, the Company put up a $640,000 earnest money
deposit to acquire a land lease to build and develop a hospital to be constructed in Shanghai, China.



During September 2004, the Company amended an existing stock option accounted for under APB No. 25. As a result the Company will take a non-cash charge of
$624,000 net of tax during the first quarter of 2004.



Subsequent to August 31, 2003, the Company acquired the remaining minority interests in the Pasadena and Baton Rouge facilities and then restructured the ownership of those facilities and the Garland facility such that the Company owns 93%
of the Pasadena facility, 90% of the Baton Rouge facility and 92% of the Garland facility.



81



---

Dynacq Healthcare, Inc.

(formerly Dynacq International, Inc.)



Schedule IIValuation and Qualifying Accounts



For the Years Ended August 31, 2003, 2002 and 2001



|                                        |  |                              |            |                            |   |                            |  |               |            |  |                         |             |   |  |   |           
|--------------------------------------- |  | ---------------------------- | ---------- | -------------------------- | - | -------------------------- |  | ------------- | ---------- |  | ----------------------- | ----------- | - |  | - | ----------
|                                        |  | Balance atBeginning ofPeriod |            | Chargedto CostsandExpenses |   | Charged toOtherAccounts(1) |  | Deductions(2) |            |  | Balance atEnd of Period
|2003                                    |  |                              |            |                            |   |                            |  |               |            |  |                         |             |   |  |   |           
|Contractual allowances                  |  | $                            | 58,892,356 |                            | $ |                           |  | $             | 74,367,153 |  | $                       | (35,097,170 | ) |  | $ | 98,162,339
|Allowance for uncollectible accounts(3) |  |                              | 443,505    |                            |   | 512,887                    |  |               |           |  |                         |            |   |  |   | 956,392   
|2002                                    |  |                              |            |                            |   |                            |  |               |            |  |                         |             |   |  |   |           
|Contractual allowances                  |  | $                            | 50,177,205 |                            | $ |                           |  | $             | 48,877,728 |  | $                       | (40,162,577 | ) |  | $ | 58,892,356
|Allowance for uncollectible accounts(3) |  |                              | 192,793    |                            |   | 250,712                    |  |               |           |  |                         |            |   |  |   | 443,505   
|2001                                    |  |                              |            |                            |   |                            |  |               |            |  |                         |             |   |  |   |           
|Contractual allowances                  |  | $                            | 28,353,464 |                            | $ |                           |  | $             | 30,293,416 |  | $                       | (8,469,675  | ) |  | $ | 50,177,205
|Allowance for uncollectible accounts(3) |  |                              | 134,534    |                            |   | 58,259                     |  |               |           |  |                         |            |   |  |   | 192,793   

---

|(1) | The amounts charged to contractual allowance are 45%, 43% and 41% of gross billed charges for fiscal years 2003, 2002 and 2001, respectively.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------



|(2) | Reflects adjustment to the contractual allowance upon receipt of cash and settlement of account receivable. When cash is received for a particular account receivable
and the Company considers the cash payment to be the final settlement of the account balance, the gross receivable is eliminated and the contractual allowance is reduced by the difference of the gross receivable and the cash collected.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(3) | The Company currently estimates uncollectible accounts expense on a monthly basis as 1% of gross outpatient revenue. Through August 31, 2003, the Company has made no
charge offs against the allowance for uncollectible accounts, as historically all charge offs have been against the contractual allowance.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



82



---

|Item 9. | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
|------- | ------------------------------------------------------------------------------------



On December 17, 2003, Ernst & Young LLP notified the Company that it resigned as the Companys independent auditor
effective immediately. On December 24, 2003, the Company filed a Form 8-K reporting Ernst & Youngs resignation as the Companys independent auditor. On April 6, 2004, the Company filed a Form 8-K/A restating and supplementing the
information provided in the Form 8-K dated December 24, 2003.



Ernst & Young was engaged as the Companys independent auditor on May 31, 2002. Ernst & Youngs report on the financial statements for the fiscal year ended August 31, 2002 contained no adverse opinion or disclaimer of
opinion and was not qualified or modified as to uncertainty, audit scope or accounting principles. See Note 2 to the consolidated financial statements for additional information regarding the financial statements for the fiscal year ended August 31,
2002. As of December 17, 2003, Ernst & Young had not completed its audit work with respect to the Companys August 31, 2003 financial statements.



The Audit Committee of the Companys Board of Directors was informed of, but did not recommend or approve, Ernst & Youngs resignation.



During the Companys fiscal year ended August 31, 2002
and the subsequent interim periods preceding Ernst & Youngs resignation, there were no disagreements between the Company and Ernst & Young on any matter of accounting principles or practices, financial statement disclosure, or auditing
scope or procedure, which disagreements, if not resolved to Ernst & Youngs satisfaction, would have caused Ernst & Young to make reference to the subject matter of the disagreement in connection with their report.



On December 15, 2003, Ernst & Young orally communicated to certain
officers of the Company Ernst & Youngs concerns relating to the Companys disclosure controls, accounting controls and controls over safeguarding of assets. Ernst & Youngs concerns arose as a result of a transaction related
to the sale of certain Company receivables to a foreign entity which is not a financial institution; the transaction did not appear to Ernst & Young to be in the ordinary course of the Companys business.



On December 17, 2003, Ernst & Young orally informed the Company that the
Company lacked the internal controls necessary to develop reliable financial statements. By letter dated December 23, 2003, Ernst & Young advised the Board of Directors of its conclusion that material weaknesses in internal control had come to
its attention during the course of performing its audit of the Companys financial statements for the year ended August 31, 2003, specifically noting (a) inadequate communication lines and internal controls relating to the authorization,
recognition, capture and review of transactions, facts, circumstances and events that may have a material impact on the Companys financial reporting process and (b) a lack of supervision, review and quality control related to the accounting
for income taxes, including the preparation of the federal income tax provision in accordance with SFAS No. 109, Accounting for Income Taxes.



In connection with (a) above, Ernst & Young stated Specifically in November 2003, the Companys Chief Executive Officer negotiated a
significant transaction to sell certain accounts receivable to another entity. This transaction was not disclosed to the Companys Chief Financial Officer, the Companys independent auditors nor the Companys Board of Directors prior
to its execution and represents significant deficiencies in the Companys disclosure controls, accounting controls and controls over the safeguarding of its assets.



Certain circumstances underlying the transaction in question were as follows: (i) funds in an amount equal to the proposed
purchase price were deposited into the Companys bank account on November 26, 2003, (ii) neither the Chief Financial Officer nor the Board of Directors of the Company had been advised of the transaction in advance, nor had the Board of
Directors authorized the transaction in advance, (iii) the receipt of funds had not been recorded in the Companys accounting records, (iv) Ernst & Young had initially been advised by outside counsel to the Company that the transaction had
closed, and (v) on December 11, 2003, the Companys Board of Directors, pending negotiation of acceptable companion agreements and subject to certain other conditions, authorized officers of the Company to execute and deliver Bills of Sale
effective as of November 26, 2003, to effect the transaction.



As of December 15, 2003, open issues still existed between the Company and the proposed purchaser with respect to the procedure, responsibility, and compensation to the Company for collecting the subject receivables. The open issues were
never resolved, and the proposed sale of receivables by the Company was never concluded. Negotiations with the proposed purchaser have terminated, and the funds were returned.



83



---

The receivables involved in the proposed transaction had a face value of approximately $34 million, but,
having remained outstanding in excess of eighteen months, had previously been written down to a book value of $1.7 million (which constituted approximately 2% of total assets as of August 31, 2003), with a proposed sale price of $3.4 million. If
such sale had been concluded prior to the filing of this Form 10-K for the year ended August 31, 2003, the completed transaction would be reported as a subsequent event. During the fiscal year ended August 31, 2003 and thereafter to date, there were
no other transactions or events similar to those involved in the proposed sale of receivables by the Company.



Neither the Companys Board of Directors nor the Audit Committee of the Companys Board of Directors has discussed with Ernst & Young its
conclusions concerning the lack of internal controls. The Company has authorized Ernst & Young to respond fully to the inquiries of the successor accountant regarding Ernst & Youngs statement that the Company lacks the internal
controls necessary to develop reliable financial statements.



The Company has previously provided Ernst & Young with a copy of the foregoing disclosures, and a copy of Ernst & Youngs letter regarding the change in certifying accountant was filed as Exhibit 16.1 to the Form 8-K/A.



On January 19, 2004, the Audit Committee of the Board of
Directors engaged the registered public accounting firm of Killman, Murrell & Company, P.C. (KMC) as the Companys new independent accountant for the fiscal year ended August 31, 2003. During the two most recent fiscal years
ended August 31, 2002 and August 31, 2003 and the subsequent interim period prior to the Companys engagement of KMC, the Company did not consult with KMC regarding the application of accounting principles to a specific transaction, either
completed or proposed, the type of audit opinion that might be rendered on the Companys consolidated financial statements, or the advice of the Companys former independent accountant that the Company lacks internal controls necessary to
develop reliable financial statements.



|Item 9A. | Controls and Procedures
|-------- | -----------------------



We have restated and obtained a re-audit of our previously reported financial statements for the fiscal year ended August 31, 2002, restated our 2001
financial statements, and restated the selected financial information for fiscal years 1999 and 2000 because of accounting errors identified in those financial statements. (For a discussion of the individual restatement adjustments, see Item
8. Financial StatementsNote 2. Restatements). The restatements arose out of the review of our accounting records and accounting policies by our current outside auditors, which was initiated in response to issues raised by our former
outside auditors. Please see Change in Independent Auditors above for a discussion of the issues raised by our former outside auditors.



In addition, the Audit Committee, with assistance from special legal counsel, conducted its own independent investigation. With respect to the material
weaknesses identified by Ernst & Young, the independent investigation conducted by the special counsel to the Audit Committee concluded that no lack of internal controls existed with respect to inadequate communication lines and lack of internal
controls with respect to authorization and review of transactions. Furthermore, the board of directors of the Company has adopted a policy that requires that any transaction in excess of $250,000 requires prior board approval. With respect to lack
of supervision, review and quality control related to income tax reporting identified by Ernst & Young, the Company has engaged its current independent auditors to prepare the Companys income tax returns for the fiscal year ended August
31, 2003. The restated financial statements reflect audit adjustments with respect to income taxes. See Note 2 to the consolidated financial statements.



Further, our current independent auditors have orally advised the audit committee on July 19, 2004 that they have identified what they consider to be
material weaknesses in our internal controls as set forth under Changes in Internal Controls below.



| | (a) | Evaluation of Disclosure Controls and Procedures
| | --- | ------------------------------------------------



Our management carried out an evaluation, with the participation of our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of
the design and operation of our disclosure controls and procedures as of August 31, 2003, the end of the period covered by this Annual Report on Form 10-K. Based on that evaluation, including consideration of the matters described in subsection (b)
below, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were not effective as of August 31,



84



---

2003. KMCs audit of the two fiscal years ended August 31, 2003 was conducted as a substantive audit without reliance on the Companys internal
controls. Similarly, KMC expects to conduct a substantive audit for fiscal year 2004, pending the Companys progress in establishing internal controls. The Company has taken the following initial steps to address the issues identified as
material weaknesses and to enhance the effectiveness of its internal controls:



| |  | Appointment of James G. Gerace, a certified public accountant, to the Board of Directors, to serve as the chair of the Audit Committee, with the Board having made the determination
that Mr. Gerace meets the standards of an audit committee financial expert as set forth in the rules promulgated by the Securities and Exchange Commission;
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | appointed a general counsel who communicates directly with the Audit Committee and with the Board of Directors; and
| | - | -------------------------------------------------------------------------------------------------------------------



| |  | established an internal audit department, recently engaged an interim internal auditor and compliance officer and is searching for a head of internal audit.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------



The Company is in the process of adopting more
rigorous policies and procedures with respect to its disclosure and financial reporting review process and we have recently engaged an outside consulting firm as an internal audit and compliance advisor to assist the company in implementing
effective compliance structures, including the companys Sarbanes-Oxley compliance program. The Company is committed to fully instituting enhanced disclosure controls and procedures that are designed to ensure that the information required to
be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SECs rules and forms, and that such information is accumulated and communicated to our management, including our
Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure based closely on the definition of disclosure controls and procedures in Rule 13a-14(c).



| | (b) | Changes in Internal Controls
| | --- | ----------------------------



In connection with the audit of our financial statements for fiscal year ended August 31, 2003 and the re-audit of our financial statements for the fiscal
year ended August 31, 2002, our current outside auditors have identified and brought to the attention of the audit committee what they consider to be material weaknesses in our internal controls relating to:



| |  | the non-compliance by various departments in submitting information in accordance with procedures to ensure proper and timely recording of accounts payable;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | family relationships among certain of our officers and employees; and
| | - | ---------------------------------------------------------------------



| |  | the failure to properly utilize the inventory software to track and report our inventory quantities on a real time basis;
| | - | -------------------------------------------------------------------------------------------------------------------------



| |  | the failure to properly account for stock options issued to non-employees; and
| | - | ------------------------------------------------------------------------------



| |  | lack of supervision, review and quality control related to the accounting for income taxes.
| | - | -------------------------------------------------------------------------------------------



Based on discussions with our outside auditors and the Audit Committee of our Board of Directors, we worked to identify the
nature, scope and materiality of the issues identified as material weaknesses in our internal controls and their impact on our fiscal year 2003 financial statements and to determine the extent to which these issues might adversely affect our
disclosure controls and procedures. Based on further detailed review of our internal controls as they relate to inventory and accounts payable during the fourth quarter of fiscal 2003, we determined that that the accounts payable process had failed
to record certain liabilities on a timely basis and the inventory management system had failed to track inventory on a continuous basis. We quantified this internal control weakness relating to accounts payable recordation by reconciling our
liabilities to our subsequent payments. We quantified the inventory process control weakness by taking complete physical inventories at the end of each quarter and reconciling the physical counts to our records.



The Company believes such deficiencies were attributable to the following
factors: the available software generally used in hospitals of our size is ineffective to properly track accounts payable and inventory and limited human resources in the Companys accounting and financial reporting function with which we
responded to the



85



---

Companys rapid growth in business operations during the course of fiscal year 2003.



We have implemented the following changes to our internal controls:



| |  | Beginning the first quarter of fiscal 2004 we switched to a more effective and reliable software system for consolidating financial information;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------



| |  | We have implemented a new software to more efficiently and timely calculate fixed assets both for book and tax purposes;
| | - | ------------------------------------------------------------------------------------------------------------------------



| |  | Our accounts payable data are now being entered into the system immediately;
| | - | ----------------------------------------------------------------------------



| |  | We have implemented more efficient and timely procedures for monthly closings;
| | - | ------------------------------------------------------------------------------



| |  | We have engaged our current outside auditors to prepare our income tax returns; and
| | - | -----------------------------------------------------------------------------------



| |  | Our board of directors has adopted a policy that prohibits any issuance of stock options to non-employees other than non-employee directors.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------



Correcting the identified material weaknesses and addressing the other issues
identified by our independent auditors, responding to the findings of the internal review and the independent investigation and continuously strengthening our internal controls and financial reporting capabilities are our highest priorities.



In light of these issues identified as material weaknesses and
the requirements enacted by the Sarbanes-Oxley Act of 2002 and the related rules and regulations adopted by the SEC, our Chief Executive Officer and Chief Financial Officer concluded that, as of August 31, 2003, there were material weaknesses and
deficiencies in our internal controls. Despite those material weaknesses and deficiencies in our internal controls as of such date, management believes that there are no material inaccuracies, or omissions of material facts necessary to make the
statements included in this report not misleading in light of the circumstances under which they are made.



In addition to identifying the internal control weaknesses relating to inventory and the accounts payable process, our outside auditors tested our other
internal controls to determine whether there were other such material weaknesses aside from the inventory and accounts payable weaknesses mentioned above that affected our financial statements for the fiscal year ended August 31, 2003. This
evaluation included substantial efforts to restate our 2002 and 2001 financial statements and to restate selected financial information for 2000 and 1999 and an effort to identify the internal controls over financial reporting that could or should
have prevented or mitigated the error. These efforts and the audit of the restated 2002 financial statements were designed to provide reasonable assurance that we have recorded all material adjustments. In particular, our outside auditors tested our
other internal controls by reviewing processes, analytical reviews and substantive testing and by reviewing disbursement activity subsequent to fiscal year-end 2003. Based on these tests, our auditors have advised us that they did not identify any
other material weaknesses in internal controls.



Our Audit
Committee and senior management are committed to a sound internal control environment. We have committed considerable resources to date on the aforementioned reviews and remedies. We are continuing our thorough review of our internal and disclosure
controls including, but not limited to, information technology systems and financial reporting as part of the Companys compliance with Section 404 of the Sarbanes-Oxley Act of 2002, but at this time we have not completed our review of the
existing controls and their effectiveness and, therefore, cannot assure you that these controls and procedures will fully satisfy the requirements of Section 404.



Other than the changes described above, there were no changes in the Companys internal control over financial
reporting during the Companys fiscal year ended August 31, 2003 that have materially affected, or are reasonably likely to materially affect, the Companys internal controls over financial reporting.



86



---

PART III



|Item 10. | Directors and Executive Officers of the Registrant
|-------- | --------------------------------------------------



The Board of Directors currently consists of six members. Pursuant to our Bylaws, the members of the Board of Directors serve for one-year terms.



Directors



Chiu M. Chan, age 51, has served as a director and as our
president, secretary, and chief executive officer since July 1992. Mr. Chan is a registered pharmacist and during the period from May 1978 to July 1992 was employed by various healthcare service organizations in Houston, Texas. Mr. Chan earned a
Bachelor of Science degree in Pharmacy from the University of Houston. Chiu M. Chan is not related to Philip S. Chan. Since January 2004, Mr. Chan has also been serving as our acting chief operating officer.



Philip S. Chan, age 53, has served as a director and as our
vice president of finance, chief financial officer, and treasurer since July 1992. Mr. Chan earned advanced accounting degrees from the University of Houston and is a CPA in the State of Texas. Prior to his employment with Dynacq, Mr. Chan has
previous corporate and outside accounting experience. Philip S. Chan is not related to Chiu M. Chan.



Stephen L. Huber, age 54, has served as a director of Dynacq since July 1992. Mr. Huber is a registered pharmacist and earned a Bachelor of
Science degree in Pharmacy from the University of Houston. Since December 1991, Mr. Huber served as the Deputy Division Head for patient care services at the University of Texas M.D. Anderson Cancer Center. Mr. Huber joined M.D. Anderson in 1984 as
Assistant Director of Operations. In 1999, Mr. Huber joined Cortex Communications, Inc., a medical education company, as president and chief operating officer. In 2001, Mr. Huber joined Medicus International, a global medical communications company
as its senior vice president. Mr. Huber continues to serve as a research consultant to M.D. Anderson.



Earl R. Votaw, age 77, has served as a director of Dynacq since July 1992. Mr. Votaw earned a Bachelor of Arts degree from the University of
the Americas in Mexico City and a certificate of graduation from the Graduate School of Mortgage Banking from Northwestern University of Chicago. Prior to his retirement in December 1993, Mr. Votaw served as a director and as the president and chief
executive officer of Capital Bank, a Texas chartered bank located in Houston, Texas, where he still serves as a director. Mr. Votaw also serves as a director of Capital Bancorp.



Ping S. Chu, age 53, has served as a director of Dynacq since May 2002. Dr. Chu received his Ph.D. degree in
chemistry from Massachusetts Institute of Technology before he went to medical school at the University of Miami, Florida. Dr. Chu finished his oncology training at M.D. Anderson Cancer Center in 1989 and has been in solo private practice since
completion. Dr. Chu is board certified in internal medicine and medical oncology.



James G. Gerace, age 66, has served as a director of Dynacq since January 2004. Mr. Gerace received his degree in Business Administration with a major in accounting from Texas A & M University in
1961. He is a Certified Public Accountant and mediator with more than thirty years of professional experience at public accounting firms, performing audits, tax planning and related services. He has served on the Board of Directors of several banks
and savings and loan associations and has maintained his own private CPA firm for approximately the last thirty-five years.



Audit Committee



The Board of Directors has a standing Audit Committee. The Audit Committee of the Board of Directors is currently comprised of Messrs. Huber, Votaw, Chu
and Gerace. The Board has determined that Mr. Gerace, who serves as the Chairman of the Audit Committee, qualifies as an audit committee financial expert as that term is defined by applicable SEC rules and that Mr. Gerace is independent
under the Nasdaq rules.



Executive Officers



The following sets forth the name, age, present title, principal occupation,
and certain biographical information for the past five years for our executive officers. Please refer to the director biographies of Messrs. Chiu Chan and Philip Chan.



87



---

James N. Baxter, age 62, has served as an executive vice president for Dynacq since July 2003. From April
to July 2003, Mr. Baxter was an independent consultant to Dynacq. From 1993 to 2003, Mr. Baxter was President of Global Investment Alliance Inc., a private company engaged in investments. From 1994 to 1999, Mr. Baxter was President of GIA Securities
Inc., a broker-dealer engaged in private placement finance.



Tammy Danberg-Farney, age 37, has served as an executive vice president, general counsel for Dynacq since December 2003. From 1995 to 2001, Ms. Danberg-Farney served as an associate with the Carter Law Firm; from 2001 to 2002 she maintained
her own private law practice; from 2002-2003 she served as counsel at the law firm of Fulbright & Jaworski L.L.P. and from August 2003 to December 2003, she served as a staff attorney at Doctors Practice Management, Inc., a wholly-owned
subsidiary of the Company.



Richard D. Valentine, age 49, has
served as Director of Operations and Development for Dynacq since January 2004. From April 2002 to January 2004, Mr. Valentine served as Vice President of Marketing and Operations for Dynacq. Mr. Valentine served as CEO and co-owner of Pine Haven
Healthcare from 1996-2000. In addition, Mr. Valentine served as CEO and co-owner of Houston Community Hospital from 2000-2002.



Code of Ethics



The Company has adopted a code of ethics that applies to its principal executive officer, principal financial officer, principal accounting officer or
controller, or persons performing similar functions. The Company has filed a copy of its code of ethics as an exhibit to this report.



Section 16(a) Beneficial Ownership Reporting Compliance



Section 16(a) of the Exchange Act requires our directors, executive officers, and the persons who beneficially own more than ten percent of our common
stock, to file reports of ownership and changes in ownership with the Securities and Exchange Commission. Copies of all filed reports are required to be furnished to us. Based solely on the reports received by us and on the representations of the
reporting persons, we believe that these persons have complied with all applicable filing requirements during the fiscal year ended August 31, 2003, except: (a) Mr. Philip S. Chan failed to timely file a Form 4 to report one transaction in August
2003, (b) Ms. Garvin failed to timely file a Form 4 to report one transaction in June 2003, and (c) Mr. Baxter failed to timely file a Form 3 in July 2003.



|Item 11. | Executive Compensation
|-------- | ----------------------



Compensation of Directors



Messrs. Chiu M. Chan and Philip S. Chan receive compensation only as officers of Dynacq. Commencing January 2003, Messrs. Chu, Votaw and Huber began to
receive a fee of $1,200 per month in exchange for their service on the Audit Committee. Effective January 2004, the board of directors appointed Mr. James G. Gerace as an independent director, and increased the stipend for all the independent
directors to $5,000 per month.



From September 2002 until
December 2002, Mr. Huber received $4,000 for consulting services. Mr. Huber no longer receives any consulting fees.



88



---

Executive Compensation



The following table contains compensation data for our named executive officers for the fiscal years ended August 31, 2003, 2002, and 2001.



SUMMARY COMPENSATION TABLE



|                                       |  |      |  |                         |  |          |                             |                             |     |  |                                 |     |  |                      
|-------------------------------------- |  | ---- |  | ----------------------- |  | -------- | --------------------------- | --------------------------- | --- |  | ------------------------------- | --- |  | ---------------------
|                                       |  |      |  | Annual Compensation (1) |  |          | Long TermCompensationAwards |                             |     | 
|Name and Principal Position            |  | Year |  | Salary($)               |  | Bonus($) |                             | Other AnnualCompensation($) |     |  | SecuritiesUnderlyingOptions (#) |     |  | All OtherCompensation
|Chiu M. Chan,                          |  | 2003 |  | 180,000                 |  |         |                             |                             |     |  |                                |     |  |                      
|President and CEO                      |  | 2002 |  | 180,000                 |  |         |                             |                             |     |  |                                |     |  |                      
|                                       |  | 2001 |  | 180,000                 |  |         |                             |                             |     |  | 200,000                         | (2) |  |                      
|                                       |  |      |  |                         |  |         
|Philip S. Chan, CFO                    |  | 2003 |  | 180,000                 |  |         |                             |                             |     |  |                                |     |  |                      
|                                       |  | 2002 |  | 180,000                 |  |         |                             |                             |     |  |                                |     |  |                      
|                                       |  | 2001 |  | 180,000                 |  |         |                             |                             |     |  | 220,000                         | (2) |  |                      
|                                       |  |      |  |                         |  |         
|Sarah C. Garvin(3)                     |  | 2003 |  | 180,000                 |  |         |                             | 18,000                      | (4) |  |                                |     |  |                      
|                                       |  | 2002 |  | 180,000                 |  |         |                             | 15,000                      | (4) |  |                                |     |  |                      
|                                       |  | 2001 |  | 120,000                 |  |         |                             | 9,000                       | (4) |  | 200,000                         | (2) |  |                      
|                                       |  |      |  |                         |  |         
|Irvin T. Gregory(5)                    |  | 2003 |  | 180,000                 |  |         |                             | 26,500                      | (6) |  |                                |     |  |                      
|                                       |  | 2002 |  | 180,000                 |  |         |                             | 28,200                      | (6) |  |                                |     |  |                      
|                                       |  | 2001 |  | 120,000                 |  |         |                             | 28,350                      | (6) |  | 200,000                         | (2) |  |                      
|                                       |  |      |  |                         |  |         
|Richard D. Valentine                   |  | 2003 |  | 175,000                 |  |         |                             |                             |     |  |                                |     |  |                      
|Director of Operations and Development |  | 2002 |  | 123,958                 |  |         |                             |                             |     |  | 100,000                         | (7) |  |                      



|(1) | Excludes perquisites and other personal benefits unless such compensation was greater than $50,000 or 10% of the total annual salary and bonus of the individual.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------



|(2) | Represents individual option grants made in December 2000, with exercise prices of $4.4375 per share, expiring in December 2005, which vested as follows: (a) 60,000
shares in December 2001, (b) 60,000 shares in December 2002, and (c) 80,000 shares in December 2003. Mr. Philip S. Chan received an additional option grant for 20,000 shares in December 2000.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(3) | Ms. Garvin resigned from her position as Executive Vice President and Chief Operating Officer
in February 2004.
|--- | ---------------------------------------------------------------------------------------------------------------



|(4) | Represents auto allowance.
|--- | --------------------------



|(5) | Mr. Gregory resigned from his position as Executive Vice President and Chief Development Officer in September 2003.
|--- | -------------------------------------------------------------------------------------------------------------------



|(6) | Represents auto, rent and other allowances.
|--- | -------------------------------------------



|(7) | Represents an option to purchase 100,000 shares, with an exercise price of $6.07 per share, which was $9.09 less than the market price on the grant date, vesting 20%
for each of the five years vesting period starting April 14, 2003 through April 14, 2007.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



89



---

Stock Options



The following table sets forth information concerning the option issuances to our named executive officers for the fiscal year ended August 31, 2003.



OPTION GRANTS
IN LAST FISCAL YEAR



|                     |  |                                                      |  |                                                                                           |  |                             |  |                |  |       |  |       
|-------------------- |  | ---------------------------------------------------- |  | ----------------------------------------------------------------------------------------- |  | --------------------------- |  | -------------- |  | ----- |  | ------
|                     |  | Individual Grants                                    |  | PotentialRealizableValue atAssumedAnnualRates ofStock PriceAppreciationfor OptionTerm (1)
|Name                 |  | Number ofSecuritiesUnderlyingOptions/SARsGranted (#) |  | Percent ofTotal Options /SARs Grantedto Employeesin Fiscal Year                           |  | Exercise orBase Price($/Sh) |  | ExpirationDate |  | 5%($) |  | 10%($)
|Chiu M. Chan         |  |                                                     |  |                                                                                          |  |                            |  |               |  |      |  |      
|Philip S. Chan       |  |                                                     |  |                                                                                          |  |                            |  |               |  |      |  |      
|Sarah C. Garvin(2)   |  |                                                     |  |                                                                                          |  |                            |  |               |  |      |  |      
|Irvin T. Gregory(3)  |  |                                                     |  |                                                                                          |  |                            |  |               |  |      |  |      
|Richard D. Valentine |  |                                                     |  |                                                                                          |  |                            |  |               |  |      |  |      



|(1) | The 5% and 10% assumed rates of appreciation are prescribed by the rules and regulations of the SEC and do not represent our estimate or projection of the future
trading prices of our common stock. We can provide no assurance that any of the values reflected in this table will be achieved.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(2) | Ms. Garvin resigned from her position as Executive Vice President and Chief Operating Officer in February 2004.
|--- | ---------------------------------------------------------------------------------------------------------------



|(3) | Mr. Gregory resigned from his position as Executive Vice President and Chief Development
Officer in September 2003.
|--- | -------------------------------------------------------------------------------------------------------------------



The following table
sets forth information concerning option exercises during the fiscal year ended August 31, 2003 and option holdings as of August 31, 2003 with respect to our named executive officers.



AGGREGATED OPTION EXERCISES IN LAST
FISCAL YEAR AND FY-END OPTION VALUES



|                     |  |                             |  |                     |  |                                                                 |  |                                                         |  |             |  |                 
|-------------------- |  | --------------------------- |  | ------------------- |  | --------------------------------------------------------------- |  | ------------------------------------------------------- |  | ----------- |  | ----------------
|Name                 |  | SharesAcquiredonExercise(#) |  | ValueRealized($)(2) |  | Number of SecuritiesUnderlying UnexercisedOptions at FY-End (#) |  | Value of Unexercised In-the-Money Options at FY-End ($)
|                     |  |                             |  |                     |  | Exercisable                                                     |  | Unexercisable                                           |  | Exercisable |  | Unexercisable(1)
|Chiu M. Chan         |  |                            |  |                    |  | 120,000                                                         |  | 80,000                                                  |  | 2,370,300   |  | 1,580,200       
|Philip S. Chan       |  | 22,500                      |  | 434,555             |  | 117,500                                                         |  | 80,000                                                  |  | 2,320,919   |  | 1,580,200       
|Sarah C. Garvin(3)   |  | 120,000                     |  | 1,236,640           |  |                                                                |  | 80,000                                                  |  |            |  | 1,580,200       
|Irvin T. Gregory(4)  |  | 77,466                      |  | 935,737             |  |                                                                |  | 80,000                                                  |  |            |  | 1,580,200       
|Richard D. Valentine |  |                            |  |                    |  | 20,000                                                          |  | 80,000                                                  |  | 362,400     |  | 1,449,600       



|(1) | Based on the fair market value of our common stock on August 29, 2003 of $24.19 per share less the exercise price payable for such shares.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------



|(2) | Based on the fair market value of our common stock on the respective dates of exercise less the exercise price payable for such shares.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------



|(3) | Ms. Garvin resigned from her position as Executive Vice President and Chief Operating Officer
in February 2004.
|--- | ---------------------------------------------------------------------------------------------------------------



|(4) | Mr. Gregory resigned from his position as Executive Vice President and Chief Development Officer in September 2003.
|--- | -------------------------------------------------------------------------------------------------------------------



90



---

Employment Contracts and Change-In-Control Arrangements



Mr. Baxter entered into a three-year employment agreement with Dynacq in
August 2003, which provides for a base salary of $160,000 per year and an automobile allowance of $20,000 per year. The employment agreement also provides for the payment of relocation expenses in the amount of $10,000 and country club membership
fees, as well as participation in employee benefit plans offered by the Company to its officers. Mr. Baxters compensation also includes an option to purchase 100,000 shares of common stock, with an exercise price of $17.75 per share, vesting
as follows: (a) 30,000 shares on July 31, 2004, (b) 30,000 shares on July 31, 2005 and (c) 40,000 shares on July 31, 2006. Upon termination of employment, any vested options may be exercised for 90 days after the date of termination and then will
lapse. In addition, if Mr. Baxter is terminated without cause, he will receive six months severance pay and will have three months after the date of termination to exercise a portion of the options which would have been exercisable following the
year the termination occurred determined by multiplying the fraction, the numerator of which is the total number of days of employment in the applicable year of termination divided by 365 days, multiplied by the total number of options which would
have vested that year.



Ms. Danberg-Farney entered into a
two-year employment agreement with DPMI on August 1, 2003, which will automatically renew for additional two-year terms unless written notice is given by either party 30 days prior to the expiration of the initial or any subsequent term. The
employment agreement provides for an initial annual salary of $120,000 for the first 90 days of employment, which increased to $150,000 after such initial 90-day period. The employment agreement also provides for participation in employee benefit
plans offered by the Company to its officers. Ms. Danberg-Farneys compensation also includes an option to purchase up to 100,000 shares of Dynacqs common stock, which will vest in increments of 20,000 shares on each August 1stfollowing her start date and have an exercise price of $17.75, the average price per share of Dynacq common stock on August 1,
2003. Upon termination of employment, any vested options may be exercised within 90 days after the date of termination and then will lapse. In addition, if Ms. Danberg-Farney is terminated for cause, her rights to exercise any vested options will be
terminated.



Mr. Valentine entered into a five-year employment
agreement with Dynacq in April 2002, which provides for a base salary of $175,000 per year and the opportunity to receive an annual bonus of 50% of his annual salary based on objective performance parameters, the satisfaction of such parameters
determined in the discretion of the Board of Directors. The employment agreement also provides an automobile allowance of $750 per month, as well as participation in employee benefit plans offered by the Company to its employees. Mr.
Valentines compensation also includes an option to purchase 100,000 shares of common stock of the Company, the terms of which are described in footnote 6 to the Summary Compensation Table. The employment agreement provides that, if
the Company enters into employment or incentive agreements with its key employees, Mr. Valentine will have the opportunity to negotiate for substantially equivalent terms. The employment agreement also contains a covenant not to compete with the
Company during the period of employment and for a period of two years following the termination for any reason. If Mr. Valentine is terminated for cause, he will be entitled to receive his base salary on a pro rata basis to the date of termination.
If Mr. Valentine is terminated without cause, he will receive six months severance pay, he will have three months after the date of termination to exercise any outstanding options (which will immediately vest on the date of such termination without
cause), and the non-competition covenant contained in his employment agreement will be terminated. In the event of a change of control, as defined in the employment agreement, all of Mr. Valentines outstanding options will immediately vest and
become exercisable and, if he is terminated within six months following such change of control, Mr. Valentine will receive six months severance pay in addition to the consideration for his non-competition covenant equal to 18 months salary, if the
covenant is not waived by the Company or its successor.



Ms.
Garvin, who resigned from her position as an executive officer in February 2004, had entered into a three-year employment agreement with Dynacq in December 2000, which provided for a base salary of $120,000. Pursuant to that agreement, Ms. Garvin
received an expense allowance and an automobile allowance. Ms. Garvins compensation included an option to purchase 200,000 shares of common stock, which were fully vested prior to Ms. Garvins resignation and which are described in the
Summary Compensation Table. The employment agreement provided for the accelerated vesting of options if Ms. Garvin was terminated without cause, or if a change of control of the Company occurred. In addition, if Ms. Garvin had been
terminated without cause, she would have received a severance payment of $60,000. Upon the expiration or termination of the employment agreement, Dynacq had the option of exercising a non-compete provision, which would have prevented Ms. Garvin from
competing with the



91



---

Company for a period of two years, in exchange for payment, on a monthly basis, of Ms. Garvins base salary on termination for the non-compete
period.Upon the expiration of her employment agreement, Ms. Garvin remained as an executive officer until February 2004 when she resigned from her position and entered into a 30-month consulting agreement with the Company. She will continue
to assist the Company on a consulting basis and will receive $10,500 per month for 18 months and $10,000 per month for the remaining 12 months of the agreement. The Consulting Agreement provides that Ms. Garvin shall not directly compete against the
Company within a 25 mile radius of any location where the Company currently operates or currently intends to operate for the duration of the Consulting Agreement.



Mr. Gregory, who resigned from his position as an executive officer in September 2003, but remained as an employee of the
Company until January 2004, had entered into a three-year employment agreement with Dynacq in December 2000, on the same terms and conditions as Ms. Garvin. The Company did not exercise its option to require a non-compete period.



Our 2000 Stock Option Plan provides for accelerated vesting of the shares of
common stock subject to outstanding options in connection with certain changes in control of Dynacq.



Compensation Committee Interlocks and Insider Participation



The Compensation Committee, which recommends compensation levels for our executive officers and is authorized to consider and make grants of options
pursuant to any approved stock option plan and to administer the plans, is comprised of Messrs. Gerace, Huber, Votaw and Dr. Chu. None of these gentlemen have been an officer or employee of Dynacq or any of its subsidiaries.



92



---

|Item 12. | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
|-------- | ----------------------------------------------------------------------------------------------



As of June 30, 2004, 14,852,072 shares of our common stock were outstanding. The following table sets forth, as of June 30,
2004, information with respect to shares beneficially owned by: (a) each person who is known by us to be the beneficial owner of more than 5% of our outstanding shares of common stock, (b) each of our directors and the named executive officers named
in the Summary Compensation Table below, and (c) all current directors and executive officers as a group.



Beneficial ownership has been determined in accordance with Rule 13d-3 under the Exchange Act. Under this rule, some shares may be deemed to be
beneficially owned by more than one person (if, for example, persons share the power to vote or the power to dispose of the shares). In addition, shares are deemed to be beneficially owned by a person if the person has the right to acquire shares
(for example, upon exercise of an option) within sixty days of the date as of which the information is provided. In computing the percentage ownership of any person, the amount of shares is deemed to include the amount of shares beneficially owned
by such person by reason of such acquisition rights. As a result, the percentage of outstanding shares of any person as shown in the following table does not necessarily reflect the persons actual voting power at any particular date.



To our knowledge, except as indicated in the footnotes to this
table and pursuant to applicable community property laws, the persons named in the table have sole voting and investing power with respect to all shares of common stock shown as beneficially owned by them. All share numbers reflect two separate
two-for-one stock dividends effected January 2000 and March 2001.



|                                                             |  |                                              |     |  |                 |  
|------------------------------------------------------------ |  | -------------------------------------------- | --- |  | --------------- | -
|                                                             |  | SHARES BENEFICIALLYOWNED AS OF JUNE 30, 2004 |    
|BENEFICIAL OWNER(1)                                          |  | NUMBER OFSHARES(2)                           |     |  | PERCENT OFCLASS |  
|Chiu M. Chan                                                 |  | 8,803,131                                    | (3) |  | 56.8            | %
|Philip S. Chan                                               |  | 517,744                                      | (4) |  | 3.3             | %
|Stephen L. Huber                                             |  | 20,000                                       | (5) |  | Less than 1     | %
|Earl R. Votaw                                                |  | 36,800                                       |     |  | Less than 1     | %
|Ping S. Chu                                                  |  | 196,973                                      | (6) |  | 1.3             | %
|James G. Gerace                                              |  |                                             |     |  |                | %
|Richard D. Valentine                                         |  | 20,000                                       |     |  | Less than 1     | %
|Sarah C. Garvin(7)                                           |  |                                             |     |  |                | %
|Irvin T. Gregory(8)                                          |  | 58,466                                       |     |  | Less than 1     | %
|All directors and executive officers as a group (11 persons) |  | 9,705,114                                    | (9) |  | 62.7            | %

---

|(1) | The address for each named person is 10304 Interstate 10 East, Houston, Texas 77029.
|--- | ------------------------------------------------------------------------------------



|(2) | Beneficial ownership is determined in accordance with SEC rules, and includes shares of stock underlying outstanding options that are currently exercisable or will
become exercisable within 60 days of June 30, 2004.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(3) | Includes 200,000 shares underlying options, which are currently exercisable, 1,610,205 shares held by Mr. Chans spouse and 204,811 shares held by Mr.
Chans son.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(4) | Includes 197,500 shares underlying options, which are currently exercisable.
|--- | ----------------------------------------------------------------------------



|(5) | Consists of options to purchase 20,000 shares of common stock, which are currently exercisable.
|--- | -----------------------------------------------------------------------------------------------



|(6) | Includes 404 shares held by one of Dr. Chus daughters and 404 shares held by another of Dr. Chus daughters.
|--- | -------------------------------------------------------------------------------------------------------------



|(7) | Ms. Garvin resigned from her position as Executive Vice President and Chief Operating Officer in February 2004.
|--- | ---------------------------------------------------------------------------------------------------------------



|(8) | Mr. Gregory resigned from his position as Executive Vice President and Chief Development Officer in September 2003.
|--- | -------------------------------------------------------------------------------------------------------------------



|(9) | Includes 487,500 shares underlying options, which are currently exercisable.
|--- | ----------------------------------------------------------------------------



93



---

SECURITIES TO BE ISSUED UNDER EQUITY COMPENSATION PLANS



The following table sets forth, as of August 31, 2003, the number of shares
of our common stock that may be issued upon the exercise of outstanding options issued under equity compensation plans, the weighted average exercise price of those options and the number of shares of common stock remaining available for future
issuance under equity compensation plans.



|                                                                                       |  |                                                                                             |  |                                                                              |  |                                                                                                                                          
|-------------------------------------------------------------------------------------- |  | ------------------------------------------------------------------------------------------- |  | ---------------------------------------------------------------------------- |  | -----------------------------------------------------------------------------------------------------------------------------------------
|Plan Category                                                                          |  | (a) Number of Securities tobe Issued UponExercise of OutstandingOptions, Warrants andRights |  | (b) Weighted-AverageExercise Price ofOutstanding Options,Warrants and Rights |  | (c) Number of SecuritiesRemaining Available forFuture Issuance underEquity CompensationPlans (excludingsecurities reflected incolumn (a))
|Equity Compensation Plans approved by security holders:                                |  |                                                                                             |  |                                                                              |  |                                                                                                                                          
|                                                                                       |  |                                                                                             | 
|      2000 Stock Incentive Plan                                                       |  | 1,116,511                                                                                   |  | 8.45                                                                         |  | 3,452,318                                                                                                                                
|Equity Compensation Plan not approved by security holders:                             |  |                                                                                             |  |                                                                              |  |                                                                                                                                          
|                                                                                       |  |                                                                                             | 
|      1995 Non-Qualified Stock Option Plan for Consultants and Non-Employee Directors |  | 84,000                                                                                      |  | 5.49                                                                         |  | 344,828                                                                                                                                  
|Total                                                                                  |  | 1,200,511                                                                                   |  | 8.25                                                                         |  | 3,797,146                                                                                                                                



The 1995 Non-Qualified
Stock Option Plan for Consultants and Non-Employee Directors authorizes the issuance of non-qualified stock options to purchase up to 1,000,000 (after adjusting for stock splits) shares of our common stock to consultants and non-employee directors
of the Company and its subsidiaries. The table above sets forth the number of shares subject to outstanding options and the number of shares remaining available for issuance under this plan. The board of directors may determine the terms of the
options granted under the plan, except that the plan specifically provides that:



| |  | the exercise price of the option may not be less than 100% of the fair market value of our common stock on the date of the grant,
| | - | ---------------------------------------------------------------------------------------------------------------------------------



| |  | no option granted under the plan will be exercisable prior to six months from the date of grant,
| | - | ------------------------------------------------------------------------------------------------



| |  | in the event of a participants death, options that vested prior to the participants death may be exercised by a participants personal representative for one year
after death,
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | in the event that a participant ceases to be a consultant or a director of the Company, options that vested prior to such termination are exercisable remain exercisable for 30 days
after the termination, and
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | no stock option is exercisable more than 10 years after the date of grant.
| | - | --------------------------------------------------------------------------



|Item 13. | Certain Relationships and Related Transactions
|-------- | ----------------------------------------------



The Company had previously leased 1,000 square feet of office space for its executive offices on a month-to-month basis for $1,286 per month. As of
September 1, 2003, the Company increased its leased space to approximately 7,250 square feet and entered into an 8 year lease for this office space. The Company will pay $1,286 per month for the first year of the lease and $6,525 per month for the
remainder of the lease term. The lessor of the office space is Capital Bank, of which Mr. Earl Votaw, one of the Companys directors, is a director. Management believes that the lease rate being paid is consistent with comparable commercial
rates available in the area.



94



---

The Company leased a residential house to its Chief Executive Officer (CEO), Mr. Chiu M. Chan at a
monthly rate of $1,400 per month through April 2003. In April 2003, the Company consummated the sale of a house to Chiu M. Chan. The house was sold to Mr. Chan in exchange for the transfer of his right to receive 25,639 shares of Dynacq common stock
held by Mr. Chan. The contract, which was signed on April 10, 2003, valued the property at $311,740, which was 10% more than the 2002 appraised value of $283,400. The shares of common stock were valued at 90% of the closing price of Dynacq common
stock on April 10, 2003. In addition, the Company paid the 2003 property taxes.



Seven members of Mr. Chiu Chans immediate family (four brothers-in-law and three sisters-in-law), are employed by the Company or its subsidiaries. Such family members received an aggregate of $279,528 in
compensation from the Company or its subsidiaries in fiscal year 2003, or 1.9% of the total Company payroll.



Three members of Mr. Philip Chans immediate family (his sister and two sister-in-laws) are employed by the Company or its subsidiaries. Such family
members received an aggregate of $106,700 in compensation from the Company or its subsidiaries in fiscal year 2003, or 0.7% of the total Company payroll.



In late January 2004, just prior to Mr. Gregorys departure from the Company but after he ceased to be an executive officer of the Company, the
Company completed the sale of its land for the previously proposed hospital site in Slidell, Louisiana to HealthGroup Partners, L.L.C. for $2.5 million, resulting in a small profit. We had determined that the Slidell hospital project was no longer
consistent with our current business plan. At the time of the transaction, Mr. Gregory was an investor in Healthgroup Partners, L.L.C. and is now the President and CEO.



Since May 2002, when Dr. Ping Chu became a director, he has paid the Company $26,870 and $17,631 during fiscal years ended
August 31, 2003 and 2002, respectively for rent and management fees. As of August 31, 2003 and 2002, the Company had accounts receivable from Dr. Chu of $22,277 and $99,476, respectively. Included in the accounts receivable balance were amounts
applicable to Dr. Chus staffs payroll for which he reimburses the Company in the ordinary course of business. Dr. Chu is currently a member of our audit committee.



|Item 14. | Principal Accounting Fees and Services
|-------- | --------------------------------------



Aggregate fees for professional services rendered by KenWood & Associates, P.C. (KenWood) and Ernst & Young LLP for the fiscal years ended August
31, 2002 and 2003, were as follows:



|               |  |      |         |     |      |   |         |    
|-------------- |  | ---- | ------- | --- | ---- | - | ------- | ---
|               |  | 2002 |         |     | 2003 |  
|Audit Fee      |  | $    | 262,400 | (1) |      | $ | 435,700 | (2)
|Tax Fees       |  |      | 9,700   |     |      |   |        |    
|All Other Fees |  | $    | 115,700 |     |      | $ | 67,460  |    



|(1) | Of this amount, $208,000 represents fees paid to Ernst & Young for professional services
rendered for the audit of our annual financial statements for the fiscal year ended August 31, 2002 and the review of the financial statements included in our quarterly report for the fiscal quarter ended May 31, 2002. During the fiscal year ended
August 31, 2002, KenWood provided professional services in connection with the reviews of the financial statements included in our quarterly reports for the periods ended November 30, 2001 and February 28, 2002, and the aggregate fees billed by
KenWood for such services was $54,400.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(2) | Of this amount, $410,145 represents fees paid to Ernst & Young for
professional services rendered for the audit of our annual financial statements for the fiscal year ended August 31, 2003 and the review of the financial statements included in our quarterly reports for the fiscal quarters ended November 30, 2002,
February 28, 2003 and May 31, 2003. During the fiscal year ended August 31, 2003, KenWood provided professional services in connection with the reviews of the financial statements included in our quarterly
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



95



---

| | reports for the periods prior to February 28, 2002, and the aggregate fees billed by KenWood for such services was $25,553.
| | ---------------------------------------------------------------------------------------------------------------------------



Audit Fees for the fiscal years ended August 31, 2002 and 2003
represent the aggregate fees billed for professional services rendered by Ernst & Young and KenWood, as applicable, for the audit of our annual financial statements and review of financial statements included in our quarterly reports on Form
10-Q or services that are normally provided in connection with statutory and regulatory filings or engagements for those fiscal years.



Tax-Related Fees for the fiscal years ended August 30, 2002 and 2003, represent the aggregate fees billed for professional services rendered by
Ernst & Young for tax compliance.



All Other Fees
for the fiscal years ended August 31, 2002 and 2003, represent the aggregate fees billed for services rendered by Ernst & Young, for litigation support services.



Audit Committee Pre-Approval Policies and Procedures



All audit and non-audit services performed by the independent auditor are pre-approved by the Audit Committee, which
considers, among other things, the possible effect of the performance of such services on the auditors independence. The Audit Committees charter provides that the Audit Committee may delegate to any of its members the authority to
pre-approve any services performed by the independent auditor, provided that such approval is presented to the Audit Committee at its next scheduled meeting. All of the audit-related, tax and all other services described above were pre-approved by
the full Audit Committee.



|Item 15. | Exhibits, Financial Statements, Schedules, and Reports on Form 8-K
|-------- | ------------------------------------------------------------------



(a)(1) Financial Statements: See Index to Consolidated Financial Statements under Item 8 on Page 49 of this Report.



(a)(2) Financial Statement Schedule: See Schedule II on Page 82 of this
Report.



(a)(3) Exhibits. The following exhibits are to be
filed as part of the annual report:



|              |  |                                                                                                                                                                                                         
|------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|EXHIBIT NO.   |  | IDENTIFICATION OF EXHIBIT                                                                                                                                                                               
|              | 
|Exhibit   3.1 |  | Certificate of Incorporation, incorporated by reference to the Definitive Information Statement filed October 21, 2003, SEC File No. 000-21574.                                                         
|              | 
|Exhibit   3.2 |  | Bylaws, incorporated by reference to the Definitive Information Statement filed October 21, 2003, SEC File # 222-21574.                                                                                 
|              | 
|Exhibit 10.1  |  | 1995 Non-Qualified Stock Option Plan for Consultants and Non-Employee Directors, filed with the Companys Annual Report on Form 10-K for the fiscal year 1996.                                          
|              | 
|Exhibit 10.2  |  | The Companys Year 2000 Stock Incentive Plan adopted on August 29, 2000, and incorporated by reference as Appendix B from the Companys Definitive Proxy Statement on Schedule 14A
filed August 9, 2000.
|              | 
|Exhibit 10.3  |  | Purchase Agreement entered into by and among the Company and Charis Hospital, LLC, filed with the Companys Annual Report on Form 10-KSB for the fiscal year 2001.                                      
|              | 
|Exhibit 10.4  |  | Unimproved Commercial Property Earnest Money Contract dated August 30, 2002 relating to purchase of Raw Land in The Woodlands, Texas.                                                                   
|              | 
|Exhibit 10.5  |  | Second Amendment to Unimproved Commercial Property Earnest Money Contract dated December 4, 2002 relating to purchase of Raw Land in The Woodlands, Texas.                                              
|              | 
|Exhibit 10.6  |  | General Warranty Deed by Vision Park Joint Venture to Vista Land Equipment, L.L.C. dated December 9, 2002                                                                                               
|              | 
|Exhibit 10.7  |  | Hospital Program Management Agreement dated November 15, 2002 between the Company and Vital Weight Control, Inc.                                                                                        



96



---

|              |  |                                                                                                                                                                                 
|------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|EXHIBIT NO.   |  | IDENTIFICATION OF EXHIBIT                                                                                                                                                       
|              | 
|Exhibit 10.8  |  | Cash Sale of Raw Land in Slidell, Louisiana dated February 18, 2003.                                                                                                            
|              | 
|Exhibit 10.9  |  | Asset Purchase Agreement dated June 30, 2003 between Tomaszek Management L.L.C. and Vista Land And Equipment.                                                                   
|              | 
|Exhibit 10.10 |  | Asset Purchase Agreement dated July 31, 2003 relating to the Garland facility.                                                                                                  
|              | 
|Exhibit 10.11 |  | Bill of Sale dated August 29, 2003 for equipment relating to the Garland facility.                                                                                              
|              | 
|Exhibit 10.12 |  | Management Support and Marketing Agreement dated October 15, 2003 between the Company and Medical Multimedia Advertising, Inc. and Addendum thereto.                            
|              | 
|Exhibit 10.13 |  | Cash Sale Agreement of Raw Land in Slidell, Louisiana dated January 23, 2004.                                                                                                   
|              | 
|Exhibit 10.14 |  | Consulting Agreement dated February 1, 2004 between Sarah Garvin and the Company.                                                                                               
|              | 
|Exhibit 10.15 |  | Employment Agreement dated August 1, 2003 between James Baxter and the Company.                                                                                                 
|              | 
|Exhibit 10.16 |  | Employment Agreement dated April 15, 2002 between Richard D. Valentine and the Company.                                                                                         
|              | 
|Exhibit 10.17 |  | Employment Agreement dated August 1, 2003 between Tammy Danberg-Farney and the Company.                                                                                         
|              | 
|Exhibit 10.18 |  | WCMA Reducing Revolver Loan and Security Agreement No. 582-07653 dated as of May 18, 2001 between Dynacq International, Inc. and Merrill Lynch Business Financial Services,
Inc.
|              | 
|Exhibit 14.1  |  | Code of Ethics for Principal Executive and Senior Financial Officers.                                                                                                           
|              | 
|Exhibit 21.1  |  | Listing of subsidiaries.                                                                                                                                                        
|              | 
|Exhibit 23.1  |  | Consent of Killman, Murrell and Company, P.C.                                                                                                                                   
|              | 
|Exhibit 31.1  |  | Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                             
|              | 
|Exhibit 31.2  |  | Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                             
|              | 
|Exhibit 32.1  |  | Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                              
|              | 
|Exhibit 32.2  |  | Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                              
|              | 
|Exhibit 99.1  |  | Audit Committee Charter                                                                                                                                                         



(b) Reports on Form
8-K. The Company filed the following reports on Form 8-K during the last quarter of the period covered by this report:



| |  | On July 17, 2003 pursuant to Item 12 of the report containing a copy of the Companys press release dated July 14, 2003 titled Dynacq Reports 52% Increase in Third
Quarter Net Income to $6.3 Million.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | On August 1, 2003 pursuant to Item 9 of the report containing a copy of the Companys press release dated July 31, 2003 titled Dynacq Comments on News Reports Regarding
New Baton Rouge HospitalTexas Judge Orders Withdrawal of Louisiana Motion to Sequester Equipment.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | On August 1, 2003 pursuant to Item 9 of the report containing a copy of the Companys press release dated August 1, 2003 titled Dynacq Agrees to Acquire Hospital in
Dallas-Ft. Worth Area.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | On August 19, 2003 pursuant to Item 9 of the report containing a copy of the Companys press release dated August 18, 2003 titled Dynacq Affiliate Acquires Dallas-Ft.
Worth HospitalFortune Names Dynacq Ninth Fastest Growing Company in America.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | On August 29, 2003 pursuant to Item 9 of the report containing a copy of the Companys press release dated August 27, 2003 titled Federal Judge Dismisses Class Action
against Dynacq International.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



97



---

SIGNATURES



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



Dynacq Healthcare, Inc.Date: July 30, 2004

By:

/s/    CHIU M. CHANChiu M. Chan, President






Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.



|                                             |  |                                                        |  |              
|-------------------------------------------- |  | ------------------------------------------------------ |  | -------------
|Signature                                    |  | Title                                                  |  | Date         
|                                             |  |                                                       
|/s/    CHIU M. CHANChiu M. Chan              |  | Chairman of the Board, CEO, President, and Secretary   |  | July 30, 2004
|(Principal Executive Officer)                |  |                                                        |  |              
|                                             |  |                                                       
|/s/    PHILIP S. CHANPhilip S. Chan          |  | Director, Vice President - Finance, CFO, and Treasurer |  | July 30, 2004
|(Principal Financial and Accounting Officer) |  |                                                        |  |              
|                                             |  |                                                       
|/s/    STEPHEN L.
HUBERStephen L.
Huber      |  | Director                                               |  | July 30, 2004
|                                             |  |                                                       
|/s/    EARL R. VOTAWEarl R. Votaw            |  | Director                                               |  | July 30, 2004
|                                             |  |                                                       
|/s/    PING S. CHUPing S. Chu                |  | Director                                               |  | July 30, 2004
|                                             |  |                                                       
|/s/    JAMES G. GERACEJames G. Gerace        |  | Director                                               |  | July 30, 2004



98



---

EXHIBIT INDEX



|              |  |                                                                                                                                                                                                         
|------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|EXHIBIT NO.   |  | IDENTIFICATION OF EXHIBIT                                                                                                                                                                               
|              | 
|Exhibit   3.1 |  | Certificate of Incorporation, incorporated by reference to the Definitive Information Statement filed October 21, 2003, SEC File No. 000-21574.                                                         
|              | 
|Exhibit   3.2 |  | Bylaws, incorporated by reference to the Definitive Information Statement filed October 21, 2003, SEC File # 222-21574.                                                                                 
|              | 
|Exhibit 10.1  |  | 1995 Non-Qualified Stock Option Plan for Consultants and Non-Employee Directors, filed with the Companys Annual Report on Form 10-K for the fiscal year 1996.                                          
|              | 
|Exhibit 10.2  |  | The Companys Year 2000 Stock Incentive Plan adopted on August 29, 2000, and incorporated by reference as Appendix B from the Companys Definitive Proxy Statement on Schedule 14A
filed August 9, 2000.
|              | 
|Exhibit 10.3  |  | Purchase Agreement entered into by and among the Company and Charis Hospital, LLC, filed with the Companys Annual Report on Form 10-KSB for the fiscal year 2001.                                      
|              | 
|Exhibit 10.4  |  | Unimproved Commercial Property Earnest Money Contract dated August 30, 2002 relating to purchase of Raw Land in The Woodlands, Texas.                                                                   
|              | 
|Exhibit 10.5  |  | Second Amendment to Unimproved Commercial Property Earnest Money Contract dated December 4, 2002 relating to purchase of Raw Land in The Woodlands, Texas.                                              
|              | 
|Exhibit 10.6  |  | General Warranty Deed by Vision Park Joint Venture to Vista Land Equipment, L.L.C. dated December 9, 2002                                                                                               
|              | 
|Exhibit 10.7  |  | Hospital Program Management Agreement dated November 15, 2002 between the Company and Vital Weight Control, Inc.                                                                                        
|              | 
|Exhibit 10.8  |  | Cash Sale of Raw Land in Slidell, Louisiana dated February 18, 2003.                                                                                                                                    
|              | 
|Exhibit 10.9  |  | Asset Purchase Agreement dated June 30, 2003 between Tomaszek Management L.L.C. and Vista Land And Equipment.                                                                                           
|              | 
|Exhibit 10.10 |  | Asset Purchase Agreement dated July 31, 2003 relating to the Garland facility.                                                                                                                          
|              | 
|Exhibit 10.11 |  | Bill of Sale dated August 29, 2003 for equipment relating to the Garland facility.                                                                                                                      
|              | 
|Exhibit 10.12 |  | Management Support and Marketing Agreement dated October 15, 2003 between the Company and Medical Multimedia Advertising, Inc. and Addendum thereto.                                                    
|              | 
|Exhibit 10.13 |  | Cash Sale Agreement of Raw Land in Slidell, Louisiana dated January 23, 2004.                                                                                                                           
|              | 
|Exhibit 10.14 |  | Consulting Agreement dated February 1, 2004 between Sarah Garvin and the Company.                                                                                                                       
|              | 
|Exhibit 10.15 |  | Employment Agreement dated August 1, 2003 between James Baxter and the Company.                                                                                                                         
|              | 
|Exhibit 10.16 |  | Employment Agreement dated April 15, 2002 between Richard D. Valentine and the Company.                                                                                                                 
|              | 
|Exhibit 10.17 |  | Employment Agreement dated August 1, 2003 between Tammy Danberg-Farney and the Company.                                                                                                                 
|              | 
|Exhibit 10.18 |  | WCMA Reducing Revolver Loan and Security Agreement No. 582-07653 dated as of May 18, 2001 between Dynacq International, Inc. and Merrill Lynch Business Financial Services,
Inc.                        
|              | 
|Exhibit 14.1  |  | Code of Ethics for Principal Executive and Senior Financial Officers.                                                                                                                                   
|              | 
|Exhibit 21.1  |  | Listing of subsidiaries.                                                                                                                                                                                
|              | 
|Exhibit 23.1  |  | Consent of Killman, Murrell & Co., P.C.                                                                                                                                                                 
|              | 
|Exhibit 31.1  |  | Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                     
|              | 
|Exhibit 31.2  |  | Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                     
|              | 
|Exhibit 32.1  |  | Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                      
|              | 
|Exhibit 32.2  |  | Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                      
|              | 
|Exhibit 99.1  |  | Audit Committee Charter