**U.S. SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-KSB**

 
| **ý**                                             | ** **                                | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934 [Fee Required]** |
|--------------------------------------------------------|-------------------------------------------|----------------------------------------------------------------------------------------------------------------|
|                                                   |                                      |                                                                                                           |
| **For the fiscal year ended September 30,  2004** | **Commission File Number:  0-17192** |
|                                                        |                                           |                                                                                                                |  |

 

**REVCARE, INC.**

(Name of small business issuer in its charter)

 
| **Nevada**                                                                           | ** ** | **84-1061382**                     |
|--------------------------------------------------------------------------------------|------------|------------------------------------|
| (State or other jurisdiction of  incorporation or organization)                      |       | (IRS Employer  Identification No.) |
|                                                                                 |       |                               |
| **5400  Orange Avenue, Suite 200, Cypress, California    90630** |
| (Address of principal executive  offices) (Zip Code)                                 |

 
| Issuer’s  Telephone Number: **(714) 995-0627**                  |       |                                         |
|----------------------------------------------------------------------|------------|----------------------------------------------|
|                                                                 |       |                                         |
| Securities  registered under Section 12(b) of the Exchange Act: |       |                                         |
| (Title of each class)                                                |       | (Name of each exchange on  which registered) |
| **NONE**                                                             | ** ** | **NONE**                                     |
| ** **                                                           | ** ** | ** **                                   |
| Securities  registered under Section 12(g) of the Exchange Act: |       |                                         |
| (Title of class)                                                     |
| **COMMON STOCK**                                                     |

 

Check whether the issuer(1) filed all reports required to be filed by Section 13 or 15(d) of theExchange Act during the past 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. YES ý  NO o

 

Check if there is nodisclosure of delinquent filers in response to Item 405 of Regulation S-B isnot contained in this form, and no disclosure will be contained, to the best ofregistrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-KSB or any amendment tothis Form 10-KSB.  ý

 

State issuer’s revenuesfor its most recent fiscal year:  $8,059,384

 

State the aggregatemarket value of the voting stock held by nonaffiliates of the registrant:  $580,582.

 

State the number ofshares outstanding of each of the issuer’s classes of common equity, as of thelatest practicable date:  21,526,909shares of Common Stock issued and outstanding as of September 30, 2004.

 

Transitional SmallBusiness Disclosure Format (Check one): Yes o  No ý

 

 

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**PART I**

 

**ITEM 1****                      DESCRIPTIONOF BUSINESS**

 

EXCEPT FOR THE HISTORICALINFORMATION CONTAINED HEREIN, THE MATTERS DISCUSSED IN THIS ANNUAL REPORT ONFORM 10-KSB ARE FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES(SUCH FORWARD-LOOKING STATEMENTS INCLUDE, WITHOUT LIMITATION, STATEMENTS USINGSUCH WORDS AS “MAY,” “POTENTIAL,” “EXPECTS,” “BELIEVES,” “ESTIMATES,” “PLANS,” “INTENDS,”“ANTICIPATES” AND SIMILAR EXPRESSIONS). FOR A DISCUSSION OF CERTAIN FACTORS WHICH MAY AFFECT THE OUTCOMESPROJECTED IN SUCH STATEMENTS, SEE “RISK FACTORS” ON PAGES 9 TO 12 OF THIS ANNUALREPORT ON FORM 10-KSB. ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THOSEPROJECTED.  THESE FORWARD-LOOKINGSTATEMENTS REPRESENT OUR JUDGMENT AS OF THE DATE OF THE FILING OF THIS ANNUALREPORT ON FORM 10-KSB.  WE DISCLAIM,HOWEVER, ANY INTENT OR OBLIGATION TO UPDATE THESE FORWARD-LOOKING STATEMENTS. 

 

***OurCompany***

 

RevCare, Inc. is one ofthe leading providers of revenue cycle management services in California,Nevada and Hawaii.  We have traditionallyfocused our services on three segments of the accounts receivable managementindustry – healthcare, banking and retail. However, with our acquisition of four healthcare revenue cyclemanagement companies in August 2000, we are now concentrating on offeringour comprehensive and integrated suite of services to manage the revenue cycleof healthcare providers.  We now have theability to provide the services required by our healthcare clients to manageall phases of their revenue cycle, which include:

 

physician and hospitalbilling,

 

non-delinquent anddelinquent receivable collections,

 

reimbursementmaximization projects

 

We have a presence in theSouthern California, Las Vegas and Hawaii healthcare markets.  We provide services to approximately 88healthcare facilities in these geographic areas.  We currently manage over $500 million inreceivables for our billing and collections clients on an annual basis.

 

We believe our uniquecombination of services will allow us to continue to access various sources ofcapital to fund our ongoing growth, which may include additional acquisitionsof companies in geographic areas where there is a demand for our services.  Our immediate goal is to become the mostprominent provider of revenue cycle management services to healthcare providersin the western region of the United States. We have continued development on two important initiatives that willenhance our client service delivery processes: 

 

anaccumulation of our clients’ data that we will process to provide informationspecific to our clients and benchmark statistics about the industry. 

 

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aprofessional development center designed to continually expand the basic,technical and regulatory compliance knowledge of our staff.

 

While we are directingour services primarily to the healthcare industry, we also continue to providenational receivable management services to certain non-healthcare companies inthe financial services, auto and retail industries. The retail industryrepresents less than 10% of our collection business. Our clients in theseindustries primarily utilize our delinquent debt recovery and litigationmanagement services. In the future, we anticipate a reduction in the percentageof business related to non-healthcare companies.

 

**OurBusiness Strategy**

 

Our business strategyfocuses on positioning ourselves as a strategic partner and business advisor tohealthcare organizations for their revenue cycle management needs.  Key elements in our strategy include:

 

OrganizationalIntelligence – We are continuing to build a knowledge base that will beenriched by the significant amount of data we receive and produce in the courseof delivering our services.** **We believe that our clients willbenefit from the specific performance information and from the industry levelbenchmark comparisons that this pool of information may provide once it isprocessed and organized, to better manage their business practices.  We intend to use the latest applicationservice provider (or ASP) technology to provide our clients with secured, readyaccess to our knowledge base through our website.

 

Technology– We plan to continue to utilize and leverage technology to provide our clientswith more services and information that are critical to their business in moreconvenient and economical ways.  

 

OurPeople – Our success will also largely depend on our ability to recruit, retooland retain smart professionals.  

 

Fundamental to ourstrategy is our attention to:

 

buildingawareness of our brand in the geographic markets that we service, which willsupport the development of our service lines in new markets**.**

 

developingstrategic alliances with finance and technology companies who focus on thehealthcare industry, and marketing and cross promotion alliances with otherservice providers to reach new clients and expand value-added services providedto existing clients.

 

enhancingfinancial performance in all our service lines by maximizing the use oftechnology to streamline internal processes, lowering the cost of service andinformation delivery, and extracting economies of scale from internal growthand acquisitions.

 

***OurHistory***

 

In August 2000, wecompleted our acquisition of California Professional Services, Inc., or CPS,which was founded in 1974 and primarily provides collections services tohealthcare clients.  As part of ouracquisition of CPS, CPS acquired the assets of Insource Medical Solutions, orInsource, Hospital Employee Labor Pool, or HELP, and RBA-RemCare, or RBA.  Insource, a physician and hospital billingcompany, started its operations in 1996. HELP, a staffing and back office outsourcing firm, started its

 

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operations in 1988.  RBA, a healthcare reimbursement maximizationconsulting company, was formed in 1990.

 

On May 30, 2000, FBRFinancial Fund II, L.P., now known as FBR Financial Services Partners, L.P.(FBR), purchased newly issued shares representing approximately 70% of ouroutstanding stock for $7.5 million.  Withthe proceeds of this investment, we were able to complete our acquisition ofCPS, Insource, HELP and RBA in August 2000.  We have combined these companies with ourpreviously owned subsidiaries Medical Control Services, Inc. and LienSolutions, Inc**.,** which specialize in thehealthcare industry and Merchants Recovery Services, Inc**.,**which focus on non-healthcare clients. These subsidiaries started their operations at various times from 1977through 1982.  As part of the transitionwe also changed our name to RevCare, Inc. We believe the combination of experience and knowledge acquired throughthe addition of these companies will allow us to provide an integrated andcomprehensive suite of services to manage the revenue cycle of most healthcareproviders.  We also extended ourgeographic presence to the Nevada and Hawaii markets with these acquisitions.

 

Our Services to theHealthcare Industry 

 

Reimbursement Solutions 

 

Managed Care Audits – Wehave a comprehensive audit program that employs technology and experiencedprofessionals on managed care accounts that have been closed for over oneyear.  This process includes a thoroughreview of all payments and/or denials received under the terms and conditionsof managed care contracts.  We retain anagreed upon percentage of the re-billed services paid by the insurancecarriers.

 

Clinical Denial Audits –Insurance carriers deny claims due to a variety of reasons.  We audit denied claims to determine whetherthey were appropriately denied.  Wetypically retain an agreed upon percentage of the payment received by ourclients from contested claims.  Thepercentage of re-billed claims varies according to the nature of the claim, theservices provided, and the processes and methods followed by the businessoffice of the healthcare provider.

 

Zero Balance Reviews - Thisservice is an extension of our managed care audit service but applies to allaccounts that have been settled at significantly less than the amountoriginally billed.  Prior to accepting anengagement, our professionals conduct a feasibility study of the client’sinternal receivable management process. We review a sample of accounts throughout the period and assess theprocesses and methods followed by the back office.  The client ordinarily pays for thefeasibility study.  We retain an agreedupon percentage of the re-billed services paid by the insurance carriers.

 

Compliance Reviews – Weprovide consulting services on healthcare regulatory compliance matters tosmall- to medium- sized medical offices. This service provides for a thorough review of the medicalfacility.  Process flow is documented foreach component of the accounts receivable management process.  The review produces detailed documentation,which forms the basis of our recommendations for implementing an effectivecompliance program.  The ultimate goal ofthe compliance program is to promote prevention, detection, and resolution ofinstances of conduct that do not conform to Federal and state laws.  Fees for this service are generally fixedrates based on the size of the office and other factors.

 

Recovery Services 

 

Pre-Collect Services – Weprovide pre-delinquency collection services to our clients by acting as anextension of our clients’ accounts receivable department.  We provide clients with speed dialing andprofessionally trained staff to help them achieve better penetration of theirnon-delinquent pool of receivables.

 

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Delinquent Debt Recovery– Whether the cause is improper processing of the claims or the patient’sreluctance or inability to pay, certain receivables require specialized skillsto achieve maximum liquidity.  Our staffis trained to identify the causes and the appropriate approaches to ensureprofessional treatment of our clients’ patients and customers.  In the future, we expect the accountsegmentation and filtration processes that may result from the informationaccumulated in our knowledge base to help us minimize the staff’s efforts onaccounts with low or no collectable value.

 

Billing Services

 

We perform coding,processing and electronic submission of claims (including Medicare and MediCal)arising from services performed by medium to large physician groups andhospitals.  We currently utilize IDXbilling technology to process claims for our clients. Additional servicesprovided either independently or in conjunction with the above billing servicesinclude; baseline and annual physician audits and physician and staffeducation.  We perform charge ticketreviews and development, as well as, reviewing the charge capture process.  Other services include; operationalconsulting services and compliance reviews. We earn our revenue either based ona contractual percentage of the dollar value of claims paid or on a fixed feebasis.

 

***OurServices to Non-Healthcare Clients***

 

We have been providingrecovery services to the financial services, retail, and commercial industriesfor over twenty years.  We have developeda particular expertise in the handling of accounts financed by retail andfinance companies, which comprise a large portion of our non-healthcare clientbase.  Most of our services involve theearlier stages of recovery of our clients’ delinquent accounts receivable.

 

***SupportServices***

 

To provide effective andthorough services to our clients, we also offer the following services andsystems to support our core operations:

 

*LitigationManagement* – We have a specialty recovery department with afull time attorney to manage litigation and bankruptcy related activities.  The attorney and support staff has more thanten years of full time employment with us. Litigation management includes filing legal actions on collectionaccounts, enforcement of judgments, and the perfecting of Chapter 13 bankruptcyclaims nationwide.

 

*Technologyand Information Systems* – We recognize the value of combininghuman resources with the latest computer and telecommunications technology tomanage the receivables assigned to us effectively.  Accordingly, we maintain sophisticated dataprocessing support and management information systems that can be easilyoperated by our billing and recovery specialists.

 

Ourreceivable management software system is compiled under a widely used, highlevel programming language.  It operatesunder a Microsoft Windows environment distributed by a Windows NT networksystem.  A central computer file serverconnected to an array of disc drives maintains our management informationdatabase.

 

Webelieve that knowledge is a key differentiating factor in our business.  Our long experience in the receivablemanagement business has allowed us to accumulate a base of knowledge which, ifproperly maintained and continually enriched, can provide significantinformation to our clients to enhance their decision making processes toinclude analysis of profitable lines of business and problem areas toavoid.  With the proper management of thedata we continuously gather from

 

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ourdaily customer interaction, we will improve our recovery strategies andmanagement reports for our clients.

 

Wecontinue to expand our data management capability by utilizing ODBC (OpenDatabase Connectivity) capable report writing on an Oracle open databasesystem.  This system integrates ourcurrent receivable management operating system and existing telecommunicationtechnology.  This system also allows usto create a more precise coding system to extract, sort, and store informationthat we believe will be useful to our clients’ decision making process withrespect to the relative values and expected performance of their outstandingreceivables.  We intend to use thissystem to develop information retrieval and delivery processes for our clientsutilizing the Internet.

 

***Marketingand Advertising***

 

Our marketing strategy isfocused on three goals - building brand awareness, acquiring specificallytargeted clients in the United States and cross selling our value-addedservices to our existing client base.  Wepursue these goals through a combination of:

 

marketingthrough selected trade shows and conventions;

 

marketingon our own website and other online opportunities;

 

directmail marketing;

 

attendanceat industry-sponsored public relations events.

 

Our advertising focuseson building awareness of the Revcare brand and related services and positioningourselves as a strategic partner and business advisor to our clients.  We place print advertisements in variousindustry publications and our website incorporates a description of thecomprehensive suite of services that we now provide to our clients.

 

***GovernmentRegulation***

 

Our healthcare billingservices are covered by various regulations prescribed by Medicare, Medicaid,TRICARE and the Health Care Financing Administration. Each major federalhealthcare payment program has it own set of complex and sometimes conflictingregulations.  Additionally, regulationshave been mandated by the Balanced Budget Act and the Health InsurancePortability and Accountability Act (HIPAA), which could have a significantimpact on our business.  Several stateshave also imposed significant regulatory programs applicable to billing andpayment for healthcare services.  TheOffice of Inspector General of the Department of Health and Human Resources hasissued compliance guidelines for third-party billing companies, recommending componentsfor an effective billing company compliance program and identifying severalrisk areas associated with medical billing. Such risk areas include routine waiver of copayments and deductibles,unbundling, billing for undocumented services, and upcoding.  The continual implementation of measures torestrict payments for healthcare services by governmental and private payorsmay result in a decrease in revenue to our provider clients, and as a result, adecrease in revenue derived by us from such clients as well as an increase inthe cost of providing services.

 

Our recovery operation is regulated by the Fair DebtCollection Practice Act and the Telephone Consumer Protection Act, which areenforced by the Federal Trade Commission. In 1996, HIPAA was

 

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passed, which addresses the compliance requirements tosafeguard patient information that is shared and communicated during thevarious billing and recovery processes. In this regard, we devote continuous efforts through ongoing trainingand monitoring to provide ethical, innovative, high quality receivablemanagement services, which meet the needs of our clients and comply withapplicable laws.

 

Although we believe that we are in compliance with allapplicable laws and regulations, there can be no assurance that we will alwaysbe able to maintain such compliance.  Ourfailure to comply with such statutes and regulations could have a materialadverse effect on us.  Furthermore, theadoption of additional statutes and regulations, changes in interpretation andenforcement of current statutes and regulations, or the expansion of ourbusiness into jurisdictions that have more stringent regulatory requirementsthan those in which we currently conduct business could have a material adverseeffect on us.

 

***Competition***

 

All aspects of our business are highlycompetitive.  We compete directly withOSI, NCOG, and approximately 6,000 small businesses operating in any, but notall of our segments. Many of our competitors such as OSI and NCOG, have fargreater resources and have access to capital markets that may be unavailable tous.

 

We believe that the principal competitive factorsaffecting our business are performance, price, and quality of serviceprovided.  We believe that our strategicfocus and innovative approaches will allow us to compete effectively withcurrent providers of like services.

 

***Employees***

 

As of September 30, 2004, we had 109 full timeemployees and 4 part time employees.  Atotal of 102 of these employees are based in Southern California, 2 are basedin Las Vegas, and 9 are based in Hawaii. None of our employees is subject to a collective bargainingagreement.  We believe that our relationswith our employees are good.  On December 1,2004, we entered into an agreement with Administaff, Inc. under which we haveoutsourced the Human Resource related functions for all our employees forSouthern California and Las Vegas.

 

RISK FACTORS

 

WE WISH TO CAUTIONREADERS THAT THE FOLLOWING IMPORTANT FACTORS, AMONG OTHERS, IN SOME CASES HAVEAFFECTED, AND IN THE FUTURE COULD AFFECT, OUR ACTUAL RESULTS AND COULD CAUSEOUR ACTUAL CONSOLIDATED RESULTS FOR FUTURE PERIODS TO DIFFER MATERIALLY FROMTHOSE EXPRESSED IN ANY FORWARD-LOOKING STATEMENTS MADE BY US OR ON OUR BEHALF.  WE EXPRESSLY DISCLAIM ANY OBLIGATION ORUNDERTAKING TO RELEASE PUBLICLY ANY UPDATES OR REVISIONS TO ANY FORWARD-LOOKINGSTATEMENTS CONTAINED HEREIN TO REFLECT ANY CHANGE IN OUR EXPECTATIONS WITHREGARD THERETO OR ANY CHANGE IN EVENTS, CONDITIONS OR CIRCUMSTANCES ON WHICHANY SUCH STATEMENT IS BASED. 

 

***Oneof our shareholders holds a large percentage of our common stock and controlsour board of directors.***

 

One of our directors, Edward Wheeler, is a managingdirector of our majority shareholder, FBR Financial Services Partners, L.P.,which beneficially owns approximately 70% of the outstanding shares of our

 

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common stock as of September 30, 2004.  In addition, George McCabe, another of ourdirectors, is a managing partner of the subadvisor to FBR Financial ServicesPartners, L.P.  Accordingly, FBR andMessrs. McCabe and Wheeler are able to control us and our affairs and business,including any future issuances of common stock or other securities, merger andacquisition decisions, declaration of dividends and the election ofdirectors.  In addition, our stock priceand our ability to raise capital could be injured if FBR was to sell asignificant portion of its holdings on the open market.  Generally, FBR may either sell its sharesunder a registration statement or in compliance with the volume limitations andother requirements imposed by Rule 144 adopted by the SEC.

 

***Wemay need additional capital, which may be unavailable.***

 

Our growth strategy, including our proposedtechnological enhancements, may require greater expenditures than expected inour current business plan.  Our capitalrequirements will depend on numerous factors, including:

 

ourrate of sales growth—fast growth may actually increase our need for capital tohire additional staff, purchase additional equipment and technology, financethe increase in accounts receivable and supply additional support services.

 

ourprogress in providing improved reporting to our clients will require additionalcapital.

 

thelevel of resources that we devote to the development and marketing of ourservices and products— decisions we make to improve, expand or simply changeour process, services or technology may require increased funds.

 

marketacceptance and demand for our services and products—although growth mayincrease our capital needs, the lack of growth would also increase our need forcapital.

 

We may be unable topredict accurately the timing and amount of our capital requirements.  We may be required to raise additional fundsthrough public or private financing, bank loans, collaborative relationships orother arrangements earlier than expected. It is possible that banks, venture capitalists and other investors mayperceive our capital structure, financial performance or reliance on thehealthcare industry and new technology as too great a risk to bear.  As a result, additional funding may not beavailable on attractive terms, or at all. If we cannot obtain additional capital when needed, we may be forced toagree to unattractive financing terms, to change our method of operation or tocurtail our operations.

 

***Ourcommon stock is subject to price volatility.***

 

The number of shares of our common stock that tradeddaily during 2004 averaged less than 5% of the average outstanding commonstock.  As a result of our low tradingvolume and various other factors beyond our control, the market price for ourcommon stock is volatile.  Some of thefactors that may subject our stock price to wide fluctuations include:

 

thetiming and announcement of acquisitions by us or our competitors.

 

governmentregulatory action.

 

quarterlyvariations in operating results.

 

announcementsof technological innovations, new services or pricing by our competitors.

 

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changesin, or failure to meet, the expectations of investors.

 

thetiming and extent of technological advancements.

 

thesales of our common stock by affiliates or other shareholders with largeholdings.

 

generalmarket conditions.

 

In addition, the stockmarket has experienced significant price and volume fluctuations that haveaffected the market price of the stock of many companies and that often havebeen unrelated to the operating performance of such companies.  These broad market fluctuations may directlyinfluence the market price of our common stock.

 

***We operate in a regulatedbusiness and if we fail to comply with government regulations our ability toconduct business may be suspended or terminated which would have a materiallyadverse effect on us. ***

 

The accounts receivable management and telemarketingindustries are regulated under various United States federal and state laws andregulations.  Many states require that webe licensed as a debt collection company. If we fail to comply with applicable laws and regulations, it couldresult in the suspension or termination of our ability to conduct accountsreceivable management or telemarketing services, which would have a materiallyadverse effect on us.  In addition, newfederal or state laws or regulations, or changes in the ways these rules orlaws are interpreted or enforced, could limit our activities in the future orsignificantly increase the cost of regulatory compliance.  

 

The healthcare industry and some of the otherindustries served by us are also subject to varying degrees of governmentregulation.  Although our clients aregenerally responsible for complying with these regulations, we could be subjectto a variety of enforcement or private actions for our failure or the failureof our clients to comply with these regulations.

 

***We compete with approximately6,000 providers in the accounts receivable management industry which couldreduce our market share and have a materially adverse effect on our futurefinancial results.***

 

We compete with approximately 6,000 providers inproviding accounts receivable management services.  We compete with large national corporationsas well as many regional and local firms. We may lose existing or prospective business to competitors that haveestablished and larger marketing and sales organizations, significantly greaterfinancial and technical resources and a larger base of customers or operate inbroader geographic areas than we do. Because of the large numbers of providers, in the future we may have toreduce our collection fees to remain competitive.  Many larger clients retain multiple accountsreceivable management providers, which expose us to continuous competition inorder to remain a preferred vendor.        

 

***Ourbusiness is dependent on the healthcare and financial services industries.***

 

Our business is dependenton clients in the healthcare and financial services sectors. If either of thesesectors performs poorly, clients in these sectors may have fewer or smaller accountsto refer to us or they may elect to perform accounts receivable managementservices in-house.  If there are anytrends in either of these sectors to reduce or eliminate the use of third-partyaccounts receivable management services, the volume of referrals to us woulddecrease.  Further, the healthcareindustry is undergoing fundamental changes resulting from political, economicand regulatory influences. Significant changes in healthcare

 

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systems could have asubstantial impact on the manner in which we conduct our business and couldrequire us to revise our strategies.

 

***Our failure to introduce valueadded services and products in a timely manner may affect our ability tocompete effectively.***

 

Our success depends in large part on sophisticatedtelecommunications and computer systems. We use these systems to identify and contact large numbers of accountdebtors and to record the results of the collection effort.  If we are not able to respond to technologicalchanges in telecommunications and computer systems in a timely manner, we maynot be able to remain competitive.  Wehave made investments in technology to remain competitive and anticipate thatit will be necessary to continue to do so in the future.  Computer and telecommunication technologiesare changing rapidly and are characterized by short product life cycles, sothat we must anticipate technological developments.  If we are not successful in anticipating,managing or adopting any technological changes on a timely basis or if we donot have the capital resources available to invest in new technologies, ourbusiness would be materially and adversely affected.

 

***If our telecommunications andcomputer systems fail or become unavailable, it could have a materially adverseeffect on our business.***

 

As noted above, our business is highly dependent onour telecommunications and computer systems. These systems could be interrupted by natural disasters, power losses,or similar events.  Our data is secureddaily and the computer hardware required to operate it can be replaced quickly.Our business also is materially dependent on service provided by various localand long distance telephone companies. If our equipment or systems cease to work or become unavailable, or ifthere is any significant interruption in telephone services, we may beprevented from providing services. Because we generally recognize income only as accounts are collected,any failure or interruption of communication services would mean that we wouldcontinue to incur payroll and other expenses without any corresponding income.

 

***Wemay not be able to manage growth.***

 

If successful, we will experience a period of growththat could place a significant strain upon our managerial, financial andoperational resources.  Ourinfrastructure, procedures and controls may not be adequate to support ouroperations and to achieve the execution necessary to successfully market ourservices.  To continue our future growth,we will also be required to improve our operational and financial systems andobtain additional management, operational and financial resources.  If we are unable to manage future expansioneffectively, our business, results of operations and financial condition willsuffer, our senior management will be less effective, and our revenues maydecrease.

 

**ITEM 2****                      DESCRIPTIONOF PROPERTY**

 

Until May 21, 2003, we owned our office building andproperty located at 5400 Orange Avenue, Cypress, California, where we conductour primary operations.  The officebuilding, which was purchased in 1993, contains approximately 53,000 squarefeet of office space.  Currently, weoccupy approximately 37,000 square feet for our operations, and the remainderof the building is available for lease to third party tenants.  

 

As previously reported on Form 8-K filed July 10,2003, on May 21, 2003, our subsidiary Medical Control Services, Inc. (MCI)which held title to our corporate facility completed the sale of the propertyto SCP Park Meadows, LLC (SCP).  On thatsame date, we entered into a Lease Agreement dated May

 

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21, 2003 with SCP (the “Lease”). The transaction wasrecorded as a financing transaction. The Lease provides, among other things,all of the following: 

 

•                  a twelve year term, with twoadditional renewal options of five years each 

 

•                  base rent of $53,937 per month forthe first three years of the Lease, with annual adjustments thereafter based onan index, subject to minimum and maximum annual increases 

 

•                  a tenant improvement allowance of$50,000 

 

•                  our responsibility for various costs,including those associated with maintaining, insuring, repairing and replacingitems on the property 

 

•                  security deposits in the form of twoirrevocable letters of credits totaling $1,050,000, $400,000 of which issubject to release if we satisfy specified conditions no sooner than 12 monthsfrom the date of the transaction, May 21, 2004, the “Initial Release Date”.  As of September 30, 2004, the Companydid not meet the specified conditions

 

•                  our option to repurchase the propertybetween the third and fifth years of the Lease term at a purchase price equalto the amount determined by dividing the annual base rent that otherwise wouldhave been payable for the 12 months following the closing of the repurchase ofthe property by 8.5% 

 

•                  our option to terminate the Leasebetween the third and fifth years of the Lease upon payment of a terminationfee equal to 50% of the amount equal to the net present value of the aggregatebase rent payments remaining through the Lease, using a discount rate of 8.5% 

 

Copies of theseagreements implementing these transactions are filed as Exhibit 10.13 through10.15 to the Form 8-K filed on July 10, 2003, and incorporated herein byreference.

 

We also have leasedoffices located at 2235 E. Flamingo Road, Suite 405, Las Vegas, NV 89119; and****at 46-001 Kamehameha Hwy, Suites 308 and 309, Kaneohe, HI96744.

 

**ITEM 3****                      LEGALPROCEEDINGS**

 

We are involved, from time to time, in litigation thatis incidental to our collection business. We regularly initiate legal proceedings as a plaintiff in connectionwith our routine collection activities. In management’s opinion, none of these legal matters individually willhave a material adverse effect on our financial position or the results of ouroperations.

 

Commencing in September 2001, in some cases whereCalifornia-based delinquent debt collection clients did not have an agreementwith the Company which required the Company to maintain the funds collected onthe clients’ behalf in a separate account, the Company transferred funds fromthe client account to its general operating account. In addition, payments tosuch clients were withheld for 90 to 120 days, and sometimes longer. TheCompany had relied upon the repeal of previous California statutes requiringsegregation of client funds by collection agencies when our client contract didnot contain an

 

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express provision requiring segregation.  In July 2003, the Company determined,despite the lack of clear authority, that the practice of transferring clientfunds to operating accounts or the delay in remitting funds might be deemed abreach of our obligations. The Company has not determined definitively if thisis the case, the Company has taken and is taking additional steps to addressthis practice. Client funds are no longer transferred to operating accounts forany reason (other than funds owed to the Company for its services to which itis contractually entitled). The Company believes that a consequence of any suchpotential breach is that certain of our California-based delinquent debtcollection clients may feel damaged and may request compensation. To the extentthe Company is unable to reach an agreement with entities that requestcompensation, such entities may initiate legal efforts to pursue claims againstthe Company. In connection with the process to reduce the collections payablebalance owed to certain of the Company’s California-based delinquent debtcollection clients, the Company, as previously reported in 2003, begancontacting those clients and paid principal plus interest to them. In 2004, theCompany has reached 459 of 720 of these former clients and paid all of theamounts due them including interest payments. As of September 30, 2004, westill have to reimburse as many as 261 former clients for collections receivedon their behalf from the past practice. Accordingly, $1,080,416 is included inCollections Payable to Customers in the accompanying consolidated financialstatements related to these former clients. This amount includes accruedinterest of $83,079. We will continue to reimburse and pay interest on theamounts due to these former clients as funds are available. However, theCompany cannot estimate at this time when or if all such liabilities includingrelated interest can be paid in full. 

 

We have provided copies of our reports on Form 8-Kfiled on July 10, 2003 and August 15, 2003, respectively, to theDivision of Enforcement of the Securities and Exchange Commission. Since thattime, the Company has been notified by the SEC that it has begun an informalinvestigation involving the Company. The Company is cooperating with the SEC inthis process.  

 

**ITEM 4**                      **SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

There were no matters submitted to a vote of securityholders during the fourth quarter of the fiscal year ended September 30,2004.

 

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**PART II**

 

**ITEM 5****                      MARKETFOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS**

# ** **

**Equity Compensation Plan Information**

 
| **Plan category**                                               | ** ** | **Number of  securities to be  issued upon  exercise of  outstanding  options, warrants  and rights** | ** ** | **Weighted-average  exercise price of  outstanding  options, warrants  and rights** | ** ** | **Number of  securities  remaining available  for future issuance  under equity  compensation plans  (excluding  securities reflected  in column (a))** | ** ** |
|-----------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                      | ** ** | **(a)**                                                                                               | ** ** | **(b)**                                                                             | ** ** | **(c)**                                                                                                                                                 | ** ** |
| **Equity compensation plans approved by security  holders**     |       | 2,134,908                                                                                             |       | $                                                                                   | 0.57       |                                                                                                                                                    | 1,215,092  |   |
| **Equity compensation plans not approved by  security holders** |       | 400,000                                                                                               |       | $                                                                                   | 3.06       |                                                                                                                                                    | —     |   |
| **Total**                                                       |       | 2,534,908                                                                                             |       | $                                                                                   | 1.00       |                                                                                                                                                    | 1,215,092  |   |

 

Our common stock, $.001 par value, is traded under thesymbol “RVCR.PK” through the OTC Electronic Bulletin Board maintained by theNational Association of Security Dealers, Inc. The OTC Electronic Bulletin Board has no financial eligibility standardsand is totally separate from the Nasdaq Stock Market.  The OTC Electronic Bulletin Board does notconstitute an active trading market and trading in our common stock is limitedand sporadic.  The following table setsforth the range of high bid and low bid quotations for our common stock for theperiods indicated.  The quotations areinter-dealer prices in the over-the-counter market without retail mark-ups,markdowns or commissions, and may not represent actual transactions.  

 
| ** **               | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|--------------------------|------------|------------|------------|------------|------------|
| ** **               | ** ** | **High**   | ** ** | **Low**    | ** ** | **High** | ** ** | **Low** | ** ** |
| ** **               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| 4th Quarter ending 9/30  |       | $          | 0.010      |       | $          | 0.010 |   | $ | 0.040 |   | $ | 0.040 |   |
| 3rd Quarter ending 6/30  |       | 0.100      |       | 0.010      |       | 0.090 |   | 0.010 |   |
| 2nd Quarter ending 3/31  |       | 0.040      |       | 0.010      |       | 0.070 |   | 0.010 |   |
| 1st Quarter ending 12/31 |       | 0.040      |       | 0.020      |       | 0.080 |   | 0.070 |   |
|                          |            |            |            |            |            |  |  |  |  |  |  |  |  |

 

As of September 30,2004 there were 1,482 holders of record of our common stock.

 

13

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***DividendPolicy***

 

We have never paid a dividend and do not anticipatepaying any cash dividends in the foreseeable future.  We intend to retain any earnings to providefunds to finance future growth.

 

**ITEM 6****                      MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

EXCEPT FOR THEHISTORICAL INFORMATION CONTAINED HEREIN, THE MATTERS DISCUSSED IN THIS ANNUALREPORT ON FORM 10-KSB ARE FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS ANDUNCERTAINTIES (SUCH FORWARD-LOOKING STATEMENTS INCLUDE, WITHOUT LIMITATION,STATEMENTS USING WORDS SUCH AS “MAY,” “POTENTIAL,” “EXPECTS,” “BELIEVES,” “ESTIMATES,”“PLANS,” “INTENDS,” “ANTICIPATES” AND SIMILAR EXPRESSIONS).  THESE FORWARD-LOOKING STATEMENTS ARE SUBJECTTO RISKS AND UNCERTAINTIES, INCLUDING THOSE SET FORTH BELOW AND IN ITEM 1 OFTHIS ANNUAL REPORT ON FORM 10-KSB UNDER THE CAPTION “RISK FACTORS,” THAT COULDCAUSE ACTUAL RESULTS TO VARY MATERIALLY FROM THOSE PROJECTED.  SUCH RISK FACTORS INCLUDE: 

 

•      One of our shareholders holds a largepercentage of our common stock and controls our board of directors.

 

•      We may need additional capital, which maybe unavailable.

 

•      Our common stock is subject to pricevolatility.

 

•                  We operate in a regulated businessand if we fail to comply with government regulations our ability to conductbusiness may be suspended or terminated which would have a materially adverseeffect on us.  

 

•                  We compete withapproximately 6,000 providers in the accounts receivable management industry,which could reduce our market share and have a materially adverse effect on ourfuture financial results.

 

•                  Our business isdependent on the healthcare and financial services industries.

 

•                  Our failure tointroduce value added services and products in a timely manner may affect ourability to compete effectively.

 

•                  If ourtelecommunications and computer systems fail or become unavailable, it couldhave a materially adverse effect on our business.  

 

•                  We may not be able to manage growth. 

 

THESEFORWARD-LOOKING STATEMENTS SPEAK ONLY AS OF THE DATE HEREOF.  WE EXPRESSLY DISCLAIM ANY OBLIGATION ORUNDERTAKING TO RELEASE PUBLICLY ANY UPDATES OR REVISIONS TO ANY FORWARD-LOOKINGSTATEMENTS CONTAINED HEREIN TO REFLECT ANY CHANGE IN OUR EXPECTATIONS WITHREGARD THERETO OR ANY CHANGE IN EVENTS, CONDITIONS OR CIRCUMSTANCES ON WHICHANY SUCH STATEMENT IS BASED.  THEFOLLOWING DISCUSSION AND ANALYSIS OF OUR FINANCIAL CONDITION AND RESULTS OFOPERATIONS SHOULD BE READ IN CONJUNCTION WITH OUR CONSOLIDATED FINANCIALSTATEMENTS (AND NOTES THERETO) CONTAINED ELSEWHERE HEREIN.

 

14

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**Criticalaccounting policies**

 

Revenue Recognition

 

The Company provides collection, auditing, billing andstaffing services for entities primarily in the healthcare industry for afee.  Revenue recognition varies betweenthe business segments based upon the services provided. 

 

Revenues from the delinquent debt and insurancecollection practices are based on a percentage of total collections per eachcontract. Such revenues are recognized upon receipt of cash from thethird-party payers that the Company collects from on behalf of its client.  

 

Revenues from the auditing and billing services arebased on respective contractual percentage of payments received by ourclients.  Debtors, comprised mostly ofinsurance companies, generally make payments to our clients who then reportsuch amounts to the Company. The Company recognizes revenues based on suchpayment reports. 

 

Allowance for Doubtful Accounts

 

We maintain allowances for doubtful accounts forestimated losses resulting from our clients’ inability to make requiredpayments.  Management reviews allaccounts receivable on a monthly basis. Specific invoices over 60 days are discussed with clients.  Based upon historical experience withindividual clients, management assesses whether a specific reserve is requiredfor each invoice or client balance.

 

The Company has generally improved the size andquality of its clients, which has reduced the level of write-offs. Thefinancial condition of a potential client is reviewed to determine creditworthiness.  Should a potential client’scredit worthiness come into question, the Company has two options; eitherreject the engagement or accept the client as a “Net” remit client.  Under the “Net” remit option, the Companyretains the portion of the collections that represent fees to the Companyinstead of remitting the entire amount collected and invoicing the client forthe fees due.  

 

Impairment of Long-Lived Assets 

 

The Company assesses the recoverability of itslong-lived assets on an annual basis or whenever adverse events or changes incircumstances or business climate indicate that expected undiscounted futurecash flows related to such long-lived assets may not be sufficient to supportthe net book value of such assets. Such a triggering event could include asignificant decrease in the market value of an asset, or a significant changein the extent or manner in which an asset is used or a significant physical changein an asset. If undiscounted cash flows are not sufficient to support therecorded assets, impairment is recognized to reduce the carrying value of thelong-lived asset to the estimated fair value. Estimated fair value will bedetermined by discounting the future expected cash flows using a currentdiscount rate in effect at the time of impairment. Cash flow projections,although subject to a degree of uncertainty, are based on trends of historicalperformance and management’s estimate of future performance, givingconsideration to existing and anticipated competitive and economic conditions.Additionally, in conjunction with the review for impairment, the remainingestimated lives of certain of the Company’s long-lived assets are assessed.

 

15

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**Overview**

 

***Business***

 

The following discussion and analysis of our financialcondition and results of our operations are based on the consolidated resultsof operations.  A more detaileddiscussion of the accounting principles used to prepare the consolidatedfinancial statements (including the assets, liabilities, and results ofoperations of the businesses and the specific entities included in theconsolidation) is set forth in Note 2 to our consolidated financial statementsincluded in this annual report on Form 10-KSB.

 

## ***Revenues***

## *** ***

Commissions and fees, which account for most of ourtotal revenues, include commissions earned from billing, recovery, and revenuemaximization projects that we provide to our clients.  Commissions and fees for our billing andrecovery operations are primarily affected by the quality and age of thereceivable pool we are asked to manage. In general, commissions and fees for our billing and recovery servicesfluctuate based on the number of accounts we process and manage.  We manage accounts aggregating over $500million as of September 30, 2004. Fees for our special projects and consulting services depend largely onthe type of service or project we perform and, therefore, are arranged on a case-by-casebasis. Such fees are primarily affected by the quality and age of thereceivable pools, as well as the efficiency of our clients’ back officeoperations.  

 

We previously purchased charged-off accountsreceivable portfolios.  Collections from theseportfolios represented a portion of our revenues.  Portions of these portfolios were also soldto provide additional revenues.  Wediscontinued purchasing these portfolios in 1999 and subsequent to September 30,2001, we sold our remaining portfolios and assets included in the Company’s1998 securitization.  The terms of thesale included an immediate payment of $300,000 and a contingency payment of upto $350,000. As of September 30, 2004, the Company has received additionalconsideration of $124,134 from the buyer for collections received through April 2004that were subject to the contingency payment. This amount was recognized as revenue on sale of portfolio receivablesin the accompanying financial statements and was settled by cash receipts of $79,037,revenue accrual of $13,000, the elimination of a $62,348 liability due to buyerand the collection of $30,251 accounts receivables. We received $50,000subsequent to September 30, 2004. Additional receipt of contingent payments will be dependent upon thesuccess of the buyer in its collections; therefore, we are unable to predictthe timing of any additional payments.

 

While our primary market going forward will behealthcare providers, a portion of our revenues in 2004 and 2003 consisted ofcommissions and fees earned from non-healthcare clients.  The following is a summary of our revenues:

 
| ** **                                  | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|---------------------------------------------|------------|------------|------------|------------|------------|
| **Revenues:**                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Recovery                                    |       | $          | 5,224,211  |       | $          | 4,912,359 |   |
| Physician Services                          |       | 1,133,022  |       | 2,056,578  |       |
| Reimbursement Solutions                     |       | 1,702,151  |       | 2,568,665  |       |
| Total revenues from continued operations    |       | 8,059,384  |       | 9,537,602  |       |
|                                        |       |       |       |       |       |
| Total revenues from discontinued operations |       | —     |       | 2,040,654  |       |
|                                        |       |       |       |       |       |
|                                        |       | $          | 8,059,384  |       | $          | 11,578,256 |   |

 

16

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***OperatingExpenses***

 

Our largest operating expense is employee compensationand benefits, which includes salaries and wages, incentive compensation andrelated employee benefits and taxes.  Ourcompensation program for recovery specialists includes incentives based on theamount of net fees they individually generate. As such, compensation expensefor this group will vary directly with the amount of fees generated by ourrecovery business.  Most of our managersreceive annual incentive compensation based on the overall results of ouroperations in each of our business lines as well as their individualperformance.  Therefore, a significantportion of compensation and benefits expense will fluctuate based on ouroperating results.  Compensation expensemay also reflect stock options granted to our employees under our stock optionplan; however, there were no charges for stock options in 2004 or 2003. 

 

Included in other operating expenses are postage andtelephone expenses that account for the next largest components of our operatingexpenses.  These expenses will fluctuatebased on the volume of accounts we manage and, correspondingly, with thecommissions and fees we generate.  Theseexpenses reflect our primary methods of communication with our clients’customers and they include costs to send customer/payor invoices and statementsas well as telecommunication costs incurred in various negotiation activitieswith such customers.

 

Depreciation expense relates primarily to the buildingfacility where we conduct a significant portion of our operations.  In addition, our investments in technologyand telecommunication equipment over the last several years will continue toimpact this expense item.  

 

The most significant income component of other incomeand expense relates primarily to net proceeds received from rental of theportion of our building that we do not occupy, the gain/loss from thedisposition of HELP and our interest expense. Interest expense is primarily interest we pay for our lines of creditand notes payable to various related parties.

 

We have experienced substantial changes in ourbusiness and operations since we completed the acquisition of certain companiesin August 2000.  Developmentalspending which includes, among other things, product and service rollouts, andcertain information technology systems improvements, is expected to bediscretionary and will vary in response to various market conditions.  However, a significant portion of ourexpenses, such as administrative salaries and wages, occupancy and equipment,and depreciation should not vary, at least in the short term, with fluctuationsin our revenues.  We expect to continueto experience periods of rapid change in the future.  Any future expansion would place, significantdemands on our administrative, operational, financial and other resources.

 

17

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**Results of Operations and Financial Overview—Yearsended September 30, 2004 and 2003**

 
| ** **                                               | ** ** | **2004**    | ** ** | **2003**                 | ** ** |
|----------------------------------------------------------|------------|-------------|------------|--------------------------|------------|
| ** **                                               | ** ** | **Amount**  | ** ** | **Percent of  Revenues** | ** ** | **Amount** | ** ** | **Percent of  Revenues** | ** ** |
| ** **                                               |       |        |       |                     |       |   |   |   |   |
| **Continuing Operations:**                               |       |        |       |                     |       |   |   |   |   |
|                                                     |       |        |       |                     |       |   |   |   |   |
| **Revenues**                                             |       |        |       |                     |       |   |   |   |   |
|                                                     |       |        |       |                     |       |   |   |   |   |
| Recovery                                                 |       | $           | 5,224,211  |                     | 64.8       | % | $ | 4,912,359 |   | 51.5 | % |
| Physician services                                       |       | 1,133,022   |       | 14.1                     | %          | 2,056,578 |   | 21.6 | % |
| Reimbursement solutions                                  |       | 1,702,151   |       | 21.1                     | %          | 2,568,665 |   | 26.9 | % |
| Total revenues                                           |       | 8,059,384   |       | 100.0                    | %          | 9,537,602 |   | 100.0 | % |
|                                                     |       |        |       |                     |       |   |   |   |   |
| **Operating expenses**                                   |       |        |       |                     |       |   |   |   |   |
|                                                     |       |        |       |                     |       |   |   |   |   |
| Employee compensation and benefit                        |       | 4,059,313   |       | 50.4                     | %          | 5,730,064 |   | 60.1 | % |
| Other operating expenses                                 |       | 1,235,496   |       | 15.3                     | %          | 1,719,089 |   | 18.1 | % |
| Selling, general & administrative                    |       | 2,995,067   |       | 37.2                     | %          | 4,248,596 |   | 44.5 | % |
| Goodwill impairment                                      |       | 625,500     |       | 7.7                      | %          | — |   | — |   |
| Depreciation and amortization                            |       | 361,308     |       | 4.5                      | %          | 433,581 |   | 4.5 | % |
|                                                     |       | 9,276,684   |       | 115.1                    | %          | 12,131,330 |   | 127.2 | % |
|                                                     |       |        |       |                     |       |   |   |   |   |
| Operating loss                                           |       | (1,217,300  | )          | (15.1                    | )%         | (2,593,728 | ) | (27.2 | )% |
| Other income (expense)                                   |       | (817,080    | )          | (10.1                    | )%         | (1,005,349 | ) | (10.5 | )% |
|                                                     |       |        |       |                     |       |   |   |   |   |
|                                                     |       | (2,034,380) |       | (25.2                    | )%         | (3,599,077 | ) | (37.7 | )% |
|                                                     |       |        |       |                     |       |   |   |   |   |
| **Discontinued operations**                              |       |        |       |                     |       |   |   |   |   |
|                                                     |       |        |       |                     |       |   |   |   |   |
| Revenues                                                 |       | —      |       | 0.0                      | %          | 2,040,654 |   | 21.4 | % |
| Employee compensation and benefit                        |       | —      |       | 0.0                      | %          | (1,633,638 | ) | (17.1 | )% |
| Other operating expenses                                 |       | —      |       | 0.0                      | %          | (57,490 | ) | (0.6 | )% |
| Income from discontinued operations                      |       | —      |       | 0.0                      | %          | 349,526 |   | 3.7 | % |
| **Gain on sale of HELP**                                 |       | —      |       | 0.0                      | %          | 1,253,767 |   | 13.2 | % |
| **Cumulative effect of change in accounting  principle** |       | —      |       | —                   |       | (1,576,328 | ) | (16.5 | )% |
|                                                     |       |        |       |                     |       |   |   |   |   |
| **Net loss**                                             |       | $           | (2,034,380 | )                        | (25.2      | )% | $ | (3,572,112 | ) | (37.5 | )% |

 

***Revenues***

 

Total revenues from continuing operations decreased by$1,478,218 or 15% to $8,059,384 for the year ended September 30, 2004 from$9,537,602 for the year ended September 30, 2003.  Revenues from the Recovery division increasedby $311,852 due primarily to improvements in liquidation rates on existing inventorywe manage. In addition, the increase also included $124,134 we received as partof the contingency payment for the portfolios we sold in previous fiscal years.Account placements from existing clients in the Recovery division during thefiscal year 2004 decreased by $49 million as

 

18

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compared to the previous fiscal year. The decrease wasdue to lost contracts for certain clients who did not renew due to variousreasons which, include among other things, 1) the Company’s decision not tomeet lower price and additional requirements, 2) certain clients were acquiredby larger entities, and 3) natural attrition. Revenues from the PhysicianServices division decreased by $923,556 due to the continuing loss of certainclients during 2004 primarily for reasons similar to those describedabove.  Reimbursement Solutions revenuedecreased $866,514 primarily due to the completion of certain largenon-recurring insurance follow-up projects and reductions in recurringoutsourced work from existing clients due to internal cost saving initiatives. 

 

***OperatingExpenses***

 

Operating expenses forcontinued operations decreased by $2,854,646 or 23% to $9,276,684 for the yearended September 30, 2004 from $12,131,330 for the year ended September 30,2003. This decrease was a result of improved monitoring and refinement ofoperational costs.  Employee compensationand benefit from continuing operations which is comprised of payroll costs inour operating segments and does not include sales and administrative personnel,decreased by approximately $1,670,751 primarily due to reductions of operatingstaff predicated by reductions in business volume and application of newproductions processes. Other operating expenses, which is comprised of allother non-payroll costs directly related to the continuing operations of ourvarious segments decreased by $483,593 to $1,235,496 for the year ended September 30,2004 from $1,719,089 for the year ended September 30, 2003. 

 

Selling, general andadministrative expenses decreased by $1,253,529 or 30%.  The overall decrease resulted from sales andadministrative personnel cutbacks as well as reductions in all administrativeoperating expenses as part of a Company wide initiative to reduce overheadexpenses. 

 

***Other Income and Expenses***

 

Interest expenses decreased $104,705 primarily due tothe lower prevailing interest rates in 2004 as compared to 2003.  Rental income net of related expensesincreased $63,842 as a result of an increase in occupancy rate and cost savingmeasures put in this area.  

 

***Discontinued Operations***

 

***HospitalEmployee Labor Pool (temporary staffing) (discontinued August 29, 2003):***

 

The restructuring processundertaken in the past resulted in an increase in revenues in this segment to$2,040,654 for the year ended September 30, 2003 as compared to $1,637,674for the year ended September 30, 2002. Operating expenses for discontinuedoperations increased by $407,468 to $1,691,128 for the year ended September 30,2003 from $1,283,660 for the year ended September 30, 2002. This increasewas due to an increase of $407,468 in employee compensation due to increases instaff hired to fulfill client orders. In addition rates paid for new staffingpersonnel increased due to the higher quality of staff hired as a result ofchanges in hiring standards. Other operating expenses for the discontinuedoperation remained the same between periods. This segment was discontinued in

 

19

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August 2003 as partof an Exchange Agreement with a former officer of the Company (see Note 12 inour consolidated financial statements).

 

***CumulativeEffect of Change in Accounting Principle***

 

The Company changed itsmethod of accounting for goodwill as of October 1, 2002, conforming toStatement of Financial Accounting Standards No. 142, “Goodwill and otherintangible assets” (see Note 2 of our consolidated financial statements fordiscussion of impact of adoption).

 

***NetLoss***

 

The net loss decreased $1,537,732 or 43% to $2,034,380for the year ended September 30, 2004 from a loss of $3,572,112 for theyear ended September 30, 2003.  As apercentage of revenues, the net loss decreased from 37% in 2003 to 25% in 2004.

 

***Liquidityand Capital Resources***

 

Historically, we havefinanced our operations through cash flows generated by operations andborrowings from credit facilities that are in place.  Capital expenditures and investments in newtechnology have been primarily financed through non-cancelable capital leases,which expire at various times through fiscal year 2006. As of September 30,2004, our net working capital deficit totaled $6,668,788 and shareholderdeficit totaled $3,045,488.  The workingcapital deficit includes $3,254,361 of principal and accumulated interest thatwe owe on the debt held by FBR, who is also our largest shareholder and hasprovided funding to the Company in the past. The Company’s cash balances are likely to be diminished during 2005 dueto many factors, including the use of cash for operations, changes in workingcapital, capital expenditures, repayment of outstanding notes payable andrelated interest and other factors. The number of major receivable managementcontracts for the Company in 2005 is expected to be a little higher than 2004. However,implementation and installation costs of new contracts will negatively impactthe Company’s cash balances. Despite these factors, the Company believes thatavailable funds and cash flows expected to be generated by current operationswill be sufficient to meet its anticipated cash needs for working capital andcapital expenditures for its operating segments for at least the next twelvemonths. However, the Company will not have sufficient cash to repaynon-operating liabilities (primarily the Notes Payable and FinancingObligations) and credit facilities that will be due during the next twelvemonths. 

 

The Company will berequired to consider other financing alternatives during the next twelve monthsor thereafter and the timing and extent of the Company’s activities will dependin part on future business developments, including any acquisitions ordivestiture of business assets, any shortfall of cash flows generated by futureoperations in meeting the Company’s ongoing cash requirements, or any inabilityof the Company to renew or replace the current credit facility after itsexpiration in February 2005. Such financing alternatives could includeselling additional equity or debt securities, obtaining long or short-termcredit facilities, or selling operating assets. Any sale of additional commonstock or convertible equity or debt securities would result in additionaldilution to the Company’s shareholders. As a component of the process ofrequesting any additional financing that may be required, management mayapproach FBR. However, there can be no assurance that such financing could bearranged on terms satisfactory to us or FBR, or at all.

 

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***ManagementChanges***

 

The Company’s ActingChief Financial Officer and Chief Information Officer, Kenneth Leighton,resigned in April and Manuel Occiano assumed the position of Acting ChiefFinancial Officer.  

 

On August 29, 2003,as part of the terms of the Exchange Agreement with Russell and SuzetteMohrmann and their affiliate Hospital Employee Labor Pool (HELP), RussellMohrmann’s employment with the Company was terminated.  

 

21

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**ITEM 7****                      FINANCIALSTATEMENTS**

 

See “Index to Consolidated Financial Statements” for alisting of the consolidated financial statements filed with this report.

 

**ITEM 8****                      CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

 None

 

**ITEM 8A    CONTROLS AND PROCEDURES**

 

The Company carried out anevaluation, under the supervision and with the participation of management,including the Chief Executive Officer and Chief Financial Officer, of theeffectiveness of the “disclosure controls and procedures” as of the end of theperiod covered by this report, pursuant to Rules 13a-15(e) under the SecuritiesExchange Act of 1934, as amended.  Basedon that evaluation, the Company’s Chief Executive Officer and Chief FinancialOfficer has concluded that the Company’s disclosure controls and procedures, asof the end of the period covered by this report, were effective in timelyalerting them to material information required to be included in the Company’speriodic SEC filings.  There has been nochange in the Company’s internal control over financial reporting during theperiod covered by this report that has materially affected, or is reasonablylikely to materially affect, the Company’s internal control over financialreporting.

 

**PART III**

 

**ITEM 9****                      DIRECTORS,EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(a)OF THE EXCHANGE ACT**

 

Information required by this item is contained in ourproxy or information statement filed with the Securities and ExchangeCommission January, 2004 and is incorporated herein by reference. 

 

Executive Compensation

 

The information required by this item is contained inour proxy or information statement to be filed with the Securities and ExchangeCommission in January, 2004 and is incorporated herein by reference.  

 

**ITEM 10****               SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT**

 

The information required by this item is contained inour proxy or information statement filed with the Securities and ExchangeCommission in January, 2004 and is incorporated herein by reference.  

 

**ITEM 11****               CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS**

 

The information required by this item is contained inour proxy or information statement filed with the Securities and ExchangeCommission in January, 2004 and is incorporated herein by reference.  

 

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**PART IV**

 

**ITEM 12****               EXHIBITS,FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K**

 

The following documents are filed as part of this Form10-KSB:

 

**(A)****                               FinancialStatements:**

 

See “Indexto Consolidated Financial Statements” on Page F1 of this Report.

 

**(B)****                               FinancialStatement Schedules:**

 

Allschedules are omitted as the information is not required, is not material or isotherwise furnished.

 

**(C)****                               Reportson Form 8-K:**

 

None

 

**(D)****                               Exhibits****   **

 

The exhibits listed below are required by Item 601 ofRegulation S-B.  Each management contractor compensatory plan or arrangement required to be filed as an exhibit to thisForm 10-KSB has been identified with an asterisk (“*”) in the table of exhibitsset forth below.

 
| **Exhibit** | ** ** | **Name of Exhibit**                                                                                                                                                                                                                                      |
|-------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1         |       | Definitive  Purchase Agreement and Plan of Reorganization dated September 12, 1995  (incorporated by reference from September 12, 1995 Form 8-K, Exhibit  7(b)(i))                                                                             |
|        |       |                                                                                                                                                                                                                                                     |
| 2.2         |       | Purchase  Agreement by and among RevCare, CPS, Impact, RBA, Insource, Russell Mohrmann,  Suzette Mohrmann, Robert Perez, Barbara Perez and Maureen Brooks dated May  30, 2000 (incorporated by reference from June 14, 2000 Form 8-K, Exhibit  2.1) |
|        |       |                                                                                                                                                                                                                                                     |
| 2.3         |       | Asset Purchase  Agreement by and among RevCare, CPS, HELP, Russell Mohrmann, Suzette Mohrmann  and Allen Berman dated May 30, 2000 (incorporated by reference from June 14,  2000 Form 8-K, Exhibit 2.2)                                            |
|        |       |                                                                                                                                                                                                                                                     |
| 3.1         |       | Amended and  Restated Articles of Incorporation as filed with the Secretary of State of  Nevada on December 7, 1995 (incorporated by reference from December 20,  1995 Form 8-K, Exhibit 3.1)                                                  |
|        |       |                                                                                                                                                                                                                                                     |
| 3.2         |       | Bylaws of  RevCare (incorporated by reference from RevCare’s registration statement on  Form S-18 (SEC No. 233-12361-LA) filed on March 18, 1987, Exhibit 3.2)                                                                                 |
|        |       |                                                                                                                                                                                                                                                     |
| 3.3         |       | Certificate of  Determination re: Series A Preferred Stock (incorporated by reference from December 27,  1996 Form 10-KSB, Exhibit 3.3)                                                                                                             |
|        |       |                                                                                                                                                                                                                                                     |
| 3.4         |       | Certificate of  Amendment of Articles of Incorporation as filed with the Secretary of State  of Nevada on August 9, 2000 (incorporated by reference from August 29,  2000 Form 8-K, Exhibit 4.3)                                               |

 

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| 4.1    |   | Specimen of  Common Stock of RevCare (incorporated by reference from RevCare’s Form 8-K  filed on December 20, 1995, Exhibit 4.2)                                                                                                                    |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                           |
| 4.2    |   | Investor’s  Rights Agreement by and among RevCare and FBR Financial Fund II, L.P., dated  May 30, 2000 (incorporated by reference from June 14, 2000 Form 8-K,  Exhibit 99.2)                                                                        |
| 4.3    |   | Investors’  Rights Agreement by and among RevCare, CPS, RBA, Insource, HELP, Russell  Mohrmann, Suzette Mohrmann, Robert Perez and Barbara Perez dated August 14,  2000 (incorporated by reference from August 29, 2000 Form 8-K, Exhibit  4.4) |
|   |   |                                                                                                                                                                                                                                                           |
| 10.1   |   | 1995 Stock Option Plan of RevCare (incorporated by  reference from RevCare’s Form 8-K filed on December 20, 1995, Exhibit 10.2)                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                           |
| 10.2   |   | Preferred Stock  Purchase Agreement dated September 30, 1996 (incorporated by reference  from RevCare’s Form 10-KSB filed on December 27, 1996)                                                                                                 |
|   |   |                                                                                                                                                                                                                                                           |
| 10.3   |   | Warrant to  Purchase 400,000 Shares of Common Stock dated February 12, 1999 issued  to Batchelder & Partners, Inc. (incorporated by reference from RevCare’s  Form 10-QSB filed on February 12, 1999)                                       |
|   |   |                                                                                                                                                                                                                                                           |
| 10.4   |   | Employment  Agreement between CPS and Russell Mohrmann dated August 14, 2000  (incorporated by reference from August 29, 2000 Form 8-K, Exhibit 10.1)                                                                                                |
|   |   |                                                                                                                                                                                                                                                           |
| 10.5   |   | Employment  Agreement between RevCare and Robert Perez dated August 14, 2000  (incorporated by reference from August 29, 2000 Form 8-K, Exhibit 10.2)                                                                                                |
|   |   |                                                                                                                                                                                                                                                           |
| 10.6   |   | Employment  Agreement between RevCare and Manuel Occiano dated May 30, 2000 (incorporated  by reference from RevCare’s Form 10-KSB filed on January 15, 2001)                                                                                        |
|   |   |                                                                                                                                                                                                                                                           |
| 10.7   |   | Common Stock  Purchase Agreement by and between RevCare and FBR Financial Fund, II, L.P.,  dated May 30, 2000 (incorporated by reference from June 14, 2000 Form  8-K, Exhibit 10.1)                                                                      |
|   |   |                                                                                                                                                                                                                                                           |
| 10.8   |   | Voting Agreement  by and among the Company, FBR Financial Fund II, L.P. and Pacific Life  Insurance Company, dated May 30, 2000 (incorporated by reference from RevCare’s  June 14, 2000 Form 8-K, Exhibit 99.1)                                     |
|   |   |                                                                                                                                                                                                                                                           |
| 10.9   |   | Forms of Secured  Convertible Promissory Notes issued by the Company dated August 14, 2000  (incorporated by reference from August 29, 2000 Form 8-K, Exhibit 4.5)                                                                                   |
|   |   |                                                                                                                                                                                                                                                           |
| 10.10  |   | Employment  Agreement between RevCare and Fred McGee dated January 2, 2001                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                           |
| 10.11  |   | Revolving Note  issued by the Company September 24, 2001                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                           |
| 10.12  |   | First Amendment  to Promissory Note issued by the Company September 24, 2001 extending  maturity date to January 2, 2003                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                           |
| 10.13  |   | Forms of First  Amendment to Secured Convertible Promissory Notes issued by the Company dated  August14, 2000 extending maturity date to January 2, 2003                                                                                                  |
|   |   |                                                                                                                                                                                                                                                           |
| 10.14  |   | Form of Secured  Convertible Promissory Note issued by the Company dated September 19,  2002 (incorporated by reference from July 10, 2003 Form 8-K, Exhibit  10.18)                                                                                 |

 

24

----

 
| 10.15  |   | Form of Secured  Promissory Note issued by the Company dated July 21, 2002 (incorporated  by reference from July 10, 2003 Form 8-K, Exhibit 10.19) |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                         |
| *10.16 |   | Form of Secured  Promissory Note issued by the Company dated February 19, 2004 to FBR                                                                   |
|   |   |                                                                                                                                                         |
| *10.17 |   | Form of Secured  Promissory Note issued by the Company dated February 9, 2004 to  Lighthouse                                                            |
|   |   |                                                                                                                                                         |
| *10.18 |   | Form of Secured  Promissory Note issued by the Company dated March 16, 2004 to FBR                                                                      |
|   |   |                                                                                                                                                         |
| *10.19 |   | Warrant to  Purchase 100,000 Shares of Common Stocks dated August 5, 2004 issued to  Bridge Bank                                                        |
|   |   |                                                                                                                                                         |
| *10.20 |   | Form of Secured  Promissory Note issued by the Company dated December 29, 2004 to FBR                                                                   |
|   |   |                                                                                                                                                         |
| *21.1  |   | Subsidiaries of  the Registrant                                                                                                                              |
|   |   |                                                                                                                                                         |
| *31.1  |   | CEO  Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                            |
|   |   |                                                                                                                                                         |
| *31.2  |   | CFO  Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                            |
|   |   |                                                                                                                                                         |
| *32.1  |   | CEO  Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                                            |
|   |   |                                                                                                                                                         |
| *32.2  |   | CFO Certfication  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                                             |

 

25

----

 

**SIGNATURES**

 

In accordance with Section 13 or 15(d) of theExchange Act, the registrant caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 
|                          | REVCARE,  INC.                                         |
|-------------------------------|--------------------------------------------------------|
|                          |                                                   |
| Date: December 29,  2004 |                                                   |
|                          |                                                   |
|                          | By:                                                    | /s/ Manuel  Occiano |   |
|                          | Manuel Occiano  President and  Chief Executive Officer |

 

In accordance with the Exchange Act, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the date indicated.

 
| **Signatures**          | ** ** | **Title**                     | ** **                            | **Date Signed** |
|-------------------------|------------|-------------------------------|---------------------------------------|-----------------|
|                    |       |                          |                                  |            |
| /s/ George  McCabe, Jr. |       |                          | Director                              |            | December 29,  2004 |
| George McCabe,  Jr.     |       |                          |                                  |            |
|                    |       |                          |                                  |            |
|                    |       |                          |                                  |            |
| /s/ Edward  Wheeler     |       |                          | Director                              |            | December 29,  2004 |
| Edward Wheeler          |       |                          |                                  |            |
|                    |       |                          |                                  |            |
|                    |       |                          |                                  |            |
| /s/ Manuel  Occiano     |       |                          | Chief Executive  Officer and Director |            | December 29,  2004 |
| Manuel Occiano          |       |                          |                                  |            |
|                    |       |                          |                                  |            |
|                    |       |                          |                                  |            |
| /s/ Manuel  Occiano     |       |                          | Acting Chief  Financial Officer and   |            | December 29,  2004 |
| Manuel Occiano          |       | Principal  Accounting Officer | ** **                            | ** **      |
|                         |            |                               |                                       |                 |  |  |

 

26

----

 
| **Index  to Consolidated Financial Statements**                                                                       | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|
|                                                                                                                  |       |
| The financial  statements required Item 12 as follows:                                                                |       |
|                                                                                                                  |       |
| Report  of Independent Registered Public Accounting Firm                                                              |       |
|                                                                                                                  |       |
| Consolidated Balance Sheet  as of September 30, 2004                                                             |       |
|                                                                                                                  |       |
| Consolidated  Statements of Operations for the Years ended  September 30, 2004 and 2003                          |       |
|                                                                                                                  |       |
| Consolidated  Statements of Shareholders’ Equity (Deficit) for the Years Ended  September 30, 2004 and 2003 |       |
|                                                                                                                  |       |
| Consolidated  Statements of Cash Flows for the Years Ended  September 30, 2004 and 2003                          |       |
|                                                                                                                  |       |
| Notes to  Consolidated Financial Statements                                                                           |       |
|                                                                                                                  |       |
| (1) Financial  Statement Schedules                                                                                    |       |

 

Financial statementschedules have been omitted since they are either not required or notapplicable, or the information is otherwise included.

 

27

----

 

**Report of Independent Registered Public AccountingFirm**

 

To RevCare, Inc.:

 

We have audited theaccompanying consolidated balance sheet of RevCare, Inc. (a Nevada corporation)and subsidiaries as of September 30, 2004, and the related consolidatedstatements of operations, shareholders’ equity (deficit), and cash flows foreach of the two years in the period ended September 30, 2004.  Theseconsolidated financial statements are the responsibility of the Company’smanagement.  Our responsibility is to express an opinion on theseconsolidated financial statements based on our audits.  

 

We conducted our auditsin accordance with the standards of the Public Company Accounting OversightBoard (United States).  Those standards require that we plan and performthe audit to obtain reasonable assurance about whether the financial statementsare free of material misstatement.  An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements.  An audit also includes assessing the accounting principlesused and significant estimates made by management, as well as evaluating theoverall financial statement presentation.  We believe that our auditsprovide a reasonable basis for our opinion.

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of RevCare, Inc. and subsidiaries asof September 30, 2004, and the results of their operations and their cashflows for each of the two years in the period ended September 30, 2004, inconformity with United States generally accepted accounting principles.

 

The accompanyingconsolidated financial statements have been prepared assuming that the Companywill continue as a going concern.  As discussed in Note 1, the Companyincurred net losses of $2,034,380 and $3,572,112 for the years ended September 30,2004 and 2003, respectively, and as of September 30, 2004, the Company’scurrent liabilities exceeded its current assets by $6,668,788 and had a deficitin shareholders’ equity of $3,045,488.  The Company also anticipates thatit will not have sufficient cash flow to fund its operations through the end offiscal 2005.  These factors, amongothers, as discussed in Note 1 to the consolidated financial statements, raisesubstantial doubt about the Company’s ability to continue as a goingconcern.  Management’s plans in regard to these matters are also describedin Note 1.  The consolidated financial statements do not include anyadjustments relating to the recoverability and classification of asset carryingamounts or the amount and classification of liabilities that might resultshould the Company be unable to continue as a going concern.

 
| /s/ Mayer  Hoffman McCann P.C. |   |
|--------------------------------|--------|
| MAYER HOFFMAN MCCANN  P.C.     |   |

 

 

Los Angeles, California

 

December 22, 2004(except with respect to the matter discussed in Note 13 as to which the date isDecember 29, 2004)

 

28

----

 

REVCARE,INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSeptember 30, 2004

 
| ASSETS                                                                                                                                                                                  |   |        |       |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------|------------|
| Current assets:                                                                                                                                                                         |   |        |       |
| Cash                                                                                                                                                                                    |   | $           | 264,808    |   |
| Restricted cash                                                                                                                                                                         |   | 1,332,658   |       |
| Accounts receivable, net of allowance for doubtful  accounts of $202,163                                                                                                                |   | 965,261     |       |
| Prepaid expenses and other                                                                                                                                                              |   | 378,506     |       |
|                                                                                                                                                                                    |   |        |       |
| Total current assets                                                                                                                                                                    |   | 2,941,233   |       |
| Goodwill                                                                                                                                                                                |   | 6,865,293   |       |
| Property and equipment, net                                                                                                                                                             |   | 2,571,041   |       |
| Note receivable from officer                                                                                                                                                            |   | 100,000     |       |
| Employee advances                                                                                                                                                                       |   | 90,000      |       |
|                                                                                                                                                                                    |   |        |       |
| Total assets                                                                                                                                                                            |   | $           | 12,567,567 |   |
|                                                                                                                                                                                    |   |        |       |
| LIABILITIES AND SHAREHOLDERS’ EQUITY (DEFICIT)                                                                                                                                     |   |        |       |
| Current liabilities:                                                                                                                                                                    |   |        |       |
| Bank overdraft                                                                                                                                                                          |   | $           | 18,063     |   |
| Accounts payable                                                                                                                                                                        |   | 1,163,771   |       |
| Collections payable to customers                                                                                                                                                        |   | 1,874,181   |       |
| Accrued liabilities                                                                                                                                                                     |   | 938,453     |       |
| Lines of credit                                                                                                                                                                         |   | 276,284     |       |
| Notes payable                                                                                                                                                                           |   | 625,000     |       |
| Current portion of notes payable to vendors                                                                                                                                             |   | 27,015      |       |
| Current portion of capital lease obligations                                                                                                                                            |   | 88,581      |       |
| Current portion of notes payable to related parties                                                                                                                                     |   | 4,211,666   |       |
| Current portion of financing obligation                                                                                                                                                 |   | 387,007     |       |
|                                                                                                                                                                                    |   |        |       |
| Total current liabilities                                                                                                                                                               |   | 9,610,021   |       |
|                                                                                                                                                                                    |   |        |       |
| Capital lease obligations, less current portion                                                                                                                                         |   | 88,524      |       |
| Notes payable to vendors, less current portion                                                                                                                                          |   | 159,923     |       |
| Note payable to Lighthouse                                                                                                                                                              |   | 260,275     |       |
| Notes payable to related parties, less current  portion                                                                                                                                 |   | 551,811     |       |
| Financing obligation, less current portion                                                                                                                                              |   | 4,942,501   |       |
|                                                                                                                                                                                    |   |        |       |
| Total liabilities                                                                                                                                                                       |   | 15,613,055  |       |
|                                                                                                                                                                                    |   |        |       |
| COMMITMENTS AND CONTINGENCIES (Note 9)                                                                                                                                                  |   |        |       |
|                                                                                                                                                                                    |   |        |       |
| SHAREHOLDERS’ EQUITY (DEFICIT):                                                                                                                                                    |   |        |       |
| Series A convertible, redeemable preferred stock,  $0.001 par value, stated at $2 liquidation preference per share, 5,000,000  shares authorized; 345,000 shares issued and outstanding |   | 690,000     |       |
| Common stock, $0.001 par value; 55,000,000 shares  authorized; 21,526,909 shares issued and outstanding                                                                                 |   | 21,520      |       |
| Paid-in capital                                                                                                                                                                         |   | 10,658,282  |       |
| Accumulated deficit                                                                                                                                                                     |   | (14,365,290 | )          |
|                                                                                                                                                                                    |   | (2,995,488  | )          |
| Less common stock in treasury at cost, 33,000 shares                                                                                                                                    |   | (50,000     | )          |
|                                                                                                                                                                                    |   |        |       |
| Total shareholders’ equity (deficit)                                                                                                                                               |   | (3,045,488  | )          |
|                                                                                                                                                                                    |   |        |       |
|                                                                                                                                                                                    |   | $           | 12,567,567 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

29

----

 

REVCARE, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OFOPERATIONSFOR THE YEARS ENDED SEPTEMBER 30, 2004 AND 2003

 
| ** **                                                                                                   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| REVENUES                                                                                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service fees                                                                                                 |       | $          | 7,935,250  |       | $          | 9,537,602 |   |
| Sale of portfolio receivables                                                                                |       | 124,134    |       | —     |       |
|                                                                                                         |       | 8,059,384  |       | 9,537,602  |       |
|                                                                                                         |       |       |       |       |       |
| OPERATING EXPENSES:                                                                                          |       |       |       |       |       |
| Salaries, wages and related benefits                                                                         |       | 4,059,313  |       | 5,730,064  |       |
| Business segments operating expenses                                                                         |       | 1,235,496  |       | 1,719,089  |       |
| Selling, general and administrative                                                                          |       | 2,995,067  |       | 4,248,596  |       |
| Goodwill impairment expense                                                                                  |       | 625,500    |       | —     |       |
| Depreciation and amortization                                                                                |       | 361,308    |       | 433,581    |       |
| Total  operating expenses                                                                                    |       | 9,276,684  |       | 12,131,330 |       |
| OPERATING LOSS                                                                                               |       | (1,217,300 | )          | (2,593,728 | )          |
| OTHER INCOME (EXPENSE):                                                                                      |       |       |       |       |       |
| Interest expense, net                                                                                        |       | (929,117   | )          | (1,033,822 | )          |
| Rental operations, net                                                                                       |       | 101,907    |       | 38,065     |       |
| Other                                                                                                        |       | 10,130     |       | (9,592     | )          |
| Total  other expenses                                                                                        |       | (817,080   | )          | (1,005,349 | )          |
| LOSS FROM CONTINUING OPERATIONS BEFORE INCOME TAXES  AND CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE |       | (2,034,380 | )          | (3,599,077 | )          |
| INCOME TAX PROVISION                                                                                         |       | —     |       | —     |       |
| LOSS FROM CONTINUING OPERATIONS BEFORE CUMULATIVE  EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE                  |       | (2,034,380 | )          | (3,599,077 | )          |
|                                                                                                         |       |       |       |       |       |
| INCOME FROM DISCONTINUED OPERATIONS, NET OF TAXES (INCLUDING  GAIN ON SALE OF HELP OF $1,253,767 IN 2003)    |       | —     |       | 1,603,293  |       |
|                                                                                                         |       |       |       |       |       |
| CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE                                                          |       | —     |       | (1,576,328 | )          |
|                                                                                                         |       |       |       |       |       |
| NET LOSS                                                                                                     |       | $          | (2,034,380 | )          | $          | (3,572,112 | ) |
|                                                                                                         |       |       |       |       |       |
| BASIC AND DILUTED LOSS PER SHARE:                                                                            |       |       |       |       |       |
| Loss from continuing operations before cumulative  effect of change in accounting principle                  |       | $          | (0.10      | )          | $          | (0.17 | ) |
| Income from discontinued operations, net of taxes (including  gain on sale of HELP of $1,253,767 in 2003)    |       | —     |       | 0.07       |       |
|                                                                                                         |       |       |       |       |       |
| Cumulative effect of change in accounting principle                                                          |       | —     |       | (0.07      | )          |
| Net Loss                                                                                                     |       | $          | (0.10      | )          | $          | (0.17 | ) |
|                                                                                                         |       |       |       |       |       |
| Weighted average shares used in all calculations  (basic and diluted)                                        |       | 21,526,909 |       | 21,526,909 |       |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

30

----

 

REVCARE, INC. AND SUBSIDIARIESConsolidated Statements ofShareholders’ Equity (Deficit)For the Years Ended September 30, 2004 and 2003

 
| ** **                                            | ** **       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **           | ** ** | ** **               | ** ** | ** **          | ** ** | ** **                                      | ** ** |
|-------------------------------------------------------|------------------|------------|------------|------------|------------|------------|------------|------------|------------|----------------------|------------|--------------------------|------------|---------------------|------------|-------------------------------------------------|------------|
| ** **                                            | ** **       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Paid-in  Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Treasury  Stock** | ** ** | **Total  Shareholders’  Equity (Deficit)** | ** ** |
| **Series A Convertible  Redeemable Preferred  Stock** | **Common Stock** |
| **Shares**                                            | ** **       | **Amount** | **Shares** | ** ** | **Amount** |
|                                                  |             |       |       |       |       |       |       |       |       |                 |       |                     |       |                |       |                                            |       |
| BALANCES, at September 30, 2002                  |             |       | 345,000    |       | $          | 690,000    |       |       | 21,526,909 |                 | $          | 21,520                   |       | $                   | 10,658,282 |                                            | $          | (8,758,798 | ) | $ | (50,000 | ) | $ | 2,561,004 |   |
|                                                  |             |       |       |       |       |       |       |       |       |                 |       |                     |       |                |       |                                            |       |
| Net Loss                                              |             | —     |       | —     |       | —     |       | —     |       | —               |       |                     | (3,572,112 | )                   | —     |                                            |       | (3,572,112 | ) |
|                                                  |             |       |       |       |       |       |       |       |       |                 |       |                     |       |                |       |                                            |       |
| BALANCES, at September 30, 2003                  |             |       | 345,000    |       | $          | 690,000    |       |       | 21,526,909 |                 | $          | 21,520                   |       | $                   | 10,658,282 |                                            | $          | (12,330,910 | ) | $ | (50,000 | ) | $ | (1,011,108 | ) |
|                                                  |             |       |       |       |       |       |       |       |       |                 |       |                     |       |                |       |                                            |       |
| Net Loss                                              |             | —     |       | —     |       | —     |       | —     |       | —               |       |                     | (2,034,380 | )                   | —     |                                            |       | (2,034,380 | ) |
|                                                  |             |       |       |       |       |       |       |       |       |                 |       |                     |       |                |       |                                            |       |
| BALANCES, at September 30, 2004                  |             |       | 345,000    |       | $          | 690,000    |       |       | 21,526,909 |                 | $          | 21,520                   |       | $                   | 10,658,282 |                                            | $          | (14,365,290 | ) | $ | (50,000 | ) | $ | (3,045,488 | ) |

 

The accompanying notesare an integral part of these consolidated financial statement.

 

31

----

 

REVCARE, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSFOR THE YEARS ENDED SEPTEMBER 30, 2004 AND 2003

 
| ** **                                                                                                        | ** ** | **2004** | ** ** | **2003**   | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|----------|------------|------------|------------|
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                                             |       |     |       |       |       |
| Loss from continuing operations                                                                                   |       | $        | (2,034,380 | )          | $          | (3,599,077 | ) |
| Adjustments to reconcile loss from continuing  operations to net cash provided by(used in) continuing operations: |       |     |       |       |       |
| Depreciation and amortization                                                                                     |       | 361,308  |       | 433,581    |       |
| Loss on disposal of property and equipment                                                                        |       | 5,803    |       | —     |       |
| Goodwill impairment                                                                                               |       | 625,500  |       | —     |       |
| Changes in operating assets and liabilities:                                                                      |       |     |       |       |       |
| Decrease in accounts receivable, net                                                                              |       | 702,941  |       | 367,168    |       |
| Decrease (Increase) in notes receivable from  customer                                                            |       | 39,139   |       | (39,139    | )          |
| Increase in prepaid expenses and other                                                                            |       | (28,969  | )          | (344,433   | )          |
| Increase in accounts payable                                                                                      |       | 101,133  |       | 364,102    |       |
| Increase (Decrease) in collections payable to  customers                                                          |       | 46,230   |       | (347,195   | )          |
| Decrease in accrued liabilities                                                                                   |       | (23,133  | )          | (321,424   | )          |
| Net cash used in continuing operations                                                                            |       | (204,428 | )          | (3,486,417 | )          |
| Income from discontinued operations                                                                               |       | —   |       | 349,526    |       |
| Net cash used in- operating activities                                                                            |       | (204,428 | )          | (3,136,891 | )          |
|                                                                                                              |       |     |       |       |       |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                                             |       |     |       |       |       |
| Purchases of property and equipment                                                                               |       | (2,900   | )          | (1,132     | )          |
| Increase in restricted cash                                                                                       |       | (280,688 | )          | (1,027,538 | )          |
|                                                                                                              |       |     |       |       |       |
| Net cash used in investing activities                                                                             |       | (283,588 | )          | (1,028,670 | )          |
|                                                                                                              |       |     |       |       |       |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                                             |       |     |       |       |       |
| Net change in lines of credit                                                                                     |       | (289,460 | )          | 120,910    |       |
| Proceeds from note payable                                                                                        |       | 625,000  |       | —     |       |
| Proceeds from note payable from Lighthouse                                                                        |       | 260,275  |       | —     |       |
| Net proceeds from financing obligation                                                                            |       | —   |       | 5,786,633  |       |
| Proceeds from related party notes payable                                                                         |       | 162,162  |       | 1,500,000  |       |
| Proceeds from notes payable to vendors                                                                            |       | 188,936  |       | —     |       |
| Principal payments on financing obligations                                                                       |       | (367,989 | )          | (89,136    | )          |
| Principal payments on notes payable to related  parties                                                           |       | (225,000 | )          | (411,048   | )          |
| Principal payments on notes payable                                                                               |       | (2,000   | )          | —     |       |
| Principal payments on mortgage note payable                                                                       |       | —   |       | (2,886,894 | )          |
| Principal payments on capital lease obligations                                                                   |       | (69,646  | )          | (93,327    | )          |
| Decrease in bank overdraft                                                                                        |       | (106,858 | )          | (66,885    | )          |
| Net cash provided by financing activities                                                                         |       | 175,420  |       | 3,860,253  |       |
|                                                                                                              |       |     |       |       |       |
| NET DECREASE IN CASH                                                                                              |       | (312,596 | )          | (305,308   | )          |
| CASH, at beginning of year                                                                                        |       | 577,404  |       | 882,712    |       |
|                                                                                                              |       |     |       |       |       |
| CASH, at end of year                                                                                              |       | $        | 264,808    |       | $          | 577,404 |   |
|                                                                                                              |       |     |       |       |       |
| SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION AND  NON-CASH INVESTING AND FINANCING ACTIVITIES:                |       |     |       |       |       |
| Interest paid                                                                                                     |       | $        | 531,124    |       | $          | 615,605 |   |
| Interest payable converted to debt                                                                                |       | $        | 19,369     |       | $          | 539,933 |   |
|                                                                                                              |       |     |       |       |       |
| Exchange of HELP for reduction of debt                                                                            |       | $        | —     |       | $          | 1,900,000 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

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REVCARE, INC. AND SUBSIDIARIESNotes to ConsolidatedFinancial Statements

 

September 30, 2004

 

1.               Organization and Basis of Presentation

 

RevCare, Inc. (formerlyknown as Cypress Financial Services, Inc.), a Nevada corporation, (togetherwith its subsidiaries, the “Company”), provides accounts receivable management,administration, and debt collection services primarily to health care providersand consumer credit issuers. 

 

The accompanyingconsolidated financial statements have been prepared on a going concern basis,which contemplates the realization of assets and settlement of obligations inthe normal course of business.  TheCompany generated net losses of $2,034,380 and $3,572,112 in fiscal years 2004and 2003, respectively.  In addition, theCompany had a deficit of $3,045,488 and a working capital deficit of $6,668,788at September 30, 2004.  The workingcapital deficit includes $3,254,361 of principal and accumulated interest thatthe Company owes to its largest shareholder, FBR, which has provided funding tothe Company in the past. The accompanying consolidated financial statements donot include any adjustments relating to the recoverability and classificationof asset carrying amounts or the amount and classification of liabilities thatmight result should the Company be unable to continue as a going concern.

 

Management believes thatthe recent losses are primarily attributable to a decrease in revenues from itsservice lines which more than compensated for significant decreases inoperating costs.  The Company lost moreclients than it gained in 2004.  TheCompany’s cash balances may be diminished during 2005 due to many factors,including the use of cash for operations, changes in working capital, capitalexpenditures, repayment of outstanding notes payable and related interest andother factors. The number of major receivable management contracts for theCompany in 2005 is expected to be a little higher than 2004 and we expect thistrend to continue.  However,implementation and installation costs of new contracts will negatively impactthe Company’s cash balances. Despite these factors, the Company believes thatavailable funds and cash flows expected to be generated by current operationswill be sufficient to meet its anticipated cash needs for working capital andcapital expenditures for its operating segments for at least the next twelvemonths. However, the Company will not have sufficient cash to repaynon-operating liabilities (primarily the Notes Payable and FinancingObligations)  and credit facilities thatwill be due during the next twelve months.

 

The Company will berequired to consider other financing alternatives during the next twelve monthsor thereafter as a result of future business developments, including anyacquisitions of business assets, any shortfall of cash flows generated byfuture operations in meeting the Company’s ongoing cash requirements, or if theCompany was unable to renew or replace the current credit facility after itsexpiration in February 2005. Such financing alternatives could includeselling additional equity or debt securities, obtaining long or short-termcredit facilities, or selling operating assets. No assurance can be given,however, that the Company could obtain such financing on terms favorable to theCompany or at all. Any sale of additional common stock or convertible equity ordebt securities would result in additional dilution to the Company’sshareholders. As a component of the process of requesting any additionalfinancing that may be required, management may approach FBR. However, there canbe no assurance that such financing could be arranged on terms satisfactory tous or FBR, or at all.

 

2.               Summary of Significant Accounting Policies

 

a.               Principles of Consolidation

 

The accompanying consolidated financial statementsinclude the accounts of RevCare, Inc. and its wholly owned subsidiaries. Allsignificant inter-company accounts have been eliminated in consolidation.

 

b.              Use of Estimates

 

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States requires managementto make certain estimates and assumptions that affect the reported amounts ofassets and liabilities and disclosure of contingent assets and liabilities atthe date of the financial

 

33

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statements and the reported amounts of revenues andexpenses during the reporting periods. Actual results could materially differfrom those estimates. 

 

c.               Revenue Recognition

 

i.  Service Fees

 

The Company provides collection, auditing, billing andstaffing services for entities primarily in the healthcare industry for a fee.  Revenue recognition varies between thebusiness segments based upon the services provided. 

 

Revenues from the delinquent debt and insurancecollection practices are based on a percentage of total collections per eachcontract. Such revenues are recognized upon receipt of cash from thethird-party payers that the Company collects from on behalf of its client.  

 

Revenues from the auditing and billing divisions arebased on respective contractual percentage of payments received by ourclients.  Customers, comprised mostly ofinsurance companies, generally make payments to our clients who then reportsuch amounts to the Company. The Company recognizes revenues based on suchpayment reports.

 

Revenue from the staffing division is recognized basedupon hourly rates, and is recorded as services are rendered.  The Company’s payroll system posts staffingdivision hours to individual projects on a monthly basis.  The Company bills its clients for the hoursincurred at the contract rates. In August 2003, we entered into anExchange Agreement with Russell and Suzette Mohrmann and their affiliate,Hospital Employee Labor Pool, a California corporation, or HELP, pursuant towhich there was a transfer of substantially all the assets related to ouradministrative and back office temporary staffing division. See Note 12, formore information regarding this matter.  

 

ii.  Sale of Portfolio Receivables andSecuritized Residual Interest

 

We previously purchased charged-off accountsreceivable portfolios.  Collections fromthese portfolios represented a portion of our revenues.  Portions of these portfolios were also soldto provide additional revenues.  Wediscontinued purchasing these portfolios in 1999 and subsequent to September 30,2001, we sold our remaining portfolios and assets included in the Company’s1998 securitization.  The terms of thesale included an immediate payment of $300,000 and a contingency payment of upto $350,000. As of September 30, 2004, the Company has received additionalconsideration of $124,134 from the buyer for collections received through April 2004that were subject to the contingency payment. This amount was recognized as revenue on sale of portfolio receivablesin the accompanying financial statements and was settled by cash receipts of$79,037, revenue accrual of $13,000, the elimination of a $62,348 liability dueto buyer and the collection of $30,251 accounts receivables. We also receivedan additional $50,000 subsequent to September 30, 2004.  Additional receipt of contingent paymentswill be dependent upon the success of the buyer in its collections; therefore,we are unable to predict the timing of any additional payments.

 

d.              Accounts Receivable and Allowance forDoubtful Accounts

 

As of September 30, 2004, accounts receivable andthe related allowance for doubtful accounts were comprised of the following:

 
| Billed receivables                                           |   | $         | 1,109,883 |   |
|--------------------------------------------------------------|--------|-----------|-----------|--------|
|                                                         |   |      |      |
| Unbilled receivables                                         |   | 57,541    |      |
|                                                         |   |      |      |
| Total                                                        |   | 1,167,424 |      |
|                                                         |   |      |      |
| Allowance for doubtful accounts                              |   | (202,163  | )         |
|                                                         |   |      |      |
| Accounts receivable, net of allowance for doubtful  accounts |   | $         | 965,261   |   |

 

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Unbilledreceivables primarily relate to the cost of services provided by our managedcare unit upon its completion of the work as required by the respectivecontracts but has not been invoiced at the end of an accounting period. Theseamounts are subsequently classified as billed receivables when the respectiveinvoices are sent to the clients.

 

TheCompany maintains allowances for doubtful accounts for estimated lossesresulting from our customer’s inability to make required payments.  Management reviews all accounts receivable ona monthly basis.  Specific invoices over60 days are discussed with clients. Based upon historical experience with individual clients, managementassesses whether a specific reserve is required for each invoice or clientbalance. 

 

TheCompany has generally improved the size and quality of its clients, which hasreduced the level of write-offs over the last fiscal year ended September 30,2004. The financial condition of a potential client is reviewed to determinecredit worthiness.  Should a potentialclient’s credit worthiness come into question, the Company has two options;either reject the engagement or accept the client as a “Net” remit client.  Under the “Net” remit option, the Companyretains the portion of the collections that represent fees to the Companyinstead of remitting the entire amount collected and invoicing the client forthe fees due.

 

e.               Property and Equipment

 

Furniture, fixtures and equipment are carried at costand depreciated using either straight-line or accelerated methods over theestimated useful lives of the assets, which are generally 4 to 7 years. Thebuilding is depreciated over a period of 39 years. Repairs and maintenance arecharged to expense as incurred; replacements and improvements that extend theuseful life of the assets are capitalized. As of May 21, 2003, the building wassold and leased back to the Company (see Note 7).

 

f.                 Impairment of Long-Lived Assets

 

TheCompany assesses the recoverability of its long-lived assets on an annual basisor whenever adverse events or changes in circumstances or business climateindicate that expected undiscounted future cash flows related to suchlong-lived assets may not be sufficient to support the net book value of suchassets. Such a triggering event could include a significant decrease in themarket value of an asset, or a significant change in the extent or manner inwhich an asset is used or a significant physical change in an asset. Ifundiscounted cash flows are not sufficient to support the recorded assets,impairment is recognized to reduce the carrying value of the long-lived assetto the estimated fair value. Estimated fair value will be determined bydiscounting the future expected cash flows using a current discount rate ineffect at the time of impairment. Cash flow projections, although subject to adegree of uncertainty, are based on trends of historical performance andmanagement’s estimate of future performance, giving consideration to existingand anticipated competitive and economic conditions. Additionally, inconjunction with the review for impairment, the remaining estimated lives ofcertain of the Company’s long-lived assets are assessed.

 

g.     Collections Payable toCustomers

 

The Company records liabilities for collectionsreceived on behalf of its customers as collections payable to customers.  Most of our customer contacts do not requirethese collected funds to be segregated from our operating cash accounts.  Accordingly, these amounts are included incash until remitted to customers.  Amountsthat are required to be segregated and held in separate accounts are shown asRestricted Cash in the accompanying consolidated balance sheet. 

 

Commencing in September 2001, in some cases whereCalifornia-based delinquent debt collection clients did not have the agreementwith the Company which required the Company to maintain the funds collected onthe clients’ behalf in a separate account, the Company transferred funds fromthe client account to its general operating account. In addition, payments tosuch clients were withheld for 90 to 120 days, and sometimes longer. TheCompany has relied upon the repeal of previous California statutes requiringsegregation of client funds by collection agencies when our client contract didnot contain an express provision requiring segregation.  In July 2003, the Company determined,despite the lack of clear authority, that the practice of transferring clientfunds to operating accounts or delay on remitting funds might be deemed abreach of our obligations. Since the Company is unable to determinedefinitively if this is the case, the Company has taken and is takingadditional steps to address this practice. Client funds are no longertransferred to operating accounts for any reason (other than funds owed to theCompany for its services to which it is contractually entitled).

 

35

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h.     Fair Value of FinancialInstruments

 

Fair value of financial instruments is estimated usingavailable market information and other valuation methodologies. Financialinstruments include accounts receivable, note receivable from officer, mortgageand notes payable and capital lease obligations.  The fair values of the Company’s financialinstruments are estimated to approximate the carrying value due to theirrelatively short-term nature and fluctuating interest rates with market rates.

 

i.      Restricted Cash

 

Restricted Cash is primarily comprised of cash inclients’ trust accounts and lease deposits. As a condition of the leaseagreement dated May 21, 2003, the Company set aside $1,050,000 in a restrictedaccount to collateralize the letters of credit used as deposits to thesubsequent lease of the property (see Note 7).

 

j.      Goodwill

 

Goodwill represents the excess of cost over the fairvalue of net assets acquired.  Thecarrying value of goodwill is reviewed on a regular basis for the existence offacts or circumstances, both internally and externally, that may suggestimpairment.  The Company periodicallyre-evaluates the original assumptions and rationale utilized in theestablishment of the carrying value and estimated useful lives of goodwill.

 

In June 2001, the FASB issued SFAS No. 142, “Goodwilland Other Intangible Assets.”  This statement addresses financialaccounting and reporting for acquired goodwill and other intangible assets andsupersedes APB Opinion No. 17, “Intangible Assets.”  SFAS No. 142addresses how intangible assets that are acquired individually or with a groupof other assets (but not those acquired in a business combination) should beaccounted for in financial statements upon their acquisition.  Thisstatement also addresses how goodwill and other intangible assets should beaccounted for after they have been initially recognized in the financialstatements.  Upon adoption of SFAS No. 142, goodwill is no longer subjectto amortization over its estimated useful life but is instead subject toperiodic testing for impairment.  The Company adopted this Statement andcompleted its initial impairment test for goodwill as of October 1,2002.  As a result of this assessment, the Company determined that one ofits segments, HELP, was impaired and recorded an impairment charge of$1,576,328 in the quarter ended December 31, 2002. The impairment has beenreported as a cumulative effect of a change in accounting principle. Inaddition to the impairment, the impact of adopting SFAS No. 142 was to ceasethe amortization of goodwill, which would have amounted to $528,960 ofamortization expense for the year ended September 30, 2003.  Net lossfor the year ended September 30, 2003, including amortization of goodwill,would have been $4,101,072 compared to $3,572,112. 

 

For the year ended September 30, 2004, theCompany recognized a goodwill impairment expense of $625,500 related to thePhysician Services segment.

 

k.               Loss Per Share

 

TheCompany reports basic and diluted earnings (loss) per share (EPS) in accordancewith SFAS No. 128.  Basic EPS is computedby dividing losses available to common shareholders by the weighted averagenumber of common shares outstanding. Diluted EPS is computed by adding to the weighted average number ofshares the dilutive effect of common stock equivalents, if any.

 

For the years ended September 30, 2004 and 2003,the computations of basic and diluted EPS were as follows:

 
| ** **                                                                                               | ** ** | **Years Ended September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                               | ** ** | **2004**                           | ** ** | **2003** | ** ** |
|                                                                                                     |       |                               |       |   |   |
| Loss from continuing operations before cumulative  effect of change in accounting principle              |       | $                                  | (2,034,380 | ) | $ | (3,599,077 | ) |
| Income from discontinued operations, net of taxes,  including gain on sale of HELP of $1,253,767 in 2003 |       | —                             |       | 1,603,293 |   |
| Cumulative effect of change in accounting principle                                                      |       | —                             |       | (1,576,328 | ) |
| Net loss                                                                                                 |       | $                                  | (2,034,380 | ) | $ | (3,572,112 | ) |
|                                                                                                     |       |                               |       |   |   |
| Loss per share (basic and diluted):                                                                      |       |                               |       |   |   |
| Loss from continuing operations before cumulative  effect of change in accounting principle              |       | $                                  | (0.10      | ) | $ | (0.17 | ) |
| Income from discontinued operations, net of taxes,  including gain on sale of HELP of $1,253,767 in 2003 |       | —                             |       | 0.07 |   |
| Cumulative effect of change in accounting principle                                                      |       | —                             |       | (0.07 | ) |
| Net loss                                                                                                 |       | $                                  | (0.10      | ) | $ | (0.17 | ) |
|                                                                                                     |       |                               |       |   |   |
| Weighted average shares used in all calculations  (basic and diluted)                                    |       | 21,526,909                         |       | 21,526,909 |   |
|                                                                                                          |            |                                    |            |  |  |  |  |  |  |

 

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Forthe periods presented there were no reconciling items in computing the basicand diluted EPS calculations for either the numerator or the denominator.

 

Forthe periods ended September 30, 2004 and 2003, the denominator in thediluted EPS computation was the same as the denominator for basic EPS due tothe anti-dilutive effects of convertible preferred stock, warrants and stockoptions on the Company’s net loss.  As of September 30, 2004 and2003, the Company had outstanding warrants, stock options and convertiblepreferred stock of 2,779,908 and 2,176,158,  respectively, that were anti-dilutive andexcluded from the computation of dilutive EPS. Additionally, the computation ofdiluted net income (loss) per share excludes the effect common stock issuableupon conversion of the Convertible Notes (Note 6) since their inclusion wouldalso have had an anti-dilutive effect. 

 

l.      Income Taxes

 

TheCompany accounts for income taxes using the asset and liability method. Underthis method, deferred tax assets and liabilities are determined based ondifferences between the financial reporting and the tax basis of assets andliabilities and are measured using the enacted tax rates and laws.  A valuation allowance is provided for certaindeferred tax assets if it is more likely than not that the Company will notrealize tax assets through future operations.

 

m.    Stock Option Plan

 

Aspermitted under SFAS No. 148, “Accounting for Stock-BasedCompensation-Transition and Disclosure,” which amended SFAS No. 123, “Accountingfor Stock-Based Compensation,” the Company has elected to continue to accountfor its stock-based compensation in accordance with the provisions ofAccounting Principles Board Opinion (APB) No. 25, “Accounting for Stock Issuedto Employees.”  Under APB 25,compensation expense is recognized over the vesting period based on the excessof the fair market value over the exercise price on the date of grant. It isthe Company’s policy to issue options at fair market value or at a 10 percentpremium over fair market value if the individual is a 10 percent or moreshareholder. Since the exercise price never exceeds fair market value, there isno compensation expense to be realized.  

 

In1995, the Company adopted, and the shareholders approved, the 1995 Stock OptionPlan (the Plan) which authorized 450,000 stock option grants to purchase theCompany’s common stock. In August 1998, the Board of Directors andShareholders approved a 500,000-share increase to the Plan increasing the totalnumber of shares reserved for issuance pursuant to the Plan to 950,000shares.  During fiscal year 2000, theBoard of Directors and Shareholders approved increasing the total number ofshares reserved for issuance pursuant to the Plan to 3,250,000 shares.

 

ThePlan provides for the grant by the Company, of options to purchase shares ofthe Company’s common stock to its officers, directors, employees, consultantsand advisors. The Plan provides that it is to be administered by a committeeappointed by the Board of Directors (the Committee) all of whom are “disinterested”under 16b-3 of the Securities Exchange Act of 1934, as amended. The Committeehas discretion, subject to the terms of the Plan, to select the personsentitled to receive options under the Plan, the terms and conditions on whichoptions are granted, the exercise price, the time period for vesting suchshares, the number of shares subject thereto, and whether such options shallqualify as “incentive stock options” within the meaning of Section 422 ofthe Internal Revenue Code, or “non-qualified stock options.”

 

TheCompany has granted 3,489,708 options under the Plan, of which 1,454,800 havebeen forfeited. These options are issued at fair market value or at a 10percent premium over fair market value if the individual is a 10 percent ormore shareholder. All options granted expire ten years from the date of grant.At September 30, 2004, there were 1,215,092 additional shares availablefor grant under the Plan.

 

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Duringfiscal year 2004, the Company granted 1,000,000 options to certain employees atan exercise price of $0.50 per share.  Nocompensation expense was recorded.  

 

Asummary of the status of the Plan at September 30, 2004 and 2003 andchanges during the years then ended is presented in the table and narrativebelow:

 
| ** **                       | ** ** | **September 30, 2004** | ** ** | **September 30, 2003**                | ** ** |
|----------------------------------|------------|-----------------------------|------------|--------------------------------------------|------------|
| ** **                       | ** ** | ** **                  | ** ** | **Weighted****Average  Exercise****Price** | ** ** | ** ** | ** ** | **Weighted****Average  Exercise****Price** | ** ** |
| ** **                       | ** ** | **Shares**                  | ** ** | ** **                                 | **Shares** | ** ** | ** ** |
| Outstanding at beginning of year |       | 1,094,908                   |       | $                                          | 0.65       |   | 1,386,658 |   | $ | 0.65 |   |
| Granted                          |       | 1,000,000                   |       | 0.50                                       |       | 50,000 |   | 0.50 |   |
| Exercised                        |       | —                      |       | —                                     |       | — |   | — |   |
| Forfeited                        |       | (60,000                     | )          | 0.29                                       |       | (341,750 | ) | 0.52 |   |
|                             |       |                        |       |                                       |       |   |   |   |   |
| Outstanding at end of year       |       | 2,034,908                   |       | $                                          | 0.59       |   | 1,094,908 |   | $ | 0.65 |   |
| Exercisable at end of year       |       | 2,034,908                   |       | $                                          | 0.59       |   | 1,091,574 |   | $ | 0.65 |   |

 
| **Range of  Exercise Price** | ** ** | **Number of  Shares  Outstanding** | ** ** | **Weighted  Average  Remaining  Contractual Life  in Years** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|------------------------------|------------|------------------------------------|------------|--------------------------------------------------------------|------------|---------------------------------------|------------|
| $0.25 – $1.03           |       | 1,766,308                          |       | 7.0                                                          |       | $                                     | 0.51       |   |
| $2.75                        |       | 268,600                            |       | 2.0                                                          |       | $                                     | 2.75       |   |
|                         |       | 2,034,908                          |       |                                                         |       |                                  |       |

 

Thefair value of each option grant is estimated on the date of grant using theBlack Scholes Option Pricing Model with the following assumptions in 2004 and2003: weighted average risk-free interest rate of 3.4 and 5.1 percent; aweighted average volatility of 93.5 and 354.9 percent; an expected life of 5and 5 years respectively; and no expected dividend yield. Under the accountingprovisions of SFAS Statement 123, the proforma impact to Net Loss and EarningsPer Share is as follows:

 
| ** **                          | ** **  | **2004** | ** ** | **2003**   | ** ** |
|-------------------------------------|-------------|----------|------------|------------|------------|
| Net Loss:                           | As Reported |     | $          | (2,034,380 | )          | $ | (3,572,112 | ) |
| Less expense recorded in net loss   |        | —   |       | —     |       |
| Plus pro forma compensation expense |        | (137     | )          | (60,771    | )          |
| Net Loss:                           | Pro Forma   |     | $          | (2,034,517 | )          | $ | (3,632,883 | ) |
|                                |        |     |       |       |       |
| Basic EPS:                          | As Reported |     | $          | (.10       | )          | $ | (.17 | ) |
|                                | Pro Forma   |     | $          | (.10       | )          | $ | (.17 | ) |
| Diluted EPS:                        | As Reported |     | $          | (.10       | )          | $ | (.17 | ) |
|                                | Pro Forma   |     | $          | (.10       | )          | $ | (.17 | ) |
|                                     |             |          |            |            |            |  |  |  |  |

 

 

 

n.              Rental Operations

 

The Company leases a portion of its building tounrelated parties. Management allocates certain costs incurred to rentaloperations based on a ratio of square footage to the total square footage ofthe respective building. The results of rental operations for the years ended September 30,2004 and 2003 are as follows:

 

38

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| ** **          | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------|------------|----------|------------|----------|------------|
|                |       |     |       |     |       |
| Rental income       |       | $        | 240,286    |     | $          | 188,998 |   |
| Utilities and other |       | (138,379 | )          | (150,933 | )          |
|                |       | $        | 101,907    |     | $          | 38,065 |   |
|                     |            |          |            |          |            |  |  |  |  |

 

o.     Recent AccountingPronouncements

 

TheFASB has issued Interpretation No. (FIN) 46, “Consolidation of VariableInterest Entities” – an interpretation of Accounting Research Bulletin (“ARB”)No. 51.  This Interpretation defines avariable interest entity and provides that if a business enterprise has acontrolling financial interest in a variable interest entity, the assets,liabilities, and results of the activities of the variable interest entityshould be included in consolidated financial statements with those of thebusiness enterprise.  Furthermore, theFASB indicates that the voting interest approach of ARB No. 51 is not effectivein identifying controlling financial interests in entities that are notcontrollable through voting interest or in which the equity investors do notbear the residual economic risk.  ThisInterpretation applies immediately to variable interest entities created after January 31,2003, and to variable interest entities in which an enterprise obtains aninterest after that date.  As a result ofthe issuance of FASB Staff Position FIN 46-6 “Effective Date of FASBInterpretation No. 46, Consolidation of Variable Interest Entities*,”* FIN 46 applies at the end of the interim or annual periodending after December 15, 2003, to variable interest entities in which anenterprise holds a variable interest that it acquired before February 1,2003.  Management adopted thisInterpretation effective the end of the three months ended December 31,2003, which did not have a material effect upon the Company’s consolidatedfinancial statements.

 

In May2003, the FASB issued SFAS No. 150, “Accounting for Certain FinancialInstruments with Characteristics of Both Liabilities and Equity.” ThisStatement establishes standards for how an issuer classifies and measurescertain financial instruments with characteristics of both liabilities andequity. It requires that an issuer classify a financial instrument that iswithin its scope as a liability (or an asset in some circumstances). This Statementis effective for financial instruments entered into or modified after May 31,2003, and otherwise is effective at the beginning of the first interim periodbeginning after June 15, 2003. The adoption of this Statement did not havea material impact on our financial condition or results from operations.

 

In June 2002, the FASB approved for issuance SFASNo. 146, “*Accounting for Costs Associated with Exit orDisposal Activities*.”  ThisStatement provides financial accounting and reporting guidance for costsassociated with exit or disposal activities and nullifies EITF Issue 94-3, “LiabilityRecognition for Certain Employee Termination Benefits and Other Costs to Exitan Activity (including Certain Costs Incurred in a Restructuring).” SFASNo.  146 is effective for exit ordisposal activities initiated after December 31, 2002.  Previously issued financial statements shouldnot be restated.  The provisions of EITFIssue 94-3 continue to apply for an exit activity initiated under an exit planthat met the criteria in EITF Issue 94-3 before the Statement’s initialapplication.  The implementation of thisstandard did not have a material effect upon the Company’s financial statements

 

In December 2002, the FASB issued SFAS No. 148, “Accountingfor Stock-Based Compensation – Transition and Disclosure”, an amendment of FASBStatement No. 123.  The disclosurerequirements of Statement 123, “Accounting for Stock-Based Compensation”, whichapply to stock compensation plans of all companies, are amended to require certaindisclosures about stock-based employee compensation plans in an entity’saccounting policy note.  Thosedisclosures include a tabular format of pro forma net income and, ifapplicable, earnings per share under the fair value method if the intrinsic valuemethod is used in any period presented. Pro forma information in a tabular format is also required in the notesto interim financial information if the intrinsic value method is used in anyperiod presented.  Before amendment bySFAS No. 148, SFAS No. 123 required entities changing to the fair value methodof accounting for stock-based employee compensation to account for the changein method prospectively.  The Boarddecided to provide a choice among three transition methods (the prospectivemethod originally required by SFAS 123, the modified prospective method, andthe retroactive restatement method) for entities voluntarily adopting the fairvalue method in periods beginning before December 16, 2003.  SFAS No. 123’s original prospectivetransition method will not be available to entities changing to the fair valuemethod in fiscal years beginning after December 15, 2003. 

 

39

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The amendments to the disclosure and transitionprovisions of Statement 123 are effective for fiscal years ending after December 15,2002.  Calendar year-end entities arerequired to include the new disclosures in their 2002 financialstatements.  The disclosure requirementfor interim financial information is effective for interim periods beginningafter December 15, 2002.  Managementdoes not intend to transition to the fair value method of accounting for stockoptions and believes implementation of this standard will not have a materialeffect upon the Company’s financial statements except to include the additionalrequired disclosures.

 

The FASB issued Interpretation No. 45, “Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others,” – an interpretation of FASB Nos. 5, 57and 107 and rescission of FASB Interpretation No. 34.  This Interpretation elaborates on thedisclosures to be made by a guarantor in its interim and annual financialstatements about its obligations under certain guarantees that it hasissued.  It also clarifies that aguarantor is required to recognize, at the inception of a guarantee, aliability for the fair value of the obligation undertaken in issuing theguarantee.  The initial recognition andmeasurement provisions of this Interpretation are applicable on a prospectivebasis to guarantees issued or modified after December 31, 2002.  Implementation of these provisions of theInterpretation did not have a material impact on the Company’s consolidatedfinancial statements. The disclosure requirements of the Interpretation are effective forfinancial statements of interim or annual periods ended after December 15,2002, and have been adopted in the accompanying consolidated financialstatements as of September 30, 2002 (see Note 9 (d)). 

 

In December 2004, the FinancialAccounting Standards Board (FASB) issued SFAS No. 123(R) Share-Based Payment,which addresses the accounting for share-based payment transactions. SFAS No.123(R) eliminates the ability to account for share-based compensation transactionsusing APB Opinion No. 25, Accounting for Stock Issued to Employees, andgenerally requires instead that such transactions be accounted and recognizedin the statement of income based on their fair value. SFAS No. 123(R) will beeffective for public companies that file as small business issuers as of thefirst interim or annual reporting period that begins after December 15,2005. SFAS No. 123(R) offers the Company alternative methods of adopting thisstandard. At the present time, the Company has not yet determined whichalternative method it will use and the resulting impact on its financialposition or results of operations. 

 

p.     Reclassification

 

Certain amounts in the accompanying 2003 consolidatedfinancial statements have been reclassified to conform to the presentation usedin 2004.

 

3.               Acquisition and Goodwill

 

On August 14,2000, Cypress Financial Services, Inc. completed the purchase of all of theoutstanding stock of Orange County Professional Service, Inc. (“OCPS”).  OCPS became a subsidiary of Cypress FinancialServices, which changed its name to RevCare Inc.  Concurrent with this acquisition, OCPSacquired substantially all of the assets of RBA Rem-Care, Inc., InsourceMedical Solutions, LLC and Hospital Employee Labor Pool, affiliates ofOCPS.  This acquisition was accounted forusing the purchase method of accounting. The Company paid approximately $11,000,000 in cash and issued notespayable for $3,675,000.  The excess ofthe purchase price over the fair value of the net assets acquired of$10,773,940 was recorded as goodwill. The operations of OCPS have been included in the accompanyingconsolidated financial statements from the date of acquisition. In 2003, wewrote off goodwill by $2,130,887 due to the impairment identified in connectionwith the adoption of SFAS No. 142 and the disposition of the Hospital EmployeeLabor Pool segment of our business (see Notes 2 and 12).  Also, in 2004, we recognized a goodwillimpairment of $625,500 related to the Physician Services segment.

 

4.               Related Party Transactions

 

In 1998, as part of Mr. Manny Occiano’s originalemployment agreement, Mr. Occiano is eligible to participate in the managementbonus pool to be established by the Board of Directors and is entitled, during1999 only, to quarterly advances of $22,500 to be credited against themanagement bonus when earned.  Mr.Occiano received four such advances in 1999 amounting to $90,000.  This amount may be credited against futuremanagement bonuses when earned.  Therehave not been any advances made since 1999. Mr. Occiano

 

40

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also received a loan of $100,000 to purchase 66,000shares of common stock on the open market. The loan is secured by a pledge of the common stock acquired and otherassets and is a full recourse obligation.

 

Inconjunction with the acquisition of OCPS, on August 14, 2000 the Companyissued $3,675,000 of secured convertible promissory notes to shareholders andofficers of OCPS, one of whom is still an employee of the Company. These noteshave been paid and/or amended since that time. One of the notes bears interest at 8% per annum and is payable through February 2007.  The remaining note bears interest at primeplus 4% per annum and is due in August 2005.  The principal balance of these notes at September 30,2004 was $1,885,038. 

 

On September 28,2001, the Company entered into a revolving line of credit agreement with twoofficers of the Company.  The agreementpermits borrowings up to $350,000 at the bank reference rate plus onepercent.  The line of credit wasunsecured and expired in June 2004. As of June 30, 2004, the Company had fully paid its borrowings onthis line of credit.

 

As of September 30,2004, the total principal balance of the Company’s borrowings from FBRFinancial Services Partners, L.P. (FBR), was $2,878,439 under securedconvertible notes payable agreements. The significant attributes of these notesinclude the following:

 

•                  The maturity date is September 1,2005 on notes totaling $2,722,325. 

 

•                  Interest rates on the notes is theprime rate charged by the Company’s lender (4.75% at September 30, 2004)plus 4% per annum payable on the maturity date. 

 

•                  All or any portion of the unpaidprincipal balance and any accrued but unpaid interest outstanding under theseNotes may be converted into fully paid and nonassessable shares of capitalstock of the Company (the “Stock”) concurrently upon or at any time following aFinancing (as defined below) at the option of Holder.  The Stock shall have all of the rights,preferences and privileges of the capital stock issued in the Financing.  The number of shares of Stock into whichthese Notes are to be converted shall be determined by dividing said unpaidprincipal balance and all accrued but unpaid interest by the ConversionPrice.  The “Conversion Price” shall bedetermined at such time as the Company closes an equity financing of Stock ordebt convertible into Stock with gross proceeds to the Company of least$500,000 (the “Financing”).  TheConversion Price shall be the price per share at which the Stock is sold in theFinancing or the price at which the debt converts into Stock.

 

On February 19,2004 and March 16, 2004 the Company entered into secured convertible notespayable agreements for $100,000 and $50,000, respectively, with FBR.  The notes bear interest at the prime rate,defined as the base rate on corporate loans posted by at least 75% of thenation’s 30 largest banks as recorded in the *Wall StreetJournal*, (4.75% at September 30, 2004) plus four percent (4%),compounded quarterly.  The principal andall accrued interest are due on November 1, 2005, the maturity date of thenotes. All or any portion of the unpaid principal balance and any accrued butunpaid interest outstanding under this Note may be converted (the “OptionalConversion”) at any time at the option of the Holder into fully paid andnonassessable shares of capital common stock of the Company (the “Stock”).  The number of shares of Stock into which thisNote is to be converted shall be determined by dividing said unpaid principalbalance and all accrued but unpaid interest by the Conversion Price.  The Conversion Price shall be calculated atthe time of the Optional Conversion based on a Company valuation of 90% of 12times the average prior 12 months monthly revenue prior to the OptionalConversion, the result will then be divided by the number of then outstandingshares on a fully converted basis.

 

Thetotal interest expense on related party notes for the years ended September 30,2004 and 2003 is $382,501 and $437,355, respectively.  

 

Thenotes are secured by substantially all of the Company’s assets, including theshares in the Company’s subsidiary, Orange County Professional Services, Inc.,pursuant to a security agreement.

 

41

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5.               Property and Equipment

 

Property and equipment consists of the following at September 30,2004:

 
| Land                              |   | $          | 866,575   |   |
|-----------------------------------|--------|------------|-----------|--------|
| Building                          |   | 1,540,577  |      |
| Furniture, fixtures and equipment |   | 2,586,367  |      |
|                              |   | 4,993,519  |      |
| Less - Accumulated depreciation   |   | (2,422,478 | )         |
|                              |   | $          | 2,571,041 |   |

 

Depreciation expense for the years ended September 30,2004 and 2003 totaled $361,308 and $433,581, respectively.

 

6.               Notes Payable and Lines of Credit

 

On February 11,2003, the Company entered into a secured line of credit, which providesborrowing up to $2,500,000 at the bank’s reference rate of prime (the minimumamount this can be according to the terms of the agreement is 4.75% at September 30,2004) plus 2.5 percent. The line automatically renews upon the one-yearanniversary of the execution, and shall continue to renew each subsequent year,unless earlier termination by either party. The maximum amount we can borrow iscontingent on and collateralized by qualified invoices, which will fluctuatefrom time to time depending on our business volume.  The outstanding balance on this line ofcredit at September 30, 2004 was $276,284, which was the maximum amountavailable to the Company under this line at that time.  

 

In November 2003,the Company entered into a “Business Financing Modification Agreement” withBridge bank whereby the Company borrowed $135,000.  The amount borrowed increased to $225,000 in January 2004and the capacity to borrow was increased to $625,000 in February 2004.  The proceeds of the note were used forworking capital.  The agreement, which bearsinterest at prime as published in the *Wall Street Journal*Westernedition (4.75% at September 30, 2004) plus 4.3%, required the Company tomake 12 monthly principal and interest payments of $19,694 through February 2005.  Under the Agreement, $625,000 is guaranteedby FBR.  The cost to the Company for thisguarantee is 8% of the total $625,000 or $50,000 due within 30 days of the endof the term of the note.  The draws underthese agreements amortize over twelve months. As of August 5, 2004, the Company signed a “Business FinancingModification Agreement” which allowed the Company to advance the remainingamount of the $625,000 and only make interest payment each month.

 

On February 9,2004 the Company entered into a secured convertible note payable agreement for$250,000 with the principal owner of Lighthouse (Lighthouse).  The note bears interest at the prime rate,defined as the base rate on corporate loans posted by at least 75% of the nation’s30 largest banks as recorded in the *Wall Street Journal*,(4.75% at September 30, 2004) plus four percent (4%), compoundedquarterly.  The principal and all accruedinterest are due on November 1, 2005, the maturity date of the note. Allor any portion of the unpaid principal balance and any accrued but unpaidinterest outstanding under this Note may be converted (the “Optional Conversion”)at any time at the option of the Holder into fully paid and nonassessableshares of capital common stock of the Company (the “Stock”).  The number of shares of Stock into which thisNote is to be converted shall be determined by dividing said unpaid principalbalance and all accrued but unpaid interest by the Conversion Price.  The Conversion Price shall be calculated atthe time of the Optional Conversion based on a Company valuation of 90% of 12times the average prior 12 months monthly revenue prior to the OptionalConversion, the result will then be divided by the number of then outstandingshares on a fully converted basis.  

 

During2004, the Company agreed with a couple of vendors to convert its outstandingaccounts payable into unsecured notes payable. Under the terms of the agreements, the Company agreed to pay fixedmonthly amortizations until the note is paid. One of the notes bears interest rate of 4.25% per annum and expires inMay 2013.  The other is a short-termnote, which bears interest rate of 10% and expires in March 2005.

 

42

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7.               Sale and Leaseback of Building

 

The Company had a mortgage note payable to a bank of$2,886,894, collateralized by land and a building, due in monthly payments of$25,984, bearing interest at an interest rate based on the yield of the U.S.Five Year Treasury Swap Rate (“the Index”) + 2.5 percent and no cap. Said ratewill be fixed for five years and adjusted on the first business day of eachfive-year anniversary date of the promissory note dated December 19, 2000through January 2021, at which time the entire principal balance becomesdue and payable. 

 

On May21, 2003, the Company’s wholly owned subsidiary, Medical Control Services, Inc.(MCI), which held title to our corporate facility, completed the sale of theproperty to SCP Park Meadows, LLC (SCP). On that same date, the Company entered into a Lease Agreement dated May21, 2003 with SCP (the “Lease”). The net proceeds from the sale of theproperty, after paying off the existing mortgage on the property and payingcommissions and expenses and depositing $1,050,000 to a restricted account tocollateralize the letters of credit used as rent deposits related to thesubsequent lease of the property, equaled $1,352,361. The transaction wasaccounted for as a financing transaction with no gain or loss recorded and theproceeds recorded as a liability.  TheLease provides, among other things, all of the following:

 

• a twelve-year term, with twoadditional renewal options of five years each;

 

• base rent of $53,937 per month forthe first three years of the Lease, with annual adjustments thereafter based onan index, subject to minimum and maximum annual increases;

 

• a tenant improvement allowance of$50,000;

 

• the Company has responsibility forvarious costs, including those associated with maintaining, insuring, repairingand replacing items on the property;

 

• security deposits in the form of twoirrevocable letters of credits totaling $1,050,000, $400,000 of which issubject to release if we satisfy specified conditions no sooner than 12 monthsfrom the date of the transaction, May 21, 2004, the “Initial Release Date”.  As of September 30, 2004, the Companydid not meet the specified conditions.

 

• the Company has an option torepurchase the property between the third and fifth years of the Lease term ata purchase price equal to the amount determined by dividing the annual baserent that otherwise would have been payable for the 12 months following theclosing of the repurchase of the property by 8.5%;  and

 

• the Company has an option toterminate the Lease between the third and fifth years of the Lease upon paymentof a termination fee equal to 50% of the amount equal to the net present valueof the aggregate base rent payments remaining through the Lease, using adiscount rate of 8.5%.

 

Accordingly, the future schedules maturities after September 2004,as disclosed below, reflect the amounts due under the Lease Agreement.

 

Future scheduled maturities of the Lease Agreement at September 30,2004 are as follows:

 

Fiscal Years Ending September 30

 
| 2005                                  |   | $          | 647,244   |   |
|---------------------------------------|--------|------------|-----------|--------|
| 2006                                  |   | 647,244    |      |
| 2007                                  |   | 647,244    |      |
| 2008                                  |   | 647,244    |      |
| 2009                                  |   | 647,244    |      |
| Thereafter                            |   | 3,667,716  |      |
|                                  |   | $          | 6,903,936 |   |
| Less amounts representing interest    |   | (1,574,428 | )         |
| Present value of financing obligation |   | $          | 5,329,508 |   |
| Less current portion                  |   | (387,007   | )         |
| Total                                 |   | $          | 4,942,501 |   |

 

43

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8.               Capital Transactions

 

a.               Series A Convertible, RedeemablePreferred Stock

 

On September 30, 1996, the Company converted thebalance of notes issued in connection with the acquisition of Medical Control Services,Inc. (“MCSI”) totaling $690,000 into 345,000 shares of the Company’s Series Aconvertible, redeemable preferred stock. MCSI was acquired in 1995 by Cypress Financial Services, Inc.  The preferred stock is convertible intoshares of common stock at $1.50 per share at the option of the holders, subjectto antidilution provisions. The Company has the right to redeem these preferredshares at $2.50 per share. The holders of the Company’s Series A convertible,redeemable preferred shares are entitled to the same voting and dividend rightsas the common shareholders. Such preferred shares have a liquidation preferenceat $2.00 per share over common shareholders.

 

b.              Common Stock

 

On May 30, 2000, the Company sold 15,000,000 shares ofits common stock to FBR Financial Services Partners, L.P. for $7,500,000 (FBR),representing 69.8 percent of the outstanding common stock of the Company on afully diluted basis.  Offering costsrelated to this transaction were $446,856.

 

In August 2000, the Company forgave a $50,000note receivable from a former officer in exchange for 33,000 shares of theCompany’s common stock.

 

c.               Warrants

 

On February 12, 1999, the Company issued awarrant to Batchelder & Partners, Inc. to purchase up to 400,000 shares ofthe Company’s common stock in connection with their agreement to act as theCompany’s non-exclusive financial advisor. This warrant is subject to specificexercise prices ranging from $1.75 to $4.75 with a weighted average exerciseprice of $3.06. Additionally, this warrant is subject to vesting provisionswhereas 100,000 shares vested immediately and the balance vests if and whencertain defined targets are achieved based upon the Company’s enterprise value,as defined.  The next 50,000 warrantsvest upon an enterprise value of $17.29 million.  The warrant is exercisable until November 13,2005.

 

The fair value of the warrant was estimated to be$415,000 on the date of grant using the Black Scholes pricing model with thefollowing assumptions: weighted average risk-free interest rate of 4.5 percent;a weighted average volatility of 86.9 percent; an expected life of 6.75 years;and no expected dividend yield. This amount will be recognized in the incomestatement during the period the services are deemed to have been provided.During the year ended September 30, 1999, the Company recognized advisoryfees of $100,000 relating to this warrant, no expense was recognized insubsequent years. Any remaining expense will be recognized in future periods ifand when various conditions to vesting have been met.

 

On August 5, 2004, the Company issued a warrantto Bridge Bank, National Association to purchase up to 100,000 shares of theCompany’s common stock in connection with their agreement to provide a creditfacility (line of credit, see Note 6) to the Company. This warrant is subjectto an exercise price of $.25 per share and expires on August 5, 2011. Thewarrant is exercisable in whole or in part and in 50,000 share increments, atany time on or before the expiration date. 

 

The fair value of the warrant was estimated to be $200on the date of the grant using the Black Scholes pricing model with thefollowing assumptions: weighted average risk-free interest rate of 4.5 percent;a weighted average volatility of 86.9 percent; an expected life of 5 years; andno expected dividend yield. The amount is not deemed material to the fairpresentation of the Company’s financial statements; hence, no expense wasrecorded during this fiscal year related to this warrant. 

 

9.               Commitments and Contingencies

 

a.                                       Lessee - The Company leases certainoffice space and equipment under non-cancelable operating and capital leasesthat expire at various times through fiscal 2007.  Future annual minimum lease payments, in theaggregate, under operating and capital leases at September 30, 2004(excluding the lease of the building discussed in Note 7) are as follows:

 

44

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YearEnding September 30

 
| ** **                                 | ** ** | **Operating** | ** ** | **Capital** | ** ** |
|--------------------------------------------|------------|---------------|------------|-------------|------------|
|                                       |       |          |       |        |       |
| 2005                                       |       | $             | 11,382     |        | $          | 111,508 |   |
| 2006                                       |       | 11,382        |       | 68,565      |       |
| 2007                                       |       | 1,897         |       | 32,800      |       |
|                                       |       |          |       |        |       |
| Total minimum lease payments               |       | $             | 24,661     |        | $          | 212,873 |   |
|                                       |       |          |       |        |       |
| Less – Amounts representing interest  |       |          |       | 35,768      |       |
| Present value of capital lease obligations |       |          |       | 177,105     |       |
| Less – current portion                |       |          |       | 88,581      |       |
|                                       |       |          |       |        |       |
|                                       |       |          |       | $           | 88,524     |   |
|                                            |            |               |            |             |            |  |  |  |

 

Rent expense under alloperating leases totaled $63,305 in 2004 and $64,859 in 2003.

 

b.                                      Lessor - As discussed in Note 2, theCompany sub-leases a portion of its building to unrelated entities underoperating leases which expire at various times through fiscal 2008. The Companyleases to several tenants on a month-to-month basis. Future annual collectionsunder non-cancelable operating leases as of September 30, 2004 arescheduled as follows:

 

YearsEnding September 30,

 
| 2005   |   | $       | 239,932 |   |
|--------|--------|---------|---------|--------|
| 2006   |   | 194,632 |    |
| 2007   |   | 114,047 |    |
| 2008   |   | 108,427 |    |
|   |   |    |    |
|   |   | $       | 657,038 |   |

 

c.               Employment Agreements

 

Chief Executive Officer Manuel Occiano’s employmentcontract expired in May 2003.  At thistime, the employment contract has not been renewed and Mr. Occiano’s employmentis considered to be at will. 

 

On August 29, 2003, Senior Vice President ofSales and Marketing Executive Robert Perez’ employment contract was extended toSeptember 1, 2005 as part of the restructuring and extension of the notepayable to Mr. Perez.  Also on the samedate, as part of the terms of the Exchange Agreement with Russell and SuzetteMohrmann and their affiliate Hospital Employee Labor Pool (HELP), RussellMohrmann’s employment with the Company was terminated.

 

d.              Guarantees

 

The Company indemnifies all directors and officers ofthe Company and any person who may have been identified by the Board ofDirectors.  The Company is obligated,among other things, to indemnify the directors and officers of the Companyagainst liabilities arising from their actions in their capacity as directorsand executive officers.  The obligationhas no maximum and extends into perpetuity. The Company carries Directors and Officers (D&O) insurance of$1,000,000 for the benefit of such persons.  Management expects suchinsurance would cover any costs that might be incurred under theindemnification agreements.  

 

e.               Litigation

 

The Company is involved, from time to time, inlitigation that is incidental to its collection business. The Company regularlyinitiates legal proceedings as a plaintiff in connection with its routinecollection activities. In management’s opinion, none of these legal mattersindividually will have a material adverse effect on the Company’s financialposition or the results of its operations.

 

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f.                 Other

 

As discussed in Note 2, the practice of transferringfunds collected on behalf of certain California-based delinquent debt clientsto operating accounts or delay in remitting funds might be deemed a breach ofthe Company’s obligations. In July 2003, the Company reported that it hasdiscontinued this practice and has taken steps to reduce the collectionspayable balance. The Company believes that a potential consequence of any suchpotential breach is that certain of our California-based delinquent debtcollection clients may feel damaged and may request compensation. To the extentthe Company is unable to reach an agreement with entities that requestcompensation, such entities may initiate legal efforts to pursue claims againstthe Company. In connection with the process to reduce the collections payablebalance owed to certain of the Company’s California-based delinquent debtcollection clients, the Company, as previously reported in 2003, begancontacting those clients and started paying this obligation including anyrelated interest. In 2004, the Company has reached 459 of 720 of these formerclients and paid amounts due to them including interest payments. As of September 30,2004, we still have to notify and reimburse 261 clients for collectionsreceived on their behalf resulting from past practice. Accordingly, $1,080,416is included in Collections Payable to Customers related to these formerclients. This amount includes accrued interest of $83,079. We will continue toreimburse and pay interest on the amounts due to these former clients as fundsare available. However, the Company cannot estimate at this time when allliabilities related to this matter can be paid in full. 

 

We have provided copies of our reports on Form 8-Kfiled on July 10, 2003 and August 15, 2003, respectively, to theDivision of Enforcement of the Securities and Exchange Commission. Since thattime, the SEC has notified the Company that it has begun an informalinvestigation involving the Company.  Weare cooperating with the SEC in this process. No provision has been included in the Financial Statements for theimpact of an unfavorable outcome, if any, should occur.  

 

10.                     Income Taxes

 

The benefits for income taxes for the years ended September 30,2004 and 2003 are shown in the table below:

 
| ** **        | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------|------------|----------|------------|----------|------------|
| Federal:          |       |     |       |     |       |
| Current           |       | $        | —     |     | $          | — |   |
| Deferred          |       | —   |       | —   |       |
| State:            |       |     |       |     |       |
| Current           |       | —   |       | —   |       |
| Deferred          |       | —   |       | —   |       |
|              |       |     |       |     |       |
| Total tax benefit |       | $        | —     |     | $          | — |   |

 

A reconciliation of the total tax benefit from theFederal statutory rate of 34 percent is as follows:

 
| ** **                                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                   |       |     |       |     |       |
| Federal statutory tax rate                             |       | (34.0    | )%         | (34.0    | )%         |
| State income taxes, net of Federal income tax  benefit |       | (5.8     | )          | (8.6     | )          |
| Other                                                  |       | 6.0      |       | 6.0      |       |
| Valuation Allowance                                    |       | 33.8     |       | 36.6     |       |
|                                                   |       |     |       |     |       |
| Actual tax benefit                                     |       | —   | %          | —   | %          |

 

Because certain items of income and expense are notrecognized in the same year in the Company’s financial statements as in itsFederal and California tax returns, deferred assets and liabilities arecreated.  As of September 30, 2004,the accompanying consolidated balance sheet reflects no deferred tax assets.The net deferred tax assets as of September 30, 2004 are disclosed in thetable below:

 

46

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| Deferred tax assets:              |   |       |   |
|-----------------------------------|--------|------------|--------|
| Allowance for doubtful accounts   |   | $          | 80,530 |   |
| Vacation accrual                  |   | 41,947     |   |
| Deferred gain on sale of building |   | 1,431,174  |   |
| Net operating loss                |   | 3,216,447  |   |
| Warrants                          |   | 42,840     |   |
| Other                             |   | 42,460     |   |
| Total deferred tax assets         |   | 4,855,398  |   |
|                              |   |       |   |
| Deferred tax liabilities:         |   |       |   |
| Securitization                    |   | (626,283   | )      |
| Other                             |   | (529       | )      |
| Total deferred tax liabilities    |   | (626,812   | )      |
| Net deferred tax asset            |   | 4,228,586  |   |
| Valuation allowance               |   | (4,228,586 | )      |
| Net deferred tax asset            |   | $          | — |   |

 

As of September 30, 2004, the Company hadapproximately $6.6 million and $3.3 million of federal and state net operatingloss carry forwards, respectively.  Thefederal amount is available to offset future taxable income, which expire invarious years through 2024.  The stateamount has been deferred by legislative action and will not be available foruse for two years beginning with the fiscal year ending September 30,2003.

 

11.                     Reportable Business Segments

 

The following disclosuresare intended to present reportable segments consistent with how the chiefoperating decision maker organizes segments within the Company for makingoperating decisions and assessing performance. The chief operating decisionmaker does not use assets to make financial decisions separately within thesegments. All assets are consolidated as a whole and are not identified bysegments. Presently, the Company is segregated into three divisions, which areas follows: 

 

*Physician Services* –

 

This division providesreceivable management services to physician service organizations. While thebulk of the services primarily relate to Practice Support services, thisdivision has also provided consulting services relating to regulatorycompliance as well as education and training of physicians with respect toapplicable regulatory matters. Practice support services generally includecoding, billings, collections and financial reporting of revenue transactionsincurred by physician service organization clients. Fees generated from practicesupport services are either fixed fee arrangements or a percentage of thevolume of revenues managed on behalf of the clients.  Hourly or per-diem rates for Training andConsulting service fees are determined based on the nature of the engagement.

 

*Recovery –*

 

This division providespre-delinquent and delinquent collection services primarily for hospitalorganizations, financial institutions, and retail organizations. This divisionspecializes on direct collections from patients or consumers. Clients pay thecompany a percentage of the amounts collected as fees for this service.

 

*Reimbursement Solutions –*

 

This division specializeson auditing, re-billing, and follow-up collections of reimbursable costs due tohospital organizations from third party payors, which, include among others,Medicare, MediCal, HMO’s,

 

47

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and health insuranceorganizations. Fees for these services vary from fixed fee arrangements,pre-determined hourly rates, to percentage of revenues generated on behalf ofthe clients.

 

Below is a summary statement of operations for thetwelve months ended September 30, 2004 and 2003. The accounting policiesused in the disclosure of business segments are the same as those described inthe summary of significant accounting policies. Certain assumptions are madeconcerning the allocations of costs between segments that may influencerelative results, most notably, allocations of various types of technology,legal, recruiting and training costs. Management believes that the allocationsutilized below are reasonable and consistent with the way it manages thebusiness.

 

The following table summarizes the results of ouroperating units for the twelve months ended September 30, 2004 and 2003:

 

*For thetwelve months ended September 30, 2004:*

 
| ** **                                     | ** ** | **Recovery** | ** ** | ** ** | ** ** | **Physician  Services** | ** ** | ** ** | ** ** | **Reimbursement  Solutions** | ** ** | ** ** | ** ** | **Total**  | ** ** | ** ** | ** ** |
|------------------------------------------------|------------|--------------|------------|------------|------------|-------------------------|------------|------------|------------|------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Revenue                                        |       | $            | 5,224,211  |       | 100        | %                       | $          | 1,133,022  |       | 100                          | %          | $          | 1,702,151  |       | 100        | %          | $          | 8,059,384 |   | 100 | % |
| Direct Labor                                   |       | 1,448,713    |       | 28         | %          | 810,456                 |       | 71         | %          | 788,645                      |       | 46         | %          | 3,047,814  |       | 38         | %          |
| Indirect Labor                                 |       | 581,136      |       | 11         | %          | 212,268                 |       | 19         | %          | 218,095                      |       | 13         | %          | 1,011,499  |       | 13         | %          |
| Other Expenses                                 |       | 856,616      |       | 16         | %          | 248,447                 |       | 22         | %          | 130,433                      |       | 8          | %          | 1,235,496  |       | 15         | %          |
| Total Expenses                                 |       | 2,886,465    |       | 55         | %          | 1,271,171               |       | 112        | %          | 1,137,173                    |       | 67         | %          | 5,294,809  |       | 66         | %          |
|                                           |       |         |       |       |       |                    |       |       |       |                         |       |       |       |       |       |       |       |
|                                           |       | $            | 2,337,746  |       | 45         | %                       | $          | (138,149   | )          | -12                          | %          | $          | 564,978    |       | 33         | %          | $          | 2,764,575 |   | 34 | % |
| Selling, general & administrative expenses |       |         |       |       |       |                    |       |       |       |                         |       |       |       | (2,995,067 | )          | -37        | %          |
| Goodwill impairment                            |       |         |       |       |       |                    |       |       |       |                         |       |       |       | (625,500   | )          | -8         | %          |
| Depreciation & amortization                |       |         |       |       |       |                    |       |       |       |                         |       |       |       | (361,308   | )          | -4         | %          |
|                                           |       |         |       |       |       |                    |       |       |       |                         |       |       |       |       |       |       |       |
| Operating loss                                 |       |         |       |       |       |                    |       |       |       |                         |       |       |       | $          | (1,217,300 | )          | -15        | % |
|                                                |            |              |            |            |            |                         |            |            |            |                              |            |            |            |            |            |            |            |  |  |  |  |  |  |  |

 

*For thetwelve months ended September 30, 2003:*

 
| ** **                                     | ** ** | **Recovery** | ** ** | ** ** | ** ** | **Physician  Services** | ** ** | ** ** | ** ** | **Reimbursement  Solutions** | ** ** | ** ** | ** ** | **Total**  | ** ** | ** ** | ** ** |
|------------------------------------------------|------------|--------------|------------|------------|------------|-------------------------|------------|------------|------------|------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Revenue                                        |       | $            | 4,912,359  |       | 100        | %                       | $          | 2,056,578  |       | 100                          | %          | $          | 2,568,665  |       | 100        | %          | $          | 9,537,602 |   | 100 | % |
| Direct Labor                                   |       | 1,613,871    |       | 33         | %          | 1,472,256               |       | 72         | %          | 1,183,395                    |       | 46         | %          | 4,269,522  |       | 45         | %          |
| Indirect Labor                                 |       | 678,150      |       | 14         | %          | 453,331                 |       | 22         | %          | 329,061                      |       | 13         | %          | 1,460,542  |       | 15         | %          |
| Other Expenses                                 |       | 1,080,189    |       | 22         | %          | 540,150                 |       | 26         | %          | 98,750                       |       | 4          | %          | 1,719,089  |       | 18         | %          |
| Total Expenses                                 |       | 3,372,210    |       | 69         | %          | 2,465,737               |       | 120        | %          | 1,611,206                    |       | 63         | %          | 7,449,153  |       | 78         | %          |
|                                           |       |         |       |       |       |                    |       |       |       |                         |       |       |       |       |       |       |       |
|                                           |       | $            | 1,540,149  |       | 31         | %                       | $          | (409,159   | )          | -20                          | %          | $          | 957,459    |       | 37         | %          | $          | 2,088,449 |   | 22 | % |
| Selling, general & administrative expenses |       |         |       |       |       |                    |       |       |       |                         |       |       |       | (4,248,596 | )          | -45        | %          |
| Depreciation & amortization                |       |         |       |       |       |                    |       |       |       |                         |       |       |       | (433,581   | )          | -5         | %          |
|                                           |       |         |       |       |       |                    |       |       |       |                         |       |       |       |       |       |       |       |
| Operating loss                                 |       |         |       |       |       |                    |       |       |       |                         |       |       |       | $          | (2,593,728 | )          | -27        | % |
|                                                |            |              |            |            |            |                         |            |            |            |                              |            |            |            |            |            |            |            |  |  |  |  |  |

 

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12.            Disposition ofBusiness Segment

 

On August 29, 2003,we entered into an Exchange Agreement with Russell and Suzette Mohrmann andtheir affiliate, Hospital Employee Labor Pool, a California corporation, orHELP, pursuant to which we transferred substantially all of the assets relatedto our administrative and back office temporary staffing division (the “StaffingBusiness”). Pursuant to the terms of the Exchange Agreement, HELP has acquiredsubstantially all of the assets of the Staffing Business.  This division specialized in providingtemporary staffing to hospital organizations and physician serviceorganizations. Temporary staffing provided to its clients includedadministrative, financial, as well as clinical and operational personnel.

 

In connection with thedisposition, the Company wrote off the remaining goodwill attributable to thissegment of $554,559, de-recognized the $1.9 million amount payable to Mr.Mohrmann, and recognized a gain of $1,253,767. The results of operations attributable to the Staffing Business havebeen shown as discontinued operations for the year ended September 30,2003 in the accompanying consolidated statements of operations. 

 

The following tablesummarizes the results of operations for the Temporary Staffing Division forthe twelve months ended September 30, 2003:

 

*For the twelve months ended September 30,2003:*

 
| Revenue                 |   | $         | 2,040,654 |   | 100    | % |
|-------------------------|--------|-----------|-----------|--------|--------|---|
| Direct Labor            |   | 1,510,251 |      | 74     | %      |
| Indirect Labor          |   | 123,387   |      | 6      | %      |
| Other Expenses          |   | 57,490    |      | 3      | %      |
| Total Expenses          |   | 1,691,128 |      | 83     | %      |
|                    |   |      |      |   |   |
| Operating income (loss) |   | $         | 349,526   |   | 17     | % |
|                         |        |           |           |        |        |   |  |

 

13.            Subsequent Events

 

On December 1, 2004, we entered into an agreementwith Administaff, Inc., under which we have outsourced the Human Resourcerelated functions for all our employees for Southern California and Las Vegas.

 

On December 29, 2004the Company entered into secured convertible note payable agreement for$100,000 with FBR.  The note bearsinterest at the prime rate, defined as the base rate on corporate loans postedby at least 75% of the nation’s 30 largest banks as recorded in the *Wall Street Journal*, (4.75% at September 30, 2004) plusfour percent (4%), compounded quarterly. The principal and all accrued interest are due on November 1, 2005,the maturity date of the notes. All or any portion of the unpaid principalbalance and any accrued but unpaid interest outstanding under this Note may beconverted (the “Optional Conversion”) at any time at the option of the Holderinto fully paid and nonassessable shares of capital common stock of the Company(the “Stock”).  The number of shares ofStock into which this Note is to be converted shall be determined by dividingsaid unpaid principal balance and all accrued but unpaid interest by theConversion Price.  The Conversion Priceshall be calculated at the time of the Optional Conversion based on a Companyvaluation of 90% of 12 times the average prior 12 months monthly revenue priorto the Optional Conversion, the result will then be divided by the number ofthen outstanding shares on a fully converted basis.

 

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