UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended JuneSeptember 30, 2004

OR

For the transition period from            to            

Commission File No. 000-50364

The Providence Service Corporation

(Exact name of registrant as specified in its charter)

(520) 747-6600

(Registrant’s telephone number, including area code)

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

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

As of August 4,November 8, 2004, there were outstanding 9,464,2349,327,211 shares (excluding treasury shares of 146,905) of the registrant’s Common Stock, $.001 par value per share.

TABLE OF CONTENTS

PART I—FINANCIAL INFORMATION

Item 1. Financial Statements.

The Providence Service Corporation

Condensed Consolidated Balance Sheets

See accompanying notes to unaudited condensed consolidated financial statements

The Providence Service Corporation

Unaudited Condensed Consolidated Statements of Operations

See accompanying notes to unaudited condensed consolidated financial statements

The Providence Service Corporation

Unaudited Condensed Consolidated Statements of Cash Flows

See accompanying notes to unaudited condensed consolidated financial statements

The Providence Service Corporation

Unaudited Supplemental Cash Flow Information

See accompanying notes to unaudited condensed consolidated financial statements

The Providence Service Corporation

Notes to Unaudited Condensed Consolidated Financial Statements

JuneSeptember 30, 2004

1. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for fair presentation have been included. Operating results for the sixnine months ended JuneSeptember 30, 2004 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2004.

The condensed consolidated balance sheet at December 31, 2003 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. The condensed consolidated financial statements contained herein should be read in conjunction with the audited financial statements and notes included in The Providence Service Corporation’s annual report on Form 10-K for the year ended December 31, 2003.

2. Summary of Significant Accounting Policies and Description of Business

Description of Business

The Providence Service Corporation (the “Company”) is a privatization company specializing in alternatives to institutional care. The Company responds to governmental privatization initiatives in adult and juvenile justice, corrections, social services, welfare systems, and education by providing home-based and community-based counseling services to at-risk families and children. These human services are purchased primarily by state, city and county levels of government, and are delivered under contracts ranging from capitation to fee-for-service arrangements. The Company also contracts with not-for-profit organizations to provide management services for a fee. The Company operates primarily in Arizona, California, Delaware, Florida, Illinois, Indiana, Maine, Massachusetts, Michigan, Nebraska, Nevada, New Mexico, North Carolina, Ohio, Oklahoma, Ohio, Pennsylvania, South Carolina, Tennessee, Texas, Virginia, West Virginia and the District of Columbia.

Restricted Cash

At December 31, 2003 and JuneSeptember 30, 2004, the Company had $447,500 and $1.1 million of restricted cash of which $272,500 and $100,000$885,825 was included in prepaid expenses and other and $175,000 and $961,000 was included in non-current other assets in the accompanying condensed consolidated balance sheets. The restricted cash serves as collateral for irrevocable standby letters of credit that provide financial assurance that the Company will fulfill its obligations with respect to certain contracts. At JuneSeptember 30, 2004, the cash was held in custody by the Bank of Tucson in the amount of $961,000$960,825 and by Key Bank in the amount of $100,000. In addition, the cash is restricted as to withdrawal or use and is currently invested in money market funds.

Intangible assets

In accordance with Statement of Financial Accounting Standards No. 141,Business Combinations(“SFAS No. 141”), the Company separately values all acquired identifiable intangible assets apart from goodwill. In connection with the Company’s recent acquisitions (described in note 3 below), the Company allocated a portion of the purchase consideration to certain management contracts and customer relationships based on the expected direct or indirect contribution to future cash flows over the useful life of the asset.

The Company assesses whether certain relevant factors limit the period over which an asset is expected to contribute directly or indirectly to future cash flows for amortization purposes. With respect to acquired management contracts, the useful life is limited by the stated terms of the agreements. The useful life of acquired customer relationships is generally limited by the terms and nature of the underlying contracts with state and local agencies to provide social services. The Company determines an appropriate useful life for acquired customer relationships based on the likelihood that the underlying contracts to provide social services will renew over future periods. The likelihood of renewal is based on the Company’s contract renewal experience and the contract renewal experiences of entities it has acquired.

The Company periodically assesses the recoverability of the unamortized balance of its intangible assets based on expected future profitability and expected cash flows and their contribution to the Company’s overall operations. Should the review indicate that the carrying value is not fully recoverable, the excess of the carrying value over the fair value of the other intangible assets would be recognized as an impairment loss.

Stock Compensation Arrangements

The Company follows the intrinsic value method of accounting for stock-based compensation plans as prescribed by Accounting Principles Board (“APB”) Opinion No. 25,Accounting for Stock Issued to Employees.plans. The following table reflects net income available to common stockholders and earnings per share had the Company’s stock options been accounted for using the fair value method under Statement of Financial Accounting Standards No. 123,Accounting for Stock-Based Compensation (“SFAS No. 123”):method:

Reclassification

Certain amounts have been reclassified in prior periods in order to conform with the current period presentation.

3. Held-To-Maturity Investments

On September 3, 2003, the Company purchased a $4.0 million zero-coupon bond, at 98.894%, or $3.9 million, issued by the Federal Home Loan Mortgage Corporation. The Company held the bond until it matured on July 15, 2004 and such bond is presented as held-to-maturity investments in the accompanying consolidated balance sheets. The Company accounts for this investment on an amortized cost basis with a yield to maturity of 1.288%. The following table details the value of the investment at June 30, 2004:

The Company has not used derivative financial instruments to alter the interest rate characteristics of its held-to-maturity investments, and thus has not recorded any gains or losses in accumulated other comprehensive income. On July 15, 2004, the bond matured with a market value of $4.0 million.

4.3. Acquisitions

The following acquisitions have been accounted for using the purchase method of accounting and the results of operations are included in the Company’s condensed consolidated financial statements from the date of acquisition. The cost of these acquisitions has been allocated to the assets and liabilities acquired based on a preliminary evaluation of their respective fair values and may change when the final valuation of certain intangible assets is determined.

Effective January 1, 2004, the Company acquired the remaining 50% member interest in and became the sole member of Rio Grande Management Company, LLC, (“Rio Grande Management”), for cash of $820,000 which was prepaid in December 2003. Rio Grande Management was formed in September 2001 by the Company and the ten agencies whose members comprise the board of directors of Rio Grande Behavioral Health Services, Inc., a not-for-profit organization that provides community based social and mental health network services in New Mexico. As a result of this acquisition, the Company acquired the entire membership interest in Rio Grande Management which has a management agreement with the not-for-profit organization pursuant to which Rio Grande Management manages the not-for-profit organization’s operations in return for a fixed management fee per network member per month.

The following represents the Company’s preliminary allocation of the purchase price:

Currently, the above goodwill is expected to be tax deductible.

On January 1, 2004, the Company acquired all of the outstanding stock of Dockside Services, Inc. (“Dockside”) for cash of $3.4 million (less $300,000 which was placed into escrow as security for any working capital adjustments) and $1.0 million in promissory notes, for a total purchase price of $4.4 million. On August 6, 2004, the working capital adjustments were finalized resulting in an amount due to the Company of $27,930 which was received by the Company in September 2004. This acquisition expands the Company’s operations in the states of Indiana and Michigan.

The following represents the Company’s preliminary allocation of the purchase price:

The amount allocated to intangibles represents acquired customer relationships. The Company valued customer relationships acquired in this acquisition based on expected future cash flows resulting from the underlying contracts with state and local agencies to provide social services. No significant residual value is estimated for these intangibles. Amortization of the acquired customer relationships will be recognized over an estimated useful life of 15 years.

Currently, the above goodwill is not expected to be tax deductible.

On May 3, 2004, the Company acquired all of the outstanding stock of Pottsville Behavioral Counseling Group, Inc. (“Pottsville”), a Pennsylvania based social services provider, for cash in the amount of $1.8 million (less $184,000 which was placed into escrow as security for any working capital

adjustments or any indemnification obligations). In connection with this acquisition, the Company entered into a management agreement with The ReDCo Group (“ReDCo”), a Pennsylvania not-for-profit social services organization whereby the Company manages ReDCo’s operations in return for a predetermined management fee. The acquisition of Pottsville and the management agreement with ReDCo expands the Company’s home and community based services into the Pennsylvania market.

The following represents the Company’s preliminary allocation of the purchase price:

The amount allocated to intangibles represents acquired customer relationships. The Company valued customer relationships acquired in this acquisition based on expected future cash flows resulting from the underlying contracts with state and local agencies to provide social services. No significant residual value is estimated for these intangibles. Amortization of the acquired customer relationships will be recognized over an estimated useful life of 10 years.

Currently, the above goodwill is not expected to be tax deductible.

In conjunction with the acquisition of Pottsville, the Company entered into a management agreement with The ReDCo Group (“ReDCo”), a Pennsylvania not-for-profit social services organization, whereby the Company provides certain management services to ReDCo in return for a predetermined management fee.

Effective June 24, 2004, the Company acquired all of the rights under existing management agreements with Care Development of Maine (“CDOM”) and FCP, Inc. (“FCP”) from Care Development, Inc., a Maine not-for-profit corporation, for cash in the amount of $1.5 million with the possibility thatmillion. The Company anticipates paying an additional amount may be paid upon completion of$1.5 million subject to a third party appraisal of the acquired contracts.definitive agreement. CDOM and FCP are not-for-profit organizations providing foster care and community based services in the States of Maine and Massachusetts, respectively. The acquisition of the management agreements with these organizations expands the Company’s foster care and community based services in Maine and opens a new market in Massachusetts.

The cost of acquiring the management agreements with ReDCo, CDOM and FCP has been allocated to intangible assets as contract acquisition costs and is being amortized on a straight-line basis concurrent with the life of the agreements.

On July 21, 2004, the Company acquired all of the equity interests in Choices Group, Inc., Aspen MSO, LLC and College Community Services, a California mutual benefit corporation (collectively referred to as the “Aspen Companies”) for cash of $10.0 million ($1.0 million of which was placed into escrow as security for any indemnification obligations and any working capital adjustments). According to the provisions of the purchase agreement, the Company will receive $2.0 million in working capital. The acquisition was retroactively effective as of July 1, 2004 in accordance with the terms of the purchase agreement. The acquisition of the Aspen Companies establishes operations in California and Nevada and adds drug court treatment to the Company’s array of social services.

The following represents the Company’s preliminary allocation of the purchase price:

The amount allocated to intangibles represents acquired customer relationships. The Company valued customer relationships acquired in this acquisition based on expected future cash flows resulting from the underlying contracts with state and local agencies to provide social services. No significant residual value is estimated for these intangibles. Amortization of the acquired customer relationships will be recognized over an estimated useful life of 15 years.

In connection with the acquisition of the Aspen Companies, the Company acquired deferred revenue of $489,000 which represents funding for certain services in advance of services actually rendered. The Company has subsequently recognized additional deferred revenue of $410,000 for the three months ended September 30, 2004. These amounts are reflected as deferred revenue in the accompanying condensed consolidated balance sheets.

Currently, the Company is determining whether all or a portion of the goodwill is tax deductible.

Changes in goodwill were as follows:

The following unaudited pro forma information presents a summary of the consolidated results of operations of the Company as if the acquisition of the Aspen Companies had occurred on January 1, 2003. The pro forma financial information is not necessarily indicative of the results of operations that would have occurred had the transactions been effected on January 1, 2003.

5.4. Long-Term Obligations

The Company’s long-term obligations were as follows:

In connection with the Company’s initial public offering, the Company agreed to pay Eos Partners SBIC, L.P. and Eos Partners SBIC II, L.P., the then holders of the Company’s mandatorily redeemable convertible preferred stock, a consent fee in the aggregate amount of $3.5 million. The consent fee was paid pursuant to subordinated notes which bore interest at the rate of 4% per annum. The notes were prepayable, without penalty, at any time by the Company and on January 27, 2004, the Company prepaid the entire outstanding balance and related accrued interest related to these subordinated notes.

On January 9, 2003, the Company entered into a new loan and security agreement with Healthcare Business Credit Corporation, which provided for a $10.0 million revolving line of credit, a $10.0 million acquisition term loan, and a $1.0 million term loan. The amount the Company may borrow under the revolving line of credit is subject to the availability of a sufficient amount of eligible accounts receivable at the time of borrowing. Advances under the acquisition term loan are subject to the lender’s approval. Proceeds initially borrowed under the revolving line of credit portion of this new credit facility were used to repay and terminate the previous revolving line of credit with a former lender. Until its amendment in September 2003, the Company’s credit facility was secured by substantially all of the Company’s assets as well as certain of its managed entities’ assets.

On September 30, 2003 following the Company’s repayment of the $1.0 million term loan portion of the credit facility, the Company’s loan and security agreement was amended with respect to the remaining $10.0 million revolving line of credit and the $10.0 million acquisition term loan to release the not-for-profit organizations managed by the Company as co-borrowers under the loan agreement and extend the maturity date of the acquisition term loan through December 1, 2006. In addition, these not-for-profit organizations established separate stand-alone credit facilities. While the Company does not guarantee any portion of these stand-alone credit facilities, it has agreed to subordinate its management fee receivable in the event of a default under these stand-alone credit facilities. The provisions of the amended loan agreement with respect to the revolving line of credit remained the same as set forth in the original loan and security agreement described above. The Company is required to maintain certain financial covenants under the credit facility and, at December 31, 2003 and JuneSeptember 30, 2004, the Company was in compliance with such covenants.

At JuneSeptember 30, 2004, the Company’s available credit under the revolving line of credit was $9.5$10.0 million. The Company is required to pay a per annum unused facility fee of 0.5% for any unborrowed amounts under the revolving line of credit and acquisition term loan.

6.5. Common Stock

The Company adopted a second amended and restated certificate of incorporation and amended and restated bylaws commensurate with the consummation of the Company’s initial public offering on August 22, 2003. The Company’s second amended and restated certificate of incorporation provides that the Company’s authorized capital stock consists of 40,000,000 shares of common stock, $0.001 par value, and 10,000,000 shares of preferred stock, $0.001 par value. At December 31, 2003 and JuneSeptember 30, 2004, there were 8,481,839 and 9,464,2349,472,161 shares of the Company’s common stock outstanding (including 135,501 and 146,905 treasury shares) and no shares of preferred stock outstanding. On April 2, 2004, the Company completed a follow-on offering of common stock in connection with which the Company sold 862,500 shares of common stock. In addition, during the sixnine months ended JuneSeptember 30, 2004, the Company issued 112,431 and 7,464120,358 shares of its common stock in connection with the exercise of employee stock options under the Company’s 1997 stock option and incentive plan, and 7,464 shares of its common stock in connection with the exercise of employee stock options under the Company’s 2003 stock option plan.

Subject to the rights specifically granted to holders of any then outstanding shares of the Company’s preferred stock, the Company’s common stockholders are entitled to vote together as a class on all matters submitted to a vote of the Company’s stockholders and are entitled to any dividends that may be declared by the Company’s board of directors. The Company’s common stockholders do not have cumulative voting rights. Upon the Company’s dissolution, liquidation or winding up, holders of the Company’s common stock are entitled to share ratably in the Company’s net assets after payment or provision for all liabilities and any preferential liquidation rights of the Company’s preferred stock then outstanding. The Company’s common stockholders do not have preemptive rights to purchase shares of the Company’s stock. The issued and outstanding shares of the Company’s common stock are not subject to any redemption provisions and are not convertible into any other shares of the Company’s capital stock. All outstanding shares of the Company’s common stock are, and the shares of common stock to be issued in any future offering will be, upon payment therefor, fully paid and non-assessable. The rights, preferences and privileges of holders of

the Company’s common stock will be subject to those of the holders of any shares of the Company’s preferred stock the Company may issue in the future.

7.6. Earnings Per Share

The following table details the computation of basic and diluted earnings (loss) per share:

For the three and nine months ended JuneSeptember 30, 2004, employee stock options to purchase 50,000185,000 and 190,000 shares of common stock, at an exercise price of $19.30 and, for the six months ended June 30, 2004, employee stock options to purchase 50,000, 25,000, 20,000 and 5,000 shares of common stock at exercise prices of $19.30, $18.49, $18.53 and $17.66respectively, were not included in the computation of diluted earnings per share as the exercise price of these options was greater than the average fair value of the common shares for the respective periods and, therefore, the effect of these options would be antidilutive.

8.7. Income Taxes

The Company’s effective income tax rate for the interim periods is based on management’s estimate of the Company’s effective tax rate for the applicable year and differs from the federal statutory income rate primarily due to nondeductible permanent differences and state income taxes.

9.8. Commitments and Contingencies

The Company is involved in various claims and legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the Company’s consolidated financial position, results of operations, or liquidity.

The Company provides management services under long-term management agreements and has relationships with certain tax-exempt organizations under Section 501(c)(3) of the Internal Revenue Code, including certain debt arrangements.Code. While recent actions of certain tax authorities have challenged whether similar relationships by other organizations may violate the federal tax-exempt status of not-for-profit organizations, management is of the opinion that its relationships with these tax-exempt organizations do not violate their tax-exempt status and any unfavorable outcomes would not have a material adverse effect on the Company’s consolidated financial position, results of operations, or liquidity.

10.9. Transactions with Related Parties

In connection with the acquisition of Pottsville and the establishment of a management agreement with ReDCo, the Company loaned $875,000 to ReDCo to fund certain long-term obligations of the entity in exchange for a promissory note for the same amount plusamount. The note assumes interest equal to a fluctuating interest rate per annum based on a weighted-average of the daily Federal Funds Rate. The terms of the promissory note require ReDCo to make quarterly interest payments over twenty-one months commencing June 30, 2004 with the principal and any accrued and unpaid interest due upon maturity on March 31, 2006. The promissory note is collateralized by a subordinated lien to ReDCo’s primary lender on substantially all of ReDCo’s assets.

11. Subsequent Events

On July 21, 2004, the Company acquired all of the equity interests in Choices Group, Inc., Aspen MSO, LLC and College Community Services, a California mutual benefit corporation (collectively referred to as the “Aspen Companies”) for cash of $10.0 million (less $1.0 million which was placed into escrow as security for any indemnification obligations). According to the provisions of the purchase agreement, the Company will receive $2.0 million in working capital. The acquisition was retroactively effective as of July 1, 2004 in accordance with the terms of the purchase agreement. The acquisition of the Aspen Companies establishes operations in California and Nevada and adds drug court treatment to the Company’s array of social services.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Overview of our business

We provide government sponsored social services directly and through not-for-profit social services organizations whose operations we manage. As a result of, and in response to, the large and growing population of eligible beneficiaries of government sponsored social services, increasing pressure on governments to control costs and increasing acceptance of privatized social services, we have increased our capacity to provide services in previously underserved geographic areas through the development of new programs and by consummating strategic acquisitions. As of JuneSeptember 30, 2004, we provided services directly and through the entities we manage to over 18,20027,700 clients from 113153 locations in 1921 states and the District of Columbia. Our goal is to be the provider of choice to the social services industry. Focusing on our core competencies in the delivery of home and community based counseling, foster care and provider managed services, we believe we are well positioned to offer the highest quality of service to our clients and provide a viable alternative to state and local governments’ current service delivery systems.

Our industry is highly fragmented, competitive and dependent on government funding. We depend on our experience, financial strength and broad presence to compete vigorously in each service offering. Challenges for us include competing with local incumbent social services providers in some of the areas we seek to enter and, in rural areas where significant growth opportunities exist, finding and retaining qualified employees. We seek strategic acquisitions as one way to enter competitive markets.

Our business is highly dependent on our obtaining contracts with government sponsored entities. When we are awarded a contract to provide services, we may incur expenses such as leasing office space,

purchasing office equipment and hiring personnel before we receive any contract payments, and, under some of the large contracts we are awarded, we are required to invest significant sums of money before receiving any contract payments. We are also required to recruit and hire qualified staff to perform the services under contract. We strive to control these start-up costs by leveraging our existing infrastructure to maximize our resources and manage our growth effectively. However, with each contract we are awarded, we face the challenge of quickly and effectively building a client base to generate revenue to recover these costs.

On August 22, 2003, we completed our initial public offering of common stock in connection with which we sold 3.0 million shares at an offering price of $12.00 per share. Additionally, on September 10, 2003, our underwriters exercised their over-allotment option pursuant to which we sold another 645,000 shares at an offering price of $12.00 per share. We received net proceeds of approximately $36.2 million after deducting the underwriting discounts and offering costs. More recently, onOn April 2, 2004, we completed a follow-on offering of common stock in connection with which we sold 862,500 shares at an offering price of $15.75 including an over-allotment of 112,500 shares exercised by our underwriters on that day. We received net proceeds of approximately $12.2 million after deducting the underwriting discounts and offering costs.

Prior to our initial public offering in 2003, we were largely funded by venture capital and mezzanine debt. We used proceeds from our initial public offering to pay off our then existing long-term debt. Our working capital requirements are now primarily funded by cash from operations. In addition, we have a $10$10.0 million revolving line of credit and a $10$10.0 million acquisition term loan with Healthcare Business Credit Corporation or HBCC. Proceeds from our initial public offering and follow-on offering as well as our credit facilities with HBCC provide funding for general corporate purposes and potential acquisitions.

How we earn our revenue

Our revenue is derived from our provider contracts with state and local government agencies and government intermediaries and from our management contracts with not-for-profit social services organizations. The government entities that pay for our services include welfare, child welfare and justice departments, public schools and state Medicaid programs. Under a majority of the contracts where we provide services directly, we are paid an hourly fee. In other such situations, we receive a set monthly amount. These revenues are presented in our financial statements as either revenue from home and community based services or foster care services. Where we contract to manage the operations of not-for-profit social services organizations, we receive a management fee that is a fixed amount per enrolled member,either based upon a percentage of the revenue of the managed entity or a predetermined fee. These revenues are presented in our financial statements as management fees. Because we are responsible for substantially all of the business operations of these entities and our management fees are largely dependent upon their revenues, we also monitor for management and disclosure purposes the revenues of our managed entities. We refer to the revenues of these entities as managed entity revenue. In addition, from time to time, we provide short-term consulting services to other social services organizations for which we receive consulting fees that are a fixed amount per contract. Any such consulting revenues are presented in our financial statementsstatement of operations as management fees.

How we grow our business and evaluate our performance

Our business grows internally, through organic expansion into new markets and increases in the number of clients served under contracts we or our managed entities are awarded, and externally through acquisitions.

We typically pursue organic expansion into markets that are contiguous to our existing markets or where we believe we can quickly establish a significant presence. In January 2004, Camelot Community Care, Inc., one of the not-for-profit entities we manage, was awarded a contract by the Florida Department of Children and Families pursuant to Florida’s Community Based Care Initiative, to provide home and community based social services in the Fort Myers area. The term of the contract is February 1, 2004 through June 30, 2008, and provides for contract payments of up to $22.0 million per year, or $97.5 million over the term. Our management fee in relation to this contract is 10% of Camelot Community Care’s revenue from the contract after deducting pass through costs. When we expand organically, we typically have no clients or perform no management services in the market and are required to incur start-up costs, including the costs of space, required permits and initial personnel. These costs are expensed as incurred,

and our new offices can be expected to incur losses for a period of time until we adequately grow our revenue from clients or management fees.

As an alternative to organic expansion, we pursue strategic acquisitions in markets where we see opportunities but where we lack the contacts and/or personnel to make a successful organic entry. During the sixnine months ended JuneSeptember 30, 2004, through our acquisitions (described below), we enhanced our presence in Indiana, Maine, Michigan and New Mexico and entered new markets in California, Massachusetts, Nevada and Pennsylvania. Unlike organic expansion which involves start-up costs that may dilute earnings, expansion through acquisitions is generally accretive to our earnings. However, we bear financing risk and where debt is used, the risk of leverage in expanding through acquisitions. We also have to integrate the acquired business into our operations, which could disrupt our business, and we may not be able to realize operating and economic efficiencies upon integration.

In all our markets, we focus on several key performance indicators in managing our business. Specifically, we focus on growth in the number of clients served as that particular metric is the key driver of our revenue growth. We also focus on the number of employees as that is our most important variable cost and the key to the management of our margins.

Acquisitions

Since December 31, 2003, we have completed the following acquisitions:

retroactively effective as of July 1, 2004 in accordance with the terms of the purchase agreement. The acquisition of the Aspen Companies establishes operations in California and Nevada and adds drug court treatment to our array of social services.

We continue to selectively identify and pursue attractive acquisition opportunities and have developed a pipeline of potential acquisition candidates. There are no assurances, however, that we will complete acquisitions in the future or that any completed acquisitions will prove profitable for us.

Critical accounting policies and estimates

General

In preparing our financial statements in accordance with accounting principles generally accepted in the United States we are required to make estimates and judgments that affect the amounts reflected in our financial statements. We base our estimates on historical experience and on various other assumptions we believe to be reasonable under the circumstances. However, actual results may differ from these estimates under different assumptions or conditions.

Critical accounting policies are those policies most important to the portrayal of our financial condition and results of operations. These policies require management’s most difficult, subjective or complex judgments, often employing the use of estimates about the effect of matters inherently uncertain. Our most critical accounting policies pertain to revenue recognition, the allowance for doubtful accounts receivable, accounting for business combinations, goodwill and other intangible assets, and our management contract relationships.

Revenue recognition

We recognize revenue at the time services are rendered at the amounts stated in our contracts and when the collection of these amounts is considered to be probable.

At times we may receive funding for certain services in advance of services actually being rendered. These amounts are reflected in the accompanying condensed consolidated balance sheets as deferred revenues until the actual services are rendered.

As services are rendered, documentation is prepared describing each service, time spent, and billing code under each contract to determine and support the value of each service provided. This documentation is used as a basis for billing under our contracts. The billing process and documentation submitted under our contracts vary among our payers. The timing, amount and collection of our revenues under these contracts are dependent, to a great extent, upon our ability to comply with the various billing requirements specified by each payer. Failure to comply with these requirements could delay the collection of amounts due to us under a contract or result in adjustments to amounts originally due under a contract.

The performance of our contracts is subject to the condition that sufficient funds are appropriated, authorized and allocated by each state, city or other local government. If sufficient appropriations, authorizations and allocations are not provided by the respective state, city or other local government, we are at risk of immediate termination or renegotiation of the financial terms of our contract. See “Liquidity and capital resources—Management agreements.”

Fee-for-service contracts. Revenues related to services provided pursuant to fee-for-service contracts are recognized as revenue at the time services are rendered and collection is determined to be probable. Such services are provided at established billing rates. Fee-for-service contracts represented approximately 70.2%70.7% and 73.6%67.5% of our revenue for the sixnine months ended JuneSeptember 30, 2003 and 2004.

Cost based service contracts. As a result of the acquisition of the Aspen Companies, we acquired cost based service contracts where revenue is recorded at one-twelfth of the annual contract amount less allowances for certain contingencies such as budgeted costs not incurred, excess cost per service over allowable rate per contract and insufficient encounters. The annual contract amount is based on projected costs to provide services under the contracts with adjustments for changes in the total contract amount. Annually, we submitted projected costs for the coming year which assist the contracting payers in establishing the annual contract amount to be paid for services provided under the contracts. After June 30, which is the contracting payers’ year end, we submit a cost report which is used by the contracting payers to determine the amount, if any, by which funds paid to us for services provided under the contracts, were greater than the allowable costs to provide these services. In cases where funds paid to us exceed the allowable costs to provide services under contract, we may be required to pay back the excess funds.

Our cost reports are routinely audited on an annual basis. We periodically review our provisional billing rates and allocation of costs and provide for estimated adjustments from the contracting payers. We believe that adequate provisions have been made in our consolidated financial statements for any adjustments that might result from the outcome of any cost report audits. Differences between the amounts provided and the settlement amounts are recorded in our consolidated statement of operations in the year of settlement. The Aspen Companies’ cost based service contracts represented approximately 7.7% of our revenue for the nine months ended September 30, 2004.

Case rate contract. We providePrior to July 1, 2004, we provided services under one contract under which we receivereceived a predetermined amount per month for a specified number of eligible beneficiaries. Under this contract, referred to as a case rate contract, we receivereceived the established amount regardless of the level of services provided to the beneficiaries during the month and thus recognizerecognized this contractual rate as revenue on a monthly basis. To the extent we provideprovided services that exceedexceeded the contracted revenue amounts, we requestrequested the payer to reimburse us for these additional costs. Historically, the payer hashad reimbursed us for all such excess costs although it hashad no ongoing legalcontractual obligation to do so under the case rate contract. Consequently, we dodid not recognize these excess cost amounts as amounts received in excess of our contracted rates, or additional revenue, until the payer actually reimbursesreimbursed us for such amounts or entersentered into an agreement contractually committing the payer to pay us the particular amount recognized and collection of such amount iswas determined to be probable.

Prior toCommencing July 1, 2003, expenses2004, we began operating under ourrevised terms of the case rate contract. The revised terms provided for the modification of the contract from a case rate contract from time to time exceededan annual block contract where we receive and recognize as revenue one-twelfth of the contracted revenue amounts primarily becauseestablished annual amount each month regardless of increases in the number of referrals requiring out-of-home

placements and increases in the amountlevel of services provided to the beneficiaries during the month. In addition, the annual contract amount we were requiredreceive from this contract was increased by $2.5 million, or 25%, to purchase from other providers, such as pharmacy and in-patient mental health care, over those estimated whenenhance our service offerings to a specialized child welfare population which historically represented a significant portion of our costs to provide services under this contract. The terms of the contract was originally negotiated. However, we successfully negotiated a 46% increase in our annual contract rate under this contract effective as of July 1, 2003, as a result of which we expect any costs overruns will be mitigated based onreviewed quarterly and amended as necessary to ensure adequate funding of our current service offerings. However, it is possible we could be required to provide additional servicesofferings under the contract that could, if the costs were significant, potentially cause us to once again have to rely on the payer’s voluntary excess cost reimbursements.contract. Our revenues under thisthe previous case rate contract and, since July 1, 2004, the annual block contract represented 19.6%19.1% and 13.8%13.1% of our total revenues for the sixnine months ended JuneSeptember 30, 2003 and 2004.

Management agreements. We maintain management agreements with a number of not-for-profit social services organizations whereby we provide the day-to-daycertain management services for these organizations. In exchange for our services, we receive a management fee that is either a fixed amount per enrolled member, based on a percentage of the revenues of these organizations or a predetermined fee. Management fees earned under our management agreements represented approximately 10.2% and 11.5%10.8% of our revenue for the sixnine months ended JuneSeptember 30, 2003 and 2004.

We recognize management fee revenues from our management agreements as such amounts are earned, as defined by the respective management agreement, and collection of such amount is considered probable. We assess the likelihood of whether any of our management fee revenues may need to be returned to help our managed entities fund their working capital needs over the average duration of the entities’ existing contracts with their customers. If the likelihood is other than remote, we will defer the recognition of all or a portion of the management fees received. To the extent we choose to defer management fees as a means of funding any of our managed entities’ losses from operations, such amounts are recorded as a reduction of management fee revenues and are not recognized as management fee revenues until they are ultimately collected from the operating income of the not-for-profit entities.

Consulting agreements. We have, commencing in December 2003, entered into consulting agreements with other entities that provide government sponsored social services, to, among other things, evaluate and make recommendations with respect to their management, administrative and operational services, and we may continue such practice on a small scale in the future. In exchange for these consulting services, we receive a fixed fee that is either payable upon completion of the services or on a monthly basis. These consulting agreements range in duration from one month to fourfive months and are subject to termination by either party at any time, for any reason, upon advance written notice. Revenues related to these services are recognized at the time such consulting services are rendered and collection is determined to be probable. Management fees earned pursuant to our consulting agreements represented approximately 1.1%0.9% of our revenue for the sixnine months ended JuneSeptember 30, 2004.

The costs associated with generating our management fee revenues are accounted for in client service expense and in general and administrative expense in our condensed consolidated statements of operations.

In December 1999, theThe Securities and Exchange Commission issued Staff Accounting Bulletin No. 101, or SAB 101, as amended by SAB 104, which requires that four basic criteria be met before recognizing revenue: persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the fee is fixed and determinable, and collectibility is reasonably assured. We believe our revenue recognition principles are consistent with the guidance set forth in SAB 101, as amended by SAB 104 on December 17, 2003.104.

Allowance for doubtful accounts receivable

We evaluate the collectibility of our accounts receivable on a monthly basis. We determine the appropriate allowance for doubtful accounts based upon specific identification of individual accounts and review of aging trends. Any account receivable older than 365 days is automatically deemed uncollectible. See “—Liquidity and capital resources—Management agreements.”

In circumstances where we are aware of a specific payer’s inability to meet its financial obligation to us, we record a specific addition to our allowance for doubtful accounts to reduce the net recognized receivable to the amount we reasonably expect to collect. If the financial condition of our payers were to deteriorate, further additions to our allowance for doubtful accounts may be required.

As a result of our acquisition of the Aspen Companies, we acquired cost based service contracts where revenues and accounts receivable are recorded at established billing rates or at the amounts realizable under these contracts. Amounts are currently based on provisional rates and allocation of contract costs to appropriate reimbursement sources that are adjusted retroactively based on annual costs reports filed by us with the contracting payers. The cost reports filed by us with the contracting payers are audited annually. We periodically review our provisional billing rates and allocation of costs and provide for estimated adjustments from the contracting payers. At the time of the acquisition, the Aspen Companies had provided for approximately $1.1 million for doubtful accounts receivable which added to our allowance for doubtful accounts receivable in consolidation. We believe that adequate provisions have been made in our condensed consolidated financial statements for any adjustments that might result from the outcome of any cost report audits.

Our write-off experience for the sixnine months ended JuneSeptember 30, 2003 and 2004 was less than 1% of revenue.

Accounting for business combinations, goodwill and other intangible assets

Goodwill and intangible assets represent the excess of consideration given over the fair value of tangible net assets acquired. Certain assumptions and estimates are employed in determining the fair value of assets acquired, including goodwill and other intangible assets. We adopted Statement of Financial Accounting Standards No. 142,Goodwill and Other Intangible Assets, or SFAS No. 142, on July 1, 2001, which discontinued the amortization of goodwill and indefinite life intangibles and requires an annual test of impairment based on a comparison of fair values to carrying values. The evaluation of impairment under SFAS No. 142 requires the use of numerous subjective projections, estimates and assumptions as to the future performance of the operations. Our determination of fair value for purposes of our impairment analysis is based on a multiple of cash flows.

Actual results could differ from projections resulting in a revision of our assumptions and, if required, recognizing an impairment loss. We analyze our goodwill for impairment annually, or more often if events or circumstances arise that indicate that it is more likely than not that the carrying value of our goodwill exceeds its fair value. We test for goodwill impairment as of our fiscal year end. We performed the annual impairment test as of December 31, 2003. The results of this test determined there was no goodwill impairment.

In accordance with SFAS No. 141,Business Combinations, we separately value all acquired identifiable intangible assets apart from goodwill. In connection with our recent acquisitions (described above), we allocated a portion of the purchase consideration to certain management contracts and customer relationships based on the expected direct or indirect contribution to future cash flows over the useful life of the asset.

We assess whether certain relevant factors limit the period over which an asset is expected to contribute directly or indirectly to future cash flows for amortization purposes. With respect to acquired management contracts the useful life is limited by the stated term of the agreement. The useful life of acquired customer relationships is generally limited by the terms and nature of the underlying contracts with state and local agencies to provide social services. We determine an appropriate useful life for acquired customer relationships based on the likelihood that the underlying contracts to provide social services will renew over future periods. The likelihood of renewal is based on our contract renewal experience and the contract renewal experiences of entities we have acquired.

We periodically assess the recoverability of the unamortized balance of our intangible assets based on expected future profitability and expected cash flows and their contribution to our overall operations. If the review indicates that the carrying value is not fully recoverable, the excess of the carrying value over the fair value of the other intangible assets would be recognized as an impairment loss.

Accounting for management agreement relationships

Due to the nature of our business and the requirement or desire by certain payers to contract with not-for-profit social services organizations, we sometimes enter into management contracts with not-for-profit social services organizations where we provide them with business development, administrative, program and other management services. These organizations contract directly or indirectly with state and local agencies to supply a variety of community based mental health and foster care services to children and adults. Each of these organizations is separately incorporated and organized with its own board of directors.

Our management agreements with these not-for-profit organizations:

All of our management services are subject to the approval or direction of the managed entities’ board of directors.

The accounting for our relationships with these organizations is based on a number of judgments regarding certain facts related to the control of these organizations and the terms of our management agreements. Any significant changes in the facts upon which these judgments are based could have a significant impact on our accounting for these relationships. We have concluded that our management agreements do not meet the provisions of Emerging Issues Task Force 97-2, “Application of FASB Statement No. 94 and APB Opinion No. 16 to Physician Practice Management Entities and Certain other Entities with Consolidated Management Agreements,” or the provisions of the Financial Accounting Standards Board Interpretation No. 46, “Consolidation of Variable Interest Entities,” (“or Interpretation No. 46”)46, thus the operations of these organizations are not consolidated with our operations. We will evaluate the impact of the provisions of Interpretation No. 46, if any, on future acquired management agreements.

Results of operations

The following table sets forth the percentage of consolidated total revenues represented by items in our consolidated statements of operations for the periods presented: