POULTON & YORDAN
ATTORNEYS AT LAW
RICHARD T. LUDLOW
February 16, 2007
Jim B. Rosenberg
Senior Assistant Chief Accountant
United States Securities and Exchange Commission
Washington, D.C. 20549
Re: Pacific Health Care Organization, Inc.
Form 10-KSB/A for the Fiscal Year Ended December 31, 2005
Filed on May 17, 2002
File No.: 000-50009
Dear Mr. Rosenberg:
At the request of the management of Pacific Health Care Organization,
Inc. (the "Company") we are responding to comments raised by the staff at
the Securities and Exchange Commission in your letter dated January 18,
2007. Following are the responses to your comments.
Form 10-KSB/A for the fiscal year ended December 31, 2005
Managements' Discussion and Analysis, page 4
- --------------------------------------------
1. You indicate in your response to prior comment one that you
provide services through two different networks. In particular,
you include an employee enrollment fee due to the state in your
billing rate to HCO customers, and certain HCO and MPN customers
have you provide data maintenance services, which you in turn
subcontract out to third party providers. Please separately
quantify in disclosure-type format the amount of revenue for each
network and any expenses for data maintenance performed by third
parties. Include an explanation as to why employee enrollment
expenses and data maintenance expenses change at different rates
than the corresponding revenues for each period presented.
As per our telephone discussion with Mr. Wyman, we propose to address
this issue prospectively in the Form 10-KSB of the Company for the year
ended December 31, 2006, which is due by March 31, 2007. As discussed with
Mr. Wyman, following please find the Company's proposed revisions to the
STATEMENT OF OPERATIONS breaking out HCO and MPN revenues and increasing
the tax expense to reflect the removal of taxes from general and
administrative expenses. Please also find the proposed revised "RESULT OF
OPERATIONS" section of the MD&A from the 2005 Form 10-KSB to provide a
sample of the disclosure we propose to provide in the Form 10-KSB for the
2006 fiscal year.
Mr. Jim Rosenberg
February 16, 2007
Page 2
<Table>
<Caption>
December 31, December 31,
2005 2004
------------ ------------
(Restated) (Restated)
Revenues
HCO fee $ 1,399,012 $ 1,548,002
MPN fee 597,404 -
Other 79,975 123,992
------------ ------------
Total revenues $ 2,076,391 $ 1,671,994
Expenses
Depreciation 11,341 22,312
Consulting fees 104,110 109,796
Salaries & wages 750,516 663,832
Professional fees 342,028 228,184
Insurance 84,341 85,364
Employment enrollment 116,540 121,000
Bad debt expense 38,000 -
General & administrative 616,059 286,702
------------ ------------
Total expenses 2,062,935 1,517,190
------------ ------------
Income (loss) from operations 13,456 154,804
Other Income (expenses)
Interest income 2,456 271
------------ ------------
Total other income (expenses) 2,456 271
------------ ------------
Income (loss) before taxes 15,912 155,075
Tax expense 45,235 671
------------ ------------
Net income (loss) $ (29,323) $ 154,404
============ ============
</Table>
Results of Operations
- ---------------------
For many years, workers' compensation costs in the State of California
have been high. This has led employers to leave the state to avoid these
excessive costs. The legislature of California has been actively involved
in attempting to control workers' compensation costs. Since 1993, the
legislature in California has enacted various laws designed to introduce
alternatives to the traditional model of worker's compensation. These laws
have focused on giving the employer greater control over the medical
treatment of the injured worker for a longer period of time.
Mr. Jim Rosenberg
February 16, 2007
Page 3
Under the traditional model of workers' compensation insurance
coverage, the employer controls the selection of the medical provider for
the first 30 days after the injury is reported. Thereafter the employee
chooses the treating physician and the employer has no further control over
the treatment of the patient.
In 1993 the California legislature passed a bill that established
Health Care Organizations or "HCOs." An HCO is a network of health care
professionals specializing in the treatment of workplace injuries and in
back-to-work rehabilitation and training. The benefit of the HCO to an
employer is two-fold. First, the employer is able to control the medical
treatment of the injured employee for 90 to 180 days rather than just
during the first 30 days. Second, the HCO provides the employer a network
of trained providers who specialize in treating injured workers to which it
can refer its injured employees.
Under the HCO guidelines, all HCOs are required to collect from each
enrolled employer annual fees that are passed on to the Division of
Workers' Compensation ("DCW"). These fees include an annual fee per
employee enrolled in the HCO. The HCO guidelines also impose extensive
data reporting requirements on the HCO and annual enrollment notice
delivery requirements. All of these requirements increase the
administrative costs of an HCO.
In 2004, the California legislature enacted new laws that created
Medical Provider Networks or "MPNs." Like an HCO, an MPN is a network of
health care professionals, although, MPN networks do not require the same
level of medical expertise in treating employees work place injuries.
Under an MPN program, the employer dictates which physician the injured
employee will see for the initial visit. Thereafter, the employee can
choose to treat with any physician within the MPN network. Under the MPN
program, however, for as long as the employee seeks treatment for his
injury he can only seek treatment from physicians within the MPN network.
By virtue of the Company's continued certification as an HCO, the
Company was statutorily deemed to be qualified as an approved MPN on
January 1, 2005. Because the Company already had qualified networks in
place through its HCO program, the Company began offering MPN services in
January 2005. As a licensed HCO and MPN, Medex is able to offer its
clients an HCO program, an MPN program and a hybrid of the HCO and MPN
programs. Under this hybrid model, an employer can enroll its employees in
the HCO program, then prior to the expiration of the 90 or 180 day
treatment period under the HCO program, the employer can enroll the
employee into the MPN program. This allows employers to take advantage of
both programs. Medex is currently the only entity that offers both
programs together in its hybrid program.
Mr. Jim Rosenberg
February 16, 2007
Page 4
Unlike HCOs, MPNs are not assessed annual fees, including annual
enrollee fees that must be paid to the DCW. MPNs have no data reporting
obligations and no annual enrollment notice delivery requirements. MPN's
are only required to provide an enrollment notice at the time the employee
first joins the MPN and a second notice must be delivered to the employee
at the time he suffers a workplace injury. Because the employer retains
control over medical treatment for the life of the claim under an MPN, and
because of the reduced administrative costs associated with an MPN, the
primary growth in the Company's business during the 2005 fiscal year was in
the number of enrollees in our MPN program.
Comparison of the years ended December 31, 2005 and 2004
--------------------------------------------------------
The Company's total revenues increased $404,397 to $2,076,391 for the
year ended December 31, 2005 compared to $1,671,994 for the year ended
December 31, 2004 as our business continued to grow. The Company
attributes this growth to its increased marketing and advertising efforts.
During the year ended December 31, 2005, the Company generated revenue
from approximately 395 employers representing approximately 123,000
enrollees. Of these 123,000 enrollees approximately 65,000 were HCO
enrollees and approximately 59,000 were MPN enrollees. By comparison,
during the year ended December 31, 2004, we had approximately 57 employers
and 64,000 enrollees in our HCOs and no MPN enrollees.
During the 2005 fiscal year, we experienced a 1.5% increase in total
HCO enrollees. Despite this increase, HCO revenue decreased about 9.5%
from $1,548,002 to $1,399,012. Every year we experience client turnover.
Fiscal 2005 was no different. Unlike prior years, however, with the
creation of MPNs in 2005, employers had a less expensive alternative to
HCOs. This created downward pricing pressure in the market. During 2005,
in general new employer enrollees were brought in at lower prices per
enrollee than the employers who terminated coverage. During the 2005
fiscal year, we also renegotiated contracts with some of our existing
enrolled employers to offer them lower per enrollee costs. These factors
worked together to result in the reduction in HCO revenue we experienced in
fiscal 2005, despite the modest increase in HCO enrollment.
Mr. Jim Rosenberg
February 16, 2007
Page 5
As discussed above, with the creation of an MPN program in 2005, the
Company was able to enroll approximately 59,000 employees into its MPN
program. As a result, revenue from MPN clients during the 2005 fiscal year
was $597,404.
During the year ended December 31, 2005, other revenue decreased from
$123,992 to $79,975 mostly due to lower nurse case management fees
While the Company believes that revenues will continue to increase, it
also believes that expenses will increase. Total expenses incurred during
the year ended December 31, 2005 were $2,062,935, compared to $1,571,190
for the corresponding period ended December 31, 2004. This overall
increase included increases in bad debt expense, legal fees, public
relations fees and salaries and wages.
During the year ended December 31, 2005, consulting fees decreased to
$104,110 from $109,796 during the year ended December 31, 2004. The
reduction was primarily the result of lower information technology
expenses. The Company anticipates consulting fees to remain constant in
the upcoming fiscal year.
Salaries & wages increased $86,684 during the year ended December 31,
2005, to $750,516, compared to $663,832 during the year ended December 31,
2004. The increase in salaries & wages in the year ended 2005 is
attributable to the increased number of Medex employees. The Company
expects salaries & wages to remain constant in 2006.
In the year ended December 31, 2005, the Company incurred professional
fees of $342,028 compared to $228,184 during the year ended December 31,
2004. The increase in professional fees in 2005 is largely attributable to
increased legal, public relations and accounting fees incurred during the
2005 fiscal year. Legal fees increased, in connection with compliance with
the reporting obligations of the Company under the Exchange Act of 1934,
and the cost to the Company of defending itself against the legal
proceeding brought by Marvin Teitelbaum and Peter Alexakis. While the
Company believes that agreeing to submit to binding arbitration will result
in lesser legal fees than if this matter were to go to trial, the Company
anticipates that the costs of arbitrating this case will result in greater
legal fees in fiscal 2006.
During the year ended December 31, 2005, the Company incurred
insurance expenses of $84,831, a $1,023 decrease over the prior year. The
decrease in 2005, is related to a reduction in professional liability
insurance premiums. The Company anticipates increases in insurance expense
in 2006.
Employment enrollment expenses decreased $4,460 to $116,540 during
the year ended December 31, 2005, compared to the year ended December 31,
2004. As discussed above, the Company is required to pay a fee to the DCW
for each person enrolled in its HCO program. Because the exact number of
enrollees in the HCO is not determined until after the year end, the
Company estimates the amount of due that will be due to the DCW and makes
an appropriate accrual. In 2004 the Company accrued more for employment
enrollment expenses than it was required to pay to DCW. Therefore, in 2005
the Company reduced the accrual to reflect its estimate of employment
enrollment fees that will be due for the 2005 fiscal year. In the future,
the Company anticipates employee enrollment expenses will increase or
decrease in direct proportion to the number of persons enrolled in its HCO
program.
Mr. Jim Rosenberg
February 16, 2007
Page 6
For the year ended December 31, 2005, general and administrative
expenses increased $329,357 to $616,059, compared to $286,702 for the year
ended December 31, 2004. This 114% increase in general & administrative
expense was largely attributable to mandatory data maintenance fees paid on
increasing numbers of employee enrollees, increased advertising costs,
increased printing costs due to enrollment notification requirements for
newly enrolled employees in both our HCO and MPN programs and mandatory
annual enrollment notification for HCO enrollees and due to increased
shareholder meeting costs. The Company anticipates general and
administrative to increase in proportion to increases in employee
enrollment in 2006.
Bad debt expense was $38,000 for the year ended December 31, 2005. A
reserve was established during the year for several past due accounts. The
Company incurred no bad debt expense in fiscal 2004.
As a result of increasing revenue, which was offset by increases in
salaries and wages, professional fees, general and administrative expense,
bad debts, and income tax expense of $21,192, the Company realized a net
loss of $29,323 for the year ended December 31, 2005, compared to net
income of $154,404 during the year ended December 31, 2004.
Income tax expense increased $44,564 to $45,235 during the year ended
December 31, 2005 compared to the year ended December 31, 2004. Since
inception the Company has had net losses for both book purposes and tax
purposes. No tax returns were filed until 2006 for the fiscal year ended
2005. At that point, all prior year Federal and state tax returns were
filed. For Federal purposes, due to the net operating loss carryforwards,
no income tax was due. For California state purposes, taxes were due
because California suspended net operation loss carryforwards for the two
years of 2002 and 2003. Thus, from fiscal years 2002 and 2004, there was
state income taxes due in the amount of $21,485. For the year ended
December 31, 2005, there were taxes due in the amount of $23,750. Since
the amount of the tax in any of these years was immaterial, the Company
decided to expense the amount in the 2005 year.
Mr. Jim Rosenberg
February 16, 2007
Page 7
2. You state in your response to prior comment two that in restating
the December 31, 2005 financial statements, you inadvertently
failed to correct the prior year footnote. Please clarify for us
how you intend to correct Note 5 with the revised disclosure
contained in your response.
The Company believes that coupled with the restated Statement of
Operations wherein the Company has removed from general and administrative
expenses the prior years' tax expenses and added them to the 2005 tax
expense, this revised disclosure now corrects Note 5.
NOTE 5 INCOME TAXES (Restated)
The Company accounts for corporate income taxes in accordance with
Statement of Accounting Standards Number 109 ("SFAS No. 109")
"Accounting for Income Taxes." SFAS No. 109 requires an asset and
liability approach for financial accounting and reporting for income
tax purposes.
The tax provision (benefit) for the year ended December 31, 2005
consisted of the following:
<Table>
<Caption>
2005 2004
Current: ------------ ------------
Federal $ 23,216 $ -
State 17,596 9,423
Deferred:
Federal (17,070) -
State (2,550) -
------------ ------------
Total tax provision (benefit) $ 21,192 $ 9,423
============ ============
</Table>
Deferred income taxes reflect the net tax effects of temporary
differences between the carrying amounts of assets and liabilities for
financial reporting purposes and the amounts used for income tax
purposes. The Company's total deferred tax liabilities, deferred tax
assets, and deferred tax asset valuation allowances at December 31,
2005 are as follows:
<Table>
============ ============
Depreciation
Federal (2,175) (3,100)
State (325) (720)
Reserve for bad debts
Federal 12,890 -
State 1,930 -
Vacation accrual
Federal 6,355 4,120
State 945 970
Deferred tax valuation allowance - (1,270)
------------ ------------
19,620 -
============ ============
Mr. Jim Rosenberg
February 16, 2007
Page 8
The reconciliation of income tax computed at statutory rates of income
tax benefits is as follows:
Expense at federal statutory rate (2,765) 52,500
State tax effects 7,707 9,423
Non deductible expenses 18,800 13,750
Taxable temporary differences 17,505 3,100
Deductible temporary differences (435) (8,600)
Deferred tax valuation allowance (19,620) (60,750)
------------ ------------
Income tax provision (benefit) 21,192 9,423
============ ============
</Table>
Notes to Financial Statements
- -----------------------------
Note 5. Income Taxes, page 26
- -----------------------------
3. Regarding your proposed revised disclosure to Note 5, please address the
following:
- Explain to us why the tax provisions for 2005 and 2004 do not agree
with your tax-provisions disclosed on the face of your Statements
of Operations.
- You previously disclosed, in your original Form 10-KSB for December
31, 2005, a deferred tax asset for net operating loss carry-
forwards and the related "evaluation" allowances, for each year.
Please explain to us why these amounts are excluded from your
revised disclosure.
- Your revised reconciliation of income tax expense includes deferred
tax valuation allowances for 2005 and 2004 that appear to be
inconsistent with the corresponding change in the deferred tax
valuation allowance. Please explain how you determined these
amounts and provide in disclosure-type format any revised
reconciling amounts consistent with changes in the beginning-of-
the-year valuation allowance balance.
As discussed above, we propose to correct the Statement of Operations to
be consistent with the disclosure in Note 5.
The $60,750 deferred valuation allowance for 2004 was the tax effect of
a net operating loss carryfoward used in the 2004 income tax return. This
net operating loss was incurred in years 2001 through 2003 and was offset by
deferred valuation allowance.
Mr. Jim Rosenberg
February 16, 2007
Page 9
4. You indicate in your response to prior comment five that for the
year ended December 31, 2005 you recorded income taxes for 2002 and
2003 in general and administrative expense because reporting back
taxes and current year taxes in the same year would distort the
tax provision. In addition, you state that since the amount of the
tax in any of these years was immaterial you decided to expense the
entire amount in the 2005 year. Please provide expended discussion
and quantification supporting your conclusion that the amount of
back taxes recorded in 2005 was not material to your net income or
loss for 2002, 2003 and 2005 and that a restatement of your 2002
and 2003 financial statements was not necessary.
As we discussed with Mr. Wyman and as disclosed above, we propose to
remove the prior years taxes from general and administrative expenses and
incorporate them into income tax expense.
In 2002 the Company's revenue was $653,000 and total assets were
$254,000. Based thereon, the Company determined that the materiality
threshold in 2002 was approximately $11,000. The Company's state tax expense
in 2002 was $2,831. The Company had no federal tax expense in 2002.
Therefore the Company concluded that the $2,831 tax expense in 2002 was not
material.
In 2003 the Company's revenue was $1,098,000 and total assets were
$592,000. Based thereon, the Company determined that the materiality
threshold in 2003 was $14,000. The Company's state tax expense was $10,319.
The Company had no federal tax expense in 2003. Therefore the Company
concluded that the $10,319 tax expense in 2003 was not material.
In 2004 the Company's revenue was $1,672,000 and total assets were
$592,000. Based thereon, the Company determined that the materiality
threshold in 2004 was $17,000. The Company's state tax expense was $9,423.
The Company had no federal tax expense in 2003. Therefore the Company
concluded that the $9,423 tax expense in 2004 was not material.
Thank you for your assistance in this matter. If you have any questions
or require additional information, please contact me directly.
Very truly yours,
POULTON & YORDAN
Richard T. Ludlow
Attorney at Law