DYNACQ HEALTHCARE INC – 10-K – Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 Our Management's Discussion and Analysis includes forward-looking statements that are subject to risks and uncertainties. Actual results may differ substantially from the statements we make in this section due to a number of factors that are discussed in Item 1A - Risk Factors.  

Our operating results for all periods presented reflect operations of our Garland facility in the U.S. and all of our subsidiaries in China and Hong Kong, except for Sino Bond, as discontinued operations.

RECENT DEVELOPMENTS

Internal Investigation

  As previously disclosed in our Current Report on Form 8-K filed with the Securities and Exchange Commission (the "SEC") on August 9, 2012, we announced that, at the request of our Board of Directors (the "Board"), we commenced an internal investigation of our past business practices, potentially encompassing members of the Board, management and third persons, and related accounting matters (the "Investigation").  The Investigation, which was performed by outside legal counsel and other outside consultants at the direction of the Board, was substantially completed on December 27, 2012. The Investigation included a review of a substantial number of Company documents and emails, as well as interviews with employees, members of the Board and other persons who were familiar with the facts surrounding the Investigation. The results of the Investigation, which were reported directly to the Board, revealed that the former Chief Financial Officer of the Company did not perform a significant review or independent analysis of transactions initiated by the former Chief Executive Officer. As a result, we believe that, for the five fiscal years ending on August 31, 2012, we did not maintain effective control over financial reporting due to the existence of a material weakness related to a failure of internal controls designed to limit the ability of management to override our system of internal controls. The results of the Investigation also revealed that the former Chief Financial Officer misrepresented certain information to our independent auditor, which we have also determined to be a material weakness in our internal control over financial reporting. We also identified the existence of a significant deficiency related to a lack of objectivity by our former executive officers with respect to accounting decisions.  Based on the results of the Investigation and recommendations made by our independent auditor regarding the foregoing material weaknesses and significant deficiencies in internal control over financial reporting, we are reviewing our internal control and compliance policies and procedures. We believe that no additional remediation efforts with respect to the material weaknesses and the significant deficiency as they relate to the former Chief Executive Officer and the former Chief Financial Officer are necessary, as the executives who occupied these offices during the events in question are no longer employed by us.  We have determined that our previously reported consolidated balance sheets for periods up to and including August 31, 2012 do not require any material adjustments and/or restatements in respect of the results of the Investigation. Further, the Investigation did not result in any material change to our previously reported net income or loss or financial position for the same periods. However, the Investigation, along with subsequent analysis performed by us and our auditors, did reveal that Company expenditures in the amount of approximately $7.8 million were authorized by former officers of the Company and paid to various third parties, and the results of the Investigation and the subsequent analysis performed by us and our auditors provided no evidence of a discernible benefit to the Company resulting from these expenditures. We have determined that the questionable nature of these expenditures may result in their reclassification in our financial statements, from operating costs and expenses to other expenses, depending on determinations that the Board may make in the future. We do not expect these reclassifications, even if they are made, to result in a material restatement of our financial statements. Please see note 16 to our consolidated financial statements for additional information.                                           22

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Delisting of Common Stock from NASDAQ Global Markets

  As discussed in our Current Report on Form 8-K filed with the SEC on October 11, 2012, and further discussed in our Current Reports on Form 8-K filed on each of September 28, 2012 and April 13, 2012, the NASDAQ Stock Market ("NASDAQ") announced on October 10, 2012 that the Company's common stock would be delisted from NASDAQ. Prior to being delisted, trading in the Company's stock was halted by NASDAQ on August 9, 2012, and NASDAQ suspended the Company's stock from trading on October 4, 2012. As discussed in the Company's Current Report on Form 8-K filed with the SEC on April 13, 2012, NASDAQ informed the Company that it would be subject to delisting upon a failure to regain compliance with (i) the $1.00 minimum bid price per share of its common stock pursuant to NASDAQ Listing Rule 5450(a)(1) for a period of at least ten consecutive business days ending on a date prior to October 9, 2012, and (ii) the minimum market value of its publicly held shares of at least $5 million pursuant to NASDAQ Listing Rule 5450(b)(1)(C) for at least ten consecutive business days prior to October 9, 2012. Further, on September 25, 2012, the Company received notification from NASDAQ stating that the Company's common stock will be delisted from NASDAQ effective at the opening of business on October 4, 2012. The delisting of the Company's common stock was a result of the Company's failure to make timely payment of certain listing fees, as required by NASDAQ Listing Rule 5250(f), in the amount of $5,000. In light of the prior NASDAQ notice described in further detail above, the Company concluded that no valid business purpose would be served by making payment of these fees. The Company did not request an appeal hearing regarding the delisting. As a result of the trading halt in effect at the time of the notice for the Company's common stock and the failure of the minimum bid price to reach $1.00 per share for 10 consecutive business days after receipt of the NASDAQ letter and prior to the commencement of the trading halt, and in light of the fact that there were fewer than ten business days remaining before October 9, 2012, the Company did not believe that it would be able to regain compliance with the NASDAQ Listing Rules discussed above prior to October 9, 2012. As a result, the Company believed that it would have become subject to delisting for failure to comply with Listing Rule 5450(a)(1) on October 9, 2012, even if it had paid the listing fees in compliance with NASDAQ Listing Rule 5250(f) on or before October 4, 2012. A Form 25 was filed with the SEC on October 11, 2012, and the Company's stock was effectively delisted ten days following this filing.  

Changes in Officers and Directors

  On May 17, 2012, Chiu M. Chan, the Chairman of our Board of Directors, passed away. His seat on the Board of Directors remains vacant while the Board considers whether to appoint a new director or permanently reduce the size of the Board to five members. As previously reported in the Company's Current Report on Form 8-K filed with the SEC on January 13, 2012, on January 10, 2012 the Board of Directors expanded the Board from five to six members and appointed Eric K. Chan, M.D. as a new member of the Board. Eric K. Chan is the son of Chiu M. Chan, who was incapacitated at the time by an unexpected illness. Eric K. Chan did not stand for election at the Annual Meeting of Shareholders held on February 15, 2012 and his term as director ended. At the conclusion of the Annual Meeting, the Board of Directors reappointed Eric K. Chan as a member of the Board. Eric K. Chan currently serves as our Chief Executive Officer and President. Dr. Chan is board certified in anesthesiology. He has been the sole owner of Redwood Health Corporation since March 2005, which furnishes physicians to provide in-house emergency medical coverage and recruits anesthesiologists and certified registered nurse anesthetists at hospitals, including the Company's Pasadena facility. Dr. Chan has also been the sole owner of Anesthesia Associates of Houston Metroplex since August 2007, which provides anesthesiology services to hospitals, including the Company's Pasadena facility. He was an Assistant Professor at Memorial Hermann Hospital, University of Texas at Houston from August 2007 to September 2008. Dr. Chan earned his M.B.A. in Health Organization Management and M.D. from Texas Tech University.  On August 8, 2012, the Board placed Mr. Philip Chan on paid administrative leave from his position as Chief Financial Officer of Dynacq. On November 28, 2012, Mr. Chan submitted to the Board his resignation from all positions at Dynacq and its affiliates, including his positions as Chief Financial Officer and Director of Dynacq. While Mr. Chan was on administrative leave, the Board appointed Hemant Khemka, the current Controller of Dynacq, to act as principal financial officer of Dynacq pending the results of the investigation. Mr. Khemka continues to act as principal financial officer of Dynacq.                                           23

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  As discussed in the Definitive Information Statement filed pursuant to Section 14(c) (the "Information Statement") of the Securities Exchange Act of 1934, as amended (the "Exchange Act"") on October 9, 2012, pursuant to an Action by Written Consent of Stockholders in lieu of a Special Meeting, stockholders of Dynacq holding more than two-thirds of the issued and outstanding shares of our common stock as of September 24, 2012 (the "Record Date") approved the removal of Ping S. Chu, James G. Gerace and Stephen L. Huber from their positions as members of our Board, to be effective on October 30, 2012. On October 24, 2012, James G. Gerace resigned. On October 30, 2012, the stockholder approval became effective, and Messrs. Chu and Huber were removed.  The sole remaining member of our Board is Dr. Eric K. Chan, who also serves as our Chief Executive Officer and President. As a result of the stockholder action and recent resignations, our Board has five vacancies, including the vacancy left by Mr. Chiu M. Chan's passing. We intend to seek qualified candidates to fill these Board vacancies, including some candidates that are deemed independent based on the independence standards of NASDAQ. There can be no assurance, however, that we will be able to fill any of these vacancies with new directors, independent or otherwise. In the interim, the sole remaining member of our Board will continue to fulfill the Board's responsibilities. The following holders of 9,966,482 shares of our common stock, constituting 68.5% of our outstanding common stock on the Record Date, consented to the stockholder action: Estate of Chiu M. Chan (represented by the widow of Mr. Chan, Ella Y.T.C. Chan, the sole executrix of the estate); Ella Y.T.C. Chan; Chan Chang Chin Ying (the aunt of Dr. Eric K. Chan); Philip S. Chan; Dr. Eric K. Chan; Edward K. Chiu (no relation to any other stockholder consenting to the action); and Bert Chan (brother of Eric K. Chan and son of Ella Y.T.C. Chan). Please see the Information Statement for additional information.  

Restatement of Financial Statements for Fiscal Year 2011 Due to Change in Benefit for Income Tax Amount

  We restated our financial statements for the fiscal year ended August 31, 2011, which produced adjustments to previously reported amounts. These adjustments are described in Note 15 to the consolidated financial statements included in this annual report on Form 10-K. The restatement did not change our previously reported net revenue or cash flow from operating activities. It reduced the benefit for income taxes and stockholders' equity. Due to the restatements, investors should not rely on the Company's previously issued financial statements for the fiscal year ended August 31, 2011.  

Critical Accounting Policies and Estimates

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

Revenue Recognition

Background

  The Company's revenue recognition policy is significant because net patient service revenue is a primary component of its results of operations. Revenue is recognized as services are delivered. The determination of the amount of revenue to be recognized in connection with the Company's services is subject to significant judgments and estimates, which are discussed below.                                           24

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Revenue Recognition Policy

  The Company has established billing rates for its medical services which it bills as gross revenue as services are delivered. Gross billed revenues are then reduced by the Company's estimate of the discount (contractual allowance) to arrive at net patient service revenues. Net patient service revenues may not represent amounts ultimately collected. The Company adjusts current period revenue for actual differences in estimated revenue recorded in prior periods and actual cash collections.  The table below sets forth the percentage of our gross patient service revenue by financial class for our Pasadena facility for the fiscal years 2012 and 2011:                                                  2012       2011                       Workers' Compensation      11 %       26 %                       Commercial                 40 %       39 %                       Medicare                   28 %       17 %                       Medicaid                    1 %        1 %                       Self-Pay                   16 %       13 %                       Other                       4 %        4 %   Contractual Allowance  The Company computes its contractual allowance based on the estimated collections on its gross billed charges. The Company computes its estimate by taking into account collections received, up to 30 days after the end of the period, for the services performed and also estimating amounts collectible for the services performed within the last six months. The following table shows gross revenues and contractual allowances for our Pasadena facility for fiscal years 2012 and 2011:                                                      2012              2011         Gross billed charges                  $ 19,619,903      $ 22,138,821         Contractual allowance(1)                14,088,670        24,116,028          Net revenue                           $  5,531,233      $ (1,977,207 )          Contractual allowance percentage(1)             72 %             109 %     

(1) The contractual allowance percentage, excluding the stop-loss fee dispute

amount booked in the quarter ended May 31, 2011, which is discussed below,

would have been 63% for the year ended August 31, 2011.

   A significant amount of our net revenue results from Texas workers' compensation claims, which are governed by the rules and regulations of the Texas Department of Workers' Compensation ("TDWC") and the workers' compensation healthcare networks. If our hospital chooses to participate in a network, the amount of revenue that will be generated from workers' compensation claims will be governed by the network contract.  For claims arising prior to the implementation of workers' compensation networks and out of network claims, inpatient and outpatient surgical services are either reimbursed pursuant to the Acute Care In-Patient Hospital Fee Guideline or at a "fair and reasonable" rate for services in which the fee guideline is not applicable. Starting March 1, 2008, the Texas Workers' Compensation 2008 Acute Care Hospital Outpatient and Inpatient Facility Fee Guidelines (the "Guidelines") became effective. Under these Guidelines, the reimbursement amounts are determined by applying the most recently adopted and effective Medicare reimbursement formula and factors; however, if the maximum allowable reimbursement for the procedure performed cannot be calculated using these Guidelines, then reimbursement is determined on a fair and reasonable basis.  Based on these Guidelines, the reimbursement due the Company for workers' compensation cases is lower than we previously experienced. The Company has continued accepting Texas workers' compensation cases, and has not made any substantial changes in its focus towards such cases. Our net patient service revenue for Texas workers' compensation cases as a percentage of gross billings has decreased primarily as a result of lower reimbursement rates for workers' compensation procedures still being performed.                                           25

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  Should we disagree with the amount of reimbursement provided by a third-party payer, we are required to pursue the MDR process at the TDWC to request proper reimbursement for services. From January 2007 to November 2008, the Company had been successful in its pursuit of collections regarding the stop-loss cases pending before the State Office of Administrative Hearings ("SOAH"), receiving positive rulings in over 90% of its claims presented for administrative determination. The 2007 district court decision upholding our interpretation of the statute as applied to the stop-loss claims was appealed by certain insurance carriers, and on November 13, 2008 the Third Court of Appeals determined that in order for a hospital to be reimbursed at 75% of its usual and customary audited charges for an inpatient admission, the hospital must not only bill at least $40,000, but also show that the admission involved unusually costly and unusually extensive services. Procedurally, the decision means that each case where a carrier raised an issue regarding whether the services provided were unusually costly or unusually extensive would be remanded to either SOAH or MDR for a case-by-case determination of whether the services provided meet these standards, once the definitions of those standards are determined. As a result of the Third Court of Appeals opinion, any stop-loss cases pending at SOAH have been remanded to the TDWC since these cases have not been reviewed or decided by the two-prong standard decided by the Third Court of Appeals. The SOAH Administrative Law judges determined that the most appropriate location for these cases is the TDWC, pending a final, non-appealable decision.  A petition asking the Texas Supreme Court to review the Third Court of Appeals decision has been denied. Therefore, the Company is bound by the Third Court of Appeals decision. The Texas Supreme Court's decision has further delayed final adjudication in these pending stop-loss cases. The uncertain outcome in these cases will depend on a very lengthy process. We anticipate further, lengthy litigation at the Travis County District Courts and the Texas Courts of Appeals. Because of this lengthy process and the uncertainty of recovery in these cases, collection of a material amount of funds in these pending stop-loss cases is not anticipated during the 2013 fiscal year.  Through August 2012, insurance carriers have voluntarily paid the awards in the decisions and orders issued by SOAH, plus interest, in approximately 180 cases, involving approximately $11 million in claims. In most of these cases, the carriers have requested refunds of the payments made in the event that the SOAH decisions and orders are reversed on appeal. Our request that the TDWC Commissioner enforce the awards which were not voluntarily paid by the carriers was refused in approximately 130 cases. Motions filed seeking a refund in some cases in which the awards were voluntarily paid have been granted and the Company has been ordered to refund approximately $3.7 million, including prejudgment interest, pending remand for a case-by-case determination of whether the services provided were unusually costly and unusually extensive. In fiscal year 2011, the Company deposited these amounts as cash deposits into the registry of the court in order to stay execution of the judgments ordering refunds. Additionally, the Company has deposited $204,000 in September 2012 for another year's interest in order to continue to stay execution of the judgments ordering refunds. We anticipate that similar motions requesting remand and a refund for awards voluntarily paid will be filed and will likely be granted by the 345th Judicial District Court of Travis County, Texas. If and when these additional motions are granted, the Company will be ordered to refund an additional $7.7 million</money>, not including prejudgment interest. The Company has appealed the judgments requiring a refund to the carriers. The briefs of the parties have been filed with the court of appeals and the Company is now waiting for the court of appeals to act on the appeals. While the appeals are pending, the adjudication of those cases remanded for determinations of whether the services provided were unusually costly and unusually extensive will continue. Voluntary payments made pursuant to the Decisions and Orders are premature payments by the carriers and may be ordered to be refunded. Once the Company is given the opportunity to present its evidence regarding whether the services provided were unusually costly and unusually extensive, the Company anticipates that it will prevail in the underlying stop-loss fee disputes and that payments refunded to the carriers will be recaptured.  Due to the uncertainties associated with these stop-loss fee dispute cases, in fiscal year 2011, the Company recognized an increase of $10,254,990 in the contractual allowance at our Pasadena facility (and an additional $779,583 in the contractual allowance at our Garland facility, which is classified as discontinued operations), and $1,751,478 in interest expense at our Pasadena facility (and an additional interest expense of $132,339 at our Garland facility). The increase in the contractual allowance resulted in the $1,977,207 negative revenue for the Pasadena facility for the year ended August 31, 2011.                                           26 

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  Claims regarding payment for ambulatory surgical center and hospital outpatient services remain pending at the TDWC. It is expected that these claims will be adjudicated at SOAH and possibly in the Texas district and appellate courts. The basis for reimbursement for these services made the subject of these pending cases is the determination of "fair and reasonable" charges. In 2007, we received unfavorable rulings from SOAH in all of our appeals of unfavorable decisions related to services provided in 2001 and 2002. The 179 cases, which have been appealed to the Travis County district courts, challenge the constitutionality of the relevant statutory language. The Company received an unfavorable ruling in its lead case in March 2009, which ruling was appealed to and was upheld by the Third Court of Appeals on August 26, 2010. The Texas Supreme Court denied a petition asking for review of the Third Court of Appeals decision. The unfavorable interpretation by the Texas Courts of Appeal in our lead case negatively affects the recovery of additional reimbursement, not only in the lead case, but in the remaining 178 pending cases. Consequently, the Company is bound by the Third Court of Appeals' ruling that interprets the applicable statute and fee guideline to require that the amount that will be paid to a provider must not only be at a "fair and reasonable rate" but also must "ensure the quality of medical care" and "achieve effective cost control" and be the same or less than that charged to others with an equivalent standard of living. This ruling will impact cases in which a fee guideline was not applicable, specifically all pending cases involving ambulatory surgical services provided from 2001 through 2004 as well as all pending cases involving hospital outpatient services provided prior to March 1, 2008, when the Guidelines took effect. Since the Third Court of Appeals' unfavorable ruling, collection, if any, in these cases depends on the Company's ability to establish the criteria in this ruling. The Company was given the opportunity to establish the criteria in approximately 80 cases, which were set for hearing on the merits from March through May 2012 and was unsuccessful. Additionally, the Company will have the opportunity to continue to establish the criteria in several thousand cases currently pending at SOAH during the 2013 fiscal year.  Due to the uncertainties regarding the accounts receivable in the MDR process, the 2008 and 2010 Third Court of Appeals' opinions and our legal counsel's advice that settlements with insurance carriers have virtually stopped, the Company had fully reserved all accounts receivable related to the MDR process as of August 31, 2008. Any monies collected for these MDR accounts receivable will be recorded as current period's net patient service revenues.  

Accounts Receivable

Accounts receivable represent net receivables for services provided by the Company. At each balance sheet date management reviews the accounts receivable for collectibility.

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

Sources of Revenue and Reimbursement

  The focal point of our business is providing patient care services, including complex orthopedic and bariatric procedures. The Company pursues optimal reimbursement from third-party payers for these services. We do not normally participate in managed care or other contractual reimbursement agreements, principally because they limit reimbursement for the medical services provided. This business model often results in increased amounts of reimbursement for the same or similar procedure, as compared to other healthcare providers. However, there are no contractual or administrative requirements for "prompt payment" of claims by third-party payers within a specified time frame. As a result, the Company has tended to receive higher amounts of per-procedure reimbursement than that which may be received by other healthcare providers performing similar services. Conversely, despite the increased reimbursement, we may take additional time to collect the expected reimbursement from third-party payers. The Company has been participating in managed care contracts since the first quarter of fiscal 2006 and anticipates entering into additional contracts in the future. So far these contracts have not resulted in any meaningful patient revenues. Increased participation in managed care contracts and programs may decrease the per-procedure reimbursement that the Company collects in the future for similar services.                                           27 

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  In addition to the fact that our collection process may be longer than other healthcare providers because of our focus on workers' compensation and other commercial payers, the collection process can be extended due to our efforts to obtain all optimal reimbursement available to the Company. Specifically, for medical services provided to injured workers, the Company may initially receive reimbursement that may not be within the fee guidelines or regulatory guidelines mandating reimbursement. For such cases in which third-party payers did not provide appropriate reimbursement pursuant to these guidelines, the Company pursues further reimbursement. The Company reviews and pursues those particular claims that are determined to warrant additional reimbursement pursuant to the fee or regulatory guidelines. The Company's pursuit of additional reimbursement amounts that it believes are due under fee or regulatory guidelines may be accomplished through established dispute resolution procedures with applicable regulatory authorities.  Surgeries are typically not scheduled unless they are pre-authorized by insurance carrier for medical necessity, with the exception of Medicare, Medicaid and self-pay surgeries. After the surgery, the Company's automated computer system generates a statement of billed charges to the third-party payer. At that time, the Company also requests payment from patients for any remaining amounts that are the responsibility of the patient. In cases where a commercial insurance payers' pre-approval is not approved subsequently, those accounts receivable may be classified to self-pay. Historically, such classifications have not been significant.  

Discontinued Operations

Revenue Recognition Policy

  In China, the local government Department of Health establishes billing rates for a hospital's sale of prescription medication and medical services. A majority of the services provided by Second People's Hospital is to cash pay patients, who pay for the services in advance. For services provided under the local government's social healthcare insurance program, we are generally paid at approximately 95% of billed charges two to three months after the date of service. The remaining 5% of billed charges is evaluated by the local government Department of Health on a semi-annual basis and may be paid to the hospital after that evaluation is complete. As of February 28, 2011, the Company terminated the management agreement with the Rui An City Department of Health. The Company had bad debt expenses of $24,755 for the six months ended February 28, 2011, related to denials under the social healthcare insurance program. Since the amount of bad debt expense is minimal, it has been included with Other Operating Expenses in the income statement.  

Accounts Receivable

Accounts receivable represent net receivables for services provided by the Company. At each balance sheet date management reviews the accounts receivable for collectibility.

  Income Taxes  We provide for income taxes by taking into account the differences between the financial statement treatment and tax treatment of certain transactions. Deferred tax assets and liabilities are recognized for the anticipated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis amounts. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates is recognized as income or expense in the period that includes the enactment date. This calculation requires us to make certain estimates about our future operations and many of these estimates of future operations may be imprecise. Changes in state, federal, and foreign tax laws, as well as changes in our financial condition, could affect these estimates. In addition, we consider many factors when evaluating and estimating income tax uncertainties. These factors include an evaluation of the technical merits of the tax position as well as the amounts and probabilities of the outcomes that could be realized upon ultimate settlement. The actual resolution of those uncertainties will inevitably differ from those estimates, and such differences may be material to the financial statements. Our estimates and judgments associated with our calculations of income taxes have been reasonable in the past, however, the possibility for changes in the tax laws, as well as the current economic uncertainty, could affect the accuracy of our income tax estimates in future periods.                                           28

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Stock-Based Compensation

  We account for stock-based compensation under ASC Topic 718. We estimate the fair value of stock options granted using the Black-Scholes option pricing model. The fair value for awards that are expected to vest is then amortized on a straight-line basis over the requisite service period of the award, which is generally the option vesting term. The amount of expense attributed is based on an estimated forfeiture rate, which is updated as appropriate. This option pricing model requires the input of highly subjective assumptions, including the expected volatility of our common stock, pre-vesting forfeiture rate and an option's expected life. The financial statements include amounts that are based on our best estimates and judgments.                                           29

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   Table of Contents  Results of Operations                                                    Year Ended August 31, 2012                                  Year Ended August 31, 2011                                    U.S. Division         Corporate             Total           U.S. Division         Corporate             Total

Net patient service revenue $ 5,531,233 $ - $ 5,531,233 $ (1,977,207 ) $ - $ (1,977,207 )

  Costs and expenses: Compensation and benefits               3,850,678          3,326,103           7,176,781            4,272,368          3,146,329           7,418,697 Medical services and supplies           1,557,792                 -            1,557,792            1,490,251                 -            1,490,251 Other operating expenses                3,158,835          1,240,448           4,399,283            3,893,930          4,271,391           8,165,321 Depreciation and amortization             454,808             95,835             550,643              445,971            122,098             568,069  Total costs and expenses                9,022,113          4,662,386          13,684,499           10,102,520          7,539,818          17,642,338  Operating loss                         (3,490,880 )       (4,662,386 )        (8,153,266 )        (12,079,727 )       (7,539,818 )       (19,619,545 )  Other income (expense): Rent and other income                      28,620            933,161             961,781               48,107          1,272,185           1,320,292 Interest income                                -           1,225,910           1,225,910                   -           1,343,091           1,343,091 Interest expense                         (578,478 )          (11,917 )          (590,395 )         (1,777,649 )          (12,014 )        (1,789,663 )  Total other income (expense), net                                      (549,858 )        2,147,154           1,597,296           (1,729,542 )        2,603,262             873,720  Loss before income taxes from continuing operations             $    (4,040,738 )     $ (2,515,232 )      

(6,555,970 ) $ (13,809,269 ) $ (4,936,556 ) (18,745,825 )

  (Provision) benefit for income taxes                                                                         (4,018,699 )                                                 1,357,468  Loss from continuing operations                                                                   (10,574,669 )                                               (17,388,357 ) Discontinued operations, net of income taxes                                                               (1,394,984 )                                                (3,522,169 ) Loss on disposal of discontinued operations, net of income taxes                                                                 (229,201 )                                                  (121,577 )  Net loss                                                                     (12,198,854 )                                               (21,032,103 ) Less: Net loss attributable to noncontrolling interest                                                           47,358                                                      15,978  Net loss attributable to Dynacq Healthcare, Inc.                                                    $ (12,151,496 )                                             $ (21,016,125 )  Operational statistics (Number of medical procedures) for Pasadena facility: Inpatient: Bariatric                                      68                                                          73 Orthopedic                                     12                                                          33 Other                                          64                                                          28  Total inpatient procedures                    144                                                         134  Outpatient: Orthopedic                                    112                                                          87 Other                                         446                                                         537  Total outpatient procedures                   558                                                         624  Total procedures                              702                                                         758                                             30 

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Comparison of the Fiscal Years Ended August 31, 2012 and August 31, 2011

U.S. Division

  Through August 2012, insurance carriers have voluntarily paid the awards in the decisions and orders issued by SOAH, plus interest, in approximately 180 cases, involving approximately $11 million in claims. In most of these cases, the carriers have requested refunds of the payments made in the event that the SOAH decisions and orders are reversed on appeal. Our request that the TDWC Commissioner enforce the awards which were not voluntarily paid by the carriers was refused in approximately 130 cases. Motions filed seeking a refund in some cases in which the awards were voluntarily paid have been granted and the Company has been ordered to refund approximately $3.7 million, including prejudgment interest, pending remand for a case-by-case determination of whether the services provided were unusually costly and unusually extensive. In fiscal year 2011, the Company deposited these amounts as cash deposits into the registry of the court in order to stay execution of the judgments ordering refunds. Additionally, the Company has deposited $204,000 in September 2012 for another year's interest in order to continue to stay execution of the judgments ordering refunds. We anticipate that similar motions requesting remand and a refund for awards voluntarily paid will be filed and will likely be granted by the 345th Judicial District Court of Travis County, Texas. If and when these additional motions are granted, the Company will be ordered to refund an additional $7.7 million, not including prejudgment interest. The Company has appealed the judgments requiring a refund to the carriers. The briefs of the parties have been filed with the court of appeals and the Company is now waiting for the court of appeals to act on the appeals. While the appeals are pending, the adjudication of those cases remanded for determinations of whether the services provided were unusually costly and unusually extensive will continue. Voluntary payments made pursuant to the Decisions and Orders are premature payments by the carriers and may be ordered to be refunded. Once the Company is given the opportunity to present its evidence regarding whether the services provided were unusually costly and unusually extensive, the Company anticipates that it will prevail in the underlying stop-loss fee disputes and that payments refunded to the carriers will be recaptured.  Due to the uncertainties associated with these stop-loss fee dispute cases, in fiscal year 2011, the Company recognized an increase of $10,254,990 in the contractual allowance at our Pasadena facility (and an additional $779,583 in the contractual allowance at our Garland facility, which is classified as discontinued operations), and $1,751,478 in interest expense at our Pasadena facility (and an additional interest expense of $132,339 at our Garland facility). The increase in the contractual allowance resulted in the $1,977,207 negative revenue for the Pasadena facility for the year ended August 31, 2011.  Excluding the above mentioned stop-loss contractual allowance of $10,254,990, net patient service revenue decreased by $2,746,550, or 33%, from $8,277,783 to $5,531,233, and total surgical cases decreased by 7% from 758 cases for the year ended August 31, 2011 to 702 cases for the year ended August 31, 2012. While the number of cases decreased by 7%, net patient service revenue decreased by 33%. The change in percentage decrease in net patient service revenue compared to the decrease in the number of cases is primarily due to a change in the surgical mix of cases. Decreases in net patient revenues and number of cases are generally attributable to the loss of physicians from our medical staff. In the fourth quarter of fiscal year 2012, a physician from our medical staff, who accounted for 19% and 7% of total gross billed charges for fiscal year 2012 and 2011, respectively, passed away. The Company is making efforts to find a replacement for this physician at the present time; however, there can be no assurance given that we will succeed in this process.  Total costs and expenses decreased by $1,080,407, or 11%, from $10,102,520 for the year ended August 31, 2011 to $9,022,113 for the year ended August 31, 2012. The following discusses the various changes in costs and expenses:    

• Compensation and benefits decreased by $421,690, or 10%, primarily

associated with reduction in workforce due to lower net patient service

revenues, partially offset by increase in the Company's self-funded health

         care cost of its employees.    

• Medical services and supplies expenses increased marginally by $67,541, or

         5%, while the number of surgery cases decreased 7%. The increase in          medical services and supplies was due to a change in the surgical mix of          cases, and also due to write-off of obsolete supplies.    

• Other operating expenses decreased by $735,095, or 19%, primarily

         associated with lower net patient service revenues.                                            31 

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  Other income (expense) for the year ended August 31, 2012 and 2011 of $(549,858) and $(1,729,542) includes interest expense associated with the stop-loss cases discussed above.  Corporate Division  Compensation and benefits for the Corporate Division includes all corporate personnel compensation and benefits, and it increased by $179,774, or 6%, in 2012, compared to 2011. The increase in compensation and benefits was due to the following reasons: (1) during the current fiscal year, the Company issued 50,000 shares of its common stock to Dr. Kelly Larkin as consideration for Dr. Larkin's employment as the Company's marketing director, and took a compensation charge of $50,000 related to the issuance, (2) the Company retained the services of Dr. Eric Chan, as its chief executive officer starting January 10, 2012, (3) the former chief financial officer of the Company had a reduction in his compensation for part of fiscal 2011, whereas for fiscal 2012, the Compensation Committee reinstated his compensation to $200,000, effective February 1, 2012, and paid him a sum of $77,000, which equates to the prior reductions in his compensation from January 1, 2010 to January 31, 2012, and (4) the Company continues to make efforts to increase its net patient service revenues and has hired additional marketing personnel during fiscal 2012. In July 2012, the employment agreement with Dr. Larkin was terminated. Partially offsetting these increases in 2012, we had a compensation expense in 2011 of $232,500 towards stock awards made during that year.  Other operating expenses includes primarily administrative expenses for managing the various projects the Company is undertaking in China and Hong Kong, related marketing expenses and rent for an apartment for our former chief executive officer in Hong Kong. The Company has made the decision to not pursue any new line of business and/or projects, and has also terminated the apartment lease. Other operating expenses also include all the corporate general and administrative expenses in the U.S. including other professional fees such as legal expenses and audit expenses. Other operating expenses decreased by $3,030,943, from $4,271,391 for the year ended August 31, 2011 to $1,240,448 for the year ended August 31, 2012. The Company incurred the following costs in fiscal 2011, with no corresponding expenses in fiscal 2012: (1) marketing cost in Hong Kong of $1,650,000, which included $1,050,000 for estimated marketing expenses that were supposed to be incurred in fiscal years 2012 and 2013 based on a contract with Kenkon Limited, which expires in May 2013 (The Company believed that the proposed businesses being pursued in China and Hong Kong would eventually be beneficial; however, due to no immediate project in an advanced stage, the Company had expensed the contractual obligation through the entire term of the contract as of August 31, 2011); (2) rental expense of $292,967 for the apartment in Hong Kong for its former chief executive officer, and (3) $476,000 in administrative support services fees. In fiscal year 2012, the Company reversed $870,000 of marketing costs and $88,000 of administrative support service fees that were expensed and accrued for in fiscal year 2011, since the amounts were determined to be not payable. The Company had incurred lower other operating expenses through the third quarter of fiscal year 2012, compared to same period in fiscal 2011, primarily associated with lower net revenues. However, due to the internal investigation discussed above, the Company has incurred legal, accounting and other professional fees associated with this review of approximately $560,000 through August 31, 2012. The Company continues to incur significant amounts of fees related to this investigation in the first two quarters of fiscal 2013, and may continue to do so for the remainder of fiscal year 2013.  Rent and other income decreased by $339,024, from $1,272,185 for the year ended August 31, 2011 to $933,161 for the year ended August 31, 2012. Rent and other income for the year ended August 31, 2012 includes (1) a foreign currency gain of $1,422,590 realized due to the monies invested in China coming back to the U.S. (The Company had invested in its foreign subsidiaries in China during the last few years, and due to a favorable change in exchange rates between the U.S. Dollar and the Chinese Yuan Renminbi, the Company had accumulated other comprehensive income of $1,422,590. This amount was realized as a gain during fiscal year 2012 upon the return of investments from the Company's foreign subsidiaries in China); (2) a loss of $318,206 on trading securities, including losses due to fair valuation of trading securities as of August 31, 2012, and (3) foreign currency exchange losses of $337,953, primarily on investments in Euro bonds. Rent and other income for the year ended August 31, 2011 includes (1) a gain of $1.3 million on call of a bond which was part of its available-for-sale securities' holdings with a book cost of $700,000, (2) foreign currency exchange gains of $302,000 primarily on investments in Euro bonds, and (3) a loss of $365,000 on short-term investments in the equity securities in Hong Kong.                                           32 

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  Interest income of $1,225,910 and $1,343,091 for the year ended August 31, 2012 and 2011, respectively, are primarily related to the Company's investments in bonds.  Investments in securities  During the fiscal year ended August 31, 2009, the Company invested approximately $9.1 million of its available cash in marketable securities. During the quarter ended August 31, 2011, one of these marketable securities with a book cost of $700,000 was called for a gain of $1.3 million. As of August 31, 2012, the balance of these securities is valued at approximately $16.8 million. Unrealized gains in these investments of $5.5 million are included in accumulated other comprehensive income in the Consolidated Balance Sheet as at August 31, 2012, net of taxes of $2.9 million. The Company intends to hold these for a minimum period of an additional 12 months, except for one particular security that was called subsequent to the year ended August 31, 2012. During the year ended August 31, 2012 and 2011, the Company also traded in initial public offerings of equity securities on the Hong Kong Stock Exchange and had losses of $318,000 and $365,000, respectively.  Discontinued Operations 

Garland Facility (discontinued operations)

Due to the uncertainties associated with the stop-loss fee dispute cases discussed above, in fiscal year 2011, the Company recognized an increase of $779,583 in the contractual allowance, and an additional interest expense of $132,339, at our Garland facility.

  The Company closed the Garland facility on September 30, 2011, and accordingly its operations for the fiscal years 2011 and 2012 continue to be classified as discontinued operations. The Company signed a commercial contract of sale on March 7, 2013 to sell its Garland facility. The sale is expected to close in May 2013. Net patient service revenue for the year ended August 31, 2012 was $397,278, primarily due to receipts on old accounts receivable that were written off earlier per the Company's revenue recognition policy. Excluding the above mentioned stop-loss contractual allowance of $779,583, net patient service revenue for the year ended August 31, 2011 was $1,866,038.  Total costs and expenses decreased from $6,254,270 for the year ended August 31, 2011 to $2,432,816 for the year ended August 31, 2012, due to the closure of the facility on September 30, 2011. The Company has taken an impairment charge of $1,058,056 as of August 31, 2012 based on the contract sales price of the facility.  

Corporate (discontinued operations)

  The Corporate Division revenue includes net patient service revenues from Second People's Hospital in Rui An, China. Due to continued losses at the Second People's Hospital, the Company terminated the management agreement as of February 28, 2011 with the Rui An City Department of Health. The loss before income taxes at the Second People's Hospital for the six months ended February 28, 2011, which is the termination date of the management agreement, was $375,890. This loss amount of $375,890 includes a $187,041 loss before taxes on disposition of the Second People's Hospital.  The Corporate Division also includes other operating expenses the Company incurred at certain of its subsidiaries in China while pursuing various projects. All of the Company's foreign subsidiaries, except for Sino Bond, have been reclassified as discontinued operations. The Company incurred $(258,151) and $881,637 in total costs and expenses at these subsidiaries during the fiscal year ended August 31, 2012 and 2011, respectively. The negative expense in 2012 is the result of reversal of expenses accrued in prior years. The expenses in fiscal year 2011 include $260,000 write-down of inventory of artifacts, and various other set up costs and operating costs of these subsidiaries. Other income in fiscal year 2011 includes a $720,696 refund received from the Rui An City                                           33 

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Department of Health as part of the negotiation of termination of the assignment agreement to manage the Third People's Hospital, and write-off of associated liabilities of $43,840 (the decision to terminate the agreement was based on the continued delays in the construction of the hospital). Income before income taxes in these subsidiaries was $106,680 and $83,193 for the fiscal year ended August 31, 2012 and 2011, respectively.  The Company had a provision for income taxes in fiscal year 2012, and the benefit for income taxes for fiscal year 2011 was lower than the statutory federal rate, due to the uncertainty of the Company's ability to recognize the benefit from the net operating losses. The Company has recorded a full valuation allowance against the deferred tax asset. The estimated income tax refund as at August 31, 2011 was overstated by $1,794,294. The restated income tax receivable as of August 31, 2011 is $569,430.  

Liquidity and Capital Resources

  The Company maintained sufficient liquidity to meet its business needs in fiscal 2012. As of August 31, 2012, its principal source of liquidity was $11.4 million in cash and net accounts receivable, and $18.1 million in investments in trading securities and available-for-sale securities. The Company has approximately $10.6 million in cash as of August 31, 2012, the majority of which is deposited in national and international banks. The amounts at these financial institutions overseas do not have insurance protection and in the U.S. are substantially in excess of FDIC and Securities Investor Protection Corporation insurance limits; however, management believes that these financial institutions are of high quality and the risk of loss is minimal.  

Cash flows from operating activities

  Cash flow used in operating activities for continuing activities was $12,947,715 during fiscal year 2012, primarily due to a net loss before discontinued operations of $10,527,311 and decreases in accounts payable and accrued liabilities of $6,709,647, of which a decrease of $3,703,252 was due to cash deposits made by the Company into the registry of the court in order to stay execution of the judgments ordering refunds in the stop-loss fee dispute cases. These decreases were partially offset by changes in income tax related accounts of $2,358,623, decreases in accounts receivable of $394,315, and depreciation and amortization expenses of $550,643.  In addition, cash flow used in operating activities for discontinued operations was $748,076 during fiscal year 2012, primarily due to a net loss from discontinued operations of $1,624,185, partially offset by an impairment charge of $1,058,056 for the Garland facility.  

Total cash flow used in operating activities for continuing and discontinued operations combined was $13,695,791 during fiscal year 2012.

Cash flows from investing activities

  Cash flow used in investing activities for continuing activities was $225,173, primarily due to purchase of equipment of $159,919, purchase of trading securities of $211,248, offset by related sales on part of these securities of $94,669. Subsequent to the year ended August 31, 2012, one of the available-for-sale securities the Company was holding was called. The sales proceeds of this security was $2.7 million, with a gain of $2.2 million. Additionally, the Company sold the apartment in Hong Kong subsequent to the year ended August 31, 2012, for net proceeds, after paying off the related $1.1 million note payable, of $1.3 million. The gain on the sale of this apartment was approximately $480,000.  

In addition, cash flow provided by investing activities for discontinued operations was $14,000 towards sale of equipment.

Total cash flow used in investing activities for continuing and discontinued operations combined was $211,173 during fiscal year 2012.

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Cash flows from financing activities

  Cash flow used in financing activities for continuing activities was $6,001. In November 2011, the Company borrowed $116,339 as note payable from a financial institution at an interest rate of 4.5%. This note payable is to be repaid in 36 monthly installments and is secured by specific equipment purchased at our Pasadena facility. The Company has paid $64,182 during the fiscal year ended August 31, 2012 towards notes payable for equipment purchased. In addition, the Company paid $64,114 towards a mortgage loan for the purchase of an apartment in Hong Kong. The Company also made payments of $94,044 on equipment purchased on capital leases for its Pasadena facility. During the fiscal year ended August 31, 2012, the Company received contributions of $100,000 for sale of non-controlling interests in our Pasadena facility's operations. Subsequent to the year ended August 31, 2012, the Company sold the apartment in Hong Kong, and as mentioned above, paid off the related note payable of $1.1 million.  

Total cash flow used in financing activities was $6,001 during fiscal year 2012.

The Company had working capital of $5,444,841 as of August 31, 2012, and maintained a liquid position by a current ratio of approximately 1.4 to 1.

We believe we will be able to meet our ongoing liquidity and cash needs for fiscal year 2013 through the combination of available cash and cash flow from operations.

Off-Balance Sheet Arrangements

We are not a party to any off-balance sheet arrangements that have, or are reasonably likely to have, a material effect on us.

Contractual Obligations and Commitments

  Due to the uncertainties associated with the stop-loss fee dispute cases, the Company has booked, in fiscal year 2011, an increase of $12.9 million in the contractual allowance and related interest expense at our Pasadena and Garland facilities. For a detailed discussion of this, see Revenue Recognition Policy under Note 1 to the Consolidated Financial Statements. Motions filed seeking a refund in some cases in which the awards were voluntarily paid have been granted and the Company has been ordered to refund approximately $3.7 million, including prejudgment interest, pending remand for a case-by-case determination of whether the services provided were unusually costly and unusually extensive. In fiscal year 2011, the Company deposited these amounts as cash deposits into the registry of the court in order to stay execution of the judgments ordering refunds. Additionally, the Company has deposited $204,000 in September 2012 for another year's interest in order to continue to stay execution of the judgments ordering refunds. We anticipate that similar motions requesting remand and a refund for awards voluntarily paid will be filed and will likely be granted by the 345th Judicial District Court of Travis County, Texas. If and when these additional motions are granted, the Company will be ordered to refund an additional $7.7 million, not including prejudgment interest. The Company has appealed the judgments requiring a refund to the carriers. The briefs of the parties have been filed with the court of appeals and the Company is now waiting for the court of appeals to act on the appeals. While the appeals are pending, the adjudication of those cases remanded for determinations of whether the services provided were unusually costly and unusually extensive will continue. Voluntary payments made pursuant to the Decisions and Orders are premature payments by the carriers and may be ordered to be refunded. Once the Company is given the opportunity to present its evidence regarding whether the services provided were unusually costly and unusually extensive, the Company anticipates that it will prevail in the underlying stop-loss fee disputes and that payments refunded to the carriers will be recaptured.  Total rent and lease expenses paid by the Company for the fiscal years 2012 and 2011 were approximately $127,000 and $470,000, respectively. The Company's total minimum rental commitments under noncancellable operating leases are approximately $63,000 in the next five fiscal years.  The Company has contracts with doctors to manage various areas of the Company's hospital and other service agreements. Payments made under these agreements for the fiscal years ending August 31, 2012 and 2011 were $1,190,000 and $1,296,000, respectively. The Company's minimum commitments under these contracts are approximately $712,000, all of which is payable in fiscal year 2013.                                           35

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  The Company has administrative support services agreements with outside organizations for administrative support services. Payments made related to these agreements for fiscal years 2012 and 2011 were $266,000 and $433,000, respectively. The Company has a total commitment of approximately $259,000, all of which is to be incurred in fiscal year 2013 related to these administrative support services agreements.  The Company, through its subsidiary, also had agreements with outside organizations that offer marketing, pre-authorization and follow up support services to prospective bariatric and orthopedic patients in areas serviced by the Pasadena facility. The facility received bariatric and orthopedic referrals from other sources, and the organizations referred clients to other area hospitals. The Company had cancelled these agreements in the first quarter of fiscal year 2011, and does not have a commitment related to these agreements anymore, and markets on a month-to-month basis. These marketing expenses for the fiscal years 2012 and 2011 were $162,000 and $762,000, respectively.  

The Company has a note payable commitment for purchase of equipment for the Pasadena facility at an interest rate of 4.5% and 6%, secured by the said equipment of approximately $88,000, of which $41,000 is payable in 2013, $40,000 in 2014 and $7,000 in 2015.

  The Company has a note payable commitment of $75,000 per year for the next 15.5 years related to an apartment purchased in Hong Kong as an investment. The Company obtained an 18-year mortgage loan of $1,245,775 from a financial institution, with a variable interest rate at the lower of 3-month Hang Seng Interbank Offered Rates plus 0.7% or 2.9% below the Hong Kong Dollar best lending rate quoted by the financial institution. The effective interest rate at August 31, 2011 was 1.12%. The total amount payable in fiscal years 2013, 2014, 2015, 2016, 2017 and thereafter are $65,000, $65,000, $66,000, $67,000, $67,000 and $762,000, respectively. Subsequent to the year ended August 31, 2012, the Company sold the apartment in Hong Kong, as well as paid off the related note payable.  The Company has purchased some equipment under capital leases, and has a total commitment to pay $203,000 under these leases, of which $113,000 is payable in fiscal year 2013 and $90,000 in 2014.  These commitments mentioned above total $12.4 million, of which $11.1 million is payable in fiscal year 2013, $219,000 in 2014, $91,000 in 2015, $82,000 in 2016, $76,000 in 2017, and approximately $807,000 is payable after five years.  

Discontinued Operations

  Total rent and lease expenses paid by the Company for its discontinued operations for the fiscal years 2012 and 2011 were approximately $117,000 and $225,000, respectively. The Company's total minimum rental commitments under noncancellable operating leases are approximately $139,000.  The Company had contracts with doctors to manage various areas of the Company's hospital and other service agreements. Payments made under these agreements for the fiscal years ended August 31, 2012 and 2011 were $-0- and $668,000, respectively.  The Company had administrative support services agreements with outside organizations for administrative support services. Payments made related to these agreements for fiscal years 2012 and 2011 were $110,000 and $210,000, respectively. The Company has a total commitment of approximately $64,000, all of which is to be incurred in fiscal year 2013, related to these administrative support services agreements.  The Company, through its subsidiary, also had agreements with outside organizations that offer marketing, pre-authorization and follow up support services to prospective bariatric and orthopedic patients in areas serviced by the Garland facility, before its closure in September 2011. The facility received bariatric and orthopedic referrals from other sources, and the organizations referred clients to other area hospitals. The Company had since cancelled these agreements in the first quarter of fiscal year 2011, and does not have a commitment related to these agreements anymore. These marketing expenses for the fiscal years 2012 and 2011 were $-0- and $124,500, respectively.                                           36 

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These commitments mentioned above for discontinued operations total $203,000.

Recent Accounting Pronouncements

See Note 1 to the Consolidated Financial Statements - Recent Accounting Pronouncements, which is incorporated here by reference.

Inflation

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

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

Not required.