INTEGRATED HEALTHCARE HOLDINGS INC – 10-Q – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

FORWARD-LOOKING INFORMATION

This Quarterly Report on Form 10-Q contains forward-looking statements, as that term is defined in the Private Securities Litigation Reform Act of 1995. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as "may," "will," "should," "expects," "plans," "anticipates," "believes," "estimates," "predicts," "potential," "continue," or the negative of these terms or other comparable terminology. These statements are only predictions and involve known and unknown risks, uncertainties and other factors, including the risks discussed under the caption "Risk Factors" in our Annual Report on Form 10-K filed on June 28, 2013 that may cause our Company's or our industry's actual results, levels of activity, performance, or achievements to be materially different from those expressed or implied by these forward-looking statements.

Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance, or achievements. Except as may be required by applicable law, we do not intend to update any of the forward-looking statements to conform these statements to actual results.

As used in this report, the terms "we," "us," "our," "the Company," "Integrated Healthcare Holdings" or "IHHI" mean Integrated Healthcare Holdings, Inc., a Nevada corporation, unless otherwise indicated.

Unless otherwise indicated, all amounts included in this Item 2 are expressed in thousands (except percentages and per share amounts).

   OVERVIEW   

On March 8, 2005, we completed our acquisition (the "Acquisition") of four Orange County, California hospitals and associated real estate, including: (i) 282-bed Western Medical Center - Santa Ana, CA; (ii) 188-bed Western Medical Center - Anaheim, CA; (iii) 178-bed Coastal Communities Hospital in Santa Ana, CA; and (iv) 114-bed Chapman Medical Center in Orange, CA (collectively, the "Hospitals") from Tenet Healthcare Corporation. The Hospitals were assigned to four of our wholly owned subsidiaries formed for the purpose of completing the Acquisition. We also acquired the following real estate, leases and assets associated with the Hospitals: (i) a fee interest in the Western Medical Center at 1001 North Tustin Avenue, Santa Ana, CA, a fee interest in the administration building at 1301 North Tustin Avenue, Santa Ana, CA, certain rights to acquire condominium suites located in the medical office building at 999 North Tustin Avenue, Santa Ana, CA; (ii) a fee interest in the Western Medical Center at 1025 South Anaheim Blvd., Anaheim, CA; (iii) a fee interest in the Coastal Communities Hospital at 2701 South Bristol Street, Santa Ana, CA, and a fee interest in the medical office building at 1901 North College Avenue, Santa Ana, CA; (iv) a lease for the Chapman Medical Center at 2601 East Chapman Avenue, Orange, CA, and a fee interest in the medical office building at 2617 East Chapman Avenue, Orange, CA; and (v) equipment and contract rights. At the closing of the Acquisition, we transferred all of the fee interests in the acquired real estate (the "Hospital Properties") to Pacific Coast Holdings Investment, LLC ("PCHI"), a company owned 51% by various physician investors and 49% by our largest shareholder.

   SIGNIFICANT CHALLENGES   

COMPANY - Our Acquisition involved significant cash expenditures, debt incurrence and integration expenses that has seriously strained our consolidated financial condition. If we are required to issue equity securities to raise additional capital or for any other reasons, existing stockholders will likely be substantially diluted, which could affect the market price of our stock. In April 2010 we issued warrants to existing shareholders and a lender. In February 2013 we repurchased certain warrants, issued new warrants, and extended the expiration dates of the remaining warrants. (see "WARRANTS").

INDUSTRY - Our Hospitals receive a substantial portion of their revenues from Medicare and Medicaid. The healthcare industry is experiencing a strong trend toward cost containment, as the government seeks to impose lower reimbursement and resource utilization group rates, limit the scope of covered services and negotiate reduced payment schedules with providers. These cost containment measures generally have resulted in a reduced rate of growth in the reimbursement for the services that we provide relative to the increase in our cost to provide such services.

Changes to Medicare and Medicaid reimbursement programs have limited, and are expected to continue to have limited, payment increases. Also, the timing of payments made under the Medicare and Medicaid programs is subject to regulatory action and governmental budgetary constraints resulting in a risk that the time period between submission of claims and payment could increase. Further, within the statutory framework of the Medicare and Medicaid programs, a substantial number of areas are subject to administrative rulings and interpretations which may further affect payments.

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Our business is subject to extensive federal, state and, in some cases, local regulation with respect to, among other things, participation in the Medicare and Medicaid programs, licensure and certification of facilities, and reimbursement. These regulations relate, among other things, to the adequacy of physical property and equipment, qualifications of personnel, standards of care, government reimbursement and operational requirements. Compliance with these regulatory requirements, as interpreted and amended from time to time, can increase operating costs and thereby adversely affect the financial viability of our business. Since these regulations are amended from time to time and are subject to interpretation, we cannot predict when and to what extent liability may arise. Failure to comply with current or future regulatory requirements could also result in the imposition of various remedies including (with respect to inpatient care) fines, restrictions on admission, denial of payment for all or new admissions, the revocation of licensure, decertification, imposition of temporary management or the closure of a facility or site of service.

We are subject to periodic audits by the Medicare and Medicaid programs, which have various rights and remedies against us if they assert that we have overcharged the programs or failed to comply with program requirements. Rights and remedies available to these programs include repayment of any amounts alleged to be overpayments or in violation of program requirements, or making deductions from future amounts due to us. These programs may also impose fines, criminal penalties or program exclusions. Other third-party payer sources also reserve rights to conduct audits and make monetary adjustments in connection with or exclusive of audit activities.

The healthcare industry is highly competitive. We compete with a variety of other organizations in providing medical services, many of which have greater financial and other resources and may be more established in their respective communities than we are. Competing companies may offer newer or different centers or services than we do and may thereby attract patients or customers who are presently our patients or customers or are otherwise receiving our services.

An increasing trend in malpractice litigation claims, rising costs of malpractice litigation, losses associated with these malpractice lawsuits and a constriction of insurers have caused many insurance carriers to raise the cost of insurance premiums or refuse to write insurance policies for hospital facilities. Also, a tightening of the reinsurance market has affected property, vehicle, and excess liability insurance carriers.

We receive all of our inpatient services revenue from operations in Orange County, California. The economic condition of this market could affect the ability of our patients and third-party payers to reimburse us for our services, through its effect on disposable household income and the tax base used to generate state funding for Medicaid programs. An economic downturn, or changes in the laws affecting our business in our market and in surrounding markets, could have a material adverse effect on our financial position, results of operations, and cash flows.

LIQUIDITY AND CAPITAL RESOURCES

The accompanying unaudited condensed consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and settlement of obligations in the normal course of business. As of June 30, 2013, we had total stockholders' equity of $15.3 million and working capital of $15.8 million. For the three months ended June 30, 2013, we had net income of $45.4 million. At June 30, 2013, we had $24.2 million in additional availability under our revolving credit facility (see "DEBT"). Through June 30, 2013, we have recorded $196.4 million in revenues and incurred $86.0 million in provider fees and other expenses relating to the 2013 hospital quality assurance fee program. For the remaining term of the 2013 hospital quality assurance fee program, we anticipate recording approximately $47.1 million in revenues and incurring approximately $21.2 million in provider fees and other expenses (See "HOSPITAL QUALITY ASSURANCE FEES"). We are reliant on funds received under the hospital quality assurance fee program and not receiving such funding could have a material adverse effect on our liquidity and financial position and value of our common stock.

Key items for the three months ended June 30, 2013 included:

         1.  Net patient service revenues (patient service revenues, net of           contractual allowances and discounts, less provision for doubtful           accounts) for the three months ended June 30, 2013 and 2012 were $223.2           million and $80.8 million, respectively, representing an increase of           $142.4 million, or 176.2%. The Hospitals serve a disproportionate           number of indigent patients and receive governmental revenues and           subsidies in support of care for these patients. Governmental revenues           include payments from Medicaid, Medicaid DSH, and Orange County, CA           (CalOptima). Governmental net revenues increased $141.7 million for the           three months ended June 30, 2013 compared to the three months ended           June 30, 2012. The increase was primarily related to Hospital Quality           Assurance Fee ("QAF") revenues received from the State of California.           For the three months ended June 30, 2013, we recorded $142.2 million in           QAF revenues compared to $0 during the three months ended June 30, 2012           (see "HOSPITAL QUALITY ASSURANCE FEES").    

Inpatient admissions decreased by 7.8% to 4.7 for the three months ended June 30, 2013 compared to 5.1 for the three months ended June 30, 2012. The decline in admissions is primarily related to reductions in managed care, shifts from inpatient to outpatient observation, and lower obstetrics admissions.

Uninsured patients, as a percentage of gross charges (retail charges), were 7.6% for the three months ended June 30, 2013 compared to 5.4% for the three months ended June 30, 2012.

   22              2.  Operating expenses: Management is working aggressively to reduce costs           without reduction in service levels. These efforts have in large part           been offset by inflationary pressures. Operating expenses for the three           months ended June 30, 2013 were $123.4 million, representing an           increase of $40.4 million, or 48.7%, compared to the three months ended           June 30, 2012. The increase is primarily related to QAF expenses of           $33.5 million incurred during the three months ended June 30, 2013           compared to $0 incurred during the three months ended June 30, 2012.    

DEBT - As of June 30, 2013, we had the following Credit Agreements:

        -   A $47.277 million Term Loan issued under the $80.0 million Restated          Credit Agreement by and among us, Silver Point Finance, LLC and its          affiliate, SPCP Group, LLC (together with Silver Point Finance, LLC,          "Silver Point"), and PCHI and Ganesha Realty, LLC, as Credit Parties,          bearing an interest rate of LIBOR plus 10%, with the LIBOR floor set at          2% (12% at June 30, 2013). If any event of default occurs and continues,          the lender can increase the interest rate by 5% per year. As of June 30,          2013, we were in compliance with all financial covenants. The stated          maturity date for this Restated Credit Agreement is April 13, 2016.          -   A $35.0 million Revolving Credit Agreement by and among us and MidCap          Funding IV, LLC, as assigned to it from MidCap Financial, LLC, as agent          and a lender, bearing an interest rate of 4.25% plus LIBOR, with a 2.5%          floor, per year (6.75% at June 30, 2013) and an unused commitment fee of          0.5% per year ($10.8 million outstanding balance at June 30, 2013). For          purposes of calculating interest, all payments we make on the Revolving          Credit Agreement are subject to a five business day clearance period. As          of June 30, 2013, we were in compliance with all financial covenants.          The stated maturity date for this Revolving Credit Agreement is March          25, 2016. At June 30, 2013, we had $24.2 million in additional          availability under this facility.    

Our outstanding debt consists of the following:

                                               June 30,       March 31,                                               2013           2013                  Current:                  Revolving line of credit   $  10,761$    30,000                  Discount                        (433 )          (473 )                                             $  10,328$    29,527                   Noncurrent:                  Term loan                  $  47,277$    47,277                  Discount                      (1,594 )        (1,747 )                                             $  45,683$    45,530

WARRANTS - On April 13, 2010 we issued three-year warrants (the "Omnibus Warrants") to purchase our common stock at an exercise price of $0.07 per share in the following denominations: 139.0 million shares to KPC or its designees and 96.0 million shares to its Term Loan lender, Silver Point (SPCP Group, LLC and SPCP Group IV, LLC) or its designees. The Omnibus Warrants also provide the holders with certain pre-emptive, information and registration rights.

In addition, on April 13, 2010, we issued a three-year warrant (the "Release Warrant") to acquire up to 170.0 million shares of common stock at $0.07 per share to Dr. Chaudhuri who facilitated a release enabling us to recover amounts due from our prior lender and a $1.0 million reduction in principal of our outstanding debt, among other benefits to us. The Release Warrant also provides the holder with certain pre-emptive, information and registration rights.

On February 7, 2013, in connection with the Restated Credit Agreement, we entered into the following transactions involving warrants:

We entered into a Warrant Repurchase Agreement with SPCP Group IV, LLC pursuant to which it repurchased the outstanding common stock warrant issued to SPCP Group IV, LLC on or about April 13, 2010 (the "Cancelled Warrant"). The Cancelled Warrant (part of the Omnibus Warrants) entitled the holder to purchase an aggregate of 16.8 million shares of our common stock at an exercise price of $0.07 per share. We repurchased the Cancelled Warrant for a purchase price of $0.12 per share minus the exercise price of $0.07 per share resulting in a net purchase price of $0.05 per share multiplied by 16.8 million shares for an aggregate purchase price of $840.9.

Immediately following the warrant repurchase, we issued a new common stock warrant (the "New Warrant") to SPCP Group, LLC for a price of $0.05 per share (an aggregate price of $840.9) on the same terms as the Cancelled Warrant entitling the holder to purchase an aggregate of 16.8 million shares of common stock at an exercise price of $0.07 per share, except that the New Warrant expires on April 13, 2016.

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Also simultaneous with the transactions described above, we extended the expiration date from April 13, 2013 to April 13, 2016 for the Omnibus Warrants issued to KPC and the remaining held by Silver Point (to purchase 79.2 million shares) and the Release Warrant issued to Dr. Chaudhuri. The extension of the warrant expiration date was intended to conform the terms of the warrants to that of the Restated Credit Agreement.

We assessed the amended credit agreement entered into in August 2012 and February 2013 under the provisions of ASC 470-50 and determined that the debt amendments should be accounted for as a debt modification. Accordingly, the recorded change in fair value as of February 7, 2013, totaling $534, of the New Warrant and the Omnibus Warrant held by SPCP Group, LLC was recognized as a component of the debt discount on the Term Loan and will be amortized to interest expense over the term of the debt agreement using the effective interest method.

The Omnibus Warrants, the Release Warrant, and the New Warrant are collectively referred to as the "IHHI Warrants." As of June 30, 2013, the fair value of the IHHI Warrants was $11.9 million.

The gain (loss) related to the change in fair value of the Company's outstanding warrants for the three months ended June 30, 2013 and 2012 was $(6.6) million and $.07 million, respectively.

HOSPITAL QUALITY ASSURANCE FEES - In October 2009, the Governor of California signed legislation supported by the hospital industry to impose a provider fee on general acute care hospitals that, combined with federal matching funds, would be used to provide supplemental Medi-Cal payments to hospitals. The state submitted the plan to the Centers for Medicare and Medicaid Services ("CMS") for a required review and approval process, and certain changes in the plan were required by CMS. Legislation amending the fee program to reflect the required changes was passed by the legislature and signed by the Governor on September 8, 2010. Among other changes, the legislation leaves distribution of "pass-through" payments received by Medi-Cal managed care plans that will be paid to hospitals under the program to the discretion of the plans. The hospital quality assurance fee program ("QAF") created by this legislation initially provided payments for up to 21 months retroactive to April 2009 and expiring on December 31, 2010 ("2010 QAF"). In February 2011, CMS gave final approval for the 2010 QAF. During fiscal year 2011, we recognized $87.2 million in revenue and recorded expenses of $47.8 million relating to the 2010 QAF.

In December 2011, CMS gave final approval for the extension of the QAF for the nine month period from January 1 through June 30, 2011 ("2011 QAF"). Accordingly, for the year ended March 31, 2012 we recognized $31.9 million in revenue and recorded expenses of $15.9 million relating to the 2011 QAF.

In June 2012, CMS conditionally approved the extension of the QAF for the thirty month period from July 1, 2011 through December 31, 2013 ("2013 QAF"). In June 2012, the California State Legislature amended the hospital fee statute to recognize separate CMS approval of the fee-for-service portion and managed care portion of the 2013 QAF, which was further clarified in legislation approved by the governor of California in September 2012. As a result, during the year ended March 31, 2013, we recognized revenue of $54.2 million and expenses of $52.5 million relating to the 2013 QAF for the periods from July 1, 2011 through March 31, 2013.

Through June 30, 2013, we have recorded $196.4 million in revenues and incurred $86.0 million in provider fees and other expenses relating to the 2013 hospital quality assurance fee program. For the remaining term of the 2013 hospital quality assurance fee program, we anticipate recording approximately $47.1 million in revenues and incurring approximately $21.2 million in provider fees and other expenses.

We cannot provide any assurances or estimates in connection with CMS's final managed care approval of the 2013 QAF (for the period from July 1, 2013 to December 31, 2013) or a possible continuation of the QAF program beyond December 31, 2013.

ELECTRONIC HEALTH RECORDS INCENTIVE PROGRAM - Provisions of the American Recovery and Reinvestment Act of 2009 provide incentive payments for the adoption and meaningful use of certified electronic health record (EHR) technology. The Medicare EHR incentive program provides incentive payments to eligible hospitals (and certain other providers) that are meaningful users of certified EHRs. The Medicaid EHR incentive program provides incentive payments to eligible hospitals (and certain other providers) for efforts to adopt, implement, upgrade, or meaningful use of certified EHR technology.

CMS has established the final rule which requires eligible providers in their first year of participation in the Medicaid incentive payment program to demonstrate that they have adopted (acquired, purchased, or secured access to), or implemented, or upgraded to certified EHR technology in order to qualify for an incentive payment. During the second and subsequent years of the program, eligible providers are required to meet other criteria, including meaningful use, to receive additional funds. We have been awarded a total amount of $13.6 million under the Medicaid EHR incentive program, which will be earned and received over a four year period. We adopted certified EHR technology and we recognized other income of $6.8 million relative to the first year under the Medicaid EHR incentive program during fiscal year 2012.

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LONG TERM LEASE COMMITMENT WITH VARIABLE INTEREST ENTITY - On April 13, 2010, we and PCHI entered into a Second Amendment to Amended and Restated Triple Net Hospital Building Lease (the "2010 Lease Amendment"). Under the 2010 Lease Amendment, the annual base rent to be paid by us to PCHI was increased from $5.4 million to $7.3 million. The base rent is subject to an annual Consumer Price Index increase on January 1 of each year; such increase shall not be less than 2% or more than 6% per year. The annual base rent is currently $7.8 million. If PCHI refinances the $47.277 million term loan, the annual base rent will increase to $8.3 million. This lease commitment with PCHI is eliminated in consolidation.

COMMITMENTS AND CONTINGENCIES - The State of California has imposed hospital seismic safety requirements. Under these requirements, the Hospitals must meet stringent seismic safety criteria in the future. In addition, there could be other remediation costs pursuant to this seismic retrofit.

The State of California has a seismic review methodology known as HAZUS. The HAZUS methodology may preclude the need for some structural modifications. All four Hospitals requested HAZUS review and received a favorable notice pertaining to structural reclassification. All Hospital buildings, with the exception of one (an administrative building), have been deemed compliant until January 1, 2030 for both structural and nonstructural retrofit. We do not have an estimate of the cost to remediate the seismic requirements for the administrative building as of June 30, 2013.

There are additional requirements that must be complied with by 2030. The costs of meeting these requirements have not yet been determined. Compliance with seismic ordinances will be costly and could have a material adverse effect on our cash flow. In addition, remediation could possibly result in certain environmental liabilities, such as asbestos abatement.

On July 1, 2011, we entered into software and services agreements with McKesson Technologies Inc. ("McKesson") to upgrade our information technology systems.

Under the agreements, McKesson will provide us with a variety of services, including new software implementation and education/training services for our personnel, software maintenance services and professional services related to movement and migration of data from legacy systems. McKesson will also furnish to us and maintain new hardware to accommodate the upgraded software and systems. The new hardware will include computers and servers, among other things, and will include installation, testing, and ongoing maintenance. We have entered into the arrangement to enhance our clinical information systems and upgrade our billing and revenue management information systems.

The agreements will initially run for a period of five years, and the recurring services may be renewed by us for successive periods. The agreements do not provide that they may be terminated by us prior to the initial expiration date. The agreements provide for one-time fees and recurring fees which aggregate a total of $22.0 million. Approximately 60% of the fees are for one-time charges, while the balance is for recurring services. As of June 30, 2013 we completed conversion of all of our facilities to the McKesson system. We are also continuing to test and develop system applications where necessary.

CASH FLOW - Net cash provided by (used in) operating activities for the three months ended June 30, 2013 and 2012 was $55.2 million and $(1.8) million, respectively. Net income (loss), adjusted for depreciation and other non-cash items, excluding the provision for bad debts and net income (loss) from non-controlling interests (not a measurement under accounting principles generally accepted in the United States of America ("GAAP"), totaled $61.4 million and $(2.9) million for the three months ended June 30, 2013 and 2012, respectively. We provided $0.8 million and $1.4 million in working capital for the three months ended June 30, 2013 and 2012, respectively. Net cash used in payment of accounts payable, accrued compensation and benefits and other current liabilities was $3.0 million and $3.5 million for the three months ended June 30, 2013 and 2012, respectively. Cash provided by accounts receivable, net of provision for bad debts, was $0.9 million and $1.0 million for the three months ended June 30, 2013 and 2012, respectively.

Net cash used in investing activities during the three months ended June 30, 2013 and 2012 was $0.3 million and $0.6 million, respectively. In the three months ended June 30, 2013 and 2012, we invested $0.3 million and $0.6 million in cash, respectively, in new property and equipment.

Net cash used in financing activities for the three months ended June 30, 2013 and 2012 was $20.1 million and $0.5 million, respectively. The increase in net cash used in financing activities for the three months ended June 30, 2013 was primarily related to a paydown on our revolving line of credit of $19.2 million.

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RESULTS OF OPERATIONS AND FINANCIAL CONDITION

The following table sets forth, for the three months ended June 30, 2013 and 2012 our unaudited condensed consolidated statements of operations expressed as a percentage of net patient service revenues.

                                                                 Three months ended June 30,                                                                2013                 2012  Revenues                                                          100.0 %              100.0 %  Operating expenses: Salaries and benefits                                              25.0 %               64.9 % Supplies                                                            6.2 %               17.2 % Other operating expenses                                           22.9 %               18.4 % Depreciation and amortization                                       1.0 %                1.2 %                                                                    55.1 %              101.7 %  Operating income (loss)                                            44.9 %               (1.7 )%  Other expense: Interest expense, net                                              (1.2 )%              (3.0 )% Income (loss) on warrants                                          (3.0 )%               0.9 %                                                                    (4.2 )%              (2.1 )%  Income (loss) before income tax provision                          40.7 %               (3.8 )% Income tax provision                                               20.3 %                0.1 % Net income (loss)                                                  20.4 %               (3.9 )% Net income attributable to noncontrolling interests                (0.1 )%              (0.4 )% Net income (loss) attributable to Integrated Healthcare Holdings, Inc.                                                     20.3 %               (4.3 )%      

THREE MONTHS ENDED JUNE 30, 2013 COMPARED TO THREE MONTHS ENDED JUNE 30, 2012

NET PATIENT SERVICE REVENUES - Net patient service revenues (patient service revenues, net of contractual allowances and discounts, less provision for doubtful accounts) for the three months ended June 30, 2013 and 2012 were $223.2 million and $80.8 million, respectively, representing an increase of $142.4 million, or 176.2%. The increase in net patient service revenues was primarily related to QAF revenues. If the QAF payments noted above are excluded, net patient service revenues for the three months ended June 30, 2013 were $0.1 million, or 0.2%, higher than the comparable period in fiscal year 2013. For the three months ended June 30, 2013, we recorded $142.2 million in QAF payments compared to $0 during the three months ended June 30, 2012. The provision for bad debts for the three months ended June 30, 2013 was $14.4 million compared to $9.9 million for the three months ended June 30, 2012, representing a 45.5% increase. The primary reason for the increase in the provision for bad debts was a $7.2 million (39.0%) increase in gross charges related to uninsured patients for the three months ended June 30, 2013 compared to the same period in fiscal 2013. Uninsured patients, as a percentage of gross charges, increased to 7.6% from 5.4% for the three months ended June 30, 2013 compared to the three months ended June 30, 2012.

Admissions for the three months ended June 30, 2013 decreased 7.8% compared to fiscal year 2013. The decline in admissions is the combined result of lower obstetrical deliveries and psychiatric admissions. Net patient service revenues per admission increased 200.6% during the three months ended June 30, 2013. This increase was primarily due to the QAF revenues. Excluding QAF revenues, the increase in net patient service revenues per admission increased 9.1% during the three months ended June 30, 2013 compared to fiscal year 2013.

Substantially all patient service revenues come from external customers. The largest payers are Medicare and Medicaid (including Medicare and Medicaid managed care plans), which combined accounted for 79% and 54% of patient service revenues for the three months ended June 30, 2013 and 2012, respectively.

The Hospitals serve a disproportionate number of indigent patients and receive governmental revenues and subsidies in support of care for these patients. Governmental revenues include payments from Medicaid, Medicaid DSH, and Orange County, CA (CalOptima). Governmental revenues (net of contractual allowances and discounts), including QAF funds, increased $141.7 million for the three months ended June 30, 2013 compared to the three months ended June 30, 2012.

Other operating revenues of $808 and $845 for the three months ended June 30, 2013 and 2012, respectively, consist primarily of rental income and cafeteria sales.

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OPERATING EXPENSES - Operating expenses for the three months ended June 30, 2013 increased to $123.4 million from $83.0 million, an increase of $40.4 million, or 48.7%, compared to fiscal year 2013. Operating expenses expressed as a percentage of revenues for the three months ended June 30, 2013 and 2012 were 54.8% and 101.7%, respectively. On a per admission basis, operating expenses increased 61.7%. The increase is primarily related to QAF expenses of $33.5 million incurred during the three months ended June 30, 2013 compared to $0 in fiscal year 2013. Also, for the three months ended June 30, 2013, depreciation and amortization relating to the conversion of all of our facilities to the McKesson computer system was $1.3 million compared to $0 in fiscal year 2013 (see "ELECTRONIC HEALTH RECORDS INCENTIVE PROGRAM" and "COMMITMENTS AND CONTINGENCIES").

Salaries and benefits increased $3.1 million (5.9%) for the three months ended June 30, 2013 compared to fiscal year 2013, the increase is primarily related to increased labor needs during the conversion of all of our facilities to the McKesson computer system (see "ELECTRONIC HEALTH RECORDS INCENTIVE PROGRAM" and "COMMITMENTS AND CONTINGENCIES").

Supplies for the three months ended June 30, 2013 were comparable to the amounts incurred in fiscal 2013.

Other operating expenses during the three months ended June 30, 2013 increased to $51.2 million from $15.0 million, an increase of $36.2 million, or 241.3%, compared to fiscal year 2013. The increase is primarily related to QAF expenses of $33.5 million incurred during the three months ended June 30, 2013 compared to $0 during the three months ended June 30, 2012.

OPERATING INCOME (LOSS) - The operating income (loss) for the three months ended June 30, 2013 and 2012 was $100.6 million and $(1.4) million, respectively.

OTHER INCOME (EXPENSE) - Interest expense for the three months ended June 30, 2013 was $2.8 million compared to $2.4 million for fiscal year 2013. The increase primarily related to higher outstanding debt during the three months ended June 30, 2013 prior to the paydown of $19.2 million on our revolving line of credit in late June 2013.

As of June 30, 2013, the aggregate fair value of the IHHI Warrants was $11.9 million. A gain (loss) relating to the change in fair value of the outstanding warrants of $(6.6) million and $731 was recorded during the three months ended June 30, 2013 and 2012, respectively. See "WARRANTS."

NET INCOME (LOSS) - Net income (loss) for the three months ended June 30, 2013 and 2012 was $45.4 million and $(3.5) million, respectively.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

PATIENT SERVICE REVENUES - Patient service revenues are recognized in the period in which services are performed and are recorded based on established billing rates (gross charges) less contractual allowances and discounts, principally for patients covered by Medicare, Medicaid, managed care, and other health plans. Gross charges are retail charges. They are not the same as actual pricing, and they generally do not reflect what a hospital is ultimately paid and therefore are not displayed in the consolidated statements of operations. Hospitals are typically paid amounts that are negotiated with insurance companies or are set by the government. Gross charges are used to calculate Medicare outlier payments and to determine certain elements of payment under managed care contracts (such as stop-loss payments). Since Medicare requires that a hospital's gross charges be the same for all patients (regardless of payer category), gross charges are also what the Hospitals charge all other patients prior to the application of discounts and allowances.

Revenues under the traditional fee-for-service Medicare and Medicaid programs are based primarily on prospective payment systems. Discounts for retrospectively cost based revenues and certain other payments, which are based on the Hospitals' cost reports, are estimated using historical trends and current factors. Cost report settlements for retrospectively cost-based revenues under these programs are subject to audit and administrative and judicial review, which can take several years until final settlement of such matters are determined and completely resolved. Estimates of settlement receivables or payables related to a specific year are updated periodically and at year end and at the time the cost report is filed with the fiscal intermediary. Typically no further updates are made to the estimates until the final Notice of Program Reimbursement is received, at which time the cost report for that year has been audited by the fiscal intermediary. There could be a time lag of several years between the submission of a cost report and receipt of the Final Notice of Program Reimbursement. Since the laws, regulations, instructions and rule interpretations governing Medicare and Medicaid reimbursement are complex and change frequently, the estimates recorded by the Hospitals could change by material amounts. We established settlement payables of $463 and $179 as of June 30 and March 31, 2013, respectively.

The Hospitals receive supplemental payments from the State of California to support indigent care (Medi-Cal Disproportionate Share Hospital payments or "DSH") and from the California Medical Assistance Commission ("CMAC") under the SB 1100 and SB 1255 programs. The Hospitals received supplemental payments of $5.6 million and $4.7 million during the three months ended June 30, 2013 and 2012, respectively. The related revenue recorded for the three months ended June 30, 2013 and 2012, was $3.3 million and $1.8 million, respectively. As of June 30 and March 31, 2013, estimated DSH receivables were $3.6 million and $5.9 million, respectively.

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Revenues under managed care plans, including Medicare and Medicaid managed care plans (with patient service revenues of $19.8 million and $23.6 million for the three months ended June 30, 2013 and 2012, respectively), are based primarily on payment terms involving predetermined rates per diagnosis, per-diem rates, discounted fee-for-service rates and/or other similar contractual arrangements. These revenues are also subject to review and possible audit by the payers. The payers are billed for patient services on an individual patient basis. An individual patient's bill is subject to adjustment on a patient-by-patient basis in the ordinary course of business by the payers following their review and adjudication of each particular bill. The Hospitals estimate the discounts for contractual allowances utilizing billing data on an individual patient basis. Management believes the estimation and review process allows for timely identification of instances where such estimates need to be revised. We do not believe there were any adjustments to estimates of individual patient bills that were material to patient service revenues.

The Hospitals provide charity care to patients whose income level is below 300% of the Federal Poverty Level. Patients with income levels between 300% and 350% of the Federal Poverty Level qualify to pay a discounted rate under AB 774 based on various government program reimbursement levels. Patients without insurance are offered assistance in applying for Medicaid and other programs they may be eligible for, such as state disability, Victims of Crime, or county indigent programs. Patient advocates from the Hospitals' Medical Eligibility Program ("MEP") screen patients in the hospital and determine potential linkage to financial assistance programs. They also expedite the process of applying for these government programs. The estimated costs of charity care (based on direct and indirect costs as a ratio of gross uncompensated charges associated with providing care to charity patients) for the three months ended June 30, 2013 and 2012 were approximately $2.3 million and $2.1 million, respectively.

We are not aware of any material claims, disputes, or unsettled matters with any payers that would affect revenues that have not been adequately provided for in the accompanying unaudited condensed consolidated financial statements.

PROVISION FOR BAD DEBTS - We provide for accounts receivable that could become uncollectible by establishing an allowance to reduce the carrying value of such receivables to their estimated net realizable value. The Hospitals estimate this allowance based on the aging of their accounts receivable, historical collections experience for each type of payer and other relevant factors. There are various factors that can impact the collection trends, such as changes in the economy, which in turn have an impact on unemployment rates and the number of uninsured and underinsured patients, volume of patients through the emergency department, the increased burden of copayments to be made by patients with insurance and business practices related to collection efforts. These factors continuously change and can have an impact on collection trends and the estimation process.

Our policy is to attempt to collect amounts due from patients, including copayments and deductibles due from patients with insurance, at the time of service while complying with all federal and state laws and regulations, including, but not limited to, the Emergency Medical Treatment and Labor Act ("EMTALA"). Generally, as required by EMTALA, patients may not be denied emergency treatment due to inability to pay. Therefore, until the legally required medical screening examination is complete and stabilization of the patient has begun, services are performed prior to the verification of the patient's insurance, if any. In nonemergency circumstances or for elective procedures and services, it is the Hospitals' policy, when appropriate, to verify insurance prior to a patient being treated.

INCOME TAXES - Deferred income tax assets and liabilities are determined based on the differences between the book and tax basis of assets and liabilities and are measured using the currently enacted tax rates and laws using the asset and liability method. We assess the realization of deferred tax assets to determine whether an income tax valuation allowance is required. We have recorded a 100% valuation allowance on our net deferred tax since they did not meet the more-likely-than-not threshold.

There is a recognition threshold and measurement attribute for recognition and measurement of a tax position taken or expected to be taken in a tax return. It also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.

We and our subsidiaries file income tax returns in the U.S. federal jurisdiction and California. Certain tax attributes carried over from prior years continue to be subject to adjustment by taxing authorities. Any penalties or interest arising from federal or state taxes are recorded as a component of our income tax provision.

INSURANCE - We accrue for estimated general and professional liability claims, to the extent not covered by insurance, when they are probable and reasonably estimable. We have purchased as primary coverage a claims-made form insurance policy for general and professional liability risks. Estimated losses within general and professional liability retentions from claims incurred and reported, along with incurred but not reported ("IBNR") claims, are accrued based upon projections and are discounted to their net present value using an interest rate of 5.0%. To the extent that subsequent claims information varies from estimates, the liability is adjusted in the period such information becomes available. As of June 30 and March 31, 2013, we had accrued $11.5 million and $10.6 million, respectively, which is comprised of $5.8 million and $5.5 million, respectively, in incurred and reported claims, along with $5.7 million and $5.1 million, respectively, in estimated IBNR. Estimated insurance recoveries were $2.3 million and $2.1 million as of June 30 and March 31, 2013, respectively.

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We have purchased statutory coverage insurance to fund our obligations under our workers compensation program. We have a large deductible rating plan program. The workers compensation program is a prefunded program, subject to a $250 deductible, per occurrence/loss limit. The prefunded program is subject to an annual adjustment until all losses are closed. We accrue for estimated workers compensation claims, to the extent not covered by insurance, when they are probable and reasonably estimable. The ultimate costs related to this program include expenses for deductible amounts associated with claims incurred and reported in addition to an accrual for the estimated expenses incurred in connection with IBNR claims. Claims are accrued based upon projections and are discounted to their net present value using an interest rate of 5.0%. To the extent that subsequent claims information varies from estimates, the liability is adjusted in the period such information becomes available. As of June 30 and March 31, 2013, we had accrued $470 and $500, respectively, comprised of $195 and $200, respectively, in incurred and reported claims, along with $275 and $300, respectively, in estimated IBNR.

In addition, we have a self-insured health benefits plan for our employees. As a result, we have established and maintained an accrual for IBNR claims arising from self-insured health benefits provided to employees. Our IBNR accruals at June 30 and March 31, 2013 were based upon projections. We determine the adequacy of this accrual by evaluating our limited historical experience and trends related to both health insurance claims and payments, information provided by our insurance broker and third party administrator, and industry experience and trends. The accrual is an estimate and is subject to change. Such change could be material to our unaudited condensed consolidated financial statements. As of June 30 and March 31, 2013, the we had accrued $1.9 million and $1.9 million, respectively, in estimated IBNR.

We have also purchased excess liability policies with aggregate limits of $25 million. The excess liability policies provide coverage in excess of the primary layer and applicable retentions for insured liability risks such as general and professional liability, auto liability, and workers compensation (employers liability).

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