UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

þ		ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2007

or

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES ACT OF 1934

For the transition period from                      to                      .

Commission file number 1-12996

Registrant’s telephone number, including area code: (615) 771-7575

Securities registered pursuant to Section 12(b) of the Act:

Title of each class		Name of each Exchange on which registered
Common Stock, $0.01 par value per share		The NASDAQ Capital Market

Securities registered pursuant to Section 12(g) of the Act:

None.

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes o No þ .

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes o No þ .

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o		Accelerated filer þ		Non-accelerated filer o		Smaller reporting company o
				(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No þ .

The aggregate market value of Common Stock held by non-affiliates on June 29, 2007 (based on the closing price of such shares on the NASDAQ Capital Market) was approximately $58,119,000. For purposes of the foregoing calculation only, all directors, named executive officers and persons known to the Registrant to be holders of 5% or more of the Registrant’s Common Stock have been deemed affiliates of the Registrant.

On March 3, 2008, 5,750,787 shares of the registrant’s $0.01 par value Common Stock were outstanding.

Documents Incorporated by Reference:

The following documents are incorporated by reference into Part III, Items 10, 11, 12, 13 and 14 of this Form 10-K: The Registrant’s definitive proxy materials for its 2008 annual meeting of shareholders.

 

 

TABLE OF CONTENTS

Key elements of our growth strategy are to:

Increase revenues and profitability at existing facilities. Our strategy includes increasing center revenues and profitability levels through increasing occupancy levels, improving quality payor mix, obtaining appropriate reimbursement and containing costs while continuing to provide high quality care. In addition to our facility renovation program, ongoing initiatives to promote higher occupancy levels and improved payor and case mixes at our nursing centers include programs to improve customer service, new contracts for insurance and other services, and units for specialized care services developed at certain centers.

Improve physical plants . Our nursing centers have an average age of approximately 31 years as of December 31, 2007. After a strategic review, management determined that renovating certain facilities offered the opportunity to improve occupancy, quality of care and profitability. Management developed a plan to identify those facilities with the greatest potential for benefit, and began the renovation program during 2005. We have completed major renovations at seven facilities and have renovations in progress at three facilities as of December 31, 2007. We completed one additional renovation in the first quarter of 2008 and plan to complete the remaining two renovations that are currently in progress by the third quarter of 2008. Major renovations result in significant cosmetic upgrades, including new flooring, wall coverings, lighting, ceilings and furniture throughout the facility. Renovations also usually include certain external work to improve curb appeal, such as concrete work, landscaping, roof and signage enhancements.

Development of additional specialty services . Our strategy includes the development of additional specialty units and programming in facilities that could benefit from these services. The specialty programming will vary depending on the needs of the specific marketplace, and may include Life Steps and Lighthouse Units and other specialty programming. These services allow our facilities to improve census and payor mix. A center specific assessment of the market is conducted related to specialty programming to determine if unmet needs exist as a predictor of the success of particular niche offerings.

Acquisition, leasing and development of new homes . We continue to pursue and investigate opportunities to acquire, lease or develop new facilities, focusing primarily on opportunities within our existing areas of operation. We have entered into an option agreement to purchase certain assets of a skilled nursing facility in West Virginia. We made an application to state regulatory authorities to allow us to operate the facility, and this application was approved in February 2008, subject to rights of appeal by contesting parties. Once final appeals, if any, are resolved, we intend to arrange financing and construct a new 90 bed replacement facility.

Nursing Centers and Services.

Advocat provides a broad range of long-term care services to the elderly including skilled nursing, ancillary health care services and assisted living. In addition to the nursing and social services usually provided in long-term care centers, we offer a variety of rehabilitative, nutritional, respiratory, and other specialized ancillary services. As of December 31, 2007, our continuing operations include 50 nursing centers containing 5,773 licensed nursing beds and 66 assisted living units.

Our nursing centers range in size from 48 to 320 licensed nursing beds. The following table summarizes certain information with respect to the nursing centers we own or lease as of December 31, 2007:

Our nursing centers provide skilled nursing health care services, including room and board, nutrition services, recreational therapy, social services and housekeeping and laundry services. Our nursing centers dispense medications prescribed by the patients’ physicians, and a plan of care is developed by professional nursing staff for each resident. We also provide for the delivery of ancillary medical services at the nursing centers we operate. These specialty services include rehabilitation therapy services, such as audiology, speech, occupational and physical therapies, which are provided through licensed therapists and registered nurses, and the provision of medical supplies, nutritional support, infusion therapies and related clinical services. The significant majority of these services are provided using our internal resources and clinicians.

Within the framework of a nursing center, we may provide other specialty care, including:

Life Steps Unit. Twelve of our nursing centers have units designated as Life Steps Units, our designation for patients requiring short term rehabilitation following an incident such as a stroke or bone fracture. These units specialize in short term rehabilitation with the goal of returning the patient to their previous level of functionality. These units provide enhanced services with emphasis on upgraded amenities including electric beds, televisions, phones at bedside and feature a separate entrance for guests and visitors. The design and programming on the unit appeals to the generally younger resident who intends to return home following intensive rehabilitation. Specialized therapeutic treatment regimens include orthopedic rehabilitation, neurological rehabilitation and complex medical rehabilitation. While these patients generally have a shorter length of stay, the intensive level of rehabilitation generally results in higher levels of reimbursement.

Lighthouse Unit. Seventeen of our nursing centers have Lighthouse Units, our designation for advanced care for dementia related disorders including Alzheimer’s disease. The goal of the units is to provide a safe, homelike and supportive environment for cognitively impaired patients, utilizing an interdisciplinary team approach. Family and community involvement compliment structured programming in the secure environment instrumental in fostering as much resident independence as possible despite diminished capacity.

Assisted Living Units. Four of our nursing centers have units designated for assisted living patients, ranging in size from 2 to 35 units. These units may be a subset of the facility or a separate freestanding building on the nursing center campus. Services and accommodations include central dining facilities, recreational areas, social programs, housekeeping, laundry and maintenance service, emergency call systems, special features for handicapped persons and transportation to shopping and special events. Generally, basic care and support services can be offered more economically in an assisted living facility than either in a nursing home or through home health care assistance.

Other Specialty Programming. We implement other specialty programming based on a center’s specific needs. We have developed one adult day care center on the campus of a nursing center. We have developed specialty programming for bariatric patients (generally, patients weighing more than 350 pounds). These individuals have unique psychosocial and equipment needs.

We have complimented our traditional therapy services with programs that provide electrotherapy, ultrasound and shortwave diathermy therapy treatments that promote pain management, wound healing, continence improvement and contractures management, improving results of therapy treatments for our patients. We currently offer these treatment programs in 21 of our facilities.

Continuous Quality Improvement . We have in place a Continuous Quality Improvement (“CQI”) program, which is focused on identifying opportunities for improvement of all aspects of the care provided in a center, as well as overseeing the initiation and effectiveness of interventions. The CQI program was designed to meet accreditation standards and to exceed state and federal government regulations. We conduct monthly audits to monitor adherence to the standards of care established by the CQI program at each center which we operate. The facility administrator, with assistance from regional nursing personnel, is primarily responsible for adherence to our quality improvement standards. In that regard, the annual operational objectives established by each facility administrator include specific objectives with respect to quality of care. Performance of these objectives is evaluated quarterly by the regional vice president or manager, and each facility administrator’s incentive compensation is based, in part, on the achievement of the specified quality objectives. A major component of our CQI program is employee empowerment initiatives, with particular emphasis placed on selection, recruitment, retention and recognition programs. Our administrators and managers include employee retention and turnover goals in the annual facility, regional and personal objectives. We also have established a quality improvement committee consisting of nursing representatives from each region. This committee periodically reviews our quality improvement programs and conducts facility audits.

Organization . Our long-term care facilities are currently organized into six regions, each of which is supervised by a regional vice president. The regional vice president is generally supported by specialists in several functions, including nursing, human resources, marketing, receivable management and clerical, all of whom are employed by us. The day-to-day operations of each owned or leased nursing center are supervised by an on-site, licensed administrator. The administrator of each nursing center is supported by other professional personnel, including a medical director, who assists in the medical management of the facility, and a director of nursing, who supervises a staff of registered nurses, licensed practical nurses and nurses aides. Other personnel include therapy, dietary, activities and social service, housekeeping, laundry and maintenance, and a business office staff. All personnel at the leased or owned facilities, including the administrators, are our employees.

Marketing.

At a local level, our sales and marketing efforts are designed to promote higher occupancy levels and optimal payor mix. We believe that the long-term care profession is fundamentally a local business in which both patients and residents and the referral sources for them are based in the immediate geographic area in which the facility is located. Our marketing plan and related support activities emphasize the role and performance of administrators, admissions coordinators and social services directors of each nursing center, all of whom are responsible for contacting various referral sources such as doctors, hospitals, hospital discharge planners, churches and various community organizations.

Administrators are evaluated based on their ability to meet specific goals and performance standards that are tied to compensation incentives. Our regional managers and marketing coordinators assist local marketing personnel and administrators in establishing relationships and follow-up procedures with such referral sources.

In addition to soliciting admissions from these sources, we emphasize involvement in community affairs in order to promote a public awareness of our nursing centers and services. We have ongoing family councils and community based “family night” functions where organizations come to the facility to educate the public on various topics such as Medicare benefits, powers of attorney, and other matters of interest. We also promote effective customer relations and seek feedback through family surveys. We typically host “open house” events once we complete a major renovation of a facility where people in the community are invited to visit and see the improvements. In addition, we have regional marketing coordinators to support the overall marketing program in each local facility, in order to promote higher occupancy levels and improved payor and case mixes at our nursing centers.

We have an internally-developed marketing program that focuses on the identification and provision of services needed by the community. The program assists each facility administrator in analysis of local demographics and competition with a view toward complementary service development. We believe that the primary referral area in the long-term care industry generally lies within a five-to-fifteen-mile radius of each facility depending on population density; consequently, local marketing efforts are more beneficial than broad-based advertising techniques.

Acquisitions and New Lease.

2007 Acquisition . Effective August 11, 2007, we purchased the leasehold interests and operations of seven skilled nursing facilities from Senior Management Services of America North Texas, Inc. (“SMSA” or “SMSA Acquisition”) for a price of approximately $10.0 million, including approximately $8.6 million in cash, the assumption of approximately $0.9 million in liabilities, and transaction costs of $0.5 million. These facilities include 1,266 licensed nursing beds, with 1,105 beds currently available for use. The SMSA facilities had unaudited revenues of approximately $52.1 million for the year ended December 31, 2006. The SMSA facilities are in our existing geographic and operational footprint and are expected to contribute to our growth strategy and existing base of operations.

Texas Facility . Effective November 1, 2007, we entered into a short term single facility lease with Omega Healthcare Investors, Inc (“Omega”) for a 102 bed skilled nursing center in Texas, and we are evaluating the possibility of entering into an agreement with Omega for the construction of a replacement facility. It is anticipated that we would supervise construction, with funding provided by Omega. Upon completion of construction, we would lease the facility from Omega under a lease agreement with an initial term of five years, with renewal options through 2035.

Divestitures.

We have undertaken several divestitures through sale of assets and lease terminations. The divested operations have generally been poor performing properties. Effective March 31, 2007, we terminated operations at a leased facility in Arkansas. The owner of the facility sold the property and we cooperated in an orderly transition to the new owner. In May 2006, we completed the sale of certain assets of eleven assisted facilities located in North Carolina for a sales price of $11.0 million. Proceeds from this transaction were used

to pay transaction costs and repay debt. We closed one remaining North Carolina assisted living facility in April 2006, and are continuing our efforts to sell this property. In September 2007, we sold the bed license for the remaining North Carolina assisted living facility for a sales price of $183,000 and recognized a pretax gain on sale of discontinued operations of $45,000. We sold two nursing centers in Texas effective February 1, 2005.

In accordance with the Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” our consolidated financial statements have been reclassified to reflect these divestitures as discontinued operations.

Nursing Center Profession.

We believe there are a number of significant trends within the long-term care industry that will support the continued growth of the nursing home segment of the long-term care industry. These trends are also likely to impact our business. These factors include:

      Demographic trends. The primary market for our long-term health care services is comprised of persons aged 75 and older. This age group is one of the fastest growing segments of the United States population. As the number of persons aged 75 and over continues to grow, we believe that there will be corresponding increases in the number of persons who need skilled nursing.

      Cost containment pressures. In response to rapidly rising health care costs, governmental and other third-party payors have adopted cost-containment measures to reduce admissions and encourage reduced lengths of stays in hospitals and other acute care settings. The federal government had previously acted to curtail increases in health care costs under Medicare by limiting acute care hospital reimbursement for specific services to pre-established fixed amounts. Other third-party payors have begun to limit reimbursement for medical services in general to predetermined reasonable charges, and managed care organizations (such as health maintenance organizations) are attempting to limit hospitalization costs by negotiating for discounted rates for hospital and acute care services and by monitoring and reducing hospital use. In response, hospitals are discharging patients earlier and referring elderly patients, who may be too sick or frail to manage their lives without assistance, to nursing homes where the cost of providing care is typically lower than hospital care. In addition, third-party payors are increasingly becoming involved in determining the appropriate health care settings for their insureds or clients based primarily on cost and quality of care.

      Limited supply of centers. As the nation’s elderly population continues to grow, life expectancy continues to expand, and there continue to be limitations on granting Certificates of Need (“CON’s”) for new skilled nursing centers, so we believe that there will be continued demand for skilled nursing beds in the markets in which we operate. The majority of states have adopted CON or similar statutes requiring that prior to adding new skilled beds or any new services, or making certain capital expenditures, a state agency must determine that a need exists for the new beds or proposed activities. We believe that this CON process tends to restrict the supply and availability of licensed skilled nursing center beds. High construction costs, limitations on state and federal government reimbursement for the full costs of construction, and start-up expenses also act to restrict growth in the supply for such centers. At the same time, skilled nursing center operators are continuing to focus on improving occupancy and expanding services to include high acuity subacute patients, who require significantly higher levels of skilled nursing personnel and care.

      Reduced reliance on family care. Historically, the family has been the primary provider of care for seniors. We believe that the increase in the percentage of women in the work force, the reduction of average family size and the increased mobility in society will reduce the role of the family as the traditional care-giver for aging parents. We believe that this trend will make it necessary for many seniors to look outside the family for assistance as they age.

Competition.

The long-term care business is highly competitive. We face direct competition for additional centers, and our centers face competition for employees, patients and residents. Some of our present and potential competitors for acquisitions are significantly larger and have or may obtain greater financial and marketing resources. Competing companies may offer new or more modern centers or new or different services that may be more attractive to patients, residents or facility owners than some of the services we offer.

The nursing centers operated by us compete with other facilities in their respective markets, including rehabilitation hospitals, other “skilled” and personal care residential facilities. In the few urban markets in which we operate, some of the long-term care providers with which our facilities compete are significantly larger and have or may obtain greater financial and marketing resources than our facilities. Some of these providers are not-for-profit organizations with access to sources of funds not available to our centers. Construction of new long-term care facilities near our existing centers could adversely affect our business. We believe that the most important competitive factors in the long-term care business are: a facility’s local reputation with referral sources, such as acute care hospitals, physicians, religious groups, other community organizations, managed care organizations, and a patient’s family and friends; physical plant condition; the ability to identify and meet particular care needs in the community; the availability of qualified

personnel to provide the requisite care; and the rates charged for services. There is limited, if any, price competition with respect to Medicaid and Medicare patients, since revenues for services to such patients are strictly controlled and are based on fixed rates and cost reimbursement principles. Although the degree of success with which our centers compete varies from location to location, we believe that our centers generally compete effectively with respect to these factors.

Payor Sources.

We classify our revenues from patients and residents into three major categories: Medicaid, Medicare and private pay. In addition to traditional Medicaid revenues, we include within the Medicaid classification revenues from other programs established to provide benefits to those in need of financial assistance in the securing of medical services. Medicare revenues include revenues received under both Part A and Part B of the Medicare program. We classify payments from individuals who pay directly for services without government assistance as private pay revenue. The private pay classification also includes revenues from commercial insurers, HMOs, and other charge-based payment sources. Veterans Administration payments are included in private pay and are made pursuant to renewable contracts negotiated with these payors.

The following table sets forth net patient and resident revenues related to our continuing operations by payor source for the years presented:

The following table sets forth average daily census by payor source for our continuing operations for the years presented:

Consistent with the nursing home industry in general, changes in the mix of a facility’s patient population among Medicaid, Medicare, and private pay can significantly affect the profitability of the facility’s operations.

Reimbursement.

A significant portion of our revenues are derived from government-sponsored health insurance programs. Our nursing centers derive revenues under Medicaid, Medicare and private pay sources. We employ specialists in reimbursement at the corporate level to monitor regulatory developments, to comply with reporting requirements, and to ensure that proper payments are made to our operated nursing centers. It is generally recognized that all government-funded programs have been and will continue to be under cost containment pressures, but the extent to which these pressures will affect our future reimbursement is unknown.

Certain per person annual Medicare Part B reimbursement limits on therapy services became effective January 1, 2006. Subject to certain exceptions, the limits impose a $1,810 per patient annual ceiling on physical and speech therapy services, and a separate $1,810 per patient annual ceiling on occupational therapy services. The Centers for Medicare and Medicaid Services (“CMS”) established an exception process to permit therapy services in certain situations, and the majority of services provided by us are reimbursed under the exceptions. In December 2007, Congress passed the Medicare, Medicaid and SCHIP Extension Act of 2007, which includes an extension of the existing exceptions process through June 30, 2008. If the exception process is discontinued after June 2008, it is expected that the reimbursement limitations will reduce therapy revenues and negatively impact our operating results and cash flows.

In December 2006, Congress passed the Tax Relief and Health Care Act of 2006 (TRHCA). The TRHCA reduces the maximum federal matching under Medicare provider assessments to 5.5% of aggregate Medicaid outlays. This reduction in funding will become effective for fiscal years beginning after January 1, 2008. This change is not expected to have a material impact on our results of operations.

Congress has implemented an annual market basket adjustment designed to increase Medicare reimbursement for the effects of inflation. CMS issued a final rule which includes a 3.3% market basket adjustment increase effective October 1, 2007. The actual amount of the market basket adjustment is based on several factors and varies for each individual center. The market basket adjustment became effective October 1, 2007, and is estimated to have resulted in an average increase in revenue of approximately 4.0% for our facilities as a group, increasing our revenue by an estimated $0.3 million per month.

The Federal Deficit Reduction Act of 2005 mandates reducing by 30% the amount that Medicare reimburses nursing centers and other non-hospital providers for bad debts arising from uncollectible Medicare coinsurance and deductibles for those individuals that are not dually eligible for Medicare and Medicaid. This provision is not expected to have a material impact on the Company.

Reduction in health care spending has become a national priority in the United States, and the field of health care regulation and reimbursement is a rapidly evolving one. President Bush’s proposed 2009 budget includes a reduction in Medicare spending by $183 billion over five years, including a reduction of $17 billion to skilled nursing facilities. The proposed budget would freeze payments to nursing centers in 2009. We are unable to predict whether the President’s proposed budget will be adopted, what, if any, reform proposals or reimbursement limitations will be implemented in the future, or the effect such changes would have on our operations. For the year ended December 31, 2007, we derived 31.2% and 55.7% of our total patient and resident revenues related to continuing operations from the Medicare and Medicaid programs, respectively. Any health care reforms that significantly limit rates of reimbursement under these programs could, therefore, have a material adverse effect on our profitability.

We will attempt to increase revenues from non-governmental sources to the extent capital is available to do so, if at all. However, private payors, including managed care payors, are increasingly demanding that providers accept discounted fees or assume all or a portion of the financial risk for the delivery of health care services. Such measures may include capitated payments, which can result in significant losses to health care providers if patients require expensive treatment not adequately covered by the capitated rate.

Employees.

As of February 1, 2008, we employed a total of approximately 5,638 individuals in connection with our continuing operations. We believe that our employee relations are good. Approximately 143 of our employees are represented by a labor union.

Although we believe we are able to employ sufficient nurses and therapists to provide our services, a shortage of health care professional personnel in any of the geographic areas in which we operate could affect our ability to recruit and retain qualified employees and could increase our operating costs. We compete with other health care providers for both professional and non-professional employees and with non-health care providers for non-professional employees. This competition contributed to a significant increase in the salaries that we had to pay to hire and retain these employees.

Supplies and Equipment.

We purchase drugs, solutions and other materials and lease certain equipment required in connection with our business from many suppliers. We have not experienced, and do not anticipate that we will experience, any significant difficulty in purchasing supplies or leasing equipment from current suppliers. In the event that such suppliers are unable or fail to sell us supplies or lease equipment, we believe that other suppliers are available to adequately meet our needs at comparable prices. National purchasing contracts are in place for all major supplies, such as food, linens and medical supplies. These contracts assist in maintaining quality, consistency and efficient pricing.

Government Regulation.

The health care industry is subject to numerous laws and regulations of federal, state and local governments. These laws and regulations include, but are not necessarily limited to, matters such as licensure, accreditation, government health care program participation requirements, reimbursement for patient services, quality of resident care and Medicare and Medicaid fraud and abuse. Over the last several years, government activity has increased with respect to investigations and allegations concerning possible violations by health care providers of fraud and abuse statutes and regulations as well as laws and regulations governing quality of care issues in the skilled nursing profession in general. Violations of these laws and regulations could result in exclusion from government health care programs together with the imposition of significant fines and penalties, as well as significant repayments for patient services previously billed. Compliance with such laws and regulations is subject to ongoing government review and interpretation, as well as regulatory actions in which government agencies seek to impose fines and penalties. The Company is involved in regulatory actions of this type from time to time. Additionally, changes in these laws and regulations, such as reimbursement policies of Medicare and Medicaid programs as a result of budget cuts by federal and state governments or other legislative and regulatory actions, could have a material adverse effect on the industry and our consolidated financial position, results of operations, and cash flows.

Licensure and Certification. All our nursing centers must be licensed by the state in which they are located in order to accept patients, regardless of payor source. In most states, nursing homes are subject to certificate of need laws, which require us to obtain government approval for the construction of new nursing homes or the addition of new licensed beds to existing homes. Our nursing centers must comply with detailed statutory and regulatory requirements on an ongoing basis in order to qualify for licensure, as well as for certification as a provider eligible to receive payments from the Medicare and Medicaid programs. Generally, the requirements for licensure and Medicare/Medicaid certification are similar and relate to quality and adequacy of personnel, quality of medical care, record keeping, dietary services, resident rights, and the physical condition of the facility and the adequacy of the equipment used therein. Each facility is subject to periodic inspections, known as “surveys” by health care regulators, to determine compliance with all applicable licensure and certification standards. Such requirements are both subjective and subject to change. If the survey concludes that there are deficiencies in compliance, the facility is subject to various sanctions, including but not limited to monetary fines and penalties, suspension of new admissions, non-payment for new admissions and loss of licensure or certification. Generally, however, once a facility receives written notice of any compliance deficiencies, it may submit a written plan of correction and is given a reasonable opportunity to correct the deficiencies. There can be no assurance that, in the future, we will be able to maintain such licenses and certifications for our facilities or that we will not be required to expend significant sums in order to comply with regulatory requirements.

Medicare and Medicaid. Medicare is a federally-funded and administered health insurance program for the aged and for certain chronically disabled individuals. Part A of the Medicare program covers inpatient hospital services and certain services furnished by other institutional providers such as skilled nursing facilities. Part B covers the services of doctors, suppliers of medical items, various types of outpatient services and certain ancillary services of the type provided by long term and acute care facilities. Medicare payments under Part A and Part B are subject to certain caps and limitations, as provided in Medicare regulations. Medicare benefits are not available for intermediate and custodial levels of nursing home care or for assisted living facility arrangements.

Medicaid is a medical assistance program for the indigent, operated by individual states with financial participation by the federal government. Criteria for medical indigence and available Medicaid benefits and rates of payment vary somewhat from state to state, subject to certain federal requirements. Basic long-term care services are provided to Medicaid beneficiaries, including nursing, dietary, housekeeping and laundry, restorative health care services, room and board and medications. Previously, under legislation known as the Boren Amendment, federal law required that Medicaid programs pay to nursing home providers amounts adequate to enable them to meet government quality and safety standards. However, the Balanced Budget Act enacted during 1997 (the “BBA”) repealed the Boren Amendment, and the BBA requires only that a state Medicaid program must provide for a public process for determination of Medicaid rates of payment for nursing facility services. Under this process, proposed rates, the methodologies underlying the establishment of such rates and the justification for the proposed rates are published. This public process gives providers, beneficiaries and concerned state residents a reasonable opportunity for review and comment. Certain of the states in which we now operate are actively seeking ways to reduce Medicaid spending for nursing home care by such methods as capitated payments and substantial reductions in reimbursement rates.

HIPAA Compliance . The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) has mandated an extensive set of regulations to standardize electronic patient health, administrative and financial data transactions, and to protect the privacy of individually identifiable health information. We have a HIPAA Compliance Committee and designated privacy and security officers.

The HIPAA transaction standards are intended to simplify the electronic claims process and other healthcare transactions by encouraging electronic transmission rather than paper submission. These regulations provide for uniform standards for data reporting, formatting and coding that we must use in certain transactions with health plans. The HIPAA security regulations establish detailed requirements for safeguarding protected health information that is electronically transmitted or electronically stored. Some of the security regulations are technical in nature, while others are addressed through policies and procedures. We implemented or upgraded computer and information systems as we believed necessary to comply with the new regulations.

The HIPAA regulations related to privacy establish comprehensive federal standards relating to the use and disclosure of individually identifiable health information or protected health information. The privacy regulations establish limits on the use and disclosure of protected health information, provide for patients’ rights, including rights to access, to request amendment of, and to receive an accounting of certain disclosures of protected health information, and require certain safeguards for protected health information. In addition, each covered entity must contractually bind individuals and entities that furnish services to the covered entity or perform a function on its behalf, and to which the covered entity discloses protected health information, to restrictions on the use and disclosure of that information. In general, the privacy regulations do not supersede state laws that are more stringent or grant greater privacy rights to individuals. Thus, we must reconcile the privacy regulations and other state privacy laws.

Although we believe that we are in material compliance with these HIPAA regulations, the HIPAA regulations are expected to continue to impact us operationally and financially and may pose increased regulatory risk.

Self-Referral and Anti-Kickback Legislation. The health care industry is subject to state and federal laws which regulate the relationships of providers of health care services, physicians and other clinicians. These self-referral laws impose restrictions on physician referrals to any entity with which they have a financial relationship, which is a broadly defined term. We believe our relationships with physicians are in compliance with the self-referral laws. Failure to comply with self-referral laws could subject us to a range of sanctions, including civil monetary penalties and possible exclusion from government reimbursement programs. There are also federal and state laws making it illegal to offer anyone anything of value in return for referral of patients. These laws, generally known as “anti-kickback” laws, are broad and subject to interpretations that are highly fact dependent. Given the lack of clarity of these laws, there can be no absolute assurance that any health care provider, including us, will not be found in violation of the anti-kickback laws in any given factual situation. Strict sanctions, including fines and penalties, exclusion from the Medicare and Medicaid programs and criminal penalties, may be imposed for violation of the anti-kickback laws.

Available Information.

We file reports with the Securities and Exchange Commission (“SEC”), including annual reports on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K. Copies of our reports filed with the SEC may be obtained by the public at the SEC’s Public Reference Room by calling the SEC at 1-800-SEC-0330. We file such reports with the SEC electronically, and the SEC maintains an Internet site at www.sec.gov that contains our reports, proxy and information statements, and other information filed electronically. We also make available, free of charge through our website, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and other materials filed with the SEC as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC. Our website address is www.irinfo.com/AVC. The information provided on our website is not part of this report, and is therefore not incorporated by reference unless such information is otherwise specifically referenced elsewhere in this report.

change in the amount of this accrual will directly affect our reported earnings and financial position for the period in which the change in accrual is made. No assurance can be given that the accrual will decline during 2008, and it may increase during this period.

Our outstanding indebtedness is subject to floating rates of interest which could be subject to fluctuations based on changing interest rates and subject to various financial covenants.

We have $34.5 million of indebtedness at December 31, 2007, with $2.0 million classified as a current liability at December 31, 2007 based on payment terms. Our indebtedness consists of 100% floating rate debt, which is at variable rates of interest and exposes us to interest rate risk. Interest rate risk is the risk of loss arising from adverse changes in interest rates associated with variable rate borrowings. If interest rates increase, there is potential that our debt service obligations would increase even though the amount borrowed would decrease or remain the same. In addition, certain of our debt agreements contain various financial covenants, the most restrictive of which relate to cash flow, net income (loss), liquidity and limits on the payment of dividends to shareholders. As of December 31, 2007, we were in compliance with these financial covenants. Our failure to comply with those covenants could result in an event of default, which, if not cured or waived, could result in the acceleration of some or all of our debts. Such non-compliance could result in a material adverse impact to our financial position, results of operations and cash flows. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources.”

We are highly dependent on reimbursement by third-party payors.

Substantially all of our nursing center revenues are directly or indirectly dependent upon reimbursement from third-party payors, including the Medicare and Medicaid programs, and private insurers. For the year ended December 31, 2007, our patient revenues from continuing operations derived from Medicaid, Medicare and private pay (including private insurers) sources were approximately 55.7%, 31.2%, and 13.1%, respectively. Changes in the mix of our patients among Medicare, Medicaid and private pay categories and among different types of private pay sources may affect our net revenues and profitability. Our net revenues and profitability are also affected by the continuing efforts of all payors to contain or reduce the costs of health care. Efforts to impose reduced payments, greater discounts and more stringent cost controls by government and other payors are expected to continue.

The Federal Government makes frequent changes to the reimbursement provided under the Medicare program. These changes could reduce significantly the reimbursement we receive. Also, a number of state governments, including several of the states in which we operate, have announced projected budget shortfalls and/or deficit spending situations. In addition, the President’s proposed budget calls for a significant reduction in the amount of Federal funds provided to the state Medicaid systems. Possible actions by these states include reductions of Medicaid reimbursement to providers such as us or the failure to increase Medicaid reimbursements to cover increased operating costs.

Any changes in reimbursement levels or in the timing of payments under Medicare, Medicaid or private pay programs and any changes in applicable government regulations could have a material adverse effect on our net revenues, net income and cash flows. We are unable to predict what reform proposals or reimbursement limitations will be adopted in the future or the effect such changes will have on our operations. No assurance can be given that such reforms will not have a material adverse effect on us. See “Item 1. Business — Government Regulation and Reimbursement.”

We are subject to significant government regulation.

The health care industry is subject to numerous laws and regulations of federal, state and local governments. These laws and regulations include, but are not necessarily limited to, matters such as licensure, accreditation, government health care program participation requirements, reimbursement for patient services, quality of resident care and Medicare and Medicaid fraud and abuse. Various federal and state laws regulate relationships among providers of services, including employment or service contracts and investment relationships. The operation of long-term care centers and the provision of services are also subject to extensive federal, state, and local laws relating to, among other things, the adequacy of medical care, distribution of pharmaceuticals, equipment, personnel, operating policies, environmental compliance, compliance with the Americans with Disabilities Act, fire prevention and compliance with building codes.

Long-term care facilities are also subject to periodic inspection to assure continued compliance with various standards and licensing requirements under state law, as well as with Medicare and Medicaid conditions of participation. The failure to obtain or renew any required regulatory approvals or licenses could adversely affect our growth and could prevent us from offering our existing or additional services. In addition, health care is an area of extensive and frequent regulatory change. Changes in the laws or new interpretations of existing laws can have a significant effect on methods and costs of doing business and amounts of payments received from governmental and other payors. Our operations could be adversely affected by, among other things, regulatory developments such as mandatory increases in the scope and quality of care to be afforded patients and revisions in licensing and certification standards. We attempt at all times to comply with all applicable laws; however, there can be no assurance that new

legislation or administrative or judicial interpretation of existing laws or regulations will not have a material adverse effect on our operations or financial condition. Future federal budget legislation, federal or state regulatory actions seeking to impose fines and penalties, and federal and state regulatory changes may negatively impact us. See “Item 1. Business — Government Regulation.” See also “Item 3. Legal Proceedings.”

The health care industry has been the subject of increased regulatory scrutiny recently.

The Office of Inspector General (“OIG”), the enforcement arm of the Medicare program, formulates a formal work plan each year for nursing homes. The OIG’s most recent work plan indicates that access to care, quality of care, survey deficiencies, compliance with minimum data set reporting, resident assessment and care planning, accuracy of coding resource utilization groups (“RUGs”) and the medical necessity of services billed and consolidated billing will be an investigative focus in 2008. We cannot predict the likelihood, scope or outcome of any such investigations on our facilities.

We have significant deferred tax assets which we may not be able to realize.

We have net deferred tax assets of $18.7 million included in our balance sheet as of December 31, 2007. Our ability to realize these deferred tax assets depends on our future taxable income. We reported taxable income for 2005, and will report taxable income for 2007 when our return is filed. The sale of certain assets during 2006 resulted in a taxable loss. We expect future operations will continue to result in taxable income that will allow these deferred tax assets to be realized. No assurance can be given that we will be able to generate taxable income in future periods or realize these deferred tax assets.

We are subject to claims under the self-referral and anti-kickback legislation.

In the United States, various state and federal laws regulate the relationships between providers of health care services, physicians, and other clinicians. These self-referral laws impose restrictions on physician referrals for designated health services to entities with which they have financial relationships. These laws also prohibit the offering, payment, solicitation or receipt of any form of remuneration in return for the referral of Medicare or state health care program patients or patient care opportunities for the purchase, lease or order of any item or service that is covered by the Medicare and Medicaid programs. To the extent that we, any of our facilities with which we do business, or any of the owners or directors have a financial relationship with each other or with other health care entities providing services to long-term care patients, such relationships could be subject to increased scrutiny. There can be no assurance that our operations will not be subject to review, scrutiny, penalties or enforcement actions under these laws, or that these laws will not change in the future. Violations of these laws may result in substantial civil or criminal penalties for individuals or entities, including large civil monetary penalties and exclusion from participation in the Medicare or Medicaid programs. Such exclusion or penalties, if applied to us, could have a material adverse effect on our profitability.

We operate in an industry that is highly competitive .

The long-term care industry generally, and the nursing home business particularly, is highly competitive. We face direct competition for the acquisition of facilities. In turn, our facilities face competition for employees, patients and residents. Some of our present and potential competitors are significantly larger and have or may obtain greater financial and marketing resources than we can. Some hospitals that provide long-term care services are also a potential source of competition. In addition, we may encounter substantial competition from new market entrants. Consequently, there can be no assurance that we will not encounter increased competition in the future, which could limit our ability to attract patients or residents or expand our business, and could materially and adversely affect our business or decrease our market share.

We have a number of policies in place that could be considered anti-takeover protections .

We have adopted a Shareholder Rights Plan (the “Plan”). In March 2005, the Board of Directors amended the Plan to extend the expiration date of the Plan to March 20, 2010 and change the exercise price of the rights under the Plan to $15. The Plan is intended to encourage potential acquirers to negotiate with our Board of Directors and to discourage coercive, discriminatory and unfair proposals. Our Certificate of Incorporation (the “Certificate”) provides for the classification of our Board of Directors into three classes, with each class of directors serving staggered terms of three years. Our Certificate requires the approval of two-thirds of the outstanding shares to amend certain provisions of the Certificate. Section 203 of the Delaware General Corporate Law restricts the ability of a Delaware corporation to engage in any business combination with an interested shareholder. We are also authorized to issue up to 795,000 shares of preferred stock, the rights of which may be fixed by the Board of Directors without shareholder approval. Provisions in certain of our executive officers’ employment agreements provide for post-termination compensation, including payment of amounts up to 2.5 times their annual salary, following certain changes in control. Our stock incentive plans provide for the acceleration of the vesting of options in the event of certain changes in control (as defined in such plans). Certain

changes in control also constitute an event of default under our bank credit facility. The foregoing matters may, together or separately, have the effect of discouraging or making more difficult an acquisition or change of control of us.

If we are unable to successfully integrate the business operations of the SMSA facilities into our business operations, we will not realize the anticipated potential benefits from the acquisition and our business could be adversely affected.

The acquisition of the facilities from SMSA involves the integration of seven nursing homes that have previously been operated by a different management group. Successful integration of these acquired facilities with our other operations will depend on our ability to consolidate operations, systems and procedures, eliminate redundancies and reduce costs. If we are unable to do so, we will not realize the anticipated potential benefits of the acquisition and our business and results of operations would be adversely affected. Difficulties could include the loss of key employees, increased demands on our management, financial, technical and other resources, the disruption of our and the new facilities’ ongoing businesses, a decline in occupancy, unanticipated cost increases and possible inconsistencies in standards, controls, procedures and policies. The acquisition could result in the diversion of management’s attention from our ongoing operations. In addition, a number of factors beyond our control could prevent us from realizing any efficiencies and cost savings we expect.

improvements made to the respective facilities as the expenditures are made. The amendments also included provisions to amend certain professional liability insurance requirements in order to cure certain defaults under the Omega Master Lease.

The Omega Master Lease prohibits us from operating any additional facilities within a certain radius of each leased facility. We are generally required to maintain comprehensive insurance covering the facilities we lease as well as personal and real property damage insurance and professional liability insurance. The failure to pay rentals within a specified period or to comply with the required operating and financial covenants generally constitutes a default, which default, if uncured, permits Omega to terminate the lease and assume the property and the contents within the facilities.

Effective November 1, 2007, we entered into a short term single facility lease with Omega for a 102 bed skilled nursing center in Texas, and we are evaluating the possibility of entering into an agreement with Omega for the construction of a replacement facility. It is anticipated that we would supervise construction, with funding provided by Omega. Upon completion of construction, we would lease the facility from Omega under a lease agreement with an initial term of five years, with renewal options through 2035.

Florida Leases. Effective April 1, 2003, we entered into leases for four nursing centers in Florida that had previously been managed by us under management contracts. Accordingly, the results of operations of these facilities are included in our results of operations beginning April 1, 2003. Omega holds mortgages on these properties and we make the lease payments directly to Omega. The lease term extends through February 2010. Lease terms require future rent increases equal to the lesser of two times the consumer price index or 3.0% in subsequent years. We are also required to fund annual capital expenditures currently equal to $357 per licensed bed over the initial lease term, subject to adjustment for increases in the Consumer Price Index.

Other Leases. We lease approximately 25,000 square feet of office space in Brentwood, Tennessee, that houses our executive offices, centralized management support functions, and the ancillary services supply operations. In addition, we lease our regional office with approximately 4,000 square feet of office space in Ashland, Kentucky. Lease periods on these facilities generally range up to seven years. Regional executives for Alabama, Arkansas, Florida and Tennessee work from offices of up to 1,500 square feet each. We believe that our leased properties are adequate for our present needs and that suitable additional or replacement space will be available as required.

PART II

for the repurchase of up to $2.5 million of our common stock from time to time pursuant to a plan under 10b5-1 and in compliance with Rule 10b-18 of the Securities Exchange Act of 1934, as amended, through November 6, 2008.

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

Advocat Inc. provides long-term care services to nursing center patients in eight states, primarily in the Southeast and Southwest. Our centers provide a range of health care services to their patients and residents. In addition to the nursing, personal care and social services usually provided in long-term care centers, we offer a variety of comprehensive rehabilitation services as well as nutritional support services.

As of December 31, 2007, our continuing operations consist of 50 nursing centers with 5,773 licensed nursing beds and 66 assisted living units. As of December 31, 2007, our continuing operations included nine owned nursing centers and 41 leased nursing centers.

Acquisitions and New Lease . Effective August 11, 2007, we purchased the leasehold interests and operations of seven skilled nursing facilities from SMSA for a price of approximately $10.0 million. Effective November 1, 2007, we entered into an agreement to lease a facility from a subsidiary of Omega, and we are evaluating the possibility of entering into an agreement with Omega for the construction and lease of a replacement facility.

Divestitures. We have undertaken certain divestitures through sale of assets and lease terminations. The divested operations have generally been poor performing properties. Effective March 31, 2007, we terminated operations at a leased facility in Arkansas. The owner of the facility sold the property and we cooperated in an orderly transition to the new owner. In May 2006, we completed the sale of certain assets of eleven assisted living facilities located in North Carolina for a sales price of $11.0 million. We closed one remaining North Carolina assisted living facility in April 2006, and are continuing our efforts to sell this property. In September 2007, we sold the bed license for the remaining North Carolina assisted living facility for a sales price of $183,000 and recognized a pretax gain on sale of discontinued operations of $45,000. In February 2005, we sold two nursing centers in Texas.

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” our consolidated financial statements have been reclassified to reflect these divestitures as discontinued operations.

Basis of Financial Statements. Our patient revenues consist of the fees charged for the care of patients in the nursing centers we own and lease. Our operating expenses include the costs, other than lease, depreciation and amortization expenses, incurred in the operation of the nursing centers we owned and leased. Our general and administrative expenses consist of the costs of the corporate office and regional support functions. Our depreciation and interest expenses include all such expenses across the range of our operations.

Selected Financial and Operating Data

     The following table summarizes the Advocat statements of continuing operations for the years ended December 31, 2007, 2006 and 2005, and sets forth this data as a percentage of revenues for the same years.

The following table presents data about the facilities we operated as part of our continuing operations as of the dates or for the years indicated:

		December 31,
		2007				2006				2005
Licensed Nursing Home Beds:
Owned			942				942				942
Leased			4,831				3,463				3,463
Total			5,773				4,405				4.405
Assisted Living Units:
Owned			17				17				17
Leased			49				49				61
Total			66				66				78
Total Beds/Units:
Owned			959				959				959
Leased			4,880				3,512				3,524
Total			5,839				4,471				4,483
Facilities:
Owned			9				9				9
Leased			41				33				33
Total			50				42				42
Average Occupancy:
Nursing centers			77.6	% (1)			78.8	%			76.9	%
Assisted living units			63.1				60.0				64.6
Total			77.4	%			78.5	%			76.7	%

Critical Accounting Policies and Judgments

A “critical accounting policy” is one which is both important to the understanding of our financial condition and results of operations and requires management’s most difficult, subjective or complex judgments often of the need to make estimates about the effect of matters that are inherently uncertain. Actual results could differ from those estimates and cause our reported net income to vary significantly from period to period. Our accounting policies that fit this definition include the following:

Revenues

Patient Revenues

The fees we charge patients in our nursing centers are recorded on an accrual basis. These rates are contractually adjusted with respect to individuals receiving benefits under federal and state-funded programs and other third-party payors. Our net revenues are derived substantially from Medicare, Medicaid and other government programs (approximately 86.9%, 87.0% and 88.0% for 2007, 2006 and 2005, respectively). Medicare intermediaries make retroactive adjustments based on changes in allowed claims. In addition, certain of the states in which we operate require complicated detailed cost reports which are subject to review and adjustments. In the opinion of management, adequate provision has been made for adjustments that may result from such reviews. Retroactive adjustments, if any, are recorded when objectively determinable, generally within three years of the close of a reimbursement year depending upon the timing of appeals and third-party settlement reviews or audits.

Allowance for Doubtful Accounts

We evaluate the collectibility of our accounts receivable by reviewing current agings of accounts receivable, historical collections data and other factors. As a percentage of revenue, our provision for doubtful accounts was approximately 0.4%, 0.8% and 0.8% for 2007, 2006 and 2005, respectively. Historical bad debts have generally resulted from uncollectible private pay balances, some uncollectible coinsurance and deductibles and other factors. Receivables that are deemed to be uncollectible are written off.

Professional Liability and Other Self-Insurance Reserves

Accrual for Professional and General Liability Claims -

Because our actual liability for existing and anticipated professional liability and general liability claims will exceed our limited insurance coverage, we have recorded total liabilities for reported professional liability claims and estimates for incurred but unreported claims of $20.7 million as of December 31, 2007. This accrual includes estimates of liability for incurred but not reported claims, estimates of liability for reported but unresolved claims, actual liabilities related to settlements, including settlements to be paid over time, and estimates of related legal costs incurred and expected to be incurred. All losses are projected on an undiscounted basis.

We retain the Actuarial Division of Willis of Tennessee, Inc. (“Willis”), a third-party actuarial firm, to estimate the appropriate accrual for incurred general and professional liability claims. The actuary, Willis, primarily uses historical data regarding the frequency and cost of our past claims over a multi-year period and information regarding our number of occupied beds to develop its estimates of our ultimate professional liability cost for current periods. The actuary estimates our professional liability accrual for past periods by using currently-known information to adjust the initial reserve that was created for that period.

On a quarterly basis, we obtain reports of claims and lawsuits that we have incurred from insurers and a third party claims administrator. These reports contain information relevant to the liability actually incurred to date with that claim as well as the third-party administrator’s estimate of the anticipated total cost of the claim. This information is reviewed by us and provided to the actuary. The actuary uses this information to determine the timing of claims reporting and the development of reserves, and compares the information obtained to its original estimates of liability. Based on the actual claim information obtained and on estimates regarding the number and cost of additional claims anticipated in the future, the reserve estimate for a particular prior period may be revised upward or downward on a quarterly basis. Final determination of our actual liability for claims incurred in any given period is a process that takes years. The following summarizes our accrual for professional liability and other claims for each policy year as of the end of the period:

Although we retain a third-party actuarial firm to assist us, professional and general liability claims are inherently uncertain, and the liability associated with anticipated claims is very difficult to estimate. As a result, our actual liabilities may vary significantly from the accrual, and the amount of the accrual has and may continue to fluctuate by a material amount in any given quarter.

Professional liability costs are material to our financial position, and differences between estimates and the ultimate amount of loss may cause a material fluctuation in our reported results of operations. Our professional liability expense was negative $1.7 million, negative $5.4 million and negative $4.5 million, for the years ended December 31, 2007, 2006 and 2005 respectively, with negative amounts representing net benefits resulting from downward revisions in previous estimates. These amounts are material in relation to our reported net income from continuing operations for the related periods of $9.5 million, $22.4 million and $31.0 million, respectively. We believe that the primary reason that we experienced these net benefits during 2005 through 2007 is that we were able during the period to settle outstanding claims on more favorable terms than we have historically. These settlements impact our professional liability in two ways. They reduce the amount of anticipated liability that was recorded in prior periods, and they may result in a lower estimate of the anticipated liability expense for unreported claims in the current period. However, the fact that these settlements have reduced our professional liability expense does not guarantee that future claims will be resolved on favorable terms and we may incur professional liability expenses in the future significantly in excess of those currently recorded, which could have a material adverse impact on our financial position and cash flows. The total liability recorded at December 31, 2007, was $20.7 million, compared to current assets of $44.2 million and total assets of $110.1 million. A significant judgment entered against us in one or more of these legal actions could have a material adverse impact on our financial position and cash flows.

Accrual for Other Self-Insured Claim s-

From June 30, 2003 until June 30, 2007, we were party to workers’ compensation insurance programs that provide coverage for claims incurred, with premium adjustments on incurred losses. We account for premium expense under these policies based on our estimate of the level of claims expected to be incurred. Any adjustments of future premiums for workers’ compensation policies and differences between actual settlements and reserves for self-insured obligations are included in expense in the period finalized. As a result of having better than expected claims filed under these programs, at December 31, 2007, we have recorded estimated premium refunds due totaling approximately $1.2 million. Effective July 1, 2007, we entered into a guaranteed cost policy for workers’ compensation insurance, under which expense will be equal to the premiums paid. As a result, there will be no premium refunds associated with this new policy.

We are self-insured for health insurance benefits for certain employees and dependents for amounts up to $150,000 per individual annually under a self insurance plan. We provide reserves for the settlement of outstanding self-insured health claims at amounts believed to be adequate, based on known claims and estimates of unknown claims based on historical information. The liability for reported claims and estimates for incurred but unreported claims is $1.1 million and $0.9 million at December 31, 2007 and 2006, respectively. The differences between actual settlements and reserves are included in expense in the period finalized. Our reserves for health insurance benefits can fluctuate materially from one year to the next depending on the number of significant health issues of our covered employees and their dependants.

Asset Impairment

We evaluate our property and equipment on a quarterly basis to determine if facts and circumstances suggest that the assets may be impaired or that the estimated depreciable life of the asset may need to be changed such as significant physical changes in the property, significant adverse changes in general economic conditions, and significant deteriorations of the underlying cash flows of the property. The need to recognize an impairment is based on estimated future cash flows from a property compared to the carrying value of that property. If recognition of an impairment is necessary, it is measured as the amount by which the carrying amount of the property exceeds the fair value of the property. We did not record any asset impairments in 2006 and 2007. We recorded asset impairments totaling approximately $4.4 million on eleven assisted living facilities during 2005 which were included in discontinued operations. These facilities were sold in 2006. If our estimates or assumptions with respect to a property change in the future, we may be required to record additional impairment charges for our assets.

Business Combinations

We account for our acquisitions in accordance with SFAS No. 141, “Business Combinations” and related interpretations. The SMSA Acquisition in 2007 has been accounted for as a purchase business combination. Purchase accounting requires that we make certain valuations based on our experience, including determining the fair value and useful lives of assets acquired and the expected settlement amount of liabilities assumed based upon their respective fair values. These valuations are subject to change during the twelve month period subsequent to the acquisition date. Such valuations require us to make significant estimates, judgments and assumptions, including projections of future events and operating performance.

Stock-Based Compensation

We recognize compensation cost for all share-based payments granted after January 1, 2006 on a straight-line basis over the vesting period. We calculated the recognized and unrecognized stock-based compensation using the Black-Scholes-Merton option valuation method, which requires us to use certain key assumptions to develop the fair value estimates. These key assumptions include expected volatility, risk-free interest rate, expected dividends and expected term. During 2007 and 2006, we recorded charges of approximately $0.6 million and $5.2 million, respectively, in stock-based compensation. The 2006 charge related to vested stock option grants awarded in December 2005 that were approved by shareholders at our annual meeting on June 1, 2006. For several years prior to 2006, we did not have available stock to be granted under a shareholder approved plan. Similar to the 2007 charge, we anticipate that expenses related to future grants will be significantly smaller than in 2006 due to longer vesting schedules and smaller number of shares granted. Stock-based compensation expense is a non-cash expense and such amounts are included as a component of general and administrative expense or operating expense based upon the classification of cash compensation paid to the related employees.

Income Taxes

We determine deferred tax assets and liabilities based upon differences between financial reporting and tax bases of assets and liabilities and measure them using the enacted tax laws that will be in effect when the differences are expected to reverse. In 2006 and 2005, we recorded a deferred tax benefit to release approximately $14.6 million and $18.1 million, respectively, of the previously recorded valuation allowance on deferred tax assets. During 2005 we assessed the valuation allowance on deferred tax assets and concluded it was more likely than not that some of the Company’s net deferred tax assets will be realized due to our achieved earnings trend and outlook. During 2006 we again assessed the valuation allowance on deferred tax assets and concluded that it is more likely than not that a larger portion of our net deferred tax assets will be realized due to our achieved earnings trend and improved liquidity and financial position. We considered many factors including recent cumulative earnings experience by taxing jurisdiction, expectations of future taxable income, the carryforward periods available, and the comprehensive refinancing of debt in August 2006. Prior to the refinancing, we had net working capital deficits, short-term debt maturities and were in default under debt agreements. As a result of the continued improvement in financial results and the completion of the comprehensive refinancing, we believe that we have addressed the uncertainties surrounding our ability to realize the benefits of our deferred tax assets in future periods. We do not anticipate recording similar benefits in future years. We continue to maintain a valuation allowance of approximately $0.9 million to reduce the deferred tax assets by the amount we believe is more likely than not to not be utilized through the turnaround of existing temporary differences, future earnings, or a combination thereof. In future periods, we will continue to assess the need for and adequacy of the remaining valuation allowance. Effective January 1, 2007, the Company adopted FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – An Interpretation of FASB Statement No. 109” (“FIN 48” or “the interpretation”). This interpretation provides guidance on financial statement recognition and measurement of tax positions taken, or expected to be taken, in tax returns. The initial adoption of the interpretation had no impact on the Company’s financial statements.

Contractual Obligations and Commercial Commitments

We have certain contractual obligations of continuing operations as of December 31, 2007, summarized by the period in which payment is due, as follows (dollar amounts in thousands):

We have employment agreements with certain members of management that provide for the payment to these members of amounts up to 2.5 times their annual salary in the event of a termination without cause, a constructive discharge (as defined), or upon a change of control of the Company (as defined). The maximum contingent liability under these agreements is approximately $1.9 million as of December 31, 2007. The terms of such agreements are from one to three years and automatically renew for one year if not terminated by us or the employee. In addition, upon the occurrence of any triggering event, those certain members of management may elect to require that we purchase equity awards granted to them for a purchase price equal to the difference in the fair market value of our common stock at the date of termination versus the stated equity award exercise price. Based on the closing price of our stock on December 31, 2007, the maximum contingent liability for the repurchase of the equity grants is approximately $1.6 million. No amounts have been accrued for this contingent liability.

Payor Sources

We classify our revenues from patients and residents into three major categories: Medicaid, Medicare and private pay. In addition to traditional Medicaid revenues, we include within the Medicaid classification revenues from other programs established to provide benefits to those in need of financial assistance in the securing of medical services. Medicare revenues include revenues received under both Part A and Part B of the Medicare program. We classify payments from individuals who pay directly for services without government assistance as private pay revenue. The private pay classification also includes revenues from commercial insurers, HMOs, and other charge-based payment sources. Veterans Administration payments are included in private pay and are made pursuant to renewable contracts negotiated with these payors.

Medicare represented approximately 31.2%, 30.6%, and 30.0% of our net revenues during 2007, 2006, and 2005, respectively. Approximately 55.7%, 56.4%, and 58.0% of our net revenues were derived from Medicaid during 2007, 2006, and 2005, respectively. Private pay represented approximately 13.1%, 13.0% and 12.0% of our net revenues during 2007, 2006, and 2005, respectively.

Consistent with the nursing home industry in general, changes in the mix of a facility’s patient population among Medicaid, Medicare and private pay can significantly affect the profitability of the facility’s operations.

Results of Operations

As discussed in the overview at the start of Management’s Discussion and Analysis of Financial Condition and Results of Operations, we have completed certain divestitures as well as a recent acquisition. We have reclassified our consolidated financial statements to present the divestitures as discontinued operations for all periods presented. We have also defined our same center operations in light of these divestitures and acquisition. Same center information excludes the operations of the acquired facilities and all discontinued operations.

As a supplement to the tables above, the following table presents the unaudited statements of income from continuing operations before income taxes and related data for the twelve month period ended December 31, 2007 and 2006 on a same center basis, excluding the effects of the acquired facilities and discontinued operations.

Year Ended December 31, 2007 Compared With Year Ended December 31, 2006

As noted in the overview, during 2007 we completed the SMSA Acquisition and entered into a lease for an additional facility in Texas (together, the “New Texas Facilities”). All results for the New Texas Facilities are included from the effective date of acquisition or inception of lease.

In addition, we have entered into certain divestiture transactions in recent periods, and our consolidated financial statements have been reclassified to present such transactions as discontinued operations. Accordingly, the related revenue, expenses, assets, liabilities and cash flows have been reported separately, and the discussion below addresses principally the results of our continuing operations.

Patient Revenues . Patient revenues increased to $245.1 million in 2007 from $214.7 million in 2006, an increase of $30.4 million, or 14.2%. Revenues related to the New Texas Facilities were $19.6 million in 2007. Same center patient revenues increased to $225.5

million in 2007 from $214.7 million in 2006, an increase of $10.8 million, or 5.0%. This increase is primarily due to increased Medicaid rates in certain states and Medicare rate increases.

The following table summarizes key revenue and census statistics for continuing operations for the year and segregates effects of the New Texas Facilities:

On a same center basis, the Company’s average rate per day for Medicare Part A patients increased 8.4% in 2007 compared to 2006 as a result of annual inflation adjustments and the acuity levels of Medicare patients in our nursing centers, which were higher in 2007 than in 2006. Our average rate per day for Medicaid patients increased 4.7% in 2007 compared to 2006 as a result of increasing patient acuity levels, certain state increases to offset minimum wage adjustments, effects of stock based compensation charges and other rate increases in certain states.

Operating expense . Operating expense increased to $187.5 million in 2007 from $163.4 million in 2006, an increase of $24.1 million, or 14.7%. Operating expense related to the New Texas Facilities was $17.1 million in 2007. Same center operating expense increased to $170.4 million in 2007 from $163.4 million in 2006, an increase of $7.0 million, or 4.3%. This increase is primarily attributable to cost increases related to wages and benefits, partially offset by reductions in bad debt expenses and costs of workers’ compensation insurance. On a same center basis, operating expense decreased to 75.6% of revenue in 2007, compared to 76.1% of revenue in 2006.

The largest component of operating expenses is wages, which increased to $111.7 million in 2007 from $97.5 million in 2006, an increase of $14.2 million, or 14.6%. Wages related to the New Texas Facilities were approximately $9.7 million. Same center wages increased approximately $4.5 million, or 4.6%, primarily due to increases in wages as a result of competitive labor markets in most of the areas in which we operate, regular merit and inflationary raises for personnel (increase of approximately 3.8% for the period), and labor costs associated with increases in patient acuity levels. Although overall Medicare census declined slightly, the acuity levels of the Company’s patients, as indicated by RUG level scores, were higher than in 2006, resulting in greater costs to care for these patients.

Employee health insurance costs were approximately $0.6 million higher in 2007 compared to 2006 on a same center basis, an increase of approximately 14.3%. The Company is self insured for the first $150,000 in claims per employee each year. Employee health insurance costs can vary significantly from year to year.

These increased costs were partially offset by reductions in bad debt expense and workers’ compensation insurance. Bad debt expense was $0.6 million lower in 2007 compared to 2006 on a same center basis. Costs of workers’ compensation insurance were approximately $0.7 million lower in 2007 compared to 2006 on a same center basis due to better than expected claims experience.

The remaining increases in operating expense are primarily due to the effects of increases in patient acuity levels.

Lease expense . Lease expense increased to $20.0 million in 2007 from $16.1 million in 2006. Lease expense related to the New Texas Facilities was $1.5 million for 2007. Same center lease expense increased to $18.5 million in 2007 from $16.1 million in 2006. Effective October 1, 2006, we renewed a master lease covering 28 nursing centers. This resulted in an increase in lease expense of $2.0 million during 2007 for the effects of recording scheduled rent increases on a straight-line basis over the term of the renewal period. This increase has no effect on cash rent payments at the start of the lease term, and will only result in additional cash outlay as the 3 percent annual increases take effect each year. In addition, there was an increase in lease expense of $0.5 million resulting from rent increases for lessor funded property renovations.

Professional liability. Professional liability in 2007 was a benefit of $1.7 million, compared to a benefit of $5.4 million in 2006, a decrease in benefit of $3.7 million. Professional liability expense related to the New Texas Facilities was $0.2 million. Our cash expenditures for professional liability costs were $2.8 million and $3.4 million for 2007 and 2006, respectively. These cash expenditures can fluctuate from year to year, and we expect that cash expenditures will be higher in 2008. During 2007, our total recorded liabilities for self-insured professional liability declined to $20.7 million at December 31, 2007, down from $25.7 million at December 31, 2006.

General and administrative expense . General and administrative expense decreased to $17.6 million in 2007 from $21.0 million in 2006, a decrease of $3.4 million or 16.5%. General and administrative expense related to the New Texas Facilities was $0.7 million in 2007 and included $0.3 million incurred for post acquisition integration costs. Same center general and administrative expense decreased to $16.9 million in 2007 from $21.0 million in 2006, a decrease of $4.1 million, or 19.8%.

The majority of the decrease in general and administrative expense is related to non-cash stock-based compensation, which was $4.4 million lower in 2007. Prior to 2007, such charges were reported as a separate income statement caption, but were reclassified for current and prior periods in the 2007 financial statements. Costs of compliance with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 were $0.7 million lower in 2007 compared to 2006.

Partially offsetting these reduced costs were increased compensation costs of approximately $0.9 million, resulting from normal merit and inflationary increases ($0.3 million, approximately 4.3%), new positions added to improve marketing, operational and financial controls ($0.3 million), and higher incentive compensation costs ($0.3 million) as a result of operating performance.

Depreciation and amortization . Depreciation and amortization expense was approximately $4.1 million in 2007 and $3.6 million in 2006. The increase in 2007 is primarily due to depreciation and amortization expenses related to the New Texas Facilities.

Foreign currency transaction gain . A foreign currency transaction gain of $808,000 was recorded in 2007, compared to $21,000 in 2006. These gains result primarily from foreign currency translation of a note receivable from the sale of our Canadian operations in 2004.

Interest expense . Interest expense decreased to $3.5 million in 2007 from $3.7 million in 2006, a decrease of $0.2 million or 4.3%. Interest expense decreased as a result of payments of debt from proceeds of the sale of discontinued operations, principal payments made in connection with a refinancing transaction in August 2006, and other principal payments. These decreases were partially offset by debt increases associated with our SMSA Acquisition, which resulted in interest expense increases of approximately $0.3 million in 2007, and fees for letters of credit issued in 2007.

Debt retirement costs. Debt retirement costs of $0.1 and $0.2 million in 2007 and 2006, respectively, are related to unamortized deferred finance costs of refinanced loans that were written off following the refinancing transactions we completed in August 2007 and August 2006.

Income from continuing operations before income taxes; income from continuing operations per common share . As a result of the above, continuing operations reported income before income taxes of $15.8 million in 2007 compared to $12.9 million in 2006. The provision for income taxes was $6.3 million in 2007, compared to a benefit for income taxes of $9.5 million in 2006. Our effective tax rate differs materially from the statutory rate in 2006 mainly due to changes in our valuation allowance for net deferred tax assets. During 2006, we recorded a deferred tax benefit to reduce deferred tax asset valuation allowances, based on improvements in our financial position and our updated forecast of income available to support the turnaround of existing net operating loss carryforward

credits. In future periods, we will continue to assess the need for and adequacy of the remaining valuation allowance. The basic and diluted income per common share from continuing operations were $1.56 and $1.49, respectively, in 2007, as compared to a basic and diluted income per common share from continuing operations of $3.81 and $3.42, respectively, in 2006.

Income from discontinued operations . As discussed in the overview at the start of Management’s Discussion and Analysis of Financial Condition and Results of Operations, we have completed certain divestitures and have reclassified our consolidated financial statements to present these divestitures as discontinued operations for all periods presented. Operating loss of discontinued operations, net of taxes, was approximately $91,000 in 2007, compared to a loss of $337,000 in 2006. The disposition of discontinued operations and completions of lease terminations resulted in a loss of $8,000, net of taxes, in 2007, compared to a loss of $114,000 in 2006.

Year Ended December 31, 2006 Compared With Year Ended December 31, 2005

In 2005 and 2006, we entered into several divestiture transactions, and our consolidated financial statements have been reclassified to present such transactions as discontinued operations. Accordingly, the related revenue, expenses, assets, liabilities and cash flows have been reported separately, and the discussion below addresses principally the results of our continuing operations.

Patient revenues . Patient revenues increased to $214.7 million in 2006 from $201.2 million in 2005, an increase of $13.5 million, or 6.7%. The increase in revenues is due to increased Medicaid rates in certain states, increased Medicare utilization, Medicare rate increases and an increase in census in 2006 as compared to 2005. The average rate of occupancy at our nursing centers increased to 78.8% in 2006 from 76.9% in 2005. As a percentage of total census, Medicare days were 13.8% in 2006 and 13.0% in 2005. Medicare revenues were 30.6% of revenue in 2006 and 30.0% in 2005, while Medicaid and similar programs were 56.4% in 2006 compared to 58.0% in 2005.

Our average rate per day for Medicare Part A patients increased to $324.48 in 2006 from $312.11 in 2005, an increase of 4.0%. We previously expected that our rate would decrease from the 2005 level due to the Medicare RUG refinements that were implemented effective January 1, 2006. The acuity levels of Medicare patients in our nursing centers were higher than expected with a resulting increase in the average Medicare rate per patient day. Our average rate per day for Medicaid patients increased to $133.78 in 2006 from $128.79 in 2005, an increase of 3.9%.

Operating expense . Operating expense increased to $163.4 million in 2006 from $153.3 million in 2005, an increase of $10.1 million, or 6.6%. As a percentage of revenues, operating expenses were 76.1% in 2006, compared to 76.2% in 2005. The increase in operating expense is primarily attributable to cost increases related to wages and benefits, partially offset by a reduction in expense related to workers’ compensation insurance expense. The decrease in operating costs as a percentage of patient and resident revenues is primarily due to the effects of increases in Medicare and Medicaid rates and increased Medicare utilization, as discussed above.

The largest component of operating expenses is wages, which increased to $97.5 million in 2006 from $90.6 million in 2005, an increase of $6.9 million, or 7.7%. This increase is primarily attributable to an increase in wages as a result of increased costs of nursing care associated with the higher Medicare census, competitive labor markets in most of the areas in which we operate, and regular merit and inflationary raises for personnel.

Employee health insurance costs were approximately $0.7 million higher in 2006 compared to 2005, an increase of approximately 18.3%. The Company is self insured for the first $150,000 in claims per employee each year. Employee health insurance costs can vary significantly from year to year.

Costs of workers’ compensation insurance were approximately $1.3 million lower in 2006 compared to 2005. Beginning with the policy year that started in July 2005, our workers’ compensation insurance policies provided us with greater premium decreases resulting from reductions in claims experience. We have had better than expected claims experience, allowing us to reduce the cost of workers’ compensation insurance.

The remaining increases in operating expense are primarily due to the effects of increases in total census and Medicare utilization.

Lease expense . Lease expense increased to $16.1 million in 2006 from $15.8 million in 2005, an increase of $0.3 million, or 1.6%. Effective October 1, 2006, we renewed a master lease covering 28 nursing centers. This resulted in an increase in lease expense of $0.7 million during 2006 for the effects of recording scheduled rent increases on a straight-line basis over the term of the renewal period and will result in increased lease expense of $2.7 million annually in future periods. This increase has no effect on cash rent payments at the start of the lease term, and will only result in additional cash outlay as the 3 percent annual increases take effect each year. In addition, there was an increase in lease expense of $0.2 million resulting from rent increases for lessor funded property

renovations. Offsetting these increases in rent were reduced rent following the purchase of a leased facility in 2005 and the extension of a lease at the beginning of 2006 covering four nursing centers that provided for the elimination of certain contingent rent expense.

Professional liability. Professional liability expense was a net benefit of $5.4 million in 2006, compared to a net benefit of $4.5 million in 2005, an increase in net benefit of $0.9 million, or 18.1%. Our cash expenditures for self-insured professional liability costs were $3.4 million and $4.1 million for the twelve month periods ended December 31, 2006 and 2005, respectively. During 2006, we reduced our total recorded liabilities for self-insured professional liability risks to $25.7 million, down from $34.5 million at December 31, 2005.

General and administrative expense . General and administrative expense increased to $21.0 million in 2006 from $13.3 million in 2005, an increase of $7.7 million or 58.0%. The increase is primarily attributable to non-cash charges for stock based compensation, increased cash compensation costs and consulting costs related to compliance with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002.

During 2006, we recorded a non-cash charge of approximately $5.1 million related to stock option grants that were approved by shareholders at our annual meeting on June 1, 2006. The majority of this charge is included in our general and administrative expense. There were no charges for stock based compensation in 2005.

Compensation costs were approximately $1.2 million higher in 2006 than in 2005. Salary costs increased approximately $0.3 million, or 4%, due to normal merit and inflationary increases and approximately $0.4 million due to new positions added to improve operating and financial controls. In addition, incentive compensation costs were approximately $0.5 million higher in 2006 compared to 2005 as a result of improved operating performance.

We were required to comply with the internal control reporting requirements of the Sarbanes-Oxley Act of 2002 beginning with our 2006 annual report on Form 10-K, and compliance costs have resulted in an increase in general and administrative expense of approximately $0.7 million in 2006 compared to 2005. As a percentage of total net revenues, general and administrative expense was approximately 9.8% in 2006 and 6.6% in 2005.

Depreciation . Depreciation expense was approximately $3.6 million in 2006 compared to $3.5 million in 2005, an increase of $0.1 million or 4.6%. The increase was primarily due to the purchase of a leased facility in 2005.

Foreign currency transaction gain . A foreign currency transaction gain of approximately $21,000 was recorded in 2006, compared to $161,000 in 2005. Foreign currency transaction gains and losses result from foreign currency translation of a note receivable from the sale of our Canadian operations in 2004.

Interest expense . Interest expense increased to $3.7 million in 2006 from $3.4 million in 2005, an increase of $0.3 million or 9.6%. Interest expense increased as a result of new debt issued in connection with the acquisition of a facility as well as the interest rate increases on our variable rate debt. These increases were partially offset by a reduction in interest as a result of payments of debt from proceeds of the sale of discontinued operations, principal payments made in connection with a refinancing transaction in August 2006, and other principal payments.

Debt retirement costs. Debt retirement costs of $0.2 million are related to unamortized deferred finance costs of refinanced loans that were written off following the refinancing transaction we completed in August 2006.

Income from continuing operations before income taxes; income from continuing operations per common share . As a result of the above, continuing operations reported income before income taxes of $12.9 million in 2006 compared to income before income taxes of $17.2 million in 2005. The benefit for income taxes was $9.5 million in 2006, compared to $13.8 million in 2005. Our effective tax rate differs materially from the statutory rate mainly due to changes in our valuation allowance for net deferred tax assets. In 2006 and 2005, we recorded a deferred tax benefit of approximately $9.7 million and $13.9 million, respectively, to reduce deferred tax asset valuation allowances, based on improvements in our financial position and our updated forecast of income available to support the turnaround of existing net operating loss carryforward credits. In future periods, we will continue to assess the need for and adequacy of the remaining valuation allowance. The basic and diluted income per common share from continuing operations were $3.81 and $3.42, respectively, in 2006, as compared to a basic and diluted income per common share from continuing operations of $5.36 and $4.76, respectively, in 2005.

Income from discontinued operations . Operating income of discontinued operations, net of taxes, was approximately $0.3 million in 2006, compared to a loss from discontinued operations of $6.1 million in 2005. Losses from the disposition of discontinued operations of $0.1 million, net of related taxes, were recorded in 2006, compared to a gain of $0.4 million recorded in 2005.

Liquidity and Capital Resources

Capital Resources

As of December 31, 2007, we had $34.5 million of outstanding borrowings, including $1.9 million in current scheduled payments of long-term debt. Current scheduled payments of long-term debt include payments required by our loan agreements from net proceeds received upon certain asset dispositions and operating cash flow. During the year ended December 31, 2007, additional principal payments of $3.0 million were made from such proceeds. In addition, our debt agreements allow for voluntary prepayments of principal outstanding, and during 2007, we made voluntary prepayments of $3.0 million. These prepayments reduce the required amounts that must be paid in future periods from excess cash flows and asset dispositions. Based on our 2007 results since the date of the financing transaction we would be required to make a mandatory prepayment based on excess cash flows of $2.0 million in March 2008 had we not made the voluntary prepayment.

In August 2007, we entered into an agreement with a bank for a $16.5 million term loan to finance the SMSA acquisition and repay certain existing indebtedness. The term loan has an interest rate of LIBOR plus 2.5%, a maturity of five years, and principal payments based on a ten year amortization, with additional payments based on cash flow from operations and amounts realized related to certain collateral. The term loan is secured by receivables and all other unencumbered assets of the company, including land held for sale, insurance refunds receivable and notes receivable. In addition to financing the acquisition, we used proceeds from this term loan to retire a $4.0 million term loan that had an interest rate of LIBOR plus 6.25% and a $2.5 million subordinated note due in September 2007 that had an interest rate of 7%.

The bank loan agreement also includes a $15 million revolving credit facility that provides revolving credit loans as well as the issuance of letters of credit. The revolver is secured by accounts receivable and replaced our previous $2.3 million line of credit. The revolver provided for a maximum draw of up to $21 million during the first six months to finance start up working capital requirements of the SMSA Acquisition, and reduced to $15 million in February 2008. There are limits on the maximum amount of loans that may be outstanding under the revolver based on borrowing base restrictions. The revolver has a term of three years and bears interest at our option of LIBOR plus 2.25% or the bank’s prime lending rate. Annual fees for letters of credit issued under this revolver are 2.25% of the amount outstanding. Historically, our accounts receivable had been pledged as security primarily for our leases with Omega. Under this refinancing, the accounts receivable serve as the collateral for the new revolver and we have issued a letter of credit of approximately $8.1 million to serve as a replacement security deposit for all of our leases with Omega. Considering the balance of eligible accounts receivable at December 31, 2007, the letter of credit and the current maximum loan of $15 million, the balance available for future revolving credit loans would be $6.9 million. Such amounts are available to fund the working capital needs of this transaction and future expansion opportunities. As of December 31, 2007, we had no borrowings outstanding under our revolving credit facility.

On August 7, 2006, we entered into an agreement with our commercial mortgage lender for a comprehensive refinancing of our long term debt. Under the terms of the new agreement, the lender provided mortgage debt of approximately $22.5 million with a five year maturity and a term note of approximately $8.1 million with a four year maturity to refinance our existing mortgage and bank term debt. As discussed above, the term note was retired in 2007. The proceeds of these new loans were used to retire the existing debt and to fund a $1.1 million renovation of a nursing center that is part of the collateral for the mortgage loans. In connection with this loan, we made a payment of approximately $2.6 million to reduce outstanding debt. During 2006, we expensed existing deferred financing costs of $0.2 million related to the debt that was retired and recorded new deferred loan costs of $0.8 million as part of the refinancing transaction.

Our debt agreements contain various financial covenants the most restrictive of which relate to cash flow, debt service coverage ratios, liquidity and limits on the payment of dividends to shareholders. We are in compliance with such covenants at December 31, 2007.

Transaction with Omega .

On October 20, 2006, we entered into a Restructuring Stock Issuance and Subscription Agreement (“Restructuring Agreement”) to restructure our Series B Redeemable Convertible Preferred Stock held by Omega Healthcare Investors (together with its subsidiaries, “Omega”), a publicly owned REIT, eliminating the option of Omega to convert the Preferred Stock into shares of Advocat common stock. Advocat and Omega also entered into a Third Amendment to Consolidated Amended and Restated Master Lease (“Lease Amendment”) to extend the term of our lease covering 28 nursing centers we currently lease from Sterling Acquisition Corp., a wholly-owned subsidiary of Omega. In addition, Omega agreed to provide up to $5 million to fund capital improvements made to certain nursing centers. Details of these transactions are described below.

Under the terms of the Restructuring Agreement, the Series B Redeemable Convertible Preferred Stock (“Series B Preferred Stock”) held by Omega was exchanged for a new Series C Preferred Stock that is not convertible. At the time of the Restructuring Agreement,

the Series B Preferred Stock had a recorded value of approximately $4.9 million, including accrued dividends, at an annual rate of 7% of the stated value compounded quarterly and was convertible into approximately 792,000 shares of common stock.

The Restructuring Agreement required us to issue to Omega 5,000 shares of Series C Preferred Stock in exchange for the 393,658 shares of Series B Preferred Stock held by Omega. The new Series C Preferred Stock has a stated value of approximately $4.9 million and carries an annual dividend rate of 7% of its stated value. Dividends on the Series C Preferred Stock are paid quarterly in cash. The Series C Preferred Stock is not convertible, but is redeemable at its stated value at Omega’s option after September 30, 2010, and is redeemable at its stated value at our option after September 30, 2007, subject to certain limitations. In connection with the termination of the conversion feature, we agreed to pay Omega an additional $687,000 annually under the Lease Amendment.

In connection with the Restructuring Agreement, we also replaced a Subordinated Promissory Note which was convertible at our option with a new Subordinated Note, which was not convertible. Except for eliminating the conversion feature, the terms of the new Subordinated Note were the same as the original subordinated Promissory Note. As described in “Capital Resources,” the new Subordinated Note was retired in connection with a financing transaction in August 2007.

Under the terms of the Lease Amendment, Advocat and Omega also agreed to amend and renew the master lease covering 28 nursing centers. The initial term of the lease was set to expire in September 2010, with a ten year renewal option. The amended master lease commenced on October 1, 2006, and extends to September 30, 2018. The Lease Amendment also provides for a renewal option of an additional twelve years. Other than the change in rent associated with the restructuring of the preferred stock described above, there was no change in the base rental amounts as a result of the Lease Amendment. Consistent with prior terms, the lease provides for annual increases in lease payments equal to the lesser of two times the increase in the consumer price index or 3 percent. Under generally accepted accounting principles, we are required to report these scheduled rent increases on a straight line basis over the 12 year term of the renewal period. As a result of accruing the scheduled rent increases, our annual rent expense increased by approximately $2.7 million effective October 1, 2006. This increase has no effect on cash rent payments at the start of the lease term, and will only result in additional cash outlay as the 3 percent annual increases take effect each year.

This Lease Amendment, together with an earlier amendment in 2005, provides financing of up to $10 million to fund capital improvements made to certain nursing centers leased from Omega. The annual base rent related to these nursing centers will be increased to reflect the amount of capital improvements made to the facilities. The increase in rent is based on a rate of 10.25% per year of the amount financed under this amendment. As of December 31, 2007, we had incurred expenditures of $8.0 million for these improvements.

New Facility Construction

Effective November 1, 2007, we entered into a short term single facility lease with Omega for a 102 bed skilled nursing center in Texas, and we are evaluating the possibility of entering into an agreement with Omega for the construction of a replacement facility. It is anticipated that we would supervise construction, with funding provided by Omega. Upon completion of construction, we would lease the facility from Omega under a lease agreement with an initial term of five years, with renewal options through 2035.

We have entered into an option agreement to purchase certain assets of a skilled nursing facility in West Virginia. We made an application to state regulatory authorities to allow us to operate the facility, and this application was approved in February 2008, subject to rights of appeal by contesting parties. Once final appeals, if any, are resolved, we intend to arrange financing and construct a new 90 bed replacement facility.

Share Repurchase

In November 2007, the Company’s Board of Directors authorized the repurchase of up to $2.5 million of our common stock pursuant to a plan under Rule 10b5-1 and in compliance with Rule 10b-18 of the Securities Exchange Act of 1934, as amended. As of November 1, 2007, there were approximately 5.9 million shares of common stock outstanding.

Share repurchases under this program are authorized through the earlier of one year from November 6, 2007 or the repurchase of the full amount authorized to be repurchased under the plan, subject to conditions specified in the plan. Repurchases may be made through open market or privately negotiated transactions in accordance with all applicable securities laws, rules, and regulations and are funded from available working capital. The share repurchase program may be terminated at any time without prior notice. During 2007, we spent $0.8 million to repurchase 74,500 shares of our common stock. See “Item 5. Market for Registrants Common Equity and Related Stockholder Matters and Issuer Purchase of Equity Securities.”

Professional Liability

We have numerous pending liability claims, disputes and legal actions for professional liability and other related issues. For several years, due to our past claim experience and increasing cost of claims throughout the long-term care industry, the premiums paid by us for professional liability and other liability insurance exceeded the coverage purchased so that it cost more than $1 to purchase $1 of insurance coverage. For this reason, effective March 9, 2001, we purchased professional liability insurance coverage for our facilities that, based on historical claims experience, was substantially less than the amount required to satisfy claims that were incurred. As a result, we have been effectively self-insured. We have essentially exhausted all general and professional liability insurance available for claims first made during the period from March 9, 2001 through March 9, 2007. For claims made during the period from March 10, 2007 through March 9, 2009, we maintain insurance coverage limits of $100,000 per medical incident and total annual aggregate policy coverage limits of $500,000.

As of December 31, 2007, we have recorded total liabilities for reported and settled professional liability claims and estimates for incurred but unreported claims of $20.7 million. A significant judgment entered against us in one or more of these legal actions could have a material adverse impact on our financial position and cash flows. Settlements of currently pending claims will require additional cash expenditures.

Liquidity

Net cash provided by operating activities of continuing operations totaled $12.7 million, $15.4 million and $9.4 million in 2007, 2006 and 2005, respectively. Discontinued operations provided cash of $22,000 in 2007 and $0.3 million in 2006 and used $0.4 million of cash in 2005.

Investing activities of continuing operations used cash of $14.1 million and $8.3 million in 2007 and 2005, respectively, and provided $6.0 million of cash in 2006. These amounts primarily represent proceeds from the sale of discontinued operations, cash used for purchases of property, plant and equipment, cash used for the SMSA Acquisition in 2007 and the purchase of a nursing center in 2005. We have used between $3.4 million and $6.8 million for capital expenditures of continuing operations in each of the three calendar years ending December 31, 2007. The capital expenditures we made during 2007 were driven by three projects or initiatives that totaled $3.6 million of the $6.8 million spent in total. We spent $0.6 million and $0.8 million at owned facilities in Arkansas and Texas, respectively, as well as $2.2 million at our New Texas facilities. Such expenditures were primarily for facility improvements and equipment, which were financed principally through working capital. For the year ending December 31, 2008, we anticipate that capital expenditures for improvements and equipment for our existing facility operations will be higher as we complete facility renovations and significant projects at certain owned and leased facilities. We expect to use approximately $4.0 million of working capital for facility renovation projects in 2008. Investing activities of discontinued operations used no cash in 2007 and used $28,000 and $0.9 million in 2006 and 2005, respectively.

Financing activities of continuing operations provided cash of $0.7 million and $1.4 million in 2007 and 2005, respectively, and used $16.4 million of cash in 2006. The cash provided in 2007 primarily represents the net funds from loan proceeds to acquire the SMSA leasehold interests, offset by the payment of existing debt and the repurchase of $0.8 million of our common stock. In 2006, proceeds from the sale of discontinued operations were used to repay debt. The cash provided in 2005 primarily represents funds from loan proceeds used to acquire a nursing center. There were no cash flows from financing activities of discontinued operations in 2007, 2006 or 2005. No interest costs or debt were allocated to discontinued operations.

Facility Renovations

During 2005, we began an initiative to complete strategic renovations of certain facilities to improve occupancy, quality of care and profitability. We developed a plan to begin with those facilities with the greatest potential for benefit, and began the renovation program during the third quarter of 2005. As of December 31, 2007, we have completed renovation projects at seven facilities. We completed another renovation in early 2008 and have 2 additional renovation projects in progress, with expected completion by the third quarter of 2008.

A total of $10.2 million has been spent on these renovation programs to date, with $8.0 million spent on facilities leased from Omega and $2.2 million spent on owned facilities. The amounts spent on the facilities leased from Omega have been financed through increased rent and are not reflected as capital expenditures. We expect the two projects currently in progress will use financing provided by Omega, and we intend to finance future renovation projects with working capital.

For the seven facilities with renovations completed before the beginning of the fourth quarter 2007 compared to the last twelve months prior to the commencement of renovation average occupancy increased from 64.6% to 72.0% in the fourth quarter of 2007, and Medicare census increased from 12.8% to 13.7% in the fourth quarter of 2007. No assurance can be given that these facilities will continue to show such occupancy or revenue mix improvement or that the other renovated facilities will experience similar improvements.

Receivables

Our operations could be adversely affected if we experience significant delays in reimbursement from Medicare, Medicaid and other third-party revenue sources. Our future liquidity will continue to be dependent upon the relative amounts of current assets (principally cash, accounts receivable and inventories) and current liabilities (principally accounts payable and accrued expenses). In that regard, accounts receivable can have a significant impact on our liquidity. Continued efforts by governmental and third-party payors to contain or reduce the acceleration of costs by monitoring reimbursement rates, by increasing medical review of bills for services, or by negotiating reduced contract rates, as well as any delay by us in the processing of our invoices, could adversely affect our liquidity and results of operations.

Accounts receivable attributable to patient services of continuing operations totaled $27.9 million at December 31, 2007, compared to $18.5 million at December 31, 2006, representing approximately 37 and 31 days in accounts receivable at each period end, respectively. The SMSA Acquisition resulted in an increase in accounts receivable of approximately $8.8 million at December 31, 2007. As part of the procedural Medicare and Medicaid change of ownership process, payments from Medicaid and Medicare for these facilities were temporarily delayed, and $4.7 million of the $8.8 million increase in receivables was due to these delays. These payments from Medicare and Medicaid are expected to be collected during the first half of 2008. Excluding these payor delays, our accounts receivable is 31 days as of December 2007.

The allowance for bad debt was $2.2 million at December 31, 2007, compared to $2.1 million at December 31, 2006. We continually evaluate the adequacy of our bad debt reserves based on patient mix trends, aging of older balances, payment terms and delays with regard to third-party payors, collateral and deposit resources, as well as other factors. We continue to evaluate and implement additional procedures to strengthen our collection efforts and reduce the incidence of uncollectible accounts.

Stock Exchange

During 2006, our common stock shares were approved for listing on the NASDAQ Capital Market and began trading there on September 12, 2006 under the symbol AVCA. Prior to our listing on the NASDAQ Capital Market our stock was quoted on the NASD’s OTC Bulletin Board under the symbol AVCA.

Inflation

We do not believe that our operations have been materially affected by inflation. We expect salary and wage increases for our skilled staff to continue to be higher than average salary and wage increases, as is common in the health care industry.

Off-Balance Sheet Arrangements

We had letters of credit outstanding of approximately $8.1 million as of December 31, 2007, which serves as a security deposit for our facility leases with Omega. The letters of credit were in connection with our revolving credit facility. Our accounts receivable serve as the collateral for this revolving credit facility.

Recent Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”). This new standard provides guidance for using fair value to measure assets and liabilities and establishes a fair value hierarchy that prioritizes the information used to develop the measurements. SFAS No. 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances. The provisions of SFAS No. 157 are effective for us beginning January 1, 2008. The adoption of SFAS No. 157 is not expected to have a material impact on our financial position, results of operations or cash flows.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities – including an Amendment of FASB Statement No. 115” (SFAS No. 159”). The new standard permits entities to choose to measure many financial instruments and certain other items at fair value. Most provisions of SFAS No. 159 will only impact those entities that elect the fair value option or have investments accounted for under FASB Statement No. 115. The provisions of SFAS No. 159 are effective for us beginning January 1, 2008. We do not expect the adoption of this new standard to have a material impact on our financial position.

In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations” (“SFAS No. 141R”). SFAS No. 141R establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any noncontrolling interest in the acquiree as well as the goodwill acquired or gain recognized in a bargain purchase. SFAS No. 141R also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination.

Forward-Looking Statements

The foregoing discussion and analysis provides information deemed by management to be relevant to an assessment and understanding of our consolidated results of operations and financial condition. This discussion and analysis should be read in conjunction with our consolidated financial statements included herein. Certain statements made by or on behalf of us, including those contained in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere, are forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from those contemplated by the forward-looking statements made herein. In addition to any assumptions and other factors referred to specifically in connection with such statements, other factors, many of which are beyond our ability to control or predict, could cause our actual results to differ materially from the results expressed or implied in any forward-looking statements including, but not limited to, our ability to integrate the seven skilled nursing facilities acquired from Senior Management Services of America North Texas, Inc. into our business and achieve the anticipated cost savings, changes in governmental reimbursement, government regulation and health care reforms, the increased cost of borrowing under our credit agreements, ability to control ultimate professional liability costs, the accuracy of our estimate of our anticipated professional liability expense, the impact of future licensing surveys, the outcome of regulatory proceedings alleging violations of laws and regulations governing quality of care or violations of other laws and regulations applicable to our business, our ability to control costs, changes to our valuation of deferred tax assets, changes in occupancy rates in our facilities, changing economic conditions as well as others. Investors also should refer to the risks identified in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” as well as risks identified in “Part 1. Item 1A. Risk Factors” for a discussion of various risk factors of the Company and that are inherent in the health care industry. Given these risks and uncertainties, we can give no assurances that these forward-looking statements will, in fact, transpire and, therefore, caution investors not to place undue reliance on them. These assumptions may not materialize to the extent assumed, and risks and uncertainties may cause actual results to be different from anticipated results. These risks and uncertainties also may result in changes to the Company’s business plans and prospects. Such cautionary statements identify important factors that could cause our actual results to materially differ from those projected in forward-looking statements. In addition, we disclaim any intent or obligation to update these forward-looking statements.

exchange rate between US and Canadian currencies, and the effect of such changes will be included as income or loss in our statement of operations in the period of change. In 2007 and 2006, we reported transaction gains of $808,000 and $21,000, respectively, as a result of the effect of changes in the currency exchange rates on this note and liabilities. A further change of 1% in the exchange rate between US and Canadian currencies would result in a corresponding increase or decrease to earnings of approximately $53,000.

Report of Independent Registered Public Accounting Firm

Board of Directors and Shareholders
Advocat Inc.
Brentwood, Tennessee

We have audited Advocat Inc.’s (the “Company”) internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the “COSO criteria”). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, Advocat Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007 based on the COSO criteria.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of the Company as of December 31, 2007 and 2006 and the related consolidated statements of income, shareholders’ equity (deficit), and cash flows for each of the three years in the period ended December 31, 2007 and our report dated March 10, 2008 expressed an unqualified opinion thereon.

/s/ BDO Seidman, LLP
Nashville, Tennessee
March 10, 2008

ITEM 9B. OTHER INFORMATION

None.

PART III

PART IV

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

ADVOCAT INC.
/s/ Wallace E. Olson
Wallace E. Olson
Chairman of the Board
March 11, 2008
/s/ William R. Council, III
William R. Council, III
President and Chief Executive Officer
(Principal Executive Officer)
March 11, 2008
/s/ L. Glynn Riddle, Jr.
L. Glynn Riddle, Jr.
Vice President, Chief Financial Officer, Secretary
(Principal Financial and Accounting Officer)
March 11, 2008

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

/s/ Wallace E. Olson				/s/ William C. O’Neil. Jr.
Wallace E. Olson				William C. O’Neil, Jr.
Chairman of the Board				Director
March 11, 2008				March 11, 2008
/s/ William R. Council, III				/s/ Richard M. Brame
William R. Council, III				Richard M. Brame
President and Chief Executive Officer				Director
Director				March 11, 2008
March 11, 2008
/s/ Robert Z. Hensley
Robert Z. Hensley
Director
March 11, 2008

ADVOCAT INC. AND SUBSIDIARIES

Consolidated Financial Statements
For the Years Ended December 31, 2007, 2006 and 2005
Together with Report of Independent Registered Public Accounting Firm

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

Report of Independent Registered Public Accounting Firm		F-1
Consolidated Balance Sheets		F-2
Consolidated Statements of Income		F-3
Consolidated Statements of Shareholders’ Equity (Deficit)		F-4
Consolidated Statements of Cash Flows		F-5
Notes to Consolidated Financial Statements		F-7
Schedule II — Valuation and Qualifying Accounts		S-1

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Shareholders
Advocat Inc.
Brentwood, Tennessee

We have audited the accompanying consolidated balance sheets of Advocat Inc. as of December 31, 2007 and 2006 and the related consolidated statements of income, shareholders’ equity (deficit), and cash flows for each of the three years in the period ended December 31, 2007. In connection with our audits of the financial statements, we have also audited the financial statement schedule listed in the accompanying index. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements and schedule. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Advocat Inc. at December 31, 2007 and 2006, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2007, in conformity with accounting principles generally accepted in the United States of America.

Also, in our opinion, the financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Advocat Inc.’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 10, 2008 expressed an unqualified opinion thereon.

/s/ BDO Seidman, LLP

Nashville, Tennessee
March 10, 2008