UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q/A QUARTERLY REPORT PURSUANT TO SECTION 13 or 15 (D)OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended September 30, 2003 Commission File Number: 0-20307 AVALON CORRECTIONAL SERVICES, INC. (Exact name of registrant as specified in its charter) Nevada 13-3592263 (State of Incorporation) (I.R.S. Employer I.D. Number) 13401 Railway Drive, Oklahoma City, Oklahoma 73114 (Address of principal executive offices) (405) 752-8802 (Issuer's telephone number) Indicate by check mark whether the registrant issuer (1) 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 such filing requirements for the past 90 days. Yes X No ______ As of October 31, 2003, 4,896,954 shares of the issuer's Class A common stock, par value $.001, were issued and outstanding. PART I - FINANCIAL INFORMATION AVALON CORRECTIONAL SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Unaudited, Restated) September 30, December 31, 2003 2002 ------------ ------------ ASSETS Current assets: Cash and cash equivalents $ 861,000 $ 1,250,000 Certificates of deposit 1,900,000 1,800,000 Accounts receivable, net 3,271,000 2,768,000 Prepaid expenses and other 435,000 287,000 ----------- ------------ Total current assets 6,467,000 6,105,000 Property and equipment, net 30,847,000 30,041,000 Intangible assets 3,177,000 3,545,000 ----------- ------------ Total assets 40,491,000 $ 39,691,000 =========== ============ LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable, accrued liabilities and other $ 1,039,000 $ 624,000 Accrued payroll 290,000 571,000 Accrued income tax 217,000 265,000 Current maturities of long-term debt 3,214,000 3,515,000 ----------- ------------ Total current liabilities 4,760,000 4,975,000 Long-term debt, less current maturities 20,712,000 20,545,000 Convertible debentures 3,850,000 3,850,000 Deferred income taxes 168,000 147,000 Redeemable common stock, $.001 par value 1,622,448 shares issued and outstanding 2,280,000 3,176,000 Stockholders' equity: Common stock: Par value $.001; 24,000,000 shares authorized; 4,896,954 shares issued and outstanding, less 1,622,448 shares subject to repurchase 3,000 3,000 Preferred stock; par value $.001; 1,000,000 shares authorized; none issued --- --- Paid-in capital 8,808,000 7,908,000 Accumulated deficit (90,000) (913,000) ----------- ----------- Total liabilities and stockholders' equity $ 40,491,000 $ 39,691,000 ============ ============ The accompanying notes are an integral part of these consolidated financial statements. Page 1 AVALON CORRECTIONAL SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited, Restated) Three Months Ended Nine Months Ended September 30, September 30, 2003 2002 2003 2002 ------------- ------------ -------------- ------------- Revenues $ 6,346,000 $ 6,878,000 $ 18,628,000 20,247,000 ------------- ------------ -------------- ------------- Costs and expenses Direct operating 4,412,000 4,891,000 13,112,000 14,008,000 General and administrative 431,000 470,000 1,214,000 1,547,000 Depreciation and amortization 459,000 566,000 1,299,000 1,668,000 Interest expense 561,000 644,000 1,744,000 1,939,000 ------------- ------------ ------------- ------------- Net income from operations before income tax expense 483,000 307,000 1,259,000 1,085,000 Income tax expense 172,000 122,000 436,000 305,000 ------------- ------------ ------------- ------------ Net income $ 311,000 $ 185,000 $ 823,000 $ 780,000 ============= ============ ============= ============ Net income per share, basic $ 0.06 $ 0.04 $ 0.17 $ 0.16 ============= ============ ============= ============ Net income per share, diluted $ 0.06 $ 0.04 $ 0.15 $ 0.14 ============= ============ ============= ============ The accompanying notes are an integral part of these consolidated financial statements. Page 2 AVALON CORRECTIONAL SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOW (Unaudited, Restated) For the nine months ended September 30, 2003 2002 ------------ ----------- OPERATING ACTIVITIES: Net income 823,000 $ 780,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 1,299,000 1,668,000 Amortization of debt issue costs 200,000 247,000 Loss on sale of property 14,000 --- Changes in operating assets and liabilities: Increase in: Accounts receivable (603,000) (251,000) Prepaid expenses and other (148,000) (480,000) Increase (decrease) in: Accounts payable, accrued liabilities, and other 415,000 (491,000) Accrued payroll (281,000) (202,000) Accrued income tax (48,000) 75,000 Deferred income taxes 21,000 (63,000) ------------ ---------- Net cash provided by operations 1,692,000 1,283,000 ------------- ---------- INVESTING ACTIVITIES: Capital expenditures (2,017,000) (653,000) Proceeds from disposition of property 67,000 --- Purchases of certificates of deposit --- (1,500,000) ------------- ----------- Net cash used in investing activities (1,950,000) (2,153,000) ------------- ----------- FINANCING ACTIVITIES: Proceeds from borrowing 21,758,000 21,303,000 Repayment of borrowing (21,893,000) (21,879,000) Proceeds from warrant and option exercise 4,000 79,000 ------------- ------------ Net cash used in financing activities (131,000) (497,000) ------------- ------------ NET DECREASE IN CASH AND CASH EQUIVALENTS (389,000) (1,367,000) CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 1,250,000 2,389,000 ------------- ------------ CASH AND CASH EQUIVALENTS, END OF PERIOD $ 861,000 $ 1,022,000 ============= ============ The accompanying notes are an integral part of these consolidated financial statements. Page 3 AVALON CORRECTIONAL SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited, Restated) NOTE 1. BASIS OF PRESENTATION Interim Financial Statements - The financial statements included herein have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Accordingly, certain disclosures normally included in financial statements prepared in conformity with accounting principles generally accepted in the United States of America have been omitted. The accompanying consolidated financial statements and notes should be read in conjunction with the December 31, 2002 Form 10-KSB filing, as amended and restated. The results of operations for the three months and the nine months ended September 30, 2003, are not necessarily indicative of the results that may be expected for the entire year ended December 31, 2003. The consolidated balance sheet as of September 30, 2003, the statements of operations for the three months and nine months ended September 30, 2003 and 2002 and the statements of cash flows for the nine months ended September 30, 2003 and 2002 are unaudited and, in the opinion of management, reflect all adjustments that are necessary for a fair presentation of the financial position as of such date and the results of operations and cash flows for the periods then ended. All such adjustments are of a normal and recurring nature. The preparation of the consolidated financial statements, in conformity with accounting principles generally accepted in the United States of America, requires the use of management's estimates and assumptions in determining the carrying values of certain assets and liabilities and disclosures of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts for certain revenues and expenses during the reporting period. Actual results could differ from those estimates. Restatement - Upon original implementation of Statement of Financial Accounting Standards ("SFAS") No. 142, the Company determined that intangible assets related to the value of contracts previously acquired in business combinations had an indefinite life, and therefore were not amortized. After communication with the SEC staff resulting in a reevaluation of the life of contract intangibles, the Company decided to restate the consolidated financial statements as of and for the year ended December 31, 2002, to amortize contract intangibles over a fifteen-year life (the life assigned prior to the implementation of SFAS No. 142 on January 1, 2002). The effect of the restatement reduced total assets from $40,884,000, as originally reported at September 30, 2003, to $40,491,000, reduced total liabilities from $29,638,000 to $29,490,000 (due to income tax effects) and therefore reduced stockholders' equity from $8,966,000 to $8,721,000. A summary of the effects of these items on previously reported results of operations follows: As Originally Effect of Third Quarter 2003 Reported Restatement Restated ---------------------------- -------------- -------------- ---------- Revenues $ 6,346,000 $ - $ 6,346,000 Costs and expenses 5,807,000 56,000 5,863,000 -------------- -------------- ----------- Net income before income tax expense 539,000 (56,000) 483,000 Income tax expense 193,000 (21,000) 172,000 -------------- -------------- ----------- Net income $ 346,000 $ (35,000) $ 311,000 ============== ============== =========== Basic income per share $ .07 $ (.01) $ .06 ============== ============== =========== Diluted income per share $ .06 $ - $ .06 ============== ============== =========== Page 4 As Originally Effect of First Nine Months 2003 Reported Restatement Restated ---------------------------- -------------- ------------- ----------- Revenues $ 18,628,000 $ - $ 18,628,000 Costs and expenses 17,200,000 169,000 17,369,000 -------------- ------------- ----------- Net income before income tax expense 1,428,000 (169,000) 1,259,000 Income tax expense 499,000 (63,000) 436,000 -------------- ------------ ----------- Net income $ 929,000 $ (106,000) $ 823,000 ============== ============ =========== Basic income per share $ .19 $ (.02) $ .17 ============== ============ =========== Diluted income per share $ .17 $ (.02) .15 ============== ============ =========== As Originally Effect of Third Quarter 2002 Reported Restatement Restated ------------------------- ------------ ------------- ---------- Revenues $ 6,878,000 $ - $ 6,878,000 Costs and expenses 6,515,000 56,000 6,571,000 ------------ ------------- ------------- Net income before income tax expense 363,000 (56,000) 307,000 Income tax expense 143,000 (21,000) 122,000 ------------ -------------- ------------ Net income $ 220,000 $ (35,000) $ 185,000 ============ ============== ============= Basic income per share $ .04 $ $ .04 ============ ============== ============= Diluted income per share $ .04 $ $ .04 ============ ============== ============= As Originally Effect of First Nine Months 2002 Reported Restatement Restated ---------------------------- ------------ -------------- ----------- Revenues $ 20,247,000 $ - $ 20,247,000 Costs and expenses 18,993,000 169,000 19,162,000 ------------ -------------- ------------ Net income before income tax expense 1,254,000 (169,000) 1,085,000 Income tax expense 368,000 (63,000) 305,000 ------------ -------------- ------------ Net income $ 886,000 $ (106,000) $ 780,000 ============ ============== ============ Basic income per share $ .18 $ (.02) $ .16 ============ ============== ============ Diluted income per share $ .16 $ (.02) $ .14 ============= ============== ============ Stock-Based Compensation - The Company has a stock-based compensation plan. The Company accounts for this plan under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under this plan had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of Financial Accounting Standards Board (FASB) Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation. Page 5 Three months ended September 30, Nine months ended September 30, --------------------------------- ------------------------------- 2003 2002 2003 2002 ----------- ------------- ------------ ---------- Net income, as reported $ 311,000 $ 185,000 $ 823,000 $ 780,000 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects 22,000 43,000 66,000 130,000 ----------- ------------ ----------- --------- Pro forma net income $ 289,000 $ 142,000 $ 757,000 $ 650,000 ========= ============ ========== ========= Earnings per share: Basic - as reported $ 0.06 $ 0.04 $ 0.17 $ 0.16 ========= ============ ========== ========= Basic - pro forma $ 0.06 $ 0.03 $ 0.15 $ 0.13 ========= ============ ========= ========= Diluted - as reported $ 0.06 $ 0.04 $ 0.15 $ 0.14 ========= ============ ========= ========= Diluted - pro forma $ 0.05 $ 0.02 $ 0.12 $ 0.10 ========== ============ ========= ========= Page 6 NOTE 2. LONG-TERM DEBT AND REDEEMABLE COMMON STOCK Long-term debt consists of the following: September 30, December 31, 2003 2002 --------------- ---------------- Revolving line of credit with finance company, collateralized by accounts receivable, with interest at 1.0% over prime (effective rate of 4.8% at September 30, 2003); due Feb 2005 $ 1,091,000 $ 1,423,000 Notes payable to banks, collateralized by transportation equipment, due in installments through March 2012 with interest ranging from 2.9% to 10.9%. 862,000 641,000 Notes payable to banks and finance companies, collateralized by land, buildings and improvements due in monthly and quarterly installments through February 2005 with interest ranging from 3.6% to 11.0% 11,809,000 11,794,000 Note payable to an investment company, uncollateralized with interest at 12.5%, payable quarterly, due in four quarterly installments beginning in 2005, including original issue premium 10,164,000 10,202,000 --------------- ---------------- 23,926,000 24,060,000 Less - current maturities 3,214,000 3,515,000 --------------- ---------------- $ 20,712,000 $ 20,545,000 =============== ================ The Company completed a $15,000,000 private placement of debt and equity with an investment company on September 16, 1998. Pursuant to the terms of the agreement, the Company tendered an unsecured subordinated note with a face value of $10,000,000 bearing interest of 12.5% with interest payable in quarterly installments until December 31, 2005, when the first of four quarterly principal installments is due. The Company also tendered 1,622,448 shares of redeemable common stock to the investment company. These shares are subject to repurchase by the Company under certain circumstances, or beginning September 16, 2003 at the holders option, at the then current average traded price of the stock. Prior to September 16, 2003, the Company was accreting the difference between the carrying value and the estimated redemption price of the stock by periodic charges / credits to additional paid-in capital. The Company is now adjusting the carrying value of the redeemable shares to the current average traded price of the stock. The Company obtained an independent fair value appraisal of the debt and equity instruments reflecting a fair value allocation of the debt of $10,365,000 and the fair value allocation of the redeemable common stock of $4,635,000. The original issue premium of $365,000 is being accreted as a reduction of interest expense over the term of the debt instrument. Debt issue costs of $1,654,000 (including $266,000 representing the fair value of warrants issued to financial advisors) have been allocated to the debt and redeemable common stock based upon their fair values. Costs of $511,000 allocated to the redeemable common stock reduced its original book value to $4,124,000. Costs of $1,143,000 allocated to the debt instrument are included in other assets and are being amortized to interest expense over the life of the debt instrument using the effective interest method. Certain notes payable to finance and investment companies contain covenants that require the Company, among other things, to maintain certain earnings and debt coverage ratios and receive approval for certain capital expenditures as defined in the agreements. The Company was in compliance with all debt covenants at September 30, 2003. Page 7 NOTE 3. STOCK OPTION PLAN The Company adopted a stock option plan (the "Plan") providing for the issuance of 250,000 shares of Class A common stock pursuant to both incentive stock options, intended to qualify under Section 422 of the Internal Revenue Code, and options that do not qualify as incentive stock options ("non-statutory"). The Option Plan was registered with the Securities and Exchange Commission in November 1995. The purpose of the Plan is to provide continuing incentives to the Company's officers, key employees, and members of the Board of Directors. The options generally vest within three years and have a ten year expiration period. The Company amended its Plan on December 1, 1996, increasing the number of shares available under the Plan to 600,000, and further amended its Plan on May 21, 2003, increasing the number of shares available to 700,000. Non-statutory options have been granted providing for the issuance of 619,680 shares of Class A common stock at exercise prices ranging from $1.32 to $4.25 per share. Options providing for the issuance of 540,144 shares were exercisable at September 30, 2003. NOTE 4. LITIGATION AND CONTINGENCIES The Company is a party to litigation arising in the normal course of business. Management believes that the ultimate outcome of these matters will not have a material effect on the Company's financial condition or results of operations. The Company holds a 15% equity interest in an assisted living center and has guaranteed debt related to the building of the investee. Debt payments are made by the investee semi-annually and range in amounts from $45,000 to $90,000 by the time of the final payment on May 1, 2016. The outstanding debt balance was $1,665,000 at September 30, 2003, was contingent, and was not recognized in the Company's consolidated financial statements. The Company would have the right to sell the living center as a going concern and use any proceeds, after payment of debts, to recover amounts owed to it by the living center in the event of default of the debt payments. The Company expects that the proceeds from the sale of the living center would exceed the existing debt. The Company believes the consolidation of this entity may be required under FIN 46 at December 31, 2003 (see note 6). Total assets of the assisted living center totaled $1,804,000 as of September 30, 2003, and losses for the nine months ending September 30, 2003 equaled $88,000. The Oklahoma Office of Juvenile Affairs (OJA), in a cost-cutting move, did not exercise the option for the final year of a five-year contract providing for the care of 80 juveniles at the Union City Juvenile Center. The contract expired on December 2, 2002 and as of October 31, 2003, the facility remains vacant while other sources of offenders are being sought. This was the first time the Company had not had a multi-year contract extension renewed. The contract is the only one the Company had with OJA. The Union City facility is a marketable facility and the Company is actively seeking a replacement population. The Company re-opened the Union City facility on October 31, 2003 to accommodate an overflow of approximately 25 private pay clients from the Company's Carver facility in Oklahoma City. Page 8 NOTE 5. EARNINGS PER SHARE The following table sets forth the computation of earnings per share and earnings per share assuming dilution. Three months ended Nine months ended September 30, September 30, 2003 2002 2003 2002 ------------ ------------ ------------- ------------ Numerator: Net income - basic $ 311,000 $ 185,000 $ 823,000 $ 780,000 Effect of dilutive securities: - interest reduction on assumed debenture conversions, net of income tax 43,000 43,000 130,000 130,000 ------------ ------------ ------------- ------------ Numerator for earnings per share, diluted $ 354,000 $ 228,000 $ 953,000 $ 910,000 ============ ============ ============= ============ Denominator for earnings per share: Weighted average shares outstanding - basic 4,896,615 4,894,628 4,895,545 4,876,664 Effect of dilutive securities: - debenture conversions 1,283,333 1,283,333 1,283,333 1,283,333 - stock options 7,799 56,477 2,364 91,162 - stock warrants --- 181,818 --- 238,636 ------------ ------------ ------------- ------------ Denominator for earnings per share, diluted 6,187,747 6,416,256 6,181,242 6,489,795 ============ ============ ============= ============ Income per share, basic $ 0.06 $ 0.04 $ 0.17 $ 0.16 ============ ============ ============= ============ Income per share, diluted $ 0.06 $ 0.04 $ 0.15 $ 0.14 ============ ============ ============= ============ Outstanding options and warrants of 1,297,780 for the three months ended September 30, 2003, 164,700 for the three months ended September 30, 2002, 1,297,780 for the nine months ended September 30, 2003, and 164,700 for the nine months ended September 30, 2002, have been excluded from the above calculations as they would be anti- dilutive. The average exercise prices of the excluded, anti-dilutive options and warrants were $1.75 for both the three months and the nine months ended September 30, 2003. For both the three and nine months ended September 30, 2002, the prices were $2.98. NOTE 6. RECENTLY ADOPTED ACCOUNTING STANDARDS In January 2003, the FASB issued Interpretation No.46, Consolidation of Variable Interest Entities (FIN 46). Subject to certain criteria defined in the Interpretation, FIN 46 will require consolidation by business enterprises of variable interest entities if the enterprise has a variable interest that will absorb the majority of the entity's expected losses, receives a majority of its expected returns, or both. The provisions of FIN 46 are effective immediately for interests acquired in variable interest entities after January 31, 2003, and at the beginning of the first interim or annual period beginning after June 15, 2003, for interests acquired in variable interest entities before February 1, 2003. The FASB has delayed the effective date until the end of the first interim or annual period ending after December 15, 2003 (for the Company, December 31, 2003). The Company is in the process of determining what impact, if any, the adoption of the provisions of FIN 46 will have upon its financial condition or results of operations. Certain transitional disclosures required by FIN 46 in all financial statements initially issued after January 31, 2003, have been included in note 4. Page 9 In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity" (SFAS 150). SFAS 150 changes the accounting for certain financial instruments that, under previous guidance, could be classified as equity or "mezzanine" equity, by now requiring those instruments to be classified as liabilities (or assets in some circumstances) in the Consolidated Balance Sheets. Further, SFAS 150 requires disclosure regarding the terms of those instruments and settlement alternatives. The guidance in SFAS 150 generally is effective for all financial instruments entered into or modified after May 31, 2003, and is otherwise effective at the beginning of the first interim period beginning after June 15, 2003. The Company has evaluated SFAS 150 and determined that it does not have an impact on its financial reporting and disclosures. NOTE 7. SUBSEQUENT EVENTS The Company manages an assisted living center and holds a 15% equity interest in the center. The Company also guarantees the indebtedness of approximately $1,665,000 on the center. The Company has pledged certain assets to obtain refinancing for the indebtedness maturing in November 2003. The Company also entered into a letter of intent in October 2003 to sell the assisted living center. Page 10 AVALON CORRECTIONAL SERVICES, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations This document contains statements that are not historical but are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These include statements regarding the expectations, beliefs, intentions or strategies for the future. The Company intends that all forward-looking statements be subject to the safe-harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements reflect the Company's views as of the date they are made with respect to future events and financial performance, but are subject to many uncertainties and risks which could cause the actual results of the Company to differ materially from any future results expressed or implied by such forward- looking statements. Examples of such uncertainties and risks include, but are not limited to: fluctuations in occupancy levels and labor costs; the ability to secure both new contracts and the renewal of existing contracts; the availability and cost of financing to redeem common shares and to expand the Company's business; and public resistance to privatization. Additional risk factors include those discussed in periodic reports filed by the Company from time to time. The Company does not undertake any obligation to update any forward-looking statements. Restatement - See Note 1 to the consolidated financial statements. Liquidity and Capital Resources - The Company's business strategy is to focus on the private community corrections industry, expanding its operations in existing and additional states through new federal and state contracts and selective acquisitions. The successful implementation of the Company's growth plan will create the need for additional capital and financing. Working capital at September 30, 2003 was $1,707,000 representing a current ratio of 1.36:1.00, compared to working capital of $1,130,000 and a current ratio of 1.23:1.00 at December 31, 2002. Capital expenditures have been $2,017,000 in 2003, compared to $653,000 in 2002. The 2003 capital expenditures include the expansion of the Phoenix Center to 208 beds, completed in June 2003. The 2002 capital expenditures include normal, operating purchases of vehicles, equipment, and building improvements, plus the beginning costs of the Phoenix Center expansion. The Company had approximately $4,232,000 of cash, short-term investments, and revolving credit available for new projects at September 30, 2003. The Company believes it has adequate cash reserves and cash flow from operations to meet its current cash requirements. The Company expects current contracts to generate sufficient income to increase cash balances. The Company has a senior credit facility with Fleet Capital Corporation consisting of a $13,500,000 term loan and a revolving line of credit equal to the lesser of $3 million or 80% of eligible accounts receivable. As of September 30, 2003, the balance of the term loan equaled $11,389,000 and the outstanding revolving line equaled $1,091,000. Results of Operations - Three Months Ended September 30, 2003 Compared to the Three Months Ended September 30, 2002. The Company's revenues decreased by 8% to $6,346,000 for the three months ended September 30, 2003 from $6,878,000 for the three months ended September 30, 2002. The decrease in net revenues was a result of the expiration of the Union City Juvenile Center contract in December 2002. The Union City revenues were $975,000 for the three months ended September 30, 2002. This reduction was partially offset by increased revenues of $443,000 from the Company's adult facilities. Earnings before interest, taxes, depreciation and amortization for the three months ended September 30, 2003 were $1,503,000 compared to $1,517,000 for the three months ended September 30, 2002. The decrease in earnings before interest, taxes, depreciation and amortization was a result of the expiration of the Union City Juvenile Center contract. Earnings before interest, taxes, depreciation and amortization can be reconciled to earnings before taxes by adding interest and depreciation and amortization expenses to net income before taxes. Page 11 Income before taxes increased 57% for the three months ended September 30, 2003 to $483,000 compared to $307,000 for the three months ended September 30, 2002. The increase in income before taxes was accomplished by increasing revenues at the adult facilities and the implementation of significant cost reductions by the Company. The Company's net income was $311,000 for the three months ended September 30, 2003 and $185,000 for the three months ended September 30, 2002. The increase of $126,000 in net income was a result of cost reduction efforts in direct and general and administrative expenses, lower depreciation and amortization, and lower interest expense, due to both lower rates and less outstanding debt. The Company's earnings per share were $.06 basic and diluted for the three months ended September 30, 2003 and $.04 basic and diluted for the three months ended September 30, 2002. Corporate. General and administrative expenses decreased 8% to $431,000 for the three months ended September 30, 2003, from $470,000 for the three months ended September 30, 2002. The decrease was a result of significant cost-containment efforts, particularly in the areas of personnel, travel and marketing, that were undertaken in light of the expiration of the Union City Juvenile Center contract. Interest expense decreased $83,000 for the three months ended September 30, 2003 versus the second quarter of 2002 as a result of lower interest rates and lower outstanding debt. Depreciation and amortization expenses decreased $107,000 as several assets were fully depreciated during 2002. Nine Months Ended September 30, 2003 Compared to the Nine Months Ended September 30, 2002. The Company's revenues decreased $1,619,000 to $18,628,000 for the nine months ended September 30, 2003 compared to $20,247,000 for the nine months ended September 30, 2002. The decreased revenues were a result of the expiration of the Union City Juvenile Center contract in December 2002. The Union City revenues were $2,866,000 for the nine months ended September 30, 2002. This reduction was partially offset by increased revenues of $1,247,000 from the Company's adult facilities. Earnings before interest, taxes, depreciation and amortization were $4,302,000 for the nine months ended September 30, 2003 compared to $4,692,000 for the nine months ended September 30, 2002. The decrease in earnings before interest, taxes, depreciation and amortization was a result of the expiration of the Union City Juvenile Center contract. Earnings before interest, taxes, depreciation and amortization can be reconciled to earnings before taxes by adding interest and depreciation and amortization expenses to net income before taxes. Income before taxes increased $174,000 to $1,259,000 for the nine months ended September 30, 2003 from $1,085,000 for the nine months ended September 30, 2002. The Company's net income was $823,000 for the nine months ended September 30, 2003 compared to $780,000 for the nine months ended September 30, 2002. The increase of $43,000 in net income was a result of cost reduction efforts in direct and general and administrative expenses, lower depreciation and amortization, and lower interest expense, due to both lower rates and less outstanding debt. The Company's earnings per share were $.17 basic and $.15 diluted for the nine months ended September 30, 2003, compared to $.16 basic and $.14 diluted for the nine months ended September 30, 2002. Corporate. General and administrative expenses decreased to $1,214,000 for the nine months ended September 30, 2003 compared to $1,547,000 for the nine months ended September 30, 2002. The decrease was a result of significant cost-containment efforts, particularly in the areas of personnel, travel and marketing. Interest expense decreased $195,000 for the nine months ended September 30, 2003 compared to the nine months ended September 30, 2002, as a result of lower interest rates and lower outstanding debt. Depreciation and amortization expenses decreased $369,000 as several assets were fully depreciated during 2002. Page 12 Critical Accounting Policies - Intangible assets. Three of Avalon's facilities - the Avalon Correctional Center, The Villa at Greeley and the Phoenix Center have intangible assets on their books representing the value allocated to the operating contracts at the time of their acquisition. Financial Accounting Standards Board SFAS 142, 'Goodwill and Other Intangible Assets, requires that intangible assets whose useful lives are estimated to be indefinite can no longer be amortized. Avalon originally determined these intangible assets had indefinite lives inasmuch as they relate to contracts that are renewable at minimal costs, are routinely renewed and are expected to be renewed for the foreseeable future. If the intangible assets are shown to be impaired in some future period, they are required to be written down to their fair value in the period when the impairment is ascertained. Intangible assets originally determined to have indefinite lives totaled $2,631,000 at September 30, 2003. Any impairments recorded would have an adverse effect on earnings, possibly materially, in the period the impairment is determined. During 2002, independent appraisals were obtained on the related properties. The value on each property was higher than the carrying value of the underlying intangible and tangible assets, so no impairment has been found to exist. Intangible assets are tested for impairment annually. The Company's 2002 financial statements and the interim financial statements included herein, have been restated to amortize contract intangibles over 15 years. See Note 1 to consolidated financial statements. Equity valuation. 1,622,448 shares of the Company's stock (approximately one-third of the issued and outstanding shares) have a put attached which can be exercised beginning in September 2003. This put is redeemable at the holder's option and requires the Company to purchase the stock at the market value. The stock is recorded on the Company's books at an estimated redemption value and is updated quarterly. This change in stock value is offset by an equal change to Paid-in Capital. Item 3. Quantitative and Qualitative Disclosures About Market Risk At September 30, 2003, approximately half of the Company's long-term debt was subject to variable interest rates ($12,600,000 of debt outstanding to Fleet Capital Corporation). The detrimental effect of a hypothetical 100 basis point increase in interest rates would be to reduce income before provision for income taxes by approximately $94,000 for the nine months ended September 30, 2003. Item 4. Controls and Procedures The Company's chief executive officer and its vice president of finance have evaluated the effectiveness of the Company's disclosure controls and procedures (as defined in Exchange Act Rules 13a-14(c) and 15d-14(c)) as of a date within 90 days of the filing date (the "Evaluation Date") of this quarterly report, and have concluded that as of the Evaluation Date, the Company's disclosure controls and procedures were adequate, effective, and ensure that material information relating to the Company and its consolidated subsidiaries would be made known to them timely by others within those entities. There were no significant changes in the Company's internal controls or in other factors that could significantly affect the Company's disclosure controls and procedures subsequent to the Evaluation Date, nor were there any significant deficiencies or material weaknesses in such disclosure controls and procedures requiring corrective actions. As a result, no corrective actions were taken. Page 13 AVALON CORRECTIONAL SERVICES, INC. AND SUBSIDIARIES PART II - OTHER INFORMATION Item 1 Legal Proceedings - None. Item 2. Changes in Securities - None. Item 3. Defaults Upon Senior Securities - None. Item 4. Submission of Matters to a Vote of Security Holders - None. Item 5. Other Information - None. Item 6. Exhibits and reports on Form 8-K - None. The following exhibits are filed as a part of this Quarterly Report on Form 10-Q: 31.1 Certification of the Chief Executive Officer of Avalon Correctional Services, Inc., pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of the Vice President of Finance of Avalon Correctional Services, Inc., pursuant to Section 302 of the Sarbanes -Oxley Act of 2002. 32.1 Certification of the Chief Executive Officer of Avalon Correctional Services, Inc., pursuant to 18 U.S.C. Section 1350, a adopted pursuant to Section 906 of the Sarbanes Oxley Act of 2002. 32.2 Certification of the Vice President of Finance of Avalon Correctional Services, Inc., pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes Oxley Act of 2002. Page 14 AVALON CORRECTIONAL SERVICES, INC. AND SUBSIDIARIES SIGNATURES In accordance with the requirement of the Exchange Act, the registrant has caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Date: February 27, 2004 AVALON CORRECTIONAL SERVICES, INC. By: s/ Donald E. Smith ------------------------------------------- Donald E. Smith, Chief Executive Officer By: s/ David Grose ------------------------------------------- David Grose, Vice President of Finance Page 15 Exhibit 31.1 CERTIFICATION I, Donald E. Smith, certify that: 1. I have reviewed this quarterly report on Form 10-Q/A of Avalon Correctional Services, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15 (e) and 15d-15 (e)) for the registrant and have: a. Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b. Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c. Disclosed in this report any changes in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a. all significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. February 27, 2004 /s/ Donald E. Smith Donald E. Smith Chief Executive Officer Exhibit 31.2 CERTIFICATION I, David Grose, certify that: 1. I have reviewed this quarterly report on Form 10-Q/A of Avalon Correctional Services, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15 (e) and 15d-15 (e)) for the registrant and have: a. Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b. Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c. Disclosed in this report any changes in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a. all significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. February 27, 2004 /s/ David Grose David Grose Vice President of Finance Exhibit 32.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Avalon Correctional Services, Inc. (the "Company") on Form 10-Q/A for the period ended September 30, 2003 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Donald E. Smith, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002, that to the best of my knowledge: (1) The Report fully complies with the requirements of section 13 (a) or 15 (d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. /s/ Donald E. Smith Donald E. Smith Chief Executive Officer February 27, 2004 Exhibit 32.2 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Avalon Correctional Services, Inc. (the "Company") on Form 10-Q/A for the period ended September 30, 2003, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, David Grose, Vice President of Finance of the Company, certify, pursuant to 18 U.S.C. section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002, that to the best of my knowledge: (1) The Report fully complies with the requirements of section 13 (a) or 15 (d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. /s/ David Grose David Grose Vice President of Finance February 27, 2004