NOTE 2. RESTATEMENT OF PREVIOUSLY ISSUED CONSOLIDATED FINANCIAL STATEMENTS

In this Amendment No.1 on Form 10-Q/A to the Company’s Quarterly Report on Form 10-Q for the three and six months ended June 30, 2012, we are restating the consolidated financial statements for the second quarter of 2012. Concurrent with the filing of this Form 10-Q/A, we are also filing amended quarterly reports on Form 10-Q/A for each of the first and third quarters of 2012 to restate our consolidated financial statements therein. The effects of these restatements, to the extent applicable, are reflected in the items revised herein. The restatements relate to the following:

· Correction in the application of the Company’s accounting for certain variable interest entities further described as follows:

As further discussed in Note 19, Variable Interest Entities, and Note 21, Related Party Transactions, found in the Company’s audited consolidated financial statements and notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 (the “Annual Report”), effective August 1, 2011 entities (the “Oklahoma Owners”) controlled by Christopher Brogdon and his spouse, Connie Brogdon (related parties to the Company) acquired five skilled nursing facilities located in Oklahoma (the “Oklahoma Facilities”). The Company entered into a Management Agreement with the Oklahoma Owners pursuant to which a wholly-owned subsidiary of the Company supervises the management of the Oklahoma Facilities for a monthly fee equal to 5% of the monthly gross revenues of the Oklahoma Facilities. Upon acquisition, the Company concluded it was the primary beneficiary of the Oklahoma Owners and pursuant to Financial Accounting Standards Board Accounting Standards Codification Topic 810-10, Consolidation-Overall, consolidated the Oklahoma Owners in its 2011 consolidated financial statements.

During the process of finalizing the 2012 consolidated financial statements, the Company re-assessed its prior conclusion that it should consolidate the Oklahoma Owners. In the reassessment process, the Company concluded that it should not have consolidated the Oklahoma Owners. In the accompanying consolidated financial statements, the Company has deconsolidated the Oklahoma Owners effective January 1, 2012 and the balance sheet, operations and cash flows of the Oklahoma Owners are not included in the Company’s 2012 consolidated financial statements. The Company further concluded that including the Oklahoma Owners in its 2011 consolidated financial statements was not material to such consolidated financial statements and therefore no adjustments have been made to the previously issued quarterly and annual 2011 consolidated financial statements.

· Accounting errors and certain accounting estimates that were identified in the process of finalizing our consolidated financial statements for the year ended December 31, 2012. These matters include the following for the six months ended June 30, 2012:

· Patient care revenues - Adjustments totaling $136,000 and $413,000 for the three and six months ended June 30, 2012, respectively, related primarily to the following items:

The timing of certain revenue recognition adjustments to ensure proper recognition in the appropriate interim reporting period with in the 2012 year. Adjustments totaling $136,000 for the three months ended June 30, 2012 related to the overstatement of $81,000 in managed care revenue due to billing errors and a $56,000 reclassification to reduce managed care revenue due to the improper recognition of bad debt expense subsequently identified by the Company. Adjustments totaling $413,000 for the six months ended June 30, 2012 relating to the overstatement of $221,000 in managed care revenue due to billing errors and a $192,000 reclassification to reduce managed care revenue due to the improper recognition of bad debt expense subsequently identified by the Company.

· Management revenues – Adjustments totaling $162,000 and $323,000 for the three and six months ended June 30, 2012, respectively, related primarily to the reversal of the eliminated management fee expense associated with the correction in the application of the Company’s accounting for certain variable interest entities which also has been recorded in costs of services for each period.

· Accounts receivable, net - Adjustments totaling $699,000 related primarily to the following:

The timing of certain revenue recognition adjustments to ensure proper recognition in the appropriate interim reporting period with in the 2012 year. Adjustments totaling $220,000 related to the overstatement in managed care revenue due to billing errors, the timing of the correction of certain operating and other costs incurred within the 2012 year that were deferred or capitalized to the balance sheet that should have been expensed in the interim reporting period in which the costs were incurred related to approximately $119,000, the issues primarily related to required adjustments resulting from the timing of recognition for state recoupments for Medicaid overpayments for certain facilities totaling $403,000, the delays in collection efforts and lack of timely follow-up on open patient accounts in 2012 for certain facilities totaling $284,000, offset by the reversal of the eliminated management fee expense and other receivables associated with the correction in the application of the Company’s accounting for certain variable interest entities in the amount of $327,000.

· Costs of services – Adjustments totaling $1,215,000 and $2,831,000 for the three and six months ended June 30, 2012, respectively, related primarily to the following items:

The timing of expense recognition related to direct care compensation obligations incurred for the facilities located in Arkansas to reflect proper recognition in the appropriate interim reporting period within the 2012 year. For the six months ended June 30, 2012 the adjustment totaled approximately $918,000 offset by the reversal of the overstated direct care compensation expense of $258,000 for the three months ended June 30, 2012 resulting in a $660,000 expense restatement for the six months ended June 30, 2012. The related expense and obligation was being recognized over the period until the respective payment date. However, the obligations should have been expensed immediately in the period incurred as the obligation related to prior services rendered.

The timing of recognition of certain payroll related operating expenses and other necessary adjustments to related accrued liabilities to ensure proper recognition in the appropriate interim reporting period within the 2012 year. The issues primarily relate to insufficient processes related to accounting for accrued vacation of $643,000 and $803,000 for the three and six months ended June 30, 2012, respectively and the untimely identification and recognition of expenses associated with certain unemployment tax accrual adjustments of $41,000 and $82,000 for the three and six months ended June 30, 2012, respectively.

The timing of the correction of certain operating and other costs incurred within the 2012 year that were deferred or capitalized to the balance sheet that should have been expensed in the interim reporting period in which the costs were incurred related to approximately $468,000 for the three months and the six months ended June 30, 2012 and the $3,000 and $5,000 of certain operating expenses that were not recorded in the interim reporting period for the three and six months ended June 30, 2012, respectively.

The adjustment of the reversal of the eliminated management fee expense associated with the correction in the application of the Company’s accounting for certain variable interest entities for approximately $162,000 and $323,000 for the three and six months ended June 30, 2012, respectively.

The timing of certain adjustments to the provision for bad debts in the appropriate interim reporting period within the 2012 year. The issues primarily related to required adjustments resulting from the timing of recognition for state recoupments for Medicaid overpayments for certain facilities totaling $403,000 for the six months ended June 30, 2012, the delays in collection efforts and lack of timely follow-up on open patient accounts in 2012 for certain facilities totaling $212,000 and $279,000 for the three and six months ended June 30, 2012, respectively, offset by the improper recognition of bad debt expense relating to managed care revenue discussed above in the amount of $56,000 and $192,000 for the three and six months ended June 30, 2012, respectively.

(Amounts in 000’s)	Three Months Ended June 30, 2012			Six Months Ended June 30, 2012

Cost of services (Exclusive of facility rent, depreciation and amortization):
1) Recognition of direct care compensation obligations incurred for the facilities located in Arkansas to reflect proper recognition in the appropriate interim reporting period with the 2012 year	$	(258	)	$	660
2) Recognition of certain payroll related operating expenses:				—
a) Incorrect accounting for accrued vacation	643			803
b) Untimely identification and recognition of expenses associated with certain unemployment tax accrual adjustments	41			82
3) Correction of certain operating and other costs incurred within the 2012 year that were incorrectly deferred or capitalized to the balance sheet that should have been expensed in the interim reporting period	468			468
4) Recognition of certain operating expenses that were not recorded in the interim reporting period	3			5
5) Reversal of the eliminated management fee expense associated with the correction in the application of the Company’s accounting for certain variable interest entities	162			323
6) Recognition of certain adjustments to the provision for bad debts in the appropriate interim reporting period within the 2012 year:
a) Untimely recognition of state recoupments for Medicaid overpayments for certain facilities	—			403
b) Delays in collection efforts and lack of timely follow-up on open patient accounts in 2012 for certain facilities	212			279
c) Offset by the improper recognition of bad debt expense relating to managed care revenue	(56		)	(192		)
Total	$	1,215		$	2,831

· General and administrative - Adjustments totaling $584,000 and $522,000 for the three and six months ended June 30, 2012, respectively, resulted primarily due to the following items:

The timing of certain payroll related operating expenses and other necessary adjustments to related accrued liabilities to ensure proper recognition in the appropriate interim reporting period within the 2012 year. The timing of the reversal of $700,000 expense relating to changes to the accrued performance-based incentive obligation during the three months ended June 30, 2012 offset by $25,000 of expense recognition related to an adjustment to the fair value of warrants granted to non-employees for the six months ended June 30, 2012.

The timing of the expense incorrectly capitalized on the balance sheet that should have been expensed in the interim reporting period in which the costs were incurred during the 2012 period of $53,000 and $74,000 for the three and six months ended June 30, 2012, respectively.

The insufficient processes related to accounting for accrued vacation of $62,000 and $77,000 for the three and six months ended June 30, 2012, respectively, and the untimely identification and recognition of expenses associated with certain unemployment tax accrual adjustments of $1,000 and $2,000 for the three and six months ended June 30, 2012.

(Amounts in 000’s)	Three Months Ended June 30, 2012			Six Months Ended June 30, 2012
General and administrative
1) Recognition of certain payroll related operating expenses and other necessary adjustments:
a) Reversal of expense relating to changes to the accrued performance-based incentive obligation	$	(700	)	$	(700	)
b) Offset by expense recognition related to an adjustment to the fair value of warrants granted to non-employees	—			25
2) Incorrect expense capitalized on the balance sheet that should have been expensed in the interim reporting period in which the costs were incurred during the 2012 period	53			74
3) Incorrect accounting for accrued vacation	62			77
4) Untimely identification and recognition of expenses associated with certain unemployment tax accrual adjustments	1			2
Total	$	(584	)	$	(522	)

· Interest expense, net — Adjustments totaling $350,000 and $349,000 for the three and six months ended June 30, 2012, respectively, related primarily to the following items:

The correction of interest capitalized on the balance sheet that should have been expensed in the interim reporting period in which the costs were incurred during the 2012 year was approximately $269,000 for the three and six months ended June 30, 2012.

The recognition of expense related to the fair value of warrants granted to non-employees in connection with loan financing fees of approximately $81,000 for the three and six months ended June 30, 2012.

(Amounts in 000’s)	Three Months Ended June 30, 2012		Six Months Ended June 30, 2012
Interest expense, net
1) Correction of interest capitalized on the balance sheet that should have been expensed in the interim reporting period in which the costs were incurred during the 2012	$	269	$	269
2) Recognition of expense related to the fair value of warrants granted to non-employees in connection with loan financing fees	81		81
3) Rounding	—		(1		)
Total	$	350	$	349

· Depreciation and amortization – Adjustments totaling a decrease of $37,000 and an increase $284,000 for the three and six months ended June 30, 2012, respectively related primarily to the impairment of an office building of $389,000 acquired through a 2011 acquisition that was vacated and abandoned in first quarter of 2012 to market value less cost to sell offset by $5,000 decrease in depreciation expense during the three months ended June 30, 2012 related to the office building impairment in first quarter of 2012 and $32,000 and $100,000 for the three and six months ended June 30, 2012, respectively, resulted from a decrease in amortization of certain intangibles related to adjustments that decreased the underlying intangible asset values and increased the related goodwill resulting from the respective acquisitions.

· Property and equipment, net – Adjustments of $1,523,000 related primarily to the $389,000 impairment of an office building acquired in 2011 acquisition offset by a $5,000 decrease in depreciation expense during the three months ended June 30, 2012 related to the office building impairment in first quarter of 2012; $100,000 decrease in amortization of certain intangibles related to adjustments that decreased the underlying intangible asset values and increased the related goodwill resulted from the respective acquisitions of $547,000 and $692,000 of expense inadvertently capitalized on the balance sheet that should have been expensed in the interim reporting period in which the costs were incurred during the 2012 period.

· Goodwill and Intangible assets bed licenses - Adjustments of $635,000 related to an acquisition reclassification to goodwill from the capitalized intangible assets bed licenses of $87,000 and $547,000 from property and equipment during the 2012 period.

· Deferred loan costs, net – Adjustment of $94,000 related to an adjustment to the fair value of warrants granted to non-employees which related to the costs incurred in connection with loan costs.

· Current portion of notes payable and other debt – Reclassification of the PrivateBank loan from long-term debt to current as a result of a loan modification agreement with PrivateBank that, among other things, amended the loan agreement to reflect a maturity date of March 30, 2013. The Company anticipates that it will re-finance the PrivateBank loan later this year with long-term financing; however, the Company does not have a formal noncancelable agreement with PrivateBank. As such, the entire balance is reflected as a current obligation at June 30, 2012 in the amount of $21.3 million.

· Revolving credit facilities and lines of credit – Reclassification of the Gemino Credit Facility from long-term Revolving credit facilities as a result of the Company’s termination and pay off of the amounts outstanding under that certain Credit Agreement, dated October 29, 2010, between Gemino and the Company on September 20, 2012. As such, the entire balance is reflected as a current obligation at June 30, 2012, in the amount of $7.0 million.

· Statement of cash flows – Adjustments to the statement of cash flows result primarily from the adjustments related to the Oklahoma Owners as discussed above; changes in net loss and the related adjustments to the various working capital related balance sheet accounts resulting from the other adjustments described above; and adjustments to show $31.4 million of debt incurred in conjunction with certain acquisitions as cash provided by financing activities and cash used in investing activities.

The following table presents the Company’s previously issued (the “As Reported”) and restated (the “As Restated”) consolidated balance sheet as of June 30, 2012 (in thousands):

	At June 30, 2012
	As Reported			Oklahoma Owners			Other Adjustments			As Restated
ASSETS
Cash and cash equivalents	$	9,373		$	(300	)	$	—		$	9,073
Restricted cash and investments	3,624			—			—			3,624
Accounts receivable, net	26,964			(1,138		)	(699		)	25,127
Prepaid expenses and other	668			(143		)	—			525
Assets of disposal group held for sale	38			—			—			38
Total current assets	40,667			(1,581		)	(699		)	38,387

Restricted cash and investments	5,812			—			—			5,812
Property and equipment, net (net of reclassification of $2,694) (Note 1)	144,399			(9,952		)	(1,523		)	132,924
Intangible assets – bed licenses	2,464			—			(87		)	2,377
Intangible assets – lease rights, net	7,925			—			—			7,925
Goodwill (reclassification of $2,694) (Note 1)	3,600			(1,123		)	635			3,112
Escrow deposits for acquisitions	1,513			—			—			1,513
Lease deposits	1,725			—			—			1,725
Deferred loan costs, net	5,733			(558		)	94			5,269
Other assets	71			—			—			71
Total assets	$	213,909		$	(13,214	)	$	(1,580	)	$	199,115

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current portion of notes payable and other debt	$	9,401		$	(196	)	$	21,280		$	30,485
Revolving credit facilities and lines of credit	1,900			—			5,164			7,064
Accounts payable	16,601			(1,320		)	328			15,609
Accrued expenses	11,424			(449		)	818			11,793
Liabilities of disposal group held for sale	143			—			—			143
Total current liabilities	39,469			(1,965		)	27,590			65,094
Senior debt, net of discounts	116,603			(12,288		)	(21,277		)	83,038
Convertible debt, net of discounts	15,035			—			—			15,035
Revolving credit facilities	7,064			—			(5,164		)	1,900
Other debt	12,880			—			—			12,880
Derivative liability	1,127			—			—			1,127
Other liabilities	1,729			—			—			1,729
Deferred tax liability	87			—			32			119
Total liabilities	193,994			(14,253		)	1,181			180,922
Common stock and additional paid-in capital	39,647			—			199			39,846
Accumulated deficit	(18,240		)	—			(2,945		)	(21,185		)
Total stockholders’ equity	21,407			—			(2,746		)	18,661
Noncontrolling interest in subsidiaries	(1,492		)	1,039			(15		)	(468		)
Total equity	19,915			1,039			(2,761		)	18,193
Total liabilities and equity	$	213,909		$	(13,214	)	$	(1,580	)	$	199,115

The following tables present the Company’s previously issued (the “As Reported”) and restated (the “As Restated”) consolidated statement of operations for the three and six months ended June 30, 2012 (in thousands, except per share information):

	Three Months Ended June 30, 2012
	As Reported			Oklahoma Owners			Other Adjustments			As Restated

Revenues
Patient care revenues	$	54,642		$	(3,240	)	$	(136	)	$	51,266
Management revenues	363			—			162			525
Total revenues	55,005			(3,240		)	26			51,791

Expenses:
Cost of services (Exclusive of facility rent, depreciation and amortization)	42,227			(3,126		)	1,215			40,316
General and administrative	4,929			—			(584		)	4,345
Facility rent expense	2,050			—			—			2,050
Depreciation and amortization	1,761			(130		)	(37		)	1,594
Total expenses	50,967			(3,256		)	594			48,305

Income from Operations	4,038			16			(568		)	3,486

Other Income (Expense):
Interest expense, net	(3,366		)	272			(350		)	(3,444		)
Acquisition costs, net of gains	(524		)	—			—			(524		)
Derivative gain	353			—			—			353
Other expense	(13		)	—			—			(13		)
Total other expense, net	(3,550		)	272			(350		)	(3,628		)

Income (Loss) from Continuing Operations Before Income Taxes	488			288			(918		)	(142		)
Income Tax Benefit (Expense)	(45		)	—			12			(33		)
Income (Loss) from Continuing Operations	443			288			(906		)	(175		)
Loss from discontinued operations, net of tax	(160		)	—			(10		)	(170		)
Net Income (Loss)	283			288			(916		)	(345		)
Net Income (Loss) Attributable to Noncontrolling Interest	396			(288		)	33			141
Net Income (Loss) Attributable to AdCare Health Systems, Inc.	$	679		$	—		$	(883	)	$	(204	)

Net Income (Loss) per Common Share - Basic:
Continuing Operations	$	0.06		$	(0.00	)	$	(0.06	)	$	0.00
Discontinued Operations	(0.01		)	—			—			(0.01		)
	$	0.05		$	(0.00	)	$	(0.06	)	$	(0.01	)

Net Income (Loss) per Common Share - Diluted
Continuing Operations	$	0.06		$	(0.00	)	$	(0.06	)	$	0.00
Discontinued Operations	(0.01		)	—			—			(0.01		)
	$	0.05		$	(0.00	)	$	(0.06	)	$	(0.01	)

	Six Months Ended June 30, 2012
	As Reported			Oklahoma Owners			Other Adjustments			As Restated

Revenues
Patient care revenues	$	104,450		$	(6,464	)	$	(413	)	$	97,573
Management revenues	726			—			323			1,049
Total revenues	105,176			(6,464		)	(90		)	98,622

Expenses:
Cost of services (Exclusive of facility rent, depreciation and amortization)	82,350			(6,058		)	2,831			79,123
General and administrative	8,860			—			(522		)	8,338
Facility rent expense	4,115			—			—			4,115
Depreciation and amortization	3,258			(238		)	284			3,304
Total expenses	98,583			(6,296		)	2,593			94,880

Income from Operations	6,593			(168		)	(2,683		)	3,742

Other Income (Expense):
Interest expense, net	(6,320		)	547			(349		)	(6,122		)
Acquisition costs, net of gains	(817		)	—			—			(817		)
Derivative gain	763			—			—			763
Other expense	(29		)	—			2			(27		)
Total other expense, net	(6,403		)	547			(347		)	(6,203		)

Income (Loss) from Continuing Operations Before Income Taxes	190			379			(3,030		)	(2,461		)
Income Tax Benefit (Expense)	(99		)	—			81			(18		)
Income (Loss) from Continuing Operations	91			379			(2,949		)	(2,479		)
Loss from discontinued operations, net of tax	(269		)	—			(10		)	(279		)
Net Loss	(178		)	379			(2,959		)	(2,758		)
Net Income (Loss) Attributable to Noncontrolling Interest	651			(379		)	14			286
Net Income (Loss) Attributable to AdCare Health Systems, Inc.	$	473		$	—		$	(2,945	)	$	(2,472	)

Net Income (Loss) per Common Share - Basic:
Continuing Operations	$	0.06		$	(0.00	)	$	(0.23	)	$	(0.17	)
Discontinued Operations	$	(0.02	)	—			—			$	(0.02	)
	$	0.04		$	(0.00	)	$	(0.23	)	$	(0.19	)

Net Income (Loss) per Common Share - Diluted
Continuing Operations	$	0.06		$	(0.00	)	$	(0.23	)	$	(0.17	)
Discontinued Operations	$	(0.02	)	—			—			$	(0.02	)
	$	0.04		$	(0.00	)	$	(0.23	)	$	(0.19	)

The following table presents the Company’s previously issued (the “As Reported)” and restated (the “As Restated”) consolidated statement of cash flows for the six months ended June 30, 2012 (in thousands):

	Six Months Ended June 30, 2012
	As Reported			Oklahoma Owners			Other Adjustments			As Restated
Cash flows from operating activities:
Net loss	$	(178	)	$	380		$	(2,960	)	$	(2,758	)
Loss from discontinued operations, net of tax	269			—			10			279
Loss from continuing operations	91			380			(2,950		)	(2,479		)
Adjustments to reconcile net loss from continuing operations to net cash provided by operating activities:
Depreciation and amortization	3,258			(238		)	284			3,304
Warrants issued for services	—			—			—			—
Stock based compensation expense	347			—			24			371
Lease expense in excess of cash	291			—			—			291
Amortization of deferred financing costs	975			(105		)	107			977
Amortization of debt discounts	429			—			(2		)	427
Derivative gain	(763		)	—			—			(763		)
Deferred tax expense	1			—			32			33
Gain on disposal of assets	(2		)	—			—			(2		)
Provision for bad debts	1,233			(52		)	495			1,676
Other noncash items	29			—			(29		)	—
Changes in certain assets and liabilities, net of acquisitions:
Accounts receivable	(9,306		)	389			97			(8,820		)
Prepaid expenses and other	(4		)	107			(1		)	102
Other assets	50			57			49			156
Accounts payable and accrued expenses	5,081			(953		)	980			5,108
Net cash provided by operating activities — continuing operations	1,710			(415		)	(914		)	381
Net cash used in operating activities — discontinued operations	(426		)	—			157			(269		)
Net cash provided by operating activities	1,284			(415		)	(757		)	112

Cash flows from investing activities:
Proceeds from sale of property and equipment	3			—			—			3
Change in restricted cash and investments and escrow deposits for acquisitions	(485		)	—			(2,198		)	(2,683		)
Acquisitions	(8,849		)	—			(27,806		)	(36,655		)
Purchase of property and equipment	(2,569		)	201			692			(1,676		)
Net cash used in investing activities — continuing operations	(11,900		)	201			(29,312		)	(41,011		)
Net cash used in investing activities — discontinued operations	—			—			—			—
Net cash used in investing activities	(11,900		)	201			(29,312		)	(41,011		)
Cash flows from financing activities:
Proceeds from debt	11,515			—			35,673			47,188
Debt issuance costs	(205		)	—			(1,321		)	(1,526		)
Change in line of credit	312			—			1			313
Exercise of warrants and options	95			—			—			95
Proceeds from stock issuances, net	3,768			—			—			3,768
Repayment of notes payable	(2,763		)	94			(4,284		)	(6,953		)
Net cash provided by financing activities — continuing operations	12,722			94			30,069			42,885
Net cash used in financing activities — discontinued operations	(97		)	—			—			(97		)
Net cash provided by financing activities	12,625			94			30,069			42,788

Net Change in Cash	2,009			(120		)	—			1,889
Cash, Beginning	7,364			(180		)	—			7,184
Cash, Ending	$	9,373		$	(300	)	$	—		$	9,073

Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest	$	4,630		$	—		$	1,177		$	5,807
Income taxes	$	46		$	—		$	(46	)	$	—
Supplemental Disclosure of Non-cash Activities:
Acquisitions in exchange for debt and equity instruments	$	32,720		$	—		$	(27,720	)	$	5,000
Warrants issued for financings costs	$	390		$	—		$	175		$	565
Noncash debt issuance costs	$	3,490		$	—		$	(3,490	)	$	—