UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

          For the quarterly period ended March 27, 2004

OR

          For the transition period from                   to                   

Commission file number 0-16453

HearUSA, Inc.

          Registrant’s Telephone Number, Including Area Code (561) 478-8770

          Indicate by check Ö 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 such filing requirements for the past 90 days Yes þ No o

          Indicate by check Ö whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

          On April 30, 2004, 29,672,848 shares of the Registrant’s Common Stock and 750,788 exchangeable shares of HEARx Canada, Inc. were outstanding.

INDEX

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Part I – Financial Information

Item 1. Financial Statements

HearUSA, Inc.
Consolidated Balance Sheets

See accompanying notes to the consolidated financial statements

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HearUSA, Inc.
Consolidated Statements of Operations
Three Months Ended March 27, 2004 and March 29, 2003

See accompanying notes to the consolidated financial statements

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HearUSA, Inc.
Consolidated Statements of Cash Flows
Three Months Ended March 27, 2004 and March 29, 2003

See accompanying notes to consolidated financial statements

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HearUSA, Inc.
Notes to Consolidated Financial Statements

The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation have been included. Operating results for the three month period ended March 27, 2004 are not necessarily indicative of the results that may be expected for the year ending December 25, 2004. For further information, refer to the audited consolidated financial statements and footnotes thereto included in the Company’s annual report on Form 10-K for the year ended December 27, 2003.

1. Description of the Company and Summary of Significant Accounting Policies

The Company

HearUSA Inc. (“HearUSA” or the “Company”), a Delaware corporation, was organized for the purpose of creating a nationwide chain of centers to serve the needs of the hearing impaired. As of March 27, 2004, the Company has a network of 156 company-owned hearing care centers in 11 states and the Province of Ontario, Canada. The Company also sponsors a network of approximately 1,400 credentialed audiology providers that participate in selected hearing benefit programs contracted by the company with employer groups, health insurers and benefit sponsors in 49 States. The centers and the network providers provide audiological products and services for the hearing impaired.

Basis of consolidation

The consolidated financial statements include the accounts of the Company and its wholly owned and majority controlled subsidiaries. Intercompany accounts and transactions have been eliminated in consolidation.

Income (loss) per common share

Net income (loss) per common share is calculated in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 128 “Earnings Per Share” which requires companies to present basic and diluted earnings per share. Net income (loss) per common share – basic is based on the weighted average number of common shares outstanding during the year. Net income (loss) per common share – diluted is based on the weighted average number of common shares and dilutive potential common shares outstanding during the year. Convertible subordinated notes, mandatorily redeemable convertible preferred stock, convertible preferred stock, stock options and stock warrants are excluded from the computations of net loss per common share because the effect of their inclusion would be anti-dilutive.

Due to the Company’s net loss in the first quarter of 2004, the following common stock equivalents for convertible subordinated notes, mandatorily redeemable convertible preferred stock, outstanding options and warrants to purchase common stock of 9,500,768 were excluded from the computation of net loss per common share – diluted at March 27, 2004 because they were anti-dilutive. For purposes of computing net income (loss) per common share – basic and diluted, for the quarters ended March 27, 2004 and March 29, 2003, the weighted average number of shares of common stock outstanding includes the effect of the 750,788 and 3,456,793, respectively, exchangeable shares of HEARx Canada, Inc., as if they were outstanding common stock of the Company on June 30, 2002, the effective date of the combination with Helix for financial reporting purposes.

Comprehensive income

Comprehensive income is defined to include all changes in equity except those resulting from

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HearUSA, Inc.
Notes to Consolidated Financial Statements

investments by owners and distributions to owners. The Company’s other comprehensive income represents a foreign currency translation adjustment.

Comprehensive income (loss) and the components of other comprehensive income are as follows:

Stock-based compensation

The Company has granted stock options to employees and directors under stock option plans. The Company accounts for those plans using the intrinsic value method under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”. Stock-based employee compensation cost reflected in net income (loss) is not significant, as all options granted under those plans had an exercise price greater than or equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income (loss) and income (loss) per share if the Company had applied the fair value recognition provisions of SFAS No. 123, (“SFAS 123”) “Accounting for Stock-Based Compensation”, to stock-based employee compensation:

For purposes of the above disclosure, the determination of the fair value of stock options granted in 2004 and 2003 was based on the following: (i) a risk free interest rate of 2.23%, and 3.42% respectively; (ii) expected option lives ranging from 5 to 7 years; (iii) expected volatility in the market price of the Company’s common stock of 94% and 95%, respectively; and (iv) no dividends on the underlying common stock.

Reclassifications

Certain amounts in the 2003 consolidated financial statements have been reclassified in order to conform to the 2004 presentation.

2. Stockholders’ Equity

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HearUSA, Inc.
Notes to Consolidated Financial Statements

Common stock

During the quarter ended March 27, 2004, 75,000 employee options were issued at an exercise price of $2.31 and no employee options or warrants were exercised.

3. Convertible Subordinated Notes

On December 19, 2003, the Company completed a private placement of $7.5 million five-year convertible subordinated notes with five-year warrants to purchase 2,642,750 shares of the Company’s common stock. The notes may not be converted and warrants to purchase 2,142,750 shares may not be exercised for a two-year period. The remaining warrants to purchase 500,000 shares are exercisable beginning in June 2005 at $1.75 per share. Beginning in December 2005 the notes may be converted at $1.75 per share and the warrants may be exercised for up to 2,142,750 shares at $1.75 per share. The quoted closing market price of the Company’s common stock on the commitment date was $2.37 per share. The notes bear interest at 11 percent per annum for the first two years and then at 8 percent per annum through the remainder of their term.

Proceeds from this financing have been used to repay the $2 million financing issued on October 3, 2003. In addition approximately $1.8 million of the net proceeds were used to make payments to Siemens in early fiscal 2004 under the Credit Agreement, including 50% against the Tranche D Loan and 50% against the Tranche E Loan. The balance of the net proceeds was used for working capital. As of December 27, 2003, $500,000 of the financing proceeds was recorded as a subscription receivable under the caption accounts and notes receivable in the accompanying consolidated balance sheet, and was received in January 2004.

For the first two years of the term of the convertible subordinated notes, beginning on March 25, 2004, the Company will make quarterly payments of interest only. Beginning on March 25, 2006, the Company will make twelve equal quarterly payments of principal plus interest. Payments of interest and principal may be made, at the Company’s option, in cash or with the Company’s common stock. If payments are made using the Company’s common stock the shares to be issued would be computed at 90% of the average closing price for the 20 day trading period immediately preceding the payment date. Approximate aggregate amount of maturities of the convertible subordinated notes maturing in future years as of March 27, 2004, is $2,500,000 in each of 2006, 2007 and 2008.

In addition to the 2,642,750 common stock purchase warrants issued to the investors in the $7.5 million financing, the Company also issued 117,143 common stock purchase warrants with the same terms as the lender warrants and paid cash of approximately $206,000 to third parties as finder fees and financing costs. These warrants were valued at approximately $220,000 using a Black-Scholes option pricing model. The total of such costs of approximately $426,000 are being amortized as interest expense using the effective interest method over the five year term of the notes.

The Company recorded a “debt discount” of approximately $7,488,000 consisting of the intrinsic value of the beneficial conversion of approximately $4,519,000 and the portion of the proceeds allocated to the warrants issued to the lenders of approximately $2,969,000, using the Black-Scholes option pricing model, based on the relative fair values of the warrants and the notes. The “debt discount” is being amortized as interest expense over the five-year term of the notes using the effective interest method.

During the first quarter of 2004, approximately $723,000 of prepaid financing fees and debt discount was amortized as interest expense, including a non-cash portion of approximately $532,000. The future amortization non-cash debt discount and prepaid finder fees will be amortized as interest expense over the next five years are approximately $1,595,000 for the remainder of 2004, $2,151,000 in 2005, $1,763,000 in 2006, $1,145,000 in 2007 and $434,000 in 2008. In the event the investors convert or exercise the debt or

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HearUSA, Inc.
Notes to Consolidated Financial Statements

warrants, the Company will be required to accelerate the debt discount to the period in which the exercise or conversion occurs.

4. Discontinued Operations

On July 15, 2003, the Company sold 100% of the shares of the Company’s three subsidiaries and selected assets associated with the management of the centers located in the Canadian Province of Quebec, to Forget & Sauve, Audioprothesistes, S.E.N.C. (“Forget & Sauve”) and 6068065 Canada Inc., private entities owned and controlled by Steve Forget, a former Helix officer and director. Mr. Forget served as an officer of HearUSA until October 2002 and as a director until May 2003. The sale agreement provided for total payments to the Company of approximately $1.7 million, which included in part payment of pre-existing debt, owed the Company by Forget & Sauve of approximately $1.6 million. The Company received an initial cash payment of $700,000 at closing and $1 million over the five following months, including an amount of approximately $103,000 received in January 2004.

The three Quebec subsidiaries and selected assets have been presented as a discontinued operation and the consolidated financial statements have been reclassified to segregate the assets, liabilities and operating results of these subsidiaries for all periods presented. The sale resulted in a loss on disposal of approximately $105,000 recorded in the second quarter of 2003. Net revenues of the discontinued operations for the quarter ended March 29, 2003 were approximately $1,168,000 and pre-tax net income of the discontinued operations was $43,478.

5. Segments

The Company operates in three business segments, which include the operation and management of centers, the establishment, maintenance and support of an affiliated network and the operation of an e-commerce business. The Company’s business units are located in the United States and Canada.

Incomes (losses) from operations at the segment level are computed before general and administrative expenses.

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HearUSA, Inc.
Notes to Consolidated Financial Statements

Information in U.S. Dollars concerning geographic areas as of and for the quarters ended March 27, 2004 and March 29, 2003 are as follows:

Net revenues by geographic area are allocated based on the location of the subsidiary operations.

6. Recent Accounting Pronouncements

Effective July 1, 2003, the Company adopted EITF Issue No. 00-21 (“EITF 00-21”), “Accounting For Revenue Arrangements with Multiple Deliverables”, which establishes criteria for whether revenue on a deliverable can be recognized separately from other deliverables in a multiple deliverable arrangement. The criteria considers whether the delivered item has stand-alone value to the customer, whether the fair value of each of the deliverable items can be reliably determined and the customer’s right of return for the delivered items. The Company’s adoption of EITF 00-21 did not have an effect on its consolidated financial statements.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” It is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. This Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. This Statement did not have a material effect on the Company’s consolidated results of operations or financial position.

7. Liquidity

Working capital decreased $1.5 million to a working capital deficit of $3.8 million as of March 27, 2004 from a working capital deficit of $2.3 million as of December 27, 2003. The working capital deficit of $3.8 million includes approximately $2.9 million representing the current portion of the long-term debt to Siemens for Tranches A, B and C, which may be repaid through preferred pricing reductions. In the first quarter of 2004, the Company incurred losses from operations of approximately $269,000 compared to income generated from operations of $825,000 in 2003. Cash and cash equivalents as of March 27, 2004 was approximately $2.6 million.

The Company believes that the shortfall in revenues in the first quarter of 2004 was not lost revenues but delayed revenues attributable to delays in the Company’s contract with the Department of Veteran Affairs and managed care contracts and related promotions. The Company expects such revenues to occur in the remainder of 2004. The Company believes that current cash and cash equivalents and expected cash flow from operations will be sufficient to support the Company’s operational needs through the next twelve months. There can be no assurance, however, that the Company will achieve its expected cash from operations or that net revenue levels will increase above the current level and that unexpected cash needs will not arise

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HearUSA, Inc.
Notes to Consolidated Financial Statements

for which the cash, cash equivalents and cash flow from operations will be sufficient. In the event of a shortfall in cash, the Company would consider short-term debt, or additional equity or debt offerings. There can be no assurance however, that such financing will be available to the Company on favorable terms or at all. The Company also is continuing its aggressive cost controls and sales and gross margin improvements.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

GENERAL

In the first quarter of 2004, the Company generated a net of loss of approximately $1.6 million, compared to a net income of approximately $201,000 in 2003. The first quarter of 2004 loss includes a non-cash interest expense of approximately $532,000 representing the amortization of the debt discount related to the $7.5 million convertible subordinated notes financing completed in December 2003.

RESULTS OF OPERATIONS

For the three months ended March 27, 2004 compared to the three months ended March 29, 2003

Net revenues in the first quarter of 2004 decreased approximately $477,000, or 2.7%, compared to the first quarter in 2003. This decrease was net of an increase of approximately $190,000 related to a favorable change in the average Canadian exchange rate from 2003 to 2004. The gross decrease of approximately $667,000 is mainly due to a decrease of approximately 8.8% in hearing aids sold during the quarter representing approximately $1.4 million in decreased revenues, offset by an increase in the average selling price of approximately 5.2% representing approximately a $720,000 increase in revenues. Unlike the first quarter of 2003, the first quarter of 2004 did not benefit from an aggregate of approximately $1.5 million in revenues from income of a special contract and an excess of undelivered hearing aids from the prior quarter. As of March 27, 2004, the cumulative amount of preferred pricing reductions received from Siemens is approximately $6,751,000, reducing the original debt (Tranches A, B and C) from approximately $14,104,000 to $ 7,353,000.

Cost of products sold in the first quarter of 2004 increased approximately $174,000, or 3.6%, compared to the first quarter in 2003. Included in the cost of products sold are preferred pricing reductions of approximately $938,000 and $1,006,000 for the first quarter 2004 and the first quarter 2003. Such pricing reductions from Siemens are accounted for as reductions of cost of products sold for financial reporting purposes and applied, pursuant to the credit agreement, against the principal and interest payments due on Tranches A, B and C. The cost of products sold as a percent of net revenues was 29.5% and 27.7% for the first quarter 2004 and the first quarter 2003, respectively. The increase in cost of products sold, in dollars and as a percent of net revenues is attributable to increases in prices from our vendors and a change in the mix of products sold. The increase, as a percent of net revenues, was partially offset by an increase in average selling price mentioned.

Center operating expenses increased approximately $727,000, or 8.6%, in the first quarter of 2004 compared to the first quarter of 2003. This increase is mainly attributable to an increase in compensation and marketing in 2004 compared to 2003 of approximately $350,000 and $300,000, respectively. The increase in compensation is attributable in part to annual increases to employees at the center level and in part to commissions and bonuses. The increase in commissions and bonuses is due to changes to some of the compensation programs during the second quarter of 2003 and the increases in the number of centers achieving their revenue goal in the first quarter of 2004 compared to the first quarter of 2003. The increase in marketing is attributable to increase in the frequency in the Company’s advertising to the private pay sector compared to the first quarter of the prior year.

General and administrative expenses for the quarter remained constant as compared to the year ago period at approximately $2.4 million.

Depreciation and amortization expense decreased $294,000 or 32.3% in 2003. This decrease is due to certain property and equipment being fully depreciated.

Interest expense increased $650,000 or 124% in the first quarter of 2004 compared to the first quarter in 2003, of which approximately $532,000 is non-cash as explained below. This increase is attributable to approximately $67,000 in interest on the credit facility with Siemens due to the issuance of Tranche E in

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March 2003 and approximately $723,000 of interest (including the non-cash portion) on the $7.5 million financing that was completed in December 2003. These increases were offset by a decrease of approximately $140,000 in interest on existing balances due to repayments of principal during 2003.

The non-cash charge of $532,000 included in the interest expense is the amortization of the debt discount resulting from the intrinsic value of the beneficial conversion option, and the proceeds allocated to the warrants to purchase 2,642,750 shares of the Company’s common stock based on relative fair values of the $7.5 million financing in December 2003. This non-cash charge does not have an impact on the liquidity and working capital of the Company.

LIQUIDITY AND CAPITAL RESOURCES

The Company has a secured credit facility from Siemens comprised of (a) a $10,875,000 five-year term loan credit facility (the Tranche A Loan); (b) a $25,000,000 five-year revolving loan credit facility (the Tranche B Loan); (c) a $3,000,000 five-year term loan facility (the Tranche C Loan); (d) a $13,000,000 five-year term loan credit facility (the Tranche D Loan); and (e)a $3,500,000 five-year term loan (the Tranche E loan). At March 27, 2004, $5,324,991, $78,000, $1,950,000, $12,090,250 and $2,590,250, respectively, representing principal on the Tranche A, Tranche B, Tranche C, Tranche D, and Tranche E Loans, were outstanding. As of March 27, 2004, approximately $24,905,000 is available to the Company for acquisitions under Tranche B of the credit facility.

The Tranche A, B and C Loans are payable quarterly over five years with the outstanding principal and interest at 10%, due and payable on the final maturity date. Principal and interest, at prime (as defined) plus 1%, on the Tranche D Loan is payable on the final maturity date. The Company is required to make monthly payments of interest only, at a rate of 10% per annum, on the Tranche E Loan in the first year. In years two through five, the Company must make monthly principal and interest payments. Quarterly principal and interest payments on the Tranche A, B and C Loans may be paid through preferred pricing reductions received from Siemens by HearUSA as long as the Company purchases certain minimum percentages of its requirements of hearing aids from Siemens. During the first quarter of 2004 and 2003, approximately $938,000 and $1,006,000, of earned preferred pricing reductions, were recorded as a reduction of cost of products sold, and $208,000 and $281,000 of interest, and $730,000 and $725,000 of principal, has been repaid through such preferred pricing reductions. The Company is also required to make additional payments on the Tranche D Loan under the following conditions: The Company must make a payment equal to 25% of net proceeds it receives from the issuance of stock or stock equivalents. In addition, within 120 days of any fiscal year end, the Company must make a payment equal to 20% of “Excess Cash Flow” (as defined in the credit agreement) for such fiscal year end. As a result of the December 2003 financing, the Company paid Siemens approximately $1.8 million in January of 2004, of which approximately $910,000 million was to against Tranche D and approximately $910,000 to Tranche E, based on approval by Siemens of the application of these payments. Also, the Company paid an amount of approximately $314,000 on April 30, 2004 to Siemens representing the payment equal to 20% of the Company’s 2003 “Excess Cash Flow”.

The Siemens credit facility includes certain financial and other covenants of the Company, which are customary for loans of this size and nature, including restrictions on the conduct of the Company’s business, the occurrence of indebtedness, merger or sale of assets, the modification of material agreements, changes in capital structure, making certain payments and paying dividends. If the Company cannot maintain compliance with these covenants, Siemens may terminate future funding under the credit facility and declare all then outstanding amounts under the facility immediately due and payable. Also, the Company’s supply agreement with Siemens requires full payment for hearing aids purchased from Siemens within 60 days from statement date. As of March 27, 2004, the Company was in compliance with those payment provisions. In the event of noncompliance, Siemens may declare the Company to be in default of the supply agreement by written notification, which, if not cured within 60 days of the date of written notification, would be an event of default under the Company’s credit facility with Siemens and Siemens would have the right to declare all amounts outstanding under the credit facility immediately due and payable. Any non-compliance with the supply agreement could have a material adverse effect on the Company’s financial condition and continued operations.

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As of March 27, 2004, working capital decreased $1.5 million to a working capital deficit of $3.8 million, from a working capital deficit of $2.3 million as of December 27, 2003. The working capital deficit of $3.8 million includes approximately $2.9 million representing the current portion of the long-term debt to Siemens for Tranches A, B and C, which may be repaid through preferred pricing reductions. In the first quarter of 2004, the Company incurred losses from operations of approximately $269,000 compared to income generated from operations of $825,000 in the first quarter of 2003. Cash and cash equivalents as of March 27, 2004 was approximately $2.6 million.

The Company believes that the shortfall in revenues in the first quarter of 2004 was not lost revenues but delayed revenues attributable to delays in the Company’s contract with the Department of Veteran Affairs and managed care contracts and related promotions. The Company expects such revenues to occur in the remaining of 2004. The Company believes that current cash and cash equivalents and expected cash flow from operations will be sufficient to support the Company’s operational needs through the next twelve months. There can be no assurance, however, that the Company will achieve its expected cash from operations or that net revenue levels will increase above the current level and that unexpected cash needs will not arise for which the cash, cash equivalents and cash flow from operations will be sufficient. In the event of a shortfall in cash, the Company would consider short-term debt, or additional equity or debt offerings. There can be no assurance however, that such financing will be available to the Company on favorable terms or at all. The Company also is continuing its aggressive cost controls and sales and gross margin improvements

Below is a chart setting forth the Company’s contractual cash payment obligations which have been aggregated to facilitate a basic understanding of the Company’s liquidity as of March 27, 2004:

Net cash provided by operating activities decreased from $1.6 million in the first quarter of 2003 to net cash used in operating activities of $2.2 million in the first quarter of 2004. The decrease in net cash provided by operating activities was primarily the result of a change from a net income of approximately

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$350,000 to a net loss of approximately $1.4 million between periods, a net increase in accounts receivable, inventories and prepaid expenses of approximately $67,000 in 2004, compared to a net decrease of approximately $1.1 million in 2003, and a net decrease in accounts payable accrued expenses of approximately $1.4 million in 2004, compared to a net decrease of approximately $1.8 million in 2003.

Net cash used in investing activities increased from approximately $114,000 in the first quarter of 2003 to net cash provided by investing activities of $2,243 in the first quarter of 2004 as a result of the collection of approximately $103,000 related to the discontinued operations. (See Note 4 of the Consolidated Financial Statements herein.)

Net cash provided by financing activities decreased from approximately $2.9 million in the first quarter of 2003 to net cash used by financing activities of approximately $1.8 million in the first quarter of 2004. This decrease is primarily the result of the net proceeds of $3,500,000 from the Siemens Tranche E Loan in 2003, offset by an increase in the payments on long-term debt of $1.6 million in 2004 compared to 2003. This increase is related to the payment of $1.8 million made to Siemens in January of 2004 on Tranches D and E as explained in Note 3 of the Consolidated Financial Statements.

CRITICAL ACCOUNTING POLICIES

Management believes the following critical accounting policies affect the significant judgments and estimates used in the preparation of the financial statements:

Goodwill

The majority of the Company’s goodwill resulted from the combination with Helix. On an annual basis, the Company is required to assess whether its goodwill is impaired. The Company elected to perform this analysis on the first day of its fourth quarter. In order to do this, management applied judgment in determining its “reporting units”, which represent distinct parts of the Company’s business. The reporting units determined by management are the centers, the network and e-commerce. The definition of the reporting units affects the Company’s goodwill impairment assessments. The annual goodwill impairment assessment involves estimating the fair value of a reporting unit and comparing it with its carrying amount. If the carrying value of the reporting unit exceeds its fair value, additional steps are required to calculate a potential impairment charge. Calculating the fair value of the reporting units requires significant estimates and long-term assumptions. The Company utilized an independent appraisal firm to test goodwill for impairment as of the first day of the Company’s fourth quarter of 2002 and 2003, and each of these tests indicated no impairment. The Company estimates the fair value of its reporting units by applying a weighted average of three methods: quoted market price, external transactions, and discounted cash flow. Significant changes in key assumptions about the business and its prospects, or changes in market conditions, stock price, interest rates or other externalities, could result in an impairment charge.

Revenue recognition

HearUSA recognizes revenues from the sale of audiological products at the time of delivery and revenues from hearing care services at the time those services are performed.

The Company has capitation contracts with certain health care organizations under which the Company is paid an amount for each enrollee of the health maintenance organization to provide to the enrollee a once every three years discount on certain hearing products and services. The amount paid to the Company by the healthcare organization is calculated on a per-capita basis and is referred to as capitation revenue. The Company defers recognition of capitation revenue until the earlier of the actual utilization by the member populations of the benefit, or the end of the contract term.

When the actual utilization of the benefit by the member population exceeds the amount received on a per-capita basis (over utilization), the excess is recorded as accounts receivable on the balance sheet. Usually, the hearing benefit is structured in a way that the member can use it only once every three years.

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In these circumstances, historical data shows that the benefit will generally be over utilized the first year, appropriately utilized the second year and under-utilized the third year. The Company estimates an allowance to reduce the accounts receivable from over-utilization to a level equivalent to the estimated future under-utilization during the remaining term of the benefit.

Allowance for doubtful accounts

Certain of the accounts receivable of the Company are from health insurance and managed care organizations and government agencies. These organizations could take up to nine months before paying a claim made by the Company and also impose a limit on the time the claim can be billed. The Company provides an allowance for doubtful accounts equal to the estimated uncollectible amounts. That estimate is based on historical collection experience, current economic and market conditions, and a review of the current status of each organization’s trade accounts receivable.

In order to estimate the allowance, the Company first identifies any known uncollectible amounts in its accounts receivable listing and charges them against the existing allowance for doubtful accounts. Then a specific percent per plan and per aging categories is applied against the remaining receivables to estimate the new allowance. Any changes in the percent assumptions per plan and aging categories could result in a change in the allowance for doubtful accounts. For example, an increase of 10% in the percent used would increase the allowance for doubtful accounts by approximately $26,000.

Sales returns

The Company provides to all patients purchasing hearing aids a specific return period of at least 30 days if the patient is dissatisfied with the product. The Company provides an allowance in accrued expenses for returns. The return period can be extended to 60 days if the patient attends the Company’s H.E.L.P. program. The Company calculates its allowance for returns using estimates based upon actual historical returns. The cost of the hearing aid is reimbursed to the Company by the manufacturer if the return is made within 90 days from the time of delivery to the hearing center.

RECENT ACCOUNTING PRONOUNCEMENTS

Effective July 1, 2003, the Company adopted EITF Issue No. 00-21 (“EITF 00-21”), “Accounting For Revenue Arrangements with Multiple Deliverables”, which establishes criteria for whether revenue on a deliverable can be recognized separately from other deliverables in a multiple deliverable arrangement. The criteria considers whether the delivered item has stand-alone value to the customer, whether the fair value of each of the deliverable items can be reliably determined and the customer’s right of return for the delivered items. The Company’s adoption of EITF 00-21 did not have an effect on its consolidated financial statements.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” It is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. This Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. This Statement did not have a material effect on the Company’s consolidated results of operations or financial position.

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Item 3. Quantitative and Qualitative Disclosures About Market Risk

The Company does not engage in derivative transactions. The Company is exposed to Canadian currency exchange rates and the Company is not hedging that exposure. Differences in the fair value of investment securities are not material; therefore the related market risk is not significant. The Company’s exposure to market risk for changes in interest rates relates primarily to the Company’s long-term debt. The following table presents the Company’s financial instruments for which fair value is subject to changing market interest rates:

Long-Term Debt and Convertible Subordinated Notes

Item 4. Controls and Procedures

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Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits:

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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.

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