SecProbe.io

CORRESP
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filename1.htm

  Suite 300,
  412 Creamery Way, Exton, PA 19341

July
12, 2005

Mr.
Michael Moran

Accounting
Branch Chief

Division
of Corporation Finance

United
State Securities and Exchange Commission

Mail
Stop 3-8

450
Fifth Street, N.W.

Washington,
D.C.  20549

Re:  Daou Systems Form 10-K for December 31, 2004
filed March 30, 2005 File No. 000-22073

Dear
Mr. Moran:

Daou
Systems, Inc. (“Daou” or the “Company”) appreciates that the Securities and
Exchange Commission’s (“SEC”) purpose is to assist Daou in its compliance with
applicable disclosure requirements and enhance the overall disclosure in its
filing.  The following are Daou’s
responses to the comments in your letter to Daou dated June 20, 2005:

SEC Comment:                    Item 6.
Selected Financial Data, page 17

1.     Include a brief description of, or cross
reference to other disclosure in your filing, the items that materially impact
the comparability of the information presented in your selected financial data,
including but not limited to:

•      The elimination of Daou Technology Center in
the first quarter of 2004;

•      The restructuring charges and credits
presented in Note 3; and

•      The suspension of the Employee Stock Purchase
Plan.

Daou Response:                   The elimination of the Daou Technology
Center (“DTC”) in the first quarter of 2004 was disclosed in the following
documents:

•      The Form 8-K dated 11/4/03 containing the
press release announcing Daou’s intention to discontinue providing support
center management services to one hospital and one Integrated Delivery Network
(IDN) in the Indianapolis, IN region (see Exhibit I
attached).

•      The Form 10-K for fiscal 2004, dated 3/30/05

a)     Item 7:
Management’s Discussion and Analysis of Financial Condition and Results
of Operations (page 20 - see Exhibit II
attached)

•      The Form 10-K for fiscal 2003, dated 3/30/04

a)     Item 7:
Management’s Discussion and Analysis of Financial Condition and Results
of Operations (page 19 - see Exhibit II
attached)

To
improve the financial disclosure of the impact of this strategic decision, Daou
proposes to amend its Form 10-K for the year ended December 31 2004 to include
a breakdown of revenue and associated costs of revenue related to its support
center management services in the supplemental information at the bottom of the
Selected Financial Data table in Item 6.
See attached Exhibit III for
proposed changes.

The
restructuring charges and credits were disclosed in the following
documents:

•      The Form 10-K for fiscal 2004, dated 3/30/05

a)     Item 7:
Management’s Discussion and Analysis of Financial Condition and Results
of Operations – Years Ended December 31, 2003 and 2002 (page 23 - see Exhibit IV attached)

b)    Footnote 3 – Restructuring Charges (pages
36-37; see Exhibit IV attached)

•      The Form 10-K for fiscal 2003, dated 3/30/04

a)     Item 7:
Management’s Discussion and Analysis of Financial Condition and Results
of Operations – Years Ended December 31, 2003 and 2002 (page 22 - see Exhibit V attached)

b)    Footnote 3 – Restructuring Charges (pages
39-40; see Exhibit V attached)

To
improve the financial disclosure of the impact of this strategic decision, Daou
proposes to amend its Form 10-K for the year ended December 31, 2004 to include
appropriate statements (in Item 7:
Management’s Discussion and Analysis of Financial Condition and Results
of Operations) regarding this restructuring activity.  This additional disclosure is included as the
attached Exhibit VI.

The
suspension of the Employee Stock Purchase Plan (ESPP) was disclosed in
the following documents:

•      The Form 10-K for fiscal 2004, dated 3/30/05

a)     Footnote 8 – Stockholders’ Equity – Employee
Stock Purchase Plan (page 40 - see Exhibit VII
attached)

•      The Form 10-K for fiscal 2003, dated 3/30/04

a)     Footnote 8 – Stockholders’ Equity – Employee
Stock Purchase Plan (page 43 - see Exhibit VII
attached)

While
Daou feels that this was an important disclosure concerning Daou’s stockholders’
equity activity, the Company believes that further disclosures were neither
required nor necessary for a full understanding of the financial statements.  The amount of shares sold to employees over the
term of the Plan was less than 3% of the total outstanding common shares, and
the Company concluded it was not material enough to warrant further discussion elsewhere
in Daou’s Form 10-K.

SEC Comment:                    Item 8.
Financial Statements, page 26

Balance Sheets, page 28

2.     Please tell us if Series A Convertible
Preferred Stock is convertible into cash and/or a fixed or variable number of
common shares.  Include in your response
the calculation to convert the preferred shares outstanding as of December 31,
2004 into common shares.  Tell us why you
present the preferred shares as permanent equity given the convertibility of
these shares is outside of your control.
See ASR No. 268 and paragraph 5 of EITF No. 05-2.

Daou Response:                   On July 26, 1999, 2,181,818 shares of Series A Preferred Stock were issued at $5.50 per share to a related party.  These shares were recently renamed Series A-1 Preferred Stock (see the Daou Response to SEC Comment number 7 below).  As of November 9, 2000, the holders of the Series A-1 Preferred Stock had the right to cause the Company to redeem their Series A-1 Preferred Stock for approximately $12.9 million.  At that time, as a consequence of the resignation of the Company’s then chief executive officer, Larry Grandia, the holders of the Series A-1 Preferred Stock and the Company entered into an agreement whereby the holders of the Series A-1 Preferred Stock permanently waived their redemption rights in return for $2.0 million in cash and warrants to purchase 3,540,000 shares of the Company’s common stock exercisable at $0.01 per share.  Additionally, as a result of this transaction, the Company reclassified the Series A-1 Preferred Stock from mezzanine equity to a component of stockholders’ equity on its consolidated balance sheet

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as the redemption of this security was no longer at the option of the holder.  This transaction and the related accounting were originally disclosed in our Form 10-K for the year ended December 31, 2000 and then in subsequent periodic filings with the SEC.

The Series A-1 Preferred Stock is not convertible into cash; it is convertible into shares of Daou’s common stock at a fixed conversion price of $5.50 per share.  The calculation of this conversion at December 31, 2004 is as follows:

  Amount

  Conversion

  Rate/Share

  Series A Preferred

  Shares

  Convertible into

  Common

  Initial Investment

  $

  12,000,000

  $

  5.50

  2,181,818

  Dividends Accrued

  5,824,622

  $

  5.50

  1,059,022

  Totals

  $

  17,824,622

  3,240,840

As a result of
the Staff’s comment, Daou reviewed the terms of the Series A-1 Preferred
Stock and noted that in the event of a tender offer which would result in the
Company’s stockholders immediately prior to such transaction not holding at
least 50% of the voting securities of the selling entity, the holders of the Series A-1
Preferred Stock would be entitled to receive for each share of such stock an
amount per share at least equal to Five Dollars and Fifty Cents ($5.50) plus
any accrued but unpaid dividends.  As
such, Daou has concluded that it is appropriate to classify the Series A-1
Preferred Stock as mezzanine equity in accordance with ASR 268 and EITF Topic D-98.  The Company will be filing an amended Form 10-K
for the year ended December 31, 2004 and an amended Form 10-Q for the
first quarter ended March 31, 2005 to reclassify the Series A-1
Preferred Stock as mezzanine equity rather than stockholders’ equity on the
balance sheet of these financial statements.

3.     Please tell us the nature of stockholder
receivable, why it is presented as a current asset in your balance sheet and
your basis for not classifying the stockholder receivable as a deduction in
stockholders’ equity section.

The
stockholder receivable, presented as a non-current asset in the fiscal
2004 Form 10-K balance sheet as “Due from Officers/stockholders”, represents
only the interest that is accruing on the interest-bearing notes that are
included in the “Notes receivable from stockholders” deduction in the
stockholders’ equity section. Daou has appropriately reflected the note
receivable from the purchase of the stock as a contra-equity account in the
balance sheet.  Since the $119,000 value
of this receivable represents only 0.6% of total assets, it was not deemed to
be a material amount requiring further disclosure.

SEC
Comment:                    Statements of Operations, page 29

4.     Please tell us where you classify
subcontractor costs for the three years ended December 31, 2004.

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Daou Response:                   Daou refers to third-party consultants, hired
for specific tasks for specific customer agreements, as subcontractors.  For each of the three years ended December
31, 2004, subcontractor costs are included in “Cost of revenue before
reimbursable expenses” in the Statements of Operations.

SEC Comment:                    Notes to Financial Statements, page 33

Organization and Summary of Significant Accounting Policies, page 33

Revenue Recognition, page 33

5.     Please tell us and disclose your policies for
the following:

1.     Describe which types of contracts are
accounted for by the percentage of completion method of accounting, your
methods of estimating revenue and costs, your policy for loss recognition and
the amount of contract losses charged in the three years December 31, 2004,
2003 and 2002;

2.     Describe which types of contracts are
accounted for in accordance with SAB No. 101 as amended by SAB No. 104; and

3.     Tell us whether you have outsourcing
contracts, if you hire client employees and, if so, your revenue recognition
policy including how you recognize contingency payments, if applicable.

Daou Response:                   None
of Daou’s contracts are accounted for under the percentage of completion method
of accounting.

Daou recognizes all of
its revenue in accordance with Staff Accounting Bulletin (“SAB”) No. 104,
Revenue Recognition, and complies with SAB 104 requirements that the following
criteria be met in determining whether revenue has been earned:

• persuasive evidence of an arrangement,

• services have been delivered,

• price is fixed and determinable, and

• collectibility is reasonably assured.

Daou records
revenue from the following types of transactions: i) services performed on an
hourly basis, ii) services performed on a fixed fee basis and iii) sales of
material and maintenance contracts. In general, Daou enters into contracts with
customers to provide services at a specified fee or rate per hour. Revenue from
professional services contracts is recognized on an hourly basis as work is
performed. Contract revenue for the development and implementation of network
solutions under fixed-fee contracts is recognized under a proportionate
performance method by determining the level of service performed based upon the
amount of labor cost incurred on the project versus the total labor costs to perform
the project as this is the most readily reliable measure of output (i.e. the
amount of the installation complete as of any date) for an installation
project.  Daou’s policy is to record a
provision for a loss on a fixed fee contract during the period when the loss
becomes probable and can be reasonably estimated.  The amount of the contract losses recognized
was $0, $30,000, and $0 for the years ended December 31, 2004, 2003, and 2002,
respectively.  Revenue from technical
support, network management and help desk services is recognized on a pro-rata
basis over the performance period.
Revenue from the sale of material or goods is recognized upon transfer
of title as long as the four elements of revenue recognition discussed above
are met.

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Daou
was engaged in approximately five (5) outsourcing contracts in 2002, four (4)
in 2003 and one (1) in the first quarter of 2004. All contracts had expired by
the end of the first quarter 2004. Daou hired client employees at the inception
of one of the five outsourcing contracts that was initiated on January 23, 1998.
Daou’s revenue recognition policy on outsourcing contracts is to recognize revenue
ratably over the period that these services are provided. One of these
contracts provided contingency payments (risk/reward) based on meeting service
level criteria each month.  Daou’s policy
on recognizing revenue for these contingency payments was to record the revenue
in the period in which the contingency was resolved. The contingency revenue
was less than 1% of the total revenue earned on this contract.

SEC Comment:                    Equipment, Furniture and Fixtures, page 34

6.     Please tell us if your landlord/tenant
allowances are recorded consistently with the staff’s views on landlord/tenant
incentives as summarized in a letter dated February 7, 2005 to the AICPA.  Include in your response whether:

1.     Landlord incentives or allowances are
recorded as leasehold improvement assets and amortized over a term consistent
with the guidance in item 1 of the letter; and

2.     Your statement of cash flows reflect cash
received and accounted for as a lease incentive within operating activities and
the acquisition of leasehold improvements for cash within investing activities.

Please
refer to http://www.sec.gov/info/accountants/staffletters/cpcaf020705.htm.

Daou Response:                   Daou’s accounting policies regarding
landlord/tenant allowances are consistent with the staff’s views on
landlord/tenant incentives as summarized in a letter dated February 7, 2005
from the SEC to the AICPA.  The amount of
property acquired through a tenant allowance was disclosed in the fiscal 2003
supplemental cash flows on page 34 of the related Form 10-K.

SEC Comment:                    7.
Stockholders’ Equity, page 39

Convertible Preferred Stock, page 39

7.     The Amended and Restated Articles of
Incorporation dated January 3, 1997 states dividends for Series A Preferred
Stock are not cumulative.  Please tell us
your basis for disclosing preferred shares possess cumulative dividend rights
and annual dividend rate increases.

Daou Response:                   The Series A Preferred Stock described in the
Company’s Amended and Restated Certificate of Incorporation  dated January 3, 1997 relates to shares of
Series A Preferred Stock that were issued and outstanding prior to the Company’s
initial public offering of its common stock in February 1997.  In connection with the Company’s initial
public offering, all shares of its then outstanding Series A Preferred Stock
were converted into common stock.
However, the Certificate of Incorporation was never amended to eliminate
this series of preferred stock.

Subsequently,
on July 23, 1999, the Company filed a Certificate of Designations with the Delaware
Secretary of State, which authorized and designated a new series of preferred
stock that was also called Series A Preferred Stock (the Certificate of
Designations was filed as Exhibit 4.1 to the Company’s Form 8-K filed with the
SEC on July 29, 1999).  At that time, the
Company sold shares of this new Series A Preferred Stock to certain
investors.  However, because the earlier
Series A Preferred Stock was never eliminated from the Company’s

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Certificate
of Incorporation, the new series of preferred stock issued in July 1999 should
have been designated as Series A-1 Preferred Stock, not Series A Preferred
Stock.  This error was recently
discovered and the Certificate of Designations was corrected by a Certificate
of Correction filed with the Delaware Secretary of State on June 14, 2005 (the
corrected certificate will be filed as an exhibit to the Company’s next
periodic report o