Medquist (MEDQ) 10-Q 2006 Q2 Quarterly report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Form 10-Q

(Mark One)
þ	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the quarterly period ended June 30, 2006.
OR
o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the transition period from          to

Commission file number:

MEDQUIST INC.

(Exact name of registrant as specified in its charter)

New Jersey	22-2531298
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
1000 BISHOPS GATE BOULEVARD SUITE 300 MOUNT LAUREL, NEW JERSEY (Address of principal executive offices)	08054-4632 (Zip Code)

(856) 206-4000

(Registrant’s telephone number, including area code)

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

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

Large accelerated filer o     Accelerated filer þ     Non-accelerated filer o

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

The number of registrant’s shares of common stock, no par value, outstanding as of July 31, 2007 was 37,483,723.

MEDQUIST INC.

INDEX

		Page
PART I.	FINANCIAL INFORMATION		1
Item 1.	Financial Statements		1
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		18
Item 3.	Quantitative and Qualitative Disclosures About Market Risk		28
Item 4.	Controls and Procedures		28
PART II.	OTHER INFORMATION		28
Item 1.	Legal Proceedings		28
Item 1A.	Risk Factors		32
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		40
Item 3.	Defaults Upon Senior Securities		40
Item 4.	Submission of Matters to a Vote of Security Holders		40
Item 5.	Other Information		40
Item 6.	Exhibits		40
Certification of Chief Executive Officer
Certification of Chief Financial Officer
Certification of Chief Executive Officer, pursuant to Section 906
Certification of Chief Financial Officer, pursuant to Section 906

i

PART I.  FINANCIAL INFORMATION

Item 1.   Financial Statements

MedQuist Inc. and Subsidiaries

Condensed Consolidated Statements of Operations
(In thousands, except per share amounts)
Unaudited

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2006			2005			2006			2005
Net revenues	$	93,359		$	103,364		$	189,373		$	211,813
Operating costs and expenses:
Cost of revenues		72,392			80,473			146,727			163,276
Selling, general and administrative		11,719			12,230			26,643			25,784
Research and development		3,057			2,482			6,258			4,946
Depreciation		3,003			4,354			5,894			8,718
Amortization of intangible assets		1,536			2,049			3,111			4,151
Cost of investigation and legal proceedings		5,336			8,455			12,873			14,681
Restructuring charges		493			—			1,705			—
Total operating costs and expenses		97,536			110,043			203,211			221,556
Operating loss		(4,177	)		(6,679	)		(13,838	)		(9,743	)
Equity in income of affiliated company		162			85			558			267
Interest income, net		1,901			1,369			3,698			2,404
Loss before income taxes		(2,114	)		(5,225	)		(9,582	)		(7,072	)
Income tax provision (benefit)		302			(1,977	)		1,305			(2,664	)
Net loss	$	(2,416	)	$	(3,248	)	$	(10,887	)	$	(4,408	)
Net loss per share:
Basic	$	(0.06	)	$	(0.09	)	$	(0.29	)	$	(0.12	)
Diluted	$	(0.06	)	$	(0.09	)	$	(0.29	)	$	(0.12	)
Weighted average shares outstanding:
Basic		37,484			37,484			37,484			37,484
Diluted		37,484			37,484			37,484			37,484

The accompanying notes are an integral part of these condensed consolidated financial statements.

1

MedQuist Inc. and Subsidiaries

Condensed Consolidated Balance Sheets
(In thousands)
Unaudited

	June 30,		December 31,
	2006		2005
Assets
Current assets:
Cash and cash equivalents	$	160,041	$	178,271
Accounts receivable, net of allowance of $5,351 and $4,389, respectively		60,711		71,761
Income tax receivable		19,652		21,708
Deferred income taxes		872		2,385
Other current assets		10,001		9,973
Total current assets		251,277		284,098
Property and equipment, net		22,520		23,961
Goodwill		123,948		123,849
Other intangible assets, net		48,194		51,278
Deferred income taxes		3,039		2,756
Other assets		6,679		7,249
Total assets	$	455,657	$	493,191
Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable	$	10,606	$	10,046
Accrued expenses		29,901		37,401
Accrued compensation		18,328		21,073
Customer accommodation and quantification		30,903		46,878
Deferred revenue		15,657		18,039
Total current liabilities		105,395		133,437
Deferred income tax liability		16,882		15,482
Other long-term liabilities		1,756		3,052
Commitments and contingencies
Shareholders’ equity:
Common stock — no par value; authorized 60,000 shares; 37,484 and 37,484 shares issued and outstanding, respectively		234,115		232,963
Retained earnings		93,748		104,635
Deferred compensation		332		332
Accumulated other comprehensive income		3,429		3,290
Total shareholders’ equity		331,624		341,220
Total liabilities and shareholders’ equity	$	455,657	$	493,191

The accompanying notes are an integral part of these condensed consolidated financial statements.

2

MedQuist Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows
(In thousands)
Unaudited

	Six Months Ended
	June 30,
	2006			2005
Operating activities:
Net cash (used in) provided by operating activities	$	(13,971	)	$	6,677
Investing activities:
Purchase of property and equipment		(4,283	)		(4,676	)
Capitalized software		(21	)		—
Net cash used in investing activities		(4,304	)		(4,676	)
Financing activities:
Repayment of debt		—			(25	)
Net cash used in financing activities		—			(25	)
Effect of exchange rate changes		45			(8	)
Net (decrease) increase in cash and cash equivalents		(18,230	)		1,968
Cash and cash equivalents — beginning of period		178,271			196,219
Cash and cash equivalents — end of period	$	160,041		$	198,187
Supplemental cash flow information:
Cash (recovered) paid for income taxes	$	(3,443	)	$	448
Accommodation payments made with credits	$	48		$	—

The accompanying notes are an integral part of these condensed consolidated financial statements.

3

MedQuist Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements
(In thousands, except per share amounts)
Unaudited

1.   Description of Business

We are a provider of medical transcription technology and services which are integral to the clinical documentation workflow. We service health systems, hospitals and large group medical practices throughout the U.S. In the clinical documentation workflow, we provide, in addition to medical transcription technology and services, digital dictation, speech recognition, electronic signature and medical coding technology and services. We are a member of the Philips Group of Companies and collaborate with Philips Medical Systems in marketing and product development.

2.   Introductory Note

In November 2003, one of our employees raised allegations that we had engaged in improper billing practices. In response, our board of directors undertook an independent review of these allegations and engaged the law firm of Debevoise and Plimpton LLP, who in turn retained PricewaterhouseCoopers LLP, to assist in the review (Review). Subsequently, on March 25, 2004, we filed a Form 8-K detailing our determination that the Review would not be completed by the March 30, 2004 filing deadline for our2003 Form 10-K. As a result of our noncompliance with the U.S. Securities and Exchange Commission’s (SEC) periodic disclosure requirements, our common stock was delisted from NASDAQ National Market on June 16, 2004.

On July 30, 2004, we issued a press release entitled “MedQuist Announces Key Findings Of Independent Review Of Client Billing,” which announced certain findings in the Review regarding our billing practices (July 2004 Press Release). The Review found, among other things, that with respect to our medical transcription services contracts that called for billing based on the “AAMT line” billing unit of measure, we used ratios and formulae to help calculate the number of AAMT transcription lines for which our customers (AAMT Customers) were billed rather than counting each of the relevant characters to determine a billable line as provided for in the contracts. With respect to these contracts, our use of ratios and formulae to arrive at AAMT line counts was generally not disclosed to our AAMT Customers.

The AAMT line unit of measure was developed in 1993 by three medical transcription industry groups, including the American Association for Medical Transcription (AAMT), in an attempt to standardize industry billing practices for medical transcription services. Following the development of the AAMT line unit of measure, customers increasingly began to request AAMT line billing. Accordingly, we, along with other vendors in the medical transcription industry, began to incorporate the AAMT line unit of measure into certain customer contracts. The AAMT line definition provides that a “line” consists of 65 characters and defined the term “character” to include such things as macros and function keys as well as other information necessary for the final appearance and content of a document. However, these definitions turned out to be inherently ambiguous and difficult to apply in practice. As a result, the AAMT line was applied inconsistently throughout the medical transcription industry. In fact, no single set of AAMT characters was ever defined or agreed upon for this unit of measure, and it was eventually renounced by the groups responsible for its development.

The Review concluded that our rationale for using ratios and formulae to determine the number of AAMT transcription lines for billing was premised on a good faith attempt to adopt a consistent and commercially reasonable billing method given the lack of common standards in the industry and ambiguities inherent in the AAMT line definition. The Review concluded that the use of ratios and formulae within the medical transcription platform setups may have resulted in over billing and under billing of some customers. In addition, in some instances, customers’ ratios and formulae were adjusted without disclosure to the AAMT Customers. However, the Review found no evidence that the amounts we billed AAMT Customers were, in general, commercially unfair or inconsistent with what competitors would have charged. Moreover, it was noted in the Review that we have been able to attract and retain customers in a competitive market.

4

MedQuist Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements
(In thousands, except per share amounts)
Unaudited

Following the issuance of the July 2004 Press Release, we began an extensive review of our historical AAMT line billing (Management’s Billing Assessment) and in August 2004 informed our current and former customers that we would be contacting them to discuss how they might have been impacted. In response, several former and current customers, including some of our largest customers, contacted us requesting, among other things, (i) an explanation of the billing methods employed by us for the customer’s account; (ii) an individualized review of the customer’s past billings,and/or (iii) a meeting with a member of our management team to discuss the July 2004 Press Release as it pertained to the customer’s particular account. Some customers demanded an immediate refund or credit to their account; others threatened to withhold payment on invoicesand/or take their business elsewhere unless we timely responded to their informationand/or audit requests.

In response to our customers’ concern over the July 2004 Press Release, we made the decision to take action to try to avoid litigation and preserve and solidify our customer business relationships by offering a financial accommodation to our AAMT Customers. See Note 6.

Disclosure of the findings of the Review, along with the delisting of our common stock, precipitated a number of governmental investigations and civil lawsuits. See Note 9.

3.   Basis of Presentation

The condensed consolidated financial statements included herein are unaudited and have been prepared by us pursuant to the rules and regulations of the SEC. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been omitted pursuant to such rules and regulations although we believe that the disclosures are adequate to make the information presented not misleading. The condensed consolidated financial statements include our accounts and the accounts of all of our wholly-owned subsidiaries. All significant inter-company accounts and transactions have been eliminated in consolidation.

These statements reflect all normal recurring adjustments that, in the opinion of management, are necessary for the fair presentation of the information contained herein. These condensed consolidated financial statements should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations. As permitted under generally accepted accounting principles, interim accounting for certain expenses, including income taxes are based upon full year assumptions. Such amounts are expensed in full in the year incurred. For interim financial reporting purposes, income taxes are recorded based upon estimated annual income tax rates.

4.   Stock-Based Compensation

On January 1, 2006, we adopted the fair value recognition provisions of Financial Accounting Standards Board (FASB) Statement 123 (revised 2004),Share-Based Payment, (Statement 123(R)), using the modified prospective transition method which requires application of Statement 123(R) on the date of adoption and, therefore, we have not retroactively adjusted results from periods prior to 2006. Under the modified prospective transition method, compensation cost associated with share-based awards recognized in 2006 includes compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant-date fair value previously estimated in accordance with the provisions of FASB Statement 123,Accounting for Stock-Based Compensation(Statement 123). Had we granted options in 2006, the compensation cost for those options would have been based on the grant-date fair value estimated in accordance with the provisions of Statement 123(R). In March 2005, the SEC issued SAB 107 (SAB 107) which provided supplemental guidance related to Statement 123(R). We have applied the provisions of SAB 107 in our adoption of Statement 123(R).

5

MedQuist Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements
(In thousands, except per share amounts)
Unaudited

Statement 123(R) requires companies to estimate the fair value of stock options on the date of grant using an option pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as compensation expense over the requisite service periods.

The following table summarizes the stock-based compensation expense related to employee stock options recognized under Statement 123(R).

	Three Months Ended		Six Months Ended
	June 30, 2006		June 30, 2006
Selling, general and administrative	$	144	$	311
Research and development		51		136
Cost of revenues		360		705
Total	$	555	$	1,152

As of June 30, 2006, total unamortized stock-based compensation cost related to non-vested stock options, net of expected forfeitures, was $2,380, which is expected to be recognized over a weighted-average period of 2.6 years.

Prior to the adoption of Statement 123(R), we accounted for stock-based awards to employees and directors using the intrinsic value method in accordance with Accounting Principles Board Opinion 25,Accounting for Stock Issued to Employees(APB 25), as allowed under Statement 123. Under the intrinsic value method, no compensation expense for employee stock options was recognized in our consolidated statements of operations because the exercise price of the stock options granted to employees was greater than or equal to the fair market value of the underlying stock at the date of grant.

The following table illustrates the pro forma effect on net loss and per share amounts as if we had applied the fair-value recognition provisions of Statement 123 to stock-based employee compensation.

	Three Months Ended			Six Months Ended
	June 30, 2005			June 30, 2005
Net loss	$	(3,248	)	$	(4,408	)
Add: Stock-based employee compensation expense included in reported net loss		—			37
Deduct: Total stock-based employee compensation expense determined under fair-value based method for all awards		(486	)		(1,119	)
Pro forma net loss	$	(3,734	)	$	(5,490	)
Basic net loss per share:
As reported	$	(0.09	)	$	(0.12	)
Pro forma	$	(0.10	)	$	(0.15	)
Diluted net loss per share:
As reported	$	(0.09	)	$	(0.12	)
Pro forma	$	(0.10	)	$	(0.15	)

The fair value of the options granted is estimated using the Black-Scholes option-pricing model.

Our stock option plans provide for the granting of options to purchase shares of common stock to eligible employees (including officers) as well as to our non-employee directors. Options may be issued with exercise prices equal to the fair market value of the common stock on the date of grant or at a price determined by a committee of

6

MedQuist Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements
(In thousands, except per share amounts)
Unaudited

our board of directors. Stock options vest and are exercisable over periods determined by the committee, generally five years, and expire no more than 10 years after the grant.

In July 2004, our board of directors affirmed our June 2004 decision to indefinitely suspend the exercise and future grant of options under our stock option plans. Ten former executives separated from us in 2005 and 2004. Notwithstanding the suspension, to the extent such executives held options that were vested as of their resignation date, such options remain exercisable for the post-termination period, generally 90 days, commencing on the date that the suspension is lifted for the exercise of options. There are 580 shares that have qualified for this post-termination exercise period. A summary of these post-termination options as of June 30, 2006 is as follows:

	Options Exercisable
					Average
	Number of		Intrinsic		Exercise
Range of Exercise Prices	Shares		Value		Price
$ 2.71 - $10.00		34	$	253	$	5.39
$10.01 - $20.00		123		—	$	15.59
$20.01 - $70.00		423		—	$	46.59
		580	$	253

The extension of the life of the awards was recorded as a modification of the grants. Under APB 25, the modification created intrinsic value for vested stock if the market value of the stock on the date of termination exceeded the exercise price. Therefore, these grants required an immediate recognition of the compensation expense with an offsetting credit to common stock. As of June 30, 2006 and 2005, we recorded a charge related to these options of $0 and $37, respectively.

Information with respect to our common stock as of June 30, 2006 is as follows:

						Weighted
				Weighted		Average
	Shares			Average		Remaining		Aggregate
	Subject to			Exercise		Contractual		Intrinsic
	Options			Price		Life in Years		Value
Outstanding, December 31, 2005		3,432		$	28.18
Forefeited		(52	)	$	22.58
Canceled		(1,078	)	$	20.88
Outstanding, June 30, 2006		2,302		$	31.72		4.6	$	359
Exercisable , June 30, 2006		2,059		$	32.82		4.4	$	359
Options vested and expected to vest as of June 30, 2006		2,221		$	32.06		4.5	$	359

There were no options granted or exercised during 2006 and 2005. The total fair value of shares vested as of June 30, 2006 was $1,050. The aggregate intrinsic value is calculated using the difference between the closing stock price on the last trading day of the quarter and the option exercise price, multiplied by the number of in-the-money options.

7

MedQuist Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements
(In thousands, except per share amounts)
Unaudited

A summary of outstanding and exercisable options as of June 30, 2006 is as follows:

Options outstanding
			Weighted				Options exercisable
			Average		Weighted				Weighted
			Remaining		Average				Average
Range of	Number		Contractual Life		Exercise		Number		Exercise
Exercise Prices	of Shares		(in years)		Price		of Shares		Price
$ 2.71 - $10.00		46		2.8	$	6.00		46	$	6.00
$10.01 - $20.00		618		4.8	$	16.59		478	$	16.34
$20.01 - $30.00		897		4.6	$	26.81		794	$	26.50
$30.01 - $40.00		202		3.4	$	32.38		202	$	32.38
$40.01 - $70.00		539		3.5	$	59.24		539	$	59.24
		2,302		4.6	$	31.72		2,059	$	32.82

As of June 30, 2006, there were 1,094 additional options available for grant under our stock option plans. When we become up to date in our reporting to the SEC, certain executive officers, in accordance with their employment agreements, will receive an aggregate of 200 options with an exercise price equal to the then market value of our common stock on the date of grant. With respect to these stock options for the three and six months ended June 30, 2006, $28 and $72 is included in selling, general and administrative expenses, respectively, and $11 and $30 is included in research and development expenses, respectively, in the accompanying condensed consolidated statement of operations. Since the exercise price of these options is not yet known, the fair value of such awards will be remeasured as of each balance sheet date until such time as the exercise price is determined.

5.   Net Loss per Share

Basic net loss per share is computed by dividing net loss by the weighted average number of shares outstanding during each period. Diluted net loss per share is computed by dividing net loss by the weighted average shares outstanding, as adjusted for the dilutive effect of common stock equivalents, which consist only of stock options, using the treasury stock method.

The following table reflects the weighted average shares outstanding used to compute basic and diluted net loss per share:

	Three Months Ended June 30,						Six Months Ended June 30,
	2006			2005			2006			2005
Net loss	$	(2,416	)	$	(3,248	)	$	(10,887	)	$	(4,408	)
Weighted average shares outstanding:
Basic		37,484			37,484			37,484			37,484
Diluted		37,484			37,484			37,484			37,484
Net loss per share:
Basic	$	(0.06	)	$	(0.09	)	$	(0.29	)	$	(0.12	)
Diluted	$	(0.06	)	$	(0.09	)	$	(0.29	)	$	(0.12	)

The computation of diluted net loss per share does not assume conversion, exercise or issuance of shares that would have an anti-dilutive effect on diluted net loss per share. For the three months ended June 30, 2006 and 2005, shares having an anti-dilutive effect on net loss per share and, therefore, excluded from the calculation of diluted loss per share, totaled 2,302 and 3,710 shares, respectively. For the six months ended June 30, 2006 and 2005, shares excluded from the calculation of diluted net loss per share, totaled 2,302 and 3,710 shares, respectively.

8

MedQuist Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements
(In thousands, except per share amounts)
Unaudited

6.   Customer Accommodation and Quantification

In connection with our decision to offer financial accommodations to our AAMT Customers, we analyzed our historical billing information and the available report-level data to develop individualized accommodation offers to be made to our AAMT Customers (Accommodation Analysis). This analysis took approximately one year to complete. The methodology utilized to develop the individual accommodation offers was designed to generate positive accommodation outcomes for our AAMT Customers. As such, the methodology was not a calculation of potential over billing nor was it intended as a measure of damages or a reflection of any admission of liability due and owed to our AAMT Customers. Instead, the Accommodation Analysis was a methodology that was developed to arrive at commercially reasonable and fair accommodation offers that would be acceptable to our AAMT Customers without negotiation.

In the fourth quarter of 2005, based on the Accommodation Analysis, our board of directors authorized management to make cash accommodation offers to AAMT customers in the aggregate amount of $65,413. In 2006, this amount was adjusted by a net additional amount of $1,157 based on a refinement of the Accommodation Analysis resulting in an aggregate amount of $66,570. By accepting our accommodation offer, an AAMT Customer must agree, among other things, to release us from any and all claims and liability regarding AAMT line and other billing related issues.

As part of this process, we also conducted an analysis in an attempt to quantify the economic consequences of potentially unauthorized adjustments to AAMT Customers’ ratios and formulae within the transcription platform setups (Quantification). This Quantification was calculated to be $9,835.

Of the authorized cash accommodation amount of $66,570, $1,157 and $57,678 were treated as consideration given by a vendor to a customer and accordingly recorded as a reduction in revenues in 2006 and 2005, respectively. The balance of $7,735 plus an additional $2,100 has been accounted for as a billing error associated with the Quantification resulting in a reduction of revenues in various reporting periods from 1999 to 2005.

The goal of our accommodation program was to reach a settlement with our AAMT Customers. However, the Accommodation Analysis for certain AAMT Customers did not result in positive accommodation outcomes. For certain other customers, the Accommodation Analysis resulted in calculated cash accommodation offers that we believed were insufficient as a percentage of their historical AAMT line billing to motivate such customers to resolve their billing disputes with us. Therefore, in 2006 we modified our accommodation program to enable us to offer this group of AAMT Customers credits for the purchase of future productsand/or services from us over a defined period of time. On July 21, 2006, our board of directors authorized management to make credit accommodation offers up to an additional $8,676 beyond amounts previously authorized. During 2006, this amount was adjusted by a net additional amount of $569 based on a refinement of the Accommodation Analysis resulting in an aggregate amount of $9,245. In connection with the credit accommodation offers we recorded a reduction in revenues and corresponding increase in accrued expenses of $9,245 in 2006.

9

MedQuist Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements
(In thousands, except per share amounts)
Unaudited

The following is a summary of the financial statement activity related to the customer accommodation and the Quantification which is included as a separate line item in the accompanying consolidated balance sheets as of June 30, 2006 and December 31, 2005:

	Six Months Ended			Year Ended
	June 30, 2006			December 31, 2005
Beginning balance	$	46,878		$	9,702
Quantification		—			133
Customer accommodation		1,198			57,678
Payments and other adjustments		(17,125	)		(20,635	)
Credits		(48	)		—
Ending balance	$	30,903		$	46,878

7.   Cost of Investigation and Legal Proceedings

For the three months ended June 30, 2006 and 2005, we recorded a charge of $5,336 and $8,455, respectively, and for the six months ended June 30, 2006 and 2005, we recorded a charge of $12,873 and $14,681, respectively, for costs associated with Management’s Billing Assessment as well as defense and other costs associated with the SEC and U.S. Department of Justice (DOJ) investigations and civil litigation that we deemed to be unusual in nature. The following is a summary of the amounts recorded in the accompanying condensed consolidated statements of operations:

	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2006		2005		2006		2005
Legal fees	$	3,819	$	4,888	$	8,225	$	9,332
Other professional fees		618		2,618		2,837		3,443
Nightingale and Associates, LLC (Nightingale) services		859		848		1,708		1,740
Other		40		101		103		166
Total	$	5,336	$	8,455	$	12,873	$	14,681

Other professional fees represent accounting and dispute analysis costs and document search and retrieval costs.

8. 2005 Restructuring Plan

During 2005, we implemented a restructuring plan (2005 Plan) based on the implementation of a centralized national service delivery model. The plan involved the consolidation of operating facilities and a related reduction

10

MedQuist Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements
(In thousands, except per share amounts)
Unaudited

in workforce. The table below reflects the financial statement activity related to the 2005 Plan which is included in accrued expenses in the accompanying consolidated balance sheet for the three and six months ended June 30, 2006:

	Three Months Ended June 30, 2006
				Non-Cancelable
	Total			Leases			Severance			Equipment
Balance as of March 31, 2006	$	1,533		$	1,299		$	234		$	—
Additional charge		493			256			173			64
Usage		(739	)		(394	)		(281	)		(64	)
Balance as of June 30, 2006	$	1,287		$	1,161		$	126		$	—

	Six Months Ended June 30, 2006
				Non-Cancelable
	Total			Leases			Severance			Equipment
Balance as of December 31, 2005	$	2,050		$	1,693		$	357		$	—
Additional charge		1,705			573			911			221
Usage		(2,468	)		(1,105	)		(1,142	)		(221	)
Balance as of June 30, 2006	$	1,287		$	1,161		$	126		$	—

9.   Commitments and Contingencies

Governmental Investigations

The SEC is currently conducting a formal investigation of us relating to our billing practices. We have been fully cooperating with the SEC since it opened its investigation in 2004. We have complied and are continuing to comply with information and document requests by the SEC.

We also received an administrative HIPAA subpoena for documents from the DOJ on December 17, 2004. The subpoena sought information primarily about our provision of medical transcription services to governmental and non-governmental customers. The information was requested in connection with a government investigation into whether we and others violated federal laws in connection with the provision of medical transcription services. We have complied and are continuing to comply with information and document requests by the DOJ.

The DOL is currently conducting a formal investigation into the administration of our 401(k) plan. We have been fully cooperating with the DOL since it opened its investigation in 2004. We have complied and are continuing to comply with information and document requests by the DOL.

Developments relating to the SEC, DOJand/or DOL investigations will continue to create various risks and uncertainties that could materially and adversely affect our business and our historical and future financial condition, results of operations, and cash flows.

Shareholder Securities Litigation

A shareholder putative class action lawsuit was filed against us in the United States District Court District of New Jersey on November 8, 2004. The action, entitledWilliam Steiner v. MedQuist, Inc., et al., CaseNo. 1:04-cv-05487-FLW (Shareholder Putative Action), was filed against us and certain of our former officers, purportedly on behalf of an alleged class of all persons who purchased our common stock during the period from April 23, 2002 through November 2, 2004, inclusive (Securities Class Period). The complaint specifically alleged that defendants violated federal securities laws by purportedly issuing a series of false and misleading statements to the market throughout the Securities Class Period, which statements allegedly had the effect of artificially inflating the market

11

MedQuist Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements
(In thousands, except per share amounts)
Unaudited

price of our securities. The complaint asserts claims under Section 10(b) and 20(a) of the Exchange Act andRule 10b-5, thereunder. Named as defendants, in addition to us, were our former President and Chief Executive Officer and our former Executive Vice President and Chief Financial Officer.

On August 16, 2005, a First Amended Complaint in the Shareholder Putative Class Action was filed against us in the United States District Court District of New Jersey. The First Amended Complaint named additional defendants, including certain current and former directors, certain of our former officers, our former and current external auditors and Philips. Like the original complaint, the First Amended Complaint asserted claims under Sections 10(b) and 20(a) of the Exchange Act andRule 10b-5 thereunder. The Securities Class Period of the original complaint was expanded 20 months to include the period from March 29, 2000 through June 14, 2004. Pursuant to an October 17, 2005 consent order approved by the Court, lead plaintiff Greater Pennsylvania Pension Fund filed a Second Amended Complaint on November 15, 2005. The Second Amended Complaint dropped Philips as a defendant, but alleged the same claims and the same purported class period as the First Amended Complaint. Plaintiffs sought unspecified damages. Pursuant to the provisions of the Private Securities Litigation Reform Act, discovery in the action was stayed pending the filing and resolution of the defendants’ motions to dismiss, which were filed on January 17, 2006, and which were fully briefed as of June 16, 2006. On September 29, 2006, the Court denied our motions to dismiss and the motion to dismiss of the individual defendants. In the same order, the Court granted the motion to dismiss filed by our former and current external auditors. On November 3, 2006, we filed our Answer denying the material allegations contained in the Second Amended Complaint. On March 23, 2007, we entered into a memorandum of understanding and a stipulation of settlement with the lead plaintiff in which we agreed to pay $7.75 million to settle all claims, throughout the class period, against all defendants in the action. On May 16, 2007, the Court issued an Order Preliminarily Approving Settlement and Providing for Notice. The Court conducted a final approval hearing and approved the settlement on August 15, 2007. Neither we nor any of the individuals named in the action has admitted to liability or any wrongdoing in connection with the settlement.

Customer Litigation

A putative class action was filed in the United States District Court for the Central District of California. The action, entitled South Broward Hospital District, d/b/a Memorial Regional Hospital, et al. v. MedQuist, Inc. et al., CaseNo. CV-04-7520-TJH-VBKx, was filed on September 9, 2004 against us and certain of our present and former officials, purportedly on behalf of an alleged class of non-Federal governmental hospitals and medical centers that the complaint claims were wrongfully and fraudulently overcharged for transcription services by defendants based primarily on our use of the AAMT line billing unit of measure. The complaint charged fraud, violation of the California Business and Professions Code, unjust enrichment, conversion, negligent supervision and violation of RICO. Plaintiffs seek damages in an unspecified amount, plus costs and interest, an injunction against alleged continuing illegal activities, an accounting, punitive damages and attorneys’ fees. Named as defendants, in addition to us, were one of our senior vice presidents, our former executive vice president of marketing and new business development, our former executive vice president and chief legal officer, and our former executive vice president and chief financial officer.

On December 20, 2004, we and the individual defendants filed motions to dismiss for lack of personal jurisdiction and improper venue, or in the alternative, to transfer the putative action to the United States District Court for the District of New Jersey. On February 2, 2005, plaintiffs filed a Second Amended Complaint both adding and deleting named plaintiffs in an attempt to keep the putative action in the United States District Court for the Central District of California. On March 30, 2005, the United States District Court for the Central District of California issued an order transferring the putative action to the United States District Court District of New Jersey.

On August 1, 2005, we and the individual defendants filed their respective Answers denying the material allegations contained in the Second Amended Complaint. On August 31, 2005, we and the individual defendants

12

MedQuist Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements
(In thousands, except per share amounts)
Unaudited

filed motions to dismiss the Second Amended Complaint for failure to state a claim and a motion to dismiss in favor of arbitration, or in the alternative, to stay pending arbitration. On December 12, 2005, the plaintiffs filed an Amendment to the Second Amended Complaint. On December 13, 2005, the Court issued an order requiring plaintiffs to file a Third Amended Complaint.

Plaintiffs filed the Third Amended Complaint on January 4, 2006. The Third Amended Complaint expands the claims made beyond issues arising from contracts based on AAMT line billing and beyond customers billed based on an AAMT line, alleging that we engaged in a scheme to inflate customers’ invoices without regard to the terms of individual contracts and even in the absence of any written contract. The Third Amended Complaint also limits plaintiffs’ claim for fraud in the inducement of the agreement to arbitrate to the three named plaintiffs whose contracts contain an arbitration provision and a subclass of similarly situated customers. On January 20, 2006 we and the individual defendants filed motions to dismiss the Third Amended Complaint for failure to state a claim and a motion to compel arbitration of all claims by the arbitration subclass and to stay the case in its entirety pending arbitration. On March 8, 2006 the Court held a hearing on these motions, and took the matter under submission. On March 30, 2007, the Court issued an order holding that plaintiffs could not make out a claim that we had violated the federal RICO statute, thus eliminating any claim against us for treble damages. The Court also found that plaintiffs could not make out a claim that we had engaged in any unfair or deceptive acts or practices in violation of state law, or that we had made any negligent misrepresentations to plaintiffs. In its ruling, the Court, without reaching a decision of whether any wrongdoing had occurred, allowed plaintiffs to proceed with their claims against us for fraud, unjust enrichment and an accounting. In its order, the Court denied our motion to compel arbitration regarding those customers whose contracts contained an agreement to arbitrate. We have appealed that decision to the Third Circuit Court of Appeals, and we moved the district court to stay the matter pending that appeal. The district court heard oral argument on our motion to stay on May 30, 2007 and took the motion under submission. On June 8, 2007, plaintiffs filed a Motion for Summary Action with the Third Circuit Court of Appeals, asking the Court to dismiss plaintiffs who did not enter into arbitration agreements with us from the appeal. We filed our opposition to this motion on June 25, 2007. The Court has referred the motion to the merits panel for decision after full briefing. In addition, on July 18, 2007, the Third Circuit Court of Appeals issued notice that the case had been assigned to mediation in the Court’s mediation program. On August 1, 2007, plaintiffs filed a motion for expedited review on appeal. We do not oppose this motion, and the parties have agreed to a schedule pursuant to which the appeal will be fully briefed by November 16, 2007. On August 21, 2007, the Third Circuit granted the motion for expedited review. Under the Court’s order, briefing is scheduled to be completed by November 16, 2007. The Third Circuit also has ordered the parties to telephonic mediation, which is scheduled to proceed on September 12, 2007. We believe that the claims asserted have no merit and intend to defend the case vigorously.

Medical Transcriptionist Litigation

Hoffmann Putative Class Action

A putative class action lawsuit was filed against us in the United States District Court for the Northern District of Georgia. The action, entitled Brigitte Hoffmann, et al. v. MedQuist, Inc., et al., CaseNo. 1:04-CV-3452, was filed with the Court on November 29, 2004 against us and certain current and former officials, purportedly on behalf of an alleged class of current and former employees and statutory workers, who are or were compensated on a “per line” basis for medical transcription services (Class Members) from January 1, 1998 to the time of the filing of the complaint (Class Period). The complaint specifically alleged that defendants systematically and wrongfully underpaid the Class Members during the Class Period. The complaint asserted the following causes of action: fraud, breach of contract, demand for accounting, quantum meruit, unjust enrichment, conversion, negligence, negligent supervision, and RICO violations. Plaintiffs sought unspecified compensatory damages, punitive damages, disgorgement and restitution. On December 1, 2005, the Hoffmann matter was transferred to the United States District Court for the District of New Jersey. On January 12, 2006, the Court ordered this case consolidated with the

13

MedQuist Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements
(In thousands, except per share amounts)
Unaudited

Myers Putative Class Action discussed below. As set forth below, we believe that the claims asserted in the consolidated Myers Putative Class Action have no merit and intend to vigorously defend that action.

Force Putative Class Action

A putative class action entitled Force v. MedQuist Inc. and MedQuist Transcriptions, Ltd., CaseNo. 05-cv-2608-WSD, was filed against us on October 11, 2005, in the United States District Court for the Northern District of Georgia. The action was brought on behalf of a putative class of current and former employees who claim they are or were compensated on a “per line” basis for medical transcription services but were allegedly underpaid due to the actions of defendants. The named plaintiff asserted claims for breach of contract, quantum meruit, unjust enrichment, and for an accounting. Upon stipulation and consent of the parties, on February 17, 2006, the Force matter was ordered transferred to the United States District Court for the District of New Jersey. Subsequently, on April 4, 2006, the parties entered into a stipulation and consent order whereby the Force matter was consolidated with the Myers Putative Class Action discussed below, and the consolidated amended complaint filed in the Myers action on January 31, 2006 was deemed to supersede the original complaint filed in the Force matter. As set forth below, we believe that the claims asserted in the consolidated Myers Putative Class Action have no merit and intend to vigorously defend that action.

Myers Putative Class Action

A putative class action entitled, Myers, et al. v. MedQuist Inc. and MedQuist Transcriptions, Ltd., CaseNo. 05-cv-4608 (JBS), was filed against us on September 22, 2005 in the United States District Court for the District of New Jersey. The action was brought on behalf of a putative class of our employee and independent contractor transcriptionists who claim that they contracted with us to be paid on a 65 character line, but were allegedly underpaid due to intentional miscounting of the number of characters and lines transcribed. The named plaintiffs asserted claims for breach of contract, unjust enrichment, and request an accounting.

The allegations contained in the Myers case are substantially similar to those contained in the Hoffmann and Force putative class actions and, as detailed above, the three actions have now been consolidated. A consolidated amended complaint was filed on January 31, 2006. In the consolidated amended complaint, the named plaintiffs assert claims for breach of contract, breach of the covenant of good faith and fair dealing, unjust enrichment and demand an accounting. On March 7, 2006 we filed a motion to dismiss all claims in the consolidated amended complaint. The motion was fully briefed and argued on August 7, 2006. The Court denied the motion on December 21, 2006. On January 19, 2007, we filed an answer denying the mutual allegations pleaded in the consolidated amended complaint. The parties are now proceeding with discovery. The deadline to complete pretrial fact discovery is October 30, 2007. No date has been set for a class certification hearing or trial. We believe that the claims asserted in the consolidated actions have no merit and intend to vigorously defend the suit.

Shareholder Derivative Litigation

On October 4, 2005, we announced the dismissal with prejudice of a shareholder derivative action filed in United States District Court for the District of New Jersey. The suit, Rhoda Kanter (Plaintiff) v. Hans M. Barella et al. (Defendants), was filed on November 12, 2004 against Philips and 10 current and former members of our board of directors. We were named as a nominal defendant.

In a ruling dated September 21, 2005, the Court found plaintiff’s allegations that our board of directors breached their fiduciary duties to us to be insufficient. The plaintiff had alleged that for a period from 2001 through 2004, the Defendants violated their fiduciary duties by permitting artificial inflation of billing figures; failing to adequately ensure accurate and lawful billing practices; and failing to accurately report our true financial condition in its published financial statements. On October 3, 2005, plaintiff filed a motion for reconsideration of the Court’s

14

MedQuist Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements
(In thousands, except per share amounts)
Unaudited

order dismissing the action with prejudice. On November 16, 2005, the Court denied plaintiff’s motion for reconsideration. On December 13, 2005, plaintiff filed a Notice of Appeal with the United States Court of Appeals for the Third Circuit. Plaintiff’s appeal was fully briefed as of May 2006, and the Court of Appeals heard oral argument on the appeal on March 1, 2007. Plaintiff’s appeal was denied by the Court of Appeals on May 25, 2007.

Other than the shareholder securities litigation discussed above, at this time, based on the stage of litigation, and a review of the current facts and circumstances, no amount is probable and no amount within a range of possible outcomes is a better amount within the range that might result from an adverse judgment or a settlement of the matters discussed above.

Developments relating to third party litigation and governmental investigations will continue to create various risks and uncertainties that could materially and adversely affect our business, financial condition, results of operations and cash flows.

Other Matters

From time to time, we have been involved in various claims and legal actions arising in the ordinary course of business. In our opinion, the outcome of such actions will not have a material adverse effect on our consolidated financial position, results of operations, liquidity or cash flows.

We provide certain indemnification provisions within our standard agreement for the sale of software and hardware (collectively, Products) to protect our customers from any liabilities or damages resulting from a claim of U.S. patent, copyright or trademark infringement by third parties relating to our Products. We believe that the likelihood of any future payout relating to these provisions is remote. Accordingly, we have not recorded any liability in our consolidated financial statements as of June 30, 2006 or December 31, 2005 related to these indemnification provisions.

We have insurance policies which provide coverage for certain of the matters related to the legal actions described herein. We filed claims for insurance recoveries, but, as of June 30, 2006, it was not probable that we would receive any of these insurance recoveries.

10.   Related Party Transactions

From time to time, we enter into transactions in the normal course of business with related parties. The audit committee of our board of directors has been charged with the responsibility of approving or ratifying all related party transactions other than those between us and Philips.

In connection with Philips’ investment in us, we have entered into various agreements with Philips. All material transactions between Philips and us are reviewed and approved by the supervisory committee of our board of directors. The supervisory committee is comprised of directors’ independent from Philips. Listed below is a summary of our material agreements with Philips.

Licensing Agreement

In connection with Philips’ tender offer, we entered into a Licensing Agreement with Philips Speech Processing GmbH, an affiliate of Philips which is now known as Philips Speech Recognition Systems GmbH (PSRS), on May 22, 2000 (Licensing Agreement). The Licensing Agreement was subsequently amended by the parties as of January 1, 2002, February 23, 2003, August 10, 2003, September 1, 2004, December 30, 2005 and February 13, 2007.

Under the Licensing Agreement, we license from PSRS its SpeechMagic speech recognition and processing software, including any updated versions of the software developed by PSRS during the term of the License

15

MedQuist Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements
(In thousands, except per share amounts)
Unaudited

Agreement (Licensed Product), for use by us anywhere in the world. We pay a fee for use of this license based upon a per line fee for each transcribed line of text processed through the Licensed Product.

Upon the expiration of its initial term on June 28, 2005, the Licensing Agreement was renewed for an additional five year term.

In connection with the Licensing Agreement, we have a consulting arrangement with PSRS whereby PSRS assists us with the integration of its speech and transcription technologies.

OEM Supply Agreement

We entered into an OEM Supply Agreement with PSRS on September 23, 2004 pursuant to which we obtained the exclusive right in North America to sell certain PSRS Products (as defined below) createdand/or developed by PSRS to third parties, to service such PSRS Products and to incorporate such PSRS Products into our own products (OEM Supply Agreement).

Upon the expiration of its initial term on June 30, 2007, the OEM Supply Agreement was renewed for an additional three year term. Unless earlier terminated, the OEM Supply Agreement automatically renews for one additional three year term, provided that we are in compliance with the OEM Supply Agreement at the end of the initial term and each renewal term.

In 2004, we made a payment to PSRS with respect to software purchases and payments under the OEM Supply Agreement in an amount equal to the sales forecast and commitment set forth in the OEM Supply Agreement for such year. We did not meet the sales forecast and commitment set forth in the OEM Supply Agreement for 2005.

If PSRS decides to discontinue all business relating to the PSRS Products in North America, PSRS has the right to terminate the OEM Supply Agreement by giving us six months prior written notice, in which case PSRS agrees to negotiate in good faith with us the terms and conditions under which it will provide training and access to source code of the PSRS Products to the extent reasonably necessary for us to continue development and to support the installed base of PSRS Products in North America.

In consideration of PSRS’s development, maintenance and support for the first version of the PSRS Products, we paid PSRS a development fee in 2004. In addition, we pay monthly license fees to PSRS, subject to certain reductions based upon the level of purchases of PSRS Products by us under the OEM Supply Agreement relative to annual forecasted amounts.

Under the OEM Supply Agreement, we are required to use reasonable commercial efforts to sell end users a software maintenance agreement. The software maintenance agreement provides that the customer will obtain certain product releases and technical support directly from PSRS or from PSRS through us. We pay a fee to PSRS for each software maintenance agreement contract sold by us.

Equipment Sales

We purchase dictation related equipment from Philips.

Insurance Coverage through Philips

We obtain all of our business insurance coverage (other than workers’ compensation) through Philips.

16

MedQuist Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements
(In thousands, except per share amounts)
Unaudited

Purchasing Agreements

We enter into annual letter agreements with Philips Electronics North America Corporation (PENAC), an affiliate of Philips, to purchase products and services from certain suppliers under the terms of the prevailing agreements between such suppliers and PENAC.

From time to time, we enter into other miscellaneous transactions with Philips including Philips purchasing certain products and implementation services from us. We recorded net revenues from sales to Philips of $12 and $155 for the three months ended June 30, 2006 and 2005, respectively, and $26 and $185 for the six months ended June 30, 2006 and 2005, respectively.

Our condensed consolidated balance sheets as of June 30, 2006 and December 31, 2005 reflect other current assets related to Philips of $824 and $1,786, respectively, and accrued expenses related to Philips of $510 and $987, respectively.

Listed below is a summary of the expenses incurred by us in connection with the various Philips agreements mentioned above for the three and six months ended June 30, 2006 and 2005. Charges related to these agreements are included in cost of revenues and selling, general and administrative expenses in the accompanying condensed consolidated statements of operations.

	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2006		2005		2006		2005
PSRS licensing	$	614	$	301	$	1,125	$	482
PSRS consulting		—		—		3		161
OEM agreement		232		472		545		541
Dictation equipment		285		405		530		768
Insurance		223		239		446		478
PENAC		10		10		20		34
Other		—		96		42		248
Total	$	1,364	$	1,523	$	2,711	$	2,712

On July 29, 2004, we entered into an agreement with Nightingale under which Nightingale agreed to provide interim chief executive services to us. On July 30, 2004, our board of directors appointed Howard S. Hoffmann to serve as our interim Chief Executive Officer (CEO). With the departure of our former President in May 2007, our board of directors appointed Mr. Hoffmann to the additional position of President in June 2007. Mr. Hoffmann serves as the Managing Partner of Nightingale. Mr. Hoffmann continues to serve as our President and Chief Executive Officer pursuant to the terms of the agreement between us and Nightingale, which expired on June 30, 2007. We are currently negotiating the terms of an extension of this agreement. Our board of directors is responsible for monitoring and reviewing the performance of Mr. Hoffmann on an ongoing basis. Our agreement with Nightingale also permits us to engage additional personnel employed by Nightingale to provide consulting services to us from time to time.

For the three months ended June 30, 2006 and 2005, we incurred charges of $859 and $848, respectively, and for the six months ended June 30, 2006 and 2005, we incurred charges of $1,708 and $1,740, respectively, for Nightingale services. As of June 30, 2006 and December 31, 2005, accrued expenses included $320 and $487, respectively, for amounts due to Nightingale for services performed.

In 2001, we entered into an Advance Agreement with A-Life Medical, Inc. (A-Life), a privately held entity that we owned 33.6% of the outstanding voting shares of during 2006 and 2005. The agreement required a prepayment of $1,000 for $1,600 in services to be provided to us by A-Life. The Advance Agreement had an expiration date of December 31, 2005.

17

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

This Quarterly Report onForm 10-Q, including the following Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and the Private Securities Litigation Reform Act of 1995, that involve a number of risks and uncertainties. Such statements are based on current expectations of future events that involve a number of risks and uncertainties that may cause the actual events to differ materially from those discussed herein. In addition, such forward-looking statements are necessarily dependent upon assumptions, estimates and dates that may be incorrect or imprecise and involve known and unknown risks and other factors. Accordingly, any forward-looking statements included herein do not purport to be predictions of future events or circumstances and may not be realized. Forward-looking statements can be identified by, among other things, the use of forward-looking terminology such as “believes,” “expects,” “may,” “could,” “will,” “should,” “seeks,” “pro forma,” “potential,” “anticipates,” “predicts,” “plans,” “estimates,” or “intends,” or the negative of any thereof, or other variations thereon or comparable terminology, or by discussions of strategy or intentions. Given these uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. Forward-looking statements should be considered in light of various important factors, including those set forth under the caption “Risk Factors” in thisForm 10-Q. All forward-looking statements, and reasons why results may differ, that are included in this report are made as of the date of this report, and except as required by law, we disclaim any obligations to update any such factors or to publicly announce the results of any revisions to any of the forward-looking statements contained herein or reasons why results might differ to reflect future events or developments.

Executive Overview

We are the leading provider of medical transcription technology and services, which are integral to the clinical documentation workflow. We service health systems, hospitals and large group medical practices throughout the U.S., and we employ approximately 6,300 skilled medical transcriptionists (MTs), making us the largest employer of MTs in the U.S. In the clinical documentation workflow, we provide, in addition to medical transcription technology and services, digital dictation, speech recognition, electronic signature and medical coding technology and services. We are a member of the Philips Group of Companies and collaborate with Philips Medical Systems in marketing and product development to leverage Philips’ technologies and professional expertise to deliver industry-leading solutions for our customers.

We were incorporated in New Jersey in 1984 and reorganized in 1987 as a group of outpatient healthcare businesses affiliated with a non-profit healthcare provider. In May 1994, we acquired our first medical transcription business. Through the date of this report, we have acquired over 50 companies. By the end of 1995, we had divested all of our non-medical transcription businesses.

In July 2000, Koninklijke Philips Electronics N.V. (Philips) completed a tender offer in which it acquired approximately 60% of our outstanding common stock. Subsequent to the completion of the tender offer, Philips increased its ownership position and currently owns approximately 69.6% of our common stock.

In 2001, we acquired Speech Machines, a company based in the United Kingdom, whose technology has since developed into our DocQment^tm Enterprise Platform (DEP). In 2002, we began the process of migrating our customers to our DEP from our many disparate transcription platforms. Following our press release in July 2004 announcing the results of the independent review of our billing practices (Review) resulting from allegations of one of our employees that we engaged in improper billing practices, we accelerated this process and completed it in the first quarter of 2007. As a result of this process, we encountered customer attrition.

In July 2002, we acquired Lanier Healthcare, LLC (Lanier), which derived revenue largely from the sale and implementation of voice-capture and document management solutions and maintenance service of these products. In conjunction with the Lanier acquisition, we began operating in two segments: a Services segment, through which we provided our customers with medical transcription and coding reimbursement services, and a Solutions segment, which was comprised of the operations of Lanier. Effective January 1, 2005, we changed the way we review our financial performance and thus began operating in one segment for financial reporting purposes.

18

The past few years have been marked by dramatic changes for both us and our industry. During this period, a significant portion of our time and attention has been devoted to matters outside the ordinary course of business such as replacing key members of our executive management team, cooperating with federal investigators, responding to ongoing legal proceedings, and completing the Review and the extensive review of our historical AAMT line billing (Management’s Billing Assessment). A summary of significant events that have occurred during this period is more fully described in our Annual Report onForm 10-K for the year ended December 31, 2005 under the caption “Significant Events Since Our Last Regular Periodic Report” in Item 1, Business and Item 3, Legal Proceedings.

We have devoted significant resources over the past few years to improving our fundamental business systems, including our corporate governance functions, financial controls, and operational infrastructure. As our organization was focusing on all of these issues, we also pursued major operational initiatives to consolidate technology platforms, communicate actively with our customers, and restructure our business.

During this same period there have been several significant developments in the medical transcription industry, including:

•  A shortage of qualified domestic MTs has increased the demand for outsourced medical transcription services byU.S.-based healthcare providers. This demand for qualified MTs, as well as budgetary pressures experienced by healthcare providers, has also caused many moreU.S.-based healthcare providers to evaluate and consider the use of offshore medical transcription labor.

•  Several low cost providers have emerged and aggressively moved into our market offering medical transcription services (performed both domestically and offshore) at prices significantly below our traditional price point. While we believe the market for outsourced medical transcription continues to expand, the growing acceptance by customers of the use of offshore labor has further increased the competitive environment in the medical transcription industry.

•  There have been technological advances by us and our competitors which have reduced the length of time required to transcribe medical reports, in turn reducing the overall cost of medical transcription services.

Although we remain the leading provider of medical transcription services in the U.S., we experience competition from many local, regional and national businesses. The medical transcription industry is highly fragmented, and we believe there are hundreds of companies in the U.S. performing medical transcription services. There are currently two large service providers, one of which is us and the other of which is Spheris Inc., several mid-sized service providers with annual revenues of between $15 million and $100 million and hundreds of smaller, independent businesses with annual revenues of less than $15 million.

We believe the outsourced portion of the medical transcription services market will increase due in part to healthcare providers seeking the following:

•  reduction in overhead and other administrative costs;

•  improvement in the quality and speed of delivery of transcribed medical reports;

•  access to leading technologies, such as speech recognition technology, without any development and investment risk;

•  expertise in implementing and managing a medical transcription system tailored to the providers’ specific requirements;

•  access to skilled MTs; and

•  support for compliance with governmental and industry mandated privacy and security requirements and electronic health record initiatives.

Although we believe the outsourced portion of the medical transcription services market continues to grow, in order to benefit from this trend we must overcome the following challenges: reverse our recent market share decline, increase our profit margins and continue to develop technological advances.

19

We evaluate our performance based upon the following factors:

•  revenues;

•  operating income;

•  net income per share;

•  net cash provided by operating activities; and

•  days sales outstanding.

Our goal is to execute our strategy to yield growth in net revenues, operating income and net income per share.

Critical Accounting Policies, Judgments and Estimates

Our discussion and analysis of our financial condition and consolidated results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of our condensed consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, net revenues and expenses and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates based upon historical experience and various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Our actual results may differ from these estimates. These critical accounting policies and estimates have been discussed with the Audit committee.

We believe that our critical accounting policies affect our more significant estimates and judgments used in the preparation of our condensed consolidated financial statements. Our Annual Report onForm 10-K for the year ended December 31, 2005 contains a discussion of these critical accounting policies. There have been no significant changes in our critical accounting policies from those disclosed in our Annual Report onForm 10-K for the year ended December 31, 2005.

Basis of Presentation

Sources of Revenues

We derive revenues primarily from the provision of medical transcription services to health systems, hospitals and large group medical practices. Our customers are generally charged a rate times the volume of work that we transcribe. In the clinical documentation workflow, we provide, in addition to medical transcription technology and services, maintenance services, digital dictation, speech recognition, electronic signature and medical coding technology and services. Our medical transcription revenues have been declining over the past several years, as prices have declined and some customers have switched to alternative vendors. Our technology products and services revenues also declined over the past several years, as many products reached end of life and new products have not replaced the lost revenue.

As a result of our analysis of our historical billing information and the available report-level data to develop individualized accommodation offers to our customers which were billed for medical transcription services using AAMT line billing, which is more fully described in our Annual Report onForm 10-K for the year ended December 31, 2005 under the caption “Significant Events Since Our Last Regular Periodic Report” contained in Item 1, Business, net revenues for the six months ended June 30, 2006 and 2005 were reduced by $1.2 million and $1.5 million, respectively.

Cost of Revenues

Cost of revenues includes compensation of MTs, other payroll costs (primarily related to operational and production management, quality assurance, quality control and customer and field service personnel), telecommunication and facility costs. Cost of revenues also includes the direct cost of technology products sold to customers. MT payroll cost is directly related to medical transcription revenues and is based on lines transcribed or

20

edited multiplied by a specific rate. Therefore, MT costs trend directly in line with revenues. Fixed costs have been reduced though not at the same pace as net revenues.

Selling, General and Administrative (SG&A)

Our SG&A expenses include marketing and sales costs, accounting costs, information technology costs, professional fees, corporate facility costs, corporate payroll and benefits expenses.

Research and Development (R&D)

Our R&D expenses consist primarily of personnel and related costs, including salaries and employee benefits for software engineers and consulting fees paid to independent consultants who provide software engineering services to us. To date, our R&D efforts have been devoted to new products and services offerings and increases in features and functionality of our existing products and services.

Depreciation and amortization

Depreciation is calculated on a straight-line basis over the estimated useful lives of the assets which range from three to seven years for furniture, equipment and software, and the lesser of the lease term or estimated useful life for leasehold improvements. Intangible assets are being amortized using the straight-line method over their estimated useful lives which range from three to 20 years.

Cost of investigation and legal proceedings

Cost of investigation and legal proceedings include legal fees incurred in connection with the SEC and DOJ investigations and proceedings and the defense of civil litigation matters described in Part II, Item 1, Legal Proceedings in this report, litigation support consulting, and consulting services provided by Nightingale and Associates, LLC (Nightingale) in connection with the Review and Management’s Billing Assessment.

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Consolidated Results of Operations

The following tables set forth our consolidated results of operations for the periods indicated below:

Comparison of Three Months Ended June 30, 2006 and 2005

	Three Months Ended June 30,
	2006						2005
				% of Net						% of Net
	Amount			Revenues			Amount			Revenues			$ Change			% Change
	($ in thousands)
Net revenues	$	93,359			100.0	%	$	103,364			100.0	%	$	(10,005	)		(9.7	)%
Operating costs and expenses:
Cost of revenues		72,392			77.5	%		80,473			77.9	%		(8,081	)		(10.0	)%
Selling, general and administrative		11,719			12.6	%		12,230			11.8	%		(511	)		(4.2	)%
Research and development		3,057			3.3	%		2,482			2.4	%		575			23.2	%
Depreciation		3,003			3.2	%		4,354			4.2	%		(1,351	)		(31.0	)%
Amortization of intangible assets		1,536			1.6	%		2,049			2.0	%		(513	)		(25.0	)%
Cost of investigation and legal proceedings		5,336			5.7	%		8,455			8.2	%		(3,119	)		(36.9	)%
Restructuring charges		493			0.5	%		—			—			493			—
Total operating costs and expenses		97,536			104.5	%		110,043			106.5	%		(12,507	)		(11.4	)%
Operating loss		(4,177	)		(4.5	)%		(6,679	)		(6.5	)%		2,502			(37.5	)%
Equity in income of affiliated company		162			0.2	%		85			0.1	%		77			90.6	%
Interest income, net		1,901			2.0	%		1,369			1.3	%		532			38.9	%
Loss before income taxes		(2,114	)		(2.3	)%		(5,225	)		(5.1	)%		3,111			(59.5	)%
Income tax expense (benefit)		302			0.3	%		(1,977	)		(1.9	)%		2,279			(115.3	)%
Net loss	$	(2,416	)		(2.6	)%	$	(3,248	)		(3.1	)%	$	832			(25.6	)%

Net revenues

Net revenues decreased $10.0 million, or 9.7%, to $93.4 million for the three months ended June 30, 2006 compared with $103.4 million for the three months ended June 30, 2005. This decrease was attributable primarily to:

•  reduced service revenues of $6.4 million resulting primarily from lower pricing to both new and existing customers and lower medical transcription volume of $7.7 million offset by a lower charge for the customer accommodation program in the 2006 period ($0.2 million) compared to the 2005 period ($1.5 million). We believe the reduction in volume was the result primarily of customer losses to other outsourced medical transcription providers due to, among other things, price competition and our requirement that our medical transcription customers migrate from disparate and older technology platforms to our DEP; and

•  reduced sales and implementations of our technology products of $3.6 million resulting primarily from the impact of certain technology products reaching the end of their life cycle.

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Cost of revenues

Cost of revenues decreased $8.1 million, or 10.0%, to $72.4 million for the three months ended June 30, 2006 compared with $80.5 million for the three months ended June 30, 2005. This decrease was attributable primarily to:

•  decreased telecommunications costs of $2.2 million associated with both the decrease in our service revenues and the transition of customers from our non-DEP medical transcription platforms, which required MTs to access dictation using traditional phone lines, to our DEP, which allows MTs to access dictation through the internet;

•  reduced medical transcription payroll costs of $2.2 million related directly to the decrease in our service revenues as well as our increased use of speech recognition technology, which reduces the payroll costs associated with the production of revenues;

•  reduced technology product costs of $1.4 million related directly to the reduction in our technology product revenues;

•  reduced costs of $1.3 million resulting from facility closures; and

•  reduced other costs of $1.0 million.

As a percentage of net revenues, cost of revenues decreased to 77.5% for the three months ended June 30, 2006 from 77.9% for the same period in 2005 as a result primarily of higher customer accommodation charges in the 2005 period offset by lower medical transcription service rates and the impact of fixed costs not declining at the same pace as net revenues.

Selling, general and administrative

SG&A expenses decreased $0.5 million, or 4.2%, to $11.7 million for the three months ended June 30, 2006 compared with $12.2 million for the three months ended June 30, 2005. This decrease was due primarily to decreased bonus expense of $1.2 million and decreased compensation costs of $0.7 million associated with the separation and replacement of certain members of our management team including members at the executive level. These decreases were offset by increases in costs associated with audit and outside consulting fees of $0.9 million related to the audit of our financial statements and the audit of our internal control over financial reporting and increase in other SG&A expenses of $0.5 million. SG&A expenses as a percentage of net revenues were 12.6% for the three months ended June 30, 2006 compared with 11.8% for the same period in 2005.

Research and development

R&D expenses increased $0.6 million, or 23.2%, to $3.1 million for the three months ended June 30, 2006 compared with $2.5 million for the three months ended June 30, 2005. This increase was attributable primarily to compensation expense of $0.3 million due to an increase in headcount and higher professional fees for outside consultants of $0.3 million. R&D expenses as a percentage of net revenues were 3.3% for the three months ended June 30, 2006 compared with 2.4% for the same period in 2005.

Depreciation

Depreciation expense decreased $1.4 million, or 31.0%, to $3.0 million for the three months ended June 30, 2006 compared with $4.4 million for the three months ended June 30, 2005. This decrease was attributable primarily to a $4.1 million write-off of assets in the fourth quarter of 2005 and assets reaching the end of their depreciable period in the 2006 period. Depreciation expense as a percentage of net revenues was 3.2% for the three months ended June 30, 2006 compared to 4.2% for the same period in 2005.

Amortization

Amortization of intangible assets decreased $0.5 million, or 25.0%, to $1.5 million for the three months ended June 30, 2006 compared with $2.0 million for the three months ended June 30, 2005. This decrease was the result primarily of several assets reaching the end of their amortization period. Amortization of intangible assets as a

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percentage of net revenues was 1.6% for the three months ended June 30, 2006 compared with 2.0% for the same period in 2005.

Cost of investigation and legal proceedings

Costs and expenses associated with the Review and Management’s Billing Assessment are being reported as cost of investigation and legal proceedings. These cost and expenses decreased $3.1 million, or 36.9%, to $5.3 million for the three months ended June 30, 2006 compared with $8.5 million for the three months ended June 30, 2005. These decreased costs and expenses include legal fees incurred in connection with the SEC and DOJ investigations and proceedings, defense of civil litigation matters and litigation support consulting of $3.1 million.

Restructuring charges

During the latter half of 2005, we implemented a restructuring plan associated with a centralized national service delivery model to streamline our organizational and operational structure to better service our customers. The 2005 restructuring plan involved the consolidation of operating facilities and the related reduction in workforce. During the three months ended June 30, 2006, we recorded a restructuring charge of $0.5 million comprised of $0.3 million for non-cancelable leases related to the closure of offices, $0.1 million for the write-off of equipment and $0.2 million for severance obligations.

Interest income, net

Interest income, net reflects interest earned on cash and cash equivalent balances. Interest income, net increased $0.5 million, or 38.9%, to $1.9 million for the three months ended June 30, 2006 compared with $1.4 million for the three months ended June 30, 2005. This increase was attributable to higher interest rates earned in the 2006 period (4.7%) compared to the 2005 period (2.8%) offset by $37 million lower average cash balance for the three months ended June 30, 2006 compared with the same period in 2005.

Income tax provision

The effective income tax rate for the three months ended June 30, 2006 was 14.3% compared with an effective income tax rate of 37.8% for the three months ended June 30, 2005. The difference in the tax rates is primarily attributable to our 2006 pre tax loss for which no tax benefit was recorded, along with an increase in deferred tax liabilities related to indefinite life assets which can not be considered as a source of future income to benefit deferred tax assets. After consideration of all evidence, both positive and negative, management concluded that it was more likely than not that the deferred tax assets would not be realized. In the six months ended June 30, 2006, adjustments were made to income tax expense to reflect the tax benefits for alternative minimum tax credits offset by adjustments for various exposures related to state taxes.

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Comparison of Six Months Ended June 30, 2006 and 2005

	Six Months Ended June 30,
	2006						2005
				% of Net						% of Net
	Amount			Revenues			Amount			Revenues			$ Change			% Change
	($ in thousands)
Net revenues	$	189,373			100.0	%	$	211,813			100.0	%	$	(22,440	)		(10.6	)%
Operating costs and expenses:
Cost of revenues		146,727			77.5	%		163,276			77.1	%		(16,549	)		(10.1	)%
Selling, general and administrative		26,643			14.1	%		25,784			12.2	%		859			3.3	%
Research and development		6,258			3.3	%		4,946			2.3	%		1,312			26.5	%
Depreciation		5,894			3.1	%		8,718			4.1	%		(2,824	)		(32.4	)%
Amortization of intangible assets		3,111			1.6	%		4,151			2.0	%		(1,040	)		(25.1	)%
Cost of investigation and legal proceedings		12,873			6.8	%		14,681			6.9	%		(1,808	)		(12.3	)%
Restructuring charges		1,705			0.9	%		—			—			1,705			—
Total operating costs and expenses		203,211			107.3	%		221,556			104.6	%		(18,345	)		(8.3	)%
Operating loss		(13,838	)		(7.3	)%		(9,743	)		(4.6	)%		(4,095	)		42.0	%
Equity in income of affiliated company		558			0.3	%		267			0.1	%		291			109.0	%
Interest income, net		3,698			2.0	%		2,404			1.1	%		1,294			53.8	%
Loss before income taxes		(9,582	)		(5.1	)%		(7,072	)		(3.3	)%		(2,510	)		35.5	%
Income tax expense (benefit)		1,305			0.7	%		(2,664	)		(1.3	)%		3,969			(149.0	)%
Net loss	$	(10,887	)		(5.7	)%	$	(4,408	)		(2.1	)%	$	(6,479	)		147.0	%

Net revenues

Net revenues decreased $22.4 million, or 10.6%, to $189.4 million for the six months ended June��30, 2006 compared with $211.8 million for the six months ended June 30, 2005. This decrease was attributable primarily to:

•  reduced service revenues of $16.5 million resulting primarily from lower pricing to both new and existing customers and lower medical transcription volume of $16.8 million offset by a lower charge for the customer accommodation program in the 2006 period ($1.2 million) compared to the 2005 period ($1.5 million). We believe the reduction in volume was the result primarily of customer losses to other outsourced medical transcription providers due to, among other things, price competition and our requirement that our medical transcription customers migrate from disparate and older technology platforms to our DEP; and

•  reduced sales and implementations of our technology products of $5.9 million resulting primarily from the impact of certain technology products reaching the end of their life cycle.

Cost of revenues

Cost of revenues decreased $16.5 million, or 10.1%, to $146.7 million for the six months ended June 30, 2006 compared with $163.3 million for the six months ended June 30, 2005. This decrease was attributable primarily to:

•  reduced medical transcription payroll costs of $5.2 million related directly to the decrease in our service revenues as well as our increased use of speech recognition technology, which reduces the payroll costs associated with the production of revenues;

•  decreased telecommunications costs of $4.4 million associated with both the decrease in our service revenues and the transition of customers from our non-DEP medical transcription platforms, which required

25

MTs to access dictation using traditional phone lines, to our DEP, which allows MTs to access dictation through the internet;

•  reduced other costs of $3.4 million related primarily to non-MT payroll;

•  reduced costs of $2.2 million resulting from facility closures; and

•  reduced technology product costs of $1.3 million related directly to the reduction in our technology product revenues.

As a percentage of net revenues, cost of revenues increased to 77.5% for the six months ended June 30, 2006 from 77.1% for the same period in 2005, as a result primarily from reduced customer accommodation charges, lower medical transcription service rates and the impact of fixed costs not declining at the same pace as net revenues.

Selling, general and administrative

SG&A expenses increased $0.9 million, or 3.3%, to $26.6 million for the six months ended June 30, 2006 compared with $25.8 million for the six months ended June 30, 2005. This increase was attributable primarily to increases in costs associated with audit and outside consulting fees of $2.8 million related to the audit of our financial statements and the audit of our internal control over financial reporting, increase in bad debt expense of $0.7 million and increases in other SG&A expenses of $0.4 million. These increases were offset by decreases in compensation costs of $2.0 million associated with the separation and replacement of certain members of our management team including members at the executive level and bonus expense of $1.0 million. SG&A expenses as a percentage of net revenues were 14.1% for the six months ended June 30, 2006 compared with 12.2% for the same period in 2005.

Research and development

R&D expenses increased $1.3 million, or 26.5%, to $6.3 million for the six months ended June 30, 2006 compared with $4.9 million for the six months ended June 30, 2005. This increase was attributable primarily to higher professional fees for outside consultants of $0.6 million, compensation expense of $0.5 million due to an increase in headcount and miscellaneous expenses of $0.2 million. R&D expenses as a percentage of net revenues were 3.3% for the six months ended June 30, 2006 compared with 2.3% for the same period in 2005.

Depreciation

Depreciation expense decreased $2.8 million, or 32.4%, to $5.9 million for the six months ended June 30, 2006 compared with $8.7 million for the six months ended June 30, 2005. This decrease was attributable primarily to a $4.1 million write-off of assets in the fourth quarter of 2005 and assets reaching the end of their depreciable period in the 2006 period. Depreciation expense as a percentage of net revenues was 3.1% for the six months ended June 30, 2006 compared to 4.1% for the same period in 2005.

Amortization

Amortization of intangible assets decreased $1.0 million, or 25.1%, to $3.1 million for the six months ended June 30, 2006 compared with $4.2 million for the six months ended June 30, 2005. This decrease was the result primarily of several assets reaching the end of their amortization period. Amortization of intangible assets as a percentage of net revenues was 1.6% for the six months ended June 30, 2006 compared with 2.0% for the same period in 2005.

Cost of investigation and legal proceedings

Costs and expenses associated with the Review and Management’s Billing Assessment are being reported as cost of investigation and legal proceedings. The costs and expenses decreased $1.8 million, or 12.3%, to $12.9 million for the six months ended June 30, 2006 compared with $14.7 million for the six months ended June 30, 2005. These decreased costs and expenses include legal fees incurred in connection with the SEC and DOJ

26

investigations and proceedings, defense of civil litigation matters and litigation support consulting of $1.7 million and other miscellaneous costs of $0.1 million.

Restructuring charges

During the latter half of 2005, we implemented a restructuring plan associated with a centralized national service delivery model to streamline our organizational and operational structure to better service our customers. The 2005 restructuring plan involved the consolidation of operating facilities and the related reduction in workforce. During the six months ended June 30, 2006, we recorded a restructuring charge of $1.7 million comprised of $0.6 million for non-cancelable leases related to the closure of offices, $0.2 million for the write-off of equipment and $0.9 million for severance obligations.

Interest income, net

Interest income, net reflects interest earned on cash and cash equivalent balances. Interest income, net increased $1.3 million, or 53.8%, to $3.7 million for the six months ended June 30, 2006 compared with $2.4 million for the six months ended June 30, 2005. This increase was attributable to higher interest rates earned in the 2006 period (4.6%) compared to the 2005 period (2.4%), offset by $30 million lower average cash balance for the six months ended June 30, 2006 compared with the same period in 2005.

Income tax provision

The effective income tax rate for the six months ended June 30, 2006 was 13.6% compared with an effective income tax rate of 37.7% for the six months ended June 30, 2005. The difference in the tax rates is primarily attributable to our 2006 pre tax loss for which no tax benefit was recorded, along with an increase in deferred income tax liabilities related to indefinite life assets which can not be considered as a source of future income to benefit deferred income tax assets. After consideration of all evidence, both positive and negative, management concluded that it was more likely than not that the deferred income tax assets would not be realized. For the six months ended June 30, 2006, adjustments were made to income tax expense to reflect the tax benefits for Alternative Minimum Tax credits offset by adjustments for various exposures related to state taxes.

Liquidity and Capital Resources

As of June 30, 2006, we had net working capital of $145.9 million compared with $150.7 million as of December 31, 2005. Our principal sources of liquidity were cash flows from operating activities and available cash on hand. Cash and cash equivalents decreased $18.2 million for the six months ended June 30, 2006 to $160.0 million as of June 30, 2006 from $178.3 million as of December 31, 2005. This decrease was driven primarily by cash used in operating activities of $14.0 million and purchases of property and equipment of $4.3 million. The $14.0 million net cash used by operating activities reflects a $10.9 million net loss and $16.1 million of customer accommodation payments offset by $9.0 million of depreciation and amortization expense and a $4.0 million increase in cash primarily from accounts receivables driven by improved days sales outstanding.

We believe our existing cash and cash equivalents and cash to be generated from operations, if any, will be sufficient to finance our operations for the foreseeable future. However, if we fail to generate adequate cash flows from operations in the future, due to an unexpected decline in our net revenues, or due to increased cash expenditures in excess of the net revenues generated, then our cash balances may not be sufficient to fund our continuing operations without obtaining additional debt or equity. There are no assurances that sufficient funding from external sources will be available to us on acceptable terms, if at all. For instance, we may have increased cash expenditures relating to:

•  the SEC, DOJ and DOL investigations and proceedings; and

•  the defense and resolution of the civil litigation matters.

Off-Balance Sheet Arrangements

We are not involved in any off-balance sheet arrangements that have or are reasonably likely to have a material current or future impact on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources.

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Item 3.   Quantitative and Qualitative Disclosures About Market Risk

None.

Item 4.   Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Our management team, under the supervision and with the participation of our principal executive officer and our principal financial officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures as such term is defined underRule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended (Exchange Act), as of the last day of the fiscal period covered by this report, June 30, 2006. The term disclosure controls and procedures means our controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to management, including our principal executive and principal financial officer, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. Based on this evaluation, our principal executive officer and our principal financial officer concluded that, because of the material weaknesses in our internal control over financial reporting described in our Annual Report onForm 10-K for the fiscal year ended December 31, 2005 and our inability to file this report within the required time period, our disclosure controls and procedures were not effective as of June 30, 2006. To compensate for the material weaknesses in our internal control over financial reporting described in our Annual Report onForm 10-K for the fiscal year ended December 31, 2005, we performed additional manual procedures and analysis and other post-closing procedures in order to prepare the condensed consolidated financial statements included in this report. As a result of these expanded procedures, we believe that the condensed consolidated financial statements contained in this report present fairly, in all material respects, our financial condition, results of operations and cash flows for the periods covered thereby in conformity with generally accepted accounting principles.

Changes in Internal Control Over Financial Reporting

Except as noted below, there have been no changes in our internal control over financial reporting during the fiscal quarter June 30, 2006 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting:

•  Established a formal month end process for identifying disposed assets and recording the appropriate entries into the fixed asset sub-ledger.

Although our remediation efforts are underway, material weaknesses identified as of December 31, 2005 will not be considered remediated until new internal controls over financial reporting are fully implemented and operational for a period of time and are operating effectively.

PART II. OTHER INFORMATION

Item 1.   Legal Proceedings

Governmental Investigations

The SEC is currently conducting a formal investigation of us relating to our billing practices. We have been fully cooperating with the SEC since it opened its investigation in 2004. We have complied and are continuing to comply with information and document requests by the SEC.

We also received an administrative HIPAA subpoena for documents from the DOJ on December 17, 2004. The subpoena sought information primarily about our provision of medical transcription services to governmental and non-governmental customers. The information was requested in connection with a government investigation into whether we and others violated federal laws in connection with the provision of medical transcription services. We have complied and are continuing to comply with information and document requests by the DOJ.

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The DOL is currently conducting a formal investigation into the administration of our 401(k) plan. We have been fully cooperating with the DOL since it opened its investigation in 2004. We have complied and are continuing to comply with information and document requests by the DOL.

Developments relating to the SEC, DOJand/or DOL investigations will continue to create various risks and uncertainties that could materially and adversely affect our business and our historical and future financial condition, results of operations, and cash flows.

Shareholder Securities Litigation

A shareholder putative class action lawsuit was filed against us in the United States District Court District of New Jersey on November 8, 2004. The action, entitledWilliam Steiner v. MedQuist, Inc., et al., CaseNo. 1:04-cv-05487-FLW (Shareholder Putative Action), was filed against us and certain of our former officers, purportedly on behalf of an alleged class of all persons who purchased our common stock during the period from April 23, 2002 through November 2, 2004, inclusive (Securities Class Period). The complaint specifically alleged that defendants violated federal securities laws by purportedly issuing a series of false and misleading statements to the market throughout the Securities Class Period, which statements allegedly had the effect of artificially inflating the market price of our securities. The complaint asserts claims under Section 10(b) and 20(a) of the Exchange Act andRule 10b-5, thereunder. Named as defendants, in addition to us, were our former President and Chief Executive Officer and our former Executive Vice President and Chief Financial Officer.

On August 16, 2005, a First Amended Complaint in the Shareholder Putative Class Action was filed against us in the United States District Court District of New Jersey. The First Amended Complaint named additional defendants, including certain current and former directors, certain of our former officers, our former and current external auditors and Philips. Like the original complaint, the First Amended Complaint asserted claims under Sections 10(b) and 20(a) of the Exchange Act andRule 10b-5 thereunder. The Securities Class Period of the original complaint was expanded 20 months to include the period from March 29, 2000 through June 14, 2004. Pursuant to an October 17, 2005 consent order approved by the Court, lead plaintiff Greater Pennsylvania Pension Fund filed a Second Amended Complaint on November 15, 2005. The Second Amended Complaint dropped Philips as a defendant, but alleged the same claims and the same purported class period as the First Amended Complaint. Plaintiffs sought unspecified damages. Pursuant to the provisions of the Private Securities Litigation Reform Act, discovery in the action was stayed pending the filing and resolution of the defendants’ motions to dismiss, which were filed on January 17, 2006, and which were fully briefed as of June 16, 2006. On September 29, 2006, the Court denied our motions to dismiss and the motion to dismiss of the individual defendants. In the same order, the Court granted the motion to dismiss filed by our former and current external auditors. On November 3, 2006, we filed our Answer denying the material allegations contained in the Second Amended Complaint. On March 23, 2007, we entered into a memorandum of understanding and a stipulation of settlement with the lead plaintiff in which we agreed to pay $7.75 million to settle all claims, throughout the class period, against all defendants in the action. On May 16, 2007, the Court issued an Order Preliminarily Approving Settlement and Providing for Notice. The Court conducted a final approval hearing and approved the settlement on August 15, 2007. Neither we nor any of the individuals named in the action has admitted to liability or any wrongdoing in connection with the settlement.

Customer Litigation

A putative class action was filed in the United States District Court for the Central District of California. The action, entitled South Broward Hospital District, d/b/a Memorial Regional Hospital, et al. v. MedQuist, Inc. et al., CaseNo. CV-04-7520-TJH-VBKx, was filed on September 9, 2004 against us and certain of our present and former officials, purportedly on behalf of an alleged class of non-Federal governmental hospitals and medical centers that the complaint claims were wrongfully and fraudulently overcharged for transcription services by defendants based primarily on our use of the AAMT line billing unit of measure. The complaint charged fraud, violation of the California Business and Professions Code, unjust enrichment, conversion, negligent supervision and violation of RICO. Plaintiffs seek damages in an unspecified amount, plus costs and interest, an injunction against alleged continuing illegal activities, an accounting, punitive damages and attorneys’ fees. Named as defendants, in addition to us, were one of our senior vice presidents, our former executive vice president of marketing and new business

29

development, our former executive vice president and chief legal officer, and our former executive vice president and chief financial officer.

On December 20, 2004, we and the individual defendants filed motions to dismiss for lack of personal jurisdiction and improper venue, or in the alternative, to transfer the putative action to the United States District Court for the District of New Jersey. On February 2, 2005, plaintiffs filed a Second Amended Complaint both adding and deleting named plaintiffs in an attempt to keep the putative action in the United States District Court for the Central District of California. On March 30, 2005, the United States District Court for the Central District of California issued an order transferring the putative action to the United States District Court District of New Jersey.

On August 1, 2005, we and the individual defendants filed their respective Answers denying the material allegations contained in the Second Amended Complaint. On August 31, 2005, we and the individual defendants filed motions to dismiss the Second Amended Complaint for failure to state a claim and a motion to dismiss in favor of arbitration, or in the alternative, to stay pending arbitration. On December 12, 2005, the plaintiffs filed an Amendment to the Second Amended Complaint. On December 13, 2005, the Court issued an order requiring plaintiffs to file a Third Amended Complaint.

Plaintiffs filed the Third Amended Complaint on January 4, 2006. The Third Amended Complaint expands the claims made beyond issues arising from contracts based on AAMT line billing and beyond customers billed based on an AAMT line, alleging that we engaged in a scheme to inflate customers’ invoices without regard to the terms of individual contracts and even in the absence of any written contract. The Third Amended Complaint also limits plaintiffs’ claim for fraud in the inducement of the agreement to arbitrate to the three named plaintiffs whose contracts contain an arbitration provision and a subclass of similarly situated customers. On January 20, 2006 we and the individual defendants filed motions to dismiss the Third Amended Complaint for failure to state a claim and a motion to compel arbitration of all claims by the arbitration subclass and to stay the case in its entirety pending arbitration. On March 8, 2006 the Court held a hearing on these motions, and took the matter under submission. On March 30, 2007, the Court issued an order holding that plaintiffs could not make out a claim that we had violated the federal RICO statute, thus eliminating any claim against us for treble damages. The Court also found that plaintiffs could not make out a claim that we had engaged in any unfair or deceptive acts or practices in violation of state law, or that we had made any negligent misrepresentations to plaintiffs. In its ruling, the Court, without reaching a decision of whether any wrongdoing had occurred, allowed plaintiffs to proceed with their claims against us for fraud, unjust enrichment and an accounting. In its order, the Court denied our motion to compel arbitration regarding those customers whose contracts contained an agreement to arbitrate. We have appealed that decision to the Third Circuit Court of Appeals, and we moved the district court to stay the matter pending that appeal. The district court heard oral argument on our motion to stay on May 30, 2007 and took the motion under submission. On June 8, 2007, plaintiffs filed a Motion for Summary Action with the Third Circuit Court of Appeals, asking the Court to dismiss plaintiffs who did not enter into arbitration agreements with us from the appeal. We filed our opposition to this motion on June 25, 2007. The Court has referred the motion to the merits panel for decision after full briefing. In addition, on July 18, 2007, the Third Circuit Court of Appeals issued notice that the case had been assigned to mediation in the Court’s mediation program. On August 1, 2007, plaintiffs filed a motion for expedited review on appeal. We do not oppose this motion, and the parties have agreed to a schedule pursuant to which the appeal will be fully briefed by November 16, 2007. On August 21, 2007, the Third Circuit granted the motion for expedited review. Under the Court’s order, briefing is scheduled to be completed by November 16, 2007. The Third Circuit also has ordered the parties to telephonic mediation, which is scheduled to proceed on September 12, 2007. We believe that the claims asserted have no merit and intend to defend the case vigorously.

Medical Transcriptionist Litigation

Hoffmann Putative Class Action

A putative class action lawsuit was filed against us in the United States District Court for the Northern District of Georgia. The action, entitled Brigitte Hoffmann, et al. v. MedQuist, Inc., et al., CaseNo. 1:04-CV-3452, was filed with the Court on November 29, 2004 against us and certain current and former officials, purportedly on behalf of an alleged class of current and former employees and statutory workers, who are or were compensated on a “per line” basis for medical transcription services (Class Members) from January 1, 1998 to the time of the filing of the

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complaint (Class Period). The complaint specifically alleged that defendants systematically and wrongfully underpaid the Class Members during the Class Period. The complaint asserted the following causes of action: fraud, breach of contract, demand for accounting, quantum meruit, unjust enrichment, conversion, negligence, negligent supervision, and RICO violations. Plaintiffs sought unspecified compensatory damages, punitive damages, disgorgement and restitution. On December 1, 2005, the Hoffmann matter was transferred to the United States District Court for the District of New Jersey. On January 12, 2006, the Court ordered this case consolidated with the Myers Putative Class Action discussed below. As set forth below, we believe that the claims asserted in the consolidated Myers Putative Class Action have no merit and intend to vigorously defend that action.

Force Putative Class Action

A putative class action entitled Force v. MedQuist Inc. and MedQuist Transcriptions, Ltd., CaseNo. 05-cv-2608-WSD, was filed against us on October 11, 2005, in the United States District Court for the Northern District of Georgia. The action was brought on behalf of a putative class of current and former employees who claim they are or were compensated on a “per line” basis for medical transcription services but were allegedly underpaid due to the actions of defendants. The named plaintiff asserted claims for breach of contract, quantum meruit, unjust enrichment, and for an accounting. Upon stipulation and consent of the parties, on February 17, 2006, the Force matter was ordered transferred to the United States District Court for the District of New Jersey. Subsequently, on April 4, 2006, the parties entered into a stipulation and consent order whereby the Force matter was consolidated with the Myers Putative Class Action discussed below, and the consolidated amended complaint filed in the Myers action on January 31, 2006 was deemed to supersede the original complaint filed in the Force matter. As set forth below, we believe that the claims asserted in the consolidated Myers Putative Class Action have no merit and intend to vigorously defend that action.

Myers Putative Class Action

A putative class action entitled, Myers, et al. v. MedQuist Inc. and MedQuist Transcriptions, Ltd., CaseNo. 05-cv-4608 (JBS), was filed against us on September 22, 2005 in the United States District Court for the District of New Jersey. The action was brought on behalf of a putative class of our employee and independent contractor transcriptionists who claim that they contracted with us to be paid on a 65 character line, but were allegedly underpaid due to intentional miscounting of the number of characters and lines transcribed. The named plaintiffs asserted claims for breach of contract, unjust enrichment, and request an accounting.

The allegations contained in the Myers case are substantially similar to those contained in the Hoffmann and Force putative class actions and, as detailed above, the three actions have now been consolidated. A consolidated amended complaint was filed on January 31, 2006. In the consolidated amended complaint, the named plaintiffs assert claims for breach of contract, breach of the covenant of good faith and fair dealing, unjust enrichment and demand an accounting. On March 7, 2006 we filed a motion to dismiss all claims in the consolidated amended complaint. The motion was fully briefed and argued on August 7, 2006. The Court denied the motion on December 21, 2006. On January 19, 2007, we filed an answer denying the mutual allegations pleaded in the consolidated amended complaint. The parties are now proceeding with discovery. The deadline to complete pretrial fact discovery is October 30, 2007. No date has been set for a class certification hearing or trial. We believe that the claims asserted in the consolidated actions have no merit and intend to vigorously defend the suit.

Shareholder Derivative Litigation

On October 4, 2005, we announced the dismissal with prejudice of a shareholder derivative action filed in United States District Court for the District of New Jersey. The suit, Rhoda Kanter (Plaintiff) v. Hans M. Barella et al. (Defendants), was filed on November 12, 2004 against Philips and 10 current and former members of our board of directors. We were named as a nominal defendant.

In a ruling dated September 21, 2005, the Court found plaintiff’s allegations that our board of directors breached their fiduciary duties to us to be insufficient. The plaintiff had alleged that for a period from 2001 through 2004, the Defendants violated their fiduciary duties by permitting artificial inflation of billing figures; failing to adequately ensure accurate and lawful billing practices; and failing to accurately report our true financial condition

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in its published financial statements. To the contrary, the Court concluded: “Far from alleging facts supporting a substantial likelihood of liability, the plaintiff here has painted a picture of a board of directors that acted responsively given the circumstances . . . .” On October 3, 2005, plaintiff filed a motion for reconsideration of the Court’s order dismissing the action with prejudice. On November 16, 2005, the Court denied plaintiff’s motion for reconsideration. On December 13, 2005, plaintiff filed a Notice of Appeal with the United States Court of Appeals for the Third Circuit. Plaintiff’s appeal was fully briefed as of May 2006, and the Court of Appeals heard oral argument on the appeal on March 1, 2007. Plaintiff’s appeal was denied by the Court of Appeals on May 25, 2007.

Item 1A.   Risk Factors

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This report contains forward-looking statements that are based on current expectations, estimates, forecasts and projections about us, the industry in which we operate and other matters, as well as management’s beliefs and assumptions and other statements regarding matters that are not historical facts. These statements include, in particular, statements about our plans, strategies and prospects. For example, when we use words such as “projects,” “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “should,” “would,” “could,” “will,” “opportunity,” “potential” or “may,” variations of such words or other words that convey uncertainty of future events or outcomes, we are making forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 (Securities Act) and Section 21E of the Exchange Act. Our forward-looking statements are subject to risks and uncertainties. Actual events or results may differ materially from the results anticipated in these forward-looking statements as a result of a variety of factors. While it is impossible to identify all such factors, factors that could cause actual results to differ materially from those estimated by us include:

•  each of the factors discussed in this Item 1A, Risk Factors as well as risks discussed elsewhere in this report;

•  each of the matters discussed in Item 1, Legal Proceedings;

•  difficulties relating to our significant management turnover;

•  our ability to recruit and retain qualified medical MTs and other employees;

•  the impact of our new services and products on the demand for our existing services and products;

•  our current dependence on medical transcription for substantially all of our business;

•  our ability to become current in our periodic reporting obligations under the Exchange Act;

•  our ability to expand our customer base;

•  changes in law, including, without limitation, the impact Health Insurance Portability and Accountability Act of 1996 (HIPAA) will have on our business;

•  infringement on the proprietary rights of others;

•  our ability to diversify into other businesses;

•  the results of our review of strategic alternatives;

•  our ability to effectively integrate newly-acquired operations;

•  competitive pricing pressures in the medical transcription industry and our response to those pressures; and

•  general conditions in the economy and capital markets.

Many of these factors are beyond our ability to predict or control. In addition, as a result of these and other factors, our past financial performance should not be relied on as an indication of future performance. The cautionary statements referred to in this section also should be considered in connection with any subsequent written or oral forward-looking statements that may be issued by us or persons acting on our behalf. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. In light of these risks and uncertainties, the forward-looking

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events and circumstances discussed in this report might not occur. Furthermore, we cannot guarantee future results, events, levels of activity, performance, or achievements.

Set forth below are certain important risks and uncertainties that could adversely affect our results of operations or financial condition and cause our actual results to differ materially from those expressed in forward-looking statements made by us. Although we believe that we have identified and discussed below the key risk factors affecting our business, there may be additional risks and uncertainties that are not presently known or that are not currently believed to be significant that may adversely affect our performance or financial condition. More detailed information regarding risk factors described below is contained in other sections of this report.

We are subject to ongoing investigations, which could require us to pay substantial fines or other penalties or subject us to sanctions and we cannot predict the timing of developments in these matters.

Prior to our July 2004 Press Release, we notified the staff of the SEC that our board of directors had commenced the Review. Following that notification, the SEC began an enforcement proceeding, including an investigation into the facts and circumstances giving rise to the Review. We have been and intend to continue cooperating fully with the SEC.

The Review overseen by our board of directors led to a delay in the filings of this and other required reports with the SEC. Because of this delay, we were not in compliance with the listing standards of The NASDAQ Stock Exchange LLC (NASDAQ) and NASDAQ delisted our common stock on June 16, 2004.

On December 17, 2004, we received an administrative HIPAA subpoena for documents from the DOJ. The subpoena seeks information primarily about our provision of medical transcription services to governmental and non-governmental customers. The information was requested in connection with a dual civil and criminal government investigation into whether we and others violated federal laws in connection with the provision of medical transcription services. We have been and intend to continue cooperating fully with the DOJ.

On November 23, 2004 we received notice from the DOL of its commencement of a formal investigation into the administration of our 401(k) plan. We have been fully cooperating with the DOL since it opened its investigation in 2004. We have complied and are continuing to comply with information and document requests by the DOL.

We cannot predict when the investigations will be completed or the timing of any other developments, nor can we predict what the result of these matters may be. See Item 1, Legal Proceedings, for a further discussion of these matters.

Expenses incurred in connection with these matters (which include substantial fees of lawyers and other professional advisors) could adversely affect our financial position, results of operations and liquidity. We may be required to pay material judgments, fines, penalties or settlements or suffer other penalties, each of which could have a material adverse effect on our business and our historical and future results of operations, financial condition and liquidity. The investigations may adversely affect our ability to obtain,and/or increase the cost of obtaining directors’ and officers’ liability insuranceand/or other types of insurance, which could have a material adverse affect on our ability to retain our current or obtain new senior management and directors. In addition, the findings and outcomes of the investigations described above may adversely affect the course of the civil litigation pending against us.

Several lawsuits have been filed against us involving our billing practices and other related matters and the outcome of these lawsuits may have a material adverse effect on our business, financial condition, results of operations and cash flows.

A number of lawsuits have been filed against us, as well as certain of our past and current officersand/or directors and current majority shareholder, relating to, among other things, allegations of violations of the federal securities laws and various common laws based on allegedly unlawful billing and payroll practices. Substantial damages or other monetary remedies assessed against us could have a material adverse effect on our business, financial condition, results of operations and cash flows. See Part II, Item 1, Legal Proceedings, for a further discussion of these matters.

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The continuing time, effort, and expense relating to the allegations raised regarding our past billing practices, our efforts to become current in our SEC filings and the development and implementation of improved internal controls and procedures may have an adverse effect on our business.

Our management team has spent considerable time and effort addressing the challenges of the various government investigations and extensive litigation we face, as well as strengthening our accounting and internal controls and updating and developing accounting policies and procedures, disclosure controls and procedures, and corporate governance policies and procedures. To the extent these matters require continued management attention, our operations may be adversely affected.

Our ability to expand our business and properly service our customers depends on our ability to effectively manage our domestic production capacity, including our ability to recruit, train and retain qualified MTs and maintain high standards of quality service in our operations, which we may not be able to do.

Our success depends, in part, upon our ability to effectively manage our domestic production capacity including our ability to attract and retain qualified MTs who can provide accurate medical transcription. There is currently a shortage of qualified MTs in the U.S. and increased workflow has created industry-wide demand for quality MTs. As a result, competition for skilled MTs is intense. We have active programs in place to attract domestic MTs and to partner with global medical transcription service providers. However, this strategy may not alleviate any issues caused by the shortage. Because medical transcription is a skilled position in which experience is valuable, we require that our MTs have substantial experience or receive substantial training before being hired. Competition may force us to increase the compensation and benefits paid to our MTs, which could reduce our operating margins and profitability. In addition, failure to recruit and retain qualified MTs may have an adverse effect on our ability to service our customers, manage our production capacity and maintain our high standards of quality service. An inability to hire and retain a sufficient number of MTs could have a negative impact on our ability to grow.

We have experienced significant management turnover.

In the past few years, we have experienced a significant turnover in our senior management. This lack of management continuity, and the resulting lack of long-term history with us, could result in operational and administrative inefficiencies and added costs, could adversely impact our stock price and our customer relationships and may make recruiting for future management positions more difficult. In addition, we must successfully integrate any new management personnel that we hire within our organization in order to achieve our operating objectives, and changes in other key management positions may temporarily affect our financial performance and results of operations as new management becomes familiar with our business. Accordingly, our future financial performance will depend to a significant extent on our ability to motivate and retain key management personnel.

We are not current in our periodic reporting obligations under the Exchange Act.

We are not current in our periodic reporting obligations under the Exchange Act. We have not filed ourForms 10-Q for the first and second quarters of 2007. In addition, we have not filed all periodic reports required during 2004 and 2005. Some of the consequences of our failure to meet our reporting obligations under the Exchange Act include:

•  our ineligibility to use certain short-form registration statements under the Securities Act, such asForms S-3 andS-8, until we have filed all reports required under the Exchange Act for a continuous period of 12 months; and

•  the unavailability of Rule 144 for holders of outstanding restricted or control securities until we have filed all reports required under the Exchange Act for a continuous period of 12 months.

In addition, our failure to meet our reporting obligations under the Exchange Act is a violation of Section 13(a) of the Exchange Act and could subject us to SEC investigations and enforcement actions, which could result in

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injunctions and monetary penalties. There is no assurance whether or when we will become current in our reporting obligations under the Exchange Act.

We have had material weaknesses in our internal control over financial reporting and cannot provide assurance that additional material weaknesses will not be identified in the future. Our failure to effectively maintain our internal control over financial reporting could result in material misstatements in our financial statements which could require us to restate financial statements, cause us to fail to meet our reporting obligations, cause investors to lose confidence in our reported financial information or have a negative affect on our stock price.

We have determined that we had deficiencies in our internal control over financial reporting as of December 31, 2005 that constituted “material weaknesses” as defined by the Public Company Accounting Oversight Board’s Audit Standard No. 2. These material weaknesses are identified in Item 9A, Controls and Procedures of our Annual Report onForm 10-K for the year ended December 31, 2005.

We cannot assure you that additional material weaknesses in our internal control over financial reporting will not be identified in the future. Any failure to maintain or implement required new or improved controls, or any difficulties we encounter in their implementation, could result in additional material weaknesses, or could result in material misstatements in our financial statements. These misstatements could result in a restatement of financial statements, cause us to fail to meet our reporting obligations or cause investors to lose confidence in our reported financial information, leading to a decline in our stock price.

We have not complied with Section 404 of the Sarbanes-Oxley Act of 2002 (SOX) for our fiscal year ended December 31, 2004.

As directed by Section 404 of SOX (Section 404), the SEC adopted rules requiring certain public companies, including us, to include management’s assessment of the effectiveness of a public company’s internal control over financial reporting in its annual report onForm 10-K. In addition, the independent registered public accounting firms auditing certain public companies’ financial statements, including ours, must attest to and report on managements’ assessment of, and the effective operation of, such companies internal control over financial reporting. Although these requirements were first applicable to our annual report onForm 10-K for our fiscal year ending December 31, 2004, we were unable to comply with these requirements for such fiscal year. The time and resources expended in connection with the Review and Management’s Billing Assessment, including the resulting changes in senior management, prevented us from completing our internal documentation, assessment and evaluation of our internal control over financial reporting, all of which are required to be undertaken to comply with Section 404. This correspondingly prevented our independent registered public accounting firm from commencing the required audit of our internal control over financial reporting as of December 31, 2004.

Since we determined that it would not be possible to complete either management’s assessment or an audit of our internal control over financial reporting as of December 31, 2004, our independent registered public accounting firm accordingly did not issue an opinion with respect to our internal control over financial reporting as of December 31, 2004. This failure to obtain an opinion does not comply with the SEC’s rules and regulations under Section 404, and this noncompliance, as well as our failure to provide the required Section 404 management assessment, has resulted in us being in violation of Section 13(a) under the Exchange Act. Section 13(a) establishes the general requirement that public companies must file with the SEC, in accordance with such rules and regulations as the SEC may prescribe, such information, documents and reports as the SEC may from time to time require for the protection of investors, includingForms 10-K and10-Q.

In general, the SEC has broad authority under the Exchange Act to institute investigations, to seek injunctions, to seek monetary penalties, and to otherwise pursue enforcement actions for violations of Section 13(a), including a failure to file aForm 10-K or for the omission of necessary statements in aForm 10-K. Therefore, our failure to comply with the Section 404 requirements in ourForm 10-K could potentially subject us to these same investigations, injunctions, penalties and enforcement actions. Section 404 is a relatively new legal requirement, and there is very little precedent establishing the consequences or appropriate response to a public company’s failure to comply with Section 404. Accordingly, although we have discussed our Section 404 noncompliance with the SEC,

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we cannot predict what action, if any, the SEC may take against us as a result of a failure to be compliant with our obligations under Section 404 or Section 13(a) of the Exchange Act.

Current and prospective investors, customers and employees may react adversely to the allegations concerning our billing practices and our inability to file in a timely manner all of our SEC filings.

Our future success depends in large part on the support of our current and future investors, customers and employees. Our inability to file on a timely basis all of our SEC filings has caused negative publicity about us and has resulted in the delisting of our common stock from NASDAQ. In addition, the allegations concerning our past billing practices and our inability to file all of our SEC filings in a timely manner could cause current and future customers to lose confidence in us, which may affect their willingness to seek services from us. Finally, employees and prospective employees may factor in these considerations relating to our stability and the value of any equity incentives in their decision-making regarding employment opportunities.

We compete with many others in the market for medical transcription services which may result in lower prices for our services, reduced operating margins and an inability to maintain or increase our market share and expand our service offerings.

We compete with other outsourced medical transcription service companies in a very fragmented market that includes national, regional and local service providers, as well as service providers with global operations. These companies offer services that are similar to ours and compete with us for both customers and qualified MTs. We also compete with the in-house medical transcription staffs of our customers. While we attempt to compete on the basis of fast, predictable turnaround times and consistently high accuracy and document quality, all offered at a reasonable price, there can be no assurance that we will be able to compete effectively against our competitors or timely implement new products and services. Many of our competitors attempt to differentiate themselves by offering lower priced alternatives to our outsourced medical transcription services. Increased competition and cost pressures affecting the healthcare markets in general may result in lower prices for our services, reduced operating margins and the inability to maintain or increase our market share.

As technology evolves, including the continued refinement of speech recognition technology, health information technology providers may provide services that replace, or reduce the need for medical transcription. Furthermore, companies that provide services complementary to medical transcription, such as electronic medical records, coding and billing, may expand the services they provide to include medical transcription. Current and potential competitors may have financial, technical and marketing resources that are greater than ours. As a result, competitors may be able to respond more quickly to evolving technological developments or changing customer needs or devote greater resources to the development, promotion or sale of their technology or services than we can. In addition, competition may increase due to consolidation of medical transcription companies. As a result of such consolidation, there may be a greater number of providers of medical transcription services with sufficient scale, service mix and financial resources to compete with us to provide services to larger, more complex organizations. Current and potential competitors may establish cooperative relationships with third parties to increase their ability to attract our current and potential customers.

We are reviewing strategic alternatives which could impact our operating results, our stock price and our business.

In July 2007 we engaged Bear, Stearns & Co. Inc. as our financial advisor to review our strategic alternatives. We are uncertain as to what impact any particular strategic alternative will have on our operating results, our stock price and our business if accomplished or whether any transaction will even occur as a result of this review. Other uncertainties and risks relating to our review of strategic alternatives include:

•  the review of strategic alternatives may disrupt our operations, affect morale, distract management and result in the loss of employees, vendors or customers, which could have a material adverse effect on our operating results and our business;

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•  the process of reviewing strategic alternatives may be more time consuming and expensive than we currently anticipate; and

•  we may not be able to identify strategic alternatives that are worth pursuing.

We may pursue future transactions which could require us to incur debt and assume contingent liabilities and expenses, and we may not be able to effectively integrate new operations.

A significant portion of our historical growth has occurred through transactions, and we may pursue transactions in the future. Transactions involve risks that the combined businesses will not perform in accordance with expectations and that business judgments concerning the value, strengths and weaknesses of the combined businesses will prove incorrect. We cannot guarantee that if we decide to pursue future transactions we will be able to identify attractive opportunities or successfully integrate any business or asset we combine with our existing business. Future transactions may involve high costs and may result in the incurrence of debt, contingent liabilities, interest expense, amortization expense or periodic impairment charges related to goodwill and other intangible assets as well as significant charges relating to integration costs.

We cannot guarantee that we will be able to successfully integrate any business we combine with our existing business or that any combined businesses will be profitable. The successful integration of new businesses depends on our ability to manage these new businesses effectively. The successful integration of future transactions may also require substantial attention from our senior management and the management of the combined businesses, which could decrease the time that they have to service and attract customers. In addition, because we may actively pursue a number of opportunities simultaneously, we may encounter unforeseen expenses, complications and delays, including difficulties in employing sufficient staff and maintaining operational and management oversight. Our inability to complete the integration of any new businesses we combine with our existing business in a timely and orderly manner could reduce our net revenues and negatively impact our results of operations.

Our success will depend on our ability to adopt and integrate new technology into our DEP, to improve our production capabilities and expand the breadth of our service offerings, as well as our ability to address any unanticipated problems with our information technology systems, which we may not be able to do quickly, or at all.

Our ability to remain competitive in the medical transcription industry is based, in part, on our ability to develop and utilize technology in the services that we provide to our customers to improve our production capabilities and expand the breadth of our service offerings. Because our services are an integral part of our customers operations, we also must quickly address any unanticipated problems with our information technology systems that could cause an interruption in service or a decrease in our responsiveness to customers. Furthermore, as our customers advance technologically, we must be able to effectively integrate our DEP with their systems and provide advanced data collection technology. We plan to develop and integrate new technologies into our current service structure to give our customers high-quality and cost-effective services. We also may need to develop technologies to provide service systems comparable to those of our competitors as they develop new technology. If we are unable to effectively develop and integrate new technologies, we may not be able to expand our technology and service offerings or compete effectively with our competitors. In addition, if the cost of developing and integrating new technologies is high, we may not realize our expected return on investment.

Due to the critical nature of medical transcription to our customers’ operations, potential customers may be reluctant to outsource or change service providers as a result of the cost and potential for disruption in services, which may inhibit our ability to attract new customers.

The up-front cost involved in changing medical transcription service providers or converting from an in-house medical transcription department to an outsourced provider may be significant. Many customers may prefer to remain with their current service provider or keep their medical transcription in-house rather than incur these costs or experience a potential disruption in services as a result of changing service providers. Also, as the maintenance of accurate medical records is a critical element of a healthcare provider’s ability to deliver quality care to its patients

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and to receive proper and timely reimbursement for the services it renders, potential customers may be reluctant to outsource such an important function.

If our intellectual property is not adequately protected, we may lose our market share to our competitors and be unable to operate our business profitably.

Our success depends, in part, upon our proprietary technology and our ability to license and renew third-party intellectual property. We regard some of the software underlying our services, including our DEP and interfaces, as proprietary, and we rely primarily on a combination of trade secrets, copyright and trademark laws, confidentiality agreements, contractual provisions and technical measures to protect our proprietary rights. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our intellectual property or obtain and use information that we regard as proprietary. There can be no assurance that our proprietary information will not be independently developed by competitors. There can be no assurance that the intellectual property we own or license will provide competitive advantages or will not be challenged or circumvented by our competitors.

We are dependent on third party speech recognition software incorporated in certain of our technologies, and impaired relations with such third party or the inability to enhance such third party software over time could harm our business.

We license speech recognition software from PSRS that we incorporate into our DEP and SpeechQ for Radiology. This license may not continue to be available on commercially reasonable terms or at all. Some of this technology would be difficult to replace. The loss of this license could significantly impact our business until we identify, license and integrate, or develop equivalent software. If we are required to enter into license agreements with third parties for replacement technology, we could face higher royalty payments and our products may lose certain attributes or features.

In addition, our products may be impacted if errors occur in the licensed software that we utilize. It may be more difficult for us to correct any defects in third-party software because the software is not within our control. Accordingly, our business could be adversely affected in the event of any errors in this software. There can be no assurance that these third-parties will continue to invest the appropriate levels of resources in their products and services to maintain and enhance the capabilities of their software.

If we fail to comply with extensive contractual obligations and applicable laws and government regulations governing the handling of patient identifiable medical information, including those imposed on our customers in connection with HIPAA, we could suffer material losses or be negatively impacted as a result of our customers being subject to material penalties and liabilities.

As part of the operation of our business, our customers provide us with certain patient identifiable medical information. Although many regulatory and governmental requirements do not directly apply to our operations, our hospital and other healthcare provider customers must comply with a variety of requirements related to the handling of patient information, including laws and regulations protecting the privacy, confidentiality and security of protected health information (PHI). Most of our customers are covered entities and, in many of our relationships, we function as a business associate. In particular, the provisions of HIPAA require our customers to have business associate agreements in place with a medical transcription company such as ours under which we are required to appropriately safeguard the PHI we create or receive on their behalf. Further, our customers are required to comply with HIPAA security regulations that require them to implement certain administrative, physical and technical safeguards to ensure the confidentiality, integrity and availability of electronic protected health information (EPHI). We are required by contract to protect the security of EPHI that we create, receive, maintain or transmit for our customers consistent with these regulations. To comply with our contractual obligations, we may have to reorganize processes and invest in new technologies. We also are required to train personnel regarding HIPAA requirements. If we, or any of our MTs or subcontractors, are unable to maintain the privacy, confidentiality and security of the PHI that is entrusted to us, our customers could be subject to civil and criminal fines and sanctions and we could be found to have breached our contracts with our customers. Additionally, because all HIPAA standards are subject to interpretation and change, we cannot predict the future impact of HIPAA on our business and operations. In the event that the standards and compliance requirements under HIPAA change or are interpreted in a way that requires

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any material change to the way in which we do business, our business, financial condition and results of operations could be adversely affected. To the extent that the laws of the states in which we or our customers operate are more restrictive than HIPAA, we may have to incur additional costs to maintain compliance with any such applicable requirements.

Proposed legislation and possible negative publicity may impede our ability to utilize global service capabilities.

Bills introduced in recent sessions of the U.S. Congress have sought to restrict the transmission of personally identifiable information regarding a U.S. resident to any foreign affiliate, subcontractor or unaffiliated third party without adequate privacy protections or without providing notice of the transmission and an opportunity to opt out. Some of the proposals would require patient consent. If enacted, these proposed laws would impose liability on healthcare businesses arising from the improper sharing or other misuse of personally identifiable information. Some proposals would create a private civil cause of action that would allow an injured party to recover damages sustained as a result of a violation of the new law. A number of states have also considered, or are in the process of considering, prohibitions or limitations on the disclosure of medical or other information to individuals or entities located outside of the U.S. Further, as a result of this negative publicity and concerns regarding the possible misuse of personally identifiable information, some of our customers have contractually limited our ability to use MTs located outside of the U.S.

Philips owns approximately 69.6% of our outstanding common stock, and its interests may conflict with the interests of our other shareholders.

Philips beneficially owns approximately 69.6% of our outstanding common stock. Philips has the ability to cause the election of all of the members of our board of directors, the appointment of new management and the approval of any action requiring the approval of our shareholders, including amendments to our certificate of incorporation and mergers or sales of substantially all of our assets. The directors elected by Philips will be able to make decisions affecting our capital structure, including decisions to issue additional capital stock, implement stock repurchase programs and declare dividends. Our interests and the interests of our affiliates, including Philips, could conflict with the interest of our other shareholders. For a further description of these relationships, see Note 10 to our condensed consolidated financial statements included in this report.

In July 2007, Philips announced that it is reviewing all of its options with respect to its ownership interest in us following a determination by Philips that it views its ownership interest in us to be a non-core holding. In connection with such review, Philips may consider possible transactions or other changes in its ownership interest.

Our stock trades on the over-the-counter “Pink Sheets” market, which may decrease the liquidity of our common stock.

On June 16, 2004, NASDAQ delisted our common stock because we were not able to file our periodic reports with the SEC in a timely manner. Since that time, our common stock has been traded on the over-the-counter “Pink Sheets” market (Pink Sheets) under the symbol “MEDQ.PK.” Broker-dealers often decline to trade in Pink Sheet stocks given that the market for such securities is often limited, the stocks are more volatile, and the risks to investors are greater. Consequently, selling our common stock can be difficult because transactions can be delayed and security analyst and news media coverage of us may be reduced. These factors could result in lower prices and larger spreads in the bid and ask prices for shares of our common stock as well as lower trading volume. Although we intend to apply for the listing of our common stock on a national securities exchange once we are current in our periodic reporting obligations with the SEC, we cannot assure you that we will be successful in those efforts. We do not expect to become current in our periodic reporting obligations until the end of the third quarter of 2007, and we will not be able to apply for listing on a stock exchange until this time. Investors should realize that they may be unable to sell shares of our common stock that they purchase. Accordingly, investors must be able to bear the financial risk of losing their entire investment in our common stock.

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Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds

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

(a) Exhibits.

No.			Description
	10	.1*(1)	Relocation Letter Agreement, dated as of April 26, 2006, between MedQuist Inc. and Adele T. Barbato
	31	.1	Certification of Chief Executive Officer required byRule 13a-14(a) orRule 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
	31	.2	Certification of Chief Financial Officer required byRule 13a-14(a) orRule 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
	32	.1	Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
	32	.2	Certification of Chief Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

*	Management contract or compensatory plan or arrangement.
(1)	Incorporated by reference to Exhibit 10.15 to our Annual Report on Form10-K for the year ended December 31, 2005 filed with the SEC on July 5, 2007.

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SIGNATURES

Pursuant to the requirements 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.

MEDQUIST INC.

/s/  Howard S. Hoffmann

Howard S. Hoffmann

President and Chief Executive Officer

(Principal Executive Officer)

Date: August 31, 2007

/s/  Kathleen E. Donovan

Kathleen E. Donovan

Senior Vice President and Chief Financial

Officer (Principal Financial Officer)

Date: August 31, 2007

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Exhibit Index

No.			Description
	31	.1	Certification of Chief Executive Officer required by Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
	31	.2	Certification of Chief Financial Officer required by Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
	32	.1	Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
	32	.2	Certification of Chief Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

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