Medquist 10Q 2007 Q3 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 September 30, 2007.


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		(I.R.S. Employer
incorporation or organization)		Identification No.)

1000 BISHOPS GATE BOULEVARD		08054-4632
SUITE 300		(Zip Code)
MOUNT LAUREL, NEW JERSEY
Address of principal executive offices)

(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 þ No o

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” in Rule 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 in Rule 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 October 31, 2007 was 37,487,323.

MEDQUIST INC.

INDEX


	Page
PART I. FINANCIAL INFORMATION		3
Item 1. Financial Statements		3
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		19
Item 4. Controls and Procedures		28
PART II. OTHER INFORMATION		29
Item 1. Legal Proceedings		29
Item 1A. Risk Factors		32
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		33
Item 3. Defaults Upon Senior Securities		33
Item 4. Submission of Matters to a Vote of Security Holders		33
Item 5. Other Information		33
Item 6. Exhibits		34
Amended and Restated OEM Supply Agreement
Certification of Chief Executive Officer
Certification of Chief Financial Officer
Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350
Certification of Chief Financial Officer pursuant to 18 U.S.C. 1350

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

MedQuist Inc. and Subsidiaries

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


	Three months ended						Nine months ended
	September 30,						September 30,
	2007			2006			2007			2006
Net revenues	$	82,518		$	82,096		$	260,276		$	271,469


Operating costs and expenses:
Cost of revenues		64,290			67,929			198,918			214,656
Selling, general and administrative		15,548			12,765			48,158			39,408
Research and development		3,808			3,447			10,073			9,705
Depreciation		2,861			3,149			8,040			9,043
Amortization of intangible assets		1,361			1,363			4,065			4,474
Cost of investigation and legal proceedings, net		4,441			(3,854	)		(456	)		9,019
Restructuring charges		554			1,234			935			2,939


Total operating costs and expenses		92,863			86,033			269,733			289,244


Operating loss		(10,345	)		(3,937	)		(9,457	)		(17,775	)

Equity in income of affiliated company		124			180			447			738
Interest income, net		2,302			1,977			6,477			5,675


Loss before income taxes		(7,919	)		(1,780	)		(2,533	)		(11,362	)

Income tax provision		1,016			324			2,402			1,629


Net loss	$	(8,935	)	$	(2,104	)	$	(4,935	)	$	(12,991	)


Net loss per share:
Basic	$	(0.24	)	$	(0.06	)	$	(0.13	)	$	(0.35	)

Diluted	$	(0.24	)	$	(0.06	)	$	(0.13	)	$	(0.35	)


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 consolidated financial statements.

MedQuist Inc. and Subsidiaries

Consolidated Balance Sheets
(In thousands)
Unaudited


	September 30,		December 31,
	2007		2006
Assets
Current assets:
Cash and cash equivalents	$	165,942	$	175,412
Accounts receivable, net of allowance of $4,053 and $4,494, respectively		54,039		54,778
Insurance receivable		—		707
Income tax receivable		1,923		1,772
Deferred income taxes		297		298
Other current assets		8,599		7,645

Total current assets		230,800		240,612

Property and equipment, net of accumulated depreciation of $45,240 and $37,838, respectively		22,231		20,969
Goodwill		125,683		124,826
Other intangible assets, net of accumulated amortization of $48,386 and $44,218, respectively		42,923		45,448
Deferred income taxes		2,335		2,378
Other assets		7,570		6,906

Total assets	$	431,542	$	441,139


Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable	$	15,101	$	10,779
Accrued expenses		19,271		28,812
Accrued compensation		16,521		15,558
Customer accommodation and quantification		18,768		24,777
Deferred revenue		15,312		15,202

Total current liabilities		84,973		95,128

Deferred income tax liability		19,957		18,034
Other non-current liabilities		2,204		458


Commitments and contingencies (Note 11)

Shareholders’ equity:
Common stock — no par value; authorized 60,000 shares; 37,484 and 37,484 shares issued and outstanding, respectively		235,526		235,080
Retained earnings		83,147		87,693
Deferred compensation		332		332
Accumulated other comprehensive income		5,403		4,414


Total shareholders’ equity		324,408		327,519


Total liabilities and shareholders’ equity	$	431,542	$	441,139

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

MedQuist Inc. and Subsidiaries

Consolidated Statements of Cash Flows
(In thousands)
Unaudited


	Nine months ended
	September 30,
	2007			2006
Operating activities:
Net loss	$	(4,935	)	$	(12,991	)
Adjustments to reconcile net loss to cash used in operating activities:
Depreciation and amortization		12,105			13,517
Equity in income of affiliated company		(447	)		(738	)
Deferred income tax provision		1,848			3,680
Stock option expense		446			1,591
Provision for doubtful accounts		3,649			4,725
Asset writeoff charges		78			498
Changes in operating assets and liabilities excluding effects of acquisitions:
Accounts receivable		(4,707	)		9,021
Income tax receivable		(151	)		1,431
Insurance receivable		707			(8,702	)
Other current assets		(954	)		1,544
Other non-current assets		(219	)		1,129
Accounts payable		3,156			1,035
Accrued expenses		(9,341	)		(9,119	)
Accrued compensation		929			(3,999	)
Customer accommodation and quantification		(4,048	)		(14,329	)
Deferred revenue		(84	)		(2,174	)
Other non-current liabilities		1,938			(2,447	)

Net cash used in operating activities	$	(30	)	$	(16,328	)


Investing activities:
Purchase of property and equipment		(8,337	)		(7,296	)
Capitalized software		(1,218	)		(21	)

Net cash used in investing activities		(9,555	)		(7,317	)

Effect of exchange rate changes		115			52

Net decrease in cash and cash equivalents		(9,470	)		(23,593	)

Cash and cash equivalents — beginning of period		175,412			178,271

Cash and cash equivalents — end of period	$	165,942		$	154,678


Supplemental cash flow information:

Cash paid (recovered) for income taxes	$	167		$	(3,465	)

Accommodation payments paid with credits	$	1,961		$	424

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

MedQuist Inc. and Subsidiaries

Notes to Consolidated Financial Statements
(In thousands, except for 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 product development. On November 2, 2007, our majority shareholder, Koninklijke Philips Electronics N.V. (Philips), announced that it was going to proceed with the sale of its ownership interest in us if a satisfactory price and other acceptable terms can be realized. In addition, on November 2, 2007 we announced, in light of Philips’ announcement, that our board of directors, in connection with its previously disclosed review of our strategic alternatives, is evaluating whether a sale of us is in our best interests and the best interests of our shareholders. See Note 11.

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 our 2003 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 the 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.

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 invoices and/or take their business elsewhere unless we timely responded to their information and/or audit requests.

MedQuist Inc. and Subsidiaries

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

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 7.

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 11.

3. Basis of Presentation

The 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 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 consolidated financial statements should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations. As permitted under U.S. generally accepted accounting principles, interim accounting for certain expenses is 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 actual year to date income tax rates as permitted by Financial Accounting Standards Board (FASB) Interpretation 18,Accounting for Income Taxes in Interim Periods.

Our accounting policies are set forth in detail in Note 3 to the consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2006 filed with the SEC on August 31, 2007.

4. Stock-Based Compensation

On January 1, 2006, we adopted the fair value recognition provisions of 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. 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 during the nine months ended September 30, 2007, 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).

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). Included in these expenses for the three months ended September 30, 2007 and 2006, were $101 and $0, respectively, and for the nine months ended September 30, 2007 and 2006, $120 and $102, respectively, that were related to options that were issued to certain executive officers on October 4, 2007, which was the date we became current in our periodic reporting obligations with the SEC.


	Three months ended September 30,				Nine months ended September 30,
	2007		2006		2007		2006
Selling, general and administrative	$	130	$	87	$	188	$	398
Research and development		39		39		62		175
Cost of revenues		70		313		196		1,018

Total	$	239	$	439	$	446	$	1,591

MedQuist Inc. and Subsidiaries

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

As of September 30, 2007, total unamortized stock-based compensation cost related to non-vested stock options, net of expected forfeitures, was $131, which is expected to be recognized over a weighted-average period of .4 years.

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 our board of directors or a committee of 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. This suspension was lifted on October 4, 2007. The extension of the life of the awards was recorded as a modification of the grants. There are 704 shares that have qualified for this post-termination exercise period. A summary of these post-termination options as of September 30, 2007 is as follows:


					Options exercisable
									Average
					Number of		Intrinsic		Exercise
Range of Exercise Prices					Shares		Value		Price
$	2.71	—	$	10.00		34	$	240	$	5.39
$	10.01	—	$	20.00		146		—	$	15.02
$	20.01	—	$	70.00		524		—	$	46.76

						704	$	240

Information with respect to our common stock as of September 30, 2007 is as follows:


						Weighted
				Weighted		Average
	Shares			Average		Remaining		Aggregate
	Subject to			Exercise		Contractual		Intrinsic
	Options			Price		Life in Years		Value
Outstanding, December 31, 2006		2,282		$	32.70
Forefeited		(110	)	$	30.76
Canceled		(4	)	$	17.45

Outstanding, September 30, 2007		2,168		$	32.82		3.0	$	246

Exercisable, September 30, 2007		2,110		$	33.25		2.9	$	246


Options vested and expected to vest as of September 30, 2007		2,130		$	33.10		3.0	$	246

There were no options granted or exercised during the nine months ended September 30, 2007 and 2006. The total fair value of shares vested during the nine months ended September 30, 2007 was $276. 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.

MedQuist Inc. and Subsidiaries

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

A summary of outstanding and exercisable options as of September 30, 2007 is as follows:


Options outstanding								Options exercisable
				Weighted
				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		34		2.0	$	5.39		34	$	5.39
$	10.01 - $20.00		543		3.8	$	16.48		485	$	16.37
$	20.01 - $30.00		819		3.5	$	26.71		819	$	26.71
$	30.01 - $40.00		218		1.7	$	32.23		218	$	32.23
$	40.01 - $70.00		554		1.8	$	59.84		554	$	59.84

			2,168		3.0	$	32.82		2,110	$	33.25

As of September 30, 2007, there were 1,151 additional options available for grant under our stock option plans. On October 4, 2007, certain executive officers, in accordance with their employment agreements, received an aggregate of 200 options with an exercise price of $11.20, which was equal to the closing price of our common stock on the date of grant as reported by the Pink Sheets, LLC. The following table reflects the expenses related to these stock options that were included as part of the Statement 123(R) stock-based compensation expense in the accompanying consolidated statements of operations with respect to these stock options:


	Three months ended September 30,				Nine months ended September 30,
	2007		2006		2007		2006
Selling, general and administrative	$	71	$	—	$	84	$	72
Research and development		30		—		36		30

Total	$	101	$	—	$	120	$	102

Since the exercise price of these options was not known until October, 2007, the fair value of such awards was remeasured as of each balance sheet date until the exercise price was determined.

5. Other Comprehensive Loss

Other comprehensive loss was as follows:


	Three months ended September 30,						Nine months ended September 30,
	2007			2006			2007			2006
Net loss	$	(8,935	)	$	(2,104	)	$	(4,935	)	$	(12,991	)
Foreign currency translation adjustment		587			486			989			625

Comprehensive loss	$	(8,348	)	$	(1,618	)	$	(3,946	)	$	(12,366	)

6. 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.

MedQuist Inc. and Subsidiaries

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

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


	Three months ended September 30,						Nine months ended September 30,
	2007			2006			2007			2006
Net loss	$	(8,935	)	$	(2,104	)	$	(4,935	)	$	(12,991	)


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	$	(0.24	)	$	(0.06	)	$	(0.13	)	$	(0.35	)
Diluted	$	(0.24	)	$	(0.06	)	$	(0.13	)	$	(0.35	)

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 September 30, 2007 and 2006, shares having an anti-dilutive effect on net loss per share and, therefore, excluded from the calculation of diluted loss per share, totaled 2,168 and 2,237 shares, respectively. For the nine months ended September 30, 2007 and 2006, shares excluded from the calculation of diluted net loss per share, totaled 2,168 and 2,237 shares, respectively.

7. 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 products and/or services from us over a defined period of time. On July 21, 2006, our board of directors authorized management to make credit

MedQuist Inc. and Subsidiaries

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

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 the third quarter of 2006.

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 September 30, 2007 and December 31, 2006:


	Nine months ended			Year ended
	September 30, 2007			December 31, 2006
Beginning balance	$	24,777		$	46,878
Customer accommodation		—			10,402
Payments and other adjustments		(4,048	)		(31,523	)
Credits		(1,961	)		(980	)

Ending balance	$	18,768		$	24,777

8. Cost of Investigation and Legal Proceedings, Net

For the three months ended September 30, 2007 and 2006, we recorded a charge of $4,441 and a credit of ($3,854), respectively, and for the nine months ended September 30, 2007 and 2006, we recorded a credit of ($456) and a charge of $9,019, 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. These costs are net of insurance claim reimbursements. We record insurance claims when the realization of the claims is probable. See Note 11. The following is a summary of the amounts recorded in the accompanying consolidated statements of operations:


	Three months ended September 30,					Nine months ended September 30,
	2007		2006			2007			2006
Legal fees	$	3,937	$	3,327		$	12,783		$	11,552
Other professional fees		504		805			1,948			3,642
Nightingale & Associates, LLC (Nightingale) services		—		648			197			2,356
Insurance claims		—		(8,702	)		(15,386	)		(8,702	)
Other		—		68			2			171

Total	$	4,441	$	(3,854	)	$	(456	)	$	9,019

9. Restructuring Plans

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


	Nine Months Ended September 30, 2007												Year Ended December 31, 2006
				Non-Cancelable												Non-Cancelable
	Total			Leases			Severance			Equipment			Total			Leases			Severance			Equipment
Beginning balance	$	712		$	648		$	64		$	—		$	2,050		$	1,693		$	357		$	—
Additional charge		404			233			146			25			3,442			1,653			1,447			342
Usage		(974	)		(739	)		(210	)		(25	)		(4,780	)		(2,698	)		(1,740	)		(342	)

Ending balance	$	142		$	142		$	—		$	—		$	712		$	648		$	64		$	—

The 2005 Plan severance was completed during the third quarter of 2007 and the non-cancelable leases will be completed in 2009.

MedQuist Inc. and Subsidiaries

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

During the third quarter of 2007, we implemented a restructuring plan (2007 Plan) related to the reduction in workforce of 104 employees as a result of the refinement of our centralized national services delivery model. We recorded $531 in severance charges and paid $24 related to the 2007 Plan during the three months ended September 30, 2007. Payments related to the 2007 Plan will be completed in 2008.

10. Income Taxes

Our consolidated income tax expense for the three and nine months ended September 30, 2007 was $1,016 and $2,402, respectively, and consists principally of an increase in deferred tax liabilities related to goodwill amortization deductions for income tax purposes during the current year as well as state and foreign income taxes. We have recorded a valuation allowance to reduce our net deferred tax assets to an amount that is more likely than not to be realized in future years.

Effective January 1, 2007, we adopted FASB Interpretation 48,Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement 109(FIN 48). FIN 48 prescribes, among other things, a recognition threshold and measurement attributes for the financial statement recognition and measurement of uncertain tax positions taken or expected to be taken in a company’s income tax return. FIN 48 utilizes a two-step approach for evaluating uncertain tax positions accounted for in accordance with FASB Statement 109,Accounting for Income Taxes. Step one,Recognition, requires a company to determine if the weight of available evidence indicates that a tax position is more likely than not to be sustained upon audit, including resolution of related appeals or litigation processes, if any. Step two,Measurement, is based on the largest amount of benefit, which is more likely than not to be realized on settlement with the taxing authority. We recorded a cumulative effect increase to retained earnings of $389 upon adoption.

As of January 1, 2007, the date of adoption, and after accounting for the cumulative effect adjustment noted above, our unrecognized tax benefits were $5,444 which includes $440 of accrued interest related to unrecognized income tax benefits, which we recognize as a component of the provision for income taxes. Of this amount $3,584 is attributable to uncertain tax positions with respect to certain deferred tax assets, which if recognized would be offset by a full valuation allowance due to the fact that it is not more likely than not that we would recognize sufficient income in the future to recognize these assets. Of the unrecognized tax benefits, $4,648 would impact the effective tax rate if recognized in a future period, not considering the impact of the current valuation allowance. $2,788 of this benefit would currently be offset by an increase in the valuation allowance as it is not more likely than not that we would have sufficient earnings to recognize this amount.

We anticipate decreases in unrecognized tax benefits of approximately $195 related to state statutes of limitations expiring as well as miscellaneous settlements during 2007.

We file income tax returns in the U.S. federal jurisdiction, all U.S. states which require income tax returns and foreign jurisdictions. Due to the nature of our operations, no state or foreign jurisdiction is individually significant. We have completed examinations by the U.S. federal jurisdiction through the year ended December 31, 2004. We are not currently under examination by the Internal Revenue Service. With limited exceptions we are no longer subject to examination by the U.S. federal or states jurisdiction for years beginning prior to 2003. We are no longer subject to examination by the UK federal jurisdiction for years beginning prior to 2005. We do have various state tax audits and appeals in process at any given time. We do not anticipate any adjustments that would result in a material change to our financial position or results of operations.

11. 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.

MedQuist Inc. and Subsidiaries

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

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, DOJ and/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., Case No. 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 asserted claims under Section 10(b) and 20(a) of the Exchange Act and Rule 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 and Rule 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 $7,750 to settle all claims throughout the class period against all defendants in the action. We accrued the aforementioned $7,750 as of December 31, 2005. In April 2007, we paid the entire $7,750 into an escrow account for the eventual distribution to the plaintiffs. 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., Case No. 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

MedQuist Inc. and Subsidiaries

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

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 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. On August 1, 2007, plaintiffs filed a motion for expedited review on appeal. We did not oppose this motion, and the Third Circuit granted the request for expedited treatment, adopting the briefing schedule agreed to by the parties. The appeal will be fully briefed by November 16, 2007, and the Third Circuit has tentatively set oral argument for December 13, 2007. The Third Circuit ordered the parties to court-sponsored mediation. The parties participated in an initial session with the mediator on September 12, 2007 and a second session on October 12, 2007. An additional telephonic conference is scheduled for November 9, 2007. We believe that the claims asserted have no merit and intend to defend the case vigorously.

Medical Transcriptionist Litigation

Hoffmann Putative Class Action

MedQuist Inc. and Subsidiaries

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

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., Case No. 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 and unjust enrichment, and demand 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., Case No. 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 and unjust enrichment, and demand 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 and 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 material allegations pleaded in the consolidated amended complaint. The parties are now proceeding with discovery.

On October 11, 2007, the Court entered a Scheduling Order, ordering plaintiffs to file their motion for class certification not later than December 14, 2007 and setting a deadline of January 14, 2008, for the conclusion of factual discovery. A further status conference is set for January 10, 2008. No date has been set for trial. We believe that the claims asserted in the consolidated actions have no merit and intend to vigorously defend the suit.

Reseller Arbitration Demand

MedQuist Inc. and Subsidiaries

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

that we: (i) would provide new products, opportunities and support to the Claimants; (ii) were committed to continuing to use Claimants; (iii) did not intend to create our own sales force with respect to the Claimants’ territory; and (iv) would stay out of the Claimants’ territories and would not attempt to take over the Claimants business and relationships with the Claimants’ customers and end-users. The Claimants assert that they are seeking damages in excess of $24,300. The AAA has not yet set a date for us to formally respond to the arbitration demand. We deny all wrongdoing and intend to defend ourselves vigorously including asserting counterclaims against the Claimants as appropriate.

Other Matters

From time to time, we have been involved in various other 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 September 30, 2007 or December 31, 2006 related to these indemnification provisions.

We have insurance policies which provided coverage for certain of the matters related to the legal actions described herein. We filed claims for insurance recoveries commencing in the third quarter of 2006 and as of September 30, 2007 we have recovered $24,794 in the aggregate. We do not expect to receive any further recoveries related to these claims.

In June 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.

On September 20, 2007, we entered into retention and strategic transaction bonus agreements with certain of our executive officers and also entered into retention bonus agreements with certain other employees. The purpose of these bonus agreements is to provide our executive officers and employees with an incentive to remain with us through February 29, 2008 and to further reward each eligible executive officer in the event we are able to successfully complete a strategic transaction.

On November 2, 2007, Philips announced that it was going to proceed with the sale of its ownership interest in us if a satisfactory price and other acceptable terms can be realized. In addition, on November 2, 2007, we announced, in light of Philips announcement, that our board of directors, in connection with its previously disclosed review of our strategic alternatives, is evaluating whether a sale of us is in our best interests and the best interests of our shareholders. There is no assurance that any sale transaction involving us will occur as a result of the evaluation.

12. 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 material 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

MedQuist Inc. and Subsidiaries

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

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 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

On September 21, 2007, we entered into an Amended and Restated OEM Supply Agreement (Amended OEM Agreement) with PSRS. The Amended OEM Agreement amends and restates a previous OEM Supply Agreement with PSRS dated September 23, 2004. In connection with the Amended OEM Agreement certain amounts paid to PSRS were capitalized in fixed assets and are being amortized over a three-year period.

Pursuant to the Amended OEM Agreement, we purchased a co-ownership interest in all rights and interests in and to SpeechQ for Radiology together with its components, including object and source code for the SpeechQ for Radiology application and the SpeechQ for Radiology integration SDK (collectively, the Product), but excluding the SpeechMagic speech recognition and processing software, which we separately license from PSRS for a fee under the Licensing Agreement. Additionally, the Amended OEM Agreement provides that we shall receive, in exchange for a fee, the exclusive right in the United States, Canada and certain islands of the Caribbean (collectively the Exclusive Territory) to sell, service and deliver the Product. In addition, PSRS has agreed that for the term of the Amended OEM Agreement it will not release a front-end multi-user reporting solution (including one similar to the Product) in the medical market in the Exclusive Territory nor will it directly authorize or assist any of its affiliates to do so either; provided that the restriction does not prevent PSRS’s affiliates from integrating SpeechMagic within their general medical application products. The Amended OEM Agreement further provides that we shall make payments to PSRS for PSRS’ development of an interim version of the software included in the Product (Interim Version). Except for the Interim Version which we and PSRS will co-own, the Amended OEM Agreement provides that any improvements, developments or other enhancements either we or PSRS makes to the Product (collectively, Improvements) shall be owned exclusively by the party that developed such Improvement. Each party has the right to seek patent or other protection of the Improvements it owns independent of the other party.

The term of the Amended OEM Agreement extends through June 30, 2010 and will automatically renew for an additional three year term provided that we are in material compliance with the Amended OEM Agreement as of such date. If PSRS decides to discontinue all business relating to the Product in the Exclusive Territory on or after June 30, 2010, PSRS can effect such discontinuation by terminating the Amended OEM Agreement by providing us with six months’ prior written notice of such discontinuation, provided the earliest such notice can be delivered is June 30, 2010. Either party may terminate the Amended OEM Agreement for cause immediately in the event that a material breach by the other party remains uncured for more than 30 days following delivery of written notice or in the event that the other party becomes insolvent or files for bankruptcy.

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.

MedQuist Inc. and Subsidiaries

Notes to Consolidated Financial Statements
(In thousands, except for 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 $0 and $0 for the three months ended September 30, 2007 and 2006, respectively, and $0 and $26 for the nine months ended September 30, 2007 and 2006, respectively.

Our consolidated balance sheets as of September 30, 2007 and December 31, 2006 reflect accrued expenses due to Philips of $3,622 and $2,030, 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 nine months ended September 30, 2007 and 2006. Charges related to these agreements are included in cost of revenues and selling, general and administrative expenses in the accompanying consolidated statements of operations.


	Three months ended September 30,					Nine months ended September 30,
	2007			2006		2007		2006
PSRS licensing	$	645		$	718	$	1,747	$	1,843
PSRS consulting		—			—		—		3
OEM agreement		1,564			383		1,865		928
Dictation equipment		292			129		613		659
Insurance		121			843		1,682		1,289
PENAC		(10	)		—		30		20
Other		—			—		—		42

Total	$	2,612		$	2,073	$	5,937	$	4,784

On July 29, 2004, we entered into an agreement with Nightingale & Associates, LLC (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). Mr. Hoffmann serves as the Managing Partner of Nightingale. 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 continues to serve as our President and Chief Executive Officer pursuant to the terms of the agreement between us and Nightingale which was amended on September 19, 2007 (Amendment). The Amendment, among other things, extends the term of Mr. Hoffmann’s role as our President and Chief Executive Officer through February 29, 2008. 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 September 30, 2007 and 2006, we incurred charges of $792 and $648, respectively, and for the nine months ended September 30, 2007 and 2006, we incurred charges of $2,279 and $2,356, respectively, for Nightingale services. During the three and nine months ended September 30, 2007, $792 and $2,082, respectively, of the charges for Nightingale’s services were recorded in selling, general and administrative expenses in the accompanying consolidated statements of operations due to Nightingale’s focus on operational matters instead of the Review and Management’s Billing Assessment. Previously charges related to Nightingale were recorded in cost of investigation and legal proceedings, net (see Note 8). As of September 30, 2007 and December 31, 2006, accrued expenses included $899 and $548, respectively, for amounts due to Nightingale for services performed.

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

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 Securities Exchange Act of 1934 (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 matters discussed in Part II, Item 1, Legal Proceedings, and Part II, Item 1A, Risk Factors;

	•		difficulties relating to our significant management turnover;

	•		our ability to recruit and retain qualified medical transcriptionists (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 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, including our evaluation of whether a sale of us is in the best interest of our shareholders and us;

	•		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.

These and other risks and uncertainties that could affect our actual results are discussed in this report and in our other filings with the SEC, particularly in Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2006 in the section entitled “Risk Factors.”

Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, events, levels of activity, performance, or achievements. We do not assume responsibility for the accuracy and completeness of the forward-looking statements other than as required by applicable law. We do not undertake any duty to update any of the forward-looking statements after the date of this report to conform them to actual results, except as required by the federal securities laws.

You should read this section in combination with the section entitled Management’s Discussion and Analysis of Financial Condition and Results of Operations for the year ended December 31, 2006, included in our Annual Report on Form 10-K for the year ended December 31, 2006.

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

5,900 skilled 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 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, 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. On November 2, 2007, Philips announced that it was going to proceed with the sale of its ownership interest in us if a satisfactory price and other acceptable terms can be realized. In addition, on November 2, 2007, we announced, in light of Philips announcement, that our board of directors, in connection with its previously-disclosed review of our strategic alternatives, is evaluating whether a sale of MedQuist is in our best interests and the best interests of our shareholders. There is no assurance that any sale transaction involving us will occur as a result of the evaluation.

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.

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 on Form 10-K for the year ended December 31, 2006 under the caption “Significant Events Over the Past Few Years” in Item 1, Business and in Part II, Item 1, Legal Proceedings in this report.

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 by U.S.-based healthcare providers. This demand for qualified MTs, as well as budgetary pressures experienced by healthcare providers, has also caused many more U.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.

	•		Other companies in the healthcare IT space have developed alternative solutions for the creation of electronic clinical documentation that, if successfully implemented, will reduce the overall demand for 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.

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 consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of our 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 of our board of directors.

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 on Form 10-K for the year ended December 31, 2006 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 on Form 10-K for the year ended December 31, 2006.

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, excluding charges for the customer accommodation program, 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.

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 costs 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 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 two 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, net

Cost of investigation and legal proceedings, net 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 during 2006 by Nightingale and Associates, LLC (Nightingale) in connection with the Review and Management’s Billing Assessment, net of insurance claims reimbursement.

Consolidated Results of Operations

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

Comparison of Three Months Ended September 30, 2007 and 2006


	Three months ended September 30,
	2007						2006
				% of Net						% of Net
($ in thousands)	Amount			Revenues			Amount			Revenues			$ Change			% Change
Net revenues	$	82,518			100.0	%	$	82,096			100.0	%	$	422			0.5	%

Operating costs and expenses:
Cost of revenues		64,290			77.9	%		67,929			82.7	%		(3,639	)		(5.4	%)
Selling, general and administrative		15,548			18.8	%		12,765			15.5	%		2,783			21.8	%
Research and development		3,808			4.6	%		3,447			4.2	%		361			10.5	%
Depreciation		2,861			3.5	%		3,149			3.8	%		(288	)		(9.1	%)
Amortization of intangible assets		1,361			1.6	%		1,363			1.7	%		(2	)		(0.1	%)
Cost of investigation and legal proceedings, net		4,441			5.4	%		(3,854	)		(4.7	%)		8,295			(215.2	%)
Restructuring charges		554			0.7	%		1,234			1.5	%		(680	)		(55.1	%)


Total operating costs and expenses		92,863			112.5	%		86,033			104.8	%		6,830			7.9	%


Operating loss		(10,345	)		(12.5	%)		(3,937	)		(4.8	%)		(6,408	)		162.8	%

Equity in income of affiliated company		124			0.2	%		180			0.2	%		(56	)		(31.1	%)
Interest income, net		2,302			2.8	%		1,977			2.4	%		325			16.4	%


Loss before income taxes		(7,919	)		(9.6	%)		(1,780	)		(2.2	%)		(6,139	)		344.9	%

Income tax provision		1,016			1.2	%		324			0.4	%		692			213.6	%


Net loss	$	(8,935	)		(10.8	%)	$	(2,104	)		(2.6	%)	$	(6,831	)		324.7	%

Net revenues

Net revenues increased $0.4 million, or 0.5%, to $82.5 million for the three months ended September 30, 2007 compared with $82.1 million for the three months ended September 30, 2006. This increase was attributable primarily to:

	•		increased transcription service revenues of $1.7 million resulting primarily from an $8.5 million charge for the customer accommodation program in the 2006 period. Excluding this charge, transcription revenue declined $6.8 million due to lower medical transcription volume and lower pricing to both new and existing customers. 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;

	•		increased other services revenues of $0.4 million; offset by

	•		reduced sales and implementations of our technology products of $1.7 million.

We continue to experience pricing pressures as our existing and potential customers seek out opportunities to reduce costs, particularly through the utilization of offshore labor.

Cost of revenues

Cost of revenues decreased $3.6 million, or 5.4%, to $64.3 million for the three months ended September 30, 2007 compared with $67.9 million for the three months ended September 30, 2006. This decrease was attributable primarily to:

	•		reduced medical transcription payroll costs of $3.3 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 $0.6 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; offset by

	•		an increase in technology product costs of $0.4 million;

As a percentage of net revenues, cost of revenues decreased to 77.9% for the three months ended September 30, 2007 from 82.7% for the same period in 2006 (the 2006 period included the aforementioned $8.5 million charge for the customer accommodation program).

Selling, general and administrative

SG&A expenses increased $2.8 million, or 21.8%, to $15.5 million for the three months ended September 30, 2007 compared with $12.8 million for the three months ended September 30, 2006. This increase was due primarily to $1.3 million of professional fees incurred related to the evaluation of strategic alternatives for us; an increase in audit fees of $0.8 million related to the audit of our consolidated financial statements and the audit of our internal control over financial reporting; an increase of $0.8 million due to the reassignment of Nightingale services in 2007 due to Nightingale’s focus on operational matters instead of the Review and Management’s Billing Assessment. These increases were partially offset by a decrease in all other SG&A expenses of $0.1 million. SG&A expenses as a percentage of net revenues were 18.8% for the three months ended September 30, 2007 compared with 15.5% for the same period in 2006.

Research and development

R&D expenses increased $0.4 million, or 10.5%, to $3.8 million for the three months ended September 30, 2007 compared with $3.4 million for the three months ended September 30, 2006. This increase was due primarily to an increase in consulting fees for enhancements being made to our speech recognition software. R&D expenses as a percentage of net revenues were 4.6% for the three months ended September 30, 2007 compared with 4.2% for the same period in 2006.

Depreciation

Depreciation expense decreased $0.3 million, or 9.1%, to $2.9 million for the three months ended September 30, 2007 compared with $3.1 million for the three months ended September 30, 2006. This decrease was attributable primarily to fixed assets reaching the end of their depreciable period. Depreciation expense as a percentage of net revenues was 3.5% for the three months ended September 30, 2007 compared with 3.8% for the same period in 2006.

Amortization

Amortization of intangible assets remained unchanged for the three months ended September 30, 2007 compared with the three months ended September 30, 2006. Amortization of intangible assets as a percentage of net revenues was 1.6% for the three months ended September 30, 2007 compared with 1.7% for the same period in 2006.

Cost of investigation and legal proceedings, net

Costs and expenses associated with the Review and Management’s Billing Assessment are being reported as cost of investigation and legal proceedings. These costs and expenses increased $8.3 million to $4.4 million for the three months ended September 30, 2007 compared with ($3.9) million for the three months ended September 30, 2006. This increase in costs was the result of the recognition of $8.7 million in insurance claim reimbursements in the three months ended September 30, 2006. In addition, for the three months

ended September 30, 2007, costs declined $0.4 million due primarily to the reassignment to SG&A expenses of Nightingale’s services in connection with its focus on operational matters instead of the Review and Management’s Billing Assessment.

Restructuring charges

We have implemented various restructuring plans to streamline our organizational and operational structure and to better service our customers. These restructuring plans have involved the consolidation of operating facilities and the related reduction in workforce. During the three months ended September 30, 2007, we recorded a restructuring charge of $0.6 million compared with $1.2 million in 2006. Restructuring charges were lower in 2007 as a majority of our actions were completed during 2006.

Interest income, net

Interest income, net reflects interest earned on cash and cash equivalent balances. Interest income, net increased $0.3 million, or 16.4%, to $2.3 million for the three months ended September 30, 2007 compared with $2.0 million for the three months ended September 30, 2006. This increase was attributable to higher interest rates earned in the 2007 period (5.6%) compared with the 2006 period (5.0%). Our average cash balance for the three months ended September 30, 2007 was $6.3 million greater than the comparable 2006 period.

Income tax provision

The effective income tax rate for the three months ended September 30, 2007 was 12.8% compared with an effective income tax rate of 18.2% for the three months ended September 30, 2006. The 2007 rate consists primarily of provisions for the deferred tax liability related to the current year tax goodwill amortization, which is indefinite in nature as well as the valuation allowance provided against a majority of U.S. deferred tax assets created in 2007. The provision also includes state and foreign income taxes and accrued interest on tax uncertainties. Also, a tax rate change in the United Kingdom reduced the value of our United Kingdom deferred tax assets. No additional current federal income taxes were provided because of the availability of deductible temporary differences. The resulting rate is a function of a fixed positive tax expense due primarily to the deferred tax liability recorded related to tax goodwill amortization and the United Kingdom tax rate change.

Comparison of Nine Months Ended September 30, 2007 and 2006


	Nine months ended September 30,
	2007						2006
				% of Net						% of Net
($ in thousands)	Amount			Revenues			Amount			Revenues			$ Change			% Change
Net revenues	$	260,276			100.0	%	$	271,469			100.0	%	$	(11,193	)		(4.1	%)


Operating costs and expenses:
Cost of revenues		198,918			76.4	%		214,656			79.1	%		(15,738	)		(7.3	%)
Selling, general and administrative		48,158			18.5	%		39,408			14.5	%		8,750			22.2	%
Research and development		10,073			3.9	%		9,705			3.6	%		368			3.8	%
Depreciation		8,040			3.1	%		9,043			3.3	%		(1,003	)		(11.1	%)
Amortization of intangible assets		4,065			1.6	%		4,474			1.6	%		(409	)		(9.1	%)
Cost of investigation and legal proceedings, net		(456	)		(0.2	%)		9,019			3.3	%		(9,475	)		(105.1	%)
Restructuring charges		935			0.4	%		2,939			1.1	%		(2,004	)		(68.2	%)


Total operating costs and expenses		269,733			103.6	%		289,244			106.5	%		(19,511	)		(6.7	%)


Operating loss		(9,457	)		(3.6	%)		(17,775	)		(6.5	%)		8,318			(46.8	%)

Equity in income of affiliated company		447			0.2	%		738			0.3	%		(291	)		(39.4	%)
Interest income, net		6,477			2.5	%		5,675			2.1	%		802			14.1	%


Loss before income taxes		(2,533	)		(1.0	%)		(11,362	)		(4.2	%)		8,829			(77.7	%)

Income tax provision		2,402			0.9	%		1,629			0.6	%		773			47.5	%


Net loss	$	(4,935	)		(1.9	%)	$	(12,991	)		(4.8	%)	$	8,056			(62.0	%)

Net revenues

Net revenues decreased $11.2 million, or 4.1%, to $260.3 million for the nine months ended September 30, 2007 compared with $271.5 million for the nine months ended September 30, 2006. This decrease was attributable primarily to:

	•		decreased transcription service revenues of $9.4 million. Excluding $9.8 million of charges for the customer accommodation program included in the 2006 period, transcription revenues declined by $19.2 million. This decline was due primarily to lower medical transcription volume and lower pricing to both new and existing customers. 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 $1.7 million.

Cost of revenues

Cost of revenues decreased $15.7 million, or 7.3%, to $198.9 million for the nine months ended September 30, 2007 compared with $214.7 million for the nine months ended September 30, 2006. This decrease was attributable primarily to:

	•		reduced medical transcription payroll costs of $7.1 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 $3.4 million associated with both the decrease in our service revenues and the transition of customers from our non-DEP medical transcription platforms, which required MTs to access dictation using traditional phone lines, to our DEP, which allows MTs to access dictation through the internet;

	•		reduced other costs of $5.3 million resulting from headcount and facility reductions associated with our 2005 restructuring plan based on a centralized national service delivery model to streamline our organizational and operating structure to better service our customers; offset by

	•		an increase in technology product costs of $0.1 million.

As a percentage of net revenues, cost of revenues decreased to 76.4% for the nine months ended September 30, 2007 from 79.1% for the same period in 2006 (the 2006 period included the aforementioned $9.8 million charge for the customer accommodation program).

Selling, general and administrative

SG&A expenses increased $8.8 million, or 22.2%, to $48.2 million for the nine months ended September 30, 2007 compared with $39.4 million for the nine months ended September 30, 2006. This increase was due primarily to an increase of $3.1 million due to higher legal fees for matters unrelated to the Review and Management’s Billing Assessment; an increase in audit fees of $2.3 million related to the audit of our consolidated financial statements and the audit of our internal control over financial reporting; $2.1 million due to the reassignment of Nightingale’s services in 2007 to SG&A due to Nightingale’s focus on operational matters instead of the Review and Management’s Billing Assessment; and an increase of $1.3 million of professional fees related to the evaluation of strategic alternatives for us. SG&A expenses as a percentage of net revenues were 18.5% for the nine months ended September 30, 2007 compared with 14.5% for the same period in 2006.

Depreciation

Depreciation expense decreased $1.0 million, or 11.1%, to $8.0 million for the nine months ended September 30, 2007 compared with $9.0 million for the nine months ended September 30, 2006. This decrease was attributable primarily to fixed assets reaching the end of their depreciable period. Depreciation expense as a percentage of net revenues was 3.1% for the nine months ended September 30, 2007 compared with 3.3% for the same period in 2006.

Amortization

Amortization of intangible assets decreased $0.4 million, or 9.1%, to $4.1 million for the nine months ended September 30, 2007 compared with $4.5 million for the nine months ended September 30, 2006. This decrease was the result primarily of several intangible assets reaching the end of their amortization period. Amortization of intangible assets as a percentage of net revenues was 1.6% for the nine months ended September 30, 2007 and for the same period in 2006.

Cost of investigation and legal proceedings, net

Costs and expenses associated with the Review and Management’s Billing Assessment are being reported as cost of investigation and legal proceedings. These costs and expenses decreased $9.5 million to ($0.5) million for the nine months ended September 30, 2007 compared with $9.0 million for the nine months ended September 30, 2006. This reduction in costs was primarily due to the recognition of $15.4 million of insurance claim reimbursements in 2007 compared with $8.7 million for the same period in 2006; $2.2 million due to the reassignment of Nightingale’s services in 2007 due to Nightingale’s focus on operational matters instead of the Review and Management’s Billing Assessment; offset by an increase in legal fees in connection with the SEC and DOJ investigations and proceedings; the defense of civil litigation matters as well as litigation support consulting of $0.6 million.

Restructuring charges

We have implemented various restructuring plans to streamline our organizational and operational structure and to better service our customers. These restructuring plans have involved the consolidation of operating facilities and the related reduction in workforce. During the nine months ended September 30, 2007, we recorded a restructuring charge of $0.9 million compared with $2.9 million in the same period in 2006. Restructuring charges were lower in 2007 as a majority of our actions were completed during 2006.

Interest income, net

Interest income, net reflects interest earned on cash and cash equivalent balances. Interest income, net increased $0.8 million, or 14.1%, to $6.5 million for the nine months ended September 30, 2007 compared with $5.7 million for the nine months ended September 30, 2006. This increase was attributable to higher interest rates earned in the 2007 period (5.2%) compared with the 2006 period (4.7%).

Income tax provision

The effective income tax rate for the nine months ended September 30, 2007 was 94.8% compared with an effective income tax rate of 14.3% for the nine months ended September 30, 2006. The 2007 rate consists primarily of provisions for deferred tax liabilities related to the current year for goodwill amortization, which is indefinite in nature as well as the valuation allowance provided against a majority of U.S. deferred tax assets created in the nine months ended September 30, 2007. The provision also includes state and foreign income taxes and accrued interest on tax uncertainties. Also a tax rate change in the United Kingdom reduced the value of our United Kingdom deferred tax assets. No additional current federal income taxes were provided because of the availability of deductible temporary differences. Additionally, favorable Texas legislation was enacted that resulted in an increase of a deferred tax asset. The resulting rate is a function of a fixed positive tax expense due primarily to the deferred tax liability recorded related to tax goodwill amortization offset by the favorable Texas legislation. The 2006 rate is impacted by adjustments made to income tax expense to reflect the tax benefits for alternative minimum tax credits offset by adjustments from various state tax exposures.

Liquidity and Capital Resources

As of September 30, 2007, we had net working capital of $145.8 million compared with $145.5 million as of December 31, 2006. Our principal sources of liquidity was available cash on hand. Cash and cash equivalents decreased $9.5 million for the nine months ended September 30, 2007 to $165.9 million as of September 30, 2007 from $175.4 million as of December 31, 2006. This decrease was driven primarily by purchases of property and equipment of $8.3 million. The slight cash usage from operating activities during the nine months ended September 30, 2007 reflects customer accommodation payments of $4.1 million, payments of $7.8 million related to the settlement of shareholder securities litigation, as well as other operating activities of $3.2 million. These payments were offset by insurance recoveries of $16.1 million during the nine months ended September 30, 2007.

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.

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 under Rule 13a-15(e) promulgated under the Exchange Act, as of the last day of the fiscal period covered by this report, September 30, 2007. 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 on Form 10-K for the fiscal year ended December 31, 2006, our disclosure controls and procedures were not effective as of September 30, 2007. To compensate for the material weaknesses in our internal control over financial reporting described in our Annual Report on Form 10-K for the fiscal year ended December 31, 2006, we performed additional manual procedures and analysis and other post-closing procedures in order to prepare the consolidated financial statements included in this report. As a result of these expanded procedures, we believe that the 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 U.S. generally accepted accounting principles.

Changes in Internal Control Over Financial Reporting

There have been no changes in our internal control over financial reporting during the fiscal quarter ended Septemer 30, 2007 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Although our remediation efforts are underway, material weaknesses identified as of December 31, 2006 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

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.

Shareholder Securities Litigation

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 asserted claims under Section 10(b) and 20(a) of the Exchange Act and Rule 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 and Rule 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

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. On August 1, 2007, plaintiffs filed a motion for expedited review on appeal. We did not oppose this motion, and the Third Circuit granted the request for expedited treatment, adopting the briefing schedule agreed to by the parties. The appeal will be fully briefed by November 16, 2007, and the Third Circuit has tentatively set oral argument for December 13, 2007. The Third Circuit ordered the parties to court-sponsored mediation. The parties participated in an initial session with the mediator on September 12, 2007, and a second session on October 12, 2007. An additional telephonic conference is scheduled for November 9, 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., Case No. 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 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., Case No. 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 and unjust enrichment and demand 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

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 and unjust enrichment and demand an accounting.

On October 11, 2007, the Court entered a Scheduling Order, ordering plaintiffs to file their motion for class certification not later than December 14, 2007, and setting a deadline of January 14, 2008, for the conclusion of factual discovery. A further status conference is set for January 10, 2008. No date has been set for trial. We believe that the claims asserted in the consolidated actions have no merit and intend to vigorously defend the suit.

Reseller Arbitration Demand

On October 1, 2007, we received, from counsel to nine current and former resellers of our products (Claimants), a copy of an arbitration demand filed by the Claimants, initiating an arbitration proceeding styled Diskriter, Inc., Electronic Office Systems, Inc., Milner Voice & Data, Inc., Nelson Systems, Inc., NEO Voice and Communications, Inc., Office Business Systems, Inc., Roach-Reid Office Systems, Inc., Stiles Office Systems, Inc. and Travis Voice and Data, Inc. v. MedQuist Inc. and MedQuist Transcriptions, Ltd. (filed on September 27, 2007, AAA, Case Number Not Yet Assigned). The arbitration demand purports to set forth claims for (i) breach of contract; (ii) breach of covenant of good faith and fair dealing; (iii) promissory estoppel; (iv) misrepresentation; and (v) tortious interference with contractual relations. The Claimants allege that we breached our written agreements with the Claimants by: (i) failing to provide reasonable training, technical support, and other services; (ii) using the Claimants’ confidential information to compete against the Claimants; (iii) directly competing with the Claimants’ territories; and (iv) failing to make new products available to the Claimants. In addition, the Claimants allege that we made false oral representations that we: (i) would provide new products, opportunities and support to the Claimants; (ii) were committed to continuing to use Claimants; (iii) did not intend to create our own sales force with respect to the Claimants’ territory; and (iv) would stay out of the Claimants’ territories and would not attempt to take over the Claimants business and relationships with the Claimants’ customers and end-users. The Claimants assert that they are seeking damages in excess of $24.3 million. The AAA has not yet set a date for us to formally respond to the arbitration demand. We deny all wrongdoing and intend to defend ourselves vigorously including asserting counterclaims against the Claimants as appropriate.

Item 1A. Risk Factors

Except as set forth below, there have been no material changes to the risks to our business described in our Annual Report on Form 10-K for the year ended December 31, 2006 filed with the SEC on August 31, 2007.

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.

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. On November 2, 2007, Philips announced that it was going to proceed with the sale of its ownership interest in us if a satisfactory price and other acceptable terms can be realized. In addition, on November 2, 2007, we announced, in light of Philips announcement, that our board of directors, in connection with its

previously-disclosed review of our strategic alternatives, is evaluating whether a sale of MedQuist is in our best interests and the best interests of our shareholders. There is no assurance that any sale transaction involving us will occur as a result of the evaluation.

If the electronic health records (EHR) companies produce solutions acceptable to large hospital systems for the creation of electronic clinical documentation that are not based on the conversion of voice to text, the overall demand for medical transcription services could be reduced.

EHR companies’ solutions for the collection of clinical data typically require physicians to directly enter and organize patient chart information through templates thereby eliminating or dramatically reducing the use of dictation or transcription. Although the EHR market is in the early stages of development and is rapidly evolving, a number of market entrants have introduced or developed products and services that are competitive with one or more components of the solutions we offer. We expect that additional companies will continue to enter this market. In new and rapidly evolving industries, there is significant uncertainty and risk as to the demand for, and market acceptance of, recently introduced solutions for the creation of electronic clinical documentation. In the event that such solutions are successful and gain wide acceptance, the overall demand for medical transcription services could be reduced. In the event that markets develop more quickly than expected, our business, financial condition and results of operations could be adversely affected.

In addition to factors set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Cautionary Statement Regarding Forward-Looking Statements,” in Part I, Item 2 of this report, you should carefully consider the factors discussed in Part I, Item 1A, “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2006, which could materially affect our business, financial condition or future results. The risks described in this report and in our Annual Report on Form 10-K are not the only risks facing us. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.

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)		Indemnification Agreement, dated as of July 3, 2007 between MedQuist Inc. and John H. Underwood

10.2* (2)		Indemnification Agreement, dated as of July 3, 2007 between MedQuist Inc. and Richard H. Stowe

10.3* (3)		Indemnification Agreements, dated August 23, 2007, with each of Howard Hoffmann, Kathy Donovan, James Brennan, Mark Sullivan, Mark Ivie, Michael Clark and Scott Bennett

10.4* (4)		Letter Agreement by and between MedQuist Inc. and Nightingale and Associates, LLC dated September 19, 2007

10.5* (5)		Retention and Strategic Transaction Bonus Agreements, dated September 20, 2007, with each of Kathy Donovan, Mark Ivie and Scott Bennett

10.6* (6)		Retention and Strategic Transaction Bonus Agreements, dated September 20, 2007, with each of Mark Sullivan and Michael Clark

10.7#		Amended and Restated OEM Supply Agreement dated September 21, 2007 by and between MedQuist Inc. and Philips Speech Recognition Systems GmbH f/k/a Philips Austria GmbH, Philips Speech Processing

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


(1)		Incorporated by reference to Exhibit 10.39 to the Company’s Form 10-K for the fiscal year ended December 31, 2005 filed with the Securities and Exchange Commission on July 5, 2007.

(2)		Incorporated by reference to Exhibit 10.40 to the Company’s Form 10-K for the fiscal year ended December 31, 2005 filed with the Securities and Exchange Commission on July 5, 2007.

(3)		Incorporated by reference to Exhibit 10.1 to the Company’s Form 8-K filed with the Securities and Exchange Commission on August 28, 2007.

(4)		Incorporated by reference to Exhibit 10.1 to the Company’s Form 8-K filed with the Securities and Exchange Commission on September 25, 2007.

(5)		Incorporated by reference to Exhibit 10.2 to the Company’s Form 8-K filed with the Securities and Exchange Commission on September 25, 2007.

(6)		Incorporated by reference to Exhibit 10.3 to the Company’s Form 8-K filed with the Securities and Exchange Commission on September 25, 2007.

*		Management contract or compensatory plan or arrangement.

#		Portions of this Exhibit were omitted and filed separately with the Secretary of the SEC pursuant to a request for confidential treatment that has been filed with the SEC.

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: November 8, 2007



	/s/ Kathleen E. Donovan
	Kathleen E. Donovan
	Senior Vice President and Chief Financial Officer (Principal Financial Officer)

Date: November 8, 2007

Exhibit Index


No.		Description
10.7#		Amended and Restated OEM Supply Agreement dated September 21, 2007 by and between MedQuist Inc. and Philips Speech Recognition Systems GmbH f/k/a Philips Austria GmbH, Philips Speech Processing

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


#		Portions of this Exhibit were omitted and filed separately with the Secretary of the SEC pursuant to a request for confidential treatment that has been filed with the SEC.

Positive
Negative
Uncertain
Constraining
Legalese
Litigous
Readability	8th grade Avg

Medquist (MEDQ) Inactive 10-Q2007 Q3 Quarterly report

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