ITEM 1. BUSINESS.
The Company was incorporated in Pennsylvania in 1986 and began operations in 1988. Its principal offices are located at 493 Nixon Road, Cheswick, Pennsylvania 15024 and its telephone number is (412) 274-2156.
The Company designs, engineers, markets and supports proprietary products which enable telephone companies to use their existing line test systems to remotely diagnose problems in "plain old telephone service" ("POTS") lines containing both copper and fiber optics. POTS lines comprise the vast majority of lines in service today throughout the world. In addition to traditional voice service, POTS includes lines for popular devices such as computer modems and fax machines. POTS excludes the more complex lines, such as data communications service lines, commonly referred to as "special services."
POTS line test systems, located at telephone companies' central offices, diagnose problems in the "local loop", which is the portion of the telephone network which connects end users to a telephone company's central office, and is comprised primarily of copper wireline. The ability to remotely test reduces the time needed to identify and resolve problems and eliminates or reduces the cost of dispatching a technician to the problem site. Most POTS line test systems were designed for use over copper wireline only, so that the introduction of fiber-optic technology into the local loop renders it inaccessible to these test systems. The Company's metallic channel unit ("MCU") products solve this problem by extending test-system access through the fiber-optic portion into the copper portion of the local loop.
Products. The Company's MCU products plug into the digital loop carrier ("DLC") systems that are large systems manufactured by equipment vendors such as AT&T, that are used by telephone companies to link the copper and fiber-optic portions of the local loop. DLC systems are located at the telephone company central offices and at remote sites within a local user area, and effectively multiplex the services of the copper lines into a single fiber-optic line. In many instances, several DLC systems are located at a single remote site to serve several thousand different end-user homes and offices. Generally, for every DLC remote site, two MCU line testing products are deployed. To ensure compatibility with these DLC systems, the Company pays royalties pursuant to license agreements for the use of
proprietary design integrated circuits ("PIDCs"). The PIDCs are the design and property of the DLC system manufacturer from which they are purchased. The Company maintains license agreements with Advanced Fibre Communications, Lucent Technologies, DSC Technologies Corporation, Fujitsu Network Transmission Systems, Inc., NEC American, Inc., Northern Telecom Inc. and Reliance Comm/Tec Corporation. In general, the current terms of these agreements expire at various times between July 1997 and November 2004, with renewal provisions (unless either party desires to terminate) for periods of between one and five years. The Company paid $254,300, $1,075,800 and $1,779,700, respectively in 1994, 1995 and 1996 as royalties under the license agreements, which royalties are calculated based on a percentage of the list price of MCU products which incorporate the technology licensed under each such agreement. Certain of the license agreements require the Company to maintain the confidentiality of the licensor's proprietary information and/or the terms and conditions of the agreement itself. Future license agreements entered into by the Company may contain terms comparable to, or materially different than, the terms of existing agreements as competitive and other conditions warrant. The loss of PDICs license agreements or the inability of the Company to maintain an adequate supply of PDICs could have a material adverse effect on the Company's business. Other MCU technology is also used with home and business alarm systems. As with home service line testing, home alarm systems must be monitored from the alarm company's headquarters along a hybrid copper and fiber-optic line. The Company's alarm-related MCU products are used to facilitate the transport of analog alarm signals from subscriber homes to alarm company monitoring stations across the hybrid telephone network. These units plug into equipment at both central office and remote locations. MCU products accounted for more than 90%, 93% and 93% of the Company's sales in 1994, 1995 and 1996, respectively.
Product and Technology Development. The Company's product development personnel are organized into teams, each of which is effectively dedicated to a specific product line or lines. Each product team also implements the Company's ongoing "value engineering" programs which are designed to replace the Company's products with successive generations having additional features and/or lower costs. The Company continuously monitors developing technologies and introduces products as defined standards and markets emerge. In addition, the Company continues to investigate the development of new applications for its MCU technology and other technologies to service the telecommunications industry. During 1994, 1995 and 1996, research and development expenses were approximately $1,585,000, $2,637,000 and $3,921,000, respectively.
Proprietary Rights. The names "Tollgrade(R)", "MCU(R)" and "Micro-Bank(R)", and the Company's corporate logo are registered trademarks of the Company. "Team Tollgrade(SM)" is a service mark of the Company. The Company has obtained three patents on the MCU products with expiration dates ranging from 2010 to the year 2014 and has two provisional patent applications pending. The Company will seek additional patents from time to time related to its research and development activities. The Company protects its trademarks, patents, inventions, trade secrets, and other proprietary rights by contract, trademark, copyright and patent registration, and internal security.
Customers. The Company's primary customers are the seven regional Bell operating companies ("RBOCs"), which are Ameritech Corporation, Bell Atlantic Corporation, BellSouth Corporation, NYNEX Corporation, Pacific Telesis Group, SBC Communications Inc., and US WEST Inc., as well as major independent telephone companies such as GTE Corporation, Sprint and The Southern New England Telephone Company. Historically, almost all of the Company's sales have been made to the RBOCs (86% in 1996). BellSouth Corporation, NYNEX Corporation, Bell Atlantic Corporation and US WEST Inc. accounted for 30%, 27%, 8% and 8%, respectively, of the Company's total sales in 1996. The Company's relationships with its customers are material to the Company's business, and the loss of any such relationship could have a material adverse effect on the Company's business.
Manufacturing. The Company's manufacturing operations consist primarily of quality control, functional testing, final assembly, burn-in and shipping. The Company uses independent third-party contract assembly and test companies on primarily a consignment basis for circuit board
assembly and in-circuit testing for all of its products. In particular, one third-party contract assembler is utilized by the Company for a significant portion of its circuit board assembly and in-circuit testing requirements. The loss of this particular subcontractor could cause delays in the Company's ability to meet production obligations and could have a material adverse effect on the Company's results of operations. In addition, shortages of raw material to, or production capacity constraints at, the Company's subcontractors could negatively affect the Company's ability to meet its production obligations and result in increased prices for affected parts. Any such reduction may result in delays in shipments of the Company's products or increases in the price of components, either of which could have a material adverse impact on the Company.
The Company currently procures all of its components from outside suppliers. Generally, the Company uses industry standard components for its products. Application specific integrated circuits ("ASICs") are a key component to the manufacturing process and are custom made to the Company's specifications. Currently the Company obtains all of its ASICs from National Semiconductor Corp. Although the Company has generally been able to obtain ASICs on a timely basis, a delay in the delivery of these components could have a material adverse impact on the Company.
Backlog. The Company's backlog at December 31, 1996 was approximately $0.9 million, as compared to approximately $2.1 million at December 31, 1995. The decrease was due largely to a $1.3 million order relating to a one-time project for a major customer that was included in the December 31, 1995 backlog and was subsequently shipped in the first quarter of 1996. The Company includes in backlog all firm purchase orders for products regardless of their ship date. Because of the quick turnaround that the customers expect on their orders, which is sometimes one to two weeks, and because of the possibility of customer changes in delivery schedules or cancellation of orders, the Company's backlog as of any particular date may not be indicative of actual revenues expected for any future period.
Competitive Conditions. The deciding competitive factors in the Company's market include price, product features, performance, reliability, service and support, breadth of product line, technical documentation and prompt delivery. The Company believes that it competes favorably on all of these factors, and certain of its products have proprietary or patented features. The Company also attempts to enter into development agreements for its MCU products with the manufacturers of DLC and other complex systems, which serves to ensure compatibility for its products. Competition would increase if new companies enter the Company's product markets or existing competitors expand their product lines. For instance, the recently enacted telecommunications reform legislation has lifted the restrictions which previously prevented the RBOCs from manufacturing telecommunications equipment. Pursuant to this legislative reform, the RBOCs, which are the Company's largest customers, may become competitors of the Company in the markets served by the Company.
For the Company's line-testing MCU devices, the primary competitive products are the remote monitoring units made by Teradyne, Inc. and the Harris Dracon division of Harris Corporation. The Company's MCU is simpler and less costly to install and permits the full complement of centralized testing to be performed as quickly and accurately as with copper by-pass wiring. The Company believes that Wiltron Company, Inc. and the Tau-Tron division of General Signal Corporation, providers of special services test systems, could expand into POTS line testing. The alarm-related MCU product's primary competitor is the Turbo 2000 unit made by Antec Corporation.
Employees. At December 31, 1996 the Company had 184 full-time employees, all in the United States. None of the Company's employees is represented by a collective bargaining agreement.
Government Regulation. The telecommunications industry is subject to regulation in the United States and other countries. Federal and state regulatory agencies, including the FCC and various state public utility commissions and public service commissions, regulate most of the Company's domestic customers. While such regulation does not typically affect the Company directly, the effects of such regulations on the Company's customers may, in turn,
adversely impact the Company's business and operating results. Governmental authorities also have promulgated regulations which, among other things, set installation and equipment standards for private telecommunications systems and require that all newly installed hardware be registered and meet certain government standards.
ITEM 2.

ITEM 2. PROPERTIES.
The Company's headquarters and principal administrative, engineering and assembly facilities are located in Cheswick, Pennsylvania and occupy approximately 58,000 square feet. The Company occupies its current facilities under a lease that expires in December, 1998 with successive options to renew through 2010. The Company believes that its current facilities are adequate to support its present level of operations and there is ample room to support continued sales growth for the foreseeable future.
ITEM 3.

ITEM 3. LEGAL PROCEEDINGS.
There are currently no outstanding or pending material legal proceedings with respect to the Company or its business.
ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
During the fourth quarter of 1996, there were no matters submitted to a vote of security holders through solicitation of proxies or otherwise.
EXECUTIVE OFFICERS OF THE COMPANY ---------------------------------
Information relating to the executive officers of the Company as of January 31, 1997 is set forth below:
PART II
ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS.
Information relating to the market for the Company's Common Stock and other matters related to the holders thereof is set forth under the caption "Common Stock Market Prices" on page 29 of the Company's 1996 Annual Report to Shareholders and is incorporated herein by reference.
ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA.
A summary of selected financial data for the Company, including each of the last five fiscal years in the period ended December 31, 1996, is set forth under the caption "Selected Consolidated Financial Data" on page 8 of the Company's 1996 Annual Report to Shareholders and is incorporated herein by reference.
ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
A discussion of the Company's financial condition and results of operations is set forth under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 9 through 13 of the Company's 1996 Annual Report to Shareholders and is incorporated herein by reference.
ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The Company's consolidated financial statements, together with the report thereon of Coopers & Lybrand L.L.P., are set forth on pages 15 through 28 of the Company's 1996 Annual Report to Shareholders and are incorporated herein by reference. Such financial statements and supplementary data are listed in Item 14(a) (1), "Exhibits, Financial Statement Schedules, and Reports on Form 8-K."
ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
In addition to the information reported in Part I of this Form 10-K, under the caption "Executive Officers of the Company", the information required by this item appears beneath the captions "Election of Directors" and "Executive Compensation -- Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's definitive proxy statement for its 1997 Annual Meeting of Shareholders and is incorporated herein by reference.
ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION.
Information relating to executive compensation is set forth beneath the caption "Executive Compensation" in the Company's definitive proxy statement for its 1997 Annual Meeting of Shareholders and is incorporated herein by reference.
ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
Information relating to the security ownership of beneficial owners of 5% or more of the Common Stock and of the executive officers and directors of the Company is set forth under the caption "Stock Ownership of Management and Certain Beneficial Owners" in the Company's definitive proxy statement for its 1997 Annual Meeting of Shareholders and is incorporated herein by reference.
ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
Information relating to certain relationships and related transactions is set forth beneath the caption "Certain Relationships and Related Transactions" in the Company's definitive proxy statement for its 1997 Annual Meeting of Shareholders and is incorporated herein by reference.
PART IV
ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a)(1) The following financial statements and supplementary data are incorporated in Item 8 of Part II of this Form 10-K by reference to pages 14 through 29 of the Company's 1996 Annual Report to Shareholders, which are incorporated herein by reference:
Statement of Management's Responsibility for Financial Reporting, dated January 29, 1997 Report of Independent Accountants, dated January 29, 1997 Consolidated Balance Sheets at December 31, 1995 and 1996 Consolidated Statements of Operations for the three years ended December 31, 1996 Consolidated Statements of Shareholders' Equity for the three years ended December 31, 1996 Consolidated Statements of Cash Flows for the three years ended December 31, 1996 Notes to Consolidated Financial Statements Statements of Operations Data by Quarter
(a)(2) The following financial statement schedule is included herewith on page 14 and made a part hereof:
Schedule II (Valuation and Qualifying Accounts)
(a)(3) The following exhibits are included herewith and made a part hereof:
* Management contract or compensatory plan, contract or arrangement required to be filed by item 601(b)(10)(iii) of Regulation S-K.
The Company agrees to furnish to the Commission upon request copies of all instruments not listed above which define the rights of holders of long-term debt of the Company.
Copies of the exhibits filed as part of this Form 10-K are available at a cost of $.20 per page to any shareholder of record upon written request to the Secretary, Tollgrade Communications, Inc., 493 Nixon Road, Cheswick, Pennsylvania 15024.
(b) Reports on Form 8-K filed during the quarter ended December 31, 1996.
None
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized as of March 19, 1997.
TOLLGRADE COMMUNICATIONS, INC.
By /s/ Christian L. Allison ---------------------------- Christian L. Allison Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities indicated as of March 19, 1997.
Report of Independent Accountants
To the Board of Directors Tollgrade Communications, Inc.:
Our report on the consolidated financial statements of Tollgrade Communications, Inc. and subsidiaries has been incorporated by reference in this Form 10-K from page 15 of the 1996 Annual Report to Shareholders of Tollgrade Communications, Inc. and subsidiaries. In connection with our audits of such financial statements, we have also audited the related financial statement schedule listed in the index on page 9 of this Form 10-K.
In our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presently fairly, in all material respects, the information required to be included therein.
/s/ COOPERS & LYBRAND L.L.P.
Pittsburgh, Pennsylvania January 29, 1997
SCHEDULE II
TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
VALUATION AND QUALIFYING ACCOUNTS For the Years Ended December 31, 1994, 1995 and 1996 (In thousands)
EXHIBIT INDEX (Pursuant to Item 601 of Regulation S-K)
- -------------- * Incorporated by reference.


ITEM 1 BUSINESS
Quest Health Care Fund VII, L.P. (the Partnership), formerly Southmark/CRCA Health Care Fund VII, L.P., was organized on July 23, 1986, as a limited partnership under the provisions of the Delaware Revised Uniform Limited Partnership Act. On September 12, 1986, a Registration Statement on Form S-1 was declared effective by the Securities and Exchange Commission whereby the Partnership offered for sale $30,000,000 of limited partnership interests (the Units). The Units represent equity interests in the Partnership and entitle the holders thereof to participate in certain allocations and distributions of the Partnership. The offering of the Units closed in June 1987, with 279,278 Units sold at $100 each, or gross proceeds of $27,927,800 to the Partnership.
The General Partner of the Partnership is Quest Rescue Partners - 7, L.P. (Quest) whose sole limited partner is Quest Financial Corp. and whose sole general partner is Quest Rescue Partners - 7 Corp. Quest became the General Partner of the Partnership on August 1, 1990.
The former general partner of the Partnership was Southmark Investment Group 86, Inc. (SIG), a Nevada corporation and a wholly-owned subsidiary of Southmark Corporation (Southmark).
The Partnership's primary business and only industry segment is to own, invest in, operate and ultimately dispose of a diversified portfolio of health care related real properties for the benefit of its Partners. At December 31, 1996, the Partnership held interests in three nursing home properties as described in Item 2

Item 2 below and the Partnership employed approximately 228 full and part time persons, including administrative, nursing, dietary, laundry, housekeeping, social services and maintenance personnel.
The services provided at the Partnership's long-term care facilities consist of intermediate and skilled nursing care. Intermediate care consists of providing assistance or supervision with daily activities such as dressing, bathing, diet or medication. Skilled nursing care consists of 24 hour a day services of registered nurses and related medical services prescribed by the resident's physician. Under the Omnibus Budget Reconciliation Act (OBRA), which became effective October 1, 1990, the distinction between skilled nursing and intermediate care facilities was eliminated. The legislation imposed a variety of new quality of care requirements on all long-term care facilities, with resulting increases in operating costs. The legislation imposed more stringent requirements regarding staff, screening and assessment of residents, resident rights, and survey and certification requirements. It also subjects facilities to a number of sanctions, including civil money penalties, for substandard survey results. Under this legislation, states are required to amend their Medicaid plans to make an appropriate adjustment in the rates at which they reimburse long- term care facilities in order to reflect the costs of these new requirements. There is, however, no requirement that the rate adjustments actually cover all new costs nor are there any assurances that state budgetary constraints will sustain the costs associated with federal mandates.
During 1995, the final regulations pertaining to OBRA 87 were instituted. OBRA 87 contained, among other things, new stringent survey requirements with severe penalties for non-compliance. In 1996, the expenses of the facilities have increased as a result of increased personnel costs necessary to comply with OBRA 87. The Partnership's facilities that provide skilled care are certified to receive benefits under the Federal Health Insurance for the Aged Act (Medicare) and under joint federal and state funded programs administered by the various states to provide medical assistance to the indigent, known generally as Medicaid. Benefits under Medicare are for skilled care only. However, Medicaid plans provide for different levels of reimbursement, depending upon the level of care and services rendered.
Medicaid reimbursement formulas are established in accordance with Federal guidelines, by each state, with the approval of the Federal government and vary from state to state. Typically, Medicaid formulas provide for reimbursement for specified services up to specified limits based on historical costs, with adjustments for inflation. Federal law requires that Medicaid reimbursement rates be reasonable and adequate to meet the cost which must be incurred by efficiently and economically operated facilities in order to provide care and services in conformity with applicable laws, regulations and quality and safety standards. Medicaid payments are set either retrospectively, prospectively, on a flat rate basis or a combination thereof. The Medicare and Medicaid programs are subject to statutory and regulatory changes, administrative rulings, political fiats, interpretations of policy and determinations by intermediaries, and to governmental funding restrictions, all of which may materially increase or decrease the rate of program payments to long-term care facilities, such as those owned by the Partnership.
In the operation of health care facilities, the Partnership competes with a number of individuals and entities, including large, national nursing home chains and small, locally owned nursing care facilities. Some competing operators have greater financial resources than the Partnership or may operate on a nonprofit basis or as charitable organizations. The degree of success with which the Partnership's facilities compete varies from location to location and depends on a number of factors. There is limited, if any, competition in price with respect to Medicaid and Medicare patients, since revenue for services to such patients is strictly controlled and based on fixed rates and cost reimbursement principles.
In light of these factors, the Partnership will continue to seek to meet competition in each locality by improving the appearances and the quality of services provided at its facilities, establishing a reputation within the local medical communities for providing competent care services, and by responding appropriately to regional variations in demographics and tastes.
During 1995, the Partnership's interest in five of the Partnership's facilities were sold. Please refer to Part II, Item 7 for further discussion.
The following table sets forth information regarding the average daily census and sources of patient revenues at the Partnership's facilities:
Because of a changing census mix, the occupancy required for a facility to achieve an operating break-even point cannot be determined precisely. Generally, a greater ratio of Medicaid patients will require a higher occupancy to reach a break-even point. However, a high Medicare census changes the break-even point due to a higher reimbursement rate even though expenses associated with Medicare qualified residents are significantly higher than Medicaid.
All licensed beds in the Partnership's facilities are being utilized, except that in some instances, semi-private rooms have been converted to private rooms to accommodate demand or a small number of rooms have been taken out of service to be utilized for office space and ancillary support areas.
ITEM 2 PROPERTIES
The following table sets forth the investment portfolio of the Partnership at December 31, 1996. The buildings and the land on which they are located are owned by the Partnership through its majority-owned partnerships in fee.
The Partnership's majority-owned partnerships were a creation of Southmark to enable the Partnership to acquire properties from Southmark affiliates without paying transfer taxes or having to perform relicensing of the homes more than once. The Southmark affiliate had already paid the tax and relicensed the facility prior to the acquisition by the Partnership. There appears to have been no adverse economic impact on the Partnership by this arrangement. Quest maintained the arrangement to avoid creating tax and relicensing problems associated with dissolving the majority owned partnerships. Quest has not received any financial benefit from this ownership structure.
ITEM 2 PROPERTIES continued
ITEM 3

ITEM 3 LEGAL PROCEEDINGS
The State of Idaho sought a deficiency lien against the Partnership's Idaho facilities for sales and use taxes for periods prior to ownership by the Partnership. The total amount claimed by the state is $372,921. Management of the Partnership is discussing a settlement of this matter with the state and has recorded its best estimate of this liability by recording a provision of $279,691 in the Partnership's Financial Statements in 1994. Management is of the opinion that the maximum exposure to the Partnership, in excess of accrued amounts, is $93,230 plus additional penalties and interest, if any. The Partnership plans to continue to vigorously defend itself against these claims. As of year end 1996, the state was reassessing their position relative to the claims. Upon settlement, the difference between the settlement amount and the $279,691 will be reflected in results from operations.
In 1994, a complaint associated with a sexual harassment and wrongful termination was filed against the Partnership. The Partnership's liability, if any, is not determinable at this time and no provision has been made in the accompanying Financial Statements. It is the opinion of management that the ultimate resolution will not have a material effect on the Partnership's financial position. There has been no significant change in the status of this litigation since 1995.
In the fourth quarter of 1996, a complaint for discrimination and wrongful termination was received by one of the Partnership's facilities. Other than the cost of defense, the complaint is not expected to have a material impact on the Partnership as management believes the complaint is without merit.
ITEM 4

ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None during the fourth quarter of 1996.
Part II
ITEM 5

ITEM 5 MARKET FOR THE REGISTRANT'S UNITS OF LIMITED PARTNERSHIP AND RELATED SECURITY HOLDER MATTERS
(A) No established public trading market for the Units exists nor is one expected to develop.
(B) Title of Class Number of Record Unit Holders -------------- ----------------------------- Limited Partnership Interests 3,768 as of February 28, 1997
(C) No cash distributions were made to the Limited Partners in 1990, 1991, 1993, 1994 or 1996. The Limited Partners received cash distributions of $488,736, $139,639 and $5,306,282 for the years ended December 31, 1989, 1992 and 1995, respectively. Cumulative distributions to the Limited Partners from the Partnership from its inception to December 31, 1996 were $8,567,428. No distributions have been made to either SIG or Quest. See the Liquidity and Capital Resources section of Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations.
ITEM 6

ITEM 6 SELECTED FINANCIAL DATA
The following table sets forth a summary of certain financial data for the Partnership. The settlement of litigation, the foreclosure of one property and the write down of other properties significantly impacted the 1993 and 1994 financial information. The gain on the sale of five properties in 1995 resulted in the significant improvement in net income. This summary should be read in conjunction with the Partnership's financial statements and the related notes appearing in Item 8.
(1) Includes gain on sale of five facilities of $548,389 or $1.94 per unit.
(2) Includes extraordinary gain of $64,012 or $.23 per unit from settlement of Healthcare Services Group payables and loss from writedown of properties of $7,180,571 or $(25.45) per unit.
(3) Includes loss from write down of properties of $3,352,459 or $(11.88) per unit, loss from transfer of property of $1,510,559 or $(5.35) per unit, and extraordinary gain of $4,869,365 or $17.26 per unit from extinguishment of debt and settlement of Southmark payables.
ITEM 7

ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
General
Certain statements in this Annual Report that are not historical fact constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Discussions containing forward-looking statements may be found in this section and in the section entitled "Business." Without limiting the foregoing, words such as "anticipates," "expects," "intends," "plans" and similar expressions are intended to identify forward-looking statements. These statements are subject to a number of risks and uncertainties. Actual results could differ materially from those projected in the forward-looking statements. The Partnership undertakes no obligation to update these forward-looking statements to reflect future events or circumstances.
RESULTS OF OPERATIONS
During 1996, the Partnership continued its efforts to sell the remaining Partnership facilities. During the fourth quarter, the Partnership reached an agreement in principal to sell the Valley Convalescent facility. Negotiations continue to sell the other two facilities.
In February 1995, the Partnership sold its interest in one facility for a gain of $200,446. The Partnership was relieved of mortgage obligations secured by the facility exceeding $1,830,000, and received cash of $1,700,000. As a result of the sale of the facility and cash on hand; the Partnership distributed $2,792,780 or $10/unit to the limited partners in March 1995.
On April 30, 1995, the Partnership sold its interests in four of its facilities to another unaffiliated third party. The Partnership reflected an estimated loss on the sale of these facilities of $4,898,869 at December 31, 1994 and recognized a gain of $347,943 upon closing of the sale on April 30, 1995. A distribution from this sale of $2,513,502 or $9/unit was made to the limited partners in June 1995.
Neither the General Partner nor its affiliates received any remuneration nor distributions from the sale of facilities.
Revenues:
Operating revenues for the twelve month period ended December 31, 1996 decreased $5,368,358 when compared to the prior period. This is primarily the result of the sale of the Partnership's interests in five facilities. On a proforma basis, removing the effect of the sales, revenues decreased $65,676 in 1996 as compared to the same period in 1995. This is partially the result of $125,000 in prior year cost report adjustments in excess of recorded estimated settlements for all facilities during the third quarter applied in 1996, reflecting amounts due to Medicare for prior years, as well as the future expected changes in Medicare allowable reimbursement levels. In addition, during the third quarter, the Valley Convalescent facility experienced lower occupancies as a result of a bed hold precipitated by a unfavorable state survey. During the fourth quarter, the facility was cleared of all deficiency claims of the state and occupancy is returning to the levels experienced prior to the survey.
Operating revenues for the twelve month period ended December 31, 1995 decreased $11,389,585 when compared to the prior period. This is primarily the result of the sale of the Partnership's interests in five facilities. On a proforma basis, removing the effect of the sales, revenues increased $514,997 in 1995 as compared to the same period in 1994. The primary source of the increase was from occupancy and rate increases at Valley Living Center and Valley Convalescent Center, as well as increased Medicare utilization. Revenue in 1995 included $5,300,332 related to the five sold facilities.
Receivables from Medicaid/Medicare eligible residents do not present a significant credit risk as the Medicaid/Medicare system is federally financed. Receivables are, however, subject to disallowance by Medicare and Medicaid upon audit. Such governmental audits are typically one or two years in arrears. Inflation is not a material factor due to the fact that reimbursement rates are set by governmental agencies, however, such agencies are not obliged to increase the reimbursement rate at the rate of inflation.
The significant components of accounts receivable at December 31, 1996 and 1995 were:
Payments by both the state and federal governments are normally received within 60-90 days. The receivables of the Partnership represent less than 48 days revenue.
Expenses:
For the twelve month period ending December 31, 1996, total expenses decreased $4,788,830 compared to the prior period. On a pro forma basis, eliminating the effect of the five sold facility interests, operating expenses increased $556,057. Two thirds of this increase relates to additional personnel necessary to comply with OBRA 87 and wage increases needed to compete for employees with
non-health care related employers. The remainder is primarily legal expense incurred defending the Partnership against former employee legal claims.
For the twelve month period ending December 31, 1995, total expenses decreased $18,578,430 compared to the prior period. On a pro forma basis, eliminating the effect of the five sold facility interests and the writedowns that occurred in 1994, operating expenses decreased $53,461. This is primarily related to increased labor costs associated with complying with the final regulations issued in 1995 relating to OBRA 87 and wage inflation offset by aggressive expense control and staff reductions at Mountain View in line with its reduced occupancy. Supplies and Ancillary expense increased $316,320 at Valley Convalescent as a result of increased occupancy and Medicare utilization. Total expenses in 1995 included $5,156,944 relating to the five sold facility interests.
Consistent with the Partnership's accounting policy as described in Note A, the Partnership reflected property and equipment as of December 31, 1994 at the lower of cost (as previously adjusted for writedowns, if applicable) or estimated net realizable value, determined on an individual nursing home basis. Loss from writedowns of properties in 1994 were $7,180,571 which included writedowns of $762,797 and $1,518,905 related to Valley Living Center and Valley Convalescent Center, respectively. (Note F).
As of December 31, 1996, management estimates that fair value exceeds the carrying value and, accordingly, does not expect any further material adjustments under Statement of Accounting Standard No. 121 unless warranted by future changes in market conditions or other relevant factors.
Based on the carrying value of the Partnership's interests in the four facilities sold in May 1995, the Partnership expected to incur a loss on the sale and, accordingly, recognized this loss at December 31, 1994 in the accompanying statements of operations of $4,898,869 consisting of a writedown of property and equipment of $4,466,946 for the Partnership's interests contracted to be sold and $431,923 for the 25% discount of accounts receivable.
Ancillary Revenue and Expense is a term that describes specialized services provided by third party unaffiliated vendors. These services include speech, occupational, physical and occasionally intravenous therapies. These revenues and expenses are subject to certain cost limitations and do not materially effect the profitability of a facility. However, the ability to provide these services enables a facility to accept residents reimbursed under the federal Medicare system. Typically, the Medicare system reimburses at a higher daily rate than Medicaid. These Medicare residents are people, not necessarily elderly, who, under another set of regulations, must be discharged from hospitals before they are well enough to go home. The result is that nursing homes that once were a final stop in life's journey have become more like auxiliary hospitals with a substantially shortened length of stay. The pursuit of high reimbursement Medicare residents limits the number of Medicaid beds available to the indigent elderly. These people will be required to live with relatives or find low skilled "foster care" or community based services. Additional challenges confronting the Partnership are market competition and state budgetary restraints.
The Valley Convalescent facility, located in the desert town of El Centro, California, has continued to experience increased personnel costs associated with attracting qualified personnel from a competency challenged labor pool. Despite a small Medicaid rate increase, after a three year freeze, the facility is highly dependent on Medicare for its profitability. Whatever action Congress may take to reduce Medicare payments will have a significant, but, as yet, un quantifiable impact on the facility.
Valley Living, in Idaho Falls, Idaho, has experienced a nearly 20% decrease in occupancy as the result of the opening of a new, competing facility in town. While the facility remains profitable, it is doubtful revenues will be sustainable at prior year levels.
Mountain View Care Center, located in Kimberly, Idaho, has not been able to successfully challenge the competition that opened in 1993, due to its age and location. To protect the interests of the Partnership, the Mountain View facility must continue operations pending a resolution of the sales tax claims and the employee complaint. (See Item 8, Note E)
Liquidity and Capital Resources
At December 31, 1996, the Partnership held cash and cash equivalents of $896,687, a decrease of $428,634 over 1995.
At December 31, 1995, the Partnership held cash and cash equivalents of $1,325,321, a decrease of $144,138 over 1994. The decrease is due to the distributions to limited partners which exceeded the cash provided by the sales and the positive cash flow from operations.
In February 1995, the Partnership sold its interest in one facility for a gain of $200,446. The Partnership was relieved of mortgage obligations secured by the facility exceeding $1,830,000, and received cash of $1,700,000. As a result of the sale of the facility and cash on hand; the Partnership distributed $2,792,780 or $10/unit to the limited partners in March 1995.
At April 30, 1995 the Partnership sold its interests in four of its facilities to another unaffiliated third party resulting in a gain of $347,943. A distribution from this sale of $2,513,502 or $9/unit was made to the limited partners in June 1995.
Neither the General Partner nor its affiliates received any remuneration or distributions from the sale of facilities.
During the fourth quarter of 1994 the State of Idaho asserted a $470,135 deficiency lien against the Partnership's Idaho properties for periods from 1976 through 1988, under a theory of successor liability. Of this amount, $372,921 relates to the remaining two facilities owned as of December 31, 1996, located in Idaho. The Partnership acquired its interests in these properties in June 1987. Although the Partnership believes it has a number of meritorious defenses to the claims of the State of Idaho, an expense was accrued in the fourth quarter of 1994 in the amount of $352,602. The liability reflected as of December 31, 1996 is $279,691 for the remaining two facilities. Any settlement with the state
for an amount different than this accrual will be reflected in the results from operations. As of year end 1996, the State of Idaho was reassessing their legal position relative to their claims.
In February 1995, the limited partners of the Partnership received hostile tender offer materials offering to purchase the units of certain limited partners of the Partnership. After a thorough analysis of the tender offer materials, the General Partner recommended that the Limited Partners vote against the tender offer, as such tender offer was not in the best interests of the limited partners of the Partnership. The unfriendly bidder amended its tender offer materials three times requiring the Partnership to respond to the offer at a cost to the Partnership. The tender offer was subsequently withdrawn. The expense of the printed materials and legal advice necessary to represent the Partnership's belief exceeded $160,000.
The Partnership's Balance Sheet, at December 31, 1994, reflected the lower of costs or estimated net realizable value, at that date, of property and equipment. The significant writedown of property and equipment in 1994 was based on the Partnership's future plans for its interests in the nursing facilities and the attendant accounting policies. At December 31, 1993, the nursing facilities were considered operating assets since it was the Partnership's plan to continue to operate the facilities as it had in the past. Consistent with generally accepted accounting principals ("GAAP") and the Partnership's accounting policy for operating assets, property and equipment were carried in the 1993 balance sheet at the lower of cost or estimated undiscounted future cash flows expected to be generated over the remaining estimated useful life of the property and equipment. The remaining estimated useful life of the property and equipment at December 31, 1993 was approximately 23 years.
It is not the objective of GAAP to reflect operating property and equipment at estimated market value less costs of disposal, otherwise known as estimated net realizable value. Instead, under GAAP most property and equipment is carried at cost less accumulated depreciation taken over the years of prior service.
During 1994, as described in the notes to the Financial Statements, the Partnership determined that it would market for sale its interests in the nursing facilities. Since the future life under these circumstances is the length of time required to dispose of the assets as opposed to the much longer term of the assets remaining useful operating life, GAAP and the Partnership's accounting policy require that the property and equipment under these circumstances be carried at the lower of cost (the then existing carrying value) or estimated net realizable value. Accordingly, under these circumstances, the time value of money (over approximately 22 remaining years), the risk of capital invested, local, national and industry conditions including competition, state and federal reimbursement plans and patient mix, among many other factors, are taken into consideration. Consequently, as a result of a change in the Partnership's future direction, a loss on property and equipment representing the difference in (1) the carrying value as determined based on the lower of cost or estimated undiscounted future cash flows over the remaining estimated useful life for operating assets, and (2) the lower of cost or estimated net realizable value at that time was recognized during 1994 in the amount of $6,748,648 and is reflected in the 1994 Financial Statements.
Effective October 1, 1990, federal legislation, OBRA, eliminated the distinction between skilled nursing and intermediate care facilities and imposed a variety of quality of care requirements on all long-term care facilities, with resulting increases in operating costs. The legislation also imposes more stringent requirements regarding staff, screening and assessment of residents, resident rights and survey and certification requirements. Under this legislation, states are required to amend their Medicaid plans to make an appropriate adjustment in the rates at which they reimburse long-term care facilities in order to reflect the costs of these new requirements. There is, however, no requirement that the rate adjustments actually cover all costs nor are there any assurances that state budgetary constraints will sustain the cost of future federal mandates.
Medicare is a federal entitlement program and Medicaid (the source of the majority of the Partnership's revenues) represents an entitlement program administered differently by each state which is partially funded by the Federal government. In August 1993, Congress enacted Title XIII of OBRA 93. This act, among other things taxed social security benefits received by the elderly and further limited payments under state Medicaid programs for which federal matching would be permitted. In October 1993, the Health Care Financial Administration (HCFA) implemented a freeze on Medicare reimbursement, on routine cost limits, certain Part B ancillaries and prospective payment system rates. In addition, HCFA eliminated the return on equity component of the reimbursement rate. Further, by the end of 1993, several states; because of federal actions and/or budgetary difficulties, had either taken action to curtail the growth in entitlement programs and/or had indicated that future action was possible. Despite the fact that health care reform proposals at the federal level are dead, activities at the state level continue and are encouraged by HCFA. In 1996, the latest idea continues to be "block grants" to the states and significant Medicare budgetary reductions. What this means to nursing facilities cannot currently be determined by management of the Partnership.
Private pay sources accounted for 12% of the Partnership's total revenue in 1996, all other revenue came from federal and state entitlement programs. Any reduction in these programs will have an immediate impact on the total revenue and cash flow of the Partnership.
In March 1995, the Financial Accounting Standards Board issued Statement of Accounting Standard No. 121 - "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of", which is effective for fiscal years beginning after December 15, 1995. Since the Partnership has recognized impairment losses , effectively adjusting the carrying value of its long-lived assets, as of December 31, 1994, to estimated net realizable value at the date of writedown and as subsequently depreciated, no material adjustment from the current carrying value to fair value is required.
ITEM 8

ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA
QUEST HEALTH CARE FUND VII, L.P.
All other schedules are omitted since they are not required, are not applicable or the financial information required is included in the financial statements or the notes thereto.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Partners Quest Health Care Fund VII, L.P.
We have audited the financial statements and financial statement schedule of Quest Health Care Fund VII, L.P. listed in the index of this Form 10-K. These financial statements and financial statement schedule are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statement schedule are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Quest Health Care Fund VII, L.P. as of December 31, 1996 and 1995, and the results of its operations and its cash flows for the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein.
As discussed in Note F to the accompanying financial statements, the Partnership decided to market for sale its operating property and equipment during 1994. Prior to that decision, in accordance with generally accepted accounting principles, the Partnership carried operating property and equipment in its consolidated financial statements at the lower of cost or estimated undiscounted future cash flows, before interest charges, on an individual property basis. As a result of this decision, the Partnership has written down its property and equipment to an estimated net realizable value as determined by management through a charge to earnings of $7,180,571 in 1994. As discussed in Note I, the Partnership is currently marketing for sale its operating assets and intends to liquidate the Partnership thereafter.
Coopers & Lybrand LLP
Raleigh, North Carolina March 27, 1997
QUEST HEALTH CARE FUND VII, L.P. BALANCE SHEETS December 31, 1996 and 1995
See notes to financial statements.
QUEST HEALTH CARE FUND VII, L.P. BALANCE SHEETS - CONTINUED December 31, 1996 and 1995
See notes to financial statements.
QUEST HEALTH CARE FUND VII, L.P. STATEMENTS OF OPERATIONS For the Years Ended December 31, 1996, 1995 and 1994
See notes to financial statements.
QUEST HEALTH CARE FUND VII, L.P. STATEMENTS OF PARTNERS' EQUITY For the Years Ended December 31, 1996, 1995 and 1994
See notes to financial statements.
QUEST HEALTH CARE FUND VII, L.P. STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1996, 1995 and 1994
See notes to financial statements.
QUEST HEALTH CARE FUND VII, L.P. STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1996, 1995 and 1994
SUPPLEMENTAL DISCLOSURE OF NON-CASH FINANCING ACTIVITIES:
See notes to financial statements.
QUEST HEALTH CARE FUND VII, L.P. NOTES TO FINANCIAL STATEMENTS
NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
1.Organization
Quest Health Care Fund VII, L.P. (the Partnership) formerly Southmark/CRCA Health Care Fund VII, L.P., was organized on July 23, 1986, as a limited partnership under the provisions of the Delaware Revised Uniform Limited Partnership Act, to acquire and operate income-producing health care related properties.
On August 1, 1990, Quest Rescue Partners - 7, L.P. (Quest) became the general partner of the Partnership. Quest's sole general partner is Quest Rescue Partners - 7 Corp. and its sole limited partner is Quest Financial Corp.
Southmark Investment Group 86, Inc. (SIG), a Nevada corporation and a wholly-owned subsidiary of Southmark Corporation (Southmark), was the general partner of the Partnership prior to August 1, 1990.
The Partnership's primary business and only industry segment is to own, invest in, operate and ultimately dispose of health care related facilities for the benefit of its partners. The services provided at the Partnership's long-term care facilities, which are primarily located in the western United States, consist of intermediate and skilled nursing care.
The financial statements include the accounts of the Partnership and its 99% owned partnerships which hold the individual properties. All significant inter-partnership balances and transactions have been eliminated. The amount of minority interest attributable to affiliates of the General Partner is immaterial.
2. Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents include cash on hand, demand deposits, money market funds and investments in certificates of deposit with original maturities when purchased of three months or less.
The Partnership maintains cash accounts with a variety of unrelated banks, all of which are covered by the Federal Deposit Insurance Corporation (FDIC). At December 31, 1996, the Partnership maintained cash balances at these banks aggregating $683,595 in excess of the $100,000 FDIC insured maximum.
3. Operating Revenue
Operating revenue is recorded when services are rendered and includes amounts reimbursable by the Medicaid and Medicare programs. Medicaid and Medicare revenues are recorded at the applicable net reimbursement rates; therefore, no contractual adjustments are reported.
The Partnership grants unsecured credit to the residents of its facilities. Inherent in this practice is a credit risk of non-collection. Management has provided an allowance which it believes will be sufficient to absorb all uncollectible amounts existing at December 31, 1996 and 1995, respectively.
QUEST HEALTH CARE FUND VII, L.P. NOTES TO FINANCIAL STATEMENTS
3. Operating Revenue continued
Accounts receivable consist primarily of amounts due from residents funded through Medicare, Medicaid, commercial insurance and private resources.
All resident receivables are recorded at their original face amount and are due and payable under "normal" market terms and conditions. In the event of non-collection, the ultimate loss to the Partnership would be limited to the recorded balance of the receivables as shown in the balance sheet.
The sources of patient revenues for years ended December 31, 1996, 1995 and 1994 are:
The significant components of accounts receivable at December 31, 1996 and 1995 are:
Payments by both the state and federal governments are normally received within 60-90 days. During the third quarter revenue was decreased by approximately $125,000 representing cost report settlements in excess of estimated amounts previously recorded.
4. Property and Equipment
Property and equipment are depreciated using the straight-line method over lives of 5 to 30 years. Amortization of Leased Assets is included in depreciation and amortization expense. Renewals and betterment are capitalized and repairs and maintenance are charged to operations as incurred.
Effective January 1, 1996, the Partnership recognizes impairment losses on property and equipment in accordance with the Statement of Financial Accounting Standards No. 121 - "Accounting for the Impairment of Long-Lived Assets and for Long- Lived Assets to be Disposed of". Since the Partnership has recognized impairment losses, as discussed in Notes F and G, effectively adjusting the carrying value of its long-lived assets to estimated net realizable value as of December 31, 1994, which has been further depreciated during 1995 and 1996, no significant adjustment of carrying value at December 31, 1996 to the lower of carrying value or fair value is currently required. Prior to 1996, the Partnership recognized an impairment loss on operating property and equipment of its long-term care facilities when it became probable that the carrying amount of the facility would not be recoverable through future operations. Write downs were charged to operations for the difference in the net carrying value and the estimated undiscounted future cash flows before interest charges of the facility.
Upon the determination that a facility will be abandoned, foreclosed, placed on the market for sale, or otherwise disposed of, the facility's carrying value is
QUEST HEALTH CARE FUND VII, L.P. NOTES TO FINANCIAL STATEMENTS
4. Property and Equipment continued
adjusted to the estimated fair value, if less than carrying value, through a charge to operations. See Note G.
5. Income Taxes
No provision has been made in the financial statements for income taxes because under current law, no income taxes are paid directly by the Partnership. The Partnership reports certain transactions differently for tax and financial statement purposes.
6. Allocation of Net Income or Net Loss and Distributions
The Partnership Agreement provides that net income (other than net income from a sale or refinancing of Partnership property), will be allocated to the Partners in proportion to cash distributions. Net losses will be allocated 99% to the Limited Partners and 1% to the General Partner.
Net profits from a sale or refinancing of Partnership property will be allocated first to any partners in proportion to and to the extent of their negative adjusted capital accounts; then in accordance with distributions of sale proceeds, refinancing proceeds and cash from other sources.
Distributions of cash from operations are made as follows:
(a) First, to the Limited Partners until they have received distributions of cash from operations equal to a prescribed (7% through April 1, 1990, and 9% thereafter in compliance with the Quest Proxy and the Amendment to the Partnership Agreement) non-cumulative return on their invested capital; then,
(b) to the General Partner in the amount of distribution advances, if any, previously advanced; then,
(c) to the General Partner until it has received cash from operations equal to 4% of the total distributions of cash from operations; then,
(d) 96% to the Limited Partners and 4% to the General Partners.
Distributions of cash from the sale or refinancing of properties will be distributed as follows:
(a) First, to all Limited Partners until they have received distributions from all sources equal to their priority return not previously distributed through distributions of cash from operations; then,
(b) to the General Partner in the amount of distribution advances, if any, previously advanced; then,
(c) to all Limited Partners until they have received distributions of cash from property sales and refinancing and cash from other sources equal to their original capital investment; then,
QUEST HEALTH CARE FUND VII, L.P. NOTES TO FINANCIAL STATEMENTS
6. Allocation of Net Income or Net Loss and Distributions continued
(d) to the General Partner until it has received distributions equal to 1% of the distributions to the Limited Partners other than in a return of the Limited Partners' original capital investment or in the payment of distribution advances to the General Partner; then,
(e) 85% to the Limited Partners and 15% to the General Partner.
7. Net Income (Loss) Per Limited Partnership Unit
Net income (loss) per Limited Partnership Unit is computed by dividing net income (loss) allocated to the Limited Partners by the weighted average number of Limited Partnership Units outstanding.
8. Use of Estimates
The preparation of financial statements in accordance with generally accepted accounting principles requires management to make certain estimates and assumptions that affect the reported amounts in the balance sheets and statements of operations. Actual results could differ from those estimates.
9. Fair Value of Financial Instruments
During 1995, the Company adopted Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments," which requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet.
The carrying value of cash and cash equivalents, approximate fair value due to the short-term nature of these instruments. There are no off-balance sheet financial instruments to which the Partnership is subject.
NOTE B TRANSACTIONS WITH AFFILIATES
The Partnership Agreement provides for payment of property management fees based on 6% of gross property operating revenue. Quest Administrative Services, L.P. (QASLP), an affiliate of Quest, receives 1% of gross property operating revenue relating to services provided directly to the facilities. Total payments to QASLP under these contracts in 1996, 1995 and 1994 and were $67,057, $113,966 and $191,258, respectively.
Quest, in an effort to continue certain health benefits for employees, created an employee benefit trust (the "Trust") in compliance with the guidelines promulgated by VEBA and ERISA. Amounts contributed to the Trust by the Partnership and Partnership employees are strictly for the benefit of employees of the participating employers, payment of excess loss reinsurance, life insurance and accidental death and dismemberment and claims and plan administration and employee medical claims. Quest has engaged a claims pre- certification organization to review all claims made by the Partnership's
QUEST HEALTH CARE FUND VII, L.P. NOTES TO FINANCIAL STATEMENTS
NOTE B TRANSACTIONS WITH AFFILIATES continued
employees. Approximately $135,120, $198,210, and $249,065 was recorded under this arrangement in 1996, 1995, and 1994, respectively.
Partnership administration costs paid through QASLP were $387,724, $579,408, and $630,987 in 1996, 1995, and 1994, respectively. Such charges represent legal costs associated with litigation and SEC filings, investor service functions and other partnership administration costs.
NOTE C LONG-TERM OBLIGATIONS
A summary of the long-term obligations of the Partnership at December 31, 1996 and 1995 follows:
NOTE D LITIGATION
During the third quarter of 1994, the Partnership settled its litigation with Healthcare Services Group, Inc., with $64,012 being recognized as a non-cash extraordinary gain for 1994.
In 1994, a complaint associated with a sexual harassment and wrongful termination was filed against the Partnership. In the fourth quarter of 1996, a complaint for discrimination and wrongful termination was received by one of the Partnership's facilities. The Partnership's liability, if any, is not determinable at this time and no provision has been made in the accompanying Financial Statements. It is the opinion of management that the ultimate resolution will not have a material effect on the Partnership's financial position. There has been no significant change in the status of this litigation.
QUEST HEALTH CARE FUND VII, L.P. NOTES TO FINANCIAL STATEMENTS
NOTE D LITIGATION continued
In December 1994, the Partnership received a Notice and Demand for Payment from the Idaho State Tax Commission resulting from sales tax audits for the years 1976 through 1988 under a theory of successor liability for approximately $470,000. The Partnership has recorded a provision in the 1994 Financial Statements for $352,602, at December 31, 1994. As a result of selling certain facility interests in 1995, this successor liability was reduced to approximately $373,000 and the reserves were reduced to $279,691. As of year end 1996 the reserve remains as $279,691. The amount of this liability could change in the near term and the difference between the final settlement and the recorded liability of $279,691 will be reflected in the results from operations. As of year end 1996, the state was reassessing their position relative to these claims.
NOTE E TAXABLE LOSS
A reconciliation between the net income (loss) for financial reporting purposes and the taxable income (loss) for income tax purposes follows:
QUEST HEALTH CARE FUND VII, L.P. NOTES TO FINANCIAL STATEMENTS
NOTE F IMPAIRMENT LOSS
Consistent with the Partnership's accounting policy as described in Note A, the Partnership reflected the property and equipment as of December 31, 1994 at the lower of cost (as previously adjusted for writedowns if applicable) or estimated net realizable value at that date, determined on an individual nursing home basis. Writedowns of $762,797 and $1,518,905 were applied to Valley Living Center and Valley Convalescent Center, respectively, which represented Management's opinion of the excess carrying value at that date over the estimated net realizable value of these two properties. The remaining facilities, except the Church Hill facility, were also adjusted to estimated net realizable value, resulting in an additional writedown of $4,898,869 (Note G). No further adjustments are believed necessary in 1996.
NOTE G SALE OF FACILITIES
In February 1995, the Partnership sold its partnership interest in one facility to an unaffiliated third party and recognized a gain of $200,446. The Partnership was relieved of the mortgage obligations secured by the facility of $1,830,000, received cash of $1,700,000 and was relieved of any obligations relating to Medicaid or Medicare settlements, audit adjustments and prior reimbursement recapture by Medicare.
In addition the Partnership sold its interests in four of its facilities in 1995 to a different unaffiliated third party. The Partnership reflected an estimated loss on the sale of these facilities of $4,898,869 at December 31, 1994 and recognized a gain of $347,943 upon closing of the sale on April 30, 1995. The contract provided for adjusting working capital, as defined, to exclude interpartnership accounts and the current portion of long term debt and to reflect a 25% discount on accounts receivable at closing for the sale of the Partnership interests in the four facilities. The contract also provided for cash consideration adjustments based on changes in working capital including the change in the 25% discount proportionate to changes in accounts receivable occurring between December 31, 1994 and the date of closing. The Partnership made a final determination of adjusted working capital when the Partnership's accountants completed certain agreed upon procedures. Total cash received by the Partnership was $3,370,998, and the purchaser assumed debt related to equipment of approximately $63,000.
The balance sheet of the Partnership reflects the effects of the sale of the Partnership's interests in the five facilities. The Partnership is seeking to liquidate the Partnership's interests in its three remaining facilities. Distributions of $2,792,780 or $10/unit were made to the limited partners in March of 1995 and $2,513,502 or $9/unit were made in June 1995.
QUEST HEALTH CARE FUND VII, L.P. NOTES TO FINANCIAL STATEMENTS
NOTE H PRO FORMA INFORMATION (UNAUDITED)
Due to the impact of the Partnership selling its interests in five of its facilities during 1995, historical results of operations may not be indicative of future results of operations and net income (loss) per limited partnership unit. The following unaudited pro forma condensed statement of operations is presented as if the transactions previously described occurred as of January 1, 1995.
The unaudited pro forma condensed financial information does not purport to present what actual results of operations would have been if the transactions previously described had occurred on such dates or to project results for any future period. It is management of the Partnership's belief that all adjustments necessary to reflect the effects of the sales, described in Note H have been made.
PRO FORMA CONDENSED STATEMENT OF OPERATIONS (B) For the Year Ended December 31, 1995 (Unaudited in thousands)
(A) The pro forma adjustments remove the revenues and expenses directly related to the five nursing homes sold.
(B) The historical statement of operations for the period ended December 31, 1995 includes a gain of $548, in thousands, from the sale of five facilities. This amount is not included in the above pro forma condensed statement of operations due to its non recurring nature.
QUEST HEALTH CARE FUND VII, L.P. NOTES TO FINANCIAL STATEMENTS
NOTE I GOING CONCERN
The Partnership's financial statements have been presented on the basis that it is a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The sale of the Partnership's interests in five nursing homes and possible future sales of any or all of its remaining facilities will have an effect on cash flow from operations in the future.
Management of the Partnership believes that successful control of facility and Partnership expenses and the established cash reserves from the sales of facilities should enable the Partnership to meet its obligations and upon the final sale of its assets, liquidate in an orderly fashion.
NOTE J SUBSEQUENT EVENT
Subsequent to December 31, 1996, the Partnership entered into a contract with an unaffiliated third party to sell all of the assets of one of its subsidiary partnerships. The contract calls for all cash consideration to be paid at the date of closing. The Partnership will distribute the proceeds of sale, should the sale be completed, as part of its final liquidation.
QUEST HEALTH CARE FUND VII, L.P. SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS For the Years Ended December 31, 1996, 1995 and 1994
ITEM 9

ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
The Partnership has had no disagreement with its accountants on accounting or financial issues during the past three years.
PART III
ITEM 10

ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The Partnership does not have officers or directors. Quest became the general partner of the Partnership on August 1, 1990. The general partner of Quest is Quest Rescue Partners - 7 Corp. The principal officers and directors of the general partner of Quest are as follows:
Effective as of September 30, 1996, Michael G. Hunter, president and a director of the general partner of the general partner of the Partnership, relinquished his stock and resigned his positions with such entity and is no longer involved in the management of the Partnership.
ITEM 11

ITEM 11 EXECUTIVE COMPENSATION
None of the executive officers of the general partner of Quest receive any direct remuneration from the Partnership. Quest is not compensated directly for its services as General Partner of the Partnership. See Item 13 for further discussion of compensation paid to affiliates of SIG and Quest.
ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
(A) Security ownership of certain beneficial owners.
No person or groups, as defined by Section 13(d)(3) of the Securities Exchange Act of 1934, known to the Partnership is the beneficial owner of more than 5% of the Units.
(B) Security ownership of management.
No officer or director of the corporate general partner of Quest possesses a right to acquire beneficial ownership of any Units.
Quest is entitled to distributions of cash from operations and from "other sources" (primarily from the sale or refinancing of Partnership properties, as set forth in Item 6, Note A.)
(C) Change in control.
There exists no arrangement known to the Partnership, the operation of which may at a subsequent date, result in a change in control of the Partnership.
ITEM 13

ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
(A) and (B) Affiliates of the General Partner in accordance with the terms of the Agreement may receive compensation for services rendered to the Partnership.
The independent management companies engaged by the Partnership receive a management fee of 5% of gross operating revenues. Quest Administrative Services, L.P., an affiliate of Quest, receives a fee of 1% of gross operating revenues for providing certain management services. These fees are proscribed in the Partnership Agreement and the structure permits a rapid and efficient method of termination of a facility manager, should the need ever arise. Total payments to QASLP under this agreement in 1996 were $67,057. Quest created an employee benefit trust in compliance with the guidelines promulgated by VEBA and ERISA. Approximately $135,120 was recorded under this arrangement in 1996. See Note B to the accompanying consolidated financial statements appearing in Item 8.
(C) No management persons are indebted to the Partnership.
(D) There have been no significant transactions with promoters.
ITEM 14

ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(A) The following documents are filed as a part of this report:
1. Consolidated Financial Statements:
Report of Independent Accountants
Consolidated Balance Sheets as of December 31, 1996 and 1995
Consolidated Statements of Operations for the Years Ended December 31, 1996, 1995 and 1994
Consolidated Statements of Partners' Equity for the Years Ended December 31, 1996, 1995 and 1994
Consolidated Statements of Cash Flows for the Years Ended December 31, 1996, 1995 and 1994
Notes to Consolidated Financial Statements
2. Financial Statement Schedules
Schedule II - Valuation and Qualifying Accounts for the Years Ended December 31, 1996, 1995 and 1994
Other schedules are omitted since they are not required, are not applicable or the financial information required is included in the consolidated financial statements or notes thereto.
3. Exhibits
The following exhibits are filed or incorporated by reference and are an integral part of this Form 10-K.
(B) Reports on Form 8-K: None during the fourth quarter of 1996.
(C) An annual report for the fiscal year 1996 will be sent to the Limited Partners subsequent to this filing and the Partnership will furnish copies of such report to the Securities and Exchange Commission at that time.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
QUEST HEALTH CARE FUND VII, L.P.
By: QUEST RESCUE PARTNERS - 7, L.P. General Partner
By: QUEST RESCUE PARTNERS - 7 CORP, General Partner
Date: March 31, 1997 By:/s/ Stuart C. Berry ------------------- -------------------------------- Stuart C. Berry President
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons, on behalf of the Registrant and in the capacities and on the dates indicated:
Date: March 31, 1997 /s/ Stuart C. Berry ------------------- -------------------------------- Stuart C. Berry CEO/CFO of the General Partner of the General Partner.