BASSETT FURNITURE INDUSTRIES INC - Quarter Report: 2005 August (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended August 27, 2005

OR

For the transition period from              to             

Commission File No. 0-209

BASSETT FURNITURE INDUSTRIES, INCORPORATED

(Exact name of Registrant as specified in its charter)

3525 Fairystone Park Highway

Bassett, Virginia 24055

(Address of principal executive offices)

(Zip Code)

(276) 629-6000

(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, and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  x    No  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12-b2 of the Exchange Act).    Yes  ¨    No  x

At August 27, 2005, 11,808,301 shares of common stock of the Registrant were outstanding.

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BASSETT FURNITURE INDUSTRIES, INCORPORATED AND SUBSIDIARIES

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PART I - FINANCIAL INFORMATION

BASSETT FURNITURE INDUSTRIES, INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND RETAINED EARNINGS

FOR THE PERIODS ENDED AUGUST 27, 2005 AND AUGUST 28, 2004 – UNAUDITED

(In thousands except per share data)

Item 1. Financial Statements

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

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PART I – FINANCIAL INFORMATION – CONTINUED

BASSETT FURNITURE INDUSTRIES, INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

AUGUST 27, 2005 AND NOVEMBER 27, 2004

(In thousands)

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

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PART I – FINANCIAL INFORMATION – CONTINUED

BASSETT FURNITURE INDUSTRIES, INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE PERIODS ENDED AUGUST 27, 2005 AND AUGUST 28, 2004 – UNAUDITED

(In thousands)

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

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BASSETT FURNITURE INDUSTRIES, INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS-UNAUDITED

AUGUST 27, 2005

(Dollars in thousands except share and per share data)

Note 1. Basis of Presentation:

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In our opinion, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.

The condensed consolidated financial statements include the accounts of Bassett Furniture Industries, Incorporated (“Bassett”, “we”, “our”, “the Company”) and our majority owned subsidiaries of which we have operating control. The equity method of accounting is used for our investments in affiliated companies in which we exercise significant influence but do not maintain control, unless consolidated pursuant to Financial Accounting Standards Board (“FASB”) Revised Interpretation No. 46 “Consolidation of Variable Interest Entities” (“FIN46R”).

Note 2. Interim Financial Presentation

All intercompany accounts and transactions have been eliminated in the consolidated financial statements. The results of operations for the three and nine months ended August 27, 2005 are not necessarily indicative of results for the fiscal year. It is suggested that the interim consolidated financial statements be read in conjunction with the consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K for the year ended November 27, 2004.

Certain amounts in the 2004 financial statements have been reclassified to more closely conform with the 2005 presentation.

Note 3. Stock-Based Compensation:

We have elected to continue to account for stock options granted to employees and directors under APB Opinion No. 25 and are required to provide pro forma disclosures of what net income and earnings per share would have been had we adopted the fair value method for recognition purposes under SFAS No. 123.

For the periods ended August 27, 2005 and August 28, 2004, the effect on earnings per share would be as follows:

The pro forma results reflect amortization of the fair value of stock options over the vesting period.

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BASSETT FURNITURE INDUSTRIES INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS-UNAUDITED

AUGUST 27, 2005

(Dollars in thousands except share and per share data)

Note 4. Inventories:

Inventories are valued at the lower of cost or market. Cost is determined for domestic furniture inventories using the last-in, first-out (LIFO) method. The costs for imported inventories are determined using the first-in, first-out (FIFO) method. Our 2005 inventories include the inventories consolidated through the acquisitions of our retail licensee stores in Dallas, Atlanta, and Upstate New York (Note 9). During the third quarter and first nine months of 2005, we liquidated certain LIFO inventories which decreased cost of sales by approximately $300 and $1,000, respectively. In 2004, we did not liquidate any LIFO inventories.

Note 5. Unconsolidated Affiliated Companies:

The International Home Furnishings Center (“IHFC”) owns and leases out floor space in a showroom facility in High Point, North Carolina. We owned 46.9% of IHFC at August 27, 2005 and August 28, 2004 and accounted for the investment using the equity method since we do not maintain operating control of IHFC. Our investment reflects a credit balance of $13,729 and $12,578 at August 27, 2005 and November 27, 2004, respectively, which is reflected in the liabilities section in the accompanying consolidated balance sheets as “distributions in excess of affiliate earnings.” We have concluded, based on the leases that tenants must sign with IHFC and based on historical earnings that IHFC will generate future earnings in excess of the amounts recorded in the accompanying balance sheets. Based on current and expected future earnings of IHFC, we believe the market value of this investment is positive and substantially greater than its negative book value of $13,729 at August 27, 2005. We recorded income from IHFC of $4,472 and $4,152 in the first nine months of 2005 and 2004, respectively. In the third quarter of 2005 we recorded income of $1,506 compared to $1,304 in the third quarter of 2004. Additionally, we received dividends of $5,623 in the first nine months of 2005 and 2004 and dividends of $3,280 and $2,343 from IHFC in the third quarter of 2005 and 2004, respectively. Summarized unaudited income statement information for IHFC for their first nine months of 2005 and 2004, respectively, is as follows:

Note 6. Real Estate Notes Payable:

We have mortgages on five real estate properties utilized by Bassett Furniture Direct (BFD) stores totaling $15,711. These notes payable mature over the next six to seven years and have interest rates ranging from 7.89% to 9.18%. The current portion of these notes, $450 at August 27, 2005, has been included as a current liability in accrued liabilities in the accompanying condensed consolidated balance sheet. These mortgages are collateralized by the respective properties with net book value of $19,098.

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BASSETT FURNITURE INDUSTRIES, INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS-UNAUDITED

AUGUST 27, 2005

(Dollars in thousands except share and per share data)

Note 7. Long-Term Debt:

We have a $40,000 revolving credit facility which is secured by substantially all of our receivables and inventories. Borrowings under the facility, which matures November 30, 2006, totaled $4,000 at August 27, 2005 and $0 at November 27, 2004. The interest rate on this facility was 5.03% at August 27, 2005, based on LIBOR plus 1.5%. Additionally, through our acquisition of retail licensee stores in Dallas, and Atlanta we assumed $2,414 of long-term debt, of which $96 has since been repaid (Note 9).

Note 8. Comprehensive Income:

For the quarters ended August 27, 2005 and August 28, 2004, total comprehensive income, net of tax, was $1,873 and $863, respectively. Included in total comprehensive income for each quarter was net income of $1,886 and $1,128, and unrealized holding losses, net of tax, of $13 and $265, respectively.

For the nine months ended August 27, 2005 and August 28, 2004, total comprehensive income, net of tax, was $5,265 and $5,198, respectively. Included in total comprehensive income for each nine month period was net income of $5,297 and $5,340, and unrealized holding losses, net of tax, of $32 and $142, respectively.

Note 9. Acquisition of Retail Licensee Stores:

On August 1, 2005, we acquired 100% ownership in our BFD licensee in Upstate, NY (“BFD-UNY”). On August 26, 2005, we acquired an additional 36% interest in our BFD licensee in Atlanta, Georgia (“BFD-Atlanta”) bringing our total ownership interest to 66%. We accounted for these transactions using the purchase method of accounting. As such, as of the end of our third quarter, we have consolidated BFD-UNY’s and BFD-Atlanta’s financial position into our condensed consolidated balance sheet. BFD-UNY operates two BFD stores in Rochester, NY and one store in Buffalo, NY. BFD-Atlanta operates four BFD stores in the greater Atlanta, Ga. metropolitan area.

The cash purchase price for these two transactions was $250. The net liabilities assumed is estimated to be $1,489, and includes $2,221 of inventories, net of inter-company profit elimination and other assets, net of recorded reserves. We are in the process of receiving third-party evaluations of certain identifiable intangible assets, valuing certain liabilities and performing other opening balance sheet procedures; thus the allocation of the purchase price is subject to refinement. In conjunction with these transactions, we recorded $1,739 of impaired asset charges related to the difference in the cash purchase price and the total fair market value of net liabilities assumed. The difference primarily relates to impairments of a portion of goodwill created through the transactions.

The following table summarizes the estimated fair market values of the assets acquired and liabilities assumed at date of acquisition which have been consolidated into our financial position.

As the BFD-UNY transaction was completed on August 1, 2005, our results of operations included BFD-UNY’s results of operations for the month of August. The BFD-Atlanta transaction was completed on August 26, 2005, so our results of operations do not include the results of operations of BFD-Atlanta. Beginning in the fourth quarter of 2005 our consolidated results of operations will include BFD-Atlanta’s results of operations.

During the second quarter of 2005, we acquired a 76% ownership interest in our Dallas, TX metropolitan area BFD store operation (“BFD-Dallas”). We accounted for this transaction using the purchase method of accounting. As such, as of the end of our second quarter, we have consolidated BFD-Dallas’ financial position into our condensed consolidated balance sheet. BFD-Dallas operates eight BFD stores in the greater Dallas, TX metropolitan area.

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BASSETT FURNITURE INDUSTRIES, INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS-UNAUDITED

AUGUST 27, 2005

(Dollars in thousands except share and per share data)

The purchase price was $3,300, which includes $800 of cash and $2,500 of notes receivable converted to equity. The net assets acquired (net of recorded reserves) was estimated to be $835 and included $3,553 of inventories, net of inter-company profit elimination. We are in the process of receiving third-party evaluations of certain identifiable intangible assets, valuing certain liabilities and performing other opening balance sheet procedures; thus the allocation of the purchase price is subject to refinement. In conjunction with this transaction, we recorded $2,465 of impaired asset charge for the difference in the purchase price and the fair market value of net assets acquired net of recorded reserves. The difference primarily relates to an impairment of a portion of goodwill created through the transaction. We have revised this disclosure from previous disclosures to better present this transaction.

The following table summarizes the estimated fair market values of the assets acquired and liabilities assumed at date of acquisition which have been consolidated into our financial position.

Our consolidated results of operations for the third quarter 2005 include the results of operations of BFD-Dallas.

The following unaudited pro forma financial information for 2005 and 2004 is presented to illustrate the estimated effect of the 2005 acquisitions of BFD-Dallas and BFD-Atlanta as if the transactions had occurred as of the beginning of each period presented below which includes an impairment charge in each period to consolidate these two entities. The pro forma results do not include the acquisition of BFD-UNY as complete and accurate financial information was not available for those periods. The pro forma information primarily includes sales net of elimination of inter-company sales, cost of sales and profit. The pro forma financial information is not necessarily indicative of the results of operations as they would have been had the transactions been effected on the assumed date nor is it necessarily indicative of future results.

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BASSETT FURNITURE INDUSTRIES, INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS-UNAUDITED

AUGUST 27, 2005

(Dollars in thousands except share and per share data)

Note 10. Contingencies:

We are involved in various legal and environmental matters, which arise in the normal course of business. Although the final outcome of these matters cannot be determined, based on the facts presently known, we believe that the final resolution of these matters will not have a material adverse effect on our financial position or future results of operations.

We lease land and buildings used in the operation of our Bassett-owned retail stores and in the operation of independent and partnership licensee BFD stores. We also lease showroom space from IHFC at the market rate. Lease terms range from three to 15 years and generally have renewal options of between five and 15 years. We had obligations of $86,524 and $47,171 at August 27, 2005 and November 27, 2004, respectively, for future minimum lease payments under non-cancelable operating leases having remaining terms in excess of one year. Obligations at August 27, 2005 include assumption of approximately $24,714 of BFD-Dallas’ and BFD-UNY’s lease obligations. Additionally, we entered into lease commitments on five new BFD stores opened in 2005.

As part of the expansion strategy for our BFD program, we have guaranteed certain lease obligations of licensee operators. Lease guarantees range from one to ten years. We were contingently liable under licensee lease obligation guarantees in the amount of $17,283 and $25,394 at August 27, 2005 and November 27, 2004, respectively. Currently, we have also guaranteed one real estate obligation for $737 and $804 and one warehouse lease obligation for $1,976 and $2,902, at August 27, 2005 and November 27, 2004, respectively.

We have also guaranteed loans to certain of our BFD licensees to finance initial inventory packages for those stores. The total contingent liabilities with respect to these loan guarantees as of August 27, 2005 and November 27, 2004 were $10,158 and $14,534, respectively.

In the event of default by an independent dealer under the guaranteed lease or loan, we believe that the risk of loss is mitigated through a combination of options that include, but are not limited to, arranging for a replacement dealer, liquidating the collateral, and pursuing payment under the personal guarantees of the independent dealer. The proceeds of the above options are expected to cover the estimated amount of our future payments under the guarantee obligations, net of recorded reserves. The fair value of lease guarantees (an estimate of the cost to the Company to perform on these guarantees) at August 27, 2005 and November 27, 2004 were $721 and $770, respectively, and are recorded in accrued liabilities in the accompanying balance sheets.

Note 11. Recent Accounting Pronouncements

SFAS No. 123 (Revised 2004), “Share-Based Payment”, issued in December 2004, is a revision of FASB Statement 123, “Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and its related implementation guidance. The Statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. SFAS No. 123 (Revised 2004) requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award (with limited exceptions). That cost will be recognized over the period during which an employee is required to provide service in exchange for the award. This statement is effective as of the beginning of the first annual reporting period that begins after June 15, 2005 and we will adopt the standard in the first quarter of fiscal 2006. Although we have not completed our assessment, we believe the impact on our consolidated financial position or results of operations will not be material given the small number of unvested stock options currently outstanding.

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BASSETT FURNITURE INDUSTRIES, INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS-UNAUDITED

AUGUST 27, 2005

(Dollars in thousands except share and per share data)

Note 12. Earnings per share:

The following reconciles basic and diluted earnings per share:

Common stock equivalent shares are excluded from the computations if their effect is anti-dilutive. The effect of stock options is not included in the diluted computation for periods in which losses occur because to do so would be anti-dilutive. Options to purchase 1.4 million and 1.6 million shares of common stock were outstanding during the first nine months of 2005 and 2004, respectively, which could potentially dilute basic EPS in the future. In 2005, approximately 748,000 of these stock options were excluded from the computation of diluted earnings per share due to their antidilutive effect.

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PART I-FINANCIAL INFORMATION-CONTINUED

BASSETT FURNITURE INDUSTRIES, INCORPORATED AND SUBSIDIARIES

AUGUST 27, 2005

(Dollars in thousands except share and per share data)

Note 13. Segment Information:

Our primary business is wholesale home furnishings. The wholesale home furnishings business is involved principally in the design, manufacture, sale and distribution of furniture products to a network of Bassett Furniture Direct stores (independently-owned stores, Bassett-owned retail stores, and partnership licensees) and independent furniture retailers and department stores.

Our wood segment is engaged in the manufacture and sourcing of casegoods products, primarily bedroom, dining room, home entertainment, occasional and juvenile furniture. Our upholstery segment is involved in the manufacture and sourcing of upholstered frames and cut upholstery items having a variety of frame and fabric options.

Our “other” business segment consists of a contemporary furniture business, real estate for non-Company-owned BFD stores and corporate selling, general and administrative expenses, which are included to reconcile segment information to the consolidated financial statements.

Our retail segment currently consists of 27 Bassett-owned stores in North Carolina, South Carolina, Texas, Georgia, and New York. This includes 8 stores operated by BFD-Dallas which were acquired on May 28, 2005 and whose results of operations began to be included in our third quarter results of operations. This also includes 3 stores operated by BFD-UNY which were acquired on August 1, 2005, and whose results of operations for the month of August are included in our results of operations and 4 stores operated by BFD-Atlanta which were acquired on August 27, 2005 and therefore, whose results of operations are not included in our results of operations but will begin to be included in our results of operations in our fourth quarter. During our third quarter, we sold our two stores in Las Vegas to an independent dealer for approximately net book value. The 2004 first nine months’ retail segment consisted of 12 stores in North Carolina, Nevada, and Texas. Our retail segment includes the revenues, expenses, retail real estate and capital expenditures directly utilized by these stores.

Inter-Company profit elimination includes both the elimination of sales and profit in inventory. Inventory profit elimination reflects the embedded wholesale profit in the Company-owned store inventory that has not been realized. These profits will be recorded when merchandise is shipped to the retail customer. Additionally, when we acquire retail licensee stores, the expense to eliminate the embedded wholesale profit in their inventory is included as part of the charge to consolidate these entities.

Operating income by business segment is defined as sales less direct operating costs and expenses. Identifiable assets are those assets used exclusively in the operations of each business segment. Identifiable assets for our wood, upholstery and retail segments consist primarily of inventories, retail real estate and property, plant and equipment.

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PART I-FINANCIAL INFORMATION-CONTINUED

BASSETT FURNITURE INDUSTRIES, INCORPORATED AND SUBSIDIARIES

AUGUST 27, 2005

(Dollars in thousands except share and per share data)

Segment information for the periods ended August 27, 2005 and August 28, 2004 was as follows:

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PART I-FINANCIAL INFORMATION-CONTINUED

BASSETT FURNITURE INDUSTRIES, INCORPORATED AND SUBSIDIARIES

AUGUST 27, 2005

(Dollars in thousands except share and per share data)

Note 14. Subsequent Event:

Subsequent to quarter end, the Company announced plans to cease operations at our wood manufacturing facility in Mt. Airy, N.C. and plans to move production of certain products from the Mt. Airy facility to our wood facility in Bassett, Va., with the remaining product being imported. At current product demand levels, we expect savings from reduced labor and fixed operating expenses of $4.0 to $5.0 million annually once this transition is complete. In connection with the closing of the Mt. Airy facility, we will record a fourth quarter pre-tax restructuring and impairment charge of approximately $2.0 to $3.0 million or $0.10 to $0.16 per share after tax, approximately half of which is asset impairment of primarily machinery and equipment and half is employee termination and benefit related costs.

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PART I-FINANCIAL INFORMATION-CONTINUED

BASSETT FURNITURE INDUSTRIES, INCORPORATED AND SUBSIDIARIES

AUGUST 27, 2005

(Dollars in thousands except share and per share data)

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

Bassett Furniture Industries, Incorporated, based in Bassett, Va., is a leading manufacturer, marketer and retailer of branded home furnishings. Bassett’s products, designed to provide quality, style and value, are sold through Bassett Furniture Direct ® stores (BFDs), At Home with Bassett ® galleries, and other furniture stores. Bassettbaby ® products, primarily cribs and casegoods, are sold through specialty stores and mass merchants.

The inception and growth of our Bassett Furniture Direct (BFD) store program, which began in 1997, entailed not only the creation of a new prototype store, but also includes an internal, cultural transformation aimed at refocusing Company practices and strategies to the ultimate end user, our consumer. The strategy also focused on restyling the Bassett lines and suites with accessories. Bassett Furniture Direct acts as both a furniture design center and a moderate price point leader - two characteristics that combined with custom product and quick delivery offer what the Company believes to be a unique selling proposition in the furniture industry.

The furniture industry continues to experience rapid change. The change has been precipitated by both the growth of imported furniture (which has included downward pressure on retail prices) and reductions in traditional channels of distribution. We embraced these changes through our BFD program and by reducing our domestic production of product that can be more efficiently sourced overseas. We strive to provide our customers with home furnishings at competitive prices and, with that goal in mind, will continue to evaluate the cost effectiveness of domestic production on a product by product basis. Approximately 33% of our year-to-date wholesale sales are of imported product compared to 27% in 2004. We define imported product as fully finished product sourced from overseas. Our domestic product includes certain products that contain components which are also sourced from overseas. We continue to believe that a blended strategy including domestically produced products primarily of a custom-order nature combined with sourcing of major collections provides the best value and quality of products to our customers. We expect that overall operating margins will be positively impacted through sourcing more products overseas as our mix of domestic versus imported product approaches a 50/50 mix over the next two years.

Our retail strategy is currently focused on continuing to improve the profitability, operations and customer experience at our 127 store BFD network. A major component of this strategy involves our growing group of Company owned stores. During 2005, we acquired a total of 15 BFD stores located in Dallas, Atlanta, and Upstate New York. We believe a strong, core Company owned retail division provides us the first-hand experience, immediate feedback and training program that is vitally important to the success of our entire BFD network. Although we do not have any more retail acquisitions planned for our fourth quarter of 2005, pursuit of this strategy will enable our retail division to acquire and operate additional BFD stores as viable opportunities arise to strengthen our retail division. Our corporate internal organizational and financial strength combined with our 27 Company owned stores provide the scale, best practices and resources needed to drive uniformity throughout our BFD program and drive the improvement needed in our recently acquired retail licensee stores.

Continual improvements to the retail program are being made through improved product, new advertising and better delivery, service and training. We expect licensees to open between 10 and 20 new stores per year over the next several years. While interest in our BFD program remains strong, we continue to be more selective in approving new licensees and remain focused on improving the profitability of our current licensee and Company owned stores.

An increasingly important component of our retail strategy and our balance sheet is real estate. We expect to continue to invest in high quality retail real estate as the BFD store program continues to expand, and may, on a selective basis, continue to provide various forms of assistance to procure retail real estate for licensees of BFD stores with a focus on lease/sub-lease arrangements or short-term lease guarantees.

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PART I-FINANCIAL INFORMATION-CONTINUED

BASSETT FURNITURE INDUSTRIES, INCORPORATED AND SUBSIDIARIES

AUGUST 27, 2005

(Dollars in thousands except share and per share data)

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued)

We intend to execute these strategies in such a way as to preserve our investments while simultaneously minimizing the need for borrowed funds. Maintenance of a strong balance sheet is a stated management goal and vital to our retail growth strategy. The BFD program entails key business risks, including the realization of receivables and the coverage of contingent liabilities. We have established decision criteria and business disciplines aimed at minimizing potential losses from these risks.

Two key components of our balance sheet are our investments in IHFC (Note 5) and the Bassett Industries Alternative Asset Fund (BIAAF), a limited partnership (See Item 3, Market Risk, for a discussion of BIAAF.)

In fiscal 2005, we have had two primary areas of focus: one, to work to improve the profitability of licensed BFD stores in part by refining and promoting more uniform business practices, and two, to improve the financial performance of our domestic wood operations.

Critical Accounting Policies

Our consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America which requires that certain estimates and assumptions be made that affect the amounts and disclosures reported in those financial statements and the related accompanying notes. Actual results could differ from these estimates and assumptions. We use our best judgment in valuing these estimates and may, as warranted, solicit external advice. Estimates are based on current facts and circumstances, prior experience and other assumptions believed to be reasonable. The following critical accounting policies, some of which are impacted significantly by judgments, assumptions and estimates, affect our consolidated financial statements.

Consolidation – The consolidated financial statements include the accounts of Bassett Furniture Industries, Incorporated and its majority-owned subsidiaries for whom we have operating control. We also consolidate variable interest entities for which we are the primary beneficiary.

Impairment of Long-Lived Assets - We periodically evaluate whether events or circumstances have occurred that indicate long-lived assets may not be recoverable or that the remaining useful life may warrant revision. When such events or circumstances are present, we assess the recoverability of long-lived assets by determining whether the carrying value will be recovered through the expected undiscounted future cash flows resulting from the use of the asset. In the event the sum of the expected undiscounted future cash flows is less than the carrying value of the asset, an impairment loss equal to the excess of the asset’s carrying value over its fair value is recorded.

Allowance for Accounts and Notes Receivable - The BFD program entails key business risks, including the realization of receivables. We have established decision criteria and business disciplines aimed at minimizing potential losses from this risk. We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. The allowance for doubtful accounts is based on a review of specifically identified accounts and notes receivable in addition to an overall aging analysis. Judgments are made with respect to the collectibility of accounts receivable based on historical experience and current economic trends. Because of varied historical experiences, differing economic conditions in various parts of the country and uncertainties with retail business conditions, additional allowances may be required.

Inventories - Inventories are stated at the lower of cost or market. Cost is determined for domestic furniture inventories using the last-in, first-out method. The cost of imported inventories is determined on a first-in, first-out basis. We estimate an inventory reserve for excess quantities and obsolete items based on specific identification and historical write-offs, taking into account future demand and market conditions. If actual demand or market conditions in the future are less favorable than those estimated, additional inventory write-downs may be required.

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PART I-FINANCIAL INFORMATION-CONTINUED

BASSETT FURNITURE INDUSTRIES, INCORPORATED AND SUBSIDIARIES

AUGUST 27, 2005

(Dollars in thousands except share and per share data)

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued)

Investments – Investments are marked-to-market and recorded at their fair value. Unrealized holding gains and losses, net of the related income tax effect, on available-for-sale securities are excluded from income and are reported as other comprehensive income in stockholders’ equity. Realized gains and losses are included in income and are determined using the specific identification method for ascertaining the cost of securities sold.

Retail Licensee Store Acquisitions – The Company accounts for the acquisition of retail licensee stores and related assets in accordance with SFAS No. 141, “Business Combinations”, which requires application of the purchase method for all business combinations. Accounting for these transactions as purchase business combinations requires the allocation of purchase price paid to the assets acquired and liabilities assumed based on their fair values as of the date of the acquisition. The amount paid in excess of the fair value of net assets acquired, net of reserves, is accounted for as goodwill. We evaluate goodwill and intangible assets at the time of acquisition and annually for potential impairment.

Revenue Recognition – Revenue is recognized when the risks and rewards of ownership and title to the product have transferred to the buyer. This occurs upon the shipment of goods to independent dealers and in the case of Bassett-owned retail stores, upon delivery to the customer. Our wholesale terms vary from 30 to 60 days. An estimate for returns and allowances has been provided in recorded sales.

Loss Reserves – We have a number of other potential loss exposures incurred in the ordinary course of business such as environmental claims, product liability, lease and loan guarantees, litigation, restructuring charges, and the recoverability of deferred income tax benefits. Establishing loss reserves for these matters requires estimates and judgments with regard to maximum risk exposure and ultimate liability or realization. As a result, these estimates and judgments are often developed with the assistance of appropriate advisors, and are based on current understanding of the underlying facts and circumstances. Because of uncertainties related to the ultimate outcome of these matters or the possibility of changes in the underlying facts and circumstances, additional charges related to these issues could be required in the future.

Results of Operations – Periods ended August 27, 2005 compared with the periods ended August 28, 2004

In the first nine months of 2005, we have acquired 15 BFD stores from licensees. This has and will continue to have a significant effect on our results of operations. Our consolidated net sales include revenue recognized at the retail level from our Company owned stores and revenue recognized at the wholesale level for sales to our non-company owned BFD stores and other customers. Retail operations typically carry higher gross margins and higher S,G&A expenses related to occupancy, advertising, delivery and commissions.

In the first nine months of 2005, we had net sales of $246,557 which was an increase of 4.7% from $235,508 of net sales reported in the first nine months of 2004. Sales for the third quarter of 2005 were $82,743 which was an increase of 5.3% from the $78,585 of net sales reported in the third quarter of 2004. The increase for the nine months and third quarter was primarily the result of growth in shipments into the BFD channel, higher retail sales by BFD-Carolinas (four company-owned stores in North and South Carolina) and the inclusion of BFD-Dallas for our third quarter. These increases were partially offset by the attrition in sales to traditional independent furniture stores. Overall business levels for the third quarter and September of 2005 have remained relatively stable. However, retail conditions may get tougher in our fourth quarter given concerns over rising energy prices and decreasing consumer confidence.

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PART I-FINANCIAL INFORMATION-CONTINUED

BASSETT FURNITURE INDUSTRIES, INCORPORATED AND SUBSIDIARIES

AUGUST 27, 2005

(Dollars in thousands except share and per share data)

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued)

We have continued our drive to open BFD stores. The BFD store network consisted of 127 BFD stores at August 27, 2005 and 107 BFD stores at August 28, 2004, which included licensees opening 16 additional stores in the first nine months of 2005 and closing five stores. The BFD stores accounted for 67% and 58% of our wholesale sales for the first nine months of 2005 and 2004, respectively.

We have continued to experience increased demand for Bassettbaby® brand products, especially with the three largest Bassettbaby® customers, Babies R Us, Burlington Coat Factory and Target. We have continued to develop new products in this category as an important means of introducing the Bassett brand to younger consumers.

Gross margin; selling, general and administrative (S,G&A) expenses; and operating income as a percentage of net sales were as follows for the periods ended August 27, 2005, and August 28, 2004: