H&R BLOCK INC - Quarter Report: 2008 July (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

FORM 10-Q

 

 

 

Commission file number 1-6089

 

 

H&R Block, Inc.

(Exact name of registrant as specified in its charter)

 

 

One H&R Block Way

Kansas City, Missouri 64105

(Address of principal executive offices, including zip code)

 

(816) 854-3000

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

 

Yes   Ö    No        

 

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

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

Yes          No   Ö  

 

The number of shares outstanding of the registrant’s Common Stock, without par value, at the close of business on July 31, 2008 was 328,088,753 shares.

 

 

Form 10-Q for the Period Ended July 31, 2008

 

 

Table of Contents

 

 

 

 

See Notes to Condensed Consolidated Financial Statements

 

 

 

The condensed consolidated balance sheet as of July 31, 2008, the condensed consolidated statements of operations and comprehensive income (loss) for the three months ended July 31, 2008 and 2007, the condensed consolidated statements of cash flows for the three months ended July 31, 2008 and 2007, and the condensed consolidated statement of stockholders’ equity for the three months ended July 31, 2008 and 2007 have been prepared by the Company, without audit. In the opinion of management, all adjustments, which include only normal recurring adjustments, necessary to present fairly the financial position, results of operations, cash flows and changes in stockholders’ equity at July 31, 2008 and for all periods presented have been made. The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.

“H&R Block,” “the Company,” “we,” “our” and “us” are used interchangeably to refer to H&R Block, Inc. or to H&R Block, Inc. and its subsidiaries, as appropriate to the context.

Certain reclassifications have been made to prior year amounts to conform to the current year presentation. These reclassifications had no effect on our results of operations or stockholders’ equity as previously reported.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted. These condensed consolidated financial statements should be read in conjunction with the financial statements and notes thereto included in our April 30, 2008 Annual Report to Shareholders on Form 10-K. All amounts presented herein as of April 30, 2008 or for the year then ended, are derived from our April 30, 2008 Annual Report to Shareholders on Form 10-K.

Operating revenues of the Tax Services and Business Services segments are seasonal in nature with peak revenues occurring in the months of January through April. Therefore, results for interim periods are not indicative of results to be expected for the full year.

 

Basic and diluted loss per share is computed using the weighted average shares outstanding during each period. The dilutive effect of potential common shares is included in diluted earnings per share except in those periods with a loss from continuing operations. Diluted earnings per share excludes the impact of shares of common stock issuable upon the lapse of certain restrictions or the exercise of options to purchase 25.7 million shares and 31.3 million shares for the three months ended July 31, 2008 and 2007, respectively, as the effect would be antidilutive due to the net loss from continuing operations during each period.

The weighted average shares outstanding for the three months ended July 31, 2008 increased to 327.1 million from 323.9 million at July 31, 2007, primarily due the issuance of treasury shares related to our stock-based compensation plans.

During the three months ended July 31, 2008 and 2007, we issued 2.3 million and 1.6 million shares of common stock, respectively, due to the exercise of stock options, employee stock purchases and awards of nonvested shares.

During the three months ended July 31, 2008, we acquired 0.2 million shares of our common stock, which represent shares swapped or surrendered to us in connection with the vesting of nonvested shares and the exercise of stock options, at an aggregate cost of $4.1 million. During the three months ended July 31, 2007, we acquired 0.2 million shares of our common stock, which represent shares swapped or surrendered to us in connection with the vesting of nonvested shares and the exercise of stock options, at an aggregate cost of $5.4 million.

During the three months ended July 31, 2008, we granted 4.1 million stock options and 0.9 million nonvested shares and units in accordance with our stock-based compensation plans. The weighted average fair value of options granted was $3.70 for manager options and $2.83 for options granted to our

seasonal associates. At July 31, 2008, the total unrecognized compensation cost for options and nonvested shares and units was $19.0 million and $34.1 million, respectively.

 

Changes in the carrying amount of goodwill for the three months ended July 31, 2008 consist of the following:

(in 000s)

		April 30, 2008				Additions				Other				July 31, 2008
Tax Services		$	431,981			$	2,350			$	(915	)		$	433,416
Business Services			399,333				-				(496	)			398,837
Consumer Financial Services			173,954				-				-				173,954
Total		$	1,005,268			$	2,350			$	(1,411	)		$	1,006,207

We test goodwill for impairment annually at the beginning of our fourth quarter, or more frequently if events occur indicating it is more likely than not the fair value of a reporting unit’s net assets has been reduced below its carrying value. No impairments of goodwill were identified within any of our operating segments during the three months ended July 31, 2008.

Intangible assets consist of the following:

(in 000s)
		July 31, 2008												April 30, 2008
		Gross												Gross
		Carrying				Accumulated								Carrying				Accumulated
		Amount				Amortization				Net				Amount				Amortization				Net
Tax Services:
Customer relationships		$	46,465			$	(23,315	)		$	23,150			$	46,479			$	(22,007	)		$	24,472
Noncompete agreements			22,966				(20,329	)			2,637				22,966				(19,981	)			2,985
Purchased technology			12,500				(2,773	)			9,727				12,500				(2,283	)			10,217
Trade name			1,025				(142	)			883				1,025				(117	)			908
Business Services:
Customer relationships			144,031				(103,143	)			40,888				143,402				(100,346	)			43,056
Noncompete agreements			32,442				(18,193	)			14,249				32,303				(17,589	)			14,714
Trade name – amortizing			3,290				(3,060	)			230				3,290				(3,043	)			247
Trade name – non-amortizing			55,637				(4,868	)			50,769				55,637				(4,868	)			50,769
Consumer Financial Services:
Customer relationships			-				-				-				293,000				(293,000	)			-
		$	318,356			$	(175,823	)		$	142,533			$	610,602			$	(463,234	)		$	147,368

Amortization of intangible assets for the three months ended July 31, 2008 and 2007 was $5.6 million and $15.5 million, respectively. Estimated amortization of intangible assets for fiscal years 2009 through 2013 is $22.8 million, $20.2 million, $18.4 million, $15.7 million and $11.7 million, respectively.

 

We file a consolidated federal income tax return in the United States and file tax returns in various state and foreign jurisdictions. The consolidated tax returns for the years 1999 – 2005 are currently under examination by the Internal Revenue Service (IRS). Tax years prior to 1999 are closed by statute. Historically, tax returns in various foreign and state jurisdictions are examined and settled upon completion of the exam.

During the three months ended July 31, 2008, we accrued an additional $2.9 million of interest & penalties related to our uncertain tax positions. We had unrecognized tax benefits of $137.2 million and $137.6 million at July 31, 2008 and April 30, 2008, respectively. There were no significant changes in our unrealized tax positions during the quarter. We have classified the liability for unrecognized tax benefits, including corresponding accrued interest, as long-term at July 31, 2008, which is included in other noncurrent liabilities on the condensed consolidated balance sheet. Amounts that we expect to pay, or for which statutes expire, within the next twelve months have been included in accounts payable, accrued expenses and other current liabilities on the condensed consolidated balance sheet.

Based upon the expiration of statutes of limitations, payments of tax and other factors in several jurisdictions, we believe it is reasonably possible that the total amount of previously unrecognized tax benefits may decrease by approximately $9 to $10 million within twelve months of July 31, 2008.

 

The following table shows the components of interest income and expense of our continuing operations. Operating interest expense is included in cost of other revenues, and interest expense on acquisition debt is included in other income, net on our consolidated statements of operations.

(in 000s)

Three Months Ended July 31,		2008				2007
Interest income:
Mortgage loans, net		$	13,265			$	22,491
Margin receivables			5,025				7,437
Other			6,948				11,910
			25,238				41,838
Operating interest expense:
Borrowings			18,430				12,360
Deposits			4,043				14,243
Federal Home Loan Bank (FHLB) advances			1,328				1,890
			23,801				28,493
Interest expense – acquisition debt			413				595
Net interest income		$	1,024			$	12,750

 

On May 1, 2008, we adopted Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosure requirements for fair value measurements. We elected to defer the application of SFAS 157 for nonfinancial assets and nonfinancial liabilities until fiscal year 2010, as provided for by FASB Staff Position FAS 157-2, “Effective Date of FASB Statement No. 157” (FSP 157-2). The adoption of SFAS 157 did not have an impact on our consolidated results of operations or financial position.

 

Fair Value Hierarchy

SFAS 157 establishes a fair value hierarchy that prioritizes the inputs used to measure fair value into three broad levels, considering the relative reliability of the inputs, as follows:

 

Estimation of Fair Value

The following is a description of the valuation methodologies used for assets and liabilities measured at fair value and the general classification of these instruments pursuant to the fair value hierarchy.

 

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The following table presents for each hierarchy level the assets that are measured at fair value on a recurring basis at July 31, 2008:

(dollars in 000s)

		Total				Level 1				Level 2				Level 3
Trading securities		$	11,664			$	1,542			$	10,122			$	-
Available-for-sale securities			52,438				4,994				47,444				-
Mortgage loans held for sale			8,804				-				8,804				-
Residual interests in securitizations			8,466				-				-				8,466
		$	81,372			$	6,536			$	66,370			$	8,466
As a percentage of total assets			1.7%				0.1%				1.4%				0.2%

The following table presents changes in Level 3 assets measured at fair value on a recurring basis for the three months ended July 31, 2008:

(in 000s)
Fair value, beginning of period		$	16,678
Losses:
Included in earnings			(4,953	)
Included in other comprehensive income (loss)			(2,320	)
Cash received			(939	)
Fair value, end of period		$	8,466

Trading securities and mortgage loans held for sale are included in prepaid expenses and other current assets, and available-for-sale securities and residual interests in securitizations are included in other assets on our condensed consolidated balance sheets.

 

Fair Value Option

We adopted Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (SFAS 159) on May 1, 2008. SFAS 159 permits an instrument by instrument irrevocable election to account for selected financial assets and financial liabilities at fair value. We did not elect to apply the fair value option to any eligible financial assets or financial liabilities on May 1, 2008 or during the three months ended July 31, 2008. Subsequent to the initial adoption, we may elect to account for selected financial assets and financial liabilities at fair value. Such an election could be made at the time an eligible financial asset, financial liability or firm commitment is recognized or when certain specified reconsideration events occur.

 

 

Registered Broker-Dealer

H&R Block Financial Advisors, Inc. (HRBFA) is subject to regulatory requirements intended to ensure the general financial soundness and liquidity of broker-dealers. At July 31, 2008, HRBFA’s net capital of $60.4 million, which was 14.4% of aggregate debit items, exceeded its minimum required net capital of $8.4 million by $52.0 million.

HRBFA had pledged customer-owned securities with a fair value of $48.5 million at July 31, 2008 with a clearing organization to satisfy margin deposit requirements of $40.4 million.

 

Banking

H&R Block Bank (HRB Bank) and the Company are subject to various regulatory capital guidelines and requirements administered by federal banking agencies. Failure to meet minimum capital requirements can trigger certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on HRB Bank and our consolidated financial statements. All savings associations are subject to the capital adequacy guidelines and the regulatory framework for prompt corrective action. HRB Bank must meet specific capital guidelines that involve quantitative measures of HRB Bank’s assets, liabilities and certain off-balance sheet items, as calculated under regulatory accounting practices. HRB Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. HRB Bank files its regulatory Thrift Financial Report (TFR) on a calendar quarter basis.

Quantitative measures established by regulation to ensure capital adequacy require HRB Bank to maintain minimum amounts and ratios of tangible equity, total risk-based capital and Tier 1 capital, as set forth in the table below. In addition to these minimum ratio requirements, HRB Bank is required to continually maintain a 12.0% minimum leverage ratio as a condition of its charter-approval order through fiscal year 2009. This condition was extended through fiscal year 2012 as a result of a Supervisory Directive issued on May 29, 2007. As of July 31, 2008, HRB Bank’s leverage ratio was 12.3%.

As of June 30, 2008, our most recent TFR filing with the Office of Thrift Supervision (OTS), HRB Bank was a “well capitalized” institution under the prompt corrective action provisions of the Federal Deposit Insurance Corporation (FDIC). The five capital categories are: (1) “well capitalized” (total risk-based capital ratio of 10%, Tier 1 Risk-based capital ratio of 6% and leverage ratio of 5%); (2) “adequately capitalized” (3) “undercapitalized” (4) “significantly undercapitalized” and (5) “critically undercapitalized.” There are no conditions or events since June 30, 2008 that management believes have changed HRB Bank’s category.

The following table sets forth HRB Bank’s regulatory capital requirements at June 30, 2008, as calculated in the most recently filed TFR:

 

 

Changes in the deferred revenue liability related to our Peace of Mind (POM) program, the current portion of which is included in accounts payable, accrued expenses and other current liabilities and the long-term portion of which is included in other noncurrent liabilities in the condensed consolidated balance sheets, are as follows:

 

(in 000s)
Three Months Ended July 31,		2008				2007
Balance, beginning of period		$	140,583			$	142,173
Amounts deferred for new guarantees issued			513				470
Revenue recognized on previous deferrals			(27,241	)			(27,237	)
Balance, end of period		$	113,855			$	115,406

The following table summarizes certain of our other contractual obligations and commitments:

 

(in 000s)
As of		July 31, 2008				April 30, 2008
Commitment to fund Franchise Equity Lines of Credit		$	78,915			$	79,134
Contingent business acquisition obligations			24,214				24,288
Media advertising purchase obligation			19,043				19,043

We routinely enter into contracts that include embedded indemnifications that have characteristics similar to guarantees. Other guarantees and indemnifications of the Company and its subsidiaries include obligations to protect counterparties from losses arising from the following: (1) tax, legal and other risks related to the purchase or disposition of businesses; (2) penalties and interest assessed by federal and state taxing authorities in connection with tax returns prepared for clients; (3) indemnification of our directors and officers; and (4) third-party claims relating to various arrangements in the normal course of business. Typically, there is no stated maximum payment related to these indemnifications, and the terms of the indemnities may vary and in many cases is limited only by the applicable statute of limitations. The likelihood of any claims being asserted against us and the ultimate liability related to any such claims, if any, is difficult to predict. While we cannot provide assurance we will ultimately prevail in the event any such claims are asserted, we believe the fair value of these guarantees and indemnifications is not material as of July 31, 2008.

 

Mortgage Loan Repurchase Liability

Sand Canyon Corporation (SCC), formerly Option One Mortgage Corporation, maintains recourse with respect to loans previously sold or securitized under indemnification of loss provisions relating to breach of representations and warranties made to purchasers or insurers. As a result, SCC may be required to repurchase loans or otherwise indemnify third-parties for losses. These representations and warranties and corresponding repurchase obligations generally are not subject to stated limits or a stated term and, therefore, may continue for the foreseeable future. SCC has established a liability related to potential losses under these indemnifications and monitors the adequacy of the repurchase liability on an ongoing basis. To the extent that future claim volumes differ from current estimates, or the value of mortgage loans and residential home prices change, future losses may be different than these estimates and those differences may be significant. The following table summarizes SCC’s loan repurchase activity:

 

(in 000s)
		Three Months Ended								Year Ended
		July 31, 2008				July 31, 2007				April 30, 2008
Loan repurchase liability at end of period		$	238,123			$	72,199			$	243,066
Loans repurchased and indemnification payments during the period			6,913				193,640				515,370
Repurchase reserves added during the period			-				157,296				582,373

 

We are party to investigations, legal claims and lawsuits arising out of our business operations. We accrue our best estimate of the probable loss upon resolution of investigations, legal claims and lawsuits, which totaled $10.5 million and $11.5 million at July 31, 2008 and April 30, 2008, respectively. With respect to most of the matters described below, we have concluded that a loss is not probable and therefore no liability has been recorded.

 

RAL Litigation

We have been named as a defendant in numerous lawsuits throughout the country regarding our refund anticipation loan programs (collectively, “RAL Cases”). The RAL Cases have involved a variety of legal theories asserted by plaintiffs. These theories include allegations that, among other things: disclosures in the RAL applications were inadequate, misleading and untimely; the RAL interest rates were usurious and unconscionable; we did not disclose that we would receive part of the finance charges paid by the

customer for such loans; untrue, misleading or deceptive statements in marketing RALs; breach of state laws on credit service organizations; breach of contract, unjust enrichment, unfair and deceptive acts or practices; violations of the federal Racketeer Influenced and Corrupt Organizations Act; violations of the federal Fair Debt Collection Practices Act and unfair competition regarding debt collection activities; and that we owe, and breached, a fiduciary duty to our customers in connection with the RAL program.

The amounts claimed in the RAL Cases have been very substantial in some instances, with one settlement resulting in a pretax expense of $43.5 million in fiscal year 2003 (the “Texas RAL Settlement”) and other settlements resulting in a combined pretax expense in fiscal year 2006 of $70.2 million.

We believe we have meritorious defenses to the remaining RAL Cases and we intend to defend them vigorously. There can be no assurances, however, as to the outcome of the pending RAL Cases individually or in the aggregate or regarding the impact of the RAL Cases on our financial statements. We are unable to determine an estimate of the possible loss or range of loss, if any, in light of the early stages of the currently pending RAL Cases. There were no significant developments regarding the RAL Cases during the three months ended July 31, 2008.

 

Peace of Mind Litigation

We are defendants in lawsuits regarding our Peace of Mind program (collectively, the “POM Cases”). The POM Cases are described below.

Lorie J. Marshall, et al. v. H&R Block Tax Services, Inc., et al., Case No. 08-CV-591 in the U.S. District Court for the Southern District of Illinois, is a class action case originally filed in the Circuit Court of Madison County, Illinois on January 18, 2002, in which class certification was granted on August 27, 2003. Plaintiffs’ claims consist of five counts relating to the POM program under which the applicable tax return preparation subsidiary assumes liability for additional tax assessments attributable to tax return preparation error. The plaintiffs allege that the sale of POM guarantees constitutes (1) statutory fraud by selling insurance without a license, (2) an unfair trade practice, by omission and by “cramming” (i.e., charging customers for the guarantee even though they did not request it or want it), and (3) a breach of fiduciary duty. In August 2003, the court certified the plaintiff classes consisting of all persons who from January 1, 1997 to final judgment (1) were charged a separate fee for POM by “H&R Block” or a defendant H&R Block class member; (2) reside in certain class states and were charged a separate fee for POM by “H&R Block” or a defendant H&R Block class member not licensed to sell insurance; and (3) had an unsolicited charge for POM posted to their bills by “H&R Block” or a defendant H&R Block class member. Persons who received the POM guarantee through an H&R Block Premium office and persons who reside in Alabama and Texas were excluded from the plaintiff class. The court also certified a defendant class consisting of any entity with names that include “H&R Block” or “HRB,” or are otherwise affiliated or associated with H&R Block Tax Services, Inc., and that sold or sells the POM product. On August 5, 2008, the court decertified the defendant class and reduced the geographical scope of the plaintiff classes from 48 states to 13 states. On August 19, 2008, we removed the case from state court in Madison County, Illinois to the U.S. District Court for the Southern District of Illinois. No trial date has been set.

There is one other putative class action pending against us in Texas that involves the POM guarantee. This case is pending before the same judge that presided over the Texas RAL Settlement, involves the same plaintiffs’ attorneys that are involved in the Marshall litigation in Illinois, and contains similar allegations. No class has been certified in this case.

We believe the claims in the POM Cases are without merit, and we intend to defend them vigorously. The amounts claimed in the POM Cases are substantial, however, and there can be no assurances as to the outcome of these pending actions individually or in the aggregate. We are unable to determine an estimate of the possible loss or range of loss, if any, in light of the early stages of the POM Cases.

 

Electronic Filing Litigation

We are a defendant in a class action filed on August 30, 2002 and entitled Erin M. McNulty and Brian J. Erzar v. H&R Block, Inc., et al., Case No. 02-CIV-4654 in the Court of Common Pleas of Lackawanna County, Pennsylvania, in which the plaintiffs allege that the defendants deceptively portray electronic filing fees as a necessary and required component of standard tax preparation services and do not inform tax preparation clients that they may (1) file tax returns free of charge by mailing the returns, (2) electronically file tax returns from personal computers either free of charge or at significantly lower

fees and (3) be eligible to electronically file tax returns free of charge via telephone. The plaintiffs seek unspecified damages and disgorgement of all electronic filing, tax preparation and related fees collected during the applicable class period. Class certification was granted in this case on September 5, 2007. In March 2008, we reached a tentative agreement to settle this case for an amount not to exceed $2.5 million and have accrued $1.5 million, representing our best estimate of ultimate loss. The settlement was preliminarily approved on June 27, 2008, with a final fairness hearing scheduled for September 2008.

 

Express IRA Litigation

On March 15, 2006, the New York Attorney General filed a lawsuit in the Supreme Court of the State of New York, County of New York (Index No. 06/401110) entitled The People of New York v. H&R Block, Inc. and H&R Block Financial Advisors, Inc. et al. The complaint alleged fraudulent business practices, deceptive acts and practices, common law fraud and breach of fiduciary duty with respect to the Express IRA product and sought equitable relief, disgorgement of profits, damages and restitution, civil penalties and punitive damages. On July 12, 2007, the Supreme Court of the State of New York issued a ruling that dismissed all defendants other than HRBFA and the claims of common law fraud. Both the New York Attorney General and HRBFA have appealed the adverse portions of the trial court’s ruling. We believe the claims in this case are without merit, and we intend to defend this case vigorously, but there are no assurances as to its outcome.

On January 2, 2008, the Mississippi Attorney General filed a lawsuit in the Chancery Court of Hinds County, Mississippi First Judicial District (Case No. G 2008 6 S 2) entitled Jim Hood, Attorney for the State of Mississippi v. H&R Block, Inc., et al. The complaint alleged fraudulent business practices, deceptive acts and practices, common law fraud and breach of fiduciary duty with respect to the Express IRA product and sought equitable relief, disgorgement of profits, damages and restitution, civil penalties and punitive damages. The defendants have filed a motion to dismiss. We believe the claims in this case are without merit, and we intend to defend this case vigorously, but there are no assurances as to its outcome.

In addition to the New York and Mississippi Attorney General actions, a number of civil actions were filed against us concerning the Express IRA product, the first of which was filed on March 17, 2006. Except for two cases pending in state court, all of the civil actions have been consolidated by the panel for Multi-District Litigation into a single action styled In re H&R Block, Inc. Express IRA Marketing Litigation in the United States District Court for the Western District of Missouri. We believe the claims in these cases are without merit, and we intend to defend these cases vigorously, but there are no assurances as to their outcome.

We are unable to determine an estimate of the possible loss or range of loss, if any, in light of the early stages of the Express IRA litigation.

 

Securities Litigation

On April 6, 2007, a putative class action styled In re H&R Block Securities Litigation was filed against the Company and certain of its officers in the United States District Court for the Western District of Missouri. The complaint alleged, among other things, deceptive, material and misleading financial statements, failure to prepare financial statements in accordance with generally accepted accounting principles and concealment of the potential for lawsuits stemming from the allegedly fraudulent nature of the Company’s operations. The complaint sought unspecified damages and equitable relief. On October 5, 2007, the court dismissed the complaint and granted the plaintiffs leave to re-file the portion of the complaint pertaining to the Company’s financial statements. On November 19, 2007, the plaintiffs re-filed the complaint, alleging, among other things, deceptive, material and misleading financial statements and failure to prepare financial statements in accordance with generally accepted accounting principles. The court dismissed the re-filed complaint on February 19, 2008. On March 11, 2008, the plaintiffs appealed the dismissal. In addition, plaintiffs in a shareholder derivative action that was consolidated into the securities litigation filed a separate appeal on March 18, 2008, contending that the derivative action was improperly consolidated. The derivative action is Iron Workers Local 16 Pension Fund v. H&R Block, et al., in the United States District Court for the Western District of Missouri, Case No. 06-cv-00466-ODS (instituted on June 8, 2006) and was brought against certain of our directors and officers purportedly on behalf of the Company. The derivative action alleges breach of fiduciary duty, abuse of control, gross mismanagement, waste, and unjust enrichment pertaining to (1) our restatement of financial results in

fiscal year 2006 due to errors in determining our state effective income tax rate and (2) certain of our products and business activities. We believe the claims in these cases are without merit and intend to defend this litigation vigorously. We currently do not believe that we will incur a material loss with respect to this litigation.

 

RSM McGladrey Litigation

RSM EquiCo, Inc., a subsidiary of RSM McGladrey, Inc. (RSM), is a party to a putative class action filed on July 11, 2006 and entitled Do Right’s Plant Growers, et al. v. RSM EquiCo, Inc., et al. Case No. 06 CC00137, in the California Superior Court, Orange County. The complaint contains allegations regarding business valuation services provided by RSM EquiCo, Inc., including fraud, negligent misrepresentation, breach of contract, breach of implied covenant of good faith and fair dealing, breach of fiduciary duty and unfair competition and seeks unspecified damages, restitution and equitable relief. We intend to defend this case vigorously. The amount claimed in this action is substantial and there can be no assurance regarding the outcome and resolution of this matter. It is reasonably possible that we could incur losses with respect to this litigation, although an estimate of such losses cannot be made in light of the early stage of the litigation.

RSM has a relationship with certain public accounting firms (collectively, “the Attest Firms”) pursuant to which (1) some RSM employees are also partners or employees of the Attest Firms, (2) many clients of the Attest Firms are also RSM clients, and (3) our RSM McGladrey brand is closely linked to the Attest Firms. The Attest Firms are parties to claims and lawsuits (collectively, “Attest Firm Claims”). Judgments or settlements arising from Attest Firm Claims, which exceed the Attest Firms’ insurance coverage, could have a direct adverse effect on Attest Firm operations, and could impair RSM’s ability to attract and retain clients and quality professionals. Accordingly, although RSM is not a direct party to significant Attest Firm Claims, such Attest Firm Claims could have a material adverse effect on RSM’s operations and impair the value of our investment in RSM. There is no assurance regarding the outcome of the Attest Firm Claims.

 

Litigation and Claims Pertaining to Discontinued Mortgage Operations

Although mortgage loan origination activities were terminated and the loan servicing business was sold during fiscal year 2008, SCC remains subject to investigations, claims and lawsuits pertaining to its loan origination and servicing activities that occurred prior to such termination and sale. These investigations, claims and lawsuits include actions by state attorneys general, other state regulators, municipalities, individual plaintiffs, and cases in which plaintiffs seek to represent a class of others alleged to be similarly situated. Among other things, these investigations, claims and lawsuits allege discriminatory or unfair and deceptive loan origination and servicing practices, public nuisance, fraud, and violations of the Truth in Lending Act, Equal Credit Opportunity Act and the Fair Housing Act. In the current non-prime mortgage environment, the number of these investigations, claims and lawsuits has increased over historical experience and is likely to continue at increased levels. The amounts claimed in these investigations, claims and lawsuits are substantial in some instances, and the ultimate resulting liability is difficult to predict. In the event of unfavorable outcomes, the amounts SCC may be required to pay in the discharge of liabilities or settlements could be substantial and, because SCC’s operating results are included in our consolidated financial statements, could have a material adverse impact on our consolidated results of operations.

On June 3, 2008, the Massachusetts Attorney General filed a lawsuit in the Superior Court of Suffolk County, Massachusetts (Case No. 08-2474-BLS) entitled Commonwealth of Massachusetts v. H&R Block, Inc., et al., alleging unfair, deceptive and discriminatory origination and servicing of mortgage loans and seeks equitable relief, disgorgement of profits, restitution and statutory penalties. We believe the claims in this case are without merit, and we intend to defend this case vigorously, but there are no assurances as to its outcome. We are unable to determine an estimate of the possible loss or range of loss, if any, in light of the early stages of this litigation.

SCC also remains subject to potential claims for indemnification and loan repurchases pertaining to loans previously sold. In the current non-prime mortgage environment, it is likely that the frequency of repurchase and indemnification claims may increase over historical experience and give rise to additional litigation. In some instances, H&R Block, Inc. was required to guarantee SCC’s obligations. The amounts involved in these potential claims may be substantial, and the ultimate resulting liability is difficult to

predict. In the event of unfavorable outcomes, the amounts SCC may be required to pay in the discharge or settlement of these claims could be substantial and, because SCC’s operating results are included in our consolidated financial statements, could have a material adverse impact on our consolidated results of operations.

 

Other Claims and Litigation

We have from time to time been party to investigations, claims and lawsuits not discussed herein arising out of our business operations. These investigations, claims and lawsuits include actions by state attorneys general, other state regulators, individual plaintiffs, and cases in which plaintiffs seek to represent a class of others similarly situated. Some of these investigations, claims and lawsuits pertain to RALs, the electronic filing of customers’ income tax returns, the POM guarantee program, wage and hour claims and investment products. We believe we have meritorious defenses to each of these claims, and we are defending or intend to defend them vigorously. The amounts claimed in these claims and lawsuits are substantial in some instances, however the ultimate liability with respect to such litigation and claims is difficult to predict. In the event of an unfavorable outcome, the amounts we may be required to pay in the discharge of liabilities or settlements could be material.

In addition to the aforementioned types of cases, we are parties to claims and lawsuits that we consider to be ordinary, routine litigation incidental to our business, including claims and lawsuits (collectively, “Other Claims”) concerning investment products, the preparation of customers’ income tax returns, the fees charged customers for various products and services, losses incurred by customers with respect to their investment accounts, relationships with franchisees, intellectual property disputes, employment matters and contract disputes. While we cannot provide assurance that we will ultimately prevail in each instance, we believe the amount, if any, we are required to pay in the discharge of liabilities or settlements in these Other Claims will not have a material adverse effect on our consolidated operating results or financial position.

 

Information concerning our operations by reportable operating segment is as follows:

 

(in 000s)
Three Months Ended July 31,		2008				2007
Revenues:
Tax Services		$	75,265			$	69,863
Business Services			174,651				192,823
Consumer Financial Services			86,679				114,372
Corporate			3,043				4,151
		$	339,638			$	381,209
Pretax income (loss):
Tax Services		$	(163,923	)		$	(172,289	)
Business Services			(295	)			(1,906	)
Consumer Financial Services			(17,736	)			6,206
Corporate			(32,662	)			(15,591	)
Loss from continuing operations before tax benefit		$	(214,616	)		$	(183,580	)

 

In June 2008, FASB Staff Position on EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions are Participating Securities” (FSP 03-6-1) was issued. FSP 03-6-1 addresses whether instruments granted in share-based payment transactions are participating securities prior to vesting and, therefore, should be included in the process of allocating earnings for purposes of computing earnings per share. This guidance is effective for financial statements issued for fiscal years and interim periods beginning after December 15, 2008. Early application is not permitted. We are currently evaluating what effect FSP 03-6-1 will have on our consolidated financial statements.

In December 2007, Statement of Financial Accounting Standards No. 141(R), “Business Combinations,” (SFAS 141R), and Statement of Financial Accounting Standards No. 160, “Non-Controlling Interests in Consolidated Financial Statements – An Amendment of ARB No. 51” (SFAS 160) were issued. These standards will require an acquiring entity to recognize all the assets acquired and liabilities assumed in a transaction, including non-controlling interests, at the acquisition-date fair value with limited exceptions. The provisions of these standards are effective as of the beginning of our fiscal year 2010. We are currently evaluating what effect the adoption of SFAS 141R and SFAS 160 will have on our consolidated financial statements.

As discussed in note 6, we adopted SFAS 157 and SFAS 159 as of May 1, 2008.

 

During fiscal year 2008, we exited the mortgage business operated through a subsidiary and sold the related loan servicing business. Our discontinued operations reflect the wind-down of our mortgage origination business and, as a result, our discontinued operations reported a net loss of $3.4 million for the three months ended July 31, 2008 compared to $192.8 million in the prior year.

The financial results of discontinued operations are as follows:

(in 000s)
Three Months Ended July 31,		2008				2007
Net revenue		$	1,137			$	(123,390	)
Loss from operations before income tax benefit			(3,957	)			(312,168	)
Impairment related to the disposition of businesses			-				(23,229	)
Pretax loss			(3,957	)			(335,397	)
Income tax benefit			(607	)			(142,640	)
Net loss from discontinued operations		$	(3,350	)		$	(192,757	)

 

Restructuring Charge

During fiscal year 2006, our mortgage business initiated a restructuring plan to reduce costs. Restructuring activities continued into the current year, including our previously announced closure of all mortgage origination activities and sale of servicing operations. We did not incur any charges during the three months ended July 31, 2008, compared to $16.1 million in the prior year. Changes in our restructuring charge liability during the three months ended July 31, 2008 are as follows:

(in 000s)
		Accrual Balance as of				Cash				Other				Accrual Balance as of
		April 30, 2008				Payments				Adjustments				July 31, 2008
Employee severance costs		$	4,807			$	(2,453	)		$	1,219			$	3,573
Contract termination costs			23,113				(3,931	)			157				19,339
		$	27,920			$	(6,384	)		$	1,376			$	22,912

 

The remaining liability related to this restructuring charge is included in accounts payable, accrued expenses and other current liabilities and accrued salaries, wages and payroll taxes on our consolidated balance sheet and primarily relates to lease obligations for vacant space resulting from branch office closings and employee severance costs, respectively.

Contract termination costs include estimates regarding the length of time required to sublease vacant space and expected recovery rates. Actual results could vary from these estimates.

 

On August 12, 2008, we announced the signing of a definitive agreement to sell HRBFA to Ameriprise Financial, Inc. The transaction is subject to customary regulatory approvals, and is expected to close in three to six months. The purchase price is $315 million in cash, subject to working capital and advisor retention adjustments at closing. The transaction is not expected to result in a material gain or loss for financial reporting purposes. The transaction involves the sale of all outstanding common stock of HRB

Financial Corporation, HRBFA’s direct parent, and is expected to result in a capital loss for income tax purposes. We currently do not expect to be able to realize a benefit for this capital loss.

This business will be presented as held-for-sale and as discontinued operations beginning with our quarter ending October 31, 2008. Major classes of assets and liabilities of HRB Financial Corporation as of July 31, 2008 are as follows:

 

(in 000s)
Cash and cash equivalents		$	110,535
Cash and cash equivalents – restricted			219,000
Accounts receivable from customers, brokers and dealers			401,859
Prepaid expenses and other assets			73,699
Goodwill			173,954
Total assets		$	979,047
Accounts payable to customers, brokers and dealers		$	592,688
Accounts payable, accrued expenses and deposits			38,486
Other liabilities			52,268
Total liabilities		$	683,422

 

Had HRBFA been reported as discontinued operations as of July 31, 2008, revenues of $67.7 million and $87.2 million for the three months ended July 31, 2008 and 2007, respectively, and a pretax loss of $1.8 million and pretax income of $3.9 million, respectively, would have been included in discontinued operations on our consolidated statements of operations. Overhead costs of a continuing nature which would have previously been allocated to HRBFA totaled $1.8 million and $2.5 million for the three months ended July 31, 2008 and 2007, respectively, and will be included in continuing operations.

 

On September 3, 2008 we announced the signing of a definitive agreement to acquire our last major independent franchise operator for approximately $278 million. This franchise includes a network of over 600 tax offices, nearly two-thirds of which will convert to company-owned offices upon the closing of the transaction. The remaining offices are currently operated by sub-franchisees and, as a result, will become our direct franchises. The transaction is expected to close by the end of our second fiscal quarter.

 

Block Financial LLC (BFC) is an indirect, wholly-owned consolidated subsidiary of the Company. BFC is the Issuer and the Company is the Guarantor of the $500.0 million credit facility entered into in April 2007, the Senior Notes issued on January 11, 2008 and October 26, 2004, our unsecured committed lines of credit (CLOCs) and other indebtedness issued from time to time. These condensed consolidating financial statements have been prepared using the equity method of accounting. Earnings of subsidiaries are, therefore, reflected in the Company’s investment in subsidiaries account. The elimination entries eliminate investments in subsidiaries, related stockholders’ equity and other intercompany balances and transactions.

 

Condensed Consolidating Income Statements																		(in 000s)
Three Months Ended		H&R Block, Inc.				BFC				Other								Consolidated
July 31, 2008		(Guarantor)				(Issuer)				Subsidiaries				Elims				H&R Block
Total revenues		$	-			$	88,504			$	252,572			$	(1,438	)		$	339,638
Cost of services			-				52,033				317,569				4				369,606
Cost of other revenues			-				39,620				3,203				-				42,823
Selling, general and administrative			-				37,829				104,083				(1,442	)			140,470
Total expenses			-				129,482				424,855				(1,438	)			552,899
Operating loss			-				(40,978	)			(172,283	)			-				(213,261	)
Other income, net			(214,616	)			(4,350	)			2,995				214,616				(1,355	)
Loss from continuing operations before tax benefit			(214,616	)			(45,328	)			(169,288	)			214,616				(214,616	)
Income tax benefit			(85,247	)			(17,712	)			(67,535	)			85,247				(85,247	)
Net loss from continuing operations			(129,369	)			(27,616	)			(101,753	)			129,369				(129,369	)
Net loss from discontinued operations			(3,350	)			(3,350	)			-				3,350				(3,350	)
Net loss		$	(132,719	)		$	(30,966	)		$	(101,753	)		$	132,719			$	(132,719	)

 

Three Months Ended		H&R Block, Inc.				BFC				Other								Consolidated
July 31, 2007		(Guarantor)				(Issuer)				Subsidiaries				Elims				H&R Block
Total revenues		$	-			$	189,100			$	194,355			$	(2,246	)		$	381,209
Cost of services			-				63,529				321,553				33				385,115
Cost of other revenues			-				37,637				5,892				-				43,529
Selling, general and administrative			-				45,469				100,535				(1,895	)			144,109
Total expenses			-				146,635				427,980				(1,862	)			572,753
Operating income (loss)			-				42,465				(233,625	)			(384	)			(191,544	)
Other income, net			(183,580	)			(5	)			7,969				183,580				7,964
Income (loss) from continuing operations before tax (benefit)			(183,580	)			42,460				(225,656	)			183,196				(183,580	)
Income tax (benefit)			(73,757	)			14,622				(88,225	)			73,603				(73,757	)
Net income (loss) from continuing operations			(109,823	)			27,838				(137,431	)			109,593				(109,823	)
Net loss from discontinued operations			(192,757	)			(190,143	)			(2,923	)			193,066				(192,757	)
Net loss		$	(302,580	)		$	(162,305	)		$	(140,354	)		$	302,659			$	(302,580	)

 

Condensed Consolidating Balance Sheets																		(in 000s)
		H&R Block, Inc.				BFC				Other								Consolidated
July 31, 2008		(Guarantor)				(Issuer)				Subsidiaries				Elims				H&R Block
Cash & cash equivalents		$	-			$	148,374			$	208,102			$	(478	)		$	355,998
Cash & cash equivalents – restricted			-				220,516				822				-				221,338
Receivables from customers, brokers and dealers, net			-				401,859				-				-				401,859
Receivables, net			3,346				116,914				262,964				-				383,224
Mortgage loans held for investment			-				868,603				-				-				868,603
Intangible assets and goodwill, net			-				173,954				974,786				-				1,148,740
Investments in subsidiaries			3,987,649				-				352				(3,987,649	)			352
Other assets			-				568,663				954,694				11				1,523,368
Total assets		$	3,990,995			$	2,498,883			$	2,401,720			$	(3,988,116	)		$	4,903,482
Accts. payable to customers, brokers and dealers		$	-			$	592,688			$	-			$	-			$	592,688
Customer deposits			-				777,558				-				(478	)			777,080
Long-term debt			-				1,101,975				40,981				-				1,142,956
Other liabilities			2				501,563				1,052,419				52				1,554,036
Net intercompany advances			3,154,271				(683,051	)			(2,471,179	)			(41	)			-
Stockholders’ equity			836,722				208,150				3,779,499				(3,987,649	)			836,722
Total liabilities and stockholders’ equity		$	3,990,995			$	2,498,883			$	2,401,720			$	(3,988,116	)		$	4,903,482