H&R BLOCK INC - Quarter Report: 2010 January (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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). 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 February 28, 2010 was 329,233,821 shares.

 

 

Form 10-Q for the Period Ended January 31, 2010

 

 

Table of Contents

 

 

 

 

CONDENSED CONSOLIDATED BALANCE SHEETS (amounts in 000s, except share and per share amounts)

 

 

See Notes to Condensed Consolidated Financial Statements

 

 

 

 

 

See Notes to Condensed Consolidated Financial Statements

 

 

 

Basis of Presentation

The condensed consolidated balance sheet as of January 31, 2010, the condensed consolidated statements of operations and comprehensive income (loss) for the three and nine months ended January 31, 2010 and 2009, and the condensed consolidated statements of cash flows for the nine months ended January 31, 2010 and 2009 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 and cash flows at January 31, 2010 and for all periods presented have been made.

The accompanying condensed consolidated financial statements include the accounts of the Company and our wholly-owned subsidiaries. Intercompany transactions and balances have been eliminated.

“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. In addition, we realigned our segments as discussed in note 14, and accordingly restated segment disclosures for prior periods. These changes 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, 2009 Annual Report to Shareholders on Form 10-K. All amounts presented herein as of April 30, 2009 or for the year then ended, are derived from our April 30, 2009 Annual Report to Shareholders on Form 10-K.

 

Management Estimates

The preparation of financial statements in conformity with 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. Significant estimates, assumptions and judgments are applied in the determination of our allowance for loan losses, potential losses from loan repurchase and indemnity obligations associated with our discontinued mortgage business, contingent losses associated with pending litigation, fair value of reporting units, reserves for uncertain tax positions and related matters. We revise our estimates when facts and circumstances dictate. However, future events and their effects cannot be determined with absolute certainty. As such, actual results could differ materially from those estimates.

 

Seasonality of Business

Our operating revenues 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.

 

Concentrations of Risk

Our mortgage loans held for investment include concentrations of loans to borrowers in certain states, which may result in increased exposure to loss as a result of changes in real estate values and underlying economic or market conditions related to a particular geographical location. Approximately 51.6% of our mortgage loan portfolio consists of loans to borrowers located in the states of Florida, California and New York.

 

 

McGladrey & Pullen LLP (M&P) is a limited liability partnership, owned 100% by certified public accountants (CPAs), which provides attest services to middle market clients.

Under state accountancy regulations, a firm cannot provide attest services unless it is majority owned and controlled by licensed CPAs. As such, RSM McGladrey, Inc. (RSM) is unable to provide attest services. Since 1999, RSM and M&P have operated in what is known as an “alternative practice structure” (APS). Through the APS, RSM and M&P are able to offer clients a full-range of attest and non-attest services in full compliance with applicable accountancy regulations.

An administrative services agreement between RSM and M&P obligates RSM to provide M&P with administrative services, information technology, office space, non-professional staff, and other infrastructure in exchange for market rate fees from M&P. RSM also provides M&P, at market rates of interest, a working capital credit facility and additional term financing to make acquisitions. Borrowings under the working capital credit facility are limited to the lower of the value of their accounts receivable, work-in-process and fixed assets or $125 million.

On July 21, 2009, M&P provided 210 days notice of its intent to terminate the administrative services agreement, resulting in termination of the APS unless revoked or modified prior to the expiration of the notice period. As a protective measure, on September 15, 2009, RSM also provided notice of its intent to terminate the administrative services agreement. Effective February 3, 2010, RSM and M&P entered into new agreements, withdrawing their prior notices of termination.

Pursuant to a Governance and Operations Agreement effective February 3, 2010, RSM and M&P agreed to be bound by a final award of an arbitration panel, dated as of November 24, 2009, regarding the applicability and enforceability of certain restrictive covenants between the parties. In the event the APS were ever terminated, M&P would generally be prohibited as a result of these restrictive covenants, from (1) engaging in businesses in which RSM operates in for 17 months, (2) soliciting any business with clients or potential clients of RSM or any of its subsidiaries or affiliates for 29 months, and (3) soliciting employees of RSM or any of its subsidiaries or affiliates for 24 months.

Although not required by the Governance and Operations Agreement, all partners of M&P, with the exception of M&P’s Managing Partner, are also managing directors employed by RSM. Approximately 86% of RSM’s managing directors are also partners in M&P. Certain other professional employees are also employed by both M&P and RSM. M&P partners receive distributions from M&P in their capacity as partners, as well as compensation from RSM in their capacity as managing directors. Distributions to M&P partners are based on the profitability of M&P and are not capped by this arrangement. Pursuant to the Governance and Operations Agreement, effective May 1, 2010, the aggregate compensation payable to RSM managing directors by RSM in any given year shall generally equal 67 percent of the combined profits of M&P and RSM less any amounts paid in their capacity as M&P partners. RSM followed a similar practice historically, except that the compensation pool for managing directors was based on 65 percent of combined profits. In practice, this means that variability in the amounts paid to RSM managing directors under these contracts can cause variability in RSM’s operating results. RSM is not entitled to any profits or residual interests of M&P, nor is it obligated to fund losses or capital deficiencies of M&P. Managing directors of RSM have historically participated in stock-based compensation plans of H&R Block. Beginning in fiscal 2011, participation in those plans will cease and be replaced by a non-qualified retirement plan.

The administrative services agreement, financing arrangements, and compensation arrangements described above all represent variable interests of RSM in M&P. Our determination of primary beneficiary of M&P was based on an assessment of which party was most closely associated with M&P. We have concluded that RSM is not the primary beneficiary of M&P and, therefore, the financial results of M&P have not been included in the accompanying condensed consolidated financial statements. RSM does not have an equity interest in M&P, nor does it have the power to direct any activities of M&P. The carrying

 

amounts included in our condensed consolidated balance sheet, and our exposure to economic loss, resulting from our interests in the various agreements with M&P is as follows at January 31, 2010:

 

(in 000s)
		Carrying Amount				Maximum Exposure to Loss
Revolving credit facility		$	60,560			$	125,000
Term loans			27,856				27,856
Compensation arrangements			N/A					(1)
Administrative Services Agreement			N/A				81,500	(2)

 

Basic and diluted earnings (loss) per share is computed using the two-class method. See note 15 for additional information on our adoption of the two-class method. The two-class method is an earnings allocation formula that determines net income per share for each class of common stock and participating security according to dividends declared and participation rights in undistributed earnings. Per share amounts are computed by dividing net income from continuing operations attributable to common shareholders by 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 9.6 million shares and 16.0 million shares for the three months ended January 31, 2010 and 2009, respectively, as the effect would be antidilutive. 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 16.8 million shares and 20.2 million shares for the nine months ended January 31, 2010 and 2009, respectively, as the effect would be antidilutive due to the net loss from continuing operations during each period.

The computations of basic and diluted loss per share from continuing operations are as follows:

 

(in 000s, except per share amounts)
		Three Months Ended January 31,								Nine Months Ended January 31,
		2010				2009				2010				2009
Net income (loss) from continuing operations attributable to shareholders		$	53,603			$	66,830			$	(203,486	)		$	(194,754	)
Amounts allocated to participating securities (nonvested shares)			(203	)			(219	)			(530	)			(613	)
Net income (loss) from continuing operations attributable to common shareholders		$	53,400			$	66,611			$	(204,016	)		$	(195,367	)
Basic weighted average common shares			332,999				337,338				334,293				331,429
Potential dilutive shares			1,298				1,349				-				-
Dilutive weighted average common shares			334,297				338,687				334,293				331,429
Earnings (loss) per share from continuing operations attributable to common shareholders:
Basic		$	0.16			$	0.20			$	(0.61	)		$	(0.59	)
Diluted			0.16				0.20				(0.61	)			(0.59	)

The weighted average shares outstanding for the three and nine months ended January 31, 2010 totaled 333.0 million and 334.3 million, respectively, compared to 337.3 million and 331.4 million for the three and nine months ended January 31, 2009, respectively.

During the three months ended January 31, 2010, we purchased and immediately retired 6.8 million shares of our common stock at a cost of $150.0 million. We may continue to repurchase and retire common

 

stock or retire shares held in treasury in the future. The cost of shares retired during the period was allocated to the components of stockholders’ equity as follows:

 

(in 000s)
Common stock		$	68
Additional paid-in capital			4,095
Retained earnings			145,839
		$	150,002

During the nine months ended January 31, 2010 and 2009, we issued 2.2 million and 5.7 million shares of common stock, respectively, due to the exercise of stock options, employee stock purchases and vesting of nonvested shares.

During the nine months ended January 31, 2010, we acquired 0.2 million shares of our common stock at an aggregate cost of $4.2 million, and during the nine months ended January 31, 2009, we acquired 0.4 million shares at an aggregate cost of $7.4 million. Shares acquired during these periods represented shares swapped or surrendered to us in connection with the vesting of nonvested shares and the exercise of stock options.

During the nine months ended January 31, 2010, we granted 4.6 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 $3.27 for management options and $2.70 for options granted to our seasonal associates. Stock-based compensation expense totaled $7.2 million and $19.3 million for the three and nine months ended January 31, 2010, respectively, and $7.0 million and $20.0 million for the three and nine months ended January 31, 2009, respectively. At January 31, 2010, unrecognized compensation cost for options totaled $14.0 million, and for nonvested shares and units totaled $19.8 million.

 

Receivables consist of the following:

 

(in 000s)
As of		January 31, 2010				January 31, 2009				April 30, 2009
Participation in tax client loans		$	1,109,795			$	1,122,347			$	29,616
Emerald Advance lines of credit			667,859				688,663				64,029
Business Services receivables			324,085				335,893				322,636
Receivables for tax preparation and related fees			286,732				309,379				50,400
Royalties from franchisees			82,943				80,603				8,741
Loans to franchisees			70,706				66,317				48,831
Other			111,563				125,076				117,102
			2,653,683				2,728,278				641,355
Allowance for doubtful accounts			(86,853	)			(85,327	)			(128,541	)
		$	2,566,830			$	2,642,951			$	512,814

 

The composition of our mortgage loan portfolio as of January 31, 2010 and April 30, 2009 is as follows:

 

														(dollars in 000s)
As of		January 31, 2010								April 30, 2009
		Amount				% of Total				Amount				% of Total
Adjustable-rate loans		$	449,758				61	%		$	534,943				65	%
Fixed-rate loans			283,040				39	%			286,894				35	%
			732,798				100	%			821,837				100	%
Unamortized deferred fees and costs			5,628								7,135
Less: Allowance for loan losses			(97,269	)							(84,073	)
		$	641,157							$	744,899

 

Activity in the allowance for loan losses for the nine months ended January 31, 2010 and 2009 is as follows:

(in 000s)

Nine Months Ended January 31,		2010				2009
Balance, beginning of the period		$	84,073			$	45,401
Provision			36,050				51,953
Recoveries			38				50
Charge-offs			(22,892	)			(21,789	)
Balance, end of the period		$	97,269			$	75,615

Our loan loss reserve as a percent of mortgage loans was 13.27% at January 31, 2010, compared to 10.23% at April 30, 2009.

In cases where we modify a loan and in so doing grant a concession to a borrower experiencing financial difficulty, the modification is considered a troubled debt restructuring (TDR). TDR loans totaled $153.4 million and $160.7 million at January 31, 2010 and April 30, 2009, respectively. The principal balance of impaired loans and real estate owned as of January 31, 2010 and April 30, 2009 is as follows:

(in 000s)

As of		January 31, 2010				April 30, 2009
Impaired loans:
30 – 59 days		$	894			$	-
60 – 89 days			12,210				21,415
90+ days, non-accrual			162,391				121,685
TDR loans, accrual			103,894				60,044
TDR loans, non-accrual			49,538				100,697
			328,927				303,841
Real estate owned(1)			31,511				44,533
Total non-performing assets		$	360,438			$	348,374

Activity related to our real estate owned is as follows:

(in 000s)

Nine Months Ended January 31,		2010				2009
Balance, beginning of the period		$	44,533			$	350
Additions			12,689				62,774
Sales			(17,528	)			(5,506	)
Impairments			(8,183	)			(5,699	)
Balance, end of the period		$	31,511			$	51,919

 

 

Changes in the carrying amount of goodwill for the nine months ended January 31, 2010 consist of the following:

(in 000s)
		Tax Services				Business Services				Total
Balance at April 30, 2009:
Goodwill		$	449,779			$	402,639			$	852,418
Accumulated impairment losses			(2,188	)			-				(2,188	)
			447,591				402,639				850,230
Changes:
Acquisitions			9,378				-				9,378
Other			(530	)			(1,024	)			(1,554	)
Impairments			-				(15,000	)			(15,000	)
Balance at January 31, 2010:
Goodwill			458,627				401,615				860,242
Accumulated impairment losses			(2,188	)			(15,000	)			(17,188	)
		$	456,439			$	386,615			$	843,054

We test goodwill for impairment annually at the beginning of our fourth quarter, or more frequently if events occur which could, more likely than not, reduce the fair value of a reporting unit’s net assets below its carrying value.

RSM EquiCo, Inc. (RSM EquiCo) is a separate reporting unit within our Business Services segment with goodwill totaling approximately $29 million. RSM EquiCo assists clients with capital markets transactions and has experienced declining revenues and profitability in the current economic environment. Accordingly, we evaluated RSM EquiCo’s goodwill for impairment at January 31, 2010. The measurement of impairment of goodwill consists of two steps. In the first step, we compared the fair value of RSM EquiCo, determined using discounted cash flows, to its carrying value. As the results of the first test indicated that the fair value of RSM EquiCo was less than its carrying value, we then performed the second step, which was to determine the implied fair value of RSM EquiCo’s goodwill, and to compare that to its carrying value. The second step included hypothetically valuing all of the tangible and intangible assets of RSM EquiCo. As a result, we recorded an impairment of the reporting unit’s goodwill of $15.0 million during the three months ended January 31, 2010, leaving a remaining goodwill balance of approximately $14 million. The impairment is included in selling, general and administrative expenses on the condensed consolidated statements of operations.

Intangible assets consist of the following:

																						(in 000s)
As of		January 31, 2010												April 30, 2009
		Gross												Gross
		Carrying				Accumulated								Carrying				Accumulated
		Amount				Amortization				Net				Amount				Amortization				Net
Tax Services:
Customer relationships		$	65,544			$	(31,199	)		$	34,345			$	54,655			$	(25,267	)		$	29,388
Noncompete agreements			22,875				(21,073	)			1,802				23,263				(20,941	)			2,322
Reacquired franchise rights			223,773				(5,021	)			218,752				229,438				(1,838	)			227,600
Franchise agreements			19,201				(1,493	)			17,708				19,201				(533	)			18,668
Purchased technology			14,500				(5,708	)			8,792				12,500				(4,240	)			8,260
Trade name			1,325				(350	)			975				1,025				(217	)			808
Business Services:
Customer relationships			145,177				(117,890	)			27,287				146,040				(111,017	)			35,023
Noncompete agreements			33,117				(21,596	)			11,521				33,068				(19,908	)			13,160
Trade name – amortizing			2,600				(2,600	)			-				2,600				(2,600	)			-
Trade name – non-amortizing			55,637				(4,868	)			50,769				55,637				(4,868	)			50,769
		$	583,749			$	(211,798	)		$	371,951			$	577,427			$	(191,429	)		$	385,998

Amortization of intangible assets for the three and nine months ended January 31, 2010 was $7.1 million and $21.4 million, respectively, and $6.8 million and $20.4 million, for the three and nine months ended

 

January 31, 2009, respectively. Estimated amortization of intangible assets for fiscal years 2010 through 2014 is $30.1 million, $27.9 million, $24.9 million, $20.5 million and $17.1 million, respectively.

 

Borrowings consist of the following:

 

(in 000s)
As of		January 31, 2010				January 31, 2009				April 30, 2009
Short-term borrowings:
Commercial paper		$	792,594			$	-			$	-
HSBC credit facility			882,500				690,485				-
		$	1,675,094			$	690,485			$	-
Long-term borrowings:
CLOC borrowings, due August 2010		$	-			$	970,813			$	-
Senior Notes, 7.875%, due January 2013			599,633				599,507				599,539
Senior Notes, 5.125%, due October 2014			398,882				398,648				398,706
Other			36,861				42,709				42,659
			1,035,376				2,011,677				1,040,904
Less: Current portion			(2,576	)			(9,030	)			(8,782	)
		$	1,032,800			$	2,002,647			$	1,032,122

At January 31, 2010, we maintained $1.95 billion in revolving credit facilities to support commercial paper issuances and general corporate purposes. These unsecured committed lines of credit (CLOCs) have a maturity date of August 2010 and carry an annual facility fee, based on our credit ratings, between six and fifteen basis points. We had no outstanding balance under the CLOCs as of January 31, 2010. The CLOCs require, among other things, that we maintain a minimum net worth of $650.0 million on the last day of any fiscal quarter. At January 31, 2010, we had net worth of $936.5 million.

Effective January 12, 2010, we entered into a $2.5 billion committed line of credit agreement with HSBC Bank USA, National Association (HSBC) for the purchase of RAL participations. This line is available up to its facility limit through March 30, 2010 and then only up to $120.0 million thereafter through June 30, 2010. The line is subject to covenants similar to those in the CLOC, but secured by the RAL participation interests. At January 31, 2010, there was $882.5 million outstanding under this facility.

On March 4, 2010, we entered into a new CLOC agreement to support commercial paper issuances, general corporate purposes, or for working capital needs. This facility replaced the CLOCs discussed above. The new facility provides funding up to $1.7 billion and matures July 31, 2013. The new facility bears interest at an annual rate of LIBOR plus 1.30% to 2.80% or PRIME plus .30% to 1.80% (depending on the type of borrowing) and includes an annual facility fee of .20% to .70% of the committed amounts, based on our credit ratings. Covenants in the new facility are substantially similar to those in the previous CLOCs including: (1) maintenance of a minimum net worth of $650.0 million on the last day of any fiscal quarter; and (2) reduction of the aggregate outstanding principal amount of short-term debt, as defined in the agreement, to $200.0 million or less for thirty consecutive days during the period March 1 to June 30 of each year (“Clean-down requirement”).

H&R Block Bank (HRB Bank) is a member of the Federal Home Loan Bank (FHLB) of Des Moines, which extends credit to member banks based on eligible collateral. At January 31, 2010, HRB Bank had total FHLB advance capacity of $252.0 million. There was $100.0 million outstanding on this facility, leaving remaining availability of $152.0 million. Mortgage loans held for investment of $487.7 million serve as eligible collateral and are used to determine total capacity.

 

We file a consolidated federal income tax return in the United States and file tax returns in various state and foreign jurisdictions. Consolidated tax returns for the years 1999 through 2007 are currently under examination by the Internal Revenue Service. 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 nine months ended January 31, 2010, we accrued additional gross interest and penalties of $5.6 million related to our uncertain tax positions. We had gross unrecognized tax benefits of

 

$124.8 million and $124.6 million at January 31, 2010 and April 30, 2009, respectively. The gross unrecognized tax benefits increased $0.2 million in the current year, due primarily to interest accrual on positions related to prior years. Except as noted below, we have classified the liability for unrecognized tax benefits, including corresponding accrued interest, as long-term at January 31, 2010, which is included in other noncurrent liabilities on the condensed consolidated balance sheets.

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 gross amount of reserves for previously unrecognized tax benefits may decrease by approximately $18.2 million within twelve months of January 31, 2010. This portion of our liability for unrecognized tax benefits has been classified as current and is included in accounts payable, accrued expenses and other current liabilities on the condensed consolidated balance sheets.

 

The following table shows the components of operating interest income and expense of our continuing operations:

 

(in 000s)
		Three Months Ended January 31,								Nine Months Ended January 31,
		2010				2009				2010				2009
Interest income:
Mortgage loans		$	7,567			$	11,131			$	23,535			$	36,494
Emerald Advance lines of credit			36,867				43,311				39,944				44,539
Other			3,912				4,162				9,267				12,465
		$	48,346			$	58,604			$	72,746			$	93,498
Interest expense:
Borrowings		$	19,617			$	21,623			$	57,088			$	60,849
Deposits			3,340				3,719				7,673				11,646
FHLB advances			509				1,326				1,526				3,981
		$	23,466			$	26,668			$	66,287			$	76,476

 

The following table presents for each hierarchy level the financial assets that are measured at fair value on both a recurring and non-recurring basis at January 31, 2010:

 

		(dollars in 000s)
		Total				Level 1				Level 2				Level 3
Recurring:
Available-for-sale securities		$	40,956			$	-			$	40,956			$	-
Non-recurring:
Impaired mortgage loans held for investment			244,757				-				-				244,757
		$	285,713			$	-			$	40,956			$	244,757
As a percentage of total assets			3.9%				-%				0.6%				3.3%

There were no significant changes to the unobservable inputs used in determining the fair values of our level 2 and level 3 financial assets.

The carrying amounts and estimated fair values of our financial instruments at January 31, 2010 are as follows:

 

(in 000s)

		Carrying				Estimated
		Amount				Fair Value
Mortgage loans held for investment		$	641,157			$	473,633
IRAs and other time deposits			747,831				747,148
Long-term debt			1,035,376				1,144,323

 

 

HRB Bank files its regulatory Thrift Financial Report (TFR) on a calendar quarter basis with the Office of Thrift Supervision (OTS). The following table sets forth HRB Bank’s regulatory capital requirements at December 31, 2009, as calculated in the most recently filed TFR:

 

(dollars in 000s)
																		To Be Well
																		Capitalized
										For Capital Adequacy								Under Prompt Corrective
		Actual								Purposes								Action Provisions
		Amount				Ratio				Amount				Ratio				Amount				Ratio
Total risk-based capital ratio(1)		$	374,952				33.7%			$	89,032				8.0%			$	111,290				10.0%
Tier 1 risk-based capital ratio(2)		$	360,715				32.4%				N/A				N/A			$	66,774				6.0%
Tier 1 capital ratio (leverage)(3)		$	360,715				16.4%			$	264,722				12.0%			$	110,301				5.0%
Tangible equity ratio(4)		$	360,715				16.4%			$	33,090				1.5%				N/A				N/A

Block Financial LLC (BFC) typically makes capital contributions to HRB Bank to help it meet its capital requirements. BFC made capital contributions to HRB Bank of $235.0 million during the nine months ended January 31, 2010, and $245.0 million during the fiscal year ended April 30, 2009.

As of January 31, 2010, HRB Bank’s leverage ratio was 13.7%.

 

Changes in deferred revenue balances 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)
Nine Months Ended January 31,		2010				2009
Balance, beginning of period		$	146,807			$	140,583
Amounts deferred for new guarantees issued			21,139				23,480
Revenue recognized on previous deferrals			(58,122)				(56,375)
Balance, end of period		$	109,824			$	107,688

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

 

						(in 000s)
As of		January 31, 2010				April 30, 2009
Franchise Equity Lines of Credit – undrawn commitment		$	20,629			$	38,055
Contingent business acquisition obligations			25,990				24,165
Media advertising purchase obligation			39,865				45,768

We routinely enter into contracts that include embedded indemnifications that have characteristics similar to guarantees. 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 are 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 guarantees and indemnifications relating to our continuing operations is not material as of January 31, 2010.

 

Discontinued Operations

Sand Canyon Corporation (SCC) 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.

At January 31, 2010 and April 30, 2009, our loan repurchase reserve totaled $198.3 million and $206.6 million, respectively. This liability is included in accounts payable, accrued expenses and other current liabilities on our condensed consolidated balance sheets.

 

We are party to investigations, legal claims and lawsuits arising out of our business operations. As required, we accrue our best estimate of loss contingencies when we believe a loss is probable and we can reasonably estimate the amount of any such loss. Amounts accrued, including obligations under indemnifications, totaled $31.6 million and $27.9 million at January 31, 2010 and April 30, 2009, respectively. Litigation is inherently unpredictable and it is difficult to predict the outcome of particular matters with reasonable certainty and, therefore, the actual amount of any loss may prove to be larger or smaller than the amounts reflected in our consolidated financial statements.

 

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 have settled all but one of the RAL Cases. The sole remaining RAL Case is a putative class action entitled Sandra J. Basile, et al. v. H&R Block, Inc., et al., April Term 1992 Civil Action No. 3246 in the Court of Common Pleas, First Judicial District Court of Pennsylvania, Philadelphia County, instituted on April 23, 1993. The plaintiffs seek unspecified actual and punitive damages, injunctive relief, attorneys’ fees and costs. A Pennsylvania class was certified, but later decertified by the trial court in December 2003. The trial court’s decertification decision is currently on appeal. We believe we have meritorious defenses to this case and intend to defend it vigorously. There can be no assurances, however, as to the outcome of this case or its impact on our consolidated results of operations.

 

Peace of Mind Litigation

We are defendants in lawsuits regarding our Peace of Mind program (collectively, the “POM Cases”), under which our applicable tax return preparation subsidiary assumes liability for additional tax assessments attributable to tax return preparation error. 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 putative class action case originally filed in the Circuit Court of Madison County, Illinois on January 18, 2002. 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. The plaintiffs seek unspecified damages, injunctive relief, attorneys’ fees and costs. The Madison County court ultimately certified a class consisting of all persons

 

residing in 13 states who from January 1, 1997 to final judgment (1) were charged a separate fee for POM by “H&R Block;” (2) were charged a separate fee for POM by an “H&R Block” entity not licensed to sell insurance; or (3) had an unsolicited charge for POM posted to their bills by “H&R Block.” Persons who received the POM guarantee through an H&R Block Premium office were excluded from the class. We subsequently removed the case to federal court in the Southern District of Illinois, where it is now pending. In November 2009, the federal court issued an order effectively vacating the state court’s class certification ruling and allowing plaintiffs time to file a renewed motion for class certification under the federal rules. Plaintiffs filed a new motion for class certification seeking certification of an 11-state class. A hearing on plaintiffs’ motion is set for April 30, 2010.

There is one other putative class action pending against us in Texas that involves the POM guarantee. This case, styled Desiri L. Soliz v. H&R Block, et al. (Cause No. 03-032-D), was filed on January 23, 2003 in the District Court of Kleberg County, Texas and 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 allegations similar to those in the Marshall case. The plaintiff seeks actual and treble damages, equitable relief, attorney fees and costs. No class has been certified in this case.

We believe we have meritorious defenses to the claims in the POM Cases, 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 or their impact on our consolidated results of operations individually or in the aggregate.

 

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 asserts nationwide jurisdiction and alleges fraudulent business practices, deceptive acts and practices, common law fraud and breach of fiduciary duty with respect to the Express IRA product and seeks equitable relief, disgorgement of profits, damages and restitution, civil penalties and punitive damages. In July 2007, the Supreme Court of the State of New York issued a ruling that dismissed all defendants other than H&R Block Financial Advisors, Inc. (HRBFA) and the claims of common law fraud. The intermediate appellate court reversed this ruling in January 2009. To avoid the cost and inherent risk associated with litigation, we reached an agreement to settle this case and the civil actions described below, subject to approval by the federal court presiding over the civil actions. Details regarding the settlement are described below. We believe we have meritorious defenses to the claims in this case and, if for any reason the settlement is not approved, we will continue to defend this case vigorously. There can be no assurances, however, as to the outcome of this case or its impact on our consolidated results of operations.

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 alleges fraudulent business practices, deceptive acts and practices, common law fraud and breach of fiduciary duty with respect to the Express IRA product and seeks equitable relief, disgorgement of profits, damages and restitution, civil penalties and punitive damages. The defendants have filed a motion to dismiss. We believe we have meritorious defenses to the claims in this case, and we intend to defend this case vigorously, but there can be no assurances as to its outcome or its impact on our consolidated results of operations.

In addition to the New York and Mississippi Attorney General actions, a number of civil actions were filed against HRBFA and us concerning the Express IRA product, the first of which was filed on March 15, 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 (Case No. 06-1786-MD-RED) in the United States District Court for the Western District of Missouri. To avoid the cost and inherent risk associated with litigation, we have reached an agreement to settle these cases and the New York Attorney General action, subject to approval by the federal court presiding over the Multi-District Litigation. The settlement would require a minimum payment of $11.4 million and a maximum payment of $25.4 million. The actual cost of the settlement would depend on the number of claims submitted by class members. The federal court granted preliminary approval of

 

the settlement on January 25, 2010 and scheduled a final fairness hearing on May 17, 2010. We believe we have meritorious defenses to the claims in these cases and, if for any reason the settlement is not approved, we will continue to defend them vigorously. We previously recorded a liability for our best estimate of the expected loss. There can be no assurances, however, as to the outcome of these cases or their impact on our consolidated results of operations.

Although we sold HRBFA effective November 1, 2008, we remain responsible for any liabilities relating to the Express IRA litigation through an indemnification agreement.

 

Securities and Shareholder Litigation

On April 6, 2007, a putative class action styled In re H&R Block Securities Litigation (Case No. 06-0236-CV-W-ODS) 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 and failure to prepare financial statements in accordance with generally accepted accounting principles. The complaint sought unspecified damages and equitable relief. The court dismissed the complaint in February 2008, and the plaintiffs appealed the dismissal in March 2008. In addition, plaintiffs in a shareholder derivative action that was consolidated into the securities litigation filed a separate appeal in March 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 alleged 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. In September 2009, the appellate court affirmed the dismissal of the securities fraud class action, but reversed the dismissal of the shareholder derivative action. We believe we have meritorious defenses to the claims in the shareholder derivative action and intend to defend the action vigorously. There can be no assurances, however, as to its outcome.

 

RSM McGladrey Litigation

RSM EquiCo, its parent and certain of its subsidiaries and affiliates, are parties to a 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 relating to business valuation services provided by RSM EquiCo, including allegations of fraud, negligent misrepresentation, breach of contract, breach of implied covenant of good faith and fair dealing, breach of fiduciary duty and unfair competition. Plaintiffs seek unspecified actual and punitive damages, in addition to pre-judgment interest and attorneys’ fees. On March 17, 2009, the court granted plaintiffs’ motion for class certification on all claims. The defendants filed two requests for interlocutory review of the decision, the last of which was denied by the Supreme Court of California on September 30, 2009. A trial date has been set for January 2011.

The certified class consists of all RSM EquiCo U.S. clients who signed platform agreements and for whom RSM EquiCo did not ultimately market their business for sale. The fees paid to RSM EquiCo in connection with these agreements total approximately $185 million, a number which substantially exceeds the equity of RSM EquiCo. We intend to defend this case vigorously. The amount claimed in this action is substantial and could have a material adverse impact on our consolidated results of operations. There can be no assurance regarding the outcome of this matter.

As more fully described in note 2, RSM and M&P operate in an alternative practice structure. Accordingly, certain claims and lawsuits against M&P could have an impact on RSM. More specifically, any judgments or settlements arising from claims and lawsuits against M&P which exceed its insurance coverage could have a direct adverse effect on M&P’s operations. Although RSM is not responsible for the liabilities of M&P, significant M&P litigation and claims could impair the profitability of the APS and impair the ability to attract and retain clients and quality professionals. This could, in turn, 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 any claims or litigation involving M&P.

 

On December 7, 2009, a lawsuit was filed in the Circuit Court of Cook County, Illinois (2009-L-014920) against M&P, RSM and H&R Block entitled Ronald R. Peterson ex rel. Lancelot Investors Fund, L.P., et al. v. McGladrey & Pullen LLP, et al. The case was removed to the United States District Court for the Northern District of Illinois on December 28, 2009, where it remains pending (Case No. 08-28225). The complaint, which was filed by the trustee for certain bankrupt investment funds, seeks unspecified damages and asserts claims against M&P for failure to meet generally accepted auditing standards and failure to detect fraud in financial statement audits. The complaint also asserts claims for vicarious liability and alter ego liability against RSM, and for equitable restitution against H&R Block. The amount claimed in this case is substantial. We believe we have meritorious defenses to the claims in this case and intend to defend it vigorously, but there can be no assurances as to its outcome or its impact on our consolidated results of operations.

 

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 seeking equitable relief, disgorgement of profits, restitution and statutory penalties. In November 2008, the court granted a preliminary injunction limiting the ability of the owner of SCC’s former loan servicing business to initiate or advance foreclosure actions against certain loans originated by SCC or its subsidiaries without (1) advance notice to the Massachusetts Attorney General and (2) if the Attorney General objects to foreclosure, approval by the court. An appeal of the preliminary injunction was denied. We believe the claims in this case are without merit, and we intend to defend this case vigorously. There can be no assurances, however, as to its outcome or its impact on our consolidated results of operations.

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

 

Other Claims and Litigation

We are from time to time 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 investigations, claims and lawsuits,

 

and we are defending or intend to defend them vigorously. The amounts claimed in these matters are substantial in some instances; however the ultimate liability with respect to such matters 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 have a material adverse impact on our consolidated results of operations.

In addition to the aforementioned types of matters, we are party to claims and lawsuits that we consider to be ordinary, routine litigation incidental to our business, including claims and lawsuits (collectively, “Other Claims”) concerning the preparation of customers’ income tax returns, the fees charged customers for various products and services, 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 financial statements.

 

Results of our continuing operations by reportable operating segment are as follows:

 

Effective May 1, 2009, we realigned certain segments of our business to reflect a new management reporting structure. The operations of HRB Bank, which was previously reported as the Consumer Financial Services segment, have now been reclassified, with activities that support our retail tax network included in the Tax Services segment, and the net interest margin and gains and losses relating to our portfolio of mortgage loans held for investment and related assets included in corporate. Presentation of prior period results reflects the new segment reporting structure.

These segment changes also resulted in the reclassification of assets between segments. Identifiable assets by reportable segment at January 31, 2010 are as follows:

 

 

In October 2009, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update 2009-13, “Revenue Recognition (Topic 605) – Multiple-Deliverable Revenue Arrangements” (ASU 2009-13). This guidance amends the criteria for separating consideration in multiple-deliverable arrangements to enable vendors to account for products or services (deliverables) separately rather than as a combined unit. This guidance establishes a selling price hierarchy for determining the selling price of a deliverable, which is based on: (1) vendor-specific objective evidence; (2) third-party evidence; or

 

(3) estimates. This guidance also eliminates the residual method of allocation and requires that arrangement consideration be allocated at the inception of the arrangement to all deliverables using the relative selling price method. In addition, this guidance significantly expands required disclosures related to a vendor’s multiple-deliverable revenue arrangements. This guidance is effective prospectively for revenue arrangements entered into or materially modified beginning with our fiscal year 2012. We are currently evaluating the effect of this guidance on our consolidated financial statements.

In June 2009, the FASB issued guidance, under Topic 810 – Consolidation. This guidance changes how a reporting entity determines when an entity that is insufficiently capitalized or is not controlled through voting or similar rights should be consolidated. The determination of whether a reporting entity is required to consolidate another entity is based on, among other things, the other entity’s purpose and design and the reporting entity’s ability to direct the activities of the other entity that most significantly impact the other entity’s economic performance. This guidance will require a reporting entity to provide additional disclosures about its involvement with variable interest entities and any significant changes in risk exposure due to that involvement, and will be effective for our fiscal year 2011. We are currently evaluating the effect of this guidance on our consolidated financial statements.

In June 2009, the FASB issued guidance, under Topic 860 – Transfers and Servicing. This guidance will require more disclosure about transfers of financial assets, including securitization transactions, and where entities have continuing exposure to the risks related to transferred financial assets. It eliminates the concept of a qualifying special purpose entity and changes the requirements for derecognizing financial assets. This guidance will be effective at the beginning of our fiscal year 2011. We are currently evaluating the effect of this guidance on our consolidated financial statements.

In December 2007, the FASB issued guidance, under Topic 805 – Business Combinations, requiring 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. This guidance will require acquisition-related expenses to be expensed and will generally require contingent consideration to be recorded as a liability at the time of acquisition. Under this guidance, subsequent changes to deferred tax valuation allowances relating to acquired businesses and acquired liabilities for uncertain tax positions will no longer be applied to goodwill but will instead be typically recognized as an adjustment to income tax expense. We adopted the provisions of this guidance as of May 1, 2009. The adoption did not have a material impact on our consolidated financial statements.

In June 2008, the FASB issued guidance, under Topic 260 – Earnings Per Share, addressing 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. We adopted the provisions of this guidance as of May 1, 2009. The adoption and retrospective application of this guidance did not change the current year or prior period earnings per share amounts for the fiscal quarter. The adoption of this accounting guidance will reduce earnings per share as previously reported for fiscal year 2009 by $0.01. See additional discussion in note 3.

 

BFC is an indirect, wholly-owned consolidated subsidiary of the Company. BFC is the Issuer and the Company is the Guarantor of the Senior Notes issued on January 11, 2008 and October 26, 2004, our 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.