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FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF

For the quarterly period ended September 30, 2004

Commission file number: 0-22141

COVANSYS CORPORATION

32605 West Twelve Mile Road

Registrant’s telephone number, including area code: (248) 488-2088

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 x     No o

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

COVANSYS CORPORATION

INDEX

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

COVANSYS CORPORATION AND SUBSIDIARIES

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

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COVANSYS CORPORATION AND SUBSIDIARIES

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

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COVANSYS CORPORATION AND SUBSIDIARIES

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

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COVANSYS CORPORATION AND SUBSIDIARIES

1. Organization and Basis of Presentation

      Covansys Corporation was founded in 1985. Covansys Corporation and its subsidiaries (the Company) is a global technology services company, with a focus on industry-specific solutions, strategic outsourcing and integration solutions. The Company addresses the most challenging technology issues companies are facing through a unique onsite, offsite, offshore delivery model that helps clients achieve rapid deployment and reduced costs. The Company offers high-level subject matter expertise in the public sector industry, as well as years of experience in retail, healthcare, distribution, manufacturing, financial services, telecommunications and utilities. The Company applies its industry-specific knowledge to deliver a wide range of outsourcing and integration services, including: application maintenance and development outsourcing (AMD/O); custom application development; e-business services; packaged software implementation, upgrades and enhancements; and other services.

      The accompanying unaudited condensed consolidated financial statements have been prepared by management pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles in the United States have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments, including normal recurring adjustments, necessary to present fairly the financial position of Covansys Corporation and subsidiaries as of September 30, 2004, the results of its operations for the three and nine month periods ended September 30, 2004 and 2003, and cash flows for the nine month periods ended September 30, 2004 and 2003. These financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in the Company’s 2003 Annual Report on Form 10-K/A for the year ended December 31, 2003.

      The results of operations for the three and nine month periods ended September 30, 2004 are not necessarily indicative of the results to be expected in future quarters or for the year ending December 31, 2004.

      Certain amounts for 2003 have been reclassified to conform with the 2004 classification.

2. Recapitalization

      On April 27, 2004, the Company announced that it had entered into a long-term Master Services Agreement and a Stock Purchase Agreement with Fidelity Information Services (“FIS”), Inc., a subsidiary of Fidelity National Financial, Inc.. The Master Services Agreement is expected to generate an anticipated $150 million in revenues to the Company over the next five years.

      Under the Stock Purchase Agreement, as amended, with FIS and approved by shareholders on September 15, 2004, the Company issued to FIS 8.7 million shares of the Company’s common stock and warrants for $95.7 million. The four tranches of warrants, each for one million shares of the Company’s common stock, have a strike price between $15 and $24 per share. FIS also acquired 2.3 million shares of the Company’s common stock from Rajendra Vattikuti, founder and chairman of the Company.

      In order to facilitate the transactions with FIS, the Company also entered into a Recapitalization Agreement, as amended, with a wholly-owned subsidiary of a private equity investment fund managed by Clayton, Dubilier & Rice, Inc. (the “CDR Stockholder”) to restructure the CDR Stockholder’s ownership interest in the Company and certain corresponding governance rights, in exchange for a combination of cash, stock, notes and warrants. The CDR Stockholder owned 200,000 shares of the Company’s Series A Voting Convertible Preferred Stock, or approximately 8.7 million shares of common stock on an as converted basis, and 5.3 million common stock warrants with a strike price ranging from $25 to $31 per share.

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      Under the terms of the Recapitalization Agreement approved by shareholders on September 15, 2004 the CDR Stockholder exchanged all of its existing holdings in the Company for consideration valued at $222.7 million consisting of $177.5 million of cash, two million shares of common stock of the Company, subordinated notes in the total amount of $17.5 million due December 31, 2005, which bears interest at LIBOR plus 2.20%, and five-year warrants for five million shares of common stock with a strike price of $18 per share. In accordance with EITF D-42, as amended by EITF 00-27, the Company recorded a reduction to income available to common shareholders of approximately $28.7 million. The Company financed the transaction with the CDR Stockholder with cash on hand as well as proceeds from the FIS investment.

      The following table summarizes the activity in shareholders’ equity for the nine months ending September 30, 2004.

3. Income Taxes

      The Company has provided federal, foreign and state income taxes in the condensed consolidated statements of operations based on the anticipated effective tax rate for fiscal years 2004 and 2003. The Company’s tax rate is impacted by permanent items such as Subpart F income and nondeductible travel and entertainment expenses as well as the mix between domestic and foreign earnings.

      Realization of deferred tax assets associated with the Company’s future deductible temporary differences and net operating loss carryforwards is dependent upon generating sufficient taxable income prior to their expiration. Although realization of the deferred tax assets is not assured, management believes it is more likely than not that the deferred tax assets will be realized through future taxable income. On a quarterly basis, management assesses whether it remains more likely than not that the deferred tax assets will be realized.

      The Company has five (four in 2003) business units in India which are entitled to a tax holiday for 10 consecutive years commencing with the year the business unit started producing computer software or until the Indian tax year ending March 31, 2009, whichever is earlier. The business units are subject to the tax holiday for various periods ranging from March 31, 2005 through March 31, 2009. As the tax holiday expires, the Company’s overall effective tax rate will be negatively impacted.

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4. Fixed Price Contracts

      The Company realized approximately 40% of its revenue during the three months and nine months ended September 30, 2004, from all fixed price contracts (percentage of completion as well as fixed price IT outsourcing and maintenance). Approximately 12% of our revenue during the three months and nine months ended September 30, 2004 was realized from fixed price contracts with respect to which we recognize revenue on a percentage of completion basis. These contracts expose the Company to collection risk on both billed and unbilled receivables in the event that contract milestones are not met or the client does not accept the product as delivered. In addition, the Company could incur unanticipated losses if it is necessary to increase its estimated cost to complete.

      The Company’s first quarter and third quarter 2004 financial results were negatively impacted by approximately $9,400 and $1,250 respectively, due to four significant fixed price contracts which it considers to be challenged, three of which were discussed in the Company’s 2003 Form 10-K/A.

      Communications with contracting parties during 2004 caused management to re-assess the collectibility of billed and unbilled receivables for two troubled projects. In both cases, the Company has been informed that its services would no longer be required to complete the project prior to its implementation. As of September 30, 2004, the Company is not performing work on either of these contracts. As a result, the Company reduced the related receivables by $5,500 and $350 to their net realizable value in the first quarter and third quarter of 2004, respectively. In accordance with the application of percentage of completion accounting, the Company reflected the changes as a contract price adjustment, and accordingly, as a reduction in revenue. The Company continues to actively review its collection options with respect to one of these contracts.

      The Company also determined it was necessary to increase its estimated cost to complete for three of these projects due to changes in 2004 in both scope and resource requirements. The revision in estimates had the effect of reducing gross margin by $3,900 and $900 in the first quarter and third quarter of 2004, respectively.

      At September 30, 2004, the Company has $4,284 in billed and unbilled receivables related to the two challenged contracts for which the Company is still performing services and which management believes are collectible.

5. Segment Information

      The Company is a provider of IT services, and is organized geographically throughout North America, India and Asia, and other international locations. The chief operating decision-maker evaluates each location’s performance based primarily on its revenues and income from operations due to the similarity of the nature of services provided to clients. Revenue for the India/ Asia operation is evaluated based on the full attribution of bill rates charged to the end customer. The segment revenue figures disclosed below are stated at full attribution. Full attribution revenue is calculated using the end customer invoice rate on intersegment engagements, as opposed to using the transfer price rate. The chief operating decision-maker does not evaluate segment performance based on assets. Assets, including the related depreciation and amortization expense, are managed primarily by corporate management. Under this organization, the operating segments have been aggregated into the following four operating segments and other.

	•	Public Sector includes all services provided to domestic state and local municipalities.
	•	Commercial includes all North American services provided to non-public sector customers. Commercial includes application services for maintenance and development outsourcing (AMD/O), legacy modernization, retail, healthcare, distribution, manufacturing, financial services, telecommunications, utilities, e-business, packaged software implementation and other services. Commercial also includes telecommunication services provided in Europe.

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	•	India/Asia includes all services performed in India or Asia.
	•	Europe includes services performed in Europe. Telecommunication services performed in Europe are excluded from the Europe figures as such services are included in the Commercial segment.
	•	Other consists primarily of the labor and supporting expenses for the corporate functions, depreciation and amortization expenses as well as lease expenses for corporate headquarters.

      The accounting policies of the operating segments are the same as those described in the summary of significant accounting policies in the Company’s 2003 Annual Report on Form 10-K/A.

      The organizational realignment initiated during the second quarter 2003 substantially modified the Company’s reporting structure and required the migration from the traditional single segment reporting presentation to a multi-segment presentation. This modified reporting format presents revenue of each segment on a full attribution basis, whereby the end customer invoice rate is presented, with inter-segment eliminations separately identified. This presentation reflects the importance and critical relationship whereby India/Asia supports, primarily, the Commercial and Public Sector segments with services. The segment operating results at the income from operations level utilizes the company’s transfer pricing methodology and thereby attributes a majority of the margin to the segments where the end customers are located. Thus the profitability of Commercial and Public Sector segments is enhanced while the profitability of India/Asia segment is directly reduced.

      India/Asia supplies substantial resources to North American and European customers. The rate charged by India to U.S. and Europe has been developed utilizing a cost plus transfer pricing methodology. This results in a large component of the available gross margin accruing to North America or Europe where the end customer is located.

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      Revenue and income (loss) from operations by segment is as follows:

6. Property and Equipment

      Subsequent to the issuance of its financial statements for the year ended December 31, 2003, the Company identified $2,561 of adjustments related to property and equipment, $1,495 of which related to prior periods requiring the Company to restate its previously filed financial statements for all periods affected by the charge. The remaining $1,066 was recorded in the first quarter of 2004, $742 of which relates to equipment that the Company has been unable to determine the period or periods during which the equipment left its possession and $324 of which relates to equipment that became obsolete in the first quarter of 2004. Of the $1,066, $39 was recorded in cost of revenue and $1,027 was recorded in selling, general and administrative expense.

7. Common Stock Repurchase Program

      In October 2002, the Company’s board of directors authorized the purchase of an additional 2,000,000 shares of the Company’s common stock, bringing the total authorization to 14,000,000 shares.

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      During the third quarter of 2004, the Company purchased the following shares:

      No shares were purchased during the six months ended June 30, 2004.

      Through September 30, 2004, the Company has purchased approximately 11,434,976 shares of its common stock for cash at a total cost of $141,980. At September 30, 2004 2,565,024 shares remain available for purchase under the board of directors authorization.

8. Net (Loss) Per Share

      Basic and diluted net income (loss) per share is computed in accordance with SFAS No. 128, “Earnings Per Share, as amended by Emerging Issues Task Force (“EITF”) Issue 03-6 by dividing net income (loss) available for common shareholders by the weighted average number of shares of common stock outstanding. For the three month and nine month periods ended September 30, 2004 and 2003, the effect of convertible redeemable preferred stock has not been included in the calculation of dilutive net income (loss) per share because to do so would be anti-dilutive. The calculation of dilutive net income (loss) per share excludes the following common stock equivalents for the respective periods because their impact was anti-dilutive.

      The Company’s Series A Voting Convertible Preferred Stock is a participating security as defined in Issue 03-6. Issue 03-6 is effective for periods beginning after March 31, 2004. The Company adopted Issue 03-6 in the second quarter ended June 30, 2004 and restated EPS for all prior periods presented. The adoption of Issue 03-6 results in a reduction in EPS available for common shareholders in periods where the Company has income and has no impact in periods where the Company has a loss. The Company’s Series A Voting Convertible Preferred Stock was redeemed as part of the Recapitalization Agreement with the CDR Shareholder (see Note 2). The Company does not expect Issue 03-6 will impact future periods.

9. Stock Option Plans

      The Company has elected to account for stock options using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Accordingly, no additional compensation expense has been recognized for our stock option plan within the accompanying consolidated statements of operations. Had compensation expense for our stock option plan been determined based on the fair value at the grant date consistent with the provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” the

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10. Comprehensive Income

      Total comprehensive income is summarized as follows:

11. Credit Agreement

      On September 7, 2004, the Company entered into a new Credit Agreement which provides for borrowings or standby and commercial letters of credit up to $30.0 million. The Credit Agreement expires on December 28, 2005 but may be extended in one-year increments at the request of the Company and the consent of the lenders. With the prior consent of the Agent, the Company may request to increase the availability under the Credit Agreement by up to $10.0 million (not to exceed an aggregate availability of $40.0 million). Borrowings under the Credit Agreement are collateralized by all domestic assets of the Company.

      Borrowings under the Credit Agreement bear interest at LIBOR plus 1.20% to 1.55% or prime minus .50%. The interest rate matrix is based on the Company’s level of outstanding credit exposure as defined in the Credit Agreement. Under the Credit Agreement, the Company pays a commitment fee of ..125% per annum on the unused portion of the commitment and a facility letter of credit fee of .90% to 1.55% per annum based on the level of outstanding credit exposure as defined in the Credit Agreement.

      The Credit Agreement contains covenants which include financial covenants which require the Company to maintain a certain interest coverage ratio, leverage ratio and a minimum total capitalization. At September 30, 2004, the Company was in compliance with these ratios. At September 30, 2004, the Company had no borrowings and $7,920 in outstanding letters of credit under this Credit Agreement. The Credit Agreement also includes a covenant which restricts the Company’s ability to repurchase shares of its common stock.

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12. Related Party Transactions

      Synova, Inc. and subsidiaries (Synova) is an IT professional services organization owned by the Chairman of the Company’s Board of Directors. During the three month periods ended September 30, 2004 and 2003, the Company provided services to Synova totaling $647 and $764, respectively and $1,954 and $2,458 for the nine month periods ended September 30, 2004 and 2003, respectively. In addition, during the three month periods ended September 30, 2004 and 2003 Synova provided services to the Company totaling $572 and $142, respectively and $1,154 and $896 for the nine month periods ended September 30, 2004 and 2003, respectively. The net balance owed to the Company by Synova at September 30, 2004 was $240. In addition, under the terms of a note payable, Synova owes the Company $3,250. This note is due in September 2005, and interest is paid quarterly in accordance with its terms.

      The Company paid approximately $104 and $190 to CDR, a shareholder, for financial, management advisory, and executive management services during the three month periods ended September 30, 2004 and 2003, respectively and $494 and $582 for the nine month periods ended September 30, 2004 and 2003, respectively. The balance owed by the Company to CDR at September 30, 2004 was $105. (See Note 2 for discussion of CDR note payable).

      In the third quarter of fiscal 2002, the Company entered into a ten-year agreement to provide outsourcing services to SIRVA, Inc. a company related through common ownership of CDR. During the three month and nine month periods ended September 30, 2004 and 2003, services provided by the Company to SIRVA, Inc. totaled approximately $1,989 and $2,415 and $6,741 and $5,870, respectively. The net balance owed to the Company by SIRVA at September 30, 2004 was $460.

      At September 30, 2004, the Company owed the Chesapeake Group, Inc., a company owned by a director, $850 for merger and acquisition consulting services.

      The Company has a note receivable in the amount of $558 from a director. This note bears interest at 8.25% and is due in December 2006.

      The Company has a note receivable in the amount of $306 from an executive officer. This note bears interest at 2.5%.

      In the second quarter of fiscal 2004, the Company entered into a Master Services Agreement with FIS to provide services over a five year period. During the three months and nine months ended September 30, 2004, services provided by the Company to FIS totaled approximately $1,058. The balance owed to the Company by FIS at September 30, 2004 was $1,058.

13. Restructuring and Other Related Charges

      The following is a roll forward of the accrual balance for Restructuring and Other Related charges for the nine month periods ended September 30, 2004 and 2003 respectively.

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      Amounts related to lease terminations will be paid out through 2008. Amounts related to severance will be paid in 2004.

14. Cost of Computer Software to be Sold, Leased or Marketed

      SFAS No. 86 “Accounting for Costs of Computer Software to be Sold, Leased or Otherwise Marketed” requires capitalized software development costs incurred subsequent to establishment of technological feasibility and prior to the availability of the product for general release to customers. During the nine months ended September 30, 2004 the Company capitalized computer software of approximately $172. Amortization of capitalized costs begins when the product is available for general release to customers and is computed on a straight-line basis over each products estimated economic life — typically five years. Amortization costs were $422 and $596 for the three months ended September 30, 2004 and 2003, respectively and $1,265 and $1,801 for the nine months ended September 30, 2004 and 2003, respectively.

15. Goodwill

      Changes in the carrying amount of goodwill for the nine months ended September 30, 2004 is as follows:

16. Other Income (Expense), Net

      Other income, net represents interest earned and realized gains and losses from the sale of short-term and long-term investments and cash equivalents and foreign currency transaction and translation gains and losses.

      Foreign currency fluctuations during the three months and nine months ended September 30, 2004 resulted in a foreign currency translation (loss) of approximately ($129) and ($139) respectively, from the remeasurement of nonfunctional currency net asset positions into the functional currency of the respective foreign subsidiary.

      Amounts in 2003 include a loss of $680 related to the sale of an investment carried at cost.

17. Recently Issued Financial Accounting Standards

      In December 2003, the FASB issued FIN 46R “Consolidation of Variable Interest Entities — an interpretation of ARB 51”. FIN 46R provides guidance on the identification of, and financial reporting for, entities over which control is achieved through means other than voting rights, which are referred to as variable-interest entities (“VIEs”). FIN 46R became effective for Covansys on January 1, 2004. The adoption of FIN 46R did not have a material effect on our results of operations or financial position.

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

      The following section should be read in conjunction with our Consolidated Financial Statements and related Notes appearing in this Form 10-Q. With the exception of statements regarding historical matters and statements concerning our current status, certain matters discussed in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” are forward-looking statements that involve substantial risks and uncertainties. Such forward-looking statements may be identified by the words “anticipate,” “believe,” “estimate,” “expect” or “intend” and similar expressions. Our actual results, performance or achievements could differ materially from these forward-looking statements.

      Factors that could cause or contribute to such material differences include actions by governmental or regulatory agencies, general economic conditions and conditions in the IT industry such as potential cost overruns on fixed price contracts, competition in the IT services industry, the demand for IT services, public sector government budgetary constraints, effective application of the percentage of completion method of accounting for fixed priced contracts, risks related to merger, acquisition and strategic investment strategy, variability of operating results, government regulation of Immigration, exposure to regulatory, political and economic conditions in India and Asia, the short-term nature and termination provisions of contracts, economic conditions unique to clients in specific industries and limited protection of intellectual property rights.

Overview

      We are a global technology services company, with a focus on industry-specific solutions, strategic outsourcing and integration solutions. We address the most challenging technology issues companies are facing through a unique onsite, offsite, offshore delivery model that helps clients achieve rapid deployment and reduced costs. We offer high-level subject matter expertise in the public sector industry, as well as years of experience in retail, healthcare, distribution, manufacturing, financial services, telecommunications and utilities. We apply our industry-specific knowledge to deliver a wide range of outsourcing and integration services, including: application maintenance and development outsourcing (AMD/O); legacy modernization; custom application development; e-business services; packaged software implementation, upgrades and enhancements; and other services. Our strategy is to establish long-term client relationships and to secure additional engagements with existing clients by providing quality services and by being responsive to client needs. For each of the past five years, over 80% of our revenues were generated from existing clients from the previous fiscal year.

      We generally assume responsibility for project management and may bill the client on either a time-and-materials or fixed-price basis. We recognize revenues on time-and-materials engagements as the services are performed. On fixed-price engagements, we recognize revenues under the percentage of completion method except for fixed-price outsourcing contracts where we recognize revenues ratably over the applicable period. For the three month periods ended September 30, 2004 and 2003, approximately 40% of our total revenues were generated from all fixed price contracts (percentage of completion as well as fixed price IT outsourcing and maintenance). Approximately 12% of our revenue during the three months ended September 30, 2004 and 2003 was realized from fixed price contracts with respect to which we recognize revenue on a percentage of completion basis.

      Our most significant cost is project personnel cost, which consists primarily of salaries, wages and benefits for our IT professionals. We strive to maintain our gross profit margin by controlling project costs and managing salaries and benefits relative to billing rates. We use a human resource management team to ensure that IT professionals are quickly placed on assignments to minimize nonbillable time and are placed on assignments that use their technical skills and allow for maximum billing rates.

      In an effort to sustain our growth and profitability, we have made and continue to make substantial investments in our infrastructure, including: (1) development centers in the United States and India; (2) system methodologies; and (3) internal systems.

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Critical Accounting Policies and Estimates

      The preparation of financial statements in conformity with generally accepted accounting principles in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses and related disclosures in the consolidated financial statements and accompanying notes. We regularly evaluate and discuss with our Audit Committee the accounting policies and estimates we use to prepare our consolidated financial statements. Estimates are used for, but not limited to, revenue recognition under the percentage-of-completion method, impairment assessments of goodwill and other long-lived assets, realization of deferred tax assets, allowance for doubtful accounts, and litigation related contingencies. These estimates are based on historical experience, project management, and various assumptions that we believe to be reasonable given the particular facts and circumstances. Although we believe that our estimates, assumptions and judgments are reasonable, they are based upon information presently available. Actual results could differ significantly from these estimates under different assumptions, judgments or conditions.

      The Securities and Exchange Commission has defined “critical accounting policies” as those that are most important to the portrayal of a company’s financial condition and results of operations, and which require the Company to make its most difficult and subjective judgments, often as a result of the need to make estimates. Based on this definition, we have identified the critical accounting policies discussed below. We have other significant accounting policies, which also involve the use of estimates, judgments and assumptions that are integral to understanding our results of operations. For a complete discussion of all significant accounting policies, see Note 1 of our Notes to Consolidated Financial Statements included in our 2003 Form 10-K/A.

      The following is an overview discussion of our critical accounting policies.

      Revenue Recognition. We recognize revenue in accordance with Staff Accounting Bulletin No. 101, as modified by Staff Accounting Bulletin No. 104, for our time-and-materials and fixed price outsourcing contracts. For those service contracts which are billed on a time and materials basis, we recognize revenues as the services are performed. In our time and materials contracts our effort, measured by our time incurred, represents the contractual milestones or output measure which is the contractual earnings pattern. For our fixed price IT outsourcing and maintenance contracts, we recognize revenue ratably over the applicable outsourcing or maintenance period as the services are performed continuously over the contract period.

      For our contracts to design, develop or modify complex information systems based upon the client’s specifications, we recognize revenue on a percentage of completion basis in accordance with Statement of Position 81-1. The percentage of completion is determined by relating the actual cost of labor performed to date to the estimated total cost of labor for each contract. Estimates of total contract revenues and costs are continuously monitored during the term of the contract, and recorded revenues and costs are subject to revision as the contract progresses. Such revisions, which may result in increases or decreases to revenue and income, are reflected in the financial statements in the period in which they are first identified. If the estimate indicates a loss on a particular contract, a provision is made for the entire estimated loss without reference to the percentage of completion.

      Covansys periodically enters into contracts that include multiple-element arrangements, which may include any combination of services, software, support/maintenance, and the re-sale of hardware or software. Contracts entered into after June 30, 2003 containing multiple elements or deliverables are segmented into separate units of accounting where the separate elements represent separate earnings processes in accordance with EITF 00-21. Revenues are allocated among the elements based on the relative fair values of the elements and are recognized in accordance with our policies for the separate elements unless the undelivered elements are essential to the functionality of the delivered elements. In circumstances where an undelivered element is essential to the functionality of the delivered element, no revenue is recognized for the delivered element until the undelivered element is delivered.

      Retainages, which are not material for any of the periods presented, are included in revenue earned in excess of billings in the accompanying condensed consolidated balance sheets. Revenue earned in excess of

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      Impairment of Long-Lived Assets. We review the recoverability of our long-lived assets, including property and equipment when events or changes in circumstances occur that indicate that the carrying value of the asset may not be recoverable and the recoverability of goodwill on an annual basis. The assessment of possible impairment is based on our ability to recover the carrying value of the asset from expected future pre-tax cash flows of the related asset group or operating segment. If these cash flows are less than the carrying value of such asset, an impairment loss is recognized for the difference between estimated fair value and carrying value. The measurement of impairment requires management to make estimates of these cash flows related to long-lived assets, as well as other fair value determinations.

      Computer Software. We perform research to develop software for various business applications. The costs of such research are charged to expense when incurred. When the technological feasibility of the product is established, subsequent costs are capitalized. Capitalized software costs are amortized on a product-by-product basis. Amortization is recorded on the straight-line method over the estimated economic life of the product, generally five years, commencing when such product is available. The establishment of technological feasibility and the ongoing assessment of the recoverability of these costs requires considerable judgment by management with respect to certain external factors including, but not limited to, anticipated future gross product revenue, estimated economic product lives and changes in software and hardware technology. These assumptions are reevaluated and adjusted as necessary at the end of each accounting period. Management reviews the valuation and amortization of capitalized development costs. We periodically consider the value of future cash flows attributable to the capitalized development costs in evaluating potential impairment of the asset. Amounts charged to expense for research and development of computer software were not material in the periods indicated.

      Income Taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

      Realization of deferred tax assets associated with the Company’s future deductible temporary differences and net operating loss carryforwards is dependent upon generating sufficient taxable income prior to their expiration. Although realization of the deferred tax assets is not assured, management believes it is more likely than not that the deferred tax assets will be realized through future taxable income. On a quarterly basis, management assesses whether it remains more likely than not that the deferred tax assets will be realized.

Recent Developments

      Strategic Transaction. On April 27, 2004, the Company announced that it had entered into a long-term Master Services Agreement and a Stock Purchase Agreement with Fidelity Information Services, Inc. (“FIS”), a subsidiary of Fidelity National Financial, Inc. (“FNF”). The Master Services Agreement is expected to generate an anticipated $150 million in revenues to the Company over the next five years.

      Under the Stock Purchase Agreement, as amended, with FIS and approved by shareholders on September 15, 2004 the Company issued to FIS 8.7 million shares of the Company’s common stock and warrants for $95.7 million. The four tranches of warrants, each for one million shares of the Company’s common stock, have a strike price between $15 and $24 per share. FIS also acquired 2.3 million shares of the Company’s common stock from Rajendra Vattikuti, founder and chairman of the Company.

      In order to facilitate the transactions with FIS, the Company also entered into a Recapitalization Agreement, as amended, with a wholly-owned subsidiary of a private equity fund managed by Clayton, Dubilier & Rice, Inc. (the “CDR Stockholder”) to restructure the CDR Stockholder’s ownership interest in the Company and certain corresponding governance rights, in exchange for a combination of cash, stock, notes

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      Under the terms of the Recapitalization Agreement, as amended, and approved by shareholders on September 15, 2004 the CDR Stockholder exchanged all of its existing holdings in the Company for consideration consisting of $177.5 million of cash, two million shares of common stock of the Company, subordinated notes in the total amount of $17.5 million due December 31, 2005, which bears interest at LIBOR plus 2.20%, and five-year warrants for five million shares of common stock with a strike price of $18 per share. The Company financed the transaction with the CDR Stockholder with cash on hand as well as proceeds from the FIS investment.

      As a result of the Recapitalization Agreement transactions with the CDR Stockholder, the Company recorded a reduction to income available to common shareholders of approximately $28.7 million upon the closing based on the closing price of the Company’s common stock at closing as well as expenses incurred in connection with the Recapitalization Agreement.

      Property and Equipment. The Company has amended its previously filed Form 10-K for the year ended December 31, 2003 and its Forms 10-Q for the periods ended March 31, 2003, June 30, 2003 and September 30, 2003, to reflect the restatement of its financial statements for the years ended December 31, 2003, 2002 and 2001. The adjustments giving rise to the Company’s need to restate its financial statements relate primarily to missing or obsolete equipment that came to light as a result of a physical inventory process that the Company completed in June 2004 in order to facilitate the conversion of its property and equipment data into a new property and equipment accounting system. As part of that endeavor, missing furniture and fixtures were quantified through an assessment based upon office closings and other restructuring activities.

      As a result of those efforts, the Company determined that assets having a net book value of approximately $2.6 million were either missing, obsolete or had been appropriately capitalized but were assigned too long a useful life. Of this amount, $0.4 million related to equipment determined to have become obsolete in the quarter ended March 31, 2004 and $1.5 million was attributed to prior years. The remaining balance of $0.7 million related to missing equipment which could not be identified with any particular period and was recorded as an additional charge in the first quarter of 2004. Additional detail regarding the restatement and related adjustments is included in Note 6 of the Notes to Consolidated Financial Statements included in this Form 10-Q.

      Fixed Price Contracts. The Company realized approximately 40% of its revenue during the three months and nine months ended September 30, 2004, from fixed price contracts (percentage of completion as well as fixed price IT outsourcing and maintenance). Approximately 12% of our revenue during the three months and nine months ended September 30, 2004 was realized from fixed price contracts with respect to which we recognize revenue on a percentage of completion basis. These contracts expose the Company to collection risk on both billed and unbilled receivables in the event that contract milestones are not met or the client does not accept the product as delivered. In addition, the Company could incur unanticipated losses if it is necessary to increase its estimated cost to complete.

      The Company’s first quarter and third quarter 2004 financial results were negatively impacted by approximately $9,400 and $1,250, respectively due to four significant fixed price contracts which it considers to be challenged, three of which were discussed in the Company’s 2003 Form 10-K/A.

      Communications with contracting parties during 2004 caused management to re-assess the collectibility of certain billed and unbilled receivables for two contracts. In both cases, the Company has been informed that its services would no longer be required to complete the project prior to its implementation. As of September 30, 2004, the Company is not performing work on either of these contracts. As a result, the Company reduced the related receivables by $5,500 and $350 to their net realizable value in the first quarter and third quarter of 2004, respectively. In accordance with the application of percentage of completion accounting, the Company reflected the changes as a contract price adjustment, and accordingly, as a reduction in revenue. The Company continues to actively review its collection options with respect to one of these contracts.

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      The Company also determined it was necessary to increase its estimated cost to complete for three of these projects due to changes in 2004 in both scope and resource requirements. The revision in estimates had the effect of reducing gross margin by $3,900 and $900 in the first quarter and third quarter of 2004, respectively.

      At September 30, 2004 the Company has $4,284 in billed and unbilled receivables related to the two challenged contracts for which the Company is still performing services and which management believes are collectible.

Results of Operations

      Revenue and gross profit by segment is as follows: