FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION

For the quarterly period ended March 31, 2005

or

For the transition period from                      to                     

Commission file number 1-6402-1

SERVICE CORPORATION INTERNATIONAL

713-522-5141
(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in the Securities Exchange Act of 1934 Rule 12b-2).

The number of shares outstanding of the registrant’s common stock as of May 1, 2005 was 309,367,376 (net of treasury shares).

SERVICE CORPORATION INTERNATIONAL
INDEX

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PART I. FINANCIAL INFORMATION

SERVICE CORPORATION INTERNATIONAL
CONSOLIDATED STATEMENT OF OPERATIONS (UNAUDITED)
(In thousands, except per share amounts)

(See notes to unaudited consolidated financial statements)

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SERVICE CORPORATION INTERNATIONAL
CONSOLIDATED BALANCE SHEET (UNAUDITED)
(In thousands, except share amounts)

(See notes to unaudited consolidated financial statements)

4

SERVICE CORPORATION INTERNATIONAL
CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)
(In thousands)

(See notes to unaudited consolidated financial statements)

5

SERVICE CORPORATION INTERNATIONAL
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY (UNAUDITED)
(In thousands)

(See notes to unaudited consolidated financial statements)

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SERVICE CORPORATION INTERNATIONAL
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in thousands, except per share amounts)

1. Nature of Operations
Service Corporation International (SCI or the Company) owns and operates funeral service locations and cemeteries worldwide. The Company also has a minority interest equity investment in funeral operations in France. The Company owns and operates Kenyon International Emergency Services, a disaster response team that engages in mass fatality and emergency response services, which is included in the Company’s funeral operations segment.

      The funeral service and cemetery operations consist of funeral service locations, cemeteries, crematoria and related businesses. Personnel at the funeral service locations provide all professional services relating to atneed funerals, including the use of funeral facilities and motor vehicles, and preparation and embalming services. Funeral related merchandise (including caskets, burial vaults, cremation receptacles, flowers and other ancillary products and services) is sold at funeral service locations. Certain funeral service locations contain crematoria. The Company sells preneed funeral services whereby a customer contractually agrees to the terms of a funeral to be performed in the future. The Company’s cemeteries provide cemetery property interment rights (including mausoleum spaces, lots and lawn crypts) and sell cemetery related merchandise (including stone and bronze memorials, burial vaults, casket and cremation memorialization products) and services (primarily merchandise installations and burial openings and closings). Cemetery items are sold on an atneed or preneed basis. Personnel at cemeteries perform interment services and provide management and maintenance of cemetery grounds. Certain cemeteries operate crematoria, and certain cemeteries contain gardens specifically for the purpose of cremation memorialization.

2. Restatement of Financial Statements
The Company has restated its previously issued unaudited financial statements for the first three interim periods of 2004, related to (1) deferred preneed cemetery contract revenues, (2) certain reconciliations of the Company’s funeral and cemetery trust assets and deferred revenues, and (3) operating leases and other reconciliations. Additionally, the Company has concluded that the impact of these adjustments to the years ended December 31, 2003, 2002, 2001 and 2000 were not material to the Company’s consolidated financial statements. As a result, the Company has recorded the net impact of the adjustments of $416 of income before tax in Other operating (expense) income as a correction of an error in its restated unaudited March 31, 2004 consolidated financial data.

Trust and Cemetery Deferred Revenue Verification Project
During 2003, the Company began the implementation of FIN 46R, the implementation of Section 404 of the Sarbanes-Oxley Act, and the implementation of its new point-of-sale system.

      The trust verification project included three primary components: preneed cemetery merchandise and service trusts; preneed funeral merchandise and service trusts; and cemetery perpetual care trusts. As the project progressed, the Company assessed the status and adjusted the general ledger accounts accordingly. At December 31, 2003 and June 30, 2004, the Company made certain adjustments to its consolidated financial statements based on its best estimate at the time. The adjustments were influenced by the percentage of verifications completed and the expected error rate of uncompleted verifications.

      As of December 31, 2004, the Company completed its verification procedures for its funeral and cemetery trust assets and funeral trust deferred revenue. The completion of the trust verification project resulted in an adjustment to the Company’s consolidated statement of operations. As a result of this adjustment, the Company reevaluated previous adjustments related to these verifications (as mentioned above) and the impact to prior annual periods. The Company believes that these adjustments have a material impact on its consolidated financial statements for the first three interim periods of 2004. As a result, the Company has restated its financial statements for the first three interim periods of 2004. The Company evaluated the materiality of these adjustments on its financial statements issued prior to January 1, 2004 and concluded that the impact of these adjustments is not material to any quarterly or annual

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period prior to January 1, 2004. As a result, the Company has recorded the cumulative effect of these adjustments in its restated March 31, 2004 quarterly financial statements as a correction of an error.

      These verification matters did not have an impact on the Company’s reported cash balance or cash flows in any period mentioned above as amounts that were deposited or withdrawn from trust by the Company were appropriately reported in the statement of cash flows in the appropriate period.

Operating Leases and Other Adjustments
The Company initiated a review of its accounting practices and determined that the Company would adjust its method of accounting for certain types of operating leases related primarily to the Company’s funeral home properties.

      Historically, the Company recorded operating lease expense, related primarily to funeral home properties, over the initial lease term without regard to reasonably assured renewal options or fixed escalation provisions. The Company now calculates its straight line operating lease expense with consideration of such reasonably assured renewal options and fixed escalation provisions, to the extent necessary, in accordance with SFAS 13, “Accounting for Leases”.

      The Company evaluated the materiality of these adjustments related to operating leases on its financial statements and concluded that the incremental impact of these adjustments is not material to any quarterly or annual period. As a result, the Company has recorded the cumulative effect of these adjustments in its restated March 31, 2004 quarterly financial statements as a correction of an error.

      During 2004, the Company also performed various other reconciliations. These reconciliations primarily resulted from the conversion of the Company’s point-of-sale system. The effect of these adjustments, when combined with the other adjustments described above, are material to the Company’s consolidated financial statements for the first three interim periods of 2004. The cumulative effect of the 2004 activity items noted above that are related to periods prior to January 1, 2004 is recorded on a net basis of $587 (after tax) in the Company’s restated March 31, 2004 quarterly financial statements as a correction of an error.

Effect of Restatements
The adjustments to income before income taxes related to the trust verification project, the cemetery verification project, operating leases and other verifications as described above are summarized below for the first three interim periods of 2004 and the cumulative adjustment for the years prior to January 1, 2004. The effect of these adjustments on the years ended December 31, 2003, 2002 and prior years were immaterial to the Company’s consolidated financial statements. The Company recorded the adjustment related to the periods prior to January 1, 2004 in its restated March 31, 2004 financial statements as a correction of an error as they are immaterial to the financial statements as detailed in the table below.

      Included in the adjustment to first quarter 2004 consolidated statement of operations are amounts related to adjustments prior to 2000. Of the $15,256 adjustment related to trust reconciliations, $6,223 related to adjustments prior to 2000. Of the $20,796 adjustment related to cemetery deferred revenues, $13,021 related to adjustments prior to 2000. Of the $3,778 adjustment related to

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operating lease adjustments, $2,667 related to adjustments prior to 2000. Of the $1,346 adjustment related to other reconciliations, $6,028 related to adjustments prior to 2000.

      The effect of the restatement on the Company’s previously reported consolidated statement of operations for the three months ended March 31, 2004 was as follows:

      As noted above, the Company recorded the net impact of the adjustments related to periods prior to January 1, 2004 as a correction of an error in Other operating (expense) income in the consolidated statement of operations for the first quarter of 2004. The table below represents the adjustments as if they had been properly recorded in the applicable line item.

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3. Summary of Significant Accounting Policies
Principles of Consolidation and Basis of Presentation
The consolidated financial statements for the three months ended March 31, 2005 and 2004 include the accounts of the Company and all majority-owned subsidiaries and are unaudited but include all adjustments, consisting of normal recurring accruals and any other adjustments, which management considers necessary for a fair presentation of the results for these periods. These consolidated financial statements have been prepared in a manner consistent with the accounting policies described in the Company’s annual report on Form 10-K, as amended, for the year ended December 31, 2004, unless otherwise disclosed herein, and should be read in conjunction therewith. The accompanying year-end consolidated balance sheet was derived from the audited consolidated financial statements but does not include all disclosures required by accounting principles generally accepted in the United States of America. Operating results for interim periods are not necessarily indicative of the results that may be expected for the full year period.

      The Company has reclassified certain prior year amounts to conform to the current period financial presentation with no effect on previously reported results of operations, financial condition or cash flows.

Use of Estimates in the Preparation of Financial Statements
The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that may affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of expenses during the reporting period. As a result, actual results could differ from these estimates.

      The effective tax rate in the three months ended March 31, 2005 was an expense of 35.0% compared to a benefit of 4.5% in the three months ended March 31, 2004. The 2004 rate was favorably impacted by non-cash tax benefits realized from the joint venture of the French operations consummated in March 2004. For more information regarding the sale of the Company’s French funeral operations, see note twelve to the consolidated financial statements.

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4. Accounting Changes and New Accounting Pronouncements
Deferred Selling Costs
Effective January 1, 2005, the Company changed its method of accounting for direct selling costs incurred related to the acquisition of preneed funeral and preneed cemetery contracts. Prior to this change, the Company capitalized such direct selling costs and amortized these deferred selling costs in proportion to the revenue recognized. Under the new method of accounting, the Company expenses these direct selling costs as incurred. The Company believes the new method is preferable because it better reflects the economics of the Company’s business.

      As of January 1, 2005, the Company recorded a cumulative effect of $187,538, net of tax of $117,428. This amount represents the cumulative balance of deferred selling costs recorded on the Company’s consolidated balance sheet in Deferred charges and other assets at the time of the accounting change. If the Company had not changed its method of accounting for direct selling costs as described above, net income for the first quarter of 2005 would have been $2,296 after tax or $.01 per basic and diluted share higher than currently reported.

      The three months ended March 31, 2004 pro forma amounts in the table below reflect the new policy to expense selling costs as incurred. The effect of the change for the quarter ended March 31, 2004 would have decreased net income from continuing operations before cumulative effects of accounting changes by approximately $2,848 after tax or $.01 per basic and diluted share.

(1)	Represents net deferred selling costs that would have been recognized under the new method of accounting adopted on January 1, 2005.

Other Than Temporary Impairments
In March 2004, the Financial Accounting Standards Board (FASB) reached consensus on the guidance provided by Emerging Issues Task Force Issue 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (EITF 03-1). The guidance is applicable to debt and equity securities that are within the scope of FASB Statement of Financial Accounting Standard (SFAS) No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (SFAS 115). EITF 03-1 specifies that an impairment would be considered other-than-temporary unless (a) the investor has the ability and intent to hold an investment for a reasonable period of time sufficient for the recovery of the fair value up to (or beyond) the cost of the investment and (b) evidence indicating the cost of the investment is recoverable within a reasonable period of time outweighs evidence to the contrary. EITF 03-1 was scheduled to be effective for reporting periods ending after June 15, 2004. The measurement and recognition provisions relating to debt and equity securities have been delayed until the FASB issues additional guidance. The Company adopted the disclosure provisions of EITF 03-1 during the period ended June 30, 2004. The adoption of the measurement and recognition provisions are not expected to have a material impact on the consolidated financial statements, results of operations, financial position, or cash flows of the Company.

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Inventory Costs
In November 2004, the FASB issued SFAS No. 151, “Inventory Costs — an amendment of ARB 43, Chapter 4” (SFAS 151). SFAS 151 amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material. SFAS 151 requires that those items be recognized as current-period charges, rather than as a portion of the inventory cost. In addition, SFAS 151 requires that allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities. SFAS 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company does not expect this statement to have a material impact on its consolidated financial statements, results of operations, financial position, or cash flows.

Income Taxes
In December 2004, the FASB issued Staff Position No. FAS 109-2 “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004” (FAS 109-2). The American Jobs Creation Act of 2004 (“Jobs Act”), enacted on October 22, 2004, provides for a temporary 85% dividends-received deduction on certain foreign earnings repatriated to a U.S. taxpayer, provided certain criteria are met. FAS 109-2 provides accounting and disclosure guidance for the repatriation provision, and was effective immediately upon issuance. The Company has adopted the provisions of FAS 109-2. The Company is in the process of evaluating whether it will repatriate earnings under the repatriation provisions of the Jobs Act, and if so, the amount that will be repatriated; therefore, as provided for in FAS 109-2, deferred tax liabilities have not been adjusted. The Company estimates the range of possible amounts of unremitted earnings under consideration is between $0 and $2,276. If the maximum amount of $2,276 were to be repatriated, the Company would accrue tax expense of approximately $434.

Share-Based Payment
In December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment” (SFAS 123R). SFAS 123R is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation”, and supersedes Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”. Among other items, SFAS 123R eliminates the use of the intrinsic value method of accounting, and requires companies to recognize the cost of employee services received in exchange for awards of equity instruments, based on the grant date fair value of those awards, in the financial statements. The effective date of SFAS 123R is the first annual reporting period beginning after June 15, 2005, which is the first quarter of 2006 for the Company.

      For disclosure purposes, the Company currently utilizes a standard option pricing model (i.e., Black-Scholes) to measure the fair value of stock options granted to employees. While SFAS 123R permits entities to continue to use such a model, the standard also permits the use of a “lattice” model. The Company will continue to utilize the Black-Scholes option pricing model to measure the fair value of its stock options.

      The Company expects to adopt SFAS 123R effective January 1, 2006. The Company is currently evaluating the impact that this adoption will have on the Company’s results of operations.

Variable Interest Entities
In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin (ARB) No. 51.” This interpretation clarifies the application of ARB No. 51, “Consolidated Financial Statements,” to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. In December 2003, the FASB revised FASB Interpretation No. 46 (FIN 46R).

      Under the provisions of FIN 46R, the Company is required to consolidate certain cemeteries and trust assets. Merchandise and service trusts and cemetery perpetual care trusts are considered variable interest entities because the trusts meet the conditions of paragraphs 5(a) and 5(b)(1) of FIN 46R. That is, as a group, the equity investors (if any) do not have sufficient equity at risk and do not have the direct or indirect ability through voting or similar rights to make decisions about the trusts’ activities that have a

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significant effect on the success of the trusts. FIN 46R requires the Company to consolidate merchandise and service trusts and cemetery perpetual care trusts for which the Company is the primary beneficiary (i.e., those for which the Company absorbs a majority of the trusts’ expected losses). The Company is the primary beneficiary of a trust whenever a majority of the assets of the trust are attributable to deposits of customers of the Company.

      Consolidation of Trusts: The Company implemented FIN 46R as of March 31, 2004, which resulted in the consolidation of the Company’s preneed funeral and cemetery merchandise and service trust assets and the Company’s cemetery perpetual care trusts. No cumulative effect of an accounting change was recognized by the Company as a result of the implementation of FIN 46R as it relates to the consolidation of the trusts. The implementation of FIN 46R affects certain line items on the Company’s consolidated balance sheet and statement of operations as described below; however, there is no impact to net income in the statement of operations as a result of the implementation. Additionally, the implementation of FIN 46R did not result in any net changes to the Company’s consolidated statement of cash flows; however, it does require certain financing and investing activities to be disclosed.

      Although FIN 46R requires consolidation of most of the merchandise and service and perpetual care trusts, it does not change the legal relationships among the trusts, the Company and its customers. In the case of merchandise and service trusts, the customers are the legal beneficiaries. In the case of cemetery perpetual care trusts, the Company does not have a legal right to the perpetual care trust assets. For these reasons, upon consolidation of the trusts, the Company recognizes non-controlling interests in its financial statements to reflect third party interests in these trusts in accordance with FASB Statement No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liability and Equity” (SFAS 150). The Company classifies deposits to merchandise and service trusts as non-controlling liability interests and classifies deposits to cemetery perpetual care trusts as non-controlling equity interests.

      The Company records cash received from customers that is payable to the trusts but not yet required to be deposited in the trusts as restricted cash in Deferred charges and other assets in its consolidated balance sheet. At March 31, 2005 and December 31, 2004, these pending deposits totaled $13,430 and $11,218, respectively. The Company continues to account for amounts received from customers prior to delivery of merchandise or services that are not required to be deposited in merchandise and service trusts as deferred revenue.

      Beginning March 31, 2004, the Company recognizes net realized investment earnings of the merchandise and service trusts and perpetual care trusts, as well as the related trustee investment expenses and taxes, within Other income, net. The Company then recognizes a corresponding expense within Other income, net representing the net realized earnings of those trusts that are attributable to the non-controlling interest holders. The corresponding credit for this expense is reflected in the Company’s consolidated balance sheet in Non-controlling interest in funeral and cemetery trusts for merchandise and service trusts or Non-controlling interest in perpetual care trusts for cemetery perpetual care trusts. The sum of these expenses recorded in Other income, net offset the net realized earnings of such trusts also recognized within Other income, net. Accordingly, the Company’s net income in the consolidated statement of operations is not affected by consolidation of the trusts in accordance with FIN 46R.

      To the extent the earnings of the trusts are distributed prior to the delivery of merchandise and/or services, a corresponding amount of non-controlling interest is reclassified to deferred revenue until the corresponding revenues are recognized. In the case of merchandise and service trusts, the Company recognizes as revenues amounts previously attributed to non-controlling interests and deferred revenues upon the performance of services and delivery of merchandise, including earnings accumulated in these trusts. In the case of the cemetery perpetual care trusts, distributable earnings are recognized in cemetery revenues to the extent of qualifying cemetery maintenance costs.

      Prior to the implementation of FIN 46R and the consolidation of the trusts, monies received from customers and deposited into merchandise and service trusts until maturity of the preneed contract were recorded as receivables due from trust assets. Upon implementation of FIN 46R, the Company replaced receivables due from trust assets with the trust assets, at market, to the extent the Company was required to consolidate the trusts.

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      An allowance for contract cancellation is provided based on historical experience. An allowance is no longer provided on the monies associated with the preneed contracts that are held in trust, currently recorded as trust assets, but previously recorded as receivables due from trust assets. As such, the amount has decreased since the implementation of FIN 46R.

      Both the merchandise and services trusts and the cemetery perpetual care trusts hold investments in marketable securities that are classified as available-for-sale by the Company under the requirements of Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (SFAS 115). In accordance with SFAS 115, available-for-sale securities of the trusts are recorded at fair value, with unrealized gains and losses excluded from earnings and initially recorded as a component of Accumulated other comprehensive income (loss) in the Company’s consolidated balance sheet. Using the guidance in EITF Topic D-41, “Adjustments in Assets and Liabilities for Holding Gains and Losses as Related to the Implementation of FASB Statement No. 115” (“Topic D-41”), unrealized gains and losses on available-for-sale securities of the trusts attributable to the non-controlling interest holders are not recorded as Accumulated other comprehensive income (loss), but are recorded as an adjustment to either Non-controlling interest in funeral and cemetery trusts or Non-controlling interest in perpetual care trusts. Therefore, unrealized gains and losses attributable to the non-controlling interest holders are reclassified from Accumulated other comprehensive income (loss) to either Non-controlling interest in funeral and cemetery trusts or Non-controlling interest in perpetual care trusts. The gross effect from applying Topic D-41 on the Company’s Accumulated other comprehensive income (loss) is disclosed in note eleven of the consolidated financial statements. However, the Company’s Accumulated other comprehensive income (loss) balance on the face of the balance sheet is ultimately not affected by consolidation of the trusts.

      Consolidation of Certain Cemeteries: Prior to December 31, 2003, the Company operated certain cemeteries in Michigan which the Company managed but did not own. During the Company’s evaluation of FIN 46R, the Company evaluated these cemeteries to determine whether such cemeteries were within the scope of FIN 46R. The investment capital of these cemeteries was financed by the Company in exchange for a long-term sales, accounting, and cash management agreement. In accordance with this agreement, the Company receives the majority of the cash flows from these cemeteries. Additionally, the Company absorbs the majority of these cemeteries’ expected losses and receives a majority of the cemeteries’ residual returns. As a result, the Company determined itself to be the primary beneficiary of these cemeteries and determined the long-term sales, accounting, and cash management agreement to be a variable interest as defined by FIN 46R. Given the circumstances above, the Company consolidated such cemeteries at March 31, 2004. The Company recognized an after tax charge of $13,475, representing the cumulative effect of an accounting change, as a result of consolidating these cemeteries. The results of operations and cash flows of these cemeteries are included in the Company’s consolidated statements of operations and cash flows beginning March 31, 2004. Excluding the cumulative effect of accounting change, the effect of consolidating these entities did not have a significant impact on the Company’s reported results of operations.

Pension Plans

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5. Debt
Debt was as follows:

      The Company’s consolidated debt had a weighted average interest rate of 7.02% at March 31, 2005 and December 31, 2004. Approximately 99% of the total debt had a fixed interest rate at March 31, 2005 and December 31, 2004.

Bank Credit Agreements
The Company’s bank credit agreement, which was executed on August 11, 2004 and matures in August of 2007, provides a total lending commitment of $200,000, including a sublimit of $175,000 for letters of credit. As of March 31, 2005, the Company has no cash borrowings under this credit facility, but has used it to support $62,042 of letters of credit. The new bank credit facility provides the Company with flexibility in terms of acquisitions, dividends and share repurchases. It is secured by the stock of the Company’s domestic subsidiaries and these domestic subsidiaries have guaranteed the Company’s indebtedness associated with this facility. The subsidiary guarantee is a guarantee of payment of the outstanding amount of the total lending commitment. It covers the term of the agreement, including extensions and totaled a maximum potential amount of $62,042 and $66,985 at March 31, 2005 and December 31, 2004, respectively. The facility contains certain financial covenants, including a minimum interest coverage ratio, a maximum leverage ratio, maximum capital expenditure limitations, minimum net worth requirements and certain cash distribution restrictions. Interest rates for the outstanding borrowings will be based on various indices as determined by the Company. The Company also pays a quarterly fee on the unused commitment, which ranges from 0.25% to 0.50%.

Debt Extinguishments and Reductions
In the first quarter of 2005, the Company purchased $7,131 aggregate principal amount of its 7.70% notes due 2009 in the open market. As a result of this transaction, the Company recognized a loss of $1,207 recorded in Loss on early extinguishment of debt, in the consolidated statement of operations.

      In March 2004, in connection with the sale of the Company’s funeral operations in France, mortgage notes and other debt was reduced by approximately $24,194 for capital lease obligations related to vehicles used in the French funeral operations.

Additional Debt Disclosures
At March 31, 2005 and December 31, 2004, the Company had deposited $14,638 and $26,707, respectively, in restricted, interest-bearing accounts that were pledged as collateral for various credit instruments and commercial commitments. They are included in Deferred charges and other assets in the consolidated balance sheet.

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6. Retirement Plans
The components of net periodic pension plan benefit cost for the three months ended March 31 were as follows:

7. Segment Reporting
The Company’s operations are both product based and geographically based, and the reportable operating segments presented below include funeral and cemetery operations. The Company’s geographic areas include North America and Other Foreign. In 2005, Other Foreign consists of the Company’s operations in Singapore, Germany and South America. In 2004, Other Foreign also included operations in France, which were disposed of in the first quarter of 2004. The Company conducts both funeral and cemetery operations in the North America and Other Foreign geographic areas.

      The Company has reclassified certain prior period amounts to conform to the current period presentation with no effect on previously reported results of operations, financial condition or cash flows.

      The Company’s reportable segment information is as follows:

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      The following table reconciles gross profit from reportable segments to the Company’s consolidated income from continuing operations before income taxes and cumulative effects of accounting changes:

      The Company’s geographic area information is as follows:

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      Included in the North America figures above are the following United States amounts:

      (a) Prior year amounts are as of December 31, 2004.

      Included in the Other Foreign figures above are the following France amounts:

      The changes in the carrying amounts of goodwill for the Company’s two segments are as follows:

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8. Supplementary Information
The detail of certain income statement accounts is as follows for the quarters ended March 31,

9. Commitments and Contingencies
Litigation
The Company is a party to various litigation matters, investigations and proceedings. For each of its outstanding legal matters, the Company evaluates the merits of the case, its exposure to the matter, possible legal or settlement strategies and the likelihood of an unfavorable outcome. If the Company determines that an unfavorable outcome is probable and can be reasonably estimated, it establishes the necessary accruals. Certain insurance policies held by the Company may reduce cash outflows with respect to an adverse outcome of certain of these litigation matters. The Company accrues such insurance recoveries when they become probable of being paid and can be reasonably estimated. The following discussion describes certain litigation and proceedings as of May 13, 2005.

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      Conley Investment Counsel v. Service Corporation International, et al; Civil Action 04-MD-1609; In the United States District Court for the Southern District of Texas, Houston Division (the 2003 Securities Lawsuit). The 2003 Securities Lawsuit resulted from the transfer and consolidation by the Judicial Panel on Multidistrict Litigation of three lawsuits—Edgar Neufeld v. Service Corporation International, et.al,; Cause No. CV-S-03-1561-HDM-PAL; In the United States District Court for the District of Nevada; and Rujira Srisythemp v. Service Corporation International, et. al.; Cause No. CV-S-03-1392-LDG-LRL; In the United States District for the District of Nevada; and Joshua Ackerman v. Service Corporation International, et. al.; Cause No. 04-CV-20114; In the United States District Court for the Southern District of Florida. The 2003 Securities Lawsuit names as defendants the Company and several of the Company’s current and former executive officers or directors. The 2003 Securities Lawsuit is a purported class action alleging that the defendants failed to disclose the unlawful treatment of human remains and gravesites at two cemeteries in Fort Lauderdale and West Palm Beach, Florida. Since the action is in its preliminary stages, no discovery has occurred, and the Company cannot quantify its ultimate liability, if any, for the payment of damages. The Company intends to aggressively defend itself in the 2003 Securities Lawsuit.

      David Hijar v. SCI Texas Funeral Services, Inc., SCI Funeral Services, Inc., and Service Corporation International.; In the County Court of El Paso, County, Texas, County Court at Law Number Three; Cause Number 2002-740, with an interlocutory appeal pending in the El Paso Court of Appeals, No. 08-05-00182-CV (Hijar Lawsuit). The Hijar Lawsuit is a state-wide class action brought on behalf of all persons, entities and organizations who purchased funeral services from the Company or its subsidiaries in Texas at any time since March 18, 1998. Plaintiffs allege that federal and Texas funeral related regulations and/or statutes (Rules) required the Company to disclose its markups on all items obtained from third parties in connection with funeral service contracts and that the failure to make certain disclosures of markups resulted in breach of contract and other legal claims. The Hijar Lawsuit seeks to recover an unspecified amount of monetary damages. The plaintiffs also seek attorneys’ fees, costs of court, pre- and post-judgment interest, and unspecified “injunctive and declaratory relief.” The Company denies that plaintiffs have standing to sue for violations of the Texas Occupations Code, denies that any breaches of contractual terms occurred, and otherwise and on other grounds denies liability on all of the plaintiffs’ claims. Finally, the Company denies that the Hijar Lawsuit satisfies the requirements for class certification.

      Each side in the Hijar Lawsuit filed motions to summarily establish that its interpretation of the Rules was correct, and the judge has ruled in favor of the plaintiffs. This ruling allows the plaintiffs to proceed with the case. The trial court entered an order certifying the class and two subclasses on April 15, 2005. On April 29, 2005, the trial court entered an order imposing sanctions against the Company and (i) finding that the Company breached its contracts by failing to disclose that funeral goods and services were purchased from third parties and resold to customers at higher prices, and by failing to disclose the amount of price mark-ups, and (ii) approving a damage calculation methodology proposed by the plaintiffs under which the damages would equal the difference between the costs to the Company of items of funeral goods and services purchased from third parties and the price at which they were resold to persons arranging funerals, minus any legally proper off-sets. On April 29, 2005, pursuant to section 51.014(a)(3) of the Texas Civil Practice and Remedies Code, the Company filed a notice of appeal regarding the trial court’s order certifying a class, and it appears from section 51.014(b) that this interlocutory appeal “also stays all other proceedings in the trial court pending resolution of that appeal.” In response to requests from the District Clerk and the court reporters responsible for preparing the appellate record, the El Paso Court of Appeals has extended the deadline for filing the Clerk’s Record to May 29, 2005 and the deadline for filing the Reporter’s Records to June 23, 2005. The briefing schedule does not begin until the last of these records is filed.

      The ultimate outcome of the Hijar Lawsuit cannot be determined at this time. An adverse decision in the Hijar Lawsuit could have a material adverse effect on the Company, its financial condition, results of operation and cash flows. However, the Company intends to aggressively defend this lawsuit and pursue the pending interlocutory appeal.

      Mary Louise Baudino, et al v. Service Corporation International, et al; the plaintiffs’ counsel in the Hijar Lawsuit initiated an arbitration claim raising similar issues in California and filed in November 2004 a case styled Mary Louise Baudino, et al v. Service Corporation International, et al; in Los Angeles County Superior Court; Case No. BC324007 (Baudino Lawsuit). The Baudino Lawsuit makes claims similar to those made in the Hijar lawsuit. However, the Baudino Lawsuit seeks a nation-wide class of

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plaintiffs. The Baudino Lawsuit is in its early stages and no discovery has been conducted. The ultimate outcome of the Baudino Lawsuit cannot be determined at this time. However, the Company intends to aggressively defend this action.

      Funeral Consumers Alliance, Inc. et al v. Service Corporation International et al; In the United States District Court for the Northern District of California; Case No. C0501804 (2005 Consumer Lawsuit). The 2005 Consumer Lawsuit, filed in May 2005, is a purported class action on behalf of all persons and entities who have purchased caskets in the United States. The suit names as defendants the Company and four other public companies involved in the funeral or casket industry. The plaintiffs allege that defendants violated federal and state antitrust laws by engaging in anticompetitive practices with respect to sales of caskets and overcharged for caskets. The 2005 Consumer Lawsuit seeks injunctions, an unspecified amount of monetary damages and treble damages. Since the 2005 Consumer Lawsuit is in its preliminary stages, no discovery has occurred and the Company cannot quantify its ultimate liability, if any, for the payment of damages. The Company intends to aggressively defend itself in this action.

10. Earnings Per Share
Basic (loss) earnings per share (EPS) excludes dilution and is computed by dividing net (loss) income by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other obligations to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the Company’s (loss) earnings.

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      A reconciliation of the numerators and denominators of the basic and diluted earnings per share computations is presented below:

      The computation of diluted (loss) earnings per share excludes outstanding stock options and convertible debt in certain periods in which the inclusion of such items would be antidilutive in the periods presented. Total options and convertible debt not currently included in the computation of dilutive (loss) earnings per share are as follows:

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11. Stockholders’ Equity
Stock Options
The Company accounts for employee stock-based compensation expense under the intrinsic value method. Under this method, no compensation expense is recognized on stock options if the grant price equals the market value on the date of grant.

      If the Company had elected to recognize compensation expense for its option plans based on the fair value method, net (loss) income and per share amounts would have changed to the pro forma amounts indicated below.

      The fair value of the Company’s stock options used to compute the pro forma net (loss) income and per share disclosures is determined by calculating the estimated fair value at grant date using the Black-Scholes option-pricing model.

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Accumulated Other Comprehensive (Loss) Income
The components of Accumulated other comprehensive (loss) income are as follows:

      The reclassification adjustment of $71,770 during the three months ended March 31, 2005 relates to the sale of the Company’s Argentina and Uruguay operations.

      The components of Comprehensive (loss) income are as follows:

Share Repurchase Program
On February 10, 2005, the Company announced an increase in the share repurchase program authorizing the investment of up to an additional $100,000 to repurchase its common stock for an aggregate authorized amount of $300,000. The Company, subject to market conditions and normal trading restrictions, makes purchases in the open market or through privately negotiated transactions. During the first quarter of 2005, the Company repurchased 14,651 shares of common stock at an aggregate cost of $103,570.

12. Gains and Impairment (Losses) on Dispositions
Gains and Impairment (Losses) on Dispositions for the Three Months Ended March 31, 2005 and 2004
As dispositions occur in the normal course of business, gains or losses on the sale of such businesses are recognized in the income statement line item Gains and impairment (losses) on dispositions, net. Additionally, as dispositions occur related to the Company’s ongoing asset sale programs, adjustments are made through this income statement line item to reflect the difference between actual proceeds received from the sale compared to the original estimates.

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      Gains and impairment (losses) on dispositions, net consists of the following:

Sale of French Operations
During 2004, the Company sold 100% of the stock of its French subsidiary to a newly formed company (NEWCO). In connection with this sale, the Company acquired a 25% share of the voting interest of NEWCO, received cash proceeds of $281,667, net of transaction costs, and received a note receivable in the amount of EUR 10,000. Also received in this transaction were EUR 15,000 of preferred equity certificates and EUR 5,955 of convertible preferred equity certificates. The Company accounted for the sale of its French subsidiary in accordance with the guidance set forth in EITF 01-2, “Interpretations of APB Opinion No. 29”, Issues 8(a) and 8(b). Consequently, the Company deferred approximately 25% of the gain associated with the sale of its French subsidiary representing the economic interest it retained in that subsidiary through its ownership of approximately 25% of NEWCO.

      The sale of stock of the Company’s French subsidiary in March 2004, resulted in a pretax gain of $12,639 and a non-cash tax benefit of $24,929 (described below) resulting in an after tax gain of $37,568. In July 2004, the Company paid $6,219 pursuant to the joint venture agreement, as a purchase price adjustment, which reduced the pretax gain to $6,420 and reduced the after tax gain to $33,624 as summarized below.

      The $24,929 non-cash tax benefit associated with the sale of the Company’s French subsidiary is primarily attributable to the reduction of tax accruals by $18,610, which were accrued as an indemnification liability upon the sale of the Company’s French subsidiary. The remaining amount of $6,319 was a non-cash tax benefit associated with the difference between book and tax basis.

      Included in the pretax gain, the Company recognized $35,768 of contractual obligations related to representations and warranties and other indemnifications resulting from the joint venture contract. During 2004, $2,400 in charges was applied to the indemnifications and related primarily to foreign taxes and legal expenses. The Company applied $772 to the indemnifications during the first quarter of 2005.

      Goodwill in the amount of $23,467 was removed from the Company’s consolidated balance sheet as a result of this transaction.

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      In the first quarter of 2005, the Company was informed that NEWCO completed a refinancing in May 2005 and is expected to complete an additional refinancing during the third quarter of 2005 in order to reduce its cost of debt. Expected to be included in this refinancing is the note payable to the Company in the amount of EUR 10,000 plus interest and the redemption of the Company’s investment in preferred equity certificates and convertible preferred equity certificates totaling EUR 20,955 plus interest. The Company has recorded interest income of $2,379 related to interest on these preferred equity certificates and convertible preferred equity certificates as of March 31, 2005. The Company’s investment in common stock and 25% voting interest is expected to remain unchanged as a result of this transaction.

Proceeds from Investment in United Kingdom Company

      During the second quarter of 2004, the Company received proceeds of $53,839 from the sale of its minority interest equity investment in the United Kingdom and the prepayment of its note receivable, with accrued interest, following a successful public offering transaction of its United Kingdom company.

Sale of Argentina and Uruguay Operations
During the second quarter of 2004, the Company recorded an impairment of its funeral and cemetery operations in Argentina in the amount of $15,189 recorded in Loss from discontinued operations in the consolidated statement of operations. As a result of the sale of the Argentina and Uruguay businesses in 2005, the Company recorded a gain of $2,041 in Income from discontinued operations in the consolidated statement of operations in December 2004 associated with the revised estimated fair value. The new carrying amount reflected the fair value based on current market conditions less costs to sell. Additionally, the Company recognized a non-cash tax benefit of $49,236 in discontinued operations during the second quarter of 2004, which represents the reduction of a previously recorded valuation allowance. The Company also recognized an additional tax benefit of $2,629 in discontinued operations during the fourth quarter of 2004, which represents the revised estimated fair value and differences between book and tax basis.

13. Discontinued Operations
The Company committed to a plan during the second quarter of 2004 to divest its existing funeral and cemetery operations in Argentina and Uruguay. Accordingly, these operations are classified as discontinued operations for all periods presented. The provision for income taxes in the amount of $594 in the first quarter of 2005 results from a state net operating loss valuation allowance and a tax accrual release. During the first quarter of 2005, the Company disposed of its operations in Argentina and Uruguay.

      The results of the Company’s discontinued operations for the three months ended March 31, 2005 and 2004 were as follows:

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

Introduction
At March 31, 2005, Service Corporation International (SCI or the Company) operated 1,190 funeral service locations (1,169 in North America) and 393 cemeteries (390 in North America). We also had a 25% minority interest equity investment in funeral operations in France. We also own Kenyon International Emergency Services, a disaster response team that engages in mass fatality and emergency response services.

      Our funeral and cemetery operations are organized into a North America division covering the United States and Canada, and an Other Foreign division including operations in Chile, Germany and Singapore. In 2004, our Other Foreign division also included operations in France, which were disposed of in the first quarter of 2004. For the quarter ended March 31, 2005, our North America operations represented approximately 97.6% of our consolidated revenues and approximately 96.9% of our consolidated gross profits.

      Our operations in the North America division are organized into 32 major markets and 42 middle markets. Each market is led by a market director with responsibility for funeral and cemetery operations and preneed sales. Within each market, the funeral homes and cemeteries realize efficiencies by sharing common resources such as personnel, preparation services and vehicles. There are four market support centers in North America to assist market directors with financial, administrative and human resource needs. These support centers are located in Houston, Miami, New York and Los Angeles. The primary functions of the market support centers are to help facilitate the execution of corporate strategies, coordinate communications between the field and corporate offices and serve as liaisons for implementation of policies and procedures.

Our Competitive Strengths

      Geographically diverse network. We operate businesses in North America in 44 states and seven Canadian provinces. We believe we are able to provide funeral services to more than 70% of the households in the United States. We believe this comprehensive national coverage enables us to be the only company in our industry to successfully implement a national branding strategy and to develop alliances with national strategic partners.

      National branding strategy. In 2000, we launched the first national branding strategy in the funeral service industry in North America under the name Dignity Memorial^®. While this branding process is intended to emphasize our seamless national network of funeral service locations and cemeteries, the original names associated with acquired locations generally remain the same. The Dignity Memorial^® brand name is a co-brand to the existing name of the business. Signage, advertising and promotional efforts emphasize both names. We believe that a national brand gives us a competitive advantage.

      Favorable demographics over the long term. The population is aging at an unprecedented rate. According to the U.S. Census Bureau, the number of persons 65 years or older totaled 36 million in 2003. They represented 12.3% of the population, or about one in every eight Americans. The number of Americans aged 65 and older is expected to climb to approximately 16% of the total population by 2020, and to approximately 20% by 2030. Approximately 75% of all deaths in the United States are at ages 65 and older. We believe these demographic trends will provide a growing demand in the future for our services on both an atneed and preneed basis.

      Stable revenues and cash flows. Our core business can be described as stable, with relatively predictable revenue and cash flows on an annual basis. We believe our ability to consistently generate strong cash flows sets us apart from others in the industry. This stability is enhanced by a large backlog of future revenues associated with preneed funeral and cemetery sales. In North America, our backlog

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of preneed funeral and cemetery sales consists of more than $5 billion of revenues that will be recognized in future periods. These unfulfilled preneed funeral and cemetery contracts are primarily supported by investments in trust funds which are included in our consolidated balance sheet or third party insurance policies, which are not included in our consolidated balance sheet.

      Financial flexibility. We believe we have significant opportunities to grow shareholder value due to our strong cash flows and liquidity, and modest debt maturities in the near term. For a further discussion about our financial flexibility, please see Financial Condition, Liquidity and Capital Resources in Item 2 of this Form 10-Q.

Business Challenges

      Increasing trend toward cremation. In North America, social trends, such as a mobile, less rooted society, religious changes, environmental issues and cultural preferences are driving an increasing preference for cremation. SCI is the largest provider of cremation services in North America where approximately 40% of the total funeral services we perform are cremation services. The mix of cremation in our business has been increasing approximately 100 to 150 basis points each year and we expect this trend to continue in the near term. Cremation services historically have generated less revenue and gross profit dollars than traditional funeral services that involve burials. Additionally, the cremation consumer may choose not to purchase cemetery property or merchandise. Industry research has shown that most consumers choose cremation for reasons other than cost, which we believe provides us significant opportunities to better serve the cremation consumer. We believe we are well positioned to respond to this trend and have experienced initial success through the use of contemporary marketing strategies and unique product and service offerings that specifically appeal to cremation consumers. See a further discussion regarding initiatives to address cremation as part of our long-term revenue growth opportunities described below.

The Path to Growth
We have taken significant actions in recent years to improve our infrastructure and reduce overhead costs as further described below. In doing so, we believe we have now established a solid platform for future growth. We believe strategies centered on our national brand, Dignity Memorial^®, and other revenue growth initiatives, along with a continued focus on cost management, will provide the framework for sustainable growth over the longer term.

Improving the Infrastructure
Historically, our infrastructure did not allow us to fully realize the inherent efficiencies of our business organization. As a result, we were unable to capitalize on all of the benefits of standardization, technology, and process improvement. Beginning in late 2002 and continuing through 2003, we moved to reduce fixed costs by reformulating our infrastructure. We redesigned our sales organization, improved business and financial processes, and outsourced certain of our accounting functions. In 2003 and continuing through 2004, we implemented a new information system in our field locations. In November 2003, we eliminated the dual management structures of sales and operations and replaced them with a single-line business management structure while also improving our corporate support system by establishing market support centers.

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Building the Brand
SCI has implemented the first national brand in the funeral service industry. This brand is called Dignity Memorial^®. We believe that a national brand name will provide us access to new customers over the long term given the increasingly mobile nature of families in North America. Internally, we are focused on ensuring that we have consistency in service standards and processes across our network of businesses.

      Externally, we continue to enhance signage and local advertising efforts using the Dignity Memorial^® name and logo. Through our national brand we are the sponsor of several nationally recognized community programs. We also have a national advertising and marketing campaign to promote awareness of our brand name throughout North America that focuses on the distinct benefits and values that set Dignity Memorial^® apart from other providers.

Growing Our Revenues
We have made significant improvements to our cost structure in the last two years; however, we realize that to achieve sustainable long-term earnings growth, we must also increase our revenues. We believe we can be successful in this regard by developing the Dignity Memorial^® brand and focusing on our customers’ concerns and satisfaction.

      Through our Dignity Memorial^® brand we are developing more contemporary and comprehensive products and services that we believe will help the consumer create a personal experience as well as help them with the administrative and legal challenges that occur when a loved one dies. Some of the exclusive items offered through Dignity Memorial^® providers include special rates on airfare, care rentals and hotel accommodations; grief counseling services; a legal services membership; internet memorial archive capabilities through Making Everlasting Memories^®, or MeM^® (www.mem.com); and the Aftercare^® Planner — a comprehensive organization system that helps families manage the many business details that arise after a death occurs. Importantly, these products and services appeal to both burial and cremation consumers.

      We are also focused on offering consumers new ways to personalize funeral services and create value in the experience. Examples include creating movies from pictures that span the person’s life and important events; displaying items that were special to the individual or that reflect a hobby; having a dove, butterfly or balloon release; or holding a memorial service in a favorite place such as a park, marina or sports venue.

Near-Term Revenue Growth Opportunities
Dignity Memorial^® packaged plans. Our national brand name represents a unique set of packaged funeral and cremation plans offered exclusively through our network on an at need and preneed basis. These packages are designed to simplify customer decision-making and include the unique value-added products and services described above that have traditionally been unavailable through funeral service locations. The plans also offer the security of a 100% service guarantee and national transferability of preneed services to any Dignity Memorial^® provider in North America. We continue to receive positive feedback from consumers regarding the value of these packages. In addition, when Dignity Memorial^® packages are sold, it results in significant incremental revenue and gross profit margin per funeral service compared to non-packaged sales due to the comprehensive product and service offerings these packages provide.

      In early 2005, we began to develop Dignity Memorial® packaged cemetery plans. These plans are being tested in a limited number of locations. After completing a successful test, we intend to begin the roll-out of this packaged plan initiative to our cemeteries in mid-2005.

Contemporary funeral merchandising strategies. We believe we can increase the selection rate of the Dignity^® packaged plans through improved merchandising strategies that place less emphasis on traditional funeral merchandise and more focus on the comprehensive product and service offerings unique to Dignity Memorial^® providers. In late 2004, we began to roll-out enhanced merchandise displays and other presentation models in our funeral homes that offer personalization options. In addition, funeral personnel at each of these locations have completed a comprehensive training and certification program to ensure their effectiveness and optimal customer satisfaction.

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Contemporary cemetery marketing strategies. We are beginning to use more contemporary marketing techniques within our cemetery segment. We have begun to employ a tiered-product model that emphasizes a wide range of product and service offerings, including a variety of grave spaces at various price levels, cremation gardens, mausoleums, lawn crypts and niches. We are particularly focused on the development of high-end cemetery property such as private family estates.

      In late 2004, we also developed and began to implement a standardized pricing methodology for each of our cemeteries. This approach incorporates marketplace demographic information and data about competitive cemeteries in the market, as well as historical retail and wholesale prices. This new pricing methodology complements our tiered-product strategy and ensures that we are capturing appropriate values for the different levels of our products.

Improved management structure. In late 2003, we eliminated the dual management structures of sales and operations and replaced them with a single-line business management structure. In addition to reducing costs, this new structure is intended to have our strongest business managers focused on producing favorable financial results in each of our markets. Under the old structure, multiple persons shared accountability and responsibility for financial results in multiple markets. Now accountability rests solely in the market director in charge of the geographical area that he or she manages. Under the new structure, many of the administrative and financial functions are now handled by market support centers. We believe this new structure allows for greater focus on developing people, growing market share, and improving profitability.

Preneed sales. At March 31, 2005, the backlog of revenues associated with unfulfilled preneed contracts sold for funeral and cemetery merchandise and services in North America totaled more than $5 billion. This includes deferred revenues associated with insurance funded contracts which are not included in the Company’s consolidated balance sheet. We believe that the sale of preneed goods and services is a primary driver of maintaining and growing market share. It also provides a level of predictability and stability to our revenues and cash flows. An important advantage of SCI preneed sales for consumers, besides protecting them from having to make important decisions at a difficult time and locking in prices at today’s level, is the ability to transfer preneed contracts to funeral homes and cemeteries throughout our geographically diverse network of properties.

Long-Term Revenue Growth Opportunities
Enhancing cremation opportunities. To grow core revenues and profits, we believe we must capitalize on the opportunities provided by the growing cremation trend. We believe a successful cremation strategy is built on product differentiation, personalization and simplicity. Along with the sale of Dignity Memorial^® cremation plans, we are developing new displays to be used in the arrangement process that clearly explain the products and services available to cremation consumers. We also own and operate National Cremation^®, which specifically targets the cremation consumer. Within the cemetery segment, we are promoting cremation gardens, which are separate sections located within certain of our cemeteries where cremated remains can be permanently placed and which contain other unique memorialization products.

Developing access to new customers. We believe that SCI has opportunities to grow market share due to its size and geographic diversity. We believe that a national brand name will provide us access to new customers over the long term. We will continue to capitalize on our nationwide network of providers to develop affinity relationships with large groups of individuals to whom we can market our products and services. We are also developing marketing strategies that will target growing segments of the population.

Expanding through acquisition, construction, or franchise. We are targeting expansion through acquisition or construction in the top 150 markets in North America where probable investment returns will exceed our cost of capital. We will focus future growth capital deployment in the major metropolitan markets where there is a large population base. We intend to focus construction efforts on developing combination operations by building funeral homes on our existing cemeteries. Combination operations create synergies between funeral and cemetery functions and provide consumers the convenience of making all arrangements at a single location.

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      Over the longer term, the potential for a franchising opportunity exists for further expansion in the smaller markets. In a franchise relationship we could recruit independent funeral providers to join the Dignity Memorial^® network and earn fees for a comprehensive range of services that we could provide to the franchisee — all at very little or no capital cost to us.

Focusing on employee development and customer satisfaction. We have developed a comprehensive education strategy in an online campus format called Dignity University™. Dignity University™ features job-focused curriculum for each position in the company. Upon completion of coursework, participants are required to pass examinations to be certified in their individual jobs. Dignity University™ uses a blended approach to learning using a combination of traditional classroom, web-based courses, virtual classroom and on-the-job training for the approximately 19,000 individuals that we employ in North America.

      We have recently partnered with J.D. Power and Associates, one of the world’s premier marketing firms specializing in customer satisfaction, to assist us with better understanding and measuring feedback from our consumers. We launched new customer surveys in March 2005. Our new survey to client families utilizes a combined approach — measuring satisfaction and loyalty and the relationship between the two.

Becoming the preplanning experts. As the Baby Boom generation ages, many are becoming more aware of their own mortality or facing their parents’ approaching need for funeral and burial arrangements. While research indicates high public approval of the pre-planning concept, the percentage of North Americans who have actually completed such arrangements is quite small.

      Historically we have focused on preplanning and prefunding funeral arrangements. Our focus for the long-term is developing a comprehensive marketing strategy to give consumers the opportunity to make the decisions about their funeral and to choose a Dignity Memorial^® funeral provider — without paying in advance if they choose not to do so.

Critical Accounting Policies and Accounting Changes
Deferred Selling Costs
Effective January 1, 2005, we changed our method of accounting for direct selling costs incurred related to the acquisition of preneed funeral and preneed cemetery contracts. Prior to this change, we capitalized such direct selling costs and amortized the costs in proportion to the revenue recognized. Under the new method of accounting, we expense these direct selling costs as incurred. We believe the new method is preferable because it better reflects the economics of the business.

      The direct selling costs were capitalized based on deferral rates that we established and varied by preneed funeral contracts and preneed cemetery items, based on the ratio of the direct selling compensation and related fringe costs to preneed funeral and cemetery production. We did not attribute deferred selling costs to each individual contract (or each item in the case of cemetery deferred selling costs). Management believed that using the proportionate method of amortization allowed for a systematic match of costs with related revenues given the relatively homogenous nature of the preneed funeral and preneed cemetery contract items. However, management believes that expensing direct selling costs as incurred is preferable as expensing such costs is consistent with Statement of Position 93-7 “Reporting on Advertising Costs” for similar types of items, given that we do not maintain direct selling costs by individual contract or item.

      Prior to the accounting change, we allocated significant employee resources to accounting for deferred selling costs and did not maintain deferred selling costs at a contract level or item detail in order to exactly amortize the item level costs when the associated revenue was appropriately recognized. We believe that expensing these selling costs as incurred is the preferable method of accounting for the reasons noted above and because it eliminates the burden of maintaining deferred selling cost records.

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      Finally, we manage our business based on free cash flow. Management believed that expensing these deferred selling costs was preferable as it better aligns the costs of obtaining the preneed funeral and preneed cemetery contract with the cash outflows associated with obtaining such contracts.

      As of January 1, 2005, we recorded a cumulative effect of $187.5 million, net of tax of $117.4 million. This amount represents the cumulative balance of deferred selling costs recorded on our consolidated balance sheet in Deferred charges and other assets at the time of the accounting change. If we had not changed our method of accounting for direct selling costs as described above, net income for the first quarter of 2005 would have been $2.3 million after tax or $.01 per basic and diluted share higher than currently reported.

      The three months ended March 31, 2004 pro forma amounts in the table below reflect the new policy to expense selling costs as incurred. The effect of the change for the quarter ended March 31, 2004 would have decreased net income from continuing operations before cumulative effects of accounting changes by approximately $2.8 million after tax or $.01 per basic and diluted share.

(1)	Represents net deferred selling costs that would have been recognized under the new method of accounting adopted on January 1, 2005.