SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

OR

Commission file number 1-6089

H&R BLOCK, INC.

4400 Main Street
Kansas City, Missouri 64111
(Address of principal executive offices, including zip code)

(816) 753-6900
(Registrant’s telephone number, including area code)

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

Yes   [ü]   No [   ]

The number of shares outstanding of the registrant’s Common Stock, without par value, at the close of business on February 27, 2004 was 174,970,755 shares.

Table of Contents

TABLE OF CONTENTS

H&R BLOCK, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
Amounts in thousands, except share amounts

See Notes to Condensed Consolidated Financial Statements

-1-

H&R BLOCK, INC.
CONDENSED CONSOLIDATED INCOME STATEMENTS
Unaudited, amounts in thousands, except per share amounts

See Notes to Condensed Consolidated Financial Statements

-2-

H&R BLOCK, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Unaudited, amounts in thousands

See Notes to Condensed Consolidated Financial Statements

-3-

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Unaudited, dollars in thousands, except per share amounts

1.		Basis of Presentation
		The condensed consolidated balance sheet as of January 31, 2004, the condensed consolidated income statements for the three and nine months ended January 31, 2004 and 2003, and the condensed consolidated statements of cash flows for the nine months ended January 31, 2004 and 2003 have been prepared by the Company, without audit. In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position, results of operations and cash flows at January 31, 2004 and for all periods presented have been made.
		Certain reclassifications have been made to prior year amounts to conform to the current year presentation. These reclassifications had no effect on the results of operations or stockholders’ equity as previously reported.
		Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted. These condensed consolidated financial statements should be read in conjunction with the financial statements and notes thereto included in the Company’s April 30, 2003 Annual Report to Shareholders on Form 10-K.
		Operating revenues of the U.S. Tax Operations, Business Services and International Tax Operations segments are seasonal in nature with peak revenues occurring in the months of January through April. Therefore, results for interim periods are not indicative of results to be expected for the full year.
		The Company files its Federal and state income tax returns on a calendar year basis. The condensed consolidated income statements reflect the effective tax rates expected to be applicable for the respective full fiscal years.
2.		Business Combinations
		During the nine months ended January 31, 2004, cash payments of $243,257 were made related to the acquisition of assets and stock in the franchise territories of ten former major franchisees. The preliminary allocation of the purchase price to assets acquired is as follows: property and equipment of $2,697; goodwill of $194,883; customer relationships of $18,167; noncompete agreements of $17,069; and $10,441 related to legal reserves for franchise litigation. The customer relationships will be amortized in conjunction with the estimated retention curve over ten years. The noncompete agreements will be amortized on a straight-line basis over three years. The weighted average life of the intangible assets is approximately seven years. Goodwill recognized in these transactions is included in the U.S. Tax Operations segment and all but $3,901 is deductible for tax purposes. Results related to these ten former major franchise territories have been included in the accompanying condensed consolidated financial statements since the respective dates company-owned operations commenced. See discussion related to

-4-

		litigation involving major franchisees in note 12 to the condensed consolidated financial statements.
3.		Earnings Per Share
		Basic earnings per share is computed using the weighted average shares outstanding during each period. The dilutive effect of potential common shares is included in diluted earnings per share. The computations of basic and diluted earnings per share are as follows:

		Diluted earnings per share excludes the impact of shares of common stock issuable upon the exercise of options to purchase 283 shares and 3.7 million shares of stock for the three and nine months ended January 31, 2004, respectively, as the options’ exercise prices were greater than the average market price of the common shares during those periods and therefore, the effect would be antidilutive. Diluted earnings per share for the three and nine months ended January 31, 2003 excludes the impact of 4.7 million shares and 2.1 million shares, respectively, issuable upon the exercise of stock options as they are antidilutive.
		The weighted average shares outstanding for the three and nine months ended January 31, 2004 decreased to 176.7 million and 178.0 million, respectively, from 178.8 million and 179.6 million last year, respectively, primarily due to the purchase of treasury shares by the Company. The effect of these purchases was partially offset by the issuance of treasury shares related to the Company’s stock-based compensation plans.
		During the nine months ended January 31, 2004, the Company issued 3.8 million shares of common stock pursuant to the exercise of stock options, employee stock purchases and awards of restricted shares, in accordance with the Company’s stock-based compensation plans. During the nine months ended January 31, 2003, the Company issued 4.4 million shares of common stock

-5-

		pursuant to the exercise of stock options, employee stock purchases and awards of restricted shares.
		During the nine months ended January 31, 2004, the Company acquired 7.8 million shares of its common stock at an aggregate cost of $371,242. During the nine months ended January 31, 2003, the Company acquired 6.6 million shares of its common stock at an aggregate cost of $317,608.
4.		Receivables
		Receivables consist of the following:

5.

Mortgage Banking Activities

Activity related to available-for-sale residual interests in securitizations for the nine months ended January 31, 2004 and 2003 and the twelve months ended April 30, 2003 consists of the following:

-6-

		The Company sold $16,940,590 and $12,412,587 of mortgage loans in whole loan sales to third-party trusts (Trusts) or other buyers during the nine months ended January 31, 2004 and 2003, respectively, with gains totaling $590,941 and $497,457, respectively, recorded on these sales.
		Residual interests valued at $199,021 and $326,395 were securitized in net interest margin (NIM) transactions during the respective nine-month periods. Net cash proceeds of $197,417 and $325,642 were received from the NIM transactions for the nine months ended January 31, 2004 and 2003, respectively. Total net additions to residual interests from NIM transactions for the nine months ended January 31, 2004 and 2003 were $1,604 and $753, respectively.
		At January 31, 2004, the Company had $52,564 of residual interests classified as trading securities. These residual interests are included in marketable securities – trading on the condensed consolidated balance sheet. There were no such trading securities recorded as of April 30, 2003.
		In the second quarter of fiscal year 2004, the Company completed a NIM transaction with a special purpose entity (SPE) that did not meet the criteria for a qualifying special purpose entity (QSPE) under Statement of Financial Accounting Standards No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” As a result, the SPE was consolidated and the transaction was accounted for as a secured financing (on-balance sheet securitization). During the third quarter, the NIM trust was terminated and the related residual interests were subsequently securitized in a NIM transaction with a QSPE.
		Cash flows of $127,997 and $117,522 were received from the securitization trusts for the nine months ended January 31, 2004 and 2003, respectively. An additional $17,000 and $142,486 was received during the nine months ended January 31, 2004 and 2003, respectively, as a result of the sale of previously securitized residuals. Cash received on residual interests is included in investing activities in the condensed consolidated statements of cash flows.
		Residual interests are classified as either available-for-sale (AFS) or trading securities and are therefore reported at fair market value (based on discounted cash flow models). Unrealized holding gains represent the write-up in value of AFS residual interests as a result of actual or projected performance factors that are better than the projected assumptions previously used in the Company’s valuation models, such as interest rates, loan losses or loan prepayments. Trading securities are marked-to-market through the income statement.
		Aggregate net unrealized gains on residual interests, which had not yet been accreted into income, totaled $107,066 at January 31, 2004 and $98,089 at April 30, 2003. These unrealized gains are recorded net of deferred taxes in other comprehensive income, and may be recognized in income in future periods either through accretion or upon further securitization or sale of the related residual interest.
		In connection with securitization transactions, the Company, as servicer, generally has a 10% clean-up call option, whereby the Company, at its discretion, may repurchase the outstanding loans in the securitization once the current value of the loans is 10% or less of their original

-7-

		value. During the nine months ended January 31, 2004, the Company exercised call options on residual interests initially recorded in 1996 and 1999. The outstanding loans were repurchased from the securitization trust, and the proceeds were used to pay off the remaining bondholders. These repurchased loans may be included in future sale transactions. At the time the call options were exercised, the book value of the corresponding residual interests was $5,875.
		Activity related to mortgage servicing rights (MSRs) consists of the following:

The key assumptions the Company used to estimate the cash flows and values of residual interests in securitizations initially recorded during the three months ended January 31, 2004 are as follows:

The following table illustrates key assumptions the Company used to estimate the cash flows and values of residual interests and MSRs held at January 31, 2004:

-8-

At January 31, 2004, the sensitivities of the current fair value of the residual interests and MSRs to 10% and 20% adverse changes in the above key assumptions are as follows:

These sensitivities are hypothetical and should be used with caution. Changes in fair value based on a 10% variation in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. Also in this table, the effect of a variation of a particular assumption on the fair value of the retained interest is calculated without changing any other assumptions. It is likely that changes in one factor may result in changes in another, which might magnify or counteract the sensitivities.

-9-

6.		Intangible Assets and Goodwill
		Intangible assets consist of the following:

Amortization of intangible assets for the three and nine months ended January 31, 2004 was $15,286 and $39,265, respectively. Amortization of intangible assets for the three and nine months ended January 31, 2003 was $11,085 and $33,322, respectively. Estimated amortization of intangible assets for fiscal years 2004 through 2008 is $53,284, $52,342, $51,313, $42,506 and $40,897, respectively.

Changes in the carrying amount of goodwill for the nine months ended January 31, 2004, consist of the following:

Preliminary additions to goodwill for U.S. Tax Operations include $194,883 related to asset and stock acquisitions involving former major franchise territories and other acquisitions of $6,371. Additions to goodwill for Business Services primarily result from the final contingent payment related to the acquisition of the non-attest assets of McGladrey & Pullen, LLP of $26,685.

The Company tests goodwill for impairment annually at the beginning of its fourth quarter, or more frequently if events occur that indicate a potential reduction in the fair value of a reporting

-10-

unit’s net assets below its carrying value. During the nine months ended January 31, 2003, a goodwill impairment charge of $24,000 was recorded for the Investment Services segment. No such impairment or events indicating potential impairment have been identified within any of the Company’s segments during the nine months ended January 31, 2004.

7.		Derivative Instruments
		The Company, in the normal course of business, enters into commitments with its customers to fund mortgage loans for specified periods of time at “locked-in” interest rates. These financial instruments represent commitments (rate-lock equivalent) to fund loans. The estimated fair value of these rate-lock equivalents is determined based on the difference in the value of the commitments to fund loans between the date of commitment and the date of valuation, taking into consideration the probability of the commitments being exercised and changes in other market conditions. At January 31, 2004 and April 30, 2003, the Company recorded assets totaling $8,620 and $12,531, respectively, in prepaid expenses and other current assets on the condensed consolidated balance sheets related to these commitments. See related discussion of Staff Accounting Bulletin No. 105, “Application of Accounting Principles to Loan Commitments,” (SAB 105) in note 14.
		The Company, in the normal course of business, enters into interest rate caps to mitigate interest rate risk and to enhance the marketability of NIM transactions. As of January 31, 2004 the Company held $52,564 in residual interests – trading securities. The Company elected not to securitize the residuals in a NIM transaction prior to quarter end. Therefore, an interest rate cap valued at $9,376 has been included in other assets on the condensed consolidated balance sheet related to these trading residual interests. The interest rate cap will be marked-to-market monthly through the income statement. The net adjustment to trading securities and the interest rate cap in the condensed consolidated income statements was zero for the three and nine months ended January 31, 2004.
		The Company entered into an agreement with Household Tax Masters, Inc. (Household) during fiscal year 2003, whereby the Company waived its right to purchase any participation interests in and receive license fees relating to RALs during the period January 1 through April 30, 2003. In consideration for waiving these rights, the Company received a series of payments from Household, subject to certain adjustments based on delinquency rates on RALs made by Household through December 31, 2003. This adjustment provision was accounted for as a derivative and was marked-to-market monthly through December 31, 2003. Accordingly, during the three and nine months ended January 31, 2004, the Company recognized $988 and $6,548, respectively, of revenues related to this instrument. The final settlement in accordance with this agreement was received in January 2004. A receivable of $5,171 was included on the condensed consolidated balance sheet as of April 30, 2003.

-11-

8.		Comprehensive Income
		The Company’s comprehensive income is comprised of net income, the change in net unrealized gain on marketable securities and foreign currency translation adjustments. The components of comprehensive income for the three and nine months ended January 31, 2004 and 2003 are:

9.

Stock-Based Compensation

Prior to fiscal year 2004, the Company accounted for stock-based compensation plans under the recognition and measurement provisions of APB Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25) as allowed under Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (SFAS 123). Effective May 1, 2003, the Company adopted the fair value recognition provisions of SFAS 123, under the prospective transition method as described in Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure” (SFAS 148). Had compensation cost for all stock-based compensation plan grants been determined in accordance with the fair value accounting method prescribed under SFAS 123, the Company’s net income and earnings per share for the three and nine months ended January 31, 2004 and 2003 would have been as follows:

-12-

10.		Supplemental Cash Flow Information
		During the nine months ended January 31, 2004, the Company paid $245,355 and $57,458 for income taxes and interest, respectively. During the nine months ended January 31, 2003, the Company paid $176,168 and $55,193 for income taxes and interest, respectively.
		During the nine months ended January 31, 2004 and 2003, the Company characterized the following as non-cash investing activities:

11.

Commitments and Contingencies

The Company offers guarantees under its Peace of Mind (POM) program to tax clients whereby the Company will assume the cost of additional tax assessments attributable to tax return preparation error for which the Company is responsible. The Company defers the revenue and direct costs associated with these guarantees, recognizing these amounts over the term of the guarantee based upon historic and actual payment of claims. The related current asset and liability are included in prepaid expenses and other current assets and accounts payable, accrued expenses and other, respectively, on the condensed consolidated balance sheets. The related noncurrent asset and liability are included in other assets and other noncurrent liabilities, respectively, on the condensed consolidated balance sheets. A loss on these POM guarantees

-13-

would be recognized if the sum of expected costs for services exceeded unearned revenue. Changes in the deferred revenue liability for the nine months ended January 31, 2004 and 2003 and the twelve months ended April 30, 2003 are as follows:

		Option One Mortgage Corporation provides a guarantee up to a maximum amount equal to approximately 10% of the aggregate principal balance of mortgage loans held by the Trusts (QSPEs) before ultimate disposition of the loans by the Trusts. This guarantee would be called upon in the event adequate proceeds were not available from the sale of the mortgage loans to satisfy the current or ultimate payment obligations of the Trusts. No losses have been sustained on this commitment since its inception. The total principal amount of Trust obligations outstanding as of January 31, 2004 and April 30, 2003 was $2,785,603 and $2,176,286, respectively. The fair value of mortgage loans held by the Trusts as of January 31, 2004 and April 30, 2003 was approximately $2,895,000 and $2,273,000, respectively.
		The Company may enter into forward loan sale commitments to be settled at a future date as a part of its interest rate risk management strategy. The Company had commitments to sell loans of approximately $4,500,000 and $1,470,000 as of January 31, 2004 and April 30, 2003, respectively.
		The Company has entered into whole loan sale agreements with investors in the normal course of business, which include standard representations and warranties customary to the mortgage banking industry. Violations of these representations and warranties may require the Company to repurchase loans previously sold. A liability has been established related to the potential loss on repurchase of loans previously sold of $21,907 and $18,859 at January 31, 2004 and April 30, 2003, respectively. This liability is included in accounts payable, accrued expenses and other on the condensed consolidated balance sheets. Repurchased loans are normally sold in subsequent sale transactions.
		The Company and its subsidiaries have various contingent purchase price obligations in connection with prior acquisitions. In many cases, contingent payments to be made in connection with these acquisitions are not subject to a stated limit. The Company estimates the potential payments (undiscounted) total approximately $7,112 and $52,290 as of January 31, 2004 and April 30, 2003, respectively. The Company’s estimate is based on current financial conditions. Should actual results differ materially from the Company’s assumptions, the

-14-

		potential payments will differ from the above estimate. Such payments, if and when paid, would be recorded as additional goodwill.
		The Company has contractual commitments to fund certain franchises requesting draws on Franchise Equity Lines of Credit (FELCs). The commitment to fund FELCs as of January 31, 2004 and April 30, 2003 totaled $61,152 and $56,070, respectively, with a related receivable balance of $46,729 and $33,341, respectively, included on the condensed consolidated balance sheets. The receivable represents the amount drawn on the FELCs as of January 31, 2004 and April 30, 2003.
		The Company and its subsidiaries routinely enter into contracts that include embedded indemnifications that have characteristics similar to guarantees. Other guarantees and indemnifications of the Company and its subsidiaries include obligations to protect counter parties from losses arising from the following: (a) tax, legal and other risks related to the purchase or disposition of businesses; (b) penalties and interest assessed by Federal and state taxing authorities in connection with tax returns prepared for clients; (c) indemnification of the Company’s directors and officers; and (d) third-party claims relating to various arrangements in the normal course of business. Typically, there is no stated maximum payment related to these indemnifications, and the term of indemnities may vary and in many cases is limited only by the applicable statute of limitations. The likelihood of any claims being asserted against the Company or its subsidiaries and the ultimate liability related to any such claims, if any, is difficult to predict. While management cannot provide assurance the Company and its subsidiaries will ultimately prevail in the event any such claims are asserted, management believes the fair value of these guarantees and indemnifications is not material as of January 31, 2004.
12.		Litigation Commitments and Contingencies
		In November 2002, the Company and a major franchisee of a subsidiary of the Company, reached an agreement with the plaintiff class in the class action lawsuit entitled Ronnie and Nancy Haese, et al. v. H&R Block, Inc. et al., Case No. CV96-423, in the District Court of Kleberg County, Texas, related to RALs. The settlement provides a five-year package of coupons class members can use to obtain a variety of tax preparation and tax planning services from the Company’s subsidiaries. The Company’s major franchisee (a co-defendant), which operates more than half of all H&R Block offices in Texas, will share a portion of the total settlement cost. As a result, the Company recorded a liability and pretax expense of $41,672, during the second quarter of fiscal year 2003, which, at the time, represented the Company’s best estimate of its share of the settlement cost for plaintiff class legal fees and expenses, tax products and associated mailing expenses. The Company’s share of the settlement is less than the total amount awarded due to amounts recoverable from a co-defendant in the case. The settlement was approved by the court as a part of a final judgment entered on June 24, 2003. No appeals of the judgment and award were filed. The Company paid the award of $49,900 of attorneys’ fees and expenses to class counsel on August 22, 2003. In addition to the liability that has already been recorded and/or paid, the Company will reduce revenues associated with tax preparation services as the coupons are redeemed each year. The settlement coupons were distributed prior to the 2004 tax season.

-15-

		The Company has been involved in a number of putative RAL class action cases since 1990. While the Company has successfully defended many such cases, several cases are still pending and the amounts claimed in some of those cases is very substantial. In order to avoid the uncertainty of litigation and the diversion of resources and personnel resulting from the lawsuits, the Company, the lending bank, and the plaintiffs in the case Joel E. Zawikowski, et al. v. Beneficial National Bank, H&R Block, Inc., et al. (renamed Lynne A. Carnegie, et al. v. H&R Block, Inc., et al.), Case No. 98-C-2178 in the United States District Court for Northern Illinois, had agreed to a settlement class and a settlement of RAL-related claims on a nationwide basis. Under that settlement, the Company and the lending bank agreed to each pay $12,500 toward a $25,000 settlement fund for the benefit of the class members. The settlement was approved by the District Court in February 2001 and the defendants paid the $25,000 into an escrow fund. Certain class members who had objected to the settlement appealed the order approving the settlement to the Seventh Circuit Court of Appeals. In April 2002, the Court of Appeals reversed the District Court’s order approving the settlement and remanded the matter back to the District Court for further consideration of the fairness and adequacy of the proposed settlement by a new District Court judge. In April 2003, the District Court judge declined to approve the $25,000 settlement, finding that counsel for the settlement plaintiffs had been inadequate representatives of the plaintiff class and failed to sustain their burden of showing that the settlement was fair. The judge appointed new counsel for the plaintiffs in the first quarter of fiscal year 2004 and named their client, Lynne A. Carnegie, as lead plaintiff. The new counsel for the plaintiffs have since filed an amended complaint and a motion for partial summary judgment. The defendants have filed a motion to dismiss, a brief in response to allegations in the plaintiffs’ amended complaint relating to class certification, and responses to plaintiffs’ motion for partial summary judgment. Rulings on these motions are pending, and extensive discovery is proceeding. The Company recorded a receivable in the amount of its $12,500 share of the settlement fund in the fourth quarter of fiscal year 2003 and recorded a reserve in such quarter of $12,500 consistent with the existing settlement authority of the Board of Directors. The defendants requested the release of the escrowed settlement fund and the $12,500 was received during the second quarter of fiscal year 2004. The Company intends to defend the case and the remaining RAL class action litigation vigorously, but there are no assurances as to their outcome.
		The Company and certain of its current and former officers and directors are named defendants in litigation entitled Paul White, et al. v. H&R Block, et al., consolidated Case Numbers 02CV8965, 02CV9661, 02CV9682 and 02CV9830 pending in the United States District Court for the Southern District of New York since the third quarter of fiscal year 2003. The respective named plaintiffs seek to represent a class of shareholders who purchased the Company’s stock between November 8, 1997 and November 6, 2002, and allege that the defendants violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder by failing to disclose to shareholders various cases in which the Company had been sued regarding the RAL program, by failing to set adequate reserves for those cases, and by failing to disclose the supposed implications of those cases for the future of the RAL program. The four securities law cases were all assigned to the same judge and consolidated for pre-trial matters. A consolidated complaint was filed in March 2003 and the defendants responded by filing a motion to dismiss in April 2003. In response to defendants’ motion to dismiss, the plaintiffs informed defendants that they wished further to amend their complaint. Defendants consented to the filing of an amended

-16-

		complaint as a pleading matter, the plaintiffs filed the amended complaint, and the defendants filed a motion to dismiss it in August 2003. The Company believes the claims in these actions are without merit, and intends to defend them vigorously.
		In January 2004, the Company and most of its former major franchisees entered into settlement of the litigation entitled William R. Smith, Inc., et al. v. H&R Block, Inc., et al., Case No. 99-CV-206379, in the Circuit Court of Jackson County, Missouri (previously known as Armstrong Business Services, Inc., et al. v. H&R Block, Inc., et al.). In this litigation, the former major franchisees alleged breaches of contract and other matters against the Company and certain subsidiaries. The Company’s subsidiary, HRB Royalty, Inc., in turn sought and received a declaration that it could elect not to renew the major franchise agreements upon expiration of their current terms. HRB Royalty subsequently notified the plaintiff major franchisees that it did not intend to renew their major franchise agreements upon expiration. During the nine months ended January 31, 2004, the plaintiffs’ major franchise agreements accordingly expired and subsidiaries of the Company acquired and began operating the tax preparation business as company-owned operations in the former major franchise territories. The major franchise agreements required HRB Royalty to pay a “fair and equitable price” to the franchisee for the franchise business. The major franchise agreements provided further such price must be no less than 80% of the franchisee’s revenues for the most recent twelve months ended April 30 plus the value of equipment and supplies and certain off-season expenses. Cash payments of $243,257 were made related to these former major franchises during the nine months ended January 31, 2004.
		The Smith settlement provides for payment to the franchisees of $130,096, which is included in the amount above, as additional payment for the value of their former franchise businesses and resolves all other disputes involved in the litigation. The settlement also resolved all issues regarding the first trial involving one of the plaintiffs in the Smith litigation held in October 2003, with the settlement payment encompassing payment of the jury verdict in the first trial of $3,197 for the franchise business and $921 for plaintiff’s claims for damages against the Company. In December 2003, one other “major” franchisee whose franchise agreement did not expire until early 2005 entered into a new franchise agreement with a limited term.
		In addition to the aforementioned cases, the Company and its subsidiaries have from time to time been parties to claims and lawsuits arising out of such subsidiaries’ business operations, including other claims and lawsuits relating to RALs, and claims and lawsuits concerning the preparation of customers’ income tax returns, the electronic filing of income tax returns, the fees charged customers for various services, the Peace of Mind guarantee program associated with income tax return preparation services, relationships with franchisees and contract disputes. Such lawsuits include actions by individual plaintiffs, as well as cases in which plaintiffs seek to represent a class of similarly situated customers. The amounts claimed in these claims and lawsuits are substantial in some instances, and the ultimate liability with respect to such litigation and claims is difficult to predict. The Company’s management considers these cases to be ordinary, routine litigation incidental to its business, believes the Company and its subsidiaries have meritorious defenses to each of them and is defending, or intends to defend, them vigorously. While management cannot provide assurance the Company and its subsidiaries will

-17-

		ultimately prevail in each instance, management believes that amounts, if any, required to be paid by the Company and its subsidiaries in the discharge of liabilities or settlements will not have a material adverse effect on the Company’s consolidated results of operations, cash flows or financial position. Regardless of outcome, claims and litigation can adversely affect the Company and its subsidiaries due to defense costs, diversion of management and publicity related to such matters.
		It is the Company’s policy to accrue for amounts related to legal matters if it is probable that a liability has been incurred and an amount is reasonably estimable. Many of the various legal proceedings are covered in whole, or in part, by insurance.
13.		Segment Information
		Information concerning the Company’s operations by reportable operating segment for the three and nine months ended January 31, 2004 and 2003 is as follows:

14.		New Accounting Pronouncements
		SAB 105
		On March 9, 2003, the SEC Staff issued SAB 105. SAB 105 states that, when valuing loan commitments, registrants may not include expected future cash flows related to the associated servicing of the loan and, similarly, may not recognize any other internally developed intangible assets as part of the loan commitment derivative. The guidance in SAB 105 is effective for new loan commitments entered into after March 31, 2004. At January 31, 2004, the Company had recorded assets totaling $8,620 related to its loan commitments. It is possible that the effect of SAB 105 will be to delay recognition of all, or a portion, of the loan commitment asset, and

-18-

		related gain, until the loans are sold. The Company is in the process of analyzing the effect of SAB 105 and has not yet determined the impact of adoption.
		SFAS 149
		In April 2003, Statement of Financial Accounting Standards No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (SFAS 149) was issued. SFAS 149 amends and clarifies the accounting for derivative instruments and incorporates many of the implementation issues cleared as a result of the Derivatives Implementation Group process. The provisions of this standard are effective for contracts entered into or modified after June 30, 2003. The adoption of this standard did not have a material impact on the Company’s consolidated financial statements.
		FIN 46
		In January 2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (FIN 46). A revision of FIN 46 was issued in December 2003. FIN 46 provides guidance with respect to the consolidation of certain variable interest entities (VIEs) whereby a VIE must be consolidated by its primary beneficiary if the entity does not effectively disperse risks among parties involved. The primary beneficiary is one who absorbs a majority of the expected losses, residual returns, or both as a result of holding variable interests. FIN 46 also requires disclosures for both the primary beneficiary of a VIE and other parties with significant variable interests in the entity.
		The provisions of FIN 46 apply immediately to VIEs created after January 31, 2003, and to VIEs in which an enterprise obtains an interest after that date. As revised, application of FIN 46 is required for interests in VIEs commonly referred to as special-purpose entities in financial statements for periods ending after December 15, 2003. Application for interests in all other types of entities is required in financial statement for periods ending after March 15, 2004.
		The Mortgage Operations segment has an interest in certain QSPEs it currently does not consolidate, which are exempt from the provisions of FIN 46. Adoption of FIN 46 where application was required during the quarter ended January 31, 2004 did not have a material impact on the Company’s consolidated financial statements.
		The Company is continuing its evaluation of interests in other potential VIEs, and will continue to monitor additional guidance as provided by the FASB.
		EITF 00-21
		In August 2003, the Company adopted Emerging Issues Task Force Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” (EITF 00-21). EITF 00-21 requires consideration received in connection with arrangements involving multiple revenue generating activities be measured and allocated to each separate unit of accounting in the arrangement. Revenue recognition is determined separately for each unit of accounting within the arrangement. EITF 00-21 impacts revenue and expense recognition related to tax preparation in the Company’s premium tax offices where POM guarantees are included in the price of a completed tax return. Prior to the adoption of EITF 00-21, revenues and expenses related to POM guarantees at

-19-

		premium offices were recorded in the same period as tax preparation revenues. Beginning May 1, 2003, revenues and direct expenses related to POM guarantees are now initially deferred and recognized over the guarantee period in proportion to POM claims paid. As a result of the adoption of EITF 00-21, the Company recorded a cumulative effect of a change in accounting principle of $6,359, net of taxes of $4,031, as of May 1, 2003.
		Restated results for the three months ended July 31, 2003 and pro forma results, as if EITF 00-21 had been applied during the three and nine months ended January 31, 2003 are as follows:

		Revenues recognized during the three and nine months ended January 31, 2004, which were initially recognized in prior periods and recorded as part of the cumulative effect of a change in accounting principle, totaled $6,206 and $26,631, respectively.
		Current Accounting Issues
		Exposure Draft – Amendment of SFAS 140 The FASB intends to reissue the exposure draft, “Qualifying Special Purpose Entities and Isolation of Transferred Assets, an Amendment of FASB Statement No. 140,” during the first quarter of calendar year 2004. The purpose of the proposal is to provide more specific guidance on the accounting for transfers of financial assets to a QSPE.
		Provisions in the first exposure draft, if adopted, may have required the Company to consolidate its current QSPEs (the Trusts) established in its Mortgage Operations segment. As of January 31, 2004, the Trusts had assets and liabilities of $2,785,603. The provisions of the exposure draft are subject to FASB due process and are subject to change. The Company will continue to monitor

-20-

		the status of the exposure draft, and consider changes, if any, to current structures as a result of the proposed rules.
15.		Condensed Consolidating Financial Statements
		Block Financial Corporation (BFC) is an indirect, wholly owned consolidated subsidiary of the Company. BFC is the Issuer and the Company is the Guarantor of the Senior Notes issued on October 21, 1997 and April 13, 2000. These condensed consolidating financial statements have been prepared using the equity method of accounting. Earnings of subsidiaries are, therefore, reflected in the Company’s investment in subsidiaries account. The elimination entries eliminate investments in subsidiaries, related stockholder’s equity and other intercompany balances and transactions.
		Condensed Consolidating Income Statements

-21-