SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

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 þ No o

The number of shares outstanding of the registrant’s Common Stock, without par value, at the close of business on August 31, 2004 was 164,886,060 shares.

H&R BLOCK, INC.
First Quarter Fiscal Year 2005 Form 10-Q

Table of Contents

H&R BLOCK, INC.

See Notes to Condensed Consolidated Financial Statements

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H&R BLOCK, INC.

See Notes to Condensed Consolidated Financial Statements

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H&R BLOCK, INC.

See Notes to Condensed Consolidated Financial Statements

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Unaudited

1.

Basis of Presentation

The condensed consolidated balance sheet as of July 31, 2004, the condensed consolidated income statements for the three months ended July 31, 2004 and 2003, and the condensed consolidated statements of cash flows for the three months ended July 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 July 31, 2004 and for all periods presented have been made.

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

     Certain reclassifications have been made to prior year amounts to conform to the current year presentation. These reclassifications had no effect on the results of operations or stockholders’ equity as previously reported. The previously reported International Tax Operations segment has been aggregated with U.S. Tax Operations in the Tax Services segment. We have modified our income statement to present aggregate costs related to our service revenues, rather than presenting operating expenses by their natural classification. All direct costs, both fixed and variable, of providing services to our customers are included in cost of services.

     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 our April 30, 2004 Annual Report to Shareholders on Form 10-K.

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

     We file our 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.

Earnings (Loss) Per Share

Basic earnings (loss) per share is computed using the weighted average shares outstanding during each period. The dilutive effect of potential common shares is included in diluted earnings (loss) per share except in those periods with a loss. The computations of basic and diluted earnings (loss) 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 18.5 million shares of stock for the three months ended July 31, 2004, as the effect would be antidilutive. Diluted earnings per share for the three months ended July 31, 2003 excludes the impact of 5.2 million shares issuable upon the exercise of stock options as the options’

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exercise prices were greater than the average market price of the common shares during the period and therefore, the effect would be antidilutive.

     The weighted average shares outstanding for the three months ended July 31, 2004 decreased to 168.6 million from 179.4 million last year, primarily due to our purchases of treasury shares. The effect of these purchases was partially offset by the issuance of treasury shares related to our stock-based compensation plans.

     During the three months ended July 31, 2004, we issued 602,634 shares of common stock pursuant to the exercise of stock options, employee stock purchases and awards of restricted shares, in accordance with our stock-based compensation plans. During the three months ended July 31, 2003, we issued 578,112 shares of common stock pursuant to the exercise of stock options, employee stock purchases and awards of restricted shares.

     During the three months ended July 31, 2004, we acquired 7.5 million shares of our common stock at an aggregate cost of $347.4 million. During the three months ended July 31, 2003, we acquired 1.9 million shares of our common stock at an aggregate cost of $83.6 million.

3.

Receivables

Receivables consist of the following:

4.

Mortgage Banking Activities

Activity related to available-for-sale residual interests in securitizations consists of the following:

     We sold $6.7 billion and $5.3 billion of mortgage loans in whole loan sales to third-party trusts (Trusts) or other buyers during the three months ended July 31, 2004 and 2003, respectively, with gains totaling $140.9 million and $193.1 million, respectively, recorded on these sales.

     We did not complete any securitizations or net interest margin (NIM) transactions during the three months ended July 31, 2004. Residual interests valued at $145.5 million were securitized in NIM transactions during the prior year, with net cash proceeds of an equal amount received.

     Cash flows of $38.8 million and $27.5 million were received from the securitization trusts for the three months ended July 31, 2004 and 2003, respectively. Cash received on residual interests is included in investing activities in the condensed consolidated statements of cash flows.

     Aggregate net unrealized gains on residual interests, which had not yet been accreted into income, totaled $151.3 million at July 31, 2004 and $112.5 million at April 30, 2004. These unrealized gains are recorded net of deferred taxes in other comprehensive income, and may be recognized in income in

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future periods either through accretion or upon further securitization or sale of the related residual interest.

     Activity related to mortgage servicing rights (MSRs) consists of the following:

     Estimated amortization of MSRs for fiscal years 2005 through 2009 is $65.3 million, $34.9 million, $14.1 million, $5.0 million and $1.1 million, respectively.

     The key assumptions we used to estimate the cash flows and values of the residual interests and MSRs at July 31, 2004 and April 30, 2004 are as follows:

     Expected static pool credit losses are as follows:

     Static pool credit losses are calculated by summing the actual and projected future credit losses and dividing them by the original balance of each pool of assets outstanding at July 31, 2004 and April 30, 2004.

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     At July 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:

(1) Adverse changes would be minimized by the Trusts’ ability to deliver loans into forward loan sale commitments.

     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.

     Mortgage loans which have been securitized at July 31, 2004 and April 30, 2004, past due sixty days or more and the related credit losses are presented below:

5.

Goodwill and Intangible Assets

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

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     We test goodwill for impairment annually at the beginning of our fourth quarter, or more frequently if events occur indicating a potential reduction in the fair value of a reporting unit’s net assets below its carrying value. No such impairment or events indicating potential impairment have been identified within any of our segments during the three months ended July 31, 2004.

     Intangible assets consist of the following:

     Amortization of intangible assets for the three months ended July 31, 2004 and 2003 was $13.3 million and $11.1 million, respectively. Estimated amortization of intangible assets for fiscal years 2005 through 2009 is $53.4 million, $51.8 million, $42.9 million, $41.1 million and $39.9 million, respectively.

6.

Derivative Instruments

In the normal course of business, we enter into commitments with our customers to fund mortgage loans for specified periods of time at “locked-in” interest rates. These derivative instruments represent commitments (rate-lock equivalent) to fund loans. At July 31, 2004 and April 30, 2004, we recorded an asset of $0.1 million and a liability of $1.4 million, respectively, related to these commitments. Changes in fair value of $1.5 million and $2.6 million were recognized in gains on sales of mortgage assets for the three months ended July 31, 2004 and 2003, respectively. We adopted SEC Staff Accounting Bulletin No. 105, “Application of Accounting Principles to Loan Commitments,” as of March 31, 2004. Upon adoption, we can no longer record an asset and the related changes fair value for non-prime commitments to fund loans.

     We sell short FNMA, FHLMC and GNMA mortgage-backed securities to reduce our risk related to our commitments to fund fixed-rate prime loans. The position on certain or all of the fixed-rate mortgage loans is closed approximately 10-15 days prior to standard Public Securities Association (PSA) settlement dates. At April 30, 2004 we recorded assets totaling $2.1 million related to these instruments. Changes in the market value of these instruments are included in gains on sales of mortgage assets and totaled a loss of $0.8 million and a gain of $1.3 million for the three months ended July 31, 2004 and 2003, respectively.

     We enter into forward loan commitments to sell our non-prime mortgage loans to manage interest rate risk. Forward loan sale commitments for non-prime loans are not considered derivative instruments and are therefore not recorded in our financial statements. The notional value and the contract value of the forward commitments at July 31, 2004 were $6.5 billion and $6.7 billion, respectively. Most of our forward commitments give us the option to under- or over-deliver by five to ten percent.

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7.

Comprehensive Income

The components of comprehensive income are:

8.

Stock-Based Compensation

Effective May 1, 2003, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (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, our net income (loss) and earnings (loss) per share would have been as follows:

9.

Supplemental Cash Flow Information

During the three months ended July 31, 2004, we paid $183.4 million and $12.5 million for income taxes and interest, respectively. During the three months ended July 31, 2003, we paid $73.1 million and $16.8 million for income taxes and interest, respectively.

     The following transactions were treated as non-cash investing activities in the condensed consolidated statement of cash flows:

10.

Commitments and Contingencies

At July 31, 2004, we maintained a $2.0 billion unsecured committed line of credit (CLOC) to support our commercial paper program and for general corporate purposes. Subsequent to July 31, 2004, we replaced our $2.0 billion CLOC with two CLOCs. The new CLOCs are from a consortium of thirty-one banks. The first $1.0 billion CLOC is subject to annual renewal in August 2005 and has a one-year term-out provision with a maturity date in August 2006. A second $1.0 billion CLOC has a maturity date of August 2009. These lines are subject to various affirmative and negative covenants, including a minimum net worth covenant.

     We offer guarantees under our Peace of Mind (POM) program to tax clients whereby we will assume the cost of additional taxes attributable to tax return preparation error for which we are responsible. In

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August 2003, we adopted Emerging Issues Task Force Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” (EITF 00-21). EITF 00-21 impacts revenue and expense recognition related to tax preparation in our 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 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 based upon historic and actual payment of claims. As a result of the adoption of EITF 00-21, we recorded a cumulative effect of a change in accounting principle of $6.4 million, net of a tax benefit of $4.0 million, as of May 1, 2003. Our financial results for the three months ended July 31, 2003 have been restated to reflect both the cumulative effect of a change in accounting principle and the recognition of deferred revenues and expenses. Changes in the deferred revenue liability are as follows:

     We have commitments to fund mortgage loans to customers as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses. The commitments to fund loans amounted to $2.7 billion and $2.6 billion at July 31, 2004 and April 30, 2004, respectively. External market forces impact the probability of commitments being exercised, and therefore, total commitments outstanding do not necessarily represent future cash requirements.

     We have 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. We have commitments to sell loans of $6.5 billion and $4.7 billion as of July 31, 2004 and April 30, 2004, respectively. Violations of these representations and warranties may require us to repurchase loans previously sold. A liability has been established related to the potential loss on repurchase of loans previously sold of $31.2 million and $25.2 million at July 31, 2004 and April 30, 2004, respectively. Repurchased loans are normally sold in subsequent sale transactions.

     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 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 July 31, 2004 and April 30, 2004 was $4.7 billion and $3.2 billion, respectively. The fair value of mortgage loans held by the Trusts as of July 31, 2004 and April 30, 2004 was $4.8 billion and $3.3 billion, respectively.

     We 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. We estimate the potential payments (undiscounted) total approximately $7.6 million and $7.8 million as of July 31, 2004 and April 30, 2004, respectively. Our estimate is based on current financial conditions. Should actual results differ materially from our assumptions, the potential payments will differ from the above estimate. Such payments, if and when paid, would be recorded as additional goodwill.

     We have contractual commitments to fund certain franchises requesting draws on Franchise Equity Lines of Credit (FELCs). Our commitment to fund FELCs as of July 31, 2004 and April 30, 2004 totaled $63.4 million and $27.0 million, respectively. We have a receivable of $36.7 million and $35.9 million, which represents the amounts drawn on the FELCs, as of July 31, 2004 and April 30, 2004, respectively.

     We routinely enter into contracts that include embedded indemnifications that have characteristics similar to guarantees, including 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

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and interest assessed by Federal and state taxing authorities in connection with tax returns prepared for clients; (c) indemnification of our 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 us and the ultimate liability related to any such claims, if any, is difficult to predict. While we cannot provide assurance that such claims will not be successfully asserted, we believe the fair value of these guarantees and indemnifications is not material as of July 31, 2004.

11.

Litigation Commitments and Contingencies

We have been involved in a number of RAL class actions and putative RAL class action cases since 1990. Although we have successfully defended many such cases, we incurred a pretax expense of $43.5 million in fiscal year 2003 in connection with the settlement of one such case. Several of these cases are still pending and the amounts claimed in some of them is very substantial. To avoid the uncertainty of litigation and the diversion of resources and personnel resulting from the lawsuits, we, 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, we and the lending bank agreed to each pay $12.5 million toward a $25.0 million settlement fund for the benefit of the class members. The settlement was approved by the District Court in February 2001. 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 $25.0 million 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 subsequently appointed new counsel for the plaintiffs who filed an amended complaint and a motion for partial summary judgment. In March 2004, the court either dismissed or decertified all of the plaintiffs’ claims other than part of one count alleging violations of the racketeering and conspiracy provision of the Racketeer Influenced and Corrupt Organizations act. We intend to continue defending the case and the remaining RAL class action litigation vigorously, but there are no assurances as to their outcome.

     On September 8, 2004, our Board of Directors approved a settlement agreement of the case Joyce Green, et al. v. H&R Block, Inc., Block Financial Corporation, et al., Case No. 97195023, in the Circuit Court for Baltimore City, Maryland. The settlement agreement provides for each class member to receive a small cash payment and a one-time rebate coupon for tax return preparation services and for the defendants to pay settlement administration costs and court-approved legal fees of class counsel. We estimate the eventual cost of this settlement to approximate $1.5 million. The settlement agreement is subject to, and will not be final until receipt of, approval from the Circuit Court.

     We and certain of our current and former officers and directors were 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. The plaintiffs in this litigation alleged 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 we 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. On July 28, 2004, the defendants’ motion to dismiss was granted and the plaintiffs’ complaint was dismissed.

     In addition to the aforementioned cases, we have from time to time been parties to claims and lawsuits arising out of our 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, the Express IRA program,

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relationships with franchisees, contract disputes and civil actions, arbitrations, regulatory inquiries and class actions arising out of our business as a broker-dealer and as a servicer of mortgage loans. 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. We consider these cases to be ordinary, routine litigation incidental to our business, and we believe we have meritorious defenses to each of them and we are defending, or intend to defend, them vigorously. While we cannot provide assurance that we will ultimately prevail in each instance, we believe that amounts, if any, required to be paid by us in the discharge of liabilities or settlements will not have a material adverse effect on our consolidated results of operations, cash flows or financial position. Regardless of outcome, claims and litigation can adversely affect us due to defense costs, diversion of management and publicity related to such matters.

     It is our 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.

12.

Segment Information

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

     Our international operations contributed $5.8 million and $5.5 million in revenues for the three months ended July 31, 2004 and 2003, respectively, and $7.8 million and $6.4 million in pretax losses, respectively. The previously reported International Tax Operations segment has been aggregated with U.S. Tax Operations in the Tax Services segment, and prior year results have been restated to reflect this change.

13.

New Accounting Pronouncements

Exposure Draft – Amendment of SFAS 140

The Financial Accounting Standards Board (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 2005. The purpose of the proposal is to provide more specific guidance on the accounting for transfers of financial assets to a qualifying special purpose entity (QSPE).

     Provisions in the first exposure draft, as well as tentative decisions reached by the Board during its deliberations, may require us to consolidate our current QSPEs (the Trusts) established in our Mortgage Services segment. As of July 31, 2004, the Trusts had assets and liabilities of $4.7 billion. The provisions of the exposure draft are subject to FASB due process and are subject to change. We will continue to monitor the status of the exposure draft, and consider changes, if any, to current structures as a result of the proposed rules.

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14.

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. The income statement and statement of cash flows for the three months ended July 31, 2003 and balance sheet as of April 30, 2004 have been adjusted to reflect intercompany royalties between BFC and other subsidiaries. These adjustments have no effect on H&R Block, Inc. (Guarantor) or Consolidated H&R Block.

Condensed Consolidating Income Statements

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Condensed Consolidating Balance Sheets

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Condensed Consolidating Statements of Cash Flows