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SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

Form 10-K

(Mark One)

For the fiscal year ended December 31, 2003

OR

For the transition period from              to             

Commission File No. 333-105746

Houghton Mifflin Company

(Exact Name of Registrant Issuer as Specified in Its Charter)

222 Berkeley Street

Boston, Massachusetts 02116

(617) 351-5000

(Address, Including Zip Code, and Telephone Number, Including Area Code, of Registrant’s Principal Executive Offices)

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

None

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 of 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.    Yes  x     No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

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

The aggregate market value of the Common Stock held by non-affiliates of the registrant on June 30, 2003 was zero.

Number of shares outstanding of each of the issuer’s classes of Common Stock as of March 30, 2004:

Common Stock, Par Value $1 Per Share, 1,000 shares.

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HOUGHTON MIFFLIN COMPANY

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Form 10-K

This Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Houghton Mifflin’s actual results could differ materially from the expectations described in the forward-looking statements. Some of the factors that might cause such a difference are discussed in the sections entitled “‘Safe Harbor’ Statement under Private Securities Litigation Reform Act of 1995” on page 12 and “Risk Factors” beginning on page 36 of this Form 10-K, respectively.

In this Form 10-K, the term “Houghton Mifflin” refers to Houghton Mifflin Company; the term “Publishing” refers to HM Publishing Corp., Houghton Mifflin’s parent; the term “Holdings” refers to Houghton Mifflin Holdings, Inc., Publishing’s parent; and the terms “we,” “our,” “ours,” “us,” and “Company” refer to Houghton Mifflin and its subsidiaries.

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PART I

Item 1. Business

(a) General Development of Business

Houghton Mifflin Company was incorporated in 1908 in Massachusetts as the successor to a partnership formed in 1880. Antecedents of the partnership date back to 1832. We are a leading publisher in the pre-kindergarten through grade twelve (“K-12”) and college education, trade and reference, and educational, clinical, and professional testing markets in the United States. In the K-12 education market, we focus on core subjects such as reading, language arts, literature, mathematics, world languages, and social studies, which we believe represent that market’s largest and highest priority funding areas. We also provide K-12 educational and clinical assessments and related services. In the college education market, we primarily target introductory courses with the largest enrollments. In the trade and reference market, we publish an extensive line of fiction and non-fiction books for adults and children, dictionaries, and other reference materials. In the professional testing markets, we provide various testing and assessment products and services. Our diverse product offerings are classified into four reporting segments:

K-12 Publishing. Our K-12 Publishing segment develops comprehensive educational programs, comprised primarily of textbooks, workbooks, supplemental materials, teaching guides, technology-based components, and other resources. We also provide testing and assessment services.

College Publishing. Our College Publishing segment publishes textbooks, ancillary products such as workbooks and study guides, technology-based instructional materials, teacher materials, and other materials, primarily for introductory college-level courses. We also sell college products in the high school advanced placement market.

Trade and Reference Publishing. This segment publishes fiction and non-fiction books for adults and children, dictionaries, and other reference materials for the trade market worldwide.

Other. This segment includes our Promissor Division as well as unallocated corporate items. Our Promissor Division develops and provides testing services and products for professional certification and licensure, as well as employment screening, placement and evaluation to regulatory entities, professional associations and corporations.

Acquisitions and Dispositions

On December 5, 2003, we acquired Edusoft, a San Francisco, California-based assessment platform provider. On October 14, 2003, we acquired Cognitive Concepts, Inc. (“CCI”), a provider of research-based supplemental education tools.

On April 1, 2003, Houghton Mifflin sold 100% of the outstanding shares of Curriculum Advantage, Inc. (“Curriculum Advantage”).

On December 30, 2002, Houghton Mifflin was acquired by, and subsequently merged with, Versailles Acquisition Corporation (the “Acquisition”), a wholly owned subsidiary of Holdings, a company beneficially owned by Thomas H. Lee Partners, L.P. and its affiliates (“THL”), Bain Capital, LLC and its affiliates (“Bain Capital”), and The Blackstone Group and its affiliates (“Blackstone” and collectively with THL and Bain Capital, the “Sponsors”). Holdings acquired all of Houghton Mifflin’s share capital from Vivendi Communications North America, Inc. (“Vivendi Communications,” together with its parent, Vivendi Universal, S.A., “Vivendi”) and on September 17, 2003 transferred its interest in Houghton Mifflin’s share capital to Publishing, its wholly owned subsidiary.

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On December 30, 2002, Houghton Mifflin acquired Kingfisher Publishing plc (“Kingfisher”), a UK-based publisher of reference material and fiction and non-fiction books for children.

On July 7, 2001, an indirect wholly owned subsidiary of Vivendi acquired 100% of Houghton Mifflin’s common stock (the “Vivendi Purchase”). Prior to the Vivendi Purchase, we were a public company.

(b) Financial Information About Segments;

Financial information about Houghton Mifflin’s reporting segments is in Part II, Item 8, Notes to Consolidated Financial Statements in Note 16 under the heading “Segment Information” beginning on page F-48, and Part II, Item 6, Selected Financial Data beginning on page 10.

(c) Narrative Description of Business

As a publisher, Houghton Mifflin shapes ideas, information, and instructional methods into various media that satisfy the lifelong need of people to learn, gain proficiency, and be entertained. We seek out, select, and generate worthwhile concepts and then enhance their value and accessibility through creative development, design, production (performed by outside suppliers), marketing, sales, and distribution. While Houghton Mifflin’s works have been published principally in printed form, we publish programs or works in other formats including computer software, laser discs, CD-ROM, and Internet-based platforms.

Business Segments

K-12 Publishing

Overview

Our K-12 Publishing segment develops and markets comprehensive educational programs and assessments targeted to the more than 53 million students in over 115,000 elementary and secondary schools in the United States, principally in the core academic subjects. Our products and services include textbooks, workbooks, supplemental materials, technology-based products, teaching guides and other resources, and provide teacher training, as part of a full-service offering to schools, educators, and students. With an in-house editorial staff supplemented by external specialists, the Company develops programs that can be aligned to state standards and customized for specific state requests. In addition, through Riverside and Edusoft, our K-12 Publishing segment offers a wide range of educational, cognitive, and developmental standardized testing products in print, CD-ROM, and online formats, targeting the educational and clinical assessment markets.

In the educational publishing industry, materials are often described as “basal” or “supplemental.” Basal materials are comprehensive programs intended to provide a complete course of study in a subject, either at a single grade level or across grade levels, and are the primary source of classroom instruction. They typically include a student textbook and a variety of ancillary materials such as teacher’s editions, charts, classroom displays, classroom handouts, workbooks, tests, CD-ROMs, and online materials. Supplemental materials provide focused information about a topic or practice in a particular skill, but not the comprehensive system of materials offered in a basal program. These materials are used both as alternatives and as supplements to core basal textbooks, enabling local educators to tailor standard programs to the specific needs of their students cost-effectively. Unlike K-12 basal programs, supplementals are purchased irrespective of adoption schedules, creating net sales and earnings that do not vary greatly with the adoption cycle. In addition, the development of supplemental materials tends to require significantly less capital investment than the development of a basal program.

Adoption Process

Adoption is the process by which public elementary and secondary schools select and purchase new instructional materials. The terms “adopt” and “adoption” are often used to describe the overall process of a state

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governing body’s official approval of basal programs for selection and purchase by that state’s school districts, or an individual school or school district’s selection and purchase of basal programs.

Twenty states approve basal programs on a statewide basis for a particular subject (“adoption states”). These states represent approximately one-half of the U.S. elementary and secondary school-age population. The selections typically occur every five to seven years according to a schedule publicized many years in advance. Historically, deviations from announced adoptions have been minimal. The funding for the purchase of the materials in an adoption state is approved at the state level and is appropriated by subject. Typically, a school or school district within an adoption state may use state funding to purchase instructional materials only from the list of programs that have been adopted by the particular state’s governing body. After the state entities have approved instructional materials, individual schools later decide the quantity and timing of their purchases.

In the other states, referred to as “open states” or “open territories,” each individual school or school district can purchase materials without restrictions. Schools and school districts in open territories often consider decisions made in large adoption states when making their own purchasing decisions.

In adoption states, the state school board’s decision to approve a certain program developed by an educational publisher depends on recommendations from textbook committees, which are often comprised of educators and curriculum specialists. To ensure the approval and subsequent successful marketing of a new textbook program, we conduct extensive market research, including: (i) discussions of the planned curriculum with the state level curriculum advisors to secure their support; (ii) development of prototype textbooks that are focus-tested with educators, often against competing programs, to gather feedback on the program’s content and design; and (iii) incorporation of qualitative input from existing customers in terms of classroom needs. Historically, it has been rare that any of the major educational publishers has failed to have a program listed in a state for which it has invested significantly in development. However, a publisher’s ultimate market share in a given state will generally depend on the quality of its program and materials, the magnitude of its marketing and sales efforts and the strength and nature of its relationships with key decision makers at the district level.

We generally develop a national edition for sale in open territories and smaller adoption states, while customizing the program for states that represent large purchasing opportunities. The sales organization presents to school boards and textbook selection committees, which in turn make recommendations to departments of education in adoption states and to district level school boards in open territories. We believe that documented success in adoption states, especially California, Texas, and Florida, which in the aggregate comprised almost 25% of the market in recent years, can often positively influence a publisher’s sales efforts in open territories.

Once an adoption schedule is set, we analyze upcoming opportunities and begin to develop content for our basal programs. The preparation for any new program includes an upfront investment in research and editorial costs, which generally begins up to three years before a major new adoption. Additional investment is required to tailor content to specific adoption states, with the amount of the investment depending upon the potential size of the opportunity but generally being less than the initial investment. Because the adoption cycle is staggered by subject, positive cash flows from existing programs are used to finance spending for new program development.

Supplementary materials and assessments are not adopted through this process. Supplementary materials are sold as off-the-shelf materials to schools and districts. Assessment programs are either bought as custom programs for state-wide assessment, following a request for proposal process, or as off-the-shelf products in schools and districts.

Operations

Our K-12 Publishing segment operates through five primary divisions: School, McDougal Littell, Great Source (including CCI), Riverside, and Edusoft. Each division benefits from strong relationships with its customers, most of which have been developed over many years through a service-based approach to designing, marketing, and implementing its programs.

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School. Our School Division develops and markets leading basal programs for the kindergarten through grade eight market utilizing the Houghton Mifflin brand. The division focuses its publishing portfolio on the subjects that have consistently received the highest priority from educators and politicians, namely reading, language arts (including spelling and English), mathematics, and social studies. In each subject, we design comprehensive learning programs and then market a variety of proprietary products to maximize teaching effectiveness, including textbooks, workbooks, teachers’ guides and resources, audio/visual aids, and technology-based products.

McDougal Littell. Our McDougal Littell Division develops and markets basal programs for the grades six through twelve market utilizing the McDougal Littell brand. The division publishes products and provides services in five of the six major educational subjects: literature/language arts, mathematics, social studies, world languages, and science. Vocational studies is the only subject in which McDougal Littell does not compete. The editorial process, like that of the School Division, involves significant market research. McDougal Littell designs broad programs for middle school grades and course-specific products for high school.

Great Source. Our Great Source Division develops and markets instructional, curriculum-based educational supplements for pre-kindergarten through grade twelve utilizing various brands, including the Write Source brand. The division offers such products as handbooks, instructional kits, summer school and after-school curricula, consumable student practice books, and test review books, as well as other resources. These materials supplement the core curriculum, allowing local educators to tailor standard programs for the specific needs of their students cost-effectively. Many of Great Source’s product lines sell well outside the adoption cycle, creating a recurring revenue stream that does not vary greatly with the adoption schedule.

Riverside. Our Riverside Division develops and markets testing and assessment products for the grades K-12 and clinical markets. The division’s tests include: (i) norm-referenced tests, or NRTs, which compare students to national performance levels; (ii) criterion-referenced tests, or CRTs, which are standards-based educational assessments, frequently customized for state educational entities; and (iii) clinical tests, which assess intellectual, cognitive and behavioral development.

Edusoft. Our Edusoft Division develops and sells testing technology to the K-12 market. The Edusoft product is a web-based assessment platform that helps school districts, administrators, teachers, and parents track student performance on state standards through three kinds of tests: state exams, district benchmarks, and in-class teacher tests. The division’s testing and reporting solution gives districts the information they need to help improve instruction and student performance.

Sales and Marketing

Our major regional sales offices for the K-12 Publishing segment are in California, Georgia, and Texas. Each division in the K-12 Publishing segment has its own dedicated sales force, comprised largely of former educators. The School and McDougal Littell Divisions each employ a sales force in excess of 200 people. The Great Source, Riverside, and Edusoft sales forces are smaller. The Great Source sales force works with the School and McDougal Littell Divisions to maximize customer relationships. McDougal Littell also markets our College Division’s texts for high school advanced placement courses.

We focus on maintaining strong relationships with decision-makers in the adoption states, including teachers, district administrators, and state policymakers. Our sales forces canvass the open territory states, strengthening relationships with decision-makers. Marketing efforts begin at the conception of the development of a new program. In the case of states where our programs are already established, marketing efforts are continuous. Formal market research efforts include educator focus groups, prototypes of student and ancillary materials, and comparisons against competing products. Additional informal market research includes ongoing feedback from the sales force in identifying teachers’ and students’ requirements. Our marketing and editorial staffs work together closely to incorporate the results of research into product development and to develop the

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most updated, research- and needs-based curricula. Once product development is complete, our sales campaign involves product presentations and sampling along with presentations by key authors. Sending free sample copies is an essential part of marketing instructional materials. In addition, once a program is purchased, we may provide a variety of free materials to purchasers. These free materials, usually called “implementation” materials, are a cost of doing business. We also conduct training sessions within a school district that has purchased our materials to help teachers learn to use our products effectively and provide professional development services for which we can charge fees.

College Publishing

Overview

Our College Publishing segment publishes textbooks, ancillary products such as workbooks and study guides, technology-based instructional materials, teacher materials, and other materials, primarily for introductory college-level courses. We target the more than 15 million students in over 4,000 institutions in the post-secondary higher education market. We concentrate on the largest introductory college courses in core disciplines such as mathematics, chemistry, history, psychology, modern languages, accounting, business, and remedial studies, although some recent growth has come from new publications for upper-level courses. Our library of titles for introductory college courses enables us to generate significant sales in the high school advanced placement market.

In the post-secondary market, the faculty generally selects the textbooks and other materials to be used in class, acting either as a committee or individually. Affiliated college bookstores and large retail chains order post-secondary educational materials based on professors’ selections for purchase by college students. Historically, approximately 30% of all student purchases in the college market are used books. In the private career school market, the institution generally purchases products directly from the publisher and requires students to purchase those products from the institution as part of the tuition. For high school advanced placement courses, which generate a significant portion of the College Division’s net sales, the selection of college-level materials is made through the adoption or open-territory selection processes described above.

College textbooks generally are updated every three to four years by authors and publishers. Textbooks with a current-year copyright date are referred to in the industry as “frontlist,” textbooks with a subsequent year copyright date are referred to as “early in-stock,” and textbooks with an older copyright date are referred to as “backlist.” The success of each year’s frontlist and early in-stock titles significantly influences sales of backlist titles in subsequent years. Consequently, most of the selling and marketing activities of college publishers focus on promoting frontlist and early in-stock titles.

Operations

The College Division’s products are offered primarily to the post-secondary higher education market in traditional print, electronic, and Internet-based formats; virtually all major print textbooks now have an integrated technology component such as a website or multimedia CD-ROM. The College Division also sells many of its products to high school advanced placement courses through a dedicated advanced placement sales force within McDougal Littell and to certificate-granting, for-profit institutions that offer skill-based training and job placement.

We have a portfolio of titles by highly regarded authors who are experts in their respective disciplines. Our authors, as is common industry practice, agree to certain non-compete provisions that prevent them from authoring for other publishers’ books and technology-based products that directly compete with the products that they create for us. Authors who are experts in their field write the majority of a book while the in-house editorial staff focuses on pedagogical development, layout, graphics, and refinement.

A significant portion of our college content is digitally stored and indexed, which enables the efficient development of new electronic and print products, optimizes the customization process, and allows publication in

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concurrent multi-media formats. Additionally, with nearly all college students utilizing the Internet, the College Division supports more than 600 textbook-related websites for students and professors.

Sales and Marketing

The College Division employs a sales and marketing force in excess of 180 people that promotes products to college faculty through a combination of on-campus visits, shipments of sample products, and direct marketing. As professors have embraced e-mail and the Internet to a greater extent in recent years, the role of direct marketing, especially e-mail correspondence, has increased significantly. Our sales force continually canvasses college faculty with our products. In addition, a dedicated McDougall Littell sales force sells advanced placement products in the high school market.

Trade and Reference Publishing

Overview

The Trade and Reference Publishing segment consists of the Trade and Reference Division, a publisher of quality fiction and non-fiction books for adults and children, dictionaries, and other reference materials, and Kingfisher, a U.K.-based publisher of childrens’ fiction and non-fiction titles and reference materials for the trade market worldwide.

We are a niche publisher specializing in high-quality adult and children’s books that generate strong backlist sales. Among our publications, our adult list includes fiction, non-fiction, field guides, and cookbooks. Our children’s list includes board books, picture books, and young adult novels. The market for reference materials, including dictionaries and thesauruses, is characterized by stable spending patterns and significant concentration among a small number of well-recognized brands. Despite the growing accessibility and desirability of the Internet as an information source, we believe the Internet has not significantly affected the usage levels of print dictionaries and thesauruses, which offer relative convenience and ease of use. Nevertheless, we believe web-based and other electronic resources will continue to develop and drive industry growth by addressing changing consumer behavior. Moreover, certain reference publishers, including us, have taken steps to digitize existing content in order to exploit online opportunities. Typically, these publishers will license their content to online providers.

Operations

The Trade and Reference Publishing segment publishes quality fiction and non-fiction books for adults and children, dictionaries, and other reference works under brands such as Houghton Mifflin, Mariner Books, Clarion Books, American Heritage dictionaries, and Kingfisher. Our Trade and Reference Publishing segment generates a majority of its sales from its backlist of more than 3,000 titles, thereby reducing its dependence on introducing bestsellers each year.

Sales and Marketing

The Trade and Reference Publishing segment’s marketing and publicity strategies focus on both booksellers and end consumers and contribute significantly to the success of an author and/or title. The Trade and Reference Publishing segment employs a sales force that principally covers the reseller marketplace, including retail chains, independent bookstores, online booksellers, wholesalers, and a variety of non-traditional book outlets. We also use our other divisions’ sales forces to sell trade and reference products into the K-12 and college markets. Reference materials, in particular, are sold to K-12 schools and colleges, as well as to office supply distributors and businesses. Our Trade and Reference Publishing segment also licenses book rights and content to paperback publishers, book clubs, websites, and other publishers as well as electronic businesses in the United States and abroad.

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Other

Overview

Promissor is a developer and provider of testing services and products for professional certification and licensure. Generally, the professional assessment market has a highly fragmented customer base with numerous niche participants competing in various segments. Regulatory and professional associations typically select vendors based on detailed responses to extensive requests for proposals. We believe the test-vendor selection process is generally based on a combination of variables that represent “best value” to the agency or organization, including the vendor’s reputation as a quality service provider and is primarily based on the quality of the service provided and the nature of the relationship developed with the key decision-maker. Services are contracted for multiple years and are characterized by high renewal rates. In addition, this segment includes unallocated corporate items.

Operations

Promissor provides testing services and products for professional certification and licensure as well as employment screening, placement, evaluation, and fingerprinting in the United States and internationally. Promissor and its predecessors have operated in the assessment industry for more than twenty years. This division has approximately 140 proprietary testing centers nationwide. In addition, it offers information technology and other certification testing services at over 500 locations internationally. It works with clients to design assessment solutions, provide content management software tools, and deliver tests or support services. On behalf of its regulatory and professional association clients, Promissor provides the tests required to license or certify insurance brokers, nurse aides, real estate agents, and many other occupations and professions.

Sales and Marketing

Promissor markets its services to regulatory, licensing and certification entities, trade associations, and corporations worldwide.

Printing and Binding; Raw Materials

We outsource the printing and binding of our products, with approximately 80% of our printing currently handled by Quebecor Publishing, R.R. Donnelly & Sons, Banta Corporation, Von Hoffman Press, Webcrafters, and Lehigh Press. We have a procurement agreement with each printer that provides volume and scheduling flexibility and price predictability. We have a longstanding relationship with each printer.

Paper is one of the principal raw materials we use. We purchase our paper directly from four suppliers and one paper merchant with whom we have various agreements that protect against price increases. We have not experienced and do not anticipate experiencing difficulty in obtaining adequate supplies of paper for our operations, as we have contracts with numerous reliable suppliers that assure us 100% availability on all main paper grades that we procure. While local prices fluctuate depending upon local market conditions, average market paper prices remained relatively flat in 2003.

Seasonality; Customers

In the K-12 market, we sell primarily to state education departments and individual school districts and schools. We market our College products to faculty at colleges; once our textbooks are selected, they are ordered by affiliated college bookstores and large retail chains for purchase by students. We market our Trade and Reference products to various retail chains, wholesalers, and bookstores, and our Promissor services to regulatory and trade associations and corporations.

In the K-12 market, we typically receive payment for our products and services from individual school districts, and to a lesser extent individual schools and states. In the college and trade and reference markets, we receive payment for our products and services from book distributors and retail booksellers. In the case of our testing and assessment products and services, we receive payment from the individually contracted parties.

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We derive approximately 85% of our revenues from educational publishing in the K-12 and College Publishing segments, which are markedly seasonal businesses. Schools and colleges make most of their purchases in the second and third quarters of the calendar year, in preparation for the beginning of the school year in September. Thus, we realize approximately 75% of consolidated net sales in these quarters.

Sales of K-12 instructional materials and customized testing products are also cyclical, with some years offering more sales opportunities than others. The amount of funding available at the state level for educational materials also has a significant effect on our year-to-year revenues. No single customer accounts for more than 10% of our consolidated net sales. Our largest single customer is Barnes & Noble, which purchases both Trade and Reference and College products. Although the loss of a single customer (including Barnes & Noble) or a few customers would not have a material adverse effect on our business, schedules of school adoptions and market acceptance of our products can materially affect year-to-year revenue performance.

Distribution

We operate five distribution facilities from which we coordinate our own distribution process: two in Indianapolis, Indiana and one in each of Geneva, Illinois; Kennesaw, Georgia; and Dallas, Texas. Additionally, some adoption states require us to use in-state textbook depositories for educational materials sold in that particular state. Riverside ships its products directly from vendor site locations. We utilize delivery firms including United Parcel Service, Inc., FedEx Corporation, and DHL Worldwide Express Inc. to facilitate the principally ground transportation of products.

Competition

We sell our products in highly competitive markets. In these markets, product quality and customer service are major factors in generating sales growth. Other factors affecting sales growth in the K-12 market include the level of student enrollment in subjects that are up for adoption and the level of spending per student in each state and/or school district. Profitability is affected by industry developments including: (i) increasingly competitive selling, sampling, and implementation costs; (ii) rising development costs due to customers’ requirements for more customized instructional materials and assessment programs; and (iii) higher technology costs due to the increased number of textbook program components developed in digital formats.

We compete with large publishers such as Reed Elsevier plc, Pearson plc, and The McGraw-Hill Companies, Inc. We have three primary competitors in the K-12 market, seven in the college market, six in the trade and reference market and two in the corporate certification and testing market.

Employees

As of February 29, 2004, we employed approximately 3,459 regular employees. Approximately 1,381 of our employees are located in Boston, Massachusetts; 1,103 in Chicago, Illinois; 422 in Philadelphia, Pennsylvania; and 232 in Indianapolis, Indiana. Our sales force makes up approximately 22% of our employees. None of our employees are subject to collective bargaining agreements. We believe that our relations with our employees are generally good.

Intellectual Property

Our principal intellectual property assets consist of our trademarks and copyrights in our content, as well as other rights in our brand names. Substantially all of our publications are protected by copyright, whether registered or unregistered, either in our name or in the name of the author of the work. Such copyrights protect our exclusive right to publish the work in the United States and in many countries abroad for specified periods: in most cases for the author’s life plus 70 years, but in any event a minimum of 28 years for works published prior to 1978 and 35 years for works published thereafter.

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We do not own any material patents, franchises or concessions, but we have registered certain trademarks and service marks in connection with our publishing businesses. We believe we have taken, and take in the ordinary course of business, all appropriate available legal steps to protect our intellectual property in all relevant jurisdictions.

Environmental Matters

We generally contract with independent printers and binders for their services, and our operations are generally not otherwise affected by environmental laws and regulations. However, as the owner and lessee of real property, regardless of fault, it is possible that we could face liability if contamination were to be discovered on the properties we own or lease. We are currently unaware of any material environmental liabilities or other material environmental issues relating to our properties or operations and anticipate no material expenditures for compliance with environmental laws or regulations.

(d) Financial Information About Geographic Areas.

Export sales are not significant to Houghton Mifflin’s four reporting segments.

Item 2. Properties

Our principal executive office is located at 222 Berkeley Street, Boston, Massachusetts.

The following table describes the approximate building areas, principal uses and the years of expiration on leased premises of our significant operating properties as of January 15, 2004. We believe that these properties are suitable and adequate for our present and anticipated business needs, satisfactory for the uses to which each is put, and, in general, fully utilized.

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In addition, we lease approximately 10 smaller sales offices. Promissor leases approximately 140 additional smaller facilities for use as testing centers.

Item 3. Legal Proceedings

We are from time to time involved in litigation incidental to the conduct of our business. We believe that no litigation currently pending against us, if adversely determined, would have a material adverse effect on our consolidated financial position or results of operations.

Item 4. Submission of Matters to a Vote of Security Holders

By written consent in lieu of a meeting of the sole stockholder of Houghton Mifflin, dated October 8, 2003, the size of the board of directors was increased from ten to eleven and Anthony Lucki was elected as a director.

The following directors continued their terms in office following the date of the consent: David Blitzer, Charles Brizius, Robert Friedman, Jonathan Goodman, Seth Lawry, James Levy, Mark Nunnelly, Michael Perik, Scott Sperling, and Michael Ward.

By written consent in lieu of a meeting of the sole stockholder of Houghton Mifflin, dated December 3, 2003, the size of the board of directors was increased from eleven to twelve and Steve Gandy was elected as a director.

The following directors continued their terms in office following the date of the consent: David Blitzer, Charles Brizius, Robert Friedman, Jonathan Goodman, Seth Lawry, James Levy, Anthony Lucki, Mark Nunnelly, Michael Perik, Scott Sperling, and Michael Ward.

PART II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of equity Securities

Houghton Mifflin has no publicly traded common stock.

Item 6. Selected Financial Data

We derived the selected historical consolidated statement of operations data and consolidated statement of cash flow data for the years December 31, 2003 and 2002 and the periods July 7, 2001 through December 31, 2001 and January 1, 2001 through July 6, 2001 and the selected historical consolidated balance sheet data as of December 31, 2003 and December 31, 2002 from the historical financial statements of Houghton Mifflin appearing elsewhere in this annual report on Form 10-K, which have been audited by PricewaterhouseCoopers LLP, independent accountants for the years ended December 31, 2003 and 2002, and Ernst & Young LLP for the periods July 7, 2001 through December 31, 2001 and January 1, 2001 through July 6, 2001. We derived the selected historical consolidated statement of operations data and consolidated statement of cash flow data for the years ended December 31, 2000 and 1999 and the selected historical consolidated balance sheet data as of December 31, 2001, 2000 and 1999 from the historical financial statements of Houghton Mifflin, which are not included in this Form 10-K, and which have been audited by Ernst & Young LLP, independent accountants.

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You should read the selected historical consolidated financial data set forth below in conjunction with, and the data is qualified by reference to, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our audited consolidated financial statements and accompanying notes thereto included elsewhere in this Form 10-K.

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

“Safe Harbor” Statement under Private Securities Litigation Reform Act of 1995:

This Form 10-K includes forward-looking statements that reflect Houghton Mifflin’s current views about future events and financial performance. Words such as “estimates,” “expects,” “anticipates,” “projects,” “plans,” “intends,” “believes,” “forecasts,” and variations of such words or similar expressions that predict or indicate future events or trends, or that do not relate to historical matters, identify forward-looking statements. Our expectations, beliefs, and projections are expressed in good faith and we believe there is a reasonable basis for them. However, there can be no assurance that management’s expectations, beliefs, and projections will result or be achieved. Investors should not rely on forward-looking statements because they are subject to a variety of risks, uncertainties, and other factors that could cause actual results to differ materially from our expectations, and we expressly do not undertake any duty to update forward-looking statements, which speak only as of the date of this release. These factors include, but are not limited to: (i) market acceptance of new educational and testing products and services, particularly reading, literature, language arts, mathematics, science, and social studies programs; criterion-referenced testing; and the Iowa Tests of Basic Skills; (ii) the seasonal and cyclical nature of educational sales; (iii) changes in funding in school systems throughout the nation, which may result in cancellation of planned purchases of educational and testing products and/or services and shifts in timing of purchases; (iv) changes in educational spending in key states such as California, Texas, and Florida, and our share of that spending; (v) changes in purchasing patterns in elementary and secondary schools and, particularly in college markets, the effect of textbook prices, technology, and the used book market on sales; (vi) changes in the competitive environment, including those which could adversely affect cost of sales, such as the increased amount of materials given away in the elementary and secondary school markets and increased demand for customized products; (vii) changes in the relative profitability of products sold; (viii) regulatory changes that could affect the purchase of educational and testing products and services; (ix) changes in the strength of the retail market for general interest publications and market acceptance of newly-published titles and new electronic products; (x) the ability of Riverside, Edusoft, and Promissor to enter into new agreements for testing services and generate net sales growth; (xi) delays and unanticipated expenses in developing new programs and other products; (xii) delays and unanticipated expenses in developing new technology products, and market acceptance

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and use of online instruction and assessment materials; (xiii) the success of Riverside’s entry into the scoring business and the criterion-referenced testing business; (xiv) the potential effect of a continued weak economy on sales of K-12, college, and general interest publications; (xv) the risk that our well-known authors will depart and write for our competitors; and (xvi) the effect of changes in accounting, regulatory, and/or tax policies and practices.

Introduction

On December 30, 2002, Holdings acquired all of the outstanding shares of Houghton Mifflin from Vivendi Communications, a wholly owned subsidiary of Vivendi. Vivendi had acquired all of the outstanding shares of Houghton Mifflin through a tender offer on July 7, 2001. Prior to the Vivendi Purchase, the stock of Houghton Mifflin was publicly traded. In accordance with the requirements of purchase accounting, the assets and liabilities of Houghton Mifflin were adjusted to their estimated fair values and the resulting goodwill computed for the Holdings and the Vivendi transactions as of their respective acquisition dates (see Note 4). The application of purchase accounting generally results in higher depreciation and amortization expense in future periods. Accordingly, and because of other effects of purchase accounting, the accompanying consolidated financial statements as of and for the periods prior to the Vivendi Purchase, as of and for the periods under Vivendi ownership and as of and subsequent to December 31, 2002, are not comparable.

We derived the consolidated statement of financial operations data of the Company for the year ended December 31, 2003 on a “Successor Basis” reflecting the Acquisition, for the periods from July 7, 2001 through December 31, 2002 on a “Predecessor Basis” for the period of Vivendi’s ownership of Houghton Mifflin, and the period January 1, 2001 through July 6, 2001 on a “Pre-predecessor Basis” for the period prior to the Vivendi Purchase from our audited historical financial statements appearing elsewhere in this report.

The discussion and analysis of historical periods prior to January 1, 2003 does not reflect the significant impact that the Acquisition and associated financing activities have had on Houghton Mifflin and will have on Houghton Mifflin, including increased leverage and increased liquidity requirements. You should read the following discussion of our financial condition and results of operations with “Selected Historical Consolidated Financial Data” and the audited historical consolidated financial statements and related notes included elsewhere in this filing.

Results discussed for the twelve months ended December 31, 2001 represent the mathematical addition of the Pre-predecessor Stub Period and the period of Vivendi’s ownership of Houghton Mifflin from July 7, 2001 through December 31, 2001 (“Predecessor Stub Period”). This approach is not in accordance with GAAP, and may yield results that are not strictly comparable on a period-to-period basis primarily due to (i) the impact of required purchase accounting adjustments and (ii) the new basis of accounting established on the closing date of the Vivendi Purchase. We believe that this is the most meaningful way to present our results of operations. Such results are not necessarily indicative of what the results for the respective periods would have been had the Vivendi Purchase not occurred.

Overview

We are a leading publisher in the K-12 and college education, trade and reference, and educational, clinical, and professional testing markets in the United States. We offer a diverse portfolio of products and services within each of these areas, including textbooks, workbooks, supplemental materials, technology-based products, teaching guides, various types of standardized and customized tests, professional assessment products, and a range of trade and reference titles. Please refer to “Business Segments—K-12 Publishing—Overview,” “Adoption Process,” and “ Sales and Marketing,” and “Business Segments—College Publishing—Overview” for a discussion of terms important to an understanding of our business, including “basal” and “supplemental” materials, the “adoption” process, “implementation,” “in-service” training, and the sales and sampling practices of the educational markets.

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We have nine divisions that offer products and services. These divisions are grouped in four reporting segments:

Our geographic area of operation is predominantly the United States. Export or foreign sales to locations outside the United States are not significant.

Company Business as a Whole

We derive approximately 85% of our revenues from educational publishing in the K-12 and College Publishing segments, which are markedly seasonal businesses. Schools and colleges make most of their purchases in the second and third quarters of the calendar year, in preparation for the beginning of the school year in September. Thus, we realize approximately 75% of consolidated net sales in these quarters.

Sales of K-12 instructional materials and customized testing products are also cyclical, with some years offering more sales opportunities than others. The amount of funding available at the state level for educational materials also has a significant effect on our year-to-year revenues. No single customer accounts for more than 10% of our consolidated net sales. Our largest single customer is Barnes & Noble, which purchases both Trade and Reference and College products. In management’s opinion, a loss of a single customer, including Barnes & Noble, would not have a material adverse effect on the Company. Although the loss of a single customer or a few customers would not have a material adverse effect on our business, schedules of school adoptions and market acceptance of our products can materially affect year-to-year revenue performance.

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Acquisitions and Dispositions

2003 Activities

On December 5, 2003, Houghton Mifflin acquired Edusoft, a San Francisco, California-based assessment platform provider for $37.0 million in cash subject to certain contractual post-closing adjustments. On October 14, 2003, Houghton Mifflin acquired CCI, a provider of research-based supplemental education tools, for $12.8 million in cash. Houghton Mifflin has accounted for the Edusoft and CCI acquisitions as purchase transactions in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations.” The operating results of these businesses are reflected in the consolidated results of operations from their respective acquisition dates and were not significant for the year ended December 31, 2003.

On April 1, 2003, Houghton Mifflin sold all of the outstanding shares of Curriculum Advantage for $0.3 million in cash and receipt of secured notes and inventory of $0.5 million. The assets and liabilities, operational results and statements of cash flows of Curriculum Advantage are reflected as discontinued operations in the accompanying financial statements.

2002 Activities

Holdings Acquisition of Houghton Mifflin

On December 30, 2002, Houghton Mifflin, was acquired by, and subsequently merged with, Versailles Acquisition Corporation, a wholly owned subsidiary of Holdings, a company beneficially owned by the Sponsors. Holdings acquired all of Houghton Mifflin’s share capital from Vivendi and on September 17, 2003 contributed Houghton Mifflin’s share capital to Publishing, its wholly owned subsidiary. The total cost of the Acquisition was approximately $1.65 billion (subject to customary post-closing adjustments), including estimated transaction fees and expenses and $375.4 million of assumed indebtedness. Houghton Mifflin accounted for this transaction in accordance with SFAS No. 141, “Business Combinations.”

As a result of the Acquisition, Houghton Mifflin’s assets and liabilities were adjusted to their fair value. These adjustments include $610.9 million allocated to goodwill, $679.1 million allocated to publishing rights (with an estimated life of 18 years), $290.2 million to trademarks and trade names (with an indefinite life), $5.2 million to customer-related intangibles (with an estimated life of 12 years), $9.9 million step-up to the fair value of its inventory, and $15.6 million step-down to the fair value of the assumed debt at the Acquisition date. In conjunction with this assessment, Houghton Mifflin included $88.7 million of existing pre-publication costs in the fair value of publishing rights.

At the time of the Acquisition, Houghton Mifflin entered into retention agreements with key employees that expire on or before June 30, 2004, that total approximately $28.9 million and are being expensed over the vesting period. The Company has also significantly increased its aggregate borrowings in connection with new financing arrangements entered into to complete the Acquisition. As a result, cost of sales were increased in 2003 due to the amortization of inventory fair value step-up from purchase accounting, and selling and administrative expenses were higher in 2003, and will be slightly higher in 2004 due to the expensing of the retention agreements.

During the period that it owned Houghton Mifflin, Vivendi provided marketing, finance, tax, administrative, and other services. In 2002, for those services, Vivendi charged Houghton Mifflin a management fee totaling $6.0 million. This fee arrangement was terminated concurrent with the Acquisition. As a result of the Acquisition, Houghton Mifflin is an independent entity, which has resulted in additional selling and administrative expenses of approximately $3.0 million in 2003 in performance of the aforementioned services. In addition, Houghton Mifflin is also paying a management fee of $5.0 million per year to the Sponsors for consulting and advisory services. See “Certain Relationships and Related Transactions.”

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Acquisition of Kingfisher

Subsequent to the Acquisition, Houghton Mifflin acquired from Vivendi all of the outstanding stock of Kingfisher for $3.9 million. Kingfisher is a U.K.-based company that publishes children’s fiction and non-fiction titles and reference materials for the trade market worldwide. Houghton Mifflin accounted for this acquisition as a purchase transaction in accordance with SFAS No. 141, “Business Combinations,” in its consolidated financial statements and the results of operations are included for periods subsequent to the acquisition date. As such, Houghton Mifflin adjusted its assets and liabilities to fair value including an increase of $6.4 million in the value of publishing rights (with an estimated life of 18 years).

Sunburst Disposition

In October 2002, Houghton Mifflin sold Sunburst Technology Corporation (“Sunburst”) for $22.8 million, including post-closing price adjustments. In May 1999, Houghton Mifflin had acquired Sunburst Communications Inc., a developer of software and video instructional materials for the elementary and secondary school markets, for an aggregate amount of $34.4 million. Houghton Mifflin subsequently merged Sunburst Communications Inc. with its Houghton Mifflin Interactive subsidiary to form Sunburst. Houghton Mifflin contributed to Sunburst the assets of the Little Planet Literacy Series, which it had acquired in January 1999 from Applied Learning Technologies, Inc. for $4.9 million in cash. Houghton Mifflin also contributed Educational Resources, Inc. and Roger Wagner Publishing Inc., distributors and developers of multimedia instructional products for the K-12 market, both of which it acquired from Vivendi concurrently with the Vivendi Purchase, for $6.4 million. The assets and liabilities, operational results and cash flows of Sunburst are reflected as discontinued operations in the accompanying financial statements.

2001 Activities

Vivendi Universal, S.A. Acquisition of Houghton Mifflin

On July 7, 2001, an indirect wholly owned subsidiary of Vivendi acquired 100% of Houghton Mifflin’s common stock for $2.35 billion, including the assumption of $613.7 million of debt. Prior to the Vivendi Purchase, Houghton Mifflin was a public company.

Prior to July 7, 2001, Houghton Mifflin incurred $51.7 million of expenses directly related to the Vivendi Purchase. This included the settlement of outstanding stock options, charitable contributions paid on behalf of Houghton Mifflin’s board of directors, and transaction-related costs.

At the time of the Vivendi Purchase, Houghton Mifflin adjusted its assets and liabilities to their fair market values. These adjustments included $706.0 million allocated to the fair value of its publishing rights (with an estimated life of 30 years), $301.0 million to trademarks and trade names (with an indefinite life), $6.4 million to the fair value of Houghton Mifflin leases (with an estimated average life of approximately six years), $26.4 million step-up to the fair value of its inventory, and $7.3 million step-up to the fair value of the debt at the Acquisition date. In conjunction with this assessment, Houghton Mifflin included $143.6 million of existing pre-publication costs in the fair value of publishing rights. Vivendi also committed to a formal plan to restructure Houghton Mifflin’s operations. Houghton Mifflin included costs related to this plan of $53.6 million in the allocation of the Acquisition price.

Other Acquisitions and Dispositions

Concurrently with the Vivendi Purchase, Houghton Mifflin acquired from Vivendi two other wholly owned subsidiaries, LKC Publications, Inc. (“LKC”) and Curriculum Advantage, for $1.1 million. LKC, a distributor of trade books, operates within Houghton Mifflin’s Trade and Reference Publishing segment. The accompanying consolidated financial statements include the operating results of LKC from the date of the Vivendi Purchase. These transactions were accounted for as a reorganization of entities under common control at historical cost. On April 1, 2003, we sold 100% of the outstanding shares of Curriculum Advantage.

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In December 2001, Houghton Mifflin acquired all of the outstanding common stock of Testing Systems, Inc. (“TSI”) from Thomson Newsprint Inc. for $17.7 million. TSI provides computer-based and paper-and-pencil test development, test administration and related services to state agencies, professional certification associations and corporations. The accompanying consolidated financial statements include TSI’s operating results from the date of acquisition in the Other segment. The acquisition was accounted for as a purchase. In 2002, Houghton Mifflin merged TSI with its wholly owned subsidiary, Computer Adaptive Technologies, to form Promissor.

In September 2000, Houghton Mifflin launched Classwell Learning Group, Inc. (“Classwell”) as a joint venture with Sylvan Ventures and Inception Capital. Houghton Mifflin initially invested $7.0 million of cash and contributed other assets in return for a fully diluted ownership interest in Classwell of approximately 32%, and accounted for its interest using the equity method. Upon the Vivendi Purchase, Sylvan Ventures and Inception Capital exercised their put right, pursuant to existing contractual requirements, and Houghton Mifflin acquired the remaining shares of Classwell held by Inception Capital in August 2001 and by Sylvan Ventures in October 2001 for $46.8 million. Beginning in August 2001, Houghton Mifflin has accounted for its investment in Classwell on a consolidated basis. In November 2002, Houghton Mifflin acquired all of the remaining shares of Classwell and it is now included in the K-12 Publishing segment.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon Houghton Mifflin’s consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates, assumptions, and judgments that affect the reported amounts of assets, liabilities, net sales, and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to book returns; allowance for bad debts; recoverability of advances to authors; valuation and recoverability of inventory; amortization periods; recoverability of long-term assets such as pre-publication costs, intangible assets, and goodwill; income taxes; restructurings, pensions and other post-retirement benefits, and contingencies; and litigation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Net Sales Recognition

The Company derives net sales primarily from the sale of textbooks and instructional materials, trade books, reference materials, assessment materials and multimedia instructional programs, license fees for book rights, content and software, and services that include test scoring, test development, and training.

Net sales from textbooks and instructional materials, trade books, reference materials, assessment materials and multimedia instructional programs are recognized in the period when persuasive evidence of an arrangement with a customer exists, the products are shipped and title and risk of loss have transferred to the customer, all significant obligations have been delivered and we consider collection to be reasonably assured.

Effective July 1, 2003, Houghton Mifflin adopted Financial Accounting Standards Board (“FASB”) Emerging Issues Task Force (“EITF”) Issue No. 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables.” EITF 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which it will perform multiple revenue-generating activities. EITF 00-21 establishes three principles: (a) revenue arrangements with multiple deliverables should be divided into separate units of accounting; (b) arrangement consideration should be allocated among the separate units of accounting based on their relative fair values; and (c) revenue recognition criteria should be considered separately for separate units of accounting. For Houghton Mifflin, the EITF applies to certain contracts having multiple elements or deliverables, a part of which will be delivered at a date(s) subsequent to the initial sale. The relative share of revenue for the undelivered items are

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deferred until such time as the products are delivered to the customer. The adoption of EITF 00-21 decreased net income by $4.4 million for the year ended December 31, 2003.

As our products are shipped with a right of return, at the time of sale we make a provision for returns on these sales, based on historical experience. We include shipping and handling fees billed to our customers in net sales. The cost of shipping and handling are included in selling and administrative costs. Our processed returns and accrual for estimated returns has ranged from 6% to 8% of total product sales over the past three years. The Company records net sales for textbooks shipped from depository locations one month in arrears based on information received from the depository.

We recognize net sales for test scoring and training in the period when the services have been completed, the fee is fixed and determinable and collection is reasonably assured. We recognize net sales for fixed-priced contracts that require significant test development as the services are provided using a cost plus margin approach. Differences between what has been billed and what has been recognized as revenue is recorded as deferred revenue. Losses on such contracts are recognized immediately when they become known.

We also enter into license agreements to license certain book publishing rights and content. We recognize net sales on those arrangements only when a contract is signed, the license term has begun, all obligations have been delivered to the customer, and collection is reasonably assured.

Inventory

We use the lower of weighted average cost or market method to value inventory and determine cost of inventories included in cost of sales in the statement of operations. Our level of obsolete and excess inventory is calculated on a program or title level by comparing the number of units in stock with the expected future demand. The expected future demand of a program or title is determined by the copyright year, the previous years’ sales history, the subsequent year’s sales forecast, known forward-looking trends including our development cycle to replace the title or program, and competing titles or programs. Based on this review, any excess stock is reserved as appropriate.

Pre-Publication Expenditures

Pre-publication expenditures are costs incurred after the completion of a final manuscript. We capitalize and amortize the cost of our investment in pre-publication expenditures from the year of publication or sale, if earlier, over two to five years using the sum-of-the-years-digits method. All of our divisions use this policy, except for our Trade and Reference Division with respect to its non-reference publications, which are expensed, and our Riverside Division, which uses the straight-line amortization method. We believe the amortization methods and periods chosen best reflect the expected sales generated from individual titles or programs. We evaluate the remaining lives and recoverability of capitalized pre-publication costs, which are often dependent upon program acceptance by state adoption authorities, by comparing the carrying amount related to each title or program with its estimated fair value. Fair value is estimated using the expected future undiscounted net cash flows expected to be generated by that title or program. If a title or program is considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the title or program pre-publication costs exceeds the estimated fair value.

Publishing Rights Intangibles

Publishing rights are contractual relationships between us and an author, allowing us to publish and republish an author’s existing and future works as well as create new works based on the author’s prior work. We determine the fair market value of the publishing rights at the date of acquisition by discounting the after-tax cash flows projected to be derived from the publishing rights and titles to their net present value using a rate of return that accounts for the time value of money and the appropriate degree of risk. The useful life of the publishing

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rights is based on the lives of the various copyrights involved. We calculate amortization using the percentage of the projected operating income before taxes derived from the titles in the current year as a percentage of the total estimated operating income before taxes over the useful life.

Goodwill and Other Intangible Assets

Effective as of January 1, 2002, Houghton Mifflin adopted SFAS No. 142, “Goodwill and Other Intangible Assets.” We test for impairment of goodwill and other indefinite lived intangible assets annually on October 1 on an implied residual basis by deducting the fair value of all assets and liabilities from the total estimated fair value of the reporting unit to determine residual fair value of goodwill and other indefinite lived intangibles. If assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the implied fair value of the assets. We estimate total fair value of reporting units using discounted cash flow analysis, and make assumptions regarding future revenues, gross margins, investments in new products, capital spending, tax cash flows, and the terminal value of the reporting unit.

In September 2002, we began to reassess the recoverability of goodwill and other long-lived assets because certain indicators of possible impairment were present, the most significant of which was the sale of Houghton Mifflin by Vivendi at an estimated selling price below the net book value of our net assets. An assessment was performed on the carrying value of our long-lived assets other than goodwill, and determined that these assets were not impaired at that time. The goodwill impairment was measured on an implied residual basis being the excess of recorded goodwill over the implied residual value, being the sale price of Houghton Mifflin. As a result of this assessment of goodwill, we recorded a $775 million impairment charge.

We completed our annual goodwill and indefinite lived intangible asset impairment test as of October 1, 2003 and determined that no impairment existed.

Trademarks, other than Edusoft, are not amortized, as we believe they have indefinite lives. Our other intangibles, including the Edusoft trademark, are amortized on a straight-line basis over their estimated useful lives between two and twelve years.

Royalty Advances

Royalty advances represent royalties paid to an author before they are earned. Royalty advances are most prevalent in the Trade and Reference Publishing segment. Advances are expensed as royalties are earned. Annually, advances are evaluated to determine if they are expected to be earned by applying the contracted royalty rate to forecasted future sales by title. In estimating total future sales, we consider, among other factors, historical and expected sales and performance of similar titles. Any portion of a royalty advance that is not expected to be earned is fully reserved. In addition, prior to publication, royalty advances in certain categories may be partially reserved against to reflect our historical experience with similar titles.

Taxes

The Company has incurred losses subsequent to the Acquisition as a result of the financings having significantly increased interest expense and the Acquisition having increased certain other costs. The Company recorded significant deferred tax liabilities as a result of purchase accounting for the Acquisition with respect to book-tax differences for identifiable intangible assets. There was no step-up in tax basis for these assets and, accordingly, there is no future tax deductibility for them.

The Company has recorded a tax benefit for the losses incurred in 2003. The recoverability of these taxable losses is adequately covered by existing taxable temporary differences that reverse before the expiration of the loss carry forward period allowed by law. The Company is projecting taxable income in the future that will utilize deferred tax assets recorded. If the Company does not anticipate sufficient taxable income in the near term, or if reversing taxable temporary differences are not sufficient, the Company would need to record a valuation allowance against deferred tax assets.

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Retirement Plans

We maintain a qualified defined benefit pension plan that covers substantially all domestic employees, a defined benefit plan for Kingfisher, and an unfunded excess plan that covers domestic employees who earn over the qualified pay limit (together the “pension plans” or the “plans”).

Our pension expense for all pension plans was approximately $13.0 million in 2003, and is calculated based upon a number of actuarial assumptions, including a weighted average expected long-term rate of return on the assets of our retirement plans of 7.96%. Our overall expected long-term rate of return on U.S. plan assets is 8.0% and 7.0% for non-U.S. plan assets. The U.S. plan assets represent close to 96% of total plan assets. In determining the expected return on U.S. plan assets, the Company considers the relative weighting of plan assets, the historical performance of plan assets and individual asset classes, and economic and other indicators of future performance. In addition, we may consult with and consider the opinions of financial and other professionals in developing appropriate return benchmarks. A similar process is used to determine this rate for our non-U.S. plan.

We regularly review our actual asset allocation and periodically rebalance our investments to our targeted allocation when appropriate. For 2004, we have maintained our weighted average expected long-term rate of return at 7.96%, as well as the associated asset allocation assumptions of approximately 60% equities and 40% fixed income investments. We will continue to evaluate our actuarial assumptions, including our weighted average expected rate of return, at least annually, and will adjust as necessary.

We base our determination of pension expense on a market-related value of assets that spreads asset gains or losses over a five-year period, which reduces year-to-year volatility. Investment gains or losses for this purpose are the difference between the expected return calculated using the market-related value of assets and the actual return. Since the market-related value of assets recognizes gains or losses over a five-year period, the future value of assets will be impacted as previously deferred gains or losses are recorded.

As a result of the Acquisition on December 30, 2002, unrecognized net actuarial losses of approximately $38.3 million were recorded on our consolidated balance sheet as part of the purchase accounting.

The discount rates that we utilize for determining future pension obligations are based on the yields on high quality fixed income investments. Moody’s Aa bond is one benchmark used for this purpose. The weighted average discount rate determined on this basis has decreased from 6.46% at December 30, 2002 to 5.74% at September 30, 2003.

We estimate that our pension expense for all plans will be approximately $14 million in 2004. This estimate is based on a weighted average expected rate of return on the assets of our pension plans of 7.96%, a weighted average discount rate of 5.74% and various other assumptions. Future actual pension expense will depend on future investment performance, changes in future discount rates and various other factors related to the populations participating in our plans.

Lowering the weighted average expected long-term rate of return on the assets of our plans by 0.5% would have increased our projected pension expense for 2004 by approximately $0.6 million. Lowering the discount rate and the salary increase assumptions each by 0.5% would have increased our projected pension expense for 2004 by $ 0.1 million.

The value of our pension plan assets, comprising only the domestic qualified and Kingfisher plans, has increased from $88.4 million at December 31, 2002 to $111.7 million at September 30, 2003, driven primarily by Company contributions and asset performance. The actuarial losses associated with the decrease in the discount rate, combined with the recognition of interest and service costs were only partially offset by cash contributions and asset returns, thereby increasing our under-funded status for these two plans from $76.4 million at December 31, 2002 to $77.2 million at December 31, 2003.

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Houghton Mifflin expects to contribute $14 million to its pension plans in 2004. However, the actual funding decision will be made after the 2004 actuarial valuations are completed. In addition, this amount could change pending Congressional review of interest rate relief for pension plans.

Post-Retirement Medical Benefits

Houghton Mifflin provides postretirement medical benefits to retired full-time, non-union employees hired before April 1, 1992, who have provided a minimum of five years of service and attained age 55. For retirements on or after January 1, 1993, the Company’s commitment to provide postretirement medical benefits is capped ($10,000 per year for coverage before age 65 and $5,000 per year for coverage at/after age 65).

As a result of the Acquisition on December 30, 2002, unrecognized net actuarial losses of approximately $6.8 million were recorded on our consolidated balance sheet as part of the purchase accounting.

Our postretirement medical expense was approximately $4.2 million in 2003, and is calculated based upon a discount rate of 6.5%, medical inflation rate grading down from 14.0% to 5.0% per annum, and a number of other actuarial assumptions.

The discount rates that we utilize for determining future benefit obligations are based on the yields on high quality fixed income investments. The weighted average discount rate determined on this basis has decreased from 6.5% at December 30, 2002 to 5.75% at September 30, 2003.

We estimate that our post-retirement medical expense will be approximately $4.3 million in 2004. This estimate is based on a discount rate of 5.75% and medical inflation grading down from 12.5% to 5.0% per annum.

On December 8, 2003, President Bush signed the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 into law. This legislation, among other things, established a Medicare prescription-drug benefit and federal subsidy to sponsors of retiree health-care plans that provide a benefit at least actuarially equivalent to the Medicare benefit. The Company has elected to defer the recognition of the impact of these changes.

Lowering the discount rate by 0.5% would have increased our projected postretirement medical expense for 2004 by approximately $0.1 million. Lowering the medical inflation rate assumption by 0.5% would have decreased our projected postretirement medical expense for 2004 by $ 0.1 million.

Restructuring

The following table sets forth the activity in restructuring reserves in the year ended December 31, 2003.

Holdings committed to a formal plan to restructure Houghton Mifflin’s operations, predominately through the rationalization of corporate functions and the reorganization and consolidation of certain K-12 business operations resulting in a reduction in workforce and closure of certain facilities. The workforce related charges included costs associated with severance, employee benefit continuation, and outplacement support for nearly 429 employees affected. The facilities charges included accruals for lease commitments for facilities made redundant. As of December 31, 2003, approximately two-thirds of the employees affected by the restructuring

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plan have been terminated. The Company’s policy is to pay severance in equal installments over time. As such, many of these employees will continue to receive severance payments in 2004. Houghton Mifflin included all material aspects of this plan and the estimated costs of $23.1 million in the allocation of the purchase price of the Acquisition. Houghton Mifflin used approximately $9.1 million in 2003, primarily to pay costs in connection with severance and lease payments. The Company expects to substantially complete its restructuring activities in 2004 and incur the majority of the work-force related and other expenses by December 31, 2004 with certain facilities related costs attributed to long-term lease obligations and severance costs paid over time extending beyond that date.

Results of Operations

The following tables set forth information regarding Houghton Mifflin’s net sales, operating income (loss) and other information from our consolidated statements of operations. As discussed above, the results and percentages for the year ended December 31, 2001 are based on the mathematical addition of the historical results from the Pre-predecessor Stub Period and Predecessor Stub Period, as set out in the following table, and are not necessarily indicative of what the results for the periods would have been had the Vivendi Purchase not occurred.

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Year Ended December 31, 2003 Compared to Year Ended December 31, 2002

We derive, on average, approximately 85% of annual net sales from educational publishing in the K-12 and College Publishing segments, which are markedly seasonal businesses. Schools and colleges make most of their purchases in the second and third quarters of the calendar year, in preparation for the beginning of the school year in late August and early September.

Net Sales

Net sales for the year ended December 31, 2003 increased $68.9 million, or 5.8%, to $1,263.5 million from $1,194.6 million in the same period for 2002.

K-12 Publishing. The K-12 Publishing segment’s net sales for the year ended December 31, 2003 increased $75.4 million, or 9.7%, to $848.4 million from $773.0 million in the same period for 2002. The increase in net sales was primarily due to market share gains and increased sales opportunities in the second year of the California reading adoption contributing $30.6 million, strong performances in secondary school social studies adoptions in other states, including Texas, North Carolina, and Indiana, of approximately $51.3 million, and higher testing net sales of approximately $18.9 million, driven by increased sales from criterion-referenced test contracts and the launch of the 5^th edition of the Stanford-Binet Intelligences Scales Test. Cyclical decreases in other adoption opportunities partially offset these increases.

College Publishing. The College Publishing segment’s net sales for the year ended December 31, 2003 increased $14.2 million, or 6.7%, to $226.1 million from $211.9 million in the same period for 2002. The net sales increase was due primarily to continued domestic market share growth from frontlist titles of approximately $9.8 million, with the balance of the increase coming from growth in secondary school advanced placement and international markets.

Trade and Reference Publishing. The Trade and Reference Publishing segment’s net sales for the year ended December 31, 2003 decreased $19.4 million, or 13.4%, to $125.1 million from $144.5 million in the same period for 2002. The decrease was mainly due to the anticipated lower J.R.R. Tolkien book sales of approximately $25.9 million and lower children’s book sales of $6.6 million. These decreases were partially offset by incremental sales from Kingfisher, which was acquired on December 30, 2002 and contributed net sales of $17.6 million.

Other. The Other segment’s net sales for the year ended December 31, 2003 decreased $1.2 million, or 1.8%, to $63.9 million from $65.1 million in the same period for 2002. The decrease was due to lower sales from Promissor, our professional testing subsidiary, mostly due to lower revenue associated with corporate certification contracts.

Cost of Sales Excluding Pre-publication and Publishing Rights Amortization

Cost of sales excluding pre-publication and publishing rights amortization for the year ended December 31, 2003 increased $30.2 million, or 6.4%, to $500.3 million from $470.1 million for the same period in 2002. The higher cost of sales was primarily due to increases in manufacturing costs, royalties, and editorial costs. Higher manufacturing costs of $21.0 million were primarily due to higher sales and increased amortization of inventory step-up charges of $5.5 million as a result of the Acquisition. The increase in royalty costs of $4.6 million was primarily attributed to increased sales. Increased editorial expenses of $2.8 million were incurred for new program development and product revisions for sales opportunities in 2004 and beyond. Cost of sales as a percentage of net sales were relatively flat at 39.6% in 2003 compared to 39.4% 2002.

Pre-publication and Publishing Rights Amortization

Pre-publication and publishing rights amortization for the year ended December 31, 2003 increased $6.1 million, or 3.9%, to $161.3 million from $155.2 million during the same period for 2002. The increase is

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attributable to an increase in publishing rights amortization of approximately $24.0 million, partially offset by lower pre-publication amortization of $17.9 million, both the result of the Acquisition accounting, whereby the fair value of publishing rights were established as of the Acquisition date, including the capitalization of approximately $88.7 million of existing pre-publication costs in the publishing rights fair value. As a percentage of net sales, pre-publication and publishing rights amortization decreased to 12.8% in 2003 from 13.0% in 2002 due primarily to increased net sales.

Selling and Administrative Expenses

Selling and administrative expenses for the year ended December 31, 2003 increased $54.7 million, or 11.0%, to $550.9 million from $496.2 million during the same period for 2002. As a percentage of net sales, selling and administrative expenses increased to 43.6% for the year ended December 31, 2003 compared to 41.5% for the same period in 2002. Higher selling and administrative expenses were due mainly to one time costs including the incremental costs for retention agreements with key employees of $23.2 million, increased professional fees of $10.2 million for increased legal, accounting, strategic, and other professional services initially required to operate as an independent business, and higher severance cost of $2.3 million. Other factors contributing to the increase in selling and administrative expenses included the acquisition of Kingfisher, which increased selling and administrative expenses by $6.1 million; added costs of approximately $3.0 million as a result of being an independent company requiring stand-alone corporate functions previously provided by Vivendi, including internal audit, treasury, and tax; and higher employee compensation and benefit costs, partially offset by lower sample costs of $3.4 million, reflecting fewer adoption opportunities in 2004 compared to 2003.

Goodwill Impairment Charge

During the year ended December 31, 2002, we recorded a $775.0 million charge relating to the impairment of the goodwill arising from the Vivendi Purchase.

Intangible Asset Amortization

Intangible asset amortization for the year ended December 31, 2003 decreased $0.2 million, or 12.6%, to $1.4 million from $1.6 million during the same period for 2002. The decrease in intangible asset amortization was due to the fair value accounting at the time of the Acquisition, offset partially by amortization recognized on intangibles acquired during the current year.

Operating Income

Operating income for the year ended December 31, 2003 increased $753.2 million to $49.7 million from an operating loss of $703.5 million for the same period in 2002. The operating loss for the year ended December 31, 2002 included the goodwill impairment charge of $775.0 million.

K-12 Publishing. The K-12 Publishing segment’s operating results for the year ended December 31, 2003 increased $523.5 million to $60.6 million from a loss of $462.9 million for the same period in 2002. The operating loss for 2002 included $505.4 million of goodwill impairment charge. The increase in operating income was primarily due to the lack of a goodwill impairment charge in 2003, higher sales and lower sample costs, partially offset by higher implementation costs, the impact of higher inventory step-up amortization from the Acquisition, higher editorial costs, and higher employee related costs including the incremental cost of retention agreements with key employees, compensation, and benefits.

College Publishing. The College Publishing segment’s operating income for the year ended December 31, 2003 increased $207.1 million to $2.4 million from a loss of $204.7 million in 2002. The operating loss for 2002 included $226.3 million for the goodwill impairment charge. The increase was mainly due to the lack of goodwill

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impairment charge in 2003 and higher sales, partially offset by higher publishing rights amortization resulting from the Acquisition, charges related to retention agreements for key employees, and higher depreciation expense for technology initiatives in digitizing our content.

Trade and Reference Publishing. The Trade and Reference Publishing segment’s operating loss decreased by $27.2 million to $6.8 million from an operating loss of $34.0 million for the year ended December 31, 2002. The 2002 operating loss included $43.3 million of goodwill impairment charge. The decrease in operating loss was primarily due to the lack of a goodwill impairment charge in 2003, partially offset by lower net sales and increased editorial costs, the result of acquiring Kingfisher, as well as higher editorial costs as a percent of sales primarily due to the lower level of net sales, and the effect of employee retention charges.

Other. The Other segment’s operating loss increased $4.7 million to a loss of $6.6 million for the period ended December 31, 2003 from a loss of $1.9 million in the same period for 2002. The decrease in operating results was due primarily to lower sales and higher depreciation expense due to the fair valuing of assets related to the Acquisition.

Net Interest Expense

Net interest expense for the year ended December 31, 2003 increased $70.0 million, or 164.2%, to $112.6 million from $42.6 million in the same period for 2002. The overall increase in net interest expense was due to higher interest rates and the increased level of debt resulting from the Acquisition and subsequent refinancings in 2003.

Debt Extinguishment Charge

In the first quarter of 2003, we recorded a $48.4 million debt extinguishment charge related to the tendering of the 2004 Senior Notes and 2006 Senior Notes and the repayment of the $500.0 million senior subordinated bridge loan facility and the $275.0 million senior term loan under the senior credit facility that were used to finance the Acquisition.

Income Taxes

Income taxes for the year ended December 31, 2003 resulted in a $41.0 million benefit compared to a $12.1 million provision in the same period for 2002. The income tax benefit in 2003 was primarily due to the loss from continuing operations and an effective tax rate of 36.8%. The goodwill impairment charge in 2002 was not tax deductible. The income tax provision in 2002 was due to income from continuing operations, excluding the impact of the goodwill impairment charge and an effective tax rate of 42.2%.

Discontinued Operations

For the year ended December 31, 2003, discontinued operations incurred a loss of $1.2 million compared to a loss of $31.8 million for the comparable period in 2002. The results of Curriculum Advantage, which was sold on April 1, 2003, are presented in discontinued operations for the year ended December 31, 2003. The results of Curriculum Advantage and Sunburst, which was sold in October 2002, are presented in discontinued operations for the comparable period in 2002. The 2002 year end results include a $31.9 million impairment charge, including $27.9 million of goodwill and $1.4 million of other intangible assets attributable to Sunburst to reflect its sale value.

Preferred Stock Dividend and Redemption Costs

The preferred stock shares of a subsidiary were auctioned and redeemed on December 30, 2002. There were no preferred stock dividends during the year ended December 31, 2003 and $8.6 million of dividends for the year ended December 31, 2002.

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Year Ended December 31, 2002 Compared to Year Ended December 31, 2001

Net Sales

Net sales for the year ended December 31, 2002 increased $65.4 million, or 5.8%, to $1,194.6 million from $1,129.2 million in the same period for 2001.

K-12 Publishing. The K-12 Publishing segment’s net sales for the year ended December 31, 2002 decreased $20.7 million, or 2.6%, to $773.0 million from $793.7 million in the same period for 2001. The sales decrease was due to reduced adoption opportunities in our core secondary school subjects, which contributed to a $50 million decrease in sales, sales decreases in open territories of $44 million primarily due to certain state funding shortfalls and decreased opportunities, uncertainties during the period regarding the implementation of the testing provisions of the NCLB Act, and an expected decline in net sales of $5.8 million from the Woodcock-Johnson III Complete Battery, which was released in 2000. These reductions were partially offset by higher sales in the California elementary school reading adoption that led to higher California elementary school sales of $72.5 million and the successful launch of new supplemental products.

College Publishing. The College Publishing segment’s net sales for the year ended December 31, 2002 increased $26.1 million, or 14.0%, to $212.0 million from $185.9 million in the same period for 2001. This increase in net sales was due to increased enrollment, strong performance in the domestic market of frontlist titles and growing high school advanced placement sales. These increases were offset by higher book returns due to the higher sales but book returns were slightly lower as a percentage of sales.

Trade and Reference Publishing. The Trade and Reference Publishing segment’s net sales for the year ended December 31, 2002 decreased $2.5 million, or 1.7%, to $144.5 million from $147.0 million in the same period for 2001. The Trade and Reference Division’s net sales in 2002 were down slightly from 2001 due to lower net sales of titles by J.R.R. Tolkien. Both 2001 and 2002 benefited from increased sales of titles by J.R.R. Tolkien, primarily due to the release of the motion pictures The Lord of the Rings: The Fellowship of the Ring in December 2001 and The Lord of the Rings: The Two Towers in December 2002. Due to market saturation, we expected that our heightened level of sales of titles by J.R.R. Tolkien would decline in 2003, and expected higher book returns in 2003 on the Tolkien titles sold in 2002. As such, we increased our book return reserve at December 31, 2002 to cover these expected returns.

Other. The Other segment’s net sales for the year ended December 31, 2002 increased $62.5 million to $65.1 million from $2.6 million in the same period for 2001. The 2002 net sales included $62.2 million from TSI, which we acquired in December 2001. During 2002, TSI was combined with the operations of Computer Adaptive Technologies and renamed Promissor.

Cost of Sales Excluding Pre-publication and Publishing Rights Amortization

Cost of sales excluding pre-publication and publishing rights amortization for the year ended December 31, 2002 decreased $41.0 million, or 8.0%, to $470.1 million from $511.1 million for the same period in 2001. Our cost of sales for 2002 included $4.4 million of inventory step-up expense compared to $22.0 million in 2001. This decrease, other than the effects of inventory step-up amortization, was primarily due to lower inventory obsolescence costs and favorable vendor pricing in 2002. For 2001, we incurred an additional $21.9 million of inventory obsolescence costs, mainly in K-12 Publishing, after disappointing performances in certain states’ elementary school adoptions. Editorial costs in 2001 included $7.0 million of non-recurring costs directly related to the Vivendi Purchase. Cost of sales in 2002 also decreased as we renegotiated more favorable pricing from certain of our major vendors. As a percentage of sales, cost of sales decreased to 39.4% for 2002 from 45.3% in 2001. The lower percentage was also due to the acquisition of TSI, which has minimal cost of sales due to the nature of its business, the delivery of computer-based testing solutions.

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Pre-publication and Publishing Rights Amortization

Pre-publication and publishing rights amortization for the year ended December 31, 2002 increased $50.0 million, or 47.5%, to $155.2 million from $105.2 million in the same period for 2001. This increase was primarily due to having twelve months of publishing rights amortization during 2002 compared to six months of amortization during 2001 as a result of an increase in the fair value of the publishing rights due to the Vivendi Purchase. As a percentage of sales, pre-publication and publishing rights amortization increased to 13.0% in 2002 from 9.3% in 2001.

Selling and Administrative Expenses

Selling and administrative expenses for the year ended December 31, 2002 increased $37.7 million, or 8.2%, to $496.2 million from $458.5 million in the same period for 2001. As a percentage of sales, selling and administrative expenses increased to 41.5% in 2002 compared to 40.6% in 2001. Selling and administrative expenses in 2001 included $44.1 million of non-recurring costs directly related to the Vivendi Purchase, a $4.0 million restructuring charge (consisting primarily of severance payments and lease termination costs) for the closing of our Morris Plains, New Jersey facility and $2.1 million of restructuring expense related to the integration of subsidiaries acquired from Vivendi. Selling and administrative expenses in the twelve months ended December 31, 2002 included approximately $10 million of retention payments and non-recurring costs related to the Vivendi Purchase and the Acquisition and a management fee of $6.0 million paid to Vivendi. The integration of TSI, which caused selling and administrative expenses to increase by $43.8 million, higher selling costs, due to an increase in the size of the sales force and increased sampling costs, reflecting more new adoption opportunities compared to the prior year, also contributed to the increase in selling and administrative expenses in 2002.

Intangible Asset Amortization

Intangible asset amortization for the year ended December 31, 2002 decreased $0.2 million, or 11.1%, to $1.6 million from $1.8 million in the same period for 2001. The decrease in intangible asset amortization was due to the Vivendi Purchase. As at July 7, 2001, we revalued other intangibles, which reduced our amortization in 2001. As a result, intangible asset amortization as a percentage of sales decreased to 0.1% of sales in 2002 from 0.2% in 2001.

Goodwill Amortization

Goodwill amortization for the year ended December 31, 2002 decreased 100.0%, to zero from $14.9 million in 2001. The decrease in goodwill amortization was due to our adoption of SFAS No. 141 and SFAS No. 142, pursuant to which we stopped amortizing goodwill after the date of the Vivendi Purchase.

Goodwill Impairment Charge

For 2002, we recorded a $775.0 million charge relating to the impairment of the goodwill arising from the Vivendi Purchase.

Operating Income (Loss)

Operating results for the year ended December 31, 2002 decreased $741.2 million to a loss of $703.5 million from income of $37.7 million in the same period for 2001. The operating loss for the year ended December 31, 2002 included a goodwill impairment charge of $775.0 million.

K-12 Publishing. The K-12 Publishing segment’s operating results for the year ended December 31, 2002 decreased $514.8 million to a loss of $462.9 million from income of $51.9 million for the same period in 2001. The operating loss for 2002 included $505.4 million of goodwill impairment charge. Lower sales, higher publishing rights amortization due to the Vivendi Purchase, and higher sampling costs due to increased sales

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opportunities, partially offset by the absence in 2002 of non-recurring expenses incurred in 2001 due to the Vivendi Purchase, lower restructuring expenses related to closing the Morris Plains, New Jersey office, lower markdown expense, and lower manufacturing costs due to favorable pricing from our major vendors, were other significant contributing factors in the decrease in operating margin.

College Publishing. The College Publishing segment’s operating results for the year ended December 31, 2002 decreased $216.2 million to a loss of $204.7 million from income of $11.5 million in the same period for 2001. The operating loss in 2002 included $226.3 million for the goodwill impairment charge. The combined effect of the goodwill impairment charge and higher publishing rights amortization, partially offset by higher sales and non-recurring costs in 2001 due to the Vivendi Purchase, were the primary contributing factors in the decrease in operating income.

Trade and Reference Publishing. The Trade and Reference Publishing segment’s operating results for the year ended December 31, 2002 decreased $36.2 million to a loss of $34.0 million from income of $2.2 million in the same period for 2001. The operating loss for 2002 included $43.3 million of goodwill impairment charge. The combined effect of the goodwill impairment charge and higher publishing rights amortization, partially offset by non-recurring expenses incurred in 2001 related to the Vivendi Purchase and restructuring expenses incurred in 2001 related to combining LKC, previously a Vivendi subsidiary, into Houghton Mifflin, were the primary drivers in the decrease in operating income.

Other. The Other segment’s operating loss for the year ended December 31, 2002 decreased by $25.9 million, or 93.2%, to $1.9 million from $27.8 million in the same period for 2001. The lower operating loss was due to non-recurring expenses incurred in 2001 related to the Vivendi Purchase, the acquisition of TSI, which contributed operating income to the segment, and lower unallocated corporate expenses.

Net Interest Expense

Net interest expense for the year ended December 31, 2002 decreased $0.6 million, or 1.4%, to $42.7 million from $43.3 million in the same period for 2001. The overall decrease in our net interest expense was due to lower interest rates, as Vivendi started funding our short term working capital needs partially offset by an increase in debt after the Vivendi Purchase. Net interest expense from affiliate loans was $10.1 million in 2001, all of which was charged in the period from July 7, 2001 to December 31, 2001, compared to $29.0 million for 2002.

Equity in Losses of Equity Method Investments

For 2001, we recorded a $4.7 million loss using the equity method, which reflected our share of the losses from our equity interest in Classwell. As of August 15, 2001, Classwell was fully consolidated into our accounts. Subsequent to this date, we have had no other equity method investments.

Other

During 2001, we recorded a charge for the write-down of an investment in an electronic library start-up company, which resulted in a pre-tax loss of $0.5 million. We also recorded $0.9 million of income related to the minority interest in 2001, representing the period in which we did not wholly own Classwell.

Income Taxes

The income tax provision for the year ended December 31, 2002 decreased $0.2 million, or 1.6%, to $12.1 million from $12.3 million in the same period for 2001. For the period of Vivendi ownership, we were a member of Vivendi’s U.S. consolidated tax group. However, we calculated our income tax provision on a stand-alone basis. For 2002, we recorded a tax expense of $12.1 million with an effective tax rate of 1.6%. The asset impairment charge was not tax deductible. Excluding the impact of the asset impairment charge, the effective tax rate for 2002 was 42.0%.

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In 2001, we recorded a tax benefit of $35.9 million for the period prior to the Vivendi Purchase (the Pre-predecessor Stub Period) with an effective tax rate of (29.1)%, and a tax provision of $48.2 million for the Predecessor Stub Period, with an effective tax rate of 42.6%. The tax benefit in the first half of 2001 included an accrual of $8.9 million for settlement with the IRS resolving all outstanding matters related to a dispute about our corporate owned life insurance.

Discontinued Operations

The loss from discontinued operations for the year ended December 31, 2002 increased $28.4 million, or 835.3%, to $31.8 million from $3.4 million in the same period for 2001. The results of Sunburst, which was sold in October 2002, and Curriculum Advantage, which was sold in April 2003, are presented in discontinued operations. In 2002, we recorded a $31.9 million impairment charge primarily related to goodwill and other intangible assets allocated to Sunburst to reflect its sale value.

Preferred Stock Dividend and Redemption Costs

The preferred stock dividend and redemption costs for the year ended December 31, 2002 increased $7.8 million, or 975%, to $8.6 million from $0.8 million in the same period for 2001. In October 2001, we issued shares of preferred stock of a subsidiary to a financial institution. This stock carried a 4.75% annual dividend rate for an after-tax charge of $3.6 million in 2002 and $0.8 million in 2001. These shares were auctioned and redeemed on December 30, 2002, prior to the Acquisition, and an additional after tax charge of $5.0 million was incurred to redeem the preferred shares.

Liquidity and Capital Resources

Our sales seasonality affects our operating cash flow. We normally incur a net cash deficit from all of our activities through the middle of the third quarter of the year. We currently fund such seasonal deficits through the drawdown of cash and marketable securities, supplemented by borrowings under our revolving senior credit facility.

Operating Activities

Net cash provided by continuing operating activities was $185.3 million for the year ended December 31, 2003, a $116.7 million decrease from the $302.0 million provided by operating activities during 2002. The decrease is primarily attributable to a net loss of $70.4 million that includes increased costs from retention agreements with key employees, higher costs incurred to operate as an independent company, including professional fees and employee related costs, and higher interest expense and debt extinguishment costs, partially offset by the increase in net sales. Changes in operating assets and liabilities used $79.3 million more cash during the year-ended December 31, 2003 in comparison to 2002 due to a tax refund received in 2002, higher pension contributions in 2003, and increased receivables due to higher sales, partially offset by lower inventories due mainly to lower purchases. Discontinued operations used $16.0 million less cash in 2003 than 2002 due to the timing of the respective sales of Curriculum Advantage on April 1, 2003 and Sunburst on October 1, 2002. See “Investing Activities.”

Net cash provided by continuing operating activities was $302.0 million in the year ended December 31, 2002, compared to $252.5 million in 2001. The increase was primarily attributable to increased net sales and the greater effects on 2001 of non-recurring costs directly related to the Vivendi Purchase partially offset by higher selling costs reflecting more new adoption opportunities. Changes in operating assets and liabilities used $30.6 million more cash in 2002 than 2001 due to higher accruals in the Pre-predecessor Stub Period. The Pre-predecessor Stub Period includes the accrual for the non-recurring expenses that were subsequently paid on behalf of Vivendi and included in the Predecessor Basis financing activities, partially offset by lower income taxes due to an income tax refund received in 2002. Discontinued operations used $20.0 million more cash in 2002 than 2001 due to the timing of the sale of Sunburst on October 1, 2002. See “Investing Activities.”

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Investing Activities

Cash used for continuing investing activities was $171.5 million for the year ended December 31, 2003, an increase of $31.0 million from the $140.5 million used in the same period in 2002. Higher acquisition activities of $44.7 million were partially offset by lower property, plant and equipment expenditures of $13.5 million due to a reduction in leasehold improvements and decreased spending on software development as certain initiatives to digitize our content were completed. Cash provided by discontinued investing activities decreased by $16.5 million primarily due to the disposal of Sunburst on October 1, 2002, net of investments in pre-publication and property, plant, and equipment expenditures during the period prior to sale.

Cash used for continuing investing activities was $140.5 million in 2002, a decrease of $5.7 million from the $146.2 million required in 2001. The decrease reflects a $22.1 million decrease in acquisitions partially offset by higher pre-publication expenditures of $6.8 million and higher property, plant, and equipment expenditures of $8.9 million. The higher pre-publication expenditures were due to increased investment in new programs for sales opportunities in 2003 and beyond. The additional property, plant, and equipment expenditures represent investments made for our new testing operations and the initiative to digitize our content. The net increase in cash provided by discontinued investing activities was primarily attributable to the sale of Sunburst in 2002, net of investment made in pre-publication and property, plant, and equipment during 2002 and 2001, respectively.

Financing Activities

Net cash provided by financing activities was $68.1 million for the year ended December 31, 2003. During 2003, we issued $600 million of 8.25%, 8-year notes due February 1, 2011 and $400 million of 9.875%, 10-year notes due February 1, 2013, resulting in net cash proceeds, net of borrowing costs, of $974.6 million. These proceeds were used to repay the $500 million senior subordinated bridge loan facility, the $275 million senior term loan under the previously existing senior credit facility, and $124.96 million of the $125 million, 7.00% senior secured notes due March 1, 2006 (the “2006 Senior Notes”). The Company also incurred $7.3 million of transaction related costs associated with the Acquisition paid on behalf of Holdings.

Net cash used in financing activities was $66.5 million in 2002, due primarily to the repayment of intercompany working capital of $43.3 million and transaction costs paid on behalf of Vivendi of $17.9 million.

At December 30, 2002, net cash used to fund the acquisition of Houghton Mifflin and Kingfisher by Holdings was $41.0 million. The net proceeds of $175.0 million from the issuance of senior term debt, $500 million from the issuance of senior subordinated bridge financing and $615 million of equity from Holdings were used to fund the acquisition of Houghton Mifflin and pay the financing fees.

The net cash used in financing activities was $95.9 million in 2001 due to the repayment of commercial paper of $183.8 million and transaction costs paid of $81.1 million, partially offset by the net proceeds of long-term financing of $119.3 million and the net proceeds of intercompany working capital borrowings of $30.7 million. Vivendi funded our working capital requirements during their ownership period, resulting in the significant reduction in commercial paper borrowings during 2001.

At December 31, 2003, we have a $325 million revolving senior credit facility for which we pay annual commitment fees of .75% on the unused portion. This agreement will expire on December 31, 2008 and requires us to comply with certain covenants, the most restrictive of which include maintaining certain interest coverage, leverage, and senior leverage ratios. The facility is available until its maturity to fund our working capital requirements, capital expenditures, and other general corporate needs. The facility is also available to issue letters of credit, of which $21.2 million were outstanding at year-end. The $21.2 million primarily represents letters of credit issued to back performance and surety bonds posted as security for our operating activities. Letters of credit outstanding are deducted from the borrowings available under the facility. At December 31, 2003, there were no other amounts outstanding under the facility.

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Debt

On a consolidated basis, our primary source of liquidity is cash flow generated from operations while our primary liquidity requirements are for debt service, pre-publication expenditures, capital expenditures, and working capital.

In connection with the Acquisition, Houghton Mifflin incurred substantial amounts of debt. Interest payments on this indebtedness have significantly increased its funding requirements. On January 3, 2003, Houghton Mifflin purchased $99.2 million of $100.0 million of its 7.125% senior secured notes due April 1, 2004 (the “2004 Senior Notes”). Houghton Mifflin borrowed an additional $100 million pursuant to its senior term loan under its then existing senior credit facility to finance this purchase. On January 30, 2003, Houghton Mifflin issued $600.0 million of 8.250% senior notes that mature on February 1, 2011 (the “Senior Notes”) and $400 million of 9.875% senior subordinated notes that mature on February 1, 2013 (the “Senior Subordinated Notes”). The senior subordinated notes were priced at 99.22% of principal amount to yield an effective interest rate of 10.0%. The net proceeds from these notes were approximately $974.6 million. The net proceeds from these two financings were used to repay Houghton Mifflin’s $500.0 million senior subordinated bridge loan facility in full, the $275.0 million senior term loan under the senior credit facility and repurchase $124.96 million of its 2006 Senior Notes.

The Amended and Restated Credit and Guaranty Agreement provides the Company with a $325 million senior secured revolving credit facility (the “Revolver”). The Revolver includes various financial covenants such as certain leverage and coverage ratios. The ratios are calculated quarterly using EBITDA, which is defined as earnings before interest, taxes, depreciation, and amortization and other adjustments allowed under the terms of the agreement, on a trailing twelve months basis. It also contains customary covenants, including limitations on the Company’s ability to incur debt, and events of default as defined by the agreement. The Revolver also limits the Company’s ability to pay dividends, to make advances, and otherwise engage in inter-company transactions.

The primary covenants under the Revolver are the total leverage ratio, senior leverage ratio, interest coverage ratio and consolidated capital expenditures for 2003. For 2003, the Revolver requires the total leverage ratio to be no greater than 5.15:1; the senior leverage ratio to be no greater than 3.50:1; the interest coverage ratio to be not less than 2.10:1 and that consolidated capital expenditures not exceed $180 million.

The unsecured 8.250% Senior Notes and the unsecured 9.875% Senior Subordinated Notes include various financial and customary covenants that limit the Company’s ability to pay dividends, make investments or sell assets, and dispose of substantially all our assets by sale or merger. Some covenants include the calculation of EBITDA, defined as earnings before interest, taxes, depreciation and amortization, and other adjustments under the indenture. These covenants are tied to the calculation of a fixed charge coverage ratio based on EBITDA, including the Company’s ability to incur additional debt or make restricted payments subject to qualifications and limitations as defined in the indenture. The fixed charge coverage ratio is required to be at least 2.0:1. Other covenants restrict the Company’s ability to enter into certain transactions with affiliates.

The Company was in compliance with the financial covenants for both the Revolver and the Senior and Senior Subordinated Notes, respectively, as of and for the year ended December 31, 2003.

On October 3, 2003, Publishing sold 11.50% senior discount notes due on October 15, 2013 (the “Senior Discount Notes”), generating initial gross proceeds of $150.9 million, in a private placement. The net proceeds from this offering of $145.2 million were distributed to the equity holders of Holdings as a return of capital. The Senior Discount Notes will not pay cash interest until after October 15, 2008, at which time the accreted value of these notes will be $265.0 million. At December 31, 2003, the accreted value of these notes was $155.2 million. Publishing is the sole obligor of these notes. Publishing’s notes are structurally subordinated to Houghton Mifflin’s debt.

Publishing conducts all of its business through Houghton Mifflin, its wholly owned subsidiary. Houghton Mifflin is not obligated to make funds available to Publishing for payment on the Senior Discount Notes. In

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addition, the terms of certain of the indentures governing the existing notes of Houghton Mifflin significantly restrict Houghton Mifflin and Publishing’s other subsidiaries from paying dividends, making distributions, and otherwise transferring assets to Publishing. For example, the ability of Houghton Mifflin to make such payments is governed by a formula based on 50% of its consolidated net income (which, as defined in such indentures, excludes goodwill impairment charges and any after tax extraordinary, unusual, or nonrecurring gains and losses) accruing from April 1, 2003. In addition, as a condition to making such payments to Publishing based on such formula, Houghton Mifflin must have a Debt Compliance Cash Flow to interest expense ratio of at least 2.0 to 1 after giving effect to any such payments. Notwithstanding any such restrictions, such indentures permit an aggregate of $25.0 million of such payments to be made whether or not there is availability under the formula or the conditions to its use are met.

The following table sets forth our consolidated long-term cash contractual obligations as of December 31, 2003: