ITEM 1. BUSINESS
GENERAL DEVELOPMENT OF BUSINESS -
H&R Block, Inc. is a financial services company with subsidiaries providing tax, investment, mortgage, and accounting and business consulting services and products. Our Tax Services segment provides income tax return preparation and other services and products related to tax return preparation to the general public in the United States, Canada and Australia. Our Business Services segment is a national accounting, tax and business consulting firm primarily serving mid-sized businesses under the RSM McGladrey name. Our Consumer Financial Services segment offers brokerage services, along with investment planning and related financial advice through H&R Block Financial Advisors and full-service banking through H&R Block Bank. Our mortgage operations offer a full range of home mortgage services through Option One Mortgage Corporation and H&R Block Mortgage Corporation. See additional discussion of our plans to dispose of our mortgage operations in “Recent Developments.”
H&R BLOCK’S MISSION -
“To help our clients achieve their financial
objectives by serving as their tax
and financial partner.”
We serve our clients’ financial needs through the consistent high quality delivery of a variety of tax and financial services. Operating through multiple lines of business allows us to better meet the changing financial needs of our clients.
H&R Block, Inc. was organized as a corporation in 1955 under the laws of the State of Missouri, and is a holding company with operating subsidiaries providing financial services and products to the general public. “H&R Block,” “the Company,” “we,” “our” and “us” are used interchangeably to refer to H&R Block, Inc. or to H&R Block, Inc. and its subsidiaries, as appropriate to the context. A complete list of our subsidiaries can be found in Exhibit 21.
RECENT DEVELOPMENTS - H&R Block Bank (HRB Bank) commenced operations on May 1, 2006, at which time H&R Block, Inc. became a savings and loan holding company. At that time, we also realigned certain segments of our business to reflect a new management reporting structure. The previously reported Investment Services segment and HRB Bank have been combined in the Consumer Financial Services segment. See “Description of Business” for additional information on this new segment.
Conditions in the non-prime mortgage industry were challenging throughout fiscal year 2007, and particularly in our fourth quarter. Our mortgage operations, as well as the entire industry, were impacted by deteriorating conditions in the secondary market, where reduced investor demand for loan purchases, higher investor yield requirements and increased estimates for future losses reduced the value of non-prime loans. Under these conditions non-prime originators generally reported significant increases in losses and many were unable to meet their financial obligations. During the fourth quarter we tightened our underwriting standards, which had the effect of reducing our loan origination volumes, but we expect will result in the origination of higher quality loans with better pricing in the secondary markets.
Our discontinued operations reported a pretax loss of $1.2 billion, which includes losses of $50.2 million from our Business Services and Tax Services discontinued operations, with the remainder from our mortgage business. The results of our mortgage operations include $388.7 million in loss provisions and repurchase reserves, impairments of residual interests of $168.9 million and impairments of other assets totaling $345.8 million.
If conditions in the industry, particularly in home appreciation, continue to decline, our future results would continue to be negatively impacted. See additional discussion of the performance of our mortgage operations in Item 7, under “Discontinued Operations.”
DISCONTINUED OPERATIONS. On November 6, 2006 we announced we would evaluate strategic alternatives for Option One Mortgage Corporation (OOMC), including a possible sale or other transaction through the public markets. On April 19, 2007, we entered into an agreement to sell OOMC for cash consideration approximately equal to the fair value of the adjusted tangible net assets of OOMC (as defined by the agreement) at closing less $300.0 million. The agreement provides for us to receive one-half of OOMC’s cumulative net income from its origination business for the 18 months following the closing, up to a maximum of $300.0 million, but no less than zero. The OOMC agreement is subject to various closing conditions and may be terminated by either party if the transaction does not close by December 31, 2007. In conjunction with this plan, we also announced we would terminate the operations of H&R Block Mortgage Corporation (HRBMC). We recorded impairments relating to the disposition of our mortgage businesses during the fourth quarter of fiscal year 2007 of $345.8 million, including the full impairment of goodwill of $152.5 million. Because the final sale price will be based on third-party bids and valuations received at closing, and because market conditions may change significantly during the period prior to closing, the value of the adjusted tangible net assets of the business at closing may be significantly different than the value as of April 30, 2007. Any such changes could impact the final impairment amount recorded at closing. We expect the sale of OOMC to close during the second quarter of fiscal year 2008. See discussion of additional conditions of the sale in Item 1A, under “Potential Sale Transaction.”
During fiscal year 2007, we committed to a plan to sell and/or completed the wind-down of three smaller lines of business previously reported in our Business Services segment, as well as our tax operations in the United Kingdom previously reported in Tax Services. We recorded an additional impairment of $5.0 million related to these businesses.
During fiscal year 2007, we met the criteria requiring us to present the related financial results of these businesses as discontinued operations and the assets and liabilities of all of the businesses being sold as held-for-sale in the consolidated financial statements. All periods presented have been reclassified to reflect our discontinued operations.
FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS -
See discussion below and in Item 8, note 21 to our consolidated financial statements.
DESCRIPTION OF BUSINESS -
TAX SERVICES
GENERAL - Our Tax Services segment is primarily engaged in providing tax return preparation and related services and products in the United States and its territories, Canada and Australia. Revenues include fees earned for services performed at company-owned retail tax offices, royalties from franchise retail tax offices, sales of Peace of Mind (POM) guarantees, sales of tax preparation and other software, fees from online tax preparation, and participation in refund anticipation loans (RALs) and Instant Money Advance Loans (IMALs). Segment revenues constituted 66.8% of our consolidated revenues of continuing operations for fiscal year 2007, 68.5% for 2006, and 74.9% for 2005.
Retail income tax return preparation and related services are provided by tax professionals via a system of retail offices operated directly by us or by franchisees. We also offer our services through seasonal offices located inside major retailers.
We offer a number of digital tax preparation alternatives. TaxCut® from H&R Block enables do-it-yourself users to prepare their federal and state tax returns easily and accurately. Our software products may be purchased through third-party retail stores, direct mail or online.
We also offer our clients many online options: multiple versions of do-it-yourself tax preparation, professional tax review, tax advice and tax preparation through a tax professional, whereby the client completes a tax organizer and sends it to a tax professional for preparation and/or signature.
By offering professional and do-it-yourself tax preparation options through multiple channels, we can serve our clients in the manner in which they choose to be served.
We also offer clients a number of options for receiving their income tax refund, including a check directly from the Internal Revenue Service (IRS), an electronic deposit directly to their bank account, a refund anticipation check or a RAL.
The following are some of the services we offer with our tax preparation service:
PEACE OF MIND GUARANTEE - The POM guarantee is offered to U.S. clients, whereby we (1) represent our clients if audited by the IRS, and (2) assume the cost, subject to certain
limits, of additional taxes owed by a client resulting from errors attributable to one of our tax professionals’ work. The POM program has a per client cumulative limit of $5,000 in additional taxes assessed with respect to the federal, state and local tax returns we prepared for the taxable year covered by the program.
RALs - RALs are offered to our U.S. clients by a designated bank primarily through a contractual relationship with HSBC Holdings plc (HSBC). An eligible, electronic filing client may apply for a RAL at one of our offices. After meeting certain eligibility criteria, clients are offered the opportunity to apply for a loan from HSBC in amounts up to $9,999 based upon their anticipated federal income tax refund. We simultaneously transmit the income tax return information to the IRS and the lending bank. Within a few days or less after the filing date, the client receives a check or direct deposit in the amount of the loan, less the bank’s transaction fee, our tax return preparation fee and other fees for client-selected services. Additionally, qualifying electronic filing clients are eligible to receive their RAL proceeds, less applicable fees, in approximately one hour after electronic filing using the Instant Money service. For a RAL to be repaid, the IRS directly deposits the participating client’s federal income tax refund into a designated account at the lending bank. See related discussion in “Loan Participations” below.
RACs - Refund Anticipation Checks (RACs) are offered to U.S. clients who would like to either (1) receive their refund faster and do not have a bank account for the IRS to direct deposit their refund or (2) have their tax preparation fees paid directly out of their refund. A RAC is not a loan and is provided through a contractual relationship with HSBC.
IMALs - IMALs are early-season loans offered to U.S. clients, beginning in November 2006, allowing them to take out a loan from HSBC in amounts up to $2,500 based upon their anticipated federal income tax refund. See related discussion in “Loan Participations” below.
H&R BLOCK PREPAID EMERALD MASTERCARD® - The H&R Block Prepaid Emerald MasterCard® allows a client to receive a tax refund from the IRS directly on a prepaid debit card, or to direct RAL or RAC proceeds to the card to avoid high-cost check-cashing fees. The card can be used for everyday purchases, bill payments, and ATM withdrawals anywhere MasterCard® is accepted. Additional funds can be added to the card account year-round though direct deposit, or at participating retail locations.
EASY SAVINGS, EASY IRA - Traditional savings and individual retirement accounts insured by the Federal Deposit Insurance Corporation (FDIC) are offered to U.S. clients as savings and tax-advantaged retirement savings tools. The accounts are held at HRB Bank.
TAX RETURN PREPARATION COURSES - We offer income tax return preparation courses to the public, which teach students how to prepare income tax returns and provide us with a source of trained tax professionals.
SOFTWARE PRODUCTS - We develop and market TaxCut® income tax preparation software, Kiplinger’s Home and Business Attorney and Kiplinger’s WILLPowerSM software products.
TaxCut® offers a simple step-by-step tax preparation interview, data imports from money management software and tax preparation software, calculations, completion of the appropriate tax forms, checking for errors and, for an additional charge, electronic filing.
During fiscal year 2007, we acquired TaxWorks LLC and its affiliated entities, a provider of commercial tax preparation software targeting the independent tax preparer market. The primary software product, TaxWorks®, is designed for small to mid-sized CPA firms that file taxes for individuals and businesses. The initial cash purchase price was $24.8 million, with a payment of $10.0 million due in May 2007 and a payment of $23.6 million due in May 2012. The $10.0 million payment due in May 2007 was paid on April 30, 2007. See Item 8, note 2 to our consolidated financial statements.
ONLINE TAX PREPARATION - We offer a comprehensive range of tax services, from tax advice to complete professional and do-it-yourself tax return preparation and electronic filing, through our websites at www.hrblock.com, www.taxcut.com, www.taxnet.com and www.taxengine.com. These websites allow clients to prepare their federal and state income tax returns using the TaxCut Online Tax Program and other platforms, access tax tips, advice and tax-related news and use calculators for tax planning.
We participate in the Free File Alliance (FFA). This alliance was created by the tax return preparation industry and the IRS, and allows qualified filers with adjusted gross incomes less than $52,000 to prepare and file their federal return online at no charge. We feel that this program provides a valuable public service and increases our visibility with new clients, while also providing an opportunity to offer our state return preparation services to these new clients at our regular prices.
CASHBACK PROGRAM - We offer a refund discount (CashBack) program to our customers in Canada. Canadian law specifies the procedures we must follow in conducting the program. In accordance with current Canadian regulations, if a customer’s tax return indicates the customer is entitled to a tax refund, we issue a check to the client. The client assigns to us the full amount of the tax refund to be issued by the Canada Revenue Agency (CRA) and the refund check is then sent by the CRA directly to us. In accordance with the law, the discount is deemed
to include both the tax return preparation fee and the fee for tax refund discounting. This program is financed by short-term borrowings. The number of returns discounted under the CashBack program in fiscal year 2007 was approximately 670,000, compared to 653,000 in 2006 and 581,000 in 2005.
CLIENTS SERVED - We, together with our franchisees, served approximately 22.9 million clients worldwide during fiscal year 2007, up from 21.9 million in 2006 and 21.4 million in 2005. See discussion of the Canadian tax season extension under “Seasonality of Business.” We served 20.3 million clients in the U.S. during fiscal year 2007, up from 19.5 million in 2006 and 19.1 million in 2005. “Clients served” includes taxpayers for whom we prepared income tax returns in offices, federal software units sold, online completed and paid federal returns, paid state returns when no federal return was purchased, taxpayers for whom we provided only paid electronic filing services and clients who received IMALs but did not return for tax preparation and/or e-filing services. Our U.S. clients served constituted 16.1% of an IRS estimate of total individual income tax returns filed as of April 30, 2007, compared to 15.7% in 2006 and 15.6% in 2005.
OWNED AND FRANCHISED OFFICES - A summary of our company-owned and franchise offices is as follows:
(1)
Shared locations include offices located within Wal-Mart, Sears or other third-party businesses.
Offices in shared locations at April 30, 2007 include 1,146 offices operated in Wal-Mart stores and 760 offices in Sears stores operated as “H&R Block at Sears.” The Wal-Mart agreement expires in May 2007 and is in the process of being renegotiated. The Sears license agreement was renewed in June 2007 and expires in July 2010. The Sears agreement is subject to standard termination rights by either party which include change in control, bankruptcy, material misuse of intellectual property, unauthorized disclosure of confidential information, failure to pay required fees, failure to comply with the agreement, or failure to carry required insurance by the other party.
We offer franchises as a way to expand our presence in the market. Our franchise arrangements provide us with certain rights designed to protect our brand. Most of our franchisees receive signs, designated equipment, specialized forms, local advertising, initial training, and supervisory services, and pay us a percentage of gross tax return preparation and related service revenues as a franchise royalty.
From time to time, we have acquired the territories of existing franchisees and other tax return preparation businesses, and will continue to do so if future conditions warrant and satisfactory terms can be negotiated. During fiscal year 2007, we acquired ExpressTax, a national franchisor of tax preparation businesses, for an aggregate cash purchase price of $5.7 million. This acquisition added 249 offices to our network, which continue to operate under the ExpressTax name.
LOAN PARTICIPATIONS - Since July 1996, we have been a party to agreements with HSBC and its predecessors to participate in RALs provided by a lending bank to H&R Block tax clients. During fiscal year 2006, we signed a new agreement with HSBC in which we obtained the right to purchase a 49.9% participation interest in all RALs obtained through our retail offices. We received a signing bonus from HSBC during the prior year in connection with this agreement, which was recorded as deferred revenue and is earned over the contract term. The new agreement is effective through June 2011. Our purchases of the participation interests are financed through short-term borrowings, and we bear all of the credit risk associated with our participation interests in the RALs. Revenue from our participation is calculated as the rate of participation multiplied by the fee paid by the borrower to the lending bank. Our RAL participation revenue was $192.4 million, $177.9 million and $182.8 million in fiscal years 2007, 2006 and 2005, respectively.
During the current year, our RAL contract was amended to include participation in IMALs. We obtained the right to purchase a 75.0% participation interest in IMALs obtained through our retail offices in 22 states. Our IMAL participation revenue was $17.6 million in fiscal year 2007. While this amendment is also effective through 2011, HSBC has elected not to offer these early-season loans next year.
SEASONALITY OF BUSINESS - Because most of our clients file their tax returns during the period from January through April of each year, substantially all of our revenues from income tax return preparation and related services and products are received during this period. As a result, our tax segment generally operates at a loss through the first eight months of the fiscal year. Additionally, the tax business is affected by economic
conditions and unemployment rates. Peak revenues occur during the applicable tax season, as follows:
In fiscal year 2006, the CRA extended the Canadian tax season to May 1, 2006. Clients served in our Canadian operations in fiscal year 2006 includes approximately 41,400 returns in both company-owned and franchise offices which were accepted by the client on May 1, 2006. The revenues related to these returns were recognized in fiscal year 2007. In fiscal year 2005, the Canadian tax season was extended to May 2, 2005. Clients served in our Canadian operations in fiscal year 2005 includes approximately 47,500 returns in both company-owned and franchise offices which were accepted by the client on May 1 and 2, 2005. The revenues related to these returns were recognized in fiscal year 2006. In fiscal year 2007, the Canadian tax season ended April 30, 2007.
COMPETITIVE CONDITIONS - The retail tax services business is highly competitive. There are a substantial number of tax return preparation firms and accounting firms offering tax return preparation services. Many tax return preparation firms and many firms not otherwise in the tax return preparation business are involved in providing electronic filing, RAL and IMAL services to the public. Commercial tax return preparers and electronic filers are highly competitive with regard to price and service. In terms of the number of offices and personal tax returns prepared and electronically filed in offices, online and via our software, we are the largest company providing direct tax return preparation and electronic filing services in the U.S. We also believe we operate the largest tax return preparation businesses in Canada and Australia.
Our digital tax solutions businesses compete with a number of companies. Intuit, Inc. is the largest supplier of tax preparation software and is also our primary competitor in the online tax preparation market. There are many smaller competitors in the online market, as well as free state-sponsored online filing programs. Price and marketing competition for tax preparation services increased in recent years.
GOVERNMENT REGULATION - Federal legislation requires income tax return preparers to, among other things, set forth their signatures and identification numbers on all tax returns prepared by them, and retain all tax returns prepared for three years. Federal laws also subject income tax return preparers to accuracy-related penalties in connection with the preparation of income tax returns. Preparers may be prohibited from further acting as income tax return preparers if they continuously and repeatedly engage in specified misconduct.
The federal government regulates the electronic filing of income tax returns in part by requiring electronic filers to comply with all publications and notices of the IRS applicable to electronic filing. We are also required to provide certain electronic filing information to the taxpayer, comply with advertising standards for electronic filers, and be subjected to possible monitoring by the IRS, penalties for disclosure or use of income tax return preparation and other preparer penalties, and suspension from the electronic filing program.
The Gramm-Leach-Bliley Act and Federal Trade Commission (FTC) regulations adopted thereunder require income tax preparers to adopt and disclose consumer privacy policies, and provide consumers a reasonable opportunity to “opt-out” of having personal information disclosed to unaffiliated third parties for marketing purposes. Some states have adopted or proposed strict “opt-in” requirements in connection with use or disclosure of consumer information.
Federal statutes and regulations also regulate an electronic filer’s involvement in RALs. Electronic filers must clearly explain the RAL is a loan and not a substitute for or a quicker way of receiving an income tax refund. Federal laws place restrictions on the fees an electronic filer may charge in connection with RALs. In addition, some states and localities have enacted laws and adopted regulations for RAL facilitators and/or the advertising of RALs.
Certain states have regulations and requirements relating to offering income tax courses. These requirements include licensing, bonding and certain restrictions on advertising.
As noted above under “Owned and Franchised Offices,” many of the income tax return preparation offices operating in the U.S. under the name “H&R Block” are operated by franchisees. Our franchising activities are subject to the rules and regulations of the FTC, and various state laws regulating the offer and sale of franchises. The FTC and various state laws require that we furnish to prospective franchisees a franchise offering circular containing prescribed information. A number of states in which we are currently franchising regulate the sale of franchises and require registration of the franchise offering circular with state authorities and the delivery of a franchise offering circular to prospective franchisees. We are currently operating under exemptions from registration in several of these states based upon our net worth and experience. Substantive state laws regulating the franchisor/franchisee relationship presently exist in a substantial number of states, and bills have been introduced in Congress from time to time that would provide for federal regulation of the franchisor/franchisee relationship in certain respects. The state laws often limit, among other things, the duration and scope of non-competition provisions, the ability of a
franchisor to terminate or refuse to renew a franchise and the ability of a franchisor to designate sources of supply. From time to time, we may have to make appropriate amendments to our franchise offering circular used to comply with our disclosure obligations under federal and state law.
We also seek to determine the applicability of all government and self-regulatory organization statutes, ordinances, rules and regulations in the international countries in which we operate (collectively, Foreign Laws) and to comply with these Foreign Laws. In addition, the Canadian government regulates the refund-discounting program in Canada. These laws have not materially affected our international operations.
See discussion in Item 1A, “Risk Factors” for additional information.
BUSINESS SERVICES
GENERAL - Our Business Services segment offers middle-market companies accounting, tax and business consulting services, wealth management and capital markets services. Segment revenues constituted 23.2% of our consolidated revenues of continuing operations for fiscal years 2007 and 2006 and 17.4% for 2005.
This segment consists primarily of RSM McGladrey, Inc. (RSM), which provides accounting, tax, and business consulting services in 97 cities in 25 states and offers services in 18 of the top 25 U.S. markets.
From time to time, we have acquired businesses, and will continue to do so if future conditions warrant and satisfactory terms can be negotiated. During fiscal year 2006, we paid $190.7 million to acquire all the outstanding common stock of American Express Tax and Business Services, Inc. (AmexTBS), which has been merged into RSM. During fiscal year 2007, we finalized purchase price adjustments relating to this acquisition resulting in a $10.1 million reduction in purchase price, which was recorded primarily as a reduction of goodwill.
During fiscal year 2007, we committed to a plan to sell and/or completed the wind-down of three smaller lines of business. As of April 30, 2007, we met the criteria requiring us to present the related financial results of these businesses as discontinued operations and the assets and liabilities of all of the businesses being sold as held-for-sale in the consolidated financial statements for all periods presented. See additional discussion in Item 8, note 20 to our consolidated financial statements.
RELATIONSHIP WITH ATTEST FIRMS - By regulation, we cannot provide audit and attest services. McGladrey & Pullen LLP (M&P) and other public accounting firms, including those public accounting firms previously associated with AmexTBS, with whom we do business (collectively, “the Attest Firms”) provide audit and review services and other services in which the Attest Firms issue written reports on client financial statements. Through a number of agreements, including agreements with these Attest Firms, we lease accounting personnel and provide accounting, payroll, human resources and other administrative services to the Attest Firms and receive a management fee for these services. We also have a cost-sharing arrangement with the Attest Firms, whereby they reimburse us for the costs of certain items, mainly supplies and for the use of RSM-owned or leased real estate, property and equipment. The Attest Firms are limited liability partnerships with their own management committees, legal and business advisors, professional liability insurance and risk management policies. Accordingly, the Attest Firms are separate legal entities and not affiliates. Some partners and employees of the Attest Firms are also employees of RSM.
SEASONALITY OF BUSINESS - Revenues for this segment are largely seasonal in nature, with peak revenues occurring during January through April.
COMPETITIVE CONDITIONS - The accounting, tax and consulting business is highly competitive. The principal methods of competition are price, service and reputation for quality. There are a substantial number of accounting firms offering similar services at the international, national, regional and local levels. As our focus is on middle-market businesses, our principal competition is with national and regional accounting firms. We believe we have a competitive advantage in the geographic areas in which we are currently located based on the breadth of services we can offer to these clients above and beyond what a traditional accounting firm can offer.
GOVERNMENT REGULATION - Many of the same federal and state regulations relating to tax preparers and the information concerning tax reform discussed previously in Tax Services apply to the Business Services segment as well. However, accountants are not subject to the same prohibition on the use or disclosure of certain income tax return information as tax professionals. Accounting firms are also subject to state and federal regulations governing accountants, auditors and financial planners.
Auditor independence rules of the Securities and Exchange Commission (SEC) and the Public Company Accounting Oversight Board (PCAOB) apply to the Attest Firms as public accounting firms. In applying its auditor independence rules, the SEC views us and the Attest Firms as a single entity and requires that the SEC independence rules for the Attest Firms apply to us and that we be independent of any SEC audit client of
the Attest Firms. The SEC regards any financial interest or prohibited business relationship we have with a client of the Attest Firms as a financial interest or prohibited business relationship between the Attest Firms and the client for purposes of applying its auditor independence rules.
We and the Attest Firms have jointly developed and implemented policies, procedures and controls designed to ensure the Attest Firms’ independence and integrity as an audit firm in compliance with applicable SEC regulations and professional responsibilities. These policies, procedures and controls are designed to monitor and prevent violations of applicable independence rules and include, among other things, (1) informing our officers, directors and other members of senior management concerning auditor independence matters, (2) procedures for monitoring securities ownership, (3) communicating with SEC audit clients regarding the SEC’s interpretation and application of relevant independence rules and guidelines, and (4) requiring RSM employees to comply with the Attest Firms’ independence and relationship policies (including the Attest Firms’ independence compliance questionnaire procedures).
See discussion in Item 1A, “Risk Factors” for additional information.
CONSUMER FINANCIAL SERVICES
GENERAL - Our Consumer Financial Services segment is primarily engaged in offering brokerage services, along with investment planning and related financial advice through H&R Block Financial Advisors, Inc. (HRBFA) and full-service banking through HRB Bank. HRBFA and HRB Bank, our “Block-branded” businesses, are focused on increasing retail tax client loyalty and retention by offering expanded financial services. Segment revenues constituted 9.7% of our consolidated revenues of continuing operations for fiscal year 2007, 8.1% for 2006 and 7.6% for 2005.
H&R BLOCK FINANCIAL ADVISORS - HRBFA offers our clients traditional brokerage services, as well as annuities, insurance, fee-based accounts, online account access, equity research and focus lists, model portfolios, asset allocation strategies, and other investment tools and information to clients in the U.S.
HRBFA is a registered broker-dealer with the SEC and is a member of the New York Stock Exchange (NYSE), other national securities exchanges, Securities Investor Protection Corporation (SIPC), and the National Association of Securities Dealers, Inc. (NASD). HRBFA is also a registered investment adviser. We act as a dealer in fixed-income securities including corporate and municipal bonds, various U.S. Government and U.S. Government Agency securities and certificates of deposit.
HRBFA is authorized to do business as a broker-dealer in all 50 states, the District of Columbia and Puerto Rico. At the end of fiscal year 2007, we operated 195 branch offices, compared to 219 offices in 2006 and 257 in 2005. The reduced number of branch offices is primarily due to the consolidation of smaller branches and the evolution of our tax-partnering program, in which financial advisors are located in retail tax offices.
FINANCIAL ADVISORS. Our future success is highly dependent on retaining and recruiting productive financial advisors. One of our key initiatives in fiscal year 2007 was to build revenues by attracting and retaining higher-producing advisors.
During fiscal years 2007, 2006 and 2005, we added 97, 193 and 258 advisors, respectively. These additions were offset by attrition, which caused our number of advisors to decline from 1,010 at April 30, 2006 to 918 at April 30, 2007. Our overall retention rate for fiscal year 2007 was approximately 80%, up from 75% last year. The retention rate for our higher-producing advisors was approximately 92%, up from 91% in 2006. The implementation of minimum production requirements caused our overall advisor retention rate to lag our higher-producing advisor retention rate. Advisor productivity by recruiting class is as follows:
Financial advisors generally reach productivity levels equal to those achieved at their prior firm approximately 24 to 36 months after they join our company.
PARTNERING WITH TAX PROFESSIONALS. The H&R Block Preferred Partner ProgramSM facilitates strategic, referral-based partnerships between tax professionals and financial advisors. The program includes the Licensed Referral Tax Professional (LRTP) program and a non-licensed option, which allows non-licensed tax professionals to gain additional rewards and recognition when making qualified client referrals to financial advisor partners. The LRTP program helps tax professionals obtain a securities license, teaming them with a financial advisor and providing a commission to the LRTP for business referred to financial advisors.
As of April 30, 2007, our Preferred Partner Program had 8,297 active tax partners, of which 612 were licensed. As a result of this initiative, we added more than 13,900 new customer accounts and assets totaling $690 million during fiscal year 2007. We expect to continue to increase the number of tax partners in the coming year.
H&R BLOCK BANK - In March 2006, the Office of Thrift Supervision (OTS) approved the charter of HRB Bank. HRB Bank commenced operations on May 1, 2006 and offers traditional consumer banking services including checking and savings accounts, home equity lines of credit, individual retirement accounts, certificates of deposit and prepaid debit card accounts to clients in the U.S. HRBFA utilizes HRB Bank for certain FDIC-insured deposits for its customers and HRB Bank also purchases loans from OOMC, HRBMC and other lenders to hold for investment purposes. In the event that, as a result of the sale of OOMC, HRB Bank can no longer purchase loans from OOMC and HRBMC, the main source of future loan purchases would be third-party loan originators.
The information required by the SEC’s Industry Guide 3, “Statistical Disclosure by Bank Holding Companies” is included in Item 7.
SEASONALITY OF BUSINESS - HRB Bank’s deposit balances can be subject to some seasonal fluctuations related to deposits of Tax Services’ clients, including the H&R Block Prepaid Emerald MasterCard®, which peak in February and taper off through the remainder of the tax season.
HRBFA does not experience significant seasonal fluctuations. Financial services businesses are cyclical, however, and directly affected by national and global economic and political conditions, trends in business and finance and changes in interest rates and the conditions of the securities markets in which our clients invest.
COMPETITIVE CONDITIONS - HRBFA competes directly with a broad range of companies seeking to attract consumer financial assets, including full-service brokerage firms, discount and online brokerage firms, mutual fund companies, investment banking firms, commercial and savings banks, insurance companies and others. The financial services industry has become more concentrated as numerous securities firms have been acquired by or merged into other firms. In addition, we expect competition from domestic and international commercial banks and larger securities firms to continue to increase as a result of legislative and regulatory initiatives in the U.S., including the passage of the Gramm-Leach-Bliley Act in November 1999 and the implementation of the U.S.A. Patriot Act in April 2002. These initiatives strive to remove or relieve certain restrictions on mergers between commercial banks and other types of financial services providers and extend privacy provisions and anti-money laundering procedures across the financial services industry.
We compete based on expertise and integration with our tax services relationships, quality of service, breadth of services offered, prices, accessibility through delivery channels and technological innovation.
GOVERNMENT REGULATION - Financial services businesses are subject to extensive regulation by U.S. federal and state regulatory agencies, securities exchanges and by various non- governmental agencies, regulatory bodies and central banks. These regulatory agencies in the U. S. include, among others, the SEC, the NASD, the NYSE, the FDIC, the Federal Reserve, the Municipal Securities Rulemaking Board and the OTS. Additional legislation, regulations and rulemaking may directly affect our manner of operation and profitability.
HRBFA is registered with the SEC and subject to regulation by the SEC and by self-regulatory organizations, such as the NYSE, NASD and the securities exchanges of which it is a member. As a registered broker-dealer, HRBFA is subject to the Uniform Net Capital Rule (Rule 15c3-1) administered by the SEC, which specifies minimum net capital requirements for registered brokers and dealers.
HRB Bank is subject to regulation, supervision and examination by the OTS, the Federal Reserve and the FDIC. All savings associations are subject to the capital adequacy guidelines and the regulatory framework for prompt corrective action. HRB Bank must meet specific capital guidelines that involve quantitative measures of HRB Bank’s assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. HRB Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. As a savings and loan holding company, H&R Block, Inc. is subject to regulation by the OTS, including maintenance of a three percent minimum ratio of adjusted tangible capital to adjusted total assets, as defined by the OTS.
See Item 7, “Regulatory Environment” and Item 8, note 17 to the consolidated financial statements for additional discussion of regulatory requirements, including discussion of our non-compliance with the three percent minimum capital requirement as of January 31, 2007 and April 30, 2007.
Also see discussion in 1A, “Risk Factors” for additional information.
DISCONTINUED OPERATIONS
GENERAL - Conditions in the non-prime mortgage industry were challenging throughout fiscal year 2007, and particularly in our fourth quarter. Our mortgage operations, as well as the entire industry, were impacted by deteriorating conditions in the secondary market, where reduced investor demand for loan purchases, higher investor yield requirements and increased estimates for future losses reduced the value of non-prime loans. Under these conditions non-prime originators generally reported significant increases in losses and many were unable to meet their financial obligations. As a result, during our fourth quarter our mortgage operations originated mortgage loans that, by the time we sold them in the secondary market, were valued at less than par. Conditions in the non-prime mortgage industry resulted in significant losses in our mortgage operations during the fourth quarter of fiscal year 2007. See additional discussion of the performance of our mortgage operations in Item 7, under “Discontinued Operations.”
On November 6, 2006 we announced we would evaluate strategic alternatives for OOMC, including a possible sale or other transaction through the public markets. On April 19, 2007, we entered into an agreement to sell OOMC. In conjunction with this plan, we also announced we would terminate the operations of HRBMC.
During fiscal year 2007, we committed to a plan to sell and/or completed the wind-down of three smaller lines of business previously reported in our Business Services segment, as well as our tax operations in the United Kingdom previously reported in Tax Services.
During fiscal year 2007, we met the criteria requiring us to present the related financial results of these businesses as discontinued operations and the assets and liabilities of all of the businesses being sold as held-for-sale in the consolidated financial statements for all periods presented. See Item 1A
ITEM 1A. RISK FACTORS
In this report, and from time to time throughout the year, we share our expectations for the Company’s future performance. The following explains the critical risk factors impacting our business and reasons actual results may differ from our expectations. This discussion does not intend to be a comprehensive list and there may be other risks and factors that may have an effect on our business.
LIQUIDITY AND CAPITAL - We use capital primarily to fund working capital requirements, pay dividends, repurchase shares of our common stock and acquire businesses. We are also dependent on commercial paper issuances and/or lines of credit to fund RAL participations and seasonal working capital needs. A disruption in such markets could adversely affect our access to these funds. To meet our future financing needs, we may issue additional debt or equity securities.
LITIGATION - We are involved in lawsuits in the normal course of our business related to RALs, our POM guarantee program, electronic filing of tax returns, Express IRAs, losses incurred by customers in their investment accounts, mortgage lending activities, business valuation services and other matters. Adverse outcomes related to litigation could result in substantial damages and could adversely affect our results of operations. Negative public opinion can also result from our actual or alleged conduct in such claims, possibly damaging our reputation and adversely affecting the market price of our stock. See Item 3, “Legal Proceedings” for additional information.
PRIVACY OF CLIENT INFORMATION - Privacy concerns relating to the disclosure of consumer financial information have drawn increased attention from federal and state governments. The IRS generally prohibits the use or disclosure by tax return preparers of taxpayers’ information without the prior written consent of the taxpayer. In addition, other regulations require financial service providers to adopt and disclose consumer privacy policies and provide consumers with a reasonable opportunity to opt-out of having personal information disclosed to unaffiliated third parties for marketing purposes. Although we have established security procedures to protect against identity theft, breaches of our clients’ privacy may occur. To the extent the measures we have taken prove to be insufficient or inadequate, we may become subject to litigation or administrative sanctions, which could result in significant fines, penalties or damages and harm to our brand and reputation.
In addition, changes in these federal and state regulatory requirements could result in more stringent requirements and could result in a need to change business practices, including how information is disclosed. These changes could have a material adverse effect on our business, financial condition and results of operations, and our ability to access the capital markets.
INTERNAL CONTROL CERTIFICATION - We have documented and tested our internal control procedures in accordance with various SEC rules governing Section 404 of the Sarbanes-Oxley Act (SOX 404). SOX 404 requires us to assess the effectiveness of our internal controls over financial reporting annually, and obtain an opinion on the effectiveness of our internal controls from our Independent Registered Public Accounting Firm. Management’s assessment of our internal controls over financial reporting may identify deficiencies that need to be addressed in our internal controls over financial reporting or other matters that may raise concerns for investors. Should we, or our independent auditors, determine in future periods that we have a material weaknesses in our internal controls over financial reporting, our results of operations or financial condition may be adversely affected and the price of our common stock may decline.
OPERATIONAL RISK - There is a risk of loss resulting from inadequate or failed processes or systems, theft or fraud. These can occur in many forms including, among others, errors, business interruptions, inappropriate behavior of or misconduct by our employees or those contracted to perform services for us, and
vendors that do not perform in accordance with their contractual agreements. These events can potentially result in financial losses or other damages. We rely on internal and external information and technological systems to manage our operations and are exposed to risk of loss resulting from breaches in the security, or other failures of these systems. Replacement of our major operational systems could have a significant impact on our ability to conduct our core business operations and increase our risk of loss resulting from disruptions of normal operating processes and procedures that may occur during the implementation of new information and transaction systems.
POTENTIAL SALE TRANSACTION - On April 19, 2007, we entered into an agreement to sell OOMC. The purchase price to be received in connection with the sale of OOMC will consist of payments based on the fair value of the adjusted tangible net assets of OOMC (as defined in the agreement) as of the date of sale less $300.0 million. Because the final sale price will be based on third-party bids and valuations received at closing as well as the ultimate value received upon disposition of certain assets after closing, and because market conditions have changed and may change significantly during the period prior to closing, the value of the adjusted tangible net assets of the business at closing may be significantly different than the value as of April 30, 2007. In addition, the transaction is subject to various closing conditions, including that (1) OOMC maintain at least $8.0 billion of total capacity in its warehouse facilities throughout the period to the closing date (of which at least $2.0 billion is to be in the form of unused capacity at the closing date), (2) OOMC have servicer ratings of at least RPS2 by Fitch, SQ2 by Moody’s and Above Average by S&P, and (3) agreed upon regulatory and other approvals and consents be obtained. See discussion of warehouse facilities and related waivers in Item 7 under “Off-Balance Sheet Financing Arrangements.” If the closing conditions are not satisfied by the requisite time, the sale could be terminated. Failure to complete this transaction could adversely affect the market price of our stock. If conditions in the non-prime mortgage industry, particularly in home appreciation, continue to decline, our operating results, capital levels and liquidity could be negatively impacted during the periods we continue to own OOMC.
TAX SERVICES
COMPETITIVE POSITION - Increased competition for tax preparation clients in our retail offices, online and software channels could adversely affect our current market share and limit our ability to grow our client base. See clients served statistics included in Item 7, under “Tax Services.”
REFUND ANTICIPATION LOANS - Changes in government regulation related to RALs could adversely affect our ability to offer RALs or our ability to purchase participation interests. Third-party financial institutions currently originating RALs and similar products could decide to cease or significantly limit such offerings and related collection practices. Changes in IRS practices could adversely affect our ability to use the IRS debt indicator to limit our bad debt exposure. Changes in any of these, as well as possible litigation related to RALs, may adversely affect our results of operations. See discussion of RAL litigation in Item 3, “Legal Proceedings.”
Since July 1996, we have been a party to agreements with HSBC and its predecessors to participate in RALs provided by a lending bank to H&R Block tax clients. During fiscal year 2006, we signed a new agreement with HSBC under which HSBC and its designated bank will provide funding of all RALs offered through June 2011. We may extend this agreement for two successive one-year periods. If HSBC and its designated bank do not continue to provide funding for RALs, we could seek other RAL lenders to continue offering RALs to our clients or consider alternative funding strategies.
The RAL program is regularly reviewed both from a business perspective and to ensure compliance with applicable state and federal laws. It is our intention to continue to offer the RAL program in the foreseeable future.
Loss of the RAL program could adversely affect our operating results. In addition to the loss of revenues and income directly attributable to the RAL program, the inability to offer RALs could indirectly result in the loss of retail tax clients and associated tax preparation revenues, unless we were able to take mitigating actions. Total revenues related directly to the RAL program (including revenues from participation interests) were $193.5 million for the year ended April 30, 2007, representing 4.8% of consolidated revenues and contributed $120.5 million to the segment’s pretax results. Revenues related directly to the RAL program totaled $179.3 million for the year ended April 30, 2006, representing 5.0% of consolidated revenues and contributed $106.5 million to the segment’s pretax results.
BUSINESS SERVICES
ALTERNATIVE PRACTICE STRUCTURE WITH ATTEST FIRMS - Our relationship with the Attest Firms requires us to comply with applicable regulations regarding the practice of public accounting and auditor independence rules and requirements. In addition, our relationship with the Attest Firms closely links our RSM McGladrey brand with the Attest Firms. If the Attest Firms were to encounter regulatory or independence issues resulting from their relationship with us or if significant litigation arose
involving the Attest Firms or their services which implicated RSM, our brand reputation and our ability to realize the mutual benefits of our relationship, such as the ability to attract and retain quality professionals, could be impaired.
CONSUMER FINANCIAL SERVICES
REGULATORY ENVIRONMENT - GENERAL - The securities and banking industries are subject to extensive regulation. The SEC, the NYSE, the NASD and other self-regulatory organizations and state securities commissions can, among other things, censure, fine, issue cease-and-desist orders or suspend or expel a broker-dealer or any of its officers or employees. The OTS may take similar action with respect to our banking activities. Similarly, the attorneys general of each state could bring legal action on behalf of the citizens of the various states to ensure compliance with local laws.
REGULATORY ENVIRONMENT - BROKER-DEALER - HRBFA must comply with many laws and rules, including rules relating to possession and control of customer funds and securities, margin lending and execution and settlement of transactions.
The SEC, NYSE and NASD and various other regulatory agencies have stringent rules with respect to the maintenance of specific levels of net capital by securities broker-dealers. Net capital is the net worth of a broker or dealer (assets minus liabilities), less deductions for certain types of assets. Failure to maintain the required net capital could result in suspension or revocation of registration by the SEC and suspension or expulsion by the NYSE and/or NASD, and could ultimately lead to the firm’s liquidation.
HRBFA will be transitioning individual clients in certain fee-in-lieu-of-commission accounts to a commission-based or alternative brokerage account, or to investment adviser accounts as a result of recent court actions on an SEC rule. As of April 30, 2007, HRBFA had approximately $2.9 billion of assets under management and realized approximately $24.0 million in revenue from these accounts for fiscal year 2007. During the process of converting these accounts, we are exposed to risk in advisor and client retention, product pricing and related production revenues.
REGULATORY ENVIRONMENT - BANKING - H&R Block, Inc., as a savings and loan holding company, and HRB Bank, as a federally chartered savings bank, are subject to extensive regulation, supervision and examination by the OTS and FDIC. Such regulation covers all banking business, including lending practices, safeguarding deposits, capital structure, recordkeeping, transactions with affiliates and conduct and qualifications of personnel.
HRB Bank is subject to various regulatory capital requirements administered by the OTS. Failure to meet minimum capital requirements may trigger actions by regulators that, if undertaken, could have a direct material effect on HRB Bank and our consolidated financial statements. HRB Bank must meet specific capital guidelines involving quantitative measures of assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. A bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about the strength of components of its capital, risk weightings of assets, off-balance sheet transactions and other factors. Quantitative measures established by regulation to ensure capital adequacy require HRB Bank to maintain minimum amounts and ratios of tangible equity, total risk-based capital and Tier 1 capital. In addition to these minimum ratio requirements, HRB Bank is required to continually maintain a 12.0% minimum leverage ratio as a condition of its charter-approval order through fiscal year 2009. This condition was extended through fiscal year 2012 as a result of a Supervisory Directive issued on May 29, 2007. There are no conditions or events since March 31, 2007 that management believes have changed HRB Bank’s category. We will monitor regulatory compliance with this ratio monthly and discuss with the OTS in the event the minimum is not maintained.
As of March 31, 2007, our most recent Thrift Financial Report (TFR) filing with the OTS, HRB Bank was a “well capitalized” institution under the prompt corrective action provisions of the FDIC. See Item 8, note 17 to the consolidated financial statements for additional information.
H&R Block, Inc. is subject to a three percent minimum ratio of adjusted tangible capital to adjusted total assets, as defined by the OTS. We fell below the three percent minimum ratio at April 30, 2007 and the OTS issued a Supervisory Directive on May 29, 2007. Failure to comply with the Supervisory Directive could trigger additional discretionary actions by the OTS such as a supervisory agreement, cease-and-desist orders and civil monetary penalties. See Item 7, “Regulatory Environment” and Item 8, note 17 to the consolidated financial statements for additional information, including discussion of our non-compliance with the three percent minimum capital requirement and actions taken by the OTS. If we are not in a position to cure deficiencies, a resulting failure could impair our ability to repurchase shares of our common stock, acquire businesses and pay dividends.
CONCENTRATION OF CREDIT RISK - The overall credit quality of HRB Bank’s mortgage loans held for investment is impacted by the strength of the U. S. economy and local economies. We continually monitor changes in the economy, particularly unemployment rates and housing prices, as these factors can impact the ability of borrowers to repay their loans. Economic trends that negatively affect housing prices and the job
market could result in, among other things, deterioration in credit quality of our loan portfolio. Our loan portfolio is concentrated in the states of Florida, California, New York and Wisconsin, which represented 18.8%, 16.3%, 12.8% and 9.7%, respectively, of our total mortgage loans held for investment at April 30, 2007. No other state held more than 5% of our loan balances.
INTEGRATION INTO THE H&R BLOCK BRAND - We are working to foster an advice-based relationship with our tax clients through our retail tax office network. This advice-based relationship is key to the integration of Consumer Financial Services into the H&R Block brand and deepening our current client relationships. If we are unable to successfully integrate, it may significantly impact our ability to differentiate our business from other financial service providers and grow our client base.
RECRUITING AND RETENTION OF FINANCIAL ADVISORS - Attracting and retaining experienced financial advisors is extremely competitive in the investment industry. Additionally, in this industry, clients tend to follow their advisors, regardless of their affiliated investment firm. The inability to recruit and retain qualified and productive advisors, may adversely affect our results of operations.
INTEREST RATE RISK - Net interest income is an important source of revenue for this segment. Our ability to manage interest rate risk could impact our financial condition. Our results of operations depend, in part, on our level of net interest income and our effective management of the impact of changing interest rates and varying asset and liability maturities. Many factors affect interest rates, including governmental monetary policies and domestic and international economic and political conditions.
RECURRING OPERATING LOSSES - Continuing operating losses at HRBFA may impact the valuation of goodwill and long-lived assets. Such losses could also necessitate additional capital contributions to comply with regulatory requirements. The inability to operate this segment in a profitable manner may adversely affect our results of operations.
DISCONTINUED OPERATIONS
LIQUIDITY AND CAPITAL - We are dependent on the use of our off-balance sheet arrangements to fund our daily non-prime mortgage loan originations, and depend on the secondary market to securitize and sell mortgage loans and residual interests. Our off-balance sheet arrangements are subject to certain covenants, including a “minimum net income” financial covenant. As of April 30, 2007, OOMC did not meet the “minimum net income” financial covenant contained in certain of its committed warehouse facilities. This covenant requires OOMC to maintain a cumulative minimum net income of at least $1 for the four consecutive fiscal quarters ended April 30, 2007. On April 27, 2007, OOMC obtained waivers of the minimum net income financial covenants from all of the warehouse facility providers. These waivers extend through various dates. Two waivers are subject to OOMC having a specified amount of total warehouse capacity. If we do not obtain extensions of facilities and waivers that expire before July 31, 2007 or expand existing capacity, we would be in violation of this warehouse capacity requirement.
OOMC will not meet this financial covenant at July 31, 2007. We have, however, obtained waivers from a sufficient number of warehouse providers to allow OOMC to continue its off-balance sheet financing activities. At our current origination levels, we estimate we would only need waivers for between $3.0 billion and $4.0 billion of available capacity at any given time. However, the sale of OOMC is subject to various closing conditions, including that OOMC maintain at least $8.0 billion of total capacity in its warehouse facilities throughout the period to the closing date (of which at least $2.0 billion is to be in the form of unused capacity at the closing date).
If OOMC cannot obtain extensions or waivers, warehouse facility providers would have the right to terminate their future funding obligations under the applicable warehouse facilities, terminate OOMC’s right to service the loans remaining in the applicable warehouse or request funding of the 10% guarantee. This termination could adversely impact OOMC’s ability to fund new loans and our ability to complete the OOMC sales transaction. See additional discussion in Item 7, under “Off-Balance Sheet Financing Arrangements.”
COMPETITIVE POSITION - The majority of our mortgage loan applications are submitted through a network of brokers who have relationships with many other mortgage lenders. Unfavorable changes in our pricing, service or other factors could result in a decline in our mortgage origination volume. A significant decline in our servicer ratings could adversely affect our pricing and origination volume. Increased competition among mortgage lenders can also result in a decline in coupon rates offered to our borrowers, which in turn lowers margins and could adversely affect our gains on sales of mortgage loans.
MARKET RISKS - Our day-to-day operating activities of originating and selling mortgage loans have many aspects of interest rate risk. Additionally, the valuation of our retained residual interests and mortgage servicing rights includes many estimates and assumptions made by management surrounding interest rates, prepayment speeds and credit losses. Variation in interest rates or the factors underlying our assumptions could affect our results of operations. See Item 7A, under “Discontinued Operations” for discussion of interest rate risk, and Item 7, “Critical Accounting Policies” for discussion of our valuation methodology.
Conditions in the non-prime mortgage industry were challenging throughout fiscal year 2007, and particularly in our fourth quarter. Our mortgage operations, as well as the entire industry, were impacted by deteriorating conditions in the secondary market, where reduced investor demand for loan purchases, higher investor yield requirements and increased estimates for future losses reduced the value of non-prime loans. Under these conditions non-prime originators generally reported significant increases in losses and many were unable to meet their financial obligations. As a result, during our fourth quarter our mortgage operations originated mortgage loans that, by the time we sold them in the secondary market, were valued at less than par. Conditions in the non-prime mortgage industry resulted in significant losses in our mortgage operations during the fourth quarter of fiscal year 2007. See additional discussion of the performance of our mortgage operations in Item 7, under “Discontinued Operations.” If conditions in the non-prime mortgage industry do not improve, it could adversely affect the results of our mortgage operations.
LEGISLATION AND REGULATION - Several states and cities are considering or have passed laws, regulations or ordinances aimed at curbing predatory lending and servicing practices. The federal government is also considering legislative and regulatory proposals in this regard. In general, these proposals involve lowering the existing federal HOEPA thresholds for defining a “high-cost” loan and establishing enhanced protections and remedies for borrowers who receive such loans. If unfavorable laws and regulations are passed, it could restrict our ability to originate loans. If rating agencies refuse to rate our loans, loan buyers may not want to purchase loans labeled as “high-cost,” and it could restrict our ability to sell our loans in the secondary market. Accordingly, all of these items could adversely affect our results of operations.
In 2002, the Federal Reserve Board adopted changes to Regulation C promulgated under the HMDA. Among other things, the new regulations require lenders to report pricing data on loans with annual percentage rates that exceed the yield on treasury bills with comparable maturities by 3%. The expanded reporting was effective in 2004 for reports filed in 2005. We anticipate that a majority of our loans would be subject to the expanded reporting requirements. The expanded reporting does not provide for additional loan information such as credit risk, debt-to-income ratio, loan-to-value ratio, documentation level or other salient loan features. However, reported information may lead to increased litigation as the information could be misinterpreted by third parties and could adversely affect our results of operations.
COUNTERPARTY CREDIT RISK - Derivative instruments involve counterparty credit risk, which is the risk that a counterparty may fail to perform on its contractual obligations. We manage this risk through the use of a policy that includes credit standard guidelines, counterparty diversification, monitoring of counterparty financial condition, use of master netting agreements with counterparties, and exposure limits based on counterparty credit, exposure amount and management risk tolerance. The policy is reviewed on an annual basis and as conditions warrant. See Item 7A, under “Discontinued Operations” and Item 8, note 20 to our consolidated financial statements for discussion of our derivative instruments.
DELINQUENCY RATES - Our underwriting criteria or collection methods may not provide adequate protection against the risks inherent in the loans we originate and sell. In the event of a default, we may be required to repurchase loans previously sold. Repurchased loans are normally sold in subsequent sale transactions. In the event a repurchased loan cannot be sold, the collateral value of the financed item may not cover the outstanding loan balance and costs of recovery. In the event our mortgage loans held for sale or mortgage loans underlying our residual interests in securitizations experience higher delinquencies, foreclosures, repossessions or losses than anticipated, our results of operations or financial condition could be adversely affected. Any sustained period of increased delinquencies, foreclosures or losses could harm our ability to originate and sell loans, the prices we receive on our loans, or the values of our mortgage servicing rights and residual interests in securitizations, which could adversely affect our financial condition and results of operations. See additional discussion of our loan repurchases in Item 8, note 20 to the consolidated financial statements.
REAL ESTATE MARKET - Our residual interests and beneficial interest in Trusts are secured by mortgage loans, which are in turn secured by residential real estate. Any material decline in real estate values would likely result in higher delinquencies, defaults and foreclosures and losses. Additionally, a significant portion of the mortgage loans we originate or service is secured by properties in California. A decline in the economy or the residential real estate market values, or the occurrence of a natural disaster not covered by standard homeowners’ insurance policies, such as an earthquake, hurricane or wildfire, could decrease the value of mortgaged properties.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2. PROPERTIES
We completed construction of new corporate headquarters during fiscal year 2007, and consolidated the majority of our Kansas City-based personnel into one facility. We own our new corporate headquarters, which is located in Kansas City, Missouri. Our former corporate headquarters building was sold during fiscal year 2007.
Most of our tax offices, except those in shared locations, are operated under leases throughout the U.S. Our Canadian executive offices are located in a leased office in Calgary, Alberta. Our Canadian tax offices are operated under leases throughout Canada.
RSM’s executive offices are located in leased offices in Bloomington, Minnesota. Its administrative offices are located in leased offices in Davenport, Iowa. RSM also leases office space throughout the U.S.
The executive offices of HRBFA are located in leased offices in Detroit, Michigan. Branch offices are operated throughout the U.S., in a combination of leased and owned facilities. HRB Bank is headquartered and its single branch location is also located in our corporate facility.
OOMC’s executive offices are located in leased offices in Irvine, California. OOMC also leases offices for its loan origination and servicing centers and branch office operations throughout the U.S. HRBMC is headquartered in leased offices in Irvine, California. HRBMC also leases offices for its loan origination centers and branch office operations throughout the U.S.
All current leased and owned facilities are in good repair and adequate to meet our needs.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The information below should be read in conjunction with the information included in Item 8, note 19 to our consolidated financial statements.
RAL LITIGATION - We have been named as a defendant in numerous lawsuits throughout the country regarding our refund anticipation loan programs (collectively, “RAL Cases”). The RAL Cases have involved a variety of legal theories asserted by plaintiffs. These theories include allegations that, among other things, disclosures in the RAL applications were inadequate, misleading and untimely; the RAL interest rates were usurious and unconscionable; we did not disclose that we would receive part of the finance charges paid by the customer for such loans; untrue, misleading or deceptive statements in marketing RALs; breach of state laws on credit service organizations; breach of contract, unjust enrichment, unfair and deceptive acts or practices; violations of the federal Racketeer Influenced and Corrupt Organizations Act; violations of the federal Fair Debt Collection Practices Act and unfair competition regarding debt collection activities; and that we owe, and breached, a fiduciary duty to our customers in connection with the RAL program.
The amounts claimed in the RAL Cases have been very substantial in some instances. We have successfully defended against numerous RAL Cases, some of which were dismissed on our motions for dismissal or summary judgment, and others were dismissed voluntarily by the plaintiffs after denial of class certification. Other cases have been settled, with one settlement resulting in a pretax expense of $43.5 million in fiscal year 2003 (the “Texas RAL Settlement”) and other settlements resulting in a combined pretax expense in fiscal year 2006 of $70.2 million (the “2006 Settlements”).
We believe we have meritorious defenses to the remaining RAL Cases and we intend to defend them vigorously. There can be no assurances, however, as to the outcome of the pending RAL Cases individually or in the aggregate. Likewise, there can be no assurances regarding the impact of the RAL Cases on our financial statements. The following is updated information regarding the pending RAL Cases that are attorney general actions or class actions or putative class actions:
Lynne A. Carnegie, et al. v. Household International, Inc., H&R Block, Inc., et al., (formerly Joel E. Zawikowski, et al. v. Beneficial National Bank, H&R Block, Inc., Block Financial Corporation, et al.) Case No. 98 C 2178, United States District Court for the Northern District of Illinois, Eastern Division, instituted on April 18, 1998. This case constitutes one of the 2006 Settlements. On April 19, 2006, we entered into a settlement agreement regarding this case, subject to final court approval. The settlement was approved by the court on August 28, 2006. One objector filed an appeal, which was dismissed on March 1, 2007. Unless a Petition for Certiorari is filed by the objector and granted by the United States Supreme Court, the settlement is final.
Sandra J. Basile, et al. v. H&R Block, Inc., et al, April Term 1992 Civil Action No. 3246 in the Court of Common Pleas, First Judicial District Court of Pennsylvania, Philadelphia County, instituted on April 23, 1993. The court decertified the class on December 31, 2003. The Pennsylvania appellate court subsequently reversed the trial court’s decertification decision. On September 26, 2006, the Pennsylvania Supreme Court reversed the appellate court’s reversal of the trial court’s
decision to decertify the class. The plaintiff is seeking further review by the appellate court.
The People of California v. H&R Block, Inc., H&R Block Services, Inc., H&R Block Enterprises, Inc., H&R Block Tax Services, Inc., Block Financial Corporation, HRB Royalty, Inc., and Does 1 through 50, Case No. CGC-06-449461, in the California Superior Court, San Francisco County, instituted on February 15, 2006 (alleging, among other things, untrue, misleading or deceptive statements in marketing RALs and unfair competition with respect to debt collection activities; seeks equitable relief, civil penalties and restitution). This case is in the discovery stage.
PEACE OF MIND LITIGATION - Lorie J. Marshall, et al. v. H&R Block Tax Services, Inc., et al., Civil Action 2003L000004, in the Circuit Court of Madison County, Illinois, is a class action case filed on January 18, 2002, that was granted class certification on August 27, 2003. Plaintiffs’ claims consist of five counts relating to the Peace of Mind (POM) program under which the applicable tax return preparation subsidiary assumes liability for additional tax assessments attributable to tax return preparation error. The plaintiffs allege that the sale of POM guarantees constitutes (i) statutory fraud by selling insurance without a license, (ii) an unfair trade practice, by omission and by “cramming” (i.e., charging customers for the guarantee even though they did not request it or want it), and (iii) a breach of fiduciary duty. In August 2003, the court certified the plaintiff classes consisting of all persons who from January 1, 1997 to final judgment (i) were charged a separate fee for POM by “H&R Block” or a defendant H&R Block class member; (ii) reside in certain class states and were charged a separate fee for POM by “H&R Block” or a defendant H&R Block class member not licensed to sell insurance; and (iii) had an unsolicited charge for POM posted to their bills by “H&R Block” or a defendant H&R Block class member. Persons who received the POM guarantee through an H&R Block Premium office and persons who reside in Alabama are excluded from the plaintiff class. The court also certified a defendant class consisting of any entity with names that include “H&R Block” or “HRB,” or are otherwise affiliated or associated with H&R Block Tax Services, Inc., and that sold or sells the POM product. The trial court subsequently denied the defendants’ motion to certify class certification issues for interlocutory appeal. Discovery is proceeding. No trial date has been set.
There is one other putative class action pending against us in Texas that involves the POM guarantee. This case is being tried before the same judge that presided over the Texas RAL Settlement, involves the same plaintiffs’ attorneys that are involved in the Marshall litigation in Illinois, and contains similar allegations. No class has been certified in this case.
We believe the claims in the POM actions are without merit, and we intend to defend them vigorously. The amounts claimed in the POM actions are substantial, however, and there can be no assurances as to the outcome of these pending actions individually or in the aggregate. Likewise, there can be no assurances regarding the impact of these actions on our consolidated financial statements.
EXPRESS IRA LITIGATION - On March 15, 2006, the New York Attorney General filed a lawsuit in the Supreme Court of the State of New York, County of New York (Index No. 06/401110) entitled The People of New York v. H&R Block, Inc. and H&R Block Financial Advisors, Inc. The complaint alleged fraudulent business practices, deceptive acts and practices, common law fraud and breach of fiduciary duty with respect to the Express IRA product and sought equitable relief, disgorgement of profits, damages and restitution, civil penalties and punitive damages. On December 1, 2006, the Supreme Court of the State of New York issued a ruling that dismissed the New York Attorney General’s lawsuit in its entirety on procedural grounds but granted leave to amend and refile the lawsuit. The amended complaint has been filed and alleges causes of action similar to those claimed in the original complaint and seeks equitable relief, disgorgement of profits, damages and restitution, civil penalties and punitive damages. We intend to defend this case vigorously, but there are no assurances as to its outcome.
In addition to the New York Attorney General action, a number of civil actions were filed against us concerning the Express IRA matter, the first of which was filed on March 17, 2006. Except for two cases pending in state court, all of the civil actions have been consolidated by the panel for Multi-District Litigation into a single action styled In re H&R Block, Inc. Express IRA Marketing Litigation in the United States District Court for the Western District of Missouri. We intend to defend these cases vigorously, but there are no assurances as to their outcome.
SECURITIES LITIGATION - On March 17, 2006, the first of three putative class actions alleging violations of certain securities laws were filed against the Company and certain of its current and former officers and directors (the “Securities Class Action Cases”). In addition, on April 5, 2006, the first of nine shareholder derivative actions purportedly brought on behalf of the Company (which is named as a “nominal defendant”) were filed against certain of the Company’s current and former directors and officers (the “Derivative Cases”). On September 20, 2006, the United States District
Court for the Western District of Missouri ordered all of the Securities Class Action Cases and the Derivative Cases consolidated into a single action styled In re H&R Block Securities Litigation. The court appointed a lead plaintiff who filed a consolidated complaint on April 6, 2007 against the Company and certain of its officers. The complaint alleges, among other things, deceptive, material and misleading financial statements, failure to prepare financial statements in accordance with generally accepted accounting principles and concealment of the potential for lawsuits stemming from the allegedly fraudulent nature of the Company’s operations. The complaint seeks unspecified damages and equitable relief. We intend to defend this litigation vigorously, but there are no assurances as to its outcome.
OTHER CLAIMS AND LITIGATION - As reported previously, the NASD brought charges against HRBFA regarding the sale by HRBFA of Enron debentures in 2001. A hearing for this matter commenced in May 2006, was recessed until October 2006 and is scheduled to continue through August 2007. We intend to defend the NASD charges vigorously, although there can be no assurances regarding the outcome and resolution of the matter.
As part of an industry-wide review, the IRS is investigating tax-planning strategies that certain RSM clients utilized during fiscal years 2000 through 2003. Specifically, the IRS is examining these strategies to determine whether RSM complied with tax shelter reporting and listing regulations and whether such strategies were abusive as defined by the IRS. If the IRS were to determine that RSM did not comply with the tax shelter reporting and listing regulations, it might assess fines or penalties against RSM. Moreover, if the IRS were to determine that the tax planning strategies were inappropriate, clients that utilized the strategies could face penalties and interest for underpayment of taxes. Some of these clients are seeking or may attempt to seek recovery from RSM. There can be no assurance regarding the outcome and resolution of this matter.
RSM EquiCo, Inc., a subsidiary of RSM, is a party to a putative class action filed on July 11, 2006 and entitled Do Right’s Plant Growers v. RSM EquiCo, Inc., RSM McGladrey, Inc., H&R Block, Inc. and Does 1-100, inclusive, Case No. 06 CC00137, in the California Superior Court, Orange County. The complaint contains allegations regarding business valuation services provided by RSM EquiCo, Inc. including fraud, negligent misrepresentation, breach of contract, breach of implied covenant of good faith and fair dealing, breach of fiduciary duty and unfair competition and seeks unspecified damages, restitution and equitable relief. There can be no assurance regarding the outcome and resolution of this matter.
We have from time to time been party to investigations, claims and lawsuits not discussed herein arising out of our business operations. These investigations, claims and lawsuits include actions by state attorneys general, other state regulators, individual plaintiffs, and cases in which plaintiffs seek to represent a class of similarly situated customers. The amounts claimed in these claims and lawsuits are substantial in some instances, and the ultimate liability with respect to such litigation and claims is difficult to predict. Some of these investigations, claims and lawsuits pertain to RALs, the origination and servicing of mortgage loans, the electronic filing of customers’ income tax returns, the POM guarantee program, and our Express IRA program and other investment products and RSM EquiCo, Inc. business valuation services. We believe we have meritorious defenses to each of these claims, and we are defending or intend to defend them vigorously, although there is no assurance as to their outcome. In the event of an unfavorable outcome, the amounts we may be required to pay in the discharge of liabilities or settlements could have a material adverse effect on our consolidated financial statements.
In addition to the aforementioned types of cases, we are parties to claims and lawsuits that we consider to be ordinary, routine litigation incidental to our business, including claims and lawsuits (Other Claims) concerning investment products, the preparation of customers’ income tax returns, the fees charged customers for various products and services, losses incurred by customers with respect to their investment accounts, relationships with franchisees, denials of mortgage loans, contested mortgage foreclosures, other aspects of the mortgage business, intellectual property disputes, employment matters and contract disputes. We believe we have meritorious defenses to each of the Other Claims, and we are defending them vigorously. While we cannot provide assurance that we will ultimately prevail in each instance, we believe the amount, if any, we are required to pay in the discharge of liabilities or settlements in these Other Claims will not have a material adverse effect on our consolidated financial statements.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth quarter of fiscal year 2007.
PART II
ITEM 5.
ITEM 5.
MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
H&R Block’s common stock is traded on the NYSE. The information called for by this item with respect to H&R Block’s common stock appears in Item 8, note 22 to our consolidated financial statements. On June 15, 2007, there were 29,455 shareholders of record and the closing stock price on the NYSE was $23.11 per share. During the fiscal year ended April 30, 2007, we issued approximately 21,000 shares of our common stock as purchase price consideration for acquisitions. These issuances were private offerings exempt from registration pursuant to Section 4(2) of the Securities Act of 1933.
A summary of our securities authorized for issuance under equity compensation plans as of April 30, 2007 is as follows:
The remaining information called for by this item relating to “Securities Authorized for Issuance under Equity Compensation Plans” is reported in Item 8, note 13 to our consolidated financial statements.
A summary of our purchases of H&R Block common stock during the fourth quarter of fiscal year 2007 is as follows:
(1)
On June 9, 2004, our Board of Directors approved the repurchase of 15.0 million shares of H&R Block common stock. On June 7, 2006, our Board approved an additional authorization to repurchase 20.0 million shares. These authorizations have no expiration date.
(2)
All shares were purchased in connection with funding employee income tax withholding obligations arising upon the exercise of stock options or the lapse of restrictions on restricted shares.
PERFORMANCE GRAPH - The following graph compares the cumulative five-year total return provided shareholders on H&R Block, Inc.’s common stock relative to the cumulative total returns of the S&P 500 index and the S&P Diversified Commercial & Professional Services index. An investment of $100, with reinvestment of all dividends, is assumed to have been made in our common stock and in each of the indexes on April 30, 2002 and its relative performance is tracked through April 30, 2007.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
We derived the selected consolidated financial data presented below as of and for each of the five years in the period ended April 30, 2007 from our consolidated financial statements. During fiscal year 2007, we met the criteria requiring us to present the related financial results of OOMC, HRBMC and four other businesses as discontinued operations and the assets and liabilities of all of the businesses being sold as held-for-sale in the consolidated financial statements. All periods presented have been reclassified to reflect our discontinued operations. The data set forth below should be read in conjunction with Item 7
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
We are a financial services company with subsidiaries delivering tax, investment, mortgage and business services and products. We are the only major company offering a full range of software, online and in-office tax preparation solutions, combined with personalized financial advice concerning retirement savings, home ownership and other opportunities to help clients build a better financial future.
Our key strategic priorities for each of our reportable segments can be summarized as follows:
§
Tax Services - expand access to our services through improved distribution of our digital offerings and continue to improve the quality of service we provide to our clients.
§
Business Services - continue expansion of our national accounting, tax and consulting business, build and manage brand awareness, build differentiated and value-driven services and improve our client service culture.
§
Consumer Financial Services - integrate the Tax Services client base into this segment and serve the broad consumer market through advisory and banking relationships.
DISCONTINUED OPERATIONS - On April 19, 2007, we entered into an agreement to sell OOMC. In conjunction with this plan, we also announced we would terminate the operations of HRBMC.
During fiscal year 2007, we committed to a plan to sell and/or completed the wind-down of three smaller lines of business previously reported in our Business Services segment, as well as our tax operations in the United Kingdom previously reported in Tax Services.
During fiscal year 2007, we met the criteria requiring us to present the related financial results of these businesses as discontinued operations and the assets and liabilities of all of the businesses being sold as held-for-sale in the consolidated financial statements. All periods presented have been reclassified to reflect our discontinued operations. See Item 1 and Item 8, note 20 to our consolidated financial statements for additional information.
RESULTS OF OPERATIONS -
TAX SERVICES
This segment primarily consists of our income tax preparation businesses - retail, online and software. This segment includes our tax operations in the United States, Canada and Australia. The following discussion excludes the results of our tax business in the United Kingdom, which is reported in discontinued operations for all periods presented.
FISCAL 2007 COMPARED TO FISCAL 2006 - Tax Services’ revenues increased $236.1 million, or 9.6%, compared to the prior year. We opened nearly 300 new company-owned offices, 250 of which were part of the expansion of our retail distribution network. This expansion contributed incremental revenues of $22.3 million and pretax losses of $5.7 million in fiscal year 2007.
Tax preparation fees from our retail offices increased $104.6 million, or 5.8%, for fiscal year 2007. This increase is primarily due to an increase of 5.9% in the net average fee per U.S. client served, while the number of U.S. clients served in company-owned offices was essentially flat compared to last year. Our international operations contributed $9.6 million to the increase, resulting from a 4.5% increase in clients served.
Other service revenue increased $96.5 million, or 47.1%, primarily due to $34.6 million in additional license fees earned from bank products, $25.9 million in additional revenues from our online tax preparation and e-filing services and a $12.2 million increase in the recognition of deferred fee revenue from our POM guarantees. Additionally, this segment earned
customer fees in connection with an agreement with HRB Bank for our new H&R Block Emerald Prepaid MasterCard® program, under which, this segment shares in the revenues and expenses associated with the program.
Royalty revenue increased $12.4 million, or 6.0%, due to a 7.6% increase in the net average fee and a 1.6% increase in clients served in franchise offices.
Loan participation fees and related revenues increased $32.2 million, or 18.1%, from the prior year. This increase is primarily due to the introduction of the IMAL, an early-season loan product, which increased our participation revenues $17.6 million. The remainder of the increase is primarily due to our new RAL participation agreement with HSBC.
Other revenues decreased $9.7 million, or 14.3%, primarily due to a decline in revenues from supply sales to franchises, as our franchises now order directly from the supplier.
Revenue from our digital business, which includes both service and product revenues, increased $29.2 million, or 21.9%, primarily due to a 19.4% increase in clients served. In fiscal year 2007, we implemented an aggressive plan to grow market share, although the required spending to achieve these results did impact our margin.
Total expenses increased $121.0 million, or 6.5%, compared to the prior year. Cost of services increased $169.6 million, or 12.9%, from the prior year. Our real estate expansion efforts have contributed to a total increase of $28.0 million across all cost of services categories. Compensation and benefits increased $72.3 million, or 9.6%, primarily due to higher wages associated with increased revenues, costs associated with our earlier office openings and initiatives addressing operational readiness for the tax season. Occupancy expenses increased $30.3 million, or 9.6%, primarily as a result of higher rent expenses, due to a 5.9% increase in company-owned offices under lease and a 3.9% increase in the average rent. Other cost of services increased $71.3 million, or 60.2%, primarily due to additional corporate shared services for information technology and other projects, and costs associated with the H&R Block Emerald Prepaid MasterCard® program, which this segment shares with HRB Bank.
Cost of other revenues, selling, general and administrative expenses increased $21.7 million, or 4.6%, primarily due to increases of $30.9 million and $26.0 million in bad debt on loan participations and marketing expenses, respectively. The higher bad debt expense is primarily due to an $18.0 million favorable adjustment to RAL bad debt recorded in the prior year and the addition of our IMAL product. These increases were partially offset by a $26.6 million reduction in corporate shared services and a $10.8 million decrease in legal expenses.
In the prior year, we recorded $70.2 million, including legal fees, related to the settlement of RAL litigation.
Pretax income for fiscal year 2007 increased $115.1 million, or 19.5%, from 2006, primarily due to higher revenues and the impact of the $70.2 million prior year RAL litigation charge.
FISCAL 2006 COMPARED TO FISCAL 2005 - Tax Services’ revenues increased $93.0 million, or 3.9%, compared to fiscal year 2005. We opened more than 750 new offices, 550 of which were part of the expansion of our company-owned retail distribution network. This expansion contributed incremental revenues of $36.4 million and pretax losses of $8.5 million in fiscal year 2006.
Tax preparation fees from our retail offices increased $73.4 million, or 4.3%, for fiscal year 2006. This increase is primarily due to an increase of 6.1% in the net average fee per U.S. client served, partially offset by a decrease of 2.3% in U.S. clients served in company-owned offices. The decrease in clients served was partially due to a number of technology problems that severely hurt the start of our filing season, coupled with increased competition due to competitors’ refund lending products. Our international operations contributed $17.1 million to the increase, resulting from a 5.4% increase in clients served.
Royalty revenue increased $10.2 million, or 5.2%, due to a 5.2% increase in the net average fee, slightly offset by a 1.0% decline in clients served in franchise offices.
Loan participation fees and related revenues earned during fiscal year 2006 decreased $4.9 million, or 2.7%, from fiscal year 2005. This decrease is primarily due to a decrease in the number of RALs, which resulted from increased competition for clients in the early months of the tax season.
Revenue from our digital business increased 8.2%, primarily due to a 23.3% increase in clients served, partially offset by planned reductions in unit prices.
Total expenses increased $168.2 million, or 9.9%, primarily due to a $70.2 million charge relating to the settlement of two RAL claims. See additional discussion below and in Item 8, note 19 to the consolidated financial statements.
Cost of services for the fiscal year 2006 increased $57.9 million, or 4.6%, from fiscal year 2005. Our real estate expansion efforts have contributed to a total increase of $43.5 million across all cost of services categories. Compensation and benefits increased $31.7 million, or 4.4%, primarily due to an increase in staff needed for our new offices and the addition of costs related to our small business initiatives. Occupancy expenses increased $35.4 million, or 12.6%, primarily as a result of higher rent
expenses, due to a 9.5% increase in company-owned offices under lease and a 7.3% increase in the average rent. Depreciation declined $9.7 million, or 17.8%, primarily due to decreased capital expenditures compared to fiscal year 2005.
Cost of other revenues, selling, general and administrative expenses increased $40.2 million, or 9.3%, primarily due to a $31.5 million increase in corporate shared services, $20.7 million of which was related to our marketing efforts. We also incurred $7.5 million in additional corporate wages and $7.1 million in additional legal costs in fiscal year 2006. During the fourth quarter of fiscal year 2006, we revised our estimate for the provision for bad debt related to our participation interests in RALs, resulting in a decrease to our provision for bad debt of $18.0 million during fiscal year 2006.
Pretax income for fiscal year 2006 decreased $75.2 million, or 11.3%, from 2005, primarily due to the impact of the RAL litigation.
RAL LITIGATION - On December 21, 2005, we entered into a settlement agreement regarding litigation pertaining to our RAL programs entitled Deadra D. Cummins, et al. v. H&R Block, Inc. et al.; Mitchell v. H&R Block, Inc. et al.; Green v. H&R Block, Inc. et al.; and Becker v. H&R Block, Inc. (the “Cummins Settlement Agreement”). Pursuant to the Cummins Settlement Agreement’s terms, we contributed a total of up to $62.5 million in cash for purposes of making payments to the settlement class, paying all attorneys’ fees and costs to class counsel, and covering service awards to the representative plaintiffs. In addition, we paid costs for providing notice of the settlement to settlement class members. Settlement of this matter resulted in a pretax charge of $50.7 million in fiscal year 2006.
On April 19, 2006, we entered into a settlement agreement, subject to final court approval, regarding litigation entitled Lynne A. Carnegie, et al. v. Household International, Inc., H&R Block, Inc., et al. (the “Carnegie Settlement Agreement”). Pursuant to the Carnegie Settlement Agreement, we contributed a total of $19.5 million in cash for purposes of making payments to the settlement class, paying all attorneys’ fees and costs to class counsel, incentive payment awards to plaintiff and all notice and administration costs. We recorded a $19.5 million pretax charge related to this settlement in the third quarter of fiscal year 2006.
We are named as a defendant in one other class-action lawsuit and one state attorney general lawsuit alleging that we engaged in wrongdoing with respect to the RAL program. We believe we have meritorious defenses to the other lawsuits and will vigorously defend our position. Nevertheless, the amounts claimed in these lawsuits are very substantial, and there can be no assurances as to their ultimate outcome, or as to their impact on our financial statements. See additional discussion of RAL Litigation in Item 3, “Legal Proceedings” and in Item 8, note 19 to the consolidated financial statements.
BUSINESS SERVICES
This segment offers middle-market companies accounting, tax and business consulting services, wealth management and capital market services. The following discussion excludes the results of the three businesses reported in discontinued operations for all periods presented.
FISCAL 2007 COMPARED TO FISCAL 2006 - Business Services’ revenues for fiscal year 2007 increased $104.2 million, or 12.6%, over the prior year.
Accounting, tax and consulting revenues increased $103.9 million, or 14.7%, over the prior year. This increase resulted primarily from the acquisition of AmexTBS, which contributed $98.7 million in additional service revenues. This acquisition, coupled with an increase in our existing business, was partially offset by a decline in consulting revenue, resulting from a change in organizational structure between the businesses we acquired from AmexTBS and the attest firms that, while not affiliates of our company, also serve our clients. As a result, we no longer record the revenues and expenses associated with leasing employees in these offices to the attest firms.
Capital markets revenues declined $10.7 million. Valuation and seminar revenues declined $23.2 million due to a 59.2% decline in the number of business valuation projects. This decrease was partially offset by a $12.6 million increase in underwriting revenues due to a 28.6% increase in transactions and a 32.2% increase in revenue per transaction. Other revenues increased primarily due to higher computer hardware and software sales.
Total expenses increased $117.2 million, or 15.5%, compared to the prior year. Cost of services increased $77.0 million, due to increases in compensation and benefits and occupancy expenses. Compensation and benefits increased $54.2 million, or 11.9%, due to an increase in the number of personnel, primarily as a result of the AmexTBS acquisition, and an increase in the average wage per employee. Occupancy expenses increased $13.0 million due to higher rent expense resulting from office locations added with the AmexTBS acquisition in fiscal year 2006. These offices only contributed seven months of expense in the prior year, compared to twelve months in the current year.
Cost of other revenues, selling, general and administrative expenses increased $40.8 million, or 24.3%, due to seven months of expense from the AmexTBS acquisition in the prior year, compared to twelve months in the current year, $5.9 million of costs incurred related to international acquisitions that will not be completed and additional costs associated with our business development initiatives.
Pretax income for the year ended April 30, 2007 of $57.7 million compares to $70.7 million in the prior year. The decline was primarily due to off-season losses of AmexTBS.
FISCAL 2006 COMPARED TO FISCAL 2005 - Business Services’ revenues for fiscal year 2006 increased $280.9 million, or 51.3%, from fiscal year 2005. This increase was primarily due to the acquisition of AmexTBS, which increased accounting, tax and consulting revenues $251.3 million. The remaining $27.7 million increase in tax, accounting and consulting revenues was primarily driven by increases in the net billed rate per hour and chargeable hours.
Capital markets revenues declined $8.4 million due to a 36.0% decline in the number of business valuation projects. Other service revenues increased $6.6 million as a result of growth in wealth management services.
Total expenses increased $253.5 million, or 50.3%, for fiscal year 2006 compared to the prior year. Cost of services increased $191.4 million, primarily due to a $149.7 million increase in compensation and benefits. Compensation and benefits increased primarily due to the AmexTBS acquisition. In addition, baseline increases in the number of personnel and the average wage per employee, driven by marketplace competition for professional staff, also contributed to the increase. Occupancy expenses increased $34.8 million primarily due to acquisitions.
Cost of other revenues, selling, general and administrative expenses increased $60.3 million primarily due to acquisitions and additional costs associated with our business development initiatives.
Pretax income for the year ended April 30, 2006 was $70.7 million, compared to $43.2 million in fiscal year 2005.
CONSUMER FINANCIAL SERVICES
This segment is primarily engaged in offering brokerage services, along with investment planning and related financial advice through HRBFA and full-service banking through HRB Bank. HRBFA and HRB Bank, our “Block-branded” businesses, are focused on increasing client loyalty and retention by offering expanded financial and banking services to our retail tax clients. HRB Bank commenced operations May 1, 2006, therefore segment results for fiscal years 2006 and 2005 include only the operations of HRBFA and are not directly comparable to fiscal year 2007.
(1)
Includes only accounts with a positive balance.
(2)
Defined as non-interest expense divided by revenue net of interest expense. See “Reconciliation of Non-GAAP Financial Information” at the end of Item 7.
(3)
Defined as net interest income divided by average assets. See “Reconciliation of Non-GAAP Financial Information” at the end of Item 7.
(4)
Defined as pretax banking income divided by average assets. See “Reconciliation of Non-GAAP Financial Information” at the end of Item 7.
(1)
Total revenues, less interest expense and loan loss reserves on mortgage loans held for investment.
FISCAL 2007 COMPARED TO FISCAL 2006 - Consumer Financial Services’ revenues, net of interest expense and provision for loan losses, for fiscal year 2007 increased $58.3 million, or 20.7%, over the prior year, primarily as a result of HRB Bank, which commenced operations May 1, 2006.
Financial advisor production revenue, which consists primarily of fees earned on assets under administration and commissions on customer trades, increased $9.2 million, or 4.8%, over the prior year, due primarily to higher annuitized revenues. The following table summarizes the key drivers of production revenue:
Other service revenues increased $36.4 million, due to revenues earned from our new H&R Block Prepaid Emerald MasterCard® program, coupled with positive sweep account rate variances and higher underwriting fees.
Net interest income on banking activities totaled $24.0 million for fiscal year 2007. The following table summarizes the key drivers of net interest revenue on banking activities:
Total expenses increased $5.7 million, or 1.8%. Cost of services increased $6.7 million, or 3.8%, primarily due to the expenses of HRB Bank, which opened May 1, 2006.
Pretax income for Consumer Financial Services for fiscal year 2007 was $19.8 million compared to the prior year loss of $32.8 million.
FISCAL 2006 COMPARED TO FISCAL 2005 - Consumer Financial Services’ revenues, net of interest expense, increased $45.2 million, or 19.1% over fiscal year 2005.
Financial advisor production revenue increased $24.6 million, or 14.8%, over fiscal year 2005, primarily due to additional annuitized revenue. Higher annuitized revenues resulted from increased sales of annuities and insurance, wealth management accounts, mutual funds, and unit investment trusts.
Annualized productivity averaged approximately $194,000 per advisor during fiscal year 2006 compared to $166,000 in the prior year. Increased productivity was due to minimum production standards put into place during the fourth quarter of fiscal year 2005.
Net interest income increased $13.6 million, or 33.4%, from the prior year, as a result of higher interest rates earned, partially offset by a decline in average margin balances.
Total expenses increased $2.6 million, or 0.8%. Cost of services increased $19.2 million, or 12.1%, primarily as a result of $18.7 million of additional compensation and benefits expenses resulting from higher production revenues.
Selling, general and administrative expenses decreased $16.5 million, or 14.2%, primarily due to a $4.8 million decline in legal expenses, due in part to a favorable arbitration outcome. Fiscal year 2006 results also improved due to reduced back-office headcount relating to cost containment efforts and gains on the disposition of certain assets during the year. These decreases were partially offset by increased bonus accruals associated with the segment’s improved performance.
The pretax loss for Consumer Financial Services for fiscal year 2006 was $32.8 million compared to a loss of $75.4 million in 2005.
DISCONTINUED OPERATIONS
Discontinued operations includes OOMC and HRBMC, mortgage businesses primarily engaged in the origination and acquisition of non-prime and prime mortgage loans, the sale and securitization of mortgage loans and residual interests, and the servicing of non-prime loans. These businesses were previously reported in our Mortgage Services segment in our Annual Report on Form 10-K for fiscal year 2006. Also included are the results of three smaller lines of business previously reported in our Business Services segment, as well as our tax operations in the United Kingdom previously reported in our Tax Services segment. Operating results presented below are net of eliminations of intercompany activities.
(1)
Represents non-prime production.
(2)
Defined as gain on sale of mortgage loans (including gain or loss on derivatives, mortgage servicing rights and net of direct origination and acquisition expenses) divided by origination volume.
(3)
See “Reconciliation of Non-GAAP Financial Information” at the end of Item 7.
(4)
Defined as total premium received divided by total balance of loans delivered to third-party investors or securitization vehicles (excluding mortgage servicing rights and the effect of loan origination expenses).
FISCAL 2007 COMPARED TO FISCAL 2006 - Conditions in the non-prime mortgage industry were challenging throughout fiscal year 2007, and particularly in our fourth quarter. Our mortgage operations, as well as the entire industry, were impacted by deteriorating conditions in the secondary market, where reduced investor demand for loan purchases, higher investor yield requirements and increased estimates for future losses reduced the value of non-prime loans. Under these
conditions non-prime originators generally reported significant increases in losses and many were unable to meet their financial obligations. During the fourth quarter we tightened our underwriting standards, which had the effect of reducing our loan origination volumes, but we expect will result in the origination of higher quality loans with better pricing in the secondary markets.
The pretax loss of $1.2 billion includes losses of $50.2 million from our Business Services and Tax Services discontinued operations, with the remainder from our mortgage business. As discussed more fully below, mortgage results include $388.7 million in loss provisions and repurchase reserves, impairments of residual interests of $168.9 million and impairments of other assets totaling $345.8 million. If conditions in the industry, particularly in home appreciation, continue to decline, our future results would continue to be negatively impacted.
The following table summarizes the key drivers of loan origination volumes and related gains on sales of mortgage loans:
(1)
Includes all direct sales and back office sales support associates.
(2)
Percentage of loans funded divided by total applications in the period.
(3)
Defined as gain on sale of mortgage loans (including gain or loss on derivatives, mortgage servicing rights and net of direct origination and acquisition expenses) divided by origination volume.
Gains on sales of mortgage assets decreased $1.2 billion from the prior year. This decrease resulted primarily from significantly lower origination volumes and loan sale premiums, increases in loan repurchase reserves and impairments of residual interests and losses on derivatives.
During the fourth quarter, concerns about credit quality in the non-prime industry resulted in lower demand for non-prime loans and a higher yield requirement by investors that purchase the loans. As a result, during the quarter we originated mortgage loans that, by the time we sold them in the secondary market, were valued at less than par. Our fourth quarter net gain on sale gross margin was a negative 6.87% and a negative 1.10% for the full fiscal year. We sold 73% and 39% of our loans through securitizations in the fourth quarter and fiscal year, respectively. Additionally, our loan sale premium declined 148 basis points from 1.42% in fiscal year 2006, to a negative 0.06% in the current year.
The disruption in the secondary market, coupled with declining credit quality and increasing early payment defaults, caused investors in our loans to become increasingly more likely to execute on early payment default provisions available to them in loan sale agreements. As a result, we experienced higher actual and expected loan repurchase activity. Additionally, after we repurchased the loans, we experienced higher severity of losses on those loans. We recorded total loss provisions of $388.7 million during fiscal year 2007 compared to $73.6 million in the prior year. The provision recorded in the current year consists of $238.8 million recorded on loans sold during the current year and $149.9 million related to loans sold in the prior year. Loss provisions as a percent of loan volumes increased 126 basis points over the prior year. See additional discussion of our reserves and repurchase obligations in Item 8, note 20 to our consolidated financial statements.
During the current year, we recorded impairments of $168.9 million in gains on sales of mortgage assets due to higher expected credit losses resulting from the decline in performance of the underlying collateral. We also recorded unfavorable pretax mark-to-market adjustments in other comprehensive income, which decreased the fair value of our residual interests $32.4 million during the current year. These adjustments were recorded net of write-ups of $18.6 million and deferred taxes of $5.3 million. We also recorded $7.0 million and $31.5 million in gains on the sale of residual interests for the years ended April 30, 2007 and 2006, respectively.
During the current year, we recorded a net $11.0 million in losses, compared to gains of $141.2 million in the prior year, related to our various derivative instruments. The decline for the current year was caused by market interest rates, based on the two-year swap, declining 6 basis points compared to an increase of 131 basis points during the prior year. See Item 8, note 20 to the consolidated financial statements.
The value of MSRs recorded in the current year increased to 64 basis points from 61 basis points in the prior year due to changes in our assumptions used to value MSRs, as well as an increase in average loan balances. However, this increase was offset by an overall decline in origination volumes, resulting in
a net decrease in gains on sales of mortgage loans of $78.3 million. See additional discussion of our MSR assumptions in “Critical Accounting Policies” and in Item 8, note 20 to the consolidated financial statements.
Interest income decreased $78.7 million from the prior year. This decrease is primarily due to higher levels of non-performing loans, lower accretion resulting from the sale of previously securitized residual interests and lower write-ups to residual interest balances.
The following table summarizes the key metrics related to our loan servicing business:
Loan servicing revenues increased $34.4 million, or 8.6%, compared to the prior year. The increase reflects higher late fee income on delinquent loans. This increase was partially offset by a reduction in our average servicing portfolio, which decreased 11.2%, to $67.2 billion. The annualized rate earned on our entire servicing portfolio was 37 basis points for the current year, compared to 38 basis points in the prior year.
Total expenses for the fiscal year ended April 30, 2007 increased $326.4 million, or 33.3%, over the prior year. Cost of services increased $28.5 million primarily as a result of higher amortization of MSRs, partially offset by reductions in compensation and occupancy expenses resulting from our mortgage restructuring activities.
Cost of other revenues decreased $149.1 million, primarily due to our ongoing restructuring plans. As a result, compensation and benefits declined $116.7 million and other expenses declined $27.4 million.
In conjunction with our agreement to sell OOMC, we recorded impairments during the fourth quarter of fiscal year 2007. The purchase price will be calculated as the fair value of the adjusted tangible net assets of OOMC (as defined by the agreement) at closing less $300.0 million. At April 30, 2007, we valued our assets and liabilities held for sale at estimated fair value at closing, less costs to sell, of $1.1 billion which resulted in an impairment charge of $345.8 million, including the full impairment of goodwill of $152.5 million. Because conditions may change during the period prior to closing, the adjusted tangible net assets of the business at the closing date may be significantly different than the estimated value we have reported as of April 30, 2007. Any changes could change the final impairment amount recorded at closing. See discussion of additional conditions of the sale in Item 1A, under “Potential Sale Transaction.”
Selling, general and administrative expenses increased $96.1 million due primarily to severance costs in connection with our ongoing restructuring plans, coupled with retention bonuses and higher consulting expenses. See additional discussion of the restructuring charge in Item 8, note 20 to the consolidated financial statements.
The pretax loss for the year ended April 30, 2007 was $1.2 billion compared to income of $316.9 million in the prior year.
The loss from discontinued operations for fiscal year 2007 of $808.0 million is net of tax benefits of $425.0 million, and includes income tax benefits related to OOMC totaling $374.6 million. Income taxes for discontinued operations also included one-time benefits of $16.2 million related to permanent deductions for the tax basis of investments in two subsidiaries that were abandoned during the year. Assets of discontinued operations held for sale includes deferred tax assets of $393.6 million, net of the related valuation allowance, and deferred tax liabilities of $94.0 million as of April 30, 2007. In addition, we recorded a valuation allowance of $55.8 million, which primarily relates to deferred tax assets for capital losses and basis differences in certain state jurisdictions. Deferred tax assets of $183.2 million relate to certain residual assets. Although the tax position associated with these deferred tax assets is more likely than not of being sustained, there is a level of uncertainty associated with the amount of benefit. We believe the net deferred tax asset at April 30, 2007 is, more likely than not, realizable.
FISCAL 2006 COMPARED TO FISCAL 2005 - Revenues from discontinued operations increased $24.4 million, or 1.9%, over fiscal year 2005. Revenues increased as a result of higher loan servicing revenues and gains on derivatives, partially offset by lower margins on mortgage loans sold and lower accretion.
Despite a 31.5% increase in loan origination volume, gains on sales of mortgage loans decreased $163.0 million, primarily as a result of moderating demand by loan buyers and rising two-year swap rates. Market interest rates, based on the two-year swap, increased from an average of 3.32% last year to 4.63% in the current year. However, our WAC increased only 51 basis points, up to 7.87% from 7.36% in the prior year. Due to competitive market conditions, we were unable to align our WAC with increases in market rates. Because of poor alignment of our WAC with market rates and increases in our funding costs, our loan sale premium declined 135 basis points, to 1.42% from 2.77% in the prior year. In fiscal year 2006, we also increased our loss reserves above our normal loss accrual,
primarily related to repurchase activity for loans sold related to early payment defaults, which reduced gains on sales of mortgage loans.
The initial value of MSRs recorded in fiscal year 2006 increased to 61 basis points from 44 basis points in the prior year, which resulted in an increase of $113.0 million in gains on sales of mortgage loans. These increases were primarily due to higher origination volumes, average loan size and interest rates, coupled with updated valuation assumptions. During fiscal year 2006 we updated our assumptions used to value our MSRs. The assumptions were updated primarily to reflect lower servicing costs, in particular interest paid to bondholders on monthly loan prepayments, and higher discount rates. These changes in assumptions increased the weighted average value of MSRs recorded during fiscal year 2006 by approximately $37.0 million (9 basis points of total retained MSRs of 61 basis points) over the prior year.
To mitigate the risk of short-term changes in market interest rates related to our loan originations and beneficial interest in Trusts, we use interest rate swaps and forward loan sale commitments. We generally enter into interest rate swap arrangements related to existing loan applications with rate-lock commitments and for rate-lock commitments we expect to make in the next two to three weeks. During fiscal year 2006, we recorded a net $141.2 million in gains, compared to $46.9 million in the prior year, related to our interest rate swaps and other derivative instruments. This increase was primarily due to rising short-term interest rates and an increase in the average notional amount of swap arrangements to $8.4 billion in fiscal year 2006, compared to $2.4 billion in fiscal year 2005.
In fiscal year 2006, we completed sales of available-for-sale residual interests and recorded a gain of $31.5 million. These sales accelerated cash flows from these residual interests, effectively realizing previously recorded unrealized gains included in other comprehensive income. We recorded a gain of $15.4 million in the prior year on a similar transaction.
During fiscal year 2006, our available-for-sale residual interests performed better than expected in our internal valuation models, with lower credit losses than originally modeled, partially offset by higher than expected interest rates. We recorded favorable pretax mark-to-market adjustments, which increased the fair value of these residual interests $53.3 million during the year. These adjustments were recorded, net of write-downs of $18.0 million and deferred taxes of $13.5 million, in other comprehensive income and will be accreted into income throughout the remaining life of those residual interests. Offsetting this increase were impairments of $34.1 million, which were recorded in gains on sales of mortgage assets. Future changes in interest rates or other assumptions, based on market conditions or actual loan pool performance, could cause additional adjustments to the fair value of these residual interests and could cause changes to the accretion of these residual interests in future periods.
Loan servicing revenues increased $125.9 million, or 46.1%, compared to the prior year. The increase reflects a higher loan servicing portfolio resulting from our loan origination growth. The average servicing portfolio for the year increased 37.9%, to $75.6 billion, even with lower volumes in our sub-servicing business. The weighted average rate earned on our entire servicing portfolio was 38 basis points for fiscal year 2006, compared to 36 basis points in the prior year.
Total expenses for fiscal year 2006 increased $197.6 million, or 25.2%, from the prior year. Cost of services increased $98.2 million, or 38.7%, mainly as a result of a higher average servicing portfolio during the current quarter year and increased amortization of MSRs.
Cost of other revenues increased $88.3 million over fiscal year 2005, and includes a $12.6 million restructuring charge associated with the closing of some of our branch offices. Compensation and benefits increased $53.8 million primarily due to an increase in the average number of sales associates during the year to support higher loan volumes and the resulting increase in origination-based incentives, coupled with $6.7 million in severance charges recorded as part of the restructuring. Occupancy expenses increased $7.8 million primarily due to $5.9 million in lease termination costs recorded as part of the restructuring. Other expenses increased $26.8 million primarily as a result of $20.1 million in additional interest expense related to mortgage loans held on our balance sheet and $5.0 million of additional depreciation and amortization of our origination and servicing software.
Selling, general and administrative expenses increased $11.0 million primarily due to $15.3 million in additional marketing expenses, $5.1 million in additional occupancy costs and $3.2 million in higher allocated shared services. These increases were partially offset by a $15.7 million decline in compensation and benefits resulting from reductions in administrative and corporate headcount and lower bonus accruals.
Pretax income decreased $173.2 million, or 35.3%, for fiscal year 2006.
CRITICAL ACCOUNTING POLICIES -
We consider the policies discussed below to be critical to understanding our financial statements, as they require the use of significant judgment and estimation in order to measure, at a specific point in time, matters that are inherently uncertain. Specific risks for these critical accounting policies are described in the following paragraphs. For all of these policies, we caution that future events rarely develop precisely as forecasted, and estimates routinely require adjustment and may require material adjustment.
REVENUE RECOGNITION - We have many different revenue sources, each governed by specific revenue recognition policies. Our revenue recognition policies can be found in Item 8, note 1 to our consolidated financial statements. Additional discussion of our recognition of gains on sales of mortgage assets follows.
VALUATION OF MORTGAGE LOANS HELD FOR INVESTMENT - Determining the allowance for credit losses for loans held for investment requires us to make estimates of losses that are highly uncertain and requires a high degree of judgment.
We record an allowance representing our estimate of credit losses inherent in our portfolio of loans held for investment at the balance sheet date. The majority of our estimated credit loss is evaluated for mortgage loans on a pooled basis. We stratify the loan portfolio based on our view of risk associated with various elements of the pool and assign estimated loss rates based on those risks. Loss rates are based on historical experience, our assessment of economic and market conditions and loss rates of comparable financial institutions. We review non-performing loans individually and record loss estimates typically based on the value of the underlying collateral. Changes in our estimates can affect our operating results.
VALUATION OF GOODWILL - We test goodwill and other indefinite life intangible assets for impairment annually, or more frequently if events occur or circumstances change which would, more likely than not, reduce the fair value of a reporting unit below its carrying value. Our goodwill impairment analysis is based on a discounted cash flow approach and market comparables, when available. This analysis, at the reporting unit level, requires significant management judgment with respect to revenue and expense forecasts, anticipated changes in working capital, and the selection and application of an appropriate discount rate. Changes in the projections or assumptions could materially affect our estimate of reporting unit fair values. The use of different assumptions would increase or decrease estimated discounted future operating cash flows and could effect our conclusions regarding the existence or amount of potential impairment.
The goodwill balance in our continuing operations was $993.9 million as of April 30, 2007 and $941.3 million as of April 30, 2006. No goodwill impairments were identified in our continuing operations during fiscal years 2007, 2006 or 2005. In fiscal year 2007, we recorded $154.9 million in goodwill impairments related to the sale or wind-down of businesses reported as discontinued operations.
LITIGATION - It is our policy to routinely assess the likelihood of any adverse judgments or outcomes related to legal matters, as well as ranges of probable losses. Assessing the likely outcome of pending litigation, including the amount of potential loss if any, is highly subjective. Our estimates may differ from actual results due to difficulties in predicting the outcome of jury trial, arbitration hearings, settlement discussions and related activity; predicting the outcome of class certification actions; and various other uncertainties.
A determination of the amount of the reserves required, if any, for these contingencies is made after thoughtful analysis of each known issue and an analysis of historical experience in accordance with Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies,” and related pronouncements. Therefore, we have recorded reserves related to certain legal matters for which we believe it is probable that a loss will be incurred and the range of such loss can be estimated. With respect to other matters, we have concluded that a loss is only reasonably possible or remote, or is not estimable and, therefore, no liability is recorded.
INCOME TAXES - We calculate our current and deferred tax provision for the fiscal year based on estimates and assumptions that could differ from the actual results reflected in income tax returns filed during the applicable calendar year. Adjustments based on filed returns are recorded in the appropriate periods when identified. We file a consolidated federal tax return on a calendar year basis, generally in the second fiscal quarter of the subsequent year.
We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. We have considered taxable income in carry-back periods, historical and forecasted earnings, future taxable income, the mix of earnings in the jurisdictions in which we operate, and tax planning strategies in determining the need for a valuation allowance against our deferred tax assets. In the event we were to determine that we would not be able to realize all or part of our deferred tax assets in the future, an adjustment to the deferred tax assets would be charged to earnings in the period in which we make such determination. Likewise, if we later determine that it is more likely than not that the deferred tax assets would be
realized, we would reverse the applicable portion of the previously provided valuation allowance.
The amount of income taxes we pay is subject to ongoing audits by federal, state and foreign tax authorities, which may result in proposed assessments. Our estimate for the potential outcome for any uncertain tax issue is highly subjective and based on our best judgments. We believe we have adequately provided for any reasonably foreseeable outcome related to these matters. However, our future results may include favorable or unfavorable adjustments to our estimated tax liabilities in the period the assessments are made or resolved or when statutes of limitation on potential assessments expire. As a result, our effective tax rate may fluctuate on a quarterly basis.
GAINS ON SALES OF MORTGAGE ASSETS - We sell substantially all of the non-prime mortgage loans we originate to the Trusts which are qualifying special purpose entities (QSPEs), with servicing rights generally retained. Prime mortgage loans are sold in loan sales, servicing released, to third-party buyers. Gains or losses on sales of mortgage loans are recognized when control of the assets is surrendered (when loans are sold to third-party buyers, including the Trusts) and are based on the difference between net proceeds received (cash proceeds less repurchase reserves) and the allocated cost of the assets sold. We determine the allocated cost of assets sold based on the relative fair values of net proceeds (i.e. the loans sold), retained MSRs and the beneficial interest in Trusts, which represents our residual interest in the ultimate expected outcome from the disposition of the loans by the Trusts.
The following is an example of a hypothetical gain on sale calculation:
Variations in the assumptions we use affect the estimated fair values and the reported net gains on sales. Gains on sales of mortgage loans totaled $102.0 million and $648.7 million for fiscal years 2007 and 2006, respectively.
Our repurchase reserves relate to potential losses that could be incurred related to the repurchase of sold loans or indemnification of losses as a result of early payment defaults or breaches of other representations and warranties customary to the mortgage banking industry.
Loans are repurchased due to a combination of factors, including delinquency and other violations of representations and warranties. In whole loan sale transactions, we guarantee the first payment to the purchaser. If this payment is not collected, it is referred to as an early payment default.
For early payment default-related losses, the amount of losses we expect to incur depends primarily on the frequency of early payment defaults, the rate at which defaulted loans subsequently become current on payments (“cure rate”), the propensity of the buyer of the loans to demand recourse under the loan sale agreement and the severity of loss incurred on loans which have been repurchased. The frequency of early payment defaults, cure rates and loss severity may vary depending on the creditworthiness of the borrower and economic factors such as home price appreciation and interest rates. To the extent actual losses related to repurchase activity are different from our estimates, the fair value of our repurchase reserves will increase or decrease. See Item 8, note 20 to our consolidated financial statements under “Commitments and Contingencies.”
During the year ended April 30, 2007, we experienced higher early payment defaults, resulting in an increase in actual and expected loan repurchase activity. As a result, we recorded total loss provisions of $388.7 million during fiscal year 2007 compared to $73.6 million in the prior year. Loss provisions recorded in the current year consist of $238.8 million recorded on loans sold during the current year and $149.9 million related to loans sold in the prior year. At April 30, 2007, we assumed that substantially all loans that failed to make timely payments according to contractual early payment default provisions will be repurchased, and that approximately 5% of loans will be repurchased from sales that have not yet reached the contractual date upon which repurchases can be determined. Based on historical experience and review of current early payment default, cure rate and loss severity trends, we assumed an average 26% loss severity for loans on which we hold a first lien position. During fiscal year 2007, we increased our estimated loss severity for on-balance sheet loans from an average of 15% to 26%.
Based on our analysis as of April 30, 2007, we estimated our liability for repurchases to be $38.4 million. The sensitivity of the
repurchase reserve to 10% and 20% adverse changes in loss assumptions is $14.4 million and $28.8 million, respectively.
VALUATION OF RESIDUAL INTERESTS - We use discounted cash flow models to determine the estimated fair values of our residual interests. We develop our assumptions for expected credit losses, prepayment speeds, discount rates and interest rates based on historical experience. Variations in our assumptions could materially affect the estimated fair values, which may require us to record impairments or unrealized gains. In addition, variations will also affect the amount of residual interest accretion recorded on a monthly basis. We recorded $13.8 million in net write-downs in other comprehensive income and $168.9 million in impairments in the income statement related to these residual interests during fiscal year 2007 as actual performance differed from our assumptions. See Item 8, note 1 to our consolidated financial statements for our methodology used in valuing residual interests. Available-for-sale (AFS) residual interests valued at $90.3 million and $159.1 million were recorded as of April 30, 2007 and 2006, respectively. Residual interests classified as trading securities totaled $72.7 million at April 30, 2007. We had no trading residual interests at April 30, 2006. See Item 8, note 20 to our consolidated financial statements for current assumptions and a sensitivity analysis of those assumptions. See Item 7A
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
GENERAL
INTEREST RATE RISK - We have a formal investment policy to help minimize the market risk exposure of our cash equivalents and AFS securities, which are primarily affected by credit quality and movements in interest rates. These guidelines focus on managing liquidity and preserving principal and earnings. Most of our interest rate-sensitive assets and liabilities are managed at the subsidiary level.
Our cash equivalents are primarily held for liquidity purposes and are comprised of high quality, short-term investments, including qualified money market funds. As of April 30, 2007, our non-restricted cash and cash equivalents had an average maturity of less than three months with an average credit quality of AAA. With such a short maturity, our portfolio’s market value is relatively insensitive to interest rate changes. We hold investments in fixed-income securities at our captive insurance subsidiary. See the table below for sensitivities to changes in interest rates. See additional discussion of interest rate risk included below in Consumer Financial Services and Discontinued Operations.
Our short-term borrowings at April 30, 2007 totaled $1.6 billion, and consisted of $1.0 billion in commercial paper, $500.0 million drawn on a new credit facility and $75.0 million in FHLB advances. For fiscal year 2007, the average issuance
term of our commercial paper was 45 days and the average outstanding balance was $1.0 billion. As commercial paper and bank borrowings are generally seasonal, interest rate risk typically increases through our third fiscal quarter and declines to zero by fiscal year-end. However, at April 30, 2007, $1.0 billion in commercial paper was outstanding due to working capital needs, primarily due to operating losses in our mortgage operations. In April 2007, we obtained a $500.0 million credit facility to provide funding for the $500.0 million of 81/2% Senior Notes which were due April 16, 2007. The facility, which was fully drawn at closing, matures on December 20, 2007. While the market value of short-term borrowings is relatively insensitive to interest rate changes, interest expense on short-term borrowings will increase and decrease with changes in the underlying short-term interest rates. See Item 7, “Financial Condition” for additional information.
Our long-term debt at April 30, 2007 consists primarily of fixed-rate Senior Notes; therefore, a change in interest rates would have no impact on consolidated pretax earnings. See Item 8, note 10 to our consolidated financial statements.
EQUITY PRICE RISK - We have exposure to the equity markets in several ways. The largest exposure, though relatively small, is through our deferred compensation plans. Within the deferred compensation plans we have mismatches in asset and liability amounts and investment choices (both fixed-income and equity). At April 30, 2007 and 2006, the impact of a 10% market value change in the combined equity assets held by our deferred compensation plans and other equity investments would be approximately $12.5 million and $11.6 million, respectively, assuming no offset for the liabilities.
TAX SERVICES
FOREIGN EXCHANGE RATE RISK - Our operations in international markets are exposed to movements in currency exchange rates. The currencies involved are the Canadian dollar and the Australian dollar. We translate revenues and expenses related to these operations at the average of exchange rates in effect during the period. Assets and liabilities of foreign subsidiaries are translated into U.S. dollars at exchange rates prevailing at the end of the year. Translation adjustments are recorded as a separate component of other comprehensive income in stockholders’ equity. Translation of financial results into U.S. dollars does not presently materially affect, and has not historically materially affected, our consolidated financial results, although such changes do affect the year-to-year comparability of the operating results in U.S. dollars of our international businesses. We estimate a 10% change in foreign exchange rates by itself would impact consolidated pretax income in fiscal years 2007 and 2006 by approximately $2.5 million and $2.1 million, respectively, and cash balances at April 30, 2007 and 2006 by $5.9 million and $6.1 million, respectively.
CONSUMER FINANCIAL SERVICES
INTEREST RATE RISK - BANKING - At April 30, 2007, approximately 91% of HRB Bank’s total assets were residential mortgage loans, with 23% of these fixed-rate and 77% adjustable-rate. These loans are sensitive to changes in interest rates, as well as expected prepayment levels. As interest rates increase, fixed rate residential mortgages tend to exhibit lower prepayments. The opposite is true in a falling rate environment. When mortgage loans prepay, mortgage origination costs are written off. Depending on the timing of the prepayment, the write-offs of mortgage origination costs may result in lower than anticipated yields.
At April 30, 2007, HRB Bank’s other investments consisted primarily of mortgage-backed securities and FHLB stock. See table below for sensitivity analysis of our mortgage-backed securities.
HRB Bank’s liabilities consist primarily of transactional deposit relationships, such as prepaid debit card accounts and checking accounts. Other liabilities include money market accounts, certificates of deposit, and collateralized borrowings from the FHLB. Money market accounts re-price as interest rates change. Certificates of deposit re-price over time, depending on maturities. FHLB advances generally have fixed rates ranging from one day through multiple years.
Under criteria published by the OTS, HRB Bank’s overall interest rate risk exposure at April 30, 2007 was characterized as “minimal.” We actively manage our interest rate risk positions. As interest rates change, we will adjust our strategy and mix of assets and liabilities to optimize our position.
INTEREST RATE RISK - BROKER-DEALER - HRBFA holds interest bearing receivables from customers, brokers, dealers and clearing organizations, which consist primarily of amounts due on margin transactions and are generally short-term in nature. We fund these short-term assets with short-term variable rate liabilities from customers, brokers and dealers, including stock loan activity. Although there may be differences in the timing of the re-pricing related to these assets and liabilities, we believe we are not significantly exposed to interest rate risk in this area. As a result, any change in interest rates would not materially impact our consolidated earnings.
Our fixed-income trading portfolio is affected by changes in market rates and prices. The risk is the loss of income arising from adverse changes in the value of the trading portfolio. We value the trading portfolio at quoted market prices and the
market value of our trading portfolio at April 30, 2007 was approximately $11.0 million, net of $0.2 million in securities sold short. See table below for sensitivities to changes in interest rates. With respect to our fixed-income securities portfolio, we manage our market price risk exposure by limiting concentration risk, maintaining minimum credit quality and limiting inventory to anticipated retail demand and current market conditions.
DISCONTINUED OPERATIONS
INTEREST RATE RISK AND CREDIT SPREADS - NON-PRIME ORIGINATIONS - Interest rate changes and credit spreads impact the value of the loans underlying our beneficial interest in Trusts, on our balance sheet or in our origination pipeline, as well as residual interests in securitizations and MSRs.
As a result of loan sales to the Trusts, we remove the mortgage loans from our balance sheet and record the gain or loss on sale, cash proceeds, MSRs, repurchase reserves and a beneficial interest in Trusts, which represents our residual interest in the ultimate expected outcome from the disposition of the loans by the Trusts. See Item 7, “Off-Balance Sheet Financing Arrangements.” At April 30, 2007, there were $1.5 billion of loans held in the Trusts and the value of our beneficial interest in Trusts was $41.1 million. At April 30, 2007, we had $222.8 million of mortgage loans held for sale on our balance sheet. Approximately half of these loans were repurchased from whole loan investors or the Trusts. Changes in interest rates and other market factors including credit spreads may result in a change in value of our beneficial interest in Trusts and mortgage loans held for sale.
We are impacted by changes in the market impacting loan sale prices including interest rates, credit spreads and other factors. We are exposed to interest rate risk and credit spreads associated with commitments to fund approved loan applications of $2.4 billion, subject to conditions and loan contract verification. In addition, we have interest rate risk related to $169.9 million in new loan applications which have not yet been approved, and $425.0 million of applications which we expect to receive prior to our next anticipated change in rates charged to borrowers. Of these amounts, we estimate only $1.6 billion will likely be originated.
We use forward loan sale commitments, interest rate swaps and put options on Eurodollar futures to reduce our interest rate risk associated with our commitment to fund non-prime loans. In addition, forward loan sale commitments reduce our exposure to credit spreads. Changes in credit spread are derived from investor demand and competition for available funds. Investor demand can be impacted by sector performance and loan collateral performance. Sector performance factors include the stability of the industry and individual competitors. Uncertainty regarding the ability of the industry as a whole to meet repurchase obligations could impact credit spread demands by investors. Loan collateral performance or anticipated performance can be driven by actual performance of the collateral or by market-related factors impacting the industry as a whole. Interest rate risk is managed through the use of forward loan sale commitments, interest rate swaps and put options on Eurodollar futures. Credit spread risk can be reduced using forward loan sale commitments. However, locking into these commitments eliminates the potential for price adjustments.
Forward loan sale commitments represent our obligation to sell a non-prime loan at a specific price in the future and increase in value as rates rise and decrease as rates fall. The Trusts may fulfill these obligations in response to the exercise of a put option by the third-party beneficial interest holders. At April 30, 2007, we had no forward loan sale commitments. Forward loan sale commitments lock in the execution price on the loans that will be ultimately delivered into a loan sale.
Interest rate swaps represent an agreement to exchange interest rate payments, whereby we pay a fixed rate and receive a floating rate. Put options on Eurodollar futures represent the right to sell a Eurodollar futures contract at a specified price in the future. These swap and put option contracts increase in value as rates rise and decrease in value as rates fall. At April 30, 2007, the interest rate swaps and put options provided interest risk coverage of $3.1 billion. At April 30, 2007, we recorded $10.8 million in assets and $37.1 million in liabilities on our balance sheet related to changes in fair value of interest rate swaps and put options, respectively.
See table below for sensitivities to changes in interest rates.
INTEREST RATE RISK - PRIME ORIGINATIONS - At April 30, 2007, we had commitments to fund prime mortgage loans totaling $66.4 million. We regularly enter into rate-lock commitments with our customers to fund prime mortgage loans within specified periods of time. The fair value of rate-lock commitments is calculated based on the current market pricing of short sales of FNMA, FHLMC and GNMA mortgage-backed securities and the coupon rates of the eligible loans. At April 30, 2007, we recorded a liability with a fair value of $1.0 million related to rate-lock commitments.
We sell short FNMA, FHLMC and GNMA mortgage-backed securities to reduce the risk related to our prime commitments to fund fixed-rate prime loans. The position on certain, or all, of the fixed-rate mortgage loans is closed approximately 10-15 days prior to standard Public Securities Association (PSA)
settlement dates. At April 30, 2007 we recorded an asset of $0.1 million related to these instruments.
To finance our prime originations, we use a warehouse facility with capacity up to $25.0 million, which bears interest at one-month LIBOR plus 140 to 200 basis points. As of April 30, 2007, the balance outstanding under this facility was $0.4 million.
RESIDUAL INTERESTS - Relative to modeled assumptions, an increase or decrease in interest rates would impact the value of our residual interests and could affect accretion income related to our residual interests. Residual interests bear the interest rate risk embedded within the securitization due to an initial fixed-rate period on the loans versus a floating-rate funding cost. Residual interests also bear the ongoing risk that the floating interest rate earned after the fixed period on the mortgage loans is different from the floating interest rate on the bonds sold in the securitization.
We enter into interest rate caps and swaps to mitigate interest rate risk associated with mortgage loans that will be securitized and residual interests that are classified as trading securities because they will be sold in a subsequent NIM transaction. The caps and swaps enhance the marketability of the securitization and NIM transactions. An interest rate cap represents a right to receive cash if interest rates rise above a contractual strike rate, its value therefore increases as interest rates rise. The interest rate used in our interest rate caps and the floating rate used in swaps are based on LIBOR. At April 30, 2007 we had no assets or liabilities recorded related to interest rate caps.
See table below for sensitivities to changes in interest rates for residual interests and swaps. See Item 8, note 20 to the consolidated financial statements for additional analysis of interest rate risk and other financial risks impacting residual interests.
It is our policy to use derivative instruments only for the purpose of offsetting or reducing the risk of loss associated with a defined or quantified exposure.
MORTGAGE SERVICING RIGHTS - Declining interest rates may cause increased refinancing activity, which reduces the life of the loans underlying the residual interests and MSRs, thereby generally reducing their fair value. The fair value of MSRs generally increases in a rising rate environment, although MSRs are recorded at the lower of cost or market value. Reductions in the fair value of these assets impact earnings through impairment charges based on individual risk stratas. See Item 7, “Critical Accounting Policies” and Item 8, note 20 to our consolidated financial statements for further sensitivity analysis of other MSR valuation assumptions.
The sensitivities of certain financial instruments to changes in interest rates as of April 30, 2007 and 2006 are presented below. The following table represents hypothetical instantaneous and sustained parallel shifts in interest rates and should not be relied on as an indicator of future expected results.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
DISCUSSION OF FINANCIAL RESPONSIBILITY -
We at H&R Block are guided by our core values of client focus, integrity, excellence, respect and teamwork. These values govern the manner in which we serve clients and each other, and are embedded in the execution and delivery of our responsibilities to our shareholders. H&R Block’s Management is responsible for the integrity and objectivity of the information contained in this document. Management is responsible for the consistency of reporting this information and for ensuring that accounting principles generally accepted in the United States are used. In discharging this responsibility, Management maintains an extensive program of internal audits and requires the management teams of our individual subsidiaries to certify their respective financial information. Our system of internal control over financial reporting also includes formal policies and procedures, including a Code of Business Ethics and Conduct program designed to encourage and assist all employees and directors in living up to high standards of integrity.
The Audit Committee of the Board of Directors, composed solely of outside and independent directors, meets periodically with management, the independent auditors and the chief internal auditor to review matters relating to our financial statements, internal audit activities, internal accounting controls and non-audit services provided by the independent auditors. The independent auditors and the chief internal auditor have full access to the Audit Committee and meet, both with and without management present, to discuss the scope and results of their audits, including internal control, audit and financial matters.
KPMG LLP audited our consolidated financial statements. Their audits were conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States).
MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING -
Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f). Under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in “Internal Control - Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) as of April 30, 2007.
Based on our assessment, management concluded that, as of April 30, 2007, the Company’s internal control over financial reporting was effective based on the criteria set forth by COSO. The Company’s external auditors, KPMG LLP, an independent registered public accounting firm, have issued an audit report on our assessment of the Company’s internal control over financial reporting
Mark A. Ernst
William L. Trubeck
Chairman of the Board, President and Chief Executive Officer
Executive Vice President and Chief Financial Officer
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM -
The Board of Directors and Stockholders of H&R Block, Inc.:
We have audited the accompanying consolidated balance sheets of H&R Block, Inc. and its subsidiaries (the Company) as of April 30, 2007 and 2006, and the related consolidated statements of income and comprehensive income, stockholders’ equity, and cash flows for each of the years in the three-year period ended April 30, 2007. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of H&R Block, Inc. and its subsidiaries as of April 30, 2007 and 2006, and the results of their operations and their cash flows for each of the years in the three-year period ended April 30, 2007, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of April 30, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated June 29, 2007 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
Kansas City, Missouri
June 29, 2007
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM -
The Board of Directors and Stockholders of H&R Block, Inc.:
We have audited management’s assessment, included in the accompanying “Management’s Report On Internal Control Over Financial Reporting” ( Item 9A(b)), that H&R Block, Inc. and subsidiaries (the Company) maintained effective internal control over financial reporting as of April 30, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that H&R Block, Inc. and subsidiaries maintained effective internal control over financial reporting as of April 30, 2007, is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued by COSO. Also, in our opinion, H&R Block, Inc. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of April 30, 2007, based on criteria established in Internal Control-Integrated Framework issued by COSO.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of H&R Block, Inc. and subsidiaries as of April 30, 2007 and 2006, and the related consolidated statements of income and comprehensive income, stockholders’ equity, and cash flows for each of the years in the three-year period ended April 30, 2007, and our report dated June 29, 2007 expressed an unqualified opinion on those consolidated financial statements.
Kansas City, Missouri
June 29, 2007
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME -
See accompanying notes to consolidated financial statements.
CONSOLIDATED BALANCE SHEETS -
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS -
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY -
See accompanying notes to consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -
NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
NATURE OF OPERATIONS - Our operating subsidiaries provide a variety of financial services to the general public, principally in the U.S. Specifically, we offer tax return preparation; accounting, tax and consulting services to business clients; investment services through a registered broker-dealer; traditional consumer banking services; tax preparation and related software; and refund anticipation loans offered by a third-party lending institution. Tax preparation services are also provided in Canada and Australia. Our discontinued operations are primarily engaged in the origination, sale and servicing of non-prime and prime mortgage loans.
PRINCIPLES OF CONSOLIDATION - The consolidated financial statements include the accounts of the Company and our wholly-owned and majority-owned subsidiaries. All material intercompany transactions and balances have been eliminated.
Some of our subsidiaries operate in regulated industries, and their underlying accounting records reflect the policies and requirements of these industries.
RECLASSIFICATIONS - Certain reclassifications have been made to prior year amounts to conform to the current year presentation. These reclassifications had no effect on the results of operations or stockholders’ equity as previously reported.
In March 2006, the Office of Thrift Supervision (OTS) approved the charter of H&R Block Bank (HRB Bank). HRB Bank commenced operations on May 1, 2006 as a wholly-owned subsidiary, at which time we realigned certain segments of our business to reflect a new management reporting structure. The previously reported Investment Services segment and HRB Bank have been combined in the Consumer Financial Services segment.
On November 6, 2006, we announced we would evaluate strategic alternatives for Option One Mortgage Corporation (OOMC), a wholly-owned subsidiary, including a possible sale or other transaction through the public markets. On April 19, 2007, we entered into an agreement to sell OOMC. In conjunction with this plan, we also announced we would terminate the operations of H&R Block Mortgage Corporation (HRBMC), a wholly-owned subsidiary of OOMC. Additionally, during fiscal year 2007, we committed to a plan to sell and/or completed the wind-down of three smaller lines of business previously reported in our Business Services segment, as well as our tax operations in the United Kingdom previously reported in Tax Services. During fiscal year 2007, we met the criteria requiring us to present the related financial results of these businesses as discontinued operations and the assets and liabilities of all of the businesses being sold as held-for-sale in the consolidated financial statements. All periods presented have been reclassified to reflect our discontinued operations. For purposes of segment reporting, financial data for discontinued businesses is no longer reflected in the previously applicable reportable segment. See note 20 for additional information.
MANAGEMENT ESTIMATES - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.
CASH AND CASH EQUIVALENTS - Cash and cash equivalents include cash on hand, cash due from banks, securities purchased under agreements to resell and federal funds sold. For purposes of the consolidated balance sheets and consolidated statements of cash flows, all non-restricted highly liquid instruments purchased with an original maturity of three months or less are considered to be cash equivalents. Book overdrafts included in accounts payable totaled $101.1 million and $128.7 million at April 30, 2007 and 2006, respectively.
Our broker-dealer purchases securities under agreements to resell and accounts for them as collateralized financings. The securities are carried at the amounts at which the securities will be subsequently resold, as specified in the respective agreements. It is our policy to take possession of securities, subject to resale agreements. The securities are revalued daily and collateral added whenever necessary to bring market value of the underlying collateral to a level equal to or greater than the repurchase amount specified in the contracts.
CASH AND CASH EQUIVALENTS - RESTRICTED - Cash and cash equivalents - restricted consists primarily of cash and securities purchased under agreements to resell which has been segregated in a special reserve account for the exclusive benefit of customers pursuant to federal regulations under Rule 15c3-3 of the Securities Exchange Act of 1934.
MARKETABLE SECURITIES - TRADING - Certain marketable debt securities held by our broker-dealer are classified as trading and carried at market value based on quoted prices, with changes in market value recorded in the consolidated income statements. These securities are included in prepaid expenses and other current assets on the consolidated balance sheets.
RECEIVABLES FROM CUSTOMERS, BROKERS, DEALERS AND CLEARING ORGANIZATIONS AND ACCOUNTS PAYABLE TO CUSTOMERS, BROKERS AND DEALERS - Customer receivables and payables consist primarily of amounts due on margin and cash transactions. These receivables are collateralized by customers’ securities held, which are not reflected in the accompanying consolidated financial statements.
Receivables from brokers are collateralized by securities in our physical possession, or on deposit with us, or receivables from customers or other brokers. The allowance for doubtful accounts represents an amount considered by management to be adequate to cover estimated losses as of the balance sheet date.
Securities borrowed and securities loaned transactions are generally reported as collateralized financings. These transactions require deposits of cash and/or collateral with the lender. Securities loaned consist of securities owned by customers that were purchased on margin. When loaning securities, cash collateral approximately equal to the value of the securities loaned is received. The amount of cash collateral is adjusted, as required, for market fluctuations in the value of the securities loaned. Interest rates paid on the cash collateral fluctuate as short-term interest rates change.
RECEIVABLES - Receivables consist primarily of Business Services’ accounts receivable. The allowance for doubtful accounts requires management’s judgment regarding current market indicators concerning general economic trends to establish an amount considered by management to be adequate to cover estimated losses as of the balance sheet date.
MARKETABLE SECURITIES - AVAILABLE-FOR-SALE - Certain marketable securities we hold are classified as available-for-sale (AFS), and are reported at their fair value. Unrealized gains and losses are calculated using the specific identification method, and reported, net of applicable taxes, as a component of accumulated other comprehensive income. Realized gains and losses on the sale of these securities are determined using the specific identification method. These securities are included in other assets on the consolidated balance sheets.
We monitor our AFS investment portfolio for impairment and consider many factors in determining whether the impairment is deemed to be other-than-temporary. These factors include, but are not limited to, the length of time the security has had a market value less than the cost basis, the severity of the loss, our intent and ability to hold the security for a period of time sufficient for a recovery in value, recent events specific to the issuer or industry, external credit ratings and recent downgrades in such ratings.
For investments in mortgage-backed securities, amortization of premiums and accretion of discounts are recognized in interest income using the interest method, adjusted for anticipated prepayments where applicable. We update our estimates of expected cash flows periodically and recognize changes in calculated effective yield as appropriate.
Our investment in the stock of the Federal Home Loan Bank (FHLB) is carried at cost as they are restricted securities which are required to be maintained by HRB Bank for regulatory purposes and borrowing availability. The cost of the stock represents its redemption value as there is no ready market value.
MORTGAGE LOANS HELD FOR INVESTMENT - Mortgage loans held for investment represent loans originated or acquired with the ability and intent to hold for the foreseeable future or to maturity. Loans held for investment are carried at amortized cost adjusted for charge-offs, net allowance for loan losses, deferred fees or costs on originated loans and unamortized premiums or discounts on purchased loans. Loan fees and certain direct loan origination costs are deferred and the net fee or cost is recognized in interest income over the lives of the related loans. Unearned income, premiums and discounts on purchased loans are amortized or accreted into income over the estimated life of the loan using methods that approximate the interest method based on assumptions regarding the loan portfolio, including prepayments adjusted to reflect actual experience.
We classify loans as nonperforming when full and timely collection of interest or principal becomes uncertain or when they are 90 days past due. Interest previously accrued, but not collected, is reversed against current interest income when a loan is placed on nonaccrual status and is considered nonperforming. Accretion of deferred fees is discontinued for nonperforming loans. Payments received on nonperforming loans are recognized as interest income when the loan is considered collectible and applied to principal when it is doubtful that full payment will be collected. Loans are not placed back on accrual status until collection of principal and interest is reasonably assured as a result of the borrower bringing the loans into compliance with the contractual terms of the loan. Prior to restoring a loan to accrual status, management considers a borrower’s prospects for continuing future contractual payments.
We record an allowance representing our estimate of credit losses inherent in the loan portfolio at the balance sheet date. Loan recoveries and the provision for credit losses increase the allowance, while loan charge-offs decrease the allowance. A current assessment of value is made no later than 180 days past due, and any loan balance in excess of the value less costs to sell the property is charged off.
The majority of our estimated credit loss is evaluated for mortgage loans on a pooled basis. We stratify the loan portfolio based on our view of risk associated with various elements of the pool and assign estimated loss rates based on those risks. Loss rates are based on historical experience, our assessment of economic and market conditions and loss rates of comparable financial institutions. This evaluation is inherently subjective as it requires estimates susceptible to significant revisions as more information becomes available. We consider a loan to be impaired when management believes it is probable that we will be unable to collect all principal and interest due according to the contractual terms of the note. Generally, loans 90 days past due are considered impaired, at which time the individual loan will be reviewed and a reserve for loss will be recorded based on the fair value of the underlying collateral.
Real estate owned represents foreclosed assets held for sale and is initially recorded at the lower of cost or fair value less estimated disposal costs. Adjustments for estimated losses are charged to operations when any decline reduces the fair value to less than the carrying value. At April 30, 2007, real estate owned totaled $1.9 million.
Of the $1.4 billion in loans held for investment, $342.9 million of these were purchased from third-parties, with the remainder acquired by HRB Bank from OOMC and HRBMC.
PROPERTY AND EQUIPMENT - Buildings and equipment are initially recorded at cost and are depreciated over the estimated useful life of the assets using the straight-line method. Leasehold improvements are initially recorded at cost and are amortized over the lesser of the term of the respective lease or the estimated useful life, using the straight-line method. Estimated useful lives are 15 to 40 years for buildings, 3 to 5 years for computers and other equipment and up to 8 years for leasehold improvements.
We capitalize certain allowable costs associated with software developed or purchased for internal use. These costs are typically amortized over 36 months using the straight-line method.
We capitalized interest costs during construction of our new corporate headquarters facility for qualified expenditures based upon interest rates in place during the construction period. Capitalized interest costs will be amortized over lives which are consistent with the constructed assets.
Substantially all of the operations of our subsidiaries are conducted in leased premises. For all lease agreements, including those with escalating rent payments or rent holidays, we recognize rent expense on a straight-line basis.
INTANGIBLE ASSETS AND GOODWILL - We test goodwill and other indefinite life intangible assets for impairment annually or more frequently, whenever events occur or circumstances change which would, more likely than not, reduce the fair value of a reporting unit below its carrying value. We have defined our reporting units as our operating segments or one level below. The first step of the impairment test is to compare the estimated fair value of the reporting unit to its carrying value. If the carrying value is less than fair value, no impairment exists. If the carrying value is greater than fair value, a second step is performed to determine the fair value of goodwill and the amount of impairment loss, if any. These tests, conducted as of February 1, were completed and no indications of goodwill impairment in our continuing operations were found during fiscal year 2007, 2006 or 2005. In fiscal year 2007, we recorded $154.9 million in goodwill impairments related to the sale or wind-down of our discontinued operations.
In addition, long-lived assets, including intangible assets with finite lives, are assessed for impairment whenever events or circumstances indicate the carrying value may not be fully recoverable by comparing the carrying value to future undiscounted cash flows. To the extent there is impairment, an analysis is performed based on several criteria, including, but not limited to, revenue trends, discounted operating cash flows and other operating factors to determine the impairment amount. No material impairment adjustments to other intangible assets or other long-lived assets of continuing operations were made during the three-year period ended April 30, 2007. The weighted-average life of intangible assets with finite lives is nine years. Intangible assets are typically amortized over the estimated useful life of the assets using the straight-line method.
ASSETS OF DISCONTINUED OPERATIONS, HELD FOR SALE -
MORTGAGE LOANS HELD FOR SALE. Mortgage loans held for sale are either loans originated but not yet sold or loans repurchased from qualifying special purpose entities (Trusts) or investors and pending resale. Loans held for sale are carried at the lower of amortized cost or fair value. We determine the fair value of loans based primarily on estimated market prices considering underlying loan defects, if any. Our estimates may vary depending on the creditworthiness of the borrower and economic factors such as home price appreciation and interest rates. These loans are included in current assets held-for-sale on the consolidated balance sheets.
RESIDUAL INTERESTS IN SECURITIZATIONS. Certain residual interests in securitizations of mortgage loans are classified as trading based on management’s intentions, carried at fair value based on discounted cash flow models and changes in fair value recorded in the consolidated income statements. These securities are included in current assets held-for-sale on the consolidated balance sheets.
Residual interests classified as AFS securities are carried at fair value based on discounted cash flow models with unrealized gains included in other comprehensive income. The residual interests are accreted over the estimated life of the securitization structure. If the carrying value exceeds fair value, the residual is written down to fair value with the realized loss, net of any unrealized gain previously recorded in other comprehensive income, included in gains on sales of mortgage assets in the consolidated income statements. These securities are included in noncurrent assets held-for-sale on the consolidated balance sheets.
We estimate future cash flows from these residuals and value them using assumptions we believe to be consistent with those of unaffiliated third-party purchasers. We estimate the fair value of residuals by computing the present value of the excess of the weighted-average interest rate on the loans sold plus estimated collections of prepayment penalty fee income over the sum of (1) the coupon on the securitization bonds, (2) a contractual servicing fee paid to the servicer of the loans, which is usually OOMC, (3) expected losses to be incurred on the portfolio of the loans sold, as projected to occur, over the lives of the loans, (4) fees payable to the trustee and insurer, if applicable, and (5) payments made to investors on net interest margin (NIM) bonds, if applicable. The residual valuation takes into consideration the current and expected interest rate environment. Prepayment and loss assumptions used in estimating the cash flows are based on evaluation of the historical experience of the servicing portfolio, the characteristics of the applicable loan portfolio, as well as also taking into consideration the current and expected economic and interest rate environment and its expected impact. The estimated cash flows are discounted at an interest rate we believe an unaffiliated third-party purchaser would require as a rate of return on a financial instrument with a similar risk profile. We evaluate, and adjust if necessary, the fair values of residual interests quarterly by updating the actual performance and expected assumptions in the discounted cash flow models based on current information and events and by estimating, or validating with third-party experts, if necessary, what a market participant would use in determining the current fair value. To the extent that actual excess cash flows are different from estimated excess cash flows, the fair value of the residual would increase or decrease.
BENEFICIAL INTEREST IN TRUSTS - TRADING. The beneficial interest in Trusts is recorded as a result of daily non-prime loan sales to Trusts. We hold an interest in the Trusts equal to the difference between the fair value of the assets and the cash proceeds, adjusted for contractual advance rates, received from the Trusts. The beneficial interest is classified as a trading security, based on management’s intentions, is carried at fair value with changes in fair value recorded in the consolidated income statements. Fair value is calculated as the present value of estimated future cash flows, limited by the ultimate expected outcome from the disposition of the loans by the Trusts. These assets are included in noncurrent assets held-for-sale on the consolidated balance sheets.
MORTGAGE SERVICING RIGHTS. Mortgage servicing rights (MSRs) retained in the sale of mortgage loans are recorded at allocated carrying amounts based on relative fair values at the time of the sale. The MSRs are carried at the lower of cost or fair value. Fair values of MSRs are determined based on the present value of estimated future cash flows related to servicing loans. Assumptions used in estimating the value of MSRs include market discount rates and anticipated prepayment speeds including default, estimated ancillary fee income, estimated third-party servicing costs and other economic factors. The prepayment speeds are estimated using our historical experience and third-party market sources. The MSRs are amortized to earnings in proportion to, and over the period of, estimated net future servicing income. MSRs are reviewed quarterly for potential impairment. Impairment is assessed based on the fair value of each risk stratum. MSRs are stratified by the vintage year, which approximates date of origination, loan type, primarily 2- and 3-year adjustable and fixed rate, and loans with and without prepayment penalties. These securities are included in noncurrent assets held-for-sale on the consolidated balance sheets.
REPURCHASE RESERVES. Our repurchase reserves relate to potential losses that could be incurred related to the repurchase of sold loans or indemnification of losses as a result of early payment defaults or breaches of other representations and warranties customary to the mortgage banking industry.
Loans are repurchased due to a combination of factors, including delinquency and other violations of representations and warranties. In whole loan sale transactions, we guarantee the first payment to the purchaser. If this payment is not collected, it is referred to as an early payment default.
For early payment default-related losses, the amount of losses we expect to incur depends primarily on the frequency of early payment defaults, the rate at which defaulted loans subsequently become current on payments (“cure rate”), the propensity of the buyer of the loans to demand recourse under the loan sale agreement and the severity of loss incurred on loans which have been repurchased. The frequency of early payment defaults, cure rates and loss severity may vary depending on the creditworthiness of the borrower and economic factors such as home price appreciation and interest rates. To the extent actual
losses related to repurchase activity are different from our estimates, the fair value of our repurchase reserve will increase or decrease. See note 20 under “Commitments and Contingencies.”
REVENUE RECOGNITION. Gains on sales of mortgage assets are recognized when control of the assets is surrendered (when loans are sold to Trusts) and are based on the difference between cash proceeds and the allocated cost of the assets sold, including any guarantees or repurchase reserves. Other components of gain on sales of mortgage loans include gains or losses on derivatives, loan sale repurchase reserves, impairments and direct origination and acquisition expenses.
Interest income consists primarily of interest earned on mortgage loans and accretion income. Accretion income represents interest earned over the life of residual interests using the effective interest method.
Service revenues consist of mortgage loan servicing fees and are recorded in the period in which the service is performed.
DERIVATIVE ACTIVITIES. We use forward loan sale commitments, interest rate swaps and other financial instruments to manage our interest rate risk related to commitments to fund mortgage loans and mortgage loans underlying our beneficial interest in Trusts. We do not enter into derivative transactions for speculative or trading purposes.
We record derivative instruments as assets or liabilities, measured at fair value. None of our derivative instruments are designated for hedge accounting treatment as of April 30, 2007 or 2006. Gains or losses on derivative instruments are presented in our consolidated statements of income and statements of cash flows in a manner consistent with the earnings effect of the economically hedged item.
LITIGATION - Our policy is to routinely assess the likelihood of any adverse judgments or outcomes related to legal matters, as well as ranges of probable losses. A determination of the amount of the reserves required, if any, for these contingencies is made after thoughtful analysis of each known issue and an analysis of historical experience in accordance with Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies,” and related pronouncements. We record reserves related to certain legal matters for which it is probable that a loss will be incurred and the range of such loss can be estimated. With respect to other matters, management has concluded that a loss is only reasonably possible or remote or not estimable and, therefore, no liability is recorded. Management discloses the facts regarding material matters assessed as reasonably possible and potential exposure, if determinable. Costs incurred with defending claims are expensed as incurred. Any receivable for insurance recoveries is recorded separately from the corresponding litigation reserve, and only if recovery is determined to be probable.
INCOME TAXES - We account for income taxes under the asset and liability method, which requires us to record deferred income tax assets and liabilities for future tax consequences attributable to differences between the financial statement carrying value of existing assets and liabilities and their respective tax basis. Deferred taxes are determined separately for each tax-paying component, within each tax jurisdiction, based on provisions of enacted tax law. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Our deferred tax assets include state and foreign tax loss carryforwards and are reduced by a valuation allowance if, based on available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Our current deferred tax assets are included in prepaid expenses and other current assets on the consolidated balance sheets. Noncurrent deferred tax assets are included in other assets on our consolidated balance sheets.
We file a consolidated federal tax return on a calendar year basis, and state tax returns on a consolidated or combined basis as permitted by authorities.
REVENUE RECOGNITION - Service revenues consist primarily of fees for preparation and filing of tax returns, both in offices and through our online programs, fees associated with our Peace of Mind (POM) guarantee program, fees for consulting services and brokerage commissions. Generally, service revenues are recorded in the period in which the service is performed. Retail and online tax preparation revenues are recorded when a completed return is filed or accepted by the customer. POM revenues are deferred and recognized over the term of the guarantee based upon historical and actual payment of claims. Revenues for services rendered in connection with the Business Services segment include fees based on time and materials, which are recognized as the services are performed and amounts are earned. Broker-dealer production revenue is recognized on a trade-date basis.
Interest income consists primarily of interest earned on customer margin loan balances and mortgage loans held for investment. Interest income on customer margin loan balances is recognized daily as earned based on current rates charged to customers for their margin balance. Interest income on mortgage loans held for investment includes deferred origination fees and costs and purchase discounts and premiums, which are amortized to income over the life of the loan using the interest method.
Product and other revenues include royalties, refund anticipation loan (RAL) participation revenues and sales of software products. Franchise royalties, which are based upon the contractual percentages of franchise revenues, are recorded in the period in which the franchise provides the service. Loan participation revenue is recognized over the life of the loans. Software revenues consist mainly of tax preparation software and other personal productivity software. Sales of software are recognized when the product is sold to the end user.
Revenue recognition is evaluated separately for each unit in multiple-deliverable arrangements. Sales tax we collect and remit to taxing authorities is recorded net in our consolidated income statements.
ADVERTISING EXPENSE - Advertising costs are primarily expensed the first time the advertisement is run. Total advertising costs of continuing operations for fiscal years 2007, 2006 and 2005 totaled $215.2 million, $179.2 million and $150.6 million, respectively.
DEFINED CONTRIBUTION PLANS - We have 401(k) defined contribution plans covering all full-time employees following the completion of an eligibility period. Contributions of our continuing operations to these plans are discretionary and totaled $21.1 million, $18.3 million and $16.8 million for fiscal years 2007, 2006 and 2005, respectively.
FOREIGN CURRENCY TRANSLATION - Assets and liabilities of foreign subsidiaries are translated into U.S. dollars at exchange rates prevailing at the end of the year. Translation adjustments are recorded as a separate component of other comprehensive income in stockholders’ equity. Revenue and expense transactions are translated at the average of exchange rates in effect during the period.
COMPREHENSIVE INCOME - Our comprehensive income is comprised of net income, foreign currency translation adjustments and the change in net unrealized gains or losses on AFS marketable securities. Included in stockholders’ equity at April 30, 2007 and 2006, the net unrealized holding gain on AFS securities was $1.3 million and $27.4 million, respectively, and the foreign currency translation adjustment was $(2.6) million and $(5.5) million, respectively. The net unrealized holding gain on AFS securities relates primarily to AFS residual interests in securitizations.
DISCLOSURE REGARDING CERTAIN FINANCIAL INSTRUMENTS - The carrying values reported in the balance sheet for cash equivalents, receivables, demand deposits, accounts payable, accrued liabilities and the current portion of long-term debt approximate fair market value due to the relative short-term nature of the respective instruments. Residual interests and beneficial interests in Trusts are recorded at estimated fair value as discussed above. See note 5 for fair value of mortgage loans held for investment, note 9 for the fair value of time deposits and note 10 for fair value of long-term debt.
NEW ACCOUNTING STANDARDS - In February 2007, Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of FASB Statement No. 115,” (SFAS 159), was issued. This standard allows a company to irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and financial liabilities on a contract-by-contract basis, with changes in fair value recognized in earnings. The provisions of this standard are effective as of the beginning of our fiscal year 2009, with early adoption permitted. We are currently evaluating what effect the adoption of SFAS 159 will have on our consolidated financial statements.
In September 2006, Statement of Financial Accounting Standards No. 157, “Fair Value Instruments,” (SFAS 157), was issued. The provisions of this standard include guidelines about the extent to which companies measure assets and liabilities at fair value, the effect of fair value measurements on earnings, and establishes a fair value hierarchy that prioritizes the information used in developing assumptions used when valuing an asset or liability. The provisions of this standard are effective as of the beginning of our fiscal year 2009. We are currently evaluating what effect the adoption of SFAS 157 will have on our consolidated financial statements.
In September 2006, Staff Accounting Bulleting No. 108, “Financial Statements - Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (SAB 108), was issued. SAB 108 provides guidance on how prior year misstatements should be quantified when determining if current year financial statements are materially misstated. These provisions are effective for the current fiscal year. The adoption of SAB 108 did not impact our consolidated financial statements.
In September 2006, Emerging Issues Task Force Issue No. 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements” (EITF 06-4) was issued. EITF 06-4 requires the recognition of a liability for an agreement with an employee to provide future postretirement benefits, as this obligation is not effectively settled upon entering into an insurance arrangement. The provisions of this standard are effective as of the beginning of our fiscal year 2009. We are currently evaluating what effect the adoption of EITF 06-4 will have on our consolidated financial statements.
In June 2006, FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48), was issued. The
interpretation requires that a tax position meet a “more-likely-than-not” recognition threshold for the benefit of the uncertain tax position to be recognized in the financial statements and provides guidance on the measurement of the benefit. The interpretation also requires interim period estimated tax benefits of uncertain tax positions to be accounted for in the period of change rather than as a component of the annual effective tax rate. The provisions of this standard are effective as of the beginning of our fiscal year 2008. The adoption of FIN 48 will not have a material impact on our consolidated financial statements.
In June 2006, Emerging Issues Task Force Issue No. 06-3, “How Sales Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross Versus Net Presentation)” (EITF 06-3) was issued. EITF 06-3 requires disclosure of the presentation of taxes on either a gross (included in revenues and costs) or a net (excluded from revenues) basis as an accounting policy decision. The provisions of this standard are effective for interim and annual reporting periods beginning after December 15, 2006. The adoption of EITF 06-3 did not have a material impact on our consolidated financial statements.
In March 2006, Statement of Financial Accounting Standards No. 156, “Accounting for Servicing of Financial Assets - An Amendment of FASB Statement No. 140,” (SFAS 156), was issued. The provisions of this standard require mortgage servicing rights to be initially valued at fair value. SFAS 156 allows servicers to choose to subsequently measure their servicing rights at fair value or to continue using the “amortization method” under SFAS 140. The provisions of this standard are effective as of the beginning of our fiscal year 2008. The adoption of SFAS 156 will not have a material impact on our consolidated financial statements. We will adopt SFAS 156 on May 1, 2007. Upon adoption we identified MSRs relating to all existing residential mortgage loans as a class of servicing rights and elected to continue to use the “amortization method” for these MSRs. Presently, this class represents all of our MSRs.
In February 2006, Statement of Financial Accounting Standards No. 155, “Accounting for Certain Hybrid Instruments - An Amendment of FASB Statements No. 133 and 140” (SFAS 155), was issued. The provisions of this standard establish a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation. The standard permits a hybrid financial instrument to be accounted for in its entirety if the holder irrevocably elects to measure the hybrid financial instrument at fair value, with changes in fair value recognized currently in earnings. The provisions of this standard are effective as of the beginning of our fiscal year 2008. Our residual interests typically have interests in derivative instruments embedded within the securitization trusts. Upon adoption, we will elect to account for our residual interests on a fair value basis, with changes in fair value recorded in earnings in the period in which the change occurs. Prior to adoption, we accounted for our residual interests as AFS securities with unrealized gains recorded in other comprehensive income.
In December 2004, Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” (SFAS 123R) was issued. SFAS 123R requires all entities to recognize the cost of employee services received in exchange for awards of equity instruments based on the grant-date fair value of those awards. Compensation expense must be recognized for the unvested portions of all awards outstanding as of the date of adoption. We adopted SFAS 123R on May 1, 2006 and it did not have a material impact on our consolidated financial statements. See note 13 for additional information on our stock-based compensation arrangements. Had compensation cost for all stock-based compensation plan awards been determined in accordance with the fair value accounting method prescribed under SFAS 123, our net income and earnings per share would have been as follows:
The estimated impact of new accounting standards not yet adopted reflects current views. There may be material differences between these estimates and the actual impact of these standards.
NOTE 2: BUSINESS COMBINATIONS
Acquisitions during fiscal years 2007, 2006 and 2005 are as follows. Results for each acquisition are included since the date of acquisition.
During fiscal year 2007 we acquired TaxWorks LLC, a provider of commercial tax preparation software targeting the independent tax preparer market. The initial cash purchase price was $24.8 million, including the present value of a payment of $10.0 million due in May 2007 and a payment of $23.6 million due in May 2012. The $10.0 million payment due in May 2007 was paid on April 30, 2007. An additional payment of up to $8.0 million, contingent on meeting certain performance targets, could be paid in April 2012 and would typically be recorded as additional purchase price, generally goodwill. Goodwill recognized in this transaction is included in the Tax Services segment and is deductible for tax purposes.
During fiscal year 2006, we acquired all outstanding common stock of American Express Tax and Business Services, Inc. (AmexTBS) for an aggregate purchase price of $190.7 million. The customer relationships and noncompete agreements are amortized on a straight-line basis and have a weighted average life of 11 years and six years, respectively. Goodwill recognized in this transaction is included in the
Business Services segment and is not deductible for tax purposes. The purchase price was subject to certain contractual post-closing adjustments, which were finalized during fiscal year 2007. As a result, we adjusted deferred tax balances initially recorded in connection with this acquisition resulting in an increase of $16.6 million to goodwill and received cash of $10.1 million, which was recorded as a reduction of goodwill.
During fiscal year 2005, our Business Services segment acquired six businesses. Cash payments related to these acquisitions totaled $19.5 million, with additional cash payments of $0.1 million over the next five years. Goodwill recognized in these transactions is included in the Business Services segment and all but $3.8 million is deductible for tax purposes.
During fiscal years 2007, 2006 and 2005, we made other acquisitions which were accounted for as purchases with cash payments totaling $32.8 million, $19.7 million and $14.4 million, respectively. Their operations, which are not material, are included in the consolidated income statements since the date of acquisition. During fiscal years 2007, 2006 and 2005, we also paid $5.4 million, $2.1 million and $3.4 million, respectively, for contingent payments on prior acquisitions.
NOTE 3: EARNINGS PER SHARE
Basic earnings per share is computed using the weighted-average number of common shares outstanding. The dilutive effect of potential common shares outstanding is included in diluted earnings per share. The computations of basic and diluted earnings per share from continuing operations are as follows:
Diluted earnings per share excludes the impact of nonvested common shares or the exercise of options to purchase 16.8 million, 8.7 million, and 1.2 million shares of stock for 2007, 2006 and 2005, respectively.
NOTE 4: MARKETABLE SECURITIES AVAILABLE-FOR-SALE
The amortized cost and fair value of securities classified as available-for-sale held in our continuing operations at April 30, 2007 and 2006 are summarized below:
Proceeds from the sales of AFS securities of continuing operations were $3.5 million, $11.2 million and $9.8 million during fiscal years 2007, 2006 and 2005, respectively. Gross realized gains on those sales during fiscal years 2007, 2006 and 2005 were $0.3 million, $0.7 million and $0.5 million, respectively; gross realized losses were $0.1 million, $0.2 million and $0.3 million, respectively.
Contractual maturities of AFS debt securities at April 30, 2007 occur at varying dates over the next three to eight years. Because expected maturities differ from contractual maturities due to the issuers’ rights to prepay certain obligations or the seller’s rights to call certain obligations, the first call date, put date or auction date for municipal bonds and notes is considered the contractual maturity date.
HRB Bank is required to maintain a restricted investment in FHLB stock for regulatory purposes and borrowing availability. The cost of this investment, $9.1 million, represents its redemption value, as these investments do not have a ready market.
NOTE 5: MORTGAGE LOANS HELD FOR INVESTMENT
The characteristics of our mortgage loan portfolio as of April 30, 2007 are as follows:
The estimated fair value of mortgage loans held for investment at April 30, 2007 was $1.4 billion. The estimated fair value was calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the interest rate risk inherent in the loans, reduced by an allocation of the allowance for loan losses.
As of April 30, 2007, accrued interest receivable on mortgage loans held for investment totaled $9.0 million. At April 30, 2007, HRB Bank had interest-only mortgage loans in its investment portfolio totaling $8.2 million. HRB Bank had no commitments to purchase mortgage loans from third-party lenders at April 30, 2007.
Activity in the allowance for loan losses for the year ended April 30, 2007 is as follows:
Impaired loans at April 30, 2007 totaled $28.3 million. The portion of our total allowance for loan losses allocated to impaired loans totaled $0.2 million at April 30, 2007.
As of April 30, 2007, loans considered more than 90 days past due and non-accrual totaled $22.9 million. We had no loans more than 90 days past due still accruing interest.
NOTE 6: PROPERTY AND EQUIPMENT
The components of property and equipment of our continuing operations are as follows:
Depreciation and amortization expense of continuing operations for fiscal years 2007, 2006 and 2005 was $93.7 million, $85.8 million and $89.2 million, respectively. Included in depreciation and amortization expense of continuing operations is amortization of capitalized software of $16.9 million, $11.9 million and $10.8 million, respectively.
As of April 30, 2007 and 2006, we have property and equipment under capital lease with a cost of $39.2 million and $22.1 million, respectively, and accumulated depreciation of $8.9 million and $4.9 million, respectively. During fiscal year 2006, we entered into an agreement to lease furniture, fixtures and equipment in conjunction with the purchase of Industrial Revenue Bonds from the City of Kansas City, Missouri as
discussed further in note 18. Assets under this capital lease at April 30, 2007 totaled $22.3 million. We also have a separate agreement to lease real estate and buildings under a noncancelable capital lease for the next 14 years with an option to purchase after two years. Total assets under this capital lease at April 30, 2007 totaled $16.8 million.
During fiscal years 2007 and 2006, we capitalized interest costs of $3.6 million and $4.7 million, respectively, relating to the construction of our new corporate headquarters.
NOTE 7: GOODWILL AND INTANGIBLE ASSETS
Changes in the carrying amount of goodwill of continuing operations by segment for the year ended April 30, 2007, are as follows:
Goodwill and other indefinite life intangible assets were tested for impairment in the fourth quarter of fiscal year 2007. No impairment existed at any of our reporting units in continuing operations during fiscal year 2007, 2006 or 2005. In fiscal year 2007, we recorded $154.9 million in goodwill impairments related to the sale or wind-down of our discontinued operations.
The purchase price for our acquisition of AmexTBS was subject to certain contractual post-closing adjustments, which were finalized during fiscal year 2007. As a result, we adjusted deferred tax balances initially recorded in connection with this acquisition resulting in an increase of $16.6 million to goodwill, and received cash of $10.1 million, which was recorded as a reduction of goodwill. All amounts relating to AmexTBS were recorded in our Business Services segment
The components of intangible assets of continuing operations are as follows:
Amortization of intangible assets of continuing operations for the years ended April 30, 2007, 2006 and 2005 was $56.6 million, $62.5 million and $60.8 million, respectively. Estimated amortization of intangible assets for fiscal years 2008, 2009, 2010, 2011 and 2012 is $40.0 million, $16.7 million, $14.1 million, $12.6 million and $9.8 million, respectively.
NOTE 8: COMMERCIAL PAPER AND OTHER SHORT-TERM BORROWINGS
Short-term borrowings are used to finance temporary liquidity needs and various financial activities. The components of short-term borrowings as of April 30, 2007 are as follows:
At April 30, 2007, we maintained $2.0 billion in back-up credit facilities to support the commercial paper program and for general corporate purposes. These unsecured committed lines of credit (CLOCs) have a maturity date of August 2010 and an annual facility fee of eight and one-half basis points per annum. These lines are subject to various affirmative and negative covenants, including (1) a minimum net worth covenant and limits on our indebtedness and (2) a requirement that we reduce the aggregate outstanding principal amount of short-term debt, as defined in the agreement, to $200.0 million or less for a minimum period of thirty consecutive days during the period from March 1 to June 30 of each year (the “Cleandown Requirement”). We obtained a waiver of the Cleandown Requirement for 2007. There was no balance outstanding on these lines at April 30, 2007.
We entered into a $3.0 billion line of credit agreement with HSBC Finance Corporation effective January 2, 2007 through the earlier of June 30, 2007 or the date of repayment, for use as a funding source for the purchase of RAL participations. This line was subject to various covenants that were similar to our primary unsecured CLOCs, and was secured by our RAL participations. All borrowings on this facility were repaid as of April 30, 2007 and the facility is now closed.
We entered into a $300.0 million committed line of credit agreement with BNP Paribas for the period January 2 through February 23, 2007 to cover our peak liquidity needs. This line was subject to various covenants that were similar to those of our primary unsecured CLOCs. This facility expired in February 2007.
We maintain a revolving credit facility in an amount not to exceed $225.0 million (Canadian) in Canada to support a commercial paper program with varying borrowing levels throughout the year, reaching its peak during February and March for the Canadian tax season. There was no balance outstanding on this facility at April 30, 2007.
In April 2007, we obtained a $500.0 million credit facility to provide funding for the $500.0 million of 81/2% Senior Notes which were due April 16, 2007. This facility matures on December 20, 2007. The facility was fully drawn at closing and is subject to various covenants that are similar to our primary CLOCs.
NOTE 9: CUSTOMER BANKING DEPOSITS
The components of customer banking deposits at April 30, 2007 are as follows:
Accrued but unpaid interest on deposits totaled $1.8 million at April 30, 2007.
Time deposit accounts in amounts of $100,000 or more with a remaining maturity of more than one year, totaled $0.1 million at April 30, 2007.
The fair value of IRAs and other time deposits was $75.0 million at April 30, 2007. The fair value of other time deposits is calculated based on the discounted value of contractual cash flows.
NOTE 10: LONG-TERM DEBT
The components of long-term debt and capital lease obligations of our continuing operations are as follows:
On October 26, 2004, we issued $400.0 million of 5.125% Senior Notes under a shelf registration statement. The Senior Notes are due October 30, 2014, and are not redeemable by the bondholders prior to maturity. The net proceeds of this transaction were used to repay $250.0 million in 63/4% Senior Notes that were due in November 2004. The remaining proceeds were used for working capital, capital expenditures, repayment of other debt and other general corporate purposes.
On April 13, 2000, we issued $500.0 million of 81/2% Senior Notes under a shelf registration statement. In fiscal year 2007 these notes became due and were replaced with a $500.0 million credit facility. See discussion of short-term borrowings in note 8.
As of April 30, 2007, we had $850.0 million remaining under our shelf registration for additional debt issuances.
HRB Bank is a member of the FHLB of Des Moines, which extends credit to member banks based on eligible collateral, which consists primarily of mortgage loans held for investment and certain AFS securities. On April 13, 2007, we borrowed $104.0 million from the FHLB for liquidity purposes. This borrowing requires monthly interest payments at a rate of 4.99% and matures April 13, 2009. At April 30, 2007, HRB Bank had FHLB advance capacity of $525.5 million based on eligible pledged collateral of $1.5 billion, and there was a balance of $179.0 million outstanding on this facility. Of the outstanding borrowings, $75.0 million was considered short-term. See discussion of short-term borrowings in note 8.
We have obligations related to various Business Services acquisitions of $13.6 million and $13.2 million at April 30, 2007 and 2006, respectively, which are due from May 2007 to October 2010.
We have a capitalized lease obligation of $12.9 million at April 30, 2007 that is collateralized by land and buildings. The obligation is due in 14 years.
The aggregate payments required to retire long-term debt are $9.3 million, $106.1 million, $3.1 million, $1.3 million, $0.6 million and $408.7 million in 2008, 2009, 2010, 2011, 2012 and beyond, respectively.
Based upon borrowing rates currently available for indebtedness with similar terms, the fair value of long-term debt was approximately $505.8 million at April 30, 2007.
NOTE 11: OTHER NONCURRENT ASSETS AND LIABILITIES
We have deferred compensation plans that permit directors and certain employees to defer portions of their compensation and accrue income on the deferred amounts. Their deferred compensation and our matching amounts have been accrued. Included in other noncurrent liabilities is $186.3 million and $153.2 million at April 30, 2007 and 2006, respectively, reflecting our obligation under these plans. We may purchase whole-life insurance contracts on certain director and employee participants to recover distributions made or to be made under the plans. The cash surrender value of the policies is recorded in other noncurrent assets and totaled $139.6 million and $127.4 million at April 30, 2007 and 2006, respectively.
In connection with our acquisition of the non-attest assets of McGladrey & Pullen, LLP (M&P) in August 1999, we assumed certain retirement liabilities related to M&P’s partners. We make payments in varying amounts on a monthly basis. Included in other noncurrent liabilities at April 30, 2007 and 2006 is $12.9 million and $14.3 million, respectively, related to this liability.
NOTE 12: STOCKHOLDERS’ EQUITY
We are authorized to issue 6.0 million shares of Preferred Stock, without par value. At April 30, 2007, we had 5.6 million shares of authorized but unissued Preferred Stock. Of the unissued shares, 0.6 million shares have been designated as Participating Preferred Stock in connection with our shareholder rights plan.
On March 8, 1995, our Board of Directors authorized the issuance of a series of 0.5 million shares of nonvoting Preferred Stock designated as Convertible Preferred Stock, without par value. At April 30, 2007, we had 0.5 million shares of authorized but unissued Convertible Preferred Stock. The holders of the Convertible Preferred Stock are not entitled to receive dividends
paid in cash, property or securities and, in the event of any dissolution, liquidation or wind-up of the Company, will share ratably with the holders of Common Stock then outstanding in the assets of the Company after any distribution or payments are made to the holders of Participating Preferred Stock or the holders of any other class or series of stock of the Company with preference over the Common Stock.
NOTE 13: STOCK-BASED COMPENSATION
Beginning May 1, 2006, we adopted SFAS 123R under the modified prospective approach. Under SFAS 123R, we continue to measure and recognize the fair value of stock-based compensation consistent with our past practice under Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” which we adopted on May 1, 2003 under the prospective transition method. The adoption of SFAS 123R did not have a material impact on our consolidated financial statements.
Stock-based compensation expense of $50.5 million, $57.0 million, and $44.1 million was recorded in fiscal years 2007, 2006 and 2005, respectively. The related tax benefits of $17.9 million, $19.8 million and $15.3 million are included in our results for fiscal years 2007, 2006 and 2005, respectively. Stock-based compensation expense of our continuing operations totaled $41.3 million, $47.2 million, and $36.9 million in fiscal years 2007, 2006 and 2005, respectively.
SFAS 123R requires excess tax benefits from stock-based compensation to be included as a financing activity in the statements of cash flows. As a result, we classified $3.2 million as a cash inflow from financing activities rather than as an operating activity for fiscal year 2007.
We have four stock-based compensation plans which have been approved by our shareholders. As of April 30, 2007, we had 25.8 million shares reserved for future awards under these plans. We issue shares from our treasury stock to satisfy the exercise or release of stock-based awards. We believe we have adequate treasury stock to issue for the exercise or release of stock-based awards.
Our 2003 Long-Term Executive Compensation Plan provides for awards of options (both incentive and nonqualified), nonvested shares, performance nonvested share units and other stock-based awards to employees. These awards entitle the holder to shares or the right to purchase shares of common stock as the award vests, typically over a three-year period with one-third vesting each year. Nonvested shares receive dividends during the vesting period and performance nonvested share units receive cumulative dividends at the end of the vesting period. We measure the fair value of options on the grant date or modification date using the Black-Scholes option valuation model. We measure the fair value of nonvested shares and performance nonvested share units based on the closing price of our common stock on the grant date. Generally, we expense the grant-date fair value, net of estimated forfeitures, over the vesting period on a straight-line basis. Upon adoption of SFAS 123R, awards granted to employees who are of retirement age, or reach retirement age at least one year after the grant date but prior to the end of the service period of the award, are expensed over the shorter of the two periods. Options are granted at a price equal to the fair market value of our common stock on the grant date and have a contractual term of ten years.
Our 1999 Stock Option Plan for Seasonal Employees provides for awards of nonqualified options to certain employees. These awards are granted to seasonal employees in our Tax Services segment and entitle the holder to the right to purchase shares of common stock as the award vests, typically over a two-year period. We measure the fair value of options on the grant date using the Black-Scholes option valuation model. We expense the grant-date fair value, net of estimated forfeitures, over the service period. Options are granted at a price equal to the fair market value of our common stock on the grant date, are exercisable during September through November in each of the two years following the calendar year of the grant and have a contractual term of 29 months.
Our 1989 Stock Option Plan for Outside Directors provides for awards of nonqualified options to outside directors. These awards entitle the holder to the right to purchase shares of common stock. We measure the fair value of options on the grant date using the Black-Scholes option valuation model. These awards vest immediately upon issuance and are therefore fully expensed on the grant date. Options are granted at a price equal to the fair market value of our common stock on the grant date and have a contractual term of ten years.
Our 2000 Employee Stock Purchase Plan (ESPP) provides employees the option to purchase shares of our Common Stock through payroll deductions. The purchase price of the stock is 90% of the lower of either the fair market value of our Common Stock on the first trading day within the Option Period or on the last trading day of the Option Period. The Option Periods are six-month periods beginning on January 1 and July 1 each year. We measure the fair value of options on the grant date utilizing the Black-Scholes option valuation model in accordance with FASB Technical Bulletin 97-1, “Accounting
under Statement 123 for Certain Employee Stock Purchase Plans with a Look-Back Option.” The fair value of the option includes the value of the 10% discount and the look-back feature. We expense the grant-date fair value over the six-month vesting period.
A summary of options for the year ended April 30, 2007 is as follows:
The total intrinsic value of options exercised during fiscal years 2007, 2006 and 2005 was $11.8 million, $43.2 million and $39.1 million, respectively. As of April 30, 2007, we had $15.2 million of total unrecognized compensation cost related to these options. The cost is expected to be recognized over a weighted-average period of one year.
We utilize the Black-Scholes option pricing model to value our options on the grant date. We estimate the expected volatility using our historical stock price data. We also use historical exercise and forfeiture behaviors to estimate the options expected term and our forfeiture rate. The dividend yield is calculated based on the current dividend and the market price of our common stock on the grant date. The risk-free interest rate is based on the U.S. Treasury zero-coupon yield curve in effect on the grant date. Both expected volatility and the risk-free interest rate are based on a period that approximates the expected term.
The following assumptions were used to value options during the periods:
A summary of nonvested shares and performance nonvested share units for the year ended April 30, 2007 is as follows:
The total fair value of shares vesting during fiscal years 2007, 2006 and 2005 was $24.9 million, $17.5 million and $8.2 million, respectively. Upon the grant of nonvested shares and performance nonvested share units, unearned compensation cost is recorded as an offset to additional paid in capital and is amortized as compensation expense over the vesting period. As of April 30, 2007, we had $40.3 million of total unrecognized compensation cost related to these shares. This cost is expected to be recognized over a weighted-average period of two years.
NOTE 14: SHAREHOLDER RIGHTS PLAN
On July 25, 1998, the rights under a shareholder rights plan, adopted by our Board of Directors on March 25, 1998, became effective. The 1998 plan was adopted to deter coercive or unfair takeover tactics and to prevent a potential acquirer from gaining control of the Company without offering a fair price to all of our stockholders. Under the 1998 plan, a dividend of one right (a “Right”) per share was declared and paid on each share of our Common Stock outstanding on July 25, 1998. Rights automatically attach to shares issued after such date.
Under the 1998 plan, a Right becomes exercisable when a person or group of persons acquires beneficial ownership of 15% or more of the outstanding shares of our Common Stock without the prior written approval of our Board of Directors (an “Unapproved Stock Acquisition”), and at the close of business on the tenth business day following the commencement of, or the public announcement of an intent to commence, a tender offer that would result in an Unapproved Stock Acquisition. We may, prior to any Unapproved Stock Acquisition, amend the plan to lower such 15% threshold to not less than the greater of (1) any percentage greater than the largest percentage of beneficial ownership by any person or group of persons then known by the Company, and (2) 10% (in which case the acquisition of such lower percentage of beneficial ownership then constitutes an Unapproved Stock Acquisition and the Rights become exercisable). When exercisable, the registered holder of each Right may purchase from the Company one four-hundredth of a share of a class of our Participating Preferred Stock, without par value, at a price of $53.75, subject to adjustment. The registered holder of each Right then also has the right (the “Subscription Right”) to purchase for the exercise price of the Right, in lieu of shares of Participating Preferred Stock, a number of shares of our Common Stock having a market value equal to twice the exercise price of the Right. Following an Unapproved Stock Acquisition, if we are involved in a merger, or 50% or more of our assets or earning power are sold, the registered holder of each Right has the right (the “Merger Right”) to purchase for the exercise price of the Right a number of shares of the common stock of the surviving or purchasing company having a market value equal to twice the exercise price of the Right.
After an Unapproved Stock Acquisition, but before any person or group of persons acquires 50% or more of the outstanding shares of our Common Stock, the Board of Directors may exchange all or part of the then outstanding and exercisable Rights for Common Stock at an exchange ratio of one share of Common Stock per Right (the “Exchange”). Upon any such Exchange, the right of any holder to exercise a Right terminates. Upon the occurrence of any of the events giving rise to the exercisability of the Subscription Right or the Merger Right or the ability of the Board of Directors to effect the Exchange, the Rights held by the acquiring person or group under the new plan will become void as they relate to the Subscription Right, the Merger Right or the Exchange.
We may redeem the Rights at a price of $0.0003125 per Right at any time prior to the earlier of (1) an Unapproved Stock Acquisition, or (2) the expiration of the rights. The Rights under the plan will expire on March 25, 2008, unless extended by the Board of Directors. Until a Right is exercised, the holder thereof, as such, will have no rights as a stockholder of the Company, including the right to vote or to receive dividends. The issuance of the Rights alone has no dilutive effect and does not affect reported earnings per share.
NOTE 15: INCOME TAXES
The components of income from continuing operations upon which domestic and foreign income taxes have been provided are as follows:
The components of income tax expense (benefit) on income from continuing operations are as follows:
The following table reconciles our federal statutory rate of 35% to our effective tax rate:
Deferred income taxes reflect the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. The components of deferred taxes of continuing operations are as follows:
The net change in the total valuation allowance for fiscal years 2007 and 2006 was $11.6 million and $5.5 million, respectively. The valuation allowance for deferred tax assets as of April 30, 2007 was $37.3 million.
We believe the net deferred tax asset at April 30, 2007 of $208.0 million is, more likely than not, realizable. We have federal taxable income in excess of approximately $1.6 billion in the aggregate for tax years 2005 and 2006, and substantial state taxable income in the carry-back period.
As of April 30, 2007, we had net operating loss (NOLs) carryforwards for tax purposes in various states and foreign countries of approximately $582.6 million. We recorded deferred tax assets of $24.5 million related to these NOLs and a related valuation allowance of $21.2 million. If not used, these carryforwards will expire in varying amounts during fiscal years 2008 through 2026.
We intend to indefinitely reinvest foreign earnings, therefore, a provision has not been made for income taxes that might be payable upon remittance of such earnings. Moreover, due to the availability of foreign income tax credits, management believes the amount of federal income taxes would be immaterial in the event foreign earnings were repatriated.
The loss from discontinued operations for fiscal year 2007 of $808.0 million is net of tax benefits of $425.0 million, and includes income tax benefits related to OOMC totaling $374.6 million. Income taxes for discontinued operations also included one-time benefits of $16.2 million related to permanent deductions for the tax basis of investments in two subsidiaries that were abandoned during the year. Assets of discontinued operations held for sale includes deferred tax assets of $393.6 million, net of the related valuation allowance, and deferred tax liabilities of $94.0 million as of April 30, 2007. In addition, we recorded a valuation allowance of $55.8 million, which primarily relates to deferred tax assets for capital losses and basis differences in certain state jurisdictions. Deferred tax assets of $183.2 million relate to certain residual assets. Although the tax position associated with these deferred tax assets is more likely than not of being sustained, there is a level of uncertainty associated with the amount of benefit. We believe the net deferred tax asset at April 30, 2007 is, more likely than not, realizable.
NOTE 16: INTEREST INCOME AND OPERATING INTEREST EXPENSE
The following table shows the components of interest income and operating interest expense of our continuing operations. Operating interest expense is included in cost of other revenues on our consolidated income statements.
NOTE 17: REGULATORY REQUIREMENTS
REGISTERED BROKER-DEALER - H&R Block Financial Advisors, Inc. (HRBFA) is subject to regulatory requirements intended to ensure the general financial soundness and liquidity of broker-dealers. At April 30, 2007, HRBFA’s net capital of $122.0 million, which was 27.8% of aggregate debit items, exceeded its minimum required net capital of $8.8 million by $113.2 million.
Pledged securities at April 30, 2007 totaled $47.0 million, an excess of $11.5 million over the margin requirement. Pledged securities at April 30, 2006 totaled $53.0 million, an excess of $9.9 million over the margin requirement.
BANKING - HRB Bank and the Company are subject to various regulatory capital guidelines and requirements administered by federal banking agencies. Failure to meet minimum capital requirements can trigger certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on HRB Bank and the consolidated financial statements. All savings associations are subject to the capital adequacy guidelines and the regulatory framework for prompt corrective action. HRB Bank must meet specific capital guidelines that involve quantitative measures of HRB Bank’s assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. HRB Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. HRB Bank files its regulatory Thrift Financial Report (TFR) on a calendar quarter basis.
Quantitative measures established by regulation to ensure capital adequacy require HRB Bank to maintain minimum
amounts and ratios of tangible equity, total risk-based capital and Tier 1 capital, as set forth in the table below. In addition to these minimum ratio requirements, HRB Bank is required to continually maintain a 12.0% minimum leverage ratio as a condition of its charter-approval order through fiscal year 2009. This condition was extended through fiscal year 2012 as a result of a Supervisory Directive issued on May 29, 2007. See further discussion of the Supervisory Directive below. As of April 30, 2007, our fiscal year end, HRB Bank’s leverage ratio was 11.6%. We have discussed this with the OTS and the OTS has indicated that we are not in violation of our minimum leverage ratio, as the requirement is as of calendar quarterly TFR filings. We will monitor regulatory compliance with this ratio monthly and discuss with the OTS in the event the minimum is not maintained.
As of March 31, 2007, our most recent TFR filing with the OTS, HRB Bank was a “well capitalized” institution under the prompt corrective action provisions of the Federal Deposit Insurance Corporation (FDIC). The five capital categories are: (1) “well capitalized” (total risk-based capital ratio of 10%, Tier 1 Risk-based capital ratio of 6% and leverage ratio of 5%); (2) “adequately capitalized”; (3) “undercapitalized”; (4) “significantly undercapitalized”; and (5) “critically undercapitalized.” There are no conditions or events since March 31, 2007 that management believes have changed HRB Bank’s category.
The following table sets forth HRB Bank’s regulatory capital requirements at March 31, 2007, as calculated in the most recently filed TFR:
(1)
Total risk-based capital divided by risk-weighted assets.
(2)
Tier 1 (core) capital less deduction for low-level recourse and residual interest divided by risk-weighted assets.
(3)
Tier 1 (core) capital divided by adjusted total assets.
(4)
Tangible capital divided by tangible assets.
In conjunction with H&R Block, Inc.’s application with the OTS for HRB Bank, we made commitments as part of our charter approval order (Master Commitment) which included, but were not limited to: (1) a three percent minimum ratio of adjusted tangible capital to adjusted total assets, as defined by the OTS; (2) maintain all HRB Bank capital within HRB Bank in accordance with the submitted three-year business plan; and (3) follow federal regulations surrounding intercompany transactions and approvals. We fell below the three percent minimum ratio at April 30, 2007. Normal seasonal operating losses are also expected to cause us to be in non-compliance until the end of fiscal year 2008. We notified the OTS of our failure to meet this requirement, and of our expectations for fiscal year 2008. We submitted a preliminary revised capital plan to the OTS that provides for us to regain compliance with the three percent minimum capital requirement by April 30, 2008. The preliminary revised capital plan contemplates that we will meet the minimum capital requirement primarily through earnings generated by our normal business operations in fiscal year 2008. On May 29, 2007, the OTS issued a Supervisory Directive, in which the OTS granted approval of our preliminary revised capital plan. Included in the Supervisory Directive were additional conditions that we will be required to meet in addition to the Master Commitment. The significant additional conditions included in the Supervisory Directive are as follows: (1) requires HRB Bank to extend its compliance with a minimum 12.0% leverage ratio through fiscal year 2012; (2) requires H&R Block, Inc. to comply with the Master Commitment at all times, except as provided herein, and at no time may we have capital lower than projected in the preliminary revised capital plan for the period May 2007 through April 2009; (3) institutes reporting requirements to the OTS quarterly and monthly by the Board of Directors and management, respectively; and (4) requires HRB Bank’s Board of Directors to have an independent chairperson and at least the same number of outside directors as inside directors.
We plan to submit our formal plan with approval from our Board of Directors to the OTS by July 31, 2007. The OTS is aware that the primary difference between our preliminary revised capital plan and the final plan to be submitted is the beginning capital levels as of April 30, 2007, as our fiscal year results were not final at the time the preliminary revised capital plan was submitted to the OTS, and they have indicated that the final plan submitted must meet the three percent requirement by April 30, 2008 to be approved. Failure to meet the conditions under our charter-approval order and the Supervisory Directive could result in the OTS taking further regulatory actions, such as a supervisory agreement, cease-and-desist orders and civil monetary penalties. At this time, the financial impact, if any, of additional regulatory actions cannot be determined. If we are not in a position to cure deficiencies, a
resulting failure could impair our ability to repurchase shares of our common stock, acquire businesses and pay dividends.
Achievement of the capital plan depends on future events and circumstances, the outcome of which cannot be assured. Nevertheless, at this time we believe that we will meet all of the OTS provisions agreed to by July 31, 2007.
NOTE 18: COMMITMENTS, CONTINGENCIES AND RISKS
COMMITMENTS AND CONTINGENCIES - We offer guarantees under our POM program to tax clients whereby we will assume the cost, subject to certain limits, of additional tax assessments, up to a cumulative per client limit of $5,000, attributable to tax return preparation error for which we are responsible. We defer all revenues and direct costs associated with these guarantees, recognizing these amounts over the term of the guarantee based upon historical and actual payment of claims. The related current asset is included in prepaid expenses and other current assets. The related liability is included in accounts payable, accrued expenses and other on the consolidated balance sheets. The related noncurrent asset and liability are included in other assets and other noncurrent liabilities, respectively, on the consolidated balance sheets. A loss on these POM guarantees would be recognized if the sum of expected costs for services exceeded unearned revenue. The changes in the deferred revenue liability for the fiscal years ended April 30, 2007 and 2006 are as follows:
On November 1, 2006 we entered into an agreement to purchase $57.2 million in media advertising between November 1, 2006 and June 30, 2009. During the current year, we purchased $19.4 million in advertising for our retail tax business, leaving a remaining commitment of $37.7 million at April 30, 2007. We expect to make payments totaling $20.6 million and $17.2 million during fiscal years 2008 and 2009, respectively.
We have various contingent purchase price obligations in connection with prior acquisitions. In many cases, contingent payments to be made in connection with these acquisitions are not subject to a stated limit. We estimate the potential payments (undiscounted) total approximately $19.9 million as of April 30, 2007. Our estimate is based on current financial conditions. Should actual results differ materially from the assumptions, the potential payments will differ from the above estimate. Such payments, if and when paid, would typically be recorded as additional purchase price, generally goodwill.
Commitments exist to loan M&P the lower of the value of their accounts receivable, work-in-process and fixed assets or $75.0 million, on a revolving basis through January 31, 2011, subject to certain termination clauses. This revolving facility bears interest at prime rate plus two percent on the outstanding amount. The loan is fully secured by the accounts receivable, work-in-process and fixed assets of M&P.
We are required, in the event of non-delivery of customers’ securities owed to us by other broker-dealers or by our customers, to purchase identical securities in the open market. Such purchases could result in losses not reflected in the accompanying consolidated financial statements.
As of April 30, 2007, we had pledged securities totaling $47.0 million, which satisfied margin deposit requirements of $35.6 million.
We monitor the credit standing of brokers and dealers and customers with whom we do business. In addition, we monitor the market value of collateral held and the market value of securities receivable from others, and seek to obtain additional collateral if insufficient protection against loss exists.
HRBFA has two secured lines of credit with an unaffiliated financial institution with a total credit limit of $51.0 million. There were no borrowings on these lines of credit during fiscal years 2007 or 2006 and no outstanding balance at April 30, 2007 or 2006.
We have contractual commitments to fund certain franchises requesting Franchise Equity Lines of Credit (FELCs). The commitment to fund FELCs as of April 30, 2007 totaled $79.6 million, with a related receivable balance of $47.3 million included in the consolidated balance sheets. The receivable represents the amount drawn on the FELCs as of April 30, 2007
We are self-insured for certain risks, including certain employee health and benefit, workers’ compensation, property and general liability claims, and claims related to our POM program. We issued three standby letters of credit to servicers paying claims related to our POM, errors and omissions and worker’s compensation insurance policies. These letters of credit are for amounts not to exceed $16.5 million, $3.5 million and
$0.9 million, respectively. At April 30, 2007 there were no balances outstanding on these letters of credit.
During fiscal year 2006, we entered into a transaction with the City of Kansas City, Missouri, to provide us with sales and property tax savings on the furniture, fixtures and equipment for our new corporate headquarters facility. Under the transaction, the City purchased equipment by issuing $31.0 million in industrial revenue bonds due in December 2015, and leased the furniture, fixtures and equipment to us for an identical term under a capital lease. The City’s bonds were purchased by us. Because the City has assigned the lease to the bond trustee for our benefit as the sole bondholder, we, in effect, control enforcement of the lease against ourselves. As a result of the capital lease treatment, the furniture, fixtures and equipment will remain a component of property, plant and equipment in our consolidated balance sheet. As a result of the legal right of offset, the capital lease obligation and the corresponding bond investments have been eliminated in consolidation. The transaction provides us with property tax exemptions for the leased furniture, fixtures and equipment. Additional revenue bonds may be issued to cover the costs of certain improvements to this facility. The total amount of revenue bonds authorized for issuance is $31.0 million. As of April 30, 2007, we have purchased $31.0 million in bonds.
Substantially all of the operations of our subsidiaries are conducted in leased premises. Most of the operating leases are for periods ranging from 3 years to 5 years, with renewal options and provide for fixed monthly rentals. Future minimum lease commitments of our continuing operations at April 30, 2007 are as follows:
Rent expense of our continuing operations for fiscal years 2007, 2006 and 2005 totaled $318.2 million, $301.8 million and $244.2 million, respectively.
In the regular course of business, we are subject to routine examinations by federal, state and local taxing authorities. In management’s opinion, the disposition of matters raised by such taxing authorities, if any, in such tax examinations would not have a material adverse impact on our consolidated financial statements.
We routinely enter into contracts that include embedded indemnifications that have characteristics similar to guarantees. Other guarantees and indemnifications of the Company and its subsidiaries include obligations to protect counter parties from losses arising from the following: (1) tax, legal and other risks related to the purchase or disposition of businesses; (2) penalties and interest assessed by federal and state taxing authorities in connection with tax returns prepared for clients; (3) indemnification of our directors and officers; and (4) third-party claims relating to various arrangements in the normal course of business. Typically, there is no stated maximum payment related to these indemnifications, and the term of indemnities may vary and in many cases is limited only by the applicable statute of limitations. The likelihood of any claims being asserted against us and the ultimate liability related to any such claims, if any, is difficult to predict. While we cannot provide assurance we will ultimately prevail in the event any such claims are asserted, we believe the fair value of these guarantees and indemnifications is not material as of April 30, 2007.
NOTE 19: LITIGATION AND RELATED CONTINGENCIES
RAL LITIGATION - We have been named as a defendant in numerous lawsuits throughout the country regarding our refund anticipation loan programs (collectively, “RAL Cases”). The RAL Cases have involved a variety of legal theories asserted by plaintiffs. These theories include allegations that, among other things, disclosures in the RAL applications were inadequate, misleading and untimely; the RAL interest rates were usurious and unconscionable; we did not disclose that we would receive part of the finance charges paid by the customer for such loans; untrue, misleading or deceptive statements in marketing RALs; breach of state laws on credit service organizations; breach of contract, unjust enrichment, unfair and deceptive acts or practices; violations of the federal Racketeer Influenced and Corrupt Organizations Act; violations of the federal Fair Debt Collection Practices Act and unfair competition regarding debt collection activities; and that we owe, and breached, a fiduciary duty to our customers in connection with the RAL program.
The amounts claimed in the RAL Cases have been very substantial in some instances. We have successfully defended against numerous RAL Cases, some of which were dismissed on our motions for dismissal or summary judgment, and others were dismissed voluntarily by the plaintiffs after denial of class certification. Other cases have been settled, with one settlement resulting in a pretax expense of $43.5 million in fiscal year 2003 (the “Texas RAL Settlement”) and other
settlements resulting in a combined pretax expense in fiscal year 2006 of $70.2 million (the “2006 Settlements”).
We believe we have meritorious defenses to the remaining RAL Cases and we intend to defend them vigorously. There can be no assurances, however, as to the outcome of the pending RAL Cases individually or in the aggregate. Likewise, there can be no assurances regarding the impact of the RAL Cases on our financial statements. The following is updated information regarding the pending RAL Cases that are attorney general actions or class actions or putative class actions:
Lynne A. Carnegie, et al. v. Household International, Inc., H&R Block, Inc., et al., (formerly Joel E. Zawikowski, et al. v. Beneficial National Bank, H&R Block, Inc., Block Financial Corporation, et al.) Case No. 98 C 2178, United States District Court for the Northern District of Illinois, Eastern Division, instituted on April 18, 1998. This case constitutes one of the 2006 Settlements. On April 19, 2006, we entered into a settlement agreement regarding this case, subject to final court approval. The settlement was approved by the court on August 28, 2006. One objector filed an appeal, which was dismissed on March 1, 2007. Unless a Petition for Certiorari is filed by the objector and granted by the United States Supreme Court, the settlement is final.
Sandra J. Basile, et al. v. H&R Block, Inc., et al, April Term 1992 Civil Action No. 3246 in the Court of Common Pleas, First Judicial District Court of Pennsylvania, Philadelphia County, instituted on April 23, 1993. The court decertified the class on December 31, 2003. The Pennsylvania appellate court subsequently reversed the trial court’s decertification decision. On September 26, 2006, the Pennsylvania Supreme Court reversed the appellate court’s reversal of the trial court’s decision to decertify the class. The plaintiff is seeking further review by the appellate court.
The People of California v. H&R Block, Inc., H&R Block Services, Inc., H&R Block Enterprises, Inc., H&R Block Tax Services, Inc., Block Financial Corporation, HRB Royalty, Inc., and Does 1 through 50, Case No. CGC-06-449461, in the California Superior Court, San Francisco County, instituted on February 15, 2006 (alleging, among other things, untrue, misleading or deceptive statements in marketing RALs and unfair competition with respect to debt collection activities; seeks equitable relief, civil penalties and restitution). This case is in the discovery stage.
PEACE OF MIND LITIGATION - Lorie J. Marshall, et al. v. H&R Block Tax Services, Inc., et al., Civil Action 2003L000004, in the Circuit Court of Madison County, Illinois, is a class action case filed on January 18, 2002, that was granted class certification on August 27, 2003. Plaintiffs’ claims consist of five counts relating to the POM program under which the applicable tax return preparation subsidiary assumes liability for additional tax assessments attributable to tax return preparation error. The plaintiffs allege that the sale of POM guarantees constitutes (i) statutory fraud by selling insurance without a license, (ii) an unfair trade practice, by omission and by “cramming” (i.e., charging customers for the guarantee even though they did not request it or want it), and (iii) a breach of fiduciary duty. In August 2003, the court certified the plaintiff classes consisting of all persons who from January 1, 1997 to final judgment (i) were charged a separate fee for POM by “H&R Block” or a defendant H&R Block class member; (ii) reside in certain class states and were charged a separate fee for POM by “H&R Block” or a defendant H&R Block class member not licensed to sell insurance; and (iii) had an unsolicited charge for POM posted to their bills by “H&R Block” or a defendant H&R Block class member. Persons who received the POM guarantee through an H&R Block Premium office and persons who reside in Alabama are excluded from the plaintiff class. The court also certified a defendant class consisting of any entity with names that include “H&R Block” or “HRB,” or are otherwise affiliated or associated with H&R Block Tax Services, Inc., and that sold or sells the POM product. The trial court subsequently denied the defendants’ motion to certify class certification issues for interlocutory appeal. Discovery is proceeding. No trial date has been set.
There is one other putative class action pending against us in Texas that involves the POM guarantee. This case is being tried before the same judge that presided over the Texas RAL Settlement, involves the same plaintiffs’ attorneys that are involved in the Marshall litigation in Illinois, and contains similar allegations. No class has been certified in this case.
We believe the claims in the POM actions are without merit, and we intend to defend them vigorously. The amounts claimed in the POM actions are substantial, however, and there can be no assurances as to the outcome of these pending actions individually or in the aggregate. Likewise, there can be no assurances regarding the impact of these actions on our consolidated financial statements.
EXPRESS IRA LITIGATION - On March 15, 2006, the New York Attorney General filed a lawsuit in the Supreme Court of the State of New York, County of New York (Index No. 06/401110) entitled The People of New York v. H&R Block, Inc. and H&R Block Financial Advisors, Inc. The complaint alleged fraudulent business practices, deceptive acts and practices, common law fraud and breach of fiduciary duty with respect to the Express IRA product and sought equitable relief, disgorgement of profits, damages and restitution, civil
penalties and punitive damages. On December 1, 2006, the Supreme Court of the State of New York issued a ruling that dismissed the New York Attorney General’s lawsuit in its entirety on procedural grounds but granted leave to amend and refile the lawsuit. The amended complaint has been filed and alleges causes of action similar to those claimed in the original complaint and seeks equitable relief, disgorgement of profits, damages and restitution, civil penalties and punitive damages. We intend to defend this case vigorously, but there are no assurances as to its outcome.
In addition to the New York Attorney General action, a number of civil actions were filed against us concerning the Express IRA matter, the first of which was filed on March 17, 2006. Except for two cases pending in state court, all of the civil actions have been consolidated by the panel for Multi-District Litigation into a single action styled In re H&R Block, Inc. Express IRA Marketing Litigation in the United States District Court for the Western District of Missouri. We intend to defend these cases vigorously, but there are no assurances as to their outcome.
SECURITIES LITIGATION - On March 17, 2006, the first of three putative class actions alleging violations of certain securities laws were filed against the Company and certain of its current and former officers and directors (the “Securities Class Action Cases”). In addition, on April 5, 2006, the first of nine shareholder derivative actions purportedly brought on behalf of the Company (which is named as a “nominal defendant”) were filed against certain of the Company’s current and former directors and officers (the “Derivative Cases”). On September 20, 2006, the United States District Court for the Western District of Missouri ordered all of the Securities Class Action Cases and the Derivative Cases consolidated into a single action styled In re H&R Block Securities Litigation. The court appointed a lead plaintiff who filed a consolidated complaint on April 6, 2007 against the Company and certain of its officers. The complaint alleges, among other things, deceptive, material and misleading financial statements, failure to prepare financial statements in accordance with generally accepted accounting principles and concealment of the potential for lawsuits stemming from the allegedly fraudulent nature of the Company’s operations. The complaint seeks unspecified damages and equitable relief. We intend to defend this litigation vigorously, but there are no assurances as to its outcome.
OTHER CLAIMS AND LITIGATION - As reported previously, the NASD brought charges against HRBFA regarding the sale by HRBFA of Enron debentures in 2001. A hearing for this matter commenced in May 2006, was recessed until October 2006 and is scheduled to continue through August 2007. We intend to defend the NASD charges vigorously, although there can be no assurances regarding the outcome and resolution of the matter.
As part of an industry-wide review, the IRS is investigating tax-planning strategies that certain RSM McGladrey (RSM) clients utilized during fiscal years 2000 through 2003. Specifically, the IRS is examining these strategies to determine whether RSM complied with tax shelter reporting and listing regulations and whether such strategies were abusive as defined by the IRS. If the IRS were to determine that RSM did not comply with the tax shelter reporting and listing regulations, it might assess fines or penalties against RSM. Moreover, if the IRS were to determine that the tax planning strategies were inappropriate, clients that utilized the strategies could face penalties and interest for underpayment of taxes. Some of these clients are seeking or may attempt to seek recovery from RSM. There can be no assurance regarding the outcome and resolution of this matter.
RSM EquiCo, Inc., a subsidiary of RSM, is a party to a putative class action filed on July 11, 2006 and entitled Do Right’s Plant Growers v. RSM EquiCo, Inc., RSM McGladrey, Inc., H&R Block, Inc. and Does 1-100, inclusive, Case No. 06 CC00137, in the California Superior Court, Orange County. The complaint contains allegations regarding business valuation services provided by RSM EquiCo, Inc., including fraud, negligent misrepresentation, breach of contract, breach of implied covenant of good faith and fair dealing, breach of fiduciary duty and unfair competition and seeks unspecified damages, restitution and equitable relief. There can be no assurance regarding the outcome and resolution of this matter.
We have from time to time been party to investigations, claims and lawsuits not discussed herein arising out of our business operations. These investigations, claims and lawsuits include actions by state attorneys general, other state regulators, individual plaintiffs, and cases in which plaintiffs seek to represent a class of similarly situated customers. The amounts claimed in these claims and lawsuits are substantial in some instances, and the ultimate liability with respect to such litigation and claims is difficult to predict. Some of these investigations, claims and lawsuits pertain to RALs, the origination and servicing of mortgage loans, the electronic filing of customers’ income tax returns, the POM guarantee program, and our Express IRA program and other investment products and RSM EquiCo, Inc. business valuation services. We believe we have meritorious defenses to each of these claims, and we are defending or intend to defend them vigorously, although there is no assurance as to their outcome. In the event of an unfavorable outcome, the amounts we may
be required to pay in the discharge of liabilities or settlements could have a material adverse effect on our consolidated financial statements.
In addition to the aforementioned types of cases, we are parties to claims and lawsuits that we consider to be ordinary, routine litigation incidental to our business, including claims and lawsuits (Other Claims) concerning investment products, the preparation of customers’ income tax returns, the fees charged customers for various products and services, losses incurred by customers with respect to their investment accounts, relationships with franchisees, denials of mortgage loans, contested mortgage foreclosures, other aspects of the mortgage business, intellectual property disputes, employment matters and contract disputes. We believe we have meritorious defenses to each of the Other Claims, and we are defending them vigorously. While we cannot provide assurance that we will ultimately prevail in each instance, we believe the amount, if any, we are required to pay in the discharge of liabilities or settlements in these Other Claims will not have a material adverse effect on our consolidated financial statements.
NOTE 20: DISCONTINUED OPERATIONS
FINANCIAL STATEMENT PRESENTATION - On November 6, 2006 we announced we would evaluate strategic alternatives for OOMC, including a possible sale or other transaction through the public markets. On April 19, 2007, we entered into an agreement to sell OOMC for cash consideration approximately equal to the estimated fair value of adjusted tangible net assets, as defined in the agreement, at closing less $300 million. The OOMC agreement is subject to various closing conditions and may be terminated by either party if the transaction does not close by December 31, 2007. In conjunction with this plan, we also announced we would terminate the operations of HRBMC. OOMC and HRBMC were previously reported in our Mortgage Services segment.
During fiscal year 2007, we committed to a plan to sell and/or completed the wind-down of three smaller lines of business previously reported in our Business Services segment, as well as our tax operations in the United Kingdom previously reported in Tax Services. As of April 30, 2007, we met the criteria requiring us to present the related financial results of these businesses as discontinued operations and the assets and liabilities of all of the businesses being sold as held-for-sale and the in the consolidated financial statements for all periods presented.
We have recorded impairments relating to the disposition of our mortgage businesses during the fourth quarter equal to $345.8 million, including the full impairment of associated goodwill equal to $152.5 million. In addition, we recorded impairments relating to other discontinued businesses totaling $5.0 million. Overhead costs previously allocated to these businesses, totaled $13.4 million, $10.8 million and $10.2 million for the fiscal years 2007, 2006 and 2005, respectively, and are included in continuing operations.
The major classes of assets and liabilities included as held for sale in our consolidated balance sheets are as follows:
Assets held for sale include deferred tax assets of $393.6, net of the related valuation allowance, and deferred tax liabilities of $94.0 million as of April 30, 2007. Deferred taxes represent the tax consequences attributable to differences between the financial statement carrying amount of assets and liabilities expected to be transferred and their respective tax bases. These differences will become currently deductible or taxable to us upon closing of the transaction.
The financial results included in discontinued operations are as follows:
MORTGAGE BANKING ACTIVITIES - We originate mortgage loans and sell most non-prime loans the same day the loans are funded to Trusts. These Trusts meet the criteria of qualifying special purpose entities (QSPEs) and are therefore not consolidated. The sale is recorded in accordance with Statement of Financial Accounting Standards No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (SFAS 140). The Trusts purchase the loans from us using eight warehouse facilities. As a result of the loan sales to the Trusts, we remove the mortgage loans from our balance sheet and record the gain or loss on the sale, cash proceeds, MSRs, repurchase reserves and a beneficial interest in Trusts, which represents our residual interest in the ultimate expected outcome from the disposition of the loans by the Trusts. The beneficial interest in Trusts was $41.1 million and $188.0 million at April 30, 2007 and 2006, respectively.
The Trusts, in response to the exercise of a put option by the third-party beneficial interest holders, either sell the loans directly to third-party investors or back to us to pool the loans for securitization. The decision of the beneficial interest holders to complete a loan sale or a securitization is dependent on market conditions. If the Trusts execute loan sales, we receive cash for our beneficial interest in Trusts. In a securitization transaction, the Trusts transfer the loans to one of our consolidated bankruptcy remote subsidiaries, and we transfer our beneficial interest in Trusts and the loans to a securitization trust. The securitization trust meets the definition of a QSPE and is therefore not consolidated. The securitization trust issues bonds, which are supported by the cash flows from the pooled loans, to third-party investors. We retain an interest in the loans in the form of a trading residual interest and usually assume the first risk of loss for credit losses in the loan pool. As the cash flows of the underlying loans and market conditions change, the value of these residual interests may also change, resulting in either additional gains or impairment of the value of the residual interests. These residual interests are classified as trading securities. We held $72.7 million in trading residual interests as of April 30, 2007 and none as of April 30, 2006.
Activity related to trading residual interests in securitizations consists of the following:
To accelerate the cash flows from our trading residual interests, we securitize the majority of these residual interests in NIM transactions. In a NIM transaction, the trading residual interests are transferred to another QSPE (NIM trust), which then issues bonds to third-party investors. The proceeds from the bonds are returned to us as payment for the residual interests. The bonds are secured by the pooled residual interests and are obligations of the NIM trust. We retain a subordinated interest in the NIM trust, and receive cash flows on our residual interest generally after the bonds issued to the third-party investors are paid in full. Residual interests retained from NIM securitizations may also be bundled and sold in a subsequent securitization. The new residual interests are classified as AFS securities.
Activity related to AFS residual interests in securitizations consists of the following:
Prime mortgage loans are sold in loan sales, servicing released, to third-party buyers.
We sold $27.5 billion and $40.3 billion of mortgage loans in loan sales to the Trusts and other buyers during the years ended April 30, 2007 and 2006, respectively. Gains totaling $102.0 million and $648.7 million were recorded on these sales, respectively.
Trading residual interests initially valued at $426.7 million and $356.8 million were securitized in NIM transactions during the years ended April 30, 2007 and 2006, respectively. Net cash proceeds of $299.1 million and $295.2 million were received from the NIM transactions for the years ended April 30, 2007 and 2006, respectively. Total net additions to AFS residual interests for the years ended April 30, 2007 and 2006 were $127.6 million and $61.7 million, respectively.
Cash flows from AFS residual interests of $13.6 million and $80.5 million were received from the securitization trusts for the years ended April 30, 2007 and 2006, respectively. An additional $25.2 million and $62.4 million was received during fiscal years 2007 and 2006, respectively, as a result of the sale of previously securitized residuals, as discussed below. Cash received on AFS residual interests is included in investing activities of discontinued operations on the consolidated statements of cash flows.
During fiscal year 2007, we completed sales of previously securitized residual interests and recorded gains of $7.0 million. We received cash proceeds of $25.2 million from the transactions and retained a $4.3 million AFS residual interest. During fiscal year 2006, we completed sales of previously securitized residual interests and recorded gains of $31.5 million. We received cash proceeds of $62.4 million from the transactions and retained a $10.0 million AFS residual interest. These sales accelerate cash flows from the residual interests, effectively realizing previously recorded unrealized gains included in other comprehensive income.
The following transactions were treated as non-cash investing activities in the consolidated statement of cash flows:
Residual interests from NIM securitizations are classified as AFS securities and are reported at fair value. Gross unrealized holding gains represent the increase in fair value of residual interests as a result of lower interest rates, loan losses or loan prepayments to date than most recently projected in our valuation models.
Aggregate net unrealized gains on AFS residual interests, which had not yet been accreted into income, totaled $1.3 million and $44.1 million at April 30, 2007 and 2006, respectively. These unrealized gains are recorded net of deferred taxes in other comprehensive income, and may be recognized in income in future periods either through accretion or upon further securitization of the related residual interest.
Included in prepaid expenses and other current assets of discontinued operations as of April 30, 2007 and 2006, is $378.6 million and $255.2 million, respectively, in default advances, escrow advances and principal and interest advances related to the servicing of non-prime loans.
Activity related to MSRs consists of the following:
Estimated amortization of MSRs for fiscal years 2008, 2009, 2010, 2011 and 2012 is $135.2 million, $67.7 million, $30.6 million, $12.1 million and $4.2 million, respectively. The fair value of MSRs at April 30, 2007 was $397.5 million.
The key assumptions we used to originally estimate the cash flows and values of our residual interests are as follows:
The key assumptions we used to estimate the cash flows and values of our residual interests and MSRs at April 30 are as follows:
We originate both adjustable and fixed rate mortgage loans. A key assumption used to estimate the cash flows and values of the residual interests is average annualized prepayment speeds. Prepayment speeds include voluntary prepayments, involuntary prepayments and scheduled principal payments.
Prepayment rate assumptions are as follows:
For fixed rate mortgages without prepayment penalties, we use an average prepayment rate of 20% over the life of the loans. Prepayment rate is projected based on actual paydown including voluntary, involuntary and scheduled principal payments.
Expected static pool credit losses are as follows:
Static pool credit losses are calculated by summing the actual and projected future credit losses and dividing them by the original balance of each pool of assets.
At April 30, 2007, the sensitivities of the current fair value of residual interests and MSRs to 10% and 20% adverse changes in the above key assumptions are presented in the following table. These sensitivities are hypothetical and should be used with caution. As the figures indicate, changes in fair value based on a 10% variation in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. Also in this table, the effect of a variation of a particular assumption on the fair value of the retained interest is calculated without changing any other assumptions; in reality, changes in one factor may result in changes in another, which might magnify or counteract the sensitivities.
Increases in prepayment rates related to AFS residuals can generate a positive impact to fair value when reductions in estimated credit losses and prepayment penalties exceed the adverse impact to accretion from accelerating the life of the AFS residual interest.
Mortgage loans that have been securitized and those held for sale at April 30, 2007 and 2006, past due sixty days or more and the related credit losses incurred are presented below:
DERIVATIVE INSTRUMENTS - A summary of our derivative instruments is as follows:
We use interest rate swaps, put options on Eurodollar futures and forward loan sale commitments to reduce interest rate risk associated with non-prime loans. We generally enter into interest rate swap arrangements related to existing loan applications and applications we expect to receive prior to our next anticipated change in rates charged to borrowers. Interest rate swaps represent an agreement to exchange interest rate payments, whereby we pay a fixed rate and receive a floating rate. Put options on Eurodollar futures represent the right to sell a Eurodollar futures contract at a specified price in the future. These swap and put option contracts increase in value as rates rise and decrease in value as rates fall. The average notional amount of swap arrangements during fiscal years 2007 and 2006 was $5.7 billion and $8.4 billion, respectively.
We enter into forward loan sale commitments to manage market risk associated with commitments to fund mortgage loans. We had no forward commitments outstanding at April 30, 2007. Most of our forward commitments give us the option to under- or over-deliver by five to ten percent.
We generally enter into interest rate caps or swaps to mitigate interest rate risk associated with mortgage loans that will be securitized and trading residual interests that will be sold in a subsequent NIM transaction. The caps and swaps enhance the marketability of the securitization and NIM transactions. An interest rate cap represents a right to receive cash if interest rates rise above a contractual strike rate, its value therefore increases as interest rates rise. The interest rates used in our interest rate caps and the floating rates used in swaps are based on LIBOR.
At April 30, 2007, we had commitments to fund both non-prime and prime mortgage loans totaling $2.4 billion for specified periods of time at “locked-in” interest rates. These derivative instruments represent commitments to fund loans (rate-lock equivalents).
We sell short FNMA, FHLMC and GNMA mortgage-backed securities to reduce our risk related to our commitments to fund fixed-rate prime loans. The position on certain or all of the fixed-rate mortgage loans is closed approximately 10-15 days prior to standard Public Securities Association (PSA) settlement dates.
None of our derivative instruments qualify for hedge accounting treatment as of April 30, 2007 and 2006.
COMMITMENTS AND CONTINGENCIES - The following table summarizes certain of our contractual obligations and commitments related to our discontinued operations:
We have commitments to fund mortgage loans to customers as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses. External market forces impact the probability of commitments being exercised, and therefore, total commitments outstanding do not necessarily represent future cash requirements.
During the fourth quarter of fiscal year 2007, we executed a whole loan trade with a third party who securitized the acquired loans. In conjunction with this sale, we entered into an agreement, whereby the purchaser had the right to sell the resulting residual interest to us at a predetermined price. At April 30, 2007, we recorded a liability of $38.4 million for this obligation on our consolidated balance sheets, which is included in current liabilities held for sale. In May 2007 the purchaser exercised that right and we now hold the residual interest from that securitization.
In the normal course of business, we maintain recourse with standard representations and warranties customary to the mortgage banking industry. Violations of these representations and warranties may require us to repurchase loans previously sold. Repurchased loans are normally sold in subsequent sale transactions. The following table summarizes our loan repurchase activity:
A liability has been established related to the potential loss on repurchase of loans previously sold of $38.4 million and $33.4 million at April 30, 2007 and 2006, respectively. On an ongoing basis, we monitor the adequacy of our repurchase liability, which is established upon the initial sale of the loans, and is included in current liabilities held for sale in the consolidated balance sheets. During the year ended April 30, 2007, we experienced higher early payment defaults, resulting in an increase in actual and expected loan repurchase activity. As a result, we increased our reserves accordingly. In establishing our reserves, we’ve assumed all loans that are currently delinquent and subject to contractual repurchase terms will be repurchased, and that approximately 5% of loans previously sold but not yet subject to contractual repurchase terms will be repurchased. Based on historical experience, we assumed an average 26% loss severity on all loans repurchased and expected to be repurchased as of April 30, 2007.
We are responsible for servicing mortgage loans for others of $63.9 billion and subservicing loans of $3.1 billion at April 30, 2007.
We are required, under the terms of our securitizations, to build and/or maintain overcollateralization (OC) to specified levels, using the excess cash flows received, until specified percentages of the securitized portfolio are attained. We fund the OC account from the proceeds of the sale. Future cash flows to the residual holder are used to amortize the bonds until a specific percentage of either the original or current balance is retained, which is specified in the securitization agreement. The bondholders’ recourse to us for credit losses is limited to the future excess cash flows and the amount of OC held by the trust. Upon maturity of the bonds, any remaining amounts in the trust are distributed. The estimated future cash flows to be distributed to us are included as part of the residual valuation and are valued based upon anticipated distribution from the OC account. As of April 30, 2007 and 2006, $744.0 million and $358.2 million, respectively, was maintained in various OC accounts. These accounts are not assets of the Company and are not reflected in the accompanying consolidated financial statements, other than to the extent potential OC cash flows are included as part of residual interest valuations.
OOMC has guaranteed up to a maximum amount equal to approximately 10% of the aggregate principal balance of mortgage loans held by the Trusts before ultimate disposition of the loans by the Trusts. This obligation can be called upon in the event adequate proceeds are not available from the sale of the mortgage loans to satisfy the current or ultimate payment obligations of the Trusts. No losses have been sustained on this commitment since its inception. The total principal amount of Trust obligations outstanding as of April 30, 2007 and 2006 was $1.5 billion and $7.8 billion, respectively. The fair value of mortgage loans held by the Trusts as of April 30, 2007 and 2006 was $1.5 billion and $7.9 billion, respectively. At April 30, 2007 and 2006 we recorded liabilities of $0.03 million and $1.7 million, respectively, which are included in current liabilities held for sale in the consolidated balance sheets. Under the warehouse agreements, we may be required to provide funds in the event of declining loan values, but only to the extent of the 10% guaranteed amount. Funds provided as a result of declining loan values at April 30, 2007 and 2006 totaled $78.3 million and $19.7 million, respectively. Of the amount provided as of April 30, 2007, $44.0 million relates to our off-balance sheet warehouse facilities and is included in the beneficial interest in Trusts while the remaining $34.3 million relates to our on-balance sheet facility. At April 30, 2006, all the funds provided were included in the beneficial interest in Trusts.
WAREHOUSE FACILITIES. Substantially all non-prime mortgage loans we originate are sold daily to the Trusts. Loans totaling $1.5 billion and $7.8 billion were held by the Trusts as of April 30, 2007 and 2006, respectively, and were not recorded on our consolidated balance sheets. The Trusts purchase the loans from us using committed warehouse facilities, arranged
by us, and totaling $9.3 billion in the aggregate. These facilities are subject to various OOMC performance triggers, limits and financial covenants, including tangible net worth, income and leverage ratios and may be subject to margin calls. We hold an interest in the Trusts equal to the difference between the fair value of the assets and cash proceeds, adjusted for contractual advance rates, received from the Trusts. In addition to the margin call feature, loans sold to the Trust are subject to repurchase if certain criteria are not met, including loan default provisions. Unfavorable fluctuations in loan value are guaranteed up to 10% of the original fair value. Additional uncommitted facilities of $2.0 billion bring total capacity to $11.3 billion at April 30, 2007.
As of April 30, 2007, OOMC did not meet the “minimum net income” financial covenant contained in certain of its committed warehouse facilities. This covenant requires OOMC to maintain a cumulative minimum net income of at least $1 for the four consecutive fiscal quarters ended April 30, 2007. On April 27, 2007, OOMC obtained waivers of the minimum net income financial covenants from all of the warehouse facility providers. These waivers extend through various dates as discussed below. Two waivers are subject to OOMC having a specified amount of total warehouse capacity. If we do not obtain extensions of facilities and waivers that expire before July 31, 2007 or expand existing capacity, we would be in violation of this warehouse capacity requirement.
OOMC will not meet this financial covenant at July 31, 2007. We have, however, obtained waivers from a sufficient number of warehouse providers to allow OOMC to continue to fund loans using its off-balance sheet financing facilities. At our current origination levels, we estimate we would only need waivers for between $3.0 billion and $4.0 billion of available capacity at any given time. However, the sale of OOMC is subject to various closing conditions, including that OOMC maintain at least $8.0 billion of total capacity in its warehouse facilities throughout the period to the closing date (of which at least $2.0 billion is to be in the form of unused capacity at the closing date).
If OOMC cannot obtain extensions and waivers, warehouse facility providers would have the right to terminate their future funding obligations under the applicable warehouse facilities, terminate OOMC’s right to service the loans remaining in the applicable warehouse or request funding of the 10% guarantee. This termination could adversely impact OOMC’s ability to fund new loans and our ability to complete the OOMC sales transaction.
Waivers of the minimum net income financial covenant obtained by OOMC on April 27, 2007 expire as follows:
During fiscal year 2007, we amended our warehouse facility with Citigroup Global Markets Realty Corp (Citigroup) to split OOMC’s existing warehouse financing arrangement with Citigroup into two separate warehouse facilities, one of which is an on-balance sheet facility with capacity of $500.0 million and the other an off-balance sheet facility. Loans totaling $52.7 million were held on the on-balance sheet line at April 30, 2007, with the related loans and liability reported in assets and liabilities held for sale.
RESTRUCTURING CHARGE - During fiscal year 2006, we initiated a restructuring plan to reduce costs within our mortgage operations. Charges incurred during fiscal year 2007 related to our ongoing restructuring plans totaled $21.5 million and are included in “other adjustments” in the table below. Changes in our restructuring charge liability during the year ended April 30, 2007 are as follows:
The remaining liability related to this restructuring charge is included in liabilities held for sale on our consolidated balance sheet and primarily relates to lease obligations for vacant space resulting from branch office closings and employee severance costs.
Employee severance costs include estimates regarding the amount of severance payments made to certain terminated associates, and contract termination costs include estimates regarding the length of time required to sublease vacant space and expected recovery rates. Actual results could vary from these estimates.
We incurred additional restructuring charges subsequent to April 30, 2007 and expect these restructuring activities to continue until the sale of OOMC is complete.
RISKS - Loans to borrowers who do not meet traditional underwriting criteria, or non-prime borrowers, present a higher level of risk of default than prime loans, because of previous credit problems, higher debt-to-income levels, lack of income documentation or limited credit history. Loans to non-prime borrowers also involve additional liquidity risks, as these loans generally have a more limited secondary market than prime loans. During fiscal year 2007 approximately 78% of our non-prime loan originations were adjustable rate mortgages, 12% of non-prime loan originations, including both adjustable rate mortgages and fixed rate mortgages, were interest-only mortgage loans, and 33% of both adjustable rate mortgages and fixed rate mortgages were loans with a 40-year amortization schedule. The actual rates of delinquencies, foreclosures and losses on loans to non-prime borrowers could be higher under adverse economic conditions than those experienced in the mortgage lending industry in general. While we believe the underwriting procedures and appraisal processes we employ enable us to mitigate certain risks inherent in loans made to these borrowers, no assurance can be given that such procedures or processes will afford adequate protection against such risks. Because we sell or securitize almost all of the mortgage loans we originate, any potential credit problems will be reflected in our consolidated financial statements in the fair value of the residual interests we hold in securitizations, or our repurchase reserves established on loans sold to third parties.
Commitments to fund loans involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amount recognized in the financial statements. Credit risk is mitigated by our evaluation of the creditworthiness of potential borrowers on a case-by-case basis.
Risks to the stability of our mortgage operations include external events impacting the asset-backed securities market and loan sale market, such as the level of and fluctuations in interest rates, real estate and other asset values, changes in the securitization market and competition.
NOTE 21: SEGMENT INFORMATION
HRB Bank commenced operations on May 1, 2006 as a wholly-owned subsidiary, at which time we realigned certain segments of our business to reflect a new management reporting structure. The previously reported Investment Services segment and HRB Bank have been combined in the Consumer Financial Services segment.
During fiscal year 2007, we met the criteria requiring us to present the related financial results of OOMC, HRBMC and other businesses as discontinued operations and the assets and liabilities of all of the businesses being sold as held-for-sale in the consolidated financial statements. All periods presented have been reclassified to reflect our discontinued operations. See additional discussion in note 20.
Management has determined the reportable segments identified below according to types of services offered and the manner in which operational decisions are made. We operate in the following reportable segments:
TAX SERVICES - This segment is primarily engaged in providing tax return preparation and related services and products in the U.S., Canada and Australia. During fiscal year 2007, our operations in the United Kingdom were closed. Segment revenues include fees earned for tax-related services performed at company-owned tax offices, royalties from franchise offices, sales of tax preparation and other software, fees from online tax preparation, and payments related to RAL participations. This segment includes the Company’s tax preparation software - TaxCut® from H&R Block, and other personal productivity software offered to the general public, and offers online do-it-yourself-tax preparation, online tax advice to the general public through various websites. Revenues of this segment are seasonal in nature.
Our international operations contributed $131.8 million, $120.3 million and $102.2 million in revenues for fiscal years 2007, 2006 and 2005, respectively, and $20.1 million, $17.7 million and $10.8 million of pretax income, respectively.
BUSINESS SERVICES - This segment offers middle-market companies accounting, tax and business consulting services, wealth management, and capital markets services in offices located throughout the U.S. Revenues of this segment are seasonal in nature.
CONSUMER FINANCIAL SERVICES - The Consumer Financial Services segment is primarily engaged in offering brokerage services, along with investment planning and related financial advice through HRBFA and full-service banking through HRB Bank. HRB Bank offers traditional banking services, including checking and
savings accounts, home equity lines of credit, individual retirement accounts, certificates of deposit and prepaid debit card accounts. HRB Bank also purchases loans from OOMC, HRBMC and other lenders to hold for investment purposes.
CORPORATE - Corporate support departments provide services to our operating segments, consisting of marketing, information technology, facilities, human resources, executive, legal, finance, government relations and corporate communications. These support department costs are largely allocated to our operating segments. Our captive insurance and franchise financing subsidiaries are also included below within Corporate. The pretax losses shown below result primarily from interest expense and overhead costs previously allocated to our discontinued operations. The pretax loss from Corporate for fiscal year 2005 includes a non-operating gain of $17.3 million, or $0.03 per diluted share, resulting from legal recoveries.
IDENTIFIABLE ASSETS - Identifiable assets are those assets, including goodwill and intangible assets, associated with each reportable segment. The remaining assets are classified as corporate assets, which consist primarily of cash, marketable securities and equipment, or assets of discontinued operations.
Information concerning the Company’s operations by reportable segment is as follows.
NOTE 22: QUARTERLY FINANCIAL DATA (UNAUDITED)
During fiscal year 2007, we met the criteria requiring us to present the related financial results of OOMC, HRBMC and other smaller businesses as discontinued operations and the assets and liabilities of all of the businesses being sold as held-for-sale in the consolidated financial statements. All periods presented have been reclassified to reflect our discontinued operations. See additional discussion in note 20.
The accumulation of four quarters in fiscal years 2007 and 2006 for earnings per share may not equal the related per share amounts for the years ended April 30, 2007 and 2006 due to the repurchase of treasury shares, the timing of the exercise of stock options and release of restricted shares, and the antidilutive effect of stock options and unvested restricted shares in the first two quarters.
NOTE 23: CONDENSED CONSOLIDATING FINANCIAL STATEMENTS
Block Financial Corporation (BFC) is an indirect, wholly-owned subsidiary of the Company. BFC is the Issuer and H&R Block, Inc. is the Guarantor of the $500.0 million credit facility entered into in April 2007, $400.0 million 5.125% Senior Notes issued on October 26, 2004 and $500.0 million 81/2% Senior Notes that matured in April 2007. Our guarantee is full and unconditional. The following condensed consolidating financial statements present separate information for BFC, the Company and for our other subsidiaries, and should be read in conjunction with our consolidated financial statements.
These condensed consolidating financial statements have been prepared using the equity method of accounting. Income of subsidiaries is, therefore, reflected in our investment in subsidiaries account. The elimination entries eliminate investments in subsidiaries, related stockholder’s equity and other intercompany balances and transactions.
CONDENSED CONSOLIDATING INCOME STATEMENTS
CONDENSED CONSOLIDATING BALANCE SHEETS
CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
(a) EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES -
We have established disclosure controls and procedures (Disclosure Controls) to ensure that information required to be disclosed in the Company’s reports filed under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the U.S. Securities and Exchange Commission’s rules and forms. Disclosure Controls are also designed to ensure that such information is accumulated and communicated to management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. Our Disclosure Controls were designed to provide reasonable assurance that the controls and procedures would meet their objectives. Our management, including the Chief Executive Officer and Chief Financial Officer, does not expect that our Disclosure Controls will prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable assurance of achieving the designed control objectives and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusions of two or more people, or by management override of the control. Because of the inherent limitations in a cost-effective, maturing control system, misstatements due to error or fraud may occur and not be detected.
As of the end of the period covered by this Form 10-K, we evaluated the effectiveness of the design and operation of our Disclosure Controls. The controls evaluation was done under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our Disclosure Controls were effective as of the end of the period covered by this Annual Report on Form 10-K.
(b) MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING -
Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f). Under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in “Internal Control - Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) as of April 30, 2007.
Based on our assessment, management concluded that, as of April 30, 2007, the Company’s internal control over financial reporting was effective based on the criteria set forth by COSO.
The Company’s external auditors, KPMG LLP, an independent registered public accounting firm, have issued an audit report on our assessment of the Company’s internal control over financial reporting. This report appears near the beginning of Item 8.
(c) CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING -
During the quarter ended April 30, 2007, there were no changes that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. As described in our Form 10-Q for the quarter ended January 31, 2007, the process for valuing certain residual interests in securitizations was enhanced at the time of our third quarter filing. The residual valuation process was effectively executed for the quarter ended April 30, 2007, such that there was no material weakness in internal controls over financial reporting as of April 30, 2007.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The following information appearing in our definitive proxy statement, to be filed no later than 120 days after April 30, 2007, is incorporated herein by reference:
§
Information appearing under the heading “Election of Directors”
§
Information appearing under the heading “Section 16(a) Beneficial Ownership Reporting Compliance”
§
Information appearing under the heading “Board of Directors’ Meetings and Committees” regarding identification of the Audit Committee and Audit Committee financial experts.
We have adopted a code of business ethics and conduct that applies to our directors, officers and employees, including our chief executive officer, chief financial officer, principal accounting officer and persons performing similar functions. A copy of the code of business ethics and conduct is available on our website at www.hrblock.com. We intend to provide information on our website regarding amendments to, or waivers from, the code of business ethics and conduct.
Information about our executive officers as of May 15, 2007 is as follows:
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information called for by this item is contained in our definitive proxy statement filed pursuant to Regulation 14A not later than 120 days after April 30, 2007, in the sections entitled “Director Compensation” and “Compensation of Executive Officers,” and is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
STOCKHOLDER MATTERS
The information called for by this item is contained in our definitive proxy statement filed pursuant to Regulation 14A not later than 120 days after April 30, 2007, in the section titled “Equity Compensation Plans” and in the section titled “Information Regarding Security Holders,” and is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information called for by this item is contained in our definitive proxy statement filed pursuant to Regulation 14A no later than 120 days after April 30, 2007, in the section titled “Employee Agreements, Change in Control and Other Arrangements,” and is incorporated herein by reference.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The information called for by this item is contained in our definitive proxy statement filed pursuant to Regulation 14A no later than 120 days after April 30, 2007, in the section titled “Audit Fees,” and is incorporated herein by reference.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a)
Documents filed as part of this Report:
1.
The following financial statements appearing in Item 8: “Consolidated Statements of Income and Comprehensive Income;” “Consolidated Balance Sheets;” “Consolidated Statements of Cash Flows;” and “Consolidated Statements of Stockholders’ Equity.”
2.
Financial Statement Schedule II - Valuation and Qualifying Accounts with the related Reports of Independent Registered Public Accounting Firms. These will be filed with the SEC but will not be included in the printed version of the Annual Report to Shareholders.
3.
Exhibits: The list of exhibits in the Exhibit Index to this Report is incorporated herein by reference. The following exhibits are required to be filed as exhibits to this Form 10-K:
The exhibits will be filed with the SEC but will not be included in the printed version of the Annual Report to Shareholders.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
H&R BLOCK, INC.
Mark A. Ernst
Chairman of the Board, President and
Chief Executive Officer
June 29, 2007
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated on June 29, 2007.
Mark A. Ernst
Chairman of the Board, President, Chief Executive
Officer and Director (principal executive officer)
Henry F. Frigon
Director
Louis W. Smith
Director
Thomas M. Bloch
Director
Roger W. Hale
Director
Rayford Wilkins, Jr.
Director
Jerry D. Choate
Director
Len J. Lauer
Director
William L. Trubeck
Executive Vice President and Chief Financial
Officer (principal financial officer)
Donna R. Ecton
Director
David B. Lewis
Director
Jeffrey E. Nachbor
Senior Vice President and Corporate Controller
(principal accounting officer)
Tom D. Seip
Director
EXHIBIT INDEX
The following exhibits are numbered in accordance with the Exhibit Table of Item 601 of Regulation S-K:
*
Indicates management contracts, compensatory plans or arrangements.
**
Confidential Information has been omitted from this exhibit and filed separately with the Commission pursuant to a confidential treatment request under Rule 24b-2.
Report of Independent Registered Public Accounting Firm on Schedule
To the Board of Directors and Stockholders of H&R Block, Inc.:
Under date of June 29, 2007, we reported on the consolidated balance sheets of H&R Block, Inc. and its subsidiaries (the Company) as of April 30, 2007 and 2006, and the related consolidated statements of income and comprehensive income, stockholders’ equity, and cash flows for each of the years in the three-year period ended April 30, 2007, which are included in the Company’s annual report filed on Form 10-K. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related financial statement schedule for each of the years in the three-year period ended April 30, 2007, included in the Form 10-K. In our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
/s/ KPMG LLP
Kansas City, Missouri
June 29, 2007
H&R BLOCK, INC.
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
YEARS ENDED APRIL 30, 2007, 2006 AND 2005
(1)
Deductions from the Allowance for Doubtful Accounts reflect recoveries and charge-offs. Deductions from the restructuring charge liability represent payments made.