**UNITEDSTATES********SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

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**FORM 10-Q/A**

** **

**AmendmentNo. 1**

 

| **ý** | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE  ACT OF 1934**                                                                                                                                                                              |
|------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                                                                                                                                                                |
| ** ** | ** ** | **For the quarterly period ended June 30,  2004**                                                                                                                                                                                                                              |
|       |       |                                                                                                                                                                                                                                                                                |
| **OR**     |
|       |       |                                                                                                                                                                                                                                                                                |
| **o**      | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE  ACT OF 1934**                                                                                                                                                                             |
|       |       |                                                                                                                                                                                                                                                                                |
| ** ** | ** ** | **For the transition period from                     to                       ** |

 

**Commissionfile number 0-27444**

 

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**SOURCECORP,INCORPORATED**

(Exact name of registrant as specified in itscharter)

 
| **DELAWARE**                                                                 | ** ** | **75-2560895**                        |
|------------------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of incorporation or organization)              |       | (I.R.S. Employer  Identification No.) |
|                                                                         |       |                                  |
| **3232  MCKINNEY AVENUE, SUITE 1000  DALLAS, TEXAS**                         | ** ** | **75204**                             |
| (Address of principal  executive offices)                                    |       | (Zip code)                            |
|                                                                         |       |                                  |
| REGISTRANT’S TELEPHONE  NUMBER, INCLUDING AREA CODE: **(214) 740-6500** |

 

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

 

Indicate by check mark whether the registrant is anaccelerated filer (as defined in Exchange Act Rule 12b-2).  Yes  ý No  o

 

As of July 30, 2004, 15,773,405 shares of theregistrant’s Common Stock, $.01 par value per share, were outstanding.

 

 

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SOURCECORP, INCORPORATED AND SUBSIDIARIES

FORM 10-Q/A

QUARTERLY PERIOD ENDED JUNE 30, 2004

 

EXPLANATORY NOTE

 

This Amendment No. 1 on Form 10-Q/A is being filedto amend the Company’s quarterly report on Form 10-Q, which was originallyfiled on August 9, 2004, to give effect to the restatement of the Company’scondensed consolidated financial statements as discussed in Note 2 to thecondensed consolidated financial statements.

 

OnOctober 27, 2004, the Company filed a Current Report on Form 8-K (asamended by Form 8-K/A filed October 27, 2004) with the Securities andExchange Commission (the “SEC”) disclosing that the Company’s previously issuedfinancial statements and related independent registered public accountants’ reportfor the year ended December 31, 2003, as well as its previously issuedfinancial statements for the 2004 quarterly periods ended March 31, 2004and June 30, 2004, should no longer be relied upon, and that the Company,under the guidance of the Audit Committee of the Board of Directors of theCompany, had initiated an investigation into the financial results of one ofthe Company’s Operating Subsidiaries in the Information ManagementDivision.  Additionally, on January 21, 2005, the Company issued apress release and subsequently filed a related Current Report on Form 8-K,disclosing that its previously issued financial statements and relatedindependent registered public accountants’ reports for the years ended December 31,2001 and 2002 should also no longer be relied upon.

 

On March 7, 2005, the Company filed a CurrentReport on Form 8-K with the SEC and issued a press release, which was filed asan Exhibit to such Form 8-K, disclosing that the Company’s internalinvestigation has been concluded.

 

Based on the results of such investigation, it wasdetermined that the Operating Subsidiary had incorrectly recognized revenue forcertain customer arrangements and omitted certain operating expenses from itsreported financial results which in turn resulted in overpayments andoveraccruals of amounts of contingent consideration due under the earn-outprovisions of the acquisition agreement for the Operating Subsidiary which hadbeen recognized as additional goodwill of the acquired business.  In connection with the restatement, theCompany has expensed such contingent consideration overpayments and adjustedgoodwill and the related accrued liability (See Note 2 to the condensedconsolidated financial statements).  As aresult, the condensed consolidated financial statements for the three monthsand six months ended June 30, 2003 and 2004 are being restated from theamounts previously reported.  Inaddition, the Company intends to restate the financial statements for the yearsended December 31, 2001, 2002 and 2003 in its 2004 Annual Report on Form 10-K.

 

Except forchanges relating to or resulting from the investigation discussed in Note 2 tothe condensed consolidated financial statements, this quarterly report does notreflect transactions or events after the date of the initial filing of thisForm 10-Q unless specifically indicated otherwise.

 

2

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**SOURCECORP, INCORPORATED ANDSUBSIDIARIES**

**FORM 10-Q/AFOR THE PERIOD ENDED JUNE 30, 2004**

 

**INDEX**

 
|       | **PART  I.   FINANCIAL INFORMATION**                                                                                      |   |
|------------|------------------------------------------------------------------------------------------------------------------------------------------|--------|
|       |                                                                                                                                     |   |
| Item 1     | Financial Statements                                                                                                                     |   |
|       |                                                                                                                                     |   |
|       | Condensed  Consolidated Balance Sheets — December 31, 2003 and June 30, 2004  (unaudited), as restated                    |   |
|       |                                                                                                                                     |   |
|       | Condensed  Consolidated Statements of Operations — Three and six months ended June 30,  2003 and 2004 (unaudited), as restated |   |
|       |                                                                                                                                     |   |
|       | Condensed  Consolidated Statements of Cash Flows — Six months ended June 30, 2003  and 2004 (unaudited), as restated           |   |
|       |                                                                                                                                     |   |
|       | Notes  to Condensed Consolidated Financial Statements (unaudited)                                                                        |   |
|       |                                                                                                                                     |   |
| Item  2    | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                              |   |
|       |                                                                                                                                     |   |
| Item  3    | Quantitative  and Qualitative Disclosures about Market Risk                                                                              |   |
|       |                                                                                                                                     |   |
| Item 4     | Controls and Procedures                                                                                                                  |   |
|       |                                                                                                                                     |   |
|       | **PART  II.   OTHER INFORMATION**                                                                                         |   |
|       |                                                                                                                                     |   |
| Item 1     | Legal Proceedings                                                                                                                        |   |
|       |                                                                                                                                     |   |
| Item  2    | Changes  in Securities and Use of Proceeds                                                                                               |   |
|       |                                                                                                                                     |   |
| Item 6     | Exhibits and  Reports on Form 8-K                                                                                                        |   |
|       |                                                                                                                                     |   |
| ** ** | **SIGNATURES**                                                                                                                           |   |
|       |                                                                                                                                     |   |
| ** ** | **Index to Exhibits**                                                                                                                    |   |

 

3

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**PART I. FINANCIAL INFORMATION**

 

**Item 1.**                   **Financial Statements**

 

**SOURCECORP,INCORPORATED AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(INTHOUSANDS, EXCEPT SHARE DATA)**

 
| ** **                                                                                                                                                                                                             | ** ** | **December 31,  2003**   | ** ** | **June 30,  2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|-------------------------|------------|
| ** **                                                                                                                                                                                                             | ** ** | **(As restated, see Note 2)** | ** ** |
| ** **                                                                                                                                                                                                             | ** ** | **(Unaudited)**               | ** ** |
| **ASSETS**                                                                                                                                                                                                             |       |                          |       |                    |       |
| **CURRENT ASSETS:**                                                                                                                                                                                                    |       |                          |       |                    |       |
| Cash and cash equivalents                                                                                                                                                                                              |       | $                             | 2,097      |                    | $          | 5,436 |   |
| Accounts and notes  receivable, less allowance for doubtful accounts of $6,843 and $6,684,  respectively                                                                                                               |       | 63,522                        |       | 77,286                  |       |
| Inventories                                                                                                                                                                                                            |       | 933                           |       | 796                     |       |
| Deferred income taxes                                                                                                                                                                                                  |       | 6,072                         |       | 6,402                   |       |
| Income tax receivable                                                                                                                                                                                                  |       | 3,000                         |       | 1,261                   |       |
| Prepaid expenses and other  current assets                                                                                                                                                                             |       | 4,318                         |       | 5,281                   |       |
| Assets of discontinued  operations                                                                                                                                                                                     |       | 14,658                        |       | 9,718                   |       |
| Total current assets                                                                                                                                                                                                   |       | 94,600                        |       | 106,180                 |       |
| **PROPERTY, PLANT AND EQUIPMENT,** net of accumulated depreciation of $53,393  and $54,509, respectively                                                                                                               |       | 35,902                        |       | 38,149                  |       |
| **GOODWILL**                                                                                                                                                                                                           |       | 307,913                       |       | 321,475                 |       |
| **INTANGIBLES,** net of amortization of $709 and $1,110,  respectively                                                                                                                                                 |       | 3,731                         |       | 5,494                   |       |
| **OTHER NONCURRENT ASSETS**                                                                                                                                                                                            |       | 10,384                        |       | 10,234                  |       |
| Total assets                                                                                                                                                                                                           |       | $                             | 452,530    |                    | $          | 481,532 |   |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                                                                         |       |                          |       |                    |       |
| **CURRENT LIABILITIES:**                                                                                                                                                                                               |       |                          |       |                    |       |
| Accounts payable and accrued  liabilities                                                                                                                                                                              |       | $                             | 52,375     |                    | $          | 45,736 |   |
| Current maturities of  long-term obligations                                                                                                                                                                           |       | 209                           |       | 103,113                 |       |
| Liabilities of  discontinued operations                                                                                                                                                                                |       | 5,423                         |       | 3,862                   |       |
| Total current liabilities                                                                                                                                                                                              |       | 58,007                        |       | 152,711                 |       |
| **LONG-TERM OBLIGATIONS,** net of current maturities                                                                                                                                                                   |       | 73,390                        |       | 1,758                   |       |
| **DEFERRED INCOME TAXES**                                                                                                                                                                                              |       | 11,753                        |       | 14,294                  |       |
| **LONG-TERM CUSTOMER LIABILITY**                                                                                                                                                                                       |       | 1,862                         |       | 3,395                   |       |
| **DEFERRED REVENUE**                                                                                                                                                                                                   |       | 5,135                         |       | 7,237                   |       |
| **OTHER LONG-TERM OBLIGATIONS**                                                                                                                                                                                        |       | 9,306                         |       | 9,686                   |       |
| Total liabilities                                                                                                                                                                                                      |       | 159,453                       |       | 189,081                 |       |
| **COMMITMENTS AND CONTINGENCIES**                                                                                                                                                                                      |       |                          |       |                    |       |
| **STOCKHOLDERS’ EQUITY:**                                                                                                                                                                                         |       |                          |       |                    |       |
| Preferred stock, $.01 par  value, 1,000,000 shares authorized, no shares issued or outstanding                                                                                                                         |       | —                        |       | —                  |       |
| Common stock, $.01 par  value, 26,000,000 shares authorized, 16,150,184 and 15,806,244 shares issued  and 16,094,156 and 15,750,216 shares outstanding at December 31, 2003  and June 30, 2004, respectively |       | 162                           |       | 158                     |       |
| Additional paid-in-capital                                                                                                                                                                                             |       | 194,999                       |       | 195,528                 |       |
| Retained earnings                                                                                                                                                                                                      |       | 101,225                       |       | 103,306                 |       |
|                                                                                                                                                                                                                   |       | 296,386                       |       | 298,992                 |       |
| Less—Treasury stock, at  cost, 56,028 shares                                                                                                                                                                      |       | (982                          | )          | (982                    | )          |
| Less—Deferred compensation                                                                                                                                                                                        |       | (2,327                        | )          | (5,559                  | )          |
| Total stockholders’ equity                                                                                                                                                                                        |       | 293,077                       |       | 292,451                 |       |
| Total liabilities and  stockholders’ equity                                                                                                                                                                       |       | $                             | 452,530    |                    | $          | 481,532 |   |

 

The accompanying notes are an integral partof these condensed consolidated financial statements.

 

4

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**SOURCECORP,INCORPORATED AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(INTHOUSANDS, EXCEPT PER SHARE DATA)**

 
| ** **                                             | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                             |       | **2003**                              |       | **2004**                            |       | **2003** |   | **2004** |   |
| ** **                                             |       | **(As restated, see Note 2)**         |       | **(As restated, see Note 2)**       |       |
| ** **                                             |       | **(Unaudited)**                       |       | **(Unaudited)**                     |       |
| **REVENUE**                                            |       | $                                     | 91,256     |                                | $          | 97,947 |   | $ | 188,613 |   | $ | 194,823 |   |
| **COST OF  SERVICES**                                  |       | 54,402                                |       | 58,194                              |       | 111,241 |   | 115,335 |   |
| **DEPRECIATION**                                       |       | 3,044                                 |       | 2,983                               |       | 6,132 |   | 6,204 |   |
| Gross profit                                           |       | 33,810                                |       | 36,770                              |       | 71,240 |   | 73,284 |   |
| **SELLING,  GENERAL AND ADMINISTRATIVE EXPENSES**      |       | 23,993                                |       | 24,414                              |       | 47,824 |   | 55,811 |   |
| **AMORTIZATION**                                       |       | 88                                    |       | 312                                 |       | 177 |   | 401 |   |
| Operating income                                       |       | 9,729                                 |       | 12,044                              |       | 23,239 |   | 17,072 |   |
| **OTHER  (INCOME) EXPENSE:**                           |       |                                  |       |                                |       |   |   |   |   |
| Interest expense                                       |       | 1,005                                 |       | 698                                 |       | 2,415 |   | 1,357 |   |
| Interest income                                        |       | (4                                    | )          | (5                                  | )          | (257 | ) | (9 | ) |
| Other (income) expense,  net                           |       | (325                                  | )          | 253                                 |       | (151 | ) | 373 |   |
| Income from continuing  operations before income taxes |       | 9,053                                 |       | 11,098                              |       | 21,232 |   | 15,351 |   |
| **PROVISION  FOR INCOME TAXES**                        |       | 3,623                                 |       | 4,439                               |       | 8,496 |   | 6,140 |   |
| **INCOME  FROM CONTINUING OPERATIONS**                 |       | 5,430                                 |       | 6,659                               |       | 12,736 |   | 9,211 |   |
| **LOSS FROM  DISCONTINUED OPERATIONS, NET OF TAX**     |       | (347                                  | )          | (1,813                              | )          | (163 | ) | (2,300 | ) |
| **NET  INCOME**                                        |       | $                                     | 5,083      |                                | $          | 4,846 |   | $ | 12,573 |   | $ | 6,911 |   |
| **NET  INCOME PER COMMON SHARE**                       |       |                                  |       |                                |       |   |   |   |   |
| **BASIC**                                              |       |                                  |       |                                |       |   |   |   |   |
| **Continuing  Operations**                             |       | $                                     | 0.33       |                                | $          | 0.42 |   | $ | 0.76 |   | $ | 0.57 |   |
| **Discontinued  Operations**                           |       | (0.02                                 | )          | (0.12                               | )          | (0.01 | ) | (0.14 | ) |
| **Total**                                              |       | $                                     | 0.31       |                                | $          | 0.30 |   | $ | 0.75 |   | $ | 0.43 |   |
| **DILUTED**                                            |       |                                  |       |                                |       |   |   |   |   |
| **Continuing  Operations**                             |       | $                                     | 0.33       |                                | $          | 0.41 |   | $ | 0.76 |   | $ | 0.56 |   |
| **Discontinued  Operations**                           |       | (0.02                                 | )          | (0.11                               | )          | (0.01 | ) | (0.14 | ) |
| **Total**                                              |       | $                                     | 0.31       |                                | $          | 0.30 |   | $ | 0.75 |   | $ | 0.42 |   |
| **WEIGHTED  AVERAGE COMMON SHARES OUTSTANDING**        |       |                                  |       |                                |       |   |   |   |   |
| **BASIC**                                              |       | 16,319                                |       | 16,014                              |       | 16,762 |   | 16,055 |   |
| **DILUTED**                                            |       | 16,381                                |       | 16,374                              |       | 16,804 |   | 16,411 |   |
|                                                        |            |                                       |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |

 

The accompanying notes are an integral partof these condensed consolidated financial statements.

 

5

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**SOURCECORP,INCORPORATED AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(INTHOUSANDS)**

 
| ** **                                                                                | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                |       | **2003**                            | ** ** | **2004** |   |
| ** **                                                                                |       | **(As restated, see Note 2)**       |       |
| ** **                                                                                |       | **(Unaudited)**                     |       |
| **CASH FLOWS FROM OPERATING  ACTIVITIES:**                                                |       |                                |       |   |   |
| Income from continuing  operations                                                        |       | $                                   | 12,736     |   | $ | 9,211 |   |
| Adjustments to reconcile  income to net cash provided by operating activities:            |       |                                |       |   |   |
| Depreciation and  amortization                                                            |       | 6,309                               |       | 6,605 |   |
| Deferred income taxes                                                                     |       | 4,023                               |       | 3,153 |   |
| Compensation expense on  restricted stock grants                                          |       | 86                                  |       | 1,120 |   |
| (Gain) loss on sale of  property, plant and equipment                                     |       | (344                                | )          | 125 |   |
| Change in operating assets  and liabilities:                                              |       |                                |       |   |   |
| Accounts and notes  receivable                                                            |       | 5,576                               |       | (12,935 | ) |
| Inventories, prepaid  expenses and other assets                                           |       | 173                                 |       | (332 | ) |
| Accounts payable and  accrued liabilities                                                 |       | 9,453                               |       | (1,784 | ) |
| Net cash provided by  operating activities from continuing operations                     |       | 38,012                              |       | 5,163 |   |
| **CASH FLOWS FROM INVESTING  ACTIVITIES:**                                                |       |                                |       |   |   |
| Purchase of property,  plant and equipment                                                |       | (6,454                              | )          | (8,339 | ) |
| Proceeds from disposition  of property, plant and equipment                               |       | 369                                 |       | 21 |   |
| Proceeds from divestitures                                                                |       | —                              |       | 750 |   |
| Cash paid for  acquisitions, net of cash acquired                                         |       | (3,044                              | )          | (14,958 | ) |
| Net cash used in investing  activities from continuing operations                         |       | (9,129                              | )          | (22,526 | ) |
| **CASH FLOWS FROM FINANCING  ACTIVITIES:**                                                |       |                                |       |   |   |
| Proceeds from exercise of  common stock options                                           |       | 9                                   |       | 389 |   |
| Cash paid for common stock  repurchased                                                   |       | (18,091                             | )          | (9,298 | ) |
| Proceeds from long-term  obligations                                                      |       | 111,946                             |       | 174,634 |   |
| Principal payments on  long-term obligations                                              |       | (125,101                            | )          | (143,510 | ) |
| Cash paid for debt  issuance costs                                                        |       | (305                                | )          | — |   |
| Net cash (used in)  provided by financing activities from continuing operations           |       | (31,542                             | )          | 22,215 |   |
|                                                                                      |       |                                |       |   |   |
| Net cash provided by (used  in) operating activities from discontinued operations         |       | 2,164                               |       | (1,513 | ) |
|                                                                                      |       |                                |       |   |   |
| **NET (DECREASE) INCREASE IN CASH  AND CASH EQUIVALENTS**                                 |       | (495                                | )          | 3,339 |   |
| **CASH AND CASH EQUIVALENTS,** beginning of period                                   |       | 3,217                               |       | 2,097 |   |
| **CASH AND CASH EQUIVALENTS,** end of period                                              |       | $                                   | 2,722      |   | $ | 5,436 |   |
| **SUPPLEMENTAL DATA:**                                                                    |       |                                |       |   |   |
| Cash paid for:                                                                            |       |                                |       |   |   |
| Income taxes, net of  income tax refunds                                                  |       | $                                   | 1,115      |   | $ | 609 |   |
| Interest                                                                                  |       | $                                   | 2,229      |   | $ | 1,352 |   |
| **NONCASH FINANCING TRANSACTIONS:**                                                       |       |                                |       |   |   |
| Assets acquired through  financing and capital lease arrangements                         |       | $                                   | 40         |   | $ | 147 |   |
| Restricted stock grants  (164,300 and 177,300 shares, respectively)                       |       | $                                   | 2,949      |   | $ | 4,486 |   |
| Common stock issued  related to business acquisitions (20,268 and 0 shares, respectively) |       | $                                   | (94        | ) | $ | — |   |
| Common stock accrued  related to business acquisitions (0 and 9,623 shares, respectively) |       | $                                   | —     |   | $ | 261 |   |

 

The accompanying notes are an integral partof these condensed consolidated financial statements.

 

6

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**SOURCECORP,INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

**1. Basis of Presentation**

 

Theaccompanying condensed consolidated financial statements and related notes tothe condensed consolidated financial statements include the accounts ofSOURCECORP, Incorporated and subsidiaries (collectively, the “Company”).  All significant intercompany accounts andtransactions have been eliminated in consolidation. These condensedconsolidated financial statements have been prepared by the Company, withoutaudit, pursuant to the rules and regulations of the Securities and ExchangeCommission. Certain information and footnote disclosures normally included infinancial statements prepared in accordance with accounting principlesgenerally accepted in the United States of America have been condensed oromitted pursuant to such rules and regulations. However, the Company believesthat all disclosures are adequate to make the information presented notmisleading.

 

In the opinion ofmanagement, all adjustments (which include normal recurring adjustments, exceptas disclosed in Note 2) necessary to fairly present the Company’s financialposition as of June 30, 2004, and results of operations and cash flows forthe three and six months ended June 30, 2004 and 2003 have been included.The results of operations for the three and six months ended June 30, 2004are not necessarily indicative of the results to be expected for the fullfiscal year or for any future periods.

 

The Company uses estimatesand assumptions required for preparation of the financial statements. Theestimates are primarily based on historical experience and business knowledgeand are revised as circumstances change. However, actual results could differfrom the estimates.

 

**2. Restatement**

 

Subsequent to the issuance of its condensed consolidated financial statements for the three and six months ended June 30, 2004, the Company, with the oversight and approval of the Audit Committee of the Board of Directors, initiated an investigation of the financial results of one of the Company’s operating subsidiaries in the Information Management and Distribution reportable segment (the “Operating Subsidiary”).  The findings of the investigation concluded that the Operating Subsidiary had incorrectly recognized revenue for certain customer arrangements and omitted certain operating expenses from its reported financial results which in turn resulted in overpayments and overaccruals of amounts of contingent consideration due under the earn-out provisions of the acquisition agreement for the Operating Subsidiary which had been recognized as additional goodwill of the acquired business.  As a result, the condensed consolidated financial statements for the three months and six months ended June 30, 2003 and 2004, and the condensed consolidated balance sheet at December 31, 2003, have been restated from the amounts previously reported.  In addition, the Company intends to restate the financial statements for the years ended December 31, 2001, 2002, and 2003 in its 2004 Annual Report on Form 10-K.

 

As described in the Company’s summary of significant accounting policies, revenue is recognizable when each of the following conditions is met:  persuasive evidence of an arrangement exists, the price is fixed or determinable, delivery has occurred or services have been rendered and collection is reasonably assured.  The investigation identified certain instances where one or more of the aforementioned revenue recognition conditions as applied to certain customer contracts were not met by the Operating Subsidiary.  As a result, the revenue previously recognized that did not meet all the revenue recognition conditions mentioned above has been reversed, resulting in a downward adjustment to certain asset accounts or the recognition of a customer liability or deferred revenue, if the customer has paid the invoices related to the reversed revenue.   Notwithstanding the reversal of revenue, the direct costs associated with the reversed revenue continue to be reported in the period incurred.  In addition, the Company has evaluated the direct costs related to deferred revenue and has determined to continue to include the costs in the period incurred due to the uncertainty regarding the future recoverability of the associated costs.  The following table identifies the revenue adjustments by issue that are reflected in the restated financial statements for the three months and six months ended June 30, 2003 and 2004:

 

7

 
| **(In Thousands)**            | ** ** | **Three Months  Ended  June 30, 2003** | ** ** | **Six Months  Ended  June 30, 2003** | ** ** | **Three Months  Ended  June 30, 2004** | ** ** | **Six Months  Ended  June 30, 2004** | ** ** |
|-------------------------------|------------|---------------------------------------------|------------|-------------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------|------------|
| Asset  accounts               |       | $                                           | (36        | )                                         | $          | (171                                        | )          | $                                         | 37         |   | $ | (2,734 | ) |
| Customer  liability, net      |       |                                        | (289       | )                                         |       | (661                                        | )          |                                      | 692        |   |   | (781 | ) |
| Deferred  revenue, net        |       |                                        | (593       | )                                         |       | (1,193                                      | )          |                                      | (232       | ) |   | (871 | ) |
| Total Net  Revenue Adjustment |       | $                                           | (918       | )                                         | $          | (2,025                                      | )          | $                                         | 497        |   | $ | (4,386 | ) |

 

**Asset accounts:**

Represents the reversal of previously recognized revenue through the downward adjustment of certain asset accounts where one or more of the aforementioned revenue recognition conditions as applied to certain customer contracts were not met by the Operating Subsidiary.  To the extent that the write-down relates to performed services that exceeded the contractual funding limitation, a portion of the revenue may be recognized in future periods upon customer authorization.

 

**Customer liability, net:**

The Operating Subsidiary in certain instances recognized revenue for services that were never performed. The customers were invoiced for the non-performed services and collection of the invoices has occurred.  A portion of the customer liability may be recognized as revenue in future periods upon successful completion of services or negotiations with the Operating Subsidiary’s customer(s).  Remaining customer liability balances will be extinguished through either customer refund or applying such remaining customer liability against future provided services.

 

**Deferred revenue, net:**

The Operating Subsidiary recognized revenue for performed services although the related contractually required services designed to meet customer-specific acceptance provisions (i.e. quality standards) were not performed.  The customers were invoiced for the performed services and collection of the invoices has occurred.  However, by not complying with the contract, the Operating Subsidiary is unable to reasonably demonstrate that the performed services met the required quality standard(s).  This has resulted in the deferral of revenue for performed services for which acceptance is contingent upon meeting the required quality standard(s).  The Operating Subsidiary will recognize the revenue for performed services upon obtaining explicit acceptance from the customer(s).  In the event customer acceptance is not obtained, the deferred revenue will be reclassified to a customer liability.  The customer liability will be extinguished through either customer refund or applying such remaining customer liability against future provided services.

 

The investigation identified certain expenses of the Operating Subsidiary that were not properly recorded in the Operating Subsidiary’s consolidated statement of operations.  Certain former members of the Operating Subsidiary’s management allegedly diverted expenses to entities they controlled, but that are unrelated to the Company, resulting in the omission of the related expenses from the Operating Subsidiary’s and, as a result, the Company’s previously reported financial results.  The Company has identified the unrecorded expenses and has recorded them in the period the expenses were incurred as an adjustment to selling, general and administrative expense.  A liability for such an amount has been recorded in other long-term obligations in the restated financial statements.  The liability will be eliminated at such time the Company recovers any contingent consideration overpayments paid to the former owners of the Operating Subsidiary, as discussed below.

 

The revenue recognition and expense omission issues affected previously paid contingent consideration related to the acquisition of the Operating Subsidiary.  As a result of the structure of the acquisition agreement, the former owners of the Operating Subsidiary had the opportunity to earn additional purchase consideration for the twelve-month periods ended February 28, 2002, February 28, 2003 and February 29, 2004 (the “Earn-out Period(s)”) based on earnings before interest and taxes of the Operating Subsidiary, in excess of designated thresholds, calculated in accordance with accounting principles generally accepted in the United States of America for each respective period (the “Earn-out Agreement”).  Based on the findings of the Company’s investigation, earnings before interest and taxes attributable to the Operating Subsidiary were overstated during the Earn-out Period(s) resulting in overpayments and overaccruals made by the Company under the provisions of the Earn-out Agreement that otherwise would not have been made.  The Company has expensed the contingent consideration overpayments in the financial statements in the period(s) in which they were paid.  These amounts had previously been accrued as contingent consideration and an addition to goodwill.  The Company has reversed these accruals and related goodwill in the periods originally recorded.  The Company will record a gain in future periods to the extent such contingent consideration overpayments are recovered.

 

Restating the financial statements for the revenue recognition, expense omission and contingent consideration overpayment issues results in an adjustment to the provision for income taxes and to certain other balance sheet tax accounts for the periods restated.

 

8

----

 

A summary of the significant effects of the restatement are as follows (in thousands, except per share data):

 

**BALANCE SHEET INFORMATION**

**(AllPeriods Presented Unaudited)**

 
| ** **                                        | ** ** | **At December 31, 2003** | ** ** | **At June 30, 2004** | ** ** |
|---------------------------------------------------|------------|-------------------------------|------------|---------------------------|------------|
| ** **                                        | ** ** | **As Previously  Reported**   | ** ** | **As  Restated**          | ** ** | **As Previously  Reported** | ** ** | **As  Restated** | ** ** |
| ** **                                        | ** ** | **(Item 1)**                  | ** ** | ** **                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Accounts and  Notes Receivable, Net               |       | $                             | 67,873     |                      | $          | 63,522 |   | $ | 82,385 |   | $ | 77,286 |   |
|                                              |       |                          |       |                      |       |   |   |   |   |
| Income Tax  Receivable                            |       | $                             | —     |                      | $          | 3,000 |   | $ | — |   | $ | 1,261 |   |
|                                              |       |                          |       |                      |       |   |   |   |   |
| Goodwill                                          |       | $                             | 324,305    |                      | $          | 307,913 |   | $ | 346,400 |   | $ | 321,475 |   |
|                                              |       |                          |       |                      |       |   |   |   |   |
| Total Assets                                      |       | $                             | 470,273    |                      | $          | 452,530 |   | $ | 510,295 |   | $ | 481,532 |   |
|                                              |       |                          |       |                      |       |   |   |   |   |
| Accounts Payable  and Accrued Liabilities         |       | $                             | 52,054     |                      | $          | 52,375 |   | $ | 53,929 |   | $ | 45,736 |   |
|                                              |       |                          |       |                      |       |   |   |   |   |   |   |   |   |
| Current  Maturities of Long-term Obligations      |       |                          | NC         |                      |       | NC |   | $ | 232 |   | $ | 103,113 |   |
|                                              |       |                          |       |                      |       |   |   |   |   |
| Income Tax  Payable                               |       | $                             | 2,186      |                      | $          | — |   | $ | 5,686 |   | $ | — |   |
|                                              |       |                          |       |                      |       |   |   |   |   |
| Long-term  Obligations, Net of Current Maturities |       | NC                            |       | NC                        |       | $ | 104,639 |   | $ | 1,758 |   |
|                                              |       |                          |       |                      |       |   |   |   |   |
| Deferred  Income Taxes                            |       | $                             | 18,084     |                      | $          | 11,753 |   | $ | 20,625 |   | $ | 14,294 |   |
|                                              |       |                          |       |                      |       |   |   |   |   |
| Long-term Customer  Liability                     |       | $                             | —     |                      | $          | 1,862 |   | $ | — |   | $ | 3,395 |   |
|                                              |       |                          |       |                      |       |   |   |   |   |
| Deferred  Revenue                                 |       | $                             | —     |                      | $          | 5,135 |   | $ | — |   | $ | 7,237 |   |
|                                              |       |                          |       |                      |       |   |   |   |   |
| Other  Long-term Obligations                      |       | $                             | 7,839      |                      | $          | 9,306 |   | $ | 8,215 |   | $ | 9,686 |   |
|                                              |       |                          |       |                      |       |   |   |   |   |
| Retained  Earnings                                |       | $                             | 119,236    |                      | $          | 101,225 |   | $ | 123,962 |   | $ | 103,306 |   |
|                                              |       |                          |       |                      |       |   |   |   |   |
| Total  Stockholders’ Equity                  |       | $                             | 311,088    |                      | $          | 293,077 |   | $ | 313,107 |   | $ | 292,451 |   |
|                                                   |            |                               |            |                           |            |  |  |  |  |  |  |  |  |  |  |

 

----

**Item 1:****  **Amounts as previously reported after givingeffect to adjustments required to reflect the Company’s discontinued operationsdiscussed in Note 4 to the consolidated financial statements.

 

**Item 2:  **NC denotes no changefrom the previously reported amount.

 

9

----

 

**STATEMENT OF OPERATIONS INFORMATION**

**(All Periods Presented Unaudited)**

 
| ** **                                            | ** ** | **Three Months Ended  June 30, 2003** | ** ** | **Three Months Ended  June 30, 2004** | ** ** | **Six Months Ended  June 30, 2003** | ** ** | **Six Months Ended  June 30, 2004** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------------|------------|--------------------------------------------|------------|------------------------------------------|------------|------------------------------------------|------------|
| ** **                                            | ** ** | **As Previously  Reported**                | ** ** | **As  Restated**                           | ** ** | **As Previously  Reported**              | ** ** | **As  Restated**                         | ** ** | **As Previously  Reported** | ** ** | **As  Restated** | ** ** | **As Previously  Reported** | ** ** | **As  Restated** | ** ** |
| ** **                                            | ** ** | **(Item 1)**                               | ** ** | ** **                                 | ** ** | ** **                               | ** ** | ** **                               | ** ** | **(Item 1)** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                                               |       | $                                          | 92,174     |                                       | $          | 91,256                                   |       | $                                        | 97,450     |   | $ | 97,947 |   | $ | 190,638 |   | $ | 188,613 |   | $ | 199,209 |   | $ | 194,823 |   |
|                                                  |       |                                       |       |                                       |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Gross Profit                                          |       | $                                          | 34,728     |                                       | $          | 33,810                                   |       | $                                        | 36,273     |   | $ | 36,770 |   | $ | 73,265 |   | $ | 71,240 |   | $ | 77,670 |   | $ | 73,284 |   |
|                                                  |       |                                       |       |                                       |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Selling, General & Administrative Expense         |       | $                                          | 23,957     |                                       | $          | 23,993                                   |       | $                                        | 24,405     |   | $ | 24,414 |   | $ | 47,750 |   | $ | 47,824 |   | $ | 55,793 |   | $ | 55,811 |   |
|                                                  |       |                                       |       |                                       |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Income From Continuing Operations Before Income Taxes |       | $                                          | 10,007     |                                       | $          | 9,053                                    |       | $                                        | 10,610     |   | $ | 11,098 |   | $ | 23,331 |   | $ | 21,232 |   | $ | 19,755 |   | $ | 15,351 |   |
|                                                  |       |                                       |       |                                       |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Provision for Income Taxes                            |       | $                                          | 4,003      |                                       | $          | 3,623                                    |       | $                                        | 4,244      |   | $ | 4,439 |   | $ | 9,332 |   | $ | 8,496 |   | $ | 7,902 |   | $ | 6,140 |   |
|                                                  |       |                                       |       |                                       |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Income From Continuing Operations                     |       | $                                          | 6,004      |                                       | $          | 5,430                                    |       | $                                        | 6,366      |   | $ | 6,659 |   | $ | 13,999 |   | $ | 12,736 |   | $ | 11,853 |   | $ | 9,211 |   |
|                                                  |       |                                       |       |                                       |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Net Income                                            |       | $                                          | 5,657      |                                       | $          | 5,083                                    |       | $                                        | 4,553      |   | $ | 4,846 |   | $ | 13,836 |   | $ | 12,573 |   | $ | 9,553 |   | $ | 6,911 |   |
|                                                  |       |                                       |       |                                       |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| **Net Income Per Common Share:**                      |       |                                       |       |                                       |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| **Basic**                                             |       |                                       |       |                                       |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Continuing Operations                                 |       | $                                          | 0.37       |                                       | $          | 0.33                                     |       | $                                        | 0.40       |   | $ | 0.42 |   | $ | 0.84 |   | $ | 0.76 |   | $ | 0.74 |   | $ | 0.57 |   |
|                                                  |       |                                       |       |                                       |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total                                                 |       | $                                          | 0.35       |                                       | $          | 0.31                                     |       | $                                        | 0.28       |   | $ | 0.30 |   | $ | 0.83 |   | $ | 0.75 |   | $ | 0.60 |   | $ | 0.43 |   |
|                                                  |       |                                       |       |                                       |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| **Diluted**                                           |       |                                       |       |                                       |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Continuing Operations                                 |       | $                                          | 0.37       |                                       | $          | 0.33                                     |       | $                                        | 0.39       |   | $ | 0.41 |   | $ | 0.83 |   | $ | 0.76 |   | $ | 0.72 |   | $ | 0.56 |   |
|                                                  |       |                                       |       |                                       |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total                                                 |       | $                                          | 0.35       |                                       | $          | 0.31                                     |       | $                                        | 0.28       |   | $ | 0.30 |   | $ | 0.82 |   | $ | 0.75 |   | $ | 0.58 |   | $ | 0.42 |   |

 

----

**Item 1:**   Amounts as previously reported after giving effectto adjustments required to reflect the Company’s discontinued operations discussedin Note 4 to the consolidated financial statements.

 

10

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**3. Stockholders’ Equity andStock-Based Compensation**

 

*Stock-Based Compensation*

 

In 2002, the Board ofDirectors and Shareholders of the Company approved the SOURCECORP, Incorporated2002 Long-Term Incentive Plan (the “2002 Plan”), which replaced the 1995 StockOption Plan, as amended (the “1995 Plan”). The 2002 Plan provides for awards ofoptions to purchase common stock and may include incentive stock options (“ISOs”)and/or non-qualified stock options (“NQSOs”), stock appreciation rights,restricted stock, deferred stock, bonus stock and awards in lieu of cashobligations, dividend equivalents and other stock based awards.

 

The Board of Directors hasappointed a committee (the “Committee”) to administer the 2002 Plan. Personseligible to receive awards under the plan include directors, officers,employees of the Company and its subsidiaries, and persons who provideconsulting services to the Company deemed by the Committee to be of substantialvalue to the Company, persons who have been offered employment by the Companyor its subsidiaries, and persons employed by an entity that the Committeereasonably expects to become a subsidiary of the Company. Awards granted underthe 2002 Plan may, at the discretion of the Committee, be granted either aloneor in addition to, in tandem with or in substitution for any other awardgranted under the 2002 Plan or any other plan of the Company, any subsidiary orany business entity to be acquired by the Company or one of its subsidiaries.The Committee determines vesting in awards granted under the 2002 Plan.

 

The Company appliesAccounting Principles Board Opinion (“APB”) No. 25, *Accounting for Stock Issued to Employees,* and relatedinterpretations in accounting for stock-based compensation and awards. Stockoption and warrant awards are granted at the market price of the common stockon the date of grant. Accordingly, no compensation expense has been recognizedfor stock options and warrants. Had compensation expense been determined basedupon the fair value at grant dates for stock options and warrants consistentwith the method of Statement of Financial Accounting Standards (“SFAS”) No.123, *Accounting for Stock-BasedCompensation,* the Company’s net income and earnings per share wouldhave been as follows (in thousands, except per share data):

 
| ** **                                                                                                                           | ** ** | **Three Months  Ended June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                                           | ** ** | **2003**                              | ** ** | **2004**                            | ** ** | **2003** | ** ** | **2004** | ** ** |
| Net income  as reported                                                                                                              |       | $                                     | 5,083      |                                | $          | 4,846 |   | $ | 12,573 |   | $ | 6,911 |   |
| Add:  Deferred compensation expense included in reported net income, net of related  tax effect                                      |       | 55                                    |       | 320                                 |       | 55 |   | 652 |   |
| Deduct:  Total stock-based employee compensation expense determined under fair value  based method for all awards, net of tax effect |       | (909                                  | )          | (676                                | )          | (1,738 | ) | (1,585 | ) |
| Proforma net  income                                                                                                                 |       | $                                     | 4,229      |                                | $          | 4,490 |   | $ | 10,890 |   | $ | 5,978 |   |
| Earnings per  share:                                                                                                                 |       |                                  |       |                                |       |   |   |   |   |
| Reported  basic earnings per share                                                                                                   |       | $                                     | 0.31       |                                | $          | 0.30 |   | $ | 0.75 |   | $ | 0.43 |   |
| Proforma  basic earnings per share                                                                                                   |       | $                                     | 0.26       |                                | $          | 0.28 |   | $ | 0.65 |   | $ | 0.37 |   |
| Reported  diluted earnings per share                                                                                                 |       | $                                     | 0.31       |                                | $          | 0.30 |   | $ | 0.75 |   | $ | 0.42 |   |
| Proforma  diluted earnings per share                                                                                                 |       | $                                     | 0.26       |                                | $          | 0.27 |   | $ | 0.65 |   | $ | 0.36 |   |

 

The fair value of stockoptions and warrants was estimated on the date of grant using the Black-Scholesoption pricing model using the following assumptions:

 
| ** **                                | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                | ** ** | **2003**                              | ** ** | **2004**                            | ** ** | **2003** | ** ** | **2004** | ** ** |
| Weighted-average  risk-free interest rate |       | 2.4                                   | %          | 3.6                                 | %          | 2.4 | % | 3.3 | % |
| Weighted-average  dividend yield          |       | 0.0                                   | %          | 0.0                                 | %          | 0.0 | % | 0.0 | % |
| Weighted-average  volatility              |       | 44.3                                  | %          | 41.6                                | %          | 44.3 | % | 41.5 | % |
| Weighted-average  expected life           |       | 3.1 years                             |       | 4.0 years                           |       | 3.1 years |   | 4.0 years |   |

 

During the three monthsended June 30, 2003, the Company awarded 164,300 shares of restrictedstock under the 2002 Plan. The restricted shares were issued at no cost to therecipients; therefore, the Company recorded deferred compensation ofapproximately $2.9 million based on the market value of the stock at the dateof issuance.  Subsequent to the grantdate, certain forfeitures of restricted stock have occurred resulting in atotal award of 155,000 shares and total deferred compensation of $2.8million.  The deferred compensationcharge is being amortized to expense over the vesting period of the restrictedstock. The restricted shares vest over a three-year period ending July 1,2006, with acceleration of the vesting period occurring if a certain stockprice or performance target is achieved. For the three months ended June 30,2003 and 2004, approximately $0.1 and $0.2 million, respectively, of deferredcompensation was amortized to expense related to this

 

11

----

 

grant.  Forthe six months ended June 30, 2003 and 2004, approximately $0.1 and $0.5million, respectively, of deferred compensation was amortized to expenserelated to this grant.

 

During the three monthsended March 31, 2004, the Company awarded 132,000 shares of restrictedstock under the 2002 Plan.  Therestricted shares were issued at no cost to the recipients; therefore, theCompany recorded deferred compensation of approximately $3.5 million based onthe market value of the stock at the date of issuance.  Subsequent to the grant date, certainforfeitures of restricted stock have occurred resulting in a total award of126,750 shares and total deferred compensation of $3.3 million.  The deferred compensation charge is beingamortized to expense over the vesting period of the restricted stock.  The restricted shares vest at the end of athree-year period ending January 10, 2007, with acceleration of thevesting period occurring if certain performance targets are achieved.  For the three and six months ended June 30,2004, approximately $0.2 million and $0.5 million of deferred compensation wasamortized to expense related to this grant.

 

During the three monthsended June 30, 2004, the Company awarded 50,550 shares of restricted stockunder the 2002 Plan.  The restrictedshares were issued at no cost to the recipients; therefore, the Companyrecorded deferred compensation of approximately $1.2 million based on themarket value of the stock at the date of issuance.  The deferred compensation charge is beingamortized to expense over the vesting period of the restricted stock.  The restricted shares vest on January 10,2007 and May 26, 2007, with acceleration of the vesting period for certainshares occurring if certain performance targets are achieved.  For the three months ended June 30,2004, approximately $0.1 million of deferred compensation was amortized toexpense related to this grant.

 

Total deferred compensationamortized to expense related to the restricted stock grants was approximately$0.5 million and $1.1 million during the three and six months ended June 30,2004, respectively, and approximately $0.1 million during the three and sixmonths ended June 30, 2003.

 

*Common Stock Repurchase Program*

 

During 2003, the Companyactivated the $30.0 million stock repurchase program authorized by the Board ofDirectors in April 2001 and purchased 1,306,979 shares of its common stockat a cost of approximately $20.7 million. During the three months ended June 30, 2004, the Company purchasedan additional 361,415 shares of its common stock at a cost of approximately$9.3 million completing the original repurchase program.  The repurchased shares were recorded in theaccompanying balance sheet as a reduction in common stock, additionalpaid-in-capital, and retained earnings. These shares have been retired and returned to the status of authorizedbut unissued shares of the Company. During the third quarter of 2004, the Board of Directors authorized the purchaseof an additional $20 million of shares from time to time in the open market asconditions warrant.

 

*Net Income Per Share:*

 

Basic and diluted net incomeper common share were computed in accordance with SFAS No. 128, *Earnings Per Share*. The differencesbetween basic weighted average common shares and diluted weighted averagecommon shares and potentially dilutive common shares are as follows (inthousands):

 
| ** **                                                                         | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                         | ** ** | **2003**                              | ** ** | **2004**                            | ** ** | **2003** | ** ** | **2004** | ** ** |
| Basic weighted  average common shares                                              |       | 16,319                                |       | 16,014                              |       | 16,762 |   | 16,055 |   |
| Weighted  average options, warrants, restricted stock and contingent consideration |       | 62                                    |       | 360                                 |       | 42 |   | 356 |   |
| Diluted  weighted average common shares                                            |       | 16,381                                |       | 16,374                              |       | 16,804 |   | 16,411 |   |

 

At June 30, 2003 and2004, approximately 3.7 million and 2.0 million, respectively, of common shareswere not included in the diluted earnings per share calculation because theywere anti-dilutive.  These potentiallydilutive common shares may be dilutive to future earnings per sharecalculations.

 

**4. Discontinued Operations**

 

During thefirst quarter of 2004, the Company completed a strategic evaluation of itsoperations based on certain criteria, such as strategic and financial fit, andfuture growth prospects.  As a result, onMay 6, 2004, the Company formally committed to a plan of divestiture forcertain non-strategic asset groups related to its Direct Mail operationsreported in the Information Management and Distribution segment in priorperiods, and two medical records management operations reported in theHealthcare, Regulatory and Legal Compliance segment in prior periods.  The Direct Mail operations and the twomedical records management operations are accounted for as discontinuedoperations.  As such, the operatingassets and liabilities of these operations are presented in the condensed consolidatedbalance sheets as Assets and Liabilities of Discontinued Operations and theresults associated with these operations are presented in the condensed consolidatedstatement of operations as Income (Loss) from Discontinued Operations, net oftax.

 

During thesecond quarter of 2004, the Company completed the sale of one of the medicalrecords management operations, which resulted in approximately $0.8 million ofcash proceeds and a pre-tax gain on disposal of approximately $0.5million.  Additionally, the Companyrecognized a pre-tax loss on disposal related to the Direct Mail operations ofapproximately $2.2 million.

 

During thethird quarter of 2004, the Company completed the sale of the Direct Mailoperations and the remaining medical records management operation, resulting inthe recognition of a net pretax gain of $0.4 million.  In connection with these transactions, theCompany received approximately $6.1 million of cash proceeds, net oftransaction costs, approximately $1.5 million of 12 percent securedsubordinated notes, which the Company fully reserved for related to the DirectMail operations and $0.6 million of contingent consideration related to a contractrenewal at the medical records management operation. 

 

12

----

 

During thefourth quarter of 2004, the contingency surrounding the contract renewal at themedical records management operation was resolved.  As such, the Company recognized additionalconsideration of $0.6 million offset by approximately $0.1 million ofincremental loss related to finalizing the consideration related to thedivestiture.

 

The collectionof the reserved subordinated notes could result in a future reduction of thetotal loss recognized related to the disposition of the Direct Mail operations.

 

13

----

 

Summarized selectedfinancial information for the discontinued operations is as follows (inthousands):

 
| ** **                                             | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                             | ** ** | **2003**                              | ** ** | **2004**                            | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                                             | ** ** | **(Unaudited)**                       | ** ** | **(Unaudited)**                     | ** ** |
| **REVENUE**                                            |       | $                                     | 9,596      |                                | $          | 6,937 |   | $ | 20,657 |   | $ | 15,526 |   |
| **COST OF  SERVICES**                                  |       | 7,245                                 |       | 6,332                               |       | 14,918 |   | 12,732 |   |
| **DEPRECIATION**                                       |       | 423                                   |       | 128                                 |       | 871 |   | 529 |   |
| Gross profit                                           |       | 1,928                                 |       | 477                                 |       | 4,868 |   | 2,265 |   |
| **SELLING,  GENERAL AND ADMINISTRATIVE EXPENSES**      |       | 2,522                                 |       | 1,735                               |       | 5,162 |   | 4,346 |   |
| **AMORTIZATION**                                       |       | —                                |       | —                              |       | — |   | — |   |
| Operating  loss                                        |       | (594                                  | )          | (1,258                              | )          | (294 | ) | (2,081 | ) |
| **OTHER  (INCOME) EXPENSE:**                           |       |                                  |       |                                |       |   |   |   |   |
| Interest and  other expense (income), net              |       | (15                                   | )          | 32                                  |       | (22 | ) | 21 |   |
| Loss on sale  of asset groups                          |       | —                                |       | 1,732                               |       | — |   | 1,732 |   |
| Loss from  discontinued operations before income taxes |       | (579                                  | )          | (3,022                              | )          | (272 | ) | (3,834 | ) |
| **PROVISION  FOR INCOME TAXES**                        |       | (232                                  | )          | (1,209                              | )          | (109 | ) | (1,534 | ) |
| **LOSS  FROM DISCONTINUED OPERATIONS**                 |       | $                                     | (347       | )                                   | $          | (1,813 | ) | $ | (163 | ) | $ | (2,300 | ) |

 

The assets and liabilitiesof the discontinued operations are stated separately on the condensedconsolidated balance sheets.  The majorasset and liability categories are as follows (in thousands):

 
| ** **                                                             | ** ** | **December 31,  2003** | ** ** | **June 30,  2004** | ** ** |
|------------------------------------------------------------------------|------------|-----------------------------|------------|-------------------------|------------|
| ** **                                                             | ** ** | **(Unaudited)**             | ** ** |
| **ASSETS  OF DISCONTINUED OPERATIONS**                                 |       |                        |       |                    |       |
| **CURRENT  ASSETS:**                                                   |       |                        |       |                    |       |
| Accounts and  notes receivable, net of allowance for doubtful accounts |       | $                           | 5,693      |                    | $          | 4,069 |   |
| Inventories                                                            |       | 1,130                       |       | 820                     |       |
| Prepaid  expenses and other current assets                             |       | 730                         |       | 503                     |       |
| Total  current assets                                                  |       | 7,553                       |       | 5,392                   |       |
| **PROPERTY,  PLANT AND EQUIPMENT,** net of accumulated depreciation    |       | 6,923                       |       | 4,168                   |       |
| **OTHER  NONCURRENT ASSETS**                                           |       | 182                         |       | 158                     |       |
| Total assets  of discontinued operations                               |       | $                           | 14,658     |                    | $          | 9,718 |   |
| **LIABILITIES OF DISCONTINUED OPERATIONS**                             |       |                        |       |                    |       |
| **CURRENT  LIABILITIES:**                                              |       |                        |       |                    |       |
| Accounts  payable and accrued liabilities                              |       | $                           | 5,423      |                    | $          | 3,862 |   |
| Total  liabilities of discontinued operations                          |       | $                           | 5,423      |                    | $          | 3,862 |   |

 

14

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**5. Business Combinations**

 

*2004 Acquisition*

 

On April 15, 2004, theCompany acquired 100% of the membership interests of KeyPointConsulting LLC (“KeyPoint”), located in Emeryville and Los Angeles,California.  The aggregate considerationpaid during the second quarter for KeyPoint consisted of $13.7 million incash. In addition, the former members of KeyPoint are eligible to receive up toan additional $1.5 million in cash less amounts used to offset indemnificationclaims, if any, for a breach of representations or warranties of theacquisition agreement. The allocation of the purchase price is set forth below(in thousands):

 
| Total  consideration                               |   | $      | 15,020 |   |
|----------------------------------------------------|--------|--------|--------|--------|
| Less  Estimated Fair Value of Identifiable Assets: |   |   |   |
| Cash                                               |   | (1,427 | )      |
| Receivables                                        |   | (1,000 | )      |
| Prepaid  expenses                                  |   | (21    | )      |
| Property,  plant and equipment, net                |   | (112   | )      |
| Total Assets                                       |   | (2,560 | )      |
| Plus  Estimated Fair Value of Liabilities:         |   |   |   |
| Accounts  payable and accrued expenses             |   | 1,393  |   |
| Accrued  compensation                              |   | 233    |   |
| Deferred tax  liability                            |   | 32     |   |
| Other  liabilities                                 |   | 753    |   |
| Total  Liabilities                                 |   | 2,411  |   |
| Goodwill and  other intangibles                    |   | $      | 14,871 |   |

 

Of the $14.9 million ofgoodwill and other intangibles recorded from the acquisition, approximately$0.3 million was assigned to customer relationships with a useful life ofeight months and approximately $1.9 million was assigned to non-competeagreements with a useful life of four years. The remaining goodwill of$12.7 million will be tested annually for impairment.  Approximately $4.6 million of the goodwill isdeductible for tax purposes.

 

*Goodwill and Intangibles*

 

The changes in the carryingvalue of goodwill and the components of intangibles are as follows (inthousands):

 

Goodwill:

 
| ** **                                           | ** ** | **Information  Management and  Distribution** | ** ** | **Healthcare,  Regulatory  and Legal  Compliance** | ** ** | **Total** | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------------|------------|-----------|------------|
| Net balance  as of January 1, 2004              |       | $                                             | 175,945    |                                               | $          | 131,968   |       | $ | 307,913 |   |
| Goodwill  acquired                                   |       | —                                        |       | 12,708                                             |       | 12,708    |       |
| Additional  contingent consideration and adjustments |       | 348                                           |       | 506                                                |       | 854       |       |
| Net balance as  of June 30, 2004                |       | $                                             | 176,293    |                                               | $          | 145,182   |       | $ | 321,475 |   |

 

Intangibles:

 
| ** **              | ** ** | **June 30, 2004**    | ** ** |
|-------------------------|------------|---------------------------|------------|
| ** **              | ** ** | **Gross  Carrying Value** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Intangibles** | ** ** |
| Customer  Relationships |       | $                         | 4,283      |   | $ | (773 | ) | $ | 3,510 |   |
| Non-Compete  Agreements |       | 2,321                     |       | (337 | ) | 1,984 |   |
| Total                   |       | $                         | 6,604      |   | $ | (1,110 | ) | $ | 5,494 |   |

 

15

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Aggregate amortizationexpense related to intangibles for the six months ended June 30, 2004 was$0.4 million. Estimated amortization expense for the periods ending December 31,2004 through December 31, 2016 is presented in the table below.

 
| **Years Ending December 31,** | ** ** | **Estimated Amortization  Expense** | ** ** |
|------------------------------------|------------|-------------------------------------|------------|
| ** **                         | ** ** | **(in thousands)**                  | ** ** |
| 2004                               |       | $                                   | 991        |   |
| 2005                               |       | 825                                 |       |
| 2006                               |       | 825                                 |       |
| 2007                               |       | 737                                 |       |
| 2008                               |       | 384                                 |       |
| 2009 through  2016                 |       | 2,133                               |       |
| Total                              |       | $                                   | 5,895      |   |

 

*Contingent Consideration*

 

Certain of the Company’sacquisitions are subject to adjustments in overall consideration and recordedgoodwill based upon the achievement of specified revenue and/or earningstargets generally over one to three year periods. In certain agreements, theCompany reserves the right to change the payment mix to use common stock versuscash in satisfying contingent consideration liabilities. In transactions wherethe Company acquired a subsidiary through a tax-free stock merger, the Companyis required to pay a minimum amount of total consideration in common stockrather than cash, including any contingent consideration payments.

 

As of June 30, 2004,approximately $1.7 million of additional consideration is accrued of which$0.9 million is classified as accounts payable and accrued liabilities andis expected to be settled in cash and $0.8 million is classified asadditional paid-in-capital and is expected to be settled in common stock withfinal valuation determined at date of issuance.

 

Not all of the periodsapplicable for earnout targets are completed and additional amounts may bepayable in future periods under the terms of the agreements.  If all earnout targets under the currentagreements were achieved, the maximum contingent consideration to be paid wouldbe $7.1 million, including the $1.7 million accrued at June 30, 2004,with approximately $1.7 million to be paid in 2004 and approximately$5.4 million to be paid in 2005.  Inaccordance with the agreements, the Company would be required to satisfyapproximately $0.8 million of the $7.1 million potential liability incommon stock related to a past tax-free stock merger and has the option tosatisfy $5.3 million of the $7.1 million potential liability incommon stock with final valuation for the number of shares to be determined atdate of issuance.  The remainingpotential liability would be paid in cash, as specified in the agreements.  These amounts exclude the contingentconsideration overpayments disclosed in Note 2.

 

# *Other AccruedConsideration*

 

During the first quarter of2004, the Company accrued additional purchase proceeds of approximately $0.4million pursuant to the purchase agreement of a past acquisition.  This amount is classified as accounts payableand accrued liabilities and is expected to be paid in cash during 2004.

 

During the three monthsended June 30, 2004, the Company accrued additional purchase proceeds ofapproximately $1.5 million related to the KeyPoint acquisition.  This amount is classified as accounts payableand accrued liabilities and, provided there is no breach of representations orwarranties of the acquisition agreement, is expected to be paid in cash during2004.

 

*Acquisition Related Payments*

 

During the six months ended June 30,2004, the Company paid net consideration of approximately $2.7 million in cashrelated to contingent consideration agreements of past acquisitions.  In addition, the Company paid $12.3 million,net of cash acquired, related to the KeyPoint acquisition and the associatedtransaction costs.

 

**6. Segment Reporting**

 

The Company aggregates itsservice offerings and operations into two reportable segments:(i) Information Management and Distribution, and (ii) Healthcare,Regulatory, and Legal Compliance. The Company’s reportable segments areorganized around customer types and service offerings possessing similareconomic characteristics. Management evaluates segment performance based onrevenue and income from continuing operations before income taxes. All centrallyincurred corporate costs are allocated to the segments based principally onoperating income. The reporting segments follow the same accounting policiesused for the Company’s consolidated financial statements.

 

16

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The identified segments areas follows:

 

**InformationManagement and Distribution.**  This segment offers BusinessProcess Outsourcing (“BPO”) solutions that help its customers manage the *Document In-flow*, *Workflow Processing* and *Statement Out-flow* of their missioncritical business document processes. This segment’s BPO solutions enablecustomers to automate their complex workflow processes by digitizing extremelylarge volumes of documents, capturing information from the documents, hostingelectronic documents on the Company’s Web-based repository, and preparingstatements that customers mail or present electronically to their end users.

 

**Healthcare,Regulatory and Legal Compliance.**  This segment offers specializedknowledge-based processing and consulting services that include medical recordsrelease, record management services for healthcare institutions, temporarystaffing for healthcare institutions, managed care compliance reviews, classaction claims administration, and professional economic research and litigationservices.

 

The Company measures segmentprofit as income from continuing operations before income taxes. Information onthe segments follows (in thousands):

 
| ** **                                             | ** ** | **THREE MONTHS ENDED JUNE 30,  2004**     | ** ** |
|--------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                             | ** ** | **Information  Management  and  Distribution** | ** ** | **Healthcare,  Regulatory  and Legal  Compliance** | ** ** | **Consolidated** | ** ** |
| Revenue                                                |       | $                                              | 54,381     |   | $ | 43,566 |   | $ | 97,947 |   |
| Income from  continuing operations before income taxes |       | 5,155                                          |       | 5,943 |   | 11,098 |   |
|                                                        |            |                                                |            |  |  |  |  |  |  |  |

 
| ** **                                             | ** ** | **THREE MONTHS ENDED JUNE 30,  2003**     | ** ** |
|--------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                             | ** ** | **Information  Management  and  Distribution** | ** ** | **Healthcare,  Regulatory  and Legal  Compliance** | ** ** | **Consolidated** | ** ** |
| Revenue                                                |       | $                                              | 51,972     |   | $ | 39,284 |   | $ | 91,256 |   |
| Income from  continuing operations before income taxes |       | 4,756                                          |       | 4,297 |   | 9,053 |   |
|                                                        |            |                                                |            |  |  |  |  |  |  |  |

 
| ** **                                             | ** ** | **SIX MONTHS ENDED JUNE 30,  2004**       | ** ** |
|--------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                             | ** ** | **Information  Management  and  Distribution** | ** ** | **Healthcare,  Regulatory  and Legal  Compliance** | ** ** | **Consolidated** | ** ** |
| Revenue                                                |       | $                                              | 106,789    |   | $ | 88,034 |   | $ | 194,823 |   |
| Income from  continuing operations before income taxes |       | 4,180                                          |       | 11,171 |   | 15,351 |   |
|                                                        |            |                                                |            |  |  |  |  |  |  |  |

 
| ** **                                             | ** ** | **SIX MONTHS ENDED JUNE 30,  2003**       | ** ** |
|--------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                             | ** ** | **Information  Management  and  Distribution** | ** ** | **Healthcare,  Regulatory  and Legal  Compliance** | ** ** | **Consolidated** | ** ** |
| Revenue                                                |       | $                                              | 105,992    |   | $ | 82,621 |   | $ | 188,613 |   |
| Income from  continuing operations before income taxes |       | 11,182                                         |       | 10,050 |   | 21,232 |   |
|                                                        |            |                                                |            |  |  |  |  |  |  |  |

 

**7. Litigation**

 

The Company is, from time totime, a party to litigation arising in the normal course of business. Thefollowing is a description of the most significant legal matters that theCompany is involved in.  In the event ofan adverse outcome in one or more of the legal proceedings, operating resultsfor a given quarter may be negatively impacted.

 

*Healthcare MarketingAssociates, Inc. vs. Managed Care Professionals, Inc.*

 

On February 9, 1995,prior to the acquisition by the Company, Managed Care Professionals, Inc.(one of the Company’s wholly-owned subsidiaries) (“MCP”) entered into an “ExclusiveMarketing Agreement” with Healthcare Marketing Associates, Inc. (“HMA”)whereby MCP granted to HMA the exclusive right to market, and HMA agreed tomarket exclusively for MCP, the MCP products and services to health careproviders in the United States for which MCP agreed to pay HMA a percentage(30%) of gross revenues paid to MCP by the provider (customer). The duration ofthe Agreement was for a period of five (5) years and expired on February 9,2000 (“Termination Date”). On April 27, 2001, HMA filed a lawsuit againstMCP in the Circuit Court of the County of St. Louis, State of Missouri,alleging entitlement to commissions on revenues generated after the TerminationDate from providers who were initially brought to MCP prior to the TerminationDate. In March 2003, this lawsuit was tried before a judge and at theconclusion of the trial, the judge ruled in the plaintiff’s favor in the amountof approximately $1.8 million plus prejudgment and post judgment interest,which equated to approximately $2.4 million in total as of December 31,2003. The judgment amount plus prejudgment interest costs were included in theCompany’s 2002 results. Post judgment interest accrues at a statutory 9%rate.  The Company appealed this rulingand oral arguments for our appeal were heard on February 24, 2004.  On May 4, 2004, the Court of

 

17

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Appeals affirmed the Circuit Court’s judgment.  

 

*Various ROI Copy Charge Matters*

 

From time to time, varioussubsidiaries of the Company that perform release of information (“ROI”)services become defendants to putative class action lawsuits generally allegingthat the charge for reproducing certain medical records is not in conformitywith such plaintiffs’ reading of the applicable regulated charge. Such suitstypically include multiple ROI companies and hospitals as defendants and demandreimbursement for prior charges as well as for prospective pricing adjustments.The Company is currently a party to several such suits in various stages ofdevelopment. The Company believes it has meritorious defenses and intends tocontinue to vigorously defend any claims made against it in these matters.

 

*Mattel v. SOURCECORP*

 

On February 18, 2003,Mattel, Inc. filed suit against the Company in the Los Angeles CountyCalifornia Superior Court. In the suit, the plaintiff alleged that one of theCompany’s subsidiaries is liable for the loss of various products, prototypesand paper documents allegedly stored at one of the subsidiary’s box storagefacilities under theories of breach of contract, breach of fiduciary duty,negligence, breach of implied covenants of good faith and fair dealing and/orconversion. The plaintiff at various times alleged damages ranging from “inexcess of $2.5 million,” to approximately $20 million.  This matter was settled prior to trial, theterms of which settlement are confidential. The settlement and related legalcosts impacted the Company’s first quarter 2004 pre-tax earnings byapproximately $3.9 million.  Furthermore,the impact of the settlement and related legal costs on the Company’s 2004 cashprovided by operating activities will be a net payment of approximately $5.7million, before consideration of taxes.

 

*Spohr. et. al. v. F.Y.I.Incorporated, et. al.*

 

In June 2000, theCompany filed an action styled *F.Y.I.Incorporated v. Spohr, et. al.* in Dallas, Texas, in which itasserted claims for breach of contract, fraud, and negligent misrepresentationagainst the sellers of two related companies the Company acquired in December 1998(the “Texas Action”). The Texas Action was later removed to federal court andultimately dismissed on jurisdictional grounds. The Company reasserted theseclaims in two actions that were later consolidated; one styled *F.Y.I. Incorporated v. Spohr, et. al.* inSuperior Court of the State of California in the County of Sacramento, CaseNo. 01-AS-00721 (the “Sacramento Action”) and one styled *Spohr, et. al. v. F.Y.I. Incorporated, et. al.*in the Superior Court of the State of California in the County of SanFrancisco, Case No. 318703 (the “San Francisco Action”). In theconsolidated action, the Company additionally filed claims against the sellers’accountants and the two sellers filed claims against the Company; however, in February 2004,the judge in the Sacramento Action dismissed the Company’s claims against thesellers’ accountants. The sellers allege that the Company’s former subsidiarywrongfully failed and refused to execute and deliver a requested estoppelcertificate, and that the failure to provide such estoppel certificate harmedthe landlord in that they were allegedly denied favorable terms on arefinancing of the property and were allegedly prevented from completing atimely sale of the property. Sellers allege damages of approximately$1.5 million. The Company asserted damages in excess of $8 million. 

 

**8. 2001Credit Agreement**

 

Pursuant tothe terms of the Company’s 2001 Credit Agreement, Earnings Before Interest, Taxes,Depreciation and Amortization (“EBITDA”) is used in calculating certainleverage and fixed cost coverage ratios. The Company exceeded the allowableleverage ratio of 2.5 times for the quarter ended June 30, 2004, as a result ofthe earn-out overpayments, previously discussed.  This has resulted in a default under the 2001Credit Agreement.  As a result, theCompany has classified the debt under such Credit Agreement as a CurrentMaturity included in the current liability section of its balance sheet, untilsuch time as an appropriate amendment is in place.  The Company is currently working with itslenders to secure such an amendment and it is anticipated that this amendmentwill soon become effective. In any event, as the maturity date of the debt underthe 2001 Credit Agreement is April 1, 2006, unless the maturity date of suchdebt is subsequently modified, such debt will be classified as a CurrentMaturity on and after April 1, 2005.

 

18

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

 

**Internal Investigation**

 

Subsequent to the issuance of our condensed consolidated financial statements for the three and six months ended June 30, 2004, the Company, with the oversight and approval of the Audit Committee of our Board of Directors, initiated an investigation of the financial results of one of our operating subsidiaries in the Information Management and Distribution reportable segment (the “Operating Subsidiary”).  The findings of the investigation concluded that the Operating Subsidiary had incorrectly recognized revenue for certain customer arrangements and omitted certain operating expenses from its reported financial results which in turn resulted in overpayments and overaccruals of amounts of contingent consideration due under the earn-out provisions of the acquisition agreement for the Operating Subsidiary which had been recognized as additional goodwill of the acquired business.  As a result, our condensed consolidated financial statements for the three months and six months ended June 30, 2003 and 2004, and our condensed consolidated balance sheet at December 31, 2003, have been restated from the amounts previously reported.  In addition, we intend to restate the financial statements for the years ended December 31, 2001, 2002 and 2003 in our 2004 Annual Report on Form 10-K.

 

As described in our critical accounting policies, revenue is recognizable when each of the following conditions is met:  persuasive evidence of an arrangement exists, the price is fixed or determinable, delivery has occurred or services have been rendered and collection is reasonably assured.  The investigation has identified certain instances where one or more of the aforementioned revenue recognition conditions as applied to certain customer contracts were not met by the Operating Subsidiary.  As such, the revenue previously recognized that did not meet all the revenue recognition conditions above has been reversed,  resulting in a downward adjustment to certain asset accounts or the recognition of a customer liability or deferred revenue, if the customer has paid the invoices related to the reversed revenue.  Notwithstanding the reversal of revenue, the direct costs associated with the reversed revenue continue to be reported in the period incurred.  In addition, we have evaluated the direct costs related to deferred revenue and have determined to continue to include the direct costs in the period incurred due to the uncertainty regarding the future recoverability of the associated costs.  The following table identifies the revenue adjustments by issue that will be reflected in the restated financial statements for the three months and six months ended June 30, 2003 and 2004:

 
| **(In Thousands)**            | ** ** | **Three Months   Ended   June 30, 2003** | ** ** | **Six Months   Ended   June 30, 2003** | ** ** | **Three Months   Ended   June 30, 2004** | ** ** | **Six Months   Ended   June 30, 2004** | ** ** |
|-------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|
| Asset  accounts               |       | $                                             | (36        | )                                           | $          | (171                                          | )          | $                                           | 37         |   | $ | (2,734 | ) |
| Customer  liability, net      |       |                                          | (289       | )                                           |       | (661                                          | )          |                                        | 692        |   |   | (781 | ) |
| Deferred  revenue, net        |       |                                          | (593       | )                                           |       | (1,193                                        | )          |                                        | (232       | ) |   | (871 | ) |
| Total Net  Revenue Adjustment |       | $                                             | (918       | )                                           | $          | (2,025                                        | )          | $                                           | 497        |   | $ | (4,386 | ) |

 

**Asset Accounts:**

Represents the reversal of previously recognized revenue through the downward adjustment of certain asset accounts where one or more of the aforementioned revenue recognition conditions as applied to certain customer contracts were not met by the Operating Subsidiary.  To the extent that the write-down relates to performed services that exceeded the contractual funding limitation, a portion of the revenue may be recognized in future periods upon customer authorization.

 

**Customer liability, net:**

The Operating Subsidiary in certain instances recognized revenue for services that were never performed. The customers were invoiced for the non-performed services and collection of the invoices has occurred.  A portion of the customer liability may be recognized as revenue in future periods upon successful completion of services or negotiations with the Operating Subsidiary’s customer(s).  Remaining customer liability balances will be extinguished through either customer refund or applying such remaining customer liability against future provided services.

 

**Deferred revenue, net:**

The Operating Subsidiary recognized revenue for performed services although the related contractually required services designed to meet customer-specific acceptance provisions (i.e. quality standards) were not performed.  The customers were invoiced for the performed services and collection of the invoices has occurred.  However, by not complying with the contract, the Operating Subsidiary is unable to reasonably demonstrate that the performed services met the required quality standard(s).  This has resulted in the deferral of revenue for performed services for which acceptance is contingent upon meeting the required quality standard(s).  The Operating Subsidiary will recognize the revenue for performed services upon obtaining explicit acceptance from the customer(s).  In the event customer acceptance is not 

 

19

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obtained, the deferred revenue will be reclassified to a customer liability.  The customer liability will be extinguished through either customer refund or applying such remaining customer liability against future provided services.

 

The investigation identified certain expenses of the Operating Subsidiary that were not properly recorded in the Operating Subsidiary’s consolidated statement of operations.  Certain former members of the Operating Subsidiary’s management allegedly diverted expenses to entities they controlled, but that are unrelated to the Company, resulting in the omission of the related expenses from the Operating Subsidiary’s and, as a result, our previously reported financial results.  We have identified the unrecorded expenses and have recorded them in the period the expenses were incurred as an adjustment to selling, general and administrative expense.  A liability for such an amount has been recorded in other long-term obligations in the restated financial statements.  The liability will be eliminated at such time we recover any contingent consideration overpayments paid to the former owners of the Operating Subsidiary, as discussed below.

 

The revenue recognition and expense omission issues affected previously paid contingent consideration related to the acquisition of the Operating Subsidiary.  As a result of the structure of the acquisition agreement, the former owners of the Operating Subsidiary had the opportunity to earn additional purchase consideration for the twelve-month periods ended February 28, 2002, February 28, 2003 and February 29, 2004 (the “Earn-out Period(s)”) based on earnings before interest and taxes of the Operating Subsidiary, in excess of designated thresholds, calculated in accordance with accounting principles generally accepted in the United States of America for each respective period (the “Earn-out Agreement”).  Based on the findings of the investigation, earnings before interest and taxes attributable to the Operating Subsidiary were overstated during the Earn-out Period(s) resulting in overpayments and overaccruals under the provisions of the Earn-out Agreement that otherwise would not have been made.  We have expensed the contingent consideration overpayments in the financial statements in the periods in which they were paid.  These amounts had previously been accrued as contingent consideration and an addition to goodwill. We have reversed these accruals and related goodwill in the periods originally recorded.  We will record a gain in future periods to the extent such contingent consideration overpayments are recovered.

 

Restating the financial statements for the revenue recognition, expense omission and contingent consideration overpayment issues results in an adjustment to the provision for income taxes and to certain other balance sheet tax accounts for the periods restated.

 

The following tables represent restated financial information from the amounts previously reported as of and for the year ended December 31, 2003 and as of and for the three and six months ended June 30, 2003 and 2004 (in thousands, except per share data):

 

**BALANCESHEET INFORMATION**

**(AllPeriods Presented Unaudited)**

 
| ** **                                        | ** ** | **At December 31, 2003** | ** ** | **At June 30, 2004** | ** ** |
|---------------------------------------------------|------------|-------------------------------|------------|---------------------------|------------|
| ** **                                        | ** ** | **As Previously  Reported**   | ** ** | **As   Restated**         | ** ** | **As Previously  Reported** | ** ** | **As   Restated** | ** ** |
| ** **                                        | ** ** | **(Item 1)**                  | ** ** | ** **                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Accounts and  Notes Receivable, Net               |       | $                             | 67,873     |                      | $          | 63,522 |   | $ | 82,385 |   | $ | 77,286 |   |
|                                              |       |                          |       |                      |       |   |   |   |   |
| Income Tax  Receivable                            |       | $                             | —     |                      | $          | 3,000 |   | $ | — |   | $ | 1,261 |   |
|                                              |       |                          |       |                      |       |   |   |   |   |
| Goodwill                                          |       | $                             | 324,305    |                      | $          | 307,913 |   | $ | 346,400 |   | $ | 321,475 |   |
|                                              |       |                          |       |                      |       |   |   |   |   |
| Total Assets                                      |       | $                             | 470,273    |                      | $          | 452,530 |   | $ | 510,295 |   | $ | 481,532 |   |
|                                              |       |                          |       |                      |       |   |   |   |   |
| Accounts  Payable and Accrued Liabilities         |       | $                             | 52,054     |                      | $          | 52,375 |   | $ | 53,929 |   | $ | 45,736 |   |
|                                              |       |                          |       |                      |       |   |   |   |   |
| Current  Maturities of Long-term Obligations      |       | NC                            |       | NC                        |       | $ | 232 |   | $ | 103,113 |   |
|                                              |       |                          |       |                      |       |   |   |   |   |
| Income tax  payable                               |       | $                             | 2,186      |                      | $          | — |   | $ | 5,686 |   | $ | — |   |
|                                              |       |                          |       |                      |       |   |   |   |   |
| Long-term  Obligations, Net of Current Maturities |       | NC                            |       | NC                        |       | $ | 104,639 |   | $ | 1,758 |   |
|                                              |       |                          |       |                      |       |   |   |   |   |
| Deferred Income  Taxes                            |       | $                             | 18,084     |                      | $          | 11,753 |   | $ | 20,625 |   | $ | 14,294 |   |
|                                              |       |                          |       |                      |       |   |   |   |   |
| Long-term Customer  Liability                     |       | $                             | —     |                      | $          | 1,862 |   | $ | — |   | $ | 3,395 |   |
|                                              |       |                          |       |                      |       |   |   |   |   |
| Deferred  Revenue                                 |       | $                             | —     |                      | $          | 5,135 |   | $ | — |   | $ | 7,237 |   |
|                                              |       |                          |       |                      |       |   |   |   |   |
| Other  Long-term Obligations                      |       | $                             | 7,839      |                      | $          | 9,306 |   | $ | 8,215 |   | $ | 9,686 |   |
|                                              |       |                          |       |                      |       |   |   |   |   |
| Retained  Earnings                                |       | $                             | 119,236    |                      | $          | 101,225 |   | $ | 123,962 |   | $ | 103,306 |   |
|                                              |       |                          |       |                      |       |   |   |   |   |
| Total  Stockholders’ Equity                  |       | $                             | 311,088    |                      | $          | 293,077 |   | $ | 313,107 |   | $ | 292,451 |   |

 

----

**Item1:**          Amounts as previouslyreported after giving effect to adjustments required to reflect the Company’sdiscontinued operations discussed in Note 4 to the consolidated financialstatements.

 

**Item2:**          NC denotes no change from the previously reported amount.

 

20

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**STATEMENT OF OPERATIONS INFORMATION**

**(AllPeriods Presented Unaudited)**

 
| ** **                                            | ** ** | **Three Months Ended   June 30, 2003** | ** ** | **Three Months Ended   June 30, 2004** | ** ** | **Six Months Ended   June 30, 2003** | ** ** | **Six Months Ended   June 30, 2004** | ** ** |
|-------------------------------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                            | ** ** | **As Previously  Reported**                 | ** ** | **As   Restated**                           | ** ** | **As Previously  Reported**               | ** ** | **As   Restated**                         | ** ** | **As Previously  Reported** | ** ** | **As   Restated** | ** ** | **As Previously  Reported** | ** ** | **As   Restated** | ** ** |
| ** **                                            | ** ** | **(Item 1)**                                | ** ** | ** **                                  | ** ** | ** **                                | ** ** | ** **                                | ** ** | **(Item 1)** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                                               |       | $                                           | 92,174     |                                        | $          | 91,256                                    |       | $                                         | 97,450     |   | $ | 97,947 |   | $ | 190,638 |   | $ | 188,613 |   | $ | 199,209 |   | $ | 194,823 |   |
|                                                  |       |                                        |       |                                        |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| Gross Profit                                          |       | $                                           | 34,728     |                                        | $          | 33,810                                    |       | $                                         | 36,273     |   | $ | 36,770 |   | $ | 73,265 |   | $ | 71,240 |   | $ | 77,670 |   | $ | 73,284 |   |
|                                                  |       |                                        |       |                                        |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| Selling, General & Administrative Expense         |       | $                                           | 23,957     |                                        | $          | 23,993                                    |       | $                                         | 24,405     |   | $ | 24,414 |   | $ | 47,750 |   | $ | 47,824 |   | $ | 55,793 |   | $ | 55,811 |   |
|                                                  |       |                                        |       |                                        |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| Income From Continuing Operations Before Income Taxes |       | $                                           | 10,007     |                                        | $          | 9,053                                     |       | $                                         | 10,610     |   | $ | 11,098 |   | $ | 23,331 |   | $ | 21,232 |   | $ | 19,755 |   | $ | 15,351 |   |
|                                                  |       |                                        |       |                                        |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| Provision for Income Taxes                            |       | $                                           | 4,003      |                                        | $          | 3,623                                     |       | $                                         | 4,244      |   | $ | 4,439 |   | $ | 9,332 |   | $ | 8,496 |   | $ | 7,902 |   | $ | 6,140 |   |
|                                                  |       |                                        |       |                                        |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| Income From Continuing Operations                     |       | $                                           | 6,004      |                                        | $          | 5,430                                     |       | $                                         | 6,366      |   | $ | 6,659 |   | $ | 13,999 |   | $ | 12,736 |   | $ | 11,853 |   | $ | 9,211 |   |
|                                                  |       |                                        |       |                                        |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| Net Income                                            |       | $                                           | 5,657      |                                        | $          | 5,083                                     |       | $                                         | 4,553      |   | $ | 4,846 |   | $ | 13,836 |   | $ | 12,573 |   | $ | 9,553 |   | $ | 6,911 |   |
|                                                  |       |                                        |       |                                        |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| **Net Income Per Common Share:**                      |       |                                        |       |                                        |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| **Basic**                                        |       |                                        |       |                                        |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| Continuing Operations                                 |       | $                                           | 0.37       |                                        | $          | 0.33                                      |       | $                                         | 0.40       |   | $ | 0.42 |   | $ | 0.84 |   | $ | 0.76 |   | $ | 0.74 |   | $ | 0.57 |   |
|                                                  |       |                                        |       |                                        |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total                                                 |       | $                                           | 0.35       |                                        | $          | 0.31                                      |       | $                                         | 0.28       |   | $ | 0.30 |   | $ | 0.83 |   | $ | 0.75 |   | $ | 0.60 |   | $ | 0.43 |   |
|                                                  |       |                                        |       |                                        |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| **Diluted**                                           |       |                                        |       |                                        |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| Continuing Operations                                 |       | $                                           | 0.37       |                                        | $          | 0.33                                      |       | $                                         | 0.39       |   | $ | 0.41 |   | $ | 0.83 |   | $ | 0.76 |   | $ | 0.72 |   | $ | 0.56 |   |
|                                                  |       |                                        |       |                                        |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total                                                 |       | $                                           | 0.35       |                                        | $          | 0.31                                      |       | $                                         | 0.28       |   | $ | 0.30 |   | $ | 0.82 |   | $ | 0.75 |   | $ | 0.58 |   | $ | 0.42 |   |

 

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**Item1:****         **Amountsas previously reported after giving effect to adjustments required to reflectthe Company’s discontinued operations discussed in Note 4 to the consolidatedfinancial statements.

 

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The following discussionshould be read in conjunction with our financial statements and the relatednotes thereto appearing elsewhere in this Report on Form 10-Q/A.  In addition, the following discussion giveseffect to the restatement adjustments discussed above.

 

**Overview**

 

We werefounded in September 1994, to create a national, single source provider ofdocument and information outsourcing solutions to document and informationintensive industries, including healthcare, legal and tax, financial services,federal and state government, and other commercial services.

 

We acquiredthe seven Founding Companies (the “Founding Companies”) simultaneously with theclosing of our initial public offering (the “IPO”) on January 26, 1996,and effectively began operations at that time. The consideration for theFounding Companies consisted of a combination of cash and common stock of ourCompany.  Since the IPO and through December 31,2003, we acquired 65 companies and divested 17 operating units by sales orclosures. We evaluate candidates for acquisition and periodically fordivestiture as a part of our strategic plan of providing customers a singlesolution for business process outsourcing and knowledge-based processing andconsulting services. The criteria for evaluation include geographic need,additional technology, market growth potential, industry expertise, serviceexpansion to broaden service offerings, expansion of our customer base, revenueand earnings growth potential, and expected sources and uses of capital.

 

On May 4,2004, we announced the acquisition of KeyPoint Consulting, LLC (“KeyPoint”).  KeyPoint, located in Emeryville and LosAngeles, California, provides economic, financial, and forensic accountingservices to law firms, corporations and government agencies.  KeyPoint merged with our legal consultingservice offering and is reported in the Healthcare, Regulatory and LegalCompliance segment.  Once integrated intothe Company’s current legal consulting service offering, Keypoint is expectedto contribute to earnings during 2005 after related intangible amortization andacquisition financing costs.

 

During thefirst quarter of 2004, we completed a strategic evaluation of our operationsbased on certain criteria, such as strategic and financial fit, and futuregrowth prospects.  As a result, on May 6,2004, we formally committed to a plan of divestiture for certain non-strategicasset groups.  The asset groups to bedivested include the Direct Mail operations, previously reported in ourInformation Management and Distribution segment, and two medical recordsmanagement operations that were reported in our Healthcare, Regulatory andLegal Compliance segment. Collectively, these asset groups incurred losses, netof tax, of $0.8 million for the full year ended December 31, 2003.  During the quarter ended June 30, 2004,we completed the sale of one of the medical records management operations.  The divestiture of the other medical recordsmanagement operation and the Direct Mail operations were completed during thequarter to end September 30, 2004. See Note 4, Discontinued Operations, of Notes to Condensed ConsolidatedFinancial Statements, for a more detailed discussion, including the adjustmentsthat were recorded during the current quarter.

 

**Basis for Management Discussion andAnalysis**

 

The following discussion andanalysis focuses on the results of operations and financial condition from theCompany’s continuing operations; as such, in accordance with Statement ofFinancial Accounting Standards No. 144, references and comparisons to priorperiods exclude the impact of our discontinued operations.

 

Our revenue possesses bothproject and recurring characteristics. Project revenue includes one-time projects in which the customerrelationship is not expected to continue after project completion. Projectrevenue margins are usually higher than our average margins and the workloadcan be highly volatile.  Project revenueis typically based on time and material arrangements and predominately occurswithin the Healthcare, Regulatory and Legal Compliance segment.  Recurring revenue is characterized bycustomer relationships that are generally for one year and may continue forlonger.  Recurring revenue is typicallybased on transaction volumes sent to us by our customers at an agreed uponfixed rate per unit.  Our customers’volumes are generally not contractually or otherwise guaranteed.  Recurring revenue typically possesses lowermargins than project revenue but is usually more predictable.

 

Cost of services consistsprimarily of compensation and benefits to employees providing goods andservices to our clients; occupancy and facility costs; equipment costs andsupplies. Our cost of services also includes the cost of products sold formicrographics supplies and equipment; computer hardware and software; andbusiness imaging supplies and 

 

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equipment.

 

Selling, general andadministrative expenses (“SG&A”) consist primarily of compensation andrelated benefits to sales and marketing, executive management, accounting,human resources and other administrative employees; other sales and marketingcosts; communications costs; general business insurance costs; and legal andaccounting professional fees and expenses.

 

In addition,except for the restatement issues identified above, the condensed consolidatedfinancial statements included in Item 1 “Financial Statements”, should be readin conjunction with our consolidated financial statements and the related notesthereto in the Annual Report on Form 10-K filed with the Securities andExchange Commission on March 12, 2004.

 

**Business Segments**

 

We aggregateour service offerings and operations into two reportable segments:(i) Information Management and Distribution, and (ii) Healthcare,Regulatory, and Legal Compliance. Service offerings are aggregated when theyare similar in the following areas: economic characteristics, products andservices, production processes, methods for distributing or deliveringproducts, and type or class of customers. We evaluate segment performance basedon revenue and income before income taxes. All centrally incurred corporatecosts are allocated to the segments based principally on operating income. Thereporting segments follow the same accounting policies used for ourconsolidated financial statements as described in the summary of critical accountingpolicies.  The identified segments are asfollows:

 

**InformationManagement and Distribution.**  We offer Business Process Outsourcing (“BPO”)solutions that help our customers manage the *DocumentIn-flow*, *Workflow Processing*and *Statement Out-flow* of theirmission critical document processes. Our BPO solutions enable customers toautomate their complex workflow processes by digitizing extremely large volumesof documents, capturing information from the documents, hosting electronicdocuments on our Web-based repository, and preparing statements that customersmail or present electronically to their end users.  We offer our BPO solutions to businesses indocument intensive industries, such as healthcare, financial services, federaland state government, and other commercial services vertical industries.  For the three months ended June 30, 2003and 2004, revenue in the Information Management and Distribution segmentconsisted of approximately $46.0 million and $48.6 million of recurringrevenue, respectively, and $6.0 million and $5.8 million of project revenue,respectively.  For the six months ended June 30, 2003 and 2004, revenue in theInformation Management and Distribution segment consisted of approximately$92.9 million and $96.1 million of recurring revenue, respectively andapproximately $13.1 million and $10.7 million of project revenue, respectively.

 

**Healthcare,Regulatory and Legal Compliance.**  We offer specialized knowledge-basedprocessing and consulting services that include medical records release, recordmanagement services for healthcare institutions, temporary staffing forhealthcare institutions, managed care compliance reviews, class action claimsadministration, and professional economic research and litigation services. Forthe three months ended June 30, 2003 and 2004, revenue in the HealthcareRegulatory and Legal Compliance segment consisted of approximately $14.0million and $14.6 million of recurring revenue, respectively, and $25.3 millionand $29.0 million of project revenue, respectively.  Forthe six months ended June 30, 2003 and 2004, revenue in the Healthcare,Regulatory and Legal Compliance segment consisted of approximately $28.4million and $28.3 million of recurring revenue, respectively, and approximately$54.2 million and $59.7 million of project revenue, respectively.

 

23

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**THREEMONTHS ENDED JUNE 30, 2003 COMPARED TO THREE MONTHS ENDED JUNE 30,2004**

 
| ** **                                                 | ** ** | **Three Months Ended June 30,** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                 | ** ** | **2003**                             | ** ** | **2004** | ** ** |
| ** **                                                 | ** ** | **($000’s)**                    | ** ** | **% of  Revenue** | ** ** | **($000’s)** | ** ** | **% of  Revenue** | ** ** |
| ** **                                                 |       |                                 |       |   |   |   |   |   |   |   |   |
| **Revenue**                                                |       | $                                    | 91,256     |   | 100.0 | % | $ | 97,947 |   | 100.0 | % |
| **Gross  Profit**                                          |       | 33,810                               |       | 37.0 | % | 36,770 |   | 37.5 | % |
| **SG&A**                                               |       | 23,993                               |       | 26.3 | % | 24,414 |   | 24.9 | % |
| **Operating  income**                                      |       | 9,729                                |       | 10.7 | % | 12,044 |   | 12.3 | % |
| **Income  from continuing operations before income taxes** |       | 9,053                                |       | 9.9 | % | 11,098 |   | 11.3 | % |
| **Income  from continuing operations**                     |       | 5,430                                |       | 6.0 | % | 6,659 |   | 6.8 | % |

 

**Revenue**

 

Our operations generatedrevenues of $97.9 million for the three months ended June 30, 2004, anincrease of 7.3% compared to the same period in 2003.  During the second quarter of 2004, weacquired KeyPoint Consulting, LLC (“KeyPoint”) as a part of ourHealthcare, Regulatory and Legal Compliance segment.  KeyPointcontributed approximately $2.0 million to the revenue increase.  Additionally, strong volumes in our projectoriented class action claims administration service offering contributedapproximately $2.4 million to the year-over-year increase.  Project revenue accounted for $34.8 millionor 35.5% of revenue in the current quarter compared to $31.3 million or 34.3%of revenue in the prior year quarter. (See “Management’s Discussion and Analysis of FinancialCondition and Results of Operations—Basis for Management Discussion andAnalysis.”)

 

Revenue within ourInformation Management and Distribution segment increased 4.6% from $52.0million for the three months ended June 30, 2003 to $54.4 million for thethree months ended June 30, 2004. Project revenue accounted for 10.5% of segment revenue in the secondquarter of 2004 compared to 11.7% for the same period in 2003.  Revenue in the Information Management serviceoffering increased as higher volumes from our financial services customers werepartially offset by lower volumes from government services customers.  Also contributing to the increase in segmentrevenue were higher volumes in our statement processing service offering, whichwere up approximately 8% or $0.6 million.

 

Revenue within ourHealthcare, Regulatory and Legal Compliance segment increased 10.9% from $39.3million for the three months ended June 30, 2003 to $43.6 million for thethree months ended June 30, 2004. Project revenue accounted for 66.7% ofsegment revenue in the second quarter of 2004 and 64.2% for the same period in2003.  The acquisition of KeyPoint contributedapproximately $2.0 million to the increase. Also contributing to the revenue increase were higher project volumes inour class action claims administration service offering, which increasedapproximately 51%, or $2.5 million, and slightly higher volumes in our releaseof medical information service offering.

 

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**Gross profit**

 

Gross profit increased 8.8%from $33.8 million, or 37.0% of revenue, for the three months ended June 30,2003 to $36.8 million, or 37.5% of revenue, for the three months ended June 30,2004 driven primarily by higher revenue. Factors impacting gross profit and gross margin are discussedbelow.

 

Asdiscussed in “Internal Investigation” above, certain revenue generated at anOperating Subsidiary in our Information Management and Distribution segment hasbeen deferred to future periods or reversed as certain revenue recognitioncriteria, as applied to certain customer contracts, were not met.  However, the costs associated with the adjustedrevenue continue to be reported in the period incurred.  As a result of the adjusted revenue, grossmargin was negatively impacted 0.7% during the three months ended June 30,2003 and positively impacted 0.3% during the three months ended June 30, 2004.

 

Also contributing to theincrease in gross margin were lower personnel related costs, which decreasedfrom 47.3% of revenue in the prior year quarter to 44.1% of revenue in thecurrent quarter.  Key contributors to thedecline were: (i) an unusually large medical claims expense of approximately$1.1 million incurred in the prior year quarter, and (ii) our productivity andtechnology initiatives, such as high speed-scanners, offshore production andpay-for-performance compensation plans.

 

Partially offsetting theimprovement in personnel related costs were: (i) a lower mix of federal government project work, (ii) higherfacilities costs related primarily to the opening of new facilities, mainly tosupport growth initiatives within our Information Management and Distributionsegment, and (iii) higher bad debt expense of approximately $0.9 million as theprior year quarter experienced an unusually large collection of accountsreceivable outstanding greater than ninety days.

 

**Selling, general and administrativeexpenses**

 

SG&Aincreased 1.8% from $24.0 million, or 26.3% of revenue, for the three monthsended June 30, 2003 to $24.4 million, or 24.9% of revenue, for the threemonths ended June 30, 2004. The slight increase in SG&A expenserelates primarily to higher travel expenses and marketing costs.

 

**Income fromcontinuing operations before income taxes**

 

Income from continuingoperations before income taxes increased 22.6% from $9.1 million, or 9.9% ofrevenue, for the three months ended June 30, 2003, to $11.1 million, or11.3% of revenue, for the three months ended June 30, 2004.  The increase in income from continuingoperations before income taxes was largely attributable to the factorsaffecting gross profit and SG&A expense discussed above.  In addition, interest expense was lower byapproximately $0.3 million in the current year quarter due to a more favorableinterest rate environment.  The prioryear quarter included a gain on sale of fixed assets of approximately $0.3million compared to a loss in the current year quarter of approximately $0.1 million.

 

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**SIX MONTHS ENDED JUNE 30, 2003COMPARED TO SIX MONTHS ENDED JUNE 30, 2004**

 
| ** **                                                 | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                 | ** ** | **2003**                           | ** ** | **2004** | ** ** |
| ** **                                                 | ** ** | **($000’s)**                  | ** ** | **% of  Revenue** | ** ** | **($000’s)** | ** ** | **%  of Revenue** | ** ** |
| ** **                                                 |       |                               |       |   |   |   |   |   |   |   |   |
| **Revenue**                                                |       | $                                  | 188,613    |   | 100.0 | % | $ | 194,823 |   | 100.0 | % |
| **Gross  Profit**                                          |       | 71,240                             |       | 37.8 | % | 73,284 |   | 37.6 | % |
| **SG&A**                                               |       | 47,824                             |       | 25.4 | % | 55,811 |   | 28.6 | % |
| **Operating  income**                                      |       | 23,239                             |       | 12.3 | % | 17,072 |   | 8.8 | % |
| **Income  from continuing operations before income taxes** |       | 21,232                             |       | 11.3 | % | 15,351 |   | 7.9 | % |
| **Income  from continuing operations**                     |       | 12,736                             |       | 6.8 | % | 9,211 |   | 4.7 | % |

 

**Revenue**

 

Our operations generatedrevenues of $194.8 million for the six months ended June 30, 2004, anincrease of 3.3% compared to the same period in 2003.  The acquisition of KeyPoint during thecurrent year quarter contributed approximately $2.0 million to the revenueincrease.  Also contributing to theyear-over-year increase in revenue were: (i) strong volumes in our projectoriented class action claims administration service offering which were up 44%or $4.9 million, and (ii) strong volumes in our statement processing serviceoffering which were up 9.7% or $1.6 million. Project revenue accounted for $70.4 million or 36.1% of revenue in thecurrent year compared to $67.3 million or 35.7% of revenue in the prior year.(See “Management’s Discussion and Analysis of Financial Condition and Resultsof Operations—Basis for Management Discussion and Analysis.”)

 

Revenue within ourInformation Management and Distribution segment increased 0.8% from $106.0million for the six months ended June 30, 2003, to $106.8 million for thesix months ended June 30, 2004. Project revenue accounted for 10.0% of segment revenue in the currentyear compared to 12.4% for the same period in 2003.  The increase in segment revenue was primarilythe result of higher volumes in our statement processing service offering,which were up approximately 9.7%, or $1.6 million, and increased volumes fromour financial services customers in the information management serviceoffering.  Partially offsetting thisrevenue growth were lower volumes from our government services customers.

 

Revenue within ourHealthcare, Regulatory and Legal Compliance segment increased 6.6% from $82.6million for the six months ended June 30, 2003, to $88.0 million for thesix months ended June 30, 2004. Project revenue accounted for 67.8% ofsegment revenue in the second quarter of 2004 and 65.6% for the same period in2003.  The acquisition of KeyPoint duringthe second quarter of 2004 contributed approximately $2.0 million to theincrease.  Also contributing to therevenue increase were higher project volumes in our class action claims administrationservice offering, which increased approximately 44%, or $4.9 million.  Partially offsetting the growth in segmentrevenues were lower volumes within our legal consulting service offering due tothree significant projects in production during the first six months of 2003and lower volumes in our medical coding service offering

 

**Gross profit**

 

Grossprofit increased 2.9% from $71.2 million, or 37.8% of revenue, for the sixmonths ended June 30, 2003, to $73.3 million, or 37.6% of revenue, for thesix months ended June 30, 2004. Factors impacting gross profit and gross margin are discussed below.

 

Asdiscussed in “Internal Investigation” above, certain revenue generated at anOperating Subsidiary in our Information Management and Distribution segment hasbeen deferred to future periods or reversed as certain revenue recognitioncriteria, as applied to certain customer contracts, were not met.  However, the costs associated with theadjusted revenue continue to be reported in the period incurred.  As a result of the adjusted revenue, grossmargin was negatively impacted 0.6% during the six months ended June 30,2003 and 1.4% during the six months ended June 30, 2004.

 

Otherfactors impacting gross margin in the current year consist of:  (i) higher facilities related expenses ofapproximately $1.8 million related to the opening of new production facilities,mainly to support growth initiatives within our Information Management andDistribution segment, and (ii) higher bad debt expense of approximately $1.2million as the prior year reflected unusually large collections of accountsreceivable balances outstanding greater than ninety days.

 

Lowerpersonnel and related costs, as a percentage of revenue, partially offset thefactors negatively impacting gross margin. Personnel related costs, as a percentage of revenue, decreased from46.2% in the prior year to 43.4% in the current year due primarily to: (i)productivity and technology initiatives, such as high speed scanners, offshoreproduction and pay-for-performance compensation plans, and (ii) $1.1 million ofexpense incurred in the prior year related to an unusually large medical claim.

 

26

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**Selling, general and administrativeexpenses**

 

SG&Aincreased 16.7% from $47.8 million, or 25.4% of revenue, for the six monthsended June 30, 2003 to $55.8 million, or 28.6% of revenue, for the sixmonths ended June 30, 2004. The increase in SG&A expense is largelyattributable to: (i) the costs associated with the settlement of a significantlegal matter in the Information Management and Distribution segment during thefirst quarter of 2004 of approximately $3.9 million, (ii) an increase indeferred compensation expense related to restricted stock of approximately $1.0million and other personnel related expense of approximately $0.8 million,(iii) higher travel and marketing costs of approximately $1.0 million, and (iv)other professional fees of approximately $0.5 million.

 

**Income from continuing operationsbefore income taxes**

 

Income from continuingoperations before income taxes decreased 27.7% from $21.2 million, or 11.3% ofrevenue, for the six months ended June 30, 2003 to $15.4 million, or 7.9%of revenue, for the six months ended June 30, 2004.  The decline in income from continuingoperations before income taxes was largely attributable to the increasedSG&A expenses and lower gross margin discussed above, partially offset bylower interest expense.  Interest expensewas lower by approximately $1.1 million in the current year due to a morefavorable interest rate environment and the expiration of the interest rateswap on March 31, 2003.  Interestincome in the prior year included a one-time payment of $0.2 million related toa $2.3 million income tax receivable that was also collected during 2003.  Finally, during the six months ended June 30,2003, a gain of approximately $0.3 million was realized related to the sale ofproperty, plant and equipment compared to a loss in the current year ofapproximately $0.1 million.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

At June 30, 2004, wehad ($46.5) million of working capital, including $5.4 million of cash, whichresulted in part from the classification of $102.9 million of our debt underour 2001 Credit Agreement as a Current Maturity as described below and in Note 8to the condensed consolidated financial statements.  Working capital at December 31, 2003 was$36.6 million, including $2.1 million of cash. For the first six months of2004, net cash provided by operating activities from continuing operations was$5.2 million compared to $38.0 million for the same period in 2003.  Factors contributing to the decline inoperating cash flow from continuing operations consist of: (i) slower cashcollections during the current year resulting in $18.5 million of lower cashprovided by operating activities, (ii) the payment of a significant legalsettlement during the current year’s second quarter of $9.2 million, (iii)higher annual incentive compensation payments compared to the prior year, and(iv) the receipt of income tax refunds of $2.3 million in the prior year.

 

During the current quarterwe experienced payment delays from several sizable customers increasing ourbalance of accounts receivable greater than 90 days outstanding.  During July 2004, we collected asignificant portion of these balances (approximately $10 million).  Days sales outstanding increased fourbusiness days during the quarter to 47 business days at June 30, 2004compared to 43 business days at March 31, 2004.

 

As previously noted, we madepayment of a significant legal settlement during the second quarter of 2004 inthe amount of $9.2 million.  During July 2004,we received an insurance reimbursement of $4.1 million related to thissettlement.  This amount will be includedas a component of our third quarter cash from operating activities.

 

For the six months ended June 30,2004, investing activities from continuing operations consisted of acquisitionsof property, plant and equipment of $8.3 million and net acquisition relatedpayments of $15.0 of which $12.3 million relates to the acquisition of KeyPointConsulting LLC and $2.7 million represents the settlement of contingentconsideration.  Divestiture proceeds of$0.8 million partially offset the cash used by investing activities.  Some future quarters will include additionalsettlements of contingent consideration on past acquisitions. Not all of theperiods applicable for contingent consideration targets have been completed andadditional amounts may be payable in future periods under the terms of theagreements.  If all contingentconsideration targets under the current agreements were achieved, the maximumamount of consideration to be paid would be $7.1 million, withapproximately $1.7 million to be paid in 2004 and approximately$5.4 million to be paid in 2005. In accordance with the agreements, theCompany would be required to satisfy approximately $0.8 million of the$7.1 million potential liability in common stock related to a past tax-freestock merger and has the option to satisfy $5.3 million of the $7.1 millionpotential liability in common stock with final valuation determined at date ofissuance.  The remaining potentialliability would be paid in cash, as specified in the agreements.  These amounts exclude the contingentconsideration overpayments discussed above in “Internal Investigation”.

 

Net cash provided byfinancing activities from continuing operations was $22.2 million for the sixmonths ended June 30, 2004. Payments of $143.5 million on our line of credit were more than offsetby net proceeds borrowed from our line of credit of $174.6 million.  Additionally, net proceeds from common stockissuances of $0.4 million were more than offset by payments of $9.3 millionrelated to shares repurchased.  Weutilize our line of credit to fund general operating requirements of theCompany as well as fund significant investments such as acquisitions or capitalexpenditures.

 

In April 2001,we entered into a line of credit agreement with Bank of America, SunTrust Bankand Wells Fargo Bank, as co-agents (the “2001 Credit Agreement”). Under thisagreement, we could from time to time borrow up to $297.5 million through April 2,2004, subject to certain financial covenants and ratios. Meeting theserequirements is highly dependent upon maintaining a minimum level of operatingresults and the continued demand for our services, among other factors.

 

Effective April 3,2002, we extended $220.0 million of the $297.5 million commitment foran additional year to

 

27

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April 2, 2005. In September 2002,additional extensions were granted by member banks, bringing the totalcommitment extended to April 2, 2005, to $290.0 million. Total feespaid in 2002 related to the extensions and amendments to the 2001 CreditAgreement were $0.3 million.

 

Effective April 3,2003, we extended $230.0 million of the $297.5 million commitment to April 1,2006. During the fourth quarter of 2003, a participating bank in the 2001Credit Agreement assigned $7.5 million of its commitment to another bankwho, effective December 4, 2003, extended this commitment to April 1,2006. Total fees paid in 2003 related to the extensions and amendments to the2001 Credit Agreement were $0.3 million.

 

Managementfully expects to replace or refinance the 2001 Credit Agreement upon itsmaturity scheduled for April 1, 2006.

 

At June 30,2004 the remaining commitment under the 2001 Credit Agreement is $290.0 millionand is scheduled to mature as follows (in millions):

 
| **Maturity Date**   | ** ** | **Commitment** | ** ** | **Remaining  Commitment** | ** ** |
|---------------------|------------|----------------|------------|---------------------------|------------|
| April 2,  2005 |       | $              | 52.5       |                      | $          | 237.5 |   |
| April 1,  2006 |       | 237.5          |       |                      |       |
| Total               |       | $              | 290.0      |                      |       |   |
|                     |            |                |            |                           |            |  |  |

 

Our ability toborrow is contingent on certain leverage and fixed cost coverage ratios. Theseratios were scheduled to become more restrictive beginning in the quarter endedDecember 31, 2002 with the leverage ratio declining from 3.0 times to 2.5times and the fixed charge coverage ratio increasing from 1.25 times to 1.50times. However, in September 2002, an amendment was approved that extendedthe fixed cost coverage ratio requirement of 1.25 until January 1, 2004and will increase to 1.35 at all times thereafter. In addition to the leverageand fixed cost coverage ratios, we are subject to minimum net worthrequirements. Effective March 26, 2003, an amendment was approved that allowsfor the reduction to the minimum net worth requirement for up to$30 million of share repurchases. In addition, effective July 30,2004, an amendment was approved that allows for the reduction to the minimumnet worth requirement for an additional $30 million of share repurchases.  

 

As a result of our internalinvestigation, more fully described above in “Internal Investigation”, we wereunable to file our September 30, 2004 Quarterly Report on Form 10-Q withinthe timeframe prescribed by the Securities Exchange Act of 1934.  The failure to timely file the September 30,2004 Quarterly Report on Form 10-Q resulted in a default under the 2001 CreditAgreement.  We entered into a waiveragreement on November 12, 2004 with the lenders party to the 2001 CreditAgreement.  Pursuant to the terms of thewaiver agreement, the lenders agreed, among other things, to waive any defaultunder the 2001 Credit Agreement that resulted from potential non-compliancewith a designated fixed charge coverage ratio, and our failure to timely fileour Quarterly Report on Form 10-Q for the September 30, 2004 quarter.  The waiver agreement also provides thatduring the period that the waiver agreement is in effect, the outstandingprincipal amount of the loans under the 2001 Credit Agreement may not exceed$112,000,000. The waiver agreement was to expire on March 15, 2005;  however, on March 15, 2005, we enteredinto on Extension and Modification of Waiver to Credit Agreement, whichextended such waiver through March 23, 2005.  The foregoing summary of the Extension andModification and Waiver to Credit Agreement is qualified by and should be readin connection with the actual text of the Extension and Modification of Waiverto Credit Agreement, which is referenced as Exhibit 10.2 to this QuarterlyReport.

 

Weare currently working with our lenders to approve anamendment to the 2001 Credit Agreement that would allow for the exclusion ofcertain contingent consideration overpayments to the former owners of theOperating Subsidiary, as described more fully above in “Internal Investigation”and in Note 2 to the condensed consolidated financial statements, from thedefinition of Earnings Before Interest, Depreciation and Amortization(“EBITDA”).  Pursuant to the terms of theCompany’s 2001 Credit Agreement, Earnings Before Interest, Taxes, Depreciationand Amortization (“EBITDA”) is used in calculating certain leverage and fixedcost coverage ratios. The Company exceeded the allowable leverage ratio of 2.5times for the quarter ended June 30, 2004, as a result of the earn-outoverpayments, previously discussed.  Thishas resulted in a default under the 2001 Credit Agreement.  As a result, the Company has classified thedebt under such Credit Agreement as a Current Maturity included in the currentliability section of its balance sheet, until such time as an appropriateamendment is in place.  The Company iscurrently working with its lenders to secure such an amendment and it isanticipated that this amendment will soon become effective. In any event, asthe maturity date of the debt under the 2001 Credit Agreement is April 1, 2006,unless the maturity date of such debt is subsequently modified, such debt willbe classified as a Current Maturity on and after April 1, 2005.

 

Managementbelieves that it has sufficient liquidity from its cash flow and its revolvingcredit facility to meet ongoing business needs. Additionally, depending on the mix of stock and cash used in ourstrategic acquisition program, if any, we may need to seek further financingthrough the public or private sale of equity or debt securities.  However, there can be no assurance we couldsecure such financing if and when it is needed or with terms we deemacceptable.

 

In January 2000,we registered on Form S-4 (Registration No. 333-92981) 3,012,217shares of common stock for issuance in connection with our acquisition program(the “Acquisition Shelf”), of which 1,390,176 shares were available as of June30, 2004; however, such registration statement may require amendment prior touse.

 

28

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**Critical Accounting Policies**

 

Management’sDiscussion and Analysis of Financial Condition and Results of Operations arebased on the related consolidated financial statements, which have beenprepared in accordance with accounting principles generally accepted in theUnited States of America. The preparation of the financial statements requiresthe use of estimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses.

 

We haveidentified the following critical accounting policies that, as a result of thejudgments, uncertainties, uniqueness and complexities of the underlyingaccounting standards and operations involved, could result in material changesto our financial condition or results of operations under different conditionsor using different assumptions. We apply a consistent methodology at the end ofeach quarter to determine our account balances that require judgmentalanalysis.

 

**RevenueRecognition.**  Werecognize our revenue as it becomes realized or realizable and earned accordingto the criteria provided by Staff Accounting Bulletin 101, *Revenue Recognition in Financial Statements*.Revenue recognition occurs once persuasive evidence of an arrangement exists,delivery has occurred or services have been rendered, the sales price is fixedor otherwise determinable, and collection is reasonably assured. Ourrevenue-earning activities possess both project and recurring customerrelationships.

 

Projectrevenue includes one-time projects in which the customer relationship is notexpected to continue after project completion. Project revenue is typicallybased on time and material arrangements. Revenue recognition occurs at thecontractual rates as the labor hours and direct expenses are incurred. Projectrevenue represented approximately 37% of total 2003 revenues from continuingoperations and typically occurs within our Healthcare, Regulatory, and LegalCompliance segment.

 

Recurringrevenue is characterized by customer relationships that are generally for oneyear and may continue for longer. Recurring revenue is typically based on thetransaction volumes provided by our customer at an agreed upon fixed rate perunit. Our customer’s volumes are typically not contractual or otherwiseguaranteed. Revenue recognition occurs once work is completed and delivery hasoccurred or services have been rendered. Recurring revenue represented theremaining 63% of total 2003 revenues from continuing operations and typicallyoccurs within our Information Management and Distribution segment.

 

As a part of providingservices to our customers, we incur incidental expenses commonly referred to as“out-of-pocket” expenses. These expenses include items such as airfare, hotels,and mileage and are often reimbursable by our customers. When reimbursable, werecord both revenue and direct cost of services in accordance with theprovisions of Emerging Issues Task Force (“EITF”) Issue 01-14, *Income Statement Characterization of ReimbursementsReceived for “Out-of-Pocket” Expenses Incurred.*

 

Unearned income, included inother current liabilities, represents payments from our customers in advance ofservices being provided. Advanced payments are deferred as unearned income whenreceived and recognized as revenue as services are rendered.

 

**Allowancefor Doubtful Accounts.**  The allowance for doubtful accounts isestablished and maintained based on our estimate of accounts receivablecollectibility. Management estimates collectibility by specifically analyzingaccounts receivable aging and other historical factors that affect collections.Such factors include the historical trends of write-offs and recovery ofpreviously written-off accounts, the financial strength of the customer and projectedeconomic and market conditions. The evaluation of these factors involvessubjective judgments and changes in these factors may significantly impact ourconsolidated financial statements.

 

**Long-LivedAsset Impairment.**  As required by SFAS No. 144, *Accounting for the Impairment or Disposal ofLong-Lived Assets,*management continually evaluates whether eventsand circumstances indicate that the carrying value of long-lived assets may notbe recoverable. When events require, management performs the valuation bycomparing the estimated undiscounted future cash flows over the remaining lifeof the long-lived assets to the carrying amount of the asset being evaluated.An impairment loss is recognized if the carrying amount of assets beingevaluated exceeds the expected future undiscounted cash flow based on thedifference between the carrying value and fair value. During the quarter ended June 30,2004, a pre-tax impairment loss of approximately $1.7 million was recognizedrelated to the divestiture of our Print and Mail operations.  See Note 4, Discontinued Operations, of Notesof Condensed Consolidated Financial Statements, for a more detailed discussion.

 

**GoodwillImpairment.**  On January 1, 2002, we adopted SFASNo. 142, *Goodwill and Other IntangibleAssets.* This statement states that goodwill and intangible assetsthat have indefinite useful lives will not be amortized but rather will betested at least annually for impairment. Our annual impairment test isperformed at October 31.  Theimpairment test is based on fair value rather than undiscounted cash flows.Additionally, goodwill is tested at a reporting unit level rather than theindividual operating unit level. A reporting unit is either at the operatingsegment level or one reporting level below and could consist of several serviceofferings aggregated into a single reporting unit. Service offerings areaggregated when they are similar in the following areas: economiccharacteristics, products and services, production processes, methods fordistributing or delivering products, and type or class of customers. Valuationmethods used in determining fair value include an analysis of the cash flowsthat the reporting units can be expected to generate in the future (IncomeApproach) and the fair value of a reporting unit as compared to similarpublicly traded companies (Market Approach). In preparing these valuations,management utilizes estimates to determine fair value of the reporting units.These estimates include future cash flows, growth rates, capital needs, andprojected earning margins among other factors. Estimates utilized in futurecalculations could differ from estimates used in the current period. Futureyears’ estimates that are unfavorable compared to current estimates

 

29

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could cause an impairment of goodwill and otherintangible assets. Due to the fact that we are primarily a services company,our business acquisitions typically result in significant amounts of goodwilland other intangible assets. Therefore, an impairment charge resulting fromgoodwill or other intangible assets could result in a material adverse impacton our financial statements during the period incurred.

 

**Self-InsuranceLiabilities and Reserves.**  We are self-insured for workmen’scompensation liabilities and a significant portion of our employee medicalcosts. We account for our self-insurance programs based on actuarial estimatesof the amount of loss inherent in that period’s claims, including losses forwhich claims have not been reported. These loss estimates rely on actuarialobservations of ultimate loss experience for similar historical events. Welimit our risk by carrying stop-loss policies for significant claims incurredfor both workmen’s compensation liabilities and medical costs.

 

**Other LossContingencies.**  We record liabilities when it is probablethat a liability has been incurred and the amount of the loss is reasonablyestimable in accordance with SFAS No. 5, *Accountingfor Contingencies*. Disclosure is required when there is a reasonablepossibility that the ultimate loss will exceed the recorded provision.Contingent liabilities are often resolved over long periods of time. Estimatingprobable losses requires analysis of multiple forecasts that often depend on judgmentsabout potential actions by third parties such as regulators. Our losscontingencies consist primarily of estimates related to the probable outcome ofcurrent litigation.

 

**RISKS ASSOCIATED WITHFORWARD-LOOKING STATEMENTS**

 

This Report contains certainforward-looking statements such as our intentions, hopes, beliefs,expectations, strategies, predictions or any other variation thereof orcomparable phraseology of our future activities or other future events orconditions within the meaning of Section 27A of the Securities Act of1933, as amended (the “Act”), and Section 21E of the Securities ExchangeAct of 1934, as amended, which are intended to be covered by the safe harborscreated thereby. Investors are cautioned that all forward-looking statementsinvolve risks and uncertainty, including, without limitation, the actual finalcosts of our internal investigation, the Company’s ongoing SEC investigation, thepotential impairment of our ability to enter into government contracts as aresult of the conduct that was the subject of our investigation, remediationcosts relating to our investigation, the potential customer impact of theresults of our investigation, the effect of our investigation and financialstatement restatement on the trading price of our stock, the risk ofintegrating our operating companies, of managing our rapid growth, of thetiming and magnitude of technological advances, of the occurrences of futureevents that could diminish our customers’ needs for our services, of a changein the degree to which companies continue to outsource business processes, ofan adverse outcome in any given legal proceeding or claim, of the denial ofinsurance on a particular claim or of a party obligated to provideindemnification being financially unable to do so, as well as such other risksset forth under the heading Risk Factors included in our most recent annualreport on Form 10-K.

 

Although we believe that theassumptions underlying the forward-looking statements contained herein arereasonable, any of the assumptions could be inaccurate, and, therefore, therecan be no assurance that the forward-looking statements included in this Reportwill prove to be accurate. In light of the significant uncertainties inherentin the forward-looking statements included herein, the inclusion of suchinformation should not be regarded as a representation by us or any otherperson that our objectives and plans will be achieved. Further, we disclaim anyobligation to update any such forward-looking statements, except as required bylaw.

 

**Item 3.****           Quantitative andQualitative Disclosures about Market Risk**

 

We are subject to interestrate risk on our term loans, revolving credit facility and Industrial RevenueBonds. A 100 basis point increase in short-term interest rates would result inapproximately $0.5 million of additional expense in 2004 based on our expectedaverage balance outstanding under the credit facility during 2004. Interestrates are fixed on the capitalized lease obligations.

 

**Item 4.**           **Controls and Procedures**

 

*(a) Evaluation of disclosure controls andprocedures.*

 

The Company maintainsdisclosure controls and procedures (as defined in Rules 13a – 15(e) and 15d –15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)), whichhave been designed to help ensure that material information related to theCompany, including its consolidated subsidiaries, is made known to a groupcomprised of designated members of the Company’s senior management, designatedmembers of functional divisions of the Company, and/or the certifying officers(i.e., Chief Executive Officer and Chief Financial Officer) (collectively, the“Disclosure Committee”), on a timely basis and that the information required tobe disclosed by the Company in reports that it files under the Exchange Act isrecorded, processed, and filed accurately and on a timely basis.  In light of the events giving rise to theCompany’s restatement, more fully described in Item 2, Management’s Discussionand Analysis of Financial Condition and Results of Operations and in Note 2 tothe condensed consolidated financial statements, the Company’s Chief ExecutiveOfficer and Chief Financial Officer concluded that the Company’s disclosurecontrols and procedures were not effective in alerting them, in an accurate andtimely fashion, to material information relating to the revenue and operatingexpenses of the Company required to be included in the Company's reports filedor submitted under the Exchange Act.

30

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We haverestated the condensed consolidated financial statements for the three and sixmonths ended June 30, 2003 and 2004.  Inaddition, we will restate the consolidated financial statements for the yearsended December 31, 2001, 2002 and 2003 in our 2004 Annual Report on Form10-K.  The restated financial resultsaddress the accounting errors described in Item 2, Management’s Discussion andAnalysis of Financial Condition and Results of Operations and in Note 2 of thenotes to the consolidated financial statements that were identified during thecourse of the investigation into the financial results of the OperatingSubsidiary.  The circumstances givingrise to these accounting errors were reported to our Audit Committee andIndependent Registered Public Accounting Firm. The restatement of our operating results is an indicator of a materialweakness under standards established by the Public Company Accounting OversightBoard. The Company’s investigation identified the following issues, whichcollectively were a material weakness in our internal control over financialreporting which were found to have existed as of June 30, 2004:

 

•                                          Certainemployees of the Operating Subsidiary responsible for the internal controlprocesses at the Operating Subsidiary either colluded with or coercedindividuals to override the internal controls related to the followingprocesses: 

 

•                                          Billingand revenue recognition.

•                                          Contractualcompliance.

•                                          Changemanagement controls over the IT environment, specifically with regard tosoftware programs designed to calculate customer invoicing and revenuerecognition.

 

•                                          Monitoringof non-system generated journal entries of the Operating Subsidiary that wererecorded by those individuals involved in the activities mentioned above.

 

In connectionwith the restatement of our operating results, we reviewed the circumstancesgiving rise to the restatement, and determined that the following actions wererequired to correct the underlying material weaknesses giving rise to therestatement: 

 

•                                          Terminatecertain individuals involved in overriding the internal controls at theOperating Subsidiary and replace them with new management.  

•                                          Performa review and make improvements to the production and revenue accounting systemsaffecting our revenue accounting and customer invoicing at the OperatingSubsidiary.

•                                          Furthersegregate internal control responsibilities of the Operating Subsidiary throughthe centralization of accounting related functions into the Company’s corporateaccounting department. 

•                                          Establishadditional monitoring controls and procedures regarding compliance with theCompany’s customer arrangements.  

•                                          IncreaseInternal Audit’s company-wide testing of internal controls related to customerinvoicing and revenue recognition to help ensure the internal controls areoperating as designed.

•                                          Theaddition of a company-wide contract compliance function.

 

*(b) Changesin internal controls*

 

The changes to internal controlover financial reporting described above were either implemented in the fourth quarterof 2004 or, in the case of the addition of a company-wide contract compliancefunction, is in the process of being implemented.   Except as described above, there has been noother significant change in our internal control over financial reportingduring the quarter ended June 30, 2004, which materially affected, or isreasonably likely to affect, our internal control over financial reporting.

 

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**PART II****. OTHER INFORMATION**

 

**Item 1.**                   **Legal Proceedings**

 

We are, fromtime to time, a party to litigation arising in the normal course of business.The following is a description of the most significant legal matters that weare involved in.  In the event of anadverse outcome in one or more of our legal proceedings, operating results fora given quarter may be negatively impacted.

 

*Healthcare MarketingAssociates, Inc. vs. Managed Care Professionals, Inc.*

 

On February 9,1995, prior to the acquisition by the Company, Managed CareProfessionals, Inc. (one of our wholly-owned subsidiaries) (“MCP”) enteredinto an “Exclusive Marketing Agreement” with Healthcare MarketingAssociates, Inc. (“HMA”) whereby MCP granted to HMA the exclusive right tomarket, and HMA agreed to market exclusively for MCP, the MCP products andservices to health care providers in the United States for which MCP agreed topay HMA a percentage (30%) of gross revenues paid to MCP by the provider(customer). The duration of the Agreement was for a period of five(5) years and expired on February 9, 2000 (“Termination Date”). On April 27,2001, HMA filed a lawsuit against MCP in the Circuit Court of the County of St.Louis, State of Missouri, alleging entitlement to commissions on revenuesgenerated after the Termination Date from providers who were initially broughtto MCP prior to the Termination Date. In March 2003, this lawsuit wastried before a judge and at the conclusion of the trial, the judge ruled in theplaintiff’s favor in the amount of approximately $1.8 million plusprejudgment and post judgment interest, which equates to approximately$2.4 million in total as of December 31, 2003. The judgment amountplus prejudgment interest costs were included in our 2002 results. Postjudgment interest accrues at a statutory 9% rate. We appealed this ruling andoral arguments for our appeal were heard on February 24, 2004.  On May 4, 2004, the Court of Appeals affirmedthe Circuit Court’s judgment.  Subsequentto the period covered by this Report, we paid such judgment and interest.

 

*Various ROI CopyCharge Matters*

 

From time totime, various of our subsidiaries that perform release of information (“ROI”)services become defendants to putative class action lawsuits generally allegingthat the charge for reproducing certain medical records is not in conformitywith such plaintiffs’ reading of the applicable regulated charge. Such suitstypically include multiple ROI companies and hospitals as defendants and demandreimbursement for prior charges as well as for prospective pricing adjustments.We are currently a party to several such suits in various stages ofdevelopment. We believe we have meritorious defenses and intend to continue tovigorously defend any claims made against us in these matters.

 

*Mattel v. SOURCECORP*

 

On February 18,2003, Mattel, Inc. filed suit against the Company in the Los AngelesCounty California Superior Court. In the suit, the plaintiff alleged that oneof our subsidiaries is liable for the loss of various products, prototypes andpaper documents allegedly stored at one of our subsidiary’s box storagefacilities under theories of breach of contract, breach of fiduciary duty,negligence, breach of implied covenants of good faith and fair dealing and/orconversion. The plaintiff at various times alleged damages ranging from “in excessof $2.5 million,” to approximately $20 million.  This matter was settled prior to trial, theterms of which settlement are confidential. The settlement and related legal costs impacted our first quarter 2004pre-tax earnings by approximately $3.9 million. Furthermore, the impact of the settlement and related legal costs on our2004 operating cash flow will be approximately $5.7 million, beforeconsideration of taxes.

 

*Spohr. et. al. v.F.Y.I. Incorporated, et. al.*

 

In June 2000,the Company filed an action styled *F.Y.I.Incorporated v. Spohr, et. al.* in Dallas, Texas, in which weasserted claims for breach of contract, fraud, and negligent misrepresentationagainst the sellers of two related companies that we acquired in December 1998(the “Texas Action”). The Texas Action was later removed to federal court andultimately dismissed on jurisdictional grounds. We reasserted these claims intwo actions that were later consolidated; one styled *F.Y.I. Incorporated v. Spohr, et. al.* in Superior Court ofthe State of California in the County of Sacramento, Case No. 01-AS-00721(the “Sacramento Action”) and one styled *Spohr,et. al. v. F.Y.I. Incorporated, et. al.* in the Superior Court of theState of California in the County of San Francisco, Case No. 318703 (the“San Francisco Action”). In the consolidated action, we additionally filedclaims against the sellers’ accountants and the two sellers filed claimsagainst us; however, in February 2004, the judge in the Sacramento Actiondismissed our claims against the sellers’ accountants. The sellers allege thatour former subsidiary wrongfully failed and refused to execute and deliver arequested estoppel certificate, and that the failure to provide such estoppelcertificate harmed the landlord in that they were allegedly denied favorableterms on a refinancing of the property and were allegedly prevented fromcompleting a timely sale of the property. Sellers allege damages ofapproximately $1.5 million. We asserted damages in excess of$8 million. Subsequent to the period covered by this Report, the partiessettled this matter on mutually acceptable terms consistent with previousamounts accrued.

 

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**Item 2.****           Changes in Securitiesand Use of Proceeds**

 

Items 2(a)through (d) are inapplicable.

(e) STOCKREPURCHASES

 
| **Period**                  | ** ** | **(a) Total Number of  Shares Purchased** | ** ** | **(b) Average  Price Paid per   Share** | ** ** | **(c) Total Number of  Shares Purchased as  Part of Publicly  Announced Plans or   Programs** | ** ** | **(d) Maximum Number of Shares (or  Approximate Dollar Value) of  Shares  that May Yet Be Purchased Under  the Plans or Programs** | ** ** |
|-----------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|-----------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------|------------|
|                        |       |                                      |       |                                    |       |                                                                                          |       |                                                                                                                               |       |
| Apr. 1,  2004-Apr. 30, 2004 |       | —                                    |       | —                                  |       | —                                                                                        |       | $                                                                                                                                  | 9,299,190  |   |
| May 1,  2004-May 31, 2004   |       | 111,123                                   |       | $                                       | 24.42      |                                                                                          | 111,123    |                                                                                                                               | $          | 6,585,915 |   |
| Jun. 1,  2004-Jun. 30, 2004 |       | 250,292                                   |       | $                                       | 26.31      |                                                                                          | 250,292    |                                                                                                                               | $          | 1,500 |   |
| August 2004            |       |                                      |       |                                    |       |                                                                                          |       | $                                                                                                                                  | 20,001,500 |   |

 

**Item 6.**           **Exhibits and Reports on Form8-K**

 

(a) Exhibits

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                     |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1*                |       | Asset Purchase Agreement, dated as of June 4, 2004, among Premier  Acquisition Corp., as Seller, *SOURCECORP*,  Incorporated, as Parent of Seller and Secure Health Information Corp., as  Buyer (Incorporated by reference to Exhibit 2.1 to the Company’s Quarterly  Report on Form 10-Q filed August 9, 2004)                                                     |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                |
| 2.2*                |       | Asset Purchase Agreement, dated as of July 8, 2004, by and among  Creative Mailing & Marketing, LLC, as Buyer and Global Direct, Inc. and  Mailing & Marketing, Inc., as Sellers and *SOURCECORP*, Incorporated (Incorporated by reference to  Exhibit 2.2 to the Company’s Quarterly Report on Form 10-Q filed August 9,  2004)                             |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                |
| 2.3*                |       | Asset Purchase and Sale Agreement, dated as of July 21, 2004,  among Iron Mountain Information Management, Inc., as Buyer, Deliverex  Acquisition Corp., as Seller and *SOURCECORP,*  Incorporated, as Limited Guarantor (Incorporated by reference to Exhibit 2.3  to the Company’s Quarterly Report on Form 10-Q filed August 9, 2004)                             |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                |
| 3.1                 |       | Restated Certificate of Incorporation of SOURCECORP, Incorporated  (Incorporated by reference to Exhibit 99.3 to Amendment No.1 to the Company’s  Registration Statement on Form 8-A filed on February 15, 2002)                                                                                                                                                          |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                |
| 3.2                 |       | Amended and Restated By-Laws of SOURCECORP, Incorporated (Incorporated  by reference to Exhibit 99.4 to Amendment No. 1 to the Company’s Registration  Statement on Form 8-A filed on February 15, 2002)                                                                                                                                                                  |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                |
| 4                   |       | Specimen certificate for the Common Stock, par value $.01 per share,  of the Registrant. (Incorporated by reference to Exhibit 99.1 to Amendment  No. 1 to the Company’s Registration Statement on Form 8-A filed on February 15,  2002)                                                                                                                                  |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                |
| 10.1*               |       | Fourth Amendment to Credit Agreement, effective as of July 30,  2004, by and among *SOURCECORP*,  Incorporated, Bank of America, N.A. and the other Lenders party thereto  (Incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on  Form 10-Q filed August 9, 2004)                                                                          |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                |
| 10.2                |       | Extension and Modification of Waiver to Credit Agreement, effective March 15,  2005, by and among SOURCECORP, Incorporated, Bank of America, N.A. as a  Lender and as Administrative Agent for Lenders and the other Agents and  Lenders party thereto (Incorporated by reference to Exhibit 99.1 to the  Company’s Current Report on Form 8-K filed March 16, 2005) |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                |
| 31.1                |       | Certification Pursuant to section 302 of Sarbanes-Oxley Act.                                                                                                                                                                                                                                                                                                                   |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                |
| 31.2                |       | Certification Pursuant to section 302 of Sarbanes-Oxley Act.                                                                                                                                                                                                                                                                                                                   |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                |
| 32.1                |       | Certification Pursuant to section 906 of Sarbanes-Oxley Act.                                                                                                                                                                                                                                                                                                                   |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                |
| 32.2                |       | Certification Pursuant to section 906 of Sarbanes-Oxley Act.                                                                                                                                                                                                                                                                                                                   |

 

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* Schedules and similar attachments are omitted in accordance with Item601(b)(2) of Regulation SK and a brief description of such omitted schedulesand similar attachments is included in the agreement.  The Company undertakes to supplementallyprovide the Commission with a copy of any such omitted schedule or similarattachment upon request.

 

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(b) Reports on Form 8-K

 

On April 23,2004, the Company filed a Current Report on Form 8-K with the Commission dated April 23,2004, reporting, under Item 7 and Item 12 thereto, the filing of a pressrelease announcing the settlement of a previously disclosed pending legalmatter and setting forth its anticipated impact on the Registrant’s results ofoperations for the first quarter of fiscal 2004.

 

On May 6,2004, the Company filed a Current Report on Form 8-K with the Commission datedMay 6, 2004, reporting, under Item 7 and Item 12 thereto, the filing of a pressrelease to announce its financial results for the first quarter ended March 31,2004.

 

On May 21, 2004, the Companyfiled a Current Report on Form 8-K with the Commission dated May 21, 2004,reporting, under Item 5 and Item 7 thereto, condensed consolidated statementsof operations for the years 2002, 2003 and the first quarter of 2004 reflectiveof the anticipated presentation giving effect to the required discontinuedoperations accounting treatment of certain asset groups to be divested.

 

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**SIGNATURES**

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, the Registrant has duly caused thisReport on Form 10-Q/A to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|                      | SOURCECORP, INCORPORATED |
|---------------------------|--------------------------|
|                      |                     |   |
| Date: March 23, 2005 | By:                      | /s/ ED H. BOWMAN, JR. |
|                      |                     | Ed H. Bowman, Jr. Chief  Executive   Officer and President |
|                      |                     |   |
| Date: March 23, 2005 | By:                      | /s/ BARRY L. EDWARDS |
|                      |                     | Barry L. Edwards Executive Vice  President and Chief Financial  Officer   (Principal Financial and Accounting   Officer) |

 

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**INDEX TOEXHIBITS**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                     |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1*                |       | Asset Purchase Agreement, dated as of June 4, 2004, among  Premier Acquisition Corp., as Seller, *SOURCECORP*,  Incorporated, as Parent of Seller and Secure Health Information Corp., as  Buyer (Incorporated by reference to Exhibit 2.1 to the Company’s Quarterly  Report on Form 10-Q filed August 9, 2004)                                                     |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                |
| 2.2*                |       | Asset Purchase Agreement, dated as of July 8, 2004,  by and among Creative Mailing & Marketing, LLC, as Buyer and Global  Direct, Inc. and Mailing & Marketing, Inc., as Sellers and *SOURCECORP*, Incorporated (Incorporated  by reference to Exhibit 2.2 to the Company’s Quarterly Report on Form 10-Q  filed August 9, 2004)                             |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                |
| 2.3*                |       | Asset Purchase and Sale Agreement, dated as of July 21,  2004, among Iron Mountain Information Management, Inc., as Buyer, Deliverex  Acquisition Corp., as Seller and *SOURCECORP,*  Incorporated, as Limited Guarantor (Incorporated by reference to Exhibit 2.3  to the Company’s Quarterly Report on Form 10-Q filed August 9, 2004)                             |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                |
| 3.1                 |       | Restated Certificate of Incorporation of SOURCECORP,  Incorporated (Incorporated by reference to Exhibit 99.3 to Amendment No.1 to  the Company’s Registration Statement on Form 8-A filed on February 15,  2002)                                                                                                                                                         |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                |
| 3.2                 |       | Amended and Restated By-Laws of SOURCECORP, Incorporated  (Incorporated by reference to Exhibit 99.4 to Amendment No. 1 to the  Company’s Registration Statement on Form 8-A filed on February 15, 2002)                                                                                                                                                                  |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                |
| 4                   |       | Specimen certificate for the Common Stock, par value $.01  per share, of the Registrant. (Incorporated by reference to Exhibit 99.1 to  Amendment No. 1 to the Company’s Registration Statement on Form 8-A filed on February 15,  2002)                                                                                                                                  |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                |
| 10.1*               |       | Fourth Amendment to Credit Agreement, effective as of July 30,  2004, by and among *SOURCECORP*,  Incorporated, Bank of America, N.A. and the other Lenders party thereto  (Incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report  on Form 10-Q filed August 9, 2004)                                                                          |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                |
| 10.2                |       | Extension and Modification of Waiver to Credit Agreement, effective March 15,  2005, by and among SOURCECORP, Incorporated, Bank of America, N.A. as a  Lender and as Administrative Agent for Lenders and the other Agents and  Lenders party thereto (Incorporated by reference to Exhibit 99.1 to the  Company’s Current Report on Form 8-K filed March 16, 2005) |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                |
| 31.1                |       | Certification Pursuant to section 302 of Sarbanes-Oxley Act.                                                                                                                                                                                                                                                                                                                   |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                |
| 31.2                |       | Certification Pursuant to section 302 of Sarbanes-Oxley Act.                                                                                                                                                                                                                                                                                                                   |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                |
| 32.1                |       | Certification Pursuant to section 906 of Sarbanes-Oxley Act.                                                                                                                                                                                                                                                                                                                   |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                |
| 32.2                |       | Certification Pursuant to section 906 of Sarbanes-Oxley Act.                                                                                                                                                                                                                                                                                                                   |

 

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* Schedules and similar attachments are omitted in accordance with Item601(b)(2) of Regulation SK and a brief description of such omitted schedulesand similar attachments is included in the agreement.  The Company undertakes to supplementallyprovide the Commission with a copy of any such omitted schedule or similarattachment upon request.

 

36

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