**UNITED STATES********SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

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**FORM 10-Q**

 
| **ý** | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES AND EXCHANGE ACT OF 1934**                                  |
|------------|------------|----------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                   |
| ** ** | ** ** | **For  the quarterly period ended September 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** |

 

**Commission file number 0-27444**

 

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**SOURCECORP, INCORPORATED**

(Exact name of registrant as specified in its charter)

 
| **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** |

 

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes o  No ý

 

Indicateby check mark whether the registrant is an accelerated filer (as defined in ExchangeAct Rule 12b-2). Yes  ý  No  o

 

Asof****February 28, 2005, 15,666,916shares of the registrant’s Common Stock, $.01 par value per share, wereoutstanding.

 

 

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**SOURCECORP, INCORPORATED AND SUBSIDIARIES**

**FORM 10-Q FOR THE PERIOD ENDED SEPTEMBER 30, 2004**

 

**INDEX**

 
| **PART I. FINANCIAL INFORMATION** |                                                                                                                                            |
|-----------------------------------|-------------------------------------------------------------------------------------------------------------------------------------------------|
|                              |                                                                                                                                            |   |
| Item 1                            | Financial Statements                                                                                                                            |   |
|                              |                                                                                                                                            |   |
|                              | Condensed  Consolidated Balance Sheets — December 31, 2003 (as restated) and September 30,  2004 (unaudited)                     |   |
|                              |                                                                                                                                            |   |
|                              | Condensed  Consolidated Statements of Operations — Three and nine months ended September 30,  2003 (as restated) and 2004 (unaudited) |   |
|                              |                                                                                                                                            |   |
|                              | Condensed  Consolidated Statements of Cash Flows — Nine months ended September 30,  2003 (as restated) and 2004 (unaudited)           |   |
|                              |                                                                                                                                            |   |
|                              | 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                           | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                                    |   |
|                              |                                                                                                                                            |   |
| Item 6                            | Exhibits                                                                                                                                        |   |
|                              |                                                                                                                                            |   |
| ** **                        | **SIGNATURES**                                                                                                                                  |   |
|                              |                                                                                                                                            |   |
| ** **                        | **Index to Exhibits**                                                                                                                           |   |

 

2

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**PART I.****FINANCIAL INFORMATION**

 

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

 

**SOURCECORP, INCORPORATED AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(IN THOUSANDS, EXCEPT SHARE DATA)**

 
| ** **                                                                                                                                                                                                                  | ** ** | **December 31,  2003**    | ** ** | **September 30,  2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                                                                                                  | ** ** | **(As restated, see  Note 2)** | ** ** | ** **                   | ** ** |
| ** **                                                                                                                                                                                                                  | ** ** | **(Unaudited)**                | ** ** |
| **ASSETS**                                                                                                                                                                                                                  |       |                           |       |                         |       |
| **CURRENT  ASSETS:**                                                                                                                                                                                                        |       |                           |       |                         |       |
| Cash and cash equivalents                                                                                                                                                                                                   |       | $                              | 2,097      |                         | $          | 1,905 |   |
| Accounts and notes receivable, less  allowance for doubtful accounts of $6,843 and $8,885, respectively                                                                                                                     |       | 63,522                         |       | 66,358                       |       |
| Inventories                                                                                                                                                                                                                 |       | 933                            |       | 981                          |       |
| Deferred income taxes                                                                                                                                                                                                       |       | 6,072                          |       | 6,904                        |       |
| Income tax receivable                                                                                                                                                                                                       |       | 3,000                          |       | 1,011                        |       |
| Prepaid expenses and other current assets                                                                                                                                                                                   |       | 4,318                          |       | 5,466                        |       |
| Assets of discontinued operations                                                                                                                                                                                           |       | 14,658                         |       | —                       |       |
| Total current assets                                                                                                                                                                                                        |       | 94,600                         |       | 82,625                       |       |
| **PROPERTY,  PLANT AND EQUIPMENT,** net of accumulated depreciation  of $53,393 and $48,477, respectively                                                                                                                   |       | 35,902                         |       | 39,101                       |       |
| **GOODWILL**                                                                                                                                                                                                                |       | 307,913                        |       | 320,805                      |       |
| **INTANGIBLES,**  net of amortization of $709 and $1,423, respectively                                                                                                                                                      |       | 3,731                          |       | 5,181                        |       |
| **OTHER  NONCURRENT ASSETS**                                                                                                                                                                                                |       | 10,384                         |       | 10,190                       |       |
| Total assets                                                                                                                                                                                                                |       | $                              | 452,530    |                         | $          | 457,902 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                               |       |                           |       |                         |       |
| **CURRENT  LIABILITIES:**                                                                                                                                                                                                   |       |                           |       |                         |       |
| Accounts payable and accrued liabilities                                                                                                                                                                                    |       | $                              | 52,375     |                         | $          | 40,305 |   |
| Current maturities of long-term obligations                                                                                                                                                                                 |       | 209                            |       | 90,611                       |       |
| Liabilities of discontinued operations                                                                                                                                                                                      |       | 5,423                          |       | —                       |       |
| Total current liabilities                                                                                                                                                                                                   |       | 58,007                         |       | 130,916                      |       |
| **LONG-TERM  OBLIGATIONS,** net of current maturities                                                                                                                                                                       |       | 73,390                         |       | 1,766                        |       |
| **DEFERRED  INCOME TAXES**                                                                                                                                                                                                  |       | 11,753                         |       | 11,780                       |       |
| **LONG-TERM  CUSTOMER LIABILITY**                                                                                                                                                                                           |       | 1,862                          |       | 4,141                        |       |
| **DEFERRED  REVENUE**                                                                                                                                                                                                       |       | 5,135                          |       | 7,839                        |       |
| **OTHER  LONG-TERM OBLIGATIONS**                                                                                                                                                                                            |       | 9,306                          |       | 9,730                        |       |
| Total liabilities                                                                                                                                                                                                           |       | 159,453                        |       | 166,172                      |       |
| **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 15,786,310 shares issued and 16,094,156 and  15,749,640 shares outstanding at December 31, 2003 and September 30,  2004, respectively |       | 162                            |       | 158                          |       |
| Additional paid-in-capital                                                                                                                                                                                                  |       | 194,999                        |       | 194,949                      |       |
| Retained earnings                                                                                                                                                                                                           |       | 101,225                        |       | 102,052                      |       |
|                                                                                                                                                                                                                        |       | 296,386                        |       | 297,159                      |       |
| Less—Treasury stock, at cost, 56,028 shares  and 36,670 shares at December 31, 2003 and September 30, 2004,  respectively                                                                                    |       | (982                           | )          | (501                         | )          |
| Less—Deferred compensation                                                                                                                                                                                             |       | (2,327                         | )          | (4,928                       | )          |
| Total stockholders’ equity                                                                                                                                                                                             |       | 293,077                        |       | 291,730                      |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                             |       | $                              | 452,530    |                         | $          | 457,902 |   |

 

The accompanying notes are an integral part of these condensedconsolidated financial statements.

 

3

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**SOURCECORP, INCORPORATED AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(IN THOUSANDS, EXCEPT PER SHARE DATA)**

 
| ** **                                                    | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                    | ** ** | **2003**                                   | ** ** | **2004**                                  | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                                                    | ** ** | **(As restated, see  Note 2)**             | ** ** | ** **                                | ** ** | **(As restated, see  Note 2)** | ** ** | ** ** | ** ** |
| ** **                                                    | ** ** | **(Unaudited)**                            | ** ** | **(Unaudited)**                           | ** ** |
| **REVENUE**                                                   |       | $                                          | 91,728     |                                      | $          | 97,674 |   | $ | 280,341 |   | $ | 292,497 |   |
| **COST OF  SERVICES EXCLUSIVE OF DEPRECIATION**               |       | 52,542                                     |       | 59,960                                    |       | 163,783 |   | 175,295 |   |
| **DEPRECIATION**                                              |       | 3,192                                      |       | 3,262                                     |       | 9,324 |   | 9,466 |   |
| Gross profit                                                  |       | 35,994                                     |       | 34,452                                    |       | 107,234 |   | 107,736 |   |
| **SELLING,  GENERAL AND ADMINISTRATIVE EXPENSES**             |       | 24,058                                     |       | 25,171                                    |       | 71,882 |   | 80,982 |   |
| **CONTINGENT  CONSIDERATION OVERPAYMENT**                     |       | 7,223                                      |       | 10,165                                    |       | 7,223 |   | 10,165 |   |
| **AMORTIZATION**                                              |       | 89                                         |       | 313                                       |       | 266 |   | 714 |   |
| Operating income                                              |       | 4,624                                      |       | (1,197                                    | )          | 27,863 |   | 15,875 |   |
| **OTHER  (INCOME) EXPENSE:**                                  |       |                                       |       |                                      |       |   |   |   |   |
| Interest expense                                              |       | 445                                        |       | 822                                       |       | 2,856 |   | 2,179 |   |
| Interest income                                               |       | —                                     |       | (51                                       | )          | (253 | ) | (60 | ) |
| Other (income) expense, net                                   |       | 135                                        |       | 253                                       |       | (16 | ) | 626 |   |
| Income (loss) from continuing operations  before income taxes |       | 4,044                                      |       | (2,221                                    | )          | 25,276 |   | 13,130 |   |
| **PROVISION  (BENEFIT) FOR INCOME TAXES**                     |       | 1,619                                      |       | (1,805                                    | )          | 10,115 |   | 4,335 |   |
| **INCOME  (LOSS) FROM CONTINUING OPERATIONS**                 |       | 2,425                                      |       | (416                                      | )          | 15,161 |   | 8,795 |   |
| **LOSS  FROM DISCONTINUED OPERATIONS, NET OF TAX**            |       | (118                                       | )          | (261                                      | )          | (281 | ) | (2,561 | ) |
| **NET  INCOME (LOSS)**                                        |       | $                                          | 2,307      |                                      | $          | (677 | ) | $ | 14,880 |   | $ | 6,234 |   |
| **NET  INCOME (LOSS) PER COMMON SHARE**                       |       |                                       |       |                                      |       |   |   |   |   |
| **BASIC**                                                     |       |                                       |       |                                      |       |   |   |   |   |
| **Continuing  Operations**                                    |       | $                                          | 0.15       |                                      | $          | (0.02 | ) | $ | 0.92 |   | $ | 0.55 |   |
| **Discontinued  Operations**                                  |       | (0.01                                      | )          | (0.02                                     | )          | (0.02 | ) | (0.16 | ) |
| **Total**                                                     |       | $                                          | 0.14       |                                      | $          | (0.04 | ) | $ | 0.90 |   | $ | 0.39 |   |
| **DILUTED**                                                   |       |                                       |       |                                      |       |   |   |   |   |
| **Continuing  Operations**                                    |       | $                                          | 0.15       |                                      | $          | (0.02 | ) | $ | 0.91 |   | $ | 0.54 |   |
| **Discontinued  Operations**                                  |       | (0.01                                      | )          | (0.02                                     | )          | (0.02 | ) | (0.16 | ) |
| **Total**                                                     |       | $                                          | 0.14       |                                      | $          | (0.04 | ) | $ | 0.89 |   | $ | 0.38 |   |
| **WEIGHTED  AVERAGE COMMON SHARES OUTSTANDING**               |       |                                       |       |                                      |       |   |   |   |   |
| **BASIC**                                                     |       | 16,188                                     |       | 15,781                                    |       | 16,571 |   | 15,964 |   |
| **DILUTED**                                                   |       | 16,355                                     |       | 15,781                                    |       | 16,654 |   | 16,300 |   |

 

The accompanying notes are an integral part of these condensedconsolidated financial statements.

 

4

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**SOURCECORP, INCORPORATED AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(IN THOUSANDS)**

 
| ** **                                                                                     | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                     | ** ** | **2003**                                  | ** ** | **2004** | ** ** |
| ** **                                                                                     | ** ** | **(As restated, see  Note 2)**            | ** ** | ** ** | ** ** |
| ** **                                                                                     | ** ** | **(Unaudited)**                           | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                                                     |       |                                      |       |   |   |
| Income from continuing operations                                                              |       | $                                         | 15,161     |   | $ | 8,795 |   |
| Adjustments to reconcile income to net cash  provided by operating activities:                 |       |                                      |       |   |   |
| Depreciation and amortization                                                                  |       | 9,591                                     |       | 10,180 |   |
| Deferred income taxes                                                                          |       | 3,288                                     |       | 168 |   |
| Compensation expense on restricted stock  grants                                               |       | 339                                       |       | 1,751 |   |
| (Gain) loss on sale of property, plant and  equipment                                          |       | (344                                      | )          | 265 |   |
| Change in operating assets and liabilities:                                                    |       |                                      |       |   |   |
| Accounts and notes receivable                                                                  |       | 8,975                                     |       | (2,135 | ) |
| Inventories, prepaid expenses and other  assets                                                |       | 655                                       |       | (579 | ) |
| Accounts payable and accrued liabilities                                                       |       | 6,382                                     |       | (2,729 | ) |
| Net cash provided by operating activities  from continuing operations                          |       | 44,047                                    |       | 15,716 |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                                     |       |                                      |       |   |   |
| Purchase of property, plant and equipment                                                      |       | (9,751                                    | )          | (12,596 | ) |
| Proceeds from disposition of property,  plant and equipment                                    |       | 369                                       |       | 37 |   |
| Proceeds from divestitures                                                                     |       | —                                    |       | 6,812 |   |
| Cash paid for acquisitions, net of cash  acquired                                              |       | (2,757                                    | )          | (17,495 | ) |
| Net cash used in investing activities from  continuing operations                              |       | (12,139                                   | )          | (23,242 | ) |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                                     |       |                                      |       |   |   |
| Proceeds from exercise of common stock  options                                                |       | 173                                       |       | 481 |   |
| Cash paid for common stock repurchased                                                         |       | (18,557                                   | )          | (10,071 | ) |
| Proceeds from long-term obligations                                                            |       | 167,617                                   |       | 246,956 |   |
| Principal payments on long-term obligations                                                    |       | (185,748                                  | )          | (228,436 | ) |
| Cash paid for debt issuance costs                                                              |       | (305                                      | )          | — |   |
| Net cash (used in) provided by financing  activities from continuing operations                |       | (36,820                                   | )          | 8,930 |   |
|                                                                                           |       |                                      |       |   |   |
| Net cash provided by (used in) operating  activities from discontinued operations              |       | 2,313                                     |       | (1,596 | ) |
|                                                                                           |       |                                      |       |   |   |
| **NET  (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS**                                      |       | (2,599                                    | )          | (192 | ) |
| **CASH AND  CASH EQUIVALENTS,** beginning of period                                       |       | 3,217                                     |       | 2,097 |   |
| **CASH AND  CASH EQUIVALENTS,** end of period                                                  |       | $                                         | 618        |   | $ | 1,905 |   |
| **SUPPLEMENTAL  DATA:**                                                                        |       |                                      |       |   |   |
| Cash paid for:                                                                                 |       |                                      |       |   |   |
| Income taxes, net of income tax refunds                                                        |       | $                                         | 2,601      |   | $ | 1,362 |   |
| Interest                                                                                       |       | $                                         | 2,839      |   | $ | 2,122 |   |
| **NONCASH  FINANCING TRANSACTIONS:**                                                           |       |                                      |       |   |   |
| Assets acquired through financing and  capital lease arrangements                              |       | $                                         | 40         |   | $ | 258 |   |
| Restricted stock grants (164,300 and  177,300 shares, respectively)                            |       | $                                         | 2,949      |   | $ | 4,486 |   |
| Common stock issued related to business  acquisitions (20,268 and 30,324 shares, respectively) |       | $                                         | 283        |   | $ | 261 |   |

 

The accompanying notes are an integral part of these condensedconsolidated financial statements.

 

5

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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.

 

Inthe opinion of management, all adjustments (which include normal recurringadjustments, except as disclosed in Note 2) necessary to fairly present theCompany’s financial position as of September 30, 2004, and results ofoperations and cash flows for the three and nine months ended September 30,2004 and 2003 have been included. The results of operations for the three andnine months ended September 30, 2004 are not necessarily indicative of theresults to be expected for the full fiscal year or for any future periods.

 

TheCompany uses estimates and assumptions required for preparation of thefinancial statements. The estimates are primarily based on historicalexperience and business knowledge and are revised as circumstances change.However, actual results could differ from the estimates.

 

**2. Restatement**

 

Subsequent to the issuance of its condensed consolidated financial statements for the three and nine months ended September 30, 2003, 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 over accruals of contingent consideration amounts due under the earn-out provisions of the acquisition agreement for the Operating Subsidiary which had been originally recognized as additional goodwill of the acquired business.  As a result, the condensed consolidated financial statements for the three months and nine months ended September 30, 2003, 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 nine months ended September 30, 2003:

 

6

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| **(In  Thousands)**          | ** ** | **Three Months  Ended  September 30, 2003** | ** ** | **Nine Months  Ended  September 30, 2003** | ** ** |
|------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| Asset accounts               |       | $                                                |  384  |                                            | $          |  213 |   |
| Customer liability, net      |       | 86                                               |       | (575                                            | )          |
| Deferred revenue, net        |       | (310                                             | )          | (1,503                                          | )          |
| Total Net Revenue Adjustment |       | $                                                |  160  |                                            | $          |  (1,865 | ) |

 

**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 financial results 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 resulting in expense of $8.6 million, $7.2 million and $10.2 million for the years ended December 31, 2002 and 2003, and the three and nine months ended September 30, 2004, respectively.  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

 

7

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overpayment issues results in an adjustment to the provision for incometaxes and to certain other balance sheet tax accounts for the periods restated.

 

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

 

**BALANCE SHEET INFORMATION**

**(Unaudited)**

 
| ** **                               | ** ** | **At December 31, 2003** | ** ** |
|------------------------------------------|------------|-------------------------------|------------|
| ** **                               | ** ** | **As Previously   Reported**  | ** ** | **As  Restated** | ** ** |
| ** **                               | ** ** | **(Item 1)**                  | ** ** | ** ** | ** ** |
| Accounts and Notes Receivable, Net       |       | $                             | 67,873     |   | $ | 63,522 |   |
|                                     |       |                          |       |   |   |
| Income Tax Receivable                    |       | $                             | —     |   | $ | 3,000 |   |
|                                     |       |                          |       |   |   |
| Goodwill                                 |       | $                             | 324,305    |   | $ | 307,913 |   |
|                                     |       |                          |       |   |   |
| Total Assets                             |       | $                             | 470,273    |   | $ | 452,530 |   |
|                                     |       |                          |       |   |   |
| Accounts Payable and Accrued Liabilities |       | $                             | 52,054     |   | $ | 52,375 |   |
|                                     |       |                          |       |   |   |
| Income Tax Payable                       |       | $                             | 2,186      |   | $ | — |   |
|                                     |       |                          |       |   |   |
| Deferred Income Taxes                    |       | $                             | 18,084     |   | $ | 11,753 |   |
|                                     |       |                          |       |   |   |
| Long-term Customer Liability             |       | $                             | —     |   | $ | 1,862 |   |
|                                     |       |                          |       |   |   |
| Deferred Revenue                         |       | $                             | —     |   | $ | 5,135 |   |
|                                     |       |                          |       |   |   |
| Other Long-term Obligations              |       | $                             | 7,839      |   | $ | 9,306 |   |
|                                     |       |                          |       |   |   |
| Retained Earnings                        |       | $                             | 119,236    |   | $ | 101,225 |   |
|                                     |       |                          |       |   |   |
| Total Stockholders’ Equity          |       | $                             | 311,088    |   | $ | 293,077 |   |

 

----

**Item 1:****         **Amounts aspreviously reported after giving effect to adjustments required to reflect theCompany’s discontinued operations discussed in Note 5 to the consolidatedfinancial statements.

 

8

----

 

**STATEMENTOF OPERATIONS INFORMATION**

**(All Periods Presented Unaudited)**

 
| ** **                                             | ** ** | **Three Months Ended  September 30, 2003** | ** ** | **Nine Months Ended  September 30, 2003** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                             | ** ** | **As Previously   Reported**                    | ** ** | **As  Restated**                               | ** ** | **As Previously   Reported** | ** ** | **As  Restated** | ** ** |
| ** **                                             | ** ** | **(Item 1)**                                    | ** ** | ** **                                     | ** ** | **(Item 1)** | ** ** | ** ** | ** ** |
|                                                   |       |                                            |       |                                           |       |   |   |   |   |
| Revenue                                                |       | $                                               | 91,568     |                                           | $          | 91,728 |   | $ | 282,206 |   | $ | 280,341 |   |
|                                                   |       |                                            |       |                                           |       |   |   |   |   |
| Gross Profit                                           |       | $                                               | 35,834     |                                           | $          | 35,994 |   | $ | 109,099 |   | $ | 107,234 |   |
|                                                   |       |                                            |       |                                           |       |   |   |   |   |
| Selling, General & Administrative  Expenses        |       | $                                               | 24,049     |                                           | $          | 24,058 |   | $ | 71,799 |   | $ | 71,882 |   |
|                                                   |       |                                            |       |                                           |       |   |   |   |   |
| Contingent Consideration Overpayment                   |       | —                                          |       | $                                              | 7,223      |   | — |   | $ | 7,223 |   |
|                                                   |       |                                            |       |                                           |       |   |   |   |   |
| Income From Continuing Operations Before  Income Taxes |       | $                                               | 11,116     |                                           | $          | 4,044 |   | $ | 34,447 |   | $ | 25,276 |   |
|                                                   |       |                                            |       |                                           |       |   |   |   |   |
| Provision for Income Taxes                             |       | $                                               | 4,446      |                                           | $          | 1,619 |   | $ | 13,778 |   | $ | 10,115 |   |
|                                                   |       |                                            |       |                                           |       |   |   |   |   |
| Income From Continuing Operations                      |       | $                                               | 6,670      |                                           | $          | 2,425 |   | $ | 20,669 |   | $ | 15,161 |   |
|                                                   |       |                                            |       |                                           |       |   |   |   |   |
| Net Income                                             |       | $                                               | 6,552      |                                           | $          | 2,307 |   | $ | 20,388 |   | $ | 14,880 |   |
|                                                   |       |                                            |       |                                           |       |   |   |   |   |
| **Net  Income Per Common Share:**                      |       |                                            |       |                                           |       |   |   |   |   |
| **Basic**                                              |       |                                            |       |                                           |       |   |   |   |   |
| Continuing Operations                                  |       | $                                               | 0.41       |                                           | $          | 0.15 |   | $ | 1.25 |   | $ | 0.92 |   |
|                                                   |       |                                            |       |                                           |       |   |   |   |   |
| Total                                                  |       | $                                               | 0.40       |                                           | $          | 0.14 |   | $ | 1.23 |   | $ | 0.90 |   |
|                                                   |       |                                            |       |                                           |       |   |   |   |   |
| **Diluted**                                            |       |                                            |       |                                           |       |   |   |   |   |
| Continuing Operations                                  |       | $                                               | 0.41       |                                           | $          | 0.15 |   | $ | 1.24 |   | $ | 0.91 |   |
|                                                   |       |                                            |       |                                           |       |   |   |   |   |
| Total                                                  |       | $                                               | 0.40       |                                           | $          | 0.14 |   | $ | 1.22 |   | $ | 0.89 |   |

 

----

| **Item 1:** | ** ** | Amounts as previously reported after giving effect to adjustments required  to reflect the Company’s discontinued operations discussed in Note 5 to the  consolidated financial statements. |
|-------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

9

----

 

**STATEMENT OF CASH FLOW INFORMATION**

**(Unaudited)**

 
| ** **                                                            | ** ** | **Nine Months Ended  September 30, 2003** | ** ** |
|-----------------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                            | ** ** | **As Previously   Reported**                   | ** ** | **As Restated** | ** ** |
| ** **                                                            | ** ** | **(Item 1)**                                   | ** ** | ** ** | ** ** |
| Net Cash Provided by Operating Activities  From Continuing Operations |       | $                                              | 51,270     |   | $ | 44,047 |   |
|                                                                  |       |                                           |       |   |   |
| Net Cash Used in Investing Activities From  Continuing Operations     |       | $                                              | (19,362    | ) | $ | (12,139 | ) |

 

----

**Item 1: :**             Amounts as previouslyreported after giving effect to adjustments required to reflect the Company’sdiscontinued operations discussed in Note 5 to the consolidated financialstatements.

 

Thecash flow categories above are impacted as a result of restating the contingentconsideration overpayments discussed above from cash paid for acquisitions(included in net cash used in investing activities from continuing operations)to net cash provided by operating activities from continuing operations as aperiod expense.  The cash flowrestatement impact of contingent consideration overpayments and related expensewas limited to the three and twelve months ended December 31, 2002 and thethree and nine months ended September 30, 2003.

 

**3. Reserves and Other Loss Contingencies**

 

**Self-Insurance Liabilities and Reserves.**  TheCompany is self-insured for workmen’s compensation liabilities and asignificant portion of its employee medical costs. The Company accounts for itsself-insurance programs based on actuarial estimates of the amount of lossinherent in that period’s claims, including losses for which claims have notbeen reported. These loss estimates rely on actuarial observations of ultimateloss experience for similar historical events. The Company limits its risk bycarrying stop-loss policies for significant claims incurred for both workmen’scompensation liabilities and medical costs. The Company’s exposure under thestop-loss policies for workmen’s compensation and medical costs is limitedbased on fixed dollar amounts.  Forworkman’s compensation, the fixed dollar amount of stop-loss coverage is$500,000 per occurrence.  For medicalcosts, the fixed dollar amount of stop-loss coverage is $100,000 per coveredparticipant for the fiscal plan year, with a lifetime limit of liability percovered participant of $1,900,000.

 

Accrualbalances related to workmen’s compensation and medical costs are as follows($000’s):

 

| ** **                  | ** ** | **December 31,  2003** | ** ** | **September 30,  2004** | ** ** |
|-----------------------------|------------|-----------------------------|------------|------------------------------|------------|
| Workmen’s Compensation |       | $                           | 1,936      |                         | $          | 2,263 |   |
| Medical Insurance           |       | 2,208                       |       | 2,357                        |       |
| Total                       |       | $                           | 4,144      |                         | $          | 4,620 |   |

 

**Other Loss Contingencies.**  TheCompany records liabilities when it is probable that a liability has been incurredand the amount of the loss is reasonably estimable in accordance with SFASNo. 5, *Accounting for Contingencies*.Disclosure is required when there is a reasonable possibility that the ultimateloss will exceed the recorded provision. Contingent liabilities are oftenresolved over long periods of time. Estimating probable losses requiresanalysis of multiple forecasts that often depend on judgments about potentialactions by third parties such as regulators. The Company’s loss contingenciesconsist primarily of estimates related to the probable outcome of currentlitigation.

 

**4. Stockholders’ Equity and Stock-Based Compensation**

 

*Stock-Based Compensation*

 

In2002, the Board of Directors and Shareholders of the Company approved theSOURCECORP, Incorporated 2002 Long-Term Incentive Plan (the “2002 Plan”), whichreplaced the 1995 Stock Option Plan, as amended (the “1995 Plan”). The 2002Plan provides for awards of options to purchase common stock and may includeincentive stock options (“ISOs”) and/or non-qualified stock options (“NQSOs”),stock appreciation rights, restricted stock, deferred stock, bonus stock andawards in lieu of cash obligations, dividend equivalents and other stock basedawards.

 

10

----

 

TheBoard of Directors has appointed a committee (the “Committee”) to administerthe 2002 Plan. Persons eligible to receive awards under the plan includedirectors, officers, employees of the Company and its subsidiaries, and personswho provide consulting services to the Company deemed by the Committee to be ofsubstantial value to the Company, persons who have been offered employment bythe Company or its subsidiaries, and persons employed by an entity that theCommittee reasonably expects to become a subsidiary of the Company. Awardsgranted under the 2002 Plan may, at the discretion of the Committee, be grantedeither alone or in addition to, in tandem with or in substitution for any otheraward granted under the 2002 Plan or any other plan of the Company, anysubsidiary or any business entity to be acquired by the Company or one of itssubsidiaries. The Committee determines vesting in awards granted under the 2002Plan.

 

TheCompany applies Accounting Principles Board Opinion (“APB”) No. 25, *Accounting for Stock Issued to Employees*, and related interpretations inaccounting for stock-based compensation and awards. Stock option and warrantawards are granted at the market price of the common stock on the date ofgrant. Accordingly, no compensation expense has been recognized for stockoptions and warrants. Had compensation expense been determined based upon thefair value at grant dates for stock options and warrants consistent with themethod of Statement of Financial Accounting Standards (“SFAS”) No. 123, *Accounting for Stock-Based Compensation,*the Company’s net income and earnings per share would have been as follows (inthousands, except per share data):

 
| ** **                                                                                                                           | ** ** | **Three Months  Ended September 30,** | ** ** | **Nine Months  Ended September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                                                           | ** ** | **2003**                                   | ** ** | **2004**                                  | ** ** | **2003** | ** ** | **2004** | ** ** |
| Net income (loss) as reported                                                                                                        |       | $                                          | 2,307      |                                      | $          | (677 | ) | $ | 14,880 |   | $ | 6,234 |   |
| Add: Deferred compensation expense included  in reported net income, net of related tax effect                                       |       | 160                                        |       | 379                                       |       | 215 |   | 1,031 |   |
| Deduct: Total stock-based employee  compensation expense determined under fair value based method for all awards,  net of tax effect |       | (627                                       | )          | (931                                      | )          | (2,364 | ) | (2,516 | ) |
| Proforma net income (loss)                                                                                                           |       | $                                          | 1,840      |                                      | $          | (1,229 | ) | $ | 12,731 |   | $ | 4,749 |   |
| Earnings per share:                                                                                                                  |       |                                       |       |                                      |       |   |   |   |   |
| Reported basic earnings (loss) per share                                                                                             |       | $                                          | 0.14       |                                      | $          | (0.04 | ) | $ | 0.90 |   | $ | 0.39 |   |
| Proforma basic earnings (loss) per share                                                                                             |       | $                                          | 0.11       |                                      | $          | (0.08 | ) | $ | 0.77 |   | $ | 0.30 |   |
| Reported diluted earnings (loss) per share                                                                                           |       | $                                          | 0.14       |                                      | $          | (0.04 | ) | $ | 0.89 |   | $ | 0.38 |   |
| Proforma diluted earnings (loss) per share                                                                                           |       | $                                          | 0.11       |                                      | $          | (0.08 | ) | $ | 0.76 |   | $ | 0.29 |   |

 

Thefair value of stock options and warrants was estimated on the date of grantusing the Black-Scholes option pricing model using the following assumptions:

 
| ** **                               | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                               | ** ** | **2003**                                   | ** ** | **2004**                                  | ** ** | **2003** | ** ** | **2004** | ** ** |
| Weighted-average risk-free interest rate |       | 0.0                                        | %          | 0.0                                       | %          | 2.4 | % | 3.3 | % |
| Weighted-average dividend yield          |       | 0.0                                        | %          | 0.0                                       | %          | 0.0 | % | 0.0 | % |
| Weighted-average volatility              |       | 0.00                                       | %          | 0.0                                       | %          | 44.3 | % | 41.5 | % |
| Weighted-average expected life           |       | 0 years                                    |       | 0 years                                   |       | 3.1 years |   | 4.0 years |   |

 

Duringthe three months ended June 30, 2003, the Company awarded 164,300 sharesof restricted stock under the 2002 Plan. The restricted shares were issued atno cost to the recipients; therefore, the Company recorded deferredcompensation of approximately $2.9 million based on the market value of thestock at the date of issuance. Subsequent to the grant date, certain forfeitures of restricted stockhave occurred resulting in a total award of 155,000 shares and total deferredcompensation of $2.8 million.  Thedeferred compensation charge is being amortized to expense over the vestingperiod of the restricted stock. The restricted shares vest over a three-yearperiod ending July 1, 2006, with acceleration of the vesting periodoccurring if a certain stock price or performance target is achieved. For thethree months ended September 30, 2003 and 2004, approximately $0.3 millionand $0.2 million, respectively, of deferred compensation was amortized toexpense related to this grant.  For thenine months ended September 30, 2003 and 2004, approximately $0.4 millionand $0.7 million, respectively, of deferred compensation was amortized toexpense related to this grant.

 

Duringthe three months ended March 31, 2004, the Company awarded 132,000 sharesof restricted stock under the 2002 Plan. The restricted shares were issued at no cost to the recipients;therefore, the Company recorded deferred compensation of approximately $3.5million based on the 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 nine months ended September 30,2004, approximately $0.3 million and $0.8 million of deferred compensation wasamortized to expense related to this grant.

 

11

----

 

Duringthe three months ended June 30, 2004, the Company awarded 50,550 shares ofrestricted stock under the 2002 Plan. The restricted shares were issued at no cost to the recipients;therefore, the Company recorded deferred compensation of approximately $1.2million based on the market 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 and nine months ended September 30,2004, approximately $0.1 million and $0.2 million of deferred compensation wasamortized to expense related to this grant.

 

Totaldeferred compensation amortized to expense related to the restricted stockgrants was approximately $0.6 million and $1.7 million during the three andnine months ended September 30, 2004, respectively, and approximately $0.3million and $0.4 million during the three and nine months ended September 30,2003, respectively.

 

*Common Stock Repurchase Program*

 

During2003, the Company activated the $30.0 million stock repurchase programauthorized by the Board of Directors in April 2001 and purchased 1,306,979shares of its common stock at a cost of approximately $20.7 million.  During the three months ended June 30,2004, the Company purchased an additional 361,415 shares of its common stock ata cost of approximately $9.3 million completing the original repurchaseprogram.  The repurchased shares wererecorded in the accompanying balance sheet as a reduction to common stock,additional paid-in-capital, and retained earnings.  These shares have been retired and returnedto the status of authorized but unissued shares of the Company.

 

Duringthe third quarter of 2004, the Board of Directors authorized the purchase of anadditional $20 million of shares from time to time in the open market asconditions warrant.  During the threemonths ended September 30, 2004, the Company purchased 34,800 shares ofcommon stock at a cost of approximately $0.8 million.

 

*Net Income Per Share:*

 

Basicand diluted net income per common share were computed in accordance with SFASNo. 128, *Earnings Per Share*. Thedifferences between basic weighted average common shares and diluted weightedaverage common shares and potentially dilutive common shares are as follows (inthousands):

 
| ** **                                                                         | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                         | ** ** | **2003**                                   | ** ** | **2004**                                  | ** ** | **2003** | ** ** | **2004** | ** ** |
| Basic weighted average common shares                                               |       | 16,188                                     |       | 15,781                                    |       | 16,571 |   | 15,964 |   |
| Weighted average options, warrants,  restricted stock and contingent consideration |       | 167                                        |       | —                                    |       | 83 |   | 336 |   |
| Diluted weighted average common shares                                             |       | 16,355                                     |       | 15,781                                    |       | 16,654 |   | 16,300 |   |

 

AtSeptember 30, 2003 and 2004, approximately 2.9 million and 2.4 million,respectively, of potentially dilutive common shares were not included in thediluted earnings per share calculation because they were anti-dilutive.  These potentially dilutive common shares maybe dilutive to future earnings per share calculations.

** **

**5. Discontinued Operations**

 

During the first quarter of 2004, the Companycompleted a strategic evaluation of its operations based on certain criteria,such as strategic and financial fit, and future growth prospects.  As a result, on May 6, 2004, the Companyformally committed to a plan of divestiture for certain non-strategic assetgroups related to its Direct Mail operations reported in the InformationManagement and Distribution segment in prior periods, and two medical recordsmanagement operations reported in the Healthcare, Regulatory and LegalCompliance segment in prior periods.  TheDirect Mail operations and the two medical records management operations areaccounted for as discontinued operations. As such, the operating assets and liabilities of these operations arepresented in the condensed consolidated balance sheets as Assets andLiabilities of Discontinued Operations and the results associated with theseoperations are presented in the condensed consolidated statement of operations asIncome (Loss) from Discontinued Operations, net of tax.

 

During the second quarter of 2004, theCompany completed the sale of one of the medical records management operations,which resulted in approximately $0.8 million of cash proceeds and a pre-taxgain on disposal of approximately $0.5 million. Additionally, the Company recognized a pre-tax loss on disposal relatedto the Direct Mail operations of approximately $2.2 million.

 

During the third quarter of 2004, the Companycompleted the sale of the Direct Mail operations and the remaining medicalrecords management operation, resulting in the recognition of a net pretax gainof $0.4 million.  In connection withthese transactions, the Company received approximately $6.1 million of cashproceeds, net of transaction costs, approximately $1.5 million of 12 percentsecured subordinated notes, which the Company fully reserved for related to theDirect Mail operations and $0.6 million of contingent consideration related toa contract renewal at the medical records management operation.

 

12

----

 

During the fourth quarter of 2004, thecontingency surrounding the contract renewal at the medical records managementoperation was resolved.  As such, theCompany recognized additional consideration of $0.6 million offset byapproximately $0.1 million of incremental loss related to finalizing theconsideration related to the divestiture.

 

The collection of the reserved subordinated notes could result in afuture reduction of the total loss recognized related to the disposition of theDirect Mail operations.

 

Summarizedselected financial information for the discontinued operations is as follows(in thousands):

 
| ** **                                             | ** ** | **Three Months Ended  September30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------------|------------|
| ** **                                             | ** ** | **2003**                             | ** ** | **2004**                                  | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                                             | ** ** | **(Unaudited)**                      | ** ** | **(Unaudited)**                           | ** ** |
| **REVENUE**                                            |       | $                                    | 9,358      |                                      | $          | 262 |   | $ | 30,014 |   | $ | 15,789 |   |
| **COST OF  SERVICES**                                  |       | 7,116                                |       | 750                                       |       | 22,032 |   | 13,484 |   |
| **DEPRECIATION**                                       |       | 414                                  |       | —                                    |       | 1,287 |   | 528 |   |
| Gross profit (loss)                                    |       | 1,828                                |       | (488                                      | )          | 6,695 |   | 1,777 |   |
| **SELLING,  GENERAL AND ADMINISTRATIVE EXPENSES**      |       | 2,049                                |       | 347                                       |       | 7,211 |   | 4,693 |   |
| Operating loss                                         |       | (221                                 | )          | (835                                      | )          | (516 | ) | (2,916 | ) |
| **OTHER  (INCOME) EXPENSE:**                           |       |                                 |       |                                      |       |   |   |   |   |
| Interest and other expense (income), net               |       | (25                                  | )          | (39                                       | )          | (48 | ) | (19 | ) |
| (Gain) loss on sale of asset groups                    |       | —                               |       | (361                                      | )          | — |   | 1,371 |   |
| Loss from discontinued operations before  income taxes |       | (196                                 | )          | (435                                      | )          | (468 | ) | (4,268 | ) |
| **PROVISION  (BENEFIT) FOR INCOME TAXES**              |       | (78                                  | )          | (174                                      | )          | (187 | ) | (1,707 | ) |
| **LOSS  FROM DISCONTINUED OPERATIONS**                 |       | $                                    | (118       | )                                         | $          | (261 | ) | $ | (281 | ) | $ | (2,561 | ) |

 

13

----

 

Theassets and liabilities of the discontinued operations are stated separately onthe Condensed Consolidated Balance Sheets. The major asset and liability categories are as follows (in thousands):

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

 

**6. Business Combinations**

 

*2004 Acquisition*

 

OnApril 15, 2004, the Company acquired 100% of the membership interests ofKeyPoint Consulting LLC (“KeyPoint”), located in Emeryville and LosAngeles, California.  KeyPoint is aneconomic consulting firm with approximately 26 principals and staff, and anetwork of academic affiliates.  KeyPointprovides economic, financial, and forensic accounting services in mattersinvolving complex litigation and regulation. KeyPoint’s clients include companies, law firms, and government andregulatory agencies.  The acquisition ofKeyPoint significantly expands SOURCECORP’s expertise in new practice areas andhelps strategically position SOURCECORP for additional growth in the Company’slegal consulting area reported in the Healthcare, Regulatory and LegalCompliance segment.  KeyPoint is expectedto add approximately $6 million in revenue in 2004, or approximately 3% oftotal segment revenue, and will be moderately accretive to 2004 earnings afterconsideration of related financing costs and amortization of identified intangibles.

 

Theaggregate consideration paid during the second quarter for KeyPoint consistedof $13.7 million in cash.   Anadditional $1.5 million in cash was paid during the third quarter, inaccordance with the acquisition 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                                        |   | (864   | )      |
| Prepaid expenses                                   |   | (21    | )      |
| Property, plant and equipment, net                 |   | (112   | )      |
| Total Assets                                       |   | (2,424 | )      |
| Plus Estimated Fair Value of Liabilities:          |   |   |   |
| Accounts payable and accrued expenses              |   | 294    |   |
| Accrued compensation                               |   | 233    |   |
| Deferred tax liability                             |   | 32     |   |
| Other liabilities                                  |   | 1,076  |   |
| Total Liabilities                                  |   | 1,635  |   |
| Goodwill and other intangibles                     |   | $      | 14,231 |   |

 

Ofthe $14.2 million of goodwill and other intangibles recorded from theacquisition, approximately $0.3 million was assigned to customerrelationships with a useful life of eight months and approximately $1.9 millionwas assigned to non-compete agreements with a useful life of four years.The remaining goodwill of $12.0 million will be tested annually forimpairment.  Approximately $4.6 millionof the goodwill is deductible for tax purposes.

 

*Goodwill and Intangibles*

 

Thechanges in the carrying value of goodwill and the components of intangibles areas follows (in thousands):

 

14

----

 

Goodwill:

 
| ** **                                | ** ** | **Information  Management and  Distribution** | ** ** | **Healthcare,  Regulatory  and Legal  Compliance** | ** ** | **Total** | ** ** |
|-------------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------------|------------|-----------|------------|
| Net balance as of January 1, 2004    |       | $                                             | 162,007    |                                               | $          | 145,906   |       | $ | 307,913 |   |
| Goodwill acquired                         |       | —                                        |       | 12,067                                             |       | 12,067    |       |
| Additional accrued consideration          |       | 319                                           |       | 506                                                |       | 825       |       |
| Net balance as of September 30, 2004 |       | $                                             | 162,326    |                                               | $          | 158,479   |       | $ | 320,805 |   |

 

Intangibles:

 
| ** **             | ** ** | **December 31, 2003** | ** ** | **September 30, 2004**   | ** ** |
|------------------------|------------|----------------------------|------------|-------------------------------|------------|
| ** **             | ** ** | **Gross Carrying  Value**  | ** ** | **Accumulated  Amortization** | ** ** | **Gross Carrying  Value** | ** ** | **Accumulated  Amortization** | ** ** |
| Customer relationships |       | $                          | 4,000      |                          | $          | (534 | ) | $ | 4,283 |   | $ | (946 | ) |
| Non-compete agreements |       | 440                        |       | (175                          | )          | 2,321 |   | (477 | ) |
| Total                  |       | $                          | 4,440      |                          | $          | (709 | ) | $ | 6,604 |   | $ | (1,423 | ) |

 

Aggregateamortization expense related to intangibles for the nine months ended September 30,2003 and 2004 was approximately $0.3 million and $0.7 million, respectively.Estimated amortization expense for the periods ending December 31, 2004through 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                                 |       |
| Thereafter                          |       | 2,133                               |       |
| Total                               |       | $                                   | 5,895      |   |

*Contingent Consideration*

 

Certainof the Company’s acquisitions are subject to adjustments in overallconsideration and recorded goodwill based upon the achievement of specifiedrevenue and/or earnings targets generally over one to three year periods. Incertain agreements, the Company reserves the right to change the payment mix touse common stock versus cash in satisfying contingent considerationliabilities. In transactions where the Company acquired a subsidiary through atax-free stock merger, the Company is required to pay a minimum amount of totalconsideration in common stock rather than cash, including any contingentconsideration payments.

 

Asof September 30, 2004, there are no accruals related to contingentconsideration.

 

Notall of the periods applicable for earnout targets are completed and additionalamounts may be payable in future periods under the terms of theagreements.  If all earnout targets underthe current agreements were achieved, the maximum contingent consideration tobe paid would be $5.3 million and would be paid in 2005.  In accordance with the agreements, theCompany has the option to satisfy the entire $5.3 million (or any partthereof) of the potential liability in common stock with final valuation forthe number of shares to be determined at date of issuance.

 

# *Other Accrued Consideration*

 

Duringthe three months ended September 30, 2004, no additional purchase proceedswere accrued.

 

*AcquisitionRelated Payments*

 

Duringthe nine months ended September 30, 2004, the Company paid netconsideration of approximately $3.4 million in cash and 30,324 shares of commonstock at an average price of $26.12 per share related to contingentconsideration agreements of

 

15

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past acquisitions.  In addition,the Company paid $13.7 million, net of cash acquired, related to the KeyPointacquisition and the associated transaction costs and $0.4 of additionalpurchase proceeds related to the purchase agreement of a past acquisition.

 

**7. Segment Reporting**

 

TheCompany aggregates its service offerings and operations into two reportablesegments: (i) Information Management and Distribution, and(ii) Healthcare, Regulatory, and Legal Compliance. The Company’sreportable segments are organized around customer types and service offeringspossessing similar economic characteristics. Management evaluates segmentperformance based on revenue and income before income taxes. All centrallyincurred corporate costs are allocated to the segments based principally onoperating income of the reportable segments measured before the inclusion ofthe expense related to the contingent consideration overpayments discussed inNote 2.  The reporting segments followthe same accounting policies used for the Company’s consolidated financialstatements.

 

Duringthe quarter ended September 30, 2004, the Company realigned certainoperations in order to leverage management expertise, reduce costs, maximizeprofitability and better align these operations with other operating units ofsimilar core competencies.  Therealignment resulted in certain operations being transferred from theInformation Management and Distribution reportable segment to the Healthcare,Regulatory and Legal Compliance reportable segment.  The Company has reclassified prior periodamounts to be consistent with the current quarter and year to date segmentreporting.

 

Theidentified segments are as follows:

 

**Information Management and Distribution.**  Thissegment offers Business Process Outsourcing (“BPO”) solutions that help itscustomers 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 largevolumes of documents, capturing information from the documents, hostingelectronic documents on the Company’s Web-based repository, and preparingstatements that the Company’s customers mail or present electronically to theirend users.

 

**Healthcare, Regulatory and Legal Compliance.**  Thissegment offers specialized knowledge-based processing and consulting servicesthat include medical records release, record management services for healthcareinstitutions, temporary staffing for healthcare institutions, managed carecompliance reviews, class action claims administration, and professionaleconomic research and litigation services.

 

16

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TheCompany measures segment profit as income from continuing operations beforeincome taxes. Information on the segments follows (in thousands):

 
| ** **                                                    | ** ** | **THREE MONTHS ENDED SEPTEMBER 30, 2004** | ** ** |
|---------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                    | ** ** | **Information  Management  and  Distribution** | ** ** | **Healthcare,  Regulatory  and Legal  Compliance** | ** ** | **Consolidated** | ** ** |
| Revenue                                                       |       | $                                              | 48,138     |   | $ | 49,536 |   | $ | 97,674 |   |
| Income (loss) from continuing operations before  income taxes |       | (7,760                                         | )          | 5,539 |   | (2,221 | ) |
|                                                               |            |                                                |            |  |  |  |  |  |  |  |

 
| ** **                                                    | ** ** | **THREE MONTHS ENDED SEPTEMBER 30, 2003** | ** ** |
|---------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                    | ** ** | **Information  Management  and  Distribution** | ** ** | **Healthcare,  Regulatory  and Legal  Compliance** | ** ** | **Consolidated** | ** ** |
| Revenue                                                       |       | $                                              | 44,897     |   | $ | 46,831 |   | $ | 91,728 |   |
| Income (loss) from continuing operations before  income taxes |       | (2,891                                         | )          | 6,935 |   | 4,044 |   |
|                                                               |            |                                                |            |  |  |  |  |  |  |  |

 
| ** **                                                    | ** ** | **NINE MONTHS ENDED SEPTEMBER 30, 2004**  | ** ** |
|---------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                    | ** ** | **Information  Management  and  Distribution** | ** ** | **Healthcare,  Regulatory  and Legal  Compliance** | ** ** | **Consolidated** | ** ** |
| Revenue                                                       |       | $                                              | 146,191    |   | $ | 146,306 |   | $ | 292,497 |   |
| Income (loss) from continuing operations before  income taxes |       | (4,833                                         | )          | 17,963 |   | 13,130 |   |
|                                                               |            |                                                |            |  |  |  |  |  |  |  |

 
| ** **                                             | ** ** | **NINE MONTHS ENDED SEPTEMBER 30, 2003**  | ** ** |
|--------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                             | ** ** | **Information  Management  and  Distribution** | ** ** | **Healthcare,  Regulatory  and Legal  Compliance** | ** ** | **Consolidated** | ** ** |
| Revenue                                                |       | $                                              | 141,454    |   | $ | 138,887 |   | $ | 280,341 |   |
| Income from continuing operations before  income taxes |       | 7,132                                          |       | 18,144 |   | 25,276 |   |
|                                                        |            |                                                |            |  |  |  |  |  |  |  |

 

**8.Litigation**

 

TheCompany is, from time to time, a party to litigation arising in the normalcourse of business. The following is a description of the most significant legalmatters that the Company is involved in. In the event of an adverse outcome in one or more of the legalproceedings, operating results for a given quarter may be negatively impacted.

### ** **

### ***Putative Securities Class Action***

TheCompany, and the Company’s CEO and CFO individually, have been named asdefendants in several putative securities class actions, in response to theCompany’s press releases dated October 27, 2004, in which the Companydisclosed that its financial statements for certain prior periods should nolonger be relied upon, and also provided updated financial guidance. Thecomplaints (collectively, the “Actions”) were filed in the United States DistrictCourt for the Northern District of Texas, Dallas Division. The Actions areputative shareholder class action lawsuits alleging violations of FederalSecurities Laws, including alleged violations of Sections 10(b) and 20(a), andRule 10b-5 of the Securities Exchange Act of 1934, as amended. The Actions arepurportedly on behalf of all persons who purchased the Company’s common stockduring the period between May 7, 2003, and October 26, 2004 or October 27,2004, depending on the Action, and seek unspecified damages.  The four Actions have been transferred to asingle judge in the Northern District of Texas, Dallas Division.  Two of these actions have been consolidatedand a motion is pending to consolidate each of the actions into a singleaction.

 

#### ***Purported Derivative Action and Demand Letter***

Apurported stockholder derivative action was filed on December 28, 2004,against certain of the Company’s current and former officers and directors asindividual defendants and the Company as a nominal defendant in the 116thDistrict Court for Dallas County, Texas (the “Purported Derivative Action”).The Purported Derivative Action alleges breach of fiduciary duty, abuse ofcontrol, gross mismanagement, waste of assets, and unjust enrichment related tothe Company’s press release dated October 27, 2004, in which the Companydisclosed that its financial statements for certain prior periods should nolonger be relied upon. All of these claims are asserted derivatively on behalfof the Company.  Further, the Chairman ofthe Company’s Board of Directors received from a purported shareholder a demandletter (the “Demand Letter”) based on the same set of facts as the PurportedDerivative Action.  The Company hasformed a special committee of the Board of Directors to evaluate the claimsmade in the Purported Derivative Action and the Demand Letter.

 

*DigitalImaging Systems*

OnAugust 5, 2004, Digital Imaging Systems, Inc. filed suit against theCompany in the United States District Court-Southern District of New York alleging,among other things, that a portion of the Company’s process for scanning andindexing images violates one of Digital Imaging Systems’ patents.  The Company has tendered this matter to oneof its software/hardware

 

17

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vendors for indemnification, which such vendor is evaluating.  The suit demands unspecified damages.

 

*Healthcare Marketing Associates, Inc. vs. Managed CareProfessionals, Inc.*

OnFebruary 9, 1995, prior to the acquisition by the Company, Managed CareProfessionals, Inc. (one of the Company’s wholly-owned subsidiaries) (“MCP”)entered into 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 $1.782 million plus prejudgment andpost judgment interest, which equated to approximately $2.4 million intotal as of December 31, 2003. The judgment amount plus prejudgmentinterest costs were included in the Company’s 2002 results. Post judgment interestaccrued at a statutory 9% rate.  TheCompany appealed this ruling and on May 4, 2004, the Court of Appeals affirmedthe Circuit Court’s judgment.  On July 23,2004, the Company filed an application for transfer of its appeal to the state’sSupreme Court, which was denied.  TheCompany subsequently paid such judgment and interest.

 

*Various ROI Copy Charge Matters*

Fromtime to time, various subsidiaries of the Company that perform release ofinformation (“ROI”) services become defendants to putative class actionlawsuits generally alleging that the charge for reproducing certain medicalrecords is not in conformity with such plaintiffs’ reading of the applicableregulated charge. Such suits typically include multiple ROI companies andhospitals as defendants and demand reimbursement for prior charges as well asfor prospective pricing adjustments. The Company is currently a party toseveral such suits in various stages of development.  One such suit styled *McShane v. Recordex Acquisition Corp. &Sourcecorp, Incorporated*, filed in the Court of Common PleasPhiladelphia County,  Pennsylvania,alleges among other things that the Company intentionally charges more forproviding copies of medical records than is permitted under Pennsylvanialaw.  In September 2004, the courtentered its order certifying a class in this matter  The Company believes it has meritoriousdefenses and intends to continue to vigorously defend any claims made againstit in these matters.

 

*Mattel v. SOURCECORP*

OnFebruary 18, 2003, Mattel, Inc. filed suit against the Company in theLos Angeles County California Superior Court. In the suit, the plaintiffalleged that one of the Company’s subsidiaries is liable for the loss ofvarious products, prototypes and paper documents allegedly stored at one of thesubsidiary’s box storage facilities under theories of breach of contract,breach of fiduciary duty, negligence, breach of implied covenants of good faithand fair dealing and/or conversion. The plaintiff at various times allegeddamages ranging from “in excess of $2.5 million,” to approximately$20 million.  This matter wassettled prior to trial, the terms of which settlement are confidential. Thesettlement and related legal costs impacted the Company’s first quarter 2004pre-tax earnings by approximately $3.9 million. Furthermore, the impact of the settlement and related legal costs on theCompany’s 2004 cash provided by operating activities was approximately $5.7million, before consideration of taxes.

 

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

InJune 2000, the Company filed an action styled *F.Y.I. Incorporated v. Spohr, et. al.* in Dallas, Texas, inwhich it asserted claims for breach of contract, fraud, and negligentmisrepresentation against the sellers of two related companies the Companyacquired in December 1998 (the “Texas Action”). The Texas Action was laterremoved to federal court and ultimately dismissed on jurisdictional grounds.The Company reasserted these claims in two actions that were laterconsolidated; one styled *F.Y.I. Incorporatedv. Spohr, et. al.* in Superior Court of the State of California inthe 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 the State of Californiain the County of San Francisco, Case No. 318703 (the “San Francisco Action”).In the consolidated action, the Company additionally filed claims against thesellers’ accountants and the two sellers filed claims against the Company;however, in February 2004, the judge in the Sacramento Action dismissedthe Company’s claims against the sellers’ accountants. The sellers allege thatthe Company’s former subsidiary wrongfully failed and refused to execute anddeliver a requested estoppel certificate, and that the failure to provide suchestoppel certificate harmed the landlord in that they were allegedly deniedfavorable terms on a refinancing of the property and were allegedly preventedfrom completing a timely sale of the property. Sellers alleged damages ofapproximately $1.5 million. The Company asserted damages in excess of$8 million. On February 3, 2005, the parties settled this matter on mutually acceptable termsconsistent with previous amounts accrued.

 

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**9.Subsequent Events**

 

*OptionsAcceleration*

 

On December 18, 2004,the Compensation Committee of the Board of Directors approved, and the Board ofDirectors ratified, the acceleration of the vesting of certain options andwarrants (specifically options and warrants issued in 2002 or earlier, and onlythose options and warrants that by their terms would not vest before June 30,2005), provided that the holders were employed by the Company as of December 31,2004.  The action was taken as a method toprovide a further incentive to maximize shareholder value without creating animmediate windfall (as substantially all of such options and warrants hadexercise prices above $30 per share).  Intaking such action, the Compensation Committee and the Board were mindful thatthe accounting treatment of stock options and warrants changes in the secondhalf of 2005, requiring the expensing of unvested stock options and warrants.  As such, the Compensation Committee and the Boardwere mindful that accelerating the vesting of such options and warrants wouldavoid an expense that did not provide any direct associated benefit toindividuals and that could otherwise negatively impact the Company’s reportedresults in future periods.  This actionresulted in the acceleration of vesting of 364,100 stock options and warrantsat a weighted-average strike price of $30.38 during the fourth quarter of2004.  Although this action established anew measurement date for the stock options and warrants under the intrinsicvalue method, there was no compensation expense associated with the vestingacceleration as the strike price related to the accelerated stock options andwarrants was above the fair market value of the Company’s common stock on December 17,2004.  As a result of the acceleration,the pro forma expense disclosure required by Statement of Financial AccountingStandards (“SFAS”) No. 123, *Accountingfor Stock Based Compensation*,contained in the Company’s 2004 Form 10-K will include approximately $2.1million, net of tax, of additional expense related to the acceleration.

 

*DiscontinuedOperations*

 

Duringthe first quarter of 2005, the Company formally committed to a plan ofdivestiture for a non-strategic asset group related to its litigation serviceoperations reported in the Healthcare, Regulatory and Legal Compliance segmentin prior periods.  During 2004, theoperation contributed approximately $3.7 million of revenue and loss beforeincome taxes of approximately ($0.3) million. The results associated with this litigation service operation will beaccounted for as discontinued operations beginning in the first quarter of2005.

 

**10. 2001Credit Agreement**

 

Pursuant to the terms of the Company’s 2001 Credit Agreement, EBITDA isused in calculating certain leverage and fixed cost coverage ratios. TheCompany exceeded the allowable leverage ratio of 2.5 times for the quartersended June 30, 2004 and September 30, 2004 as a result of the earn-outoverpayments, previously discussed.  Thishas resulted in a default under the 2001 Credit 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 currentlyworking with its lenders to secure such an amendment and it is anticipated thatthis amendment will soon become effective. In any event, as the maturity dateof the debt under the 2001 Credit Agreement is April 1, 2006, unless thematurity date of such debt is subsequently modified, such debt will beclassified as a Current Maturity on and after April 1, 2005.

 

19

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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 nine months ended September 30, 2003, 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 financial results which in turn resulted in overpayments and over accruals of contingent consideration amounts due under the earn-out provisions of the acquisition agreement for the Operating Subsidiary which had been originally recognized as additional goodwill of the acquired business.  As a result, our condensed consolidated financial statements for the three months and nine months ended September 30, 2003, 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.  We have 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 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 are reflected in the restated financial statements for the three months and nine months ended September 30, 2003:

 
| **(In  Thousands)**          | ** ** | **Three Months  Ended  September 30, 2003** | ** ** | **Nine Months  Ended  September 30, 2003** | ** ** |
|------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| Asset accounts               |       | $                                                | 384        |                                            | $          | 213 |   |
| Customer liability, net      |       | 86                                               |       | (575                                            | )          |
| Deferred revenue, net        |       | (310                                             | )          | (1,503                                          | )          |
| Total Net Revenue Adjustment |       | $                                                | 160        |                                            | $          | (1,865 | ) |

 

**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

 

20

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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 financial results 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 to 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.

 

Therevenue recognition and expense omission issues affected previously paidcontingent consideration related to the acquisition of the OperatingSubsidiary.  As a result of the structureof the acquisition agreement, the former owners of the Operating Subsidiary hadthe opportunity to earn additional purchase consideration for the twelve-monthperiods ended February 28, 2002, February 28, 2003 and February 29,2004 (the “Earn-out Period(s)”) based on earnings before interest and taxes ofthe Operating Subsidiary, in excess of designated thresholds, calculated inaccordance with accounting principles generally accepted in the United Statesof 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 Subsidiarywere overstated during the Earn-out Period(s) resulting in overpayments andoveraccruals under the provisions of the Earn-out Agreement that otherwisewould not have been made.  We haveexpensed the contingent consideration overpayments in the financial statementsin the periods in which they were paid, resulting in expense of $8.6 million, $7.2million and $10.2 million for the years ended December 31, 2002 and 2003,and the three and nine months ended September 30, 2004, respectively.  These amounts had previously been accrued ascontingent consideration and an addition to goodwill.  We have reversed these accruals and relatedgoodwill in the periods originally recorded.  We will record a gain in future periods to theextent 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.

 

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

 

**BALANCE SHEET INFORMATION**

**(Unaudited)**

 
| ** **                               | ** ** | **At December 31, 2003** | ** ** |
|------------------------------------------|------------|-------------------------------|------------|
| ** **                               | ** ** | **As Previously  Reported**   | ** ** | **As  Restated** | ** ** |
| ** **                               | ** ** | **(Item 1)**                  | ** ** | ** ** | ** ** |
| Accounts and Notes Receivable, Net       |       | $                             | 67,873     |   | $ | 63,522 |   |
|                                     |       |                          |       |   |   |
| Income Tax Receivable                    |       | $                             | —     |   | $ | 3,000 |   |
|                                     |       |                          |       |   |   |
| Goodwill                                 |       | $                             | 324,305    |   | $ | 307,913 |   |
|                                     |       |                          |       |   |   |
| Total Assets                             |       | $                             | 470,273    |   | $ | 452,530 |   |
|                                     |       |                          |       |   |   |
| Accounts Payable and Accrued Liabilities |       | $                             | 52,054     |   | $ | 52,375 |   |
|                                     |       |                          |       |   |   |
| Income Tax Payable                       |       | $                             | 2,186      |   | $ | — |   |
|                                     |       |                          |       |   |   |
| Deferred Income Taxes                    |       | $                             | 18,084     |   | $ | 11,753 |   |
|                                     |       |                          |       |   |   |
| Long-term Customer Liability             |       | $                             | —     |   | $ | 1,862 |   |
|                                     |       |                          |       |   |   |
| Deferred Revenue                         |       | $                             | —     |   | $ | 5,135 |   |
|                                     |       |                          |       |   |   |
| Other Long-term Obligations              |       | $                             | 7,839      |   | $ | 9,306 |   |
|                                     |       |                          |       |   |   |
| Retained Earnings                        |       | $                             | 119,236    |   | $ | 101,225 |   |
|                                     |       |                          |       |   |   |
| Total Stockholders’ Equity          |       | $                             | 311,088    |   | $ | 293,077 |   |
|                                          |            |                               |            |  |  |  |  |  |  |

 

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**Item 1:****         **Amounts aspreviously reported after giving effect to adjustments required to reflect theCompany’s discontinued operations discussed in Note 5 to the consolidatedfinancial statements.

 

22

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**STATEMENTOF OPERATIONS INFORMATION**

**(All Periods Presented Unaudited)**

 
| ** **                                             | ** ** | **Three Months Ended  September 30, 2003** | ** ** | **Nine Months Ended  September 30, 2003** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                             | ** ** | **As Previously  Reported**                     | ** ** | **As  Restated**                               | ** ** | **As Previously  Reported** | ** ** | **As  Restated** | ** ** |
| ** **                                             | ** ** | **(Item 1)**                                    | ** ** | ** **                                     | ** ** | **(Item 1)** | ** ** | ** ** | ** ** |
|                                                   |       |                                            |       |                                           |       |   |   |   |   |
| Revenue                                                |       | $                                               | 91,568     |                                           | $          | 91,728 |   | $ | 282,206 |   | $ | 280,341 |   |
|                                                   |       |                                            |       |                                           |       |   |   |   |   |
| Gross Profit                                           |       | $                                               | 35,834     |                                           | $          | 35,994 |   | $ | 109,099 |   | $ | 107,234 |   |
|                                                   |       |                                            |       |                                           |       |   |   |   |   |
| Selling, General & Administrative  Expense         |       | $                                               | 24,049     |                                           | $          | 24,058 |   | $ | 71,799 |   | $ | 71,882 |   |
|                                                   |       |                                            |       |                                           |       |   |   |   |   |
| Contingent Consideration Overpayment                   |       | $                                               | —     |                                           | $          | 7,223 |   | $ | — |   | $ | 7,223 |   |
|                                                   |       |                                            |       |                                           |       |   |   |   |   |
| Income From Continuing Operations Before  Income Taxes |       | $                                               | 11,116     |                                           | $          | 4,044 |   | $ | 34,447 |   | $ | 25,276 |   |
|                                                   |       |                                            |       |                                           |       |   |   |   |   |
| Provision for Income Taxes                             |       | $                                               | 4,446      |                                           | $          | 1,619 |   | $ | 13,778 |   | $ | 10,115 |   |
|                                                   |       |                                            |       |                                           |       |   |   |   |   |
| Income From Continuing Operations                      |       | $                                               | 6,670      |                                           | $          | 2,425 |   | $ | 20,669 |   | $ | 15,161 |   |
|                                                   |       |                                            |       |                                           |       |   |   |   |   |
| Net Income                                             |       | $                                               | 6,552      |                                           | $          | 2,.307 |   | $ | 20,388 |   | $ | 14,880 |   |
|                                                   |       |                                            |       |                                           |       |   |   |   |   |
| **Net  Income Per Share:**                             |       |                                            |       |                                           |       |   |   |   |   |
| **Basic**                                              |       |                                            |       |                                           |       |   |   |   |   |
| Continuing Operations                                  |       | $                                               | 0.41       |                                           | $          | 0.15 |   | $ | 1.25 |   | $ | 0.92 |   |
|                                                   |       |                                            |       |                                           |       |   |   |   |   |
| Total                                                  |       | $                                               | 0.40       |                                           | $          | 0.14 |   | $ | 1.23 |   | $ | 0.90 |   |
|                                                   |       |                                            |       |                                           |       |   |   |   |   |
| **Diluted**                                            |       |                                            |       |                                           |       |   |   |   |   |
| Continuing Operations                                  |       | $                                               | 0.41       |                                           | $          | 0.15 |   | $ | 1.24 |   | $ | 0.91 |   |
|                                                   |       |                                            |       |                                           |       |   |   |   |   |
| Total                                                  |       | $                                               | 0.40       |                                           | $          | 0.14 |   | $ | 1.22 |   | $ | 0.89 |   |
|                                                        |            |                                                 |            |                                                |            |  |  |  |  |  |  |  |  |  |  |  |

 

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**Item1:****         **Amountsas previously reported after giving effect to adjustments required to reflectthe Company’s discontinued operations discussed in Note 5 to the consolidatedfinancial statements.

 

23

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**STATEMENT OF CASH FLOW INFORMATION**

**(Unaudited)**

 
| ** **                                                            | ** ** | **Nine Months Ended  September 30, 2003** | ** ** |
|-----------------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                            | ** ** | **As Previously  Reported**                    | ** ** | **As Restated** | ** ** |
| ** **                                                            | ** ** | **(Item 1)**                                   | ** ** | ** ** | ** ** |
| Net Cash Provided by Operating Activities  From Continuing Operations |       | $                                              | 51,270     |   | $ | 44,047 |   |
|                                                                  |       |                                           |       |   |   |
| Net Cash Used in Investing Activities From  Continuing Operations     |       | $                                              | (19,362    | ) | $ | (12,139 | ) |

 

----

**Item1:****         **Amountsas previously reported after giving effect to adjustments required to reflectthe Company’s discontinued operations discussed in Note 5 to the consolidatedfinancial statements.  The cash flowrestatement impact of contingent consideration overpayments and related expensewas limited to the three and twelve months ended December 31, 2002 and thethree and nine months ended September 30, 2003.

 

The cash flow categories above are impacted as a result of restating thecontingent consideration overpayments discussed above from cash paid foracquisitions (included in net cash used in investing activities from continuingoperations) to net cash provided by operating activities from continuingoperations as a period expense.

 

Thefollowing discussion should be read in conjunction with our financialstatements and the related notes thereto appearing elsewhere in this Report onForm 10-Q.  In addition, the followingdiscussion gives effect to the restatement adjustments discussed above.

 

**Overview**

 

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

 

Weacquired the seven Founding Companies (the “Founding Companies”) simultaneouslywith the closing 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.

 

OnMay 4, 2004, we announced the acquisition of KeyPoint Consulting, LLC (“KeyPoint”).  KeyPoint is an economic consulting firm withapproximately 26 principals and staff, and a network of academicaffiliates.  KeyPoint provides economic,financial, and forensic accounting services in matters involving complexlitigation and regulation.  KeyPoint’sclients include companies, law firms, and government and regulatoryagencies.  The acquisition of KeyPointsignificantly expands SOURCECORP’s expertise in new practice areas and helpsstrategically position SOURCECORP for additional growth in our legal consultingarea.  Keypoint joined our legalconsulting service offering and is reported in the Healthcare, Regulatory andLegal Compliance segment.  KeyPoint isexpected to add approximately $6 million in revenue in 2004, or approximately3% of total segment revenue, and will be moderately accretive to 2004 earningsafter consideration of related financing costs and amortization of identifiedintangibles.

 

Duringthe first quarter of 2004, we completed a strategic evaluation of ouroperations based on certain criteria, such as strategic and financial fit, andfuture growth prospects.  As a result, onMay 6, 2004, we formally committed to a plan of divestiture for certainnon-strategic asset groups.  The assetgroups to be divested include the Direct Mail operations, previously reportedin our Information 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 ended September 30, 2004. See Note 5, Discontinued Operations, of the Notes to CondensedConsolidated Financial Statements, for a more detailed discussion, includingthe adjustments that were recorded during the current quarter.

 

During the third quarter of2004, we identified certain operating trends that continued into the fourthquarter of 2004. As discussed below, continuing revenue declines within ourHealthcare service offerings and the completion of several large projects

 

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during the third quarter within our Class Action Claims Administrationservice offering result in lower revenue and gross profit during the fourthquarter of 2004.  In addition, thefactors discussed below contributing to higher SGA expense in the third quarterof 2004 continue into the fourth quarter of 2004 resulting in approximately$4.7 million of incremental SGA expense. Both the revenue and SGA trends are offset by the $10.2 millioncontingent consideration overpayment expensed during the third quarter of2004.  Collectively, these issues areexpected to result in increased income from continuing operations before tax of$3.1 million when comparing the fourth and third quarters of 2004.

 

During the first quarter of2005, we entered into an agreement with one of our customers impacted by thefacts relating to the subject of our internal investigation, more fullydescribed in “Internal Investigation” above and in Note 2 to the condensedconsolidation financial statements.  As aresult of the agreement, we expect to recognize, during the first quarter of2005, revenue of $4.1 million related to deferred revenue and customerliability restatement adjustments.

 

**Other Matters**

 

*SECInvestigation*

 

TheCompany received written confirmation from the Securities and ExchangeCommission (“SEC”) on January 14, 2005, that the SEC has converted itsinformal inquiry in connection with the Company’s internal investigation andrestatement into a formal investigation. The Company intends to fully cooperatewith the SEC in connection with the investigation.  The Company initially had contacted theenforcement division of the SEC on a voluntary basis to notify the agency ofthe Company’s understanding of the events leading to its internalinvestigation.

 

*NasdaqListing*

 

The NASDAQ ListingQualification Panel previously granted the Company a listing requirementsexception that contemplated among other things that the Company would file itsthird quarter 2004 Quarterly Report on Form 10-Q and certain prior periodfinancial information by March 16, 2005. The Company requested a further modification to its Nasdaq exception tocontemplate the filing of its third quarter 2004 Quarterly Report on Form 10-Q,and certain unaudited prior period financial information, by March 23,2005, and the filing of its 2004 Annual Report on Form 10-K by March 31,2005.  By letter dated March 22, 2005,the Nasdaq Listing Qualification Panel granted this modified exception with theadditional requirement that the Company, by March 31, 2005, provide the Panelwith a brief written summary of the status and focus of the above referencedSEC investigation, which the Company intends to provide.  If the Company is unable to satisfy all ofthe requirements of the modified exception, the Company’s Common Stock would bedelisted from trading on the NASDAQ Stock Market unless an additional exceptionis considered and granted.

 

**Basis for Management Discussion and Analysis**

 

Thefollowing discussion and analysis focuses on the results of operations andfinancial condition from the Company’s continuing operations; as such, inaccordance with Statement of Financial Accounting Standards No. 144, referencesand comparisons to prior periods exclude the impact of our discontinuedoperations.

 

Ourrevenue possesses both project and recurring characteristics.  Project revenue includes one-time projects inwhich the customer relationship is not expected to continue after project completion.Project revenue margins are usually higher than our average margins and theworkload can be highly volatile.  Projectrevenue is typically based on time and material arrangements and predominatelyoccurs within 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 typically basedon transaction volumes sent to us by our customers at an agreed upon fixed rateper unit.  Our customers’ volumes aregenerally not contractually or otherwise guaranteed.  Recurring revenue typically possesses lowermargins than project revenue but is usually more predictable.

 

Costof services consists primarily of compensation and benefits to employeesproviding goods and services to our clients; occupancy and facility costs;equipment costs and supplies. Our cost of services also includes the cost ofproducts sold for micrographics supplies and equipment; computer hardware andsoftware; and business imaging supplies and equipment.

 

Selling,general and administrative expenses (“SG&A”) consist primarily ofcompensation and related benefits to sales and marketing, executive management,accounting, human resources and other administrative employees; other sales andmarketing costs; communications costs; general business insurance costs; andlegal and accounting 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 filed with the Securities and Exchange Commissionon March 12, 2004.

 

**Business Segments**

 

Weaggregate our 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 ofthe reportable segments measured before the inclusion of the expense related tothe contingent consideration overpayments discussed above. The reportingsegments follow the same accounting policies used for our consolidatedfinancial statements as described in the summary of critical accountingpolicies.

 

25

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Duringthe quarter ended September 30, 2004, we realigned certain operations inorder to leverage management expertise, reduce costs, maximize profitabilityand better align these operations with other operating units of similar corecompetencies.  The realignment resultedin certain operations being transferred from the Information Management andDistribution reportable segment to the Healthcare, Regulatory and LegalCompliance reportable segment.  We havereclassified prior period amounts to be consistent with the current quarter andyear to date segment reporting.

 

Theidentified segments are as follows:

 

**Information Management and Distribution.**  Weoffer Business Process Outsourcing (“BPO”) solutions that help our customersmanage the *Document In-flow*, *Workflow Processing* and *Statement Out-flow* of their missioncritical document processes. Our BPO solutions enable customers to automatetheir complex workflow processes by digitizing extremely large volumes ofdocuments, 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 September 30,2003 and 2004, revenue in the Information Management and Distribution segmentconsisted of approximately $40.0 million and $42.7 million of recurring revenue,respectively, and $4.9 million and $5.4 million of project revenue,respectively.  For the nine months ended September 30,2003 and 2004, revenue in the Information Management and Distribution segmentconsisted of approximately $123.4 million and $130.2 million of recurringrevenue, respectively, and approximately $18.1 million and $16.0 million ofproject revenue, respectively.

 

**Healthcare, Regulatory and Legal Compliance.**  Weoffer specialized knowledge-based processing and consulting services that includemedical records release, record management services for healthcareinstitutions, temporary staffing for healthcare institutions, managed carecompliance reviews, class action claims administration, and professionaleconomic research and litigation services. For the three months ended September 30,2003 and 2004, revenue in the Healthcare Regulatory and Legal Compliancesegment consisted of approximately $18.6 million and $20.0 million of recurringrevenue, respectively, and $28.2 million and $29.5 million of project revenue,respectively.  For the nine months ended September 30,2003 and 2004, revenue in the Healthcare, Regulatory and Legal Compliancesegment consisted of approximately $56.6 million and $59.1 million of recurringrevenue, respectively, and approximately $82.3 million and $87.2 million ofproject revenue, respectively.

 

26

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**THREE MONTHS ENDED SEPTEMBER 30, 2003 COMPARED TOTHREE MONTHS ENDED SEPTEMBER 30, 2004**

 
| ** **                                                        | ** ** | **Three Months Ended September 30,** | ** ** |
|-------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                        | ** ** | **2003**                                  | ** ** | **2004** | ** ** |
| ** **                                                        | ** ** | **($000’s)**                         | ** ** | **% of  Revenue** | ** ** | **($000’s)** | ** ** | **% of  Revenue** | ** ** |
| **Revenue**                                                       |       | $                                         | 91,728     |   | 100.0 | % | $ | 97,674 |   | 100.0 | % |
| **Gross  Profit**                                                 |       | 35,994                                    |       | 39.2 | % | 34,452 |   | 35.3 | % |
| **SG&A**                                                      |       | 24,058                                    |       | 26.2 | % | 25,171 |   | 25.8 | % |
| **Operating  income (loss)**                                      |       | 4,624                                     |       | 5.0 | % | (1,197 | ) | (1.2 | )% |
| **Income  (loss) from continuing operations before income taxes** |       | 4,044                                     |       | 4.4 | % | (2,221 | ) | (2.3 | )% |
| **Income  (loss) from continuing operations**                     |       | 2,425                                     |       | 2.6 | % | (416 | ) | (0.4 | )% |
|                                                                   |            |                                           |            |  |  |  |  |  |  |  |  |

 

**Revenue**

 

Ouroperations generated revenues of $97.7 million for the three months ended September 30,2004, an increase of 6.5% compared to the same period in 2003.  During the second quarter of 2004, weacquired KeyPoint Consulting, LLC (“KeyPoint”) as a part of our Healthcare,Regulatory and Legal Compliance segment. KeyPoint contributed approximately $2.0 million to the revenueincrease.  Additionally, strong volumesin our project oriented class action claims administration service offeringcontributed approximately $2.8 million to the year-over-year increase.  Project revenue accounted for $34.9 millionor 35.8% of revenue in the current quarter compared to $33.1 million or 36.0%of revenue in the prior year quarter. (See “Management’s Discussion andAnalysis of Financial Condition and Results of Operations—Basis for ManagementDiscussion and Analysis.”)

 

Revenuewithin our Information Management and Distribution segment increased 7.2% from$44.9 million for the three months ended September 30, 2003 to $48.1million for the three months ended September 30, 2004.  Project revenue accounted for 11.2% ofsegment revenue in the third quarter of 2004 compared to 11.0% for the sameperiod in 2003.  The increase in segmentrevenue was primarily the result of higher volumes from existing customers and volumesfrom new customer contracts in our information management service offering,particularly in the Healthcare and Financial Services vertical markets. Revenuein the statement processing service offering was essentially flat compared tothe prior year quarter.

 

Revenuewithin our Healthcare, Regulatory and Legal Compliance segment increased 5.8%from $46.8 million for the three months ended September 30, 2003 to $49.5million for the three months ended September 30, 2004. Project revenueaccounted for 59.6% of segment revenue in the third quarter of 2004 and 60.1%for the same period in 2003.  Theacquisition of KeyPoint 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 34%, or $2.8 million whilecompleting several large projects during the current year quarter.  Project volumes from this service offeringhave decreased to a more sustainable level during the fourth quarter of 2004.  Volumes in our Healthcare businesses declinedapproximately $0.5 million compared to the prior year quarter offsetting thefavorable year-over-year comparison within class action claims administration.

 

**Gross profit**

 

Grossprofit decreased 4.3% from $36.0 million, or 39.2% of revenue, for the threemonths ended September 30, 2003 to $34.5 million, or 35.3% of revenue, forthe three months ended September 30, 2004. The 390 basis point decline in gross margin was primarily relatedto:  (i) higher facilities costs ofapproximately $1.0 million related primarily to the opening of new facilities,mainly to support growth initiatives within our Information Management andDistribution segment, (ii) higher bad debt expense of approximately $0.7million, (iii) higher personnel related costs of approximately $0.7 million,and (iv) lower mix of federal government project work.  Personnel related costs, as a percentage ofrevenue, increased from 43.7% in the prior year quarter to 44.4% in the currentquarter.  In addition, the factorscausing the lower gross margin during the third quarter of 2004 continuedthrough the fourth quarter of 2004 resulting in a similar gross margin.

 

Additionally,as discussed above in “Internal Investigation”, 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 positively impacted 0.1% during the three months ended September 30,2003 and 0.4% during the three months ended September 30, 2004 due to therecognition of reversed revenue as a result of satisfying remaining revenuerecognition conditions at minimal incremental cost.

 

**Selling, general and administrative expenses**

 

SG&Aincreased 4.6% from $24.1 million, or 26.2% of revenue, for the three monthsended September 30, 2003 to $25.2 million, or 25.8% of revenue, for thethree months ended September 30, 2004. The increase in SG&A expenserelates primarily to higher personnel and related costs and higher professionalfees associated with Sarbanes Oxley compliance activity.  During the fourth quarter of 2004 the higherSG&A trend continued due to higher personnel and related costs and higherprofessional fees associated with Sarbanes Oxley compliance activities and theinvestigation, discussed more fully in “Internal Investigation” above and inNote 2 to the condensed consolidated financial statements.

 

**Income (loss) from continuing operations before incometaxes**

 

Income(loss) from continuing operations before income taxes decreased from $4.0million for the three months ended September 30, 2003 to ($2.2) millionfor the three months ended September 30, 2004.   The decrease was partly the result of thefactors impacting gross margin and SG&A discussed above.  In addition, as discussed more fully above in“Internal Investigation”, revenue recognition and expense omission issues at anoperating subsidiary affected previously paid contingent consideration paymentsrelated to the acquisition of the operating subsidiary.  As a result, payments made under theprovisions of the Earn-out Agreements that were determined to be overpaymentshave been expensed in the periods paid resulting in expense of $7.2 million and$10.2 million for the three months ended September 30, 2003 and 2004,respectively.  Finally, interest expensewas higher by

 

27

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approximately $0.4 million in the current year quarter due to higherdebt balances.

 

**Provision (benefit) for income taxes**

 

Duringthe third quarter of 2004, we have reported a net benefit from income taxes inthe amount of $1.8 million.  The netbenefit results from the loss from continuing operations before income taxes atour effective tax rate of 40% and an additional benefit in the amount ofapproximately $0.7 million related to the favorable resolution of certain opentax issues as well as the expiration of statutes of limitations on certainstrategic tax positions and an additional benefit of $0.3 million related toincreased state tax credits.  The firstof the events giving rise to the lower effective rate during the third quarterof 2004 continued into the fourth quarter of 2004.

 

**NINE MONTHS ENDED SEPTEMBER 30, 2003 COMPARED TO NINEMONTHS ENDED SEPTEMBER 30, 2004**

 
| ** **                                                 | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                 | ** ** | **2003**                                 | ** ** | **2004** | ** ** |
| ** **                                                 | ** ** | **($000’s)**                        | ** ** | **% of  Revenue** | ** ** | **($000’s)** | ** ** | **% of  Revenue** | ** ** |
| **Revenue**                                                |       | $                                        | 280,341    |   | 100.0 | % | $ | 292,497 |   | 100.0 | % |
| **Gross  Profit**                                          |       | 107,234                                  |       | 38.3 | % | 107,736 |   | 36.8 | % |
| **SG&A**                                               |       | 71,882                                   |       | 25.6 | % | 80,982 |   | 27.7 | % |
| **Operating  income**                                      |       | 27,863                                   |       | 9.9 | % | 15,875 |   | 5.4 | % |
| **Income from  continuing operations before income taxes** |       | 25,276                                   |       | 9.0 | % | 13,130 |   | 4.5 | % |
| **Income  from continuing operations**                     |       | 15,161                                   |       | 5.4 | % | 8,795 |   | 3.0 | % |
|                                                            |            |                                          |            |  |  |  |  |  |  |  |  |

 

**Revenue**

 

Ouroperations generated revenues of $292.5 million for the nine months ended September 30,2004, an increase of $12.2 million or 4.3% compared to the same period in2003.  The acquisition of KeyPoint duringthe second quarter of 2004 contributed approximately $4.1 million to therevenue increase.  Also contributing tothe year-over-year increase in revenue were: (i) strong volumes in our projectoriented class action claims administration service offering which were up 40%or $7.8 million, and (ii) strong volumes in our statement processing serviceoffering which were up 7.5% or $1.9 million. Project revenue accounted for $103.2 million or 35.3% of revenue in thecurrent year compared to $100.4 million or 35.8% of revenue in the prior year.(See “Management’s Discussion and Analysis of Financial Condition and Resultsof Operations—Basis for Management Discussion and Analysis.”)

 

Revenuewithin our Information Management and Distribution segment increased 3.3% from$141.5 million for the nine months ended September 30, 2003 to $146.2million for the nine months ended September 30, 2004.  Project revenue accounted for 11.0% ofsegment revenue in the current year compared to 12.8% for the same period in2003.  The increase in segment revenuewas primarily the result of higher volumes in our statement processing serviceoffering, which were up approximately 7.5%, or $1.9 million, and increasedvolumes from existing customers and volumes from new customer contracts in the informationmanagement service offering.  Partiallyoffsetting this revenue growth were lower volumes from our government servicescustomers.

 

Revenuewithin our Healthcare, Regulatory and Legal Compliance segment increased 5.3%from $138.9 million for the nine months ended September 30, 2003 to $146.3million for the nine months ended September 30, 2004. Project revenueaccounted for 59.6% of segment revenue in the current year compared to 59.3%for the same period in 2003.  Theacquisition of KeyPoint during the second quarter of 2004 contributedapproximately $4.1 million to the increase. Higher project volumes in our class action claims administration serviceoffering, which increased approximately 40%, or $7.8 million also contributedto the increase in segment.  Partiallyoffsetting the growth in segment revenues were lower volumes within our legalconsulting service offering due to three significant projects in productionduring the first six months of 2003 and lower volumes in our medical codingservice offering and release of information service offering.

 

**Gross profit**

 

Gross profit increased 0.5% from $107.2 million, or 38.3% of revenue, forthe nine months ended September 30, 2003 to $107.7 million, or 36.8% ofrevenue, for the nine months ended September 30, 2004.  Factors impacting gross profit and grossmargin are discussed below.

 

As discussed above in “Internal Investigation”, certain revenuegenerated at an Operating Subsidiary in our Information Management andDistribution segment has been deferred to future periods or reversed as certainrevenue recognition criteria, as applied to certain customer contracts, werenot met.  However, the costs associatedwith the adjusted revenue continue to be reported in the period incurred.  As a result of the adjusted revenue, grossmargin was negatively impacted 0.4% during the nine months ended September 30,2003 and 0.9% during the nine months ended September 30, 2004.

 

Also contributing to the decline in gross profit were higher facilitiesrelated expenses of approximately $2.7 million related to the opening of newproduction facilities, mainly to support growth initiatives within ourInformation Management and

 

28

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Distribution segment, and higher bad debt expense of approximately $1.8million as the prior year reflected unusually large collections of accountsreceivable balances outstanding greater than ninety days.

 

Partially offsetting the declines in gross margin discussed above werelower personnel related costs, as a percentage of revenue.  Personnel related costs decreased from 45.4%in the prior year to 43.7% in the current year due primarily to ourproductivity and technology initiatives, such as high speed scanners, offshoreproduction and pay-for-performance compensation plans, and expense of $1.1million incurred in the prior year related to an unusually large medical claim.

 

**Selling, general and administrative expenses**

 

SG&Aincreased 12.7% from $71.9 million, or 25.6% of revenue, for the nine monthsended September 30, 2003 to $81.0 million, or 27.7% of revenue, for thenine months ended September 30, 2004. The increase in SG&A expense islargely attributable to: (i) the costs associated with the settlement of asignificant legal matter in the Information Management and Distribution segmentduring the first quarter of 2004 of approximately $3.9 million, (ii) anincrease in deferred compensation expense related to restricted stock ofapproximately $1.4 million and other personnel related expense of approximately$1.1 million, (iii) higher travel and marketing costs of approximately $1.1million,  (iv) higher hardware andsoftware maintenance costs  ofapproximately $0.5 million (v) higher professional fees of approximately $0.4million associated with Sarbanes Oxley compliance activity.

 

**Income from continuing operations before income taxes**

 

Incomefrom continuing operations before income taxes decreased from $25.3 million forthe nine months ended September 30, 2003 to $13.1 million for the ninemonths ended September 30, 2004.  The decrease was largely the result of the factors impacting grossmargin and SG&A discussed above.  Inaddition, as discussed above, revenue recognition and expense omission issuesat an operating subsidiary affected previously paid contingent considerationpayments related to the acquisition of the operating subsidiary.  As a result, payments made under the provisionsof the Earn-out Agreements that were determined to be overpayments have beenexpensed in the periods paid resulting in expense of $7.2 million and $10.2million for the three months ended September 30, 2003 and 2004,respectively.  Finally, the current yearincludes a net loss of $0.3 million on the disposition of property, plant andequipment compared to a gain of $0.3 million in the prior year.

 

Interestexpense was lower by approximately $0.7 million in the current year due theexpiration of the interest rate swap on March 31, 2003 and a morefavorable interest rate environment during the current year.  Interest income in the prior year included aone-time payment of $0.2 million related to a $2.3 million income taxreceivable that was also collected during 2003.

 

**Provision (benefit) for income taxes**

 

Wereported a net benefit from income taxes in the amount of $1.8 million for thethree months ended September 30, 2004. The net benefit results from the loss from continuing operations beforeincome taxes during the three months at our effective tax rate of 40% and anadditional benefit in the amount of approximately $0.7 million related to thefavorable resolution of certain open tax issues as well as the expiration ofstatutes of limitations on certain strategic tax positions and an additionalbenefit of approximately $0.3 million related to increased state taxcredits.  Collectively, the additionalbenefits had the affect of lowering our effective tax rate for the nine monthsended September 30, 2004.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

AtSeptember 30, 2004, we had ($48.3) million of working capital, including$1.9 million of cash, which resulted in part from the classification of $90.3million of our debt under our 2000 Credit Agreement as a Current Maturity asdescribed below and in Note 10 to the condensed consolidated financialstatements.  Working capital at December 31,2003 was $36.6 million, including $2.1 million of cash. For the first ninemonths of 2004, net cash provided by operating activities from continuingoperations was $15.7 million compared to $44.5 million for the same period in2003.  Factors contributing to thedecline in operating cash flow from continuing operations consist of: (i) lowerearnings in the current year, (ii) slower cash collections during the currentyear resulting in $11.1 million of lower cash provided by operating activities,(iii) the payment of significant legal settlements during the current yeartotaling $7.5 million, (iv) higher annual incentive compensation paymentscompared to the prior year, (v) the receipt of income tax refunds of $2.3million in the prior year, and (vi) higher contingent considerationoverpayments in the amount of $3.4 million related to the Operating Subsidiaryunder investigation, as more fully described above in “Internal Investigation”and in Note 2 to the condensed consolidated financial statements.

 

Dayssales outstanding decreased three business days during the quarter to 44business days at September 30, 2004 compared to 47 business days at June 30,2004.

 

Forthe nine months ended September 30, 2004, investing activities fromcontinuing operations consisted of acquisitions of property, plant andequipment of $12.6 million and net acquisition related payments of $17.5million of which $13.7 million relates to the acquisition of KeyPointConsulting LLC and $3.8 million represents the settlement of contingentconsideration and other acquisition related payments.  Partially offsetting the capital expendituresand cash paid for acquisitions was divestiture proceeds of $6.8 million,related to the divestiture of our Direct Mail operations and two medicalrecords management operations.  Somefuture quarters will include additional settlements of contingent considerationon past acquisitions. Not all of the periods applicable for contingentconsideration targets have been completed and additional amounts may be payablein future periods under the terms of the agreements related to the achievementof specified revenue and/or earnings targets. If all contingent consideration targets under the current agreementswere achieved, the maximum amount of consideration to be paid would be$5.3 million, and would be paid

 

29

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in 2005. In accordance with the agreements, the Company has the optionto satisfy the entire $5.3 million (or any part thereof) of the potentialliability in common stock with final valuation determined at date of issuance.

 

Netcash provided by financing activities from continuing operations was $8.9million for the nine months ended September 30, 2004.  Borrowings from our line of credit of $247.0million were partially offset by payments on our line of credit of $228.4million.  Additionally, net proceeds fromcommon stock issuances of $0.5 million were more than offset by payments of$10.1 million related to shares repurchased. We utilize our line of credit to fund general operating requirements ofthe Company as well as fund significant investments such as acquisitions orcapital expenditures.

 

InApril 2001, we entered into a line of credit agreement with Bank ofAmerica, SunTrust Bank and Wells Fargo Bank, as co-agents (the “2001 CreditAgreement”). Under this agreement, we could from time to time borrow funds upto $297.5 million through April 2, 2004, subject to certain financialcovenants and ratios. Meeting these requirements is highly dependent uponmaintaining a minimum level of operating results and the continued demand forour services, among other factors.

 

EffectiveApril 3, 2002, we extended $220.0 million of the $297.5 millioncommitment for an additional year to 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.

 

EffectiveApril 3, 2003, we extended $230.0 million of the $297.5 millioncommitment to April 1, 2006. During the fourth quarter of 2003, a participatingbank in the 2001 Credit Agreement assigned $7.5 million of its commitmentto another bank who, effective December 4, 2003, extended this commitmentto April 1, 2006. Total fees paid in 2003 related to the extensions andamendments to the 2001 Credit Agreement were $0.3 million.

 

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

 

AtSeptember 30, 2004, the remaining commitment under the 2001 CreditAgreement is $290.0 million and is scheduled to mature as follows (inmillions):

 

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

 

Ourability to borrow is contingent on certain leverage and fixed cost coverageratios. These ratios were scheduled to become more restrictive beginning in thequarter ended December 31, 2002 with the leverage ratio declining from 3.0times to 2.5 times and the fixed charge coverage ratio increasing from 1.25times to 1.50 times. However, in September 2002, an amendment was approvedthat extended the fixed cost coverage ratio requirement of 1.25 until January 1,2004 and will increase to 1.35 at all times thereafter. In addition to theleverage and fixed cost coverage ratios, we are subject to minimum net worthrequirements. Effective March 26, 2003, an amendment was approved thatallows for 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.

 

Asa result of our internal investigation, more fully described above in “InternalInvestigation” and in Note 2 to the condensed consolidated financialstatements, we were unable to file our September 30, 2004 Quarterly Reporton Form 10-Q within the timeframe prescribed by the Securities Exchange Act of1934.  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. Thewaiver 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.

 

We are currently workingwith our lenders to approve an amendment to the 2001 Credit Agreementthat would allow for the exclusion of certain contingent considerationoverpayments to the former owners of the Operating Subsidiary,

 

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as described more fully abovein “Internal Investigation” and in Note 2 to the condensed consolidatedfinancial statements, from the definition of Earnings Before Interest,Depreciation and Amortization (“EBITDA”). Pursuant to the terms of the Company’s 2001 Credit Agreement, EBITDA isused in calculating certain leverage and fixed cost coverage ratios. TheCompany exceeded the allowable leverage ratio of 2.5 times for the quartersended June 30, 2004 and September 30, 2004 as a result of the earn-outoverpayments, previously discussed.  Thishas resulted in a default under the 2001 Credit 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 currentlyworking with its lenders to secure such an amendment and it is anticipated thatthis amendment will soon become effective. In any event, as the maturity dateof the debt under the 2001 Credit Agreement is April 1, 2006, unless thematurity date of such debt is subsequently modified, such debt will beclassified as a Current Maturity on and after April 1, 2005.

 

Management believes thatit has sufficient liquidity from its cash flow and its revolving creditfacility 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.

 

InJanuary 2000, we registered on Form S-4 (RegistrationNo. 333-92981) 3,012,217 shares of common stock for issuance in connectionwith our acquisition program (the “Acquisition Shelf”), of which 1,359,852shares were available as of September 30, 2004; however, such registrationstatement may require amendment prior to use.

 

**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.

 

Wehave identified the following critical accounting policies that, as a result ofthe judgments, 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.

 

**Revenue Recognition.**  Revenue is recognized as it becomes realized or realizable and earnedaccording to the criteria provided by Staff Accounting Bulletin 104, *Revenue Recognition*. Revenue recognitionoccurs once persuasive evidence of an arrangement exists, delivery has occurredor services have been rendered, the sales price is fixed or otherwisedeterminable, and collection is reasonably assured. The Company’srevenue-earnings activities possess project and recurring customerrelationships.

 

Recurring revenue is characterized by customer relationships that aregenerally for one year or longer. Recurring revenue is typically based on the transactionvolumes provided by the Company’s customer at an agreed upon fixed rate perunit. The Company’s customer volumes are typically not contractual or otherwiseguaranteed. Revenue recognition occurs once work is completed and delivery hasoccurred or services have been rendered. Recurring revenue represents 63% oftotal 2003 revenues and typically occurs within the Company’s InformationManagement and Distribution segment.

 

Project revenue includes one-time projects in which the customerrelationship is not expected to continue after project completion. Projectrevenue is typically based on time and material arrangements. Revenuerecognition occurs at the contractual rates as the labor hours and directexpenses are incurred. Project revenue represents approximately 37% of total2003 revenues and typically occurs within the Company’s Healthcare, Regulatory,and Legal Compliance segment.

 

Revenuerecognition policies related to offerings within the Company’s InformationManagement and Distribution segment are based upon objective criteria that donot require significant estimates or uncertainties. For example, businessprocess outsourcing services are recognized proportionally as services arerendered, based on specific, objective criteria under the contracts for thenumber of accounts or transactions processed. Accordingly, revenues recognizedunder these methods do not require the use of significant estimates that aresusceptible to change.

 

Revenue recognition policies within the Company’s Healthcare, Regulatory,and Legal Compliance segment are based upon objective criteria that do notrequire significant estimates or uncertainties. For example, transaction volumes and time and costs under time andmaterial and cost reimbursable arrangements are based on specific, objectivecriteria under the contracts.  Thefollowing outlines specific revenue recognition policies related to certainofferings within this segment:

 

*Medical records release services* — revenue is recognized upon completion ofthe processing of the requested medical records.  Revenue recognition for this service is basedon an agreed upon and in some cases, a regulated rate applied to the number ofrecords processed.  When a fee is paid tothe hospital, the revenue related to that fee is reported on a net basis inaccordance with Emerging Issues Task Force (“EITF”) 99-19, *Reporting Revenue Gross as a Principal versus Net asan Agent,* due to the fact that: (a) the primary obligation in thearrangement is borne partially by both SOURCECORP and the hospital; (b)SOURCECORP has no discretion with respect to the supplier of the medicalrecord; and (c) SOURCECORP is not involved in the determination of product orservice specifications.

 

*Record management services* — revenue is recognized as storage servicesare provided based on key terms, which is generally linear feet of documentsstored times a monthly rate for shelf storage and based on a monthly per imagerate for images

 

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stored electronically.  TheCompany recognizes fees for processing, retrieval, delivery and return tostorage as revenue upon completion of the service at the agreed upon rateapplied to the unit count of items serviced.

 

*Additional healthcare and compliance services* — revenue is recognized for document and dataconversion services as the services are provided based upon an agreed upon rateper patient file applied to the number of files processed.  Storage and archiving fees are recognized asrevenue as the services are provided based upon an agreed upon monthly rate perfile stored or otherwise archived. Revenue related to coding and abstracting of medical records andstaffing services is recognized as the services are provided based on an agreedupon rate applied to the billable hours worked and eligible out-of-pocketexpenses defined by the service agreement. The out-of-pocket expense component is recognized as revenue and cost ofservices on a gross basis in accordance with EITF Issue 01-14, *Income Statement Characterization of ReimbursementsReceived for “Out-of-Pocket” Expenses Incurred. *Revenue related to compliance reviews is based primarily onan agreed upon percentage (or commission) of amounts identified and recoveredfrom the third party payers as a fee for services provided.  Revenue is recognized upon successfulrecovery of underpayments to our clients by their managed care and commercialpayers at the agreed upon percentage (or commission).

 

*Class action claims administration services* — revenue is recognized as these services areprovided based on the agreed upon rate applied to the number of hours spentproviding services related to administering the legal settlements and expensesincurred.  The out-of-pocket expensecomponent is recognized as revenue and cost of services on a gross basis inaccordance with EITF Issue 01-14, *IncomeStatement Characterization of Reimbursements Received for “Out-of-Pocket”Expenses Incurred. *Inaddition, revenue related to the design and implementation of comprehensivenotification plans is based on an agreed upon percentage (i.e., commission) ofthe cost to place the media communication. Revenue is recognized at the time of public delivery of the notificationthrough the various media outlets at the agreed upon percentage (or commission).

 

*Professional economic research and litigation services* — revenue is recognized as these services areprovided based on consulting hours worked at agreed upon rates at the timeservices are rendered and expenses are incurred.  The out-of-pocket expense component isrecognized as revenue and cost of services on a gross basis in accordance withEITF Issue 01-14, *Income StatementCharacterization of Reimbursements Received for “Out-of-Pocket” ExpensesIncurred.*

 

Asa part of providing services to its customers, the Company incurs incidentalexpenses commonly referred to as “out-of-pocket” expenses. These expensesinclude items such as airfare, hotels, mileage, etc. and are often reimbursableby the Company’s customers. When reimbursable, the Company records both revenueand direct cost of services in accordance with the provisions of EITF Issue01-14, *Income Statement Characterization ofReimbursements Received for “Out-of-Pocket’ Expenses Incurred.*

 

Unearnedincome, included in other current liabilities, represents payments from theCompany’s customers in advance of the services being provided. Advancedpayments are deferred as unearned income when received and recognized asrevenue as services are rendered.

 

**Allowance for Doubtful Accounts.**  Theallowance for doubtful accounts is established and maintained based on ourestimate of accounts receivable collectibility. Management estimatescollectibility by specifically analyzing accounts receivable aging and otherhistorical factors that affect collections. Such factors include the historicaltrends of write-offs and recovery of previously written-off accounts, thefinancial strength of the customer and projected economic and marketconditions. The evaluation of these factors involves subjective judgments andchanges in these factors may significantly impact our consolidated financialstatements.

 

**Long-Lived Asset and Other Intangible Asset Impairment.**  Asrequired by SFAS No. 144, *Accountingfor the Impairment or Disposal of Long-Lived Assets,*management continuallyevaluates whether events and circumstances indicate that the carrying value oflong-lived assets or other intangible assets may not be recoverable. Whenevents require, management performs the valuation by comparing the estimatedundiscounted future cash flows over the remaining life of the long-lived assetsor other intangible 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 September 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 5, Discontinued Operations, of theNotes of Condensed Consolidated Financial Statements, for a more detaileddiscussion.

 

**Goodwill Impairment.**  On January 1, 2002, weadopted SFAS No. 142, *Goodwill andOther Intangible Assets.* This statement states that goodwill andintangible assets that have indefinite useful lives will not be amortized butrather will be tested at least annually for impairment. Our annual impairmenttest is performed at October 31. The impairment test is based on fair value rather than undiscounted cashflows. Additionally, goodwill is tested at a reporting unit level rather thanthe individual operating unit level. A reporting unit is either at theoperating segment level or one reporting level below and could consist ofseveral service offerings aggregated into a single reporting unit. Serviceofferings are aggregated 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

 

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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 could causean impairment of goodwill and other intangible assets. Due to the fact that weare primarily a services company, our business acquisitions typically result insignificant amounts of goodwill and other intangible assets. Therefore, animpairment charge resulting from goodwill or other intangible assets couldresult in a material adverse impact on our financial statements during theperiod incurred.

 

**Self-Insurance Liabilities and Reserves.**  We areself-insured for workmen’s compensation liabilities and a significant portionof our employee medical costs. We account for our self-insurance programs basedon actuarial estimates of the amount of loss inherent in that period’s claims,including losses for which claims have not been reported. These loss estimatesrely on actuarial observations of ultimate loss experience for similarhistorical events. We limit our risk by carrying stop-loss policies forsignificant claims incurred for both workmen’s compensation liabilities andmedical costs. SOURCECORP’s exposure under the stop-loss policies for workmen’scompensation and medical costs is limited based on fixed dollar amounts.  For workman’s compensation, the fixed dollaramount of stop-loss coverage is $500,000 per occurrence.  For medical costs, the fixed dollar amount ofstop-loss coverage is $100,000 per covered participant for the fiscal planyear, with a lifetime limit of liability per covered participant of $1,900,000.

 

**Other Loss Contingencies.**  Werecord liabilities when it is probable that a liability has been incurred andthe amount of the loss is reasonably estimable in accordance with SFASNo. 5, *Accounting for Contingencies*.Disclosure is required when there is a reasonable possibility that the ultimateloss will exceed the recorded provision. Contingent liabilities are oftenresolved over long periods of time. Estimating probable losses requiresanalysis of multiple forecasts that often depend on judgments about potentialactions by third parties such as regulators. Our loss contingencies consistprimarily of estimates related to the probable outcome of current litigation.

 

**RISKS ASSOCIATED WITH FORWARD-LOOKING STATEMENTS**

 

ThisReport contains certain forward-looking statements such as our intentions,hopes, beliefs, expectations, strategies, predictions or any other variationthereof or comparable phraseology of our future activities or other futureevents or conditions within the meaning of Section 27A of the SecuritiesAct of 1933, as amended (the “Act”), and Section 21E of the SecuritiesExchange Act of 1934, as amended, which are intended to be covered by the safeharbors created thereby. Investors are cautioned that all forward-lookingstatements involve risks and uncertainty, including, without limitation, theactual final costs of our internal investigation, the Company’s ongoing SECinvestigation, the potential impairment of our ability to enter into governmentcontracts as a result of the conduct that was the subject of our investigation,remediation costs relating to our investigation, the potential customer impactof the results of our investigation, the effect of our investigation andfinancial statement restatement on the trading price of our stock, the risk of integrating our operatingcompanies, of managing our rapid growth, of the timing and magnitude oftechnological advances, of the occurrences of future events that could diminishour customers’ needs for our services, of a change in the degree to whichcompanies continue to outsource business processes, of an adverse outcome inany given legal proceeding or claim, of the denial of insurance on a particularclaim or of a party obligated to provide indemnification being financiallyunable to do so, as well as such other risks set forth under the heading RiskFactors included in our most recent annual report on Form 10-K.

 

Althoughwe believe that the assumptions underlying the forward-looking statementscontained herein are reasonable, any of the assumptions could be inaccurate,and, therefore, there can be no assurance that the forward-looking statementsincluded in this Report will prove to be accurate. In light of the significantuncertainties inherent in the forward-looking statements included herein, theinclusion of such information should not be regarded as a representation by usor any other person that our objectives and plans will be achieved. Further, wedisclaim any obligation to update any such forward-looking statements, exceptas required by law.

 

**Item 3****.**                **Quantitative and QualitativeDisclosures about Market Risk**

 

Weare subject to interest rate risk on our term loans, revolving credit facilityand Industrial Revenue Bonds. A 100 basis point increase in short-term interestrates would result in approximately $0.5 million of additional expense in 2004based on our expected average balance outstanding under the credit facilityduring 2004. Interest rates are fixed on the capitalized lease obligations.

 

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**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 “DisclosureCommittee”), on a timely basis and that the information required to bedisclosed 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 Discussion and Analysis of Financial Condition andResults of Operations and in Note 2 to the condensed consolidatedfinancial statements, the Company’s Chief Executive Officer and Chief FinancialOfficer concluded that the Company’s disclosure controls and procedures werenot effective in alerting them, in an accurate and timely fashion, to materialinformation relating to the revenue and operating expenses of the Companyrequired to be included in the Company's reports filed or submitted under theExchange Act.

 

We have restated the condensed consolidatedfinancial statements for the three and nine months ended September 30,2003.  In addition, we will restate theconsolidated financial statements for the years ended December 31, 2001, 2002and 2003 in our 2004 Annual Report on Form 10-K.  The restated financial results address theaccounting errors described in Item 2,Management’s Discussion and Analysis of Financial Condition and Results ofOperations and in Note 2 of the notes to the consolidated financialstatements that were identified during the course of the investigation into thefinancial results of the Operating Subsidiary. Thecircumstances giving rise to these accounting errors were reported to our AuditCommittee and Independent Registered Public Accounting Firm.  The restatement of our operating results isan indicator of a material weakness under standards established by the PublicCompany Accounting Oversight Board. The Company’s investigation identified thefollowing issues, which collectively were a material weakness in our internalcontrol over financial reporting which were found to have existed as ofSeptember 30, 2004:

 

•      Certain employees of the OperatingSubsidiary responsible for the internal control processes at the OperatingSubsidiary either colluded with or coerced individuals to override the internalcontrols related to the following processes:

•      Billing and revenue recognition.

•      Contractual compliance.

•      Change management controls over the ITenvironment, specifically with regard to software programs designed tocalculate customer invoicing and revenue recognition.

 

•      Monitoring of non-system generated journalentries of the Operating Subsidiary that were recorded by those individualsinvolved in the activities mentioned above.

 

In connection with therestatement of our operating results, we reviewed the circumstances giving riseto the restatement, and determined that the following actions were required tocorrect the underlying material weaknesses giving rise to the restatement:

 

•     Terminate certain individuals involved in overridingthe internal controls at the Operating Subsidiary and replace them with newmanagement.

•     Perform a review and make improvements to theproduction and revenue accounting systems affecting our revenue accounting andcustomer invoicing at the Operating Subsidiary.

•     Further segregate internal control responsibilities ofthe Operating Subsidiary through the centralization of accounting relatedfunctions into the Company’s corporate accounting department.

•     Establish additional monitoring controls andprocedures regarding compliance with the Company’s customer arrangements.

•     Increase Internal Audit’s company-wide testing ofinternal controls related to customer invoicing and revenue recognition to helpensure the internal controls are operating as designed.

•     The addition of a company-wide contract compliancefunction.

 

*(b) Changes in internal controls*

 

Thechanges to internal control over financial reporting described above wereeither implemented in the fourth quarter of 2004 or, in the case of theaddition of a company-wide contract compliance function, is in the process ofbeing implemented.   Except as describedabove, there has been no other significant change in our internal control overfinancial reporting during the quarter ended September 30, 2004, which materiallyaffected, or is reasonably likely to affect, our internal control overfinancial reporting.

 

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**PART II.OTHER INFORMATION**

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

 

Weare, from time to time, a party to litigation arising in the normal course ofbusiness. The following is a description of the most significant legal mattersthat we are involved in.  In the event ofan adverse outcome in one or more of our legal proceedings, operating resultsfor a given quarter may be negatively impacted.

### ** **

### ***Putative Securities Class Action***

 

TheCompany, and the Company’s CEO and CFO individually, have been named asdefendants in several putative securities class actions, in response to theCompany’s press releases dated October 27, 2004, in which the Companydisclosed that its financial statements for certain prior periods should nolonger be relied upon, and also provided updated financial guidance. Thecomplaints (collectively, the “Actions”) were filed in the United StatesDistrict Court for the Northern District of Texas, Dallas Division. The Actionsare putative shareholder class action lawsuits alleging violations of FederalSecurities Laws, including alleged violations of Sections 10(b) and 20(a), andRule 10b-5 of the Securities Exchange Act of 1934, as amended. The Actions arepurportedly on behalf of all persons who purchased the Company’s common stockduring the period between May 7, 2003, and October 26, 2004 or October 27,2004, depending on the Action, and seek unspecified damages.  The four Actions have been transferred to asingle judge in the Northern District of Texas, Dallas Division.  Two of these actions have been consolidatedand a motion is pending to consolidate each of the actions into a singleaction.

 

#### ***Purported Derivative Action and Demand Letter***

 

Apurported stockholder derivative action was filed on December 28, 2004,against certain of the Company’s current and former officers and directors asindividual defendants and the Company as a nominal defendant in the 116thDistrict Court for Dallas County, Texas (the “Purported Derivative Action”).The Purported Derivative Action alleges breach of fiduciary duty, abuse ofcontrol, gross mismanagement, waste of assets, and unjust enrichment related tothe Company’s press release dated October 27, 2004, in which the Companydisclosed that its financial statements for certain prior periods should nolonger be relied upon, and also provided updated financial guidance. All ofthese claims are asserted derivatively on behalf of the Company.  Further, the Chairman of the Company’s Boardof Directors received from a purported shareholder a demand letter (the “DemandLetter”) based on the same set of facts as the Purported DerivativeAction.  The Company has formed a specialcommittee of the Board of Directors to evaluate the claims made in thePurported Derivative Action and the Demand Letter.

 

*DigitalImaging Systems*

 

OnAugust 5, 2004,  Digital ImagingSystems, Inc. filed suit against the Company in the United States DistrictCourt-Southern District of New York alleging, among other things, that aportion of the Company’s process for scanning and indexing images violates oneof Digital Imaging Systems’ patents.  TheCompany has tendered this matter to one of its software/hardware vendors forindemnification, which such vendor is evaluating.  The suit demands unspecified damages.

 

*Healthcare Marketing Associates, Inc. vs. Managed CareProfessionals, Inc.*

 

OnFebruary 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 $1.782 million plus prejudgment andpost judgment interest, which equates to approximately $2.4 million intotal as of December 31, 2003. The judgment amount plus prejudgmentinterest costs were included in our 2002 results. Post judgment interestaccrued at a statutory 9% rate. We appealed this ruling and on May 4, 2004, theCourt of Appeals affirmed the Circuit Court’s judgment.  On July 23, 2004, we filed anapplication for transfer of our appeal to the state’s Supreme Court, which wasdenied.  We subsequently paid suchjudgment and interest.

 

*Various ROI Copy Charge Matters*

 

Fromtime to time, 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.  One such suit is styled *McShane v. Recordex Acquisition Corp. &Sourcecorp, Incorporated*, filed in the Court of Common PleasPhiladelphia County in Pennsylvania, alleges among other things that theCompany intentionally charges more for providing copies of medical records thanis permitted under Pennsylvania law.  In

 

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September 2004, the court entered its order certifying a class inthis matter.  We believe we havemeritorious defenses and intend to continue to vigorously defend any claimsmade against us in these matters.

 

*Mattel v. SOURCECORP*

 

OnFebruary 18, 2003, Mattel, Inc. filed suit against the Company in theLos Angeles County California Superior Court. In the suit, the plaintiffalleged that one of our subsidiaries is liable for the loss of variousproducts, prototypes and paper documents allegedly stored at one of oursubsidiary’s box storage facilities under theories of breach of contract,breach of fiduciary duty, negligence, breach of implied covenants of good faithand fair dealing and/or conversion. The plaintiff at various times allegeddamages ranging from “in excess of $2.5 million,” to approximately$20 million.  This matter wassettled prior to trial, the terms of which settlement are confidential.  The settlement and related legal costsimpacted our first quarter 2004 pre-tax earnings by approximately $3.9million.  Furthermore, the impact of thesettlement and related legal costs on our 2004 operating cash flow wereapproximately $5.7 million, before consideration of taxes.

 

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

 

InJune 2000, the Company filed an action styled *F.Y.I. Incorporated v. Spohr, et. al.* in Dallas, Texas, inwhich we asserted claims for breach of contract, fraud, and negligentmisrepresentation against the sellers of two related companies that we acquiredin December 1998 (the “Texas Action”). The Texas Action was later removedto federal court and ultimately dismissed on jurisdictional grounds. Wereasserted these claims in two actions that were later consolidated; one styled*F.Y.I. Incorporated v. Spohr, et. al.*in Superior 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, we additionally filed claims against the sellers’accountants and the two sellers filed claims against us; however, in February 2004,the judge in the Sacramento Action dismissed our claims against the sellers’accountants. The sellers allege that our former subsidiary wrongfully failedand refused to execute and deliver a requested estoppel certificate, and thatthe failure to provide such estoppel certificate harmed the landlord in thatthey were allegedly denied favorable terms on a refinancing of the property andwere allegedly prevented from completing a timely sale of the property. Sellersalleged damages of approximately $1.5 million. We asserted damages inexcess of $8 million. On February 3, 2005, the parties settled thismatter on mutually acceptable terms.

 

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**Item 2.****          ****Unregistered Sales of EquitySecurities and Use of Proceeds**

 

Items2(a) and (b) are inapplicable.

 

(c)STOCK REPURCHASES

 
| **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** | ** ** |
|---------------------------------|------------|-------------------------------------------|------------|----------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------|------------|
|                            |       |                                      |       |                                   |       |                                                                                         |       |                                                                                                                              |       |
| Jul 1, 2004 – Jul 30, 2004 |       | —                                    |       | —                                 |       | —                                                                                       |       | $                                                                                                                                 | 1,500      |   |
| Aug 1, 2004 - Aug 31, 2004      |       | —                                    |       | $                                      | —     |                                                                                         | —     |                                                                                                                              | $          | 20,001,500 |   |
| Sep 1, 2004 – Sep 30, 2004 |       | 34,800                                    |       | $                                      | 22.22      |                                                                                         | 34,800     |                                                                                                                              | $          | 19,228,118 |   |

 

**Item 6.**           **Exhibits**

 

(a)Exhibits

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                      |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1*                |       | Asset  Purchase Agreement, dated as of September 4, 2004, among Premier  Acquisition Corp., as Seller, *SOURCECORP*,  Incorporated, as Parent of Seller and Secure Health Information Corp., as  Buyer                                                                                                                                                                          |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                 |
| 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                                                                                                                                                       |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                 |
| 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                                                                                                                                                       |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                 |
| 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                                                                                                                                                                                                      |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                 |
| 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 Item 601(b)(2)of Regulation SK and a brief description of such omitted schedules and similarattachments is included in the agreement. The Company undertakes to supplementally provide the Commission with acopy of any such omitted schedule or similar attachment upon request.

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this Report on Form 10-Q to be signed on its behalf by theundersigned thereunto duly 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 TO EXHIBITS**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                      |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1*                |       | Asset  Purchase Agreement, dated as of September 4, 2004, among Premier  Acquisition Corp., as Seller, *SOURCECORP*,  Incorporated, as Parent of Seller and Secure Health Information Corp., as  Buyer                                                                                                                                                                          |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                 |
| 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                                                                                                                                                       |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                 |
| 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                                                                                                                                                       |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                 |
| 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                                                                                                                                                                                                      |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                 |
| 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 Item 601(b)(2)of Regulation SK and a brief description of such omitted schedules and similarattachments is included in the agreement. The Company undertakes to supplementally provide the Commission with acopy of any such omitted schedule or similar attachment upon request.

 

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