**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

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**FORM 10-K**

**ANNUAL REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

**FORTHE FISCAL YEAR ENDED OCTOBER 28, 2006**

**Commission File Number 000-24990**

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**WESTAFF, INC.**

(Exactname of registrant as specified in its charter)

| **DELAWARE**                                                     |   | **94-1266151**                        |
|------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |

 

**298NORTH WIGET LANE, WALNUT CREEK, CA 94598-2453**

(Addressof principal executive offices, including zip code)

**(925)930-5300**

(Registrant’stelephone number, including area code)

Securities registered pursuantto Section 12(b) of the Act:

**CommonStock, $0.01 par value per share**

(Titleof class)

**Securities registered pursuant to Section 12(g) ofthe Act:**

**None**

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in 405 of theSecurities Act. Yes o    No x

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Exchange Act. Yes o    No x

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

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of Registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. x

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange.

| Large accelerated filer o | Accelerated filer  o | Non-accelerated  filer x |
|---------------------------|----------------------|--------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes o    No x

As of April 15, 2006,the aggregate market value of the registrant’s common stock held bynon-affiliates of the registrant was $38,806,262 based on the closing saleprice as reported on the Nasdaq National Market.

As of January 25,2007, the Registrant had outstanding 16,595,920 shares of Common Stock.

**DOCUMENTSINCORPORATED BY REFERENCE**

The following documents(or portions thereof) are incorporated herein by reference:

Portions of the Registrant’sProxy Statement for the 2007 Annual Meeting of Stockholders are incorporatedherein by reference into Part III of this Form 10-K Report.

 

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**INDEXWESTAFF, INC.**

|                   | ** ** |                                                                                                                     | ** ** | ** ** | **PAGE NO** | ** ** |
|-------------------|------------|---------------------------------------------------------------------------------------------------------------------|------------|------------|-------------|------------|
| **PART I**   |       |                                                                                                                |       |       |
| ITEM 1.           |       | BUSINESS                                                                                                            |       | 3          |
| ITEM 1A.          |       | RISK FACTORS                                                                                                        |       | 11         |
| ITEM 1B.          |       | UNRESOLVED STAFF COMMENTS                                                                                           |       | 17         |
| ITEM 2.           |       | PROPERTIES                                                                                                          |       | 17         |
| ITEM 3.           |       | LEGAL PROCEEDINGS                                                                                                   |       | 17         |
| ITEM 4.           |       | SUBMISSION OF MATTERS TO A VOTE OF  SECURITY HOLDERS                                                                |       | 18         |
| **PART II**  |       |                                                                                                                |       |       |
| ITEM 5.           |       | MARKET FOR REGISTRANT’S COMMON  EQUITY, RELATED STOCKHOLDER  MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES |       | 19         |
| ITEM 6.           |       | SELECTED FINANCIAL DATA                                                                                             |       | 20         |
| ITEM 7.           |       | MANAGEMENT’S DISCUSSION AND  ANALYSIS OF FINANCIAL CONDITIONAND RESULTS OF  OPERATIONS                         |       | 21         |
| ITEM 7A.          |       | QUANTITATIVE AND QUALITATIVE  DISCLOSURES ABOUT MARKET RISK                                                         |       | 33         |
| ITEM 8.           |       | FINANCIAL STATEMENTS AND  SUPPLEMENTARY DATA                                                                        |       | 33         |
| ITEM 9.           |       | CHANGES IN AND DISAGREEMENTS WITH  ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE                               |       | 34         |
| ITEM 9A.          |       | CONTROLS AND PROCEDURES                                                                                             |       | 34         |
| ITEM 9B.          |       | OTHER INFORMATION                                                                                                   |       | 34         |
| **PART III** |       |                                                                                                                |       |       |
| ITEM 10.          |       | DIRECTORS AND EXECUTIVE OFFICERS OF  THE REGISTRANT                                                                 |       | 35         |
| ITEM 11.          |       | EXECUTIVE COMPENSATION                                                                                              |       | 35         |
| ITEM 12.          |       | SECURITY OWNERSHIP OF CERTAIN  BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS                     |       | 35         |
| ITEM 13.          |       | CERTAIN RELATIONSHIPS AND RELATED  TRANSACTIONS                                                                     |       | 35         |
| ITEM 14.          |       | PRINCIPAL ACCOUNTANT FEES AND  SERVICES                                                                             |       | 35         |
| **PART IV**  |       |                                                                                                                |       |       |
| ITEM 15.          |       | EXHIBITS AND FINANCIAL STATEMENT  SCHEDULES                                                                         |       | 36         |
|              |       | SIGNATURES                                                                                                          |       | IV-1       |
|              |       | POWER OF ATTORNEY                                                                                                   |       | IV-1       |

 

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**PART I.**

**Cautionary Note**

*This Annual Reporton Form 10-K contains forward-looking statements within the meaningof Section 27A of the Securities Act of 1933 and Section 21E of theSecurities Exchange Act of 1934, which are subject to a number of risks and uncertainties.All statements that are not historical facts are forward-looking statements,including statements about our business strategy, the timing of theintroduction of our services, the effect of Generally Accepted AccountingPrinciples (“GAAP”) pronouncements, uncertainty regarding our future operatingresults and our profitability, anticipated sources of funds and all plans,objectives, expectations and intentions and the statements regarding revenue,expected domestic revenue growth rates for fiscal 2007, gross margins and ourprospects for fiscal 2007. These statements appear in a number of places andcan be identified by the use of forward-looking terminology such as “may,”“will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,”“future,” “intend,” or “certain” or the negative of these terms or othervariations or comparable terminology, or by discussions of strategy.*

*Actual results mayvary materially from those in such forward-looking statements as a result ofvarious factors that are identified in “Item 7—Management’s Discussion andAnalysis of Financial Condition and Results of Operations,” “Item 1A.—RiskFactors” and elsewhere in this document. No assurance can be given that therisk factors described in this Annual Report on Form 10-K are all ofthe factors that could cause actual results to vary materially from theforward-looking statements. All forward-looking statements speak only as of thedate of this Annual Report on Form 10-K. Readers should not placeundue reliance on these forward-looking statements and are cautioned that anysuch forward-looking statements are not guarantees of future performance. Weassume no obligation to update any forward-looking statements.*

*References in thisAnnual Report on Form 10-K to (i) the “Company,” the“Registrant,” “Westaff,” “we,” “our,” and “us” refer to Westaff, Inc., itspredecessor and their respective subsidiaries, unless the context otherwiserequires, and (ii) ”franchise agents” refer to the Company’s franchiseesin their roles as limited agents of the Company in recruiting job applicants,soliciting job orders, filling those orders and assisting with collectionmatters upon request, but otherwise refer to the Company’s franchisees in theirroles as independent contractors of the Company.*

*This Annual Report on Form 10-K includesservice marks of Westaff, Inc. Products or service names of othercompanies mentioned in this Annual Report on Form 10-K may betrademarks or registered trademarks of their respective owners. Investors andsecurity holders may obtain a free copy of the Annual Report on Form 10-Kand other documents filed by Westaff with the Securities and ExchangeCommission (“SEC”) at the SEC’s website at http://www.sec.gov. Free copies ofthe Annual Report on Form 10-K and other documents filed by Westaffwith the SEC may also be obtained from Westaff by directing a request toWestaff, Attention: Linda Gaebler, Vice President, Marketing andCommunications, 298 North Wiget Lane, Walnut Creek, CA 94598-2453, (925)930-5300.*

**ITEM 1.**                BUSINESS.

**General**

We provide staffing services primarily in suburban andrural markets (“secondary markets”), as well as in the downtown areas ofcertain major urban centers (“primary markets”) in the United States, theUnited Kingdom, Australia and New Zealand. Through our network of Company-owned,franchise agent and licensed offices, we offer a wide range of staffingsolutions, including permanent placement, replacement, supplemental and on-sitetemporary programs to businesses and government agencies. Our primary focus ison recruiting and placing clerical/administrative and light industrialpersonnel. We have over 50 years of experience in the staffing industry and, asof October 28, 2006, operated through 239 offices in 45 states and threeforeign countries. As of October 28, 2006, 75% of these offices were ownedby us and 25% were operated by franchise agents and one licensee.

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We have four reportable segments: Domestic BusinessServices, United Kingdom, Australia and New Zealand. Domestic Business Servicesprovides a variety of staffing services, primarily in clerical and lightindustrial positions, through a network of company-owned and franchise agentoffices. The segment consists of eight geographically diverse company regionsunder the direction of regional managers and one combined franchise region. Theinternational reportable segments comprise company-owned offices, primarilyproviding clerical and light industrial staffing services. We employ a managingdirector who oversees operations in the United Kingdom and a managing directorwho oversees operations in Australia and New Zealand. Revenue is attributed toeach country based on the location of the respective country’s principaloffices. Please see discussions in Note 14 to our consolidated financialstatements attached to this Annual Report of Form 10-K for adiscussion on financial information on our segments for the past three fiscalyears.

We were founded in 1948 and incorporated in Californiain 1954. In October 1995, we reincorporated in Delaware. Our corporatename was changed to Westaff, Inc. in September 1998. Our executiveoffices are located at 298 North Wiget Lane, Walnut Creek, California 94598-2453,and our telephone number is (925) 930-5300. We transact business throughour subsidiaries, the largest of which is Westaff (USA), Inc., aCalifornia corporation, which is the primary operating entity.

During the third quarterof fiscal 2005, we sold our operations in Norway and Denmark, and, duringfiscal 1999, we sold our medical business, primarily operated through WesternMedical Services, Inc. (“Western Medical”), a wholly owned subsidiary ofus. As a result, we have classified these operations as discontinued operationsin our consolidated financial statements.

**Services**

Our service offerings are focused primarily on placingclerical/administrative and light industrial personnel into both temporary andpermanent positions.

*Clerical/AdministrativeServices.**  *Clerical/administrative services personnel areplaced for a broad range of general business positions including receptionists,administrative assistants, data entry operators, word processors, customerservice representatives, telemarketers and various other general office,accounting, bookkeeping and clerical staff. Clerical/administrative positionsalso include call center agents, such as customer service, help desk andtechnical support staff.

*LightIndustrial Services.**  *Light industrialservices personnel are placed for a variety of assignments including generalfactory and manufacturing work (including production, assembly and supportworkers, merchandise packers and machine operators), warehouse work (such asgeneral laborers, stock clerks, material handlers, order pickers, forkliftoperators and shipping/receiving clerks), technical work (such as labtechnicians, inspectors, quality control technicians and drafters) and generalservices (such as maintenance and repair personnel, janitors and food serviceworkers).

*PermanentPlacement Services.**  *Permanent placement services are typicallycontingent fee-based services to recruit and fill regular staff positions forcustomers. These services include locating, screening and assessing candidateson behalf of customers. If the candidate is hired by the customer, we aregenerally paid a fee based on a percentage of the annual starting compensationfor the candidate placed.

Management believes that clerical/administrative andlight industrial staffing services are the foundation of the staffing industry andwill remain a significant market for the foreseeable future. Management alsobelieves that employees performing clerical/administrative and light industrialstaffing functions are, and will remain, an integral part of the labor marketin local, regional and national economies in which we operate.

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We also provide other services within theclerical/administrative and light industrial staffing market such astemp-to-hire services, payrolling, on-site and on-location services, and otherprofessional services including skills and behavioral assessments andcoordination of drug testing and background checking.

·       Temp-to-hire services represent the placement of temporary staff with acustomer with the option to convert the temporary staff to a permanent customeremployee at a later date.

·       Payrolling typically involves the transfer of some of the customer’sshort-term seasonal or special use employees to our payroll for a designatedperiod.

·       On-site programs provide administrative services for our customers suchas coordinating all temporary staffing services throughout a customer’slocation, including skills assessment and training.

·       On-location programs provide for an independent branch office located atthe customer’s facility. They are typically intended for large non-seasonalaccounts with more than $1.0 million in annual revenue. This type of branchoffice is generally staffed by at least one manager-level employee.

Both on-site and on-location relationships providecustomers with dedicated account management, which can more effectively meetthe customer’s changing staffing needs with high quality, consistent service.These programs tend to have comparatively lower operating expenses andrelatively longer customer relationships.

To complement our service offerings, we utilize anumber of tools focused on increasing the pool of qualified candidates usingadvanced selection procedures for potential candidates (Talent Trak®) as wellas technology-based management services that allow clients to maximize workforceproductivity (Time Trak®). We believe that these tools enhance our competitiveedge and position us to more effectively pursue high growth market niches suchas financial services, customer interaction centers and high-end administrativeplacement.

*TalentTrak®.**  *To ensure high quality placements for customersand employees, we use Talent Trak® to strengthen the quality of our selectionprocess. This comprehensive selection process includes flexible recruitingmethods, interviewing and reference checking. We conduct advanced skills andbehavioral assessments using Talent Trak®, and also provide the option for bothbackground and drug testing that can be customized to meet a customer’sspecific needs. We maintain contracts with national drug testing andbackground testing service providers to help ensure high quality andconsistency in assessing our candidates.

*Time Trak®.**  *This tool provides customers with a web-basedmanagement system to assist in maximizing workforce productivity. Time Trak® isa flexible system allowing customers access to information to track a varietyof performance measurements such as workforce hours, labor costs, attendanceand staff performance. Time Trak® also includes features to automate timecardand payroll processing.

**Markets**

We provide staffing services primarily in “secondarymarkets,” as well as in the downtown areas of certain “primary markets” in theUnited States, the United Kingdom, Australia and New Zealand.

We capitalize on our presence in secondary markets tobuild market share by targeting small to medium-sized customers, includingdivisions of Fortune 500 companies. We believe that in many cases, such marketsare less competitive and less costly to operate in than in the more centralareas of primary markets, where a large number of staffing services companiesfrequently compete for business and occupancy costs are relatively high. Inaddition, management believes that secondary markets are more 

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likely to provide theopportunity to sell commercial and recurring business that is characterized byrelatively higher gross margins.

We augment this concentration on secondary markets byalso focusing on selected national contracts with customers having a largepresence in these marketplaces. Such accounts include large clients in multiplelocations supported by a dedicated corporate-level business relationshipmanager. We currently have existing national accounts across many differentbusiness sectors such as manufacturing, government, financial services,technology and communications. We maintain a professional sales team thatservices and leverages existing relationships to retain and grow theseaccounts. In addition, we continue to develop aggressive marketing programs totarget and acquire additional clients that fit our branch system footprint.Management believes that our geographic alignment allows us to effectivelycompete for some of these national contracts.

We market our staffingservices to local and regional customers through a network of Company-owned andfranchise agent offices, as well as through our on-site and on-location servicelocations and through one licensed office. Domestically, our national marketingcampaigns are coordinated through our corporate headquarters in cooperationwith U.S. field offices. Marketing efforts for regional and internationalmarkets are generally conducted at the local level. New customers are developedby the field offices primarily through direct sales efforts and referrals. Wehave a robust targeted marketing program and a consultative sales process thatincludes telemarketing, e-mail marketing and direct mail campaigns.

**Recruiting**

We believe that a keycomponent of our success is the ability to recruit and maintain a pool ofqualified personnel and regularly place them into desirable and appropriatepositions. We use comprehensive methods to identify, assess, select and, whenappropriate, measure the skills of our temporary employees and permanentplacement candidates to meet the needs of our customers. Domestically, webelieve one of our key competitive advantages in attracting and retainingstaffing personnel is our payroll system, which provides us with the ability toprint payroll checks at virtually all of our branch offices within 24 hoursafter receipt of a timecard. Most Company-owned offices offer temporaryemployees a benefit package, including a service bonus and holiday pay. Franchiseagent offices have the option to offer this benefit. All eligible temporaryemployees have the option to participate in our 401(k) plan and discountedemployee stock purchase plan.

**Operations**

We operate each Company-owned office as a separateprofit center and provide managers considerable operational autonomy andfinancial incentives. We also operate franchise agent offices in appropriatemarkets. Managers focus on business opportunities within markets and areprovided centralized support to achieve success in those markets. We believethat this structure allows us to recruit and retain highly motivated managerswho have demonstrated the ability to succeed in a competitive environment. Thisstructure also allows managers and staff to focus on market development whilerelying on centralized services for support in back-office operations, such asrisk management programs and unemployment insurance, credit, collections,accounting, advice on legal and regulatory matters, quality standards andmarketing.

As of October 28, 2006, we operated through anetwork of 239 offices in 45 states and three foreign countries. In addition,from time to time we establish recruiting offices both for recruitingcandidates and for testing demand for our services in new market areas. Ouroperations are decentralized with branch, market and district managers,regional vice presidents and franchise agents enjoying considerable autonomy inhiring, determining business mix and advertising.

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Thefollowing table sets forth information as to the number of offices in operationas of the dates indicated:

| ** **                          | ** ** | **Nov. 2,  2002** | ** ** | **Nov. 1,  2003** | ** ** | **Oct. 30,  2004** | ** ** | **Oct. 29,  2005** | ** ** | **Oct. 28,  2006** | ** ** |
|-------------------------------------|------------|------------------------|------------|------------------------|------------|-------------------------|------------|-------------------------|------------|-------------------------|------------|
| Number  of Offices by Ownership(1): |       |                   |       |                   |       |                    |       |                    |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Company-owned                       |       |                   | 217        |                   |       |                    | 197        |                    |       |                    | 187        |   |   |   | 175 |   |   |   | 180 |   |   |
| Franchise agent                     |       |                   | 77         |                   |       |                    | 72         |                    |       |                    | 68         |   |   |   | 63 |   |   |   | 58 |   |   |
| Licensed                            |       |                   | 5          |                   |       |                    | 1          |                    |       |                    | 1          |   |   |   | 1 |   |   |   | 1 |   |   |
| Total                               |       |                   | 299        |                   |       |                    | 270        |                    |       |                    | 256        |   |   |   | 239 |   |   |   | 239 |   |   |
| Number  of Offices by Location(1):  |       |                   |       |                   |       |                    |       |                    |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Domestic                            |       |                   | 246        |                   |       |                    | 221        |                    |       |                    | 207        |   |   |   | 193 |   |   |   | 192 |   |   |
| International                       |       |                   | 53         |                   |       |                    | 49         |                    |       |                    | 49         |   |   |   | 46 |   |   |   | 47 |   |   |
| Total                               |       |                   | 299        |                   |       |                    | 270        |                    |       |                    | 256        |   |   |   | 239 |   |   |   | 239 |   |   |

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(1)          ExcludesCompany-owned recruiting offices.

*Company-OwnedOffices.**  *Employees of each Company-owned office typicallyreport to a branch or market manager who is responsible for day-to-dayoperations and the profitability of a market that consists of one to severaloffices. Domestically, branch or market managers typically report to districtmanagers or regional vice presidents. District managers report to regional vicepresidents who, in turn, report to the President and Chief Executive Officer.As of December 31, 2006, therewere six regional vice presidents and eight district managers. We have avariety of incentive plans in place for our domestic and international offices.One or more of these plans may be offered to branch staff as well as market anddistrict managers and regional vice presidents. These plans are designed tomotivate employees to maximize the growth and profitability of their office,district or region, as well as to achieve budgeted goals. Management believesthat our incentive-based compensation plans encourage employees in ourCompany-owned offices to increase sales and profits, resulting in a creativeand committed team.

*FranchiseAgent Offices.**  *Our franchise agents have the exclusive right bycontract to sell certain of our services and to use our service marks, businessnames and systems in a specified geographic territory. Our franchiseagent agreements generally allow franchise agents to open multiple officeswithin their exclusive territories. As of October 28, 2006, our 29franchise agents operated 58 franchise agent offices. Sales generated byfranchise agent operations and related costs are included in our consolidatedrevenue and costs of services, respectively, and during fiscal 2004, 2005, and2006 franchise agent sales represented 29.0%, 28.1%, and 27.5% respectively, ofour revenue.

The franchise agent, as an independent contractor, isresponsible for establishing and maintaining an office and paying relatedadministrative and operating expenses, such as rent, utilities and salaries ofits branch office staff. Each franchise agent functions as a limited agent ofthe Company in recruiting job applicants, soliciting job orders, filling thoseorders and assisting and cooperating with collection matters upon request, butotherwise functions as an independent contractor. As franchisor, we are theemployer of the temporary employees and the owner of the customer accountsreceivable and are responsible for paying the wages of the temporary employeesand all related payroll taxes and insurance. As a result, we provide asubstantial portion of the working capital needed for the franchise agentoperations.

Franchise agents are required to follow our operatingprocedures and standards in recruiting, screening, classifying and retainingtemporary personnel.

Our sale of franchises is regulated by the FederalTrade Commission and by state business opportunity and franchise laws. We havefiled registrations, been exempted from registration or filed a notice in all15 states that require pre-sale registration or a notice filing under franchiseinvestment laws in 

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order to offer the sale offranchises. We have not sought registration in one state in which no pre-salenotice is required.

*LicensedOffices.**  *As of October 28, 2006, one licenseeoperated one licensed office. We are no longer offering the license program.The licensee is the employer of the temporary employees and the owner of thecustomer accounts receivable. We finance the licensee’s temporary employeepayroll, payroll taxes and insurance. This indebtedness is secured by a pledgeof the licensee’s accounts receivable, tangible and intangible assets, and thelicense agreement. Borrowings under the lines of credit bear interest at a rateequal to the reference rate of Bank of America, N.A. plus two percentagepoints. Interest is charged on the borrowings only if the outstanding balanceexceeds certain specified limits. The licensee is required to operate withinthe framework of our policies and standards, but must obtain its own workers’compensation, liability, fidelity bonding and state unemployment insurancecoverage, which determines its payroll costs.

Our franchise and licenseagreements have an initial term of five years and are renewable for multiplefive-year terms. The agreements generally contain two-year non-competitioncovenants which we vigorously seek to enforce. Efforts to enforce thenon-competition covenants have resulted in litigation brought by us followingtermination of certain franchise agent and license agreements.

**Seasonality**

We have experienced significantfluctuations in our operating results and anticipate that these fluctuationswill continue. Operating results may fluctuate due to a number of factors,including seasonality, the demand for our services, the level of competitionwithin our markets, our ability to increase the productivity of our existingoffices, control costs and expand operations and the availability of qualifiedpersonnel. In addition, our results of operations could be, and have in thepast been, adversely affected by severe weather conditions. Our fourth fiscalquarter generally consists of 16 weeks, while our first, second and thirdfiscal quarters consist of 12 weeks each. Moreover, our results of operationshave also historically been subject to seasonal fluctuations. Demand for ourservices historically has been greatest during our fourth fiscal quarter duelargely to the planning cycles of many of our customers. Furthermore, sales forthe first fiscal quarter are typically lower due to national holidays as wellas customer shutdowns during and after the holiday season. These shutdowns andpost-holiday season declines in economic activity negatively impact job ordersreceived by us, particularly in the light industrial sector.

**Customers**

We service small andmedium-sized companies as well as divisions of Fortune 500 companies and local,state and federal government agencies. As is common in the staffing industry,our engagements to provide temporary services to our customers are generally ofa non-exclusive, short-term nature and subject to termination by the customerwith little or no notice. During fiscal 2006, no single customer accounted formore than 3.8% of our revenue. Our ten highest volume customers in fiscal 2006accounted for an aggregate of 15.1% of our revenue.

**Competition**

The staffing industry is highly competitive with fewbarriers to entry. We believe that the majority of commercial staffingcompanies are local, full-service or specialized operations with less than fiveoffices. Within local markets, typically no single company has a dominant shareof the market. We also compete for qualified candidates and customers withlarger, national full-service and specialized competitors in local, regional,national and international markets. The principal national competitors areAdecco SA, Spherion Corporation (commercial staffing segment), KellyServices, Inc., Manpower Inc., Remedy 

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Intelligent Staffing,Express Personnel Services, Inc., and Randstad North America. Many of ourprincipal competitors have greater financial, marketing and other resourcesthan us. In addition, there are a number of medium-sized firms which competewith us in certain markets where they may have a stronger presence, such asregional or specialized markets.

We believe that thecompetitive factors in obtaining and retaining customers include understandingcustomers’ specific job requirements, providing qualified temporary personneland permanent placement candidates in a timely manner, monitoring quality ofjob performance and pricing of services. We believe that the primarycompetitive factors in obtaining qualified candidates for temporary employmentassignments are wages, benefits and flexibility and responsiveness of workschedules.

**Management Information Systems**

Our domestic management information systems providesupport to both branch office locations and the corporate back-office. Branchoffices utilize a proprietary application designed to assist in candidatesearches, recruiting, customer order management, customer service, salesmanagement and payroll entry and submission. The application also provides forthe sharing of information between branch offices and corporate headquarters.Utilizing this system, field offices capture and input customer, employee,billing and payroll information. This information is electronically captured oncentralized servers where payroll, billing and financial information isprocessed. These systems allow us to print checks at our branch offices within24 hours or less after receipt of the timecard. Invoices are also processeddaily and distributed from our centralized corporate office. These systems alsosupport branch office operations with daily, weekly, monthly and quarterlyreports that provide information ranging from customer activity to officeprofitability.

Each of our international operations have implementedcustomized or third-party front office and/or back office operating systemsthat are designed to meet the specific information technology and reportingrequirements within the local jurisdiction.

During fiscal 2004, weentered into a license agreement for a domestic Business Process Management, orBPM, system which is being implemented in three phases. The initial phase, whichconsisted of the human resources system for our regular employees, was successfullyimplemented in July 2005. The second phase, which includes the corefinancial systems and the accounts receivable module, went live in thebeginning of fiscal year 2006. The final phase, which will include fullyintegrated front office functionality along with payroll and billing fortemporary associates, is currently scheduled to go live in the fourth quarterof fiscal 2007. In addition, we made certain technology infrastructure upgradesin our Australian operation during fiscal 2006 and are in the process ofimplementing a new front office system in our United Kingdom operation.

**Risk Management Programs**

Domestically, we are responsible for allemployee-related expenses for the temporary staff employees of ourCompany-owned and franchise agent offices including workers’ compensation,unemployment insurance, social security taxes, state and local taxes and othergeneral payroll expenses.

We provide workers’ compensation insurance coveringour domestic regular and temporary employees through a long-term relationshipwith Travelers Property Casualty Company of America (“Travelers”). For fiscalyears 2005 and 2006, we retained a $500,000 deductible per occurrence for thesepolicies. This retention was $750,000 per claim for fiscal 2004. We also purchaseworkers’ compensation insurance coverage based upon actual payrollclassifications in the monopolistic state of North Dakota, and we areself-insured in the states of Ohio and Washington.

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We are contractually required to collateralize ourrecorded obligations under the workers’ compensation insurance contracts withTravelers through irrevocable letters of credit, surety bonds or cash. As ofOctober 28, 2006, these aggregate collateral requirements have beensatisfied through $35 million of letters of credit.

Our nationwide riskmanagement program is managed by our Risk Management Department consisting ofrisk management and workers’ compensation professionals as well as claimadministrators who monitor the disposition of all claims and oversee, throughan on-line system, all workers’ compensation claim activity. The departmentutilizes a variety of creative and aggressive workers’ compensation lossprevention and claim management strategies. The risk management programincludes safety programs, claim strategy reviews with the carrier andthird-party administrator, a return-to-work modified duty program,pre-placement customer safety evaluations and light industrial job approvals,the use of personal protective equipment, and the use of individual localoffice expense allocation formulas.

**Employees**

As of October 28,2006, we had approximately 24,700 temporary employees on assignment andemployed 809 regular staff. Our employees are not covered by any collectivebargaining agreements. Management believes that its relationships with its employeesare good.

**Service Marks**

We have various service marks registered with theUnited States Patent and Trademark Office, with the State of California and invarious foreign countries, including our primary Westaff® service mark.

We also own other service marks, including theWestaff® logo, Talent Trak®, Time Trak®, Ms. Carmen Courtesy®, and Stafffor Business Jobs for People®. We have filed applications to register theservice marks Learning TrakSM and West-TekSM.

Federal and state servicemark registrations may be renewed indefinitely as long as the underlying markremains in use.

**Available Information**

We file electronically with the Securities andExchange Commission, or SEC, our annual report on From 10-K, quarterlyinterim reports on Form 10-Q, current reports on Form 8-K,and amendments to those reports pursuant to Section 13(a) or15(d) of the Securities Exchange Act of 1934. We maintain a site on theworldwide web at http://www.westaff.com; however, information found on ourwebsite is not incorporated by reference into this report. We make availablefree of charge on or through our website our SEC filings, including our annualreport on Form 10-K, quarterly interim reports on Form 10-Q,current reports on Form 8-K, and amendments to those reports filedor furnished pursuant to Section 13(a) or 15(d) of the ExchangeAct as soon as reasonably practicable after we electronically file suchmaterial with, or furnish it to, the SEC. Further, a copy of this Annual Reporton Form 10-K is located at the Securities and Exchange Commission’sPublic Reference Rooms at 100 F Street, N.E., Washington, D.C. 20549.Information on the operation of the Public Reference Room can be obtainedby calling the Securities and Exchange Commission at 1-800-SEC-0330.The Securities and Exchange Commission maintains a website that containsreports, proxy and information statements and other information regarding ourfilings at http://www.sec.gov. Furthermore, we will provide electronic or papercopies of filings free of charge upon written request to our Chief FinancialOfficer or Investor Relations representative.

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**ITEM 1A.**        RISK FACTORS.

**Factors Affecting Future Operating Results**

This Form 10-K contains forward-lookingstatements concerning our future programs, products, expenses, revenue,liquidity and cash needs as well as our plans and strategies. These forward-lookingstatements are based on current expectations and we assume no obligation toupdate this information, except as required by applicable laws and regulations.Numerous factors could cause actual results to differ significantly from theresults described in these forward-looking statements, including the followingrisk factors.

Investing in oursecurities involves risk. The following risk factors, issues and uncertaintiesshould be considered when evaluating our future prospects. In particular,please consider these risk factors when reading “forward-looking” statementswhich appear throughout this report. Forward-looking statements relate to ourexpectations for future events and time periods. Generally, words such as“expect,” “intend,” “anticipate” and similar expressions identifyforward-looking statements. Each of these forward-looking statements involvesrisks and uncertainties, and future events and circumstances could differsignificantly from those anticipated in the forward-looking statements. Any oneof the following risks could harm our operating results or financial conditionand could result in a significant decline in value of an investment in us.Further, additional risks and uncertainties that have not yet been identifiedor which we currently believe are immaterial may also harm our operatingresults and financial condition.

*Price competition in the staffing industry continuesto be intense, and pricing pressures from both competitors and customers couldadversely impact our financial results.*

The staffing industry is highly competitive withlimited barriers to entry and continues to undergo consolidation. We compete inregional and local markets with large full service agencies, specializedtemporary and permanent placement services agencies and small local companies.While some competitors are smaller than us, they may enjoy an advantage indiscrete geographic markets because of a stronger local presence. Othercompetitors have greater marketing, financial and other resources than us that,among other things, could enable them to attempt to maintain or increase theirmarket share by reducing prices. Furthermore, in past years there has been anincrease in the number of customers consolidating their staffing servicespurchases with a single provider or with a small number of providers. The trendto consolidate staffing services purchases has in some cases made it moredifficult for us to obtain or retain business.

We expect the level ofcompetition to remain high in the future, and competitive pricing pressureswill continue to make it difficult for us to raise our prices to immediatelyand fully offset increased costs of doing business, including increased laborcosts, costs for workers’ compensation and, domestically, state unemploymentinsurance. If we are not able to effectively compete in our targeted markets,our operating margins and other financial results will be harmed and the priceof our securities could decline.

*The amount of collateral that we are required tomaintain to support our workers’ compensation obligations could increase,reducing the amount of capital that we have available to support and grow ourfield operations.*

We are contractuallyobligated to collateralize our workers’ compensation obligations under ourworkers’ compensation program through irrevocable letters of credit, suretybonds or cash. As of October 28, 2006, our aggregate collateralrequirements under these contracts have been secured through $35.3 million ofletters of credit; however, under certain circumstances, such as an inabilityto maintain minimum borrowing availability, we could be required to increaseour letters of credit by $5 million. Further, our workers’ compensation programexpires November 1, 2008, and as part of the renewal, could be subject toan increase in collateral. These collateral requirements are significant andplace pressure on our liquidity and working capital capacity. We believe thatour current sources of liquidity are adequate to 

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satisfyour immediate needs for these obligations; however, our available sources ofcapital are limited. Depending on future changes in collateral requirements, wecould be required to seek additional sources of capital in the future, whichmay not be available on commercially reasonable terms.

*Our reserves for workers’ compensation claims may beinadequate to cover our ultimate liability, and we may incur additional chargesif the actual amounts exceed the reserved amounts.*

We maintain reserves tocover our estimated liabilities for workers’ compensation claims based uponactuarial estimates of the future cost of claims and related expenses whichhave been reported but not settled, and that have been incurred but not yetreported. The determination of these reserves is based on a number of factors,including current and historical claims activity, medical cost trends anddevelopments in existing claims. Reserves do not represent an exact calculationof liability and are affected by both internal and external events, such asadverse development on existing claims, changes in medical costs, claimshandling procedures, administrative costs, inflation, legal trends andlegislative changes. Reserves are adjusted as necessary to reflect new claimsand existing claims development, and such adjustments are reflected in theresults of the periods in which the reserves are adjusted. While we believe ourjudgments and estimates are adequate, if our reserves are insufficient to coverour actual losses, an adjustment could be charged to expense that may be materialto our earnings.

*Workers’ compensation costs for temporary employeesmay continue to rise and reduce margins and require more liquidity.*

In the United States, weare responsible for and pay workers’ compensation costs for our regular andtemporary employees. In recent years, these costs have risen substantially as aresult of increased claims, general economic conditions, increases inhealthcare costs and governmental regulations. In fiscal 2006, the increase inthe volume of claims has fallen despite an increase in our domestic revenue,yet the increases in cost per claim have continued. Under our workers’compensation insurance program, we maintain “per occurrence” insurance, whichonly covers claims for a particular event above a $500,000 deductible. Ourworkers’ compensation insurance policy expires November 1, 2008 and wecannot guarantee that we will be able to successfully renew such policy.Further, there are covenants associated with the continuation of the policy andthere can be no guarantee that we will continue to meet those covenants goingforward. Should our workers’ compensation premium costs continue to increase inthe future, there can be no assurance that we will be able to increase the feescharged to our customers to keep pace with increased costs or if we were unableto obtain insurance on reasonable terms or forced to significantly increase ourdeductible per claim, our results of operations, financial condition andliquidity could be adversely affected.

*We have significant working capital requirements andare heavily dependent upon our ability to borrow money to meet these workingcapital requirements.*

We require significant amounts of working capital tooperate our business and to pay expenses relating to employment of temporaryemployees. Temporary personnel are generally paid on a weekly basis whilepayments from customers are generally received 30 to 60 days after billing. Asa result, we must maintain sufficient cash availability to pay temporarypersonnel prior to receiving payment from customers.

We finance our operations primarily through borrowingsunder our revolving credit facilities and also through cash generated by ouroperating activities. As of October 28,2006, our total borrowing capacity was $19.8 million consisting of $10.6million for the domestic operations, $4.7 million for the United Kingdomoperations and $4.5 million for the Australian operations.

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The amount we are entitled to borrow under ourrevolving credit facilities is calculated daily and is dependent on eligibletrade accounts receivable generated from operations, which are affected byfinancial, business, economic and other factors, as well as by the daily timingof cash collections and cash outflows. If we experience a significant andsustained drop in operating profits, or if there are unanticipated reductionsin cash inflows or increases in cash outlays, we may be subject to cashshortfalls. If such a shortfall were to occur for even a brief period of time,it may have a significant adverse effect on our business. Furthermore, ourreceivables may not be adequate to allow for borrowings for other corporatepurposes, such as capital expenditures or growth opportunities, and we would beless able to react to changes in the market or industry conditions.

The credit facilities contain covenants which, amongother things, require us to maintain a minimum fixed charge coverage ratio andminimum earnings before interest, taxes, depreciation and amortization, orEBITDA. At the end of fiscal 2006, the minimum EBITDA covenant increased to$13.0 million on a trailing thirteen period basis. We failed to comply withthat covenant and were required to obtain a waiver from our lenders, which wedid in conjunction with our Tenth Amendment executed January 2, 2007. Anyfuture failure to comply with the covenants under our credit facilities couldresult in an event of default which, if not cured or waived, could triggerprepayment obligations. If we were forced to refinance borrowings under thecurrent facilities, there can be no assurance that such financing would beavailable or that such financing would not have a material adverse effect onour business and financial condition. Even if such refinancing were available,the terms could be less favorable and our results of operations and financialcondition could be adversely affected by increased costs and rates.

We typically experience significant seasonal and otherfluctuations in our borrowings and borrowing availability, particularly in theUnited States, and have, in the past, been required to aggressively manage ourcash to ensure adequate funds to meet working capital requirements. Such stepsincluded working to improve collections and adjusting the timing of cashexpenditures, reducing operating expenses where feasible and working togenerate cash from a variety of other sources.

We have historicallyexperienced periods of negative cash flow from operations and investmentactivities, especially during seasonal peaks in revenue experienced in thethird and fourth fiscal quarters of the year. In addition, we are required topledge amounts to secure letters of credit that collateralize certain workers’compensation obligations, and these amounts may increase in future periods. Anysuch increase in pledged amounts or sustained negative cash flows woulddecrease amounts available for working capital purposes and could have anadverse effect on our liquidity and financial condition.

*Any significant economic downturn could result in ourcustomers using fewer staffing services, which could materially adverselyaffect our business.*

Demand for staffingservices is significantly affected by the general level of economic activity.As economic activity slows, many customers reduce their utilization oftemporary employees before undertaking layoffs of their regular full-timeemployees. Further, demand for permanent placement services also slows as thelabor pool directly available to our customers increases, making it easier forthem to identify new employees directly. Typically, we may experience increasedpricing pressures from other staffing companies during periods of economicdownturn, which could have a material adverse effect on our financialcondition. The domestic economic recession of 2001 and 2002 did have a materialadverse effect on our business. Additionally, in geographic areas where wederive a significant amount of business, a regional or localized economicdownturn could adversely affect our operating results and financial position.

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*We assume the obligation to make wage, tax, andregulatory payments to our temporary employees and are then exposed to accountsreceivable risks from our customers.*

We generally assumeresponsibility for and manage the risks associated with our payrollobligations, including liability for payment of salaries and wages, payrolltaxes as well as group health insurance. These obligations are fixed and becomea liability of ours, whether or not the associated client where these employeeshave been assigned makes payments required by our service agreement, whichexposes us to credit risks. We attempt to mitigate this risk by billing on afrequent basis, which typically occurs daily or weekly. In addition, weestablish an allowance for doubtful accounts for estimated losses resultingfrom the inability of our customers to make required and timely payments.Further, we carefully monitor the timeliness of our customers’ payments andimpose strict credit standards. Finally, the majority of our accountsreceivable is used to secure our revolving credit facilities, which we rely onfor liquidity. If we fail to adequately manage our credit risks associated withaccounts receivable, our financial position could be adversely impacted.

*We derive asignificant portion of our revenue from franchise agent operations.*

Franchise agent operationscomprise a significant portion of our revenue. For fiscal 2006, 27.5% of ourtotal revenue was derived from franchise agent operations. In addition, our tenlargest franchise agents for fiscal 2006 (based on sales volume) accounted for17.3% of our revenue. There can be no assurances that we will be able toattract new franchisees or that we will be able to retain our existingfranchisees. The loss of one or more of our franchise agents and any associatedloss of customers and sales could have a material adverse effect on our resultsof operations.

*We are subject tobusiness risks associated with international operations and fluctuatingexchange rates.*

We presently haveoperations in the United Kingdom, Australia and New Zealand, which comprised21.6% of our revenue during fiscal 2006. Operations in foreign markets areinherently subject to certain risks, including in particular:

·       differentcultures and business practices,

·       overlappingor differing tax structures,

·       economicand political uncertainties,

·       complianceissues associated with accounting and reporting requirements, and

·       changing,complex or ambiguous foreign laws and regulations, particularly as they relateto employment.

All of our sales outsideof the United States are denominated in local currencies and, accordingly, weare subject to risks associated with fluctuations in exchange rates, whichcould cause a reduction in our profits. There can be no assurance that any ofthese factors will not have a material adverse effect on our business, resultsof operations, cash flows or financial condition.

*The loss of any ofour key personnel could harm our business.*

Our future financialperformance is significantly impacted by our ability to attract, motivate andretain key management personnel including our Chief Executive Officer and othermembers of the senior management team. Competition for qualified managementpersonnel is very competitive and in the event that we experience turnover insenior management positions, we cannot assure you that we will be able torecruit suitable replacements on a timely basis. We must also successfullyintegrate all new management and other key positions within our organization toachieve our operating objectives. Even if we are 

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successful,turnover in key management positions could temporarily harm our financialperformance and results of operations until the new management becomes familiarwith our business.

*Our success isimpacted by our ability to attract and retain qualified temporary and permanentcandidates.*

We compete with otherstaffing services to meet our customers’ needs, and we must continuouslyattract reliable candidates to meet the staffing requirements of our customers.Consequently, we must continuously evaluate and upgrade our base of availablequalified personnel to keep pace with changing customer needs and emergingtechnologies. Furthermore, a substantial number of our temporary employeesduring any given year will terminate their employment with us and accept regularstaff employment with our customers. Competition for individuals with provenskills remains intense, and demand for these individuals is expected to remainstrong for the foreseeable future. There can be no assurance that qualifiedcandidates will continue to be available to us in sufficient numbers and onacceptable terms to us. The failure to identify, recruit, train and placecandidates as well as retain qualified temporary employees over a long periodof time could materially adversely affect our business.

*Our service agreements may be terminated on shortnotice, leaving us vulnerable to loss of a significant amount of customers in ashort period of time.*

Our service agreements aregenerally cancellable with little or no notice by the customer to us. As aresult, our customers can terminate their agreement with us at any time, makingus particularly vulnerable to a significant decrease in revenue within a shortperiod of time that could be difficult to quickly replace.

*The cost ofunemployment insurance for temporary employees may rise and reduce our margins.*

In the United States, weare responsible for and pay unemployment insurance premiums for our temporaryand regular employees. At times, these costs have risen as a result ofincreased claims, general economic conditions and government regulations.Should these costs continue to increase, there can be no assurance that we willbe able to increase the fees charged to our customers in the future to keeppace with the increased costs, and if we do not, our results of operations andliquidity could be adversely affected.

*Our informationtechnology systems are critical to the operations of our business.*

Our information managementsystems are essential for data exchange and operational communications withbranches spread across large geographical distances. We have replaced keycomponent hardware and software including backup systems within the past twelvemonths and are currently working towards replacing further key components overthe next twelve to eighteen months. Any interruption, impairment or loss ofdata integrity or malfunction of these systems could severely impact ourbusiness, especially our ability to timely and accurately pay employees andbill customers. Further, any significant delay in our plans to replace theremaining key components could adversely affect the business. Issues witheither would require that we commit significant additional capital as well asmanagement resources in order to resolve the interruption or delay.

*We may be exposedto employment-related claims and costs that could materially adversely affectour business.*

We are in thebusiness of employing people and placing them in the workplace of otherbusinesses on either a temporary or permanent basis. As a result, we aresubject to a large number of laws and regulations relating to employment. Therisks related to engaging in such business include but are not limited to:

·       claimsof discrimination and harassment,

·       violationsof wage and hour laws,

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·       criminalactivity,

·       claimsrelating to actions by customers including property damage and personal injury,misuse of proprietary information and misappropriation of assets, and

·       immigrationrelated claims.

In addition, some or all of these claims may give riseto litigation, which could be time-consuming to our management team, andtherefore, could have a negative effect on our business. In some instances, wehave agreed to indemnify our customers against some or all of these types ofliabilities. We have policies and guidelines in place to help reduce ourexposure to these risks and have purchased insurance policies against certainrisks in amounts that we currently believe to be adequate. However, there canbe no assurance that our insurance will be sufficient in amount or scope tocover these types of liabilities or that we will be able to secure insurancecoverage for such risks on affordable terms. Furthermore, there can be noassurance that we will not experience these issues in the future or that theycould have a material adverse effect on our business.

*Our Founder and Chairman controls a significant amountof our outstanding stock thus allowing him to exert significant influence onour management and affairs.*

Our Chairman and Founder,W. Robert Stover, beneficially owns directly or indirectly, or has voting powerover, in excess of 39% of our outstanding stock. As the principal stockholderof Westaff, Mr. Stover has the ability to materially influence all matterssubmitted to the stockholders for approval and to exert significant influenceon our management and affairs. For example, Mr. Stover has the ability tosell his shares independently and to strongly influence the election of theBoard of Directors and the appointment of executive management. He also has theability to strongly influence any merger, consolidation, sale of substantiallyall of our assets or other strategic decisions affecting us or the market valueof the stock. This concentration of stock and voting power could be used by Mr. Stoverto delay or prevent an acquisition of Westaff or other strategic action orresult in strategic decisions that could negatively impact the value andliquidity of our outstanding stock.

*The market for ourstock may be limited, and the stock price may continue to be extremelyvolatile.*

The average daily tradingvolume for our common stock on the NASDAQ Global Market was approximately33,000 shares from January 1, 2006, through December 31, 2006.Accordingly, the market price of our common stock is subject to significantfluctuations that have been, and may continue to be, exaggerated because anactive trading market has not developed for the stock. We believe that thecommon stock price has also been negatively affected by the fact that our stockis thinly traded and also due to the absence of analyst coverage. The lack ofanalyst reports about our stock may make it difficult for potential investorsto make decisions about whether to purchase our stock and may make it lesslikely that investors will purchase the stock, thus further depressing thestock price. These negative factors may make it difficult for stockholders tosell our common stock, which may result in losses for investors.

*The compliance costs associated with Section 404of the Sarbanes-Oxley Act regarding internal control over financial reportingcould be substantial, while failure to achieve and maintain compliance couldhave an adverse effect on our stock price.*

Pursuant toSection 404 of the Sarbanes-Oxley Act of 2002 and current Securities andExchange Commission (“SEC”) regulations and proposed rules, beginning with ourAnnual Report for the fiscal year ended November 1, 2008, we expect to berequired to furnish a report by our management on our internal control overfinancial reporting. Further, we expect that our external auditors will berequired to audit our internal control over financial reporting report andinclude their attestation on that report in our annual report on Form 10-Kstarting from our annual report for the 2009 fiscal year. The process of fully 

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documentingand testing our internal control procedures in order to satisfy theserequirements will result in increased general and administrative expenses andmay shift management time and attention from profit-generating activities tocompliance activities. Furthermore, during the course of our internal controltesting, we may identify deficiencies which we may not be able to remediate intime to meet the reporting deadline under Section 404. Failure to achieveand maintain an effective internal control environment or complete ourSection 404 certifications could have a material adverse effect on ourstock price.

*We are involved inan action taken by the California Employment Development Department.*

During the fourth quarterof fiscal 2005, we were notified by the California Employment DevelopmentDepartment, or EDD, that our domestic operating subsidiaries unemployment taxrates would be increased retroactively for both calendar years 2005 and 2004,which would result in additional unemployment taxes of approximately $0.9 million.We have timely appealed the ruling by the EDD and are working with our outsidecounsel to resolve this matter. Although we believe that we have properlycalculated our unemployment insurance tax and are in compliance with allapplicable laws and regulations, there can be no assurances this will besettled in our favor.

*We are a defendant in a variety of litigation andother actions from time to time, which may have a material adverse effect onour business, financial condition and results of operations.*

We are regularly involvedin a variety of litigation arising out of our business and, in recent years,have paid significant amounts as a result of adverse arbitration awards. We donot have insurance for some of these claims, and there can be no assurance thatthe insurance coverage we have will cover all claims that may be assertedagainst us. Should the ultimate judgments or settlements not be covered byinsurance or exceed our insurance coverage, they could have a material adverseeffect on our results of operations, financial position and cash flows. Therecan also be no assurance that we will be able to obtain appropriate andsufficient types or levels of insurance in the future or that adequatereplacement policies will be available on acceptable terms, if at all.

**ITEM 1B.**       UNRESOLVED STAFF COMMENTS.

None.

**ITEM 2.**                PROPERTIES.

We lease three adjacent buildings in Walnut Creek,California, consisting of approximately 50,000 square feet, which houseour executive and administrative offices. The lease is for a term of sevenyears commencing on January 12, 2003, with an additional five-year optionto renew.

In addition, we leasespace for our Company-owned offices in the United States and abroad. The majorityof the leases are for fixed terms of one to five years and contain customaryterms and conditions. Management believes that its facilities are adequate forits current needs and does not anticipate any difficulty replacing suchfacilities or locating additional facilities, if needed.

**ITEM 3.**                LEGAL PROCEEDINGS.

In the ordinary course of our business, we areperiodically threatened with or named as a defendant in various lawsuits. Theprincipal risks that we insure against, subject to and upon the terms andconditions of our various insurance policies, are workers’ compensation,general liability, automobile liability, property damage, alternative staffingerrors and omissions, fiduciary liability and fidelity losses.

During the fourth quarter of fiscal 2005, we werenotified by the EDD that our domestic operating subsidiaries unemployment taxrates would be increased retroactively for both calendar years 2005 and 

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2004, which would resultin additional unemployment taxes of approximately $0.9 million. Managementbelieves that it has properly calculated its unemployment insurance tax and isin compliance with all applicable laws and regulations. We have timely appealedthe ruling by the EDD and are working with our outside counsel to resolve thismatter.

We are not currently aparty to any material litigation. However, from time to time we have beenthreatened with, or named as a defendant in litigation brought by formerfranchisees or licensees, and administrative claims and lawsuits brought byformer employees. Management believes the resolution of these matters will nothave a material adverse effect on our financial statements.

**ITEM 4.**                SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS.

None.

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**PART II**

**ITEM 5.     MARKET FOR REGISTRANT’S COMMON EQUITY,RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.**

*Market Information.*   OurCommon Stock has been included for quotation in the Nasdaq National Market (“NASDAQ”)under the symbol “WSTF” since April 30, 1996. The following table setsforth, for the periods indicated, the high and low closing sales prices of theCommon Stock as reported on NASDAQ.

| ** **                                 | ** ** | **High** | ** ** | **Low** | ** ** |
|--------------------------------------------|------------|----------|------------|---------|------------|
| Fiscal 2005:                               |       |     |       |    |       |
| First Quarter ended January 22, 2005  |       | 6.47     |       | 3.05    |       |
| Second Quarter ended April 16, 2005   |       | 5.59     |       | 3.21    |       |
| Third Quarter ended July 9, 2005      |       | 3.73     |       | 3.01    |       |
| Fourth Quarter ended October 29, 2005 |       | 4.71     |       | 3.41    |       |
| Fiscal 2006:                               |       |     |       |    |       |
| First Quarter ended January 21, 2006  |       | 5.20     |       | 4.45    |       |
| Second Quarter ended April 15, 2006   |       | 4.60     |       | 3.70    |       |
| Third Quarter ended July 8, 2006      |       | 4.60     |       | 3.86    |       |
| Fourth Quarter ended October 28, 2006 |       | 4.43     |       | 3.47    |       |
| Fiscal 2007                                |       |     |       |    |       |
| First Quarter  ended January 20, 2007 |       | 5.73     |       | 4.15    |       |

 

On January 20, 2007, the last reported salesprice on NASDAQ for our Common Stock was $4.96 per share. As of January 20,2007, there were approximately 73 shareholders of record.

*Salesof Unregistered Securities.*   Duringfiscal 2006, we did not sell any unregistered securities.

*IssuerPurchases of Equity Securities.**  *Noneduring the fourth quarter of fiscal 2006.

*Dividends.*   Wedid not declare or pay dividends during fiscal 2005 or fiscal 2006. Further,our current credit facilities prohibit payment of dividends, so we are notcurrently contemplating a dividend declaration.

*Securities AuthorizedUnder Equity Plans.  *The following table sets forth securities authorized for issuance underequity compensation plans as of October 28, 2006. All applicable equitycompensation plans were previously approved by security holders.

**EQUITYCOMPENSATION PLAN INFORMATION**

| **Plan Category**                                        | ** ** | ** ** | ** ** | **Number of securities to  be issued upon exercise of  outstanding options,  warrants and rights** | ** ** | **Weighted-average  exercise price of  outstanding options,  warrants and rights** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation  plans (excluding  securities reflected in  column (a))** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                    | ** ** | **(a)**    | ** ** | **(b)**                                                                                                                                              | ** ** | **(c)**                                                                                                     | ** ** |
| Equity compensation plans approved by securities holders |       |       | 417,000    |                                                                                                                                                 |       |                                                                                                        | $          | 3.39                                                                                                                                                                                                         |       |   |   | 1,500,000 |   |   |
|                                                               |            |            |            |                                                                                                                                                      |            |                                                                                                             |            |                                                                                                                                                                                                              |            |  |  |  |  |  |  |  |

 

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**ITEM6.     SELECTED FINANCIAL DATA.**

| ** **                                                                                                                                    | ** ** | **Fiscal Year**                                                                                                     | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **2006**                                                                                                                 | ** ** | **2005** | ** ** | **2004** | ** ** | **2003(2)** | ** ** | **2002** | ** ** |
| ** **                                                                                                                                    | ** ** | **(Amounts in Thousands, Except Per Share  Amounts and Number of Offices)** | ** ** |
| Revenue                                                                                                                                       |       | $                                                                                                                        | 614,950    |   | $ | 612,861 |   | $ | 589,861 |   | $ | 518,738 |   | $ | 502,211 |   |
| Operating income  (loss) from continuing operations                                                                                           |       | 4,545                                                                                                                    |       | 6,128 |   | 5,409 |   | (2,909 | ) | (3,292 | ) |
| Income (loss)  from continuing operations before discontinued operations and cumulative  effect of change in accounting principle(1)          |       | 3,119                                                                                                                    |       | 20,097 |   | 3,157 |   | (4,784 | ) | (1,157 | ) |
| Earnings (loss) per  share—continuing operations before discontinued operations and cumulative  effect of change in accounting principle |       |                                                                                                                     |       |   |   |   |   |   |   |   |   |
| Basic                                                                                                                                         |       | $                                                                                                                        | 0.19       |   | $ | 1.24 |   | $ | 0.20 |   | $ | (0.30 | ) | $ | (0.07 | ) |
| Diluted                                                                                                                                       |       | $                                                                                                                        | 0.19       |   | $ | 1.23 |   | $ | 0.20 |   | $ | (0.30 | ) | $ | (0.07 | ) |
| **Balance Sheet data (at end of  period):**                                                                                                   |       |                                                                                                                     |       |   |   |   |   |   |   |   |   |
| Working capital                                                                                                                               |       | $                                                                                                                        | 41,892     |   | $ | 40,626 |   | $ | 33,604 |   | $ | 21,237 |   | $ | 24,072 |   |
| Total assets                                                                                                                                  |       | 139,265                                                                                                                  |       | 138,782 |   | 122,408 |   | 113,147 |   | 121,955 |   |
| Short-term debt  and capital lease  obligations                                                                                               |       | 7,135                                                                                                                    |       | 8,911 |   | 16,199 |   | 25,842 |   | 25,167 |   |
| Long-term debt  and capital lease obligations (excluding current portion)                                                                |       | 833                                                                                                                      |       | 3,174 |   | 2,125 |   | 2,590 |   | 2,000 |   |
| Stockholders’  equity                                                                                                                    |       | 66,009                                                                                                                   |       | 61,621 |   | 39,847 |   | 35,456 |   | 38,950 |   |
| **Other operating data:**                                                                                                                     |       |                                                                                                                     |       |   |   |   |   |   |   |   |   |
| Number of offices (at  end of period)                                                                                                         |       |                                                                                                                     |       |   |   |   |   |   |   |   |   |
| Company-owned                                                                                                                                 |       | 180                                                                                                                      |       | 175 |   | 187 |   | 197 |   | 217 |   |
| Franchise agent                                                                                                                               |       | 58                                                                                                                       |       | 63 |   | 68 |   | 72 |   | 77 |   |
| Licensed                                                                                                                                      |       | 1                                                                                                                        |       | 1 |   | 1 |   | 1 |   | 5 |   |
| Total                                                                                                                                         |       | 239                                                                                                                      |       | 239 |   | 256 |   | 270 |   | 299 |   |

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(1)   Fiscal 2005includes the reversal of $16,681 of domestic deferred tax valuation allowance($1.02 per diluted share).

(2)   At thebeginning of fiscal 2003, we adopted Statement of Financial AccountingStandards No. 142, *Goodwill and OtherIntangible Assets.*

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**ITEM 7.**                MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS.

The following discussionis intended to assist in the understanding and assessment of significantchanges and trends related to the results of operations and financial conditionof Westaff, Inc., together with its consolidated subsidiaries. Thisdiscussion and analysis should be read in conjunction with the Company’sConsolidated Financial Statements and Notes thereto included elsewhere in thisAnnual Report on Form 10-K for the fiscal year ended October 28,2006.

**CautionaryStatement**

This notice is intended totake advantage of the “safe harbor” provided by the Private SecuritiesLitigation Reform Act of 1995 with respect to forward-looking statements.Except for the historical information contained herein, the matters discussedshould be considered forward-looking statements and readers are cautioned notto place undue reliance on those statements. The forward-looking statements inthis discussion are made based on information available as of the date hereofand are subject to a number of risks and uncertainties that could cause theCompany’s actual results and financial position to differ materially from thoseexpressed or implied in the forward-looking statements and to be below theexpectations of public market analysts and investors. These risks anduncertainties include, but are not limited to, those discussed in “Item 1A.—RiskFactors” under the heading “Factors Affecting Future Operating Results”. TheCompany undertakes no obligation to publicly release the results of anyrevisions to these forward-looking statements to reflect events orcircumstances after the date hereof or to reflect the occurrence ofunanticipated events, except as required by applicable laws and regulations.

**Critical AccountingPolicies**

The preparation of our Consolidated FinancialStatements and Notes thereto requires management to make estimates andassumptions that affect the amounts and disclosures reported within thosefinancial statements. On an ongoing basis, management evaluates its estimates,including those related to revenue recognition, workers’ compensation costs,collectibility of accounts receivable, impairment of goodwill and intangibleassets, contingencies, litigation and income taxes. Management bases itsestimates and judgments on historical experiences and on various other factorsbelieved to be reasonable under the circumstances. Actual results undercircumstances and conditions different than those assumed could result indifferences from the estimated amounts in the financial statements.

Management believes the following critical accountingpolicies reflect the more significant judgments and estimates used in thepreparation of our consolidated financial statements. There have been nomaterial changes to these policies during fiscal 2006.

*Revenue Recognition.**  *We record revenue from the sale of temporarystaffing, permanent placement fees, and temp-to-hire fees by our Company-ownedand franchised operations. Temporary staffing revenue and the related laborcosts and payroll taxes are recorded in the period in which the services areperformed. Temp-to-hire fees are generally recorded when the temporary employeeis hired directly by the customer. Permanent placement fees are recorded whenthe candidate commences full-time employment and, if necessary, sales allowancesare established to estimate losses due to placed candidates not remainingemployed for the permanent placement guarantee period, which is typically fourweeks.

We account for our revenue and the related directcosts of our franchise arrangements in accordance with Emerging Issues TaskForce (“EITF”) 99-19, *Recording Revenue Gross asa Principal versus Net as an Agent*. We first assess whether we actas a principal in our transactions or as an agent acting on the behalf ofothers. When we are the principal in a transaction and have the risks andrewards of ownership, we record the transaction gross in our income statement.Where we act merely as an agent, only the net fees earned are recorded in theincome statement. Under our traditional franchise agreement, we have the 

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direct contractualarrangements with our customers and the contracts are binding on us. We arealso the employer of all temporary employees in the franchise agents’operations and, as such, are obligated for the temporary employee payroll,related payroll taxes and the risk of loss for accounts receivable collection.As we retain the risks and rewards of ownership, the revenue and costs ofservices of our franchise agents are included in our Results of Operations.Each accounting period, we remit to each franchisee either a portion of thegross profit or a portion of the sales generated by its office(s), based onwhat the relevant franchise agreement dictates. Franchise agents’ salesrepresented 27.5%, 28.1% and 29.0% of the Company’s total revenue for fiscal2006, 2005 and 2004, respectively. Franchise agents’ share of gross profitrepresents the net distribution paid to the franchise agents for their servicesin marketing to customers, recruiting temporary employees and servicingcustomer accounts.

We also have a licensing program in which the lonelicensee has the direct contractual relationships with the customers, holdstitle to the related customer receivables and is the legal employer of thetemporary employees. Accordingly, revenue and costs of services generated bythe license operation are not included in our consolidated financialstatements. We advance funds to our licensee for payroll, payroll taxes,insurance and other related items. Fees are paid to us based either on apercentage of revenue or of gross profit generated by the licensee and suchlicense fees are recorded by us as license fees and included in revenue. We areno longer offering license agreements to new prospects.

*Workers’ Compensation Reserves.*   Weself-insure the deductible amount related to domestic workers’ compensationclaims, which was $500,000 per claim for policy years 2006 and 2005, and$750,000 per claim for policy year 2004. We maintain reserves for workers’compensation costs based upon actuarial methods utilized to estimate theremaining undiscounted liability for the deductible portion of all claims,including those incurred but not reported. This process includes establishingloss development factors based on our historical claims experience and thestaffing industry, and applying those factors to current claims information toderive an estimate of our ultimate claims liability. The calculated ultimateliability is computed for each policy year and is then reduced by thecumulative claims payments to determine the required reserves. We evaluate thereserve and the underlying assumptions regularly throughout the year and makeadjustments accordingly. At least annually, we obtain an independentactuarially determined calculation of the estimated costs of claims actuallymade to date, as well as claims incurred but not yet reported. If the actualcosts of such claims and related expenses exceed the amounts estimated,additional reserves may be required. These reserves amounted to $24.3 millionand $19.6 million at October 28, 2006, and October 29, 2005,respectively. While we believe that the recorded reserves are adequate, therecan be no assurances that future, unfavorable changes to estimates relied uponin the determination of these reserves will not occur.

*Collectibility of Accounts Receivable.  *Weprovide an allowance for uncollectible accounts receivable based on anestimation of losses which could occur if customers are unable to make requiredpayments. We evaluate this allowance on a regular basis throughout the year andmake adjustments as the evaluation warrants. If the financial condition of ourcustomers were to deteriorate resulting in an impairment of their ability tomake payments, additional allowances may be required. These allowances were $0.8 millionat October 28, 2006, and $1.0 million at October 29, 2005. Ourestimates are influenced by numerous factors including our large, diversecustomer base, which is disbursed across a wide geographical area. No singlecustomer accounted for more than 10% of accounts receivable for fiscal year2006.

*Goodwill and Other Intangible Assets.  *Statementof Financial Accounting Standards (“SFAS”) No. 142, *Goodwill andOther Intangible Assets* (“SFAS No. 142”) requires that goodwilland certain intangible assets with indefinite useful lives no longer beamortized but instead be subject to an impairment test performed on an annualbasis or whenever events or circumstances indicate that impairment may haveoccurred. Intangible assets with finite useful lives continue to be amortizedover their useful lives. We utilize an independent third-party valuation firmto determine the fair value of our individual reporting units. The valuationmethodologies considered include analyses of discounted cash 

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flows at the reportingunit level, publicly traded companies multiples within the temporary staffingindustry and historical control premiums paid by acquirers purchasing companiessimilar to ours. We perform our annual impairment tests in the fourth quarterof each fiscal year.

*Income Taxes.  *We accountfor income taxes by utilizing an asset and liability approach that requiresrecording deferred tax assets and liabilities for the future year consequencesof events that have been recognized in our financial statements or tax returns.As required under SFAS No. 109, *Accounting for IncomeTaxes*, we measure these expected future tax consequences based uponprovisions of tax law as currently enacted. The effects of future changes intax laws are not anticipated. Variations in the actual outcome of these futuretax consequences could materially impact our financial position or our resultsof operations. We also provide a reserve for tax contingencies when we believea probable and estimatable exposure exists. At October 30, 2004,substantially all of our net deferred tax assets were offset with a valuationallowance of $18.7 million. During the fourth quarter of fiscal 2005, weassessed the realizability of our deferred tax assets. As a result of ourpositive domestic earnings in fiscal 2004 and 2005, the favorable projectedearnings outlook, our long-term history of profitability as well as theimprovements in our financial position, we determined that it is more likelythan not that the deferred tax asset will be realized. Accordingly, during thefourth quarter of fiscal 2005, we reversed our full domestic deferred tax assetvaluation allowance of $16.7 million.

*Reserves for Legal and RegulatoryLiabilities.  *There are various claims, lawsuits andpending actions against us incident to our operations for which we haverecorded liabilities that we believe are appropriate. We evaluate this reserveregularly throughout the year and make adjustments as needed. If the actualoutcome of these matters is different than expected, an adjustment is chargedor credited to expense in the period the outcome occurs or the period in whichthe estimate changes. Whereas management believes the recorded liabilities areadequate, there are inherent limitations in the estimation process wherebyfuture actual losses may exceed projected losses, which could materiallyadversely affect our financial condition.

**Executive Overview**

Fiscal 2006 marks our highest revenue since fiscal2000 and the highest gross profit since fiscal 2001. We are also very pleasedto report a third consecutive profitable year following three challenging yearsin fiscal 2001 through 2003.

Our gross profit grew steadily quarter-over-quarterduring the year to conclude at a 3% increase over fiscal 2005 and a 10%increase over fiscal 2004. Gross margins mirrored these results, increasingfrom 16.8% in fiscal 2004 to 17.3% in fiscal 2005 and to 17.7% in fiscal 2006.Our continued success with permanent placement revenue, which increased 38% ascompared to fiscal 2005, along with a focus on higher-margin business are thepredominant reasons underlying these increases. At this point, we believemargins will continue to grow into fiscal 2007, although there can be noassurance this will occur.

We closed fiscal 2006 with an improved financialposition, including working capital of $41.9 million and borrowing capacity of$19.8 million. These, coupled with strong cash flow from our operatingactivities, should be more than sufficient to meet expected working capitalrequirements for fiscal 2007.

We believe that we arewell positioned, both strategically and financially, to continue generatingimproved operating results in fiscal 2007.

**DiscontinuedOperations**

Effective June 15, 2005, we sold our Norway andDenmark operations to Personalhuset AS, a recruitment and staffing companyheadquartered in Norway. Net proceeds from the sale were approximately $2.7million. Of the total proceeds, approximately $0.2 million is being held in aninterest bearing escrow account as security for potential Westaff Norwaypension claims. The escrowed funds, net 

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of any claim payments,will be remitted to us in June 2007. We recorded a net gain on the sale of$1.2 million. We have classified the operations as discontinued operations inthe accompanying financial statements and notes thereto.

As required under the terms of our MulticurrencyCredit Agreement, the net proceeds from the sale of the Norway and Denmarkoperations were used to pay down borrowings on our revolving credit facility.Interest expense has been allocated to these discontinued operations inaccordance with EITF 87-24.

During fiscal 1999, we discontinued our medicalbusiness (“Western Medical”) principally through a sale to Intrepid U.S.A.Under the terms of the sale, we retained the majority of accounts receivable,including trade and Medicare accounts receivable balances. During the thirdquarter of 2004, we resolved certain significant legal and liability claims andevaluated future risks associated with remaining pending claims and, as aresult, recorded $0.2 million of income from the medical discontinuedoperations. As of October 28, 2006, there are remaining currentliabilities of the discontinued medical operations of $23,000, primarily forsettled but unpaid claims.

**Results ofContinuing Operations**

Thetable below sets forth, for the three most recent fiscal years, certain resultsof continuing operations data as a percentage of revenue.

| ** **                                             | ** ** | **Fiscal Year** | ** ** |
|--------------------------------------------------------|------------|----------------------|------------|
| ** **                                             | ** ** | **2006**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue                                                |       | 100.0                | %          | 100.0 | % | 100.0 | % |
| Costs of services                                      |       | 82.3                 | %          | 82.7 | % | 83.2 | % |
| Gross profit                                           |       | 17.7                 | %          | 17.3 | % | 16.8 | % |
| Franchise agents’  share of gross profit          |       | 3.0                  | %          | 3.1 | % | 3.1 | % |
| Selling and  administrative expenses                   |       | 13.2                 | %          | 12.5 | % | 11.8 | % |
| Depreciation and  amortization                         |       | 0.8                  | %          | 0.7 | % | 0.7 | % |
| Arbitration  expenses                                  |       | 0.0                  | %          | 0.0 | % | 0.2 | % |
| Operating income  from continuing operations           |       | 0.7                  | %          | 1.0 | % | 0.9 | % |
| Interest expense                                       |       | 0.2                  | %          | 0.3 | % | 0.4 | % |
| Interest income                                        |       | *                    |       | * |   | * |   |
| Income from  continuing operations before income taxes |       | 0.6                  | %          | 0.8 | % | 0.6 | % |
| Income tax  provision (benefit)                        |       | 0.1                  | %          | (2.5 | )% | * |   |
| Income from continuing  operations                     |       | 0.5                  | %          | 3.3 | % | 0.5 | % |

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*                    lessthan 0.1%

**Fiscal 2006compared to Fiscal 2005**

*Revenue*

Revenue increased $2.1 million or 0.3% for fiscal 2006as compared to fiscal 2005. Domestic revenue increased $11.2 million or 2.4%,largely due to an increase in average bill rates of 2.0%, coupled with anincrease in permanent placement revenue of 84%. These increases were partiallyoffset by a slight decrease in billed hours of 0.1%, which reflects the effectsof a shift in business mix in an effort to increase gross margin. The increasein average bill rates primarily stems from a bill rate increase implemented in May 2006,coupled with a generally more positive economic environment in fiscal 2006compared to fiscal 2005, which allowed us to price new business at higher ratesas compared to fiscal 2005. Further, the increase in our domestic permanentplacement revenue is the result of both our focused training efforts and havinga full compliment of permanent placement consultants in place for fiscal 2006.The hiring of these consultants commenced in the latter half of fiscal 2005,and we intend to maintain or increase the 

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number of theseconsultants during fiscal 2007. As a percentage of revenue, domestic permanentplacement fees increased to 1.0% in fiscal 2006 as compared to 0.6% in fiscal2005. Based on our continuing efforts in this service line, coupled with arelatively low domestic unemployment rate, we are optimistic we can increasethis revenue during fiscal 2007.

Offsetting the domestic revenue growth was a decreasein international revenue of $9.1 million or 6.4%. The largest cause of thisdecrease was a $6.5 million decrease in revenue from our Australian subsidiary,primarily due to decreased revenue from several large, national accounts.Billed hours decreased 8% in Australia, and the average bill rate remainedessentially the same in fiscal 2006 as it had been in fiscal 2005. Partiallyoffsetting this decrease in temporary services revenue, Australia’s permanentplacement revenue increased 45% or $0.7 million.

In addition to the decrease noted in Australia,revenue from our United Kingdom operations decreased $1.4 million, or 3.4%.This is primarily the result of a 3.9% decrease in billable hours and averagebill rates remaining essentially the same in fiscal 2006 as compared to fiscal2005. The United Kingdom operations were without a Managing Director for muchof fiscal 2006 and, consequently, the operation did not have as robust a focuson sales as it should have, resulting in an overall decrease in revenue.

Finally, revenue from ourNew Zealand operations decreased $1.2 million, or 16%. Billable hours fortemporary services decreased 9.5% while the average bill rate decreased 6.4%,primarily due to the loss of one national account, the volume of which was notreplaced during the fiscal year.

*Costs of Servicesand Gross Profit*

Costs of services include hourly wages of temporaryemployees, employer payroll taxes, state unemployment and workers’ compensationinsurance and other employee-related costs. On a consolidated basis, costs ofservices decreased $0.9 million, or 0.2%, in fiscal 2006 as compared to fiscal2005. This decrease is primarily attributable to an overall decrease inbillable hours of 1.3%, partially offset by an overall increase in average payrates of 1.1%. This overall decrease in costs of services, coupled with theincrease in revenue noted above, caused gross profit to increase $3.0 million,or 2.8%, and also caused gross margin to increase to 17.7% as compared to 17.3%for fiscal 2005. Gross margin increased primarily as a result of bill rateincreases and increases in permanent placement revenue, both explained above,coupled with stabilization of workers’ compensation costs and stateunemployment insurance costs as explained below.

Our domestic workers’ compensation costs tend to varydepending upon the mix of business between clerical/administrative and lightindustrial. Unexpected adverse development of open claims and increases in ourincurred but not reported (IBNR) claims can also significantly affect workers’compensation costs. We monitor claim activity and evaluate actuarial estimatesto ensure that accruals and resulting costs remain appropriate in light of losstrends. Further, we aggressively work to close out claims on terms that arefavorable to us and continually monitor costs and accrual rates in light ofactual loss trends. However, there can be no assurance that our efforts to controlworkers’ compensation costs will be effective or that loss development trendswill not require additional increases in workers’ compensation accruals infuture periods. As a percent of direct labor, domestic workers’ compensationcosts remained stable at 5.4% for both fiscal 2006 and 2005.

As a percent of domestic direct labor costs, stateunemployment rates remained stable at 3.1% for both fiscal 2006 and fiscal2005. This stabilization assisted our efforts to manage consolidated costs ofservices in fiscal 2006.

We continue to focus ourefforts on improving gross margin through development of our permanentplacement service line and movement of our business mix to those opportunitiesoffering higher margins. 

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Theseefforts, coupled with both low domestic unemployment rates and strong nationaleconomies in the United Kingdom, Australia and New Zealand, should allow us tocontinue improving gross margins into fiscal 2007. However, there can be noassurance we will be successful in that regard.

*Franchise agents’share of gross profit*

Franchise agents’ share ofgross profit represents the net distribution paid to franchise agents basedeither on a percentage of the sales or gross profit generated by the franchiseagents’ operations. As a percentage of consolidated revenue, franchise agents’share of gross profit decreased from 3.1% of revenue for fiscal 2005 to 3.0%for fiscal 2006, primarily due to the conversion of two franchised operationsinto company-owned operations. During the second fiscal quarter of 2006, weacquired our Houston, Texas, franchised operations and at the beginning of ourthird fiscal quarter, we acquired our Raleigh, North Carolina, franchisedoperation. Therefore, upon acquisition, we maintained revenue streams fromthese operations yet were no longer paying out a portion of the gross profits.

*Selling andadministrative expenses*

Selling and administrativeexpenses increased $4.6 million, or 6.0%, for the 2006 fiscal year as comparedto fiscal 2005. As a percentage of revenue, selling and administrative expensesincreased to 13.2% in fiscal 2006 from 12.5% in fiscal 2005. The increase isdue to a combination of cost increases, including increased domestic salariesrelating to revenue-producing staff placed into our field offices in the amountof $1.1 million, an enhanced field incentive plan to stimulate domestic salesgrowth in the amount of $1.2 million, increased employee health-relatedbenefits of $0.6 million, an increase in bank service charges of $0.4 millionand increased remote server hosting costs to support our Business Process Management,or BPM, system of $0.3 million. In addition, throughout fiscal 2006 a number ofmanagement personnel were replaced and some positions eliminated bothdomestically and internationally, which led to severance costs for the departedemployees in the amount of $1.0 million.

*Depreciation andamortization*

Depreciation and amortization increased $0.6 millionor 15.6%, primarily due to higher depreciation associated with portions of ourdomestic BPM system that have been placed into service. Currently, weanticipate depreciation expense to increase in fiscal 2007 as a result ofadditional modules of the BPM system being placed in service, which willactivate depreciation and amortization on these modules.

*Interest expense*

Interest expense decreased$0.3 million for fiscal 2006 as compared to fiscal 2005 primarily as a resultof lower average borrowings outstanding during the year partially offset byhigher average interest rates. Contingent on maintaining or reducing ouroutstanding debt, coupled with no significant increase in interest rates, ourinterest expense would be expected to decline in fiscal 2007.

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*Income taxprovision*

We record income taxesusing an asset and liability approach that requires the recognition of deferredtax assets and liabilities for the expected future tax consequences of eventsthat have been recognized in our financial statements or tax returns. Avaluation allowance is established when management determines it is more likelythan not that a deferred tax asset is not realizable in the foreseeable future.During the fourth quarter of fiscal 2005, management assessed the realizabilityof its deferred tax assets. As a result of our positive domestic earnings infiscal 2004 and 2005, the favorable projected earnings outlook, our long-termhistory of profitability as well as the improvements in our financial position,management determined that it is more likely than not that the deferred taxasset will be realized. Accordingly, during the fourth quarter of fiscal 2005,we reversed our full, domestic deferred tax asset valuation allowance of $16.7million, which resulted in an increase in net income for fiscal 2005 of $16.7million, or $1.02 per diluted share. No similar reversal was expected orrecorded during fiscal 2006. The income tax provision recorded during fiscal2006 differs from statutory rates primarily due to federal tax credits we takeadvantage of, primarily as a result of the workers opportunity tax creditprogram.

**Fiscal 2005compared to Fiscal 2004**

*Revenue*

Revenue increased $23.0 million or 3.9% for fiscal2005 as compared to fiscal 2004. Domestic revenue increased $0.6 million or0.1%, while international revenue increased 18.8% over fiscal 2004.

The domestic revenue increase is the result of adecrease in billed hours of 2.6%, which was offset by an increase in averagebill rates of 2.6%. The decline in domestic billed hours reflects the effectsof the November 2004 divestiture of one of our franchises, theAugust 2005 divestiture of another of our franchises and a shift inbusiness mix in an effort to increase gross margin. The increase in averagebill rates reflects the generally more positive economic environment with lowernational unemployment rates, which allows us to pass along bill rate increasesto customers in certain circumstances.

Permanent placement fees increased from $6.1 millionin fiscal 2004 to $7.1 million in fiscal 2005, an increase of 16.1%. Thisincrease is virtually all attributable to our domestic operations, which grewfrom $1.7 million in fees in fiscal 2004 to $2.7 million in fiscal 2005, anincrease of 58.5%. As a percentage of revenue, permanent placement fees in theU.S. were 0.6% in fiscal 2005 as compared to 0.4% in fiscal 2004.

Of the 18.8% increase ininternational revenue noted above, 5.3% is attributable to higher currencyexchange rates. International billed hours increased 7.9% and average billrates increased 5.8%. Local currency revenue from Australia increased 28.4% asa result of strong national account sales growth. Local currency revenue in theU.K. declined 7.7% during fiscal 2005, primarily due to “off-shoring” ofcertain staffing functions by a number of Westaff’s U.K. customers.

*Costs of Services*

Costs of services include hourly wages of temporaryemployees, employer payroll taxes, state unemployment and workers’ compensationinsurance and other employee-related costs. Costs of services increased $16.4million, or 3.3%, in fiscal 2005 as compared to fiscal 2004. Fiscal 2005 grossprofit increased $6.6 million, or 6.7%, and gross margin increased to 17.3% ascompared to 16.8% for fiscal 2004. Gross margin increased primarily as a resultof stabilization of workers’ compensation costs as noted below, bill rateincreases, changes in business mix and increased permanent placement fees asnoted above, partially offset by higher state unemployment insurance costs.

Our domestic workers’ compensation costs tend to varydepending upon the mix of business between clerical/administrative and lightindustrial staffing. Unexpected adverse development of open claims and 

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increases in our IBNRclaims can also significantly affect the level of accruals needed to coverworkers’ compensation costs. We review interim and annual actuarial estimatesand monitor claim activity to ensure that accruals remain appropriate in lightof loss trends. However, unanticipated adverse loss development trends can resultin a need for additional charges to be recorded. As a percent of direct labor,domestic workers’ compensation costs decreased from 5.9% in fiscal 2004 to 5.4%in fiscal 2005. The fiscal 2004 fourth quarter included a charge of $1.7million to increase our domestic workers’ compensation reserves as a result ofunfavorable loss development trends. During fiscal 2005, we increased our basicaccrual rates for workers’ compensation which, combined with more stable losstrends, resulted in no such charge in fiscal 2005. We aggressively work toclose out claims on terms that are favorable to us and continually monitor ourcosts and accrual rates in light of actual loss trends.

As a percent of directlabor, domestic state unemployment rates increased from 2.6% in fiscal 2004 to3.1% in fiscal 2005. This increase is largely due to an increase in theunemployment tax rate assessed in the State of California. During the fourthquarter of fiscal 2005, we were notified by the EDD that our Californiaunemployment tax rates would be increased retroactively for both calendar years2005 and 2004. This rate increase was based on the EDD finding that ourwholly-owned domestic operating subsidiaries would be considered as a singlereporting entity for California unemployment tax reporting purposes. Managementbelieves that it has properly calculated its unemployment insurance tax and isin compliance with all applicable laws and regulations. We have timely appealedthe ruling by the EDD and are working with our outside counsel to resolve thismatter. We accrued a portion of the increased tax during the fourth quarter offiscal 2005. However, management believes that it has strong defenses and legalarguments with respect to approximately $0.9 million of the assessment andaccordingly has not accrued for that portion of the assessment as ofOctober 29, 2005 or October 28, 2006.

*Franchise agents’share of gross profit*

Franchise agents’ share ofgross profit represents the net distribution paid to franchise agents based eitheron a percentage of the sales or gross profit generated by the franchise agents’operations. As a percentage of consolidated revenue, franchise agents’ share ofgross profit was 3.1% for both fiscal 2005 and fiscal 2004. InNovember 2004, we sold one of our franchise agents’ operations,representing four franchise offices, back to the franchise agent. Revenue forthis franchise agent comprised 3.2% of total domestic revenue for the fiscalyear ended October 30, 2004. In August 2005, we sold one additionalfranchise agent operation, representing two franchise offices, back to thefranchise agent. Year-to-date fiscal 2005 revenue for this franchise agentthrough the date of the sale comprised approximately 0.7% of our fiscal 2005domestic revenue.

*Selling andadministrative expenses*

Selling and administrativeexpenses increased $6.8 million, or 9.7%, for the 2005 fiscal year as comparedto fiscal 2004, due primarily to investments in new and existing personnelalong with associated benefits and payroll taxes. As a percentage of revenue,selling and administrative expenses increased to 12.5% in fiscal 2005 from11.8% in fiscal 2004. We are continuing our investment in our field officestaff, increasing full-time equivalent positions by approximately 11% as of theend of fiscal 2005 as compared to the prior year end. These staff increaseshave been made to support the development of our domestic permanent placementline of business along with increasing staff in selected offices to helpsupport future growth and business development. Additionally, we have increasedstaffing to support the implementation of our new business process managementsystem. The fiscal 2005 fourth quarter included $0.5 million of costsassociated with a restructure, while the fiscal 2005 second quarter includedseparation costs of $0.5 million for our former chief executive officer.Selling and administrative expenses in the second quarter of fiscal 2004 werereduced by a $0.7 million gain on the sale of the executive headquarters buildingin 

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WalnutCreek, California. The fiscal 2004 fourth quarter included costs of $0.9million associated with an unfavorable arbitration ruling.

*Depreciation andamortization*

Depreciation andamortization decreased $0.2 million or 5.0%, primarily due to assets becomingfully depreciated, partially offset by higher depreciation starting in thefourth quarter associated with the portions of our BPM system that have beenplaced in service.

*Interest expense*

Interest expense decreased$0.5 million for fiscal 2005 as compared to fiscal 2004 primarily as a resultof lower average borrowings outstanding during the year partially offset byhigher average interest rates.

*Income taxprovision*

We record income taxesusing an asset and liability approach that requires the recognition of deferredtax assets and liabilities for the expected future tax consequences of eventsthat have been recognized in our financial statements or tax returns. Avaluation allowance is established when management determines it is more likelythan not that a deferred tax asset is not realizable in the foreseeable future.At October 30, 2004, substantially all of our net deferred tax assets wereoffset with a valuation allowance of $18.7 million. During the fourth quarterof fiscal 2005, we assessed the realizability of our deferred tax assets. As aresult of our positive domestic earnings in fiscal 2004 and 2005, the favorableprojected earnings outlook, our long-term history of profitability as well asthe improvements in our financial position, we determined that it is morelikely than not that the deferred tax asset will be realized. Accordinglyduring the fourth quarter of fiscal 2005, we reversed our full, domesticdeferred tax asset valuation allowance of $16.7 million, which resulted in an increasein net income for fiscal 2005 of $16.7 million, or $1.02 per diluted share.

**Liquidity andCapital Resources**

We require significant amounts of working capital tooperate our business and to pay expenses relating to employment of temporaryemployees. Our traditional use of cash is for financing of accounts receivable,particularly during periods of economic upswings and growth and during periodswhere sales are seasonally high. Temporary personnel are generally paid on aweekly basis while payments from customers are generally received 30 to60 days after billing.

We finance our operations primarily through cashgenerated by our operating activities and borrowings under our revolving creditfacilities. Net cash provided by operating activities was $13.2 million for thefiscal year ended October 28, 2006, compared to $7.6 million for thefiscal year ended October 29, 2005. The largest portion of the fiscal 2006cash provided by operating activities was generated from managing receivables,which provided $7.5 million of the operating cash flow. Our days salesoutstanding, or DSO, was significantly reduced as compared to fiscal year end2005.

Cash used for investing activities was $9.1 million infiscal 2006 as compared to $4.6 million in fiscal 2005. Capital expenditures,which is primarily for BPM system initiatives, other software, computers andperipherals, and office furniture and equipment, was $5.1 million of thisamount during fiscal 2006. We continue to invest in enhancements and upgradesto our computer-based technologies. During fiscal 2004, we entered into alicense agreement for a domestic BPM system which is being implemented in threephases. The initial phase, which consisted of the human resources system forregular Westaff employees, was successfully implemented in July 2005. Thesecond phase, which includes the core financial systems and the accountsreceivable module, went live in the beginning of fiscal year 2006. The finalphase, which will include fully integrated front office functionality alongwith payroll and billing for temporary associates, is currently scheduled to golive in the fourth quarter of fiscal 2007. Capital expenditures 

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associated with thissystem implementation were approximately $2.7 million during fiscal year 2006.In addition, we made certain technology infrastructure upgrades in ourAustralian operation during fiscal 2006 and are also in the process ofimplementing a new front office system in our United Kingdom operation. Ourcredit agreement currently allows up to a maximum of $6.0 million in capitalexpenditures for fiscal 2007.

In addition, cash used by investing activities infiscal 2006 included $3.8 million for a Westaff franchise located in Houston,Texas. We believe the terms and conditions of the preexisting relationship wereconsistent with other relationships we have with other franchisees, andaccordingly have not recorded a settlement gain or loss. The transactionresulted in us recording $3.4 million of franchise rights, $0.1 million ofnon-compete agreements, and $0.3 million of goodwill.

We have generated cash in the past through sales ofcompany-owned offices to franchise owners or sales of franchise agent andlicense offices back to the franchise agent or license owner. In the firstquarter of fiscal 2005, we sold one of our franchise agents’ operations back tothe franchise agent for cash proceeds of $1.0 million. We secured the franchiseagents’ note payable obligation to the bank that funded the purchase through a$1.0 million letter of credit that declines as the note obligation is paid bythe franchise agent. As of October 28, 2006, the balance on the letter ofcredit was $0.8 million. The $1.0 million gain on the sale of the franchiseoperations has been deferred, and is being recognized as the note obligationpayments are made. During the fourth quarter of fiscal 2005, we sold anadditional franchise agent’s operations to the franchise agent for cashproceeds and a net gain of $0.5 million.

As noted above in “Discontinued Operations,” in June 2005,we sold our Norway and Denmark operations for net proceeds of approximately$2.7 million. Of the total proceeds, approximately $0.2 million is being heldin an interest bearing escrow account as security for potential claims underNorway’s pension plans. The escrowed funds, net of any claim payments, will beremitted to us in June 2007. The proceeds received were used to pay downborrowings under our revolving credit facility. We recorded a net gain on thesale of $1.2 million. No similar sale occurred during fiscal 2006.

Cash used for financing activities was $3.6 million infiscal 2006 and $6.9 million in fiscal 2005. In both years, the primary causebehind this usage was repayments under our lines of credit, which amounted to$3.9 million in fiscal 2006 and $7.1 million in fiscal 2005.

In May 2002, we entered into agreements with GECapital, as primary agent, to provide senior secured multicurrency creditfacilities that originally expired in May 2007. The credit facilitycomprised a five-year syndicated Credit Agreement (the “Multicurrency CreditAgreement”) consisting of a $50.0 million U.S. Revolving Loan Commitment, a£2.74 million U.K. Revolving Loan Commitment (U.S. dollar equivalent ofapproximately $4.0 million at the date of the agreement), and a$5.0 million term loan, which was repaid during fiscal 2003. In addition,a five-year Australian dollar facility agreement (the “A$ Facility Agreement”)was executed on May 16, 2002, consisting of an A$12.0 million revolvingcredit facility (U.S. dollar equivalent of approximately $6.0 million at thedate of the A$ Facility Agreement).

In August 2005, the Multicurrency CreditAgreement was amended to allow an add-back of approximately $1.0 million to theearnings before income taxes, depreciation and amortization, or EBITDA,covenant relating to separation and restructuring costs incurred or to beincurred during fiscal 2005. The amendment also allowed the gain from the saleof the Registrant’s Norway and Denmark operations of approximately $1.1 millionto be included in determining compliance with the EBITDA and fixed chargecovenants. Additionally, the amendment increased the maximum capitalexpenditures allowed for fiscal 2005 from $6.0 million to $8.5 million and alsoincreased the letter of credit sub-limit from $35.0 million to $40.0 million.

In March 2006, we and our lenders executed anEighth Amendment to the Multicurrency Credit Agreement. Among other things, theamendment reset minimum EBITDA covenants for fiscal 2006 and 

30

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beyond, adjusted the fixedcharge coverage ratio for our second quarter of fiscal 2006, extended thecredit facility for one additional year to May 2008 and added anadditional pricing grid that will allow us to benefit from reduced interestrates and letter of credit fees upon achieving certain minimum EBITDA targets.Additionally, the amendment increased the maximum amount of the U.S. RevolvingLoan Commitment by $5.0 million to $55.0 million and increased the letter ofcredit sub-limit from $40.0 million to $45.0 million. 

In July 2006, we and our lenders executed a NinthAmendment to the Multicurrency Credit Agreement for the purpose of determiningthe financial covenants. The amendment allows for a one-time add-backadjustment of approximately $0.5 million to EBITDA commencing the fiscalquarter ending April 15, 2006, for the separation and transition chargesrelated to the termination of employment for two of our former executives.

On January 2, 2007, we and our lenders executed aTenth Amendment to the Multicurrency Credit Agreement. Among other things, thisamendment reduces the interest rates if certain financial benchmarks areachieved and resets the future minimum EBITDA covenants. The amendment extendedthe credit facility for one additional year to May 2009. We were not incompliance with its minimum EBITDA covenant as of the end of fiscal 2006, andthe amendment included a waiver of this covenant violation.

On January 25, 2007, we and our lenders executedan amendment to the A$ Facility Agreement, which extended the agreement for twoadditional years to May 2009.

As of October 28, 2006, we had $4.8 millionoutstanding under our credit facilities all of which was outstanding under theA$ Facility Agreement. We have combined available borrowing capacity under ourcredit facilities of $19.8 million consisting of $10.6 million for the U.S.,$4.7 million for the U.K. and $4.5 million for Australia.

In February 2004, we completed the sale of ourformer corporate headquarters’ building for cash proceeds of $1.9 million. Theproceeds were used to pay down outstanding borrowings under our revolvingcredit facilities. We have an outstanding $0.7 million irrevocable standbyletter of credit as a security deposit for the December 2002 saleleaseback of the land and buildings housing our administrative offices.

We have an unsecured subordinated promissory notepayable to our principal stockholder and Chairman of the Board of Directors inthe amount of $2.0 million with a maturity date of August 18, 2007,and an interest rate equal to an indexed rate as calculated under our creditfacilities plus seven percent (15.25% at October 28, 2006), compoundedmonthly and payable 60 calendar days after the end of each of our fiscalquarters. Payment of interest is contingent on us meeting minimum availabilityrequirements under our credit facilities. Additionally, payments of principalor interest are prohibited in the event of any default under the creditfacilities. The Sixth Amendment to our Multicurrency Credit Agreement providesfor optional prepayment of the note subject to certain borrowing availabilitylimits on the U.S. revolving loan commitment portion of the credit facilities.

We work to balance our worldwide cash needs throughdividends from and loans to our international subsidiaries. These loans anddividends are limited by the cash availability and needs of each respectivesubsidiary, restrictions imposed by our senior secured debt facilities and, insome cases, statutory regulations of the subsidiary. The U.S. operations cannotdirectly draw on the excess borrowing availability of the U.K. or Australianoperations; however, we may request dividends from the U.K. During fiscal 2004,the U.K. utilized cash from operations and excess borrowing capacity to paydividends to the U.S. totaling $2.7 million. The U.S. can also requestrepayments on its intercompany loan to Australia, along with intercompanyinterest and royalties, although remittances from Australia may be limited bycertain covenants under the terms of the Australia credit facility. Outstandingprincipal on the intercompany loan to Australia was $4.2 million as ofOctober 28, 2006, and $4.1 million as of October 29, 2005.

31

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We are responsible for and pay workers’ compensationcosts for our domestic temporary and regular employees and are self-insured forthe deductible amount related to workers’ compensation claims ($500,000 perclaim for fiscal years 2006 and 2005 and $750,000 per claim for fiscal 2004). Generallyspeaking, each policy year the terms of the agreement with the insurancecarrier are renegotiated. The insurance carrier requires us to collateralizeour obligations through the use of irrevocable standby letters of credit,surety bonds or cash. In April 2005, our insurance carrier reduced ourcollateral requirements for us through the cancellation of a $3.8 millionsurety bond thereby eliminating any remaining outstanding surety bond. Currently,we do not believe that surety bonds will be available or required in theforeseeable future to secure workers’ compensation obligations.

Under the terms of our 2006 policy year agreement, wemade cash payments totaling $4.9 million, paid in equal monthly installments,which commenced on November 1, 2005.

During the fourth quarter of fiscal 2005, we and ourinsurance carrier negotiated the return of $11.0 million of the fiscal 2005cash collateral and we issued $11.0 million of letters of credit in its place.During the first quarter of fiscal 2006, we issued an additional $1.9 millionof letters of credit in exchange for $1.2 million in cash, which representedall of the cash remaining in the 2005 collateral fund.

For our 2007 policy year insurance program, weanticipate total cash payments of $4.8 million will be paid during fiscal 2007in equal monthly installments, which commenced on November 1, 2006. Cashpayments for 2007 policy year claims will be paid directly by us. As ofJanuary 2007, we had outstanding $35.3 million of letters of credit tosecure all outstanding obligations under our workers’ compensation program forall years except 2003, which is fully funded although subject to annualretroactive premium adjustments based on actual claims activity. Under certaincircumstances, we may be required to increase our letters of credit by $5million. We will also make ongoing cash payments for claims for all other openpolicy years (except for 2003 as noted above).

We continue to evaluateother opportunities to further strengthen our financial position. However, webelieve that the borrowing capacity provided under the amended creditagreement, together with cash generated through our operating performance, willbe sufficient to meet our working capital needs for the foreseeable future.

**Off-Balance SheetArrangements**

None.

32

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**ContractualObligations**

The following summarizesour contractual cash obligations in future fiscal years (in millions) as ofOctober 28, 2006: 

| ** **                                      | ** ** | **Payment Due by Period** | ** ** |
|-------------------------------------------------|------------|------------------------------------------|------------|
| **Contractual Obligations**                | ** ** | ** **                               | ** ** | **Total** | ** ** | **Less than one  fiscal year** | ** ** | **1 to 3  fiscal years** | ** ** | **4 to 5  fiscal years** | ** ** | **More than 5  fiscal years** | ** ** |
| Credit facilities(1)                            |       | $                                        | 4.8        |   |   | $ | 4.8 |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   |
| Promissory note(2)                              |       | 2.0                                      |       |   | 2.0 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Operating leases                                |       | 11.6                                     |       |   | 4.3 |   |   |   | 5.5 |   |   |   | 1.6 |   |   |   | 0.2 |   |   |
| Workers’ compensation  policy year 2007(3) |       | 4.8                                      |       |   | 4.8 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Capital leases-principal                        |       | 1.2                                      |       |   | 0.3 |   |   |   | 0.9 |   |   |   | — |   |   |   | — |   |   |
| Capital leases-interest                         |       | 0.3                                      |       |   | 0.2 |   |   |   | 0.1 |   |   |   | — |   |   |   | — |   |   |
| Total Contractual  Obligations                  |       | $                                        | 24.7       |   |   | $ | 16.4 |   |   |   | $ | 6.5 |   |   |   | $ | 1.6 |   |   |   | $ | 0.2 |   |   |
|                                                 |            |                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          The credit agreementexpires in May 2009, but our lenders could require accelerated payment ofamounts outstanding under the credit facilities in the event of default on oneor more of the debt covenants contained therein. 

(2)          Payments under thepromissory note are subject to certain restrictions regarding borrowingcapacity and compliance within our senior secured credit facilities. 

(3)          Workers’compensation obligations for policy year 2007 are based on estimates. If actualresults differ from these estimates, we could be required to make additionalpayments to, or receive refunds from, our insurance carrier in years subsequentto 2007.

**ITEM 7A.**   QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

We are exposed tocertain market risks from transactions that are entered into during the normalcourse of business. Our primary market risk exposure relates to interest raterisk. At October 28, 2006, our outstanding debt under variable-rateinterest borrowings was approximately $6.8 million. A change of two percentagepoints in the interest rates would cause a change in interest expense ofapproximately $0.1 million on an annual basis. Our exposure to market risk forchanges in interest rates is not significant with respect to interest income,as our investment portfolio is not material to our consolidated balance sheet.We currently have no plans to hold an investment portfolio that includesderivative financial instruments.

For the fiscal year endedOctober 28, 2006, our international operations comprised 21.6% of ourrevenue and, as of the end of that period, 19.3% of our total assets. We areexposed to foreign currency risk primarily due to our investments in foreignsubsidiaries. Our multicurrency credit facility, which allows our Australianand United Kingdom subsidiaries to borrow in local currencies, partiallymitigates the exchange rate risk resulting from fluctuations in foreigncurrency denominated net investments in these subsidiaries in relation to the U.S.dollar. We do not currently hold any market risk sensitive instruments enteredinto for hedging transaction risks related to foreign currencies. In addition,we have not entered into any transactions with derivative financial instrumentsfor trading purposes.

**ITEM 8.**   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

Our Financial Statementsand Supplementary Data required by this Item are set forth at thepages indicated at Item 15(a).

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**ITEM 9.**   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTSON ACCOUNTING AND FINANCIAL DISCLOSURE.

None.

**ITEM 9A.**   CONTROLS AND PROCEDURES.

We carried out anevaluation, under the supervision and with the participation of our management,including the Chief Executive Officer and Chief Financial Officer, of theeffectiveness of the design and operation of our “disclosure controls andprocedures” (as defined under Rules 13a—15(e) and 15d—15(e) underthe Securities Exchange Act of 1934 as amended). Based on this evaluation, theChief Executive Officer and Chief Financial Officer concluded that, as of October 28,2006 (the end of the period covered by this report) our disclosure controls andprocedures are effective in timely alerting them to material informationrequired to be included in this report. There was no change in our internalcontrol over financial reporting that occurred during the fiscal year endedOctober 28, 2006, that has materially affected, or is reasonably likely tomaterially affect, our internal controls over financial reporting.

**ITEM 9B.**   OTHER INFORMATION.

None.

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**PART III**

**ITEM 10.**         DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.

The information requiredby this Item is incorporated herein by reference from our Proxy Statement forthe 2007 Annual Meeting of Stockholders. We have adopted a Code of Ethics thatapplies to all our principal executive, financial and accounting officers. TheCode of Ethics is posted on our website at *www.westaff.com*.We intend to satisfy the requirements under Item 5.05 of Form 8-Kregarding disclosure of amendments to, or waivers from, provisions of our Codeof Ethics that apply, by posting such information on our website. Copies of theCode of Ethics will be provided, free of charge, upon written request directedto Investor Relations, Westaff, Inc., P.O. Box 9280, Walnut Creek, CA94598.

**ITEM 11.**         EXECUTIVE COMPENSATION.

The information requiredby this Item is incorporated herein by reference from our Proxy Statement forthe 2007 Annual Meeting of Stockholders.

**ITEM 12.**         SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ANDRELATED STOCKHOLDER MATTERS.

The information requiredby this Item is incorporated herein by reference from our Proxy Statement forthe 2007 Annual Meeting of Stockholders.

**ITEM 13.**         CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

Our wholly-owned subsidiary known as Westaff(USA), Inc., a California corporation (“Westaff (USA)”) executed anunsecured subordinated promissory note dated April 1, 2002, payable to W.Robert Stover, its principal stockholder and Chairman of the Board ofDirectors, in the amount of $2.0 million. The initial term of the note was oneyear with an interest rate of 12% per annum, payable monthly on the lastbusiness day of each calendar month. On May 17, 2002, the note was amendedand restated to extend the maturity date to August 18, 2007. Additionally,the interest rate and payment schedule were amended to a rate equal to the U.S.Index Rate as calculated under our Multicurrency Credit Agreement with GeneralElectric Capital Corporation (“Credit Agreement”), plus seven percent, compoundedmonthly payable 60 calendar days after the end of each of our fiscal quarters.The interest rate in effect on October 28, 2006, was 15.25%. Payment ofinterest is contingent on us meeting minimum availability requirements underour credit facilities. Additionally, payments of principal or interest areprohibited in the event of any default under the credit facilities. Theinterest paid in fiscal 2006 was $0.3 million.

Any future transactionsbetween us and our officers, directors, and affiliates will be on terms no lessfavorable to us than can be obtained from unaffiliated third parties. Suchtransactions with such persons will be subject to approval of our AuditCommittee.

**ITEM 14.**         PRINCIPAL ACCOUNTANT FEES AND SERVICES.

The information required by this Item is incorporatedherein by reference from our Proxy Statement for the 2007 Annual Meeting ofStockholders.

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**PART IV**

**ITEM 15.**   EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.

(a)           The following documents have been filed as a partof this Annual Report on Form 10-K.

| 1.     |   | Financial Statements                                                                                                                      |   |   |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
|   |   | Report of Independent Registered Public Accounting  Firm                                                                                  |   | F-1    |
|   |   | Consolidated Balance Sheets—As of the Fiscal Year  Ended October 28, 2006 and the Fiscal Year Ended October 29,  2005 |   | F-2    |
|   |   | Consolidated Statements of Income—For Each of the  Three Years in the Period Ended October 28, 2006                             |   | F-3    |
|   |   | Consolidated Statements of Stockholders’ Equity—For  Each of the Three Years in the Period Ended October 28, 2006          |   | F-4    |
|   |   | Consolidated Statements of Cash Flows—For Each of the  Three Years in the Period Ended October 28, 2006                    |   | F-5    |
|   |   | Notes to Consolidated Financial Statements                                                                                                |   | F-7    |

 

2.                 FinancialStatement Schedules.

All schedules areomitted because they are not applicable or not required or because the requiredinformation is included in the Consolidated Financial Statements or the Notesthereto.

3.                 Exhibits.

Thefollowing exhibits are filed as part of, or incorporated by reference into,this Annual Report:
| Exhibit   Number  | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | ** ** | **Description** |
|-------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
|   3.1.2 |       | Fourth Amended and Restated  Certificate of Incorporation.(5)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|   3.2.4 |       | Amended and Restated  Bylaws, effective March 1, 2004.(10)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|   4.1.1 |       | Form of Specimen Certificate for the Company’s  Common Stock.(2)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.1              |       | Form of Indemnification Agreement between the  Company and the Officers and Key Employees of the Company.(1)                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.2              |       | Form of Indemnification Agreement between the  Company and the Directors of the Company.(1)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.3.4            |       | Employment Agreement with W. Robert Stover.(2)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.3.5            |       | Employment Contract between the Company and Dirk A.  Sodestrom.(3)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.3.5.1          |       | First Amendment to Employment Contract by and  between Westaff Support, Inc. and Dirk A. Sodestrom.(8)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.3.5.2          |       | Second Amendment to Employment Contract by and  between Westaff Support, Inc. and Dirk A. Sodestrom.(12)                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.3.9            |       | Addendum made the 26th day of January 2005 to agreement  between Westaff (UK) Limited (“the Company”) and Patricia M. Newman (“the  Employee”) supplemental to an agreement made as of the 1st day of December 1998 between the  Company and the Employee, an addendum made as of the 4th day of February 1999 between the  Company and the Employee, a letter dated the 3rd day of April 2001 from Bob Stover to  Employee; and a memorandum dated the 23rd February 2004 between the Company and  the Employee.(13) |
| 10.3.9.1          |       | Employment Agreement executed on April 7, 2005  between Westaff, Inc., Westaff Support, Inc. and Patricia M.  Newman.(15)                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10..9.2           |       | Notice of Restricted Stock Award and Restricted  Stock Agreement dated April 7, 2005.(15)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.3.9.4          |       | Notices of Grant of Stock Option dated April 7,  2005 (replaces Exhibit 10.3.9.3).(15)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |

36

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| 10.3.9.5   |   | First Amendment to Employment Agreement between  Westaff, Inc., Westaff Support, Inc. and Patricia M. Newman.(18)                                                                                                                                                                                                                                                                                                                        |
|------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.3.10.1  |   | Third Amendment to Employment Contract by and  between the Company and Stephen Russo dated August 17, 2005, Second  Amendment to Employment Contract by and between the Company and Stephen Russo  dated July 1, 2004, First Amendment to Employment Contract by and  between the Company and Stephen Russo dated July 1, 2004, and Employment  Contract by and between the Company and Stephen Russo dated July 1,  2004.(18) |
| 10.3.11.1  |   | Employment Agreement dated as of February 20,  2001, by and between John P. Sanders and the Company.(20)                                                                                                                                                                                                                                                                                                                                      |
| 10.3.11.2  |   | Key Employee Transition Compensation Plan, dated as  of September 20, 2004, by and between John P. Sanders and the  Company.(20)                                                                                                                                                                                                                                                                                                              |
| 10.3.11.3  |   | First Amendment to Employment Contract executed on  April 21, 2006, by and between John P. Sanders and the Company.(23)                                                                                                                                                                                                                                                                                                                       |
| 10.3.12.1  |   | Employment Agreement dated as of March 20,  2006, by and between Matthew G. J. Parker and the Company.(20)                                                                                                                                                                                                                                                                                                                                    |
| 10.3.12.2  |   | First Amendment to Westaff Employment Contract  executed on April 24, 2006, between Matthew G. J. Parker and the  Company.(23)                                                                                                                                                                                                                                                                                                                |
| 10.7       |   | Westaff, Inc. 1996 Stock Option/Stock Issuance  Plan, as amended and restated.(12)                                                                                                                                                                                                                                                                                                                                                            |
| 10.8.20    |   | Credit Agreement dated as of May 17, 2002.(4)                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.8.20.1  |   | First Amendment to Multicurrency Credit Agreement,  Limited Waiver and Consent of Guarantors.(6)                                                                                                                                                                                                                                                                                                                                                   |
| 10.8.20.2  |   | Second Amendment to Multicurrency Credit Agreement,  Limited Waivers and Consent of Guarantors.(7)                                                                                                                                                                                                                                                                                                                                                 |
| 10.8.20.3  |   | Third Amendment to Multicurrency Credit Agreement,  Limited Waiver and Consent of Guarantors.(8)                                                                                                                                                                                                                                                                                                                                                   |
| 10.8.20.4  |   | Fourth Amendment to Multicurrency Credit Agreement,  Limited Waivers and Consent of Guarantors.(9)                                                                                                                                                                                                                                                                                                                                                 |
| 10.8.20.5  |   | Fifth Amendment to Multicurrency Credit Agreement  and Consent of Guarantors.(11)                                                                                                                                                                                                                                                                                                                                                                  |
| 10.8.20.6  |   | Sixth Amendment to Multicurrency Credit Agreement  and Consent of Guarantors.(14)                                                                                                                                                                                                                                                                                                                                                                  |
| 10.8.20.7  |   | Seventh Amendment to Multicurrency Credit Agreement  and Consent of Guarantors.(17)                                                                                                                                                                                                                                                                                                                                                                |
| 10.8.20.8  |   | Eight Amendment to Multicurrency Credit Agreement  and Consent of Guarantors.(19)                                                                                                                                                                                                                                                                                                                                                                  |
| 10.8.20.9  |   | Ninth Amendment to Multicurrency Credit Agreement  and Consent of Guarantors.(24)                                                                                                                                                                                                                                                                                                                                                                  |
| 10.8.20.10 |   | Tenth Amendment to Multicurrency Credit Agreement  and Consent of Guarantors.(25)                                                                                                                                                                                                                                                                                                                                                                  |
| 10.8.21    |   | Deed of Trust, Absolute Assignment of Leases and  Rents, Security Agreement and Fixture Filing effective as of May 17,  2002.(4)                                                                                                                                                                                                                                                                                                              |
| 10.8.22    |   | Pledge Agreement dated as of May 17, 2002.(4)                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.8.23    |   | Security Agreement dated as of May 17, 2002.(4)                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.8.24    |   | Parent Guaranty dated as of May 17, 2002.(4)                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.8.25    |   | Subsidiary Guaranty dated as of May 17,  2002.(4)                                                                                                                                                                                                                                                                                                                                                                                             |
| 10.8.26    |   | Amended and Restated Unsecured Subordinated Note  dated May 17, 2002.(4)                                                                                                                                                                                                                                                                                                                                                                      |
| 10.8.27    |   | Unsecured Subordinated Draw Down Note dated  September 25, 2003.(8)                                                                                                                                                                                                                                                                                                                                                                           |
| 10.11      |   | Westaff, Inc. Employee Stock Purchase Plan.(3)                                                                                                                                                                                                                                                                                                                                                                                                |
| 10.11.3    |   | International Employee Stock Purchase Plan(3)                                                                                                                                                                                                                                                                                                                                                                                                      |
| 10.11.4    |   | Westaff, Inc. Employee Stock Purchase Plan (as  Amended and Restated July 26, 2006).                                                                                                                                                                                                                                                                                                                                                     |
| 10.11.5    |   | Westaff, Inc. International Employee Stock  Purchase Plan (as Amended and Restated July 26, 2006).                                                                                                                                                                                                                                                                                                                                       |
| 10.12      |   | Westaff Key Employee Transition Compensation  Plan.(12)                                                                                                                                                                                                                                                                                                                                                                                            |

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| 10.13   |   | Form of Employment Contract with Certain Named  Executive Officers.(3)                                                                                       |
|---------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.14.1 |   | Westaff, Inc. 2006 Stock Incentive Plan.(22)                                                                                                                 |
| 10.14.2 |   | Westaff, Inc. 2006 Non-Employee Director Option  Program.(22)                                                                                                |
| 10.14.3 |   | Form Notice of Stock Option Award and Stock  Option Award Agreement.(22)                                                                                     |
| 10.14.4 |   | Form Notice of Non-Qualified Stock Option Award  and Stock Option Award Agreement.(22)                                                                       |
| 21.1    |   | Subsidiaries of the Company.                                                                                                                                      |
| 23.1    |   | Consent of Independent Registered Public Accounting  Firm                                                                                                         |
| 24.1    |   | Power of Attorney (see page IV-1).                                                                                                                           |
| 31.1    |   | Certification of the Chief Executive Officer  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                     |
| 31.2    |   | Certification of the Chief Financial Officer  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                     |
| 32.1    |   | Certification of the Chief Executive Officer  pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |
| 32.2    |   | Certification of the Chief Financial Officer  pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |
| 99.1    |   | Mutual Release, dated as of March 31, 2006, by  and between Dirk A. Sodestrom and the Company.(21)                                                           |

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       (1)        Incorporated herein by reference to the exhibit with the samenumber filed with the Company’s Registration Statement on Form S-1(File No. 33-85536) declared effective by the Securities andExchange Commission on April 30, 1996.

       (2)        Incorporated herein by reference to the exhibit with the samenumber filed with the Company’s Annual Report on Form 10-K for thefiscal year ended October 31, 1998.

       (3)        Incorporated herein by reference to the exhibit with the samenumber filed with the Company’s Annual Report on Form 10-K for thefiscal year ended November 3, 2001.

       (4)        Incorporated herein by reference to the exhibit with the samenumber filed with the Company’s Quarterly Report on Form 10-Q forthe quarter ended April 20, 2002.

       (5)        Incorporated herein by reference to the exhibit with the samenumber filed with the Company’s Quarterly Report on Form 10-Q forthe quarter ended July 13, 2002.

       (6)        Incorporated herein by reference to the exhibit with the samenumber filed with the Company’s Annual Report on Form 10-K for thefiscal year ended November 2, 2002.

       (7)        Incorporated herein by reference to the exhibit with the samenumber filed with the Company’s Quarterly Report on Form 10-Q forthe quarter ended July 12, 2003.

       (8)        Incorporated herein by reference to the exhibit with the samenumber filed with the Company’s Annual Report on Form 10-K for thefiscal year ended November 1, 2003.

       (9)        Incorporated herein by reference to the exhibit with the samenumber filed with the Company’s Quarterly Report on Form 10-Q forthe quarter ended January 24, 2004.

(10)        Incorporated herein by reference to the exhibit with the samenumber filed with the Company’s Current Report on Form 8-K datedMarch 1, 2004.

(11)        Incorporated herein by reference to the exhibit with the samenumber filed with the Company’s Quarterly Report on Form 10-Q forthe quarter ended July 10, 2004.

38

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(12)        Incorporated herein by reference to the exhibit with the samenumber filed with the Company’s Current Report on Form 8-K datedSeptember 20, 2004.

(13)        Incorporated herein by reference to the exhibit with the samenumber filed with the Company’s Annual Report on Form 10-K for thefiscal year ended October 20, 2004.

(14)        Incorporated herein by reference to the exhibit with the samenumber filed with the Company’s Current Report on Form 8-K datedJanuary 5, 2005.

(15)        Incorporated herein by reference to the exhibit with the samenumber filed with the Company’s Current Report on Form 8-K datedApril 7, 2005.

(16)        Incorporated herein by reference to the exhibit with the samenumber filed with the Company’s Quarterly Report on Form 10-Q forthe quarter ended April 16, 2005.

(17)        Incorporated herein by reference to the exhibit with the samenumber filed with the Company’s Current Report on Form 8-K datedAugust 19, 2005.

(18)        Incorporated herein by reference to the exhibit with the samenumber filed with the Company’s Annual Report on Form 10-K for the fiscalyear ended October 29, 2005.

(19)        Incorporated herein by reference to the exhibit with the samenumber filed with the Company’s Current Report on Form 8-K datedMarch 1, 2006.

(20)        Incorporated herein by reference to Exhibits 10.1, 10.2, and10.3 filed with the Company’s Current Report on Form 8-K datedMarch 24, 2006.

(21)        Incorporated herein by reference to the exhibit with the samenumber filed with the Company’s Current Report on Form 8-K datedMarch 31, 2006.

(22)        Incorporated herein by reference to Exhibits 10.1, 10.2, 10.3and 10.4 filed with the Company’s Current Report on Form 8-K datedApril 19, 2006.

(23)        Incorporated herein by reference to Exhibits 10.1 and 10.2filed with the Company’s Current Report on Form 8-K datedApril 21, 2006.

(24)        Incorporated herein by reference to the exhibit with the samenumber filed with the Company’s Current Report on Form 8-K datedJuly 25, 2006.

(25)        Incorporated herein by reference to the exhibit with the samenumber filed with the Company’s Current Report on Form 8-K datedJanuary 2, 2007.

39

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board of Directors and Stockholders ofWestaff, Inc.

We have audited the accompanying consolidated balancesheets of Westaff, Inc. and subsidiaries (the Company) as ofOctober 28, 2006 and October 29, 2005, and the related consolidatedstatements of income, stockholders’ equity, and cash flows for each of thethree years in the period ended October 28, 2006. These financialstatements are the responsibility of the Company’s management. Our responsibilityis to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. The Company is not required to have, nor were we engaged toperform, an audit of its internal control over financial reporting. Our audits includedconsideration of internal control over financial reporting as a basis fordesigning audit procedures that are appropriate in the circumstances, but notfor the purpose of expressing an opinion on the effectiveness of the Company’sinternal control over financial reporting. Accordingly, we express no suchopinion. An audit also includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statementspresent fairly, in all material respects, the financial position ofWestaff, Inc. and its subsidiaries as of October 28, 2006 andOctober 29, 2005, and the results of their operations and their cash flowsfor each of the three years in the period ended October 28, 2006, inconformity with accounting principles generally accepted in the United Statesof America.

As discussed in Notes 2and 12 to the consolidated financial statements, effective October 30,2005, the Company changed its method of accounting for share-based paymentarrangements to conform to Statement of Financial Accounting StandardsNo. 123(R), *Share-Based Payment*.

/s/ DELOITTE & TOUCHE LLP

Oakland, CaliforniaJanuary 26, 2007

F-1

----

**Westaff, Inc.Consolidated Balance Sheets**

| ** **                                                                                                                                                        | ** ** | **October 28,**                                                                        | ** ** | **October 29,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                                                                                                        | ** ** | **2006**                                                                                    | ** ** | **2005**             | ** ** |
| **ASSETS**                                                                                                                                                        | ** ** | **(In thousands, except share   and per share amounts)** | ** ** |
| Current assets:                                                                                                                                                   |       |                                                                                        |       |                 |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                                         |       |                                                                                        | $          | 3,545                |       |   |   | $ | 3,014 |   |   |
| Trade accounts receivable, less allowance for  doubtful accounts   of $811 and $997                                                                               |       |                                                                                        | 76,267     |                 |       |   | 83,416 |   |   |
| Deferred income taxes                                                                                                                                             |       |                                                                                        | 5,834      |                 |       |   | 5,097 |   |   |
| Prepaid expenses                                                                                                                                                  |       |                                                                                        | 4,732      |                 |       |   | 3,847 |   |   |
| Other current assets                                                                                                                                              |       |                                                                                        | 4,694      |                 |       |   | 1,419 |   |   |
| Total current assets                                                                                                                                              |       |                                                                                        | 95,072     |                 |       |   | 96,793 |   |   |
| Property and  equipment, net                                                                                                                                      |       |                                                                                        | 15,046     |                 |       |   | 15,184 |   |   |
| Deferred income  taxes                                                                                                                                            |       |                                                                                        | 12,404     |                 |       |   | 11,951 |   |   |
| Goodwill                                                                                                                                                          |       |                                                                                        | 12,367     |                 |       |   | 11,770 |   |   |
| Intangible assets                                                                                                                                                 |       |                                                                                        | 3,425      |                 |       |   | 8 |   |   |
| Other long-term  assets                                                                                                                                           |       |                                                                                        | 951        |                 |       |   | 3,076 |   |   |
|                                                                                                                                                              |       |                                                                                        | $          | 139,265              |       |   |   | $ | 138,782 |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                    |       |                                                                                        |       |                 |       |   |   |   |   |
| Current liabilities:                                                                                                                                              |       |                                                                                        |       |                 |       |   |   |   |   |
| Borrowings under revolving credit facilities                                                                                                                      |       |                                                                                        | $          | 4,790                |       |   |   | $ | 8,568 |   |   |
| Current portion of capital lease obligations                                                                                                                      |       |                                                                                        | 345        |                 |       |   | 343 |   |   |
| Note payable to related party                                                                                                                                     |       |                                                                                        | 2,000      |                 |       |   | — |   |   |
| Accounts payable                                                                                                                                                  |       |                                                                                        | 5,245      |                 |       |   | 3,755 |   |   |
| Accrued expenses                                                                                                                                                  |       |                                                                                        | 39,695     |                 |       |   | 42,684 |   |   |
| Income taxes payable                                                                                                                                              |       |                                                                                        | 1,105      |                 |       |   | 817 |   |   |
| Total current liabilities                                                                                                                                         |       |                                                                                        | 53,180     |                 |       |   | 56,167 |   |   |
| Note payable to  related party                                                                                                                                    |       |                                                                                        | —     |                 |       |   | 2,000 |   |   |
| Long-term capital  lease obligations                                                                                                                              |       |                                                                                        | 833        |                 |       |   | 1,174 |   |   |
| Other long-term  liabilities                                                                                                                                      |       |                                                                                        | 19,243     |                 |       |   | 17,820 |   |   |
| Total liabilities                                                                                                                                                 |       |                                                                                        | 73,256     |                 |       |   | 77,161 |   |   |
| Commitments and  contingencies (Notes 2, 13 and 15)                                                                                                               |       |                                                                                        |       |                 |       |   |   |   |   |
| Stockholders’ equity:                                                                                                                                        |       |                                                                                        |       |                 |       |   |   |   |   |
| Preferred stock,  $0.01 par value; authorized and unissued: 1,000,000 shares                                                                                 |       |                                                                                        |       |                 |       |   |   |   |   |
| Common stock, $0.01 par value; authorized:  25,000,000 shares; issued: 16,561,520 shares at October 28, 2006 and  16,377,958 shares at October 29, 2005 |       |                                                                                        | 166        |                 |       |   | 164 |   |   |
| Additional paid-in capital                                                                                                                                        |       |                                                                                        | 38,617     |                 |       |   | 37,803 |   |   |
| Deferred stock compensation                                                                                                                                       |       |                                                                                        | —     |                 |       |   | (54 | ) |   |
| Retained earnings                                                                                                                                                 |       |                                                                                        | 27,270     |                 |       |   | 24,151 |   |   |
| Accumulated other comprehensive loss                                                                                                                              |       |                                                                                        | (44        | )                    |       |   | (443 | ) |   |
| Total stockholders’ equity                                                                                                                                   |       |                                                                                        | 66,009     |                 |       |   | 61,621 |   |   |
|                                                                                                                                                              |       |                                                                                        | $          | 139,265              |       |   |   | $ | 138,782 |   |   |

 

See accompanying notes to consolidated financial statements.

F-2

----

**Westaff, Inc.Consolidated Statements of Income**

| ** **                                             | ** ** | **Fiscal Year Ended**                                       | ** ** |
|--------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                             | ** ** | **October 28,**                                                  | ** ** | **October 29,** | ** ** | **October 30,** | ** ** |
| ** **                                             | ** ** | **2006**                                                              | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                             | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Revenue                                                |       |                                                                  | $          | 614,950 |   |   |   | $ | 612,861 |   |   |   | $ | 589,861 |   |   |
| Costs of services                                      |       |                                                                  | 506,167    |   |   |   | 507,052 |   |   |   | 490,664 |   |   |
| Gross profit                                           |       |                                                                  | 108,783    |   |   |   | 105,809 |   |   |   | 99,197 |   |   |
| Franchise agents’ share of gross profit           |       |                                                                  | 18,157     |   |   |   | 18,884 |   |   |   | 18,494 |   |   |
| Selling and  administrative expenses                   |       |                                                                  | 81,270     |   |   |   | 76,635 |   |   |   | 70,914 |   |   |
| Depreciation and  amortization                         |       |                                                                  | 4,811      |   |   |   | 4,162 |   |   |   | 4,380 |   |   |
| Operating income from continuing operations            |       |                                                                  | 4,545      |   |   |   | 6,128 |   |   |   | 5,409 |   |   |
| Interest expense                                       |       |                                                                  | 1,241      |   |   |   | 1,587 |   |   |   | 2,098 |   |   |
| Interest income                                        |       |                                                                  | (151       | ) |   |   | (148 | ) |   |   | (85 | ) |   |
| Income from continuing operations before income  taxes |       |                                                                  | 3,455      |   |   |   | 4,689 |   |   |   | 3,396 |   |   |
| Income tax  provision (benefit)                        |       |                                                                  | 336        |   |   |   | (15,408 | ) |   |   | 239 |   |   |
| Income from continuing operations                      |       |                                                                  | 3,119      |   |   |   | 20,097 |   |   |   | 3,157 |   |   |
| Discontinued  operations:                              |       |                                                                  |       |   |   |   |   |   |   |   |   |   |   |
| Income (loss) from discontinued operations             |       |                                                                  | —     |   |   |   | (134 | ) |   |   | 316 |   |   |
| Gain on sale, net of income taxes of $34               |       |                                                                  | —     |   |   |   | 1,163 |   |   |   | — |   |   |
| Total  discontinued operations, net of income taxes    |       |                                                                  | —     |   |   |   | 1,029 |   |   |   | 316 |   |   |
| Net income                                             |       |                                                                  | $          | 3,119 |   |   |   | $ | 21,126 |   |   |   | $ | 3,473 |   |   |
| Earnings per  share:                                   |       |                                                                  |       |   |   |   |   |   |   |   |   |   |   |
| Continuing  operations                                 |       |                                                                  |       |   |   |   |   |   |   |   |   |   |   |
| Basic                                                  |       |                                                                  | $          | 0.19 |   |   |   | $ | 1.24 |   |   |   | $ | 0.20 |   |   |
| Diluted                                                |       |                                                                  | $          | 0.19 |   |   |   | $ | 1.23 |   |   |   | $ | 0.20 |   |   |
| Discontinued operations—basic and diluted         |       |                                                                  | $          | — |   |   |   | $ | 0.06 |   |   |   | $ | 0.02 |   |   |
| Net income                                             |       |                                                                  |       |   |   |   |   |   |   |   |   |   |   |
| Basic                                                  |       |                                                                  | $          | 0.19 |   |   |   | $ | 1.30 |   |   |   | $ | 0.22 |   |   |
| Diluted                                                |       |                                                                  | $          | 0.19 |   |   |   | $ | 1.29 |   |   |   | $ | 0.22 |   |   |
| Weighted average shares outstanding—basic         |       |                                                                  | 16,454     |   |   |   | 16,271 |   |   |   | 16,033 |   |   |
| Weighted average shares  outstanding—diluted      |       |                                                                  | 16,526     |   |   |   | 16,420 |   |   |   | 16,081 |   |   |

 

See accompanying notes to consolidated financial statements.

F-3

----

**Westaff, Inc.Consolidated Statements of Stockholders’ Equity**

| ** **                                        | ** ** | ** **              | ** ** | ** **  | ** ** | ** **       | ** ** | **Retained**      | ** ** | **Accumulated** | ** ** | ** **       | ** ** | ** ** | ** ** |
|---------------------------------------------------|------------|-------------------------|------------|-------------|------------|------------------|------------|-------------------|------------|-----------------|------------|------------------|------------|------------|------------|
| ** **                                        | ** ** | ** **              | ** ** | ** **  | ** ** | **Additional**   | ** ** | **earnings**      | ** ** | **other**       | ** ** | **Deferred**     | ** ** | ** ** | ** ** |
| ** **                                        | ** ** | **Common stock**   | ** ** | **paid-in** | ** ** | **(accumulated** | ** ** | **comprehensive** | ** ** | **stock**       | ** ** | ** **       | ** ** |
| ** **                                        | ** ** | **Shares**              | ** ** | **Amount**  | ** ** | **capital**      | ** ** | **deficit)**      | ** ** | **loss**        | ** ** | **compensation** | ** ** | **Total**  | ** ** |
| ** **                                        | ** ** | **(In thousands)** | ** ** |
| Balance at November 1, 2003                  |       |                    | 16,015     |        |       |             | $          | 160               |       |            |       | $                | 36,706     |       |       |   | $ | (448 | ) |   |   | $ | (962 | ) |   |   | $ | — |   |   | $ | 35,456 |   |
| Comprehensive income:                             |       |                    |       |        |       |             |       |              |       |            |       |             |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income                                        |       |                    | —     |        |       |             | —     |              |       |            | —     |             |       |       | 3,473      |   |   |   | — |   |   |   | — |   |   |   |   |
| Currency translation  adjustments                 |       |                    | —     |        |       |             | —     |              |       |            | —     |             |       |       | —     |   |   |   | 856 |   |   |   | — |   |   |   |   |
| Total  comprehensive income                       |       |                    | —     |        |       |             | —     |              |       |            | —     |             |       |       | —     |   |   |   | — |   |   |   | — |   |   | 4,329 |   |
| Stock issued under  employee stock plans          |       |                    | 32         |        |       |             | —     |              |       |            | 62         |             |       |       | —     |   |   |   | — |   |   |   | — |   |   | 62 |   |
| Balance at October 30, 2004                  |       |                    | 16,047     |        |       |             | 160        |              |       |            | 36,768     |             |       |       | 3,025      |   |   |   | (106 | ) |   |   | — |   |   | 39,847 |   |
| Comprehensive income:                             |       |                    |       |        |       |             |       |              |       |            |       |             |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income                                        |       |                    | —     |        |       |             | —     |              |       |            | —     |             |       |       | 21,126     |   |   |   | — |   |   |   | — |   |   |   |   |
| Currency  translation adjustments                 |       |                    | —     |        |       |             | —     |              |       |            | —     |             |       |       | —     |   |   |   | (337 | ) |   |   | — |   |   |   |   |
| Total  comprehensive income                       |       |                    | —     |        |       |             | —     |              |       |            | —     |             |       |       | —     |   |   |   | — |   |   |   | — |   |   | 20,789 |   |
| Stock issued under  employee stock plans          |       |                    | 331        |        |       |             | 4          |              |       |            | 826        |             |       |       | —     |   |   |   | — |   |   |   | (64 | ) |   | 766 |   |
| Tax benefits from  employee stock plans           |       |                    | —     |        |       |             | —     |              |       |            | 209        |             |       |       | —     |   |   |   | — |   |   |   | — |   |   | 209 |   |
| Amortization of  deferred stock compensation |       |                    | —     |        |       |             | —     |              |       |            | —     |             |       |       | —     |   |   |   | — |   |   |   | 10 |   |   | 10 |   |
| Balance at October 29,2005                   |       |                    | 16,378     |        |       |             | 164        |              |       |            | 37,803     |             |       |       | 24,151     |   |   |   | (443 | ) |   |   | (54 | ) |   | 61,621 |   |
| Comprehensive income:                             |       |                    |       |        |       |             |       |              |       |            |       |             |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income                                        |       |                    | —     |        |       |             | —     |              |       |            | —     |             |       |       | 3,119      |   |   |   | — |   |   |   | — |   |   |   |   |
| Currency  translation adjustments                 |       |                    | —     |        |       |             | —     |              |       |            | —     |             |       |       | —     |   |   |   | 399 |   |   |   | — |   |   |   |   |
| Total  comprehensive income                       |       |                    | —     |        |       |             | —     |              |       |            | —     |             |       |       | —     |   |   |   | — |   |   |   | — |   |   | 3,518 |   |
| Reclassification  of deferred stock compensation  |       |                    | —     |        |       |             | —     |              |       |            | (54        | )                |       |       | —     |   |   |   | — |   |   |   | 54 |   |   | — |   |
| Stock issued under  employee stock plans          |       |                    | 184        |        |       |             | 2          |              |       |            | 563        |             |       |       | —     |   |   |   | — |   |   |   | — |   |   | 565 |   |
| Tax benefits from  employee stock plans           |       |                    | —     |        |       |             | —     |              |       |            | 45         |             |       |       | —     |   |   |   | — |   |   |   | — |   |   | 45 |   |
| Share-based  compensation                         |       |                    | —     |        |       |             | —     |              |       |            | 260        |             |       |       | —     |   |   |   | — |   |   |   | — |   |   | 260 |   |
| Balance at  October 28, 2006                 |       |                    | 16,562     |        |       |             | $          | 166               |       |            |       | $                | 38,617     |       |       |   | $ | 27,270 |   |   |   | $ | (44 | ) |   |   | $ | — |   |   | $ | 66,009 |   |

 

See accompanying notes to consolidated financial statements.

F-4

----

**Westaff, Inc. Consolidated Statements of Cash Flows**

| ** **                                                                         | ** ** | **Fiscal Year Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                         | ** ** | **October 28,**            | ** ** | **October 29,** | ** ** | **October 30,** | ** ** |
| ** **                                                                         | ** ** | **2006**                        | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                         | ** ** | **(In thousands)**         | ** ** |
| **Cash flows from operating activities**                                           | ** ** |                            | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Net income                                                                         |       |                            | $          | 3,119 |   |   |   | $ | 21,126 |   |   |   | $ | 3,473 |   |   |
| Adjustments to reconcile net income to net cash  provided by operating activities: |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Gain on sale of  discontinued operations, net of income taxes                      |       |                            | —     |   |   |   | (1,163 | ) |   |   | — |   |   |
| Tax benefits from  employee stock plans                                            |       |                            | 21         |   |   |   | 209 |   |   |   | — |   |   |
| Depreciation and  amortization                                                     |       |                            | 4,811      |   |   |   | 4,190 |   |   |   | 4,474 |   |   |
| Stock-based compensation                                                           |       |                            | 260        |   |   |   | 10 |   |   |   | — |   |   |
| Provision for losses on  doubtful accounts                                         |       |                            | 192        |   |   |   | 582 |   |   |   | 1,168 |   |   |
| Amortization of deferred  gain on sale-leaseback                                   |       |                            | (745       | ) |   |   | (744 | ) |   |   | (754 | ) |   |
| Amortization of debt  issuance costs                                               |       |                            | 370        |   |   |   | 597 |   |   |   | 556 |   |   |
| Deferred income taxes                                                              |       |                            | (1,174     | ) |   |   | (16,766 | ) |   |   | (278 | ) |   |
| Income from sales of  affiliate operations                                         |       |                            | (305       | ) |   |   | (605 | ) |   |   | (25 | ) |   |
| (Gain) loss on sale or  disposal of assets                                         |       |                            | 13         |   |   |   | 65 |   |   |   | (657 | ) |   |
| Changes in assets and liabilities:                                                 |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Trade accounts  receivable                                                         |       |                            | 7,480      |   |   |   | (1,511 | ) |   |   | (9,209 | ) |   |
| Other assets                                                                       |       |                            | (1,675     | ) |   |   | (3,901 | ) |   |   | 140 |   |   |
| Accounts payable and  accrued expenses                                             |       |                            | (1,699     | ) |   |   | 5,480 |   |   |   | 14,678 |   |   |
| Income taxes payable                                                               |       |                            | 277        |   |   |   | 151 |   |   |   | (11 | ) |   |
| Other liabilities                                                                  |       |                            | 2,285      |   |   |   | (165 | ) |   |   | 268 |   |   |
| Net cash provided by  operating activities                                         |       |                            | 13,230     |   |   |   | 7,555 |   |   |   | 13,823 |   |   |
| **Cash flows from investing activities**                                           | ** ** |                            | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Capital expenditures                                                               |       |                            | (5,070     | ) |   |   | (7,544 | ) |   |   | (3,369 | ) |   |
| Payments for purchases  of affiliate operations                                    |       |                            | (3,893     | ) |   |   | — |   |   |   | — |   |   |
| Proceeds from sales of  affiliate operations                                       |       |                            | 161        |   |   |   | 1,517 |   |   |   | 41 |   |   |
| Proceeds from sales of  assets                                                     |       |                            | —     |   |   |   | — |   |   |   | 1,945 |   |   |
| Proceeds from sale of  discontinued operations, net of cash acquired by purchaser  |       |                            | —     |   |   |   | 1,238 |   |   |   | — |   |   |
| Other, net                                                                         |       |                            | (317       | ) |   |   | 227 |   |   |   | (170 | ) |   |
| Net cash used by  investing activities                                             |       |                            | (9,119     | ) |   |   | (4,562 | ) |   |   | (1,553 | ) |   |
| **Cash flows from financing activities**                                           | ** ** |                            | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Net repayments under  line of credit agreements                                    |       |                            | (3,872     | ) |   |   | (7,117 | ) |   |   | (9,903 | ) |   |
| Proceeds from issuance  of notes payable to related party                          |       |                            | —     |   |   |   | — |   |   |   | 1,000 |   |   |
| Payment of note payable  to related party                                          |       |                            | —     |   |   |   | — |   |   |   | (1,000 | ) |   |
| Principal payments on  capital lease obligations                                   |       |                            | (339       | ) |   |   | (476 | ) |   |   | (432 | ) |   |
| Payment of debt issuance  costs                                                    |       |                            | (22        | ) |   |   | (67 | ) |   |   | (178 | ) |   |
| Excess tax benefits from  stock-based compensation                                 |       |                            | 24         |   |   |   | — |   |   |   | — |   |   |
| Proceeds from issuance  of common stock                                            |       |                            | 565        |   |   |   | 764 |   |   |   | 63 |   |   |
| Net cash used by  financing activities                                             |       |                            | (3,644     | ) |   |   | (6,896 | ) |   |   | (10,450 | ) |   |
| Effect of exchange rate  changes on cash                                           |       |                            | 64         |   |   |   | (76 | ) |   |   | 414 |   |   |
| Net change in cash and  cash equivalents                                           |       |                            | 531        |   |   |   | (3,979 | ) |   |   | 2,234 |   |   |
| Cash and cash  equivalents at beginning of year                                    |       |                            | 3,014      |   |   |   | 6,993 |   |   |   | 4,759 |   |   |
| Cash and cash equivalents at end of year                                           |       |                            | $          | 3,545 |   |   |   | $ | 3,014 |   |   |   | $ | 6,993 |   |   |

 

See accompanying notes to consolidated financial statements.

F-5

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**Westaff, Inc. Consolidated Statements of Cash Flows (Continued)**

 

| ** **                                                                | ** ** | **Fiscal Year Ended** | ** ** |
|---------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                | ** ** | **October 28,**            | ** ** | **October 29,** | ** ** | **October 30,** | ** ** |
| ** **                                                                | ** ** | **2006**                        | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Supplemental disclosures of  cash flow information**                    | ** ** |                            | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Cash paid during  the year for:                                           |       |                            |       | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |
| Interest                                                                  |       |                            | $          | 898 | ** ** |   |   | $ | 1,256 | ** ** |   |   | $ | 1,481 | ** ** |   |
| Income taxes paid, net                                                    |       |                            | 1,189      | ** ** |   |   | 685 | ** ** |   |   | 786 | ** ** |   |
| **Supplemental schedule of  noncash investing and financing activities:** | ** ** |                            | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Equipment  purchased with capital leases                                  |       |                            | $          | — | ** ** |   |   | $ | 1,405 | ** ** |   |   | — | ** ** |   |
|                                                                           |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

See accompanying notes to consolidated financial statements.

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**Westaff, Inc.Notes to Consolidated Financial Statements**

**1.**                 Basisof Presentation

**Basis ofpresentation**

Westaff, Inc. (theParent), a Delaware corporation, and its domestic and foreign subsidiaries(together, the Company), provide staffing services in the United States, theUnited Kingdom, Australia and New Zealand. The consolidated financialstatements include the accounts of the Parent and its domestic and foreignsubsidiaries. Intercompany accounts and transactions have been eliminated.

**Translation of foreigncurrencies**

The functional currencyfor each of the Company’s foreign operations is the applicable local currency.All assets and liabilities that are denominated in foreign currencies aretranslated into U.S. dollars at exchange rates as of the date of the balancesheet and all revenue and expense accounts are translated using weightedaverage exchange rates for the periods presented. Translation adjustments andgains or losses on intercompany loans that are of a long-term investmentnature are included as a separate component of stockholders’ equity. Aggregatetransaction gains (losses) included in determining net income were $(9,000),$(37,000) and $182,000 for fiscal years 2006, 2005 and 2004, respectively, andare included in selling and administrative expenses.

**Discontinuedoperations**

In June 2005, theCompany sold its operations in Norway and Denmark, and during fiscal year 1999,the Company sold its medical business, primarily operated through WesternMedical Services, Inc. (Western Medical), a wholly-owned subsidiary of theCompany (see Note 4). As a result, the Company has classified these operationsas discontinued operations and, accordingly, has segregated the assets,liabilities, revenue and expenses of these discontinued operations in the ConsolidatedBalance Sheets, Statements of Income and notes thereto. Cash flows pertainingto discontinued operations are not disclosed separately in the ConsolidatedStatements of Cash Flows.

**2.**                 Summaryof Significant Accounting Policies

**Fiscal year**

The Company’s fiscal yearis a 52-week period ending the Saturday nearest the end of October. Forinterim reporting purposes, the first three fiscal quarters comprise 12 weekseach while the fourth fiscal quarter consists of 16 weeks.

**Accounting estimates**

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenue and expenses during thereporting period. Actual results could differ from those estimates. Significantestimates included in the Company’s financial statements include allowance fordoubtful accounts, workers’ compensation liabilities and income taxes.

F-7

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**Fair value offinancial instruments**

The carrying amounts ofcash, accounts receivable, accounts payable and all other accrued expensesapproximate fair value at October 28, 2006 and October 29, 2005because of the short maturity of these items. The fair value of the Company’sdebt instruments approximates the carrying value as of October 28, 2006and October 29, 2005 based on current rates available to the Company fordebt with similar terms.

**Cash and cashequivalents**

The Company considers allinvestments with maturities at purchase of three months or less to be cashequivalents.

**Concentrations ofcredit risk**

The Company’s financialinstruments that potentially subject the Company to concentrations of creditrisk consist principally of trade receivables. However, concentrations ofcredit risk are limited due to the large number of customers comprising theCompany’s customer base and their dispersion across different business andgeographic areas. Furthermore, the Company routinely assesses the financialstrength of its customers.

**Revenue recognition**

Revenue from the sale of services is recognized at thetime the service is performed. The Company maintains an allowance for doubtfulaccounts on accounts receivable for projected estimated losses. The Company’srevenue is derived from company-owned operations and affiliate operations,which consist of franchise agents and one licensed operation.

The Company follows the guidance of Emerging IssuesTask Force (EITF) 99-19, *Recording Revenue Gross asa Principal versus Net as an Agent*, for its presentation of revenueand direct costs. This guidance requires the Company to assess whether it actsas a principal in the transaction or as an agent acting on behalf of others.Where the Company is the principal in the transaction and has the risks andrewards of ownership, the transactions are recorded gross in the statements ofincome. Revenue and related costs of services generated by both company-ownedoffices and franchise agents are included as part of the Company’s consolidatedrevenue and costs of services, respectively, since the Company has the directcontractual relationships with the customers, holds title to the relatedcustomer receivables and is the legal employer of the temporary employees.

The franchise agent acts as the Company’s agent andlocal business representative in a similar manner as a branch manager incompany-owned locations. In the franchise arrangement, all advertising,signage, invoices and correspondence with the customer are in the Company’sname. The Company has the direct contractual relationships with its customersand contracts with customers are binding to the Company. The Company is alsothe employer of all temporary employees in the franchise agents’ operationsand, as such, is obligated for the temporary employee payroll and relatedpayroll taxes regardless of customer acceptance of the temporary laborservices. These factors, among others, designate the Company as principal withrespect to its franchise agent operations. Franchise agents’ sales represented27.5%, 28.1% and 29.0% of the Company’s total revenue for fiscal 2006, 2005 and2004, respectively. Franchise agents’ share of gross profit represents the netdistribution paid to the franchise agent for their services in marketing tocustomers, recruiting temporary employees and servicing customer accounts.

The Company also has a licensing program in which thelicensee has the direct contractual relationships with the customers, holdstitle to the related customer receivables and is the legal employer of thetemporary employees. Accordingly, sales and costs of services generated by thelicense operation are not included in the Company’s consolidated financialstatements. The Company advances funds to the 

F-8

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licensee for payroll,payroll taxes, insurance and other related items. Fees are paid to the Companybased either on a percentage of sales or of gross profit generated by thelicensee and such license fees are recorded by the Company as license fees andincluded in revenue. Advances to the licensee are secured by a pledge of thelicensee’s trade receivables, tangible and intangible assets and the licenseagreement. Advances due from the licensee bear interest at prime plus twopercent but only to the extent the aggregate advances exceed the amount ofqualified trade receivables securing the outstanding advances. Under the termsof a lockbox arrangement between the Company and its licensee, the advances arereduced as remittances are received related to the licensee’s trade accountsreceivable. The licensee has pledged trade receivables of $210,000 at October 28,2006 and $311,000 at October 29, 2005 as collateral for such advances.Sales generated by license offices (and excluded from the Company’s revenue)were $2.4 million, $2.2 million and $1.6 million for fiscal 2006, 2005 and2004, respectively. The Company currently has only one remaining licensee andis no longer offering license agreements to new prospects.

Although the Company hasthe contractual right to charge an initial franchise or license fee thatencompasses start-up supplies and material and training, the Company has notcharged or collected such fees during the fiscal years ended 2006, 2005 and2004, respectively; therefore, there is no recorded fee income of this typeincluded in the Consolidated Statements of Income for those years.

**Allowance fordoubtful accounts**

TheCompany records an allowance for doubtful accounts based on historicalexperience. A summary of changes in the reserve for fiscal years 2006, 2005 and2004 is as follows:

| ** **                      | ** ** | ** **              | ** ** | **Additions**                   | ** ** | ** **                       | ** ** | ** **          | ** ** |
|---------------------------------|------------|-------------------------|------------|---------------------------------|------------|----------------------------------|------------|---------------------|------------|
| ** **                      | ** ** | **Balance at**     | ** ** | **Charged to**             | ** ** | ** **                       | ** ** | **Balance at** | ** ** |
| **Fiscal Year Ended** | ** ** | ** **              | ** ** | **Beginning of Year** | ** ** | **Costs and Expenses** | ** ** | **Deductions**      | ** ** | **End of Year** | ** ** |
| ** **                      | ** ** | **(In thousands)** | ** ** |
| October 28,  2006          |       |                    | $          | 997                             |       |                             |       | 192                 |       |   |   | 378 |   |   |   | $ | 811 |   |   |
| October 29, 2005           |       |                    | $          | 1,085                           |       |                             |       | 548                 |       |   |   | 636 |   |   |   | $ | 997 |   |   |
| October 30,  2004          |       |                    | $          | 1,027                           |       |                             |       | 1,046               |       |   |   | 988 |   |   |   | $ | 1,085 |   |   |
|                                 |            |                         |            |                                 |            |                                  |            |                     |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Property, plant andequipment**

Property, plant andequipment are stated at cost. Depreciation is computed using the straight-linemethod over the estimated useful lives of the related assets, which aregenerally one to seven years for computer hardware and software, and three toten years for furniture, equipment and fixtures. Major improvements to leasedoffice space are capitalized and amortized over the shorter of their usefullives or the terms of the leases, generally three to five years. The Companycapitalizes internal and external costs incurred in connection with developingor obtaining internal use software in accordance with Statement of Position(SOP) 98-1 “Accounting for the Costs of Computer Software Developed orObtained for Internal Use.”

**Intangible assets**

The Company follows the provisions of Statement ofFinancial Accounting Standards (SFAS) No. 142 “Goodwill and OtherIntangible Assets.” SFAS No. 142 provides that goodwill and otherintangible assets with indefinite lives are evaluated for impairment at areporting unit level by applying a fair-value based test. The Companydetermined its reporting units as its operating segments under SFAS No. 131.

The first step in the impairment test compares thefair value of a reporting unit with its carrying value, including goodwill. Ifthe carrying value of a reporting unit exceeds its fair value, the second stepof the goodwill impairment is performed to determine the amount of anyimpairment loss by comparing the implied fair value of the reporting unit’sgoodwill with the respective carrying value.

F-9

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The Company performed its annual impairmentevaluations in the fourth quarters of fiscal 2006, 2005 and 2004 with noimpairments being identified.

Thefollowing table shows the change to goodwill during the fiscal year ended October 28,2006:

| ** **                                        | ** ** | **Domestic  Business  Services** | ** ** | **Australia** | ** ** | **Total** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|---------------|------------|-----------|------------|
| ** **                                        | ** ** | **(In thousands)**          | ** ** |
| Balance at  October 29, 2005                 |       | $                                | 10,797     |          |       | $         | 973        |   |   | $ | 11,770 |   |
| Acquisitions of  affiliate operations             |       | 572                              |       |          | —     |      |       | 572 |   |
| Effect of foreign  currency translation and other |       | —                           |       |          | 25         |      |       | 25 |   |
| Balance at  October 28, 2006                 |       | $                                | 11,369     |          |       | $         | 998        |   |   | $ | 12,367 |   |

 

Thefollowing table shows the change to acquired intangible assets during thefiscal year ended October 28, 2006:

| ** **                                                 | ** ** | **Domestic Business Services** | ** ** |
|------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                 | ** ** | **Gross Carrying**                  | ** ** | **Accumulated** | ** ** | **Net** | ** ** |
| ** **                                                 | ** ** | **Amount**                               | ** ** | **Amortization** | ** ** | **Amount** | ** ** |
| ** **                                                 | ** ** | **(In thousands)**                  | ** ** |
| Amortized intangible  assets - Non-compete Agreements      |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Balance at  October 29, 2005                          |       |                                     | $          | 104 |   |   |   | $ | (96 | ) |   |   | $ | 8 |   |   |
| Fiscal 2006  acquisitions                                  |       |                                     | 70         |   |   |   | — |   |   |   | 70 |   |   |
| Amortization                                               |       |                                     | —     |   |   |   | (23 | ) |   |   | (23 | ) |   |
| Balance at  October 28, 2006                          |       |                                     | $          | 174 |   |   |   | $ | (119 | ) |   |   | $ | 55 |   |   |
| Unamortized  intangible assets as of October 28, 2006 |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Franchise rights (See  Note 3)                             |       |                                     | $          | 3,370 |   |   |   |   |   |   |   |   |   |   |

 

|                                 | ** ** | **(In thousands)** | ** ** |
|---------------------------------|------------|-------------------------|------------|
| Estimated  amortization expense |       |                    |       |   |   |
| Fiscal 2007                     |       |                    | $          | 20 |   |   |
| Fiscal 2008                     |       |                    | 19         |   |   |
| Fiscal 2009                     |       |                    | 16         |   |   |
|                                 |            |                         |            |  |  |  |

 

**Long-lived assets**

The Company accounts forits long-lived assets in accordance with SFAS No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets.” The Company’s primary long-livedassets are property and equipment. SFAS No. 144 requires a company toassess the recoverability of its long-lived assets whenever events andcircumstances indicate the carrying value of an asset or asset group may not berecoverable from estimated future cash flows expected to result from its useand eventual disposition. Additionally, the standard requires expected futureoperating losses from discontinued operations to be displayed in discontinuedoperations in the period(s) in which the losses are incurred, rather thanas of the measurement date. No impairment charges were recorded in fiscal years2006, 2005 or 2004.

**Workers’compensation**

Domestically, the Company is responsible for and paysworkers’ compensation costs for its temporary and regular employees and is self-insuredfor the deductible amount related to workers’ compensation claims ($500,000 perclaim for fiscal 2006 and 2005, and $750,000 per claim for fiscal year 2004).The Company accrues the estimated costs of workers’ compensation claims basedupon the expected loss rates within the various temporary employment categoriesprovided by the Company. At least annually, the 

F-10

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Company obtains anindependent actuarial valuation of the estimated costs of claims reported butnot settled, and claims incurred but not reported, and may adjust the accrualsbased on the results of the valuations. As of October 28, 2006 and October 29,2005, the workers’ compensation liabilities were $24.3 million and $19.6million, respectively, of which $16.4 million at October 28, 2006 and$14.2 million at October 29, 2005 are included in other long-termliabilities on each of the respective balance sheets for obligations that arenot expected to be paid in the following fiscal year.

Periodically, the terms ofthe agreement with the insurance carrier are renegotiated. The insurancecarrier requires the Company to collateralize its recorded obligations underthe workers’ compensation insurance contracts with Travelers Indemnity Companythrough the use of irrevocable letters of credit, surety bonds or cash. As of October 28,2006, the Company had $35.3 million of letters of credit securing its domesticworkers’ compensation obligations.

**Income taxes**

The Company records incometaxes using an asset and liability approach that requires the recognition ofdeferred tax assets and liabilities for the expected future tax consequences ofevents that have been recognized in the Company’s financial statements or taxreturns. A valuation allowance is established when it is more likely than notthat a deferred tax asset is not realizable in the foreseeable future. Inestimating future tax consequences, the Company generally considers allexpected future events other than enactments of changes in the tax law orrates.

**Accounting forstock-based compensation**

In December 2004, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123(revised 2004) “Share-Based Payment” (SFAS 123(R)). SFAS 123(R) replacesFASB Statement No. 123 “Accounting for Stock-Based Compensation,” and supersedesAPB Opinion No 25, “Accounting for Stock Issued to Employees.” The statementestablishes standards for accounting for share-based payment transactions.Share-based payment transactions are those in which an entity exchanges itsequity instruments for goods or services or in which an entity incursliabilities in exchange for goods or services that are based on the fair valueof the entity’s equity instruments or that may be settled by the issuance ofthose equity instruments. SFAS 123(R) covers a wide range of share-basedcompensation arrangements including share options, restricted share plans,performance-based awards, share appreciation rights and employee share purchaseplans. SFAS 123(R) requires a public entity to measure the cost ofemployee services received in exchange for an award of equity instruments basedon the fair value of the award on the grant date (with limited exceptions).That cost will be recognized in the entity’s financial statements over theperiod during which the employee is required to provide services in exchangefor the award.

The Company adopted SFAS123(R) at the beginning of fiscal 2006 utilizing the modified prospectivemethod, which does not require restatement of prior periods. The modifiedprospective method requires that compensation expense be recorded for allunvested stock options and restricted stock awards over the requisite serviceperiod (generally the vesting schedule). Prior to fiscal 2006, the Companymeasured compensation cost for employee stock options and similar equityinstruments using the intrinsic value-based method of accounting prescribed byAPB 25.

**Reclassifications**

Certain amounts in thefiscal 2005 and fiscal 2004 financials have been reclassified to conform to thecurrent year presentation.

F-11

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**Recent accountingpronouncements**

In June 2006, FASBissued FASB Interpretation No. 48, “Accounting for Uncertainty in IncomeTaxes—an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48prescribes a recognition threshold and measurement process for recording in thefinancial statements uncertain tax positions taken or expected to be taken in atax return in accordance with SFAS No. 109, “Accounting for Income Taxes.”Tax positions must meet a more-likely-than-not recognition threshold at theeffective date to be recognized upon the adoption of FIN 48 and in subsequentperiods. The accounting provisions of FIN 48 will be effective for the Companybeginning in fiscal year 2008. The Company has not yet completed its evaluationof the impact of adoption on the Company’s financial position or results ofoperations.

**3.**                 Acquisition

In January 2006, theCompany acquired certain assets of Peggy Fruhwirth Enterprises, Inc.,previously a Westaff franchise located in Houston, Texas. The Company paid $3.8million in cash for the assets and the selling shareholders’ non-competeagreements, which included a contingent earn-out based on the level offinancial performance achieved by the business through July 8, 2006. TheCompany believes the terms and conditions of the preexisting relationship wereconsistent with other relationships the Company has with other franchisees, andaccordingly has not recorded a settlement gain or loss. The transactionresulted in the Company recording $3.4 million of franchise rights and $65,000of non-compete agreements (both intangible assets), $344,000 of goodwill and$21,000 of fixed assets. The non-compete agreements are being amortized over 48months through September 2009, the term of the agreements.

**4.**                 DiscontinuedOperations

In June 2005, the Company sold its Norway andDenmark operations to Personalhuset AS, a recruitment and staffing companyheadquartered in Norway, for approximately $2.7 million. Of the total proceeds,approximately $0.2 million is being held in an interest bearing escrow accountas security for potential Westaff Norway pension claims, which the Companycurrently estimates to be zero. The escrowed funds, net of any claim payments,are scheduled to be remitted to the Company in June 2007. The Companyrecorded a net gain on the sale of $1.2 million.

As required by the terms of the Company’sMulticurrency Credit Agreement, the net proceeds on the sale of the Norway andDenmark operations, including the intercompany debt repayment, were used to paydown borrowings on the Company’s revolving credit facility. In accordance withEITF 87-24, the Company has allocated interest expense to thediscontinued operations of $92,000 and $111,000 for fiscal 2005 and fiscal2004, respectively.

Summarizedfinancial data on discontinued operations is as follows:

| ** **                                  | ** ** | **Fiscal Year Ended** | ** ** |
|---------------------------------------------|------------|---------------------------------|------------|
| ** **                                  | ** ** | **October 29,**            | ** ** | **October 30,** | ** ** |
| ** **                                  | ** ** | **2005**                        | ** ** | **2004** | ** ** |
| ** **                                  | ** ** | **(In thousands)**         | ** ** |
| Revenue                                     |       |                            | $          | 7,808 |   |   |   | $ | 12,151 |   |   |
| Costs and expenses                          |       |                            | 7,942      |   |   |   | 11,835 |   |   |
| Income (loss)  from discontinued operations |       |                            | $          | (134 | ) |   |   | $ | 316 |   |   |

 

| ** **                              | ** ** | **October 28,**    | ** ** | **October 29,** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|----------------------|------------|
| ** **                              | ** ** | **2006**                | ** ** | **2005**             | ** ** |
| ** **                              | ** ** | **(In thousands)** | ** ** |
| Accrued expenses                        |       |                    | $          | 23                   |       |   |   | $ | 75 |   |   |
| Liabilities of  discontinued operations |       |                    | $          | 23                   |       |   |   | $ | 75 |   |   |

 

F-12

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**5.**                 Earningsper Share

Thefollowing table sets forth the computation of basic and diluted earnings pershare from continuing operations:

| ** **                                                                                                 | ** ** | **Fiscal Year Ended**                                       | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                                                                 | ** ** | **October 28,**                                                  | ** ** | **October 29,** | ** ** | **October 30,** | ** ** |
| ** **                                                                                                 | ** ** | **2006**                                                              | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                                 | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Income from  continuing operations                                                                         |       |                                                                  | $          | 3,119 |   |   |   | $ | 20,097 |   |   |   | $ | 3,157 |   |   |
| Denominator for  basic earnings per share—weighted average shares                                     |       |                                                                  | 16,454     |   |   |   | 16,271 |   |   |   | 16,033 |   |   |
| Effect of  dilutive securities—Stock options and awards                                               |       |                                                                  | 72         |   |   |   | 149 |   |   |   | 48 |   |   |
| Denominator for  diluted earnings per share—adjusted weighted average shares and assumed  conversions |       |                                                                  | 16,526     |   |   |   | 16,420 |   |   |   | 16,081 |   |   |
| Earnings per  share from continuing operations                                                             |       |                                                                  |       |   |   |   |   |   |   |   |   |   |   |
| Basic                                                                                                      |       |                                                                  | $          | 0.19 |   |   |   | $ | 1.24 |   |   |   | $ | 0.20 |   |   |
| Diluted                                                                                                    |       |                                                                  | $          | 0.19 |   |   |   | $ | 1.23 |   |   |   | $ | 0.20 |   |   |
| Antidilutive weighted  shares excluded from diluted earnings per share                                     |       |                                                                  | 260        |   |   |   | 85 |   |   |   | 416 |   |   |

 

**6.**                 Transactionswith Related Parties

In 2002, the Company executed an unsecuredsubordinated promissory note payable to its principal stockholder and Chairmanof the Board of Directors in the amount of $2.0 million with a maturity date ofAugust 18, 2007 and an interest rate equal to an indexed rate ascalculated under the Company’s credit facilities plus seven percent, compoundedmonthly and payable 60 calendar days after the end of each of the Company’sfiscal quarters. The interest rate in effect on October 28, 2006 was15.25%. Payment of interest is contingent on the Company meeting minimumavailability requirements under its credit facilities. Additionally, paymentsof principal or interest are prohibited in the event of any default under thecredit facilities. Interest paid on this note during fiscal 2006, fiscal 2005and fiscal 2004 was $287,000, $246,000 and $222,000, respectively.

In September 2003, the Company executed aone-year unsecured subordinated draw down note with its principal stockholderand Chairman of the Board of Directors. The note provided for the Chairman tomake advances to the Company upon request, at his sole discretion and with noobligation to do so, in an aggregate principal amount not to exceed $1.0million outstanding at any one time. In December 2003, the Chairman made a$1.0 million advance to the Company, which was repaid in August 2004.Total interest paid on the advance during fiscal 2004 was $68,000.

F-13

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**7.**                 Property,Plant and Equipment

Property,plant and equipment consists of the following:

| ** **                                     | ** ** | **October 28,**    | ** ** | **October 29,** | ** ** |
|------------------------------------------------|------------|-------------------------|------------|----------------------|------------|
| ** **                                     | ** ** | **2006**                | ** ** | **2005**             | ** ** |
| ** **                                     | ** ** | **(In thousands)** | ** ** |
| Computer hardware  and software                |       |                    | $          | 40,012               |       |   |   | $ | 37,251 |   |   |
| Computer equiment  under capital lease         |       |                    | 2,774      |                 |       |   | 2,774 |   |   |
| Equipment,  furniture and fixtures             |       |                    | 13,813     |                 |       |   | 12,199 |   |   |
|                                           |       |                    | 56,599     |                 |       |   | 52,224 |   |   |
| Less accumulated depreciation and amortization |       |                    | (41,553    | )                    |       |   | (37,040 | ) |   |
|                                           |       |                    | $          | 15,046               |       |   |   | $ | 15,184 |   |   |

 

Included in computer hardware and software isconstruction in process for information management systems of $4.8 million at October 28,2006 and $5.7 million at October 29, 2005.

Depreciation expense from continuing operations was$4.8 million, $4.2 million and $4.4 million for fiscal years 2006, 2005 and2004, respectively. Amortization of capital leased equipment included indepreciation expense was $329,000 for fiscal 2006, $456,000 for fiscal 2005 and$466,000 for fiscal 2004.

In February 2004, theCompany sold a corporate headquarters’ building for proceeds of $1.9 million.The $725,000 gain on the sale of the land and the building is included inselling and administration expenses for the fiscal year ended October 30,2004.

**8.**                 BorrowingsUnder Revolving Credit Facilities and Loans Payable

The Company has credit facilities with GE Capital, asprimary agent, expiring in May 2009. The facilities comprise a five-yearsyndicated Multicurrency Credit Agreement consisting of a $55.0 million U.S.Revolving Loan Commitment and a £2.74 million U.K. Revolving Loan Commitment.In addition, the Company’s Australian subsidiary maintains a $12.0 millionAustralian dollar facility agreement (the A$ Facility Agreement) that expiresin May 2009. Each agreement includes a letter of credit sub-facility.Letters of credit under the agreements expire one year from date of issuance,but are automatically renewed for one additional year unless written notice isgiven to or from the holder.

The U.S. Revolving Loan Commitment provides for anaggregate $55.0 million commitment subject to a borrowing base calculation oneligible domestic accounts receivable. Direct advances are also limited byoutstanding irrevocable standby letters of credit up to a maximum of $40.0million. Interest on borrowings are based either on an index rate equal to thehigher of the Federal Funds Rate plus 0.50% or the bank prime loan rate, eachplus applicable margins of up to 0.50%, or on LIBOR plus margins ranging from2.25% to 2.75%. Borrowings outstanding under the U.S. Revolving Loan Commitmentat October 28, 2006 were zero, and at October 29, 2005 were $2.9million at a weighted average interest rate of 6.78%.

The U.K. Revolving Loan Commitment is subject to aborrowing base calculation on eligible Westaff (U.K.) accounts receivable.Interest on outstanding borrowings is based on the British prime rate plusmargins of up to 0.50%. Borrowings outstanding under the U.K. Revolving LoanCommitment were zero at October 28, 2006, and U.S. $12,000 at October 29,2005 with an interest rate of 4.75%.

The A$ Facility Agreement is subject to a borrowingbase calculation on eligible Westaff (Australia) accounts receivable. Directadvances are limited by outstanding letters of credit up to a maximum ofA$500,000. Interest on borrowings is based on the Australian 90-day BankBill Swap Rate plus a margin of 2.5% to 3.5%. At October 28, 2006,borrowings of U.S. $4.8 million were outstanding under the A$ Facility 

F-14

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Agreement at an interestrate of 9.22% and at October 29, 2005, borrowings outstanding were of U.S.$5.7 million at an interest rate of 8.69%.

The credit facilities are secured by substantially allof the assets of the Company. GE Capital, in its role as primary agent underthe credit facilities, has sole dominion and control over the Company’s primaryU.S., United Kingdom and Australia cash receipts accounts. Cash receipts intothese accounts are applied against the Company’s respective outstandingobligations under the facilities, with additional borrowings under therevolving facilities directed into the Company’s disbursement accounts.

The Company has classified all of its borrowings underthe revolving credit facilities as a current liability in accordance withEmerging Issues Task Force (EITF) 95-22 “Balance Sheet Classifications ofBorrowings Outstanding under Revolving Credit Agreements That Include Both aSubjective Acceleration Clause and a Lock-Box Arrangement,” although theCompany has the ability and the intent to maintain these obligations for longerthan one year.

The credit facilities contain covenants which, amongother things, require the Company to maintain a minimum fixed charge coverageratio and a minimum earnings before interest, taxes, depreciation andamortization (“EBITDA”). The covenants also generally restrict, limit or, incertain circumstances, prohibit the Company with respect to payment ofdividends, capital expenditures, disposition of assets, incurrence of debt,mergers and acquisitions, loans to affiliates and purchases of investments.

On January 2, 2007, the Company and its lendersexecuted a Tenth Amendment to its Multicurrency Credit Agreement. Thisamendment reduced the interest rates within the first level of the pricing gridimplemented with the Eighth Amendment, resets future minimum EBITDA covenantsand reduced some of the reporting requirements provided minimum borrowingrequirements are met. Further, the amendment extended the credit facility forone additional year to May 2009. Finally, the Company was not incompliance with its minimum EBITDA covenant as of the end of the fiscal year2006, and the amendment included a waiver of this covenant violation.

On January 25, 2007, the Company and its lenderexecuted an amendment to the A$ Facility Agreement which extended the Agreementfor two additional years to May 2009.

At October 28, 2006,the Company had $19.8 million available under the credit facilities and $36.8million letters of credit outstanding.

**9.**                 AccruedExpenses

Accruedexpenses consist of the following:

| ** **                                          | ** ** | **October 28,**    | ** ** | **October 29,** | ** ** |
|-----------------------------------------------------|------------|-------------------------|------------|----------------------|------------|
| ** **                                          | ** ** | **2006**                | ** ** | **2005**             | ** ** |
| ** **                                          | ** ** | **(In thousands)** | ** ** |
| Accrued payroll  and payroll taxes                  |       |                    | $          | 15,066               |       |   |   | $ | 15,989 |   |   |
| Accrued insurance  and workers’ compensation   |       |                    | 11,037     |                 |       |   | 10,474 |   |   |
| Taxes other than  income taxes                      |       |                    | 2,919      |                 |       |   | 3,184 |   |   |
| Checks  outstanding in excess of book cash balances |       |                    | 5,559      |                 |       |   | 6,508 |   |   |
| Other                                               |       |                    | 5,114      |                 |       |   | 6,529 |   |   |
|                                                |       |                    | $          | 39,695               |       |   |   | $ | 42,684 |   |   |

 

**10.**          IncomeTaxes

During the fourth quarter of fiscal 2005, the Companyreversed $16.7 million of its domestic deferred tax asset valuation allowance,as it was determined that it is more likely than not that the deferred taxasset will be realized.

F-15

----

Theprovision (benefit) for income taxes from continuing operations consists of thefollowing:

| ** **                                                              | ** ** | **Fiscal year ended** | ** ** |
|-------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                              | ** ** | **October 28,**            | ** ** | **October 29,** | ** ** | **October 30,** | ** ** |
| ** **                                                              | ** ** | **2006**                        | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                              | ** ** | **(In thousands)**         | ** ** |
| **Current:**                                                            | ** ** |                            | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Federal                                                                 |       |                            | $          | 944 |   |   |   | $ | 514 |   |   |   | $ | (350 | ) |   |
| State and local                                                         |       |                            | 229        |   |   |   | 330 |   |   |   | 175 |   |   |
| Foreign                                                                 |       |                            | 353        |   |   |   | 509 |   |   |   | 414 |   |   |
|                                                                    |       |                            | 1,526      |   |   |   | 1,353 |   |   |   | 239 |   |   |
| **Deferred:**                                                           | ** ** |                            | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Federal                                                                 |       |                            | (1,457     | ) |   |   | (13,497 | ) |   |   | — |   |   |
| State and local                                                         |       |                            | 252        |   |   |   | (2,870 | ) |   |   | — |   |   |
| Foreign                                                                 |       |                            | 15         |   |   |   | (394 | ) |   |   | — |   |   |
|                                                                    |       |                            | (1,190     | ) |   |   | (16,761 | ) |   |   | — |   |   |
| Total provision (benefit) for income taxes from  continuing operations: |       |                            | $          | 336 |   |   |   | $ | (15,408 | ) |   |   | $ | 239 |   |   |

 

Areconciliation of income taxes provided at the statutory federal rate (35%) andincome taxes reported in the Consolidated Statements of Income is as follows:

| ** **                                                         | ** ** | **Fiscal Year Ended** | ** ** |
|--------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                         | ** ** | **October 28,**            | ** ** | **October 29,** | ** ** | **October 30,** | ** ** |
| ** **                                                         | ** ** | **2006**                        | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                         | ** ** | **(In thousands)**         | ** ** |
| Income tax  provision computed at federal statutory rate           |       |                            | $          | 1,175 |   |   |   | $ | 1,641 |   |   |   | $ | 1,247 |   |   |
| State taxes                                                        |       |                            | 315        |   |   |   | 286 |   |   |   | 175 |   |   |
| Permanent  differences                                             |       |                            | 649        |   |   |   | 304 |   |   |   | 1,868 |   |   |
| Tax credits                                                        |       |                            | (1,802     | ) |   |   | (1,046 | ) |   |   | (2,706 | ) |   |
| Valuation  allowances (net of state tax effect of $1,043 for 2005) |       |                            | —     |   |   |   | (16,681 | ) |   |   | (122 | ) |   |
| Other                                                              |       |                            | (1         | ) |   |   | 88 |   |   |   | (223 | ) |   |
| Income tax  provision (benefit)                                    |       |                            | $          | 336 |   |   |   | $ | (15,408 | ) |   |   | $ | 239 |   |   |

 

Theapproximate tax effect of temporary differences and carryforwards that giverise to deferred tax balances are as follows:

|                                                              | ** ** | **October 28,**    | ** ** | **October 29,** | ** ** |
|--------------------------------------------------------------|------------|-------------------------|------------|----------------------|------------|
| ** **                                                   | ** ** | **2006**                | ** ** | **2005**             | ** ** |
| ** **                                                   | ** ** | **(In thousands)** | ** ** |
| Workers’  compensation                                  |       |                    | $          | 10,300               |       |   |   | $ | 9,336 |   |   |
| Accruals relating  to discontinued operations                |       |                    | 1          |                 |       |   | 23 |   |   |
| Other liabilities  and accruals                              |       |                    | 118        |                 |       |   | 135 |   |   |
| Federal, state  and foreign net operating loss carryforwards |       |                    | 805        |                 |       |   | 882 |   |   |
| Depreciation and  amortization                               |       |                    | 2,124      |                 |       |   | 2,777 |   |   |
| Sales of property                                            |       |                    | 1,257      |                 |       |   | 1,653 |   |   |
| Tax credits                                                  |       |                    | 3,633      |                 |       |   | 2,242 |   |   |
| Net deferred tax  asset                                      |       |                    | $          | 18,238               |       |   |   | $ | 17,048 |   |   |

 

F-16

----

Thedomestic and foreign components of income from continuing operations beforeincome taxes are as follows:

| ** **                                             | ** ** | **Fiscal year ended** | ** ** |
|--------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                             | ** ** | **October 28,**            | ** ** | **October 29,** | ** ** | **October 30,** | ** ** |
| ** **                                             | ** ** | **2006**                        | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                             | ** ** | **(In thousands)**         | ** ** |
| Domestic                                               |       |                            | $          | 3,072 |   |   |   | $ | 2,535 |   |   |   | $ | 777 |   |   |
| Foreign                                                |       |                            | 383        |   |   |   | 2,154 |   |   |   | 2,619 |   |   |
| Income from  continuing operations before income taxes |       |                            | $          | 3,455 |   |   |   | $ | 4,689 |   |   |   | $ | 3,396 |   |   |

 

At October 28, 2006, the Parent had cumulativeundistributed earnings from foreign subsidiaries of approximately $3.6 million.Income taxes have not been provided on the undistributed earnings because the Companyhas deemed the earnings of its foreign subsidiaries as permanently reinvested.These earnings could become subject to additional tax if they were remitted asdividends, or if foreign earnings were lent to the Company. However, to theextent that these earnings were previously taxed in foreign jurisdictions, theCompany anticipates the resulting tax amount would qualify for a domestic taxcredit.

The Company’s deferred taxassets resulting from net operating loss carryforwards expire at varying futuredates, with $9,000 expiring during fiscal 2007, $15,000 expiring during fiscal2008, $26,000 expiring during fiscal 2009, $154,000 expiring through fiscal2024 and $601,000 with no expiration dates. The Company has no remainingdeferred tax assets resulting from foreign tax credit carryforwards. TheCompany’s deferred tax assets resulting from Work Opportunity Tax Creditcarryforwards in the amount of $3.6 million expire through 2026.

**11.**          SavingsPlans

The Company has anonqualified deferred savings plan for highly compensated employees and a 401(k) savingsplan for eligible domestic employees. Under both the deferred and 401(k) savingsplans for fiscal year 2006 and fiscal year 2005, employees can elect tocontribute up to 60% of their eligible annual compensation subject to statutorylimits. The Company currently is not providing employer matching contributions.

**12.**          Stockholders’Equity

**Treasury stock**

From time to time, theCompany has repurchased shares of its common stock on the open market and maydo so in the future.

**Employee stockpurchase plan**

In July 2006, theBoard of Directors adopted and approved an amendment and restatement of theCompany’s 1996 Employee Stock Purchase Plan to (i) bifurcate the PurchasePlan into the Company’s Employee Stock Purchase Plan and the Company’sInternational Employee Stock Purchase Plan, (together the “Purchase Plans”), (ii) extendthe term of the Purchase plans to the last business day of January 2017, (iii) expandthe actions that we can take in connection with a “Corporate Transaction” and (iv) modifythe participating subsidiaries to these Purchase Plans to cover the employeesof certain of our subsidiaries. In addition, effective for purchase periodscommencing on and after August 1, 2006, the purchase price for sharespurchased under the Purchase Plans will equal 90% of the lower of (i) thefair market value at the beginning of the purchase period or (ii) the fairmarket value on the last day of the purchase period. Under the Purchase Plans,eligible employees may authorize payroll deductions of up to 10% of eligiblecompensation for the purchase of the Company’s common stock during eachsemiannual purchase period. 

F-17

----

ThePurchase Plans provide for the issuance of up to 750,000 shares of the Company’scommon stock. As of October 28, 2006, shares issued under the PurchasePlans totaled 663,457.

**Stock option plan**

The Company’s 1996 Stock Option/Stock Issuance Planterminated in April 2006. In April 2006, the stockholders approvedthe 2006 Stock Incentive Plan. The 2006 Stock Incentive Plan provides for thegranting of incentive and nonqualified stock options, restricted stock awardsand stock appreciation rights. Incentive stock options may be granted at aprice not less that 100% of the fair market value of the Company’s common stockat the date of grant. Although nonqualified options may be granted at a pricenot less than 85% of the fair market value of the Company’s common stock at thedate of grant, the Company has historically issued option grants with exerciseprices equal to fair market value on the date of grant. The options’ vestingschedules vary subject to the participant’s period of future service or to theCompany’s or the option holder’s attainment of designated performance goals, orotherwise at the discretion of the Board of Directors. Standard vesting is overfour years with 25% of the options vesting upon completion of one year ofservice from the vesting commencement date, and the remaining options vestingin 36 equal monthly installments. No option may have a term in excess of 10years. As of October 28, 2006, there were 1.5 million shares available forissuance under this plan and no options or stock appreciation rights wereoutstanding under this plan.

In April 2005, the Company granted 20,000 restrictedshares of its common stock to its President and Chief Executive Officer underthe 1996 Stock Option/Stock Issuance Plan. 5,000 shares are scheduled to vestat the end of each of the Company’s fiscal years 2006 and 2007 provided certainperformance criteria are met, with the remainder vesting in fiscal 2008.Because certain performance criteria were not met in fiscal year 2006, the5,000 shares that were scheduled to vest in 2006, are now scheduled to vest infiscal 2008. If the relevant performance criteria for fiscal 2007 are not met,those 5,000 shares would be rescheduled to vest in fiscal 2008.

Thefollowing table summarizes the stock option transactions under the Company’splan:

| ** **                                                       | ** ** | **October 28, 2006**                                          | ** ** | **October 29, 2005** | ** ** | **October 30, 2004** | ** ** |
|------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|
| ** **                                                       | ** ** | ** **                                                              | ** ** | **Weighted**                   | ** ** | ** **                     | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                                                       | ** ** | ** **                                                              | ** ** | **average**                    | ** ** | ** **                     | ** ** | **average** | ** ** | ** ** | ** ** | **average** | ** ** |
| ** **                                                       | ** ** | **Shares**                                                              | ** ** | **exercise price**        | ** ** | **Shares**                     | ** ** | **exercise price** | ** ** | **Shares** | ** ** | **exercise price** | ** ** |
| ** **                                                       | ** ** | **(In thousands, except for exercise prices)** | ** ** |
| Options  outstanding, beginning of year                          |       |                                                                    | 640        |                           |       |                           | $          | 3.69 |   |   |   | 1,035 |   |   |   | $ | 3.07 |   |   |   | 1,080 |   |   |   | $ | 3.09 |   |   |
| Granted at market value                                          |       |                                                                    | 9          |                           |       |                           | 4.05       |   |   |   | 219 |   |   |   | 3.33 |   |   |   | 44 |   |   |   | 2.53 |   |   |
| Exercised                                                        |       |                                                                    | (143       | )                              |       |                           | 3.04       |   |   |   | (281 | ) |   |   | 2.40 |   |   |   | — |   |   |   | — |   |   |
| Cancelled                                                        |       |                                                                    | (89        | )                              |       |                           | 6.17       |   |   |   | (333 | ) |   |   | 2.61 |   |   |   | (89 | ) |   |   | 3.14 |   |   |
| Options  outstanding, end of year                                |       |                                                                    | 417        |                           |       |                           | $          | 3.39 |   |   |   | 640 |   |   |   | $ | 3.69 |   |   |   | 1,035 |   |   |   | $ | 3.07 |   |   |
| Options exercisable, end of year                                 |       |                                                                    | 242        |                           |       |                           | $          | 3.42 |   |   |   | 354 |   |   |   | $ | 4.02 |   |   |   | 562 |   |   |   | $ | 3.47 |   |   |
| Options available for grant, end of year                         |       |                                                                    | 1,500      |                           |       |                           |       |   |   |   | 1,482 |   |   |   |   |   |   |   | 1,389 |   |   |   |   |   |   |
| Total options  authorized                                        |       |                                                                    | 1,917      |                           |       |                           |       |   |   |   | 2,424 |   |   |   |   |   |   |   | 2,424 |   |   |   |   |   |   |
| Weighted average  fair value of options granted during the year: |       |                                                                    |       |                           |       |                           | $          | 3.68 |   |   |   |   |   |   |   | $ | 3.08 |   |   |   |   |   |   |   | $ | 2.36 |   |   |

 

F-18

----

**Adoption of SFAS123(R)**

The Company adopted SFAS 123(R) at the beginningof fiscal 2006 utilizing the modified prospective method, which does notrequire restatement of prior periods. The modified prospective method requiresthat compensation expense be recorded for all unvested stock options andrestricted stock awards over the requisite service period (generally thevesting schedule). Prior to fiscal 2006, the Company measured compensation costfor employee stock options and similar equity instruments using the intrinsicvalue-based method of accounting prescribed by APB 25.

Thefair value of each option is estimated on the date of grant using theBlack-Scholes option-pricing model that uses the weighted average assumptionsnoted in the following table. Expected volatilities are based on historicalvolatility of our stock through the date of grant. The Company uses historicaldata to estimate the options’ expected term, which represents the period oftime that options granted are expected to be outstanding. The risk-freeinterest rate used is based on the U.S. Treasury constant maturities at thetime of grant having a term that approximates the expected life of the option.

| ** **               | ** ** | **Years Ended**           | ** ** |
|--------------------------|------------|--------------------------------|------------|
| ** **               | ** ** | **October 28, 2006** | ** ** | **October 29, 2005** | ** ** | **October 30, 2004** | ** ** |
| Expected life  (years)   |       |                           | 6          |   |   |   | 6 |   |   |   | 6 |   |   |
| Risk-free  interest rate |       |                           | 4.9        | % |   |   | 4.2 | % |   |   | 3.9 | % |   |
| Volatility               |       |                           | 133        | % |   |   | 140 | % |   |   | 145 | % |   |
| Dividend yield           |       |                           | None       |   |   |   | None |   |   |   | None |   |   |

 

The total intrinsic value of options exercised was$148,000 and $592,000 during the years ended October 28, 2006 and October 29,2005. There were no options exercised during the year ended October 30,2004. The Company issues new shares upon the exercise of options.

Thefollowing table summarizes information about stock options outstanding at October 28,2006:

| ** **                                                                                  | ** **          | **Options outstanding** | ** ** | **Options exercisable**                                | ** ** |
|---------------------------------------------------------------------------------------------|---------------------|------------------------------|------------|-------------------------------------------------------------|------------|
| **Range ofexercise prices**                                                       | ** **          | **Shares**                   | ** ** | **Weighted average  remaining  contractual life** | ** ** | **Weighted average  exercise price** | ** ** | **Shares** | ** ** | **Weighted average  exercise price** | ** ** |
| **(In thousands, except for years and exercise prices)** | ** **          |
|                                                                                        | $ 2.20 - 2.56  |                         |       |                                                        | 37         |   |   |   | 5.96 |   |   |   | $ | 2.39 |   |   |   | 37 |   |   |   | $ | 2.39 |   |   |
|                                                                                        | $ 3.15 - 3.15  |                         |       |                                                        | 125        |   |   |   | 5.79 |   |   |   | 3.15 |   |   |   | 125 |   |   |   | 3.15 |   |   |
|                                                                                        | $ 3.20 - 3.20  |                         |       |                                                        | 3          |   |   |   | 4.57 |   |   |   | 3.20 |   |   |   | 3 |   |   |   | 3.20 |   |   |
|                                                                                        | $ 3.22 - 3.22  |                         |       |                                                        | 200        |   |   |   | 8.44 |   |   |   | 3.22 |   |   |   | 40 |   |   |   | 3.22 |   |   |
|                                                                                        | $ 3.50 - 16.17 |                         |       |                                                        | 52         |   |   |   | 6.00 |   |   |   | 5.33 |   |   |   | 37 |   |   |   | 5.61 |   |   |
|                                                                                        | $ 2.20 - 16.17 |                         |       |                                                        | 417        |   |   |   | 7.09 |   |   |   | $ | 3.39 |   |   |   | 242 |   |   |   | $ | 3.42 |   |   |
|                                                                                             |                     |                              |            |                                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The total intrinsic value of stock options outstandingand stock options exercisable as of October 28, 2006 were $396,000 and$243,000, respectively. The intrinsic value is calculated as the differencebetween the market value as of October 28, 2006 and the exercise price ofthe shares. The market value as of October 28, 2006 was $4.17 as reportedby the NASDAQ Global Market System. At October 28, 2006, the Company had20,000 restricted shares outstanding with an intrinsic value of $19,000 andrecorded liabilities for payroll withholdings of $34,000 under its employeestock purchase plan to be used to purchase shares at a weighted averageexercise price of $3.44 with an estimated aggregate intrinsic value of $13,000.As of October 28, 2006, total deferred compensation cost related tononvested stock options and awards not yet recognized is $241,000, which isexpected to be recognized over a weighted-average term of 1.8 years. The totalnumber of in-the-money options exercisable as of October 28, 2006 is228,000.

F-19

----

Duringfiscal 2006, the Company recognized $260,000 in compensation expense related tooptions granted to employees and directors. Stock-based compensation expense isincluded in selling and administration expense.

Thefollowing table represents pro forma net income and pro forma earnings pershare for the years ended October 29, 2005 and October 30, 2004 hadcompensation cost been determined using the fair value method:

| ** **                                                                               | ** ** | **Fiscal Year Ended**                                                                                                                          | ** ** |
|------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                               | ** ** | **October 29,**                                                                                                                                     | ** ** | **October 30,** | ** ** |
| ** **                                                                               | ** ** | **            2005            ** | ** ** | **            2004            ** | ** ** |
| ** **                                                                               | ** ** | **(In thousands, except per share data)**                                                                                       | ** ** |
| Net income as  reported                                                                  |       |                                                                                                                                                     | $          | 21,126 |   |   |   | $ | 3,473 |   |   |
| Employee  stock-based compensation expense determined under the fair value based  method |       |                                                                                                                                                     | (223       | ) |   |   | (443 | ) |   |
| Pro forma net  income                                                                    |       |                                                                                                                                                     | $          | 20,903 |   |   |   | $ | 3,030 |   |   |
| Earnings per share as reported                                                           |       |                                                                                                                                                     |       |   |   |   |   |   |   |
| Basic                                                                                    |       |                                                                                                                                                     | $          | 1.30 |   |   |   | $ | 0.22 |   |   |
| Diluted                                                                                  |       |                                                                                                                                                     | $          | 1.29 |   |   |   | $ | 0.22 |   |   |
| Pro forma earnings per share                                                             |       |                                                                                                                                                     |       |   |   |   |   |   |   |
| Basic                                                                                    |       |                                                                                                                                                     | $          | 1.28 |   |   |   | $ | 0.19 |   |   |
| Diluted                                                                                  |       |                                                                                                                                                     | $          | 1.27 |   |   |   | $ | 0.19 |   |   |

 

As stock-basedcompensation expense recognized in the Consolidated Statements of Income forthe year ended October 28, 2006 is based on awards ultimately expected tovest, it has been reduced for estimated forfeitures. SFAS 123(R) requiresforfeitures to be estimated at the time of grant and revised, if necessary, insubsequent periods if actual forfeitures differ from those estimates.Forfeitures were estimated based on historical experience. In the Company’s proforma information required under SFAS 123 for the periods prior to October 28,2006, the Company accounted for forfeitures as they occurred.

**13.**          Leases

The Company leases real and personal property underoperating leases with terms generally ranging from one to five years. Some ofthese leases have renewal options and contain provisions for escalation basedon increases in certain costs incurred by the landlord and on Consumer PriceIndex adjustments. Rental expense from continuing operations, includingmonth-to-month rentals, amounted to $6.3 million in fiscal 2006, $6.1 millionin fiscal 2005, and $6.1 million in fiscal 2004. The Company also receivesrental income from subleases which expire on various dates. Sublease income wasnot material to the Company’s results of operations for any periods presented.

In fiscal 2003, the Company entered into asale-leaseback transaction whereby the Company sold and leased back itsadministrative offices’ land and buildings. The lease, which is being accountedfor as an operating lease, has a term of seven years with an option to renewfor an additional five years. The result of the sale was a net pre-tax gain ofapproximately $5.3 million that the Company deferred and is amortizing as anoffset to rent expense over the seven year lease term. In connection with thelease agreement, the Company issued a $700,000 irrevocable standby letter ofcredit as a security deposit.

F-20

----

Futureminimum lease payments for all non-cancelable operating leases at October 28,2006 are as follows:

| ** **                        | ** ** | **(In thousands)** | ** ** |
|-----------------------------------|------------|-------------------------|------------|
| Minimum lease payments: | ** ** | ** **              | ** ** |
| Fiscal 2007                       |       |                    | $          | 4,251 |   |   |
| Fiscal 2008                       |       |                    | 3,176      |   |   |
| Fiscal 2009                       |       |                    | 2,386      |   |   |
| Fiscal 2010                       |       |                    | 1,204      |   |   |
| Fiscal 2011                       |       |                    | 400        |   |   |
| Thereafter                        |       |                    | 199        |   |   |
| Total minimum  lease payments     |       |                    | $          | 11,616 |   |   |

 

The followingis a summary of future minimum payments under capitalized leases, primarily forinformation technology equipment, at October 28, 2006:

| ** **                                       | ** ** | **(In thousands)** | ** ** |
|--------------------------------------------------|------------|-------------------------|------------|
| Minimum lease payments:                          | ** ** |                    | ** ** | ** ** |   |
| Fiscal 2007                                      |       |                    | $          | 510 |   |   |
| Fiscal 2008                                      |       |                    | 509        |   |   |
| Fiscal 2009                                      |       |                    | 468        |   |   |
| Fiscal 2010                                      |       |                    | 6          |   |   |
| Total minimum  lease payments                    |       |                    | 1,493      |   |   |
| Less amount representing interest                |       |                    | (315       | ) |   |
| Present value of  net minimum lease payments     |       |                    | 1,178      |   |   |
| Less current portion of capital lease obligation |       |                    | (345       | ) |   |
| Long-term capital lease  obligation              |       |                    | $          | 833 |   |   |

 

**14.**          OperatingSegments

The Company has four reportable segments: DomesticBusiness Services, United Kingdom, Australia and New Zealand. Domestic BusinessServices provides a variety of temporary staffing and permanent placementservices, primarily in clerical and light industrial positions, through anetwork of company-owned and franchise agent offices. The segment consists ofeight geographically diverse company regions under the direction of regionalmanagers and one combined franchise region, each identified as an operatingsegment. Revenue from Domestic Business Services is derived wholly from theUnited States and its territories. The domestic operating segments meet theaggregation criteria specified under SFAS No. 131, “Disclosures aboutSegments of an Enterprise and Related Information” for reporting purposes. Theinternational operating segments comprise company-owned offices, primarilyproviding clerical and light industrial temporary staffing and permanentplacement services. The Company employs a managing director who overseesoperations in the United Kingdom and a managing director who overseesoperations in Australia and New Zealand. Revenue is attributed to each countrybased on the location of the respective country’s principal offices. Summarizedfinancial data for the Norway and Denmark discontinued operations is includedin Note 4.

The Company evaluates the performance of and allocatesresources to the reportable segments based on operating income. The accountingpolicies of the segments are the same as those described in Note 2. Certainoperating expenses of the Company’s corporate headquarters, which are includedin Domestic Business Services, are charged to the international entities in theform of royalties. Domestic assets relating to the generation of the royalties,primarily property, plant and equipment, have not been 

F-21

----

allocated due toimpracticality and are not considered material for purposes of assessingperformance and making operating decisions.

Thefollowing summarizes reporting segment data for fiscal years 2006, 2005 and2004:

| ** **                                          | ** ** | **Fiscal Year Ended October 28, 2006** | ** ** |
|-----------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                          | ** ** | **(In thousands)**                                         | ** ** |
| ** **                                          | ** ** | **Domestic**                                                    | ** ** | **United** | ** ** | ** ** | ** ** | **New** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                          | ** ** | **Business Svcs**                                          | ** ** | **Kingdom** | ** ** | **Australia** | ** ** | **Zealand** | ** ** | **Adjustments(1)** | ** ** | **Consolidated** | ** ** |
| Revenue                                             |       |                                                            | $          | 482,153 |   |   | $ | 41,140 |   | $ | 85,538 |   |   | $ | 6,119 |   |   |   |   |   |   |   | $ | 614,950 |   |   |
| Operating income  (loss) from continuing operations |       |                                                            | $          | 3,613 |   |   | $ | 871 |   | $ | (189 | ) |   | $ | 250 |   |   |   |   |   |   |   | $ | 4,545 |   |   |
| Depreciation and  amortization                      |       |                                                            | $          | 4,177 |   |   | $ | 275 |   | $ | 322 |   |   | $ | 37 |   |   |   |   |   |   |   | $ | 4,811 |   |   |
| Purchases of fixed  assets                          |       |                                                            | $          | 4,390 |   |   | $ | 280 |   | $ | 355 |   |   | $ | 45 |   |   |   |   |   |   |   | $ | 5,070 |   |   |
| Total long-lived  assets                            |       |                                                            | $          | 27,995 |   |   | $ | 646 |   | $ | 2,064 |   |   | $ | 78 |   |   |   |   |   |   |   | $ | 30,783 |   |   |
| Total assets                                        |       |                                                            | $          | 118,753 |   |   | $ | 8,462 |   | $ | 16,752 |   |   | $ | 1,705 |   |   |   | $ | (6,407 | ) |   |   | $ | 139,265 |   |   |
|                                                     |            |                                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                   | ** ** | **Fiscal Year Ended October 29, 2005** | ** ** |
|----------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                   | ** ** | **(In thousands)**                                         | ** ** |
| ** **                                   | ** ** | **Domestic**                                                    | ** ** | **United** | ** ** | ** ** | ** ** | **New** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                   | ** ** | **Business Svcs**                                          | ** ** | **Kingdom** | ** ** | **Australia** | ** ** | **Zealand** | ** ** | **Adjustments(1)** | ** ** | **Consolidated** | ** ** |
| Revenue                                      |       |                                                            | $          | 470,971 |   |   | $ | 42,582 |   | $ | 92,026 |   |   | $ | 7,282 |   |   |   |   |   |   |   | $ | 612,861 |   |   |
| Operating income  from continuing operations |       |                                                            | $          | 3,395 |   |   | $ | 1,133 |   | $ | 1,040 |   |   | $ | 560 |   |   |   |   |   |   |   | $ | 6,128 |   |   |
| Depreciation and  amortization               |       |                                                            | $          | 3,421 |   |   | $ | 341 |   | $ | 356 |   |   | $ | 44 |   |   |   |   |   |   |   | $ | 4,162 |   |   |
| Purchases of  fixed assets                   |       |                                                            | $          | 7,254 |   |   | $ | 134 |   | $ | 633 |   |   | $ | 11 |   |   |   | $ | 12 |   |   |   | $ | 8,044 |   |   |
| Total long-lived  assets                     |       |                                                            | $          | 24,291 |   |   | $ | 601 |   | $ | 1,987 |   |   | $ | 75 |   |   |   |   |   |   |   | $ | 26,954 |   |   |
| Total assets                                 |       |                                                            | $          | 115,161 |   |   | $ | 8,736 |   | $ | 18,126 |   |   | $ | 1,358 |   |   |   | $ | (4,599 | ) |   |   | $ | 138,782 |   |   |

 

| ** **                                   | ** ** | **Fiscal Year Ended October 30, 2004** | ** ** |
|----------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                   | ** ** | **(In thousands)**                                         | ** ** |
| ** **                                   | ** ** | **Domestic**                                                    | ** ** | **United** | ** ** | ** ** | ** ** | **New** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                   | ** ** | **Business Svcs**                                          | ** ** | **Kingdom** | ** ** | **Australia** | ** ** | **Zealand** | ** ** | **Adjustments(1)** | ** ** | **Consolidated** | ** ** |
| Revenue                                      |       |                                                            | $          | 470,414 |   |   | $ | 45,088 |   | $ | 67,708 |   |   | $ | 6,651 |   |   |   |   |   |   |   | $ | 589,861 |   |   |
| Operating income  from continuing operations |       |                                                            | $          | 2,317 |   |   | $ | 2,172 |   | $ | 722 |   |   | $ | 198 |   |   |   |   |   |   |   | $ | 5,409 |   |   |
| Depreciation and  amortization               |       |                                                            | $          | 3,561 |   |   | $ | 361 |   | $ | 394 |   |   | $ | 64 |   |   |   |   |   |   |   | $ | 4,380 |   |   |
| Purchases of  fixed assets                   |       |                                                            | $          | 2,827 |   |   | $ | 374 |   | $ | 128 |   |   | $ | 11 |   |   |   | $ | 29 |   |   |   | $ | 3,369 |   |   |
| Total long-lived  assets                     |       |                                                            | $          | 19,184 |   |   | $ | 868 |   | $ | 1,710 |   |   | $ | 98 |   |   |   |   |   |   |   | $ | 21,860 |   |   |
| Total assets                                 |       |                                                            | $          | 94,031 |   |   | $ | 10,433 |   | $ | 13,604 |   |   | $ | 1,613 |   |   |   | $ | 2,727 |   |   |   | $ | 122,408 |   |   |

----

(1)          Adjustmentsreflect assets related to discontinued operations and elimination of domestic investments in internationalsubsidiaries.

**15.**          Commitmentsand Contingencies

In the ordinary course of its business, the Company isperiodically threatened with or named as a defendant in various lawsuits. Theprincipal risks that the Company insures against are workers’ compensation,general liability, automobile liability, property damage, alternative staffingerrors and omissions, fiduciary liability and fidelity losses.

F-22

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During fiscal 2003, Bond International Software, Inc.(“Bond”) filed a demand for arbitration with the American ArbitrationAssociation (“AAA”) seeking compensation for the Company’s alleged breach of a2001 software agreement. The Company filed a counterclaim, seeking the returnof monies previously paid to Bond. The Final Award was issued by the arbitratorin December 2004 and as a result, the Company recorded a charge of $1.1million in fiscal 2004 for the award and related legal fees.

During the fourth quarter of fiscal 2005, the Companywas notified by the California Employment Development Department (“EDD”) thatWestaff’s domestic operating subsidiaries unemployment tax rates would beincreased retroactively for both calendar years 2005 and 2004, which wouldresult in additional unemployment taxes of approximately $900,000. The Companybelieves that it has properly calculated its unemployment insurance tax and isin compliance with all applicable laws and regulations. The Company has timelyappealed the ruling by the EDD and is working with its outside counsel toresolve this matter. The Company believes that it has strong defenses and legalarguments with respect to the unaccrued assessment and, accordingly, has notaccrued for that portion of the assessment as of October 28, 2006.

Other than the actionlisted above, the Company is not currently a party to any material litigation.However, from time to time the Company has been threatened with, or named as adefendant in, litigation brought by former franchisees or licensees, andadministrative claims and lawsuits brought by employees or former employees.Management believes the resolution of these matters will not have a materialadverse effect on the Company’s financial statements.

F-23

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**16.**          QuarterlyFinancial Information (Unaudited)

Thefollowing is a summary of the unaudited quarterly financial information for thefiscal years ended October 28, 2006 and October 29, 2005.

| ** **                                                    | ** ** | **First**                                                             | ** ** | **Second**  | ** ** | **Third**   | ** ** | **Fourth**  | ** ** |
|---------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|
| ** **                                                    | ** ** | **Quarter**                                                           | ** ** | **Quarter** | ** ** | **Quarter** | ** ** | **Quarter** | ** ** |
| ** **                                                    | ** ** | **(In thousands, except per share amounts)** | ** ** |
| **Fiscal year ended  October 28, 2006**                  | ** ** | ** **                                                            | ** ** | ** **  | ** ** | ** **  | ** ** | ** **  | ** ** |
| Revenue                                                       |       | $                                                                     | 138,600    |        | $          | 138,635     |       | $           | 140,859    |   | $ | 196,856 |   |
| Gross profit                                                  |       | $                                                                     | 23,237     |        | $          | 24,076      |       | $           | 25,439     |   | $ | 36,031 |   |
| Operating income (loss) from continuing operations            |       | $                                                                     | (222       | )           | $          | (147        | )          | $           | 1,465      |   | $ | 3,449 |   |
| Net income (loss)                                             |       | $                                                                     | (396       | )           | $          | (266        | )          | $           | 1,182      |   | $ | 2,599 |   |
| Earnings (loss)  per share                                    |       |                                                                  |       |        |       |        |       |        |       |
| Net income (loss)                                             |       |                                                                  |       |        |       |        |       |        |       |
| Basic and Diluted                                             |       | $                                                                     | (0.02      | )           | $          | (0.02       | )          | $           | 0.07       |   | $ | 0.16 |   |
| **Fiscal  year ended October 29, 2005**                  | ** ** | ** **                                                            | ** ** | ** **  | ** ** | ** **  | ** ** | ** **  | ** ** |
| Revenue                                                       |       | $                                                                     | 135,305    |        | $          | 135,521     |       | $           | 141,053    |   | $ | 200,982 |   |
| Gross profit                                                  |       | $                                                                     | 22,857     |        | $          | 23,153      |       | $           | 24,628     |   | $ | 35,171 |   |
| Operating income (loss) from continuing operations            |       | $                                                                     | 1,139      |        | $          | (49         | )          | $           | 1,708      |   | $ | 3,330 |   |
| Income (loss) from continuing operations (1)                  |       | $                                                                     | 568        |        | $          | (328        | )          | $           | 1,079      |   | $ | 18,778 |   |
| Income from  discontinued operations                          |       | $                                                                     | (62        | )           | $          | (43         | )          | $           | (29        | ) | $ | — |   |
| Gain on sale of  discontinued operations, net of income taxes |       | $                                                                     | —     |        | $          | —      |       | $           | 1,163      |   | $ | — |   |
| Net income (loss)                                             |       | $                                                                     | 506        |        | $          | (371        | )          | $           | 2,213      |   | $ | 18,778 |   |
| Earnings (loss)  per share                                    |       |                                                                  |       |        |       |        |       |        |       |
| Income (loss)  from continuing operations                     |       |                                                                  |       |        |       |        |       |        |       |
| Basic                                                         |       | $                                                                     | 0.04       |        | $          | (0.02       | )          | $           | 0.07       |   | $ | 1.15 |   |
| Diluted                                                       |       | $                                                                     | 0.03       |        | $          | (0.02       | )          | $           | 0.07       |   | $ | 1.14 |   |
| Discontinued operations - basic and diluted                   |       | $                                                                     | *          |        | $          | *           |       | $           | 0.07       |   | $ | - |   |
| Net income (loss)                                             |       |                                                                  |       |        |       |        |       |        |       |
| Basic                                                         |       | $                                                                     | 0.03       |        | $          | (0.02       | )          | $           | 0.14       |   | $ | 1.15 |   |
| Diluted                                                       |       | $                                                                     | 0.03       |        | $          | (0.02       | )          | $           | 0.14       |   | $ | 1.14 |   |

----

*                    Less than$(0.01)

(1)          Net income for thefourth quarter of fiscal 2005 includes the reversal of $16,681, or $1.02 perdiluted share, of domestic deferred tax valuation allowances.

F-24

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the Registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.

|          | WESTAFF, INC. |
|----------|--------------------|
|     | By:                | /s/  PATRICIA M. NEWMAN |
|     |               | Patricia M. Newman |
| * * | * *           | *President and Chief Executive  Officer* |
|     |               | Date: January 26, 2007 |

 

**POWER OF ATTORNEY**

**KNOW ALL PERSONS BY THESE PRESENTS:**

That the undersigned officers and directors of Westaff, Inc.,a Delaware corporation, do hereby constitute and appoint Patricia M. Newman andJohn P. Sanders the lawful attorney-in-fact, each with full power ofsubstitution, for her or him in any and all capacities, to sign any amendmentsto this report on Form 10-K and to file the same, with exhibitsthereto and other documents in connection therewith, with the Securities andExchange Commission, hereby ratifying and confirming all that each of saidattorney-in-fact or his substitute or substitutes may do or cause to be done byvirtue hereof.

IN WITNESS WHEREOF, each of the undersigned hasexecuted this Power of Attorney as of the date indicated.

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the Registrant and inthe capacities and on the dates indicated.

|                         | **Signature** | ** **                                     | ** ** | ** **            | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|-------------------------|---------------|------------------------------------------------|------------|-----------------------|-----------|------------|------------|------------|----------|------------|
| /s/ W. ROBERT STOVER    |          | Chairman  of the Board                         |       | January 26, 2007 |
| W. Robert Stover        |          |                                           |       |                  |
| /s/  PATRICIA M. NEWMAN |          | President and Chief Executive Officer and      |       | January 26, 2007 |
| Patricia M. Newman      |          | Director  (Principal Executive Officer)        |       |                  |
| /s/  JOHN P. SANDERS    |          | Senior Vice President, Chief Financial Officer |       | January 26, 2007 |
| John P. Sanders         |          | and  Treasurer (Principal Financial Officer)   |       |                  |
| /s/  JACK D. SAMUELSON  |          | Director                                       |       | January 26, 2007 |
| Jack D. Samuelson       |          |                                           |       |                  |
| /s/  RONALD D. STEVENS  |          | Director                                       |       | January 26, 2007 |
| Ronald D. Stevens       |          |                                           |       |                  |
| /s/  JANET M. BRADY     |          | Director                                       |       | January 26, 2007 |
| Janet M. Brady          |          |                                           |       |                  |

 

IV-1

----