**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

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** **

**FORM 10-K**

 

**ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE**

**ACT OF 1934**

** **

**FOR THE FISCAL YEAR ENDED OCTOBER30, 2004**

 

**Commission File Number 000-24990**

 

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** **

**WESTAFF, INC.**

(Exact name of registrant as specified in its charter)

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

 

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

(Address of principal executive offices, including zip code)

 

**(925) 930-5300**

(Registrant’s telephone number, including area code)

 

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

**None**

 

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

**Common Stock, $0.01 par value per share**

(Title of class)

 

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

 

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the best of Registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K.  ý

 

Indicateby check mark whether Registrant is an accelerated filer (as defined in Rule12b-2 of the Act). Yes o No ý

 

Theaggregate market value of the voting and non-voting common stock held bynon-affiliates based upon the last sales price for the registrant’s commonstock on the Nasdaq National Market on April 16, 2004, the last business day ofthe registrant’s most recently completed second fiscal quarter, was$20,652,690.

 

Asof January 27, 2005, the Registrant had outstanding 16,050,812 shares of CommonStock.

 

## **DOCUMENTSINCORPORATED BY REFERENCE**

## ** **

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

 

Portionsof the Registrant’s Proxy Statement for the 2005 Annual Meeting of Stockholdersare incorporated herein by reference into Part III of this Form 10-K Report.

 

 

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## **INDEX**

**WESTAFF, INC.**

** **
| ** **    | ** **                                                                                                          | **PAGE  NO** |
|---------------|---------------------------------------------------------------------------------------------------------------------|--------------|
| **PART I**    | ** **                                                                                                          |         |
| ITEM 1.       | BUSINESS                                                                                                            | 3            |
| ITEM  2.      | PROPERTIES                                                                                                          | 13           |
| ITEM 3.       | LEGAL PROCEEDINGS                                                                                                   | 13           |
| ITEM  4.      | SUBMISSION  OF MATTERS TO A VOTE OF SECURITY HOLDERS                                                                | 13           |
| ITEM 4A.      | EXECUTIVE  OFFICERS OF THE REGISTRANT                                                                               | 13           |
| **PART II**   | ** **                                                                                                          |         |
| ITEM 5.       | MARKET FOR REGISTRANT’S  COMMON EQUITY, RELATED STOCKHOLDER  MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES | 14           |
| ITEM 6.       | SELECTED FINANCIAL DATA                                                                                             | 16           |
| ITEM 7.       | MANAGEMENT’S DISCUSSION AND  ANALYSIS OF FINANCIAL CONDITION AND  RESULTS OF OPERATIONS                   | 16           |
| ITEM 7A.      | QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                                         | 24           |
| ITEM 8.       | FINANCIAL  STATEMENTS AND SUPPLEMENTARY DATA                                                                        | 24           |
| ITEM 9.       | CHANGES IN  AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE                               | 24           |
| ITEM 9A.      | CONTROLS  AND PROCEDURES                                                                                            | 25           |
| ITEM 9B.      | OTHER  INFORMATION                                                                                                  | 25           |
| **PART  III** | ** **                                                                                                          |         |
| ITEM 10.      | DIRECTORS  AND EXECUTIVE OFFICERS OF THE REGISTRANT                                                                 | 25           |
| ITEM 11.      | EXECUTIVE  COMPENSATION                                                                                             | 25           |
| ITEM 12.      | SECURITY  OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER  MATTERS                    | 25           |
| ITEM 13.      | CERTAIN  RELATIONSHIPS AND RELATED TRANSACTIONS                                                                     | 25           |
| ITEM 14.      | PRINCIPAL  ACCOUNTANT FEES AND SERVICES                                                                             | 25           |
| **PART IV**   | ** **                                                                                                          |         |
| ITEM 15.      | EXHIBITS  AND FINANCIAL STATEMENT SCHEDULES                                                                         | 25           |
|          | SIGNATURES                                                                                                          | IV-1         |
|          | POWER OF ATTORNEY                                                                                                   | IV-1         |

 

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## **PARTI**

## ** **

**CautionaryNote**

 

This Annual Report contains forward-looking statementsthat involve risks and uncertainties regarding Westaff, Inc. (the “Company”).As discussed in greater detail under “Cautionary Statement” in Item 7, suchstatements are identified by terms expressing the Company’s future expectationsor projections. The Company’s actual results could differ materially from thoseanticipated in these forward-looking statements as a result of certain factorsincluding those set forth under the heading “Factors Affecting Future OperatingResults” beginning on page 9  below andelsewhere in, or incorporated by reference into, this Annual Report on Form10-K. Forward-looking statements speak only as of the date of this report, andthe Company undertakes no obligation to update or revise such statements toreflect events or circumstances after the date hereof or to reflect theoccurrence of unanticipated events except as required by applicable laws and regulations.This Form 10-K for the fiscal year ended October 30, 2004, contains servicemarks of the Company.

 

ITEM 1. BUSINESS.

 

**General**

 

TheCompany provides temporary staffing services primarily in suburban and ruralmarkets (“secondary markets”), as well as in the downtown areas of certainmajor urban centers (“primary markets”) in the United States and selectedinternational markets. Through its network of Company-owned, franchise agentand licensed offices, the Company offers a wide range of temporary staffingsolutions, including direct hire, replacement, supplemental and on-siteprograms to businesses and government agencies. The Company’s primary focus ison recruiting and placing temporary light industrial andclerical/administrative personnel. The Company has over 50 years of experiencein the staffing industry and, as of October 30, 2004, operated through 256offices in 44 states and five foreign countries. As of October 30, 2004, 73% ofthese offices were owned by the Company and 27% were operated by franchiseagents and a licensee.

 

TheCompany was founded in 1948 and incorporated in California in 1954.  In October 1995, the Company reincorporatedin Delaware. The Company’s corporate name was changed to Westaff, Inc. inSeptember 1998. The Company’s executive offices are located at 298 North WigetLane, Walnut Creek, California 94598-2453, and its telephone number is (925)930-5300. The Company transacts business through its subsidiaries, the largestof which is Westaff (USA), Inc., a California corporation, which is the primaryoperating entity.

 

Duringfiscal 1999, the Company sold its medical business, primarily operated throughWestern Medical Services, Inc., a wholly-owned subsidiary of the Company. As aresult, the Company has classified its medical operations as discontinuedoperations in the Company’s consolidated financial statements and provides aseparate discussion of the medical operations in this Business section.

 

Referencesin this Form 10-K to (i) the “Company,” the “Registrant” or “Westaff” refer toWestaff, Inc., its predecessor and their respective subsidiaries, unless thecontext otherwise requires, and (ii) “franchise agents” refer to the Company’sfranchisees in their roles as limited agents of the Company in recruiting jobapplicants, soliciting job orders, filling those orders and handling collectionmatters upon request, but otherwise refer to the Company’s franchisees in theirroles as independent contractors of the Company.

 

**Services**

 

TheCompany’s service offerings are focused primarily on placing temporary lightindustrial and clerical/administrative staffing personnel and providing directhire services.

 

*Light Industrial Services.*Light industrial services personnel are placed for a variety ofassignments including general factory and manufacturing work (includingproduction, assembly and support workers, merchandise packers and machineoperators), warehouse work (such as general laborers, stock clerks, materialhandlers, order pickers, forklift operators and shipping/receiving clerks),technical work (such as lab technicians, inspectors, quality controltechnicians and drafters) and general services (such as maintenance and repairpersonnel, janitors and food service workers).

 

*Clerical/Administrative Services.*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 positions also include call center agents, suchas customer service, help desk and technical support staff.

 

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*Direct Hire Services.* Direct hire services are typically contingent, fee-based services torecruit and fill regular staff positions for customers.  These services include locating, screeningand assessing candidates on behalf of customers.  If the candidate is hired by the customer,the Company is generally paid a contingent fee based on a percentage of theannual starting compensation for the candidate placed.

 

TheCompany believes that temporary light industrial and clerical/administrativestaffing services are the foundation of the staffing industry and will remain asignificant market for the foreseeable future. The Company also believes thatemployees performing temporary light industrial and clerical/administrativestaffing functions are, and will remain, an integral part of the labor marketin local, regional and national economies around the world.

 

TheCompany also provides other services within the light industrial andclerical/administrative staffing market such as temp-to-hire services,payrolling, on-site and on-location services, and other professional servicesincluding skills and behavioral assessments and coordination of drug testingand background checking:

 

•Temp-to-hire services represent the placement oftemporary staff with a customer with the option to convert the   temporary staff to a regular customeremployee at a later date.

 

•Payrolling typically involves the transfer of acustomer’s short-term seasonal or special use employees to the Company’spayroll for a designated period.

 

•On-site programs provide administrative servicesfor the Company’s customers such as coordinating all temporary staffingservices throughout a customer’s location, including skills assessment andtraining.

 

•On-location programs provide for an independentbranch office located at the customer’s facility. They are typically intendedfor large non-seasonal accounts with more than $500,000 in annual revenue. Thebranch office is typically staffed by at least one manager-level employee.

 

Bothon-site and on-location relationships provide customers with dedicated accountmanagement which can more effectively meet the customer’s changing staffingneeds with high quality, consistent service. These programs tend to havecomparatively lower operating expenses and relatively longer customer relationships.

 

Tocomplement its service offerings, the Company utilizes a number of toolsfocused on increasing the pool of qualified candidates using advanced selectionprocedures for potential candidates (Talent Trak®) as well as technology-basedmanagement services that allow clients to maximize workforce productivity (TimeTrak®). The Company believes that these tools enhance its competitive edge andposition it to more effectively pursue high growth market niches such asfinancial services, customer interaction centers and high end administrativeplacement.

 

*Talent Trak*®.  To ensure high quality placements forcustomers and employees, Westaff uses Talent Trak® to strengthen the quality ofits selection process. This comprehensive selection process includes flexiblerecruiting methods, interviewing and reference checking. Westaff conductsadvanced skills and behavioral assessments using Talent Trak®, and alsoprovides the option for both background and drug testing that can be customizedto meet a customer’s specific needs.

 

*Time Trak*®.  This tool provides customers with a web-basedmanagement system to assist in maximizing workforce productivity. TimeTrak®  is a flexible system allowingcustomers access to information to track a variety of performance measurementssuch as workforce hours, labor costs, attendance and staff performance. TimeTrak® also includes features to automate timecard and payroll processing.

 

**Markets**

 

TheCompany provides temporary staffing services primarily in “secondary markets”,as well as in the downtown areas of certain “primary markets” in the UnitedStates and selected international markets.

 

TheCompany’s strategy is to capitalize on its presence in secondary markets and tobuild market share by targeting small to medium-sized customers, includingdivisions of Fortune 500 companies. The Company believes that in many cases,such markets are less competitive and less costly to operate in than in themore central areas of primary markets, where a large number of staffing servicescompanies frequently compete for business and occupancy costs are relativelyhigh. In addition, the Company believes that secondary markets are more likelyto provide the opportunity to sell retail and recurring business that ischaracterized by relatively higher gross margins.

 

TheCompany augments this concentration on secondary markets by also focusing onnational contracts with 

 

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customershaving a large presence in these marketplaces. Such accounts include largeclients in multiple locations supported by a dedicated corporate-level businessrelationship manager. The Company currently has existing national accountsacross many different business sectors such as manufacturing, government,financial services, technology and communications. The Company maintains aprofessional sales team that services and leverages existing relationships toretain and grow these accounts. In addition, the Company continues to developaggressive marketing programs to target and acquire additional clients that fitthe Westaff branch system footprint. The Company believes that its geographicalignment allows it to effectively compete for some of these nationalcontracts.

 

TheCompany markets its temporary staffing services to local and regional customersthrough a network of Company-owned and franchise agent offices, as well asthrough its on-site and on-location service locations and through one licensedoffice. The Company’s national marketing campaigns are coordinated through itscorporate headquarters in cooperation with US field offices. Marketing effortsfor regional and international markets are conducted at the local level. Newcustomers are developed by the field offices primarily through direct salesefforts and referrals. The Company has a robust targeted marketing program anda consultative sales process that includes telemarketing and e-mail marketing.

 

**Recruiting**

 

TheCompany believes that a key component of its success is the ability to recruitand maintain a pool of qualified personnel and regularly place them intodesirable and appropriate positions. The Company uses comprehensive methods toidentify, assess, select and, when appropriate, measure the skills of itstemporary employees to meet the needs of its customers. The Company believesone of its key competitive advantages in attracting and retaining temporarylight industrial and clerical/administrative staffing personnel is its payrollsystem, which provides it with the ability to print payroll checks at virtuallyall of its branch offices within 24 hours after receipt of a timecard. MostCompany-owned offices offer temporary employees a benefit package, including aservice bonus and holiday pay. Franchise agent offices have the option to offerthis benefit. All eligible temporary employees have the option to participatein the Company’s 401(k) plan and discounted employee stock purchase plan.

 

**Operations**

 

TheCompany operates each Company-owned office as a separate profit center andprovides certain managers considerable operational autonomy and financialincentives. The Company also operates franchise agent offices in appropriatemarkets. Managers focus on business opportunities within markets and areprovided centralized support to achieve success in those markets. The Companybelieves that this structure allows it to recruit and retain highly motivatedmanagers who have demonstrated the ability to succeed in a competitiveenvironment. This structure also allows managers and staff to focus on marketdevelopment while relying on centralized services for support in back-officeoperations, such as risk management programs and unemployment insurance,credit, collections, accounting, advice on legal and regulatory matters,quality standards and marketing.

 

Asof October 30, 2004, the Company operated through a network of 256 offices in44 states and five foreign countries. In addition, the Company from time totime establishes recruiting offices both for recruiting potential temporaryemployees and for testing demand for its services in new market areas. TheCompany’s operations are decentralized, with branch/market, district/regionaland zone managers and franchise agents enjoying considerable autonomy inhiring, determining business mix and advertising.

 

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

 
| ** **                          | ** ** | **Oct. 30,  2000** | ** ** | **Nov. 3,  2001** | ** ** | **Nov. 2,  2002** | ** ** | **Nov. 1,  2003** | ** ** | **Oct. 30,  2004** | ** ** |
|-------------------------------------|------------|--------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|--------------------|------------|
| Number of Offices by Ownership (1): |       |               |       |              |       |              |       |              |       |               |       |
| Company-owned                       |       | 257                |       | 254               |       | 217               |       | 197               |       | 187                |       |
| Franchise agent                     |       | 81                 |       | 85                |       | 77                |       | 72                |       | 68                 |       |
| Licensed                            |       | 16                 |       | 10                |       | 5                 |       | 1                 |       | 1                  |       |
| Total                               |       | 354                |       | 349               |       | 299               |       | 270               |       | 256                |       |
|                                |       |               |       |              |       |              |       |              |       |               |       |
| Number of Offices by Location (1):  |       |               |       |              |       |              |       |              |       |               |       |
| Domestic                            |       | 299                |       | 291               |       | 246               |       | 221               |       | 207                |       |
| International                       |       | 55                 |       | 58                |       | 53                |       | 49                |       | 49                 |       |
| Total                               |       | 354                |       | 349               |       | 299               |       | 270               |       | 256                |       |

 

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(1)   Excludes Company-owned recruiting offices.

 

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*Company-Owned Offices.*Employees of each Company-owned office typically report to a branch ormarket manager who is responsible for day-to-day operations and theprofitability of a market that consists of one to several offices. Branch ormarket managers typically report to district or regional managers. Districtmanagers, regional managers and zone sales managers typically report to zonemanagers.  As of December 31, 2004, there were three zone managers, three zonesales managers, six regional managers and nine district managers. The Company has a variety of incentive plans in placefor its domestic and international offices. One or more of these plans may beoffered to branch staff as well as market, district, regional, zone sales andzone managers. These plans are designed to motivate employees to maximize thegrowth and profitability of their offices. The Company believes that itsincentive-based compensation plans encourage employees in its Company-ownedoffices to increase sales and profits, resulting in a creative and committedteam.

 

*Franchise Agent Offices.*The Company’s franchise agents have the exclusive right by contract tosell certain of the Company’s services and to use the Company’s service marks,business names and systems in a specified geographic territory.

 

TheCompany’s franchise agent agreements generally allow franchise agents to openmultiple offices within their exclusive territories. As of October 30, 2004,the Company’s 36 franchise agents operated 68 franchise agent offices. Salesgenerated by franchise agent operations and related costs are included in theCompany’s consolidated revenue and costs of services, respectively, and duringfiscal 2002, 2003, and 2004 franchise agent sales represented 24.1%, 26.4%, and28.4% respectively, of the Company’s revenue.

 

Thefranchise agent, as an independent contractor, is responsible for establishingand maintaining an office and paying related administrative and operatingexpenses, such as rent, utilities and salaries of its branch office staff. Eachfranchise agent functions as a limited agent of the Company in recruiting jobapplicants, soliciting job orders, filling those orders and assisting andcooperating with collection matters upon request, but otherwise functions as anindependent contractor. As franchisor, the Company is the employer of thetemporary employees and the owner of the customer accounts receivable and isresponsible for paying the wages of the temporary employees and all relatedpayroll taxes and insurance. As a result, the Company provides a substantialportion of the working capital needed for the franchise agent operations.

 

Franchiseagents are required to follow the Company’s operating procedures and standardsin recruiting, screening, classifying and retaining temporary personnel.

 

*Licensed Offices.* As of October 30, 2004, one licensee operatedone licensed office. The Company is no longer offering the license program. Thelicensee is the employer of the temporary employees and the owner of thecustomer accounts receivable. The Company finances the licensees’ temporaryemployee payroll, payroll taxes and insurance. This indebtedness is secured bya pledge of the licensees’ accounts receivable, tangible and intangible assets,and the license agreement. Borrowings under the lines of credit bear interestat a rate equal to the reference rate of Bank of America, N.A. plus twopercentage points. Interest is charged on the borrowings only if theoutstanding balance exceeds certain specified limits. Licensees are required tooperate within the framework of the Company’s policies and standards, but mustobtain their own workers’ compensation, liability, fidelity bonding and stateunemployment insurance coverage, which determines their payroll costs.

 

TheCompany’s franchise and license agreements have an initial term of five yearsand are renewable for multiple five-year terms. The agreements generallycontain two-year non-competition covenants which the Company vigorously seeksto enforce. Efforts to enforce the non-competition covenants have resulted inlitigation brought by the Company following termination of certain franchiseagent and license agreements. In the past five fiscal years, the Company hascommenced one action to enforce the non-competition covenants, which wasresolved in the Company’s favor.

 

TheCompany’s sale of franchises and licenses is regulated by the Federal TradeCommission and by state business opportunity and franchise laws. The Companyhas either registered, or been exempted from registration, in 13 of the 15states that require registration in order to offer franchises or licenses. Intwo of the 15 states, the Company has not yet sought registration and istherefore not currently authorized to offer franchise arrangements.

 

Forfinancial information about operating segments for fiscal years 2002, 2003 and2004, see Note 15 to the consolidated financial statements included in thisAnnual Report.

 

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**Seasonality**

 

TheCompany has experienced significant fluctuations in its operating results andanticipates that these fluctuations may continue. Operating results mayfluctuate due to a number of factors, including the demand for the Company’sservices, the level of competition within its markets, the Company’s ability toincrease the productivity of its existing offices, control costs and expandoperations and the availability of qualified temporary personnel. In addition,the Company’s results of operations could be, and have in the past been,adversely affected by severe weather conditions. The Company’s fourth fiscalquarter consists of 16 or 17 weeks, while its first, second and third fiscalquarters consist of 12 weeks each. Moreover, the Company’s results ofoperations have also historically been subject to seasonal fluctuations. Demandfor temporary staffing historically has been greatest during the Company’sfourth fiscal quarter due largely to the planning cycles of many of itscustomers. Furthermore, sales for the first fiscal quarter are typically lowerdue to national holidays as well as plant shutdowns during and after theholiday season. These shutdowns and post-holiday season declines negativelyimpact job orders received by the Company, particularly in the light industrialsector.

 

**Customers**

 

TheCompany services small and medium sized companies as well as divisions ofFortune 500 companies and local, state and federal government agencies. As iscommon in the temporary staffing industry, the Company’s engagements to provideservices to its customers are generally of a non-exclusive, short-term natureand subject to termination by the customer with little or no notice. Duringfiscal 2004, no single customer accounted for more than 4.5% of the Company’srevenue. The Company’s 10 highest volume customers in fiscal 2004 accounted foran aggregate of approximately 14.2% of the Company’s revenue.

 

**Competition**

 

Thetemporary staffing industry is highly competitive with few barriers to entry.The Company believes that the majority of commercial temporary 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. The Company also competes for qualified temporary personnel andcustomers with larger, national full-service and specialized competitors inlocal, regional, national and international markets. The principal nationalcompetitors are Adecco SA, Spherion Corporation (commercial staffing segment),Kelly Services, Inc. (U.S. commercial staffing and international segments),Manpower Inc., RemedyTemp, Inc. (clerical and light industrial services),Express Personnel Services, Inc., and Randstad North America.  Many of the Company’s principal competitorshave greater financial, marketing and other resources than the Company. Inaddition, there are a number of medium-sized firms which compete with theCompany in certain markets where they may have a stronger presence, such asregional or specialized markets.

 

TheCompany believes that the competitive factors in obtaining and retainingcustomers include understanding customers’ specific job requirements, providingqualified temporary personnel in a timely manner, monitoring quality of jobperformance and pricing of services. Due to competitive pressures it has beendifficult for the Company to raise prices even though its costs have increased.The Company believes that the primary competitive factors in obtainingqualified candidates for temporary employment assignments are wages, benefitsand flexibility and responsiveness of work schedules. The Company believes thatwithin its primary light industrial and clerical/administrative markets,timeliness of pay is also a key competitive factor.

 

**ManagementInformation Systems**

 

The Company’s domesticmanagement information systems provide support to both branch office locationsand the corporate back-office. Branch offices utilize a proprietary applicationdesigned to assist in candidate search, recruiting, customer order management,customer service, sales management and payroll entry and submission. Theapplication also provides for the sharing of information between branch officesand corporate headquarters. Utilizing this system, field offices capture andinput customer, employee, billing and payroll information. This information iselectronically captured on centralized servers where payroll, billing andfinancial information is processed overnight. These systems allow the Companyto print checks at its branch offices within 24 hours after receipt of thetimecard. Invoices are also processed daily and distributed from the Company’scentralized corporate office. These systems also support branch officeoperations with daily, weekly, monthly and quarterly reports that provideinformation ranging from customer activity to office profitability.

 

Each of the Company’sinternational operations have implemented customized or third party frontoffice and/or back office operating systems that are designed to meet thespecific information technology and reporting requirements within the localjurisdiction.

 

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**RiskManagement Programs**

 

TheCompany is responsible for all employee-related expenses for the temporarystaff employees of its Company-owned and franchise agent offices includingworkers’ compensation, unemployment insurance, social security taxes, state andlocal taxes and other general payroll expenses.

 

TheCompany provides workers’ compensation insurance covering its domestic regularand temporary employees through a long-term relationship with St.Paul-Travelers Indemnity Company (“Travelers”). The Company is self-insured inthe states of Ohio and Washington. For fiscal years 2002 and 2003, the Companyretained a $500,000 deductible per occurrence for these policies. Thisretention increased to $750,000 per claim for fiscal 2004, but has been reducedback to $500,000 for fiscal 2005. The Company also purchases workers’compensation insurance coverage based upon actual payroll classifications inthe monopolistic states of Wyoming, North Dakota and West Virginia.

 

TheCompany is contractually required to collateralize its recorded obligationsunder the workers’ compensation insurance contracts with Travelers throughirrevocable letters of credit, surety bonds or cash. As of October 30, 2004,the aggregate collateral requirements have been satisfied through $22.1 millionof letters of credit and a $3.8 million surety bond.

 

TheCompany’s nationwide risk management program is managed by its Risk ManagementDepartment consisting of risk management and workers’ compensationprofessionals as well as claim administrators who monitor the disposition ofall claims and oversee, through an on-line system, all workers’ compensationclaim activity. The department utilizes a variety of creative and aggressiveworkers’ compensation loss prevention and claim management strategies. The riskmanagement program includes claim strategy reviews with the carrier and thirdparty administrator, a return-to-work modified duty program, pre-placementcustomer safety evaluations and light industrial job approvals, the use of personalprotective equipment, and the use of individual local office expense allocationformulas.

 

**Employees**

 

Asof October 30, 2004, the Company had approximately 28,000 temporary employeeson assignment and employed 834 regular staff. The Company’s employees are notcovered by any collective bargaining agreements. The Company believes that itsrelationships with its employees are good.

 

**ServiceMarks**

 

The Company has variousservice marks registered with the United States Patent and Trademark Office,with the State of California and in various foreign countries, including itsprimary Westaff® service mark.

 

The Company also ownsother service marks, including Westaff® (wave design), Talent Trak®, TimeTrak®, Ms. Carmen Courtesy®, Accountants USA®, AUSA®, College Greens®, TheEssential Support Services Leader®, E Team®, Job Squad®, On Location &Essential® and Staff for Business Jobs for People®.  The Company has filed an application toregister the service mark Learning Traksm.

 

Federal and state servicemark registrations may be renewed indefinitely as long as the underlying markremains in use.  The Company also hasservice marks related to its former name “Western,” including Western StaffServices®, Western Accounting Services®, Western Legal Services®, and WesternMarketing Services®.

 

**MedicalServices**

 

Duringfiscal 1999, the Company discontinued its medical business (Western Medical)principally through a sale to Intrepid U.S.A. Inc.  Under the terms of the sale, the Companyretained the majority of accounts receivable, including the trade and Medicareaccounts receivable balances.

 

Priorto fiscal 2003, the Company appealed Western Medical’s 1996 Medicare costreport settlement. During the first quarter of fiscal 2003, as a result of thefavorable appeal settlement, the Company recorded $0.3 million in income fromdiscontinued operations.

 

Duringthe third quarter of fiscal 2004, the Company resolved certain significantlegal and liability claims and evaluated future risks associated with remainingpending claims.  As a result, $0.2million of income from discontinued operations was recognized and is reflectedin the Consolidated Statement of Operations for the fiscal year ended October30, 2004.

 

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Asof October 30, 2004, the remaining net current liabilities of the discontinuedmedical operations of $0.2 million are primarily for settled but unpaid legalclaims. The Company believes it has adequately reserved for the reasonableoutcome of future events; however, should actual costs differ materially fromthose estimated by management, the Company would record additional losses (orgains) in future periods.

 

**Availabilityof Reports**

 

Westaffmakes its SEC filings, including financial reports on Form 10-K, 10-Q or 8-K,available free of charge on its web site at www.westaff.com as soon aspracticable after filing. Furthermore, Westaff will provide electronic or papercopies of filings free of charge upon written request to the Company’s ChiefFinancial Officer or Investor Relations representative.

 

**FactorsAffecting Future Operating Results**

 

ThisForm 10-K contains forward-looking statements concerning the Company’s futureprograms, products, expenses, revenue, liquidity and cash needs as well as theCompany’s plans and strategies. These forward-looking statements are based oncurrent expectations and the Company assumes no obligation to update thisinformation, except as required by applicable laws and regulations. Numerousfactors could cause actual results to differ significantly from the resultsdescribed in these forward-looking statements, including the following riskfactors.

 

*Pricecompetition in the staffing industry continues to be intense and pricingpressures from both competitors and customers may result in reduced sales andmargins to the Company.*

 

Thetemporary staffing industry is highly competitive with limited barriers toentry and continues to undergo consolidation. The Company expects the level ofcompetition to remain high in the future, and increasing competitive pricingpressures will continue to make it difficult for the Company to raise itsprices even though its costs have increased, and may have an adverse effect onthe Company’s market share and operating margins. The Company competes in national,regional and local markets with full service agencies and with specializedtemporary services agencies. Many competitors are smaller than the Company butmay enjoy an advantage over the Company in discrete geographic markets becauseof their stronger local presence. Other competitors have greater marketing,financial and other resources than the Company that, among other things, couldenable them to attempt to maintain or increase their market share by reducingprices. Furthermore, there has been an increase in the number of customersconsolidating their staffing services purchases with a single provider or witha small number of providers. The trend to consolidate staffing servicespurchases has in some cases made it more difficult for Westaff to obtain orretain business.

 

*Unemploymentinsurance premiums and workers’ compensation costs and collateral for Westaff’stemporary employees may continue to rise and reduce Westaff’s margins andcreate liquidity problems.*

 

Westaffis responsible for and pays unemployment insurance premiums and workers’compensation costs for its regular and temporary employees. Recently, thesecosts have risen as a result of increased claims, general economic conditionsand governmental regulations. There can be no assurance that Westaff will beable to increase the fees charged to its customers in the future to keep pacewith increased costs and if it does not, its results of operations, financialcondition and liquidity could be adversely affected.

 

Westaffretains a portion of the risk under its workers’ compensation program (see “Business—RiskManagement Programs”). The estimated remaining deductible liability for allexisting and incurred but not reported claims is accrued based upon actuarialmethods using current claims information, as well as prior experience, and maybe subsequently revised each quarter based on new developments related to suchclaims. Changes in the estimates underlying the claims reserve are charged orcredited to earnings in the period determined, and therefore large fluctuationsin any given quarter could materially adversely affect earnings in that period.

 

TheCompany is contractually required to collateralize its obligations to itsinsurance carrier under these workers’ compensation insurance contractsthrough irrevocable letters of credit, surety bonds or cash. As of October 30,2004, the Company’s aggregate collateral requirements under these contractshave been satisfied through $22.1 million of letters of credit and a $3.8million surety bond.

 

Inrecent years, Westaff has funded its annual workers’ compensation obligationsto its insurance carrier through monthly installments which totaled $16.0million in fiscal 2003, $17.9 million in fiscal 2004 and, based on the 2005policy, are projected to be $20.6 million for fiscal 2005.

 

9

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Asnoted above, annual funding and collateral requirements for the Company’sworkers’ compensation program are significant and place pressure on the Company’sliquidity and working capital availability. While the funding agreement is in place for fiscal 2005, the Company’sinsurance carrier has the right to request additional collateral based onactual claims.  Should the Company berequired to provide further collateral in addition to the fiscal 2005 payments,such additional collateral would reduce the Company’s borrowing capacity andits liquidity.

 

*Anysignificant recurrent economic downturn could result in the Company’s customersusing fewer temporary employees, which could materially adversely affect theCompany.*

 

Demandfor the Company’s staffing services is significantly affected by the generallevel of economic activity and unemployment in the United States and thecountries in which the Company operates. Frequently, customers use temporarystaffing services to manage personnel costs and staffing needs. When economicactivity increases, temporary employees are often added before full-timeemployees are hired. However, as economic activity slows, many customers reducetheir utilization of temporary employees before releasing regular full-timeemployees. Typically, the Company may experience less demand for its servicesand more competitive pricing pressure during periods of economic downturn. Therecent domestic economic recession and resultant economic uncertainty had amaterial adverse effect on the Company’s business, results of operations, cashflows and financial condition. A recurrent recession or a significant lag ineconomic recovery would likely have a further material adverse effect on theCompany’s business, results of operations, cash flows or financial position.

 

***Westaff has significant workingcapital requirements and is heavily dependent upon its ability to borrow moneyto meet these working capital requirements.***

** **

The Company requiressignificant amounts of working capital to operate its business and to payexpenses relating to employment of temporary employees.  Temporary personnel are generally paid on aweekly basis while payments from customers are generally received 30 to 60 daysafter billing.  As a result, the Companymust maintain sufficient cash availability to pay temporary personnel prior toreceiving payment from customers.

 

The Company finances itsoperations primarily through borrowings under its revolving credit facilitiesand also through cash generated by its operating activities.  As of December 25, 2004, the Company’s totalborrowing availability was $19.8 million, with $13.8 million, $3.3 million and$2.7 million available in the US, UK and Australia, respectively.

 

The amount the Company isentitled to borrow under its US revolving credit facility is calculated eachday and is dependent on the trade accounts receivable generated fromoperations, which are affected by financial, business, economic and otherfactors, as well as by the daily timing of cash collections and cashoutflows.  If the Company experiences asignificant and sustained drop in operating profits, or if there areunanticipated reductions in cash inflows or increases in cash outlays, theCompany may be subject to cash shortfalls. If such a shortfall were to occur,for even a brief period of time, it may have a significant adverse effect onthe Company’s business. Furthermore, the Company’s receivables may not beadequate to allow for borrowings for other corporate purposes, such as capitalexpenditures or growth opportunities, and the Company would be less able toreact to changes in the market or industry conditions.

 

The credit facilitiescontain covenants which, among other things, require the Company to maintain aminimum fixed charge coverage ratio and a minimum earnings before interest,taxes, depreciation and amortization (EBITDA). The Company has, in the past, failed to comply with certain of thesecovenants and has been required to obtain a waiver or amendment to the creditagreement from its lenders.  Any futurefailure to comply with the covenants under the Company’s credit facilitiescould result in an event of default which, if not cured or waived, couldtrigger prepayment obligations. If the Company were forced to refinanceborrowings under the current facilities, there can be no assurance that suchfinancing would be available or that such financing would not have a materialadverse effect on the Company’s business and financial condition. Even if suchrefinancing were available, the terms could be less favorable and the Company’sresults of operations and financial condition could be adversely affected byincreased costs and rates.

 

During fiscal 2003 andfiscal 2004, the Company experienced significant seasonal and otherfluctuations in its borrowings and borrowing availability, particularly in theUS, and has, in the past, been required to aggressively manage its cash toensure adequate funds to meet working capital requirements.  Such steps included working to improvecollections and adjusting the timing of cash expenditures, reducing operatingexpenses where feasible and working to generate cash from a variety of other sources.

 

The Company hashistorically experienced periods of negative cash flow from operations andinvestment activities, especially during seasonal peaks in revenue experiencedin the third and fourth quarter of the year. In 

 

10

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addition, the Company isrequired to pledge amounts to secure letters of credit that collateralizecertain workers’ compensation obligations and these amounts may increase infuture periods. Any such increase in pledged amounts or sustained negative cashflows would decrease amounts available for working capital purposes and couldhave an adverse affect on the Company’s liquidity and financial condition.

 

*Westaff’s information technologysystems are critical to its daily operations and the Company has initiated aprocess to replace these systems beginning in fiscal 2005.*

 

The Company’s domesticinformation management systems, located at a co-location facility and corporateheadquarters, are critical to daily operations of the Company’s business. Whilebackup and recovery systems are in place, should these key systems fail itcould severely impact the Company’s business and operations, specifically itsability to timely and accurately pay employees and bill customers.

 

The Company’s domesticback office payroll and billing systems are at the end of their life cycle andare no longer supported by the companies who originally supplied them. Westaffcurrently utilizes internal support to maintain and update these systems. Thisincludes the process of applying updates to remain in compliance with taxmandates and other additional regulatory requirements. This potentially createsexposure should an update not occur in a timely fashion, which could have amaterial adverse effect on the Company’s business. In fiscal 2005, the Companywill begin implementing a new enterprise-wide information system to replaceexisting legacy systems. This project will require significant investments innew hardware and consulting fees as well as significant internal personnelresources.  While the Company anticipatesa successful implementation, there can be no assurance that this initiativewill yield the intended results.  Delaysin completing or an inability to successfully complete these technologyinitiatives could adversely affect the Company’s operations.

 

*Westaff’ssuccess depends upon its ability to attract and retain qualified temporarypersonnel.*

 

Westaffdepends upon its ability to attract and retain qualified temporary personnelwho possess the skills and experience necessary to meet the staffingrequirements of its customers. Westaff must continually evaluate and upgradeits base of available qualified personnel to keep pace with changing clientneeds and emerging technologies. Furthermore, a substantial number of theCompany’s temporary employees during any given year will terminate theiremployment with the Company and accept regular staff employment with customersof the Company. Competition for individuals with proven skills remains intense,and demand for these individuals is expected to remain strong for theforeseeable future. There can be no assurance that qualified personnel willcontinue to be available to Westaff in sufficient numbers and on terms ofemployment acceptable to the Company. The failure to recruit, train and retainqualified temporary employees could materially adversely affect the Company’sbusiness.

 

*Westaff maybe exposed to employment-related claims and costs that could materiallyadversely affect its business.*

 

Westaffis in the business of employing people and placing them in the workplace ofother businesses.  Attendant risks ofthese activities include:

 

•possible claims by customers of employee misconduct or negligence,

•claims by employees of discrimination or harassment (including claims relatingto actions of Westaff’s customers),

• fines and costs related to the inadvertentemployment of illegal aliens,

• payment of workers’ compensation claims andother similar claims,

• violations of wage and hour requirements,

• errors and omissions of temporary employees, and

•claims by customers relating to employees’ misuse of customer proprietyinformation, misappropriation of funds, other criminal activity or torts orsimilar claims.

 

Inaddition, some or all of these claims may give rise to litigation, which couldbe time-consuming to the Company’s management team as well as costly andtherefore could have a negative effect on its business. In some instances,Westaff has agreed to indemnify its customers against some or all of thesetypes of liabilities. Westaff has policies and guidelines in place to helpreduce its exposure to these risks and has purchased insurance policies againstcertain risks in amounts that it believes to be adequate. However, there can beno assurance that Westaff’s insurance will be sufficient in amount or scope tocover these types of risks in the future. Furthermore, there can be noassurance that Westaff will not experience these problems in the future or thatWestaff will not incur fines or other losses or negative publicity with respectto these problems that could have a material adverse effect on Westaff’sbusiness.

 

11

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*Westaff’sFounder and Chairman controls more than 50% of the Company’s outstanding stockthus allowing him to exert significant influence on the Company’s managementand affairs.*

 

TheCompany’s Chairman and Founder, W. Robert Stover, beneficially owns directly orindirectly, or has voting power over, more than 50% of the Company’soutstanding stock. As the principal stockholder of the Company, Mr. Stover hasthe ability to control substantially all matters submitted to the stockholdersfor approval and to exert significant influence on the Company’s management andaffairs. For example, Mr. Stover has the ability to sell his sharesindependently, and to control the election of the Board of Directors and theappointment of executive management. He also has the ability to control anymerger, consolidation, sale of substantially all of the Company’s assets orother strategic decisions affecting the Company or the market value of thestock. This concentration of stock and voting power could be used by Mr. Stoverto delay or prevent an acquisition of the Company or other strategic action orresult in strategic decisions that could negatively impact the value andliquidity of the outstanding stock.

 

*The marketfor Westaff’s stock may be limited and the stock price may continue to beextremely volatile.*

 

Theaverage daily trading volume for Westaff’s common stock on the Nasdaq NationalMarket was approximately 8,800 shares from January 1, 2004, through December31, 2004, and there have been numerous days with virtually no trading in thestock. Accordingly, the market price of Westaff’s common stock is subject tosignificant fluctuations that have been, and may continue to be, exaggeratedbecause an active trading market has not developed for the stock. The Companybelieves that the common stock price has also been negatively affected by thefact that the Company’s stock is thinly traded and the absence of analystcoverage. The lack of analyst reports about the Company’s stock may make itdifficult for potential investors to make decisions about whether to purchasethe Company’s stock and may make it less likely that investors will purchasethe stock, thus further depressing the stock price. These negative factors maymake it difficult for stockholders to sell the Company’s common stock, whichmay result in losses for investors.

 

*Westaff’sbusiness may suffer if it loses its key personnel.*

 

Westaff’soperations are dependent on the continued efforts of its executive officers andsenior management. Additionally, Westaff is dependent on the performance andproductivity of its local managers and field personnel. Westaff’s ability toattract and retain business is significantly affected by local relationshipsand the quality of service rendered. The loss of those key executive officersand senior management who have acquired experience in operating a staffingservice company may cause a significant disruption to Westaff’s business.Moreover, the loss of Westaff’s key local managers and field personnel mayjeopardize existing customer relationships with businesses that continue to useWestaff’s staffing services based upon past direct relationships with theselocal managers and field personnel. Either of these types of losses couldadversely affect Westaff’s operations, including Westaff’s ability to establishand maintain customer relationships.

 

*Westaffderives a significant portion of its revenue from franchise agent operations.*

 

Franchiseagent operations comprise a significant portion of the Company’s revenue. Forfiscal 2004, 28.4% of the Company’s total revenue was derived from franchiseagent operations. In addition, the Company’s ten largest franchise agents forfiscal 2004 (based on sales volume) accounted for 17.0% of the Company’srevenue. The loss of one or more of the Company’s franchise agents and anyassociated loss of customers and sales, could have a material adverse effect onthe Company’s results of operations.

 

*Westaff issubject to business risks associated with international operations andfluctuating exchange rates.*

 

TheCompany presently has operations in the United Kingdom (UK), Australia, NewZealand, Norway and Denmark, which comprised 21.9% of the Company’s revenueduring fiscal 2004. Operations in foreign markets are inherently subject tocertain risks, including, in particular, different cultures and businesspractices, overlapping or differing tax structures, economic and politicaluncertainties, compliance issues associated with accounting and reportingrequirements and changing, complex or ambiguous foreign laws and regulations,particularly as they relate to employment. All of the Company’s sales outsideof the United States are denominated in local currencies and, accordingly, theCompany is subject to risks associated with fluctuations in exchange rateswhich could cause a reduction in the Company’s profits. There can be noassurance that any of these factors will not have a material adverse effect onthe Company’s business, results of operations, cash flows or financialcondition.

 

*Westaff isa defendant in a variety of litigation and other actions from time to time,which may have a material adverse effect on the Company’s business, financialcondition and results of operations.*

 

12

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Westaffis regularly involved in a variety of litigation arising out of its businessand, in recent years, has paid significant amounts as a result of adversearbitration awards. The Company does not have insurance for some of theseclaims and there can be no assurance that the insurance coverage it has willcover all claims that may be asserted against the Company. Should the ultimatejudgments or settlements not be covered by insurance or exceed its insurancecoverage, they could have a material adverse effect on the Company’s results ofoperations, financial position and cash flows. There can also be no assurancethat the Company will be able to obtain appropriate and sufficient types orlevels of insurance in the future or that adequate replacement policies will beavailable on acceptable terms, if at all.

 

*The Companyis subject to the risk of new regulations, which could harm the Company’sbusiness.*

 

TheCompany is subject to bills introduced in Congress and various statelegislatures, as well as in the foreign countries in which it operates, which,if enacted, could impose conditions that could have a negative financial impacton the Company.  Such conditions couldinclude new or additional benefits, taxes or other requirements that mayincrease the Company’s costs of operations and reduce future earnings.

 

ITEM 2. PROPERTIES.

 

The Company leases threeadjacent buildings in Walnut Creek, California consisting of approximately50,000 square feet which house its executive and administrative offices. Thelease is for a term of seven years commencing on January 12, 2003, with anadditional five-year option to renew.

 

In addition, the Companyleases space for its Company-owned offices in the United States andabroad.  The majority of the leases arefor fixed terms of one to five years and contain customary terms andconditions.  The Company believes thatits facilities are adequate for its current needs and does not anticipate anydifficulty replacing such facilities or locating additional facilities, ifneeded.

 

ITEM 3. LEGAL PROCEEDINGS.

 

In the ordinarycourse of its business, the Company is periodically threatened with or named asa defendant in various lawsuits.  Theprincipal risks that the Company insures against, subject to and upon the termsand conditions of its various insurance policies, are workers’ compensation,general liability, automobile liability, property damage, alternative staffingerrors and omissions, fiduciary liability and fidelity losses.

 

On October 28,2003, Bond International Software, Inc. (“Bond”) filed a demand for arbitrationwith the American Arbitration Association (“AAA”).  Bond sought compensation for the Company’salleged breach of a 2001 software agreement. The Company filed a counterclaim, seeking the return of moniespreviously paid to Bond.  The arbitrationhearing was held in September 2004.  Thearbitrator issued an interim award on October 25, 2004, agreeing that theCompany had the right to terminate the agreement but granting Bond “terminationcharges” in the amount of $422,807, plus interest from January 2002.  The arbitrator denied Bond’s claim fordamages for breach of the implied covenant of good faith and fair dealing, anddenied the Company’s counterclaim.  Inthe final award issued December 4, 2004, the arbitrator ordered the Company topay Bond $291,352 in attorneys’ fees and costs, and to pay the AAAadministrative fees and arbitrator compensation totaling $43,570.  The Company has paid the foregoing adverseaward.  The Company is not currently aparty to any material litigation.  However,from time to time the Company has been threatened with, or named as a defendantin litigation brought by former franchisees or licensees, and administrativeclaims and lawsuits brought by former employees.  Management believes the resolution of thesematters will not have a material adverse effect on the Company’s financialstatements.

 

ITEM4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

 

None.

 

ITEM4A. EXECUTIVE OFFICERS OF THE REGISTRANT* .

 

Theexecutive officers of the Company and their respective ages as of January 28,2005, are set forth below.

 
| **Name**           | ** ** | **Age** | ** ** | **Position(s) Held**                                             |
|--------------------|------------|---------|------------|------------------------------------------------------------------|
| Dwight S. Pedersen |       | 59      |       | President and Chief Executive Officer                            |
| Patricia M. Newman |       | 53      |       | Chief Operating Officer                                          |
| Dirk A. Sodestrom  |       | 47      |       | Senior Vice President and  Chief Financial Officer               |
| Christa C. Leonard |       | 47      |       | Vice President and Treasurer                                     |
| Richard G. Gross   |       | 49      |       | Senior Vice President, Director of Strategic  Business Solutions |

 

13

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| Joseph R. Coute |   | 57 |   | Vice President and Director of  Human Resources |
|-----------------|--------|----|--------|-------------------------------------------------|
| David P. Wilson |   | 42 |   | Vice President, Information  Services           |

 

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*Included pursuant to Instruction 3 to Item 401(b) of Regulation S-K.

 

*Dwight S. Pedersen.*Mr. Pedersen was appointed as President and Chief Executive Officer ofthe Company effective January 14, 2002. He has been a director of the Companysince May 1, 2001. He served on the Audit Committee of the Board of Directorsfrom and after that date until he resigned from that committee upon becoming anemployee of the Company.  Prior tojoining the Company, he was the Executive Vice President of Pinkertons, Inc.,where he was employed since January 1, 2000, following the acquisition ofAmerican Protective Services, Inc. He was employed by American ProtectiveServices, Inc. for twenty-six years, having started as its first Controller in1974. After a series of promotions, including service as VicePresident-Finance, Senior Vice President and Executive Vice President of thatcompany, he was named President and a director in 1988 and he became its ChiefExecutive Officer in 1992. His previous work history includes approximatelyfour years with Wolf & Co., an accounting firm. He is a certified publicaccountant on inactive status.

 

*Patricia M. Newman.* Ms. Newman was appointed as Chief Operating Officer of theCompany effective November 1, 2004. She joined the Company as UK ManagingDirector in December 1998.  In November2002, she took on the added responsibility of overseeing the Company’s Denmarkand Norway operations.  Prior to joiningthe Company, Ms. Newman was employed by Kelly Services in the United Kingdomfrom 1989 to 1998, most recently as Commercial Operations Director. From 1979to 1989 she was employed by Manpower in the United Kingdom.

 

*Dirk A. Sodestrom.*Mr. Sodestrom joined the Company as Controller in February 1991. InDecember 1992, he was elected to the additional position of Vice President. InJune 1998, Mr. Sodestrom was named a Senior Vice President of the Company.Effective January 1, 2001, Mr. Sodestrom was appointed as Chief FinancialOfficer. Mr. Sodestrom was employed from 1980 to 1991 by Price Waterhouse LLP,most recently as a Senior Audit Manager. He is a certified public accountant oninactive status.

 

*Christa C. Leonard.*Ms. Leonard was hired as Vice President and Treasurer of the Company inNovember 2000.  Ms. Leonard waspreviously employed by USI Insurance Services Corp. as Vice President, Treasuryand Tax, from 1996 to 2000. She has approximately nine years’ prior workexperience in the public accounting field, most recently from 1995 to 1996 withRoberts Schultz & Co., and also with Wallace Meyer & Co. from 1992 to1994, and KPMG Peat Marwick & Co. from 1987 to 1992.  She is acertified public accountant on inactive status.

 

*Richard G. Gross.*Mr.Gross was hired on October 7, 2002, as Senior Vice President, Director ofStrategic Business Solutions. He was previously employed by Spherion as GroupVice President from 2000 to 2002. From 1997 to 2000, he was employed by TandemStaffing for Industry as District Sales Manager and then promoted to Directorof Sales Operations and Personnel. From 1996 to 1997, he was employed byProfessional Detailing Network as District Sales Manager. From 1994 to 1996, hewas employed by The Advantage Medical Group, Inc. as Chief Operating Officer.From 1991 to 1994, he was self-employed as a sales and marketing consultant. Hewas employed from 1978 to 1991 by Allergan Pharmaceuticals and most recentlywas its Senior Product Manager.

 

*Joseph R. Coute.*Mr.Coute has been employed by the Company since January 1997, as Vice Presidentand Director of Human Resources. His previous employer was Bank of America forapproximately 26 years, including 16 years in human resources and ten years inbranch operations.

 

*David P. Wilson.*Mr.Wilson was hired in December 1997, as Field Automation Manager, focusing on thefield automation process. In June 1998, he was assigned the additional task ofmanaging the customer service and help desk functions of the Company’sInformation Services Department. Mr. Wilson was promoted to Vice President,Information Services in January 2001.  Hehas approximately 20 years work experience in information services, mostrecently with Triad Systems Corporation as Manager, Financial and MarketingSystems, from 1991 to 1997 and Franklin Covey, Application Design Specialistfrom 1985 to 1991.

 

## **PARTII**

## ** **

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

 

*MarketInformation*.   TheCompany’s Common Stock has been included for quotation in the Nasdaq NationalMarket (“Nasdaq”) under the symbol “WSTF” since April 30, 1996.  The following table sets forth, for theperiods indicated, the high and low closing sales prices of the Common Stock asreported on Nasdaq.

 

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| ** **                             | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------------------------------|------------|----------|------------|---------|------------|
| Fiscal 2003:                           |       |     |       |    |       |
| First Quarter  ended January 25, 2003  |       | 2.50     |       | 1.95    |       |
| Second Quarter  ended April 19, 2003   |       | 2.35     |       | 1.80    |       |
| Third Quarter  ended July 12, 2003     |       | 2.90     |       | 2.00    |       |
| Fourth Quarter  ended November 1, 2003 |       | 2.43     |       | 1.60    |       |
| Fiscal 2004:                           |       |     |       |    |       |
| First Quarter  ended January 24, 2004  |       | 2.54     |       | 1.90    |       |
| Second Quarter  ended April 17, 2004   |       | 2.75     |       | 1.75    |       |
| Third Quarter  ended July 10, 2004     |       | 3.58     |       | 2.16    |       |
| Fourth Quarter  ended October 30, 2004 |       | 3.53     |       | 2.95    |       |
| Fiscal 2005:                           |       |     |       |    |       |
| First Quarter  ended January 22, 2005  |       | 6.47     |       | 3.05    |       |

 

On December 31, 2004, thelast reported sales price on Nasdaq for the Common Stock was $3.77 pershare.  As of December 31, 2004, therewere approximately 75 shareholders of record.

 

*Sales ofUnregistered Securities*. During fiscal 2004, the Company did not sell any unregisteredsecurities.

 

*IssuerPurchases of Equity Securities.*  None during the fourth quarter of fiscal2004.

 

*Dividends*.  The Company did not declare or pay dividendsduring fiscal 2003 or fiscal 2004. Further, the Company’s current credit facilities prohibit payment ofdividends so the Company is not currently contemplating a dividend declaration.

 

*Securities Authorized Under Equity Plans.*  Thefollowing table sets forth securities authorized for issuance under equitycompensation plans as of October 30, 2004. All applicable equity compensationplans 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 |       | 1,035,000                                                                                          |       | $                                                                                  | 3.07       |                                                                                                                                                  | 1,389,000  |   |
|                                                          |            |                                                                                                    |            |                                                                                    |            |                                                                                                                                                       |            |  |

 

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ITEM 6.SELECTED FINANCIAL DATA.

 
| ** **                                                                                                                | ** ** | **Fiscal Year**                                                            | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------|------------|
| ** **                                                                                                                | ** ** | **2004**                                                                   | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                                                                                                | ** ** | **(Amounts in Thousands Except Per Share  Amounts and Number of Offices)** | ** ** |
| Revenue                                                                                                                   |       | $                                                                          | 601,476    |   | $ | 530,299 |   | $ | 515,253 |   | $ | 572,592 |   | $ | 669,205 |   |
| Operating income  (loss) from continuing operations                                                                       |       | 5,665                                                                      |       | (2,837 | ) | (3,545 | ) | (18,679 | ) | 14,793 |   |
| Income (loss)  from continuing operations before cumulative effect of change in accounting  principle                     |       | 3,323                                                                      |       | (4,774 | ) | (1,431 | ) | (32,101 | ) | 7,235 |   |
| Diluted earnings  (loss) per share—continuing operations before cumulative effect of change in  accounting principle |       | $                                                                          | 0.21       |   | $ | (0.30 | ) | $ | (0.09 | ) | $ | (2.02 | ) | $ | 0.46 |   |
| **Balance  Sheet data (at end of period):**                                                                               |       |                                                                       |       |   |   |   |   |   |   |   |   |
| Working capital                                                                                                           |       | $                                                                          | 33,514     |   | $ | 21,237 |   | $ | 24,072 |   | $ | 16,562 |   | $ | 61,767 |   |
| Total assets                                                                                                              |       | 122,408                                                                    |       | 113,147 |   | 121,955 |   | 123,175 |   | 183,072 |   |
| Short-term debt  and capital lease obligations                                                                            |       | 16,199                                                                     |       | 25,842 |   | 25,167 |   | 30,000 |   | 13,250 |   |
| Long-term debt  and capital lease obligations (excluding current portion)                                                 |       | 2,125                                                                      |       | 2,590 |   | 2,000 |   | — |   | 37,250 |   |
| Stockholders’  equity                                                                                                |       | 39,847                                                                     |       | 35,456 |   | 38,950 |   | 39,492 |   | 73,166 |   |
| **Other  operating data:**                                                                                                |       |                                                                       |       |   |   |   |   |   |   |   |   |
| Number of  offices (at end of period)                                                                                     |       |                                                                       |       |   |   |   |   |   |   |   |   |
| Company-owned                                                                                                             |       | 187                                                                        |       | 197 |   | 217 |   | 254 |   | 257 |   |
| Franchise agent                                                                                                           |       | 68                                                                         |       | 72 |   | 77 |   | 85 |   | 81 |   |
| Licensed                                                                                                                  |       | 1                                                                          |       | 1 |   | 5 |   | 10 |   | 16 |   |
| Total                                                                                                                     |       | 256                                                                        |       | 270 |   | 299 |   | 349 |   | 354 |   |

 

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS.

 

Thefollowing discussion is intended to assist in the understanding and assessmentof significant changes and trends related to the results of operations andfinancial condition of Westaff, Inc., together with its consolidated subsidiaries.   This discussion and analysis should be readin conjunction with the Company’s Consolidated Financial Statements and Notesthereto included elsewhere in this Annual Report on Form 10-K for the fiscalyear ended October 30, 2004.

 

### **CautionaryStatement**

 

Thisnotice is intended to take advantage of the “safe harbor” provided by thePrivate Securities Litigation Reform Act of 1995 with respect to forward-lookingstatements. Except for the historical information contained herein, the mattersdiscussed should be considered forward-looking statements and readers arecautioned not to place undue reliance on those statements. The forward-lookingstatements in this discussion are made based on information available as of thedate hereof and are subject to a number of risks and uncertainties that couldcause the Company’s actual results and financial position to differ materiallyfrom those expressed or implied in the forward-looking statements and to bebelow the expectations of public market analysts and investors. These risks anduncertainties include, but are not limited to, those discussed in Item 1. “FactorsAffecting 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.

 

### **CriticalAccounting Policies**

 

Thepreparation of the Company’s Consolidated Financial Statements and Notesthereto requires management to make estimates and assumptions affecting theamounts and disclosures reported within those financial statements. Theseestimates are evaluated on an ongoing basis by management and generally affectrevenue recognition, collectibility of accounts receivable, workers’compensation costs, impairment of goodwill, income taxes, including thevaluation allowance for deferred tax assets, and contingencies andlitigation.  Management’s estimates and 

 

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assumptions are based onhistorical experiences and other factors believed to be reasonable under thecircumstances.  However, actual resultsunder circumstances and conditions different than those assumed could result indifferences from the estimated amounts in the financial statements.

 

TheCompany believes the following critical accounting policies are those mostsignificantly affected by management’s assumptions or the use of estimates, andare important to the understanding of its business operations and results fromoperations.

 

*RevenueRecognition.*  TheCompany accounts for revenue and the related direct costs in accordance withEmerging Issues Task Force No. 99-19, “Reporting Revenue Gross versus Netas an Agent.” Revenue generated by franchise agents and related costs ofservices are included as part of the Company’s consolidated revenue and costsof services, respectively, since the Company has the direct contractualrelationships with the customers, holds title to the related customerreceivables and is the legal employer of the temporary employees.  Franchise agents’ sales represented 28.4%,26.4% and 24.1% of the Company’s revenue for fiscal 2004, 2003 and 2002,respectively. The Company also has a licensing program in which the licenseehas the direct contractual relationships with the customers, holds title to therelated customer receivables and is the legal employer of the temporaryemployees. Accordingly, sales and costs of services generated by the licenseoperation are not included in the Company’s consolidated financialstatements.  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. As of October 30, 2004, the Company had only one remaininglicensee and is no longer offering license agreements to new prospects.

 

*Collectibilityof Accounts Receivable.* The Company maintains an allowance for doubtful accounts on its accountsreceivable balances for estimated losses projected to result from the inabilityof its customers to make required payments. These allowances, which are $1.1million each at October 30, 2004 and November 1, 2003, are largely determinedbased on customers’ financial conditions, the Company’s historical experiences,interactions with customers and industry trends.  If the financial condition of these customerswere to deteriorate to the point it would impair their ability to make the requiredpayments, additional allowances may be required, which could materiallyadversely affect the financial condition of the Company.

 

*Workers’Compensation Costs.* The Company self-insures the deductible amount related to workers’compensation claims, which was $750,000 per claim for policy year 2004 and$500,000 per claim for policy year 2003, and maintains accruals for theseobligations. These accruals amounted to $16.4 million and $9.8 million atOctober 30, 2004 and November 1, 2003, respectively.  The Company accrues the estimated costs ofthese claims based upon the expected loss rates incurred within the varioustemporary employment categories provided by the Company. At least annually, theCompany obtains an independent actuarially determined calculation of theestimated costs of claims actually made to date, as well as claims incurred butnot yet reported. The resulting calculation is partially based on the Company’shistorical loss development trends as well as overall industry trends.  As a result of updates in the actuary’svaluation, revisions may be made to recorded liabilities. Whereas managementbelieves the recorded liabilities are adequate, there are inherent limitationsin the estimation process whereby future actual loss rates may exceed projectedloss rates, which could materially adversely affect the financial condition ofthe Company.

 

*Goodwilland Other Intangible Assets.* Effective November 3, 2002, theCompany adopted Statement of Financial Accounting Standards (SFAS) No. 142 “Goodwilland Other Intangible Assets”.  SFASNo. 142 requires that goodwill and intangible assets that have indefiniteuseful lives no longer be amortized but instead be evaluated for impairment byapplying a fair-value-based test at least annually or if events orcircumstances change that may indicate the fair value of a reporting unit isbelow its book value. Intangible assets with finite useful lives continue to beamortized over their useful lives. The Company utilizes an independentthird-party valuation firm to determine the fair-value of its individualreporting units.  The valuationmethodologies considered include analyses of discounted cash flows at thereporting unit level, publicly traded companies multiples within the temporarystaffing industry and historical control premiums paid by acquirers purchasingcompanies similar to Westaff.  As aresult of the initial impairment tests upon adoption of SFAS No. 142, theCompany recorded a non-cash charge of $0.7 million to reduce the carrying valueof goodwill in its Australia operations. This charge is reflected as a cumulative effect of a change inaccounting principle in the Company’s consolidated statement of operations forthe fiscal year ended November 1, 2003. The Company performs its annual impairment tests in the fourth quarterof each fiscal year.

 

17

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*IncomeTaxes.*  The Companyrecords income taxes using an asset and liability approach that requires therecognition of deferred tax assets and liabilities for the expected future taxconsequences of events that have been recognized in the Company’s financialstatements or tax returns. A valuation allowance is established when managementdetermines it is more likely than not that a deferred tax asset is notrealizable in the foreseeable future. At October 30, 2004, substantially all ofthe Company’s net deferred tax assets were offset with a valuation allowanceof  $18.7 million and at November 1,2003, 100% of the Company’s net deferred tax assets were offset with avaluation allowance of $19.4 million. The allowances were recorded because theCompany assessed it unlikely that these deferred taxes would be realized infuture years.  If, in future assessmentsof the realizability of the deferred tax assets, the Company determines that areduction in the allowance is required, both the valuation allowance and incometax expense would be reduced in the period of such determination.

 

*Contingenciesand Litigation.*  In theordinary course of its business, the Company is periodically threatened with ornamed as a defendant in various lawsuits, claims and pending actions. 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. If a potentialloss arising from these lawsuits, claims and actions is probable and reasonablyestimable, the Company records the estimated liability based on circumstancesand assumptions existing at the time. Whereas management believes the recorded liabilities are adequate, thereare inherent limitations in the estimation process whereby future actual lossesmay exceed projected losses, which could materially adversely affect thefinancial condition of the Company.

 

### **Executive Overview**

### ** **

**Fiscal 2004 marks the Company’shighest revenue since fiscal 2000, both for the fourth fiscal quarter and forthe fiscal year.  The Company is alsovery pleased to report a return to profitability during fiscal 2004, withannual earnings per share of $0.22 and fourth quarter earnings per share of$0.15.**

** **

**Domestic revenue grew steadilyquarter-over-quarter during the year to conclude at a 10.1% annual increaseover fiscal 2003.  International revenueincreased 27.5% for the year, aided by favorable currency exchange rates.  On a constant currency basis, internationalrevenue increased 12.1%.  As the Companyhas been reporting, in recent years gross margins for the staffing industryhave been negatively impacted by higher workers’ compensation and stateunemployment costs, as well as continued competitive pricing pressures.  The Company is encouraged, however, by theincreased demand for temporary staffing services throughout fiscal 2004.  This, and the Company’s continued focus ongrowing direct hire revenue, leads the Company to believe that the marginerosion is slowing and a turn around in margins may be forthcoming in theforeseeable future, but there can be no assurances that this will occur.**

** **

**The Company closed fiscal 2004 withan improved financial position and ample borrowing capacity to meet expectedworking capital requirements for fiscal 2005. The Company’s strong operating performance enabled it to negotiateamendments to its credit facilities that considerably increased its borrowingcapacity.  The Company was also able tosuccessfully negotiate with its insurance carrier the return of $13.8 millionin cash that was being held as collateral for its 2004 workers’ compensationobligations in exchange for $9.8 million in letters of credit.  In addition, the Company was able to reduceits outstanding surety bond from $9.8 million to $3.8 million, and anticipateselimination of the surety bond completely in the third fiscal quarter of 2005.**

** **

**The Company believes it is wellpositioned, both strategically and financially, to take advantage of a morestable and growing economy as it moves into fiscal 2005.**

** **

**Discontinued Operations**

** **

**During fiscal 1999, the Companydiscontinued its medical business (Western Medical) principally through a saleto Intrepid U.S.A. Under the terms of the sale, the Company retained themajority of accounts receivable, including trade and Medicare accountsreceivable balances.**

** **

**Prior to fiscal 2003, the Companyappealed Western Medical’s 1996 Medicare cost report settlement.  During the first quarter of fiscal 2003, as aresult of the favorable appeal settlement, the Company recognized $316,000 ofincome from discontinued operations.**

 

18

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During the third quarter of fiscal 2004, the Companyresolved certain significant legal and liability claims and evaluated futurerisks associated with remaining pending claims. As a result, $150,000 of income from discontinued operations was recordedfor the fiscal year ended October 30, 2004.

 

**Results of Continuing Operations**

 

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

 
| ** **                                                                                                             | ** ** | **Fiscal Year** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|-----------------|------------|
| ** **                                                                                                             | ** ** | **2004**        | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                                                                                                   |       |            |       |   |   |   |   |
| Revenue                                                                                                                |       | 100.0           | %          | 100.0 | % | 100.0 | % |
| Costs of  services                                                                                                     |       | 83.1            | %          | 82.9 | % | 81.5 | % |
| Gross profit                                                                                                           |       | 16.9            | %          | 17.1 | % | 18.5 | % |
| Franchise  agents’ share of gross profit                                                                          |       | 3.1             | %          | 3.1 | % | 3.0 | % |
| Selling and  administrative expenses                                                                                   |       | 12.0            | %          | 13.3 | % | 14.7 | % |
| Depreciation and  amortization                                                                                         |       | 0.7             | %          | 1.0 | % | 1.3 | % |
| Arbitration  expenses                                                                                                  |       | 0.2             | %          | 0.2 | % | (0.1 | )% |
| Restructuring  charges                                                                                                 |       | —          |       | — |   | 0.4 | % |
| Operating income  (loss) from continuing operations                                                                    |       | 0.9             | %          | (0.5 | )% | (0.7 | )% |
| Interest expense                                                                                                       |       | 0.4             | %          | 0.3 | % | 0.5 | % |
| Interest income                                                                                                        |       |            | *     |   | *  | (0.1 | )% |
| Income (loss)  from continuing operations before income taxes and cumulative effect of  change in accounting principle |       | 0.6             | %          | (0.8 | )% | (1.1 | )% |
| Income tax  provision (benefit)                                                                                        |       |            | *     | 0.1 | % | (0.8 | )% |
| Income (loss)  from continuing operations before cumulative effect of change in accounting  principle                  |       | 0.6             | %          | (0.9 | )% | (0.3 | )% |

 

----

*  less than0.1%

 

**Fiscal 2004 compared to Fiscal2003**

 

Revenueincreased $71.2 million or 13.4% for fiscal 2004, as compared to fiscal2003.  Domestic revenue increased 10.1%,while international revenue, before discounting the effects of favorableexchange rates, increased 27.5% over fiscal 2003.

 

Thedomestic revenue increase is the result of an increase in billed hours of 8.4%coupled with a modest increase in average bill rates of 1.5%.  The growth in domestic billed hours reflectsnew business as well as increases in volume with various existing customers.Excluding the effect of exchange rate fluctuations, international revenue increased12.1%, with an increase of 9.9% in billed hours and, on a constant currencybasis, an increase in average bill rates of 1.9%.

 

Fiscal2004 consecutive quarterly revenue increases for the Company were 3.9%, 12.7%,21.4% and 14.9%, respectively, for the first, second, third and fourth quartersas compared to fiscal 2003.  For thefirst two four-week accounting periods in fiscal 2005, consolidated revenue forthe Company increased 14.0% as compared to the same periods in fiscal 2004.  Based on the Company’s view of industrytrends as well as recent trends in temporary staffing as reported by the Bureauof Labor Statistics, the Company expects these revenue increases to moderateduring fiscal 2005.

 

Costsof services include hourly wages of temporary employees, employer payrolltaxes, state unemployment and workers’ compensation insurance and otheremployee-related costs.  Costs ofservices increased $59.8 million, or 13.6%, in fiscal 2004, as compared tofiscal 2003.  Gross margin declined from17.1% for fiscal 2003 to 16.9% for fiscal 2004. The margin decline reflects the industry-wide strain on domestic marginsdue to competitive pressures and higher relative state unemployment and workers’compensation costs.  As a percent ofdirect labor, domestic state unemployment rates increased 0.5 percentage pointsand domestic workers’ compensation rates increased 0.3 percentage points overthe fiscal 2003 rates.  Internationalgross margins increased from 20.9% for fiscal 2003 to 21.1% for fiscal 2004,with margin improvements in Australia, Norway and the United Kingdom drivenlargely by increases in direct hire fees. It is currently anticipated that gross margins will remain relativelyflat, or increase slightly, in fiscal 2005 as a result of higher direct hirefees and increases in bill rates relative to costs partially offset by expectedincreases in domestic state unemployment insurance rates and increased workers’compensation costs.

 

19

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TheCompany’s workers’ compensation costs tend to vary depending upon the mix ofbusiness between clerical/administrative and light industrial staffing.  Unexpected adverse development of open claimsand increases in the Company’s incurred but not reported (IBNR) claims can alsosignificantly affect the level of accruals needed to cover workers’compensation costs.  The Company reviewsinterim and annual actuarial estimates and monitors claim activity to ensurethat accruals remain appropriate in light of loss trends.  However, unanticipated adverse lossdevelopment trends can result in a need for additional charges to berecorded.  Based on the results of itsannual actuarial valuation, the Company recorded a charge of $1.7 million inthe fourth quarter of fiscal 2004 to increase its domestic workers’compensation reserves.   The fourthquarter of fiscal 2003 included a similar charge of $1.8 million.  Approximately $1.4 million of the fiscal 2004charge related to adverse loss development for policy years prior to 2004, withapproximately $0.8 million of that amount relating to policy years 2000 andearlier.  The Company aggressively worksto close out claims associated with these earlier years; however, many olderclaims remain problematic.  Accordingly,the Company strengthened its overall workers’ compensation reserves to takeinto account these negative historical trends.    However, there can be no assurance that theCompany’s efforts to control workers’ compensation costs will be effective orthat loss development trends will not require additional increases in workers’compensation accruals in future periods.

 

Franchiseagents’ share of gross profit represents the net distribution paid to franchiseagents based either on a percentage of the sales or gross profit generated bythe franchise agents’ operations.  As apercentage of consolidated revenue, franchise agents’ share of gross profit was3.1% for both fiscal 2004 and fiscal 2003. In the first quarter of fiscal 2005, the Company sold one of itsfranchise agents’ operations back to the franchise agent.  These sold operations comprised 3.2% of totaldomestic revenue for the fiscal year ended October 30, 2004, and representedfour of the Company’s 68 franchise agent offices in operation on October 30,2004.

 

Sellingand administrative expenses increased $1.9 million, or 2.7% for the 2004 fiscalyear as compared fiscal 2003 primarily due to higher exchange rates used totranslate international local currency expenses into U.S. dollars.   As a percentage of revenue these expensesdecreased from 13.3% to 12.0% largely as a result of the Company generatingrevenue increases of 13.4% in the current year while limiting selling andadministrative expenditure increases to only 2.7%.  Selling and administrative expenses for the2004 fiscal year include a $0.7 million gain on the sale of the Company’sremaining unoccupied corporate headquarters’ building.

 

Depreciationand amortization decreased $1.0 million or 18.6%, primarily due to reducedcapital expenditures, assets becoming fully depreciated and the sales of theCompany’s corporate headquarters’ buildings.

 

Duringthe fourth quarter of fiscal 2004, the Company received an unfavorablearbitration ruling relating to a contract dispute with one of its vendors.  Total costs associated with this claim,including the arbitration award plus related attorneys’ fees, were $1.1 millionfor fiscal 2004.  Fiscal 2003 included acharge of $1.0 million for an unfavorable California appellate court decision,which reversed a superior court ruling regarding a binding arbitration awardissued in January of 2002.

 

Interestexpense increased $0.4 million for fiscal 2004 as compared to fiscal 2003primarily as a result of higher average borrowings outstanding during the yearcombined with higher average interest rates. Additionally, fiscal 2004 interest expense includes $0.1 million ofinterest expense related to the unfavorable arbitration ruling discussedabove.  It is currently anticipated thataverage interest rates will continue to rise during fiscal 2005.

 

Effective November 3,2002, the Company adopted Statement of Financial Accounting Standards (SFAS)No. 142 “Goodwill and Other Intangible Assets”. SFAS No. 142 provides that goodwill and other intangible assets withindefinite lives are no longer amortized, but rather are evaluated forimpairment by applying a fair-value based test. During fiscal 2003, the Company performed tests for impairment inaccordance with the new standard.   Inthe initial test under the transitional provisions of SFAS No. 142, the Companydetermined that an impairment of $0.7 million existed in its Australiareporting unit.  In accordance with SFASNo. 142, the impairment was classified as a cumulative effect of a change inaccounting principle and resulted in a restatement of the Company’s net lossfor the first fiscal quarter of 2003. The Company performed its annual impairment valuations in the fourthquarters of fiscal 2004 and 2003.  Noadditional impairments were identified.

 

**Fiscal2003 compared to Fiscal 2002**

 

Totalrevenue increased $15.0 million, or 2.9% for fiscal 2003 as compared tofiscal 2002, primarily due to the effect of favorable exchange rates oninternational revenue.  Increases inrevenue as a result of slight increases in average bill rates were substantiallyoffset by decreased bill hours.

 

20

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Domesticrevenue declined 0.3%.  The decline waslargely attributable to a reduction in sales for certain high volume, lowmargin government business, as well decreased demand for staffing services dueto the lingering effects of the U.S. economic downturn and competitive pricingpressures on bill rates. The revenue decline also reflects the Company’sclosure or consolidation of underperforming branches.  International revenue increased 18.5% overfiscal 2002.  Excluding the effect ofexchange rate fluctuations, international revenue in fiscal 2003 increased 4.0%with increases of 11.3% in the United Kingdom and 7.4% in Australia offset bynet declines in the other international operations.

 

Costsof services increased $19.9 million, or 4.7%, in fiscal 2003 as compared tofiscal 2002.  Gross margin declined from18.5% in fiscal 2002 to 17.1% in fiscal 2003 primarily due to decreases in theaverage markup of bill rates over pay rates, due largely to the highlycompetitive environment surrounding the temporary staffing industry duringfiscal 2003.  The decline in gross marginwas also caused by increased workers’ compensation costs and higher stateunemployment insurance costs, most notably in the states of California,Illinois and Texas which comprised approximately 26.0% of total domestictemporary payroll.

 

Workers’compensation costs rose to $18.6 million, or 5.0% of direct labor forfiscal 2003, up from $14.8 million, or 4.1% of direct labor for fiscal2002.  Continued upward trends in theCompany’s actuarially estimated ultimate costs for all open policy yearsresulted in an increase in the Company’s workers’ compensation accruals forthese estimated costs.  Although thefrequency of the Company’s claims decreased, rising medical costs and theadverse development of several open claims resulted in the need for increasedaccruals in fiscal 2003.

 

Franchiseagents’ share of gross profit increased $1.2 million, or 7.7%, for fiscal2003 as compared to fiscal 2002.  As apercentage of total revenue, franchise agents’ share of gross profit was 3.1%for fiscal 2003 and 3.0% for fiscal 2002. In the fourth quarter of fiscal 2002, the Company sold its operations inHawaii and these were converted to franchise offices.  During the fourth quarter of fiscal 2003, onelicensee’s operations converted to the franchise agent program and twoadditional company-owned branches were sold and converted to franchise offices.

 

Sellingand administrative expenses decreased $5.3 million, or 7.0% for fiscal2003 as compared to fiscal 2002. The decrease, partially offset by higherexchange rates for the international operations, reflects reduced costs throughpersonnel reductions, office closures and controlled spending.  As a percent of revenue, selling andadministrative expenses decreased from 14.7% in fiscal 2002 to 13.3% fiscal2003.

 

Thedecrease in depreciation and amortization primarily reflects the cessation ofgoodwill amortization under SFAS No. 142 as noted in “Goodwill” under “CriticalAccounting Policies” above.

 

InFebruary 2002, a favorable arbitration ruling reduced a January 2002 adversearbitration award and the Company determined that $0.7 million of therecorded liabilities were no longer needed. Subsequent to that ruling, the claimants filed a motion with the superiorcourt to correct and confirm the January arbitration ruling.  The motion was denied, and the claimants thenfiled an appeal of the denial.  Theappellate court overturned the superior court ruling and, as a result, theCompany recorded a charge to earnings in the fourth quarter of fiscal 2003 for$950,000.

 

Interestexpense decreased $0.6 million, or 24.8%, for fiscal 2003 as compared tofiscal 2002 primarily due to lower debt levels. Interest income decreased $0.2 million or 51.9% during the sameperiod as a result of reduced cash levels.

 

Theprovision for income taxes for fiscal 2003 consisted of international incometax provisions of $0.5 million partially offset by certain domestic nettax benefits.  At November 1, 2003,the Company maintained valuation allowances equivalent to 100% of itsoutstanding deferred tax assets, which amounted to $19.4 million.

 

**Liquidity and Capital Resources**

 

TheCompany requires significant amounts of working capital to operate its businessand to pay expenses relating to employment of temporary employees.  The Company’s traditional use of cash is forfinancing of accounts receivable, particularly during periods of economicupswings and growth and during periods where sales are seasonally high.  Temporary personnel are generally paid on aweekly basis while payments from customers are generally received 30 to60 days after billing.

 

TheCompany finances its operations primarily through cash generated by itsoperating activities and borrowings under its revolving credit facilities.  Net cash provided by operating activities was$13.8 million for the fiscal year ended October 30, 2004 compared to net cashused by operating activities of $4.9 million for the fiscal year ended November1,

 

21

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2003.  The increase in cash provided by operatingactivities during fiscal 2004 is primarily due to positive net income combinedwith a more beneficial funding program for its 2004 workers’ compensationobligations, whereby the Company was able to satisfy its collateralrequirements through issuance of letters of credit rather than cash.  These increases were partially offset byincreased trade accounts receivable as a result of fiscal 2004’s revenuegrowth.  In fiscal 2003, the Company wasrequired to fully fund its 2003 workers’ compensation obligations through cashdeposits.

 

Cashused for capital expenditures, which are primarily for management informationsystems initiatives, other software, computers and peripherals, and officefurniture and equipment, totaled $3.4 million for fiscal 2004.  The Company continues to invest inenhancements and upgrades to its computer-based technologies.  On August 19, 2004, the Company entered intoa license agreement for a new back office system.  Capital expenditures for this system wereapproximately $1.7 million during the fourth quarter of fiscal 2004 and areexpected to range from $4.0 million to $5.0 million during fiscal year2005.  The Company’s credit agreementcurrently allows up to a maximum of $6.0 million in capital expenditures forfiscal 2005.

 

OnFebruary 12, 2004, the Company completed the sale of its remaining unoccupiedcorporate headquarters’ building for cash proceeds of $1.9 million.  The proceeds were used to pay downoutstanding borrowings under the Company’s revolving credit facilities.   The Company has an outstanding $0.7 millionirrevocable standby letter of credit as a security deposit for the December2002 sale leaseback of the land and buildings housing its administrative offices.

 

TheCompany has generated cash in the past through sales of Company-owned officesto franchise owners or sales of franchise agent and license offices back to thefranchise agent or license owner.  In thefirst quarter of fiscal 2005, the Company sold one of its franchise agents’operations back to the franchise agent for cash proceeds of $1.0 million.  The Company has secured the franchise agents’note payable obligation to the bank that funded the purchase, through a $1.0million letter of credit that will decline as the note obligation is paid bythe franchise agent.

 

On May 17, 2002,the Company entered into agreements with GE Capital, as primary agent, toprovide senior secured credit facilities totaling $65.0 million, expiring inMay 2007.  The facilities comprise afive-year syndicated Multicurrency Credit Agreement consisting of a $50.0million US Revolving Loan Commitment, a £2.7 million UK Revolving LoanCommitment (US dollar equivalent of approximately $4.0 million at the date ofthe agreement), and a $5.0 term loan (the Term Loan), which was repaid duringfiscal 2003.  In addition, a five-yearAustralian dollar facility agreement (the A$ Facility Agreement) was executedon May 16, 2002, consisting of an A$12.0 million revolving credit facility (USdollar equivalent of approximately $6.0 million at the date of the agreement).

 

AtNovember 1, 2003, and through the first quarter of fiscal 2004, the Company wasout of compliance with certain financial covenants under its MulticurrencyCredit Agreement, including a minimum earnings before interest, taxes,depreciation and amortization (EBITDA) covenant.  In February 2004 a fourth amendment to theagreement was executed which, among other things, allowed certain one timeaddbacks to EBITDA for the fiscal period ended November 1, 2003, whichcorrected the covenant defaults and reset the EBITDA and certain othercovenants going forward.

 

EffectiveJuly 31, 2004, the Company and the lenders executed a fifth amendment to theMulticurrency Credit Agreement.  Theamendment increased the eligible trade accounts receivable the Company uses incalculating the amount it is allowed to borrow, and eliminated previouslyin-place reserves that had reduced the available borrowings, significantlyincreasing the availability compared to prior 2004 periods.  In addition, the amendment lowered the rangeof margins on bank borrowings and outstanding irrevocable letters of credit,reset the consolidated EBITDA covenant going forward and increased allowablecapital expenditures for the fiscal 2004 year to $5.0 million.

 

OnJanuary 5, 2005, a sixth amendment to the Multicurrency Credit Agreement wasexecuted.  The amendment, among otherthings, allows a $1.4 million add-back adjustment to the EBITDA covenant atOctober 30, 2004, for the additional workers’ compensation charges the Companyincurred during the fourth quarter of fiscal 2004, as discussed above inResults of Operations for the fiscal year 2004. The add-back will assist the Company in maintaining its minimum EBITDAand fixed charge covenants throughout fiscal 2005.

 

AtOctober 30, 2004, the Company had $22.6 million available under the creditfacilities and was in compliance with all covenants under its creditagreements.

 

TheCompany has an unsecured subordinated promissory note payable to its principalstockholder and Chairman of the Board of Directors in the amount of$2.0 million with a maturity date of August 18, 2007, and an interestrate equal to an indexed rate as calculated under the Company’s credit facilitiesplus seven percent, compounded monthly and payable

 

22

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60 calendar days afterthe end of each of the Company’s fiscal quarters.  Payment of interest is contingent on theCompany meeting minimum availability requirements under its creditfacilities.  Additionally, payments ofprincipal or interest are prohibited in the event of any default under thecredit facilities.   The sixth amendmentto the Company’s Multicurrency Credit Agreement provides for optionalprepayment of the note subject to certain borrowing availability limits on theU.S. revolving loan commitment portion of the credit facilities.

 

On September 25,2003, the Company executed a one-year unsecured subordinated draw down notewith its principal stockholder and Chairman of the Board of Directors.  The note provided for the Chairman to makeadvances to the Company upon request, at his sole discretion and with noobligation to do so, in an aggregate principal amount not to exceed $1.0 millionoutstanding at any one time. On December 23, 2003, the Chairman made a $1.0million advance to the Company under the terms of the note. The advance plusaccrued interest was repaid on August 3, 2004.

 

The Company works to balance its worldwide cash needsthrough dividends from and loans to its international subsidiaries.  These loans and dividends are limited by theimmediate future cash availability and needs of each respective subsidiary,restrictions imposed by the Company’s senior secured debt facilities and, insome cases, statutory regulations of the subsidiary.  The US operations cannot directly draw on theexcess borrowing availability of the UK or Australian operations; however, theCompany may request dividends from the UK. During fiscal 2004, the UK utilized cash from operations and excessborrowing capacity to pay dividends to the US totaling $2.7 million.  The US can also request repayments on itsintercompany loan to Australia, along with intercompany interest and royalties,although any significant remittances from Australia are currently restrictedunder the terms of the Australia credit facility.  However, as a result of positive operatingperformance in Australia in fiscal 2003 and fiscal 2004, the Company wasnotified by its Australian lender that these restrictions will be reduced oreliminated during fiscal 2005. Outstanding principal on the intercompany loan to Australia was $4.1million on October 30, 2004.

 

TheCompany is responsible for and pays workers’ compensation costs for its temporaryand regular employees and is self-insured for the deductible amount related toworkers’ compensation claims ($750,000 per claim for fiscal year 2004 and$500,000 per claim for fiscal 2003.) Each policy year the terms of the agreement with the insurance carrierare renegotiated.  The insurance carrierrequires the Company to collateralize its obligations through the use ofirrevocable standby letters of credit, surety bonds or cash.  At October 30, 2004, the Company had $22.3million of outstanding letters of credit to secure its domestic workerscompensation obligations.  During fiscal2004, the Company was cash collateralizing its fiscal 2004 policy year throughpayments totaling $13.8 million.  Duringthe fourth quarter of fiscal 2004, the Company and its insurance carriernegotiated the return of this cash collateral and the Company issued $9.8million of letters of credit in its place.

 

TheCompany recently completed negotiations for its 2005 policy year insuranceprogram.  Total payments of $20.6 millionwill be paid in monthly installments, which commenced on November 1, 2004, inthe amounts of $2.7 million for the first three installments and $1.4 millionfor the remaining nine installments.  Ofthese payments, $15.8 million will serve to cash collateralize the Company’sfiscal 2005 obligations in lieu of issuance of additional letters ofcredit.  Cash payments for 2005 policyyear claims will be paid out of this cash collateral fund.  The Company will also make ongoing cashpayments for claims for all other open policy years except 2003, which is fullyfunded although subject to annual retroactive premium adjustments based onactual claims activity.

 

Inaddition to its outstanding letters of credit, the Company has an outstandingfinancial guarantee bond that secures a portion of its workers’ compensationpremium and deductible obligations.  Thesurety bond was $9.8 million at the end of fiscal 2003 and has been reduced to$3.8 million as of the end of fiscal 2004. Based upon the terms of the 2005 policy agreement with its insurancecarrier, the Company anticipates eliminating the surety bond during the thirdquarter of fiscal 2005.

 

Asnoted above in Results of Operations for the fiscal year 2004, the Companyreceived an unfavorable arbitration ruling relating to a contract dispute withone of its vendors.  Payments of $0.9million for the award plus remaining related attorneys’ fees were paid duringthe first quarter of fiscal 2005.

 

Duringthe first quarter of fiscal 2005, the Company received $0.5 million of domesticfederal income tax refunds relating to carryback provisions.

 

The Company continues toevaluate other opportunities to further strengthen its financial position.  However, the Company believes that theadditional borrowing capacity provided under the amended credit agreement,together with cash generated through its improving operating performance, willbe sufficient to meet the Company’s working capital needs for the foreseeablefuture.

 

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# **Off-BalanceSheet Arrangements**

# ** **

None.

 

# **ContractualObligations**

# ** **

The following summarizesthe Company’s contractual cash obligations in future fiscal years (in millions)as of October 30, 2004:

 
| ** **                                   | ** ** | **Payment Due by Period (1)** | ** ** |
|----------------------------------------------|------------|-------------------------------|------------|
| **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                           |       | $                             | 15.7       |   | $ | 15.7 |   |   |   |   |   |   |   |
| Promissory note                              |       | 2.0                           |       |   |   | $ | 2.0 |   |   |   |   |   |
| Operating leases                             |       | 11.3                          |       | 4.0 |   | 2.6 |   | $ | 1.7 |   | $ | 1.4 |   |
| Workers’  compensation policy year 2005 |       | 20.6                          |       | 20.6 |   |   |   |   |   |   |   |
| Capital lease                                |       | 0.6                           |       | 0.5 |   | 0.1 |   |   |   |   |   |
| Total  Contractual Obligations               |       | $                             | 50.2       |   | $ | 40.8 |   | $ | 4.7 |   | $ | 1.7 |   | $ | 1.4 |   |

 

----

(1) The credit agreementexpires in May 2007, but the Company’s lenders could require acceleratedpayment of amounts outstanding under the credit facilities in the event ofdefault on one or more of the debt covenants contained therein.  Payments under the promissory note are subjectto certain restrictions regarding borrowing capacity and compliances within theCompany’s senior secured credit facilities. Workers’ compensation obligations for policy year 2005 are based onestimates.  If actual results differ fromthese estimates the Company could be required to make additional payments to,or receive refunds from, its insurance carrier in years subsequent to 2005.

 

ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK.

 

The Company is exposed tocertain market risks from transactions that are entered into during the normalcourse of business.  The Company’sprimary market risk exposure relates to interest rate risk.  At October 30, 2004, the Company’soutstanding debt under variable-rate interest borrowings was approximately$17.7 million.  A change of 2% in theinterest rates would cause a change in interest expense of approximately $0.2million on an annual basis.  TheCompany’s exposure to market risk for changes in interest rates is notsignificant with respect to interest income, as its investment portfolio is notmaterial to its consolidated balance sheet. The Company currently has no plans to hold an investment portfolio thatincludes derivative financial instruments.

 

For the fiscal year endedOctober 30, 2004, the Company’s international operations comprised 23.4% of itsrevenue and, as of the end of that period, 21.9% of its total assets.  The Company is exposed to foreign currencyrisk primarily due to its investments in foreign subsidiaries.  The Company’s multicurrency credit facility,which allows the Company’s Australia and United Kingdom subsidiaries to borrowin local currencies, partially mitigates the exchange rate risk resulting fromfluctuations in foreign currency denominated net investments in thesesubsidiaries in relation to the U.S. dollar. The Company does not currently hold any market risk sensitiveinstruments entered into for hedging transaction risks related to foreigncurrencies.  In addition, the Company hasnot entered into any transactions with derivative financial instruments fortrading purposes.

 

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

 

The Financial Statementsand Supplementary Data of the Company required by this Item are set forth atthe pages indicated at Item 15(a).

 

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING ANDFINANCIAL DISCLOSURE.

 

None.

 

24

----

 

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

### ** **

The Company carried outan evaluation, under the supervision and with the participation of the Company’smanagement, including the Chief Executive Officer and Chief Financial Officer,of the effectiveness of the design and operation of the Company’s “disclosurecontrols and procedures” (as defined under Rules 13a – 15(e) and 15d – 15(e)under the Securities Exchange Act of 1934 as amended).  Based on this evaluation, the Chief ExecutiveOfficer and Chief Financial Officer concluded that, as of October 30, 2004 (theend of the period covered by this report) the Company’s disclosure controls andprocedures are effective in timely alerting them to material informationrequired to be included in this report. There was no change in the Company’s internal control over financialreporting that occurred during the fiscal period ended October 30, 2004, thathas materially affected, or is reasonably likely to materially affect, theCompany’s internal controls over financial reporting.

 

ITEM 9B. OTHER INFORMATION.

 

None.

 

## **PARTIII**

## ** **

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THEREGISTRANT.

 

Theinformation required by this Item is incorporated herein by reference to theCompany’s Proxy Statement for the 2005 Annual Meeting of Stockholders.Information required by this item as to the executive officers of the Companyis included as Item 4A of Part I of this Annual Report on Form 10-K aspermitted by Instruction 3 to Item 401(b) of Regulation S-K.  The Company has adopted a Code of Ethics thatapplies to all the Company’s principal executive, financial and accountingofficers. The Code of Ethics is posted on the Company website atwww.westaff.com. The Company intends to satisfy the requirements under Item5.05 of Form 8-K regarding disclosure of amendments to, or waivers from,provisions of its Code of Ethics that apply, by posting such information on theCompany’s website. Copies of the Code of Ethics will be provided, free ofcharge, upon written request directed to Investor Relations, Westaff, Inc.,P.O. Box 9280, Walnut Creek, CA 94598.

 

ITEM 11. EXECUTIVE COMPENSATION.

 

Theinformation required by this Item is incorporated herein by reference to theCompany’s Proxy Statement for the 2005 Annual Meeting of Stockholders.

 

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERSAND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.

 

Theinformation required by this Item is incorporated herein by reference to theCompany’s Proxy Statement for the 2005 Annual Meeting of Stockholders.

 

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

 

SeeNote 7 of “Notes to Consolidated Financial Statements” under Item 15 of thisForm 10-K. The information required by this Item is incorporated herein byreference to the Company’s Proxy Statement for the 2005 Annual Meeting ofStockholders.

 

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.

 

Theinformation required by this Item is incorporated herein by reference to theCompany’s Proxy Statement for the 2005 Annual Meeting of Stockholders.

 

## **PARTIV**

## ** **

ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.

 

(a)The following documents have been filed as a part of this Annual Report on Form10-K.

 
| 1.     | Financial Statements                                                                                                       |   |
|--------|----------------------------------------------------------------------------------------------------------------------------|--------|
|   | Report  of Independent Registered Public Accounting Firm                                                                   |   |
|   | Consolidated  Balance Sheets—As of the Fiscal Year Ended October 30, 2004 and the Fiscal  Year Ended November 1, 2003 |   |

 

25

----

 
|   | Consolidated  Statements of Operations—For Each of the Three Years in the Period Ended  October 30, 2004                                                                              |   |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|   | Consolidated  Statements of Stockholders’ Equity—For Each of the Three Years in the Period  Ended October 30, 2004                                                               |   |
|   | Consolidated  Statements of Cash Flows—For Each of the Three Years in the Period Ended  October 30, 2004                                                                              |   |
|   | Notes to  Consolidated Financial Statements                                                                                                                                                |   |
|   |                                                                                                                                                                                       |
| 2.     | Financial Statement Schedules.                                                                                                                                                             |
|   | All schedules are omitted because they are not  applicable or not required or because the required information is included in  the Consolidated Financial Statements or the Notes thereto. |
|   |                                                                                                                                                                                       |
| 3.     | Exhibits.  The  following 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. (7)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 3.2.4               |       | Amended and Restated  Bylaws, effective March 1, 2004. (12)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 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. (9)                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 10.3.5.2            |       | Second Amendment to  Employment Contract By and Between Westaff Support, Inc. and Dirk A.  Sodestrom. (13)                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.3.8              |       | Employment Agreement  between the Company and Dwight S. Pedersen. (5)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 10.3.8.1            |       | Notice of Grant to  Dwight S. Pedersen of Stock Option (Incentive) with Exhibit A, Stock Option  Agreement. (15)                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.3.8.2            |       | Notice of Grant to  Dwight S. Pedersen of Stock Option (Non-Statutory) with Exhibit A, Stock  Option Agreement. (15)                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.3.8.3            |       | First Amendment to  Employment Contract By and Among Westaff Support, Inc., Westaff, Inc. and  Dwight S. Pedersen. (9)                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.3.8.4            |       | Second Amendment to  Employment Agreement By and Among Westaff Support, Inc., Westaff, Inc. and  Dwight S. Pedersen. (13)                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.3.8.5            |       | Third Amendment to  Employment Agreement By and Among Westaff Support, Inc., Westaff, Inc. and  Dwight S. Pedersen. (15)                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 10.3.8.6            |       | 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 23rd February 2004 between the Company and the  Employee. |
| 10.7                |       | Westaff, Inc. 1996  Stock Option/Stock Issuance Plan, as amended and restated. (4)                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.8.20             |       | Credit Agreement dated  as of May 17, 2002. (6)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.8.20.1           |       | First Amendment to  Multicurrency Credit Agreement, Limited Waiver and Consent of Guarantors. (8)                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.8.20.2           |       | Second Amendment to  Multicurrency Credit Agreement, Limited Waivers and Consent of Guarantors.  (9)                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.8.20.3           |       | Third Amendment to  Multicurrency Credit Agreement, Limited Waiver and Consent of Guarantors.  (10)                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.8.20.4           |       | Fourth Amendment to  Multicurrency Credit Agreement, Limited Waivers and Consent of Guarantors.  (11)                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 10.8.20.5           |       | Fifth Amendment to  Multicurrency Credit Agreement and Consent of Guarantors. (13)                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.8.20.6           |       | Sixth Amendment to  Multicurrency Credit Agreement and Consent of Guarantors. (16)                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.8.21             |       | Deed of Trust, Absolute  Assignment of Leases and Rents, Security Agreement and Fixture Filing  effective as of May 17, 2002. (6)                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.8.22             |       | Pledge Agreement dated  as of May 17, 2002. (6)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.8.23             |       | Security Agreement  dated as of May 17, 2002. (6)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.8.24             |       | Parent Guaranty dated  as of May 17, 2002. (6)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 10.8.25             |       | Subsidiary Guaranty  dated as of May 17, 2002. (6)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |

 

26

----

 
| 10.8.26 |   | Amended and Restated  Unsecured Subordinated Noted dated May 17, 2002. (6)                                                                              |
|---------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.8.27 |   | Unsecured Subordinated  Draw Down Note dated September 25, 2003. (10)                                                                                   |
| 10.11   |   | Westaff, Inc. Employee  Stock Purchase Pan. (4)                                                                                                         |
| 10.11.3 |   | International Employee  Stock Purchase Plan. (4)                                                                                                        |
| 10.12   |   | Westaff Key Employee  Transition Compensation Plan. (14)                                                                                                |
| 10.13   |   | Form of Employment  Contract with Certain Named Executive Officers. (4)                                                                                 |
| 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. |

 

----

(1)                                  Incorporatedherein by reference to the exhibit with the same number filed with the Company’sRegistration Statement on Form S-1 (File No. 33-85536) declared effective bythe Securities and Exchange Commission on April 30, 1996.

 

(2)                                  Incorporatedherein by reference to the exhibit with the same number filed with the Company’sAnnual Report on Form 10-K for the fiscal year ended October 31, 1998.

 

(3)                                  Incorporatedherein by reference to the exhibit with the same number filed with the Company’sAnnual Report on Form 10-K for the fiscal year ended October 28, 2000.

 

(4)                                  Incorporatedherein by reference to the exhibit with the same number filed with the Company’sAnnual Report on Form 10-K for the fiscal year ended November 3, 2001.

 

(5)                                  Incorporatedherein by reference to the exhibit with the same number filed with the Company’sQuarterly Report on Form 10-Q for the quarter ended January 26, 2002.

 

(6)                                  Incorporatedherein by reference to the exhibit with the same number filed with the Company’sQuarterly Report on Form 10-Q for the quarter ended April 20, 2002.

 

(7)                                  Incorporatedherein by reference to the exhibit with the same number filed with the Company’sQuarterly Report on Form 10-Q for the quarter ended July 13, 2002.

 

(8)                                  Incorporatedherein by reference to the exhibit with the same number filed with the Company’sAnnual Report on Form 10-K for the fiscal year ended November 2, 2002.

 

(9)                                  Incorporatedherein by reference to the exhibit with the same number filed with the Company’sQuarterly Report on Form 10-Q for the quarter ended July 12, 2003.

 

(10)                            Incorporatedherein by reference to the exhibit with the same number filed with the Company’sAnnual Report on Form 10-K for the fiscal year ended November 1, 2003.

 

(11)                            Incorporatedherein by reference to the exhibit with the same number filed with the Company’sQuarterly Report on Form 10-Q for the quarter ended January 24, 2004.

 

(12)                            Incorporatedherein by reference to the exhibit with the same number filed with the Company’sCurrent Report on Form 8-K dated March 1, 2004.

 

(13)                            Incorporatedherein by reference to the exhibit with the same number filed with the Company’sQuarterly Report on Form 10-Q for the quarter ended July 10, 2004.

 

(14)                            Incorporatedherein by reference to the exhibit with the same number filed with the Company’sCurrent Report on Form 8-K dated September 20, 2004.

 

(15)                            Incorporatedherein by reference to the exhibit with the same number filed with the Company’sCurrent Report on Form 8-K dated October 4, 2004.

 

27

----

 

(16)                            Incorporatedherein by reference to the exhibit with the same number filed with the Company’sCurrent Report on Form 8-K dated January 5, 2005.

 

28

----

 

REPORT OF INDEPENDENTREGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Stockholders of Westaff, Inc.

 

We have audited the accompanying consolidated balance sheets ofWestaff, Inc. and subsidiaries (the Company) as of October 30, 2004 andNovember 1, 2003, and the related consolidated statements of operations,stockholders’ equity, and cash flows for each of the three years in the periodended October 30, 2004.  These financialstatements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the PublicCompany Accounting Oversight Board (United States).  Those standards require that we plan andperform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting theamounts and disclosures in the financial statements.  An audit also includes assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

In our opinion, such consolidated financial statements present fairly,in all material respects, the financial position of the Company as of October30, 2004 and November 1, 2003, and the results of their operations and theircash flows for each of the three years in the period ended October 30, 2004, inconformity with accounting principles generally accepted in the United Statesof America.

 

As discussed in Note 5, effective November 3, 2002 the Company changedits method of accounting for goodwill and other intangibles to conform toStatement of Financial Accounting Standards No. 142, Goodwill and OtherIntangible Assets.

 

 

DELOITTE & TOUCHE LLP

 

Oakland, California

January 26, 2005

 

F-1

----

 

**Westaff, Inc.**

** **

**Consolidated Statements of Operations**

**(Amounts in thousands except per share amounts)**

 
| ** **                                                                                                                                 | ** ** | **October 30,** | ** ** | **November 1,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|------------|-----------------|------------|
| ** **                                                                                                                                 | ** ** | **2004**        | ** ** | **2003**        | ** ** |
| **ASSETS**                                                                                                                                 |       |            |       |            |       |
| Current assets:                                                                                                                            |       |            |       |            |       |
| Cash and cash  equivalents                                                                                                                 |       | $               | 6,993      |            | $          | 4,759 |   |
| Trade accounts  receivable, less allowance for doubtful accounts of $1,124 and $1,067                                                      |       | 84,712          |       | 74,564          |       |
| Income taxes  receivable                                                                                                                   |       | 847             |       | 536             |       |
| Deferred income  taxes                                                                                                                     |       | 286             |       |            |       |
| Prepaid expenses                                                                                                                           |       | 4,530           |       | 2,833           |       |
| Other current  assets                                                                                                                      |       | 877             |       | 1,741           |       |
| Total current  assets                                                                                                                      |       | 98,245          |       | 84,433          |       |
|                                                                                                                                       |       |            |       |            |       |
| Property and  equipment, net                                                                                                               |       | 10,184          |       | 12,569          |       |
| Goodwill                                                                                                                                   |       | 11,760          |       | 11,687          |       |
| Other long-term assets                                                                                                                     |       | 2,219           |       | 4,458           |       |
|                                                                                                                                       |       | $               | 122,408    |            | $          | 113,147 |   |
|                                                                                                                                       |       |            |       |            |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                             |       |            |       |            |       |
| Current  liabilities:                                                                                                                      |       |            |       |            |       |
| Borrowings under  revolving credit facilities                                                                                              |       | $               | 15,734     |            | $          | 25,410 |   |
| Current portion  of capital lease obligations                                                                                              |       | 465             |       | 432             |       |
| Accounts payable                                                                                                                           |       | 2,731           |       | 2,013           |       |
| Accrued expenses                                                                                                                           |       | 44,944          |       | 34,086          |       |
| Income taxes  payable                                                                                                                      |       | 632             |       | 626             |       |
| Net liabilities  of discontinued operations                                                                                                |       | 225             |       | 629             |       |
| Total current  liabilities                                                                                                                 |       | 64,731          |       | 63,196          |       |
|                                                                                                                                       |       |            |       |            |       |
| Note payable to  related party                                                                                                             |       | 2,000           |       | 2,000           |       |
| Long-term  capital lease obligations                                                                                                       |       | 125             |       | 590             |       |
| Other long-term  liabilities                                                                                                               |       | 15,705          |       | 11,905          |       |
| Total  liabilities                                                                                                                         |       | 82,561          |       | 77,691          |       |
|                                                                                                                                       |       |            |       |            |       |
| Commitments and  contingencies (Notes 2, 14 and 16)                                                                                        |       |            |       |            |       |
|                                                                                                                                       |       |            |       |            |       |
| Stockholders’  equity:                                                                                                                |       |            |       |            |       |
| Preferred stock,  $.01 par value; authorized and unissued: 1,000 shares                                                                    |       |            |       |            |       |
| Common stock,  $.01 par value; authorized: 25,000 shares; issued: 16,047 shares at October  30, 2004 and 16,015 shares at November 1, 2003 |       | 160             |       | 160             |       |
| Additional  paid-in capital                                                                                                                |       | 36,768          |       | 36,706          |       |
| Retained  earnings (accumulated deficit)                                                                                                   |       | 3,025           |       | (448            | )          |
| Accumulated  other comprehensive loss                                                                                                      |       | (106            | )          | (962            | )          |
| Total  stockholders’ equity                                                                                                           |       | 39,847          |       | 35,456          |       |
|                                                                                                                                       |       | $               | 122,408    |            | $          | 113,147 |   |

 

See accompanying notes toconsolidated financial statements.

 

F-2

----

 

**Westaff, Inc.**

** **

**Consolidated Statements ofOperations**

**(Amounts in thousands except per share amounts)**

** **
| ** **                                                                                                             | ** ** | **Fiscal year ended**   | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                                                             | ** ** | **October 30,****2004** | ** ** | **November 1,****2003** | ** ** | **November 2,****2002** | ** ** |
|                                                                                                                   |       |                    |       |   |   |   |   |
| Revenue                                                                                                                |       | $                       | 601,476    |   | $ | 530,299 |   | $ | 515,253 |   |
|                                                                                                                   |       |                    |       |   |   |   |   |
| Costs of  services                                                                                                     |       | 499,630                 |       | 439,801 |   | 419,932 |   |
|                                                                                                                   |       |                    |       |   |   |   |   |
| Gross profit                                                                                                           |       | 101,846                 |       | 90,498 |   | 95,321 |   |
|                                                                                                                   |       |                    |       |   |   |   |   |
| Franchise  agents’ share of gross profit                                                                          |       | 18,494                  |       | 16,599 |   | 15,409 |   |
| Selling and  administrative expenses                                                                                   |       | 72,155                  |       | 70,286 |   | 75,537 |   |
| Depreciation and  amortization                                                                                         |       | 4,474                   |       | 5,500 |   | 6,601 |   |
| Impairment of  intangible assets                                                                                       |       |                    |       |   |   | 116 |   |
| Arbitration  expenses (Note 16)                                                                                        |       | 1,058                   |       | 950 |   | (693 | ) |
| Restructuring  charges (Note 4)                                                                                        |       |                    |       |   |   | 1,896 |   |
|                                                                                                                   |       |                    |       |   |   |   |   |
| Operating income  (loss) from continuing operations                                                                    |       | 5,665                   |       | (2,837 | ) | (3,545 | ) |
|                                                                                                                   |       |                    |       |   |   |   |   |
| Interest expense                                                                                                       |       | 2,209                   |       | 1,762 |   | 2,343 |   |
| Interest income                                                                                                        |       | (106                    | )          | (186 | ) | (387 | ) |
|                                                                                                                   |       |                    |       |   |   |   |   |
| Income (loss)  from continuing operations before income taxes and cumulative effect of  change in accounting principle |       | 3,562                   |       | (4,413 | ) | (5,501 | ) |
| Provision  (benefit) for income taxes                                                                                  |       | 239                     |       | 361 |   | (4,070 | ) |
|                                                                                                                   |       |                    |       |   |   |   |   |
| Income (loss)  from continuing operations before cumulative effect of change in accounting  principle                  |       | 3,323                   |       | (4,774 | ) | (1,431 | ) |
|                                                                                                                   |       |                    |       |   |   |   |   |
| Income from  discontinued operations                                                                                   |       | 150                     |       | 316 |   |   |   |
| Cumulative  effect of change in accounting principle                                                                   |       |                    |       | (670 | ) |   |   |
| Net income  (loss)                                                                                                     |       | $                       | 3,473      |   | $ | (5,128 | ) | $ | (1,431 | ) |
|                                                                                                                   |       |                    |       |   |   |   |   |
| Earnings (loss)  per share - basic and diluted                                                                         |       |                    |       |   |   |   |   |
|                                                                                                                   |       |                    |       |   |   |   |   |
| Continuing  operations before cumulative effect of change in accounting principle                                      |       | $                       | 0.21       |   | $ | (0.30 | ) | $ | (0.09 | ) |
| Discontinued  operations                                                                                               |       | $                       | 0.01       |   | $ | 0.02 |   | $ | — |   |
| Cumulative  effect of change in accounting principle                                                                   |       | $                       | —     |   | $ | (0.04 | ) | $ | — |   |
|                                                                                                                   |       |                    |       |   |   |   |   |
| Net income  (loss)                                                                                                     |       | $                       | 0.22       |   | $ | (0.32 | ) | $ | (0.09 | ) |
|                                                                                                                   |       |                    |       |   |   |   |   |
| Weighted average  shares outstanding - basic                                                                           |       | 16,033                  |       | 15,996 |   | 15,945 |   |
| Weighted average  shares outstanding - diluted                                                                         |       | 16,081                  |       | 15,996 |   | 15,945 |   |

 

See accompanying notes toconsolidated financial statements.

 

F-3

----

 

**Westaff, Inc.**

** **

**Consolidated Statements ofStockholders’ Equity**

**(Amounts in thousands)**

** **
| ** **                                               | ** ** | ** **        | ** ** | ** **  | ** ** | ** **     | ** ** | ** **                 | ** ** | **Accumulated**     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------------------------|------------|-------------------|------------|-------------|------------|----------------|------------|----------------------------|------------|---------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                               | ** ** | ** **        | ** ** | ** **  | ** ** | **Additional** | ** ** | **Retained**               | ** ** | **other**           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                               | ** ** | **Common  stock** | ** ** | **paid-in** | ** ** | **earnings**   | ** ** | **comprehensive**          | ** ** | **Treasury  stock** | ** ** | ** ** | ** ** |
| ** **                                               | ** ** | **Shares**        | ** ** | **Amount**  | ** ** | **capital**    | ** ** | **(accumulated  deficit)** | ** ** | **loss**            | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Total**  | ** ** |
| ** **                                               | ** ** | ** **        | ** ** | ** **  | ** ** | ** **     | ** ** | ** **                 | ** ** | ** **          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balance at  November 3, 2001                             |       | 15,948            |       | $           | 159        |           | $          | 36,582                     |       | $                   | 6,209      |       | $          | (3,301     | )          | 34         |       | $ | (157 | ) | $ | 39,492 |   |
| Comprehensive  loss:                                     |       |              |       |        |       |           |       |                       |       |                |       |       |       |       |       |       |       |
| Net loss                                                 |       |              |       |        |       |           |       | (1,431                     | )          |                |       |       |       |       |       |       |       |
| Currency  translation adjustments                        |       |              |       |        |       |           |       |                       |       | 784                 |       |       |       |       |       |       |       |
| Total  comprehensive loss                                |       |              |       |        |       |           |       |                       |       |                |       |       |       |       |       | (647       | )          |
| Purchase of  treasury stock                              |       |              |       |        |       |           |       |                       |       |                |       | 5          |       | (13        | )          | (13        | )          |
| Stock issued  under employees’ stock purchase plans |       | 24                |       | 1           |       | 45             |       | (98                        | )          |                |       | (39        | )          | 170        |       | 118        |       |
|                                                     |       |              |       |        |       |           |       |                       |       |                |       |       |       |       |       |       |       |
| Balance at  November 2, 2002                             |       | 15,972            |       | 160         |       | 36,627         |       | 4,680                      |       | (2,517              | )          |       |       |       |       | 38,950     |       |
| Comprehensive  loss:                                     |       |              |       |        |       |           |       |                       |       |                |       |       |       |       |       |       |       |
| Net loss                                                 |       |              |       |        |       |           |       | (5,128                     | )          |                |       |       |       |       |       |       |       |
| Currency  translation adjustments                        |       |              |       |        |       |           |       |                       |       | 1,555               |       |       |       |       |       |       |       |
| Total  comprehensive loss                                |       |              |       |        |       |           |       |                       |       |                |       |       |       |       |       | (3,573     | )          |
| Stock issued  under employees’ stock purchase plans |       | 43                |       |        |       | 79             |       |                       |       |                |       |       |       |       |       | 79         |       |
|                                                     |       |              |       |        |       |           |       |                       |       |                |       |       |       |       |       |       |       |
| 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 employees’ stock purchase plans |       | 32                |       |        |       | 62             |       |                       |       |                |       |       |       |       |       | 62         |       |
|                                                     |       |              |       |        |       |           |       |                       |       |                |       |       |       |       |       |       |       |
| Balance at  October 30, 2004                             |       | 16,047            |       | $           | 160        |           | $          | 36,768                     |       | $                   | 3,025      |       | $          | (106       | )          | —     |       | $ | — |   | $ | 39,847 |   |
|                                                          |            |                   |            |             |            |                |            |                            |            |                     |            |            |            |            |            |            |            |  |  |  |  |  |  |  |  |  |  |

 

See accompanying notes toconsolidated financial statements.

 

F-4

----

** **

**Westaff, Inc.**

** **

**Consolidated Statements of CashFlows**

**(Amounts in thousands)**

 
| ** **                                                                                        | ** ** | **Fiscal year ended** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                        | ** ** | **October 30,**       | ** ** | **November 1,** | ** ** | **November 2,** | ** ** |
| ** **                                                                                        | ** ** | **2004**              | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Cash  flows from operating activities**                                                         |       |                  |       |   |   |   |   |
| Net income  (loss)                                                                                |       | $                     | 3,473      |   | $ | (5,128 | ) | $ | (1,431 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided (used) by operating  activities: |       |                  |       |   |   |   |   |
| Income from  discontinued operations                                                              |       | (150                  | )          | (316 | ) |   |   |
| Cumulative  effect of change in accounting principle                                              |       |                  |       | 670 |   |   |   |
| Loss on  impairment of intangible assets                                                          |       |                  |       |   |   | 116 |   |
| Depreciation and  amortization                                                                    |       | 4,474                 |       | 5,500 |   | 6,601 |   |
| Provision for  losses on doubtful accounts                                                        |       | 1,168                 |       | 639 |   | 1,703 |   |
| Deferred income  taxes                                                                            |       | (278                  | )          |   |   | 1,350 |   |
| Income from  sales of affiliate operations                                                        |       | (25                   | )          | (128 | ) | (197 | ) |
| (Gain) loss on  sale or disposal of assets                                                        |       | (657                  | )          | 51 |   | 193 |   |
| Other                                                                                             |       | (198                  | )          | (268 | ) | 60 |   |
| Changes in  assets and liabilities:                                                               |       |                  |       |   |   |   |   |
| Trade accounts  receivable                                                                        |       | (9,209                | )          | (3,221 | ) | (737 | ) |
| Other assets                                                                                      |       | 133                   |       | (4,541 | ) | (5,259 | ) |
| Accounts payable  and accrued expenses                                                            |       | 15,089                |       | 1,499 |   | 50 |   |
| Income taxes  payable                                                                             |       | (11                   | )          | (179 | ) | 201 |   |
| Other  liabilities                                                                                |       | 268                   |       | 145 |   | 1,455 |   |
| Net cash  provided (used) by continuing operations                                                |       | 14,077                |       | (5,277 | ) | 4,105 |   |
| Net cash (used)  provided by discontinued operations                                              |       | (254                  | )          | 340 |   | 413 |   |
| Net cash  provided (used) by operating activities                                                 |       | 13,823                |       | (4,937 | ) | 4,518 |   |
| **Cash  flows from investing activities**                                                         |       |                  |       |   |   |   |   |
| Capital  expenditures                                                                             |       | (3,369                | )          | (2,593 | ) | (2,089 | ) |
| Payments for  intangibles                                                                         |       | (4                    | )          |   |   | (223 | ) |
| Proceeds from  sales of affiliate operations                                                      |       | 41                    |       | 328 |   | 1,258 |   |
| Proceeds from  sales of assets                                                                    |       | 1,945                 |       | 7,386 |   | 21 |   |
| Other, net                                                                                        |       | (166                  | )          | 48 |   | 241 |   |
| Net cash (used)  provided by investing activities                                                 |       | (1,553                | )          | 5,169 |   | (792 | ) |
| **Cash  flows from financing activities**                                                         |       |                  |       |   |   |   |   |
| Net (repayments)  borrowings under line of credit agreements                                      |       | (9,903                | )          | 5,008 |   | 19,551 |   |
| Proceeds from  issuance of notes payable to related parties                                       |       | 1,000                 |       |   |   | 3,000 |   |
| Payments of notes  payable to related parties                                                     |       | (1,000                | )          | (1,000 | ) |   |   |
| Proceeds from  issuance of long-term debt                                                         |       |                  |       |   |   | 5,000 |   |
| Principal  payments on long-term debt and capital lease obligations                               |       | (432                  | )          | (4,848 | ) | (30,500 | ) |
| Payment of debt  issuance costs                                                                   |       | (178                  | )          | (362 | ) | (1,987 | ) |
| Issuance of  common stock                                                                         |       | 63                    |       | 79 |   | 118 |   |
| Purchase of  common stock                                                                         |       |                  |       |   |   | (13 | ) |
| Net cash used by  financing activities                                                            |       | (10,450               | )          | (1,123 | ) | (4,831 | ) |
| Effect of  exchange rate changes on cash                                                          |       | 414                   |       | 166 |   | 146 |   |
| Net change in  cash and cash equivalents                                                          |       | 2,234                 |       | (725 | ) | (959 | ) |
| Cash and cash  equivalents at beginning of year                                                   |       | 4,759                 |       | 5,484 |   | 6,443 |   |
| Cash and cash  equivalents at end of year                                                         |       | $                     | 6,993      |   | $ | 4,759 |   | $ | 5,484 |   |
| ** **                                                                                        |       |                  |       |   |   |   |   |
| **Supplemental  disclosures of cash flow information**                                            |       |                  |       |   |   |   |   |
| Cash paid during  the year for:                                                                   |       |                  |       |   |   |   |   |
| Interest                                                                                          |       | $                     | 1,481      |   | $ | 1,252 |   | $ | 3,101 |   |
| Income taxes  paid (refunded), net                                                                |       | 786                   |       | (4,220 | ) | (1,949 | ) |
|                                                                                              |       |                  |       |   |   |   |   |
| **Supplemental  schedule of noncash investing and financing activities:**                         |       |                  |       |   |   |   |   |
| Equipment  purchased with capital leases                                                          |       |                  |       | $ | 1,369 |   |   |   |

 

See accompanying notes toconsolidated financial statements.

 

F-5

----

 

**Westaff, Inc.**

** **

**Notes to Consolidated FinancialStatements**

**(Amounts in thousands except per share amounts)**

 

**1.****              Basis ofPresentation**

 

**Basis ofpresentation**

Westaff, Inc. (theParent), a Delaware corporation, and its domestic and foreign subsidiaries(together, the Company), provide temporary staffing services in the United States,the United Kingdom, Denmark, Australia, New Zealand and Norway.  The consolidated financial statements includethe accounts of the Parent and its domestic and foreign subsidiaries.  Intercompany accounts and transactions havebeen eliminated.

 

**Translationof foreign currencies**

The functionalcurrency for each of the Company’s foreign operations is the applicable localcurrency.  All assets and liabilitiesthat are denominated in foreign currencies are translated into U.S. dollars atexchange rates as of the date of the balance sheet and all revenue and expenseaccounts are translated using weighted average exchange rates for the periodspresented.  Translation adjustments andgains or losses on intercompany loans that are of a long-term investment natureare included as a separate component of stockholders’ equity. Aggregatetransaction gains included in determining income (loss) from continuingoperations were $182, $221 and $251 for fiscal years 2004, 2003 and 2002,respectively, and are included in selling and administrative expenses.

 

**Discontinuedoperations**

During fiscal year1999, the Company sold its medical business, primarily operated through WesternMedical Services, Inc. (Western Medical), a wholly-owned subsidiary of theCompany (see Note 3).  As a result, theCompany has classified its medical operations as discontinued operations and,accordingly, has segregated the net liabilities of the discontinued operationsin the Consolidated Financial Statements and notes thereto.

 

**2.****              Summary of SignificantAccounting Policies**

 

**Fiscalyear**

The Company’sfiscal year is a 52 or 53 week period ending the Saturday nearest the end ofOctober.  Fiscal years 2004, 2003 and2002 each include 52 weeks.  For interimreporting purposes, the first three fiscal quarters comprise 12 weeks eachwhile the fourth fiscal quarter consists of 16 or 17 weeks.

 

**Accountingestimates**

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 coulddiffer from those estimates.

 

**Fairvalue of financial instruments**

The carryingamounts of cash, accounts receivable, accounts payable and all other accruedexpenses approximate fair value at October 30, 2004 and November 1, 2003 becauseof the short maturity of these items. The fair value of the Company’s debt instruments approximates thecarrying value as of October 30, 2004 and November 1, 2003 based on currentrates available to the Company for debt with similar terms.

 

**Cash andcash equivalents**

The Companyconsiders all investments with maturities at purchase of three months or lessto be cash equivalents.

 

**Concentrationsof credit risk**

The Company’sfinancial instruments that potentially subject the Company to concentrations ofcredit risk consist principally of trade receivables.  However, concentrations of credit risk arelimited due to the large number of customers comprising the Company’s customerbase and their dispersion across different business and geographic areas.  Furthermore, the Company routinely assessesthe financial strength of its customers.

 

**Revenuerecognition**

Revenue from the sale ofservices is recognized at the time the service is performed.  The Company maintains an allowance fordoubtful accounts on accounts receivable for estimated losses.  A portion of the Company’s revenue is derivedfrom affiliate operations which consist of franchise agent and licenseoperations.

 

F-6

----

 

Revenue generated byfranchise agents and related costs of services are included as part of theCompany’s consolidated revenue and costs of services, respectively, since theCompany has the direct contractual relationships with the customers, holdstitle to the related customer receivables and is the legal employer of thetemporary employees.  Franchise agentssales represented 28.4%, 26.4% and 24.1% of the Company’s total revenue forfiscal 2004, 2003 and 2002, respectively. The net distribution paid to the franchise agent for services renderedis based either on a percentage of sales or of the gross profit generated bythe franchise agent’s operation and is reflected as franchise agents’ share ofgross profit in the Consolidated Statements of Operations.

 

The Company also has alicensing program in which the licensee has the direct contractualrelationships with the customers, holds title to the related customerreceivables and is the legal employer of the temporary employees.  Accordingly, sales and costs of servicesgenerated by the license operation are not included in the Company’sconsolidated financial statements.  TheCompany advances funds to licensees for payroll, payroll taxes, insurance andother related items. Fees are paid to the Company based either on a percentageof sales or of gross profit generated by the licensee and such license fees arerecorded by the Company as license fees and included in revenue.  Advances to licensees are secured by a pledgeof the licensee’s trade receivables, tangible and intangible assets and the licenseagreement. Advances due from licensees bear interest at prime plus two percentbut only to the extent the aggregate advances exceed the amount of qualifiedtrade receivables securing the outstanding advances.  Under the terms of a lockbox arrangement betweenthe Company and its licensees, the advances are reduced as remittances arereceived related to licensees’ trade accounts receivable.  Licensees have pledged trade receivables of$255 at October 30, 2004 and $229 at November 1, 2003, respectively, ascollateral for such advances. Sales generated by license offices (and excludedfrom the Company’s revenue) were $1,562, $4,417, and $6,102 for fiscal 2004,2003 and 2002, respectively. The Company currently has only one remaininglicensee and is 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 2004, 2003 and2002, respectively, therefore there is no recorded fee income of this typeincluded in the Consolidated Statements of Operations for those years.

 

**Allowance for doubtful accounts**

The Company records anallowance for doubtful accounts based on historical experience.  A summary of changes in the reserve forfiscal years 2004, 2003 and 2002 is as follows:

 
| **Fiscal Year Ended** | ** ** | **Balance at   Beginning of Year** | ** ** | **Additions   Charged to   Costs and Expenses** | ** ** | **Deductions** | ** ** | **Balance at   End of Year** | ** ** |
|-----------------------|------------|------------------------------------|------------|-------------------------------------------------|------------|----------------|------------|------------------------------|------------|
|                  |       |                               |       |                                            |       |           |       |                         |       |
| October 30, 2004      |       | $                                  | 1,067      |                                            | 1,075      |           | 1,018      |                         | $          | 1,124 |   |
|                  |       |                               |       |                                            |       |           |       |                         |       |
| November 1, 2003      |       | $                                  | 1,316      |                                            | 639        |           | 888        |                         | $          | 1,067 |   |
|                  |       |                               |       |                                            |       |           |       |                         |       |
| November 2, 2002      |       | $                                  | 1,260      |                                            | 1,510      |           | 1,454      |                         | $          | 1,316 |   |

 

**Property,plant and equipment**

Property, plantand equipment are stated at cost. Depreciation is computed using the straight-line method over theestimated useful lives of the related assets, which are twenty-five to thirty-oneyears for buildings and three to ten years for furniture and equipment.  Major improvements to leased office space arecapitalized and amortized over the shorter of their useful lives or the termsof the leases, generally three to five years. The Company capitalizes internal and external costs incurred in connectionwith developing or obtaining internal use software in accordance with Statementof Position (SOP) 98-1 “Accounting for the Costs of Computer Software Developedor Obtained for Internal Use.”

 

**Goodwill**

Effective November3, 2002, the Company adopted Statement of Financial Accounting Standards (SFAS)No. 142 “Goodwill and Other Intangible Assets”. SFAS No. 142 provides that goodwill and other intangible assets withindefinite lives are no longer amortized, but rather are evaluated forimpairment by applying a fair-value based test. During fiscal 2004 and fiscal 2003 the Company performed tests forimpairment in accordance with the new standard (see Note 5).  Prior to adoption of SFAS No. 142, theCompany’s management assessed the recoverability of its long-lived assets,including goodwill, under the provisions of SFAS

 

F-7

----

 

No.121 by determiningwhether the projected undiscounted future cash flows expected to result fromthe use of the asset were less than the carrying value of the asset.  In fiscal 2002, this assessment resulted in apre-tax goodwill impairment charge of $116.

 

**Long-livedassets**

Effective November 3,2002, the Company adopted SFAS No. 144, “Accounting for the Impairment orDisposal of Long-Lived Assets”.  TheCompany’s primary long-lived assets are property and equipment.  SFAS No. 144 requires a company to assess therecoverability of its long-lived assets whenever events and circumstancesindicate the carrying value of an asset or asset group may not be recoverablefrom estimated future cash flows expected to result from its use and eventualdisposition.  Additionally, the standardrequires expected future operating losses from discontinued operations to bedisplayed in discontinued operations in the period(s) in which the losses areincurred, rather than as of the measurement date.  No impairment charge has been recorded sincethe adoption of SFAS No. 144.

 

**Workers’compensation**

The Company self-insuresthe deductible amount related to workers’ compensation claims. The deductibleamount was $750 per claim for policy year 2004 and $500 per claim for policy years2003 and 2002.  The Company accrues theestimated costs of workers’ compensation claims based upon the expected lossrates within the various temporary employment categories provided by theCompany.  At least annually, the Companyobtains an independent actuarial valuation of the estimated costs of claimsincurred and reported and claims incurred but not reported and may adjust theaccruals based on the results of the valuations.  As of October 30, 2004 and November 1,2003, the workers’ compensation liabilities were $16,382 and $9,756,respectively, of which $11,900 at October 30, 2004 and $7,500 at November  1, 2003 are included in other long-term liabilitiesfor obligations which are not expected to be paid in the following fiscalyear.  In fiscal 2003, the Company wasrequired to fully fund its 2003 policy year workers’ compensation obligationsthrough cash deposits, which essentially offset the related accruals recordedfor that policy year.

 

The Company iscontractually required to collateralize its recorded obligations under theworkers’ compensation insurance contracts with Travelers Indemnity Companythrough cash, irrevocable letters of credit or surety bonds.  During fiscal 2004, the Company was cashcollateralizing its fiscal 2004 policy year through payments totaling$13,779.  In the fourth quarter of fiscal2004, Travelers returned the cash collateral and the Company issued $9,779 ofadditional letters of credit in its place. As of October 30, 2004, the aggregate collateral requirements weresatisfied through $22,311 of letters of credit and a $3,843 million suretybond.

 

**Incometaxes**

The Companyrecords income taxes using an asset and liability approach that requires therecognition of deferred tax assets and liabilities for the expected future taxconsequences of events that have been recognized in the Company’s financialstatements or tax returns.  A valuationallowance is established when it is more likely than not that a deferred taxasset is not realizable in the foreseeable future.  In estimating future tax consequences, theCompany generally considers all expected future events other than enactments ofchanges in the tax law or rates.

 

**Accountingfor stock-based compensation**

The Company measurescompensation cost for employee stock options and similar equity instrumentsusing the intrinsic value-based method of accounting prescribed by AccountingPrinciples Board Opinion No. 25, “Accounting for Stock Issued to Employees”(APB 25), and follows the disclosure-only provisions ofSFAS No. 123, “Accounting for Stock-Based Compensation”, as amended by SFAS No.148, “Accounting for Stock-Based Compensation — Transition and Disclosure”.  Accordingly, compensation cost is notrecognized for options granted at fair market value.  The following table represents pro forma netincome (loss) and pro forma earnings (loss) per share had compensation costbeen determined using the fair value method:

 
| ** **                                 | ** ** | **Fiscal year ended** | ** ** |
|--------------------------------------------|------------|-----------------------|------------|
| ** **                                 | ** ** | **October 30,**  | ** ** | **November 1,** | ** ** | **November 2,** | ** ** |
| ** **                                 | ** ** | **2004**              | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                       |       |                  |       |   |   |   |   |
| Net  income (loss) as reported             |       | $                     | 3,473      |   | $ | (5,128 | ) | $ | (1,431 | ) |
| Employee  stock based compensation expense |       |                  |       |   |   |   |   |
| determined  under fair value based method  |       | (443                  | )          | (466 | ) | (477 | ) |
| Pro  forma net income (loss)               |       | $                     | 3,030      |   | $ | (5,594 | ) | $ | (1,908 | ) |
|                                       |       |                  |       |   |   |   |   |
| Earnings  (loss) per share as reported     |       | $                     | 0.22       |   | $ | (0.32 | ) | $ | (0.09 | ) |
| Pro  forma earnings (loss) per share       |       | $                     | 0.19       |   | $ | (0.35 | ) | $ | (0.12 | ) |

 

Because stock optionsgenerally become exercisable over several years and additional grants arelikely to be made in future years, the pro forma amounts for compensation costmay not be indicative of the effects on net income and earnings per share forfuture years.  See Note 13 forinformation on the assumptions used in determining the fair value of optiongrants.

 

**Reclassifications**

Certain amounts inthe fiscal 2003 and fiscal 2002 financials have been reclassified to conform tothe current year presentation.

 

F-8

----

 

**Recentaccounting pronouncements**

In December 2004,the Financial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standards No. 123 (revised 2004) “Share-Based Payment” (SFAS 123(R)).  SFAS 123 (R) replaces FASBStatement No. 123 “Accounting for Stock-Based Compensation”, and supersedes APBOpinion No 25 “Accounting for Stock Issued to Employees”. The statementestablishes standards for accounting for share-based payment transactions.  Share-based payment transactions are those inwhich an entity exchanges its equity instruments for goods or services, or inwhich an entity incurs liabilities in exchange for goods or services,that are based on the fair value of the entity’s equity instruments orthat may be settled by the issuance of those 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 publicentity to measure the cost of employee services received in exchange for anaward of equity instruments based on the fair value of the award on the grantdate (with limited exceptions).  Thatcost will be recognized in the entity’s financial statements over the periodduring which the employee is required to provide services in exchange for theaward.  The Company is required to adoptSFAS 123(R) in the fourth quarter of fiscal 2005, and has not currentlyevaluated the impact of adoption on its overall results of operations orfinancial position.

 

In January 2003, theFASB issued FASB Interpretation No. 46, “Consolidation of Variable InterestEntities, an Interpretation of Accounting Research Bulletin No. 51” (FIN46).  FIN 46 provides guidance onidentifying variable interest entities and assessing whether or not they shouldbe consolidated.  In December 2003,the FASB issued a revised interpretation (FIN-46R) primarily to clarify therequired accounting for interests in variable interest entities.  The Company adopted the interpretation duringfiscal 2004.  The adoption did not have amaterial impact on the Company’s consolidated results of operations orfinancial position.

 

**3.****              DiscontinuedOperations**

 

During fiscal 1999 theCompany discontinued its medical business (Western Medical) principally througha sale to Intrepid U.S.A. Under the terms of the sale, the Company retained themajority of accounts receivable, including trade and Medicare accountsreceivable balances.

 

Prior to fiscal 2003, theCompany appealed Western Medical’s 1996 Medicare cost report settlement.  During the first quarter of fiscal 2003, as aresult of the favorable appeal settlement, the Company recognized $316 ofincome from discontinued operations.

 

During the third quarterof 2004, the Company resolved certain significant legal and liability claimsand evaluated future risks associated with remaining pending claims.  As a result, $150 of income from discontinuedoperations was recognized and is reflected in the Statement of Operations forthe fiscal year ended October 30, 2004.

 

As of October 30,2004, the remaining current liabilities of the discontinued medical operationsare for settled but unpaid claims of $190 and other costs of $35.

 
| ** **                                  | ** ** | **Fiscal Year Ended**      | ** ** |
|---------------------------------------------|------------|----------------------------|------------|
| ** **                                  | ** ** | **October 20,  2004** | ** ** | **November 1,  2003** | ** ** |
|                                        |       |                       |       |   |   |
| Balance  sheet data:                        |       |                       |       |   |   |
| Current  assets                             |       |                       |       | $ | 15 |   |
| Current  liabilities                        |       | $                          | (225       | ) | (644 | ) |
| Net  liabilities of discontinued operations |       | $                          | (225       | ) | $ | (629 | ) |

 

**4.****              RestructuringCharges**

 

During fiscal 2002, the Companyimplemented a restructuring plan designed to improve the Company’s profitability.  The restructuring plan resulted in a fiscal2002 pre-tax charge to operations of $1,896. Of this amount, $993 was theresult of abandoning front and back office management information systems thatwere under development with two software vendors.  One of these vendors chose to cease furtherdevelopment of its portion of the project and that caused the continueddevelopment of these systems to no longer be cost-effective for the Company.  In conjunction with this abandonment, theCompany recognized the historical fees paid to vendors, fees paid toconsultants and certain in-house development costs as expenses, all of whichhad been previously capitalized. An additional $629 resulted from severance andother employment termination costs due to planned personnel reductions.  Finally, as of the date the restructuringplan was finalized, the Company decided to close 18 offices within the UnitedStates and the resulting termination costs, including lease terminations, wereestimated to be $274.

 

**5.****              Goodwill**

 

Effective November 3,2002, the Company adopted SFAS No. 142 “Goodwill and Other Intangible Assets”.  SFAS No. 142 provides that goodwill and otherintangible assets with indefinite lives are no longer amortized, but rather areevaluated for

 

F-9

----

 

impairment by applying a fair-value basedtest.  The impairment test is comprisedof two parts.  The first step comparesthe fair value of a reporting unit with its carrying value, includinggoodwill.  If the carrying value of areporting unit exceeds its fair value, the second step of the goodwillimpairment test must be performed.  Thesecond step compares the implied fair value of the reporting units’ goodwillwith the respective carrying value to determine the amount of impairment loss,if any.

 

During fiscal 2003, theCompany performed tests for impairment in accordance with the newstandard.  In the initial test under thetransitional provisions of SFAS No. 142, the Company determined that animpairment of $670 existed in its Australia reporting unit.  In accordance with SFAS No. 142, theimpairment was classified as a cumulative effect of a change in accountingprinciple and resulted in a restatement of the Company’s net loss for thefiscal quarter ended January 25, 2003.

 

The Company performed itsannual impairment evaluations in the fourth quarters of fiscal 2003 and fiscal2004.  No additional impairments wereidentified.

 

In accordance with SFASNo. 142, no amortization of goodwill was recorded for fiscal 2004 and fiscal2003.  During fiscal 2002, the Companyrecorded goodwill amortization of $875. Excluding this amortization expense, the net loss for fiscal 2002 wouldhave been $556 or $(0.4) per share.  Theincrease in the carrying amount of goodwill of $73 during the fiscal year endedOctober 30, 2004 was due to the effect of foreign currency translation.

 

**6.****              Earnings per Share**

 

The following table setsforth the computation of basic and diluted earnings (loss) per share fromcontinuing operations:

 
| ** **                                                                                                                          | ** ** | **Fiscal Year Ended**      | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                                                          | ** ** | **October 30,  2004** | ** ** | **November 1,  2003** | ** ** | **November 2,  2002** | ** ** |
|                                                                                                                                |       |                       |       |   |   |   |   |
| Income  (loss) from continuing operations before cumulative effect of change in  accounting principle                               |       | $                          | 3,323      |   | $ | (4,774 | ) | $ | (1,431 | ) |
|                                                                                                                                |       |                       |       |   |   |   |   |
| Denominator  for basic earnings per share - weighted average shares                                                                 |       | 16,033                     |       | 15,996 |   | 15,945 |   |
|                                                                                                                                |       |                       |       |   |   |   |   |
| Effect  of dilutive securities:                                                                                                     |       |                       |       |   |   |   |   |
| Stock  options                                                                                                                      |       | 48                         |       | — |   | — |   |
|                                                                                                                                |       |                       |       |   |   |   |   |
| Denominator  for diluted earnings per share - adjusted weighted average shares and assumed  conversions                             |       | 16,081                     |       | 15,996 |   | 15,945 |   |
|                                                                                                                                |       |                       |       |   |   |   |   |
| Basic  and diluted earnings (loss) per share from continuing operations before  cumulative effect of change in accounting principle |       | $                          | 0.21       |   | $ | (0.30 | ) | $ | (0.09 | ) |
|                                                                                                                                |       |                       |       |   |   |   |   |
| Antidilutive  weighted shares excluded from diluted earnings per share                                                              |       | 416                        |       | 1,061 |   | 366 |   |

 

**7.****              Transactions withRelated Parties**

 

In 2002, the Company executed anunsecured subordinated promissory note payable to its principal stockholder andChairman of the Board of Directors in the amount of $2,000 with a maturity dateof August 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 ineffect on October 30, 2004 was 11.75%. 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 thisnote during fiscal 2004, fiscal 2003 and fiscal 2002 was $222, $230 and $68,respectively.

 

On September 25, 2003 theCompany executed a one-year unsecured subordinated draw down note with itsprincipal stockholder and Chairman of the Board of Directors.  The note provided for the Chairman to makeadvances to the Company upon request, at his sole discretion and with no obligationto do so, in an aggregate principal amount not to exceed $1,000 outstanding atany one time. On December 23, 2003 the Chairman made a $1,000 advance tothe Company which was repaid on August 3, 2004.  Total interest paid on the advance duringfiscal 2004 was $68.

 

**8.****              Property, Plant andEquipment**

 

Property, plantand equipment consists of the following:

 
| ** **                                      | ** ** | **October 30,  2004** | ** ** | **November 1,  2003** | ** ** |
|-------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
|                                            |       |                       |       |                       |       |
| Land  and buildings                             |       |                       |       | $                          | 2,251      |   |
| Computer  hardware and software                 |       | $                          | 24,542     |                       | 25,794     |   |
| Computer  equiment under capital lease          |       | 1,369                      |       | 1,369                      |       |
| Equipment,  furniture and fixtures              |       | 17,787                     |       | 20,003                     |       |
|                                            |       |                       |       |                       |       |
|                                            |       | 43,698                     |       | 49,417                     |       |
|                                            |       |                       |       |                       |       |
| Less  accumulated depreciation and amortization |       | (33,514                    | )          | (36,848                    | )          |
|                                            |       |                       |       |                       |       |
|                                            |       | $                          | 10,184     |                       | $          | 12,569 |   |

 

Depreciationexpense was $4,465, $5,307, and $5,388 for fiscal years 2004, 2003 and 2002,respectively. Amortization of capital leased equipment included in depreciationexpense was $466 for fiscal 2004 and $365 for fiscal 2003.

 

In February 2004,the Company completed the sale of its remaining unoccupied corporateheadquarters’ building for proceeds of $1,938. The $725 gain on the sale of the land and the building is included inselling and administration expenses for the fiscal year ended October 30,2004.

 

F-10

----

 

**9.****              Borrowings Under Revolving Credit Facilities and Loans Payable**

 

On May 17, 2002 the Company enteredinto agreements with GE Capital, as primary agent, to provide senior securedcredit facilities totaling $65,000, expiring in May 2007. The facilities comprisea five-year syndicated Multicurrency Credit Agreement consisting of a $50,000US Revolving Loan Commitment, a £2,740 UK Revolving Loan Commitment (US dollarequivalent of approximately $4,000 at the date of the agreement), and a $5,000term loan (the Term Loan), which was repaid during fiscal 2003.  In addition, a five-year Australian dollarfacility agreement (the A$ Facility Agreement) was executed on May 16, 2002,consisting of an A$12,000 revolving credit facility (US dollar equivalent ofapproximately $6,000 at the date of the agreement).  Each agreement includes a letter of creditsub-facility.  Letters of credit underthe agreements expire one year from date of issuance but are automaticallyrenewed for one additional year unless written notice is given to or from theholder.

 

The US Revolving Loan Commitmentprovides for an aggregate $50,000 commitment subject to a borrowing basecalculation on eligible domestic accounts receivable.  Direct advances are also limited byoutstanding irrevocable standby letters of credit up to a maximum of$35,000.  Interest on borrowings underthe commitment is based either on an index rate equal to the higher of theFederal Funds Rate plus 0.50% or the bank prime loan rate, each plus applicablemargins of up to 0.50%, or on LIBOR plus margins ranging from 2.25% to 2.75%.Borrowings outstanding under the US Revolving Loan Commitment at October 30,2004 were $10,974 at a weighted average interest rate of 4.62% and at November 1,2003 were $21,585 at a weighted average interest rate of 4.36%.

 

The UK Revolving Loan Commitment issubject to a borrowing base calculation on eligible Westaff (U.K.) accountsreceivable.  Interest on outstandingborrowings is based on the British prime rate plus margins of up to 0.50%.  Borrowings outstanding under the UK RevolvingLoan Commitment were US$1,408 at October 30, 2004 with an interest rate of4.75% and US$5 at November 1, 2003 with an interest rate of 4.75%.

 

The A$ Facility Agreement issubject to a borrowing base calculation on eligible Westaff (Australia)accounts receivable.  Direct advances arelimited by outstanding letters of credit up to a maximum of A$500.  Interest on borrowings is based on theAustralian 90-day Bank Bill Swap Rate plus a margin of 2.5% to 3.5%.  At October 30, 2004, borrowings ofUS$3,352 were outstanding under the A$ Facility Agreement at an interest rate of  5.47% and at November 2,2003 borrowings outstanding were US$3,820 at an interest rate of 4.95%.

 

The credit facilities expire in May2007.  The Company has classified all ofits borrowings under the revolving credit facilities as a current liability inaccordance with Emerging Issues Task Force (EITF) 95-22 “Balance SheetClassifications of Borrowings Outstanding under Revolving Credit AgreementsThat Include Both a Subjective Acceleration Clause and a Lock-Box Arrangement”,although the Company has the ability and the intent to maintain theseobligations for longer than one year.

 

The credit facilities are securedby substantially all of the assets of the Company.  GE Capital, in its role as primary agentunder the credit facilities, has sole dominion and control over the Company’sprimary U.S., United Kingdom and Australia cash receipts accounts.  Cash receipts into these accounts are appliedagainst the Company’s respective outstanding obligations under the facilities,with additional borrowings under the revolving facilities directed into theCompany’s disbursement accounts.

 

The credit facilities containcovenants which, among other things, require the Company to maintain a minimumfixed charge coverage ratio and a minimum earningsbefore interest, taxes, depreciation and amortization (EBITDA). The covenantsalso generally restrict, limit or, in certain circumstances, prohibit theCompany with respect to payment of dividends, capital expenditures, dispositionof assets, incurrence of debt, mergers and acquisitions, loans to affiliatesand purchases of investments.

 

On February 20, 2004, theCompany and its lending agents executed a fourth amendment to theagreement.  The amendment allowed certainone-time add-backs to EBITDA for the fiscal period ended November 1, 2003,which corrected certain covenant defaults and reset the EBITDA and certainother covenants going forward.  Theamendment also required a separate EBITDA covenant calculation for the Company’sdomestic operations on a stand-alone basis. In addition, the amendment reset the reserves which affect the Company’sborrowing capacity, redefined eligible trade accounts receivable for purposesof calculating the US and UK borrowing base, increased the applicable marginson outstanding irrevocable letters of credit by 1.0% and reduced maximumcapital expenditures allowed for fiscal 2004 by $1,000.

 

Effective July 31,2004 the Company and its lenders executed a fifth amendment to theMulticurrency Credit Agreement. The amendment increased the eligible collateralthat may be used for the Company’s borrowing base and eliminated certainreserves against the borrowing availability. Additionally, the amendment reset consolidated minimum EBITDA covenants,eliminated the requirement for a separate EBITDA covenant calculation fordomestic operations, reduced the range of margins on bank borrowings andoutstanding letters of credit and increased allowable capital expenditures forfiscal 2004 to $5,000.

 

F-11

----

 

On January 5, 2005,a sixth amendment to the Multicurrency Credit Agreement was executed.  The amendment, among other things, allows a$1,400 add-back adjustment to the EBITDA covenant at October 30, 2004 foradditional workers’ compensation charges the Company incurred during the fourthquarter of fiscal 2004 relating to adverse loss development on historicalclaims.

 

At October 30, 2004, theCompany had $22,631 available under the credit facilities,  $23,011 in letters of creditoutstanding and was in compliance with all covenants under the creditagreement.

 

 In addition to its outstanding letters ofcredit, the Company has an outstanding financial guarantee bond in the amountof $3,843 that secures a portion of its workers’ compensation premium anddeductible obligations.  Ninety dayadvance written notice of non-renewal is required.  Based upon the terms of the 2005 policyagreement with its insurance carrier, the Company expects to eliminate thesurety bond in the third quarter of fiscal 2005.

 

**10.****       Accrued Expenses**

 

Accrued expensesconsist of the following:

 
| ** **                                          | ** ** | **October 30,  2004** | ** ** | **November 1,  2003** | ** ** |
|-----------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
|                                                |       |                       |       |                       |       |
| Accrued  payroll and payroll taxes                  |       | $                          | 17,460     |                       | $          | 14,244 |   |
| Accrued  insurance/workers’ compensation       |       | 9,392                      |       | 6,571                      |       |
| Arbitration  award and related fees                 |       | 780                        |       | 950                        |       |
| Taxes  other than income taxes                      |       | 3,448                      |       | 2,643                      |       |
| Checks  outstanding in excess of book cash balances |       | 5,123                      |       | 3,754                      |       |
| Other                                               |       | 8,741                      |       | 5,924                      |       |
|                                                |       | $                          | 44,944     |                       | $          | 34,086 |   |
|                                                     |            |                            |            |                            |            |  |  |  |

 

**11.****         Income Taxes**

 

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

 
| ** **                                                                  | ** ** | **Fiscal year ended**      | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                  | ** ** | **October 30,  2004** | ** ** | **November 1,  2003** | ** ** | **November 2,  2002** | ** ** |
|                                                                        |       |                       |       |   |   |   |   |
| **Current:**                                                                |       |                       |       |   |   |   |   |
| Federal                                                                     |       | $                          | (350       | ) | $ | (211 | ) | $ | (5,842 | ) |
| State  and local                                                            |       | 175                        |       | 52 |   | 104 |   |
| Foreign                                                                     |       | 414                        |       | 520 |   | 317 |   |
|                                                                        |       |                       |       |   |   |   |   |
|                                                                        |       | 239                        |       | 361 |   | (5,421 | ) |
|                                                                        |       |                       |       |   |   |   |   |
| **Deferred:**                                                               |       |                       |       |   |   |   |   |
| Federal                                                                     |       |                       |       |   |   | 1,345 |   |
| Foreign                                                                     |       |                       |       |   |   | 6 |   |
|                                                                        |       |                       |       |   |   |   |   |
|                                                                        |       | —                     |       | — |   | 1,351 |   |
| **Total provision (benefit) for income taxes from  continuing operations:** |       | $                          | 239        |   | $ | 361 |   | $ | (4,070 | ) |

 

A reconciliationof income taxes provided at the statutory federal rate (35%) and income taxesreported in the Consolidated Statements of Operations is as follows:

 
| ** **                                                         | ** ** | **Fiscal year ended**      | ** ** |
|--------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                         | ** ** | **October 30,  2004** | ** ** | **November 1,  2003** | ** ** | **November 2,  2002** | ** ** |
|                                                               |       |                       |       |   |   |   |   |
| Income  tax provision (benefit) computed at federal statutory rate |       | $                          | 1,247      |   | $ | (1,545 | ) | $ | (1,926 | ) |
| State  taxes (net of federal benefit in 2002)                      |       | 175                        |       | 52 |   | 67 |   |
| Permanent  differences                                             |       | 1,868                      |       | (102 | ) | 63 |   |
| Tax  credits                                                       |       | (2,706                     | )          |   |   |   |   |
| Valuation  allowances                                              |       | (122                       | )          | 1,994 |   | (2,377 | ) |
| Other                                                              |       | (223                       | )          | (38 | ) | 103 |   |
|                                                               |       |                       |       |   |   |   |   |
| Income  tax provision (benefit)                                    |       | $                          | 239        |   | $ | 361 |   | $ | (4,070 | ) |

 

The approximatetax effect of temporary differences and carryforwards that give rise todeferred tax balances are as follows (includes the tax effect of temporarydifferences from discontinued operations):

 
| ** **                                                   | ** ** | **October 30,  2004** | ** ** | **November 1,  2003** | ** ** |
|--------------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
|                                                         |       |                       |       |                       |       |
| Workers’  compensation                                  |       | $                          | 8,133      |                       | $          | 5,888 |   |
| Accruals  relating to discontinued operations                |       | 86                         |       | 269                        |       |
| Other  liabilities and accruals                              |       | 1,049                      |       | 1,393                      |       |
| Federal,  state and foreign net operating loss carryforwards |       | 2,552                      |       | 5,452                      |       |
| Depreciation  and amortization                               |       | 3,027                      |       | 4,476                      |       |
| Sales  of property                                           |       | 1,566                      |       | 1,896                      |       |
| Tax  credits                                                 |       | 2,556                      |       |                       |       |
|                                                         |       |                       |       |                       |       |
| Gross  deferred tax assets                                   |       | 18,969                     |       | 19,374                     |       |
| Valuation  allowance                                         |       | (18,683                    | )          | (19,374                    | )          |
| Net  deferred tax asset                                      |       | $                          | 286        |                       | $          | 0 |   |
|                                                              |            |                            |            |                            |            |  |  |  |

 

At October 30,2004 all of the Company’s net deferred tax assets, except for $286, were offsetwith a valuation allowance as it is more likely than not that the deferred taxassets will not be realizable in the foreseeable future.  The net deferred tax asset of $286 pertainsto net operating losses in Australia which are expected to be realizable in theforeseeable future.  The decrease in thevaluation allowance in the current year is primarily the result of a decreasein the net deferred tax assets. The Company’s deferred tax assets resultingfrom net operating loss carryforwards expire at varying future dates, with $5expiring during fiscal 2006, $58 expiring during fiscal 2007, $41 expiringduring fiscal 2008 and $2,448 expiring through fiscal 2024.  The Company’s deferred tax assets resultingfrom tax credits are $703 for foreign tax credit carryforwards expiring in 2014and $1,853 for Work Opportunity Tax Credit carryforwards expiring through 2024.

 

The domestic andforeign components of income (loss) from continuing operations before incometaxes are as follows:

 
| ** **                                                                                                   | ** ** | **Fiscal year ended**      | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                                   | ** ** | **October 30,  2004** | ** ** | **November 1,  2003** | ** ** | **November 2,  2002** | ** ** |
|                                                                                                         |       |                       |       |   |   |   |   |
| Domestic                                                                                                     |       | $                          | 667        |   | $ | (5,041 | ) | $ | (4,734 | ) |
| Foreign                                                                                                      |       | 2,895                      |       | 628 |   | (767 | ) |
|                                                                                                         |       |                       |       |   |   |   |   |
| Income  (loss) from continuing operations before income taxes and cumulative change  in accounting principle |       | $                          | 3,562      |   | $ | (4,413 | ) | $ | (5,501 | ) |
|                                                                                                              |            |                            |            |  |  |  |  |  |  |  |  |

 

At October 30,2004, the Parent had cumulative undistributed earnings from foreignsubsidiaries of approximately $3,038. Income taxes have not been provided on the undistributed earningsbecause the Company has deemed the earnings of its foreign subsidiaries aspermanently reinvested.  These earningscould become subject to additional tax if they were remitted as dividends, orif foreign earnings were lent to the Company. However, to the extent that these earnings were previously taxed inforeign jurisdictions, the Company anticipates the resulting tax amount wouldqualify for a domestic tax credit.

 

F-12

----

 

**12.****       Savings Plans**

 

The Company has anonqualified deferred savings plan for highly compensated employees and a401(k) savings plan for eligible domestic employees.  Under both the deferred and 401(k) savingsplans for fiscal year 2004 and fiscal year 2003, employees can elect tocontribute up to 60% of their eligible annual compensation subject to statutorylimits.  During the fiscal 2003 year, theCompany suspended its employer matching contribution of 10% of participantcontributions up to the first 10% of the employee’s contributions.  The Company’s contribution for fiscal 2003was $77 and for fiscal 2002 was $145.

 

**13.****       Stockholders’ Equity**

 

**Treasurystock**

From time to time,the Company repurchases shares of its common stock on the open market.  The repurchased shares may be used forreissuance under the Company’s stock option and employee stock purchaseplans.  When treasury shares arereissued, any excess of the proceeds over the acquisition cost of the shares iscredited to additional paid-in-capital. Excess acquisition cost over the proceeds from reissuance, determined ona first-in first-out basis, is charged to additional paid-in-capital to theextent of previous net “gains”, and then to retained earnings.

 

**Employeestock purchase plan**

Under the Company’s1996 Employee Stock Purchase Plan, eligible employees may authorize payrolldeductions of up to 10% of eligible compensation for the purchase of theCompany’s common stock during each semi-annual purchase period.  The purchase price will equal the lower of85% of the fair market value at the beginning of the purchase period or on thelast day of the purchase period.  Theplan provides for the issuance of up to 750 shares of the Company’s commonstock.  As of October 30, 2004,shares issued under the plan totaled 594.

 

**Stock option plan**

The 1996 Stock Option/StockIssuance Plan provides for the granting of incentive and nonqualified stockoptions and stock appreciation rights. Incentive stock options may be grantedat a price not less than 100% of the fair market value of the Company’s commonstock at the date of grant.  Nonqualifiedoptions may be granted at a price not less than 85% of the fair market value ofthe Company’s common stock at the date of grant. The options’ vesting schedulesvary subject to the participant’s period of future service or to the Company’sor the option holder’s attainment of designated performance goals, or otherwiseat the discretion of the Board of Directors. Standard vesting is over four years with 25% of the options vesting uponcompletion of one year of service from the vesting commencement date, and theremaining options vesting in thirty-six equal monthly installments.  No option may have a term in excess of 10years. At October 30, 2004 there were 2,424 shares reserved for issuanceunder the plan.  The maximum number of shares with respect to which stock options, stockappreciation rights and direct stock issuances may be granted to an individualin any calendar year are 1,000 shares. No stock appreciation rights have been granted under the plan.

 

The following table summarizesthe stock option transactions under the Company’s plan. The fair value of eachoption included in the table is estimated on the date of grant using theBlack-Scholes option-pricing model with the following weighted averageassumptions for options granted in fiscal 2004, 2003 and 2002, respectively:zero dividend yield, expected volatility of 145%, 154% and 156%, expected livesof 6 years; and risk-free interest rates of 3.9%, 3.2% and 4.1%.

 
| ** **                                                       | ** ** | **October 30, 2004** | ** ** | **November 1, 2003** | ** ** | **November 2, 2002** | ** ** |
|------------------------------------------------------------------|------------|---------------------------|------------|---------------------------|------------|---------------------------|------------|
| ** **                                                       | ** ** | ** **                | ** ** | **Weighted**              | ** ** | ** **                | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                                                       | ** ** | ** **                | ** ** | **average**               | ** ** | ** **                | ** ** | **average** | ** ** | ** ** | ** ** | **average** | ** ** |
| ** **                                                       | ** ** | **Shares**                | ** ** | **exercise price**        | ** ** | **Shares**                | ** ** | **exercise price** | ** ** | **Shares** | ** ** | **exercise price** | ** ** |
|                                                             |       |                      |       |                      |       |                      |       |   |   |   |   |   |   |
| Options  outstanding, beginning of year                          |       | 1,080                     |       | $                         | 3.09       |                      | 1,419      |   | $ | 3.10 |   | 1,251 |   | $ | 3.13 |   |
| Granted  at market value                                         |       | 44                        |       | 2.53                      |       | 52                        |       | 2.16 |   | 384 |   | 3.12 |   |
| Granted  in excess of market value                               |       |                      |       |                      |       |                      |       |   |   | 550 |   | 2.35 |   |
| Cancelled                                                        |       | (89                       | )          | 3.14                      |       | (391                      | )          | 2.97 |   | (766 | ) | 2.63 |   |
| Options  outstanding, end of year                                |       | 1,035                     |       | $                         | 3.07       |                      | 1,080      |   | $ | 3.09 |   | 1,419 |   | $ | 3.10 |   |
|                                                             |       |                      |       |                      |       |                      |       |   |   |   |   |   |   |
| Options  exercisable, end of year                                |       | 562                       |       | $                         | 3.47       |                      | 482        |   | $ | 3.64 |   | 705 |   | $ | 3.41 |   |
|                                                             |       |                      |       |                      |       |                      |       |   |   |   |   |   |   |
| Options  available for grant, end of year                        |       | 1,389                     |       |                      |       | 1,344                     |       |   |   | 1,005 |   |   |   |
| Total  options authorized                                        |       | 2,424                     |       |                      |       | 2,424                     |       |   |   | 2,424 |   |   |   |
|                                                             |       |                      |       |                      |       |                      |       |   |   |   |   |   |   |
| Weighted  average fair value of options granted during the year: |       |                      |       |                      |       |                      |       |   |   |   |   |   |   |
| At  market value                                                 |       |                      |       | $                         | 2.36       |                      |       |   | $ | 2.04 |   |   |   | $ | 2.97 |   |
| In  excess of market value                                       |       |                      |       |                      |       |                      |       |   |   |   |   | $ | 2.15 |   |

 

The following tablesummarizes information about stock options outstanding at October 30,2004:

 
| ** **                      | ** **    | **Options outstanding** | ** ** | **Options exercisable**                           | ** ** |
|---------------------------------|---------------|-------------------------|------------|---------------------------------------------------|------------|
| **Range  of   exercise prices** | ** **    | **Shares**              | ** ** | **Weighted average  remaining  contractual life** | ** ** | **Weighted average  exercise price** | ** ** | **Shares** | ** ** | **Weighted average  exercise price** | ** ** |
|                            |          |                    |       |                                              |       |   |   |   |   |   |   |
| $                               | 1.63 -2.35    |                    | 597        |                                              | 7.26       |   | $ | 2.33 |   | 282 |   | $ | 2.32 |   |
| $                               | 2.45 -4.00    |                    | 370        |                                              | 7.67       |   | 3.14 |   | 212 |   | 3.19 |   |
| $                               | 6.00 -6.33    |                    | 12         |                                              | 3.01       |   | 8.22 |   | 12 |   | 6.22 |   |
| $                               | 9.33 -9.58    |                    | 53         |                                              | 2.06       |   | 9.43 |   | 53 |   | 9.43 |   |
| $                               | 16.17 - 16.17 |                    | 3          |                                              | 3.41       |   | 16.17 |   | 3 |   | 16.17 |   |
| $                               | 1.63 - 16.17  |                    | 1,035      |                                              | 7.08       |   | $ | 3.07 |   | 562 |   | $ | 3.47 |   |

 

**14.****       Leases**

 

The Company leasesreal and personal property under operating leases with terms generally rangingfrom one to five years. Some of these leases have renewal options and containprovisions for escalation based on increases in certain costs incurred by thelandlord and on Consumer Price Index adjustments. Rental expense, includingmonth-to-month rentals, amounted to $6,421 in fiscal 2004, $6,699 in fiscal2003, and $6,279 in fiscal 2002.  TheCompany also receives rental income from subleases which expire on variousdates.  Sublease income was not materialto the Company’s results of operations for any periods presented.

 

In fiscal 2003, theCompany entered into a sale-leaseback transaction whereby the Company sold andleased back its administrative offices’ land and buildings. The lease, which isbeing accounted for as an operating lease, has a term of seven years

 

F-13

----

 

withan option to renew  for an additionalfive years.  The result of the sale was anet pre-tax gain of approximately $5,300 that the Company deferred and isamortizing as an offset to rent expense over the seven year lease term.  A portion of the net proceeds from the saleof $6,866 was used to repay the outstanding principal and interest under a termloan of $4,515 (see Note 8). Additionally, the Company used $1,020 of the net proceeds to pay theoutstanding principal and interest of a promissory note payable to the Company’sPresident and Chief Executive Officer. The remainder of the net proceeds wasused to repay outstanding borrowings under the Company’s revolving creditfacilities.  In connection with the leaseagreement, the Company issued a $700 irrevocable standby letter of credit as asecurity deposit.

 

Future minimumlease payments for all non-cancelable operating leases at October 30, 2004are as follows:

 
| **Fiscal year**               |   |   |   |
|-------------------------------|--------|--------|--------|
|                          |   |   |   |
| 2005                          |   | $      | 4,022  |   |
| 2006                          |   | 2,599  |   |
| 2007                          |   | 1,734  |   |
| 2008                          |   | 1,413  |   |
| 2009                          |   | 1,257  |   |
| Thereafter                    |   | 325    |   |
|                          |   |   |   |
| Total  minimum lease payments |   | $      | 11,350 |   |

 

 

In December 2002,the Company entered into a lease transaction for certain information technologyequipment.  This lease, which has a termof 37 months, is being accounted for as a capital lease.  Capital lease obligations as of October 30,2004 are as follows:

 
| ** **                                        | ** ** | **October 30,** | ** ** |
|---------------------------------------------------|------------|----------------------|------------|
| ** **                                        | ** ** | **2004**             | ** ** |
|                                              |       |                 |       |
| Minimum  lease payments:                          |       |                 |       |
| Fiscal  2005                                      |       | $                    | 493        |   |
| Fiscal  2006                                      |       | 134                  |       |
| Total  minimum lease payments                     |       | 627                  |       |
| Less  amount representing interest                |       | (36                  | )          |
| Present  value of net minimum lease payments      |       | 591                  |       |
| Less  current portion of capital lease obligation |       | (466                 | )          |
| Long-term  capital lease obligation               |       | $                    | 125        |   |

 

**15.****       Operating Segments**

 

The Company has fourreportable segments:  Domestic Business Services,United Kingdom, Australia and Other International.  Domestic Business Services provides a varietyof temporary staffing services and permanent placements, primarily in clericaland light industrial positions, through a network of company-owned andfranchise agent offices.  The segmentconsists of 16 geographically diverse company regions or districts under thedirection of regional/district managers and one combined franchise region, eachidentified as an operating segment. Revenue from Domestic Business Services is derived wholly from theUnited States and its territories.  Thedomestic operating segments meet the aggregation criteria specified under SFASNo. 131 “Disclosures about Segments of an Enterprise and Related Information”for reporting purposes.  Theinternational operations comprise company-owned offices providing primarilyclerical and light industrial temporary staffing services and permanentplacements in Australia, the United Kingdom, Norway, Denmark and NewZealand.  The Company employs managingdirectors who oversee all operations in one or more countries.  Revenue is attributed to each country basedon the location of the respective country’s principal offices.  Where appropriate, two or more internationaloperations have been combined into one reportable segment as they share amajority of the aggregation criteria and are not individually reportable.

 

The Company evaluates theperformance of and allocates resources to the reportable segments based onoperating income.  The accountingpolicies of the segments are the same as those described in Note 2.  Certain operating expenses of the Company’scorporate headquarters, which are included in Domestic Business Services, arecharged to the international entities in the form of royalties.  Domestic assets relating to the generation ofthe royalties, primarily property, plant and equipment, have not been allocateddue to impracticality and are not considered material for purposes of assessingperformance and making operating decisions.

 

The following summarizesreporting segment data for fiscal years 2004, 2003 and 2002:

 

F-14

----

 
| ** **                                   | ** ** | **Fiscal Year Ended October 30, 2004** | ** ** |
|----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                   | ** ** | **Domestic  Business Svcs**                 | ** ** | **United Kingdom** | ** ** | **Australia** | ** ** | **Other  International** | ** ** | **Adjustments (1)** | ** ** | **Consolidated** | ** ** |
|                                         |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Revenue                                      |       | $                                           | 469,878    |   | $ | 45,088 |   | $ | 67,708 |   | $ | 18,802 |   |   |   | $ | 601,476 |   |
|                                         |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Operating  income from continuing operations |       | $                                           | 2,439      |   | $ | 2,172 |   | $ | 722 |   | $ | 332 |   |   |   | $ | 5,665 |   |
|                                         |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Depreciation  and amortization               |       | $                                           | 3,561      |   | $ | 361 |   | $ | 394 |   | $ | 158 |   |   |   | $ | 4,474 |   |
|                                         |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Expenditures  for purchases of fixed assets  |       | $                                           | 2,849      |   | $ | 374 |   | $ | 128 |   | $ | 40 |   |   |   | $ | 3,391 |   |
|                                         |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Total  long-lived assets                     |       | $                                           | 19,184     |   | $ | 868 |   | $ | 1,710 |   | $ | 182 |   |   |   | $ | 21,944 |   |
|                                         |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Total  assets                                |       | $                                           | 94,031     |   | $ | 10,433 |   | $ | 13,604 |   | $ | 6,463 |   | $ | (2,123 | ) | $ | 122,408 |   |
|                                              |            |                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                          | ** ** | **Fiscal Year Ended November 1, 2003** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                          | ** ** | **Domestic  Business Svcs**                 | ** ** | **United Kingdom** | ** ** | **Australia** | ** ** | **Other  International** | ** ** | **Adjustments (1)** | ** ** | **Consolidated** | ** ** |
|                                                |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Revenue                                             |       | $                                           | 427,097    |   | $ | 33,409 |   | $ | 52,340 |   | $ | 17,453 |   |   |   | $ | 530,299 |   |
|                                                |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Operating  income (loss) from continuing operations |       | $                                           | (3,696     | ) | $ | 1,316 |   | $ | (406 | ) | $ | (51 | ) |   |   | $ | (2,837 | ) |
|                                                |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Depreciation  and amortization                      |       | $                                           | 4,594      |   | $ | 290 |   | $ | 399 |   | $ | 217 |   |   |   | $ | 5,500 |   |
|                                                |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Expenditures  for purchases of fixed assets         |       | $                                           | 1,816      |   | $ | 369 |   | $ | 284 |   | $ | 124 |   |   |   | $ | 2,593 |   |
|                                                |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Total  long-lived assets                            |       | $                                           | 21,319     |   | $ | 795 |   | $ | 1,868 |   | $ | 275 |   |   |   | $ | 24,257 |   |
|                                                |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Total  assets                                       |       | $                                           | 91,576     |   | $ | 8,796 |   | $ | 11,555 |   | $ | 5,337 |   | $ | (4,117 | ) | $ | 113,147 |   |
|                                                     |            |                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                          | ** ** | **Fiscal Year Ended November 2, 2002** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                          | ** ** | **Domestic  Business Svcs**                 | ** ** | **United Kingdom** | ** ** | **Australia** | ** ** | **Other  International** | ** ** | ** ** | ** ** | **Consolidated** | ** ** |
|                                                |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Revenue                                             |       | $                                           | 428,187    |   | $ | 27,686 |   | $ | 41,811 |   | $ | 17,569 |   |   |   | $ | 515,253 |   |
|                                                |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Operating  income (loss) from continuing operations |       | $                                           | (2,925     | ) | $ | 760 |   | $ | (645 | ) | $ | (735 | ) |   |   | $ | (3,545 | ) |
|                                                |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Depreciation  and amortization                      |       | $                                           | 5,725      |   | $ | 284 |   | $ | 392 |   | $ | 200 |   |   |   | $ | 6,601 |   |
|                                                |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Expenditures  for purchases of fixed assets         |       | $                                           | 1,639      |   | $ | 213 |   | $ | 147 |   | $ | 90 |   |   |   | $ | 2,089 |   |
| Payments  for intangibles                           |       | 223                                         |       | — |   | — |   | — |   |   |   | 223 |   |
| Total  expenditures for long-lived assets           |       | $                                           | 1,862      |   | $ | 213 |   | $ | 147 |   | $ | 90 |   |   |   | $ | 2,312 |   |

 

----

(1)          Adjustments reflectassets related to discontinued operations and elimination of domesticinvestments in international subsidiaries.

 

**16.****       Commitments andContingencies**

 

In the ordinary course ofits business, the Company is periodically threatened with or named as adefendant 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.

 

On October 28, 2003,Bond International Software, Inc. (“Bond”) filed a demand for arbitration withthe American Arbitration Association (“AAA”). Bond sought compensation for the Company’s alleged breach of a 2001software agreement.  The Company filed acounterclaim, seeking the return of monies previously paid to Bond.  The arbitration hearing was held in September 2004.  The arbitrator issued an Interim Award on October 25,2004, agreeing that the Company had the right to terminate the agreement, butgranting Bond “termination charges” in the amount of $423 plus interest from January 2002.  The arbitrator denied Bond’s claim fordamages for breach of the implied covenant of good faith and fair dealing, anddenied the Company’s counterclaim.  Inthe Final Award issued December 4, 2004, the arbitrator ordered theCompany to pay Bond $291 in attorneys’ fees and costs, and to pay the AAAadministrative fees and arbitrator compensation totaling $44.  As a result of the arbitration, the Companyrecorded a charge of $1,058 in fiscal 2004 for the award and related legalfees.

 

On March 9, 2000, Synergy Staffing, Inc.  (“claimant”) filed a complaint against the Company alleging,among other things, that the Company fraudulently induced the plaintiff to sellthe assets of The Personnel Connection, Inc. On January 9, 2002, anarbitration panel rendered an interim award in favor of the claimant forcompensatory damages of $2,224 plus interest, as well as reasonable attorneys’fees and other costs incurred in the proceeding.  During the fourth quarter of fiscal 2001, theCompany recorded an accrued liability and related pretax charge of $3,600 forthe estimated costs of the award.  On February 11,2002, the arbitration panel issued an Order Modifying Interim Award, creditingthe Company for $800 previously paid under a price protection clause in theasset purchase agreement and thereby reducing the principal amount of the awardto $1,424.  As a result of the interimaward, the Company determined that $693 of the initial estimated liabilitieswere no longer required, and recorded the reduction in its fourth fiscalquarter of 2002. The claimant asked the superior court to correct and confirmthe interim award.  On September 25,2002, the court denied the plaintiff’s motion. The claimant then filed an appeal of the denial with the appellatecourt.   On October 21, 2003 theappellate court reversed the superior court’s denial of the claimant’s motion.  The Company filed a petition for rehearing,which was denied.  In December 2003,the claimants agreed to a settlement of $930. Accordingly, the Company recorded a $950 charge to earnings in fiscal2003 for the cost of the settlement plus related attorneys’ fees.

 

From time to time theCompany has been threatened with, or named as a defendant in, lawsuits,including countersuits brought by former franchise agents or licensees, andadministrative claims and lawsuits brought by employees or former employees.  The Company does not believe the outcome ofany proceedings on these actions would have a material adverse effect on itsfinancial position, results of operations or cash flows.  The Company is not currently a party to anymaterial litigation, except as disclosed above.

 

**17.****       Quarterly FinancialInformation (Unaudited)**

 

The following is asummary of the unaudited quarterly financial information for the fiscal yearsended October 30, 2004 and November 1, 2003.

 
| ** **                                                                                   | ** ** | **First  Quarter** | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter (1)** | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|-------------------------|------------|
| **Fiscal year ended October 30, 2004**                                                  |       |               |       |                |       |               |       |                    |       |
| Revenue                                                                                      |       | $                  | 122,483    |                | $          | 131,172            |       | $                       | 142,266    |   | $ | 205,555 |   |
| Gross  profit                                                                                |       | $                  | 20,646     |                | $          | 21,985             |       | $                       | 24,627     |   | $ | 34,588 |   |
|                                                                                         |       |               |       |                |       |               |       |                    |       |
| Income  (loss) from continuing operations                                                    |       | $                  | (906       | )                   | $          | 168                |       | $                       | 1,605      |   | $ | 2,455 |   |
| Income  from discontinued operations                                                         |       |               |       |                |       | 150                |       |                    |       |
| Net  income (loss)                                                                           |       | $                  | (906       | )                   | $          | 168                |       | $                       | 1,755      |   | $ | 2,455 |   |
|                                                                                         |       |               |       |                |       |               |       |                    |       |
| Basic  and diluted earnings (loss) per share                                                 |       |               |       |                |       |               |       |                    |       |
| Income  (loss) from continuing operations                                                    |       | $                  | (0.06      | )                   | $          | 0.01               |       | $                       | 0.10       |   | $ | 0.15 |   |
| Income  from discontinued operations                                                         |       | $                  | —     |                | $          | —             |       | $                       | 0.01       |   | $ | — |   |
| Net  income (loss)                                                                           |       | $                  | (0.06      | )                   | $          | 0.01               |       | $                       | 0.11       |   | $ | 0.15 |   |
|                                                                                         |       |               |       |                |       |               |       |                    |       |
| **Fiscal year ended November 1, 2003**                                                  |       |               |       |                |       |               |       |                    |       |
| Revenue                                                                                      |       | $                  | 117,834    |                | $          | 116,442            |       | $                       | 117,149    |   | $ | 178,874 |   |
| Gross  profit                                                                                |       | $                  | 20,371     |                | $          | 19,810             |       | $                       | 20,670     |   | $ | 29,647 |   |
|                                                                                         |       |               |       |                |       |               |       |                    |       |
| Loss  from continuing operations before cumulative effect of change in accounting  principle |       | $                  | (664       | )                   | $          | (2,663             | )          | $                       | (847       | ) | $ | (600 | ) |
| Income  from discontinued operations                                                         |       | 316                |       |                |       |               |       |                    |       |
| Cumulative  effect of change in accounting principle                                         |       | (670               | )          |                |       |               |       |                    |       |
| Net  loss                                                                                    |       | $                  | (1,018     | )                   | $          | (2,663             | )          | $                       | (847       | ) | $ | (600 | ) |
|                                                                                         |       |               |       |                |       |               |       |                    |       |
| Basic  and diluted earnings (loss) per share                                                 |       |               |       |                |       |               |       |                    |       |
| Loss  from continuing operations before cumulative effect of change in accounting  principle |       | $                  | (0.04      | )                   | $          | (0.17              | )          | $                       | (0.05      | ) | $ | (0.04 | ) |
| Income  from discontinued operations                                                         |       | $                  | 0.02       |                | $          | —             |       | $                       | —     |   | $ | — |   |
| Cumulative  effect of change in accounting principle                                         |       | $                  | (0.04      | )                   | $          | —             |       | $                       | —     |   | $ | — |   |
| Net  loss                                                                                    |       | $                  | (0.06      | )                   | $          | (0.17              | )          | $                       | (0.05      | ) | $ | (0.04 | ) |

 

----

| (1)    |   | The results for the  fourth quarter of fiscal 2004 include a $1,655 charge for increased workers’  compensation costs due primarily to adverse loss development of historical  claims.  The quarter also includes a  $1,058 charge related to an adverse arbitration award (Note 16). |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                            |   |
|   |   | The fourth quarter of  fiscal 2003 includes a workers’ compensation charge of $1,838 and a $950  charge as a result of an arbitration ruling (Note 16).                                                                                                                                    |

 

F-15

----

 

## **SIGNATURES**

## ** **

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

 
|   | WESTAFF,  INC. |
|--------|----------------|
|   |           |
|   |           |
|   | By:            | /s/  DWIGHT S. PEDERSEN |   |
|   |           | Dwight  S. Pedersen |
|   |           | *President  and Chief Executive Officer* |
|   |           | Date:  January 28, 2005 |

 

#### **POWER OF ATTORNEY**

#### ** **

KNOWALL PERSONS BY THESE PRESENTS:

 

Thatthe undersigned officers and directors of Westaff, Inc., a Delawarecorporation, do hereby constitute and appoint Dwight S. Pedersen and Dirk A.Sodestrom the lawful attorney-in-fact, each with full power of substitution,for him in any and all capacities, to sign any amendments to this report onForm 10-K and to file the same, with exhibits thereto and other documents inconnection therewith, with the Securities and Exchange Commission, herebyratifying and confirming all that each of said attorney-in-fact or hissubstitute or substitutes may do or cause to be done by virtue hereof.

 

INWITNESS WHEREOF, each of the undersigned has executed this Power of Attorney asof 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   |       |                                        |       |                   |
| W.  Robert Stover       |       | Chairman  of the Board                      |       | January 28,  2005 |
|                    |       |                                        |       |                   |
|                    |       |                                        |       |                   |
| /s/  DWIGHT S. PEDERSEN |       |                                        |       |                   |
| Dwight  S. Pedersen     |       | President  and Chief Executive Officer      |       |                   |
|                    |       | and  Director (Principal Executive Officer) |       | January 28,  2005 |
|                    |       |                                        |       |                   |
|                    |       |                                        |       |                   |
| /s/  DIRK A. SODESTROM  |       |                                        |       |                   |
| Dirk  A. Sodestrom      |       | Senior  Vice President and Chief Financial  |       |                   |
|                    |       | Officer  (Principal Financial Officer)      |       | January 28,  2005 |
|                    |       |                                        |       |                   |
|                    |       |                                        |       |                   |
| /s/  JACK D. SAMUELSON  |       |                                        |       |                   |
| Jack  D. Samuelson      |       | Director                                    |       | January 28,  2005 |
|                    |       |                                        |       |                   |
|                    |       |                                        |       |                   |
| /s/  RONALD D. STEVENS  |       |                                        |       |                   |
| Ronald  D. Stevens      |       | Director                                    |       | January 28,  2005 |

 

IV-1

----

 
|                |   |     |   |                   |
|---------------------|--------|----------|--------|------------------------|
| /s/  JANET M. BRADY |   |     |   |                   |
| Janet  M. Brady     |   | Director |   | January 28,  2005 |

 

 
| *By:                   |   |   |
|------------------------|--------|--------|
| /s/  DIRK A. SODESTROM |   |   |
| Dirk  A. Sodestrom     |   |
| *Attorney-in-Fact*     |   |

 

----