##### Table ofContents

 

#####  

 

##### **UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D. C.  20549**

 

##### **FORM 10-Q**

 

| **x**                                                  | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934.** |
|--------------------------------------------------------|----------------------------------------------------------------------------------------------------------|
|                                                   |                                                                                                     |
| **For the quarterly period ended  July 12, 2008** |
|                                                   |                                                                                                     |
| **o**                                                  | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |

 

**For the transition periodfrom              to              **

 

**Commissionfile number 000-24990**

 

**WESTAFF, INC.**

(Exact name of registrant as specified in itscharter)

 

| **Delaware**                       | ** ** | **94-1266151**         |
|------------------------------------|------------|------------------------|
| (State or other  jurisdiction      |       | (I.R.S. employer       |
| of incorporation or  organization) |       | identification number) |

 

##### **298 NorthWiget Lane**

##### **WalnutCreek, California  94598-2453**

##### (Address of registrant’sprincipal executive offices, including zip code)

#####  

**(925)930-5300**

(Registrant’s telephone number, including areacode)

 

Securities registered pursuant to Section 12(b) ofthe Act:

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

 

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90days.    Yes x    No o

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, a non-accelerated filer, or a smaller reportingcompany. See definitions of “large accelerated filer,” “accelerated filer,” and“smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

| Large accelerated filer o                     |   | Accelerated filer o         |
|-----------------------------------------------|--------|----------------------------------|
|                                          |   |                             |
| Non-accelerated filer o                       |   | Smaller reporting company x |
| (Do not check if a smaller reporting company) |   |                             |

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the ExchangeAct).    Yes o    No x

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of the latest practicable date:

 

| **Class**                                | ** ** | **Outstanding at August 25, 2008** |
|------------------------------------------|------------|-----------------------------------------|
| Common Stock, $0.01 par  value per share |       | 16,697,010 shares                       |

 

 

##### ** **

##### 

##### Table of Contents

 

##### **WESTAFF, INC.**

 

FORM 10-Q

For the quarterly period ended July 12,2008

#####  

**INDEX**

 
| ** **        | ** **                                                                                                                           | **Page** |
|-------------------|--------------------------------------------------------------------------------------------------------------------------------------|----------|
|              |                                                                                                                                 |     |
| **Part I.**  | **Financial Information**                                                                                                            | 3        |
|              |                                                                                                                                 |     |
| Item 1.           | Condensed Consolidated  Financial Statements (Unaudited)                                                                             | 3        |
|              |                                                                                                                                 |     |
|              | Condensed  Consolidated Balance Sheets (Unaudited) as of July 12, 2008 and  November 3, 2007                               | 3        |
|              |                                                                                                                                 |     |
|              | Condensed  Consolidated Statements of Operations (Unaudited) for the 12 and 36 Weeks  Ended July 12, 2008 and July 7, 2007 | 4        |
|              |                                                                                                                                 |     |
|              | Condensed  Consolidated Statements of Cash Flows (Unaudited) for the 36 Weeks Ended  July 12, 2008 and July 7, 2007        | 5        |
|              |                                                                                                                                 |     |
|              | Notes to Condensed Consolidated Financial Statements  (Unaudited)                                                                    | 6        |
|              |                                                                                                                                 |     |
| Item 2.           | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                          | 16       |
|              |                                                                                                                                 |     |
| Item 3.           | Quantitative  and Qualitative Disclosures About Market Risk                                                                          | 25       |
|              |                                                                                                                                 |     |
| Item 4T.          | Controls and  Procedures                                                                                                             | 26       |
|              |                                                                                                                                 |     |
| **Part II.** | **Other Information**                                                                                                                | 27       |
|              |                                                                                                                                 |     |
| Item 1.           | Legal Proceedings                                                                                                                    | 27       |
|              |                                                                                                                                 |     |
| Item 1A.          | Risk Factors                                                                                                                         | 28       |
|              |                                                                                                                                 |     |
| Item 2.           | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                         | 35       |
|              |                                                                                                                                 |     |
| Item 3.           | Defaults Upon  Senior Securities                                                                                                     | 35       |
|              |                                                                                                                                 |     |
| Item 4.           | Submission of  Matters to a Vote of Security Holders                                                                                 | 35       |
|              |                                                                                                                                 |     |
| Item 5.           | Other Information                                                                                                                    | 35       |
|              |                                                                                                                                 |     |
| Item 6.           | Exhibits                                                                                                                             | 35       |
|              |                                                                                                                                 |     |
|              | Signatures                                                                                                                           | 36       |

 

2

----

Table of Contents

 

**Part l. Financial Information**

**Item 1. Financial Statements (Unaudited)**

**Westaff, Inc.**

**Condensed Consolidated Balance Sheets(Unaudited)**

 
| ** **                                                                                                                                         | ** ** | **July 12,**                   | ** ** | **November 3,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|----------------------|------------|
| ** **                                                                                                                                         | ** ** | **2008**                            | ** ** | **2007**             | ** ** |
| ** **                                                                                                                                         | ** ** | **(In thousands, except** | ** ** |
| ** **                                                                                                                                         | ** ** | **per share amounts)**    | ** ** |
| ** **                                                                                                                                         |       |                                |       |                 |       |
| **ASSETS**                                                                                                                                         |       |                                |       |                 |       |
| Current assets:                                                                                                                                    |       |                                |       |                 |       |
| Cash and cash equivalents                                                                                                                          |       | $                                   | 1,841      |                 | $          | 3,277 |   |
| Restricted cash                                                                                                                                    |       | 5,017                               |       | —               |       |
| Trade accounts receivable, less allowance  for doubtful accounts of $1,246 and $1,274                                                              |       | 51,383                              |       | 76,098               |       |
| Income taxes receivable                                                                                                                            |       | 241                                 |       | —               |       |
| Deferred income taxes                                                                                                                              |       | —                              |       | 9,688                |       |
| Prepaid expenses                                                                                                                                   |       | 2,839                               |       | 4,059                |       |
| Other current assets                                                                                                                               |       | 1,154                               |       | 1,833                |       |
| Total current assets                                                                                                                               |       | 62,475                              |       | 94,955               |       |
| Property and equipment, net                                                                                                                        |       | 11,724                              |       | 16,186               |       |
| Deferred income taxes                                                                                                                              |       | 840                                 |       | 12,076               |       |
| Goodwill                                                                                                                                           |       | 1,337                               |       | 12,628               |       |
| Intangible assets                                                                                                                                  |       | 3,509                               |       | 3,695                |       |
| Other long-term assets                                                                                                                             |       | 2,020                               |       | 1,752                |       |
| Total Assets                                                                                                                                       |       | $                                   | 81,905     |                 | $          | 141,292 |   |
|                                                                                                                                               |       |                                |       |                 |       |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                      |       |                                |       |                 |       |
| Current liabilities:                                                                                                                               |       |                                |       |                 |       |
| Borrowing under revolving credit facilities                                                                                                        |       | $                                   | 3,089      |                 | $          | 6,837 |   |
| Current portion of capital lease  obligations                                                                                                      |       | 601                                 |       | 544                  |       |
| Note payable to related party                                                                                                                      |       | 2,000                               |       | 2,000                |       |
| Accounts payable                                                                                                                                   |       | 2,701                               |       | 2,226                |       |
| Accrued expenses (See Note 8)                                                                                                                      |       | 23,973                              |       | 34,147               |       |
| Short-term portion of workers compensation                                                                                                         |       | 8,766                               |       | 9,897                |       |
| Income taxes payable                                                                                                                               |       | 80                                  |       | 113                  |       |
| Total current liabilities                                                                                                                          |       | 41,210                              |       | 55,764               |       |
|                                                                                                                                               |       |                                |       |                 |       |
| Long-term capital lease obligations                                                                                                                |       | 325                                 |       | 752                  |       |
| Long-term portion of workers compensation                                                                                                          |       | 15,000                              |       | 16,000               |       |
| Other long-term liabilities                                                                                                                        |       | 1,465                               |       | 2,881                |       |
| Total liabilities                                                                                                                                  |       | 58,000                              |       | 75,397               |       |
|                                                                                                                                               |       |                                |       |                 |       |
| Commitments and contingencies                                                                                                                      |       |                                |       |                 |       |
|                                                                                                                                               |       |                                |       |                 |       |
| Stockholders’ equity:                                                                                                                         |       |                                |       |                 |       |
| Preferred stock, $0.01 par value;  authorized and unissued: 1,000,000 shares                                                                       |       |                                |       |                 |       |
| Common stock, $0.01 par value; authorized:  25,000,000 shares; issued and outstanding: 16,697,010 at July 12, 2008  and November 3, 2007 |       | 167                                 |       | 167                  |       |
| Additional paid-in capital                                                                                                                         |       | 39,623                              |       | 39,561               |       |
| Retained earnings (accumulated deficit)                                                                                                            |       | (17,827                             | )          | 24,355               |       |
| Accumulated other comprehensive income                                                                                                             |       | 1,942                               |       | 1,812                |       |
| Total stockholders’ equity                                                                                                                    |       | 23,905                              |       | 65,895               |       |
| Total Liabilities and Stockholders’ Equity                                                                                                    |       | $                                   | 81,905     |                 | $          | 141,292 |   |

 

See accompanying notes to condensedconsolidated financial statements.

 

3

----

Tableof Contents

 

**Westaff, Inc.**

**Condensed Consolidated Statements ofOperations (Unaudited)**

 
| ** **                                                    | ** ** | **12 Weeks Ended**                                          | ** ** | **36 Weeks Ended** | ** ** |
|---------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                    | ** ** | **July 12,**                                                     | ** ** | **July 7,**             | ** ** | **July 12,** | ** ** | **July 7,** | ** ** |
| ** **                                                    | ** ** | **2008**                                                              | ** ** | **2007**                     | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                                    | ** ** | **(In thousands, except per share amounts)** | ** ** |
|                                                          |       |                                                                  |       |                         |       |   |   |   |   |   |   |   |   |
| Revenue                                                       |       | $                                                                     | 99,431     |                         | $          | 122,421 |   | $ | 310,319 |   | $ | 363,221 |   |
|                                                          |       |                                                                  |       |                         |       |   |   |   |   |   |   |   |   |
| Costs of services                                             |       | 83,122                                                                |       | 101,105                      |       | 259,587 |   | 300,377 |   |
|                                                          |       |                                                                  |       |                         |       |   |   |   |   |
| Gross profit                                                  |       | 16,309                                                                |       | 21,316                       |       | 50,732 |   | 62,844 |   |
|                                                          |       |                                                                  |       |                         |       |   |   |   |   |
| Franchise agents’ share of gross profit                  |       | 3,288                                                                 |       | 4,025                        |       | 10,046 |   | 11,083 |   |
| Selling and administrative expenses                           |       | 14,488                                                                |       | 16,912                       |       | 44,994 |   | 48,929 |   |
| Impairment of goodwill and intangibles                        |       | 11,540                                                                |       | —                       |       | 11,540 |   | — |   |
| Restructuring expense (benefit)                               |       | —                                                                |       | 2,300                        |       | (150 | ) | 2,300 |   |
| Depreciation and amortization                                 |       | 1,015                                                                 |       | 796                          |       | 4,131 |   | 2,441 |   |
|                                                          |       |                                                                  |       |                         |       |   |   |   |   |
| Operating loss from continuing operations                     |       | (14,022                                                               | )          | (2,717                       | )          | (19,829 | ) | (1,909 | ) |
|                                                          |       |                                                                  |       |                         |       |   |   |   |   |
| Interest expense                                              |       | 470                                                                   |       | 530                          |       | 2,134 |   | 1,620 |   |
| Interest income                                               |       | (71                                                                   | )          | (40                          | )          | (134 | ) | (122 | ) |
|                                                          |       |                                                                  |       |                         |       |   |   |   |   |
| Loss from continuing operations before  income taxes          |       | (14,421                                                               | )          | (3,207                       | )          | (21,829 | ) | (3,407 | ) |
| Income tax expense (benefit)                                  |       | 464                                                                   |       | (361                         | )          | 20,188 |   | (591 | ) |
|                                                          |       |                                                                  |       |                         |       |   |   |   |   |
| Loss from continuing operations                               |       | (14,885                                                               | )          | (2,846                       | )          | (42,017 | ) | (2,816 | ) |
|                                                          |       |                                                                  |       |                         |       |   |   |   |   |
| Discontinued operations:                                      |       |                                                                  |       |                         |       |   |   |   |   |
| Loss from discontinued operations                             |       | —                                                                |       | (73                          | )          | (1,160 | ) | (363 | ) |
| Gain (loss) on sale, net of income taxes of  $722             |       | (188                                                                  | )          | —                       |       | 995 |   | — |   |
|                                                          |       |                                                                  |       |                         |       |   |   |   |   |
| Total loss from discontinued operations,  net of income taxes |       | (188                                                                  | )          | (73                          | )          | (165 | ) | (363 | ) |
|                                                          |       |                                                                  |       |                         |       |   |   |   |   |
| Net loss                                                      |       | $                                                                     | (15,073    | )                            | $          | (2,919 | ) | $ | (42,182 | ) | $ | (3,179 | ) |
|                                                          |       |                                                                  |       |                         |       |   |   |   |   |
| Loss per share:                                               |       |                                                                  |       |                         |       |   |   |   |   |
| Continuing operations - basic and diluted                     |       | $                                                                     | (0.89      | )                            | $          | (0.17 | ) | $ | (2.52 | ) | $ | (0.17 | ) |
|                                                          |       |                                                                  |       |                         |       |   |   |   |   |   |   |   |   |
| Discontinued operations - basic and diluted                   |       | $                                                                     | (0.01      | )                            | $          | (0.01 | ) | $ | (0.01 | ) | $ | (0.02 | ) |
| Loss per share:                                               |       |                                                                  |       |                         |       |   |   |   |   |
| Basic and diluted                                             |       | $                                                                     | (0.90      | )                            | $          | (0.18 | ) | $ | (2.53 | ) | $ | (0.19 | ) |
|                                                          |       |                                                                  |       |                         |       |   |   |   |   |   |   |   |   |
| Weighted average shares outstanding - basic  and diluted      |       | 16,697                                                                |       | 16,623                       |       | 16,697 |   | 16,607 |   |

 

See accompanying notes to condensedconsolidated financial statements.

 

4

----

Tableof Contents

 

**Westaff, Inc.**

**Condensed Consolidated Statements of CashFlows (Unaudited)**

 
| ** **                                                                                    | ** ** | **36 Weeks Ended** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                                    | ** ** | **July 12,**            | ** ** | **July 7,** | ** ** |
| ** **                                                                                    | ** ** | **2008**                     | ** ** | **2007** | ** ** |
| ** **                                                                                    | ** ** | **(In thousands)**      | ** ** |
| **Cash flows from operating activities**                                                      |       |                         |       |   |   |
| Net loss                                                                                      |       | $                            | (42,182    | ) | $ | (3,179 | ) |
| Adjustments to reconcile net loss to net  cash provided by operating activities:              |       |                         |       |   |   |
| Gain on sale of discontinued operations,  net of income taxes                                 |       | (995                         | )          | — |   |
| Impairment of goodwill and intangibles                                                        |       | 11,540                       |       | — |   |
| Depreciation and amortization                                                                 |       | 4,337                        |       | 2,703 |   |
| Stock-based compensation                                                                      |       | 63                           |       | 547 |   |
| Tax benefits from employee stock plans                                                        |       | —                       |       | (88 | ) |
| Provision for losses on doubtful accounts                                                     |       | 649                          |       | 721 |   |
| Amortization of deferred gain on  sale-leaseback                                              |       | (515                         | )          | (515 | ) |
| Amortization of debt issuance costs                                                           |       | 521                          |       | 193 |   |
| Deferred income taxes                                                                         |       | 20,875                       |       | (475 | ) |
| Amortization of deferred gain from sales of  affiliate operations                             |       | (647                         | )          | (110 | ) |
| Loss on sale or disposal of assets                                                            |       | 109                          |       | 18 |   |
| Changes in assets and liabilities:                                                            |       |                         |       |   |   |
| Trade accounts receivable                                                                     |       | 19,268                       |       | 3,063 |   |
| Other assets                                                                                  |       | 798                          |       | 2,023 |   |
| Accounts payable and accrued expenses                                                         |       | (7,851                       | )          | (2,001 | ) |
| Income taxes payable                                                                          |       | (835                         | )          | (1,110 | ) |
| Other liabilities                                                                             |       | (1,236                       | )          | 1,030 |   |
|                                                                                          |       |                         |       |   |   |
| Net cash provided by operating activities                                                     |       | 3,899                        |       | 2,820 |   |
|                                                                                          |       |                         |       |   |   |
| **Cash flows from investing activities**                                                      |       |                         |       |   |   |
| Capital expenditures                                                                          |       | (339                         | )          | (3,194 | ) |
| Payments for the purchase of affiliate  operations                                            |       | —                       |       | (307 | ) |
| Proceeds from sale of discontinued  operations, net of cash acquired by purchaser   of $1,104 |       | 5,375                        |       | — |   |
| Expenses relating to sale of discontinued  operations                                         |       | (204                         | )          | — |   |
| Other, net                                                                                    |       | 113                          |       | (11 | ) |
|                                                                                          |       |                         |       |   |   |
| Net cash (used in) provided by investing  activities                                          |       | 4,945                        |       | (3,512 | ) |
|                                                                                          |       |                         |       |   |   |
| **Cash flows from financing activities**                                                      |       |                         |       |   |   |
| Restricted cash under line of credit                                                          |       | (5,017                       | )          | — |   |
| Net repayments under line of credit  agreements                                               |       | (3,883                       | )          | (584 | ) |
| Principal payments on capital lease  obligations                                              |       | (370                         | )          | (233 | ) |
| Payment of debt issuance costs                                                                |       | (979                         | )          | (157 | ) |
| Proceeds from the issuance of common stock                                                    |       | —                       |       | 245 |   |
| Excess tax benefits from stock based  compensation                                            |       | —                       |       | 126 |   |
|                                                                                          |       |                         |       |   |   |
| Net cash used in financing activities                                                         |       | (10,249                      | )          | (603 | ) |
|                                                                                          |       |                         |       |   |   |
| Effect of exchange rate changes on cash                                                       |       | (31                          | )          | 125 |   |
|                                                                                          |       |                         |       |   |   |
| Net change in cash and cash equivalents                                                       |       | (1,436                       | )          | (1,170 | ) |
| Cash and cash equivalents at beginning of  period                                             |       | 3,277                        |       | 3,545 |   |
| Cash and cash equivalents at end of period                                                    |       | $                            | 1,841      |   | $ | 2,375 |   |
|                                                                                          |       |                         |       |   |   |
| **Supplemental dislosures of cash flow  information**                                         | ** ** | ** **                   | ** ** | ** ** | ** ** |
| Interest                                                                                      |       | $                            | 2,136      |   | $ | 1,620 |   |
| Income taxes paid, net                                                                        |       | (10                          | )          | 629 |   |

 

See accompanying notes tocondensed consolidated financial statements.

 

5

----

Table ofContents

 

**Westaff, Inc.**

**Notes to Condensed ConsolidatedFinancial Statements (Unaudited)**

 

**1.****    ****Company background**

 

Westaff, Inc. (togetherwith its domestic and foreign subsidiaries, the “Company” or “Westaff”)provides staffing services primarily in suburban and rural markets (“secondarymarkets”), and in certain major urban centers (“primary markets”) in the UnitedStates (“US”), Australia and New Zealand. On March 31, 2008, the Company sold its former United Kingdomoperations and related subsidiary. The Company providesstaffing solutions, including permanent placement, replacement, supplementaland on-site temporary programs to businesses and government agencies through itsnetwork of Company-owned, franchise agent and licensed offices.  Westaff’s primary focus is on recruiting andplacing clerical/administrative and light industrial personnel. Its corporateheadquarters provides support services to the field offices in marketing, humanresources, risk management, legal, strategic sales, accounting, and informationtechnology.

 

**Basis of Presentation and GoingConcern Considerations**

 

The accompanying condensed consolidatedfinancial statements of Westaff, Inc. and its domestic and foreignsubsidiaries, as of July 12, 2008 and for the 12-week and 36-week periodsended July 12, 2008 and July 7, 2007 are unaudited.

 

The condensed consolidated financialstatements, in the opinion of management, reflect all adjustments, which are ofa normal recurring nature, necessary for a fair presentation of the financialposition, results of operations and cash flows for the periods presented.  The condensed consolidated balance sheet asof November 3, 2007 presented herein, has been derived from the auditedconsolidated balance sheet included in the Company’s Annual Report on Form 10-Kfor the fiscal year ended November 3, 2007.

 

The Company’s primary credit facility is afinancing agreement that the Company has (through its wholly-owned subsidiaryWestaff (USA), Inc.) with U.S. Bank National Association (“U.S. Bank”), asagent for itself and Wells Fargo Bank, National Association (“Wells Fargo”), aslenders, which provides for a five-year revolving credit facility (the “FinancingAgreement”).  As discussed in Note 9 theCompany is currently in default under certain covenants of the FinancingAgreement and has entered into a Forbearance Agreement with U.S. Bank and WellsFargo that provides for a forbearance period ending on August 26,2008.  While the Company is negotiatingwith its lenders for a waiver or continued forbearance in respect of thisdefault, there can be no assurances that a waiver or continued forbearance canbe obtained.  If the Company is unable toobtain a waiver or continued forbearance from U.S. Bank on acceptable terms,the Company may be unable to access the funds necessary for its liquidityrequirements or may be unable to obtain letters of credit under the facilityneeded for the Company to obtain workers’ compensation insurance.  In that case, its business and operatingresults would be adversely affected, and the Company may be unable to continueits operations as a going concern.  Inresponse to the continued default, the Company secured a $3.0 millionsubordinated loan facility subsequent to the end of the quarter and asdescribed in Note 19.  This facility maybe used by the Company for their working capital and general business purposes.

 

The Company’s critical accounting policiesare described in Item 7, “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” and in the notes to the auditedconsolidated financial statements included in the Company’s previously-filedAnnual Report on Form 10-K for the fiscal year ended November 3,2007.  Except as disclosed herein, therewere no changes to these policies during the 36-week period ended July 12,2008.  Certain financial informationnormally included in annual financial statements prepared in accordance withaccounting principles generally accepted in the United States that is notrequired for interim reporting purposes has been condensed or omitted.  The accompanying condensed consolidatedfinancial statements should be read in conjunction with the auditedconsolidated financial statements and notes thereto included in the Company’sAnnual Report on Form 10-K for the fiscal year ended November 3,2007.

 

The Company’s fiscal year is a 52 or 53-weekperiod ending the Saturday nearest the end of October.  For interim reporting purposes, the firstthree fiscal quarters comprise 12 weeks each, while the fourth fiscal quarterconsists of 16 or 17 weeks.  The resultsof operations for the 12-week and 36-week periods ended July 12, 2008 arenot necessarily indicative of the results to be expected for the full fiscalyear or for any future period.

 

On March 31, 2008, the Company sold its United Kingdom operations andrelated subsidiary.  The results ofoperations of the discontinued operations are separately stated in theaccompanying condensed consolidated statements of operations for the 12-weekand 36-week periods ended July 12, 2008 and for the same periods of fiscal2007. The assets and liabilities of these discontinued operations have not beenreclassified in the accompanying consolidated balance sheets and relatednotes.  The cash flows from discontinuedoperations are not separately classified in the Company’s consolidatedstatements of cash flows.

 

Accounts receivable as originally reported onthe November 3, 2007 balance sheet have been increased by $962,000 toreflect unbilled amounts to customers related to services performed in theUnited Kingdom previously included in other current assets.  The Company’s policy is to record as tradeaccounts receivables the amounts earned for the final week of the period butnot billed to customers.

 

6

----

Table ofContents

 

The Company has included as part of interestexpense certain amounts paid to GE Capital for letters of credit issued to theCompany’s insurance carrier to secure liabilities reflected on the balancesheet. These costs are charged based on a percentage of the outstanding lettersof credit.  These costs during the fiscalyear 2007 that were originally classified as selling and administrativeexpenses have been reclassified to interest expense to conform to the fiscalyear 2008 presentation.  Thereclassifications had no change to net income or earnings per share and are shownbelow:

 
| ** **                                         | ** ** | **12 weeks ended**                                                          | ** ** | **36 weeks ended** | ** ** |
|----------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                         | ** ** | **July 7, 2007**                                                            | ** ** | **July 7, 2007**   | ** ** |
| ** **                                         | ** ** | **(in thousands)**                                                               |
| ** **                                         | ** ** | **As originally  reported as  adjusted for  discontinued  operations** | ** ** | **As  reclassified**         | ** ** | **Change** | ** ** | **As originally  reported as   adjusted for   discontinued  operations** | ** ** | **As  reclassified** | ** ** | **Change** | ** ** |
| Selling and administrative expenses                |       | $                                                                                     | 17,164     |                         | $          | 16,912 |   | $ | (252 | ) | $ | 49,684 |   | $ | 48,929 |   | $ | (755 | ) |
| Operating (loss) income from continuing operations |       | $                                                                                     | (2,969     | )                            | $          | (2,717 | ) | $ | 252 |   | $ | (2,664 | ) | $ | (1,909 | ) | $ | 755 |   |
| Interest expense                                   |       | $                                                                                     | 278        |                         | $          | 530 |   | $ | 252 |   | $ | 865 |   | $ | 1,620 |   | $ | 755 |   |
| Net loss                                           |       | $                                                                                     | (2,919     | )                            | $          | (2,919 | ) | $ | — |   | $ | (3,179 | ) | $ | (3,179 | ) | $ | — |   |

 

**2.****   ****Out of period adjustment**

 

During the 12 weeks ended April 19,2008, the Company recorded $880,000 in depreciation expense and accumulated depreciation,relating to assets purchased prior to fiscal year 2004, which should have beendepreciated over a 4 year period.  Thedepreciation expense and accumulated depreciation, however, were not previouslyrecorded.  The Company reviewed thisadditional expense and considered the impact of the adjustment under StaffAccounting Bulletin No. 99 “Materiality”. The Company concluded that reporting the $880,000 as an adjustment tocurrent period depreciation expense and accumulated depreciation is not materialto the current fiscal year 2008 or prior fiscal years.

 

**3.****   ****Restricted cash**

 

During the 12 weeks ended July 12,2008, the cash proceeds of $5.0 million from the sale of the U.K. operationswas held as collateral for U.S. Bank related to the Financing Agreement, asdescribed in Note 9.

 

**4.****   ****Adoption of recent pronouncement**

 

During the first quarter of fiscal year 2008,the Company adopted the provisions of Financial Accounting Standards Board (“FASB”)Interpretation No. (“FIN”) 48, “Accounting for Uncertainty in IncomeTaxes, an interpretation of FASB Statement No. 109” (“FIN 48”) effective November 4,2007.  FIN 48 clarifies the accountingfor uncertainty in income taxes recognized in an enterprise’s financialstatements in accordance with FASB Statement No. 109, “Accounting forIncome Taxes”, and prescribes a recognition threshold and measurement processfor financial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return. FIN 48 also provides guidance on de-recognition, classification,interest and penalties, accounting in interim periods, disclosure andtransition.

 

As a result of the implementation of FIN 48,the Company made a comprehensive review of its portfolio of uncertain taxpositions in accordance with recognition standards established by FIN 48, andconcluded that there were no material uncertain tax positions requiringrecognition in our financial statements at adoption or as of July 12,2008.  The Company performed evaluationsfor the tax years ended 2007, 2006, 2005 and 2004, which were subject toexamination by tax authorities.  Uponimplementation of FIN 48, the Company adopted a methodology for recognition ofinterest and penalties accruals related to unrecognized tax benefits andpenalties within its provision for income taxes.  The Company had no such interest andpenalties accrued at July 12, 2008.

 

**5.****            ****Discontinued Operations**

 

In March 2008, theCompany sold its former United Kingdom operations and related subsidiary toFortis Recruitment Group Limited, a recruiting and staffing companyheadquartered in England, for approximately $6.7 million. The Company recordeda pre-tax gain of $2.0 million ($1.2 million net of tax).  Cash payments received totaled $6.5 millionand transaction costs totaled $0.2 million. During the 12 weeks ended July 12, 2008, the Company reduced thegain on the sale by about $0.3 million ($0.2 million net of tax) as a result ofan amendment to the original sales agreement to forgive Fortis RecruitmentGroup Limited of various payables and royalties due to Westaff in lieu ofagreeing to any working capital adjustments.

 

7

----

Table of Contents

 

In accordance with theprovisions of Statement of Financial Accounting Standard No. 144, “Accountingfor Impairment or Disposal of Long-Lived Assets,” the gain recognized inconjunction with the sale of the UK, as well as the results of operations forthe current and prior periods, have been reported as discontinued operations inthe Company’s statements of operations. Summarized financial data ondiscontinued operations is as follows:

 
| ** **                                                   | ** ** | **12 Weeks Ended** | ** ** | **36 Weeks Ended** | ** ** |
|--------------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                                   | ** ** | **July 12,**            | ** ** | **July 7,**             | ** ** | **July 12,** | ** ** | **July 7,** | ** ** |
| ** **                                                   | ** ** | **2008**                     | ** ** | **2007**                     | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                                   | ** ** | **(In thousands)**      | ** ** |
|                                                         |       |                         |       |                         |       |   |   |   |   |
| Revenue                                                      |       | $                            | —     |                         | $          | 10,320 |   | $ | 15,215 |   | $ | 29,298 |   |
| Operating loss from discontinued operations                  |       | —                       |       | (86                          | )          | (1,184 | ) | (463 | ) |
| Plus: Income taxes and net interest income                   |       | —                       |       | 13                           |       | 24 |   | 100 |   |
| Loss from discontinued operations, net of tax                |       | —                       |       | (73                          | )          | (1,160 | ) | (363 | ) |
| Gain (loss) on sale of discontinued operations               |       | (286                         | )          | —                       |       | 1,717 |   | — |   |
| Less: Income taxes (benefit)                                 |       | (98                          | )          | —                       |       | 722 |   | — |   |
|                                                         |       |                         |       |                         |       |   |   |   |   |
| Gain (loss) on sale of discontinued operations, net of tax   |       | (188                         | )          | —                       |       | 995 |   | — |   |
|                                                         |       |                         |       |                         |       |   |   |   |   |
| Total loss from discontinued operations, net of income taxes |       | $                            | (188       | )                            | $          | (73 | ) | $ | (165 | ) | $ | (363 | ) |

 
| ** **                             | ** ** | **November 3,  2007** | ** ** |
|----------------------------------------|------------|-----------------------|------------|
| Cash and cash equivalents              |       | $                     | 1,335      |   |
| Trade accounts receivable, net         |       | 7,848                 |       |
| Prepaid expenses                       |       | 484                   |       |
| Property and equipment, net            |       | 901                   |       |
| Other current assets                   |       | 64                    |       |
| Assets of discontinued operations      |       | $                     | 10,632     |   |
|                                   |       |                  |       |
| Accounts payable                       |       | $                     | 131        |   |
| Accrued expenses                       |       | 4,177                 |       |
| Other liabilities                      |       | 17                    |       |
| Liabilities of discontinued operations |       | $                     | 4,325      |   |

 

**6.****             ****Income Taxes and RelatedValuation Allowance**

 

For the 12 weeks ended July 12,2008, the Company had an income tax provision from continuing operations ofapproximately $0.5 million on a pre-tax loss from continuing operations of$14.4 million, which represents an effective tax rate of -3.2%.  The tax provision was primarily generatedfrom tax on foreign operations, and interim period adjustments to deferred taxassets related to federal and Australian net operating losses.

 

For the 36 weeks ended July 12,2008, the Company had an income tax provision from continuing operations ofapproximately $20.2 million on a pre-tax loss from continuing operations of$21.8 million, which represents an effective tax rate of -92.5%.  The tax provision was primarily generatedfrom the establishment of a valuation allowance during the second quarter offiscal 2008 on its net deferred tax assets, with the exception of thosedeferred tax assets related to certain net operating losses because it believesit can realize this asset by carrying the net operating loss back to a priorperiod.  The Company has not set up avaluation allowance against deferred tax assets of  $0.8 million related to the estimated federaland Australian net operating loss because it believes these assets are morelikely than not of being realized.  Theforeign deferred tax assets relate to net operating losses in jurisdictionswhich have not experienced cumulative losses in recent periods.

 

**7.****            ****Goodwill and Intangibles**

 

TheCompany’s goodwill represents the excess of the cost of businesses acquiredover the fair value of the net assets acquired at the date of acquisition.  The primary other identifiable intangibleassets of the Company with indefinite lives are reacquired franchiserights.  These assets are not amortizedbut rather tested for impairment at least annually in accordance with Statementof Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and OtherIntangible Assets” and SFAS No. 144 “Accounting for the Impairment orDisposal of Long-Lived Assets”.  Thistest is generally performed by the Company during its fourth fiscal quarter ormore frequently if the Company believes impairment indicators are present.  The Company determined its reporting units tobe the same as its operating segments under SFAS 131 “Disclosures aboutSegments of an Enterprise and Related Information”.  See Note 17.

 

8

----

Table ofContents

 

Duringthe Company’s second quarter several factors led management to consider whetherits goodwill and other intangibles might be impaired. These factors includedthree possible indicators of impairment, including: a) a decline in the marketcapitalization of the company to a level below the book carrying value of itsequity; 2) the sale of its UK subsidiary below the fair value as determined at September 1,2007; and 3) unexpected revenue declines for its U.S. domestic reporting unitthrough the end of its second fiscal quarter. As a result of these conditions, the Company performed the first step inthe impairment test required by SFAS 142 which compares the fair value of areporting unit to its carrying value, including goodwill and intangibles andconcluded that the fair value of its US Domestic Reporting Unit exceeded thecarrying value and market capitalization which indicated that the Company’sgoodwill was not impaired.  Therefore theCompany did not perform the second step of the impairment test and no impairmentcharge was recorded in the second quarter. In light of the continued decline in revenue and market capitalizationfor Westaff, the Company determined that an interim impairment test wasnecessary during the third quarter of 2008.

 

Priorto performing Step 1 of the goodwill impairment testing process for a reportingunit under SFAS 142, if there is reason to believe that other non-goodwillrelated intangible assets may be impaired, these other intangible assets mustfirst be tested for impairment under SFAS 142 or SFAS 144.  Assets governed by SFAS 144 require arecoverability test whereby the gross undiscounted cash flows are determinedspecific to the asset.  For non-goodwillrelated indefinite-lived assets, a fair value determination is made.  If the carrying value of the asset exceedsthe fair value, then impairment occurs. The carrying values of these assets are impaired as necessary to providethe appropriate carrying value for the goodwill impairment calculation.

 

Basedon the impairment evaluation as of July 12, 2008, it was determined thatthe indefinite life franchise right intangible was impaired by $171,000.  Such an impairment charge was measured inaccordance with SFAS 142 as the excess of the carrying value over the fairvalue of the asset.

 

Aftercompleting the intangible asset impairments, the Company compared the fairvalue of the US Reporting Unit to its carrying value and determined that thereporting unit was impaired.  Uponcompletion of step two of the impairment test, the Company recorded a goodwillimpairment of $11.4 million in relation to its U.S. domestic services reportingunit.  The fair value of the Australiaand New Zealand reporting units were greater than the net book value andaccordingly, no second step was required.  The Company’s impairment evaluations were performed by management.  The evaluations for other goodwill and otherintangible assets included reasonable and supportable assumptions andprojections and were based on estimates of projected future cash flows.

 

Thegoodwill and intangible assets impairment charge is non-cash in nature and doesnot affect the Company’s liquidity, cash flows from operating activities, ordebt covenants, or have any impact on future operations.

 

The following table shows the change to goodwill andintangible assets during the first three quarters of fiscal 2008.

 
| ** **                                                                       | ** ** | **Gross goodwill and intangible assets** | ** ** | **July 12, 2008** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                       | ** ** | **Year End**                                            | ** ** | **Impairments**             | ** ** | **Gross** | ** ** | **Accumulated** | ** ** | **Effects of** | ** ** | **Net** | ** ** |
| ** **                                                                       | ** ** | **November 3, 2007**                               | ** ** | **2008**                    | ** ** | **Amount** | ** ** | **Amortization** | ** ** | **foreign currency** | ** ** | **Amount** | ** ** |
| ** **                                                                       | ** ** | **(In thousands)**                                      | ** ** |
| ** **                                                                       | ** ** | ** **                                                   | ** ** | ** **                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Domestic Business Services amortized intangible assets - Non-compete  agreements |       | $                                                            | 177        |                        | $          | — |   | $ | 177 |   | $ | (155 | ) | **$** | **—** |   | $ | 22 |   |
| Domestic Business Services indefinite life intangible assets -  Franchise rights |       | 3,658                                                        |       | (171                        | )          | 3,487 |   | — | ** ** | **—** |   | 3,487 |   |
| Total intangible assets                                                          |       | 3,835                                                        |       | (171                        | )          | 3,664 |   | (155 | ) | — |   | 3,509 |   |
| ** **                                                                       | ** ** | ** **                                                   | ** ** | ** **                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Domestic Business Services goodwill                                              |       | 11,369                                                       |       | (11,369                     | )          | — |   | — |   | — |   | — |   |
| Australia goodwill                                                               |       | 1,259                                                        |       | —                      |       | 1,259 |   | — |   | 78 |   | 1,337 |   |
| Total goodwill                                                                   |       | 12,628                                                       |       | (11,369                     | )          | 1,259 |   | — |   | 78 |   | 1,337 |   |
| Total goodwill and intangible assets                                             |       | $                                                            | 16,463     |                        | $          | (11,540 | ) | $ | 4,923 |   | $ | (155 | ) | $ | 78 |   | $ | 4,846 |   |

 

Total estimated amortization expense for theremaining 16 weeks of fiscal year 2008 is $5,000 and for fiscal year 2009 is$17,000.  

 

9

----

Table ofContents

 

**8.****    ****Accrued Expenses**

 
| ** **                                         | ** ** | **July 12,**       | ** ** | **November 3,** | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|----------------------|------------|
| ** **                                         | ** ** | **2008**                | ** ** | **2007**             | ** ** |
| ** **                                         | ** ** | **(In thousands)** | ** ** |
|                                               |       |                    |       |                 |       |
| Accrued payroll and payroll taxes                  |       | $                       | 12,503     |                 | $          | 16,356 |   |
| Accrued insurance                                  |       | 2,024                   |       | 3,151                |       |
| Checks outstanding in excess of book cash balances |       | 169                     |       | 4,753                |       |
| Taxes other than income taxes                      |       | 3,001                   |       | 4,120                |       |
| Franchise commisions payable                       |       | 1,007                   |       | 1,599                |       |
| Restructuring accrual (Note 15)                    |       | 367                     |       | 1,146                |       |
| Other                                              |       | 4,902                   |       | 3,022                |       |
|                                               |       | $                       | 23,973     |                 | $          | 34,147 |   |

 

**9.****             ****Credit Agreements**

 

On February 14, 2008, the Company (through itswholly-owned subsidiary Westaff (USA), Inc.) entered into a financingagreement with U.S. Bank National Association (“U.S. Bank”), as agent, and thelenders thereto, which provides for a five-year revolving credit facility thatpreviously provided for an aggregate commitment of up to $50.0 million,including a letter of credit sub-limit of $35.0 million (the “FinancingAgreement”).  Borrowings under theFinancing Agreement bear interest, at the Company’s election, at either U.S.Bank’s prime rate or at LIBOR plus an applicable LIBOR rate margin ranging from1.25% to 2.00%. The Financing Agreement provides that a default rate wouldapply on all loan obligations in the event of default under the FinancingAgreement and related documents, at a rate per annum of 2.0% above theapplicable interest rate.  Interest ispayable on a monthly basis.

 

On May 23, 2008, the Company received a notice ofdefault from U.S. Bank National Association (“U.S. Bank”) (as agent for itselfand Wells Fargo Bank, National Association (“Wells Fargo”), as lenders, statingthat (1) an Event of Default (as defined in the Financing Agreement) hadoccurred due to the Company’s failure to achieve a minimum required FixedCharge Coverage Ratio (as defined in the Financing Agreement) for the fiscalperiod ended April 19, 2008; and (2) as a result of the Event ofDefault, effective May 21, 2008, U.S. Bank increased the rate of interestto the default rate of interest on the borrowings outstanding under theFinancing Agreement.  The Company had$27.3 million of letters of credit supporting workers’ compensation obligationsoutstanding under the U.S. Bank credit facility at July 12, 2008, but nooutstanding borrowings.

 

On July 31, 2008, the Company entered into aForbearance Agreement with U.S. Bank and the lenders.  Pursuant to the terms of the ForbearanceAgreement, (i) the lenders agreed to forbear from exercising any of theirdefault rights and remedies in response to the occurrence and continuance ofthe Event of Default commencing on the date of the Forbearance Agreement andending on August 26, 2008, (ii) the Company agreed to a reduction inthe aggregate amount of the commitments under the Financing Agreement from$50.0 million to $33.0 million effective as of June 23, 2008, and (iii) U.S.Bank agreed to maintain a reserve against the revolving credit availability tocover the Company’s payroll and payroll tax obligations.

 

The Company is currently in discussions with U.S. Bankin order to seek a waiver or continued forbearance in respect of the Event ofDefault.  There can be no assurance thatthe Company will be able to obtain a waiver or continued forbearance or thatsuch a waiver or continued forbearance would be on terms acceptable to theCompany.  If the Company is unable toobtain a waiver or continued forbearance and the lenders elect to pursue remediesunder the Financing Agreement, such as limiting or terminating the Company’sright to borrow under the Financing Agreement or electing not to renew lettersof credit supporting the Company’s workers’ compensation insurance, it wouldhave a material adverse effect on the Company’s business, financial condition,results of operations and cash flows.  Inresponse to the continued default, the Company secured $3.0 millionsubordinated loan facility, subsequent to the end of the quarter and asdescribed in Note 19.  This facilityis available for working capital and general business purposes.

 

The Company’s Australian subsidiary maintains an A$12million Australian dollar facility agreement (the “A$ Facility Agreement”) withGE Capital, as primary agent, expiring in May 2009.  The A$ Facility Agreement includes a letterof credit sub-facility.  The outstandingbalance on the Australia Facility Agreement at July 12, 2008 was $3.1million at a 10.31% rate per annum.

 

During the 36 weeks ended July 12, 2008, theCompany recorded a charge to earnings for the previously capitalized costsassociated with the former credit facility of approximately $0.4 million.

 

10

----

Tableof Contents

 

**10.****      ****Related Party Transactions**

 

The Company has anunsecured subordinated promissory note in an amount of $2.0 million, dated May 17,2002 and payable to the former Chairman of the Board of Directors.  The note matured on August 18, 2007, isnow past due and has an interest rate equal to an indexed rate as calculatedunder the Company’s credit facilities plus seven percent, compounded monthlyand payable 60 calendar days after the end of each of the Company’s fiscalquarters.  The effective interest rate onJuly 12, 2008 was 12.0%. Payment of interest is contingent on the Companymeeting minimum availability requirements under its credit facilities.  Additionally, payments of principal orinterest are prohibited in the event of any default under the creditfacilities.  Following a default under aprior loan facility at the end of the third quarter of fiscal 2007, a formerlender exercised its right to prohibit repayment of the note at itsmaturity.  U.S. Bank has also exercisedits right to prohibit repayment of this note during the 12-week period ended July 12,2008.  Accrued and unpaid interest onthis note at July 12, 2008 was $297,000 and is included in accruedexpenses in the Company’s consolidated balance sheets.

 

**11.****      ****Commitments and Contingencies**

 

In the ordinary course of its business, the Company is periodicallythreatened with or named as a defendant in various lawsuits, including, amongother, litigation brought by former franchisees or licensees, and administrativeclaims and lawsuits brought by employees or former employees, etc.  The Company insures itself to cover principalrisks like workers’ compensation, general liability, automobile liability,property damage, alternative staffing errors and omissions, fiduciary liabilityand fidelity losses. Management believes there are no matters that will have amaterial adverse effect on the Company’s consolidated financial statements.

 

During the fourth quarter of fiscal 2005, the Company was notified bythe California Employment Development Department (“EDD”) that its domesticoperating subsidiaries unemployment tax rates would be increased retroactivelyfor both calendar years 2005 and 2004, which would result in additionalunemployment taxes of approximately $0.9 million together with interest atapplicable statutory rates.  Managementbelieves that it has properly calculated its unemployment insurance tax and isin compliance with all applicable laws and regulations. The Company has timelyappealed the ruling by the EDD and is working with outside counsel to resolvethis matter.  A hearing officer has beenassigned to the matter and a confirmation of a hearing date from the EDD isawaited.  Management believes theresolution of this matter will not have a material adverse effect on theCompany’s consolidated financial statements.

 

**12.****      ****Workers’ Compensation**

 

Domestically, theCompany is responsible for and pays workers’ compensation costs for itstemporary and regular employees and is self-insured for the deductible amountrelated to workers’ compensation claims. The Company accrues the estimated costs of workers’ compensation claimsbased upon the expected loss rates within the various temporary employmentcategories provided by the Company.  Atleast annually, the Company obtains an independent actuarial valuation of theestimated costs of claims reported but not settled, and claims incurred but notreported (IBNR), and adjusts the accruals based on the results of thevaluations.  The following summarizes theworkers’ compensation liability as of July 12, 2008 and November 3,2007:

 
| ** **                            | ** ** | **July 12, 2008** | ** ** | **November 3, 2007** | ** ** |
|---------------------------------------|------------|-----------------------------|------------|--------------------------------|------------|
| ** **                            | ** ** | **(in millions)**      | ** ** |
| Current portion                       |       | $                           | 8.8        |                           | $          | 9.9 |   |
| Long-term portion                     |       | 15.0                        |       | 16.0                           |       |
| Total Liabilities                     |       | $                           | 23.8       |                           | $          | 25.9 |   |
|                                  |       |                        |       |                           |       |
| Self-insurance deductible (per claim) |       | $                           | 0.75       |                           | $          | 0.50 |   |
| Letters of Credit (1)                 |       | $                           | 27.3       |                           | $          | 28.4 |   |

 

As of July 12, 2008 and November 3, 2007, the currentliabilities include $0.1 and $0.5 million respectively, in workers compensationexpense related to Australia.

 

----

(1)The insurance carrier requires the Company to collateralize itsrecorded obligations through the use of irrevocable letters of credit, suretybonds or cash.

 

**13.**** ****Stock-Based Compensation**

 

*StockIncentive Plan and Employee Stock Purchase Plan*.  The Company has a stock incentive plan and anEmployee Stock Purchase Plan.  Pleaserefer to Note 14 of the Company’s audited consolidated financial statements included in theCompany’s Annual Report on Form 10-K for the year ended November 3,2007 for additional information related to these stock-based compensationplans.

 

11

----

Table ofContents

 

*Restricted Stock Units. *On May 30,2008, the Company granted 90,000 restricted stock units to certain employees.  Each grant entitles the recipient to convertunits to shares of common stock subject to terms of the awards.  The maximum units to be awarded, if allperformance conditions are met, are 135,000 units.  The restricted stock units will vest, if allconditions are met, 50% on October 30, 2010 and 50% on October 29,2011.  Besides the condition that therecipient must complete a period of continuous service to the Company throughand including the vest dates, there is a performance condition and a marketcondition, both of which must be met. First, for each of three fiscal years, beginning with fiscal 2008, thecompany must meet an EBITDA target and second, the company’s stock price mustmeet certain requirements as compared to a designated “peer” group’s averagestock price.  As of July 12, 2008,the achievement of performance based criteria is not probable; therefore nocompensation expense has been recognized.

 

*Stock-basedcompensation*. Effective with the beginning of the first quarter of fiscal 2006, the Companyadopted Statement of Financial Accounting Standards No. 123 (revised 2004)Share-Based Payment (“SFAS 123(R)”) using the modified prospective method ofadoption.

 

For the 12-week and 36-weekperiods ended July 12, 2008 and July 7, 2007, the Company recognizedstock-based compensation expense as follows:

 
| ** **               | ** ** | **12 Weeks Ended** | ** ** | **36 Weeks Ended** | ** ** |
|--------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **               | ** ** | **July 12,**            | ** ** | **July 7,**             | ** ** | **July 12,** | ** ** | **July 7,** | ** ** |
| ** **               | ** ** | **2008**                     | ** ** | **2007**                     | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **               | ** ** | **(In thousands)**      | ** ** |
| Stock-based compensation |       | $                            | 50         |                         | $          | 408 |   | $ | 63 |   | $ | 547 |   |
|                          |            |                              |            |                              |            |  |  |  |  |  |  |  |  |

 

Stock-based compensationexpense is included in selling and administrative expenses.

 

The determination of thefair value of stock options, using the Black-Scholes model, is affected by theCompany’s stock price as well as assumptions as to the Company’s expected stockprice volatility over the term of the awards, actual and projected employeestock option exercise behavior, the risk-free interest rate, and expecteddividends.

 

The Company estimates the volatility of the common stock by usinghistorical volatility over a period equal to the award’s expected term. Therisk-free interest rates that are used in the valuation models are based uponyields of the U.S. Treasury constant maturities at the time of grant having aterm that approximates the expected life of the options. Dividend yield is zeroas the Company did not declare or pay dividends during fiscal 2008 or fiscal2007, and its current credit facilities prohibit payment of dividends.  The Company does not currently have plans todeclare dividends in future years.

 

SFAS 123(R) requirescompanies to estimate future expected forfeitures at the date of grant andrevise those estimates in subsequent periods if actual forfeitures differ fromthose estimates.  In previous years, theCompany had recognized the impact of forfeitures as they occurred.  Under SFAS 123(R), the Company useshistorical data to estimate pre-vesting forfeiture rates in determining theamount of stock-based compensation expense to recognize.  During the 36 weeks ended July 12, 2008, theCompany increased its forfeiture rate by analyzing historic forfeiture ratesand reviewing outstanding unvested option grants which resulted in a decreaseto stock-based compensation expense. The 12 and 36 weeks ended July 7, 2007included $373,000 of expense related to the acceleration of options andrestricted stock awards upon the departure of a specific executive.  No such expense was present during the 12 and36 weeks ended July 12, 2008.

 

All stock-based compensationawards are amortized on a straight-line basis over the requisite serviceperiods of the awards.

 

12

----

Table ofContents

 

**14.****      ****Loss per share**

 

Basic loss pershare of common stock is computed as loss divided by the weighted averagenumber of common shares outstanding for the period.  Diluted loss per share of common stock iscomputed as loss divided by the weighted average number of common shares andpotentially dilutive common stock equivalents outstanding during theperiod.  Diluted loss per share reflectsthe potential dilution that could occur from common stock issuances as a resultof stock option exercises. The following table sets forth thecomputation of basic and diluted (loss) earnings per share:

 
| ** **                                                                  | ** ** | **12 Weeks Ended**                                          | ** ** | **36 Weeks Ended** | ** ** |
|-----------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                  | ** ** | **July 12,**                                                     | ** ** | **July 7,**             | ** ** | **July 12,** | ** ** | **July 7,** | ** ** |
| ** **                                                                  | ** ** | **2008**                                                              | ** ** | **2007**                     | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                                                  | ** ** | **(In thousands, except per share amounts)** | ** ** |
|                                                                        |       |                                                                  |       |                         |       |   |   |   |   |
| Loss from continuing operations                                             |       | $                                                                     | (14,885    | )                            | $          | (2,846 | ) | $ | (42,017 | ) | $ | (2,816 | ) |
| Loss from discontinued operations, net of tax                               |       | (188                                                                  | )          | (73                          | )          | (165 | ) | (363 | ) |
| Net loss                                                                    |       | $                                                                     | (15,073    | )                            | $          | (2,919 | ) | $ | (42,182 | ) | $ | (3,179 | ) |
| Denominator for basic and diluted loss per share - weighted average  shares |       | 16,697                                                                |       | 16,623                       |       | 16,697 |   | 16,607 |   |
|                                                                        |       |                                                                  |       |                         |       |   |   |   |   |
| Basic and Diluted earnings per share                                        |       |                                                                  |       |                         |       |   |   |   |   |
| Net loss from continuing operations                                         |       | $                                                                     | (0.89      | )                            | $          | (0.17 | ) | $ | (2.52 | ) | $ | (0.17 | ) |
| Net loss from discontinued operations                                       |       | (0.01                                                                 | )          | (0.01                        | )          | (0.01 | ) | (0.02 | ) |
| Loss per share                                                              |       |                                                                  |       |                         |       |   |   |   |   |
| Basic and diluted                                                           |       | $                                                                     | (0.90      | )                            | $          | (0.18 | ) | $ | (2.53 | ) | $ | (0.19 | ) |
| Anti-dilutive weighted shares excluded from diluted earnings per  share     |       | 419                                                                   |       | 157                          |       | 416 |   | 153 |   |

 

**15.****      ****Company Restructuring**

 

In the thirdquarter of fiscal 2007, the Company approved a restructuring plan to, amongother things, reduce its workforce and consolidate facilities.  Restructuring charges have been recorded toalign the Company’s cost structure with changing market conditions and tocreate a more efficient organization. The Company’s restructuring charges have been comprised primarily of: (i) severanceand termination benefit costs related to the reduction of our workforce; and (ii) leasetermination costs and costs associated with permanently vacating certainfacilities.

 

The Companyaccounted for each of these costs in accordance with FASB 146, “Accountingfor Costs Associated with Exit or Disposal Activities.”  In the third quarter of fiscal 2007, theCompany started a series of changes to its operations that management believeswill significantly reduce its costs. The Company terminated 86 positions atfield and corporate offices and closed 26 branch offices.  The customers served by these closed officeshave been transferred to other offices within the proximity of the closedoffices.  The detail is as follows:

 
| ** **                                                                      | ** ** | **36 weeks ended** | ** ** |
|---------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                      | ** ** | **July 12, 2008**  | ** ** |
| ** **                                                                      | ** ** | **(In thousands)**      | ** ** |
| ** **                                                                      | ** ** | **Facilities**               | ** ** |
| Restructuring accrual - November 3, 2007                                   |       |                         |       |
| Rent expense under non-cancellable leases reduced by estimated  sublease income |       | $                            | 1,146      |   |
| Rents paid reduced by sublease income                                           |       | (629                         | )          |
| Restructuring benefit                                                           |       | (150                         | )          |
| Restructuring accrual - July 12, 2008                                      |       | $                            | 367        |   |

 

Duringthe 36 weeks ended July 12, 2008, the Company successfully negotiatedearly termination agreements for nine locations and entered into a sublease forthree locations, the effects of which resulted in a $150,000 reduction in ourestimated accrual.  The Company is stillresponsible for lease payments on 12 locations and is actively negotiatingearly terminations, where possible, and sublease opportunities to mitigate itsobligation.  The restructuring accrual,representing rent expense under non-cancellable leases has been reduced by thecurrent estimated future sublease income.

 

13

----

Tableof Contents

 

**16.  Comprehensiveloss**

 

Comprehensive lossconsists of the following:

 

| ** **                       | ** ** | **12 Weeks Ended** | ** ** | **36 Weeks Ended** | ** ** |
|----------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                       | ** ** | **July 12,**            | ** ** | **July 7,**             | ** ** | **July 12,** | ** ** | **July 7,** | ** ** |
| ** **                       | ** ** | **2008**                     | ** ** | **2007**                     | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                       | ** ** | **(In thousands)**      | ** ** | **(In thousands)**      | ** ** |
|                             |       |                         |       |                         |       |   |   |   |   |
| Net loss                         |       | $                            | (15,073    | )                            | $          | (2,919 | ) | $ | (42,182 | ) | $ | (3,179 | ) |
| Currency translation adjustments |       | 209                          |       | 285                          |       | 130 |   | 1,153 |   |
| Comprehensive loss               |       | $                            | (14,864    | )                            | $          | (2,634 | ) | $ | (42,052 | ) | $ | (2,026 | ) |

 

**17.  OperatingSegments**

 

The following tablesummarizes reporting segment data:

 
| ** **                                          | ** ** | **Domestic**               | ** ** | ** **              | ** ** | **New**     | ** ** | ** ** | ** ** |
|-----------------------------------------------------|------------|----------------------------|------------|-------------------------|------------|-------------|------------|------------|------------|
| ** **                                          | ** ** | **Business Services** | ** ** | **Australia**           | ** ** | **Zealand** | ** ** | **Total**  | ** ** |
| ** **                                          | ** ** | ** **                 | ** ** | **(In thousands)** | ** ** | ** **  | ** ** | ** ** | ** ** |
| 12 Weeks Ended July 12, 2008                   |       |                       |       |                    |       |        |       |       |       |
| Revenue                                             |       | $                          | 71,894     |                    | $          | 25,732      |       | $          | 1,805      |   | $ | 99,431 |   |
| Operating income (loss) from continuing  operations |       | $                          | (14,255    | )                       | $          | 200         |       | $          | 33         |   | $ | (14,022 | ) |
|                                                |       |                       |       |                    |       |        |       |       |       |
| 12 Weeks Ended July 7, 2007                    |       |                       |       |                    |       |        |       |       |       |
| Revenue                                             |       | $                          | 99,401     |                    | $          | 21,446      |       | $          | 1,574      |   | $ | 122,421 |   |
| Operating income (loss) from continuing  operations |       | $                          | (2,794     | )                       | $          | 89          |       | $          | (12        | ) | $ | (2,717 | ) |
|                                                |       |                       |       |                    |       |        |       |       |       |
| 36 Weeks Ended July 12, 2008                   |       |                       |       |                    |       |        |       |       |       |
| Revenue                                             |       | $                          | 228,186    |                    | $          | 76,974      |       | $          | 5,159      |   | $ | 310,319 |   |
| Operating income (loss) from continuing  operations |       | $                          | (20,561    | )                       | $          | 644         |       | $          | 88         |   | $ | (19,829 | ) |
|                                                |       |                       |       |                    |       |        |       |       |       |
| 36 Weeks Ended July 7, 2007                    |       |                       |       |                    |       |        |       |       |       |
| Revenue                                             |       | $                          | 294,931    |                    | $          | 63,292      |       | $          | 4,998      |   | $ | 363,221 |   |
| Operating income (loss) from continuing  operations |       | $                          | (2,273     | )                       | $          | 297         |       | $          | 67         |   | $ | (1,909 | ) |

 

 

**18.****      ****Recent Accounting Pronouncements**

 

In September 2006, the FASB issued SFAS No. 157, “Fair ValueMeasurements.”  SFAS 157 definesfair value, establishes a framework for measuring fair value in generallyaccepted accounting principles and expands disclosures about fair valuemeasurements.  SFAS 157 applies underother accounting pronouncements that require or permit fair value measurements,the FASB having previously concluded in those accounting pronouncements thatfair value is the relevant measurement attribute. Accordingly, SFAS 157does not require any new fair value measurements. SFAS 157 is effectivefor fiscal years beginning after November 15, 2007.  On November 14, 2007 the FASB partiallydeferred the effective date of the standard for certain non-financial assetsand liabilities.   In February 2008,the FASB issued Final FASB staff Position, or FSP 157-2.  The FSP which was effective upon issuance,delays the effective date of SFAS 157 for nonfinancial assets and nonfinancialliabilities, except for items that are recognized or disclosed at fair value atleast once a year, to fiscal years beginning after November 15, 2008.  The Company is currently evaluating theimpact, if any, that the adoption of SFAS No. 157 will have on itsoperating income or net earnings.

 

In February 2007, the FASB issued SFAS No. 159, “The FairValue Option for Financial Assets and Financial Liabilities.”  SFAS 159 permits companies to choose tomeasure many financial instruments and certain other items at fair value.SFAS 159 is effective for fiscal years beginning after November 15,2007. Companies are not allowed to adopt SFAS 159 on a retrospective basisunless they choose early adoption.  TheCompany is evaluating the impact, if any, the adoption of SFAS 159 willhave on its operating income or net earnings.

 

14

----

Table of Contents

 

In December 2007, the FASB issued SFAS No. 141(R), “BusinessCombinations.”   SFAS 141(R) requiresall business combinations completed after the effective date to be accountedfor by applying the acquisition method (previously referred to as the purchasemethod).  Companies applying this methodwill have to identify the acquirer, determine the acquisition date and purchaseprice and recognize at their acquisition-date fair values the identifiableassets acquired, liabilities assumed, and any non-controlling interests in theacquiree.  In the case of a bargainpurchase the acquirer is required to reevaluate the measurements of therecognized assets and liabilities at the acquisition date and recognize a gainon that date if an excess remains. SFAS 141(R) is effective for fiscalperiods beginning after December 15, 2008. The Company is currently evaluating the impact of SFAS 141(R).

 

In December 2007, the FASB issued SFAS No. 160, “Non-controllingInterests in Consolidated Financial Statements” (an Amendment of ARB 51).  SFAS 160 establishes accounting and reportingstandards for the non-controlling interest in a subsidiary and for thedeconsolidation of a subsidiary.  Thestatement requires consolidated net income to be reported at amounts thatinclude the amounts attributable to both the parent and the non-controllinginterest.  It also requires disclosure onthe face of the consolidated statement of income, of the amounts ofconsolidated net income attributable to the parent and to the non-controllinginterest.  In addition this statementestablishes a single method of accounting for changes in a parent’s ownershipinterest in a subsidiary that do not result in deconsolidation and requiresthat a parent recognize a gain or loss in net income when a subsidiary isdeconsolidated. SFAS 160 becomes effective for fiscal periods beginning after December 15,2008.  The Company is currentlyevaluating the impact of SFAS 160.

 

In May 2008, the FASB issued SFAS No. 162, “The Hierarchy ofGenerally Accepted Accounting Principles.” SFAS No. 162 identifies the sources of accounting principles andthe framework for selecting the principles used in the preparation of financialstatements which are presented in conformity with generally accepted accountingprinciples (“GAAP”) in the United States. SFAS No. 162 will become effective 60 days following the SEC’sapproval of the Public Company Accounting Oversight Board amendments to AU Section 411,“The Meaning of*Present Fairly in Conformity With GenerallyAccepted Accounting Principles.*”* *We do not expect the adoption ofSFAS No. 162 to have a material impact on our consolidated financialstatements.

 

**19.****      ****Subsequent Events**

 

On August 25, 2008, the Company entered into a Subordinated LoanAgreement with its principal stockholder, Delstaff, LLC, which provides a loanfacility allowing the Company to request loan advances in an aggregateprincipal amount of up to $3.0 million. The maturity date of the Subordinated Loan Agreement is August 15,2009 (the “Maturity Date”).

 

The unpaid principal balance under the Subordinated Loan bears interestat an annual rate of twenty percent (20%). Interest is payable-in-kind and accrues monthly in arrears on the firstday of each month as an increase in the principal amount of the SubordinatedLoan.  A default rate applies on allobligations under the Subordinated Loan Agreement from and after the MaturityDate and also during the existence of an Event of Default (as defined in theSubordinated Loan Agreement) at an annual rate of ten percent (10%) also payable-in-kindover the then-existing applicable interest rate and if principal is not repaidon the Maturity Date, an additional 5% of outstanding principal must be paidalong with the default rate interest. The obligations under the Subordinated Loan Agreement are secured by asecurity interest in substantially all of the existing and future assets (the “SubordinatedCollateral”) of the Company.  The liengranted to the Subordinated Lender in the Subordinated Collateral issubordinated to the lien in that same collateral granted to U.S. Bank.  The Subordinated Loan is available forworking capital and general business purposes. Borrowings in excess of $1.0 million require the SubordinatedLender approval.  The Subordinated Loanmay be prepaid without penalty, subject to approval by U.S. Bank and the termsof an Intercreditor Agreement.

 

Under certain circumstances, the Company must prepay all or a portionof any amounts outstanding under the Subordinated Loan Agreement, subject tothe terms of the Intercreditor Agreement.

 

Under the terms of the Subordinated Loan Agreement, the Company hasagreed to pay to the Subordinated Lender a facility fee at the closing whichwill be added to the principal of the Subordinated Loans at the closing, butwill not reduce the availability of the $3.0 million facility.

 

15

----

Tableof Contents

 

**Item2.  Management’s Discussion and Analysisof Financial 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 consolidatedsubsidiaries.  This discussion andanalysis should be read in conjunction with the condensed consolidatedfinancial statements and notes thereto included elsewhere in this Quarterly Report on Form 10-Q and theaudited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-Kfor the fiscal year ended November 3, 2007.

 

References in this Quarterly Report on Form 10-Q to the “Company,”“Westaff,” “we,” “our,” and “us” refer to Westaff, Inc., its predecessorand their respective subsidiaries, unless the context otherwise requires.

 

### **CautionaryStatement Regarding Forward-Looking Statements**

###  

ThisQuarterly Report on Form 10-Q contains forward-looking statements withinthe “safe harbor” provisions of the Private Securities Litigation Reform Act of1995.  Except for statements that arepurely historical, all statements included in this Quarterly Report on Form 10-Qare forward-looking statements, and readers are cautioned not to place unduereliance on those statements.  You canalso identify these statements by the fact that they do not relate strictly tocurrent facts and use words such as “will,” “anticipate,” “estimate,” “expect,”“project,” “intend,” “plan,” “believe,” “target,” “forecast,” and other wordsand terms of similar meaning in connection with any discussion of futureoperating or financial performance.  Theforward-looking statements include, without limitation our ability to achievebetter people and process efficiencies as a result of changes to ouroperational structure, our ability to enhance the profitability of our accountsthrough hiring industry-proven placement consultants, and our ability to reduceselling and administrative costs.  Thesestatements are only predictions, and actual events or results may differmaterially.  The forward-lookingstatements provide our current expectations or forecasts of future events.  These forward-looking statements are madebased on information available as of the date of this report and are subject toa number of risks and uncertainties that could cause the Company’s actualresults and financial position to differ materially from those expressed orimplied in forward-looking statements and to be below the expectations ofpublic market analysts and investors. Investors should bear this in mind asthey consider forward-looking statements.

 

Theserisks and uncertainties include, but are not limited to, those discussed in Part II,Item 1A, “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q.  You should understand that it is not possibleto predict or identify all such factors. Consequently, you should not consider any such list to be a complete setof all potential risks or uncertainties faced by us.

 

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.

 

**CompanyOverview**

 

Weprovide staffing services primarily in suburban and rural markets (“secondarymarkets”), as well as in the downtown areas of certain major urban centers (“primarymarkets”) in the United States (“US”), Australia and New Zealand through ournetwork of Company-owned, franchise agent and licensed offices. On March 31,2008, the Company sold its formerUnited Kingdom operations and related subsidiary, as described in Note 5to the condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q. We offer a wide range of staffing solutions,including permanent placement, replacement, supplemental and on-site temporaryprograms to businesses and government agencies. Our primary focus is onrecruiting and placing clerical/administrative and light industrialpersonnel.  We have 60 years of experiencein the staffing industry and, as of July 12, 2008, operated through 177offices in 46 states and two foreign countries. As of July 12, 2008, 64% of these offices were Company-owned andoperated and 36% were operated by franchise agents. Our corporate headquartersprovides support services to the field offices, in areas such as marketing,human resources, risk management, legal, strategic sales, accounting, andinformation technology.

 

Tocomplement our service offerings, which include temporary staffing, permanentplacement, temp-to-hire services, payroll services and on-location programs, weutilize a number of tools focused on increasing our pool of qualifiedcandidates.  Additionally, we employ arobust, targeted marketing program as well as a consultative sales process, andboth of these tools assist in our sales efforts to new and existingcustomers.  Management believes all ofthese tools enhance our competitive edge and position us to effectively pursuehigh growth market niches.

 

The staffing industry is highly competitive with generally few barriersto entry, which contributes to significant price competition as competitorsattempt to maintain or gain market share. On a prospective basis, we believe our focus on increasing clerical andadministrative sales, improving results from underperforming field offices andprudently managing costs will permit us to improve our operating margins.

 

16

----

Tableof Contents

 

Ourbusiness tends to be seasonal, with sales for the first fiscal quartertypically lower than other fiscal quarters. This decrease results from the traditional holidays that are includedwithin the first fiscal quarter, as well as other customer closures for theholiday season.  These closures andpost-holiday season declines in business activity negatively impact ordersreceived from customers, particularly in the light industrial sector. Demandfor staffing services historically tends to grow during the second and thirdfiscal quarters and has historically been greatest during the fourth fiscalquarter due largely to customers’ planning and business cycles.  The recent economic downturn in the firsthalf of fiscal 2008 has negatively impacted this expected historical growth,reducing demand for temporary employees and adversely affecting our sales.  We anticipate that we may continue toexperience weaker demand for temporary employees through the remainder offiscal 2008.

 

Domestically,payroll taxes and related benefits fluctuate with the level of payroll costs,but tend to represent a smaller percentage of revenue and payroll costs laterin our fiscal year as federal and state statutory wage limits for unemploymentare exceeded on a per employee basis. Workers’ compensation expense, which is incurred domestically and inAustralia, generally varies with both the frequency and severity of workplaceinjury claims reported during a quarter. Adverse and positive loss development of prior period claims during a subsequentquarter may also contribute to the volatility in our estimated workers’compensation expense.

 

### **CriticalAccounting Policies**

###  

Thepreparation of financial statements in conformity with generally acceptedaccounting principles in the United States of America requires management tomake certain estimates and assumptions affecting the amounts and disclosuresreported within those financial statements. These estimates are evaluated on an ongoing basis by management andgenerally affect revenue recognition, workers’ compensation costs,collectability of accounts receivable, impairment of goodwill and intangibleassets, contingencies, litigation and income taxes.  Management’s estimates and assumptions arebased on historical experiences and other factors believed to be reasonableunder the circumstances.  Actual resultsunder circumstances and conditions different than those assumed could result indifferences from the estimated amounts in the financial statements.

 

Our critical accounting policies are describedin the notes to the audited consolidated financial statements included in theCompany’s previously-filed Annual Report on Form 10-K for the fiscal yearended November 3, 2007.  During thefirst quarter of fiscal year 2008, we adopted the provisions of FIN 48effective November 4, 2007.  Pleasesee Note 4 to the condensed consolidated financial statements includedelsewhere in this Quarterly Report on Form 10-Q.  Except for the adoption of the provisions ofFIN 48, there were no changes to these policies during the 36-week period endedJuly 12, 2008.

 

**Executive Overview**

** **

Ourgross revenues for the 12-week period ended July 12, 2008 were $99.4million, which represents a decline of $23.0 million from gross revenues forthe same period last year, and gross revenues for the 36-week period ended on July 12,2008 were $310.3 million, which represents a decline of $52.9 million from thesame period last year.  The decline inrevenues was attributable to a softening economy during the first threequarters of fiscal 2008, our closing of a number of branch offices in fiscal2007, the termination of a number of unprofitable customer accounts, and thedisruption in billing caused by our implementation of a new Pay/Bill systemduring the first quarter.

 

Ourloss from continuing operations for the 12-week period ended July 12, 2008was $14.9 million which includes an impairment charge of $11.5 million comparedto a loss of $2.8 million for the same period last year.  The loss from continuing operations for the36-week period ended July 12, 2008 was $42 million, which includes $20.2million income tax expense and an impairment charge of $11.5 million comparedto income from continuing operations of $2.8 million for the same period lastyear.

 

Wehave made changes in our domestic operational structure in an effort to achievebetter people and process efficiencies. We are committed to enhancing the profitability of our organization by hiringindustry-proven placement consultants whom we expect will enhance the profitabilityof our existing accounts and will increase market share.  We have had success in reducing our domestic sellingand administrative costs in total and we are evaluating and implementingadditional opportunities for savings. Further, we divested an unprofitable international subsidiary in orderto concentrate on our core business.

 

On March 31,2008, the company sold its Westaff U.K. subsidiary operations, as described inNote 5 and recognized a gain of $1.2 million net of tax.  During the 12 weeks ended July 12, 2008,the Company reduced the gain on the sale by about $0.3 million ($0.2 millionnet of tax) as a result of an amendment to the original sales agreement toforgive Fortis Recruitment Group Limited of various payables and royalties dueto Westaff in lieu of agreeing to any working capital adjustments.

 

17

----

Tableof Contents

 

**GoingConcern Considerations**

 

TheCompany has incurred operating losses and negative operating cash flow sincethe second quarter of fiscal 2007, offset by slight operating income in thefourth quarter of fiscal 2007.  TheCompany may incur additional losses in the future, particularly because ofcurrent soft economic conditions.

 

TheCompany’s operations, even if they perform in accordance with management’sexpectations, may not generate sufficient cash flow to finance the Company’soperations at current levels or to permit the Company to expand its business.  As a result, the Company expects to continueto rely on borrowing to finance its operations because equity financing is notlikely to be available.

 

Asdiscussed in Note 9 to the condensed consolidated financial statements included elsewhere in this Quarterly Reporton Form 10-Q, the Companyhas (through its wholly-owned subsidiary, Westaff (USA), Inc.) a financingagreement with U.S. Bank National Association (“U.S. Bank”) and Wells FargoBank, National Association (“Wells Fargo”), as lenders, which provides for afive-year revolving credit facility with an aggregate commitment of up to $33.0million (the “Financing Agreement”).  TheCompany is currently in default under certain covenants of the FinancingAgreement and has entered into a Forbearance Agreement that provides for aforbearance period ending on August 26, 2008.  While the Company is negotiating with itslenders for a waiver or continued forbearance in respect of this default, therecan be no assurances that a waiver or continued forbearance can beobtained.  If the Company is unable toobtain a waiver or continued forbearance on acceptable terms, the Company maybe unable to access the funds necessary to satisfy its liquidity requirements,or may be unable to obtain letters of credit under the facility needed for theCompany to obtain workers’ compensation insurance.  In that case, its business and operatingresults would be adversely affected and the Company may be unable to continueits operations as a going concern.  Inresponse to the continued default, the Company secured $3.0 millionsubordinated loan facility, subsequent to the end of the quarter and asdescribed in Note 19. This facility may be used by the Company for theirworking capital and general business purposes during the term of the facility.

 

18

----

Tableof Contents

 

**Results of Operations – 12 weeks ended July 12, 2008 and July 7,2007**

 

***Revenue***

 

Grossrevenue from consolidated continuing operations declined by $23.0 million or18.8% to $99.4 million for the 12 weeks ended July 12, 2008 as compared tothe same period in the prior year. Domestic revenue declined by $27.5 millionor 27.7% to $71.9 million driven largely by a 29.9% decrease in billed hours.  Revenue from domestic franchise operationsdeclined from $35.8 million or 17.3% to $29.6 million driven largely by a 21.4%decrease in billed hours due to the economic downturn. Revenue from domesticcompany-owned operations declined from $63.6 million or 33.5% to $42.3 milliondriven largely by a 34.9% decrease in billed hours due to the economic downturn and customer losses related to the restructuring plan implemented in thethird quarter of fiscal 2007.  Thisdecline was particularly notable in the lower billings for several of ourlarger customers in the 12 weeks ended July 12, 2008.  Total billings for the top 20 customers inthe 12 weeks ended July 12, 2008 declined by $2.4 million or 11.2% to$18.6 million compared to the same period for fiscal 2007, offset slightly byan increase in our average bill rate. Our average bill rate on a per hour basis for temporary servicesincreased 3.5% in the third quarter of fiscal 2008 compared with the thirdquarter of fiscal 2007.  Additionally,revenue from domestic permanent placement, transition, and transfer feesdeclined by 26.1% or $1 million to $2.9 million for the 12 weeks ended July 12,2008 as compared to the same period in the prior year.

 

Internationally,gross revenue increased by $4.5 million or 19.6% to $27.5 million for the 12weeks ended July 12, 2008 as compared to the same period in the prioryear.  The increase was predominantlyattributable to Australia primarily resulting from new business totaling $3.1million. Additionally, total billings for the top ten customers forAustralia in the 12 weeks ended July 12, 2008 increased $1.3 million or12.7% compared to the same period for fiscal 2007.  Australia accounted for $4.3 million of thegross revenue increase and New Zealand accounted for $0.2 million.

 

***Costs of services and gross margin***

 

Consolidatedcosts of services include hourly wages of temporary employees, employer payrolltaxes, state unemployment and workers’ compensation costs and other temporaryemployee-related costs. Costs of services from continuing operations decreased$18.0 million or 17.8% to $83.1 million for the 12 weeks ended July 12,2008 as compared to the same period in the prior year.  The larger percentage decrease in consolidatedgross revenue than in direct costs caused consolidated gross margin percentageto decrease to 16.4% in the 12 weeks ended July 12, 2008 compared to 17.4%in the same period in the prior year.

 

Domesticgross margin decreased to 17.7% in the 12 weeks ended July 12, 2008compared to 18.2% in the same period in the prior year.  This decrease is primarily as result of adecrease in permanent placement revenue in the 12 weeks ended July 12,2008 compared to the same period in the prior year.  Our average pay rate on a per hour basis fordomestic temporary services increased 2.7% in the third quarter of fiscal 2008compared with the third quarter of fiscal 2007.  The resulting bill pay spread on domestictemporary services in the third quarter has increased 5.5% in the 12 weeksended July 12, 2008 over the same period in the prior year. The change in the paybill spread is a result of the continued focus of our sales efforts onopportunities yielding a higher gross margin, which has resulted in decreasedsales revenue from lower margin business.

 

Thegross margin in Australia, including permanent placements, decreased to 12.1%in the 12 weeks ended July 12, 2008 from 13.4% in the same period in theprior year.  The gross margin fortemporary labor in Australia decreased slightly to 11.2% in the 12 weeks ended July 12,2008 from 11.7% in the same period in the prior year.

 

***Franchise agents’ share of gross profit***

 

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. Franchise agents’ share of gross profitdecreased $0.7 million or 18.3% to $3.3 million which was slightly more thanthe decline in overall franchise owned gross revenue.  Franchisees generally receive a greater shareof permanent placement revenue which declined at a lesser rate than the overalldecline in permanent placement revenue in the third quarter of fiscal 2008.  As a percentage of consolidated revenue,franchise agents’ share of gross profit remained at 3.3% for the fiscal 2007quarter and for the fiscal 2008 quarter.

 

***Selling and administrative expenses***

 

Consolidatedselling and administrative expenses decreased $2.4 million or 14.3% to $14.5million for the 12 weeks ended July 12, 2008 as compared to the sameperiod in the prior year. This decrease is primarily attributable to decreasedsalary and related costs of $1.5 million as a result of decreased headcount inthe domestic operations following the restructuring in the third quarter offiscal 2007.

 

Weachieved cost savings in domestic operations in the areas of facilities,advertising and promotion and supplies totaling $0.8 million as we consciouslylooked at opportunities to reduce spending in light of the significant declinein gross revenue.  In addition, weincurred lower communications and services costs, largely due to improvementsmade in our information systems infrastructure.   We achieved a $0.3 million reduction in baddebt expense due to management closely monitoring slow paying customers inlight of the slowdown in the domestic U.S. economy and management being moreproactive in reserving for those amounts in the early stages of identifyingconcerns.

 

19

----

Tableof Contents

 

Asa percentage of revenue, selling and administrative expenses were 14.6% for the12 weeks ended July 12, 2008, compared to 13.8% for same period in theprior year. The increase as a percent of sales is primarily due to thedecreased level of sales as total selling and administrative costs declined ata slower rate for the 12 weeks ended July 12, 2008 as compared to the sameperiod in the prior year.

 

***Depreciation and amortization***

 

Depreciationand amortization increased $0.2 million or 27.5% to $1.0 million, excluding thewrite-down of intangibles of $11.5 million as described in Note 7, for thethird quarter of fiscal 2008, as compared to fiscal 2007.  This increase is primarily attributable tothe new Pay-Bill system implementation costs, which were previously capitalizedduring pre-launch stages and now are amortized to income concurrent with thelaunch of the system in the first quarter of fiscal 2008.

 

***Impairment of goodwill and intangible assets***

 

As s result of the continued decline in revenue partially due to a lossof a major customer and the continued decline in market capitalization forWestaff, the Company determined that an interim impairment test was necessaryduring the third quarter of 2008. Accordingly, in accordance with SFAS No. 142, “Goodwill and OtherIntangible Assets” and SFAS No. 144 “Accounting for the Impairment ofDisposal of Long-Lived Assets,” the Company applied impairment tests to itsintangible assets, including goodwill during the third quarter of 2008.  The Company determined its reporting units tobe the same as its operating segments. See Note 17.  As a result of thistesting and in accordance with SFAS No. 142, the Company recorded apre-tax, non-cash charge of approximately $11.5 million in the third quarter offiscal 2008 related to the impairment of intangible assets and goodwillassociated with the US reporting unit.

 

***Net interest expense***

 

Net interest expense decreased by $91,000 or 18.5% to $0.4 million forthe 12 weeks ended July 12, 2008 as compared to the same period in theprior year.  The decrease is primarilyattributable to a decrease in the rate of interest resulting from the newfinancing agreement with U.S. Bank during fiscal 2008 and as described in Note9.

 

***Net loss***

 

Theresult of the aforementioned items was a loss for the third quarter of fiscal2008 of $15.1 million, or $0.90 per share, as compared with net loss of $2.9million, or $0.18 per share for the third quarter of fiscal 2007.

 

20

----

Tableof Contents

 

**Results of Operations – 36 weeks ended July 12, 2008 and July 7,2007**

 

***Revenue***

 

Grossrevenue from consolidated continuing operations declined by $52.9 million or14.6% to $310.3 million for the 36 weeks ended July 12, 2008 as comparedto the same period in the prior year. Domestic revenue declined by $66.7 million or 22.6% to $228.2 milliondriven largely by a 24.9% decrease in billed hours. Revenue from domesticfranchise operations declined from $101.7 million or 8.6% to $93.0 milliondriven largely by a 12.6% decrease in billed hours due to economic downturn.Revenue from domestic company-owned operations declined from $193.2 million or 30.0%to $135.2 million driven largely by a 31.7% decrease in billed hours due to theeconomic down turn and customer losses related to the restructuring planimplemented in the third quarter of fiscal 2007.  This decline was particularly notable in thelower billings for several of our larger customers.  Total billings for the top 20 customers inthe 36 weeks ended July 12, 2008 declined by $7.0 million or 10.6% to$59.1 million compared to the same period for fiscal 2007, offset slightly byan increase in our average bill rate. Our average bill rate on a per hour basis for temporary servicesincreased 3.2% in the 36 weeks ended fiscal 2008 compared with the same periodin the prior year.  Additionally, revenuefrom domestic permanent placement, transition, and transfer fees declined by22.3% or $2.8 million to $9.8 million for the 36 weeks ended July 12, 2008 ascompared to the same period in the prior year.

 

Internationally,gross revenue increased by $13.8 million or 20.3% to $82.1 million for the 36week ended July 12, 2008 as compared to the same period in the prioryear.    The increase was predominantlyattributable to Australia primarily resulting from new business totaling $6.6million.  $13.6 million of the grossrevenue increase was attributed to Australia and New Zealand accounted for $0.2million.

 

***Costs of services and gross margin***

 

Consolidatedcosts of services include hourly wages of temporary employees, employer payrolltaxes, state unemployment and workers’ compensation costs and other temporaryemployee-related costs.  Costs ofservices from continuing operations decreased $40.8 million or 13.6% to $259.6million for the 36 weeks ended July 12, 2008 as compared to the same periodin the prior year.  The larger percentagedecrease in gross revenue than in direct costs caused consolidated gross marginpercentage to decrease to 16.4% in the 36 weeks ended July 12, 2008 from17.3% compared to the same period in the prior year.

 

Domesticgross margin decreased slightly to 17.5% in the 36 weeks ended July 12,2008 from 18.0% compared to the same period in the prior year.  This decrease is primarily as result of adecrease in permanent placement revenue in the 36 weeks ended July 12,2008 compared to the same period in the prior year.  Our average pay rate on a per hour basis for domestictemporary services increased 3.4% in the 36 weeks ended July 12, 2008 ascompared to the same period in the prior year. The resulting bill pay spread ondomestic temporary services in the 36 weeks ended July 12, 2008 has increased2.8% over the same period in the prior year. The change in the pay bill spreadis a result of the continued focus of our sales efforts on opportunitiesyielding a higher gross margin, which has resulted in decreased sales revenuefrom lower margin business.

 

Thegross margin in Australia, decreased to 12.2% in the 36 weeks ended July 12,2008 from 13.5 % compared to the same period in the prior year.

 

***Franchise agents’ share of gross profit***

 

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. Franchise agents’ share of gross profitdecreased $1.0 million or 9.4% to $10.0 million which was slightly greater thanthe decline in overall franchise owned gross revenue.  Franchisees generally receive a greater shareof permanent placement revenue which declined as a lesser rate than the overalldecline in permanent placement revenue in the first 36 weeks of fiscal2008.  As a percentage of consolidatedrevenue, franchise agents’ share of gross profit increased slightly from 3.1%for the fiscal 2007 quarters to 3.2% for the fiscal 2008 quarters.  The increase was a result of franchiseerevenue not dropping as significantly as the total decline in domestic revenue.

 

***Selling and administrative expenses***

 

Consolidatedselling and administrative expenses decreased $3.9 million or 8.0% to $45.0 millionfor the 36 weeks ended July 12, 2008 as compared to the same period in theprior year. This decrease is primarily attributable to decreased salary andrelated costs of $3.7 million as a result of decreased headcount in thedomestic operations following the restructuring in the third quarter of fiscal2007.  We experienced a decrease of $3.9million of salary and related costs in our domestic operations which wereoffset by an increase internationally of approximately $0.2 million.

 

Weachieved cost savings in domestic operations in the areas of facilities,advertising and promotion and supplies totaling $2.0 million as we consciouslylooked at opportunities to reduce spending in light of the significant declinein gross revenue.  In addition, we incurredlower communications and services costs, largely due to improvements made inour information systems infrastructure.  We achieved a reduction in bad debt expense of $0.1 million in the first36 weeks of fiscal 2008 as compared to the first 36 weeks of fiscal 2007.  Management is also closely monitoring slowpaying customers in light of the slow down in the domestic U.S. economy and ismore proactive in reserving for those amounts in the early stages of identifyingconcerns.

 

21

----

Tableof Contents

 

Asa percentage of revenue, selling and administrative expenses were 14.5% for the36 weeks ended July 12, 2008, compared to 13.5% for the third fiscalquarter of 2007. The increase as a percent of sales is primarily due to thedecreased level of sales as total selling and administrative costs declined ata slower rate for the 36 weeks ended July 12, 2008 as compared to the sameperiod in the prior year.

 

***Restructuring benefit***

 

Werecorded restructuring charges in the third and fourth quarter of fiscal 2007related to reduction in force and closure of several branch offices.  In connection with the closure we recorded anexpense in the third and fourth quarter for severance payments and an estimatefor lease termination costs calculated for the remainder of the lease termreduced by an estimate for sublease income. During the 36 weeks ended July 12, 2008, the Company successfullynegotiated early termination agreements for nine locations and entered into asublease for three locations, the effects of which resulted in a $150,000reduction in our estimated accrual.  TheCompany is still responsible for lease payments on 12 locations and is activelynegotiating early terminations, where possible, and sublease opportunities tomitigate its obligation.  Therestructuring accrual, representing rent expense under non-cancellable leaseshas been reduced by the current estimated future sublease income.

 

***Depreciation and amortization***

 

Depreciationand amortization increased $1.7 million or 69.2% to $4.1 million, excluding thewrite-down of intangibles of $11.5 million as described in Note 7, for the 36weeks ended July 12, 2008 as compared to the same period in the prioryear.  This increase is primarilyattributable to an out of period adjustment of $0.9 million in the secondquarter of fiscal 2008, resulting in additional depreciation that should havebeen depreciated in prior periods.  Inaddition, the increase was caused by the new Pay-Bill system implementationcosts, which were previously capitalized during pre-launch stages and now areamortized to income concurrent with the launch of the system in the firstquarter of fiscal 2008.

 

***Impairment of goodwill and intangible assets***

 

As a result of the continued decline in revenue partially due to a lossof a major customer and the continued decline in market capitalization forWestaff, the Company determined that an interim impairment test was necessary duringthe third quarter of 2008.  Accordingly,in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets”and SFAS No. 144 “Accounting for the Impairment of Disposal of Long-LivedAssets,” the Company applied impairment tests to its intangible assets,including goodwill during the third quarter of 2008.  The Company determined its reporting units tobe the same as its operating segments. See Note 17.  As a result of thistesting and in accordance with SFAS No. 142, the Company recorded a pre-tax,non-cash charge of approximately $11.5 million in the third quarter of fiscal2008 related to the impairment of intangible assets and goodwill associatedwith the US reporting unit.

 

***Net interest expense***

 

Netinterest expense increased by $0.5 million or 33.5% to $2.0 million for thefirst 36 weeks of fiscal 2008 as compared to the first 36 weeks of fiscal2007.  The increase is primarilyattributable to the early termination of our credit facility with GeneralElectric Capital Corporation inthe second quarter of fiscal 2008, resulting in additional amortization expenseof $0.4 million from the write-off of deferred debt issue costs.

 

***Income taxes***

 

Forthe 36 weeks ended July 12, 2008, we recorded a consolidated income taxprovision on continuing operations of $20.2 million on a pre-tax loss of $21.8million.  The difference between the yearto date tax provision of $20.2 million and the prior period year to datebenefit of $0.6 million relates primarily to the establishment of a valuationallowance against a significant portion of the Company’s deferred tax assets inthe second quarter of fiscal 2008.  TheCompany recorded a valuation allowance in the second quarter of fiscal 2008 dueto cumulative losses in recent periods and revised projections indicatingcontinued losses for the remainder of fiscal 2008.  Although it is possible these deferred taxassets could still be realized in the future, the Company believes that is itmore likely than not that these deferred tax assets will not be realized in theforeseeable future.  The Company intendsto reevaluate its position with respect to the valuation allowanceperiodically.

 

***Net loss***

 

Theresult of the aforementioned items was a net loss for the first 36 weeks offiscal 2008 of $42.2 million, or $2.53 per share, as compared with net loss of$3.2 million, or $0.19 per share in the same period of fiscal 2007.

 

22

----

Table of Contents

 

**Liquidity and Capital Resources**

 

We require significantamounts of working capital to operate our business and to pay expenses relatingto employment of temporary employees. Our traditional use of cash is forfinancing of accounts receivable, particularly during periods of economicupswings and growth, when sales are seasonally high. Temporary personnel aretypically paid on a weekly basis while payments from customers are generallyreceived 30 to 60 days after billing.

 

We finance our operationsprimarily through cash generated by our operating activities and borrowingsunder our revolving credit facilities. Net cash provided by operations was $3.9 million for the 36 weeks ended July 12,2008, compared to cash provided of $2.8 million for the same period in theprior year.  Changes in accountsreceivable due to decreased sales and increased cash collections was thelargest significant source of cash providing $19.3 million during the 36 weeksended July 12, 2008 as compared to $3.1 million for the same period in theprior year.  This increase in changes incash provided by accounts receivable was offset by an increase in changes inaccounts payable and accrued expenses of $7.9 million.  The increase in changes in accountsreceivable was offset by a net loss of $42.2 million for the 36 weeks ended July 12,2008, which includes $20.9 million of non-cash income tax expense, as describedin Note 6, $4.3 million in non-cash depreciation and amortization and$11.5 million non-cash impairment,as described in Note 7, compared with a net loss of $3.2 million and $2.7million in non-cash depreciation and amortization for the same period in theprior year.  Additionally, included inthe Company’s net loss for the 36 weeks ended July 12, 2008, is a recordedgain, net of tax, of $1.0 million resulting from the sale of our former UnitedKingdom operations and related subsidiary on March 31, 2008.

 

We saw a decrease in ourdomestic days sales outstanding, measured by dividing our ending net accountsreceivable balance by total sales multiplied by the number of days in thefiscal quarter, (DSO) to 42.5 days at July 12, 2008 compared to 45.7 daysat July 7, 2007.  This decrease wasoffset slightly by our Australian DSO increasing to 45.7 days at July 12,2008 compared to 45.0 days at July 7, 2007.  New Zealand accounts receivable are not asignificant driver of our consolidated DSO.

 

Cash provided by investingactivities was $4.9 million for the 36 weeks ended July 12, 2008, ascompared to cash used for investing activities of $3.5 million for the sameperiod in the prior year.  Capitalexpenditures, which are primarily for information system initiatives bothdomestically and internationally, represented the majority of this decreasefrom $3.2 million for the 36 weeks ended July 7, 2007 compared to $0.3million for the 36 weeks ended July 12, 2008.  As noted above in Discontinued Operations,effective March 31, 2008 the Company sold its U.K. subsidiary operationsfor net proceeds of approximately $5.4 million.

 

Cash used for financing activitieswas $10.2 million in 36 weeks ended July 12, 2008 compared with cash usedfor financing activities of $0.6 million for the same period in the prioryear.  This increase in cash used forfinancing activities is primarily attributable to an increase in restrictedcash of $5.0 million during the 36 weeks ended July 12, 2008, as described inNote 3.  There was no change inrestricted cash for the same period in the prior year.  We paid down our line of credit by $3.9million primarily as a result of our increase in accounts receivablecollections.

 

On February 14,2008, the Company (through its wholly-owned subsidiary Westaff (USA), Inc.)entered into a financing agreement with U.S. Bank National Association (“U.S.Bank”), as agent, and the lenders thereto, which provides for a five-yearrevolving credit facility that previously provided for an aggregate commitmentof up to $50.0 million, including a letter of credit sub-limit of $35.0 million(the “Financing Agreement”).  Borrowingsunder the Financing Agreement bear interest, at the Company’s election, ateither U.S. Bank’s prime rate or at LIBOR plus an applicable LIBOR rate marginranging from 1.25% to 2.00%. The Financing Agreement provides that a defaultrate would apply on all loan obligations in the event of default under theFinancing Agreement and related documents, at a rate per annum of 2.0% abovethe applicable interest rate.  Interestis payable on a monthly basis.  The Companyhas $27.3 million of letters of credit supporting workers’ compensationobligations outstanding under the U.S. Bank Credit facility at July 12, 2008, butno cash borrowings.

 

On May 23,2008, the Company received a notice of default from U.S. Bank NationalAssociation (“U.S. Bank”) (as agent for itself and Wells Fargo Bank, NationalAssociation (“Wells Fargo”), as lenders, stating that (1) an Event ofDefault (as defined in the Financing Agreement) had occurred due to the Company’sfailure to achieve a minimum required Fixed Charge Coverage Ratio (as definedin the Financing Agreement) for the fiscal period ended April 19, 2008;and (2) as a result of the Event of Default, effective May 21, 2008,U.S. Bank increased the rate of interest to the default rate of interest on theborrowings outstanding under the Financing Agreement.

 

On July 31,2008, the Company entered into a Forbearance Agreement with U.S. Bank and thelenders.  Pursuant to the terms of theForbearance Agreement, (i) the lenders agreed to forbear from exercisingany of their default rights and remedies in response to the occurrence andcontinuance of the Event of Default commencing on the date of the ForbearanceAgreement and ending on August 26, 2008, (ii) the Company agreed to areduction in the aggregate amount of the commitments under the Financing Agreementfrom $50.0 million to $33.0 million effective as of June 23, 2008, and (iii) U.S.Bank agreed to maintain a reserve against the revolving credit availability tocover the Company’s payroll and payroll tax obligations.

 

23

----

Table of Contents

 

The Company iscurrently in discussions with U.S. Bank in order to seek a waiver or continuedforbearance in respect of the Event of Default.  There can be no assurance that the Companywill be able to obtain a waiver or continued forbearance or that such a waiveror continued forbearance would be on terms acceptable to the Company.  If the Company is unable to obtain a waiveror continued forbearance and the lenders elect to pursue remedies under theFinancing Agreement, such as limiting or terminating the Company’s right toborrow under the Financing Agreement or electing not to renew letters ofcredit, it would have a material adverse effect on the Company’s business,financial condition, results of operations and cash flows.

 

The Companysecured $3.0 million subordinated loan facility, subsequent to the end of thequarter and as described in Note 19. This facility may be used by the Companyfor working capital and general business purposes during the term of thefacility.

 

The Company’sAustralian subsidiary maintains an A$12 million Australian dollar facilityagreement (the “A$ Facility Agreement”) with GE Capital, as primary agent,expiring in May 2009.  The A$Facility Agreement includes a letter of credit sub-facility.

 

The Company has anunsecured subordinated promissory note in an amount of $2.0 million, dated May 17,2002 and payable to the former Chairman of the Board of Directors. The note,matured on August 18, 2007, is now past due and has an interest rate equalto an indexed rate as calculated under the Company’s credit facilities plusseven percent, compounded monthly and payable 60 calendar days after the end ofeach of the Company’s fiscal quarters. The effective interest rate on July 12,2008 was 12.0%. Payment of interest is contingent on the Company meetingminimum availability requirements under its credit facilities. Additionally,payments of principal or interest are prohibited in the event of any defaultunder the credit facilities.  U.S. Bank,which is the agent and a lender under our primary credit facility, hasexercised its right to prohibit repayment of the note. Accrued and unpaid intereston this note at July 12, 2008 was $297,000 and is included in accruedexpenses in the Company’s consolidated balance sheets.

 

We work to balance ourworldwide cash needs through dividends from and loans to our internationalsubsidiaries. These loans and dividends are limited by the cash availabilityand needs of each respective subsidiary, restrictions imposed by our seniorsecured debt facilities and, in some cases, statutory regulations of thesubsidiary. The U.S. operations cannot directly draw on the excess borrowingavailability of the Australian operations; however, we may request repaymentson its intercompany loan to Australia, along with intercompany interest androyalties, although remittances from Australia may be limited by certaincovenants under the terms of the Australia credit facility.  Outstanding principal on the intercompanyloan to Australia was approximately $5.2 million as of July 12, 2008.  An additional $1.4 million was outstandingfrom New Zealand to the U.S.

 

We are responsible for andpay workers’ compensation costs for our domestic temporary and regularemployees and are self-insured for the $750,000 deductible amount related toworkers’ compensation claims for fiscal 2008 claims. Typically, each policyyear the terms of the agreement with the insurance carrier are renegotiated.The insurance carrier requires us to collateralize our obligations through theuse of irrevocable standby letters of credit, surety bonds or cash.

 

For our 2008 policy yearinsurance program, we anticipate total cash premium payments of $4.2 millionwill be paid during fiscal 2008 in equal monthly installments, which commencedon November 1, 2007, as compared to $4.8 million paid during fiscal 2007.Cash payments for 2008 policy year claims will be paid directly by us up to ourdeductible which was increased from $500,000 per claim to $750,000 per claimfor fiscal 2008 claims. As of July 12, 2008, we had outstanding $27.3million of letters of credit to secure all estimated outstanding obligationsunder our workers’ compensation program for all years except 2003, which isfully funded although subject to annual retroactive premium adjustments basedon actual claims activity. We will also make ongoing cash payments for claimsfor all other open policy years (except for 2003 as noted above).

 

We calculate the estimatedliabilities associated with these programs based on our estimate of theultimate costs to settle known claims as well as claims incurred but not yetreported to us (“IBNR claims”) as of the balance sheet date. Our estimatedliabilities are not discounted and are based on information provided by ourinsurance brokers, insurers and actuary, combined with our judgment regarding anumber of assumptions and factors, including the frequency and severity ofclaims, claims development history, case jurisdiction, applicable legislationand our claims settlement practices. We maintain stop-loss coverage with thirdparty insurers to limit our total exposure for each of these programs.  Significant judgment is required to estimateIBNR amounts as parties have yet to assert such claims. If actual claimstrends, including the severity or frequency of claims, differ from ourestimates, our financial results could be impacted.

 

We continue to evaluateother opportunities to further strengthen our financial position and improveour liquidity.

 

For a discussion regardinggoing concern considerations, please see “Going Concern Considerations” aboveelsewhere in this Management’s Discussion and Analysis of FinancialCondition and Results of Operations.

 

24

----

Table ofContents

 

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

 

We are exposed to certainmarket risks from transactions that are entered into during the normal courseof business.  Our primary market riskexposure relates to interest rate risk. At July 12, 2008, our outstanding debt under variable-rate interestborrowings was approximately $5.1 million. A change of two percentage points in the interest rates would cause achange in interest expense of approximately $0.1 million on an annualbasis.  Our exposure to market risk forchanges in interest rates is not significant with respect to interest income,as our investment portfolio is not material to our consolidated balancesheet.  We currently have no plans tohold an investment portfolio that includes derivative financial instruments.

 

For the 36 weeks ended July 12, 2008, our international operationscomprised 26.5% of our gross revenue and, as of the end of that period, 25.3%of our total assets.  We are exposed toforeign currency risk primarily due to our investments in foreignsubsidiaries.  The Company’s Australiansubsidiary maintains a A$12 million Australian dollar facility agreement, whichallows our Australian subsidiary to borrow in local currency and partiallymitigates the exchange rate risk resulting from fluctuations in foreigncurrency denominated net investments in these subsidiaries in relation to theU.S. dollar.  We do not currently holdany market risk sensitive instruments entered into for hedging risks related toforeign currencies. In addition, we have not entered into any transactions withderivative financial instruments for trading purposes.

 

25

----

Table ofContents

 

### **Item4T.  Controls and Procedures**

 

We maintain disclosurecontrols and procedures that are designed to ensure that information requiredto be disclosed in our reports filed under the Securities Exchange Act of 1934,as amended (the “Exchange Act”), is recorded, processed, summarized andreported within the time periods specified in the SEC’s rules and forms,and that such information is accumulated and communicated to our management,including our Chief Executive Officer and Chief Financial Officer, asappropriate, to allow timely decisions regarding required disclosure.  In designing and evaluating the disclosurecontrols and procedures, management recognizes that any controls andprocedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving the desired control objectives, andmanagement necessarily is required to apply its judgment in evaluating the cost-benefitrelationship of possible controls and procedures.

 

We carried out anevaluation, under the supervision and with the participation of our seniormanagement, including our Chief Executive Officer and Chief Financial Officer,of the effectiveness of the design and operation of our disclosure controls andprocedures as of July 12, 2008, which is the end of the period covered bythis Quarterly Report on Form 10-Q. Based upon this evaluation, our Chief Executive Officer and ChiefFinancial Officer concluded that our disclosure controls and procedures werenot effective as of July 12, 2008 due to the existence of a continuingmaterial weakness relating to a lack of qualified resources within theaccounting department as previously identified in our Quarterly Reports on Form 10-Qfor the quarterly periods ended January 26, 2008 and April 19,2008.  These prior Quarterly Reports alsoidentified several other weaknesses in our disclosure controls and procedures,which we believe have been remedied, including burdens placed on our existingaccounting department by billing system implementation issues, since resolved,a delayed finalization of our fiscal year 2007 audit, since completed, andissues in completing account reconciliations on a timely basis, which theCompany is making progress in resolving by improving the Company’s focus on andprioritizing this process.

 

In fiscal 2008, theCompany underwent a change in senior financial management with the resignationof the Chief Financial Officer and Controller, effective May 15,2008.  Subsequently, effective June 16,2008, the Company underwent a further change in management, including thehiring of a new Chief Operating Officer and Chief Financial Officer, both withsignificant industry and Company experience.  The Company continues to undertake a number ofsteps, including retaining executive search firms, to fill the vacantController position.

 

Other than improvementsin our situation discussed above, there was no change in our internal controlover financial reporting that occurred during the quarterly period ended July 12,2008 that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting**.**

 

26

----

Table ofContents

 

### **Part II.   Other Information**

###  

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

 

In theordinary course of our business, we are periodically threatened with or namedas a defendant in various lawsuits.  Theprincipal risks that we insure against are workers’ compensation, generalliability, automobile liability, property damage, alternative staffing errorsand omissions, fiduciary liability and fidelity losses.

 

During the fourth quarter offiscal 2005, we were notified by the California Employment DevelopmentDepartment (the “EDD”) that our domestic operating subsidiaries unemploymenttax rates would be increased retroactively for both calendar years 2005 and2004, which would result in additional unemployment taxes of approximately $0.9million together with interest at applicable statutory rates.  Management believes that it has properlycalculated its unemployment insurance tax and is in compliance with allapplicable laws and regulations. We have timely appealed the ruling by the EDDand are working with our outside counsel to resolve this matter.  A hearing officer has been assigned to thematter.  We are awaiting confirmation ofa hearing date from the EDD.

 

Otherthan the action listed above, we are not currently a party to any materiallitigation.  However, from time to timewe have been threatened with, or named as a defendant in litigation brought byformer franchisees or licensees, and administrative claims and lawsuits broughtby employees or former employees. Management believes the resolution of these matters would not have amaterial adverse effect on our consolidated financial statements.

 

27

----

Table of Contents

 

### **Item 1A.  Risk Factors**

 

Investing in our common stock involves a high degreeof risk. The following risk factors, issues and uncertainties should becarefully considered before deciding to buy, hold or sell our common stock. Setforth below and elsewhere in this Quarterly Report on Form 10-Q, and inother documents that we file with the SEC, are risks and uncertainties that could cause the Company’s actual resultsand financial position to differ materially from those expressed or implied inforward-looking statements and to be below the expectations of public marketanalysts and investors. See “Cautionary Statement Regarding Forward-LookingStatements” in Part I, Item 2, “Management’s Discussion and Analysisof Financial Condition and Results of Operations.” Any one of the following risks could harm our operating resultsor financial condition and could result in a significant decline in the valueof an investment in us. Further, additional risks and uncertainties that havenot yet been identified or which we currently believe are immaterial may alsoharm our operating results and financial condition.

 

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

 

Demand for staffing services is significantly affectedby the general level of economic activity. We expect that the recent downturn in the economy will continue toimpact the demand for staffing services and the Company’s performance.  As economic activity slows, many customersreduce their utilization of temporary employees before undertaking layoffs oftheir regular full-time employees.  Further,demand for permanent placement services also slows as the labor pool directlyavailable to our customers increases, making it easier for them to identify newemployees directly.  Typically, we mayexperience increased pricing pressures from other staffing companies duringperiods of economic downturn, which could have a material adverse effect on ourfinancial condition. Additionally, in geographic areas where we derive asignificant amount of business, a regional or localized economic downturn couldadversely affect our operating results and financial position.

 

*We have significant working capital requirementsand are heavily dependent upon our ability to borrow money to meet theseworking capital requirements.*

 

We require significant amounts of working capital tooperate our business and to pay expenses relating to employment of temporaryemployees.  Temporary personnel aregenerally paid on a weekly basis while payments from customers are generallyreceived 30 to 60 days after billing. As a result, we must maintain sufficientcash availability to pay temporary personnel prior to receiving payment fromcustomers.  Any lack of access to liquidworking capital would have an immediate, material, and adverse impact on ourbusiness.  There can be no assurance thatwe will be able to access the funds necessary for our liquidity requirements,especially in light of the recent downturn in the economy and dislocations inthe credit and capital markets.

 

We finance our operations primarily through cashgenerated by our operating activities and through borrowings under ourrevolving credit facilities.  Our primarycredit facility is the Financing Agreement with U.S. Bank and Wells Fargo,which provides for a five-year revolving credit facility with an aggregatecommitment of up to $33.0 million.  Inaddition, our Australian subsidiary maintains an A$12.0 million Australiandollar facility agreement with GE Capital that expires in May 2009.  As of July 12, 2008, our total borrowingcapacity was $13.2 million, consisting of $5.3 million for our domesticoperations and $7.9 million for our Australian operations.

 

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

 

We typically experience significant seasonal and otherfluctuations in our borrowings and borrowing availability, particularly in theUnited States, and aggressively manage our cash to ensure adequate funds tomeet working capital requirements.  Suchsteps include working to improve collections and adjusting the timing of cashexpenditures and reducing operating expenses where feasible.

 

We have historically experienced periods of negativecash flow from operations and investment activities, especially during seasonalpeaks in revenue experienced in the third and fourth fiscal quarters of theyear.  In addition, we are required topledge amounts to secure letters of credit that collateralize certain workers’compensation obligations, and these amounts may increase in future periods.  Any such increase in pledged amounts or sustainednegative cash flows would decrease amounts available for working capitalpurposes and could have a material adverse effect on our liquidity andfinancial condition.

 

*We are currently in default under the primarycredit facility that we use to finance our operations.  If we are unable to obtain a waiver orcontinued forbearance with respect to this default, we may be unable to satisfyour liquidity requirements and continue our operations as a going concern.*

 

We finance our operations primarily through cashgenerated by our operating activities and through borrowings under ourrevolving line of credit with U.S. Bank, National Association (“U.S. Bank”) andWells Fargo Bank, National Association, as lenders.  On May 23, 2008, we received a notice ofdefault from U.S. Bank (as agent for itself and Wells Fargo Bank) stating that (1) anEvent of Default (as defined in the Financing Agreement) had occurred due toour failure to achieve a minimum required Fixed Charge Coverage Ratio (asdefined in the Financing Agreement) for our fiscal period ended April 19,2008; and (2) as a result of the Event of Default, effective May 21,2008, U.S. Bank increased the rate of interest to the default rate of intereston the borrowings outstanding under our line of credit. We had no borrowingsoutstanding under the Financing Agreement, but do have $27.3 million of lettersof credit outstanding supporting our workers’ compensation obligations.

 

On July 31, 2008, we entered into a ForbearanceAgreement with U.S. Bank and the lenders. Pursuant to the terms of the Forbearance Agreement, (i) the lendersagreed to forbear from exercising any of their default rights and remedies inresponse to the occurrence and continuance of the Event of Default commencingon the date of the Forbearance Agreement and ending on August 26, 2008, (ii) weagreed to a reduction in the aggregate amount of the commitments under our lineof credit from $50.0 million to $33.0 million effective as of June 23,2008, and (iii) U.S. Bank agreed to maintain a reserve against therevolving credit availability to cover our payroll and payroll tax obligations.

 

We are currently in discussions with U.S. Bank inorder to seek a waiver or continued forbearance in respect to the Event ofDefault.  There can be no assurance thatwe will be able to obtain a waiver or continued forbearance on terms acceptableto us, or at all.  If we are unable toobtain a waiver and the lenders elect to pursue their remedies under the lineof credit, such as limiting or terminating our right to borrow or electing notto renew letters of credit, we may be unable to obtain the liquidity we need tocontinue our operations as a going concern or obtain workers’ compensationinsurance needed to operate.  Even if weare able to obtain funds through the line of credit, it is possible thatlimitations on the terms under which such borrowing may be made could adverselyaffect our business and operating results.

 

On August 25, 2008, we entered into a SubordinatedLoan Agreement with our principal stockholder, Delstaff, LLC, which provides aloan facility allowing us to request loan advances in an aggregate principalamount of up to $3.0 million.  Thematurity date of the Subordinated Loan Agreement is August 15, 2009 (the “MaturityDate”).

 

The unpaid principal balance due under theSubordinated Loan bears interest at an annual rate of twenty percent(20%).  Interest is payable-in-kind andaccrues monthly in arrears on the first day of each month as an increase in theprincipal amount of the Subordinated Loan. A default rate applies on all obligations under the Subordinated LoanAgreement from and after the Maturity Date and also during the existence of anEvent of Default (as defined in the Subordinated Loan Agreement) at an annualrate of ten percent (10%) also payable-in-kind over the then-existingapplicable interest rate and if principal is not repaid on the Maturity Date,an additional 5% of outstanding principal must be paid along with the defaultrate interest.  Our obligations under theSubordinated Loan Agreement are secured by a security interest in substantiallyall of our existing and future assets (the “Subordinated Collateral”).  The lien granted to the Subordinated Lenderin the Subordinated Collateral is subordinated to the lien in that samecollateral granted to U.S. Bank.  We mayuse the Subordinated Loan for working capital and general business purposes.  Any borrowings in excess of $1.0 millionrequire Subordinated Lender approval.  TheSubordinated Loan may be prepaid without penalty, subject to approval by U.S.Bank, and the terms of an Intercreditor Agreement.

 

Under certain circumstances, we must prepay all or aportion of any amounts outstanding under the Subordinated Loan Agreement,subject to the terms of the Intercreditor Agreement.

 

28

----

Tableof Contents

 

Under the terms of the Subordinated Loan Agreement,the Company has agreed to pay to the Subordinated Lender a facility fee at theclosing which will be added to the principal of the Subordinated Loans at theclosing, but will not reduce the availability of the $3.0 million facility.

 

*We may be unable to adequately collateralize ourworkers’ compensation obligations at their current levels or at all.*

 

We are contractually obligated to collateralize ourworkers’ compensation obligations under our workers’ compensation programthrough irrevocable letters of credit, surety bonds or cash.  As of July 12, 2008, our aggregatecollateral requirements under these contracts have been secured through $27.3million of letters of credit obtained through our U.S. Bank facility.  Our workers’ compensation program expires November 1,2008, and as part of the renewal, could be subject to an increase incollateral.  These collateralrequirements are significant and place pressure on our liquidity and workingcapital capacity.  If we are not able toobtain a renewal of our letters of credit at a level sufficient to meet ourcollateral requirements, we could be unable to obtain sufficient workers’compensation coverage to support our operations.

 

*We have had significant turnover in our managementteam and further loss of any of our key personnel or failure to recruit  for key open positions could harm ourbusiness.*

 

We have experienced substantial, ongoing turnoveramong members of our senior management team since the middle of 2007.  This turnover and other staffing issues havesignificantly affected both our operations and finance organizations, and, inthe case of our finance organizations, directly contributed to the creation andexistence of a continuing material weakness in our disclosure controls andprocedures as discussed in Item 4T, “Controls and Procedures” included elsewhere in thisQuarterly Report on Form 10-Q.  Anyfurther loss of senior management personnel or difficulties in filling openpositions may harm our business.

 

On June 4, 2008, we announced the appointment ofMark Bierman as our Senior Vice President and Chief Information Officer.  On June 16, 2008, we hired a new ChiefOperating Officer, Stephen J. Russo, and Chief Financial Officer, Christa C.Leonard, both with significant industry and Company experience.  We continue to undertake a number of steps,including retaining executive search firms, to fill our vacant Controllerposition.

 

Our future financial performance is significantlyimpacted by our ability to attract, motivate and retain key managementpersonnel and other members of the senior management team.  Competition for qualified managementpersonnel is intense and in the event that we experience additional turnover insenior management positions, we cannot assure that we will be able to recruitsuitable replacements on a timely basis. We must also successfully integrate all new management and other keypositions within our organization to achieve our operating objectives.  Even if we are successful, turnover in keymanagement positions could temporarily harm our financial performance andresults of operations until the new management becomes familiar with ourbusiness.

 

*The staffing industry is highly competitive withlimited barriers to entry which could limit our ability to maintain or increasemarket share.*

 

29

----

Tableof Contents

 

The staffing industry is highly competitive withlimited barriers to entry and continues to undergo consolidation.  We compete in regional and local markets withlarge full service agencies, specialized temporary and permanent placementservices agencies and small local companies. While some competitors are smaller than us, they may enjoy an advantagein discrete geographic markets because of a stronger local presence.  Other competitors have greater marketing,financial and other resources than we do that, among other things, could enablethem to attempt to maintain or increase their market share by reducing prices.  Furthermore, in past years there has been anincrease in the number of customers consolidating their staffing servicespurchases with a single provider or with a small number of providers.  The trend to consolidate staffing servicespurchases has in some cases made it more difficult for us to obtain or retainbusiness.

 

*Price competition in the staffing industrycontinues to be intense, and pricing pressures from both competitors andcustomers could adversely impact our financial decisions.*

 

We expect the level of competition to remain high in thefuture, and competitive pricing pressures will continue to make it difficultfor us to raise our prices to immediately and fully offset increased costs ofdoing business, including increased labor costs, costs for workers’compensation and, domestically, state unemployment insurance.  If we are not able to effectively compete inour targeted markets, our operating margins and other financial results will beharmed and the price of our securities could decline.  We also face the risk that our current or prospectivecustomers may decide to provide services internally.

 

*Failureto implement our new strategies could impede our growth and result insignificant added costs.*

 

In fiscal 2007, we madesignificant changes to our field structure and hired several new key executiveslate in the fiscal year to seek to grow new business markets for theCompany.  Our failure to implement thesenew strategies could impede our growth and result in significant added costs.  Even if our new strategies are successfullyimplemented, they may not have the favorable impact on our business andoperations that we anticipate.

 

*Our principal stockholder, together with itsaffiliates, controls a significant amount of our outstanding common stock thusallowing them to exert significant influence on our management and affairs.*

 

As of July 12, 2008, our principal stockholder,DelStaff LLC (“DelStaff’), together with its affiliates, controls approximately44.1% of the total outstanding shares of our common stock.  The members of DelStaff are H.I.G. Staffing,2007, Ltd., Alarian Associates, Inc. and Michael T. Willis.  As our principal stockholder, DelStaff andits affiliates have the ability to significantly influence all matterssubmitted to our stockholders for approval, including the election ofdirectors, and to exert significant influence over our management andaffairs.  On April 30, 2007, weentered into a Governance Agreement with DelStaff, Mr. Willis and Mr. Stover.On May 9, 2007, pursuant to the terms of the Governance Agreement, weexpanded the size of our Board of Directors from five to nine directors andappointed the following DelStaff nominees to the Board: Michael T. Willis, JohnR. Black, Michael R. Phillips, Gerald E. Wedren and John G. Ball.  DelStaff also has the ability to stronglyinfluence any merger, consolidation, sale of substantially all of our assets orother strategic decisions affecting us or the market value of the stock.  This concentration of stock and voting powercould be used by DelStaff to delay or prevent an acquisition of Westaff orother strategic action or result in strategic decisions that could negativelyimpact the value and liquidity of our outstanding stock.

 

30

----

Tableof Contents

 

*Our reserves for workers’ compensation claims maybe inadequate to cover our ultimate liability, and we may incur additionalcharges if the actual amounts exceed the reserved amounts.*

 

We maintain reserves to cover our estimatedliabilities for workers’ compensation claims based upon actuarial estimates ofthe future cost of claims and related expenses which have been reported but notsettled, and that have been incurred but not yet reported.  The determination of these reserves is basedon a number of factors, including current and historical claims activity,medical cost trends and developments in existing claims.  Reserves do not represent an exactcalculation of liability and are affected by both internal and external events,such as adverse development on existing claims, changes in medical costs,claims handling procedures, administrative costs, inflation, legal trends andlegislative changes.  Reserves are adjustedas necessary to reflect new claims and existing claims development, and suchadjustments are reflected in the results of the periods in which the reservesare adjusted.  While we believe ourjudgments and estimates are adequate, if our reserves are insufficient to coverour actual losses, an adjustment could be charged to expense that may bematerial to our earnings.

 

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

 

In the United States, we are responsible for and payworkers’ compensation costs for our regular and temporary employees.  In recent years, these costs have risensubstantially as a result of increased claims, general economic conditions,increases in healthcare costs and governmental regulations.  The frequency of new claims has fallen infiscal 2008 as compared to prior years, yet the cost per claim continues toincrease.  Under our workers’compensation insurance program, we maintain “per occurrence” insurance, whichonly covers claims for a particular event above a deductible.  This deductible has been increased for ourpolicy year ending November 1, 2008 from $500,000 to $750,000 per claimfor fiscal 2008 claims.  Our workers’compensation insurance policy expires November 1, 2008 and we cannotguarantee that we will be able to successfully renew such policy.  Further, there are covenants associated withthe continuation of the policy and there can be no guarantee that we willcontinue to meet those covenants going forward. Should our workers’ compensation premium costs continue to increase inthe future, there can be no assurance that we will be able to increase the feescharged to our customers to keep pace with increased costs or if we were unableto obtain insurance on reasonable terms or forced to significantly increase ourdeductible per claim, our results of operations, financial condition andliquidity could be adversely affected.

 

*We are exposed to credit risks on collections fromour customers due to, among other things, our assumption of the obligation tomake wage, tax, and regulatory payments to our temporary employees.*

 

We are exposed to the credit risk of some of ourcustomers.  Temporary personnel aretypically paid on a weekly basis while payments from customers are generallyreceived 30 to 60 days after billing.  Wegenerally assume responsibility for and manage the risks associated with ourpayroll obligations, including liability for payment of salaries and wages,payroll taxes as well as group health insurance.  These obligations are fixed and become aliability of ours, whether or not the associated client to whom these employeeshave been assigned makes payments required by our service agreement, whichexposes us to credit risks.  We attemptto mitigate these risks by billing on a frequent basis, which typically occursdaily or weekly.  In addition, weestablish an allowance for doubtful accounts for estimated losses resultingfrom the inability of our customers to make required and timely payments.  Further, we carefully monitor the timelinessof our customers’ payments and impose strict credit standards.  However, there can be no assurance that suchsteps will be effective in reducing these risks.  Finally, the majority of our accountsreceivable is used to secure our revolving credit facilities, which we rely onfor liquidity.  If we fail to adequatelymanage our credit risks associated with accounts receivable, our financialposition could be adversely impacted. Additionally, to the extent that recent turmoil in the credit marketsmakes it more difficult for some customers to obtain financing, those customers’ability to pay could be adversely impacted, which in turn could have a materialadverse effect on our business, financial condition or results of operations.

 

31

----

Tableof Contents

 

*We derive a significant portion of our revenue fromfranchise agent operations.*

 

Franchise agent operations comprise a significantportion of our revenue.  For the first 36weeks of 2008, franchisees represented 30.0% of gross receipts.  In addition, our ten largest franchise agentsfor the first 36 weeks of fiscal 2008 (based on sales volume) accounted for20.2% of our revenue.  There can be noassurances that we will be able to attract new franchisees or that we will beable to retain our existing franchisees. The loss of one or more of our franchise agents and any associated lossof customers and sales could have a material adverse effect on our results ofoperations.

 

*We are subject to business risks associated withinternational operations and fluctuating exchange rates.*

 

We presently have operations in Australia and NewZealand, which comprised 26.5% of our revenue for 36-week period ended July 12,2008.  Operations in foreign markets areinherently subject to certain risks, including in particular:

 

·                  differences in cultures andbusiness practices;

 

·                  overlapping or differing taxlaws and regulations;

 

·                  economic and politicaluncertainties;

 

·                  differences in accountingand reporting requirements;

 

·                  changing, complex orambiguous foreign laws and regulations, particularly as they relate toemployment; and

 

·                  litigation and claims.

 

All of our sales outside of the United States aredenominated in local currencies and, accordingly, we are subject to risksassociated with fluctuations in exchange rates, which could cause a reductionin our profits.  There can be noassurance that any of these factors will not have a material adverse effect onour business, results of operations, cash flows or financial condition.

 

*Our success is impacted by our ability to attractand retain qualified temporary and permanent candidates.*

 

We compete with other staffing services to meet ourcustomers’ needs, and we must continuously attract reliable candidates to meetthe staffing requirements of our customers. Consequently, we must continuouslyevaluate and upgrade our base of available qualified personnel to keep pacewith changing customer needs and emerging technologies.  Furthermore, a substantial number of ourtemporary employees during any given year will terminate their employment withus and accept regular staff employment with our customers.  Competition for individuals with provenskills remains intense, and demand for these individuals is expected to remainstrong for the foreseeable future.  Therecan be no assurance that qualified candidates will continue to be available tous in sufficient numbers and on acceptable terms to us.  The failure to identify, recruit, train andplace candidates as well as retain qualified temporary employees over a longperiod of time could materially adversely affect our business.

 

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

 

Our service agreements are generally cancellable withlittle or no notice by the customer to us. As a result, our customers canterminate their agreement with us at any time, making us particularlyvulnerable to a significant decrease in revenue within a short period of timethat could be difficult to quickly replace.

 

*The cost of unemployment insurance for temporaryemployees may rise and reduce our margins.*

 

In the United States, we are responsible for and payunemployment insurance premiums for our temporary and regular employees.  At times, these costs have risen as a resultof increased claims, general economic conditions and governmentregulations.  Should these costs continueto increase, there can be no assurance that we will be able to increase thefees charged to our customers in the future to keep pace with the increasedcosts, and if we do not, our results of operations and liquidity could beadversely affected.

 

*Our information technology systems are critical tothe operations of our business.*

 

Our information management systems are essential fordata exchange and operational communications with branches spread across largegeographical distances.  We have replacedkey component hardware and software including backup systems within the pasttwelve months.  On November 12,2007, we implemented a new accounts receivable billing and temporary payrollsystem.  The new system receivesinformation from our custom built front office system.  We experienced technical issues after conversionthat were not detected during the testing phases.  These issues affected both the payroll andbilling systems.  We believe that we haveidentified and resolved the significant issues. These issues were disruptive to our business and could affect customerand employee relations.  Additionally,these issues required significant amount of management time that impacted ourability to sell new services during the first half of fiscal 2008.  We have made progress in resolving thesespecific payroll and billing systems issues. However, any future interruption, impairment or loss of data integrityor malfunction of these systems could severely impact our business, especiallyour ability to timely and accurately pay employees and bill customers.

 

32

----

Tableof Contents

 

*Our business is subject to extensive governmentregulation, which may restrict the types of employment services that we arepermitted to offer or result in additional tax or other costs that adverselyaffect our revenues and earnings.*

 

We are in the business of employing people and placingthem in the workplace of other businesses on either a temporary or permanentbasis.  As a result, we are subject toextensive laws and regulations relating to employment.  Changes in laws or government regulations mayresult in prohibition or restriction of certain types of employment services weare permitted to offer or the imposition of new or additional benefit,licensing or tax requirements that could reduce our revenues and earnings.  There can be no assurance that we will beable to increase the fees charged to our customers in a timely manner and in asufficient amount to cover increased costs as a result of any changes in lawsor government regulations.  Any futurechanges in laws or government regulations may make it more difficult orexpensive for us to provide staffing services and could have a material adverseeffect on our business, financial condition or results of operations.

 

*We may be exposed to employment-related claims andcosts that could materially adversely affect our business.*

 

The risks related to engaging in our business includebut are not limited to:

 

·                  claims by our placedpersonnel of discrimination and harassment directed at them, including claimsarising from the actions of our customers;

 

·                  workers’ compensation claimsand other similar claims;

 

·                  violations of wage and hourlaws and requirements;

 

·                  claims of misconduct,including criminal activity or negligence on the part of our placed personnel;

 

·                  claims by our customersrelating to actions by our placed personnel, including property damage andpersonal injury, misuse of proprietary information and misappropriation ofassets or other similar claims; and

 

·                  immigration related claims.

 

In addition, some or all of these claims may give riseto litigation, which could be time-consuming to our management team, andtherefore, could have a negative effect on our business, financial conditionsand results of operations. In some instances, we have agreed to indemnify ourcustomers against some or all of these types of liabilities.  We have policies and guidelines in place tohelp reduce our exposure to these risks and have purchased insurance policiesagainst certain risks in amounts that we currently believe to be adequate.  However, there can be no assurance that ourinsurance will be sufficient in amount or scope to cover these types ofliabilities or that we will be able to secure insurance coverage for such riskson affordable terms.  Furthermore, therecan be no assurance that we will not experience these issues in the future orthat they could have a material adverse effect on our business.

 

*The market for our stock may be limited, and thestock price has been and may continue to be extremely volatile.*

 

The average daily trading volume for our common stockon the NASDAQ Global Market was approximately 16,500 shares during the 36 weeksended July 12, 2008.  Accordingly,the market price of our common stock is subject to significant fluctuationsthat have been, and may continue to be, exaggerated because an active tradingmarket has not developed for our common stock. We believe that the price of ourcommon stock has also been negatively affected by the fact that our commonstock is thinly traded and also due to the absence of analyst coverage.  The lack of analyst reports about our stockmay make it difficult for potential investors to make decisions about whetherto purchase our stock and may make it less likely that investors will purchasethe stock, thus further depressing the stock price.  These negative factors may make it difficultfor stockholders to sell our common stock, which may result in losses forinvestors.

 

*The compliance costs associated with Section 404and other requirements of the Sarbanes-Oxley Act of 2002 regarding internalcontrol over financial reporting could be substantial, while failure to achieveand maintain compliance could have an adverse effect on our stock price.*

 

33

----

Tableof Contents

 

Pursuant to Section 404 of the Sarbanes-Oxley Actof 2002 and current SEC regulations, beginning with our Annual Report on Form 10-Kfor the fiscal year ending November 1, 2008, we will be required tofurnish a report by our management on our internal control over financialreporting.  We will be required to haveour independent registered public accounting firm attest to management’sassessment on our internal control over financial reporting beginning with ourAnnual Report on Form 10-K for the fiscal year ending October 30,2010.  The process of fully documentingand testing our internal control procedures in order to satisfy theserequirements will result in increased general and administrative expenses andmay shift management time and attention from business activities to complianceactivities. Furthermore, during the course of our internal control testing, wemay identify deficiencies which we may not be able to remediate in time to meetthe reporting deadline under Section 404. Failure to achieve and maintain an effective internal controlenvironment or complete our Section 404 certifications could have amaterial adverse effect on our stock price.

 

*We are involved in an action taken by theCalifornia Employment Development Department.*

 

During the fourth quarter of fiscal 2005, the Companywas notified by the EDD that its domestic operating subsidiaries unemploymenttax rates would be increased retroactively for both calendar years 2005 and2004, which would result in additional unemployment taxes of approximately $0.9million together with interest at applicable statutory rates. Managementbelieves that it has properly calculated its unemployment insurance tax and isin compliance with all applicable laws and regulations. The Company has timelyappealed the ruling by the EDD and is working with the outside counsel toresolve this matter.  Although we believethat we have properly calculated our unemployment insurance tax and are incompliance with all applicable laws and regulations, there can be no assurancesthis will be settled in our favor.

 

*We have assets on our balance sheet for which theirrealization is dependent on our future profitability.*

 

Asof July 12, 2008, we have intangibles of $3.5 million. During the Company’sthird quarter of fiscal year 2008 in light of the continued decline in revenuepartially due to a loss of a major customer and the continued decline in marketcapitalization for Westaff, the Company determined that an interim impairmenttest was necessary during the third quarter of 2008.  Based on the impairment evaluation as of July 12,2008, it was determined that the indefinite life franchise right intangible wasimpaired by $0.2 million.  Such animpairment charge was measured in accordance with SFAS 142 as the excess of thecarrying value over the fair value of the asset.   After completing the intangible assetimpairments, the Company compared the fair value of the US Reporting Unit toits carrying value and determined that the reporting unit was impaired.  Upon completion of step two of the impairmenttest, the Company recorded a goodwill impairment of $11.4 million in relationto its U.S. domestic services reporting unit.

 

A majority of the remaining intangible asset balanceof $3.5 million as of July 12, 2008 relates to an indefinite lifefranchise right intangible relating to the Houston market.  If we are unable to maintain our projectedlevels of profitability for this market, we may need to write off a portion orall of these assets which would result in a reduction of our assets andstockholders equity.

 

Under U.S. GAAP, we are required to evaluate therealizability of the deferred tax assets based on our ability to generate futuretaxable income.  During the secondquarter of fiscal 2008, the Company established a valuation allowance of $23.2million against deferred tax assets.   As of July 12, 2008 we had deferred tax assets after valuationallowance of $0.8 million.  These allowanceswere recorded against the deferred tax assets because the Company has recentlyreassessed the potential for their realization in future years. Although it ispossible these deferred tax assets could still be realized in the future, theCompany believes that it is more likely than not that these deferred tax assetswill not be realized in the foreseeable future. The Company intends to reevaluate its position with respect to thevaluation allowance in future periods.

 

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

 

We are regularly involved in a variety of litigationarising out of our business and, in recent years, have paid significant amountsas a result of adverse arbitration awards. We do not have insurance for some of these claims, and there can be noassurance that the insurance coverage we have will cover all claims that may beasserted against us.  Should the ultimatejudgments or settlements not be covered by insurance or exceed our insurancecoverage, they could have a material adverse effect on our results ofoperations, financial position and cash flows. There can also be no assurance that we will be able to obtainappropriate and sufficient types or levels of insurance in the future or thatadequate replacement policies will be available on acceptable terms, if at all.

 

*Improper disclosure of employee and customer datacould result in liability and harm to our reputation.*

 

Our business involves the use, storage andtransmission of information about our employees and their customers.  It is possible that our security controlsover personal data and other practices we and our third party service providersfollow may not prevent the improper access to or disclosure of personallyidentifiable information.  Suchdisclosure could harm our reputation and subject us to liability under ourcontracts and laws that protect personal data, resulting in increased costs orloss of revenue.  Further, data privacyis subject to frequently changing rules and regulations.  Our failure to adhere to or successfullyimplement processes in response to changing regulatory requirements in thisarea could result in legal liability or impairment to our reputation in themarketplace.

 

34

----

Tableof Contents

 

**Item2.    Unregistered Sales of EquitySecurities and Use of Proceeds**

 

Not applicable.

 

**Item3.    Defaults Upon Senior Securities**

 

Not applicable.

 

**Item4.    Submission of Matters to a Vote ofSecurity Holders**

 

                None.

 

**Item5.    Other Information**

 

No events.

 

**Item6.    Exhibits**

 

Set forth below is a list of the exhibits included as part of this Quarterly Report:

 

| 10.3.13.5 |   | Settlement Agreement  and Release in Full by and between the Jeffrey A. Elias and the Company and  Westaff Support, Inc. dated June 2, 2008                           |
|-----------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.3.15.1 |   | First Amendment to  Executive Employment Agreement between Michael T. Willis and Westaff  Support, Inc., Westaff (USA), Inc. and the Company dated  June 3, 2008 |
| 10.3.18   |   | Employment Agreement,  effective as of June 16, 2008, by and among Westaff Support, Inc.,  Westaff (USA), Inc. and Westaff, Inc. and Stephen J. Russo (1)   |
| 10.3.19   |   | Employment Agreement,  effective as of June 16, 2008, by and among Westaff Support, Inc.,  Westaff (USA), Inc. and Westaff, Inc. and Christa C. Leonard (2) |
| 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)                                  Incorporated herein by reference to Exhibit 10.1filed with the Company’s Current Report on Form 8-K dated June 16,2008.

 

(2)                                  Incorporated herein by reference to Exhibit 10.2filed with the Company’s Current Report on Form 8-K dated June 16,2008.

 

35

----

Table ofContents

 

**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|                       |   | WESTAFF, INC.                                      |
|-----------------------|--------|----------------------------------------------------|
|                  |   |                                               |
|                  |   |
| August 26,  2008 |   |                                               | /s/ Christa C. Leonard |
| Date                  |   |                                               |    Christa  C. Leonard |
|                  |   | Senior Vice  President and Chief Financial Officer |
|                       |        |                                                    |  |  |

 

36

----