**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, DC 20549**

 

**FORM 10-Q/A**

**Amendment No. 1**

 

**ý****        QUARTERLY REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the Quarterly PeriodEnded June 30, 2005**

 

**OR**

 

**o****        TRANSITION REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the transitionperiod**               **to**               

 

**Commission File Number 1-14472**

 

**CORNELL COMPANIES, INC.**

(Exact name ofregistrant as specified in its charter)

 

| **Delaware**                                                                  | ** ** | **76-0433642**       |
|-------------------------------------------------------------------------------|------------|----------------------|
| (State or  other jurisdiction                                                 |       | (I.R.S.  Employer    |
| of  incorporation or organization)                                            |       | Identification  No.) |
|                                                                          |       |                 |
| **1700 West Loop South,  Suite 1500, Houston, Texas**                    | ** ** | **77027**            |
| (Address of  Principal Executive Offices)                                     |       | (Zip Code)           |
|                                                                          |       |                 |
| Registrant’s  telephone number, including area code: **(713)  623-0790** |

 

Indicateby a check mark whether Registrant (1) has filed all reports required tobe filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months, and (2) has been subject to such filingrequirements for the past 90 days.

 

Yes ý  No o

 

Indicateby a check mark whether Registrant is an accelerated filer (as defined inExchange Act Rule 12b-2).

 

Yes ý  No o

 

At July 31, 2005 Registranthad outstanding 13,626,821 shares of its Common Stock.

 

 

----

 

**EXPLANATORY NOTE**

 

Cornell Companies, Inc. (the “Company”) is filing thisAmendment No. 1 to its Quarterly Report on Form 10-Q forthe quarter ended June 30, 2005 to revise information inits Notes to Consolidated Financial Statements, Note 12, Guarantor Disclosures,included in Part I, Item 1 of such Form 10-Q.****  ****Therevisions have been made to correct four inadvertent errors. In the CondensedConsolidating Statement of Cash Flows, (1) the amount noted in the “GuarantorSubsidiary” column for “Capital expenditures” of $14.6 million was not carriedto the “Consolidated” column; (2) the caption “Acquisition of a business” wasexcluded from the “Cash flows from investing activities;” and (3) the “Net cashused by investing activities” for the six months ended June 30, 2005 shouldhave been reported as $17.1 million. Also, Deferred tax liabilities in the “Consolidated”column in the Condensed Consolidating Balance Sheet as of June 30, 2005 shouldhave been $7,534.  Accordingly, the informationincluded herein is filed to amend and replace Part I, Item 1information in the Company’s Form 10-Q for the quarter ended June 30,2005, as originally filed on August 9, 2005 (the “Previous Filing”).

 

Except for the amendment described above, this Amendment No. 1 to Form 10-Qdoes not modify or update other disclosures in, or exhibits to, the PreviousFiling.

 

**PART I          FINANCIAL INFORMATION**

 

**ITEM 1.          Financial Statements**

 

**CORNELL COMPANIES, INC.**

**CONSOLIDATED BALANCESHEETS**

**(Unaudited)**

**(in thousands, exceptshare data)**

 
| ** **                                                                                                                                                            | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                            | ** ** | **2005**          | ** ** | **2004**              | ** ** |
| **ASSETS**                                                                                                                                                            |       |              |       |                  |       |
|                                                                                                                                                                  |       |              |       |                  |       |
| **CURRENT  ASSETS:**                                                                                                                                                  |       |              |       |                  |       |
| Cash and cash  equivalents                                                                                                                                            |       | $                 | 12,947     |                  | $          | 9,895 |   |
| Investment securities  available for sale                                                                                                                             |       | 39,450            |       | 51,740                |       |
| Accounts receivable -  trade (net of allowance for doubtful accounts of $2,306 and $3,544,  respectively)                                                             |       | 51,245            |       | 60,174                |       |
| Other receivables (net  of allowance for doubtful accounts of $5,040)                                                                                                 |       | 3,214             |       | 4,691                 |       |
| Debt service fund and other  restricted assets                                                                                                                        |       | 25,390            |       | 19,713                |       |
| Deferred tax assets                                                                                                                                                   |       | 10,246            |       | 8,520                 |       |
| Prepaid expenses and  other                                                                                                                                           |       | 9,103             |       | 9,106                 |       |
| Total current assets                                                                                                                                                  |       | 151,595           |       | 163,839               |       |
| **PROPERTY  AND EQUIPMENT, net**                                                                                                                                      |       | 292,190           |       | 282,255               |       |
| **OTHER  ASSETS:**                                                                                                                                                    |       |              |       |                  |       |
| Debt service reserve  fund                                                                                                                                            |       | 23,800            |       | 23,801                |       |
| Goodwill, net                                                                                                                                                         |       | 10,588            |       | 7,721                 |       |
| Intangible assets, net                                                                                                                                                |       | 10,136            |       | 7,026                 |       |
| Deferred costs and  other                                                                                                                                             |       | 22,938            |       | 22,989                |       |
| **Total  assets**                                                                                                                                                     |       | $                 | 511,247    |                  | $          | 507,631 |   |
| ** **                                                                                                                                                            | ** ** | ** **        | ** ** | ** **            | ** ** |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                         |       |              |       |                  |       |
| ** **                                                                                                                                                            | ** ** | ** **        | ** ** | ** **            | ** ** |
| **CURRENT  LIABILITIES:**                                                                                                                                             |       |              |       |                  |       |
| Accounts payable and  accrued liabilities                                                                                                                             |       | $                 | 53,044     |                  | $          | 47,237 |   |
| Current portion of  long-term debt                                                                                                                                    |       | 9,001             |       | 9,005                 |       |
| **Total  current liabilities**                                                                                                                                        |       | 62,045            |       | 56,242                |       |
| LONG-TERM DEBT, net of  current portion                                                                                                                               |       | 279,752           |       | 279,528               |       |
| DEFERRED TAX  LIABILITIES                                                                                                                                             |       | 7,534             |       | 8,088                 |       |
| OTHER LONG-TERM LIABILITIES                                                                                                                                           |       | 2,294             |       | 2,461                 |       |
| **Total  liabilities**                                                                                                                                                |       | 351,625           |       | 346,319               |       |
| **COMMITMENTS  AND CONTINGENCIES**                                                                                                                                    |       |              |       |                  |       |
| ** **                                                                                                                                                            | ** ** | ** **        | ** ** | ** **            | ** ** |
| **STOCKHOLDERS’  EQUITY:**                                                                                                                                       |       |              |       |                  |       |
| Preferred stock, $.001  par value, 10,000,000 shares authorized, none issued                                                                                          |       | —            |       | —                |       |
| Common stock, $.001 par  value, 30,000,000 shares authorized, 15,078,939 and 14,845,107 shares issued  and 13,605,265 and 13,297,524 shares outstanding, respectively |       | 15                |       | 15                    |       |
| Additional paid-in  capital                                                                                                                                           |       | 147,871           |       | 145,825               |       |
| Retained earnings                                                                                                                                                     |       | 24,201            |       | 26,785                |       |
| Treasury stock (1,547,583  shares of common stock, at cost)                                                                                                           |       | (12,573           | )          | (12,573               | )          |
| Deferred compensation                                                                                                                                                 |       | (1,048            | )          | (432                  | )          |
| Accumulated other  comprehensive income                                                                                                                               |       | 1,156             |       | 1,692                 |       |
| **Total  stockholders’ equity**                                                                                                                                  |       | 159,622           |       | 161,312               |       |
| **Total  liabilities and stockholders’ equity**                                                                                                                  |       | $                 | 511,247    |                  | $          | 507,631 |   |

 

The accompanying notes are an integralpart of these consolidated financial statements.

 

2

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**CORNELL COMPANIES, INC.**

**CONSOLIDATED STATEMENTSOF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)**

**(Unaudited)**

**(in thousands, exceptper share data)**

 
| ** **                                                                                                                           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                                                                           | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                                                                                                                           | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                                                                 |       |                   |       |                 |       |   |   |   |   |
| REVENUES                                                                                                                             |       | $                      | 78,502     |                 | $          | 66,377 |   | $ | 152,142 |   | $ | 131,952 |   |
| OPERATING EXPENSES                                                                                                                   |       | 59,508                 |       | 51,280               |       | 114,039 |   | 102,953 |   |
| PRE-OPENING AND  START-UP EXPENSES                                                                                                   |       | 2,152                  |       | 990                  |       | 6,846 |   | 1,268 |   |
| DEPRECIATION AND  AMORTIZATION                                                                                                       |       | 3,816                  |       | 3,093                |       | 7,545 |   | 6,169 |   |
| GENERAL AND  ADMINISTRATIVE EXPENSES                                                                                                 |       | 4,899                  |       | 5,605                |       | 11,237 |   | 9,765 |   |
|                                                                                                                                 |       |                   |       |                 |       |   |   |   |   |
| INCOME FROM OPERATIONS                                                                                                               |       | 8,127                  |       | 5,409                |       | 12,475 |   | 11,797 |   |
| INTEREST EXPENSE                                                                                                                     |       | 6,244                  |       | 4,663                |       | 12,584 |   | 9,681 |   |
| INTEREST INCOME                                                                                                                      |       | (664                   | )          | (447                 | )          | (1,260 | ) | (817 | ) |
| LOSS ON EXTINGUISHMENT  OF DEBT                                                                                                      |       | 3⁄4                 |       | 2,357                |       | 3⁄4 |   | 2,357 |   |
|                                                                                                                                 |       |                   |       |                 |       |   |   |   |   |
| INCOME (LOSS) FROM  CONTINUING OPERATIONS BEFORE PROVISION (BENEFIT) FOR INCOME TAXES                                                |       | 2,547                  |       | (1,164               | )          | 1,151 |   | 576 |   |
| PROVISION (BENEFIT) FOR  INCOME TAXES                                                                                                |       | 1,176                  |       | (477                 | )          | 620 |   | 236 |   |
|                                                                                                                                 |       |                   |       |                 |       |   |   |   |   |
| INCOME (LOSS) FROM  CONTINUING OPERATIONS                                                                                            |       | 1,371                  |       | (687                 | )          | 531 |   | 340 |   |
|                                                                                                                                 |       |                   |       |                 |       |   |   |   |   |
| DISCONTINUED  OPERATIONS, NET OF TAX BENEFIT OF $904 AND $1,677 IN 2005 AND $286 AND $509  IN 2004                                   |       | (1,682                 | )          | (412                 | )          | (3,115 | ) | (733 | ) |
|                                                                                                                                 |       |                   |       |                 |       |   |   |   |   |
| NET LOSS                                                                                                                             |       | $                      | (311       | )                    | $          | (1,099 | ) | $ | (2,584 | ) | $ | (393 | ) |
|                                                                                                                                 |       |                   |       |                 |       |   |   |   |   |
| EARNINGS (LOSS) PER  SHARE:                                                                                                          |       |                   |       |                 |       |   |   |   |   |
| BASIC                                                                                                                                |       |                   |       |                 |       |   |   |   |   |
| Income (loss) from continuing  operations                                                                                            |       | $                      | .10        |                 | $          | (.05 | ) | $ | .04 |   | $ | .03 |   |
| Loss from discontinued  operations, net of tax                                                                                       |       | (.12                   | )          | (.03                 | )          | (.23 | ) | (.06 | ) |
| Net loss                                                                                                                             |       | $                      | (.02       | )                    | $          | (.08 | ) | $ | (.19 | ) | $ | (.03 | ) |
|                                                                                                                                 |       |                   |       |                 |       |   |   |   |   |
| DILUTED                                                                                                                              |       |                   |       |                 |       |   |   |   |   |
| Income (loss) from  continuing operations                                                                                            |       | $                      | .10        |                 | $          | (.05 | ) | $ | .04 |   | $ | .03 |   |
| Loss from discontinued  operations, net of tax                                                                                       |       | (.12                   | )          | (.03                 | )          | (.23 | ) | (.06 | ) |
| Net loss                                                                                                                             |       | $                      | (.02       | )                    | $          | (.08 | ) | $ | (.19 | ) | $ | (.03 | ) |
|                                                                                                                                 |       |                   |       |                 |       |   |   |   |   |
| NUMBER OF SHARES USED  IN PER SHARE COMPUTATION:                                                                                     |       |                   |       |                 |       |   |   |   |   |
| BASIC                                                                                                                                |       | 13,474                 |       | 13,146               |       | 13,451 |   | 13,114 |   |
| DILUTED                                                                                                                              |       | 13,600                 |       | 13,146               |       | 13,686 |   | 13,330 |   |
|                                                                                                                                 |       |                   |       |                 |       |   |   |   |   |
| COMPREHENSIVE INCOME  (LOSS):                                                                                                        |       |                   |       |                 |       |   |   |   |   |
| Net loss                                                                                                                             |       | $                      | (311       | )                    | $          | (1,099 | ) | $ | (2,584 | ) | $ | (393 | ) |
| Unrealized gain (loss)  on derivative instruments, net of tax (benefit) provision of $239 and $53 in  2005 and $754 and $435 in 2004 |       | 344                    |       | (1,085               | )          | 77 |   | (627 | ) |
| Comprehensive income  (loss)                                                                                                         |       | $                      | 33         |                 | $          | (2,184 | ) | $ | 2,507 |   | $ | (1,020 | ) |
|                                                                                                                                      |            |                        |            |                      |            |  |  |  |  |  |  |  |  |  |  |  |

 

The accompanying notes are an integralpart of these consolidated financial statements.

 

3

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**CORNELL COMPANIES, INC.**

# **CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Unaudited)**

**(in thousands)**

 
| ** **                                                                                                        | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                                                        | ** ** | **June 30,**    | ** ** |
| ** **                                                                                                        | ** ** | **2005**             | ** ** | **2004** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                                            |       |                 |       |   |   |
| Net loss                                                                                                          |       | $                    | (2,584     | ) | $ | (393 | ) |
| Adjustments to reconcile  net loss to net cash provided by operating activities -  Loss on extinguishment of debt |       | —               |       | 2,357 |   |
| Depreciation                                                                                                      |       | 6,722                |       | 5,799 |   |
| Amortization of  intangibles and other assets                                                                     |       | 973                  |       | 539 |   |
| Amortization of  deferred compensation                                                                            |       | (401                 | )          | 127 |   |
| Amortization of  deferred financing costs                                                                         |       | 886                  |       | 578 |   |
| Amortization of Senior  Notes discount                                                                            |       | 92                   |       | — |   |
| Provision for bad debts                                                                                           |       | 1,958                |       | 343 |   |
| Gain on sale of  property and equipment                                                                           |       | (7                   | )          | (10 | ) |
| Deferred income taxes                                                                                             |       | (2,955               | )          | 296 |   |
| Change in assets and  liabilities:                                                                                |       |                 |       |   |   |
| Accounts receivable                                                                                               |       | 8,205                |       | 1,265 |   |
| Debt service fund and  other restricted assets                                                                    |       | 119                  |       | (418 | ) |
| Other assets                                                                                                      |       | 2,812                |       | 2,180 |   |
| Accounts payable and  accrued liabilities                                                                         |       | 4,817                |       | (4,680 | ) |
| Deferred revenues and  other liabilities                                                                          |       | (109                 | )          | (41 | ) |
| Net cash provided by  operating activities                                                                        |       | 20,528               |       | 7,942 |   |
|                                                                                                              |       |                 |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                                            |       |                 |       |   |   |
| Capital expenditures                                                                                              |       | (14,552              | )          | (20,559 | ) |
| Purchases of investment  securities                                                                               |       | (665,845             | )          | — |   |
| Sales of investment  securities                                                                                   |       | 678,135              |       | — |   |
| Acquisition of a  business                                                                                        |       | (9,064               | )          | — |   |
| Receipt from restricted  escrow arrangement                                                                       |       | —               |       | 5,000 |   |
| Purchase of facility  management contract                                                                         |       | —               |       | (2,900 | ) |
| Return of restricted  assets from deferred bonus plan                                                             |       | —               |       | 86 |   |
| Payments to restricted  debt payment account, net                                                                 |       | (5,795               | )          | (5,523 | ) |
| Proceeds from sale of fixed  assets                                                                               |       | —               |       | 163 |   |
| Net cash used in  investing activities                                                                            |       | (17,121              | )          | (23,733 | ) |
|                                                                                                              |       |                 |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                                            |       |                 |       |   |   |
| Proceeds from long-term  debt and line of credit                                                                  |       | —               |       | 69,000 |   |
| Payments on line of  credit                                                                                       |       | —               |       | (71,000 | ) |
| Payments on acquired  debt                                                                                        |       | (1,905               | )          | — |   |
| Payments on synthetic  lease                                                                                      |       | —               |       | (52,495 | ) |
| Proceeds from Senior  Notes, net of discount                                                                      |       | —               |       | 110,527 |   |
| Payments for debt  issuance and other financing costs                                                             |       | —               |       | (5,033 | ) |
| Payments on capital  lease obligations                                                                            |       | (170                 | )          | (6 | ) |
| Proceeds from exercise  of stock options                                                                          |       | 1,720                |       | 1,040 |   |
| Purchases of treasury  stock                                                                                      |       | —               |       | (116 | ) |
| Net cash (used in) provided  by financing activities                                                              |       | (355                 | )          | 51,917 |   |
|                                                                                                              |       |                 |       |   |   |
| NET INCREASE IN CASH  AND CASH EQUIVALENTS                                                                        |       | 3,052                |       | 36,126 |   |
| CASH AND CASH  EQUIVALENTS AT BEGINNING OF PERIOD                                                                 |       | 9,895                |       | 40,171 |   |
| CASH AND CASH  EQUIVALENTS AT END OF PERIOD                                                                       |       | $                    | 12,947     |   | $ | 76,297 |   |
|                                                                                                              |       |                 |       |   |   |
| OTHER NON-CASH  INVESTING AND FINANCING ACTIVITIES:                                                               |       |                 |       |   |   |
| Increase in fair value  of interest rate swap                                                                     |       | $                    | 38         |   | $ | — |   |
| Other comprehensive  income (loss), net of tax                                                                    |       | 77                   |       | (627 | ) |
| Common stock issued for  board of directors fees                                                                  |       | 111                  |       | — |   |

 

The accompanying notes are an integralpart of these consolidated financial statements.

 

4

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**CORNELL COMPANIES, INC.**

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

 

**1.****             ****Basis of Presentation**

 

The accompanying unauditedconsolidated financial statements have been prepared by Cornell Companies, Inc.(the “Company”) pursuant to the rules and regulations of the Securitiesand Exchange Commission.  Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with generally accepted accounting principles in theUnited States (GAAP) have been condensed or omitted pursuant to such rules andregulations.  In the opinion ofmanagement, adjustments and disclosures necessary for a fair presentation ofthese financial statements have been included. Estimates were used in the preparation of these financialstatements.  Actual results could differfrom those estimates.  These financialstatements should be read in conjunction with the financial statements and notesthereto included in our 2004 Annual Report on Form 10-K, as amended, asfiled with the Securities and Exchange Commission.

 

**2.     Accounting Policies**

 

Seea description of our accounting policies in our 2004 Annual Report on Form 10-K,as amended.

 

***AccountingFor Stock-Based Compensation***

 

Inaccordance with the provisions of Statement of Financial Accounting Standard(SFAS) No. 123, “Accounting for Stock-Based Compensation,” we have electedto account for our stock-based compensation plans under the intrinsic valuemethod established by Accounting Principles Board Opinion (APB) No. 25, “Accountingfor Stock Issued to Employees.”  Inaccordance with the provisions of APB No. 25, the fair value of fixedstock options granted to employees is not reflected in net income, as alloptions granted under those plans had an exercise price equal to or in excessof the market value of the underlying common stock on the date of grant.  The following table illustrates, inaccordance with SFAS No. 148, “Accounting for Stock-Based Compensation –Transition and Disclosure, an Amendment of SFAS No. 123,” the effect onour net loss and loss per share as if we had applied the fair value recognitionprovisions of SFAS No. 123 to stock-based employee compensation (inthousands, expect per share amounts):

 

| ** **                                                                                                                                  | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                                                                                  | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                                                                                                                                  | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                                                                        |       |                   |       |                 |       |   |   |   |   |
| Net loss, as reported                                                                                                                       |       | $                      | (311       | )                    | $          | (1,099 | ) | $ | (2,584 | ) | $ | (393 | ) |
| Add: total stock-based  compensation recorded, net of tax                                                                                   |       | 31                     |       | 32                   |       | 65 |   | 32 |   |
| Less: total stock-based  employee compensation expense determined under fair value based method for  all awards, net of related tax effects |       | (405                   | )          | (343                 | )          | (796 | ) | (499 | ) |
| Pro forma net loss                                                                                                                          |       | $                      | (685       | )                    | $          | (1,410 | ) | $ | (3,315 | ) | $ | (860 | ) |
| Loss per share:                                                                                                                             |       |                   |       |                 |       |   |   |   |   |
| Basic, as reported                                                                                                                          |       | $                      | (.02       | )                    | $          | (.08 | ) | $ | (.19 | ) | $ | (.03 | ) |
| Basic, pro forma                                                                                                                            |       | (.05                   | )          | (.11                 | )          | (.25 | ) | (.07 | ) |
| Diluted, as reported                                                                                                                        |       | (.02                   | )          | (.08                 | )          | (.19 | ) | (.03 | ) |
| Diluted, pro forma                                                                                                                          |       | (.05                   | )          | (.11                 | )          | (.25 | ) | (.07 | ) |

 

5

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***New AccountingPronouncements***

*** ***

InDecember 2004, the Financial Accounting Standards Board (FASB) issued SFASNo. 123R, “Share Based Payment,” that requires companies to expense thevalue of employee stock options and other types of equity-based compensationbased on the fair value of the options at the award’s grant date based on theestimated number of awards that are expected to vest.  Compensation cost for awards that vest wouldnot be reversed if the awards expired without being exercised.  When measuring fair value, companies canchoose an option-pricing model (e.g., Black-Sholes or binominal models) thatapproximately reflects their specific circumstances and the economics of theirtransactions.  Companies will recognizecompensation cost for share-based payment awards as they vest, including therelated tax effects.  The effective dateof SFAS No. 123R, as amended, applies to annual periods beginning after June 15,2005, and applies to all outstanding and unvested share based payment awards atthe company’s adoption date.  We arecurrently evaluating the alternative transition methods permitted by SFAS No. 123R.

 

Under SFAS No. 123R,compensatory employee stock purchase plans (ESPP) are required to recognizecompensation cost over the requisite service period for grants made under theESPP.  The criteria that an ESPP mustmeet to be considered non-compensatory are more restrictive under SFAS No. 123Rthan they were under APB No. 25.  Weare currently evaluating the impact on our ESPP by SFAS No. 123R.

 

The FASB issued SFAS No. 154, “Accounting Changes and ErrorCorrections – a replacement of APB Opinion No. 20 and FASB Statement No. 3.”  SFAS No. 154 is effective, and will beadopted, for accounting changes made in fiscal years beginning after December 15,2005 and is to be applied retrospectively. SFAS No. 154 requires that retroactive application of a change inaccounting principle be limited to the direct effects of the change.  Our adoption of SFAS No. 154 is notexpected to have a material effect on our financial position or results ofoperations.

 

***Reclassifications***

 

Certain reclassificationshave been made to the prior year financial statements contained herein toconform to current year presentation.

 

**3.****             ****Discontinued Operations andManagement Restructuring**

 

We classify as discontinued operations those components of our businessthat we hold for sale or disposition that have been disposed and cash flowsthat are clearly distinguishable operationally and for financial reportingpurposes from the rest of our operations. For those components, we have nosignificant continuing involvement after disposal and their operations areeliminated from our ongoing operations. During the three and six months ended June 30, 2005, we classifiedcertain components as discontinued operations. This was the result of amanagement decision to initiate the shut down of operations at certainfacilities in the first quarter of 2005. These facilities and programs include the Residential School, the MapleCreek Home and our mental health wrap programs in Pennsylvania in the first quarterof 2005.  In the second quarter of 2005,we shut down the operations of the Northside Clinic and the Jos-ArzAcademy.  Notifications have been made tothe required contracting entities regarding the termination of the relatedprograms.  At June 30, 2005, we hadnet property and equipment of approximately $0.7 million pertaining to theseoperations.   These discontinuedoperations generated revenues of approximately $0.7 million and $3.6 millionfor the three months ended June 30, 2005 and 2004, respectively, andrevenues of approximately $2.6 million and $7.4 million for the six monthsended June 30, 2005 and 2004, respectively.

 

During the first quarter of 2005, a review was performed of ourmanagement structure and, as a result, approximately 14 positions wereeliminated.  In conjunction with thisaction, a charge of approximately $2.1 million was recorded in the firstquarter of 2005.  Approximately $1.0million of this charge was reflected in operating expenses and $1.1 million ingeneral and administrative expenses.  Theaccrued liability pertaining to this charge was approximately $1.5 million at June 30,2005.  There are no significantadditional costs expected to be incurred in conjunction with this activity infuture periods.

 

6

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**4.     Acquisitionof Correctional Systems, Inc.**

 

In April 2005, wecompleted our acquisition of Correctional Systems, Inc. (CSI), a SanDiego-based provider of privatized jail, community corrections and alternativesentencing services.  The transaction wasconsumated in cash of approximately $ 9.1 million, net of cash acquired,all of which was paid April 1, 2005.  Theacquisition included the operations of eight jails, six adult community-basedcorrection facilities and five alternative sentencing programs located inCalifornia, New Mexico, Texas and Kansas. The acquisition added approximately 986 corrections beds, as well asalternatives to incarceration services. The results of operations for CSI subsequent to the date of acquisitionare included in our consolidated financial statements.

 

We acquired substantially allof CSI’s assets and assumed all of their liabilities.  The excess of the purchase price over thefair value of the assets acquired and liabilities assumed was allocated togoodwill.  The following table summarizesthe estimated fair values of the assets acquired and liabilities assumed as ofthe acquisition date (in thousands).  Ourpurchase price allocations are preliminary and have not been finalized as weare awaiting the completion by an outside appraiser of the valuations of certainproperty and equipment acquired.  We donot anticipate any significant differences between current book values and thefair values upon the completion of the asset valuations.  The initial purchase price allocations may beadjusted within one year of the purchase date for changes in the estimates ofthe fair values of assets acquired and liabilities assumed.

 
| ** **                                | ** ** | **April 1,** | ** ** |
|-------------------------------------------|------------|-------------------|------------|
| ** **                                | ** ** | **2005**          | ** ** |
|                                      |       |              |       |
| Receivables                               |       | $                 | 1,769      |   |
| Deferred Tax Asset                        |       | 49                |       |
| Prepaid assets                            |       | 256               |       |
| Property and equipment                    |       | 2,097             |       |
| Contract value                            |       | 4,121             |       |
| Other assets                              |       | 1,351             |       |
| Goodwill                                  |       | 2,866             |       |
| Assets acquired                           |       | 12,509            |       |
|                                      |       |              |       |
| Accounts payable and  accrued liabilities |       | $                 | 1,076      |   |
| Long-term debt                            |       | 2,239             |       |
| Other long-term liabilities               |       | 130               |       |
| Liabilities assumed                       |       | 3,445             |       |
| Net assets acquired                       |       | $                 | 9,064      |   |

 

We believe that the CSI acquisitionresulted in the recognition of goodwill because of its industry position,operational strength and potential to provide additional growth opportunitiesfor us.

 

Our amortization period foracquired contracts is the greater of the acquired contract life or seven years.

 

On unaudited pro-forma basis, the effects of the CSI acquisitionwere not significant to our results of operations.

 

**5.     IntangibleAssets**

 

Intangibleassets at June 30, 2005 and December 31, 2004 consisted of thefollowing (in thousands):

 
| ** **                   | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                   | ** ** | **2005**          | ** ** | **2004**              | ** ** |
|                         |       |              |       |                  |       |
| Non-compete agreements       |       | $                 | 9,900      |                  | $          | 9,840 |   |
| Acquired contract value      |       | 6,428             |       | 2,405                 |       |
| Accumulated  amortization    |       | (6,192            | )          | (5,219                | )          |
| Identified intangibles,  net |       | 10,136            |       | 7,026                 |       |
| Goodwill, net                |       | 10,588            |       | 7,721                 |       |
| Total intangibles, net       |       | $                 | 20,724     |                  | $          | 14,747 |   |

 

Amortization expense for our non-competeagreements was approximately $0.3 million for the three months ended June 30,2005 and 2004 and approximately $0.6 million and $0.5 million for the sixmonths ended June 30, 2005 and 2004, respectively.  Amortization expense for our non-competeagreements is expected to be approximately $1.1 million for each of the next fouryears ended December 31 and approximately $0.7 million for the fifth year.

 

Amortization expense for our acquiredcontract value was approximately $0.3 million and $0.4 million for the threeand six months ended June 30, 2005. Amortization expense for our acquired contract value is expected to beapproximately $1.1 million for each of the next four years ended December 31and approximately $0.6 million for the fifth year.

 

7

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**6.****               ****Credit Facilities**

 

Ourlong-term debt at June 30, 2005 and December 31, 2004 consisted ofthe following (in thousands):

 

| ** **                                                                                                                                                          | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                          | ** ** | **2005**          | ** ** | **2004**              | ** ** |
| **Debt  of Cornell Companies, Inc.:**                                                                                                                          |       |              |       |                  |       |
| Senior Notes,  unsecured, due July 2012 with an interest rate of 10.75%, net of  discount                                                                      |       | $                 | 110,711    |                  | $          | 110,619 |   |
| Fair-value adjustment  of Senior Notes as a result of interest rate swap                                                                                            |       | 3,170             |       | 3,208                 |       |
| Revolving Line of  Credit due June 2008 with an interest rate of LIBOR plus 2.25% to 3.5%  or prime plus 0.75% to 2.00% (the “2004 Credit Facility”) |       | —            |       | 3⁄4                |       |
| Capital lease  obligations                                                                                                                                          |       | 172               |       | 6                     |       |
| Subtotal                                                                                                                                                            |       | 114,053           |       | 113,833               |       |
| ** **                                                                                                                                                          | ** ** | ** **        | ** ** | ** **            | ** ** |
| **Debt  of Special Purpose Entity:**                                                                                                                                |       |              |       |                  |       |
| 8.47% Bonds due 2016                                                                                                                                                |       | 174,700           |       | 174,700               |       |
|                                                                                                                                                                |       |              |       |                  |       |
| Total consolidated debt                                                                                                                                             |       | 288,753           |       | 288,533               |       |
|                                                                                                                                                                |       |              |       |                  |       |
| Less: current  maturities                                                                                                                                           |       | (9,001            | )          | (9,005                | )          |
|                                                                                                                                                                |       |              |       |                  |       |
| Consolidated long-term  debt                                                                                                                                        |       | $                 | 279,752    |                  | $          | 279,528 |   |

 

***Long-Term Credit Facilities.***  The2004 Credit Facility provides for borrowings of up to $60.0 million under arevolving line of credit, and is reduced by outstanding letters of credit.  The available commitment under the 2004Credit Facility was approximately $51.4 million at June 30, 2005.  We had no outstanding borrowings on the 2004Credit Facility at June 30, 2005, but we had outstanding letters of creditof approximately $8.6 million.  Subjectto certain requirements, we have the right to increase the aggregatecommitments under the 2004 Credit Facility up to an aggregate amount of $100.0 million.  The 2004 Credit Facility matures in June 2008and bears interest, at our election, depending on our total leverage ratio, ateither the prime rate plus a margin ranging from 0.75% to 2.00%, or a ratewhich ranges from 2.25% to 3.50% above the applicable LIBOR rate. The 2004Credit Facility is collateralized by substantially all of our assets, includingthe assets and stock of all of our subsidiaries.  The 2004 Credit Facility is not secured bythe assets of MCF.  The 2004 CreditFacility contains standard covenants including compliance with laws,limitations on capital expenditures, restrictions on dividend payments,limitations on mergers and compliance with financial covenants.

 

MCFis obligated for the outstanding balance of its 8.47% Taxable Revenue Bonds, Series 2001.  The bonds bear interest at a rate of 8.47%per annum and are payable in semi-annual installments of interest and annualinstallments of principal.  All unpaidprincipal and accrued interest on the bonds is due on the earlier of August 1,2016 (maturity) or as noted under the bond documents.  The bonds are limited, nonrecourseobligations of MCF and secured by the property and equipment, bond reserves,assignment of subleases and substantially all assets related to the facilitiesincluded in the 2001 Sale and Leaseback Transaction.  The bonds are not guaranteed by us.

 

InJune 2004, we issued $112.0 million in principal of 10.75% Senior Notes(the “Senior Notes”) due July 1, 2012. The Senior Notes are unsecured senior indebtedness and are guaranteed byall of our existing and future subsidiaries (collectively, the “Guarantors”).  The Senior Notes are not guaranteed by MCF(the “Non-Guarantor”).    Interest on theSenior Notes is payable semi-annually on January 1 and July 1 of eachyear, commencing January 1, 2005. On or after July 1, 2008, we may redeem all or a portion of theSenior Notes at the redemption prices (expressed as a percentage of theprincipal amount) listed below, plus accrued and unpaid interest, if any, onthe Senior Notes redeemed, to the applicable date of redemption, if redeemedduring the 12-month period commencing on July 1 of the years indicatedbelow:

 

8

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| **Year**            | ** ** | **Percentages** | ** ** |
|---------------------|------------|-----------------|------------|
|                |       |            |       |
| 2008                |       | 105.375         | %          |
| 2009                |       | 102.688         | %          |
| 2010 and thereafter |       | 100.000         | %          |

 

Any time prior to July 1, 2007, we may redeem up to 35% of theoriginal aggregate principal amount of the Senior Notes at a redemption priceof 110.75% of the principal amount thereof with the net cash of publicofferings of equity, provided that at least 65% of the original aggregateprincipal amount of the Notes remains outstanding after the redemption andother conditions are met.  Upon theoccurrence of specified change of control events, unless we have exercised our optionto redeem all the Senior Notes as described above, each holder will have theright to require us to repurchase all or a portion of such holder’s SeniorNotes at a purchase price in cash equal to 101% of the aggregate principalamount of the notes repurchased plus accrued and unpaid interest, if any, onthe Senior Notes repurchased, to the applicable date of purchase.  The Senior Notes were issued under anindenture (the “Indenture”) which limits our ability and the ability of ourGuarantors to, among other things, incur additional indebtedness, pay dividendsor make other distributions, make other restricted payments and investments,create liens, incur restrictions on the ability of the Guarantors to paydividends or other payments to us, enter into transactions with affiliates, andengage in mergers, consolidations and certain sales of assets.

 

In conjunction with the issuance of the Senior Notes, we entered intoan interest rate swap transaction with a financial institution to hedge ourexposure to changes in the fair value on $84.0 million of our SeniorNotes.  The purpose of this transactionwas to convert future interest due on $84.0 million of the Senior Notes to avariable rate.  The terms of the interestrate swap contract and the underlying debt instrument are identical.  We have designated the swap agreement as afair value hedge.  The swap has anotional amount of $84.0 million and matures in July 2012 to mirror thematurity of the Senior Notes.  Under theagreement, we pay on a semi-annual basis (each January 1 and July 1)a floating rate based on a six-month U.S. dollar LIBOR rate, plus a spread, andreceive a fixed-rate interest of 10.75%. For the three and six months ended June 30, 2005, we recordedinterest savings related to this interest rate swap of approximately $0.3 millionand $0.8 million, respectively, which is reflected as a reduction to interestexpense in the accompanying financial statements.  The swap agreements are marked to market eachquarter with a corresponding mark-to-market adjustment reflected as either a discountor premium on the Senior Notes.  At June 30,2005 and December 31, 2004, the fair value of this derivative instrumentwas approximately $3.2 million, and is included in other assets in ourConsolidated Balance Sheets.  Thecarrying value of the Senior Notes as of these dates was increased by the sameamount. Because the swap agreement is considered an effective fair-value hedge,there will be no effect on our results of operations from the mark-to-marketadjustment as long as the swap is in effect.

 

**7.     Projects Under Development, Construction orRenovation**

 

***Moshannon Valley Correctional Center***

** **

InMarch 2003, we reached an agreement with the Commonwealth of Pennsylvaniathat resolved all outstanding administrative issues relative to the contractawarded by the Bureau of Prisons (BOP) to operate the Moshannon ValleyCorrectional Center. In October 2004, we received the signed Finding of NoSignificant Impact for the facility. Construction of the facility, which will house 1,300 male federalinmates, began immediately.  We have athree-year contract with the BOP to operate the facility and the BOP has theoption to grant seven one-year extensions. The facility is scheduled to begin operations in early 2006.

 

InSeptember 2004, we resolved our claim with the BOP for the reimbursementof a portion of the expenses we incurred in connection with the issuance of theStop-Work Order and the delay of the project (included among these expenses wasapproximately $1.4 million in accounts receivable for expenses incurred by usafter the September 1999 issuance of the Stop-Work Order).  We settled the claim, as well as the claimfor the reimbursement of costs related to the original construction effortsincurred beginning in 1999, with the BOP and were reimbursed approximately $7.0million in September 2004.  Theexcess reimbursement of approximately $5.6 million over the $1.4 million inaccounts receivable was credited against the carrying cost of the facility.

 

9

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As of June 30, 2005, we had incurred (net of the BOPreimbursement) approximately $31.1 million for the design,construction and development costs and capitalized interest related to theMoshannon Valley Correctional Center facility. We believe that our existing cash and credit facilities will provideadequate funding to complete the construction of the facility.

 

***New Morgan Academy***

** **

Weclosed the New Morgan Academy in the fourth quarter of 2002 and arecurrently considering several options ranging from the utilization of thefacility for another type of program or the sale or lease of the facility. Asof June 30, 2005, we are principally focusing our efforts on the potentialinsertion of a program.  In addition, weare considering the possible sale or lease of the facility.  We are maintaining a small staff to secure and maintain the facility.  We have recognized pre-tax costs ofapproximately $0.9 million and $1.8 million in our Consolidated Statements ofOperations and Comprehensive Income (Loss) for the three and six months ended June 30,2005 and pre-tax costs of $0.8 million and $1.6 million for the three and sixmonths ended June 30, 2004, for related holding costs (depreciation,interest, property, taxes and other maintenance costs).

 

The developing inability during late 2004 of various governmentalagencies with whom we had been in negotiations to obtain the level of fundingto contract with us for the use of the New Morgan Academy indicated anexpectation of continuing losses associated with this facility.  As a result, we recorded an impairment chargeof $9.3 million, pursuant to the requirements of SFAS No. 144, at December 31,2004.  As of June 30, 2005, webelieve that, pursuant to the provisions of SFAS No. 144, no additionalimpairment allowance is necessary. The carrying value of the property andequipment for the New Morgan Academy, after the impairment charge, wasapproximately $20.1 million and $20.4 million at June 30, 2005 and December 31,2004, respectively.

 

***CentralCalifornia Treatment Center***

** **

In January 2004, wepurchased a building in Los Angeles, California for which our carrying value wasapproximately $2.7 million at June 30, 2005. This new facility could provide service to 220 inmates in awork-furlough type program.  Although wedo not currently have a contract for this facility, the facility has beensubmitted and is under consideration in several recent proposals.  We believe that due to the growth of theinmate population, severe budget crisis and recent legal settlements requiringadditional community services, this facility will fill a small part of theoverall demand in California.  Thepotential uses for the facility range from a “halfway back” program to acomprehensive drug and alcohol treatment program.

 

**8.     Earnings Per Share**

 

Basicearnings per share (EPS) is computed by dividing net income by the weightedaverage number of shares of common stock outstanding during the period.  Diluted EPS reflects the potential dilutionfrom common stock equivalents such as stock options and warrants.  For the three months ended June 30, 2005and 2004, there were 317,546 shares ($12.63 average price) and 423,229 shares($13.61 average price), respectively, of stock options that were not includedin the computation of diluted EPS because to do so would have beenanti-dilutive.  For the six months ended June 30,2005 and 2004 there were 203,207 shares ($16.83 average price) and 415,956shares ($14.64 average price), respectively, of stock options that were notincluded in the computation of diluted EPS because to do so would have beenanti-dilutive.

 

10

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The following table summarizes the calculation of net earnings (loss) andweighted average common shares and common equivalent shares outstanding forpurposes of the computation of earnings (loss) per share (in thousands, exceptper share data):

 

| ** **                                                               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                               | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                                                               | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Income (loss) from  continuing operations                                |       | $                      | 1,371      |                 | $          | (687 | ) | $ | 531 |   | $ | 340 |   |
| Loss from discontinued  operations, net of taxes                         |       | (1,682                 | )          | (412                 | )          | (3,115 | ) | (733 | ) |
| Net loss                                                                 |       | $                      | (311       | )                    | $          | (1,099 | ) | $ | (2,584 | ) | $ | (393 | ) |
|                                                                     |       |                   |       |                 |       |   |   |   |   |
| Weighted average common  shares outstanding                              |       | 13,474                 |       | 13,146               |       | 13,451 |   | 13,114 |   |
| Weighted average common  share equivalents outstanding                   |       | 126                    |       | 3⁄4               |       | 235 |   | 216 |   |
|                                                                     |       |                   |       |                 |       |   |   |   |   |
| Weighted average common  shares and common share equivalents outstanding |       | 13,600                 |       | 13,146               |       | 13,686 |   | 13,330 |   |
|                                                                     |       |                   |       |                 |       |   |   |   |   |
| Basic earnings (loss)  per share:                                        |       |                   |       |                 |       |   |   |   |   |
| Income (loss) from  continuing operations                                |       | $                      | .10        |                 | $          | (.05 | ) | $ | .04 |   | $ | .03 |   |
| Loss from discontinued  operations, net of tax                           |       | (.12                   | )          | (.03                 | )          | (.23 | ) | (.06 | ) |
| Net loss                                                                 |       | $                      | (.02       | )                    | $          | (.08 | ) | $ | (.19 | ) | $ | (.03 | ) |
|                                                                     |       |                   |       |                 |       |   |   |   |   |
| Diluted earnings (loss)  per share:                                      |       |                   |       |                 |       |   |   |   |   |
| Income (loss) from  continuing operations                                |       | $                      | .10        |                 | $          | (.05 | ) | $ | .04 |   | $ | .03 |   |
| Loss from discontinued  operations, net of tax                           |       | (.12                   | )          | (.03                 | )          | (.23 | ) | (.06 | ) |
| Net loss                                                                 |       | $                      | (.02       | )                    | $          | (.08 | ) | $ | (.19 | ) | $ | (.03 | ) |

 

**9.     Commitments and Contingencies**

 

## **LegalProceedings**

## ** **

##### ***SouthernPeaks Regional Treatment Center***

##### * *

OnJanuary 5, 2004, we initiated legal proceedings in the lawsuit styled *Cornell Corrections of California, Inc. v.Longboat Global Advisors, LLC, et al*., No.2004 CV79761 in theSuperior Court of Fulton County, Georgia under theories of fraud, conversion,breach of contract and other theories to determine the location of and torecover funds previously deposited by us into what we believed to be an escrowaccount in connection with the development and construction of the SouthernPeaks Regional Treatment Center.  Of thefunds previously deposited, approximately $5.3 million remains to be recoveredat June 30, 2005.  In December 2004,the case was tried before a jury and the jury verdict awarded approximately$6.5 million in compensatory damages and approximately $1.4 million in punitivedamages, plus attorneys’ fees.  We expectthat the actual damages awarded under the verdict will be adjusted downward tothe $5.4 million actually lost by us and that the punitive damages award may beadjusted downward because of a Georgia statute regarding caps on punitivedamages awards.  No judgement has yetbeen entered on this verdict.  The awardfor compensatory damages accrues pre-judgment interest at a rate of 7 percentfrom the date of loss through the date of judgment. Following the jury verdicts, we collected approximately $0.4 million in January 2005in funds which had been previously frozen under a temporary restraining orderissued at the time that we commenced this litigation.  Currently, certain of the defendants havefiled motions to move for a new trial. No judgment will be entered on theverdict until after these motions for a new trial have been heard and ruled onby the court.  Due to the continueduncertainty surrounding the ultimate recovery of the funds previouslydeposited, we will continue to maintain our existing reserve of approximately$5.0 million in an allowance for doubtful accounts.

 

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**ShareholderLawsuits**

 

In March andApril 2002, the Company, Steven W. Logan (our former President and ChiefExecutive Officer), and John L. Hendrix (our former Chief Financial Officer),were named as defendants in four federal putative class action lawsuits styledas follows: (1) *Graydon Williams, OnBehalf of Himself and All Others Similarly Situated v. Cornell Companies, Inc,et al.*, No. H-02-0866, in the United States District Court forthe Southern District of Texas, Houston Division; (2) *Richard Picard, On Behalf of Himself and All OthersSimilarly Situated v. Cornell Companies, Inc., et al.*, No. H-02-1075,in the United States District Court for the Southern District of Texas, HoustonDivision; (3) *Louis A. Daly, On Behalfof Himself and All Others Similarly Situated v. Cornell Companies, Inc.,et al.,* No. H-02-1522, in the United States District Court forthe Southern District of Texas, Houston Division, and (4) *Anthony J. Scolaro, On Behalf of Himself and AllOthers Similarly Situated v. Cornell Companies, Inc., et al.,* No. H-02-1567,in the United States District Court for the Southern District of Texas, HoustonDivision.  The aforementioned lawsuitswere putative class action lawsuits brought on behalf of all purchasers of ourcommon stock between March 6, 2001 and March 5, 2002 and relate toour restatement in 2002 of certain financial statements.  The lawsuits involved disclosures madeconcerning two prior transactions executed by us: the August 2001 saleleaseback transaction and the 2000 synthetic lease transaction.  These four lawsuits were consolidated intothe *Graydon Williams* action andFlyline Partners, LP was appointed lead plaintiff.  As a result, a consolidated complaint wasfiled by Flyline Partners, LP.  RichardPicard and Anthony Scolaro were also named as plaintiffs.  Since then, the court allowed plaintiffs tofile an amended consolidated complaint. The amended consolidated complaintalleges that the defendants violated Section 10(b) of the SecuritiesExchange Act of 1934 (the “Exchange Act”), Rule 10b-5 promulgated under Section 10(b) ofthe Exchange Act, Section 20(a) of the Exchange Act, Section 11of the Securities Act of 1933 (the “Securities Act”) and/or Section 15 ofthe Securities Act.  The amendedconsolidated complaint seeks, among other things, restitution damages,compensatory damages, rescission or a rescissory measure of damages, costs,expenses, attorneys’ fees and expert fees. The Company filed a motion to dismiss the lawsuit.  In an order entered April 1, 2005, thecourt granted the motion to dismiss with respect to the plaintiffs’ securitiesfraud claims pursuant to Sections 10(b) and 20(a) of the Exchange Actand Rule 10b-5.  The court deniedthe motion to dismiss as to the remaining claims covering the Company’ssecondary offering in 2001.  Subject tocourt approval and documentation, the parties have agreed to settle thismatter.  Under the proposed agreement,the Company has not admitted any wrongdoing. Settlement in the amount of $7 million will be funded through theCompany’s Directors’ and Officers’ liability insurance.  The Company has not reached settlement in thepending derivative litigation discussed below.

 

In March 2002,the Company, our directors, and our former independent auditor Arthur AndersenLLP, were sued in a derivative action styled as *William Williams, Derivatively and on Behalf of Nominal DefendantCornell Companies, Inc. v. Anthony R. Chase, et al.*, No. 2002-15614,in the 127th Judicial District Court of Harris County, Texas.  The lawsuit related to our restatement in2002 of certain financial statements. The lawsuit alleged breaches of fiduciary duty by all of the individualdefendants and asserted breach of contract and professional negligence claimsonly against Arthur Andersen LLP.  Thislawsuit has been dismissed without prejudice by agreement.

 

On January 27,2004, we received a letter from William Williams, the plaintiff in the *William Williams* action discussed above,demanding that we pursue breach of fiduciary duty claims against variousofficers and directors based on the August 2001 sale leaseback transactionand the subsequent restatement.  We haveissued a preliminary response to the letter indicating that the Board willconsider the request and inform Mr. Williams of its decision.

 

In May andSeptember 2002, the Company and our directors were sued in three otherderivative lawsuits styled as follows: (1) *Juan Guitierrez, Derivatively on Behalf of Cornell Companies, Inc.v. Steven W. Logan, et. al.,* No. H-02-1812, in the UnitedStated District Court for the Southern District of Texas, Houston Division; (2) *Thomas Pagano, Derivatively on Behalf of CornellCompanies, Inc. v. Steven W. Logan, et. al.*, No. H-02-1896,in the United Stated District Court for the Southern District of Texas, HoustonDivision; and (3) *Jesse Menning,Derivatively on Behalf of Cornell Companies, Inc. v. Steven W. Logan, et.al.,* No. 2002-28924, in the 164th Judicial DistrictCourt of Harris County, Texas.  Theselawsuits relate to our restatement in 2002 of certain financial statements.  These lawsuits all allege breaches offiduciary duty and waste of corporate assets by all of the defendants.  A motion to dismiss the *Guitierrez* and *Pagano* lawsuits was filed. The court dismissed the *Pagano*action as duplicative of the *Guitierrez*action.  The motion to dismiss the *Guitierrez* action is still pending.  The *Menning*action has been dismissed, but with an agreement that the

 

12

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plaintiff’s claims as to Cornell are tolled until 30 days following thefinal resolution of the *Guitierrez*case, including any appeals.

 

The plaintiffs in these caseshave not quantified their claim of damages and the outcome of the mattersdiscussed above cannot be predicted with certainty.  However, we believe we have good defenses andintend to vigorously defend against the claims asserted in these actions.  We have not recorded any loss accrualsrelated to these claims.

 

Certain insurance policies held by us to cover potential director andofficer liability may limit our cash outflows in the event of a decisionadverse to us in the matters discussed above. However, if an adverse decision in these matters exceeds the insurancecoverage or if the insurance coverage is deemed not to apply to these matters,an adverse decision to us in these matters could have a material adverse effecton us, our financial condition, results of operations and future prospects.

 

***Other***

 

Additionally, we currently and from time to time are subject to claimsand suits arising in the ordinary course of business, including claims fordamages for personal injuries or for wrongful restriction of or interferencewith offender privileges and employment matters. If an adverse decision inthese matters exceeds our insurance coverage, or if our coverage is deemed notto apply to these matters, or if the underlying insurance carrier were unableto fulfill their obligation under the insurance coverage provided, it couldhave a material adverse effect on our financial position, results of operationsor cash flows.

 

During theperiod of August 2000 through May 2003, our general liability andprofessional liability coverage was provided by Specialty Surplus InsuranceCompany, a Kemper Insurance Company (“Kemper”) group member.  In June 2004, the Illinois Department ofInsurance gave Kemper permission to proceed with a run-off plan it hadpreviously submitted.  The three-yearplan is designed to help Kemper meet its goal of resolving, to the maximumextent possible, all valid policyholder claims. In view of the risks and uncertainties involved in implementing theplan, including the need to achieve significant policy buybacks, commutation ofreinsurance agreements, and further agreements with regulators, no assurancecan be given that the plan will be successfully implemented by Kemper.  In the year ended December 31, 2004, werecorded a reserve of $0.6 million, and estimated our range of additionalexposure to be approximately $0.5 million with respect to outstanding claimsincurred during this policy period with Kemper which would become ourobligation to resolve if not settled through Kemper.

 

During the six months ended June 30, 2005, Kemper continued toimplement its run-off plan.  As a result,several of our significant claims were settled by Kemper in the second quarterof 2005. In conjunction with these settlements, we booked a charge against ourexisting reserve in the amount of $0.3 million. While we believe that the uncertainty surrounding the ability of Kemperto settle our remaining outstanding claims still exists, we feel no additionalreserve is necessary at June 30, 2005. We believe our estimated range of exposure, above our existing $0.3million reserve, to be approximately $0.3 million related to the outstandingclaims which could become our obligation to resolve if not settled throughKemper.

 

While the outcome of such matters cannot be predicated with certainty,based on the information known to date, we believe that the ultimate resolutionof these matters will not have a material adverse effect on our financialposition, operating results or cash flow.

 

**10.  DerivativeFinancial Instruments and Guarantees**

 

***Debt Service Reserve Fund and Debt ServiceFund***

 

In August 2001, MCFcompleted a bond offering to finance the 2001 Sale and Leaseback Transaction.  In connection with this bond offering, tworeserve fund accounts were established by MCF pursuant to the terms of theindenture: (1) MCF’s Debt Service Reserve Fund, aggregating $23.8 millionat June 30, 2005, was established to make

 

13

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paymentson MCF’s outstanding bonds in the event we (as lessee) should fail to make thescheduled rental payments to MCF and (2) MCF’s Debt Service Fund,aggregating $22.9 million and $17.1 million at June 30, 2005 and December 31,2004, respectively, used to accumulate the monthly lease payments that MCFreceives from us until such funds are used to pay MCF’s semi-annual bondinterest and annual bond principal payments. Both reserve fund accounts are subject to the agreements with the MCFEquity Investors whereby guaranteed rates of return of 3.0% and 5.08%,respectively, are provided for in the balance of the Debt Service Reserve Fundand the Debt Service Fund.  Theguaranteed rates of return are characterized as cash flow hedge derivativeinstruments.  At inception, thederivatives had an aggregate fair value of $4.0 million, which has beenrecorded as a decrease to the equity investment in MCF made by the MCF EquityInvestors (MCF minority interest) and as a deferred liability in ourConsolidated Balance Sheets. Changes in the fair value of the derivativeinstruments are recorded as an adjustment to other long-term liabilities andreported as other comprehensive income (loss) in our Consolidated Statements ofOperations and Comprehensive Income (Loss). At June 30, 2005 and December 31, 2004, the fair value ofthese derivative instruments was approximately $2.0 million and $2.2 million,respectively.  As a result, ourConsolidated Statements of Operations and Comprehensive Income (Loss) includeother comprehensive income (loss) of approximately $0.3 million and ($1.1)million for the three months ended June 30, 2005 and 2004, respectively,and $0.1 million and ($0.6) million for the six months ended June 30, 2005and 2004, respectively.  The $0.1 millionunrealized gain reported in comprehensive income (loss) for the six monthsended June 30, 2005 includes an adjustment of $0.6 million for the taxeffect of changes in fair value during the years ended December 31, 2002and 2003. This adjustment decreased accumulated other comprehensive income andincreased deferred tax liabilities in our Consolidated Balance Sheet as of June 30,2005.

 

In connection with MCF’sbond offering, the MCF Equity Investor provided a guarantee of the Debt ServiceReserve Fund if a bankruptcy of the Company were to occur and a trustee for theestate of the Company were to include the Debt Service Reserve Fund as an assetof the Company’s estate.  This guaranteeis characterized as an insurance contract and is being amortized to expenseover the life of the debt.

 

**11.****      ****Segment Disclosure**

 

Our three operatingdivisions are our reportable segments. The adult secure institutional services segment consists of theoperations of secure adult incarceration facilities.  The juvenile segment consists of providingresidential treatment and educational programs and non-residential community-basedprograms to juveniles between the ages of 10 and 17 who have either beenadjudicated or suffer from behavioral problems. The adult community-based corrections and treatment services segmentconsists of providing pre-release and halfway house programs for adultoffenders who are either on probation or serving the last three to six-monthsof their sentences on parole and preparing for re-entry into society at largeas well as community-based treatment and education programs as an alternativeto incarceration.  All of our customersand long-lived assets are located in the United States of America.  The accounting policies of our reportablesegments are the same as those described in the summary of significantaccounting policies in our 2004 Annual Report on Form 10-K, asamended.  Intangible assets are notincluded in each segment’s reportable assets, and the amortization of intangibleassets is not included in the determination of a segment’s operatingincome.  We evaluate performance based onincome or loss from operations before general and administrative expenses,incentive bonuses, amortization of intangibles, impairment charges onlong-lived assets, interest and income taxes. Corporate and other assets are comprised primarily of cash, investmentsecurities available for sale, accounts receivable, debt service fund,deposits, property and equipment, deferred taxes, deferred costs and otherassets.  Corporate and other income fromoperations primarily consists of depreciation and amortization on the corporateoffice facilities and equipment, and is presented separately as such charges cannotbe readily identified for allocation to a particular segment.

 

14

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The following table excludes the resultsof discontinued operations for the revenue, pre-opening and start-up expensesand income from operations categories for all periods presented.  The only significant non-cash item reportedin the respective segment’s income from operations is depreciation andamortization (excluding intangibles) (in thousands).

 
| ** **                                         | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                         | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                                         | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                               |       |                   |       |                 |       |   |   |   |   |
| Revenues                                           |       |                   |       |                 |       |   |   |   |   |
| Adult secure  institutional                        |       | $                      | 32,295     |                 | $          | 26,681 |   | $ | 63,154 |   | $ | 52,465 |   |
| Juvenile                                           |       | 30,319                 |       | 27,796               |       | 60,454 |   | 55,403 |   |
| Adult community-based                              |       | 15,888                 |       | 11,900               |       | 28,534 |   | 24,084 |   |
| Total revenues                                     |       | $                      | 78,502     |                 | $          | 66,377 |   | $ | 152,142 |   | $ | 131,952 |   |
|                                               |       |                   |       |                 |       |   |   |   |   |
| Pre-opening and  start-up expenses                 |       |                   |       |                 |       |   |   |   |   |
| Adult secure  institutional                        |       | $                      | 2,152      |                 | $          | 514 |   | $ | 5,042 |   | $ | 670 |   |
| Juvenile                                           |       | —                 |       | 476                  |       | 1,804 |   | 598 |   |
| Adult community-based                              |       | —                 |       | —               |       | — |   | — |   |
| Total pre-opening and  start-up expenses           |       | $                      | 2,152      |                 | $          | 990 |   | $ | 6,846 |   | $ | 1,268 |   |
|                                               |       |                   |       |                 |       |   |   |   |   |
| Income from operations                             |       |                   |       |                 |       |   |   |   |   |
| Adult secure  institutional                        |       | $                      | 6,315      |                 | $          | 5,972 |   | $ | 12,424 |   | $ | 11,859 |   |
| Juvenile                                           |       | 4,468                  |       | 3,602                |       | 7,693 |   | 6,939 |   |
| Adult community-based                              |       | 3,125                  |       | 2,145                |       | 5,313 |   | 4,223 |   |
| Subtotal                                           |       | 13,908                 |       | 11,719               |       | 25,430 |   | 23,021 |   |
| General and  administrative expense                |       | (4,899                 | )          | (5,605               | )          | (11,237 | ) | (9,765 | ) |
| Amortization of  intangibles                       |       | (545                   | )          | (270                 | )          | (973 | ) | (539 | ) |
| Corporate and other                                |       | (337                   | )          | (435                 | )          | (745 | ) | (920 | ) |
| Total income from  operations                      |       | $                      | 8,127      |                 | $          | 5,409 |   | $ | 12,475 |   | $ | 11,797 |   |
|                                               |       |                   |       |                 |       |   |   |   |   |
| Loss on discontinued  operations, net of tax       |       |                   |       |                 |       |   |   |   |   |
| Adult secure  institutional                        |       | $                      | —     |                 | $          | — |   | $ | — |   | $ | — |   |
| Juvenile                                           |       | (1,639                 | )          | (442                 | )          | (3,087 | ) | (789 | ) |
| Adult community-based                              |       | (43                    | )          | 30                   |       | (28 | ) | 56 |   |
| Total loss on  discontinued operations, net of tax |       | $                      | (1,682     | )                    | $          | (412 | ) | $ | (3,115 | ) | $ | (733 | ) |

 
| ** **                  | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                  | ** ** | **2005**          | ** ** | **2004**              | ** ** |
| Assets                      |       |              |       |                  |       |
| Adult secure  institutional |       | $                 | 178,122    |                  | $          | 172,793 |   |
| Juvenile                    |       | 106,880           |       | 123,890               |       |
| Adult community-based       |       | 68,031            |       | 62,984                |       |
| Intangible assets, net      |       | 20,724            |       | 14,747                |       |
| Corporate and other         |       | 137,490           |       | 133,217               |       |
| Total assets                |       | $                 | 511,247    |                  | $          | 507,631 |   |

 

**12.  Guarantor Disclosures**

 

Wecompleted an offering of $112.0 million of Senior Notes in June 2004.  The Senior Notes are guaranteed by each ofour subsidiaries (Guarantor Subsidiaries). These guarantees are joint and several obligations of the GuarantorSubsidiaries. MCF does not guarantee the Senior Notes (Non-Guarantor Subsidiary).The following condensed consolidating financial information presents thefinancial condition, results of operations and cash flows of the GuarantorSubsidiaries and the Non-Guarantor Subsidiary, together with the consolidatingadjustments necessary to present our results on a consolidated basis.

 

15

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**Condensed Consolidating Balance Sheet as of June 30,2005 (in thousands) (unaudited)**

 
| ** **                                       | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|--------------------------------------------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| ** **                                       | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**    | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Assets**                                       |       |       |       |             |       |              |       |             |       |             |       |
| Current assets:                                  |       |       |       |             |       |              |       |             |       |             |       |
| Cash and cash  equivalents                       |       | $          | 11,695     |             | $          | 1,171             |       | $                | 81         |             | $          | — |   | $ | 12,947 |   |
| Investment securities                            |       | 39,450     |       | —           |       | —            |       | —           |       | 39,450           |       |
| Accounts receivable                              |       | 1,813      |       | 52,288           |       | 358               |       | —           |       | 54,459           |       |
| Debt service fund and other  restricted assets   |       | 1          |       | 2,453            |       | 22,936            |       | —           |       | 25,390           |       |
| Prepaids and other                               |       | 15,731     |       | 3,618            |       | —            |       | —           |       | 19,349           |       |
| Total current assets                             |       | 68,690     |       | 59,530           |       | 23,375            |       | —           |       | 151,595          |       |
| Property and equipment,  net                     |       | 608        |       | 140,874          |       | 156,753           |       | (6,045           | )          | 292,190          |       |
| Other assets:                                    |       |       |       |             |       |              |       |             |       |             |       |
| Debt service reserve  fund                       |       | —     |       | —           |       | 23,800            |       | —           |       | 23,800           |       |
| Deferred costs and  other                        |       | 42,240     |       | 26,236           |       | 9,067             |       | (33,881          | )          | 43,662           |       |
| Investment in  subsidiaries                      |       | 15,304     |       | 1,856            |       | —            |       | (17,160          | )          | —           |       |
| Total assets                                     |       | $          | 126,842    |             | $          | 228,496           |       | $                | 212,995    |             | $          | (57,086 | ) | $ | 511,247 |   |
| ** **                                       | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Liabilities and stockholders’ equity**    |       |       |       |             |       |              |       |             |       |             |       |
|                                             |       |       |       |             |       |              |       |             |       |             |       |
| Current liabilities:                             |       |       |       |             |       |              |       |             |       |             |       |
| Accounts payable and  accrued liabilities        |       | $          | 41,165     |             | $          | 8,284             |       | $                | 6,191      |             | $          | (2,596 | ) | $ | 53,044 |   |
| Current portion of  long-term debt               |       | —     |       | 1                |       | 9,000             |       | —           |       | 9,001            |       |
| Total current  liabilities                       |       | 41,165     |       | 8,285            |       | 15,191            |       | (2,596           | )          | 62,045           |       |
| Long-term debt, net of  current portion          |       | 113,881    |       | 171              |       | 165,700           |       | —           |       | 279,752          |       |
| Deferred tax  liabilities                        |       | 8,516      |       | (1,763           | )          | —            |       | 781              |       | 7,534            |       |
| Other long-term  liabilities                     |       | 5,530      |       | 189              |       | 32,156            |       | (35,581          | )          | 2,294            |       |
| Intercompany                                     |       | (201,872   | )          | 201,872          |       | —            |       | —           |       | —           |       |
| Total liabilities                                |       | (32,780    | )          | 208,754          |       | 213,047           |       | (37,396          | )          | 351,625          |       |
| Stockholders’ equity                        |       | 159,622    |       | 19,742           |       | (52               | )          | (19,690          | )          | 159,622          |       |
| Total liabilities and  stockholders’ equity |       | $          | 126,842    |             | $          | 228,496           |       | $                | 212,995    |             | $          | (57,086 | ) | $ | 511,247 |   |

 

16

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**Condensed Consolidating Balance Sheet as of December 31,2004 (in thousands)**

 
| ** **                                       | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|--------------------------------------------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| ** **                                       | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**    | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Assets**                                       |       |       |       |             |       |              |       |             |       |             |       |
| Current assets:                                  |       |       |       |             |       |              |       |             |       |             |       |
| Cash and cash  equivalents                       |       | $          | 9,559      |             | $          | 296               |       | $                | 40         |             | $          | — |   | $ | 9,895 |   |
| Investment securities                            |       | 51,740     |       | —           |       | —            |       | —           |       | 51,740           |       |
| Accounts receivable                              |       | 3,298      |       | 61,189           |       | 378               |       | —           |       | 64,865           |       |
| Restricted assets                                |       | 121        |       | 2,451            |       | 17,141            |       | —           |       | 19,713           |       |
| Prepaids and other                               |       | 15,664     |       | 1,962            |       | —            |       | —           |       | 17,626           |       |
| Total current assets                             |       | 80,382     |       | 65,898           |       | 17,559            |       | —           |       | 163,839          |       |
| Property and equipment,  net                     |       | 672        |       | 128,965          |       | 158,863           |       | (6,245           | )          | 282,255          |       |
| Other assets:                                    |       |       |       |             |       |              |       |             |       |             |       |
| Debt service reserve  fund                       |       | —     |       | —           |       | 23,801            |       | —           |       | 23,801           |       |
| Deferred costs and  other                        |       | 39,392     |       | 19,225           |       | 9,362             |       | (30,243          | )          | 37,736           |       |
| Investment in  subsidiaries                      |       | 20,613     |       | 1,856            |       | —            |       | (22,469          | )          | —           |       |
| Total assets                                     |       | $          | 141,059    |             | $          | 215,944           |       | $                | 209,585    |             | $          | (58,957 | ) | $ | 507,631 |   |
| ** **                                       | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Liabilities and stockholders’ equity**    |       |       |       |             |       |              |       |             |       |             |       |
| Current liabilities:                             |       |       |       |             |       |              |       |             |       |             |       |
| Accounts payable and  accrued liabilities        |       | $          | 36,191     |             | $          | 7,369             |       | $                | 6,197      |             | $          | (2,520 | ) | $ | 47,237 |   |
| Current portion of  long-term debt               |       | —     |       | 5                |       | 9,000             |       | —           |       | 9,005            |       |
| Total current  liabilities                       |       | 36,191     |       | 7,374            |       | 15,197            |       | (2,520           | )          | 56,242           |       |
| Long-term debt, net of  current portion          |       | 113,827    |       | 1                |       | 165,700           |       | —           |       | 279,528          |       |
| Deferred tax  liabilities                        |       | 7,966      |       | —           |       | —            |       | 122              |       | 8,088            |       |
| Other long-term  liabilities                     |       | 5,846      |       | 80               |       | 28,546            |       | (32,011          | )          | 2,461            |       |
| Intercompany                                     |       | (184,083   | )          | 184,083          |       | —            |       | —           |       | —           |       |
| Total liabilities                                |       | (20,253    | )          | 191,538          |       | 209,443           |       | (34,409          | )          | 346,319          |       |
| Stockholders’ equity                        |       | 161,312    |       | 24,406           |       | 142               |       | (24,548          | )          | 161,312          |       |
| Total liabilities and  stockholders’ equity |       | $          | 141,059    |             | $          | 215,944           |       | $                | 209,585    |             | $          | (58,957 | ) | $ | 507,631 |   |

 

17

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**Condensed Consolidating Statement ofOperations for the three months ended June 30, 2005****(in thousands) (unaudited)**

 
| ** **                                                                            | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------------------------------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                            | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**    | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                                            | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| Revenues                                                                              |       | $          | 4,483      |             | $          | 88,270            |       | $                | 4,502      |             | $          | (18,753 | ) | $ | 78,502 |   |
| Operating expenses                                                                    |       | 4,197      |       | 73,716           |       | 14                |       | (18,419          | )          | 59,508           |       |
| Pre-opening and  start-up expenses                                                    |       | —     |       | 2,152            |       | —            |       | —           |       | 2,152            |       |
| Depreciation and  amortization                                                        |       | 21         |       | 2,843            |       | 1,055             |       | (103             | )          | 3,816            |       |
| General and  administrative expenses                                                  |       | 4,880      |       | —           |       | 19                |       | —           |       | 4,899            |       |
| Income (loss) from  operations                                                        |       | (4,615     | )          | 9,559            |       | 3,414             |       | (231             | )          | 8,127            |       |
| Overhead allocations                                                                  |       | (6,665     | )          | 6,665            |       | —            |       | —           |       | —           |       |
| Interest, net                                                                         |       | 557        |       | 1,527            |       | 3,485             |       | 11               |       | 5,580            |       |
| Equity earnings in  subsidiaries                                                      |       | (601       | )          | —           |       | —            |       | 601              |       | —           |       |
| Income (loss) from  continuing operations before provision (benefit) for income taxes |       | 892        |       | 1,367            |       | (71               | )          | 359              |       | 2,547            |       |
| Provision (benefit) for  income taxes                                                 |       | 1,203      |       | —           |       | —            |       | (27              | )          | 1,176            |       |
| Income (loss) from  continuing operations                                             |       | (311       | )          | 1,367            |       | (71               | )          | 386              |       | 1,371            |       |
| Discontinued  operations, net of income tax benefit of $904                           |       | —     |       | (1,682           | )          | —            |       | —           |       | (1,682           | )          |
| Net income (loss)                                                                     |       | $          | (311       | )                | $          | (315              | )          | $                | (71        | )                | $          | 386 |   | $ | (311 | ) |

 

18

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**Condensed Consolidating Statement ofOperations for the three months ended June 30, 2004****(in thousands) (unaudited)**

 
| ** **                                                                            | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------------------------------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                            | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**    | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                                            | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| Revenues                                                                              |       | $          | 4,531      |             | $          | 74,601            |       | $                | 4,502      |             | $          | (17,257 | ) | $ | 66,377 |   |
| Operating expenses                                                                    |       | 5,900      |       | 62,354           |       | 23                |       | (16,997          | )          | 51,280           |       |
| Pre-opening and  start-up expenses                                                    |       | —     |       | 990              |       | —            |       | —           |       | 990              |       |
| Depreciation and  amortization                                                        |       | (20        | )          | 2,134            |       | 1,055             |       | (76              | )          | 3,093            |       |
| General and  administrative expenses                                                  |       | 5,574      |       | —           |       | 19                |       | 12               |       | 5,605            |       |
| Income (loss) from  operations                                                        |       | (6,923     | )          | 9,123            |       | 3,405             |       | (196             | )          | 5,409            |       |
| Overhead allocations                                                                  |       | (8,604     | )          | 8,604            |       | —            |       | —           |       | —           |       |
| Interest, net                                                                         |       | (1,117     | )          | 1,689            |       | 3,633             |       | 11               |       | 4,216            |       |
| Loss on extinguishment  of debt                                                       |       | —     |       | 2,357            |       | —            |       | —           |       | 2,357            |       |
| Equity earnings in  subsidiaries                                                      |       | (3,475     | )          | —           |       | —            |       | 3,475            |       | —           |       |
| Income (loss) from  continuing operations before provision (benefit) for income taxes |       | (677       | )          | (3,527           | )          | (228              | )          | 3,268            |       | (1,164           | )          |
| Provision (benefit) for  income taxes                                                 |       | 422        |       | (794             | )          | —            |       | (105             | )          | (477             | )          |
| Income (loss) from  continuing operations                                             |       | (1,099     | )          | (2,733           | )          | (228              | )          | 3,373            |       | (687             | )          |
| Discontinued  operations, net of income tax benefit of $286                           |       | —     |       | (412             | )          | —            |       | —           |       | (412             | )          |
| Net income (loss)                                                                     |       | $          | (1,099     | )                | $          | (3,145            | )          | $                | (228       | )                | $          | 3,373 |   | $ | (1,099 | ) |

 

19

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**Condensed Consolidating Statement ofOperations for the six months ended June 30, 2005****(in thousands) (unaudited)**

 
| ** **                                                                            | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------------------------------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                            | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**    | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                                            | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| Revenues                                                                              |       | $          | 9,010      |             | $          | 171,727           |       | $                | 9,004      |             | $          | (37,599 | ) | $ | 152,142 |   |
| Operating expenses                                                                    |       | 8,462      |       | 142,485          |       | 24                |       | (36,932          | )          | 114,039          |       |
| Pre-opening and  start-up expenses                                                    |       | —     |       | 6,846            |       | —            |       | —           |       | 6,846            |       |
| Depreciation and  amortization                                                        |       | 42         |       | 5,592            |       | 2,111             |       | (200             | )          | 7,545            |       |
| General and  administrative expenses                                                  |       | 11,199     |       | —           |       | 38                |       | —           |       | 11,237           |       |
| Income (loss) from  operations                                                        |       | (10,693    | )          | 16,804           |       | 6,831             |       | (467             | )          | 12,475           |       |
| Overhead allocations                                                                  |       | (15,590    | )          | 15,590           |       | —            |       | —           |       | —           |       |
| Interest, net                                                                         |       | 1,478      |       | 2,800            |       | 7,025             |       | 21               |       | 11,324           |       |
| Equity earnings in  subsidiaries                                                      |       | (5,307     | )          | —           |       | —            |       | 5,307            |       | —           |       |
| Income (loss) from  continuing operations before provision (benefit) for income taxes |       | (1,888     | )          | (1,586           | )          | (194              | )          | 4,819            |       | 1,151            |       |
| Provision (benefit) for  income taxes                                                 |       | 696        |       | —           |       | —            |       | (76              | )          | 620              |       |
| Income (loss) from  continuing operations                                             |       | (2,584     | )          | (1,586           | )          | (194              | )          | 4,895            |       | 531              |       |
| Discontinued  operations, net of income tax benefit of $1,677                         |       | —     |       | (3,115           | )          | —            |       | —           |       | (3,115           | )          |
| Net income (loss)                                                                     |       | $          | (2,584     | )                | $          | (4,701            | )          | $                | (194       | )                | $          | 4,895 |   | $ | (2,584 | ) |

 

20

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**Condensed Consolidating Statement ofOperations for the six months ended June 30, 2004****(in thousands) (unaudited)**

 
| ** **                                                                            | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------------------------------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                            | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**    | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                                            | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| Revenues                                                                              |       | $          | 9,088      |             | $          | 148,926           |       | $                | 9,004      |             | $          | (35,066 | ) | $ | 131,952 |   |
| Operating expenses                                                                    |       | 11,723     |       | 125,954          |       | 23                |       | (34,747          | )          | 102,953          |       |
| Pre-opening and  start-up expenses                                                    |       | —     |       | 1,268            |       | —            |       | —           |       | 1,268            |       |
| Depreciation and  amortization                                                        |       | —     |       | 4,205            |       | 2,111             |       | (147             | )          | 6,169            |       |
| General and  administrative expenses                                                  |       | 9,715      |       | —           |       | 38                |       | 12               |       | 9,765            |       |
| Income (loss) from  operations                                                        |       | (12,350    | )          | 17,499           |       | 6,832             |       | (184             | )          | 11,797           |       |
| Overhead allocations                                                                  |       | (15,834    | )          | 15,834           |       | —            |       | —           |       | —           |       |
| Interest, net                                                                         |       | (1,970     | )          | 3,427            |       | 7,386             |       | 21               |       | 8,864            |       |
| Loss on extinguishment  of debt                                                       |       | —     |       | 2,357            |       | —            |       | —           |       | 2,357            |       |
| Equity earnings in  subsidiaries                                                      |       | (4,706     | )          | —           |       | —            |       | 4,706            |       | —           |       |
| Income (loss) from  continuing operations before provision (benefit) for income taxes |       | 748        |       | (4,119           | )          | (554              | )          | 4,501            |       | 576              |       |
| Provision (benefit) for  income taxes                                                 |       | 1,141      |       | (654             | )          | —            |       | (251             | )          | 236              |       |
| Income (loss) from  continuing operations                                             |       | (393       | )          | (3,465           | )          | (554              | )          | 4,752            |       | 340              |       |
| Discontinued  operations, net of income tax benefit of $509                           |       | —     |       | (733             | )          | —            |       | —           |       | (733             | )          |
| Net income (loss)                                                                     |       | $          | (393       | )                | $          | (4,198            | )          | $                | (554       | )                | $          | 4,752 |   | $ | (393 | ) |

 

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**CondensedConsolidating Statement of Cash Flows for the six months ended June 30,2005 (in thousands) (unaudited)**

 
| ** **                                            | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|-------------------------------------------------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| ** **                                            | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**    | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Cash  flows from operating activities:**            |       |       |       |             |       |              |       |             |       |             |       |
| Net cash provided by  (used in) operating activities  |       | $          | (905       | )                | $          | 15,597            |       | $                | 5,836      |             | $          | — |   | $ | 20,528 |   |
| ** **                                            | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash  flows from investing activities:**            |       |       |       |             |       |              |       |             |       |             |       |
| Capital expenditures                                  |       | —     |       | (14,552          | )          |              |       |             |       | (14,552          | )          |
| Purchases of investment  securities                   |       | (665,845   | )          | —           |       | —            |       | —           |       | (665,845         | )          |
| Sales of investment securities                        |       | 678,135    |       | —           |       | —            |       | —           |       | 678,135          |       |
| Acquisition of a business                             |       | (9,064     | )          | —           |       | —            |       | —           |       | (9,064           | )          |
| Payments to restricted  debt payment account, net     |       | —     |       | —           |       | (5,795            | )          | —           |       | (5,795           | )          |
| Net cash provided by (used)  in investing activities  |       | $          | 3,226      |             | $          | (14,552           | )          | $                | (5,795     | )                | $          | — |   | $ | (17,121 | ) |
| ** **                                            | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash  flows from financing activities:**            |       |       |       |             |       |              |       |             |       |             |       |
| Payments on acquired  debt                            |       | (1,905     | )          | —           |       | —            |       | —           |       | (1,905           | )          |
| Payments on capital  lease obligations                |       | —     |       | (170             | )          | —            |       | —           |       | (170             | )          |
| Proceeds from exercise  of stock options              |       | 1,720      |       |             |       |              |       |             |       | 1,720            |       |
| Net cash provided by (used)  in financing activities  |       | (185       | )          | (170             | )          | —            |       | —           |       | (355             | )          |
| ** **                                            | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Net  increase in cash and cash equivalents**        |       | 2,136      |       | 875              |       | 41                |       | —           |       | 3,052            |       |
| ** **                                            | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash  and cash equivalents at beginning of period** |       | 9,559      |       | 296              |       | 40                |       | —           |       | 9,895            |       |
| ** **                                            | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash  and cash equivalents at end of period**       |       | $          | 11,695     |             | $          | 1,171             |       | $                | 81         |             | $          | — |   | $ | 12,947 |   |

 

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**CondensedConsolidating Statement of Cash Flows for the six months ended June 30,2004 (in thousands) (unaudited)**

 
| ** **                                                | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|-----------------------------------------------------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| ** **                                                | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**    | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Cash  flows from operating activities:**                |       |       |       |             |       |              |       |             |       |             |       |
| Net cash provided by  (used in) operating activities      |       | $          | (20,656    | )                | $          | 23,080            |       | $                | 5,518      |             | $          | — |   | $ | 7,942 |   |
| ** **                                                | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash  flows from investing activities:**                |       |       |       |             |       |              |       |             |       |             |       |
| Capital expenditures                                      |       | —     |       | (20,559          | )          | —            |       | —           |       | (20,559          | )          |
| Purchase of facility  management contract                 |       | —     |       | (2,900           | )          | —            |       | —           |       | (2,900           | )          |
| Refund from restricted  escrow arrangement                |       | 5,000      |       | —           |       | —            |       | —           |       | 5,000            |       |
| Payments to restricted  debt payment account, net         |       | —     |       | —           |       | (5,523            | )          | —           |       | (5,523           | )          |
| Return of restricted  assets from deferred bonus plan     |       | 86         |       | —           |       | —            |       | —           |       | 86               |       |
| Proceeds from sale of fixed  assets                       |       | —     |       | 163              |       | —            |       | —           |       | 163              |       |
| Net cash provided by  (used in) investing activities      |       | $          | 5,086      |             | $          | (23,296           | )          | $                | (5,523     | )                | $          | — |   | $ | (23,733 | ) |
|                                                      |       |       |       |             |       |              |       |             |       |             |       |
| **Cash  flows from financing activities:**                |       |       |       |             |       |              |       |             |       |             |       |
| Proceeds from long-term  debt and line of credit          |       | 69,000     |       | —           |       | —            |       | —           |       | 69,000           |       |
| Payments on line of  credit                               |       | (71,000    | )          | —           |       | —            |       | —           |       | (71,000          | )          |
| Payments on synthetic lease                               |       | —     |       | (52,495          | )          | —            |       | —           |       | (52,495          | )          |
| Intercompany transfers                                    |       | (52,495    | )          | 52,495           |       | —            |       | —           |       | —           |       |
| Proceeds from Senior  Notes, net of discount              |       | 110,527    |       | —           |       | —            |       | —           |       | 110,527          |       |
| Payments for debt  issuance and other financing costs     |       | (5,033     | )          | —           |       | —            |       | —           |       | (5,033           | )          |
| Payments on capital  lease obligations                    |       | (6         | )          | —           |       | —            |       | —           |       | (6               | )          |
| Proceeds from exercise  of stock options                  |       | 1,040      |       | —           |       | —            |       | —           |       | 1,040            |       |
| Purchases of treasury  stock                              |       | (116       | )          | —           |       | —            |       | —           |       | (116             | )          |
| Net cash provided by  financing activities                |       | 51,917     |       | —           |       | —            |       | —           |       | 51,917           |       |
|                                                      |       |       |       |             |       |              |       |             |       |             |       |
| **Net  increase (decrease) in cash and cash equivalents** |       | 36,347     |       | (216             | )          | (5                | )          | —           |       | 36,126           |       |
| ** **                                                | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash  and cash equivalents at beginning of period**     |       | 39,827     |       | 289              |       | 55                |       | —           |       | 40,171           |       |
| ** **                                                | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash  and cash equivalents at end of period**           |       | $          | 76,174     |             | $          | 73                |       | $                | 50         |             | $          | — |   | $ | 76,297 |   |
|                                                           |            |            |            |                  |            |                   |            |                  |            |                  |            |  |  |  |  |  |  |

 

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**ITEM 6.****                            ****Exhibits**

 
| **Exhibit No.** | ** ** | **Description**                                            |
|----------------------|------------|------------------------------------------------------------|
| 31.1                 |       | Section 302  Certification of Chief Executive Officer |
| 31.2                 |       | Section 302  Certification of Chief Financial Officer |
| 32.1                 |       | Section 906  Certification of Chief Executive Officer |
| 32.2                 |       | Section 906  Certification of Chief Financial Officer |

 

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**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,thereunto duly authorized.

 

 
|                                               |   | **CORNELL COMPANIES, INC.**           |   |
|----------------------------------------------------|--------|---------------------------------------|--------|
|                                               |   |                                  |   |
|                                               |   |                                  |   |
| Date:    August 19, 2005  | By:    | /s/ James E. Hyman                    |   |
|                                               |   | JAMES E. HYMAN                        |   |
|                                               |   | Chief Executive Officer  and          |   |
|                                               |   | Chairman of the Board                 |   |
|                                               |   | (Principal Executive  Officer)        |   |
|                                               |   |                                  |   |
|                                               |   |                                  |   |
| Date:    August 19,  2005 | By:    | /s/ John R. Nieser                    |   |
|                                               |   | JOHN R. NIESER                        |   |
|                                               |   | Chief Financial Officer and Treasurer |   |
|                                               |   | (Principal Financial Officer)         |   |
|                                                    |        |                                       |        |  |

 

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