We adopted SFAS No. 144 on January 1, 2002. In accordance with SFAS No. 144, long-lived assets, such as property and equipment and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. We recognized an impairment loss on identifiable intangible assets subject to amortization of $1.0 million in 2002, $4.2 million in 2003, $2.4 million in 2004 and $5.0 million in 2005. Prior to the adoption of SFAS No. 144, we accounted for long-lived assets in accordance with SFAS No. 121. For the year ended December 31, 2001, we recorded an impairment loss on intangibles subject to amortization of $2.3 million.
(b) Our borrowings are made under a bank line that is structured as a revolving credit facility and is due on June 15, 2008, unless we elect to convert the credit facility to a term loan, in which case it will amortize over one year, with a principal payment due on December 15, 2008 and with a final maturity on June 15, 2009. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources-Borrowings.”
(d) As a measure of financial performance, we calculate the internal growth rate of the revenue of our firms. This calculation compares the change in revenue of a comparable group of firms for the same time period in successive years. We include firms in this calculation at the beginning of the first fiscal quarter that begins one year after acquisition by us unless a firm has merged with another owned firm or has made a sub-acquisition that represents more than 25% of the base earnings of the acquiring firm. With respect to two owned firms that merge, the combined firm is excluded from the calculation from the time of the merger until the first fiscal quarter that begins one year after acquisition by us of the most recently acquired firm participating in the merger. However, if both firms involved in a merger are included in the internal
growth rate calculation at the time of the merger, the combined firm continues to be included in the calculation after the merger. With respect to the sub-acquisitions described above, to the extent the sub-acquired firm does not separately report financial statements to NFP, the acquiring firm is excluded from the calculation from the time of the sub-acquisition until the first fiscal quarter beginning one year following the sub-acquisition. Sub-acquisitions that represent less than 25% of the base earnings of the acquiring firms are considered to be internal growth. For further information about sub-acquisitions, see “Business-Operations-Sub-Acquisitions.” With respect to dispositions, we include these firms up to the time of disposition and exclude these firms for all periods after the disposition. The calculation described above is not adjusted for intercompany transactions that result in the same item of revenue being recorded by two firms.
We are a leading independent distributor of financial services products primarily to high net worth individuals and growing entrepreneurial companies. Founded in 1998, and commencing operations on January 1, 1999, we have grown internally and through acquisitions and, as of December 31, 2005, operate a national distribution network with over 1,900 producers in 41 states and Puerto Rico operating through 160 owned firms and over 210 affiliated third-party distributors. We acquired 24, 19 and 26 firms in 2003, 2004 and 2005, respectively. Our operating results have improved from a net loss of $(5.7) million in 2001 to net income of $56.2 million in 2005. As a result of new acquisitions and the growth of previously acquired firms, total revenues have grown from $268.2 million in 2001 to $891.4 million of revenue in 2005, a compound annual growth rate over 35%.
Our firms earn revenue that consists primarily of commissions and fees earned from the sale of financial products and services to their clients and incur commission and fee expense and operating expense in the course of earning revenue. We pay management fees to non-employee principals of our firms based on the financial performance of each respective firm. We refer to revenue earned by our firms minus the expenses of our firms, including management fees, as gross margin. We exclude amortization and depreciation and stock-based compensation from gross margin. These amounts are included in amounts disclosed separately as part of “Corporate and other expenses”. Management uses gross margin as a measure of the performance of the firms that we have acquired. Through acquisitions and internal growth, gross margin has grown from $61.4 million in 2001 to $175.1 million in 2005.
Our gross margin is offset by expenses that we incur at the corporate level, including corporate and other expenses. Corporate and other expenses have grown from $62.9 million in 2001 to $79.0 million in 2005. Corporate and other expenses include general and administrative expenses, which are the operating expenses of our corporate headquarters. General and administrative expenses have grown from $20.9 million in 2001 to $41.2 million in 2005. General and administrative expenses as a percent of revenue declined from 7.8% in 2001 to 4.6% in 2005.
Many external factors affect our revenues and profitability, including economic and market conditions, legislative and regulatory developments and competition. Because many of these factors are unpredictable and generally beyond our control, our revenues and earnings may fluctuate from year to year and quarter to quarter. In 2005, our revenues and net income benefited from strong sales of financed life insurance products. Management believes that such sales were driven by premium financing opportunities that may be diminished in the future.
We enter into a management agreement with principals and/or certain entities they own. Under the management agreement, the principals and/or such entities are entitled to management fees consisting of:
Corporate and executive benefits commissions and fees. Our firms earn commissions on the sale of insurance policies written for benefit programs. The commissions are paid each year as long as the client continues to use the product and maintain its broker of record relationship with the firm. Our firms also earn fees for the development and implementation of corporate and executive benefit programs as well as fees for the duration that these programs are administered. Asset-based fees are also earned for administrative services or consulting related to certain benefits plans.
Some of our firms also earn additional compensation in the form of incentive and marketing support revenue from manufacturers of financial services products, based on the volume, persistency and profitability of business generated by us from these three sources. These forms of payments are earned both with respect to sales by our owned firms and sales by our network of over 210 affiliated third-party distributors.
The following table sets forth certain of our expenses as a percentage of revenue for the periods indicated:
Commissions and fees. Commissions and fees are typically paid to non-principal producers, who are employed or affiliated with our firms. Commission and fees are also paid to non-affiliated producers who utilize the services of one or more of our life or benefits brokerage entities including our life settlements brokerage entity. When business is generated solely by a principal, no commission expense is incurred because principals are only paid from a share of the cash flow of the acquired firm through management fees. However, when income is generated by a non-principal producer, the producer is generally paid a portion of the commission income, which is reflected as commission expense of the acquired firm. In addition, NFPSI pays commissions to our affiliated third-party distributors who transact business through NFPSI.
(1) Excludes amortization and depreciation and stock-based compensation shown separately as part of Corporate and other expenses.
In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” (SFAS No. 123R) which revises SFAS No. 123 and supercedes APB Opinion No. 25 and becomes effective January 1, 2006. Had we adopted SFAS 123R in prior periods the impact of that standard would have approximated the impact of SFAS 123. In March 2005 the SEC
released its Staff Accounting Bulletin No. 107 (SAB 107) which provides that a company should present the expense related to share-based payments in the same line as cash compensation paid to the same employees. Prior to adoption of SFAS 123R a previously accepted practice was to present all stock-based compensation in a single line item. Effective with the adoption of SFAS 123R these amounts will be included in operating expenses under the caption “Cost of services.” The cost of the stock awards to employees of our acquired firms issued prior to the adoption of SFAS 123R totaled approximately $0.1 million, $0.2 million and $1.1 million in 2003, 2004 and 2005, respectively.
Gross margin before management fees and gross margin before management fees as a percentage of revenue is presented in the table on p.41.
Through acquisitions and internal growth, we have achieved revenue growth of 33%, 38% and 39% in the years ended December 31, 2003, 2004 and 2005, respectively. This growth was driven by our acquisitions and internal growth in the revenue of our acquired firms, augmented by the growth of NFPISI and NFPSI. In 2003, 2004 and 2005, our firms had an internal revenue growth rate of 14%, 16% and 22%, respectively.
Our management also monitors acquired firm revenue, commissions and fees expense and operating expense from new acquisitions as compared with existing firms. For this purpose, a firm is considered to be a new acquisition for the twelve months following the acquisition. After the first twelve months, a firm is considered to be an existing firm. Within any reported period, a firm may be considered to be a new acquisition for part of the period and an existing firm for the remainder of the period. Additionally, NFPSI and NFPISI are considered to be existing firms. Sub-acquisitions that do not separately report their results are considered to be part of the firm making the acquisition, and the results of firms disposed of are included in the calculations. The results of operations discussions set forth below include analysis of the relevant line items on this basis.
Commissions and fees. Commissions and fees increased $251.9 million, or 39.4%, to $891.4 million in 2005 from $639.5 million in 2004. Our revenue growth was derived from both internal growth at existing firms and the acquisition of new firms. Commissions and fees generated from existing firms totaled $770.4 million in 2005, an increase of $130.9 million over the prior year’s total revenues. Commissions and fees from existing firms benefited in part from strong sales of financed life insurance products. Commissions and fees totaled $104.1 million for firms acquired in 2005, including $71.0 million from the acquisition of Highland Capital Holding Corporation which was acquired effective April 1, 2005.
Commissions and fees. Commissions and fees expense increased $84.0 million, or 51.3%, to $247.8 million in 2005 from $163.8 million in 2004. Commissions and fees expense from existing firms increased $81.7 million, to $217.1 million in 2005 from $135.4 million in 2004. Commissions and fees expense from firms acquired in 2005 totaled $26.0 million. As a percentage of revenue, commissions and fees expense increased to 27.8% in 2005 from 25.6% in 2004. An increase in commission payouts at several of our wholesale entities resulted in higher commission expense as a percentage of revenue.
Management fees. Management fees increased $63.5 million, or 43.8%, to $208.6 million in 2005 compared with $145.1 million in 2004. Management fees as a percentage of revenue increased to 23.4% in 2005 from 22.7% in 2004. The increase in management fees resulted from higher earnings at acquired firms. The increase in management fees as a percentage of revenue is due to significantly higher earnings at certain of our acquired firms, incentive accruals and an additional management fee expense of $6.1 million. During the fourth quarter of 2005 we determined it was appropriate as part of our efforts to enhance controls over this significant expense item to transition to a single methodology for both calculating and paying management fees. As part of this transition process, additional balances became due to principals which resulted in further expense. Additionally, a higher percentage of our earnings in 2005 were earned by firms in which the principals have a greater economic interest, compared with 2004. This resulted in a greater proportion of management fees being accrued in 2005 than in the prior period. Further, management fees included an accrual of $13.6 million for ongoing incentive plans in 2005 compared with $9.3 million in 2004, primarily reflecting growth at firms who are in their incentive cycle. Partially offsetting this increase were higher earnings at NFPISI and NFPSI, for which no management fee expense was incurred.
General and administrative. General and administrative expenses increased $5.8 million, or 16.4%, to $41.2 million in 2005 compared with $35.4 million in 2004. The increase resulted primarily from $4.0 million of expenses related to our internal review of our insurance operations coupled with an increase in compensation and related costs of $2.7 million principally due to planned increases in the corporate infrastructure to support acquisitions and internal growth, partially offset by lower cost related to the implementation of Sarbanes-Oxley. As a percentage of revenue, general and administrative expense declined to 4.6% in 2005 compared with 5.5% in 2004, as we continued to benefit from the absorption of corporate expenses over an expanding revenue base.
Stock-based compensation. Stock-based compensation expense increased $3.1 million to $4.5 million in 2005 compared with $1.4 million in 2004. The increase was primarily due to new awards granted during the fourth quarter of 2004 as well as during 2005. As a percentage of revenue, stock-based compensation expense was 0.5% in 2005 compared with 0.2% in 2004. Stock-based compensation expense attributable to firm employees totaled $1.1 million and $0.2 million in 2005 and 2004, respectively. Beginning with the adoption of SFAS 123R on January 1, 2006, we will report stock-based compensation expense related to employees of our acquired firms in cost of services.
Amortization. Amortization increased $4.2 million, or 21.5%, to $23.7 million in 2005 compared with $19.5 million in 2004. Amortization expense increased as a result of a 20.9% increase in amortizing intangible assets resulting primarily from new acquisitions. As a percentage of revenue, amortization was 2.7% in 2005 compared with 3.0% in 2004.
Gain on sale of businesses. Gain on sale of businesses increased $6.2 million to $6.3 million in 2005 compared with $0.1 million in 2004. The gain on sale resulted from the disposal of four subsidiaries and from the sale of assets in 2005 and the disposal of one subsidiary in 2004.
Interest and other income. Interest and other income increased $4.2 million, to $6.4 million in 2005 compared with $2.2 million in 2004. The increase was primarily attributable to a $2.3 million net contribution related to benefits received under our key person life insurance program. It is our practice to maintain key person life insurance on our principals during the initial term of their management contracts and on a selective basis subsequent thereto.
that are not deductible for tax purposes, as well as the effects of state and local taxes. The effective tax rate declined in 2005 principally as a result of the proportional increase in pretax income relative to nondeductible expenses and the tax benefit of key person life insurance proceeds partially offset by taxable income resulting from the restructuring of certain management contracts.
Commissions and fees. Commissions and fees increased $175.1 million, or 37.7%, to $639.5 million in 2004 compared with $464.4 million in 2003. The increase was due to business generated by firms that were
acquired in 2003 and in 2004 as well as an increased volume of business from our existing firms. Commissions and fees from new acquisitions was approximately $88.0 million in 2004. Commissions and fees from existing firms was $551.5 million in 2004, an increase of $87.1 million, or 18.8%, from $464.4 million in 2003.
Operating expenses. Operating expenses increased $39.9 million, or 26.5%, to $190.2 million in 2004 compared with $150.3 million in 2003. The increase was principally due to business generated by firms which were acquired during 2003 and 2004 and internal growth at our existing firms. As a percentage of revenue, operating expenses declined to 29.7% in 2004 from 32.4% in 2003 as the rate of expense growth was below the rate of revenue growth. Operating expenses from new acquisitions were approximately $15.4 million in 2004. Operating expenses from existing firms were approximately $174.8 million in 2004 compared with $150.3 million in 2003.
Management fees. Management fees increased $50.7 million, or 53.7%, to $145.1 million in 2004 compared with $94.4 million in 2003. The increase resulted from higher earnings at our acquired firms generated primarily through new acquisitions and internal growth of existing firms. Management fees represented 50.8% of gross margin before management fees in 2004 compared with 46.6% in 2003. A higher percentage of our firms operated at or above target earnings in 2004 compared with 2003. This resulted in a greater proportion of management fees being accrued than in the prior period. In addition, management fees included an accrual of $9.3 million for ongoing incentive plans in 2004 compared with $2.4 million in 2003, primarily reflecting growth at firms that we have owned for at least three years, and that are ending their incentive cycle. Offsetting the increase were higher earnings at NFPISI and NFPSI, for which no management fee expense is realized. Management fees as a percentage of revenue increased to 22.7% in 2004 from 20.3% in 2003.
General and administrative. General and administrative expenses increased $9.2 million, or 35.1%, to $35.4 million in 2004 compared with $26.2 million in 2003. The increase was primarily due to cost associated with the implementation of Sarbanes-Oxley and other corporate initiatives. In 2004, expenses associated with Sarbanes-Oxley compliance totaled approximately $3.8 million. In addition, we incurred one-time expenses of $1.0 million related to a reserve for notes receivable related primarily to two previously unwound firms and severance. As a percentage of revenue, general and administrative expense declined to 5.5% in 2004 compared with 5.7% in 2003, as we continued to benefit from the absorption of corporate expenses over an expanding revenue base.
Depreciation. Depreciation expense increased $2.0 million, or 42.6%, to $6.7 million in 2004 compared with $4.7 million in 2003. The increase in depreciation resulted from an increase in the number of owned firms and a higher level of capital expenditures as some firms moved into newer or larger facilities, purchased office furniture and made investments in new technology. As a percentage of revenue, depreciation expense was 1.1% in 2004 and 1.0% in 2003.
During 2005, cash provided by operating activities was $87.2 million resulting primarily from net income and an increase in due to principals and/or certain entities they own, accounts payable and accrued liabilities. The increase was partially offset by an increase in commissions, fees and premiums receivable, net, notes receivables, net non-current and other non-current assets. During 2004, cash provided by operating activities was $86.1 million resulting primarily from net income and an increase in premiums payable to insurance carriers, due to principals and/or certain entities they own and accrued liabilities. The increase was partially offset by an increase in cash, cash equivalents and securities purchased under resale agreements in premium trust accounts, commissions, fees and premiums receivable, net, and other current assets. During 2003, cash provided by operating activities was $50.3 million, resulting primarily from net income and an increase in premiums payable to insurance carriers, accrued liabilities and due to principals and/or certain entities they own, and partially offset by an increase in cash, cash equivalents and securities purchased under resale agreements in premium trust accounts, and commissions, fees and premium receivable, net.
During 2005, 2004 and 2003, cash used in investing activities was $113.1 million, $70.9 million and $59.2 million, respectively, in each case for the acquisition of firms and property and equipment. During 2005, 2004 and 2003, we used $113.1 million, $60.2 million, and $52.3 million, respectively, for payments for acquired firms, net of cash acquired, and contingent consideration. In each period, payments for acquired firms represented the largest use of cash in investing activities.
During 2005, 2004 and 2003, cash provided by (used in) financing activities was $48.5 million, $(3.4) million and $48.3 million, respectively. During 2005, cash provided by financing activities was primarily the result of proceeds from our line of credit of $231.2 million and cash proceeds received from the exercise of stock options, including tax benefit, offset by payments on the line of credit of $191.2 and approximately $17.0 million in dividend payments. In 2004, cash used in financing activities was largely the result of $13.3 million of common stock dividends paid offset by $8.0 million of cash proceeds from the exercise of stock options,
On June 15, 2005, we entered into a $175 million credit facility with JPMorgan Chase Bank, N.A., as administrative agent, Bank of America, N.A., successor by merger to Fleet National Bank, as syndication agent, and the several lenders from time to time parties thereto. This credit facility replaced our previous $90 million credit facility and is used to finance acquisitions and fund general corporate purposes.
As of December 31, 2005, the combined year-to-date weighted average interest rate for both credit facilities was 6.0%.
We paid a quarterly cash dividend of $0.12 per share of our common stock on January 7, 2005, April 7, 2005, July 7, 2005 and October 7, 2005 and of $0.10 per share on January 7, 2004, April 7, 2004, July 7, 2004 and October 7, 2004. On November 16, 2005, we declared a quarterly cash dividend of $0.15 per share of our common stock that was paid on January 6, 2006 to stockholders of record on December 16, 2005. On February 15, 2006, our Board of Directors declared a quarterly cash dividend of $0.15 per share of common stock payable on April 7, 2006 to stockholders of record at the close of business on March 17, 2006. The declaration and payment of future dividends to holders of our common stock will be at the discretion of our Board of Directors and will depend upon many factors, including our financial condition, earnings, legal requirements, and other factors as our Board of Directors deems relevant. Based on the most recent quarterly dividend declared of $0.15 per share of common stock and the number of shares held by stockholders of record on December 16, 2005, the total annual cash requirement for dividend payments would be approximately $22.1 million.
We encourage succession planning in the management of our firms. See “Business-Operations-Succession Planning.” We have financed several purchases of interests in entities owned by principals or applicable management agreements to facilitate succession. This financing is secured by management fees and, in many cases, is secured by other assets.
We typically advance management fees monthly to principals and/or certain entities they own for up to nine months while monitoring the performance of the firms to determine if the actual earnings are on track to meet or exceed target earnings. If earnings are not equal to or greater than pro rata target earnings, we cease to pay or reduce the management fee advance. If an overadvance of a management fee exists, the principal and/or such entities are expected to repay the advance within thirty days of the end of the calendar year. If a principal and/or such entities cannot repay the overadvance, we have allowed principals and/or such entities to repay the advance over time. In these cases, we generally required the principals and/or such entities to provide us with an interest-bearing note in an amount equal to the overadvance, secured by the principals’ and/or such entities’ shares of our common stock.
We have from time to time disposed of firms. We have also agreed, in certain cases, to reduce the levels of base earnings and target earnings in exchange for a payment from the principals of a firm. In these situations, we typically take back a note for a portion of the cost of the disposition or the restructuring to the principal.
In the ordinary course of business, we are involved in lawsuits and other claims. Management considers these lawsuits and claims to be without merit and we intend to defend them vigorously. Management believes that the resolution of these lawsuits or claims will not have a material adverse impact on our consolidated financial position. In addition, the sellers of firms that we acquire typically indemnify us for loss or liability resulting from acts or omissions occurring prior to the acquisition, whether or not the sellers were aware of these acts or omissions. Several of the existing lawsuits and claims have triggered these indemnity obligations.
In March 2006, we received a subpoena from the New York Attorney General’s Office seeking information regarding life settlement transactions. One of our subsidiaries received a subpoena seeking the same information. We intend to cooperate fully with the Attorney General’s investigation. The investigation, however, is ongoing and we are unable to predict the investigation’s outcome.
At December 31, 2005, future minimum rentals for operating leases (which are subject to escalation clauses) primarily consisted of real estate and equipment leases that had initial or uncancelable lease terms in excess of one year and were payable as follows:
Our $175 million credit facility provides for the issuance of letters of credit of up to $10 million on our behalf, provided that, after giving effect to the letters of credit, our available borrowing amount is greater than zero. As of December 31, 2005 we were contingently obligated for letters of credit in the amount of $1.3 million.
As of December 31, 2004, we were contingently obligated for letters of credit under our previous $90 million credit facility in the amount of $1.8 million.
Contingent consideration payable for acquisitions consummated in 2002 would generally be payable by the end of 2005. We currently anticipate using contingent consideration arrangements in future acquisitions, which would result in an increase in the maximum contingent consideration amount in 2006 and thereafter.
The maximum contingent consideration is generally payable upon a firm achieving a 35% rate of growth, or higher, in earnings during the first three years following acquisition. The payments of purchase consideration are generally made in cash and our common stock (based on the average closing price of our common stock for the twenty trading days up to and including the end of the period), in proportions that vary among acquisitions. Contingent firm employee payments are payable in cash.
Since our formation we have completed over 192 acquisitions. All of these acquisitions have been accounted for using the purchase method, and their related net assets and results of operations were included in our consolidated financial statements commencing on their respective acquisition dates. Certain of the acquisitions have provisions for contingent additional consideration based upon the financial results achieved over a multi-year period. This additional consideration is reflected as an increase in goodwill when results are achieved and the outcome of the contingency is determinable beyond a reasonable doubt.
In connection with our acquisition of Highland Capital Holding Corporation, we recognized institutional customer relationships as a new intangible asset during 2005. Institutional customer relationships consist of relationships with institutions such as banks, wire houses, regional broker dealers and CPA networks. The value of the asset is derived from recurring income generated from these institutional customers in place at the time of the acquisition, net of an allocation of expenses and is assumed to decrease over the life of the asset due to attrition of the institutional relationships acquired. Institutional customer relationships was valued at $15.7 million at the time of the acquisition at April 1, 2005 and will be amortized using the straight-line method over an 18-year period.
customer relationships. Prior to December 31, 2001, goodwill and tradename in connection with acquisitions before July 1, 2001 was amortized over a 25-year period. In accordance with SFAS 142 all amortization of goodwill ceased on January 1, 2002.
In accordance with SFAS No. 142, we recognized an impairment loss on goodwill and identifiable intangible assets not subject to amortization of $5.7 million, $2.4 million and $3.1 million for the years ended December 31, 2003, 2004 and 2005 respectively.
Future events could cause us to conclude that impairment indicators exist and that our remaining goodwill and other intangibles are impaired. Any resulting impairment loss could have a material adverse effect on our reported financial position and results of operations for any particular quarterly or annual period.
Insurance and annuity commissions paid by insurance companies are based on a percentage of the premium that the insurance company charges to the policyholder. First-year commissions are calculated as a percentage of the first twelve months’ premium on the policy and earned in the year that the policy is originated. In many
Our firms earn additional compensation in the form of incentive and marketing support revenue payments, from manufacturers of financial services products, based on the volume, persistency and profitability of business generated by our firms from these three sources. Incentive and marketing support revenue is recognized at the earlier notification of a payment or when payment is received.
We are authorized under our Amended and Restated 1998, 2000 and 2002 Stock Incentive Plans, and our Amended and Restated 2000 and 2002 Stock Incentive Plans for Principals and Managers, to grant stock options, stock appreciation rights, restricted stock units, and performance units to officers, employees, principals of our acquired firms and/or certain entities principals own, independent contractors, consultants, non-employee directors and certain advisory board members. Awards granted under the 1998, 2000 and 2002 Stock Incentive Plans are generally subject to a vesting period from 0 to 10 years from the date of grant. Awards granted under the 2000 and 2002 Stock Incentive Plans for Principals and Managers generally vest immediately upon grant.
for the options granted through December 31, 2002, and have adopted only the disclosure requirements of SFAS No. 123. Effective January 1, 2003, we have adopted the fair value recognition provisions of SFAS No. 123 in accordance with SFAS No. 148 and have adopted the “prospective” method for transition. (See New Accounting Pronouncements below).
We account for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes,” which requires the recognition of tax benefits or expenses on the temporary differences between the financial reporting and tax bases of our assets and liabilities. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Valuation allowances are established when necessary to reduce the deferred tax assets to the amounts expected to be realized.
In December 2004, the Financial Accounting Standards Board issued SFAS No. 123 (revised), “Share-Based Payment” (“SFAS 123R”). SFAS 123R eliminates the intrinsic value method under APB 25 as an alternative method of accounting for stock-based awards. SFAS 123R also revises the value-based method of accounting for share-based payment liabilities, forfeitures and modifications of stock-based awards and clarifies SFAS 123’s guidance in several areas, including measuring fair value, classifying an award as equity or as a liability and attributing compensation cost to reporting periods. In addition, SFAS 123R amends SFAS No. 95, “Statement of Cash Flows”, to require that excess tax benefits be reported as a financing cash inflow rather than as a reduction of taxes paid, which is included within operating cash flows. In April 2005, the Securities and Exchange Commission amended the required adoption date of SFAS 123R, which is effective for public companies at the beginning of the next fiscal year instead of the first interim or annual period beginning after June 15, 2005. We will adopt SFAS 123R on January 1, 2006 and expect the results of the adoption of this standard will not differ materially from the disclosure of pro forma net income and earnings per share as shown in Note 2 to our Consolidated Financial Statements included elsewhere in this report.