e10vq
Table of Contents

 
 
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
(Mark One)
     
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended July 31, 2006
OR
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                      to                     
Commission file number 1-6089
(H&R BLOCK LOGO)
H&R Block, Inc.
(Exact name of registrant as specified in its charter)
     
MISSOURI   44-0607856
(State or other jurisdiction of   (I.R.S. Employer
incorporation or organization)   Identification No.)
4400 Main Street
Kansas City, Missouri 64111
(Address of principal executive offices, including zip code)
(816) 753-6900
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes þ No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one)
Large accelerated filer þ Accelerated filer o Non-accelerated filer o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o No þ
The number of shares outstanding of the registrant’s Common Stock, without par value, at the close of business on August 31, 2006 was 321,682,760 shares.
 
 

 


 

(H&R BLOCK LOGO)
Form 10-Q for the Period Ended July 31, 2006
Table of Contents
         
    Page  
PART I Financial Information
       
 
       
    1  
 
       
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    20  
 
       
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    35  
 
       
    38  
 
       
    38  
 
       
    39  
 
       
    40  
 Description of Executive Officer Compensation
 Omnibus Amendment #3 to Option One Owner Trust
 302 Certification of Chief Executive Officer
 302 Certification of Chief Financial Officer
 906 Certification of Chief Executive Officer
 906 Certification of Chief Financial Officer

 


Table of Contents

( H&R BLOCK LOGO)
CONDENSED CONSOLIDATED BALANCE SHEETS   (amounts in 000s, except share amounts)
                 
    July 31, 2006     April 30, 2006  
    (Unaudited)          
ASSETS
               
 
               
Cash and cash equivalents
  $ 390,068     $ 694,358  
Cash and cash equivalents – restricted
    345,729       394,069  
Marketable securities – trading
    77,219       16,141  
Receivables from customers, brokers, dealers and clearing organizations, net
    437,697       496,577  
Receivables, less allowance for doubtful accounts of $60,732 and $64,480
    370,307       467,677  
Mortgage loans held for sale
    245,006       236,399  
Prepaid expenses and other current assets
    522,675       483,215  
 
           
Total current assets
    2,388,701       2,788,436  
Residual interests in securitizations – available-for-sale
    145,779       159,058  
Beneficial interest in Trusts – trading
    125,628       188,014  
Mortgage servicing rights
    275,266       272,472  
Mortgage loans held for investment, net
    541,361       407,538  
Property and equipment, at cost less accumulated depreciation and amortization of $735,426 and $704,792
    452,010       443,785  
Intangible assets, net
    205,101       219,494  
Goodwill, net
    1,104,273       1,100,452  
Other assets
    398,149       409,886  
 
           
Total assets
  $ 5,636,268     $ 5,989,135  
 
           
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
 
               
Liabilities:
               
Commercial paper
  $ 189,356     $  
Current portion of long-term debt
    515,305       506,992  
Accounts payable to customers, brokers and dealers
    716,305       781,303  
Customer banking deposits
    404,030        
Accounts payable, accrued expenses and other current liabilities
    703,730       768,505  
Accrued salaries, wages and payroll taxes
    146,346       330,946  
Accrued income taxes
    259,509       505,690  
 
           
Total current liabilities
    2,934,581       2,893,436  
Long-term debt
    411,734       417,539  
Other noncurrent liabilities
    478,384       530,361  
 
           
Total liabilities
    3,824,699       3,841,336  
 
           
Stockholders’ equity:
               
Common stock, no par, stated value $.01 per share, 800,000,000 shares authorized, 435,890,796 shares issued at July 31, 2006 and April 30, 2006
    4,359       4,359  
Additional paid-in capital
    649,451       653,053  
Accumulated other comprehensive income
    20,255       21,948  
Retained earnings
    3,320,197       3,492,059  
Less cost of 114,315,001 and 107,377,858 shares of common stock in treasury
    (2,182,693 )     (2,023,620 )
 
           
Total stockholders’ equity
    1,811,569       2,147,799  
 
           
Total liabilities and stockholders’ equity
  $ 5,636,268     $ 5,989,135  
 
           
See Notes to Condensed Consolidated Financial Statements

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Table of Contents

( H&R BLOCK LOGO)
CONDENSED CONSOLIDATED STATEMENTS OF
INCOME AND COMPREHENSIVE INCOME
  (Unaudited, amounts in 000s,
except per share amounts)
                 
Three months ended July 31,   2006     2005  
 
Revenues:
               
Service revenues
  $ 421,699     $ 315,128  
Other revenues:
               
Gains on sales of mortgage assets, net
    63,913       236,431  
Interest income
    41,010       49,253  
Product and other revenues
    14,157       14,181  
 
           
 
    540,779       614,993  
 
           
 
               
Operating expenses:
               
Cost of services
    446,089       347,688  
Cost of other revenues
    92,014       123,357  
Selling, general and administrative
    215,998       184,782  
 
           
 
    754,101       655,827  
 
           
 
               
Operating loss
    (213,322 )     (40,834 )
Interest expense
    (12,135 )     (12,435 )
Other income, net
    6,798       7,400  
 
           
Loss before income tax benefit
    (218,659 )     (45,869 )
Income tax benefit
    (87,282 )     (17,875 )
 
           
Net loss
  $ (131,377 )   $ (27,994 )
 
           
Basic and diluted loss per share
  $ (0.41 )   $ (0.08 )
 
           
Basic and diluted shares
    323,671       330,714  
 
           
Dividends per share
  $ 0.13     $ 0.11  
 
           
Comprehensive income (loss):
               
Net loss
  $ (131,377 )   $ (27,994 )
Change in unrealized gain on available-for-sale securities, net
    (2,511 )     (5,811 )
Change in foreign currency translation adjustments
    818       824  
 
           
Comprehensive income (loss)
  $ (133,070 )   $ (32,981 )
 
           
See Notes to Condensed Consolidated Financial Statements

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( H&R BLOCK LOGO)
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS   (Unaudited, amounts in 000s)
                 
Three months ended July 31,   2006     2005  
 
Cash flows from operating activities:
               
Net loss
  $ (131,377 )   $ (27,994 )
Adjustments to reconcile net loss to net cash used in operating activities:
               
Depreciation and amortization
    46,394       44,085  
Accretion of residual interests in securitizations
    (13,509 )     (30,777 )
Impairments of available-for-sale residual interests
    17,266       11,875  
Additions to trading residual interests in securitizations, net
    (58,417 )     (100,462 )
Proceeds from net interest margin transactions, net
          40,371  
Additions to mortgage servicing rights
    (50,122 )     (49,306 )
Amortization and impairment of mortgage servicing rights
    47,328       27,212  
Tax benefits from stock-based compensation
    8,075       12,699  
Excess tax benefits from stock-based compensation
    (1,114 )      
Other, net of acquisitions
    (322,939 )     (238,218 )
 
           
Net cash used in operating activities
    (458,415 )     (310,515 )
 
           
 
               
Cash flows from investing activities:
               
Cash received from residual interests in securitizations
    4,567       24,031  
Mortgage loans originated for investment, net
    (135,161 )      
Purchases of property and equipment, net
    (42,868 )     (30,330 )
Payments made for business acquisitions, net of cash acquired
    (4,627 )     (3,452 )
Other, net
    7,068       7,935  
 
           
Net cash used in investing activities
    (171,021 )     (1,816 )
 
           
 
               
Cash flows from financing activities:
               
Repayments of commercial paper
    (1,034,210 )      
Proceeds from issuance of commercial paper
    1,223,566        
Customer deposits
    404,030        
Dividends paid
    (40,485 )     (36,537 )
Acquisition of treasury shares
    (186,339 )     (131,642 )
Excess tax benefits from stock-based compensation
    1,114        
Proceeds from exercise of stock options
    6,791       27,180  
Other, net
    (49,321 )     (14,082 )
 
           
Net cash provided by (used in) financing activities
    325,146       (155,081 )
 
           
 
               
Net decrease in cash and cash equivalents
    (304,290 )     (467,412 )
Cash and cash equivalents at beginning of the period
    694,358       1,100,213  
 
           
Cash and cash equivalents at end of the period
  $ 390,068     $ 632,801  
 
           
 
               
Supplementary cash flow data:
               
Income taxes paid
  $ 190,378     $ 35,278  
Interest paid
    18,702       13,830  
See Notes to Condensed Consolidated Financial Statements

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS   (Unaudited)
1.   Basis of Presentation
 
    The condensed consolidated balance sheet as of July 31, 2006, the condensed consolidated statements of income and comprehensive income for the three months ended July 31, 2006 and 2005, and the condensed consolidated statements of cash flows for the three months ended July 31, 2006 and 2005 have been prepared by the Company, without audit. In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position, results of operations and cash flows at July 31, 2006 and for all periods presented have been made.
 
         “H&R Block,” “the Company,” “we,” “our” and “us” are used interchangeably to refer to H&R Block, Inc. or to H&R Block, Inc. and its subsidiaries, as appropriate to the context.
 
         Certain reclassifications have been made to prior year amounts to conform to the current year presentation. These reclassifications had no effect on our results of operations or stockholders’ equity as previously reported. In March 2006, the Office of Thrift Supervision (OTS) approved the charter of H&R Block Bank (HRB Bank). The bank commenced operations on May 1, 2006, at which time we realigned certain segments of our business to reflect a new management reporting structure. The previously reported Investment Services segment, H&R Block Mortgage Corporation (HRBMC), which was previously included in the Mortgage Services segment, and H&R Block Bank have been combined in the Consumer Financial Services segment. Presentation of prior-year results reflects the new segment alignment. See note 11 for additional information on this new segment.
 
         Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted. These condensed consolidated financial statements should be read in conjunction with the financial statements and notes thereto included in our April 30, 2006 Annual Report to Shareholders on Form 10-K.
 
         Operating revenues of the Tax Services and Business Services segments are seasonal in nature with peak revenues occurring in the months of January through April. Therefore, results for interim periods are not indicative of results to be expected for the full year.
 
2.   Earnings (Loss) Per Share
 
    Basic and diluted loss per share is computed using the weighted average shares outstanding during each period. The dilutive effect of potential common shares is included in diluted earnings per share except in those periods with a loss. Diluted earnings per share excludes the impact of shares of common stock issuable upon the lapse of certain restrictions or the exercise of options to purchase 32.9 million shares and 33.7 million shares of stock for the three months ended July 31, 2006 and 2005, respectively, as the effect would be antidilutive due to the net loss recorded during the period.
 
         The weighted average shares outstanding for the three months ended July 31, 2006 decreased to 323.7 million from 330.7 million last year, primarily due to purchases of treasury shares. The effect of these purchases was partially offset by the issuance of treasury shares related to our stock-based compensation plans.
 
         During the three months ended July 31, 2006 and 2005, we issued 1.4 million and 2.5 million shares of common stock, respectively, pursuant to the exercise of stock options, employee stock purchases and awards of nonvested shares, in accordance with our stock-based compensation plans.
 
         During the three months ended July 31, 2006, we acquired 8.4 million shares of our common stock, of which 8.1 million shares were purchased from third parties with the remaining shares swapped or surrendered to us, at an aggregate cost of $186.3 million. During the three months ended July 31, 2005, we acquired 4.6 million shares of our common stock, of which 4.4 million shares were purchased from third parties with the remaining shares swapped or surrendered to us, at an aggregate cost of $131.6 million.

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3.   Mortgage Banking Activities
 
    Activity related to trading residual interests in securitizations consists of the following:
                 
(in 000s)
Three months ended July 31,   2006     2005  
 
Balance, beginning of period
  $     $  
Additions resulting from securitization of mortgage loans
    63,424       96,967  
Cash received
    (4,546 )      
Accretion
    909        
Change of fair value
    (461 )     3,495  
Residuals securitized in NIM transactions
          (42,480 )
 
           
Balance, end of period
  $ 59,326     $ 57,982  
 
           
         At July 31, 2006 and 2005, we had $59.3 million and $58.0 million, respectively, in residual interests classified as trading securities, which are included in marketable securities – trading on the condensed consolidated balance sheet. These residual interests are the result of the initial securitization of mortgage loans and those held at July 31, 2006 are expected to be securitized in a NIM transaction during our second quarter. There were no such trading securities recorded as of April 30, 2006. Cash received on trading residual interests is included in operating activities in the condensed consolidated statements of cash flows.
 
         Activity related to available-for-sale residual interests in securitizations consists of the following:
                 
(in 000s)
Three months ended July 31,   2006     2005  
 
Balance, beginning of period
  $ 159,058     $ 205,936  
Additions from net interest margin (NIM) transactions
          2,109  
Cash received
    (4,567 )     (24,031 )
Accretion
    12,600       30,777  
Impairment of fair value
    (17,266 )     (11,875 )
Other
          (330 )
Changes in unrealized holding gains, net
    (4,046 )     (9,379 )
 
           
Balance, end of period
  $ 145,779     $ 193,207  
 
           
         Cash flows from available-for-sale residual interests of $4.6 million and $24.0 million were received from the securitization trusts for the three months ended July 31, 2006 and 2005, respectively. Cash received on available-for-sale residual interests is included in investing activities in the condensed consolidated statements of cash flows.
 
         Aggregate net unrealized gains on available-for-sale residual interests not yet accreted into income totaled $40.1 million at July 31, 2006 and $44.1 million at April 30, 2006. These unrealized gains are recorded net of deferred taxes in other comprehensive income, and may be recognized in income in future periods either through accretion or upon further securitization or sale of the related residual interest.
 
         Activity related to mortgage servicing rights (MSRs) consists of the following:
                 
(in 000s)
Three months ended July 31,   2006     2005  
 
Balance, beginning of period
  $ 272,472     $ 166,614  
Additions
    50,122       49,306  
Amortization and impairment of fair value
    (47,328 )     (27,212 )
 
           
Balance, end of period
  $ 275,266     $ 188,708  
 
           
         Estimated amortization of MSRs for fiscal years 2007 through 2011 is $120.9 million, $92.1 million, $40.4 million, $15.9 million and $6.0 million, respectively.

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         The key weighted average assumptions we used to estimate the cash flows and values of the residual interests initially recorded during the three months ended July 31, 2006 and 2005 are as follows:
                 
Three months ended July 31,   2006     2005  
 
Estimated credit losses
    3.51 %     2.70 %
Discount rate
    18.00 %     21.57 %
Variable returns to third-party beneficial interest holders   LIBOR forward curve at closing date
         The key weighted average assumptions we used to estimate the cash flows and values of the residual interests and MSRs at July 31, 2006 and April 30, 2006 are as follows:
                 
    July 31, 2006     April 30, 2006  
 
Estimated credit losses
    3.10 %     3.07 %
Discount rate – residual interests
    20.24 %     21.98 %
Discount rate – MSRs
    18.00 %     18.00 %
Variable returns to third-party beneficial interest holders   LIBOR forward curve at valuation date
         We originate both adjustable and fixed rate mortgage loans. A key assumption used to estimate the cash flows and values of the residual interests and MSRs is average annualized prepayment speeds. Prepayment speeds include voluntary prepayments, involuntary prepayments and scheduled principal payments. Prepayment rate assumptions are as follows:
                         
            Months Outstanding After  
    Prior to Initial     Initial Rate Reset Date  
    Rate Reset Date     Zero - 3     Remaining Life  
 
Adjustable rate mortgage loans:
                       
With prepayment penalties
    31 %     72 %     39 %
Without prepayment penalties
    35 %     52 %     34 %
Fixed rate mortgage loans:
                       
With prepayment penalties
    30 %     48 %     38 %
         For fixed rate mortgages without prepayment penalties, we use an average prepayment rate of 32% over the life of the loans. Prepayment rate is projected based on actual paydown including voluntary, involuntary and scheduled principal payments.
 
         Expected static pool credit losses are as follows:
                                                         
    Mortgage Loans Securitized in Fiscal Year  
    Prior to 2002     2002     2003     2004     2005     2006     2007  
 
As of:
                                                       
July 31, 2006
    4.75 %     2.69 %     2.12 %     2.20 %     2.29 %     3.19 %     3.51 %
April 30, 2006
    4.75 %     2.69 %     2.13 %     2.18 %     2.48 %     3.05 %      
April 30, 2005
    4.52 %     2.53 %     2.08 %     2.30 %     2.83 %            
April 30, 2004
    4.46 %     3.58 %     4.35 %     3.92 %                  
         Static pool credit losses are calculated by summing the actual and projected future credit losses and dividing them by the original balance of each pool of assets.
 
         At July 31, 2006, the sensitivities of the current fair value of the residual interests and MSRs to 10% and 20% adverse changes in the above key assumptions are as presented in the following table. These sensitivities are hypothetical and should be used with caution. As the figures indicate, changes in fair value based on a 10% variation in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. Also in this table, the effect of a variation of a particular assumption on the fair value of the retained interest is calculated without changing any other assumptions; in reality, changes in one factor may result in changes in another, which might magnify or counteract the sensitivities.

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(dollars in 000s)
    Residential Mortgage Loans        
    NIM     Beneficial Interest     Trading        
    Residuals     in Trusts     Residuals     MSRs  
 
Carrying amount/fair value
  $ 145,779     $ 125,628     $ 59,326     $ 275,266  
Weighted average remaining life (in years)
    2.1       1.9       1.2       1.3  
 
Prepayments (including defaults):
                               
Adverse 10% – $ impact on fair value
  $ 5,159     $ (2,019 )   $ (1,720 )   $ (41,994 )
Adverse 20% – $ impact on fair value
    13,390       (1,692 )     (897 )     (70,642 )
 
Credit losses:
                               
Adverse 10% – $ impact on fair value
  $ (43,684 )   $ (4,216 )   $ (2,601 )   Not applicable
Adverse 20% – $ impact on fair value
    (73,023 )     (8,095 )     (5,197 )   Not applicable
 
Discount rate:
                               
Adverse 10% – $ impact on fair value
  $ (5,305 )   $ (2,021 )   $ (1,090 )   $ (4,473 )
Adverse 20% – $ impact on fair value
    (10,255 )     (3,987 )     (2,139 )     (8,813 )
 
Variable interest rates (LIBOR forward curve):
                               
Adverse 10% – $ impact on fair value
  $ (3,988 )   $ (29,141 )   $ 756     Not applicable
Adverse 20% – $ impact on fair value
    (10,171 )     (55,963 )     1,357     Not applicable
         Increases in prepayment rates related to available-for-sale NIM residuals can generate a positive impact to fair value when reductions in estimated credit losses and increases in prepayment penalties exceed the adverse impact to accretion from accelerating the life of the available-for-sale residual interest.
         Mortgage loans that have been securitized at July 31, 2006 and April 30, 2006, past due sixty days or more and the related credit losses incurred are presented below:
                                                 
(in 000s)
    Total Principal     Principal Amount of        
    Amount of Loans     Loans 60 Days or     Credit Losses  
    Outstanding     More Past Due     (net of recoveries)  
    July 31,     April 30,     July 31,     April 30,     Three months ended  
    2006     2006     2006     2006     July 31, 2006     April 30, 2006  
 
Securitized mortgage loans
  $ 10,486,419     $ 10,046,032     $ 1,067,076     $ 1,012,414     $ 29,636     $ 35,307  
Mortgage loans in warehouse Trusts
    4,268,181       7,845,834                          
Mortgage loans held for sale
    265,133       255,224       124,635       98,906       22,208       33,504  
 
                                   
Total loans
  $ 15,019,733     $ 18,147,090     $ 1,191,711     $ 1,111,320     $ 51,844     $ 68,811  
 
                                   
4.   Goodwill and Intangible Assets
 
    Changes in the carrying amount of goodwill for the three months ended July 31, 2006 consist of the following:
                                 
(in 000s)
    April 30, 2006     Additions     Other     July 31, 2006  
 
Tax Services
  $ 376,515     $ 1,683     $ (9 )   $ 378,189  
Mortgage Services
    136,586                   136,586  
Business Services
    397,516       2,147             399,663  
Consumer Financial Services
    189,835                   189,835  
 
                       
Total goodwill
  $ 1,100,452     $ 3,830     $ (9 )   $ 1,104,273  
 
                       
         We test goodwill for impairment annually at the beginning of our fourth quarter, or more frequently if events occur indicating it is more likely than not the fair value of a reporting unit’s net assets has been reduced below its carrying value. No such events were identified within any of our segments during the three months ended July 31, 2006.

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Intangible assets consist of the following:
                                                 
(in 000s)
    July 31, 2006     April 30, 2006  
    Gross                     Gross              
    Carrying     Accumulated             Carrying     Accumulated        
    Amount     Amortization     Net     Amount     Amortization     Net  
 
Tax Services:
                                               
Customer relationships
  $ 27,750     $ (11,726 )   $ 16,024     $ 27,257     $ (10,842 )   $ 16,415  
Noncompete agreements
    18,904       (17,778 )     1,126       18,879       (17,686 )     1,193  
Business Services:
                                               
Customer relationships
    153,767       (84,657 )     69,110       153,844       (81,178 )     72,666  
Noncompete agreements
    32,521       (15,169 )     17,352       32,534       (14,300 )     18,234  
Trade name – amortizing
    4,050       (2,163 )     1,887       4,050       (1,823 )     2,227  
Trade name – non-amortizing
    55,637       (4,868 )     50,769       55,637       (4,868 )     50,769  
Consumer Financial Services:
                                               
Customer relationships
    293,000       (244,167 )     48,833       293,000       (235,010 )     57,990  
 
                                   
Total intangible assets
  $ 585,629     $ (380,528 )   $ 205,101     $ 585,201     $ (365,707 )   $ 219,494  
 
                                   
         Amortization of intangible assets for the three months ended July 31, 2006 and 2005 was $15.0 million and $15.2 million, respectively. Estimated amortization of intangible assets for fiscal years 2007 through 2011 is $56.7 million, $38.9 million, $15.7 million, $13.3 million and $11.8 million, respectively.
 
         In October 2005, we acquired all outstanding common stock of American Express Tax and Business Services, Inc. for an aggregate purchase price of $190.7 million. The preliminary purchase price allocations are subject to change and will be adjusted based upon resolution of several matters including, but not limited to, determination of the post-closing adjustment and final purchase price, determination of final liabilities relating to planned exit activities and determination of the tax basis of acquired assets and liabilities, and deferred tax balances of the acquired business.
 
5.   Derivative Instruments
 
    A summary of our derivative instruments as of July 31, 2006 and April 30, 2006, and gains or losses incurred during the three months ended July 31, 2006 and 2005 is as follows:
                                 
(in 000s)
                    Gain (Loss) for the Three  
    Asset (Liability) Balance at     Months Ended July 31,  
    July 31, 2006     April 30, 2006     2006     2005  
 
Rate-lock equivalents
  $ 7,428     $ (317 )   $ 7,745     $ (1,093 )
Interest rate swaps
    6,240       8,831       13,179       25,543  
Put options on Eurodollar futures
    2,108       3,282       (38 )      
Prime short sales
    (1,176 )     777       (561 )     996  
Forward loan sale commitments
    (5,121 )     1,961       (7,082 )      
Interest rate caps
                      640  
 
                       
 
  $ 9,479     $ 14,534     $ 13,243     $ 26,086  
 
                       
         The notional amount of interest rate swaps to which we were a party at July 31, 2006 was $3.9 billion, with a weighted average duration of 1.9 years. The notional value and the contract value of our forward loan sale commitments at July 31, 2006 was $3.2 billion and $3.3 billion, respectively.
 
         None of our derivative instruments qualify for hedge accounting treatment as of July 31, 2006 or April 30, 2006.
6.   Stock-Based Compensation
 
    Beginning May 1, 2006, we adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” (SFAS 123R) under the modified prospective approach. Under SFAS 123R, we continue to measure and recognize the fair value of stock-based compensation consistent with our past practice under Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” which we adopted on May 1, 2003 under the prospective transition method. The adoption of SFAS 123R did not have a material impact on our consolidated financial statements.

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     The following is a comparison of reported and pro forma results had compensation cost for all stock-based compensation grants been determined in accordance with SFAS 123 for the three months ended July 31, 2005.
         
(in 000s, except per share amounts)  
 
Net loss as reported
  $ (27,994 )
Add: Stock-based compensation expense included in reported net loss, net of related tax effects
    5,765  
Deduct: Total stock-based compensation expense determined under fair value method for all awards, net of related tax effects
    (8,309 )
 
     
Pro forma net loss
  $ (30,538 )
 
     
Basic and diluted loss per share:
       
As reported
  $ (0.08 )
Pro forma
    (0.09 )
     Stock-based compensation expense of $10.5 million and the related tax benefits of $3.7 million are included in our results for the three months ended July 31, 2006.
     SFAS 123R requires the reclassification, in the statement of cash flows, of the excess tax benefits from stock-based compensation from operating cash flows to financing. As a result, we classified $1.1 million as a cash inflow from financing activities rather than as an operating activity for the three months ended July 31, 2006.
     We have four stock-based compensation plans which have been approved by our shareholders. As of July 31, 2006, we had approximately 21.7 million shares reserved for future awards under these plans. We issue shares from our treasury stock to satisfy the exercise or release of stock-based awards.
     Our 2003 Long-Term Executive Compensation Plan provides for awards of options (both incentive and nonqualified), nonvested shares, performance nonvested share units and other stock-based awards to employees. These awards are granted to employees and entitle the holder to shares or the right to purchase shares of common stock as the award vests, typically over a three-year period with one-third vesting each year. Nonvested shares receive dividends during the vesting period and performance nonvested share units receive cumulative dividends at the end of the vesting period. We measure the fair value of options on the grant date or modification date using the Black-Scholes option valuation model. We measure the fair value of nonvested shares and performance nonvested share units based the average of the high and low quoted price of our common stock on the grant date. Generally, we expense the grant-date fair value, net of estimated forfeitures, over the vesting period on a straight-line basis. Upon adoption of SFAS 123R, awards granted to employees who are of retirement age, or reach retirement age at least one year after the grant date but prior to the end of the service period of the award, are expensed over the shorter of the two periods. Options are granted at a price equal to the fair market value of our common stock on the grant date and have a contractual term of ten years.
     Our 1999 Stock Option Plan for Seasonal Employees provides for awards of nonqualified options to employees. These awards are granted to seasonal employees in our Tax Services segment and entitle the holder to the right to purchase shares of common stock as the award vests, typically over a two-year period. We measure the fair value of options on the grant date using the Black-Scholes option valuation model. We expense the grant-date fair value, net of estimated forfeitures, over the service period. Options are granted at a price equal to the fair market value of our common stock on the grant date, are exercisable during September through November in each of the two years following the calendar year of the grant and have a contractual term of 29 months.
     Our 1989 Stock Option Plan for Outside Directors provides for awards of nonqualified options to outside directors. These awards are granted to outside directors and entitle the holder to the right to purchase shares of common stock. We measure the fair value of options on the grant date using the Black-Scholes option valuation model. These awards vest immediately upon issuance and are therefore fully expensed on the grant date. Options are granted at a price equal to the fair market value of our common stock on the grant date and have a contractual term of ten years.

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     Our 2000 Employee Stock Purchase Plan (ESPP) provides employees the option to purchase shares of our Common Stock through payroll deductions. The purchase price of the stock is 90% of the lower of either the fair market value of our Common Stock on the first trading day within the Option Period or on the last trading day of the Option Period. The Option Periods are six-month periods beginning on January 1 and July 1 each year. We measure the fair value of options on the grant date utilizing the Black-Scholes option valuation model in accordance with FASB Technical Bulletin 97-1, “Accounting under Statement 123 for Certain Employee Stock Purchase Plans with a Look-Back Option.” We expense the grant-date fair value over the six-month vesting period.
     A summary of options for the three months ended July 31, 2006 is as follows:
                                 
(in 000s, except per share amounts)  
                    Weighted Average        
            Weighted Average     Remaining     Aggregate  
    Shares     Exercise Price     Contractual Term     Intrinsic Value  
 
Outstanding, beginning of period
    26,048     $ 21.40                  
Granted
    4,943       23.86                  
Exercised
    (460 )     14.84                  
Forfeited or expired
    (191 )     22.98                  
 
                             
Outstanding, end of period
    30,340       21.89     5 years   $ 80,521  
 
                             
                                 
Exercisable, end of period
    18,301     $ 19.35     4 years   $ 75,626  
Exercisable and expected to vest
    28,547       21.70     5 years   $ 80,265  
     The total intrinsic value of options exercised during the three months ended July 31, 2006 and 2005 were $0.5 million and $7.8 million, respectively. We utilize the Black-Scholes option pricing model to value our options on the grant date. We estimated the expected volatility using our historical stock price data. We also used historical exercise and forfeiture behaviors to estimate the options expected term and our forfeiture rate. The following assumptions were used to value options during the periods:
                 
Three months ended July 31,   2006     2005  
 
Options – management and director:
               
Expected volatility
    23.67% - 29.06 %     27.05% - 27.30 %
Expected term
  4 - 7 years   5 years
Dividend yield
    2.15% - 2.35 %     1.71 %
Risk-free interest rate
    4.77% - 5.10 %     3.65% - 3.75 %
Weighted-average fair value
  $ 5.17     $ 7.42  
 
               
Options – seasonal:
               
Expected volatility
    20.05 %     23.28 %
Expected term
  2 years   2 years
Dividend yield
    2.26 %     1.71 %
Risk-free interest rate
    5.11 %     3.61 %
Weighted-average fair value
  $ 3.17     $ 4.16  
 
               
ESPP options:
               
Expected volatility
    26.30 %     24.52 %
Expected term
  0.5 years   0.5 years
Dividend yield
    2.26 %     1.71 %
Risk-free interest rate
    5.24 %     3.37 %
Weighted-average fair value
  $ 1.91     $ 2.12  
     A summary of nonvested shares and performance nonvested share units for the three months ended July 31, 2006 is as follows:
                 
(shares in 000s)  
            Weighted Average  
    Shares     Grant Date Fair Value  
 
Outstanding, beginning of period
    2,455     $ 25.27  
Granted
    944       23.93  
Released
    (738 )     25.01  
Forfeited
    (77 )     24.63  
 
             
Outstanding, end of period
    2,584       24.95  
 
             

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     The total fair value of shares vesting during the three months ended July 31, 2006 and 2005 was $17.6 million and $16.3 million, respectively. Upon the grant of nonvested shares and performance nonvested share units, unearned compensation cost is recorded as an offset to additional paid in capital and is amortized as compensation expense over the vesting period. As of July 31, 2006, we had $57.1 million of total unrecognized compensation cost related to these shares. This cost is expected to be recognized over a weighted-average period of two years.
7.   Supplemental Cash Flow Information
 
    The following transactions were treated as non-cash investing activities in the condensed consolidated statement of cash flows:
                 
(in 000s)
Three months ended July 31,   2006     2005  
 
Residual interest mark-to-market
  $ 531     $ 12,942  
Additions to residual interests
          2,109  
8.   Regulatory Requirements
 
    Registered Broker-Dealer
 
    HRBFA is subject to regulatory requirements intended to ensure the general financial soundness and liquidity of broker-dealers. At July 31, 2006, HRBFA’s net capital of $124.2 million, which was 26.4% of aggregate debit items, exceeded its minimum required net capital of $9.4 million by $114.8 million.
     Pledged securities at July 31, 2006 totaled $42.5 million, an excess of $5.9 million over the margin requirement. Pledged securities at April 30, 2006 totaled $53.0 million, an excess of $9.9 million over the margin requirement.
Banking
HRB Bank is subject to various regulatory capital guidelines and requirements administered by Federal banking agencies. Failure to meet minimum capital requirements can trigger certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on HRB Bank’s operations. Under these capital adequacy guidelines and the regulatory framework for prompt corrective action, HRB Bank must meet specific capital guidelines that involve quantitative measures of HRB Bank’s assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. HRB Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
     Quantitative measures established by regulation to ensure capital adequacy require HRB Bank to maintain minimum amounts and ratios of capital to assets. As shown in the table below, at June 30, 2006, the most recent date of reporting to Federal banking agencies, HRB Bank is categorized as “well capitalized” for regulatory purposes, which is the highest classification. There are no conditions or events since June 30, 2006 that management believes have changed the Bank’s category. At July 31, 2006, management believes that HRB Bank meets all capital adequacy requirements to which it is subject. However, events beyond management’s control, such as fluctuations in interest rates or a downturn in the economy in areas in which HRB Bank’s loans or securities are concentrated, could adversely affect future earnings and consequently, HRB Bank’s ability to meet its future capital requirements.

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     HRB Bank’s capital amounts and ratios as of June 30, 2006 are presented in the table below:
                                 
(dollars in 000s)
                    Minimum Required to  
                    Qualify as Well  
    Actual     Capitalized  
    Amount     Ratio     Amount     Ratio  
 
Tier 1 capital to adjusted total assets (leverage)
  $ 160,270       33.70 %   $ 23,776       5.0 %
Total risk-based capital to total risk-weighted assets
  $ 161,393       67.20 %   $ 24,017       10.0 %
     Additionally, H&R Block, Inc. is now subject to a three percent minimum ratio of adjusted tangible capital to adjusted total assets, as defined by the OTS.

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9.   Commitments and Contingencies
 
    Changes in the deferred revenue liability related to our Peace of Mind (POM) program are as follows:
                 
(in 000s)
Three months ended July 31,   2006     2005  
 
Balance, beginning of period
  $ 141,684     $ 130,762  
Amounts deferred for new guarantees issued
    511       408  
Revenue recognized on previous deferrals
    (28,738 )     (23,900 )
 
           
Balance, end of period
  $ 113,457     $ 107,270  
 
           
     The following table summarizes certain of our other contractual obligations and commitments:
                 
(in 000s)
As of   July 31, 2006     April 30, 2006  
 
Commitment to fund mortgage loans
  $ 3,664,877     $ 4,032,045  
Commitment to sell mortgage loans
    3,185,000       3,052,688  
Commitment to fund Franchise Equity Lines of Credit
    75,965       75,909  
Contingent business acquisition obligations
    22,845       24,482  
     In the normal course of business, we maintain recourse with standard representations and warranties customary to the mortgage banking industry. Violations of these representations and warranties, such as early payment defaults by borrowers, may require us to repurchase loans previously sold. In accordance with these loan sale agreements, we repurchased loans previously sold into the secondary market with an outstanding principal balance of $92.3 million and $60.0 million during the three months ended July 31, 2006 and 2005, respectively. Repurchased loans are normally sold in subsequent sale transactions. We established a liability related to the potential loss we expect to incur on repurchase of loans previously sold and premium recapture, totaling $104.0 million and $33.4 million at July 31, 2006 and April 30, 2006, respectively. This liability relates to loans not yet repurchased. On an ongoing basis, we monitor the adequacy of this liability, which is established upon the initial sale of the loans, and is included in accounts payable, accrued expenses and other current liabilities in the condensed consolidated balance sheets. During the three months ended July 31, 2006 we experienced higher early payment defaults, resulting in an increase in actual and expected loan repurchase activity. As a result, we increased our reserves accordingly. In establishing our reserves, we’ve assumed all loans that are currently delinquent and subject to contractual repurchase terms will be repurchased, and that 5% of loans previously sold but not yet subject to contractual repurchase terms will be repurchased. Based on historical experience, we assumed 30% of all loans we repurchase will cure with no loss incurred, and of those that do not cure, we assumed an average 15% loss severity.
     HRB Bank is a member of the Federal Home Loan Bank (FHLB) of Des Moines, which extends credit availability to member banks based on eligible collateral and asset size. At July 31, 2006, HRB Bank had FHLB advance capacity of $198.0 million, but no amounts had been drawn on this facility.
     We routinely enter into contracts that include embedded indemnifications that have characteristics similar to guarantees, including obligations to protect counterparties from losses arising from the following: (a) tax, legal and other risks related to the purchase or disposition of businesses; (b) penalties and interest assessed by Federal and state taxing authorities in connection with tax returns prepared for clients; (c) indemnification of our directors and officers; and (d) third-party claims relating to various arrangements in the normal course of business. Typically, there is no stated maximum payment related to these indemnifications, and the term of indemnities may vary and in many cases is limited only by the applicable statute of limitations. The likelihood of any claims being asserted against us and the ultimate liability related to any such claims, if any, is difficult to predict. While we cannot provide assurance that such claims will not be successfully asserted, we believe the fair value of these guarantees and indemnifications is not material as of July 31, 2006.

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    Restructuring Charge
 
    During fiscal year 2006, we initiated a restructuring plan to reduce costs within our mortgage operations. Changes in the restructuring charge liability during the three months ended July 31, 2006 are as follows:
                         
(in 000s)
    Accrual Balance     Cash     Accrual Balance  
    as of April 30, 2006     Payments     as of July 31, 2006  
 
Employee severance costs
  $ 1,737     $ (1,737 )   $  
Contract termination costs
    5,821       (2,889 )     2,932  
 
                 
 
  $ 7,558     $ (4,626 )   $ 2,932  
 
                 
     The remaining liability related to this restructuring charge is included in accounts payable, accrued expenses and other current liabilities on our condensed consolidated balance sheet and relates to lease obligations for vacant space resulting from branch office closings.
10. Litigation and Related Contingencies
 
    We have been named as a defendant in numerous lawsuits throughout the country regarding our RAL programs (the “RAL Cases”). The RAL Cases have involved a variety of legal theories asserted by plaintiffs. These theories include allegations that, among others, (i) disclosures in the RAL applications were inadequate, misleading and untimely; (ii) the RAL interest rates were usurious and unconscionable; (iii) we did not disclose that we would receive part of the finance charges paid by the customer for such loans; (iv) untrue, misleading or deceptive statements in marketing RALs; (v) breach of state laws on credit service organizations; (vi) breach of contract, unjust enrichment, unfair and deceptive acts or practices; (vii) violations of the federal Racketeer Influenced and Corrupt Organizations Act; (viii) violations of the federal Fair Debt Collection Practices Act and unfair competition with respect to debt collection activities; and (ix) we owe, and breached, a fiduciary duty to our customers in connection with the RAL program.
     The amounts claimed in the RAL Cases have been very substantial in some instances. We have successfully defended against numerous RAL cases, some of which were dismissed on our motions for dismissal or summary judgment, and others were dismissed voluntarily by the plaintiffs after denial of class certification. Other cases have been settled, with the combined pretax expense for such settlements in fiscal year 2006 totaling $70.2 million. During the three months ended July 31, 2006, the 2006 settlements were paid in full.
     One RAL class action case and a state attorney general lawsuit are still pending, with the amounts claimed on a collective basis being very substantial. The ultimate cost of this litigation could be substantial. We believe we have meritorious defenses to the remaining RAL Cases and we intend to defend them vigorously. There can be no assurances, however, as to the outcome of the pending RAL Cases individually or in the aggregate or the associated impact on our financial statements.
     We are also a party to claims and lawsuits pertaining to our electronic tax return filing services, our POM guarantee program, our Express IRA product, business valuation services and tax planning services. These claims and lawsuits include actions by individual plaintiffs, as well as cases in which plaintiffs seek to represent a class of similarly situated customers. The amounts claimed in these claims and lawsuits are substantial in some instances, and the ultimate liability with respect to such litigation and claims is difficult to predict. We intend to continue defending these cases vigorously, although there are no assurances as to their outcome.
     In addition we and certain of our current and former directors and officers are party to several putative class actions alleging violations of certain securities laws, and certain of our current and former officers and directors are defendants in several putative shareholder derivative actions, which have purportedly been brought on behalf of the Company and in which the Company is named as a nominal defendant. The putative securities class actions allege, among other things, deceptive, material and misleading financial statements, failure to prepare financial statements in accordance with generally accepted accounting principles and concealment of the potential for lawsuits stemming from the allegedly fraudulent nature of our operations. The shareholder derivative cases

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pertain primarily to our recent financial restatement and certain of our products and business activities and generally allege breach of fiduciary duty, abuse of control, gross mismanagement, waste and unjust enrichment. The amounts claimed in these claims and lawsuits are substantial in some instances, and the ultimate liability with respect to such litigation and claims is difficult to predict. We intend to continue defending these cases vigorously, although there are no assurances as to their outcome.
     In addition to the aforementioned types of cases, we are parties to claims and lawsuits that we consider to be ordinary, routine disputes incidental to our business (Other Claims and Lawsuits), including claims and lawsuits concerning the preparation of customers’ income tax returns, tax planning services, the fees charged customers for various services, investment products, relationships with franchisees, contract disputes, employment matters and civil actions, arbitrations, regulatory inquiries and class actions arising out of our business as a broker-dealer and provider of investment products and as a servicer of mortgage loans. We believe we have meritorious defenses to each of the Other Claims and Lawsuits and are defending them vigorously. Although we cannot provide assurance we will ultimately prevail in each instance, we believe that amounts, if any, required to be paid in the discharge of liabilities or settlements pertaining to Other Claims and Lawsuits will not have a material adverse effect on our consolidated financial statements. Regardless of outcome, claims and litigation can adversely affect us due to defense costs, diversion of management attention and time, and publicity related to such matters.
11.   Segment Information
 
    Information concerning our operations by reportable operating segment is as follows:
                                                         
(in 000s)
                            Consumer                    
    Tax     Mortgage     Business     Financial                    
    Services     Services     Services     Services     Corporate     Eliminations     Consolidated  
 
Three months ended July 31, 2006:
                                                       
Revenues:
                                                       
External
  $ 66,018     $ 166,961     $ 205,017     $ 100,288     $ 2,495     $     $ 540,779  
Loan sales to HRB Bank
          10,378                         (10,378 )      
HRBMC loan sales to Option One
          (8,472 )           8,472                    
Other intersegment
    17       809       114       (462 )     3,063       (3,541 )      
 
                                         
 
  $ 66,035     $ 169,676     $ 205,131     $ 108,298     $ 5,558     $ (13,919 )   $ 540,779  
 
                                         
 
                                                       
Pretax loss
  $ (153,148 )   $ (4,924 )   $ (14,565 )   $ (7,780 )   $ (28,512 )   $ (9,730 )   $ (218,659 )
 
                                         
 
                                                       
Three months ended July 31, 2005:
                                                       
Revenues:
                                                       
External
  $ 57,165     $ 308,276     $ 126,739     $ 120,145     $ 2,668     $     $ 614,993  
HRBMC loan sales to Option One
          (4,235 )           4,235                    
Other intersegment
    26       1,006       107             2,336       (3,475 )      
 
                                         
 
  $ 57,191     $ 305,047     $ 126,846     $ 124,380     $ 5,004     $ (3,475 )   $ 614,993  
 
                                         
 
                                                       
Pretax income (loss)
  $ (144,506 )   $ 130,664     $ (6,765 )   $ (3,748 )   $ (21,762 )   $ 248     $ (45,869 )
 
                                         
     HRB Bank commenced operations on May 1, 2006, at which time we realigned certain segments of our business to reflect a new management reporting structure. The previously reported Investment Services segment, HRBMC (which was previously included in the Mortgage Services segment), and HRB Bank are now reported in the Consumer Financial Services segment. Presentation of prior-year results reflects the new segment alignment.
     The Consumer Financial Services segment is primarily engaged in offering advice-based brokerage services and investment planning through HRBFA, mortgage loans through HRBMC and full-service banking through HRB Bank. HRB Bank offers traditional banking services, including

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checking and savings accounts, home equity lines of credit, individual retirement accounts, certificates of deposit and prepaid debit card deposit accounts. HRB Bank also purchases loans from Option One Mortgage Corporation (OOMC) to hold for investment purposes. HRBMC originates non-prime loans for sale to OOMC and prime loans for sale to other third-party buyers.
     All intersegment transactions are eliminated in consolidation. The largest intersegment revenue transactions include gains recognized on loans sold to HRB Bank by OOMC and mortgage fees earned by HRBMC on loans sold to OOMC.
12.   New Accounting Pronouncements
 
  In June 2006, FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48), was issued. The interpretation requires that a tax position meet a “more-likely-than-not” recognition threshold for the benefit of the uncertain tax position to be recognized in the financial statements and provides guidance on the measurement of the benefit. The interpretation also requires interim period estimated tax benefits of uncertain tax positions to be accounted for in the period of change rather than as a component of the annual effective tax rate. The provisions of this standard are effective as of the beginning of our fiscal year 2008. We are currently evaluating what effect the adoption of FIN 48 will have on our consolidated financial statements.
     In June 2006, Emerging Issues Task Force Issue No. 06-3, “How Sales Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross Versus Net Presentation)” (EITF 06-3) was issued. EITF 06-3 requires disclosure of the presentation of taxes on either a gross (included in revenues and costs) or a net (excluded from revenues) basis as an accounting policy decision. The provisions of this standard are effective for interim and annual reporting periods beginning after December 15, 2006. We do not expect the adoption of EITF 06-3 to have a material impact on our consolidated financial statements.
     In March 2006, Statement of Financial Accounting Standards No. 156, “Accounting for Servicing of Financial Assets – An Amendment of FASB Statement No. 140,” (SFAS 156), was issued. The provisions of this standard require mortgage servicing rights to be initially valued at fair value. SFAS 156 allows servicers to choose to subsequently measure their servicing rights at fair value or to continue using the “amortization method” under SFAS 140. The provisions of this standard are effective as of the beginning of our fiscal year 2008. We are currently evaluating what effect the adoption of SFAS 156 will have on our consolidated financial statements.
     In February 2006, Statement of Financial Accounting Standards No. 155, “Accounting for Certain Hybrid Instruments – An Amendment of FASB Statements No. 133 and 140” (SFAS 155), was issued. The provisions of this standard establish a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation. The standard permits a hybrid financial instrument to be accounted for in its entirety if the holder irrevocably elects to measure the hybrid financial instrument at fair value, with changes in fair value recognized currently in earnings. The provisions of this standard are effective as of the beginning of our fiscal year 2008. Our residual interests typically have interests in derivative instruments embedded within the securitization trusts. If we elect to account for our residual interests on a fair value basis, changes in fair value will impact earnings in the period in which the change occurs. We are currently evaluating what effect the adoption of SFAS 155 will have on our consolidated financial statements.
Exposure Draft – Amendment of SFAS 140
In August 2005, the Financial Accounting Standards Board (FASB) issued an exposure draft which amends Statement of Financial Accounting Standards No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” This exposure draft seeks to clarify the derecognition requirements for financial assets and the initial measurement of interests related to transferred financial assets that are held by a transferor. Our current off-balance sheet warehouse facilities (the Trusts) in our Mortgage Services segment would be required to be consolidated in our financial statements based on the provisions of the exposure draft. We will

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continue to monitor the status of the exposure draft and consider what changes, if any, could be made to the structure of the Trusts to continue to derecognize mortgage loans transferred to the Trusts. At July 31, 2006, the Trusts held loans and debt totaling $4.2 billion, which we would be required to consolidate into our financial statements under the provisions of this exposure draft. The final standard for this exposure draft is scheduled to be issued in the second quarter of calendar year 2007.
13.   Condensed Consolidating Financial Statements
 
    Block Financial Corporation (BFC) is an indirect, wholly owned consolidated subsidiary of the Company. BFC is the Issuer and the Company is the Guarantor of the Senior Notes issued on April 13, 2000 and October 26, 2004. These condensed consolidating financial statements have been prepared using the equity method of accounting. Earnings of subsidiaries are, therefore, reflected in the Company’s investment in subsidiaries account. The elimination entries eliminate investments in subsidiaries, related stockholder’s equity and other intercompany balances and transactions.
                                         
Condensed Consolidating Income Statements                             (in 000s)
Three months ended   H&R Block, Inc.     BFC     Other             Consolidated  
July 31, 2006   (Guarantor)     (Issuer)     Subsidiaries     Elims     H&R Block  
 
Total revenues
  $     $ 323,661     $ 218,565     $ (1,447 )   $ 540,779  
 
                             
 
                                       
Cost of services
          125,798       320,259       32       446,089  
Cost of other revenues
          88,691       3,323             92,014  
Selling, general and administrative
          101,591       115,886       (1,479 )     215,998  
 
                             
Total expenses
          316,080       439,468       (1,447 )     754,101  
 
                             
Operating income (loss)
          7,581       (220,903 )           (213,322 )
Interest expense
          (11,808 )     (327 )           (12,135 )
Other income, net
    (218,659 )     2,772       4,026       218,659       6,798  
 
                             
Loss before tax benefit
    (218,659 )     (1,455 )     (217,204 )     218,659       (218,659 )
Income tax benefit
    (87,282 )     (567 )     (86,715 )     87,282       (87,282 )
 
                             
Net loss
  $ (131,377 )   $ (888 )   $ (130,489 )   $ 131,377     $ (131,377 )
 
                             
                                         
Three months ended   H&R Block, Inc.     BFC     Other             Consolidated  
July 31, 2005   (Guarantor)     (Issuer)     Subsidiaries     Elims     H&R Block  
 
Total revenues
  $     $ 460,640     $ 157,665     $ (3,312 )   $ 614,993  
 
                             
 
                                       
Cost of services
          109,353       238,246       89       347,688  
Cost of other revenues
          120,900       2,457             123,357  
Selling, general and administrative
          91,188       96,995       (3,401 )     184,782  
 
                             
Total expenses
          321,441       337,698       (3,312 )     655,827  
 
                             
Operating income (loss)
          139,199       (180,033 )           (40,834 )
Interest expense
          (11,810 )     (625 )           (12,435 )
Other income, net
    (45,869 )           7,400       45,869       7,400  
 
                             
Income (loss) before tax (benefit)
    (45,869 )     127,389       (173,258 )     45,869       (45,869 )
Income taxes (benefit)
    (17,875 )     49,682       (67,557 )     17,875       (17,875 )
 
                             
Net income (loss)
  $ (27,994 )   $ 77,707     $ (105,701 )   $ 27,994     $ (27,994 )
 
                             

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Condensed Consolidating Balance Sheets                                   (in 000s)
    H&R Block, Inc.     BFC     Other             Consolidated  
July 31, 2006   (Guarantor)     (Issuer)     Subsidiaries     Elims     H&R Block  
 
Cash & cash equivalents
  $     $ 214,375     $ 175,693     $     $ 390,068  
Cash & cash equivalents – restricted
          332,757       12,972             345,729  
Receivables from customers, brokers and dealers, net
          437,697                   437,697  
Receivables, net
    69       103,955       266,283             370,307  
Mortgage loans held for investment
          541,361                   541,361  
Intangible assets and goodwill, net
          377,991       931,383             1,309,374  
Investments in subsidiaries
    5,027,345       215             (5,027,345 )     215  
Other assets
          1,545,035       696,754       (272 )     2,241,517  
 
                             
Total assets
  $ 5,027,414     $ 3,553,386     $ 2,083,085     $ (5,027,617 )   $ 5,636,268  
 
                             
 
                                       
Commercial paper
  $     $ 189,356     $     $     $ 189,356  
Accts. payable to customers, brokers and dealers
          716,305                   716,305  
Long-term debt
          398,060       13,674             411,734  
Other liabilities
    2       1,467,295       1,040,007             2,507,304  
Net intercompany advances
    3,215,843       (1,005,129 )     (2,210,714 )            
Stockholders’ equity
    1,811,569       1,787,499       3,240,118       (5,027,617 )     1,811,569  
 
                             
Total liabilities and stockholders’ equity
  $ 5,027,414     $ 3,553,386     $ 2,083,085     $ (5,027,617 )   $ 5,636,268  
 
                             
                                         
    H&R Block, Inc.     BFC     Other             Consolidated  
April 30, 2006   (Guarantor)     (Issuer)     Subsidiaries     Elims     H&R Block  
 
Cash & cash equivalents
  $     $ 151,561     $ 542,797     $     $ 694,358  
Cash & cash equivalents – restricted
          377,445       16,624             394,069  
Receivables from customers, brokers and dealers, net
          496,577                   496,577  
Receivables, net
    161       128,123       339,393             467,677  
Intangible assets and goodwill, net
          387,194       932,752             1,319,946  
Investments in subsidiaries
    5,237,611       215       456       (5,237,611 )     671  
Other assets
          2,116,900       499,477       (540 )     2,615,837  
 
                             
Total assets
  $ 5,237,772     $ 3,658,015     $ 2,331,499     $ (5,238,151 )   $ 5,989,135  
 
                             
 
                                       
Accts. payable to customers, brokers and dealers
  $     $ 781,303     $     $     $ 781,303  
Long-term debt
          398,001       19,538             417,539  
Other liabilities
    2       1,042,611       1,599,881             2,642,494  
Net intercompany advances
    3,089,971       (355,358 )     (2,734,567 )     (46 )      
Stockholders’ equity
    2,147,799       1,791,458       3,446,647       (5,238,105 )     2,147,799  
 
                             
Total liabilities and stockholders’ equity
  $ 5,237,772     $ 3,658,015     $ 2,331,499     $ (5,238,151 )   $ 5,989,135  
 
                             

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Condensed Consolidating Statements of Cash Flows                             (in 000s)
Three months ended   H&R Block, Inc.     BFC     Other             Consolidated  
July 31, 2006   (Guarantor)     (Issuer)     Subsidiaries     Elims     H&R Block  
 
Net cash provided by (used in) operating activities:
  $ 16,281     $ 263,292     $ (737,988 )   $     $ (458,415 )
 
                             
Cash flows from investing:
                                       
Cash received on residuals
          4,567                   4,567  
Mortgage loans originated for investment, net
          (135,161 )                 (135,161 )
Purchase property & equipment
          (3,691 )     (39,177 )           (42,868 )
Payments for business acquisitions
                (4,627 )           (4,627 )
Net intercompany advances
    196,279                   (196,279 )      
Other, net
                7,068             7,068  
 
                             
Net cash provided by (used in) investing activities
    196,279       (134,285 )     (36,736 )     (196,279 )     (171,021 )
 
                             
Cash flows from financing:
                                       
Repayments of commercial paper
          (1,034,210 )                 (1,034,210 )
Proceeds from commercial paper
          1,223,566                   1,223,566  
Customer deposits
          404,030                   404,030  
Dividends paid
    (40,485 )                       (40,485 )
Acquisition of treasury shares
    (186,339 )                       (186,339 )
Proceeds from stock options
    6,791                         6,791  
Excess tax benefits on stock-based compensation
    1,114                         1,114  
Net intercompany advances
          (649,771 )     453,492       196,279        
Other, net
    6,359       (9,808 )     (45,872 )           (49,321 )
 
                             
Net cash provided by (used in) financing activities
    (212,560 )     (66,193 )     407,620       196,279       325,146  
 
                             
Net increase (decrease) in cash
          62,814       (367,104 )           (304,290 )
Cash – beginning of period
          151,561       542,797             694,358  
 
                             
Cash – end of period
  $     $ 214,375     $ 175,693     $     $ 390,068  
 
                             
                                         
Three months ended   H&R Block, Inc.     BFC     Other             Consolidated  
July 31, 2005   (Guarantor)     (Issuer)     Subsidiaries     Elims     H&R Block  
 
Net cash provided by (used in) operating activities:
  $ 15,721     $ (51,974 )   $ (274,262 )   $     $ (310,515 )
 
                             
Cash flows from investing:
                                       
Cash received on residuals
          24,031                   24,031  
Purchase property & equipment
          (9,255 )     (21,075 )           (30,330 )
Payments for business acquisitions
          (2,994 )     (458 )           (3,452 )
Net intercompany advances
    120,140                   (120,140 )      
Other, net
          330       7,605             7,935  
 
                             
Net cash provided by (used in) investing activities
    120,140       12,112       (13,928 )     (120,140 )     (1,816 )
 
                             
Cash flows from financing:
                                       
Dividends paid
    (36,537 )                       (36,537 )
Acquisition of treasury shares
    (131,642 )                       (131,642 )
Proceeds from stock options
    27,180                         27,180  
Net intercompany advances
          14,587       (134,727 )     120,140        
Other, net
    5,138       10,579       (29,799 )           (14,082 )
 
                             
Net cash provided by (used in) financing activities
    (135,861 )     25,166       (164,526 )     120,140       (155,081 )
 
                             
Net decrease in cash
          (14,696 )     (452,716 )           (467,412 )
Cash – beginning of period
          162,983       937,230             1,100,213  
 
                             
Cash – end of period
  $     $ 148,287     $ 484,514     $     $ 632,801  
 
                             

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
H&R Block is a diversified company delivering tax services and financial advice, investment, mortgage and banking services, and business and consulting services. For more than 50 years, we have been developing relationships with millions of tax clients and our strategy is to expand on these relationships. Our Tax Services segment provides income tax return preparation services, electronic filing services and other services and products related to income tax return preparation to the general public in the United States, Canada, Australia and the United Kingdom. Our Mortgage Services segment offers a full range of home mortgage services through Option One Mortgage Corporation (OOMC). RSM McGladrey Business Services, Inc. (RSM) is a national accounting, tax and business consulting firm primarily serving midsized businesses. Our Consumer Financial Services segment offers investment services through H&R Block Financial Advisors, Inc. (HRBFA), full-service banking through H&R Block Bank (HRB Bank) and mortgage services through H&R Block Mortgage Corporation (HRBMC).
Our Mission
To help our clients achieve their financial objectives
by serving as their tax and financial partner.
     Key to achieving our mission is the enhancement of client experiences through consistent delivery of valuable services and advice. Operating through multiple lines of business allows us to better meet the changing financial needs of our clients.
     The analysis that follows should be read in conjunction with the tables below and the condensed consolidated income statements found on page 2.
                 
Tax Services - Operating Results           (in 000s)  
Three months ended July 31,   2006     2005  
 
Service revenues:
               
Tax preparation and related fees
  $ 25,662     $ 23,637  
Other services
    35,028       28,967  
 
           
 
    60,690       52,604  
Royalties
    2,923       2,396  
Other
    2,422       2,191  
 
           
Total revenues
    66,035       57,191  
 
           
 
               
Cost of services:
               
Compensation and benefits
    45,840       42,592  
Occupancy
    67,671       59,313  
Depreciation
    9,254       10,169  
Other
    48,237       39,967  
 
           
 
    171,002       152,041  
Other, selling, general and administrative
    48,181       49,656  
 
           
Total expenses
    219,183       201,697  
 
           
Pretax loss
  $ (153,148 )   $ (144,506 )
 
           
Three months ended July 31, 2006 compared to July 31, 2005
Tax Services’ revenues increased $8.8 million, or 15.5%, for the three months ended July 31, 2006 compared to the prior year.
     Tax preparation and related fees increased $2.0 million, or 8.6%, for the current quarter. This increase is primarily due to improved performance in our Canadian operations coupled with an increase of 8.7% in the average fee per U.S. client served.
     Other service revenues increased $6.1 million, or 20.9%, primarily due to an increase in the recognition of deferred fee revenue from our POM guarantees, which resulted from a more favorable claims pattern.

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     Total expenses increased $17.5 million, or 8.7%, for the three months ended July 31, 2006. Cost of services increased $19.0 million, or 12.5%, from the prior year. Our real estate expansion efforts have contributed to a total increase of $5.1 million across all cost of services categories. Compensation and benefits increased $3.2 million, or 7.6%, primarily due to severance costs associated with district realignments. Occupancy expenses increased $8.4 million, or 14.1%, primarily as a result of higher rent expenses due to a 10.0% increase in company-owned offices under lease and a 6.2% increase in the average rent. Other cost of services increased $8.3 million, or 20.7%, due to $3.3 million in additional corporate shared services for information technology projects, coupled with increases in travel expenses and expenses associated with our POM guarantee.
     Selling, general and administrative expenses decreased $1.5 million, or 3.0%, primarily due to a $2.7 million decrease in corporate shared services and a $2.5 million decrease in legal expenses, partially offset by a $2.9 million increase in corporate wages.
     The pretax loss was $153.1 million for the three months ended July 31, 2006 compared to a loss of $144.5 million in the prior year.
RAL Litigation
We are named as a defendant in one pending class-action lawsuit and one pending state attorney general lawsuit alleging that we engaged in wrongdoing with respect to the RAL program. We believe we have strong defenses to these lawsuits and will vigorously defend our position. Nevertheless, the amounts claimed in these lawsuits are, in some instances, very substantial. In fiscal year 2006, we entered into settlement agreements regarding several RAL Cases, with the combined pretax expense for such settlements totaling $70.2 million. There can be no assurances as to the ultimate outcome of the remaining pending RAL Cases, or as to their impact on our financial statements. See additional discussion of RAL Litigation in note 10 to the consolidated financial statements and in Part II, Item 1, “Legal Proceedings.”

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MORTGAGE SERVICES
This segment is primarily engaged in the origination and acquisition of non-prime mortgage loans through an independent broker network and its relationship with HRBMC, the sale and securitization of mortgage loans and residual interests, and the servicing of non-prime loans.
                 
Mortgage Services - Operating Statistics           (dollars in 000s)  
Three months ended July 31,   2006     2005  
 
Volume of loans originated and purchased:
               
Third-party brokers
  $ 7,207,631     $ 9,537,227  
Intersegment (HRBMC)
    584,426       950,806  
 
           
 
  $ 7,792,057     $ 10,488,033  
 
           
 
               
Loan characteristics:
               
Weighted average FICO score
    614       623  
Weighted average interest rate for borrowers (WAC)
    8.68 %     7.52 %
Weighted average loan-to-value
    82.6 %     81.1 %
Origination margin (% of origination volume): (1)
               
Loan sale premium
    1.58 %     2.30 %
Residual cash flows from beneficial interest in Trusts
    0.57 %     0.49 %
Gain on derivative instruments
    0.16 %     0.27 %
Loan sale repurchase reserves
    (1.19 %)     (0.17 %)
Retained mortgage servicing rights
    0.64 %     0.47 %
 
           
 
    1.76 %     3.36 %
Cost of acquisition
    (0.52 %)     (1.08 %)
Direct origination expenses
    (0.43 %)     (0.44 %)
 
           
Net gain on sale — gross margin (2)
    0.81 %     1.84 %
Other revenues
    (0.05 %)     %
Other cost of origination
    (0.98 %)     (0.94 %)
 
           
Net margin
    (0.22 %)     0.90 %
 
           
Total cost of origination (1)
    1.41 %     1.38 %
Total cost of origination and acquisition
    1.93 %     2.46 %
Loan delivery:
               
Loan sales:
               
Third-party buyers
  $ 7,654,445     $ 10,443,411  
Intersegment (HRB Bank)
    553,502        
 
           
 
  $ 8,207,947     $ 10,443,411  
 
           
Execution price (3)
    1.31 %     2.54 %
 
(1)   See “Reconciliation of Non-GAAP Financial Information” at the end of Part I, Item 2.
 
(2)   Defined as gain on sale of mortgage loans (including gain or loss on derivatives, mortgage servicing rights and net of direct origination and acquisition expenses) divided by origination volume.
 
(3)   Defined as total premium received divided by total balance of loans delivered to third-party investors or securitization vehicles (excluding mortgage servicing rights and the effect of loan origination expenses).

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Mortgage Services - Operating Results           (in 000s)  
Three months ended July 31,   2006     2005  
 
Components of gains on sales:
               
Gain on mortgage loans
  $ 50,348     $ 168,968  
Gain on derivatives
    12,520       23,947  
Impairment of residual interests
    (17,266 )     (11,875 )
 
           
 
    45,602       181,040  
 
           
 
               
Interest income:
               
Accretion — residual interests
    13,509       30,777  
Other
    1,525       2,768  
 
           
 
    15,034       33,545  
 
           
Loan servicing revenue
    109,040       90,269  
Other
          193  
 
           
Total revenues
    169,676       305,047  
 
           
 
               
Cost of services
    78,688       64,392  
Cost of other revenues:
               
Compensation and benefits
    34,184       50,829  
Occupancy
    4,506       9,568  
Other
    20,732       20,123  
 
           
 
    59,422       80,520  
Selling, general and administrative
    36,490       29,471  
 
           
Total expenses
    174,600       174,383  
 
           
Pretax income (loss)
  $ (4,924 )   $ 130,664  
 
           
Three months ended July 31, 2006 compared to July 31, 2005
Mortgage Services’ revenues decreased $135.4 million, or 44.4%, for the three months ended July 31, 2006 compared to the prior year. Revenues decreased primarily as a result of a decline in gains on sales of mortgage loans, partially offset by higher loan servicing revenue.
     The following table summarizes the key drivers of loan origination volumes and related gains on sales of mortgage loans:
                 
(dollars in 000s)
Three months ended July 31,   2006     2005  
 
Application process:
               
Total number of applications
    70,718       106,087  
Number of sales associates (1)
    2,066       2,341  
Closing ratio (2)
    53.8 %     59.7 %
Originations:
               
Total number of loans originated/acquired
    38,033       63,362  
WAC
    8.68 %     7.52 %
Average loan size
  $ 205     $ 166  
Total volume of loans originated/acquired
  $ 7,792,057     $ 10,488,033  
Direct origination and acquisition expenses, net
  $ 74,594     $ 160,020  
Revenue (loan value):
               
Net gain on sale — gross margin (3)
    0.81 %     1.84 %
 
(1)   Includes all direct sales and back office sales support associates.
 
(2)   Percentage of loans funded divided by total applications in the period.
 
(3)   Defined as gain on sale of mortgage loans (including gain or loss on derivatives, mortgage servicing rights and net of direct origination and acquisition expenses) divided by origination volume.
     Gains on sales of mortgage loans decreased $118.6 million and our net gain on sale - gross margin declined 103 basis points from the prior year. These decreases resulted primarily from higher loss provisions for loan repurchases recorded during the current quarter, lower premiums on loan sales and lower origination volumes, partially offset by improved cost of acquisition.
     During the quarter we experienced higher early payment defaults, resulting in an increase in actual and expected loan repurchase activity. As a result, we recorded total loss provisions of $102.1 million during the three months ended July 31, 2006, which included $9.8 million in premium recapture reserves, compared to $16.9 million in the prior year.

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The provision recorded in the current quarter consists of $46.1 million recorded on loans sold during the current quarter and $56.0 million related to loans sold in prior quarters. Loss provisions as a percent of origination volume increased 102 basis points over the prior year. In establishing loss reserves on recent production, we’ve assumed all loans that are currently delinquent and subject to contractual repurchase terms will be repurchased, and that 5% of loans previously sold but not yet subject to contractual repurchase terms will be repurchased. Based on historical experience, we assumed 30% of all loans we repurchase will cure with no loss incurred, and of those that do not cure, we assumed an average 15% loss severity. See additional discussion of our reserves and repurchase obligations in note 9 to our condensed consolidated financial statements.
     Market interest rates, based on the two-year swap, increased from an average of 4.06% last year to 5.51% in the current quarter. However, our WAC increased only 116 basis points, up to 8.68% from 7.52% in the prior year. These changes in interest rates, coupled the higher loss provisions, caused our premium on loan sales to decline 72 basis points, to 1.58% from 2.30% last year.
     The value of MSRs recorded in the first quarter increased to 64 basis points from 47 basis points in the prior year due to changes in our assumptions used to value MSRs and other factors. However this increase was offset by a decline in origination volumes, which resulted in a net increase of $0.8 million in gains on sales of mortgage loans.
     Our cost of acquisition improved 56 basis points to 0.52% primarily as a result of a decrease in the cost to acquire loans from HRBMC and lower third-party broker commissions.
     For the three months ended July 31, 2006, gains on sales of mortgage loans includes $10.4 million in gains on sales of loans to HRB Bank and $8.5 million in acquisition costs paid to HRBMC to purchase its non-prime loans, both of which are eliminated in consolidation.
     To mitigate the risk of short-term changes in market interest rates related to our loan originations, we use interest rate swaps, forward loan sale commitments and rate-lock equivalents. We generally enter into interest rate swap arrangements related to existing loan applications with rate-lock commitments and for rate-lock commitments we expect to make in the next two to three weeks. During the current quarter, we recorded a net $12.5 million in gains, compared to $23.9 million in the prior year, related to our various derivative instruments. See note 5 to the condensed consolidated financial statements.
     During the current quarter, our available-for-sale residual interests performed worse than expected in our internal valuation models, with higher credit losses and interest rates than originally modeled. We recorded impairments of $17.3 million in gains on sales of mortgage assets. We also recorded favorable pretax mark-to-market adjustments, which increased the fair value of our residual interests $3.4 million during the quarter. These adjustments were recorded, net of write-downs of $2.9 million and deferred taxes of $0.2 million, in other comprehensive income and will be accreted into income throughout the remaining life of those residual interests. Future changes in interest rates or other assumptions, based on market conditions or actual loan pool performance, could cause additional adjustments to the fair value of the residual interests and could cause changes to the accretion of these residual interests in future periods.
     Accretion of residual interests of $13.5 million for the three months ended July 31, 2006 represents a decrease of $17.3 million from the prior year. This decrease is primarily due to the sale of previously securitized residual interests during fiscal year 2006 and lower write-ups to residual interest balances.

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     The following table summarizes the key metrics related to our loan servicing business:
                 
(dollars in 000s)  
Three months ended July 31,   2006     2005  
 
Average servicing portfolio:
               
With related MSRs
  $ 63,562,956     $ 49,635,474  
Without related MSRs
    10,443,256       20,070,745  
 
           
 
  $ 74,006,212     $ 69,706,219  
 
           
Ending servicing portfolio:
               
With related MSRs
  $ 64,187,360     $ 52,015,774  
Without related MSRs
    10,333,107       18,526,932  
 
           
 
  $ 74,520,467     $ 70,542,706  
 
           
Number of loans serviced
    439,707       451,310  
Average delinquency rate
    7.33 %     4.28 %
Weighted average FICO score
    621       621  
Weighted average interest rate (WAC) of portfolio
    7.93 %     7.43 %
Carrying value of MSRs
  $ 275,266     $ 188,708  
     Loan servicing revenues increased $18.8 million, or 20.8%, compared to the prior year. The increase reflects a higher average loan servicing portfolio. The average servicing portfolio for the three months ended July 31, 2006 increased $4.3 billion, or 6.2%, to $74.0 billion. The annualized rate earned on our entire servicing portfolio was 35 basis points for the current quarter, compared to 37 basis points in the prior year.
     Total expenses for the three months ended July 31, 2006 were essentially flat compared to the prior year. Cost of services increased $14.3 million as a result of a higher average servicing portfolio during the current quarter and increased amortization of MSRs.
     Cost of other revenues decreased $21.1 million, primarily due to $16.6 million in lower compensation and benefits as a result of the restructuring in the prior year. Occupancy expenses decreased $5.1 million primarily due to the closing of certain offices during the fourth quarter of fiscal year 2006.
     Selling, general and administrative expenses increased $7.0 million due primarily to a $5.3 million reduction in costs allocated to HRBMC.
     The pretax loss for the three months ended July 31, 2006 was $4.9 million compared to income of $130.7 million in the prior year.

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BUSINESS SERVICES
This segment offers middle-market companies accounting, tax and consulting services, wealth management, retirement resources, payroll and benefits services, corporate finance and financial process outsourcing.
                 
Business Services - Operating Statistics  
Three months ended July 31,   2006     2005  
 
Accounting, tax and consulting:
               
Chargeable hours
    1,024,649       597,202  
Chargeable hours per person
    276       270  
Net billed rate per hour
  $ 143     $ 134  
Average margin per person
  $ 19,666     $ 17,321  
                 
Business Services - Operating Results           (in 000s)  
Three months ended July 31,   2006     2005  
 
Service revenues:
               
Accounting, tax and consulting
  $ 161,850     $ 83,828  
Capital markets
    13,660       15,472  
Payroll, benefits and retirement services
    7,410       8,277  
Other services
    12,933       9,882  
 
           
 
    195,853       117,459  
Other
    9,278       9,387  
 
           
Total revenues
    205,131       126,846  
 
           
Cost of services:
               
Compensation and benefits
    121,619       71,647  
Occupancy
    19,308       8,163  
Other
    12,446       10,810  
 
           
 
    153,373       90,620  
Amortization of intangible assets
    4,879       3,803  
Selling, general and administrative
    61,444       39,188  
 
           
Total expenses
    219,696       133,611  
 
           
Pretax loss
  $ (14,565 )   $ (6,765 )
 
           
Three months ended July 31, 2006 compared to July 31, 2005
Business Services’ revenues for the three months ended July 31, 2006 increased $78.3 million, or 61.7%, from the prior year. This increase was primarily due to the acquisition of American Express Tax and Business Services, Inc. (AmexTBS) as of October 1, 2005, which increased accounting, tax and consulting revenues $72.4 million.
     Capital markets revenues declined due to a decline in the number of business valuation projects. Other service revenues increased $3.1 million due to growth in our financial process outsourcing and wealth management services.
     Total expenses increased $86.1 million, or 64.4%, for the three months ended July 31, 2006 compared to the prior year. Cost of services increased $62.8 million, due to increases in compensation and benefits and occupancy expenses. Compensation and benefits increased $50.0 million, primarily due to the AmexTBS acquisition. Increases in the number of personnel and the average wage per employee, driven by marketplace competition for professional staff, also contributed to the increase. Occupancy expenses increased $11.1 million primarily due to the AmexTBS acquisition.
     Selling, general and administrative expenses increased $22.3 million primarily due to acquisitions and additional costs associated with our business development initiatives.
     The pretax loss for the three months ended July 31, 2006 of $14.6 million compares to a pretax loss of $6.8 million in the prior year.

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CONSUMER FINANCIAL SERVICES
This segment is primarily engaged in offering advice-based brokerage services and investment planning through HRBFA, full-service banking through HRB Bank and prime and non-prime mortgage loans through HRBMC. HRBFA, HRB Bank and HRBMC, our “Block-branded” businesses, are focused on increasing client loyalty and retention by offering expanded financial services to our retail tax clients. HRBFA offers our customers traditional brokerage services, as well as annuities, insurance, fee-based accounts, online account access, equity research and focus lists, model portfolios, asset allocation strategies, and other investment tools and information. HRB Bank offers traditional banking services including checking and savings accounts, home equity lines of credit, individual retirement accounts, certificates of deposit and prepaid debit card deposit accounts. HRB Bank also purchases loans from OOMC to hold for investment purposes and HRBFA utilizes HRB Bank for certain FDIC-insured deposits for its customers. HRBMC originates mortgage loans for sale to OOMC or other third-party buyers.
                 
Consumer Financial Services - Operating Statistics  
Three months ended July 31,   2006     2005  
 
Broker-dealer:
               
Traditional brokerage accounts (1)
    409,147       431,046  
New traditional brokerage accounts funded by HRB Tax clients
    3,188       4,224  
Average assets per traditional brokerage account
  $ 75,311     $ 68,870  
Average margin balances (millions)
  $ 451     $ 573  
Average customer payable balances (millions)
  $ 647     $ 841  
Number of advisors
    938       985  
Banking:
               
Efficiency ratio (2)
    35 %     N/A  
Annualized net interest margin (3)
    3.65 %     N/A  
Annualized return on average assets (4)
    1.15 %     N/A  
Total assets (thousands)
  $ 566,792       N/A  
Loans purchased from OOMC (thousands)
  $ 553,502       N/A  
Retail mortgage activities:
               
Volume of loans originated (thousands):
               
Total
  $ 844,314     $ 1,350,402  
Loans originated to HRB Tax clients
  $ 140,243     $ 326,521  
Average loan size (thousands)
  $ 175     $ 149  
Loans sold to OOMC (thousands)
  $ 584,426     $ 950,806  
 
(1)   Includes only accounts with a positive balance.
 
(2)   Defined as non-interest expense divided by revenue net of interest expense. See “Reconciliation of Non-GAAP Financial Information” at the end of Part I, Item 2.
 
(3)   Defined as annualized net interest revenue divided by average assets. See “Reconciliation of Non-GAAP Financial Information” at the end of Part I, Item 2.
 
(4)   Defined as annualized pretax banking income divided by average assets. See “Reconciliation of Non-GAAP Financial Information” at the end of Part I, Item 2.

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Consumer Financial Services - Operating Results           (in 000s)  
Three months ended July 31,   2006     2005  
 
Service revenues:
               
Financial advisor production revenue
  $ 47,019     $ 45,106  
Other
    8,368       8,207  
 
           
 
    55,387       53,313  
 
           
Gain on sale of mortgage loans, net
    29,382       56,397  
Net interest revenue on:
               
Margin lending and other
    13,742       12,737  
Banking activities
    3,729        
 
           
 
    17,471       12,737  
 
           
Loan loss reserves — mortgage loans held for investment
    (1,338 )      
Other
    356       577  
 
           
Total revenues (1)
    101,258       123,024  
 
           
Cost of services:
               
Compensation and benefits
    31,864       30,535  
Occupancy
    5,061       5,165  
Other
    5,165       4,935  
 
           
 
    42,090       40,635  
Cost of other revenues
    13,840       35,168  
Amortization of intangible assets
    9,156       9,156  
Selling, general and administrative
    43,952       41,813  
 
           
Total expenses
    109,038       126,772  
 
           
Pretax loss
  $ (7,780 )   $ (3,748 )
 
           
 
(1)   Total revenues, less interest expense and loan loss reserves on mortgage loans held for investment.
Three months ended July 31, 2006 compared to July 31, 2005
Consumer Financial Services’ revenues, net of interest expense and loan loss reserves, for the three months ended July 31, 2006 decreased $21.8 million, or 17.7%, from the prior year, primarily due to lower gains on sales of mortgage loans.
     Financial advisor production revenue, which consists primarily of fees earned on assets under administration and commissions on customer trades, increased $1.9 million, or 4.2%, over the prior year due primarily to higher annuitized revenues, partially offset by declining transactional revenues. The following table summarizes the key drivers of production revenue:
                 
Three months ended July 31,   2006     2005  
 
Customer trades
    224,048       226,378  
Average revenue per trade
  $ 112.68     $ 126.71  
Ending balance of assets under administration (billions)
  $ 31.1     $ 30.0  
Annualized productivity per advisor
  $ 195,000     $ 180,000  
     Gain on sale of mortgage loans decreased $27.0 million, or 47.9%, from the prior year primarily due to a 37.5% decline in origination volumes, coupled with lower margins on mortgage loans sold. Origination volumes fell primarily due to a decline in applications as well as a decline in the closing ratio. HRBMC sells its non-prime loans to OOMC and its prime loans to other third-party buyers. For the three months ended July 31, 2006, gains on sales of mortgage loans includes $8.5 million in gains on loans sold to OOMC, which is eliminated in consolidation.
     Net interest revenue on margin lending and other increased $1.0 million, or 7.9%, from the prior year, as a result of higher interest rates earned, partially offset by a decline in average margin balances.

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     Net interest revenue on banking activities totaled $3.7 million for the three months ended July 31, 2006. The following table summarizes the key drivers of net interest revenue on banking activities:
                 
(in 000s)  
Three months ended July 31,   2006     2005  
 
Average loans
  $ 380,866       N/A  
Average investments
  $ 20,879       N/A  
Average deposits
  $ 247,445       N/A  
     Total segment expenses decreased $17.7 million, or 14.0%, over the prior year. Cost of other revenues decreased $21.3 million, or 60.6%, primarily as a result of the restructuring of our mortgage operations in fiscal year 2006.
     Selling, general and administrative expenses increased $2.1 million, or 5.1%, primarily due to expenses of HRB Bank, which opened May 1, 2006.
     The pretax loss for Consumer Financial Services for the three months ended July 31, 2006 was $7.8 million compared to the prior year loss of $3.7 million.
FINANCIAL CONDITION
These comments should be read in conjunction with the condensed consolidated balance sheets and condensed consolidated statements of cash flows found on pages 1 and 3, respectively.
CAPITAL RESOURCES & LIQUIDITY BY SEGMENT
Our sources of capital include cash from operations, issuances of common stock and debt. We use capital primarily to fund working capital requirements, pay dividends, repurchase our shares and acquire businesses.
     Cash From Operations. Cash used in operations totaled $458.4 million and $310.5 million for the three months ended July 31, 2006 and 2005, respectively. The increase in cash used in operating activities is primarily due to a $155.1 million increase in income tax payments.
     Issuance of Common Stock. We issue shares of common stock, in accordance with our stock-based compensation plans, out of treasury shares. Proceeds from the issuance of common stock totaled $13.2 million and $32.3 million for the three months ended July 31, 2006 and 2005, respectively.
     Dividends. Dividends paid totaled $40.5 million and $36.5 million for the three months ended July 31, 2006 and 2005, respectively.
     Share Repurchases. On June 7, 2006, our Board approved an additional authorization to repurchase 20.0 million shares. During the three months ended July 31, 2006, we repurchased 8.1 million shares pursuant to this authorization and a prior authorization at an aggregate price of $180.9 million or an average price of $22.22 per share. There are 22.4 million shares remaining under these authorizations at July 31, 2006. We plan to continue to purchase shares on the open market in accordance with this authorization, subject to various factors including the price of the stock, the availability of excess cash, our ability to maintain liquidity and financial flexibility, securities law restrictions, targeted capital levels and other investment opportunities available.
     Debt. We plan to refinance our $500.0 million in Senior Notes, which are due in April 2007.
     Restricted Cash. We hold certain cash balances that are restricted as to use. Cash and cash equivalents — restricted totaled $345.7 million at July 31, 2006 compared to $394.1 million at April 30, 2006. Consumer Financial Services held $315.0 million of this total segregated in a special reserve account for the exclusive benefit of its broker-dealer customers. Restricted cash held by Mortgage Services totaled $17.8 million and is held primarily for outstanding commitments to fund mortgage loans. Restricted cash of $12.7 million at July 31, 2006 held by Business Services is related to funds held to pay payroll taxes on behalf of its customers.

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     Segment Cash Flows. A condensed consolidating statement of cash flows by segment for the three months ended July 31, 2006 follows. Generally, interest is not charged on intercompany activities between segments.

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(in 000s)  
                            Consumer                
    Tax     Mortgage     Business     Financial             Consolidated  
    Services     Services     Services     Services     Corporate     H&R Block  
 
Cash provided by (used in):
                                               
Operations
  $ (299,762 )   $ 188,852     $ 41,412     $ 45,464     $ (434,381 )   $ (458,415 )
Investing
    (7,373 )     (1,599 )     (7,096 )     (138,613 )     (16,340 )     (171,021 )
Financing
    (36,534 )           (5,599 )     394,222       (26,943 )     325,146  
Net intercompany
    322,395       (178,397 )     (38,562 )     (252,750 )     147,314        
     Net intercompany activities are excluded from investing and financing activities within the segment cash flows. We believe that by excluding intercompany activities, the cash flows by segment more clearly depicts the cash generated and used by each segment. Had intercompany activities been included, those segments in a net lending situation would have been included in investing activities, and those in a net borrowing situation would have been included in financing activities.
     Tax Services. Tax Services has historically been our largest provider of annual operating cash flows. The seasonal nature of Tax Services generally results in a large positive operating cash flow in the fourth quarter. Tax Services used $299.8 million in its current three-month operations to cover off-season costs and working capital requirements. This segment used $7.4 million in investing activities primarily related to capital expenditures and acquisitions, and used $36.5 million in financing activities related to book overdrafts.
     Mortgage Services. This segment primarily generates cash as a result of the sale and securitization of mortgage loans and residual interests, and as its residual interests begin to cash flow. Mortgage Services provided $188.9 million in cash from operating activities primarily due to higher accounts payable and escrow deposits, and loan sales exceeding loan originations during the three months ended July 31, 2006. Cash flows used in investing activities consist of $7.2 million in capital expenditures, partially offset by $4.6 million in cash receipts on available-for-sale residual interests.
     We believe the sources of liquidity available to the Mortgage Services segment are sufficient for its needs.
     Business Services. Business Services funding requirements are largely related to receivables for completed work and “work in process.” We provide funding sufficient to cover their working capital needs. This segment provided $41.4 million in operating cash flows during the first three months of the year. Business Services used $7.1 million in investing activities primarily related to capital expenditures.
     Consumer Financial Services. In the first three months of fiscal year 2007, Consumer Financial Services provided $45.5 million in cash from its operating activities primarily due to the timing of cash deposits that are restricted for the benefit of its broker-dealer customers. The segment also used $138.6 million in investing activities primarily for the purchase of mortgage loans held for investment and provided $394.2 million in financing activities due primarily to $404.0 million in FDIC-insured deposits held at HRB Bank.
     To finance our prime mortgage loan originations, we utilize an on-balance sheet warehouse facility with capacity up to $25 million. This annual facility bears interest at one-month LIBOR plus 140 to 200 basis points. As of July 31, 2006 and April 30, 2006, the balance outstanding under this facility was $5.9 million and $1.6 million, respectively.
     HRB Bank is a member of the FHLB of Des Moines, which extends credit availability to member banks based on eligible collateral and asset size. At July 31, 2006, HRB Bank had FHLB advance capacity of $198.0 million, but no amounts had been drawn on this facility.
     We believe the funding sources for Consumer Financial Services are stable. Liquidity risk within this segment is primarily limited to maintaining sufficient capital levels to obtain securities lending liquidity to support margin borrowing by customers.

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OFF-BALANCE SHEET FINANCING ARRANGEMENTS
There have been no material changes in our off-balance sheet financing arrangements from those reported at April 30, 2006 in our Annual Report on Form 10-K.
COMMERCIAL PAPER ISSUANCE AND SHORT-TERM BORROWINGS
There have been no material changes in our commercial paper program from those reported at April 30, 2006 in our Annual Report on
Form 10-K.
CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
There have been no material changes in our contractual obligations and commercial commitments from those reported at April 30, 2006 in our Annual Report on Form 10-K.
REGULATORY ENVIRONMENT
In March 2006, the OTS approved the federal savings bank charter of HRB Bank. The bank commenced operations on May 1, 2006, at which time H&R Block, Inc. became a savings and loan holding company. As a savings and loan holding company, H&R Block, Inc. is subject to regulation by the OTS. Federal savings associations are subject to extensive regulation and examination by the OTS, their primary federal regulator, as well as the Federal Deposit Insurance Corporation (FDIC). H&R Block, Inc. is now subject to a three percent minimum ratio of adjusted tangible capital to adjusted total assets, as defined by the OTS, and HRB Bank is subject to various OTS capital requirements. A banking institution’s capital category depends upon where its capital levels are in relation to relevant capital measures, which include a risk-based capital measure, a leverage ratio capital measure, a tangible equity ratio measure, and certain other factors. See note 8 to the condensed consolidated financial statements for additional discussion of regulatory capital requirements and classifications.
     HRB Bank is an indirect wholly-owned subsidiary of H&R Block, Inc. and is insured by the FDIC. If an insured institution fails, claims for administrative expenses of the receiver and for deposits in U.S. branches (including claims of the FDIC as subrogee of the failed institution) have priority over the claims of general unsecured creditors. In addition, the FDIC has authority to require H&R Block, Inc. to reimburse it for losses it incurs in connection with the failure of HRB Bank or with the FDIC’s provision of assistance to a banking subsidiary that is in danger of failure.
     Other than the items discussed above, there have been no material changes in our regulatory environment from those reported at April 30, 2006 in our Annual Report on Form 10-K.
CRITICAL ACCOUNTING POLICIES
The following discussion is an update to previous disclosure regarding certain of our critical accounting policies and should be read in conjunction with the complete critical accounting policies disclosures included in our Annual Report on Form 10-K for the year ended April 30, 2006. For all of our critical accounting policies, we caution that future events rarely develop precisely as forecasted, and estimates routinely require adjustment and may require material adjustment.
Gains on Sales of Mortgage Assets
We sell substantially all of the non-prime mortgage loans we originate to warehouse trusts (the ‘Trusts”) which are qualifying special purpose entities (QSPEs), with servicing rights generally retained. Prime mortgage loans are sold in loan sales, servicing released, to third-party buyers. Gains on sales of mortgage assets are recognized when control of the assets is surrendered (when loans are sold to third-party buyers, including the Trusts) and are based on the difference between net proceeds received (cash proceeds less recourse obligations) and the allocated cost of the assets sold. We determine the allocated cost of assets sold based on the relative fair values of net proceeds (i.e. the loans sold), retained MSRs and the beneficial interest in Trusts, which represents our residual interest in the ultimate expected outcome from the disposition of the loans by the Trusts.
The following is an example of a hypothetical gain on sale calculation:
                         
                (in 000s)  
 
Acquisition cost of underlying mortgage loans
          $ 1,000,000          
 
                     
Fair values:
                       
Net proceeds
                       
Cash received
  $ 999,000                  
Less recourse obligation
    (4,000 )   $ 995,000          
 
                     
Beneficial interest in Trusts
            20,000          
MSRs
            7,000          
 
                     
 
          $ 1,022,000          
 
                     
Computation of gain on sale:
                       
Net proceeds
          $ 995,000          
Less allocated cost ($995,000 / $1,022,000 x $1,000,000)
            973,581          
 
                     
Recorded gain on sale
          $ 21,419          
 
                     
Recorded beneficial interest in Trusts ($20,000 / $1,022,000 x $1,000,000)
          $ 19,570          
 
                     
Recorded value of MSRs ($7,000 / $1,022,000 x $1,000,000)
          $ 6,849          
 
                     
Recorded liability for recourse obligation
          $ 4,000          
 
                     
 
     Variations in the assumptions we use affect the estimated fair values and the reported gains on sales. Gains on sales of mortgage loans totaled $45.6 million and $181.0 million for three months ended July 31, 2006 and 2005, respectively.

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     Our recourse obligation relates to potential losses that could be incurred related to the repurchase of sold loans or indemnification of losses as a result of early payment defaults or breaches of other representations and warranties customary to the mortgage banking industry.
     The substantial majority of loan repurchases or indemnification for losses occurs within nine months from the date the loans are sold. We estimate the fair value of the recourse liability at the time the loan is sold. Provisions for losses are charged to gain on sale of mortgage loans and credited to the recourse liability while actual losses are charged to the liability. We evaluate, and adjust if necessary, the fair value of the recourse obligation quarterly based on current information and trends in underlying loan performance. The amount of losses we expect to incur related to the repurchase of sold loans depends primarily on the frequency of early payment defaults, the rate at which defaulted loans subsequently become current on payments (“cure rate”), the propensity of the buyer of the loans to demand recourse under the loan sale agreement and the severity of loss incurred on loans which have been repurchased. The frequency of early payment defaults, cure rates and loss severity may vary depending on the creditworthiness of the borrower and economic factors such as home price appreciation and interest rates. To the extent actual losses related to repurchase activity are different from our estimates, the fair value of our recourse obligation will increase or decrease.
     During the quarter ended July 31, 2006 we experienced higher early payment defaults, resulting in an increase in actual and expected loan repurchase activity. As a result, we recorded total loss provisions of $102.1 million during the three months ended July 31, 2006, which included $9.8 million in premium recapture reserves, compared to $16.9 million in the prior year. Loss provisions recorded in the current quarter consist of $46.1 million recorded on loans sold during the current quarter and $56.0 million related to loans sold in prior quarters. At July 31, 2006, we assumed that substantially all loans that failed to make timely payments according to contractual early payment default provisions will be repurchased, and that 5% of loans will be repurchased from sales that have not yet reached the contractual date upon which repurchases can be determined. Based on historical experience and review of current early payment default, cure rate and loss severity trends, we assumed 30% of all loans we repurchase will cure with no loss incurred, and of those that do not cure, we assumed an average 15% loss severity.
     Based on our analysis as of July 31, 2006, we estimated our liability for recourse obligations to be $104.0 million. The sensitivity of the recourse liability to 10% and 20% adverse changes in loss assumptions is $10.4 million and $20.8 million, respectively.
Valuation of MSRs
MSRs are recorded when we sell to third-parties with the servicing of those loans retained. At the time of the loan sale, we determine and record on our balance sheet the allocated historical cost of the MSRs attributable to loans sold, as illustrated above. These MSRs are amortized into expense over the estimated life of the underlying loans. MSRs are carried at the lower of cost or market (LOCOM). On a quarterly basis, MSRs are assessed to determine if our carrying value exceeds fair value. Fair value is estimated using a discounted cash flow approach by stratifying the MSRs based on underlying loan characteristics, including the calendar year the loans are sold. To the extent fair value is less than carrying value we record an impairment charge and adjust the carrying value of the MSRs.
     A market price of our MSRs is not readily available because non prime MSRs are not actively traded in the marketplace. Therefore, the fair value of our MSRs is estimated using a discounted cash flow approach, using valuation methods and assumptions we believe incorporate assumptions used by market participants. Certain of these assumptions are subjective and require a high level of management judgment. MSR valuation assumptions are reviewed and approved by management on a quarterly basis. In determining the assumptions to be used to value MSRs, we review the historical performance of our MSRs, including backtesting of the performance of certain individual assumptions (comparison of actual results to those expected). In addition, we periodically review third-party valuations of certain of our MSRs and peer group MSR valuation surveys to assess the reasonableness of our valuation assumptions and resulting fair value estimates.
     Critical assumptions used in our discounted cash flow model include mortgage prepayment speeds, discount rates, costs to service and ancillary income. Variations in our assumptions could materially affect the estimated fair values. Changes to our assumptions are made when current trends and market data indicate that new trends have developed. Certain assumptions, such as ancillary interest income, may change from quarter to quarter as market conditions and projected interest rates change. Other assumptions, such as expected prepayment speeds, discount rates and costs of servicing may change less frequently as they are less sensitive to near-term market conditions.
     Prepayment speeds may be affected by economic factors such as home price appreciation, market interest rates, the availability of other credit products to our borrowers, and customer payment patterns. Prepayment speeds include the impact of all borrower prepayments including full payoffs, additional principal payments and the impact of loans paid off due to foreclosure liquidations. As market interest rates decline, prepayment speeds will generally increase as customers refinance existing mortgages under more favorable interest rate terms. As prepayment speeds increase, anticipated cash flows will generally decline resulting in a potential reduction, or impairment, to the fair value of the capitalized MSRs. Alternatively, an increase in market interest rates may cause a decrease in prepayment speeds, and an increase in fair value of MSRs. Many of our loans include prepayment penalties during the first two to three years. Prepayment penalties tend to lower prepayment speeds during the early life of our loans, regardless of market interest rate movements, therefore decreasing the sensitivity of expected prepayment speeds to changes in interest rates. Prepayment speeds are estimated based on historical experience and third-party market sources. Changes are made as necessary to ensure such estimates reflect current market conditions specific to our individual MSR stratas.

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     Discount rates are determined by reviewing market rates used by market participants. These rates may vary based on economic factors such as market perception of risk and changes in the risk-free interest rates. Changes are made as necessary to ensure such estimates reflect current market conditions for MSR assets.
     Costs to service includes the cost to process loan payments, make payments to bondholders, collect delinquent accounts and administrative foreclosure activities. Market trends and changes to underlying expenses are evaluated to determine if updates to assumptions are necessary. The economic factors affecting costs to service include unemployment rates, the housing market and the cost of labor. Higher unemployment may lead to higher delinquency and foreclosure rates resulting in higher costs to service loans. The housing market, including home price appreciation rates, impacts sale prices for homes in foreclosure and our borrowers’ ability to refinance or sell their properties in the event that they can no longer afford their homes, thus impacting delinquencies and foreclosures.
     Ancillary fees and income include late charges, non-sufficient funds fees, collection fees and interest earning funds held in deposit. These fees could be impacted by state legislation efforts, customer behavior, fee waiver policies and industry trends.
     During the period from July 31, 2005 to the current quarter ended July 31, 2006, assumptions used in valuing MSRs have been updated. The significant changes and their impact, both in dollars and basis points of loans sold during the quarter of initial implementation, are outlined below beginning with the most recent changes.
             
            (dollars in 000s)
Description   Change   Impact   Quarter Implemented
 
Ancillary fees
  Decreased average number of days of interest collected related to prepayments   ($3,677) or (5) basis points   July 31, 2006
 
           
Discount rate
  15% to 18%   ($2,555) or (3) basis points   January 31, 2006
 
           
Costs to service
  Decreased the number of days of interest paid to investors   $12,893 or
11 basis points
  October 31, 2005
 
     During the quarter ended July 31, 2006, we updated our assumption related to the average number of days of interest collected on funds received as a result of prepayments (Ancillary fees on the table above). We decreased the average number of days of interest collected following a review of the servicing portfolio data. During the quarter ended January 31, 2006, we increased the discount rate assumption (Discount rate on the table above) used to determine the fair value of MSRs from 15% to 18% as a result of an analysis of third party data including rates used by other market participants. During the quarter ended October 31, 2005, we updated our assumption for number of days of interest paid to investors (Costs to service on the table above) on monthly loan prepayments upon the completion of a review of the historical performance of the servicing portfolio. The cumulative net impact of the changes outlined above and other less significant changes made during the period from July 31, 2005 to July 31, 2006 was an increase of approximately 5 basis points for MSRs initially recorded in the current quarter compared to the prior year quarter.
     The changes outlined above are applied not only when we determine the allocated historical cost of MSRs, but are also used in our evaluation of the fair value of the MSR portfolio in conjunction with our impairment review. The changes in assumptions primarily impact the recognition of our initial MSR value through calculation of the gain on sale of mortgage assets. Because MSRs are recorded at LOCOM, we are unable to adjust our MSR portfolio value upward, thus have not recognized the positive impact of the assumption changes on the MSR portfolio as a whole.
     MSRs with a book value of $275.3 million are included in our condensed consolidated balance sheet at July 31, 2006. While changes in any assumption could impact the value of our MSRs, the primary drivers of significant changes to the value of our MSRs are prepayment speeds, discount rates, costs to service and ancillary fees. Below is a table showing the effect of a variation of a particular assumption on the fair value of our MSRs without changing any other assumptions. In reality, changes in one factor may result in changes in another, which might magnify or counteract the sensitivities.
             
 
Assumption   Impact on Fair Value        
 
Prepayments (including defaults):
           
Adverse 10% — % impact on fair value
  (15%)        
Adverse 20% — % impact on fair value
  (26%)        
Discount rate:
           
Adverse 10% — % impact on fair value
  (2%)        
Adverse 20% — %$impact on fair value
  (3%)        
Ancillary Fees and Income:
           
Adverse 10% — %impact on fair value
  (1%)        
Adverse 20% — % impact on fair value
  (5%)        
Costs to service:
           
Adverse 10% — % impact on fair value
  (3%)        
Adverse 20% — % impact on fair value
  (7%)        
 
FORWARD-LOOKING INFORMATION
In this report, and from time to time throughout the year, we share our expectations for our future performance. These forward-looking statements are based upon current information, expectations, estimates and projections regarding the Company, the industries and markets in which we operate, and our assumptions and beliefs at that time. These statements speak only as of the date on which they are made, are not guarantees of future performance, and involve certain risks, uncertainties and assumptions, which are difficult to predict. Therefore, actual outcomes and results could materially differ from what is expressed, implied or forecast in these forward-looking statements. Words such as “believe,” “will,” “plan,” “expect,” “intend,” “estimate,” “approximate,” and similar expressions may identify such forward-looking statements.
RECONCILIATION OF NON-GAAP FINANCIAL INFORMATION
We report our financial results in accordance with generally accepted accounting principles (GAAP). However, we believe certain non-GAAP performance measures and ratios used in managing the business may provide additional meaningful comparisons between current year results and prior periods. Reconciliations to GAAP financial measures are provided below. These non-GAAP financial measures should be viewed in addition to, not as an alternative for, our reported GAAP results.
                 
Origination Margin           (dollars in 000s)  
Three months ended July 31,   2006     2005  
Total expenses
  $ 174,600     $ 174,383  
Add: Expenses netted against gain on sale revenues
    74,594       160,020  
Less:
               
Cost of services
    (78,688 )     (64,392 )
Cost of acquisition
    (40,688 )     (113,010 )
Allocated support departments
    (5,294 )     (4,770 )
Other
    (14,382 )     (7,105 )
 
           
 
  $ 110,142     $ 145,126  
 
           
Divided by origination volume
  $ 7,792,057     $ 10,488,033  
Total cost of origination
    1.41 %     1.38 %

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Banking Ratios   (dollars in 000s)  
Three months ended July 31, 2006        
 
Efficiency Ratio:
       
Total Consumer Financial Services expenses
  $ 116,078  
Less: Interest and non-banking expenses
    (114,744 )
 
     
Non-interest banking expenses
  $ 1,334  
 
     
Total Consumer Financial Services revenues
  $ 108,298  
Less: Non-banking revenues and interest expense
    (104,457 )
 
     
Net interest revenue — banking
  $ 3,841  
 
     
 
    35 %
Net Interest Margin (annualized):
       
Net banking interest revenue
  $ 3,729  
Net banking interest revenue (annualized)
  $ 14,916  
 
     
Divided by average assets
  $ 408,117  
 
     
 
    3.65 %
Return on Average Assets (annualized):
       
Total Consumer Financial Services pretax loss
  $ (7,780 )
Less: Non-banking pretax loss
    8,949  
 
     
Pretax banking income
  $ 1,169  
 
     
Pretax banking income (annualized)
  $ 4,676  
 
     
Divided by average assets
  $ 408,117  
 
     
 
    1.15 %
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
There have been no material changes in our market risks from those reported at April 30, 2006 in our Annual Report on Form 10-K.
ITEM 4. CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
As of the end of the period covered by this Form 10-Q, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures. The controls evaluation was done under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective as of the end of the period covered by this Quarterly Report on Form 10-Q.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
There were no changes that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II — OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The information below should be read in conjunction with the information included in note 10 to our condensed consolidated financial statements.
RAL LITIGATION
We reported in our annual report on Form 10-K for the year ended April 30, 2006, certain events and information regarding lawsuits throughout the country regarding our refund anticipation loan programs (collectively, “RAL Cases”). The RAL Cases have involved a variety of legal theories asserted by plaintiffs. These theories include allegations that, among other things, disclosures in the RAL applications were inadequate, misleading and untimely; the RAL interest rates were usurious and unconscionable; we did not disclose that we would receive part of the finance charges paid by the customer for such loans; untrue, misleading or deceptive statements in marketing RALs; breach of state laws on credit service organizations; breach of contract, unjust enrichment, unfair and

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deceptive acts or practices; violations of the federal Racketeer Influenced and Corrupt Organizations Act; violations of the federal Fair Debt Collection Practices Act and unfair competition with respect to debt collection activities; and that we owe, and breached, a fiduciary duty to our customers in connection with the RAL program.
     The amounts claimed in the RAL Cases have been very substantial in some instances. We have successfully defended against numerous RAL Cases, some of which were dismissed on our motions for dismissal or summary judgment, and others were dismissed voluntarily by the plaintiffs after denial of class certification. Other cases have been settled, with one settlement resulting in a pretax expense of $43.5 million in fiscal year 2003 (the “Texas RAL Settlement”) and other settlements resulting in a combined pretax expense in fiscal year 2006 of $70.2 million (the “2006 Settlements”). During the three months ended July 31, 2006, the 2006 settlements were paid in full.
     We believe we have meritorious defenses to the remaining RAL Cases and we intend to defend them vigorously. There can be no assurances, however, as to the outcome of the pending RAL Cases individually or in the aggregate. Likewise, there can be no assurances regarding the impact of the RAL Cases on our financial statements. We have accrued our best estimate of the probable loss related to the RAL Cases. The following is updated information regarding the pending RAL Cases that are attorney general actions or class actions or putative class actions:
     Lynne A. Carnegie, et al. v. Household International, Inc., H&R Block, Inc., et al., (formerly Joel E. Zawikowski, et al. v. Beneficial National Bank, H&R Block, Inc., Block Financial Corporation, et al.) Case No. 98 C 2178, United States District Court for the Northern District of Illinois, Eastern Division, instituted on April 18, 1998. This case constitutes one of the 2006 Settlements. On April 19, 2006, we entered into a settlement agreement regarding this case, subject to final court approval. The settlement was approved by the court on August 28, 2006.
PEACE OF MIND LITIGATION
Lorie J. Marshall, et al. v. H&R Block Tax Services, Inc., et al., Civil Action 2003L000004, in the Circuit Court of Madison County, Illinois, is a class action case filed on January 18, 2002, that was granted class certification on August 27, 2003. Plaintiffs’ claims consist of five counts relating to the Peace of Mind (POM) program under which the applicable tax return preparation subsidiary assumes liability for additional tax assessments attributable to tax return preparation error. The plaintiffs allege that the sale of POM guarantees constitutes (i) statutory fraud by selling insurance without a license, (ii) an unfair trade practice, by omission and by “cramming” (i.e., charging customers for the guarantee even though they did not request it or want it), and (iii) a breach of fiduciary duty. In August 2003, the court certified the plaintiff classes consisting of all persons who from January 1, 1997 to final judgment (i) were charged a separate fee for POM by “H&R Block” or a defendant H&R Block class member; (ii) reside in certain class states and were charged a separate fee for POM by “H&R Block” or a defendant H&R Block class member not licensed to sell insurance; and (iii) had an unsolicited charge for POM posted to their bills by “H&R Block” or a defendant H&R Block class member. Persons who received the POM guarantee through an H&R Block Premium office and persons who reside in Alabama are excluded from the plaintiff class. The court also certified a defendant class consisting of any entity with names that include “H&R Block” or “HRB,” or are otherwise affiliated or associated with H&R Block Tax Services, Inc., and that sold or sells the POM product. The trial court subsequently denied the defendants’ motion to certify class certification issues for interlocutory appeal. Discovery is proceeding. No trial date has been set.
     There is one other putative class action pending against us in Texas that involves the POM guarantee. This case is being tried before the same judge that presided over the Texas RAL Settlement, involves the same plaintiffs’ attorneys that are involved in the Marshall litigation in Illinois, and contains similar allegations. No class has been certified in this case.
     We believe the claims in the POM actions are without merit, and we intend to defend them vigorously. The amounts claimed in the POM actions are substantial, however, and there can be no assurances as to the outcome of these pending actions individually or in the aggregate. Likewise, there can be no assurances regarding the impact of these actions on our consolidated financial statements.

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EXPRESS IRA LITIGATION
On March 15, 2006, the New York Attorney General filed a lawsuit in the Supreme Court of the State of New York, County of New York (Index No. 06/401110) entitled The People of New York v. H&R Block, Inc. and H&R Block Financial Advisors, Inc. The complaint alleges fraudulent business practices, deceptive acts and practices, common law fraud and breach of fiduciary duty with respect to the Express IRA product. The complaint seeks equitable relief, disgorgement of profits, damages and restitution, civil penalties and punitive damages. A number of civil actions were subsequently filed against us concerning the matter. We intend to defend these cases vigorously, but there are no assurances as to their outcome.
SECURITIES AND SHAREHOLDER DERIVATIVE LITIGATION
Six shareholder derivative actions purportedly brought on behalf of the Company (which is named as a “nominal defendant”) are pending against certain of the Company’s current and former directors and officers. These cases generally involve allegations of breach of fiduciary duty, abuse of control, gross mismanagement, waste and unjust enrichment pertaining to (i) the Company’s restatement of financial results due to errors in determining the Company’s state effective income tax rate and (ii) certain of the Company’s products and other business activities. We intend to defend these cases vigorously, but there are no assurances as to their outcome. These are Hibbard v. H&R Block, Inc., et al., in the United States District Court for the Western District of Missouri, Case No. 06- CV -06059 (instituted on May 16, 2006); Gottlieb v. H&R Block, et al., in the United States District Court for the Western District of Missouri, Case No. 06-CV-00496 (instituted on June 5, 2006); Lebowitz v. H&R Block, et al., in the United States District Court for the Western District of Missouri, Case No. 06-CV-00496 (instituted on June 5, 2006); Staehr v. H&R Block, Inc., et al., in the United States District Court for the Western District of Missouri, Case No. 06- CV-00284 (instituted on April 5, 2006); Momentum Partners v. H&R Block, et al., in the United States District Court for the Western District of Missouri, Case No. 06- CV-00465 (instituted on June 8, 2006); and Iron Workers Local 16 Pension Fund v. H&R Block, et al., in the United States District Court for the Western District of Missouri, Case No. 06- CV-00466 (instituted on June 8, 2006).
     In addition to the shareholder derivative actions, three putative class actions alleging violations of certain securities laws are pending against the Company and certain of its current and former officers and directors. These actions allege, among other things, deceptive, material and misleading financial statements, failure to prepare financial statements in accordance with generally accepted accounting principles and concealment of the potential for lawsuits stemming from the allegedly fraudulent nature of the Company’s operations. The actions seek unspecified damages and equitable relief. We intend to defend these cases vigorously, but there are no assurances as to their outcome. These cases are Nettie v. H&R Block, Inc. and Mark A. Ernst in the United States District Court for the Western District of Missouri, Case No. 06- CV- 0235 (instituted on March 17, 2006); Winters v. H&R Block, Inc., et al., in the United States District Court for the Western District of Missouri, Case No. 06-CV-00243 (instituted on March 20, 2006); and Kadagian v. H&R Block, Inc., et al., in the United States District Court for the Western District of Missouri , Case No. 06-CV-00574 (instituted on March 24, 2006).
OTHER CLAIMS AND LITIGATION
As reported previously, the NASD brought charges against HRBFA regarding the sale by HRBFA of Enron debentures in 2001. A hearing for this matter commenced in May 2006 and was recessed until the fall of 2006. We intend to defend the NASD charges vigorously, although there can be no assurances regarding the outcome and resolution of the matter.
     As part of an industry-wide review, the IRS is investigating tax-planning strategies that certain RSM clients utilized during fiscal years 2000 through 2003. Specifically, the IRS is examining these strategies to determine whether RSM complied with tax shelter reporting and listing regulations and whether such strategies were abusive as defined by the IRS. If the IRS were to determine that RSM did not comply with the tax shelter reporting and listing regulations, it might assess fines or penalties against RSM. Moreover, if the IRS were to determine that the tax planning strategies were inappropriate, clients that utilized the strategies could face penalties and interest for underpayment

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of taxes. Some of these clients are seeking or may attempt to seek recovery from RSM. There can be no assurance regarding the outcome of and resolution of this matter.
     We have from time to time been party to claims and lawsuits not discussed herein arising out of our business operations. These claims and lawsuits include actions by state attorneys general, individual plaintiffs, and cases in which plaintiffs seek to represent a class of similarly situated customers. The amounts claimed in these claims and lawsuits are substantial in some instances, and the ultimate liability with respect to such litigation and claims is difficult to predict. Some of these claims and lawsuits pertain to RALs, the electronic filing of customers’ income tax returns, the POM guarantee program, business valuation services and our Express IRA program. We believe we have meritorious defenses to each of these claims, and we are defending or intend to defend them vigorously, although there is no assurance as to their outcome.
     In addition to the aforementioned types of cases, we are parties to claims and lawsuits that we consider to be ordinary, routine litigation incidental to our business, including claims and lawsuits (Other Claims) concerning investment products, the preparation of customers’ income tax returns, the fees charged customers for various products and services, losses incurred by customers with respect to their investment accounts, relationships with franchisees, denials of mortgage loans, contested mortgage foreclosures, other aspects of the mortgage business, intellectual property disputes, employment matters and contract disputes. We believe we have meritorious defenses to each of the Other Claims, and we are defending them vigorously. While we cannot provide assurance that we will ultimately prevail in each instance, we believe the amount, if any, we are required to pay in the discharge of liabilities or settlements in these Other Claims will not have a material adverse effect on our consolidated financial statements.
ITEM 1A. RISK FACTORS
Consumer Financial Services. H&R Block, Inc. is a savings and loan holding company, and HRB Bank is a federal savings bank, which is subject to regulation by the OTS and FDIC. Federal and state laws and regulations govern numerous matters including: changes in the ownership or control of banks and bank holding companies; maintenance of adequate capital and the financial condition of a financial institution; permissible types, amounts and terms of extensions of credit and investments; permissible non-banking activities; the level of reserves against deposits; and restrictions on dividend payments. If we do not comply with these regulations, it could result in regulatory actions and negative publicity, which could adversely affect our results of operations.
     Other than the item discussed above, there have been no material changes in our risk factors from those reported at April 30, 2006 in our Annual Report on Form 10-K.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES
A summary of our purchases of H&R Block common stock during the first quarter of fiscal year 2007 is as follows:
                                 
(shares in 000s)  
                    Total Number of Shares     Maximum Number  
      Total     Average     Purchased as Part of     of Shares that May  
      Number of Shares     Price Paid     Publicly Announced     Be Purchased Under  
      Purchased (1)     per Share     Plans or Programs (2)     the Plans or Programs (2)  
 
May 1 - May 31
    6,633     $ 22.02     6,633     3,862  
June 1 - June 30
    158     $ 22.92     156     23,706  
July 1 - July 31
    1,579     $ 23.21     1,354     22,352  
 
(1)   We purchased 227,344 shares in connection with the funding of employee income tax withholding obligations arising upon the exercise of stock options or the lapse of restrictions on nonvested shares.
 
(2)   On June 9, 2004, our Board of Directors approved the repurchase of 15.0 million shares of H&R Block, Inc. common stock. On June 7, 2006, our Board approved an additional authorization to repurchase 20.0 million shares. These authorizations have no expiration date.

-38-


Table of Contents

ITEM 6. EXHIBITS
10.1   Description of Executive Officer Compensation.
10.2   Omnibus Amendment Number Three to the Option One Owner Trust 2005-6 Warehouse Facility dated as of June 29, 2006, among Option One Owner Trust 2005-6, Option One Loan Warehouse Corporation, Option One Mortgage Corporation, Wells Fargo Bank, N. A. and Lehman Brothers Bank.
31.1   Certification by Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2   Certification by Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1   Certification by Chief Executive Officer furnished pursuant to 18 U.S.C. 1350, as adopted by Section 906 of the Sarbanes-Oxley Act of 2002.
32.2   Certification by Chief Financial Officer furnished pursuant to 18 U.S.C. 1350, as adopted by Section 906 of the Sarbanes-Oxley Act of 2002.

-39-


Table of Contents

SIGNATURES
     Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
     
 
  H&R BLOCK, INC.
 
  -s- Mark A. Ernst
 
  Mark A. Ernst
 
  Chairman of the Board, President
 
  and Chief Executive Officer
 
  September 11, 2006
 
   
 
  -s- William L. Trubeck
 
  William L. Trubeck
 
  Executive Vice President and
 
  Chief Financial Officer
 
  September 11, 2006
 
   
 
  -s- Jeffrey E. Nachbor
 
  Jeffrey E. Nachbor
 
  Senior Vice President and
 
  Corporate Controller
 
  September 11, 2006

-40-

exv10w1
 

Exhibit 10.1
SUMMARY SHEET FOR
EXECUTIVE OFFICER COMPENSATION
Annual Incentive (Short-Term) Compensation Earned in Fiscal 2006
The amounts of the short-term incentive compensation awards for the Company’s Named Executive Officers (as defined in Item 402(a)(3) of Regulation S-K) for the fiscal year ended April 30, 2006 were as follows:
             
Name   Position   Award  
 
           
Mark A. Ernst
  Chairman of the Board, President and Chief Executive Officer     *        
William L. Trubeck
  Executive Vice President and Chief Financial Officer   $ 185,000  
Robert E. Dubrish
  President and Chief Executive Officer, Option One Mortgage Corporation     75,000  
Steven Tait
  President, RSM McGladrey Business Services, Inc.     300,000  
Nicholas J. Spaeth
  Senior Vice President and Chief Legal Officer     93,000  
*   Although Mr. Ernst earned a short-term incentive award under the Company’s short-term incentive compensation programs for the fiscal year ended April 30, 2006, he declined such award.
Long-Term Incentive Compensation Awarded in Fiscal 2007
Long-term incentive compensation awards under the Company’s 2003 Long-Term Executive Compensation Plan were granted on June 30, 2006 to the Named Executive Officers in the following amounts:
                 
    Securities     Performance
Name   Underlying Options   Shares
 
               
Mark A. Ernst
    376,885       33,335  
William L. Trubeck
    125,000       15,000  
Robert E. Dubrish
    125,000       15,000  
Steven Tait
    100,000       10,000  
Nicholas J. Spaeth
    55,000       6,000  
The stock options vest in equal annual installments over three years following the date of grant. The performance shares vest after three years, subject to pre-established performance objectives based on the Company’s total shareholder return as measured against a broad market index and/or cumulative financial performance tied to specific business responsibilities. The actual number of performance shares an executive will receive will vary based on actual performance against the pre-established performance objectives, with the maximum number of shares received being one and one-half times the target award amount and the minimum number of shares received being one-half of the target award amount. The grant of stock options and performance shares will be made pursuant to the terms of the 2003 Long-Term Executive Compensation Plan.

 


 

Fiscal 2007 Base Salary Increases
The following table sets for the annual base salaries of the Named Executive Officers for fiscal years 2006 and 2007:
                 
Name   2006     2007  
 
               
Mark A. Ernst
  $ 860,000     $ 860,000 *
William L. Trubeck
    463,500       475,000  
Robert E. Dubrish
    490,000       500,000  
Steven Tait
    425,000       465,000  
Nicholas J. Spaeth
    412,000       412,000  
* Mr. Ernst declined an increase in base salary for the fiscal year ended April 30, 2007.
Performance Criteria for Fiscal 2007 Short-Term Incentive Compensation
The Company’s short-term incentive compensation is based upon annual financial targets tied to business unit or overall corporate results. Fiscal year 2007 performance criteria will vary among business segments, but generally will consist of the following: (i) diluted earnings per share growth; (ii) business segment pre-tax earnings growth; (iii) revenue unit growth; and (iv) improved cost-of-service performance. Participants in the Company’s short-term incentive programs can earn more or less than the target award (from 0% to 200% of the target award) depending upon how actual results compare to the pre-established performance targets.

 

exv10w2
 

Exhibit 10.2
OMNIBUS AMENDMENT NUMBER THREE
to the
OPTION ONE OWNER TRUST 2005-6 WAREHOUSE FACILITY
          This OMNIBUS AMENDMENT NUMBER THREE (this “Amendment”) is made and is effective as of this 29th day of June, 2006, among Option One Owner Trust 2005-6 as issuer (the “Issuer”), Option One Loan Warehouse Corporation as depositor (the “Depositor”), Option One Mortgage Corporation as loan originator and servicer (“Option One”), Wells Fargo Bank, N.A. as indenture trustee (the “Indenture Trustee”) and Lehman Brothers Bank as noteholder agent and purchaser (“Lehman Brothers”) to (i) the Note Purchase Agreement, dated as of June 1, 2005 (as amended, supplemented or otherwise modified from time to time, the “Note Purchase Agreement”), among the Issuer, the Depositor and Lehman Brothers, (ii) the Sale and Servicing Agreement, dated as of June 1, 2005 (as amended, supplemented or otherwise modified from time to time, the “Sale and Servicing Agreement”), among the Issuer, the Depositor, Option One and the Indenture Trustee, (iii) the Indenture, dated as of June 1, 2005 (as amended, supplemented or otherwise modified from time to time, the “Indenture”), among the Issuer and the Indenture Trustee and (iv) the Pricing Letter, dated as of June 1, 2005 (as amended, supplemented or otherwise modified from time to time, the “Pricing Letter” and collectively with the Note Purchase Agreement, the Sale and Servicing Agreement and the Indenture, the “Transaction Documents”), among the Issuer, the Depositor, Option One and the Indenture Trustee.
RECITALS
          WHEREAS, the parties have previously entered into the Transaction Documents; and
          NOW THEREFORE, for good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, and of the mutual covenants herein contained, the parties hereto hereby agree as follows:
          SECTION 1. Defined Terms. Capitalized terms used but not defined herein shall have the meanings ascribed to such terms in the Transaction Documents.
          SECTION 2. Amendment to Pricing Letter.
     (a) Subsection (4) of the definition of “Collateral Value” in the Section 1 of the Pricing Letter is hereby amended by deleting “1%” and replacing it with “5%” such that it reads as follows:
     ”(4) which is more than 150 days past its date of origination, provided, however that up to 5% of the Pool Principal Balance may be between 150-240 days past the date of origination;”

1


 

     (b) The definition of “Collateral Value” in the Section 1 of the Pricing Letter is hereby amended by deleting in its entirety subsection (A)(iv) relating to High LTV Loans and replacing it with the following:
     ”(iv) The weighted average CLTV of the aggregate outstanding Principal Balance of Mortgage Loans may not at any time exceed 90%.”
     (c) Subsection (A)(vi) of the definition of “Collateral Value” in the Section 1 of the Pricing Letter is hereby amended by deleting “15%” and replacing it with “10%.”
     (d) Subsection (A)(xi) of the definition of “Collateral Value” in the Section 1 of the Pricing Letter is hereby amended by deleting “1%” and replacing it with “3%.”
     (e) The term “High LTV Loans” in Section 1 of the Pricing Letter is hereby deleted in its entirety.
          SECTION 3. Amendment to Sale and Servicing Agreement.
     (a) The definition of “Defaulted Loan” in Section 1.01 of the Sale and Servicing Agreement is hereby deleted in its entirety and replaced with the following:
     “Defaulted Loan: With respect to any Determination Date, any Loan, including, without limitation, any Liquidated Loan with respect to which any of the following has occurred as of the end of the related Remittance Period: (a) foreclosure or similar proceedings have been commenced; or (b) the Servicer or any Subservicer has determined in good faith and in accordance with the servicing standard set forth in Section 4.01 of the Servicing Addendum that such Loan is in default.”
     (b) The definition of “QSPE Affiliate” in Section 1.01 of the Sale and Servicing Agreement is hereby deleted in its entirety and replaced with the following:
     “QSPE Affiliate: Any of Option One Owner Trust 2001-1A, Option One Owner Trust 2001-1B, Option One Owner Trust 2002-3, Option One Owner Trust 2003-4, Option One Owner Trust 2003-5, Option One Owner Trust 2005-6, Option One Owner Trust 2005-7, Option One Owner Trust 2005-8, Option One Owner Trust 2005-9 or any other Affiliate which is a “qualified special purpose entity” in accordance with Financial Accounting Standards Board’s Statement No. 140 or 125.”
     (c) The definition of “Revolving Period” in Section 1.01 of the Sale and Servicing Agreement is hereby deleted in its entirety and replaced with the following:
     “Revolving Period: With respect to the Notes, the period commencing on June 29, 2006 and ending on the earlier of (i) 364 days after such date and (ii) the date on which the Revolving Period is terminated pursuant to Section 2.07.”

2


 

     (d) Section 2.07 of the Sale and Servicing Agreement is hereby amended by deleting it in entirety and replacing it with the following:
     “Upon the occurrence of (i) an Event of Default or Default or (ii) the Unfunded Transfer Obligation Percentage equals 4% or less or (iii) Option One or any of its Affiliates shall default under, or fail to perform as requested under, or shall otherwise materially breach the terms of any repurchase agreement, loan and security agreement or similar credit facility or agreement entered into by Option One or any of its Affiliates, including without limitation, the Sale and Servicing Agreement, dated as of April 1, 2001, among the Option One Owner Trust 2001-1A, the Depositor, Option One and the Indenture Trustee, the Sale and Servicing Agreement, dated as of April 1, 2001, among the Option One Owner Trust 2001-1B, the Depositor, Option One and the Indenture Trustee, the Sale and Servicing Agreement, dated as of July 2, 2002, among the Option One Owner Trust 2002-3, the Depositor, Option One and the Indenture Trustee, the Sale and Servicing Agreement, dated as of August 8, 2003, among the Option One Owner Trust 2003-4, the Depositor, Option One and the Indenture Trustee, the Sale and Servicing Agreement, dated as of September 1, 2005, among Option One Owner Trust 2005-7, the Depositor, Option One and the Indenture Trustee, the Sale and Servicing Agreement, dated as of October 1, 2005 among Option One Owner Trust 2005-8, the Depositor, Option One and the Indenture Trustee and the Sale and Servicing Agreement, dated as of December 30, 2005 among Option One Owner Trust 2005-9, the Depositor, Option One and the Indenture Trustee and such default, failure or breach shall entitle any counterparty to declare the Indebtedness thereunder to be due and payable prior to the maturity thereof. The Initial Noteholder may, in any such case, in its sole discretion, terminate the Revolving Period.”
          SECTION 4. Amendment to Note Purchase Agreement.
     (a) Section 2.02 of the Note Purchase Agreement is hereby deleted in its entirety and replaced with the following:
          “SECTION 2.02 Closing. The closing (the “Closing”) of the execution of the Basic Documents and issuance of the Notes shall take place at 10:00 a.m. at the offices of Thacher Proffitt & Wood, Two World Financial Center, New York, New York 10281, or if the conditions to closing set forth in Article IV of this Note Purchase Agreement shall not have been satisfied or waived by such date, as soon as practicable after such conditions shall have been satisfied or waived, or at such other time, date and place as the parties shall agree upon.”
          SECTION 5. Representations. To induce Lehman to execute and deliver this Amendment, each of the Issuer and the Depositor hereby jointly and severally represents to Lehman Brothers that as of the date hereof, after giving effect to this Amendment, (a) all of its respective representations and warranties in the Basic Documents are true and correct, and (b) it is otherwise in full compliance with all of the terms and conditions of the Basic Documents.

3


 

          SECTION 6. Fees and Expenses. The Issuer and the Depositor jointly and severally covenant to pay as and when billed by Lehman all of the reasonable out-of-pocket costs and expenses incurred in connection with the transactions contemplated hereby and in the other Basic Documents including, without limitation, (i) all reasonable fees, disbursements and expenses of counsel to Lehman Brothers, (ii) all reasonable fees and expenses of the Indenture Trustee and Owner Trustee and their counsel and (iii) all reasonable fees and expenses of the Custodian and its counsel.
          SECTION 7. Limited Effect. Except as expressly amended and modified by this Amendment, the Transaction Documents shall continue in full force and effect in accordance with its terms. Reference to this Amendment need not be made in any of the Transaction Documents or any other instrument or document executed in connection therewith, or in any certificate, letter or communication issued or made pursuant to, or with respect to, the Transaction Documents, any reference in any of such items to the Transaction Documents being sufficient to refer to the Transaction Documents as amended hereby.
          SECTION 8. GOVERNING LAW. THIS AMENDMENT SHALL BE GOVERNED BY AND CONSTRUED IN ACCORDANCE WITH THE LAWS OF THE STATE OF NEW YORK, WITHOUT REGARD TO THE CONFLICT OF LAWS DOCTRINE APPLIED IN SUCH STATE.
          SECTION 9. Counterparts. This Amendment may be executed by each of the parties hereto in any number of separate counterparts, each of which when so executed shall be an original and all of which taken together shall constitute one and the same instrument.
          SECTION 10. Limitation on Liability. It is expressly understood and agreed by the parties hereto that (a) this Amendment is executed and delivered by Wilmington Trust Company, not individually or personally, but solely as Owner Trustee of Option One Owner Trust 2005-6 in the exercise of the powers and authority conferred and vested in it, (b) each of the representations, undertakings and agreements herein made on the part of the Issuer is made and intended not as personal representations, undertakings and agreements by Wilmington Trust Company but is made and intended for the purpose for binding only the Issuer, (c) nothing herein contained shall be construed as creating any liability on Wilmington Trust Company, individually or personally, to perform any covenant either expressed or implied contained herein, all such liability, if any, being expressly waived by the parties hereto and by any Person claiming by, through or under the parties hereto and (d) under no circumstances shall Wilmington Trust Company be personally liable for the payment of any indebtedness or expenses of the Issuer or be liable for the breach or failure of any obligation, representation, warranty or covenant made or undertaken by the Issuer under this Amendment or any other related documents.

4


 

          IN WITNESS WHEREOF, the parties hereto have caused this Amendment to be executed and delivered by their duly authorized officers as of the day and year first above written.
         
  OPTION ONE OWNER TRUST 2005-6
 
  By: Wilmington Trust Company, not in its
individual capacity but solely as owner
trustee
 
 
  By:   /s/ Jeanne M. Oiler    
    Name:   Jeanne M. Oiler   
    Title:   Senior Financial Services Officer   
 
  OPTION ONE LOAN WAREHOUSE CORPORATION
 
 
  By:      
    Name:      
    Title:      
 
  OPTION ONE MORTGAGE CORPORATION
 
 
  By:      
    Name:      
    Title:      
 
  WELLS FARGO BANK, N.A.
 
 
  By:      
    Name:      
    Title:      
 
  LEHMAN BROTHERS BANK
 
 
  By:      
    Name:      
    Title:      

 


 

         
          IN WITNESS WHEREOF, the parties hereto have caused this Amendment to be executed and delivered by their duly authorized officers as of the day and year first above written.
         
  OPTION ONE OWNER TRUST 2005-6
 
 
       
  By: Wilmington Trust Company, not in its
individual capacity but solely as owner
trustee
 
 
  By:      
    Name:      
    Title:      
 
  OPTION ONE LOAN WAREHOUSE CORPORATION
 
 
  By:   /s/ Philip Laren    
    Name:   Philip Laren   
    Title:   Vice President   
 
  OPTION ONE MORTGAGE CORPORATION
 
 
  By:   /s/ Philip Laren    
    Name:   Philip Laren   
    Title:   Senior Vice President   
 
  WELLS FARGO BANK, N.A.
 
 
  By:      
    Name:      
    Title:      
 
  LEHMAN BROTHERS BANK
 
 
  By:      
    Name:      
    Title:      

 


 

         
          IN WITNESS WHEREOF, the parties hereto have caused this Amendment to be executed and delivered by their duly authorized officers as of the day and year first above written.
         
  OPTION ONE OWNER TRUST 2005-6
 
 
       
  By: Wilmington Trust Company, not in its
individual capacity but solely as owner
trustee
 
 
  By:      
    Name:      
    Title:      
 
  OPTION ONE LOAN WAREHOUSE CORPORATION
 
 
  By:      
    Name:      
    Title:      
 
  OPTION ONE MORTGAGE CORPORATION
 
 
  By:      
    Name:      
    Title:      
 
  WELLS FARGO BANK, N.A.
 
 
  By:   /s/ Reid Denny    
    Name:   Reid Denny    
    Title:   Vice President   
 
  LEHMAN BROTHERS BANK
 
 
  By:      
    Name:      
    Title:      
 

 


 

         
          IN WITNESS WHEREOF, the parties hereto have caused this Amendment to be executed and delivered by their duly authorized officers as of the day and year first above written.
         
  OPTION ONE OWNER TRUST 2005-6
 
       
  By: Wilmington Trust Company, not in its
individual capacity but solely as owner
trustee
 
 
  By:      
    Name:      
    Title:      
 
  OPTION ONE LOAN WAREHOUSE CORPORATION
 
 
  By:      
    Name:      
    Title:      
 
  OPTION ONE MORTGAGE CORPORATION
 
 
  By:      
    Name:      
    Title:      
 
  WELLS FARGO BANK, N.A.
 
 
  By:      
    Name:      
    Title:      
 
  LEHMAN BROTHERS BANK
 
 
  By:   /s/ Fred Madonne    
    Name:   Fred Madonne   
    Title:   Authorized Signature   
 

 

exv31w1
 

Exhibit 31.1
CERTIFICATION PURSUANT TO
SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002
I, Mark A. Ernst, Chief Executive Officer, certify that:
1. I have reviewed this quarterly report on Form 10-Q of H&R Block, Inc.;
2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:
(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
(b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principals;
(c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
(d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and
5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):
a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.
         
     
Date: September 11, 2006  /s/ Mark A. Ernst    
  Mark A. Ernst   
  Chief Executive Officer
H&R Block, Inc. 
 
 

exv31w2
 

Exhibit 31.2
CERTIFICATION PURSUANT TO
SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002
I, William L. Trubeck, Chief Financial Officer, certify that:
1. I have reviewed this quarterly report on Form 10-Q of H&R Block, Inc.;
2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:
(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
(b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principals;
(c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
(d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and
5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):
a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.
         
     
Date: September 11, 2006  /s/ William L. Trubeck    
  William L. Trubeck   
  Chief Financial Officer
H&R Block, Inc. 
 
 

exv32w1
 

Exhibit 32.1
CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
     In connection with the quarterly report of H&R Block, Inc. (the “Company”) on Form 10-Q for the period ending July 31, 2006 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Mark A. Ernst, Chief Executive Officer of the Company, certify pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that:
  (1)   The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and
 
  (2)   The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.
         
     
  /s/ Mark A. Ernst    
  Mark A. Ernst   
  Chief Executive Officer
H&R Block, Inc. 
September 11, 2006
 
 

exv32w2
 

Exhibit 32.2
CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
     In connection with the quarterly report of H&R Block, Inc. (the “Company”) on Form 10-Q for the period ending July 31, 2006 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, William L. Trubeck, Chief Financial Officer of the Company, certify pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that:
  (1)   The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and
 
  (2)   The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.
         
     
  /s/ William L. Trubeck    
  William L. Trubeck   
  Chief Financial Officer
H&R Block, Inc. 
September 11, 2006