FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D. C. 20549

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2005

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 1-6402-1

713-522-5141

(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 and (2) has been subject to the filing requirements for the past 90 days.

YES þ		NO o

Indicate by check mark whether the registrant is an accelerated filer (as defined in the Securities Exchange Act of 1934 Rule 12b-2).

YES þ		NO 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 as of October 7, 2005 was 298,148,297 (net of treasury shares).

 

 

SERVICE CORPORATION INTERNATIONAL

INDEX

			Page
Part I. Financial Information
Item 1. Financial Statements
Unaudited Condensed Consolidated Statement of Operations - Three and Six Months Ended June 30, 2005 and 2004			3
Unaudited Condensed Consolidated Balance Sheet - June 30, 2005 and December 31, 2004			4
Unaudited Condensed Consolidated Statement of Cash Flows - Six Months Ended June 30, 2005 and 2004			5
Unaudited Condensed Consolidated Statement of Stockholders’ Equity - Six Months Ended June 30, 2005			6
Notes to Unaudited Condensed Consolidated Financial Statements			7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Introduction			30
Our Competitive Strengths			31
Business Challenges			31
The Path to Growth			32
Near-Term Revenue Growth Opportunities			33
Long-Term Revenue Growth Opportunities			34
Critical Accounting Policies and Accounting Changes			35
Results of Operations – Three Months Ended June 30, 2005 and 2004			39
Comparable Results of Operations – Three Months Ended June 30, 2005 and 2004			41
Results of Operations – Six Months Ended June 30, 2005 and 2004			44
Comparable Results of Operations – Six Months Ended June 30, 2005 and 2004			46
Financial Condition, Liquidity and Capital Resources			49
Preneed Funeral and Cemetery Activities			51
Cautionary Statement on Forward-Looking Statements			59
Item 3. Quantitative and Qualitative Disclosures about Market Risk			60
Item 4. Controls and Procedures			61
Part II. Other Information
Item 1. Legal Proceedings			66
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities			66
Item 4. Submission of Matters to a Vote of Security Holders			67
Item 6. Exhibits			68
Signature			69
Agreement of Resignation, Appointment of Acceptance dated 12/12/2005
Agreement of Resignation, Appointment of Acceptance dated 12/12/2005
Ratio of Earnings to Fixed Charges for six months
Certification of PEO pursuant to Section 302
Certification of PFO pursuant to Section 302
Certification of PEO pursuant to Section 906
Certification of PFO pursuant to Section 906

PART I. FINANCIAL INFORMATION

(See notes to unaudited condensed consolidated financial statements)

(See notes to unaudited condensed consolidated financial statements)

(See notes to unaudited condensed consolidated financial statements)

SERVICE CORPORATION INTERNATIONAL

     However, in light of the material impact of the errors identified in the second quarter of 2005, as detailed below under “Current Period Restatement”, the Company concluded that prior period financial statements for the fiscal years ended 2004, 2003 and 2002 should be restated and has corrected such prior periods for the $416 net impact to Other operating (expense) income described above. Please refer to the Company’s 2004 Form 10-K/A (Amendment No. 2) for details related to the impacts of this restatement on the Company’s consolidated statements for each of the five years ended December 31, 2004; all four interim periods of 2004; and all four interim periods of 2003.

Current Period Restatement

Preneed Funeral and Cemetery Trust Verification and Reconciliation Project

During 2003, the Company began implementation of the revised Financial Accounting Standards Board (FASB) Interpretation No. 46, “ Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin (ARB) No. 51 ” (FIN 46R), the preparation for the implementation of Section 404 of the Sarbanes Oxley Act, and the implementation of its new funeral and cemetery point-of-sale system. As a result of these events, the Company began a project to reconcile its preneed funeral and cemetery trust accounts and verify its preneed funeral and preneed cemetery contracts.

     The preneed funeral and cemetery trust verification and reconciliation project included three primary components: (1) the reconciliation of assets and deferred revenue related to preneed cemetery merchandise and service trusts; preneed funeral merchandise and service trusts; and cemetery perpetual care trusts, (2) the verification of approximately 430,000 preneed funeral contracts to determine if those contracts were appropriately included in the Company’s new point-of-sale system, and (3) the verification of each individual item on each preneed cemetery contract (approximately 3.6 million contract items) to determine if revenue was appropriately recognized at the time of delivery or at the time of service.

     As these projects progressed, the Company assessed their status and adjusted the applicable general ledger accounts accordingly. At December 31, 2003, June 30, 2004, and December 31, 2004, the Company made certain adjustments to its consolidated financial statements based on its best estimates at that time. These adjustments were based on statistical sampling methods which were influenced by the percentage of reconciliations and verifications completed at the location level and the expected error rate of such uncompleted verifications and reconciliations. Please see the Company’s 2004 Form 10-K/A (Amendment No. 2) for additional information related to the history of these projects.

     By March 2005, the Company completed its examination of the 430,000 preneed funeral contracts and had also implemented the reconciliation procedures described above, which resulted in the identification of a significant number of reconciling items. In light of these reconciling items, the Company reevaluated previous adjustments related to these projects and the impact to previously issued financial statements. The Company determined that these adjustments had a material impact on its consolidated financial statements for the first three interim periods of 2004. As a result, the Company restated its unaudited quarterly financial data for the first three interim periods of 2004 in its original 2004 Form 10-K. The Company evaluated the materiality of these adjustments on its consolidated financial statements issued prior to January 1, 2004 and concluded that the impact of these adjustments was not material to the fiscal period ended 2004 or any quarterly or annual period prior to January 1, 2004. As a result, the Company recorded the net aggregate effect of these adjustments ($416 increase to pretax income) in Other operating income (expense) in its restated first quarter 2004 financial statements as a correction of an error.

During the first and second quarters of 2005, the Company continued to find and record these reconciling items to its trust asset and deferred revenue detailed records. During the second quarter of 2005, the Company determined that certain of the reconciling items had been reflected improperly in its initial reconciliation process at December 31, 2004 which resulted in the identification of errors to the Company’s consolidated financial statements. The Company previously recorded a $1,600 charge in its first quarter 2005 consolidated financial statements for similar prior period adjustments arising from the aforementioned reconciliation process.

Also during the second quarter of 2005, the Company identified other adjustments, one of which related to a point-of-sale system error that caused preneed funeral trust income accounts to be understated in the fourth quarter of 2004 and the first quarter of 2005 by $1,570 and $2,700, respectively, and another

of which related to the recognition of a loss on a disposition recorded in April 2005 that should have been recognized in the Company’s first quarter 2005 unaudited consolidated financial statements. In addition, in connection with the asset divestitures, the Company did not write off certain covenant-not-to-compete agreements, which should have been recorded in the Company’s 2002 consolidated financial statements.

Additionally, the Company adjusted its method of accounting for certain types of operating leases related primarily to the Company’s funeral home properties. Historically, the Company recorded operating lease expense, related primarily to funeral home properties, over the initial lease term without regard to reasonably assured renewal options or fixed escalation provisions. The Company now calculates its straight-line operating lease expense over the lease term (including certain renewal options and fixed escalation provisions, to the extent necessary) in accordance with SFAS 13, “ Accounting for Leases ”.

Materiality Assessment

The Company evaluated the materiality of these adjustments (including the $1,600 charge recorded in the first quarter 2005 and the adjustments aggregating to $416 associated with the restatement of the first three interim periods of 2004 described above) on its consolidated financial statements for the second quarter of 2005, its unaudited quarterly financial statements for 2004 and 2003, and for each of the five prior annual periods ended December 31, 2004. The Company determined that the net effect of these adjustments ($5,192 charge to pretax income), which primarily relate to periods prior to 2000, is not material to the Company’s previously reported consolidated financial statements for periods described above; however, the Company determined that such impact is material to the Company’s second quarter 2005 consolidated financial statements. As a result, the Company has restated its consolidated statements of operations for the three and six months ended June 30, 2004, its consolidated statement of cash flows for the six months ended June 2004, and its consolidated balance sheet at December 31, 2004.

     As discussed above, the quarterly financial statements for the three and six months ended June 30, 2004 have been further restated in connection with the restatement. We have also reflected the effects of this restatement in notes four, seven, eight, ten, eleven, and twelve. The effect of the adjustments to the Company’s consolidated statement of operations for the three and six months ended June 30, 2004 is as follows:

The effect of the restatement on the Company’s previously reported consolidated balance sheet as of December 31, 2004 is as follows:

3. Summary of Significant Accounting Policies

Principles of Consolidation and Basis of Presentation

The consolidated financial statements for the three and six months ended June 30, 2005 and 2004 include the accounts of the Company and all majority-owned subsidiaries and are unaudited but include all adjustments, consisting of normal recurring accruals and any other adjustments, which management considers necessary for a fair presentation of the results for these periods. These consolidated financial statements have been prepared in a manner consistent with the accounting policies described in the Company’s annual report on Form 10-K, as amended, for the year ended December 31, 2004, unless otherwise disclosed herein, and should be read in conjunction therewith. The accompanying year-end consolidated balance sheet was derived from the audited consolidated financial statements but does not include all disclosures required by accounting principles generally accepted in the United States of America. Operating results for interim periods are not necessarily indicative of the results that may be expected for the full year period.

     The Company has reclassified certain prior year amounts to conform to the current period financial presentation with no effect on previously reported results of operations, financial condition or cash flows.

Use of Estimates in the Preparation of Financial Statements

The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that may affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of expenses during the reporting period. As a result, actual results could differ from these estimates.

     The effective tax rate in the three months ended June 30, 2005 was an expense of 42.5% compared to a benefit of 403.5% in the three months ended June 30, 2004. The effective tax rate in the first six months of 2005 was an expense of 37.4% compared to a benefit of 14.3% in the first six months of 2004. The unusual tax rates in 2005 were negatively impacted by permanent differences between book and tax bases of North American asset dispositions. The unusual tax rates in 2004 are due to non-cash tax benefits recognized from the disposition of the Company’s French operations consummated in the first quarter of 2004 and the sale of the Company’s equity investment in a United Kingdom company in the second quarter of 2004. For more information regarding these transactions, see note twelve to the consolidated financial statements.

4. Accounting Changes and New Accounting Pronouncements

Accounting Changes and Error Corrections

In May 2005, the FASB issued Statement No. 154, “ Accounting Changes and Error Corrections – A Replacement of APB Opinion No. 20 and FASB Statement No. 3 ” (SFAS 154). SFAS 154 primarily requires retrospective application to prior period financial statements for the direct effects of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005.

Deferred Selling Costs

Effective January 1, 2005, the Company changed its method of accounting for direct selling costs related to the acquisition of preneed funeral and preneed cemetery contracts. Prior to this change, the Company capitalized such direct selling costs and amortized these deferred selling costs in proportion to the revenue recognized. Under the new method of accounting, the Company expenses these direct selling costs as incurred. The Company believes the new method is preferable because it better reflects the economics of the Company’s business.

     As of January 1, 2005, the Company recorded a cumulative effect of $187,538, net of tax of $117,428. This amount represents the cumulative balance of deferred selling costs recorded on the Company’s consolidated balance sheet in Deferred charges and other assets at the time of the accounting change. If the Company had not changed its method of accounting for direct selling costs as described above, net income for the three months ended June 30, 2005 would have been approximately $2,594 after tax, or $.01 per basic and diluted share higher than currently reported. If the Company had not changed its method of accounting for direct selling costs as described above, net income for the six months ended June 30, 2005 would have been approximately $4,890 after tax, or $.02 per basic and diluted share higher than currently reported.

     The three and six months ended June 30, 2004 pro forma amounts in the table below reflect the new policy to expense selling costs as incurred. The effect of the change for the three months ended June 30, 2004 would have decreased net income from continuing operations approximately $4,035 after tax, or $.02 per diluted share. The effect of the change for the six months ended June 30, 2004 would have decreased net income from continuing operations before cumulative effects of accounting changes by approximately $6,883 after tax, or $.02 per diluted share.

Other-Than-Temporary Impairments

In June 2005, the FASB decided not to provide additional guidance on the meaning of other-than-temporary impairment, and directed the staff to issue proposed FSP EITF 03-1-a, Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1 , as final. The final FSP will supersede EITF Issued No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments , and EITF Topic No. D-44, Recognition of Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value . The final FSP (retitled FSP FAS 115-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments ) will replace the guidance set forth in paragraphs 10-18 of EITF Issue 03-1 with references to existing other-than-temporary impairment guidance. FSP FAS 115-1 will codify the guidance set forth in EITF Topic D-44 and clarify that an investor should recognize an impairment loss no later than when the impairment is deemed other-than- temporary, even if a decision to sell has not been made. FSP FAS 115-1 will be effective for other-than-temporary analysis conducted in periods beginning after September 15, 2005. The Company does not expect this statement to have a material impact on its consolidated financial statements, results of operations, financial position, or cash flows.

Inventory Costs

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs – an amendment of ARB 43, Chapter 4” (SFAS 151). SFAS 151 amends the guidance in Accounting Research Bulletin (ARB) No. 43, Chapter 4, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material. SFAS 151 requires that those items be recognized as current-period charges, rather than as a portion of the inventory cost. In addition, SFAS 151 requires that allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities. SFAS 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company does not expect this statement to have a material impact on its consolidated financial statements, results of operations, financial position, or cash flows.

Income Taxes

In December 2004, the FASB issued Staff Position No. FAS 109-2 “ Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004 ” (FAS 109-2). The American Jobs Creation Act of 2004 (Jobs Act), enacted on October 22, 2004, provides for a temporary 85% dividends-received deduction on certain foreign earnings repatriated to a U.S. taxpayer, provided certain criteria are met. FAS 109-2 provides accounting and disclosure guidance for the repatriation

provision, and was effective immediately upon issuance. The Company has adopted the provisions of FAS 109-2. The Company has evaluated the repatriation provisions of the Jobs Act, and does not expect to repatriate earnings in the foreseeable future.

Share-Based Payment

In December 2004, the FASB issued SFAS No. 123R, “ Share-Based Payment ” (SFAS 123R). SFAS 123R is a revision of SFAS No. 123, “ Accounting for Stock-Based Compensation ”, and supersedes APB Opinion No. 25, “ Accounting for Stock Issued to Employees ”. Among other items, SFAS 123R eliminates the use of the intrinsic value method of accounting, and requires companies to recognize the cost of employee services received in exchange for awards of equity instruments, based on the grant date fair value of those awards, in the financial statements. The effective date of SFAS 123R is the first annual reporting period beginning after June 15, 2005, which is the first quarter of 2006 for the Company.

     The Company currently uses the intrinsic value method to account for stock options. For disclosure purposes, the Company currently utilizes a standard option pricing model (i.e., Black-Scholes) to measure the fair value of stock options granted to employees. The Company will continue to utilize the Black-Scholes option pricing model to measure the fair value of its stock options. The Company expects to adopt SFAS 123R effective January 1, 2006. The Company is currently evaluating the impact that this adoption will have on the Company’s results of operations.

Variable Interest Entities

In January 2003, the FASB issued FIN 46. This interpretation clarifies the application of ARB No. 51, “Consolidated Financial Statements,” to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. In December 2003, the FASB revised FIN 46.

     Under the provisions of FIN 46R, the Company is required to consolidate certain cemeteries and trust assets. Merchandise and service trusts and cemetery perpetual care trusts are considered variable interest entities because the trusts meet the conditions of paragraphs 5(a) and 5(b)(1) of FIN 46R. That is, as a group, the equity investors (if any) do not have sufficient equity at risk and do not have the direct or indirect ability through voting or similar rights to make decisions about the trusts’ activities that have a significant effect on the success of the trusts. FIN 46R requires the Company to consolidate merchandise and service trusts and cemetery perpetual care trusts for which the Company is the primary beneficiary (i.e., those for which the Company absorbs a majority of the trusts’ expected losses). The Company is the primary beneficiary of a trust whenever a majority of the assets of the trust are attributable to deposits of customers of the Company.

      Consolidation of Trusts: The Company implemented FIN 46R as of March 31, 2004, which resulted in the consolidation of the Company’s preneed funeral and cemetery merchandise and service trust assets and the Company’s cemetery perpetual care trusts. No cumulative effect of an accounting change was recognized by the Company as a result of the implementation of FIN 46R as it relates to the consolidation of the trusts. The implementation of FIN 46R affects certain line items on the Company’s consolidated balance sheet and statement of operations as described below; however, there is no impact to net income in the statement of operations as a result of the implementation. Additionally, the implementation of FIN 46R did not result in any net changes to the Company’s consolidated statement of cash flows; however, it does require certain financing and investing activities to be disclosed.

     Although FIN 46R requires consolidation of most of the merchandise and service and perpetual care trusts, it does not change the legal relationships among the trusts, the Company and its customers. In the case of merchandise and service trusts, the customers are the legal beneficiaries. In the case of cemetery perpetual care trusts, the Company does not have a legal right to the perpetual care trust assets. For these reasons, upon consolidation of the trusts, the Company recognizes non-controlling interests in its financial statements to reflect third party interests in these trusts in accordance with FASB Statement No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liability and Equity” (SFAS 150). The Company classifies deposits to merchandise and service trusts as non-controlling liability interests and classifies deposits to cemetery perpetual care trusts as non-controlling equity interests.

     The Company records cash received from customers that is payable to the trusts but not yet required to be deposited in the trusts as restricted cash in Deferred charges and other assets in its consolidated balance sheet. At June 30, 2005 and December 31, 2004, these pending deposits totaled $11,311 and $11,218, respectively. The Company continues to account for amounts received from customers prior to delivery of merchandise or services that are not required to be deposited in merchandise and service trusts as deferred revenue.

     Beginning March 31, 2004, the Company recognizes net realized investment earnings of the merchandise and service trusts and perpetual care trusts, as well as the related trustee investment expenses and taxes, within Other income, net . The Company then recognizes a corresponding expense within Other income, net representing the net realized earnings of those trusts that are attributable to the non-controlling interest holders. The corresponding credit for this expense is reflected in the Company’s consolidated balance sheet in Non-controlling interest in funeral and cemetery trusts for merchandise and service trusts or Non-controlling interest in perpetual care trusts for cemetery perpetual care trusts. The sum of these expenses recorded in Other income, net offsets the net realized earnings of such trusts also recognized within Other income, net . Accordingly, the Company’s net income in the consolidated statement of operations is not affected by consolidation of the trusts in accordance with FIN 46R.

     To the extent the earnings of the trusts are distributed prior to the delivery of merchandise and/or services, a corresponding amount of non-controlling interest is reclassified to deferred revenue until the amounts qualify for revenue recognition. In the case of merchandise and service trusts, the Company recognizes as revenues amounts previously attributed to non-controlling interests and deferred revenues upon the performance of services and delivery of merchandise, including earnings accumulated in these trusts. In the case of the cemetery perpetual care trusts, distributable earnings are recognized in cemetery revenues to the extent of qualifying cemetery maintenance costs.

     Prior to the implementation of FIN 46R and the consolidation of the trusts, funds received from customers and deposited into merchandise and service trusts until maturity of the preneed contract were recorded as receivables due from trust assets. Upon implementation of FIN 46R, the Company replaced receivables due from trust assets with the trust assets, at market.

     An allowance for contract cancellation is provided based on historical experience. An allowance is no longer provided on the funds associated with the preneed contracts that are held in trust, currently recorded as trust assets, but previously recorded as receivables due from trust assets. As such, the amount has decreased since the implementation of FIN 46R.

     Both the merchandise and services trusts and the cemetery perpetual care trusts hold investments in marketable securities that are classified as available-for-sale by the Company under the requirements of SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (SFAS 115). In accordance with SFAS 115, available-for-sale securities of the trusts are recorded at fair value, with unrealized gains and losses excluded from earnings and initially recorded as a component of Accumulated other comprehensive income (loss) in the Company’s consolidated balance sheet. Using the guidance in EITF Topic D-41, “ Adjustments in Assets and Liabilities for Holding Gains and Losses as Related to the Implementation of FASB Statement No. 115 ” (Topic D-41), unrealized gains and losses on available-for-sale securities of the trusts attributable to the non-controlling interest holders are not recorded as Accumulated other comprehensive income (loss) , but are recorded as an adjustment to either Non-controlling interest in funeral and cemetery trusts or Non-controlling interest in perpetual care trusts . Therefore, unrealized gains and losses attributable to the non-controlling interest holders are reclassified from Accumulated other comprehensive income (loss) to either Non-controlling interest in funeral and cemetery trusts or Non-controlling interest in perpetual care trusts . The gross effect from applying Topic D-41 on the Company’s Accumulated other comprehensive income (loss) is disclosed in note eleven of the consolidated financial statements. However, the Company’s Accumulated other comprehensive income (loss) balance on the face of the balance sheet is ultimately not affected by consolidation of the trusts.

      Consolidation of Certain Cemeteries: Prior to December 31, 2003, the Company operated certain cemeteries in Michigan which the Company managed but did not own. During the Company’s evaluation of FIN 46R, the Company evaluated these cemeteries to determine whether such cemeteries were within the scope of FIN 46R. The investment capital of these cemeteries was financed by the Company in exchange for a long-term sales, accounting, and cash management agreement. In accordance with this agreement, the Company receives the majority of the cash flows from these cemeteries. Additionally, the Company absorbs the majority of these

cemeteries’ expected losses and receives a majority of the cemeteries’ residual returns. As a result, the Company concluded that it was the primary beneficiary of these cemeteries and that the long-term sales, accounting, and cash management agreement is a variable interest as defined by FIN 46R. Given the circumstances above, the Company consolidated such cemeteries at March 31, 2004. The Company recognized an after tax charge of $13,957, representing the cumulative effect of an accounting change, as a result of consolidating these cemeteries. The results of operations and cash flows of these cemeteries are included in the Company’s consolidated statements of operations and cash flows beginning March 31, 2004. Excluding the cumulative effect of accounting change, the effect of consolidating these entities did not have a significant impact on the Company’s reported results of operations.

Pension Plans

Effective January 1, 2004, the Company changed its accounting for gains and losses on its pension plan assets and obligations. The Company now recognizes such gains and losses in its consolidated statement of operations as such gains and losses are incurred. Prior to January 1, 2004, the Company amortized the difference between actual and expected investment returns and actuarial gains and losses over seven years (except to the extent that settlements with employees required earlier recognition). The Company believes the new method of accounting better reflects the economic nature of the Company’s pension plans and recognizes gains and losses on the pension plan assets and liabilities in the year the gains or losses occur. As a result of this accounting change, the Company recognized a charge for the cumulative effect of an accounting change of $33,599 (net of tax) as of January 1, 2004. This amount represents accumulated unrecognized net losses related to the pension plan assets and liabilities. In addition, for interim periods, the Company records net pension expense or income reflecting estimated returns on plan assets and obligations. The Company will recognize actual gains and losses on plan assets and obligations as actuarial information becomes available upon review of the annual remeasurement.

5. Debt

Debt was as follows:

     The Company’s consolidated debt had a weighted average interest rate of 7.00% at June 30, 2005 and 7.02% at December 31, 2004. Approximately 99% of the total debt had a fixed interest rate at June 30, 2005 and December 31, 2004.

Bank Credit Agreements

The Company’s bank credit agreement, which was executed on August 11, 2004, and matures in August of 2007, provides a total lending commitment of $200,000, including a sublimit of $175,000 for letters of credit. As of June 30, 2005, the Company has no cash borrowings outstanding under this credit facility, but has used the facility to support $57,494 of letters of credit. This bank credit facility is secured by the stock of the Company’s domestic subsidiaries and these domestic subsidiaries have guaranteed the Company’s

indebtedness associated with this facility. The subsidiary guarantee is a guarantee of payment of the outstanding amount of the total lending commitment. It covers the term of the agreement, including extensions and totaled a maximum potential amount of $57,494 and $66,985 at June 30, 2005 and December 31, 2004, respectively. The facility contains certain financial covenants, including a minimum interest coverage ratio, a maximum leverage ratio, maximum capital expenditure limitations, minimum net worth requirements and certain cash distribution restrictions. Interest rates for the outstanding borrowings will be based on various indices as determined by the Company. The Company also pays a quarterly fee on the unused commitment, which ranges from 0.25% to 0.50%.

Debt Extinguishment, Reductions and Additions

In the first quarter of 2005, the Company purchased $7,131 aggregate principal amount of its 7.70% notes due 2009 in the open market. As a result of this transaction, the Company recognized a loss of $1,207 recorded in Loss on early extinguishment of debt , in its consolidated statement of operations. In the second quarter of 2005, the Company purchased an additional $9,500 aggregate principal amount of its 7.70% notes due 2009, and $304 aggregate principal amount of its 6.00% notes due 2005 in the open market. As a result of this transaction, the Company recognized a loss of $1,252 recorded in Loss on early extinguishment of debt , in its consolidated statement of operations. Also in the second quarter of 2005, the Company redeemed $129,978 aggregate principal amount of its 6.875% notes due 2007 and $139,302 aggregate principal amount of its 7.20% notes due 2006 pursuant to a tender offer for such notes. These transactions resulted in a loss of $11,799 recorded in Loss on early extinguishment of debt , in the Company’s consolidated statement of operations.

     On June 15, 2005, the Company issued $300,000 of senior unsecured 7.00% notes due June 15, 2017, which pay interest semi-annually beginning December 15, 2005. The Company used the net proceeds, together with available cash, to purchase existing indebtedness pursuant to the tender offer described in the previous paragraph. The Company is entitled to redeem the notes at any time by paying a make-whole premium. The notes are subject to the provisions of the Company’s Senior Indenture dated as of February 1, 1993, as amended, which includes certain covenants limiting, among other things, the creation of liens securing indebtedness and sale-leaseback transactions. The Company is in compliance with all its debt covenants.

Additional Debt Disclosures

At June 30, 2005 and December 31, 2004, the Company had deposited $30,494 and $26,707, respectively, in restricted, interest-bearing accounts that were pledged as collateral for various credit instruments and commercial commitments. This restricted cash is included in Deferred charges and other assets in the consolidated balance sheet.

6. Retirement Plans

The components of net periodic pension plan benefit cost for the three and six months ended June 30 were as follows:

7. Segment Reporting

The Company’s operations are both product based and geographically based, and the reportable operating segments presented below include the Company’s funeral and cemetery operations. The Company’s geographic areas include North America and Other Foreign.

     In 2005, Other Foreign consists of the Company’s operations in Singapore, Germany and South America. In 2004, Other Foreign also included operations in France, which were disposed of in the first quarter of 2004. The Company conducts both funeral and cemetery operations in the North America and Other Foreign geographic areas.

The Company’s reportable segment information is as follows:

     The following table reconciles gross profit from reportable segments to the Company’s consolidated income from continuing operations before income taxes and cumulative effects of accounting changes:

     The Company’s geographic area information is as follows:

     Included in the North America figures above are the following United States amounts:

     Included in the Other Foreign figures above are the following France amounts:

     The changes in the carrying amounts of goodwill for the Company’s two reportable segments are as follows:

8. Supplementary Information

The detail of certain income statement accounts is as follows for the three and six months ended June 30:

9. Commitments and Contingencies

Purchase Commitments

The Company entered into a purchase agreement for its North America operations with a major casket manufacturer, having an original minimum commitment of $750,000 for a six-year period that expired at the end of 2004. The agreement contained provisions for annual price adjustments and provided for a one-year extension period to December 31, 2005 in which the Company is allowed to satisfy any remaining commitment that exists at the end of the original term. The Company elected to extend the contract to December 31, 2005 in order to satisfy its minimum commitment. In the first quarter of 2005, the Company amended its original purchase

agreement. This amendment allows the Company to continue purchasing caskets through 2006 subject to price increase limitations. At June 30, 2005, the remaining commitment was $83,900.

Management, Consulting and Non-Competition Agreements

The Company has entered into management, employment, consulting and non-competition agreements, generally for five to ten years, with certain officers and employees of the Company and former owners of businesses acquired. The Company has modified several of the above agreements as part of cost rationalization programs (see note twelve to the consolidated financial statements). At June 30, 2005, the maximum estimated future cash commitment under agreements with remaining commitment terms was as follows:

Litigation

     The Company is a party to various litigation matters, investigations and proceedings. For each of its outstanding legal matters, the Company evaluates the merits of the case, its exposure to the matter, possible legal or settlement strategies and the likelihood of an unfavorable outcome. If the Company determines that an unfavorable outcome is probable and can be reasonably estimated, it establishes the necessary accruals. Certain insurance policies held by the Company may reduce cash outflows with respect to an adverse outcome of certain of these litigation matters. The Company accrues such insurance recoveries when they become probable of being paid and can be reasonably estimated. The following discussion describes certain litigation and proceedings as of October 24, 2005.

      Conley Investment Counsel v. Service Corporation International, et al; Civil Action 04-MD-1609; In the United States District Court for the Southern District of Texas, Houston Division (the 2003 Securities Lawsuit). The 2003 Securities Lawsuit resulted from the transfer and consolidation by the Judicial Panel on Multidistrict Litigation of three lawsuits— Edgar Neufeld v. Service Corporation International, et.al,; Cause No. CV-S-03-1561-HDM-PAL; In the United States District Court for the District of Nevada; and Rujira Srisythemp v. Service Corporation International, et. al .; Cause No. CV-S-03-1392-LDG-LRL; In the United States District Court for the District of Nevada; and Joshua Ackerman v. Service Corporation International, et. al.; Cause No. 04-CV-20114; In the United States District Court for the Southern District of Florida. The 2003 Securities Lawsuit names as defendants the Company and several of the Company’s current and former executive officers or directors. The 2003 Securities Lawsuit is a purported class action alleging that the defendants failed to disclose the unlawful treatment of human remains and gravesites at two cemeteries in Fort Lauderdale and West Palm Beach, Florida. Since the action is in its preliminary stages, no discovery has occurred, and the Company cannot quantify its ultimate liability, if any, for the payment of damages.

      David Hijar v. SCI Texas Funeral Services, Inc., SCI Funeral Services, Inc., and Service Corporation International ; In the County Court of El Paso, County, Texas, County Court at Law Number Three; Cause Number 2002-740, with an interlocutory appeal pending in the El Paso Court of Appeals, No. 08-05-00182-CV (Hijar Lawsuit). The Hijar Lawsuit is a state-wide class action brought on behalf of all persons, entities and organizations who purchased funeral services from the Company or its subsidiaries in Texas at any time since March 18, 1998. Plaintiffs allege that federal and Texas funeral related regulations and/or statutes (Rules) required the Company to disclose its markups on all items obtained from third parties in connection with funeral service contracts and that the

failure to make certain disclosures of markups resulted in breach of contract and other legal claims. The Hijar Lawsuit seeks to recover an unspecified amount of monetary damages. The plaintiffs also seek attorneys’ fees, costs of court, pre- and post-judgment interest, and unspecified “injunctive and declaratory relief.” The Company denies that plaintiffs have standing to sue for violations of the Texas Occupations Code, denies that any breaches of contractual terms occurred, and on other grounds denies liability on all of the plaintiffs’ claims. Finally, the Company denies that the Hijar Lawsuit satisfies the requirements for class certification.

     Over the course of the Hijar Lawsuit, the parties have disputed the proper scope and substance of discovery. Each side has filed various motions to compel, motions for protection and/or to quash, motions for sanctions, motions to reconsider, and/or motions to lift sanctions. The trial court has signed several discovery orders against the Company, some of which were effectively vacated when the Company sought relief from the Texas Supreme Court and, in response to that Court’s stay and request for briefing, the sole plaintiff at that time withdrew his requested discovery until summary judgment issues were decided the following year.

     Each side in the Hijar Lawsuit filed motions to summarily establish that its interpretation of the Rules was correct. The Company contends that the items at issue, which plaintiffs contend were not disclosed properly under the Rules, were not “cash advance items” that would have been required by the Federal Trade Commission (FTC) Funeral Rule and Texas counterpart to be disclosed in a certain way on invoices. The International Cemetery and Funeral Association, the Texas Funeral Directors Association, the National Funeral Directors Association, the National Funeral Directors and Morticians Association, Inc., the Texas Funeral Service Commission, and three industry competitors filed Amicus Curiae briefs during the course of the Hijar Lawsuit, asserting that their interpretation of the Rules was the same as the Company’s. Additionally, the FTC provided the Company with an informal staff opinion supporting the Company’s interpretation. Despite these authorities, the trial court granted Hijar’s summary judgment motion, which summarily determined certain elements of liability based on a finding that the items at issue were “cash advance items.” This ruling allowed the plaintiffs to proceed to a certification hearing.

     The trial court entered an order certifying the class and two subclasses on April 15, 2005. On April 29, 2005, the trial court entered an order imposing sanctions against the Company and (i) finding that the Company breached its contracts by failing to disclose that funeral goods and services were purchased from third parties and resold to customers at higher prices, and by failing to disclose the amount of price mark-ups, and (ii) approving a damage calculation methodology proposed by the plaintiffs under which the damages would equal the difference between the costs to the Company of items of funeral goods and services purchased from third parties and the price at which they were resold to persons arranging funerals, minus any legally proper off-sets. On April 29, 2005, pursuant to section 51.014(a)(3) of the Texas Civil Practice and Remedies Code, the Company filed a notice of appeal regarding the trial court’s order certifying a class, and it appears from section 51.014(b) that this interlocutory appeal “also stays all other proceedings in the trial court pending resolution of that appeal.” The Company filed its brief of the case with the El Paso Court of Appeals in October 2005.

     On July 7, 2005, the FTC issued a letter advisory opinion regarding the lawful construction of the term “cash advance item” as used in the federal Funeral Rule. This opinion had been requested by a Texas legislator who had asked “whether a Texas trial court is correct in ruling that ‘all goods or services purchased from a third-party vendor, even though not included on the contract, are “cash advances”’ under the Funeral Rule.” The FTC expressly identified this “Texas trial court” as the trial court in the Hijar Lawsuit and specifically referenced the trial court’s summary judgment ruling. As stated in the letter, “The Commission believes that the court is incorrect in ruling that all goods or services purchased from a third-party vendor are cash advance items. This interpretation sweeps far too broadly, potentially bringing within its scope every component good or service that comprise a funeral. This was not and is not the Commission’s intention in the “cash advance” provisions of the Rule. In our opinion, the term ‘cash advance item’ in the Rule applies only to those items that the funeral provider represents expressly to be ‘cash advance items’ or represents by implication to be procured on behalf of a particular customer and provided to that customer at the same price the funeral provider paid for them.” The FTC set forth its analysis in the remainder of the letter.

      Mary Louise Baudino, et al v. Service Corporation International, et al; the plaintiffs’ counsel in the Hijar Lawsuit initiated an arbitration claim raising similar issues in California and filed in November 2004 a case styled Mary Louise Baudino, et al v. Service Corporation International, et al; in Los Angeles County Superior Court; Case No. BC324007 (Baudino Lawsuit). The Baudino

Lawsuit makes claims similar to those made in the Hijar lawsuit. However, the Baudino Lawsuit seeks a nation-wide class of plaintiffs. The Baudino Lawsuit is in its early stages and no discovery has been conducted.

     Funeral and Casket Antitrust Litigation: As previously reported, the Company is a defendant in Cause No. C-05-01804; In re: Funeral Consumers Antitrust Litigation; In the United States District Court for the Northern District of California — San Francisco Division (“Funeral Consumers Case”). Five separate class action lawsuits have been consolidated into this case. This is a purported class action on behalf of casket consumers throughout the United States. The plaintiffs allege that the Company and several other companies involved in the funeral industry violated federal antitrust laws and state consumer laws by engaging in various anti-competitive conduct associated with the sale of caskets.

     The Company is also a defendant in Cause No. C-05-02806; Pioneer Valley Casket, et al. v. Service Corporation International, et al.; In the United States District Court of Northern District of California — San Francisco Division. This lawsuit makes the same allegations as the Funeral Consumers Case and is also brought against several other companies involved in the funeral industry. Unlike the Funeral Consumers Case, this case is a purported class action on behalf of all independent casket distributors that are in the business or were in the business any time between July 18, 2001 and to present.

     On September 23, 2005, the federal judge transferred the Funeral Consumers Case and the Pioneer Valley Casket litigation to the United States District Court for the Southern District of Texas.

     Another class action lawsuit that makes the same allegations as the Funeral Consumers Case has been filed against the Company in Cameron County, Texas. It is styled Cause No. 2005-CCL-1023-C; Leoncio Solis v. Service Corporation International; In the County Court at Law No. 3 of Cameron County, Texas. This lawsuit has been filed on behalf of all consumers located in the state of Texas who purchased Batesville Casket Company, Inc. caskets from SCI and all consumers who are threatened with injury by the alleged conspiracies. SCI has removed this case to federal court.

     The funeral and casket antitrust lawsuits seek injunctions, unspecified amounts of monetary damages and treble damages. Since the litigation is in its preliminary stages, the Company cannot quantify its ultimate liability, if any, for the payment of damages.

     In addition to the funeral and casket antitrust lawsuits, the Company has received a Civil Investigative Demand, dated August 4, 2005, from the Attorney General of Maryland on behalf of itself and other undisclosed state attorneys general, who have commenced an investigation of alleged anticompetitive practices in the funeral industry. The Company has also received similar Civil Investigative Demands from the Attorneys General of Florida and Connecticut.

     The ultimate outcome of the litigation matters described in this note nine cannot be determined at this time. An adverse decision in one or more of such matters could have a material adverse effect on the Company, its financial condition, results of operation and cash flows. However, the Company intends to aggressively defend the lawsuits.

10. Earnings Per Share

Basic earnings (loss) per share (EPS) excludes dilution and is computed by dividing net income (loss) by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other obligations to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the Company’s earnings (loss).

     A reconciliation of the numerators and denominators of the basic and diluted earnings (loss) per share computations is presented below: