TGIS Thomas Grp., Inc. (MM)

THOMAS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

        1.      Basis of Presentation —The unaudited consolidated financial statements of Thomas Group, Inc. (the "Company") include all adjustments, which include only normal recurring adjustments, which are, in the opinion of management, necessary to present fairly the results of operations of Thomas Group for the interim periods presented. The unaudited financial statements should be read in conjunction with the consolidated financial statements and notes thereto in the Thomas Group Form 10-K for the 2006 fiscal year, filed with the Securities and Exchange Commission. The results of operations for the three and nine month periods ended September 30, 2007 are not necessarily indicative of the results of operations for the entire year ending December 31, 2007. Certain amounts from prior periods have been reclassified to conform to the 2007 presentation.

        2.      Earnings per Share —Basic earnings per share is based on the number of weighted average shares outstanding. Diluted earnings per share includes the effect of dilutive securities such as stock options, stock warrants, and restricted stock awards expected to vest. The following table reconciles basic earnings per share to diluted earnings per share under the provisions of Statement of Financial Accounting Standards No. 128, "Earnings Per Share."

        Stock options and warrants outstanding that are not included in the diluted earnings per share computation due to the antidilutive effects were approximately 82,000 and 27,000 for the three and nine month periods ended September 30, 2007, and 33,000 and 86,000 for the three and nine month periods ended September 30, 2006, respectively. Such options and warrants are excluded due to exercise prices exceeding the average market value of Thomas Group's common stock.

        3.      Stock Based Compensation —We grant incentive and non-qualified stock options and had reserved 3,550,000 shares of common stock for issuance under our 1988, 1992 and 1997 stock option plans, of which none remain available for grant. Options to purchase shares of Thomas Group common stock have been granted to directors, officers and employees. The majority of the options granted become exercisable at the rate of 20% per year, and generally expire ten years after the date of grant. At September 30, 2007, options to purchase 293,629 shares of our common stock were outstanding and exercisable.

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        Since the adoption of our 2005 Omnibus Stock and Incentive Plan ("2005 Plan"), we have granted restricted stock awards to employees representing 720,000 shares of our common stock pursuant to this Plan. The majority of these awards vest annually over a three-year period if we achieve certain established profit levels during such time. One of these awards vests quarterly over a five-year period based on the per share market price of our common stock. The awards automatically terminate and expire on the earlier of (i) the date on which all restricted shares have become vested shares, or (ii) the date the Holder's full-time employment with us is terminated for any reason, and upon the date of such termination all restricted shares which have not previously vested will be permanently forfeited. Shares are not delivered to the Holder until all restrictions on the shares have lapsed under the terms of the individual award. At September 30, 2007, 313,000 shares remain authorized and available for grant under the 2005 Plan. The 2005 Plan will terminate on December 20, 2015.

        Prior to October 1, 2005, we accounted for its stock option plans under the recognition and measurement provisions of APB Opinion No. 25, "Accounting for Stock Issued to Employees," and related Interpretations. No stock-based employee compensation cost was reflected in net income for the three or nine month periods ending September 30, 2005, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. However, as part of the restatement resulting from the review of stock option granting procedures, described in more detail in Note 15 to the Notes to the Consolidated Financial Statements included in this Quarterly Report on Form 10-Q, the financial statements for the three and nine month periods ending September 30, 2005, now include amounts to reflect stock based employee compensation. Effective October 1, 2005, we adopted the fair value recognition provisions of FASB Statement No. 123(R), "Share-Based Payment," which revises FASB Statement No. 123, "Accounting for Stock-Based Compensation" using the modified prospective application method. Under the modified prospective application method of adoption selected under the provisions of FASB Statement No. 148, "Accounting for Stock-Based Compensation—Transition and Disclosure," compensation cost recognized in the three and nine months ended September 30, 2006 is the same as that which would have been recognized had the recognition provisions of FAS 123 been applied from its original effective date. The fair value of stock options were estimated at the date of grant using the Black-Scholes model and the restricted stock awards were estimated using the binomial lattice method. Both pricing models use a risk-free interest rate based on the U.S. 10-year Treasury Bond yield. Beginning in October 2005, with the adoption of FAS 123(R), the expected life of stock options and grants are estimated using the term of the awards granted and historical experience. The expected life of the restricted stock awards are based on the anticipated time to maturity of the individual award, typically between one and five years. This information is summarized as follows:

        On November 10, 2005, the FASB issued Staff Position No. 123(R)-3 ("FSP 123R-3"), "Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards." We elected not to adopt the alternative transition method provided in FSP 123R-3, which provides an alternative (and

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simplified) method to calculate the pool of excess income tax benefits upon the adoption of SFAS No. 123(R), and chose the transition method presented in FAS 123(R).

        4.      Significant Clients —We recorded revenue from one client, CACI, Inc.—Federal, a wholly owned subsidiary of CACI International, Inc. ("CACI") (www.caci.com), of $5.7 million, or 43% of revenue, and $17.6 million, or 42% of revenue, for the three and nine month periods ended September 30, 2007, respectively. Revenue from the same client totaled $7.3 million, or 46% of revenue, and $22 million, or 49% of revenue, for the three and nine month periods ended September 30, 2006, respectively. All revenues derived from CACI represent contracts with the United States Navy in which we utilize CACI as the prime contractor.

        We recorded revenue from a second client, the United States Navy (the "Navy"), of $6.1 million, or 46% of revenue, and $19.6 million, or 46% of revenue, for the three and nine month periods ended September 30, 2007, respectively. Revenue from the same client totaled $7.2 million, or 45% of revenue, and $19.3 million, or 43% of revenue, for the three and nine month periods ended September 30, 2006, respectively.

        There were no other clients from whom revenue exceeded 10% of total revenue in the three and nine month periods ended September 30, 2007 and 2006, respectively.

        5.      Concentration of Credit Risk —Financial instruments that potentially subject us to concentrations of credit risk consist primarily of trade receivables. We encounter a certain amount of credit risk as a result of a concentration of receivables among a few significant customers. Accounts receivable from our largest customer, CACI, totaled $4.1 million and $4.8 million, or 41% and 38%, of accounts receivable at September 30, 2007 and December 31, 2006, respectively. Accounts receivable from another client, the Navy, totaled $4.3 million and $5.8 million, or 42% and 46%, of accounts receivable at September 30, 2007 and December 31, 2006, respectively. Accounts receivable from all customers dependent on the financial condition of the Navy totaled $8.8 million and $10.9 million, or 88% and 87%, of accounts receivable at September 30, 2007 and December 31, 2006, respectively.

        6.      Supplemental Disclosure of Cash Flow Information

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        7.      Geographical Data— We operate in one industry segment and conduct our business primarily in North America with minimal activity in Asia/Pacific and Europe. Information regarding these areas follows:

        8.      Property and Equipment— Our office lease in Troy, Michigan expired on March 31, 2007. As a result, we sold or disposed of a significant portion of the office space's equipment and furniture and recognized a loss of $18,000. During the nine months ended September 30, 2007, we made significant acquisitions of equipment and furniture for, and improvements to, our training facilities in our office space located in Irving, Texas. This activity is summarized below:

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        9.      Stockholder's Equity

Restricted Stock Awards

        Total expense related to restricted stock awards was $52,000 and $153,000 for the three and nine month periods ended September 30, 2007, respectively. The second quarter of 2007 included a reversal of $0.2 million related to amounts accrued in the first quarter of 2007. Total expense related to restricted stock awards was $314,000 and $867,000 for the three and nine months ended September 30, 2006, respectively. At September 30, 2007, there was approximately $2.8 million of stock based compensation costs related to nonvested restricted stock awards to be recognized over an average vesting period of 5.4 years. A summary of the status of our restricted stock awards to employees for the nine months ended September 30, 2007 is presented below:

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(1)

Fully restricted shares are subject to issuance under the awards if specified vesting conditions are met, but do not constitute issued and outstanding common stock for any corporate purposes and the holder has no rights, powers or privileges of a holder of unrestricted shares.

(2)

Available Shares are issued upon the satisfaction of specified vesting conditions. The holder of Available Shares has all rights, powers and privileges of a holder of unrestricted shares of Thomas Group common stock, including (in most cases) the right to receive distributions thereon except that such shares shall not be issued to the holder thereof until the date on which they become Vested Shares.

(3)

Vested Shares are shares on which all restrictions have lapsed under the terms of the award, and have been issued to the holder as unrestricted shares, constitute issued and outstanding common stock and the holder has all rights, powers and privileges of a holder of unrestricted shares of Thomas Group stock.

Stock Appreciation Rights ("SAR")

        Effective April 8, 2003, we entered into a SARs agreement with James T. Taylor, our current President and CEO, granting him 99,351 SARs at a price of $0.42 per SAR. The SARs were exercisable in full or in part immediately upon grant and entitled Mr. Taylor to a cash payment equal to the fair market value (defined as the last reported sale price of our common stock on the Nasdaq Capital Market on the last business day of the quarter immediately preceding the quarter in which an exercise occurs) of a share of Thomas Group common stock over $0.42 per share. On September 25, 2006, Mr. Taylor notified us of his election to exercise the SARs in their entirety, and the resulting payment to be made was reviewed by our Audit Committee of the Board of Directors. On October 25, 2006, the Audit Committee determined the closing price of $14.02 on June 30, 2006, as reported on the Nasdaq Capital Market, was the fair market value for purposes of this SAR exercise, and approved payment to the SAR holder under the terms of the agreement. On October 25, 2006, $1.35 million was paid to Mr. Taylor under the terms of the agreement, less required withholding taxes.

        The total amount recorded for SARs expense was $0 for the three and nine month periods ended September 30, 2007. The total amount recorded for the SAR expense was $175,000 and $569,000 for the three and nine months ended September 30, 2006.

        There were no additional SARs issued during the three and nine month periods ended September 30, 2007, or the comparative periods of 2006 and no SARs were outstanding and exercisable at September 30, 2007, or December 31, 2006.

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        10.    Income Taxes —We follow SFAS No. 109, "Accounting for Income Taxes," which requires use of the asset and liability method of accounting for deferred income taxes and providing deferred income taxes for all significant temporary differences.

        Income tax expense of $3.3 million for the first nine months of 2007 reflected an effective rate of 37%, compared to $3.9 million, or an effective rate of 34%, for the first nine months of 2006. The lower effective rate in 2006 was the result of a reduction in the deferred tax valuation allowance of $0.3 million during the first quarter of 2006 which created a tax benefit of $0.03 per diluted share in that quarter. Beginning in 2001, we provided a valuation allowance for the full amount of our net deferred tax assets. During the three months ended March 31, 2006, we determined the future sources of taxable income, the reversing of temporary differences and other tax planning strategies will be sufficient to realize certain components of our deferred tax asset. Therefore, approximately $0.3 million of the deferred tax asset valuation allowance was removed during the three months ended March 31, 2006. At December 31, 2006, after further evaluation of operating results of the most recent three-year period and comparison of all positive and negative evidence, we determined that a valuation allowance was only appropriate on approximately $117,000 of the net operating loss carryforward, due to annual limitations under Section 382 of the Internal Revenue Code of 1986, as amended. Therefore, we removed $1.5 million of the valuation allowance, which decreased income tax expense and increased assets. As of September 30, 2007, our valuation allowance was approximately $117,000.

        We adopted the provisions of FASB Interpretation No. 48 ("FIN 48"), "Accounting for Uncertainty in Income Taxes," on January 1, 2007. As a result of the implementation of FIN 48, we recognized a $40,000 increase in the liability for unrecognized tax benefits, which was recorded as a reduction of retained earnings in our Consolidated Balance Sheets at January 1, 2007. We see no significant changes to the facts and circumstances underlying ours reserves and allowances. We recognize deductible interest accrued related to tax penalties as interest expense in our Consolidated Statements of Operations and we recognize non-deductible accrued interest and penalties as income tax expense in our Consolidated Statements of Operations. We recorded $0 and $11,000 in non-deductible penalties and interest during the three and nine month periods ended September 30, 2007, respectively.

        As of September 30, we were under a routine audit by the Internal Revenue Service ("IRS") for the calendar year 2005 and are currently subject to the statutes of limitations for federal and state income taxes in the states in which we perform our services.

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        11.    Discontinued Operations— In the second quarter of 2005, we committed to an exit plan related to our wholly owned subsidiary in Switzerland. This action was taken in response to declining revenue and cash flows from the operations of this subsidiary during 2004 and 2005. All existing revenue contracts of this subsidiary were completed in the second quarter of 2004, and the subsidiary had no significant assets or operations. Selling efforts during 2004 and the first quarter of 2005 were unsuccessful, and as a result, management decided to liquidate the Swiss subsidiary. In December 2005, we liquidated the remaining investment in our Swiss subsidiaries and will have no significant continuing involvement in Switzerland. We eliminated the operations and cash flows of the Swiss subsidiaries from ongoing operations, and have presented the results of the Swiss subsidiaries as discontinued operations for all periods. There were no payments made during the three and nine month periods ended September 30, 2007 related to exit activities and, as of September 30, 2007, there were no accrued costs related to the exit activities of this subsidiary. The effect of the discontinued Swiss operations was $0, net of tax, or $0.00 per diluted share, for the three and nine month periods ended September 30, 2007. For the three and nine months ended September 30, 2006, approximately $63,000 and $156,000, respectively, in cash was paid related to exit activities. The effect of the discontinued Swiss operations was a gain of $4,000, net of tax, or $0.00 per diluted share, for the three months ended September 30, 2006, and a gain of $1,000, net of tax, or $0.00 per diluted share, for the nine months ended September 30, 2006.

        The presentation of all prior periods is revised to reflect the Swiss operations as discontinued operations.

        12.    Comprehensive Income or Loss— Comprehensive income or loss includes all changes in equity (foreign currency translation), except those resulting from investments by owners and distributions to owners. For the three and nine month periods ended September 30, 2007 and 2006, net income is the only component of comprehensive income.

        13.    Sublease activity —On August 1, 2006, we were notified that the subtenant of our Reston, Virginia office space had filed bankruptcy under Chapter 7 of the U.S. Bankruptcy Code on July 31, 2006. On September 28, 2006, we signed an occupancy agreement with the bankruptcy trustee. The terms provided rent payments by the bankruptcy trustee at approximately the same monthly rate as the subtenant previously paid through December 31, 2006, and as of January 1, 2007, the subtenant no longer occupied our office space. The remaining rent reserve balance of approximately $23,000 at September 30, 2007, is being amortized ratably against rent expense until the expiration of the lease on October 31, 2007.

        14.    Financing Agreement— On December 15, 2006, we entered into a credit agreement with JPMorgan Chase Bank, N.A. This credit agreement forms the basis of a $5.5 million revolving line of credit maturing March 31, 2009. Interest on the outstanding amount under the credit facility is payable either quarterly or at the end of the applicable LIBOR interest period elected by us, at a rate equal to, at our option, either (i) the bank's prime rate then currently in effect minus 1.5% or (ii) the LIBOR rate plus 1.25%. Our obligations under the credit facility are secured by a security interest in our accounts and related collateral as well as a security interest in our equity ownership of all subsidiaries. The credit agreement limits our ability to, among other things, make certain distributions and dividends, incur liens, dispose of our assets and consummate any merger, certain acquisitions and other business combination transactions. We are also required to meet certain financial covenants under the credit agreement, including maintaining a minimum tangible net worth as defined in the credit

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agreement. Prior to August 31, 2006, and during 2005 and 2004, we utilized a $5.5 million revolving line of credit with Bank of America, N.A.

        For the three and nine month periods ended September 30, 2007 and 2006, we had no borrowings or repayments on our current or former credit facility and we had no outstanding balance on our current credit facility as of September 30, 2007, or December 31, 2006. At September 30, 2007, and at December 31, 2006, we were in compliance with all of our debt covenants.

        15.    Review of Stock Option Grant Practices —As previously announced on February 2, 2007, our Board of Directors, with concurrence and oversight by our Audit Committee, which is comprised solely of independent directors, initiated a review of our historical stock option practices and related accounting during the period 1988 to 2006. This voluntary review was initiated in connection with our assessment of our historical capitalization documentation and not in response to any specific concerns from within Thomas Group about option practices or any inquiry from the Securities and Exchange Commission or any other regulatory agency. The review was conducted with the assistance of our outside legal counsel and specially-retained forensic accountants. Based on the preliminary findings of this review, we restated our financial statements and related footnote disclosures for fiscal years ending December 31, 2002 through 2005 and the first three quarters of the 2006 fiscal year.

        The investigation has been completed and our Board of Directors received a report on the results of that investigation on March 30, 2007 from our outside counsel and specially-retained forensic accountants. At that time, such counsel and accountants also submitted recommendations for proposed remedial measures to the Board, which are outlined below. Those proposals did not include any remedial measures pertaining to our directors or senior management team. Except as noted below, those recommendations were reviewed by the Board for possible implementation. After consideration of the report, the Board affirmed its confidence in our senior management team and their continued ability to sign certifications with respect to our periodic SEC reports and our financial statements. We self reported the internal investigation and the restatement to the Securities and Exchange Commission and cooperated with informational or other requests from the SEC. On June 8, 2007, the SEC formally notified us that its investigation related to our historical stock option granting practices had been terminated and that no enforcement action had been recommended.

        During the course of the internal investigation, the investigation team reviewed available electronic and hard copy documentation and conducted interviews of selected current and former officers, directors and employees.

        The following background pertaining to our historical stock option grant practices was confirmed through the investigation.

        From our initial public offering in August 1993 to January 2003, our historical stock option granting process has generally reflected a lack of either Board or Compensation Committee authorization for specific option grants, although a few instances exist where our Board or Compensation Committee took appropriate granting action under Delaware law and our option plans. Instead, from August 1993 to January 2003, we ran a CEO-centric option granting process with additional participation by the President from time to time and with minimal oversight by either our Board or Compensation Committee—particularly with respect to grants to rank and file employees. Our current and former Board members who were interviewed generally recalled periodic discussions concerning option grants to senior executives and directors, but, except for the instances noted above,

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there is a general lack of confirmatory written evidence in our records that would evidence these discussions. We last issued stock options in January 2003.

        Our CEOs and/or Presidents through January 2003 thought they had the apparent authority to grant options. Although the investigation discovered 1992 Board resolutions purporting to delegate authority to the CEO and President to grant stock options, it does not appear from the investigation that the CEOs and/or Presidents acted pursuant to such delegation but instead acted based on their perceived apparent authority resulting from their positions as senior officers of Thomas Group.

        During the review period, we granted options under the following circumstances: (i) grants to new employees at or near start dates; (ii) grants as part of an annual review process; (iii) grants to employees on their fifth and tenth year anniversaries; (iv) grants that were awarded to a key group of officers and employees; (v) grants made in connection with business developed through the Company's CEO center; (vi) periodic grants to directors for Board service; and (vii) grants made periodically to employees for other reasons. Documents identified pursuant to which CEOs prior to 2003 made option grants include notices of grant awards, stock option agreements, memos, notes and emails directing employees to document the granting of stock options.

        Based on our historical process deficiencies noted above, we concluded that we were required to adjust the accounting measurement dates for certain of our stock option grants as more fully discussed below. In addition to the process deficiencies noted above that allowed grants to be made without proper stock option plan or Delaware statutory approval, our investigation also identified some evidence that could be construed as manipulative for certain option grants and option exercises, including the following: (i) evidence of possible rearward selection of certain grant dates and exercise prices, including due to administrative delays in initiation and/or finalization of stock option terms; (ii) the use of an incorrect calculation to determine exercise prices under two of our stock option plans; (iii) evidence of the extension of expiration dates of certain stock option grants not properly accounted for; (iv) evidence that a limited number of rank and file employees were allowed to exercise options after expiration dates and (v) evidence of the possible rearward selection of an exercise date in one case. Notwithstanding the foregoing, the investigation team concluded that the totality of the information obtained and reviewed does not indicate that (i) stock option grants were intentionally back-dated on a widespread basis in order to obtain more favorable pricing for directors, officers or employees or (ii) option exercises were intentionally manipulated on a widespread basis. The investigation team also concluded that our internal control over financial reporting and our legal processes in connection with stock option grants and exercises have been ineffective.

        In connection with the investigation, the investigation team made the following recommendations with respect to proposed remedial measures: (i) establish modified accounting measurement dates for option grants not properly authorized by either Board or Compensation Committee resolutions, which we did in connection with the restatement; (ii) in order to correct the lack of complete legal documentation, adopt resolutions ratifying all prior option grants that may not have been previously authorized by specific Board or Compensation Committee resolutions, which resolutions were adopted by the Board on March 30, 2007; (iii) adopt and document an effective system of internal control over financial reporting that governs our stock option granting and/or other equity award processes; and (iv) adopt written equity granting practices and procedures that provide for option grants or other equity awards only by our Compensation Committee, consisting of outside independent directors, and that equity awards be made only on a quarterly basis during a meeting of the Compensation Committee.

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        Based upon the results of the investigation, we established an accounting measurement date for each grant in accordance with the earliest evidence that the recipient of the grant as well as the number of shares subject to such award were set with finality as described in more detail below. We also concluded that, on balance, our process deficiencies and lack of historical documentation of certain stock option grants did not preclude us from concluding, from an accounting perspective, that such options had been properly granted or that such stock options should be accounted for on a date other than the purported date of grant reflected in our stock option administration software. For stock option grants that were not otherwise evidenced by specific Board or Compensation Committee action, we have determined that it is appropriate to rely upon ancillary documentation that was found in our files and records, when such documentation confirms stock options had been granted. This conclusion is supported by Hein & Associates, our independent public accounting firm. This conclusion is also supported by the SEC's published September 2006 guidance, which generally indicates that the accounting for stock options may depend on the facts and circumstances surrounding a company's stock option grant practices when definitive documentation is not available.

        In conducting the review of our stock option practices, the investigation team reviewed all available documentation, including but not limited to corporate minute books, Board of Directors' packages, employment offer letters, employment agreements, notices of stock option grants, stock option agreements and personnel files. We focused on the identified documentation and other evidence that support a determination that a stock option grant was awarded with finality, even if such documentation was not sufficient to otherwise support a conclusion that all necessary legal steps were taken to authorize such an award. In particular, we focused on correspondence or agreements with employees that indicate the employees knew stock option awards were outstanding. We also relied upon internal documents that indicate we recognized the awards were outstanding. Where ancillary documentation existed for a stock option grant and was dated, we determined to use the date of earliest supporting documentation in establishing a revised measurement date. We used the following documents in establishing revised measurement dates:

•

Offer letters



•

Notices of grant awards



•

Section 16 filings



•

Stock option grant lists



•

Company worksheets prepared to support earnings per share calculations



•

Other correspondence to employees recognizing existence of outstanding stock option grants



•

Director and officer questionnaires listing outstanding stock option grants

        In connection with the internal investigation, our Board of Directors, with the approval of our Audit Committee, determined that the cumulative non-cash stock-based compensation expense adjustment was material and that our consolidated financial statements for each of the first three quarters of fiscal year ended December 31, 2006, each of the quarters in the fiscal year ended December 31, 2005 and the fiscal years ended December 31, 2005 and 2004 as well as the selected consolidated financial data for the fiscal years ended December 31, 2003 and 2002 should be restated to record additional stock-based compensation expense resulting from stock options granted during 1993 to 2003 that were incorrectly accounted for under GAAP, and related income tax effects.

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        We have determined that the cumulative, pre-tax, non-cash stock-based compensation expense resulting from revised measurement dates was approximately $2.1 million during the period from our initial public offering in August 1993 through December 31, 2006. The adjustments relate to options covering approximately 1.9 million shares. We recorded additional stock-based compensation expense of $5,532, $48,567 and $53,722 for the fiscal years ended December 31, 2006, 2005 and 2004, respectively, and $2.0 million for fiscal years ending prior to fiscal 2002. Previously reported total revenues were not impacted by our restatement. The table below reflects the cumulative effect on our stockholders' equity during the period from our initial public offering in August 1993 through December 31, 2006 (in thousands):

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        The table below reflects the breakdown by year of the cumulative adjustment to retained earnings. Our consolidated financial statements included in previously filed periodic reports with the SEC for such periods have not been amended. The consolidated financial statements included in our December 31, 2006 Annual Report on Form 10-K have been restated. (in thousands)

(1)

Estimated taxes, interest and penalties on stock options for which a revised measurement date resulted in a non-qualified, or discounted stock option.

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        The following table illustrates the effect of the restatement on net income and earnings per share for the three and nine months ended September 30, 2006:

        In connection with the restatement of our consolidated financial statements discussed above, we assessed the impact of the findings of our internal investigation into our historical stock option grant practices and other tax matters on our reported income tax benefits and deductions, including income tax deductions previously taken for cash and stock-based executive compensation under the provisions of Section 162(m). In connection with that assessment, we determined that no adjustments were required to our (i) income tax expense previously reported in our Consolidated Statements of Income; (ii) tax benefits on stock option exercises previously reported in our Consolidated Statements of Cash Flows and Consolidated Statement of Changes in Stockholders' Equity or (iii) deferred tax assets previously reported in our Consolidated Balance Sheets.

        Section 409A of the Internal Revenue Code ("Section 409A") provides that option holders with options granted with a below-market exercise price, to the extent the options were not vested as of December 31, 2004, may be subject to adverse Federal income tax consequences. Holders of these options will likely be required to recognize taxable income at the date of vesting for those options vesting after December 31, 2004, rather than upon exercise, on the difference between the amount of the fair market value of our common stock on the date of vesting and the exercise price, plus an additional 20 percent penalty tax and interest on any income tax to be paid. To the extent this process is available to affected employees, we have decided to follow the IRS Settlement Offer issued in February 2007 to pay penalty and interest to the IRS on behalf of the employees and potentially gross-up employees for tax costs. The IRS Settlement Offer is available for exercises of discounted

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stock rights by all employees and former employees, other than those who were Section 16 persons on the grant date of the discounted stock rights and those who are currently Section 16 persons, who exercised a discounted stock right in 2006.

        Certain grants of stock options made during the period under investigation were priced below fair market value, rather than at fair market value. Consequently, certain grants intended to be classified as ISOs, requiring pricing at no less than fair market value on the date of grant, should have been classified as nonqualified stock options, or NQs. Given the significant differences in the tax treatment between ISOs and NQs, we underreported or underwithheld certain payroll taxes for those options which were exercised during the period through 2006. We have recorded certain tax liabilities related to these issues in the period of exercise with related penalties and interest charged in subsequent periods, except for periods closed by the statute of limitations where no liability is recorded. We intend to pursue a negotiated settlement with the IRS as soon as practicable; however, there can be no assurance that we will settle these issues for amounts consistent with the estimated liabilities we have recorded. In the aggregate, the financial impact of these tax errors was approximately $0.1 million and is included in the adjustment.

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