UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

for the Quarterly Period Ended September 30, 20032004

or

for the transition period from            to            

Commission File Number: 000-26926

SCANSOURCE, INC.

(Exact name of registrant as specified in its charter)

(864) 288-2432

(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

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.

Yesx    No¨

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

Yesx    No¨

As of November 1, 2003, 12,352,2032004, 12,618,792 shares of the registrant’s common stock, no par value, were outstanding.

SCANSOURCE, INC.

INDEX TO FORM 10-Q

September 30, 20032004

Cautionary Statements

Certain of the statements contained in this Form 10-Q, as well as in the Company’s other filings with the Securities and Exchange Commission (“SEC”), that are not historical facts are forward-looking statements subject to the safe harbor created by the Private Securities Litigation Reform Act of 1995. The Company cautions readers of this report that a number of important factors could cause the Company’s activities and/or actual results in fiscal year 2004 and beyond to differ materially from those expressed in any such forward-looking statements. These factors include, without limitation,limitation: the Company’s dependence on vendors, product supply, senior management, centralized functions and third-party shippers,shippers; the Company’s ability to compete successfully in a highly competitive market abilityand to manage significant additions in personnel and increases in working capital,capital; the Company’s ability to collect outstanding accounts receivable,receivable; the Company’s entry into new product markets in which it has no prior experience,experience; the Company’s susceptibility to quarterly fluctuations in net sales and results of operations,operations; the Company’s ability to manage successfully pricing or stock rotation opportunities associated with inventory value decreases,decreases; other factors such as narrow profit margins, inventory risks due to shifts in market demand, dependence on information systems, credit exposure due to the deterioration in the financial condition of our customers, a downturn in the general economy, the inability to obtain required capital, potential adverse effects of acquisitions, fluctuations in interest rates, foreign currency exchange rates and exposure to foreign markets [including the imposition of governmental controls, currency devaluations, export license requirements, restrictions on the export of certain technology, political instability, trade restrictions, tariff changes, difficulties in staffing and managing international operations, changes in the interpretation and enforcement of laws (in particular related to items such as duty and taxation), longer collection periods and the impact of local economic conditions and practices], the impact of changes in income tax legislation, acts of war or terrorism, exposure to natural disasters, potential impact of labor strikes, volatility of common stock, and the accuracy of forecast data; and other factors described herein and in other reports and documents filed by the Company with the Securities and Exchange Commission,SEC, including Exhibit 99.1 to the Company’s Form 10-K for the year ended June 30, 2003.2004.

Additional discussion of these and other factors affecting our business and prospects is contained in our periodic filings with the Securities and Exchange Commission (“SEC”),SEC, copies of which can be obtained at the Investor Relations section of our website at www.scansource.com. We provide our annual and quarterly reports free of charge on www.scansource.com, as soon as reasonably practicable after they are electronically filed, or furnished to, the SEC. We provide a link to all SEC filings where current reports on Form 8-K and any amendments to previously filed reports may be accessed, free of charge.

PART 1. FINANCIAL1.FINANCIAL INFORMATION

Item 1. Financial1.Financial Statements

SCANSOURCE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)

(In thousands)

* Derived from audited financial statements at June 30, 2003.

See notes to condensed consolidated financial statements (unaudited).

SCANSOURCE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)

(In thousands, except for share information)

(Continued)

* Derived from audited financial statements at June 30, 2003.

See notes to condensed consolidated financial statements (unaudited).

SCANSOURCE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED INCOME STATEMENTS (UNAUDITED)

(In thousands)

See notes to condensed consolidated financial statements (unaudited).

SCANSOURCE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED INCOME STATEMENTS (UNAUDITED)

(In thousands, except per share data)

(Continued)

See notes to condensed consolidated financial statements (unaudited).

SCANSOURCE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(In thousands)

See notes to condensed consolidated financial statements (unaudited).

SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(1) Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of ScanSource,ScanSource, Inc. (the “Company”) have been prepared by the Company’s management in accordance with generally accepted accounting principles for interim financial information and applicable rules and regulations of the Securities Exchange Act of 1934, as amended. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles in the United States for annual financial statements. The unaudited condensed consolidated financial statements included herein contain all adjustments (consisting of only normal recurring accruals)adjustments) which are, in the opinion of management, necessary to present fairly the financial position as of September 30, 20032004 and June 30, 2003,2004, the results of operations for the quarters ended September 30, 20032004 and 20022003 and statement of cash flows for the three month periodsquarters ended September 30, 20032004 and 2002.2003. The results of operations for the quarters ended September 30, 20032004 and 20022003 are not necessarily indicative of the results to be expected for a full year. These financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2003.

Reclassifications – Certain reclassifications of prior period data have been made to conform with the current period reporting.2004.

(2) Business Description Certain Accounting Policies and Recent Accounting Pronouncements

The Company is a leading distributor of specialty technology products, providing both value-added distribution sales to technology resellers and e-logistics services toin the specialty technology markets. The Company has two geographic distribution segments: one serving North America from the Memphis distribution center, and an international segment currently serving Latin America (including Mexico) and Europe. The North American Distributiondistribution segment markets automatic identification and data capture (“AIDC”) and point-of-sale (“POS”) products through its ScanSource sales unit; voice, data and converged communications equipment through its CatalystTelecom sales unit; and voice, data and converged communications products through its Paracon sales unit; and electronic security products through its ScanSource Security Distribution unit. The International Distributioninternational distribution segment markets AIDC and POS products.products through its ScanSource sales unit.

Stock Split –Effective January 28, 2003, the Board3) Summary of Directors approved a two-for-one stock split of the common stock effected in the form of a 100% common stock dividend. The effect of the stock split has been recognized retroactively in all shareSignificant Accounting Policies and per share data in the accompanying consolidated financial statements and the related notes to the consolidated financial statements.Accounting Standards Recently Issued

Consolidation Policy –

The consolidated financial statements include the accounts of the Company and all wholly-owned and majority-owned subsidiaries. All significant intercompanyinter-company accounts and transactions have been eliminated.

Minority Interest –

Minority interest represents that portion of the net equity of majority-owned subsidiaries of the Company that is held by minority shareholders. The minority shareholders’ share of the subsidiaries’ income or loss is listed separately in the consolidated income statements.Consolidated Income Statements. Effective July 1, 2003, the Company purchased the remaining 10% minority interest in ChannelMax, Inc. (“ChanelMax”). The Company now owns 100% of ChannelMax. Effective August 15, 2003,2004, the Company acquired an additional 12% of Outsourcing Unlimited, Inc. (“OUI”). Effective October 1, 2003, the Company acquired and an additional 8% of Netpoint International, Inc. (“Netpoint”). The Company now owns 76%88% of OUI, and 68%76% of Netpoint.

SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Use of estimates –Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis management evaluates its estimates, including those related to the allowance for uncollectible accounts receivable and inventory reserves to reduce inventories to the lower of cost or market. Management bases its estimates on historical experience and on various other assumptions that management believes to be reasonable under the circumstances, the results of which form a basis for making judgments about the carrying value of assets and liabilities that are not readily available from other sources. Actual results may differ from these estimates under different assumptions or conditions; however, management believes that its estimates, including those for the above described items, are reasonable and that the actual results will not vary significantly from the estimated amounts.

SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The following significant accounting policies relate to the more significant judgments and estimates used in the preparation of the consolidated financial statements:

(a) Allowances for Accounts Receivable

The Company maintains an allowance for uncollectible accounts receivable for estimated losses resulting from customers’ failure to make payments on accounts receivable due to the Company. Management determines the estimate of the allowance for uncollectible accounts receivable considering a number of factors, including: (1) historical experience, (2) aging of the accounts receivable and (3) specific information obtained by the Company on the financial condition and the current credit worthiness of its customers. If the financial condition of the Company’s customers were to deteriorate and reduce the ability of the Company’s customers to make payments on their accounts, the Company may be required to increase its allowance by recording additional bad debt expense. Likewise, should the financial condition of the Company’s customers improve and result in payments or settlements of previously reserved amounts, the Company may be required to record a reduction in bad debt expense to reverse the recorded allowance. In addition, the Company maintains an allowance for credits to customers that will be applied against future purchases.

(b) Inventory Reserves

Management determines the inventory reserves required to reduce inventories to the lower of cost or market based principally on the effects of technological changes, quantities of goods on hand, and other factors. An estimate is made of the market value, less costs to dispose, of products whose value is determined to be impaired. If these products are ultimately sold at less than estimated amounts, additional reserves may be required. Likewise, if these products are sold for more than the estimated amounts, reserves may be reduced.

Cash and Cash Equivalents

The Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents. Book overdrafts of $25,030,000 and $8,953,000 as of September 30, 2004 and June 30, 2004, respectively, are included in accounts payable.

Derivative Financial Instruments

The Company’s foreign currency exposure results from selling to customers internationally in several foreign currencies. In addition, the Company has foreign currency risk related to debt that is denominated in currencies other than the U.S. Dollar. The Company may reduce its exposure to fluctuations in foreign exchange rates by creating offsetting positions through the use of derivative financial instruments. The market risk related to the foreign exchange agreements is offset by changes in the valuation of the underlying items hedged. The Company currently does not use derivative financial instruments for trading or speculative purposes, nor is the Company a party to leveraged derivatives.

Derivative financial instruments are accounted for on an accrual basis with gains and losses on these contracts recorded in income in the period in which their value changes. These contracts are generally for a duration of 90 days or less. The Company has elected not to designate its foreign currency contracts as hedging instruments. They are, therefore, marked to market with changes in their value recorded in the Consolidated Income Statement each period. The underlying exposures are denominated primarily in British Pounds, Euros, and Canadian Dollars. Summarized financial information related to these derivative contracts and changes in the underlying value of the foreign currency exposures follows:

SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The Company had no currency forward contracts outstanding as of September 30, 2004. At June 30, 2004, the Company had one currency forward contract outstanding with a net liability under this contract of $21,000 which was included in accrued expenses and other liabilities. The following table provides information about the outstanding foreign currency derivative financial instrument as of June 30, 2004:

The notional amount of forward exchange contracts is the amount of foreign currency to be bought or sold at maturity. Notional amounts are indicative of the extent of the Company’s involvement in the various types and uses of derivative financial instruments and are not a measure of the Company’s exposure to credit or market risks through its use of derivatives. The estimated fair value of derivative financial instruments represents the amount required to enter into similar offsetting contracts with similar remaining maturities based on quoted market prices.

Inventories

Inventories (consisting of AIDC, POS, business phone, converged communications equipment, and electronic security system products) are stated at the lower of cost (first-in, first-out method) or market.

Vendor Programs

Funds received from vendors for marketing programs and product rebates have been accounted for as a reduction of selling, general and administrative expenses (“SG&A”) or product cost according to the nature of the program, in accordance with Emerging Issues Task Force (“EITF”) No. 02-16,Accounting for Cash Consideration Received from a Vendor.

Product Warranty

The Company’s vendors generally warrant the products distributed by the Company and allow the Company to return defective products, including those that have been returned to the Company by its customers. The Company does not independently warrant the products it distributes. However, to maintain customer relations, the Company facilitates vendor warranty policies by accepting for exchange, with the Company’s prior approval, most defective products within 30 days of invoicing.

Long-Lived Assets

Property and equipment are recorded at cost. Depreciation is computed using the straight-line method over estimated useful lives of 3 to 5 years for furniture and equipment, 3 to 5 years for computer software, 40 years for buildings and 15 years for building improvements. Leasehold improvements are amortized over the shorter of the lease term or the estimated useful life. Maintenance, repairs and minor renewals are charged to expense as incurred. Additions, major renewals and betterments to property and equipment are capitalized.

SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

For long-lived assets other than goodwill, if the sum of the expected cash flows, undiscounted and without interest, is less than the carrying amount of the asset, an impairment loss is recognized as the amount by which the carrying amount of the asset exceeds its fair value.

The Company reviews its long-lived assets for impairment whenever events or circumstances indicate that the carrying amount of an asset may not be recoverable or may be impaired. The Company recognized charges of $30,000 and $0 for the quarters ended September 30, 2004 and September 30, 2003, respectively, in operating expenses for the impairment of certain capitalized software for the North American distribution segment. This software was no longer functional based on current operational needs.

Goodwill and Other Identifiable Intangible Assets

Goodwill represents the excess of the purchase price over the fair value of the identifiable net assets acquired in acquisitions accounted for using the purchase method. With the adoption of Statement of Financial Accounting Standards (“SFAS”) No. 142,Goodwill and Other Intangible Assets, on July 1, 2001, the Company discontinued the amortization of goodwill. During fiscal year 2004 and 2003, the Company performed its annual test of goodwill to determine if there was impairment. These tests included the determination of each reporting unit’s fair value using market multiples and discounted cash flows modeling. No impairment was required to be recorded related to the Company’s annual impairment testing under this pronouncement.

The Company reviews the carrying value of its intangible assets with finite lives, which includes customer lists and non-compete agreements, as current events and circumstances warrant to determine whether there are any impairment losses. If indicators of impairment are present in intangible assets used in operations, and future cash flows are not expected to be sufficient to recover the assets’ carrying amount, an impairment loss is charged to expense in the period identified. These assets are included in other assets. The customer lists are amortized using the straight-line method over a period of 5 years. The non-compete agreements are amortized over their expected life and the debt issue costs are amortized over the term of the credit facility (see Note 7).

Fair Value of Financial Instruments

The fair value of financial instruments is the amount at which the instrument could be exchanged in a current transaction between willing parties. The carrying values of financial instruments such as accounts receivable, accounts payable, accrued liabilities, borrowings under the revolving credit facility and the subsidiary lines of credits approximate fair value, based upon either short maturities or variable interest rates of these instruments.

Contingencies

The Company accrues for contingent obligations, including estimated legal costs, when it is probable that a liability is incurred and the amount is reasonably estimable. As facts concerning contingencies become known, management reassesses its position and makes appropriate adjustments to the financial statements. Estimates that are particularly sensitive to future changes include tax, legal, and other regulatory matters, which are subject to change as events evolve and as additional information becomes available during the administrative and litigation process.

Revenue Recognition–

Revenue is recognized once four criteria are met: (1) the Company must have persuasive evidence that an arrangement exists; (2) delivery must occur, which happens at the point of shipment (this includes the transfer of both title and risk of loss, provided that no significant obligations remain); (3) the price must be fixed and determinable; and (4) collectibility must be reasonably assured. A provision for estimated losses on returns is recorded at the time of sale based on historical experience.

SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The Company alsohas service revenue associated with configuration and marketing which is recognized when work is complete and all obligations are substantially met. Revenue from multiple element arrangements is allocated to the various elements based on the relative fair value of the elements, and each revenue cycle is considered a separate accounting unit with recognition of revenue based on the criteria met for the individual element of the multiple deliverables. The Company has arrangements in which it earns a service fee determined as a percentage of the value of products shipped on behalf of the manufacturer, who retains the risk of credit loss. In the event of termination of the programs,arrangements, the Company has the right to return certain inventory to the manufacturer. Such service fees earned by the Company are included in net sales and were less than 1% of net sales for each of the quarters ended September 30, 20032004 and 2002, respectively. 2003.

Shipping Costs

Shipping revenue is included in net sales and related costs are included in the cost of productsgoods sold.

Inventories –Advertising CostsInventories (consisting

The Company defers advertising related costs until the advertising is first run in trade or other publications or in the case of AIDC, POS, business phonebrochures, until the brochures are printed and converged communications equipment)available for distribution. Advertising costs, included in marketing costs, after vendor reimbursement, were not significant in the quarters ended September 30, 2004 or 2003. Deferred advertising costs at September 30, 2004 and 2003 were not significant.

Foreign Currency

The currency effects of translating the financial statements of the Company’s foreign entities that operate in their local currency are statedincluded in the cumulative currency translation adjustment component of accumulated other comprehensive income. The assets and liabilities of these foreign entities are translated into U.S. Dollars using the exchange rate at the lowerend of cost (first-in, first-out method) or market.the respective period. Sales, costs and expenses are translated at average exchange rates effective during the respective period.

Foreign currency transactional and remeasurement gains and losses are included in other expense (income) in the Condensed Consolidated Income Statement. Such losses, net of gains, were $35,000 for the quarter ended September 30, 2004. Such gains, net of losses, were $222,000 for the quarter ended September 30, 2003.

Income Taxes

Income taxes are accounted for using the liability method. Deferred taxes reflect tax consequences on future years of differences between the tax bases of assets and liabilities and their financial reporting amounts. Valuation allowances are provided against deferred tax assets that are unlikely to be realized. Federal income taxes are not provided on the undistributed earnings of foreign subsidiaries because it has been the practice of the Company to reinvest those earnings in the business outside of the United States.

Stock-Based Compensation

Stock Based Compensation –The Company has fourthree stock-based employee compensation plans.plans and a plan for its non-employee directors. The Company has adopted the disclosure provisions of SFASStatement of Financial Accounting Standards (“SFAS”) No. 148,Accounting for Stock-Based Compensation—Transition and Disclosure, which amends SFAS No. 123,Accounting for Stock-Based Compensation. SFAS No. 148 allows for continued use of the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25 and related interpretations in accounting for those plans. The

SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Company applies the recognition and measurement principles of APB Opinion No. 25, and related interpretations in accounting for those plans. No stock-based employee compensation expense is reflected in net income 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. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions to stock-based employee compensation. Such disclosure is not necessarily indicative of the fair value of stock options that could be granted by the Company in future fiscal years or of the value of all options currently outstanding.

SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Foreign Currencies –The currency effects of translating the financial statements of the Company’s foreign entities that operate in their local currency are included in the cumulative currency translation adjustment component of accumulated other comprehensive income. The assets and liabilities of these foreign entities are translated into U.S. dollars using the exchange rate at the end of the respective period. Sales, costs and expenses are translated at average exchange rates effective during the respective period.

Foreign currency transactional gains and losses are included in other expense (income) in the consolidated statement of income and were less than 2.3% of income before taxes forFor the quarters ended September 30, 2004 and 2003, the number of options exercised for shares of common stock were 58,603 and 2002,96,293, respectively.

Comprehensive Income –

Comprehensive income is comprised of net income and foreign currency translation adjustments.translation. The foreign currency translation gains or losses are not tax-effected because the earnings of foreign subsidiaries are considered by Company management to be permanently reinvested. For the quarters ended September 30, 20032004 and 2002,2003, comprehensive income consisted of net income of the Company of $6.1$8.9 million and $6.0$6.1 million, respectively, and translation adjustments of $4,000 and $229,000, and $5,000, respectively.

Vendor Programs –Funds received from vendors for marketing programs and product rebates have been accounted for as a reduction of selling, general and administrative expenses (“SG&A”) or product cost according to the nature of the program. In December 2002, the Emerging Issues Task Force (“EITF”) issued pronouncement No. 02-16,Accounting for Cash Consideration Received from a Vendor, which requires the Company to recognize vendor reimbursement as a reduction of the cost of the products purchased from the vendor, unless it meets certain criteria under the pronouncement.

SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Contingencies– The Company accrues for contingent obligations, including estimated legal costs, when it is probable and the amount is reasonably estimable. As facts concerning contingencies become known, management reassesses its position and makes appropriate adjustments to the financial statements. Estimates that are particularly sensitive to future changes include tax, legal, and other regulatory matters, which are subject to change as events evolve and as additional information becomes available during the administrative and litigation process.

Cash and Cash Equivalents– The Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents. Book overdrafts of $15,356,000 and $17,412,000 as of September 30, 2003 and June 30, 2003, respectively, are included in accounts payable.

Derivative Financial Instruments– The Company sells to customers internationally in several foreign currencies. The Company may reduce its exposure to fluctuations in foreign exchange rates by creating offsetting positions through the use of derivative financial instruments. The market risk related to the foreign exchange agreements is offset by changes in the valuation of the underlying items being hedged. The Company’s derivative financial instruments have terms of 90 days or less. The Company currently does not use derivative financial instruments for trading or speculative purposes, nor is the Company a party to leveraged derivatives.

Derivative financial instruments are accounted for on an accrual basis with gains and losses on these contracts recorded in income in the period in which their value changes. The Company has elected not to designate its foreign currency contracts as hedging instruments, and therefore they are marked to market with changes in their value recorded in the income statement each period. The underlying exposures are denominated primarily in British Pounds.

The notional amount of forward exchange contracts and options is the amount of foreign currency to be bought or sold at maturity. Notional amounts are indicative of the extent of the Company’s involvement in the various types and uses of derivative financial instruments and are not a measure of the Company’s exposure to credit or market risks through its use of derivatives. The estimated fair value of derivative financial instruments represents the amount required to enter into similar offsetting contracts with similar remaining maturities based on quoted market prices. The Company had no derivative financial instruments outstanding at September 30, 2003 and June 30, 2003. The Company did not recognize any gains or losses related to foreign currency exchange contracts during the quarter ended September 30, 2003.

Income Taxes – Income taxes are accounted for under the liability method. Deferred taxes reflect tax consequences on future years of differences between the tax bases of assets and liabilities and their financial reporting amounts. Deferred taxes have not been provided on the cumulative undistributed earnings of foreign subsidiaries or the cumulative translation adjustment related to those investments since such amounts are expected to be reinvested indefinitely.

Accounting Standards Recently AdoptedIssued – In November 2002, the FASB issued FASB Interpretation (“FIN”) No. 45,Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (an interpretation of FASB Statements of Financial Accounting Standards No. 5, 57, and 107 and rescission of FASB Interpretation No. 34).FIN No. 45 clarifies the requirements of SFAS No. 5,Accounting for Contingencies, relating to a guarantor’s accounting for, and disclosure of, the issuance of certain types of guarantees. The initial recognition and initial measurement provisions of FIN No. 45 are applicable to guarantees issued or modified after December 31, 2002 and the disclosure requirements are applicable to financial statements for periods ending after December 15, 2002. The adoption of FIN No. 45 had no effect on the Company’s financial position or results of operations.

In December 2002, the FASB issued SFAS No. 148,Accounting for Stock-Based Compensation—Transition and Disclosure. This statement amends the transition requirements of SFAS No. 123,Accounting for Stock-Based Compensation,to provide alternative, voluntary methods of transition to the fair value method of

SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

accounting for stock-based employee compensation. It also amends the disclosure provisions of SFAS No. 123 to require disclosure in the summary of significant accounting policies of the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements. The disclosure provision is required for all companies with stock-based employee compensation, regardless of whether the Company utilizes the fair value method of accounting described in SFAS No. 123 or the intrinsic value method described in APB Opinion No. 25,Accounting for Stock Issued to Employees. The amendments to the transition and annual disclosure provisions of SFAS No. 123 were effective for the Company’s fiscal year ended June 30, 2003. The Company continues to account for stock-based employee compensation under the intrinsic value method described by APB Opinion No. 25. The adoption of SFAS No. 148 had no effect on the Company’s financial position or results of operations.

In December 2002, the FASB’s EITF issued Issue No. 02-16. This issue addresses the appropriate accounting, by a distributor, for cash consideration received from a vendor and became effective for the Company on January 1, 2003. The adoption of EITF No. 02-16 requires that cash consideration received from a vendor should be recorded as a direct reduction to cost of goods sold, unless certain criteria are met. If these criteria are met, then the cash consideration should be a reduction of the operating expense for which it is being reimbursed. The guidance is applicable to all of the Company’s vendor arrangements entered into after December 15,31, 2002.

SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”),“Consolidation of Variable Interest Entities.”FIN 46 clarifies the application of Accounting Research Bulletin No. 51, “ConsolidatedConsolidated 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. FIN 46 applies immediately to variable interest entities (“VIE’s”VIEs”) created after January 31, 2003, and to VIE’sVIEs in which an enterprise obtains an interest after that date. In December 2003, the FASB published a revision to FIN 46 to clarify some of the provisions and to exempt certain entities from its requirements. Under the new guidance, special effective date provisions apply to enterprises that have fully or partially applied FIN 46 prior to issuance of the revised interpretation. Otherwise, application of Interpretation 46R (“FIN 46R”) is required in financial statements of public entities that have interests in structures that are commonly referred to as special-purpose entities (“SPEs”) for periods ending after December 15, 2003. Application by public entities, other than small business issuers, for all other types of VIEs other than SPEs is required in financial statements for periods ending after March 15, 2004. The Company has completed its evaluation of all potential VIEs relationships existing prior to February 1, 2003. The Company did not create or obtain any interest in a variable interest entity during the period February 1, 2003 through September 30, 2003.2004. However, changes in the Company’s business relationships with various entities could occur which may impact its financial statements under the requirements of FIN 46. In October 2003,46R. The Company has concluded that these relationships do not meet the FASB issued FASB Staff Position No. FIN 46-6, “ Effective Date of FASB Interpretation No. 46, Consolidation of Variable Interest Entities”. This position has delayed the provisions requiredrequirements under the original pronouncement until the Company’s fiscal quarter ending after December 15, 2003. The Companyprovision and therefore, there is in the process of evaluating the potential VIEs relationships existing prior to February 1, 2003, and theno effect of these relationships on the Company’s consolidated financial position or results of operations is unknown.as of September 30, 2004.

In April 2003, the FASB issued SFAS No. 149,Amendment of Statement 133 on Derivative Instruments and Hedging ActivitiesActivities.. SFAS No. 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts. SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The adoption of SFAS No. 149 had no effect on the Company’s financial position or results of operations.

In May 2003, the FASB issued SFAS No. 150,Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS No. 150 requires that certain financial instruments, which under previous guidance were accounted for as equity, must now be accounted for as liabilities. The financial instruments affected include mandatorily redeemable stock, certain financial instruments that require or may require the issuer to buy back some of its shares in exchange for cash or other assets and certain obligations that can be settled with shares of stock. SFAS No. 150 is effective for all financial instruments entered into or modified after May 31, 2003 and must be applied to the Company’s existing financial instruments effective July 1, 2003, the beginning of the first fiscal period after June 15, 2003. The Company adopted SFAS No. 150 on July 1, 2003. The adoption of this statement had no effect on the Company’s financial position or results of operations.

SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(4) Earnings Per Share

Basic earnings per share are computed by dividing net income by the weighted-average number of common shares outstanding. Diluted earnings per share are computed by dividing net income by the weighted-average number of common and potential common shares outstanding.

For the quarters ended September 30, 2004 and 2003, there were 0 and 18,000 shares, respectively, excluded from the computation of diluted earnings per share because their effect would have been antidilutive.

SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(3)(5) Revolving Credit Facility and Subsidiary Lines of Credit

TheAt September 30, 2004, the Company has renewed itshad a $100 million multi-currency revolving credit facility with its bank group extendingwhich matures on July 31, 2008. The new credit facility was entered into on July 16, 2004. This facility has an accordion feature that allows the termination dateCompany to increase the revolving credit line up to an additional $50 million, the first $30 million of which is committed with the existing bank group and the remaining $20 million is subject to syndication. The facility bears interest at either the 30-day LIBOR rate of interest in the United States or the 30, 60, 90 or 180-day LIBOR rate of interest in Europe. The interest rate is the appropriate LIBOR rate plus a rate varying from .75% to 1.75% tied to the Company’s funded debt to EBITDA ratio ranging from 0.00:1.00 to 2.50:1.00 and a fixed charge coverage ratio of not less than 1.50:1. The effective weighted average interest rate at September 30, 20052004 was 3.08% and the outstanding borrowings included $18.4 million denominated in U.S. Dollars, $8.9 million denominated in Euros, and $5.5 million denominated in British Pounds, totaling $32.8 million on a calculated borrowing base of $100 million, leaving $67.2 million available for additional borrowings. The facility is collateralized by domestic assets, primarily accounts receivable and inventory. The agreement contains other restrictive financial covenants, including among other things, total liabilities to tangible net worth ratio and capital expenditure limits. The Company was in compliance with its covenants at September 30, 2004.

At June 30, 2004, the Company’s former revolving credit facility with its bank group had a borrowing limit of the lesser of (i) $80 million or (ii) the sum of 85% of eligible accounts receivable plus the lesser of (a) 50% of eligible inventory or (b) $40 million. The facility bears interest atrate was the 30-day LIBOR rate of interest plus a rate varying from 1.00% to 2.50% tied to the Company’s funded debt to EBITDA ratio ranging from 2.50:1 to 4.25:1 and a fixed charge coverage ratio of not less than 2.75:1. The effective interest rate at SeptemberJune 30, 20032004 was 2.12%2.13% and the outstanding balance was $22.1$32.6 million on a calculated borrowing base of $80 million, leaving $57.9 million available for additional borrowings. The effective interest rate at June 30, 2003 was 2.57% and the outstanding balance was $18.1 million on a calculated borrowing base of $80 million, leaving $61.9$47.4 million available for additional borrowings. The revolving credit facility iswas collateralized by accounts receivable and eligible inventory. The credit agreement containscontained various restrictive covenants, including among other things, minimum net worth requirements, capital expenditure limits, maximum funded debt to EBITDA ratio and a fixed charge coverage ratio. Effective August 6, 2003, the Company obtained a waiver for certain loan covenants as of June 30, 2003, relating to total amounts of investment, additional debt, and loans and advances, relating to the Company’s subsidiaries. In addition, effective August 6, 2003, the Company amended its loan agreement to increase the respective ceilings on these covenants. The Company was in compliance with its covenants at SeptemberJune 30, 2003.2004 and at the restatement date of the credit agreement.

At September 30, 2004, Netpoint, doing business as ScanSource Latin America, had an asset-based line of credit with a bank that was due on demand and had a borrowing limit of $1 million (increased from $600,000 as of August 27, 2004). The facility matures on August 27, 2005 and is collateralized by accounts receivable and eligible inventory. The facility contains a restrictive covenant which requires an average deposit of $50,000 at the bank. The Company has renewedguaranteed 76% of the balance on the line, while the remaining 24% of the balance was guaranteed by Netpoint’s minority shareholder. The facility bears interest at the bank’s prime rate minus one percent. At September 30, 2004, the effective interest rate was 3.75%. There was no outstanding balance at September 30, 2004 and the outstanding standby letters of credit totaled $40,000, leaving $960,000 available for borrowings. Netpoint was in compliance with its covenant at September 30, 2004.

At June 30, 2004, Netpoint had an asset-based line of credit agreement with a bank that iswas due on demand, maturing on August 30, 2004.demand. The borrowing limit on the line iswas the lesser of $600,000 or the sum of 75% of domestic accounts receivable and 50% of foreign accounts receivable, plus 10% of eligible inventory (up to $250,000). The facility bears interest atrate was the bank’s prime rate minus one percent, as of the August 30, 2003 renewal date, which was 3.25% at September 30, 2003. Prior to the renewal, the facility bore an interest rate at the bank’s prime rate of interest plus one percent, which was 5.00%3.00% at June 30, 2003.2004. All of the subsidiary’sNetpoint’s assets collateralizecollateralized the line of credit. The Company hashad guaranteed 68% of the balance on the line, while the remaining 32% of the balance iswas guaranteed by the subsidiary’sNetpoint’s minority shareholder. The line of credit contains certain financial covenants including minimum thresholds for the leverage ratio and current ratio. At September 30, 2003 and June 30, 2003 respectively,2004, there were no outstanding borrowings on the line of credit, however, at September 30, 2003 and June 30, 2003,credit. However, outstanding standby letters of credit totaled $40,000 leaving $560,000 available for additional borrowings. The subsidiaryNetpoint was in compliance with all loanits covenants at SeptemberJune 30, 2003.2004.

SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(4)(6) Long-term Debt

Long-term debt consists of the following at September 30, 20032004 and June 30, 2003:2004:

The notes payable secured by the distribution center and the motor coach contain certain financial covenants, including minimum net worth, capital expenditure limits, and a maximum debt to tangible net worth ratio, and prohibit the payment of dividends. The Company was in compliance with the various covenants at September 30, 2003.2004.

(5)    Earnings Per Share

Basic earnings per share are computed by dividing net incomeThe note payable secured by the weighted-average numberdistribution center land and building matures on September 5, 2005 with a balloon payment of approximately $4.8 million. The Company has ample borrowing capacity under its existing credit facility and is reviewing its various financing options. As of September 30, 2004, the $5.4 million balance was classified as current debt. As of June 30, 2004, the current portion of the debt was $647,000 and the long-term portion was $4.9 million.

SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

common shares outstanding. Diluted earnings per share are computed by dividing net income by the weighted-average number of common and potential common shares outstanding.

At September 30, 2003 and 2002, there were 18,000 and 0 shares, respectively, excluded from the computation of diluted earnings per share because their effect would have been antidilutive.

(6)(7) Goodwill and Identifiable Intangible Assets

In accordance with SFAS No. 142, “GoodwillGoodwill and Other Intangible Assets”, the Company performs its annual test of goodwill at the end of each fiscal year to determine if impairment has occurred. This testing includes the determination of each reporting unit’s fair value using market multiples and discounted cash flows modeling. At the end of fiscal year 2003,2004, no impairment charge was recorded. During thisthe first quarter the Company recorded a reduction of goodwill related tofiscal year 2005, the purchase of the additional 10% minority interest, as it related to the restructuring of the ChannelMax segment in the amount of $172,000, as required by purchase accounting under SFAS 141. The Company acquired additional goodwill through the acquisition of an additional 12% interest in OUI during the first quarter.and an additional 8% interest in Netpoint. Changes in the carrying amount of goodwill and other intangibles assets for the three months ended September 30, 2003,2004, by operating segment, are as follows:

The following tables summarize the Company’s net sales results for the quarters ended September 30, 2003 and 2002 (net of inter-segment sales):

North American Distribution

North American Distribution sales include sales to technology resellers in the United States and Canada (sales to Canada accounts for less than 2% of total net sales) from the Company’s Memphis, Tennessee distribution center. Sales to technology resellers in Canada account for less than 3% of total net sales for the quarters ended September 30, 2004 and 2003. The 30.6% increase in North American Distribution sales for the quarter ended September 30, 2004, as compared to the same period in the prior year, was driven by strong salesdue to an increase in large orders and a gain in market share.

Sales of the AIDC and POS product categories. The worldwide AIDC and POS product categories grew 17% for the North America distribution segment increased 24.3% as compared to the prior year quarter.The ScanSource selling unit benefited from the aforementioned larger orders and market share gain.

Sales of converged communications products increased 38.2% as compared to the prior year quarter.Both CatalystTelecom, which distributes small and medium business (SMBS) and enterprise (ECG) products, and Paracon, which distributes communication products, experienced record sales for the quarter due to the recruitment of additional resellers and to larger orders.

International Distribution

The international distribution segment includes sales to Latin America (including Mexico) and Europe from the ScanSource selling unit. Sales for the overall international segment increased 37.3% or $8.8 million for the quarter ended September 30, 2004 as compared to the same period in the prior year. The increase in the AIDC and POS net sales was mainly driven by increased volume in the North America markets. Salesfavorable Euro versus U.S. Dollar exchange rate accounts for approximately $2.0 million of the telephony product category decreased 6%increase for the quarter as compared toended September 30, 2004. Without the same periodbenefit of the prior year. Management believesforeign exchange rates, the decrease was a result of the continued general decline in the telephony market demand.

The Company restructured its ChannelMax segment into the North American Distribution segment as of July 1, 2003. This included the purchase of the outstanding minority interest in ChannelMax. The segment is now presented in the North American Distribution amounts above. The decrease inincrease for the quarter over quarter revenues of 52%would have been 28.8% or $1.7 million of ChannelMax has been included in the AIDC and POS product line results discussed above.

International Distribution

The International Distribution segment commenced in November 2001 with the acquisition of Netpoint International, Inc. (“ScanSource Latin America”), a Miami-based distributor that exports primarily to Latin America. On January 1, 2003, ScanSource, Inc. of the North American Distribution segment sold its Mexico unit to ScanSource Latin America at book value with no gain or loss being recorded. The Mexico unit continues to focus on sales of AIDC and POS technologies to the Mexican market.

In January 2002, the Company opened a headquarters and distribution center in Belgium, serving all of Europe. In May 2002, the Company acquired ABC Technology Distribution, a United Kingdom-based distributor that serves the United Kingdom, Ireland and the remainder of Europe. During the quarter ended March 31, 2003, the Company completed its consolidation of the UK distribution center into the Belgium facility. The Company centralized its accounting and sales structure in the Belgium headquarters location. Sales for the overall international segment increased 62% in the first fiscal quarter of 2004 as compared to the same quarter in the prior year.$6.8 million. The increase in sales was primarily attributable to obtaining additional market share in Europe and Latin America and favorable foreign exchange rates of the Euro versus the United States Dollar (“USDs”). The favorable Euro versus USD exchange rate accounts for approximately $2.0 million USDs of theAmerica.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

increase in sales for the quarter ended September 30, 2003.

Gross Profit.Profit

The following tables summarize the Company’s gross profit:

North American Distribution

Gross profit for the North American Distribution segment increased $5.4 million for the quarter ended September 30, 2004 as compared to the prior year quarter. The increase in gross profit quarter over quarter is a result of increased sales volume of the segment.

Gross profit as a percentage of net sales for the North American Distribution segment decreased duringcompared to the quarter ended September 30, 2003 primarily fromprior year quarter. The decrease is a result of product sales mix, including a greater percentage of large orders with a low value-add requirement, and changes in vendor purchasing programs which had the continued effect of ChannelMax’s reduced fee-based revenues. Over the past year, some customers had significantly decreased their usage of fee-based e-logistic services. Fee-based services are recorded directly to net sales thus having a greater impact on the margin of the segment.increasing unit costs.

International Distribution

Gross profit for the international distribution segment increased $756,000 for the quarter ended September 30, 2004 as compared to the prior year quarter. The increase was primarily due to increased distribution sales volume as the segment gained additional resellers and market share.

Gross profit, as a percentage of net sales, which is typically greater than the North American Distribution segment, decreased overfor the same periodquarter ended September 30, 2004 due to changes in product mix for Latin America and the inclusion of additional freight costs in the prior year. The decrease in the gross margin is due to an increase in the sales mix of lower margin products.European business.

Operating Expenses.Expenses

The following table summarizes the Company’s operating expenses:

For the quarter ended September 30, 2004, operating expenses included additional bad debt expense of $865,000 over the same period in prior year. Operating expenses as a percentage of net sales decreased for the quarter ended September 30, 2004 due to greater economics of scale in selling, general and administrative expenses as the sales volume increased.

For the quarter ended September 30, 2003, included approximately $2.3 million ofthe Company incurred restructuring costs for the ChannelMax segment and a discretionary profit sharing contribution of $800,000. Operating expenses for the quarter ended September 30, 2002 included a discretionary profit sharing contribution of $1.4 million, and a charitable contribution of $700,000.

Operating Income.    The following table summarizes the Company’s operating income:

approximately $2.3 million.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations