which the date of acquisition is July 1, 2001 or later. The adoption of SFAS No. 141 by the Company had no effect on its consolidated financial statements.

        The provisions of SFAS No. 142 were required to be applied starting with fiscal years beginning after December 15, 2001. The Company adopted SFAS No. 142 as of the beginning of the first quarter of 2002. The effect of SFAS No. 142 on the Company, iswhich was adopted as of the beginning of 2002, included the elimination of the amortization of goodwill, which prior to 2002 was amortized over 40 years,the identification of reporting units for the purpose of assessing potential future impairments of goodwill and the testing for impairmentimpairments of goodwill on an annual basis. Had the adoption of SFAS No. 142 occurred at the beginning of the previous year, the results would have been as follows (in thousands, except per share amounts):

        See Management's Discussion and Analysis of Financial Condition and Results of Operations for proforma disclosure of this accounting change which additionally incorporates the impact of the change in the tax rate discussed in Note 4 on the reported results for 2001. The Company performed a review of goodwill asduring the first quarter of January 1, 2002 by comparing the fair value of the Company'sCompany’s reporting units (funeral home businessbusinesses by region) to the carrying value of the reporting units and no impairment was recorded at the implementation date of the new accounting standard. Goodwill acquired during the ninethree months ended September 30,March 31, 2002, included $1.0 million for performance-based contingent consideration payments on a prior year acquisition and $0.9 million for a funeral home acquisition in the second quarter of 2002.2001 acquisition.

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(b)

Impairment of Long-Lived Assets

In August 2001 the Financial Accounting Standards Board issued SFAS No. 144, "Accounting“Accounting for the Impairment or Disposal of Long-Lived Assets"Assets”.  SFAS No. 144 addresses financial accounting and reporting of long-lived assets, other than goodwill, that are to be disposed by sale or otherwise (e.g. discontinued operations), and is effective for financial statements issued for fiscal years beginning after December 15, 2001.  The Company adopted SFAS No. 144 as of the beginning of the first quarter of 2002. The effects of adopting SFAS No. 144 were that the businesses that Carriage intends to sell no longer met the criteria to be classified as “assets held for sale”.

(c)               Costs Associated with Disposal Activities

In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.”  SFAS No. 146 addresses financial accounting and reporting for costs associated with exit or disposal activities.  This statement requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred.  Previous guidance, provided under Emerging Issues Task Force (“EITF”) No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including certain costs incurred in a restructuring),” required an exit cost liability to be recognized at the date of an entity’s commitment to an exit plan.  The provisions of this statement are effective for exit or disposal activities that are initiated by a company after December 31, 2002.

(d)              Stock-Based Compensation

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure.” SFAS 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of Statement 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. This Statement is effective for financial statements for fiscal years ending after December 15, 2002.   The Company accounts for stock options and shares issued pursuant to its employee stock purchase plan under APB Opinion No. 25, under which had no effect oncompensation expense is recognized in the Company's financial position orConsolidated Statement of Operations.  Had the Company accounted for stock options and shares pursuant to its employee stock benefit plans under SFAS No. 123 for the three months ended March 31, 2002 and 2003, the results of operations.would have been as follows (in thousands, except per share amounts):

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(e)               Consolidation of Variable Interest Entities

In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities.” FIN No. 46 clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements”, to require consolidation of business entities under certain circumstances, particularly with respect 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. An enterprise that consolidates a variable interest entity is the primary beneficiary of the variable interest entity.  The primary beneficiary of a variable interest entity is the party that absorbs a majority of the entity’s expected losses, receives a majority of its expected residual returns, or both, as a result of holding variable interests, which are the ownership, contractual, or other primary interests in an entity. The Company is currently evaluating FIN No. 46 to determine if its application would change the manner in which it accounts for preneed trusts. The provisions of this statement would be effective beginning with Carriage’s third quarter of 2003.

3.                   MAJOR SEGMENTS OF BUSINESS

Carriage conducts funeral and cemetery operations only in the United States.  The following table presents external revenue, net income and total assets by segment (in thousands):

(1)

4.                   INCOME TAXES

 For 2001, the

The Company had anestimates that its effective tax rate will be 37.5 percent for financial statement purposes in 2003.  Carriage records a valuation allowance to reflect the estimated amount of deferred tax ratefor which realization is uncertain. Management reviews the valuation allowance at the end of 20 percent, reflectingeach quarter and makes adjustments if it is determined that it is more likely than not that the benefit of previously unrecognized tax losses from prior periods related to the Fresh Start restructuring program.benefits will be realized. When the Company incurred the Fresh Start restructuring costs and write-downs in late 2000 and proceeded to dispose of low performing businesses, it could not be assured that it would generate enough future taxable income to

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utilize the sizeable tax benefits created by the tax losses on asset sales. To acknowledge this uncertainty, at the time, the Company recorded a "valuation allowance"valuation allowance to offset these tax benefits until such time that itis could be determined thatit would be more likely than not the Company would be able to deduct them.realize the tax benefits. Based on the positive operating results subsequent to 2000 and management'smanagement’s forecast of future positive operating results, management determined in the first quarter of 2002 that it is more likely than not that the Company will be able to utilize substantially all of these previously unrecognized tax benefits. Accordingly, in the first quarter of 2002 the Company recorded a special one-time tax benefit in the amount of $12.8 million, equal to $0.73 per diluted share, which eliminated substantially alla substantial portion of the valuation allowance. Excluding the $12.8 million tax benefit, income taxes were recorded at the effective rate of 38.2 percent during the first quarter of 2002.

5.                   DEFERRED COMPENSATION AND RESTRICTED STOCK

In January 2003, the Company issued 227,000 shares of restricted stock to certain officers of the Company for bonuses earned during 2002.  Twenty-five percent of the shares vest annually on each of the next four anniversary dates of the grant.  The Company estimates that its effective tax ratevalue of the stock was $3.97 per share, for a total of $902,000, which will be 38.5 percent for financial statement purposes in 2002, excludingamortized into expense over the reduction of the deferred tax valuation allowance. Had the Company also used the 38.5 percent tax rate for the nine months ended September 30, 2001, net income for that period, excluding the effect of the change in accounting for goodwill amortization discussed in Note 2, would have been lower by $1,495,000 or $0.09 per diluted share.

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Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW
four-year vesting period.

 Carriage

OVERVIEW

Our business strategy is a leading provider of death care services and products in the United States. Our historical focus has been on operational enhancements at facilities currently owned to increase revenues and gross profit, as well as growth through acquisitions (although we have not pursued the acquisition strategy since 1999). That focus has resulted in high standards of service, operational performance, and an infrastructure containing measurement and management systems. In 2000, the operating strategy was dramatically shifted to focus uponemphasize increasing operating cash flow. In November 2000, we launched a multi-faceted, restructuring program, called "Fresh-Start", which was designedflow and improving profitability at each business location through strategies that carry out our culture of service and leadership excellence. We do not expect our strategy will require significant investments of new capital over the next two years. We plan to increase financial and operating performance, improve cash flow, reduce debt, and assist Carriage in fulfilling our mission of being the highest quality funeral and cemetery service organization in the industry. Beginning with the fourth quarter of 2000, we have been focused on executing elements of Fresh Start.

        The goals of Fresh Start were and remain restoring credibility to our operating and consolidation model, increasing and better aligning our earnings and cash flow, restoring market credibility to our balance sheet,continue reducing our debt and re-accessing the capital markets.

        The principal elements of Fresh Start include downsizingimproving our corporate organization; changing our operating leadership; changing our preneed funeral organizational strategy; stratifying by performance our funeral and cemetery portfolios; implementing action plansleverage ratios. Our focus is on continuing to improve underperforming businesses; disposingour organizational leadership and quality of some underperforming businesses; adjusting the carrying basis of other underperforming businesses;personnel. Successful execution during 2001 and modifying financial covenants with lenders to facilitate execution of Fresh Start. Most of the elements of Fresh Start have been accomplished and we are seeing the benefits of these actions2002 has, in our operating results.view, positioned the Company as a leader in our industry and improved our financial flexibility. We expect to replace our revolving credit facility during 2003 and prior to its maturity in June 2004. We expect to resume selective acquisitions in 2005.

Net income totaled $18.6$2.1 million infor the first ninethree months of 2003, or $0.12 per diluted share as compared to net income of $16.6 million for the first quarter of 2002, or $1.06 per diluted share. Excluding a $12.8 million, or $0.73 per share special tax benefit, net income was $5.8 million, or $0.33$0.95 per diluted share. Two significant accounting events occurred duringitems significantly impacted the nine months ended September 30, 2002:results and comparability of the eliminationtwo periods. The first quarter of goodwill amortization in connection with the implementation of SFAS No.142, which totaled $3.4 million2002 included an income tax benefit in the first nine monthsamount of 2001, and$12.8 million, equal to $0.73 per diluted share, related to the changereversal of a valuation allowance on deferred tax assets established in 2000. Excluding the Company'simpact of this tax rate from 20 percent to 38.5 percent. Had those two events occurred at the beginning of 2001, net income andbenefit, diluted earnings per share would have totaled $7.0 million and $0.40, respectively, for the first nine monthsquarter of 2001.

        The full year impact to diluted earnings per share, by quarter, for 2001 of these two events2002 would have been as follows:

        Income from operations, which we define as earnings before interest and$0.22. Net income taxes, increased as a percentage of net revenues, from 15.3% for the thirdfirst quarter of 2001 to 15.6%2003 was negatively impacted by the operating results of the funeral segment, which accounts for the third quarter of 2002 and from 19.1% for the nine months ended September 30, 2001 to 20.7% for the nine months ended September 30, 2002. This improvement was primarily due to the elimination of amortization for goodwill beginning January 1, 2002, offset in part by a $0.7 million charge related to

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the termination of an employment agreement with a former officer, $0.5 million in professional fees incurred in connection with changes in tax accounting methods and higher insurance costs. Revenues from funeral homes decreased 2.6% and revenues from cemeteries decreased 8.6% in the third quarter of 2002 compared to the same period in 2001 primarily as a result of a decline in same-store revenues period to period, lower preneed insurance commission revenue and lower cemetery preneed property sales. Other factors that attributed to a decrease in funeral revenue are a lower national death rate compared to the third quarter of 2001 and competition from independent operators in some local markets. Also, approximately 7280 percent of its funeral revenue was generated from traditional funeral services and 28 percent from cremation services, as compared to 73 percent and 27 percent in the third quarter of last year. The average revenue for cremation services increased by 0.6 percentCompany’s revenues, which, when compared to the third quarter of last year. Cemetery revenues were negatively impacted by a weaker economy that resulted in lower discretionary spending by consumer and lower returns on investment funds. Specifically, we experienced a 2.8% decrease in preneed merchandise and service deliveries, a 6.1% decrease in sales of interment and entombment sites and a 1.9% decrease in income from perpetual care trusts and finance charges. The decline in cemetery revenue was offset partially by a 2.2% increase in at-need sales of property, services and merchandise.

        Gross margins for the funeral homes increased from 21.0% in the third quarter of 2001 to 26.1% in the thirdfirst quarter of 2002, primarily becausereported a revenue decline of 7.2 percent and an increase in segment costs and expenses of 3.3 percent. These operating variances combined to reduce the gross profit of the eliminationCompany by $3.1 million compared to the first quarter of goodwill amortization. As a percentage2002. Substantially all of cemetery net revenues, cemetery gross margin was 24.1%the revenue decline in the third quarter of 2002 compared to 24.6%funeral segment revenues was represented by an 8.6 percent decline in same-store funeral services (partially offset by a 1.6 percent increase in the third quarteraverage revenue per service) which was largely due to a decline in the number of 2001.deaths and a loss in market share in an estimated 15 to 20 funeral home businesses.

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CRITICAL ACCOUNTING POLICIES AND ESTIMATES

        Management'sManagement’s discussion and analysis of financial condition and results of operations are based upon our consolidated financial statements presented herewith, which have been prepared in accordance with generally accepted accounting principles.principles in the United States of America.  Our significant accounting policies are summarized in Note 1 to the consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2001.2002.  We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

Funeral and Cemetery Operations

We record the sales of funeral merchandise and services when the funeral service is performed.  Sales of cemetery interment rights are recorded as revenue in accordance with the retail land sales provisions of Statement of Financial Accounting Standards (SFAS) No 66, "Accounting“Accounting for Sales of Real Estate"Estate”.  This method provides for the recognition of revenue in the period in which the customer'scustomer’s cumulative payments exceed 10% of the contract price related to the real estate.  Costs related to the sales of interment rights, which include property and other costs related to cemetery development activities, are charged to operations using the specific identification method in the period in which the sale of the interment right is recognized as revenue.  Revenue from the sales of cemetery merchandise and services are recognized in the period in which the merchandise is delivered or the service is performed.  Revenues to be recognized from the delivery of merchandise and performance of services related to contracts that were acquired in acquisitions are typically lower than those originated by the Company and are likely to exceed the cash collected from the contract and received from the trust at maturity.

Allowances for customer cancellations, refunds and bad debts are provided at the date of sale based on our historical experience.  In addition, we monitor changes in delinquency rates and provide additional bad debt and cancellation reserves when warranted.  When preneed funeral services and merchandise are funded through third-party insurance policies, we earn a commission on the sale of the

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