Annual Report 2005 Aaron Rents, Inc. serves consumers and businesses through the sale and lease ownership, rental and retailing of consumer electronics, residential and office furniture, household appliances, computers and accessories with over 1,200 Company-operated and franchised stores in the United States, Puerto Rico and Canada. The Company’s major operations are the Aaron’s Sales & Lease Ownership division, the Corporate Furnishings division and MacTavish Furniture Industries. Aaron Rents is the industry leader in serving the moderate income consumer, offering affordable payment plans, quality merchandise and superior service. The Company’s strategic focus is on growing the sales and lease ownership business through the addition of new Company-operated stores by both internal expansion and acquisitions, as well as through our successful and expanding franchise program. Contents Financial Highlights Financial Highlights . . . . . . . . . . . . . . . . . . . 1 Letter to Shareholders . . . . . . . . . . . . . . . . . . 2 (Dollar Amounts in Thousands, Except Per Share) Year Ended December 31, 2005 Year Ended December 31, 2004 Percentage Change The Aaron’s Story . . . . . . . . . . . . . . . . . . . . .4 Sales and Lease Ownership . . . . . . . . . . . 5 The Franchise System . . . . . . . . . . . . . . . . 7 Corporate Furnishings . . . . . . . . . . . . . . . 8 Products . . . . . . . . . . . . . . . . . . . . . . . . . . 8 Manufacturing . . . . . . . . . . . . . . . . . . . . . 9 Funding Growth . . . . . . . . . . . . . . . . . . 10 Marketing . . . . . . . . . . . . . . . . . . . . . . . 10 The Aaron’s Corporate Culture . . . . . . . . . 12 Financial Information . . . . . . . . . . . . . . . . . 14 Store Locations . . . . . . . . . . . . . . . . . . . . . . 43 Board of Directors and Officers . . . . . . . . . 44 Corporate and Shareholder Information . . . 44 O P E R AT I N G R E S U LT S Revenues Earnings Before Taxes Net Earnings Earnings Per Share Earnings Per Share Assuming Dilution $1,125,505 92,337 57,993 1.16 1.14 F I N A N C I A L P O S I T I O N Total Assets Rental Merchandise, Net Credit Facilities Shareholders’ Equity Book Value Per Share Debt to Capitalization Pre-tax Profit Margin Net Profit Margin Return on Average Equity $858,515 550,932 211,873 434,471 8.68 32.8% 8.2 5.2 14.3 S T O R E S O P E N AT Y E A R E N D Sales and Lease Ownership Sales and Lease Ownership Franchised* Corporate Furnishings 748 392 58 $946,480 84,506 52,616 1.06 1.04 $700,288 425,567 116,655 375,178 7.54 23.7% 8.9 5.6 15.1 616 357 58 Total Stores 1,198 1,031 18.9% 9.3 10.2 9.4 9.6 22.6% 29.5 81.6 15.8 15.1 21.4% 9.8 0 16.2% * Sales and Lease Ownership franchised stores are not owned or operated by Aaron Rents, Inc. Revenues By Year Net Earnings By Year 1 0200,000400,000600,000800,0001,000,000$1,200,00020042005200120022003($inthousands)010,00020,00030,00040,00050,000$60,00020042005200120022003($inthousands) To Our Shareholders Aaron Rents has never been better positioned for growth after achieving record revenues and earnings in 2005, our 50th year. We celebrated the anniversary by exceeding $1 billion in revenues and increasing our total store count to almost 1,200 despite the impact of two unprecedented back-to-back hurricanes in major markets. Highlights of 2005 include: • Our revenues reached $1.13 billion, a 19% increase over 2004, fueled by a 21% increase in revenues in the Aaron’s Sales & Lease Ownership division, the key driver of our growth. • Franchised Aaron’s Sales & Lease Ownership stores increased their revenues 17% for the year to $419.7 million. Revenues of franchisees, however, are not revenues of Aaron Rents. • Fully diluted earnings per share were $1.14 compared to $1.04 in 2004. Excluding the gains recorded in both years from the sale of our investment positions in several competitors’ stock, net earnings increased over 17% for the year, an exceptional performance by our people given the challenges posed by the hurricanes in the third quarter. Including the $355,000 and $3.4 million in after-tax gains in 2005 and 2004, respectively, from the sales of several competi- tors’ stock, net earnings increased 10.2%. • Nearly 11% of our stores — approximately 125 Company-operated and five franchised stores — felt the effects of Hurricanes Katrina and Rita. Yet despite significant loss of merchandise and property damage, and lost business from store closures, evacuations and displaced employees and residents, our employees rose to the challenge, reopening stores within weeks. • Thirty-eight sales and lease ownership stores in our system achieved annual revenues in excess of $2 million, a record high number that is a validation of Aaron’s business concept. • Our aggressive pace of store openings added a net 167 combined Company-operated and franchised stores in 2005, a 16% increase over the previous year. • The Aaron’s Corporate Furnishings division increased revenues 8% for the year due to higher corporate demand and the immediate need for temporary furnishings resulting from the hurricanes. • Our 50th anniversary provided exceptional opportunities for promotional events which leveraged our multifaceted marketing programs to dramatically increase Aaron’s excellent name recognition. The Company’s revenues increased 19% for the year to a record $1.13 billion compared to $946.5 million for the same period in 2004. Net earnings rose 10% to $58.0 million versus $52.6 million a year ago, or $1.14 per diluted share for 2005 compared to $1.04 per diluted share for 2004. Our Aaron’s Sales & Lease Ownership division increased revenues 21% to $1.0 billion from $831.1 million in 2004. Same store revenues for stores open the entirety of both years advanced 8.3%. The Aaron’s Corporate Furnishings division increased its revenues 8% to $117.5 million from $108.5 million in 2004, the best performance in a number of years. At the end of 2005, we had 1,198 stores open, of which the Aaron’s Sales & Lease Ownership division accounted for 739 Company-operated stores, 392 franchised stores and nine RIMCO stores. In addition, the Aaron’s Corporate Furnishings division operated 58 stores. 2 From left to right: Robin Loudermilk, Charlie Loudermilk, and Ken Butler, President of Aaron’s Sales & Lease Ownership, celebrating the Company’s 50th year at the National Managers Meeting. We awarded new area development agree- ments for the opening of 64 new Aaron’s Sales & Lease Ownership franchised stores last year. At year end we had 272 franchised stores in the pipeline to be opened over the next few years. During 2005, our furniture manufacturing division, MacTavish Furniture Industries, produced more than $80 million, at cost, of furniture for our stores. Most of our manufacturing facilities operated at capacity in the third quarter to meet demand from hurricane-related business. In addition, we expanded our distribution network again last year and now have 16 fulfillment centers across the United States, enhancing the vertical integration essential to our superior customer service and enabling our stores to offer same- or next-day delivery as well as quick response to sudden changes in demand. The Company’s financial position and balance sheet are very strong and continue to provide a competitive advantage. In July, we completed a $60 million private placement of debt. These 5.03% senior unsecured notes due in 2012 provide long- term financing at historically low borrowing rates. The Company also negotiated a new franchise loan facility for inventory financing to our Canadian franchisees. And for the second year, we increased the cash dividend to shareholders. During the year, Ingrid Saunders Jones, Senior Vice President of Corporate External Affairs for The Coca-Cola Company, resigned from our Board of Directors. We are extremely grateful for her 10 years of service. Elected to succeed her was John Schuerholz, the Executive Vice President and General Manager of the Atlanta Braves. His managerial ability and business acumen make him a valuable addition to our Board of Directors. Our management team was further strengthened during the year as Christopher M. Champion joined the Company as Vice President, General Counsel. Within the Aaron’s Sales & Lease Ownership division, Paul A. Doize was promoted to Vice President, Controller, from Controller, and Steven A. Michaels was promoted to Vice President, Franchise Finance, from Director of Franchise Finance. The tremendous growth of our Company in recent years and its success over half a century are a credit to the people of Aaron Rents, our franchisees, our financial and business partners, our shareholders and a management team without equal. We begin Aaron’s second half-century with great anticipation that the best is yet to come! Sincerely, R. Charles Loudermilk, Sr. Chairman and Chief Executive Officer Robert C. Loudermilk, Jr. President and Chief Operating Officer 3 The Aaron’s Story The story of Aaron Rents began half a century ago with the vision and determination of founder Charlie Loudermilk. After graduating from the University of North Carolina at Chapel Hill, Loudermilk became a highly successful salesman for a major pharmaceutical company. But he dreamed of his own rental business. He returned to his hometown of Atlanta in 1954 to help his mother open a new restaurant, and the next year he started his rental business on the proverbial shoestring, choosing the name Aaron Rents to get first listing in the Yellow Pages, the main source of customers. The first order was for 300 chairs for an estate sale in Atlanta’s upscale Buckhead section. Charlie agreed to rent chairs he didn’t have for 10 cents apiece per day. With the order in hand, he borrowed $500 from a bank and recruited a salesman friend to invest $500 as partner in the new enterprise. They rented a truck, bought 300 Army surplus folding chairs, delivered and set up the chairs under a tent, then picked them up — hard work in the midsummer heat. It was too much for the partner. He sold his interest to Loudermilk, who was undaunted by work or heat and determined to make his dream a reality. The strategy from the start was the same as it is today — to let the customers dictate the products. “Aaron Rents Almost Everything” was the slogan. The business found a ready market for folding chairs and party supplies, then patient care equipment and television sets. For the first seven years of operation, all profits were reinvested in inventory, and Charlie Loudermilk continued to work part-time at his mother’s restaurant, the Rose Bowl. The business outgrew its first building within a few years and moved into a larger facility. The product line continued to expand in response to customer needs. As a historical footnote, the Company rented four outdoor tents to the civil rights marchers on the historic Selma to Montgomery march in 1965. It was the post-World War II job boom in the Atlanta area that changed Aaron’s market focus to furniture — first, apartment furniture rented for a three-month minimum for newly arrived workers and, ultimately, longer term rentals of residential and office furniture. Longer rental terms resulted in lower operating costs. The Company’s first furniture only rental store opened in 1964. Focusing on furniture, the Company was able to develop a stronger corporate image and a more defined target market. During the 1960s, consumers’ credit options were somewhat limited. Credit cards were in the early stages of development and primarily a tool for business expenditures. Demand for furniture was strong, and the development of a furniture rental concept allowed Aaron Rents to service customers who liked the flexibility of renting as well as consumers who had few financing The 1950s The 1950s were a time of great advances in consumer convenience — Clarence Birdseye introduced frozen vegetables and Diner’s Club intro- duced the first credit card. Color television, Silly Putty and the golden arches of McDonald’s appeared on the landscape. “I Love Lucy” and “Wagon Train” entertained families each week. A young man from Mississippi, Elvis Presley, signed a contract with Sun Records, and teenaged girls across the country fell in love. 300 chairs could be rented for 10 cents per day 4 And in 1955, Charlie Loudermilk was working in Atlanta, helping his mother run a restaurant. With a partner and a $500 loan, Loudermilk bought 300 chairs from an Army surplus store and rented warehouse space and a truck to make deliveries. The Company was named Aaron Rents to guarantee first listing in telephone directories. Within a month, the partner wanted his investment back, and Aaron Rents was solely owned by Charlie Loudermilk. The corporate strategy was to offer for rental whatever customers desired, including party supplies, exercise equipment, seating and patient health care equipment. Appropriately, the Company’s slogan in those early years was “Aaron Rents Almost Everything.” alternatives. The new business model enabled the Company to enter new markets, and the first store outside of Atlanta was opened in Baltimore in 1967. By the 15th year of operations, Aaron Rents had annual revenues in excess of $2 million and an inventory investment of over $3 million. Sales and Lease Ownership By the late 1980s, the consumer marketplace was again undergoing significant change. Furniture retailing was increasingly becoming the domain of large national and regional chains with in-house financing capability. Furniture rental was becoming more of a corporate relo- cation business with furnished apartments emerging as significant competition. Opportunities for growth in the short-term furniture rental business were slowing. In 1987, Aaron Rents introduced the concept of sales and lease ownership in existing rental stores and subsequently opened stand-alone stores. Aaron’s Sales & Lease Ownership is now the engine of growth. Sales and lease ownership is a hybrid of retail and rental, offering credit- constrained consumers an attractive vehicle to acquire home furnishings and electronics. Key features of the Company’s sales and lease ownership concept include • Monthly or semimonthly payments • A broad range of quality brand-name products • Same- or next-day delivery, free of charge • No application fees, no balloon payments • No long-term obligation • Flexible payment options (cash, check, credit or debit card) • Lower total cost than rent-to-own competitors • Repair or replacement guarantee The Aaron’s Sales & Lease Ownership concept is based on 12-, 18- or 24-month lease payment options. A “cash and carry” price is also displayed and is competitive within the discount retail marketplace. Aaron’s also offers a 90-day “same as cash” option for cash purchases. The average customer currently has a monthly payment of over $145. For the customer who takes ownership of The 1960s Man first walked on the moon and the Beatles first set foot in America. The compact audio cassette was introduced and the first communications satellite launched. Sean Connery starred in the first James Bond movie, “Dr. No.” The Civil Rights Movement dramatically changed American society, and Aaron Rents supplied the tents for the Selma march. 1965–Companyprovides 4tentsforcivilrights marchfromSelmato Montgomery,Alabama 1 9 6 7 – S t o r e o p e n s t h e f i r s t i n B a l t i m o r e , m a r k e t o u t s i d e o f A t l a n t a 5 the leased merchandise, Aaron’s prices are typically over 30% less than competitors. The customer may terminate the lease at any point without additional obligation. A significant number of Aaron’s customers have leased from the Company before, an indicator of the Company’s customer loyalty and commitment to service. The Aaron’s stores, which average 9,000 square feet, are open six days a week, normally closing at 7 p.m. (6 p.m. on Saturdays) and can be operated with less than 10 employees. A typical store will draw from up to a 10-mile radius in an urban market or two to three rural counties. The organizational structure has evolved and been adapted to best manage the Company during various phases of growth. With stores now in 46 states, Canada and Puerto Rico, decentralization based on regional management has proven most effective in managing the store system. Support functions such as marketing and vendor selection are centralized, but a regional management structure allows variations in product offerings based on local market characteristics and improved site selection. Execution is critical to success of the sales and lease ownership business, and the Company pays tight attention to inventory manage- ment, cost controls and cash management. The growth prospects for the Aaron’s Sales & Lease Ownership concept remain bright. The Company has identified potential markets that would accommodate more than a doubling in the store base from current lev- els. The market for sales and lease ownership is estimated at 43% of U.S. households, defined as households with $50,000 or below in annual income, and the Company believes it is expanding the market at the top end. In addition, growth has been achieved through the addition of new product categories. Repeat business from a loyal customer base has been a key to strong and sustained same store revenue growth. During 2005, the Company averaged opening at least three new stores each week and ended the year with 748 Company-operated and 392 franchised sales and lease ownership stores in 46 states. The Company plans 15% growth in store count per annum for the next several years. The 1970s Intel introduced the microprocessor in 1971. Popular Mechanics featured a kit for a personal computer in 1975, and Bill Gates dropped out of Harvard to start a software company. The Watergate break-in led to an unprecedented presidential resignation. Aaron Rents established a furniture manufacturing operation which has been expanded numerous times to keep up with corporate growth. 1971–Plant acquired, Aaron Rents begins to manufacture furniture 6 1974 – Ken Butler joins the Company The Franchise System By 1992, the Company was ready to launch a fran- chise program as an additional growth vehicle and as a way to extend the sales and lease ownership concept into new markets. Franchising has allowed the Company to establish a national presence much more quickly than would have been possible with only Company-operated stores. In addition, franchising leverages the Company’s manufacturing and distribution systems as well as marketing programs. Typically, a franchisee initially acquires the rights for one to six stores. The typical franchisee owns and operates three to four stores, but several franchisee groups operate over 10 locations. There are over 100 different franchisee organizations with the largest franchisee owning and operating over 50 stores. Franchised stores are located in 43 states and Canada, and at the end of 2005 there were 272 franchise stores awarded that are expected to open within the next three to four years. 130 franchised stores, providing franchisees with an attractive exit strategy and the Company with additional high performing stores. The franchisees have access to all of the Company’s expertise including site selection, merchandising, training and assistance in obtaining inventory financing. Initial franchise terms are for 10-year periods, and many franchisees have renewed for a second 10-year term. Franchisees pay a $50,000 franchise fee for each store opened and a royalty of either 5% or 6% which affords full access to the Company’s marketing and promotional programs as well as management training programs through “Aaron’s University.” Periodic meetings of the franchise association provide venues to discuss current issues and operational strategies and to preview new merchandise and marketing initiatives. Company Revenues From Franchising Company Pre-tax Profit From Franchising Franchise fees and royalties now contribute over 20% of the Company’s earnings. Since the inception of the franchise program, Aaron Rents has acquired over The 1980s The space shuttle was first launched in 1981 and the Berlin Wall fell in 1989. The Global Positioning System (GPS) was launched with orbiting satellites. Aaron Rents completed an initial public offering of stock and introduced a new concept, rent-to-own, the predecessor of the sales and lease ownership program. 1982–Initial public offering of stock 1 9 8 6 – A n n u a l r e v e n u e s p a s s $ 1 0 0 , 0 0 0 , 0 0 0 1982 – Starts manufacturing operations in Coolidge, Georgia 1985–EdQuiñones joinstheCompany 1987–Therent-to- ownconcept,the predecessorofthesales andleaseownership program,introduced 1 9 8 7 – c a s h r s t F i d i v i d e n d 7 200120022003200405,00010,00015,00020,000$25,0002005($inthousands)05,00010,00015,00020,00025,000$30,00020042005200120022003($inthousands) Products At various times in its corporate history, Aaron Rents has offered convention equipment, business equip- ment, home health care products and other items. For many years, residential and office furniture formed the foundation of the product lineup, but consumer demand has changed, and many new products for the home have been introduced over the past 30 years. In the early 1980s, the Company began to test electronic products, which have continued to experience strong growth. Electronics currently generate over 40% of revenues. The product line has expanded to include household appliances, accessories and specialty items including lawn tractors and jewelry. Personal computers were added to the product line in the late 1990s and now generate over 13% of revenues in the Aaron’s Sales & Lease Ownership division. Aaron’s offers nationally recognized brands including GE, Maytag, Frigidaire, Simmons, La-Z-Boy, Sony, Mitsubishi and Dell. The Company is the largest vendor of RCA widescreen TVs in the United States. The Company’s strategy is to identify desirable products that are either household essentials (furniture and appli- ances, for example) or declining in price and becoming more affordable to a 1992 – First franchised store awarded and opened 1 9 9 4 – S e c o n d a r y o f f e r i n g o f 1 . 3 m i l l i o n s h a r e s r a i s e s $ 1 4 m i l l i o n Corporate Furnishings The Company’s legacy business of the rent-to-rent division, now called Aaron’s Corporate Furnishings, remains a vital part of Company operations but with a corporate rather than consumer focus. Historically, this division serviced the temporary furniture needs of consumers (for example, snowbirds, military families and students) and corporate employee relocations. Over time, the short-term rental market changed significantly with the advent of furnished apart- ments and extended stay hotels. Increasingly, this division serves corporate customers, providing temporary rentals related to new business locations and temporary employee postings or relocations. This division rents office furniture including wall panel systems, desks and work stations as well as residential furniture, electronics and appliances out of 58 stores located in 15 states. The 1990s The first reality television show was introduced on MTV. Tiger Woods won his first Masters Tournament at 21, and Lance Armstrong won his first Tour de France. The first cloned animal, Dolly the sheep, was born. Aaron Rents opened its 250th store and hired the 2,000th employee. The Company initiat- ed a franchise program, launch- ing a new avenue of growth, and the stock was listed on the New York Stock Exchange. 8 Company-Operated Sales & Lease Ownership Store Rental Revenues broader consumer market, such as high definition tele- visions and personal computers. Typically, the price points of electronics begin to decline within a few years of introduction, and this pattern has held true with video- cassette recorders, DVDs, big screen televisions and other items. New products in the electronics market have been important to growth and Aaron Rents should continue to benefit from the proliferation of entertainment products and declining product costs. Flat screen televisions, for example, are becoming a mass market product, and Aaron Rents recently introduced three LCD (liquid crystal display) models as pricing has declined to levels affordable to the Company’s target market. Recently, the Company began an experiment offering a large selection of custom rims and tires for lease. Personalization and accessoriza- tion of cars have broadened from a niche market of aftermarket aficionados to a large nationwide market, particularly with young adults. With nine recently opened RIMCO stores, the Company is testing participation in this rapidly growing aftermarket automotive market. Manufacturing In order to maintain a high level of customer service, assure timely deliveries and control the quality of the furniture offered, Aaron Rents opened a 10,000 square-foot furniture manufacturing plant in Gwinnett County, Georgia, in 1971. The original plant was expanded exponentially within several years, and the MacTavish Furniture Industries division was established with additional plants in Florida and Georgia. The Florida furniture plants were sold and operations relo- cated to the expanded Georgia facilities a few years ago. At the time of the Company’s initial public offering in 1982, MacTavish produced slightly over $5 million, at cost, of furniture per year. In 2005, the MacTavish division manufactured furniture valued in excess of $80 million for distribution to the Company’s stores. The Company continues to believe that vertical integration is a competitive advantage, though a changed one. MacTavish designs and manufactures furniture using modular components so that products can easily be refurbished and returned to rental inventory or sold after coming off rent. Products are built for durability and comfort with extra coils, padding and hardwood. Because the vast majority of furniture is now on lease rather than short-term rentals, the refurbishment function has become far less important. The range of products manufactured has also changed over the years based on cost consider- ations and other variables. MacTavish produces bedding, upholstered furniture, lamps 1 9 9 6 – D e a t h o f l k , A d d i e L o u d e r m i m o t h e r a n d e a r l y p a r t n e r i e L o u d e r m i o f C h a r l l k 1998–Stock listed on the NYSE R N T 1998 – Secondary offering of 2.1 million shares raises $40 million 9 Electronics and Appliances 52% Furniture 33%Computers 13%Other 2%Electronics and Appliances 52% Furniture35%Computers 12%Other 1% and office systems, all in 12 modern manufacturing plants. Most case goods are sourced overseas through estab- lished vendor relationships. Products are distributed through a network of 16 modern fulfillment centers strategically located in 14 states and Puerto Rico, enabling the Company to offer same- or next-day delivery. Vertical integration allows the Company to respond quickly to shifts in demand or styling. This was dramatically proven during the third quarter of 2005 when the manufacturing division worked beyond capacity to achieve a 39% increase in production in order to meet the demands for replacement furniture in the hurricane-impacted markets of Louisiana and Texas. Funding Growth By 1982, the Company was approaching $50 million in revenues and operated over 60 stores in 11 states. Historically, the Company had been funded through bank borrowings and private debt. An initial offering of 1 million shares of common stock was completed in 1982. This offering significantly increased the Company’s financial flexibility and avenues of funding, also provid- ing shareholders with an attractive growth vehicle. Since that initial public offering, Aaron Rents has completed three additional equity offerings, raising an aggregate of $88 million. Cash dividends were first paid in 1987, and the payout has increased several times. Shares of the Company’s stock have been split five times since the ini- tial public offering. A thousand dollars invested in Aaron Rents at the time the Company went public would be worth approximately $18,500 at December 31, 2005. Management continues to believe that being a public company is a competitive advantage, providing access to growth capital through public and private channels. The Company’s balance sheet and financial position are extremely strong. Marketing As the Aaron’s Sales & Lease Ownership division has grown, marketing has become more sophisticated and national in scope. For many years, newspaper and direct mail circulars were the primary avenues to reach consumers, but current marketing efforts are multifaceted, utilizing many dis- tribution channels including television, radio, direct mail, promotions and sponsorships. The in-house marketing department has developed a port- folio of marketing tools, such as Store Growth The 2000s Y2K came and went. Since 2000, the iPOD has been introduced and cellphones now incorporate cameras. A U.S. space mission has landed on Mars. Aaron Rents has passed $1.0 billion in revenues and opened the first stores in Canada. 10 2000 – Acquired 82 locations from Heilig-Meyers 2 0 0 0 – 5 0 0 t h s t o r e o p e n s 2002–Secondary offeringof1.7 millionsharesraising $34million 2 0 0 3 – To t a l C o m p a n y a n d f r a n c h i s e d s t o r e r e v e n u e s e x c e e d i o n l l $ 1 . 0 b i 02004006008001,0001,20020042005200120022003(numberofstores) referral coupons, grand opening catalogs, VIP cards and door hangers, which can be used by store managers depending on local market dynamics. In addition, over the past year, all in-store signage has been retooled with improved graphics and detailed information on the advantages of leasing. The Company has developed targeted marketing for the Hispanic community, utilizing Spanish-language print and broadcast media. Aaron’s in- house advertising and promotions department distributes over 20 million direct mail circulars each month which highlight featured merchandise and illustrate the cost advantage to consumers of sales and lease ownership compared to competitors’ rent-to-own programs. “Aaron’s 312” Busch Series race and the “Aaron’s 499” Nextel race at Talladega Super Speedway. The NASCAR sponsor- ship is integrated into advertising, promotional and marketing initiatives, significantly boosting the Company’s brand awareness and customer loyalty. A significant portion of the marketing program is based on the “Drive Dreams Home” sponsorship of NASCAR, a sport with demographics highly aligned with those of the Company’s customers. To celebrate the 50th anni- versary of Aaron Rents, the Company planned a full year of marketing and promotional activities culminating with the awarding of a grand prize — a 1955 mint condition Chevrolet Bel Air — at the Texas Motor Speedway in November of 2005. Aaron’s Sales & Lease Ownership is the title sponsor of the Other key sports sponsor- ships include rapidly growing Arena Football, NBA professional basketball, wrestling telecasts and other regional telecasts. Marketing programs for the Aaron’s Corporate Furnishings division are primarily print-based and targeted to corporate customers. In addition, the division has a national accounts program that develops strategic partnerships to service clients’ nationwide needs. As an example, the Corporate Furnishings division has devel- oped an alliance with a large trailer company to handle all of the short-term furnishing needs for trailers used at NASCAR races. The division is also sponsor of the Tour de Georgia professional cycling racing program. 2004 – Move from semiannual to quarterly cash dividends, payout doubled 2003–Firststores inCanadaopened, byfranchisee 2005–Company celebrates 50th Anniversary 2 0 0 5 – G r o u n d b r e a k i n g f o r 1 , 0 0 0 t h A a r o n ’s s t o r e 11 The Aaron’s Corporate Culture Astrong corporate culture has been the foundation of Aaron Rents’ growth story. Many members of top management have been with the Company for over 20 years. Charlie Loudermilk continues to stress the importance of a strong corporate culture and commitment to employee development. Aaron’s University offers a broad line of training and continuing education initia- tives that are available to Company employees and franchisee organizations. The Aaron's University cur- riculum also ensures standardization of store operations within a nationwide system. Most regional managers and operational managers began in store operations and have moved up through the ranks. The long tenure of the management team is a key to the Company’s success and the consistency of a strong cor- porate culture. ACORP (Aaron’s Community Outreach Program), another example of the strong corporate culture, was initiated in 1999. This program awards $500 a month to each store that achieves specified performance goals which can be disbursed to local charities designated by the store’s associates. Stores and associates have also been active in Warrick Dunn’s Home for the Holidays program, which awards homes to deserving single mothers. Aaron’s has furnished homes in communities ranging from Atlanta to Orlando to St. Louis. Over the past seven years, ACORP has donated over $2.7 million to a variety of organizations in communities across America. The Aaron Rents corporate culture and commitments to employees were tested and reinforced by the back-to- back hurricanes in the Gulf Coast region in August and September of 2005. Over 100 of the Company’s stores were impacted in some way by Hurricanes Katrina and Rita and many employees suffered extensive damage to their homes. The Company kept all employees of closed Ken Butler, President of Aaron’s Sales & Lease Ownership, and Shirley Franklin, Mayor of Atlanta, participate in the dedication of a Warrick Dunn Home for the Holidays house. 12 stores on the payroll for an extended period of time and guaranteed all affected employees jobs within the Aaron Rents system. The management team and employees pulled together and reopened stores as quickly as possible, in some cases setting up a temporary store in a parking lot. The MacTavish employees worked weeks of overtime in order to meet the spike in demand in the corporate furnishings division as businesses relocated and set up temporary offices. The Company sent teams of associates to the affected areas to facilitate deliveries and store operations. Our corporate culture was, indeed, tested in 2005 and emerged stronger than ever. Scenes from Hurricane Katrina in Louisiana and a note left on a storefront by Aaron’s employees. 13 Financial Contents Selected Financial Information . . . . . . . . . . 15 Consolidated Statements of Management Report on Internal Management’s Discussion and Analysis of Financial Condition Shareholders’ Equity . . . . . . . . . . . . . . . . . . 26 Control Over Financial Reporting . . . . . . . 39 Consolidated Statements of Cash Flows . . . 27 Reports of Independent Registered Public and Results of Operations . . . . . . . . . . . . . . 16 Notes to Consolidated Accounting Firm . . . . . . . . . . . . . . . . . . . . . 40 Consolidated Balance Sheets . . . . . . . . . . . . 25 Financial Statements . . . . . . . . . . . . . . . . . . 28 Common Stock Market Consolidated Statements of Earnings . . . . . 26 Prices and Dividends . . . . . . . . . . . . . . . . . .42 14 Selected Financial Information (Dollar Amounts in Thousands, Except Per Share) OPERATING RESULTS Revenues: Rentals and Fees Retail Sales Non-Retail Sales Franchise Royalties and Fees Other Costs and Expenses: Retail Cost of Sales Non-Retail Cost of Sales Operating Expenses Depreciation of Rental Merchandise Interest Earnings Before Income Taxes Income Taxes Net Earnings Earnings Per Share Earnings Per Share Assuming Dilution Dividends Per Share: Common Class A FINANCIAL POSITION Rental Merchandise, Net Property, Plant and Equipment, Net Total Assets Interest-Bearing Debt Shareholders’ Equity AT YEAR END Stores Open: Company-Operated Franchised Rental Agreements in Effect Number of Employees Year Ended December 31, 2005 Year Ended December 31, 2004 Year Ended December 31, 2003 Year Ended December 31, 2002 Year Ended December 31, 2001 $ 845,162 58,366 185,622 29,474 6,881 1,125,505 39,054 172,807 507,158 305,630 8,519 1,033,168 92,337 34,344 57,993 1.16 1.14 $ $ $ .054 .054 $ 550,932 133,759 858,515 211,873 434,471 806 392 723,000 7,600 $694,293 56,259 160,774 25,093 10,061 946,480 39,380 149,207 414,518 253,456 5,413 861,974 84,506 31,890 $ 52,616 1.06 $ 1.04 $ .039 .039 $425,567 111,118 700,288 116,655 375,178 674 357 582,000 6,400 $553,773 68,786 120,355 19,328 4,555 766,797 50,913 111,714 344,884 195,661 5,782 708,954 57,843 21,417 $ 36,426 .74 $ .73 $ .022 .022 $343,013 99,584 559,884 79,570 320,186 560 287 464,800 5,400 $459,179 72,698 88,969 16,595 3,247 640,688 53,856 82,407 293,346 162,660 4,767 597,036 43,652 16,212 $ 27,440 .58 $ .57 $ .018 .018 $317,287 87,094 487,468 73,265 280,545 482 232 369,000 4,800 $403,385 60,481 66,212 13,620 2,983 546,681 43,987 61,999 276,682 137,900 6,258 526,826 19,855 7,519 $ 12,336 .28 $ .27 $ .018 .018 $258,932 77,282 403,881 77,713 219,967 439 209 314,600 4,200 The Company adopted Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, on January 1, 2002. If the Company had applied the non-amortization provisions of Statement 142 for all periods presented, net earnings and diluted net earnings per share would have increased by $688,000 ($.013 per share) for the year ended December 31, 2001. 15 Management’s Discussion and Analysis of Financial Condition and Results of Operations Executive Summary Key Components of Income Aaron Rents, Inc. is a leading U.S. company engaged in the combined businesses of the rental, lease ownership and specialty retailing of consumer electronics, residential and office furniture, household appliances, and accessories. As of December 31, 2005, we had 1,198 stores, which includes both our Company-operated and franchised stores, and operated in 46 states, Puerto Rico and Canada. Our major operating divisions are the Aaron’s Sales & Lease Ownership division, the Aaron Rents’ Corporate Furnishings division, and the MacTavish Furniture Industries division. • Our sales and lease ownership division now operates in excess of 740 stores and has more than 390 franchised stores in 46 states, Puerto Rico and Canada. Our sales and lease ownership division represents the fastest growing segment of our business, accounting for 89%, 88%, and 86% of our total revenues in 2005, 2004, and 2003, respectively. • Our corporate furnishings division, which we have operated since our Company was founded in 1955, remains an important part of our business. The corporate furnishings division is one of the largest providers of temporary rental furniture in the United States, operating 58 stores in 14 states as of December 31, 2005. • Our MacTavish Furniture Industries division manufactures and supplies nearly one-half of the furniture and related accessories rented and sold in our stores. Most of our growth comes from the opening of new sales and lease ownership stores and increases in same store revenues for previously opened stores. We added a net of 167 sales and lease ownership stores in 2005, through the opening of new Company-operated stores, franchised stores, and acquisitions. We acquire sales and lease ownership stores from time to time, generally either from small operators of rental stores or from our franchisees. In 2005, we added 21 stores acquired from other operators and 35 stores acquired from our franchisees. We expect to open approximately 90 Company-operated stores in 2006. We also use our franchise program to help us expand our sales and lease ownership concept more quickly and into more areas than we otherwise would by opening only Company-operated stores. Our franchisees opened 71 stores in 2005. We expect to open approximately 70 franchise stores in 2006. Franchise royalties and other related fees represent a growing source of revenue for us, accounting for 2.6%, 2.7%, and 2.5% of our total revenues in 2005, 2004, and 2003, respectively. In this management’s discussion and analysis section, we review the results of our sales and lease ownership and corpo- rate furnishings divisions, as well as the five components of our revenues: rentals and fees, retail sales, non-retail sales, franchise royalties and fees, and other revenues. We separate our cost of sales into two components: retail and non-retail. REVENUES. We separate our total revenues into five components: rentals and fees, retail sales, non-retail sales, franchise royalties and fees, and other revenues. Rentals and fees includes all revenues derived from rental agreements from our sales and lease ownership and corporate furnishings stores, including agreements that result in our customers acquiring ownership at the end of the term. Retail sales represents sales of both new and rental return merchandise from our sales and lease ownership and corporate furnishings stores. Non-retail sales mainly represents merchandise sales to our franchisees from our sales and lease ownership division. Franchise royalties and fees represent fees from sale of franchise rights and royalty payments from franchisees, as well as other related income from our franchised stores. Other revenues includes income from the sale of equity investments and other miscellaneous revenues. COST OF SALES. We separate our cost of sales into two components: retail and non-retail. Retail cost of sales represents the original or depreciated cost of merchandise sold through our Company-operated stores. Non-retail cost of sales primarily represents the cost of merchandise sold to our franchisees. DEPRECIATION OF RENTAL MERCHANDISE. Depreciation of rental merchandise reflects the expense associated with depreciating merchandise held for rent and rented to customers by our Company-operated sales and lease ownership and corporate furnishings stores. Critical Accounting Policies Revenue Recognition Rental revenues are recognized in the month they are due on the accrual basis of accounting. For internal management reporting purposes, rental revenues from the sales and lease ownership division are recognized as revenue in the month the cash is collected. On a monthly basis, we record an accrual for rental revenues due but not yet received, net of allowances, and a deferral of revenue for rental payments received prior to the month due. Our revenue recognition accounting policy matches the rental revenue with the corresponding costs, mainly depreciation, associated with the rental merchandise. At the years ended December 31, 2005 and 2004, we had a revenue deferral representing cash collected in advance of being due or otherwise earned totaling $20.3 million and $15.9 million, and an accrued revenue receivable net of allowance for doubtful accounts based on historical collection rates of $4.8 million and $4.1 million, respectively. Revenues from the sale of merchandise to franchisees are recognized at the time of receipt by the franchisee and revenues from such sales to other customers are recognized at the time of shipment. 16 Management’s Discussion and Analysis of Financial Condition and Results of Operations Rental Merchandise Our sales and lease ownership division depreciates merchandise over the agreement period, generally 12 to 24 months when rented, and 36 months when not rented, to 0% salvage value. Our corporate furnishings division depreciates merchandise over its estimated useful life, which ranges from six months to 60 months, net of salvage value, which ranges from 0% to 60%. Sales and lease ownership merchandise is generally depreciated at a faster rate than our corporate furnishings merchandise. As sales and lease ownership revenues continue to comprise an increasing percentage of total revenues, we expect rental merchandise depreciation to increase at a correspondingly faster rate. Our policies require weekly rental merchandise counts by store managers and write-offs for unsalable, damaged, or missing merchandise inventories. Full physical inventories are generally taken at our fulfillment and manufacturing facilities on a quarterly basis with appropriate provisions made for missing, damaged and unsalable merchandise. In addition, we monitor rental merchandise levels and mix by division, store and fulfillment center, as well as the average age of merchandise on hand. If unsalable rental merchandise cannot be returned to vendors, its carrying value is adjusted to net realizable value or written off. All rental merchandise is available for rental and sale. Effective September 30, 2004, we began recording rental merchandise carrying value adjustments on the allowance method, which estimates the merchandise losses incurred but not yet identified by management as of the end of the accounting period. Previously, we accounted for merchandise inventory adjustments using the direct write-off method, which recognized merchandise losses only after they were specifically identified. This adoption of the allowance method had the effect of increasing expenses in the third quarter of 2004 for a one-time adjustment of $2.5 million to establish a rental merchandise allowance reserve on our balance sheet. We expect rental merchandise adjustments in the future under this new method to be materially consistent with the prior years’ adjustments under the direct write-off method. The 2005 rental merchandise adjustments include write-offs of merchan- dise in the third quarter that resulted from losses associated with Hurricanes Katrina and Rita. These hurricane related write-offs were $2.8 million net of expected insurance pro- ceeds. Rental merchandise adjustments, including the effect of the establishment of the reserve mentioned above, totaled $21.8 million, $18.0 million, and $11.9 million during the years ended December 31, 2005, 2004, and 2003, respectively. Leases and Closed Store Reserves The majority of our Company-operated stores are operated from leased facilities under operating lease agreements. The substantial majority of these leases are for periods that do not exceed five years. Leasehold improvements related to these leases are generally amortized over periods that do not exceed the lesser of the lease term or five years. While a majority of our leases do not require escalating payments, for the leases which do contain such provisions we record the related lease expense on a straight-line basis over the lease term. Finally, we do not generally obtain significant amounts of lease incentives or allowances from landlords. The total amount of incentives and allowances received in 2005, 2004, and 2003 totaled $1.5 million, $1.3 million, and $.6 million, respectively. Such amounts are recognized ratably over the lease term. From time to time, we close or consolidate stores. Our primary cost associated with closing or consolidating stores is the future lease payments and related commitments. We record an estimate of the future obligation related to closed or con- solidated stores based upon the present value of the future lease payments and related commitments, net of estimated sublease income which we base upon historical experience. For the years ended December 31, 2005 and 2004, our reserve for closed or consolidated stores was $1.3 million and $2.2 million. If our estimates related to sublease income are not correct, our actual liability may be more or less than the liability recorded at December 31, 2005. Insurance Programs Aaron Rents maintains insurance contracts to fund workers compensation and group health insurance claims. Using actuarial analysis and projections, we estimate the liabilities associated with open and incurred but not reported workers compensation claims. This analysis is based upon an assessment of the likely outcome or historical experience, net of any stop loss or other supplementary coverages. We also calculate the projected outstanding plan liability for our group health insurance program. Effective September 30, 2004, we revised certain estimates related to our accrual for group health self-insurance based on our experience that the time periods between our liability for a claim being incurred and the claim being reported had declined and favorable claims experience which resulted in a reduction in expenses of $1.4 million for the nine month period ended September 30, 2004. Our liability for workers compensation insurance claims and group health insurance was $3.1 million and $3.2 million at the years ended December 31, 2005 and 2004, respectively. If we resolve existing workers compensation claims for amounts that are in excess of our current estimates and within policy stop loss limits, we will be required to pay additional amounts beyond those accrued at December 31, 2005. Additionally, if the actual group health insurance liability exceeds our projections, we will be required to pay additional amounts beyond those accrued at December 31, 2005. The assumptions and conditions described above reflect management’s best assumptions and estimates, but these items involve inherent uncertainties as described above, which may or may not be controllable by management. As a result, the accounting for such items could result in different amounts if management used different assumptions or if different conditions occur in future periods. Same Store Revenues We refer to changes in same store revenues as a key performance indicator. For the year ended December 31, 2005 we calculated this amount by comparing revenues as of December 31, 2005 and 2004 for all stores open for the entire 24-month period ended December 31, 2005, excluding stores that received rental agreements from other acquired, closed or merged stores. For the year ended December 31, 2004 we cal- culated this amount by comparing revenues as of December 31, 2004 and 2003 for all stores open for the entire 24-month peri- od ended December 31, 2004, excluding stores that received rental agreements from other acquired, closed or merged stores. 17 Management’s Discussion and Analysis of Financial Condition and Results of Operations Results of Operations Year Ended December 31, 2005 Versus Year Ended December 31, 2004 The following table shows key selected financial data for the years ended December 31, 2005 and 2004, and the changes in dollars and as a percentage to 2005 from 2004. (In Thousands) REVENUES: Rentals and Fees Retail Sales Non-Retail Sales Franchise Royalties and Fees Other COSTS AND EXPENSES: Retail Cost of Sales Non-Retail Cost of Sales Operating Expenses Depreciation of Rental Merchandise Interest EARNINGS BEFORE INCOME TAXES INCOME TAXES NET EARNINGS Year Ended December 31, 2005 Year Ended December 31, 2004 Increase/ (Decrease) in Dollars to 2005 from 2004 % Increase/ (Decrease) to 2005 from 2004 $ 845,162 58,366 185,622 29,474 6,881 1,125,505 39,054 172,807 507,158 305,630 8,519 1,033,168 92,337 34,344 57,993 $ $694,293 56,259 160,774 25,093 10,061 946,480 39,380 149,207 414,518 253,456 5,413 861,974 84,506 31,890 $ 52,616 $150,869 2,107 24,848 4,381 (3,180) 179,025 (326) 23,600 92,640 52,174 3,106 171,194 7,831 2,454 $ 5,377 21.7% 3.7 15.5 17.5 (31.6) 18.9 (0.8) 15.8 22.3 20.6 57.4 19.9 9.3 7.7 10.2% Revenues The 18.9% increase in total revenues in 2005 from 2004 is primarily attributable to continued growth in our sales and lease ownership division, from both the opening and acquisition of new Company-operated stores and improvement in same store revenues. Revenues for our sales and lease ownership division, including sales to franchisees, increased $173.7 million to $1,004.8 million in 2005 compared with $831.1 million in 2004, a 20.9% increase. This increase was attributable to an 8.3% increase in same store revenues and the addition of 248 sales and lease ownership stores since the beginning of 2004. The 21.7% increase in rentals and fees revenues was attributable to a $143.1 million increase from our sales and lease ownership division related to the growth in same store revenues and the increase in the number of stores described above. Rental revenues in our corporate furnishings division increased $7.7 million, or 10.1%, to $83.7 million in 2005 from $76.0 million in 2004 as a result of generally improved economic conditions. Revenues from retail sales increased 3.7% primarily due to a $1.5 million increase in our corporate furnishings division as a result of generally improved economic conditions. The 15.5% increase in non-retail sales in 2005 reflects the significant growth of our franchise operations. The total number of franchised stores at December 31, 2005 was 392, reflecting a net addition of 105 since the beginning of 2004. The 17.5% increase in franchise royalties and fees primarily reflects an increase in royalty income from franchisees, increasing $3.8 million to $21.6 million in 2005 compared to $17.8 million in 2004, with increased franchise and financing fee revenues comprising the majority of the remainder. Revenue increased in this area primarily due to the previously mentioned growth of stores and an in increase in certain royalty rates. The 31.6% decrease in other revenues is primarily attribu- table to recognition of a $5.5 million gain in 2004 on the sale of our holdings of Rainbow Rentals, Inc. common stock in connection with that company’s merger with Rent-A-Center, Inc., partially offset by the recognition of a $565,000 gain in 2005 on the sale of our holdings of Rent-Way, Inc. common stock. In addition, included in other income in 2005 is $934,000 of expected proceeds from business interruption insurance associated with the operations of hurricane- affected areas. Cost of Sales Retail cost of sales decreased 0.8%, with retail cost of sales as a percentage of retail sales decreasing to 66.9% from 70.0%, primarily due to higher margins on certain retail sales in our sales and lease ownership division. Cost of sales from non-retail sales increased 15.8%, following the increase in non-retail sales described above, with the margin on non-retail sales remaining comparable between the periods. 18 Management’s Discussion and Analysis of Financial Condition and Results of Operations Expenses The 22.3% increase in 2005 operating expenses was due primarily to the growth of our sales and lease ownership division described above. Operating expenses for the year also included the write-off of $4.4 million of rental merchandise and property destroyed or severely damaged by Hurricanes Katrina and Rita, of which approximately $1.9 million is expected to be covered by insurance proceeds. The net pre-tax expense recorded for the year for these damages was $2.5 million. As a percentage of revenues, operating expenses increased to 45.1% in 2005 compared to 43.8% in 2004. The 20.6% increase in depreciation of rental merchandise was driven by the growth of our sales and lease ownership division described above. As a percentage of total rentals and fees, depreciation of rental merchandise decreased slightly to 36.2% in 2005 from 36.5% in 2004. The 57.4% increase in interest expense is primarily a result of higher debt levels, which increased by 82.6% at December 31, 2005 compared to December 31, 2004, coupled with increasing rates on our revolving credit facility, partially offset by a shift of our borrowings to a new private placement financing in 2005 which had lower rates. The reduction in the effective tax rate to 37.2% in 2005 compared to 37.7% in 2004 is due to lower state income taxes, including adjustments resulting from favorable state income allocations in connection with the Company’s filing of its 2004 tax return. The tax provision reflects the year-to-date effect of such adjustments. Net Earnings The 10.2% increase in net earnings was primarily due to the maturation of new Company-operated sales and lease ownership stores added over the past several years contributing to an 8.3% increase in same store revenues, and a 17.5% increase in franchise fees, royalty income, and other related franchise income. As a percentage of total revenues, net earn- ings decreased to 5.2% in 2005 from 5.6% in 2004 primarily related to increased expenses in 2005 and merchandise losses due to Hurricanes Katrina and Rita, as well as a $3.4 million after-tax gain in 2004 on the sale of Rainbow Rentals, Inc. common stock. Year Ended December 31, 2004 Versus Year Ended December 31, 2003 The following table shows key selected financial data for the years ended December 31, 2004 and 2003, and the changes in dollars and as a percentage to 2004 from 2003. (In Thousands) REVENUES: Rentals and Fees Retail Sales Non-Retail Sales Franchise Royalties and Fees Other COSTS AND EXPENSES: Retail Cost of Sales Non-Retail Cost of Sales Operating Expenses Depreciation of Rental Merchandise Interest EARNINGS BEFORE INCOME TAXES INCOME TAXES NET EARNINGS Year Ended December 31, 2004 Year Ended December 31, 2003 Increase/ (Decrease) in Dollars to 2004 from 2003 % Increase/ (Decrease) to 2004 from 2003 $694,293 56,259 160,774 25,093 10,061 946,480 39,380 149,207 414,518 253,456 5,413 861,974 84,506 31,890 $ 52,616 $553,773 68,786 120,355 19,328 4,555 766,797 50,913 111,714 344,884 195,661 5,782 708,954 57,843 21,417 $ 36,426 $140,520 (12,527) 40,419 5,765 5,506 179,683 (11,533) 37,493 69,634 57,795 (369) 153,020 26,663 10,473 $ 16,190 25.4% (18.2) 33.6 29.8 120.9 23.4 (22.7) 33.6 20.2 29.5 (6.4) 21.6 46.1 48.9 44.4% 19 Management’s Discussion and Analysis of Financial Condition and Results of Operations Revenues The 23.4% increase in total revenues in 2004 from 2003 is primarily attributable to continued growth in our sales and lease ownership division, from both the opening and acquisition of new Company-operated stores and improvement in same store revenues. Revenues for our sales and lease ownership division increased $174.6 million to $831.1 million in 2004 compared with $656.5 million in 2003, a 26.6% increase. This increase was attributable to an 11.6% increase in same store revenues and the addition of 204 Company- operated stores since the beginning of 2003. The 25.4% increase in rentals and fees revenues was attributable to a $139.8 million increase from our sales and lease ownership division related to the growth in same store revenues and the increase in the number of stores described above. Rental revenues in our corporate furnishings division increased $.7 million to $76.0 million in 2004 from $75.3 million in 2003. Revenues from retail sales fell 18.2% due to a decline of $11.6 million in our sales and lease ownership division which reflects a decreased focus on retail sales in certain stores and the impact of the introduction of an alternative shorter-term lease, which we believe replaced many retail sales. The 33.6% increase in non-retail sales in 2004 reflects the significant growth of our franchise operations. This franchisee-related revenue growth is the result of the net addi- tion of 125 franchised stores since the beginning of 2003 and improving operating revenues at maturing franchised stores. The 29.8% increase in franchise royalties and fees primarily reflects an increase in royalty income from franchisees, increas- ing $3.8 million to $17.8 million in 2004 compared to $14.0 million in 2003, with increased franchise and franchising fee revenues comprising the majority of the remainder. The 120.9% increase in other revenues is attributable to recognition of a $5.5 million gain on the sale of our holdings of Rainbow Rentals, Inc. common stock in connection with that company’s merger with Rent-A-Center, Inc. Cost of Sales The 22.7% decrease in retail cost of sales is primarily a result of a decrease in retail sales in our sales and lease owner- ship division, for the same reasons discussed under retail sales revenue above. Retail cost of sales as a percentage of retail sales decreased to 70.0% in 2004 from 74.0% in 2003 due to the 2004 discontinuation of certain low-margin retail sales. Cost of sales from non-retail sales increased 33.6%, primarily due to the growth of our franchise operations as described above, corresponding to the similar increase in non-retail sales. As a percentage of non-retail sales, non-retail cost of sales remained steady at 92.8% in both 2004 and 2003. Expenses The 20.2% increase in 2004 operating expenses was due primarily to the growth of our sales and lease ownership division described above. As a percentage of total revenues, operating expenses improved to 43.8% for 2004 from 45.0% for 2003, with the decrease driven by the maturing of new Company-operated sales and lease ownership stores added over the past several years and an 11.6% increase in same store revenues. As explained in our discussion of critical accounting policies above, effective September 30, 2004, we began record- ing rental merchandise carrying value adjustments on the allowance method rather than the direct write-off method. In connection with the change of methods, we recorded a catch-up adjustment of $2.5 million to establish a rental merchandise allowance reserve. We expect rental merchandise adjustments in the future under this new method to be materi- ally consistent with adjustments under the former method. In addition, as discussed above, the revision of certain estimates related to our accrual for group health self-insurance resulted in a reduction in expenses of $1.4 million in 2004, partially offsetting the merchandise allowance reserve expense. The 29.5% increase in depreciation of rental merchandise was driven by the growth of our sales and lease ownership division described above. As a percentage of total rentals and fees, depreciation of rental merchandise increased slightly to 36.5% in 2004 from 35.3% in 2003. The increase as a per- centage of rentals and fees reflects increased depreciation expense as a result of a larger number of short-term leases in 2004 as described above under retail sales. The decrease in interest expense as a percentage of total revenues is primarily due to the growth of our sales and lease ownership division related to increased same-store revenues and store count described above. The 48.9% increase in income tax expense between years is primarily attributable to a comparable increase in pre-tax income, in addition to a slightly higher effective tax rate of 37.7% in 2004 compared to 37.0% in 2003 arising from higher state income taxes. Net Earnings The 44.4% increase in net earnings was primarily due to the maturing of Company-operated sales and lease ownership stores opened and acquired over the past several years, an 11.6% increase in same store revenues, a 29.8% increase in franchise fees, royalty income, and other related franchise income, and the recognition of a $3.4 million after-tax gain on the sale of Rainbow Rentals, Inc. common stock. As a percentage of total revenues, net earnings improved to 5.6% in 2004 from 4.8% in 2003. Balance Sheet CASH. The Company’s cash balance increased to $7.0 million at December 31, 2005 from $5.9 million at December 31, 2004. The increase between periods is the result of normal fluctuations in the Company’s cash balances that are the result of timing differences between when our stores deposit cash and when that cash is available for application against the Company’s outstanding revolving credit facility. For additional information, refer to the Liquidity and Capital Resources section below. RENTAL MERCHANDISE. The increase of $125.4 million in rental merchandise, net of accumulated depreciation, to $550.9 million from $425.6 million at December 31, 2005 and 2004, respectively, is primarily the result of a net increase of 132 Company-operated sales and lease ownership stores and two fulfillment centers since December 31, 2004. 20 Management’s Discussion and Analysis of Financial Condition and Results of Operations GOODWILL AND OTHER INTANGIBLES. The $26.2 million increase in goodwill and other intangibles, to $101.1 million on December 31, 2005 from $74.9 million on December 31, 2004, is the result of a series of acquisitions of sales and lease ownership businesses, net of amortization of certain finite-life intangible assets. The aggregate purchase price for these asset acquisitions totaled $46.6 million, with the principal tangible assets acquired consisting of rental merchandise and certain fixtures and equipment. PREPAID EXPENSES AND OTHER ASSETS. Prepaid expenses and other assets decreased $27.2 million to $23.0 million on December 31, 2005 from $50.1 million on December 31, 2004. The decrease is in part the result of the collection during the year of $15.2 million in income tax refunds that were receivable at December 31, 2004 and the sale of shares of Rent-Way, Inc. common stock with a carrying value of $6.1 million in 2005. DEFERRED INCOME TAXES PAYABLE. The decrease of $20.0 million in deferred income taxes payable at December 31, 2005 from December 31, 2004 is primarily the result of previously benefiting from the additional first-year or “bonus” depreciation allowance under U.S. federal income tax law, which generally allowed the Company to accelerate the depreciation on rental merchandise it acquired after September 10, 2001 and placed in service prior to January 1, 2005. The Company anticipates having to make future tax payments on its income as a result of expected profitability and the taxes that are now due on accelerated or “bonus” depreciation deductions that were taken in prior periods. CREDIT FACILITIES. The $95.2 million increase in the amounts we owe under our credit facilities to $211.9 million from $116.7 million on December 31, 2005 and 2004, respectively, reflects net borrowings under our revolving credit facility and notes during 2005 primarily to fund purchases of rental merchandise, real estate, acquisitions, tax payments and working capital. In 2005, we entered into a note purchase agreement with a consortium of insurance companies. Pursuant to this agreement, the Company and its two subsidiaries as co-obligors issued $60.0 million in senior unsecured notes to the purchasers in a private placement. The Company used the proceeds from this financing to replace shorter-term borrowings under the Company’s revolving credit agreement. Liquidity and Capital Resources General Cash flows (used by) and generated from operating activities for the years ended December 31, 2005 and 2004 were $(6.5) million and $34.7 million, respectively. Our cash flows include profits on the sale of rental return merchandise. Our primary capital requirements consist of buying rental merchandise for both Company-operated sales and lease ownership and cor- porate furnishings stores. As Aaron Rents continues to grow, the need for additional rental merchandise will continue to be our major capital requirement. These capital requirements historically have been financed through: • cash flow from operations • bank credit • trade credit with vendors • proceeds from the sale of rental return merchandise • private debt • stock offerings At December 31, 2005, $81.3 million was outstanding under our revolving credit agreement. Additionally, we entered into an $18.0 million demand note as a means of temporary financing and at December 31, 2005 $10.0 million was outstanding under this note. The increase in borrowings is primarily attributable to cash borrowed for purchases of rental merchandise, acquisitions, tax payments, and working capital. Our revolving credit agreement provides for maximum bor- rowings of $87.0 million and expires on May 28, 2007. We have $40.0 million in aggregate principal amount of 6.88% senior unsecured notes due August 2009 currently outstanding, the first principal repayments for which were due and paid in 2005 in the aggregate amount of $10.0 million. Additionally, we have $60.0 million in aggregate principal amount of 5.03% senior unsecured notes due July 2012 currently outstanding, principal repayments for which are first required in 2008. From time to time, we use interest rate swap agreements as part of our overall long-term financing program. Our revolving credit agreement, senior unsecured notes, and the construction and lease facility and franchisee loan program discussed below, contain financial covenants which, among other things, forbid us from exceeding certain debt to equity levels and require us to maintain minimum fixed charge coverage ratios. If we fail to comply with these covenants, we will be in default under these agreements, and all amounts would become due immediately. These covenants were amended in July 2005 as a result of entry into the note purchase agree- ment for $60.0 million in senior unsecured notes. The credit agreements were amended for the purpose of permitting the new issuance of the note purchase agreement and amending the negative covenants in the revolving credit agreement. We were in compliance with all of these covenants at December 31, 2005. On February 27, 2006, we entered into a second amendment to the revolving credit agreement to increase the maximum borrowing limit to $140.0 million from $87.0 million and extend the expiration date to May 28, 2008. The franchise loan facility and guaranty was amended to decrease the maximum commitment amount from $140.0 million to $115.0 million. We purchase our common shares in the market from time to time as authorized by our Board of Directors. As of December 31, 2005, Aaron Rents was authorized by its Board of Directors to purchase up to an additional 2,670,502 common shares. We have a consistent history of paying dividends, having paid dividends for 19 consecutive years. A $.013 per share dividend on Common Stock and Class A Common Stock was paid in January 2004 and July 2004. In addition, in July 2004 our Board of Directors declared a 3-for-2 stock split, effected in the form of a 50% stock dividend, which was distributed to shareholders in August 2004. In August 2004, our Board of Directors announced an increase in the frequency of the $0.013 per share cash dividends on both Common Stock and Class A 21 Management’s Discussion and Analysis of Financial Condition and Results of Operations Common Stock from a semi-annual to a quarterly basis. The payment for the third quarter of 2004 was distributed in October 2004 for a total fiscal year cash outlay of $2.0 million. The payment for the fourth quarter of 2004 was paid in January 2005. The payment for the first quarter 2005 was paid in April 2005, the payment for the second quarter was paid in July 2005, and the payment for the third quarter was paid in November 2005 for a total cash outlay of $2.6 million in 2005. The payment for the fourth quarter was paid in January 2006. Our Board of Directors increased the dividend 7.7% for the third quarter of 2005 on August 4, 2005 to $.014 per share from the previous quarterly dividend of $.013 per share. The fourth quarter of 2005 dividend was also $.014 per share. Subject to sufficient operating profits, to any future capital needs and to other contingencies, we currently expect to continue our policy of paying dividends. If we achieve our expected level of growth in our operations, we anticipate we will supplement our expected cash flows from operations, existing credit facilities, vendor credit, and proceeds from the sale of rental return merchandise by expanding our existing credit facilities, by securing additional debt financing, or by seeking other sources of capital to ensure we will be able to fund our capital and liquidity needs for at least the next 24 months. We believe we can secure these additional sources of liquidity in the ordinary course of business. Commitments CONSTRUCTION AND LEASE FACILITY. On October 31, 2001, we renewed our $25.0 million construction and lease facility. From 1996 to 1999, we arranged for a bank holding company to purchase or construct properties identified by us pursuant to this facility, and we subsequently leased these properties from the bank holding company under operating lease agreements. The total amount advanced and outstanding under this facility at December 31, 2005 was $24.5 million. Since the resulting leases are accounted for as operating leases, we do not record any debt obligation on our balance sheet. This construction and lease facility expires in 2006. The construction and lease facility was amended in July 2005 as a result of entry into a note purchase agreement for $60.0 million in senior unsecured notes. The facility was amended for the purpose of permitting the new issuance of the note purchase agreement and amending the negative covenants in the revolving credit agreement. Lease payments fluctuate based upon current interest rates and are generally based upon LIBOR plus 135 basis points. The lease facility contains residual value guarantee and default guarantee provisions that would require us to make payments to the lessor if the under- lying properties are worth less at termination of the facility than agreed upon values in the agreement. Although we have not recognized any liability to date under the guarantee provisions and believe the likelihood of funding to be remote, the maximum guarantee obligation under the residual value and default guarantee provisions upon termination are $20.9 million and $24.5 million, respectively, at December 31, 2005. INCOME TAXES. During 2005, we made $51.2 million in income tax payments. During 2006, we anticipate that we will make cash payments for 2005 income taxes approximating $55 million. The Company has in the past benefited from the additional first-year or “bonus” depreciation allowance under U.S. federal income tax law, which generally allowed the Company to accelerate the depreciation on rental merchandise it acquired after September 10, 2001 and placed in service prior to January 1, 2005. The Company anticipates having to make future tax payments on its income as a result of expected profitability and the taxes that are now due on accelerated or “bonus” depreciation deductions that were taken in prior periods. LEASES. We lease warehouse and retail store space for substantially all of our operations under operating leases expiring at various times through 2021. Most of the leases contain renewal options for additional periods ranging from one to 15 years or provide for options to purchase the related property at predetermined purchase prices that do not represent bargain purchase options. We also lease transportation and computer equipment under operating leases expiring during the next five years. We expect that most leases will be renewed or replaced by other leases in the normal course of business. We have 24 capital leases, 22 of which are with limited liability companies (“LLCs”) whose owners include certain Aaron Rents’ executive officers and our controlling shareholder. Eleven of these related party leases relate to properties pur- chased from Aaron Rents in October and November 2004 by one of the LLCs for a total purchase price of $6.8 million. This LLC is leasing back these properties to Aaron Rents for a 15-year term, with a five-year renewal at the Company’s option, at an aggregate annual rental of $883,000. Another eleven of these related party leases relate to properties pur- chased from Aaron Rents in December 2002 by one of the LLCs for a total purchase price of approximately $5.0 million. This LLC is leasing back these properties to Aaron Rents for a 15-year term at an aggregate annual rental of $702,000. The other related party capital lease relates to a property sold by Aaron Rents to a second LLC for $6.3 million in April 2002 and leased back to Aaron Rents for a 15-year term at an annual rental of $681,000. See Note D to the Consolidated Financial Statements. None of the sale transactions resulted in any gain or loss in our financial statements, and we did not change the basis of the assets subject to the leases. These transactions were accounted for as financings. We finance a portion of our store expansion through sale- leaseback transactions. The properties are sold at net book value and the resulting leases qualify and are accounted for as operating leases. We do not have any retained or contingent interests in the stores nor do we provide any guarantees, other than a corporate level guarantee of lease payments, in connection with the sale-leasebacks. The operating leases that resulted from these transactions are included in the table below. 22 Management’s Discussion and Analysis of Financial Condition and Results of Operations FRANCHISE GUARANTY. We have guaranteed the borrow- ings of certain independent franchisees under a franchise loan program with several banks. In the event these franchisees are unable to meet their debt service payments or otherwise experience an event of default, we would be unconditionally liable for a portion of the outstanding balance of the fran- chisee’s debt obligations, which would be due in full within 90 days of the event of default. At December 31, 2005, the portion that we might be obligated to repay in the event our franchisees defaulted was $100.6 million. However, due to franchisee borrowing limits, we believe any losses associated with any defaults would be mitigated through recovery of rental merchandise and other assets. Since its inception, we have had no losses associated with the franchisee loan and guaranty program. We have no long-term commitments to purchase merchan- dise. See Note F to the Consolidated Financial Statements for further information. The following table shows our approximate contractual obligations and commitments to make future payments as of December 31, 2005: (In Thousands) Total Credit Facilities, Period Less Than 1 Year Period 2–3 Years Period 4–5 Years Period Over 5 Years Excluding Capital Leases $194,667 $20,004 $113,346 $34,012 $27,305 Capital Leases 17,206 643 1,663 2,108 12,792 Operating Leases 247,974 68,269 96,562 42,349 40,794 Total Contractual Cash Obligations $459,847 $88,916 $211,571 $78,469 $80,891 The following table shows the Company’s approximate commercial commitments as of December 31, 2005: (In Thousands) Total Period Less Than 1 Year Period 2–3 Years Period 4–5 Years Period Over 5 Years Guaranteed Borrowings of Franchisees $100,631 $100,631 $ — $ —— $ —— Residual Value Guarantee Under Operating Leases Total Commercial Commitments 20,858 20,858 — —— —— $121,489 $121,489 $ — $ —— $ —— Purchase orders or contracts for the purchase of rental merchandise and other goods and services are not included in the table above. We are not able to determine the aggregate amount of such purchase orders that represent contractual obligations, as purchase orders may represent authorizations to purchase rather than binding agreements. Our purchase orders are based on our current distribution needs and are fulfilled by our vendors within short time horizons. We do not have significant agreements for the purchase of rental mer- chandise or other goods specifying minimum quantities or set prices that exceed our expected requirements for three months. Market Risk From time-to-time, we manage our exposure to changes in short-term interest rates, particularly to reduce the impact on our variable payment construction and lease facility and floating-rate borrowings, by entering into interest rate swap agreements. These swap agreements involve the receipt of amounts by us when floating rates exceed the fixed rates and the payment of amounts by us to the counterparties when fixed rates exceed the floating rates in the agreements over their term. We accrue the differential we may pay or receive as interest rates change, and recognize it as an adjustment to the floating rate interest expense related to our debt. The counterparties to these contracts are high credit quality commercial banks, which we believe largely minimizes the risk of counterparty default. At December 31, 2005 we did not have any swap agreements. We do not use any market risk sensitive instruments to hedge commodity, foreign currency, or risks other than interest rate risk, and hold no market risk sensitive instruments for trading or speculative purposes. Recent Accounting Pronouncements In September 2004, the Emerging Issues Task Force (EITF) of the FASB issued EITF Issue No. 04-1, Accounting for Preexisting Relationships Between the Parties to a Business Combination (EITF 04-1). EITF 04-1 requires an acquirer in a business combination to evaluate any preexisting relationships with the acquired party to determine if the business combination in effect contains a settlement of the preexisting relationship. A business combination between parties with a preexisting rela- tionship should be viewed as a multiple element transaction. EITF 04-1 is effective for business combinations after October 13, 2004, but requires goodwill resulting from prior business combinations involving parties with a preexisting relationship to be tested for impairment by applying the guidance in the consensus. The adoption of EITF 04-1 did not have a material impact on the Company’s financial condition or results of operations. 23 Management’s Discussion and Analysis of Financial Condition and Results of Operations In November 2004, the FASB issued Statement of Financial Accounting Standards No. 151, Inventory Costs — An Amendment of ARB No. 43, Chapter 4 (SFAS 151). SFAS 151 amends ARB 43, Chapter 4, to clarify that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges. In addition, this Statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS 151 is effective for the Company beginning January 1, 2006. Management is currently assessing the impact of SFAS 151, but does not expect the impact to be material. In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123 (revised 2004), Share-based Payment (SFAS 123R). SFAS 123R amends SFAS 123 to require adoption of the fair value method of accounting for employee stock options effective June 30, 2005. The transition guidance in SFAS 123R specifies that compensation expense for options granted prior to the effective date be recognized over the remaining vesting period of those options, and that compensation expense for options granted subsequent to the effective date be recognized over the vesting period of those options. Management is currently assessing the impact of SFAS No. 123R, but does not expect the impact to be material. In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections — a replacement of APB Opinion No. 20 and FASB Statement No. 3. SFAS 154 replaces APB Opinion No. 20, Accounting Changes and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements, and changes the requirements for the accounting for and reporting of a change in accounting principle. SFAS 154 applies to all voluntary changes in an accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. SFAS 154 is effective for accounting changes and error corrections occurring in fiscal years beginning after December 15, 2005. The adoption of SFAS 154 is not anticipated to have a material effect on the Company’s financial position or results of operations. In March 2005, the FASB issued Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations (FIN 47). FIN 47 clarifies that the term “conditional asset retirement obligation” as used in SFAS No. 143, Accounting for Asset Retirement Obligations, refers to a legal obligation to perform an asset retirement activity in which the timing and method of settlement are conditional on a future event that may or may not be within the control of the entity. FIN 47 is effective no later than the end of fiscal years ending after December 15, 2005. The Company’s leases contain asset retirement obligations related to the removal of signage at the termination of these leases. The Company adopted FIN 47 for the year ended December 31, 2005. The impact of adoption was not material. Forward-Looking Statements Certain written and oral statements made by our Company may constitute “forward-looking statements” as defined under the Private Securities Litigation Reform Act of 1995, including statements made in this report and in the Company’s filings with the Securities and Exchange Commission. All statements which address operating performance, events, or developments that we expect or anticipate will occur in the future — including growth in store openings, franchises awarded, and market share, and statements expressing general optimism about future operating results — are forward-looking statements. Forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially. The Company undertakes no obligation to publicly update or revise any forward-looking statements. For a discussion of such risks and uncertainties, see “Risk Factors” in Item 1A of the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission. 24 Consolidated Balance Sheets (In Thousands, Except Share Data) ASSETS Cash Accounts Receivable (net of allowances of $2,742 in 2005 and $1,963 in 2004) Rental Merchandise Less: Accumulated Depreciation Property, Plant and Equipment, Net Goodwill and Other Intangibles, Net Prepaid Expenses and Other Assets Total Assets LIABILITIES AND SHAREHOLDERS’ EQUITY Accounts Payable and Accrued Expenses Dividends Payable Deferred Income Taxes Payable Customer Deposits and Advance Payments Credit Facilities Total Liabilities Commitments and Contingencies Shareholders’ Equity: Common Stock, Par Value $.50 Per Share; Authorized: 50,000,000 Shares; Shares Issued: 44,989,602 at December 31, 2005 and 2004 Class A Common Stock, Par Value $.50 Per Share; Authorized: 25,000,000 Shares; Shares Issued: 12,063,856 at December 31, 2005 and 2004 Additional Paid-In Capital Retained Earnings Accumulated Other Comprehensive Loss Less: Treasury Shares at Cost, Common Stock, 3,358,521 and 3,625,230 Shares at December 31, 2005 and 2004, respectively Class A Common Stock, 3,667,623 Shares at December 31, 2005 and 2004 Total Shareholders’ Equity Total Liabilities and Shareholders’ Equity The accompanying notes are an integral part of the Consolidated Financial Statements. December 31, 2005 December 31, 2004 $ 6,973 $ 5,865 42,812 811,335 (260,403) 550,932 133,759 101,085 22,954 32,736 639,192 (213,625) 425,567 111,118 74,874 50,128 $858,515 $700,288 $112,817 $ 93,565 699 75,197 23,458 211,873 424,044 647 95,173 19,070 116,655 325,110 22,495 22,495 6,032 92,852 349,377 (14) 470,742 6,032 91,032 294,077 (539) 413,097 (20,367) (22,015) (15,904) 434,471 $858,515 (15,904) 375,178 $700,288 25 Consolidated Statements of Earnings (In Thousands, Except Per Share) REVENUES Rentals and Fees Retail Sales Non-Retail Sales Franchise Royalties and Fees Other COSTS AND EXPENSES Retail Cost of Sales Non-Retail Cost of Sales Operating Expenses Depreciation of Rental Merchandise Interest Earnings Before Income Taxes Income Taxes Net Earnings Earnings Per Share Earnings Per Share Assuming Dilution The accompanying notes are an integral part of the Consolidated Financial Statements. Consolidated Statements of Shareholders’ Equity Year Ended December 31, 2005 Year Ended December 31, 2004 Year Ended December 31, 2003 $ 845,162 58,366 185,622 29,474 6,881 1,125,505 39,054 172,807 507,158 305,630 8,519 1,033,168 92,337 34,344 57,993 1.16 1.14 $ $ $ $694,293 56,259 160,774 25,093 10,061 946,480 39,380 149,207 414,518 253,456 5,413 861,974 84,506 31,890 $ 52,616 1.06 $ 1.04 $ $553,773 68,786 120,355 19,328 4,555 766,797 50,913 111,714 344,884 195,661 5,782 708,954 57,843 21,417 $ 36,426 0.74 $ 0.73 $ (In Thousands, Except Per Share) BALANCE, JANUARY 1, 2003 Dividends, $.022 per share Stock Dividend Reissued Shares Net Earnings Change in Fair Value of Financial Instruments, Net of Income Taxes of $1,209 BALANCE, DECEMBER 31, 2003 Dividends, $.039 per share Stock Dividend Reissued Shares Net Earnings Change in Fair Value of Financial Instruments, Net of Income Taxes of $119 BALANCE, DECEMBER 31, 2004 Dividends, $.054 per share Reissued Shares Net Earnings Change in Fair Value of Financial Instruments, Net of Income Taxes of $284 Treasury Stock Common Stock Shares Amount Common Class A (8,197) ($41,696) $9,998 $2,681 306 1,635 4,999 1,340 Accumulated Other Comprehensive Income (Loss) Additional Paid-In Capital Retained Earnings Derivatives Designated Marketable Securities As Hedges ($1,972) $ 104 $87,502 $223,928 (1,090) (6,340) (54) 857 36,426 (7,891) (40,061) 14,997 4,021 88,305 598 2,142 7,498 2,011 (80) 2,807 (7,293) (37,919) 22,495 6,032 91,032 267 1,648 1,820 252,924 (1,954) (9,509) 52,616 294,077 (2,693) 57,993 1,031 (941) 837 941 662 (1,201) (279) (260) 279 246 BALANCE, DECEMBER 31, 2005 (7,026) ($36,271) $22,495 $6,032 $92,852 $349,377 $ —0 ($ 14) The accompanying notes are an integral part of the Consolidated Financial Statements. 26 Consolidated Statements of Cash Flows (In Thousands) OPERATING ACTIVITIES: Net Earnings Depreciation and Amortization Additions to Rental Merchandise Book Value of Rental Merchandise Sold or Disposed Deferred Income Taxes Gain on Marketable Securities Loss (Gain) on Sale of Property, Plant and Equipment Change in Income Taxes Receivable, Included in Prepaid Expenses and Other Assets Change in Accounts Payable and Accrued Expenses Change in Accounts Receivable Other Changes, Net Cash (Used by) Provided by Operating Activities INVESTING ACTIVITIES: Additions to Property, Plant and Equipment Contracts and Other Assets Acquired Proceeds from Sale of Marketable Securities Investment in Marketable Securities Proceeds from Sale of Property, Plant and Equipment Cash Used by Investing Activities FINANCING ACTIVITIES: Proceeds from Sale of Senior Notes Proceeds from Credit Facilities Repayments on Credit Facilities Dividends Paid Issuance of Stock Under Stock Option Plans Cash Provided by Financing Activities Increase in Cash Cash at Beginning of Year Cash at End of Year Cash Paid During the Year: Interest Income Taxes The accompanying notes are an integral part of the Consolidated Financial Statements. Year Ended December 31, 2005 Year Ended December 31, 2004 Year Ended December 31, 2003 $ 57,993 333,131 (647,657) 233,861 (20,261) (579) 148 18,553 17,025 (10,076) 11,375 (6,487) (61,449) (46,725) 6,993 — 14,000 (87,181) 60,000 450,854 (415,636) (2,641) 2,199 94,776 1,108 5,865 $ 52,616 277,187 (528,255) 206,589 39,919 (5,481) 84 (20,023) 4,118 (1,858) 9,842 34,738 (37,723) (38,497) 7,592 (6,436) 4,760 (70,304) — 287,307 (250,222) (2,042) 1,701 36,744 1,178 4,687 $ 36,426 215,397 (384,429) 178,460 3,496 — (814) — 17,275 (3,905) 6,630 68,536 (37,898) (44,347) — (715) 8,025 (74,935) — 86,424 (80,119) (924) 1,789 7,170 771 3,916 $ 6,973 $ 5,865 $ 4,687 $ 8,395 $ 51,228 $ 5,361 $ 16,783 $ 6,759 $ 4,987 27 Notes to Consolidated Financial Statements Note A: Summary of Significant Accounting Policies As of December 31, 2005 and 2004, and for the Years Ended December 31, 2005, 2004 and 2003. BASIS OF PRESENTATION — The consolidated financial statements include the accounts of Aaron Rents, Inc. and its wholly owned subsidiaries (the Company). All significant intercompany accounts and transactions have been eliminated. The preparation of the Company’s consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in these financial statements and accompanying notes. Actual results could differ from those estimates. Generally, actual experience has been consistent with management’s prior estimates and assumptions. Management does not believe these estimates or assumptions will change significantly in the future absent unsurfaced or unforeseen events. On July 12, 2004, the Company announced a 3-for-2 stock split effected in the form of a 50% stock dividend on both Common Stock and Class A Common Stock. New shares were distributed on August 16, 2004 to shareholders of record as of the close of business on August 2, 2004. All share and per share information has been restated for all periods presented to reflect this stock dividend. On July 21, 2003, the Company announced a 3-for-2 stock split effected in the form of a 50% stock dividend on both Common Stock and Class A Common Stock. New shares were distributed on August 15, 2003 to shareholders of record as of the close of business on August 1, 2003. All share and per share information has been restated for all periods presented to reflect this stock dividend. LINE OF BUSINESS — The Company is engaged in the business of renting and selling residential and office furniture, consumer electronics, appliances, computers, and other mer- chandise throughout the U.S., Puerto Rico, and Canada. The Company manufactures furniture principally for its corporate furnishings and sales and lease ownership operations. CASH — In balance sheet and statement of cash flow pre- sentations prior to December 31, 2004, checks outstanding were classified as a reduction to cash. Since the financial institutions with checks outstanding and those with deposits on hand did not and do not have legal right of offset, we have reclassified checks outstanding in certain zero balance bank accounts to accounts payable for all consolidated balance sheets and consolidated statements of cash flows presented. This reclassification had the effect of increasing both cash and accounts payable and accrued expenses by $4.6 million and $3.8 million for the years ended December 31, 2003 and 2002, respectively. Certain transactions previously reflected as a reduction of book value of rental merchandise sold or disposed in the accompanying consolidated statement of cash flows for the years ended December 31, 2003 are reflected as an addition to rental merchandise for the year ended December 31, 2004. These transactions were reclassified in the accompanying consolidated statements of cash flows resulting in increases 28 in both additions to rental merchandise and book value of rental merchandise sold or disposed of $10.6 million for the year ended December 31, 2003. RENTAL MERCHANDISE — The Company’s rental mer- chandise consists primarily of residential and office furniture, consumer electronics, appliances, computers, and other mer- chandise and is recorded at cost. The sales and lease ownership division depreciates merchandise over the rental agreement period, generally 12 to 24 months when on rent and 36 months when not on rent, to a 0% salvage value. The cor- porate furnishings division depreciates merchandise over its estimated useful life, which ranges from six months to 60 months, net of its salvage value, which ranges from 0% to 60% of historical cost. The Company’s policies require weekly rental merchandise counts by store managers, which include write-offs for unsalable, damaged, or missing merchandise inventories. Full physical inventories are generally taken at the fulfillment and manufacturing facilities on a quarterly basis, and appropriate provisions are made for missing, damaged and unsalable merchandise. In addition, the Company monitors rental merchandise levels and mix by division, store, and fulfill- ment center, as well as the average age of merchandise on hand. If unsalable rental merchandise cannot be returned to vendors, it is adjusted to its net realizable value or written off. All rental merchandise is available for rental or sale. On a monthly basis, all damaged, lost or unsalable merchandise identified is written off. Effective September 30, 2004, the Company began recording rental merchandise adjustments on the allowance method. In connection with the adoption of this method, a one-time adjustment of $2.5 million was recorded to establish a rental merchandise allowance reserve. Rental merchandise adjustments in the future under this new method are expected to be materially consistent with the prior year’s adjustments under the direct-write off method. Rental mer- chandise write-offs, including the effect of the establishment of the reserve mentioned above, totaled $22.9 million, $18.0 million, and $11.9 million during the years ended December 31, 2005, 2004, and 2003, respectively, and are included in operating expenses in the accompanying consolidated statements of earnings. PROPERTY, PLANT AND EQUIPMENT — The Company records property, plant, and equipment at cost. Depreciation and amortization are computed on a straight-line basis over the estimated useful lives of the respective assets, which are from 8 to 40 years for buildings and improvements and from one to five years for other depreciable property and equipment. Gains and losses related to dispositions and retirements are recognized as incurred. Maintenance and repairs are also expensed as incurred; renewals and betterments are capitalized. Depreciation expense, included in operating expenses in the accompanying consolidated statements of earnings, for plant, property, and equipment was $25.6 million, $22.2 million, and $19.2 million during the years ended December 31, 2005, 2004, and 2003, respectively. GOODWILL AND OTHER INTANGIBLES — Goodwill represents the excess of the purchase price paid over the fair value of the net assets acquired in connection with business acquisitions. The Company accounts for goodwill and other intangible assets in accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Notes to Consolidated Financial Statements Assets (SFAS No. 142). SFAS No. 142 requires that entities assess the fair value of the net assets underlying all acquisition- related goodwill on a reporting unit basis. When the fair value is less than the related carrying value, entities are required to reduce the carrying value of goodwill. The approach to evaluating the recoverability of goodwill as outlined in SFAS No. 142 requires the use of valuation techniques using esti- mates and assumptions about projected future operating results and other variables. The Company has elected to perform this annual evaluation on September 30. More frequent evaluations will be completed if indicators of impairment become evident. The impairment approach required by SFAS No. 142 may have the effect of increasing the volatility of the Company’s earnings if goodwill impairment occurs at a future date. Other Intangibles represent the value of customer relationships acquired in connection with business acquisitions as well as acquired franchise development rights, recorded at fair value as determined by the Company. As of December 31, 2005 and 2004, the net intangibles other than goodwill was $3.6 million and $1.9 million, respectively. The customer relation- ship intangible is amortized on a straight-line basis over a two-year useful life while acquired franchise development rights are amortized over the unexpired life of the franchisee’s ten year area development agreement. Amortization expense on intangibles, included in operating expenses in the accompany- ing consolidated statements of earnings, was $2.0 million, $1.6 million, and $.5 million during the years ended December 31, 2005, 2004, and 2003, respectively. IMPAIRMENT — The Company assesses its long-lived assets other than goodwill for impairment whenever facts and circumstances indicate that the carrying amount may not be fully recoverable. To analyze recoverability, the Company projects undiscounted net future cash flows over the remaining life of such assets. If these projected cash flows were less than the carrying amount, an impairment would be recognized, resulting in a write-down of assets with a corresponding charge to earnings. Impairment losses, if any, are measured based upon the difference between the carrying amount and the fair value of the assets. INVESTMENTS IN MARKETABLE SECURITIES — The Company holds certain marketable equity securities and has designated these securities as available-for-sale. The fair value of these securities was $59,000 and $6.0 million as of December 31, 2005 and 2004, respectively. These amounts are included in prepaid expenses and other assets in the accompanying consolidated balance sheets. In May of 2004, the Company sold its holdings in Rainbow Rentals, Inc. with a cost basis of $2.1 million for cash proceeds of $7.6 million in connection with Rent-A-Center, Inc.’s acquisition of Rainbow Rentals, Inc. The Company recognized an after-tax gain of $3.4 million on this transaction. In May and June of 2005, the Company sold its holdings in Rent-Way, Inc. with a cost basis of $6.4 million for cash proceeds of $7.0 million. The Company recognized an after-tax gain of $355,000 on this transaction. In connection with this gain recognition, $355,000 and $3.4 million was transferred from unrealized gains within accumulated other comprehensive income to net income on the accompanying consolidated statement of earnings for the years ended December 31, 2005 and 2004, respectively. DEFERRED INCOME TAXES — are provided for temporary differences between the amounts of assets and liabilities for financial and tax reporting purposes. Such temporary differ- ences arise principally from the use of accelerated depreciation methods on rental merchandise for tax purposes. FAIR VALUE OF FINANCIAL INSTRUMENTS — The carrying amounts reflected in the consolidated balance sheets for cash, accounts receivable, bank and other debt approximate their respective fair values. The fair value of the liability for interest rate swap agreements, included in accounts payable and accrued expenses in the accompanying consolidated balance sheets, was $346,000 at December 31, 2004, based upon quotes from financial institutions. At December 31, 2004 the carrying amount for variable rate debt approximates fair market value since the interest rates on these instruments are reset periodically to current market rates. At December 31, 2005 the Company did not have any swap agreements. At December 31, 2005 and 2004 the fair market value of fixed rate long-term debt was $113.9 million and $51.4 million, respectively, based on quoted prices for similar instruments. REVENUE RECOGNITION — Rental revenues are recog- nized as revenue in the month they are due. Rental payments received prior to the month due are recorded as deferred rental revenue. Until all payments are received under sales and lease ownership agreements, the Company maintains ownership of the rental merchandise. Revenues from the sale of merchandise to franchisees are recognized at the time of receipt by the franchisee, and revenues from such sales to other customers are recognized at the time of shipment, at which time title and risk of ownership are transferred to the customer. Please refer to Note I for discussion of recognition of other franchise related revenues. COST OF SALES — Included in cost of sales is the net book value of merchandise sold, primarily using specific identification in the sales and lease ownership division and first-in, first-out in the corporate furnishings division. It is not practicable to allocate operating expenses between selling and rental operations. SHIPPING AND HANDLING COSTS — The Company classifies shipping and handling costs as operating expenses in the accompanying consolidated statements of earnings and these costs totaled $40.5 million in 2005, $31.1 million in 2004, and $24.9 million in 2003. ADVERTISING — The Company expenses advertising costs as incurred. Advertising costs are recorded as expense the first time an advertisement appears. Such costs aggregated $27.1 million in 2005, $22.4 million in 2004, and $18.7 million in 2003. In addition certain advertising expenses were offset by cooperative advertising consideration received from vendors, substantially all of which represents reimbursement of specific, identifiable, and incremental costs incurred in selling those vendors’ products. STOCK BASED COMPENSATION — The Company has elected to follow Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees and related Interpretations in accounting for its employee stock options and adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock Based Compensation (SFAS 123). The Company grants stock options for a fixed number of shares to employees primarily 29 Notes to Consolidated Financial Statements with an exercise price equal to the fair value of the shares at the date of grant and, accordingly, recognizes no compensation expense for these stock option grants. The Company also has granted stock options for a fixed number of shares to certain key executives with an exercise price below the fair value of the shares at the date of grant (“Key Executive grants”). Compensation expense for Key Executive grants is recognized over the three-year vesting period of the options for the difference between the exercise price and the fair value of a share of Common Stock on the date of grant times the number of options granted. Income tax benefits resulting from stock option exercises credited to additional paid-in capital totaled $1.9 million, $3.2 million, and $703,000 in 2005, 2004, and 2003, respectively. For purposes of pro forma disclosures under SFAS No. 123 as amended by SFAS No. 148, the estimated fair value of the options is amortized to expense over the options’ vesting period. The following table illustrates the effect on net earnings and earnings per share if the fair value based method had been applied to all outstanding and unvested awards in each period: (In Thousands) Net Earnings before effect of Key Executive grants Expense effect of Key Executive grants recognized Net earnings as reported Deduct: total stock-based employee compensation expense determined under fair-value-based method for all awards, net of related tax effects Pro forma net earnings Earnings per share: Year Ended Year Ended Year Ended December 31, December 31, December 31, 2004 2003 2005 $58,522 $52,854 $36,426 (529) 57,993 (238) 52,616 — 36,426 (1,996) $55,997 (1,687) $50,929 (1,345) $35,081 Basic — as reported Basic — pro forma Diluted — as reported Diluted — pro forma $ 1.16 $ 1.12 $ 1.14 1.11 $ $ 1.06 $ 1.03 $ 1.04 $ 1.01 $ $ $ $ .74 .71 .73 .70 CLOSED STORE RESERVES — From time to time the Company closes or consolidates stores. The charges related to the closing or consolidating of these stores primarily consist of reserving the net present value of future minimum payments under the stores’ real estate leases. As of both December 31, 2005 and 2004, accounts payable and accrued expenses in the accompanying consolidated balance sheets included $1.3 million and $2.2 million, respectively, for closed store expenses. INSURANCE RESERVES — Estimated insurance reserves are accrued primarily for group health and workers compensation benefits provided to the Company’s employees. Estimates for these insurance reserves are made based on actual reported but unpaid claims and actuarial analyses of the projected claims run off for both reported and incurred but not reported claims. 30 Effective on September 30, 2004, the Company revised certain estimates related to the accrual for group health self-insurance based on favorable claims experience as well as on the experi- ence that the time periods between the liability for a claim being incurred and the claim being reported had declined. The change in estimates resulted in a reduction in expenses of $1.4 million in 2004. The group health self-insurance liability and expense are included in accounts payable and accrued expenses, and in operating expenses in the accompanying consolidated balance sheets and statements of earnings, respectively. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES — From time to time, the Company uses interest rate swap agreements to synthetically manage the interest rate characteristics of a portion of its outstanding debt and to limit the Company’s exposure to rising interest rates. The Company designates at inception that interest rate swap agreements hedge risks associated with future variable interest payments and monitors each swap agreement to determine if it remains an effective hedge. The effectiveness of the derivative as a hedge is based on a high correlation between changes in the value of the underlying hedged item and the derivative instrument. The Company records amounts to be received or paid as a result of interest swap agreements as an adjustment to interest expense. Generally, the Company’s interest rate swaps are designated as cash flow hedges. In the event of early termination or redesig- nation of interest rate swap agreements, any resulting gain or loss would be deferred and amortized as an adjustment to interest expense of the related debt instrument over the remain- ing term of the original contract life of the agreement. In the event of early extinguishment of a designated debt obligation, any realized or unrealized gain or loss from the associated swap would be recognized in income or expense at the time of extinguishment. There was no net income effect related to swap ineffectiveness in 2004. For the year ended December 31, 2003, the Company’s net income included an after-tax benefit of $170,000 related to swap ineffectiveness. The Company does not enter into derivatives for speculative or trading purposes. The fair value of the swaps as of December 31, 2004 and 2003 of $.3 million and $1.4 million, respectively, are included in accounts payable and accrued expenses in the accompanying consolidated balance sheets. At December 31, 2005 the Company did not have any swap agreements. COMPREHENSIVE INCOME — For the years ended December 31, 2005, 2004 and 2003, comprehensive income totaled approximately $58.0 million, $52.1 million, and $38.3 million, respectively. NEW ACCOUNTING PRONOUNCEMENTS — In September 2004, the Emerging Issues Task Force (EITF) of the FASB issued EITF Issue No. 04-1, Accounting for Preexisiting Relationships Between the Parties to a Business Combination (EITF 04-1). EITF 04-1 requires an acquirer in a business combination to evaluate any preexisting relationships with the acquired party to determine if the business combination in effect contains a settlement of the preexisting relationship. A business combination between parties with a preexisting rela- tionship should be viewed as a multiple element transaction. EITF 04-1 is effective for business combinations after October 13, 2004, but requires goodwill resulting from prior business combinations involving parties with a preexisting relationship Notes to Consolidated Financial Statements to be tested for impairment by applying the guidance in the consensus. The adoption of EITF 04-1 did not have a material impact on the financial condition or results of operations. In November 2004, the FASB issued Statement of Financial Accounting Standards No. 151, Inventory Costs — An Amendment of ARB No. 43, Chapter 4 (SFAS 151). SFAS 151 amends ARB 43, Chapter 4, to clarify that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges. In addition, this Statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS 151 is effective for the Company beginning January 1, 2006. Management is currently assessing the impact of SFAS 151, but does not expect the impact to be material. In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123 (revised 2004), Share-based Payment (SFAS 123R). SFAS 123R amends SFAS 123 to require adoption of the fair-value method of accounting for employee stock options. In April 2005, the SEC extended the adoption date of SFAS 123R to January 1, 2006 for calendar- year companies. The transition guidance in SFAS 123R specifies that compensation expense for options granted prior to the effective date be recognized over the remaining vesting period of those options, and that compensation expense for options granted subsequent to the effective date be recognized over the vesting period of those options. Management is currently assessing the impact of SFAS No. 123R, but does not expect the impact to be material. In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections — a replacement of APB Opinion No. 20 and FASB Statement No. 3. SFAS 154 replaces APB Opinion No. 20, Accounting Changes and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements, and changes the requirements for the accounting for and reporting of a change in accounting principle. SFAS 154 applies to all voluntary changes in an accounting principle. It also applies to changes required by an accounting pronounce- ment in the unusual instance that the pronouncement does not include specific transition provisions. SFAS 154 is effective for accounting changes and error corrections occurring in fiscal years beginning after December 15, 2005. The adoption of SFAS 154 is not anticipated to have a material effect on the Company’s financial position or results of operations. In March 2005, the FASB issued Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations (FIN 47). FIN 47 clarifies that the term “conditional asset retirement obligation” as used in SFAS No. 143, Accounting for Asset Retirement Obligations, refers to a legal obligation to perform an asset retirement activity in which the timing and method of settlement are conditional on a future event that may or may not be within the control of the entity. FIN 47 is effective no later than the end of fiscal years ending after December 15, 2005. The Company’s leases contain asset retirement obligations related to the removal of signage at the termination of these leases. The Company adopted FIN 47 for the year ended December 31, 2005. The impact of adoption was not material. Note B: Earnings Per Share Earnings per share is computed by dividing net income by the weighted average number of Common and Class A Common shares outstanding during the year, which were approximately 49,846,000 shares in 2005, 49,602,000 shares in 2004, and 48,964,000 shares in 2003. The computation of earnings per share assuming dilution includes the dilutive effect of stock options and awards. Such stock options and awards had the effect of increasing the weighted average shares outstanding assuming dilution by approximately 959,000 in 2005, 973,000 in 2004, and 819,000 in 2003. Note C: Property, Plant and Equipment Following is a summary of the Company’s property, plant, and equipment at December 31: (In Thousands) Land Buildings and Improvements Leasehold Improvements and Signs Fixtures and Equipment Assets Under Capital Lease: With Related Parties With Unrelated Parties Construction in Progress Less: Accumulated Depreciation and Amortization 2005 2004 $ 15,934 46,805 72,842 45,343 $ 11,687 39,305 63,291 36,518 15,734 1,475 6,449 $204,582 15,734 1,475 4,339 $172,349 (70,823) $133,759 (61,231) $111,118 Note D: Credit Facilities Following is a summary of the Company’s credit facilities at December 31: (In Thousands) Bank Debt Senior Unsecured Notes Capital Lease Obligations: With Related Parties With Unrelated Parties Other Debt 2005 2004 $ 91,336 100,000 $ 45,528 50,000 16,141 1,066 3,330 $211,873 16,596 1,197 3,334 $116,655 31 Notes to Consolidated Financial Statements BANK DEBT — The Company has a revolving credit agreement dated May 28, 2004 with several banks providing for unsecured borrowings up to $87.0 million, which includes a $12.0 million credit line to fund daily working capital requirements. Amounts borrowed bear interest at the lower of the lender’s prime rate or LIBOR plus 125 basis points. The pricing under the working capital line is based upon overnight bank borrowing rates. At December 31, 2005 and 2004, respectively, an aggregate of $81.3 million (bearing interest at 5.35%) and $45.5 million (bearing interest at 3.41%) was out- standing under the revolving credit agreement. The Company pays a .20% commitment fee on unused balances. The weighted average interest rate on borrowings under the revolving credit agreement (before giving effect to interest rate swaps in 2004 and 2003) was 4.42% in 2005, 2.72% in 2004, and 2.53% in 2003. The revolving credit agreement expires May 28, 2007. See Note N for subsequent event disclosures. The revolving credit agreement contains certain covenants which require that the Company not permit its consolidated net worth as of the last day of any fiscal quarter to be less than the sum of (a) $338,340,000 plus (b) 50% of the Company’s consolidated net income (but not loss) for the period beginning April 1, 2004 and ending on the last day of such fiscal quarter. It also places other restrictions on additional borrowings and requires the maintenance of certain financial ratios. The revolving credit agreement was amended in July 2005 as a result of entry into a note purchase agreement for $60.0 million in senior unsecured notes. The agreement was amended for the purpose of permitting a new issuance of senior unsecured notes and amending the negative covenants in the revolving credit agreement. At December 31, 2005, $47.2 million of retained earnings was available for dividend payments and stock repur- chases under the debt restrictions, and the Company was in compliance with all covenants. On December 16, 2005 the Company entered into an $18.0 million demand note as a means of temporary financing and at December 31, 2005 $10.0 million was outstanding at a rate of LIBOR plus 100 basis points. SENIOR UNSECURED NOTES — On August 14, 2002, the Company sold $50.0 million in aggregate principal amount of senior unsecured notes in a private placement to a consortium of insurance companies. The unsecured notes mature August 13, 2009. Quarterly interest only payments at an annual rate of 6.88% are due for the first two years followed by annual $10,000,000 principal repayments plus interest for the five years thereafter. The notes were amended in July 2005 as a result of entry into a note purchase agreement for an additional $60.0 million in senior unsecured notes to the purchasers in a private placement. The agreement was amended for the pur- pose of permitting the new issuance of the notes and amending the negative covenants in the revolving credit agreement. On July 27, 2005, the Company entered into a note purchase agreement with a consortium of insurance companies. Pursuant to this agreement, the Company and its two sub- sidiaries as co-obligors issued $60.0 million in senior unsecured notes to the purchasers in a private placement. The notes bear interest at a rate of 5.03% per year and mature on July 27, 2012. Interest only payments are due quarterly for the first two years, followed by annual $12 million principal repayments plus interest for the five years thereafter, beginning on July 27, 2008. The Company used the proceeds from this financing to replace shorter-term borrowings under the Company’s revolving credit agreement. The new note purchase agreement contains financial maintenance covenants, negative covenants regarding the Company’s other indebtedness, its guarantees and investments, and other customary covenants substantially similar to the covenants in the Company’s existing note purchase agreement, revolving credit facility, loan facility agreement and guaranty, and its construction and lease facility, as modified by the amendments described herein. CAPITAL LEASES WITH RELATED PARTIES — In October and November 2004, the Company sold eleven properties, including leasehold improvements, to a separate limited liability corporation (“LLC”) controlled by a group of Company executives and managers, including the Company’s chairman, chief executive officer, and controlling shareholder. The LLC obtained borrowings collateralized by the land and buildings totaling $6.8 million. The Company occupies the land and buildings collateralizing the borrowings under a 15-year term lease, with a five-year renewal at the Company’s option, at an aggregate annual rental of $883,000. The transaction has been accounted for as a financing in the accompanying consolidated financial statements. The rate of interest implicit in the leases is approximately 9.7%. Accordingly, the land and buildings, associated depreciation expense, and lease obliga- tions are recorded in the Company’s consolidated financial statements. No gain or loss was recognized in this transaction. In December 2002, the Company sold eleven properties, including leasehold improvements, to a separate limited liability corporation (“LLC”) controlled by a group of Company executives and managers, including the Company’s chairman, chief executive officer, and controlling shareholder. The LLC obtained borrowings collateralized by the land and buildings totaling approximately $5.0 million. The Company occupies the land and buildings collateralizing the borrowings under a 15-year term lease at an aggregate annual rental of approxi- mately $702,000. The transaction has been accounted for as a financing in the accompanying consolidated financial statements. The rate of interest implicit in the leases is approximately 11.1%. Accordingly, the land and buildings, associated depreciation expense, and lease obligations are recorded in the Company’s consolidated financial statements. No gain or loss was recognized in this transaction. In April 2002, the Company sold land and buildings with a carrying value of $6.3 million to a limited liability corporation (“LLC”) controlled by the Company’s major shareholder. Simultaneously, the Company and the LLC entered into a 15-year lease for the building and a portion of the land, with two five-year renewal options at the discretion of the Company. The LLC obtained borrowings collateralized by the land and building totaling $6.4 million. The Company occupies the land and building collateralizing the borrowings under a 15-year term lease at an aggregate annual rental of $681,000. The transaction has been accounted for as a financing in the accompanying consolidated financial statements. The rate of interest implicit in the lease financing is 8.7%. Accordingly, the 32 Notes to Consolidated Financial Statements land and building, associated depreciation expense, and the debt obligation are recorded in the Company’s consolidated financial statements. No gain or loss was recognized in this transaction. LEASES — The Company finances a portion of store expan- sion through sale-leaseback transactions. The properties are sold at net book value and the resulting leases qualify and are accounted for as operating leases. The Company does not have any retained or contingent interests in the stores nor does the Company provide any guarantees, other than a corporate level guarantee of lease payments, in connection with the sale-leasebacks. OTHER DEBT — Other debt at December 31, 2005 and 2004 includes $3.3 million of industrial development corpora- tion revenue bonds. The average weighted borrowing rate on these bonds in 2005 was 2.61%. No principal payments are due on the bonds until maturity in 2015. Future maturities under the Company’s Credit Facilities are as follows: (In Thousands) 2006 2007 2008 2009 2010 Thereafter $20,647 92,094 22,915 23,004 13,116 40,097 Note E: Income Taxes Following is a summary of the Company’s income tax expense for the years ended December 31: (In Thousands) 2005 2004 2003 Current Income Tax Expense (Benefit): Federal State Deferred Income Tax (Benefit) Expense: Federal State $50,064 4,541 54,605 ($7,720) (309) (8,029) $16,506 1,415 17,921 (17,751) (2,510) (20,261) $34,344 35,967 3,952 39,919 $31,890 3,220 276 3,496 $21,417 Significant components of the Company’s deferred income tax liabilities and assets at December 31 are as follows: (In Thousands) 2005 2004 Deferred Tax Liabilities: Rental Merchandise and Property, Plant and Equipment Other, Net Total Deferred Tax Liabilities Deferred Tax Assets: Accrued Liabilities Advance Payments Other, Net Total Deferred Tax Assets Less Deferred Tax Valuation Allowance* Net Deferred Tax Assets Net Deferred Tax Liabilities $81,388 6,543 87,931 $101,577 4,054 105,631 4,915 7,556 3,256 15,727 (2,993) 12,734 $75,197 4,948 5,510 2,918 13,376 (2,918) 10,458 $95,173 * The Company has a net tax loss carryforward of $1.9 million which expires on varying dates through December 31, 2012. The Company’s effective tax rate differs from the statutory U.S. federal income tax rate for the years ended December 31 as follows: 2005 2004 2003 35.0% 35.0% 35.0% 2.2 — 37.2% 2.8 (0.1) 37.7% 2.0 — 37.0% Statutory Rate Increases in U.S. Federal Taxes Resulting From: State Income Taxes, Net of Federal Income Tax Benefit Other, Net Effective Tax Rate Note F: Commitments The Company leases warehouse and retail store space for substantially all of its operations under operating leases expiring at various times through 2019. The Company also leases certain properties under capital leases that are more fully described in Note D. Most of the leases contain renewal options for additional periods ranging from one to 15 years or provide for options to purchase the related property at predetermined purchase prices that do not represent bargain purchase options. In addition, certain properties occupied under operating leases contain normal purchase options. The Company also has a $25.0 million construction and lease facility. Properties acquired by the lessor are purchased or constructed and then leased to the Company under operating 33 Notes to Consolidated Financial Statements lease agreements. The total amount advanced and outstanding under this facility at December 31, 2005 was $24.5 million. Since the resulting leases are operating leases, no debt obliga- tion is recorded on the Company’s balance sheet. The Company also leases transportation and computer equipment under operating leases expiring during the next five years. Management expects that most leases will be renewed or replaced by other leases in the normal course of business. Future minimum rental payments required under operating leases that have initial or remaining non-cancelable terms in excess of one year as of December 31, 2005, are as follows: $68.3 million in 2006; $55.7 million in 2007; $40.9 million in 2008; $27.2 million in 2009; $15.1 million in 2010; and $40.8 million thereafter. Certain operating leases expiring in 2006 contain residual value guarantee provisions and other guarantees in the event of a default. Although the likelihood of funding under these guarantees is considered by the Company to be remote, the maximum amount the Company may be liable for under such guarantees is $24.5 million. The Company has guaranteed certain debt obligations of some of the franchisees amounting to approximately $100.6 and $99.7 million at December 31, 2005, and 2004, respectively. The Company receives guarantee fees based on such fran- chisees’ outstanding debt obligations, which it recognizes as the guarantee obligation is satisfied. The Company has recourse rights to the assets securing the debt obligations. As a result, the Company has never incurred any, nor does management expect to incur any, significant losses under these guarantees. Rental expense was $59.9 million in 2005, $50.3 million in 2004, and $44.1 million in 2003. The Company maintains a 401(k) savings plan for all full-time employees with at least one year of service with the Company and who meet certain eligibility requirements. The plan allows employees to contribute up to 10% of their annual compensation with 50% matching by the Company on the first 4% of compensation. The Company’s expense related to the plan was $676,000 in 2005, $506,000 in 2004, and $512,000 in 2003. Note G: Shareholders’ Equity The Company held 7,026,144 common shares in its treasury and was authorized to purchase an additional 2,670,502 shares at December 31, 2005. The Company’s articles of incorporation provide that no cash dividends may be paid on the Class A Common Stock unless equal or higher dividends are paid on the Common Stock. If the number of the Class A Common Stock (voting) falls below 10% of the total number of outstanding shares of the Company, the Common Stock (non-voting) automatically converts into Class A Common Stock. The Common Stock 34 may convert to Class A Common Stock in certain other limited situations whereby a national securities exchange rule might cause the Board of Directors to issue a resolution requiring such conversion. Management considers the likelihood of any conversion to be remote at the present time. The Company has 1,000,000 shares of preferred stock authorized. The shares are issuable in series with terms for each series fixed by the Board and such issuance is subject to approval by the Board of Directors. No preferred shares have been issued. Note H: Stock Options The Company has stock option plans under which options to purchase shares of the Company’s Common Stock are granted to certain key employees. Under the plans, options granted become exercisable after a period of three years and unexercised options lapse ten years after the date of the grant. Options are subject to forfeiture upon termination of service. Under the plans, approximately 954,000 of the Company’s shares are reserved for future grants at December 31, 2005. The weighted average fair value of options granted was $8.09 in 2005, $5.18 in 2004, and $5.48 in 2003. Pro forma information regarding net earnings and earnings per share, presented in Note A, is required by SFAS 123, and has been determined as if the Company had accounted for its employee stock options granted in 2005, 2004 and 2003 under the fair value method. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted average assumptions for 2005, 2004, and 2003, respectively: risk-free interest rates of 3.86%, 3.16%, and 3.41%; a dividend yield of .25%, .28%, and .23%; a volatility factor of the expected market price of the Company’s Common Stock of .43, .43, and .52; and weighted average expected lives of the option of five, four, and six years. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company’s employee stock options have charac- teristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. Notes to Consolidated Financial Statements The following table summarizes information about stock options outstanding at December 31, 2005: Range of Exercise Prices Number Outstanding December 31, 2005 Options Outstanding Weighted Average Remaining Contractual Life (in years) Options Exercisable Weighted Average Exercise Price Number Exercisable December 31, 2005 Weighted Average Exercise Price $ 4.38 – 10.00 10.01 – 15.00 15.01 – 20.00 20.01 – 24.94 $ 4.38 – 24.94 1,622,626 689,250 108,750 605,646 3,026,272 3.78 8.04 7.78 8.90 5.92 $ 6.51 14.02 15.60 22.40 $11.73 1,477,501 3,000 — 2,000 1,482,501 $ 6.28 13.49 — 21.84 $ 6.31 The table below summarizes option activity for the periods indicated in the Company’s stock option plans: Outstanding at January 1, 2003 Granted Exercised Forfeited Outstanding at December 31, 2003 Granted Exercised Forfeited Outstanding at December 31, 2004 Granted Exercised Forfeited Outstanding at December 31, 2005 Exercisable at December 31, 2005 Options (In Thousands) Weighted Average Exercise Price 3,010 738 (321) (142) 3,285 865 (738) (89) 3,323 102 (266) (133) 3,026 1,483 $ 6.31 13.29 6.18 8.08 7.82 19.79 5.30 13.27 11.35 23.17 8.01 18.39 $11.73 $ 6.31 Note I: Franchising of Aaron’s Sales & Lease Ownership Stores The Company franchises Aaron’s Sales & Lease Ownership stores. As of December 31, 2005 and 2004, 664 and 658 franchises had been awarded, respectively. Franchisees typically pay a non-refundable initial franchise fee of $50,000 and an ongoing royalty of either 5% or 6% of gross revenues. Franchise fees and area development fees are generated from the sale of rights to develop, own and operate Aaron’s Sales & Lease Ownership stores. These fees are recognized as income when substantially all of the Company’s obligations per location are satisfied, generally at the date of the store opening. Franchise fees and area development fees received before the substantial completion of the Company’s obligations are deferred. Substantially all of the amounts reported as non- retail sales and non-retail cost of sales in the accompanying consolidated statements of earnings relate to the sale of rental merchandise to franchisees. Franchise agreement fee revenue was $3.0 million, $3.3 million, and $2.2 million and royalty revenues $21.6 million, $17.8 million, and $14.0 million for the years ended December 31, 2005, 2004 and 2003, respectively. Deferred franchise and area development agreement fees, included in customer deposits and advance payments in the accompanying consolidated balance sheets, were $5.2 million and $4.8 million as of December 31, 2005 and 2004, respectively. Franchised Aaron’s Sales & Lease Ownership store activity is summarized as follows: Franchised stores open at January 1 Opened Added through acquisition Purchased by the Company Closed Franchised stores open 2005 357 71 0 (35) (1) 2004 287 79 12 (19) (2) 2003 232 79 3 (26) (1) at December 31 392 357 287 35 Notes to Consolidated Financial Statements Company-operated Aaron’s Sales & Lease Ownership store activity is summarized as follows: Company-operated stores open at January 1 Opened Added through acquisition Closed or merged Company-operated stores open at December 31 2005 2004 2003 616 82 56 (6) 500 68 61 (13) 748 616 412 38 59 (9) 500 In 2005, the Company acquired the rental contracts, merchandise, and other related assets of 96 stores, including 35 franchised stores. Many of these stores and/or their accom- panying assets were merged into other stores resulting in a net gain of 56 stores. In 2004, the Company acquired the rental contracts, merchandise, and other related assets of 85 stores, including 19 franchised stores. Many of these stores and/or their accompanying assets were merged into other stores resulting in a net gain of 61 stores. In 2003, the Company acquired the rental contracts, merchandise, and other related assets of 98 stores, including 26 franchised stores. Many of these stores and/or their accompanying assets were merged into other stores resulting in a net gain of 59 stores. Note J: Acquisitions and Dispositions During 2005, the Company acquired the rental contracts, merchandise, and other related assets of 96 sales and lease ownership stores with an aggregate purchase price of $46.6 million. Fair value of acquired tangible assets included $16.8 million for rental merchandise, $1.5 million for fixed assets, and $1.4 million for other assets. Fair value of liabilities assumed approximated $.4 million. The excess cost over the fair value of the assets and liabilities acquired in 2005, repre- senting goodwill was $24.7 million. The fair value of acquired separately identifiable intangible assets included $2.6 million for customer lists and $.4 million for acquired franchise development rights. The estimated amortization of these customer lists and acquired franchise development rights in future years approximates $1.8 million, $912,000, $82,000, $60,000, and $52,000 for 2006, 2007, 2008, 2009, and 2010, respectively. The purchase price allocations for certain acquisitions during December 2005 are preliminary pending finalization of the Company’s assessment of the fair values of tangible assets acquired. During 2004, the Company acquired the rental contracts, merchandise, and other related assets of 85 sales and lease ownership stores with an aggregate purchase price of $36.0 million. The fair value of acquired tangible assets included approximately $12.9 million for rental merchandise, $0.8 million for fixed assets, and $2.4 million for other assets. Fair value of liabilities assumed approximated $47,000. The excess cost over the fair value of assets and liabilities acquired, representing goodwill was $19.4 million. Fair value of acquired separately identifiable intangible assets included $1.2 million for customer lists. The estimated amortization of these cus- tomer lists in future years approximates $456,000 and $19,000 for 2006 and 2007, respectively. In addition, in 2004 the Company acquired three corporate furnishings stores. The purchase price of the 2004 corporate furnishings acquisitions was $2.2 million. Fair value of acquired tangible assets included $1.5 million for rental merchandise and $309,000 for other assets. The excess cost over the fair value of tangible assets acquired, representing goodwill was $399,000. The fair value of acquired separately identifiable intangible assets included $42,000 for customer lists. The results of operations of the acquired businesses are included in the Company’s results of operations from their dates of acquisition. The effect of these acquisitions on the 2005, 2004 and 2003 consolidated financial statements was not significant. The Company sold five of its sales and lease ownership locations to an existing franchisee in 2005. In 2004, the Company sold two of its sales and lease ownership locations to an existing franchisee. In 2003, the Company sold three of its sales and lease ownership locations to an existing franchisee and sold one of its corporate furnishings stores. The effect of these sales on the consolidated financial statements was not significant. Note K: Segments Description of Products and Services of Reportable Segments Aaron Rents, Inc. has four reportable segments: sales and lease ownership, corporate furnishings (formerly known as rent-to-rent), franchise, and manufacturing. The sales and lease ownership division offers electronics, residential furniture, appliances, and computers to consumers primarily on a monthly payment basis with no credit requirements. The corporate fur- nishings division rents and sells residential and office furniture to businesses and consumers who meet certain minimum credit requirements. The Company’s franchise operation sells and supports franchises of its sales and lease ownership concept. The manufacturing division manufactures upholstered furni- ture, office furniture, lamps and accessories, and bedding predominantly for use by the other divisions. Earnings before income taxes for each reportable segment are generally determined in accordance with accounting principles generally accepted in the United States with the following adjustments: • A predetermined amount of each reportable segment’s revenues is charged to the reportable segment as an allocation of corporate overhead. This allocation was approximately 2.3% in 2005, 2004, and 2003. • Accruals related to store closures are not recorded on the reportable segments’ financial statements, but are rather maintained and controlled by corporate headquarters. 36 Notes to Consolidated Financial Statements • The capitalization and amortization of manufacturing variances are recorded on the consolidated financial statements as part of Cash to Accrual and Other Adjustments and are not allocated to the segment that holds the related rental merchandise. • Advertising expense in the sales and lease ownership division is estimated at the beginning of each year and then allocated to the division ratably over time for management reporting purposes. For financial reporting purposes, advertising expense is recognized when the related advertising activities occur. The difference between these two methods is reflected as part of the Cash to Accrual and Other Adjustments line below. • Sales and lease ownership rental merchandise write-offs are recorded using the direct write-off method for manage- ment reporting purposes and, effective in 2004, using the allowance method for financial reporting purposes. The difference between these two methods is reflected as part of the Cash to Accrual and Other Adjustments line below for 2004. • Interest on borrowings is estimated at the beginning of each year. Interest is then allocated to operating segments based on relative total assets. • Sales and lease ownership revenues are reported on the cash basis for management reporting purposes. Revenues in the “Other” category are primarily from leasing space to unrelated third parties in the corporate headquarters building and revenues from several minor unrelated activities. The pre-tax losses in the “Other” category are the net result of the activity mentioned above, net of the portion of corporate overhead not allocated to the reportable segments for management purposes, and the $565,000 and $5.5 million gains recognized on the sale of marketable securities in 2005 and 2004, respectively. Measurement of Segment Profit or Loss and Segment Assets The Company evaluates performance and allocates resources based on revenue growth and pre-tax profit or loss from operations. The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies except that the sales and lease ownership division revenues and certain other items are presented on a cash basis. Intersegment sales are completed at internally negotiated amounts ensuring competitiveness with outside vendors. Since the intersegment profit and loss affect inventory valuation, depreciation and cost of goods sold are adjusted when intersegment profit is eliminated in consolidation. Factors Used by Management to Identify the Reportable Segments The Company’s reportable segments are business units that service different customer profiles using distinct payment arrangements. The reportable segments are each managed separately because of differences in both customer base and infrastructure. Information on segments and a reconciliation to earnings before income taxes are as follows: Year Ended Year Ended Year Ended December 31, December 31, December 31, 2004 2005 2003 (In Thousands) Revenues From External Customers: Sales and Lease Ownership $ 975,026 117,476 Corporate Furnishings 29,781 Franchise 5,411 Other 83,803 Manufacturing Elimination of $804,723 108,453 25,253 10,185 70,440 $634,489 109,083 19,347 4,206 60,608 Intersegment Revenues Cash to Accrual Adjustments Total Revenues From External Customers Earnings Before Income Taxes: (83,509) (2,483) (70,884) (1,690) (60,995) 59 $1,125,505 $946,480 $766,797 Sales and Lease Ownership $ Corporate Furnishings Franchise Other Manufacturing 63,317 10,802 22,143 (585) 1,280 $56,578 8,842 18,374 2,118 (175) $ 43,325 6,341 13,600 (2,356) 1,222 Earnings Before Income Taxes For Reportable Segments Elimination of Intersegment (Profit) Loss Cash to Accrual and Other Adjustments Total Earnings Before Income Taxes Assets: 96,957 85,737 62,132 (1,103) 178 (2,338) (3,517) (1,409) (1,951) $ 92,337 $ 84,506 $ 57,843 Sales and Lease Ownership $ 669,376 91,536 Corporate Furnishings 26,902 Franchise 46,355 Other 24,346 Manufacturing $ 858,515 Total Assets Depreciation and Amortization: Sales and Lease Ownership $ 309,022 20,376 Corporate Furnishings 924 Franchise 1,373 Other 1,436 Manufacturing $524,492 83,478 23,495 50,452 18,371 $700,288 $255,606 19,213 722 711 935 $412,836 79,984 19,493 29,244 18,327 $559,884 $191,777 21,266 547 839 968 Total Depreciation and Amortization Interest Expense: $ 333,131 $277,187 $215,397 Sales and Lease Ownership $ Corporate Furnishings Franchise Other Total Interest Expense $ 7,326 1,382 93 (282) 8,519 $ 5,197 1,044 96 (924) $ 5,413 $ 5,215 1,583 93 (1,109) $ 5,782 37 Notes to Consolidated Financial Statements Note L: Related Party Transactions The Company leases certain properties under capital leases with certain related parties that are more fully described in Note D above. As part of its marketing program, the Company sponsors professional driver Michael Waltrip’s Aaron’s Dream Machine in the NASCAR Busch Series. In 2005, as part of this market- ing program, the Company began sponsoring a driver develop- ment program implemented by Mr. Waltrip’s company. The two drivers participating in the driver development program for 2005 are both the sons of the president of the Company’s sales and lease ownership division. The portion of the Company’s sponsorship of Michael Waltrip attributable to the driver development program is $890,000 for 2005. Note M: Effects of Hurricanes Katrina and Rita Operating expenses for the year also include the write off of $4.4 million of rental merchandise and property destroyed or severely damaged by Hurricanes Katrina and Rita, of which approximately $1.9 million is expected to be covered by insur- ance proceeds. The net pre-tax expense recorded for the year for these damages is $2.5 million. In addition, included in other income for 2005 is $934,000 of expected proceeds from business interruption insurance associated with the operations of hurricane affected areas. Note N: Quarterly Financial Information (Unaudited) (In Thousands, Except Per Share) YEAR ENDED DECEMBER 31, 2005 Revenues Gross Profit* Earnings Before Taxes Net Earnings Earnings Per Share Earnings Per Share Assuming Dilution YEAR ENDED DECEMBER 31, 2004 Revenues Gross Profit* Earnings Before Taxes Net Earnings Earnings Per Share Earnings Per Share Assuming Dilution First Quarter Second Quarter Third Quarter Fourth Quarter $279,348 142,260 29,618 18,422 .37 .36 $242,493 116,856 20,706 12,817 .26 .26 $271,338 139,797 25,644 16,120 .32 .32 $230,286 114,641 24,928 15,385 .31 .30 $278,667 142,287 13,506 8,843 .18 .17 $231,648 116,320 17,551 10,647 .21 .21 $296,152 147,315 23,569 14,608 .29 .29 $242,053 121,466 21,321 13,767 .28 .27 * Gross profit is the sum of rentals and fees, retail sales, and non-retail sales less retail cost of sales, non-retail cost of sales, and depreciation of rental merchandise. During the fourth quarter of 2004, the Company recorded an adjustment reducing the liability for personal property taxes and personal property tax expense by $1.3 million. These items are included in accounts payable and accrued expenses in the accompanying consolidated balance sheet, and operating expenses in the accompanying consolidated statements of earnings, respectively. In addition, during the fourth quarter of 2004, an adjustment was recorded relating to the Company’s treatment of vendor consideration under EITF 02-16. This adjustment resulted in decreases in rental merchandise net of depreciation of $579,000, rental merchandise depreciation expense of $126,000, retail cost of goods sold of $146,000, and non- retail cost of goods sold of $202,000, offset by an increase in advertising expenses, included in operating expenses in the accompanying consolidated statements of earnings, of $1.1 million. 38 Notes to Consolidated Financial Statements Note O: Subsequent Event (Unaudited) On February 27, 2006, the Company entered into a second amendment to the revolving credit agreement to increase the maximum borrowing limit to $140.0 million from $87.0 million and extend the expiration date to May 28, 2008. The franchise loan facility and guaranty was amended to decrease the maximum commitment amount from $140.0 million to $115.0 million. Management Report Management Report on Internal Control Over Financial Reporting Management of Aaron Rents, Inc. (the “Company”) is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate. Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, the risk. The Company’s management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005. In making this assessment, the Company’s management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control — Integrated Framework. Based on our assessment, management believes that, as of December 31, 2005, the Company’s internal control over financial reporting is effective based on those criteria. The Company’s independent auditor has issued an audit report on our assessment of the Company’s internal control over financial reporting. March 14, 2006 39 Public Accounting Reports Report of Independent Registered Public Accounting Firm on the Consolidated Financial Statements The Board of Directors and Shareholders of Aaron Rents, Inc. We have audited the accompanying consolidated balance sheets of Aaron Rents, Inc. and Subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of earnings, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2005. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Aaron Rents, Inc. and Subsidiaries at December 31, 2005 and 2004, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Aaron Rents, Inc.’s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 14, 2006 expressed an unqualified opinion thereon. Atlanta, Georgia March 14, 2006 40 Public Accounting Reports Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting The Board of Directors and Shareholders of Aaron Rents, Inc. We have audited management’s assessment, included in the accompanying Management Report on Internal Control Over Financial Reporting that Aaron Rents, Inc. maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Aaron Rents, Inc.’s manage- ment is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management’s assessment that Aaron Rents, Inc. maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Aaron Rents, Inc. maintained, in all material respects, effective internal control over financial reporting as December 31, 2005, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Aaron Rents, Inc. as of December 31, 2005 and 2004, and the related consolidated statement of earnings, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2005 of Aaron Rents, Inc. and our report dated March 14, 2006 expressed an unqualified opinion thereon. Atlanta, Georgia March 14, 2006 41 Common Stock Market Prices and Dividends The following table shows the range of high and low Subject to our ongoing ability to generate sufficient income prices per share for the Common Stock and Class A Common Stock and the cash dividends declared per share for the periods indicated. The Company’s Common Stock and Class A Common Stock are listed on the New York Stock Exchange under the symbols “RNT” and “RNT.A”, respectively. The number of shareholders of record of the Company’s Common Stock and Class A Common Stock at February 24, 2006 was 389. The closing prices for the Common Stock and Class A Common Stock at February 24, 2006 were $26.24 and $24.50, respectively. through operations, to any future capital needs, and to other contingencies, we expect to continue our policy of paying dividends. Our articles of incorporation provide that no cash dividends may be paid on our Class A Common Stock unless equal or higher dividends are paid on the Common Stock. Under our revolving credit agreement, we may pay cash dividends in any fiscal year only if the dividends do not exceed 50% of our consolidated net earnings for the prior fiscal year plus the excess, if any, of the cash dividend limita- tion applicable to the prior year over the dividend actually paid in the prior year. Common Stock High Low Cash Dividends Per Share Class A Common Stock High Low D E C E M B E R 3 1 , 2 0 0 5 D E C E M B E R 3 1 , 2 0 0 5 First Quarter Second Quarter Third Quarter Fourth Quarter D E C E M B E R 3 1 , 2 0 0 4 First Quarter Second Quarter Third Quarter Fourth Quarter $25.15 25.29 25.73 23.00 $17.13 22.11 22.60 25.23 $19.20 17.38 19.62 18.90 $13.44 16.13 18.50 21.15 $.013 .013 .014 .014 $.013 .013 .013 First Quarter Second Quarter Third Quarter Fourth Quarter D E C E M B E R 3 1 , 2 0 0 4 First Quarter Second Quarter Third Quarter Fourth Quarter $22.20 22.75 23.60 20.30 $14.93 20.15 21.11 22.60 $17.20 15.55 19.30 17.50 $12.31 14.00 17.70 19.49 Cash Dividends Per Share $.013 .013 .014 .014 $.013 .013 .013 42 Locations in the United States, Puerto Rico, and Canada Board of Directors R. Charles Loudermilk, Sr. Chairman of the Board, Chief Executive Officer, Aaron Rents, Inc. Ronald W. Allen (1) Retired Chairman of the Board, President and Chief Executive Officer, Delta Air Lines, Inc. Officers Corporate R. Charles Loudermilk, Sr. * Chairman of the Board, Chief Executive Officer Robert C. Loudermilk, Jr.* President, Chief Operating Officer Aaron’s Sales & Lease Ownership Division William K. Butler, Jr.* President K. Todd Evans* Vice President, Franchising Mitchell S. Paull* Senior Vice President, Merchandising and Logistics Aaron’s Corporate Furnishings Division Eduardo Quiñones* President Leo Benatar (2) Principal, Benatar & Associates William K. Butler, Jr. President, Aaron’s Sales & Lease Ownership Division Gilbert L. Danielson Executive Vice President, Chief Financial Officer, Aaron Rents, Inc. Earl Dolive (1) Vice Chairman of the Board, Emeritus, Genuine Parts Company David L. Kolb (1) Retired Chairman and Chief Executive Officer, Mohawk Industries, Inc. Robert C. Loudermilk, Jr. President, Chief Operating Officer, Aaron Rents, Inc. Ray M. Robinson (2) President Emeritus, East Lake Golf Club and Vice Chairman, East Lake Community Foundation John Schuerholz Executive Vice President and General Manager, The Atlanta Braves (1) Member of Audit Committee (2) Member of Compensation Committee Gilbert L. Danielson* Executive Vice President, Chief Financial Officer B. Lee Landers, Jr.* Vice President, Chief Information Officer Marc S. Rogovin* Vice President, Real Estate and Construction James L. Cates* Senior Group Vice President, Corporate Secretary Michael W. Jarnagin Vice President, Manufacturing Christopher Champion* Vice President, General Counsel James C. Johnson Vice President, Internal Audit Gregory G. Bellof Vice President, Mid-Atlantic Operations Joseph N. Fedorchak Vice President, Eastern Operations David A. Boggan Vice President, Mississippi Valley Operations Bert L. Hanson Vice President, Mid-American Operations David L. Buck Vice President, Southwestern Operations Michael B. Hickey Vice President, Management Development Paul A. Doize Vice President, Controller Christopher D. Counts Vice President, Western Region Kevin J. Hrvatin Vice President, Western Operations Philip J. Karl Vice President, Southeast Region Corporate and Shareholder Information Corporate Headquarters 309 E. Paces Ferry Rd., N.E. Atlanta, Georgia 30305-2377 (404) 231-0011 http://www.aaronrents.com May 2, 2006, at 10:00 a.m. EDT on the 4th Floor, SunTrust Plaza, 303 Peachtree Street, Atlanta, Georgia 30303 Subsidiaries Aaron Investment Company 4005 Kennett Pike Greenville, Delaware 19807 (302) 888-2351 Aaron Rents, Inc. Puerto Rico Avenue Barbosa #376 Hato Rey, Puerto Rico 00917 (787) 764-0420 Annual Shareholders Meeting The annual meeting of the shareholders of Aaron Rents, Inc. will be held on Tuesday, Transfer Agent and Registrar SunTrust Bank, Atlanta Atlanta, Georgia General Counsel Kilpatrick Stockton LLP Atlanta, Georgia Form 10-K Shareholders may obtain a copy of the Company’s annual report on Form 10-K filed with the Securities and Exchange Commission upon written request, without charge. Such requests should be sent to the attention of Gilbert L. Danielson, Execu- tive Vice President, Chief Financial Officer, Aaron Rents, Inc., 309 E. Paces Ferry Rd., N.E., Atlanta, Georgia 30305-2377. The certifications of our Chief Executive and Chief Financial Officer required by Section 302 of the Sarbanes- Oxley Act of 2002, which address, among other things, the content of our Annual Report on Form 10-K, appear as exhibits to the Form 10-K. 44 Robert P. Sinclair, Jr.* Vice President, Corporate Controller Danny Walker, Sr. Vice President, Internal Security Steven A. Michaels Vice President, Franchise Finance Tristan J. Montanero Vice President, Central Operations Michael P. Ryan Vice President, Northern Operations Mark A. Rudnick Vice President, Marketing Donald P. Lange Vice President, Marketing and Advertising * Executive Officer Stock Listing Aaron Rents, Inc.’s Common R N T Stock and Class A Common Stock are traded on the New York Stock Exchange under the symbols “RNT” and “RNT.A,” respectively. Pursuant to the requirements of the New York Stock Exchange, in 2005 our Chief Executive Officer cer- tified to the NYSE, subject to the conditions set forth in his written affirmation, that he was not aware of any violation by Aaron Rents, Inc. of the NYSE’s corporate governance listing standards. 309 E. Paces Ferry Rd., N.E. Atlanta, Georgia 30305-2377 (404) 231-0011 www.aaronrents.com 46