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

Liquidity and Capital Resources

Operating activities provided cash flow of $1.9 million during the three months ended October 31, 2012. This was mainly attributable to net income of $.5 million, a $2.0 million increase in accrued payroll costs and a $.9 million decrease in net contract receivables. Accrued payroll costs increased during the period due mainly to an additional week of payroll accrued at Ecology and Environment, Inc. (Parent Company). Net contract receivables decreased overall due to the reduction in revenue associated with the overall uncertainty of global economic conditions impacting the Company. Offsetting these was an increase in other current assets and a decrease in billings in excess of revenue. Other current assets increased $1.2 million during the three months ended October 31, 2012 mainly due to an increase in prepaid insurance at the Parent Company. Billings in excess of revenue decreased $1.1 million during the first three months of fiscal year 2013 mainly attributable to work performed on contracts at the Company's majority owned subsidiaries Gestion Ambiental Consultores (GAC) and Ecology and Environment do Brasil LTDA (E&E Brasil).

Investment activities consumed $2.8 million of cash during the three months ended October 31, 2012 mainly attributable to the purchase of $1.6 million of investment securities and the Company's purchases of property, building and equipment of $1.2 million.

Financing activities provided $.5 million of cash during the three months ended October 31, 2012 mainly from net debt proceeds of $2.1 million less dividend payments of $1.0 million and distributions to non-controlling interests of $.6 million. Short term debt has increased this year due mainly to the delinquency of the receivables in the Middle East and China.

Ecology and Environment, Inc. (Company) maintains unsecured lines of credit available for working capital and letters of credit of $32.5 million at the parent company with interest rates ranging from 2.5% to 3% at July 31, 2012 and an additional $1.6 million in lines of credit at the Company's subsidiaries with interest rates ranging from 4.5% to 5% at July 31, 2012. The Company guarantees the lines of credit of Walsh. Its lenders have reaffirmed the Company's lines of credit within the past twelve months. At October 31, 2012 and July 31, 2012, the Company had letters of credit and amounts outstanding under lines of credit totaling approximately $16.1 million and $14.9 million, which is inclusive of outstanding letters of credit of $1.5 million and $4.1 million, respectively. After letters of credit and amounts outstanding under lines of credit, there was $18.0 million of availability under the lines of credit at October 31, 2012. The Company maintained a cash balance of $10.1 million at October 31, 2012, however borrowings of $1.2 million against the Company's line of credit were necessary during the fiscal year due to the cash requirements at Ecology and Environment (Parent Company). The Company believes that cash flows from operations and borrowings against the lines of credit will be sufficient to cover all working capital requirements for at least the next twelve months and the foreseeable future.

Results of Operations

Revenue

First Quarter 2013 vs 2012

Revenue for the first quarter of fiscal year 2013 was $36.8 million, a decrease of $5.5 million or 13% from the $42.3 million reported for the first quarter of fiscal year 2012. The Company's majority owned subsidiary Walsh Environmental (Walsh) reported revenue of $7.7 million for the first quarter of fiscal year 2013, a decrease of $3.4 million or 31% from the $11.1 million reported in the prior year due to decrease in overall sales volume. Revenue at the Parent Company was $20.8 million, a decrease of $1.9 million or 8% due mainly to decreases in the Company's federal, international and domestic energy markets. This decrease was partially offset by an increase in revenue at E&E do Brasil E&E do Brasil reported revenue of $4.1 million during the first quarter of fiscal year 2013, an increase of $.8 million over the prior year due to work in the transmission and energy markets.

Income Before Income Taxes

First Quarter 2013 vs 2012

The Company's income before income taxes was $.9 million for the first quarter of fiscal year 2013, a decrease of $1.2 million or 57% from the $2.1 million reported in the first quarter of fiscal year 2012 due mainly to the reduced revenue. Revenue less subcontract costs were $29.8 million, a decrease of $3.4 million from the $33.2 million reported in the first quarter of the prior year, mainly due to the decrease in revenue in the Parent Company. Gross profits (revenue less cost of professional services, other direct operating expenses and subcontract costs) decreased $1.1 million during the first quarter of fiscal year 2013. Indirect costs for the first quarter of fiscal year 2013 were $14.9 million, down slightly from the $15.1 reported in the first quarter of prior year. The Parent Company was adversely impacted by excess staffing levels due to delays in resolving issues on several contracts in China. Foreign exchange losses were $45,000 for the quarter mainly due to fluctuations in the exchange rates on receivables carried in Kuwaiti Dinar translated to US dollars.

Income Taxes

The estimated effective tax rate for the three months ended October 31, 2012 and October 29, 2011 was 39.5% and 32.6%, respectively. The increase is mainly a result of decreased income from foreign entities in countries with a lower effective tax rate than in the U.S, decreased income from U.S. partnerships, recognition of nondeductible expenses in a foreign jurisdiction and additional foreign taxes.

Critical Accounting Policies and Use of Estimates

Management's discussion and analysis of financial condition and results of operations discuss the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, management evaluates its estimates and judgments, including those related to revenue recognition, allowance for doubtful accounts, income taxes, impairment of long-lived assets and contingencies. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Recent Accounting Pronouncements

An accounting standard related to the presentation of other comprehensive income was issued to increase the prominence of items reported in other comprehensive income. The amended standard requires the components of net income and the components of other comprehensive income to be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements, and other disclosures. Among the new provisions of this standard was a requirement for entities to present reclassification adjustments out of accumulated other comprehensive income by component in both the statement in which net income is presented and the statement in which other comprehensive income is presented (for both interim and annual financial statements); however, a subsequent accounting standard update was issued, which indefinitely deferred the reclassification requirement. Further deliberations on this topic by the FASB are expected at a future date. Excluding the deferred reclassification requirement, the remaining portion of the standard was effective for us beginning with our first quarter of fiscal year 2012; however, we have historically presented the components of net income and the components of other comprehensive income in two separate, but consecutive, statements.

An accounting standard update regarding fair value measurement was issued to conform the definition of fair value and common requirements for measurement of and disclosure about fair value under U.S. GAAP and International Financial Reporting Standards. The amended standard also clarifies the application of existing fair value measurement requirements and expands the disclosure requirements for fair value measurements that are estimated using significant unobservable Level 3 inputs. The standard update was effective for us beginning with our first interim period of fiscal year 2012. The adoption of the standard did not have a material impact on our consolidated financial statements.

An accounting standard update related to new disclosures about balance sheet offsetting and related arrangements was issued. For derivatives and financial assets and liabilities, the amendments require the disclosure of gross asset and liability amounts, amounts offset on the balance sheet, and amounts subject to the offsetting requirements but not offset on the balance sheet. The standard update is effective for us beginning with our first interim period in fiscal year 2013. This standard does not amend the existing guidance on when it is appropriate to offset. The adoption of the standard did not have a material impact on our consolidated financial statements.

Revenue Recognition

The Company's revenues are derived primarily from the professional and technical services performed by its employees or, in certain cases, by subcontractors engaged to perform on under contracts entered into with our clients. The revenues recognized, therefore, are derived from our ability to charge clients for those services under the contracts. Sales and cost of sales at the Company's South American subsidiaries exclude tax assessments by governmental authorities, which are collected by the Company from its customers and then remitted to governmental authorities.

The Company employs three major types of contracts: "cost-plus contracts," "fixed-price contracts" and "time-and-materials contracts." Within each of the major contract types are variations on the basic contract mechanism. Fixed-price contracts generally present the highest level of financial and performance risk, but often also provide the highest potential financial returns. Cost-plus contracts present a lower risk, but generally provide lower returns and often include more onerous terms and conditions. Time-and-materials contracts generally represent the time spent by our professional staff at stated or negotiated billing rates.

Fixed price contracts are accounted for on the "percentage-of-completion" method, wherein revenue is recognized as project progress occurs. Time and material contracts are accounted for over the period of performance, in proportion to the costs of performance, predominately based on labor hours incurred. If an estimate of costs at completion on any contract indicates that a loss will be incurred, the entire estimated loss is charged to operations in the period the loss becomes evident.

The use of the percentage of completion revenue recognition method requires the use of estimates and judgment regarding the project's expected revenues, costs and the extent of progress towards completion. The Company has a history of making reasonably dependable estimates of the extent of progress towards completion, contract revenue and contract completion costs.
However, due to uncertainties inherent in the estimation process, it is possible that completion costs may vary from estimates.

Most of our percentage-of-completion projects follow a method which approximates the "cost-to-cost" method of determining the percentage of completion. Under the cost-to-cost method, we make periodic estimates of our progress towards project completion by analyzing costs incurred to date, plus an estimate of the amount of costs that we expect to incur until the completion of the project. Revenue is then calculated on a cumulative basis (project-to-date) as the total contract value multiplied by the current percentage-of-completion. The revenue for the current period is calculated as cumulative revenues less project revenues already recognized. The recognition of revenues and profit is dependent upon the accuracy of a variety of estimates. Such estimates are based on various judgments we make with respect to those factors and are difficult to accurately determine until the project is significantly underway.

For some contracts, using the cost-to-cost method in estimating percentage-of-completion may overstate the progress on the project. For projects where the cost-to-cost method does not appropriately reflect the progress on the projects, we use alternative methods such as actual labor hours, for measuring progress on the project and recognize revenue accordingly. For instance, in a project where a large amount of equipment is purchased or an extensive amount of mobilization is involved, including these costs in calculating the percentage-of-completion may overstate the actual progress on the project. For these types of projects, actual labor hours spent on the project may be a more appropriate measure of the progress on the project.

The Company's contracts with the U.S. government contain provisions requiring compliance with the Federal Acquisition Regulation (FAR), and the Cost Accounting Standards (CAS). These regulations are generally applicable to all of the Company's federal government contracts and are partially or fully incorporated in many local and state agency contracts. They limit the recovery of certain specified indirect costs on contracts subject to the FAR. Cost-plus contracts covered by the FAR provide for upward or downward adjustments if actual recoverable costs differ from the estimate billed. Most of our federal government contracts are subject to termination at the convenience of the client. Contracts typically provide for reimbursement of costs incurred and payment of fees earned through the date of such termination.

Federal government contracts are subject to the FAR and some state and local governmental agencies require audits, which are performed for the most part by the Defense Contract Audit Agency (DCAA). The DCAA audits overhead rates, cost proposals, incurred government contract costs, and internal control systems. During the course of its audits, the DCAA may question incurred costs if it believes we have accounted for such costs in a manner inconsistent with the requirements of the FAR or CAS and recommend that our U.S. government financial administrative contracting officer disallow such costs. Historically, we have not experienced significant disallowed costs as a result of such audits. However, we can provide no assurance that such audits will not result in material disallowances of incurred costs in the future.

The Company maintains reserves for cost disallowances on its cost based contracts as a result of government audits. Government audits have been completed and final rates have been negotiated through fiscal year 2005. The Company has estimated its exposure based on completed audits, historical experience and discussions with the government auditors. If these estimates or their related assumptions change, the Company may be required to record additional charges for disallowed costs on its government contracts.

Allowance for Doubtful Accounts and Contract Adjustments

We reduce our contract receivables and costs and estimated earnings in excess of billings on contracts in process by establishing an allowance for amounts that, in the future, may become uncollectible or unrealizable, respectively. We determine our estimated allowance for uncollectible amounts and allowance for contract adjustments based on management's judgments regarding our operating performance related to the adequacy of the services performed, the status of change orders and claims, our experience settling change orders and claims and the financial condition of our clients, which may be dependent on the type of client and current economic conditions.

Deferred Income Taxes

We use the asset and liability approach for financial accounting and reporting for income taxes. Deferred income tax assets and liabilities are computed annually for differences between the financial statement and tax bases of assets and liabilities that will result in taxable or deductible amounts in the future based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances based on our judgments and estimates are established when necessary to reduce deferred tax assets to the amount expected to be realized in future operating results. Management believes that realization of deferred tax assets in excess of the valuation allowance is more likely than not. Our estimates are based on facts and circumstances in existence as well as interpretations of existing tax regulations and laws applied to the facts and circumstances, with the help of professional tax advisors. Therefore, we estimate and provide for amounts of additional income taxes that may be assessed by the various taxing authorities.

Uncertain Tax Positions

A tax position is a position in a previously filed tax return or a position expected to be taken in a future tax filing that is reflected in measuring current or deferred income tax assets and liabilities. Tax positions shall be recognized only when it is more likely than not (likelihood of greater than 50%), based on technical merits, that the position will be sustained. Tax positions that meet the more likely than not threshold should be measured using a probability weighted approach as the largest amount of tax benefit that is greater than 50% likely of being realized upon settlement. Whether the more-likely-than-not recognition threshold is met for a tax position, is a matter of judgment based on the individual facts and circumstances of that position evaluated in light of all available evidence. The Company recognizes interest accrued related to unrecognized tax benefits in interest expense and penalties in administrative and indirect operating expenses.

Changes in Corporate Entities

On January 4, 2012, the Company purchased an additional 1.3% of Walsh from noncontrolling shareholders for approximately $254,000. Two thirds of the purchase price was paid in cash while the remaining one third was paid for with E&E stock. With this purchase E&E's ownership share in Walsh increased to approximately 86% of that company.

On December 14, 2011, the Company increased its capital investment in its Brazilian subsidiary (Ecology and Environment do Brasil, LTDA.) by $1.5 million, which increased the Company's ownership in the entity to 68%. The Company also purchased an additional 4% of the entity from its president for approximately $180,000, which increased the Company's ownership in the entity to 72%. The Brazilian company has experienced increased revenue growth and the additional $1.5 million investment will be used for working capital needs in the country.

On November 18, 2011, the Company purchased an additional 3.9% of Walsh Peru from noncontrolling shareholders for approximately $432,000. The entire purchase price was paid in cash.

Inflation

Inflation has not had a material impact on the Company's business because a significant amount of the Company's contracts are either cost based or contain commercial rates for services that are adjusted annually.