UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Form 10-Q/A-2

Commission File No. 1-13071

Hanover Compressor Company

(281) 447-8787
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes x No o

Number of shares of the Common Stock of the registrant outstanding as of November 7, 2003: 82,297,300 shares.

Table of Contents

EXPLANATORY NOTE

We are filing this Quarterly Report on Form 10-Q/A-2 for the quarterly period ended September 30, 2003 in order to record a goodwill impairment charge for our subsidiary, Belleli Energy S.r.l. (“Belleli”). During the performance of our annual goodwill impairment review in the fourth quarter of 2003, we determined the present value of Belleli’s expected future cash flows was less than our carrying value of Belleli. This resulted in a full impairment charge for the $35.5 million in goodwill associated with Belleli. Upon further analysis, it was determined that the factors resulting in the goodwill impairment charge were also present during the third quarter of 2003 and that the exercise of our purchase option in the third quarter of 2003 and the presence of such factors should have resulted in an interim goodwill impairment test under Statement of Financial Accounting Standards 142, Goodwill and Other Intangible Assets (“SFAS 142”) and an impairment charge at that time. Our financial results previously reported for the third quarter of 2003 did not include the impairment charge. The table below indicates the impact of this adjustment (in thousands):

The goodwill impairment has been reflected in the unaudited condensed consolidated financial statements for the three and nine months ended September 30, 2003 included in this Form 10-Q/A-2. We have also revised our discussion in “Part I, Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” to reflect the foregoing.

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Part I. Financial Information

ITEM 1. FINANCIAL STATEMENTS

HANOVER COMPRESSOR COMPANY
CONDENSED CONSOLIDATED BALANCE SHEET
(in thousands of dollars, except for par value and share amounts)
(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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HANOVER COMPRESSOR COMPANY
CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS
(in thousands of dollars, except per share amounts)
(unaudited)

     The accompanying notes are an integral part of these condensed consolidated financial statements.

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HANOVER COMPRESSOR COMPANY
CONDENSED CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (LOSS)
(in thousands of dollars)
(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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HANOVER COMPRESSOR COMPANY
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
(in thousands of dollars)
(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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HANOVER COMPRESSOR COMPANY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements of Hanover Compressor Company (“Hanover”, “we”, “us”, “our” or the “Company”) included herein have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America are not required in these interim financial statements and have been condensed or omitted. It is the opinion of our management that the information furnished includes all adjustments, consisting only of normal recurring adjustments, which are necessary to present fairly the financial position, results of operations, and cash flows of Hanover for the periods indicated. The financial statement information included herein should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2002. These interim results are not necessarily indicative of results for a full year.

Earnings Per Common Share

Basic earnings (loss) per common share is computed by dividing income (loss) available to common shareholders by the weighted average number of shares outstanding for the period. Diluted earnings (loss) per common share is computed using the weighted average number of shares outstanding adjusted for the incremental common stock equivalents attributed to outstanding options and warrants to purchase common stock, restricted stock, convertible senior notes and mandatorily redeemable preferred securities, unless their effect would be anti-dilutive.

The table below indicates the potential common shares issuable which were included in computing the dilutive potential common shares used in diluted earnings (loss) per common share (in thousands):

The table below indicates the potential common shares issuable which were excluded from net dilutive potential common shares issuable as their effect would be anti-dilutive (in thousands):

Stock-Based Compensation

Certain of our employees participate in stock option plans that provide for the granting of options to purchase Hanover common shares. In accordance with Statement of Financial Standards No. 123, “Accounting for Stock-Based Compensation,” (“SFAS 123”) Hanover measures compensation expense for its stock-based employee compensation plans using the intrinsic value method prescribed in APB Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). The following pro forma net income (loss) and earnings (loss) per share data illustrates the effect on net income (loss) and net earnings (loss) per share if the fair value method had been applied to all outstanding and unvested stock options in each period (in thousands).

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In July 2003, we granted 430,000 restricted shares of Hanover common stock to certain employees as part of an incentive compensation plan. The restricted stock grants vest equally over four years. As of September 30, 2003, 514,000 restricted shares were outstanding under our incentive compensation plans. We will recognize compensation expense equal to the fair value of the stock at the date of grant over the vesting period related to these grants. During the nine months ended September 30, 2003 and 2002, we recognized $732,000 and $254,000, respectively, in compensation expense related to these grants.

Reclassifications

Certain amounts in the prior period’s financial statements have been reclassified to conform to the 2003 financial statement classification as more fully discussed in Notes 11 and 13. These reclassifications have no impact on net income. See Note 13 for a discussion of discontinued operations.

2. BUSINESS ACQUISITIONS AND COMBINATIONS

2003 Acquisitions

Belleli Acquisition. In 2002, we increased our ownership of Belleli to 51% from 20.3% by converting $13.4 million in loans, together with approximately $3.2 million in accrued interest thereon, into additional equity ownership and in November 2002 began consolidating the results of Belleli’s operations. Belleli has three manufacturing facilities, one in Mantova, Italy and two in the United Arab Emirates (Jebel Ali and Hamriyah). During 2002, we also purchased certain operating assets used by Belleli for approximately $22.4 million from a bankruptcy estate of Belleli’s former parent and leased these assets to Belleli for approximately $1.2 million per year, for a term of seven years.

In connection with our increase in ownership in 2002, we entered into an agreement with the minority owner of Belleli that provided the minority owner the right, until June 30, 2003, to purchase our interest for an amount that approximated our investment in Belleli. The agreement also provided us with the right, beginning in July 2003, to purchase the minority owner’s interest in Belleli. In addition, the minority owner historically had been unwilling to provide its proportionate share of capital to Belleli. We believed that our ability to maximize value would be enhanced if we were able to exert greater control through the exercise of our purchase right. Thus, in August 2003, we exercised our option to acquire the remaining 49% interest in Belleli for approximately $15.0 million in order to gain complete control of Belleli. As a result of these transactions and intervening foreign exchange rate changes, we recorded $4.8 million in identifiable intangible assets, with a weighted average life of approximately 17 years, and $35.5 million in goodwill.

During the third quarter of 2003, we recorded a $35.5 million impairment charge for the goodwill associated with Belleli. As a result of the war in Iraq, the strengthening of the Euro and generally unfavorable economic conditions, we believe that the estimated fair value of Belleli declined significantly during 2003. Upon gaining complete control of Belleli and assessing our long-term growth strategy, we determined that these general factors in combination with the specific economic factors impacting Belleli had significantly and adversely impacted the timing and amount of the future cash flows that we expected Belleli to generate. We currently do not expect to realize our original growth expectations for Belleli in the timeframe that we originally forecasted.

2002 Acquisitions

In July 2002, we acquired a 92.5% interest in Wellhead Power Gates, LLC (“Gates”) for approximately $14.4 million and had loaned approximately $6 million to Gates prior to our acquisition. Gates is a developer and owner of a forty-six megawatt cycle power facility in Fresno County, California. This investment was accounted for as a consolidated subsidiary and was classified as an asset held for sale and its operating results were reported in income (loss) from discontinued operations, until sold in September 2003. See Note 13 for a discussion of discontinued operations.

In July 2002, we acquired a 49.0% interest in Wellhead Power Panoche, LLC (“Panoche”) for approximately $6.8 million and had loaned approximately $5.0 million to Panoche prior to the acquisition of our interest. Panoche is a developer and owner of a forty-nine megawatt cycle power facility in Fresno County, California, which is under contract with the California Department of Water Resources. This investment was classified as an asset held for sale and the equity income (loss) from this non-consolidated subsidiary was reported in income (loss) from discontinued operations, until sold in June 2003. See Note 13 for a discussion of discontinued operations.

In July 2002, we acquired certain assets of Voyager Compression Services, LLC a natural gas compression services company located in Gaylord, Michigan, for approximately $2.5 million in cash.

See discussion of 2002 Belleli acquisition above.

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3. INVENTORIES

Inventory consisted of the following amounts (in thousands):

As of September 30, 2003 and December 31, 2002 we had inventory valuation reserves of approximately $13.4 million and $14.2 million, respectively.

4. PROPERTY, PLANT AND EQUIPMENT

Property, plant and equipment consisted of the following (in thousands):

During the quarter ended September 30, 2003, we recorded a $14.4 million impairment charge in depreciation expense to write-down a portion of our rental fleet to be sold or scrapped.

On July 1, 2003, we adopted the provisions of FASB Interpretation No. 46, “Consolidation of Variable Interest Entities, an interpretation of ARB 51” (“FIN 46”) as they relate to the special purpose entities that lease compression equipment to us. As a result of the adoption, we added approximately $1,089 million in compressor equipment assets, $192.3 million of accumulated depreciation (including approximately $58.6 million of accumulated depreciation related to periods before the sale and leaseback of the equipment), $1,105.0 million in debt and $34.6 million in minority interest obligations to our balance sheet, and we reversed $108.8 million of deferred gains that were recorded on our balance sheet as a result of the sale leaseback transactions. See Note 6 for a discussion of the impact of our partial adoption of FIN 46.

5. DEBT

Short-term debt consisted of the following (in thousands):

In November 2002, we increased our ownership in Belleli to 51%. In August 2003, we exercised our option to purchase the remaining interest not owned by us (see Note 2). Belleli has financed its operations through the factoring of its receivables. Such factoring is typically short term in nature and at September 30, 2003 bore interest at a weighted average rate of 4.0%. In addition, Belleli’s revolving credit facilities bore interest at a weighted average rate of 3.7% and 3.0% at September 30, 2003 and December 31, 2002, respectively. These revolving credit facilities expire in December 2003 and are partially secured by letters of credit issued and outstanding under Hanover’s bank credit facility of $9.4 million as of September 30, 2003.

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Long-term debt consisted of the following (in thousands):

Maturities of long-term debt (excluding interest to be accrued thereon) at September 30, 2003 are (in thousands): 2003—$367; 2004—$369,511; 2005—$361,511; 2006—$407; 2007—$180,577; 2008—$492,045; and $309,934 thereafter.

In February 2003, we executed an amendment to our bank credit facility (our “bank credit facility”) and the agreements related to certain of our compression equipment lease obligations that we entered into in 1999 and 2000. The amendment, which was effective as of December 31, 2002, modified certain financial covenants to allow us greater flexibility in accessing the capacity under the bank credit facility to support our short-term liquidity needs. In addition, at the higher end of our permitted consolidated leverage ratio, the amendment increased the commitment fee under the bank credit facility by 0.125% and increased the interest rate margins used to calculate the applicable interest rates under all of the agreements by up to 0.75%. Any increase in our interest costs as a result of the amendment as compared to the bank credit facility prior to the amendment depends on our consolidated leverage ratio at the end of each quarter, the amount of indebtedness outstanding and the interest rate quoted for the benchmark selected by us. As part of the amendment, we granted the lenders under these agreements a security interest in the inventory, equipment and certain other property of Hanover and its domestic subsidiaries, and pledged 66% of the equity interest in certain of our foreign subsidiaries. This amendment also restricts our capital spending to $200 million in 2003. In consideration for obtaining the amendment, we agreed to pay approximately $1.8 million in fees to the lenders under these agreements.

Our bank credit facility as so amended provides for a $350 million revolving credit facility that matures on November 30, 2004. Advances bear interest at (a) the greater of the administrative agent’s prime rate, the federal funds effective rate, or the base CD rate, or (b) a eurodollar rate, plus, in each case, a specified margin (3.4% and 3.2% weighted average interest rate at September 30, 2003 and December 31, 2002, respectively). A commitment fee based upon a percentage of the average available commitment is payable quarterly to the lenders participating in the bank credit facility. This fee ranges from 0.25% to 0.50% per annum and fluctuates with our consolidated leverage ratio. In addition to the drawn balance on our bank credit facility, as of September 30, 2003, we had $71.7 million in letters of credit outstanding under the bank credit facility. Our bank credit facility contains certain financial covenants and limitations on, among other things, indebtedness, liens, leases and sales of assets. Our bank credit facility also limits the payment of cash dividends on our common stock to 25% of our net income for the period from December 1, 2001 through November 30, 2004.

As of September 30, 2003, we were in compliance with all material covenants and other requirements set forth in our bank credit facility, agreements related to our compression equipment lease obligations and indentures. Giving effect to the covenant limitations in our bank credit facility, the liquidity available under that facility as of September 30, 2003 was approximately $25 million. Our cash balance amounted to $33.5 million at September 30, 2003. Because our bank credit facility will mature in November 2004, it will be reported as a current liability on our balance sheet for the year ended December 31, 2003, if not amended or replaced prior to such date.

While there is no assurance, we believe based on our current projections that we will be in compliance with the financial covenants in our bank credit facility and the agreements related to our compression equipment lease obligations at December 31, 2003, although, with respect to certain of the covenants, a relatively small change in our actual results as compared to our current projections could cause us not to be in compliance with such covenants.

Under the February 2003 amendment, certain of the financial covenants contained in our bank credit facility and the agreements related to certain of our compression equipment lease obligations revert back to more restrictive covenants with which we must be in compliance at the end of each fiscal quarter ending after December 31, 2003, or we will be in default under the bank credit facility. With respect to the more restrictive financial covenants that will be in effect at March 31, 2004, if our bank credit facility is not amended or replaced by such date, we believe based on our current projections that we would probably not be in compliance with such covenants at such date. However, we currently have bank commitments totaling $345 million for a new bank credit facility (the “Proposed Bank Credit Facility”) with different and/or less restrictive covenants which would apply to us for fiscal quarters ending after December 31, 2003. While there is no assurance, we believe based on our current projections that we will be in compliance with the financial covenants contained in the Proposed Bank Credit Facility at March 31, 2004.

The bank commitments under the Proposed Bank Credit Facility expire on December 31, 2003, and if we do not close the Proposed Bank Credit Facility prior to that date, we will have to request that the banks extend their commitments. There is no assurance that the banks will extend their commitments on the same terms or at all. In addition, the closing of this Proposed Bank Credit Facility is contingent on the finalization of documentation, the contemporaneous or earlier closing of at least $275

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million of specified new financing to repay the $200 million 1999A equipment lease and a portion of our bank credit facility borrowings and satisfaction of other customary conditions. There is no assurance that we will be able to satisfy all the conditions to close the Proposed Bank Credit Facility, including in particular the requirement to effect at least $275 million of new financings on required terms. If we are not able to close the Proposed Bank Credit Facility on a timely basis, then we expect to seek an amendment or waiver of the applicable financial covenants in our existing agreements. Although we believe we would be able to obtain a satisfactory amendment or waiver, there is no assurance we will be able to do so. Such an amendment or waiver could impose additional restrictions on us and could involve additional fees payable to the banks, which could be significant. If we are unable to meet the applicable financial covenants under our bank credit facility and we fail to obtain an amendment or waiver with respect thereto, then we could be in default under our bank credit facility and certain of our agreements related to our compression equipment lease obligations and other debt. A default under our bank credit facility or these agreements would trigger cross-default provisions in certain of our other debt agreements. Such defaults would have a material adverse effect on the Company’s liquidity, financial position and operations.

In addition to purchase money and similar obligations, the indentures and the agreements related to our compression equipment lease obligations for our 2001A and 2001B sale leaseback transactions permit us to incur indebtedness up to the $350 million credit limit under our bank credit facility, plus (1) an additional $75 million in unsecured indebtedness and (2) any additional indebtedness so long as, after incurring such indebtedness, our ratio of the sum of consolidated net income before interest expense, income taxes, depreciation expense, amortization of intangibles, certain other non-cash charges and rental expense to total fixed charges (all as defined and adjusted by the agreements), or our “coverage ratio,” is greater than 2.25 to 1.0 and no default or event of default has occurred or would occur as a consequence of incurring such additional indebtedness and the application of the proceeds thereon. The indentures and agreements for our 2001A and 2001B sale leaseback transactions define indebtedness to include the present value of our rental obligations under sale leaseback transactions and under facilities similar to our compression equipment operating leases. As of September 30, 2003, Hanover’s coverage ratio was less than 2.25 to 1.0 and therefore as of such date we could not incur indebtedness other than under our bank credit facility and up to an additional $75 million in unsecured indebtedness and certain other permitted indebtedness, including certain refinancing indebtedness. We believe the Proposed Credit Facility is within the types of refinancing indebtedness allowed under these agreements.

In January 2003, we gave notice of our intent to exercise our right to put our interest in the PIGAP II joint venture back to Schlumberger. If not exercised, the put right would have expired as of February 1, 2003. Hanover acquired its interest in PIGAP II as part of its purchase of Production Operators Corporation’s natural gas compression business, ownership interest in certain joint venture projects in South America, and related assets (“POC”) from Schlumberger in August 2001. PIGAP II is a joint venture that operates a natural gas compression facility in Venezuela and is currently owned 70% by a subsidiary of The Williams Companies Inc. and 30% by us. On May 14, 2003, we entered into an agreement with Schlumberger to terminate our right to put our interest in the PIGAP II joint venture to Schlumberger. We also agreed with Schlumberger to restructure the $150 million subordinated note that Schlumberger received from us in August 2001 as part of the purchase price for the acquisition of POC. As a result, we retained our ownership interest in PIGAP II.

A comparison of the primary financial terms of the original $150 million subordinated note and the restructured note are shown in the table below.

As of March 31, 2003, the date from which the interest rate was adjusted, the $150 million subordinated note had an outstanding principal balance of approximately $171 million, including accrued interest. Under the restructured terms, the maturity of the restructured note has been extended to March 31, 2007, from the original maturity of December 31, 2005. The note is a zero coupon note with original issue discount accreting at 11.0% for its remaining life, up to a total principal amount of $262.6 million payable at maturity. The note will accrue an additional 2.0% interest upon the occurrence and during the continuance of an event of default under the note. The note will also accrue an additional 3.0% interest if Hanover’s consolidated leverage ratio, as defined in the note agreement, exceeds 5.18 to 1.0 as of the end of two consecutive fiscal quarters. Notwithstanding the foregoing, the note will accrue additional interest of a total of 3.0% if both of the previously mentioned circumstances occur. The note also contains a covenant that limits our ability to incur additional indebtedness if Hanover’s consolidated leverage ratio exceeds 5.6 to 1.0, subject to certain exceptions. Schlumberger will no longer have a first call on any proceeds from the issuance of any shares of capital stock or other equity interests by Hanover and the note is not callable by Hanover until March 31, 2006. As agreed upon with Schlumberger, Hanover has agreed to bear the cost of and has filed a shelf registration statement with the Securities and Exchange Commission (“SEC”) covering the resale of the restructured note by Schlumberger.

Also on May 14, 2003, we agreed with Schlumberger Surenco, an affiliate of Schlumberger, to the modification of the repayment terms of a $58 million obligation that was accrued as a contingent liability on our balance sheet since the acquisition of POC and was associated with the PIGAP II joint venture. The obligation was converted into a non-recourse promissory note (“PIGAP Note”) payable by Hanover Cayman Limited, our indirect wholly-owned consolidated subsidiary, with a 6% interest rate compounding semi-annually until maturity in December 2053. This note was paid in full in October 2003 upon closing of the project financing by the PIGAP II joint venture (see Note 14).

For financial accounting purposes, the above described changes to the restructured subordinated note and PIGAP Note were not considered an extinguishment of debt, but have been accounted for as debt modifications which resulted in no income or expense recognition related to the transaction.

6. LEASING TRANSACTIONS AND ACCOUNTING CHANGE FOR FIN 46

Leasing Transactions

We are the lessee in five transactions involving the sale of compression equipment by us to special purpose entities, which in turn lease the equipment back to us. At the time we entered into the leases, these transactions had a number of advantages over other sources of capital then available to us. The sale leaseback transactions (i) enabled us to affordably extend the duration of our financing arrangements and (ii) reduced our cost of capital.

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Prior to our first sale leaseback transaction in 1998, we financed our growth in compression assets by drawing down on our bank credit facility with a commercial bank. While highly flexible and well priced, the bank credit facility represented a short term funding strategy to finance long-term assets. Sale leaseback transactions can reduce refinancing risk by extending the duration of our capital commitments.

Sale leaseback transactions also provided capital to us at a lower cost compared to other sources then available to us. Lenders to the special purpose entities did not require as high a rate of interest because their capital risk is mitigated by a perfected, first priority security interest in the compression equipment, as well as a residual value guarantee provided by us. The reduced capital risk associated with our sale leaseback transactions had the effect of reducing our leasing expense as compared to an unsecured borrowing. We will continue to evaluate sale leaseback transactions as well as consider other forms of financing for cost effectiveness as future capital needs arise.

We also believe that the sale leaseback transactions represent a source of capital in addition to the commercial bank financing that we traditionally use. This diversification of our capital sources has broadened our access to capital and allowed us to expand our operations.

In August 2001 and in connection with the acquisition of POC, we completed two sale leaseback transactions involving certain compression equipment. Concurrent with these transactions, we exercised our purchase option under our July 1998 operating lease for $200.0 million. Under one sale leaseback transaction, we received $309.3 million in proceeds from the sale of compression equipment. Under the second sale leaseback transaction, we received $257.8 million in proceeds from the sale of additional compression equipment. Under the first transaction, the equipment was sold and leased back by us for a seven year period and will continue to be deployed by us in the normal course of our business. The agreement calls for semi-annual rental payments of approximately $12.8 million in addition to quarterly rental payments of approximately $0.2 million. Under the second transaction, the equipment was sold and leased back by us for a ten year period and will continue to be deployed by us in the normal course of our business. The agreement calls for semi-annual rental payments of approximately $10.9 million in addition to quarterly rental payments of approximately $0.2 million. We have options to repurchase the equipment under certain conditions as defined by the lease agreements. Through September 30, 2003, we incurred transaction costs of approximately $18.6 million related to these transactions. These costs are included in intangible and other assets and are being amortized over the respective lease terms.

In October 2000, we completed a $172.6 million sale leaseback transaction of compression equipment. In March 2000, we entered into a separate $200.0 million sale leaseback transaction involving certain compression equipment. Under the March transaction, we received proceeds of $100.0 million from the sale of compression equipment at the first closing in March 2000, and in August 2000, we completed the second half of the equipment lease and received an additional $100.0 million for the sale of additional compression equipment. In June 1999, we completed a $200.0 million sale leaseback transaction involving certain compression equipment. Under these lease agreements, the equipment was sold and leased back by us for a five year term and will be used by us in our business. We have options to repurchase the equipment under the 2000 and 1999 leases, subject to certain conditions set forth in these lease agreements. The lease agreements call for variable quarterly payments that fluctuate with the London Interbank Offering Rate and have covenant restrictions similar to our bank credit facility. We incurred an aggregate of approximately $7.5 million in transaction costs for the leases entered into in 2000 and 1999, which are included in intangible and other assets on the balance sheet and are being amortized over the respective lease terms of the respective transactions.

The following table summarizes the proceeds and the residual guarantee (maximum exposure to loss) and the lease termination date for equipment leases (in thousands of dollars):

We made residual value guarantees under these lease agreements that are due upon termination of the leases and which may be satisfied by a cash payment or the exercise of our equipment purchase options under the terms of the lease agreements. The residual value guarantees and other lease terms, which are based on negotiation between Hanover and third party lessors, were supported by equipment appraisals and analysis.

In connection with the compression equipment leases entered into in August 2001, the Company was obligated to prepare registration statements and complete an exchange offering to enable the holders of the notes issued by the lessors to exchange their notes with notes registered under the Securities Act of 1933. Because of the restatement of our financial statements, the exchange offering was not completed pursuant to the time line required by the agreements and the Company was required to pay additional lease expense in an amount equal to $105,600 per week until the exchange offering was completed. The additional lease expense began accruing on January 28, 2002 and increased the Company’s lease expense by $5.1 million during 2002. The registration statements became effective in February 2003. The exchange offer was completed and the requirement to pay the additional lease expense ended on March 13, 2003.

In February 2003, we executed an amendment to our bank credit facility and the compression equipment leases entered into in 1999 and 2000 (see Note 5).

Accounting Change

Prior to July 1, 2003, these five lease transactions were recorded as a sale and leaseback of the compression equipment and were treated as operating leases for financial reporting purposes. On July 1, 2003, we adopted the provisions of FIN 46 as they relate to the special purpose entities that lease compression equipment to us. As a result of the adoption, we added approximately $1,089 million in compressor equipment assets, $192.3 million of accumulated depreciation (including approximately $58.6 million of accumulated depreciation related to periods before the sale and leaseback of the equipment), $1,105.0 million in debt and $34.6 million in minority interest obligations to our balance sheet, and we reversed $108.8 million of deferred gains that were recorded on our balance sheet as a result of the sale leaseback transactions. On July 1, 2003, we recorded a $133.7 million charge ($86.9 million net of tax) to record the cumulative effect from the adoption of FIN 46 related to prior

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period depreciation of the compression equipment assets. Additionally, we estimate that, after adoption, we will record approximately $17 million per year in additional depreciation expense on our leased compression equipment as a result of the inclusion of the compression equipment on our balance sheet and will also record the payments made under our compression equipment leases as interest expense. As of September 30, 2003, the compression assets that are owned by the entities that lease equipment to us but are now included in property, plant and equipment in our consolidated financial statements had a net book value of approximately $983.3 million, including improvements made to these assets after the sale leaseback transactions.

7. ACCRUED LIABILITIES

Accrued liabilities consisted of the following (in thousands):

The decrease of $60.7 million for the additional purchase price for POC is due to the reclassification of a $58 million contingent liability and accrued interest associated with the PIGAP II joint venture that was restructured into the PIGAP Note (see Note 5).

8. ACCOUNTING FOR DERIVATIVES

We adopted SFAS 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”), as amended by SFAS 137 and SFAS 138, effective January 1, 2001. SFAS 133 requires that all derivative instruments (including certain derivative instruments embedded in other contracts) be recognized in the balance sheet at fair value, and that changes in such fair values be recognized in earnings unless specific hedging criteria are met. Changes in the values of derivatives that meet these hedging criteria will ultimately offset related earnings effects of the hedged item pending recognition in earnings. Prior to 2001, we entered into two interest rate swaps with notional amounts of $75 million and $125 million and strike rates of 5.51% and 5.56%, respectively. These swaps were to expire in July 2001; however, they were extended for an additional two years at the option of the counterparty and expired in July 2003. The difference paid or received on the swap transactions was recorded as an accrued liability and recognized in leasing expense in all periods before July 1, 2003, and in interest expense thereafter. Because management decided not to designate the interest rate swaps as hedges at the time they were extended by the counterparty, we recognized an unrealized gain of approximately $4.1 million and $1.5 million, respectively, related to the change in the fair value of these interest rate swaps in lease expense in our statement of operations during the nine months ended September 30, 2003 and 2002 and recognized an unrealized gain of approximately $0.5 million in interest expense during the three months ended September 30, 2003. Prior to July 1, 2003, these amounts, which were reported as “Change in Fair Value of Derivative Financial Instruments” in our Consolidated Statement of Operations and have been reclassified as interest and lease expense in the attached Condensed Consolidated Statement of Operations. The fair value of these interest rate swaps fluctuated with changes in interest rates over their terms and the fluctuations were recorded in our statement of operations.

During the second quarter of 2001, we entered into three additional interest rate swaps to convert variable lease payments under certain lease arrangements to fixed payments as follows:

These three swaps, which we have designated as cash flow hedging instruments, meet the specific hedge criteria and any changes in their fair values have been recognized in other comprehensive income. During the nine months ended September 30, 2003 and 2002, we recorded income of approximately $4.3 million and a loss of $13.6 million, respectively, related to these three swaps, ($2.8 million and $8.8 million, net of tax) in other comprehensive income. As of September 30, 2003, a total of approximately $12.2 million was recorded in current liabilities and approximately $6.5 million in long-term liabilities with respect to the fair value adjustment related to these three swaps.

The counterparties to the interest rate swap agreements are major international financial institutions. We continually monitor the credit quality of these financial institutions and do not expect non-performance by any counterparty, although such non-performance could have a material adverse effect on us.

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9. COMMITMENTS AND CONTINGENCIES

Hanover has issued the following guarantees which are not recorded on our accompanying balance sheet:

As part of the POC acquisition purchase price, Hanover may be required to make a contingent payment to Schlumberger based on the realization of certain tax benefits by Hanover over the next 15 years. To date we have not realized any of such tax benefits or made any payments to Schlumberger in connection with them.

Litigation and Securities and Exchange Commission Investigation

Commencing in February 2002, approximately 15 putative securities class action lawsuits were filed against us and certain of our current and former officers and directors in the United States District Court for the Southern District of Texas. These class actions (together with subsequently filed actions) were consolidated into one case, Pirelli Armstrong Tire Corporation Retiree Medical Benefits Trust, On Behalf of Itself and All Others Similarly Situated, Civil Action No. H-02-0410, naming as defendants Hanover, Mr. Michael J. McGhan, Mr. William S. Goldberg and Mr. Michael A. O’Connor. The complaints asserted various claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and sought unspecified amounts of compensatory damages, interest and costs, including legal fees. The court entered an order appointing Pirelli Armstrong Tire Corporation Retiree Medical Benefits Trust and others as lead plaintiffs on January 7, 2003 and appointed Milberg, Weiss, Bershad, Hynes & Lerach LLP as lead counsel. On September 5, 2003, lead plaintiffs filed an amended complaint in which they continued to seek relief under Sections 10(b) and 20(a) of the Securities Exchange Act against Hanover, certain former officers and directors and our auditor, PricewaterhouseCoopers LLP, on behalf of themselves and the class of persons who purchased Hanover securities between May 4, 1999 and December 23, 2002.

Commencing in February 2002, four derivative lawsuits were filed in the United States District Court for the Southern District of Texas, two derivative lawsuits were filed in state district court for Harris County, Texas (one of which was nonsuited and the second of which was removed to Federal District Court for the Southern District of Texas) and one derivative lawsuit was filed in the Court of Chancery for the State of Delaware in and for New Castle County. These derivative lawsuits, which were filed by certain of our shareholders purportedly on behalf of Hanover, alleged, among other things, that our directors breached their fiduciary duties to shareholders and sought unspecified amounts of damages, interest and costs, including legal fees. The derivative lawsuits in the United States District Court for the Southern District of Texas were consolidated on August 19 and August 26, 2002 into the Harbor Finance Partners derivative lawsuit. With that consolidation, the pending derivative lawsuits were:

On October 2, 2003, the Harbor Finance Partners derivative lawsuit was consolidated into the Pirelli Armstrong Tire Corporation Retiree Medical Benefits Trust securities class action.

On and after March 26, 2003, three plaintiffs filed separate putative class actions against Hanover, certain named individuals and other purportedly unknown defendants, in the United States District Court for the Southern District of Texas. The alleged class is comprised of persons who participated in or were beneficiaries of The Hanover Companies Retirement and Savings Plan, which was established by Hanover pursuant to Section 401(k) of the United States Internal Revenue Code of 1986, as amended. The purported class action seeks relief under the Employee Retirement Income Security Act (ERISA) based upon Hanover’s and the individual defendants’ alleged mishandling of Hanover’s 401(k) Plan. The three ERISA putative class actions are entitled: Kirkley v. Hanover, Case No. H-03-1155; Angleopoulos v. Hanover, Case No. H-03-1064; and Freeman v. Hanover, Case No. H-03-1095. On August 1, 2003, the three ERISA class actions were consolidated

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into the Pirelli Armstrong Tire Corporation Retiree Medical Benefits Trust federal securities class action. On October 9, 2003, a consolidated amended complaint was filed by the plaintiffs in the ERISA class action against Hanover, Michael McGhan, Michael O’Connor and William Goldberg , which included the same allegations as indicated above, and was filed on behalf of themselves and a class of persons who purchased or held Hanover securities in their 401(k) Plan between May 4, 1999 and December 23, 2002.

On October 23, 2003, we entered into a Stipulation of Settlement, which, subject to court approval, will settle the claims underlying the securities class actions, the ERISA class actions and the shareholder derivative actions described above. The terms of the proposed settlement provide for us to: (i) make a cash payment of approximately $30 million (of which $26.7 million was funded by payments from Hanover’s directors and officers insurance carriers), (ii) issue 2.5 million shares of our common stock, and (iii) issue a contingent note with a principal amount of $6.7 million. The note is payable, together with accrued interest, on March 31, 2007 but can be extinguished (with no monies owing under it) if our common stock trades at or above the average price of $12.25 per share for 15 consecutive days at any time between March 31, 2004 and March 31, 2007. As part of the settlement, we have also agreed to implement corporate governance enhancements, including allowing large shareholders to participate in the process to appoint two independent directors to our Board. Our independent auditor, PricewaterhouseCoopers LLP, is not a party to the settlement and will continue to be a defendant in the consolidated securities class action.

GKH Investments, L.P. and GKH Private Limited (collectively “GKH”), which together own approximately ten percent of Hanover’s outstanding common stock and which sold shares in the Company’s March 2001 secondary offering of common stock, are parties to the proposed settlement and have agreed to settle claims against them that arise out of that offering as well as other potential securities, ERISA, and derivative claims. The terms of the proposed settlement provide for GKH to transfer 2.5 million shares of Hanover common stock from their holdings or from other sources.

In connection with this settlement, we initially recorded a pre-tax charge of approximately $68.7 million ($54.0 million after tax) in our first quarter 2003 financial statements. This charge included approximately $42.1 million ($27.4 million after tax), net of insurance recoveries, for our contribution of cash and estimated costs, 2.5 million Hanover common shares, and the contingent note. The charge also included approximately $26.6 million, without tax benefit, for 2.5 million Hanover common shares to be funded by GKH. Because this settlement could be considered to be a related party transaction as defined in SEC Staff Accounting Bulletin 5-T, the fair value of the Hanover common shares to be paid by GKH was recorded as an expense in Hanover’s statement of operations.

As discussed in our Quarterly Report on Form 10-Q for the three months ended March 31, 2003, we planned to seek guidance from the Office of the Chief Accountant of the SEC to determine whether the Hanover common shares provided by GKH should be recorded as an expense by us. After the submission of a detailed letter and discussions with the SEC Staff, the Staff informed us that it would not object to GKH’s portion of the settlement not being considered a related party transaction as defined in SEC Staff Accounting Bulletin 5-T. Accordingly, the $26.6 million charge related to the 2.5 million Hanover common shares being paid by GKH could be reversed from our first quarter 2003 financial statements.

On August 5, 2003, we filed an amendment to our Quarterly Report on Form 10-Q for the three months ended March 31, 2003 to amend our first quarter 2003 financial statements to exclude the $26.6 million charge related to the 2.5 million Hanover common shares being funded by GKH. As a result, in our first quarter 2003 financial statements, as amended, we recorded a pre-tax charge of approximately $42.1 million ($27.4 million after tax), net of insurance recoveries, for our contribution of cash and estimated costs, 2.5 million Hanover common shares, and the contingent note.

In addition, in the second quarter of 2003, we adjusted our estimate of the settlement and recorded an additional $1.7 million charge due to the change in the value from May 14 to June 30, 2003 of the 2.5 million Hanover common shares contributed by us to the settlement. In the third quarter of 2003, we recorded a reduction in the charge of $3.5 million to adjust our estimate of the settlement due to additional change in the value of such stock since June 30, 2003.

Based on the terms of the settlement agreement, we determined that a liability related to these lawsuits was probable and that the value was reasonably estimable. Accordingly, we evaluated the individual components of the settlement in consideration of existing market conditions and established an estimate for the cost of the litigation settlement. The details of this estimate are as follows (in thousands):

The $5.2 million estimated fair value of the note to be issued was based on the present value of the future cash flows discounted at borrowing rates currently available to us for debt with similar terms and maturities. Utilizing a market-borrowing rate of 11%, the principal value and stipulated interest rate required by the note of 5% per annum, an estimated discount of $1.5 million was computed on the note to be issued. Upon the issuance of the note, the discount will be amortized to interest expense over the term of the note. Because the note could be extinguished without a payment (if our common stock trades at or above the average price of $12.25 per share for 15 consecutive days at any time between March 31, 2004 and March 31, 2007), we will be required to record an asset in future periods for the value of the embedded derivative, as required by SFAS 133, when the note is issued. This asset will be marked to market in future periods with any increase or decrease included in our statement of operations.

As of September 30, 2003, our accompanying balance sheet includes a $30.2 million long-term liability pending approval by the courts and satisfaction of certain other conditions and $34.6 million in accrued liabilities related to amounts which are expected to be paid in the next twelve months. During the second quarter, the $26.7

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million receivable from the insurance carriers and $2.8 million of our portion of the cash settlement was paid into an escrow fund and is included in the accompanying balance sheet as restricted cash. Upon approval of the settlement by the court, we will record such amounts in liabilities and stockholders’ equity, respectively, and will include the shares in our outstanding shares used for earnings per share calculations.

The final value of the settlement may differ significantly from the estimates currently recorded depending on the market value of our common stock when approved by the court and potential changes in the market conditions affecting the valuation of the note to be issued. Additionally, the settlement is contingent on court approval and certain other conditions. Accordingly, we will revalue our estimate of the cost of the settlement on a quarterly basis until the settlement is approved by the court.

On July 18, 2003, the parties entered into an Amended Memorandum of Understanding which did not alter the aggregate amount to be paid under the settlement described above, but in which the counsel for the named plaintiffs in the Angleopoulos and the Freeman ERISA class actions agreed to become parties to the settlement. As partial consideration therefore, it was agreed that an additional $0.8 million (for a total of $1.8 million) from the settlement fund that was previously designated for relief for the securities class actions would be reallocated to provide relief in connection with the ERISA class actions. On October 13, 2003, the parties entered into a Second Amended and Restated Memorandum of Understanding that included an additional $225,000 contribution to the settlement (to be funded equally by Hanover and GKH) and by which counsel in the Harbor Finance derivative action became a party to the settlement. As part of this arrangement, Hanover agreed to certain additional governance procedures including certain enhancements to its code of conduct.

On October 23, 2003, the parties to the Second Amended and Restated Memorandum of Understanding entered into a Stipulation of Settlement which, subject to court approval, will fully and finally resolve all of the securities class actions, ERISA class actions and shareholder derivative actions filed against Hanover and certain other individuals. PricewaterhouseCoopers LLP is not a party to the Stipulation of Settlement and will remain a defendant in the federal securities class action. On October 24, 2003, the parties moved the court for preliminary approval of the proposed settlement and sought permission to provide notice to the potentially affected persons and to set a date for a final hearing to approve the proposed settlement. The settlement, therefore, remains subject to court approval and could be the subject of an objection by potentially affected persons.

On November 14, 2002, the SEC issued a Formal Order of Private Investigation relating to the transactions underlying and other matters relating to the restatements of our financial statements announced in 2002. We have cooperated with the Fort Worth District Office Staff of the SEC in its investigation. Based upon our discussions to date with the Fort Worth District Office Staff of the SEC, we currently believe that a settlement of the investigation will be reached on terms that we do not believe will have a material adverse impact on our business, consolidated financial position, results of operations or cash flows. However, we can give no assurances in this regard, and we expect any settlement with the SEC to include findings of violations of the securities laws by us with respect to certain of the restated transactions. We understand that any resolution of the investigation reached by us with the Fort Worth District Office Staff of the SEC will have no legal effect until it is reviewed and, if appropriate, approved by the SEC in Washington, D.C., and we cannot predict what action might ultimately be taken against us by the SEC. As such, we do not anticipate announcing any resolution of the investigation unless and until such resolution is approved by the SEC in Washington, D.C.

As of September 30, 2003, we had incurred approximately $14.0 million in legal related expenses in connection with the internal investigations, the putative class action securities lawsuits, the derivative lawsuit and the SEC investigation. Of this amount, we advanced approximately $2.2 million on behalf of current and former officers and directors in connection with the above-named proceedings. We intend to advance the litigation costs of our officers and directors, subject to the limitations imposed by Delaware and other applicable law and Hanover’s certificate of incorporation and bylaws. We expect to incur approximately $4.4 million in additional legal fees and administrative expenses in connection with the settlement of the securities-related litigation, the SEC investigation and advances on behalf of current and former officers and directors for legal fees.

On June 25, 1999, we notified the Air Quality Bureau of the Environmental Protection Division, New Mexico Environment Department of potential violations of regulatory and permitting requirements. The violations included failure to conduct required performance tests, failure to file required notices and failure to pay fees for compressor units located on sites for more than one year. We promptly paid the required fees and corrected the violations. On June 12, 2001, after the violations had been corrected, the Director of the Division issued a compliance order to us in connection with the alleged violations. The compliance order assessed a civil penalty of $15,000 per day per regulatory violation and permit; no total penalty amount was proposed in the compliance order. On October 3, 2003, the Division notified us that the total proposed penalty would be $759,072. However, since the alleged violations had been self-disclosed, that amount was reduced to $189,768. We expect to respond to the penalty assessment, challenging some of the calculations, and will propose an alternative settlement amount, which we expect to be less than $100,000.

In the ordinary course of business we are involved in various other pending or threatened legal actions, including environmental matters. While management is unable to predict the ultimate outcome of these actions, it believes that any ultimate liability arising from these actions will not have a material adverse effect on our consolidated financial position, results of operations or cash flows.

10. RELATED-PARTY TRANSACTIONS

In connection with the restatements announced by Hanover in 2002, certain present and former officers and directors have been named as defendants in putative stockholder class actions, stockholder derivative actions and have been involved with the investigation being conducted by the Staff of the SEC. Pursuant to the indemnification provisions of our certificate of incorporation and bylaws, we paid legal fees on behalf of certain employees, officers and directors involved in these proceedings. In connection with these proceedings, we advanced, on behalf of indemnified officers and directors, during 2002 and the first nine months of 2003, $1.1 million and $1.1 million, respectively, in the aggregate.

During 2002, $0.4 million was advanced on behalf of former director and officer William S. Goldberg; $0.3 million was advanced on behalf of former director and officer Michael J. McGhan; $0.1 million was advanced on behalf of former officer Charles D. Erwin; $0.1 million was advanced on behalf of former officer Joe S. Bradford; $0.1 million was advanced on behalf of directors Ted Collins, Jr., Robert R. Furgason, Rene Huck (former director), Melvyn N. Klein, Michael A. O’Connor (former director), and Alvin V. Shoemaker, who were elected prior to 2002; and $0.1 million was advanced on behalf of directors I. Jon Brumley, Victor E. Grijalva, and Gordon T. Hall who were elected during 2002.

During 2003, $0.3 million was advanced on behalf of former director and officer William S. Goldberg; $0.2 million was advanced on behalf of former director and officer Michael J. McGhan; $0.1 million was advanced on behalf of former officer Charles D. Erwin; $0.1 million was advanced on behalf of former officer Joe S. Bradford; and $0.4 million was advanced on behalf of various employees of the Company.

In 2001, the Company advanced cash of $2.2 million in return for promissory notes to Michael J. McGhan, Hanover’s former president and chief executive officer who resigned on August 1, 2002. The notes bore interest at 4.88%, matured on April 11, 2006, and were collateralized by personal real estate and Hanover common stock with full recourse. On May 19, 2003, Mr. McGhan paid in full the $2.2 million loan together with the applicable accrued interest.

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On May 14, 2003, Hanover entered into agreements with Schlumberger to terminate our right to put our interest in the PIGAP II joint venture, to restructure a $150 million subordinated promissory note and to modify the repayment terms of a $58 million obligation (see Notes 5 and 14).

On July 30, 2003, the Company’s subsidiary, Hanover Compression Limited Partnership (“HCLP”) entered into a Membership Interest Redemption Agreement pursuant to which its 10% interest in Energy Transfer Group, LLC (“ETG”) was redeemed, and as a result HCLP withdrew as a member of ETG. In consideration for the surrender of HCLP’s 10% membership interest in ETG, pursuant to a Partnership Interest Purchase Agreement dated as of July 30, 2003, subsidiaries of ETG sold to subsidiaries of the Company their entire 1% interest in Energy Transfer Hanover Ventures, L.P. (“Energy Ventures”). As a result of the transaction, the Company now owns, indirectly, 100% of Energy Ventures. The Company’s 10% interest in ETG was carried on the Company’s books for no value. Ted Collins, Jr., a Director of the Company, owns 100% of Azalea Partners, which in turn owns 13% of ETG.

11. NEW ACCOUNTING PRONOUNCEMENTS

In June 2001, the FASB issued SFAS 143, “Accounting for Obligations Associated with the Retirement of Long-Lived Assets” (“SFAS 143”). SFAS 143 establishes the accounting standards for the recognition and measurement of an asset retirement obligation and its associated asset retirement cost. This statement became effective for Hanover on January 1, 2003. The adoption of this new standard did not have a material effect on our consolidated results of operations, cash flows or financial position.

In April 2002, the FASB issued SFAS 145, “Rescission of FASB Statements 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections” (“SFAS 145”). The Statement updates, clarifies and simplifies existing accounting pronouncements. Provisions of SFAS 145 related to the rescission of Statement 4 became effective for us on January 1, 2003. The provisions of SFAS 145 related to SFAS 13 are effective for transactions occurring after May 15, 2002. We have adopted the provisions of the new standard, which had no material effect on our consolidated results of operations, cash flows or financial position.

In June 2002, the FASB issued SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS 146”), which addresses accounting for restructuring and similar costs. SFAS 146 supersedes previous accounting guidance, principally Emerging Issues Task Force Issue (“EITF”) No. 94-3. We adopted the provision of SFAS 146 for restructuring activities initiated after December 31, 2002, which had no material effect on our financial statements. SFAS 146 requires that the liability for costs associated with an exit or disposal activity be recognized when the liability is incurred. Under EITF No. 94-3, a liability for an exit cost was recognized at the date of the commitment to an exit plan. SFAS 146 also establishes that the liability should initially be measured and recorded at fair value. Accordingly, SFAS 146 may affect the timing of recognizing future restructuring costs as well as the amounts recognized.

In November 2002, the EITF reached a consensus on Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” (“EITF 00-21”). EITF 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which the vendor will perform multiple revenue generating activities. EITF 00-21 became effective for interim periods beginning after June 15, 2003. We have adopted the provisions of EITF 00-21, which did not have a material effect on our consolidated results of operations, cash flow or financial position.

In November 2002, the FASB issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others”, which clarifies disclosure and recognition/measurement requirements related to certain guarantees. The disclosure requirements are effective for financial statements issued after December 15, 2002 and the recognition/measurement requirements are effective on a prospective basis for guarantees issued or modified after December 31, 2002. The adoption of the provisions of this interpretation did not have a material effect on our consolidated results of operations, cash flow or financial position.

In December 2002, the FASB issued Statement of SFAS 148, “Accounting for Stock-Based Compensation—Transition and Disclosure” (“SFAS 148”). SFAS 148 amends SFAS 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), to provide alternative methods of transition for a voluntary change to the fair value-based method of accounting for stock-based employee compensation. In addition, SFAS 148 amends the disclosure requirements of SFAS 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The transition guidance and annual disclosure provisions of SFAS 148 were effective for fiscal years ending after December 15, 2002. The interim disclosure provisions are effective for financial reports containing financial statements for interim periods beginning after December 15, 2002. We have adopted the disclosure provisions that are included within these financial statements.

In January 2003, the FASB issued FIN 46. The primary objectives of FIN 46 are to provide guidance on the identification of entities for which control is achieved by means other than through voting rights (“variable interest entities” or “VIEs”) and the determination of when and which business enterprise should consolidate the VIE in its financial statements (the “primary beneficiary”). This new model for consolidation applies to an entity in which either (i) the equity investors (if any) do not have a controlling financial interest or (ii) the equity investment at risk is insufficient to finance that entity’s activities without receiving additional subordinated financial support from other parties. In addition, FIN 46 requires that both the primary beneficiary and all other enterprises with a significant variable interest in a VIE make additional disclosures. On October 8, 2003, the FASB provided a deferral of the latest date by which all public companies must adopt FIN 46. The deferral provides that FIN 46 be applied, at the latest, to the first reporting period ending after December 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. In addition, the deferral allowed companies to elect to adopt early the provisions of FIN 46 for some but not all of the variable interest they hold.

Prior to July 1, 2003, we entered into five lease transactions that were recorded as a sale and leaseback of the compression equipment and were treated as operating leases for financial reporting purposes. On July 1, 2003, we adopted the provisions of FIN 46 as they relate to the special purpose entities that lease compression equipment to us. As a result of the adoption, we added approximately $1,089 million in compressor equipment assets, $192.3 million of accumulated depreciation (including approximately $58.6 million of accumulated depreciation related to periods before the sale and leaseback of the equipment), $1,105.0 million in debt and $34.6 million in minority interest obligations to our balance sheet, and we reversed $108.8 million of deferred gains that were recorded on our balance sheet as a result of the sale leaseback transactions. On July 1, 2003, we recorded a $133.7 million charge ($86.9 million net of tax) to record the cumulative effect from the adoption of FIN 46 related to prior period depreciation of the compression equipment assets. Additionally, we estimate that, after adoption, we will record approximately $17 million per year in additional depreciation expense on our leased compression equipment as a result of the inclusion of the compression equipment on our balance sheet and will also record the payments made under our compression equipment leases as interest expense. As of September 30, 2003, the compression assets that are owned by the entities that lease equipment to us but are now included in property, plant and equipment in our consolidated financial statements had a net book value of approximately $983.3 million, including improvements made to these assets after the sale leaseback transactions.

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We have a consolidated subsidiary trust that has Mandatorily Redeemable Preferred Securities outstanding which have a liquidation value of $86.3 million. These securities are reported on our balance sheet as Mandatorily Redeemable Convertible Preferred Securities. The trust may be a VIE under FIN 46 because we only have a limited ability to make decisions about its activities and we may not be the primary beneficiary of the trust. If the trust is a VIE under FIN 46, the trust and the Mandatorily Redeemable Preferred Securities issued by the trust may no longer be reported on our balance sheet. Instead, we would report our subordinated notes payable to the trust as a liability. These intercompany notes have previously been eliminated in our consolidated financial statements. The above-described changes on our balance sheet would be reclassifications. Because we are still evaluating whether we will be required to make these reclassifications and other potential changes in connection with our adoption of FIN 46, if any, we have not adopted the provisions of FIN 46 other than for the entities that lease compression equipment to us, as discussed above.

In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“SFAS 149”). This Statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS 133, “Accounting for Derivative Instruments and Hedging Activities.” This Statement is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. All provisions of this Statement will be applied prospectively. We have adopted the provisions SFAS 149, which did not have a material effect on our consolidated results of operations, cash flow or financial position.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“SFAS 150”). The Statement changes the accounting for certain financial instruments that, under previous guidance, issuers could account for as equity. The new Statement requires that those instruments be classified as liabilities in statements of financial position. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective for interim periods beginning after June 15, 2004. On November 7, the FASB issued Staff Position 150-4 that delayed the effective date for certain types of financial instruments. We do not believe the adoption of the guidance currently provided in SFAS 150 will have a material effect on our consolidated results of operations or cash flow. However, we may be required to classify as debt approximately $34.6 million in sale leaseback obligations that are currently reported as “Minority interest” on our Condensed Consolidated Balance Sheet pursuant to FIN 46 (see Note 6). These Minority interest obligations represent the equity of the entities that lease compression equipment to us. In accordance with the provisions of our compression equipment lease obligations, the equity certificate holders are entitled to quarterly or semi-annual yield payments on the aggregate outstanding equity certificates. As of September 30, 2003, the yield rates on the outstanding equity certificates ranged from 4.4% to 9.5%. Equity certificate holders may receive a return of capital payment upon lease termination or our purchase of the leased compression equipment after full payment of all debt obligations of the entities that lease compression equipment to us. At September 30, 2003, the carrying value of the minority interest obligations approximated the fair market value of assets that would be required to be transferred to redeem the minority interest obligations.

12. REPORTABLE SEGMENTS

We manage our business segments primarily based upon the type of product or service provided. We have five principal industry segments: Domestic Rentals; International Rentals; Parts, Service and Used Equipment; Compressor and Accessory Fabrication; and Production and Processing Equipment Fabrication. The Domestic and International Rentals segments primarily provide natural gas compression and production and processing equipment rental and maintenance services to meet specific customer requirements on Hanover-owned assets. The Parts, Service and Used Equipment segment provides a full range of services to support the surface production needs of customers from installation and normal maintenance and services to full operation of a customer’s owned assets and surface equipment as well as sales of used equipment. The Compressor and Accessory Fabrication Segment involves the design, fabrication and sale of natural gas compression units and accessories to meet unique customer specifications. The Production and Processing Equipment Fabrication Segment designs, fabricates and sells equipment used in the production and treating of crude oil and natural gas and engineering, procurement and construction of heavy wall reactors for refineries and desalination plants.

We evaluate the performance of our segments based on segment gross profit. Segment gross profit for each segment includes direct operating expenses. Costs excluded from segment gross profit include selling, general and administrative, depreciation and amortization, leasing, interest, foreign currency translation, provision for estimated cost of litigation settlement, goodwill impairment, other expenses and income taxes. Amounts defined as “Other” include equity in income of nonconsolidated affiliates, results of other insignificant operations and corporate related items primarily related to cash management activities. Revenues include sales to external customers and intersegment sales. Intersegment sales are accounted for at cost, except for compressor fabrication sales which are accounted for on an arms length basis. Intersegment sales and any resulting profits are eliminated in consolidation. Identifiable assets are tangible and intangible assets that are identified with the operations of a particular segment or geographic region, or which are allocated when used jointly.

The following tables present sales and other financial information by industry segment for the three months ended September 30, 2003 and 2002.

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The following tables present sales and other financial information by industry segment for the nine months ended September 30, 2003 and 2002.

13. DISCONTINUED OPERATIONS

During 2002, Hanover’s Board of Directors approved management’s plan to dispose of our non-oilfield power generation projects, which were part of our domestic rental business, and certain used equipment businesses, which were part of our parts and service business. These disposals meet the criteria established for recognition as discontinued operations under SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” (“SFAS 144”). SFAS 144 specifically requires that such amounts must represent a component of a business composed of operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity. These businesses have been reflected as discontinued operations in our statement of operations for the periods ended September 30, 2003 and 2002. We believe we will sell the majority of these assets during the remainder of 2003 or early in 2004 and the assets and liabilities are reflected as assets held for sale on our balance sheet.

Summary of operating results of the discontinued operations (in thousands):

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Summary balance sheet data for discontinued operations as of September 30, 2003 (in thousands):