UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

Form 10-Q

(Mark One)

Commission file number 033-19694

FirstCity Financial Corporation

(Exact name of registrant as specified in its charter)

(254) 761-2800

(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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o  No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one.)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o  No x

The number of shares of common stock, par value $.01 per share, outstanding at August 10, 2010 was 10,187,714.

TABLE OF CONTENTS

PART I

FINANCIAL INFORMATION

Item 1.  Financial Statements

FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except share data)

See accompanying notes to consolidated financial statements.

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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

(Dollars in thousands, except per share data)

See accompanying notes to consolidated financial statements.

3

FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

(Dollars in thousands)

See accompanying notes to consolidated financial statements.

4

FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (Unaudited)

(Dollars in thousands)

See accompanying notes to consolidated financial statements.

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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(Dollars in thousands)

See accompanying notes to consolidated financial statements.

6

FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

(1)  Basis of Presentation and Summary of Significant Accounting Policies

Nature of Operations

FirstCity Financial Corporation, a Delaware corporation, is a financial services company headquartered in Waco, Texas with offices throughout the United States and Mexico and a presence in Europe and South America. When we refer to “FirstCity,” “the Company,” “we,” “our” or “us” in this Quarterly Report on Form 10-Q, we mean FirstCity Financial Corporation and subsidiaries (consolidated).

The Company engages in two major business segments — Portfolio Asset Acquisition and Resolution and Special Situations Platform. The Portfolio Asset Acquisition and Resolution business has been the Company’s core business segment since it commenced operations in 1986. In the Portfolio Asset Acquisition and Resolution business, the Company acquires portfolios of performing and non-performing loans and other assets (collectively, “Portfolio Assets” or “Portfolios”), generally at a discount to their legal principal balances or appraised values, and services and resolves such Portfolio Assets in an effort to maximize the present value of the ultimate cash recoveries. FirstCity acquires the Portfolio Assets for its own account or through investment entities formed with one or more other co-investors (each such entity, an “Acquisition Partnership”). The Company engages in its Special Situations Platform business through its majority ownership in an investment company that was formed in April 2007. Through its Special Situations Platform, the Company provides investment capital to privately-held middle-market companies through flexible capital structuring arrangements to generate an attractive risk-adjusted return. These capital investments primarily take the form of senior and junior financing arrangements, but also include direct equity investments, common equity warrants, distressed debt transactions, and leveraged buyouts. Refer to Note 18 for additional information on the Company’s major business segments.

Basis of Presentation

The accompanying unaudited consolidated financial statements in this Form 10-Q were prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim information and with instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, the consolidated financial statements do not include all of the information and footnote disclosures required by GAAP for complete consolidated financial statements. In the opinion of management, the accompanying consolidated financial statements include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the Company’s financial position and results of operations. The interim results of operations disclosed herein are not necessarily indicative of the results that may be expected for a full year or any future period. Certain amounts in the consolidated financial statements and disclosures for prior periods were reclassified to conform to the current period presentation. These interim consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements and footnotes thereto included in our annual report on Form 10-K for the year ended December 31, 2009, as amended (“2009 Form 10-K”).

The consolidated financial statements in this Form 10-Q include the accounts of FirstCity, its wholly-owned and majority-owned subsidiaries, and certain variable interest entities (“VIEs”). All significant intercompany transactions and balances have been eliminated in consolidation. We consolidate all VIEs where we are the primary beneficiary as prescribed by the Financial Accounting Standards Board’s (the “FASB”) accounting guidance on the consolidation of VIEs. The primary beneficiary of a VIE is the party that has the power to direct the activities that most-significantly impact the economic performance of the entity and the obligation to absorb losses or the right to receive benefits that could potentially be significant to the entity. Refer to Note 16 for more information.

The Company does not consolidate equity investments in 20%- to 50%-owned entities that are not VIEs where the Company does not have an effective controlling interest, or equity investments in 20%- to 50%-owned entities that are VIEs where the Company is not the primary beneficiary. Rather, such investments are accounted for under the equity-method of accounting since the Company has the ability to exercise significant influence over the investees’ operating and financial policies. The Company also accounts for its unconsolidated equity investments in less than 20%-owned entities under the equity-method of accounting. FirstCity has the ability to exercise significant influence over the operating and financial policies of these entities, despite its comparatively smaller ownership percentage, due primarily to its active participation in the policy-making process as well as its involvement in the daily management activities.

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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Correction of an Error in Previously Issued Consolidated Statements of Cash Flows

The Company determined that it has incorrectly reported certain amounts related to Portfolio Asset activities as “Cash flows from operating activities” in the consolidated statements of cash flows for all reporting periods prior to September 30, 2009. Upon subsequent review, the Company determined that applicable Portfolio Asset transactions, primarily purchases and principal collections, should be reported as “Cash flows from investing activities.” In this Form 10-Q, for reasons described below, the Company is revising its consolidated statement of cash flows for the prior reporting period so that applicable Portfolio Asset transactions are reported as “Cash flows from investing activities” instead of “Cash flows from operating activities.” All financial information contained in this Form 10-Q gives effect to these revisions. The revisions did not result in a change to the Company’s previously-reported revenues, expenses, net earnings (loss), cash and cash equivalents, or stockholders’ equity.

Company management considered all of the relevant quantitative and qualitative factors related to the correction of the error under Securities and Exchange Commission (“SEC”) guidance on considering the effects of prior period misstatements when quantifying misstatements in the current period financial statements, and determined that the impact on previously-issued financial statements was not material. Therefore, the Company is revising the prior period consolidated statement of cash flows for the immaterial error in this Form 10-Q and is not amending previously-filed reports.

The following tables reconcile the Company’s consolidated statement of cash flows from the previously-reported results to the revised results for the six-month period ended June 30, 2009:

Out-of-Period Adjustments

In the first quarter of 2010, upon the determination that deferred tax items related to our foreign jurisdictions had been misstated by $1.5 million as of December 31, 2009, the Company recorded a $1.0 million adjustment to deferred tax benefit and a $0.5 million adjustment to equity in earnings of unconsolidated subsidiaries in order to properly state the net deferred tax asset.  The adjustment was not material to our consolidated financial statements for the quarterly or year-to-date periods ended March 31, 2010 or June 30, 2010 or the year ended December 31, 2009.

In addition, in the first quarter of 2010, the Company recorded certain loan impairments that included $1.2 million in impairments that should have been recorded during the year ended December 31, 2009. The out-of-period adjustments were not material to our consolidated financial statements for the quarterly or year-to-date periods ended March 31, 2010 or June 30, 2010 or the year ended December 31, 2009.

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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Estimates that are particularly susceptible to significant change in the near-term relate to the estimation of future collections on Portfolio Assets used in the calculation of income from Portfolio Assets; valuation of deferred tax assets and assumptions used in the calculation of income taxes; valuation of servicing assets, investment securities, loans receivable (including loans receivable held in securitization trusts), and real estate; valuation of assets, liabilities, non-controlling interests and contingencies attributable to business combinations; guarantee obligations and indemnifications; and legal contingencies. These estimates and assumptions are based on management’s best estimates and judgment. Management evaluates its estimates and assumptions on an ongoing basis using historical experience and other factors, including the current economic environment. We adjust such estimates and assumptions when facts and circumstances dictate. Illiquid credit markets, along with volatile financial, real estate and foreign currency markets, have combined to increase the uncertainty inherent in such estimates and assumptions. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. Changes in these estimates resulting from continuing changes in the economic environment will be reflected in the financial statements in future periods.

Portfolio Assets

The Company invests in Portfolio Assets and services and resolves such Portfolio Assets in an effort to maximize the present value of the ultimate cash recoveries. The Portfolio Assets are generally non-homogeneous assets, including loans of varying qualities that are secured by diverse collateral types and real estate. Some Portfolio Assets are loans for which resolution is tied primarily to the real estate securing the loan, while others may be collateralized business loans, the resolution of which may be based on the cash flows of the business or the underlying collateral.

The following is a description of the classifications and related accounting policies for the Company’s significant classes of Portfolio Assets:

Purchased Credit-Impaired Loans

The Company accounts for acquired loans and loan portfolios with evidence of credit deterioration since origination (“Purchased Credit-Impaired Loans”) at fair value on the acquisition date. The amounts paid for Purchased Credit-Impaired Loans reflect the Company’s determination that the loans have experienced deterioration in credit quality since origination and that it is probable the Company will be unable to collect all amounts due according to the contractual terms of the underlying loans. At acquisition, the Company reviews each individual loan to determine whether there is evidence of deterioration of credit quality since origination and if it is probable that the Company will be unable to collect all amounts due according to the loan’s contractual terms. If both conditions exist, the Company determines whether each such loan is to be accounted for individually or whether such loans will be assembled into static pools based on common risk characteristics (primarily loan type and collateral). Static pools of individual loan accounts may be established and accounted for as a single economic unit for the recognition of income, principal payments and loss provision. Once a static loan pool is established, individual accounts are generally not added to or removed from the pool (unless the Company sells, forecloses or writes-off the loan). At acquisition, the Company determines the excess of the scheduled contractual payments over all cash flows expected to be collected for the loan or loan pool as an amount that should not be accreted (“nonaccretable difference”). The excess of the cash flows from the loan or loan pool expected to be collected at acquisition over the initial investment (“accretable difference”) is recognized as interest income over the remaining life of the loan or loan pool on a level-yield basis (“accretable yield”). The discount (i.e. the difference between the cost of each loan or loan pool and the related aggregate contractual receivable balance) is not recorded because the Company does not expect to fully collect each contractual receivable balance. As a result, these loans and loan pools are recorded at cost (which approximates fair value) at the time of acquisition.

The Company accounts for Purchased Credit-Impaired Loans using either the interest method or a non-accrual method (through application of the cost-recovery or cash basis method of accounting). Application of the interest method is dependent on management’s ability to develop a reasonable expectation as to both the timing and amount of cash flows expected to be collected. In the event the Company cannot develop or establish a reasonable expectation as to both the timing and amount of cash flows expected to be collected, the Company uses the cost-recovery or cash basis method of accounting.

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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Interest method of accounting.  Under the interest method, an effective interest rate, or internal rate of return (“IRR”), is applied to the cost basis of the loan or loan pool. The excess of the contractual cash flows over expected cash flows cannot be recognized as an adjustment of income or expense or on the balance sheet. The IRR that is calculated when the loan is purchased remains constant as the basis for subsequent impairment testing (performed at least quarterly) and income recognition. Subsequent decreases in projected cash flows do not change the IRR, but are recognized as an impairment of the cost basis of the loan or loan pool (to maintain the then-current IRR), and are reflected in the consolidated statements of operations through provisions charged to operations, with a corresponding valuation allowance offsetting the loan or loan pool in the consolidated balance sheets. FirstCity establishes valuation allowances for loans and loan pools acquired with credit deterioration to reflect only those losses incurred after acquisition — that is, the cash flows expected at acquisition that are no longer expected to be collected. Significant increases in actual or expected future cash flows are used first to reverse any existing valuation allowance for that loan or loan pool, and any remaining increase may be recognized prospectively through an upward adjustment of the IRR over the remaining life of the loan or loan pool. Any increase to the IRR then becomes the new benchmark for impairment testing and income recognition. Income from loans and loan pools accounted for under the interest method is accrued based on the IRR of each loan or loan pool applied to the respective adjusted cost basis. Gross collections in excess of the interest accrual and impairments will reduce the carrying value of the loan or loan pool, while gross collections less than the interest accrual will increase the carrying value. The IRR is calculated based on the timing and amount of anticipated cash flows using the Company’s proprietary collection models.

Cost-recovery method of accounting.  If the amount and timing of future cash collections on a loan are not reasonably estimable, the Company accounts for such asset on the cost-recovery method. Under the cost-recovery method, no income is recognized until the Company has fully collected the cost of the loan, or until such time as the Company considers the timing and amount of collections to be reasonably estimable and begins to recognize income based on the interest method as described above. At least quarterly, the Company performs an evaluation to determine if the remaining amount that is probable of collection is less than the carrying value of the loan or loan pool, and if so, recognizes impairment through provisions charged to operations. The carrying value of Purchased Credit-Impaired Loans accounted for under the cost-recovery method approximated $66.4 million (including $2.5 million of loans pending management’s post-purchase evaluation) at June 30, 2010, and $96.3 million (including $12.7 million of loans pending management’s post-purchase evaluation) at December 31, 2009.

Cash basis method of accounting.  If only the amount of future cash collections on a loan is reasonably estimable, the Company accounts for such asset on an individual loan basis under the cash basis method of accounting. Under the cash basis method, no income is recognized unless collections are received during the period, or until such time as the Company considers the timing of collections to be reasonably estimable and begins to recognize income based on the interest method as described above. Income is recognized for the difference between the collections and a pro-rata portion of cost on a loan. Cost allocation is based on a proration of actual collections divided by total projected collections on the loan. Significant increases in future cash flows may be recognized prospectively as income over the remaining life of the loan through increased amounts allocated to income when collections are subsequently received. Subsequent decreases in projected cash flows are recognized as impairment of the loan’s cost basis to maintain a constant cost allocation based on initial projections. Management implemented the cash basis method of accounting for such eligible loans in 2009 as a result of increased uncertainty in the timing of future collections (attributable primarily to the borrowers’ inability to obtain financing to refinance the loans). The carrying value of Purchased Credit-Impaired Loans accounted for under the cash basis method approximated $112.7 million and $42.1 million at June 30, 2010 and December 31, 2009, respectively.

UBN Loan Portfolio

In September 2008, the Company, through a wholly-owned subsidiary, acquired an additional ownership interest in UBN, SA (“UBN”) in a transaction that was accounted for as a step acquisition under FASB’s business combination accounting guidance. As a result of the transaction, UBN became a consolidated subsidiary of the Company. As such, FirstCity added UBN’s loan portfolio to its consolidated balance sheet in September 2008. On the date of the acquisition, the amount of loans and allowance for loan losses related to UBN’s loan portfolio approximated $69.1 million (including $67.3 million of non-performing loans) and $66.6 million, respectively.

The allowance for loan losses on the UBN loan portfolio represents management’s estimate of credit losses inherent in the loan portfolio at the balance sheet date. Management establishes an allowance for loan losses through a provision charged to operations when a loan is determined to be impaired. A loan is considered to be impaired when, based on current information and events, it is probable the Company will not be able to collect all amounts due according to the contractual terms of the loan agreement. Loans are

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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

charged-off against the allowance when all possible means of collection have been exhausted and the remaining balance due is deemed uncollectible. At least quarterly, management evaluates the need for an allowance on an individual-loan basis for the UBN loan portfolio by considering information about specific borrower situations, legal collection proceedings, estimated collateral values, general economic conditions, and other factors. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revisions as more information becomes available.

Real Estate

Portfolio Assets consisting of real estate include properties that were purchased from a variety of sellers or acquired through loan foreclosure. Rental income, net of expenses, is generally recognized when received. The Company accounts for its real estate properties on an individual-asset basis as opposed to a pool basis. The following is a description of the classifications and related accounting policies for the Company’s various classes of real estate Portfolio Assets:

Classification and Impairment Evaluation

Real estate held for sale primarily includes real estate acquired through loan foreclosure. The Company classifies a property as held for sale if (1) management commits to a plan to sell the property; (2) the Company actively markets the property in its current condition for a price that is reasonable in comparison to its fair value; and (3) management considers the sale of such property within one year of the balance sheet date to be probable. Real estate held for sale is stated at the lower of cost or fair value less estimated disposition costs. Real estate is not depreciated while it is classified as held for sale. Impairment losses are recorded if a property’s fair value less estimated disposition costs is less than its carrying amount, and charged to operations in the period the impairment is identified.

Real estate held for investment generally includes acquired properties and is carried at cost less depreciation and amortization, as applicable. The Company classifies a property as held for investment if the property is still under development and/or management does not expect the property to be sold within one year of the balance sheet date. The Company periodically reviews its property held for investment for impairment whenever events or changes in circumstances indicate the carrying amount of the asset may not be recoverable. Recoverability of property held for investment is measured by comparison of the carrying amount of the asset to future net undiscounted cash flows expected to be generated by the property. If the property is considered impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the property exceeds its fair value. Fair value is determined by discounted cash flows or market comparisons.

Cost Capitalization and Allocation

Real estate properties acquired through, or in lieu of, loan foreclosure are initially recorded at the lower of cost (i.e. the underlying loan’s carrying value) or estimated fair value less disposition costs at the date of foreclosure — establishing a new cost basis. The amount, if any, by which the carrying value of the underlying loan exceeds the property’s fair value less estimated disposition costs at the foreclosure date is charged as a loss against operations. Expenditures for repairs, maintenance, and other holding costs are charged to operations as incurred.

Real estate properties acquired through a purchase transaction are initially recorded at the cost of the acquisition. The cost of acquired property includes the purchase price of the property, legal fees, and certain other acquisition costs. Subsequent to acquisition, the Company capitalizes capital improvements and expenditures related to significant betterments and replacements, including costs related to the development and improvement of the property for its intended use. Expenditures for repairs, maintenance, and other holding costs are charged to operations as incurred.

Disposition of Real Estate

Gains on disposition of real estate are recognized upon the sale of the underlying property if the transaction qualifies for gain recognition under the full accrual method, as prescribed by the FASB’s accounting guidance on real estate sales transactions. If the transaction does not meet the criteria for the full accrual method of profit recognition based on our assessment, we account for the sale based on an appropriate deferral method determined by the nature and extent of the buyer’s investment and our continuing involvement.

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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Loans Receivable

The portion of U.S. Small Business Administration (“SBA”) loans that are guaranteed by the SBA are classified by management as loans held for sale. These loans are recorded at the lower of aggregate cost or estimated fair value. The fair value of SBA loans held for sale is based primarily on what secondary markets are currently offering for loans with similar characteristics, or the contractual price for loan sales already consummated but which cannot be recognized as accounting sales until the expiration of a recourse period. Net unrealized losses, if any, are recognized through a valuation allowance through a charge to income. The carrying value of SBA loans held for sale is net of premiums as well as deferred origination fees and costs. Premiums and net origination fees and costs are deferred and included in the basis of the loans in calculating gains and losses upon sale. SBA loans are generally secured by the borrowing entities’ assets such as accounts receivable, property and equipment, and other business assets. The Company generally sells the guaranteed portion of each loan to a third-party investor and retains the servicing rights. The non-guaranteed portion of SBA loans is classified as held for investment. As described in Note 2, effective January 1, 2010, the Company adopted new accounting guidance that requires SBA loan transactions subject to the SBA’s 90-day premium recourse provision to be accounted for initially as secured borrowings rather than asset sales. After the premium recourse provision has elapsed, the transaction will be recorded as a sale and the resulting net gain on sale will be recognized — which is based on the difference between the proceeds received and the allocated carrying value of the loan sold.

Loans receivable consisting of loans made to affiliated entities (including Acquisition Partnerships and other equity-method investees) and non-affiliated entities, and the non-guaranteed portion of SBA loans, are classified by management as held for investment. These loans are reported at their outstanding principal balances net of any unearned income, charge-offs, unamortized deferred fees and costs on originated loans, and unamortized premiums or discounts on purchased loans. Loan origination fees and costs, as well as purchase premiums and discounts, are amortized as level-yield adjustments over the respective loan terms. Unamortized net fees, costs, premiums or discounts are recognized upon early repayment or sale of the loan. Repayment of the loans is generally dependent upon future cash flows of the borrowers, future cash flows of the underlying collateral, and distributions made from affiliated entities. Interest is accrued when earned in accordance with the contractual terms of the loans. Interest is recognized on an accrual basis at the applicable interest rate on the principal amount outstanding.

The Company evaluates the need for impairment on loans receivable held for investment on an individual-loan basis at least quarterly by reviewing the collectibility of the loans in light of various factors, as applicable, such as estimated future cash receipts of the borrower or underlying collateral, historical experience, estimated value of underlying collateral, prevailing economic conditions, and industry concentrations. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. We consider a loan to be impaired when, based on current information and events, we determine it is probable that we will not be able to collect all amounts due according to the loan’s contractual terms (including scheduled interest payments). When management identifies a loan as impaired, we measure the impairment based on discounted future cash flows, except when the source of repayment is the operation or liquidation of the collateral. In these cases, we use the current fair value of the collateral, less estimated selling costs, instead of discounted cash flows. When a loan is determined to be impaired, we cease to accrue interest on the note and interest previously accrued but not collected becomes part of our recorded investment in the loan and is collectively reviewed for impairment. When ultimate collectibility of the impaired note is in doubt, all collections are applied to reduce the principal amount of such notes until the principal has been recovered, and collections thereafter are recognized as interest income. We return a loan to accrual status when we determine that the collectibility of principal and interest is reasonably assured. Impairment losses are charged against an allowance account through provisions charged to operations in the period impairment is identified. Loans are written-off against the allowance when all possible means of collection have been exhausted and the potential for recovery is considered remote.

Revenue Recognition — Special Situations Platform Subsidiaries

The Company’s manufacturing subsidiary, which engages principally in the design, production and sale of wireless transmission equipment and software solutions, recognizes revenue derived from the sale of equipment upon shipment of the product. Revenue associated with software solutions is recognized ratably over the period of the underlying agreements. Effective June 30, 2010, the Company began accounting for its investment in this manufacturing subsidiary as an equity-method investment (instead of a controlled, consolidated subsidiary) — refer to Note 3 for additional information.

The Company’s consolidated railroad subsidiary, which interchanges rail cars with connecting carriers and provides rail freight services for on-line customers, recognizes freight revenue at the time the shipment is either delivered to or received from the

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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

connecting carrier at the point of interchange. Industrial switching and other service revenues are recognized as such services are provided.

The Company’s consolidated coal mine subsidiary, which engages primarily in the purchase and sale of coal and coal-related products, generates revenue under a short-term coal sales contract with a major utility company (the contract is scheduled to expire on or around December 2010). Revenue is recognized when coal is delivered to the customer at an agreed-upon destination as specified in the related contract (at which point title and risk of loss passes to the customer). The Company consolidated the coal mine subsidiary effective April 1, 2010 after it obtained control of the entity at such time (refer to Note 3 for additional information).

(2)  New Accounting Guidance

Consolidation of Variable Interest Entities (“VIEs”)

Effective January 1, 2010, the Company adopted the FASB’s accounting guidance on the consolidation of VIEs (issued in June 2009). This new guidance eliminates the exemption for QSPEs; revises previous guidance by replacing the quantitative-based risks and rewards calculation for determining which enterprise, if any, has a controlling financial interest in a VIE with a qualitative approach focused on identifying which enterprise has both the power to direct the activities of the VIE that most-significantly impacts the entity’s economic performance and has the obligation to absorb losses or the right to receive benefits that could be significant to the entity; requires reconsideration of whether an entity is a VIE when any changes in facts and circumstances occur such that the holders of the equity investment at risk, as a group, lose the power from voting rights or similar rights of those investments to direct the activities of the entity that most significantly impact the entity’s economic performance; and requires ongoing assessments of whether an enterprise is the primary beneficiary of a VIE and additional disclosures about an enterprise’s involvement in VIEs. The adoption of this guidance did not have a material impact on our consolidated financial statements. Refer to Note 16 for additional information about the Company’s involvement with VIEs.

Transfers of Financial Assets

Effective January 1, 2010, the Company adopted the FASB’s guidance on accounting for transfers of financial assets (issued in June 2009). This guidance amends previous guidance which, among other changes, eliminates the concept of a QSPE, changes the requirements for de-recognizing financial assets, defines the term “participating interest” to establish specific conditions for reporting a transfer of a portion of a financial asset as a sale, and requires additional disclosures. The recognition and measurement provisions are effective for transfers occurring on or after January 1, 2010. The new accounting guidance delays the Company’s recognition of the sale of guaranteed portions of SBA loans until expiration of the 90-day premium recourse provision, and requires such transactions to be accounted for initially as a secured borrowing. As such, the Company did not recognize any gains related to SBA loan sales for the first three months of 2010. Once the premium recourse provision has elapsed, the transaction will be recorded as a sale with the guaranteed portion of the SBA loan and the secured borrowing removed from the balance sheet and the resulting gain on sale recorded. Refer to Notes 1 and 5 for additional information.

Fair Value

In January 2010, the FASB issued new accounting guidance that amended existing guidance for fair value disclosures. This guidance requires separate disclosures of significant transfers of items in and out of Levels 1 and 2 in the fair value hierarchy and the reasons for the transfers; requires disclosure of purchases, sales, issuances and settlements activity on a gross (rather than net) basis relative in the Level 3 reconciliation of fair value measurements for assets and liabilities measured at fair value on a recurring basis; and clarifies, among other things, that fair value measurement disclosures should be provided for each class of assets and liabilities, and that disclosures of inputs and valuation techniques should be provided for both recurring and non-recurring Level 2 and Level 3 fair value measurements. We adopted this new guidance for the quarterly period ended March 31, 2010, except for the requirement to provide Level 3 activity of purchases, sales, issuances and settlements on a gross basis, which will be effective beginning the first quarter of 2011. Since this guidance is disclosure-only in nature, our adoption of the guidance did not significantly impact the Company’s consolidated financial statements. Refer to Note 15 for additional information.

Subsequent Events

In March 2010, the FASB issued guidance that amends existing guidance (issued in May 2009) that established the general standards of accounting and disclosure for subsequent events. Among other things, the new guidance eliminates the requirement for

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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEC filers, as defined in the guidance, to disclose the date through which subsequent events have been evaluated. That change is effective immediately. SEC filers continue to be required to evaluate subsequent events through the date the financial statements are issued. Although the new guidance eliminates the requirement for SEC filers to disclose the date through which subsequent events have been evaluated, it does not prohibit SEC filers from disclosing such date. The new guidance also clarifies the requirement to disclose the date through which subsequent events have been evaluated in reissued financial statements to apply only to such statements that have been restated to correct an error or to apply U.S. GAAP retrospectively. The adoption of this guidance did not have a material impact on our consolidated financial statements.

Loan Modifications and Loan Pool Accounting

In April 2010, the FASB issued guidance that clarifies the accounting for loan modifications when the loan is part of a pool that is accounted for as a single asset. The new guidance provides that modifications of loans that are accounted for within a pool do not result in the removal of those loans from the pool even if the modification of those loans would otherwise be considered a troubled debt restructuring. An entity will continue to be required to consider whether the pool of assets in which the loan is included is impaired if expected cash flows for the pool change. This guidance does not affect the accounting for loans that are not accounted for within pools. Loans accounted for individually continue to be subject to the troubled debt restructuring accounting provisions. The new guidance also allows entities to make a one-time election to terminate accounting for loans in a pool, which may be made on a pool-by-pool basis, upon adoption of this new guidance. We early-adopted the provisions of this new guidance, as permitted, effective April 1, 2010. The adoption of this guidance did not have a material impact on our consolidated financial statements.

(3)  Business Combinations and Deconsolidation of a Subsidiary

Coal Mine Operation — Business Combination

Effective April 1, 2010, the Company, through its majority-owned Special Situations Platform subsidiary, obtained control of an equity-method investee (coal mine operation) after the investee acquired and redeemed the 55.5% ownership interest held by the then-majority shareholder in exchange for a $4.6 million note payable. As a result of the equity interest redemption, the Company’s ownership interest in the investee increased to 88.8% from 39.5% and the coal mine operation became a consolidated subsidiary of the Company. The transfer of a controlling interest in the investee to the Company was accounted for as a business combination, and accordingly, all of the assets and liabilities of the coal mine operation were measured at fair value on the date control was obtained and included in the Company’s consolidated balance sheet, net of intercompany account balances that were eliminated in consolidation. The following table reflects the estimated fair value of the coal mine operation’s identifiable assets and liabilities, and the estimated fair value of the noncontrolling interest, that were included in the Company’s consolidated balance sheet at April 1, 2010 (in thousands):

(1)  Included in “Other assets” on the Company’s consolidated balance sheet as of June 30, 2010.

(2)  Included in “Other liabilities” on the Company’s consolidated balance sheet as of June 30, 2010.

(3)  Eliminated in consolidation with the Company’s consolidated financial statements.

In addition to measuring the subsidiary’s assets and liabilities at fair value at the date control was obtained on April 1, 2010, the Company’s carrying value of its previously-held equity-method investment in the coal mine subsidiary was re-measured to fair value under accounting guidance applicable to business combinations. The fair value of the Company’s total interest in the subsidiary after

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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

the business combination exceeded the carrying value of its previously-held equity interest by approximately $4.8 million, which the Company recognized as “Gain on business combinations” in its consolidated statement of operations for the six-month period ended June 30, 2010. The Company’s carrying value of its previously-held equity investment in the coal mine subsidiary included the effects of the investee’s distribution of a wholly-owned equipment subsidiary (i.e. spin-off transaction), effective April 1, 2010, to the owners in proportion to their then-existing ownership percentages. The spin-off transaction effected by the investee was recorded at carrying value and the Company’s proportionate share of equity in the distributed entity approximated $2.7 million — which it continued to record as an equity-method investment after the spin-off.

The Company’s application of business combination accounting in connection with obtaining control of the coal mine subsidiary resulted in the Company’s recognition of an asset for an above-market-price coal supply agreement and a liability for an above-market-price coal purchase agreement. The fair values of the coal supply and coal purchase agreements were based on discounted cash flow calculations of the difference between the expected contract revenues and costs based on the stated contractual terms and the estimated net contract revenues and costs derived from applying forward-market commodity prices as of April 1, 2010. The discount rate used for the calculations was obtained from independent pricing reflecting broker market quotes. The coal supply asset and coal purchase liability are being amortized over the actual amount of tons shipped under each contract (which are both scheduled to expire in December 2010).

Domestic Acquisition Partnerships — Business Combinations

On March 31, 2010, the Company acquired an additional 50% ownership interest in three domestic Acquisition Partnerships for $4.4 million. As a result of this transaction, the Company’s ownership interest in each of these entities increased to 100% and the Company obtained control of such entities, resulting in these Acquisition Partnerships becoming consolidated subsidiaries of the Company. The transaction was accounted for as a business combination, and accordingly, all of the assets and liabilities of these Acquisition Partnerships were measured at fair value on the acquisition date and included in the Company’s consolidated balance sheet. The following table reflects the fair value of the Acquisition Partnerships’ assets and liabilities that were included in the Company’s consolidated balance sheet on the acquisition date (in thousands):

Recognized amounts of identified assets acquired and liabilities assumed (at fair value):

Pursuant to accounting provisions applicable to business combinations, the Company’s carrying value of its previously-held equity-method investments in these Acquisition Partnerships was re-measured to fair value at the acquisition date. The fair value of the Company’s previously-held equity interests exceeded the aggregate carrying values by approximately $0.9 million. As such, the Company recognized a $0.9 million gain attributable to the re-measurement of its previously-held equity interests on the acquisition date (included in “Gain on business combinations” in the Company’s consolidated statement of operations for the six-month period ended June 30, 2010).

Manufacturing Subsidiary — Deconsolidation

In December 2009, the Company, through its majority-owned Special Situations Platform subsidiary, acquired a majority controlling interest in a manufacturing subsidiary (involved in the design, production and sale of wireless transmission equipment and software solutions). The manufacturing subsidiary’s accounts and results of operations have been included in the Company’s consolidated financial statements since the acquisition. However, effective June 30, 2010, the Company and the noncontrolling owners consented to certain amendments to the subsidiary’s operating agreement that resulted in the Company ceasing to have a controlling interest, but retaining a noncontrolling interest and elevated economic interests, in the manufacturing entity. Accordingly, the Company deconsolidated and removed the carrying values of the manufacturing subsidiary’s assets ($9.9 million) and liabilities ($9.6 million) and the carrying value of the noncontrolling interest ($39,000) attributed to the subsidiary from its consolidated balance sheet

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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

on June 30, 2010. The Company also recorded its retained noncontrolling interest in the manufacturing entity at estimated fair value of approximately $0.3 million at June 30, 2010. No gain or loss was recognized by the Company as a result of deconsolidating this subsidiary. On June 30, 2010, the Company began to account for its retained investment in the manufacturing entity using the equity-method of accounting; consequently, the Company will no longer report the individual revenue and expense line-items of the manufacturing entity’s operations in its consolidated statement of operations (rather, the Company will record its share of the subsidiary’s net earnings as “Equity in earnings of unconsolidated subsidiaries” beginning July 1, 2010).

(4)  Portfolio Assets

Portfolio Assets are summarized as follows: