Middlefield Banc 10K 2005 Annual report | MBCN Filing

REPORT OF REGISTERED INDEPENDENT PUBLIC ACCOUNTING FIRM

Board of Directors and Stockholders
Middlefield Banc Corp.

We have audited the accompanying consolidated balance sheet of Middlefield Banc Corp. and subsidiary as of December 31, 2005 and 2004, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2005. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Middlefield Banc Corp. and subsidiary as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ending December 31, 2005, in conformity with U.S. generally accepted accounting principles.


/s/ S. R. Snodgrass, A.C.

S. R. Snodgrass, A.C.

Wexford, PA
February 10, 2006

MIDDLEFIELD BANC CORP.
CONSOLIDATED BALANCE SHEET


	December 31,
	2005			2004
ASSETS
Cash and due from banks	$	5,294,641		$	5,311,776
Interest-bearing deposits in other institutions		526,523			614,506
Investment securities available for sale		57,887,130			57,240,965
Investment securities held to maturity (estimated market value of $232,967 and $243,810)		221,453			221,412
Loans		234,054,797			215,653,283
Less allowance for loan losses		2,841,098			2,623,431

Net loans		231,213,699			213,029,852
Premises and equipment		6,624,776			6,617,594

Bank-owned life insurance		5,632,982			5,424,304
Accrued interest and other assets		3,812,987			2,753,577


TOTAL ASSETS	$	311,214,191		$	291,213,986


LIABILITIES
Deposits:
Non-interest-bearing demand	$	39,782,375		$	36,331,809
Interest-bearing demand		9,362,399			8,817,873
Money market		13,078,829			15,666,730
Savings		66,495,057			78,935,512
Time		120,730,980			100,133,527

Total deposits		249,449,640			239,885,451
Short-term borrowings		6,710,914			1,871,763
Other borrowings		26,578,211			23,683,324
Accrued interest and other liabilities		1,186,061			951,424

TOTAL LIABILITIES		283,924,826			266,391,962


STOCKHOLDERS’ EQUITY
Common stock, no par value; 10,000,000 shares authorized, 1,434,987 and 1,355,488 shares issued		15,976,335			12,815,927
Retained earnings		14,959,891			15,004,552
Accumulated other comprehensive loss		(677,088	)		(28,682	)
Treasury stock, at cost (89,333 shares)		(2,969,773	)		(2,969,773	)

TOTAL STOCKHOLDERS’ EQUITY		27,289,365			24,822,023

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	311,214,191		$	291,213,986


See accompanying notes to consolidated financial statements.

MIDDLEFIELD BANC CORP.
CONSOLIDATED STATEMENT OF INCOME


	Year Ended December 31,
	2005		2004			2003
INTEREST AND DIVIDEND INCOME
Interest and fees on loans	$	15,040,518	$	13,617,560		$	12,846,525
Interest-bearing deposits in other institutions		15,500		5,641			17,188
Federal funds sold		35,173		50,608			48,947
Investment securities:
Taxable		1,353,035		1,400,063			1,196,221
Tax-exempt		864,745		604,399			486,485
Other dividend income		69,533		54,265			51,797

Total interest and dividend income		17,378,504		15,732,536			14,647,163


INTEREST EXPENSE
Deposits		5,520,206		4,905,899			4,905,826
Short-term borrowings		103,836		2,180			4,048
Other borrowings		1,030,572		860,819			815,033

Total interest expense		6,654,614		5,768,898			5,724,907


NET INTEREST INCOME		10,723,890		9,963,638			8,922,256

Provision for loan losses		302,000		174,000			315,000


NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES		10,421,890		9,789,638			8,607,256


NONINTEREST INCOME
Service charges on deposit accounts		1,579,121		1,402,027			1,033,928
Investment securities gains (losses), net		—		(98,375	)		542
Earnings on bank-owned life insurance		208,677		221,919			202,385
Other income		331,439		253,660			191,289

Total noninterest income		2,119,237		1,779,231			1,428,144


NONINTEREST EXPENSE
Salaries and employee benefits		3,568,603		3,442,262			3,085,451
Occupancy		495,982		494,759			403,591
Equipment		432,635		356,346			333,163
Data processing costs		625,856		538,349			470,393
Professional fees		293,138		252,731			218,838
Ohio state franchise tax		284,950		285,050			265,050
Advertising		302,679		253,858			168,849
Postage and freight		189,970		178,717			161,632
Other expense		1,230,826		1,163,634			998,483

Total noninterest expense		7,424,639		6,965,706			6,105,450


Income before income taxes		5,116,488		4,603,163			3,929,950
Income taxes		1,415,156		1,330,000			1,131,330


NET INCOME	$	3,701,332	$	3,273,163		$	2,798,620


EARNINGS PER SHARE
Basic	$	2.77	$	2.41		$	2.09
Diluted		2.73		2.39			2.08

See accompanying notes to consolidated financial statements.

MIDDLEFIELD BANC CORP.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY


								Accumulated
								Other						Total
	Common Stock				Retained			Comprehensive			Treasury			Stockholders’			Comprehensive
	Shares		Amount		Earnings			Income			Stock			Equity			Income
Balance, December 31, 2002		1,209,123		7,883,155		15,051,110			475,428			(1,663,285	)		21,746,408

Net income						2,798,620									2,798,620		$	2,798,620
Other comprehensive income:
Unrealized gain on available for sale securities net of taxes of $180,421									(350,229	)					(350,229	)		(350,229	)

Comprehensive income																	$	2,448,391

Exercise of stock options		847		19,916											19,916
Common stock issued		5,612		170,513											170,513
Sale of treasury stock															—
Purchase of treasury stock												(81,624	)		(81,624	)
Five percent stock dividend (including cash paid for fractional shares)		57,972		1,797,165		(1,801,961	)								(4,796	)
Dividend reinvestment plan		5,574		167,407											167,407
Cash dividends ($.72 per share)						(961,901	)								(961,901	)


Balance, December 31, 2003		1,279,128		10,038,156		15,085,868			125,199			(1,744,909	)		23,504,314

Net income						3,273,163									3,273,163		$	3,273,163
Other comprehensive income:
Unrealized gain on available for sale securities net of taxes of $79,272									(153,881	)					(153,881	)		(153,881	)

Comprehensive income																	$	3,119,282

Exercise of stock options		521		14,198											14,198
Sale of treasury stock		8,154		277,171											277,171
Purchase of treasury stock												(1,224,864	)		(1,224,864	)
Five percent stock dividend (including cash paid for fractional shares)		61,387		2,271,282		(2,283,646	)								(12,364	)
Dividend reinvestment plan		6,298		215,120											215,120
Cash dividends ($.79 per share)						(1,070,833	)								(1,070,833	)


Balance, December 31, 2004		1,355,488		12,815,927		15,004,552			(28,682	)		(2,969,773	)		24,822,023

Net income						3,701,332									3,701,332		$	3,701,332
Other comprehensive income:
Unrealized loss on available for sale securities, net of tax benefit of $334,058									(648,406	)					(648,406	)		(648,406	)

Comprehensive income																	$	3,052,926

Exercise of stock options		2,583		71,386											71,386
Common stock issued		7,158		285,669											285,669
Five percent stock dividend (including cash paid for fractional shares)		63,549		2,557,847		(2,572,949	)								(15,102	)
Dividend reinvestment plan		6,209		245,506											245,506
Cash dividends ($.88 per share)						(1,173,044	)								(1,173,044	)


Balance, December 31, 2005		1,434,987	$	15,976,335	$	14,959,891		$	(677,088	)	$	(2,969,773	)	$	27,289,364


	2005			2004			2003
Components of comprehensive income (loss):
Change in net unrealized gain (loss) on investments available for sale	$	(648,406	)	$	(218,808	)	$	(349,871	)
Realized gains included in net income, net of taxes of $0, $33,448, and ($184)		—			64,927			(358	)


Total	$	(648,406	)	$	(153,881	)	$	(350,229	)


See accompanying notes to consolidated financial statements.

CONSOLIDATED STATEMENT OF CASH FLOWS


	Year Ended December 31,
	2005			2004			2003
OPERATING ACTIVITIES
Net income	$	3,701,332		$	3,273,163		$	2,798,620
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		302,000			174,000			315,000
Depreciation and amortization		448,386			403,916			377,546
Amortization of premium and discount on investment securities		289,111			260,198			259,890
Amortization of net deferred loan costs (fees)		(139,722	)		(134,758	)		(117,524	)
Investment securities gains		—			98,375			(542	)
Earnings on bank-owned life insurance		(208,677	)		(221,919	)		(202,385	)
Deferred income taxes		(85,339	)		(33,704	)		(69,934	)
Increase in accrued interest receivable		(217,022	)		(75,303	)		(11,796	)
Increase (decrease) in accrued interest payable		155,449			(25,617	)		(77,862	)
Other, net		(285,535	)		299,533			184,434

Net cash provided by operating activities		3,959,983			4,017,884			3,455,447


INVESTING ACTIVITIES
Decrease (increase) in interest-bearing deposits in other institutions, net		614,506			(75,359	)		32,822
Investment securities available for sale:
Proceeds from repayments and maturities		11,361,937			14,857,656			16,167,324
Purchases		(13,279,687	)		(27,638,162	)		(32,985,572	)
Proceeds from sales		—			4,912,619			1,991,917
Investment securities held to maturity:
Proceeds from repayments and maturities		—			1,639,200			4,370,070
Purchases		—			—			—
Increase in loans, net		(18,346,125	)		(22,710,211	)		(17,913,713	)
Purchase of Federal Home Loan Bank stock		(63,300	)		(53,300	)		(52,000	)
Purchase of bank-owned life insurance		—			—			(5,000,000	)
Purchase of premises and equipment		(455,568	)		(213,580	)		(704,746	)

Net cash used for investing activities		(20,168,237	)		(29,281,137	)		(34,093,898	)


FINANCING ACTIVITIES
Net increase in deposits		9,564,189			20,045,541			32,455,416
Increase (decrease) in short-term borrowings, net		4,839,151			1,426,944			(340,959	)
Proceeds from other borrowings		7,000,000			9,000,000			5,000,000
Repayment of other borrowings		(4,100,112	)		(2,982,337	)		(3,024,392	)
Purchase of treasury stock		—			(1,224,864	)		(81,624	)
Exercise of stock options		71,386			14,198			19,916
Common stock issued		285,669			277,171			170,513
Proceeds from dividend reinvestment plan		245,506			215,120			167,407
Cash dividends		(1,188,147	)		(1,083,197	)		(966,697	)

Net cash provided by financing activities		16,717,642			25,688,576			33,399,580


Increase (decrease) in cash and cash equivalents		509,388			425,323			2,761,129

CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR		5,311,776			4,886,453			2,125,324


CASH AND CASH EQUIVALENTS AT END OF YEAR	$	5,821,164		$	5,311,776		$	4,886,453


SUPPLEMENTAL INFORMATION
Cash paid during the year for:
Interest on deposits and borrowings	$	6,499,166		$	5,794,515		$	5,802,769
Income taxes		1,540,000			1,280,000			1,295,000

See accompanying notes to consolidated financial statements.

MIDDLEFIELD BANC CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

A summary of the significant accounting and reporting policies applied in the presentation of the accompanying financial statements follows:

Nature of Operations and Basis of Presentation

Middlefield Banc Corp. (the “Company”) is an Ohio corporation organized to become the holding company of The Middlefield Banking Company (the “Bank”). The Bank is a state-chartered bank located in Ohio. The Company and its subsidiary derive substantially all of their income from banking and bank-related services, which includes interest earnings on residential real estate, commercial mortgage, commercial and consumer financings as well as interest earnings on investment securities and deposit services to its customers through five locations. The Company is supervised by the Board of Governors of the Federal Reserve System, while the Bank is subject to regulation and supervision by the Federal Deposit Insurance Corporation and the Ohio Division of Financial Institutions.

The consolidated financial statements of the Company include its wholly owned subsidiary, the Bank. Significant intercompany items have been eliminated in preparing the consolidated financial statements.

The financial statements have been prepared in conformity with U.S. generally accepted accounting principles. In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the balance sheet date and revenues and expenses for the period. Actual results could differ significantly from those estimates.

Investment Securities

Investment securities are classified at the time of purchase, based on management’s intention and ability, as securities held to maturity or securities available for sale. Debt securities acquired with the intent and ability to hold to maturity are stated at cost adjusted for amortization of premium and accretion of discount, which are computed using a level yield method and recognized as adjustments of interest income. Certain other debt securities have been classified as available for sale to serve principally as a source of liquidity. Unrealized holding gains and losses for available-for-sale securities are reported as a separate component of stockholders’ equity, net of tax, until realized. Realized security gains and losses are computed using the specific identification method. Interest and dividends on investment securities are recognized as income when earned.

Common stock of the Federal Home Loan Bank (“FHLB”) represents ownership in an institution that is wholly owned by other financial institutions. This equity security is accounted for at cost and classified with other assets.

Loans

Loans are reported at their principal amount net of the allowance for loan losses. Interest income is recognized as income when earned on the accrual method. The accrual of interest is discontinued on a loan when management believes, after considering economic and business conditions, the borrower’s financial condition is such that collection of interest is doubtful. Interest received on nonaccrual loans is recorded as income against principal according to management’s judgment as to the collectibility of such principal.

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Loans (Continued)

Loan origination fees and certain direct loan origination costs are being deferred and the net amount amortized as an adjustment of the related loan’s yield. Management is amortizing these amounts over the contractual life of the related loans.

Allowance for Loan Losses

The allowance for loan losses represents the amount which management estimates is adequate to provide for probable loan losses inherent in its loan portfolio. The allowance method is used in providing for loan losses. Accordingly, all loan losses are charged to the allowance, and all recoveries are credited to it. The allowance for loan losses is established through a provision for loan losses which is charged to operations. The provision is based on management’s periodic evaluation of the adequacy of the allowance for loan losses, which encompasses the overall risk characteristics of the various portfolio segments, past experience with losses, the impact of economic conditions on borrowers, and other relevant factors. The estimates used in determining the adequacy of the allowance for loan losses, including the amounts and timing of future cash flows expected on impaired loans, are particularly susceptible to significant change in the near term.

A loan is considered impaired when it is probable the borrower will not repay the loan according to the original contractual terms of the loan agreement. Management has determined that first mortgage loans on one-to-four family properties and all consumer loans represent large groups of smaller-balance homogeneous loans that are to be collectively evaluated. Loans that experience insignificant payment delays, which are defined as 90 days or less, generally are not classified as impaired. A loan is not impaired during a period of delay in payment if the Company expects to collect all amounts due, including interest accrued, at the contractual interest rate for the period of delay. All loans identified as impaired are evaluated independently by management. The Company estimates credit losses on impaired loans based on the present value of expected cash flows or the fair value of the underlying collateral if the loan repayment is expected to come from the sale or operation of such collateral. Impaired loans, or portions thereof, are charged off when it is determined a realized loss has occurred. Until such time, an allowance for loan losses is maintained for estimated losses. Cash receipts on impaired loans are applied first to accrued interest receivable unless otherwise required by the loan terms, except when an impaired loan is also a nonaccrual loan, in which case the portion of the payment related to interest is recognized as income.

Mortgage loans secured by one-to-four family properties and all consumer loans are large groups of smaller-balance homogeneous loans and are measured for impairment collectively. Loans that experience insignificant payment delays, which are defined as 90 days or less, generally are not classified as impaired. Management determines the significance of payment delays on a case-by-case basis, taking into consideration all circumstances concerning the loan, the creditworthiness and payment history of the borrower, the length of the payment delay, and the amount of shortfall in relation to the principal and interest owed.

Premises and Equipment

Premises and equipment are stated at cost net of accumulated depreciation. Depreciation is computed on the straight-line method over the estimated useful lives of the assets, which range from 3 to 20 years for furniture, fixtures, and equipment and 3 to 40 years for buildings and leasehold improvements. Expenditures for maintenance and repairs are charged against income as incurred. Costs of major additions and improvements are capitalized.

Bank-Owned Life Insurance (BOLI)

The Company purchased life insurance policies on certain key employees. BOLI is recorded at its cash surrender value or the amount that can be realized.

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Income Taxes

The Company and the Bank file a consolidated federal income tax return. Deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes.

Earnings Per Share

The Company provides dual presentation of basic and diluted earnings per share. Basic earnings per share are calculated utilizing net income as reported in the numerator and average shares outstanding in the denominator. The computation of diluted earnings per share differs in that the dilutive effects of any stock options, warrants, and convertible securities are adjusted in the denominator.

Stock Options

The Company maintains a stock option plan for key officers, employees, and nonemployee directors. Had compensation expense for the stock option plans been recognized in accordance with the fair value accounting provisions of FAS No. 123,Accounting for Stock-Based Compensation,net income applicable to common stock and basic and diluted net income per common share for the year ended December 31 would have been as follows:


	2005		2004		2003
Net income as reported:	$	3,701,331	$	3,273,163	$	2,798,620
Less pro forma expense related to option		60,259		57,308		52,459

Pro forma net income	$	3,641,072	$	3,215,855	$	2,746,161


Basic net income per common share:
As reported	$	2.77	$	2.41	$	2.09
Pro forma		2.72		2.37		2.04
Diluted net income per common share:
As reported	$	2.73	$	2.39	$	2.08
Pro forma		2.68		2.35		2.04

For purposes of computing pro forma results, the Company estimated the fair values of stock options using the Black-Scholes option-pricing model. The model requires the use of subjective assumptions that can materially affect fair value estimates. Therefore, the pro forma results are estimates of results of operations as if compensation expense had been recognized for the stock option plans. The fair value of each stock option granted was estimated using the following weighted-average assumptions:


	Expected
Grant	Dividend			Risk-Free			Expected			Expected
Year	Yield			Interest Rate			Volatility			Life (in years)
2002		2.72	%		4.19	%		27.04	%		9.94
2003		2.72			4.25			14.00			9.94
2004		2.39			4.00			8.79			9.94
2005		2.35			4.49			18.05			9.94

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Cash Flow Information

The Company has defined cash and cash equivalents as those amounts included in the Consolidated Balance Sheet captions and “Cash and due from banks.”

Advertising Costs

Advertising costs are expensed as the costs are incurred. Advertising expenses amounted to $302,679, $253,858, and $168,849, for 2005, 2004, and 2003, respectively.

Recent Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123 (revised 2004),Share-Based Payment(FAS No. 123R). FAS No. 123R revised FAS No. 123,Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25,Accounting for Stock Issued to Employees, and its related implementation guidance. FAS No. 123R will require compensation costs related to share-based payment transactions to be recognized in the financial statement (with limited exceptions). The amount of compensation cost will be measured based on the grant-date fair value of the equity or liability instruments issued. Compensation cost will be recognized over the period that an employee provides service in exchange for the award.

In April 2005, the Securities and Exchange Commission adopted a new rule that amends the compliance dates for FAS No. 123R. The statement requires that compensation cost relating to share-based payment transactions be recognized in financial statements and that this cost be measured based on the fair value of the equity or liability instruments issued. FAS No. 123R covers a wide range of share-based compensation arrangements, including share options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. The Company will adopt FAS No. 123R on January 1, 2006, management has determined that unless additional options are granted, there will be no impact to future earnings.

In March 2005, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 107 (“SAB No. 107”),Share-Based Payment, providing guidance on option valuation methods, the accounting for income tax effects of share-based payment arrangements upon adoption of FAS No. 123R, and the disclosures in MD&A subsequent to the adoption. The Company will provide SAB No. 107 required disclosures upon adoption of FAS No. 123R on January 1, 2006.

In December 2004, the FASB issued FAS No. 153,Exchanges of Nonmonetary Assets – An Amendment of APB Opinion No. 29. The guidance in APB Opinion No. 29,Accounting for Nonmonetary Transactions, is based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. The guidance in that opinion, however, included certain exceptions to that principle. FAS No. 153 amends Opinion No. 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. The provisions of FAS No. 153 are effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. Early application is permitted and companies must apply the standard prospectively. The adoption of this standard is not expected to have a material effect on the Company’s results of operations or financial position.

In June 2005, the FASB issued FAS No. 154,Accounting Changes and Errors Corrections, a replacement of APB Opinion No. 20 and FAS No. 3. The statement applies to all voluntary changes in accounting principle and changes the requirements for accounting for and reporting of a change in accounting principle. FAS No. 154

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Recent Accounting Pronouncements (Continued)

requires retrospective application to prior periods’ financial statements of a voluntary change in accounting principle unless it is impractical. APB Opinion No. 20 previously required that most voluntary changes in accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. FAS No. 154 improves the financial reporting because its requirements enhance the consistency of financial reporting between periods. The provisions of FAS No. 154 are effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The adoption of this standard is not expected to have a material effect on the Company’s results of operations or financial position.

EARNINGS PER SHARE

There are no convertible securities that would affect the numerator in calculating basic and diluted earnings per share; therefore, net income as presented on the Consolidated Statement of Income will be used as the numerator. The following table sets forth the composition of the weighted-average common shares (denominator) used in the basic and diluted earnings per share computation.


	2005			2004			2003
Weighted-average common shares outstanding		1,425,649			1,413,806			1,402,047

Average treasury stock shares		(89,333	)		(55,588	)		(54,833	)


Weighted-average common shares and common stock equivalents used to calculate basic earnings per share		1,336,316			1,358,218			1,347,214

Additional common stock equivalents (stock options) used to calculate diluted earnings per share		20,159			12,321			3,696


Weighted-average common shares and common stock equivalents used to calculate diluted earnings per share		1,356,475			1,370,539			1,350,910

There were no options to purchase shares of common stock that were anti-dilutive.

STOCK DIVIDEND

The Board of Directors approved a 5 percent stock dividend to stockholders of record as of December 1, 2005, payable December 14, 2005. As a result of the dividend, 63,549 additional shares of the Company’s common stock were issued, common stock was increased by $2,557,847, and retained earnings decreased by $2,572,949.

The Board of Directors approved a 5 percent stock dividend to stockholders of record as of December 1, 2004, payable December 15, 2004. As a result of the dividend, 61,387 additional shares of the Company’s common stock were issued, common stock was increased by $2,271,282, and retained earnings decreased by $2,283,646.

The Board of Directors approved a 5 percent stock dividend to stockholders of record as of December 3, 2003, payable December 12, 2003. As a result of the dividend, 57,972 additional shares of the Company’s common stock were issued, common stock was increased by $1,797,165, and retained earnings decreased by $1,801,961.

Fractional shares paid were paid in cash. All average shares outstanding and all per share amounts included in the financial statements are based on the increased number of shares after giving retroactive effects to the stock dividend.

INVESTMENT SECURITIES AVAILABLE FOR SALE

The amortized cost and estimated market values of securities available for sale are as follows:


	2005
			Gross		Gross			Estimated
	Amortized		Unrealized		Unrealized			Market
	Cost		Gains		Losses			Value
U.S. government agency securities	$	7,260,666	$	10,229	$	(111,690	)	$	7,159,205
Obligations of states and political subdivisions:
Taxable		748,530		—		(23,178	)		725,352
Tax-exempt		28,231,048		97,897		(330,847	)		27,998,098
Mortgage-backed securities		22,228,515		15,432		(639,968	)		21,603,979

Total debt securities		58,468,759		123,558		(1,105,683	)		57,486,634
Equity securities		444,264		1,050		(44,818	)		400,496

Total	$	58,913,023	$	124,608	$	(1,150,501	)	$	57,887,130


	2004
			Gross		Gross			Estimated
	Amortized		Unrealized		Unrealized			Market
	Cost		Gains		Losses			Value
U.S. government agency securities	$	5,273,091	$	70,704	$	(17,637	)	$	5,326,158
Obligations of states and political subdivisions:
Taxable		748,196		—		(11,129	)		737,067
Tax-exempt		21,239,335		303,433		(65,776	)		21,476,992
Mortgage-backed securities		29,625,481		80,530		(403,583	)		29,302,428

Total debt securities		56,886,103		454,667		(498,125	)		56,842,645
Equity securities		398,320		—		—			398,320

Total	$	57,284,423	$	454,667	$	(498,125	)	$	57,240,965

The amortized cost and estimated market value of debt securities at December 31, 2005, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.


			Estimated
	Amortized		Market
	Cost		Value
Due in one year or less	$	6,529,300	$	6,495,757
Due after one year through five years		11,192,145		11,095,900
Due after five years through ten years		11,233,086		11,069,894
Due after ten years		29,514,228		28,825,083

Total	$	58,468,759	$	57,486,634

Investment securities with an approximate carrying value of $22,867,265 and $21,669,555 at December 31, 2005 and 2004, respectively, were pledged to secure deposits and other purposes as required by law.

4.		INVESTMENT SECURITIES AVAILABLE FOR SALE (Continued)

		The following is a summary of proceeds received, gross gains, and gross losses realized on the sale of investment securities available for sale for the years ended December 31, 2005, 2004, and 2003.


	2005		2004		2003
Proceeds from sales	$	—	$	4,912,619	$	1,991,917
Gross gains		—		—		6,350
Gross losses		—		98,375		5,808

5.		INVESTMENT SECURITIES HELD TO MATURITY

		The amortized cost and estimated market values of investment securities held to maturity are as follows:


	2005
			Gross		Gross		Estimated
	Amortized		Unrealized		Unrealized		Market
	Cost		Gains		Losses		Value
Obligations of states and political subdivisions:
Tax-exempt	$	221,453	$	11,514	$	—	$	232,967


	2004
			Gross		Gross		Estimated
	Amortized		Unrealized		Unrealized		Market
	Cost		Gains		Losses		Value
Obligations of states and political subdivisions:
Tax-exempt	$	221,412	$	22,398	$	—	$	243,810


			Estimated
	Amortized		Market
	Cost		Value
Due in one year or less	$	89,956	$	90,857
Due after one year through five years		31,497		33,368
Due after five years through ten years		100,000		108,742
Due after ten years		—		—


Total	$	221,453	$	232,967

Investment securities held to maturity with carrying values of approximately $89,957 and $89,915 and estimated market values of approximately $90,857 and $89,915 at December 31, 2005 and 2004, respectively, were pledged to secure public deposits and other purposes required by law.

6.		UNREALIZED LOSSES ON SECURITIES

		The following table shows the Company’s gross unrealized losses and fair value, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position, at December 31, 2005.


	Less than Twelve Months					Twelve Months or Greater					Total
	Estimated		Gross			Estimated		Gross			Estimated		Gross
	Market		Unrealized			Market		Unrealized			Market		Unrealized
	Value		Losses			Value		Losses			Value		Losses
U.S. government agency securities	$	3,576,063	$	(43,743	)	$	2,421,251	$	(67,947	)	$	5,997,314	$	(111,690	)
Obligations of states and political subdivisions		16,016,108		(236,088	)		4,576,188		(117,937	)		20,592,296		(354,025	)
Mortgage-backed securities		6,205,491		(119,155	)		14,511,847		(520,813	)		20,717,338		(639,968	)

Equity securities		353,495		(44,818	)		—		—			353,495		(44,818	)

Total	$	26,151,157	$	(443,804	)	$	21,509,286	$	(706,697	)	$	47,660,443	$	(1,150,501	)

		The policy of the Company is to recognize an other-than-temporary impairment on equity securities where the fair value has been significantly below cost for three consecutive quarters. For fixed maturity investments with unrealized losses due to interest rates where the Company has the positive intent and ability to hold the investment for a period of time sufficient to allow a market recovery, declines in value below cost are not assumed to be other than temporary. There are 129 securities that are considered temporarily impaired at December 31, 2005. The Company reviews its position quarterly and has asserted that at December 31, 2005, the declines outlined in the above table represent temporary declines and the Company does have the intent and ability either to hold those securities to maturity or to allow a market recovery.

		The Company has concluded that any impairment of its investment securities portfolio is not other than temporary but is the result of interest rate changes, sector credit rating changes, or Company-specific rating changes that are not expected to result in the noncollection of principal and interest during the period.

7.		LOANS

		Major classifications of loans are summarized as follows:


	2005		2004
Commercial and industrial	$	65,161,490	$	52,148,055
Real estate — construction		2,724,958		3,143,706
Real estate — mortgage:
Residential		151,981,388		147,425,466
Commercial		8,208,572		7,026,582
Consumer installment		5,978,389		5,909,474

		234,054,797		215,653,283
Less allowance for loan losses		2,841,098		2,623,431


Net loans	$	231,213,699	$	213,029,852

The Company’s primary business activity is with customers located within its local trade area, eastern Geauga County, and contiguous counties to the north, east, and south. Commercial, residential, consumer, and agricultural loans are granted. Although the Company has a diversified loan portfolio at December 31, 2005 and 2004, loans outstanding to individuals and businesses are dependent upon the local economic conditions in its immediate trade area.

7.		LOANS (Continued)

		Nonperforming loans consist of commercial and consumer loans which are on a nonaccrual basis and loans contractually past due 90 days or more but are not on nonaccrual status because they are well secured or in the process of collection.

		Information regarding nonperforming loans at December 31 is as follows:


	2005		2004
90 days or more past due and accruing interest	$	326,633	$	1,191,242
Nonaccrual loans		1,487,446		279,319


Total nonperforming loans	$	1,814,079	$	1,470,561

At December 31, 2005, the total investment in impaired loans, all of which had allowances determined in accordance with SFAS No. 114 and No. 118, amounted to $1,106,221. The average recorded investment in impaired loans amounted to $764,396. The allowance for loan losses related to impaired loans amounted to $224,155. Interest income on impaired loans of $23,152 was recognized for cash payments received in 2005. There were no impaired loans at December 31, 2004.

8.		ALLOWANCE FOR LOAN LOSSES

		Changes in the allowance for loan losses for the years ended December 31 are as follows:


	2005		2004		2003
Balance, January 1	$	2,623,431	$	2,521,270	$	2,300,485
Add:
Provisions charged to operations		302,000		174,000		315,000
Recoveries		95,077		46,643		49,942
Less loans charged off		179,410		118,482		144,157


Balance, December 31	$	2,841,098	$	2,623,431	$	2,521,270

9.		PREMISES AND EQUIPMENT

		Major classifications of premises and equipment are summarized as follows:


	2005		2004
Land and land improvements	$	1,295,938	$	1,295,938
Building and leasehold improvements		6,999,015		6,859,242
Furniture, fixtures, and equipment		3,142,025		2,826,230

		11,436,978		10,981,410
Less accumulated depreciation and amortization		4,812,202		4,363,816


Total	$	6,624,776	$	6,617,594

Depreciation and amortization charged to operations was $448,386 in 2005, $403,916 in 2004, and $377,547 in 2003.

10.

OTHER ASSETS

The components of other assets are as follows:


	2005		2004
FHLB stock	$	1,414,300	$	1,351,000
Accrued interest on investment securities		347,580		274,740
Accrued interest on loans		675,268		531,086
Deferred tax asset, net		680,191		450,449
Other		695,649		146,302


Total	$	3,812,988	$	2,753,577

11.		DEPOSITS

		Time deposits at December 31, 2005, mature $64,220,054, $22,763,280, $19,076,099, $8,564,183, and $6,107,364 during 2006, 2007, 2008, 2009, and 2010, respectively.

		Time deposits include certificates of deposit in denominations of $100,000 or more. Such deposits aggregated $27,398,766 and $21,920,929 at December 31, 2005 and 2004, respectively.

		Maturities on time deposits of $100,000 or more at December 31, 2005, are as follows:


Within three months	$	3,860,127
Beyond three but within six months		3,442,934
Beyond six but within twelve months		6,231,038
Beyond one year		13,864,667


Total	$	27,398,766

12.		SHORT-TERM BORROWINGS

		The outstanding balances and related information of short-term borrowings, which includes securities sold under agreements to repurchase and federal funds purchased, are summarized as follows:


	2005			2004
Balance at year-end	$	6,710,914		$	1,871,763
Average balance outstanding		1,844,018			298,500
Maximum month-end balance		6,710,914			2,057,054
Weighted-average rate at year-end		4.38	%		3.80	%
Weighted-average rate during the year		5.63			0.73

		Average balances outstanding during the year represent daily average balances, and average interest rates represent interest expense divided by the related average balance.

		The Company maintains a $4,000,000 line of credit at an adjustable rate, currently 7.0 percent, from Lorain National Bank. At December 31, 2005, there were no outstanding balances of this line. At December 31, 2004, the Company had outstanding borrowings of $1,200,000.

13.

OTHER BORROWINGS

Other borrowings consist of advances from the FHLB as follows:


					Weighted-			Stated interest
	Maturity range				average			rate range
Description	from		to		interest rate			from			to			2005		2004
Fixed rate		08/09/06		09/13/07		3.47	%		3.37	%		4.27	%	$	5,510,000	$	3,035,000
Fixed rate amortizing		07/01/07		06/01/25		3.83			2.70			6.40			13,068,211		12,648,324
Convertible		09/04/08		07/28/10		5.43			4.53			6.45			8,000,000		8,000,000

														$	26,578,211	$	23,683,324

The scheduled maturities of advances outstanding are as follows:


	2005
Year Ending			Weighted-
December 31,	Amount		average Rate
2006	$	4,091,765		3.78	%
2007		7,671,543		3.85
2008		7,970,667		4.74
2009		1,472,896		3.69
2010		3,092,373		5.48
Beyond 2010		2,278,967		3.76


	$	26,578,211		4.28	%

		The Bank entered into a ten-year “Convertible Select” fixed commitment advance arrangement with the FHLB. Rates may be reset at the FHLB’s discretion on a quarterly basis based on the three-month LIBOR rate. At each rate change the Bank may exercise a put option and satisfy the obligation without penalty.

		Advances from the FHLB maturing July 1, 2007, February 1, 2012, June 4, 2012, February 2, 2013, February 26, 2014, July 28, 2014, September 13, 2014, June 1, 2015, June 4, 2017, February 1, 2018, February 26, 2019, February 1, 2023, and June 1, 2025, require monthly principal and interest payments and an annual 20 percent paydown of outstanding principal. Monthly principal and interest payments are adjusted after each 20 percent paydown. Under terms of a blanket agreement, collateral for the FHLB borrowings are secured by certain qualifying assets of the Bank, which consist principally of first mortgage loans. Under this credit arrangement, the Bank has a remaining borrowing capacity of approximately $120 million at December 31, 2005.

14.		OTHER LIABILITIES

		The components of other liabilities are as follows:


	2005		2004
Accrued interest payable	$	537,916	$	382,467
Other		648,145		568,957


Total	$	1,186,061	$	951,424

15.

INCOME TAXES

The provision for federal income taxes consists of:


	2005			2004			2003
Current payable	$	1,500,495		$	1,363,704		$	1,201,264
Deferred		(85,339	)		(33,704	)		(69,934	)


Total provision	$	1,415,156		$	1,330,000		$	1,131,330

The tax effects of deductible and taxable temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities are as follows:


	2005		2004
Deferred tax assets:
Allowance for loan losses	$	897,040	$	823,034
Net unrealized loss on securities		348,804		14,776
Supplemental retirement plan		68,716		50,764

Gross deferred tax assets		1,314,560		888,574


Deferred tax liabilities:
Deferred origination fees, net		136,037		118,061
Premises and equipment		145,392		181,273
Other		163,315		138,791

Gross deferred tax liabilities		444,744		438,125


Net deferred tax assets	$	869,816	$	450,449

No valuation allowance was established at December 31, 2005 and 2004, in view of the Company’s ability to carryback to taxes paid in previous years and certain tax strategies, coupled with the anticipated future taxable income as evidenced by the Company’s earnings potential.

The reconciliation between the federal statutory rate and the Company’s effective consolidated income tax rate is as follows:


	2005						2004						2003
				% of						% of						% of
				Pretax						Pretax						Pretax
	Amount			Income			Amount			Income			Amount			Income
Provision at statutory rate	$	1,739,606			34.0	%	$	1,565,076			34.0	%	$	1,336,030			34.0	%
Tax-free income		(295,146	)		(5.8	)		(208,593	)		(6.1	)		(236,760	)		(6.1	)
Nondeductible interest expense		38,639			0.8			26,485			0.6			22,789			0.6
Other		(67,923	)		(1.4	)		(52,968	)		0.4			9,271			0.3


Actual tax expense and effective rate	$	1,415,176			27.6	%	$	1,330,000			28.9	%	$	1,131,330			28.8	%

16.		EMPLOYEE BENEFITS

		Retirement Plan

		The Bank maintains a section 401(k) employee savings and investment plan for all full-time employees and officers of the Bank with more than one year of service. The Bank’s contribution to the plan is based on 50 percent matching of voluntary contributions up to 6 percent of compensation. An eligible employee can contribute up to 15 percent of salary. Employee contributions are vested at all times, and the Bank contributions are fully vested after six years beginning at the second year in 20 percent increments. Contributions for 2005, 2004, and 2003 to this plan amounted to $62,755, $63,083, and $56,731, and respectively.

		Supplemental Retirement Plan

		The Bank maintains a Directors Retirement Plan to provide postretirement payments over a ten-year period to members of the Board of Directors who have completed five or more years of service. The Plan requires payment of 25 percent of the final average annual board fees paid to a director in the three years preceding the director’s retirement.

		The following table illustrates the components of the net periodic pension cost for the Directors retirement plans for the years ended:


	Directors’ Retirement Plan
	2005		2004		2003
Components of net periodic pension cost
Service cost	$	12,756	$	25,684	$	36,089
Interest cost		9,948		8,380		7,804

Net periodic pension cost	$	22,704	$	34,064	$	43,893

		Stock Option and Restricted Stock Plan

		The Company maintains a stock option and restricted stock plan (“the Plan”) for granting incentive stock options, nonqualified stock options, and restricted stock for key officers and employees and nonemployee directors of the Company. A total of 139,621 shares of authorized and unissued or issued common stock are reserved for issuance under the Plan, which expires ten years from the date of stockholder ratification. The per share exercise price of an option granted will not be less than the fair value of a share of common stock on the date the option is granted. No option shall become exercisable earlier than one year from the date the Plan was approved by the stockholders.

		The following table presents share data related to the outstanding options:


				Weighted-					Weighted-
				average					average
				Exercise					Exercise
	2005			Price		2004			Price
Outstanding, January 1		68,646		$	26.43		54,398		$	24.62
Granted		8,800			40.50		14,820			33.01
Exercised		(2,729	)		26.32		(572	)		24.71
Forfeited		(412	)		21.42		—			—


Outstanding, December 31		74,305		$	28.13		68,646		$	26.43


Exercisable at year-end		74,305			28.13		53,826			24.61

16.		EMPLOYEE BENEFITS (Continued)

		Stock Option and Restricted Stock Plan (Continued)

		The following table summarizes the characteristics of stock options at December 31, 2005:


			Outstanding						Exercisable
					Remaining		Average				Average
	Exercise				Average		Exercise				Exercise
Grant Date	Price		Shares		Life		Price		Shares		Price
June 14, 1999	$	26.12		6,280		3.45	$	26.12		6,280	$	26.12
November 23, 1999		25.50		2,908		3.90		25.50		2,908		25.50
December 11, 2000		19.74		11,362		4.95		19.74		11,362		19.74
December 9, 2002		24.62		10,629		6.94		24.62		10,629		24.62
December 8, 2003		26.77		20,138		7.94		26.77		20,138		26.77
May 12, 2004		30.16		1,798		8.33		30.16		1,798		30.16
December 13, 2004		33.57		12,390		8.95		33.57		12,390		33.57
December 14, 2005		40.50		8,800		9.95		40.50		8,800		40.50


				74,305						74,305

For the years ended December 31, 2005, 2004, and 2003, the Company granted 80 shares, 884 shares, and 110 shares, respectively, of common stock under the restricted stock plan. The Company recognizes compensation expense in the amount of fair value of the common stock at the grant date and as an addition to stockholders’ equity. The Company recognized compensation expense of $4,035, $31,080, and $3,410, for the years ended December 31, 2005, 2004, and 2003, respectively.

17.		COMMITMENTS

		In the normal course of business, there are various outstanding commitments and certain contingent liabilities which are not reflected in the accompanying consolidated financial statements. These commitments and contingent liabilities represent financial instruments with off-balance sheet risk. The contract or notional amounts of those instruments reflect the extent of involvement in particular types of financial instruments which were composed of the following:


	2005		2004
Commitments to extend credit	$	45,678,316	$	33,925,423
Standby letters of credit		125,000		222,675


Total	$	45,803,316	$	34,148,098

		These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the Consolidated Balance Sheet. The Company’s exposure to credit loss, in the event of nonperformance by the other parties to the financial instruments, is represented by the contractual amounts as disclosed. The Company minimizes its exposure to credit loss under these commitments by subjecting them to credit approval and review procedures and collateral requirements as deemed necessary. Commitments generally have fixed expiration dates within one year of their origination.

		Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Performance letters of credit represent conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. These instruments are issued primarily to support bid or performance-related contracts. The coverage period for these instruments is typically a one-year period with an annual renewal option subject to prior approval by management. Fees earned from the issuance of these letters are

recognized over the coverage period. For secured letters of credit, the collateral is typically Bank deposit instruments or customer business assets.

18.		REGULATORY RESTRICTIONS

		Loans

		Federal law prevents the Company from borrowing from the Bank unless the loans are secured by specific obligations. Further, such secured loans are limited in amount of 10 percent of the Bank’s common stock and capital surplus.

		Dividends

		The Bank is subject to a dividend restriction that generally limits the amount of dividends that can be paid by an Ohio state-chartered bank. Under the Ohio Banking Code, cash dividends may not exceed net profits as defined for that year combined with retained net profits for the two preceding years less any required transfers to surplus. Under this formula, the amount available for payment of dividends for 2006 approximates $4,136,000 plus 2006 profits retained up to the date of the dividend declaration.

19.		REGULATORY CAPITAL

		Federal regulations require the Company and the Bank to maintain minimum amounts of capital. Specifically, each is required to maintain certain minimum dollar amounts and ratios of Total and Tier I capital to risk-weighted assets and of Tier I capital to average total assets.

		In addition to the capital requirements, the Federal Deposit Insurance Corporation Improvement Act (“FDICIA”) established five capital categories ranging from “well capitalized” to “critically undercapitalized.” Should any institution fail to meet the requirements to be considered “adequately capitalized,” it would become subject to a series of increasingly restrictive regulatory actions.

		As of December 31, 2005 and 2004, the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be classified as a well capitalized financial institution, Total risk-based, Tier 1 risk-based, and Tier 1 Leverage capital ratios must be at least 10 percent, 6 percent, and 5 percent, respectively.

		The Company’s actual capital ratios are presented in the following table that shows the Company met all regulatory capital requirements. The capital position of the Bank does not differ significantly from the Company’s.


	2005					2004
	Amount		Ratio			Amount		Ratio
Total Capital (to Risk-weighted Assets)

Actual	$	30,593,729		14.41	%	$	27,231,794		14.28	%
For Capital Adequacy Purposes		16,997,337		8.00			15,251,438		8.00
To Be Well Capitalized		21,246,671		10.00			19,064,298		10.00

Tier I Capital (to Risk-weighted Assets)

Actual	$	27,937,566		13.16	%	$	24,850,706		13.04	%
For Capital Adequacy Purposes		8,500,442		4.00			7,625,719		4.00
To Be Well Capitalized		12,750,662		6.00			11,438,579		6.00

Tier I Capital (to Average Assets)

Actual	$	27,937,566		9.10	%	$	24,850,706		8.51	%


	2005				2004
	Amount		Ratio		Amount		Ratio
For Capital Adequacy Purposes		12,273,560		4.00		11,678,293		4.00
To Be Well Capitalized		15,341,950		5.00		14,597,866		5.00

20.		FAIR VALUE DISCLOSURE OF FINANCIAL INSTRUMENTS

		The estimated fair value of the Company’s financial instruments at December 31 are as follows:


	2005				2004
	Carrying		Fair		Carrying		Fair
	Value		Value		Value		Value
Financial assets:
Cash and due from banks	$	5,294,641	$	5,294,641	$	5,311,776	$	5,311,776
Interest-bearing deposits in other institutions		526,523		526,523		614,506		614,506
Investment securities:
Available for sale		57,887,130		57,887,130		57,240,965		57,240,965
Held to maturity		221,453		232,967		221,412		243,810
Net loans		231,213,699		233,988,263		213,029,852		219,485,000
Bank-owned life insurance		5,632,982		5,632,982		5,424,304		5,424,304
Federal Home Loan Bank stock		1,414,300		1,414,300		1,351,000		1,351,000
Accrued interest receivable		1,022,848		1,022,848		805,826		805,826

Financial liabilities:
Deposits	$	249,449,640	$	248,814,640	$	239,885,451	$	241,129,000
Short-term borrowings		6,710,914		6,710,914		1,871,763		1,871,763
Other borrowings		26,578,211		26,102,461		23,683,324		22,160,000
Accrued interest payable		537,916		537,916		382,467		382,467

		Financial instruments are defined as cash, evidence of ownership interest in an entity, or a contract which creates an obligation or right to receive or deliver cash or another financial instrument from/to a second entity on potentially favorable or unfavorable terms.

		Fair value is defined as the amount at which a financial instrument could be exchanged in a current transaction between willing parties other than in a forced liquidation sale. If a quoted market price is available for a financial instrument, the estimated fair value would be calculated based upon the market price per trading unit of the instrument.

		If no readily available market exists, the fair value estimates for financial instruments should be based upon management’s judgment regarding current economic conditions, interest rate risk, expected cash flows, future estimated losses, and other factors as determined through various option pricing formulas or simulation modeling. Since many of these assumptions result from judgments made by management based upon estimates which are inherently uncertain, the resulting estimated fair values may not be indicative of the amount realizable in the sale of a particular financial instrument. In addition, changes in assumptions on which the estimated fair values are based may have a significant impact on the resulting estimated fair values.

		As certain assets such as deferred tax assets and premises and equipment are not considered financial instruments, the estimated fair value of financial instruments would not represent the full value of the Company.

		The Company employed simulation modeling in determining the estimated fair value of financial instruments for which quoted market prices were not available based upon the following assumptions:

20.		FAIR VALUE DISCLOSURE OF FINANCIAL INSTRUMENTS (Continued)

		Cash and Due From Banks, Interest-Bearing Deposits in Other Institutions, Federal Home Loan Bank Stock, Accrued Interest Receivable, Accrued Interest Payable, and Short-Term Borrowings

		The fair value is equal to the current carrying value.

		Bank-Owned Life Insurance

		The fair value is equal to the cash surrender value of the life insurance policies.

		Investment Securities

		The fair value of investment securities available for sale and held to maturity is equal to the available quoted market price. If no quoted market price is available, fair value is estimated using the quoted market price for similar securities.

		Loans, Deposits, and Other Borrowings

		The fair value of loans, certificates of deposit, and other borrowings is estimated by discounting the future cash flows using a simulation model which estimates future cash flows and constructs discount rates that consider reinvestment opportunities, operating expenses, noninterest income, credit quality, and prepayment risk. Demand, savings, and money market deposit accounts are valued at the amount payable on demand as of year-end.

		Commitments to Extend Credit

		These financial instruments are generally not subject to sale, and estimated fair values are not readily available. The carrying value, represented by the net deferred fee arising from the unrecognized commitment or letter of credit, and the fair value, determined by discounting the remaining contractual fee over the term of the commitment using fees currently charged to enter into similar agreements with similar credit risk, are not considered material for disclosure. The contractual amounts of unfunded commitments and letters of credit are presented in Note 17.

21. PARENT COMPANY

Following are condensed financial statements for the Company.

CONDENSED BALANCE SHEET


	December 31,
	2005		2004
ASSETS
Cash and due from banks	$	349,385	$	229,399
Interest-bearing deposits in other institutions		526,522		614,506
Investment securities available for sale		400,495		398,319
Other assets		14,882		—
Investment in subsidiary bank		25,998,081		24,779,799


TOTAL ASSETS	$	27,289,365	$	26,022,023


LIABILITIES
Other borrowings	$	—	$	1,200,000

STOCKHOLDERS’ EQUITY		27,289,365		24,822,023


TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	27,289,365	$	26,022,023

CONDENSED STATEMENT OF INCOME


	Year Ended December 31,
	2005			2004				2003
INCOME
Dividends from subsidiary bank	$	1,999,052		$	1,092,122			$	1,044,637
Interest income		12,017			5,369				5,179

Total income		2,011,069			1,097,491				1,049,816


EXPENSES
Interest expense		54,107			—				—
Other		163,275			168,524				99,473

Total expense		217,382			168,524				99,473


Income before income tax benefit		1,793,687			928,967				950,343

Income tax benefit		(69,844	)		(46,000	)			(32,056	)


Income before equity in undistributed net income of subsidiary		1,863,531			974,967				982,399

Equity in undistributed net income of subsidiary		1,837,801			2,298,196				1,816,221

							��
NET INCOME	$	3,701,332		$	3,273,163			$	2,798,620

21. PARENT COMPANY (Continued)

CONDENSED STATEMENT OF CASH FLOWS


	Year Ended December 31,
	2005			2004			2003
OPERATING ACTIVITIES
Net income	$	3,701,332		$	3,273,163		$	2,798,620
Adjustments to reconcile net income to net cash provided by operating activities:
Equity in undistributed net income of subsidiary		(1,837,801	)		(2,298,196	)		(1,816,221	)
Other		—			—			—

Net cash provided by operating activities		1,863,531			974,967			982,399


INVESTING ACTIVITIES
Decrease (increase) in interest-bearing deposits in other institutions		614,506			(75,359	)		(255,178	)

Purchase of investment securities		(45,944	)		(398,320	)		—

Net cash provided by (used for) investing activities		568,562			(473,679	)		(255,178	)


FINANCING ACTIVITIES
Net increase (decrease) in short term borrowing		(1,200,000	)		1,200,000			—
Purchase of treasury stock		—			(1,224,864	)		(81,624	)
Exercise of stock options		71,386			14,198			19,916
Common stock issued		285,669			277,171			170,513
Proceeds from dividend reinvestment plan		245,506			215,120			167,407
Cash dividends		(1,188,146	)		(1,083,197	)		(966,697	)

Net cash used for financing activities		(1,785,585	)		(601,572	)		(690,485	)


Increase (decrease) in cash		646,508			(100,284	)		36,736

CASH AT BEGINNING OF YEAR		229,399			329,683			292,947


CASH AT END OF YEAR	$	875,907		$	229,399		$	329,683

22. SELECTED QUARTERLY FINANCIAL DATA (Unaudited)


	Three Months Ended
	March 31,		June 30,		September 30,		December 31,
	2005		2005		2005		2005
Total interest income	$	4,115,912	$	4,274,683	$	4,427,392	$	4,560,517
Total interest expense		1,547,711		1,628,943		1,663,422		1,814,538


Net interest income		2,568,201		2,645,740		2,763,970		2,745,979
Provision for loan losses		60,000		60,000		75,000		107,000


Net interest income after provision for loan losses		2,508,201		2,585,740		2,688,970		2,638,979

Total noninterest income		481,104		526,515		559,275		552,343
Total noninterest expense		2,013,215		1,846,301		1,882,004		1,683,119


Income before income taxes		976,090		1,265,954		1,366,241		1,508,203
Income taxes		262,000		349,000		390,000		414,156
									��

Net income	$	714,090	$	916,954	$	976,241	$	1,094,047


Per share data:
Net income
Basic	$	0.54	$	0.69	$	0.73	$	0.82
Diluted		0.53		0.68		0.72		0.80
Average shares outstanding
Basic		1,329,800		1,335,145		1,338,314		1,342,105
Diluted		1,336,957		1,356,819		1,359,988		1,362,500

22. SELECTED QUARTERLY FINANCIAL DATA (Unaudited) (Continued)


	Three Months Ended
	March 31,		June 30,		September 30,		December 31,
	2004		2004		2004		2004
Total interest income	$	3,798,928	$	3,889,197	$	3,978,576	$	4,065,835
Total interest expense		1,383,071		1,411,961		1,456,471		1,517,395


Net interest income		2,415,857		2,477,236		2,522,105		2,548,440
Provision for loan losses		30,000		30,000		51,000		63,000


Net interest income after provision for loan losses		2,385,857		2,447,236		2,471,105		2,485,440

Total noninterest income		396,719		485,889		484,244		412,379
Total noninterest expense		1,781,318		1,682,607		1,803,558		1,698,223


Income before income taxes		1,001,258		1,250,518		1,151,791		1,199,596
Income taxes		316,000		342,000		330,000		342,000


Net income	$	685,258	$	908,518	$	821,791	$	857,596


Per share data:
Net income
Basic	$	0.51	$	0.67	$	0.60	$	0.63
Diluted		0.51		0.67		0.60		0.62
Average shares outstanding
Basic		1,349,225		1,356,816		1,364,001		1,362,456
Diluted		1,356,722		1,365,406		1,372,590		1,377,315

Management’s Discussion and Analysis of

Financial Condition and Results of Operations

Overview

The consolidated review and analysis of Middlefield Banc Corp. (“Middlefield” or “Company”) is intended to assist the reader in evaluating the performance of Middlefield for the years ended December 31, 2005, 2004 and 2003. This information should be read in conjunction with the consolidated financial statements and accompanying notes to the financial statements.

Middlefield is an Ohio corporation organized to become the holding company of The Middlefield Banking Company (“Bank”). The Bank is a state-chartered bank located in Middlefield, Ohio. Middlefield and its subsidiary bank derive substantially all of their income from banking and bank-related services, including interest earnings on residential real estate, commercial mortgage, commercial, and consumer financings as well as interest earnings on investment securities and deposit services to its customers through six locations.

The Bank is subject to examination and comprehensive regulation by the FDIC and the Ohio Department of Banking. Middlefield is a member of the Federal Home Loan Bank (FHLB) of Cincinnati, which is one of the twelve regional banks comprising the FHLB System.

This Management Discussion and Analysis section of the Annual Report contains certain forward-looking statements. Forward-looking statements are based upon a variety of estimates and assumptions. The estimates and assumptions involve judgments about a number of things, including future economic, competitive, and financial market conditions and future business decisions. These matters are inherently subject to significant business, economic, and competitive uncertainties, all of which are difficult to predict and many of which are beyond Middlefield’s control. Although Middlefield believes its estimates and assumptions are reasonable, actual results could vary materially from those shown. Inclusion of forward-looking information does not constitute a representation by Middlefield or any other person that the indicated results will be achieved. Investors are cautioned not to place undue reliance on forward-looking information.

These forward-looking statements may involve significant risks and uncertainties. Although the Company believes that the expectations reflected in such forward-looking statements are reasonable, actual results may differ materially from the results in these forward-looking statements.

Significant Financial Events in 2005

Middlefield’s board of directors declared a 5 percent share dividend for shareholders of record on December 1, 2005, and a quarterly cash dividend of $0.235 per common share. On December 15, 2005, shareholders of record received additional stock shares equal to 5% of their holdings. Payment of the fourth quarter cash dividend in the amount of $0.235 per share was on the total holdings including the share dividend. The fourth quarter cash dividend, after adjustment for the stock dividend, is 11.9% higher than the fourth quarter 2004 cash payout. All share and related price and dividend amounts discussed herein have been adjusted to reflect this stock dividend where applicable.

Critical Accounting Policies

Allowance for loan losses

Arriving at an appropriate level of allowance for loan losses involves a high degree of judgment. The Company’s allowance for loan losses provides for probable losses based upon evaluations of known, and inherent risks in the loan portfolio.

Management uses historical information to assess the adequacy of the allowance for loan losses as well as the prevailing business environment, which is affected by changing economic conditions and various external factors and which may impact the portfolio in ways currently unforeseen. The allowance is increased by provisions for loan losses and by recoveries of loans previously charged-off and reduced by loans charged-off. For a full discussion of the Company’s methodology of assessing the adequacy of the reserve for loan losses, refer to Note 1 of “Notes to Consolidated Financial Statements” commencing on the following pages of this Annual Report.

The allowance for loan losses at December 31, 2005 totaled $2.8 million, compared to $2.6 million at December 31, 2004. The variance

in the allowance from 2004 to 2005 is primarily the result of the growth of the loan portfolio of 8.5% for the year.

Changes in Financial Condition

General.The Company’s total assets increased $20.0 million or 7% to $311.2 million at December 31, 2005 from $291.2 million at December 31, 2004. This increase was composed of a net increase in securities of $646,000, net loans receivable of $18.2 million and Bank-owned life insurance of $209,000.

The increase in the Company’s total assets reflects a corresponding increase in total liabilities of $17.5 million or 6.6% to $283.9 million at December 31, 2005 from $266.4 million at December 31, 2004 and a increase in total stockholders’ equity of $2.4 million or 9.9% to $27.3 million at December 31, 2005 from $24.8 million at December 31, 2004. The increase in total liabilities was primarily due to increases in deposits, short-term borrowings and other borrowing of $9.6, $4.8 and $2.9 million respectively. The net increase in total stockholders’ equity can be attributed to an increase in common stock and net income offset by an increase in accumulated other comprehensive loss of $648,000.

Cash on hand and Interest-earning deposits.Cash on hand and interest-earning deposits both decreased for the year by $17,000 and $88,000 respectively. Deposits from customers into savings and checking accounts, loan and security repayments and proceeds from borrowed funds typically increase these accounts. Decreases result from customer withdrawals, new loan originations, security purchases and repayments of borrowed funds. The net decrease in 2005 can be attributed principally to increases in loans.

Securities.The Company’s loan and securities portfolios represent its two largest balance sheet asset classifications, respectively. The Company’s securities portfolio increased slightly a net $646,000 or 1.1% to $58.1 million at December 31, 2005 from $57.5 million at December 31, 2004. During 2005, the Company recorded purchases of available for sale securities of $13.3 million, consisting primarily of agencies and municipal bonds. Partially offsetting the purchases were $11.4 million of maturities and repayments that principally relates to mortgage-backed securities. The Company’s deposits and borrowings primarily fund the securities portfolio.

Loans receivable.The loans receivable category consists primarily of single family mortgage loans used to purchase or refinance personal residences located within the Company’s market area and commercial real estate loans used to finance properties that are used in the borrowers businesses or to finance investor-owned rental properties, and to a lesser extent commercial and consumer loans. Net loans receivable increased $18.2 million or 8.5% to $231.2 million at December 31, 2005 from $213.0 million at December 31, 2004. Included in this growth were increases in all types of loans including commercial, home equity and mortgage loans with growth of $13.2, $3.0, and $2.0 million respectively. The result was an increase to the yield on the Company’s loan portfolio from 6.67% in 2004 to 6.75% in 2005.

FHLB stock.FHLB stock increased $63,000 or 4.7% to $1,414,000 at December 31, 2005 from $1,351,000 at December 31, 2004, primarily as a result of the increase in total assets of the bank that is used to calculate the minimum stock requirement.

Bank owned life insurance.Bank owned life insurance (BOLI) is universal life insurance, purchased by the Bank, on the lives of the Bank’s officers. The beneficial aspects of these universal life insurance policies are tax-free earnings and a tax-free death benefit, which are realized by the Bank as the owner of the policies. BOLI increased by $209,000 to $5.6 million as of December 31, 2005 from $5.4 million at the end of 2004 as a result of the earnings of the underlying insurance policies.

Deposits.The Company considers various sources when evaluating funding needs, including but not limited to deposits, which represented 88.2% of the Company’s total funding sources at December 31, 2005. Total deposits increased $9.5 million or 4% to $249.5 million at December 31, 2005 from $239.9 million at December 31, 2004.

For the year, the Company’s noninterest-bearing demand deposits increased $3.5 million or 9.5%, with time deposits showing the largest increase of $20.6 million or 20.6%. Savings deposits and money market accounts both declined for the year by $12.4 million and $2.6 million respectively.

Borrowed funds.The Company utilizes short and long-term borrowings as another source of funding used for asset growth and liquidity needs. These borrowings primarily include FHLB advances and repurchase agreement borrowings. Borrowed funds increased $7.7 million or 30% to $33.3 million at December 31, 2005 from $25.5 million at December 31, 2004. FHLB advances increased $8.4 million or 35.5% and repurchase agreements increased $100,000. The increase in borrowed funds for the year reflects the Company’s decision to complement deposits in the support of asset growth.

Stockholders’ equity.Stockholders’ equity increased by $2.5 million or 9.9% to $27.3 million at December 31, 2005 from $24.8 million at December 31, 2004. The net increase in total stockholders’ equity can be attributed to net income of $3.7 million, partially offset by cash dividends of $1.2 million and an increase in accumulated other comprehensive loss of $648,000.

Changes in Results of Operations

2005 Results Compared to 2004 Results

General.The Company reported net income of $3.7 million and $3.3 million for 2005 and 2004, respectively. The $428,000 or 13% increase in net income between 2005 and 2004 can primarily be attributed to a increase in interest income of $1.7 million, and an increase in non-interest income of $340,000, which were partially offset by a increase in interest expense of $886,000 and an increase in non-interest expense of $459,000. Basic earnings per share increased by $.36 a share or 14.9% to $2.77 at December 31, 2005 from $2.41 at December 31, 2004.

Average Balance Sheet and Yield/Rate Analysis.The following table sets forth, for the periods indicated, information concerning the total dollar amounts of interest income from interest-earning assets and the resultant average yields, the total dollar amounts of interest expense on interest-bearing liabilities and the resultant average costs, net interest income, interest rate spread and the net interest margin earned on average interest-earning assets. For purposes of this table, average balances are calculated using monthly averages and the average loan balances include non-accrual loans and exclude the allowance for loan losses, and interest income includes accretion of net deferred loan fees. Yields on tax-exempt securities (tax-exempt for federal income tax purposes) are shown on a fully tax equivalent basis utilizing a federal tax rate of 34%.


	For the Year Ended Dec 31,
	2005							2004							2003
	Average				Average			Average				Average			Average				Average
	Balance		Interest		Yield/Cost			Balance		Interest		Yield/Cost			Balance		Interest		Yield/Cost
			(Dollars in thousands)							(Dollars in thousands)							(Dollars in thousands)
Interest-earning assets:
Loans receivable	$	222,926	$	15,041		6.75	%	$	204,191	$	13,618		6.67	%	$	183,683	$	12,847		6.99	%
Investments securities		59,370		2,218		4.49	%		54,413		2,004		4.25	%		45,011		1,683		4.30	%
Interest-bearing deposits with other banks		2,698		120		4.45	%		5,723		111		1.94	%		6,883		117		1.70	%

Total interest-earning assets		284,994		17,379		6.21	%		264,327		15,733		6.07	%		235,577		14,647		6.32	%

Non-interest-earning assets		16,926							15,030							12,327
																		��
Total assets	$	301,920						$	279,357						$	247,904

Interest-bearing liabilities:
Interest — bearing demand deposits	$	9,371		75		0.80	%	$	8,759		56		0.64	%	$	8,623		61		0.71	%
Money market deposits		15,016		297		1.98	%		15,145		277		1.83	%		13,355		259		1.94	%
Savings deposits		69,680		1,047		1.50	%		73,067		1,030		1.41	%		57,413		828		1.44	%
Certificates of deposit		115,969		4,101		3.54	%		103,022		3,543		3.44	%		98,512		3,758		3.81	%
Borrowings		26,577		1,135		4.27	%		20,630		863		4.18	%		19,635		819		4.17	%

Total interest-bearing liabilities		236,613		6,655		2.81	%		220,623		5,769		2.61	%		197,538		5,725		2.90	%

Non-interest-bearing liabilities				6,655
Other liabilities		39,682							34,236							27,773
Stockholders’ equity		25,625							24,498							22,594
Total liabilities and stockholders’ equity	$	301,920						$	279,357						$	247,905

Net interest income			$	10,724						$	9,964						$	8,922

Interest rate spread (1)						3.39	%						3.46	%						3.42	%
Net yield on interest-earning assets (2)						3.92	%						3.89	%						3.89	%
Ratio of average interest-earning assets to average interest-bearing liabilities						120.45	%						119.81	%						119.26	%


(1)		Interest rate spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities.

(2)		Net yield on interest-earning assets represents net interest income as a percentage of average interest-earning assets.


	Year Ended December 31,							Year Ended December 31,
	2005 vs. 2004							2004 vs. 2003
	Increase (Decrease)							Increase (Decrease)
	Due to							Due to
	Volume			Rate		Total		Volume			Rate			Total
				(In Thousands)							(In Thousands)
Interest income:
Loans Receivable	$	1,249		$	174	$	1,423	$	1,434		$	(663	)	$	771
Investment securities		211			3		214		404			(83	)		321
Other interest-earning assets		(59	)		68		9		(20	)		14			(6	)

Total interest-earning assets		1,401			245		1,646		1,818			(732	)		1,086

Interest expense:
Interest-bearing demand		4			15		19		11			(16	)		(5	)
Money market		(2	)		22		20		79			(61	)		18
Savings		(48	)		65		17		563			(361	)		202
Certificates		445			113		558		487			(702	)		(215	)
Other interest-bearing liabilities		249			23		272		212			(168	)		44

Total interest-bearing liabilities		648			238		886		1,352			(1,308	)		44

Change in net interest income	$	753		$	7	$	760	$	466		$	576		$	1,042

Net interest income.Net interest income, which is the Company’s largest revenue source, is the difference between interest income on earning assets and interest expense paid on liabilities. Net interest income is affected by the changes in interest rates and the composition of interest earning assets and liabilities. Net interest income increased considerably by $760,000 or 7.6% to $10.7 million for 2005, compared to $10.0 million for 2004. This increase in net interest income can be attributed to an increase in interest income of approximately $1.7 million, offset partially by an increase in interest expense of $886,000.

Interest income.Interest income increased $1.7 million or 10.5% to $17.4 million for 2005, compared to $15.7 million for 2004. This increase in interest income can be attributed to an increase in interest earned on loans receivable of $1.4 million and interest earned on securities of $213,000.

Interest earned on loans receivable increased $1.4 million or 10.5% to $15.0 million for 2005, compared to $13.6 million for 2004. This increase was primarily attributable to an increase in the average balance of loans outstanding of $18.7 million or 9.2% to $222.9 million for the year ended December 31, 2005 as compared to $204.2 million for the year ended December 31, 2004. In addition to growth there was also an increase in the loan yield to 6.75% for 2005, compared to 6.67% for 2004.

Interest earned on securities increased $214,000 or 10.7% to $2.2 million for 2005, compared to $2.0 million for 2004. This increase was primarily attributable to an increase in the average balance of securities of $5.0 million to $59.4 million for the year ended December 31, 2005 as compared to $54.4 million for the year ended December 31, 2004.

Interest expense.Interest expense increased by $886,000 or 15.4% to $6.7 million for 2005, compared to $5.8 million for 2004. This increase in interest expense can be attributed to both an increase in the average balance of interest-bearing liabilities along with a 20 basis point increase in the rate paid on these liabilities. For the year ended December 31, 2005 the average balance of interest-bearing liabilities grew by $16.0 million to $236.6 million as compared to $220.6 million for the year ended December 31, 2004. Interest incurred on deposits grew by $614,000 for the year from $4.9 million in 2004 to $5.5 million for year-end 2005. This change was due to a shift in deposit growth from savings accounts to higher cost certificates. Interest incurred on FHLB advances, repurchase agreements and other borrowings increased $272,000 or 31.5% to $1.1 million for 2005, compared to $863,000 million for 2004. This increase was primarily attributable to an increase in the average balance of FHLB advances.

and guaranties, pending legal action for collection of loans and related guaranties, and current economic conditions. The loan loss provision reflects management’s judgment of the current period cost-of-credit risk inherent in the loan portfolio. Although management believes the loan loss provision has been sufficient to maintain an adequate allowance for loan losses, actual loan losses could exceed the amounts that have been charged to operations. The change in the loan loss provision in 2005 was principally a result of an increase in loan volume during the year.

Non-interest income.Non-interest income increased $340,000 or 19.1% to $2.1 million for 2005, compared to $1.8 million for 2004. This increase can be attributed to increases in fees and service charges of $177,000 and other income of $77,000. In addition there was a loss realized on the sale of investment securities that was not duplicated in 2005. Partially offsetting these increases was a $13,000 decline in the earnings on bank-owned life insurance.

Non-interest expense.Non-interest expenses increased $459,000 or 6.6% to $7.4 million for 2005, compared to $7.0 million for 2004. The growth can be attributed to increases in compensation and employee benefits, data processing and equipment expense which, increased $126,000, $88,000 and $76,000 respectively.

Compensation and employee benefits expense increased $126,000 or 3.7% to $3.6 million for 2005, compared to $3.4 million for 2004. This increase can be attributed to increases in payroll expenses, group health insurance and the cost employee education of $199,000, $13,000 and $12,000, respectively.

Data processing expense increased $88,000 or 16.3% to $626,000 for 2005, compared to $538,000 for 2004. The increase to data processing expense is a reflection of the Company’s commitment to continually improve technology in order to enhance service to its customer base.

Provision for Income Taxes. The provision for income taxes increased $85,000 or 6.4% to $1.4 million for 2005, compared to $1.3 million for 2004. This increase was primarily the result of an increase in income before income taxes $513,000 or 11.2% to $5.1 million for 2005, compared to $4.6 million for 2004.

2004 Results Compared to 2003 Results

General.The Company reported net income of $3.3 million and $2.8 million for 2004 and 2003, respectively. The $475,000 or 17% increase in net income between 2004 and 2003 can primarily be attributed to a increase in interest income of $1.1 million, and an increase in non-interest income of $351,000, which were partially offset by a increase in interest expense of $44,000 and an increase in non-interest expense of $860,000. Basic earnings per share increased by $.32 a share or 15.6% to $2.41 at December 31, 2004 from $2.09 at December 31, 2003.

Net interest income.Net interest income, which is the Company’s largest revenue source, is the difference between interest income on earning assets and interest expense paid on liabilities. Net interest income is affected by the changes in interest rates and the composition of interest earning assets and liabilities. Net interest income increased considerably by $1.0 million or 11.7% to $10 million for 2004, compared to $8.9 million for 2003. This increase in net interest income can be attributed to an increase in interest income of approximately $1.1 million, offset partially by an increase in interest expense of $44,000.

Interest income.Interest income increased $1.1 million or 7.4% to $15.7 million for 2004, compared to $14.6 million for 2003. This increase in interest income can be attributed to an increase in interest earned on loans receivable of $771,000 and interest earned on securities of $322,000.

Interest earned on loans receivable increased $771,000 or 6.0% to $13.6 million for 2004, compared to $12.8 million for 2003. This increase was primarily attributable to an increase in the average balance of loans outstanding of $20.5 million or 11.2% to $204.2 million for the year ended December 31, 2004 as compared to $183.7 million for the year ended December 31, 2003. An offset to the growth was a decline in the yield on loans to 6.67% for 2004, compared to 6.99% for 2003.

Interest earned on securities increased $322,000 or 19.1% to $2.0 million for 2004, compared to $1.7 million for 2003. This increase was primarily attributable to an increase in the average balance of securities of $9.4 million to $54.4 million for the year ended December 31, 2004 as compared to $45.0 million for the year ended December 31, 2003.

Interest expense.Interest expense increased slightly by $44,000 or less than 1% to $5.8 million for 2004, compared to $5.7 million for 2003. This increase in interest expense can be attributed to an increase in the average balance of interest-bearing liabilities of $23.1 million to $220.6 million for the year ended December 31, 2004 as compared to $197.5 million for the year ended December 31, 2003.

Interest incurred on deposits stayed the same at $4.9 million for both 2004 and 2003. This lack of change was due to a shift in deposit growth from certificates to lower cost savings and demand deposit accounts along with an 11.7% increase in average interest-bearing liabilities. Interest incurred on FHLB advances, repurchase agreements and other borrowings increased $44,000 or 5.4% to $863,000 for 2004, compared to $819,000 million for 2003. This slight increase was primarily attributable to an increase in the average balance of FHLB advances.

Loan Loss Provision— The provision for loan losses is an operating expense recorded to maintain the related balance sheet allowance for loan losses at an amount considered adequate to cover probable losses incurred in the normal course of lending. The provision for loan losses was $174,000 in 2004 as compared to $315,000 in 2003. The loan loss provision is based upon management’s assessment of a variety of factors, including types and amounts of non-performing loans, historical loss experience, collectibility of collateral values and guaranties, pending legal action for collection of loans and related guaranties, and current economic conditions. The loan loss provision reflects management’s judgment of the current period cost-of-credit risk inherent in the loan portfolio. Although management believes the loan loss provision has been sufficient to maintain an adequate allowance for loan losses, actual loan losses could exceed the amounts that have been charged to operations. The change in the loan loss provision in 2004 was principally a result of an increase in loan volume during the year.

Non-interest income.Non-interest income increased $351,000 or 24.6% to $1.8 million for 2004, compared to $1.4 million for 2003. This increase can be attributed to increases in fees and service charges of $368,000 and the earnings on bank-owned life insurance of $20,000. Partially offsetting these increases were the net realized loss on sales of securities available for sale of $98,000.

Fees and service charges increased $368,000 or 35.6% to $1.4 million for 2004, compared to $1.0 million for 2003. This increase resulted from the Company introducing a new overdraft service in the second quarter of 2004.

Non-interest expense.Non-interest expenses increased $860,000 or 14.1% to $7 million for 2004, compared to $6.1 million for 2003. The growth can be attributed to increases in salaries and employee benefits, occupancy and advertising expense which, increased $357,000, $91,000 and $85,000 respectively.

Compensation and employee benefits expense increased $357,000 or 11.6% to $3.4 million for 2004, compared to $3.1 million for 2003. This increase can be attributed to increases to payroll expenses, the cost of health benefits and profit sharing expenses of $224,000, $54,000 and $49,000, respectively.

Data processing expense increased $68,000 or 14.5% to $538,000 for 2004, compared to $470,000 for 2003. The increase to data processing expense is a reflection of the Company’s commitment to continually improve technology in order to enhance service to its customer base.

Occupancy expense increased $91,000 or 22.6% to $495,000 for 2004, compared to $404,000 for 2003. The increased occupancy expense was due in part to increased utility costs as well as leasehold improvements to the Mantua facility.

Advertising expense increased $85,000 or 50.4% to $254,000 for 2004, compared to $169,000 for 2003. The increase in Advertising was due to the Company’s commitment to enhance the marketing budget for Bank promotions.

Other expenses increased $165,000 or 16.5% to $1.2 million for 2004, compared to $1.0 million for 2003. The increase to other noninterest expense is a result in part to the rising cost of examination and auditing expense brought about by the continuing regulatory burdens on the banking industry.

Provision for Income Taxes. The provision for income taxes increased $199,000 or 17.6% to $1.3 million for 2004, compared to $1.1 million for 2003. This increase was primarily the result of an increase in income before income taxes $673,000 or 17.1% to $4.6 million for 2004, compared to $3.9 million for 2003.

Asset and Liability Management

The primary objective of the Company’s asset and liability management function is to maximize the Company’s net interest income while simultaneously maintaining an acceptable level of interest rate risk given the Company’s operating environment, capital and liquidity requirements, performance objectives and overall business focus. The principal determinant of the exposure of the Company’s earnings to interest rate risk is the timing difference between the re-pricing or maturity of interest-earning assets and the repricing or maturity of its interest-bearing liabilities. The Company’s asset and liability management policies are designed to decrease interest rate sensitivity primarily by shortening the maturities of interest-earning assets while at the same time extending the maturities of interest-bearing liabilities. The Board of Directors of the Company continues to believe in strong asset/liability management in order to insulate

the Company from material and prolonged increases in interest rates. As a result of this policy, the Company emphasizes a larger, more diversified portfolio of residential mortgage loans in the form of mortgage-backed securities. Mortgage-backed securities generally increase the quality of the Company’s assets by virtue of the insurance or guarantees that back them, are more liquid than individual mortgage loans and may be used to collateralize borrowings or other obligations of the Company.

The Company’s Board of Directors has established an Asset and Liability Management Committee consisting of outside directors and senior management. This committee, which meets quarterly, generally monitors various asset and liability management policies and strategies, which were implemented by the Company over the past few years.

Interest Rate Sensitivity Simulation Analysis

The Company utilizes income simulation modeling in measuring its interest rate risk and managing its interest rate sensitivity. The Asset and Liability Management Committee of the Company believes that simulation modeling enables the Company to more accurately evaluate and manage the possible effects on net interest income due to the exposure to changing market interest rates, the slope of the yield curve and different loan and mortgage-backed security prepayment and deposit decay assumptions under various interest rate scenarios.

Earnings simulation modeling, assumptions about the timing and variability of cash flows are critical in net portfolio equity valuation analysis. Particularly important are the assumptions driving mortgage prepayments and the assumptions about expected attrition of the core deposit portfolios. These assumptions are based on the Company’s historical experience and industry standards and are applied consistently across the different rate risk measures.

The Company has established the following guidelines for assessing interest rate risk:

Net interest income simulation. Given a 200 basis point parallel gradual increase or decrease in market interest rates, net interest income may not change by more than 10% for a one-year period.

Portfolio equity simulation. Portfolio equity is the net present value of the Company’s existing assets and liabilities. Given a 200 basis point immediate and permanent increase or decrease in market interest rates, portfolio equity may not correspondingly decrease or increase by more than 20% of stockholders’ equity.

The following table presents the simulated impact of a 200 basis point upward or downward shift of market interest rates on net interest income, and the change in portfolio equity. This analysis was done assuming that the interest-earning asset and interest-bearing liability levels at December 31, 2005 remained constant. The impact of the market rate movements was developed by simulating the effects of rates changing gradually over a one-year period from the December 31, 2005 levels for net interest income, and portfolio equity The impact of market rate movements was developed by simulating the effects of an immediate and permanent change in rates at December 31, 2005 for portfolio equity:


	Increase			Decrease
	+200			-200
	BP			BP
Net interest income — increase (decrease)		5.33	%		(6.91	)%
Portfolio equity — increase (decrease)		(3.16	)%		(1.19	)%

Allowance for Loan Losses. The allowance for loan losses represents the amount management estimates are adequate to provide for probable losses inherent in the loan portfolio as of the balance sheet date. Accordingly, all loan losses are charged to the allowance, and all recoveries are credited to it. At December 31, 2005, Middlefield’s allowance for loan losses increased to $2.8 million from $2.6 million at December 31, 2004, and now represents 1.21% of the gross loan portfolio as compared to 1.22% for the previous period. The allowance for loan losses is established through a provision for loan losses, which is charged to operations. The provision is based on management’s periodic evaluation of the adequacy of the allowance for loan losses, taking into account the overall risk characteristics of

the various portfolio segments, the bank’s loan loss experience, the impact of economic conditions on borrowers, and other relevant factors. The estimates used to determine the adequacy of the allowance for loan losses, including the amounts and timing of future cash flows expected on impaired loans, are particularly susceptible to significant change in the near term. The total allowance for loan losses is a combination of a specific allowance for identified problem loans, a formula allowance, and an unallocated allowance.

The specific allowance incorporates the results of measuring impaired loans as provided in Statement of Financial Accounting Standards (“FAS”) No. 114,Accounting by Creditors for Impairment of a Loan, and FAS No. 118,Accounting by Creditors for Impairment of a Loan—Income Recognition and Disclosures. These accounting standards prescribe the measurement methods, income recognition and disclosures for impaired loans. The formula allowance is calculated by applying loss factors to outstanding loans by type, excluding loans for which a specific allowance has been determined. Loss factors are based on management’s determination of the amounts necessary for concentrations and changes in mix and volume of the loan portfolio, and consideration of historical loss experience.

The unallocated allowance is determined based upon management’s evaluation of existing economic and business conditions affecting the key lending areas of the bank and other conditions, such as new loan products, credit quality trends, collateral values, specific industry conditions within portfolio segments that existed as of the balance sheet date, and the impact of those conditions on the collectibility of the loan portfolio. Management reviews these conditions quarterly. The unallocated allowance is subject to a higher degree of uncertainty because it considers risk factors that may not be reflected in the historical loss factors.

Although management believes that it uses the best information available to make such determinations and that the allowance for loan losses was adequate at December 31, 2005, future adjustments could be necessary if circumstances or economic conditions differ substantially from the assumptions used in making the initial determinations. A downturn in the local economy and employment could result in increased levels of non-performing assets and charge-offs, increased loan loss provisions, and reductions in income. Additionally, as an integral part of the examination process, bank regulatory agencies periodically review a bank’s loan loss allowance. The banking agencies could require the recognition of additions to the loan loss allowance based on their judgment of information available to them at the time of their examination.

The following table sets forth information concerning the Middlefield’s allowance for loan losses at the dates and for the periods presented.


	For the Years Ended
	December 31,
	2005			2004			2003			2002			2001
	(Dollars in thousands)
Allowance balance at beginning of period	$	2,623		$	2,521		$	2,300			2,062		$	2,037

Loans charged off:
Commercial and industrial		(103	)		(61	)		(75	)		(67	)		(74	)
Real estate-construction		—			—			—			—			—
Real estate-mortgage:		—			—			—			—			—
Residential		(15	)		—			(32	)		—			(29	)
Commercial		—			—			—			—			(92	)
Consumer installment		(61	)		(57	)		(37	)		(52	)		(71	)


Total loans charged off		(179	)		(118	)		(144	)		(119	)		(266	)


Recoveries of loans previously charged-off:
Commercial and industrial		64			27			28			24			4
Real estate-construction		—			—			—			—			—
Real estate-mortgage:		—			—			—			—			—
Residential		17			3			—			—			—
Commercial		—			—			—			—			95


	For the Years Ended
	December 31,
	2005			2004			2003			2002			2001
	(Dollars in thousands)
Consumer installment		14			16			22			33			22


Total recoveries		95			46			50			57			121


Net loans recovered (charged off)		(84	)		(72	)		(94	)		(62	)		(145	)

Provision for loan losses		302			174			315			300			170


Allowance balance at end of period	$	2,841		$	2,623		$	2,521			2,300		$	2,062


Loans outstanding:
Average	$	222,926		$	204,191		$	183,683			163,828		$	143,560
End of period		234,055			215,653			192,880			174,943			152,828

Ratio of allowance for loan losses to loans outstanding at end of period		1.21	%		1.22	%		1.31			1.31	%		1.35

Net recoveries (charge offs) to average loans		(0.04	)		(0.04	)		(0.05	)		(0.04	)		(0.10	)

The following table illustrates the allocation of Middlefield’s allowance for probable loan losses for each category of loan for each reported period. The allocation of the allowance to each category is not necessarily indicative of future loss in a particular category and does not restrict our use of the allowance to absorb losses in other loan categories.


			Percent of					Percent of					Percent of					Percent of					Percent of
			Loans in Each					Loans in Each					Loans in Each					Loans in Each					Loans in Each
			Category to					Category to					Category to					Category to					Category to
	Amount		Total Loans			Amount		Total Loans			Amount		Total Loans			Amount		Total Loans			Amount		Total Loans
(Dollars in Thousands)
Type of Loans:
Commercial and industrial	$	1,151		27.6	%	$	1,139		24.1	%	$	568		21.8	%	$	611		18.8	%	$	722		18.5	%
Real estate construction		50		1.2			31		1.8			32		1.8			38		1.8			37		2.1
Mortgage:
Residential		965		64.9			1,019		68.4			844		69.5			888		70.8			781		74.0
Commercial		297		3.5			145		3.2			228		4.1			230		5.4			161		2.2
Consumer installment		128		2.8			123		2.7			120		2.9			124		3.1			111		3.2
Unallocated		250		—			166		—			435		—			409		—			250		—


Total	$	2,841		100	%	$	2,623		100	%	$	2,227		100	%	$	2,300		100	%	$	2,062		100	%

Accrual of interest is discontinued on a loan when management believes, after considering economic and business conditions, the borrower’s financial condition is such that collection of interest is doubtful. Payments received on nonaccrual loans are recorded as income or applied against principal according to management’s judgment as to the collectibility of principal.

payment if the bank expects to collect all amounts due, including interest accrued at the contractual interest rate for the period of delay. Management evaluates all loans identified as impaired individually. The bank estimates credit losses on impaired loans based on the present value of expected cash flows, or the fair value of the underlying collateral if loan repayment is expected to come from the sale or operation of the collateral. Impaired loans, or portions thereof, are charged off when it is determined a realized loss has occurred. Until that time, an allowance for loan losses is maintained for estimated losses.

Unless otherwise required by the loan terms, cash receipts on impaired loans are applied first to accrued interest receivable, except when an impaired loan is also a nonaccrual loan, in which case the portion of the payment related to interest is recognized as income.

Nonperforming loans as a percentage of total net loans at December 31, 2005 increased to 0.78% from 0.68% for 2004. The bank had nonaccrual loans of $1,478,000 and $279,000 at December 31, 2005 and 2004, respectively. Interest income recognized on nonaccrual loans during all of the periods was insignificant. Management does not believe the nonaccrual loans or any amounts classified as nonperforming had a significant effect on operations or liquidity in 2005. Furthermore, management is not aware of any trends or uncertainties related to any loans classified as doubtful or substandard that might have a material effect on earnings, liquidity, or capital resources. Management is not aware of any information pertaining to material credits that would cause it to doubt the ability of borrowers to comply with repayment terms.

The following table summarizes nonperforming assets by category.


	At December 31,
	2005			2004			2003			2002			2001
Loans accounted for on a nonaccrual basis:

Commercial and industrial	$	859		$	—		$	—		$	—		$	—
Real estate-construction		—			—			—			—			—
Real estate-mortgage:
Residential		607			279			372			357			48
Commercial		—			—			—			—			—
Consumer installment		21			—			—			—			—

Total nonaccrual loans		1,487			279			372			357			48

Accruing loans which are contractually past due 90 days or more:
Commercial and industrial		248			239			4			30			9
Real estate-construction		—			—			—			—			—
Real estate-mortgage:		—			—			—			—			—
Residential		70			722			114			144			216
Commercial		—			209			—			—			—
Consumer installment		9			25			19			7			20

Total accruing loans which are contractually past due 90 days or more		327			1,195			137			181			245

Total non — performing loans		1,814			1,474			509			538			293
Real estate owned		—			—			—			—			—
Other non-performing assets		—			—			—			—			—

Total non-performing assets	$	1,814		$	1,474		$	509		$	538		$	293

Total non-performing loans to total loans		0.78	%		0.68	%		0.26	%		0.31	%		0.19	%

Total non-performing loans to total assets		0.58	%		0.51	%		0.19	%		0.24	%		0.15	%

Total non-performing assets to total assets		0.58	%		0.51	%		0.19	%		0.24	%		0.15	%


(1)		Represents accruing loans delinquent greater than 90 days that are considered by management to be well secured and that are in the process of collection.

Liquidity and Capital Resources

Liquidity.Liquidity management for Middlefield is measured and monitored on both a short- and long-term basis, allowing management to better understand and react to emerging balance sheet trends. After assessing actual and projected cash flow needs, management seeks to obtain funding at the most economical cost to Middlefield. Both short- and long-term liquidity needs are addressed by maturities and sales of investments securities, loan repayments and maturities, and liquidating money market investments such as federal funds sold. The use of these resources, in conjunction with access to credit, provides the core ingredients for satisfying depositor, borrower, and creditor needs.

Middlefield’s liquid assets consist of cash and cash equivalents, which include investments in very short-term investments (i.e. federal funds sold), and investment securities classified as available for sale. The level of these assets is dependent on Middlefield’s operating, investing, and financing activities during any given period. At December 31, 2005, cash and cash equivalents totaled $5.8 million or 1.9% of total assets while investment securities classified as available for sale totaled $57.9 million or 18.6% of total assets. Management believes that the liquidity needs of Middlefield are satisfied by the current balance of cash and cash equivalents, readily available access to traditional funding sources, FHLB advances, and the portion of the investment and loan portfolios that mature within one year. These sources of funds will enable Middlefield to meet cash obligations and off-balance sheet commitments as they come due.

Operating activities provided net cash of $4.5 million, $4.0 million, and $3.5 million for 2005, 2004, and 2003, respectively, generated principally from net income of $3.7 million, $3.3 million, and $2.8 million in each of these respective periods.

Investing activities consist primarily of loan originations and repayments and investment purchases and maturities. These cash usages primarily consisted of loan originations of $18.3 million, as well as investment purchases of $13.3 million. Partially offsetting the usage of investment activities is $11.4 million of proceeds from investment security maturities and repayments. For the same period ended 2004, investing activities used $29.3 million in funds, principally for the net origination of loans and the purchase of investment securities of $22.7 million and $27.6 million, respectively. During the same period ended 2003, cash usages primarily consisted of loan originations of $17.9 million, as well as investment purchases of $33.0 million.

Financing activities consist of the solicitation and repayment of customer deposits, borrowings and repayments, treasury stock activity, and the payment of dividends. During 2005, net cash provided by financing activities totaled $16.7 million, principally derived from an increase in deposit accounts in general, and certificates specifically. Also contributing to this influx of cash was proceeds from other borrowings of $13.0 million. During 2004, net cash provided by financing activities totaled $25.7 million, principally derived from an increase in deposit accounts. During the same period ended 2003, net cash provided by financing activities was $33.4 million, principally derived from an increase in deposit accounts.

Liquidity may be adversely affected by unexpected deposit outflows, excessive interest rates paid by competitors, and similar matters. Management monitors projected liquidity needs and determines the level desirable, based in part on Middlefield’s commitment to make loans, as well as management’s assessment of Middlefield’s ability to generate funds. Middlefield anticipates that it will have sufficient liquidity to satisfy estimated short-term and long-term funding needs.

Capital Resources. Middlefield’s primary source of capital has been retained earnings. Historically, Middlefield has generated net retained income to support normal growth and expansion. Management has developed a capital planning policy to not only ensure compliance with regulations, but also to ensure capital adequacy for future expansion.

Middlefield is subject to federal regulations imposing minimum capital requirements. Management monitors both Middlefield’s and the Bank’s Total risk-based, Tier I risk-based and Tier I leverage capital ratios to assess compliance with regulatory guidelines. At December 31, 2005, both Middlefield and the Bank exceeded the minimum risk-based and leverage capital ratio requirements. Middlefield’s Total risk-based, Tier I risk-based and Tier I leverage ratios were 14.41%, 13.16%, and 9.10%, and the Bank’s were 13.83%, 12.58%, and 8.68%, respectively, at December 31, 2005.

The Company has various financial obligations, including contractual obligations and commitments that may require future cash payments.

Contractual Obligations

The following table discloses our contractual obligations and commitments as of December 31, 2005


			Less Than						After
	Total		1 Year		1 - 3 Years		4 - 5 Years		5 Years
	(Dollars in thousands)
Short-term borrowings	$	6,711	$	6,711	$	—	$	—	$	—

Federal Home Loan Bank advances		26,578		4,092		15,642		4,565		2,279


Total	$	33,289	$	10,803	$	15,642	$	4,565	$	2,279


	Total
	Amounts		Less Than						After
	Committed		1 Year		1 - 3 Years		4 - 5 Years		5 Years
	(Dollars in thousands)
Standby letters of credit	$	125	$	125	$	—	$	—	$	—

Other commitments to extend credit (1)		45,678		45,678		—		—		—


Total	$	45,803	$	45,803	$	—	$	—	$	—


(1)		Represents amounts committed to customers.

Commitments to extend credit, include loan commitments, standby letters of credit and do not necessarily represent future cash requirements, in that these commitments often expire without being drawn upon.

Market for Middlefield’s Common Equity and Related Stockholder Matters

Middlefield had approximately 846 stockholders of record as of February 22, 2006. There is no established market for Middlefield common stock. The stock is traded very infrequently. Bid prices are quoted from time to time on the National Quotation Bureau’s “pink sheets” under the symbol “MBCN.” The following table shows the high and low bid prices of and cash dividends paid on Middlefield common stock in 2005 and 2004, adjusted for stock splits and stock dividends. This information does not reflect retail mark-up, markdown or commissions, and does not necessarily represent actual transactions.


					Cash Dividends
	High Bid		Low Bid		per share
2005
First Quarter	$	37.811	$	37.769	$	0.210
Second Quarter	$	39.563	$	39.531	$	0.210
Third Quarter	$	38.459	$	38.412	$	0.224
Fourth Quarter	$	39.084	$	38.885	$	0.235

2004
First Quarter	$	29.245	$	29.125	$	0.190
Second Quarter	$	29.895	$	29.361	$	0.190
Third Quarter	$	32.267	$	32.072	$	0.200
Fourth Quarter	$	34.130	$	34.110	$	0.210


Financial Highlights	2001			2002			2003			2004			2005
Interest income	$	13,706,569		$	14,119,963		$	14,647,163		$	15,732,536		$	17,378,504
Interest Expense	$	6,747,922		$	6,148,086		$	5,724,907		$	5,768,898		$	6,654,614

Net interest Income	$	6,958,647		$	7,971,877		$	8,922,256		$	9,963,638		$	10,723,890
Provision for loan loss	$	170,000		$	300,000		$	315,000		$	174,000		$	302,000

Net interest Income After Provision for loan losses	$	6,788,647		$	7,671,877		$	8,607,256		$	9,789,638		$	10,421,890
Noninterest Income, Including Security Gains/Losses	$	1,194,193		$	1,143,217		$	1,428,144		$	1,779,231		$	2,119,237
Noninterest Expense	$	4,741,374		$	5,206,339		$	6,105,450		$	6,965,706		$	7,424,640

Income Before Income Taxes	$	3,241,466		$	3,608,755		$	3,929,950		$	4,603,163		$	5,116,487
Income Taxes	$	970,859		$	1,107,806		$	1,131,330		$	1,330,000		$	1,415,156

Net Income	$	2,270,607		$	2,500,949		$	2,798,620		$	3,273,163		$	3,701,331


Total Assets	$	197,857,964		$	226,245,533		$	262,369,448		$	291,213,986		$	311,214,191
Deposits	$	167,382,728		$	187,384,494		$	219,839,910		$	239,885,451		$	249,449,640
Equity Capital	$	19,786,807		$	21,746,408		$	23,504,314		$	24,822,024		$	27,289,365
Equity Capital to Total Assets		10.00	%		9.61	%		8.96	%		8.52	%		8.77	%
Loans Outstanding, Net	$	150,766,103		$	172,642,646		$	190,358,883		$	213,029,852		$	231,213,699
Allowance For Loan Losses	$	2,062,252		$	2,300,485		$	2,521,270		$	2,623,431		$	2,841,098
Net Charge-Offs (Recoveries)	$	145,070		$	61,767		$	94,215		$	71,839		$	84,333
Full Time Employees (Average Equivalents)		64			66			72			73			75
Number of Offices		5			5			6			6			6

Earnings Per Share		1.69			1.86			2.09			2.41			2.77
Dividends Per Share		0.58			0.64			0.72			0.79			0.91
Book Value Per Share		14.76			16.31			17.42			18.31			19.02
Dividends Pay-out Ratio		34.00	%		34.30	%		34.37	%		32.72	%		32.10	%

Cash Dividends Paid	$	772,068		$	857,751		$	961,901		$	1,070,833		$	1,188,145
Return on Average Assets		1.22	%		1.17	%		1.13	%		1.17	%		1.23	%
Return on Average Equity		11.89	%		12.08	%		12.39	%		13.36	%		14.43	%

Notes


(1)	The above per share amounts have been restated to reflect a 5% stock dividend paid in 2002, 2003, 2004 and 2005.

Positive
Negative
Uncertain
Constraining
Legalese
Litigous
Readability	8th grade Avg

Middlefield Banc (MBCN) 10-K2005 FY Annual report

Content analysis