Page 1 of 87 FORM 10-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2002. OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _____________ to _____________. Commission file number 000-18445. Benchmark Bankshares, Inc. (Exact name of registrant as specified in its charter) Virginia 54-1380808 -------- ---------- (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 100 South Broad Street Kenbridge, Virginia 23944 ------------------- ----- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code (434)676-8444. Securities registered pursuant to Section 12(b) of the Act: None Title of each class Name of each exchange on which registered ------------------- ----------------------------------------- - ---------------------------- ----------------------------- Securities registered pursuant to Section 12(g) of the Act: Common Stock, Par Value $0.21 a share (Title of Class) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [X] Yes [ ] No Indicate by check mark if the disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). [ ] Yes [ ] No The number of shares outstanding of the registrant's common stock, $0.21 par value was 2,959,718.059 at March 1, 2003. DOCUMENTS INCORPORATED BY REFERENCE None Page 2 of 87 Benchmark Bankshares, Inc. Table of Contents Page No. Part I Item 1. Business 3 Item 2. Properties 6 Item 3. Legal Proceedings 7 Item 4. Submission of Matters to a Vote of Security Holders 7 Part II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters 8 Item 6. Selected Financial Data 10 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 11 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 34 Item 8. Financial Statements and Supplementary Data 34 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 63 Part III Item 10. Directors and Executive Officers of the Registrant 64 Item 11. Executive Compensation 65 Item 12. Security Ownership of Certain Beneficial Owners and Management 66 Item 13. Certain Relationships and Related Transactions 68 Part IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K 69 Page 3 of 87 PART I ITEM I BUSINESS Benchmark Bankshares, Inc. Benchmark Bankshares, Inc. (the "Company"), formerly Lunenburg Community Bankshares, Inc., is a bank holding company incorporated under the laws of the Commonwealth of Virginia on March 7, 1986. The Company became a one bank holding company under the Bank Holding Company Act of 1956 on January 1, 1987 subsequent to its acquiring all of the issued and outstanding shares of The Lunenburg County Bank's, now Benchmark Community Bank (the "Bank"), common stock. The Company does not own or operate any other businesses. At December 31, 2002, the Company and its subsidiary employed 92 full-time and 11 part-time persons. Benchmark Community Bank The Bank opened for business on September 8, 1971 under its original name of The Lunenburg County Bank. It started business in temporary quarters and in 1974 moved to its present location at 100 South Broad Street, Kenbridge, Virginia 23944. Also in 1974, the Bank opened its first full-service branch in the Town of Victoria, Virginia. Today, the Bank has nine full-service banking offices in the Towns of Kenbridge and Victoria in Lunenburg County, the Town of Farmville (two offices) in Prince Edward County, the Town of Crewe in Nottoway County, the Towns of South Hill, Clarksville, and Chase City in Mecklenburg County, and the Town of Lawrenceville in Brunswick County. The Bank is also in the process of establishing a new branch location in the Town of Blackstone in Nottoway County. All offices are located in the State of Virginia. The Bank offers a wide range of banking and related financial services to individuals and small to medium ranged businesses. The services offered are in the form of checking, savings accounts, NOW and money market accounts, certificates of deposit, business loans, personal loans, mortgage loans, and other consumer oriented financial services including IRAs, safe deposit, drive-up, night deposit, internet banking, and automatic-teller machines at each office. The Bank does not offer any trust services. Competition The Bank encounters strong competition for its banking services within its primary market area. There are eight commercial banks actively engaged in business in the market area, including five major statewide banking organizations. The Bank is the only community bank actively engaged in business in Lunenburg and Brunswick Counties, and one of two such banks in the Town of Farmville, Prince Edward County, and one of three such banks in Mecklenburg County. Finance companies, mortgage companies, credit unions, and savings banks also compete with the Bank for loans and deposits. In addition, the Bank must compete for deposits with money market mutual funds that are marketed nationally. Supervision and Regulation The summaries of statutes and regulations included in the information provided below do not purport to be complete and are qualified in their entirety by reference to the pertinent statutes and regulations. The Company is subject to the Bank Holding Company Act of 1956. As such, the Company is required to file with the Federal Reserve Board annual reports and other information regarding the business operations of itself and its subsidiaries and is subject to examination by the Federal Reserve Board. Page 4 of 87 A bank holding company is required to obtain Federal Reserve Board approval prior to acquiring ownership or control of the voting shares of any bank if, after the acquisition, it would own or control more than 5% of the voting stock of that bank, unless it already owns a majority of the voting stock of the bank. A bank holding company is, with limited exceptions, prohibited from acquiring ownership or control of voting stock of any company which is not a bank or a bank holding company and must engage only in the business of banking, managing or controlling banks, or furnishing services to or performing services for subsidiary banks. The Federal Reserve Board is authorized to approve the ownership of shares by a bank holding company in any company, the activities of which the Federal Reserve Board has determined to be so closely related to banking or to managing or controlling banks as to be a proper incident thereto. The Federal Reserve Board has determined that certain activities are closely related to banking, including making loans that would be made by mortgage, finance, credit card, or factoring companies; acting as an investment or financial advisor; performing the functions of a trust company; providing certain data processing services; leasing certain personal property; and acting as an insurance agent or broker for insurance directly related to the extension of credit or other financial services. Although, a bank holding company may file an application for approval of other nonbanking activities involved in a particular case, the Federal Reserve Board has stated that, at present, permissible nonbanking activities do not include real estate brokerage and syndication, land development, property management, underwriting, operation of savings and loan associations, management consulting, or industrial development corporations. A bank holding company and its subsidiaries are also prohibited from acquiring any voting shares of, or interest in, any banks located outside of the state in which the operations of the bank holding company's banking subsidiaries are located unless the acquisition is specifically authorized by the statutes of the state in which the bank to be acquired is located. Further, a bank holding company and its subsidiaries generally may not extend credit, lease or sell property, or furnish any services on the condition that the customer obtain or provide some additional credit, property, or services from or to the bank holding company or its subsidiaries, or that the customer obtain some other credit, property, or services from a competitor. Bank Supervision and Regulation The Bank is a member of the Federal Reserve System and is subject to regulation and supervision, of which regular bank examinations are a part, by the Virginia Bureau of Financial Institutions and the Federal Reserve Bank as are all state member banks. The Bank by virtue of its Federal Reserve membership qualifies for Federal Deposit Insurance Corporation (FDIC) insurance coverage of up to a maximum of $100,000 per depositor. For the deposit insurance protection, the Bank pays a semi-annual statutory assessment and is subject to the rules and regulations of the FDIC. The Company is an "affiliate" of the Bank, and that status imposes restrictions on loans by the Bank to the Company, on investment by the Bank in the Company, and on the use of Company stock or securities as collateral security for loans by the Bank to any borrower. The Company is also subject to certain restrictions on its engaging in the business of issuing, floatation, underwriting, public sale, and distribution of securities. Government Monetary Policies and Economic Controls The monetary policies of regulatory authorities, most notably the Federal Reserve Bank, have a significant effect on the operating results of bank holding companies and banks. In particular, the Federal Reserve Board regulates money and credit conditions and interest rates in order to influence general economic conditions. These policies have a significant influence on the overall growth and distribution of bank loans, investments and deposits, and affect interest rates charged on loans or paid for time and savings deposits. Federal Reserve Board monetary policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future; however, the Company and its subsidiary bank are unable to predict the specific nature or extent of these effects on their business and earnings. Page 5 of 87 Restrictions Investments As required by the Virginia Security for Public Deposits Act, the Bank has pledged $8,869,362 at cost of its investment portfolio to safeguard State and local municipalities' deposits as of December 31, 2002. By virtue of the Bank holding deposits for the Federal government, it is subject to Section 31CFR202 of the Code of Federal Regulation, which requires, in part, the collateralization of Federal deposits. As of December 31, 2002, the Bank had $124,651 pledged for Federal deposits. The Bank is required by Section 19 of the Federal Reserve Act to maintain a certain level of reserves consisting of cash and other liquid assets in proportion to types of deposit accounts held. At year end 2002, the Bank's vault cash met the statutory requirement so designated by the Act. Anti-Takeover Provisions The Articles of Incorporation and Bylaws of the Company contain certain anti-takeover provisions. Said provisions provide (i) for division of the Board of Directors into three classes, with one class elected each year to serve a three year term; (ii) that Directors may be removed only upon the affirmative vote of the holders of 80% of the outstanding voting stock; (iii) that any vacancy on the Board may be filled by the remaining Directors; (iv) that advance notification is required for a stockholder to bring business before a stockholders' meeting or to nominate a person for election as a Director; and (v) that the affirmative vote of the holders of 80% of the outstanding voting stock is required to alter, amend, or repeal the foregoing provisions. The Articles also contain a "fair price" provision that requires the affirmative vote of the holders of 80% of the outstanding voting stock as a condition for certain mergers or business combinations, unless the transaction is either approved by a majority of the disinterested Directors or certain minimum price and procedural requirements are met. The foregoing provisions of the Articles and Bylaws are intended to prevent inequitable stockholder treatment in a two-tier takeover and to reduce the possibility that a third party could effect a sudden or surprise change in majority control of the Board of Directors without the support of the incumbent Board, even if such a change were desired by or would be beneficial to a majority of the Company's stockholders. Such provisions may have the effect of discouraging certain unsolicited tender offers for the Company's capital stock and, at the same time, may provide for a continuation of current Company's philosophy and leadership style. Limitation on Liability The Company's Articles of Incorporation provide, in part in accordance with the provisions of a recent amendment to the Virginia Stock Corporation Act (the "Act"), that in every instance permitted by the Act, the liability of a Director or Officer of the Company for monetary damages arising out of a single transaction, occurrence, or course of conduct shall be limited to one dollar. This limit on damages does not apply in the event of willful misconduct or a knowing violation of the criminal law or any Federal or State securities law. The limitation does not change or eliminate a Director's or Officer's duty of care to the Company; it only eliminates, in certain circumstances, monetary damages occasioned by a breach of that duty. It should also be noted that such limitation of liability in no way limits or otherwise affects liability for the violation of, or otherwise relieves the Company or its Directors or Officers from the necessity of complying with, the Federal or State securities laws. Page 6 of 87 Indemnification The Articles of Incorporation of the Company mandate indemnification of Directors and Officers as a result of liability incurred by them in proceedings instituted against them by third parties, or by or on behalf of the Company itself, relating to the manner in which they have performed their duties unless they have been guilty of "willful misconduct or a knowing violation of the criminal law" in the performance of their duties. The indemnification provision is consistent with another recent amendment to the Corporation Act. Thus, the protection of the proposed amendment will extend to grossly negligent conduct but not to willful misconduct. The Company's Board of Directors is authorized to contract in advance to indemnify any Director or Officer and to indemnify or contract in advance to indemnify other persons including Directors and Officers of subsidiaries and employees and agents of the Company and its subsidiaries, to the same extent that it is required to indemnify Directors and Officers of the Company. The Act and the Company's Articles of Incorporation permit the advancement of expenses incurred by a Director or Officer in a proceeding. The Company has entered into indemnification agreements with each of its Directors and Officers, entitling them to (i) indemnification to the full extent permitted by the Act, and (ii) reimbursement of all expense advancements, including attorneys' fees, paid or incurred in connection with any claim relating to any indemnifiable event. Executive Officers For information concerning the Executive Officers of the Company, refer to Part III, Item 10, found on pages 64 and 65 of this report. ITEM 2 PROPERTIES The main office of the Bank, which is owned by the Bank, consists of three contiguous buildings. The combined office is a two-story building of masonry construction and contains approximately 6,200 square feet of space on the first floor, all of which is used for a full-service banking operation, including four teller windows, loan offices, an automatic-teller machine, and customer service for Kenbridge. The bookkeeping and computer operations for the entire bank are located on the second floor of the office, which has 3,200 square feet of floor space. Administrative offices for the entire Bank are also located in this building. Additionally, there is an adjacent, but separate, three-lane drive-up facility located just behind the office. The Victoria branch office, also owned by the Bank, was constructed in 1982 and contains approximately 2,500 square feet of floor space. It houses four teller windows, has a drive-up unit, which serves two lanes of traffic, and an automatic-teller machine. The Farmville branch office, which opened in June of 1989, contains approximately 1,650 square feet of floor space and is a leased facility. The Bank signed a new lease effective October 15, 1998. The lease has a five year original term with five additional options to renew for additional twelve month terms. The current monthly lease amount as of December 31, 2002 was $1,150. The office contains three teller windows. Currently, the office has no drive-up unit. The Bank added a third office to the Branch in 1998. The South Hill office, which opened for business in September, 1989, is also housed in a leased facility. During 2000, the Bank renegotiated its lease to extend the agreement to June 30, 2005. The lease provides for renewal options of twelve month periods for an additional five years. The current monthly lease amount as of December 31, 2002 was $1,850. This amount can be renegotiated in August of 2003. This office contains approximately 2,900 square feet of floor space and operates four teller windows, a drive-up unit, which serves two lanes of traffic, and an automatic-teller machine. Page 7 of 87 In 1993, the Bank opened a second office in the Town of Farmville on South Main Street at Milnwood Road. The office is a two story structure of modern design. The first floor contains 3,967 square feet and provides space for the operation of three loan offices, four teller windows, a large customer lobby and new accounts area, a three-lane drive-up unit, and an automatic-teller machine. The branch office's second floor has 2,240 square feet of space available for future expansion. On May 31, 1996, the Bank opened a full-service branch in Crewe. The office is a one story brick structure. The office contains 2,600 square feet of floor space, which provides for an open lobby with three teller windows, two loan offices, and a new accounts area. The office has a three-lane drive-up unit with an automatic-teller machine. During 1999, the Bank opened three offices, one each in the Towns of Chase City, Clarksville, and Lawrenceville. In Chase City, the Bank has remodeled a former banking office of a state-wide financial institution facility and opened a full-service office in January of 2001. The branch building consists of 2,142 square feet and contains a lobby, teller windows, a two-lane drive-up unit, and automatic-teller machine. The facility is constructed of brick and is situated in a shopping center on the east side of town. During 2001, the Bank opened a full-service banking facility on Highway 15 South in Clarksville. The branch building consists of 1,680 square feet and contains a lobby, teller windows, three offices, a two-lane drive-up and automatic-teller unit. The facility is a modular unit. During 1999, the Bank began operating a full-service bank in a temporary location in Lawrenceville. In 2000, the Bank moved to a permanent banking facility which is a one-story brick building. The facility contains 2,021 square feet on the ground level which houses a lobby, teller stations, a two-lane drive-up unit, and an automatic-teller machine. There is also a full basement which is currently being utilized for storage. As of December 31, 2002, the Bank had begun negotiations to acquire three adjoining lots in Blackstone, Virginia upon which a new facility, similar in size and structure to the Bank's facility in Crewe, would be constructed. Plans are to lease an adjacent lot and begin operating out of a leased, temporary facility during the construction of the new branch building. A lease for the temporary Bank facility was entered into on December 9, 2002 and has a monthly payment of $775 for a term of no less than 12 months. The lease for the vacant lot was entered into on December 11, 2002 and has a monthly payment of $600. This lease terminates on January 2, 2004. The construction period is anticipated to last 12 months, after which time the Bank would move its banking operations in Blackstone from the temporary facility into the new building. ITEM 3 LEGAL PROCEEDINGS None ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None Page 8 of 87 PART II ITEM 5 MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Market for Common Equity The Company's stock is listed and quoted daily in the Virginia Over the Counter Section. This information is supplied daily by the National Association of Security Dealers to Virginia newspapers. The following table sets forth information concerning the closing market price of the stock since its initial listing: Closing Price of Common Stock 2002 First Quarter $10.60 Second Quarter 13.00 Third Quarter 12.00 Fourth Quarter 12.60 2001 First Quarter $ 9.25 Second Quarter 10.00 Third Quarter 10.00 Fourth Quarter 10.00 2000 First Quarter $ 9.00 Second Quarter 8.88 Third Quarter 9.75 Fourth Quarter 9.25 1999 First Quarter $12.50 Second Quarter 12.75 Third Quarter 12.00 Fourth Quarter 10.75 1998 First Quarter $19.00 Second Quarter 19.00 Third Quarter 15.50 Fourth Quarter 13.75 During 2002, the Company declared an $0.18 per share semi-annual dividend in June and $0.20 per share semi-annual dividend in December. The semi-annual dividends declared in 2001 amounted to $0.18 per share in June and $0.18 per share in December. As of December 31, 2002, there were 950 stock certificates issued to holders of record. Page 9 of 87 Related Stockholder Matters Article III, Section 1 of the Articles of Incorporation of the Company authorize the issuance of 200,000 shares of a preferred class stock with a par value of $25.00. Except to the extent to which the Board of Directors shall have specified voting power with respect to the preferred stock of any series and except as otherwise provided by law, the exclusive voting power shall be vested in the common stock. The dividends of the preferred stock shall have a fixed rate of dividends if and when declared by the Board of Directors. Such dividends shall be cumulative. As of December 31, 2002, there has been no issuance of preferred stock as authorized in the Articles of Incorporation. Page 10 of 87 ITEM 6 SELECTED FINANCIAL DATA Years Ended December 31, 2002 2001 2000 1999 1998 ---- ---- ---- ---- ---- (In thousands of dollars, except per share amounts) Interest income $ 17,047 $ 17,401 $ 16,422 $ 15,126 $ 14,328 Interest expense 7,200 8,755 8,002 7,376 7,006 -------- -------- -------- -------- -------- Net interest income 9,847 8,646 8,420 7,750 7,322 Provision for loan losses 419 198 201 606 357 Other operating revenue 1,395 1,044 1,006 742 647 Other operating expense 6,085 5,600 5,069 4,317 3,825 -------- -------- -------- -------- -------- Income Before Income Taxes 4,738 3,892 4,156 3,569 3,787 Income Taxes 1,340 1,156 1,311 1,057 1,143 -------- -------- -------- -------- -------- Net Income 3,398 2,736 2,845 2,512 2,644 Per Share Data (1) Net income 1.15 0.92 0.95 0.83 0.89 Cash dividends declared 0.38 0.36 0.34 0.32 0.31 Balance Sheet Amounts (at end of period) Total assets 265,058 241,813 205,253 193,324 185,381 Total loans (2) 198,256 176,077 163,038 150,675 133,033 Total deposits 236,544 216,361 181,197 164,741 164,892 Total equity 26,546 23,477 22,185 20,048 19,015 Book value per share (at end of period) 8.96 7.90 7.38 6.65 6.34 Selected Financial Ratios (as a percentage) Net income to average equity 15.45 13.61 14.89 13.30 15.65 Net income to average assets 1.39 1.23 1.42 1.31 1.53 Loans to deposits (3) 83.81 82.20 90.90 92.39 81.62 Primary capital to total assets (at end of period) (4) 10.28 10.30 11.46 10.65 10.95 Net interest yield (5) 4.37 4.12 4.50 4.33 4.54 Allowance for loan losses to loans (at end of period) (6) 1.00 1.00 1.01 1.00 1.16 Nonperforming loans to loans (at end of period) (7) 0.05 0.70 0.92 1.04 1.05 Net charge offs to average loans (3) 0.11 0.05 0.04 0.45 0.15 (1) Average shares outstanding. (2) Total loans net of unearned discount on installment loans and reserve for loan losses. (3) For purposes of this ratio, loans represent gross loans less unearned interest income. (4) Equity exclusive of unrealized securities gains (losses) plus allowance for loan loss less the deferred taxes related to loan losses to assets. (5) Net interest income to total average earning assets. (6) The difference of gross loans minus unearned interest income divided into the allowance for loan losses. (7) Nonperforming loans are loans accounted for on a nonaccrual basis and loans which are contractually past due 90 days or more. Average loans are gross average loans minus the average unearned interest income. Page 11 of 87 ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This section of the report should be read in conjunction with the statistical information, financial statements and related notes, and the selected financial data appearing elsewhere in the report. Since the Bank is the only subsidiary of the Company, all operating data will be referred to in this discussion as that of the Bank. Overview The Company continued to grow through its subsidiary, Benchmark Community Bank, as the Bank experienced steady growth in both loans and deposits. As a result of record low interest rates, the Bank's overall cost of deposits declined during the year, thus reducing interest expense which lead to increased profitability. Loan growth, led by the Bank's Clarksville branch, outpaced the growth of deposits, increasing the Bank's loan to deposit ratio. As a result, earnings were enhanced through this increased utilization of resources into high-yielding loans, as opposed to being placed in Federal funds or investment securities. The decrease in the cost of deposits, coupled with increased loan demand, served to increase net income to a record level in 2002, surpassing the $3,000,000 mark for the first time in the Bank's history. Management continues to focus on growth by researching ways to improve existing services, by implementing new services such as internet banking, and by looking for additional expansion opportunities throughout Southside Virginia. With this in mind, the Bank has made plans to establish a new branch location in Blackstone, Virginia during the first quarter of 2003, increasing the total number of office locations to ten. A Comparison of 2002 Versus 2001 Results of Operations and Financial Conditions Net income of $3,398,040 in 2002 was an increase of $662,272 or 24.21% from net income of $2,735,768 in 2001. Earnings per share of $1.15 in 2002 increased $0.23 or 25.00% from earnings per share of $0.92 in 2001. Growth in loans, with a corresponding but lesser growth in deposits, resulted in an increase in the loan to deposit ratio to 83.81% from 82.20% for the previous year. Gross loans grew $20,402,716 or 11.47% while deposits increased $20,183,329 or 9.33% during the year. In 2002, the Bank achieved a return on average assets of 1.39% as compared to a 1.23% return on average assets in 2001. Increased loan demand, which provided a higher yielding alternative for incoming funds than short-term investments, combined with a lower cost of funds due to declining interest rates, accounted for the higher rate of return. Return on equity of 15.45% for the year ended 2002 reflected an increase over the 2001 level of 13.61%. The higher rate of return resulted from an increase in earnings due to the continued decline in interest rates, which lowered the Bank's cost of funds, along with an increase in noninterest income that served to offset a decline in interest income. Net Interest Income Net interest income of $9,846,151 in 2002 reflected an increase of $1,200,142 or 13.88% over net interest income of $8,646,009 in 2001. Total interest income of $17,046,551 in 2002 was down $354,515 or 2.04% from total interest income of $17,401,066 in 2001. Total interest expense of $7,200,400 in 2002 reflected a decrease of $1,554,657 or 17.76% from total interest expense of $8,755,057 in 2001. Page 12 of 87 The increase in net interest income resulted from a continued decline in interest rates, which, despite the negative impact on interest received from loans, served to reduce the Bank's cost of funds. (Refer to Table D, "Analysis of Changes in Net Interest Income," for an analysis of the impact of volume and rate.) Although market rates declined in 2002, the Bank experienced a higher interest margin. The cost of deposits dropped 126 basis points while the decline in interest income rates amounted to 80 basis points, resulting in an interest rate spread of 3.77% in 2002 versus an interest rate spread of 3.31% in 2001. (Refer to Table C, "Interest Rates Earned and Paid," for further analysis of interest rate activity.) Loans The Bank utilizes the following types of loans in servicing the trade area: Commercial (Time and Demand) 11.03% Consumer (Installment) 15.08% Real Estate (Construction) 0.82% Real Estate (Mortgage) 73.07% These types of loans have traditionally provided the Bank with a steady source of quality interest-earning assets. The maturities of these loans range from commercial loans and real estate construction loans maturing in less than one year to installment and real estate credits that may exceed five years. With the exception of home equity loans, which are short-term in nature, mortgage loans, which represent 73.07% of the portfolio, are typically fifteen to twenty year payback loans with three to five year balloon options. By setting maturities of loans for a short-term, the Bank can effectively manage its asset/liability mix, as most deposit accounts mature in one year or less. Allowance for Loan Losses The 2002 year ending level of the allowance for loan losses amounted to $1,982,559. This amount represented an increase of $207,927 or 11.72% over the 2001 level of $1,774,632. Loans collateralized by real estate represented a majority of the loans. By obtaining a high degree of collateral, the Bank has avoided a portion of credit risk; however, the Bank constantly monitors its loan portfolio for credit weaknesses. As of the year end 2002, the Bank's allowance for loan losses represented 1.00% of gross loans. The Bank incurred net charge offs for loan losses for the year of $210,655. As a result of the increased level of net charge offs, the current year provision was $220,696 higher when compared to the prior year. The year 2002 level represented a 111.53% increase over the amount expended in 2001. Noninterest Income and Noninterest Expense Total noninterest income, i.e., fees charged for customer services, for 2002 was $1,395,329. This represents an increase of $351,941 or 33.73% over the 2001 level of $1,043,388. Gains were experienced in service charges on deposit accounts and other operating income as the Bank increased its customer base due to the continued growth of the Bank's branches. Total noninterest expense in 2002 of $6,084,979 reflects an increase of $485,142 or 8.66% over the 2001 level of $5,599,837. The increase resulted from normal increases in operating expenses, salaries, and employee benefits. Premises and Equipment The Bank's premises and equipment increased $447,021 during the year. Page 13 of 87 Increase in Capitalized Premises and Equipment Equipment, Leasehold Furniture, and Office/Area Land Building Improvements Fixtures Kenbridge $51,500 $ - $ - $ 57,333 Victoria - - - 45,507 Farmville #1 - - - 43,102 South Hill - - - 55,834 Farmville #2 - - - 50,237 Crewe - - - 18,934 Lawrenceville - 28,921 - 26,287 Clarksville - 27,162 - 17,776 Chase City - - - 24,429 ------- ------- ------- -------- Total $51,500 $56,083 $ - $339,439 ======= ======= ======= ======== Securities Pursuant to guidelines established in FAS 115, the Bank has elected to classify a majority of its current portfolio as securities available-for-sale. This category refers to investments that are not actively traded but are not anticipated by management to be held-to-maturity. Typically, these types of investments will be utilized by management to meet short-term asset/liability management needs. For purposes of financial statement reporting, securities classified as available-for-sale are to be reported at fair market value as of the date of the statements; however, unrealized holding gains and losses are to be excluded from earnings and reported as a net amount in a separate component of stockholders' equity until realized. The impact of this unrealized gain on securities positively impacted stockholders' equity in the amount of $701,647, therefore, affecting the book value of the Company's stock. The book value per share of the stock inclusive of the FAS 115 adjustment was $8.96, while the book value per share is $8.72 when reported exclusive of the FAS 115 impact. Off-Balance-Sheet Instruments/Credit Concentrations The Bank is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to facilitate the transaction of business between these parties where the exact financial amount of the transaction is unknown, but a limit can be projected. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. There is a fee charged for this service. As of December 31, 2002, the Bank had $1,152,056 in outstanding letters of credit. These instruments are based on the financial strength of the customer and the existing relationship between the Bank and the customer. At current year end, the Bank also had unused commitments resulting from credit line deeds of trust, home equity lines, construction loans, and unfunded business loans. The total amount of these commitments amounted to $37,149,451. Page 14 of 87 Concentrations The Bank has no concentrations of credit involving an individual borrower and his related interest. The Bank does have a concentration in loan type in that a majority of the loan portfolio is secured by noncommercial real estate. Due to the subjectivity of the real estate market to the condition of the economy and sensitivity to interest rate fluctuation, there is an inherent risk; however, the Bank has, as a matter of policy, a loan-to-collateral percentage that allows for a level of decline in collateral value without affecting the quality of the loan. Liquidity The Bank's funding requirements are supplied by a wide range of traditional banking sources, including various types of demand, money market, savings, certificates of deposit, and Federal funds purchased. Large certificates of deposit of $100,000 or more increased by $6,228,093 or 20.03% in 2002. These deposits currently represent 15.78% of the total deposit base. The Bank feels that the large certificates are more of a function of customer service than a competitive bid situation. The amount of these certificates of deposit maturing during 2003 is $9,936,497, while $15,810,498 matures between one and five years. A GAP analysis is presented in Table L. This analysis reflects the difference between maturing and repricing of interest-earning assets and interest-bearing liabilities. A positive gap indicates more assets are maturing than liabilities. Conversely, a negative gap indicates more liabilities mature than assets during a given period. Assets classified as immediately maturing are those assets which can be repriced or converted to cash immediately upon demand. Liabilities classified as immediately maturing are those which can be withdrawn on demand except that the Bank has assigned a 90% retention rate on core savings, money market, and checking deposits. The GAP analysis shows a net positive gap of $11,894 when immediately maturing interest-bearing liabilities are deducted from immediately maturing interest-earning assets. The cumulative gap changes to a negative gap of $15,298 when comparing assets and liabilities maturing up to one year; however, the cumulative gap shifts to a positive position of $32,546 for the "over five years" period. The deficit gap results from the customer preference for short-term liquidity in the current period of fluctuating rates, which affects not only deposits but also callable investments. The nature of the large gap deficit is an industry-wide situation that is typical of the banking industry where a bulk of the assets is financed by short-term deposits. To further compound the situation, Bank customers have shown a preference for longer terms on loans versus deposits as financial rates have continued to decline. The Bank is satisfied that it can meet the liquidity needs by utilizing three to five year balloon notes for real estate financing and a one year maturity for commercial loans. This strategy, while not meeting exact liquidity needs on a dollar for dollar asset/liability mix, does provide a near match without sacrificing a positive interest rate spread. To compensate for the resultant mismatching of assets and liabilities, the Bank has invested in highly liquid investments. In the unlikely event of a liquidity hardship, these investments are available to be sold to fund assets currently being supported by deposit liabilities. The GAP model does not consider the impact of core deposit loyalty. Management feels that these core deposits along with the highly marketable securities available will provide sufficient reserves to fund any short-term loss of deposits. As mentioned previously, management has factored in anticipated retention levels for core deposits. Capital Resources and Adequacy In the past, the Company has blended internally generated retained earnings with capital stock sales to maintain a strong capital position necessary to support future growth. Page 15 of 87 The Company began a capital buyback program during 1999. Through this program, the Company has repurchased 14,000 shares of stock amounting to $141,500 during the year of 2002. The Company continued to experience strong earnings through the operation of the Bank. Through earnings, the Company generated an additional $2,270,446 in capital. This activity, plus the sale of $89,450 common stock through the stock option plan, raised year end capital exclusive of unrealized security gains net of tax effect to a level of $25,844,260 or a 9.39% increase over the 2001 year ending level of $23,625,972. The primary capital to total assets ratio stands at 10.28% as of December 31, 2002. This amount is well above current industry standards. Refer to Item 14(d)(5) for additional capital ratio analysis. Due to the increase in earnings, subsequent earnings retention, and sale of common stock, the Company's capital position was strengthened and, as a result, the Company remains well capitalized for the banking industry even after initiating a stock buyback program. Pursuant to regulations of the Federal Reserve Board, the Company is required to maintain certain minimum levels of capital in its bank subsidiary. At December 31, 2002, the Bank maintained the following capital ratios: Total Risk-Based Capital Ratio 11.46% Tier I Risk-Based Capital Ratio 10.54% Tier I Leverage Ratio 8.87% These ratios exceed the minimum ratios required by regulatory authorities for the Bank to be considered well capitalized. Inflationary Factors The Bank's earnings are greatly impacted by inflation and the actions of the Federal Reserve Board. The year 2002 was a period of falling interest rates as the Federal Reserve attempted to stimulate the economy by lowering the Federal discount window rate and the targeted Federal funds rate. The interest spread margin for the year was 3.77% versus a 3.31% margin spread for 2001. Refer to Table C. Lending and Funding Strategies The Bank relies on traditional sources of funding such as demand deposits, interest- bearing checking, money market deposit accounts, savings accounts, and certificates of deposit for funding its activities. These funds are subsequently loaned to the local community, with the exception of cash and prudent liquidity needs. Traditionally, the Bank has experienced a strong loan demand. At year end 2002, the loan-to-deposit ratio had risen as the rate of loan growth exceeded inflow of deposits. Looking Forward The Bank has experienced tremendous success in its operation, particularly since 1989 when it moved into two new market areas and raised additional capital. The capital provided a solid foundation upon which to grow by affording the Bank a degree of aggressiveness in operation during a favorable economic climate for banks and banking services. This aggressiveness took the form of expansion and competitive pricing of services. Management plans to utilize this capital in a way that will increase market share without sacrificing quality of service to its customers. The Bank experienced significant growth during the last decade. By expanding the trade area into neighboring counties and towns, the Bank has been able to attract quality loans and deposits at profitable levels. As management looks to the future, it feels that the trade area provides future growth potential as the Bank offers new financial services. The new data processing system acquired during 1998 has the capability to expand the Bank's services beyond the traditional services offered, thus providing a solid technological platform upon which to grow. Page 16 of 87 During 2002, the Bank also completed the installation of a wide area computer network, linking all of its offices, and introduced internet banking for its customers. Additionally, the implementation of a check imaging system, along with new lending and deposit documentation software, will allow the Bank to realize operational efficiencies moving forward. The Bank has also implemented a technology plan to allow for the periodic review of emerging technologies that may provide additional opportunities for improved service and cost efficiency. A Comparison of 2001 Versus 2000 Results of Operations and Financial Conditions Net income of $2,735,768 in 2001 resulted in a decrease of $109,293 or 3.84% from net income of $2,845,061 in 2000. Earnings per share of $0.92 in 2001 decreased $0.03 or 3.16% from earnings per share of $0.95 in 2000. Growth in deposits with a corresponding but lesser growth in loans resulted in a decline in the loan to deposit ratio to 82.20% from 90.90% for the previous year. Deposits increased $35,164,294 or 19.41% while gross loans grew $13,145,692 or 7.98%. In 2001, the Bank achieved a return on average assets of 1.23% as compared to a 1.42% return on average assets in 2000. The lower rate of return was a result of two factors. First, the demand for loans did not grow as fast as deposits resulting in a drop in the loan to deposit ratio, and, secondly, the market rates fell putting pressure on the interest margin spread. The year ended 2001 reflected a decrease in return on equity as net income to average equity declined to 13.61% as compared to the 2000 level of 14.89%. The lower rate of return resulted from a decline in earnings as the nationwide economic growth dipped after a sustained level of growth throughout the 1990's. Net Interest Income Net interest income of $8,646,009 in 2001 reflected an increase of $226,192 or 2.69% over net interest income of $8,419,817 in 2000. Total interest income of $17,401,066 in 2001 grew by $979,348 or 5.96% over total interest income of $16,421,718 in 2000. Total interest expense of $8,755,057 in 2001 reflected an increase of $753,156 or 9.41% over total interest expense of $8,001,901 in 2000. The increase in interest income resulted from an increase in loans despite a decline in interest rates. (Refer to Table D, "Analysis of Changes in Net Interest Income," for an analysis of the impact of volume and rate.) Due to a decline in market rates, the Bank experienced a lower interest margin. The cost of deposits dropped 25 basis points while the decline in interest income rates amounted to 41 basis points. (Refer to Table C, "Interest Rates Earned and Paid," for further analysis of interest rate activity.) Loans The Bank utilizes the following types of loans in servicing the trade area: Commercial (Time and Demand) 10.85% Consumer (Installment) 18.53% Real Estate (Construction) .53% Real Estate (Mortgage) 70.09% Page 17 of 87 These types of loans have traditionally provided the Bank with a steady source of quality interest-earning assets. The maturities of these loans range from commercial loans and real estate construction loans maturing in less than one year to installment and real estate credits that may exceed five years. With the exception of home equity loans, which are short-term in nature, mortgage loans, which represent 70.09% of the portfolio, are typically fifteen to twenty year payback loans with three to five year balloon options. By setting maturities of loans for a short-term, the Bank can effectively manage its asset/liability mix, as most deposit accounts mature in one year or less. Allowance for Loan Losses The 2001 year ending level of the allowance for loan losses amounted to $1,774,632. This amount represented an increase of $106,909 or 6.41% over the 2000 level of $1,667,723. Loans collateralized by real estate represented a majority of the loans. By obtaining a high degree of collateral, the Bank has avoided a portion of credit risk; however, the Bank constantly monitors its loan portfolio for credit weaknesses. As of the year end 2001, the Bank's allowance for loan losses represented 1.0% of gross loans. The Bank incurred net charge offs for loan losses for the year of $90,977. As a result of the low level of net charge offs, the current year provision was $3,301 lower when compared to the prior year. The year 2001 level represented a 1.64% decrease over the amount expended in 2000. Noninterest Income and Noninterest Expense Total noninterest income, i.e., fees charged for customer services, for 2001 was $1,043,388. This represents an increase of $36,750 or 3.65% over the 2000 level of $1,006,638. Gains were experienced in service charges on deposit accounts and other operating income as the Bank increased its customer base due to the growth of the new full-service branches. Total noninterest expense in 2001 of $5,599,837 reflects an increase of $531,005 or 10.48% over the 2000 level of $5,068,832. The increase resulted from normal increases in operations and salaries and benefits, as the Bank's three newest offices were in full operation throughout the year. Premises and Equipment The Bank's premises and equipment increased $1,100,702 during the year. The activity herein detailed includes a transfer of $55,848 from construction in progress. Increase in Capitalized Premises and Equipment Equipment, Leasehold Furniture, and Office/Area Land Building Improvements Fixtures Kenbridge $ - $ 2,911 $ - $ 45,097 Victoria - 2,017 - 41,192 Farmville #1 - - - 43,010 South Hill - - 2,735 42,278 Farmville #2 - 19,750 - 41,288 Crewe - - - 35,342 Lawrenceville - - - 39,860 Clarksville 45,312 320,673 - 134,627 Chase City - 191,180 - 149,278 ------- -------- ------ -------- Total $45,312 $536,531 $2,735 $571,972 ======= ======== ====== ======== Page 18 of 87 Securities Pursuant to guidelines established in FAS 115, the Bank has elected to classify a majority of its current portfolio as securities available-for-sale. This category refers to investments that are not actively traded but are not anticipated by management to be held-to-maturity. Typically, these types of investments will be utilized by management to meet short-term asset/liability management needs. For purposes of financial statement reporting, securities classified as available-for-sale are to be reported at fair market value as of the date of the statements; however, unrealized holding gains and losses are to be excluded from earnings and reported as a net amount in a separate component of stockholders' equity until realized. The impact of this unrealized loss on securities negatively impacted stockholders' equity in the amount of $148,811, therefore, affecting the book value of the Company's stock. The book value per share of the stock inclusive of the FAS 115 adjustment was $7.90, while the book value per share is $7.95 when reported exclusive of the FAS 115 impact. Off-Balance-Sheet Instruments/Credit Concentrations The Bank is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to facilitate the transaction of business between these parties where the exact financial amount of the transaction is unknown, but a limit can be projected. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. There is a fee charged for this service. As of December 31, 2001, the Bank had $914,814 in outstanding letters of credit. These instruments are based on the financial strength of the customer and the existing relationship between the Bank and the customer. At current year end, the Bank also had unused commitments resulting from credit line deeds of trust, home equity lines, and unfunded business loans. The total amount of these commitments amounted to $29,349,224. Concentrations The Bank has no concentrations of credit involving an individual borrower and his related interest. The Bank does have a concentration in loan type in that a majority of the loan portfolio is secured by noncommercial real estate. Due to the subjectivity of the real estate market to the condition of the economy and sensitivity to interest rate fluctuation, there is an inherent risk; however, the Bank has, as a matter of policy, a loan-to-collateral percentage that allows for a level of decline in collateral value without affecting the quality of the loan. Liquidity The Bank's funding requirements are supplied by a wide range of traditional banking sources, including various types of demand, money market, savings, certificates of deposit, and Federal funds purchased. Large certificates of deposit of $100,000 or more increased by $11,737,464 or 60.61% in 2001. These deposits currently represent 14.37% of the total deposit base. The Bank feels that the large certificates are more of a function of customer service than a competitive bid situation. The amount of these certificates of deposit maturing during 2002 is $20,531,603, while $10,569,972 matures between one and five years. Page 19 of 87 A GAP analysis is presented in Table L. This analysis reflects the difference between maturing and repricing of interest-earning assets and interest-bearing liabilities. A positive gap indicates more assets are maturing than liabilities. Conversely, a negative gap indicates more liabilities mature than assets during a given period. Assets classified as immediately maturing are those assets which can be repriced or converted to cash immediately upon demand. Liabilities classified as immediately maturing are those which can be withdrawn on demand except that the Bank has assigned a 90% retention rate on core deposits. The GAP analysis shows a net positive gap of $8,530 when immediately maturing interest-bearing liabilities are deducted from immediately maturing interest-earning assets. The cumulative gap changes to a negative gap of $27,049 when comparing assets and liabilities maturing up to one year; however, the cumulative gap shifts to a positive position of $38,084 for over five years. The deficit gap results from the customer preference for short-term liquidity in the current period of fluctuating rates, which affects not only deposits but also callable investments. The nature of the large gap deficit is an industry-wide situation that is typical of the banking industry where a bulk of the assets is financed by short-term deposits. To further compound the situation, Bank customers have shown a preference for longer terms on loans versus deposits as financial rates fluctuate. The Bank is satisfied that it can meet the liquidity needs by utilizing three to five year balloon notes for real estate financing and a one year maturity for commercial loans. This strategy, while not meeting exact liquidity needs on a dollar for dollar asset/liability mix, does provide a near match without sacrificing a positive interest rate spread. To compensate for the resultant mismatching of assets and liabilities, the Bank has invested in highly liquid investments. In the unlikely event of a liquidity hardship, these investments are available to be sold to fund assets currently being supported by deposit liabilities. The GAP model does not consider the impact of core deposit loyalty. Management feels that these core deposits along with the highly marketable securities available will provide sufficient reserves to fund any short-term loss of deposits. As mentioned previously, management has factored in an anticipated retention level for core deposits. Capital Resources and Adequacy In the past, the Company has blended internally generated retained earnings with capital stock sales to maintain a strong capital position necessary to support future growth. The Company began a capital buyback program during 1999. Through this program, the Company has repurchased 39,200 shares of stock amounting to $376,769 during the year of 2001. The Company continued to experience strong earnings through the operation of the Bank. Through earnings, the Company generated an additional $1,664,244 in capital. This activity, plus the sale of $22,140 common stock through the stock option plan, raised year end capital exclusive of unrealized security gains net of tax effect to a level of $23,625,972 or a 5.87% increase over the 2000 year ending level of $22,316,522. The primary capital to total assets ratio stands at 10.30% as of December 31, 2001. This amount is well above current industry standards. Refer to Item 14(d)(5) for additional capital ratio analysis. Due to the increase in earnings, subsequent earnings retention, and sale of common stock, the Company's capital position was strengthened and, as a result, the Company remains well capitalized for the banking industry even after initiating a stock buyback program. Pursuant to regulations of the Federal Reserve Board, the Company is required to maintain certain minimum levels of capital in its bank subsidiary. At December 31, 2001, the Bank maintained the following capital ratios: Total Risk-Based Capital Ratio 13.10% Tier I Risk-Based Capital Ratio 12.02% Tier I Leverage Ratio 08.33% Page 20 of 87 These ratios exceed the minimum ratios required by regulatory authorities for the Bank to be considered well capitalized. Inflationary Factors The Bank's earnings are greatly impacted by inflation and the actions of the Federal Reserve Board. The year 2001 was a period of falling interest rates as the Federal Reserve attempted to stimulate the economy by lowering the Federal discount window rate. The interest spread margin for the year was 3.93% versus a 4.18% margin spread for 2000. Refer to Table C. Lending and Funding Strategies The Bank relies on traditional sources of funding such as demand deposits, interest- bearing checking, money market deposit accounts, savings accounts, and certificates of deposit for funding its activities. These funds are subsequently loaned to the local community, with the exception of cash and prudent liquidity needs. Traditionally, the Bank has experienced a strong loan demand. At year end 2001, the loan-to-deposit ratio had fallen as the rate of deposit growth exceeded loan production. Page 21 of 87 TABLE A. COMPARATIVE SUMMARY OF EARNINGS Years Ending December 31, 2002 2001 2000 (In thousands of dollars, except per share data) Interest Income Interest and fees on loans $ 15,383 $ 15,611 $ 14,557 Interest on investment securities U. S. Government agencies and mortgage backed securities 806 721 980 State and political subdivisions 746 579 451 Other securities - 10 24 Interest on Federal funds sold 112 481 410 ------------- ------------- ------------- Total Interest Income 17,047 17,402 16,422 Interest Expense Interest-bearing checking deposits 430 626 768 Savings deposits 183 250 287 Time deposits 6,577 7,879 6,892 Federal funds purchased 10 - 54 Other - - 1 ------------- ------------- ------------- Total Interest Expense 7,200 8,755 8,002 ------------- ------------- ------------- Net Interest Income 9,847 8,647 8,420 Provision for Loan Losses 419 198 201 ------------- ------------- ------------- Net Interest Income After Provision for Loan Losses 9,428 8,449 8,219 Noninterest Income Service charges on deposit accounts 641 555 509 Other operating income 646 482 456 Net investment securities gains (losses) 9 2 (3) Gain (Loss) on sale of other assets 58 4 45 Dividends 41 - - ------------- ------------- ------------- Total Noninterest Income 1,395 1,043 1,007 Noninterest Expense Salaries 3,085 2,837 2,661 Employee benefits 866 652 600 Occupancy expense 338 327 297 Other operating expense 1,796 1,784 1,512 ------------- ------------- ------------- Total Noninterest Expense 6,085 5,600 5,070 ------------- ------------- ------------- Net Income Before Taxes 4,738 3,892 4,156 Provision for Income Tax 1,340 1,155 1,311 ------------- ------------- ------------- Net Income $ 3,398 $ 2,737 $ 2,845 ============= ============= ============= Per Share - Based on Weighted Average Net income $ 1.15 0.92 0.95 Average shares outstanding 2,967,443.297 2,970,003.060 3,008,522.578 Page 22 of 87 TABLE B. AVERAGE BALANCE SHEETS (In thousands of dollars) Years Ended December 31, 2002 2001 2000 ---- ---- ---- Amount % Amount % Amount % Assets Cash and due from banks $ 8,652 3.55 $ 6,491 2.92 $ 5,480 2.74 Investment securities 31,843 13.05 24,282 10.94 24,529 12.28 Federal funds sold 7,543 3.09 14,225 6.41 6,351 3.18 Loans (net) 186,078 76.28 169,434 76.31 156,089 78.13 Bank premises and equipment 4,319 1.77 3,981 1.79 3,673 1.84 Accrued interest 1,395 0.57 1,599 0.72 1,578 0.79 Cash value life insurance 1,972 0.81 - - - - Other assets 2,150 0.88 2,014 0.91 2,072 1.04 -------- ------ -------- ------ -------- ------ $243,952 100.00 $222,026 100.00 $199,772 100.00 ======== ====== ======== ====== ======== ====== Liabilities and Stockholders' Equity Deposits Demand $ 47,728 19.57 $ 44,599 20.09 $ 41,582 20.81 Savings and MMA 26,613 10.91 19,859 8.94 17,591 8.81 Time 145,881 59.80 136,054 61.28 119,671 59.90 Federal funds purchased 427 0.18 - - 867 0.43 Accrued interest 767 0.31 929 0.42 810 0.41 Other liabilities 546 0.22 485 0.22 150 0.08 Stockholders' equity 21,990 9.01 20,100 9.05 19,101 9.56 -------- ------ -------- ------ -------- ------ $243,952 100.00 $222,026 100.00 $199,772 100.00 ======== ====== ======== ====== ======== ====== Page 23 of 87 TABLE C. INTEREST RATES EARNED AND PAID (In thousands of dollars) 2002 2001 2000 ---- ---- ---- Average Yield/ Average Yield/ Average Yield/ Description Balance Interest Rate Balance Interest Rate Balance Interest Rate - ----------- ------- -------- ---- ------- -------- ---- ------- -------- ---- Interest-Earning Assets Investment securities $ 31,843 $ 1,552 4.87% $ 24,282 $ 1,309 5.39% $ 24,529 $ 1,455 5.93% Federal funds sold 7,543 112 1.48% 14,225 481 3.38% 6,351 410 6.46% Loans (1) (2) 187,950 15,383 8.18% 171,145 15,611 9.12% 157,671 14,557 9.23% -------- ------- -------- ------- -------- ------- $227,336 17,047 7.50% $209,652 17,401 8.30% $188,551 16,422 8.71% ======== ======== ======== Interest-Bearing Liabilities Deposits $192,655 7,190 3.73% $175,291 8,755 4.99% $157,028 7,948 5.06% Federal funds purchased 427 10 2.34% - - 0.00% 867 54 6.23% -------- ------- ----- -------- ------- ----- -------- ------- ----- Total Interest-Bearing Liabilities $193,082 7,200 3.73% $175,291 8,755 4.99% $157,895 8,002 5.07% ======== ------- ======== ------- ======== ------- Net interest income/yield (3) (4) $ 9,847 $ 8,646 $ 8,420 ======= ======= ======= Interest spread (5) 3.77% 3.31% 3.64% (1) Loans net of unearned income. (2) These figures do not reflect interest and fees to be collected on nonaccrual loans. To date, the impact of nonaccrual loans on the interest income earned has been minimal. Refer to Table G. (3) Net interest income is the difference between income from earning assets and interest expense. (4) Net interest yield is net interest income divided by total average earning assets. (5) Interest spread is the difference between the average interest rate received on earning assets and the average interest rate paid for interest-earning liabilities. Page 24 of 87 TABLE D. ANALYSIS OF CHANGE IN NET INTEREST INCOME (In thousands of dollars) Year 2002 over 2001 Year 2001 over 2000 Increase (Decrease) Total Increase (Decrease) Total Due to Change In: Increase Due to Change In: Increase Volume Rate (Decrease) Volume Rate (Decrease) Increase (Decrease) in Investment securities $ 369 $ (126) $ 243 $ 50 $(197) $ (147) Federal funds sold (226) (143) (369) 510 (438) 72 Loans 157 (385) (228) 1,240 (186) 1,054 -------- ------- ------- ------- ------ ------- Total 300 (654) (354) 1,800 (821) 979 Interest Expense Deposit accounts 1,343 (2,908) (1,565) 1,108 (301) 807 Federal funds purchased 10 - 10 (54) - (54) -------- ------- ------- ------- ------ ------- Total 1,353 (2,908) (1,555) 1,054 (301) 753 -------- ------- ------- ------- ------ ------- Increase (Decrease) in Net Interest Income $(1,053) $2,254 $1,201 $ 746 $(520) $ 226 ======== ======= ======= ======= ====== ======= Year 2000 over 1999 Increase (Decrease) Total Due to Change In: Increase Volume Rate (Decrease) Increase (Decrease) in Investment securities $ (185) $ 87 $ (98) Federal funds sold (78) 124 46 Loans 1,298 50 1,348 -------- ------- ------- Total 1,035 261 1,296 Interest Expense Deposit accounts 242 370 612 Federal funds purchased 3 10 13 -------- ------- ------- Total 245 380 625 -------- ------- ------- Increase (Decrease) in Net Interest Income $ 790 $ (119) $ 671 ======== ======= ======= Page 25 of 87 TABLE E. INVESTMENT SECURITIES The carrying amount and approximate market values of investment securities are summarized below: Book Unrealized Unrealized Market Value Gains Losses Value Available-for-Sale December 31, 2002 Mortgage backed securities $10,849,727 $ 363,783 $ - $11,213,510 State and political subdivisions 14,858,319 699,318 - 15,557,637 Other securities 195,490 - - 195,490 ----------- ---------- -------- ----------- $25,903,536 $1,063,101 $ - $26,966,637 =========== ========== ======== =========== December 31, 2001 U. S. Government agencies $ 497,917 $ 3,682 $ - $ 501,599 Mortgage backed securities 17,513,927 29,082 213,314 17,329,695 State and political subdivisions 17,049,625 116,902 161,826 17,004,701 Other securities 195,490 - - 195,490 ----------- ---------- -------- ----------- $35,256,959 $ 149,666 $375,140 $35,031,485 =========== ========== ======== =========== Held-to-Maturity December 31, 2002 Mortgage backed securities $ - $ - $ - $ - State and political subdivisions 511,809 17,497 - 529,306 ----------- ---------- -------- ----------- $ 511,809 $ 17,497 $ - $ 529,306 =========== ========== ======== =========== December 31, 2001 U. S. Government agencies $ 1,000,000 $ 900 $ - $ 1,000,900 State and political subdivisions 513,266 9,341 - 522,607 ----------- ---------- -------- ----------- $ 1,513,266 $ 10,241 $ - $ 1,523,507 =========== ========== ======== =========== The maturities of investment securities at December 31, 2002 were as follows: Book Value Market Value Available-for-Sale Due in one year or less $ 1,265,289 $ 1,281,024 Due from one to five years 8,960,758 9,236,404 Due from five to ten years 13,076,683 13,749,587 After ten years 2,405,316 2,504,132 Other securities 195,490 195,490 Held-to-Maturity Due from one to five years 511,809 529,306 Securities having a market value of $8,994,013 and $5,736,895 at December 31, 2002 and 2001, respectively, were pledged to secure public deposits and for other purposes. In the event of the sale of securities, the cost basis of the security, adjusted for the amortization of premium or discounts, will be used when calculating gains or losses. Page 26 of 87 The maturity distribution, book value, and approximate tax equivalent yield (assuming a 34% Federal income tax rate) of the investment securities portfolio at December 31, 2002 is presented in the following table (in thousands of dollars): Maturity After One but After Five but Within One Year Within Five Within Ten After Ten Amount Yield(2) Amount Yield(2) Amount Yield(2) Amount Yield(2) Mortgage Backed Securities $ - 0.000% $ 442 5.630% $10,408 5.450% $ - 0.000% State and Political Subdivisions - 0.000% 2,301 6.580% 9,139 6.367% 3,930 6.577% Other - 0.000% - 0.000% - 0.000% - 0.000% -------- ------ ------- ------ Total(1) $ - 0.000% $2,743 0.000% $19,547 0.000% $3,930 0.000% ======== ====== ======= ====== (1) Values stated at book value, exclusive of other securities, which include Federal Reserve Bank stock, Community Bankers' Bank stock, and Bankers' Title, which amount to $195,490 at year end 2002. (2) The yield is the weighted average Federal Tax Equivalent yield on cost. Page 27 of 87 TABLE F. LOAN PORTFOLIO The table below classifies gross loans by major category and percentage distribution at December 31 for 2002, 2001, and 2000: 2002 2001 2000 Amount % Amount % Amount % Commercial $ 21,872,278 11.03 $ 19,293,070 10.85 $ 19,810,083 12.03 Installment 29,903,542 15.08 32,954,231 18.53 27,509,990 16.70 Real Estate - Construction 1,619,807 0.82 947,775 0.53 1,211,625 0.74 Real Estate - Mortgage 144,860,038 73.07 124,657,873 70.09 116,185,571 70.53 The following table shows maturities of the major loan categories and their sensitivity to changes in investment rates at December 31, 2002 for fixed interest rate and floating interest rate loans: Due After One Year One Year but Within Due After or Less Five Years Five Years Fixed Rate Fixed Rate Fixed Rate Total Commercial $19,980,563 $ 1,031,196 $ - $ 21,011,759 Installment 2,703,565 26,381,740 765,111 29,850,416 Real Estate - Construction 1,619,807 - - 1,619,807 Real Estate - Mortgage 28,840,350 95,020,192 14,398,859 138,259,401 ----------- ------------ ----------- ------------ Total $53,144,285 $122,433,128 $15,163,970 $190,741,383 =========== ============ =========== ============ Over One Year but One Year Within Five Over or Less Years Five Years Floating Rate Floating Rate Floating Rate Total Commercial $ 765,105 $ 95,414 $ - $ 860,519 Installment 15,932 37,194 - 53,126 Real Estate - Mortgage 5,476,853 1,123,784 - 6,600,637 ----------- ------------ ----------- ------------ Total $ 6,257,890 $ 1,256,392 $ - $ 7,514,282 =========== ============ =========== ============ Page 28 of 87 TABLE G. NONPERFORMING LOANS The loan portfolio of the Bank is reviewed by senior officers to evaluate loan performance. The frequency of the review is based on predefined guidelines approved by the Board of Directors that include individual review of certain loans by the Loan Committee and the Board if certain past due or nonperformance criteria are met. The areas of criteria include in part net worth, credit history, and customer relationship. The evaluations emphasize different factors depending upon the type of loan involved. Commercial and real estate loans are reviewed on the basis of estimated net realizable value through an evaluation of collateral and the financial strength of the borrower. Installment loans are evaluated largely on the basis of delinquency data because of the large number of such loans and relatively small size of each individual loan. Management's review of commercial and other loans may result in a determination that a loan should be placed on a nonaccrual basis. Nonaccrual loans consist of loans which are both contractually past due 90 days or more and are not considered fully secured or in the process of liquidation. It is the policy of the Bank to discontinue the accrual of interest of any loan on which full collection of principal and/or interest is doubtful. Subsequent collection of interest is recognized as income on a cash basis upon receipt. Placing a loan on nonaccrual status for the purpose of income recognition is not in itself a reliable indication of potential loss of principal. Other factors, such as the value of the collateral securing the loan and the financial condition of the borrower, serve as more reliable indications of potential loss of principal. Nonperforming loans consist of loans accounted for on a nonaccrual basis and loans which are contractually past due 90 days or more as to interest and/or principal payments regardless of the amount of collateral held. The following table presents information concerning nonperforming loans for the periods indicated: December 31, 2002 2001 2000 ---- ---- ---- (In thousands of dollars) Commercial Nonaccrual $ - $ - $ - Contractually past due 90 days or more - 18 6 Installment Nonaccrual - 74 22 Contractually past due 90 days or more 53 - 40 Real Estate Nonaccrual 1,048 604 393 Contractually past due 90 days or more 97 273 989 ------ ----- ------ $1,198 $ 969 $1,450 ====== ===== ====== Nonperforming loans to gross loans at year end 0.60% 0.54% 0.92% Effect of nonaccrual loans on interest revenue $ 9 $ 34 $ 37 Page 29 of 87 TABLE H. SUMMARY OF LOAN LOSS EXPERIENCE Loan losses have not been a significant negative factor for the Bank. The following table presents the Bank's loan loss experience and selected loan ratios for the three years ended December 31, 2002, 2001, and 2000: 2002 2001 2000 ---- ---- ---- (In thousands of dollars) Allowance for loan losses at beginning of year $ 1,775 $ 1,668 $ 1,523 Loan Charge Offs Commercial - (1) (35) Installment (192) (242) (181) Real Estate (82) (9) (60) --------- --------- --------- Total Charge Offs (274) (252) (276) Recoveries of Loans Previously Charged Off Commercial - - 107 Installment 63 118 100 Real Estate - 43 13 --------- --------- --------- Total Recoveries 63 161 220 --------- --------- --------- Net loans charged off (211) (91) (56) Provision for loan losses 418 198 201 --------- --------- --------- Allowance for loan losses at end of year $ 1,982 $ 1,775 $ 1,668 ========= ========= ========= Average total loans (net of unearned income) $187,950 $171,149 $157,671 Total loans (net of unearned income) at year end 198,255 177,852 164,706 Selected Loan Loss Ratios Net charge offs to average loans 0.11% 0.05% 0.04% Provision for loan losses to average loans 0.22% 0.12% 0.13% Provision for loan losses to net charge offs % 198.10% 217.58% 358.93% Allowance for loan losses to year end loans 1.00% 1.00% 1.01% Loan loss coverage(1) 24.44X 44.95X 77.81X (1) Income before income taxes plus provision for loan losses, divided by net charge offs. Page 30 of 87 TABLE I. COMPOSITION OF ALLOWANCE FOR LOAN LOSSES (In thousands of dollars) 2002 2001 2000 ---- ---- ---- Percentage Percentage Percentage Allowance Breakdown of Loans Allowance Breakdown of Loans Allowance Breakdown of Loans Amount % Outstanding Amount % Outstanding Amount % Outstanding ------ - ----------- ------ - ----------- ------ - ----------- Commercial $ 99 4.99 11.03 90 5.00 10.85 215 12.89 12.03 Installment 693 34.96 15.08 990 55.00 18.53 689 41.31 16.70 Real Estate - Construction - - 0.82 - - 0.53 - - 0.74 Real Estate - Mortgage 1,190 60.05 73.07 720 40.00 70.09 764 45.80 70.53 ------ ------ ------ ------ ------ ------ ------ ------ ------ Total $1,982 100.00 100.00 $1,800 100.00 100.00 $1,668 100.00 100.00 ====== ====== ====== ====== ====== ====== ====== ====== ====== Page 31 of 87 TABLE J. DEPOSITS The breakdown on average deposits for the years indicated is as follows (in thousands of dollars): 2002 2001 2000 ---- ---- ---- Average Average Average Balance Rate Balance Rate Balance Rate Noninterest-bearing demand deposits $ 27,567 - $ 25,221 - $ 21,816 - Interest-bearing demand deposits 20,161 0.90 19,378 1.80 19,766 2.59 Money market accounts 13,794 1.74 9,543 2.97 7,544 3.38 Savings 12,819 1.44 10,316 2.43 10,047 2.85 Time 145,881 4.51 136,054 5.83 119,671 5.77 -------- -------- -------- $220,222 $200,512 $178,844 ======== ======== ======== Remaining maturities of time certificates of deposit of $100,000 or more at December 31, 2002 are shown below (in thousands of dollars): Maturity December 31, 2002 Three months or less $ 4,421 Three to six months 7,162 Six to twelve months 9,936 One to three years 8,478 Three to five years 7,332 ------- Total $37,329 ======= Page 32 of 87 TABLE K. RETURN ON EQUITY AND ASSETS The following table highlights certain ratios for the three years ended December 31, 2002, 2001, and 2000 (in thousands of dollars): 2002 2001 2000 ---- ---- ---- Income before securities gains and losses to Average total assets 1.39% 1.23% 1.43% Average stockholders' equity 15.45% 13.60% 14.91% Net income to Average total assets 1.39% 1.23% 1.42% Average stockholders' equity 15.45% 13.61% 14.91% Dividend pay out ratio (dividends declared per share divided by net income per share) 33.04% 39.13% 35.93% Average stockholders' equity to average total assets ratio 9.01% 9.05% 9.56% Page 33 of 87 TABLE L. GAP Analysis December 31, 2002 The following table reflects interest-rate sensitive assets and liabilities only. The following table sets forth at December 31, 2002 interest-earning assets and interest-bearing liabilities scheduled to mature or reprice within a specific period (in thousands of dollars): Scheduled Maturity or Repricing Immediately 3 Months Adjusted or Less 3-12 Months 1-3 Years 3-5 Years Over 5 Years Total -------- ------- ----------- --------- --------- ------------ ----- Gross loans $ 39 $23,346 $ 36,056 $43,227 $80,462 $15,049 $198,179 Investment securities (1) - - - 640 2,103 24,540 27,283 Federal funds sold 17,255 - - - - - 17,255 ------- ------- --------- -------- -------- ------- -------- Total Interest-Earning Assets $17,294 $23,346 $ 36,056 $43,867 $82,565 $39,589 $242,717 ======= ======= ========= ======== ======== ======== ======== Interest-Bearing Liabilities Interest-bearing demand deposits(2) $ 2,326 $ - $ - $ - $20,932 $ - $ 23,258 Money market deposits(2) 1,739 - - - 15,655 - 17,394 Savings(2) 1,335 - - - 12,013 - 13,348 Time deposits - 20,212 66,382 41,438 28,139 - 156,171 ------- ------- -------- -------- -------- ------- -------- Total Interest-Bearing Deposits $ 5,400 $20,212 $ 66,382 $41,438 $76,739 $ - $210,171 ======= ======= ======== ======== ======== ======= ======== Difference Between Interest-Earning Assets and Interest-Bearing Liabilities Period (GAP) $11,894 $ 3,134 $(30,326) $ 2,429 $ 5,826 $39,589 $ 32,546 Cumulative (GAP) 11,894 15,028 (15,298) (12,869) (7,043) 32,546 Cumulative interest-earning assets to interest-bearing liabilities 320.26% 158.68% 83.37% 90.36% 96.65% 115.49% (1) Does not include $87,000 in Federal Reserve stock, $50,000 in Community Bankers' Bank stock, and $58,000 in Bankers' Title. (2) Assumes core deposits will retain 90% up to five years. Page 34 of 87 ITEM 7A QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Refer to Footnote 18 in the annual financial statements included in this document on page 57. ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Management's Report on Financial Statements Independent Auditor's Report Financial Statements Consolidated Statements of Financial Condition - December 31, 2002 and 2001 Consolidated Statements of Income - Years Ended December 31, 2002, 2001, and 2000 Consolidated Statements of Changes in Stockholders' Equity - Years Ended December 31, 2002 and 2001 Consolidated Statements of Cash Flows - Years Ended December 31, 2002, 2001, and 2000 Notes to Consolidated Financial Statements - December 31, 2002, 2001, and 2000 Page 35 of 87 Management's Report on Financial Statements The following consolidated financial statements and related notes of Benchmark Bankshares, Inc. and its subsidiary, Benchmark Community Bank, were prepared by management which has the primary responsibility for the integrity of the financial information. The statements have been prepared in conformity with accounting principles generally accepted in the United States of America appropriate in the circumstances and include amounts that are based on management's best estimates and judgments. Financial information elsewhere in the Annual Report is presented on a basis consistent with that in the financial statements. In meeting its responsibility for the accuracy of the financial statements, management relies on the Company's internal accounting controls. This system provides reasonable assurance that assets are safeguarded and transactions are recorded to permit the preparation of appropriate financial information. The financial statements have been audited by Creedle, Jones, and Alga, P. C., the Company's independent certified public accountants. Their audit is conducted in accordance with auditing standards generally accepted in the United States of America and includes a review of internal controls and a test of transactions in sufficient detail to allow them to report on the fair presentation of the consolidated operating results and financing condition of Benchmark Bankshares, Inc. and its subsidiary, Benchmark Community Bank. Page 36 of 87 Benchmark Bankshares, Inc. Report on Audit of Financial Statements Page 37 of 87 Benchmark Bankshares, Inc. Table of Contents Pages Independent Auditor's Report 38 Exhibits A Consolidated Statements of Financial Condition 39-40 B Consolidated Statements of Income 41-42 C Consolidated Statements of Changes in Stockholders' Equity 43 D Consolidated Statements of Cash Flows 44-45 Notes to Consolidated Financial Statements 46-62 Page 38 of 87 Independent Auditor's Report Board of Directors Benchmark Bankshares, Inc. Kenbridge, Virginia We have audited the accompanying consolidated statements of financial condition of Benchmark Bankshares, Inc. (a Virginia corporation) and Subsidiary, as of December 31, 2002 and 2001, and the related consolidated statements of income, changes in stockholders' equity, and cash flows for each of the three years then ended. 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 auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Benchmark Bankshares, Inc. and Subsidiary, as of December 31, 2002 and 2001, and the consolidated results of their operations and their cash flows for each of the three years then ended, in conformity with accounting principles generally accepted in the United States of America. Creedle, Jones, and Alga, P. C. Certified Public Accountants South Hill, Virginia January 20, 2003 Page 39 of 87 Exhibit A Page 1 Benchmark Bankshares, Inc. Consolidated Statements of Financial Condition December 31, 2002 and 2001 A S S E T S 2002 2001 ---- ---- Cash and due from banks $ 13,340,576 $ 8,215,994 Federal funds sold 17,255,000 12,740,000 Investment securities 27,478,446 36,544,751 Loans 198,255,665 177,852,949 Less Unearned interest income - (970) Allowance for loan losses (1,982,559) (1,774,632) ------------- ------------- Net Loans 196,273,106 176,077,347 Premises and equipment - net 4,285,102 4,283,656 Accrued interest receivable 1,292,070 1,425,945 Deferred income taxes 195,611 560,315 Other real estate 502,734 1,156,464 Cash value life insurance 3,632,755 - Other assets 802,744 808,517 ------------- ------------- Total Assets $265,058,144 $241,812,989 ============= ============= Page 40 of 87 Exhibit A Page 2 Benchmark Bankshares, Inc. Consolidated Statements of Financial Condition December 31, 2002 and 2001 Liabilities and Stockholders' Equity 2002 2001 ---- ---- Deposits Demand (noninterest-bearing) $ 26,372,882 $ 27,504,768 NOW accounts 23,258,069 20,304,603 Money market accounts 17,394,138 10,939,010 Savings 13,347,995 11,160,289 Time, $100,000 and over 37,329,668 31,101,575 Other time 118,841,688 115,350,866 ------------ ------------- Total Deposits 236,544,440 216,361,111 Accrued interest payable 803,167 1,002,261 Accrued income tax payable 32,516 39,405 Dividends payable 593,088 534,600 Other liabilities 539,026 398,451 ------------ ------------- Total Liabilities 238,512,237 218,335,828 Stockholders' Equity Common stock, par value $.21 per share, authorized 4,000,000 shares; issued and outstanding 12-31-02 2,967,443.301, issued and outstanding 12-31-01 2,970,003.06 shares 623,164 623,701 Capital surplus 4,005,238 4,056,859 Retained earnings 21,215,858 18,945,412 Unrealized security gains net of tax effect 701,647 (148,811) ------------ ------------- Total Stockholders' Equity 26,545,907 23,477,161 ------------ ------------- Total Liabilities and Stockholders' Equity $265,058,144 $241,812,989 ============ ============= See independent auditor's report and accompanying notes to financial statements. Page 41 of 87 Exhibit B Page 1 Benchmark Bankshares, Inc. Consolidated Statements of Income Years Ended December 31, 2002, 2001, and 2000 2002 2001 2000 ---- ---- ---- Interest Income Interest and fees on loans $15,383,312 $15,610,703 $14,556,973 Interest on investment securities U. S. Government agencies and mortgage backed securities 806,026 720,685 980,155 State and political subdivisions 745,723 578,611 451,320 Other securities - 9,674 23,537 Interest on Federal funds sold 111,490 481,393 409,733 ----------- ----------- ------------ Total Interest Income 17,046,551 17,401,066 16,421,718 Interest Expense Interest-bearing checking deposits 429,474 625,880 768,009 Savings deposits 183,290 250,242 286,908 Time deposits 6,577,285 7,878,935 6,892,050 Federal funds purchased 10,351 - 54,283 Other - - 651 ----------- ----------- ------------ Total Interest Expense 7,200,400 8,755,057 8,001,901 ----------- ----------- ------------ Net Interest Income 9,846,151 8,646,009 8,419,817 Provision for Loan Losses 418,582 197,886 201,187 ----------- ----------- ------------ Net Interest Income After Provision for Loan Losses 9,427,569 8,448,123 8,218,630 Other Income Service charges on deposit accounts 641,399 555,495 508,704 Other operating income 646,362 481,636 455,775 Net investment securities gains (losses) 8,879 2,434 (3,308) Gain on sale of other assets 58,272 3,823 45,467 Dividends 40,417 - - ----------- ----------- ------------ Total Other Income 1,395,329 1,043,388 1,006,638 Other Expenses Salaries 3,085,290 2,837,297 2,660,892 Employee benefits 865,803 651,720 599,515 Occupancy expense 337,523 327,230 296,888 Other operating expenses 1,796,363 1,783,590 1,511,537 ----------- ----------- ------------ Total Other Expenses 6,084,979 5,599,837 5,068,832 ----------- ----------- ------------ Income Before Income Taxes 4,737,919 3,891,674 4,156,436 Provision for Income Taxes 1,339,879 1,155,906 1,311,375 ----------- ----------- ------------ Net Income $ 3,398,040 $ 2,735,768 $ 2,845,061 =========== =========== ============ Page 42 of 87 Exhibit B Page 2 2002 2001 2000 ---- ---- ---- Earnings Per Share of Common Stock $ 1.15 $ 0.92 $ 0.95 ============= ============= ============= Average Shares Outstanding 2,967,443.297 2,982,679.694 3,008,522.578 ============= ============= ============= See independent auditor's report and accompanying notes to financial statements. Page 43 of 87 Exhibit C Benchmark Bankshares, Inc. Consolidated Statements of Changes in Stockholders' Equity Years Ended December 31, 2002 and 2001 Unrealized Securities Common Retained Gain Shares Stock Surplus Earnings (Loss)(1) Total Balance January 1, 2001 3,006,219.501 $631,307 $4,404,047 $17,281,168 $(131,331) $22,185,191 Net Income Parent 2,735,768 2,735,768 Equity in income of subsidiary - - Sale of Stock 3,000.000 630 21,510 22,140 Redemption of Stock (16.441) (4) (161) (165) Stock repurchase (39,200.000) (8,232) (368,537) (376,769) Semi-Annual Cash Dividend Declared June 21, 2001, $.18 per share (536,528) (536,528) December 20, 2001, $.18 per share (534,600) (534,600) Adjustments (396) (396) Other Comprehensive Income (Net of Tax) Unrealized Security Gains (Losses) (17,480) (17,480) -------------- --------- ----------- ------------ ---------- ------------ Balance December 31, 2001 2,970,003.060 623,701 4,056,859 18,945,412 (148,811) 23,477,161 Net Income Parent (25,897) (25,897) Equity in income of subsidiary 3,423,937 3,423,937 Sale of Stock 11,450.000 2,405 87,045 89,450 Redemption of Stock (9.759) (2) (106) (108) Stock repurchase (14,000.000) (2,940) (138,560) (141,500) Semi-Annual Cash Dividend Declared June 20, 2002, $.18 per share (532,988) (532,988) December 19, 2002, $.20 per share (593,088) (593,088) Adjustments (1,518) (1,518) Other Comprehensive Income (Net of Tax) Unrealized Security Gains (Losses) 850,458 850,458 -------------- --------- ----------- ------------ ---------- ------------ Balance December 31, 2002 2,967,443.301 $623,164 $4,005,238 $21,215,858 $ 701,647 $26,545,907 ============== ========= =========== ============ ========== ============ (1) Net of tax effect. See independent auditor's report and accompanying notes to financial statements. Page 44 of 87 Exhibit D Page 1 Benchmark Bankshares, Inc. Consolidated Statements of Cash Flows Years Ended December 31, 2002, 2001, and 2000 2002 2001 2000 ---- ---- ---- Cash Flows from Operating Activities Interest received $16,258,101 $17,553,659 $15,400,186 Fees and commissions received 2,610,393 1,028,469 833,005 Interest paid (7,399,494) (8,746,489) (7,997,952) Cash paid to suppliers and employees (6,084,979) (5,383,602) (3,813,312) Income taxes paid (1,378,385) (1,178,176) (1,381,930) ------------ ------------ ------------ Net Cash Provided by Operating Activities 4,005,636 3,273,861 3,039,997 Cash Flows from Investing Activities Proceeds from sale of investment securities available-for-sale 4,542,862 200,719 4,958,619 Proceeds from maturity or calls of investments 6,063,889 13,435,348 105,000 Purchase of investment securities (509,913) (25,667,579) (1,235,466) Loans originated (98,624,431) (90,687,195) (92,018,273) Principal collected on loans 78,221,715 77,541,503 79,574,713 Purchase premises and equipment (455,579) (1,100,702) (795,249) Cash value life insurance (3,632,755) - - ------------ ------------ ------------ Net Cash (Used) by Investing Activities (14,394,212) (26,277,906) (9,410,656) Cash Flows from Financing Activities Net increase (decrease) in Federal funds purchased - - (7,035,000) Net increase in demand deposits and savings accounts 10,464,414 10,468,711 5,510,983 Payments for maturing certificates of deposit (57,686,984) (34,598,237) (50,604,717) Proceeds from sales of certificates of deposit 67,405,899 59,293,820 61,550,011 Dividends paid (1,067,588) (1,078,044) (963,489) Proceeds from sale of common stock 89,450 22,140 55,985 Payments to reacquire stock (141,608) (376,934) (155,410) Proceeds from sale of other assets 964,575 359,846 347,753 ------------ ------------ ------------ Net Cash Provided by Financing Activities 20,028,158 34,091,302 8,706,116 ------------ ------------ ------------ Net Increase (Decrease) in Cash and Cash Equivalents 9,639,582 11,087,257 2,335,457 Cash and Cash Equivalents - Beginning of Year 20,955,994 9,868,737 7,533,280 ------------ ------------ ------------ Cash and Cash Equivalents - End of Year $30,595,576 $20,955,994 $ 9,868,737 ============ ============ ============ Page 45 of 87 Exhibit D Page 2 2002 2001 2000 ---- ---- ---- Reconciliation of Net Income to Net Cash Provided by Operating Activities Net income $ 3,398,040 $ 2,735,768 $ 2,845,061 Adjustments to reconcile net income to net cash provided by operating activities Depreciation 440,854 346,621 288,909 Provision for probable credit losses and recoveries 481,711 358,977 145,091 (Increase) Decrease in Interest receivable 133,875 152,593 (188,528) Other real estate (249,647) (347,956) (140,700) Other assets 5,773 (14,919) (118,928) Deferred taxes exclusive of unrealized security gains (losses) (72,411) (61,675) (58,991) Increase (Decrease) in Interest payable (199,094) 18,102 217,195 Taxes payable (6,889) 27,964 (11,564) Other liabilities 140,575 64,643 104,611 (Gain) Loss on sale of securities (8,879) (2,434) 3,308 (Gain) Loss on sale of other assets (58,272) (3,823) (45,467) ------------ ------------ ------------ Net Cash Provided by Operating Activities $ 4,005,636 $ 3,273,861 $ 3,039,997 ============= ============ ============ For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, and Federal funds sold. Generally, Federal funds sold are purchased and sold for one day periods. During 2002 net gains of $1,727 and during 2001 net gains of $1,855 in securities available-for-sale resulted from sales of mortgage backed securities that had experienced significant paydowns. There was no capitalized interest during the year. See independent auditor's report and accompanying notes to financial statements. Page 46 of 87 Benchmark Bankshares, Inc. Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001, and 2000 1. Significant Accounting Policies and Practices The accounting policies and practices of Benchmark Bankshares, Inc. conform to generally accepted accounting principles and general practice within the banking industry. Certain of the more significant policies and practices follow: (a) Consolidated Financial Statements. The consolidated financial statements of Benchmark Bankshares, Inc. and its wholly-owned subsidiary, Benchmark Community Bank, include the accounts of both companies. All material inter-company balances and transactions have been eliminated in consolidation. (b) Use of Estimates in Preparation of Financial Statements. The preparation of the accompanying combined financial statements in conformity with generally accepted accounting principles requires management to make certain estimates and assumptions that directly affect the results of reported assets, liabilities, revenue, and expenses. Actual results may differ from these estimates. (c) Cash and Cash Equivalents. The term cash as used in the Condensed Consolidated Statement of Cash Flows refers to all cash and cash equivalent investments. For purposes of the statement, Federal funds sold, which have a one day maturity, are classified as cash equivalents. (d) Investment Securities. Pursuant to guidelines established in FAS 115, Accounting for Certain Investments in Debt and Equity Securities, the Company has elected to classify a majority of its current portfolio as securities available-for-sale. This category refers to investments that are not actively traded but are not anticipated by management to be held-to-maturity. Typically, these types of investments will be utilized by management to meet short-term asset/liability management needs. For purposes of financial statement reporting, securities classified as available-for-sale are to be reported at fair market value as of the date of the statements; however, unrealized holding gains or losses are to be excluded from earnings and reported as a net amount in a separate component of stockholders' equity until realized. The impact of this unrealized gain on securities positively impacted stockholders' equity in the amount of $701,647 as of December 31, 2002. Premiums and discounts are amortized or accreted over the life of the related security as an adjustment to yield using methods that approximate the interest method. (e) Loans. Interest on loans is computed by methods which generally result in level rates of return on principal amounts outstanding (simple interest). In December, 1986, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases. This statement requires loan origination and commitment fees and certain direct loan origination costs to be deferred and the net amount amortized as an adjustment of the related loan's yield. This standard has been adopted for all loan types with an original maturity greater than one year. Page 47 of 87 (f) Allowance for Loan Losses. The allowance for loan losses is increased by provisions charged to expense and decreased by loan losses net of recoveries. The provision for loan losses is based on the Bank's loan loss experience and management's detailed review of the loan portfolio which considers economic conditions, prior loan loss experience, and other factors affecting the collectibility of loans. With the exception of loans secured by 1-4 family residential property, accrual of interest is discontinued on loans past due 90 days or more when collateral is inadequate to cover principal and interest or immediately if management believes, after considering economic and business conditions and collection efforts, that the borrower's financial condition is such that collection is doubtful. (g) Premises and Equipment. Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed generally by the straight-line method over the estimated useful lives of the assets. Additions to premises and equipment and major betterments and replacements are added to the accounts at cost. Maintenance, repairs, and minor replacements are expensed as incurred. Gains and losses on dispositions are reflected in current earnings. (h) Other Real Estate. As a normal course of business, the Bank periodically has to foreclose on property used as collateral on nonperforming loans. The assets are recorded at cost plus capital improvement cost. (i) Depreciation. For financial reporting, property and equipment are depreciated using the straight-line method; for income tax reporting, depreciation is computed using statutory accelerated methods. Leasehold improvements are amortized on the straight-line method over the estimated useful lives of the improvements. Income taxes in the accompanying financial statements reflect the depreciation method used for financial reporting and, accordingly, include a provision for the deferred income tax effect of depreciation which will be recognized in different periods for income tax reporting. (j) Earnings Per Share. Earnings per share of common stock are calculated on the basis of the weighted average number of shares outstanding during the period. (k) Income Taxes. Deferred income taxes are reported for temporary differences between items of income or expense reported in the financial statements and those reported for income tax purposes. Deferred taxes also reflect the impact of the unrealized security losses which are reflected on the balance sheet only, pursuant to FAS 115 guidelines. The differences relate principally to the provision for loan losses, depreciation, and unrealized security losses. The table below reflects the components of the Net Deferred Tax Asset account as of December 31, 2002: Deferred tax assets resulting from loan loss reserves $577,960 Deferred tax asset resulting from deferred compensation 127,874 Deferred tax liability resulting from unrealized security gains (361,454) Deferred tax liabilities resulting from depreciation (167,362) Deferred tax asset resulting from insurance investment 18,593 --------- Net Deferred Tax Asset $195,611 ========= Page 48 of 87 2. Investment Securities The carrying amount and approximate market values of investment securities are summarized below: Book Unrealized Unrealized Market Value Gains Losses Value Available-for-Sale December 31, 2002 Mortgage backed securities $10,849,727 $ 363,783 $ - $11,213,510 State and political subdivisions 14,858,319 699,318 - 15,557,637 Other securities 195,490 - - 195,490 ----------- ---------- -------- ----------- $25,903,536 $1,063,101 $ - $26,966,637 =========== ========== ======== =========== December 31, 2001 U. S. Government agencies $ 497,917 $ 3,682 $ - $ 501,599 Mortgage backed securities 17,513,927 29,082 213,314 17,329,695 State and political subdivisions 17,049,625 116,902 161,826 17,004,701 Other securities 195,490 - - 195,490 ----------- ---------- -------- ----------- $35,256,959 $ 149,666 $375,140 $35,031,485 =========== ========== ======== =========== Held-to-Maturity December 31, 2002 Mortgage backed securities $ - $ - $ - $ - State and political subdivisions 511,809 17,497 - 529,306 ----------- ---------- -------- ----------- $ 511,809 17,497 $ $ 529,306 =========== ========== ======== =========== December 31, 2001 U. S. Government agencies $ 1,000,000 $ 900 $ - $ 1,000,900 State and political subdivisions 513,266 9,341 - 522,607 ----------- ---------- -------- ----------- $ 1,513,266 $ 10,241 $ - $ 1,523,507 =========== ========== ======== =========== The maturities of investment securities at December 31, 2002 were as follows: Book Value Market Value Available-for-Sale Due in one year or less $ 1,265,289 $ 1,281,024 Due from one to five years 8,960,758 9,236,404 Due from five to ten years 13,076,683 13,749,587 After ten years 2,405,316 2,504,132 Other securities 195,490 195,490 Held-to-Maturity Due from one to five years 511,809 529,306 Securities having a market value of $8,994,013 and $5,736,895 at December 31, 2002 and 2001, respectively, were pledged to secure public deposits and for other purposes. In the event of the sale of securities, the cost basis of the security, adjusted for the amortization of premium or discounts, will be used when calculating gains or losses. Page 49 of 87 Other securities consist of required investments in Federal Reserve Bank stock, a regional bankers' bank stock, and a title opinion company. All of these investments are booked at cost. These investments are recorded at original cost. 3. Loans A summary of loans net of participation-out activity by type follows: 2002 2001 ---- ---- Commercial $ 21,872,278 $ 19,293,070 Consumer 29,903,542 32,954,231 Real estate 146,479,845 125,605,648 ------------ ------------ $198,255,665 $177,852,949 Demand deposit overdrafts amounting to $25,786 have been reclassified as short-term loans for reporting purposes. 4. Allowance for Loan Losses An analysis of the transactions in the allowance for loan losses follows: 2002 2001 2000 ---- ---- ---- Balance - Beginning of Year $1,774,632 $1,667,723 $1,522,632 Provision for loan losses 418,582 197,886 201,187 Recoveries on loans 63,129 161,091 219,806 Loans charged off (273,784) (252,068) (275,902) ----------- ----------- ----------- Balance - End of Year $1,982,559 $1,774,632 $1,667,723 =========== =========== =========== As of December 31, 2002, the Bank had no restructured loans in the portfolio. There were $98,630 in nonaccrual loans and $10,920,663 in loans identified by management as having various degrees of weakness. As of the same date in 2001, the Bank had no restructured loans, $603,508 in nonaccrual loans, and $11,288,755 in loans with weaknesses. 5. Office Buildings, Equipment, and Leasehold Improvements Major classifications of these assets are summarized as follows: Estimated Useful Lives (Years) 2002 2001 ------------- ---- ---- Land $1,014,560 $ 963,060 Buildings and improvements 6-40 3,080,651 3,024,568 Furniture and equipment 2-10 2,353,744 2,014,306 Leasehold improvements 5-6 66,854 66,854 ----------- ---------- 6,515,809 6,068,788 Less: Accumulated depreciation (2,230,707) (1,785,132) ----------- ----------- $4,285,102 $4,283,656 =========== =========== Page 50 of 87 The cost basis of fully depreciated assets totaled $541,113 at December 31, 2002. 6. Other Real Estate As of December 31, 2002, the Bank held other real estate in the amount of $502,734. The amount represents cost related to converting collateral on nonperforming loans from the customer to the Bank. All properties are being marketed or being prepared for marketing. 7. Time Deposits The maturities of time deposits are as follows: $100,000 or Less Than Greater $100,000 Due in six months $11,582,673 $38,413,912 Due from six months to one year 9,936,497 26,661,656 Due from one year to three years 8,478,548 32,958,833 Due from three years to five years 7,331,950 20,807,287 ----------- ------------ Total $37,329,668 $118,841,688 =========== ============ Interest expense on time deposits greater than or equal to $100,000 was $1,364,468 in 2002. 8. Federal Income Taxes Federal income taxes payable, as of December 31, 2002 and 2001, were as follows: 2002 2001 Currently payable $ 32,516 $ 39,405 Deferred (195,611) (560,315) ---------- ---------- $(163,095) $(520,910) ========== ========== The components of applicable income taxes are as follows: 2002 2001 ---- ---- Current $1,704,583 $1,094,231 Deferred from income and expense items (364,704) 61,675 ----------- ----------- Total $1,339,879 $1,155,906 =========== =========== Page 51 of 87 Temporary differences in the recognition of income and expenses for tax and financial reporting purposes resulted in the deferred income tax asset as follows: 2002 2001 Accelerated depreciation $ (47,572) $11,654 Excess (Deficiency) of provision for loan losses over deduction for Federal income tax purposes 79,236 35,872 Deferred compensation 23,154 23,154 Cash value life insurance 18,593 - ---------- -------- Total Tax Impact of Temporary Differences in Recognition of Income and Expenses 73,411 70,680 Tax impact of balance sheet recognition of unrealized security losses (438,115) (9,005) ---------- -------- Total Change to Deferred Tax for the Year $(364,704) $61,675 ========== ======== The reasons for the difference between income tax expense and the amount computed by applying the statutory Federal income tax rates are as follows: 2002 2001 ---- ---- Statutory rates 34% 34% Income tax expense at statutory rates $1,610,892 $1,155,906 Increase (Decrease) due to Tax exempt income (252,770) (184,205) Other 52,779 245,880 ----------- ----------- $1,410,901 $1,217,581 =========== =========== Federal income tax returns are subject to examination for all years which are not barred by the statute of limitations. 9. Commitments and Contingent Liabilities At December 31, 2002 and 2001, commitments under standby letters of credit aggregated $1,152,056 and $914,814, respectively. These commitments are an integral part of the banking business and the Bank does not anticipate any losses as a result of these commitments. These commitments are not reflected in the consolidated financial statements. (See Note 13). During the year ended December 31, 2002, the Bank incurred operating lease expense amounting to $36,980 in addition to $7,175 depreciated for leasehold improvements. Page 52 of 87 Minimum lease payments at December 31, 2002 under noncancelable real property operating lease commitments for succeeding years are: 2003 $33,050 2004 23,900 2005 14,350 ------- Total $71,300 ======= The Bank has options to renew the leased properties. The additional lease expense resulting from the future exercising of these options is not included in the 2002 totals listed herein. The Bank has entered into several agreements to service and maintain equipment. The only long-term commitment relates to a maintenance agreement on the elevator and internet banking equipment and service. The amount of payments can be adjusted annually based on labor cost. The terms based on current rates are as follows: 2003 $15,655 2004 15,655 2005 15,655 2006 11,805 -------- Total $58,770 ======== At year end, the Bank had entered into several purchase commitments amounting to $173,000. These commitments relate to the establishment of a new full- service branch banking office in Blackstone, Virginia. 10. Retirement Plan The Bank provides for a retirement program for all qualified employees through a 401(k) plan. The plan offers a salary reduction election of up to 14% of W-2 compensation less incentive pay. The plan also has a proportional matching feature by the Company. In addition, the plan provides for the Company to make discretionary contributions. Both the percentage of the employer match and the annual discretionary contribution are based on the Bank's performance. During 2002, Bank payments through matching and discretionary contributions totaled $163,130 while employees' salary reduction amounted to $152,620. The cost of administration for the 401(k) plan paid in 2002 amounted to $4,948. 11. Incentive Compensation The Bank offers its employees incentive compensation and/or bonus arrangements based on the Bank's annual financial performance and other criteria such as length of service and officer classification. Incentive compensation totaled $163,974 and $90,030 for the years ended December 31, 2002 and 2001, respectively. Page 53 of 87 12. Related Parties Loans Loans to Directors and Executive Officers of the Bank and loans to companies in which they have a significant interest are made on substantially the same terms as those prevailing at the time for other loan customers. The balances of such loans outstanding were $7,637,532 and $5,540,819 at December 31, 2002 and 2001, respectively. During the year of 2002, new loans to the group totaled $3,058,727, while repayments amounted to $962,014. Certain Directors and Executive Officers have home equity loans. The net activity of these open-end credits has been reported herein. As of December 31, 2002, W. J. Callis, Director, had outstanding loans in excess of 5% of stockholders' equity. The beginning balance of loans was $3,321,515 with current year activity consisting of $1,401,297 in advances and $505,633 in repayments for an ending balance of $4,217,179. Deposits As of December 31, 2002, the Bank held deposits of Directors, Executive Officers, and their related interest amounting to $2,414,448. 13. Off-Balance-Sheet Instruments/Credit Concentrations The Bank is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. Unless noted otherwise, the Bank does not require collateral or other security to support these financial instruments. Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to facilitate the transaction of business between these parties where the exact financial amount of the transaction is unknown but a limit can be projected. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. There is a fee charged for this service. As noted in Note 9 on December 31, 2002, the Bank had outstanding letters of credit. These instruments are based on the financial strength of the customer and the existing relationship between the Bank and the customer. As of December 31, 2002, the Bank also had unused commitments resulting from credit line deeds of trust, home equity lines, construction lines, and an unfunded business loan. The total amount of these commitments amounted to $37,149,451. For related information concerning contract commitments not reflected in the balance sheet refer to Note 9. Concentrations The Bank has no concentrations of credit concerning an individual borrower or economic segment. The Bank confines its lending activities to within the state and more specifically its local geographic areas. The concentrations of credit by loan type are set forth in Note 3. Regulatory requirements limit the Bank's aggregate loans to any one borrower to a level of approximately $3,875,000. Page 54 of 87 14. Regulatory Matters Pursuant to regulations of the Federal Reserve Board, the banking operation of the Company is required to maintain certain minimum levels of capital. The Bank maintained the following capital ratios as of December 31: 2002 2001 Actual Actual Minimum Rate Rate Standards Total Capital to Risk Weighted Assets 11.46% 13.10% 10.00% ====== ====== ====== Tier I Capital to Risk Weighted Assets 10.54% 12.02% 6.00% ====== ====== ===== Tier I Capital to Total Average Assets 8.87% 8.33% 5.00% ===== ===== ===== The capital ratios continued to exceed minimum standards and were strengthened due to both increased earnings and the stock repurchase program. 15. Capital Beginning in 2000, the Company discontinued the dividend reinvestment plan. The Company continued the stock repurchase program initiated in 1999. Through the repurchase program, the Company bought back 14,000 shares of common stock in 2002. The Company also sold stock through the employee stock option plan. The sales for the year amounted to 11,450 shares of common stock. The net result of the stock plans resulted in a decline of $537 in common stock and $51,621 in capital surplus. The Company is authorized to issue 200,000 shares of preferred stock with a par value of $25.00. To date, no preferred stock has been issued by the Company. Currently, management has no plans to utilize this second class of stock. 16. Stock Option Plan On April 20, 1995, the stockholders retroactively approved two incentive stock option plans with an effective date of March 16, 1995. One plan, consisting of option awards to purchase 120,000 shares of the Company's common stock, was approved for the employees of the Company, while the second plan consisting of option awards to purchase 80,000 shares of the Company's common stock was approved for the "outside" Directors of the Company. All participants must have been employed for two calendar years. At the annual stockholders meeting held on April 15, 1999, the stockholders approved a plan that increased the number of shares in the Employee Stock Option Plan from 120,000 shares by an additional 150,000 shares for a total of 270,000 shares. All of the options expire ten years from the date of grant. Page 55 of 87 The table below details the status of the shares in the plan as of December 31, 2002 and 2001: 2002 Prior Year Current Year Activity Exercised and Incentive Stock Original Outstanding Options Options Options Remaining Option Plan Pool Options Granted Exercised Canceled in Pool Employees 270,000 129,928 10,000 6,450 8,800 110,328 Directors 80,000 69,000 12,000 5,000 - 2,000 2001 Prior Year Current Year Activity Exercised and Incentive Stock Original Outstanding Options Options Options Remaining Option Plan Pool Options Granted Exercised Canceled in Pool Employees 270,000 121,928 17,000 - 9,000 113,928 Directors 80,000 66,000 - 3,000 - 14,000 The Company has elected to report the results of the plan pursuant to APB Opinion Number 25. Due to the pricing schedule, there is no impact on earnings under the fair value based method. 17. Disclosures about Fair Value of Financial Instruments The intent of FAS 107 is to depict the market's assessment of the present value of net future cash flows discounted to reflect current interest rates. The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value. Cash and Short-Term Investments For those short-term investments, the carrying amount is a reasonable estimate of fair value. For reporting purposes, the Bank has included Cash and Due from Banks as well as Federal Funds Sold in this category. Investment Securities For marketable equity securities classified as available-for-sale and held-to- maturity, fair values are based on quoted market prices or dealer quotes. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. Loans Receivable The fair value of the basic loan groups is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. For open-end revolving loans, the carrying amount is a reasonable estimate of fair value. Page 56 of 87 Deposit Liabilities The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. Commitments to Extend Credit and Letters of Credit The fair value of commitments and letters of credit is the amount of the unfunded commitment, as a market rate will be set at the time of the funding of the commitment. The estimated fair values of the Bank's financial instruments are as follows: 2002 2001 ---- ---- Carrying Fair Carrying Fair Amount Value Amount Value Financial Assets Cash and due from banks $ 13,340,576 $ 13,340,576 $ 8,215,994 $ 8,215,994 Federal funds sold 17,255,000 17,255,000 12,740,000 12,740,000 Investments Available-for-sale 26,966,637 26,966,637 35,031,485 35,031,485 Held-to-maturity 511,809 529,306 1,513,266 1,523,507 Loans Commercial loans 21,872,278 20,988,557 19,293,070 20,189,688 Consumer loans 29,903,542 29,906,419 32,954,230 31,503,862 Real estate loans 147,321,191 127,340,941 125,605,649 128,450,993 Participation loans - out 841,346 841,346 3,606,970 3,606,970 Financial Liabilities Deposits Demand (noninterest- bearing) 26,372,882 26,372,882 27,504,768 27,504,768 Demand (interest- bearing) 40,652,207 40,652,207 31,243,613 31,243,613 Savings 13,347,995 13,347,995 11,160,289 11,160,289 Certificates of deposit 156,171,356 156,963,338 146,452,441 146,442,943 Unrecognized Financial Instruments Unused loan commitments 37,149,451 37,149,451 29,349,224 29,349,224 Unissued letters of credit 1,152,056 1,152,056 914,814 914,814 Page 57 of 87 18. Quantitative and Qualitative Disclosures About Market Risk As with the banking industry in general, market risk is inherent in the Company's operation. A majority of the business is built around financial products, which are sensitive to changes in market rates. Such products, categorized as loans, investments, and deposits are utilized to transfer financial resources. These products have varying maturities, however, and this provides an opportunity to match assets and liabilities so as to offset a portion of the market risk. Management follows an operating strategy that limits the interest rate risk by offering only shorter-term products that typically have a term of no more than five years. By effectively matching the maturities of inflows and outflows, management feels it can effectively limit the amount of exposure that is inherent in its financial portfolio. As a separate issue, there is also the inherent risk of loss related to loans and investments. The impact of loss through default has been considered by management through the utilization of an aggressive loan loss reserve policy and a conservative investment policy that limits investments to higher quality issues; therefore, only the risk of interest rate variations is considered in the following analysis. The Company does not currently utilize derivatives as part of its investment strategy. The tables below present principal amounts of cash flow as it relates to the major financial components of the Company's balance sheet. The cash flow totals represent the amount that will be generated over the life of the product at its stated interest rate. The present value discount is then applied to the cash flow stream at the current market rate for the instrument to determine the current value of the individual category. Through this two-tiered analysis, management has attempted to measure the impact not only of a rate change, but also the value at risk in each financial product category. Only financial instruments that do not have price adjustment capabilities are herein presented. In Table One, the cash flows are spread over the life of the financial products in annual increments as of December 31 each year with the final column detailing the present value discounting of the cash flows at current market rates. For purposes of this footnote disclosure, the other investments which consist of nonliquid stocks and investments are not included. Benchmark Bankshares, Inc. Fair Value of Financial Assets December 31, 2002 Current Categories 2003 2004 2005 2006 2007 Thereafter Value - ---------- ---- ---- ---- ---- ---- ---------- ----- Loans Commercial $21,848,089 $ - $ - $ - $ - $ - $ 20,988,557 Consumer 13,809,515 9,637,365 5,843,069 3,887,101 1,027,981 185,733 29,906,419 Mortgage 31,757,081 27,318,914 22,476,011 30,797,257 33,005,845 8,008,940 126,499,595 Investments Mortgage Backed Securities 2,803,007 2,181,202 1,730,939 1,544,203 1,055,736 3,020,734 11,213,509 Municipals Nontaxable 1,917,874 613,755 613,755 1,253,755 2,150,678 10,157,201 15,026,686 Taxable 61,693 556,572 31,450 31,450 31,450 578,625 1,060,259 Page 58 of 87 Current Categories 2003 2004 2005 2006 2007 Thereafter Value - ---------- ---- ---- ---- ---- ---- ---------- ----- Certificates of Deposits < 182 days 4,228,981 - - - - - 4,210,026 182 - 364 days 11,971,785 - - - - - 11,882,532 1 year - 2 years 49,072,641 1,508,865 - - - - 49,565,709 2 years - 3 years 6,905,702 10,229,870 824,281 - - - 17,178,635 3 years - 4 years 4,426,632 3,316,516 3,926,872 63,354 - - 11,029,969 4 years - 5 years 667,112 849,717 721,577 706,359 - - 2,707,359 5 years and over 11,109,200 6,221,500 19,260,168 10,400,979 21,429,646 270,485 60,389,108 In the above table, the cash flows are spread over the life of the financial products in annual increments as of December 31 of each year with the final column, current value, detailing the present value discounting of the cash flows at current market rates. Benchmark Bankshares, Inc. Variable Interest Rate Disclosure December 31, 2002 Valuation of Securities No Valuation of Securities Given an Interest Rate Change In Given an Interest Rate Decrease of (x) Basis Points Interest Increase of (x) Basis Points Categories (200 BPS) (100 BPS) Rate 100 BPS 200 BPS - ---------- --------- --------- ---- ------- ------- Loans Commercial $ 21,247,169 $ 21,117,227 $ 20,988,557 $ 20,861,141 $ 20,734,964 Consumer 31,075,155 30,480,627 29,906,419 29,351,571 28,815,180 Mortgage 134,212,495 130,263,454 126,499,595 122,909,659 119,483,216 Investments Mortgage Backed Securities 11,977,057 11,595,283 11,213,510 10,831,736 10,449,963 Municipals Nontaxable 16,462,912 15,749,943 15,026,686 14,247,216 13,377,751 Taxable 1,140,681 1,098,912 1,060,259 1,024,619 991,870 Certificates of Deposit < 182 days 4,241,701 4,225,811 4,210,026 4,194,346 4,178,769 182 - 364 days 12,031,884 11,956,835 11,882,532 11,808,966 11,736,127 1 year - 2 years 50,586,717 50,071,013 49,565,709 49,070,494 48,585,069 2 years - 3 years 17,747,203 17,458,942 17,178,635 16,905,938 16,640,696 3 years - 4 years 11,459,487 11,241,234 11,029,969 10,825,393 10,627,222 4 years - 5 years 2,841,089 2,772,936 2,707,359 2,644,232 2,583,435 5 years and over 64,405,339 62,349,093 60,389,108 58,519,766 53,735,836 Only financial instruments that do not have daily price adjustment capabilities are herein presented. Page 59 of 87 19. Parent Company Financial statements for Benchmark Bankshares, Inc. (not consolidated) are herein presented. Since the parent company has not entered into any substantial transactions, only the parent company's statements are presented. Page 60 of 87 Benchmark Bankshares, Inc. (Parent Company Only) Balance Sheets December 31, 2002, 2001, and 2000 Assets 2002 2001 2000 ---- ---- ---- Cash $ 3,720,694 $ 3,867,818 $ 4,324,894 Investment in subsidiary 23,418,301 20,143,862 18,401,336 Receivable - reimbursement - 81 81 ----------- ----------- ----------- Total Assets $27,138,995 $24,011,761 $22,726,311 =========== =========== =========== Liabilities and Stockholders' Equity Liabilities Dividends payable $ 593,088 $ 534,600 $ 541,120 Stockholders' Equity Common stock, par value $.21 per share, authorized 4,000,000 shares; issued and outstanding 12-31-02 2,967,443.301, issued and outstanding 12-31-01 2,970,003.06, issued and outstanding 12-31-00 3,006,219.501 623,164 623,701 631,307 Surplus 4,005,238 4,056,859 4,404,047 Retained earnings 21,917,505 18,796,601 17,149,837 ----------- ----------- ----------- Total Stockholders' Equity 26,545,907 23,477,161 22,185,191 ----------- ----------- ----------- Total Liabilities and Stockholders' Equity $27,138,995 $24,011,761 $22,726,311 =========== =========== =========== Statements of Income Years Ended December 31, 2002, 2001, and 2000 2002 2001 2000 ---- ---- ---- Income Dividends from subsidiary $ 1,000,000 $ 1,000,000 $ 2,300,000 ----------- ----------- ----------- Total Income 1,000,000 1,000,000 2,300,000 Expenses Professional fees 12,550 12,872 11,500 Supplies, printing, and postage 13,347 10,515 10,809 Taxes - miscellaneous - 850 900 ----------- ----------- ----------- Total Expenses 25,897 24,237 23,209 ----------- ----------- ----------- Income Before Equity in Undistributed Income of Subsidiary 974,103 975,763 2,276,791 Equity in Income of Subsidiary (includes tax benefit of parent company operating loss) 2,423,937 1,760,005 568,270 ----------- ----------- ----------- Net Income $ 3,398,040 $ 2,735,768 $ 2,845,061 =========== =========== =========== Page 61 of 87 Benchmark Bankshares, Inc. (Parent Company Only) Statements of Changes in Stockholders' Equity Years Ended December 31, 2002, 2001, and 2000 Unrealized Common Retained Securities Stock Surplus Earnings Gain (Loss)* Total Balance January 1, 2000 $633,272 $4,501,508 $15,455,510 $(542,544) $20,047,746 Net Income Parent 2,276,791 2,276,791 Equity in income of subsidiary 568,270 568,270 Sale of Stock 1,593 54,391 55,984 Redemption of Stock (3) (111) (114) Stock repurchase (3,555) (151,741) (155,296) Semi-Annual Cash Dividend Declared June 15, 2000, $.16 per share (480,996) (480,996) December 21, 2000, $.18 per share (541,120) (541,120) Adjustments 2,713 2,713 Unrealized Security Gains (Losses) 411,213 411,213 --------- ----------- ------------ ---------- ------------ Balance December 31, 2000 631,307 4,404,047 17,281,168 (131,331) 22,185,191 Net Income Parent 975,763 975,763 Equity in income of subsidiary 1,760,005 1,760,005 Sale of Stock 630 21,510 22,140 Redemption of Stock (4) (161) (165) Stock repurchase (8,232) (368,537) (376,769) Semi-Annual Cash Dividend Declared June 21, 2001, $.18 per share (536,528) (536,528) December 20, 2001, $.18 per share (534,600) (534,600) Adjustments (396) (396) Unrealized Security Gains (Losses) (17,480) (17,480) --------- ----------- ------------ --------- ------------ Balance December 31, 2001 623,701 4,056,859 18,945,412 (148,811) 23,477,161 Net Income Parent 974,103 974,103 Equity in income of subsidiary 2,423,937 2,423,937 Sale of Stock 2,405 87,045 89,450 Redemption of Stock (2) (106) (108) Stock repurchase (2,940) (138,560) (141,500) Semi-Annual Cash Dividend Declared June 20, 2002, $.18 per share (532,988) (532,988) December 19, 2002, $.20 per share (593,088) (593,088) Adjustments (1,518) (1,518) Unrealized Security Gains (Losses) 850,458 850,458 --------- ----------- ------------ --------- ------------ Balance December 31, 2002 $623,164 $4,005,238 $21,215,858 $701,647 $26,545,907 ========= =========== ============ ========= ============ * Net of tax effect. Page 62 of 87 Benchmark Bankshares, Inc. (Parent Company Only) Statements of Cash Flows Years Ended December 31, 2002, 2001, and 2000 2002 2001 2000 ---- ---- ---- Cash Flows from Operating Activities Net income $3,398,040 $2,735,768 $2,845,061 Decrease in payables (81) - - ----------- ----------- ----------- Net Cash Provided by Operating Activities 3,397,959 2,735,768 2,845,061 Cash Flows from Investing Activities (Un)distributed earnings of subsidiary (2,423,937) (1,760,005) (568,270) Capital adjustment (1,400) (1) (34) ----------- ----------- ----------- Net Cash (Used) by Investing Activities (2,425,337) (1,760,006) (568,304) Cash Flows from Financing Activities Sale of stock 89,450 22,140 55,984 Redemption of stock (108) (165) (114) Stock repurchase (141,500) (376,769) (155,296) Dividends paid (1,067,588) (1,078,044) (963,489) ----------- ----------- ----------- Net Cash (Used) by Financing Activities (1,119,746) (1,432,838) (1,062,915) ----------- ----------- ----------- Net Increase (Decrease) in Cash (147,124) (457,076) 1,213,842 Cash - Beginning of Year 3,867,818 4,324,894 3,111,052 ----------- ----------- ----------- Cash - End of Year $3,720,694 $3,867,818 $4,324,894 =========== =========== =========== Page 63 of 87 ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None Page 64 of 87 PART III ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The Directors of the Company, their ages, and principal occupations are set forth in the table below as of December 31, 2002: Principal Occupation for Last Five Years Director of the Company Name (Age) Position Held with Company and Subsidiary or Subsidiary Since R. Michael Berryman Retired Pharmacist 1978 (62) Principal, Smith's Pharmacy, Inc. Pharmacy Associates, Inc. Chairman of Board, Company and Subsidiary David K. Biggs Principal, Biggs Construction Co., Inc. 2002 (46) Mark F. Bragg Principal, Atlantic Medical, Inc. 1999 (41) Lewis W. Bridgforth Physician 1971 (63) William J. Callis Building Contractor 1989 (60) Vice President, Kenbridge Construction Co., Inc. Vice Chairman of Board, Company and Subsidiary Earl H. Carter, Jr. Principal, Taylor-Forbes Equipment 2000 (54) Company, Inc. Earl C. Currin, Jr. Provost, 1986 (59) John H. Daniel Campus of Southside Virginia Community College Mary Jane Elkins Dean of Institutional Advancement, 2002 (51) Southside Virginia Community College C. Edward Hall Pharmacist 1971 (62) Partner, Victoria Drug Company J. Ryland Hamlett Retired Personnel Manager, 1986 (60) Southside Electric Cooperative Wayne J. Parrish Principal, Parrish Trucking Co., Inc. 1979 (64) Ben L. Watson, III President and CEO, 1976 (59) Company and Subsidiary Executive Officers of the Company The Executive Officers of the Bank and their positions are set forth below: Name (Age) Position Held with Subsidiary Officer Since Ben L. Watson, III (A) Director, President and CEO 1971 (59) Michael O. Walker (B) Executive Vice President for Branch Administration and 1975 (52) Marketing and Recording Secretary Janice W. Pernell (C) Senior Vice President, Cashier, Assistant 1976 (56) Secretary, and Compliance Officer Page 65 of 87 (A) Mr. Watson serves in a dual capacity of President and CEO for both the Company and the subsidiary. (B) Mr. Walker also serves as Recording Secretary of the Company. (C) Mrs. Pernell also serves as Cashier and Treasurer of the Company. Mr. Watson and Mrs. Pernell have served the Bank since it commenced business in 1971. Mr. Watson started with the Bank as Operations Officer, was appointed Cashier in 1973, appointed Executive Vice President in 1975, and appointed to his current position in March of 1990. Mrs. Pernell was appointed Operations Officer and Cashier in 1978, Assistant Vice President and Cashier in 1980, Vice President, Cashier, and Compliance Officer in 1988, and to her current position of Senior Vice President, Cashier, Assistant Secretary, and Compliance Officer in 1993. Mr. Walker came to the Bank in 1974 as Branch Manager of the Victoria office. He was appointed Assistant Vice President in 1980, Vice President in 1988, Vice President for Branch Administration and Marketing in 1989, Senior Vice President in 1993, and to his current position of Executive Vice President in 2002. ITEM 11 EXECUTIVE COMPENSATION A. Summary of Cash and Certain Other Compensation to Executive Officer Long-Term Annual Compensation Compensation (1) (2) Number of Other Securities Name and Principal Incentive Annual Underlying All Other Position Year Salary Bonus Compensation Option Compensation -------- ---- ------ ----- ------------ ------ ------------ Ben L. Watson, III 2002 $126,684 $35,063 $3,600 4,000(3) None President and Chief 2001 121,812 22,022 3,000 6,000(3) None Executive Officer 2000 116,004 24,039 5,050 6,000(3) None Michael O. Walker 2002 96,552 22,790 2,100 6,000 None Executive 2001 89,268 15,835 1,800 6,000 None Vice President 2000 85,008 16,709 1,950 6,000 None Janice W. Pernell 2002 92,844 22,790 None 5,850 None Senior Vice President 2001 89,268 15,835 None 5,850 None 2000 85,008 16,709 None 5,850 None (1) The value of perquisites and other personal benefits did not exceed the lesser of $50,000 or 10% of total annual salary and incentive bonus. (2) Other Annual Compensation represents Director's fees paid to Mr. Watson for services performed as a Director of the Bank, and fees paid to Mr. Walker for services performed as Recording Secretary of the Board of the Bank. (3) Mr. Watson exercised 500 options on January 7, 2002, 500 on January 25, 2002, 500 on August 7, 2002, and 500 on December 13, 2002. B. Compensation to Directors No fees are paid to Directors for service on the Board of the Company. During 2002, each Director was paid $300 for each Board meeting and, with the exception of Mr. Watson, each Director received $225 for each Committee meeting attended during the year. Page 66 of 87 C. Employment Agreements The Company, or its subsidiary, has no employment agreements with any of its employees. ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth information regarding the beneficial ownership of the Company's common stock as of March 3, 2003: Shares Beneficially Owned % of Shares Director/Officer of Beneficially Name and Age Principal Occupation Company/Subsidiary Owned R. Michael Berryman Retired Pharmacist 1978 85,113.000(1) (62) 2.88% David K. Biggs Principal, 2002 2,600.000(2) (46) Biggs Construction Co., Inc. .09% Mark F. Bragg Principal, Atlantic 1999 5,597.409(3) (41) Medical, Inc. .19% Lewis W. Bridgforth Physician 1971 35,680.657(4) (63) 1.21% William J. Callis Building Contractor 1989 36,620.974(5) (60) 1.24% Earl H. Carter, Jr. Principal, Taylor-Forbes 2000 2,305.000 (54) Equipment Company, Inc. .08% Earl C. Currin, Jr. Provost 1986 13,178.000 (59) .45% Mary Jane Elkins Dean of Institutional 2002 700.000 (51) Advancement, .03% Southside Virginia Community College C. Edward Hall Pharmacist 1971 36,185.037(6) (62) 1.23% J. Ryland Hamlett Retired Personnel Manager 1986 44,977.000(7) (60) 1.52% Wayne J. Parrish Principal, Parrish 1979 28,878.872(8) (64) Trucking Co., Inc. .98% Ben L. Watson, III President and CEO, 1971 22,471.508(9) (59) Company and Subsidiary .76% Page 67 of 87 Janice W. Pernell Senior Vice President 1976 11,536.375(10) (56) .39% Michael O. Walker Executive Vice President 1975 52,000.000(11) (52) 1.76% All Directors and 377,843.832 Executive Officers as 12.77% a Group (1) Includes 45,073 shares owned solely by Mr. Berryman's wife. (2) Includes 1,400 shares owned by Biggs Construction Co., Inc. (3) Includes 97.409 shares held jointly with Mr. Bragg's wife. (4) Includes 20,337.218 shares owned solely by Dr. Bridgforth's wife. (5) Includes 21,640.644 shares held jointly with Mr. Callis's wife. (6) Includes 260 shares owned solely by Mr. Hall's wife and 5,040 shares held jointly with his mother. (7) Includes 17,128 shares held as trustee for the John A Cordle Family Trust and 17,128 shares held as trustee for the Mary F. Cordle Marital Trust. (8) Includes 6,971.168 shares held jointly with Mr. Parrish's wife and 7,419.035 shares owned solely by her. (9) Includes 457.508 shares owned solely by Mr. Watson's wife and 4,000 unexercised option shares for him. (10) Includes 4,650 unexercised option shares. (11) Includes 25,000 shares held jointly with Mr. Walker's wife and 6,000 unexercised option shares for him. The share ownership listed above reflects the shares necessary to meet the ownership requirements for bank directors pursuant to the Virginia Banking Act. No person owned of record or was known to own beneficially more than 5.0% of the outstanding common stock of the Company as of December 31, 2002. The following table details information concerning a stock certificate holder that is in the business of marketing investments. Actual ownership of shares or partial shares by investors through this company is not known by management. The following table provides certificate holder information: No. of Shares Percentage Name in Certificates of Shares Held CEDE & Company 957,378 32.26% Box 20 Bowling Green Station New York, New York 10081 Page 68 of 87 ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Loans to Related Parties During the past year, Directors and Executive Officers of the Company, their affiliates, and members of their immediate families were customers of, and had borrowing transactions with, the Company's banking subsidiary in the normal course of business. All outstanding loans and commitments included in such transactions are made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons and did not involve more than normal risk of collectivity or present other unfavorable features. Balances, as of December 31, of the year are summarized below: 2002 2001 2000 ---- ---- ---- Executive Officers and their families $ 300,198 $ 297,313 $ 377,564 Directors and their families (1) 652,248 522,267 679,499 Corporations in which Directors and Officers had an interest 6,685,086 4,721,239 3,387,868 ---------- ---------- ---------- Total $7,637,532 $5,540,819 $4,444,931 ========== ========== ========== (1) Loans to Mr. Watson that are reported as loans to Executive Officers are not included in loans to Directors. Refer to Item 14(a) - Financial Statement Schedules At year end 2002, Directors and Executive Officers had been granted lines of credit in the amount of $3,587,500. As of December 31, 2002, $2,686,897 of these lines was unexercised and available. Stock Sales to Related Parties The current Directors and Executive Officers acquired 13,444 shares of Company stock during 2002 through exercising of stock options and purchases of shares on the open market. The average price of shares purchased was $9.48. Page 69 of 87 PART IV ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1) The following consolidated financial statements of Benchmark Bankshares, Inc. and its subsidiary, Benchmark Community Bank, included in the annual report of the registrant to its stockholders for the year ended December 31, 2002 are included in Item 8: Consolidated Statements of Financial Condition - December 31, 2002 and 2001 Consolidated Statements of Income - Years Ended December 31, 2002, 2001, and 2000 Consolidated Statements of Changes in Stockholders' Equity - Years Ended December 31, 2002 and 2001 Consolidated Statements of Cash Flows - Years Ended December 31, 2002, 2001, and 2000 Notes to Consolidated Financial Statements - December 31, 2002, 2001, and 2000 (2) The following consolidated financial statement schedules of Benchmark Bankshares, Inc. and its subsidiary, Benchmark Community Bank, are included in Item 14 (d): Schedule II - Indebtedness to Related Parties Schedule V - Property, Plant, and Equipment Schedule VI - Accumulated Depreciation, Depletion, and Amortization of Property, Plant, and Equipment Supplemental Information to the Audited Financial Statements pursuant to SEC regulations. All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and, therefore, have been omitted. Page 70 of 87 ITEM 14 (a) (3) LISTING OF EXHIBITS INCLUDED IN 14 (c) Page Number of Incorporation by Reference to ( 1) Articles of Incorporation Page 57 - Item 14(c) - Exhibit 1 of Form 10K, December 31, 1989 ( 2) (a) Amendments to Articles of Page 76 - Item 14(c) - Exhibit 2 of Incorporation Form 10K, December 31, 1989 (b) Amendments to Articles of Page 58 - Item 14(c) - Exhibit 2(b) Incorporation of Form 10K, December 31, 1990 (c) Amendment to Articles of Page 68 - Item 14(c) - Exhibit 2(c) Incorporation of Form 10K, December 31, 1992 ( 3) Bylaws of Incorporation Page 83 - Item 14(c) - Exhibit 3 of Form 10K, December 31, 1989 ( 4) Amendments to Bylaws Page 106 - Item 14(c) - Exhibit 4 of Form 10K, December 31, 1989 ( 5) Indemnity Agreement Page II-11-26 in Exhibit 10.1 of Form S-1 filed September 1, 1989 ( 6) List of Subsidiaries ( 7) Bonus Plans of Bank Officers Page 60 - Item 14(c) - Exhibit 7(a) -7(b) of Form 10K, December 31, 1990 ( 8) Directors Performance Page 72 - Item 14(c) - Exhibit 8 of Compensation Schedule Form 10K, December 31, 1992 ( 9) Resolution to Amend the Articles Page 71 - Item 14(c) - Exhibit 9(a) of Incorporation to increase the of Form 10K, December 31, 1993 number of authorized shares from 2,000,000 to 4,000,000 concurrent with the Directors election to have a 2 for 1 stock split (10) Stock Option Plans Exhibits A and B of 1995 Proxy and Information Statement for the April 20, 1995 Annual Meeting of Stockholders (11) Section 906 Certification (12) Controls and Procedures Certification Page 71 of 87 ITEM 14(b) REPORTS ON FORM 8-K There was no required filing of Form 8-K warranted as a result of action taken by the Company during the reporting period. Page 72 of 87 ITEM 14(c) EXHIBIT 6 The only subsidiary of the Registrant is Benchmark Community Bank, a Virginia banking corporation, located in Kenbridge, Lunenburg County, Virginia. It is owned 100% by Registrant. Page 73 of 87 Item 14(c)10 REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS Board of Directors Benchmark Bankshares, Inc. We have audited the consolidated balance sheets of Benchmark Bankshares, Inc. and Subsidiary as of December 31, 2002 and 2001, and the related consolidated statements of income, changes in stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 2002. 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 generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Benchmark Bankshares, Inc. and Subsidiary as of December 31, 2002 and 2001 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2002, in conformity with generally accepted accounting principles. Our audits referred to above included audits of the financial statement schedules listed under Item 14(a)(2). In our opinion, those financial statement schedules present fairly, in all material respects, in relation to the financial statements taken as a whole, the information required to be stated therein. Creedle, Jones, and Alga, P. C. Certified Public Accountants South Hill, Virginia March 17, 2003 Page 74 of 87 Item 14(c)11 STATEMENT OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER PURSUANT TO 18 U.S.C. SECTION 1350 In connection with the Form 10-K of Benchmark Bankshares, Inc. for the year ended December 31, 2002, we, Ben L. Watson, III, President and Chief Executive Officer of Benchmark Bankshares, Inc., and Janice W. Pernell, Senior Vice President, Treasurer, and Assistant Secretary of Benchmark Bankshares, Inc., hereby certify pursuant to 18 U.S.C.ss.1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to our knowledge: (a) such Form 10-K for the year ended December 31, 2002 fully complies with the requirements of Section 13(a) of the Securities Exchange Act of 1934, as amended; and (b) the information contained in such Form 10-K for the year ended December 31, 2002 fairly presents, in all material respects, the financial condition and results of operations of Benchmark Bankshares, Inc. as of, and for, the year presented in such Form 10-K. By: Ben L. Watson, III Date: March 17, 2003 President and Chief Executive Officer By: Janice W. Pernell Date: March 17, 2003 Senior Vice President, Treasurer, and Assistant Secretary Page 75 of 87 Item 14(c)12 Section 302 Certification I, Ben L. Watson, III, certify that: 1. I have reviewed this annual report on Form 10-K of Benchmark Bankshares, Inc.; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the year covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the years presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the year in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's Board of Directors (or persons performing the equivalent functions): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize, and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 17, 2003 Ben L. Watson, III President and Chief Executive Officer Page 76 of 87 Item 14(c)12 Section 302 Certification I, Janice W. Pernell, certify that: 1. I have reviewed this annual report on Form 10-K of Benchmark Bankshares, Inc.; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the year covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the years presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the year in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's Board of Directors (or persons performing the equivalent functions): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize, and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 17, 2003 Janice W. Pernell Senior Vice President, Treasurer, and Assistant Secretary Page 77 of 87 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant had duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on March 17, 2003. Benchmark Bankshares, Inc. (formerly Lunenburg Community Bankshares, Inc.) (Registrant) By Ben L. Watson, III By Janice W. Pernell President Cashier and Treasurer Pursuant to the requirements of the Securities Exchange Act of 1934, the following persons on behalf of the registrant and in the capacities have signed this report on March 17, 2003. C. Edward Hall 03-17-03 Wayne J. Parrish 03-17-03 - -------------------------------------- ------------------------------------- Mark F. Bragg 03-17-03 Earl C. Currin, Jr. 03-17-03 - -------------------------------------- ------------------------------------- Mary Jane Elkins 03-17-03 David K. Biggs 03-17-03 - -------------------------------------- ------------------------------------- J. Ryland Hamlett 03-17-03 Lewis W. Bridgforth 03-17-03 - -------------------------------------- ------------------------------------- William J. Callis 03-17-03 R. Michael Berryman 03-17-03 - -------------------------------------- ------------------------------------- Earl H. Carter, Jr. 03-17-03 Ben L. Watson, III 03-17-03 - -------------------------------------- ------------------------------------- Page 78 of 87 ITEM 14(d) SCHEDULE II - INDEBTEDNESS TO RELATED PARTIES Year Ended December 31, 2002 Balance Balance at Beginning at End of Name of Person of Period Additions Deductions Period Executive Officers, Directors, and Their Related Interest $5,540,819 $3,058,728 $ 962,015 $7,637,532 W. J. Callis, Director(1)(2)(3) 3,321,515 1,401,297 505,633 4,217,179 Year Ended December 31, 2001 Executive Officers, Directors, and Their Related Interest $4,444,931 $2,407,743 $1,311,855 $5,540,819 W. J. Callis, Director(1)(2)(3) 2,433,923 1,112,942 225,350 3,321,515 Year Ended December 31, 2000 Executive Officers, Directors, and Their Related Interest $3,212,221 $2,117,778 $ 885,068 $4,444,931 W. J. Callis, Director(1)(2)(3) 1,996,624 790,000 352,701 2,433,923 (1) Loans to related parties that exceed 5% of the capital of the Company. (2) Loans to business interest. (3) Loans are included in the totals presented for the Executive Officers, Directors, and their interest. Page 79 of 87 ITEM 14(d) SCHEDULE V - PROPERTY, PLANT, AND EQUIPMENT Page 1 Benchmark Bankshares, Inc. Year Ended December 31, 2002 Col. A Col. B Col. C Col. D Col. E Col. F Balance at Other Balance Beginning Additions Changes at End of Classification of Period at Cost Retirement Add (Deduct) Period Land $ 963,060 $ 51,500 $ - $ - $1,014,560 Buildings and improvements 3,024,568 56,083 - - 3,080,651 Leasehold improvements 66,854 - - - 66,854 Construction in progress - - - - - ---------- ---------- ------------ ---------- ---------- 3,091,422 56,083 - - 3,147,505 Equipment, furniture, and fixtures 2,014,306 397,856 (58,418) - 2,353,744 ---------- ---------- ------------ ----------- ---------- Total $6,068,788 $ 505,439 $ (58,418) $ - $6,515,809 ========== ========== ============ =========== ========== Year Ended December 31, 2001 Land $ 917,748 $ 45,312 $ - $ - $ 963,060 Buildings and improvements 2,633,457 491,218 (100,107) - 3,024,568 Leasehold improvements 167,390 2,734 (103,270) - 66,854 Construction in progress 217,042 - - (217,042) - ---------- ---------- ------------ ----------- ---------- 3,017,889 493,952 (203,377) (217,042) 3,091,422 Equipment, furniture, and fixtures 2,257,349 599,330 (842,373) - 2,014,306 ---------- ---------- ------------ ----------- ---------- Total $6,192,986 $1,138,594 $(1,045,750) $ (217,042) $6,068,788 ========== ========== ============ =========== ========== Page 80 of 87 ITEM 14(d) SCHEDULE V - PROPERTY, PLANT, AND EQUIPMENT Page 2 Year Ended December 31, 2000 Land $ 799,690 $ 118,058 $ - $ - $ 917,748 Buildings and improvements 2,401,090 232,367 - - 2,633,457 Leasehold improvements 166,521 869 - - 167,390 Construction in progress 187,969 430,668 - (401,595) 217,042 ---------- ---------- ------------ ----------- ---------- 2,755,580 663,904 - (401,595) 3,017,889 Equipment, furniture, and fixtures 2,033,002 224,347 - - 2,257,349 ---------- ---------- ------------ ----------- ---------- Total $5,588,272 $1,006,309 $ - $ (401,595) $6,192,986 ========== ========== ============ =========== ========== Page 81 of 87 ITEM 14(d) SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT, AND EQUIPMENT Benchmark Bankshares, Inc. Year Ended December 31, 2002 Additions Balance at Charged to Other Balance at Beginning Cost and Changes End of Description of Period Expenses Retirements Add (Deduct) Period Building and improvements $ 901,133 $132,967 $ - $ - $1,034,100 Leasehold improvements 32,886 7,175 - - 40,061 ---------- -------- ------------ -------- ---------- Total 934,019 140,142 - - 1,074,161 Equipment, furniture, and fixtures 851,113 363,851 (58,418) - 1,156,546 ---------- -------- ------------ -------- ---------- Total $1,785,132 $503,993 $ (58,418) $ - $2,230,707 ========== ======== ============ ======== ========== Year Ended December 31, 2001 Building and improvements $ 886,356 $114,884 $ (100,107) $ - $ 901,133 Leasehold improvements 129,040 7,116 (103,270) - 32,886 ---------- -------- ------------ -------- ---------- Total 1,015,396 122,000 (203,377) - 934,019 Equipment, furniture, and fixtures 1,438,006 224,621 (811,514) - 851,113 ---------- -------- ------------ -------- ---------- Total $2,453,402 $346,621 $(1,014,891) $ - $1,785,132 ========== ======== ============ ======== ========== Year Ended December 31, 2000 Building and improvements $ 784,675 $101,681 $ - $ - $ 886,356 Leasehold improvements 122,409 6,631 - - 129,040 ---------- -------- ------------ -------- ---------- Total 907,084 108,312 - - 1,015,396 Equipment, furniture, and fixtures 1,257,409 180,597 - - 1,438,006 ---------- -------- ------------ -------- ---------- Total $2,164,493 $288,909 $ - $ - $2,453,402 ========== ======== ============ ======== ========== Page 82 of 87 ITEM 14(d)(1) SUPPLEMENTAL INFORMATION TO AUDITED FINANCIAL STATEMENTS PURSUANT TO SEC REGULATIONS Benchmark Bankshares, Inc. (Parent Company Only) Balance Sheet, December 31, 2002, 2001, and 2000 Assets 2002 2001 2000 ---- ---- ---- Cash $ 3,720,694 $ 3,867,818 $ 4,324,894 Investment in subsidiary 23,418,301 20,143,862 18,401,336 Receivable - reimbursement - 81 81 ----------- ----------- ----------- Total Assets $27,138,995 $24,011,761 $22,726,311 =========== =========== =========== Liabilities and Stockholders' Equity Liabilities Dividends payable $ 593,088 $ 534,600 $ 541,120 Stockholders' Equity Common stock, par value $.21 per share, authorized 4,000,000 shares; issued and outstanding 12-31-02 2,967,443.301, issued and outstanding 12-31-01 2,970,003.06, issued and outstanding 12-31-00 3,006,219.501 623,164 623,701 631,307 Surplus 4,005,238 4,056,859 4,404,047 Retained earnings 21,917,505 18,796,601 17,149,837 ----------- ----------- ----------- Total Stockholders' Equity 26,545,907 23,477,161 22,185,191 ----------- ----------- ----------- Total Liabilities and Stockholders' Equity $27,138,995 $24,011,761 $22,726,311 =========== =========== =========== Page 83 of 87 ITEM 14(d)(2) SUPPLEMENTAL INFORMATION TO AUDITED FINANCIAL STATEMENTS Page 1 PURSUANT TO SEC REGULATIONS Benchmark Bankshares, Inc. (Parent Company Only) Statements of Income Years Ended December 31, 2002, 2001, and 2000 2002 2001 2000 ---- ---- ---- Income Dividends from subsidiary $1,000,000 $1,000,000 $2,300,000 ---------- ---------- ---------- Total Income 1,000,000 1,000,000 2,300,000 Expenses Professional fees 12,550 12,872 11,500 Supplies, printing, and postage 13,347 10,515 10,809 Taxes - miscellaneous - 850 900 ---------- ---------- ---------- Total Expenses 25,897 24,237 23,209 ---------- ---------- ---------- Income Before Equity in Undistributed Income of Subsidiary 974,103 975,763 2,276,791 Equity in Income of Subsidiary (includes tax benefit of parent company operating loss) 2,423,937 - 568,270 ---------- ---------- ---------- Net Income $3,398,040 $ 975,763 $2,845,061 ========== ========== ========== Page 84 of 87 ITEM 14(d)(2) SUPPLEMENTAL INFORMATION TO AUDITED FINANCIAL STATEMENTS Page 2 PURSUANT TO SEC REGULATIONS Benchmark Bankshares, Inc. (Parent Company Only) Statement of Changes in Stockholders' Equity Years Ended December 31, 2002, 2001, and 2000 Unrealized Common Retained Securities Stock Surplus Earnings Gain (Loss)* Total Balance January 1, 2000 $633,272 $4,501,508 $15,455,510 $(542,544) $20,047,746 Net Income Parent 2,276,791 2,276,791 Equity in income of subsidiary 568,270 568,270 Sale of Stock 1,593 54,391 55,984 Redemption of Stock (3) (111) (114) Stock Repurchase (3,555) (151,741) (155,296) Semi-Annual Cash Dividend Declared June 15, 2000, $.16 per share (480,996) (480,996) December 21, 2000, $.18 per (541,120) (541,120) Adjustments 2,713 2,713 Unrealized Security Gains (Losses) 411,213 411,213 --------- ----------- ------------ ---------- ------------ Balance December 31, 2000 631,307 4,404,047 17,281,168 (131,331) 22,185,191 Net Income Parent 975,763 975,763 Equity in income of subsidiary 1,760,005 1,760,005 Sale of Stock 630 21,510 22,140 Redemption of Stock (4) (161) (165) Stock Repurchase (8,232) (368,537) (376,769) Semi-Annual Cash Dividend Declared June 21, 2001, $.18 per share (536,528) (536,528) December 20, 2001, $.18 per share (534,600) (534,600) Adjustments (396) (396) Unrealized Security Gains (Losses) (17,480) (17,480) --------- ----------- ------------ ---------- ------------ Balance December 31, 2001 623,701 4,056,859 18,945,412 (148,811) 23,477,161 Net Income Parent 974,103 974,103 Equity in income of subsidiary 2,423,937 2,423,937 Sale of Stock 2,405 87,045 89,450 Redemption of Stock (2) (106) (108) Stock Repurchase (2,940) (138,560) (141,500) Semi-Annual Cash Dividend Declared June 20, 2002, $.18 per share (532,988) (532,988) December 19, 2002, $.20 per share (593,088) (593,088) Adjustments (1,518) (1,518) Unrealized Security Gains (Losses) 850,458 850,458 --------- ----------- ------------ ---------- ------------ Balance December 31, 2002 $623,164 $4,005,238 $21,215,858 $ 701,647 $26,545,907 ========= =========== ============ ========== ============ * Net of tax effect. Page 85 of 87 ITEM 14(d)(3) SUPPLEMENTAL INFORMATION TO AUDITED FINANCIAL STATEMENTS PURSUANT TO SEC REGULATIONS Benchmark Bankshares, Inc. (Parent Company Only) Statements of Cash Flows Years Ended December 31, 2002, 2001, and 2000 2002 2001 2000 ---- ---- ---- Cash Flows from Operating Activities Net income $3,398,040 $2,735,768 $2,845,061 Decrease in payables (81) - - ----------- ----------- ----------- Net Cash Provided by Operating Activities 3,397,959 2,735,768 2,845,061 Cash Flows from Investing Activities (Un)distributed earnings of subsidiary (2,423,937) (1,760,005) (568,270) Capital adjustment (1,400) (1) (34) ----------- ----------- ----------- Net Cash (Used) by Investing Activities (2,425,337) (1,760,006) (568,304) Cash Flows from Financing Activities Sale of stock 89,450 22,140 55,984 Redemption of stock (108) (165) (114) Stock repurchase (141,500) (376,769) (155,296) Dividends paid (1,067,588) (1,078,044) (963,489) ----------- ----------- ----------- Net Cash (Used) by Financing Activities (1,119,746) (1,432,838) (1,062,915) ----------- ----------- ----------- Net Increase (Decrease) in Cash (147,124) (457,076) 1,213,842 Cash - Beginning of Year 3,867,818 4,324,894 3,111,052 ----------- ----------- ----------- Cash - End of Year $3,720,694 $3,867,818 $4,324,894 =========== =========== =========== Page 86 of 87 ITEM 14(d)(4) SUPPLEMENTAL INFORMATION TO AUDITED FINANCIAL STATEMENTS PURSUANT TO SEC REGULATIONS Investment Securities - Realized Gains and Losses Realized Realized Gains Losses For the Year Ended December 31, 2002 U. S. Government Agencies $ 1,890 $ - Pooled Securities 6,584 (4,857) State and Political Subdivisions 9,814 (4,552) ------- -------- Total $18,288 $(9,409) ======= ======== For the Year Ended December 31, 2001 U. S. Government Agencies $ - $ - Pooled Securities - - State and Political Subdivisions 2,434 - ------- -------- Total $ 2,434 $ - ======= ======== Page 87 of 87 ITEM 14(d)(5) SUPPLEMENTAL INFORMATION TO AUDITED FINANCIAL STATEMENTS PURSUANT TO SEC REGULATIONS Capital Ratios for the Bank Subsidiary Bank Ratios Total Risk-Based Capital Ratio 11.46% Tier 1 Risk-Based Capital Ratio 10.54% Tier 1 Leverage Ratio 8.87%