SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2003 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: 333-35799 UNION COMMUNITY BANCORP (Exact name of registrant specified in its charter) Indiana 35-2025237 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 221 East Main Street Crawfordsville, Indiana 47933 (Address of principal executive offices, including Zip Code) (765) 362-2400 (Registrant's telephone number, including area code) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such report), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X] The number of shares of the Registrant's common stock, without par value, outstanding as of June 30, 2003 was 2,100,000. Union Community Bancorp Form 10-Q Index Page No. FORWARD LOOKING STATEMENT 3 PART I. FINANCIAL INFORMATION 4 Item 1. Financial Statements 4 Consolidated Condensed Balance Sheets 4 Consolidated Condensed Statements of Income 5 Consolidated Condensed Statement of Shareholders' Equity 6 Consolidated Condensed Statements of Cash Flows 7 Notes to Unaudited Consolidated Condensed Financial Statements 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. 10 Item 3. Quantitative and Qualitative Disclosures about Market Risk 14 Item 4. Controls and Procedures 14 PART II. OTHER INFORMATION Item 1. Legal Proceedings 15 Item 2. Changes in Securities and Use of Proceeds 15 Item 3. Defaults Upon Senior Securities 15 Item 4. Submission of Matters to a Vote of Security Holders 15 Item 5. Other Information 15 Item 6. Exhibits and Reports on Form 8-K 15 SIGNATURES 16 CERTIFICATIONS 17 FORWARD LOOKING STATEMENT This Quarterly Report on Form 10-Q ("Form 10-Q") contains statements which constitute forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements appear in a number of places in this Form 10-Q and include statements regarding the intent, belief, outlook, estimate or expectations of the Company (as defined in the notes to the consolidated condensed financial statements), its directors or its officers primarily with respect to future events and the future financial performance of the Company. Readers of this Form 10-Q are cautioned that any such forward looking statements are not guarantees of future events or performance and involve risks and uncertainties, and that actual results may differ materially from those in the forward looking statements as a result of various factors. The accompanying information contained in this Form 10-Q identifies important factors that could cause such differences. These factors include changes in interest rates; loss of deposits and loan demand to other financial institutions; substantial changes in financial markets; changes in real estate values and the real estate market; or regulatory changes. PART I FINANCIAL INFORMATION Item 1. Financial Statements UNION COMMUNITY BANCORP AND SUBSIDIARY Consolidated Condensed Balance Sheets June 30, December 31, 2003 2002 ------------------------ ------------------------- (Unaudited) Assets Cash $ 670,028 $ 992,705 Interest-bearing demand deposits 37,295,429 35,593,482 ------------------------ ------------------------- Cash and cash equivalents 37,965,457 36,586,187 Interest-bearing deposits 145,107 145,107 Investment securities Available for sale 5,006,250 ---- Held to maturity 759,372 1,636,513 ------------------------ ------------------------- Total investment securities 5,765,622 1,636,513 Loans, net of allowance for loan losses of $1,097,787 and $1,030,000 209,646,063 216,703,469 Premises and equipment 4,628,011 3,238,899 Federal Home Loan Bank stock 3,468,900 3,423,600 Investment in limited partnership 846,609 836,609 Foreclosed assets and real estate held for development, net 1,464,163 1,607,146 Goodwill 2,392,808 2,296,927 Core deposit intangible 441,532 484,820 Interest receivable 1,208,379 1,276,538 Other assets 6,032,666 1,080,502 ------------------------ ------------------------- Total assets $ 274,005,317 $ 269,316,317 ======================== ========================= Liabilities Deposits Noninterest-bearing $ 3,691,567 $ 3,849,659 Interest-bearing 193,532,436 186,341,769 ------------------------ ------------------------- Total deposits 197,224,003 190,191,428 Federal Home Loan Bank advances 39,514,178 39,751,631 Note payable 131,892 302,892 Interest payable 491,998 650,182 Dividends payable 315,000 341,700 Other liabilities 1,379,581 889,967 ------------------------ ------------------------- Total liabilities 239,056,652 232,127,800 ======================== ========================= Commitments and Contingent Liabilities Shareholders' Equity Preferred stock, no par value Authorized and unissued - 2,000,000 shares Common stock, no-par value Authorized - 5,000,000 shares Issued and outstanding - 2,100,000 and 2,278,000 shares 22,361,852 24,159,185 Retained earnings 14,439,199 15,032,214 Accumulated other comprehensive income 4,270 ---- Unearned employee stock ownership plan (ESOP) shares (1,276,200) (1,323,401) Unearned recognition and retention plan (RRP) shares (580,456) (679,481) ------------------------ ------------------------- Total shareholders' equity 34,948,665 37,188,517 ------------------------ ------------------------- Total liabilities and shareholders' equity $ 274,005,317 $ 269,316,317 ======================== ========================= See notes to consolidated condensed financial statements. UNION COMMUNITY BANCORP AND SUBSIDIARY Consolidated Condensed Statements of Income (Unaudited) Three Months Ended Six Months Ended June 30 June 30 ------------------ ------------------- ----------------- --------------- 2003 2002 2003 2002 ------------------ ------------------- ----------------- --------------- Interest and Dividend Income Loans $ 3,723,641 $ 4,421,951 $ 7,745,632 $ 8,873,844 Investment securities 47,748 77,665 79,571 154,045 Dividends on Federal Home Loan Bank stock 47,477 53,347 91,476 103,998 Deposits with financial institutions 133,330 105,807 261,987 146,840 ------------------ ------------------- ----------------- --------------- Total interest and dividend income 3,952,196 4,658,770 8,178,666 9,278,727 ------------------ ------------------- ----------------- --------------- Interest Expense Deposits 1,327,926 1,615,994 2,796,754 3,311,332 Federal Home Loan Bank advances 456,898 488,808 909,128 900,870 ------------------ ------------------- ----------------- --------------- Total interest expense 1,784,824 2,104,802 3,705,882 4,212,202 ------------------ ------------------- ----------------- --------------- Net Interest Income 2,167,372 2,553,968 4,472,784 5,066,525 Provision for loan losses 30,000 20,000 60,000 60,000 ------------------ ------------------- ----------------- --------------- Net Interest Income After Provision for Loan Losses 2,137,372 2,533,968 4,412,784 5,006,525 ------------------ ------------------- ----------------- --------------- Other Income (Losses) Service charges on deposit accounts 35,345 39,822 71,083 72,076 Equity in income (losses) of limited partnerships --- (7,500) 10,000 (12,500) Net realized gains on sales of available for sale securities --- 2,574 --- 8,534 Other income 49,151 15,100 72,295 59,061 ------------------ ------------------- ----------------- --------------- Total other income 84,496 49,996 153,378 127,171 ------------------ ------------------- ----------------- --------------- Other Expenses Salaries and employee benefits 759,072 714,776 1,479,355 1,425,610 Net occupancy expenses 70,655 42,728 146,657 100,183 Equipment expenses 78,305 80,035 158,192 151,522 Legal and professional fees 88,551 68,462 174,076 108,981 Data processing fees 102,988 69,205 204,237 549,246 Other expenses 294,496 238,973 574,297 478,966 ------------------ ------------------- ----------------- --------------- Total other expenses 1,394,067 1,214,179 2,736,814 2,814,508 ------------------ ------------------- ----------------- --------------- Income Before Income Tax 827,801 1,369,785 1,829,348 2,319,188 Income tax expense 276,817 476,702 633,500 779,182 ------------------ ------------------- ----------------- --------------- Net Income $ 550,984 $ 893,083 $ 1,195,848 $ 1,540,006 ================== =================== ================= =============== Basic Earnings per Share $ .28 $ .39 $ .59 $ .69 Diluted Earnings per Share .28 .39 .58 .69 Dividends per Share .15 .12 .30 .23 See notes to consolidated condensed financial statements. UNION COMMUNITY BANCORP AND SUBSIDIARY Consolidated Condensed Statement of Shareholders' Equity For the Six Months Ended June 30, 2003 (Unaudited) Accumulated Common Stock Other Unearned ----------------------- Shares Comprehensive Retained Comprehensive ESOP Unearned Outstanding Amount Income Earnings Income Shares Compensation Total ----------- ----------- -------------- ---------- ------------- ---------- ------------- ----------- Balances, January 1, 2003 2,278,000 $24,159,185 $15,032,214 $(1,323,401) $(679,481) $37,188,517 Comprehensive income Net income for the period $1,195,848 1,195,848 1,195,848 Other comprehensive income, net of tax Unrealized gains on 4,270 $ 4,270 4,270 securities ---------- Comprehensive income $1,200,118 ========== Cash dividends ($.15 per (616,997) (616,997) share) Purchase of common stock 178,000 (1,828,434) (1,171,866) (3,000,300) Amortization of unearned compensation expense 99,025 99,025 ESOP shares earned 31,101 47,201 78,302 ----------- ------------- ----------- ------------ ------------ ------------- ----------- Balances, June 30, 2003 2,100,000 $22,361,852 $14,439,199 $ 4,270 $(1,276,200) $(580,456) 34,948,665 =========== ============= =========== ============ ============ ============= =========== See notes to consolidated condensed financial statements. UNION COMMUNITY BANCORP AND SUBSIDIARY Consolidated Condensed Statements of Cash Flows (Unaudited) Six Months Ended June 30, ---------------- --------------- 2003 2002 ---------------- --------------- Operating Activities Net income $ 1,195,848 $ 1,540,006 Adjustments to reconcile net income to net cash provided by operating activities Provision for loan losses 67,787 60,000 Depreciation and amortization 162,152 158,550 Investment securities accretion, net (432) (1,649) Gain on sale of investment securities available for sale --- (8,534) Loss on sale of real estate owned 14,045 22,399 Equity in losses of limited partnerships (10,000) 12,500 Amortization of purchase accounting adjustments (169,689) (453,847) Amortization of unearned compensation expense 99,025 145,633 ESOP shares earned 78,302 70,986 Net change in: Interest receivable 68,159 154,426 Interest payable (158,184) (194,788) Other adjustments (4,951,785) 934,322 ---------------- --------------- Net cash provided by (used in) operating activities (3,604,772) 2,440,004 ---------------- --------------- Investing Activities Net change in interest-bearing deposits --- 94,976 Investment securities Purchase of investment securities available for sale (8,000,000) Proceeds from sales of investment securities available for sale --- 75,613 Proceeds from maturities of securities held to maturity and paydowns of mortgage-backed securities 3,877,573 353,976 Net changes in loans 6,800,243 4,328,598 Net cash received in acquisition --- 15,866,825 Additions to real estate owned (124,138) (42,923) Proceeds from real estate sales 389,657 356,769 Purchases of property and equipment (1,537,055) (155,070) Other investing activities (95,881) ---- ---------------- --------------- Net cash provided by investing activities 1,310,399 20,878,764 ---------------- --------------- Financing Activities Net change in Interest-bearing demand and savings deposits 13,278,109 12,030,961 Certificates of deposit (6,084,534) (24,264,383) Proceeds from borrowings ---- 20,000,000 Repayment of borrowings (317,890) (20,311,993) Cash dividends (616,997) (545,383) Repurchase of common stock (3,000,300) (4,875,570) Net change in advances by borrowers for taxes and insurance 415,255 9,377 ---------------- --------------- Net cash provided by (used in) financing activities 3,673,643 (17,956,991) ---------------- --------------- Net Change in Cash and Cash Equivalents 1,379,270 5,361,777 Cash and Cash Equivalents, Beginning of Period 36,586,187 13,564,902 ---------------- --------------- Cash and Cash Equivalents, End of Period $ 37,965,457 $ 18,926,679 ================ =============== Additional Cash Flows Information Interest paid $ 3,864,066 $ 4,406,990 Income tax paid 696,913 455,991 Loans transferred to foreclosed real estate 150,790 184,399 See notes to consolidated condensed financial statements. UNION COMMUNITY BANCORP AND SUBSIDIARY Notes to Unaudited Consolidated Condensed Financial Statements Note 1: Basis of Presentation The consolidated financial statements include the accounts of Union Community Bancorp, an Indiana corporation (the "Company") and its wholly owned subsidiary, Union Federal Savings and Loan Association, a federally chartered savings and loan association ("Union Federal"). A summary of significant accounting policies is set forth in Note 1 of Notes to Financial Statements included in the December 31, 2002 Annual Report to Shareholders. All significant intercompany accounts and transactions have been eliminated in consolidation. The interim consolidated financial statements have been prepared in accordance with instructions to Form 10-Q, and therefore do not include all information and footnotes necessary for a fair presentation of financial position, results of operations and cash flows in conformity with generally accepted accounting principles. The interim consolidated financial statements at June 30, 2003, and for the three and six months ended June 30, 2003 and 2002, have not been audited by independent accountants, but reflect, in the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position, results of operations and cash flows for such periods. The results of operations for the six-month period ended June 30, 2003, are not necessarily indicative of the results which may be expected for the entire year. The consolidated condensed balance sheet of the Company as of December 31, 2002 has been derived from the audited consolidated balance sheet of the Company as of that date. Note 2: Earnings Per Share Earnings per share have been computed based upon the weighted-average common shares outstanding. Unearned Employee Stock Ownership Plan shares have been excluded from the computation of average common shares outstanding. Three Months Ended Three Months Ended June 30, 2003 June 30, 2002 ------------- ------------- Weighted Weighted Average Per Share Average Per Share Income Shares Amount Income Shares Amount ------ ------ ------ ------ ------ ------ Basic earnings per share Income available to common shareholders $550,984 1,973,814 $ .28 $893,083 2,278,959 $ .39 =========== ============= Effect of dilutive RRP awards and stock options 23,577 3,900 -------------- --------------- ------------ ------------- Diluted earnings per share Income available to common shareholders and assumed conversions $ 550,984 1,997,391 $ .28 $ 893,083 2,282,859 $ .39 ============== =============== =========== ============ ============= ============= Six Months Ended Six Months Ended June 30, 2003 June 30, 2002 ------------- ------------- Weighted Weighted Average Per Share Average Per Share Income Shares Amount Income Shares Amount ------ ------ ------ ------ ------ ------ Basic earnings per share Income available to common shareholders $ 1,195,848 2,032,240 $ .59 $ 1,540,006 2,222,956 $ .69 =========== ============= Effect of dilutive RRP awards and stock options 19,381 1,950 -------------- --------------- ------------- ------------- Diluted earnings per share Income available to common shareholders and assumed conversions $ 1,195,848 2,051,621 $ .58 $ 1,540,006 2,224,906 $ .69 ============== =============== =========== ============= ============= ============= Note 4: Stock Options The Company has a stock-based employee compensation plan, which is described more fully in the Notes to Financial Statements included in the December 31, 2002 Annual Report to shareholders. The Company accounts for this plan under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under the plan had an exercise price equal to the market value of the underlying common stock on the grant date. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value provisions of Statement of Financial Accounting Standards ("SFAS") No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation. Three Months Ended June Three Months Ended 30, 2003 June 30, 2002 ----------------------------------------------------- Net income, as reported $ 550,984 $ 893,083 Less: Total stock-based employee compensation cost determined under the fair value based method, net of income taxes 9,133 12,016 ----------------------------------------------------- Pro forma net income $ 541,851 $ 881,067 ===================================================== Earnings per share: Basic - as reported $ .28 $ .39 Basic - pro forma $ .27 $ .39 Diluted - as reported $ .28 $ .39 Diluted - pro forma $ .27 $ .39 Six Months Ended Six Months Ended June 30, 2003 June 30, 2002 ----------------------------------------------------- Net income, as reported $ 1,195,848 $1,540,006 Less: Total stock-based employee compensation cost determined under the fair value based method, net of income taxes 18,267 24,032 ----------------------------------------------------- Pro forma net income $ 1,177,581 $1,515,974 ===================================================== Earnings per share: Basic - as reported $ .59 $ .69 Basic - pro forma $ .58 $ .68 Diluted - as reported $ .58 $ .69 Diluted - pro forma $ .57 $ .68 Note 5: Effect of Recent Accounting Pronouncements The Financial Accounting Standards Board ("FASB") adopted SFAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure. This Statement amends FASB Statement No. 123, Accounting for Stock-Based Compensation. SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require more prominent and more frequent disclosures in financial statements about the effects of stock-based compensation. Under the provisions of SFAS No. 123, companies that adopted the fair value based method were required to apply that method prospectively for new stock option awards. This contributed to a "ramp-up" effect on stock-based compensation expense in the first few years following adoption, which caused concern for companies and investors because of the lack of consistency in reported results. To address that concern, SFAS No. 148 provides two additional methods of transition that reflect an entity's full complement of stock-based compensation expense immediately upon adoption, thereby eliminating the ramp-up effect. SFAS No. 148 also improves the clarity and prominence of disclosures about the proforma effects of using the fair value based method of accounting for stock-based compensation for all companies - regardless of the accounting method used - by requiring that the data be presented more prominently and in a more user-friendly format in the footnotes to the financial statements. In addition, SFAS No. 148 improves the timeliness of those disclosures by requiring that this information be included in interim as well as annual financial statements. In the past, companies were required to make proforma disclosures only in annual financial statements. The transition guidance and annual disclosure provisions of SFAS No. 148 are effective for fiscal years ending after December 15, 2002, with earlier application permitted in certain circumstances. The interim disclosure provisions are effective for financial reports containing financial statements for interim periods beginning after December 15, 2002. The FASB has stated it intends to issue a new statement on accounting for stock-based compensation and will require companies to expense stock options using a fair value based method at date of grant. The date of implementation for this proposed statement is not known. In November 2002, the FASB issued Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others ("FIN 45"). FIN 45 will change current practice in the accounting for and disclosure of guarantees. Guarantees meeting the characteristics described in FIN 45 are required to be initially recorded at fair value, which is different from the general current practice of recording a liability only when a loss is probable and reasonably estimable, as those terms are defined in FASB Statement No. 5, Accounting for Contingencies. FIN 45 also requires a guarantor to make new disclosures for virtually all guarantees even if the likelihood of the guarantor's having to make payments under the guarantee is remote. In general, FIN 45 applies to contracts or indemnification agreements that contingently require the guarantor to make payments to the guaranteed party based on changes in an underlying asset, liability, or an equity security of the guaranteed party such as financial standby letters of credit. Disclosure requirements of FIN 45 are effective for financial statements of interim or annual periods ending after December 31, 2002. The initial recognition and measurement provisions are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor's fiscal year-end. The guarantor's previous accounting for guarantees issued prior to the date of FIN 45 initial applications should not be revised or restated to reflect the provisions of FIN 45. The Company adopted FIN 45 on January 1, 2003. The adoption of FIN 45 does not currently have a material impact on the Company's consolidated financial statements. Note 6: Reclassifications Certain reclassifications have been made to the 2002 consolidated condensed financial statements to conform to the June 30, 2003 presentation. Item 2: Management's Discussion and Analysis of Financial Condition and Results of Operations General The Company was organized in September 1997. On December 29, 1997, it acquired the common stock of Union Federal upon the conversion of Union Federal from a federal mutual savings and loan association to a federal stock savings and loan association. The Company acquired Montgomery Financial Corporation ("Montgomery") in a transaction that closed on January 2, 2002. In the transaction, Montgomery was merged with and into the Company, and Montgomery Savings, a federally chartered thrift, was merged with and into Union Federal. Following the merger, MSA Service Corp ("MSA") became a subsidiary of Union Federal. Union Federal was organized as a state-chartered savings and loan association in 1913. Union Federal conducts its business from its main office located in Crawfordsville, Indiana. In addition, Union Federal has two branch offices in Crawfordsville and branch offices in Covington, Williamsport and Lafayette, Indiana. Four of the above mentioned branch offices were added in connection with the acquisition of Montgomery. Union Federal offers a variety of lending, deposit and other financial services to its retail and commercial customers. Union Federal's principal business consists of attracting deposits from the general public and originating fixed-rate and adjustable-rate loans secured primarily by first mortgage liens on one- to four-family residential real estate. Union Federal's deposit accounts are insured up to applicable limits by the Savings Association Insurance Fund of the Federal Deposit Insurance Corporation. Union Federal offers a number of financial services, which include: (i) residential real estate loans; (ii) multi-family loans; (iii) commercial real estate loans; (iv) construction loans; (v) home improvement loans and consumer loans, including single-pay loans, loans secured by deposits, installment loans and commercial loans; (vi) money market demand accounts; (vii) passbook savings accounts; and (viii) certificates of deposit. Union Federal currently owns two subsidiaries, UFS Service Corp. ("UFS"), whose sole asset is its investment in Pedcor Investments 1993-XVI, L.P. ("Pedcor") and MSA, which is a real estate management and development company. Pedcor is an Indiana limited partnership that was established to organize, build, own, operate and lease a 48-unit apartment complex in Crawfordsville, Indiana known as Shady Knoll II Apartments (the "Project"). Union Federal owns the limited partner interest in Pedcor. The general partner is Pedcor Investments LLC. The Project, operated as a multi-family, low- and moderate-income housing project, which is completed and is performing as planned. Because UFS engages exclusively in activities that are permissible for a national bank, OTS regulations permit Union Federal to include its investment in UFS in its calculation of regulatory capital. At present, MSA owns a tract of land in Crawfordsville, Indiana, which is being developed for the construction of seven condominium units. Union Federal's investment in MSA is excluded from its calculation of regulatory capital. Union Federal's results of operations depend primarily upon the level of net interest income, which is the difference between the interest income earned on interest-earning assets, such as loans and investments, and costs incurred with respect to interest-bearing liabilities, primarily deposits and borrowings. Results of operations also depend upon the level of Union Federal's non-interest income, including fee income and service charges, and the level of its non-interest expenses, including general and administrative expenses. Critical Accounting Policies Note 1 to the consolidated financial statements contains a summary of the Company's significant accounting policies presented on pages 25 through 27 of the Annual Report to Shareholders for the year ended December 31, 2002, which was filed on Form 10-K with the Commission on March 28, 2003. Certain of these policies are important to the portrayal of the Company's financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Management believes that its critical accounting policies include determining the allowance for loan losses, the valuation of the foreclosed assets and real estate held for development, and the valuation of intangible assets. Allowance for loan losses The allowance for loan losses is a significant estimate that can and does change based on management's assumptions about specific borrowers and current general economic and business conditions, among other factors. Management reviews the adequacy of the allowance for loan losses at least on a quarterly basis. The evaluation includes a review of payment performance, adequacy of collateral and financial condition of all major borrowers. A review of all nonperforming loans and other identified problem loans is performed and the probability of collecting all amounts due thereunder is determined. In addition, changes in the composition of the loan portfolio, the total outstanding loans and past loss experience are reviewed to determine the adequacy of the allowance for loan losses. Current economic and market conditions and potential negative changes to economic conditions are also reviewed in determining possible loan losses. Although it is the intent of management to fully evaluate and estimate the potential effects of economic and market conditions, changes in the conditions are susceptible to significant changes beyond those projected. A worsening or protracted economic decline beyond management's projections would increase the likelihood of additional losses due to the additional credit and market risk and could create the need for additional loss reserves. Foreclosed assets and real estate held for development Foreclosed assets and real estate held for development are carried at the lower of cost or fair value less estimated selling costs. Management estimates the fair value of the properties based on current appraisal information. Reviews of estimated fair value are performed on at least an annual basis. Economic environment, market conditions and the real estate market are continually monitored and decreases in the carried value are written down through current operations when any of these factors indicate a decrease to the market value of the assets. Future worsening or protracted economic conditions and a decline in the real estate market would increase the likelihood of a decline in property values and could create the need for future write downs of the properties held. Intangible assets Management periodically assesses the impairment of its goodwill and the recoverability of its core deposit intangible. Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value. If actual external conditions and future operating results differ from management's judgments, impairment and/or increased amortization charges may be necessary to reduce the carrying value of these assets to the appropriate value. A review of the fair value of the Company's goodwill and core deposit intangible was performed in the fourth quarter of 2002 and it was management's opinion that there was no impairment of these intangible assets as of the date of the review. Financial Condition Total assets increased $4.7 million to $274.0 million at June 30, 2003 from $269.3 million at December 31, 2002. Net loans decreased $7.1 million to $209.6 million at June 30, 2003. Cash and cash equivalents increased $1.4 million from December 31, 2002 to June 30, 2003. Investment securities increased $4.1 million from $1.6 million at December 31, 2002 to $5.7 million at June 30, 2003. This increase was due to an increase in available for sale investments of $5.0 million and a decrease in held to maturity investments $877,000 in payments on mortgage-backed securities. Premises and equipment increased $1.4 million to $4.6 million at June 30, 2003 primarily due to the cost of the current remodeling of Union Federal's home office. Real estate owned and held for investment decreased $143,000 to $1.5 million at June 30, 2003. In connection with the Montgomery acquisition, the balance of goodwill and core deposit intangibles are $2.4 million and $442,000 respectively. Goodwill will be reviewed annually for impairment and core deposit intangibles are currently being amortized. Other assets increased from $1.1 million at December 31, 2002 to $6.0 million at June 30, 2003. This increase is primarily due to a $5.0 million purchase of bank owned life insurance. Total liabilities increased $6.9 million from $232.1 million at December 31, 2002 to $239.0 million at June 30, 2003. Deposits increased by $7.0 million to $197.2 million during the six months ended June 30, 2003 primarily accounting for the change in total liabilities. Shareholders' equity decreased $2.2 million to $34.9 million at June 30, 2003. The decrease was primarily due to repurchase of 178,000 shares of common stock at a total cost of $3.0 million, or an average cost of $16.86 per share, and the payment of cash dividends in the amount of $617,000 partially offset by net income of $1.2 million, Employee Stock Ownership Plan shares earned of $78,000 and unearned compensation amortization of $99,000. Comparison of Operating Results for the Three Months Ended June 30, 2003 and 2002 Net income decreased $342,000 from $893,000 for the three months ended June 30, 2002 to $551,000 for the three months ended June 30, 2003. The return on average assets for the three months ended June 30, 2003 was .79% compared to 1.32% for the comparable period in 2002. The return on average equity for the three months ended June 30, 2003 was 6.02% compared to 9.25% for the comparable period in 2002. For the three months ended June 30, 2003, interest income was $4.0 million as compared to $4.7 million for the three months ended June 30, 2002. Interest income decreased primarily due to a decrease in the yield on interest-earning assets from 7.22% during the 2002 period to 5.96% during the 2003 period, which was partially offset by an increase in average interest-earning asset from $256.2 million at June 30, 2002 to $265.2 million at June 30, 2003. For the three months ended June 30, 2003, interest expense was $1.8 million as compared to $2.1 million for the three months ended June 30, 2002. Interest expense decreased primarily due to a decrease in the cost of interest-bearing liabilities from 3.72% during the 2002 period to 3.02% during the 2003 period, which was offset by an increase in average interest-bearing liabilities from $226.8 million at June 30, 2002 to $236.5 million at June 30, 2003. Amortization of purchase accounting adjustments also impacted interest expense during the 2002 and 2003 periods. The amortization of purchase accounting adjustments reduced interest expense by $126,000 in the 2003 period compared to a reduction of $276,000 for the 2002 period. The provision for loan losses for the three months ended June 30, 2003 was $30,000 as compared to $20,000 for the comparable period in 2002. A review is performed quarterly to determine the adequacy of the current balance in the allowance for loan losses. Total other income increased $35,000 from $50,000 for the three months ended June 30, 2002 to $85,000 for the 2003 comparable period. Total other expenses increased $180,000 from $1,214,000 for the three months ended June 30, 2002 to $1,394,000 for the comparable period in 2003. Salaries and employee benefits increased $44,000 during the comparable three-month periods primarily due to an increase in expense in funding the defined benefit pension plan in the amount of $19,000, an increase of $16,000 in employee insurance expense and an $8,000 increase in employee compensation. Net occupancy expense increased $28,000 during the comparable periods primarily due to general increases in expenses and the loss of office rental income due to the Montgomery acquisition. Legal and professional fees increased $20,000 to $89,000 for the three-months ended June 30, 2003. This increase was due to an increase in legal fees of $6,000 and an increase in consulting fees of $31,000 primarily due to the use of consultants for daily monitoring of information technology service and needs, this being partially offset by a decrease in audit and accounting expense in the amount of $17,000. Data processing expense increased $34,000 for the comparative periods due to an increase in services provided by the service bureau. Other expenses increased $55,000 from $239,000 for the three months ended June 30, 2002 to $294,000 for the 2003 comparable period. The two major increases in other expenses was an increase in advertising expense of $35,000 and an increase in directors compensation of $11,000. Comparison of Operating Results for the Six Months Ended June 30, 2003 and 2002 Net income decreased $344,000 from $1,540,000 for the six months ended June 30, 2002 to $1,196,000 for the six months ended June 30, 2003. The return on average assets for the six months ended June 30, 2003 was .86% compared to 1.13% for the comparable period in 2002. The return on average equity for the six months ended June 30, 2003 was 6.46% compared to 7.84% for the comparable six-month period in 2002. For the six months ended June 30, 2003, interest income was $8.2 million as compared to $9.3 million for the six months ended June 30, 2002. Interest income decreased primarily due to a decrease in the yield on interest-earning assets from 7.10% during the 2002 period to 6.16% during the 2003 period, which was partially offset by an increase in average interest-earning asset from $261.4 million at June 30, 2002 to $265.6 million at June 30, 2003. For the six months ended June 30, 2003, interest expense was $3.7 million as compared to $4.2 million for the six months ended June 30, 2002. Interest expense decreased primarily due to a decrease in the cost of interest-bearing liabilities from 3.73% during the 2002 period to 3.16% during the 2003 period, which was offset by an increase in average interest-bearing liabilities from $225.6 million at June 30, 2002 to $234.8 million at June 30, 2003. Amortization of purchase accounting adjustments also impacted interest expense during the 2002 and 2003 periods. The amortization of purchase accounting adjustments reduced interest expense by $252,000 in the 2003 period compared to a reduction of $552,000 for the 2002 period. The provision for loan losses for both six-month periods was $60,000. A review is performed quarterly to determine the adequacy of the current balance in the allowance for loan losses. Total other income increased $26,000 from $127,000 for the six months ended June 30, 2002 to $153,000 for the 2003 comparable period. Total other expenses decreased $78,000 from $2,815,000 for the six months ended June 30, 2002 to $2,737,000 for the comparable period in 2003. Salaries and employee benefits increased $54,000 during the comparable six-month periods primarily due to an increase in expense in funding the defined benefit pension plan in the amount of $49,000, an increase of $25,000 in employee insurance expense and a $21,000 increase in employee compensation partially offset by a decrease in unearned compensation expense of $47,000. Net occupancy expense increased $47,000 during the comparable periods primarily due to general increases in expenses and the loss of office rental income due to the Montgomery acquisition. Legal and professional fees increased $65,000 to $174,000 for the six-months ended June 30, 2003. This increase was due to an increase in legal fees of $6,000 and an increase in consulting fees of $66,000 primarily due to the use of consultants for daily monitoring of information technology service and needs this being partially offset by a decrease in audit and accounting expense in the amount of $7,000. Data processing expense decreased $345,000 for the comparative periods due to a one-time terminations fee for data processing services charged to expense during the 2002 comparative period offset by the cost of additional services being offered. Other expenses increased $96,000 from $479,000 for the six months ended June 30, 2002 to $575,000 for the 2003 comparable period. The three major increases in other expenses was an increase in advertising expense of $45,000, an increase in directors compensation of $21,000 and an increase in real estate owned expense of $15,000. Asset Quality Union Federal currently classifies loans as special mention, substandard, doubtful and loss to assist management in addressing collection risks and pursuant to regulatory requirements which are not necessarily consistent with generally accepted accounting principles. Special mention loans represent credits that have potential weaknesses that deserve management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects or Union Federal's credit position at some future date. Substandard loans represent credits characterized by the distinct possibility that some loss will be sustained if deficiencies are not corrected. Doubtful loans possess the characteristics of substandard loans, but collection or liquidation in full is doubtful based upon existing facts, conditions and values. A loan classified as a loss is considered uncollectible. At June 30, 2003 Union Federal had $6.6 million in classified assets as compared to $7.0 million at December 31, 2002. Union Federal had $2.9 million and $2.7 million in loans classified as special mention as of June 30, 2003 and December 31, 2002 respectively. In addition, Union Federal had $3.4 million and $4.2 million of loans classified as substandard at June 30, 2003 and December 31, 2002, respectively. At June 30, 2003 and December 31, 2002 Union Federal had $214,000 and $103,000, respectively, in loans classified as doubtful and no loans were classified as loss at either period end. At June 30, 2003, and December 31, 2002, respectively, $3.6 million and $3.1 million of the substandard and doubtful loans were non-accrual loans. The allowance for loan losses was $1,098,000 or .52% of loans at June 30, 2003 as compared to $1,030,000 or .47% of loans at December 31, 2002. Liquidity and Capital Resources The standard measure of liquidity for savings associations is the ratio of cash and eligible investments to a certain percentage of net withdrawable savings accounts and borrowings due within one year. The minimum required ratio is currently set by the Office of Thrift Supervision regulation at 4%. As of June 30, 2003, Union Federal had liquid assets of $38.2 million and a liquidity ratio of 15.7%. Off-balance Sheet Arrangements As of the date of this Report, Union Federal does not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on the Union Federal's financial condition, change in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors. The term "off-balance sheet arrangement" generally means any transaction, agreement, or other contractual arrangement to which an entity unconsolidated with Union Federal is a party under which Union Federal has (i) any obligation arising under a guarantee contract, derivative instrument or variable interest; or (ii) a retained or contingent interest in assets transferred to such entity or similar arrangement that serves as credit, liquidity or market risk support for such assets. Other The Securities and Exchange Commission maintains a Web site that contains reports, proxy information statements, and other information regarding registrants that file electronically with the Commission, including the Company. The address is http://www.sec.gov. Item 3. Quantitative and Qualitative Disclosures About Market Risk Presented below, as of March 31, 2003 and 2002, is the most recent available analyses performed by the OTS of Union Federal's interest rate risk as measured by changes in net portfolio value ("NPV") for instantaneous and sustained parallel shifts in the yield curve, in 100 basis point increments. Union Federal: At March 31, 2003 At March 31, 2002 ----------------- ----------------- Changes In Rates $ Change in NPV % Change in NPV $ Change in NPV % Change in NPV ---------------- --------------- --------------- --------------- --------------- +300 bp $ (9,982) (22)% $ (16,375) (37)% +200 bp (5,577) (13) (10,659) (24) +100 bp (1,841) (4) (5,035) (11) 0 bp 0 0 0 0 -100 bp (612) (1) 3,078 7 Management believes that at June 30, 2003 and March 31, 2003, there have been no material changes in market interest rates or in the Company's interest rate sensitive instruments which would cause a material change in the market risk exposures which affect the quantitative and qualitative risk disclosures as presented on pages 17-19 of the Company's Annual Report on Form 10-K for the period ended December 31, 2002. Item 4. Controls and Procedures (a) Evaluation of disclosure controls and procedures. The Company's chief executive officer and chief financial officer, after evaluating the effectiveness of the Company's disclosure controls and procedures (as defined in Sections 13a-15(e) and 15d-15(e) of the regulations promulgated under the Securities Exchange Act of 1934, as amended), as of the end of the most recent fiscal quarter covered by this quarterly report (the "Evaluation Date"), have concluded that as of the Evaluation Date, the Company's disclosure controls and procedures were adequate and are designed to ensure that material information relating to the Company would be made known to such officers by others within the Company on a timely basis. (b) Changes in internal controls. There were no significant changes in the Company's internal control over financial reporting identified in connection with the Company's evaluation of controls that occurred during the Company's last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. PART II. OTHER INFORMATION Item 1. Legal Proceedings None. Item 2. Changes in Securities and Use of Proceeds None. Item 3. Defaults Upon Senior Securities. None. Item 4. Submission of Matters to Vote of Security Holders. On April 16, 2003, Union Community Bancorp held its Annual Meeting of Shareholders. Four directors were elected to terms expiring in 2006 by the following votes: C. Rex Henthorn For: 1,823,930 Withheld: 240,901 Samuel H. Hildebrand For: 1,877,689 Withheld: 187,142 Joseph M. Malott For: 1,877,862 Withheld: 186,969 Harry A. Siamas For: 1,966,176 Withheld: 98,655 The terms of office of the following directors of Union Community Bancorp continued after the Annual Shareholder Meeting: Name Term Expires In ---- --------------- Philip L. Boots 2004 Mark E. Foster 2004 John M. Horner 2004 Marvin L. Burkett 2005 Phillip E. Grush 2005 Joseph E. Timmons 2005 Item 5. Other Information. None. Item 6. Exhibits and Reports on Form 8-K. (a) Exhibits 31(1)Certification required by 17 C.F.R. Section 240.13a-14(a) 31(1) Certification required by 17 C.F.R. Section 240.13a-14(a) 32 Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (b) Reports on Form 8-K 1. Earnings release for the quarter ended March 31, 2003 filed on April 22, 2003. 2. Press release announcing the completion of the stock repurchase program that began on March 25, 2003 filed on May 30, 2003. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. LINCOLN BANCORP Date: August 13, 2003 By: /s/ Alan L. Grimble --------------------------------------- T. Tim Unger President and Chief Executive Officer Date: August 13, 2003 By: /s/ John M. Baer ------------------------------- John M. Baer Treasurer