FIRST NATIONAL CORPORATION To Our Shareholders, Customers and Friends We have completed another record breaking year at First National. As you are aware, we celebrated 90 years in the banking business in July 1997. Thanks to the vision of those individuals who started our bank in 1907, today we can boast that we are the largest and best independent community home town bank in the area. First Bank and First National Corporation set new records during 1997. As can be noted from this report, our earnings for the year were $1,611,322 reflecting an increased after tax income of 10.80%. This equates to $2.08 per share compared to $1.88 for last year. Our dividend was increased from $.70 per share in 1996 to $.82 per share for this year reflecting an increase of 17.14%. Our asset growth was very impressive at over 16% followed by loan growth of more than 14% and deposit growth of almost 13%. As this report shows, total assets now are nearing $165 million. As we continue to reflect on our company's accomplishments for the past year, we are proudest of our new headquarters facility. We celebrated our 90th anniverary with the completion of this new building. Again, we thank our customers and employees for your patience during the construction process. Our loan department, which has grown from $61 million to $112 million over the last four years, occupies the first floor of our new addition. Administration, accounting, and the board room occupy the second floor. The third floor is occupied by bookkeeping and data processing. Our new facility should accommodate our needs for many years. Our bank continues to make progress toward becoming a full service financial center. Our full brokerage service has met with much success during the year. The availability of mutual funds, annuities, life insurance, equities, IRAs and many other services and products meet the needs of our customers. Another service that has benefited our customers during the year is our Business Manager Program. We purchase accounts receivable from our commercial customers and submit invoices to their customers. These payments come directly to the bank. This process gives our commercial customer additional cash to accomplish other company goals. We have been very fortunate to have had good economic conditions for 1997. The banking industry continues to go through major changes and consolidation, but banking remains healthy. There were no bank closures during the year due to insolvency. With the consolidation of three major banks in our market area, we are in an excellent position to take advantage of the ever changing banking environment. FIRST NATIONAL CORPORATION A challenge we have in our immediate future is complying with year 2000 and other technology. Although we have to depend on our vendors, we will be in full compliance with year 2000 by the end of 1998. We have a plan in place and are monitoring it very closely. We have many other technology opportunities to be considered. At the top of our list is a Corporate Cash Management program. Commercial customers will be able to receive information on their accounts 24 hours a day, 7 days a week via computer. We have a wide array of information available to our customers via the telephone. You have access to your account information 24 hours a day, 7 days a week through BankLine. We continue to expand our Automatic Teller Machine network. We placed one in the Shenandoah Memorial Hospital in Woodstock this year and have plans for additional ATMs in 1998 including one at our Wards Plaza Office. Your First Bank Visa Check Card can be used at many locations in our community and throughout the United States and the world. We continue to monitor Home/Electonic Banking and will follow the progress very carefully. Our website is available to you at www.firstbank-va.com. As we have shared with you before, First National Corporation's shares are listed on the OTC Bulletin Board under the symbol FXNC. Several brokers make a market in our stock. Call your broker or First Bank to assist you should you have interest in buying or selling shares of First National Corporation. Our Dividend Reinvestment Plan is still very popular with our shareholders. Should you have interest in easily obtaining additional shares of our stock through reinvesting current dividends, please contact any employee at First Bank. As we look to the future, we can be pleased with the progress of our bank. A new year is here and we have many challenges facing us. We have invested in the future of our bank by offering quality products and services. We have a well trained and dedicated staff. We also enjoy the support of a very involved Board of Directors. We thank our customers for their loyalty and patronage and say "Thank You" to the shareholders for your continued support. We were real pleased to have 212 individuals attend our 1997 annual shareholders meeting at the Ramada Inn in Woodstock. We continue to be pleased as we set new records with attendance at our annual shareholders meeting. Noel M. Borden, Chairman of the Board, and Ronald F. Miller, President/Chief Executive Officer, view the Bank's website on the Internet. Noel M. Borden Chairman of the Board Ronald F. Miller President/Chief Executive Officer FIRST NATIONAL CORPORATION Independent Auditor's Report To the Stockholders and Directors First National Corporation Strasburg, Virginia We have audited the accompanying consolidated balance sheets of First National Corporation and Subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of income, changes in stockholders' equity and cash flows for the years ended December 31, 1997, 1996 and 1995. These financial statements are the responsibility of the Corporation'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 consolidated financial statements referred to above present fairly, in all material respects, the financial position of First National Corporation and Subsidiaries as of December 31, 1997 and 1996, and the results of its operations and its cash flows for the years ended December 31, 1997, 1996 and 1995, in conformity with generally accepted accounting principles. Yount, Hyde & Barbour, P.C. Winchester, Virginia January 9, 1998 FIRST NATIONAL CORPORATION December 31 1997 1996 Assets Cash and due from banks $ 3,623,386 $ 3,510,451 Securities (fair value: 1997, $41,699,077; 1996, $33,739,775) (Note 2) 41,698,525 33,742,045 Loans, net (Notes 3, 4 and 13) 112,493,701 98,421,131 Bank premises and equipment (Note 5) 3,933,602 3,320,025 Interest receivable 1,148,462 891,350 Other real estate 919,239 803,808 Other assets (Note 9) 771,836 640,296 -------------- ------------- Total assets $ 164,588,751 $ 141,329,106 ============== ============= Liabilities and Liabilities Stockholders' Deposits: Equity Noninterest bearing demand deposits $ 16,969,015 $ 14,512,930 Savings and interest bearing demand deposits 68,289,401 53,606,918 Time deposits (Note 6) 54,503,436 55,968,567 -------------- ------------- Total deposits $ 139,761,852 $ 124,088,415 Federal funds purchased 1,417,000 315,000 Long-term debt (Note 8) 6,461,236 1,481,424 Accrued expenses (Note 11) 766,388 607,073 Commitments and contingent liabilities (Notes 12 and 16) -------------- ------------- Total liabilities $ 148,406,476 $ 126,491,912 Stockholders' Equity -------------- ------------- Common stock, par value $5 per share; authorized 2,000,000 shares; issued and outstanding 777,547 and 774,406 shares (Note 15) $ 3,887,735 $ 3,872,030 Surplus 1,187,023 1,132,638 Retained earnings (Note 10) 10,772,543 9,801,091 Unrealized gain on securities available for sale, net 334,974 31,435 -------------- ------------- Total stockholders' equity $ 16,182,275 $ 14,837,194 -------------- ------------- Total liabilities and stockholders' equity $ 164,588,751 $ 141,329,106 ============== ============= See Notes to Consolidated Financial Statements. Liabilities and Stockholders' Equity FIRST NATIONAL CORPORATION Years Ended December 31 1997 1996 1995 Interest Interest and fees on loans $ 9,626,462 $ 8,686,663 $ 7,564,195 Income Interest on federal funds sold 72,338 98,316 56,714 Interest on deposits in banks 27,828 24,626 12,644 Interest on investment securities, taxable 142,761 237,132 606,318 Interest and dividends on securities available for sale: Taxable 1,669,348 1,336,188 1,353,292 Nontaxable 356,755 383,185 289,889 Dividends 78,267 67,175 59,823 ------------- ------------ ------------ Total interest income $ 11,973,759 $ 10,833,285 $ 9,942,875 ------------- ------------ ------------ Interest Interest on deposits $ 5,614,295 $ 4,995,935 $ 4,597,178 Expense Interest on federal funds purchased 19,612 2,799 24,577 Interest on Federal Home Loan Bank advances -- -- 105,644 Interest on long-term debt 104,182 98,241 5,137 ------------- ------------ ------------ Total interest expense $ 5,738,089 $ 5,096,975 $ 4,732,536 ------------- ------------ ------------ Net interest income $ 6,235,670 $ 5,736,310 $ 5,210,339 Provision for loan losses (Note 4) 220,000 120,000 -- ------------- ------------ ------------ Net interest income after provision for loan losses $ 6,015,670 $ 5,616,310 $ 5,210,339 ------------- ------------ ------------ Other Service charges $ 568,276 $ 471,680 $ 492,203 Operating Commissions and fees from fiduciary Income activities -- -- 3,374 Fees for other customer services 118,097 87,545 87,919 Profits (loss) on securities available for sale 11,149 19,549 (7,818) Gain (loss) on sale of assets and other real estate 2,268 (23,059) 1,613 Other 178,678 92,185 225,951 ------------- ------------ ------------ Total other operating income $ 878,468 $ 647,900 $ 803,242 ------------- ------------ ------------ Other Salaries and employee benefits (Note 11) $ 2,365,875 $ 2,230,677 $ 2,204,369 Operating Occupancy expense 245,429 215,270 212,222 Expenses Equipment expense 528,289 527,615 504,974 FDIC insurance assessment 15,579 2,000 121,250 Advertising 271,294 202,839 134,630 Supplies and stationery 124,874 123,600 113,953 Telephone 138,256 107,143 91,369 Other 956,885 870,204 835,048 ------------- ------------ ------------ Total other operating expenses $ 4,646,481 $ 4,279,348 $ 4,217,815 ------------- ------------ ------------ Income before income taxes $ 2,247,657 $ 1,984,862 $ 1,795,766 Provision for income taxes (Note 9) 636,335 530,596 481,218 ------------- ------------ ------------ Net income $ 1,611,322 $ 1,454,266 $ 1,314,548 Earnings Per Common Share, basic (Note 20) $ 2.08 $ 1.88 $ 1.70 ============= ============ ============ Earnings Per Common Share, diluted (Note 20) $ 2.06 $ 1.88 $ 1.69 ============= ============ ============ Cash Dividends Per Share $ .82 $ .70 $ .60 ============= ============ ============ See Notes to Consolidated Financial Statements. FIRST NATIONAL CORPORATION Consolidated Statements of Cash Flows Years Ended December 31 1997 1996 1995 Cash Flows Net income $ 1,611,322 $ 1,454,266 $ 1,314,548 from Operating from Operating Activities Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 419,751 443,274 424,141 Provision for loan losses 220,000 120,000 -- (Gain) loss on sale of assets and other real estate (2,268) 23,059 (1,613) (Profits) loss on securities available for sale (11,149) (19,549) 7,818 Accretion of security discounts (49,763) (30,764) (18,531) Amortization of security premiums 107,910 99,723 97,339 Deferred tax expense (benefit) (70,181) 9,726 95,649 Changes in assets and liabilities: (Increase) in interest receivable (257,112) (51,077) (154,887) (Increase) decrease in other assets (217,728) 143,932 (127,094) (Increase) in other real estate (115,431) -- -- Increase (decrease) in accrued expenses 159,315 (18,225) (117,995) Net cash provided by ------------- ------------ ------------- operating activities $ 1,794,666 $ 2,174,365 $ 1,519,375 ------------- ------------ ------------- Cash Flows Proceeds from sale of securities available from Investing for sale $ 9,105,427 $ 2,319,615 $ 14,779,108 Activities Proceeds from maturities, calls, and principal payments of investment securities 1,364,430 3,041,039 3,512,479 Proceeds from maturities, calls, and principal payments of securities available for sale 5,892,658 6,399,218 2,963,092 Purchases of investment securities -- -- (253,281) Purchase of securities available for sale (23,906,086) (8,993,267) (17,898,434) Proceeds on sale of equipment 13,030 -- 7,123 Purchases of bank premises and equipment (1,044,089) (673,897) (784,910) Net (increase) in loans (14,292,570) (12,822,646) (10,772,500) Proceeds on sale of other real estate -- 244,416 -- Net cash (used in) ------------- ------------ ------------- investing activities $ (22,867,200) $ (10,485,522) $ (8,447,323) ------------- ------------ ------------- See Notes to Consolidated Financial Statements. FIRST NATIONAL CORPORATION Consolidated Statements of Cash Flows continued Years Ended December 31 1997 1996 1995 Cash Flows Net increase in demand deposits, from Financing NOW accounts, and savings accounts $ 17,138,568 $ 9,200,571 $ 12,545,376 Activities Net (decrease) in certificates of deposit (1,465,131) (1,122,247) (2,768,874) Proceeds from Federal Home Loan Bank advances -- -- 6,000,000 Proceeds from long-term debt 5,000,000 -- 1,500,000 Principal payments to Federal Home Loan Bank -- -- (9,000,000) Principal payments on long-term debt (20,188) (18,576) -- Net proceeds from issuance of common stock 70,090 55,717 18,076 Cash dividends paid (639,870) (540,872) (462,642) Increase (decrease) in federal funds purchased 1,102,000 (67,000) 382,000 Net cash provided by ------------- ------------ ------------ financing activities $ 21,185,469 $ 7,507,593 $ 8,213,936 Increase (decrease) in cash ------------- ------------ ------------ and cash equivalents $ 112,935 $ (803,564) $ 1,285,988 Cash and Cash Beginning 3,510,451 4,314,015 3,028,027 ------------- ------------ ------------ Equivalents Ending $ 3,623,386 $ 3,510,451 $ 4,314,015 ============= ============ ============ Supplemental Cash payments for: Disclosures of Cash Interest $ 5,714,898 $ 5,091,883 $ 4,705,842 ============= ============ ============ Flow Information Income taxes $ 652,286 $ 540,281 $ 556,468 ============= ============ ============ Supplemental Other real estate acquired in Disclosures of settlement of loans $ -- $ 267,475 $ 460,627 ============= ============ ============ Noncash Investing and Financing Unrealized gain (loss) on securities Activities available for sale $ 459,908 $ (60,474) $ 1,367,619 ============= ============ ============ See Notes to Consolidated Financial Statements. FIRST NATIONAL CORPORATION Consolidated Statements of Changes in Stockholders' Equity Years Ended December 31, 1997, 1996 and 1995 Unrealized Gain (Loss) on Securities Common Retained Available for Stock Surplus Earnings Sale, Net Total Balances, December 31, 1994 $3,854,510 $1,076,365 $ 8,035,791 $ (831,281) $12,135,385 Issuance of 210 shares of common stock, employee stock options 1,050 3,765 -- -- 4,815 Issuance of 586 shares of common stock, dividend reinvestment plan 2,930 10,331 -- -- 13,261 Net income -- -- 1,314,548 -- 1,314,548 Cash dividends -- -- (462,642) -- (462,642) Change in unrealized gain (loss) on securities available for sale, net of deferred income taxes of $464,991 -- -- -- 902,628 902,628 --------- --------- ---------- --------- ---------- Balances, December 31, 1995 $3,858,490 $1,090,461 $ 8,887,697 $ 71,347 $13,907,995 Issuance of 2,708 shares of common stock, dividend reinvestment plan 13,540 42,177 -- -- 55,717 Net income -- -- 1,454,266 -- 1,454,266 Cash dividends -- -- (540,872) -- (540,872) Change in unrealized gain (loss) on securities available for sale, net of deferred income taxes of $20,562 -- -- -- (39,912) (39,912) --------- --------- ---------- --------- ---------- Balances, December 31, 1996 $3,872,030 $1,132,638 $ 9,801,091 $ 31,435 $14,837,194 Issuance of 3,141 shares of common stock, dividend reinvestment plan 15,705 54,385 -- -- 70,090 Net income -- -- 1,611,322 -- 1,611,322 Cash dividends -- -- (639,870) -- (639,870) Change in unrealized gain (loss) on securities available for sale, net of deferred income taxes of $156,369 -- -- -- 303,539 303,539 --------- --------- ---------- --------- ---------- Balances, December 31, 1997 $3,887,735 $1,187,023 $10,772,543 $ 334,974 $16,182,275 ========= ========= ========== ========= ========== See Notes to Consolidated Financial Statements. FIRST NATIONAL CORPORATION Notes to Consolidated Financial Statements Note 1 Nature of Banking Activities and Significant Accounting Policies - -------------------------------------------------------------------------------- First National Corporation and Subsidiaries (the Corporation) grant commercial, financial, agricultural, residential and consumer loans to customers in the Shenandoah Valley Region of Virginia. The loan portfolio is well diversified and generally is collateralized by assets of the customers. The loans are expected to be repaid from cash flow or proceeds from the sale of selected assets of the borrowers. The accounting and reporting policies of the Corporation conform to generally accepted accounting principles and to accepted practices within the banking industry. Principles of Consolidation: The consolidated financial statements of First National Corporation and its wholly-owned subsidiaries, First Bank (the Bank) and First Bank Financial Corporation (the Financial Corporation), include the accounts of all three companies. All material intercompany balances and transactions have been eliminated in consolidation. Securities: The Corporation has adopted FASB No. 115, "Accounting for Certain Investment in Debt and Equity Securities." This statement addresses the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. Those investments are classified in three categories and are accounted for as follows: a. Securities Held to Maturity Securities classified as held to maturity are those debt securities the Corporation has both the intent and ability to hold to maturity regardless of changes in market conditions, liquidity needs or changes in general economic conditions. These securities are carried at cost adjusted for amortization of premium and accretion of discount, computed by the interest method over their contractual lives. b. Securities Available for Sale Securities classified as available for sale are those debt and equity securities that the Corporation intends to hold for an indefinite period of time, but not necessarily to maturity. Any decision to sell a security classified as available for sale would be based on various factors, including significant movements in interest rates, changes in the maturity mix of the Corporation's assets and liabilities, liquidity needs, regulatory capital considerations, and other similar factors. Securities available for sale are carried at fair value. Unrealized gains or losses are reported as increases or decreases in stockholders' equity, net of the related deferred tax effect. Realized gains or losses, determined on the basis of the cost of specific securities sold, are included in earnings. c. Trading Securities Trading securities, which are generally held for the short term in anticipation of market gains, are carried at fair value. Realized and unrealized gains and losses on trading account assets are included in interest income on trading account securities. The Corporation held no assets classified as trading securities at December 31, 1997 and 1996. Derivatives: The Corporation has no securities defined as derivatives by FASB No. 119, "Disclosures for Derivative Financial Instruments." Loans: Loans are shown on the balance sheets net of unearned discounts and the allowance for loan losses. Interest is computed by methods which result in level rates of return on principal. Loans are charged off when in the opinion of management they are deemed to be uncollectible after taking into consideration such factors as the current financial condition of the customer and the underlying collateral and guarantees. The Corporation adopted FASB No. 114, "Accounting by Creditors for Impairment of a Loan." This statement has been amended by FASB No. 118, "Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures." Statement 114, as amended, requires that the impairment of loans that have been separately identified for evaluation is to be measured based on the present value of expected future cash flows or, alternatively, the observable market price of the loans or the fair value of the collateral. However, for those loans that are collateral dependent (that is, if repayment of those loans is expected to be provided solely by the underlying collateral) and for which management has determined foreclosure is probable, the measure of impairment of those loans is to be based on the fair value of the collateral. Statement 114, as amended, also requires certain disclosures about investments in impaired loans and the allowance for credit losses and interest income recognized on loans. The Corporation considers all consumer installment loans and residential mortgage loans to be homogeneous loans. These loans are not subject to impairment under FASB 114. A loan is considered impaired when it is probable that the Corporation will be unable to collect all principal and interest amounts according to the contractual terms of the loan agreement. Factors involved in determining impairment include, but are not limited to, expected future cash flows, financial condition of the borrower, and the current economic conditions. A performing loan may be considered impaired, if the factors above indicate a need for impairment. A loan on nonaccrual status may not be impaired if in the process of collection or there is an insignificant shortfall in payment. An insignificant delay of less than 30 days or a shortfall of less than 5% of the required principal and interest payment generally does not indicate an impairment situation, if in management's judgment the loan will be paid in full. Loans that meet the regulatory definitions of doubtful or loss generally qualify as an impaired loan under FASB 114. Charge-offs for FIRST NATIONAL CORPORATION Note 1 Nature of Banking Activities and Significant Accounting Policies continued - -------------------------------------------------------------------------------- impaired loans occur when the loan, or a portion of the loan is determined to be uncollectible, as is the case for all loans. The Corporation had no loans subject to FASB 114 at December 31, 1997 and 1996. Loans are placed on nonaccrual when a loan is specifically determined to be impaired or when principal or interest is delinquent for 90 days or more. Any unpaid interest previously accrued on those loans is reversed from income. Interest income generally is not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest payments received on such loans are applied as a reduction of the loan principal balance. Interest income on other nonaccrual loans is recognized only to the extent of interest payments received. Allowance for Loan Losses: The allowance for loan losses is maintained at a level which, in management's judgment, is adequate to absorb credit losses inherent in the loan portfolio. The amount of the allowance is based on management's evaluation of the collectibility of the loan portfolio, including the nature of the portfolio, credit concentrations, trends in historical loss experience, specific impaired loans, and economic conditions. Allowances for impaired loans are generally determined based on the collateral values or the present value of estimated cash flows. The allowance is increased by a provision for loan losses, which is charged to expense and reduced by charge-offs, net of recoveries. Changes in the allowance relating to impaired loans are charged or credited to the provision for loan losses. Because of uncertainties inherent in the estimation process, management's estimate of credit losses inherent in the loan portfolio and the related allowance may change in the near term. Bank Premises and Equipment: Bank premises and equipment are stated at cost less accumulated depreciation. For financial reporting, depreciation is computed using the straight-line method over the estimated useful lives of the assets, which range from five to forty years. Gains and losses on routine dispositions are reflected in current operations. Other Real Estate: Real estate acquired by foreclosure is carried at the lower of cost or fair market value less estimated costs of disposal. Income Taxes: Deferred taxes are provided on a liability method whereby deferred tax assets are recognized for deductible temporary differences, operating loss carryforwards, and tax credit carryforwards. Deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are differences between the reported amounts of assets and liabilities and their tax bases. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. Pension Plan: The Corporation has a trusteed, noncontributory pension plan covering substantially all employees. The Corporation computes the net periodic pension cost of the plan in accordance with FASB No. 87, "Employers' Accounting for Pensions." Earnings Per Share: In 1997, the Corporation adopted FASB No. 128, "Earnings Per Share." Statement 128 replaced the calculation of primary and fully diluted earnings per share with basic and diluted earnings per share. Basic earnings per share excludes any dilutive effects of options, warrants and convertible securities. Diluted earnings per share is very similar to the previously reported fully diluted earnings per share. All earnings per share amounts for all periods have been presented, and where appropriate, restated to conform to the Statement 128 requirements. Nonrefundable Loan Fees and Costs: Loan origination and commitment fees and certain direct loan origination costs are being deferred and the net amount amortized as an adjustment of the related loan's yield. Cash and Cash Equivalents: The Corporation has defined cash equivalents as those amounts included in the balance sheet caption "Cash and Due from Banks." Use of Estimates: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Advertising Costs: The Corporation follows the policy of charging the production costs of advertising to expense as incurred. Note 2 Securities - -------------------------------------------------------------------------------- Amortized costs and fair values of securities being held to maturity as of December 31, 1997 and 1996, are as follows: 1997 ----------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Fair Cost Gains (Losses) Value Mortgage-backed securities $ 1,661,684 $ 3,012 $ (2,460) $ 1,662,236 =========== ============ ============ =========== 1996 ----------------------------------------------------------- Mortgage-backed securities $ 3,032,999 $ 8,729 $ (10,999) $ 3,030,729 =========== ============ =========== =========== Maturities may differ from contractual maturities in mortgage-backed securities because the mortgages underlying the securities may be FIRST NATIONAL CORPORATION Note 2 Securities continued - -------------------------------------------------------------------------------- called or repaid without any penalties, therefore these securities are not included in a maturity analysis. Amortized costs and fair values of securities available for sale as of December 31, 1997 and 1996 are as follows: 1997 ----------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Fair Cost Gains (Losses) Value U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 31,961,244 $ 225,632 $ (25,039) $ 32,161,837 Obligations of states and political subdivisions 6,478,299 306,944 -- 6,785,243 Corporate securities 4,010 -- -- 4,010 Other 1,085,751 -- -- 1,085,751 ----------- -------- ---------- ----------- $ 39,529,304 $ 532,576 $ (25,039) $ 40,036,841 =========== ======== ========== =========== 1996 ----------------------------------------------------------- U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 19,694,145 $ 122,220 $ (98,485) $ 19,717,880 Obligations of states and political subdivisions 6,530,114 129,310 (100,340) 6,559,084 Corporate securities 4,010 -- -- 4,010 Mortgage-backed securities 3,376,438 14,427 (19,503) 3,371,362 Other 1,056,710 -- -- 1,056,710 ----------- -------- ---------- ----------- $30,661,417 $ 265,957 $ (218,328) $ 30,709,046 =========== ======== ========== =========== The amortized cost and fair value of securities available for sale as of December 31, 1997, by contractual maturity, are shown below. Maturities may differ from contractual maturities in corporate and mortgage-backed securities because the securities and mortgages underlying the securities may be called or repaid without any penalties. Therefore, these securities are not included in the maturity categories in the following maturity summary. Amortized Fair Cost Value Due in one year or less $ 1,369,947 $ 1,377,449 Due after one year through five years 16,074,089 16,221,281 Due after five years through ten years 14,325,017 14,476,858 Due after ten years 6,670,490 6,871,492 Corporate securities 4,010 4,010 Other 1,085,751 1,085,751 ------------ ------------ $ 39,529,304 $ 40,036,841 ============ ============ There were no sales of securities being held to maturity during 1997, 1996 and 1995. Proceeds from sales of securities available for sale during 1997, 1996 and 1995 were $9,105,427, $2,319,615 and $14,779,108, respectively. Gross gains of $41,973, $19,549 and $73,262 and gross losses of $30,824, $-0- and $81,080 were realized on those sales. Securities having a book value of $9,403,358 and $10,213,984 at December 31, 1997 and 1996, were pledged to secure public deposits and for other purposes required by law. FIRST NATIONAL CORPORATION Note 3 Loans - -------------------------------------------------------------------------------- Loans at December 31, 1997 and 1996, are summarized as follows: 1997 1996 (Thousands) Real estate loans: Construction and land development $ 3,583 $ 2,127 Secured by farm land 947 993 Secured by 1-4 family residential 45,133 43,615 Other real estate loans 17,126 16,959 Loans to farmers (except those secured by real estate) 647 770 Commercial and industrial loans (except those secured by real estate) 19,576 13,548 Loans to individuals for personal expenditures 26,574 21,397 All other loans 461 1,075 ---------- ---------- Total loans $ 114,047 $ 100,484 Less: Unearned income 441 1,089 Allowance for loan losses 1,112 974 ---------- ---------- Loans, net $ 112,494 $ 98,421 ========== ========== Note 4 Allowance for Loan Losses - -------------------------------------------------------------------------------- Transactions in the allowance for loan losses for the years ended December 31, 1997, 1996 and 1995, were as follows: 1997 1996 1995 Balance at beginning of year $ 974,412 $ 900,812 $ 1,155,104 Provision charged to operating expense 220,000 120,000 -- Loan recoveries 14,914 16,425 35,395 Loan charge-offs (97,008) (62,825) (289,687) ----------- ---------- ---------- Balance at end of year $ 1,112,318 $ 974,412 $ 900,812 =========== ========== ========== Nonaccrual loans excluded from impaired loan disclosure under FASB 114 amounted to $23,642 and $12,827 at December 31, 1997 and 1996, respectively. If interest on these loans had been accrued, such income would have approximated $3,490 and $566 for 1997 and 1996. Note 5 Bank Premises and Equipment - -------------------------------------------------------------------------------- Bank premises and equipment are summarized as follows at December 31, 1997 and 1996: 1997 1996 Land $ 468,785 $ 468,785 Buildings and leasehold improvements 3,392,827 2,226,750 Furniture and equipment 3,827,693 3,316,908 Construction in progress -- 657,124 ---------- ---------- $ 7,689,305 $ 6,669,567 Less accumulated depreciation 3,755,703 3,349,542 ---------- ---------- $ 3,933,602 $ 3,320,025 ========== ========== Depreciation expense included in operating expenses for 1997, 1996 and 1995 was $419,751, $443,274 and $424,141, respectively. Note 6 Deposits - -------------------------------------------------------------------------------- The aggregate amount of short-term jumbo CDs, each with a minimum denomination of $100,000, was approximately $12,243,178 and $12,130,029 in 1997 and 1996, respectively. At December 31, 1997, the scheduled maturities of CDs are as follows: 1998 $ 25,129,255 1999 through 2000 22,703,468 2001 and thereafter 6,670,713 ------------ $ 54,503,436 ============ FIRST NATIONAL CORPORATION Note 7 Short-Term Borrowings - -------------------------------------------------------------------------------- The Corporation had unused lines of credit totaling $31,239,282 with non-affiliated banks at December 31, 1997. Note 8 Long-Term Debt - -------------------------------------------------------------------------------- At December 31, 1997, the Corporation had borrowings from the Federal Home Loan Bank system totaling $6,461,236 which mature through December 12, 2005. The interest rate on these notes payable ranges from 5.58% to 6.25%. The Corporation has pledged real estate loans and Federal Home Loan Bank stock as collateral on these borrowings. Principal payments on these notes are due as follows: 1998 $ 21,940 1999 23,843 2000 25,912 2001 28,161 2002 5,030,604 Later years 1,330,776 ----------- $ 6,461,236 =========== Note 9 Income Taxes - -------------------------------------------------------------------------------- Net deferred tax assets consist of the following components as of December 31, 1997 and 1996: 1997 1996 Deferred tax assets: Allowance for loan losses $ 292,020 $ 244,908 Pension payable 103,545 58,528 Interest on nonaccrual loans 1,187 192 ------------- ------------ $ 396,752 $ 303,628 ------------- ------------ Deferred tax liabilities: Depreciation $ 53,822 $ 43,865 Bond accretion 6,107 8,893 Loan origination costs 67,178 51,406 Securities available for sale 172,562 16,194 ------------- ------------ $ 299,669 $ 120,358 ------------- ------------ $ 97,083 $ 183,270 ============= ============ The provision for income taxes charged to operations for the years ended December 31, 1997, 1996 and 1995 consists of the following: 1997 1996 1995 Current tax expense $ 706,516 $ 520,870 $ 385,569 Deferred tax expense (benefit) (70,181) 9,726 95,649 ------------- ------------ ------------ $ 636,335 $ 530,596 $ 481,218 ============= ============ ============ The income tax provision differs from the amount of income tax determined by applying the U.S. federal income tax rate to pretax income for the years ended December 31, 1997, 1996 and 1995, due to the following: caption> 1997 1996 1995 Computed "expected" tax expense $ 764,203 $ 674,853 $ 610,560 (Decrease) in income taxes resulting from: Tax exempt interest income (110,540) (128,063) (116,234) Other (17,328) (16,194) (13,108) ------------- ------------ ------------ $ 636,335 $ 530,596 $ 481,218 ============= ============ ============ Low income housing credits totalled $32,179 for each of the years ended December 31, 1997, 1996 and 1995, respectively. FIRST NATIONAL CORPORATION Note 10 Fund Restrictions and Reserve Balance - -------------------------------------------------------------------------------- Transfers of funds from the banking subsidiary to the parent corporation in the form of loans, advances and cash dividends are restricted by federal and state regulatory authorities. As of December 31, 1997, the aggregate amount of unrestricted funds which could be transferred from the banking subsidiary to the parent corporation, without prior regulatory approval, totalled $3,006,885. The Bank must maintain a reserve against its deposits in accordance with Regulation D of the Federal Reserve Act. For the final weekly reporting period in the years ended December 31, 1997 and 1996, the aggregate amounts of daily average required balances were approximately $612,000 and $537,000, respectively. Note 11 Employee Benefit Plans - -------------------------------------------------------------------------------- The amount charged to expense for the Company's pension plan totalled $132,404, $131,041 and $110,565 for 1997, 1996 and 1995, respectively. The components of the pension cost charged to expense consisted of the following: 1997 1996 1995 Service cost $ 145,319 $ 133,691 $ 102,027 Interest cost on projected benefit obligation 105,042 91,351 75,910 Actual return on plan assets (114,345) (91,375) (65,016) Net amortization and deferral (3,612) (2,626) (2,356) ------------- ------------- ------------- $ 132,404 $ 131,041 $ 110,565 ============= ============= ============= The following table sets forth the plan's funded status as of September 30, 1997 and 1996 and the amount recognized in the accompanying balance sheets as of December 31, 1997 and 1996: <caption 1997 1996 Actuarial present value of benefit obligations: Vested benefits $ 951,747 $ 735,307 ============ ============ Accumulated benefits $ 1,015,816 $ 784,268 ============ ============ Projected benefits $ (1,822,867) $ (1,400,560) Plan assets at fair value 1,689,889 1,270,505 ------------ ------------ Projected benefit obligation in excess of plan assets $ (132,978) $ (130,055) Unrecognized net asset (23,133) (26,448) Unrecognized net gain (148,432) (166,426) ------------ ------------ Liability on balance sheet as of September 30 $ (304,543) $ (322,929) Fourth quarter entries, employer contribution -- 150,790 ------------ ------------ Liability on balance sheet as of December 31 $ (304,543) $ (172,139) ============ ============ The weighted-average discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the benefit obligations for the year ended December 31, 1997 were 7.5% and 5.0%, respectively. The weighted-average discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the benefit obligations for the year ended December 31, 1996 were 7.5% and 6.0%, respectively. The expected long-term rate of return on plan assets was 9.0% for both years. The Corporation provides a profit sharing thrift plan for all eligible employees. Participating employees may elect to contribute up to 6% of their salaries. The Corporation contributes an amount equal to one-half of the employees' contributions. The Corporation's contributions in 1997, 1996 and 1995 were $54,399, $52,616 and $47,456, respectively. Note 12 Commitments and Contingencies - -------------------------------------------------------------------------------- In the normal course of business, there are outstanding various commitments and contingent liabilities, such as guarantees, commitments to extend credit, etc., which are not reflected in the accompanying financial statements. The Corporation does not anticipate losses as a result of these transactions. See Note 16 with respect to financial instruments with off-balance-sheet risk. Note 13 Transactions With Related Parties - -------------------------------------------------------------------------------- During the year, employees, executive officers and directors (and companies controlled by them) were customers of and had transactions with the Corporation in the normal course of business. These transactions were made on substantially the same terms as those prevailing for other customers. An analysis of loans (exclusive of loans to any such person which in the aggregate did not exceed $60,000) made by the Corporation to directors, executive officers, or principal stockholders or to any associate of such persons is shown in the following table: <>caption> Balance New Loan Balance January 1, 1997 Loans Repayments December 31, 1997 $2,962,158 $534,464 $436,796 $3,059,826 ========== ======== ======== ========== FIRST NATIONAL CORPORATION Note 14 Winchester Branch Office - -------------------------------------------------------------------------------- The branch office in Winchester has been leased for a five-year period beginning June 1, 1986, with options to renew for three additional five-year periods. The current annual rent is $20,039, with an allowable increase based on the Consumer Price Index. The annual rent for the third five-year period cannot exceed $21,175. Note 15 Dividend Reinvestment Plan - -------------------------------------------------------------------------------- The Company has in effect a Dividend Reinvestment Plan which provides an automatic conversion of dividends into common stock for enrolled shareholders. Stock is issued at 100% of fair market value on each dividend record date. Note 16 Financial Instruments With Off-Balance-Sheet Risk - -------------------------------------------------------------------------------- The Corporation is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement the Corporation has in particular classes of financial instruments. The Corporation's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. The Corporation uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. A summary of the contract or notional amount of the Corporation's exposure to off-balance-sheet risk as of December 31, 1997 and 1996, is as follows: 1997 1996 Financial instruments whose contract amounts represent credit risk: Commitments to extend credit $9,442 000 $15,110,000 Standby letters of credit $ 348,700 $ 201,030 Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Corporation evaluates each customer's credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Corporation upon extension of credit, is based on management's credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property and equipment, and income-producing commercial properties. Standby letters of credit are conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Corporation holds security agreements on accounts receivable, inventory and equipment as collateral supporting those commitments for which collateral is deemed necessary. The extent of collateral held for those commitments at December 31, 1997, varies from 0 percent to 100 percent; the average amount collateralized is 34 percent. The Corporation has cash accounts in other commercial banks. The amount on deposit at these banks at December 31, 1997, exceeded the insurance limits of the Federal Deposit Insurance Corporation by approximately $125,164. Note 17 Disclosures about Fair Value of Financial Instruments - -------------------------------------------------------------------------------- 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 instruments, the carrying amount is a reasonable estimate of fair value. Securities: For securities held for investment purposes, fair values are based on quoted market prices or dealer quotes. Loan Receivables: For certain homogeneous categories of loans, such as some residential mortgages, and other consumer loans, fair value is estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. The fair value of other types of loans 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. 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. Short-term Borrowings: The carrying amounts of federal funds purchased, borrowings under repurchase agreements and other short-term borrowings maturing within 90 days approximate their fair values. Fair values of other short-term FIRST NATIONAL CORPORATION Note 17 Disclosures about Fair Value of Financial Instruments continued - -------------------------------------------------------------------------------- borrowings are estimated using discounted cash flow analysis based on the Corporation's current incremental borrowing rates for similar types of borrowing arrangements. Off-Balance Sheet Financial Instruments: The fair value of commitments to extend credit is estimated using the fees currently charged to enter similar agreements, taking into account the remaining terms of the agreements and the present credit worthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date. At December 31, 1997 and 1996, the carrying amounts and fair values of loan commitments and standby letters of credit were deemed immaterial. The estimated fair values of the Corporation's financial instruments are as follows: 1997 1996 Carrying Fair Carrying Fair Amount Value Amount Value (in thousands) (in thousands) - --------------------------------------------------------------------------------------------------------------------------- Financial assets: Cash and short-term investments $ 3,623 $ 3,623 $ 3,510 $ 3,510 Securities 41,699 41,699 33,742 33,740 Loans 113,606 114,091 99,395 99,007 Less: allowance for loan losses 1,112 -- 974 -- ---------- ----------- ---------- ---------- Total financial assets $ 157,816 $ 159,413 $ 135,673 $ 136,257 ========== =========== ========== ========== Financial liabilities: Deposits $ 139,762 $ 139,788 $ 123,984 $ 124,000 Federal funds purchased 1,417 1,417 315 315 Long-term debt 6,461 6,304 1,481 1,437 ---------- ----------- ---------- ---------- Total financial liabilities $ 147,640 $ 147,509 $ 125,780 $ 125,752 ========== =========== ========== ========== Note 18 Regulatory Matters - -------------------------------------------------------------------------------- The Corporation is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory - possibly additional discretionary - actions by regulators that, if undertaken, could have a direct material effect on the Corporation's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Corporation must meet specific capital guidelines that involve quantitative measures of the Corporation's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Corporation's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Corporation to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets, and of Tier 1 capital to average assets. Management believes, as of December 31, 1997, that the Corporation meets all capital adequacy requirements to which it is subject. As of December 31, 1997, the most recent notification from the Federal Reserve Bank categorized the Corporation as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Corporation must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the institution's category. The Corporation's actual capital amounts and ratios are also presented in the table. To Be Well Capitalized Under For Capital Prompt Corrective Actual Adequacy Purposes Action Provisions Amount Ratio Amount Ratio Amount Ratio (Amount in Thousands) As of December 31, 1997: - ----------------------------------------------------------------------------------------------------------------------------- Total Capital (to Risk Weighted Assets): Consolidated $ 16,959 15.2% > $ 8,945 > 8.0% N/A First Bank $ 16,700 15.0% > $ 8,930 > 8.0% > $11,162 > 10.0% Tier 1 Capital (to Risk Weighted Assets): Consolidated $ 15,847 14.2% > $ 4,472 > 4.0% N/A First Bank $ 15,588 14.0% > $ 4,465 > 4.0% > $ 6,697 > 6.0% Tier 1 Capital (to Average Assets) Consolidated $ 15,847 10.0% > $ 6,343 > 4.0% N/A First Bank $ 15,588 9.8% > $ 6,337 > 4.0% > $ 7,922 > 5.0% FIRST NATIONAL CORPORATION Note 18 Regulatory Matters continued - -------------------------------------------------------------------------------- As of December 31, 1996: ---------------------------------------------------------------- Total Capital (to Risk Weighted Assets): Consolidated $ 15,780 16.6% > $ 7,604 > 8.0% N/A First Bank $ 15,485 16.3% > $ 7,593 > 8.0% > $ 9,491 > 10.0% Tier 1 Capital (to Risk Weighted Assets): Consolidated $ 14,806 15.6% > $ 3,802 > 4.0% N/A First Bank $ 14,511 15.3% > $ 3,796 > 4.0% > $ 5,695 > 6.0% Tier 1 Capital (to Average Assets): Consolidated $ 14,806 10.4% > $ 5,680 > 4.0% N/A First Bank $ 14,511 10.2% > $ 5,674 > 4.0% > $ 7,093 > 5.0% Note 19 Incentive Stock Option Plan - -------------------------------------------------------------------------------- The Corporation has an incentive stock option plan for all full-time employees. Under the plan, the Corporation may grant options for up to 21,000 shares of the common stock. The exercise price of each option is equal to the market price of the Corporation's stock on the date of grant. The maximum term of the option is five years, and they vest immediately upon grant. The Corporation applies APB Opinion 25 in accounting for its incentive stock option plan. Accordingly, no compensation cost has been recognized for the plan in 1997 and 1996. Had compensation cost been determined on the basis of fair value pursuant to FASB Statement No. 123, net income and earnings per share would not have been materially different from the amounts presented. The status of the stock option plan during 1997 and 1996 is as follows: 1997 1996 ------------------------------------------------------------------- Weighted Weighted Average Average Number of Exercise Number of Exercise Shares Price Shares Price Outstanding at January 1 19,003 $ 23.55 23,179 $ 23.40 Granted -- -- -- -- Exercised -- -- -- -- Forfeited (3,223) 23.76 (4,176) 22.72 -------- -------- Outstanding at December 31 15,780 23.51 19,003 23.55 ======== ======== The status of the options outstanding at December 31, 1997 is as follows: Weighted Weighted Number Average Average Outstanding Remaining Exercise and Contractual Price Exercisable Life $ 23.75 3,255 .33 years 24.00 5,540 1.54 years 23.00 6,985 2.29 years ------ 23.51 15,780 1.62 years ====== Note 20 Earnings Per Share - -------------------------------------------------------------------------------- The following table presents the amounts used in computing earnings per share and the effect on the weighted average number of shares of dilutive potential common stock. 1997 1996 1995 Per Share Per Share Per Share Shares Amount Shares Amount Shares Amount Weighted average number of common shares used in earnings per common share, basic 775,508 $ 2.08 772,557 $ 1.88 771,039 $ 1.70 ====== ====== ====== Effect of dilutive securities, stock options 7,464 -- 5,566 ------- ------- -------- Weighted number of common shares and dilutive potential common stock used in earnings per share - diluted 782,972 $ 2.06 772,557 $ 1.88 776,605 $ 1.69 ======= ====== ======= ====== ======= ====== Options on 19,003 and 6,510 shares of common stock were not included in computing diluted earnings per share for the years ended December 31, 1996 and 1995, because their effects were antidilutive. FIRST NATIONAL CORPORATION Note 21 Parent Corporation Only Financial Statements - -------------------------------------------------------------------------------- December 31 1997 1996 Balance Sheets Assets Cash $ 70,493 $ 89,196 Investment in subsidiaries, at cost, plus undistributed net income 15,923,036 14,542,190 Other assets 188,746 205,808 -------------- ------------- Total assets $ 16,182,275 $ 14,837,194 ============== ============= Liabilities and Stockholders' Equity Liabilities Accounts payable $ -- $ -- -------------- ------------- Stockholders' Equity Common stock $ 3,887,735 $ 3,872,030 Surplus 1,187,023 1,132,638 Retained earnings 10,772,543 9,801,091 Unrealized gain on securities available for sale, net 334,974 31,435 -------------- ------------- Total stockholders' equity $ 16,182,275 $ 14,837,194 -------------- ------------- Total liabilities and stockholders' equity $ 16,182,275 $ 14,837,194 ============== ============= Years Ended December 31 1997 1996 1995 Statements of Income, dividends from subsidiary $ 535,000 $ 465,000 $ 365,000 -------------- -------------- ------------- Income Expenses: Registration fees $ 850 $ 850 $ 850 Stationery and supplies 10,363 11,686 12,166 Legal and professional fees 6,677 12,610 18,253 Other 32,358 19,447 7,657 -------------- -------------- ------------- Total expenses $ 50,248 $ 44,593 $ 38,926 -------------- -------------- ------------- Income before allocated tax benefits and undistributed income of subsidiary $ 484,752 $ 420,407 $ 326,074 Allocated income tax benefits 49,263 47,341 45,414 -------------- -------------- ------------- Income before equity in undistributed income of subsidiary $ 534,015 $ 467,748 $ 371,488 Equity in undistributed income of subsidiary 1,077,307 986,518 943,060 -------------- -------------- ------------- Net income $ 1,611,322 $ 1,454,266 $ 1,314,548 ============== ============== ============= Years Ended December 31 1997 1996 1995 Statements of Cash Flows from Operating Activities Cash Flows Net income $ 1,611,322 $ 1,454,266 $ 1,314,548 Adjustments to reconcile net income to net cash provided by operating activities: Undistributed earnings of subsidiary (1,077,307) (986,518) (943,060) Decrease in other assets 17,062 11,877 9,367 Increase (decrease) in accounts payable -- (319) 319 -------------- -------------- ------------- Net cash provided by operating activities $ 551,077 $ 479,306 $ 381,174 -------------- -------------- ------------- Cash Flows from Financing Activities Net proceeds from issuance of common stock $ 70,090 $ 55,717 $ 18,076 Cash dividends paid (639,870) (540,872) (462,642) -------------- -------------- ------------- Net cash (used in) financing activities $ (569,780) $ (485,155) $ (444,566) -------------- -------------- ------------- (Decrease) in cash and cash equivalents $ (18,703) $ (5,849) $ (63,392) Cash and Cash Equivalents Beginning 89,196 95,045 158,437 -------------- -------------- ------------- Ending $ 70,493 $ 89,196 $ 95,045 ============== ============== ============= FIRST NATIONAL CORPORATION - -------------------------------------------------------------------------------- Management's Discussion and Analysis of Financial Condition and Results of Operations First National Corporation (the "Company") is the holding company for First Bank (the "Bank") and First Bank Financial Services Inc. ("Financial Services"). The following discussion and analysis of the financial condition and results of operations of the Company for the years ended December 31, 1997, 1996 and 1995 should be read in conjunction with the consolidated financial statements and related notes. Overview Earnings and assets grew in 1997. Net income for 1997 was $1,611,322 compared to $1,454,266 in 1996 and $1,314,548 in 1995. Net income per share increased $0.20 in 1997 from 1996 ($2.08 per share versus $1.88 per share). The increase in earnings resulted primarily from a continuing increase in the Bank's interest income which was greater than the increase in interest expense. Return on average assets was 1.07% in 1997, 1.06% in 1996 and 1.03% in 1995. Return on average equity was 10.56% in 1997, 10.36% in 1996 and 10.28% in 1995. Assets grew 16.46% in 1997, an increase over the 1996 growth rate of 6.7%. Growth occurred in both the loan portfolio where loans, net of unearned income and allowance for loan losses, increased $14.1 million to $112.5 million and in the securities portfolio which increased $8.0 million to $41.7 million. Funding for this loan growth was provided by an increase in deposits of $15.7 million and an increase in long term debt of $5.0 million. Results of Operations Net interest income represents the primary source of earnings for the Company. Net interest income equals the amount by which interest income on earning assets, predominately loans and securities, exceeds interest expense on interest bearing liabilities, predominately deposits, short-term and long-term borrowings. The provision for loan losses and the amount of non-interest income and expense also have an effect on net income. Non-interest income and expense consists of income from service charges on deposit accounts, fees charged for various services, gains and losses from the sale of assets, both fixed assets and securities, and various administrative, operating and income tax expenses. Changes in the volume and mix of interest-earning assets and interest-bearing liabilities, as well as their respective yields and rates, have significant impact on the level of net interest income. Net interest margin is calculated by dividing tax equivalent net interest income by average earning assets and reflects the Company's net yield on its earning assets. General. Net income has increased in each of the last three years. Income increased in 1995 as a result of a growth in earning assets and an increase in non-interest income from nonrecurring items. The continued increase in income in 1996 was caused by further growth in earning assets and by the funding of higher yielding assets, in part, from lower yielding assets. In 1997, net interest income increased as a result of interest earning assets growing faster than interest bearing liabilities. Net Interest Income. Net interest income, after provision for loan losses, was $6.02 million for the year ended December 31, 1997, up $0.40 million or 7.11% over the $5.62 million reported for the same period in 1996. This increase in net interest income, after provision for loan losses, resulted from an increase in interest-bearing assets. In 1996 net interest income, after provision for loan losses increased 7.79% or $0.41 million from $5.21 million in 1995. Both the net interest margin and interest rate spread increased between 1995 and 1996 and they both declined between 1996 and 1997. Interest expense as a percent of average earning assets increased from 3.86% in 1995 to 3.92% in 1996 and increased again in 1997 to 4.02%. Interest income as a percent of average earning assets, on the other hand, increased from 8.26% in 1995 to 8.50% in 1996 and declined slightly to 8.4% in 1997. The decreases in 1997 resulted from a decline in yield on each earning asset portfolio with an increase in interest cost on interest bearing liabilities. The net interest spread decreased to 3.54% in 1997 increasing to 3.78% in 1996 from 3.49% in 1995. The net interest margin also decreased to 4.37% in 1997 from 4.51% in 1996 after declining from 4.40% in 1995. The above ratios reflect management's attempt to grow the loan portfolio resulting in a lower yield while the cost of funding this growth increased. Provision for Loan Losses. There was no provision made in 1995 as a result of management's analysis of the allowance for loan losses which found that the balance was sufficient to cover anticipated losses. In 1996, in anticipation of growth in the loan portfolio, a provision of $120,000 was made to the allowance for loan losses. Management continued to make provisions in 1997, adding an additional $220,000 in provisions. Non-Interest Income. Non-interest income increased $230,568 in 1997 due to the introduction of fees on noncustomer ATM transactions, an increase in fees on deposit accounts and several nonrecurring income items. Non-Interest Expense. In 1997, non-interest expenses increased $367,133 or 8.58% over 1996. This increase was larger than the increase in 1996 of $61,533. Income Taxes. The company has adopted FASB Statement No. 109, "Accounting for Income Taxes". A more detailed discussion of the Company's tax calculation is contained in Note 9 to the consolidated financial statements. FIRST NATIONAL CORPORATION Management`s Discussion and Analysis continued - -------------------------------------------------------------------------------- Selected Consolidated Financial Data - -------------------------------------------------------------------------------- Years ended December 31, 1997 1996 1995 1994 1993 (In thousands, except ratios and per share amounts) Income Statement Data: Interest income $ 11,974 $ 10,833 $ 9,943 $ 8,441 $ 8,340 Interest expense 5,738 5,097 4,733 3,605 3,428 ---------- ---------- ----------- ---------- --------- Net interest income 6,236 5,736 5,210 4,836 4,912 Provision for loan losses 220 120 0 0 240 ---------- ---------- ----------- ---------- --------- Net interest income after provision for loan losses 6,016 5,616 5,210 4,836 4,672 Noninterest income 867 628 811 526 518 Securities gains (losses) 11 20 (8) 73 92 Noninterest expense 4,646 4,279 4,217 4,053 3,357 ---------- ---------- ----------- ---------- --------- Income before income taxes 2,247 1,985 1,796 1,382 1,925 Income taxes 636 531 481 341 551 ---------- ---------- ----------- ---------- --------- Net income $ 1,611 $ 1,454 $ 1,315 $ 1,041 $ 1,374 ========== ========== =========== ========== ========= Per Share Data: Net income, basic $ 2.08 $ 1.88 $ 1.70 $ 1.35 $ 1.79 Cash dividends 0.82 0.70 0.60 0.52 0.48 Book value at period end 20.81 19.16 18.02 15.74 15.98 Balance Sheet Data: Assets $ 164,589 $ 141,329 $ 132,321 $ 122,008 $ 109,701 Loans, net of unearned income 112,493 98,421 85,986 76,829 62,274 Securities 41,699 33,742 36,619 38,441 39,346 Deposits 139,762 123,984 115,906 106,129 96,758 Stockholders' equity 16,182 14,837 13,908 12,135 12,297 Average shares outstanding 776 773 771 771 768 Performance Ratios: Return on average assets 1.07% 1.06% 1.03% 0.91% 1.28% Return on average equity 10.41% 10.36% 10.28% 8.66% 11.94% Dividend payout 39.71% 37.19% 35.19% 38.50% 26.66% Capital and Liquidity Ratios Leverage 9.99% 10.43% 10.70% 11.19% 11.42% Risk-based capital ratios: Tier 1 capital 14.20% 15.58% 16.46% 17.89% 20.70% Total capital 15.19% 16.60% 17.53% 19.27% 21.95% Financial Condition General. Management's plan to aggressively increase the size of the loan portfolio continued in 1997. Loans, net of unearned discounts and allowance for loan losses, increased $14.1 million or 14.3% from $98.4 million in 1996 to $112.5 million in 1997. This growth in loans was reflected in a 16.46% increase in assets during the year. Assets began the year at $141.3 million and grew $23.3 million to $164.6 million by year end. Loans. The Bank is an active lender with a loan portfolio which includes commercial and residential mortgages, commercial loans, consumer loans, both installment and credit card, real estate construction loans and home equity loans. The Bank's lending activity is concentrated on individuals and small- to medium-sized businesses in its primary trade area of the Virginia counties of Shenandoah, Warren, Frederick and the City of Winchester. As a provider of community oriented financial services, the Bank does not attempt to geographically diversify its loan portfolio by undertaking significant lending activity outside its primary trade area. The total amount of commercial and industrial loans increased $6.03 million in 1997. Residential real estate mortgage loans increased $1.5 million in 1997. The growth in the consumer loan area continued in 1997 with an increase of $5.2 million which was greater than the increase of $1.1 million in 1996. FIRST NATIONAL CORPORATION Management`s Discussion and Analysis continued - -------------------------------------------------------------------------------- Asset Quality. The Allowance for Loan Losses ("ALL") balance at December 31, 1997 was $1,112,318, representing 0.975% of total loans and 118% of non-performing assets. At December 31, 1996, these amounts were 0.98% and 115%. These amounts were 1.04% and 97.5% at December 31, 1995. Total losses charged against the ALL in 1997 were $97,008, compared to $62,825 in 1996 and $289,687 in 1995. The losses in 1995 were due to a $200,000 charge off resulting from the Bank's receiving real estate by deed in lieu of foreclosure. Recoveries, consisting of the recovery of principal on loans previously charge against the allowance, totaled $14,914 in 1997, $16,425 in 1996, and $35,395 in 1995. Management believes, based upon its review and analysis, that the Bank has sufficient reserves to cover any projected losses within the total loan portfolio. Nonperforming Assets. Management classifies as nonperforming both those loans on which payment has been delinquent 90 days or more and for which there is a risk of loss to either principal or interest, and Other Real Estate Owned. Other Real Estate Owned represents real property taken by the Bank either through foreclosure or through a deed in lieu thereof from the borrower. Other Real Estate Owned is booked at the lower of cost or market less estimated selling costs, and is actively marketed by the Bank through brokerage channels. Nonaccrual loans totaled $23,642 at year end, representing 0.021% of the net loan portfolio. These numbers increased from the 1996 balance of $12,827or 0.013% of the net loan portfolio. The Bank has allocated a portion of the Allowance for Loan Losses to cover anticipated losses from these loans. When a loan is placed on nonaccrual status there are several negative implications as a result. First, all interest accrued but unpaid at the time of the classification is deducted from the interest income totals for the Bank. Second, accruals of interest are discontinued until it becomes certain that both principal and interest can be repaid. Third, there may be actual losses which necessitate additional provisions for credit losses charged against earnings. For the fiscal year 1997 interest income not recognized on nonaccural loans amounted to $3,490. Securities. The Company adopted FASB No. 115, "Accounting for Certain Investment in Debt and Equity Securities" effective beginning January 1, 1994. The Company reclassified its securities portfolio into those securities that would be held to maturity and those that were available for sale. The securities that were classified as available for sale were recorded at fair value in accordance with FASB No. 115 and the Company recognized the effect of unrealized gains/losses net of tax effects in stockholders' equity. As of December 31, 1997, neither the Company nor the Bank held any derivative financial instruments in their respective investment security portfolios. Deposits. The Bank has made an effort in recent years to increase core deposits and reduce costs of funds. Deposits provide funding for the Company's investments in loans and securities, and the interest paid for deposits must be managed carefully to control the level of interest expense. Deposits at December 31, 1997 were $139.8 million, an increase of $15.7 million or 12.63% from $124.1 million at December 31, 1996. This increase was concentrated in Savings Accounts which increased $15.3 million and was caused by growth in floating rate money market savings accounts during the year. Large local government deposits on which rates were set by competitive bid caused an increase in Certificates of Deposit with balances equal to or in excess of $100 thousand. Liquidity. Liquidity represents an institutions ability to meet present and future financial obligations through either the sale or maturity of existing assets or the acquisition of additional funds through liability management. Liquid assets include cash, interest-bearing deposits with banks, federal funds sold, investments in Treasury securities, and loans maturing within one year. As a result of the Bank's management of liquid assets and the ability to generate liquidity through liability funding, management believes that the Bank maintains overall liquidity sufficient to satisfy its depositors' requirements and to meet its customers' credit needs. At December 31, 1997, cash, interest bearing and non-interest bearing deposits with banks, federal funds sold, investments in Treasury securities, and loans maturing within one year were $39.6 million. As of December 31, 1997, approximately 33.095% or $37.7 million of the loan portfolio would mature or reprice within a one year period. Nondeposit sources of funds in use at December 31, 1997 consisted of two Federal Home Loan Bank advances and federal funds purchased. Both Federal Home Loan Bank advances were draws by the Bank against its line at the Federal Home Loan Bank of Atlanta with an original balance of $1.5 million bearing interest at 6.25% with a maturity of December 12, 2005, and the other having an original balance of $5 million bearing interest of 5.58% with an ultimate maturity of December 16, 2002. Security for both advances consists of qualifying real estate loans and Federal Home Loan Bank stock. These advances were used to fund growth in the loan portfolio. Capital Resources. The adequacy of the Company's capital is reviewed by management on an ongoing basis with reference to the size, composition, and quality of the Company's asset and liability levels and consistent with regulatory requirements and industry standards. Management seeks to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and absorb potential losses. The Board of Governors of the Federal Reserve System has adopted capital guidelines to supplement the existing definitions of capital for regulatory purposes and to establish minimum capital standards. Specifically, the guidelines categorize assets and off-balance sheet items into four risk-weighted categories. The minimum ratio of qualifying total capital to risk-weighted assets is 8.0%, of which at least 4.0% must be Tier 1 capital, composed of common equity, retained earnings and a limited amount of perpetual preferred stock, less certain goodwill items. The Company had a ratio of risk-weighted assets to total capital of 15.19% at December 31, 1997 and a ratio of risk-weighted assets to Tier 1 capital of 14.20%. Both of these exceed the capital requirements adopted by the federal regulatory agencies. FIRST NATIONAL CORPORATION Shareholder Information - -------------------------------------------------------------------------------- Common Stock First National Corporation's common stock is traded on the over-the-counter (OTC) market and quoted in the OTC Bulletin Board where our symbol is FXNC. Copies of Form 10-K Copies of First National Corporation's Anual Report to the Securities and Exchange Commission on Form 10-K may be obtained by shareholders at no charge by writing: Harry S. Smith, Vice President and Secretary First National Corporation 112 West King Street Strasburg, Virginia 22657 Stock Transfer Agent and Registrar Registrar and Transfer Company 10 Commerce Drive Cranford, New Jersey 07016 800-368-5948 Dividend Reinvestment Registered holders of First Natonal Corporaton stock are eligible to participate in te Corporation's Dividend Reinvestment Plan, a convenient and economical way to purchase additional shares of First National Corporation common stock. For a information and authorizaton form or to receive additional informaton on this plan, contact: Registrar and Transfer Company, 10 Commerce Drive, Cranford, New Jersey 07016, 800-368-5948. Shareholder Information For additional information, contact: Debbie Bly First National Corporation 112 West King Street Strasburg, Virginia 22657 800-465-8515 Independent Auditors Yount, Hyde & Barbour, P.C. Post Office Box 2560 Winchester, Virginia 22604 This stateent has not been reviewed, or confirmed for accuracy or relevance by the Federal Reserve System. Corporate Information Board of Directors Officers of Officers of First National Corp. First National Corp. First Bank continued First Bank Noel M. Borden Nancy F.Abe Sarah F. Miller Chairman of the Board Vice President Assistant Vice President Consumer Loan Manager Director of Technology Douglas C. Arthur Douglas C. Arthur Attorney at Law Vice Chairman Julia A. Tyler Gayle M. Davison Assistant Vice President Ronald F. Miller Vice President Branch Manager, Winchester Noel M. Borde President C.R. A. Officer Chairman Chief Executive Officer Compliance Officer C. Renee Cummins First National Corporation Assistant Vice President First Bank Harry S. Smith Dennis A. Dysart Mortgage Loan Officer President, H.L. Borden Lumber Co. Vice President/Secretary Vice President Investment Manager Cynthia G. Allen Dr. Byron A. Brill Dana A. Froom Human Resources Officer Periodontist Comptroller James E. Pomeroy, III Vice President Patricia R. Clem Elizabeth H. Cottrell Officers of First Bank Commercial Loan Officer Assistant Cashier President Customer Service Riverwood Technologies Noel M. Borden Kevin F. Smith Representative Chairman Vice President Christopher E. French Commercial Loan Manager Nancy T. Fitchett President, Shenandoah Assistant Cashier Telecommunications Co. and Douglas C. Arthur Operatons Officer Subsidiaries Vice Chairman Joseph L. Thompson, III Vice President Jacquelyn B. Pomeroy Mortgage Loan Manager Assistant Cashier Charles E. Maddox, Jr. The Executive Comittee Head Bookkeeper Chief Engineer William B. Whipple G.W. Clifford & Associates Ronald F. Miller Vice President Brenda LeDane President/Chief Executive Branch Manager, Woodstock Assistant Branch Manager, Ronald F. Miller Officer Woodstock President Greg T. Coons Chief Executive Officer Harry S. Smith Assistant Vice President Audrey Pattyson First National Corporation Executive Vice President/ Commercial Loan Officer Assistant Branch Manager, First Bank Cashier Winchester Belita B. Ford W. Allen Nicholls Don Collins Assistant Vice President Pam Ramsey President Sr. Vice President/ Branch Manager, Front Royal Assistant Branch Manager, Nicholls Construction, Inc. Sr. Loan Officer Kernstown Cindy Larrick Henry L. Shirkey Dana A. Froom Assistant Vice President Jane Ryon Customer Service Represetative Sr. Vice President Branch Manager, Kernstown Assistant Branch Manager Holtzman Oil Company Front Royal Retired Community Banker Mary T. Levi Assistant Vice President Sherri Totten Main Office Manager Loan Officer Security Officer Gail Shaholtz Fay C. Miller Loan Officer Assistant Vice President Consumer Loan Officer Office Locations - -------------------------------------------------------------------------------- 112 W. King St. 2210 Valley Ave. 508 N. Commerce Ave. 3143 Valley Pike 860 S. Main Street Strasburg, Va Ward Plaza Front Royal, VA Winchester, VA Woodstock, VA 22657 Winchester, Va 22630 22602 22664 540-465-9121 22601 540-636-6149 540-662-9594 540-459-9510 540-667-8300