QNB Corp. and Subsidiary
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FINANCIAL HIGHLIGHTS
(in thousands, except per share data)
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Year Ended December 31, 1997 1996 1995 1994 1993
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Financial Performance
Net interest income $ 12,056 $ 11,403 $11,379 $ 11,406 $ 10,814
Provision for loan losses 400 400 1,010 600 470
Non-interest income 1,995 1,850 1,393 1,598 2,484
Non-interest expense 9,267 9,004 9,539 9,719 10,545
Net income 3,131 2,801 1,687 2,004 1,818
Per Share Data:
Net income - basic 2.19 1.97 1.19 1.41 1.28
Net income - diluted 2.18 1.95 1.18 1.41 1.28
Book value 18.05 15.97 14.66 12.53 13.31
Cash dividends .64 .56 .50 .50 .50
Selected Average Balances
Total assets $ 288,698 $ 274,533 $269,833 $ 259,344 $ 250,288
Total earning assets 272,226 258,308 253,503 241,478 232,883
Investment securities 107,087 98,376 96,042 84,027 75,982
Loans, net of unearned income 161,096 155,175 151,839 151,726 151,076
Deposits 253,366 242,082 239,513 232,705 224,831
Shareholders' equity 23,886 21,653 19,933 18,980 18,065
Balance Sheet Data
Total assets $ 305,772 $ 280,447 $276,049 $ 268,260 $ 257,062
Investment securities available-for-sale 75,920 52,779 55,380 49,838 54,366
Investment securities held-to-maturity 40,400 42,699 42,515 35,636 27,894
Loans, net of unearned income 167,720 159,278 155,957 153,993 152,764
Deposits 267,166 246,744 242,887 240,896 231,125
Shareholders' equity 25,832 22,775 20,866 17,784 18,859
Selected Ratios
Return on average assets 1.08% 1.02% .63% .77% .73%
Return on average shareholders' equity 13.11 12.94 8.46 10.56 10.06
Net interest margin 4.60 4.58 4.64 4.89 4.79
Average shareholders' equity to average total assets 8.27 7.89 7.39 7.32 7.22
1
QNB Corp. and Subsidiary
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TABLE OF CONTENTS
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Management's Discussion and Analysis 7
Consolidated Balance Sheets 28
Consolidated Statements of Income 29
Consolidated Statements of Shareholders' Equity 30
Consolidated Statements of Cash Flows 31
Notes to Consolidated Financial Statements 32
Independent Auditor's Report 42
Corporate Information 42
Board of Directors 43
Directors, Officers & Office Locations 44
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MANAGEMENT'S DISCUSSION AND ANALYSIS
AVERAGE BALANCES, RATES, AND INTEREST INCOME AND EXPENSE SUMMARY
(TAX-EQUIVALENT BASIS)
1997 1996 1995
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Average Average Average Average Average Average
Balance Rate Interest Balance Rate Interest Balance Rate Interest
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Assets
Interest-bearing balances $ 40 3.70% $ 2 $ 26 2.35% $ 1 $ 24 3.10% $ 1
Federal funds sold 4,003 5.50 220 4,731 5.31 252 5,598 5.91 331
Investment securities
available-for-sale:
Taxable 64,272 6.52 4,190 54,810 6.28 3,449 58,497 6.07 3,549
Tax-exempt 404 8.17 33 - - - - - -
Investment securities
held-to-maturity:
Taxable 31,862 6.39 2,038 33,035 6.46 2,140 29,419 6.61 1,946
Tax-exempt 10,549 7.33 773 10,531 7.30 771 8,126 7.46 606
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Total investment securities 107,087 6.57 7,034 98,376 6.45 6,360 96,042 6.35 6,101
Loans, net of unearned income 161,096 8.90 14,342 155,175 8.79 13,671 151,839 9.01 13,676
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Total earning assets 272,226 7.93 21,598 258,308 7.83 20,284 253,503 7.93 20,109
Cash and due from banks 9,584 9,011 8,497
Allowance for loan losses (2,673) (2,499) (2,232)
Other assets 9,561 9,713 10,065
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Total assets $ 288,698 7.48% $ 274,533 7.37% $269,833 7.45%
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Liabilities and
Shareholders' Equity
Interest-bearing deposits
NOW accounts $ 40,262 1.75% 706 $ 38,936 1.81% 707 $ 37,335 2.20% 820
Money market deposit accounts 33,218 2.86 951 36,301 2.78 1,011 40,392 2.77 1,119
Savings accounts 35,215 2.17 765 34,932 2.20 772 35,044 2.27 795
Time deposits 97,944 5.48 5,365 89,208 5.36 4,799 84,340 5.19 4,380
Time deposits of $100,000 or more 16,502 5.86 968 14,633 5.88 863 15,986 6.04 966
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Total interest-bearing deposits 223,141 3.92 8,755 214,010 3.80 8,152 213,097 3.79 8,080
Short-term borrowings 8,911 3.48 311 8,317 3.13 261 7,955 3.23 257
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Total interest-bearing liabilities 232,052 3.91 9,066 222,327 3.77 8,413 221,052 3.77 8,337
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Non-interest-bearing deposits 30,225 28,072 26,416
Other liabilities 2,535 2,481 2,432
Shareholders' equity 23,886 21,653 19,933
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Total liabilities and
shareholders' equity $ 288,698 3.14% $ 274,533 3.06% $269,833 3.09%
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Net interest rate spread 4.02% 4.06% 4.16%
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Margin/net interest income 4.60% $12,532 4.58% $11,871 4.64% $11,772
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Tax-exempt securities and loans were adjusted to a tax-equivalent basis and
are based on the marginal Federal corporate tax rate of 34 percent.
Non-accrual loans are included in earning assets.
7
QNB Corp. and Subsidiary
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MANAGEMENT'S DISCUSSION AND ANALYSIS
CONSOLIDATED FINANCIAL REVIEW
The intent of this section is to provide the reader with a better understanding
of the consolidated results of operations and financial condition of QNB Corp.
and its wholly owned subsidiary, The Quakertown National Bank, for the years
1997, 1996 and 1995. The results of operations and financial condition discussed
herein are presented on a consolidated basis and the consolidated entity is
referred to herein as "QNB." QNB's consolidated financial condition and results
of operations consist almost entirely of The Quakertown National Bank's
financial condition and results of operations. This section should be read in
conjunction with the financial statements and notes beginning on page 28.
Current performance may not be indicative of future performance. Tabular
information is presented in thousands, except share data.
QNB Corp. (the "Corporation") is a bank holding company headquartered in
Quakertown, Pennsylvania, which provides a full range of commercial and retail
banking services through its banking subsidiary, The Quakertown National Bank
(the "Bank"), a 120 year old community bank with locations in Upper Bucks,
Northern Montgomery and Southern Lehigh Counties.
In addition to historical information, this management discussion and analysis
contains forward-looking statements. The forward-looking statements contained
herein are subject to certain risks and uncertainties that could cause actual
results to differ materially from those projected in the forward-looking
statements. Readers are cautioned not to place undue reliance on these
forward-looking statements, which reflect management's analysis only as of the
date hereof. The Corporation undertakes no obligation to publicly revise or
update these forward-looking statements to reflect events or circumstances that
arise after the date hereof. Readers should carefully review the risk factors
described in other documents the Corporation files from time to time with the
Securities and Exchange Commission, including Quarterly Reports on Form 10-Q to
be filed by the Corporation in 1998, and any Current Reports on Form 8-K filed
by the Corporation.
RESULTS OF OPERATIONS
QNB's performance for 1997 was highlighted by the second consecutive year of
record earnings, strong asset and deposit growth; with assets surpassing the
three hundred million mark, and continued improvement in asset quality. During
the fourth quarter of 1997 the Bank completed its acquisition of the deposits of
the Quakertown office of First Lehigh Bank. QNB's earnings for 1997 were
$3,131,000, an 11.8 percent increase from the $2,801,000 reported in 1996. This
represents basic earnings per share of $2.19 for 1997, compared to $1.97 for
1996. On a diluted basis, earnings per share was $2.18 and $1.95 for 1997 and
1996, respectively. The results for 1997 reflect higher net interest income
achieved through growth in earning assets and a slight increase in the net
interest margin. A 7.8 percent increase in non-interest income also positively
contributed to the results. Despite a 2.9 percent increase in non-interest
expense in 1997, QNB's efficiency ratio continues to improve. Net income for
1995 was $1,687,000 or $1.19 per share basic and $1.18 on a diluted basis. The
lower net income in 1995 reflects the costs associated with implementing
strategies to strengthen the balance sheet and position of the company for
future growth and increased profitability in the extremely competitive financial
services industry. These strategies included a corporate reorganization and a
strengthening of the allowance for loan losses. The record earnings recorded in
1997 and 1996 reflect the results of these actions.
In February 1997, the Financial Accounting Standards Board issued Statement No.
128 (SFAS No. 128), "Earnings per Share." SFAS No. 128 replaced the calculation
of primary and fully diluted earnings per share with basic and diluted earnings
per share. Unlike primary earnings per share, basic earnings per share excludes
any dilutive effects of options and is computed by dividing net income by the
weighted average number of shares outstanding during the period. Diluted
earnings per share gives effect to all dilutive potential common shares that
were outstanding during the period. All earnings per share amounts for all
periods have been presented to conform to SFAS No. 128 requirements.
Two important measures of profitability in the banking industry are an
institution's return on average assets and return on average shareholders'
equity. Return on average assets and return on average shareholders' equity were
1.08 percent and 13.11 percent, respectively, in 1997 compared with 1.02 percent
and 12.94 percent in 1996 and .63 percent and 8.46 percent in 1995.
NET INTEREST INCOME
Net interest income is the primary source of operating income for QNB. Net
interest income is interest income, dividends, and fees on earning assets, less
interest expense incurred for funding sources. Earning assets primarily include
loans, investment securities and Federal funds sold. Sources used to fund these
assets include deposits, borrowed funds and shareholders' equity. Net interest
income is affected by changes in interest rates, the volume and mix of earning
assets and interest-bearing liabilities, and the amount of earning assets funded
by non-interest-bearing deposits and shareholders' equity.
For purposes of this discussion, interest income, and the average yield earned
on loans and investment securities, is adjusted to a tax-equivalent basis as
detailed in the Average Balances, Rates, and Interest Income and Expense Summary
that appears on page 7. This provides a basis for comparison of tax-exempt loans
and investments with taxable loans and investments by giving effect to interest
earned on tax-exempt loans and investments by an amount equivalent to the
Federal income taxes which would have been paid if the interest earned on those
assets were taxable at the statutory tax rate of 34 percent.
The net interest rate spread is the difference between average rates received on
earning assets and average rates paid on interest-bearing liabilities, while the
net interest rate margin includes interest-free sources of funds.
On a fully tax-equivalent basis, net interest income for 1997 increased $661,000
or 5.6 percent to $12,532,000. A 5.4 percent increase in average earning assets
in conjunction with a slight increase in the net interest margin account for the
growth in net interest income. While the net interest margin increased by two
basis points, the net interest rate spread declined by four basis points. The
net interest rate spread decreased to 4.02 percent in 1997 from 4.06 percent in
1996 while the net interest rate margin increased to 4.60 percent in 1997 from
4.58 percent in 1996. The impact of rates paid on interest-bearing liabilities
increasing to a greater degree than the rates earned on assets was reduced by a
7.7 percent increase in non-interest-bearing deposits.
It is necessary to review the changes in market interest rates during 1997 and
1996 to understand the impact of interest rates on interest income. Market
interest rates were volatile during 1997 and 1996 as expectations regarding
interest rates changed. The yield on the 30-year
8
QNB Corp. and Subsidiary
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MANAGEMENT'S DISCUSSION AND ANALYSIS
Treasury bond began 1997 at 6.64 percent and rose during much of the spring,
hitting 7.17 percent in early April on concern that the Federal Reserve would
raise interest rates repeatedly during the year to combat inflation caused by
the economy's strong growth and low unemployment rate. In fact, the Federal
Reserve only raised rates once at the end of March, increasing the Federal funds
rate 25 basis points to 5.50 percent, taking back the decrease of January 1996.
At the same time the prime rate increased 25 basis points to 8.50 percent. The
interest rate levels achieved in April 1997 were as high as they would go for
the year, as future inflation reports showed that despite the economy's strength
and the tight labor market, inflation was falling. The result was falling
interest rates and a flattening of the yield curve. The 30-year Treasury bond
ended the year at 5.92 percent, only a 27 basis point spread from the two-year
Treasury bond which finished the year at 5.65 percent. This spread was 76 basis
points at the end of 1996 when the yield on the two-year bond was 5.88 percent.
The interest rate cycle of 1997 contrasts to what occurred during 1996. Most
economists entered 1996 believing that the economy was poised to head into a
recession and that the Federal Reserve would be forced to lower interest rates.
At the end of January 1996 the Federal Reserve did just that by lowering the
Federal funds rate 25 basis points to 5.25 percent. The national prime rate also
dropped 25 basis points to 8.25 percent at that time. This would be the only
Federal Reserve action with respect to interest rates during 1996. In February,
as it became apparent that the economy was stronger than expected, wage
pressures emerged as a concern and market interest rates began to head upward,
with the peak in interest rates coming during the summer. In the fall, interest
rates headed back down as it appeared likely that the Federal Reserve would not
raise interest rates during 1996. As an example of the volatility during the
year, the benchmark 30-year Treasury bond yield started the year at 5.95 percent
and moved as high as 7.20 percent in July before finishing the year at 6.64
percent.
Total interest income increased $1,314,000 in 1997 to $21,598,000. The
Rate-Volume Analysis table below highlights the impact of changing rates and
volumes on total interest income and interest expense. Growth in earning assets
contributed $991,000 to the increase in interest income, with higher securities
volume accounting for $540,000 of the increase and higher loan volume accounting
for $491,000 of the increase. Average investments increased $8,711,000 or 8.9
percent, while average loans increased $5,921,000 or 3.8 percent. Higher
interest rates contributed $323,000 to the increase in interest income. The
yield on earning assets increased 10 basis points to 7.93 percent with the
average rates on investment securities and loans increasing 12 basis points and
11 basis points, respectively, during 1997. The increase in the yield on
investment securities occurred primarily in the available-for-sale portfolio.
The yield on this portfolio increased 25 basis points to 6.53 percent. The
purchase of approximately $500,000 of 15 year municipal securities and some five
to ten year callable agency bonds with two to three years of call protection
contributed to the increase in yield. Many of these bonds were purchased in the
first half of the year when interest rates were higher and had yields over 7.00
percent. A slight lengthening of the available-for-sale portfolio also occurred
as a result of these purchases. The yield on the taxable portion of the
held-to-maturity portfolio decreased by approximately 7 basis points resulting
from maturities and paydowns on some higher yielding mortgage-backed securities.
RATE-VOLUME ANALYSIS OF CHANGES IN NET INTEREST INCOME (TAX-EQUIVALENT BASIS)
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1997 vs. 1996 1996 vs. 1995
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Change due to Total Change due to Total
Volume Rate Change Volume Rate Change
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Interest income:
Interest-bearing balances - $ 1 $ 1 - - -
Federal funds sold $ (40) 8 (32) $ (50) $ (29) $ (79)
Investment securities available-for-sale:
Taxable 587 154 741 (217) 117 (100)
Tax-exempt 33 - 33 - - -
Investment securities held-to-maturity:
Taxable (80) (22) (102) 244 (50) 194
Tax-exempt - 2 2 182 (17) 165
Loans 491 180 671 317 (322) (5)
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Total interest income 991 323 1,314 476 (301) 175
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Interest expense:
NOW accounts 23 (24) (1) 35 (148) (113)
Money market accounts (88) 28 (60) (110) 2 (108)
Savings 5 (12) (7) (3) (20) (23)
Time 458 108 566 261 158 419
Time over $100,000 108 (3) 105 (80) (23) (103)
Short-term borrowings 19 31 50 13 (9) 4
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Total interest expense 525 128 653 116 (40) 76
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Net interest income $ 466 $ 195 $ 661 $ 360 $ (261) $ 99
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Variances which were not specifically attributed to volume or rate were
allocated proportionately between volume and rate. Tax-exempt securities
and loans were adjusted to a tax-equivalent basis and are based on the
marginal Federal corporate tax rate of 34 percent. Non-performing assets
are treated as a change due to rate.
9
QNB Corp. and Subsidiary
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MANAGEMENT'S DISCUSSION AND ANALYSIS
NET INTEREST INCOME (CONTINUED)
The 11 basis point increase in the yield on loans can be attributed in part to
the increase in the prime rate. The average prime rate for 1997 was 8.44
percent, an increase of 17 basis points from the average prime rate for 1996.
QNB's yield on its loan portfolio did not increase proportionately, since only
approximately 19 percent of the entire portfolio reprices immediately with
changes in the prime rate. As occurred during 1996, the amount of fixed rate
loans as a percentage of total loans increased.
[GRAPHIC OMITTED]
Non-accrual loans of $1,209,000 in 1997 and $2,700,000 in 1996 resulted in the
non-recognition of $154,000 and $265,000 in interest income for the respective
periods. Non-accrual loans are included in the impact of rate changes.
Total interest expense increased $653,000 or 7.8 percent in 1997 to $9,066,000.
A 4.4 percent increase in average interest-bearing liabilities resulted in an
increase in interest expense of $525,000. This increase was primarily in the
area of time deposits with average balances increasing by 10.2 percent and
interest expense increasing by $566,000. An 8.5 percent decline in average money
market account balances caused interest expense on money market accounts to
decline by approximately $88,000 during 1997.
The impact of changing interest rates accounted for approximately a $128,000
increase in interest expense. The rate paid on total interest-bearing
liabilities increased to 3.91 percent in 1997 from 3.77 percent in 1996. The
increase in the rate paid on interest-bearing liabilities was the result of
higher rates on time deposits and a change in rate structure on money market
accounts and cash management accounts included in short-term borrowings. During
the first quarter of 1997, QNB introduced a 30-month certificate of deposit that
enables the holder to increase the interest rate twice during the term of the
certificate, should rates offered on the 30-month time deposits increase. As a
result of this promotion QNB experienced a small shift of funds from lower
yielding non-maturity deposits to higher yielding time deposits. During the
third quarter of 1997 QNB changed the rate structure on money market accounts
and cash management accounts to a tiered structure that pays a higher rate of
interest on higher balances. The largest impact was on the cash management
account, which was increased significantly to compete with brokerage house and
mutual fund money market products. The rate on time deposit accounts increased
to 5.53 percent in 1997 from 5.44 percent in 1996, while the rate paid on
short-term borrowings increased to 3.48 percent from 3.13 percent during the
same time period. While Treasury rates declined during the second half of 1997,
rates on certificates of deposit remained stable as the competition for funding
sources remained fierce.
When comparing 1996 to 1995 net interest income on a fully tax-equivalent basis
increased $99,000 or .8 percent to $11,871,000. A 1.9 percent increase in
average earning assets offset a decline in both the net interest rate spread and
net interest rate margin. The net interest rate spread decreased to 4.06 percent
in 1996 from 4.16 percent in 1995 while the net interest rate margin decreased
to 4.58 percent in 1996 from 4.64 percent in 1995. A 6.3 percent increase in
non-interest-bearing deposits reduced the impact of lower yielding earning
assets on the net interest margin and was a major reason that the net interest
rate margin did not decline to the same degree as the net interest rate spread.
Total interest income increased $175,000 in 1996 to $20,284,000. Lower rates on
earning assets, particularly the rates earned on loans, negatively impacted
total interest income by approximately $301,000. The yield on earning assets
decreased 10 basis points to 7.83 percent with the average rates on Federal
funds sold, held-to-maturity investment securities and loans decreasing 60 basis
points, 14 basis points and 22 basis points, respectively, during 1996. The
yield on available-for-sale investment securities increased 21 basis points
during the year. The increase in the yield on these securities is the result of
the realignment of the portfolio that took place in the fourth quarter of 1995;
investing more in callable agency securities which provide a higher yield than
non-callable agencies, while slightly lengthening the average life of the
portfolio. The decrease in the yield on loans can be attributed in part to the
drop in the prime rate. The average prime rate for 1996 was 8.27 percent, a
decrease of 56 basis points from the average prime rate for 1995. QNB's yield on
its loan portfolio did not decline proportionately, since only approximately 20
percent of the entire portfolio reprices immediately with the prime rate.
Higher volumes of earning assets, particularly loans and held-to-maturity
investment securities, accounted for $476,000 of the increase in interest
income. One of the goals of management during 1996 was to increase the amount of
loans outstanding. Average loans increased $3,336,000 or 2.2 percent, and
contributed $317,000 of the increase in interest income related to volume.
Total interest expense increased $76,000 in 1996 to $8,413,000. A .6 percent
increase in average interest-bearing liabilities resulted in an increase in
interest expense of $116,000. Interest rates on total interest-bearing
liabilities were basically unchanged from 1995 at 3.77 percent. While the
overall rate paid on interest-bearing liabilities did not change, the mix of
deposits as well as the rates paid on the various products did change. While
average NOW account balances increased 4.3 percent to $38,936,000, the rate paid
on these accounts declined by 39 basis points to 1.81 percent. A portion of
these accounts are indexed to the Federal funds rate, and the reduction in that
rate during 1996 accounted for the decline in the yield on NOW accounts. The
interest rate on money market accounts was basically unchanged during 1996. As a
result, the average balance in these accounts decreased by $4,091,000 or 10.1
percent. Customers moved their balances from these accounts to higher paying
time deposits. Time deposits were more sensitive to rising rates as financial
institutions
10
QNB Corp. and Subsidiary
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MANAGEMENT'S DISCUSSION AND ANALYSIS
were more likely to increase rates on these deposits as opposed to
non-maturity deposits. Time deposits under $100,000 increased $4,868,000 or 5.8
percent while the rate paid on these deposits increased 17 basis points to 5.36
percent.
Management expects the net interest margin to decline during 1998 as a result of
lower yields on earning assets, particularly investment securities and loans. A
decline in Treasury rates may cause some of the callable agency bonds to be
called and reinvested in lower yielding securities. Lower interest rates would
also cause an increase in the amount of mortgages refinanced, which would cause
prepayments to increase on both mortgage-backed securities and mortgage loans.
The extreme competition for loans is causing the pricing of loans to decline for
both new and existing commercial customers. If QNB can achieve its primary goals
of loan growth and an increase in the loan-to-deposit ratio, the impact on
interest income and the net interest margin of lower rates may be lessened, as
QNB can generally yield more on its loans than on its investment securities. On
the deposit side, management anticipates that rates will remain near current
levels as the competition for funding sources remains strong.
PROVISION FOR LOAN LOSSES
The provision for loan losses represents management's determination of the
amount necessary to be charged to operations to bring the allowance for loan
losses to a level considered adequate in relation to the risk of possible losses
in the loan portfolio. Actual loan losses, net of recoveries, serve to reduce
the allowance. The provision was $400,000 in both 1997 and 1996 compared to
$1,010,000 in 1995. Despite a slightly higher amount of loan charge-offs in
1997, QNB was able to maintain the provision at the same level that was recorded
in 1996 because of continuing improvement in asset quality. Net charge-offs for
1997 were $315,000 versus $199,000 for 1996 and $650,000 for 1995. The primary
reason for the significant provision for loan losses in 1995 was the increase in
the amount of charged-off loans collateralized by real estate, both residential
and commercial. Since the majority of the loan portfolio is collateralized by
real estate, charge-offs of real estate collateralized loans have a significant
impact on the allowance for loan loss model, which is heavily weighted for
historical charge-offs. Management's decision to strengthen the balance sheet by
increasing the coverage of the allowance for loan losses to non-performing loans
and total loans also contributed to the higher provision for loan losses in
1995. Management anticipates that the provision for loan losses in 1998 will
remain near the amounts recorded for the past two years despite the expected
continuing improvement in asset quality and expected reduction in loan
charge-offs. Anticipated loan growth will make any reduction in the provision
for loan losses unlikely.
NON-INTEREST INCOME
QNB, through its core banking business, generates various fees and service
charges. Total non-interest income is composed of service charges on deposit
accounts, mortgage servicing fees, gains on the sale of investment securities,
gains on the sale of residential mortgage loans and student loans, and other
miscellaneous fee income. QNB reviews all service charges and fee schedules
related to its products and services on an annual basis. QNB has not materially
changed these schedules during 1997 or 1996. QNB prices its products and
services competitively. The continual development of new products and services
should help generate additional non-interest income. Total non-interest income
was $1,995,000 in 1997, compared to $1,850,000 in 1996 and $1,393,000 in 1995.
Fees for services to customers, the largest component of total non-interest
income, are primarily comprised of service charges on deposit accounts. These
fees declined $19,000 or 1.7 percent during 1997 to $1,076,000. A lower volume
of overdraft charges and a decrease in fees related to reduced volume usage of
out-of-network ATM machines were the primary reasons for the decline during the
year. QNB does not surcharge for the use of its ATM machines.
Fees for services to customers increased $168,000 or 18.1 percent from 1995 to
1996. Charges related to overdrafts account for approximately $128,000 of the
increase in fee income. QNB increased the overdraft fee in November of 1995.
Also during 1995, QNB implemented a transaction fee for customers that use an
out-of-network ATM. The income generated by this fee increased by approximately
$7,000 or 33.3 percent. This is a result of the fee being in place for an entire
year, and an increase in volume. Service charges on business deposit accounts,
monthly fees and transaction activity fees, increased $24,000 or 18.1 percent in
1996. A reduction in the earnings credit rate resulted in businesses paying for
more of their services.
To date, when QNB sells its residential mortgages in the secondary market, it
retains servicing rights. A normal servicing fee is retained on all loans sold
and serviced. Mortgage servicing fees decreased $27,000 or 13.0 percent in 1997,
to $181,000. This followed a decrease of $21,000 or 9.2 percent in 1996, to
$208,000. The level of mortgages serviced decreased $5,630,000 to $67,783,000 at
December 31, 1997. This 7.7 percent decrease in mortgages serviced from year-end
1996 to year-end 1997 followed an 8.1 percent decline between 1995 and 1996. The
average balance of mortgages serviced for others decreased 7.7 percent in 1997
to $70,370,000 and 8.3 percent in 1996 to $76,260,000. The decrease in the
volume of mortgages serviced for others during both 1997 and 1996 was a result
of fewer residential mortgage originations and management's decision to retain
15 and 20 year mortgages, which would have been sold in prior years.
Management anticipates that mortgage-servicing fees will continue to decline as
principal reductions outpace loans sold. The volume of mortgage originations and
sales should increase during 1998 as a result of mortgage refinances due to the
decline in interest rates and management's decision to start selling 20 year
mortgage originations again.
In June 1996, SFAS No. 125, "Accounting for Transfers and Servicing of Financial
Assets and Extinguishment of Liabilities," was issued. This Statement is
effective for transactions entered into after December 31, 1996 and is required
to be applied prospectively. This Statement superceded SFAS No. 122 "Accounting
for Mortgage Servicing Rights" which was effective January 1, 1996.
SFAS No. 125 requires an entity to recognize its obligation to service financial
assets that are retained in a transfer of assets in the form of a servicing
asset or liability. The servicing asset or liability is to be amortized in
proportion to and over the period of net servicing income or loss. Servicing
assets and liabilities are to be assessed for impairment based on their fair
value. The adoption of this Statement did not have a material impact on the
Corporation's financial position or results of operations.
11
QNB Corp. and Subsidiary
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MANAGEMENT'S DISCUSSION AND ANALYSIS
NON-INTEREST INCOME (CONTINUED)
Net gain on the sale of investment securities was $134,000 in 1997.
This amount represents gains on the sale of marketable equity securities of
$159,000 netted against a net loss of $25,000 on the sale of debt securities.
During the fourth quarter of 1997, QNB sold approximately $4,000,000 in low
yielding securities at a loss of $31,000. These securities had an average yield
of 5.29 percent. The proceeds of this sale were used to fund higher yielding
loans, which were booked at the end of the year. This replacement of lower
yielding securities with higher yielding loans should benefit QNB in 1998.
Earlier in the year approximately $9,500,000 of U.S. Treasury and agency
securities were sold for liquidity purposes at a gain of $6,000.
QNB recorded net gains on the sale of investment securities of $102,000 in 1996.
Sales of equity securities, with a cost of $75,000, netted a $77,000 gain. Sales
of approximately $18,350,000 in available-for-sale debt securities netted a gain
of $25,000. During the second quarter of 1996 QNB sold approximately $5,500,000
in U.S. Treasury and agency securities. QNB took advantage of a steep slope in
the short end of the Treasury yield curve to "pre-fund" bonds that were maturing
over the next year and a half and reinvested in bonds in the three to four year
range. This allowed QNB to record a profit on the sale of $23,000, and also to
increase the overall book yield of the portfolio. During the third and fourth
quarters QNB sold approximately $12,850,000 of U.S. Treasury and agency
securities and netted a gain of $2,000. These sales were for liquidity purposes
and were in direct response to the seasonality of one customer's deposits.
Net losses on investment securities were $79,000 in 1995. To assist in
increasing future profitability, QNB sold approximately $7,885,000 of lower
yielding investment securities at a loss of $79,000 in the fourth quarter of
1995 and reinvested the proceeds in higher yielding investment securities which
would provide for higher interest income in future years.
The Corporation owns a portfolio of marketable equity securities, consisting of
stocks of other financial institutions. At December 31, 1997, these securities
had an amortized cost of $1,266,000 and a market value of $1,975,000. Management
anticipates realizing some of this gain during 1998.
Student and residential mortgage loans to be sold are identified at time of
origination. The net gain on the sale of loans was $81,000, $89,000 and $108,000
in 1997, 1996 and 1995, respectively. Included within these amounts are gains on
the sale of student loans of $35,000, $32,000 and $68,000, respectively. QNB
sold approximately $1,464,000 and $1,495,000 of loans to SallieMae during 1997
and 1996. In June 1995 QNB sold approximately $2,558,000 of student loans to
SallieMae. Since then, QNB changed the manner in which it originates and sells
student loans to SallieMae. This change provides a lower cost method of
originating student loans while also providing an opportunity for gains on the
sale of the originated loans. The amount of the gain depends upon the size and
type of loans originated.
The net gain on residential mortgage sales is directly related to the volume of
mortgages sold and the timing of the sales relative to the interest rate
environment. Net gains on the sale of residential mortgages were $46,000 in
1997, $57,000 in 1996 and $40,000 in 1995. Significant interest rate swings have
had a major impact on the volume of mortgages originated and the gains recorded
on the sale of these mortgages. QNB sold approximately $2,493,000, $3,512,000
and $2,598,000 of residential mortgages in the secondary market in 1997, 1996
and 1995, respectively. Management decided in 1995 to sell primarily only
30-year fixed rate mortgage originations. However, during the third quarter of
1997 declining interest rates provided an opportunity to sell some lower
yielding 15 and 20 year mortgages that had been in portfolio. As mentioned
previously, it is management's intention to sell both 20 and 30-year
originations during 1998. If rates remain low or decline further and the volume
of mortgage refinancing activity increases, gains on the sale of mortgages
should increase in 1998. However, if rates were to increase prior to the sale of
the originated mortgages, a loss could occur since these loans are accounted for
at the lower of cost or market. The implementation of SFAS No. 122 as superceded
by SFAS No. 125 increased the gain on the sale of residential mortgages in 1997
and 1996 by approximately $25,000 and $41,000.
Other operating income was $523,000, $356,000 and $208,000 in 1997, 1996 and
1995, respectively. The $167,000 or 46.9 percent increase between 1997 and 1996
is primarily the result of increases in the following areas: rental income on
other real estate owned, check card fee income, ATM interchange income and
merchant processing income. Rental income on other real estate owned increased
$113,000 from 1996. Most of the properties foreclosed on at the end of 1996 and
during 1997 provide rental income. This source of income will decline during
1998 as the properties are sold. Income on the check card introduced in December
1996 accounts for an additional $67,000 of the increase in other income. The
increase in ATM interchange income is a result of QNB's practice of not
surcharging ATM customers. QNB receives a fee from the non-customer's bank when
non-customers use a QNB machine. The volume of these non-customer transactions
has increased as a result of other banks in the market area surcharging
transactions. Merchant processing income provided an additional $26,000 in
income during 1997. At the end of 1996, QNB analyzed its merchant processing
operations and adjusted the pricing of the service to make it more profitable.
Partially offsetting these increases was the impact of the gain on the sale of
other real estate owned of $67,000 recorded in 1996. During 1997, QNB had losses
of $25,000 on the sale of other real estate owned. These losses are included in
other real estate owned expense.
When comparing 1996 to 1995 other operating income increased $148,000. Net gains
on the sale of other real estate owned and rental income on other real estate
owned account for $67,000 and $20,000,
Change from Prior Year
------------------------------------------
NON-INTEREST INCOME COMPARISON 1997 1996
- ------------------------------------------------------------------------------------------------------------------------------
1997 1996 1995 Amount Percent Amount Percent
- ------------------------------------------------------------------------------------------------------------------------------
Fees for services to customers $1,076 $1,095 $ 927 $ (19) (1.7)% $ 168 18.1 %
Mortgage servicing fees 181 208 229 (27) (13.0) (21) (9.2)
Net gain (loss) on investment securities 134 102 (79) 32 31.4 181 --
Net gain on sale of loans 81 89 108 (8) (9.0) (19) (17.6)
Other operating income 523 356 208 167 46.9 148 71.2
- -------------------------------------------------------------------------------------------------------------------------------
Total $1,995 $1,850 $1,393 $ 145 7.8 % $ 457 32.8 %
- -------------------------------------------------------------------------------------------------------------------------------
12
QNB Corp. and Subsidiary
- --------------------------------------------------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS
Change from Prior Year
----------------------
NON-INTEREST EXPENSE COMPARISON 1997 1996
- -------------------------------------------------------------------------------------------------------------------------------
1997 1996 1995 Amount Percent Amount Percent
- -------------------------------------------------------------------------------------------------------------------------------
Salaries and employee benefits $5,411 $5,185 $5,369 $ 226 4.4% $(184) (3.4)%
Net occupancy expense 666 687 675 (21) (3.1) 12 1.8
Furniture and equipment expense 697 697 721 - - (24) (3.3)
Marketing expense 303 287 247 16 5.6 40 16.2
Supplies expense 180 209 222 (29) (13.9) (13) (5.9)
Professional fees 180 160 263 20 12.5 (103) (39.2)
Insurance expense 104 104 404 - - (300) (74.3)
Other real estate owned expense 273 253 356 20 7.9 (103) (28.9)
Other expense 1,453 1,422 1,282 31 2.2 140 10.9
- -------------------------------------------------------------------------------------------------------------------------------
Total $9,267 $9,004 $9,539 $ 263 2.9% $(535) (5.6)%
- -------------------------------------------------------------------------------------------------------------------------------
respectively, of the increase in 1996. During the third quarter of 1995, QNB
began offering retail investment products through a third party vendor. QNB
received commissions of $30,000 in 1996 versus $3,000 in 1995. Commission income
on the sale of consumer loan life and disability insurance contributed
approximately $16,000 more to other operating income in 1996. Increased loan
volume, in addition to a more concerted sales effort, resulted in the increased
commissions. Higher ATM card income, a result of an increase in the number of
cards outstanding as well as an increase in the annual fee charged, resulted in
a $13,000 increase in income. Other operating income in 1995 included a $10,000
gain on the sale of equipment. There were no equipment sales during 1996.
NON-INTEREST EXPENSE
Non-interest expense is comprised of costs related to salaries and employee
benefits, net occupancy, furniture and equipment, marketing, supplies,
professional fees, insurance, other real estate owned and various other
operating expenses. The trend of expense reduction that began in 1994 came to an
end in 1997 as total non-interest expense increased 2.9 percent to $9,267,000.
Total non-interest expense declined 5.6 percent in 1996 to $9,004,000 and 1.9
percent in 1995 to $9,539,000. Despite the slight increase in 1997, total
non-interest expense is significantly below levels reported between 1993 and
1995.
Salaries and benefits expense is the largest component of non-interest expense.
Salaries and benefits expense for 1997 increased $226,000 or 4.4 percent to
$5,411,000. Salary expense for 1997 increased by $192,000 or 4.7 percent to
$4,312,000, while benefits expense increased by $34,000 to $1,099,000. If the
impact of bank-wide performance bonuses and severance pay are excluded, the
increase to salary expense for 1997 is $19,000 or .5 percent.
The increase in benefits expense in 1997 is partially a result of higher payroll
related taxes. Social security and Medicare taxes increased approximately
$15,000 while state unemployment taxes increased by approximately $26,000. The
increase in state unemployment taxes is the outcome of a higher rate resulting
from the corporate reorganizations of 1994 and 1995. This rate and therefore the
expense should decline in 1998. Another factor in the increase in benefit
expense relates to QNB's retirement plans, whose costs increased by
approximately $18,000 in 1997. This increase was a result of an increase in
eligible wages and the costs of converting the plans to new investment funds and
a new record-keeper. These conversion costs should be recouped through lower
administration costs in 1998. Partially offsetting these increases were lower
costs related to disability and life insurance premiums, which declined by
approximately $17,000. A change in insurance carrier accounted for the decrease.
Expense for employee education also decreased by $13,000 in 1997 as a result of
several employees completing their programs in 1996.
Salaries and benefits expense for 1996 declined $184,000 or 3.4 percent, to
$5,185,000 when compared to 1995. Salary expense for 1996 decreased by $141,000
to $4,120,000 while benefits expense decreased by $43,000 to $1,065,000. The
reduction in salary expense related to the reorganization plan implemented
during the second quarter of 1995. The cost of the severance packages expensed
in 1995 was approximately $244,000. If the severance expense were excluded from
1995 figures, salary expense in 1996 would have increased by approximately 2.6
percent as a result of performance increases and a slight increase in the number
of full-time equivalent employees. The decrease in benefits expense is also
directly related to the decline in the number of employees resulting from the
reorganization. Payroll tax expense declined by $14,000 as a result of lower
salary expense. Medical premiums declined by $57,000 while life and disability
premiums declined by $7,000. Lower rates for medical premiums also positively
impacted the amount of benefits expense. Partially offsetting these reductions
was an increase in pension expense of approximately $13,000, higher unemployment
taxes of $6,000 and higher education expense of $16,000.
Net occupancy expense decreased $21,000 or 3.1 percent in 1997 to $666,000.
Declines in building depreciation expense and building repairs and maintenance
expense offset the impact of higher utility costs. Depreciation expense and
repairs and maintenance costs declined by $17,000 and $21,000, respectively,
while utility costs increased by $12,000. When comparing 1996 to 1995, net
occupancy expense increased $12,000 or 1.8 percent to $687,000. Increases in
utility costs, building insurance premiums, real estate taxes and higher rental
expense for branch locations contributed to the increase in 1996. A decline in
depreciation expense for owned buildings and leasehold improvements offset some
of the impact of the higher costs. Net occupancy expenses will likely increase
slightly in 1998 as a result of increases in utility costs, insurance costs,
real estate taxes, and branch rent expense. Depreciation expense and building
repairs and maintenance expense will also likely increase as some proposed
projects are completed.
13
QNB Corp. and Subsidiary
- --------------------------------------------------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS
NON-INTEREST EXPENSE (CONTINUED)
Furniture and equipment expense was $697,000 for both 1997 and 1996 and $721,000
for 1995. Depreciation expense on furniture and equipment continues to decline.
Depreciation expense on furniture and equipment decreased $13,000 in 1997 to
$359,000. This followed decreases of $74,000 in 1996 and $36,000 in 1995. QNB
uses an accelerated method of depreciation on its furniture and equipment. This
provides for higher expense in the earlier years of an asset's life. QNB
purchased approximately $200,000 of furniture and equipment in 1997 compared to
$326,000 in 1996 and $143,000 in 1995. Furniture and equipment purchases for
1994 and 1993 totaled $1,108,000. The smaller amounts of furniture and equipment
purchased in the past three years, along with lower depreciation expense as an
asset ages, account for the decline in depreciation expense over the years.
Offsetting the reduction in depreciation expense in both 1997 and 1996 was an
increase in equipment maintenance costs, which increased $18,000 in 1997 after
increasing $44,000 between 1995 and 1996. These costs have increased as a result
of more equipment being placed under maintenance agreements, as well as an
increase in maintenance needed as the equipment ages. Furniture and equipment
expense may increase in 1998 as a result of higher depreciation expense
associated with QNB's expansion of its investment in new technology and as older
equipment is replaced.
Marketing expense increased $16,000 or 5.6 percent in 1997 to $303,000. A
significant donation to a local non-profit organization accounts for most of the
increase. When comparing 1996 to 1995, marketing expense increased $40,000 or
16.2 percent to $287,000. A more focused marketing strategy using targeted
mailings as well as an increase in specific product advertising directed at
customers of consolidating banks contributed to the increase. The promotion and
advertising of QNB's new products: Youth Trek, Account Access and check cards,
also contributed to the increase in marketing expense in 1996. Advertising
expense is anticipated to increase in 1998 as QNB targets the customers impacted
by the pending merger of two large regional banks.
[GRAPHIC OMITTED]
Supplies expense was $180,000, $209,000 and $222,000 for the years ended 1997,
1996 and 1995, respectively. A more aggressive competitive bidding process in
addition to improved monitoring procedures and a reduction in the number of
employees contributed to the decline in supplies expense. This trend should
continue in 1998 as a result of benefits achieved through the competitive
bidding process as well as the replacement of purchased forms with in-house
laser printed documents.
Professional fees include legal, accounting and consulting expense. These fees
increased $20,000 or 12.5 percent to $180,000 for 1997. Legal and accounting
costs associated with the purchase of deposits from First Lehigh Bank
contributed to the increase. When comparing 1996 to 1995, professional fees
showed dramatic improvement, declining $103,000 to $160,000. Legal expense and
accounting expense declined $40,000 and $31,000, respectively, while consulting
expense declined $32,000. Less reliance on legal counsel for loan workout
situations resulting from the improvement in asset quality reduced the amount of
legal expense. Costs associated with outplacement services for terminated
employees were the primary reason for the higher consulting expense in 1995.
Insurance expense, which includes Federal Deposit Insurance Corporation (FDIC)
premiums as well as directors and officers liability insurance, banker's bond
and worker's compensation insurance, was $104,000 in both 1997 and 1996 and
$404,000 in 1995. The FDIC has been granted unlimited assessment authority to
increase or decrease premiums under the Federal Deposit Insurance Corporation
Act of 1991. FDIC insurance premiums are based on assigned risk classifications.
FDIC premiums account for $31,000, $2,000 and $306,000 of total insurance
expense for the three years. In August 1995, the FDIC announced that the Bank
Insurance Fund (BIF) had met its legally set coverage ratios as of May 1995, and
as a result FDIC premiums for "well capitalized" institutions were dramatically
reduced starting with the third quarter of 1995 assessment. By achieving the
coverage ratios, the FDIC premiums for "well capitalized" institutions in 1996
were eliminated except for the legally set annual minimum of $2,000. This
minimum was subsequently eliminated in 1997. However, as a result of the Deposit
Insurance Act of 1996, QNB contributes to the payment of the Financing
Corporation (FICO) obligations. Lower premiums for workers compensation and
directors and officers insurance offset the increase in the F.D.I.C. assessment.
Other real estate owned expense increased $20,000 or 7.9 percent to $273,000 in
1997. The increase is primarily the result of net losses on the disposition or
write-down of properties during the year. These net losses amounted to $25,000.
Expenses related to the maintenance of the properties, which includes insurance,
utilities, taxes and repairs expense decreased by $5,000 in 1997. Management
anticipates a substantial reduction in these costs during 1998, as these costs
are eliminated as properties are sold. Other real estate owned expense in 1996
was $253,000, a decrease of $103,000 from the $356,000 reported in 1995.
Included in other real estate owned expense in 1995 were net losses on
write-downs and sales of properties of $149,000. In 1996 QNB recorded $67,000 of
net gains on other real estate owned. These gains are reflected in other
non-interest income. Expenses related to the maintenance of other real estate
owned increased approximately $46,000 when comparing 1996 to 1995. The payment
of real estate taxes on a group of properties foreclosed upon in the fourth
quarter of 1996 accounts for the increase from 1995.
The major categories that comprise other expense are postage, telecommunications
costs, Comptroller of the Currency expense, state taxes and loan related costs.
Other expense was $1,453,000 in 1997, $1,422,000 in 1996 and $1,282,000 in 1995.
The 2.2 percent increase in 1997 is a result of a number of factors including an
increase
14
QNB Corp. and Subsidiary
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MANAGEMENT'S DISCUSSION AND ANALYSIS
in directors fees, state taxes, ATM and check card expense and fraud losses. The
increase in directors fees of $28,000 resulted from an increase in the number of
Bank directors and the fees paid per meeting. Costs related to the startup,
distribution and maintenance of the check card account for $12,000 of the
increase. The amortization of the deposit premium, which is being amortized over
10 years, contributed to the increase in other expense and will have an even
greater impact in 1998. These increases were partially offset by lower loan
appraisal costs and foreclosure costs.
One reason for the increase between 1996 and 1995 was the increase in loan
related costs. These costs, which include property appraisals, credit reports
and expense associated with foreclosures and repossessions, increased
approximately $80,000 in 1996. The increase in foreclosure costs is related to
the payment of real estate taxes and insurance for several loans where the
borrower failed to make the payments. Costs associated with the development and
production of the new check card were $34,000 in 1996. Postage expense increased
in 1996 by approximately $29,000. A significant portion of this increase was
related to direct mail marketing promotions.
INCOME TAXES
QNB uses the asset and liability method of Statement of Financial Accounting
Standard No. 109 (SFAS No. 109), "Accounting for Income Taxes," to provide for
income taxes. Deferred tax assets and liabilities are recognized for the future
tax consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. The effect of a change in
tax rates on deferred tax assets and liabilities is recognized in income in the
period that includes the enactment date.
Applicable income taxes and effective tax rates were $1,253,000 or 28.6 percent
for 1997 compared to $1,048,000 or 27.2 percent for 1996, and $536,000 or 24.1
percent for 1995. The increases in the effective tax rate are a result of higher
pre-tax income and a decrease in the percentage of income derived from
non-taxable loans and investments.
FINANCIAL CONDITION
The consolidation of the financial services industry that began in 1995
continued in 1996 and 1997, with the completion of and announcement of many
mergers. What had initially started as primarily bank mergers has now broadened
to include the consolidation of banks with brokerage houses, savings
institutions, credit card companies and mortgage banking firms. The largest
pending merger that will impact QNB is the combination of CoreStates Bank with
First Union Bank. CoreStates has locations in every market in which QNB
operates. QNB will use this merger as an opportunity to attract current
CoreStates customers, by stressing the advantages of banking with a locally
owned community bank. These mergers have changed the landscape in which QNB
operates. QNB's primary competition in the banking segment of the financial
services industry is comprised of a large regional bank, several large community
banks and a thrift institution. The consolidation of the banking industry and
the increased availability of loans from all types of companies in the financial
services industry have led to increased price competition for both deposits and
loans. Insurance companies have become a major competitor in the lending arena.
Record highs in the stock markets as well as record inflows of cash into mutual
funds have also had a direct impact on the competition for deposits.
In spite of this increased competition, QNB was able, for the first time in
years, to experience significant balance sheet growth in 1997. Total assets at
year-end 1997 were $305,772,000, compared with $280,447,000 at December 31,
1996, an increase of 9.0 percent. This followed growth rates of 1.6 percent and
2.9 percent in 1996 and 1995. The growth in 1997 was enhanced by the purchase of
approximately $6,800,000 of deposits from the Quakertown office of First Lehigh
Bank on October 30, 1997. Excluding this purchase assets would have increased by
6.6 percent.
Average total assets increased 5.2 percent or $14,165,000 in 1997 to
$288,698,000. This followed an increase in average total assets of 1.7 percent
or $4,700,000 in 1996. Total loans at December 31, 1997 were $167,720,000, an
increase of 5.3 percent from December 31, 1996. This followed a 2.1 percent
increase from December 31, 1995. Average total loans increased 3.8 percent in
1997 and 2.2 percent in 1996. Loan growth was and remains one of the primary
goals of QNB. Funding sources, which include deposits and short-term borrowings,
increased 8.7 percent from year-end 1996 to year-end 1997 and 1.0 percent from
year-end 1995 to year-end 1996. Excluding the purchase of deposits, funding
sources would have increased by 6.0 percent in 1997. Average funding sources
increased 4.7 percent in 1997 and 1.2 percent in 1996. The following discussion
will further detail QNB's financial condition during 1997 and 1996.
INVESTMENT SECURITIES AND OTHER
SHORT-TERM INVESTMENTS
Investment policies, approved by QNB's Board of Directors, include strict
standards regarding permissible investment categories, credit quality, maturity
intervals and investment concentrations. Total investment securities at December
31, 1997 and 1996 were $116,320,000 and $95,478,000. At both December 31, 1997
and 1996, approximately 90 percent of QNB's investment securities were either
U.S. Government or U.S. Government agency debt securities, or U.S. Government
agency issued mortgage-backed securities.
QNB did not hold any securities which, in the aggregate from any issuer
(excluding the U.S. Government and its agencies), were in excess of 10 percent
of shareholders' equity. In addition, Federal funds sold, which would be
affected by the economic status of the banking industry, are short-term in
nature and sold to banks with a minimum "A" rating at the date of the sale.
Average investment securities increased $8,711,000 or 8.9 percent to
$107,087,000 in 1997 compared with a $2,334,000 or 2.4 percent increase in 1996.
Average Federal funds sold decreased 15.4 percent in 1997 to $4,003,000 and 15.5
percent in 1996 to $4,731,000. The increase in the size of the investment
portfolio in 1997 was fueled by the growth in average funding sources, which
increased by $11,878,000. This growth was enhanced by the previously discussed
purchase of approximately $6,800,000 in deposits from another financial
institution. The amount of activity in the investment portfolio remained high
with over $31,000,000 in maturities, calls or sales and over $51,000,000 in
purchases during 1997.
15
QNB Corp. and Subsidiary
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MANAGEMENT'S DISCUSSION AND ANALYSIS
INVESTMENT PORTFOLIO HISTORY
- ---------------------------------------------------------------------------------------------------------------------------------
December 31, 1997 1996 1995
- ---------------------------------------------------------------------------------------------------------------------------------
Investment Securities Available-for-Sale
U.S. Treasuries $ 9,633 $ 9,555 $12,732
U.S. Government agencies 55,586 39,422 40,415
State and municipal securities 511 - -
Mortgage-backed securities 8,152 3,045 1,859
Equity and other debt securities 2,038 757 374
- ---------------------------------------------------------------------------------------------------------------------------------
Total investment securities available-for-sale $ 75,920 $ 52,779 $55,380
- ---------------------------------------------------------------------------------------------------------------------------------
Investment Securities Held-to-Maturity
U.S. Treasuries - - $ 2,006
State and municipal securities $ 10,136 $ 10,563 9,531
Mortgage-backed securities 30,186 32,058 30,900
Equity securities 78 78 78
- ---------------------------------------------------------------------------------------------------------------------------------
Total investment securities held-to-maturity $ 40,400 $ 42,699 $42,515
- ---------------------------------------------------------------------------------------------------------------------------------
Total investment securities $116,320 $ 95,478 $97,895
- ---------------------------------------------------------------------------------------------------------------------------------
INVESTMENT PORTFOLIO WEIGHTED AVERAGE YIELDS
- -------------------------------------------------------------------------------------------------------------------------------
Under 1-5 5-10 Over 10
December 31, 1997 1 Year Years Years Years Total
- -------------------------------------------------------------------------------------------------------------------------------
Investment Securities Available-for-Sale
U.S. Treasuries:
Fair value $ 501 $ 9,132 - - $ 9,633
Weighted average yield 5.70% 6.19% 6.16%
U.S. Government agencies:
Fair value $ 498 $21,041 $ 34,047 - $ 55,586
Weighted average yield 5.43% 6.40% 7.02% 6.77%
State and municipal securities:
Fair value - - - $ 511 $ 511
Weighted average yield 8.21% 8.21%
Mortgage-backed securities:
Fair value $ 21 $ 7,126 $ 1,005 - $ 8,152
Weighted average yield 8.46% 6.74% 6.75% 6.75%
Equity and other debt securities:
Fair value $ 1,987 $ 51 - - $ 2,038
Weighted average yield 4.46% 7.87% 4.59%
- -------------------------------------------------------------------------------------------------------------------------------
Total fair value $ 3,007 $37,350 $ 35,052 $ 511 $ 75,920
Weighted average yield 4.86% 6.42% 7.01% 8.21% 6.66%
- -------------------------------------------------------------------------------------------------------------------------------
Investment Securities Held-to-Maturity
State and municipal securities:
Amortized cost - $ 1,986 $ 8,150 - $ 10,136
Weighted average yield 7.66% 7.24% 7.32%
Mortgage-backed securities:
Amortized cost $10,339 $19,694 $ 153 - $ 30,186
Weighted average yield 6.19% 6.62% 7.00% 6.48%
Equity securities:
Amortized cost $ 78 - - - $ 78
Weighted average yield 6.00% 6.00%
- -------------------------------------------------------------------------------------------------------------------------------
Total amortized cost $10,417 $21,680 $ 8,303 - $ 40,400
Weighted average yield 6.19% 6.72% 7.24% 6.69%
- -------------------------------------------------------------------------------------------------------------------------------
Securities are assigned to categories based on stated contractual maturity
except for mortgage-backed securities which are based on anticipated
payment periods. See interest rate sensitivity section for practical
payment and repricing characteristics. Tax-exempt securities were adjusted
to a tax-equivalent basis and are based on the marginal Federal corporate
tax rate of 34 percent. Weighted average yields on investment securities
available-for-sale are based on historical cost.
16
QNB Corp. and Subsidiary
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MANAGEMENT'S DISCUSSION AND ANALYSIS
INVESTMENT SECURITIES (CONTINUED)
The low rate of growth in the investment portfolio in 1996 was a result of
slower growth in funding sources and an increase in average loans. While the
average growth rate of the portfolio was low, the amount of activity in the
portfolio was not. Over $42,000,000 of the portfolio matured, was called or was
sold during the year. Purchases during the year were approximately $40,000,000.
Despite the amount of activity during 1997, the composition of the portfolio did
not change significantly. U.S. Government agency securities increased to 47.8
percent of the portfolio at December 31, 1997, from 41.3 percent of the
portfolio at December 31, 1996. The percentage of U.S. Treasury securities
declined to approximately 8.3 percent of the portfolio from 10.0 percent while
mortgage-backed securities decreased to 33.0 percent from 36.8 percent. State
and municipal securities decreased to 9.2 percent from 11.1 percent of the
portfolio at December 31, 1997 and 1996, respectively. The increase in the
percentage of the portfolio in U.S. Government agency securities is a result of
management's opinion that the callable agency sector in which QNB was active
provided greater value than other alternative investments. Management
anticipates that investment portfolio activity will remain high during 1998, due
to the relatively low interest rate environment, as some callable agency bonds
are called and prepayments increase on mortgage-backed securities. The growth in
the investment portfolio should be minimal in 1998 as anticipated loan growth
replaces some of the maturities and calls of securities.
[GRAPHIC OMITTED]
At December 31, 1997 and 1996, investment securities totaling $36,510,000 and
$34,381,000 were pledged as collateral for repurchase agreements, public
deposits and other deposits as provided by law.
QNB accounts for its investments by classifying its securities into three
categories. Securities that QNB has the positive intent and ability to hold to
maturity are classified as held-to-maturity securities and reported at amortized
cost. Debt and equity securities that are bought and held principally for the
purpose of selling them in the near term are classified as trading securities
and reported at fair value, with unrealized gains and losses included in
earnings. Debt and equity securities not classified as either held-to-maturity
securities or trading securities are classified as available-for-sale securities
and reported at fair value, with unrealized gains and losses, net of tax,
excluded from earnings and reported as a separate component of shareholders'
equity. Management determines the appropriate classification of securities at
the time of purchase. QNB held no trading securities as of December 31, 1997 and
1996.
INVESTMENTS AVAILABLE-FOR-SALE
Investment securities available-for-sale includes securities that management
intends to use as part of its asset/liability management strategy. They may be
sold in response to changes in market interest rates and related changes in the
security's prepayment risk or in response to the need for liquidity. The
available-for-sale portfolio is primarily comprised of U.S. Treasuries and U.S.
Government agencies due to their high degree of liquidity. Also included are
certain mortgage-backed securities to ensure QNB's ability to react to changes
in prepayment activity. At December 31, 1997, the fair value of investment
securities available-for-sale was $75,920,000 or $1,323,000 above the amortized
cost of $74,597,000. This compares to a fair value of $52,779,000 or $170,000
above the amortized cost of $52,609,000 at December 31, 1996. An unrealized
holding gain, net of taxes, of $873,000 and $112,000 was recorded as an increase
to shareholders' equity at December 31, 1997 and 1996, respectively. The
available-for-sale portfolio had a weighted average maturity of approximately 5
years and 4 years and 1 month and a weighted average tax-equivalent yield of
6.66 percent and 6.38 percent at December 31, 1997 and 1996, respectively.
The weighted average maturity is based on the stated contractual maturity of all
securities except for mortgage-backed securities, which are based on estimated
average life. The maturity of the portfolio may be shorter because of call
features in many of the debt securities and because of prepayments on
mortgage-backed securities. The interest rate sensitivity analysis on page 25
reflects the expected maturity distribution of the securities portfolio based
upon estimated call dates and anticipated cash flows assuming management's most
likely interest rate environment. The expected weighted average life of the
available-for-sale portfolio was 1 year and 10 months at December 31, 1997, and
2 years and 1 month at December 31, 1996, based on these assumptions. The
expected weighted average maturity declined despite the lengthening of the
stated average maturity because of the callable nature of the securities and the
decline in interest rates at the end of 1997, which makes these call features
more likely to be exercised.
INVESTMENTS HELD-TO-MATURITY
Investment securities held-to-maturity are recorded at amortized cost. Included
in this portfolio are state and municipal securities with original maturities
less than 10 years and most mortgage-backed securities. They are designated as
held-to-maturity as they represent a large component of QNB's core investment
earnings and are purchased with the intent and ability to hold to maturity.
Certain mortgage-backed securities with the highest degree of yield and average
life stability are included in this classification. At December 31, 1997 and
1996, the amortized cost of investment securities held-to-maturity was
$40,400,000 and $42,699,000 and the fair value was $40,713,000 and $42,760,000,
respectively. The held-to-maturity portfolio had a weighted average maturity of
approximately 2 years and 10 months and 3 years and 6 months and a weighted
average tax-equivalent yield of 6.69 percent and 6.68 percent at December 31,
1997 and 1996, respectively.
17
QNB Corp. and Subsidiary
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MANAGEMENT'S DISCUSSION AND ANALYSIS
LOANS
QNB's primary function and responsibility is to accept deposits and to make
loans to meet the credit needs of the communities it serves. Loans are the most
significant component of earning assets. Inherent within the lending function is
the evaluation and acceptance of credit risk and interest rate risk along with
the opportunity cost of alternative deployment of funds. QNB manages credit risk
associated with its lending activities through portfolio diversification,
underwriting policies and procedures, and loan monitoring practices.
[GRAPHIC OMITTED]
QNB has comprehensive policies and procedures which define and govern both
commercial and retail loan origination and management of risk. All loans are
underwritten in a manner that emphasizes the borrowers' capacity to pay. The
measurement of capacity to pay delineates the potential risk of nonpayment or
default. The higher potential for default determines the need for and amount of
collateral required. QNB makes unsecured loans when the capacity to pay is
considered substantial. As capacity lessens, collateral is required to provide a
secondary source of repayment and to mitigate the risk of loss. Various policies
and procedures provide guidance to the lenders on such factors as amount, terms,
price, maturity and appropriate collateral levels. Each risk factor is
considered critical to assuring that QNB receives an adequate return for the
risk undertaken, and that the risk of loss is minimized.
QNB effectively manages the risk associated with commercial loans, which
generally have balances larger than retail loans, by having lenders work in
tandem with credit underwriting personnel. To further assess loan portfolio
quality, a Loan Committee and the Board of Directors approve loans that meet
certain qualifications.
QNB's commercial lending activity is focused on small businesses within the
local community. Commercial and industrial loans represent commercial purpose
loans that are either secured by collateral other than real estate or unsecured.
Real estate commercial loans include commercial purpose loans collateralized at
least in part by commercial real estate. These loans may not be for the
expressed purpose of conducting commercial real estate transactions. Real estate
residential loans include loans secured by one-to-four family units. These loans
include home equity loans, loans to individuals for residential mortgages and
commercial purpose loans. Prior to 1995, substantially all originations of loans
to individuals for residential mortgages were sold in the secondary market.
Beginning in 1995, QNB decided it would sell primarily only 30-year mortgages in
the secondary market. This has been further modified in 1997 to include the sale
of 20 year residential mortgages. Included in real estate residential loans at
December 31, 1997 and 1996 are $481,000 and $103,000 of residential mortgage
loans held-for-sale.
The loan portfolio composition changed slightly from year-end 1996. Loans
collateralized by commercial and residential properties decreased to 75.1
percent of the portfolio at December 31, 1997 from 77.5 percent of the portfolio
at December 31, 1996. Commercial and industrial loans increased to 19.5 percent
of the portfolio at year-end 1997 from 14.4 percent at December 31, 1996.
Construction loans and consumer loans declined from 2.3 and 4.0 percent at
year-end 1996 to .5 percent and 3.2 percent at December 31, 1997, respectively.
QNB's commercial loans are not considered to be concentrated, except those loans
to real estate developers and investors which account for $25,688,000 or 15.3
percent of the loan portfolio. Concentration is based upon Standard Industrial
Classification codes used for bank regulatory purposes and is considered to be
10 percent or more of total loans in any particular industry. Diversification is
achieved through lending to various industries located within the market area.
This diversification is believed to reduce investment risk associated with
changes in economic conditions. At December 31, 1997, the ten largest commercial
customers of QNB had outstanding balances of $21,556,000 and unexercised
commitments of $7,044,000.
Loans, net of unearned income, increased $8,442,000 to $167,720,000 at December
31, 1997. The commercial and industrial loan category showed the largest
increase with outstandings increasing $9,821,000 to $32,794,000. Loans secured
by commercial real estate and residential real estate increased $1,194,000 and
$1,418,000, respectively from December 31, 1996 to 1997. These were the
categories that had shown the largest increase the previous year. Construction
loans and consumer loans decreased $2,827,000 and $1,165,000, respectively.
Growth in loans during 1997 was primarily focused upon increasing loans for
commercial purposes. The increase in the commercial and industrial category is a
direct result of this focus. Although a certain amount of these loans are
considered unsecured, the majority are secured by non-real estate collateral
such as equipment, vehicles, accounts receivable and inventory. While the growth
in loans secured by commercial real estate was not as significant in 1997 as it
was in 1996, the growth is net of some larger relationships that paid off their
loans during the year and other relationships that were transferred to other
real estate owned during the year.
The increase in residential real estate loans that began in 1995 is the result
of the change in strategy in selling loans in the secondary market, and a new
plan to accept a small percentage of quality loans that are nonconforming to
Freddie Mac standards and therefore are not salable to them. These include loans
that have excess land value, loans that exceed a dollar threshold or loans where
the debt to income ratio slightly exceeds Freddie Mac's guidelines but where QNB
has had an ongoing relationship with the customer. Aggressive fixed rate home
equity loan promotions and pricing during 1997 and 1996 also impacted the growth
of loans secured by residential real estate. The increase in home equity loans
also negatively impacted the amount of consumer loans outstanding. Customers
chose to benefit from the competitive rate of home equity loans as well as the
tax deductibility of the interest, by paying off other loans with home equity
loans. Additionally, consumer loans outstanding continued to decline as a result
of the decision made in 1995 to discontinue indirect vehicle lending through
automobile dealers.
18
QNB Corp. and Subsidiary
- --------------------------------------------------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS
LOAN PORTFOLIO
- --------------------------------------------------------------------------------------------------------------------------------
December 31, 1997 1996 1995 1994 1993
- --------------------------------------------------------------------------------------------------------------------------------
Commercial and industrial $ 32,794 $ 22,973 $ 27,002 $ 24,599 $ 20,405
Agricultural 2,845 2,828 2,451 2,823 1,268
Construction 813 3,640 6,641 5,253 6,019
Real estate-commercial 58,783 57,589 51,368 54,015 56,510
Real estate-residential 67,621 66,203 61,339 57,486 59,154
Consumer 5,312 6,477 7,538 10,208 9,830
- --------------------------------------------------------------------------------------------------------------------------------
Total loans 168,168 159,710 156,339 154,384 153,186
Less unearned income 448 432 382 391 422
- --------------------------------------------------------------------------------------------------------------------------------
Total loans, net of unearned income $ 167,720 $ 159,278 $ 155,957 $ 153,993 $152,764
- --------------------------------------------------------------------------------------------------------------------------------
LOAN MATURITIES AND INTEREST SENSITIVITY
- --------------------------------------------------------------------------------------------------------------------------------
Under 1-5 Over
December 31, 1997 1 Year Years 5 Years Total
- --------------------------------------------------------------------------------------------------------------------------------
Commercial and industrial $ 11,876 $ 16,690 $ 4,228 $ 32,794
Agricultural 522 442 1,881 2,845
Construction 798 15 - 813
Real estate-commercial 8,419 9,221 41,143 58,783
Real estate-residential 9,667 16,600 41,354 67,621
Consumer 2,080 3,015 217 5,312
- --------------------------------------------------------------------------------------------------------------------------------
Total $ 33,362 $ 45,983 $ 88,823 $168,168
- --------------------------------------------------------------------------------------------------------------------------------
Demand loans, loans having no stated schedule of repayment and no stated
maturity, are included in under one year.
The following shows the amount of loans due after one year that have fixed,
variable or adjustable interest rates at December 31, 1997:
Loans with fixed predetermined interest rates $74,672
Loans with variable or adjustable interest rates $60,134
NON-PERFORMING ASSETS
- ------------------------------------------------------------------------------------------------------------------------------
December 31, 1997 1996 1995 1994 1993
- ------------------------------------------------------------------------------------------------------------------------------
Loans past due 90 days or more not on non-accrual status
Commercial and industrial $ 99 - $ 66 $ 5 -
Construction - - - 299 -
Real estate-commercial - - 107 100 $ 191
Real estate-residential 60 $ 162 96 313 253
Consumer - 3 3 4 78
- ------------------------------------------------------------------------------------------------------------------------------
Total loans past due 90 days or more and accruing 159 165 272 721 522
Loans accounted for on a non-accrual basis
Commercial and industrial 25 43 120 123 312
Construction - - 686 846 1,132
Real estate-commercial 744 1,790 2,588 1,157 2,097
Real estate-residential 440 867 1,084 1,755 1,543
Consumer - - 10 24 11
- ------------------------------------------------------------------------------------------------------------------------------
Total non-accrual loans 1,209 2,700 4,488 3,905 5,095
Other real estate owned 1,564 1,395 775 1,973 2,604
- ------------------------------------------------------------------------------------------------------------------------------
Total non-performing assets $2,932 $4,260 $ 5,535 $ 6,599 $8,221
- ------------------------------------------------------------------------------------------------------------------------------
Total as a percent of total assets .96% 1.52% 2.01% 2.46% 3.20%
19
QNB Corp. and Subsidiary
- --------------------------------------------------------------------------------------------------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS
ALLOWANCE FOR LOAN LOSS ALLOCATION
- --------------------------------------------------------------------------------------------------------------------------------
December 31, 1997 1996 1995 1994 1993
- --------------------------------------------------------------------------------------------------------------------------------
Percent Percent Percent Percent Percent
Gross Gross Gross Gross Gross
Amount Loans Amount Loans Amount Loans Amount Loans Amount Loans
- --------------------------------------------------------------------------------------------------------------------------------
Balance at end of period applicable to:
Commercial and industrial $ 205 19.5% $ 115 14.4% $ 792 17.3% $ 749 15.9% $ 936 13.3%
Agricultural 13 1.7 13 1.8 13 1.6 12 1.8 11 .9
Construction 3 .5 34 2.3 43 4.2 56 3.4 53 3.9
Real estate-commercial 354 34.9 643 36.1 363 32.9 535 35.0 436 36.9
Real estate-residential 215 40.2 378 41.4 547 39.2 289 37.3 273 38.6
Consumer 37 3.2 39 4.0 44 4.8 36 6.6 97 6.4
Unallocated 1,843 1,363 582 347 415
- --------------------------------------------------------------------------------------------------------------------------------
Total $2,670 100.0% $2,585 100.0% $2,384 100.0% $2,024 100.0% $2,221 100.0%
- --------------------------------------------------------------------------------------------------------------------------------
Gross loans represent loans before unamortized net loan fees. Percentage
gross loans lists the percentage of each loan type to total loans.
ALLOWANCE FOR LOAN LOSSES
- -----------------------------------------------------------------------------------------------------------------------------
1997 1996 1995 1994 1993
- -----------------------------------------------------------------------------------------------------------------------------
Allowance for loan losses:
Balance, January 1 $ 2,585 $ 2,384 $ 2,024 $ 2,221 $ 2,928
Charge-offs
Commercial and industrial 16 44 4 567 1,038
Construction 10 - - - -
Real estate-commercial 99 115 320 222 115
Real estate-residential 189 52 325 62 82
Consumer 30 48 54 38 66
- -----------------------------------------------------------------------------------------------------------------------------
Total charge-offs 344 259 703 889 1,301
Recoveries
Commercial and industrial 7 35 12 55 106
Construction 1 - - - -
Real estate-commercial - - 10 11 -
Real estate-residential 9 8 4 3 3
Consumer 12 17 27 23 15
- -----------------------------------------------------------------------------------------------------------------------------
Total recoveries 29 60 53 92 124
- -----------------------------------------------------------------------------------------------------------------------------
Net charge-offs (315) (199) (650) (797) (1,177)
Provision for loan losses 400 400 1,010 600 470
- -----------------------------------------------------------------------------------------------------------------------------
Balance, December 31 $ 2,670 $ 2,585 $ 2,384 $ 2,024 $ 2,221
- -----------------------------------------------------------------------------------------------------------------------------
Total loans:
Average $161,096 $155,175 $151,839 $151,726 $151,076
Year-end 167,720 159,278 155,957 153,993 152,764
Ratios:
Net charge-offs to:
Average loans .20% .13% .43% .53% .78%
Loans at year-end .19 .12 .42 .52 .77
Allowance for loan losses 11.80 7.70 27.27 39.38 52.99
Provision for loan losses 78.75 49.75 64.36 132.83 250.43
Allowance for loan losses to:
Average loans 1.66% 1.67% 1.57% 1.33% 1.47%
Loans at year-end 1.59 1.62 1.53 1.31 1.45
Non-performing loans 195.20 90.20 50.10 43.80 39.50
20
QNB Corp. and Subsidiary
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MANAGEMENT'S DISCUSSION AND ANALYSIS
LOANS (CONTINUED)
Management's primary focus during recent years has been asset quality and the
reduction of non-performing assets. While one of QNB's goals in 1998 is to
continue to reduce the amount of non-performing assets, its primary focus will
be loan and deposit growth. This will be accomplished through an aggressive
business development and calling program encompassing lending personnel, branch
personnel and executive management. The focus of this program is to both develop
new lending and deposit relationships as well as to strengthen existing
relationships.
NON-PERFORMING ASSETS
Non-performing assets are defined as accruing loans past due 90 days or more,
non-accruing loans, restructured loans and other real estate owned. QNB
continues to make significant progress in reducing its level of non-performing
assets. The table on page 19 shows the dramatic improvement in non-performing
assets over the past five years. QNB achieved its goal in 1997 to reduce total
non-performing assets to less than 1.00 percent of total assets. Total
non-performing assets were $2,932,000 at December 31, 1997, or .96 percent of
total assets. This represents a reduction of 31.2 percent from the December 31,
1996 balance of $4,260,000. Non-performing assets at December 31, 1996
represented 1.52 percent of total assets. It is management's goal to continue to
reduce the level of non-performing assets in 1998 through the sale of other real
estate owned.
Non-accrual loans are those on which the accrual of interest has ceased.
Commercial loans are placed on non-accrual status immediately if, in the opinion
of management, collection is doubtful, or when principal or interest is past due
90 days or more and collateral is insufficient to protect principal and
interest. Interest accrued, but not collected at the date a loan is placed on
non-accrual status, is reversed and charged against interest income. Subsequent
cash receipts are applied either to the outstanding principal or recorded as
interest income, depending on management's assessment of ultimate collectibility
of principal and interest. Loans are returned to an accrual status when the
borrower's ability to make periodic principal and interest payments has returned
to normal (i.e. - brought current with respect to principal or interest, or
restructured) and the paying capacity of the borrower and/or the underlying
collateral is deemed sufficient to protect principal and interest. Consumer
loans, including residential mortgage loans, are not automatically placed on
non-accrual status when principal or interest payments are 90 days past due, but
in most instances, consumer loans are charged-off when deemed uncollectible or
after reaching 120 days past due.
Included in the loan portfolio are loans on non-accrual status of $1,209,000 and
$2,700,000 at December 31, 1997 and 1996. The significant decline in non-accrual
loans is a result of several factors including the payment of loans by
borrowers, the foreclosure and movement to other real estate owned or through
charge-off. These activities were performed with minimal loss to QNB. If
interest had been accrued throughout the period, interest income for the years
ended December 31, 1997, 1996 and 1995 would have increased approximately
$154,000, $265,000 and $320,000, respectively. The amount of interest income on
these loans included in net income in 1997, 1996 and 1995 was $7,000, $50,000
and $220,000, respectively. There were no restructured loans as of December 31,
1997 or 1996, as defined in Statement of Financial Accounting Standards No. 15,
"Accounting by Debtors and Creditors for Troubled Debt Restructurings," that
have not already been included in loans past due 90 days or more or non-accrual
loans.
Other real estate owned totaled $1,564,000 at December 31, 1997 and $1,395,000
at December 31, 1996. This real estate is recorded at the fair value of the
property less estimated costs to sell. $735,000 of the balance at December 31,
1997 is under agreement of sale and is expected to settle in the first quarter
of 1998.
Loans not included in past due, non-accrual or restructured categories, but
where known information about possible credit problems causes management to be
uncertain as to the ability of the borrowers to comply with the present loan
repayment terms totaled $2,022,000 and $1,721,000 at December 31, 1997 and 1996,
respectively.
ALLOWANCE FOR LOAN LOSSES
The determination of an appropriate level of the allowance for loan losses is
based upon an analysis of the risk inherent in QNB's loan portfolio. Management
uses various tools to assess the adequacy of the allowance for loan losses. One
tool is a model recommended by the Office of the Comptroller of the Currency.
This model considers a number of relevant factors including: historical loan
loss experience, the assigned risk rating of the credit, current and projected
credit worthiness of the borrower, current value of the underlying collateral,
levels of and trends in delinquencies and non-accrual loans, trends in volume
and terms of loans, concentrations of credit, and national and local economic
trends and conditions. Other tools include ratio analysis and peer group
analysis.
QNB utilizes a risk weighting system that assigns a risk code to every
commercial loan. This risk weighting system is supplemented with a program that
encourages account officers to identify potentially deteriorating loan
situations. The officer analysis program is used to complement the on-going
analysis of the loan portfolio performed by the loan review officer. In
addition, QNB has a committee that meets quarterly to review the adequacy of the
allowance for loan losses based on the current and projected status of all
relevant factors pertaining to the loan portfolio. In addition, regulatory
authorities, as an integral part of their examinations, periodically review the
allowance for loan losses. They may require additions to the allowance based
upon their judgements about information available to them at the time of
examination.
A loan is considered impaired, based on current information and events, if it is
probable that QNB will be unable to collect the scheduled payments of principal
or interest when due according to the contractual terms of the loan agreement.
The measurement of impaired loans is generally based on the present value of
expected future cash flows discounted at the effective interest rate, except
that all collateral-dependent loans are measured for impairment based on the
fair value of the collateral.
At December 31, 1997 and 1996, the recorded investment in loans for which
impairment has been recognized totaled $1,123,000 and $2,604,000, respectively.
The entire balance of loans defined as impaired as of December 31, 1997 required
no valuation allowance while $1,288,000 of the loans identified as of December
31, 1996 required no valuation allowance. As of December 31, 1996 $1,316,000 of
loans required a valuation allowance of approximately $408,000. Most of the
loans identified as impaired are collateral-dependent. For the years ended
December 31, 1997, 1996 and 1995, the average recorded investment in impaired
loans was approximately
21
QNB Corp. and Subsidiary
- --------------------------------------------------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS
ALLOWANCE FOR LOAN LOSSES (CONTINUED)
$2,105,000, $4,288,000 and $3,676,000, respectively. QNB recognized $86,000,
$50,000 and $220,000 of interest income on these loans in 1997, 1996 and 1995,
respectively.
Net charge-offs were $315,000 in 1997 compared with $199,000 in 1996 and
$650,000 in 1995. This level of charge-offs represents .20 percent of average
loans in 1997, compared with .13 percent and .43 percent in 1996 and 1995,
respectively. The increase in the level of charge-offs in 1997 relates to the
charge-off and write-down on transfer of loans to other real estate owned of two
groups of investment property loans to two different borrowers. These loans
account for $204,000 of the charge-offs in 1997. The improvement in the net
charge-off level between 1996 and 1995 reflects QNB's loan recovery efforts and
the continued improvement in overall asset quality.
The allowance for loan losses was $2,670,000 at December 31, 1997, which
represents 1.59 percent of total loans, compared to $2,585,000 and 1.62 percent
of total loans at December 31, 1996. While the allowance is allocated to
specific loans or loan categories, the total allowance is considered available
for losses in the entire loan portfolio. While QNB believes that its allowance
is adequate to cover losses in the loan portfolio, there remain inherent
uncertainties regarding future economic events and their potential impact on
asset quality.
DEPOSITS
QNB primarily attracts deposits from within its market area by offering various
deposit products, including demand deposits, NOW accounts, money market
accounts, savings accounts and certificates of deposit.
Total deposits increased 8.3 percent to $267,166,000 at December 31, 1997, from
$246,744,000 at year-end 1996. The purchase of approximately $6,800,000 in
deposits from First Lehigh Bank contributed to this increase. An analysis of the
change in average deposits provides a more meaningful measure of deposit change.
Average total deposits increased 4.7 percent in 1997 and 1.1 percent in 1996.
Average non-interest-bearing deposits increased 7.7 percent to $30,225,000 in
1997. This followed a 6.3 percent increase in 1996. Non-interest-bearing
deposits are an important source of funds for QNB because they are low cost.
Average NOW accounts increased 3.4 percent in 1997 to $40,262,000 and 4.3
percent in 1996 to $38,936,000. The increase in NOW account balances is
primarily the result of obtaining the deposit relationship of a local school
district and the impact of NOW account promotions. Average time deposits
increased 10.2 percent in 1997 and 3.5 percent in 1996, while average money
market accounts decreased 8.5 percent and 10.1 percent for the same time
periods. Approximately $4,600,000 of the increase in time deposits was a result
of the purchase of deposits. Also positively impacting time deposit balances was
a promotion introduced during the first quarter of 1997 that enables the holder
of a 30-month certificate of deposit to increase the interest rate twice during
the term of the certificate, should rates offered on the 30-month time deposits
increase. The change in the mix of deposits from money market accounts to time
deposits started in 1994 as rates on time deposits began to increase and
substantially outperform bank money market products. To help retain and attract
money market accounts, QNB, during the third quarter of 1997 changed the rate
structure on these accounts to a tiered structure that pays a higher rate of
interest on higher balances. To continue to attract and retain deposits, QNB
will have to be competitive with respect to rates and will have to continuously
develop new products that appeal to customers.
LIQUIDITY
Liquidity represents an institution's ability to generate cash or otherwise
obtain funds at reasonable rates to satisfy commitments to borrowers and demands
of depositors. QNB manages its mix of cash, Federal funds sold, investment
securities and loans in order to match the volatility, seasonality, interest
sensitivity and growth trends of its deposit funds. Liquidity is provided from
asset sources through maturities and repayments of loans and investment
securities, net interest income and fee income. The portfolio of investment
securities available-for-sale and QNB's policy of selling certain residential
mortgage originations and student loans in the secondary market also provide
sources of liquidity.
Cash and due from banks, Federal funds sold, available-for-sale securities and
loans held-for-sale totaled $91,915,000 at December 31, 1997 and $72,730,000 at
December 31, 1996. These sources were adequate to meet seasonal deposit
withdrawals during 1997 and should be adequate to meet normal fluctuations in
loan demand and deposit withdrawals. The Bank is currently in the process of
applying for membership in the Federal Home Loan Bank. This would provide QNB
with an additional source of liquidity through the ability to borrow both
short-term and longer term funds from the Federal Home Loan Bank.
The consolidated statements of cash flows present the changes in cash and cash
equivalents from operating, investing and financing activities. QNB's cash and
cash equivalents increased $115,000 to $12,574,000 at December 31, 1997. This
follows a decrease in 1996 of $491,000 and an increase in 1995 of $1,523,000.
After adjusting net income for non-cash transactions, operating activities
provided $3,034,000 in cash flow in 1997, compared to $3,453,000 in 1996 and
$3,307,000 in 1995. An increase in interest receivable and an increase in other
assets, primarily the deposit premium, account for the decline in cash provided
by operating activities in 1997.
Net cash used by investing activities of $24,171,000 in 1997 was primarily a
result of the purchase of investment securities exceeding the maturity, call or
sale of securities, and loan growth. Purchases of investment securities totaled
over $51,000,000 while proceeds from securities were only $31,595,000. Net loan
outstandings increased by over $8,000,000. A decrease in Federal funds sold of
$4,458,000 funded some of this activity in 1997. Net cash used by investing
activities of $5,595,000 in 1996 was primarily a result of loan growth and an
increase in Federal funds sold. Net activity in the investment portfolio
provided $2,305,000, while the sale of loans and other real estate owned
provided cash of $5,096,000 and $1,072,000, respectively. Net cash used by
investing activities of $5,657,000 in 1995 resulted largely from the growth in
the investment portfolio and the slight increase in loans outstanding. Net usage
from purchases, sales, maturities and calls of investment securities was
$9,471,000. Investing activities which provided cash during 1995 were the sale
of student loans, residential mortgage loans and other real estate owned which
provided cash of $2,626,000, $2,638,000 and $1,320,000, respectively. A
$5,493,000 decrease in Federal funds sold also provided cash in 1995.
Cash provided by financing activities of $21,252,000 in 1997 was a result of
strong deposit growth. Non-interest-bearing deposits increased $6,659,000 while
interest-bearing deposits increased $13,763,000. Increased marketing and
business development activities along with competitive rates and products
contributed to the growth in deposits. The purchase of $6,800,000 in deposits
also contributed to the increase in financing activities. A 14.3 percent
increase in the
22
QNB Corp. and Subsidiary
- --------------------------------------------------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS
AVERAGE DEPOSITS BY MAJOR CLASSIFICATION
- ------------------------------------------------------------------------------------------------------------------------
1997 1996 1995
- ------------------------------------------------------------------------------------------------------------------------
Balance Rate Balance Rate Balance Rate
- ------------------------------------------------------------------------------------------------------------------------
Non-interest-bearing deposits $ 30,225 - $ 28,072 - $ 26,416 -
NOW accounts 40,262 1.75% 38,936 1.81% 37,335 2.20%
Money market accounts 33,218 2.86 36,301 2.78 40,392 2.77
Savings 35,215 2.17 34,932 2.20 35,044 2.27
Time 97,944 5.48 89,208 5.36 84,340 5.19
Time deposits of $100,000 or more 16,502 5.86 14,633 5.88 15,986 6.04
- ------------------------------------------------------------------------------------------------------------------------
Total $253,366 3.46% $242,082 3.36% $239,513 3.37%
- ------------------------------------------------------------------------------------------------------------------------
MATURITY OF TIME DEPOSITS OF $100,000 OR MORE
- ------------------------------------------------------------------------------------------------------------------------
Year Ended December 31, 1997 1996 1995
- ------------------------------------------------------------------------------------------------------------------------
Three months or less $ 3,189 $ 3,083 $ 2,815
Over three months through six months 3,396 3,615 4,508
Over six months through twelve months 4,665 1,797 2,062
Over twelve months 4,452 5,638 5,067
- ------------------------------------------------------------------------------------------------------------------------
Total $15,702 $14,133 $14,452
- ------------------------------------------------------------------------------------------------------------------------
cash dividend from $.56 to $.64 per share decreased the cash provided by
financing activities. Cash provided by financing activities of $1,651,000 in
1996 was a result of growth in time deposits of $8,177,000. This offset
withdrawals of money market accounts of $5,006,000, a decrease in short-term
borrowings of $1,424,000 and the payment of $797,000 in common stock dividends.
Growth in non-interest-bearing deposits and short-term borrowings of $3,692,000
and $2,562,000 was primarily responsible for the cash provided from financing
activities of $3,873,000 in 1995. A decline in interest-bearing deposits,
primarily money market accounts and savings accounts, and the payment of
dividends were financing activities which used cash in 1995.
CAPITAL ADEQUACY
A strong capital position is fundamental to support continued growth and
profitability, to serve the needs of depositors, and to yield an attractive
return for shareholders. QNB's shareholders' equity at December 31, 1997 was
$25,832,000 or 8.45 percent of total assets, compared to shareholders' equity of
$22,775,000 or 8.12 percent at December 31, 1996. At December 31, 1997,
shareholders' equity included a positive adjustment of $873,000 related to the
unrealized holding gains, net of taxes, on investment securities
available-for-sale, while shareholders' equity at December 31, 1996 included a
positive adjustment of $112,000. Without these adjustments shareholders' equity
to total assets would have been 8.16 percent and 8.08 percent at December 31,
1997 and 1996, respectively.
CAPITAL ANALYSIS
- --------------------------------------------------------------------------------
December 31, 1997 1996
- --------------------------------------------------------------------------------
Tier I
Shareholders' equity $ 25,832 $ 22,775
Net unrealized securities gains (873) (112)
Intangible assets (505) -
- --------------------------------------------------------------------------------
Total Tier I risk-based capital 24,454 22,663
Tier II
Allowable portion of the allowance
for loan losses 2,271 2,160
- --------------------------------------------------------------------------------
Total risk-based capital $ 26,725 $ 24,823
- --------------------------------------------------------------------------------
Risk-weighted assets $181,249 $172,348
- --------------------------------------------------------------------------------
Capital Ratios
- --------------------------------------------------------------------------------
December 31, 1997 1996
- --------------------------------------------------------------------------------
Tier I capital/risk-weighted assets 13.49% 13.15%
Total risk-based capital/risk-weighted assets 14.74 14.40
Tier I capital/average assets (leverage ratio) 8.23 8.14
Shareholders' equity averaged $23,886,000 during 1997, an increase of 10.36
percent compared to 1996. The ratio of average total equity to average total
assets improved to 8.27 percent for 1997, compared to 7.89 percent for 1996. The
increase in the equity to asset ratio is a function of significantly higher net
income, an increase in capital retention despite a 14.3 percent increase in the
cash dividend, and modest growth in average assets.
23
QNB Corp. and Subsidiary
- --------------------------------------------------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS
CAPITAL ADEQUACY (CONTINUED)
The Corporation is subject to restrictions on the payment of dividends to its
stockholders pursuant to the Pennsylvania Business Corporation Law as amended
(the "BCL"). The BCL operates generally to preclude dividend payments if the
effect thereof would render the Corporation insolvent, as defined. As a
practical matter, the Corporation's payment of dividends is contingent upon its
ability to obtain funding in the form of dividends from the Bank. Payment of
dividends to the Corporation by the Bank is subject to the restrictions set
forth in the National Bank Act. Generally, the National Bank Act would permit
the Bank to declare dividends in 1998 of approximately $3,108,000, plus an
amount equal to the net profits of the Bank in 1998 up to the date of any such
dividend declaration.
[GRAPHIC OMITTED]
QNB is subject to various regulatory capital requirements as issued by Federal
regulatory authorities. Regulatory capital is defined in terms of Tier I capital
(shareholders' equity excluding unrealized gains or losses on available-for-sale
securities and intangible assets), Tier II capital which includes a portion of
the allowance for loan losses, and total capital (Tier I plus Tier II).
Risk-based capital ratios are expressed as a percentage of risk-weighted assets.
Risk-weighted assets are determined by assigning various weights to all assets
and off-balance sheet arrangements, such as letters of credit and loan
commitments, based on associated risk. Regulators have also adopted minimum Tier
I leverage ratio standards, which measure the ratio of Tier I capital to total
assets. The minimum regulatory capital ratios are 4.00 percent for Tier I, 8.00
percent for total risk-based capital and 4.00 percent for leverage. Under the
requirements, QNB has a Tier I capital ratio of 13.49 percent and 13.15 percent,
a total risk-based ratio of 14.74 percent and 14.40 percent and a leverage ratio
of 8.23 percent and 8.14 percent at December 31, 1997 and 1996, respectively.
The Federal Deposit Insurance Corporation Improvement Act of 1991 established
five capital level designations ranging from "well capitalized" to "critically
undercapitalized." At December 31, 1997 and 1996 QNB met the "well capitalized"
criteria which requires minimum Tier I and total risk-based capital ratios of
6.00 percent and 10.00 percent, respectively, and a Tier I leverage ratio of
5.00 percent.
INTEREST RATE SENSITIVITY
Since the assets and liabilities of QNB have diverse repricing characteristics
that influence net interest income, management analyzes interest sensitivity
through the use of gap analysis and simulation models. Interest rate sensitivity
management seeks to minimize the effect of interest rate changes on net interest
margins and interest rate spreads, and to provide growth in net interest income
through periods of changing interest rates. The Asset/Liability Management
Committee (ALCO) is responsible for managing interest rate risk and for
evaluating the impact of changing interest rate conditions on net interest
income.
Gap analysis measures the difference between volumes of rate-sensitive assets
and liabilities and quantifies these repricing differences for various time
intervals. Static gap analysis describes interest rate sensitivity at a point in
time. However, it alone does not accurately measure the magnitude of changes in
net interest income since changes in interest rates do not impact all categories
of assets and liabilities equally or simultaneously. Interest rate sensitivity
analysis also involves assumptions on certain categories of assets and deposits.
For purposes of interest rate sensitivity analysis, assets and liabilities are
stated at their contractual maturity, estimated likely call date, or earliest
repricing opportunity. Mortgage-backed securities and amortizing loans are
scheduled based on their anticipated cash flow. Savings accounts, including
passbook, statement savings, money market, and NOW accounts, do not have a
stated maturity or repricing term and can be withdrawn or repriced at any time.
This may impact QNB's margin if more expensive alternative sources of deposits
are required to fund loans or deposit runoff. Management projects the repricing
characteristics of these accounts based on historical performance and
assumptions that it believes reflect their rate sensitivity. A positive gap
results when the amount of interest rate sensitive assets exceeds interest rate
sensitive liabilities. A negative gap results when the amount of interest rate
sensitive liabilities exceeds interest rate sensitive assets.
QNB primarily focuses on the management of the one-year interest rate
sensitivity gap. At December 31, 1997, interest-earning assets scheduled to
mature or likely to be called, repriced or repaid in one year were $111,723,000.
Interest sensitive liabilities scheduled to mature or reprice within one year
were $108,353,000. The one year cumulative gap, which reflects QNB's interest
sensitivity over a period of time, was a positive $3,370,000 at December 31,
1997. The cumulative one-year gap equals 1.18 percent of total earning assets.
This positive or asset sensitive gap will generally benefit QNB in a rising
interest rate environment, while falling interest rates could negatively impact
QNB.
During 1995, QNB began using a simulation model to assess the impact of changes
in interest rates on net interest income. The model reflects management's
assumptions related to asset yields and rates paid on liabilities, deposit
sensitivity, and the size, composition and maturity or repricing characteristics
of the balance sheet. The assumptions are based on what management believes at
that time to be the most likely interest rate environment. Management also
evaluates the impact of higher and lower interest rates.
Actual results may differ from simulated results due to various factors
including time, magnitude and frequency of interest rate changes, the
relationship or spread between various rates, loan pricing and deposit
sensitivity, and asset/liability strategies. Based on management's estimate of
balance sheet growth and composition and interest rates for the next year, net
interest income in 1998 is expected to increase
24
QNB Corp. and Subsidiary
- -------------------------------------------------------------------------------------------------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS
INTEREST RATE SENSITIVITY
- -------------------------------------------------------------------------------------------------------------------------------
Within 4 to 6 7 months 1 to 3 3 to 5 After
December 31, 1997 3 months months to 1 year years years 5 years Total
- -------------------------------------------------------------------------------------------------------------------------------
Assets
Interest-bearing balances $ 129 - - - - - $ 129
Federal funds sold 2,022 - - - - - 2,022
Investment securities 17,582 $ 4,373 $ 15,256 $ 54,186 $ 13,667 $ 11,256 116,320
Loans 42,129 12,813 17,419 51,073 23,337 20,949 167,720
- -------------------------------------------------------------------------------------------------------------------------------
Total rate sensitive assets 61,862 17,186 32,675 105,259 37,004 32,205 $286,191
Total cumulative assets $61,862 $79,048 $111,723 $216,982 $253,986 $286,191
- -------------------------------------------------------------------------------------------------------------------------------
Liabilities
NOW, money market and savings deposits $ 7,836 $ 2,271 $ 12,062 $ 60,675 $ 14,805 $ 13,676 $111,325
Time deposits less than $100,000 19,503 12,185 32,904 32,806 4,026 23 101,447
Time deposits over $100,000 3,189 3,396 4,665 4,323 129 - 15,702
Short-term borrowings 10,342 - - - - - 10.342
- -------------------------------------------------------------------------------------------------------------------------------
Total rate sensitive liabilities 40,870 17,852 49,631 97,804 18,960 13,699 $238,816
Total cumulative liabilities $40,870 $58,722 $108,353 $206,157 $225,117 $238,816
- -------------------------------------------------------------------------------------------------------------------------------
Gap during period $20,992 $ (666) $(16,956) $ 7,455 $ 18,044 $ 18,506 $ 47,375
- -------------------------------------------------------------------------------------------------------------------------------
Cumulative gap $20,992 $20,326 $ 3,370 $ 10,825 $ 28,869 $ 47,375
- -------------------------------------------------------------------------------------------------------------------------------
Cumulative gap/earning assets 7.33% 7.10% 1.18% 3.78% 10.09% 16.55%
- -------------------------------------------------------------------------------------------------------------------------------
Cumulative gap ratio 1.51 1.35 1.03 1.05 1.13 1.20
- -------------------------------------------------------------------------------------------------------------------------------
compared with 1997 net interest income. The projected increase in net interest
income is primarily the result of forecasted growth in total assets and a change
in the composition of earning assets, with the loan to earning assets ratio
increasing. These factors will be partially offset by a slight decrease in the
net interest margin.
If interest rates are 100 basis points lower than management's most likely
interest rate environment, the simulation model projects net interest income for
the next twelve months to slightly exceed the most likely scenario. Conversely,
if interest rates were 100 basis points higher, net interest income for the most
likely scenario would decline slightly. These results are inconsistent with the
results of the gap analysis described above. The inconsistency results from the
fact that gap analysis looks at a point in time and does not consider that
assets and liabilities react differently to changing rates with respect to
prepayments and calls. Gap analysis also does not consider that interest rates
on assets and liabilities do not change by the same magnitude when interest
rates change. Simulation analysis considers these factors as well as other
detailed assumptions.
Management believes that the assumptions utilized in evaluating the
vulnerability of QNB's net interest income to changes in interest rates
approximate actual experience; however, the interest rate sensitivity of QNB's
assets and liabilities as well as the estimated effect of changes in interest
rates on net interest income could vary substantially if different assumptions
are used or actual experience differs from the experience on which the
assumptions were based.
In the event QNB should experience a mismatch in its desired gap ranges or an
excessive decline in its net interest income subsequent to an immediate and
sustained change in interest rate, it has a number of options which it could
utilize to remedy such a mismatch. QNB could restructure its investment
portfolio through sale or purchase of securities with more favorable repricing
attributes. It could also emphasize loan products with appropriate maturities or
repricing attributes, or it could attract deposits or obtain borrowings with
desired maturities.
The nature of QNB's current operation is such that it is not subject to foreign
currency exchange or commodity price risk. Additionally, neither the Corporation
nor the Bank owns trading assets. At December 31, 1997, QNB did not have any
hedging transactions in place such as interest rate swaps, caps or floors.
The table below summarizes estimated changes in net interest income over a
twelve month period, under alternative interest rate scenarios.
- --------------------------------------------------------------------------------
Change in Interest Rates Net Interest Income Dollar Change Percent Change
- --------------------------------------------------------------------------------
+300 Basis Points $11,692 $(927) (7.35)%
+200 Basis Points 12,023 (596) (4.72)
+100 Basis Points 12,351 (268) (2.12)
FLAT RATE 12,619 - -
- -100 Basis Points 12,757 138 1.10
- -200 Basis Points 12,810 191 1.51
- -300 Basis Points 12,658 39 .31
25
QNB Corp. and Subsidiary
- --------------------------------------------------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS
IMPACT OF YEAR 2000
QNB is currently in the process of addressing the challenge that faces all users
of automated systems, including information systems. Many computer systems
process transactions based on two digits representing the year of transaction,
rather than a full four digits. These computer systems may not operate properly
when the last two digits become "00", as will occur on January 1, 2000. The
problem could affect a wide variety of automated information systems, such as
mainframe applications, personal computers, communication systems, environmental
systems and other information systems.
At the beginning of 1997, QNB developed a five phase plan to address the year
2000 issue. These phases are Awareness, Assessment, Renovation, Validation and
Implementation. The Awareness phase included the establishment of a team of
employees, including executive management, and the development of strategies to
make employees and customers aware of the situation. The Assessment phase
included the identification of areas of operations critical for the delivery of
products and services. This phase also included the inventory of all hardware
and software applications and the identification of customer and vendor
interdependencies. The majority of the programs and applications used by QNB are
purchased from outside vendors. The vendors providing the software are
responsible for maintenance of the systems and modifications to enable
uninterrupted usage after December 31, 1999. These two phases have been
completed.
The Renovation phase includes vendor certification, code enhancement, and
hardware and software upgrades as needed. The vendor of QNB's core operating
system has informed management that changes are approximately 80 percent
complete and that certification of compliance should be received by June, 1998.
The Validation phase includes testing of all of the impacted applications, both
internally developed and third party provided. Testing of the systems has begun
and will continue throughout 1998. Contingency plans, if any are needed, will be
developed during 1998 to address any shortcomings that are identified. The
Implementation phase includes incorporating all changes, achieving certification
of year 2000 compliance and implementing contingency plans, if necessary. QNB's
plan also includes reviewing any potential risks associated with the loan and
investment portfolios due to the year 2000 issue. QNB's goal is to have the plan
complete and be fully compliant by December 31, 1998.
Based on the currently available information, management does not anticipate
that the cost to address year 2000 issues will have an impact on QNB's financial
condition, results of operations, liquidity or capital resources. A significant
portion of the anticipated costs are not expected to be incremental, but rather
will represent the redeployment of existing information technology resources.
OTHER ITEMS
Management is not aware of any current specific recommendations by regulatory
authorities or proposed legislation, which if they were implemented, would have
a material adverse effect upon the liquidity, capital resources, or results of
operations, although the general cost of compliance with numerous and multiple
federal and state laws and regulations does have, and in the future may have, a
negative impact on QNB's results of operations.
CONSOLIDATED QUARTERLY FINANCIAL DATA
- ----------------------------------------------------------------------------------------------------------------------------
Quarters Ending 1997 Quarters Ending 1996
March 31 June 30 Sept. 30 Dec. 31 March 31 June 30 Sept. 30 Dec. 31
- ----------------------------------------------------------------------------------------------------------------------------
Interest income $5,063 $5,252 $5,398 $5,409 $4,840 $4,896 $5,031 $5,049
Interest expense 2,162 2,247 2,301 2,356 2,041 2,014 2,174 2,184
- ----------------------------------------------------------------------------------------------------------------------------
Net interest income 2,901 3,005 3,097 3,053 2,799 2,882 2,857 2,865
Provision for loan losses 100 100 100 100 100 100 100 100
Non-interest income 627 449 482 445 496 380 427 547
Non-interest expense 2,279 2,254 2,238 2,504 2,140 2,200 2,271 2,393
- ----------------------------------------------------------------------------------------------------------------------------
Income before income taxes 1,149 1,100 1,241 894 1,055 962 913 919
Provision for income taxes 328 319 361 245 294 262 245 247
- ----------------------------------------------------------------------------------------------------------------------------
Net Income $ 821 $ 781 $ 880 $ 649 $ 761 $ 700 $ 668 $672
- ----------------------------------------------------------------------------------------------------------------------------
Net Income Per Share - basic $ .58 $ .55 $ .62 $ .45 $ .53 $ .49 $ .47 $ .47
- ---------------------------------------------------------------------------------------------------------------------------
Net Income Per Share - diluted $ .57 $ .54 $ .61 $ .45 $ .53 $ .49 $ .47 $ .47
- ----------------------------------------------------------------------------------------------------------------------------
26
QNB Corp. and Subsidiary
- -----------------------------------------------------------------------------------------------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS
SELECTED FINANCIAL AND OTHER DATA
- -----------------------------------------------------------------------------------------------------------------------------
Year Ended December 31, 1997 1996 1995 1994 1993
- -----------------------------------------------------------------------------------------------------------------------------
Income and Expense
Interest income $ 21,122 $ 19,816 $ 19,716 $ 17,865 $ 17,663
Interest expense 9,066 8,413 8,337 6,459 6,849
- -----------------------------------------------------------------------------------------------------------------------------
Net interest income 12,056 11,403 11,379 11,406 10,814
Provision for loan losses 400 400 1,010 600 470
Non-interest income 1,995 1,850 1,393 1,598 2,484
Non-interest expense 9,267 9,004 9,539 9,719 10,545
- -----------------------------------------------------------------------------------------------------------------------------
Income before income taxes and cumulative
effect of change in accounting principle 4,384 3,849 2,223 2,685 2,283
Provision for income taxes 1,253 1,048 536 681 517
- -----------------------------------------------------------------------------------------------------------------------------
Income before cumulative effect of change
in accounting principle 3,131 2,801 1,687 2,004 1,766
- -----------------------------------------------------------------------------------------------------------------------------
Cumulative effect of change
in tax accounting method - - - - 52
- -----------------------------------------------------------------------------------------------------------------------------
Net income $ 3,131 $ 2,801 $ 1,687 $ 2,004 $ 1,818
- -----------------------------------------------------------------------------------------------------------------------------
Per Share Data
Net income before cumulative effect of
change in accounting principle $ 2.19 $ 1.97 $ 1.19 $ 1.41 $ 1.25
Cumulative effect of change in tax accounting method - - - - .03
Net income - basic 2.19 1.97 1.19 1.41 1.28
Net income - diluted 2.18 1.95 1.18 1.41 1.28
Book value 18.05 15.97 14.66 12.53 13.31
Cash dividends .64 .56 .50 .50 .50
Average common shares outstanding - basic 1,427,981 1,424,112 1,421,378 1,417,395 1,415,828
Average common shares outstanding - diluted 1,433,943 1,433,179 1,426,720 1,419,958 1,417,611
Balance Sheet at Year-end
Loans, net of unearned income $ 167,720 $ 159,278 $ 155,957 $ 153,993 $ 152,764
Investment securities available-for-sale 75,920 52,779 55,380 49,838 54,366
Investment securities held-to-maturity 40,400 42,699 42,515 35,636 27,894
Other earning assets 2,151 6,488 2,915 8,439 5,395
Total assets 305,772 280,447 276,049 268,260 257,062
Deposits 267,166 246,744 242,887 240,896 231,125
Other interest-bearing liabilities 10,342 8,675 10,099 7,537 5,179
Shareholders' equity 25,832 22,775 20,866 17,784 18,859
Selected Financial Ratios
Net interest margin 4.60% 4.58% 4.64% 4.89% 4.79%
Net income as a percentage of:
Average total assets 1.08 1.02 .63 .77 .73
Average shareholders' equity 13.11 12.94 8.46 10.56 10.06
Average shareholders' equity to average total assets 8.27 7.89 7.39 7.32 7.22
Dividend payout ratio 29.22 28.47 42.13 35.36 38.95
27
QNB Corp. and Subsidiary
- -----------------------------------------------------------------------------------------------------------
CONSOLIDATED BALANCE SHEETS
(in thousands)
- -----------------------------------------------------------------------------------------------------------
December 31, 1997 1996
- -----------------------------------------------------------------------------------------------------------
Assets
Cash and due from banks $ 12,574 $ 12,459
Federal funds sold 2,022 6,480
Investment securities
available-for-sale 75,920 52,779
held-to-maturity (market value $40,713 and $42,760) 40,400 42,699
Total loans, net of unearned income of $448 and $432 167,720 159,278
Allowance for loan losses (2,670) (2,585)
- -----------------------------------------------------------------------------------------------------------
Net loans 165,050 156,693
Premises and equipment, net 4,066 4,358
Other real estate owned 1,564 1,395
Accrued interest receivable 2,007 1,689
Other assets 2,169 1,895
- -----------------------------------------------------------------------------------------------------------
Total assets $305,772 $280,447
- -----------------------------------------------------------------------------------------------------------
Liabilities
Deposits
Demand, non-interest-bearing $ 38,692 $ 32,033
NOW accounts 42,176 39,566
Money market accounts 32,520 31,847
Savings 36,629 34,287
Time 101,447 94,878
Time over $100,000 15,702 14,133
- -----------------------------------------------------------------------------------------------------------
Total deposits 267,166 246,744
Short-term borrowings 10,342 8,675
Accrued interest payable 1,057 1,012
Other liabilities 1,375 1,241
- -----------------------------------------------------------------------------------------------------------
Total liabilities 279,940 257,672
- -----------------------------------------------------------------------------------------------------------
Commitments and contingencies
Shareholders' Equity
Common stock, par value $1.25 per share;
authorized 5,000,000 shares; issued 1,431,240 shares and 1,425,951 shares 1,789 1,782
Surplus 4,369 4,296
Retained earnings 18,801 16,585
Unrealized holding gains, net of taxes,
on investment securities available-for-sale 873 112
- -----------------------------------------------------------------------------------------------------------
Total shareholders' equity 25,832 22,775
- -----------------------------------------------------------------------------------------------------------
Total liabilities and shareholders' equity $305,772 $280,447
- -----------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial
statements.
28
QNB Corp. and Subsidiary
- -----------------------------------------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except share data)
- -----------------------------------------------------------------------------------------------------------------
Year Ended December 31, 1997 1996 1995
- -----------------------------------------------------------------------------------------------------------------
Interest Income
Interest and fees on loans $14,141 $13,470 $13,492
Interest and dividends on investment securities:
Taxable 6,229 5,585 5,493
Tax-exempt 532 509 400
Interest on Federal funds sold 220 252 331
- -----------------------------------------------------------------------------------------------------------------
Total interest income 21,122 19,816 19,716
- -----------------------------------------------------------------------------------------------------------------
Interest Expense
Interest on deposits
NOW accounts 706 707 820
Money market accounts 951 1,011 1,119
Savings 765 772 795
Time 5,365 4,799 4,380
Time over $100,000 968 863 966
Interest on short-term borrowings 311 261 257
- -----------------------------------------------------------------------------------------------------------------
Total interest expense 9,066 8,413 8,337
- -----------------------------------------------------------------------------------------------------------------
Net interest income 12,056 11,403 11,379
Provision for loan losses 400 400 1,010
- -----------------------------------------------------------------------------------------------------------------
Net interest income after provision for loan losses 11,656 11,003 10,369
- -----------------------------------------------------------------------------------------------------------------
Non-Interest Income
Fees for services to customers 1,076 1,095 927
Mortgage servicing fees 181 208 229
Net gain (loss) on investment securities available-for-sale 134 102 (79)
Net gain on sale of loans 81 89 108
Other operating income 523 356 208
- -----------------------------------------------------------------------------------------------------------------
Total non-interest income 1,995 1,850 1,393
- -----------------------------------------------------------------------------------------------------------------
Non-Interest Expense
Salaries and employee benefits 5,411 5,185 5,369
Net occupancy expense 666 687 675
Furniture and equipment expense 697 697 721
Marketing expense 303 287 247
Supplies expense 180 209 222
Professional fees 180 160 263
Insurance expense 104 104 404
Other real estate owned expense 273 253 356
Other expense 1,453 1,422 1,282
- -----------------------------------------------------------------------------------------------------------------
Total non-interest expense 9,267 9,004 9,539
- -----------------------------------------------------------------------------------------------------------------
Income before income taxes 4,384 3,849 2,223
Provision for income taxes 1,253 1,048 536
- -----------------------------------------------------------------------------------------------------------------
Net Income $ 3,131 $ 2,801 $ 1,687
- -----------------------------------------------------------------------------------------------------------------
Net Income Per Share - Basic $2.19 $1.97 $1.19
- -----------------------------------------------------------------------------------------------------------------
Net Income Per Share - Diluted $2.18 $1.95 $1.18
- -----------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial
statements.
29
QNB Corp. and Subsidiary
- --------------------------------------------------------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
- --------------------------------------------------------------------------------------------------------------------------------
Unrealized
Number Common Retained Holding
(in thousands, except share data) of Shares Stock Surplus Earnings Gain (Loss) Total
- --------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1994 1,419,700 $1,774 $4,258 $13,605 $(1,853) $17,784
Net income - - - 1,687 - 1,687
Cash dividends paid
($.50 per share) - - - (711) - (711)
Stock issue - 401(k) plan 462 1 10 - - 11
Stock issued for options exercised 3,676 5 15 - - 20
Change in net unrealized holding
gains (losses), net of taxes,
on investment securities available-for-sale - - - - 2,075 2,075
- --------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1995 1,423,838 1,780 4,283 14,581 222 20,866
- --------------------------------------------------------------------------------------------------------------------------------
Net income - - - 2,801 - 2,801
Cash dividends paid
($.56 per share) - - - (797) - (797)
Stock issue - 401(k) plan 435 - 14 - - 14
Stock issued for options exercised 1,678 2 (1) - - 1
Change in net unrealized holding
gains (losses), net of taxes,
on investment securities available-for-sale - - - - (110) (110)
- --------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1996 1,425,951 1,782 4,296 16,585 112 22,775
- --------------------------------------------------------------------------------------------------------------------------------
Net income - - - 3,131 - 3,131
Cash dividends paid
($.64 per share) - - - (915) - (915)
Stock issued - 401(k) plan 311 - 9 - - 9
Stock issued - Employee stock purchase plan 1,154 2 34 - - 36
Stock issued for options exercised 3,824 5 30 - - 35
Change in net unrealized holding
gains (losses), net of taxes,
on investment securities available-for-sale - - - - 761 761
- --------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1997 1,431,240 $1,789 $4,369 $18,801 $ 873 $25,832
- --------------------------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial
statements.
30
QNB Corp. and Subsidiary
- ---------------------------------------------------------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
- ------------------------------------------------------------------------------------------------------------------------------
Year Ended December 31, 1997 1996 1995
- ------------------------------------------------------------------------------------------------------------------------------
Operating Activities
Net income $ 3,131 $ 2,801 $ 1,687
Adjustments to reconcile net income to net cash provided by operating activities
Provision for loan losses 400 400 1,010
Depreciation and amortization 491 521 602
Securities (gains) losses (134) (102) 79
Net gain on sale of loans (81) (89) (108)
Loss (gain) on disposal of premises and equipment 1 - (10)
Writedowns, net of losses (gains) on sales of other real estate owned 25 (67) 149
Deferred income tax provision (24) (69) 21
Change in income taxes payable (10) (183) 146
Net (increase) decrease in accrued interest and dividends receivable (318) 254 (261)
Net amortization of premiums and discounts 4 48 115
Net increase (decrease) in accrued interest payable 45 (28) (42)
Increase in other assets (630) (196) (198)
Increase in other liabilities 134 163 117
- ------------------------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 3,034 3,453 3,307
- ------------------------------------------------------------------------------------------------------------------------------
Investing Activities
Proceeds from maturities and calls of investment securities
available-for-sale 11,506 16,170 13,026
held-to-maturity 6,170 7,531 2,928
Proceeds from sales of investment securities
available-for-sale 13,919 18,526 8,888
Purchase of investment securities
available-for-sale (47,310) (32,233) (24,501)
held-to-maturity (3,844) (7,689) (9,812)
Net decrease (increase) in Federal funds sold 4,458 (3,573) 5,493
Proceeds from sales of student loans 1,499 1,527 2,626
Proceeds from sales of residential mortgages 2,539 3,569 2,638
Originations of residential mortgages held-for-sale (1,052) (3,069) (3,859)
Net increase in loans (12,284) (7,083) (4,182)
Net purchases of premises and equipment (200) (343) (222)
Proceeds from the sale of other real estate owned 428 1,072 1,320
- ------------------------------------------------------------------------------------------------------------------------------
Net cash used by investing activities (24,171) (5,595) (5,657)
- ------------------------------------------------------------------------------------------------------------------------------
Financing Activities
Net increase in non-interest-bearing deposits 6,659 151 3,692
Net increase (decrease) in interest-bearing deposits 13,763 3,706 (1,701)
Net increase (decrease) in short-term borrowings 1,667 (1,424) 2,562
Cash dividends paid (915) (797) (711)
Proceeds from issuance of common stock 78 15 31
- ------------------------------------------------------------------------------------------------------------------------------
Net cash provided by financing activities 21,252 1,651 3,873
- ------------------------------------------------------------------------------------------------------------------------------
Increase (decrease) in cash and cash equivalents 115 (491) 1,523
Cash and cash equivalents at beginning of year 12,459 12,950 11,427
- ------------------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of year $12,574 $12,459 $12,950
- ------------------------------------------------------------------------------------------------------------------------------
Supplemental Cash Flow Disclosures
Interest paid $ 9,021 $ 8,441 $ 8,379
Income taxes paid 1,280 1,250 370
Non-Cash Transactions
Transfer of loans to other real estate owned 622 1,625 271
Change in net unrealized holding gains (losses), net of taxes, on investment securities 761 (110) 2,075
The accompanying notes are an integral part of the consolidated financial
statements.
31
QNB Corp. and Subsidiary
- --------------------------------------------------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Business
- --------------------------------------------------------------------------------
QNB Corp. through its subsidiary bank, The Quakertown National Bank, provides a
full range of banking services to individual and corporate customers through its
branch banking system located in Upper Bucks, Northern Montgomery and Southern
Lehigh Counties in Pennsylvania. The Quakertown National Bank is subject to
competition from other financial institutions and other financial services
companies with respect to these services and customers. QNB Corp. is also
subject to the regulations of certain federal agencies and undergoes periodic
examinations by such regulatory authorities.
Basis of Financial Statement Presentation
- --------------------------------------------------------------------------------
The consolidated financial statements include the accounts of QNB Corp. and its
wholly owned subsidiary, The Quakertown National Bank (QNB). Such statements
have been prepared in accordance with generally accepted accounting principles
and general practice within the banking industry. All significant intercompany
accounts and transactions have been eliminated in the consolidated financial
statements. Tabular information other than share data is presented in thousands
of dollars. Certain previously reported amounts have been reclassified to
conform to current presentation standards. These reclassifications had no effect
on net income.
Use of Estimates
- --------------------------------------------------------------------------------
In preparing the consolidated financial statements, management is required to
make estimates and assumptions that affect the reported amounts of 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 such estimates.
Investment Securities
- --------------------------------------------------------------------------------
Investment securities that QNB has the positive intent and ability to hold to
maturity are classified as held-to-maturity securities and reported at amortized
cost. Debt and equity securities that are bought and held principally for the
purpose of selling in the near term are classified as trading securities and
reported at fair value, with unrealized gains and losses included in earnings.
Debt and equity securities not classified as either held-to-maturity securities
or trading securities are classified as available-for-sale securities and
reported at fair value, with unrealized gains and losses, net of tax, excluded
from earnings and reported as a separate component of shareholders' equity.
Management determines the appropriate classification of securities at the time
of purchase.
Available-for-sale securities include securities that management intends to use
as part of its asset/liability management strategy and that may be sold in
response to changes in market interest rates and related changes in the
securities' prepayment risk or to meet liquidity needs.
Premiums and discounts on debt securities are recognized in interest income
using a constant yield method. Gains and losses on sales of investment
securities are computed on the specific identification method and included in
non-interest income.
Loans
- --------------------------------------------------------------------------------
Loans are stated at the principal amount outstanding, net of deferred loan fees
and costs. Interest income is accrued on the principal amount outstanding. Loan
origination and commitment fees and related direct costs are deferred and
amortized to income over the term of the respective loan and loan commitment
period as a yield adjustment.
Loans held-for-sale primarily consist of residential mortgages and are carried
at the lower of aggregate cost or market value. Gains and losses on residential
mortgages held-for-sale are included in non-interest income.
Non-performing Assets
- --------------------------------------------------------------------------------
Non-performing assets are comprised of non-accrual loans and other real estate
owned. Non-accrual loans are those on which the accrual of interest has ceased.
Commercial loans are placed on non-accrual status immediately if, in the opinion
of management, collection is doubtful, or when principal or interest is past due
90 days or more and collateral is insufficient to cover principal and interest.
Interest accrued, but not collected at the date a loan is placed on non-accrual
status, is reversed and charged against interest income. Subsequent cash
receipts are applied either to the outstanding principal or recorded as interest
income, depending on management's assessment of ultimate collectibility of
principal and interest. Loans are returned to an accrual status when the
borrower's ability to make periodic principal and interest payments has returned
to normal (i.e. - brought current with respect to principal or interest or
restructured) and the paying capacity of the borrower and/or the underlying
collateral is deemed sufficient to cover principal and interest. Consumer loans,
including residential mortgage loans, are not automatically placed on
non-accrual status when principal or interest payments are 90 days past due,
but; in most instances, are charged-off when deemed uncollectible or after
reaching 120 days past due.
Other real estate owned is comprised of properties acquired through foreclosure
proceedings or acceptance of a deed in lieu of foreclosure. Other real estate
owned is recorded at the lower of the carrying value of the loan or the fair
value of the property. Loan losses arising from the acquisition of such
properties are charged against the allowance for possible loan losses. After
acquisition, such properties are carried at the lower of cost or fair value
minus estimated costs to sell. Holding expenses related to the operation and
maintenance of properties are expensed as incurred. Gains and losses upon
disposition are reflected in earnings as realized.
32
QNB Corp. and Subsidiary
- --------------------------------------------------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Allowance for Loan Losses
- --------------------------------------------------------------------------------
The provision for loan losses charged to operating expense reflects the amount
deemed appropriate by management to produce an adequate reserve to meet the
present and foreseeable risk characteristics of the existing loan portfolio.
Management's judgement is based on the evaluation of individual loans, past
experience, the assessment of current economic conditions, and other relevant
factors. Loan losses are charged directly against the allowance for loan losses
and recoveries on previously charged-off loans are added to the allowance.
Significant estimates are made by management in determining the allowance for
loan losses. Consideration is given to a variety of factors in establishing
these estimates including current economic conditions, diversification of the
loan portfolio, delinquency statistics, results of internal loan reviews,
borrowers' perceived financial and managerial strengths, the adequacy of
underlying collateral, if collateral dependent, or present value of future cash
flows, and other relevant factors. Since the allowance for loan losses is
dependent, to a great extent, on conditions that may be beyond QNB's control, it
is at least reasonably possible that management's estimates of the allowance for
loan losses, and actual results could differ in the near term.
In addition, regulatory authorities, as an integral part of their examinations,
periodically review the allowance for loan losses. They may require additions to
the allowance based upon their judgements about information available to them at
the time of examination.
Accounting for impairment in the performance of a loan is required when it is
probable that all amounts, including both principal and interest, will not be
collected in accordance with the loan agreement. Impaired loans are measured
based on the present value of expected future cash flows discounted at the
loan's effective interest rate or, as a practical expedient, at the loan's
observable market price or the fair value of the collateral if the loan is
collateral dependent. Impairment criteria are applied to the loan portfolio
exclusive of smaller homogeneous loans such as residential mortgage and consumer
loans which are evaluated collectively for impairment.
Transfers and Servicing of Financial Assets
- --------------------------------------------------------------------------------
In June 1996, SFAS No. 125, "Accounting for Transfers and Servicing of Financial
Assets and Extinguishment of Liabilities," was issued. This statement is
effective for transactions entered into after December 31, 1996 and is required
to be applied prospectively. This statement superceded SFAS No. 122, "Accounting
for Mortgage Servicing Rights," which was effective January 1, 1996.
This Statement specifies when financial assets and liabilities are to be removed
from an entity's financial statements and specifies the accounting for servicing
assets and liabilities. Under SFAS No. 125, an entity recognizes only assets it
controls and liabilities it has incurred, derecognizes assets only when control
has been surrendered, and derecognizes liabilities only when they have been
paid, or the entity is legally released from being the primary obligor under the
liability judicially or by the creditor. SFAS No. 125 requires that the selling
entity continue to carry retained interests, including servicing assets,
relating to assets it has derecognized. Such retained interests are recorded
based on the relative fair values of the retained interests and derecognized
assets at the date of transfer. Transfers not meeting the criteria for sale
recognition are accounted for as a secured borrowing with a pledge of
collateral.
SFAS No. 125 requires an entity to recognize its obligation to service financial
assets that are retained in a transfer of assets in the form of a servicing
asset or liability. The servicing asset or liability is to be amortized in
proportion to and over the period of net servicing income or loss. Servicing
assets and liabilities are to be assessed for impairment based on their fair
value. The adoption of this statement did not have a material impact on QNB's
financial position or results of operations.
Premises and Equipment
- --------------------------------------------------------------------------------
Premises and equipment are stated at cost, less accumulated depreciation and
amortization. Depreciation and amortization are calculated principally on an
accelerated or straight-line basis over the estimated useful lives of the assets
as follows: buildings--10 to 40 years, and equipment--3 to 10 years, or, in the
case of leasehold improvements, over the term of the lease. Expenditures for
maintenance and repairs are charged to operations as incurred. Gains or losses
upon disposition are reflected in earnings as realized.
Income Taxes
- --------------------------------------------------------------------------------
QNB Corp. and its subsidiary file a consolidated Federal income tax return and
the amount of income tax expense or benefit is computed and allocated on a
separate return basis. To provide for income taxes, QNB uses the asset and
liability method under which deferred tax assets and liabilities are recognized
for the future tax consequences attributable to the difference between the
financial statement carrying amounts of existing assets and liabilities and
their respective tax bases. Deferred tax assets and liabilities are measured
using enacted tax rates expected to apply to taxable income in the years in
which those temporary differences are expected to be recovered or settled. The
effect of a change in tax rates on deferred tax assets and liabilities is
recognized in income in the period which includes the enactment date.
33
QNB Corp. and Subsidiary
- --------------------------------------------------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Net Income Per Share
- --------------------------------------------------------------------------------
In February 1997, the Financial Accounting Standards Board (FASB) issued
Statement No. 128 (SFAS No. 128), "Earnings per Share." SFAS No. 128 replaced
the calculation of primary and fully diluted earnings per share with basic and
diluted earnings per share. Unlike primary earnings per share, basic earnings
per share excludes any dilutive effects of options and is computed by dividing
net income by the weighted average number of shares outstanding during the
period. Diluted earnings per share gives effect to all dilutive potential common
shares that were outstanding during the period. All earnings per share amounts
for all periods have been presented to conform to SFAS No. 128 requirements.
Other Accounting Pronouncements
- --------------------------------------------------------------------------------
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income."
SFAS No. 130 requires the inclusion of comprehensive income, either in a
separate statement, or as part of a combined statement of income and
comprehensive income in a full set of general-purpose financial statements.
Comprehensive income is defined as the change in equity of a business entity
during a period from transactions and other events and circumstances, excluding
those resulting from investments by and distributions to owners. For QNB, the
primary component of comprehensive income is the unrealized holding gains or
losses on available-for-sale investment securities.
SFAS No. 130 is effective for fiscal years beginning after December 15, 1997.
This Statement requires the presentation of information already contained in
QNB's financial statements and therefore is not expected to have an impact on
QNB's financial position or results of operations.
In June 1997, the FASB also issued SFAS No. 131, "Disclosures About Segments of
an Enterprise and Related Information." SFAS No. 131 establishes standards for
the reporting of information about operating segments by public business
enterprises in their annual and interim reports issued to shareholders.
SFAS No. 131 requires that a public business enterprise report financial and
descriptive information including profit or loss, certain revenue and expense
items, and segment assets, about its reportable operating segments. Operating
segments are defined as components of an enterprise about which separate
financial information is available that is evaluated regularly by the chief
operating decision-maker in deciding how to allocate resources and in assessing
performance.
SFAS No. 131 is effective for financial statements for periods beginning after
December 15, 1997. This Statement is a disclosure requirement and therefore is
not expected to have an effect on QNB's financial position or results of
operations.
Statement of Cash Flows
- --------------------------------------------------------------------------------
Cash and cash equivalents for purposes of this statement consist of cash and due
from banks.
NOTE 2 - EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted earnings per
share (share and per share data not in thousands):
- --------------------------------------------------------------------------------
1997 1996 1995
- --------------------------------------------------------------------------------
Numerator for basic
and diluted earnings
per share - net income $3,131 $2,801 $1,687
- --------------------------------------------------------------------------------
Denominator for basic
earnings per share - weighted
average shares outstanding 1,427,981 1,424,112 1,421,378
Effect of dilutive securities -
employee stock options 5,962 9,067 5,342
- --------------------------------------------------------------------------------
Denominator for diluted earnings
per share - adjusted weighted
average shares outstanding 1,433,943 1,433,179 1,426,720
- --------------------------------------------------------------------------------
Earnings per share - basic $ 2.19 $ 1.97 $ 1.19
Earnings per share - diluted $ 2.18 $ 1.95 $ 1.18
- --------------------------------------------------------------------------------
NOTE 3 - ACQUISITION
On October 30, 1997, QNB completed its purchase of certain assets and
liabilities of the Quakertown office of First Lehigh Bank. Included in the
purchase were approximately $6,800,000 of deposits. The transaction was
accounted for using the purchase method of accounting. The premium on deposits
will be amortized over a 10 year period.
NOTE 4 - CASH AND DUE FROM BANKS
Included in cash and due from banks are reserves in the form of deposits with
the Federal Reserve Bank of $1,481,000 and $509,000 to satisfy federal
regulatory requirements as of December 31, 1997 and 1996.
34
QNB Corp. and Subsidiary
- --------------------------------------------------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5 - INVESTMENT SECURITIES
Available-For-Sale
The amortized cost and estimated fair values of investment
securities available-for-sale at December 31, 1997 and 1996 were as follows:
- --------------------------------------------------------------------------------------------------------------------------------
December 31, 1997 1996
Gross Gross Gross Gross
Aggregate unrealized unrealized Aggregate unrealized unrealized
fair holding holding Amortized fair holding holding Amortized
value gains losses cost value gains losses cost
- --------------------------------------------------------------------------------------------------------------------------------
U.S. Treasury $ 9,633 $ 99 - $ 9,534 $ 9,555 $ 42 $ 13 $ 9,526
U.S. Government agencies 55,586 497 $42 55,131 39,422 149 197 39,470
State and municipal securities 511 21 - 490 - - - -
Mortgage-backed securities 8,152 55 17 8,114 3,045 1 39 3,083
Equity and other debt securities 2,038 710 - 1,328 757 227 - 530
- --------------------------------------------------------------------------------------------------------------------------------
Total investment securities
available-for-sale $75,920 $1,382 $59 $74,597 $52,779 $419 $249 $52,609
- --------------------------------------------------------------------------------------------------------------------------------
The amortized cost and estimated fair value of debt securities
available-for-sale by contractual maturity at December 31, 1997 are shown in the
following table. Expected maturities will differ from contractual maturities
because borrowers may have the right to call or prepay obligations with or
without call or prepayment penalties. Mortgage-backed securities are shown
separately due to the amortization and prepayment of principal occurring
throughout the life of these instruments.
- --------------------------------------------------------------------------------
Aggregate
fair Amortized
December 31, 1997 value cost
- --------------------------------------------------------------------------------
Due in one year or less $ 999 $ 1,001
Due after one year through five years 30,224 30,069
Due after five years through ten years 34,047 33,645
Due after ten years 511 490
Mortgage-backed securities 8,152 8,114
- --------------------------------------------------------------------------------
Total debt securities available-for-sale $73,933 $73,319
- --------------------------------------------------------------------------------
Proceeds from sales of investment securities available-for-sale are as follows:
- --------------------------------------------------------------------------------
1997 1996 1995
- --------------------------------------------------------------------------------
Proceeds $13,919 $18,526 $8,888
Gross gains 181 122 1
Gross losses 47 20 88
Held-To-Maturity
The amortized cost and estimated fair values of investment securities
held-to-maturity at December 31, 1997 and 1996 were as follows:
- --------------------------------------------------------------------------------------------------------------------------------
December 31, 1997 1996
Gross Gross Gross Gross
unrealized unrealized Aggregate unrealized unrealized Aggregate
Amortized holding holding fair Amortized holding holding fair
cost gains losses value cost gains losses value
- --------------------------------------------------------------------------------------------------------------------------------
State and municipal securities $10,136 $171 $ 1 $10,306 $10,563 $136 $ 16 $10,683
Mortgage-backed securities 30,186 193 50 30,329 32,058 129 188 31,999
Equity securities 78 - - 78 78 - - 78
- --------------------------------------------------------------------------------------------------------------------------------
Total investment securities
held-to-maturity $40,400 $364 $51 $40,713 $42,699 $265 $204 $42,760
- --------------------------------------------------------------------------------------------------------------------------------
35
QNB Corp. and Subsidiary
- --------------------------------------------------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The amortized cost and estimated fair values of debt securities held-to-maturity
by contractual maturity at December 31, 1997 are shown in the following table.
Expected maturities will differ from contractual maturities because borrowers
may have the right to call or prepay obligations with or without penalties.
Mortgage-backed securities are shown separately due to the amortization and
prepayment of principal occurring throughout the life of these instruments.
- --------------------------------------------------------------------------------
Aggregate
Amortized fair
December 31, 1997 cost value
- --------------------------------------------------------------------------------
Due in one year or less - -
Due after one year through five years $ 1,986 $ 2,023
Due after five years through ten years 8,150 8,283
Due after ten years - -
Mortgage-backed securities 30,186 30,329
- --------------------------------------------------------------------------------
Total debt securities held-to-maturity $ 40,322 $40,635
- --------------------------------------------------------------------------------
There were no sales of investment securities classified as held-to-maturity
during 1997, 1996 or 1995. At December 31, 1997 and 1996, investment securities
totaling $36,510,000 and $34,381,000 were pledged as collateral for repurchase
agreements, public deposits and other deposits as provided by law.
NOTE 6 - LOANS
- --------------------------------------------------------------------------------
December 31, 1997 1996
- --------------------------------------------------------------------------------
Commercial and industrial $ 32,794 $ 22,973
Agricultural 2,845 2,828
Construction 813 3,640
Real estate-commercial 58,783 57,589
Real estate-residential 67,621 66,203
Consumer 5,312 6,477
- --------------------------------------------------------------------------------
Total loans 168,168 159,710
Less unearned income 448 432
- --------------------------------------------------------------------------------
Total loans, net of unearned income $167,720 $159,278
- --------------------------------------------------------------------------------
Real estate commercial loans include all loans collateralized at least in part
by commercial real estate. These loans may not be for the expressed purpose of
conducting commercial real estate transactions.
Included in real estate residential loans at December 31, 1997 and 1996, are
$481,000 and $103,000 of residential mortgage loans held-for-sale. Included in
consumer loans at these same dates are $918,000 and $909,000 of student loans
held-for-sale.
At December 31, 1997 and 1996, the recorded investment in loans for which
impairment has been recognized totaled $1,123,000 and $2,604,000, respectively.
The entire balance of loans defined as impaired as of December 31, 1997 required
no valuation allowance while $1,288,000 of the loans identified as of December
31, 1996 required no valuation allowance. As of December 31, 1996 $1,316,000 of
loans required a valuation allowance of approximately $408,000. Most of the
loans identified as impaired are collateral-dependent. For the years ended
December 31, 1997, 1996 and 1995, the average recorded investment in impaired
loans was approximately $2,105,000, $4,288,000 and $3,676,000, respectively. QNB
recognized $86,000, $50,000 and $220,000 of interest income on these loans in
1997, 1996 and 1995, respectively.
Included within the loan portfolio are loans on non-accrual status of $1,209,000
and $2,700,000 at December 31, 1997 and 1996, respectively. If interest had been
accrued throughout the period, interest income for the years ended December 31,
1997, 1996 and 1995, would have increased approximately $154,000, $265,000 and
$320,000, respectively. The amount of interest income on these loans that was
included in net income in 1997, 1996 and 1995 was $7,000, $50,000 and $220,000,
respectively.
QNB generally lends in its trade area which is comprised of Quakertown and
surrounding communities. To a large extent QNB makes loans collateralized at
least in part by real estate. Its lending activities could be affected by
changes in the general economy, the regional economy, or real estate values.
NOTE 7 - ALLOWANCE FOR LOAN LOSSES
Activity in the allowance for loan losses is shown below:
- --------------------------------------------------------------------------------
December 31, 1997 1996 1995
- --------------------------------------------------------------------------------
Balance at beginning of year $2,585 $2,384 $2,024
- --------------------------------------------------------------------------------
Charge-offs (344) (259) (703)
Recoveries 29 60 53
- --------------------------------------------------------------------------------
Net charge-offs (315) (199) (650)
Provision for loan losses 400 400 1,010
- --------------------------------------------------------------------------------
Balance at end of year $2,670 $2,585 $2,384
- --------------------------------------------------------------------------------
NOTE 8 - PREMISES AND EQUIPMENT
Premises and equipment, stated at cost less accumulated depreciation and
amortization, are summarized below:
- --------------------------------------------------------------------------------
December 31, 1997 1996
- --------------------------------------------------------------------------------
Land and buildings $ 4,844 $4,835
Furniture and equipment 4,835 4,658
Leasehold improvements 469 469
- --------------------------------------------------------------------------------
Book value 10,148 9,962
Accumulated depreciation
and amortization (6,082) (5,604)
- --------------------------------------------------------------------------------
Net book value $ 4,066 $4,358
- --------------------------------------------------------------------------------
Depreciation and amortization expense on premises and equipment amounted to
$491,000, $521,000 and $602,000, for the years ended December 31, 1997, 1996 and
1995, respectively.
Rental expense on operating leases amounted to approximately $152,000, $131,000
and $133,000 for the years ended December 31, 1997, 1996 and 1995, respectively.
Most leases have options for renewal. Future minimum annual rental payments due
on non-cancelable leases for each of the years 1998 through 2002 are
approximately $112,000, $97,000, $71,000, $64,000 and $30,000, respectively.
NOTE 9 - TIME DEPOSITS
The aggregate amount of time deposits including deposits in denominations of
$100,000 or more was $117,149,000 and $109,011,000 at December 31, 1997 and
1996, respectively. The scheduled maturities of time deposits as of December 31,
1997 for the years 1998 through 2002 and thereafter are approximately
$74,426,000, $31,790,000, $6,755,000, $3,897,000, $258,000 and $23,000,
respectively.
36
QNB Corp. and Subsidiary
- --------------------------------------------------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 10 - SHORT-TERM BORROWINGS
- --------------------------------------------------------------------------------
Securities
Sold under Other
Agreements Short-term
December 31, to Repurchase(a) Borrowings(b)
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
1997
Balance $ 9,742 $ 600
Maximum indebtedness at any month end 10,405 653
Daily average indebtedness outstanding 8,307 603
Average rate paid for the year 3.36% 5.20%
Average rate on period-end borrowings 3.59 5.25
- --------------------------------------------------------------------------------
1996
Balance $ 8,156 $ 519
Maximum indebtedness at any month end 13,118 600
Daily average indebtedness outstanding 7,832 485
Average rate paid for the year 3.01% 5.19%
Average rate on period-end borrowings 3.01 5.15
- --------------------------------------------------------------------------------
(a) Securities sold under agreements to repurchase mature within 30 days. The
repurchase agreements were collateralized by U.S. Treasury and U.S. Government
agency securities with an amortized cost of $11,060,000 and $9,831,000 and a
fair value of $11,151,000 and $9,821,000 at December 31, 1997 and 1996,
respectively.
(b) Other short-term borrowings include Treasury tax and loan notes and Federal
Reserve borrowings.
NOTE 11 - INCOME TAXES
The components of the provision for income taxes are as follows:
- --------------------------------------------------------------------------------
Year Ended December 31, 1997 1996 1995
- --------------------------------------------------------------------------------
Federal income taxes
currently payable $1,277 $1,117 $515
Deferred income taxes (24) (69) 21
- --------------------------------------------------------------------------------
Net provision $1,253 $1,048 $536
- --------------------------------------------------------------------------------
At December 31, 1997, 1996 and 1995, the tax effects of temporary differences
that represent the significant portion of deferred tax assets and liabilities
are as follows:
- --------------------------------------------------------------------------------
Year Ended December 31, 1997 1996 1995
- --------------------------------------------------------------------------------
Deferred tax assets
Allowance for loan losses $666 $637 $569
Other real estate owned reserves 35 21 22
Deferred compensation 142 143 149
Deferred loan fees 32 40 20
Other 5 - 6
- --------------------------------------------------------------------------------
Total deferred tax assets 880 841 766
Deferred tax liabilities
Net unrealized holding gains on
investment securities
available-for-sale 450 58 114
Other 66 51 45
- --------------------------------------------------------------------------------
Total deferred tax liabilities 516 109 159
- --------------------------------------------------------------------------------
Net deferred tax asset $364 $732 $607
- --------------------------------------------------------------------------------
The realizability of deferred tax assets is dependent upon a variety of factors,
including the generation of future taxable income, the existence of taxes paid
and recoverable, the reversal of deferred tax liabilities and tax planning
strategies. Based upon these and other factors, management believes it is more
likely than not that QNB will realize the benefits of these deferred tax assets.
The net deferred tax asset is included in other assets on the consolidated
balance sheet.
A reconciliation between the statutory and effective tax rate for net income was
as follows:
- --------------------------------------------------------------------------------
Year Ended December 31, 1997 1996 1995
- --------------------------------------------------------------------------------
Provision at statutory rate $1,491 $1,309 $756
Tax-exempt interest income (276) (270) (229)
Other 38 9 9
- --------------------------------------------------------------------------------
Total provision $1,253 $1,048 $536
- --------------------------------------------------------------------------------
NOTE 12 - EMPLOYEE BENEFIT PLANS
QNB maintains a money purchase defined contribution plan which covers all
employees who meet the age and service requirements. QNB makes contributions to
the money purchase plan equivalent to 5 percent of total compensation (as
defined by the plan). QNB contributed and expensed $191,633, $187,595 and
$174,393 to this plan in 1997, 1996 and 1995, respectively. QNB also has a
401(k) profit sharing plan pursuant to the provisions of 401(k) of the Internal
Revenue Code. The plan covers substantially all employees who meet the age and
service requirements. The 401(k) plan provides for elective employee
contributions up to 9 percent of compensation and a matching company
contribution limited to 3 percent. QNB makes contributions to the profit sharing
plan as directed by its Board of Directors. For 1997, 1996 and 1995, QNB
contributed and expensed $114,000, $100,792 and $100,195 respectively, to the
401(k) profit sharing plan.
QNB's Employee Stock Purchase Plan (the "Plan") offers eligible employees an
opportunity to purchase from the Corporation shares of QNB Corp. Common Stock at
a 5 percent discount from the lesser of fair market value on the first or last
day of each offering period (as defined by the plan). The Plan authorizes the
issuance of 25,000 shares. The initial offering period of the Plan commenced on
December 1, 1996 and no shares were issued during 1996. During 1997, 1,154
shares were issued at $29.69 per share. The Plan is considered compensatory as
defined by SFAS No. 123, "Accounting for Stock-Based Compensation," and as such
a charge to earnings of $2,000 was recorded for the difference between the
purchase price and the fair value on the date of issue.
NOTE 13 - RELATED PARTY TRANSACTIONS
The following table presents activity in the amounts due from directors,
principal officers, and their related interests. All of these transactions were
made in the ordinary course of business on substantially the same terms,
including interest rates and collateral, as those prevailing at the time for
comparable transactions with other persons. Also, they did not involve a more
than normal risk of collectibility or present any other unfavorable features.
- --------------------------------------------------------------------------------
Balance, December 31, 1996 $ 3,355
New loans 13,733
Repayments and other changes (10,354)
- --------------------------------------------------------------------------------
Balance, December 31, 1997 $ 6,734
- --------------------------------------------------------------------------------
QNB allowed its directors to defer a portion of their compensation. The amount
of deferred compensation accrued as of December 31, 1997 and 1996, was $419,000
and $422,000, respectively.
37
QNB Corp. and Subsidiary
- --------------------------------------------------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 14 - STOCK OPTION PLAN
QNB sponsors a Stock Option Plan (the "Plan") administered by a committee which
consists of three or more members of QNB's Board of Directors. The Plan provides
to key employees the granting of either (i) Non-Qualified Stock Options (NQSOs)
or (ii) Incentive Stock Options (ISOs). The exercise price of an option is the
fair market value of QNB's common stock at the date of grant. The plan
authorizes the issuance of 82,000 shares. ISOs expire 5 years from the date of
grant. Changes in total options outstanding during 1997, 1996 and 1995, were as
follows:
- --------------------------------------------------------------------------------
Number Exercise Price Average
of Options per Option Exercise Price
- --------------------------------------------------------------------------------
December 31, 1994 23,200 $16.50-$19.50 $17.96
ISOs Exercised (9,440) 16.50- 21.00 18.00
ISOs Granted 9,200 21.00 21.00
- -------------------------------------------------------------------------------
December 31, 1995 22,960 16.88- 21.00 19.17
ISOs Exercised (3,410) 16.88- 17.63 16.89
ISOs Granted 9,200 29.50 29.50
- -------------------------------------------------------------------------------
December 31, 1996 28,750 17.63- 29.50 22.75
ISOs Exercised (6,150) 17.63- 29.50 18.09
ISOs Granted 10,000 32.00 32.00
- -------------------------------------------------------------------------------
December 31, 1997 32,600 $19.50-$32.00 $26.46
- -------------------------------------------------------------------------------
The following table summarizes information about stock options outstanding at
December 31, 1997:
Exercisable
- --------------------------------------------------------------------------------
Average
Exercise Price Range Options Average Life(1) Exercise Price
- --------------------------------------------------------------------------------
$19.50-$21.00 13,500 1.60 $20.31
29.50- 32.00 19,100 3.59 30.81
- --------------------------------------------------------------------------------
Total 32,600 2.76 $26.46
- --------------------------------------------------------------------------------
(1) Average contractual life remaining in years
SFAS No. 123 provides an alternative method of accounting for stock-based
compensation arrangements. This method is based on fair value of the stock-based
compensation determined by an option pricing model utilizing various assumptions
regarding the underlying attributes of the options and QNB's stock, rather than
the existing method of accounting for stock-based compensation which is provided
in Accounting Principles Board Opinion No. 25 (APB No. 25), "Accounting for
Stock Issued to Employees." The Financial Accounting Standards Board encourages
entities to adopt the fair value based method, but does not require the adoption
of this method.
QNB applies APB No. 25 and related Interpretations in accounting for the Plan.
The following table sets forth pro forma net income and earnings per share as if
compensation expense was recognized for stock options in accordance with SFAS
No. 123.
- --------------------------------------------------------------------------------
Reported Pro forma
- --------------------------------------------------------------------------------
Net income
1997 $3,131 $3,082
1996 2,801 2,763
1995 1,687 1,654
Basic earnings per share
1997 $ 2.19 $ 2.16
1996 1.97 1.94
1995 1.19 1.16
Diluted earnings per share
1997 $ 2.18 $ 2.15
1996 1.95 1.93
1995 1.18 1.16
- --------------------------------------------------------------------------------
For purposes of computing pro forma results QNB estimated the fair value of
stock options on the date of the grant using the Black-Scholes option pricing
model. The model requires the use of numerous assumptions, many of which are
highly subjective in nature. Therefore, the pro forma results are, of a
necessity, estimates of results of operations as if compensation expense had
been recognized for all stock-based compensation plans and are not indicative of
the impact on future periods. The following assumptions were used in the option
pricing model for purposes of estimating pro forma results.
- --------------------------------------------------------------------------------
Year ended December 31, 1997 1996 1995
- --------------------------------------------------------------------------------
Risk free interest rate 6.29% 5.32% 7.86%
Dividend yield 2.50 2.50 2.50
Volatility 20.00 20.00 20.00
Expected life 5 yrs. 5 yrs. 5 yrs.
- --------------------------------------------------------------------------------
The weighted average fair value of options granted during 1997, 1996 and 1995
was $7.34, $6.19 and $5.50, respectively.
NOTE 15 - COMMITMENTS AND CONTINGENCIES
In the normal course of business there are various legal proceedings,
commitments, and contingent liabilities which are not reflected in the financial
statements. Management does not anticipate any material losses as a result of
these transactions and activities. They include, among other things, commitments
to extend credit and standby letters of credit. Outstanding standby letters of
credit amounted to $2,196,000 and $1,583,000 and commitments to extend credit
totaled $34,925,000 and $33,883,000 at December 31, 1997 and 1996, respectively.
The maximum exposure to credit loss, which represents the possibility of
sustaining a loss due to the failure of the other parties to a financial
instrument to perform according to the terms of the contract, is represented by
the contractual amount of these instruments. QNB uses the same lending standards
and policies in making credit commitments as it does for on-balance sheet
instruments. The activity is controlled through credit approvals, control
limits, and monitoring procedures.
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 the 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. QNB evaluates each customer's
creditworthiness on a case-by-case basis.
Standby letters of credit are conditional commitments issued to guarantee the
performance of a customer to a third party. The credit risk and collateral
policy involved in issuing letters of credit are essentially the same as those
involved in extending loan commitments.
The amount of collateral obtained for letters of credit and commitments to
extend credit is based on management's credit evaluation of the customer.
Collateral varies but may include real estate, accounts receivable, marketable
securities, pledged deposits, inventory or equipment.
38
QNB Corp. and Subsidiary
- --------------------------------------------------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 16 - DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
All entities are required to disclose estimated fair values for their financial
instruments, whether or not recognized in the balance sheet. For QNB, as for
most financial institutions, substantially all of its assets and liabilities are
considered financial instruments.
Estimates of fair value are made at a specific point in time, based upon, where
available, relevant market prices and information about the financial
instrument. Such estimates do not include any premium or discount that could
result from offering for sale at one time the Company's entire holdings of a
particular financial instrument. For a substantial portion of the Company's
financial instruments, no quoted market exists. Therefore, estimates of fair
value are necessarily based on a number of significant assumptions regarding the
amount and timing of estimated future cash flows which are discounted to reflect
varying degrees of risk. Given the uncertainties surrounding these assumptions,
the reported fair values may not represent actual values of financial
instruments that could have been realized as of year-end or that will be
realized in the future. Use of different assumptions or methodologies is likely
to result in significantly different fair value estimates.
The fair value of non-interest bearing demand deposits, NOW accounts, money
market accounts and savings accounts is equal to the carrying amount because
these deposits have no stated maturity. This approach to estimating fair value
excludes the significant benefit that results from the low-cost funding provided
by such deposit liabilities, as compared to alternative sources of funding. As a
consequence, the amounts disclosed may distort the actual fair value of a
banking organization that is a going concern.
The estimated fair values and carrying amounts are summarized as follows:
- ------------------------------------------------------------------------------------------------------------
December 31, 1997 1996
- ------------------------------------------------------------------------------------------------------------
Estimated Carrying Estimated Carrying
Fair Value Amount Fair Value Amount
- ------------------------------------------------------------------------------------------------------------
Financial Assets
Cash and due from banks $ 12,574 $ 12,574 $ 12,459 $12,459
Federal funds sold 2,022 2,022 6,480 6,480
Investment securities available-for-sale 75,920 75,920 52,779 52,779
Investment securities held-to-maturity 40,713 40,400 42,760 42,699
Net loans 166,449 165,050 157,679 156,693
Accrued interest receivable 2,007 2,007 1,689 1,689
Financial Liabilities
Deposits with no stated maturities 150,017 150,017 137,733 137,733
Deposits with stated maturities 117,474 117,149 109,307 109,011
Short-term borrowings 10,339 10,342 8,673 8,675
Accrued interest payable 1,057 1,057 1,012 1,102
The following methods and assumptions were used to estimate the fair value of
each major classification of financial instruments at December 31, 1997 and
1996.
Cash and due from banks and Federal funds sold:
Current carrying amounts approximate estimated fair value.
Investment securities:
Current quoted market prices were used to determine fair value.
Loans:
Fair values were estimated using the present value of the estimated cash flows,
using interest rates currently being offered for loans with similar terms to
borrowers of similar credit quality.
Deposit liabilities:
The fair value of deposits with no stated maturity (e.g. demand deposits, NOW
accounts, money market accounts and savings accounts) are by definition, equal
to the amount payable on demand at the reporting date (i.e. their carrying
amounts). Deposits with a stated maturity (time deposits) have been valued using
the present value of cash flows discounted at rates approximating the current
market for similar deposits.
Short-term borrowings:
Short-term borrowings have been valued using the present value of cash flows
discounted at rates approximating the current market for similar liabilities.
Off-balance-sheet instruments:
Off-balance-sheet instruments are primarily comprised of loan commitments which
are generally priced at market at the time of funding. Fees on commitments to
extend credit and standby letters of credit are deemed to be immaterial and
these instruments are expected to be settled at face value or expire unused. It
is impractical to assign any fair value to these instruments.
39
QNB Corp. and Subsidiary
- --------------------------------------------------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 17 - PARENT COMPANY FINANCIAL INFORMATION
Condensed financial statements of QNB Corp. only:
Balance Sheets
- --------------------------------------------------------------------------------
December 31, 1997 1996
- --------------------------------------------------------------------------------
Assets
Cash and due from banks $ 129 $ 8
Investment securities available-for-sale 1,975 694
Investment in subsidiary 24,000 22,155
Other assets - 5
- --------------------------------------------------------------------------------
Total assets $26,104 $22,862
- --------------------------------------------------------------------------------
Liabilities
Other liabilities $ 272 $ 87
Shareholders' equity
Common stock 1,789 1,782
Surplus 4,369 4,296
Retained earnings 18,801 16,585
Unrealized holding gains (losses),
net of taxes, on investment
securities available-for-sale 873 112
- --------------------------------------------------------------------------------
Total liabilities and shareholders' equity $26,104 $22,862
- --------------------------------------------------------------------------------
Statements of Income
- --------------------------------------------------------------------------------
Year Ended December 31, 1997 1996 1995
- --------------------------------------------------------------------------------
Dividends from subsidiary $1,664 $ 1,098 $ 673
Interest and dividend income 31 14 10
Securities gains 159 77 -
Other income 1 2 -
- --------------------------------------------------------------------------------
Total income 1,855 1,191 683
Expenses 106 99 34
- --------------------------------------------------------------------------------
Income before applicable income
taxes and equity in undistributed
income of subsidiary 1,749 1,092 649
Income taxes (benefit) 22 (5) (10)
- --------------------------------------------------------------------------------
Income before equity in undistributed
income of subsidiary 1,727 1,097 659
Equity in undistributed
income of subsidiary 1,404 1,704 1,028
- --------------------------------------------------------------------------------
Net income $3,131 $2,801 $1,687
- --------------------------------------------------------------------------------
Statements of Cash Flows
- ----------------------------------------------------------------------------------------------------
Year Ended December 31, 1997 1996 1995
- ----------------------------------------------------------------------------------------------------
Operating Activities
Net income $3,131 $2,801 $1,687
Adjustments to reconcile net income to net cash
provided by operating activities:
Equity in undistributed income from subsidiary (1,404) (1,704) (1,028)
Securities gains (159) (77) -
Decrease (increase) in other assets 5 5 (10)
Increase in other liabilities 23 9 -
- ----------------------------------------------------------------------------------------------------
Net cash provided by operating activities 1,596 1,034 649
- ----------------------------------------------------------------------------------------------------
Investing Activities
Purchase of investment securities (1,126) (404) -
Proceeds from sale of investment securities 488 152 -
- ----------------------------------------------------------------------------------------------------
Net cash used by investing activities (638) (252) -
- ----------------------------------------------------------------------------------------------------
Financing Activities
Cash dividends paid (915) (797) (711)
Stock issue 78 15 31
- ----------------------------------------------------------------------------------------------------
Net cash used by financing activities (837) (782) (680)
- ----------------------------------------------------------------------------------------------------
Increase (decrease) in cash and cash equivalents 121 - (31)
Cash and cash equivalents at beginning of year 8 8 39
- ----------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of year $ 129 $ 8 $ 8
- ----------------------------------------------------------------------------------------------------
40
QNB Corp. and Subsidiary
- --------------------------------------------------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 18 - REGULATORY RESTRICTIONS
Dividends payable by QNB Corp. and its bank subsidiary are subject to various
limitations imposed by statutes, regulations and policies adopted by bank
regulatory agencies. Under current regulations regarding dividend availability,
the bank subsidiary may declare dividends in 1998 to the holding company
totaling $3,108,000, plus additional amounts equal to the net profit earned by
the bank subsidiary for the period from January 1, 1998, through the date of
declaration, less dividends previously declared in 1998.
QNB is subject to regulatory capital requirements administered by Federal
banking agencies. Failure to meet minimum capital requirements can initiate
actions by regulators that could have an effect on the company's financial
statements. Under the framework for prompt corrective action, the company must
meet capital guidelines that involve quantitative measures of the company's
assets, liabilities, and certain off-balance-sheet items. The company's capital
amounts and classification are also subject to qualitative judgements by the
regulators. Management believes, as of December 31, 1997, that the company meets
all capital adequacy requirements to which it is subject.
As of the most recent notification, the Federal Reserve Bank and the Comptroller
of the Currency considered the company to be "well capitalized" under the
regulatory framework. There are no conditions or events since that notification
that management believes have changed the company's category. To be categorized
as well capitalized, the company must maintain minimum ratios set forth in the
table. The company's actual capital amounts and ratios are presented below:
Capital Levels
- ---------------------------------------------------------------------------------------------------------------------------
Actual Adequately Capitalized Well Capitalized
------------------ ---------------------- ----------------
As of December 31, 1997 Amount Ratio Amount Ratio Amount Ratio
- ---------------------------------------------------------------------------------------------------------------------------
Total risk-based capital (to risk weighted assets):(1)
Consolidated $26,725 14.74% $14,500 8.00% $18,125 10.00%
Quakertown National Bank 25,348 14.07 14,417 8.00 18,022 10.00
Tier I capital (to risk weighted assets):(1)
Consolidated 24,454 13.49 7,250 4.00 10,875 6.00
Quakertown National Bank 23,090 12.81 7,209 4.00 10,813 6.00
Tier I capital (to average assets):(1)
Consolidated 24,454 8.23 11,879 4.00 14,848 5.00
Quakertown National Bank 23,090 7.81 11,829 4.00 14,786 5.00
- ---------------------------------------------------------------------------------------------------------------------------
Capital Levels
- ---------------------------------------------------------------------------------------------------------------------------
Actual Adequately Capitalized Well Capitalized
------------------ ---------------------- ----------------
As of December 31, 1996 Amount Ratio Amount Ratio Amount Ratio
- ---------------------------------------------------------------------------------------------------------------------------
Total risk-based capital (to risk weighted assets):(1)
Consolidated $24,823 14.40% $13,788 8.00% $17,235 10.00%
Quakertown National Bank 24,345 14.16 13,750 8.00 17,188 10.00
Tier I capital (to risk weighted assets):(1)
Consolidated 22,663 13.15 6,894 4.00 10,341 6.00
Quakertown National Bank 22,191 12.91 6,875 4.00 10,313 6.00
Tier I capital (to average assets):(1)
Consolidated 22,663 8.14 11,143 4.00 13,928 5.00
Quakertown National Bank 22,191 7.98 11,123 4.00 13,903 5.00
- ---------------------------------------------------------------------------------------------------------------------------
(1) As defined by the regulators
41
QNB Corp. and Subsidiary
- --------------------------------------------------------------------------------
INDEPENDENT AUDITOR'S REPORT
{LOGO]
To the Board of Directors and Shareholders of QNB Corp:
We have audited the accompanying consolidated balance sheets of QNB Corp. and
subsidiary as of December 31, 1997 and 1996, and the related consolidated
statements of income, shareholders' equity and cash flows for each of the years
then ended. These consolidated financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits. The accompanying
consolidated financial statements of QNB Corp. and subsidiary for the year ended
December 31, 1995 were audited by other auditors whose report thereon dated
January 25, 1996, expressed an unqualified opinion on those statements.
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 1997 and 1996 consolidated financial statements referred to
above present fairly, in all material respects, the financial position of QNB
Corp. and subsidiary as of December 31, 1997 and 1996, and the results of their
operations and their cash flows for the years then ended in conformity with
generally accepted accounting principles.
/s/ KPMG Peat Marwick LLP
KPMG Peat Marwick LLP
January 28, 1998
- --------------------------------------------------------------------------------
CORPORATE INFORMATION
ANNUAL MEETING
The Annual Meeting of Shareholders of QNB Corp. will be held at the offices of
The Quakertown National Bank, 320 West Broad Street, Quakertown, PA on May 5,
1998, at 11:00 a.m.
MARKET MAKERS
As of December 31, 1997, the following firms made a market in QNB Corp.
common stock:
Legg Mason Wood Walker, Inc. Ryan, Beck & Company
Allentown, PA 18105 Shrewsbury, NJ 07702
Wheat First Union
Quakertown, PA 18951
TRANSFER AGENT
Registrar and Transfer Company
10 Commerce Drive
Cranford, NJ 07016-3572
(800) 368-5948
FORM 10-K
A copy of QNB Corp.'s Annual Report on Form 10-K, as filed with the Securities
and Exchange Commission, is available, without charge to shareholders, by
writing Tara E. Zuck, QNB Corp., P.O. Box 9005, Quakertown, PA 18951-9005.
The Annual Report and other Company reports are also filed electronically
through the Electronic Data Gathering, Analysis, and Retrieval System ("EDGAR")
which performs automated collection, validation, indexing, acceptance, and
forwarding of submissions to the Securities and Exchange Commission (SEC) and is
accessible by the public using the Internet at http://www.sec.gov./edgarhp.htm.
AUDITORS KPMG
Peat Marwick LLP
1600 Market Street
Philadelphia, PA 19103
STOCK INFORMATION
QNB Corp. common stock is traded in the over-the-counter market. Quotations for
QNB Corp. common stock appear in the pink sheets published by the National
Quotations Bureau, Inc.
The following table sets forth representative high and low bid and ask stock
prices for QNB Corp. common stock on a quarterly basis during 1997 and 1996:
- --------------------------------------------------------------------------------
High Low Cash
---------------- ----------------- Dividend
Bid Ask Bid Ask Per Share
- --------------------------------------------------------------------------------
1997
First Quarter $32 $33 $31 $32 $.16
Second Quarter 31-1/4 33-1/4 31 32 .16
Third Quarter 32 33-3/4 31-1/4 33 .16
Fourth Quarter 32 34 29-1/2 33 .16
1996
First Quarter $35 $36-1/2 $29-1/8 $30-1/2 $.14
Second Quarter 32-1/4 33-1/2 32-1/4 33-1/2 .14
Third Quarter 32-1/4 33-1/4 32-1/4 33 .14
Fourth Quarter 32-1/2 33-5/8 32-1/4 33 .14
- --------------------------------------------------------------------------------
DIRECT DEPOSIT OF DIVIDENDS
Shareholders of record may elect to have dividends deposited directly to a
checking or savings account at their financial institution. For additional
information about Direct Deposit of Dividends, please write to: Tara E. Zuck,
QNB Corp., P.O. Box 9005, Quakertown, PA 18951-9005.
42