EXHIBIT 13
FORWARD-LOOKING STATEMENTS
This annual report contains forward-looking statements that are based on
assumptions and may describe future plans, strategies and expectations of
Tri-County Financial Corporation (the "Company") and Community Bank of
Tri-County (the "Bank"). These forward-looking statements are generally
identified by use of the words "believe," "expect," "intend," "anticipate,"
"estimate," "project" or similar expressions.
The Company and the Bank's ability to predict results or the actual effect of
future plans or strategies is inherently uncertain. Factors that could have a
material adverse effect on the operations of the Company and its subsidiaries
include, but are not limited to, changes in interest rates, national and
regional economic conditions, legislative and regulatory changes, monetary and
fiscal policies of the U.S. government, including policies of the U.S. Treasury
and the Federal Reserve Board, the quality and composition of the loan or
investment portfolios, demand for loan products, deposit flows, competition,
demand for financial services in the Company and the Bank's market area, changes
in real estate market values in the Company and the Bank's market area, and
changes in relevant accounting principles and guidelines.
These risks and uncertainties should be considered in evaluating forward-looking
statements and undue reliance should not be placed on such statements. Except as
required by applicable law or regulation, the Company does not undertake, and
specifically disclaims any obligation, to release publicly the result of any
revisions that may be made to any forward-looking statements to reflect events
or circumstances.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
OVERVIEW
Since its conversion to a commercial bank charter in 1997, the Bank has sought
to increase total assets as well as certain targeted loan types. The Bank feels
that its ability to offer fast, flexible and local decision-making in the
commercial, commercial real estate and consumer loan areas will continue to
attract significant new loans and enhance asset growth. The Bank's local focus
and targeted marketing is also directed towards increasing its balances of
consumer and business transaction deposit accounts. The Bank believes that
increases in these account types will lessen the Bank's dependence on time
deposits, such as certificates of deposit, to fund loan growth. Although
management believes that the strategy outlined above will increase financial
performance over time, we recognize that products, such as commercial lending
and transaction accounts, will also increase the Bank's noninterest expense. We
also recognize that certain lending and deposit products also increase the
possibility of losses from credit and other risks. In December 2004 and December
2005, the Company declared three for two stock splits in the form of a stock
dividend. All per share numbers in the following discussion reflect retroactive
application of the stock splits.
CRITICAL ACCOUNTING POLICIES
The Company's consolidated financial statements are prepared in accordance with
accounting principles generally accepted in the United States of America and the
general practices of the United States banking industry. Application of these
principles requires management to make estimates, assumptions and judgments that
affect the amounts reported in the financial statements and accompanying notes.
These estimates, assumptions and judgments are based on information available as
of the date of the financial statements. Accordingly, as this information
changes, the financial statements could reflect different estimates,
assumptions, and judgments. Certain policies inherently have a greater reliance
on the use of estimates, assumptions and judgments and as such have a greater
possibility of producing results that could be materially different than
originally reported. The Company considers its determination of the allowance
for loan losses and the valuation allowance on its foreclosed real estate to be
critical accounting policies. Estimates, assumptions, and judgments are
necessary when assets and liabilities are required to be recorded at fair value,
when a decline in the value of an asset not carried on the financial statements
at fair value warrants an impairment write-down or valuation reserve to be
established, or when an asset or liability needs to be recorded contingent upon
a future event. Carrying assets and liabilities at fair value inherently results
in more financial statement volatility. The fair values and the information used
to record valuation adjustments for certain assets and liabilities are based
either on quoted market prices or are provided by other third-party sources,
when available. When these sources are not available, management makes estimates
based upon what it considers to be the best available information.
1
The allowance for loan losses is an estimate of the losses that may be sustained
in the loan portfolio. The allowance is based on two principles of accounting:
(a) Statement on Financial Accounting Standards ("SFAS") No. 5, "Accounting for
Contingencies," which requires that losses be accrued when they are probable of
occurring and are estimable and (b) SFAS No. 114, "Accounting by Creditors for
Impairment of a Loan," which requires that losses be accrued when it is probable
that the Company will not collect all principal and interest payments according
to the contractual terms of the loan. The loss, if any, is determined by the
difference between the loan balance and the value of collateral, the present
value of expected future cash flows, or values observable in the secondary
markets.
The loan loss allowance balance is an estimate based upon management's
evaluation of the loan portfolio. Generally the allowance is comprised of a
specific and a general component. The specific component consists of
management's evaluation of certain classified loans and their underlying
collateral. Loans are examined to determine a specific allowance based upon the
borrower's payment history, economic conditions specific to the loan or
borrower, or other factors that would impact the borrower's ability to repay the
loan on its contractual basis. Management assesses the ability of the borrower
to repay the loan based upon any information available. Depending on the
assessment of the borrower's ability to pay the loan as well as the type,
condition, and amount of collateral, management will establish an allowance
amount specific to the loan.
In establishing the general component of the allowance, management analyzes
non-classified and non-impaired loans in the portfolio including changes in the
amount and type of loans. Management also examines the Bank's history of
write-offs and recoveries within each loan category. The state of the local and
national economy is also considered. Based upon these factors, the Bank's loan
portfolio is categorized and a loss factor is applied to each category. These
loss factors may be higher or lower than the Bank's actual recent average losses
in any particular loan category, particularly in loan categories where the Bank
is rapidly increasing the size of its portfolio. Based upon these factors, the
Bank will adjust the loan loss allowance by increasing or decreasing the
provision for loan losses.
Management has significant discretion in making the judgments inherent in the
determination of the provision and allowance for loan losses, including in
connection with the valuation of collateral, a borrower's prospects of repayment
and in establishing allowance factors on the general component of the allowance.
Changes in allowance factors will have a direct impact on the amount of the
provision and a corresponding effect on net income. Errors in management's
perception and assessment of the global factors and their impact on the
portfolio could result in the allowance not being adequate to cover losses in
the portfolio, and may result in additional provisions or charge-offs. For
additional information regarding the allowance for loan losses, refer to Notes 1
and 4 to the Consolidated Financial Statements and the discussion under the
caption "Provision for Loan Losses" below.
In addition to the loan loss allowance the Company also maintains a valuation
allowance on its foreclosed real estate. As with the allowance for loan losses,
the valuation allowance on foreclosed real estate is based on SFAS No. 5,
"Accounting for Contingencies," as well as SFAS No. 144 "Accounting for the
Impairment or Disposal of Long-Lived Assets." These statements require that the
Company establish a valuation allowance when it has determined that the carrying
amount of a foreclosed asset exceeds its fair value. Fair value of a foreclosed
asset is measured by the cash flows expected to be realized from its subsequent
disposition. These cash flows should be reduced for the costs of selling or
otherwise disposing of the asset.
In estimating the cash flows from the sale of foreclosed real estate, management
must make significant assumptions regarding the timing and amount of cash flows.
In cases where the real estate acquired is undeveloped land, management must
gather the best available evidence regarding the market value of the property,
including appraisals, cost estimates of development, and broker opinions. Due to
the highly subjective nature of this evidence, as well as the limited market,
long time periods involved, and substantial risks, cash flow estimates are
highly subjective and subject to change. Errors regarding any aspect of the
costs or proceeds of developing, selling, or otherwise disposing of foreclosed
real estate could result in the allowance being inadequate to reduce carrying
costs to fair value and may require an additional provision for valuation
allowances.
COMPARISON OF RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2005, 2004
AND 2003
GENERAL. For the year ended December 31, 2005, the Company reported consolidated
net income of $3,979,343 ($2.30 basic and $2.16 diluted earnings per share)
compared to consolidated net income of $3,719,834 ($2.16 basic and $2.07 diluted
earnings per share) for the year ended December 31, 2004. The increase in net
income for 2005
2
was primarily attributable to an increase in net interest income, a decline in
provision for loan loss, and a small increase in noninterest income which was
partially offset by increases in noninterest expenses. The Bank also
substantially increased its loan portfolio and lower cost deposit balances. In
2005, the Bank used increases in loan and deposit balances to reduce securities
and wholesale borrowings balances. In 2005, the Bank also used funds from the
issuance of $5 million in trust preferred securities to further increase assets.
These changes led to further increases in net interest income in 2005. Provision
for loan losses declined in 2005 from 2004 levels as loan growth in certain
areas declined and the Bank maintained an excellent record in loan quality.
Noninterest income increased in 2005 because the Bank had recognized a decline
in the value of certain securities in 2004 while no recognition was required in
2005. Noninterest expenses increased primarily due to increases in personnel,
occupancy, data processing and professional fees. Income tax expenses increased
by $610,950, or 42.40%, in 2005.
For the year ended December 31, 2004, net interest income was $13,799,929
compared to $10,468,526 for the year ended December 31, 2003, an increase of
$3,331,403 or 31.82%. In 2004, the Bank used funds from the issuance of $7
million of trust preferred securities and wholesale borrowing to purchase
certain securities. Provision for loan losses increased by $136,035, or 42.92%
due to an increase in the size of the loan portfolio. Noninterest income
declined as the Bank had a large decline in gains on selling loans held for sale
and a temporary decline in the market value of certain marketable securities,
offset by an increase in service charges. Noninterest expenses increased by
$1,340,648, or 15.91%, to $9,768,419. Increases in noninterest expenses were
primarily the result of increases in salary and employee benefits expenses due
to additional employees. Income tax expense increased by 39.57% to $1,440,994.
NET INTEREST INCOME. The primary component of the Company's net income is its
net interest income, which is the difference between income earned on assets and
interest paid on the deposits and borrowings used to fund them. Net interest
income is determined by the spread between the yields earned on the Company's
interest-earning assets and the rates paid on interest-bearing liabilities as
well as the relative amounts of such assets and liabilities. Net interest
income, divided by average interest-earning assets, represents the Company's net
interest margin.
Net interest income for the year ended December 31, 2005 was $15,571,081
compared to $13,799,929 for the year ended December 31, 2004 and $10,468,526 for
the year ended December 31, 2003. The $1,771,152 increase in the most recent
year was due an increase in interest income of $7,541,373, partially offset by
the increase in interest expense of $5,770,221. For the year ended December 31,
2004, the $3,331,403 increase was due to an increase of $5,448,414 in interest
income offset by an increase of $2,117,011 in interest expense for the same
period. Changes in the components of net interest income due to changes in
average balances of assets and liabilities and to changes caused by changes in
interest rates are presented in the rate volume analysis below.
During 2005, the Company's interest-rate spread declined because the Bank's
yield on interest-earning assets increased at a slower rate than the increase in
costs for interest-bearing liabilities. The Bank's yield on loans increased as
rates on certain loan types, particularly those based on the prime rate,
increased as the Federal Reserve increased short-term interest rates. The
Company's investment securities yields increased at a much slower rate than
loans, as most of the investments are fixed rate, and the Company did not make
significant purchases of investments after the first quarter of 2005. The cost
of both wholesale borrowings and deposits increased from 2004 due to the Federal
Reserve increasing interest rates.
During 2004, the Company's interest-rate spread declined because the Bank's
yield on interest earning assets fell while its cost for interest-bearing
liabilities was the same. The Bank's yield on loans declined due to the
continued pay off of higher interest rate loans in its portfolio. These loans
were generally replaced by lower rate loans. The Bank's investment yield
increased during 2004 as the Bank purchased securities with a longer maturity,
which resulted in a higher yield. While the cost of both deposits and borrowings
fell, the proportion of total interest-bearing liabilities that were represented
by higher cost borrowings increased, leading to a stable average cost in 2004
compared to 2003.
The following table presents information on the average balances of the
Company's interest-earning assets and interest-bearing liabilities and interest
earned or paid thereon for the past three fiscal years.
3
Net Interest Income and Margin Analysis
(Dollars in Thousands)
For the Year Ended December 31,
----------------------------------------------------------------------------------------
2005 2004 2003
---------------------------- --------------------------- ---------------------------
AVERAGE AVERAGE AVERAGE
AVERAGE YIELD/ AVERAGE YIELD/ AVERAGE YIELD/
BALANCE INTEREST COST BALANCE INTEREST COST BALANCE INTEREST COST
------- -------- ----- ------- -------- ------- --------- -------- ----
ASSETS
Interest-earning assets
Loan portfolio(1) $ 332,348 $ 22,358 6.73% $ 254,605 $ 16,033 6.30% $ 201,440 $ 13,412 6.66%
Investment securities, federal
funds sold and interest-bearing
deposits 178,095 6,797 3.82 147,274 5,580 3.79 93,261 2,753 2.95
--------- -------- --------- -------- --------- --------
Total interest-earning assets 510,443 29,155 5.71 401,879 21,613 5.38 294,701 16,165 5.49
Cash and cash equivalents 5,437 2,937 2,648
Other assets 19,262 17,807 10,088
--------- --------- ---------
Total assets $ 535,142 $ 422,623 $ 307,437
========= ========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Interest-bearing liabilities
Savings $ 36,696 $ 216 0.59% $ 37,776 $ 176 0.47 $ 32,772 $ 166 0.51%
Interest-bearing demand and money
market accounts 89,394 1,387 1.55 85,212 755 0.89 67,346 442 0.66
Certificates of deposit 146,512 4,869 3.32 93,267 2,298 2.46 82,248 2,260 2.75
Long-term debt 93,409 3,966 4.25 73,830 3,280 4.44 60,024 2,732 4.55
Short-term debt 82,665 2,565 3.10 64,736 1,164 1.80 7,568 96 1.26
Guaranteed preferred beneficial
interest in junior subordinated
debentures 9,916 581 5.86 3,255 140 4.31 - - -
--------- -------- --------- -------- --------- --------
Total interest-bearing liabilities 458,592 13,584 2.96 358,076 7,813 2.18 249,958 5,696 2.28
Noninterest-bearing demand deposits 39,855 32,909 30,277
Other liabilities 4,474 3,178 1,415
Stockholders' equity 32,221 28,460 25,788
--------- --------- ---------
Total liabilities and
stockholders' equity $ 535,142 $ 422,623 $ 307,438
========= ========= =========
Net interest income $ 15,571 $ 13,800 $ 10,469
======== ======== ========
Interest rate spread 2.75% 3.20% 3.21%
====== ====== ======
Net yield on interest-earning assets 3.05% 3.43% 3.55%
====== ====== ======
Ratio of average interest-earning
assets to average interest-bearing
liabilities 111.31% 112.23% 117.90%
====== ====== ======
(1) Average balance includes non-accrual loans.
4
The table below sets forth certain information regarding changes in interest
income and interest expense of the Bank for the periods indicated. For each
category of interest-earning asset and interest-bearing liability, information
is provided on changes attributable to (1) changes in volume (changes in volume
multiplied by old rate); and (2) changes in rate (changes in rate multiplied by
old volume). Changes in rate-volume (changes in rate multiplied by the change in
volume) have been allocated to changes due to volume.
YEAR ENDED DECEMBER 31, 2005 YEAR ENDED DECEMBER 31, 2004
COMPARED TO YEAR ENDED COMPARED TO YEAR ENDED
DECEMBER 31,2004 DECEMBER 31,2003
DUE TO DUE TO
---------------------------- ----------------------------
VOLUME RATE TOTAL VOLUME RATE TOTAL
------- ------- ------- -------- ------- -------
Interest income
Loan portfolio $ 5,231 $ 1,094 $ 6,325 $ 3,352 $ (731) $ 2,621
Investment securities, federal funds
sold and interest bearing deposits 1,176 41 1,217 2,045 782 2,827
------- ------- ------- -------- ------- -------
Total interest-earning assets 6,407 1,135 7,542 5,397 51 5,448
------- ------- ------- -------- ------- -------
Interest-bearing liabilities
Savings (7) 47 40 23 (13) 10
Interest-bearing demand and money
market accounts 65 567 632 158 155 313
Certificates of deposit 1,770 801 2,571 272 (234) 38
Noninterest-bearing demand deposits
Long-term debt 831 (145) 686 613 (65) 548
Short-term debt 556 845 1,401 1,028 40 1,068
Guaranteed preferred beneficial
interest in junior subordinated
debentures 391 50 441 140 - 140
------- ------- ------- -------- ------- -------
Total interest-bearing
liabilities 3,606 2,165 5,771 2,234 (117) 2,117
------- ------- ------- -------- ------- -------
Net change in net interest income $ 2,801 $(1,030) $ 1,771 $ 3,163 $ 168 $ 3,331
======= ======= ======= ======== ======= =======
PROVISION FOR LOAN LOSSES. Provision for loan losses for the year ended December
31, 2005 was $329,467, compared to $452,998 and $316,963 for the years ended
December 31, 2004 and 2003, respectively. The loan loss provision declined in
2005 as the Bank continued to have excellent results in loan quality measures
such as write-offs and delinquency. For the year ended December 31, 2005, the
Company recorded net charge-offs of $4,000 (.001% of average loans) compared to
net recoveries of $32,000 (.01% of average loans) in 2004 and net charge off of
$58,000 (0.03% of average loans) in 2003. The loan loss allowance and the
provision for loan losses is determined based upon an analysis of individual
loans and the application of certain loss factors to different loan categories.
Individual loans are analyzed for impairment as the facts and circumstances
warrant. In addition, a general component of the loan loss allowance is added
based on a review of the portfolio's size and composition. At December 31, 2005,
the allowance for loan loss equaled 573% of non-accrual and past due loans
compared to 453% and 678% at December 31, 2004 and 2003, respectively.
5
NONINTEREST INCOME.
YEARS ENDED DECEMBER 31, % CHANGE % CHANGE
---------------------------------------- 2005 vs. 2004 vs.
2005 2004 2003 2004 2003
----------- ----------- ----------- ---------- ----------
Loan appraisal, credit, and miscellaneous charges $ 178,424 $ 229,125 $ 261,387 (22.13)% (12.34)%
Net gain on sale of loans held for sale - 21,404 505,435 (100.00) (96.00)
Income from bank owned life insurance 251,220 261,411 230,607 (3.90) 13.36
Service charges 1,186,184 1,189,001 695,128 (0.24) 71.05
Gain on sale of asset 39,756 8,250 - 381.89 -
Loss on the sale of investment securities (14,581) (61,875) - (76.43) -
Recognition of other than temporary decline in
value of marketable securities - (65,000) - (100.00) -
Other - - 61,981 - (100.00)
----------- ----------- -----------
Total noninterest income $ 1,641,003 $ 1,582,316 $ 1,754,538 3.71 % (9.82)%
=========== =========== ===========
Changes in noninterest income over the past three years have been the result of
wide fluctuations in certain noninterest income categories including gain on
sale of loans, other income, service charges, and loan fees. Loan appraisal,
credit and miscellaneous charges are highly variable. Increases and decreases in
this category reflect changes in lending volumes and patterns as well as
competitive pressures. Gain on sale of loans held for sale has been highly
variable reflecting the overall interest rate environment and the Bank's desire
to keep certain loans in its portfolio. Gain on the sale of loans decreased in
2005 due to the Bank's decision to not sell its loans to third party investors
in 2005. Income from bank owned life insurance (BOLI) has been stable in the
last year as BOLI balances have not increased appreciably. BOLI income increased
from 2003 to 2004 as the BOLI purchase was made in 2003 and 2004 reflects a full
year of ownership. Service charges and fees are primarily generated by the
Bank's ability to attract and retain transaction-based deposit accounts and by
loan servicing fees net of amortization of and valuation allowances on mortgage
servicing rights. In 2005, service charges were comparable to the prior year,
reflecting the Bank's higher balances of transaction deposits, offset by lower
balances of loans serviced for others and slightly lower average fees per
transaction deposit reflecting the Bank's response to market pressures to limit
certain transaction fees. In 2004, service charges reflected higher deposit
volumes and lower total amortization of mortgage servicing rights. In 2005, the
smaller loss on the sale of securities reflected a lower volume of sales of
securities in 2005.
NONINTEREST EXPENSES.
YEARS ENDED DECEMBER 31, % CHANGE % CHANGE
------------------------------------------ 2005 vs. 2005 vs.
2005 2004 2003 2004 2004
------------ ----------- ----------- --------- ---------
Salary and employee benefits $ 5,849,226 $ 5,432,898 $ 4,702,181 7.66% 15.54%
Occupancy expense 1,156,775 858,891 750,567 34.68 14.43
Advertising 411,811 539,715 308,951 (23.70) 74.69
Data processing expense 665,981 550,781 403,967 20.92 36.34
Depreciation of furniture, fixtures, and
equipment 452,037 372,237 507,236 21.44 (26.61)
Telephone communications 85,436 103,421 166,553 (17.39) (37.91)
Valuation allowance on foreclosed real
estate - 114,606 - (100.00) -
ATM expenses 277,566 345,454 274,188 (19.65) 25.99
Office supplies 138,407 151,862 131,228 (8.86) 15.72
Professional fees 629,126 261,458 185,188 140.62 41.19
Office equipment expenses 50,318 90,520 129,849 (44.41) (30.29)
Other 1,134,647 946,576 867,863 19.87 9.07
------------ ----------- -----------
Total noninterest expenses $ 10,851,330 $ 9,768,419 $ 8,427,771 11.09% 15.91%
============ =========== ===========
6
The increases reflect growth in the Bank's workforce to fully staff branches, an
increasing need for highly skilled employees due to the higher complexity level
of the Bank's business, and continued increases in the Bank's benefit and
incentive costs. Expenses also included certain supplemental retirement
benefits, which were funded by the BOLI income. In 2005, occupancy expenses
reflected the opening of a new branch as well as continuing repairs and
maintenance to existing locations. In 2004, occupancy expenses reflected the
refurbishment of certain offices and other renovation costs. Advertising
expenses have fluctuated during the three-year period. In 2005, advertising
expenses declined as certain ad campaigns were curtailed. In 2004, advertising
costs reflected several major advertising campaigns and marketing efforts. The
increases in data processing costs are reflective of the Bank's increased size
of the loan and deposit portfolios as well as increases in certain third party
processing costs related to data processing. In 2005, depreciation of furniture,
fixtures, and equipment increased as the Bank opened a new branch requiring
major purchases of these items adding to the amount of assets being depreciated.
In 2004, depreciation declined as certain assets purchased in 2001 and 2002 in
anticipation of the 2002 systems conversion were fully depreciated in early
2004. Telephone communications expenses decreased reflecting changes in vendors
and renegotiation of vendor contracts. In 2004, ATM expenses included costs
relating to a systems conversion, which were nonrecurring. Office supplies
expense decreased in 2005 due to a major overhaul of certain marketing materials
was carried out which increased expenses in 2004. Professional fees including
accounting, legal, consulting and other fees, has increased substantially over
the last three years. These expenses reflected increased levels of outside
resources relating to efforts to prepare the Company for the reporting
requirements of the Sarbanes-Oxley legislation. Substantial resources were also
expended in 2005 and 2004 to provide outsourced internal audit services. Office
equipment expenses decreased as a result of declining needs for certain
specialized equipment, which is no longer needed after our systems conversion.
Other noninterest expense increased due to the growing size of the Bank.
INCOME TAX EXPENSE. During the year ended December 31, 2005, the Company
recorded income tax expense of $2,051,944 compared to expenses of $1,440,994 and
$1,032,432 in the two prior years. The Company's effective tax rates for the
years ended December 31, 2005, 2004, and 2003 were 34.02%, 27.92% and 29.68%,
respectively. The 2005 effective tax rate increased as the 2004 effective rate
reflected a large donation of property made in 2004. The decline in the
effective tax rate from 2003 to 2004 also reflected this donation.
COMPARISON OF FINANCIAL CONDITION AT DECEMBER 31, 2005 AND 2004
In 2005, the Bank used the payments received from the maturation and repayment
of its investment securities portfolio to make loans. The Bank also increased
retail deposits and used the funds to pay down short term wholesale borrowings
as well as to increase earning assets. In 2005, the Company, through a trust
subsidiary, sold trust preferred securities totaling $5,000,000 and invested the
proceeds in the Bank. These proceeds were used primarily to make loans.
In 2005, cash and due from banks increased to $7,262,547 from $6,018,096 in
2004, an increase of $1,244,451 or 20.68%. Interest-bearing deposits with banks
increased by 34.36% or $3,751,711. Due to higher cash operating needs caused by
higher loan activity, the Bank has increased its total cash. Securities
available for sale fell by $5,770,077, or 44.56%, and securities held to
maturity fell by $46,254,470 or 28.42% to $116,486,685. Generally the proceeds
of the maturation and repayment securities in both portfolios were used to make
loans. The Company purchased $25,758,903 of securities during 2005. Total
securities balances decreased by $52,024,547 or 29.61%. Stock in the Federal
Home Loan Bank increased due to stock purchases made necessary by increased
Federal Home Loan Bank borrowing levels. Loans receivable increased by
$80,267,202 or 27.74%, as the Bank continued to build assets in 2005 to increase
net interest income. Loan growth was concentrated in the following loan types:
commercial real estate, residential real estate, commercial business loans and
construction and land development. The growth in these particular types of loans
reflect strong market demand and the Bank's concentration on these areas. Other
lending products such as consumer lending have not been emphasized due to
declining margins brought about by competitors such as captive finance
companies.
Premises and equipment increased to $6,460,545 from $6,011,913 an increase of
7.46% or $448,632. This increase was due to the costs of a new branch and some
renovations at our home office. BOLI increased due to the retention of income in
the policies. Accrued interest receivable increased due to higher interest
7
earning asset balances. Other assets increased to $2,487,280 due to an increase
in certain prepaid tax accounts.
In 2005, total liabilities increased by $32,065,771 or 6.76%. Deposits increased
to $363,373,740 at December 31, 2005 compared to $266,754,504 for the prior
year. Both noninterest and interest-bearing deposit totals increased due to the
Bank's continued marketing efforts. Short-term borrowings declined, as the Bank
replaced short-term borrowings with deposits and long-term debt. The decrease in
short-term borrowing was $95,229,235 or 82.59%. Long-term debt increased by
$24,892,646 or 30.02%. The Company completed a trust preferred issue of
$5,000,000 in 2005. The proceeds were used to increase the Bank's equity and
support a larger asset base.
The Company experienced a $3,454,581, or 11.10%, increase in stockholders'
equity for the year ended December 31, 2005. The increase in stockholders'
equity was attributable to the retention of earnings from the period of
$3,979,343, less cash dividends of $930,669. Equity was also increased by the
exercise of stock options totaling $259,986 as well as by the proceeds of a
private placement totaling $473,040. Other increases included the tax effects of
the exercise of non-incentive stock options of $44,662 and changes in ESOP
shares of $60,389. These increases were partially offset by a decline in
accumulated other comprehensive income of $136,778 and the repurchase of 10,012
shares of common stock (adjusted to reflect the 3-for -2 stock split) at a cost
of $295,393.
ASSET/LIABILITY MANAGEMENT
Net interest income, the primary component of the Company's net income, arises
from the difference between the yield on interest-earning assets and the cost of
interest-bearing liabilities and the relative amounts of such assets and
liabilities. The Company manages its assets and liabilities by coordinating the
levels of and gap between interest-rate sensitive assets and liabilities to
control changes in net interest income and in the economic value of its equity
despite changes in market interest rates.
Among the tools used to monitor interest rate risk is a "gap" report which
measures the dollar difference between the amount of interest-earning assets and
interest-bearing liabilities subject to repricing within a given time period. A
gap is considered negative when the amount of interest rate sensitive
liabilities exceeds the amount of interest rate sensitive assets. Generally,
during a period of rising interest rates, an institution with a negative gap
position would be in a worse position to invest in higher-yielding assets which,
consequently may result in the yield on interest-earning assets increasing at a
slower rate than its cost of interest-bearing liabilities than if it had a
positive gap. While, conversely, during a period of falling interest rates, an
institution with a negative gap would tend to have its interest-earning assets
repricing downward at a slower rate than its interest-rate liabilities as
compared to an institution with a positive gap which, consequently, may tend to
adversely affect net interest income. The following sets forth the amounts of
interest-earning assets and interest-bearing liabilities outstanding at December
31, 2005, which are anticipated by the Company, based on certain assumptions, to
reprice or mature in each of the future time periods shown:
8
OVER OVER ONE OVER
ZERO TO THREE TO THROUGH FIVE NON-SENSITIVE
THREE MONTHS 12 MONTHS FIVE YEARS YEARS FUNDS TOTAL
------------ --------- ---------- -------- ------------- ---------
(DOLLARS IN THOUSANDS)
ASSETS
Cash and due from banks $ - $ - $ - $ - $ 7,263 $ 7,263
Interest-bearing deposits 14,672 - - - - 14,672
Fed funds sold 641 - - - - 641
Securities 51,034 20,923 47,001 4,708 - 123,666
Loans 106,875 26,368 143,865 96,471 (3,987) 369,592
Other assets - - - - 25,453 25,453
---------- -------- --------- ------- --------- --------
Total assets 173,222 47,291 190,866 101,179 28,729 541,287
LIABILITIES
Noninterest-bearing deposits - - - - 44,325 44,325
Interest-bearing demand deposits 48,666 - - - - 48,666
Money market deposits 40,196 - - - - 40,196
Savings 34,801 - - - - 34,801
Certificates of deposit 23,494 104,382 67,479 31 - 195,386
Short-term debt 20,075 - - - 20,075
Long-term debt 5,000 7,000 40,000 55,824 107,824
Guaranteed preferred beneficial
interest in junior
subordinated debentures 12,000 - - - - 12,000
Other liabilities - - - - 3,437 3,437
STOCKHOLDERS' EQUITY - - - - 34,578 34,578
---------- -------- --------- ------- --------- --------
Total liabilities and
stockholders' equity 184,232 111,382 107,479 55,855 82,340 541,287
Gap (11,010) (64,091) 83,387 45,324 (53,611) -
Cumulative gap (11,010) (75,101) 8,286 53,610 - -
Cumulative gap as a percentage of
total assets (2.03)% (13.87)% 1.53% 9.90% - -
The foregoing analysis assumes that the Bank's assets and liabilities move with
rates at their earliest repricing opportunities based on final maturity.
Mortgage-backed securities are assumed to mature during the period in which they
are estimated to prepay and it is assumed that loans and other securities are
not called nor do they prepay prior to maturity. Certificates of deposit and IRA
accounts are presumed to reprice at maturity. NOW and savings accounts are
assumed to reprice within three months although it is the Company's experience
that such accounts may be less sensitive to changes in market rates.
The Bank has an excess of liabilities over assets repricing or maturing within
one year. This would indicate that the Bank's net interest income would decline
if interest rates were to increase. The cumulative one year gap has become less
negative both in dollars and as a percentage of total assets in the last year.
This change was primarily caused by a decline in the Bank's level of funding
provided by short term borrowing. The Bank has also increased the level of
adjustable rate loans on its balance sheet which has also caused a decline in
the negative gap. A decrease in net interest income as a result of a general
increase in rates is likely, but the Bank has the ability to moderate the effect
of a general increase in interest rates by controlling increases in rates on
transaction accounts, using available cash to reduce the amounts in particularly
rate sensitive liability accounts, and increasing total assets through increased
leverage. In addition, the analysis above substantially understates the amount
of loan prepayments the Bank has historically experienced even in periods of
rising interest rates.
9
LIQUIDITY AND CAPITAL RESOURCES
The Company currently has no business other than holding the stock of the Bank
and engaging in certain passive investments and does not currently have any
material funding requirements, except for payment of interest on subordinated
debentures, the payment of dividends and the repurchase of stock. The Company's
principal sources of liquidity are cash on hand and dividends received from the
Bank. The Bank is subject to various regulatory restrictions on the payment of
dividends.
The Bank's principal sources of funds for investment and operations are net
income, deposits from its primary market area, borrowings, principal and
interest payments on loans, interest received on investment securities and
proceeds from the maturity and sale of investment securities. Its principal
funding commitments are for the origination or purchase of loans, the purchase
of securities, and the payment of maturing deposits. Deposits are considered the
primary source of funds supporting the Bank's lending and investment activities.
The Bank also uses borrowings from the FHLB of Atlanta to supplement deposits.
The amount of FHLB advances available to the Bank is limited to the lower of 40%
of Bank assets or the amount supportable by eligible collateral including FHLB
stock, current residential first mortgage loans, and certain securities.
The Bank's most liquid assets are cash, cash equivalents, and federal funds
sold. The levels of such assets are dependent on the Bank's operating, financing
and investment activities at any given time. The variations in levels of cash
and cash equivalents are influenced by deposit flows and anticipated future
deposit flows.
Cash, cash equivalents, and interest-bearing deposits as of December 31, 2005
totaled $22,575,240, an increase of $4,839,461, or 27.43%, from the December 31,
2004 total of $17,715,779. This increase was due to the Bank's increase in
deposits and long-term borrowings.
The Bank's principal sources of cash flows are its financing activities
including deposits and borrowings. During 2005, all financing activities
provided $30,894,663 in cash compared to $149,495,359 during 2004 and
$68,939,687 during 2003. The decrease in cash flows from financing activities
during the most recent period was principally due to a sharp decrease in
borrowing activity in 2005. The proceeds of long-term borrowing remained
constant at $30,000,000 in 2005 compared to $30,000,000 in 2004, and increased
from $15,000,000 in 2003. In 2005, short-term borrowing decreased by
$95,229,235. By contrast, in 2004, short-term borrowing provided a net increase
in cash of $84,112,925 and in 2003, $30,438,987. During 2005, net deposit growth
was $96,619,236 compared to $39,199,936 in 2004, and $24,529,456 in 2003. In
2005, the Company also issued subordinated debentures in the amount of
$5,000,000 compared to $7,000,000 in 2004, the proceeds of which were invested
in the Bank. The Bank also receives cash from its operating activities which
provided $5,242,895 in 2005 compared to cash flows of $6,290,408 and $2,982,991
during 2004 and 2003, respectively.
The Bank's principal use of cash has been in investing activities including its
investments in loans for portfolio, investment securities and other assets. In
2005, the level of investing declined from the totals of 2004 and 2003. During
the year ended December 31, 2005, the Bank invested a total of $31,278,097,
compared to $150,239,788 in 2004 and $85,289,663 in 2003. The principal reason
for the decline in cash used in investing activities was a decrease in the
purchase of investments.
Federal banking regulations require the Company and the Bank to maintain
specified levels of capital. At December 31, 2005, the Company was in compliance
with these requirements with a leverage ratio of 8.55%, a Tier 1 risk-based
capital ratio of 11.04% and total risk-based capital ratio of 11.84%. At
December 31, 2005, the Bank met the criteria for designation as a
well-capitalized depository institution under FRB regulations. See Note 14 of
the consolidated financial statements.
OFF BALANCE SHEET ARRANGEMENTS
In the normal course of its business, the Bank has committed to make credit
available to its borrowers under various loan and other agreements provided that
certain terms and conditions are met. For a discussion of these agreements
including collateral and other arrangements see Note 11 to the consolidated
financial statements.
10
CONTRACTUAL OBLIGATIONS
In the normal course of its business, the Bank commits to make future payments
to others to satisfy contractual obligations. These commitments include
commitments to repay short and long-term borrowings, and commitments incurred
under operating lease agreements. These commitments are summarized below:
PAYMENTS DUE BY PERIOD (IN THOUSANDS)
LESS THAN ONE TO THREE TO MORE THAN
TOTAL ONE YEAR THREE YEARS FIVE YEARS FIVE YEARS
Long term debt obligations $107,824 $ 12,000 $ 5,000 $ 35,000 $ 55,824
Short term debt obligations 20,075 20,075 - - -
Deposits 363,374 295,864 55,688 11,822 -
Purchase obligations 1,729 765 964 - -
Operating lease obligations 1,599 266 464 329 540
-------- -------- -------- -------- --------
$494,601 $328,970 $ 62,116 $ 47,151 $ 56,364
======== ======== ======== ======== ========
IMPACT OF INFLATION AND CHANGING PRICES
The consolidated financial statements and notes thereto presented herein have
been prepared in accordance with generally accepted accounting principles, which
require the measurement of financial position and operating results in terms of
historical dollars without considering the changes in the relative purchasing
power of money over time due to inflation. Unlike most industrial companies,
nearly all of the Company's assets and liabilities are monetary in nature. As a
result, interest rates have a greater impact on the Company's performance than
do the effects of general levels of inflation. Interest rates do not necessarily
move in the same direction or to the same extent as the prices of goods and
services.
11
SELECTED FINANCIAL DATA
YEAR ENDED DECEMBER 31,
----------------------------------------------------------
(DOLLARS IN THOUSANDS EXCEPT PER SHARE DATA)
2005 2004 2003 2002 2001
---------- ---------- ---------- ---------- ----------
OPERATIONS DATA
Net interest income $ 15,571 $ 13,800 $ 10,469 $ 10,745 $ 9,757
Provision for loan losses 329 453 317 160 360
Noninterest income 1,641 1,582 1,755 1,847 1,402
Noninterest expense 10,851 9,768 8,428 9,398 6,995
Net income 3,979 3,720 2,446 1,968 2,486
SHARE DATA
Basic net income per common share $ 2.30 $ 2.16 $ 1.44 $ 1.15 $ 1.44
Diluted net income per common share 2.16 2.07 1.36 1.09 1.38
Cash dividends paid per common share 0.53 0.31 0.24 0.22 0.18
Weighted average common shares
outstanding
Basic 1,731,871 1,719,509 1,696,599 1,713,188 1,725,586
Diluted 1,842,410 1,798,020 1,791,047 1,809,275 1,797,271
FINANCIAL CONDITION DATA
Total assets $ 541,287 $ 505,767 $ 351,730 $ 282,128 $ 261,957
Loans receivable, net 369,592 289,325 217,740 197,449 193,450
Total deposits 363,374 266,755 227,555 203,025 183,117
Long and short term debt 127,899 198,235 94,242 48,922 50,463
Total stockholders' equity 34,578 31,124 27,912 26,873 25,586
PERFORMANCE RATIOS
Return on average assets 0.74% 0.87% 0.78% 0.72% 0.97%
Return on average equity 12.11 12.89 8.99 7.50 10.09
Net interest margin 3.05 3.43 3.55 4.20 4.00
Efficiency ratio 63.04 63.50 68.95 74.73 62.68
Dividend payout ratio 23.39 14.56 17.27 20.04 12.44
CAPITAL RATIOS
Average equity to average assets 8.62 9.29 8.04 9.53 9.64
Leverage ratio 8.62 9.29 8.04 9.53 9.64
Total risk-based capital ratio 11.84 11.89 12.20 13.77 14.08
ASSET QUALITY RATIOS
Allowance for loan losses to total loans 0.91 1.04 1.16 1.15 1.16
Nonperforming loans to total loans 0.16 0.23 0.17 0.30 0.12
Allowance for loan losses to
nonperforming loans 572.96 452.97 678.30 387.60 996.07
Net charge-offs to average loans 0.00 (0.01) 0.03 0.06 0.01
All per share amounts have been adjusted for the three for two stock splits
which were effected in December 2004 and 2005.
12
MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS
MARKET INFORMATION. The following table sets forth high and low bid quotations
reported on the OTC Bulletin for the Company's common stock for each quarter
during 2005 and 2004. These quotes reflect inter-dealer prices without retail
mark-up, mark-down or commission and may not necessarily reflect actual
transactions. All per share amounts have been adjusted to reflect the three for
two stock dividends effected in December 2004 and December 2005.
2004 High Low
------ ------
Fourth Quarter $30.00 $22.33
Third Quarter 21.78 20.91
Second Quarter 25.78 20.22
First Quarter 19.56 18.47
2005 High Low
------ ------
Fourth Quarter $33.43 $30.13
Third Quarter 33.33 28.67
Second Quarter 28.67 27.33
First Quarter 28.00 26.06
HOLDERS. The number of stockholders of record of the Company at March 17, 2006
was 529.
DIVIDENDS. The Company has paid annual cash dividends since 1994. During fiscal
years 2005 and 2004, the Company paid cash dividends of $0.53 and $0.47,
respectively.
The Company's ability to pay dividends is governed by the policies and
regulations of the Federal Reserve Board (the "FRB"), which prohibits the
payment of dividends under certain circumstances dependent on the Company's
financial condition and capital adequacy. The Company's ability to pay dividends
is also depending on the receipt of dividends from the Bank.
Federal regulations impose certain limitations on the payment of dividends and
other capital distributions by the Bank. The Bank's ability to pay dividends is
governed by the Maryland Financial Institutions Code and the regulations of the
FRB. Under the Maryland Financial Institutions Code, a Maryland bank (1) may
only pay dividends from undivided profits or, with prior regulatory approval,
its surplus in excess of 100% of required capital stock and (2) may not declare
dividends on its common stock until its surplus funds equals the amount of
required capital stock, or if the surplus fund does not equal the amount of
capital stock, in an amount in excess of 90% of net earnings.
Without the approval of the FRB, a state member bank may not declare or pay a
dividend if the total of all dividends declared during the year exceeds its net
income during the current calendar year and retained net income for the prior
two years. The Bank is further prohibited from making a capital distribution if
it would not be adequately capitalized thereafter. In addition, the Bank may not
make a capital distribution that would reduce its net worth below the amount
required to maintain the liquidation account established for the benefit of its
depositors at the time of its conversion to stock form.
13
TRI-COUNTY FINANCIAL CORPORATION
REPORT ON AUDITS OF
CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED
DECEMBER 31, 2005, 2004, AND 2003
17
TABLE OF CONTENTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Page
----
CONSOLIDATED FINANCIAL STATEMENTS
Balance Sheets 19
Statements of Income 20
Statements of Changes in Stockholders' Equity 22
Statements of Cash Flows 23
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 25
18
Report of Independent Registered Public Accounting Firm
Board of Directors and Stockholders
Tri-County Financial Corporation
We have audited the accompanying consolidated balance sheets of Tri-County
Financial Corporation as of December 31, 2005 and 2004, and the related
consolidated statements of income, changes in stockholders' equity and cash
flows for each of the three years in the period ended December 31, 2005. These
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.
We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
Tri-County Financial Corporation as of December 31, 2005 and 2004, and the
results of its consolidated operations and cash flows for each of the three
years in the period ended December 31, 2005, in conformity with accounting
principles generally accepted in the United States of America.
/s/ Stegman & Company
Baltimore, Maryland
March 18, 2006
19
TRI-COUNTY FINANCIAL CORPORATION
CONSOLIDATED BALANCE SHEETS
DECEMBER 31,
2005 2004
-------------- --------------
ASSETS
Cash and due from banks $ 7,262,547 $ 6,018,096
Fed funds sold 640,818 777,519
Interest-bearing deposits with banks - at fair value 14,671,875 10,920,164
Securities available for sale 7,178,894 12,948,971
Securities held to maturity at amortized cost (fair value
approximates $114,271,786 and $161,664,754, respectively) 116,486,685 162,741,155
Federal Home Loan Bank and Federal Reserve Bank stock - at cost 7,190,300 6,144,300
Loans receivable - net of allowance for loan losses
of $3,383,334 and $3,057,558, respectively 369,592,253 289,325,051
Premises and equipment, net 6,460,545 6,011,913
Foreclosed real estate 475,561 475,561
Accrued interest receivable 2,406,542 1,870,135
Investment in bank owned life insurance 6,434,175 6,182,955
Other assets 2,487,280 2,351,303
------------- -------------
Total assets $ 541,287,475 $ 505,767,123
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits
Noninterest-bearing $ 44,325,083 $ 35,552,503
Interest-bearing 319,048,657 231,202,001
------------- -------------
Total deposits 363,373,740 266,754,504
Short-term borrowings 20,074,975 115,304,210
Long-term debt 107,823,759 82,931,113
Guaranteed preferred beneficial interest in junior subordinated
debentures 12,000,000 7,000,000
Accrued expenses and other liabilities 3,436,845 2,653,721
------------- -------------
Total liabilities 506,709,319 474,643,548
------------- -------------
Commitments and contingencies (Note 11)
STOCKHOLDERS' EQUITY
Common stock - par value $.01; authorized - 15,000,000 shares;
issued 1,760,991 and 1,146,864 shares, respectively 17,610 11,469
Additional paid in capital 9,057,805 8,252,152
Retained earnings 25,580,634 22,833,112
Accumulated other comprehensive income 49,362 186,140
Unearned ESOP shares (127,255) (159,298)
------------- -------------
Total stockholders' equity 34,578,156 31,123,575
------------- -------------
Total liabilities and stockholders' equity $ 541,287,475 $ 505,767,123
============= =============
See notes to consolidated financial statements
20
TRI-COUNTY FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
YEARS ENDED DECEMBER 31,
2005 2004 2003
------------- ------------- ------------
Interest and dividend income
Loans, including fees $ 22,357,616 $ 16,033,239 $ 13,411,904
Taxable interest and dividends on investment securities 6,707,913 5,551,943 2,688,451
Interest on deposits with banks 89,183 28,157 64,570
------------ ------------ ------------
Total interest and dividend income 29,154,712 21,613,339 16,164,925
------------ ------------ ------------
Interest expense
Deposits 6,472,032 3,229,502 2,868,709
Short-term borrowings 2,564,550 1,163,647 95,707
Long-term debt 4,547,049 3,420,261 2,731,983
------------ ------------ ------------
Total interest expenses 13,583,631 7,813,410 5,696,399
------------ ------------ ------------
Net interest income 15,571,081 13,799,929 10,468,526
Provision for loan losses 329,467 452,998 316,963
------------ ------------ ------------
Net interest income after provision for loan losses 15,241,614 13,346,931 10,151,563
------------ ------------ ------------
Noninterest income
Loan appraisal, credit, and miscellaneous charges 178,424 229,125 261,387
Net gain on sale of loans held for sale - 21,404 505,435
Income from bank owned life insurance 251,220 261,411 230,607
Service charges 1,186,184 1,189,001 695,128
Gain on sale of asset 39,756 8,250 -
Loss on the sale of investment securities (14,581) (61,875) -
Recognition of other than temporary decline in value of marketable
Securities - (65,000)
Other - - 61,981
------------ ------------ ------------
Total noninterest income 1,641,003 1,582,316 1,754,538
------------ ------------ ------------
21
TRI-COUNTY FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
YEARS ENDED DECEMBER 31,
2005 2004 2003
----------- ----------- -----------
Noninterest expense
Salary and employee benefits 5,849,226 5,432,898 4,702,181
Occupancy expense 1,156,775 858,891 750,567
Advertising 411,811 539,715 308,951
Data processing expense 665,981 550,781 403,967
Depreciation of furniture, fixtures, and equipment 452,037 372,237 507,236
Telephone communications 85,436 103,421 166,553
Valuation allowance on foreclosed real estate - 114,606 -
ATM expenses 277,566 345,454 274,188
Office supplies 138,407 151,862 131,228
Professional fees 629,126 261,458 185,188
Office equipment expense 50,318 90,520 129,849
Other 1,134,647 946,576 867,863
----------- ----------- -----------
Total noninterest expenses 10,851,330 9,768,419 8,427,771
----------- ----------- -----------
Income before income taxes 6,031,287 5,160,828 3,478,330
Income tax expense 2,051,944 1,440,994 1,032,432
----------- ----------- -----------
Net income $ 3,979,343 $ 3,719,834 $ 2,445,898
=========== =========== ===========
Earnings per share
Basic $ 2.30 $ 2.16 $ 1.44
Diluted $ 2.16 $ 2.07 $ 1.36
See notes to consolidated financial statements
* Share and per share data have been retroactively adjusted to effect the
three-for-two common stock splits effected on December 22, 2004 and December
12, 2005 as if they had occurred January 1, 2003.
22
TRI-COUNTY FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 2005, 2004, AND 2003
ACCUMULATED
OTHER UNEARNED
COMMON PAID-IN RETAINED COMPREHENSIVE ESOP
STOCK CAPITAL EARNINGS INCOME (LOSS) SHARES TOTAL
--------- ---------- ----------- ------------- --------- -----------
Balance at January 1, 2003 $ 7,598 $7,716,906 $18,817,615 $ 493,691 $(163,045) $26,872,765
Comprehensive income
Net Income - - 2,445,898 - - 2,445,898
Change in unrealized gains (losses) on
investment securities net of tax of $268,756 (496,821) (496,821)
-----------
Total comprehensive income 1,949,077
Cash dividend $0.24 per share (422,361) (422,361)
Excess of fair market value over cost of leveraged ESOP
shares released 39,533 39,533
Exercise of stock options 116 200,435 200,551
Repurchase of common stock (197) (769,522) (769,719)
Net change in unearned ESOP shares 16 23,886 23,902
Tax effect of the exercise of non-ISO stock options - 18,161 - - - 18,161
--------- ---------- ----------- ------------- --------- -----------
Balance at December 31, 2003 7,533 7,975,035 20,071,630 (3,130) (139,159) 27,911,909
Comprehensive income
Net Income 3,719,834 3,719,834
Change in unrealized gains on investment securities
net of tax of $97,503 189,270 189,270
-----------
Total comprehensive income 3,909,104
Cash dividend $0.31 per share (541,633) (541,633)
Excess of fair market value over cost of leveraged ESOP
shares released 28,670 28,670
Exercise of stock options 214 241,261 241,475
Repurchase of common stock (93) (412,880) (412,973)
Net change in unearned ESOP shares (24) (20,139) (20,163)
Three for two stock split in the form of a dividend 3,839 (3,839) -
Tax effect of the exercise of non-ISO stock options - 7,186 - - - 7,186
--------- ---------- ----------- ------------- --------- -----------
Balance at December 31, 2004 11,469 8,252,152 22,833,112 186,140 (159,298) 31,123,575
Comprehensive income
Net Income 3,979,343 3,979,343
Change in unrealized gains on investment securities
net of tax of $70,460 (136,778) (136,778)
-----------
Total comprehensive income 3,842,565
Cash dividend $0.53 per share (930,669) (930,669)
Excess of fair market value over cost of leveraged ESOP
shares released 28,354 28,354
Exercise of stock options 231 259,755 259,986
Proceeds of private placement 158 472,882 473,040
Net change in unearned ESOP shares (7) 32,043 32,036
Repurchase of common stock (60) (295,333) (295,393)
Three for two stock split in the form of a dividend 5,819 (5,819) -
Tax effect of the exercise of non-ISO stock options - 44,662 - - - 44,662
--------- ---------- ----------- ------------- --------- -----------
Balance at December 31, 2005 $ 17,610 $9,057,805 $25,580,634 $ 49,362 $(127,255) $34,578,156
========= ========== =========== ============= ========= ===========
All per share amounts have been adjusted for stock split. See notes to
consolidated financial statements.
23
TRI-COUNTY FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31
2005 2004 2003
------------- ------------- -------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 3,979,343 $ 3,719,834 $ 2,445,898
Adjustments to reconcile net income to net
cash provided by operating activities:
Valuation allowance on foreclosed real estate - 114,606 -
Provision for loan losses 329,467 452,998 316,963
Loss on sale of investment security 14,581 126,875 -
Depreciation and amortization 811,866 636,711 663,134
Net amortization of premium/discount on mortgage-backed
securities and investments 341,858 116,256 447,503
Increase in cash surrender of bank owned life insurance (251,220) (261,411) (221,544)
Deferred income tax expense (benefit) (452,351) 65,850 (22,219)
Increase in accrued interest receivable (536,407) (551,817) (275,865)
Increase (decrease) in deferred loan fees (160,660) 114,618 (17,849)
Increase (decrease) in accrued expenses and other liabilities 783,124 349,818 (1,332,467)
Decrease in other assets 386,834 906,843 179,439
Loss (gain) on disposal of premises and equipment 36,216 (8,250) 12,241
Origination of loans held for sale - - (16,792,123)
Proceeds from sale of loans held for sale - 496,284 18,085,314
Loss (gain) on sale of other real estate owned (39,756) 32,597 -
Gain on sales of loans held for sale - (21,404) (505,434)
------------- ------------- -------------
Net cash provided by operating activities 5,242,895 6,290,408 2,982,991
------------- ------------- -------------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of investment securities available for sale (9,655) (27,944,571) (65,726,882)
Proceeds from sale, redemption or principal payments of
investment securities available for sale 5,540,515 53,031,692 67,772,952
Purchase of investment securities held to maturity (25,749,248) (143,349,900) (64,384,597)
Proceeds from maturities or principal payments of investment
securities held to maturity 71,679,258 42,511,543 5,898,120
Net purchase of FHLB and Federal Reserve stock (1,046,000) (1,367,450) (2,040,100)
Loans originated or acquired (202,475,708) (192,785,961) (172,289,356)
Principal collected on loans 122,039,699 120,633,447 151,699,369
Purchase of premises and equipment (1,296,714) (1,068,435) (528,169)
Proceeds from disposal of premises and equipment - 8,250 9,000
Purchase of bank owned life insurance policies - - (5,700,000)
Sale of foreclosed real estate 39,756 91,597 -
------------- ------------- -------------
Net cash used in investing activities (31,278,097) (150,239,788) (85,289,663)
------------- ------------- -------------
See notes to consolidated financial statements.
24
TRI-COUNTY FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31
2005 2004 2003
------------- ------------- -------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in deposits 96,619,236 39,199,936 24,529,456
Net (decrease) increase in short-term borrowings (95,229,235) 84,112,925 30,438,987
Dividends paid (930,669) (541,633) (422,361)
Exercise of stock options 304,648 248,661 218,712
Proceeds from private placement of common stock 473,040 - -
Net change in unearned ESOP shares 60,390 8,508 63,436
Repurchase of common stock (295,393) (412,973) (769,719)
Proceeds from long-term borrowings 30,000,000 30,000,000 15,000,000
Payments of long-term borrowings (5,107,354) (10,120,063) (118,824)
Proceeds from issuance of trust preferred debentures 5,000,000 7,000,000 -
------------- ------------- -------------
Net cash provided by financing activities 30,894,663 149,495,361 68,939,687
------------- ------------- -------------
Increase (decrease) in Cash and Cash Equivalents 4,859,461 5,545,981 (13,366,985)
Cash and Cash Equivalents at Beginning of Year 17,715,779 12,169,798 25,536,783
------------- ------------- -------------
Cash and Cash Equivalents at End of Year $ 22,575,240 $ 17,715,779 $ 12,169,798
============= ============= =============
Supplementary Cash Flow Information
Cash paid during the year for
Interest $ 13,503,581 $ 7,784,244 $ 5,647,280
Income taxes 2,032,500 1,232,500 1,715,369
See notes to consolidated financial statements.
25
TRI-COUNTY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2005, 2004, AND 2003
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of Tri-County
Financial Corporation and its wholly owned subsidiaries, Community Bank of
Tri-County (the "Bank"), Tri-County Capital Trust I and Tri-County Capital Trust
II, and the Bank's wholly owned subsidiaries, Tri-County Investment Corporation
and Community Mortgage Corporation of Tri-County (collectively, the "Company").
All significant intercompany balances and transactions have been eliminated in
consolidation. The accounting and reporting policies of the Company conform with
accounting principles generally accepted in the United States of America and to
general practices within the banking industry. Certain reclassifications have
been made to amounts previously reported to conform with classifications made in
2005.
NATURE OF OPERATIONS
The Company provides a variety of financial services to individuals and small
businesses through its offices in southern Maryland. Its primary deposit
products are demand, savings, and time deposits and its primary lending products
are consumer and commercial mortgage loans and commercial loans.
USE OF ESTIMATES
In preparing consolidated financial statements in conformity with accounting
principles generally accepted in the United States of America, management is
required to make estimates and assumptions that affect the reported amounts of
assets and liabilities as of the date of the balance sheet and reported amounts
of revenues and expenses during the reporting period. Actual results could
differ from those estimates. Material estimates that are particularly
susceptible to significant change in the near term relate to the determination
of the allowance for loan losses, the valuation of foreclosed real estate, and
deferred tax assets.
SIGNIFICANT GROUP CONCENTRATIONS OF CREDIT RISK
Most of the company's activities are with customers located in the Southern
Maryland area comprising St. Mary's, Charles and Calvert counties. Note 3
discusses the types of securities held by the Company. Note 4 discusses the type
of lending in which the Company is engaged. The Company does not have any
significant concentration to any one customer or industry.
CASH AND CASH EQUIVALENTS
For purposes of the consolidated statements of cash flows, the Company considers
all highly liquid debt instruments with original maturities of three months or
less when purchased to be cash equivalents.
SECURITIES
Debt securities that management has the positive intent and ability to hold to
maturity are classified as "held to maturity" and recorded at amortized cost.
Securities not classified as held to maturity or trading, including equity
securities with readily determinable fair values are classified as "available
for sale" and recorded at estimated fair value, with unrealized gains and losses
excluded from earnings and reported in other comprehensive income.
Purchase premiums and discounts are recognized in interest income using the
interest method over the terms of the securities. Declines in the estimated fair
value of held to maturity and available for sale securities below their cost
that are deemed to be other than temporary are reflected in earnings as realized
losses. In estimating other than temporary impairment losses, management
considers (1) the length of time and the extent to which the fair value has been
less than cost, (2) the financial condition and near term prospects of the
issuer, and (3) the intent and ability of the Company to retain its investment
in the issuer for a period of time sufficient to allow for any anticipated
recovery in fair value. Gains and losses on the sale of securities are recorded
on the trade date and are determined using the specific identification method.
Investment in Federal Reserve Bank and Federal Home Loan Bank of Atlanta stock
are recorded at cost and are considered restricted as to marketability. The Bank
is required to maintain investments in the Federal Reserve Bank and Federal Home
Loan Bank based upon levels of financial activity.
LOANS HELD FOR SALE
Loans originated and intended for sale in the secondary market are carried at
the lower of cost or estimated fair value, in the aggregate. Net unrealized
losses, if any, are recognized through a valuation allowance by charges to
income.
Mortgage loans held for sale are generally sold with the mortgage servicing
rights retained by the Company. The carrying value of mortgage loans sold is
reduced by the cost allocated to the associated servicing rights. Gains or
losses on sales of mortgage loans are recognized based on the difference between
the selling price and the carrying value of the related mortgage loans sold,
using the specific identification method.
26
LOANS
The Company originates mortgage, commercial, and consumer loans to customers. A
substantial portion of the loan portfolio is represented by loans throughout
southern Maryland. The ability of the Company's debtors to honor their contracts
is dependent upon the real estate and general economic conditions in this area.
Loans that management has the intent and ability to hold for the foreseeable
future or until maturity or payoff are reported at their outstanding unpaid
principal balances adjusted for the allowance for loan losses and any deferred
fees or costs on originated loans. Interest income is accrued on the unpaid
principal balance. Loan origination fees, net of certain direct origination
costs, are deferred and recognized as an adjustment of the related loan yield
using the interest method.
The accrual of interest on mortgage and commercial loans is discontinued at the
time the loan is 90 days delinquent unless the credit is well secured and in the
process of collection. Consumer loans are charged-off no later than 180 days
past due. In all cases, loans are placed on non-accrual or charged-off at an
earlier date if collection of principal or interest is considered doubtful.
All interest accrued but not collected from loans that are placed on non-accrual
or charged-off is reversed against interest income. The interest on these loans
is accounted for on the cash-basis or cost-recovery method, until qualifying for
return to accrual. Loans are returned to accrual status when all principal and
interest amounts contractually due are brought current and future payments are
reasonably assured.
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is established as probable losses are estimated to
have occurred through a provision for loan losses charged to earnings. Loan
losses are charged against the allowance when management believes that the
uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any,
are credited to the allowance.
The allowance for loan losses is evaluated on a regular basis by management and
is based upon management's periodic review of the collectibility of the loans in
light of historical experience, the nature and volume of the loan portfolio,
adverse situations that may affect the borrower's ability to repay, estimated
value of any underlying collateral and prevailing economic conditions. This
evaluation is inherently subjective as it requires estimates that are
susceptible to significant revision as more information becomes available.
The allowance for loan losses consists of a specific component and a general
component. The specific component relates to loans that are classified as either
doubtful, substandard, or special mention. For such loans that are also
classified as impaired, an allowance is established when the discounted cash
flows (or collateral value or observable market price) of the impaired loan is
lower than carrying value of that loan. The general component covers the
non-classified loans and is based on historical loss experience, peer group
comparisons, industry data and loss percentages used for similarly graded loans
adjusted for qualitative factors.
A loan is considered impaired when, based on current information and events, it
is probable that the Company will be unable to collect the scheduled payments of
principal or interest when due according to the contractual terms of the loan
agreement. Factors considered by management in determining impairment include
payment status, collateral value and the probability of collecting scheduled
principal and interest payments when due. Loans that experience insignificant
payment delays and payment shortfalls generally are not classified as impaired.
Management determines the significance of payment delays and payment shortfalls
on a case-by-case basis, taking into consideration all of the circumstances
surrounding the loan and the borrower, including the length of the delay, the
reasons for the delay, the borrower's prior payment record, and the amount of
the shortfall in relation to the principal and interest owed. Impairment is
measured on a loan by loan basis for commercial and construction loans by either
the present value of expected future cash flows discounted at the loan's
effective interest rate, the loan's observable market price, or the fair value
of the collateral if the loan is collateral dependent.
Large groups of smaller homogeneous loans are collectively evaluated for
impairment. Accordingly, the Company does not separately identify individual
consumer and residential loans for impairment disclosures, unless such loans are
the subject of a restructuring agreement.
SERVICING
Servicing assets are recognized as separate assets when rights are acquired
through purchase or through the sale of financial assets. Generally, purchased
servicing rights are capitalized at the cost to acquire the rights. For sales of
mortgage loans, a portion of the cost of originating the loan is allocated to
the servicing based on relative estimated fair value. Estimated fair value is
based on market prices for comparable mortgage servicing contracts, when
available, or alternatively, is based on a valuation model that calculates the
present value of estimated future net servicing. The valuation model
incorporates assumptions that market participants would use in estimating future
net servicing income, such as the cost to service, the discount rate, an
inflation rate, ancillary income, prepayment speeds and default rates and
losses. Capitalized servicing rights are reported in other assets and are
amortized into noninterest income in proportion to, and over the period of, the
estimated future net servicing income of the underlying financial assets.
Servicing assets are evaluated for impairment based upon the estimated fair
value of the rights as compared to amortized cost. Impairment is determined by
stratifying rights into tranches based on predominant risk characteristics, such
as interest rate, loan type and investor type. Impairment is recognized through
a valuation allowance for an individual tranche, to the extent that fair value
is less than the capitalized amount for the tranche. If the Company later
determines that all or a portion of the impairment no longer exists for a
particular tranche, a reduction of the allowance may be recorded as an increase
to income.
27
Servicing fee income is recorded for fees earned for servicing loans. The fees
are based on a contractual percentage of the outstanding principal; or a fixed
amount per loan and recorded as income when earned. The amortization of mortgage
servicing rights is netted against loan servicing fee income.
PREMISES AND EQUIPMENT
Land is carried at cost. Premises and improvements and equipment are carried at
cost, less accumulated depreciation and amortization computed by the
straight-line method over the estimated useful lives of the assets, which are as
follows
Buildings and improvements 10 - 50 years
Furniture and equipment 3 - 15 years
Automobiles 5 years
Maintenance and repairs are charged to expense as incurred while improvements
that extend the useful life of premises and equipment are capitalized.
FORECLOSED REAL ESTATE
Assets acquired through, or in lieu of, loan foreclosure are held for sale and
are initially recorded at the lower of cost or estimated fair value at the date
of foreclosure, establishing a new cost basis. Subsequent to foreclosure,
valuations are periodically performed by management and the assets are carried
at the lower of carrying amount or estimated fair value less cost to sell.
Revenue and expenses from operations and changes in the valuation allowance are
included in noninterest expense.
TRANSFERS OF FINANCIAL ASSETS
Transfers of financial assets are accounted for as sales, when control over the
assets has been surrendered. Control over transferred assets is deemed to be
surrendered when (1) the assets have been isolated from the Company, (2) the
transferee obtains the right (free of conditions that constrain it from taking
advantage of that right) to pledge or exchange the transferred assets, and (3)
the Company does not maintain effective control over the transferred assets
through an agreement to repurchase them before their maturity.
ADVERTISING COSTS
The Company expenses advertising costs as incurred.
INCOME TAXES
The Company files a consolidated federal income tax return with its
subsidiaries. Deferred tax assets and liabilities are determined using the
liability (or balance sheet) method. Under this method, the net deferred tax
asset or liability is determined based on the tax effects of the temporary
differences between the book and tax bases of the various balance sheet assets
and liabilities and gives current recognition to changes in tax rates and laws.
OFF BALANCE SHEET CREDIT RELATED FINANCIAL INSTRUMENTS
In the ordinary course of business, the Company has entered into commitments to
extend credit, including commitments under commercial lines of credit, letters
of credit, and standby letters of credit. Such financial instruments are
recorded when they are funded.
STOCK-BASED COMPENSATION
Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock
Based Compensation, encourages all entities to adopt a fair value based method
of accounting for employee stock compensation plans, whereby compensation cost
is measured at the grant date based on the value of the award and is recognized
over the service period, which is usually the vesting period. However, it also
allows an entity to continue to measure compensation cost for these plans using
the intrinsic value based method of accounting prescribed by Accounting
Principles Board Opinion No. 25, Accounting for Stock Issued to Employees,
whereby compensation cost is the excess, if any, of the quoted market price of
the stock at the grant date (or other measurement date) over the amount an
employee must pay to acquire the stock. The Company has elected to continue with
the accounting methodology in Opinion No. 25. Stock options issued under the
Company's stock option plans have no intrinsic value at the grant date, and
under Opinion No. 25 no compensation cost is recognized for them.
However, SFAS No. 123 was revised as SFAS No. 123R in December 2004. This
revision is discussed further in the "Recent Accounting Pronouncements" section
of this Note.
At December 31, 2005, the Company maintains stock-based compensation plans,
which are more fully described in Note 12. Had compensation cost for the
Company's stock option plans been determined based on the fair value based
method of accounting at the grant dates for awards under the plan consistent
with the method prescribed by SFAS No. 123, the Company's net income and
earnings per share would have been adjusted to the pro forma amounts indicated
below:
28
YEARS ENDED DECEMBER 31,
2005 2004 2003
------------- ------------- -------------
Net income, as reported $ 3,979,343 $ 3,719,834 $ 2,445,898
Additional expense had the Company adopted SFAS 123R (942,297) (735,180) (141,000)
------------- ------------- -------------
Pro forma net income $ 3,037,046 $ 2,984,654 $ 2,304,898
============= ============= =============
Earnings per share as reported
Basic $ 2.30 $ 2.16 $ 1.44
Diluted $ 2.16 $ 2.07 $ 1.36
Pro forma earnings per share
Basic $ 1.75 $ 1.73 $ 1.35
Diluted $ 1.65 $ 1.66 $ 1.29
Per share amounts have been adjusted retroactively to reflect the three for two
stock splits in December 2004 and December 2005.
For the purpose of computing the pro forma amounts indicated above, the fair
value of each option on the date of grant is estimated using the Black-Scholes
option pricing model with the following weighted-average assumptions used for
the grants:
2005 2004 2003
------ ------ ------
Dividend yield 1.02% 1.80% 2.17%
Expected volatility 34.89 25.51 17.24
Risk-free interest rate 4.66 4.31 4.29
Expected lives (in years) 10 10 10
Weighted average fair value $15.83 $ 8.45 $ 6.81
EARNINGS PER COMMON SHARE
Basic earnings per common share represents income available to common
stockholders divided by the weighted average number of common shares outstanding
during the period. Diluted earnings per share reflects additional common shares
that would have been outstanding if dilutive potential common shares had been
issued, as well as any adjustment to income that would result from the assumed
issuance. Potential common shares that may be issued by the Company relate
solely to outstanding stock options and are determined using the treasury stock
method. In 2005 and 2004 there were 59,526 and 69,407 options with an exercise
price that exceeded the current market price, which were excluded from the
calculation as their effect would be anti-dilutive.
Earnings per common share have been computed based on the following:
YEARS ENDED DECEMBER 31,
2005 2004 2003
---------- ---------- ----------
Net Income $3,979,343 $3,719,834 $2,445,898
========== ========== ==========
Average number of common shares outstanding 1,731,871 1,719,509 1,696,599
Effect of dilutive options 110,539 78,512 94,449
---------- ---------- ----------
Average number of shares used to
calculate earnings per share outstanding 1,842,410 1,798,020 1,791,048
========= ========= =========
The numbers of common shares outstanding have been adjusted to give retroactive
effect to the three for two stock splits in December 2004 and 2005.
COMPREHENSIVE INCOME
Accounting principles generally require that recognized revenue, expenses, gains
and losses be included in net income. Although certain changes in assets and
liabilities, such as unrealized gains and losses on available for sale
securities, are reported as a separate component of the equity section of the
balance sheet, such items, along with net income, are components of
comprehensive income.
29
The components of other comprehensive income and related tax effects are as
follows:
YEARS ENDED DECEMBER 31,
2005 2004 2003
----------- ----------- -----------
Net Income $ 3,979,343 $ 3,719,834 $ 2,445,898
Other comprehensive income items
Unrealized holding (losses) gains on available for sale
securities net of tax expense (benefit) of $(75,419),
$74,465, and $(268,756), respectively (146,110) 148,473 (496,821)
Plus: reclassification adjustment for losses net of tax benefit
of $5,249 and $21,038 respectively. 9,332 40,797 -
----------- ----------- -----------
Total other comprehensive income $ (136,778) $ 189,270 $ (496,821)
----------- ----------- -----------
Total comprehensive income $ 3,842,565 $ 3,909,104 $ 1,949,077
----------- ----------- -----------
The components of accumulated other comprehensive income, included in
stockholders' equity are as follows:
DECEMBER 31,
2005 2004 2003
--------- --------- ---------
Net unrealized gains (losses) on securities available for sale $ 74,793 $ 282,031 $ 4,741
Tax effect (25,431) (95,891) (1,612)
--------- --------- ---------
Net of tax amount $ 49,362 $ 186,140 $ 3,129
========= ========= =========
RECENT ACCOUNTING PRONOUNCEMENTS
In January 2005, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 123R, Share-Based Payment (Revised 2004), which establishes standards for
accounting for transactions in which an entity (i) exchanges its equity
instruments for goods and services, or (ii) incurs liabilities in exchange for
goods and services that are based on an entity's equity instruments or that may
be settled by the issuance of equity instruments. SFAS 123R eliminates the
ability to account for stock-based compensation using Accounting Principles
Board ("APB") No. 25 and requires that such transactions be recognized as
compensation cost in the income statement based on their fair values on the date
of the grant. SFAS 123R is effective for fiscal periods beginning after December
15, 2005. The Company will transition to fair value-based compensation using a
modified version of the prospective application, which means the fair
value-based method prescribed under SFAS 123R will apply to new awards,
modification of previous awards, repurchases and cancellations after January 1,
2006. Additionally, compensation cost for awards for which requisite service has
not been rendered, (non-vested options of stock grants) that are outstanding as
of December 31, 2005 must be recognized as the remaining requisite service is
rendered during the period of and/or the periods after the adoption of SFAS
123R. The Company has no such awards outstanding as of December 31, 2005. Future
levels of compensation expense related to stock-based compensation may be
impacted by new awards, modifications, repurchases or cancellations of existing
awards both before and after the adoption of this standard.
In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets,
an amendment of APB No. 29, Accounting for Nonmonetary Transactions. This
statement amends the principle that exchanges of nonmonetary assets should be
measured based on the fair value of the assets exchanged and more broadly
provides for exceptions regarding exchanges occurring in fiscal periods
beginning after June 15, 2005. The adoption of this standard did not have a
material impact on the Company's financial condition, results of operations, or
liquidity.
In March 2004, the FASB Emerging Issues Task Force (EITF) released Issue 03-01,
Meaning of Other Than Temporary Impairment, which addressed other-than-temporary
impairment for certain debt and equity investments. The recognition and
measurement requirements of Issue 03-01, and other disclosure requirements not
already implemented, were effective for periods after June 15, 2004. In
September 2004, the FASB staff issued FASB Staff Position ("FSP") EITF 03-01-1,
which delayed the effective date for certain measurement and recognition
guidance during the period of delay until a final consensus is reached. We do
not anticipate the issuance of the final rules will have a material impact on
the Company's financial condition, results of operations or liquidity.
In June of 2005, the Financial Accounting Standards Board (FASB) issued
Statement No. 154 (SFAS 154), "Accounting Changes and Error Corrections", a
replacement of APB No. 20, "Accounting Changes" and FASB Statement No. 3,
"Reporting Accounting Changes in Interim Financial Statements". SFAS 154 applies
to all voluntary changes in accounting principle and changes the requirements
for accounting for, and reporting of, a change in accounting principle.
Previously, most voluntary changes in accounting principles were required to be
recognized by way of a cumulative effect adjustment within net income during the
period of the change. SFAS 154 requires retrospective application to prior
periods' financial statements, unless it is impracticable to determine either
the period specific effects or the cumulative effect of the change. SFAS 154 is
effective for accounting changes and corrections of errors made in fiscal years
beginning after December 15, 2005. The
30
implementation of FAS 154 is not expected to have a material impact on the
Company's consolidated financial statements.
NOTE 2 - RESTRICTIONS ON CASH AND AMOUNTS DUE FROM BANK
The Bank is required to maintain average balances on hand or with the Federal
Reserve Bank. At December 31, 2005 and 2004, these reserve balances amounted to
$4,359,000 and $4,045,000, respectively.
NOTE 3 - INVESTMENT SECURITIES
The amortized cost and estimated fair values of securities with gross unrealized
losses and gains are as follows
DECEMBER 31, 2005
-----------------
GROSS
AMORTIZED UNREALIZED GROSS UNREALIZED ESTIMATED
COST GAINS LOSSES FAIR VALUE
------------ ------------ ---------------- ------------
Securities available for sale
Asset-backed securities issued by GSEs $ 6,494,335 $ 42,077 $ 203,717 $ 6,332,695
Corporate equity securities 481,010 239,338 1,000 719,348
Bond mutual funds 128,756 - 1,905 126,851
------------ ------------ ------------ ------------
Total securities available for sale $ 7,104,101 $ 281,415 $ 206,622 $ 7,178,894
============ ============ ============ ============
Securities held-to-maturity
Asset-backed securities issued by
GSEs $ 78,001,293 $ 182,831 $ 1,777,533 $ 76,406,591
Other 37,382,662 53,007 673,204 36,762,465
------------ ------------ ------------ ------------
Total debt securities held-to-maturity 115,383,955 235,838 2,450,737 113,169,056
U.S. Government obligations 499,091 - - 499,091
Other investments 603,639 - - 603,639
------------ ------------ ------------ ------------
Total securities held-to-maturity $116,486,685 $ 235,838 $ 2,450,737 $114,271,786
============ ============ ============ ============
December 31, 2004
-----------------
Amortized Gross Unrealized Gross Unrealized Estimated
Cost Gains Losses Fair Value
------------ ---------------- ---------------- ------------
Securities available for sale
Asset-backed securities issued by GSEs $ 11,543,520 $ 113,741 $ 104,584 $ 11,552,677
Corporate equity securities 481,010 290,467 5,000 766,477
Bond mutual funds 642,408 - 12,591 629,817
------------ ------------ ------------ ------------
Total securities available for sale $ 12,666,938 $ 404,208 $ 122,175 $ 12,948,971
============ ============ ============ ============
Securities held-to-maturity
Asset-backed securities issued by
GSEs $108,862,740 $ 127,154 $ 1,275,511 $107,714,383
Other 51,796,259 350,848 234,149 51,912,958
------------ ------------ ------------ ------------
Total debt securities held-to-maturity 160,658,999 478,002 1,509,660 159,627,341
U.S. Government obligations 301,181 - 726 300,455
Other investments 1,780,975 - 44,017 1,736,958
------------ ------------ ------------ ------------
Total securities held-to-maturity $162,741,155 $ 478,002 $ 1,554,403 $161,664,754
============ ============ ============ ============
Other investments consist of certain certificate of deposit strip instruments
whose fair value is based on market returns on similar risk and maturity
instruments because no active market exists for these instruments. At December
31, 2005, U.S. government obligations with a carrying value of $499,091 were
pledged to secure municipal deposits. In addition, at December 31, 2005, certain
other securities with a carrying value of $4,731,000 were pledged to secure
certain deposits. At December 31, 2005, securities with a carrying value of
$53,987,000 were pledged as collateral for advances from the Federal Home Loan
Bank of Atlanta.
31
Gross unrealized losses and estimated fair value by length of time that the
individual available-for-sale securities have been in a continuous unrealized
loss position at December 31, 2005 are as follows
CONTINUOUS UNREALIZED LOSSES EXISTING FOR
------------------------------------------------------
LESS THAN 12 MORE THAN 12 TOTAL UNREALIZED
FAIR VALUE MONTHS MONTHS LOSSES
---------- ------------ ------------ ----------------
Asset-backed securities issued by GSE's $5,562,030 $ 66,646 $ 137,071 $ 203,717
Corporate equity securities 434,000 - 1,000 1,000
Bond mutual funds 91,013 - 1,905 1,905
---------- ---------- ---------- ----------
$6,087,043 $ 66,646 $ 139,976 $ 206,622
========== ========== ========== ==========
The available-for-sale investment portfolio has a fair value of $7,178,894 of
which $6,087,043 of the securities have some unrealized losses from their
amortized cost. Of these securities, $5,562,030, or 92%, are mortgage-backed
securities issued by GSEs, $91,013 or 1% are short duration mutual fund shares,
and $434,000 or 7% are equity securities. The unrealized losses that exist in
the mortgage-backed securities and mutual fund shares are the result of market
changes in interest rates since the original purchase.
The mutual fund shares have a modest duration and are backed by one year
adjustable-rate mortgage-backed securities. The asset-backed securities have an
average duration of 3.3 years and are guaranteed by their issuer as to credit
risk. Total unrealized losses on these investments are small (approximately 3%).
We believe that the losses in the equity securities are temporary. Persistent
losses may require a reevaluation of these losses. These factors coupled with
the fact the Company has both the intent and ability to hold these investments
for a period of time sufficient to allow for any anticipated recovery in fair
value substantiates that the unrealized losses in the available-for-sale
portfolio are temporary.
Gross unrealized losses and estimated fair value by length of time that the
individual held-to-maturity securities have been in a continuous unrealized loss
position at December 31, 2005 are as follows
CONTINUOUS UNREALIZED LOSSES EXISTING FOR
--------------------------------------------------------
LESS THAN 12 MORE THAN 12 TOTAL UNREALIZED
FAIR VALUE MONTHS MONTHS LOSSES
----------- ------------ ------------ ----------------
Asset-backed securities issued by GSE's $57,693,786 $ 271,336 $ 1,506,197 $ 1,777,533
Asset-backed securities issued by other 34,302,722 307,172 366,032 673,204
----------- ----------- ----------- -----------
$91,996,508 $ 578,508 $ 1,872,229 $ 2,450,737
=========== =========== =========== ===========
The held-to-maturity investment portfolio has an estimated fair value of
$114,271,786 of which $91,996,508 of the securities have some unrealized losses
from their purchase price. Of these securities, $57,693,786 or 63%, are
mortgage-backed securities issued by GSE's and the remainder, or $34,302,722,
are mortgage-backed securities issued by others. The asset-backed securities
have a duration of approximately four years, are guaranteed as to payment by the
issuer, and have minimal losses compared to carrying value (approximately 2.6%).
The unrealized losses that exist are the result of market changes in interest
rates since the original purchase. These factors coupled with the Company's
intent and ability to hold these investments for a period of time sufficient to
allow for any anticipated recovery in fair value substantiates that the
unrealized losses in the held-to-maturity portfolio are temporary.
The amortized cost and estimated fair value of debt securities at December 31,
2005, by contractual maturity, are shown below. Expected maturities will differ
from contractual maturities because the issuers of the securities may have the
right to prepay obligations without prepayment penalties.
AVAILABLE FOR SALE HELD TO MATURITY
---------------------------------------------------------
ESTIMATED ESTIMATED
AMORTIZED FAIR AMORTIZED FAIR
COST VALUE COST VALUE
------------ ------------ ------------ ------------
Within one year $ 128,756 $ 126,851 $ 958,292 $ 958,292
Over one year through five years - - 144,438 144,438
Over five years through ten years - - - -
------------ ------------ ------------ ------------
128,756 126,851 1,102,730 1,102,730
Mortgage-backed securities 6,494,335 6,332,695 115,383,955 113,169,056
------------ ------------ ------------ ------------
$ 6,623,091 $ 6,459,546 $116,486,685 $114,271,786
============ ============ ============ ============
32
Total sales of investments available for sale during 2005 and 2004 were
$1,350,000 and $36,900,000, these sales produced a net loss of $14,582 and
$61,875. There were no sales of investment securities available for sale during
2003. Asset-backed securities are comprised of mortgage-backed securities as
well as mortgage-derivative securities such as collateralized mortgage
obligations and real estate mortgage investment conduits.
NOTE 4 - LOANS RECEIVABLE AND ALLOWANCE FOR LOAN LOSSES
A summary of the balances of loans are as follows
2005 2004
------------ ------------
Commercial real estate $166,850,838 $136,341,597
Residential first mortgages 73,627,717 59,087,000
Construction and land development 32,608,002 17,597,911
Home equity and second mortgage 25,884,406 23,925,108
Commercial loans 54,737,693 39,136,778
Consumer loans 3,128,425 3,462,613
Commercial equipment 16,742,220 13,595,978
------------ ------------
373,579,301 293,146,983
------------ ------------
Less
Deferred loan fees, net 603,714 764,374
Allowance for loan loss 3,383,334 3,057,558
------------ ------------
3,987,048 3,821,932
------------ ------------
$369,592,253 $289,325,051
============ ============
An analysis of the allowance for loan losses follows
2005 2004 2003
---------- ---------- ----------
Balance January 1, $3,057,558 $2,572,799 $2,314,074
Add
Provision charged to operations 329,466 452,998 316,963
Recoveries 5,185 49,083 2,445
Less
Charge-offs 8,875 17,322 60,684
---------- ---------- ----------
Balance as of December 31 $3,383,334 $3,057,558 $2,572,799
========== ========== ==========
No loans included within the scope of SFAS No. 114 were identified as being
impaired at December 31, 2005, 2004 or 2003 and for the years then ended.
Loans on which the recognition of interest has been discontinued, which were not
included within the scope of SFAS No. 114, amounted to approximately $591,000,
$675,000, and $379,000 at December 31, 2005, 2004, and 2003, respectively. If
interest income had been recognized on nonaccrual loans at their stated rates
during 2005, 2004, and 2003, interest income would have been increased by
$67,558, $44,391, and $11,626, respectively. Income in the amount of $7,763,
$21,955 and $29,066 was recognized on these loans in 2005, 2004, and 2003,
respectively.
Included in loans receivable at December 31, 2005 and 2004 is $1,682,994 and
$1,268,353 due from officers and directors of the Bank. These loans are made in
the ordinary course of business at substantially the same terms and conditions
as those prevailing at the time for comparable transactions with outsiders and
are not considered to involve more than the normal risk of collectibility. For
the years ending December 31, 2005 and 2004 all loans to directors and officers
of the Bank were performing according to the original loan terms. Activity in
loans outstanding to officers and directors is summarized as follows:
33
2005 2004
----------- -----------
Balance, beginning of year $ 1,268,353 $ 593,452
New loans made during year 524,708 1,211,526
Repayments made during year (110,067) (285,765)
Reductions due to change in directors and officers - (250,860)
----------- -----------
Balance at end of year $ 1,682,994 $ 1,268,353
=========== ===========
NOTE 5 - LOAN SERVICING
Loans serviced for others are not reflected in the accompanying balance sheets.
The unpaid principal balances of mortgages serviced for others were $34,530,296
and $39,327,875 at December 31, 2005 and 2004, respectively.
Servicing loans for others generally consists of collecting mortgage payments,
maintaining escrow accounts, disbursing payments to investors and foreclosure
processing. Loan servicing income is recorded on the accrual basis and includes
servicing fees from investors and certain charges collected from borrowers, such
as late payment fees. The following table presents the activity of the mortgage
servicing rights ("MSR").
YEAR ENDED DECEMBER 31,
2005 2004 2003
--------- --------- ----------
Balance at beginning of the year $ 477,202 $ 676,940 $ 780,408
Additions - 7,861 284,327
Amortization (151,141) (207,599) (177,795)
Application of valuation allowance to permanently impaired MSR's - - (210,000)
--------- --------- ---------
$ 326,061 $ 477,202 $ 676,940
========= ========= =========
NOTE 6 - FORECLOSED REAL ESTATE
Foreclosed assets are presented net of an allowance for losses. An analysis of
the allowance for losses on foreclosed assets is as follows
YEARS ENDED DECEMBER 31,
2005 2004 2003
--------- -------- ---------
Balance at beginning of year $ 671,740 $ 972,899 $ 972,899
Provision for losses - 114,606 -
Charge-offs (30,000) (415,765) -
--------- --------- ---------
Balance at end of year $ 671,740 $ 671,740 $ 972,899
========= ========= =========
Expenses applicable to foreclosed assets include the following
YEARS ENDED DECEMBER 31,
2005 2004 2003
-------- -------- --------
Net gain on sale of foreclosed real estate $ - $ - $ -
Donation of property - 25,000
Provision for losses - 114,606 -
Operating expenses 3,083 6,278 10,153
-------- -------- --------
$ 3,083 $145,884 $ 10,153
======== ======== ========
NOTE 7 - PREMISES AND EQUIPMENT
A summary of the cost and accumulated depreciation of premises and equipment
follows
34
2005 2004
---------- ----------
Land $1,368,077 $1,368,077
Building and improvements 5,579,868 5,048,190
Furniture and equipment 2,662,799 3,137,954
Automobiles 168,426 168,426
---------- ----------
Total cost 9,779,170 9,722,647
Less accumulated depreciation 3,318,625 3,710,734
---------- ----------
Premises and equipment, net $6,460,545 $6,011,913
========== ==========
Certain bank facilities are leased under various operating leases. Rent expense
was $238,573, $190,306, and $197,157 in 2005, 2004 and 2003, respectively.
Future minimum rental commitments under noncancellable operating leases are as
follows
2006 $ 265,910
2007 265,460
2008 199,010
2009 198,560
2010 130,160
Thereafter 540,320
----------
Total $1,599,420
==========
NOTE 8 - DEPOSITS
Deposits at December 31 consist of the following:
2005 2004
------------ ------------
Noninterest-bearing demand $ 44,325,083 $ 35,552,503
Interest-bearing
Demand 48,666,460 57,855,850
Money market deposits 40,195,630 34,692,434
Savings 34,800,535 36,851,743
Certificates of deposit 195,386,032 101,801,974
------------ ------------
Total interest-bearing 319,048,657 231,202,001
------------ ------------
Total deposits $363,373,740 $266,754,504
============ ============
The aggregate amount of time deposits in denominations of $100,000 or more at
December 31, 2005 and 2004 was $64,722,620 and $32,268,000, respectively.
At December 31, 2005, the scheduled maturities of time deposits are as follows
(in thousands)
2006 $127,876
2007 49,567
2008 6,121
2009 4,832
2010 6,959
2011 31
--------
$195,386
========
35
NOTE 9 - SHORT-TERM BORROWINGS AND LONG-TERM DEBT
The Bank's long-term debt consists of advances from the Federal Home Loan Bank
of Atlanta. The Bank classifies debt based upon original maturity and does not
reclassify debt to short term status during its life. These include fixed-rate,
adjustable-rate, fixed convertible, and variable convertible advances. Rates and
maturities on these advances are as follows
FIXED ADJUSTABLE FIXED RATE VARIABLE
2005 RATE RATE CONVERTIBLE CONVERTIBLE
---- ---- ----------- -----------
Highest rate 5.43% N/A 6.25% 3.88%
Lowest rate 1.13% N/A 3.27% 3.88%
Weighted average rate 3.99% N/A 4.54% 3.88%
Matures through 2022 N/A 2014 2020
2004
Highest rate 5.43% 1.96% 6.25% N/A
Lowest rate 1.13% 1.96% 3.27% N/A
Weighted average rate 3.98% 1.96% 4.68% N/A
Matures through 2022 2005 2014 N/A
Average rates of long and short-term debt were as follows
AT OR FOR THE YEAR ENDED DECEMBER 31,
(DOLLARS IN THOUSANDS)
-------------------------------------
2005 2004 2003
-------- -------- --------
Long-term debt
Maximum outstanding long-term debt of any month end $107,826 $ 82,931 $ 74,062
Average outstanding long-term debt 93,409 73,830 60,024
Approximate average rate paid on long-term debt 4.25% 4.39% 4.56%
Short-term debt
Maximum outstanding short-term debt at any month end $123,968 $122,693 $ 40,000
Average outstanding short-term debt 82,665 64,736 7,568
Approximate average rate paid on short-term debt 3.10% 1.80% 1.26%
The Bank's fixed-rate debt generally consists of advances with monthly interest
payments and principal due at maturity. The Bank's adjustable-rate long-term
debt adjusts quarterly based upon a margin over the three month London Interbank
Offered Rate ("LIBOR"). The margin was set at 80 basis points. The debt had a
minimum interest of 0.80% and a maximum rate of 5.30%. The Bank's fixed-rate,
convertible, long-term debt is callable by the issuer, after an initial period
ranging from six months to five years. Advances become callable on dates ranging
from 2006 to 2009. Depending on the specific instrument, the instrument is
callable either continuously after the initial period (Bermuda option) or only
at the date ending the initial period (European). All advances have a prepayment
penalty, determined based upon prevailing interest rates. Variable convertible
advances have an initial variable rate based on a discount to LIBOR. The debt
has a discount of 43 basis points to LIBOR. After an initial period of five
years, the advance will convert at the issuer's option to a fixed-rate advance
at a rate of 4.0% and a term of ten years. The contractual maturities of
long-term debt are as follows
DECEMBER 31, 2005 DECEMBER 31, 2004
---------------------------------------------- -----------------------------
FIXED FIXED RATE VARIABLE
RATE CONVERTIBLE CONVERTIBLE TOTAL TOTAL
------------ ----------- ----------- ----------- ------------
Due in 2006 $ 12,000,000 $ - $ - $ 12,000,000 $ 12,000,000
Due in 2007 5,000,000 - - 5,000,000 5,000,000
Due in 2008 - - - - -
Due in 2009 15,000,000 - - 15,000,000 15,000,000
Due in 2010 5,000,000 15,000,000 - 20,000,000 20,000,000
Thereafter 10,823,759 35,000,000 10,000,000 55,823,759 25,857,113
------------ ------------ ------------ ------------ ------------
$ 47,823,759 $ 50,000,000 $ 10,000,000 $107,823,759 $ 77,857,113
============ ============ ============ ============ ============
From time to time, the Bank also has daily advances outstanding, which are
classified as short-term debt. These advances are repayable at the Bank's option
at any time and reprice daily. These advances totaled $19,500,000 and
$36,000,000 at December 31, 2005 and 2004,
36
respectively. The rates on the short-term debt at December 31, 2005 and 2004
were 4.58% and 2.44% respectively.
Under the terms of an Agreement for Advances and Security Agreement with Blanket
Floating Lien (the "Agreement"), the Company maintained eligible collateral
consisting of one to four unit residential first mortgage loans, discounted at
80% of the unpaid principal balance, equal to 100% of its total outstanding long
and short-term Federal Home Loan Bank advances. During 2003 and 2004, the Bank
entered into addendums to the Agreement that expanded the types of eligible
collateral under the Agreement to include certain commercial real estate and
second mortgage loans. These loans are subject to eligibility rules, and
collateral values are discounted at 50% of the unpaid loan principal balance. In
addition, only 50% of total collateral for Federal Home Loan Bank advances may
consist of commercial real estate loans. In addition the Bank has pledged its
Federal Home Loan Bank stock of $6,740,000 and securities with a carrying value
of $53,987,000 as additional collateral for its advances. The Bank is limited to
total advances of up to 40% of assets or $216,000,000. At December 31, 2005, the
Bank had filed collateral statements identifying collateral sufficient to borrow
$158,226,000, and had identified additional collateral enabling it to borrow an
additional $58,417,000, which had not been filed with the Federal Home Loan Bank
of Atlanta.
In addition, the Bank had outstanding notes payable to the U.S. Treasury, which
are federal treasury tax and loan deposits accepted by the Bank and remitted on
demand to the Federal Reserve Bank. At December 31, 2005 and 2004, such
borrowings were $574,975 and $454,210, respectively. The Bank pays interest on
these balances at a slight discount to the federal funds rate. The notes are
secured by investment securities with an amortized cost of approximately
$624,000 and $5,949,000 at December 31, 2005 and 2004, respectively.
In addition to the other short-term borrowings noted above, the Bank has had
outstanding agreements to repurchase certain securities that had been sold.
These agreements were classified as short-term debt and were reflected as the
cash received in connection with the transaction. Generally these agreements
matured within three months. The Bank was sometimes required to provide
additional collateral based on the fair value of these underlying securities.
There were no amounts outstanding under these agreements at December 31, 2005
and $78,850,000 at December 31, 2004.
NOTE 10 - INCOME TAXES
Allocation of federal and state income taxes between current and deferred
portions is as follows
2005 2004 2003
----------- ----------- -----------
Current
Federal $ 2,219,558 $ 1,284,026 $ 961,686
State 284,737 91,118 92,965
----------- ----------- -----------
2,504,295 1,375,144 1,054,651
----------- ----------- -----------
Deferred
Federal (398,238) 57,973 (19,561)
State (54,113) 7,877 (2,658)
----------- ----------- -----------
(452,351) 65,850 (22,219)
----------- ----------- -----------
Total Income Tax Expense $ 2,051,944 $ 1,440,994 $ 1,032,432
=========== =========== ===========
The reasons for the differences between the statutory federal income tax rate
and the effective tax rates are summarized as follows
2005 2004 2003
PERCENT
PERCENT OF OF PRE- PERCENT OF
PRE-TAX TAX PRE-TAX
AMOUNT INCOME AMOUNT INCOME AMOUNT INCOME
------------ ---------- ----------- ------ ------------ ----------
Expected income tax expense at
federal tax rate $ 2,050,638 34.00% $ 1,754,682 34.00% $ 1,182,632 34.00%
State taxes net of federal benefit 152,212 2.52 65,337 1.27 59,603 1.70
Nondeductible expenses 3,124 0.05 2,527 0.05 14,130 0.40
Nontaxable income (154,337) (2.55) (179,442) (3.48) (213,613) (6.10)
Donation of property - 0.00 (202,109) (3.92) - -
Other 307 0.00 - 0.00 (10,320) (0.30)
----------- ----------- ----------- -----
$ 2,051,944 34.02% $ 1,440,994 27.92% $ 1,032,432 29.70
=========== ===== =========== ===== =========== =====
37
The net deferred tax assets in the accompanying balance sheets include the
following components:
2005 2004
---------- ----------
DEFERRED TAX ASSETS
Deferred fees $ 4,583 $ 7,609
Allowance for loan losses 1,277,020 1,151,205
Deferred compensation 471,786 159,396
Valuation allowance on foreclosed real estate 259,991 259,991
---------- ----------
2,013,380 1,578,201
---------- ----------
DEFERRED TAX LIABILITIES
FHLB stock dividends 152,896 152,896
Depreciation 389,626 406,797
Unrealized gain on investment securities available for sale 25,431 95,891
---------- ----------
567,953 655,584
---------- ----------
$1,445,427 $ 922,617
========== ==========
Retained earnings at December 31, 2005, included approximately $1.2 million of
bad debt deductions allowed for federal income tax purposes (the "base year tax
reserve") for which no deferred income tax has been recognized. If, in the
future, this portion of retained earnings is used for any purpose other than to
absorb bad debt losses, it would create income for tax purposes only and income
taxes would be imposed at the then prevailing rates. The unrecorded income tax
liability on the above amount was approximately $463,000 at December 31, 2005.
Prior to January 1, 1996, the Bank computed its tax bad debt deduction based
upon the percentage of taxable income method as defined by the Internal Revenue
Code. The bad debt deduction allowable under this method equaled 8% of taxable
income determined without regard to the bad debt deduction and with certain
adjustments. The tax bad debt deduction differed from the bad debt expense used
for financial accounting purposes.
In August 1996, the Small Business Job Protection Act (the "Act") repealed the
percentage of taxable income method of accounting for bad debts effective for
years beginning after December 31, 1995. The Act required the Bank to change its
method of computing reserves for bad debts to the experience method. This method
is available to banks with assets less than $500 million and allows the Bank to
maintain a tax reserve for bad debts and to take bad debt deductions for
reasonable additions to the reserve. As a result of this change, the Bank has to
recapture into income a portion of its existing tax bad debt reserve. This
recapture occurs ratably over a six-taxable year period, beginning with the 1998
tax year. For financial reporting purposes, this recapture does not result in
additional tax expense as the Bank adequately provided deferred taxes in prior
years. Furthermore, this change does not require the Bank to recapture its
base-year tax reserve.
NOTE 11 - COMMITMENTS AND CONTINGENCIES
The Bank is party to financial instruments with off-balance-sheet risk in the
normal course of business to meet the financing needs of its customers. These
financial instruments are commitments to extend credit. These instruments may,
but do not necessarily, involve, to varying degrees, elements of credit and
interest rate risk in excess of the amount recognized in the balance sheets. The
Bank's exposure to credit loss in the event of nonperformance by the other party
to the financial instrument is represented by the contractual amount of those
instruments. The Bank uses the same credit policies in making commitments as it
does for on-balance-sheet loans receivable.
As of December 31, 2005 and 2004, in addition to the undisbursed portion of
loans receivable of approximately $23,051,485 and $25,796,553, respectively, the
Bank had outstanding loan commitments approximating $5,537,000 and $578,000,
respectively.
Standby letters of credit written are conditional commitments issued by the Bank
to guarantee the performance of a customer to a third party. These guarantees
are issued primarily to support construction borrowing arrangements. The credit
risk involved in issuing letters of credit is essentially the same as that
involved in extending loan facilities to customers. The Bank holds cash or a
secured interest in real estate as collateral to support those commitments for
which collateral is deemed necessary. Standby letters of credit outstanding
amounted to $8,183,000 and $8,998,000 at December 31, 2005 and 2004,
respectively. In addition to the commitments noted above, customers had
approximately $48,001,000 and $39,200,000 available under lines of credit at
December 31, 2005 and 2004, respectively.
NOTE 12 - STOCK OPTION AND INCENTIVE PLAN
The Company has stock option and incentive plans to attract and retain personnel
and provide incentive to employees to promote the success of the business. On
January 31, 2005, the Company's 1995 Stock Option and incentive Plan and 1995
Stock Option Plan for Non-Employee
38
Directors each expired. All shares authorized and available under this plan were
awarded as of December 31, 2004. In May 2005, the 2005 Equity Compensation Plan
was approved by the shareholders. The exercise price for options granted under
this plan is set at the discretion of the committee administering this plan, but
is not less than the market value of the shares as of the date of grant. An
option's maximum term is ten years and the options vest at the discretion of the
committee administering this plan. All outstanding options were fully vested at
December 31, 2005.
The following tables summarize activity in the plans:
2005 2004 2003
--------------------------- ---------------------------- ---------------------------
WEIGHTED AVERAGE WEIGHTED AVERAGE WEIGHTED AVERAGE
SHARES EXERCISE PRICE SHARES EXERCISE PRICE SHARES EXERCISE PRICE
------- ---------------- ------- ---------------- ------ ----------------
Outstanding at beginning of year 268,921 $ 16.08 231,291 $ 11.21 219,603 $ 9.54
Granted 59,526 33.43 86,956 23.01 37,835 18.43
Exercised (31,320) 8.30 (46,207) 4.97 (26,145) 7.66
Forfeitures (625) 17.99 (3,119) 12.85 - -
------- ------- -------
Outstanding at end of year 296,502 20.38 268,921 16.08 231,293 11.21
======= ======= =======
Option amounts and exercise prices have been adjusted retroactively to give
effect to the three for two stock splits. Options outstanding are all currently
exercisable and are summarized as follows
NUMBER OUTSTANDING WEIGHTED AVERAGE WEIGHTED AVERAGE
DECEMBER 31, 2005 REMAINING CONTRACTUAL LIFE EXERCISE PRICE
----------------- -------------------------- --------------
30,893 3 years 10.75
15,656 4 years 11.82
28,649 5 years 11.84
28,283 6 years 11.86
15,721 7 years 17.33
48,593 8 years 19.35
69,182 9 years 23.83
59,525 10 years 33.43
-------
296,502 20.38
=======
NOTE 13--EMPLOYEE BENEFIT PLANS
The Bank has an Employee Stock Ownership Plan (ESOP) which covers substantially
all its employees. The ESOP acquires stock of Tri-County Financial Corporation.
The Company accounts for its ESOP in accordance with AICPA Statement of Position
93-6. Accordingly, unencumbered shares held by the ESOP are treated as
outstanding in computing earnings per share. Shares issued to the ESOP but
pledged as collateral for loans obtained to provide funds to acquire the shares
are not treated as outstanding in computing earnings per share. Dividends on
ESOP shares are recorded as a reduction of retained earnings. Contributions are
made at the discretion of the Board of Directors. Expense recognized for the
years ending 2005, 2004, and 2003 totaled $64,837, $78,421, and $100,079
respectively. As of December 31, 2005, the ESOP plan held 116,061 allocated and
7,528 unallocated shares with an approximate market value of $3,879,919 and
$251,661, respectively.
The Company also has a 401(k) plan. The Company matches a portion of the
employee contributions. This ratio is determined annually by the Board of
Directors. In 2005, 2004, and 2003, the Company matched one-half of the
employee's first 8% deferral. All employees who have completed one year of
service and have reached the age of 21 are covered under this defined
contribution plan. Contributions are determined at the discretion of management
and the Board of Directors. For the years ended December 31, 2005, 2004, and
2003, the Company charged $92,000, $89,000, and $81,000, respectively, against
earnings to fund the plan.
The Bank has a separate nonqualified retirement plan for non-employee directors.
Directors are eligible for a maximum benefit of $3,500 a year for ten years
following retirement from the Board of Community Bank of Tri-County. The maximum
benefit is earned at 15 years of service as a non-employee director. Full
vesting occurs after two years of service. Expense recorded for this plan was
$5,173, $18,000, and $24,000 for the years ending December 31, 2005, 2004, and
2003, respectively.
In addition, the Bank has established a separate supplemental retirement plan
for certain of the Bank's key executives. This plan provides a
39
retirement income payment for 15 years from the date of the employee's expected
retirement date. The payments are set at the discretion of the Board of
Directors and vesting occurs ratably from the date of employment to the expected
retirement date. Expense recorded for this plan totaled $286,000, $316,000, and
$286,000 for 2005, 2004, and 2003 respectively.
NOTE 14--REGULATORY MATTERS
The Company and the Bank are subject to various regulatory capital requirements
administered by the federal and state banking agencies. Failure to meet minimum
capital requirements can initiate certain mandatory and possible additional
discretionary actions by regulators that, if undertaken, could have a direct
material effect on the Company's financial statements. Under capital adequacy
guidelines and the regulatory framework for prompt corrective action, the Bank
must meet specific capital guidelines that involve quantitative measures of the
Bank's assets, liabilities and certain off-balance-sheet items as calculated
under regulatory accounting practices. The Bank's capital amounts and
classification are also subject to qualitative judgments by the regulators about
components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy
require the Company and the Bank to maintain minimum amounts and ratios (set
forth in the table below) of tangible and core capital (as defined in the
regulations) to total adjusted assets (as defined), and of risk-based capital
(as defined) to risk-weighted assets (as defined). Management believes, as of
December 31, 2004, that the Company and the Bank meet all capital adequacy
requirements to which they are subject.
As of December 31, 2005, the most recent notification from the Federal Reserve
categorized the Bank as well-capitalized under the regulatory framework for
prompt corrective action. To be categorized as well-capitalized, the Bank must
maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios
as set forth in the table. There are no conditions or events since that
notification that management believes have changed the Company's or the Bank's
category. The Company's and the Bank's actual capital amounts and ratios for
2005 and 2004 are presented in the tables below.
TO BE CONSIDERED WELL
REQUIRED FOR CAPITAL CAPITALIZED UNDER PROMPT
ACTUAL ADEQUACY PURPOSES CORRECTIVE ACTION
--------------------- ---------------------- ------------------------
AT DECEMBER 31, 2005
Total capital (to risk weighted assets)
The Company $49,544 11.84% $33,463 8.00%
The Bank $48,753 11.67% $33,391 8.00% $ 41,739 10.00%
Tier 1 capital (to risk weighted assets)
The Company $46,161 11.04% $16,731 4.00%
The Bank $45,370 10.87% $16,696 4.00% $ 25,044 6.00%
Tier 1 capital (to average assets)
The Company $46,161 8.55% $21,590 4.00%
The Bank $45,370 8.42% $21,550 4.00% $ 26,937 5.00%
AT DECEMBER 31, 2004
Total capital (to risk weighted assets)
The Company $41,368 11.89% $27,842 8.00%
The Bank $40,605 11.67% $27,826 8.00% $ 34,782 10.00%
Tier 1 capital (to risk weighted assets)
The Company $38,310 11.01% $13,921 4.00%
The Bank $37,548 10.80% $13,913 4.00% $ 20,869 6.00%
Tier 1 capital (to average assets)
The Company $38,310 9.29% $16,494 4.00%
The Bank $37,548 9.13% $16,454 4.00% $ 20,568 5.00%
NOTE 15--FAIR VALUE OF FINANCIAL INSTRUMENTS
The estimated fair value amounts have been determined by the Company using
available market information and appropriate valuation methodologies. However,
considerable judgment is necessarily required to interpret market data to
develop the estimates of fair value. Accordingly, the estimates presented herein
are not necessarily indicative of the amounts the Company could realize in a
current market
40
exchange. The use of different market assumptions and/or estimation
methodologies may have a material effect on the estimated fair value amounts.
Therefore, any aggregate unrealized gains or losses should not be interpreted as
a forecast of future earnings or cash flows. Furthermore, the fair values
disclosed should not be interpreted as the aggregate current value of the
Company.
DECEMBER 31, 2005 DECEMBER 31, 2004
----------------------------- -----------------------------
CARRYING ESTIMATED CARRYING ESTIMATED
AMOUNT FAIR VALUE AMOUNT FAIR VALUE
------------ ------------ ------------ ------------
ASSETS
Cash and cash equivalents $ 22,575,240 $ 22,575,240 $ 17,715,779 $ 17,715,779
Investment securities and stock in FHLB
and FRB 130,855,879 128,640,980 181,834,426 180,758,025
Loans receivable, net 369,592,253 370,164,000 289,325,051 292,988,000
LIABILITIES
Savings, NOW, and money market accounts 167,987,707 167,987,707 164,952,530 164,952,530
Time certificates 195,386,032 189,574,936 101,801,974 101,448,140
Long-term debt and other borrowed funds 127,898,734 $126,788,777 198,235,323 199,752,029
Guaranteed preferred beneficial interest in junior
subordinated securities $ 12,000,000 $ 12,000,000 $ 7,000,000 $ 7,000,000
At December 31, 2005 and 2004, the Company had outstanding loan commitments and
standby letters of credit of $14 million and $9 million, respectively. Based on
the short-term lives of these instruments, the Company does not believe that the
fair value of these instruments differs significantly from their carrying
values.
Valuation Methodology
Cash and Cash Equivalents - For cash and cash equivalents, the carrying amount
is a reasonable estimate of fair value.
Investment Securities - Fair values are based on quoted market prices or dealer
quotes. If a quoted market price is not available, fair value is estimated using
quoted market prices for similar securities.
Loans Receivable - For conforming residential first-mortgage loans, the market
price for loans with similar coupons and maturities was used. For nonconforming
loans with maturities similar to conforming loans, the coupon was adjusted for
credit risk. Loans which did not have quoted market prices were priced using the
discounted cash flow method. The discount rate used was the rate currently
offered on similar products. Loans priced using the discounted cash flow method
included residential construction loans, commercial real estate loans, and
consumer loans. The estimated fair value of loans held for sale is based on the
terms of the related sale commitments.
Deposits - The fair value of checking accounts, saving accounts, and money
market accounts was the amount payable on demand at the reporting date.
Time Certificates - The fair value was determined using the discounted cash flow
method. The discount rate was equal to the rate currently offered on similar
products.
Long-Term Debt and Other Borrowed Funds - These were valued using the discounted
cash flow method. The discount rate was equal to the rate currently offered on
similar borrowings.
Guaranteed Preferred Beneficial Interest in Junior Subordinated Securities-These
were valued using discounted cash flows. The discount rate was equal to the rate
currently offered on similar borrowings.
Off-Balance Sheet Instruments - The Company charges fees for commitments to
extend credit. Interest rates on loans for which these commitments are extended
are normally committed for periods of less than one month. Fees charged on
standby letters of credit and other financial guarantees are deemed to be
immaterial and these guarantees are expected to be settled at face amount or
expire unused. It is impractical to assign any fair value to these commitments.
The fair value estimates presented herein are based on pertinent information
available to management as of December 31, 2005 and 2004. Although management is
not aware of any factors that would significantly affect the estimated fair
value amounts, such amounts have not been comprehensively revalued for purposes
of these financial statements since that date and, therefore, current estimates
of fair value may differ significantly from the amount presented herein.
41
NOTE 16 - GUARANTEED PREFERRED BENEFICIAL INTEREST IN JUNIOR SUBORDINATED
DEBENTURES
On June 15, 2005, Tri-County Capital Trust II ("Capital Trust II"), a Delaware
business trust formed, funded and wholly owned by the Company, issued $5,000,000
of variable-rate capital securities with an interest rate of 5.07% in a private
pooled transaction. The variable rate is based on the 90-day LIBOR rate plus
1.70%. The Trust used the proceeds from this issuance to purchase $5,155,000 of
the Company's junior subordinated debentures. The interest rate on the
debentures and the trust preferred securities is variable and adjusts quarterly.
The Company has, through various contractual arrangements, fully and
unconditionally guaranteed all of Capital Trust II's obligations with respect to
the capital securities. These capital securities qualify as Tier I capital and
are presented in the Consolidated Balance Sheets as "Guaranteed Preferred
Beneficial Interests in Junior Subordinated Debentures." Both the capital
securities of Capital Trust II and the junior subordinated debentures are
scheduled to mature on June 15, 2035, unless called by the Company not earlier
than June 15, 2010.
On July 22, 2004, Tri-County Capital Trust I ("Capital Trust I"), a Delaware
business trust formed, funded and wholly owned by the Company, issued $7,000,000
of variable-rate capital securities with an interest rate of 4.22% in a private
pooled transaction. The variable rate is based on the 90-day LIBOR rate plus
2.60%. The Trust used the proceeds from this issuance, along with the Company's
$217,000 capital contribution for Capital Trust 1's common securities, to
purchase $7,217,000 of the Company's junior subordinated debentures. The
interest rate on the debentures and the trust preferred securities is variable
and adjusts quarterly. The Company has, through various contractual
arrangements, fully and unconditionally guaranteed all of Capital Trust I's
obligations with respect to the capital securities. These debentures qualify as
Tier I capital and are presented in the Consolidated Balance Sheets as
"Guaranteed Preferred Beneficial Interests in Junior Subordinated Debentures."
Both the capital securities of Capital Trust I and the junior subordinated
debentures are scheduled to mature on July 22, 2034, unless called by the
Company not earlier than July 22, 2009.
Costs associated with the issuance of the trust-preferred securities were less
than $10,000 and were expensed as period costs.
NOTE 17 - PRIVATE PLACEMENT
On December 30, 2005, the Company completed a private placement of securities in
an offering exempt from registration under the Securities Act. The seven
investors were officers, directors, and counsel for the Company. The offering
was for 15,768 shares at $30.00 per share and raised $473,040. The costs of the
offering were less than $5,000 and were expensed.
NOTE 18 - CONDENSED FINANCIAL STATEMENTS - PARENT COMPANY ONLY
Financial information pertaining only to Tri-County Financial Corporation is as
follows
BALANCE SHEETS
DECEMBER 31,
2005 2004
------------ ------------
ASSETS
Cash - noninterest bearing $ 881,185 $ 269,072
Cash - interest bearing 167,830 181,516
Investment securities available for sale 35,838 34,666
Investment in wholly owned subsidiaries 45,791,231 37,951,438
Other assets 853,740 194,074
------------ ------------
Total assets $ 47,729,824 $ 38,630,766
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities $ 779,668 $ 290,191
Guaranteed preferred beneficial interest in junior subordinated debentures 12,372,000 7,217,000
------------ ------------
Total liabilities 13,151,668 7,507,191
------------ ------------
STOCKHOLDERS' EQUITY
Common stock 17,610 11,469
Surplus 9,057,805 8,252,152
Retained earnings 25,580,634 22,833,112
Total accumulated other comprehensive income 49,363 186,140
Unearned ESOP shares (127,256) (159,298)
------------ ------------
Total stockholders' equity 34,578,156 31,123,575
------------ ------------
Total liabilities and stockholders' equity $ 47,729,824 $ 38,630,766
============ ============
42
CONDENSED STATEMENTS OF INCOME
YEAR ENDED DECEMBER 31,
2005 2004 2003
----------- ----------- -----------
Dividends from subsidiary $ 1,700,000 $ - $ 500,000
Interest income 16,059 6,349 10,356
Interest expense 580,584 140,341 -
----------- ----------- -----------
Net interest income 1,135,475 (133,992) 510,356
Miscellaneous expenses (257,031) (166,364) (174,595)
----------- ----------- -----------
Income before income taxes and equity in 878,444 (300,356) 335,761
undistributed net income of subsidiary
Federal and state income tax benefit 279,328 102,120 55,841
Equity in undistributed net income of subsidiary 2,821,571 3,918,070 2,054,296
----------- ----------- -----------
NET INCOME $ 3,979,343 $ 3,719,834 $ 2,445,898
=========== =========== ===========
CONDENSED STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31,
2005 2004 2003
----------- ----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 3,979,343 $ 3,719,834 $ 2,445,898
Adjustments to reconcile net income to net cash provided by
operating activities
Equity in undistributed earnings of subsidiary (2,821,571) (3,918,070) (2,054,296)
(Decrease) increase in other assets (659,666) 763,470 (72,560)
Increase in current liabilities 489,477 30,835 5,008
----------- ----------- -----------
Net cash provided by operating activities 987,583 596,069 324,050
----------- ----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of investment securities available for sale (1,172) (1,514) (714)
Net cash used by investing activities (1,172) (1,514) (714)
----------- ----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES
Sale of guaranteed preferred beneficial interests in junior
subordinated securities 5,155,000 7,217,000 -
Downstream of capital to subsidiary (5,000,000) (7,000,000)
Investment in trust subsidiary (155,000) (217,000)
Dividends paid (930,669) (541,633) (422,361)
Proceeds from private placement 473,040 - -
Exercise of stock options 304,648 248,661 218,713
Net change in ESOP loan 60,390 8,506 63,435
Redemption of common stock (295,393) (412,973) (769,720)
----------- ----------- -----------
Net cash used in financing activities (387,984) (697,439) (909,933)
----------- ----------- -----------
INCREASE (DECREASE) IN CASH 598,427 (102,884) (586,597)
CASH AT BEGINNING OF YEAR 450,588 553,472 1,140,069
----------- ----------- -----------
CASH AT END OF YEAR $ 1,049,015 $ 450,588 $ 553,472
=========== =========== ===========
43
NOTE 19 - QUARTERLY FINANCIAL RESULTS (UNAUDITED)
A summary of selected consolidated quarterly financial data for the two years
ended December 31, 2005 is reported as follows
2005 FOURTH 2005 THIRD 2005 SECOND 2005 FIRST 2004 FOURTH 2004 THIRD 2004 SECOND 2004 FIRST
QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER
----------- ---------- ----------- ---------- ----------- ---------- ----------- ----------
Interest and dividend income $7,872,103 $7,433,702 $7,284,039 $6,564,868 $6,455,056 $5,915,854 $4,648,618 $4,593,811
Interest expense 3,838,465 3,566,630 3,369,456 2,809,080 2,560,878 2,086,208 1,602,035 1,564,289
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Net interest income 4,033,638 3,867,072 3,914,583 3,755,788 3,894,178 3,829,646 3,046,583 3,029,522
Provision for loan loss 129,160 11,183 126,097 63,027 136,028 232,996 13,772 70,202
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Net interest income after
provision 3,904,478 3,855,889 3,788,486 3,692,761 3,758,150 3,596,650 3,032,811 2,959,320
Noninterest income 339,218 466,650 433,806 401,329 422,187 329,876 434,025 396,228
Noninterest expense 2,943,137 2,769,564 2,589,915 2,548,714 2,747,623 2,307,562 2,317,511 2,395,723
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Income before income taxes 1,300,559 1,552,975 1,632,377 1,545,376 1,432,714 1,618,964 1,149,325 959,825
Provision for income taxes 414,733 562,908 553,288 521,015 486,960 537,658 345,749 70,627
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Net income $ 885,826 $ 990,067 $1,079,089 $1,024,361 $ 945,754 $1,081,306 $ 803,576 $ 889,198
========== ========== ========== ========== ========== ========== ========== ==========
Earnings per common share(1,2)
Basic $ 0.51 $ 0.57 $ 0.62 $ 0.59 $ 0.54 $ 0.63 $ 0.47 $ 0.53
Diluted 0.48 0.53 0.59 0.56 0.52 0.60 0.45 0.50
(1) All per share amounts have been adjusted for the three for two stock
splits effected in December 2005 and December 2004.
(2) Earnings per share are based upon quarterly results and may not be
additive to the annual earnings per share amounts.
44