Exhibit 13
TO OUR SHAREHOLDERS
Farmers & Merchants Bancorp enjoyed another record year in 2004, continuing an
established trend of improved profit performance which now spans twenty-eight
consecutive quarters; seven sequential years. Once again, the commitment of our
skilled employees, the patronage of the Company's valued customers and the
strong support received from the nine communities served combined to produce
another successful year. Taking cues from F&M's rich history, we have maintained
the longstanding practices of delivering a robust level of customer service, as
well as generously reinvesting back into the communities served. This time
tested formula once again rewarded the Company and the shareholders in 2004.
We are pleased to report that for 2004 Farmers & Merchants Bancorp generated
record net income of $16,450,000 or $20.65 per share of common stock, a 12.2%
increase over the prior year. Gross loans reached $867 million, up 7.4%, and
total deposits expanded 10.8% to $1.0 billion. Importantly, our net interest
margin improved 15 basis points over 2003, driven by strong growth in lower cost
transaction deposits, together with improved loan pricing due to increases in
short-term market interest rates during the latter half of 2004. Return on
average assets was 1.40% and return on average equity reached 14.50%, an 82
basis points increase over 2003.
Based on the Company's strong performance, the Board of Directors unanimously
approved the 30th consecutive annual 5% stock dividend last April. In addition,
the Board of Directors also unanimously declared two cash dividends totaling
$5,723,000 or $7.20 per share of common stock. The cash dividends declared
during 2004 represented a 20.8% increase over 2003. The Company has now declared
cash dividends for seventy consecutive years.
Our previous reports to you profiled Management's emphasis on implementation of
the Company's Long Term Strategic Plan. These efforts included modernization of
our technology and work processes together with expansion of product lines.
During 2004 our focus turned to expanding the Company's branch delivery system.
Management carefully examined the Company's existing branch network, along with
the availability and desirability of additional branch locations, and decided to
initiate a major branch expansion, relocation and renovation program. New
branches will be opened during 2005 in Sacramento, Galt, Lodi and Stockton and
the Turlock Main Office will be relocated to a new facility. Many of our
branches will receive significant makeovers to modernize interior decor,
exterior signage and enhance overall customer service. A separate and
distinctive motif is currently being designed for our larger wholesale oriented
branches to complement the dramatic look of our new retail office architecture.
Heritage cues are being combined with fresh design facets to create a wholesale
office environment which will resonate a relaxed, but sophisticated atmosphere
accentuating our focus on delivering upscale customer service.
Management and the Board of Directors anticipate that the financial impact of
the capital expenditures related to the branch enhancement program could affect
the Company's profit trends for the next thirty-six to forty-eight months. In
Management's opinion, over the long term, these extensive premises projects
should create material value for the Company's shareholders. This significant
investment reflects our commitment to better serve current and contiguous
markets and confirms our outlook for the Central Valley economy over the coming
years.
During 2004 we also took initial steps to terminate the Company's defined
benefit pension plan. In 2001, the plan was amended to freeze the benefit
accruals for most employees. A new defined contribution profit sharing plan was
implemented to replace the defined benefit pension plan. These actions were
based on Management and the Board of Directors' evaluation of the long term
value of the new plan to both the Company and employees. Final termination and
distribution of the benefits under the defined benefit pension plan are
scheduled to occur during the second half of 2005. Additional financial details
are included in the attached Notes to the 2004 Consolidated Financial
Statements.
As a result of Management's asset/liability practices, the Company is well
positioned to benefit should the Federal Reserve Bank (FRB) continue to increase
short term market interest rates in 2005. A rising rate environment is expected
to further improve Farmers & Merchants Bancorp's net interest margin due to the
Company's asset sensitivity. Management continues to actively evaluate the
Company's asset/liability pricing mix with the objective of protecting the
Company's earnings stream from extreme movements in market rates.
We appreciate the significant contributions made by the Board of Directors
during 2004, and wish to acknowledge their ongoing commitment to represent the
shareholders' best interests. Special recognition is also owed to our
exceptional employees for their dedication and tremendous accomplishments this
past year. Their ability to consistently deliver outstanding customer service
played a major role in the creation of shareholder value in 2004.
On behalf of the Directors and staff at Farmers & Merchants Bancorp, thank you
for your confidence and support. We extend our best wishes to you for a healthy
and prosperous 2005.
Sincerely,
/s/Kent A. Steinwert /s/Ole R. Mettler
Kent A. Steinwert Ole R. Mettler
President & Chief Executive Officer Chairman of the Board
1
Report of Management on Internal Control Over Financial Reporting
Management is responsible for establishing and maintaining adequate internal
control over financial reporting at Farmers & Merchants Bancorp ("the Company").
Internal control over financial reporting includes controls over the preparation
of financial statements in accordance with the instructions to the Consolidated
Financial Statements for Bank Holding Companies (Form FR Y-9C) to comply with
the reporting requirements of Section 112 of the Federal Deposit Insurance
Corporation Improvement Act ("FDICIA").
Management has assessed the effectiveness of the Company's internal control over
financial reporting as of December 31, 2004 based on criteria described in
"Internal Control-Integrated Framework" issued by the Committee of Sponsoring
Organizations of the Treadway Commission. Based on that assessment, management
concluded that the Company maintained effective internal control over financial
reporting as of December 31, 2004.
PricewaterhouseCoopers LLP, the independent registered public accounting firm
that audited the financial statements included in this Annual Report has audited
management's assessment of the effectiveness of the Company's internal control
over financial reporting as of December 31, 2004, as stated in their report
which follows this report.
/s/ Kent A. Steinwert /s/ Stephen W. Haley
Kent A. Steinwert Stephen W. Haley
President & Chief Executive Officer Executive Vice President
& Chief Financial Officer
2
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of Farmers & Merchants Bancorp:
We have completed an integrated audit of Farmers & Merchants Bancorp's 2004
consolidated financial statements and of its internal control over financial
reporting as of December 31, 2004 and audits of its 2003 and 2002 consolidated
financial statements in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Our opinions, based on our audits,
are presented below.
Consolidated financial statements
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of income, of changes in shareholders' equity, of
comprehensive income and of cash flows present fairly, in all material respects,
the financial position of Farmers & Merchants Bancorp and its subsidiaries at
December 31, 2004 and 2003, and the results of their operations and their cash
flows for each of the three years in the period ended December 31, 2004 in
conformity with accounting principles generally accepted in the United States of
America. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits. We conducted our audits of these statements 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 of financial statements includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 12 to the consolidated financial statements, effective
January 1, 2004, the Company made a change in accounting principle to accelerate
the recognition of gain/loss over a two year amortization period to match the
remaining life of their defined benefit pension plan in connection with a
decision to terminate that plan.
Internal control over financial reporting
Also, in our opinion, management's assessment, included in the accompanying
Report of Management on Internal Control Over Financial Reporting, that the
Company maintained effective internal control over financial reporting as of
December 31, 2004 based on criteria established in Internal Control - Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO), is fairly stated, in all material respects, based on those
criteria. Furthermore, in our opinion, the Company maintained, in all material
respects, effective internal control over financial reporting as of December 31,
2004, based on criteria established in Internal Control - Integrated Framework
issued by the COSO. The Company's management is responsible for maintaining
effective internal control over financial reporting and for its assessment of
the effectiveness of internal control over financial reporting. Our
responsibility is to express opinions on management's assessment and on the
effectiveness of the Company's internal control over financial reporting based
on our audit. We conducted our audit of internal control over financial
reporting 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 effective
internal control over financial reporting was maintained in all material
respects. An audit of internal control over financial reporting includes
obtaining an understanding of internal control over financial reporting,
evaluating management's assessment, testing and evaluating the design and
operating effectiveness of internal control, and performing such other
procedures as we consider necessary in the circumstances. We believe that our
audit provides a reasonable basis for our opinions.
A company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. Management's assessment and our
audit of Farmers & Merchants Bancorp's internal control over financial reporting
also included controls over the preparation of financial statements in
accordance with the instructions to the Consolidated Financial Statements for
Bank Holding Companies (Form FR Y-9C) to comply with the reporting requirements
of Section 112 of the Federal Deposit Insurance Corporation Improvement Act
(FDICIA). A company's internal control over financial reporting includes those
policies and procedures that (i) pertain to the maintenance of records that, in
reasonable detail, accurately and fairly reflect the transactions and
dispositions of the assets of the company; (ii) provide reasonable assurance
that transactions are recorded as necessary to permit preparation of financial
statements in accordance with generally accepted accounting principles, and that
receipts and expenditures of the company are being made only in accordance with
authorizations of management and directors of the company; and (iii) provide
reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use, or disposition of the company's assets that could have a
material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
PricewaterhouseCoopers LLP
San Francisco, California
March 14, 2005
3
Consolidated Statements of Income
- -------------------------------------------------------------------------- ----------- ----------- -----------
(in thousands except per share data)
Year Ended December 31,
2004 2003 2002
- -------------------------------------------------------------------------- ----------- ----------- -----------
Interest Income
Interest and Fees on Loans $49,302 $44,886 $41,911
Interest on Federal Funds Sold and Securities Purchased
Under Agreements to Resell 194 190 555
Interest on Investment Securities:
Taxable 7,558 7,065 9,400
Tax-Exempt 2,246 2,743 2,372
- -------------------------------------------------------------------------- ----------- ----------- -----------
Total Interest Income 59,300 54,884 54,238
- -------------------------------------------------------------------------- ----------- ----------- -----------
Interest Expense
Deposits 6,661 8,115 11,369
Borrowed Funds 2,703 2,942 2,227
Subordinated Debentures 454 16 -
- -------------------------------------------------------------------------- ----------- ----------- -----------
Total Interest Expense 9,818 11,073 13,596
- -------------------------------------------------------------------------- ----------- ----------- -----------
Net Interest Income 49,482 43,811 40,642
Provision for Loan Losses 1,275 625 4,926
- -------------------------------------------------------------------------- ----------- ----------- -----------
Net Interest Income After Provision for Loan Losses 48,207 43,186 35,716
- -------------------------------------------------------------------------- ----------- ----------- -----------
Non-Interest Income
Service Charges on Deposit Accounts 4,791 4,892 4,760
Net Gain on Sale of Investment Securities 1,886 935 276
Credit Card Merchant Fees 1,753 1,658 1,415
Gain on Sale of Assets 171 - 2,800
Increase in Cash Surrender Value of Life Insurance 1,582 1,540 1,433
Other 4,084 3,893 3,182
- -------------------------------------------------------------------------- ----------- ----------- -----------
Total Non-Interest Income 14,267 12,918 13,866
- -------------------------------------------------------------------------- ----------- ----------- -----------
Non-Interest Expense
Salaries and Employee Benefits 24,103 21,058 17,796
Occupancy Expense 1,730 1,591 1,709
Equipment Expense 2,319 2,415 2,146
Other 8,023 8,222 7,458
- -------------------------------------------------------------------------- ----------- ----------- -----------
Total Non-Interest Expense 36,175 33,286 29,109
- -------------------------------------------------------------------------- ----------- ----------- -----------
Income Before Income Taxes 26,299 22,818 20,473
Provision for Income Taxes 9,625 8,043 7,054
- -------------------------------------------------------------------------- ----------- ----------- -----------
Net Income Before Cumulative Effect of Change in Accounting Principle 16,674 14,775 13,419
Cumulative Effect of Change in Accounting Principle, Net of Tax* (224) - -
- -------------------------------------------------------------------------- ----------- ----------- -----------
Net Income $16,450 $14,775 $13,419
========================================================================== =========== =========== ===========
Earnings Per Share Before Cumulative Effect of Change
in Accounting Principle $ 20.93 $ 18.40 $ 16.54
Cumulative Effect of Change in Accounting Principle, Net of Tax $ (0.28) $ - $ -
- -------------------------------------------------------------------------- ----------- ----------- -----------
Earnings Per Share $ 20.65 $ 18.40 $ 16.54
========================================================================== =========== =========== ===========
The accompanying notes are an integral part of these consolidated financial
statements * See Note 12 for full disclosure.
4
Consolidated Balance Sheets
- --------------------------------------------------------------------------------------- ------------- --------------
(in thousands except per share data)
December 31,
Assets 2004 2003
- --------------------------------------------------------------------------------------- ------------- --------------
Cash and Cash Equivalents:
Cash and Due from Banks $ 32,170 $ 35,800
Federal Funds Sold and Securities Purchased Under Agreements to Resell - -
- --------------------------------------------------------------------------------------- ------------- --------------
Total Cash and Cash Equivalents 32,170 35,800
- --------------------------------------------------------------------------------------- ------------- --------------
Investment Securities:
Available-for-Sale 185,488 223,965
Held-to-Maturity 89,952 37,957
- --------------------------------------------------------------------------------------- ------------- --------------
Total Investment Securities 275,440 261,922
- --------------------------------------------------------------------------------------- ------------- --------------
Loans: 866,908 806,906
Less: Allowance for Loan Losses 17,727 17,220
- --------------------------------------------------------------------------------------- ------------- --------------
Loans, Net 849,181 789,686
- --------------------------------------------------------------------------------------- ------------- --------------
Premises and Equipment, Net 14,971 11,209
Interest Receivable and Other Assets 54,533 49,948
- --------------------------------------------------------------------------------------- ------------- --------------
Total Assets $1,226,295 $1,148,565
======================================================================================= ============= ==============
Liabilities
Deposits:
Demand $ 273,799 $ 223,000
Interest-Bearing Transaction 108,213 96,869
Savings 301,225 276,016
Time 318,873 308,464
- --------------------------------------------------------------------------------------- ------------- --------------
Total Deposits 1,002,110 904,349
- --------------------------------------------------------------------------------------- ------------- --------------
Federal Funds Purchased - 1,000
Federal Home Loan Bank Advances 80,889 111,928
Subordinated Debentures 10,310 10,310
Interest Payable and Other Liabilities 16,439 11,373
- --------------------------------------------------------------------------------------- ------------- --------------
Total Liabilities 1,109,748 1,038,960
- --------------------------------------------------------------------------------------- ------------- --------------
Commitments & Contingencies (See Note 15)
Shareholders' Equity
Preferred Stock: No Par Value. 1,000,000 Authorized, None Issued or Outstanding - -
Common Stock: Par Value $0.01, 2,000,000 Shares Authorized, 792,722 and
800,703 Issued and Outstanding at December 31, 2004 and 2003, respectively 8 8
Additional Paid-In Capital 82,237 72,506
Retained Earnings 35,332 37,650
Accumulated Other Comprehensive (Loss) (1,030) (559)
- --------------------------------------------------------------------------------------- ------------- --------------
Total Shareholders' Equity 116,547 109,605
- --------------------------------------------------------------------------------------- ------------- --------------
Total Liabilities and Shareholders' Equity $1,226,295 $1,148,565
======================================================================================= ============= ==============
The accompanying notes are an integral part of these consolidated financial
statements
5
Consolidated Statements of Changes in Shareholders' Equity
- ------------------------------------------------- -------------- -------- ------------ ----------- ------------------- ------------
(in thousands except per share data)
Accumulated
Common Additional Other Total
Shares Common Paid-In Retained Comprehensive Shareholders'
Outstanding Stock Capital Earnings Income(Loss) Equity
- ------------------------------------------------- -------------- -------- ------------ ----------- ------------------- ------------
Balance, December 31, 2001 719,269 $ 7 $61,360 $36,499 $2,870 $100,736
- ------------------------------------------------- -------------- -------- ------------ ----------- ------------------- ------------
Net Income 13,419 13,419
Cash Dividends Declared on
Common Stock (4,404) (4,404)
5% Stock Dividend 34,501 8,625 (8,625) -
Cash Paid in Lieu of Fractional
Shares Related to Stock Dividend (140) (140)
Repurchase of Stock (20,749) (5,006) (5,006)
Unrealized Gains on Derivative Instruments 117 117
Minimum Pension Plan Liability Adjustment (731) (731)
Change in Net Unrealized Loss on
Securities Available-for-Sale (426) (426)
- ------------------------------------------------- -------------- -------- ------------ ----------- ------------------- ------------
Balance, December 31, 2002 733,021 $ 7 $64,979 $36,749 $ 1,830 $103,565
- ------------------------------------------------- -------------- -------- ------------ ----------- ------------------- ------------
Net Income 14,775 14,775
Cash Dividends Declared on
Common Stock (4,736) (4,736)
5% Stock Dividend 35,985 1 8,995 (8,996) -
Cash Paid in Lieu of Fractional
Shares Related to Stock Dividend (142) (142)
Repurchase of Stock (5,732) (1,468) (1,468)
Change in Net Unrealized Gains on
Derivative Instruments (29) (29)
Minimum Pension Plan Liability Adjustment (1,257) (1,257)
Change in Net Unrealized Loss on
Securities Available-for-Sale (1,103) (1,103)
- ------------------------------------------------- -------------- -------- ------------ ----------- ------------------- ------------
Balance, December 31, 2003 763,274 $ 8 $72,506 $37,650 ($559) $109,605
- ------------------------------------------------- -------------- -------- ------------ ----------- ------------------- ------------
Net Income 16,450 16,450
Cash Dividends Declared on
Common Stock (5,723) (5,723)
5% Stock Dividend 37,429 12,838 (12,838) -
Cash Paid in Lieu of Fractional
Shares Related to Stock Dividend (207) (207)
Repurchase of Stock (7,981) (3,107) (3,107)
Change in Net Unrealized Gains on
Derivative Instruments (68) (68)
Minimum Pension Plan Liability Adjustment 971 971
Change in Net Unrealized Loss on
Securities Available-for-Sale (1,374) (1,374)
- ------------------------------------------------- -------------- -------- ------------ ----------- ------------------- ------------
Balance, December 31, 2004 792,722 $ 8 $82,237 $35,332 $ (1,030) $116,547
================================================= ============== ======== ============ =========== =================== ============
The accompanying notes are an integral part of these consolidated financial
statements
6
Consolidated Statements of Comprehensive Income
- ---------------------------------------------------------------------------------------- ----------- ----------- -----------
(in thousands)
Year Ended December 31,
2004 2003 2002
- ---------------------------------------------------------------------------------------- ----------- ----------- -----------
Net Income $16,450 $14,775 $13,419
Other Comprehensive (Loss) Income
Unrealized Gains (Losses) on Derivative Instruments:
Unrealized holding gains (losses) arising during the period, net
of income tax effects of $81, $(21) and $85 for the years ended
December 31, 2004, 2003 and 2002, respectively. 111 (29) 117
Less: Reclassification adjustment for realized gains
included in net income, net of related income tax effects
of $(130), $0 and $0 for the years ended December 31,
2004, 2003 and 2002, respectively. (179) - -
Unrealized Gain (Loss) on Minimum Pension Liability Adjustment:
Unrealized gain (loss) arising during the period, net of income
tax effects of $703, $(910) and $(531) for the years
ended December 31, 2004, 2003 and 2002, respectively. 971 (1,257) (731)
Unrealized Losses on Securities:
Unrealized holding losses arising during the period, net
of income tax effects of $(664), $(480) and $(117) for the
years ended December 31, 2004, 2003 and 2002, respectively. (915) (662) (266)
Less: Reclassification adjustment for realized gains
included in net income, net of related income tax effects
of $(333), $(320) and $(116) for the years ended December 31,
2004, 2003 and 2002, respectively. (459) (441) (160)
- ---------------------------------------------------------------------------------------- ----------- ----------- -----------
Total Other Comprehensive (Loss) (471) (2,389) (1,040)
- ---------------------------------------------------------------------------------------- ----------- ----------- -----------
Comprehensive Income $15,979 $12,386 $12,379
======================================================================================== =========== =========== ===========
The accompanying notes are an integral part of these consolidated financial
statements
7
Consolidated Statements of Cash Flows
- -------------------------------------------------------------------------------- ------------- -------------- -------------
(in thousands)
Year Ended December 31,
2004 2003 2002
- -------------------------------------------------------------------------------- ------------- -------------- -------------
Operating Activities
Net Income $ 16,450 $ 14,775 $ 13,419
Adjustments to Reconcile Net Income to Net Cash Provided
by Operating Activities:
Provision for Loan Losses 1,275 625 4,926
Cumulative Effect of Accounting Change 224 - -
Depreciation and Amortization 1,574 1,554 1,584
Provision for Deferred Income Taxes (1,771) (727) (836)
Net Amortization of Investment Security Premium & Discounts 857 1,725 10
Net Gain on Sale of Investment Securities (1,886) (935) (276)
Net (Gain) Loss on Sale of Property & Equipment (171) - -
Net Change in Operating Assets & Liabilities:
Net Increase in Interest Receivable and Other Assets (915) (1,874) (865)
Net Increase (Decrease) in Interest Payable and Other Liabilities 4,842 (949) (12)
- -------------------------------------------------------------------------------- ------------- -------------- -------------
Net Cash Provided by Operating Activities 20,479 14,194 17,950
- -------------------------------------------------------------------------------- ------------- -------------- -------------
Investing Activities
Securities Available-for-Sale:
Purchased (133,854) (217,309) (113,687)
Sold or Matured 170,934 196,640 150,026
Securities Held-to-Maturity:
Purchased (61,256) (22,340) (329)
Matured 9,317 12,328 5,214
Purchase of Life Insurance Contracts - (2,600) (10,080)
Net Increase in Loans (61,068) (110,928) (95,792)
Principal Collected on Loans Previously Charged Off 298 608 335
Net Additions to Premises and Equipment (5,384) (1,421) (1,495)
Proceeds from Sale of Property & Equipment 219 - -
- -------------------------------------------------------------------------------- ------------- -------------- -------------
Net Cash Used by Investing Activities (80,794) (145,022) (65,808)
- -------------------------------------------------------------------------------- ------------- -------------- -------------
Financing Activities
Net Increase in Demand, Interest-Bearing Transaction
and Savings Deposits 87,352 64,278 34,066
Net Increase (Decrease) in Time Deposits 10,409 (10,154) (3,552)
Net (Decrease) Increase in Federal Funds Purchased (1,000) (15,997) 16,997
Net (Decrease) Increase in Federal Home Loan Bank Advances (31,039) 70,963 (35)
Subordinated Debentures - 10,310 -
Stock Repurchases (3,107) (1,468) (5,006)
Cash Dividends (5,930) (4,878) (4,544)
- -------------------------------------------------------------------------------- ------------- -------------- -------------
Net Cash Provided by Financing Activities 56,685 113,054 37,926
- -------------------------------------------------------------------------------- ------------- -------------- -------------
Decrease in Cash and Cash Equivalents (3,630) (17,774) (9,932)
Cash and Cash Equivalents at Beginning of Year 35,800 53,574 63,506
- -------------------------------------------------------------------------------- ------------- -------------- -------------
Cash and Cash Equivalents at End of Year $32,170 $35,800 $53,574
================================================================================ ============= ============== =============
Supplementary Data
Cash Payments Made for Income Taxes $11,650 $ 8,050 $ 7,200
Interest Paid $ 9,863 $11,475 $14,260
================================================================================ ============= ============== =============
The accompanying notes are an integral part of these consolidated financial
statements
8
Notes to Consolidated Financial Statements
1. Significant Accounting Policies
Farmers & Merchants Bancorp (the Company) was organized March 10, 1999. Primary
operations are related to traditional banking activities through its subsidiary
Farmers & Merchants Bank of Central California (the Bank) which was established
in 1916. The consolidated financial statements of the Company and its
subsidiary, the Bank, are prepared in conformity with generally accepted
accounting principles and prevailing practices within the banking industry. In
preparing the financial statements, management is required to make estimates and
assumptions that affect reported amounts as of the date of the balance sheet and
revenues and expenses for the period. These estimates are based on information
available as of the date of the financial statements. Therefore, actual results
could differ from those estimates. The following is a summary of the significant
accounting and reporting policies used in preparing the consolidated financial
statements.
Basis of Presentation
The accompanying consolidated financial statements include the accounts of the
Company and the Company's wholly owned subsidiaries, F & M Bancorp, Inc. and the
Bank, along with the Bank's wholly owned subsidiaries, Farmers & Merchants
Investment Corporation and Farmers/Merchants Corp. Significant intercompany
transactions have been eliminated in consolidation. F & M Bancorp, Inc. was
created in March 2002 to protect the name F & M Bank. Farmers & Merchants
Investment Corporation has been dormant since 1991. Farmers/Merchants Corp. acts
as trustee on deeds of trust originated by the Bank. In December 2003, the
Company formed a wholly owned subsidiary, FMCB Statutory Trust I. FMCB Statutory
Trust I, is a non-consolidated subsidiary per generally accepted accounting
principals (GAAP), and was formed for the sole purpose of issuing Trust
Preferred Securities.
Certain amounts in the prior years' financial statements and related footnote
disclosures have been reclassified to conform to the current-year presentation.
These reclassifications have no effect on previously reported income.
Cash and Cash Equivalents
For purposes of the Consolidated Statements of Cash Flows, the Company has
defined cash and cash equivalents as those amounts included in the balance sheet
captions Cash and Due from Banks, Federal Funds Sold and Securities Purchased
Under Agreements to Resell. Generally, these transactions are for one-day
periods. For these instruments, the carrying amount is a reasonable estimate of
fair value.
Investment Securities
Investment securities are classified at the time of purchase as held-to-maturity
if it is management's intent and the Company has the ability to hold the
securities until maturity. These securities are carried at cost, adjusted for
amortization of premium and accretion of discount using a level yield of
interest over the estimated remaining period until maturity. Losses, reflecting
a decline in value judged by the Company to be other than temporary, are
recognized in the period in which they become known.
Securities are classified as available-for-sale if it is management's intent, at
the time of purchase, to hold the securities for an indefinite period of time
and/or to use the securities as part of the Company's asset/liability management
strategy. These securities are reported at fair value with aggregate, unrealized
gains or losses excluded from income and included as a separate component of
shareholders' equity, net of related income taxes. Fair values are based on
quoted market prices or broker/dealer price quotations on a specific
identification basis. Gains or losses on the sale of these securities are
computed using the specific identification method. Unrealized losses on these
securities, reflecting a decline in value judged by the Company to be other than
temporary, are recognized in the period in which they become known.
Trading securities, if any, are acquired for short-term appreciation and are
recorded in a trading portfolio and are carried at fair value, with unrealized
gains and losses recorded in non-interest income.
Loans
Loans are reported at the principal amount outstanding net of unearned discounts
and deferred loan fees. Interest income on loans is accrued daily on the
outstanding balances using the simple interest method. Loan origination fees are
deferred and recognized over the contractual life of the loan as an adjustment
to the yield. Loans are placed on a non-accrual status when the collection of
principal or interest is in doubt or when they become past due for 90 days or
more unless they are both well-secured and in the process of collection. For
this purpose a loan is considered well-secured if it is collateralized by
property having a net realizable value in excess of the amount of the loan or is
guaranteed by a financially capable party. When a loan is placed on non-accrual
status, the accrued and unpaid interest receivable is reversed and charged
against current income, thereafter, interest income is recognized only as it is
collected in cash. Loans placed on a non-accrual status are returned to accrual
status when the loans are paid current as to principal and interest and future
payments are expected to be made in accordance with the contractual terms of the
loan.
9
A loan is impaired when, based on current information and events, it is probable
that the Company will be unable to collect all amounts due according to the
contractual terms of the loan agreement. When a loan is impaired, the recorded
amount of the loan in the Consolidated Balance Sheets is based on the present
value of expected future cash flows discounted at the loan's effective interest
rate, or the observable or estimated market price of the loan or on the fair
value of the collateral if the loan is collateral dependent. Impaired loans are
placed on a non-accrual status with income reported accordingly. Cash payments
are first applied as a reduction of the principal balance until collection of
the remaining principal and interest can be reasonably assured. Thereafter,
interest income is recognized as it is collected in cash.
Allowance for Loan Losses
As a financial institution which assumes lending and credit risks as a principal
element in its business, the Company anticipates that credit losses will be
experienced in the normal course of business. Accordingly, the allowance for
loan losses is maintained at a level considered adequate by management to
provide for losses that are inherent in the portfolio. The allowance is
increased by provisions charged to operating expense on recoveries on loans
previously charged-off and reduced by net charge-offs. Management employs a
systematic methodology for determining the allowance for loan losses. On a
quarterly basis, management reviews the credit quality of the loan portfolio and
considers problem loans, delinquencies, internal credit reviews, current
economic conditions, loan loss experience and other factors in determining the
adequacy of the allowance balance.
The conditions evaluated in connection with the allowance may include existing
general economic and business conditions affecting the key lending areas of the
Company, credit quality trends, collateral values, loan volumes and
concentration, seasoning of the loan portfolio, specific industry conditions,
recent loss experience, duration of the current business cycle, bank regulatory
examination results and findings of the Company's internal credit examiners.
The allowance also incorporates the results of measuring impaired loans as
provided in Statement of Financial Accounting Standards (SFAS) No. 114,
"Accounting by Creditors for Impairment of a Loan" and SFAS No. 118, "Accounting
by Creditors for Impairment of a Loan-Income Recognition and Disclosures". These
accounting standards prescribe the measurement methods, income recognition and
disclosures related to impaired loans, which are discussed more fully in Note 4.
While the Company utilizes a systematic methodology in determining its
allowance, the allowance is based on estimates, and ultimate losses may vary
from current estimates. The estimates are reviewed periodically and, as
adjustments become necessary, are reported in earnings in the periods in which
they become known.
Premises and Equipment
Premises, equipment and leasehold improvements are stated at cost, less
accumulated depreciation and amortization. Depreciation is computed principally
by the straight line method over the estimated useful lives of the assets.
Estimated useful lives of buildings range from 30 to 40 years, and for furniture
and equipment from 3 to 8 years. Leasehold improvements are amortized over the
lesser of the terms of the respective leases, or their useful lives, which are
generally 5 to 10 years. Remodeling and capital improvements are capitalized
while maintenance and repairs are charged directly to occupancy expense.
Other Real Estate
Other real estate owned, which is included in other assets, is comprised of
properties acquired through foreclosures in satisfaction of indebtedness. These
properties are recorded at fair value less estimated selling costs upon
acquisition. Revised estimates to the fair value less cost to sell are reported
as adjustments to the carrying amount of the asset, provided that such adjusted
value is not in excess of the carrying amount at acquisition. Initial losses on
properties acquired through full or partial satisfaction of debt are treated as
credit losses and charged to the Allowance for Loan Losses at the time of
acquisition. Subsequent declines in value from the recorded amounts, routine
holding costs, and gains or losses upon disposition, if any, are included in
non-interest income or expense as incurred.
10
Income Taxes
As required, the Company uses the liability method of accounting for income
taxes. This method results in the recognition of deferred tax assets and
liabilities that are reflected at currently enacted income tax rates applicable
to the period in which the deferred tax assets or liabilities are expected to be
realized or settled. As changes in tax laws or rates are enacted, deferred tax
assets and liabilities are adjusted through the provision for income taxes. The
deferred provision for income taxes is the result of the net change in the
deferred tax asset and deferred tax liability balances during the year. This
amount combined with the current taxes payable or refundable results in the
income tax expense for the current year.
Earnings Per Share
Earnings per share amounts are computed by dividing net income by the weighted
average number of common shares outstanding for the period. The weighted average
number of shares outstanding for the years ending December 31, 2004, 2003 and
2002 were 796,751, 802,862 and 811,495. Prior years have been restated for the
5% stock dividend paid in each of the years presented.
Segment Reporting
The Statement of Financial Accounting Standards No. 131, "Disclosures about
Segments of an Enterprise and Related Information" requires that public
companies report certain information about operating segments. It also requires
that public companies report certain information about their products and
services, the geographic areas in which they operate, and their major customers.
The Company is a holding company for a community bank which offers a wide array
of products and services to its customers. Pursuant to its banking strategy,
emphasis is placed on building relationships with its customers, as opposed to
building specific lines of business. As a result, the Company is not organized
around discernable lines of business and prefers to work as an integrated unit
to customize solutions for its customers, with business line emphasis and
product offerings changing over time as needs and demands change. Therefore, we
only report one segment. Thus, all necessary requirements of SFAS No. 131 have
been met by the Company as of December 31, 2004.
Derivative Instruments and Hedging Activities
The Statement of Financial Accounting Standards, No. 133, "Accounting for
Derivative Instruments and Certain Hedging Activities" as amended by the
Statement of Financial Accounting Standards, No. 138, establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, and for hedging activities. All
derivatives, whether designated in hedging relationships or not, are required to
be recorded on the balance sheet at fair value. Changes in the fair value of
those derivatives are accounted for depending on the intended use of the
derivative and the resulting designation under specified criteria. If the
derivative is designated as a fair value hedge, the changes in the fair value of
the derivative and of the hedged item attributable to the hedged risk are
recognized in earnings. If the derivative is designated as a cash flow hedge,
designed to minimize interest rate risk, the effective portions of the change in
the fair value of the derivative are recorded in other comprehensive income net
of related income taxes. Ineffective portions of changes in the fair value of
cash flow hedges are recognized in earnings.
The Company utilizes derivative financial instruments such as interest rate
caps, floors, swaps and collars. These instruments are purchased and/or sold to
reduce the Company's exposure to changing interest rates. The Company marks to
market the value of its derivative financial instruments and reflects gain or
loss in earnings in the period of change or in other comprehensive income.
Comprehensive Income
The Statement of Financial Accounting Standards No. 130, "Reporting
Comprehensive Income" establishes standards for the reporting and display of
comprehensive income and its components in the financial statements. Other
comprehensive income refers to revenues, expenses, gains and losses that
generally accepted accounting principles recognize as changes in value to an
enterprise but are excluded from net income. For the Company, comprehensive
income (loss) includes net income and changes in fair value of its
available-for-sale investment securities, minimum pension liability adjustments
and cash flow hedges.
2. Securities Purchased Under Agreements to Resell
The Company enters into purchases and sales of securities under agreements to
resell substantially identical securities. These types of security transactions
are generally for one day periods and are primarily whole loan securities rated
AA or better. During 2004 and 2003, the underlying securities purchased under
resale agreements were delivered into the Bank's account at a third-party
custodian that recognizes the Company's rights and interest in these securities.
11
3. Investment Securities
The amortized cost, fair values and unrealized gains and losses of the
securities available-for-sale are as follows:
(in thousands)
Amortized Gross Unrealized Fair/Book
---------------------
December 31, 2004 Cost Gains Losses Value
- ------------------------------------------------------------------------------------------------------------------
Securities of U.S. Government Agencies $75,608 $ 32 $575 $75,065
Obligations of States and Political Subdivisions 17,453 556 - 18,009
Mortgage-Backed Securities 86,042 73 284 85,831
Other 6,440 143 - 6,583
- --------------------------------------------------------------------------------------------------------------------
Total $185,543 $804 $859 $185,488
Amortized Gross Unrealized Fair/Book
---------------------
December 31, 2003 Cost Gains Losses Value
- --------------------------------------------------------------------------------------------------------------------
Securities of U.S. Government Agencies $75,842 $631 $ 75 $76,398
Obligations of States and Political Subdivisions 27,850 965 21 28,794
Mortgage-Backed Securities 108,661 600 308 108,953
Other 9,296 524 - 9,820
- --------------------------------------------------------------------------------------------------------------------
Total $221,649 $2,720 $404 $223,965
====================================================================================================================
The book values, estimated fair values and unrealized gains and losses of
investments classified as held-to-maturity are as follows: (in thousands)
Amortized Gross Unrealized Fair/Book
---------------------
December 31, 2004 Cost Gains Losses Value
- -------------------------------------------------------------------------------------------------------------------
Securities of U.S. Government Agencies $ 19,943 $22 $118 $ 19,847
Obligations of States and Political Subdivisions 56,240 519 136 56,623
Mortgage-Backed Securities 13,471 - 43 13,428
Other 298 16 - 314
- -------------------------------------------------------------------------------------------------------------------
Total $ 89,952 $557 $297 $90,212
===================================================================================================================
Amortized Gross Unrealized Fair/Book
---------------------
December 31, 2003 Cost Gains Losses Value
- -------------------------------------------------------------------------------------------------------------------
Obligations of States and Political Subdivisions $ 37,582 $ 924 $167 $38,339
Other 375 25 - 400
- -------------------------------------------------------------------------------------------------------------------
Total $ 37,957 $ 949 $167 $38,739
===================================================================================================================
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.
The remaining principal maturities of debt securities as of December 31, 2004
and 2003 are shown below. Mortgage-Backed Securities are presented below based
on expected maturities. Expected maturities may differ from contractual
maturities as borrowers may have the right to call or prepay obligations with or
without call or prepayment penalties.
12
After 1 After 5 Total
Securities Available-for-Sale Within but but Over Fair
December 31, 2004 (in thousands) 1 Year Within 5 Within 10 10 years Value
- ------------------------------------------------------------------------------------------------------------------
Securities of U.S. Government Agencies $ 15,100 $50,119 $9,846 - $75,065
Obligations of States and Political Subdivisions 707 16,358 - 944 18,009
Mortgage-Backed Securities - 66,752 8,724 10,355 85,831
Other 6,583 - - - 6,583
- -------------------------------------------------------------------------------------------------------------------
Total $ 22,390 $133,229 $18,570 $11,299 $185,488
===================================================================================================================
2003 Totals $ 34,119 $172,771 $16,117 $ 958 $223,965
===================================================================================================================
After 1 After 5 Total
Securities Held-to-Maturity Within but but Over Fair
December 31, 2004 (in thousands) 1 Year Within 5 Within 10 10 years Value
- -------------------------------------------------------------------------------------------------------------------
Securities of U.S. Government Agencies - $10,039 $9,904 - $19,943
Obligations of States and Political Subdivisions 7,124 12,794 13,187 23,135 56,240
Mortgage-Backed Securities - 13,471 - - 13,471
Other - - 207 91 298
- -------------------------------------------------------------------------------------------------------------------
Total $ 7,124 $36,304 $23,298 $23,226 $89,952
===================================================================================================================
2003 Totals $ 6,147 $ 17,784 $ 11,402 $2,624 $ 37,957
===================================================================================================================
The following table shows those investments with gross unrealized losses and
their market value aggregated by investment category and length of time that
individual securities have been in a continuous unrealized loss position at
December 31, 2004.
Less Than 12 Months 12 Months or More Total
------------------- ------------------ -----
Fair Unrealized Fair Unrealized Fair Unrealized
(in thousands) Value Loss Value Loss Value Loss
- ---------------------------------------------------------------------------------------------------------------------
Securities of U.S. Government Agencies $69,892 $692 $ - $ - $69,892 $ 692
Obligations of States and Political Subdivisions 22,093 129 292 7 22,385 136
Mortgage-Backed Securities 65,588 239 7,063 88 72,651 327
Other - - - - - -
- ---------------------------------------------------------------------------------------------------------------------
Total $157,573 $1,060 $7,355 $95 $164,928 $1,155
Proceeds from sales of securities available-for-sale were as follows:
(in thousands) Gross Gross Gross
Proceeds Gains Losses
- --------------------------------------------------------------------------------------------------------------------
2004 $74,775 $ 1,976 $ 91
2003 65,406 1,096 161
2002 24,862 276 -
As of December 31, 2004, securities carried at $169,018,000 were pledged to
secure public and other deposits as required by law. This amount at December 31,
2003 was $111,400,000. The Company has reviewed its securities portfolio in
accordance with FASB 115 and the latest available information found in EITF 3-01
"Other-Than-Temporary Impairment of Investments" and found no securities that
match the criterion in the above rulings.
13
4. Loans and Allowance for Loan Losses Loans as of December 31, consisted of the
following:
(in thousands) 2004 2003
- --------------------------------------------------------------------------------------------------------------------
Real Estate $431,746 $386,735
Real Estate Construction 62,446 77,115
Home Equity 63,782 55,827
Agricultural 151,002 134,862
Commercial 142,133 136,955
Consumer 17,973 17,504
- --------------------------------------------------------------------------------------------------------------------
869,082 808,998
Less: Unearned Income on Loans (2,174) (2,092)
------------------------------------------------------------------------------------------------------------------
Total Loans $866,908 $806,906
==================================================================================================================
Non-Accrual Loans $ 214 $ 2,367
==================================================================================================================
Changes in the allowance for loan losses consisted of the following:
(in thousands)
2004 2003 2002
- --------------------------------------------------------------------------------------------------------------------
Balance, January 1 $17,220 $16,684 $12,709
Provision Charged to Operating Expense 1,275 625 4,926
Recoveries of Loans Previously Charged Off 298 608 335
Loans Charged Off (955) (697) (1,286)
Reclassification Adjustment* (111) - -
- --------------------------------------------------------------------------------------------------------------------
Balance, December 31 $17,727 $17,220 $16,684
====================================================================================================================
*As of December 31, 2004, the Company reclassified $111,000 of the Allowance for
Loan Losses that pertained to commitments under commercial and standby letters
of credit to the "other liabilities" section of the Consolidated Balance Sheets.
All impaired loans have been assigned a related allowance for credit losses. As
of December 31, 2004 and 2003, the total recorded investment in impaired loans
was $214,000 and $2,367,000, respectively. The related allowance for impaired
loans was $104,000 and $861,000 for the years ended 2004 and 2003, respectively.
The average balance of impaired loans was $1.6 million, $3.0 million and $4.7
million for the years ended 2004, 2003 and 2002, respectively. There was no
interest income reported on impaired loans in 2004, 2003 and 2002. Interest
income forgone on loans placed on nonaccrual status was $30,000, $356,000 and
$331,000 for the years ended December 31, 2004, 2003 and 2002, respectively. A
portion of pledged loans totaling $310,162,000 were used to secure Federal Home
Loan Bank advances of $40,000,000 and the unused commitments.
5. Premises and Equipment
Premises and equipment as of December 31, consisted of the following:
(in thousands) 2004 2003
- -------------------------------------------------------------------------------------------------------------------
Land and Buildings $18,934 $16,535
Furniture, Fixtures and Equipment 17,173 14,481
Leasehold Improvements 1,167 1,064
- -------------------------------------------------------------------------------------------------------------------
37,274 32,080
Less: Accumulated Depreciation and Amortization 22,303 20,871
- -------------------------------------------------------------------------------------------------------------------
Total $14,971 $11,209
===================================================================================================================
14
Depreciation and amortization on premises and equipment included in occupancy
and equipment expense amounted to $1,574,000, $1,554,000 and $1,585,000 for the
years ended December 31, 2004, 2003 and 2002, respectively. Total rental expense
for premises were $265,000, $255,000 and $248,000 for the years ended December
31, 2004, 2003 and 2002, respectively. Rental income was $115,000, $81,000 and
$73,000 for the years ended December 31, 2004, 2003 and 2002, respectively.
6. Other Real Estate
The Bank reported no other real estate at December 31, 2004 and 2003. Other real
estate includes property no longer utilized for business operations and property
acquired through foreclosure proceedings. These properties are carried at the
lower of cost or fair value less selling costs determined at the date acquired.
Losses arising from the acquisition of these properties are charged against the
allowance for loan losses. Subsequent declines in value, routine holding costs
and net gains or losses on disposition are included in other operating expense
as incurred.
7. Time Deposits
Time Deposits of $100,000 or more were as follows:
(in thousands)
December 31,
2004 2003
- -------------------------------------------------------------------
Balance $173,550 $156,586
===================================================================
At December 31, 2004, the scheduled maturities of time deposits were as follows:
Scheduled
(in thousands) Maturities
- ------------------------------------------------------------
2005 $279,402
2006 33,273
2007 5,245
2008 853
2009 100
Thereafter -
- ------------------------------------------------------------
Total $318,873
============================================================
8. Income Taxes
Current and deferred income tax expense (benefit) provided for the years ended
December 31, consisted of the following:
(in thousands) 2004 2003 2002
- -------------------------------------------------------------------------------------------------------------------
Current
Federal $8,071 $ 6,235 $5,506
State 3,228 2,535 2,384
- -------------------------------------------------------------------------------------------------------------------
Total Current 11,299 8,770 7,890
- -------------------------------------------------------------------------------------------------------------------
Deferred
Federal (1,379) (493) (503)
State (458) (234) (333)
- -------------------------------------------------------------------------------------------------------------------
Total Deferred (1,837) (727) (836)
- -------------------------------------------------------------------------------------------------------------------
Total Provision for Taxes* $9,462 $ 8,043 $7,054
===================================================================================================================
*The Provision for Taxes for 2004 includes the $163,000 tax impact associated
with the cumulative effect of change in accounting principle shown net of tax on
the Consolidated Statements of Income.
15
The total provision for income taxes differs from the federal statutory rate as
follows:
(in thousands)
2004 2003 2002
Amount Rate Amount Rate Amount Rate
- -------------------------------------------------------------------------------------------------------------------
Tax Provision at Federal Statutory Rate $9,069 35.0 % $7,986 35.0 % $7,165 35.0 %
Interest on Obligations of States
and Political Subdivisions
Exempt from Federal Taxation (769) (3.0)% (933) (4.0)% (806) (3.9)%
State and Local Income Taxes,
Net of Federal Income Tax Benefit 1,801 6.9% 1,496 6.5% 1,333 6.5 %
Bank Owned Life Insurance (645) (2.5)% (576) (2.5)% (523) (2.6)%
Other, Net 6 0.0% 70 0.0% (115) (0.6)%
- -------------------------------------------------------------------------------------------------------------------
Total Provision for Taxes $9,462 36.4% $8,043 35.0% $7,054 34.4 %
===================================================================================================================
The components of the net deferred tax assets as of December 31 are as follows:
(in thousands)
2004 2003
- --------------------------------------------------------------------------------
Deferred Tax Assets
Allowance for Loan Losses $7,500 $ 7,240
Accrued Liabilities 1,268 391
Deferred Compensation 1,635 1,320
Unrealized Loss on Minimum Pension Liability 737 1,441
State Franchise Tax 1,069 887
Interest on Non-Accrual Loans 13 150
- --------------------------------------------------------------------------------
Total Deferred Tax Assets 12,222 11,429
- --------------------------------------------------------------------------------
Deferred Tax Liabilities
Depreciation (Loss) (560) (401)
Unrealized Gain on Securities Available-for-Sale 468 (974)
Securities Accretion (407) (636)
Pension (413) (857)
Other (468) (250)
- --------------------------------------------------------------------------------
Total Deferred Tax Liabilities (1,380) (3,118)
- --------------------------------------------------------------------------------
Net Deferred Tax Assets $10,842 $8,311
================================================================================
The net deferred tax assets are reported in Interest Receivable and Other Assets
on the Company's Consolidated Balance Sheets.
9. Short Term Borrowings
As of December 31, 2004 and 2003, the Company had unused lines of credit
available for short term liquidity purposes of $399 million and $370 million,
respectively. Federal Funds purchased and advances from the Federal Reserve Bank
are generally issued on an overnight basis.
16
10. Federal Home Loan Bank Advances
The Company's advances from the Federal Home Loan Bank of San Francisco consist
of the following as of December 31,
(in thousands) 2004 2003
- -------------------------------------------------------------------------------------------------------------------
5.35% note payable due February 4, 2008 with interest due quarterly, callable February 2,
2003 and quarterly thereafter. $25,000 $25,000
5.38% note payable due August 12, 2008 with interest due quarterly, callable August 12,
2003 and quarterly thereafter. 15,000 15,000
5.60% amortizing note, interest and principal payable monthly with final maturity of
September 25, 2018. 889 928
1.13% fixed rate credit advance, interest payable monthly with a maturity of February 2,
2004. - 71,000
2.34% fixed rate credit advance, interest payable weekly with a maturity of January 5, 2005 30,000 -
2.04% variable rate credit advance, interest payable daily with a maturity of January 3, 2005 10,000 -
- -------------------------------------------------------------------------------------------------------------------
Total $80,889 $111,928
===================================================================================================================
In accordance with the Collateral Pledge and Security Agreement, advances are
secured by all Federal Home Loan Bank stock held by the Company and by agency
and mortgage-backed securities, classified as available-for-sale, with carrying
values of $44,884,000. A portion of pledged loans totaling $310,162,000 were
used to secure Federal Home Loan Bank advances of $40,000,000 and the unused
commitments.
11. Shareholders' Equity
Beginning in 1975 and continuing through 2004, the Company has issued an annual
5% stock dividend. Earnings per share amounts have been restated for each year
presented to reflect the stock dividend.
Dividends from the Bank constitute the principal source of cash to the Company.
The Company is a legal entity separate and distinct from the Bank. Under
regulations controlling California state chartered banks, the Bank is, to some
extent, limited in the amount of dividends that can be paid to shareholders
without prior approval of the State Department of Financial Institutions. These
regulations require approval if total dividends declared by a state chartered
bank in any calendar year exceed the bank's net profits for that year combined
with its retained net profits for the preceding two calendar years. As of
December 31, 2004, the Bank could declare dividends of $27,145,000 without
approval of the California State Banking Department. These regulations apply to
all California state chartered banks (see Note 19).
The Company and the Bank are subject to various regulatory capital requirements
administered by the federal banking agencies. Failure to meet minimum capital
requirements can initiate certain mandatory, and possibly discretionary, actions
by regulators that, if undertaken, could have a direct material effect on the
Company and the Bank's financial statements. Under capital adequacy guidelines
and the regulatory framework for prompt corrective action, the Company and the
Bank must meet specific capital guidelines that involve quantitative measures of
the Company and the Bank's assets, liabilities, and certain off-balance-sheet
items as calculated under regulatory accounting practices. The Company and 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 Total and Tier I capital (as defined in the
regulations) to risk-weighted assets (as defined in the regulations), and of
Tier I capital (as defined in the regulations) to average assets (as defined in
the regulations). 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 June 30, 2004, the most recent notification from the Federal Reserve Bank
categorized the Company and the Bank as well capitalized under the regulatory
framework for prompt corrective action. To be categorized as well capitalized,
the Company and the Bank must maintain minimum Total risk-based, Tier I
risk-based, Tier I leverage ratios as set forth in the table below. There are no
conditions or events since that notification that management believes have
changed the institutions' categories.
17
Well Capitalized
Regulatory Capital Under Prompt
(in thousands) Actual Requirements Corrective Action
December 31, 2004 Amount Ratio Amount Ratio Amount Ratio
- --------------------------------------------------------------------------------------------------------------------
Total Bank Capital to Risk Weighted Assets $136,916 13.00% $84,243 8.0% $105,303 10.0%
Total Consolidated Capital to Risk Weighted Assets $140,828 13.34% $84,437 8.0% N/A N/A
Tier I Bank Capital to Risk Weighted Assets $123,695 11.75% $42,121 4.0% $63,182 6.0%
Tier I Consolidated Capital to Risk Weighted Assets $127,577 12.09% $42,218 4.0% N/A N/A
Tier I Bank Capital to Average Assets $123,695 10.41% $47,540 4.0% $59,425 5.0%
Tier I Consolidated Capital to Average Assets $127,577 10.69% $47,720 4.0% N/A N/A
December 31, 2003 Amount Ratio Amount Ratio Amount Ratio
- --------------------------------------------------------------------------------------------------------------------
Total Bank Capital to Risk Weighted Assets $123,825 12.39% $79,966 8.0% $99,958 10.0%
Total Consolidated Capital to Risk Weighted Assets $132,751 13.24% $80,189 8.0% N/A N/A
Tier I Bank Capital to Risk Weighted Assets $111,272 11.13% $39,983 4.0% $59,975 6.0%
Tier I Consolidated Capital to Risk Weighted Assets $120,164 11.99% $40,095 4.0% N/A N/A
Tier I Bank Capital to Average Assets $111,272 9.91% $44,908 4.0% $56,135 5.0%
Tier I Consolidated Capital to Average Assets $120,164 10.67% $45,036 4.0% N/A N/A
12. Employee Benefit Plans
The Company, through the Bank, sponsors a defined benefit Pension Plan (the
Plan) that covers employees of Farmers & Merchants Bank of Central California.
Effective June 9, 2001 the Plan was amended to freeze the benefit accruals in
the Plan. With the exception of employees who had reached age 55 and who had
accumulated 10 years of Plan service, the effect of the amendment was to freeze
the participants' monthly pension benefit. Employees who had reached age 55 and
had accumulated 10 years of Plan service as of December 31, 2000 continue to
accrue benefits under the Plan. The Bank uses a December 31 measurement date for
the Plan.
The Plan provides benefits, up to a maximum stated in the Plan, based on each
covered employee's years of service and highest five-year average compensation
earned while a participant in the Plan. Plan benefits are fully vested after
five years of Plan service.
The Company's funding policy is to contribute annually an amount that is not
less than the ERISA minimum funding requirement and not in excess of the maximum
tax-deductible contribution as developed in accordance with the aggregate cost
method. The Bank expects to contribute $1.6 million to its Pension Plan in 2005.
At the February 1, 2005 meeting of the Board of Directors, it was decided to
terminate the Defined Benefit Pension Plan in 2005, subject to receipt of the
required approvals by the Internal Revenue Service and the Pension Benefit
Guarantee Corporation.
Because of the Company's decision to terminate the Plan in 2005, it elected to
accelerate the recognition of gain/loss over a two year amortization period
effective January 1, 2004, to match the remaining life of the Plan. This change
in amortization period resulted in a cumulative adjustment in the amount of
$387,000 ($224,000, net of tax).
18
The following schedule states the change in benefit obligations for the years
ended December 31:
(in thousands) 2004 2003
- --------------------------------------------------------------------------------------------------------------------
Benefit Obligation at Beginning of Year $5,369 $3,541
Service Cost 47 52
Interest Cost 255 224
Benefits Paid (483) (920)
Increase Due to Actuarial Loss and Assumption Change 320 2,472
- --------------------------------------------------------------------------------------------------------------------
Total Benefit Obligation at End of Year $5,508 $5,369
====================================================================================================================
The Change in Plan Assets are as follows: (in thousands) 2004 2003
- --------------------------------------------------------------------------------------------------------------------
Fair Value of Plan Assets at Beginning of Year $4,191 $3,104
Employer Contribution 225 1,974
Benefits Paid (483) (920)
Actual Return on Plan Assets 147 33
- --------------------------------------------------------------------------------------------------------------------
Total Fair Value of Plan Assets at End of Year $4,080 $4,191
====================================================================================================================
The following table sets forth the Plan's funded status along with amounts
recognized and not recognized in the Bank's Consolidated Balance Sheets for the
years ended December 31:
(in thousands) 2004 2003
- --------------------------------------------------------------------------------------------------------------------
Benefit Obligation $5,508 $ 5,369
Fair Value of Plan Assets 4,080 4,191
- --------------------------------------------------------------------------------------------------------------------
Funded Status (1,428) (1,178)
Unrecognized Net Loss 1,855 3,524
Cumulative Adjustment Required to Recognize Minimum Liability (1,756) (3,429)
- --------------------------------------------------------------------------------------------------------------------
Net Amounts Recognized $(1,329) $(1,083)
====================================================================================================================
Amounts Recognized: (in thousands)
- --------------------------------------------------------------------------------------------------------------------
Prepaid Benefit Cost $ - $ -
Accrued Benefit Liability (1,329) (1,083)
Intangible Asset - -
- --------------------------------------------------------------------------------------------------------------------
Net Amounts Recognized $(1,329) $(1,083)
====================================================================================================================
The accumulated benefit obligation for the defined benefit Pension Plan was $5.4
million and $5.3 million at December 31, 2004 and 2003, respectively.
The components of the net periodic benefit costs are as follows:
(in thousands) 2004 2003 2002
- --------------------------------------------------------------------------------------------------------------------
Service Cost $ 48 $ 52 $ 33
Interest Cost 255 224 222
Expected Return on Plan Assets (114) (127) (217)
Amortization of :
Unrecognized Prior Service Cost - - (1)
Unrecognized Net Loss 1,569 377 13
- --------------------------------------------------------------------------------------------------------------------
Total Net Periodic Benefit Cost $1,757 $ 526 $ 50
====================================================================================================================
(Decrease) /Increase in minimum liability included in other
comprehensive income $(1,674) $2,167 $1,262
====================================================================================================================
Weighted-average assumptions used to determine benefit obligations at December
31,
2004 2003
- ---------------------------------------------------------------------------------------------------------
Assumptions Used in the Accounting were:
Discount Rate (Settlement Rate) 4.89% 5.12%
Rate of Compensation Increase 4.00% 4.00%
=========================================================================================================
19
Weighted-average assumptions used to determine net benefit cost for years ended
December 31,
2004 2003 2002
- --------------------------------------------------------------------------------------------------------------------
Assumptions Used in the Accounting were:
Discount Rate (Settlement Rate) 5.12% 4.96% 7.25%
Expected Return on Plan Assets 3.00% 3.00% 6.00%
Rate of Compensation Increase 4.00% 4.00% 4.00%
====================================================================================================================
The Bank's Pension Plan weighted-average asset allocations for the years ended
December 31, 2004 and 2003, by asset category are as follows:
(in thousands) 2004 2003
- --------------------------------------------------------------------------------------------------------------------
Savings Deposit 0% 50%
Certificates of Deposit 0% 30%
Money Market Funds 30% 11%
Bonds 51% 4%
Equity Securities 19% 2%
Mutual Funds 0% 3%
- --------------------------------------------------------------------------------------------------------------------
Total 100% 100%
====================================================================================================================
As of December 31, 2004 and 2003 the Plan assets are invested as follows:
(in thousands) 2004 2003
- --------------------------------------------------------------------------------------------------------------------
Corporate Bonds 0% 13%
Government Bonds 0% 43%
Equity Securities 0% 24%
Savings Deposits 0% 0%
Money Market Funds 100% 20%
Mutual Funds 0% 0%
- --------------------------------------------------------------------------------------------------------------------
Total 100% 100%
====================================================================================================================
This mix may change as projected cash flows or market conditions change.
The Bank sponsors a Profit Sharing Plan for substantially all full-time
employees of the Bank with one or more years of service. Participants receive up
to two annual employer contributions, one is discretionary and the other is
mandatory. The discretionary contributions to the Profit Sharing Plan are
determined annually by the Board of Directors. The discretionary contributions
totaled $660,000, $635,000 and $625,000 for the years ended December 31, 2004,
2003 and 2002, respectively. The mandatory contributions to the Profit Sharing
Plan are made according to a predetermined set of criteria. Mandatory
contributions totaled $645,000, $575,000 and $522,000 for the years ended
December 31, 2004, 2003 and 2002, respectively. Bank employees are permitted,
within limitations imposed by tax law, to make pretax contributions to the
401(k) feature of the Profit Sharing Plan. The Bank does not match employee
contributions within the 401(k) feature of the Profit Sharing Plan and the Bank
can terminate the Profit Sharing Plan at any time.
Employees who have continued to accrue benefits under the Defined Benefit
Pension Plan since it was frozen in 2001 only participate in the discretionary
contributions to the Profit Sharing Plan (when the Defined Benefit Pension Plan
is terminated in 2005 these employees will begin to participate in the mandatory
contributions to the Profit Sharing Plan).
The Bank sponsors a Deferred Bonus Plan for certain employees. Deferred bonuses
are granted and benefits accumulate based on the cumulative profits during the
employee's participation period. The Bank contributed $248,000, $213,000 and
$222,000 for the years ended December 31, 2004, 2003 and 2002, respectively.
The Bank sponsors an Indexed Retirement Plan for certain employees. The plan is
designed to provide participants with supplemental non-qualified retirement
income. The Bank contributed $751,000 and $270,000 for the years ended December
31, 2004 and 2003, respectively.
20
13. Fair Value of Financial Instruments
The following disclosure of the estimated fair value of financial instruments is
made in accordance with the requirements of SFAS No. 107, "Disclosure about Fair
Value of Financial Instruments." The estimated fair value amounts have been
determined by the Company using available market information and appropriate
valuation methodologies. The use of assumptions and various valuation
techniques, as well as the absence of secondary markets for certain financial
instruments, will likely reduce the comparability of fair value disclosures
between financial institutions. In some cases, book value is a reasonable
estimate of fair value due to the relatively short period of time between
origination of the instrument and its expected realization. The following table
summarized the book value and estimated fair value of financial instruments as
of December 31:
2004 2003
Carrying Estimated Carrying Estimated
ASSETS: (in thousands) Amount Fair Value Amount Fair Value
- ------------------------------------------------------------- ------------- ------------- ------------ -------------
Cash and Cash Equivalents $32,170 $32,170 $35,800 $35,800
Investment Securities Held-to-Maturity 89,952 90,212 37,957 38,739
Investment Securities Available-for-Sale 185,488 185,488 223,965 223,965
Loans, Net of Unearned Income 866,908 865,206 806,906 812,067
Less: Allowance for Loan Losses 17,727 17,727 17,220 17,220
Loans, Net of Allowance 849,181 847,479 789,686 795,227
LIABILITIES:
Deposits:
Non-Interest Bearing 273,799 273,709 223,000 223,000
Interest-Bearing 728,311 727,509 681,349 682,880
Federal Home Loan Bank Advances 80,889 83,260 111,928 115,706
Subordinated Debentures 10,310 10,306 10,310 10,348
The methods and assumptions used to estimate the fair value of each class of
financial instrument listed in the table above are explained below.
Cash and cash equivalents: The carrying amounts reported in the balance sheet
for cash and due from banks and federal funds sold are a reasonable estimate of
fair value.
Investment securities: Fair values for investment securities are based on quoted
market prices, where available. If quoted market prices are not available, fair
values are based on quoted market prices of comparable instruments.
Loans: For variable-rate loans that reprice frequently and with no significant
change in credit risk, fair values are based on carrying values. The fair values
for fixed-rate loans are estimated using discounted cash flow analyses, using
interest rates currently being offered for loans with similar terms to borrowers
of similar credit quality.
Commitments to extend credit and standby letters of credit: The fair value of
commitments is estimated using the fees currently charged to enter into similar
agreements, taking into account the remaining terms of the agreements and the
present creditworthiness of the counterparties. For fixed-rate loan commitments,
fair value also considers the difference between current levels of interest
rates and the committed rates. The fair value of letters of credit is based on
fees currently charged for similar agreements or on the estimated cost to
terminate them or otherwise settle the obligations with the counterparties at
the reporting date.
Deposit liabilities: The fair value of demand deposits, interest bearing
transaction accounts and savings accounts is the amount payable on demand as of
December 31, 2004 and 2003. The fair value of fixed-maturity certificates of
deposit is estimated by discounting expected future cash flows utilizing
interest rates currently being offered for deposits of similar remaining
maturities.
21
Borrowings: The fair value of federal funds purchased and other short-term
borrowings is approximated by the book value. The fair value for Federal Home
Loan Bank borrowings is determined using discounted future cash flows.
Limitations: Fair value estimates presented herein are based on pertinent
information available to management as of December 31, 2004 and 2003. 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
amounts presented above.
14. Derivative Instruments and Hedging Activities
The Company uses derivative instruments to limit its exposure to changes in
interest rates. The Company has developed a Hedging Policy to provide guidelines
that address instruments to be used, authority limits, implementation
guidelines, guidelines for evaluating hedge alternatives, reporting
requirements, and the credit worthiness of the instrument's counterparty.
The Company reviews compliance with these guidelines annually with the ALCO
Committee and the Board of Directors. The guidelines may change as the Company's
business needs dictate.
In January of 2004, the Company terminated an interest rate swap agreement with
a notional amount of $12 million and maturity of December 8, 2006. As a result
of this termination, the Company recorded a deferred gain of $112,500 to be
amortized over the original remaining life of the interest rate swap as follows:
$37,500 in 2004, $37,500 in 2005 and $37,500 in 2006.
In February of 2004, the Company terminated an interest rate swap agreement with
a notional amount of $20 million and maturity of November 4, 2005. As a result
of this termination, the Company recorded a deferred gain of $60,000 to be
amortized over the original remaining life of the interest rate swap as follows:
$32,000 in 2004 and $28,000 in 2005.
In June of 2004, the Company entered into a $10 million, two year interest rate
swap maturing June 1, 2006 and a $5 million, three year interest rate swap
maturing June 1, 2007. The interest rate swap agreements effectively converted
$15 million of the Company's variable rate loans to a fixed rate consistent with
its interest rate management strategy during that period to limit exposure to
declining interest rates. The interest rate swaps received a fixed rate of 5.69%
and 6.25% respectively, and paid a floating rate based on Prime. In November
2004, the Company terminated both remaining swap positions resulting in a
combined loss of $73,000. Therefore, at December 31, 2004, there were no
remaining derivative positions.
As required, the Company records in the balance sheet the interest rate swaps at
fair value. Because the transactions meet the criteria for a cash-flow hedge,
changes in fair value are reported in other comprehensive income. In the event
that a portion of the hedge becomes ineffective, the ineffective portion of the
derivative's change in fair value will be immediately recognized in earnings.
15. Commitments and Contingencies
In the normal course of business, the Company is a party to financial
instruments with off-balance sheet risk to meet the financing needs of its
customers and to reduce its own exposure to fluctuations in interest rates.
These instruments include commitments to extend credit, letters of credit and
financial guarantees that are not reflected in the Consolidated Balance Sheets.
The Company's exposure to credit loss in the event of nonperformance by the
other party with regard to standby letters of credit, undisbursed loan
commitments and financial guarantees is represented by the contractual notional
amount of those instruments. Commitments to extend credit are agreements to lend
to a customer as long as there is no violation of any condition established in
the contract. The Company uses the same credit policies in making commitments
and conditional obligations as it does for recorded balance sheet items. The
Company may or may not require collateral or other security to support financial
instruments with credit risk. Evaluations of each customer's creditworthiness
are performed on a case-by-case basis.
22
Standby letters of credit are conditional commitments issued by the Company to
guarantee performance of or payment for a customer to a third party. The Company
had standby letters of credit outstanding of $15,766,000 at December 31, 2004,
and $12,218,000 at December 31, 2003. Outstanding standby letters of credit had
original terms ranging from 1 to 37 months with final expiration in 2008.
Commitments to extend credit are agreements to lend to a customer as long as
there is no violation of any condition contained in the contract. Commitments
generally have fixed expiration dates or other termination clauses and may
require payment of a fee. Undisbursed loan commitments totaled $378,840,000 and
$308,436,000 as of December 31, 2004 and 2003, respectively. Since many of these
commitments are expected to expire without fully being drawn upon, the total
commitment amounts do not necessarily represent future cash requirements.
The Company is obligated under a number of noncancellable operating leases for
premises and equipment used for banking purposes. Minimum future rental
commitments under noncancellable operating leases as of December 31, 2004 were
$262,000, $116,000, $49,000, $49,000, and $49,000 for the years 2005 to 2009 and
$8,000 thereafter.
In the ordinary course of business, the Company becomes involved in litigation
arising out of its normal business activities. Management, after consultation
with legal counsel, is of the opinion that the ultimate liability, if any,
resulting from the disposition of such claims would not be material in relation
to the financial position of the Company.
The Company may be required to maintain average reserves on deposit with the
Federal Reserve Bank primarily based on deposits outstanding. There were no
reserve requirements during 2004 or at December 31, 2004 and 2003.
16. Transactions with Related Parties
The Company, in the ordinary course of business, has had, and expects to have in
the future, deposit and loan transactions with Directors, executive officers and
their affiliated companies. These transactions were on substantially the same
terms, including interest rates, as those prevailing at the time for comparable
transactions with unaffiliated parties and do not involve more than normal
credit risk or other unfavorable features.
Loan transactions with Directors, executive officers and their affiliated
companies during the year ended December 31, 2004, were as follows:
(in thousands)
- ------------------------------------------------------------
Loan Balances December 31, 2003 $2,833
Disbursements During 2004 3,986
Loan Reductions During 2004 (3,264)
- ------------------------------------------------------------
Loan Balances December 31, 2004 $3,555
============================================================
17. Recent Accounting Developments
In June 2004, the Emerging Issues Task Force of the FASB issued final guidance
on its Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and Its
Application to Certain Investments." A consensus was reached regarding
disclosures about unrealized losses on available-for-sale debt and equity
securities accounted for under FASB Statements No. 115, "Accounting for Certain
Investments in Debt and Equity Securities."
This EITF describes a model involving three steps: (1) determine whether an
investment is impaired; (2) determine whether the impairment is
other-than-temporary; and (3) recognize the impairment loss in earnings.
The EITF also requires several additional disclosures for cost-method
investments. The EITF's impairment accounting guidance was effective for
reporting periods beginning after June 15, 2004. For all other investments
within the scope of this Issue, the disclosures are effective in annual
financial statements for fiscal years ending after June 15, 2004. The additional
disclosures for cost method investments are effective for fiscal years ending
after June 15, 2004.
The adoption of this EITF did not have a material impact on the Company's
consolidated financial statements. At December 31, 2004, management believed the
impairments described above are temporary and, accordingly, no impairment loss
has been recognized in the Company's consolidated statement of income.
23
Additionally, the Financial Accounting Standards Board (FASB) staff has
indicated that the FASB will likely delay until 2005 the finalization of FASB
Staff Position No. EITF Issue 03-1-a, "Implementation Guidance for the
Application of Paragraph 16 of EITF Issue No. 03-1, `The Meaning of
Other-than-temporary Impairment and Its Application to Certain Investments'"
(EITF 03-1). It is expected that the FASB will be taking a "fresh look" at
accounting for marketable securities and the meaning of other-than-temporary
impairment, and thus will reconsider EITF 03-1 in its entirety. Accordingly, FSP
No. EITF 03-1-a was not issued before the end of 2004.
FASB Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN
46") may have an impact on the treatment of the trust preferred securities we
have issued and the ability for those instruments to continue to provide the
Company with Tier 1 capital. FIN 46 prevents the Company from consolidating the
trust entity that issued these trust preferred securities. The Federal Reserve
has issued Supervisory Letter (SR 03-13) which allows for the inclusion of these
instruments in Tier 1 capital regardless of the impact of FIN 46 on the
consolidation of the trusts. There remains the potential that this determination
by the Federal Reserve may be changed at a later date (see Managements
Discussion and Analysis - Capital). We do not expect FIN 46 to have any other
material impact on the Company's financial condition or operating results.
On March 9, 2004, the Staff of the Securities and Exchange Commission (the "SEC
Staff") issued Staff Accounting Bulletin No. 105, "Application of Accounting
Principles to Loan Commitments" ("SAB 105"). SAB 105 provides guidance on the
initial recognition and measurement of loan commitments that meet the definition
of a derivative, and summarizes the related disclosure requirements. SAB 105 is
effective for all loan commitments accounted for as derivatives that are entered
into, or substantially modified, on or after April 1, 2004. SAB 105 addresses
loan commitments that the Financial Accounting Standards Board (FASB) defines as
derivatives in paragraph 6 of FASB Statement No. 133, Accounting for Derivative
Instruments and Hedging Activities, as amended by FASB Statement No. 149,
Amendment of Statement 133 on Derivative Instruments and Hedging Activities
("FAS 133"). These loan commitments relate to the origination of mortgage loans
that will be held for sale. SAB 105 does not apply to (1) commitments to
purchase mortgage loans that do not meet the definition of a derivative under
paragraph 6 of FAS 133; or (2) commitments that are explicitly excluded from the
scope of FAS 133 (i.e., commitments to originate mortgage loans that will be
held for investment purposes and loan commitments to originate other types of
loans). The Company does not currently originate mortgage loans to be held for
sale. If that should change in the future, we would take SAB 105 into
consideration but do not expect it to have a material impact on the Company's
financial condition or operating results.
18. Parent Company Financial Information
The financial information below is presented as of December 31, 2004 and
December 31, 2003.
Farmers & Merchants Bancorp
Balance Sheet
(in thousands) 2004 2003
- --------------------------------------------------------------------------------------------------------------------
Cash $ 2,244 $ 6,905
Investment in Farmers & Merchants Bank of Central California 123,694 111,272
Investment Securities 251 1,296
Loans 785 335
Other Assets 1,359 1,119
- --------------------------------------------------------------------------------------------------------------------
Total Assets $128,333 $120,927
====================================================================================================================
Subordinated Debentures $ 10,310 $ 10,310
Liabilities 363 174
Shareholders' Equity 117,660 110,443
- --------------------------------------------------------------------------------------------------------------------
Total Liabilities and Shareholders' Equity $ 128,333 $ 120,927
====================================================================================================================
24
Farmers & Merchants Bancorp
Income Statement
Year Ended December 31,
(in thousands) 2004 2003 2002
- --------------------------------------------------------------------------------------------------------------------
Equity Earnings in Farmers & Merchants Bank of Central California $ 16,593 $ 15,203 $ 13,561
Interest Income 27 78 167
Other Expenses, Net (170) (506) (309)
- --------------------------------------------------------------------------------------------------------------------
Net Income $ 16,450 $ 14,775 $ 13,419
====================================================================================================================
Farmers & Merchants Bancorp
Statement of Cash Flows
Year Ended December 31,
(in thousands) 2004 2003 2002
- -------------------------------------------------------------------------------------------------------------------
Cash Flows from Operating Activities:
Net Income $16,450 $14,775 $13,419
Adjustments to Reconcile Net Income to Net Cash Used in Operating Activities:
Equity in Undistributed Net Earnings from Subsidiary (9,243) (12,442) (5,460)
Gain on Sale of Securities (1,095) - -
Net Increase in Interest Receivable and Other Assets (110) (448) (200)
Net Increase in Interest Payable and Other Liabilities 189 174 -
- -------------------------------------------------------------------------------------------------------------------
Net Cash Provided by Operating Activities 6,191 2,059 7,759
- -------------------------------------------------------------------------------------------------------------------
Investing Activities:
Securities Purchased - (393) (47)
Securities Sold or Matured 1,815 13 1,423
Net Loans Originated (451) (335) 87
- -------------------------------------------------------------------------------------------------------------------
Net Cash Provided (Used) by Investing Activities 1,364 (715) 1,463
- -------------------------------------------------------------------------------------------------------------------
Financing Activities:
Subordinated Debentures Issued - 10,310 -
Stock Redemption (3,107) (1,468) (5,006)
Downstream of Trust Preferred Proceeds (3,180) - -
Cash Dividends (5,929) (4,878) (4,544)
- -------------------------------------------------------------------------------------------------------------------
Net Cash (Used) Provided by Financing Activities (12,216) 3,964 (9,550)
- -------------------------------------------------------------------------------------------------------------------
(Decrease) Increase in Cash and Cash Equivalents (4,661) 5,308 (328)
Cash and Cash Equivalents at Beginning of Year 6,905 1,597 1,925
- -------------------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents at End of Year $2,244 $6,905 $1,597
===================================================================================================================
19. Long-term Subordinated Debentures
In December 2003, the Company formed a wholly owned Connecticut statutory
business trust, FMCB Statutory Trust I ("Statutory Trust I"), which issued
$10,000,000 of guaranteed preferred beneficial interests in the Company's junior
subordinated deferrable interest debentures (the "Trust Preferred Securities").
These debentures qualify as Tier 1 capital under Federal Reserve Board
guidelines. All of the common securities of Statutory Trust I are owned by the
Company. The proceeds from the issuance of the common securities and the Trust
Preferred Securities were used by FMCB Statutory Trust to purchase $10,310,000
of junior subordinated debentures of the Company, which carry a floating rate
based on three-month LIBOR plus 2.85%. The debentures represent the sole asset
of Statutory Trust I. The Trust Preferred Securities accrue and pay
distributions at a floating rate of three-month LIBOR plus 2.85% per annum of
the stated liquidation value of $1,000 per capital security. The Company has
entered into contractual arrangements which, taken collectively, fully and
unconditionally guarantee payment of: (i) accrued and unpaid distributions
required to be paid on the Trust Preferred Securities; (ii) the redemption price
with respect to any Trust Preferred Securities called for redemption by
Statutory Trust I, and (iii) payments due upon a voluntary or involuntary
dissolution, winding up or liquidation of Statutory Trust I. The Trust Preferred
Securities are mandatorily redeemable upon maturity of the debentures on
December 17, 2033, or upon earlier redemption as provided in the indenture. The
Company has the right to redeem the debentures purchased by Statutory Trust I,
in whole or in part, on or after December 17, 2008. As specified in the
indenture, if the debentures are redeemed prior to maturity, the redemption
price will be the principal amount and any accrued but unpaid interest.
Additionally, if the Company decided to defer interest on the subordinated
debentures, the Company would be prohibited from paying cash dividends on the
Company's common stock.
25
Five Year Financial Summary of Operations
(in thousands, except for per share data)
Summary of Income: 2004 2003 2002 2001 2000
- -----------------------------------------------------------------------------------------------------------------------------------
Total Interest Income $ 59,300 $ 54,884 $ 54,238 $ 63,530 $ 66,127
Total Interest Expense 9,818 11,073 13,596 23,280 24,757
- -----------------------------------------------------------------------------------------------------------------------------------
Net Interest Income 49,482 43,811 40,642 40,250 41,370
Provision for Loan Losses 1,275 625 4,926 1,000 2,800
- -----------------------------------------------------------------------------------------------------------------------------------
Net Interest Income After
Provision for Loan Losses 48,207 43,186 35,716 39,250 38,570
Total Non-Interest Income 14,267 12,918 13,866 8,374 6,648
Total Non-Interest Expense 36,175 33,286 29,109 27,486 27,548
- -----------------------------------------------------------------------------------------------------------------------------------
Income Before Income Taxes 26,299 22,818 20,473 20,138 17,670
Provision for Income Taxes 9,625 8,043 7,054 7,821 6,650
- -----------------------------------------------------------------------------------------------------------------------------------
Net Income Before Cumulative Effect of Change in Accounting Principle 16,674 14,775 13,419 12,317 11,020
Cumulative Effect of a Change in Accounting Principle (net of tax) (224) - - - -
- -----------------------------------------------------------------------------------------------------------------------------------
Net Income $ 16,450 $ 14,775 $ 13,419 $ 12,317 $ 11,020
===================================================================================================================================
Balance Sheet Data:
- -----------------------------------------------------------------------------------------------------------------------------------
Total Assets $1,226,295 $1,148,565 $1,021,907 $ 970,883 $905,551
Loans 866,908 806,906 696,675 602,169 497,397
Allowance for Loan Losses 17,727 17,220 16,684 12,709 11,876
Investment Securities 275,440 261,922 233,933 275,550 320,654
Deposits 1,002,110 904,349 850,225 819,711 764,678
Federal Home Loan Bank Advances 80,889 111,928 40,965 41,000 41,033
Shareholders' Equity 116,547 109,605 103,565 100,736 90,883
- -----------------------------------------------------------------------------------------------------------------------------------
Selected Ratios
Return on Average Assets 1.40% 1.36% 1.41% 1.35% 1.29%
Return on Average Equity 14.50% 13.68% 13.16% 12.84% 12.94%
Dividend Payout Ratio 36.05% 33.02% 33.86% 32.93% 33.66%
Average Loans to Average Deposits 86.41% 85.29% 79.71% 68.37% 59.96%
Average Equity to Average Assets 9.68% 9.97% 10.71% 10.49% 9.94%
Period-end Shareholders' Equity to Total Assets 9.50% 9.54% 10.13% 10.38% 10.04%
Per Share Data
Net Income (1) $20.65 $18.40 $16.54 $14.87 $13.25
Cash Dividends Declared $7.20 $6.20 $6.00 $5.45 $5.00
(1) Based on the weighted average number of shares outstanding of 796,751,
802,862, 811,495, 828,554 and 831,388 for the years ended December 31, 2004,
2003, 2002, 2001, and 2000 respectively. Prior years have been adjusted for 5%
stock dividends issued in each of the above years.
26
Quarterly Financial Data
(in thousands, except for per share data)
First Second Third Fourth
2004 Quarter Quarter Quarter Quarter Total
- -------------------------------------------------------------------- ----------- ------------ ------------ ----------- ------------
Total Interest Income $ 14,045 $ 14,565 $ 15,114 $ 15,576 $ 59,300
Total Interest Expense 2,413 2,414 2,488 2,503 9,818
- -------------------------------------------------------------------- ----------- ------------ ------------ ----------- ------------
Net Interest Income 11,632 12,151 12,626 13,073 49,482
Provision for Loan Losses 375 350 350 200 1,275
- -------------------------------------------------------------------- ----------- ------------ ------------ ----------- ------------
Net Interest Income After
Provision for Loan Losses 11,257 11,801 12,276 12,873 48,207
Total Non-Interest Income 3,544 3,435 2,950 4,338 14,267
Total Non-Interest Expense 8,698 8,730 8,508 10,239 36,175
- -------------------------------------------------------------------- ----------- ------------ ------------ ----------- ------------
Income Before Income Taxes 6,103 6,506 6,718 6,972 26,299
Cumulative Effect of a Change in Accounting Principle (net of tax) - - - (224) (224)
Provision for Income Taxes 2,201 2,402 2,494 2,528 9,625
- -------------------------------------------------------------------- ----------- ------------ ------------ ----------- ------------
Net Income $ 3,902 $ 4,104 $ 4,224 $ 4,220 $ 16,450
==================================================================== =========== ============ ============ =========== ============
Earnings Per Share (1) $ 4.88 $ 5.14 $ 5.31 $ 5.32 $ 20.65
==================================================================== =========== ============ ============ =========== ============
First Second Third Fourth
2003 Quarter Quarter Quarter Quarter Total
- -------------------------------------------------------------------- ----------- ------------ ------------ ----------- ------------
Total Interest Income $ 13,199 $ 13,870 $ 13,775 $ 14,040 $ 54,884
Total Interest Expense 2,878 2,947 2,710 2,538 11,073
- -------------------------------------------------------------------- ----------- ------------ ------------ ----------- ------------
Net Interest Income 10,321 10,923 11,065 11,502 43,811
Provision for Loan Losses 200 125 150 150 625
- -------------------------------------------------------------------- ----------- ------------ ------------ ----------- ------------
Net Interest Income After
Provision for Loan Losses 10,121 10,798 10,915 11,352 43,186
Total Non-Interest Income 2,951 3,187 3,210 3,570 12,918
Total Non-Interest Expense 7,749 8,320 8,072 9,145 33,286
- -------------------------------------------------------------------- ----------- ------------ ------------ ----------- ------------
Income Before Income Taxes 5,323 5,665 6,053 5,777 22,818
Provision for Income Taxes 1,922 2,021 2,173 1,927 8,043
- -------------------------------------------------------------------- ----------- ------------ ------------ ----------- ------------
Net Income $ 3,401 $ 3,644 $ 3,880 $ 3,850 $ 14,775
==================================================================== =========== ============ ============ =========== ============
Earnings Per Share (1) $ 4.22 $ 4.54 $ 4.84 $ 4.80 $ 18.40
==================================================================== =========== ============ ============ =========== ============
Farmers & Merchants Bancorp stock is not traded on any exchange. The shares are
primarily held by local residents and are not actively traded. Dividends
declared semiannually during the past three years were for the following
amounts: June 2004, 2003 and 2002, $2.80, $2.10 and $2.00 per share,
respectively, and for December 2004, 2003, and 2002, $4.40, $4.10 and $4.00 per
share, respectively. Based on information from shareholders and from Company
stock transfer records, the prices paid in 2004, 2003 and 2002 ranged from
$238.00 to $455.00 per share. Additional information about the Company's common
stock is available in Part II, Item 5. of the Company's 2004 Form 10-K.
(1) Prior years' per share data has been restated for the 5% stock dividend
issued in each of the above years.
27
Management's Discussion and Analysis of Financial Condition and Results of
Operations
Forward-Looking Statements
This annual report contains various forward-looking statements, usually
containing the words "estimate," "project," "expect," "objective," "goal," or
similar expressions and includes assumptions concerning the Company's
operations, future results, and prospects. These forward-looking statements are
based upon current expectations and are subject to risk and uncertainties. In
connection with the "safe-harbor" provisions of the private Securities
Litigation Reform Act, the Company provides the following cautionary statement
identifying important factors which could cause the actual results of events to
differ materially from those set forth in or implied by the forward-looking
statements and related assumptions.
Such factors include the following: (i) the effect of changing regional and
national economic conditions; (ii) significant changes in interest rates and
prepayment speeds; (iii) credit risks of commercial, agricultural, real estate,
consumer, and other lending activities; (iv) changes in federal and state
banking laws or regulations; (v) competitive pressure in the banking industry;
(vi) changes in governmental fiscal or monetary policies; (vii) uncertainty
regarding the economic outlook resulting from the continuing war on terrorism,
as well as actions taken or to be taken by the U.S. or other governments as a
result of further acts or threats of terrorism; (viii) dividend restrictions;
(ix) asset/liability pricing risks and liquidity risks; (x) changes in the
securities markets; (xi) certain operational risks involving data processing
systems or fraud; (xii) the State of California's fiscal difficulties; and
(xiii) other external developments which could materially impact the Company's
operational and financial performance.
Readers are cautioned not to place undue reliance on these forward-looking
statements which speak only as of the date hereof. The Company undertakes no
obligation to update any forward-looking statements to reflect events or
circumstances arising after the date on which they are made.
Introduction
Farmers & Merchants Bancorp is a bank holding company formed March 10, 1999. Its
subsidiary, Farmers & Merchants Bank of Central California is a California
state-chartered bank formed in 1916. The Bank services the northern Central
Valley of California with 18 banking offices. The service area includes
Sacramento, San Joaquin, Stanislaus and Merced Counties with branches in
Sacramento, Elk Grove, Galt, Lodi, Stockton, Linden, Modesto, Turlock and
Hilmar.
Substantially all of the Company's business activities are conducted within its
market area.
This section should be read in conjunction with the consolidated financial
statements and the notes thereto, along with other financial information
included in this report.
Overview
The Company's primary service area encompasses the northern Central Valley of
California, a region that is impacted by the seasonal needs of the agricultural
industry. Accordingly, discussion of the Company's Financial Condition and
Results of Operations is influenced by the seasonal banking needs of its
agricultural customers (e.g., during the spring and summer customers draw down
their deposit balances and increase loan borrowing to fund the purchase of
equipment and planting of crops. Correspondingly, deposit balances are
replenished and loans repaid in fall and winter as crops are harvested and
sold).
28
The Five Year Period: 2000 through 2004
The following table presents key performance data for the Company over the past
five years.
(in thousands, except per share data)
- -----------------------------------------------------------------------------------------------------------------------
Financial Performance Indicator 2004 2003 2002 2001 2000
- -----------------------------------------------------------------------------------------------------------------------
Net Income $ 16,450 $ 14,775 $ 13,419 $ 12,317 $ 11,020
- -----------------------------------------------------------------------------------------------------------------------
Total Assets $ 1,226,295 $ 1,148,565 $ 1,021,907 $970,883 $905,551
- -----------------------------------------------------------------------------------------------------------------------
Total Loans $ 866,908 $ 806,906 $ 696,675 $602,169 $497,397
- -----------------------------------------------------------------------------------------------------------------------
Total Deposits $ 1,002,110 $ 904,349 $ 850,225 $819,711 $764,678
- -----------------------------------------------------------------------------------------------------------------------
Total Shareholders' Equity $ 116,547 $ 109,605 $ 103,565 $100,736 $ 90,883
- -----------------------------------------------------------------------------------------------------------------------
Total Risk-Based Capital Ratio 13.34% 13.24% 12.25% 13.76% 15.41%
- -----------------------------------------------------------------------------------------------------------------------
Non-Performing Loans as a % of Total Loans 0.03% 0.32% 0.42% 0.40% 0.30%
- -----------------------------------------------------------------------------------------------------------------------
Net Charge-Offs to Average Loans 0.08% 0.01% 0.15% 0.03% 0.16%
- -----------------------------------------------------------------------------------------------------------------------
Loan Loss Allowance as a % of Total Loans 2.04% 2.13% 2.39% 2.11% 2.39%
- -----------------------------------------------------------------------------------------------------------------------
Return on Average Assets 1.40% 1.36% 1.41% 1.35% 1.29%
- -----------------------------------------------------------------------------------------------------------------------
Return on Average Equity 14.50% 13.68% 13.16% 12.84% 12.94%
- -----------------------------------------------------------------------------------------------------------------------
Earnings Per Share $ 20.65 $ 18.40 $ 16.54 $ 14.87 $ 13.25
- -----------------------------------------------------------------------------------------------------------------------
Cash Dividends Per Share (1) $ 7.20 $ 6.20 $ 6.00 $ 5.45 $ 5.00
- -----------------------------------------------------------------------------------------------------------------------
Cash Dividends Declared (2) $ 5,723 $ 4,736 $ 4,404 $ 3,923 $ 3,609
- -----------------------------------------------------------------------------------------------------------------------
# Shares Repurchased During Year 7,981 5,732 20,749 2,053 5,994
- -----------------------------------------------------------------------------------------------------------------------
Average Share Price of Repurchased Shares $ 389 $ 256 $ 241 $ 238 $ 210
- -----------------------------------------------------------------------------------------------------------------------
High Stock Price - Fourth Quarter $ 455.00 $ 375.00 $ 300.00 $ 250.00 $ 245.00
- -----------------------------------------------------------------------------------------------------------------------
Low Stock Price - Fourth Quarter $ 400.00 $ 300.00 $ 250.00 $ 250.00 $ 240.00
- -----------------------------------------------------------------------------------------------------------------------
(1) Prior years' per share data has been restated for the 5% stock dividend
issued in each of the above years. (2) Not including cash paid in lieu of
fractional shares related to the stock dividend. These payments totaled $722,000
over the five year period.
During the five year period 2000 through 2004, the Company's operating
performance improved every year.
o Annual net income increased 49% to $16.4 million from $11.0 million.
o Earnings Per Share increased 56% to $20.65 from $13.25.
o Return on Average Equity increased from 12.94% to 14.50%, a 156 basis point
increase.
o Total assets increased 36% to $1.23 billion.
o Total loans increased 74% to $866.9 million.
Importantly, during this period of asset and earnings growth:
o The Company's risk based capital ratio has remained above the 10% level that
federal and state banking regulators require for banks to be considered "well
capitalized" (see Financial Condition - Capital).
o The Company's asset quality has remained strong, as reflected by net
charge-offs never exceeding 0.16% of average loans in any year and
non-performing loans totaling 0.03% of total loans at December, 31, 2004 (see
Financial Condition - Non-Performing Assets).
o The Company's allowance for loan losses has been maintained above 2% of total
loans, reflecting a conservative approach to providing` for loan losses (see
Results of Operations - Provision and Allowance for Loan Losses).
29
As a result of this strong earnings performance, capital position and asset
quality, shareholders have benefited well in excess of overall stock market
returns over the past five years.
o Return on Average Equity has increased every year from 12.94% in 2000 to
14.50% in 2004.
o Cash Dividends per Share have increased 60% since 1999, and totaled $29.85
per share over the five year period.
o The market price of the Company's stock has increased $215 per share from a
close of $210 in the fourth quarter of 1999 to a close of $425 in the fourth
quarter of 2004. This increase in shareholder value has been further enhanced
by the 5% stock dividend declared each year, resulting in the average
shareholder owning approximately 126 shares at December 31, 2004 for every
100 shares they owned at December 31, 1999.
o The combination of cash dividends, stock dividends, cash payments in lieu of
fractional shares from stock dividends and increase in market value of the
stock has provided investors with a total return exceeding 170% during the
five year period. Management believes that this compares very favorably to
overall stock market returns as represented by the AMEX Market Index and the
CoreData Group Index of Banks and Bank Holding Companies (see Performance
Graph in the Company's definitive proxy statement for the 2005 Annual Meeting
of Shareholders).
o The total market capitalization of the Company has increased by $198 million
over the five year period.
As part of an overall capital management program, beginning in 1998 the Company
implemented a stock repurchase program. Since 1999, the Company has repurchased
over 44,000 shares for total consideration of $11.7 million. The Company will
continue to repurchase shares when it believes it is in the best long-term
interest of shareholder value.
The Current Year: 2004
At the completion of our 88th year, management and the Board are pleased to
report the highest net income in the Company's history. As of December 31, 2004,
Farmers & Merchants Bancorp reported net income of $16.4 million, earnings per
share of $20.65, return on average assets of 1.40% and return on average equity
of 14.50%.
The Company's continuing strong earnings performance in 2004 was due to a
combination of (1) growth in earning assets, (2) improvement in the mix of
earning assets as reflected by an increase in loans as a percentage of average
earning assets, and (3) continued strong expense control as reflected in an
efficiency ratio of 57%.
The following is a summary of the financial accomplishments achieved during
2004.
o Net income increased 11.3% to $16.4 million from $14.8 million.
o Earnings per share increased 12.2% to $20.65 from $18.40.
o Net interest income increased 12.9% to $49.5 million from $43.8 million.
o Total assets increased 6.9% to $1.23 billion from $1.15 billion.
o Investment securities increased 5.2% to $275.4 million from $261.9 million.
o Gross loans increased 7.4% to $866.9 million from $806.9 million.
30
o Total deposits increased 10.8% to $1.0 billion from $904.3 million.
o Total shareholders' equity increased 6.3% to $116.5 million from $109.6
million, after dividends of $5.7 million, stock buybacks of $3.1 million and
a decline in Accumulated Other Comprehensive Income of $471,000.
o Total market capitalization increased $49 million.
Looking Forward: 2005 and Beyond
In management's opinion, the following key issues will influence the financial
results of the Company in 2005 and future years:
o Between June and December 2004, the Company's net interest margin improved
approximately 30 basis points as a result of the Federal Reserve's 125 basis
point increase in short-term market rates. Management's current expectation
is that short-term market rates will continue to rise in 2005; however, no
assurance can be given that rates will continue to rise. Should market rates
continue to rise, the Company's net interest margin is expected to improve
further. For each 10 basis point increase in the Company's net interest
margin, net interest income is expected to increase approximately $1.15
million.
o As of December 31, 2004 non-performing loans were $225,000 compared to $2.6
million at December 31, 2003. If credit quality continues to remain at these
levels, the Company may be able to reduce its 2005 Provision for Loan Losses
relative to the $1.27 million recorded in 2004.
o The Company has decided to terminate its Defined Benefit Pension Plan in 2005
(see Note 12 of Notes to Consolidated Financial Statements). This will result
in increased expense recognition in 2005 of approximately $1.4 million over
previously forecasted amounts, but will eliminate the need for approximately
$575,000 per year in expense recognition in 2006 and future years.
In addition to the preceding issues, management has carefully examined the
Company's existing branch delivery system, along with the availability and
desirability of additional branch locations, and decided to initiate a major
branch expansion, relocation and renovation program. New branches will be
opened during 2005 in Sacramento, Galt, Lodi and Stockton and the Turlock
branch will be relocated to a new facility. Renovations are being undertaken at
many branches, both to update these facilities and comply with the Americans
with Disabilities Act. In management's opinion, these moves are integral to the
long-term strategic positioning of the Company.
The Company currently estimates that the capital expenditures associated with
this branch program will be in excess of $10 million over the next twelve to
eighteen months, which will result in an increase in the Company's 2005
occupancy expense as compared to 2004. In addition, the staffing and other
operating expense implications of new branches will place pressure on the
Company's earnings over the next 36-48 months, the timeframe in which these
branches are estimated to reach break-even.
Results of Operations
The following discussion and analysis is intended to provide a better
understanding of Farmers & Merchants Bancorp and its subsidiaries' performance
during 2004 and 2003, the material changes in financial condition, operating
income and expense of the Company and its subsidiaries as shown in the
accompanying financial statements.
31
Net Interest Income
Net interest income is the amount by which the interest and fees on loans and
other interest earning assets exceed the interest paid on interest bearing
sources of funds. For the purpose of analysis, the interest earned on tax-exempt
investments and municipal loans is adjusted to an amount comparable to interest
subject to normal income taxes. This adjustment is referred to as "taxable
equivalent" adjustment and is noted wherever applicable. Interest income and
expense are affected by changes in the volume and mix of average interest
earning assets and average interest bearing liabilities, as well as fluctuations
in interest rates. Therefore, increases or decreases in net interest income are
analyzed as changes in volume, changes in rate and changes in the mix of assets
and liabilities.
The Company's earning assets and rate sensitive liabilities are subject to
repricing at different times, which exposes the Company to income fluctuations
when interest rates change. In order to minimize income fluctuations, the
Company attempts to match asset and liability maturities. However, some maturity
mismatch is inherent in the asset and liability mix. See Quantitative and
Qualitative Disclosures About Market Risk under Market Risk-Interest Rate Risk.
Net interest income increased 12.9% to $49.5 million during 2004. During 2003,
net interest income was $43.8 million, representing an increase of 7.8% from
2002. On a fully taxable equivalent basis, net interest income increased 11.9%
and totaled $50.8 million during 2004, compared to $45.4 million for 2003. In
2002, on a fully taxable equivalent basis, net interest income increased 1.0% or
$400,000 from that of 2001. The primary reason for the increase in net interest
income during 2004 was an improvement in the volume and mix (as reflected by an
increase in loans as a percentage of average earning assets) of earning assets.
However, since the Federal Reserve began increasing market interest rates in
June, 2004, the Company's net interest income has started to benefit from an
increase in the yield on earning assets.
Net interest income on a taxable equivalent basis, expressed as a percentage of
average total earning assets, is referred to as the net interest margin. For
2004, the Company's net interest margin was 4.65% compared to 4.50% in 2003.
Although this improvement is primarily a result of a decrease in the cost of
interest bearing liabilities, the Company's yield on earning assets has begun to
improve as a result of the Federal Reserve's 125 basis point increase in market
rates since June 30, 2004. Should market rates continue to rise, the Company's
net interest margin is expected to improve further.
Loans, generally the Company's highest earning assets, increased $60.0 million
as of December 31, 2004 compared to December 31, 2003. On an average balance
basis, loans increased by $86.6 million for the year ended December 31, 2004. As
a result of this loan growth, the mix of the Company's earning assets improved
as loans increased from 73.1% of average earning assets during 2003 to 75.5% in
2004. Due to the continued lagging impact of the decline in market interest
rates during 2003 and the first half of 2004, the year-to-date yield on the loan
portfolio decreased 10 basis points to 5.98% for the year ended December 31,
2004 compared to 6.08% for the year ended December 31, 2003. Since the Federal
Reserve began raising rates in June 2004, this decline in loan portfolio yields
has begun to reverse. This decrease in yield was offset by the growth in loan
balances, which resulted in interest revenue from loans increasing 9.8% to $49.3
million for 2004.
The investment portfolio is the other main component of the Company's earning
assets. The Company invests primarily in mortgage-backed securities, U.S.
Government Agencies, and high-grade municipals. Since the risk factor for these
types of investments is significantly lower than that of loans, the yield earned
on investments is generally less than that of loans.
Average investment securities remained relatively unchanged from the prior year.
Average balances decreased $2.5 million in 2004 compared to the average balance
during 2003 and interest income on securities decreased $275 thousand for the
year ended December 31, 2004. The declining market interest rate environment in
2003 and early 2004, and the fact that rates have remained low for a substantial
time, resulted in maturities in the portfolio being reinvested at rates slightly
below prior years. The average yield, on a taxable equivalent basis, in the
investment portfolio was 4.4% in 2004 compared to 4.5% in 2003. Net interest
income on the Schedule of Year-to-Date Average Balances and Interest Rates in
the Company's Form 10-K is shown on a taxable equivalent basis, which is higher
than net interest income as reflected on the Consolidated Statements of Income
because of adjustments that relate to income on securities that are exempt from
federal income taxes.
32
Average interest-bearing sources of funds increased $39.4 million or 5.1% during
2004. Of that increase, average borrowed funds (primarily FHLB Advances)
decreased $19.1 million, interest-bearing deposits increased $48.6 million, and
subordinated debt increased $9.9 million.
During 2004, the Company was able to grow average interest bearing deposits by
$48.6 million. The increase was primarily in lower cost savings and interest
bearing DDA deposits, which grew $37.7 million, as higher cost time deposits
grew by $10.9 million. Total interest expense on deposit accounts for 2004 was
$6.7 million as compared to $8.1 million in 2003. Even as deposits increased,
due to a continuing decline in market interest rates throughout the first half
of 2004, interest expense on deposits decreased 17.9% or $1.5 million in 2004.
The average rate paid on interest-bearing deposits was 0.9% in 2004 and 1.2% in
2003.
Provision and Allowance for Loan Losses
As a financial institution that assumes lending and credit risks as a principal
element of its business, credit losses will be experienced in the normal course
of business. The allowance for loan losses is established to absorb losses
inherent in the loan portfolio. The allowance for loan losses is maintained at a
level considered by management to be adequate to provide for risks inherent in
the loan portfolio. The allowance is increased by provisions charged to
operating expense and reduced by net charge-offs. In determining the adequacy of
the allowance for loan losses, management takes into consideration examinations
by the Company's supervisory authorities, results of internal credit reviews,
financial condition of borrowers, loan concentrations, prior loan loss
experience, and general economic conditions. The allowance is based on estimates
and ultimate losses may vary from the current estimates. Management reviews
these estimates periodically and, when adjustments are necessary, they are
reported in the period in which they become known.
After reviewing all factors, management concluded that the allowance for loan
losses as of December 31, 2004 was adequate.
The Company has established credit management policies and procedures that
govern both the approval of new loans and the monitoring of the existing
portfolio. The Company manages and controls credit risk through comprehensive
underwriting and approval standards, dollar limits on loans to one borrower and
by restricting loans made primarily to its principal market area where
management believes it is better able to assess the applicable risk.
Additionally, management has established guidelines to ensure the
diversification of the Company's credit portfolio such that even within key
portfolio sectors such as real estate or agriculture, the portfolio is
diversified across factors such as location, building type, crop type, etc.
Management reports regularly to the Board of Directors regarding trends and
conditions in the loan portfolio and regularly conducts credit reviews of
individual loans. Loans that are performing but have shown some signs of
weakness are subjected to more stringent reporting and oversight.
The provision for loan losses totaled $1.3 million in 2004, compared to $625,000
in 2003. The increase in the provision was the result of management's evaluation
of the adequacy of the allowance for loan losses relative to factors such as the
credit quality of the loan portfolio, loan growth, current loan losses, the
prevailing economic climate, and its effect on borrowers' ability to repay loans
in accordance with the terms of the notes.
As of December 31, 2004, the allowance for loan losses was $17.7 million, which
represented 2.0% of the total loan balance. At December 31, 2003 the allowance
for loan losses was $17.2 million or 2.1% of the total loan balance.
33
The table below illustrates the change in the allowance for loan losses for the
years 2004 and 2003.
Allowance for Loan Losses
(in thousands) 2004 2003
Allowance at Beginning of Year $ 17,220 $ 16,684
Provision Charged to Expense 1,275 625
Recoveries of Loans Previously Charged Off 298 608
Loans Charged Off (955) (697)
Reclassification Adjustment* (111) -
- -----------------------------------------------------------------------------
Allowance at End of Year $ 17,727 $ 17,220
=============================================================================
*As of December 31, 2004, the Company reclassified $111,000 of the Allowance for
Loan Losses that pertained to commitments under commercial and standby letters
of credit to the "other liabilities" section of the Consolidated Balance Sheets.
Non-Interest Income
Non-interest income includes income derived from services such as merchant
bankcard, investment services and other miscellaneous business services. It also
includes service charges and fees from deposit accounts, net gains and losses
from the sale of investment securities, increases in the cash surrender value of
bank owned life insurance and gains and losses from the sale of assets and other
real estate owned.
Non-interest income totaled $14.3 million for 2004. This represents an increase
of $1.3 million or 10.4% from non-interest income of $12.9 million for 2003.
During 2003, non-interest income decreased $948,000 or 6.8% from non-interest
income of $13.9 million for 2002. The decrease in non-interest income between
2002 and 2003 was primarily due to the fact that during 2002 the Company
recorded a gain of $2.8 million from the sale of preferred stock previously
acquired through a troubled debt restructuring. After adjusting for this
non-recurring transaction, non-interest income increased $1.8 million or 16.7%
in 2003 over 2002.
Service charges on deposit accounts totaled $4.8 million in 2004. This
represents a decrease of $101,000 or 2.1% from service charges on deposit
accounts of $4.9 million in 2003. Service charges on demand deposit accounts for
business customers are generally charged based on an analysis of their activity.
The activity charges for a given month may be offset by an earnings credit which
will impact the overall level of service charges. Service charges in 2003
increased $132,000 or 2.8% over service charges on deposit accounts of $4.8
million in 2002.
Gain on sale of investment securities totaled $1.9 million in 2004. This
represents an increase of $951,000 or 101.7% over 2003. During the fourth
quarter of 2004 the Company sold $1.8 million in common stock that it had
acquired for a gain of $1.1 million.
The Company provides merchant bankcard services to business customers in its
service area. Fee income of $1.8 million was generated in 2004. This represents
an increase of $95,000 or 5.7% over fee income of $1.7 million in 2003. Fee
income of $1.4 million was generated in 2002. The increase during 2004 was due
to an increase in merchant volume during the year.
During 2004, the Company sold some fully depreciated and previously written off
fixed assets resulting in a gain of $171,000.
During 2002 and 2003, the Company purchased life insurance on its key
executives. The increase in the cash surrender value of such policies for 2004
was $1.6 million, an increase of $42,000 or 2.7% over 2003.
Other non-interest income totaled $4.1 million in 2004, an increase of $191,000
or 4.9% over 2003. In 2003, other non-interest income totaled $3.9 million
compared to $3.2 million in 2002. Fees from these services include ATM fees,
wire transfer fees, gain on sale of mortgage loans and other miscellaneous
charges.
34
Non-Interest Expense
Non-interest expense for the Company includes expenses for salaries and employee
benefits, occupancy, equipment, supplies, legal fees, professional services,
data processing, marketing, deposit insurance, merchant bankcard operations, and
other miscellaneous expenses.
Overall, non-interest expense increased $2.9 million or 8.7% for the year ended
December 31, 2004, primarily as a result of a $3.0 million increase in salaries
and employee benefits. This increase was due to: (1) officer salary merit
increases which occurred in May 2004; (2) increased contributions to the
Company's incentive compensation and supplemental retirement plans; and (3)
increased expense recognition associated with the planned termination of
Company's defined benefit pension plan in 2005 (see Note 12 of Notes to
Consolidated Financial Statements). At the end of 2004, the Company had 288 full
time equivalent employees compared to 291 at the end of 2003 and 292 at the end
of 2002.
Occupancy and equipment expenses represent the cost of operating and maintaining
branch and administrative facilities, including the purchase and maintenance of
furniture, fixtures, and office equipment and data processing equipment.
Occupancy expense in 2004 totaled $1.7 million, an increase of $139,000 or 8.7%
over 2003. During 2003, occupancy expense decreased $118,000 or 6.9% over 2002.
Equipment expense in 2004 totaled $2.3 million, a decrease of $96,000 or 4.0%
over 2003. During 2003, equipment expense increased 12.5% or $269,000 over 2002.
Other operating expense totaled $8.0 million, a 2.4% decrease from the prior
year. This decrease in other operating expense during 2004 was due primarily to
a decrease of $242,000 in legal fees and $130,000 in operating losses. During
2003, other operating expense was $8.2 million compared to $7.5 million in 2002.
Income Taxes
The provision for income taxes increased $1.6 million during 2004. The effective
tax rate in 2004 was 36.5% compared to 35.2% in 2003 and 34.5% in 2002. The
increase in the effective tax rate was due primarily to reduced municipal
security income. The effective rates were lower than the statutory rate of 42%
due primarily to benefits regarding the cash surrender value of life insurance;
the California bad debt deduction; California enterprise zone interest income
exclusion; and tax exempt interest income on municipal securities and loans.
Current tax law causes the Company's current taxes payable to approximate or
exceed the current provision for taxes on the income statement. Two provisions
have had a significant effect on the Company's current income tax liability; the
restrictions on the deductibility of loan losses and the mandatory use of
accrual accounting for taxes rather than the cash basis method of accounting.
Financial Condition
Investment Securities
The Financial Accounting Standards Board statement, Accounting for Certain
Investments in Debt and Equity Securities, requires the Company to classify its
investments as held-to-maturity, trading or available-for-sale. Securities are
classified as held-to-maturity and are carried at amortized cost when the
Company has the positive intent and ability to hold the securities to maturity.
Trading securities are securities acquired for short-term appreciation and are
carried at fair value, with unrealized gains and losses recorded in non-interest
income. As of December 31, 2004 and 2003 there were no securities in the trading
portfolio. Securities classified as available-for-sale include securities, which
may be sold to effectively manage interest rate risk exposure, prepayment risk,
satisfy liquidity demands and other factors. These securities are reported at
fair value with aggregate, unrealized gains or losses excluded from income and
included as a separate component of shareholders' equity, net of related income
taxes.
The investment portfolio provides the Company with an income alternative to
loans. The Company's investment portfolio at the end of 2004 was $275.4 million,
an increase of $13.5 million or 5.2% from 2003. The Company's total investment
portfolio represented 22.5% of the Company's total assets during 2004 and 22.8%
of the Company's total assets during 2003. Not included in the investment
portfolio are overnight investments in Federal Funds Sold. In 2004, average
Federal Funds Sold on a year to date basis was $14.3 million compared to $15.9
million in 2003.
35
Note 3 in the Notes to Consolidated Financial Statements displays the
classifications of the Company's investment portfolio, the market value of the
Company's investment portfolio and the maturity distribution.
Loans
The Company's loan portfolio at December 31, 2004 increased $60.0 million from
December 31, 2003. The increase was due to strong loan demand in the Company's
market area, along with an aggressive calling program on high quality loan
prospects. Additionally, on an average balance basis, loans have increased $86.6
million or 11.7%. In 2003, average balances increased from the prior year by
15.7% or $100.1 million. The table following sets forth the distribution of the
loan portfolio by type as of the dates indicated.
Loan Portfolio As Of:
(in thousands) December 31, 2004 December 31, 2003
- ---------------------------------------------------------------------------
Real Estate $431,746 $386,735
Real Estate Construction 62,446 77,115
Home Equity 63,782 55,827
Agricultural 151,002 134,862
Commercial 142,133 136,955
Consumer 17,973 17,504
- ---------------------------------------------------------------------------
Gross Loans 869,082 808,998
Less:
Unearned Income 2,174 2,092
Allowance for Loan Losses 17,727 17,220
- ---------------------------------------------------------------------------
Net Loans $849,181 $789,686
===========================================================================
In the ordinary course of business, the Company enters into commitments to
extend credit to its customers. These commitments are not reflected in the
accompanying consolidated financial statements. As of December 31, 2004, the
Company had entered into loan commitments amounting to $378.8 million compared
to $308.4 million at December 31, 2003. Letters of credit issued by the Company
at December 31, 2004, and December 31, 2003, were $15.8 million and $12.2
million, respectively.
Non-Performing Assets
Non-performing assets are comprised of non-performing loans (defined as
non-accrual loans plus accruing loans past due 90 days or more) and other real
estate owned. As set forth in the table below, non-performing loans as of
December 31, 2004 were $225,000 compared to $2.6 million at December 31, 2003.
The Company reported no other real estate owned at both December 31, 2004 and
December 31, 2003.
The Company's policy is to place loans on non-accrual status when, for any
reason, principal or interest is past due for ninety days or more unless it is
both well secured and in the process of collection. Any interest accrued, but
unpaid, is reversed against current income. Thereafter, interest is recognized
as income only as it is collected in cash. Accrued interest reversed from income
on loans placed on a non-accrual status totaled $30,000 at December 31, 2004
compared to $356,000 at December 31, 2003. Non-performing loans as a percentage
of total loans for the year ended 2004 was .03%. For the year ended 2003 the
percentage was 0.3%.
36
Non-Performing Assets
(in thousands) December 31, 2004 December 31, 2003
- --------------------------------------------------- -----------------------
Non-Performing Loans $225 $2,584
Other Real Estate Owned - -
- --------------------------------------------------- -----------------------
Total $225 $2,584
=================================================== =======================
Non-Performing Assets
as a % of Total Loans 0.03% 0.32%
Allowance for Loan Losses as a % of
Non-Performing Loans 7,878.7% 666.4%
Except for non-performing loans shown in the table above, the Company's
management is not aware of any loans as of December 31, 2004 for which known
credit problems of the borrower would cause serious doubts as to the ability of
such borrowers to comply with their present loan repayment terms, or any known
events that would result in the loan being designated as non-performing at some
future date. The Company's management cannot, however, predict the extent to
which any deterioration in general economic conditions, real estate values,
increase in general rates of interest, change in the financial conditions or
business of a borrower may adversely affect a borrower's ability to pay.
Although management believes that non-performing loans are generally
well-secured and that potential losses are provided for in the Company's
allowance for loan losses, there can be no assurance that future deterioration
in economic conditions or collateral values will not result in future credit
losses.
Deposits
One of the key sources of funds to support earning assets is the generation of
deposits from the Company's customer base. The ability to expand the customer
base and subsequently deposits is a significant element in the performance of
the Company.
At December 31, 2004, deposits totaled $1.0 billion. This represents an increase
of 10.8% or $97.8 million from December 31, 2003. The increase was focused in
demand and savings deposit accounts, which increased $50.8 million and $25.2
million, respectively. The Bank's calling efforts for prospective customers
includes acquiring both loan and deposit relationships which results in new
demand, interest bearing transaction and savings accounts. Although the
Company's time deposits have increased by $10.4 million since December 31, 2003,
this growth has been entirely due to increased use of public deposits as part of
the Company's asset/liability management funding strategies (see Federal Home
Loan Bank Advances). Due to strong growth in demand, interest bearing
transaction and savings balances, the Company has reduced its focus on growing
higher cost time deposits; therefore, non-public time deposits have decreased
$5.7 million year over year. This reduced reliance on higher cost time deposits
has had, and should continue to have, a positive impact on the Company's net
interest margin (see Net Interest Income).
The most volatile deposits in any financial institution are certificates of
deposit over $100,000. The Company has not found its certificates of deposit
over $100,000 to be as volatile as some other financial institutions as it does
not solicit these types of deposits from brokers nor does it offer interest rate
premiums. It has been the Company's experience that large depositors have placed
their funds with the Company due to its strong reputation for safety, security
and liquidity.
Federal Home Loan Bank Advances
Advances from the Federal Home Loan Bank (FHLB) are another key source of funds
to support earning assets. These advances are also used to manage the Bank's
interest rate risk exposure, and as opportunities exist to borrow and invest the
proceeds at a positive spread through the investment portfolio. FHLB advances as
of December 31, 2004 were $80.9 million compared to $111.9 million as of
December 31, 2003. During June 2004, the Company's Asset/Liability Management
Committee decided to replace some FHLB advances with three and six month public
time deposits since the rates on these public funds were lower than the
equivalent FHLB advance rates. The average rate paid for FHLB advances was 3.3%
in 2004 compared to 3.0% in 2003.
37
Long-term Subordinated Debentures
On December 17, 2003 the Company raised $10 million through an offering of trust
preferred securities (see Note 19 of Notes to Consolidated Financial
Statements). Although this amount is reflected as subordinated debt on the
Company's balance sheet, under applicable regulatory guidelines, trust preferred
securities qualify as regulatory capital (see Capital). These securities accrue
interest at a variable rate based upon 3-month Libor plus 2.85%. Interest rates
reset quarterly (the next reset is March 17, 2005) and were 5.35% as of December
31, 2004. The average rate paid for these securities in 2004 was 4.4%.
Additionally, if the Company decided to defer interest on the subordinated
debentures, the Company would be prohibited from paying cash dividends on the
Company's common stock.
Capital
The Company relies primarily on capital generated through the retention of
earnings to satisfy its capital requirements. The Company engages in an ongoing
assessment of its capital needs in order to support business growth and to
insure depositor protection. Shareholders' Equity totaled $116.5 million at
December 31, 2004 and $109.6 million at the end of 2003.
The Company and the Bank are subject to various regulatory capital requirements
administered by the federal banking agencies. Failure to meet minimum capital
requirements can initiate certain mandatory, and possibly discretionary, actions
by regulators that, if undertaken, could have a direct material effect on the
Company and the Bank's financial statements. Under capital adequacy guidelines
and the regulatory framework for prompt corrective action, the Company and the
Bank must meet specific capital guidelines that involve quantitative measures of
the Company and the Bank's assets, liabilities, and certain off-balance-sheet
items as calculated under regulatory accounting practices. The Company and 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 Total and Tier I capital (as defined in the
regulations) to risk-weighted assets (as defined in the regulations), and of
Tier I capital (as defined in the regulations) to average assets (as defined in
the regulations). http://www.pwccomperio.com/search97cgi/s97is_english.dll -
pnote13Management believes, as of December 31, 2004, that the Company and the
Bank meet all capital adequacy requirements to which they are subject.
As of June 30, 2004, the most recent notification from the Federal Reserve Bank
categorized the Company and the Bank as well capitalized under the regulatory
framework for prompt corrective action. To be categorized as well capitalized,
the Company and the Bank must maintain minimum Total risk-based, Tier I
risk-based, Tier I leverage ratios as set forth in the table below.
http://www.pwccomperio.com/search97cgi/s97is_english.dll - pnote14There are no
conditions or events since that notification that management believes have
changed the institutions' categories.
38
To Be Well
Capitalized Under
Regulatory Capital Prompt Corrective
(in thousands) Actual Requirements Action Provisions
- ------------------------------------------------------------------------------------------------------------------
The Company: Amount Ratio Amount Ratio Amount Ratio
- ------------------------------------------------------------------------------------------------------------------
As of December 31, 2004
Total Capital to Risk Weighted Assets $140,828 13.34% $ 84,437 8.0% N/A N/A
Tier I Capital to Risk Weighted Assets $127,577 12.09% $ 42,218 4.0% N/A N/A
Tier I Capital to Average Assets $127,577 10.69% $ 47,720 4.0% N/A N/A
To Be Well
Capitalized Under
Regulatory Capital Prompt Corrective
(in thousands) Actual Requirements Action Provisions
- ------------------------------------------------------------------------------------------------------------------
The Bank: Amount Ratio Amount Ratio Amount Ratio
- ------------------------------------------------------------------------------------------------------------------
As of December 31, 2004
Total Capital to Risk Weighted Assets $136,916 13.00% $ 84,243 8.0% $ 105,303 10.0%
Tier I Capital to Risk Weighted Assets $123,695 11.75% $ 42,121 4.0% $ 63,182 6.0%
Tier I Capital to Average Assets $123,695 10.41% $ 47,540 4.0% $ 59,425 5.0%
As previously discussed (see Long-term Subordinated Debentures), in order to
supplement its regulatory capital base, during December 2003 the Company raised
$10 million of trust preferred securities (see Note 19 of Notes to Consolidated
Financial Statements). Under applicable regulatory guidelines, trust preferred
securities qualify as Tier 1 capital up to a maximum of 25% of Tier 1 capital.
Any additional portion of trust preferred securities would qualify as Tier 2
capital. The Company has received notification from the Federal Reserve Bank of
San Francisco that all of the Company's trust preferred securities currently
qualify as Tier 1 capital.
In accordance with the provisions of Financial Accounting Standards Board
Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"),
the Company does not consolidate the subsidiary trust which has issued the trust
preferred securities. Previously, financing subsidiaries were generally
consolidated with their parents under GAAP. As a result of this new accounting
interpretation, on July 2, 2003, the Federal Reserve Board issued Supervisory
Letter (SR 03-13) which preserves the historical capital treatment of trust
preferred securities as Tier I capital despite the deconsolidation of these
securities. That Supervisory Letter remained in effect at December 31, 2003 and
December 31, 2004, and the Company continues to include these securities in its
Tier I capital.
On May 6, 2004, the FRB issued a proposed ruling on the continuing eligibility
of trust preferred securities as Tier I capital. As drafted, the proposed ruling
retains the current 25% limit but nets goodwill from the calculation of Tier I
capital. Since the Company currently has no goodwill, if implemented, this
change would have no impact. Public comments on the proposed ruling were
required by July 11, 2004 with a final ruling to follow. The Company cannot
predict the ultimate outcome of this issue, however, even in the unlikely event
that Tier I capital treatment for the Company's trust preferred securities was
fully disallowed the Company would remain "well-capitalized". Additionally, if
Tier I capital treatment were disallowed, the Company may be able to redeem the
trust preferred securities pursuant to their terms, and have the ability to
identify and obtain alternative sources of capital.
In 1998, the Board approved the Company's first stock repurchase program which
expired on May 1, 2001. During the second quarter of 2004, the Board approved a
second stock repurchase program because it concluded that the Company continues
to have more capital than it needs to meet present and anticipated regulatory
guidelines to be classified as "well capitalized".
Repurchases under the second program will be made on the open market or through
private transactions. The aggregate price to be paid by the Company for all
repurchased stock will not exceed $10,000,000 and the program will expire on May
31, 2007. The repurchase program also requires that no purchases may be made if
the Company would not remain "well-capitalized" after the repurchase. All shares
repurchased under the repurchase program will be retired (see the Company's 2004
Form 10-K, Part II, Item 5. Market for Registrant's Common Equity, Related
Stockholder Matters and Issuer Purchases of Equity Securities).
During 2004, the Company repurchased 7,981 shares at an average share price of
$389 per share. In 2003, the Company repurchased 5,732 shares at an average
share price of $256. Since 1999, the Company has repurchased over 44,000 shares
for total consideration of $11.7 million.
39
Critical Accounting Policies and Estimates
This "Management's Discussion and Analysis of Financial Condition and Results of
Operations," is based upon the Company's consolidated financial statements,
which have been prepared in accordance with accounting principles generally
accepted in the United States. In preparing the Company's financial statements
management makes estimates and judgments that affect the reported amounts of
assets, liabilities, revenues and expenses. Management believes that the most
significant subjective judgments that it makes include the following:
o Allowance for Loan Losses. As a financial institution which assumes lending
and credit risks as a principle element in its business, the Company
anticipates that credit losses will be experienced in the normal course of
business. Accordingly, the allowance for loan losses is maintained at a level
considered adequate by management to provide for losses that are inherent in
the portfolio. The allowance is increased by provisions charged to operating
expense and reduced by net charge-offs. Management employs a systematic
methodology for determining the allowance for loan losses. On a quarterly
basis, management reviews the credit quality of the loan portfolio and
considers problem loans, delinquencies, internal credit reviews, current
economic conditions, loan loss experience and other factors in determining
the adequacy of the allowance balance.
While the Company utilizes a systematic methodology in determining its
allowance, the allowance is based on estimates, and ultimate losses may vary
from current estimates. The estimates are reviewed periodically and, as
adjustments become necessary, are reported in earnings in the periods in
which they become known. For additional information, see Note 4 of Notes to
Consolidated Financial Statements.
o Fair Value. As required by Generally Accepted Accounting Principles, the
Company discloses the fair value of financial instruments and the methods and
significant assumptions used to estimate those fair values. The estimated
fair value amounts have been determined by the Company using available market
information and appropriate valuation methodologies. The use of assumptions
and various valuation techniques, as well as the absence of secondary markets
for certain financial instruments, will likely reduce the comparability of
fair value disclosures between financial institutions. In some cases, book
value is a reasonable estimate of fair value due to the relatively short
period of time between origination of the instrument and its expected
realization. For additional information, see Note 13 of Notes to Consolidated
Financial Statements.
o Income Taxes. As required, the Company uses the liability method of
accounting for income taxes. This method results in the recognition of
deferred tax assets and liabilities that are reflected at currently enacted
income tax rates applicable to the period in which the deferred tax assets or
liabilities are expected to be realized or settled. As changes in tax laws or
rates are enacted, deferred tax assets and liabilities are adjusted through
the provision for income taxes. The deferred provision for income taxes is
the result of the net change in the deferred tax asset and deferred tax
liability balances during the year. This amount combined with the current
taxes payable or refundable results in the income tax expense for the current
year. For additional information, see Note 8 of Notes to Consolidated
Financial Statements.
o Pension Plan. The Company sponsors a defined benefit pension plan. The
Company's recorded liability for plan benefits is based on a number of
assumptions, including life expectancies, retirement rates, long-term
interest rates, long-term rates of return on investments and future
compensation levels. These assumptions are periodically reviewed by the
Company and revised when appropriate. Changes in one or more of these
assumptions could affect the amount of the Company's recorded pension expense
for plan benefits. If the actual experience differs from expectations, the
Company's results of operations in future periods could be affected. For
additional information, see Note 12 of Notes to Consolidated Financial
Statements.
40
Off-Balance Sheet Arrangements and Aggregate Contractual Obligations and
Commitments
Off-balance sheet arrangements are any contractual arrangement to which an
unconsolidated entity is a party, under which the Company has: (1) any
obligation under a guarantee contract; (2) a retained or contingent interest in
assets transferred to an unconsolidated entity or similar arrangement that
serves as credit, liquidity or market risk support to that entity for such
assets; (3) any obligation under certain derivative instruments; or (4) any
obligation under a material variable interest held by us in an unconsolidated
entity that provides financing, liquidity, market risk or credit risk support to
the Company, or engages in leasing, hedging or research and development services
with the Company.
Our most significant off-balance sheet arrangements are limited to: (1) the full
and unconditional payment guarantee of accrued distributions relating to $10
million of Trust Preferred Securities issued by FMCB Statutory Trust (see Note
19 of the Consolidated Financial Statements); (2) derivative instruments indexed
to the Prime Rate (see Note 14 of the Consolidated Financial Statements); (3)
obligations under guarantee contracts such as financial and performance standby
letters of credit for our credit customers (see Note 15 of the Consolidated
Financial Statements); (4) commercial letters of credit (see Note 15 of the
Consolidated Financial Statements); (5) unfunded commitments to lend (see Note
15 of the Consolidated Financial Statements); and (6) property lease contracts
(see Note 15 of the Consolidated Financial Statements). It is our belief that
none of these arrangements expose us to any greater risk of loss than is already
reflected on our balance sheet. We do not have any off-balance sheet
arrangements in which we have any retained or contingent interest (as we do not
transfer or sell our assets to entities in which we have a continuing
involvement), any exposure to derivative instruments that are indexed to stock
indices nor any variable interests in any unconsolidated entity to which we may
be a party.
The following table presents, as of December 31, 2004, our significant and
determinable contractual obligations by payment date. The payment amounts
represent those amounts contractually due to the recipient and do not include
any unamortized premiums or discount, hedge basis adjustments or other similar
carrying value adjustments. For further information on the nature of each
obligation type, see applicable note disclosure in "Notes to Consolidated
Financial Statements".
Payments Due By Period
(in thousands)
- ----------------------------------------------------------------------------------------------------------------------
Contractual Total Less than 1-3 Years 3-5 years More than
Obligations 1 Year 5 Years
- ----------------------------------------------------------------------------------------------------------------------
Operating Lease Obligations $ 533 $ 262 $ 165 $ 98 $ 8
- ----------------------------------------------------------------------------------------------------------------------
Other Long-Term Liabilities Reflected On the
Company's Balance Sheet under GAAP 10,310 - - - 10,310
- ----------------------------------------------------------------------------------------------------------------------
Total $ 10,843 $ 262 $ 165 $ 98 $ 10,318
- ----------------------------------------------------------------------------------------------------------------------
Quantitative and Qualitative Disclosures About Market Risk
Risk Management
The Company has adopted a Risk Management Plan which aims to ensure the proper
control and management of all risk factors inherent in the operation of the
Company. Specifically, credit risk, interest rate risk, liquidity risk,
compliance risk, strategic risk, reputation risk and price risk can all affect
the market risk of the Company. These specific risk factors are not mutually
exclusive. It is recognized that any product or service offered by the Company
may expose the Company to one or more of these risk factors.
41
Credit Risk
Credit risk is the risk to earnings or capital arising from an obligor's failure
to meet the terms of any contract or otherwise fail to perform as agreed. Credit
risk is found in all activities where success depends on counterparty, issuer or
borrower performance.
Credit risk in the investment portfolio and correspondent bank accounts is
addressed through defined limits in the Company's policy statements. In
addition, certain securities carry insurance to enhance credit quality of the
bond.
Credit risk in the loan portfolio is controlled by limits on industry
concentration, aggregate customer borrowings and geographic boundaries.
Standards on loan quality also are designed to reduce loan credit risk. Senior
Management, Directors' Committees, and the Board of Directors are regularly
provided with information intended to identify, measure, control and monitor the
credit risk of the Company.
The Company's methodology for assessing the appropriateness of the allowance is
applied on a regular basis and considers all loans. The systematic methodology
consists of two major elements. The first major element includes a detailed
analysis of the loan portfolio in two phases. The first phase is conducted in
accordance with SFAS No. 114, "Accounting by Creditors for the Impairment of a
Loan" as amended by SFAS No. 118, "Accounting by Creditors for Impairment of a
Loan -- Income Recognition and Disclosures." Individual loans are reviewed to
identify loans for impairment. A loan is impaired when principal and interest
are deemed uncollectable in accordance with the original contractual terms of
the loan. Impairment is measured as either the expected future cash flows
discounted at each loan's effective interest rate, the fair value of the loan's
collateral if the loan is collateral dependent, or an observable market price of
the loan (if one exists). Upon measuring the impairment, the Company will ensure
an appropriate level of allowance is present or established.
Central to the first phase and the Company's credit risk management is its loan
risk rating system. The originating credit officer assigns borrowers an initial
risk rating, which is based primarily on a thorough analysis of each borrower's
financial position in conjunction with industry and economic trends. Approvals
are made based upon the amount of inherent credit risk specific to the
transaction and are reviewed for appropriateness by senior credit administration
personnel. Credits are monitored by credit administration personnel for
deterioration in a borrower's financial condition, which would impact the
ability of the borrower to perform under the contract. Risk ratings are adjusted
as necessary.
Based on the risk rating system specific allowances are established in cases
where management has identified significant conditions or circumstances related
to a credit that management believes indicates the possibility of loss.
Management performs a detailed analysis of these loans, including, but not
limited to, cash flows, appraisals of the collateral, conditions of the
marketplace for liquidating the collateral and assessment of the guarantors.
Management then determines the inherent loss potential and allocates a portion
of the allowance for losses as a specific allowance for each of these credits.
The second phase is conducted by segmenting the loan portfolio by risk rating
and into groups of loans with similar characteristics in accordance with SFAS
No. 5, "Accounting for Contingencies". In this second phase, groups of loans are
reviewed and applied the appropriate allowance percentage to determine a
portfolio formula allowance.
The second major element of the analysis, which considers all known relevant
internal and external factors that may affect a loan's collectibility, is based
upon management's evaluation of various conditions, the effects of which are not
directly measured in the determination of the formula and specific allowances.
The evaluation of the inherent loss with respect to these conditions is subject
to a higher degree of uncertainty because they are not identified with specific
problem credits or portfolio segments. The conditions evaluated in connection
with the second element of the analysis of the allowance include, but are not
limited to the following conditions that existed as of the balance sheet date:
|X| then-existing general economic and business conditions affecting the key
lending areas of the Company;
|X| credit quality trends (including trends in non-performing loans expected to
result from existing conditions);
|X| collateral values;
|X| loan volumes and concentrations;
|X| seasoning of the loan portfolio;
42
|X| specific industry conditions within portfolio segments;
|X| recent loss experience within portfolio segments;
|X| duration of the current business cycle;
|X| bank regulatory examination results; and
|X| findings of the Company's internal credit examiners.
Management reviews these conditions in discussion with the Company's senior
credit officers. To the extent that any of these conditions is evidenced by a
specifically identifiable problem credit or portfolio segment as of the
evaluation date, management's estimate of the effect of such condition may be
reflected as a specific allowance applicable to such credit or portfolio
segment. Where any of these conditions is not evidenced by a specifically
identifiable problem credit or portfolio segment as of the evaluation date,
management's evaluation of the inherent loss related to such condition is
reflected in the second major element allowance.
Implicit in lending activities is the risk that losses will and do occur and
that the amount of such losses will vary over time. Consequently, the Company
maintains an allowance for loan losses by charging a provision for loan losses
to earnings. Loans determined to be losses are charged against the allowance for
loan losses. The Company's allowance for loan losses is maintained at a level
considered by management to be adequate to provide for estimated losses inherent
in the existing portfolio.
Management believes that the allowance for loan losses at December 31, 2004 was
adequate to provide for both recognized losses and estimated inherent losses in
the portfolio. No assurances can be given that future events may not result in
increases in delinquencies, non-performing loans or net loan charge offs that
would increase the provision for loan losses and thereby adversely affect the
results of operations.
Market Risk - Interest Rate Risk
The mismatch between maturities of interest sensitive assets and liabilities
results in uncertainty in the Company's earnings and economic value and is
referred to as interest rate risk. The Company does not attempt to predict
interest rates and positions the balance sheet in a manner which seeks to
minimize the effects of changing interest rates.
The Company measures interest rate risk in terms of potential impact on both its
economic value and earnings. The methods for governing the amount of interest
rate risk include: analysis of asset and liability mismatches (GAP analysis),
the utilization of a simulation model and limits on maturities of investment,
loan and deposit products which reduces the market volatility of those
instruments.
The Gap analysis measures, at specific time intervals, the divergence between
earning assets and interest bearing liabilities for which repricing
opportunities will occur. A positive difference, or Gap, indicates that earning
assets will reprice faster than interest-bearing liabilities. This will
generally produce a greater net interest margin during periods of rising
interest rates and a lower net interest margin during periods of declining
interest rates. Conversely, a negative Gap will generally produce a lower net
interest margin during periods of rising interest rates and a greater net
interest margin during periods of decreasing interest rates.
The interest rates paid on deposit accounts do not always move in unison with
the rates charged on loans. In addition, the magnitude of changes in the rates
charged on loans is not always proportionate to the magnitude of changes in the
rate paid for deposits. Consequently, changes in interest rates do not
necessarily result in an increase or decrease in the net interest margin solely
as a result of the differences between repricing opportunities of earning assets
or interest bearing liabilities.
The Company also utilizes the results of a dynamic simulation model to quantify
the estimated exposure of net interest income to sustained interest rate
changes. The sensitivity of the Company's net interest income is measured over a
rolling one-year horizon.
43
The simulation model estimates the impact of changing interest rates on interest
income from all interest earning assets and the interest expense paid on all
interest bearing liabilities reflected on the Company's balance sheet. This
sensitivity analysis is compared to policy limits, which specify a maximum
tolerance level for net interest income exposure over a one-year horizon
assuming no balance sheet growth, given a 200 basis point upward and a 100 basis
point downward shift in interest rates. A shift in rates over a 12-month period
is assumed. Results that exceed policy limits, if any, are analyzed for risk
tolerance and reported to the Board with appropriate recommendations. At
December 31, 2004, the Company's estimated net interest income sensitivity to
changes in interest rates, as a percent of net interest income was an increase
in net interest income of 3.34% if rates increase by 200 basis points and a
decrease in net interest income of 2.53% if rates decline 100 basis points.
The estimated sensitivity does not necessarily represent a Company forecast and
the results may not be indicative of actual changes to the Company's net
interest income. These estimates are based upon a number of assumptions
including: the nature and timing of interest rate levels including yield curve
shape; prepayments on loans and securities; pricing strategies on loans and
deposits; replacement of asset and liability cashflows; and other assumptions.
While the assumptions used are based on current economic and local market
conditions, there is no assurance as to the predictive nature of these
conditions including how customer preferences or competitor influences might
change. See Note 13 of the Notes to the Consolidated Financial Statements.
Liquidity Risk
Liquidity risk is the risk to earnings or capital resulting from the Company's
inability to meet its obligations when they come due without incurring
unacceptable losses. It includes the ability to manage unplanned decreases or
changes in funding sources and to recognize or address changes in market
conditions that affect the Company's ability to liquidate assets or acquire
funds quickly and with minimum loss of value. The Company endeavors to maintain
a cash flow adequate to fund operations, handle fluctuations in deposit levels,
respond to the credit needs of borrowers and to take advantage of investment
opportunities as they arise. The principal sources of liquidity include credit
facilities from correspondent banks, brokerage firms and the Federal Home Loan
Bank, as well as, interest and principal payments on loans and investments,
proceeds from the maturity or sale of investments, and growth in deposits.
In general, liquidity risk is managed daily by controlling the level of Federal
Funds and the use of funds provided by the cash flow from the investment
portfolio. The Company maintains overnight investments in Federal Funds as a
cushion for temporary liquidity needs. During 2004, Federal Funds averaged $14.3
million. The Company maintains Federal Fund credit lines of $50 million with
major banks subject to the customary terms and conditions for such arrangements
and $175 million in repurchase lines with major brokers. In addition the Company
has additional borrowing capacity of $156.9 million from the Federal Home Loan
Bank.
At December 31, 2004, the Company had available sources of liquidity, which
included cash and cash equivalents and unpledged investment securities of
approximately $126.2 million, which represents 10.3% of total assets.
Controls and Procedures
The Company maintains controls and procedures designed to ensure that all
relevant information is recorded and reported in all filings of financial
reports. Such information is reported to the Company's management, including its
Chief Executive Officer and its Chief Financial Officer to allow timely and
accurate disclosure based on the definition of "disclosure controls and
procedures" in Rule 13a-15(e). In designing these controls and procedures,
management recognizes that they can only provide reasonable assurance of
achieving the desired control objectives. Management also evaluated the
cost-benefit relationship of possible controls and procedures.
As of the end of the period covered by this report, the Company carried out an
evaluation of the effectiveness of the Company's controls and disclosure
procedures under the supervision and with the participation of the Chief
Executive Officer, the Chief Financial Officer and other senior management of
the Company. Based on the foregoing, the Company's Chief Executive Officer and
the Chief Financial Officer concluded that the Company's disclosure controls and
procedures were effective.
There have been no significant changes in the Company's internal controls or in
other factors that could significantly affect the internal controls subsequent
to the date the Company completed its evaluation.
44
Available Information
Company reports filed with the Securities and Exchange Commission (the
"Commission") including the annual report on Form 10-K, quarterly reports on
Form 10-Q, current reports on Form 8-K, proxy statements and ownership reports
filed by directors, executive officers and principal shareholders can be
accessed through the Company's web site at http://www.fmbonline.com. The link to
the Securities and Exchange Commission is on the About F & M Bank page.
45