UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2004 Commission File Number 0-22787 FOUR OAKS FINCORP, INC. ----------------------- (Exact name of registrant as specified in its charter) North Carolina 56-2028446 ------------------------------- ---------------------------- (State or other jurisdiction of (IRS Employer Identification incorporation or organization) Number) 6114 U.S. 301 South Four Oaks, North Carolina (Address of principal executive offices) 27524 (Zip Code) Registrant's telephone number, including area code: (919) 963-2177 -------------- Securities registered under Section 12(b) of the Act: NONE Securities registered under Section 12(g) of the Act: Common Stock, par value $1.00 per share (Title of Class) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: |X| YES [ ] NO Indicate by check mark whether disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. |X| Check whether the registrant is an accelerated filer (as defined by Rule 12b-2 of the Act). [ ] YES |X| NO $51,043,440 ----------- (Aggregate value of voting and non-voting common equity held by non-affiliates of the registrant based on the price at which the registrant's Common Stock, par value $1.00 per share was sold on June 30, 2004) 3,454,241 --------- (Number of shares of Common Stock, par value $1.00 per share, outstanding as of March 7, 2005) Documents Incorporated by Reference Where Incorporated (1) Proxy Statement for the 2005 Annual Part III Meeting of Shareholders to be held April 25, 2005 -1- FORWARD-LOOKING INFORMATION Information set forth in this Annual Report on Form 10-K under the caption "Business" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" contains various "forward looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which statements represent our judgment concerning the future and are subject to risks and uncertainties that could cause our actual operating results and financial position to differ materially. Such forward looking statements can be identified by the use of forward looking terminology, such as "may," "will," "expect," "anticipate," "estimate," or "continue" or the negative thereof or other variations thereof or comparable terminology. We caution that any such forward looking statements are further qualified by important factors that could cause our actual operating results to differ materially from those in the forward looking statements, including, without limitation, the effects of future economic conditions, governmental fiscal and monetary policies, legislative and regulatory changes, the risks of changes in interest rates on the level and composition of deposits, the effects of competition from other financial institutions, the failure of assumptions underlying the establishment of the allowance for possible loan losses and the low trading volume of our common stock. PART I ITEM 1 - BUSINESS. On February 5, 1997, Four Oaks Bank & Trust Company (referred to herein as the "bank") formed Four Oaks Fincorp, Inc. for the purpose of serving as a holding company for the bank. Four Oaks Fincorp, Inc. has no significant assets other than cash and the capital stock of the bank as well as $695,000 in securities available for sale. Our corporate offices are located at 6114 US 301 South, Four Oaks, North Carolina 27524. The bank was incorporated under the laws of the State of North Carolina in 1912. The bank is a state-chartered member of the Federal Reserve System. In Four Oaks, the main office is located at 6144 US 301 South and an additional branch is located at 111 North Main Street. The bank also operates a branch office in Clayton, North Carolina at 102 East Main Street, two in Smithfield, North Carolina at 128 North Second Street, and 403 South Brightleaf Boulevard, one in Garner, North Carolina at 200 Glen Road, one in Benson, North Carolina at 200 East Church Street, one in Fuquay-Varina, North Carolina at 325 North Judd Parkway Northeast, one in Wallace, North Carolina at 406 East Main Street and one in Holly Springs at 101 Avent Ferry Road, Holly Springs, North Carolina. On January 10, 2005, the bank opened a new branch office at 590 Tomahawk Highway, Harrells, North Carolina and a loan production office at 1100 South Horner Boulevard, Sanford, North Carolina. The bank is a community bank engaged in the general commercial banking business in Johnston, Wake, Sampson and Duplin Counties, North Carolina. Johnston County is contiguous to Wake, Wayne, Wilson, Harnett, Sampson and Nash counties. Wake County is contiguous to Johnston, Durham, Harnett, Nash, Franklin, Granville and Chatham counties. Sampson County is contiguous to Duplin, Pender, Bladen, Harnett, Cumberland, Johnston, and Wayne counties. Duplin County is contiguous to Pender, Sampson, Wayne, Lenoir, Jones and Onslow counties. As of December 31, 2004, we had assets of $398.5 million, net loans outstanding of $308.8 million and deposits of $315.3 million. We have enjoyed considerable growth over the past five (5) years as evidenced by the 72% increase in assets, the 88% increase in net loans outstanding, and the 62% increase in deposits since December 31, 1999. The bank provides a full range of banking services, including such services as checking accounts, savings accounts, individual retirement accounts, NOW accounts, money market accounts, certificates of deposit, a student checking and savings program; loans for businesses, agriculture, real estate, personal uses, home improvement and automobiles; mortgage loans; equity lines of credit; credit cards; safe deposit boxes; money orders; electronic funds transfer services, including wire transfers; internet banking and bill pay services; telephone banking; cashier's checks; traveler's checks; and free notary services to all bank customers. The bank also provides financial services, offering a complete line of insurance and investment services, including financial strategies, mutual funds, annuities, insurance, stock brokerage, IRAs, discount brokerage services, employee benefit plans, 401(k)'s and SEPs. In addition, the bank provides worldwide automated teller machine access to its customers for cash withdrawals through the services of the Star, Cirrus, or Visa networks by using ATM or Visa check cards. The Visa check cards may also be used at merchant locations worldwide through the Star, Cirrus, or Visa networks. In 2003, the bank began issuing stored value cards which are marketed by independent sales organizations and provide access to funds through the Visa, Plus, Interlink, Mastercard, Maestro, Cirrus, and Star networks. At present, the bank does not provide the services of a trust department. 2 The majority of the bank's customers are individuals and small to medium-size businesses located in Johnston, Wake, and Duplin Counties and surrounding areas. The deposits and loans are well diversified with no material concentration in a single industry or group of related industries. There are no seasonal factors that would have any material adverse effect on the bank's business, and the bank does not rely on foreign sources of funds or income. From its headquarters located in Four Oaks and its twelve locations in Four Oaks, Clayton, Smithfield, Garner, Benson, Fuquay-Varina, Wallace, Holly Springs, Harrells and a loan production office in Sanford, the bank serves a major portion of Johnston County, part of Wake, Harnett, Duplin, Sampson and Lee Counties. Johnston County has a diverse economy and is not dependent on any one particular industry. The leading industries in the area include retail trade, manufacturing, pharmaceuticals, government, services, construction, wholesale trade and agriculture. In an effort to offer a more diversified and competitive product line to better serve our customers and community, we have discontinued our provision of secondary market-type mortgages through the bank and, through a joint venture with Centex Corporation, formed Four Oaks Mortgage Company, L.P. During 2003, Four Oaks Mortgage Company, L.P. started providing secondary market-type mortgages and will be the vehicle through which all of our mortgage and funding business will be run going forward. Four Oaks Mortgage Company, L.P. is owned 49.99% by our wholly-owned subsidiary, Four Oaks Mortgage Services, L.L.C., and 50.01% by its general partner, CTX Mortgage Ventures, LLC, a wholly-owned indirect subsidiary of Centex Corporation. Amounts spent on research activities relating to the development or improvement of services have been immaterial over the past two years. At December 31, 2004, the bank employed 131 full time equivalent employees. The following table sets forth certain of our financial data and ratios for the years ended December 31, 2004, 2003, and 2002. This information should be read in conjunction with and is qualified in its entirety by reference to the more detailed audited financial statements and notes thereto included in this report: 2004 2003 2002 -------- -------- -------- (In thousands, except ratios) Net income $ 4,375 $ 2,918 $ 2,916 Average equity capital accounts $ 35,135 $ 32,341 $ 29,931 Ratio of net income to average equity capital accounts 12.45% 9.02% 9.74% Average daily total deposits $295,524 $255,038 $242,878 Ratio of net income to average daily total deposits 1.48% 1.14% 1.20% Average daily loans (gross) $298,783 $249,240 $216,620 Ratio of average daily loans to average daily total deposits 101.10% 97.73% 89.19% COMPETITION Commercial banking in North Carolina is extremely competitive due in large part to statewide branching. The bank competes in its market area with some of the largest banking organizations in the state and the country and other financial institutions, such as federally and state-chartered savings and loan institutions and credit unions, as well as consumer finance companies, mortgage companies and other lenders engaged in the business of extending credit. Many of the bank's competitors have broader geographic markets and higher lending limits than those of the bank and are also able to provide more services and make greater use of media advertising. The enactment of legislation authorizing interstate banking has caused great increases in the size and financial resources of some of the bank's competitors. In addition, as a result of interstate banking, out-of-state commercial banks may acquire North Carolina banks and heighten the competition among banks in North Carolina. See "Holding Company Regulation" below. 3 Despite the competition in its market areas, the bank believes that it has certain competitive advantages that distinguish it from its competition. The bank believes that its primary competitive advantages are its strong local identity, its affiliation with the community and its emphasis on providing specialized services to small and medium-sized business enterprises, as well as professional and upper-income individuals. The bank offers customers modern, high-tech banking without forsaking community values such as prompt, personal service and friendliness. The bank offers many personalized services and attracts and retains customers by being responsive and sensitive to their individualized needs. The bank also relies on goodwill and referrals from our shareholders and the bank's satisfied customers, as well as traditional media, to attract new customers. To enhance a positive image in the community, the bank supports and participates in local events, and its officers and directors serve on boards of local civic and charitable organizations. GOVERNMENTAL REGULATION Holding companies, banks and many of their non-bank affiliates are extensively regulated under both federal and state law. The following is a brief summary of certain statutes, rules and regulations affecting us and the bank. This summary is qualified in its entirety by reference to the particular statutory and regulatory provisions referred to below and is not intended to be an exhaustive description of the statutes or regulations applicable to our business or the business of the bank. Supervision, regulation and examination of us and the bank by bank regulatory agencies is intended primarily for the protection of the bank's depositors rather than our shareholders. HOLDING COMPANY REGULATION GENERAL. We are a holding company registered with the Board of Governors of the Federal Reserve System under the Bank Holding Company Act of 1956 (the "BHCA"). As such, we are subject to the supervision, examination and reporting requirements contained in the BHCA and the regulation of the Federal Reserve. The bank is also subject to the BHCA. The BHCA requires that a bank holding company obtain the prior approval of the Federal Reserve before (i) acquiring direct or indirect ownership or control of more than five percent of the voting shares of any bank, (ii) taking any action that causes a bank to become a subsidiary of the bank holding company, (iii) acquiring all or substantially all of the assets of any bank or (iv) merging or consolidating with any other bank holding company. The BHCA generally prohibits a bank holding company, with certain exceptions, from engaging in activities other than banking, or managing or controlling banks or other permissible subsidiaries, and from acquiring or retaining direct or indirect control of any company engaged in any activities other than those activities determined by the Federal Reserve to be closely related to banking, or managing or controlling banks, as to be a proper incident thereto. In determining whether a particular activity is permissible, the Federal Reserve must consider whether the performance of such an activity can reasonably be expected to produce benefits to the public, such as greater convenience, increased competition or gains in efficiency, that outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. For example, banking, operating a thrift institution, extending credit or servicing loans, leasing real or personal property, providing securities brokerage services, providing certain data processing services, acting as agent or broker in selling credit life insurance and certain other types of insurance underwriting activities have all been determined by regulations of the Federal Reserve to be permissible activities. Pursuant to delegated authority, the Federal Reserve Bank of Richmond has authority to approve certain activities of holding companies within its district, including us, provided the nature of the activity has been approved by the Federal Reserve. Despite prior approval, the Federal Reserve has the power to order a holding company or its subsidiaries to terminate any activity or to terminate its ownership or control of any subsidiary when it believes that continuation of such activity or such ownership or control constitutes a serious risk to the financial safety, soundness or stability of any bank subsidiary of that bank holding company. FINANCIAL HOLDING COMPANIES. The Gramm-Leach-Bliley Modernization Act of 1999 (the "GLB"), which was enacted on November 12, 1999, allows bank holding companies that meet certain new regulatory standards regarding management, capital and the Community Reinvestment Act, to engage in a broader range of non-banking activities than previously permissible, including insurance underwriting and making merchant banking investments in commercial and financial companies; allows insurers and other financial services companies to acquire banks; removes various restrictions that applied to bank holding company ownership of securities firms and mutual fund advisory companies; and establishes the overall regulatory structure applicable to bank holding companies that also engage in insurance and securities operations. 4 At the present time, we have elected to remain a bank holding company, and therefore we remain subject to the same regulatory framework as before the enactment of the GLB. However, the financial holding company structure created by the GLB permits insurance companies or securities firms operating under the financial holding company structure to acquire us, and, if we elect to become a financial holding company in the future, we could acquire insurance companies or securities firms. In addition to creating the more flexible financial holding company structure, the GLB introduced several additional customer privacy protections that will apply to us and the bank. The GLB's privacy provisions require financial institutions to, among other things, (i) establish and annually disclose a privacy policy, (ii) give consumers the right to opt out of disclosures to nonaffiliated third parties, with certain exceptions, (iii) refuse to disclose consumer account information to third-party marketers and (iv) follow regulatory standards to protect the security and confidentiality of consumer information. Pursuant to the GLB's rulemaking provisions, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation and the Office of Thrift Supervision adopted regulations, establishing standards for safeguarding customer information. Such regulations provide financial institutions guidance in establishing and implementing administrative, technical and physical safeguards to protect the security, confidentiality and integrity of customer information. MERGERS AND ACQUISITIONS. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the "IBBEA") permits interstate acquisitions of banks and bank holding companies without geographic limitation, subject to any state requirement that the bank has been organized for a minimum period of time, not to exceed five (5) years, and the requirement that the bank holding company, prior to or following the proposed acquisition, controls no more than ten percent (10%) of the total amount of deposits of insured depository institutions in the U.S. and no more than thirty percent (30%) of such deposits in any state (or such lesser or greater amount set by state law). In addition, the IBBEA permits a bank to merge with a bank in another state as long as neither of the states has opted out of the IBBEA prior to May 31, 1997. In 1995, the state of North Carolina "opted in" to such legislation. In addition, a bank may establish and operate a de novo branch in a state in which the bank does not maintain a branch if that state expressly permits de novo interstate branching. As a result of North Carolina having opted-in, unrestricted interstate de novo branching is permitted in North Carolina. ADDITIONAL RESTRICTIONS AND OVERSIGHT. Subsidiary banks of a bank holding company are subject to certain restrictions imposed by the Federal Reserve on any extensions of credit to the bank holding company or any of its subsidiaries, investments in the stock or securities thereof and the acceptance of such stock or securities as collateral for loans to any borrower. A bank holding company and its subsidiaries are also prevented from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services. An example of a prohibited tie-in would be any arrangement that would condition the provision or cost of services on a customer obtaining additional services from the bank holding company or any of its other subsidiaries. The Federal Reserve may issue cease and desist orders against bank holding companies and non-bank subsidiaries to stop actions believed to present a serious threat to a subsidiary bank. The Federal Reserve also regulates certain debt obligations, changes in control of bank holding companies and capital requirements. Under the provisions of the North Carolina law, we are registered with and subject to supervision by the North Carolina Commissioner of Banks. CAPITAL REQUIREMENTS. The Federal Reserve has established risk-based capital guidelines for bank holding companies and state member banks. The minimum standard for the ratio of capital to risk-weighted assets (including certain off balance sheet obligations, such as standby letters of credit) is eight percent (8%). At least half of this capital must consist of common equity, retained earnings and a limited amount of perpetual preferred stock and minority interests in the equity accounts of consolidated subsidiaries, less goodwill items and certain other items ("Tier 1 capital"). The remainder ("Tier 2 capital") may consist of mandatory convertible debt securities and a limited amount of other preferred stock, subordinated debt and loan loss reserves. 5 In addition, the Federal Reserve has established minimum leverage ratio guidelines for bank holding companies. These guidelines provide for a minimum leverage ratio of Tier 1 capital to adjusted average quarterly assets less certain amounts ("Leverage Ratio") equal to three percent for bank holding companies that meet certain specified criteria, including having the highest regulatory rating. All other bank holding companies will generally be required to maintain a Leverage Ratio of between four percent and five percent. The guidelines also provide that bank holding companies experiencing significant growth, whether through internal expansion or acquisitions, will be expected to maintain strong capital ratios substantially above the minimum supervisory levels without significant reliance on intangible assets. The same heightened requirements apply to bank holding companies with supervisory, financial, operational or managerial weaknesses, as well as to other banking institutions if warranted by particular circumstances or the institution's risk profile. Furthermore, the guidelines indicate that the Federal Reserve will continue to consider a "tangible Tier 1 Leverage Ratio" (deducting all intangibles) in evaluating proposals for expansion or new activity. The Federal Reserve has not advised us of any specific minimum Leverage Ratio or tangible Tier 1 Leverage Ratio applicable to us. As of December 31, 2004, we had Tier 1 risk-adjusted, total regulatory capital and leverage capital of approximately 11.70%, 12.95% and 9.53%, respectively, all in excess of the minimum requirements to be considered well-capitalized under prompt corrective action provisions. USA PATRIOT ACT OF 2001. Title III of the USA Patriot Act of 2001 contains the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001 (the "IMLAFA"). The anti-money laundering provisions of IMLAFA impose affirmative obligations on a broad range of financial institutions, including banks, brokers, and dealers. Among other requirements, IMLAFA requires all financial institutions to establish anti-money laundering programs that include, at minimum, internal policies, procedures, and controls; specific designation of an anti-money laundering compliance officer; ongoing employee training programs; and an independent audit function to test the anti-money laundering program. IMLAFA requires financial institutions that establish, maintain, administer, or manage private banking accounts for non-United States persons or their representatives to establish appropriate, specific, and, where necessary, enhanced due diligence policies, procedures, and controls designed to detect and report money laundering. Additionally, IMLAFA provides for the Department of Treasury to issue minimum standards with respect to customer identification at the time new accounts are opened. As of the date of this filing, we believe that IMLAFA has not had a material impact on the bank's operations. The bank has established policies and procedures to ensure compliance with the IMLAFA, which are overseen by an Anti-Money Laundering Officer who was appointed by our Board of Directors. BANK REGULATION The bank is subject to numerous state and federal statutes and regulations that affect its business, activities, and operations, and is supervised and examined by the North Carolina Commissioner of Banks and the Federal Reserve. The Federal Reserve and the North Carolina Commissioner of Banks regularly examine the operations of banks over which they exercise jurisdiction. They have the authority to approve or disapprove the establishment of branches, mergers, consolidations, and other similar corporate actions, and to prevent the continuance or development of unsafe or unsound banking practices and other violations of law. The Federal Reserve and the North Carolina Commissioner of Banks regulate and monitor all areas of the operations of banks and their subsidiaries, including loans, mortgages, issuances of securities, capital adequacy, loss reserves, and compliance with the Community Reinvestment Act of 1977 (the "CRA") as well as other laws and regulations. Interest and certain other charges collected and contracted for by banks are also subject to state usury laws and certain federal laws concerning interest rates. The deposit accounts of the bank are insured by the Bank Insurance Fund (the "BIF") of the Federal Deposit Insurance Corporation (the "FDIC") up to a maximum of one hundred thousand dollars ($100,000) per insured depositor. Any insured bank that is not operated in accordance with or does not conform to FDIC regulations, policies, and directives may be sanctioned for noncompliance. Civil and criminal proceedings may be instituted against any insured bank or any director, officer or employee of such bank for the violation of applicable laws and regulations, breaches of fiduciary duties or engaging in any unsafe or unsound practice. The FDIC has the authority to terminate insurance of accounts pursuant to procedures established for that purpose. Under the North Carolina Business Corporation Act, we may not pay a dividend or distribution, if after giving it effect, we would not be able to pay our debts as they become due in the usual course of business or our total assets would be less than our liabilities. In general, our ability to pay cash dividends is dependent upon the amount of dividends paid to us by the bank. The ability of the bank to pay dividends to us is subject to statutory and regulatory restrictions on the payment of cash dividends, including the requirement under the North Carolina banking laws that cash dividends be paid only out of undivided profits and only if the bank has surplus of a specified level. The Federal Reserve also imposes limits on the bank's payment of dividends. 6 Like us, the bank is required by federal regulations to maintain certain minimum capital levels. The levels required of the bank are the same as those required of us. At December 31, 2004, the bank had Tier 1 risk-adjusted, total regulatory capital and leverage capital of approximately 10.59%, 11.84% and 8.63%, respectively, in excess of the minimum requirements to be considered well-capitalized under prompt corrective action provisions. The bank is subject to insurance assessments imposed by the FDIC, including a risk-based assessment schedule providing for annual assessment rates ranging from 0% to .27% of an institution's average assessment base, applicable to institutions insured by both the BIF and the Savings Association Insurance Fund ("SAIF"). The actual assessment to be paid by each insured institution is based on the institution's assessment risk classification, which focuses on whether the institution is considered "well capitalized, " "adequately capitalized" or "under capitalized," as such terms are defined in the applicable federal regulations. Within each of these three risk classifications, each institution will be assigned to one of three subgroups based on supervisory risk factors. In particular, regulators will assess supervisory risk based on whether the institution is financially sound with only a few minor weaknesses (Subgroup A), whether it has weaknesses which, if not corrected, could result in an increased risk of loss to the BIF (Subgroup B) or whether such weaknesses pose a substantial risk of loss to the BIF unless corrective action is taken (Subgroup C). The FDIC also is authorized to impose one or more special assessments in an amount deemed necessary to enable repayment of amounts borrowed by the FDIC from the United States Treasury Department and, beginning in 1997, all banks are required to pay additional annual assessments as set by the Financing Corporation, which was established by the Competitive Equality Banking Act of 1987. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") provides for, among other things, (i) publicly available annual financial condition and management reports for certain financial institutions, including audits by independent accountants, (ii) the establishment of uniform accounting standards by federal banking agencies, (iii) the establishment of a "prompt corrective action" system of regulatory supervision and intervention, based on capitalization levels, with greater scrutiny and restrictions placed on depository institutions with lower levels of capital, (iv) additional grounds for the appointment of a conservator or receiver and (v) restrictions or prohibitions on accepting brokered deposits, except for institutions which significantly exceed minimum capital requirements. FDICIA also provides for increased funding of the FDIC insurance funds and the implementation of risk-based premiums. A central feature of FDICIA is the requirement that the federal banking agencies take "prompt corrective action" with respect to depository institutions that do not meet minimum capital requirements. Pursuant to FDICIA, the federal bank regulatory authorities have adopted regulations setting forth a five-tiered system for measuring the capital adequacy of the depository institutions that they supervise. Under these regulations, a depository institution is classified in one of the following capital categories: "well capitalized, " "adequately capitalized," "under capitalized," "significantly undercapitalized," and "critically undercapitalized. "An institution may be deemed by the regulators to be in a capitalization category that is lower than is indicated by its actual capital position if, among other things, it receives an unsatisfactory examination rating with respect to asset quality, management, earnings or liquidity. FDICIA provides the federal banking agencies with significantly expanded powers to take enforcement action against institutions which fail to comply with capital or other standards. Such action may include the termination of deposit insurance by the FDIC or the appointment of a receiver or conservator for the institution. Banks are also subject to the CRA, which requires the appropriate federal bank regulatory agency, in connection with its examination of a bank, to assess such bank's record in meeting the credit needs of the community served by that bank, including low and moderate-income neighborhoods. Each institution is assigned one of the following four ratings of its record in meeting community credit needs: "outstanding, " "satisfactory, " "needs to improve" or "substantial noncompliance. " The regulatory agency's assessment of the bank's record is made available to the public. Further, such assessment is required of any bank which has applied to (i) charter a national bank, (ii) obtain deposit insurance coverage for a newly chartered institution, (iii) establish a new branch office that will accept deposits, (iv) relocate an office or (v) merge or consolidate with, or acquire the assets or assume the liabilities of, a federally regulated financial institution. In the case of a bank holding company applying for approval to acquire a bank or other bank holding company, the Federal Reserve will assess the record of each subsidiary bank of the applicant bank holding company, and such records may be the basis for denying the application. 7 In addition, the GLB's "CRA Sunshine Requirements" call for financial institutions to disclose publicly certain written agreements made in fulfillment of the CRA. Banks that are parties to such agreements also must report to federal regulators the amount and use of any funds expended under such agreements on an annual basis, along with such other information as regulators may require. This annual reporting requirement is effective for any agreements made after May 12, 2000. MONETARY POLICY AND ECONOMIC CONTROLS Both us and the bank are directly affected by governmental policies and regulatory measures affecting the banking industry in general. Of primary importance is the Federal Reserve Board, whose actions directly affect the money supply which, in turn, affects banks' lending abilities by increasing or decreasing the cost and availability of funds to banks. The Federal Reserve Board regulates the availability of bank credit in order to combat recession and curb inflationary pressures in the economy by open market operations in United States government securities, changes in the discount rate on member bank borrowings, changes in reserve requirements against bank deposits, and limitations on interest rates that banks may pay on time and savings deposits. Deregulation of interest rates paid by banks on deposits and the types of deposits that may be offered by banks have eliminated minimum balance requirements and rate ceilings on various types of time deposit accounts. The effect of these specific actions and, in general, the deregulation of deposit interest rates has generally increased banks' cost of funds and made them more sensitive to fluctuations in money market rates. In view of the changing conditions in the national economy and money markets, as well as the effect of actions by monetary and fiscal authorities, no prediction can be made as to possible future changes in interest rates, deposit levels, or loan demand on our business and earnings or those of the bank. As a result, banks, including the bank, face a significant challenge to maintain acceptable net interest margins. OUR EXECUTIVE OFFICERS The following table sets forth certain information with respect to our executive officers: POSITIONS AND OFFICES WITH FOUR OAKS FINCORP, INC. AND FOUR OAKS BANK & TRUST YEAR FIRST COMPANY AND BUSINESS EXPERIENCE DURING NAME AGE EMPLOYED PAST FIVE (5) YEARS - --------------------------------------------------------------------------------------------------------------------------- Ayden R. Lee, Jr. 56 1980 Chief Executive Officer, President and Director of Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company Clifton L. Painter 55 1986 Senior Executive Vice President, Chief Operating Officer of Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company Nancy S. Wise 49 1991 Executive Vice President, Chief Financial Officer of Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company. Previously, Senior Vice President, Chief Financial Officer of Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company W. Leon Hiatt, III 37 1994 Executive Vice President of Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company, Chief Administrative Officer of Four Oaks Bank & Trust Company. Previously, Senior Vice President Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company, Loan Administrator of Four Oaks Bank & Trust Company. Jeff D. Pope 48 1991 Executive Vice President of Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company, Branch Administrator of Four Oaks Bank & Trust Company. Previously, Senior Vice President, Loan Officer and Regional/Branch Administrator Four Oaks Bank and Trust Company 8 ITEM 2 - PROPERTIES. The bank owns its main office, which is located at 6144 US 301 South, Four Oaks, North Carolina. The main office, which was constructed by the bank in 1985, is a 12,000 square foot facility on 1.64 acres of land. The bank leases a limited-service facility in downtown Four Oaks located at 111 North Main Street from M.S. Canaday, who is one of our directors as well as a director of the bank. Under the terms of the lease, which the bank believes to be arms-length, the bank paid $908 per month in rent in 2004. The lease is month-to-month and we review its terms on an annual basis. The bank also leases a branch office located at 101 Avent Ferry Road, Holly Springs, North Carolina. Under the terms of the lease, the bank will pay $2,166 per month for a period of five years. The bank's Harrells office located at 590 Tomahawk Highway, Harrells, North Carolina is under a lease with terms specifying the bank will pay $600 each month for the period beginning January 1, 2006 and ending December 31, 2009. In addition, the bank has entered into a yearly lease with an annual option to renew on its Sanford office located at 1100 South Horner Boulevard, Sanford, North Carolina. Under the terms of the lease, the bank will pay $1,300 each month. The bank owns a 5,000 square foot facility renovated in 1992 on 1.15 acres of land located at 5987 US 301 South, Four Oaks, North Carolina which houses its training center. The bank also owns a 15,000 square foot facility built in 2000 located at 6114 US 301 South, Four Oaks, North Carolina, which houses its administrative offices, data operations, loan operations and wide area network central link. In addition, the bank owns the following: Location Year Built Present Function Square Feet -------- ---------- ---------------- ----------- 102 East Main Street Clayton, North Carolina 1986 Branch Office 4,700 200 East Church Street Benson, North Carolina 1987 Branch Office 2,000 128 North Second Street Smithfield, North Carolina 1991 Branch Office 5,000 403 South Brightleaf Boulevard Smithfield, North Carolina 1995 Limited-Service Facility 720 200 Glen Road Garner, North Carolina 1996 Branch Office 3,600 325 North Judd Parkway Northeast Fuquay-Varina, North Carolina 2002 Branch Office 8,900 406 East Main Street Wallace, North Carolina 2003 Branch Office (modular) 2,800 Management believes each of the properties referenced above is adequately covered by insurance. ITEM 3 - LEGAL PROCEEDINGS. We are not involved in any material legal proceedings at the present time. 9 ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. PART II Item 5 - Market for Registrant's Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities. Our common stock trades on the OTC Bulletin Board under the symbol "FOFN." The range of high and low bid prices of our common stock for each quarter during the two most recent fiscal years, as published by the OTC Bulletin Board, is as follows (prices reflect inter-dealer prices, without retail mark-up, mark-down or commissions and may not necessarily represent actual transactions): Fiscal Year Ended December 31, ----------------------------------------------------------------- 2003 2004 ------------------------------- ----------------------------- High Low High Low --------- ------------- ------------- ----------- First quarter $ 15.04 $ 14.11 $ 20.80 $ 16.80 Second quarter 15.36 14.43 19.60 17.60 Third quarter 14.72 14.08 18.40 17.60 Fourth quarter 20.80 14.40 25.00 18.60 As of March 7, 2005, the approximate number of holders of record of our common stock was 1,400. We have no other class of equity securities. The bank's ability to declare a dividend to us and our ability to pay dividends are subject to the restrictions of the North Carolina Business Corporation Act. There also are state banking laws that require a surplus of at least 50% of paid-in capital stock be maintained in order for the bank to declare a dividend to us. Subject to the legal availability of funds to pay dividends, cash dividends paid by us in 2004 and 2003, after giving effect to the 5-for-4 stock split during 2004, were $.32 and $.29 per share, respectively. We did not sell any securities in 2004 that were not registered under the Securities Act of 1933 as amended. We did not make any purchases of our equity securities registered pursuant to Section 12 of the Securities Exchange Act of 1934, as amended during the fourth quarter of 2004. ITEM 6 - SELECTED FINANCIAL DATA The following table sets forth our historical consolidated financial data for the periods indicated. The selected historical annual consolidated statement of operations and balance sheet data as of and for each of the five fiscal years presented are derived from, and are qualified in their entirety by, our consolidated financial statements. Historical results are not necessarily indicative of the results to be expected in the future. You should read the following data together with "Item 1. Business," "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations," and our consolidated financial statements and the related notes appearing in "Item 8. Financial Statements." (Dollars in thousands, except per share data). 10 AS OF AND FOR THE YEAR ENDED DECEMBER 31, ----------------------------------------------------------------------- 2004 2003 2002 2001 2000 ------------ ------------ ----------- ------------- ------------- OPERATING DATA: Total interest income $ 21,748 $ 18,943 $ 19,785 $ 21,462 $ 20,808 Total interest expense 5,811 5,922 7,640 10,167 9,647 ------------ ------------ ----------- ------------- ------------- Net interest income 15,937 13,021 12,145 11,295 11,161 Provision for loan losses 1,596 1,373 1,248 834 808 ------------ ------------ ----------- ------------- ------------- Net interest income after provision for loan losses 14,341 11,648 10,897 10,461 10,353 Noninterest income 3,849 3,470 2,810 2,284 1,852 Noninterest expense 11,507 10,588 9,485 8,834 7,425 ------------ ------------ ----------- ------------- ------------- Income before income taxes 6,683 4,530 4,222 3,911 4,780 Provision for income taxes 2,308 1,612 1,306 1,255 1,664 ------------ ------------ ----------- ------------- ------------- Net income $ 4,375 $ 2,918 $ 2,916 $ 2,656 $ 3,116 ============ ============ =========== ============= ============= PER SHARE DATA: Earnings per share - basic $ 1.29 $ 0.87 $ 0.88 $ 0.81 $ 0.97 Earnings per share - diluted 1.28 0.86 0.87 0.81 0.96 Cash dividends declared 0.32 0.29 0.26 0.26 0.23 Market price High 25.00 20.80 15.04 16.00 17.20 Low 16.80 14.08 13.12 11.52 11.09 Close 22.00 16.80 15.04 13.06 14.72 Book value 10.85 9.83 9.31 8.51 7.81 Weighted average shares outstanding Basic 3,397,345 3,356,070 3,325,960 3,266,517 3,221,822 Diluted 3,416,680 3,368,041 3,336,866 3,283,683 3,237,491 SELECTED YEAR-END BALANCE SHEET DATA: Total assets $ 398,500 $ 341,721 $ 318,289 299,970 258,329 Loans 312,815 272,623 229,570 209,822 194,497 Allowance for loan losses 4,055 3,430 2,860 2,650 2,770 Deposits 315,307 272,918 250,573 235,604 216,693 Borrowings 43,160 33,160 33,160 33,173 12,990 Shareholders' equity 37,295 32,880 31,193 28,025 25,348 SELECTED AVERAGE BALANCES: Total assets $ 376,422 $ 324,222 308,334 274,054 241,165 Loans 298,783 249,240 216,620 202,500 182,874 Total interest-earning assets 349,596 300,672 290,294 256,476 226,191 Deposits 295,524 255,038 242,878 226,476 198,072 Total interest-bearing liabilities 282,743 244,024 236,661 208,381 183,135 Shareholders' Equity 35,135 32,341 29,931 27,306 23,550 SELECTED PERFORMANCE RATIOS: Return on average assets 1.16% 0.90% 0.95% 0.97% 1.29% Return on average equity 12.45% 9.02% 9.74% 9.73% 13.23% Net interest spread 4.16% 3.87% 3.59% 3.49% 3.93% Net interest margin 4.56% 4.33% 4.18% 4.40% 4.93% Non-interest income to total revenue 19.45% 21.04% 18.79% 16.82% 14.23% Non-interest income to average assets 1.02% 1.07% 0.91% 0.83% 0.77% Non-interest expense to average assets 3.06% 3.27% 3.08% 3.22% 3.08% Efficiency ratio 58.16% 64.20% 63.42% 65.06% 57.06% Dividend payout ratio 24.81% 33.33% 29.55% 31.50% 23.84% ASSET QUALITY RATIOS: Nonperforming loans to period-end loans 0.30% 0.39% 0.67% 0.97% 0.85% Allowance for loan losses to period-end loans 1.30% 1.26% 1.25% 1.26% 1.42% Allowance for loan losses to nonperforming loans 429.56% 323.89% 186.08% 129.65% 167.47% Nonperforming assets to total assets 0.34% 0.33% 0.62% 0.74% 0.67% Net loan charge-offs to average loans 0.32% 0.32% 0.48% 0.47% 0.21% 11 AS OF AND FOR THE YEAR ENDED DECEMBER 31, ----------------------------------------------------------------------- 2004 2003 2002 2001 2000 ------------ ------------ ----------- ------------- ------------- CAPITAL RATIOS: Total risk-based capital - Bank 11.80% 12.30% 14.00% 14.10% 12.86% Tier 1 risk-based capital - Bank 10.60% 11.10% 12.80% 13.90% 13.70% Leverage ratio - Bank 8.60% 9.00% 9.70% 9.50% 12.40% Equity to assets ratio 9.33% 9.62% 9.80% 9.34% 9.81% Equity to assets ratio (averages) 9.33% 9.97% 9.71% 9.96% 9.77% Average interest-earning assets to average total assets 92.87% 92.74% 94.15% 93.59% 93.79% Average loans to average total deposits 101.10% 97.73% 89.19% 89.41% 92.33% Average interest-bearing liabilities to average interest-earning assets 80.88% 81.16% 81.52% 81.25% 80.96% Other Data: Number of banking offices 10 10 9 8 8 Number of full time equivalent employees 131 126 122 112 100 ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following discussion and analysis provides information about the major components of our results of operations and financial condition, liquidity and capital resources and should be read in conjunction with our Consolidated Financial Statements and Notes thereto which are contained in this report. Additional discussion and analysis related to fiscal 2004 is contained in our Quarterly Reports on Form 10-Q for the fiscal quarters ended March 31, 2004, June 30, 2004 and September 30, 2004, respectively. OVERVIEW We have experienced significant sustained growth in assets and deposits over the last five years. Our assets have increased from $231.5 million at December 31, 1999 to $398.5 million at December 31, 2004, while our total deposits have increased from $194.7 million to $315.3 million over that same period. In addition, for 69 consecutive years, we have paid dividends (of course, prior to 1997 when we reorganized into a holding company, it was our wholly owned subsidiary, Four Oaks Bank & Trust Company, which paid dividends). For the past five years, dividends have averaged 25.6% of our average net income. We set interest rates on deposits and loans at competitive rates while maintaining spreads of 4.16% and 3.87% in 2004 and 2003, respectively, between interest earned on average loans and investments and interest paid on average interest-bearing deposits and borrowings. Our gross loans have increased from $166.6 million at December 31, 1999 to $312.8 million at December 31, 2004, while our average net annual charge-offs over the same period were $831,000. The sustained growth provided by operations resulted in increases in total assets of 16.6%, 7.4% and 6.1% for 2004, 2003 and 2002, respectively. Our gross loans grew 14.7% and 18.8% in 2004 and 2003, respectively. Our total investments (including interest-earning deposits and FHLB stock) increased 29.0% in 2004 following a decrease of 31.9% in 2003, which the decline was primarily due to the decision to build the portfolio as interest rates began to rise. We closely monitor changes in the financial markets in order to maximize the yield on our assets. The growth in loans for 2004 and 2003 was funded by deposit growth of 15.5% and 8.9% in 2004 and 2003, net income of $4.4 million in 2004 and $2.9 million in 2003 and for the year 2003, a reduction of lower yielding investments. Net income for 2004 was $4.4 million, an increase of 49.9% over 2003's net income of $2.9 million. This increase was primarily due to an increase in net interest income. Strategic pricing of both loans and deposits provided improvement in our net interest margin for 2004. Reduced overhead costs resulting from the effects of cost containment initiatives begun in prior years also improved net income in 2004. During 2004 and 2003, Four Oaks Mortgage Company, L.P. provided secondary market-type mortgages. Four Oaks Mortgage Company, L.P. is owned 49.99% by our wholly owned subsidiary, Four Oaks Mortgage Services, L.L.C., and 50.01% by its general partner, CTX Mortgage Ventures, LLC, a wholly owned indirect subsidiary of Centex Corporation. 12 In December 2004, we added the Retail Real Estate Lending division which will work with individuals, developers and contractors involved in real estate acquisition and development. Management historically has monitored and controlled increases in overhead expenses while being committed to developing the skills and enhancing the professionalism of our employees. Employee turnover has been minimal, while the number of full-time equivalent employees has increased from 100 at December 31, 1999 to 131 at December 31, 2004. RESULTS OF OPERATIONS COMPARISON OF FINANCIAL CONDITION AT DECEMBER 31, 2004 AND 2003 During 2004, our total assets increased by $56.8 million, or 16.6%, from $341.7 million at December 31, 2003 to $398.5 million at December 31, 2004. This increase in our total assets resulted primarily from growth in our net loans, which increased from $269.2 million at December 31, 2003 to $308.8 million at December 31, 2004, an increase of $39.6 million. Additionally, our securities portfolio increased $14.1 million to $52.3 million at December 31, 2004, and other assets increased $4.1 million in 2004 due to our investment in bank-owned life insurance during the year of $3.2 million. The funding for our loan growth, increases in our securities portfolio and investment in bank-owned life insurance was primarily funded by considerable deposit growth of $42.4 million, or 15.5% during 2004 to $315.3 million at December 31, 2004 compared with $272.9 million at December 31, 2003. Shareholders' equity increased by $4.4 million during 2004. This increase resulted from our net income of $4.4 million, dividend reinvestment plan proceeds of $506,000 and proceeds from the exercise of stock options of $924,000, net of repurchases of stock totaling $65,000, and dividends paid of $1.1 million. COMPARISON OF FINANCIAL CONDITION AT DECEMBER 31, 2003 AND 2002 During 2003, our total assets increased by $23.4 million, or 7.4%, from $318.3 million at December 31, 2002 to $341.7 million at December 31, 2003. This increase in our total assets resulted primarily from growth in our net loans, which increased from $226.7 million at December 31, 2002 to $269.2 million at the end of 2003, an increase of $42.5 million. Additionally, our other assets increased $3.1 million in 2003 due to our investment in bank-owned life insurance during the year of $2.9 million. These increases in our assets were partially offset by the decrease during 2003 in our liquid assets, which consists of cash and cash equivalents and investment securities, of $22.4 million. This decrease in our liquid assets resulted principally from the net decrease in our securities portfolio during the year of $18.6 million. In addition to the aforementioned use of our liquid assets, the funding for our loan growth and investment in bank-owned life insurance came from deposits, which increased by $22.3 million during 2003 to $272.9 million at December 31, 2003 compared with $250.6 million at December 31, 2002. Shareholders' equity increased by $1.7 million during 2003 compared to 2002. This increase resulted from our net income of $2.9 million, dividend reinvestment plan proceeds of $469,000 and proceeds from the exercise of stock options of $300,000, net of repurchases of stock totaling $993,000, and dividends paid of $952,000. COMPARISON OF OPERATING RESULTS FOR THE YEARS ENDED DECEMBER 31, 2004 AND 2003 NET INCOME We earned net income of $4.4 million or $1.29 basic net income per share for 2004, which was a 49.9% increase over net income of $2.9 million, or $.87 basic net income per share for 2003. We believe strategic pricing of both our loans and deposits improved our net interest margin by lowering our overall cost of funds and allowing us to attract the higher balance, higher quality loans in our markets. Cost containment initiatives that began in prior years continue to positively impact our overhead levels. We incurred only a moderate increase in non-interest expense of 8.7% in 2004 over the prior year despite expenses incurred in preparation of the opening of two new offices in January 2005. Non-interest expense increased 11.6% for the year 2003 over the prior year when one new branch was opened and one branch was permanently relocated from temporary quarters. 13 NET INTEREST INCOME Like most financial institutions, the primary component of earnings for the bank is net interest income. Net interest income is the difference between interest income, principally from loan and investment securities, and interest expense, principally on customer deposits and borrowings. Changes in net interest income result from changes in volume, spread and margin. For this purpose, volume refers to the average dollar level of interest-earning assets and interest-bearing liabilities, spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities, and margin refers to net interest income divided by average interest-earning assets. Margin is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities, as well as by levels of non-interest-bearing liabilities and capital. Net interest income increased to $15.9 million in 2004, with a net yield of 4.56%, compared to $13.0 million and a net yield of 4.33% in 2003, which was an increase of $2.9 million or 23 basis points from 2003. Our level of average interest-earning assets increased from $300.7 million for 2003 to $349.6 million for 2004. Although the average rate we earned on these assets dropped 8 basis points from 6.30% in 2003 to 6.22% in 2004, the average growth in volume of earning assets, primarily loans, provided additional interest income of $3.4 million offsetting the $546,000 decrease due to decline in yields. Interest paid on interest-bearing liabilities declined $111,000 for 2004 due to declines in rates paid on interest-bearing funds. Our average interest-bearing liabilities, primarily time deposits, grew 15.9% to $282.7 million for the year 2004 resulting in an increase in interest expense of $828,000. However, declines in rates paid on interest-bearing funds provided a decrease in interest expense of $939,000 primarily in time deposits where the average rates paid for time deposits greater than $100,000 declined 56 basis points and other time deposits declined 32 basis points. The growth in our non-interest-bearing demand deposits of 22.9% also contributed to our increase in net interest income. PROVISION FOR LOAN LOSSES AND ASSET QUALITY Our provision for loan losses was $1.6 million during 2004 and $1.4 million during 2003. Net charge-offs in 2004 were $971,000 compared to $803,000 in 2003. This increase resulted primarily from the growth in our loan portfolio during the year. The allowance for loan losses is maintained at a level deemed adequate to absorb probable losses inherent in the loan portfolio and results from management's consideration of such factors as the financial condition of borrowers, past and expected loss experience, current economic conditions, and other factors management feels deserve recognition in establishing an appropriate reserve. Although management attempts to maintain the allowance at a level deemed adequate, future additions to the allowance may be necessary based upon changes in market conditions or the status of the loans included in the loan portfolio. In addition, various regulatory agencies periodically review our allowance for loan losses. These agencies may require us to make adjustments based upon their judgments about information available to them at the time of their examination. Our non-performing assets, which consist of loans past due 90 days or more, real estate acquired in the settlement of loans, and loans in nonaccrual status, decreased from $1.8 million at December 31, 2003 to $1.6 million at December 31, 2004. Our allowance for loan losses, expressed as a percentage of gross loans, was 1.30% and 1.26% at December 31, 2004 and 2003, respectively. At December 31, 2004, the allowance for loan losses amounted to $4.1 million, which management believes is adequate to absorb losses inherent in its loan portfolio. NON-INTEREST INCOME Non-interest income increased 10.9% from $3.5 million during 2003 to $3.8 million in 2004. Our non-interest income is comprised primarily of service charges on deposit accounts, insurance commissions, gain or loss on sale of investment securities, gain on sale of loans, merchant fees, bank-owned life insurance income and various other sources of miscellaneous operating income. The $379,000 increase in non-interest income from 2003 to 2004 primarily resulted from increases in service charges on deposits accounts of $74,000, merchant fees of $23,000, other service charges of $389,000 as well as increases in income from bank-owned life insurance of $235,000 all of which were in part offset by declines in net gains from sales of securities and loans. Our net gains on sales of loans declined $140,000 in 2004 compared to the previous year. The decline in loan sales was attributable to a slow down in funding of government-backed loans, which generated net gains of $212,000 during 2003. NON-INTEREST EXPENSE Our non-interest expense increased from $10.6 million in 2003 to $11.5 million in 2004, an increase of $919,000. Approximately 48.9% of this increase was due to increases in salaries and benefits. In addition to normal salary increases and increased benefits costs, we opened two new offices in January 2005, incurring additional expense during the fourth quarter of 2004 in preparation for these two new locations. Professional fees increased due to our preparation for compliance with Section 404 of the Sarbanes-Oxley Act of 2002. 14 COMPARISON OF OPERATING RESULTS FOR THE YEARS ENDED DECEMBER 31, 2003 AND 2002 NET INCOME We earned net income of $2.9 million or $.87 basic net income per share for 2003, as compared with net income of $2.9 million or $.88 basic net income per share for 2002. We were able to maintain the level of our earnings despite the challenges presented by the historically low rates during the year, which fell to their lowest level in June 2003. We believe strategic pricing of both our loans and deposits improved our net interest margin by lowering our overall cost of funds and allowing us to attract the higher balance, higher quality loans in our market. Cost containment initiatives that began in prior years continue to positively impact our overhead levels. Despite opening one new branch and permanently locating a branch opened in temporary quarters late in 2002, our non-interest expenses only increased 11.6% in 2003 as compared to 2002. NET INTEREST INCOME Net interest income increased to $13.0 million in 2003, compared to the $12.1 million earned in 2002, an increase of $876,000. During 2003, our level of average interest-earning assets increased from $290.3 million in 2002 to $300.7 million, but the average rate we earned on those assets dropped 52 basis points from 6.82% in 2002 to 6.30% in 2003. This decrease in the average rate we earned on our assets more than offset the effect of the increase in our average interest earning assets during the year and resulted in the decrease in our interest income of $842,000 in 2003. This decrease in our interest income, however, was negated by the decrease in our interest expense during 2003. While our average interest-bearing liabilities increased from $236.7 million in 2002 to $244.0 million in 2003, it is important to note that 16.1% of the increase in deposits occurred in our money market and interest-bearing demand deposit accounts, which have rates significantly less than our other types of interest-bearing liabilities. The average rate we paid for our interest-bearing liabilities during the year dropped 80 basis points during 2003 from 3.23% in 2002 to 2.43% in 2003, resulting in a decrease of $1.7 million in our total interest expense in 2003. We also grew noninterest-bearing demand deposit accounts by 18.7% in 2003 compared to 2002. PROVISION FOR LOAN LOSSES AND ASSET QUALITY Our provision for loan losses was $1.4 million during 2003 and $1.2 million in 2002. Loan charge-offs in 2003 and 2002 were $1.1 million and $1.2 million, respectively. This increase resulted primarily from the growth in our loan portfolio during the year. Our non-performing assets decreased from $2.1 million at December 31, 2002 to $1.8 million at December 31, 2003. Our allowance for loan losses, expressed as a percentage of gross loans, was 1.26% and 1.25% at December 31, 2003 and 2002, respectively. At December 31, 2003, the allowance for loan losses amounted to $3.4 million, which management believes is adequate to absorb losses inherent in its loan portfolio. NON-INTEREST INCOME Non-interest income increased 23.5% from $2.8 million during 2002 to $3.5 million in 2003. The $660,000 increase in non-interest income from 2002 to 2003 primarily resulted from increases in the net gains on sale of securities of $281,000 and merchant fees of $115,000, as well as increases in income from bank-owned life insurance of $159,000. NON-INTEREST EXPENSE Our non-interest expense increased from $9.5 million in 2002 to $10.6 million in 2003, an increase of $1.1 million. Approximately 64.5% of this increase was due to salaries and benefits expenses. We opened one new office in June of 2003. Another office which opened in temporary quarters late in 2002, relocated to their permanent location in January 2003. These new locations contributed to the increase in salaries and benefits and to the increase in our occupancy and equipment expenses during 2003. 15 LIQUIDITY AND CAPITAL RESOURCES Our liquidity position is primarily dependent upon the bank's need to respond to loan demand, the short-term demand for funds caused by withdrawals from deposit accounts (other than time deposits) and the liquidity of its assets. The bank's primary liquidity sources include cash and amounts due from other banks, federal funds sold, and U.S. Government Agency and other short-term investment securities. In addition, the bank has the ability to borrow funds from the Federal Reserve Bank and the Federal Home Loan Bank of Atlanta, to purchase federal funds from other financial institutions and to obtain wholesale deposits. Our management believes that our liquidity sources are adequate to meet our operating needs and the operating needs of the bank for the next eighteen months. Total shareholders' equity was $37.3 million or 9.4% of total assets at December 31, 2004 and $32.9 million or 9.6% of total assets at December 31, 2003. INTEREST RATE SENSITIVITY ANALYSIS As a part of our interest rate risk management policy, we periodically perform an interest rate sensitivity analysis. Interest rate sensitivity analysis is a common, though imperfect, measure of interest rate risk, which measures the relative dollar amounts of interest-earning assets and interest-bearing liabilities that reprice within a specific time period, either through maturity or rate adjustment. Any resulting interest rate "gap" is the difference between the amounts of such assets and liabilities that are subject to repricing. A positive gap for a given period means that the amount of interest-earning assets maturing or otherwise repricing within that period exceeds the amount of interest-bearing liabilities maturing or otherwise repricing within the same period. Accordingly, in a declining interest rate environment, an institution with a positive gap would generally be expected, absent the effects of other factors, to experience a decrease in the yield on its assets greater than the decrease in the cost of its liabilities, and its net interest income should be negatively affected. Conversely, the yield on its assets for an institution with a positive gap would generally be expected to increase more quickly than the cost of funds in a rising interest rate environment, and such institution's net interest income generally would be expected to be positively affected by rising interest rates. Changes in interest rates generally have the opposite effect on an institution with a negative gap. The table below sets forth the amounts of our interest-earning assets and interest-bearing liabilities outstanding as of December 31, 2004 that are projected to reprice or mature in each of the future time periods shown. Except as stated below, the amounts of assets and liabilities shown which reprice or mature within a particular period were determined in accordance with the contractual terms of the assets or liabilities. Loans with adjustable rates are shown as being due at the end of the next upcoming adjustment period. Money market deposit accounts and negotiable order of withdrawal or other transaction accounts are assumed to be subject to immediate repricing and depositor availability and have been placed in the shortest period. In making the gap computations, none of the traditional assumptions regarding prepayment rates and deposit decay rates have been used for any interest-earning assets or interest-bearing liabilities. In addition, the table does not reflect scheduled principal payments that will be received throughout the lives of the loans or investments. The interest rate sensitivity of our assets and liabilities illustrated in the following table would vary substantially if different assumptions were used or if actual experience differs from that indicated by such assumptions. (Dollars in thousands). 16 INTEREST RATE SENSITIVITY AS OF DECEMBER 31, 2004 --------------------------------------------------------------- OVER 3 MONTHS 3 MONTHS TOTAL WITHIN OVER 12 OR LESS TO 12 MONTHS 12 MONTHS MONTHS TOTAL --------- ------------- ----------- ---------- ---------- INTEREST-EARNING ASSETS: Loans $227,741 $ 9,456 $237,197 $ 75,618 $312,815 Securities available for sale -- 926 926 51,416 52,342 Other earning assets 3,615 -- 3,615 2,621 6,236 -------- -------- -------- -------- -------- Total interest-earning assets $231,356 $ 10,382 $241,738 $129,655 $371,393 ======== ======== ======== ======== ======== Percent of total interest-earning assets 62.74% 2.82% 65.55% 34.91% 100.00% Cumulative percent of total interest- earning assets 62.74% 65.55% 65.55% 100.00% 100.00% INTEREST-BEARING LIABILITIES: Fixed maturity deposits $ 54,684 $ 66,256 $120,940 $ 64,472 $185,412 All other deposits 70,367 -- 70,367 -- 70,367 Borrowings -- -- -- 43,160 43,160 -------- -------- -------- -------- -------- Total interest-bearing liabilities $125,051 $ 66,256 $191,307 $107,632 $298,939 ======== ======== ======== ======== ======== Percent of total interest-bearing liabilities 41.83% 22.16% 64.00% 36.00% 100.00% Cumulative percent of total interest- bearing liabilities 41.83% 64.00% 64.00% 100.00% 100.00% Interest sensitivity gap $106,305 $(55,874) $ 50,431 $ 22,023 $ 72,454 Cumulative interest sensitivity gap 106,305 50,431 50,431 72,454 72,454 Cumulative interest sensitivity gap as a percent of total interest-earning assets 28.83% 13.68% 13.68% 19.51% 19.51% Cumulative ratio of interest-sensitive assets to interest-sensitive liabilities 185.01% 126.36% 126.36% 124.24% 124.24% CONTRACTUAL OBLIGATIONS AND COMMITMENTS In the normal course of business there are various outstanding contractual obligations that require future cash outflows. The following table shows our expected contractual obligations and future operating lease commitments as of December 31, 2004 (in thousands): PAYMENTS DUE BY PERIOD ------------------------------------------------------------------------- LESS THAN MORE THAN TOTAL 1 YEAR 1-3 YEARS 3-5 YEARS 5 YEARS ------------ ------------ ------------ ------------- ------------- Borrowings $ 43,160 $ - $ 10,160 $ - $ 33,000 Operating leases 130 42 66 22 - Deposits 185,412 120,940 33,453 5,017 26,002 Purchase obligations 650 650 - - - ------------ ------------ ------------ ------------- ------------ Total $ 229,352 $ 121,632 $ 43,679 $ 5,039 $ 59,002 ============ ============ ============ ============= ============ The following table shows our undisbursed lines of credit, other commitments to extend, undisbursed portion of construction loans and stand-by letters of credit as of December 31, 2004 (in thousands): AMOUNT OF COMMITMENT EXPIRATION PER PERIOD ------------------------------------------------------------------------- LESS THAN MORE THAN TOTAL 1 YEAR 1-3 YEARS 3-5 YEARS 5 YEARS ------------ ------------ ------------ ------------- ------------- Undisbursed lines of credit $ 21,221 $ 34 $ 6,851 $ 278 $ 14,058 Other commitments to extend 49,003 39,107 8,481 900 515 Undisbursed portion of construction loans 19,153 15,542 1,911 1,700 - Stand-by letters of credit 1,726 823 870 33 - ------------ ------------ ------------ ------------- ------------ Total $ 91,103 $ 55,506 $ 18,113 $ 2,911 $ 14,573 ============ ============ ============ ============= ============ 17 INFLATION The effect of inflation on financial institutions differs somewhat from the effect it has on other businesses. The performances of banks, with assets and liabilities that are primarily monetary in nature, are affected more by changes in interest rates than by inflation. Interest rates generally increase as the rate of inflation increases, but the magnitude of the change in rates may not be the same. During periods of high inflation, there are normally corresponding increases in the money supply, and banks will normally experience above average growth in assets, loans and deposits. Also, general increases in the price of goods and services will generally result in increased operating expenses. INCOME TAXES Income taxes, as a percentage of income before income taxes, for 2004 and 2003 were 34.54% and 35.58%, respectively. The decrease was the result of management's redirection of funds between loans and different types of taxable and tax exempt interest-bearing assets in response to economic conditions and the bank's liquidity requirements. DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY; INTEREST RATES AND INTEREST DIFFERENTIAL The following schedule presents average balance sheet information for the years 2004, 2003 and 2002, along with related interest earned and average yields for interest-earning assets and the interest paid and average rates for interest-bearing liabilities: AVERAGE DAILY BALANCES, INTEREST INCOME/EXPENSE, AVERAGE YIELD/RATE FOR THE YEARS ENDED DECEMBER 31, ----------------------------------------------------------------------------------------- 2004 2003 2002 ------------------------ ------------------------------ ---------------------------- AVERAGE AVERAGE AVERAGE AVERAGE AVERAGE AVERAGE BALANCE INTEREST RATE BALANCE INTEREST RATE BALANCE INTEREST RATE -------- -------- ------ --------- -------- -------- -------- --------- ------- (DOLLARS IN THOUSANDS) Interest-earning assets: Loans $298,783 $19,968 6.68% $249,240 $17,318 6.95% $216,620 $16,746 7.73% Investment securities - taxable 40,729 1,470 3.61% 40,691 1,272 3.13% 52,348 2,482 4.74% Investment securities - tax-exempt 4,278 162 3.79% 4,968 212 4.27% 4,716 213 4.52% Other 5,806 148 2.55% 5,773 141 2.44% 16,610 344 2.07% -------- ------- -------- ------- -------- ------- Total interest-earning assets 349,596 21,748 6.22% 300,672 18,943 6.30% 290,294 19,785 6.82% ------- ---- ------- ------- ------- ------ Other assets 26,826 23,550 18,040 -------- -------- -------- Total assets $376,422 $324,222 $308,334 ======== ======== ======== Interest-bearing liabilities: Deposits: NOW and money market $ 52,677 361 .69% $39,313 238 .61% $ 32,431 302 .93% Savings 13,967 59 .42% 12,659 63 .50% 11,427 124 1.09% Time deposits greater than $100,000 94,313 1,978 2.10% 70,567 1,878 2.66% 70,543 2,541 3.60% Other time deposits 78,987 1,725 2.18% 87,285 2,186 2.50% 89,100 3,136 3.52% Borrowings 42,799 1,688 3.94% 34,200 1,557 4.55% 33,160 1,537 4.64% -------- ------- -------- ------- -------- ------- Total interest-bearing liabilities 282,743 5,811 2.06% 244,024 5,922 2.43% 236,661 7,640 3.23% ------- ---- ------- ------- ------- ------ Non-interest-bearing deposits 55,580 45,214 39,377 Other liabilities 2,964 2,643 2,365 Shareholders' equity 35,135 32,341 29,931 -------- -------- -------- Total liabilities and shareholders' equity $376,422 $324,222 $308,334 ======== ======== ======== Net interest income and interest rate spread $ 15,937 4.16% $13,021 3.87% $12,145 3.59% ========= ==== ======= ======= ======= ====== Net yield on average interest- earning assets 4.56% 4.33% 4.18% ==== ======= ====== Ratio of average interest-earning assets to average interest-bearing liabilities 123.64% 123.21% 122.66% ======== ======== ======== 18 The following table shows changes in interest income and expense by category and rate/volume variances for the years ended December 31, 2004 and 2003. The changes due to rate and volume were allocated on their absolute values: YEAR ENDED YEAR ENDED DECEMBER 31, 2004 VS. 2003 DECEMBER 31, 2003 VS. 2002 ----------------------------- ------------------------------ INCREASE (DECREASE) DUE TO INCREASE (DECREASE) DUE TO ----------------------------- ------------------------------ VOLUME RATE TOTAL VOLUME RATE TOTAL ------- ---- ------ ------ ---- ----- (IN THOUSANDS) Interest income: Loans $ 3,377 $(727) $ 2,650 $ 2,394 $(1,822) $ 572 Investment securities - taxable 1 197 198 (459) (751) (1,210) Investment securities - tax-exempt (28) (22) (50) 11 (12) (1) Other 1 6 7 (245) 42 (203) ------- ----- ------- ------- ------- -------- Total interest income 3,351 (546) 2,805 1,701 (2,543) (842) ------- ----- ------- ------- ------- -------- Interest expense: Deposits: NOW and money market 86 37 123 53 (117) (64) Savings 6 (10) (4) 10 (71) (61) Time deposits greater than $100,000 566 (466) 100 1 (664) (663) Other time deposits (195) (266) (461) (55) (895) (950) Borrowings 365 (234) 131 48 (28) 20 ------- ----- ------- ------- ------- -------- Total interest expense 828 (939) (111) 57 (1,775) (1,718) ------- ----- ------- ------- ------- -------- Net interest income increase (decrease) $ 2,523 $ 393 $ 2,916 $ 1,644 $ (768) $ 876 ======= ===== ======= ======= ======= ======== Market Risk Like most financial institutions, our most significant market risk exposure is the risk of economic loss resulting from adverse changes in market price and interest rates. This risk of loss can be reflected in diminished current market values and/or reduced potential net interest income in future periods. Our market risk arises primarily from interest rate risk inherent in our lending and deposit-taking activities. The structure of our loan and deposit portfolios is such that a significant decline in interest rates may adversely impact net market values and net interest income. We do not maintain a trading account nor are we subject to currency exchange risk or commodity price risk. Interest rate risk is monitored as part of the bank's asset/liability management function. The following table presents information about the contractual maturities, average interest rates and estimated fair values of our financial instruments we considered market risk sensitive as of December 31, 2004. (Dollars in thousands). AVERAGE BEYOND INTEREST ESTIMATED 2005 2006 2007 2008 2009 FIVE YEARS TOTAL RATE FAIR VALUE --------- -------- -------- -------- -------- ---------- --------- -------- ---------- Financial assets: Loans: Fixed rate $ 18,372 $ 10,396 $ 15,232 $ 20,398 $ 16,081 $ 13,511 $ 93,990 7.35% $ 93,976 Variable Rate 218,825 - - - - - 218,825 5.79% 218,792 Securities available for sale 926 - 5,963 10,973 5,840 28,640 52,342 3.89% 52,342 Other earning assets 3,615 - - - - - 3,615 2.10% 3,615 --------- -------- -------- -------- -------- -------- --------- --------- Total $ 241,738 $ 10,396 $ 21,195 $ 31,371 $ 21,921 $ 42,151 $ 368,772 5.88% $ 368,725 ========= ======== ======== ======== ======== ======== ========= ========= Financial liabilities: Money market, NOW and savings deposits $ 70,367 - - - - - $ 70,367 0.39% $ 63,959 Time deposits 120,940 $ 13,490 $ 13,754 $ 6,209 $ 20,019 $ 11,000 185,412 2.54% 186,314 Borrowings - 10,160 - - - 33,000 43,160 3.87% 41,651 --------- -------- -------- -------- -------- -------- --------- --------- Total $ 191,307 $ 23,650 $ 13,754 $ 6,209 $ 20,019 $ 44,000 $ 298,939 2.23% $ 291,924 ========= ======== ======== ======== ======== ======== ========= ========= 19 Derivative Financial Instruments A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to an underlying instrument, index or reference rate. These instruments primarily consist of interest rate swaps, caps, floors, financial forward and futures contracts and options written or purchased. Derivative contracts are written in amounts referred to as notional amounts. Notional amounts only provide the basis for calculating payments between counterparties and do not represent amounts to be exchanged between parties and are not a measure of financial risks. Credit risk arises when amounts receivable from a counterparty exceed amounts payable. We control our risk of loss on derivative contracts by subjecting counterparties to credit reviews and approvals similar to those used in making loans and other extensions of credit. We have used interest rate swaps in the management of interest rate risk. Interest rate swaps are contractual agreements between two parties to exchange a series of cash flows representing interest payments. A swap allows both parties to alter the repricing characteristics of assets or liabilities without affecting the underlying principal positions. Through the use of a swap, assets and liabilities may be transformed from fixed to floating rates, from floating rates to fixed rates, or from one type of floating rate to another. At December 31, 2004, swap derivatives with a total notional value of $51.0 million, with terms ranging up to six years, were outstanding. Although off-balance sheet derivative financial instruments do not expose us to credit risk equal to the notional amount, such agreements generate credit risk to the extent of the fair value gain in an off-balance sheet derivative financial instrument if the counterparty fails to perform. We minimize such risk by evaluating the creditworthiness of the counterparties and consistently monitoring these agreements. The counterparties to these arrangements are primarily large commercial banks and investment banks. Where appropriate, master netting agreements are arranged or collateral is obtained in the form of rights to securities. At December 31, 2004, our interest rate swaps reflected a net unrealized loss of $213,000. Other risks associated with interest-sensitive derivatives include the effect on fixed rate positions during periods of changing interest rates. Indexed amortizing swaps' notional amounts and maturities change based on certain interest rate indices. Generally, as rates fall the notional amounts decline more rapidly, and as rates increase notional amounts decline more slowly. As of December 31, 2004, we had no indexed amortizing swaps outstanding. Under unusual circumstances, financial derivatives also increase liquidity risk, which could result from an environment of rising interest rates in which derivatives produce negative cash flows while being offset by increased cash flows from variable rate loans. We consider such risk to be insignificant due to the relatively small derivative positions we hold. A discussion of derivatives is presented in Note I to our consolidated financial statements, which are presented under Item 8 in this Form 10-K. QUARTERLY FINANCIAL INFORMATION The following table, sets forth, for the periods indicated, certain of our consolidated quarterly financial information. This information is derived from our unaudited financial statements, which include, in the opinion of management, all normal recurring adjustments which management considers necessary for a fair presentation of the results for such periods. This information should be read in conjunction with our consolidated financial statements included elsewhere in this report. The results for any quarter are not necessarily indicative of results for any future period. (Dollars in thousands, except per share data). 20 YEAR ENDED DECEMBER 31, 2004 YEAR ENDED DECEMBER 31, 2003 -------------------------------------- ------------------------------------- FOURTH THIRD SECOND FIRST FOURTH THIRD SECOND FIRST QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER -------- -------- -------- ------- ------- ------- ------- ------- OPERATING DATA: Total interest income $5,856 $5,609 $5,215 $5,068 $4,954 $4,685 $4,690 $4,614 Total interest expense 1,567 1,505 1,401 1,338 1,345 1,411 1,511 1,655 -------- -------- -------- ------- ------- ------- ------- ------- Net interest income 4,289 4,104 3,814 3,730 3,609 3,274 3,179 2,959 Provision for loan losses 205 401 422 568 322 285 423 343 -------- -------- -------- ------- ------- ------- ------- ------- Net interest income after provision 4,084 3,703 3,392 3,162 3,287 2,989 2,756 2,616 Non-interest income 938 1,071 982 858 798 951 860 861 Non-interest expense 3,068 2,789 2,860 2,790 2,628 2,661 2,753 2,546 -------- -------- -------- ------- ------- ------- ------- ------- Income before income taxes 1,954 1,985 1,514 1,230 1,457 1,279 863 931 Provision for income taxes 691 654 532 431 547 517 245 303 -------- -------- -------- ------- ------- ------- ------- ------- Net income $1,263 $1,331 $ 982 $ 799 $ 910 $ 762 $ 618 $ 628 ======== ======== ======== ======= ======= ======= ======= ======= PER SHARE DATA: Net income: Basic $ 0.37 $ 0.39 $ 0.29 $ 0.24 $ 0.27 $ 0.23 $ 0.18 $ 0.19 Diluted 0.37 0.39 0.28 0.24 $ 0.27 $ 0.22 $ 0.18 $ 0.19 Cash dividends declared 0.08 0.08 0.08 0.08 0.08 0.07 0.07 0.07 Common stock price: High $25.00 $18.40 $19.60 $20.80 $20.80 $14.72 $15.36 $15.04 Low 18.60 17.60 17.60 16.80 14.40 14.08 14.43 14.11 INVESTMENT PORTFOLIO The valuations of investment securities at December 31, 2004, 2003 and 2002, respectively, were as follows (in thousands): AVAILABLE FOR SALE -------------------------------------------------------------------------------- 2004 2003 2002 ------------------------ ------------------------- -------------------------- AMORTIZED ESTIMATED AMORTIZED ESTIMATED AMORTIZED ESTIMATED COST FAIR VALUE COST FAIR VALUE COST FAIR VALUE ----------- ---------- ----------- ----------- ----------- ------------ U.S. Government and agency securities $ 34,991 $ 34,958 $ 15,866 $ 15,914 $ 27,147 $ 27,361 State and municipal securities 3,573 3,632 4,664 4,955 4,616 4,860 Mortgage-backed securities 12,759 12,775 16,535 16,502 23,671 23,933 Other 628 977 567 832 552 635 ----------- ---------- ----------- ----------- ----------- ------------ Total securities $ 51,951 $ 52,342 $ 37,632 $ 38,203 $ 55,986 $ 56,789 =========== ========== =========== =========== =========== ============ Pledged securities $ 33,408 $ 12,329 $ 15,339 ========== =========== ============ The following table sets forth the carrying value of our available for sale investment portfolio at December 31, 2004 (in thousands): CARRYING VALUE ----------------------------------------------------------------------- AFTER 1 YEAR AFTER 5 YEARS THROUGH THROUGH AFTER 1 YEAR 5 YEARS 10 YEARS 10 YEARS TOTAL --------- ------------ --------------- ----------- --------- U.S. Government and Agency securities $ - $ 20,251 $ 14,707 $ - $34,958 State and municipal securities - 134 2,390 1,108 3,632 Mortgage-backed securities - 2,388 7,968 2,419 12,775 Other - - - 977 977 --------- -------- -------- ------- ------- Total $ - $ 22,773 $ 25,065 $ 4,504 $52,342 ========= ======== ======== ======= ======= 21 The following table sets forth the weighted average yield by maturity of our available for sale investment portfolio at December 31, 2004: WEIGHTED AVERAGE YIELDS ----------------------------------------------------------------------- AFTER 1 YEAR AFTER 5 YEARS THROUGH THROUGH AFTER 1 YEAR 5 YEARS 10 YEARS 10 YEARS TOTAL --------- ------------ --------------- ----------- --------- U.S. Government and agency securities - 3.66% 3.90% - 3.76% State and municipal securities - 4.76% 3.65% 3.94% 3.78% Mortgage-backed securities - 3.51% 3.76% 4.57% 3.87% Other - - - 3.48% 3.48% --------- -------- --------------- ----------- --------- Total weighted average yields - 3.65% 3.83% 4.18% 3.78% ========= ======== =============== =========== ========= LOAN PORTFOLIO Loans consisted of the following, as extracted from the Call Reports of December 31, 2004, 2003, 2002, 2001 and 2000 (in thousands): 2004 2003 2002 2001 2000 --------- --------- --------- ------- ------- Loans receivable: Loans secured by real estate: Construction and land development $ 90,742 $ 66,242 $ 56,780 $44,770 $35,751 Secured by farmland 15,203 13,384 8,290 7,171 7,576 Secured by 1-4 family residential properties: Revolving open-end loans & lines of credit 23,295 18,879 16,569 14,603 12,394 All other 58,158 55,113 43,821 48,190 48,589 Secured by multifamily residential properties 5,088 3,634 3,265 2,621 1,170 Secured by nonfarm nonresidential properties 72,611 63,372 42,941 38,446 31,300 Loans to finance agricultural production and other loans to farmers 4,020 5,084 6,277 6,329 5,954 Commercial and industrial loans 26,005 27,872 29,908 26,420 30,344 Loans to individuals for household, family and other personal expenditures: Credit cards and related plans 3,807 3,574 3,527 2,917 2,354 Other 13,400 14,458 17,177 17,169 18,120 Obligations of states and political subdivisions in the U.S.: Tax exempt obligations 225 332 -- 202 280 All other loans 628 836 921 953 712 Lease financing receivables 12 13 14 20 33 Deferred cost (unearned income) on loans 379 170 (80) (11) 80 --------- --------- --------- ---------- --------- Total loans 312,815 272,623 229,570 209,822 194,497 Allowance for loan losses (4,055) (3,430) (2,860) (2,650) (2,770) --------- --------- --------- ---------- --------- Net loans $ 308,760 $ 269,193 $ 226,710 $207,172 $ 191,727 ========= ========= ========= ========== ========= Commitments and contingencies: Commitments to make loans $ 89,377 $ 68,731 $ 44,525 $ 45,510 $ 35,810 Standby letters of credit $ 1,726 $ 1,003 $ 2,408 $ 653 $ 1,473 22 CERTAIN LOAN MATURITIES The maturities and carrying amounts of certain loans as of December 31, 2004 are summarized as follows (in thousands): REAL ESTATE COMMERCIAL CONSTRUCTION FINANCIAL AND AND LAND AGRICULTURAL DEVELOPMENT TOTAL -------------- ------------- --------- Due within one year $ 30,424 $67,898 $98,322 Due after one year to five years: Fixed rate 19,570 4,938 24,508 Variable rate 60,521 12,497 73,018 Due after five years: Fixed rate 771 370 1,141 Variable rate 6,156 5,039 11,195 -------- ------- -------- Total $117,442 $90,742 $208,184 ======== ======= ======== RISK ELEMENTS Past due and nonaccrual loans, as extracted from the Call Reports of December 31, 2004, 2003, 2002, 2001 and 2000 were as follows (in thousands): 2004 2003 2002 2001 2000 ------ ------ ------ ------ ------ Nonaccrual loans: Real estate loans $ 614 $ 739 $1,059 $1,651 $1,150 Installment loans 80 96 191 62 445 Commercial and all other loans 250 224 287 331 59 ------ ------ ------ ------ ------ Total $ 944 $1,059 $1,537 $2,044 $1,654 ====== ====== ====== ====== ====== Agricultural loans included above $ 197 $ 110 $ 163 $ 82 $ 10 ====== ====== ====== ====== ====== Past due 90 days or more and still accruing: Real estate loans $ 188 $ 597 $ -- $ 24 $ 367 Installment loans 1 5 36 19 21 Credit cards and related plans 11 18 17 9 22 Commercial and all other loans 26 15 30 65 -- ------ ------ ------ ------ ------ Total $ 226 $ 635 $ 83 $ 117 $ 410 ====== ====== ====== ====== ====== Agricultural loans included above $ 26 $ -- $ 17 $ 65 $ -- ====== ====== ====== ====== ====== Foreclosed assets (included in other assets) were $404,000, $75,000, $442,000, $170,000, and $85,000 at December 31, 2004, 2003, 2002, 2001 and 2000, respectively. Allowance for Loan Losses and Summary of Loan Loss Experience As a matter of policy, the bank maintains an allowance for loan losses. The allowance for loan losses is created by direct charges to income, and losses on loans are charged against the allowance when realized. The amount of the allowance is based on management's evaluation of the portfolio, the financial condition of borrowers, current economic conditions, past and expected loan loss experience, and other factors management deems appropriate. The bank's management believes its allowance for loan losses is adequate under existing economic conditions to absorb loan losses inherent in its loan portfolio. 23 The following table summarizes the bank's loan loss experience for the years ending December 31, 2004, 2003, 2002, 2001 and 2000 (in thousands, except ratios): 2004 2003 2002 2001 2000 ------- ------- ------ ------- ------ Balance at beginning of period $3,430 $2,860 $2,650 $2,770 $2,350 Charge-offs: Commercial and other 417 311 604 668 192 Real estate 395 342 240 174 39 Installment loans to individuals 237 396 283 176 240 Credit cards and related plans 297 88 72 60 75 ------- ------- ------ ------- ------ 1,346 1,137 1,199 1,078 546 ------- ------- ------ ------- ------ Recoveries: Commercial and other 206 31 74 38 32 Real estate 27 134 13 24 12 Installment loans 56 159 62 53 97 Credit cards and related plans 86 10 12 9 17 ------- ------- ------ ------- ------ 375 334 161 124 158 ------- ------- ------ ------- ------ Net charge-offs 971 803 1,038 954 388 ------- ------- ------ ------- ------ Additions charged to operations 1,596 1,373 1,248 834 808 ------- ------- ------ ------- ------ Balance at end of year $4,055 $3,430 $2,860 $2,650 $2,770 ======= ======= ====== ======= ====== Ratio of net charge-offs during the year to average gross loans outstanding during the year .32% .32% .48% .47% .21% The following table summarizes the bank's allocation of allowance for loan losses for the years ending December 31, 2004, 2003, 2002, 2001 and 2000 (in thousands, except ratios): AT DECEMBER 31, --------------------------------------------------------------------------- 2004 2003 2002 ----------------------- -------------------------- ----------------------- % OF TOTAL % OF TOTAL % OF TOTAL AMOUNT LOANS (1) AMOUNT LOANS (1) AMOUNT LOANS (1) ---------- ----------- ----------- ----------- ---------- ------------- Real estate loans $ 3,432 84% $ 2,773 81% $ 2,139 75% Commercial and industrial loans 389 10% 415 12% 451 16% Installment loans 223 6% 227 7% 258 9% Unallocated 11 -% 15 -% 12 -% ---------- ----------- ----------- --------- ---------- ------------ Total $ 4,055 100% $ 3,430 100% $ 2,860 100% ========== =========== =========== ========= ========== ============ AT DECEMBER 31, ------------------------------------------------ 2001 2000 ----------------------- ----------------------- % OF TOTAL % OF TOTAL AMOUNT LOANS (1) AMOUNT LOANS (1) ---------- ---------- ---------- ---------- Real estate loans $ 1,967 74% $ 1,946 70% Commercial and industrial loans 414 16% 517 19% Installment loans 254 10% 292 11% Unallocated 15 -% 15 -% ---------- ----------- ---------- ---------- Total $ 2,650 100% $ 2,770 100% ========== =========== ========== ========== - -------------------------------------------- (1) Represents total of all outstanding loans in each category as a percentage of total loans outstanding. 24 DEPOSITS Time certificates in amounts of $100,000 or more outstanding at December 31, 2004 by maturity were as follows (in thousands): Three months or less $ 36,122 Over three months through twelve months 28,076 Over twelve months through three years 16,765 Over three years 27,692 -------- Total $108,655 ======== BORROWINGS The bank borrows funds principally from the Federal Home Loan Bank of Atlanta. Information regarding such borrowings is as follows (in thousands, except rates): 2004 2003 2002 ------------ ------------ ------------- Balance outstanding at December 31 $ 43,160 $ 33,160 $ 33,160 Weighted average rate at December 31 3.86% 4.58% 4.60% Maximum borrowings during the year $ 43,160 $ 35,760 $ 33,160 Average amounts outstanding during year $ 42,799 $ 34,200 $ 33,160 Weighted average rate during year 3.94% 4.55% 4.64% CRITICAL ACCOUNTING ESTIMATES AND POLICIES We prepare our consolidated financial statements in conformity with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates. Critical accounting estimates and policies are those we believe are both most important to the portrayal of our financial condition and results, and require our most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Judgments and uncertainties affecting the application of those policies may result in materially different amounts being reported under different conditions or using different assumptions. We believe that the allowance for loan losses represents a particularly sensitive accounting estimate. The amount of the allowance is based on management's evaluation of the collectibility of the loan portfolio, including the maturity of the loan portfolio, credit concentration, trends in historical loss experience, specific impaired loans and general economic conditions. See Note A to the consolidated financial statements for a comprehensive discussion of our accounting policy for the allowance for loan losses. NEW ACCOUNTING STANDARDS In December 2004, the FASB issued SFAS 123 (revised 2004), Share-Based Payment, ("SFAS No. 123(R)"), which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123(R) supersedes Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees ("APB 25"), and amends SFAS No. 95 Statement of Cash Flows. SFAS No. 123(R) establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. This Statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. SFAS No. 123(R) requires that the fair value of such equity instruments be recognized as an expense in the historical financial statements as services are performed. Prior to SFAS No. 123(R), only certain pro forma disclosures of fair value were required. The provisions of this Statement are effective for the first interim reporting period that begins after June 15, 2005. Accordingly, we will adopt SFAS No. 123(R) commencing with the quarter ending September 30, 2005. If we had included the cost of employee stock option compensation in our consolidated financial statements, our net income for the fiscal years ended December 31, 2004, 2003 and 2002 would have decreased by approximately $64,000, $68,000, and $52,000, respectively. Accordingly, the adoption of SFAS No. 123(R) is not expected to have a material effect on our consolidated financial statements. 25 Item 7A - Quantitative and Qualitative Disclosures About Market Risk. This information is included under Item 7 of this report under the captions "Interest Rate Sensitivity," "Market Risk," and "Derivative Financial Instruments." Item 8 - Financial Statements. 26 [LOGO] DIXON HUGHES PLLC CERTIFIED PUBLIC ACCOUNTANTS AND ADVISORS REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Shareholders Four Oaks Fincorp, Inc. Four Oaks, North Carolina We have audited the accompanying consolidated balance sheets of Four Oaks Fincorp, Inc. and Subsidiaries as of December 31, 2004 and 2003 and the related consolidated statements of operations, comprehensive income, shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 2004. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Four Oaks Fincorp, Inc. and Subsidiaries as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. /s/ Dixon Hughes PLLC Sanford, North Carolina March 18, 2005 27 FOUR OAKS FINCORP, INC. CONSOLIDATED BALANCE SHEETS DECEMBER 31, 2004 AND 2003 - ---------------------------------------------------------------------------------------------------- 2004 2003 ----------------------- ------------------- (AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) ASSETS Cash and due from banks $ 10,634 $ 10,548 Interest-earning deposits 3,615 5,277 Investment securities available for sale 52,342 38,203 Loans 312,815 272,623 Allowance for loan losses (4,055) (3,430) --------- --------- Net loans 308,760 269,193 Accrued interest receivable 2,210 1,893 Bank premises and equipment, net 10,149 10,582 FHLB stock 2,621 1,923 Investment in life insurance 6,054 2,896 Other assets 2,115 1,206 --------- --------- Total assets $ 398,500 $ 341,721 ========= ========= LIABILITIES AND SHAREHOLDERS' EQUITY Deposits: Non-interest-bearing demand $ 59,528 $ 50,829 Money market and NOW accounts 55,467 43,927 Savings 14,900 13,038 Time deposits, $100,000 and over 108,655 85,100 Other time deposits 76,757 80,024 --------- --------- Total deposits 315,307 272,918 Borrowings 43,160 33,160 Accrued interest payable 1,201 1,284 Other liabilities 1,537 1,479 --------- --------- Total liabilities 361,205 308,841 --------- --------- Shareholders' equity: Common stock; $1.00 par value, 10,000,000 shares authorized; 3,438,107 and 2,676,263 shares issued and outstanding at December 31, 2004 and 2003, respectively 3,438 2,676 Additional paid-in capital 8,788 8,029 Retained earnings 25,091 21,867 Accumulated other comprehensive income (loss) (22) 308 --------- --------- Total shareholders' equity 37,295 32,880 --------- --------- Total liabilities and shareholders' equity $ 398,500 $ 341,721 ========= ========= - -------------------------------------------------------------------------------- The accompanying notes are an integral part of these consolidated financial statements 28 FOUR OAKS FINCORP, INC. CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002 - -------------------------------------------------------------------------------------------------------------- 2004 2003 2002 (AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA) Interest and dividend income: Loans, including fees $ 19,968 $ 17,318 $ 16,746 Investment securities: Taxable 1,470 1,272 2,482 Tax-exempt 162 212 213 Dividends 109 88 114 Interest-earning deposits 39 53 230 -------- -------- -------- Total interest and dividend income 21,748 18,943 19,785 -------- -------- -------- Interest expense: Deposits 4,123 4,365 6,103 Borrowings 1,688 1,557 1,537 -------- -------- -------- Total interest expense 5,811 5,922 7,640 -------- -------- -------- Net interest income 15,937 13,021 12,145 Provision for loan losses 1,596 1,373 1,248 -------- -------- -------- Net interest income after provision for loan losses 14,341 11,648 10,897 -------- -------- -------- Non-interest income: Service charges on deposit accounts 1,941 1,867 1,827 Other service charges, commissions and fees 1,024 635 618 Gains (loss) on sale of investment securities 71 273 (8) Gains on sale of loans 72 212 175 Merchant fees 347 324 198 Income from investment in bank-owned life insurance 394 159 -- -------- -------- -------- Total non-interest income 3,849 3,470 2,810 -------- -------- -------- Non-interest expenses: Salaries 5,354 4,934 4,320 Employee benefits 1,037 1,008 910 Occupancy expenses 508 493 397 Equipment expenses 1,223 1,124 983 Professional and consulting fees 747 664 730 Other taxes and licenses 251 251 164 Merchant processing expenses 304 277 192 Other operating expenses 2,083 1,837 1,789 -------- -------- -------- Total non-interest expenses 11,507 10,588 9,485 -------- -------- -------- Income before income taxes 6,683 4,530 4,222 Provision for income taxes 2,308 1,612 1,306 -------- -------- -------- Net income $ 4,375 $ 2,918 $ 2,916 ======== ======== ======== Basic net income per common share $ 1.29 $ .87 $ .88 ======== ======== ======== Diluted net income per common share $ 1.28 $ .86 $ .87 ======== ======== ======== - -------------------------------------------------------------------------------- The accompanying notes are an integral part of these consolidated financial statements 29 FOUR OAKS FINCORP, INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME FOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002 - ------------------------------------------------------------------------------------- 2004 2003 2002 -------- -------- -------- (AMOUNTS IN THOUSANDS) Net income $ 4,375 $ 2,918 $ 2,916 ------- ------- ------- Other comprehensive income: Securities available for sale: Unrealized holding gains (losses) on available for sale securities (109) 40 699 Tax effect 44 (17) (280) Reclassification of (gains) losses recognized in (71) (273) 8 net income Tax effect 28 109 (3) ------- ------- ------- Net of tax amount (108) (141) 424 ------- ------- ------- Cash flow hedging activities: Unrealized holding losses on cash flow hedging activities (370) (56) -- Tax effect 148 22 -- ------- ------- ------- Net of tax amount (222) (34) -- ------- ------- ------- Total other comprehensive income (loss) (330) (175) 424 ------- ------- ------- Comprehensive income $ 4,045 $ 2,743 $ 3,340 ======= ======= ======= - -------------------------------------------------------------------------------- The accompanying notes are an integral part of these consolidated financial statements 30 FOUR OAKS FINCORP, INC. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002 - -------------------------------------------------------------------------------------------------------------------- ACCUMULATED COMMON STOCK ADDITIONAL OTHER TOTAL ------------ PAID-IN RETAINED COMPREHENSIVE SHAREHOLDERS' SHARES AMOUNT CAPITAL EARNINGS INCOME (LOSS) EQUITY ----------- ---------- ---------- ---------- -------------- ------------- (AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA) BALANCE, DECEMBER 31, 2001 2,106,477 $ 2,106 $ 6,706 $ 19,154 $ 59 $ 28,025 Net income -- -- -- 2,916 -- 2,916 Other comprehensive income -- -- -- -- 424 424 Issuance of common stock 54,655 55 957 -- -- 1,012 Current income tax benefit -- -- 53 -- -- 53 Purchases and retirement of common stock (16,921) (17) -- (368) -- (385) Cash dividends of $.26 per share -- -- -- (852) -- (852) --------- ---------- ---------- ---------- ---------- ---------- BALANCE, DECEMBER 31, 2002 2,144,211 2,144 7,716 20,850 483 31,193 Net income -- -- -- 2,918 -- 2,918 Other comprehensive loss -- -- -- -- (175) (175) Effect of 5-for-4 stock split 533,706 534 (542) -- -- (8) Issuance of common stock 42,014 42 837 -- -- 879 Current income tax benefit -- -- 18 -- -- 18 Purchases and retirement of common stock (43,668) (44) -- (949) -- (993) Cash dividends of $.29 per share -- -- -- (952) -- (952) --------- ---------- ---------- ---------- ---------- ---------- BALANCE, DECEMBER 31, 2003 2,676,263 2,676 8,029 21,867 308 32,880 Net income -- -- -- 4,375 -- 4,375 Other comprehensive loss -- -- -- -- (330) (330) Effect of 5-for-4 stock split 682,474 683 (683) -- -- -- Issuance of common stock 82,170 82 1,348 -- -- 1,430 Current income tax benefit -- -- 94 -- -- 94 Purchases and retirement of common stock (2,800) (3) -- (62) -- (65) Cash dividends of $.32 per share -- -- -- (1,089) -- (1,089) --------- ---------- ---------- ---------- ---------- ---------- BALANCE, DECEMBER 31, 2004 3,438,107 $ 3,438 $ 8,788 $ 25,091 $ (22) $ 37,295 ========= ========== ========== ========== ========== ========== - -------------------------------------------------------------------------------- The accompanying notes are an integral part of these consolidated financial statements 31 FOUR OAKS FINCORP, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002 - ------------------------------------------------------------------------------------------------- 2004 2003 2002 --------- --------- ----------- (AMOUNTS IN THOUSANDS) Cash flows from operating activities: Net income $ 4,375 $ 2,918 $ 2,916 Adjustments to reconcile net income to net cash provided by operations: Provision for loan losses 1,596 1,373 1,248 Provision for depreciation and amortization 1,008 946 824 Deferred income tax expense (benefit) (188) (129) 32 Net amortization of bond premiums and discounts 109 595 290 Gain on sale of loans (72) (212) (175) (Gain) loss on sale of investment securities (71) (273) 8 Loss on sale of foreclosed assets 25 15 26 (Gain) loss on disposition of premises and equipment 7 -- (5) Increase in cash surrender value of life insurance (394) (159) -- Changes in assets and liabilities: Other assets 545 (130) 349 Loans held for sale -- -- 1,483 Interest receivable (317) (122) 339 Other liabilities 52 (155) 1,357 Interest payable (83) (501) (946) --------- --------- --------- Net cash provided by operating activities 6,592 4,166 7,746 --------- --------- --------- Cash flows from investing activities: Proceeds from sales and calls of investment securities available for sale 41,422 44,835 100,678 Proceeds from maturities of investment securities available for sale -- 10,516 2,739 Purchase of investment securities available for sale (55,779) (37,320) (97,595) Purchase of FHLB stock (698) (273) -- Net increase in loans (42,305) (43,811) (22,679) Additions to premises and equipment (568) (848) (1,867) Purchases of bank-owned life insurance (3,552) (2,896) -- Proceeds from sale of foreclosed assets 860 521 302 Expenditures on foreclosed assets -- (2) (15) --------- --------- --------- Net cash used by investing activities (60,620) (29,278) (18,437) --------- --------- --------- Cash flows from financing activities: Net proceeds from borrowings 10,000 -- (13) Net increase in deposit accounts 42,176 22,345 14,877 Proceeds from issuance of common stock 1,430 879 1,012 Purchases and retirement of common stock (65) (993) (385) Cash dividends paid (1,089) (960) (852) --------- --------- --------- Net cash provided by financing activities 52,452 21,271 14,639 --------- --------- --------- Net increase (decrease) in cash and cash equivalents (1,576) (3,841) 3,948 Cash and cash equivalents at beginning of year 15,825 19,666 15,718 --------- --------- --------- Cash and cash equivalents at end of year $ 14,249 $ 15,825 $ 19,666 ========= ========= ========= - -------------------------------------------------------------------------------- The accompanying notes are an integral part of these consolidated financial statements 32 FOUR OAKS FINCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 AND 2003 - -------------------------------------------------------------------------------- NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation The consolidated financial statements include the accounts and transactions of Four Oaks Fincorp, Inc. (the "Company"), a bank holding company incorporated under the laws of the State of North Carolina, and its wholly owned subsidiaries, Four Oaks Bank & Trust Company, Inc. (the "Bank") and Four Oaks Mortgage Services, LLC, the Company's mortgage origination subsidiary. All significant intercompany transactions have been eliminated. NATURE OF OPERATIONS The Company was incorporated under the laws of the State of North Carolina on February 5, 1997. The Company's primary function is to serve as the holding company for its wholly owned subsidiary, the Bank. The Bank operates ten offices in eastern and central North Carolina, and its primary source of revenue is derived from loans to customers and from its securities portfolio. The loan portfolio is comprised mainly of real estate, commercial and consumer loans. These loans are primarily collateralized by residential and commercial properties, commercial equipment, and personal property. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES USE OF ESTIMATES In preparing consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses. CASH AND CASH EQUIVALENTS For the purpose of presentation in the consolidated statements of cash flows, cash and cash equivalents are defined as those amounts included in the balance sheet captions cash and due from banks and interest-earning deposits. Federal regulations require institutions to set aside specified amounts of cash as reserves against transactions and time deposits. As of December 31, 2004, the daily average gross reserve requirement was $5 million. INVESTMENT SECURITIES Investment securities are classified into three categories: (1) Held to Maturity - Debt securities that the Company has the positive intent and the ability to hold to maturity are classified as held to maturity and reported at amortized cost; (2) Trading - Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings; and - -------------------------------------------------------------------------------- 33 FOUR OAKS FINCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 AND 2003 - -------------------------------------------------------------------------------- NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Investment Securities (Continued) (3) Available for Sale - Debt and equity securities not classified as either securities held to maturity or trading securities are reported at fair value, with unrealized gains and losses excluded from earnings and reported, net of income taxes, as other comprehensive income, a separate component of shareholders' equity. The Company has historically classified all securities as available for sale. Gains and losses on sales of securities, computed based on specific identification of adjusted cost of each security, are included in income at the time of the sale. Premiums and discounts are amortized into interest income using a method that approximates the interest method over the period to maturity. LOANS AND ALLOWANCE FOR LOAN LOSSES Loans are stated at the amount of unpaid principal, reduced by an allowance for loan losses. Interest on loans is calculated by using the simple interest method on daily balances of the principal amount outstanding. Loan origination fees are deferred, as well as certain direct loan origination costs. Such costs and fees are recognized as an adjustment to yield over the contractual lives of the related loans utilizing the interest method. The Company evaluates its loan portfolio in accordance with Statement of Financial Accounting Standards ("SFAS") No. 114, Accounting by Creditors for Impairment of a Loan, as amended by SFAS No. 118, Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosure. Under these standards, a loan is considered impaired, based on current information and events, if it is probable that the Company will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Uncollateralized loans are measured for impairment based on the present value of expected future cash flows discounted at the historical effective interest rate, while all collateral-dependent loans are measured for impairment based on the fair value of the collateral. The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loans are charged against the allowance for loan losses when management believes that the uncollectibility of a loan balance is confirmed. The provision for loan losses is based upon such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, and current economic conditions and trends that may affect the borrowers' ability to pay. Because these factors may change, it is possible that management's assessment of the allowance may change. In addition, regulatory examiners may require the Bank to recognize changes to the allowance for loan losses based on their judgments about information available to them at the time of their examination. - -------------------------------------------------------------------------------- 34 FOUR OAKS FINCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 AND 2003 - -------------------------------------------------------------------------------- NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) INCOME RECOGNITION ON IMPAIRED AND NONACCRUAL LOANS Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-secured and in the process of collection. If a loan or a portion of a loan is classified as doubtful or is partially charged-off, the loan is generally classified as nonaccrual. Loans that are on a current payment status or past due less than 90 days may also be classified as nonaccrual if repayment in full of principal and/or interest is in doubt. Loans may be returned to accrual status when all principal and interest amounts contractually due (including arrearages) are reasonably assured of repayment within an acceptable period of time and there is a sustained period of repayment performance (generally a minimum of six months) by the borrower, in accordance with the contractual terms. While a loan is classified as nonaccrual and the future collectibility of the recorded loan balance is doubtful, collections of interest and principal are generally applied as a reduction to the principal outstanding, except in the case of loans with scheduled amortizations where the payment is generally applied to the oldest payment due. When the future collectibility of the recorded loan balance is expected, interest income may be recognized on a cash basis. In the case where a nonaccrual loan had been partially charged-off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Receipts in excess of that amount are recorded as recoveries to the allowance for loan losses until prior charge-offs have been fully recovered. FORECLOSED ASSETS Assets acquired as a result of foreclosure are valued at fair value at the date of foreclosure establishing a new cost basis. After foreclosure, valuations of the property are periodically performed by management and the assets are carried at the lower of cost or fair value minus estimated costs to sell. Losses from the acquisition of property in full or partial satisfaction of debt are treated as credit losses. Routine holding costs, subsequent declines in value, and gains or losses on disposition are included in other income and expense. BANK PREMISES AND EQUIPMENT Land is carried at cost. Bank premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method based on the estimated useful lives of assets. Useful lives range from 5 to 10 years for furniture and equipment and 40 years for premises. Expenditures for repairs and maintenance are charged to expense as incurred. - -------------------------------------------------------------------------------- 35 FOUR OAKS FINCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 AND 2003 - -------------------------------------------------------------------------------- NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) INCOME TAXES Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the tax bases of assets and liabilities and their carrying amounts for financial reporting purposes. Deferred tax assets are also recognized for operating loss carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which the temporary differences are expected to be recovered or settled. Deferred tax assets are reduced by a valuation allowance if it is more likely than not that the tax benefits will not be realized. STOCK IN FEDERAL HOME LOAN BANK OF ATLANTA As a requirement for membership, the Company invests in stock of the Federal Home Loan Bank of Atlanta ("FHLB"). This investment is carried at cost. Due to the redemptive provisions of the FHLB, the Company estimated that fair value equals cost and that this investment was not impaired as of December 31, 2004. COMPREHENSIVE INCOME Comprehensive income is defined as the change in equity during a period for non-owner transactions and is divided into net income and other comprehensive income. Other comprehensive income includes revenues, expenses, gains, and losses that are excluded from earnings under current accounting standards. Components of other comprehensive income for the Company consist of the unrealized gains and losses, net of taxes, in the Company's available for sale securities portfolio and unrealized gains and losses, net of taxes, in the Company's cash flow hedge instruments. Accumulated other comprehensive income at December 31, 2004, 2003 and 2002 consists of the following: 2004 2003 2002 ------ ------ ------- (AMOUNTS IN THOUSANDS) Unrealized holding gains - investment securities available for sale $ 391 $ 571 $ 803 Deferred income taxes (157) (229) (320) ------ ------ ------ Net unrealized holding gains - investment securities available for sale 234 342 483 ----- ------ ------ Unrealized holding losses - cash flow hedge instruments (426) (56) -- Deferred income taxes 170 22 -- ----- ------ ------ Net unrealized holding losses - cash flow hedge instruments (256) (34) -- ----- ------ ------ Total accumulated other comprehensive income (loss) $ (22) $ 308 $ 483 ===== ====== ====== - -------------------------------------------------------------------------------- 36 FOUR OAKS FINCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 AND 2003 - -------------------------------------------------------------------------------- NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Stock Compensation Plans SFAS No. 123, Accounting for Stock-Based Compensation, encourages all entities to adopt a fair value based method of accounting for employee stock compensation plans, whereby compensation cost is measured at the grant date based on the value of the award and is recognized over the service period, which is usually the vesting period. However, it also allows an entity to continue to measure compensation cost for those plans using the intrinsic value based method of accounting prescribed by Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued to Employees, whereby compensation cost is the excess, if any, of the quoted market price of the stock at the grant date (or other measurement date) over the amount an employee must pay to acquire the stock. Stock options issued under the Company's stock option plans have no intrinsic value at the grant date and, under APB Opinion No. 25, no compensation cost is recognized for them. The Company has elected to continue with the accounting methodology in APB No. 25 and, as a result, has provided pro forma disclosures of net income and earnings per share and other disclosures as if the fair value based method of accounting had been applied. 2004 2003 2002 ----------- ---------- ---------- (AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA) Net income: As reported $ 4,375 $ 2,918 $ 2,916 Deduct: Total stock-based employee compensation expense determined under fair value method for all awards, net of related tax effects (64) (68) (52) --------- ---------- -------- Pro forma $ 4,311 $ 2,850 $ 2,864 ========= ========== ======== Basic earnings per share: As reported $ 1.29 $ .87 $ .88 Pro forma 1.27 .85 .86 Diluted earnings per share: As reported $ 1.28 $ .86 $ .87 Pro forma 1.26 .85 .86 Net Income Per Common Share and Common Shares Outstanding Basic earnings per share represents income available to common shareholders divided by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. The weighted average number of shares outstanding during each period have been retroactively adjusted for a 25% stock split distributed October 29, 2004 and November 10, 2003. Potential common shares that may be issued by the Company relate solely to outstanding stock options. - -------------------------------------------------------------------------------- 37 FOUR OAKS FINCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 AND 2003 - -------------------------------------------------------------------------------- NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Net Income Per Common Share and Common Shares Outstanding (Continued) Basic and diluted net income per common share have been computed based upon net income as presented in the accompanying consolidated statements of operations divided by the weighted average number of common shares outstanding or assumed to be outstanding as summarized below: 2004 2003 2002 ---------- --------- ---------- Weighted average number of common shares used in computing basic net income per common share 3,397,345 3,356,070 3,325,960 Effect of dilutive stock options 19,335 11,971 10,906 ---------- --------- ---------- Weighted average number of common shares and dilutive potential common shares used in computing diluted net income per common share 3,416,680 3,368,041 3,336,866 ========= ========= ========= There were no antidilutive shares outstanding for the years ended December 31, 2004, 2003 and 2002. . DERIVATIVE INSTRUMENTS The Company utilizes interest rate swaps in the management of interest rate risk. Interest rate swaps are contractual agreements between two parties to exchange a series of cash flows representing interest payments. A swap allows both parties to alter the repricing characteristics of assets or liabilities without affecting the underlying principal positions. Through the use of a swap, assets and liabilities may be transformed from fixed to floating rates, from floating rates to fixed rates, or from one type of floating rate to another. Swap terms generally range from one year to ten years depending on the need. The net interest payable or receivable on interest rate swaps that are designated as hedges is accrued and recognized as an adjustment to the interest income or expense of the related asset or liability. Gains and losses from early terminations of derivatives are deferred and amortized as yield adjustments over the shorter of the remaining term of the hedged asset or liability or the remaining term of the derivative instrument. Upon disposition or settlement of the asset or liability being hedged, deferral accounting is discontinued and any gains or losses are recognized in income. Unrealized holding gains and losses on derivatives designated as cash flow hedges are reported, net of applicable income tax effect, in accumulated other comprehensive income. Derivative financial instruments that fail to qualify as a hedge are carried at fair value with gains and losses recognized in current earnings. - -------------------------------------------------------------------------------- 38 FOUR OAKS FINCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 AND 2003 - -------------------------------------------------------------------------------- NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) New Accounting Standards On March 9, 2004, the SEC Staff issued Staff Accounting Bulletin No. 105, Application of Accounting Principles to Loan Commitments ("SAB 105"). SAB 105 clarifies existing accounting practices relating to the valuation of issued loan commitments, including interest rate lock commitments ("IRLC"), subject to SFAS No. 149 and Derivative Implementation Group Issue C13, Scope Exceptions: When a Loan Commitment is included in the Scope of Statement 133. Furthermore, SAB 105 disallows the inclusion of the values of a servicing component and other internally developed intangible assets in the initial and subsequent IRLC valuation. The provisions of SAB 105 were effective for loan commitments entered into after March 31, 2004. The adoption of SAB 105 did not have a material impact on the Company's consolidated financial statements. In March 2004, the ("EITF") released EITF Issue 03-01, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments. The Issue provides guidance for determining whether an investment is other-than-temporarily impaired and requires certain disclosures with respect to these investments. The recognition and measurement guidance for other-than-temporary impairment has been delayed by the issuance of FASB Staff Position EITF 03-1-1 on September 30, 2004. The adoption of Issue 03-1 did not result in any other-than-temporary impairment. In December 2003, the American Institute of Certified Public Accountants (AICPA) issued Statement of Position (SOP) 03-3, Accounting for Loans or Certain Debt Securities Acquired in a Transfer. The SOP addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor's initial investment in loans or debt securities acquired in a transfer if those differences relate to a deterioration of credit quality. The SOP also prohibits companies from "carrying over" or creating a valuation allowance in the initial accounting for loans acquired that meet the scope criteria of the SOP. The SOP is effective for loans acquired in fiscal years beginning after December 15, 2004. The adoption of this SOP is not expected to have a material impact on the Company's financial position or results of operations. In December 2004, the FASB issued SFAS 123 (revised 2004), Share-Based Payment, ("SFAS No. 123(R)"), which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123(R) supersedes Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees ("APB 25"), and amends SFAS No. 95 Statement of Cash Flows. SFAS No. 123(R) establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. This Statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. SFAS No. 123(R) requires that the fair value of such equity instruments be recognized as an expense in the historical financial statements as services are performed. Prior to SFAS No. 123(R), only certain pro forma disclosures of fair value were required. The provisions of this Statement are effective for the first interim reporting period that begins after June 15, 2005. Accordingly, we will adopt SFAS No. 123(R) commencing with the quarter ending September 30, 2005. If we had included the cost of employee stock option compensation in our consolidated financial statements, our net income for the fiscal years ended December 31, 2004, 2003 and 2002 would have decreased by approximately $64,000, $68,000, and $52,000, respectively. Accordingly, the adoption of SFAS No. 123(R) is not expected to have a material effect on our consolidated financial statements. - -------------------------------------------------------------------------------- 39 FOUR OAKS FINCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 AND 2003 - -------------------------------------------------------------------------------- NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Reclassifications Certain items included in the 2003 and 2002 consolidated financial statements have been reclassified to conform to the 2004 presentation. These reclassifications have no effect on the net income or shareholders' equity previously reported. NOTE B - INVESTMENT SECURITIES The amortized cost, gross unrealized gains, gross unrealized losses and fair values of securities available for sale as of December 31, 2004 and 2003 are as follows: GROSS GROSS AMORTIZED UNREALIZED UNREALIZED COST GAINS LOSSES FAIR VALUE ------- -------- -------- ---------- (AMOUNTS IN THOUSANDS) 2004: U.S. Government and agency securities $34,991 $ 57 $ 90 $34,958 State and municipal securities 3,573 72 13 3,632 Mortgage-backed securities 12,759 53 37 12,775 Other 628 349 -- 977 ------- ------- ------- ------- $51,951 $ 531 $ 140 $52,342 ======= ======= ======= ======= GROSS GROSS AMORTIZED UNREALIZED UNREALIZED COST GAINS LOSSES FAIR VALUE ------- -------- -------- ---------- (AMOUNTS IN THOUSANDS) 2003: U.S. Government and agency securities $15,866 $ 54 $ 6 $15,914 State and municipal securities 4,664 291 -- 4,955 Mortgage-backed securities 16,535 41 74 16,502 Other 567 265 -- 832 ------- ------- ------- ------- $37,632 $ 651 $ 80 $38,203 ======= ======= ======= ======= The following table shows gross unrealized losses and fair values of investment securities, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position, at December 31, 2004 and 2003. As of December 31, 2004, the unrealized losses relate to eleven U.S. government agency securities and four mortgage-backed securities, of which none and two such securities, respectively, had continuous unrealized losses for more than twelve months. The unrealized losses relate to debt securities that have incurred fair value reductions due to higher market interest rates since the securities were purchased. The unrealized losses are not likely to reverse unless and until market interest rates decline to the levels that existed when the securities were purchased. Since none of the unrealized losses relate to the marketability of the securities or the issuer's ability to honor redemption obligations, none of the securities are deemed to be other than temporarily impaired. (Amounts in thousands) - -------------------------------------------------------------------------------- 40 FOUR OAKS FINCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 AND 2003 - -------------------------------------------------------------------------------- NOTE B - INVESTMENT SECURITIES (Continued) 2004 --------------------------------------------------------------------------------------- LESS THAN 12 MONTHS 12 MONTHS OR MORE TOTAL ------------------------- ----------------------- --------------------------- FAIR UNREALIZED FAIR UNREALIZED FAIR UNREALIZED VALUE LOSSES VALUE LOSSES VALUE LOSSES ------- --------- ------- ---------- -------- ----------- Securities available for sale: U.S. government and agency securities $18,892 $ 90 $ -- $ -- $18,892 $ 90 State and municipal securities 1,968 13 -- -- 1,968 13 Mortgage-backed securities 2,056 15 2,924 22 4,980 37 ------- ------- ------- ------- -------- ------- Total temporarily impaired securities $22,916 $ 118 $ 2,924 $ 22 $25,840 $ 140 ======= ======= ======== ======== ======== ======= 2003 --------------------------------------------------------------------------------------- LESS THAN 12 MONTHS 12 MONTHS OR MORE TOTAL ------------------------- ----------------------- --------------------------- FAIR UNREALIZED FAIR UNREALIZED FAIR UNREALIZED VALUE LOSSES VALUE LOSSES VALUE LOSSES ------- --------- ------- ---------- -------- ----------- Securities available for sale: U.S. government and agency securities $ 750 $ 6 $ -- $ -- $ 750 $ 6 Mortgage-backed securities 8,938 74 -- -- 8,938 74 ------- ------- ------- ------- -------- ------- Total temporarily impaired securities $ 9,688 $ 80 $ -- $ -- $ 9,688 $ 80 ======= ======= ======== ======== ======== ======= The amortized cost and fair value of debt securities at December 31, 2004 by contractual maturities are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. AMORTIZED COST FAIR VALUE ------- -------- (AMOUNTS IN THOUSANDS) Due after one year through five years $22,761 $22,773 Due after five years through ten years 25,051 25,065 Due after ten years 4,139 4,504 ------- ------- $51,951 $52,342 ======= ======= Securities with a carrying value of approximately $33.4 million and $12.3 million at December 31, 2004 and 2003, respectively, were pledged to secure public deposits and for other purposes required or permitted by law. Sales and calls of securities available for sale during 2004 and 2003 generated gross realized gains of $224,000 and $295,000, respectively. Gross realized losses amounted to $153,000 and $22,000, respectively. - -------------------------------------------------------------------------------- 41 FOUR OAKS FINCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 AND 2003 - -------------------------------------------------------------------------------- NOTE C - LOANS AND ALLOWANCE FOR LOAN LOSSES Major classifications of loans as of December 31, 2004 and 2003 are summarized as follows: 2004 2003 --------- ---------- (AMOUNTS IN THOUSANDS) Real estate - residential and other $ 159,152 $ 140,998 Real estate - agricultural 15,203 13,384 Construction and land development 90,742 66,242 Other agricultural 4,020 5,084 Consumer loans 17,207 16,475 Commercial loans 26,005 27,872 Other loans 865 2,738 --------- ---------- 313,194 272,793 Less: Net deferred loan costs (379) (170) Allowance for loan losses (4,055) (3,430) --------- ---------- $ 308,760 $ 269,193 ========= ========== Nonperforming assets at December 31, 2004 and 2003 consist of the following: 2004 2003 -------- ------- (AMOUNTS IN THOUSANDS) Loans past due ninety days or more $ 226 $ 635 Nonaccrual loans 944 1,059 Foreclosed assets (included in other assets) 404 75 -------- ------- $1,574 $1,769 ======== ======= At December 31, 2004 and 2003, the recorded investment in loans considered impaired in accordance with SFAS No. 114 totaled $944,000 and $1.1 million, respectively, and consisted entirely of nonaccrual loans. Impaired loans of $944,000 and $1.1 million had related allowances for loan losses of $151,000 and $165,000 at December 31, 2004 and 2003, respectively. For the years ended December 31, 2004 and 2003, the average recorded investment in impaired loans was approximately $1.5 million and $1.2 million, respectively. The amount of interest recognized on impaired loans during the portion of the year that they were impaired was not material. A summary of the allowance for loan losses for the years ended December 31, 2004, 2003 and 2002 is as follows: 2004 2003 2002 ------- ------- ------- (AMOUNTS IN THOUSANDS) Balance, beginning $ 3,430 $ 2,860 $ 2,650 Provision for loan losses 1,596 1,373 1,248 Loans charged-off (1,346) (1,137) (1,199) Recoveries of loans previously charged-off 375 334 161 ------- ------- ------- Balance, ending $ 4,055 $ 3,430 $ 2,860 ======= ======= ======= - -------------------------------------------------------------------------------- 42 FOUR OAKS FINCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 AND 2003 - -------------------------------------------------------------------------------- NOTE C - LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued) The Bank had loan and deposit relationships with most of its directors and executive officers and with companies with which certain directors and executive officers are associated. The following is a reconciliation of loans directly outstanding to executive officers, directors, and their affiliates (amounts in thousands): Balance at December 31, 2003 $ 5,053 New loans 3,760 Principal repayments (4,103) ------- Balance at December 31, 2004 $ 4,710 ======= As a matter of policy, these loans and credit lines are approved by the Company's Board of Directors and are made with interest rates, terms, and collateral requirements comparable to those required of other borrowers. In the opinion of management, these loans do not involve more than the normal risk of collectibility. At December 31, 2004, the Company had pre-approved but unused lines of credit totaling $135,000 to executive officers, directors and their affiliates. NOTE D - BANK PREMISES AND EQUIPMENT Bank premises and equipment at December 31, 2004 and 2003 are as follows: 2004 2003 -------- -------- (AMOUNTS IN THOUSANDS) Land $ 2,237 $ 2,237 Building 7,042 6,957 Furniture and equipment 6,952 6,522 -------- --------- 16,231 15,716 Less accumulated depreciation (6,082) (5,134) -------- --------- $ 10,149 $ 10,582 ======== ========= Depreciation expense for the years ended December 31, 2004 and 2003 amounted to $994,000 and $932,000, respectively. NOTE E - DEPOSITS At December 31, 2004, the scheduled maturities of time deposits are as follows (amounts in thousands): LESS THAN $100,000 $100,000 OR MORE TOTAL ---------- --------- -------- Within one year $ 56,742 $ 64,198 $120,940 Over one year through three years 16,688 16,765 33,453 Over three years 3,327 27,692 31,019 -------- -------- -------- $ 76,757 $108,655 $185,412 ======== ======== ======== - -------------------------------------------------------------------------------- 43 FOUR OAKS FINCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 AND 2003 - -------------------------------------------------------------------------------- NOTE F - BORROWINGS At December 31, 2004 and 2003, borrowed funds consisted of the following FHLB advances (amounts in thousands): Maturity Interest Rate 2004 2003 ----------------- ---------------- ------- -------- March 2006 2.52% - Variable $10,000 $ - July 2010 5.75% - Fixed 10,000 10,000 July 2011 4.44% - Fixed 5,000 5,000 September 2011 4.38% - Fixed 3,000 3,000 October 2011 4.30% - Fixed 7,000 7,000 November 2011 2.31% - Variable 8,000 - November 2011 3.54% - Fixed - 8,000 ------- -------- $43,000 $ 33,000 ======= ======== The above advances are secured by a floating lien covering the Company's loan portfolio of qualifying residential (1-4 units) first mortgage loans. At December 31, 2004, the Company had available lines of credit totaling $111.5 million at various financial institutions for borrowing, dependent on adequate collateralization. The weighted average rates for the above borrowings at December 31, 2004 and 2003 were 3.86% and 4.58%, respectively. At December 31, 2004 and 2003, the Company was obligated under an outstanding promissory note for $160,000 for the purchase of property. The note calls for set monthly interest only payments, with a balloon payment at maturity on June 2006. The note bears interest at 7.50%. NOTE G - INCOME TAXES Allocation of income tax expense between current and deferred portions is as follows: YEARS ENDED DECEMBER 31, ---------------------------------------- 2004 2003 2002 -------- ------- -------- (AMOUNTS IN THOUSANDS) Current tax expense: Federal $ 2,086 $ 1,470 $ 1,085 State 410 271 189 -------- ------- -------- 2,496 1,741 1,274 -------- ------- -------- Deferred tax expense: Federal (161) (106) 26 State (27) (23) 6 -------- ------- -------- (188) (129) 32 -------- ------- -------- $ 2,308 $ 1,612 $ 1,306 ======== ======= ======== - -------------------------------------------------------------------------------- 44 FOUR OAKS FINCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 AND 2003 - -------------------------------------------------------------------------------- NOTE G - INCOME TAXES (Continued) The reconciliation of expected income tax at the statutory federal rate of 34% with income tax expense is as follows: YEARS ENDED DECEMBER 31, ----------------------------------------- 2004 2003 2002 ------- --------- -------- (AMOUNTS IN THOUSANDS) Expense computed at statutory rate of 34% $ 2,272 $ 1,540 $ 1,435 Effect of state income taxes, net of federal benefit 304 164 129 Tax exempt income (101) (123) (203) Bank owned life insurance income (152) (61) -- Other, net (15) 92 (55) ------- ------- ------- $ 2,308 $ 1,612 $ 1,306 ======= ======= ======= Deferred income taxes consist of the following: YEARS ENDED DECEMBER 31, ----------------------------------------- 2004 2003 2002 ------- --------- -------- (AMOUNTS IN THOUSANDS) Deferred tax assets: Allowance for loan losses $ 1,518 $ 1,277 $ 1,058 Unamortized investment premiums 49 44 135 Net deferred loan fees 146 66 -- Other 38 31 53 ------- ------- ------- Total deferred tax assets 1,751 1,418 1,246 ------- ------- ------- Deferred tax liabilities: Property and equipment 857 818 744 Other comprehensive income (13) 207 320 Net deferred loan costs 93 -- 31 Unaccreted investment discounts 13 -- -- ------- ------- ------- Total deferred tax liabilities 950 1,025 1,095 ------- ------- ------- Net deferred tax assets $ 801 $ 393 $ 151 ======= ======= ======= NOTE H - REGULATORY RESTRICTIONS The Bank, as a North Carolina banking corporation, may pay dividends to the Company only out of undivided profits as determined pursuant to North Carolina General Statutes Section 53-87. However, regulatory authorities may limit payment of dividends by any bank when it is determined that such a limitation is in the public interest and is necessary to ensure the financial soundness of the bank. Current Federal regulations require that the Bank maintain a minimum ratio of total capital to risk weighted assets of 8%, with at least 4% being in the form of Tier 1 capital, as defined in the regulations. In addition, the Bank must maintain a leverage ratio of 4%. As of December 31, 2004, the Bank's capital exceeded the current capital requirements. The Bank currently expects to continue to exceed these minimums without altering current operations or strategy. - -------------------------------------------------------------------------------- 45 FOUR OAKS FINCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 AND 2003 - -------------------------------------------------------------------------------- NOTE H - REGULATORY RESTRICTIONS (Continued) The Bank is subject to various regulatory capital requirements administered by the federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Bank's financial statements. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios, as set forth in the table below. Management believes, as of December 31, 2004, that the Bank meets all capital adequacy requirements to which it is subject. As of December 31, 2004, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum amounts and ratios as set forth in the table below. There are no conditions or events since that notification that management believes have changed the Bank's category. The Bank's actual capital amounts and ratios are also presented in the table below (amounts in thousands, except ratios): MINIMUM TO BE WELL MINIMUM CAPITALIZED UNDER FOR CAPITAL PROMPT CORRECTIVE ACTUAL ADEQUACY PURPOSES ACTION PROVISIONS ----------------------- ------------------------ ----------------------- AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO ------- ----- -------- ----- ------- ----- As of December 31, 2004: - ------------------------ Total Capital (to Risk Weighted Assets) $37,642 11.8% $25,427 8.0% $31,784 10.0% Tier I Capital (to Risk Weighted Assets) 33,668 10.6% 12,714 4.0% 19,071 6.0% Tier I Capital (to Average Assets) 33,668 8.6% 15,605 4.0% 19,506 5.0% As of December 31, 2003: - ------------------------ Total Capital (to Risk Weighted Assets) $33,792 12.3% $21,973 8.0% $27,467 10.0% Tier I Capital (to Risk Weighted Assets) 30,362 11.1% 10,987 4.0% 16,480 6.0% Tier I Capital (to Average Assets) 30,362 9.0% 13,421 4.0% 16,776 5.0% The Company is also subject to these capital requirements. At December 31, 2004 and 2003, the Company's total capital to risk weighted assets, Tier 1 capital to risk weighted assets and Tier 1 capital to average assets were 13.0% and 13.1%, 11.7% and 11.8%, and 9.5% and 9.7%, respectively. NOTE I - DERIVATIVES DERIVATIVE FINANCIAL INSTRUMENTS The Company has stand-alone derivative financial instruments in the form of interest rate swap agreements, which derive their value from underlying interest rates. These transactions involve both credit and market risk. The notional amounts are amounts on which calculations, payments, and the value of the derivative are based. Notional amounts do not represent direct credit exposures. Direct credit exposure is limited to the net difference between the calculated amounts to be received and paid, if any. Such difference, which - -------------------------------------------------------------------------------- 46 FOUR OAKS FINCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 AND 2003 - -------------------------------------------------------------------------------- NOTE I - DERIVATIVES (Continued) represents the fair value of the derivative instruments, is reflected on the Company's consolidated balance sheets as derivative assets and derivative liabilities. The Company is exposed to credit-related losses in the event of nonperformance by the counterparties to these agreements. The Company controls the credit risk of its financial contracts through credit approvals, limits and monitoring procedures, and does not expect any counterparties to fail their obligations. The Company deals only with primary dealers. Derivative instruments are generally either negotiated over-the-counter ("OTC") contracts or standardized contracts executed on a recognized exchange. Negotiated OTC derivative contracts are generally entered into between two counterparties that negotiate specific agreements terms, including the underlying instruments, amount, exercise prices and maturity. RISK MANAGEMENT POLICIES - HEDGING INSTRUMENTS The primary focus of the Company's asset/liability management program is to monitor the sensitivity of the Company's net portfolio value and net income under varying interest rate scenarios to take steps to control its risks. On a quarterly basis, the Company simulates the net portfolio value and net income expected to be earned over a twelve-month period following the date of simulation. The simulation is based on a projection of market interest rates at varying levels and estimates the impact of such market rates on the levels of interest-earning assets and interest-bearing liabilities during the measurement period. Based upon the outcome of the simulation analysis, the Company considers the use of derivatives as a means of reducing the volatility of net portfolio value and projected net income within certain ranges of projected changes in interest rates. The Company evaluates the effectiveness of entering into any derivative instrument agreement by measuring the cost of such an agreement in relation to the reduction in net portfolio value and net income volatility within an assumed range of interest rates. INTEREST RATE RISK MANAGEMENT - CASH FLOW HEDGING INSTRUMENTS The Company originates variable rate loans for its loan portfolio. These loans expose the Company to variability in interest receipts due to changes to interest rates. If interest rates increase, interest income increases. Conversely, if interest rates decrease, interest income decreases. Management believes it is prudent to limit the variability of a portion of its interest receipts therefore, generally hedges a portion of its variable-rate interest receipts. To meet this objective, management enters into interest rate swap agreements whereby the Company receives fixed rate payments and makes variable interest rate payments during the contract period. At December 31, 2004 and 2003, the information pertaining to an outstanding interest rate swap agreement used to hedge variable rate loans is as follows (amounts in thousands): 2004 2003 ------------ ----------- Notional amount $ 25,000 $ 25,000 Weighted average pay rate 4.38% 4.00% Weighted average receive rate 5.85% 5.85% Weighted average maturity in years 2.7 3.7 Unrealized loss relating to interest rate swaps $ (426) $ (56) This agreement requires the Company to make payments at a variable rate determined by a specified index (prime) in exchange for receiving payments at a fixed rate. - -------------------------------------------------------------------------------- 47 FOUR OAKS FINCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 AND 2003 - -------------------------------------------------------------------------------- NOTE I - DERIVATIVES (Continued) At December 31, 2004 and 2003, the Company's interest rate swaps used to hedge variable rate loans reflected an unrealized loss of $426,000 and $56,000, respectively. The unrealized losses are included in other comprehensive income, net of tax, in the accompanying consolidated balance sheet. Risk management results for the year ended December 31, 2004 related to the balance sheet hedging of variable rate loans indicate that the hedges were 100% effective and that there was no component of the derivative instruments' gain or loss which was excluded from the assessment of hedge effectiveness. At December 31, 2004, the unrealized loss relating to use of interest rate swaps was recorded in derivative liabilities in accordance with SFAS No. 133. Changes in the fair value of interest rate swaps designated as hedging instruments of the variability of cash flows associated with variable rate loans are reported in other comprehensive income. INTEREST RATE RISK MANAGEMENT - FAIR VALUE HEDGING INSTRUMENTS The Company uses fixed rate time deposits for use in its lending and investment activities and other general purposes. These debt obligations expose the Company to variability in their fair value due to changes in the level of interest rates. Management believes that it is prudent to limit the variability in the fair value of a portion of its fixed-rate funding. It is the Company's objective to hedge the change in fair value of fixed-rate funding coverage levels that are appropriate, given anticipated or existing interest rate levels and other market considerations, as well as the relationship of change in this liability to other liabilities of the Company. To meet this objective, on December 31, 2004, the Company utilized interest rate swaps as an asset/liability management strategy to hedge the change in value of the funding due to changes in expected interest rate assumptions. These interest rate swap agreements are contracts to make a series of floating rate payments in exchange for receiving a series of fixed rate payments. At December 31, 2004 and 2003, the information pertaining to outstanding interest rate swap agreements used to hedge fixed-rate funding is as follows (amounts in thousands): 2004 2003 ---------- ----------- Notional amount $ 26,000 $ 5,000 Weighted average pay rate 2.30% 1.17% Weighted average receive rate 3.66% 3.25% Weighted average maturity in years 5.6 5.5 Unrealized gain relating to interest rate swaps $ 213 $ -- These agreements require the Company to make payments at variable-rate determined by a specified index (LIBOR) in exchange for receiving payments at a fixed-rate. During 2004, an interest rate swap was called at par, with no corresponding gain or loss recognized. No interest rate swaps were terminated during 2004. At December 31, 2004, the Company's interest rate swaps used to hedge fixed-rate funding reflected an unrealized gain of $213,000 which is recorded in other liabilities in the accompanying consolidated balance sheet. - -------------------------------------------------------------------------------- 48 FOUR OAKS FINCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 AND 2003 - -------------------------------------------------------------------------------- NOTE J - COMMITMENTS AND CONTINGENCIES The Bank is a party to financial instruments with off-balance sheet credit risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement the Bank has in particular classes of financial instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of conditions established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank, upon extension of credit is based on management's credit evaluation of the borrower. Collateral obtained varies but may include real estate, stocks, bonds, and certificates of deposit. Unfunded commitments under lines of credit are commitments for possible future extensions of credit to existing customers. These lines of credit usually do not contain a specified maturity date and may not be drawn upon to the total extent to which the Bank is committed. Stand-by letters of credit are conditional lending commitments issued by the Bank to guarantee the performance of a customer to a third party. Those letters of credit are primarily issued to support public and private borrowing arrangements. Essentially all letters of credit issued have expiration dates within one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. A summary of the contract amount of the Bank's exposure to off-balance sheet credit risk as of December 31, 2004 is as follows (amounts in thousands): Financial instruments whose contract amounts represent credit risk: Commitments to extend credit $ 68,156 Undisbursed lines of credit 21,221 Financial stand-by letters of credit 159 Performance stand-by letters of credit 1,567 NOTE K - STOCK OPTION PLAN The Company has a non-qualified stock option plan for certain key employees under which it is authorized to issue options for up to 781,250 shares of common stock. Options are granted at the discretion of the Company's Board of Directors at a price approximating market, as determined by a committee of Board members. All options granted subsequent to a 1997 amendment will be 100% vested one year from the grant date and will expire after such a period as is determined by the Board at the time of grant. Options granted prior to the amendment have ten year lives and a five year level vesting provision. - -------------------------------------------------------------------------------- 49 FOUR OAKS FINCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 AND 2003 - -------------------------------------------------------------------------------- NOTE K - STOCK OPTION PLAN (Continued) A summary of the status of the Company's stock options, after giving retroactive effect to stock splits, as of December 31, 2004, 2003 and 2002, and changes during the years ending on those dates is presented below: OPTIONS OPTION PRICE OUTSTANDING PER SHARE ----------- --------------- Balance December 31, 2001 149,285 $7.39 - 13.23 Granted 38,375 $12.80 Exercised (44,910) $9.10 - 13.23 Forfeited (10,501) $12.37 - 13.23 ----------- Balance December 31, 2002 132,249 $7.39 - 13.23 Granted 45,079 $14.40 Exercised (24,456) $12.37 Forfeited - - Expired (153) $12.37 ----------- Balance December 31, 2003 152,719 $7.39 - 14.08 Granted 33,875 $17.60 Exercised (61,862) $13.11 Forfeited (1) $12.80 Expired (7) $13.23 ----------- Balance December 31, 2004 124,724 $14.42 =========== The weighted average exercise price of all exercisable options at December 31, 2004 is $13.24. There were 326,477 shares reserved for future issuance at December 31, 2004. Additional information concerning the Company's stock options at December 31, 2004 is as follows: REMAINING NUMBER CONTRACTUAL NUMBER EXERCISE PRICE OUTSTANDING LIFE EXERCISABLE ---------------- ---------------- ----------- ----------------- $7.40 5,274 2.19 years 5,274 $12.80 42,841 .83 years 42,841 $14.40 42,734 2.16 years 42,734 $17.60 33,875 3.15 years - ------- ------ 124,724 90,849 ======= ====== - -------------------------------------------------------------------------------- 50 FOUR OAKS FINCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 AND 2003 - -------------------------------------------------------------------------------- NOTE K - STOCK OPTION PLAN (Continued) The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions used for grants in 2004, 2003 and 2002: 2004 2003 2002 -------- -------- ------- Dividend yield 2.06% 1.69% 1.77% Expected volatility 21.92% 21.65% 22.04% Risk free interest rate 3.00% 2.82% 3.00% Expected life 4 years 4 years 4 years The weighted average fair value of options granted during 2004, 2003 and 2002 was $3.07, $3.21, and $2.91, respectively. NOTE L - OTHER EMPLOYEE BENEFITS SUPPLEMENTAL RETIREMENT In 1998, the Company's subsidiary, Four Oaks Bank & Trust Company, adopted a Supplemental Executive Retirement Plan ("SERP") for its president. The Company has purchased life insurance policies in order to provide future funding of benefit payments. Plan benefits will accrue and vest during the period of employment and will be paid in annual benefit payments over the officer's remaining life commencing with the officer's retirement. The liability accrued under the plan amounts to $99,000 and $79,000 at December 31, 2004 and 2003, respectively. During 2004, 2003 and 2002, the expense attributable to this plan amounted to $20,000, $18,000 and $16,000, respectively. EMPLOYMENT AGREEMENTS The Company has entered into employment agreements with certain of its executive officers to ensure a stable and competent management base. The agreements provide for benefits as spelled out in the contracts and cannot be terminated by the Company's Board of Directors, except for cause, without prejudicing the officers' rights to receive certain vested rights, including compensation. In addition, the Company has entered into severance compensation agreements with certain of its executive officers to provide them with severance pay benefits in the event of a change in control of the Company, as outlined in the agreements, the acquirer will be bound to the terms of the contracts. DEFINED CONTRIBUTION PLAN The Company sponsors a contributory profit-sharing plan in effect for substantially all employees. Participants may make voluntary contributions resulting in salary deferrals in accordance with Section 401(k) of the Internal Revenue Code. The plans provide for employee contributions up to $13,000 of the participant's annual salary and an employer contribution of 25% matching of the first 6% of pre-tax salary contributed by each participant. Expenses related to these plans for the years ended December 31, 2004, 2003 and 2002 were $47,000, $56,000 and $92,000, respectively. Contributions under the plan are made at the discretion of the Company's Board of Directors. - -------------------------------------------------------------------------------- 51 FOUR OAKS FINCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 AND 2003 - -------------------------------------------------------------------------------- NOTE L - OTHER EMPLOYEE BENEFITS (CONTINUED) EMPLOYEE STOCK OWNERSHIP PLAN The Company sponsors an employee stock ownership plan (ESOP) which makes the employees of a company, owners of stock in the company. The Four Oaks Bank & Trust Company's Employee Stock Ownership Trust is available to full-time employees at least 21 years of age after six months of service. Contributions are voluntary by the Company and employees cannot contribute. Stock issued is purchased on the open market and the Company does not issue new shares in conjunction with this plan. Voluntary contributions are determined by the Company's Board of Directors annually based on Company performance and are allocated to employees based on annual compensation. Contribution expenses for this plan for 2004, 2003, and 2002 were $180,000, 189,000, and 150,000, respectively. EMPLOYEE STOCK PURCHASE AND BONUS PLAN The Employee Stock Purchase and Bonus Plan (the "Purchase Plan") is a voluntary plan that enables full-time employees of the Company and its subsidiaries to purchase shares of our common stock. The Purchase Plan is administered by a committee of the Board of Directors, which has broad discretionary authority to administer the Purchase Plan. The Company's Board of Directors may amend or terminate the Purchase Plan at any time. The Purchase Plan is not intended to be qualified as an employee stock purchase plan under Section 423 of the Internal Revenue Code of 1986, as amended. Once a year, participants in the Purchase Plan purchase the Company's common stock at fair market value. Participants are permitted to purchase shares under the Purchase Plan up to (5%) of their compensation, with a maximum purchase amount of $1,000 per year. The Company matches, in cash, fifty percent (50%) of the amount of each participant's purchase, up to $500. After withholding for income and employment taxes, participants use the balance of our matching grant to purchase shares of our common stock. As of December 31, 2004, 156,250 shares of our common stock had been reserved for issuance under the Purchase Plan, and 85,294 shares had been purchased. During 2004, 6,578 shares were purchased under the Purchase Plan. NOTE M - LEASES The Bank has entered into non-cancelable operating leases for three branch facilities. Future minimum lease payments under the leases for year ending December 31, 2004 is as follows (amounts in thousands): 2005 $ 42 2006 33 2007 33 2008 15 2009 7 ------ $ 130 ====== In addition, the Bank has leased a building from one of its directors for $908 and $891 per month in 2004 and 2003, respectively under an operating lease on a month-to-month basis. Total rental expense under operating leases for the years ended December 31, 2004, 2003 and 2002 amounted to $45,000 and $31,000 and $14,000, respectively. - -------------------------------------------------------------------------------- 52 FOUR OAKS FINCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 AND 2003 - -------------------------------------------------------------------------------- NOTE N - PARENT COMPANY FINANCIAL INFORMATION Condensed financial information of Four Oaks Fincorp, Inc., the parent company, at December 31, 2004 and 2003 and for the years ended December 31, 2004, 2003 and 2002 is presented below: 2004 2003 --------- --------- (AMOUNTS IN THOUSANDS) CONDENSED BALANCE SHEETS Assets: Cash and cash equivalents $ 3,074 $ 1,709 Equity investment in subsidiaries 33,665 30,681 Securities available for sale 695 595 Other assets -- -- ------- ------- Total assets $37,434 $32,985 ======= ======= Liabilities and Shareholders' Equity: Liabilities: Other liabilities $ 139 $ 105 Shareholders' equity 37,295 32,880 ------- ------- Total liabilities and shareholders' equity $37,434 $32,985 ======= ======= 2004 2003 2002 -------- -------- -------- (AMOUNTS IN THOUSANDS) CONDENSED STATEMENTS OF OPERATIONS Equity in earnings of subsidiaries $ 4,361 $ 2,897 $ 2,922 Interest income 30 22 34 Other investment income 15 17 9 Miscellaneous expenses (31) (18) (49) -------- ------- ------- Net income $ 4,375 $ 2,918 $ 2,916 ======== ======= ======= - -------------------------------------------------------------------------------- 53 FOUR OAKS FINCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 AND 2003 - -------------------------------------------------------------------------------- NOTE N - PARENT COMPANY FINANCIAL INFORMATION (Continued) 2004 2003 2002 ------- --------- --------- (AMOUNTS IN THOUSANDS) CONDENSED STATEMENTS OF CASH FLOWS Operating activities: Net income $ 4,375 $ 2,918 $ 2,916 Equity in undistributed earnings of subsidiaries (4,361) (2,897) (2,922) Amortization -- -- 10 Decrease in other assets -- -- 67 ------- ------- ------- Cash flows provided by operating activities 14 21 71 ------- ------- ------- Investing activities: Purchase of securities available for sale (14) (16) (9) Investment in subsidiaries -- -- (31) Upstream dividend received from subsidiary 1,089 1,166 584 ------- ------- ------- Cash flows provided by investing activities 1,075 1,150 544 ------- ------- ------- Financing activities: Proceeds from issuance of common stock 1,430 879 1,012 Purchases and retirements of common stock (65) (993) (385) Dividends paid (1,089) (960) (852) ------- ------- ------- Cash flows used by financing activities 276 (1,074) (225) ------- ------- ------- Net increase in cash and cash equivalents 1,365 97 390 Cash and cash equivalents, beginning of year 1,709 1,612 1,222 ------- ------- ------- Cash and cash equivalents, end of year $ 3,074 $ 1,709 $ 1,612 ======= ======= ======= NOTE O - FAIR VALUE OF FINANCIAL INSTRUMENTS SFAS No. 107, Disclosures about Fair Value of Financial Instruments, requires the disclosure of estimated fair values for financial instruments. Quoted market prices, if available, are utilized as an estimate of the fair value of financial instruments. Because no quoted market prices exist for a significant part of the Company's financial instruments, the fair value of such instruments has been derived based on management's assumptions with respect to future economic conditions, the amount and timing of future cash flows and estimated discount rates. Different assumptions could significantly affect these estimates. Accordingly, the net realizable value could be materially different from the estimates presented below. In addition, the estimates are only indicative of individual financial instruments' values and should not be considered an indication of the fair value of the Company taken as a whole. The following methods and assumptions were used to estimate the fair value of each class of financial instrument. - -------------------------------------------------------------------------------- 54 FOUR OAKS FINCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 AND 2003 - -------------------------------------------------------------------------------- NOTE O - FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued) CASH AND CASH EQUIVALENTS The carrying amounts of cash and cash equivalents are equal to the fair value due to the liquid nature of the financial instruments. INVESTMENT SECURITIES AVAILABLE FOR SALE Fair values of investment securities available for sale are based on quoted market prices. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. LOANS Fair values have been estimated by type of loan: residential real estate loans, consumer loans, and commercial and other loans. For variable-rate loans that reprice frequently and with no significant credit risk, fair values are based on carrying values. The fair values of fixed rate loans are estimated by discounting the future cash flows using the current rates at which loans with similar terms would be made to borrowers with similar credit ratings and for the same remaining maturities. The Company has assigned no fair value to off-balance sheet financial instruments since they are either short term in nature or subject to immediate repricing. FHLB STOCK The carrying amount of FHLB stock approximates fair value. INVESTMENT IN LIFE INSURANCE The carrying value of life insurance approximates fair value because this investment is carried at cash surrender value, as determined by the insurer. DEPOSITS The fair value of demand deposits, savings accounts and money market deposits is the amount payable on demand at year-end. Fair value of time deposits is estimated by discounting the future cash flows using the current rate offered for similar deposits with the same maturities. BORROWINGS The fair values are based on discounting expected cash flows at the interest rate for debt with the same or similar remaining maturities and collection requirements. ACCRUED INTEREST RECEIVABLE AND PAYABLE The carrying amounts of accrued interest approximate fair value. DERIVATIVE FINANCIAL INSTRUMENTS Fair values for interest rate swap agreements are based upon the amounts required to settle the contracts. - -------------------------------------------------------------------------------- 55 FOUR OAKS FINCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 AND 2003 - -------------------------------------------------------------------------------- NOTE O - FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued) The following table presents information for financial assets and liabilities as of December 31, 2004 and 2003 (amounts in thousands): 2004 2003 --------------------------- ---------------------------- CARRYING ESTIMATED CARRYING ESTIMATED VALUE FAIR VALUE VALUE FAIR VALUE --------- ----------- ---------- ----------- FINANCIAL ASSETS: Cash and cash equivalents $ 14,249 $ 14,249 $ 15,825 $ 15,825 Securities available for sale 52,342 52,342 38,203 38,203 Loans, net 308,760 308,713 269,193 271,566 FHLB stock 2,621 2,621 1,923 1,923 Investment in life insurance 6,054 6,054 2,896 2,896 Accrued interest receivable 2,210 2,210 1,893 1,893 FINANCIAL LIABILITIES: Deposits $ 315,307 $ 309,801 $ 272,918 $ 270,127 Borrowings 43,160 41,651 33,160 30,665 Accrued interest payable 1,201 1,201 1,284 1,284 DERIVATIVE FINANCIAL INSTRUMENTS: Interest rate swap agreements: Liabilities, net (213) (213) 56 56 NOTE P - CASH FLOW SUPPLEMENTAL DISCLOSURES The following information is supplemental information regarding the cash flows for the years ended December 31, 2004, 2003 and 2002: 2004 2003 2002 -------- -------- -------- (AMOUNTS IN THOUSANDS) Cash paid for: Interest on deposits and borrowings $ 5,895 $ 4,365 $ 8,586 Income taxes 2,192 1,637 997 Summary of noncash investing and financing activities: Transfer from loans to foreclosed assets 1,214 167 585 Loans to facilitate the sale of foreclosed assets 393 111 137 Tax benefit from the exercise of non-qualified stock options 94 18 53 Increase (decrease) in fair value of securities available for sale, net of tax (108) (141) 424 Decrease in fair value of cash flow hedge, net of tax (222) (34) -- - -------------------------------------------------------------------------------- 56 FOUR OAKS FINCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 AND 2003 - -------------------------------------------------------------------------------- NOTE Q - STOCK PURCHASE PLAN On December 10, 2001, the Company's Board of Directors approved a Stock Purchase Program authorizing the Company to purchase up to 100,000 shares, or approximately 4.7% of the then outstanding shares of common stock. During 2003, the Company purchased 43,668 shares at an average cost of $21.73 per share. During 2004, the Company purchased 2,800 shares at an average cost of $23.25 per share. Neither 2004 nor 2003 purchase amounts reflect of the 5-for-4 stock split during 2004 to shareholders of record as of October 15, 2004, payable on or after October 29, 2004. In December 2004, the Company's Board of Directors extended this stock purchase plan until December 31, 2005. - -------------------------------------------------------------------------------- 57 Item 9 - Changes In and Disagreements with Accountants on Accounting and Financial Disclosure. Not Applicable. Item 9A - Controls and Procedures As required by paragraph (b) of Rule 13a-15 under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), our Chief Executive Officer and our Chief Financial Officer have evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. Based on such evaluation, our Chief Executive Officer and our Chief Financial Officer conclude that, as of the end of the period covered by this report, our disclosure controls and procedures are effective, in that they provide reasonable assurance that the information we are required to disclose in the reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods required by the United States Securities and Exchange Commission's rules and forms. There have been no changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fourth quarter of fiscal 2004 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Item 9B - Other Information Not Applicable. PART III Item 10 - Directors and Executive Officers of the Registrant. Director information is incorporated by reference from the sections entitled "Information about Our Board of Directors," "Election of Directors," and under the section entitled "Section 16(a) Beneficial Ownership Reporting Compliance," in our Proxy Statement for the 2005 Annual Meeting of Shareholders. Information on our executive officers is included under the caption "Our Executive Officers" on Page 8 and 9 of this report. Information about our Code of Ethics is incorporated by reference from the section entitled "Code of Ethics," in our Proxy Statement for the 2005 Annual Meeting of Shareholders. Item 11 - Executive Compensation. This information is incorporated by reference from the sections entitled "Executive Compensation," "Board Compensation Committee Report on Executive Compensation," "Compensation Committee Interlocks and Insider Participation" and "Comparison of Cumulative Total Return" in our Proxy Statement for the 2005 Annual Meeting of Shareholders. Item 12 - Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters. This information is incorporated by reference from the section entitled "Security Ownership of Management and Certain Beneficial Owners" and the sections entitled "Equity Compensation Plan Information," "Nonqualified Stock Option Plan" and "Employee Stock Purchases and Bonus Plan" in our Proxy Statement for the 2005 Annual Meeting of Shareholders. Item 13 - Certain Relationships and Related Transactions. This information is incorporated by reference from the section entitled "Certain Transactions" in our Proxy Statement for the 2005 Annual Meeting of Shareholders. Item 14 - Principal Accountant Fees and Services Information regarding principal accountant fees and services is incorporated by reference from the section entitled "Audit Firm Fee Summary" in our Proxy Statement for the 2005 Annual Meeting of Shareholders. 58 Item 15 - Exhibits, Financial Statement Schedules . (a)(1) Financial Statements. The following financial statements and supplementary data are included in Item 8 of this annual report. Form 10-K Page -------------- Financial Statements Report of Independent Public Auditors, Dixon Hughes PLLC, dated March 18, 2005 27 Consolidated Balance Sheets as of December 31, 2004 and 2003 28 Consolidated Statements of Operations for the years ended December 31, 2004, 29 2003 and 2002 Consolidated Statements of Comprehensive Income for the years ended December 31, 30 2004, 2003 and 2002 Consolidated Statements of Shareholders' Equity for the years ended December 31, 31 2004, 2003 and 2002 Consolidated Statements of Cash Flows for the years ended December 31, 2004, 32 2003 and 2002 Notes to Consolidated Financial Statements 33 (a)(2) Financial Statement Schedules. All applicable financial statement schedules required under Regulation S-X have been included in the Notes to Consolidated Financial Statements. (a)(3) Exhibits. The following exhibits are filed as part of this annual report. Exhibit No. Description of Exhibit ----------- --------------------------------------------------------------------------------- 2(1) Agreement and Plan of Reorganization and Merger by and between Four Oaks Bank & Trust Company and Four Oaks Fincorp, Inc. dated February 24, 1997 3.1 Articles of Incorporation of Four Oaks Fincorp, Inc. including Articles of Amendment to Articles of Incorporation 3.2(1) Bylaws of Four Oaks Fincorp, Inc. 4(1) Specimen of Certificate for Four Oaks Fincorp, Inc. Common Stock 10.1(2)* Employment Agreement with Ayden R. Lee, Jr. 10.2(2)* Severance Compensation Agreement with Ayden R. Lee, Jr. 10.3(3)* Amended and Restated Nonqualified Stock Option Plan 10.4(3)* Amended and Restated Employee Stock Purchase and Bonus Plan 10.5(4)* Amended and Restated Dividend Reinvestment and Stock Purchase Plan 10.6(5)* Four Oaks Bank & Trust Company Supplemental Executive Retirement Plan 10.7(6)* Employment Agreement with Clifton L. Painter 10.8(7)* Severance Compensation Agreement with Clifton L. Painter 10.9(8)* Executive Employment Agreement with W. Leon Hiatt, III 10.10(8)* Severance Compensation Agreement with W.Leon Hiatt, III 10.11(8)* Executive Employment Agreement with Nancy S. Wise 10.12(8)* Severance Compensation Agreement with Nancy S. Wise 10.13(9)* Form of Stock Option Agreement (Non-Employee Director) 10.14(9)* Form of Stock Option Agreement (Employee) 10.15* Executive Employment Agreement with Jeff D. Pope 10.16* Severance Compensation Agreement with Jeff D. Pope 21 Subsidiaries of Four Oaks Fincorp, Inc. 23 Consent of Dixon Hughes PLLC 31.1 Certification of Chief Executive Officer Pursuant to Rule 13a-14/15d-14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2 Certification of Chief Financial Officer Pursuant to Rule 13a-14/15d-14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.1 Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 ----------------------- *Management Contract or Compensatory Plan (1) Filed as an exhibit to the Current Report on Form 8-K12G3 filed with the SEC on July 2, 1997 and incorporated herein by reference. (2) Filed as an exhibit to the Quarterly Report on Form 10-Q for the period ended June 30, 1997 and incorporated herein by reference. (3) Filed as an exhibit to the Quarterly Report on Form 10-Q for the period ended June 30, 2004 and incorporated herein by reference. (4) Filed as an exhibit to the Current Report on Form 8-K filed with the SEC on September 9, 2004 and incorporated herein by reference. (5) Filed as an exhibit to the Annual Report on Form 10-KSB for the period ended December 31, 1998 and incorporated herein by reference. (6) Filed as an exhibit to the Annual Report on Form 10-KSB for the period ended December 31, 2001 and incorporated herein by reference. (7) Filed as an exhibit to the Annual Report on Form 10-KSB for the period ended December 31, 2002 and incorporated herein by reference. (8) Filed as an exhibit to the Annual Report on Form 10-KSB for the period ended December 31, 2003 and incorporated herein by reference. (9) Filed as an exhibit to the Current Report on Form 8-K filed with the SEC on March 1, 2005 and incorporated herein by reference. (b) See (a)(3) above. (c) See (a)(2) above. - -------------------------------------------------------------------------------- 59 61 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. FOUR OAKS FINCORP, INC. Date: March 29, 2005 By: /s/ Ayden R. Lee, Jr. ------------------------------------- Ayden R. Lee, Jr. President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Date: March 29, 2005 /s/ Ayden R. Lee, Jr. ---------------------------------------- Ayden R. Lee, Jr. President, Chief Executive Officer and Director Date: March 29, 2005 /s/ Nancy S. Wise ---------------------------------------- Nancy S. Wise Executive Vice President and Chief Financial Officer Date: March 29, 2005 /s/ William J. Edwards ---------------------------------------- William J. Edwards Director Date: March 29, 2005 /s/ Warren L. Grimes ---------------------------------------- Warren L. Grimes Director Date: March 29, 2005 /s/ Dr. R. Max Raynor, Jr. ---------------------------------------- Dr. R. Max Raynor, Jr. Director Date: March 29, 2005 /s/ Percy Y. Lee ---------------------------------------- Percy Y. Lee Director Date: March 29, 2005 /s/ Merwin S. Canaday ---------------------------------------- Merwin S. Canaday Director Date: March 29, 2005 /s/ Paula C. Bowman ---------------------------------------- Paula C. Bowman Director Date: March 29, 2005 /s/ William Ashley Turner ---------------------------------------- William Ashley Turner Director 60 EXHIBIT INDEX Exhibit No. Description of Exhibit ----------- --------------------------------------------------------------------------------- 2(1) Agreement and Plan of Reorganization and Merger by and between Four Oaks Bank & Trust Company and Four Oaks Fincorp, Inc. dated February 24, 1997 3.1 Articles of Incorporation of Four Oaks Fincorp, Inc. including Articles of Amendment to Articles of Incorporation 3.2(1) Bylaws of Four Oaks Fincorp, Inc. 4(1) Specimen of Certificate for Four Oaks Fincorp, Inc. Common Stock 10.1(2)* Employment Agreement with Ayden R. Lee, Jr. 10.2(2)* Severance Compensation Agreement with Ayden R. Lee, Jr. 10.3(3)* Amended and Restated Nonqualified Stock Option Plan 10.4(3)* Amended and Restated Employee Stock Purchase and Bonus Plan 10.5(4)* Amended and Restated Dividend Reinvestment and Stock Purchase Plan 10.6(5)* Four Oaks Bank & Trust Company Supplemental Executive Retirement Plan 10.7(6)* Employment Agreement with Clifton L. Painter 10.8(7)* Severance Compensation Agreement with Clifton L. Painter 10.9(8)* Executive Employment Agreement with W. Leon Hiatt, III 10.10(8)* Severance Compensation Agreement with W.Leon Hiatt, III 10.11(8)* Executive Employment Agreement with Nancy S. Wise 10.12(8)* Severance Compensation Agreement with Nancy S. Wise 10.13(9)* Form of Stock Option Agreement (Non-Employee Director) 10.14(9)* Form of Stock Option Agreement (Employee) 10.15* Executive Employment Agreement with Jeff D. Pope 10.16* Severance Compensation Agreement with Jeff D. Pope 21 Subsidiaries of Four Oaks Fincorp, Inc. 23 Consent of Dixon Hughes PLLC 31.1 Certification of Chief Executive Officer Pursuant to Rule 13a-14/15d-14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2 Certification of Chief Financial Officer Pursuant to Rule 13a-14/15d-14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.1 Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 ----------------------- *Management Contract or Compensatory Plan (1) Filed as an exhibit to the Current Report on Form 8-K12G3 filed with the SEC on July 2, 1997 and incorporated herein by reference. (2) Filed as an exhibit to the Quarterly Report on Form 10-Q for the period ended June 30, 1997 and incorporated herein by reference. (3) Filed as an exhibit to the Quarterly Report on Form 10-Q for the period ended June 30, 2004 and incorporated herein by reference. (4) Filed as an exhibit to the Current Report on Form 8-K filed with the SEC on September 9, 2004 and incorporated herein by reference. (5) Filed as an exhibit to the Annual Report on Form 10-KSB for the period ended December 31, 1998 and incorporated herein by reference. (6) Filed as an exhibit to the Annual Report on Form 10-KSB for the period ended December 31, 2001 and incorporated herein by reference. (7) Filed as an exhibit to the Annual Report on Form 10-KSB for the period ended December 31, 2002 and incorporated herein by reference. (8) Filed as an exhibit to the Annual Report on Form 10-KSB for the period ended December 31, 2003 and incorporated herein by reference. (9) Filed as an exhibit to the Current Report on Form 8-K filed with the SEC on March 1, 2005 and incorporated herein by reference. (b) See (a)(3) above. (c) See (a)(2) above. 61