10-Q/A 1 form10-qamend_3rdqtr2002.txt 3RD QUARTER 2002 10-Q AMENDMENT FORM 10-Q/A UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2002 For Quarter Ended September 30, 2002 Commission File Number: 1.000-26099 FARMERS & MERCHANTS BANCORP (Exact name of registrant as specified in its charter) Delaware 94-3327828 (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification No.) 121 W. Pine Street, Lodi, California 95240 (Address of principal Executive offices) (Zip Code) Registrant's telephone number, including area code (209) 334-1101 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. Yes [ X ] No [ ] Number of shares of common stock of the registrant: Par value $0.01, authorized 2,000,000 shares; issued and outstanding 734,942 as of November 6, 2002. Registrant hereby amends the Signature Page of its Report on Form 10-Q for the quarter ended September 30, 2002, to include the Certifications of its Chief Executive Officer and its Chief Financial Officer, as required by Rule 13a-14 of the Securities and Exchange Commission, which certifications were inadvertently omitted form the Form 10-Q as filed. 2 FARMERS & MERCHANTS BANCORP FORM 10-Q/A TABLE OF CONTENTS PART I. - FINANCIAL INFORMATION Page Item 1 - Financial Statements Consolidated Balance Sheets as of September 30, 2002, December 31, 2001 and September 30, 2001. 4 Consolidated Statements of Income for the Three Months and Nine Months Ended September 30, 2002 and 2001. 5 Consolidated Statements of Comprehensive Income for the Three Months and Nine Months Ended September 30, 2002 and 2001. 6 Statement of Changes in Shareholders' Equity for the Nine Months Ended September 30, 2002 and 2001. 7 Consolidated Statement of Cash Flows for the Nine Months Ended September 30, 2002 and 2001. 8 Notes to Consolidated Financial Statements 9 Item 2 - Management's Discussion and Analysis 14 Item 3 - Quantitative and Qualitative Disclosures About Market Risk 22 Item 4 - Controls and Procedures 23 PART II. - OTHER INFORMATION 28 ----------------- SIGNATURES 29 Certifications 29 Index to Exhibits 32 3 PART I. - FINANCIAL INFORMATION Item 1 - Financial Statements FARMERS & MERCHANTS BANCORP
Consolidated Balance Sheets ---------------------------------------------------------------------------------------------------------- (in thousands) September 30, December 31, September 30, 2002 2001 2001 Assets (Unaudited) (Unaudited) ---------------------------------------------------------------------------------------------------------- Cash and Cash Equivalents: Cash and Due From $34,875 $32,406 $33,391 Federal Funds Sold 20,985 31,100 46,600 ---------------------------------------------------------------------------------------------------------- Total Cash and Cash Equivalents 55,860 63,506 79,991 Investment Securities: Available-for-Sale 147,092 242,852 251,117 Held-to-Maturity 28,261 32,698 32,113 ---------------------------------------------------------------------------------------------------------- Total Investment Securities 175,353 275,550 283,230 ---------------------------------------------------------------------------------------------------------- Loans 685,941 603,185 558,584 Less: Unearned Income (1,554) (1,016) (586) Less: Allowance for Loan Losses (13,118) (12,709) (13,029) ---------------------------------------------------------------------------------------------------------- Loans, Net 671,269 589,460 544,969 ---------------------------------------------------------------------------------------------------------- Land, Buildings & Equipment 11,307 11,432 11,643 Interest Receivable and Other Assets 41,436 30,935 12,755 ---------------------------------------------------------------------------------------------------------- Total Assets $955,225 $970,883 $932,588 ========================================================================================================== Liabilities & Shareholders' Equity Deposits: Demand $184,982 $198,316 $166,128 Interest Bearing Transaction 82,707 100,574 80,058 Savings 226,567 198,651 189,847 Time Deposits 306,963 322,170 344,504 ---------------------------------------------------------------------------------------------------------- Total Deposits 801,219 819,711 780,537 ---------------------------------------------------------------------------------------------------------- Fed Funds Purchased/Borrowings 40,974 41,000 41,009 Other Liabilities 9,110 9,436 9,755 ---------------------------------------------------------------------------------------------------------- Total Liabilities 851,303 870,147 831,301 ---------------------------------------------------------------------------------------------------------- Shareholders' Equity Common Stock 7 7 7 Additional Paid In Capital 65,464 61,360 61,392 Retained Earnings 36,089 36,499 36,063 Accumulated Other Comprehensive Income 2,362 2,870 3,825 ---------------------------------------------------------------------------------------------------------- Total Shareholders' Equity 103,922 100,736 101,287 ---------------------------------------------------------------------------------------------------------- Total Liabilities & Shareholders' Equity $955,225 $970,883 $932,588 ==========================================================================================================
The accompanying notes are an integral part of these consolidated financial statements 4 FARMERS & MERCHANTS BANCORP
Consolidated Statements of Income (Unaudited) ------------------------------------------------------------------------------------------------------------------- (in thousands) Three Months Nine Months Ended September 30, Ended September 30, 2002 2001 2002 2001 ------------------------------------------------------------------------------------------------------------------- Interest Income: Interest & Fees on Loans $10,954 $11,065 $31,082 $33,808 Federal Funds Sold 55 458 385 1,560 Securities: Investments Available-for-Sale: Taxable 1,966 3,605 7,539 11,453 Non-taxable 241 242 718 692 Investments Held-to-Maturity: Taxable 7 37 25 190 Non-taxable 341 381 1,054 1,214 ------------------------------------------------------------------------------------------------------------------- Total Interest Income 13,564 15,788 40,803 48,917 ------------------------------------------------------------------------------------------------------------------- Interest Expense: Interest Bearing Transaction 61 159 225 507 Savings 422 957 1,562 2,827 Time Deposits 2,173 4,165 7,070 13,237 Interest on Borrowed Funds 562 570 1,668 1,680 ------------------------------------------------------------------------------------------------------------------- Total Interest Expense 3,218 5,851 10,525 18,251 ------------------------------------------------------------------------------------------------------------------- Net Interest Income 10,346 9,937 30,278 30,666 Provision for Loan Losses 500 150 1,000 750 ------------------------------------------------------------------------------------------------------------------- Net Interest Income After Provision for Loan Losses 9,846 9,787 29,278 29,916 ------------------------------------------------------------------------------------------------------------------- Non-Interest Income Service Charges on Deposit Accounts 1,267 1,102 3,511 3,058 Net Gain (Loss) on Sale of Investment Securities - 39 276 105 Other 1,464 1,194 4,099 2,978 ------------------------------------------------------------------------------------------------------------------- Total Non-Interest Income 2,731 2,335 7,886 6,141 ------------------------------------------------------------------------------------------------------------------- Non-Interest Expense Salaries & Employee Benefits 4,425 4,265 13,173 13,007 Occupancy 429 445 1,264 1,258 Equipment 502 496 1,694 1,459 Other Operating 1,796 1,745 5,526 5,021 ------------------------------------------------------------------------------------------------------------------- Total Non-Interest Expense 7,152 6,951 21,657 20,745 ------------------------------------------------------------------------------------------------------------------- Net Income Before Taxes 5,425 5,171 15,507 15,312 Provision for Taxes 1,980 2,009 5,680 5,949 ------------------------------------------------------------------------------------------------------------------- Net Income $3,445 $3,162 $9,827 $9,363 =================================================================================================================== Earning Per Share $ 4.68 $ 4.19 $ 13.29 $ 12.39 ===================================================================================================================
The accompanying notes are an integral part of these consolidated financial statements 5 FARMERS & MERCHANTS BANCORP
Consolidated Statements of Comprehensive Income (Unaudited) ------------------------------------------------------------------------------------------------------------------- (in thousands) Three Months Ended Nine Months Ended Sept. 30, Sept. 30, Sept. 30, Sept. 30, 2002 2001 2002 2001 ------------------------------------------------------------------------------------------------------------------- Net Income $ 3,445 $ 3,162 $ 9,827 $ 9,363 Other Comprehensive Income (Loss) - Unrealized holding gains (losses) arising during the period, net of income tax effects of ($234) and $980 for the quarters ended September 30, 2002 and 2001, respectively, and of ($177) and $2,167 for the nine months ended September 30, 2002 and 2001, respectively. (479) 1,400 (348) 3,096 Less: Reclassification adjustment for realized (gains) losses included in net income, net of related income tax effects of $0 and ($16) for the quarters ended September 30, 2002 and 2001, respectively, and of ($115) and ($44) for the nine months ended September 30, 2002 and 2001, respectively. - (23) (160) (61) ------------------------------------------------------------------------------------------------------------------- Total Other Comprehensive Income (479) 1,377 (508) 3,035 ------------------------------------------------------------------------------------------------------------------- Comprehensive Income $ 2,966 $ 4,539 $ 9,319 $ 12,398 ===================================================================================================================
The accompanying notes are an integral part of these consolidated financial statements 6 FARMERS & MERCHANTS BANCORP
Consolidated Statements of Changes in Shareholders' Equity (Unaudited) ------------------------------------------------------------------------------------------------------------------- (in thousands except share data) Accumulated Common Additional Other Total Shares Common Paid-In Retained Comprehensive Shareholders' Outstanding Stock Capital Earnings Income Equity ------------------------------------------------------------------------------------------------------------------- Balance, December 31, 2000 687,491 $ 7 $ 53,559 $ 36,527 $ 790 $90,883 =================================================================================================================== Net Income - - 9,363 - 9,363 Cash Dividends Declared on - Common Stock - - (1,406) - (1,406) 5% Stock Dividend 33,831 - 8,288 (8,288) - - Cash Paid in Lieu of Fractional Shares Related to Stock Dividend - - (133) - (133) Redemption of Stock (1,924) - (455) - - (455) Changes in Net Unrealized Gain (Loss) on Securities Available for Sale - - - 3,035 3,035 ------------------------------------------------------------------------------------------------------------------- Balance, September 30, 2001 719,398 $ 7 $ 61,392 $ 36,063 $ 3,825 $101,287 =================================================================================================================== ------------------------------------------------------------------------------------------------------------------- Balance, December 31, 2001 719,269 $ 7 $ 61,360 $ 36,499 $ 2,870 $100,736 =================================================================================================================== Net Income - - 9,827 - 9,827 Cash Dividends Declared on - Common Stock - - (1,472) - (1,472) 5% Stock Dividend 34,501 - 8,625 (8,625) - - Cash Paid in Lieu of Fractional Shares Related to Stock Dividend - - (140) - (140) Redemption of Stock (18,807) - (4,521) - - (4,521) Changes in Net Unrealized Gain (Loss) on Securities Available for Sale - - - (508) (508) ------------------------------------------------------------------------------------------------------------------- Balance, September 30, 2002 734,963 $ 7 $ 65,464 $ 36,089 $ 2,362 $103,922 ===================================================================================================================
The accompanying notes are an integral part of these consolidated financial statements 7 FARMERS & MERCHANTS BANCORP
Consolidated Statement of Cash Flows (Unaudited) Nine Months Ended ------------------------------------------------------------------------------------------------------- (in thousands) Sept. 30, Sept. 30, 2002 2001 ------------------------------------------------------------------------------------------------------- Operating Activities: Net Income $9,827 $9,363 Adjustments to Reconcile Net Income to Net Cash Provided by (Used in) Operating Activities: Provision for Loan Losses 1,000 750 Depreciation and Amortization 1,210 1,172 Provision for Deferred Income Taxes (30) (720) Net Accretion of Investment Securities (94) (307) Net (Gain) on Sale of Investment Securities (378) (90) Net Change in Operating Assets & Liabilities: Increase in Interest Receivable and Other Assets (152) (112) (Increase) Decrease in Interest Payable and Other Liabilities (326) 798 ------------------------------------------------------------------------------------------------------- Net Cash Provided by (Used in) Operating Activities 11,057 10,854 Investing Activities: Securities Available-for-Sale: Purchased (20,113) (14,985) Sold or Matured 115,505 48,105 Securities Held-to-Maturity: Purchased (297) (629) Matured 4,773 9,972 Purchase of Life Insurance Contracts (10,080) - Net Loans Originated or Acquired (83,245) (60,855) Principal Collected on Loans Charged Off 490 657 Net Additions to Premises and Equipment (1,085) (1,259) ------------------------------------------------------------------------------------------------------- Net Cash Provided by (Used by) Investing Activities 5,948 (18,994) Financing Activities: Net Decrease in Demand, Interest-Bearing Transaction, and Savings Accounts (3,285) (4,157) Increase (Decrease) in Time Deposits (15,207) 20,016 Federal Home Loan Bank Borrowings: Advances - - Paydowns (26) (24) Cash Dividends (1,612) (1,539) Stock Redemption (4,521) (455) ------------------------------------------------------------------------------------------------------- Net Cash Provided by (Used in) Financing Activities (24,651) 13,841 Increase (Decrease) in Cash and Cash Equivalents (7,646) 5,701 Cash and Cash Equivalents at Beginning of Year 63,506 74,290 ------------------------------------------------------------------------------------------------------- Cash and Cash Equivalents as of Sept. 30, 2002 and Sept. 30, 2001 $55,860 $79,991 =======================================================================================================
The accompanying notes are an integral part of these consolidated financial statements 8 FARMERS & MERCHANTS BANCORP NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (unaudited) For the nine months ended September 30, 2002 and 2001 1. Significant Accounting Policies Farmers & Merchants Bancorp (the Company) was organized April 30, 1999. Its primary operations are related to traditional banking activities through its subsidiary Farmers & Merchants Bank of Central California (the Bank). The consolidated financial statements of the Company and its subsidiary, the Bank, are prepared in conformity with generally accepted accounting principles and prevailing practices within the banking industry. In preparing the financial statements, management is required to make estimates and assumptions that affect reported amounts as of the date of the balance sheet and revenues and expenses for the period. These estimates are based on information available as of the date of the financial statements. Therefore, actual results could differ from those estimates. The following is a summary of the significant accounting and reporting policies used in preparing the consolidated financial statements. Basis of Presentation The accompanying consolidated financial statements include the accounts of the Company and the Company's wholly owned subsidiary, the Bank, along with the Bank's wholly owned subsidiaries, Farmers & Merchants Investment Corporation and Farmers/Merchants Corp. The investment in the Bank is carried at the Company's equity in the underlying net assets. Significant intercompany transactions have been eliminated in consolidation. Farmers & Merchants Investment Corporation has been dormant since 1991. Farmers/Merchants Corp. acts as trustee on deeds of trust originated by the Bank. Certain amounts in the prior years' financial statements have been reclassified to conform with the current presentation. These reclassifications have no effect on previously reported income. Nature of Operations The Company's primary operations are related to traditional banking activities, including the acceptance of deposits and the lending of money through the operations of the Bank. The Company services the northern Central Valley of California with 18 banking offices. The area includes Sacramento, San Joaquin, Stanislaus and Merced Counties with branches in Sacramento, Elk Grove, Galt, Lodi, Stockton, Linden, Modesto, Turlock and Hilmar. Through its network of banking offices, the Company emphasizes personalized service along with a full range of banking services to businesses and individuals located in the service areas of its offices. Cash and Cash Equivalents For purposes of the Consolidated Statement of Cash Flows, the Company has defined cash and cash equivalents as those amounts included in the balance sheet captions Cash and Due From Banks and Federal Funds Sold and Securities Purchased Under Agreements to Resell. Generally, these transactions are for one-day periods. For these instruments, the carrying amount is a reasonable estimate of fair value. Investment Securities Investment securities are classified at the time of purchase as held-to-maturity if it is management's intent and the Bank has the ability to hold the securities until maturity. These securities are carried at cost, adjusted for amortization of premium and accretion of discount using a methodology which approximates a level yield of interest over the estimated remaining period until maturity. Losses, reflecting a decline in value judged by the Bank to be other than temporary, are recognized in the period in which they become known. 9 Securities are classified as available-for-sale if it is management's intent, at the time of purchase, to hold the securities for an indefinite period of time and/or to use the securities as part of the Company's asset/liability management strategy. Securities classified as available-for-sale include securities which may be sold to effectively manage interest rate risk exposure, prepayment risk, satisfy liquidity demands and other factors. These securities are reported at fair value with aggregate, unrealized gains or losses excluded from income and included as a separate component of shareholders' equity, net of related income taxes. Fair values are based on quoted market prices or broker/dealer price quotations on a specific identification basis. Gains or losses on the sale of these securities are computed using the specific identification method. Unrealized losses on these securities, reflecting a decline in value judged by the Company to be other than temporary, are recognized in the period in which they become known. Trading securities, if any, are acquired for short-term appreciation and are recorded in a trading portfolio and are carried at fair value, with unrealized gains and losses recorded in non-interest income. Loans Loans are reported at the principal amount outstanding net of unearned discounts and deferred loan fees. Interest income on loans is accrued daily on the outstanding balances using the simple interest method. Loan origination fees are deferred and recognized over the contractual life of the loan as an adjustment to the yield. Loans are placed on a non-accrual status when the collection of principal or interest is in doubt or when they become past due for 90 days or more unless they are both well-secured and in the process of collection. For this purpose a loan is considered well-secured if it is collateralized by property having a net realizable value in excess of the amount of the loan or is guaranteed by a financially capable party. When a loan is placed on non-accrual status, the accrued and unpaid interest receivable is reversed and charged against current income, thereafter, interest income is recognized only as it is collected in cash. Loans placed on a non-accrual status are returned to accrual status when the loans are paid current as to principal and interest and future payments are expected to be made in accordance with the contractual terms of the loan. A loan is impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. When a loan is impaired, the recorded amount of the loan in the Consolidated Balance Sheets is based on the present value of expected future cash flows discounted at the loan's effective interest rate or on the observable or estimated market price of the loan or the fair value of the collateral if the loan is collateral dependent. Impaired loans are placed on a non-accrual status with income reported accordingly. Cash payments are first applied as a reduction of the principal balance until collection of the remaining principal and interest can be reasonably assured. Allowance for Loan Losses As a financial institution which assumes lending and credit risks as a principal element in its business, the Company anticipates that credit losses will be experienced in the normal course of business. Accordingly, the allowance for loan losses is maintained at a level considered adequate by management to provide for losses that can be reasonably anticipated. The allowance is increased by provisions charged to operating expense and reduced by net charge-offs. Management reviews the credit quality of the loan portfolio on a quarterly basis and considers problem loans, delinquencies, internal credit reviews, current economic conditions, loan loss experience and other factors in determining the adequacy of the allowance balance. The Company's methodology for assessing the adequacy of the allowance consists of several key elements, which include the formula allowance, specific allowances and the unallocated allowance. 10 The formula allowance is calculated by applying loss factors to outstanding loans and certain unused commitments. Loss factors are based on the Company's historical loss experience and may be adjusted for significant factors that, in management's judgment, affect the collectibility of the portfolio as of the evaluation date. The Company derives the loss factors for loans from a loss migration model and the historical average net charge-offs during a business cycle. Specific allowances are established in cases where management has identified conditions or circumstances related to a credit that management believes indicates the probability a loss has been incurred in excess of the amount determined by the application of the formula allowance. The unallocated allowance is composed of attribution factors, which are based upon management's evaluation of various conditions that are not directly measured in the determination of the formula and specific allowances. The conditions evaluated in connection with the unallocated allowance may include existing general economic and business conditions affecting the key lending areas of the Company, credit quality trends, collateral values, loan volumes and concentration, seasoning of the loan portfolio, specific industry conditions, recent loss experience, duration of the current business cycle, bank regulatory examination results and findings of the Company's internal credit examiners. The allowance also incorporates the results of measuring impaired loans as provided in Statement of Financial Accounting Standards (SFAS) No. 114, "Accounting by Creditors for Impairment of a Loan" and SFAS No. 118, "Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures". These accounting standards prescribe the measurement methods, income recognition and disclosures related to impaired loans, which are discussed more fully in Note 4 of the 2001 Annual Report. While the Company utilizes a systematic methodology in determining its allowance, the allowance is based on estimates, and ultimate losses may vary from current estimates. The estimates are reviewed periodically and, as adjustments become necessary, are reported in earnings in the periods in which they become known. Management has allocated specific reserves to various loan categories. Nevertheless, the allowance is general in nature and is available for the loan portfolio as a whole. Premises and Equipment Premises, equipment and leasehold improvements are stated at cost, less accumulated depreciation and amortization. Depreciation is computed principally by the straight-line method over the estimated useful lives of the assets. Estimated useful lives of buildings range from 30 to 40 years, and for furniture and equipment from 3 to 8 years. Leasehold improvements are amortized over the lesser of the terms of the respective leases, or their useful lives, which are generally 5 to 10 years. Remodeling and capital improvements are capitalized while maintenance and repairs are charged directly to occupancy expense. Other Real Estate Other real estate owned, which is included in other assets, is comprised of properties acquired through foreclosures in satisfaction of indebtedness. These properties are carried at the lower of the recorded loan balance or their estimated fair value, net of selling costs, based on current appraisals. Initial losses on properties acquired through full or partial satisfaction of debt are treated as credit losses and charged to the Allowance for Loan Losses at the time of acquisition. Subsequent declines in value from the recorded amounts, routine holding costs, and gains or losses upon disposition, if any, are included in non-interest income or expense as incurred. 11 Income Taxes As required, the Company uses the liability method of accounting for income taxes. This method results in the recognition of deferred tax assets and liabilities that are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. The deferred provision for income taxes is the result of the net change in the deferred tax asset and deferred tax liability balances during the year. This amount combined with the current taxes payable or refundable results in the income tax expense for the current year. Earnings Per Share The actual number of shares outstanding at September 30, 2002, was 734,963. Basic earnings per share is calculated on the basis of the weighted average number of shares outstanding during the period. Weighted average number of shares for the nine months ending September 30, 2002 and 2001 were 739,417 and 755,581, respectively. Earnings per share for the nine months ending September 30, 2002 and 2001 were $13.29 and $12.39, respectively. Weighted average number of shares for the three months ending September 30, 2002 and 2001 were 735,482 and 755,306, respectively. Earnings per share for the three months ending September 30, 2002 and 2001 were $4.68 and $4.19, respectively. Prior periods per share amounts have been restated for the 5% stock dividend declared during 2002 and 2001. Dividends Farmers & Merchants Bancorp common stock is not traded on any exchange. The shares are primarily held by local residents and are not actively traded. A stock dividend of $2.00 per share was declared in June 2002. In June 2001 the per share dividend was $1.95. Additionally, a 5% stock dividend was declared in March 2002. Segment Reporting The Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information" requires that public companies report certain information about operating segments. It also requires that public companies report certain information about their products and services, the geographic areas in which they operate, and their major customers. The Company is a community bank which offers a wide array of products and services to its customers. Pursuant to its banking strategy, emphasis is placed on building relationships with its customers, as opposed to building specific lines of business. As a result, the Company is not organized around discernible lines of business and prefers to work as an integrated unit to customize solutions for its customers, with business line emphasis and product offerings changing over time as needs and demands change. Thus, all necessary requirements of SFAS No. 131 have been met by the Company as of December 31, 2001. Derivative Instruments and Hedging Activities The Statement of Financial Accounting Standards, No. 133, "Accounting for Derivative Instruments and Certain Hedging Activities" as amended by the Statement of Financial Accounting Standards, No. 138, establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. All derivatives, whether designated in hedging relationships or not, are required to be recorded on the balance sheet at fair value. Changes in the fair values of those derivatives are accounted for depending on the intended use of the derivative and the resulting designation under specified criteria. If the derivative is designated as a fair value hedge, the changes in the fair value of the derivative and of the hedged item attributable to the hedged risk are recognized in earnings. If the derivative is designated as a cash flow hedge, the effective portions of the changes in the fair value of the derivative are recorded in other comprehensive income and are recognized income statement when the hedged items affect earnings. Ineffective portions of changes in the fair value of cash flow hedges are recognized in earnings. As required, SFAS No. 133 was adopted by the Company effective January 1, 2001. 12 The Company utilizes derivative financial instruments such as interest rate caps, floors, swaps and collars. These instruments are purchased and/or sold to reduce the Company's exposure to changing interest rates. The Company marks to market the value of its derivative financial instruments and reflects gain or loss in accordance with SFAS No. 133. Comprehensive Income The Statement of Financial Accounting Standards, "Reporting Comprehensive Income" establishes standards for the reporting and display of comprehensive income and its components in the financial statements. Other comprehensive income refers to revenues, expenses, gains and losses that generally accepted accounting principles recognize as changes in value to an enterprise but are excluded from net income. For the Company, comprehensive income includes net income (loss) and changes in fair value of its available-for-sale investment securities. Recent Accounting Pronouncements -In June 2001, the FASB issued Statement No. 143, Accounting for Asset Retirement Obligations. This Statement addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. This Statement requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. This Statement is effective for financial statements issued for fiscal years beginning after June 15, 2002. The Company does not anticipate that the adoption of Statement No. 143 will have a material impact on the financial condition or operating results of the Company. In April 2002, the FASB issued Statement No. 145, Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections. This Statement rescinds FASB Statement No. 4, Reporting Gains and Losses from Extinguishment of Debt, and an amendment of that Statement, FASB Statement No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements. This Statement also rescinds FASB Statement No. 44, Accounting for Intangible Assets of Motor Carriers. This Statement amends FASB Statement No. 13, Accounting for Leases, to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. This Statement also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. The provisions of this Statement related to the rescission of Statement 4 shall be applied in fiscal years beginning after May 15, 2002. The provisions of this Statement related to Statement 13 shall be effective for transactions occurring after May 15, 2002. All other provisions of this statement shall be effective for financial statements issued on or after May 15, 2002. The Company does not anticipate that the adoption of Statement No. 145 will have a material impact on the financial condition or operating results of the Company. In July 2002, the Financial Accounting Standards Board ("FASB") issued SFAS 146, "Accounting for Costs Associated with Exit or Disposal Activities," which addresses financial accounting and reporting for costs associated with exit or disposal activities and supersedes Emerging Issues Task Force (EITF) Issue 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Under Issue 94-3, a liability for an exit cost as defined in EITF 94-3 was recognized at the date of an entity's commitment to an exit plan. SFAS 146 also establishes that the liability should initially be measured and recorded at fair value. We will adopt the provisions of SFAS 146 for exit or disposal activities that are initiated after December 31, 2002. The Company does not anticipate that the adoption of Statement No. 146 will have a material impact on the financial condition or operating results of the Company. 13 In October 2002, the Financial Accounting Standards Board ("FASB") issued SFAS 147, "Acquisitions of Certain Financial Institutions, an amendment of FASB Statements No. 72 and 144 and FASB Interpretation No. 9". This Statement addresses the financial accounting and reporting for the acquisition of all or part of a financial institution, except for a transaction between two or more mutual enterprises. This Statement removes acquisitions of financial institutions, other than transactions between two or more mutual enterprises, from the scope of FASB Statement No. 72, "Accounting for Certain Acquisitions of Banking or Trust Institutions", and FASB Interpretation No. 9, "Applying APB Opinions No. 16 and 17 When a Savings and Loan Association or a Similar Institution Is Acquired in a Business Combination Accounted for by the Purchase Method". This Statement also provides guidance on the accounting for the impairment or disposal of acquired long-term customer-relationship intangible assets (such as depositor- and borrower-relationship intangible assets and credit cardholder intangible assets), including those acquired in transactions between two or more mutual enterprises. We will adopt the provisions of SFAS 147 for acquisitions for which the date of acquisition is on or after October 1, 2002. The Company does not anticipate that the adoption of Statement No. 147 will have a material impact on the financial condition or operating results of the Company. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS Management's discussion and analysis is written to provide greater insight into the results of operations and the financial condition of Farmers & Merchants Bancorp and its subsidiaries. Throughout this discussion, "Company" refers to Farmers & Merchants Bancorp and its subsidiaries as a consolidated entity and "Bank" refers to Farmers & Merchants Bank of Central California. For a more complete understanding of the Company and its operations, reference should be made to the financial statements included in this report and in the Company's 2001 Annual Report on Form 10-K. Certain statements in this Report on Form 10-Q constitute "forward-looking statements" and usually contain the words "estimate," "project," "expect," "objective," "goal," or similar expressions and include assumptions concerning the Company's operations, future results, and prospects. These forward-looking statements are based upon current expectations and are subject to risk and uncertainties. In connection with the "safe-harbor" provisions of the private Securities Litigation Reform Act of 1995, the Company provides the following cautionary statement identifying important factors which could cause the actual results of events to differ materially from those set forth in or implied by the forward-looking statements and related assumptions. Such factors include the following: (i) the effect of changing regional and national economic conditions; (ii) significant changes in interest rates and prepayment speeds; (iii) credit risks of commercial, real estate, consumer, and other lending activities; (iv) changes in federal and state Banking regulations and; (v) other external developments which could materially impact the Company's operational and financial performance. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The Company undertakes no obligation to update any forward-looking statements to reflect events or circumstances arising after the date on which they are made. 14 Analysis of the Results of Operations Overview For the three and nine months ended September 30, 2002, Farmers & Merchants Bancorp reported net income of $3,445,000 and $9,827,000 earnings per share of $4.68 and $13.29, return on average assets of 1.45% and 1.39%. Return on average shareholders' equity (net of accumulated other comprehensive income) was 13.86% and 13.34% for the three and nine months ended September 30, 2002. For the three and nine months ending September 30, 2001, net income totaled $3,162,000 and 9,363,000, earnings per share was $4.19 and $12.39, return on average assets was 1.37% and 1.39%. Return on average shareholders' equity (net of accumulated other comprehensive income) was 13.32% for both the three and nine months ended September 30, 2001. The Company's improved earnings performance in 2002 was due to a combination of change in asset mix, improvement in non-interest income, control of non-interest expense and a reduction of the Company's effective tax rate. The following is a summary of the financial results for the nine-month period ending September 30, 2002 compared to September 30, 2001. o Net income for the period totaled $9.8 million, up 4.9% over one year ago. o Net interest income decreased 1.3% to $30.3 million from $30.7 million. o The provision for loan losses totaled $1.0 million for the period compared to $750 thousand one year ago. o Non-interest income increased 28.4% to $7.9 million, from the $6.1 million reported for 2001. o Non-interest expense increased 4.4% to $21.6 million, from $20.7 million in 2001. o Total assets increased 2.4% to $955.2 million. o Gross loans increased 22.8% to $685.9 million, an increase of $127.3 million. o Total deposits increased 2.6% to $801.2 million. o Investment securities totaled $175.4 million compared to $283.2 million at September 30, 2001. o Total shareholders' equity increased $2.6 million to $103.9 million. Net Interest Income Net interest income is the amount by which the interest and fees on loans and interest earning assets exceed the interest paid on interest bearing sources of funds. For the purpose of analysis, the interest earned on tax-exempt investments and municipal loans is adjusted to an amount comparable to interest subject to normal income taxes. This adjustment is referred to as "taxable equivalent" and is noted wherever applicable. Interest income and expense are affected by changes in the volume and mix of average interest earning assets and average interest bearing liabilities, as well as fluctuations in interest rates. Therefore, increases or decreases in net interest income are analyzed as changes in volume, changes in rate and changes in the mix of assets and liabilities. 15 Net interest income declined 1.3% to $30.3 million during the first nine months of 2002, compared to $30.7 million at September 30, 2001. Net interest income for the quarter ended September 30, 2002 and 2001 totaled $10.3 and $9.9 million, respectively. On a fully taxable equivalent basis, net interest income decreased 1.4% and totaled $31.2 million at September 30, 2002, compared to $31.6 million for the first nine months of 2001. Net interest income on a taxable equivalent basis, expressed as a percentage of average total earning assets, is referred to as the net interest margin, which represents the average net effective yield on earning assets. . For the nine months ended September 30, 2002, the net interest margin was 4.8% compared to 4.9% in 2001. For the three months ended September 30, 2002, the net interest margin was 4.8% compared to 4.6% for the same period in 2001. Loans, the Company's highest earning asset, increased $127.4 million as of September 30, 2002 compared to September 30, 2001. On an average balance basis, loans increased by $130.2 million for the three months ended September 30, 2002 and $112.4 million for the nine months ended September 2002. Due to the decline in interest rates during 2001, the yield on the loan portfolio decreased 164 and 214 basis points to 6.5% and 6.6% for the three and nine months ending September 30, 2002 compared to 8.12% and 8.79% for the three and nine months ending September 30, 2001. This decrease in yield was partially offset by the growth in loan balances, which minimized the decrease in interest revenue from loans to $2.7 million for the first nine months of 2002. The investment portfolio is the other main component of the Company's earning assets. The Company's investment policy is conservative. The Company primarily invests in mortgage-backed securities, U.S. Treasuries, U.S. Government Agencies, and high-grade municipals. Since the risk factor for these types of investments is significantly lower than that of loans, the yield earned on investments is less than that of loans. Average investment securities decreased $82.2 million compared to the average balance at September 30, 2001. As securities matured, the proceeds were used to fund loan growth. The decrease in the average balance of investment securities was followed with a corresponding decrease in interest income of $4.3 million for the nine months ending September 30, 2002. The average yield, on a taxable equivalent basis, in the investment portfolio was 6.4% in 2002 compared to 6.5% in 2001. Net interest income on the Average Balance Sheet is shown on a taxable equivalent basis, which is higher than net interest income on the Consolidated Statements of Income because of adjustments that relate to income on certain securities that are exempt from federal income taxes. Average interest-bearing deposits increased $20.5 million or 3.4% from a year ago. As a result of the decline in interest rates, interest expense on interest-bearing deposits decreased 46.5%. Overall, the average interest cost on interest bearing deposits was 1.9% for the nine-month period ended September 30, 2002 and 3.7% at September 30, 2001. The Company's earning assets and rate sensitive liabilities are subject to repricing at different times, which exposes the Company to income fluctuations when interest rates change. In order to minimize income fluctuations, the Company attempts to match asset and liability maturities. However, some maturity mismatch is inherent in the asset and liability mix. 16 Allowance for Loan Losses As a financial institution that assumes lending and credit risks as a principal element of its business, the Company anticipates that credit losses will be experienced in the normal course of business. The allowance for loan losses is established to absorb losses inherent in the portfolio. The allowance for loan losses is maintained at a level considered by management to be adequate to provide for risks inherent in the loan portfolio. In determining the adequacy of the allowance for loan losses, management takes into consideration examinations by the Company's supervisory authorities, results of internal credit reviews, financial condition of borrowers, loan concentrations, prior loan loss experience, and general economic conditions. The allowance is based on estimates and ultimate losses may vary from the current estimates. Management reviews these estimates periodically and, when adjustments are necessary, they are reported in the period in which they become known. The Company's written lending policies, along with applicable laws and regulations governing the extension of credit, require risk analysis as well as ongoing portfolio and credit management through loan product diversification, lending limits, ongoing credit reviews and approval policies prior to funding of any loan. The Company manages and controls credit risk through diversification, dollar limits on loans to one borrower and by primarily restricting loans made to its principal market area. Loans that are performing but have shown some signs of weakness are subjected to more stringent reporting. Fixed-rate real estate loans are comprised primarily of loans with maturities of less than five years. Generally, long-term residential loans are originated by the Company and sold on the secondary market. The appropriate allowance amount is based upon growth in the loan portfolio, management's evaluation of the credit quality of the loan portfolio, the prevailing economic climate, and its effect on borrowers' ability to repay loans in accordance with the terms of the notes and current loan losses. After reviewing all factors, management concluded that the current allowance for loan losses was adequate. As of September 30, 2002, the allowance for loan losses was $13.1million, which represents 1.9% of the total loan balances. For the period ended September 30, 2001, the allowance was $13.0 million and 2.3% of total loans. The table below illustrates the change in the allowance for the first nine months of 2002 and 2001.
Allowance for Loan Losses (in thousands) -------------------------- Balance, December 31, 2001 $ 12,709 Provision Charged to Expense 1,000 Recoveries of Loans Previously Charged Off 490 Loans Charged Off (1,081) ============================================================= Balance, September 30, 2002 13,118 ============================================================= Balance, December 31, 2000 $ 11,876 Provision Charged to Expense 750 Recoveries of Loans Previously Charged Off 657 Loans Charged Off (254) ============================================================= Balance, September 30, 2001 $ 13,029 =============================================================
17 Non-Interest Income Overall, non-interest income increased $1.7 million or 28.4% for the nine months ending September 30, 2002 compared to the same period of 2001. For the third quarter of 2002, non-interest income increased 17.0% over the same quarter of last year. Service charges on deposits increased $453 thousand for the nine months ended September 30, 2002, due to additional services offered and pricing considerations. $16.7 million in investment securities, which were close to their maturity date, were sold to aid in funding loan growth. This sale resulted in a gain of $263 thousand during second quarter of 2002. Other non-interest income grew $1.1 million through the third quarter of 2002. The increase was the result of the increase in the cash surrender value of life insurance contracts, which is recognized as other non-interest income. Non-Interest Expense Salaries and Employee Benefits increased $166 thousand or 1.3% from the prior year due to merit increases and additional staffing requirements. Occupancy expense increased less than one percent from the prior year. For the quarter ended September 30, 2002, occupancy expense decreased $16 thousand from the quarter ended September 30, 2001. Equipment expense increased $235 thousand or 16.1% from the prior year. This increase was due to the purchase and installation of a new voice and data system during first quarter of 2002. Also, software and hardware maintenance increased in 2002 compared to 2001 due to the conversion to a new core operating system during second quarter of 2001. Other operating expense increased $505 thousand or 10.1% from September 30, 2001, due to an increase in outside professional fees and an increase in marketing expenditures promoting various loan products. Overall, non-interest expense increased $912 thousand or 4.4% over the third quarter of 2001. It is anticipated that the future growth rate in other operating expense will remain modest and comparable to the growth in assets. Income Taxes The provision for income taxes decreased 1.4% to $2.0 million for the third quarter of 2002, and 4.5% to $5.7 million for the first nine months of 2002. This was due to the purchase of insurance contracts in which the increase in the cash surrender value, which is recorded in non-interest income, is exempt from federal and state income taxes. For the nine months ended September 30, 2001, the provision totaled $5.9 million. Additionally, the Company's effective tax rate decreased for the first nine months of 2002 and was 36.6% compared to 38.8% for the same period in 2001. Balance Sheet Analysis Investment Securities The Financial Accounting Standards Board statement, Accounting for Certain Investments in Debt and Equity Securities, requires the Company to classify its investments as held-to-maturity, trading or available-for-sale. Securities are classified as held-to-maturity and accounted for at amortized cost when the Company has the positive intent and ability to hold the securities to maturity. Trading securities are securities acquired for short-term appreciation and are carried at fair value, with unrealized gains and losses recorded in non-interest income. Securities classified as available-for-sale include securities, which may be sold to effectively manage interest rate risk exposure, prepayment risk, satisfy liquidity demand and other factors. These securities are reported at fair value with aggregate, unrealized gains or losses excluded from income and included as a separate component of shareholders' equity, net of related income taxes. 18 The investment portfolio provides the Company with an income alternative to loans. As of September 30, 2002 the investment portfolio represented 18.4% of the Company's total assets. Total investment securities decreased $107.9 million from a year ago and now total $175.4 million. This decrease was used to fund the Bank's strong loan growth. Not included in the investment portfolio are overnight investments in Federal Funds Sold. For the nine months ended September 30, 2002, average Federal Funds Sold was $30.2 million compared to $46.3 in 2001. Loans The Company's loan portfolio at September 30, 2002 increased $127.4 million from September 30, 2001. The increase is the result of an aggressive calling program on high quality loan prospects. Additionally, on an average balance basis loans have increased $112.4 million or 21.9%. Management believes that loans will continue to grow at a moderate rate through fourth quarter, 2002. The table following sets forth the distribution of the loan portfolio by type as of the dates indicated.
Loan Portfolio As Of: (in thousands) September 30, 2002 Dec. 31, 2001 September 30, 2001 ---------------------------------------- ------------------------- ---------------------- ------------------------- Real Estate Construction $ 54,255 $ 49,692 $ 40,588 Real Estate - Other 360,097 304,451 284,649 Commercial 251,970 227,909 210,560 Consumer 19,619 21,133 22,787 ---------------------------------------- ------------------------- ---------------------- ------------------------- Gross Loans 685,941 603,185 558,584 Less: Unearned Income 1,554 1,016 586 Allowance for Loan Losses 13,118 12,709 13,029 ---------------------------------------- ------------------------- ---------------------- ------------------------- Net Loans $ 671,269 $ 589,460 $ 544,969 ======================================== ========================= ====================== =========================
In the ordinary course of business, the Company enters into commitments to extend credit to its customers. These commitments are not reflected in the accompanying consolidated financial statements. As of September 30, 2002, the Company had entered into commitments with certain customers amounting to $238.0 million compared to $226.4 million at December 31, 2001. Letters of credit at September 30, 2002, and December 31, 2001, were $13.8 million and $3.6 million, respectively. Non-Performing Assets As set forth in the table below, non-performing loans as of September 30, 2002, were $3.7 million compared to $1.5 million at September 30, 2001. Accrued interest reversed from income on loans placed on a non-accrual status totaled $285 thousand at September 30, 2002 compared to $36 thousand at September 30, 2001. The Company reported no other real estate owned for both September 30, 2002 and September 30, 2001.
Non-Performing Assets (dollar amounts in thousands) Sept. 30, 2002 Dec. 31, 2001 Sept. 30, 2001 ---------------------------------------- ----------------------- ------------------------ ----------------------- Nonperforming Loans $3,721 $2,409 $1,537 Other Real Estate Owned 0 0 0 ======================================== ======================= ======================== ======================= Total $3,721 $2,409 $1,537 ======================================== ======================= ======================== ======================= Non-Performing Assets as a % of Total Loans 0.5% 0.4% 0.3% Allowance for Loan Losses as a % of Non-Performing Loans 352.5% 527.6% 847.7%
19 Except for non-performing loans shown in the table above, the Bank's management is not aware of any loans as of September 30, 2002 for which known credit problems of the borrower would cause serious doubts as to the ability of such borrowers to comply with their present loan repayment terms, or any known events that would result in the loan being designated as non-performing at some future date. The Bank's management cannot, however, predict the extent to which the deterioration in general economic conditions, real estate values, increase in general rates of interest, change in the financial conditions or business of a borrower may adversely affect a borrower's ability to pay. Deposits The primary source of funds to support earning assets (loans and investments) is the generation of deposits from the Company's customer base. The ability to grow the customer base and subsequently deposits is a significant element in the performance of the Company. At September 30, 2002, deposits totaled $801.2 million. This represents an increase of 2.6% or $20.7 million from September 30, 2001. The increase was focused in demand, interest bearing transaction (IBT) and savings accounts, which increased $18.8 million, $2.6 million and $36.7 million, respectively. The Bank's calling efforts for prospective customers includes acquiring both loan and deposit relationships which results in new demand, IBT and savings accounts. While demand, IBT and savings accounts have increased; time deposit balances have decreased $37.5 million or 10.9%. Rates are low and as existing customers' CD's mature those customers are opting to instead invest in short-term deposits. It is expected that this trend will continue through fourth quarter of 2002. Capital Much attention has been directed at the capital adequacy of the financial institution industry. The Company relies on capital generated through the retention of earnings to satisfy its capital requirements. The Company engages in an ongoing assessment of its capital needs in order to support business growth and to insure depositor protection. Shareholders' Equity totaled $103.9 million at September 30, 2002 and $101.3 million at September 30, 2001, which represents an increase of $2.6 million or 2.6%. The Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation have adopted risk-based capital guidelines. The guidelines are designed to make capital requirements more sensitive to differences in risk related assets among Banking organizations, to take into account off-balance sheet exposures and to aid in making the definition of Bank capital uniform. Company assets and off-balance sheet items are categorized by risk. The results of these regulations are that assets with a higher degree of risk require a larger amount of capital; assets, such as cash, with a low degree of risk have little or no capital requirements. Under the guidelines the Company is currently required to maintain regulatory risk based capital equal to at least 8.0%. As of September 30, 2002 the Company meets all capital adequacy requirements to which it is subject. The following table illustrates the relationship between regulatory capital requirements and the Company and Bank's capital position.
To Be Well Capitalized Under Regulatory Capital Prompt Corrective (in thousands) Actual Requirements Action Provisions ------------------------------------------------------------------------------------------------------------------ The Company: Amount Ratio Amount Ratio Amount Ratio ------------------------------------------------------------------------------------------------------------------ As of September 30, 2002 Total Capital to Risk Weighted Assets $112,622 12.76% $70,629 8.0% N/A N/A Tier I Capital to Risk Weighted Assets $101,561 11.50% $35,315 4.0% N/A N/A Tier I Capital to Average Assets $101,561 10.70% $37,979 4.0% N/A N/A
20
To Be Well Capitalized Under Regulatory Capital Prompt Corrective (in thousands) Actual Requirements Action Provisions ------------------------------------------------------------------------------------------------------------------ The Bank: Amount Ratio Amount Ratio Amount Ratio ------------------------------------------------------------------------------------------------------------------ As of September 30, 2002 Total Capital to Risk Weighted Assets $108,205 12.31% $70,348 8.0% $87,935 10.0% Tier I Capital to Risk Weighted Assets $97,187 11.05% $35,174 4.0% $52,761 6.0% Tier I Capital to Average Assets $97,187 10.28% $37,806 4.0% $47,257 5.0%
Risk Management The Company has adopted a Risk Management Plan to ensure the proper control and management of all risk factors inherent in the operation of the Company and the Bank. Specifically, credit risk, interest rate risk, liquidity risk, compliance risk, strategic risk, reputation risk and price risk can all affect the market risk of the Company. These specific risk factors are not mutually exclusive. It is recognized that any product or service offered by the Company may expose the Company and Bank to one or more of these risk factors. Credit Risk Credit risk is the risk to earnings or capital arising from an obligor's failure to meet the terms of any contract or otherwise fail to perform as agreed. Credit risk is found in all activities where success depends on counterparty, issuer, or borrower performance. Central to the Company's credit risk management is a proven loan risk rating system. Limitations on industry concentration, aggregate customer borrowings and geographic boundaries also reduce loan credit risk. Credit risk in the investment portfolio is minimized through clearly defined limits in the Bank's policy statements. Senior Management, Directors Committees, and the Board of Directors are provided with timely and accurate information to appropriately identify, measure, control and monitor the credit risk of the Company and the Bank. The allowance for loan losses is based on estimates of probable losses inherent in the loan portfolio. The amount actually incurred with respect to these losses can vary significantly from the estimated amounts. The Company's methodology includes several features which are intended to reduce the difference between estimated and actual losses. Implicit in lending activities is the risk that losses will and do occur and that the amount of such losses will vary over time. Consequently, the Company maintains an allowance for loan losses by charging a provision for loan losses to earnings. Loans determined to be losses are charged against the allowance for loan losses. The Company's allowance for loan losses is maintained at a level considered by management to be adequate to provide for estimated credit losses inherent in the portfolio. The Company's methodology for assessing the appropriateness of the allowance consists of several key elements, which include the formula allowance and specific allowances for identified problem loans and portfolio segments. Specific allowances are established in cases where management has identified conditions or circumstances related to credit that management believes indicate the possibility that a loss may be incurred in excess of the amount determined by the application of the formula reserve. Management performs a detailed analysis of these loans, including, but not limited to appraisals of the collateral, conditions of the marketplace for liquidating the collateral and assessment of the guarantors. Management then determines the loss potential and allocates a portion of the allowance for losses for each of these credits. 21 Management believes that the allowance for loan losses at September 30, 2002 was adequate to provide for recognized, unidentified and estimated inherent losses in the portfolio. No assurances can be given that future events may not result in increases in delinquencies, non-performing loans or net loan chargeoffs that would increase the provision for loan losses and thereby adversely affect the results of operations. Item 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Asset / Liability Management - Interest Rate Risk The mismatch between maturities of interest sensitive assets and liabilities results in uncertainty in the Company's earnings and economic value and is referred to as interest rate risk. Farmers & Merchants Bancorp's primary objective in managing interest rate risk is to minimize the potential for significant loss as a result of changes in interest rates. The Company measures interest rate risk in terms of potential impact on both its economic value and earnings. The methods for governing the amount of interest rate risk include: analysis of asset and liability mismatches (GAP analysis), the utilization of a simulation model and limits on maturities of investment, loan and deposit products to relatively short periods which reduces the market volatility of those instruments. The gap analysis measures, at specific time intervals, the divergence between earning assets and interest bearing liabilities for which repricing opportunities will occur. A positive difference, or gap, indicates that earning assets will reprice faster than interest-bearing liabilities. This will generally produce a greater net interest margin during periods of rising interest rates and a lower net interest margin during periods of declining interest rates. Conversely, a negative gap will generally produce a lower net interest margin during periods of rising interest rates and a greater net interest margin during periods of decreasing interest rates. The interest rates paid on deposit accounts do not always move in unison with the rates charged on loans. In addition, the magnitude of changes in the rates charged on loans is not always proportionate to the magnitude of changes in the rate paid for deposits. Consequently, changes in interest rates do not necessarily result in an increase or decrease in the net interest margin solely as a result of the differences between repricing opportunities of earning assets or interest bearing liabilities. The Company also utilizes the results of a dynamic simulation model to quantify the estimated exposure of net interest income to sustained interest rate changes. The sensitivity of the Company's net interest income is measured over a rolling one-year horizon. The simulation model estimates the impact of changing interest rates on interest income from all interest earning assets and the interest expense paid on all interest bearing liabilities reflected on the Company's balance sheet. This sensitivity analysis is compared to policy limits, which specify a maximum tolerance level for net interest income exposure over a one-year horizon assuming no balance sheet growth, given both a 200 basis point upward and downward shift in interest rates. A parallel and pro rata shift in rates over a 12-month period is assumed. Results that exceed policy limits, if any, are analyzed for risk tolerance and reported to the Board with appropriate recommendations. At September 30, 2002, the Company's estimated net interest income sensitivity to changes in interest rates, as a percent of net interest income was an increase in net interest income of 4.7% if rates increase by 200 basis points and a decrease in net interest income of 2.2% if rates decline 100 basis points. 22 The estimated sensitivity does not necessarily represent a Company forecast and the results may not be indicative of actual changes to the Company's net interest income. These estimates are based upon a number of assumptions including: the nature and timing of interest rate levels including yield curve shape, prepayments on loans and securities, pricing strategies on loans and deposits, replacement of asset and liability cashflows, and other assumptions. While the assumptions used are based on current economic and local market conditions, there is no assurance as to the predictive nature of these conditions including how customer preferences or competitor influences might change. Liquidity Liquidity risk is the risk to earnings or capital resulting from the Bank's inability to meet its obligations when they come due without incurring unacceptable losses. It includes the ability to manage unplanned decreases or changes in funding sources and to recognize or address changes in market conditions that affect the Bank's ability to liquidate assets or acquire funds quickly and with minimum loss of value. The Company endeavors to maintain a cash flow adequate to fund operations, handle fluctuations in deposit levels, respond to the credit needs of borrowers and to take advantage of investment opportunities as they arise. The principal sources of liquidity include interest and principal payments on loans and investments, proceeds from the maturity or sale of investments, and growth in deposits. In general, liquidity risk is managed daily by controlling the level of Fed Funds and the use of funds provided by the cash flow from the investment portfolio. The Company maintains overnight investments in Fed Funds as a reserve for temporary liquidity needs. During the first nine months of 2002, Federal Funds averaged $30.2 million. In addition, the Company maintains Federal Fund credit lines of $136 million with major correspondent banks subject to the customary terms and conditions for such arrangements. At September 30, 2002, the Company had available liquid assets, which included cash and unpledged investment securities of approximately $112.5 million, which represents 11.8% of total assets. For short term liquidity needs the Bank has $50 million in unused fed funds lines with other financial institutions. On a long term basis the Bank relies on deposit growth and has available funding sources of an additional $243 million through the Federal Home loan Bank and approved brokered deposit sources. ITEM 4. CONTROLS AND PROCEDURES The Company maintains controls and procedures designed to ensure that information is recorded and reported in all filings of financial reports. Such information is reported to the Company's management, including its Chief Executive Officer and its Chief Financial Officer to allow timely and accurate disclosure based on the definition of "disclosure controls and procedures" in Rule 13a-14(c). In designing these controls and procedures, management recognizes that they can only provide reasonable assurance of achieving the desired control objectives. Management also evaluated the cost-benefit relationship of possible controls and procedures. Within 90 days prior to the date of this report, the Company carried out an evaluation of the effectiveness of Company's controls and disclosure procedures under the supervision and with the participation of the Chief Executive Officer, the Chief Financial Officer and other senior management of the Company. Based on the foregoing, the Company's Chief Executive Officer and the Chief Financial Officer concluded that the Company's disclosure controls and procedures were effective. There have been no significant changes in the Company's internal controls or in other factors that could significantly affect the internal controls subsequent to the date the Company completed its evaluation. 23 Average Balance Sheets The tables on the following pages reflect the Company's average balance sheets and volume and rate analysis for the three-month and nine-month periods ending September 30, 2002 and 2001. The average yields on earning assets and average rates paid on interest-bearing liabilities have been computed on an annualized basis for purposes of comparability with full year data. Average balance amounts for assets and liabilities are the computed average of daily balances. The volume and rate analysis of net interest revenue summarizes the changes in average asset and liability balances and interest earned and paid resulting from changes in average asset and liability balances (volume) and changes in average interest rates and the total net change in interest income and expenses. The changes in interest due to both rate and volume have been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amount of the change in each. 24 Farmers & Merchants Bancorp Quarterly Average Balances and Interest Rates (Interest and Rates on a Taxable Equivalent Basis) (in thousands)
Three Months Ended September 30, Three Months Ended September 30, 2002 2001 Assets Balance Interest Rate Balance Interest Rate ---------------------------------------------------------------------------------------------------------------------------------- Federal Funds Sold $ 24,857 $ 55 0.88% $ 52,125 $ 458 3.49% Investment Securities Available-for-Sale U.S. Treasuries 0 0 0.00% 0 0 0.00% U.S. Agencies 0 0 0.00% 5,078 72 5.63% Municipals - Taxable 1,469 22 6.07% 1,850 30 6.43% Municipals - Non-Taxable 21,989 368 6.79% 22,161 369 6.61% Mortgage Backed Securities 122,101 1,794 5.96% 215,810 3,410 6.27% Other 8,306 149 7.18% 6,099 93 6.05% ---------------------------------------------------------------------------------------------------------------------------------- Total Investment Securities Available-for-Sale 153,865 2,333 6.14% 250,998 3,974 6.28% ---------------------------------------------------------------------------------------------------------------------------------- Investment Securities Held-to-Maturity U.S. Treasuries 0 0 0.00% 0 0 0.00% U.S. Agencies 0 0 0.00% 0 0 0.00% Municipals - Taxable 0 0 0.00% 1,012 21 8.23% Municipals - Non-Taxable 28,435 521 7.44% 31,643 581 7.29% Mortgage Backed Securities 0 0 0.00% 0 0 0.00% Other 530 8 6.12% 635 16 10.00% ---------------------------------------------------------------------------------------------------------------------------------- Total Investment Securities Held-to-Maturity 28,965 529 7.41% 33,290 618 7.37% ---------------------------------------------------------------------------------------------------------------------------------- Loans Real Estate 400,300 6,834 6.77% 314,255 6,590 8.32% Commercial 251,125 3,687 5.82% 203,390 3,876 7.56% Installment 15,155 339 8.87% 18,973 491 10.27% Credit Card 3,306 77 9.24% 3,358 95 11.22% Municipal 1,205 17 5.60% 887 13 5.81% ---------------------------------------------------------------------------------------------------------------------------------- Total Loans 671,091 10,954 6.48% 540,863 11,065 8.12% ---------------------------------------------------------------------------------------------------------------------------------- Total Earning Assets 878,778 $13,871 6.26% 877,276 $16,115 7.29% ========================= ========================= Unrealized Gain/(Loss) on Securities Available-for-Sale 4,597 4,210 Allowance for Loan Losses (13,257) (12,987) Cash and Due From Banks 28,438 29,309 All Other Assets 52,400 24,598 ------------------------------------------------------------------- ------------- Total Assets $950,956 $922,406 =================================================================== ============= Liabilities & Shareholders' Equity Interest Bearing Deposits Interest Bearing DDA $85,062 $ 61 0.28% $78,712 $ 159 0.80% Savings 223,153 422 0.75% 186,783 957 2.03% Time Deposits 311,618 2,173 2.77% 346,865 4,165 4.76% ---------------------------------------------------------------------------------------------------------------------------------- Total Interest Bearing Deposits 619,833 2,656 1.70% 612,360 5,281 3.42% Other Borrowed Funds 40,979 562 5.44% 41,012 570 5.51% ---------------------------------------------------------------------------------------------------------------------------------- Total Interest Bearing Liabilities 660,812 $3,218 1.93% 653,372 $5,851 3.55% ========================= ========================= Demand Deposits (Non-Interest Bearing) 179,196 161,383 All Other Liabilities 8,877 10,191 ------------------------------------------------------------------- ------------- Total Liabilities 848,885 824,946 Shareholders' Equity 102,071 97,460 ------------------------------------------------------------------- ------------- Total Liabilities & Shareholders' Equity $950,956 $922,406 =================================================================== ============= Net Interest Margin 4.81% 4.64% ==================================================================================================================================
Notes: Yields on municipal securities have been calculated on a fully taxable equivalent basis using the applicable Federal and State income tax rates for the period. Recognized loan Fees are included in interest income for loans. Unearned discount is included for rate calculation purposes. Nonaccrual loans have been included in the average balances. Yields on securities available-for-sale are based on historical cost. 25 Farmers & Merchants Bancorp Year-to-Date Average Balances and Interest Rates (Interest and Rates on a Taxable Equivalent Basis) (in thousands)
Nine Months Ended September 30, Nine Months Ended September 30, 2002 2001 Assets Balance Interest Rate Balance Interest Rate ---------------------------------------------------------------------------------------------------------------------------------- Federal Funds Sold $ 30,203 $ 385 1.70% $ 46,302 $ 1,560 4.49% Investment Securities Available-for-Sale U.S. Treasuries 0 0 0.00% 1,365 55 5.37% U.S. Agencies 3,363 133 5.35% 5,655 243 5.72% Municipals - Taxable 1,567 73 6.30% 1,942 91 6.24% Municipals - Non-Taxable 21,899 1,097 6.77% 21,903 1,056 6.42% Mortgage Backed Securities 150,659 6,874 6.17% 225,320 10,778 6.37% Other 8,721 459 7.03% 5,441 279 6.83% ---------------------------------------------------------------------------------------------------------------------------------- Total Investment Securities Available-for-Sale 186,209 8,636 6.27% 261,626 12,502 6.37% ---------------------------------------------------------------------------------------------------------------------------------- Investment Securities Held-to-Maturity U.S. Treasuries 0 0 0.00% 0 0 0.00% U.S. Agencies 0 0 0.00% 491 22 5.97% Municipals - Taxable 0 0 0.00% 2,291 114 6.63% Municipals - Non-Taxable 29,231 1,610 7.45% 33,088 1,852 7.45% Mortgage Backed Securities 0 0 0.00% 0 0 0.00% Other 538 25 6.28% 651 49 10.03% ---------------------------------------------------------------------------------------------------------------------------------- Total Investment Securities Held-to-Maturity 29,769 1,635 7.43% 36,521 2,037 7.43% ---------------------------------------------------------------------------------------------------------------------------------- Loans Real Estate 376,570 19,808 7.03% 301,020 20,322 8.99% Commercial 228,337 9,936 5.82% 187,168 11,627 8.28% Consumer 15,666 1,053 8.99% 19,908 1,515 10.14% Credit Card 3,304 235 9.51% 3,428 280 10.88% Municipal 987 50 6.77% 894 57 8.49% ---------------------------------------------------------------------------------------------------------------------------------- Total Loans 624,864 31,082 6.65% 512,418 33,801 8.79% ---------------------------------------------------------------------------------------------------------------------------------- Total Earning Assets 871,045 $41,738 6.41% 856,867 $49,900 7.76% ========================= ========================= Unrealized Gain/(Loss) on Securities Available-for-Sale 4,868 2,940 Allowance for Loan Losses (13,115) (12,469) Cash and Due From Banks 28,443 27,912 All Other Assets 48,926 25,518 ------------------------------------------------------------------- ------------- Total Assets $940,167 $900,768 =================================================================== ============= Liabilities & Shareholders' Equity Interest Bearing Deposits Interest Bearing DDA $87,252 $ 225 0.34% $75,376 $ 507 0.90% Savings 216,258 1,562 0.97% 181,402 2,827 2.08% Time Deposits 311,897 7,070 3.03% 338,108 13,237 5.22% ---------------------------------------------------------------------------------------------------------------------------------- Total Interest Bearing Deposits 615,407 8,857 1.92% 594,886 16,571 3.71% Other Borrowed Funds 40,988 1,668 5.44% 41,021 1,680 5.46% ---------------------------------------------------------------------------------------------------------------------------------- Total Interest Bearing Liabilities 656,395 $10,525 2.14% 635,907 $18,251 3.82% ========================= ========================= Demand Deposits (Non-Interest Bearing) 174,231 159,882 All Other Liabilities 8,503 9,513 ------------------------------------------------------------------- ------------- Total Liabilities 839,129 805,302 Shareholders' Equity 101,038 95,466 ------------------------------------------------------------------- ------------- Total Liabilities & Shareholders' Equity $940,167 $900,768 =================================================================== ============= Net Interest Margin 4.79% 4.92% ==================================================================================================================================
Notes: Yields on municipal securities have been calculated on a fully taxable equivalent basis using the applicable Federal and State income tax rates for the period. Recognized loan Fees are included in interest income for loans. Unearned discount is included for rate calculation purposes. Nonaccrual loans have been included in the average balances. Yields on securities available-for-sale are based on historical cost. 26 Farmers & Merchants Bancorp Volume and Rate Analysis of Net Interest Revenue (Rates on a Taxable Equivalent Basis)
(in thousands) Three Months Ended Nine Months Ended Sept. 30, 2002 vs. Sept. 30, 2001 Sept. 30, 2002 vs. Sept. 30, 2001 Interest Earning Assets Volume Rate Net Chg. Volume Rate Net Chg. --------------------------------------------------------------------------------------------------------------------------------- Federal Funds Sold $ (166) $ (237) $ (403) $ (423) $ (752) $ (1,175) Investment Securities Available for Sale U.S. Treasuries 0 0 0 (27) (27) (54) U.S. Agencies (36) (37) (73) (94) (15) (109) Municipals - Taxable (7) (2) (9) (19) 1 (18) Municipals - Non-Taxable (18) 18 0 0 41 41 Mortgage Backed Securities (1,450) (165) (1,615) (3,560) (344) (3,904) Other 31 25 56 167 12 179 --------------------------------------------------------------------------------------------------------------------------------- Total Investment Securities Available for Sale (1,480) (161) (1,641) (3,533) (332) (3,865) --------------------------------------------------------------------------------------------------------------------------------- Investment Securities Held to Maturity U.S. Treasuries 0 0 0 0 0 0 U.S. Agencies 0 0 0 (11) (11) (22) Municipals - Taxable (10) (10) (20) (57) (57) (114) Municipals - Non-Taxable (128) 68 (60) (241) (2) (243) Mortgage Backed Securities 0 0 0 0 0 0 Other (2) (6) (8) (7) (16) (23) --------------------------------------------------------------------------------------------------------------------------------- Total Investment Securities Held to Maturity (140) 52 (88) (316) (86) (402) --------------------------------------------------------------------------------------------------------------------------------- Loans: Real Estate 5,935 (5,691) 244 6,041 (6,556) (515) Commercial 3,474 (3,663) (189) 3,195 (4,886) (1,691) Installment (91) (61) (152) (302) (160) (462) Credit Card (2) (17) (19) (10) (35) (45) Other 7 (3) 4 8 (15) (7) --------------------------------------------------------------------------------------------------------------------------------- Total Loans 9,323 (9,435) (112) 8,932 (11,652) (2,720) --------------------------------------------------------------------------------------------------------------------------------- Total Earning Assets 7,537 (9,781) (2,244) 4,660 (12,822) (8,162) --------------------------------------------------------------------------------------------------------------------------------- Interest Bearing Liabilities Interest Bearing Deposits: Transaction 80 (178) (98) 112 (395) (283) Savings 1,003 (1,538) (535) 731 (1,995) (1,264) Time Deposits (388) (1,603) (1,991) (963) (5,204) (6,167) --------------------------------------------------------------------------------------------------------------------------------- Total Interest Bearing Deposits 695 (3,319) (2,624) (120) (7,594) (7,714) Other Borrowed Funds (1) (8) (9) (2) (10) (12) --------------------------------------------------------------------------------------------------------------------------------- Total Interest Bearing Liabilities 694 (3,327) (2,633) (122) (7,604) (7,726) --------------------------------------------------------------------------------------------------------------------------------- Total Change $ 6,843 $ (6,454) $ 389 $ 4,782 $ (5,218) $ (436) =================================================================================================================================
Notes: Rate/volume variance is allocated based on the percentage relationship of changes in volume and changes in rate to the total "net change." The above figures have been rounded to the nearest whole number. 27 PART II. OTHER INFORMATION ITEM 1. Legal Proceedings None ITEM 2. Changes in Securities None ITEM 3. Defaults Upon Senior Securities Not applicable ITEM 4. Submission of Matters to a Vote of Security Holders None ITEM 5. Other Information None ITEM 6(a). Exhibits See Exhibit Index on Page 32 ITEM 6(b). Reports on Form 8-K None 28 SIGNATURES Pursuant to the requirement 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. FARMERS & MERCHANTS BANCORP Date: November 26, 2002 /s/Kent A. Steinwert ------------------------ Kent A. Steinwert President and Chief Executive Officer (Principal Executive Officer) Date: November 26, 2002 /s/John R. Olson ------------------------ John R. Olson Executive Vice President and Chief Financial Officer (Principal Accounting Officer) Certification I, Kent A. Steinwert, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Farmers & Merchants Bancorp; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and 29 c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: November 26, 2002 /s/Kent A. Steinwert ---------------------------- Kent A. Steinwrt President & Chief Executive Officer Certification I, John R. Olson, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Farmers & Merchants Bancorp; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; 30 b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: November 26, 2002 /s/John R. Olson ---------------------------- John R. Olson Executive Vice President & Chief Financial Officer 31 Index to Exhibits Exhibit No. Description 2 Plan of Reorganization as filed on Form 8-K dated April 30, 1999, are incorporated herein by reference. 3(i) Amended and Restated Certificate of Incorporation of Farmers & Merchants Bancorp, filed as Exhibit 3(i) to Registrant's 8-K dated April 30, 1999, is incorporated herein by reference. 3(ii)By-Laws of Farmers & Merchants Bancorp, filed as Exhibit 3(i) to Registrant's 8-K dated April 30, 1999, is incorporated herein by reference. 10.1 Employment Agreement dated July 8, 1997, between Farmers & Merchants Bank of Central California and Kent A. Steinwert, filed as Exhibit 10.1 to Registrant's 8-K dated April 30, 1999, is incorporated herein by reference. 10.2 Employment Agreement dated July 8, 1997, between Farmers & Merchants Bank of Central California and Richard S. Erichson, filed as Exhibit 10.2 to Registrant's 8-K dated April 30, 1999, is incorporated herein by reference. 10.3 Deferred Bonus Plan of Farmers & Merchants Bank of Central California adopted as of March 2, 1999, filed as Exhibit 10.3 to Registrant's 8-K dated April 30, 1999, is incorporated herein by reference. 10.4 Amended and Restated Deferred Bonus Plan of Farmers & Merchants Bank of Central California, executed May 11, 1999, filed as Exhibit 10.4 to Registrant's 8-K dated April 30, 1999, is incorporated herein by reference. 99.1 Chief Executive Officer Certification pursuant to 10 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 99.2 Chief Financial Officer Certification pursuant to 10 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32