10-K 1 ames10k.txt SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------ FORM 10-K Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the fiscal year ended December 31, 2004. Commission File Number 0-32637. AMES NATIONAL CORPORATION ------------------------------------------------------ (Exact name of registrant as specified in its charter) IOWA 42-1039071 -------------------------------------------------------------------------------- (State or other jurisdiction (I.R.S. Employer Identification No.) of incorporation or organization) 405 FIFTH STREET, AMES, IOWA 50010 -------------------------------------------------------------------------------- (Address of principal executive offices) (Zip Code) (515) 232-6251 ---------------------------------------------------- (Registrant's telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: NONE Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK, $5.00 PAR VALUE ----------------------------- (Title of Class) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 (the "Act") 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 _____ Indicate bycheck mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes __X__ No _____ As of June 30,2004, the aggregate market value of voting stock held by non-affiliates of the registrant, based upon the closing sale price for the registrant's common stock in the over the counter market, was $162,670,109. Shares of common stock beneficially owned by each executive officer and director of the Company and by each person who owns 5% or more of the outstanding common stock have been excluded on the basis that such persons may be deemed to be an affiliate of the registrant. This determination of affiliate status is not necessarily a conclusive determination for any other purpose. The number of shares outstanding of the registrant's common stock on February 28, 2005, was 3,137,066. DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrant's definitive proxy statement, as filed with the Securities and Exchange Commission on March 16, 2005, are incorporated by reference into Part III of this Form 10-K. 1 TABLE OF CONTENTS Part I Item 1. Business..................................................... 3 Item 2. Properties................................................... 14 Item 3. Legal Proceedings............................................ 14 Item 4. Submission of Matters to a Vote of Shareholders.............. 14 Part II Item 5. Market for Registrant's Common Stock and Related Shareholder Matters..................................... 14 Item 6. Selected Financial Data...................................... 16 Item 7. Management's Discussion and Analysis of Financial Condition and Results Of Operations..................... 16 Item 7A. Quantitative and Qualitative Disclosures about Market Risk... 35 Item 8. Financial Statements and Supplementary Data.................. 37 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure................................ 58 Item 9 A. Controls and Procedures...................................... 58 Item 9 B. Other Information............................................ 58 Part III Item 10. Directors and Executive Officers of the Registrant........... 58 Item 11. Executive Compensation....................................... 59 Item 12. Security Ownership of Certain Beneficial Owners and Management 59 Item 13. Certain Relationships and Related Transactions............... 59 Item 14. Principal Accounting Fees and Services ...................... 60 Part IV Item 15. Exhibits and Financial Statement Schedules................... 60 2 PART I ITEM 1. BUSINESS General Ames National Corporation (the "Company") is an Iowa corporation and bank holding company registered under the Bank Holding Company Act of 1956, as amended. The Company owns 100% of the stock of five banking subsidiaries consisting of two national banks and three state-chartered banks, as described below. All of the Company's operations are conducted in the State of Iowa and primarily within the central Iowa counties of Boone, Story and Marshall where the Company's banking subsidiaries are located. The Company does not engage in any material business activities apart from its ownership of its banking subsidiaries. The principal executive offices of the Company are located at 405 Fifth Street, Ames, Iowa 50010 and its telephone number is (515) 232-6251. The Company was organized and incorporated on January 21, 1975 under the laws of the State of Iowa to serve as a holding company for its principal banking subsidiary, First National Bank, Ames, Iowa ("First National") located in Ames, Iowa. In 1983, the Company acquired the stock of the State Bank & Trust Co. ("State Bank") located in Nevada, Iowa; in 1991, the Company, through a newly-chartered state bank known as Boone Bank & Trust Co. ("Boone Bank"), acquired certain assets and assumed certain liabilities of the former Boone State Bank & Trust Company located in Boone, Iowa; in 1995, the Company acquired the stock of the Randall-Story State Bank ("Randall-Story Bank") located in Story City, Iowa; and in 2002, the Company chartered and commenced operations of a new national banking organization, United Bank & Trust NA ("United Bank"), located in Marshalltown, Iowa. First National, State Bank, Boone Bank, Randall-Story Bank and United Bank are each operated as a wholly owned subsidiary of the Company. These five financial institutions are referred to in this Form 10-K collectively as the "Banks" and individually as a "Bank". The principal sources of Company revenue are: (i) interest and fees earned on loans made by the Banks; (ii) service charges on deposit accounts maintained at the Banks; (iii) interest on fixed income investments held by the Banks; (iv) fees on trust services provided by those Banks exercising trust powers; and (v) securities gains and dividends on equity investments held by the Company and the Banks. The Banks' lending activities consist primarily of short-term and medium-term commercial and residential real estate loans, agricultural and business operating loans and lines of credit, equipment loans, vehicle loans, personal loans and lines of credit, home improvement loans and secondary mortgage loan origination. The Banks also offer a variety of demand, savings and time deposits, cash management services, merchant credit card processing, safe deposit boxes, wire transfers, direct deposit of payroll and social security checks and automated teller machine access. Four of the five Banks also offer trust services. The Company provides various services to the Banks which include, but are not limited to, management assistance, auditing services, human resources services and administration, compliance management, marketing assistance and coordination, loan review and assistance with respect to computer systems and procedures. Banking Subsidiaries First National Bank, Ames, Iowa. First National is a nationally chartered, commercial bank insured by the Federal Deposit Insurance Corporation (the "FDIC"). It was organized in 1903 and became a wholly owned subsidiary of the Company in 1975 through a bank holding company reorganization whereby the then shareholders of First National exchanged all of their First National stock for stock in the Company. First National provides full-service banking to businesses and residents within the Ames community and surrounding area. It provides a variety of products and services designed to meet the needs of the market it serves. It has an experienced staff of bank officers including many who have spent the majority of their banking careers with First National and who emphasize long-term customer relationships. First National conducts business out of three full-service offices and one super market location, all located in the city of Ames. As of December 31, 2004, First National had capital of $40,482,000 and 91 full-time equivalent employees. Full-time equivalents represent the number of people a business would employ if all its employees were employed on a full-time basis. It is calculated by dividing the total number of hours worked by all full and part-time employees by the number of hours a full-time individual would work for a given period of time. First National had net income of $6,949,000 in 2004, $6,621,000 in 2003 and $6,294,000 in 2002. Total assets as of December 31, 2004, 2003 and 2002 were $436,074,000, $381,086,000 and $375,341,000, respectively. 3 State Bank & Trust Co., Nevada, Iowa. State Bank is an Iowa, state-chartered, FDIC insured commercial bank. State Bank was acquired by the Company in 1983 through a stock transaction whereby the then shareholders of State Bank exchanged all their State Bank stock for stock in the Company. State Bank was organized in 1939 and provides full-serve banking to businesses and residents within the Nevada area from its main Nevada location and two offices; one in McCallsburg, Iowa and the other in Colo, Iowa. It is strong in agricultural, commercial and residential real estate lending. As of December 31, 2004, State Bank had capital of $11,288,000 and 22 full-time equivalent employees. It had net income of $1,707,000 in 2004, $1,554,000 in 2003 and $1,501,000 in 2002. Total assets as of December 31, 2004, 2003 and 2002 were $112,599,000, $100,712,000 and $104,079,000, respectively. Boone Bank & Trust Co., Boone, Iowa. Boone Bank is an Iowa, state-chartered, FDIC insured commercial bank. Boone Bank was organized in 1992 by the Company under a new state charter in connection with a purchase and assumption transaction whereby Boone Bank purchased certain assets and assumed certain liabilities of the former Boone State Bank & Trust Company in exchange for a cash payment. It provides full service banking to businesses and residents within the Boone community and surrounding area. It is actively engaged in agricultural, consumer and commercial lending, including real estate, operating and equipment loans. It conducts business from its main office and a full service branch office, both located in Boone. As of December 31, 2004, Boone Bank had capital of $12,622,000 and 28 full-time equivalent employees. It had net income of $2,059,000 in 2004, $1,920,000 in 2003 and $1,827,000 in 2002. Total assets as of December 31, 2004, 2003 and 2002 were $112,578,000, $110,712,000 and $96,829,000, respectively. Randall-Story State Bank, Story City, Iowa. Randall-Story Bank is an Iowa, state-chartered, FDIC insured commercial bank. Randall-Story Bank was acquired by the Company in 1995 through a stock transaction whereby the then shareholders of Randall-Story Bank exchanged all their Randall-Story Bank stock for stock in the Company. Randall-Story Bank was organized in 1928 and provides full-service banking to Story City and the surrounding area from its main location in Story City and a full service office in Randall, Iowa. While its primary emphasis is in agricultural lending, Randall-Story Bank also provides the traditional lending services typically offered by community banks. As of December 31, 2004, Randall-Story Bank had capital of $7,857,000 and 16 full-time equivalent employees. It had net income of $1,036,000 in 2004, $810,000 in 2003 and $1,009,000 in 2002. Total assets as of December 31, 2004, 2003 and 2002 were $74,427,000, $72,581,000 and $64,946,000, respectively. United Bank & Trust NA, Marshalltown, Iowa. United Bank is a nationally chartered, commercial bank insured by the FDIC. It was newly chartered in June of 2002 and offers a broad range of deposit and loan products, as well as Internet banking and trust services to customers located in the Marshalltown and surrounding Marshall County area. As of December 31, 2004, United Bank had capital of $6,902,000 and 17 full-time equivalent employees. United Bank had a profit of $105,000 in 2004 and posted a net loss in 2003 of $465,000 and for the six and one-half month period ended December 31, 2002 a loss of $524,000. Total assets as of December 31, 2004, 2003 and 2002 were $89,653,000, $68,397,000 and $30,355,000, respectively. Business Strategy and Operations As a locally owned, multi-bank holding company, the Company emphasizes strong personal relationships to provide products and services that meet the needs of the Banks' customers. The Company seeks to achieve growth and maintain a strong return on equity. To accomplish these goals, the Banks focus on small to medium size businesses that traditionally wish to develop an exclusive relationship with a single bank. The Banks, individually and collectively, have the size to give the personal attention required by business owners, in addition to the credit expertise to help businesses meet their goals. 4 The Banks offer a full range of deposit services that are typically available in most financial institutions, including checking accounts, savings accounts and time deposits of various types, ranging from money market accounts to longer term certificates of deposit. One major goal in developing the Banks' product mix is to keep the product offerings as simple as possible, both in terms of the number of products and the features and benefits of the individual services. The transaction accounts and time certificates are tailored to each Bank's principal market area at rates competitive in that Bank's market. In addition, retirement accounts such as IRAs (Individual Retirement Accounts) are available. The FDIC insures all deposit accounts up to the maximum amount. The Banks solicit these accounts from small-to-medium sized businesses in their respective primary trade areas, and from individuals who live and/or work within these areas. No material portion of the Banks' deposits has been obtained from a single person or from a few persons. Therefore, the Company does not believe that the loss of the deposits of any person or of a few persons would have an adverse effect on the Banks' operations or erode their deposit base. Loans are provided to creditworthy borrowers regardless of their race, color, national origin, religion, sex, age, marital status, disability, receipt of public assistance or any other basis prohibited by law. The Banks intend to fulfill this commitment while maintaining prudent credit standards. In the course of fulfilling this obligation to meet the credit needs of the communities which they serve, the Banks give consideration to each credit application regardless of the fact that the applicant may reside in a low to moderate income neighborhood, and without regard to the geographic location of the residence, property or business within their market areas. The Banks provide innovative, quality financial products, such as Internet banking and trust services that meet the banking needs of their customers and communities. The loan programs and acceptance of certain loans may vary from time-to-time depending on the funds available and regulations governing the banking industry. The Banks offer all basic types of credit to their local communities and surrounding rural areas, including commercial, agricultural and consumer loans. The types of loans within these categories are as follows: Commercial Loans. Commercial loans are typically made to sole proprietors, partnerships, corporations and other business entities such as municipalities and individuals where the loan is to be used primarily for business purposes. These loans are typically secured by assets owned by the borrower and often times involve personal guarantees given by the owners of the business. The types of loans the Banks offer include: - financing guaranteed under Small Business Administration programs - operating and working capital loans - loans to finance equipment and other capital purchases - commercial real estate loans - business lines of credit - term loans - loans to professionals - letters of credit Agricultural Loans. The Banks by nature of their location in central Iowa are directly and indirectly involved in agriculture and agri-business lending. This includes short-term seasonal lending associated with cyclical crop and livestock production, intermediate term lending for machinery, equipment and breeding stock acquisition and long-term real estate lending. These loans are typically secured by the crops, livestock, equipment or real estate being financed. The basic tenet of the Banks' agricultural lending philosophy is a blending of strong, positive cash flow supported by an adequate collateral position, along with a demonstrated capacity to withstand short-term negative impact if necessary. Applicable governmental subsidies and affiliated programs are utilized if warranted to accomplish these parameters. Approximately 14% of the Banks' loans have been made for agricultural purposes. The Banks have not experienced a material adverse effect on their business as a result of defaults on agricultural loans and do not anticipate at the present time experiencing any such effect in the future. Consumer Loans. Consumer loans are typically available to finance home improvements and consumer purchases, such as automobiles, household furnishings, boats and education. These loans are made on both a secured and an unsecured basis. The following types of consumer loans are available: - automobiles and trucks - boats and recreational vehicles - personal loans and lines of credit - home equity lines of credit - home improvement and rehabilitation loans - consumer real estate loans 5 Other types of credit programs, such as loans to nonprofit organizations, to public entities, for community development and to other governmental offered programs also are available. First National, Boone Bank, State Bank and United Bank offer trust services typically found in a commercial bank with trust powers, including the administration of estates, conservatorships, personal and corporate trusts and agency accounts. The Banks also provide farm management, investment and custodial services for individuals, businesses and non-profit organizations. The Banks earn income from the origination of residential mortgages that are sold in the secondary real estate market without retaining the mortgage servicing rights. The Banks offer traditional banking services, such as safe deposit boxes, wire transfers, direct deposit of payroll and social security checks, automated teller machine access and automatic drafts (ACH) for various accounts. Credit Management The Company strives to achieve sound credit risk management. In order to achieve this goal, the Company has established uniform credit policies and underwriting criteria for the Banks' loan portfolios. The Banks diversify in the types of loans offered and are subject to regular credit examinations, annual internal and external loan audits and annual review of large loans, as well as quarterly reviews of loans experiencing deterioration in credit quality. The Company attempts to identify potential problem loans early, charge off loans promptly and maintain an adequate allowance for loan losses. The Company has established credit guidelines for the Banks' lending portfolios which include guidelines relating to the more commonly requested loan types, as follows: Commercial Real Estate Loans - Commercial real estate loans, including agricultural real estate loans, are normally based on loan to appraisal value ratios of 75% and secured by a first priority lien position. Loans are typically subject to interest rate adjustments no less frequently than 5 years from origination. Fully amortized monthly repayment terms normally do not exceed twenty years. Projections and cash flows that show ability to service debt within the amortization period are required. Property and casualty insurance is required to protect the Banks' collateral interests. Commercial and agricultural real estate loans represent approximately 45% of the loan portfolio. Major risk factors for commercial real estate loans, as well as the other loan types described below, include a geographic concentration in central Iowa; the dependence of the local economy upon several large governmental entities, including Iowa State University and the Iowa Department of Transportation; and the health of Iowa's agricultural sector that is dependent on weather conditions and government programs. Commercial and Agricultural Operating Lines - These loans are made to businesses and farm operations with terms up to twelve months. The credit needs are generally seasonal with the source of repayment coming from the entity's normal business cycle. Cash flow reviews are completed to establish the ability to service the debt within the terms of the loan. A first priority lien on the general assets of the business normally secures these types of loans. Loan to value limits vary and are dependent upon the nature and type of the underlying collateral and the financial strength of the borrower. Crop and hail insurance is required for most agricultural borrowers. Loans are generally guaranteed by the principal(s). Commercial and Agricultural Term Loans - These loans are made to businesses and farm operations to finance equipment, breeding stock and other capital expenditures. Terms are generally the lesser of five years or the useful life of the asset. Term loans are normally secured by the asset being financed and are often additionally secured with the general assets of the business. Loan to value is generally 75% of the cost or value of the assets. Loans are normally guaranteed by the principal(s). Commercial and agricultural operating and term loans represent approximately 20% of the loan portfolio. Residential First Mortgage Loans - Proceeds of these loans are used to buy or refinance the purchase of residential real estate with the loan secured by a first lien on the real estate. Most of the residential mortgage loans originated by the Banks (including servicing rights) are sold in the secondary mortgage market due to the higher interest rate risk inherent in the 15 and 30 year fixed rate terms consumers prefer. Loans that are originated and not sold in the secondary market generally have higher interest rates and have rate adjustment periods of no longer than seven years. The maximum amortization of first mortgage residential real estate loans is 30 years. The loan-to-value ratios normally do not exceed 80% without credit enhancements such as mortgage insurance. Property insurance is required on all loans to protect the Banks' collateral position. Loans secured by one to four family residential properties represent approximately 24% of the loan portfolio. 6 Home Equity Term Loans - These loans are normally for the purpose of home improvement or other consumer purposes and are secured by a junior mortgage on residential real estate. Loan-to-value ratios normally do not exceed 90% of market value. Home Equity Lines of Credit - The Banks offer a home equity line of credit with a maximum term of 60 months. These loans are secured by a junior mortgage on the residential real estate and normally do not exceed a loan-to-market value ratio of 90% with the interest adjusted quarterly. Consumer Loans - Consumer loans are normally made to consumers under the following guidelines. Automobiles - loans on new and used automobiles generally will not exceed 80% and 75% of the value, respectively. Recreational vehicles and boats - 66% of the value. Mobile home - maximum term on these loans is 180 months with the loan-to-value ratio generally not exceeding 66%. Each of these loans is secured by a first priority lien on the assets and requires insurance to protect the Banks' collateral position. Unsecured - The term for unsecured loans generally does not exceed 12 months. Consumer and other loans represent approximately 6% of the loan portfolio. Employees At December 31, 2004, the Banks had a total of 174 full-time equivalent employees and the Company had an additional 10 full-time employees. The Company and Banks provide their employees with a comprehensive program of benefits, including comprehensive medical and dental plans, long-term and short-term disability coverage, and a 401(k) profit sharing plan. Management considers its relations with employees to be satisfactory. Unions represent none of the employees. Market Area The Company operates five commercial banks with locations in Story, Boone and Marshall Counties in central Iowa. First National is located in Ames, Iowa with a population of 50,731. The major employers are Iowa State University, Ames Laboratories, Iowa Department of Transportation, Mary Greeley Medical Center, National Veterinary Services Laboratory, Ames Community Schools, City of Ames, Barilla, Sauer-Danfoss and McFarland Clinic. First National's primary business includes providing retail banking services and business and consumer lending. First National has a minimum exposure to agricultural lending. Boone Bank is located in Boone, Iowa with a population of 12,800. Boone is the county seat of Boone County. The major employers are Fareway Stores, Inc., Patterson Dental Supply Co., Union Pacific Railroad, and Communication Data Services. Boone Bank provides lending services to the agriculture, commercial and real estate markets. State Bank is located in Nevada, Iowa with a population of 6,658. Nevada is the county seat of Story County. The major employers are Print Graphics, General Financial Supply, Central Iowa Printing, Burke Corporation and Almaco. State Bank provides various types of loans with a major agricultural presence. It provides a wide variety of banking services and products including insurance services to its customers. Randall-Story Bank is located in Story City, Iowa with a population of 3,228. The major employers are Pella Corporation, Bethany Manor, American Packaging, Precision Machine and Record Printing. Located in a major agricultural area, it has a strong presence in this type of lending. As a full service commercial bank it provides a full line of products and services. United Bank is located in Marshalltown, Iowa with a population of 26,123. The major employers are Swift & Co., Fisher Controls International, Lenox Industries and Marshalltown Medical & Surgical Center. The newly chartered bank offers a full line of loan, deposit, and trust services. Competition The geographic market area served by the Banks is highly competitive with respect to both loans and deposits. The Banks compete principally with other commercial banks, savings and loan associations, credit unions, mortgage companies, finance divisions of auto and farm equipment companies, agricultural suppliers and other financial service providers. Some of these competitors are local, while others are statewide or nationwide. The major commercial bank competitors include F & M Bank, U.S. Bank National Association and Wells Fargo Bank, each of which have a branch office or offices within the Banks' primary trade areas. Among the advantages such larger banks have are their ability to finance extensive advertising campaigns and to allocate their investment assets to geographic regions of higher yield and demand. These larger banking organizations have much higher legal lending limits than the Banks and thus are better able to finance large regional, national and global commercial customers. 7 In order to compete with the other financial institutions in their primary trade areas, the Banks use, to the fullest extent possible, the flexibility which is accorded by independent status. This includes an emphasis on specialized services, local promotional activity and personal contacts by the Banks' officers, directors and employees. In particular, the Banks compete for deposits principally by offering depositors a wide variety of deposit programs, convenient office locations, hours and other services. The Banks compete for loans primarily by offering competitive interest rates, experienced lending personnel and quality products and services. As of December 31, 2004, there were 25 FDIC insured institutions having approximately 57 offices or branch offices within Boone, Story and Marshall County, Iowa where the Banks' offices are located. First National, State Bank and Randall-Story Bank together have the largest percentage of deposits in Story County and Boone Bank has the highest percentage of deposits in Boone County. The Banks also compete with the financial markets for funds. Yields on corporate and government debt securities and commercial paper affect the ability of commercial banks to attract and hold deposits. Commercial banks also compete for funds with equity, money market, and insurance products offered by brokerage and insurance companies. This competitive trend will likely continue in the future. The Company anticipates bank competition will continue to change materially over the next several years as more financial institutions, including the major regional and national banks, continue to consolidate. Credit unions, because of their income tax benefits, will continue to show substantial growth. Supervision and Regulation The following discussion generally refers to certain statutes and regulations affecting the banking industry. These references provide brief summaries and therefore do not purport to be complete and are qualified in their entirety by reference to those statutes and regulations. In addition, due to the numerous statutes and regulations that apply to and regulate the operation of the banking industry, many are not referenced below. USA Patriot Act. The USA Patriot Act was enacted in 2001 which, together with regulations issued pursuant to this act, substantially broadened previously existing anti-money laundering law and regulation, increased compliance, due diligence and reporting obligations for financial institutions, created new crimes and penalties and required federal banking agencies, in reviewing merger and other acquisition transactions, to consider the effectiveness of the parties in combating money laundering activities. The act requires all financial institutions to establish certain anti-money laundering compliance and due diligence programs that are reasonably designed to detect and report instances of money laundering. The Company believes its compliance policies, procedures and controls satisfy the material requirements of the Patriot Act and regulations. Sarbanes-Oxley Act. The Sarbanes-Oxley Act was enacted in 2002 to, among other things, increase corporate responsibility and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the federal securities laws. This act generally applies to all companies that are required to file periodic reports with the Securities and Exchange Commission under the Securities Exchange Act of 1934. The act implements significant changes in the responsibilities of officers and directors of public companies and makes certain changes to the corporate reporting obligation of those companies and their external auditors. Among the requirements and prohibitions addressed by the act are certifications required by CEOs and CFOs of periodic reports filed with the SEC; accelerated reporting of stock transactions by directors, officers and large shareholders; prohibitions against personal loans from companies to directors and executive officers (except loans made in the ordinary course of business); new requirements for public companies' audit committees; new requirements for auditor independence; the forfeiture of bonuses or other incentive-based compensation and profits from the sale of an issuer's securities by directors and executive officers in the 12-month period following initial publication of any financial statements that later require restatement; various increased criminal penalties for violations of securities laws; and the creation of a public company accounting oversight board. Rules adopted by the SEC to implement various provisions of the act include CEO and CFO certifications related to fair presentation of financial statements and financial information in public filings, as well as management's evaluation of disclosure controls and procedures; disclosure of whether any audit committee members qualify as a "financial expert"; disclosures related to audit committee composition and auditor pre-approval policies; disclosure related to adoption of a written code of ethics; reconciling non-GAAP financial information with GAAP in public communications; disclosure of off-balance sheet transactions; and disclosure related to director independence and the director nomination process. The Company has adopted modifications to its corporate governance procedures to comply with the provisions of the act and regulations. 8 The Company and the Banks are subject to extensive federal and state regulation and supervision. Regulation and supervision of financial institutions is primarily intended to protect depositors and the FDIC rather than shareholders of the Company. The laws and regulations affecting banks and bank holding companies have changed significantly over recent years, particularly with the passage of the Financial Services Modernization Act. There is reason to expect that similar changes will continue in the future. Any change in applicable laws, regulations or regulatory policies may have a material effect on the business, operations and prospects of the Company. The Company is unable to predict the nature or the extent of the effects on its business and earnings that any fiscal or monetary policies or new federal or state legislation may have in the future. The Company The Company is a bank holding company by virtue of its ownership of the Banks, and is registered as such with the Board of Governors of the Federal Reserve System (the "Federal Reserve"). The Company is subject to regulation under the Bank Holding Company Act of 1956, as amended (the "BHCA"), which subjects the Company and the Banks to supervision and examination by the Federal Reserve. Under the BHCA, the Company files with the Federal Reserve annual reports of its operations and such additional information as the Federal Reserve may require. Source of Strength to the Banks. The Federal Reserve takes the position that a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe or unsound manner. In addition, it is the Federal Reserve's position that in serving as a source of strength to its subsidiary banks, bank holding companies should use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity. It should also maintain the financial flexibility and capital raising capacity to obtain additional resources for providing assistance to its subsidiary banks. A bank holding company's failure to meet its obligations to serve as a source of strength to its subsidiary banks will generally be considered by the Federal Reserve to be an unsafe and unsound banking practice or a violation of the Federal Reserve's regulations or both. Federal Reserve Approval. Bank holding companies must obtain the approval of the Federal Reserve before they: (i) acquire direct or indirect ownership or control of any voting stock of any bank if, after such acquisition, they would own or control, directly or indirectly, more than 5% of the voting stock of such bank; (ii) merge or consolidate with another bank holding company; or (iii) acquire substantially all of the assets of any additional banks. Non-Banking Activities. With certain exceptions, the BHCA also prohibits bank holding companies from acquiring direct or indirect ownership or control of voting stock in any company other than a bank or a bank holding company unless the Federal Reserve finds the company's business to be incidental to the business of banking. When making this determination, the Federal Reserve in part considers whether allowing a bank holding company to engage in those activities would offer advantages to the public that would outweigh possible adverse effects. A bank holding company may engage in permissible non-banking activities on a de novo basis, if the holding company meets certain criteria and notifies the Federal Reserve within ten (10) business days after the activity has commenced. Under the Financial Services Modernization Act, eligible bank holding companies may elect (with the approval of the Federal Reserve) to become a "financial holding company." Financial holding companies are permitted to engage in certain financial activities through affiliates which had previously been prohibited activities for bank holding companies. Such financial activities include securities and insurance underwriting and merchant banking. At this time, the Company has not elected to become a financial holding company, but may choose to do so at some time in the future. Control Transactions. The Change in Bank Control Act of 1978, as amended, requires a person or group of persons acquiring "control" of a bank holding company to provide the Federal Reserve with at least 60 days prior written notice of the proposed acquisition. Following receipt of this notice, the Federal Reserve has 60 days to issue a notice disapproving the proposed acquisition, but the Federal Reserve may extend this time period for up to another 30 days. An acquisition may be completed before the disapproval period expires if the Federal Reserve issues written notice of its intent not to disapprove the action. Under a rebuttable presumption established by the Federal Reserve, the acquisition of 10% or more of a class of voting stock of a bank holding company with a class of securities registered under Section 12 of the Securities Exchange Act of 1934, as amended, would constitute the acquisition of control. In addition, any "company" would be required to obtain the approval of the Federal Reserve under the BHCA before acquiring 25% (or 5% if the "company" is a bank holding company) or more of the outstanding shares of the Company, or otherwise obtain control over the Company. 9 Affiliate Transactions. The Company and the Banks are deemed affiliates within the meaning of the Federal Reserve Act, and transactions between affiliates are subject to certain restrictions. Generally, the Federal Reserve Act: (i) limits the extent to which the financial institution or its subsidiaries may engage in "covered transactions" with an affiliate; and (ii) requires all transactions with an affiliate, whether or not "covered transactions," to be on terms substantially the same, or at least as favorable to the institution or subsidiary, as those provided to a non-affiliate. The term "covered transaction" includes the making of loans, purchase of assets, issuance of a guarantee and similar transactions. State Law on Acquisitions. Iowa law permits bank holding companies to make acquisitions throughout the state. However, Iowa currently has a deposit concentration limit of 15% on the amount of deposits in the state that any one banking organization can control and continue to acquire banks or bank deposits (by acquisitions), which applies to all depository institutions doing business in Iowa. Banking Subsidiaries Applicable federal and state statutes and regulations governing a bank's operations relate, among other matters, to capital adequacy requirements, required reserves against deposits, investments, loans, legal lending limits, certain interest rates payable, mergers and consolidations, borrowings, issuance of securities, payment of dividends, establishment of branches and dealings with affiliated persons. First National and United Bank are national banks subject to primary federal regulation and supervision by the Office of the Comptroller of the Currency (the "OCC"). The FDIC, as an insurer of the deposits, also has some limited regulatory authority over First National and United Bank. State Bank, Boone Bank and Randall-Story Bank are state banks subject to regulation and supervision by the Iowa Division of Banking. The three state Banks are also subject to regulation and examination by the FDIC, which insures their respective deposits to the maximum extent permitted by law. The federal laws that apply to the Banks regulate, among other things, the scope of their business, their investments, their reserves against deposits, the timing of the availability of deposited funds and the nature and amount of and collateral for loans. The laws and regulations governing the Banks generally have been promulgated to protect depositors and the deposit insurance fund of the FDIC and not to protect stockholders of such institutions or their holding companies. The OCC and FDIC each has authority to prohibit banks under their supervision from engaging in what it considers to be an unsafe and unsound practice in conducting their business. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") requires federal banking regulators to adopt regulations or guidelines in a number of areas to ensure bank safety and soundness, including internal controls, credit underwriting, asset growth, management compensation, ratios of classified assets to capital and earnings. FDICIA also contains provisions which are intended to change independent auditing requirements, restrict the activities of state-chartered insured banks, amend various consumer banking laws, limit the ability of "undercapitalized banks" to borrow from the Federal Reserve's discount window, require regulators to perform periodic on-site bank examinations and set standards for real estate lending. Borrowing Limitations. Each of the Banks is subject to limitations on the aggregate amount of loans that it can make to any one borrower, including related entities. Subject to numerous exceptions based on the type of loans and collateral, applicable statutes and regulations generally limit loans to one borrower of 15% of total equity and reserves. Each of the Banks is in compliance with applicable loans to one borrower requirements. FDIC Insurance. Generally, customer deposit accounts in banks are insured by the FDIC for up to a maximum amount of $100,000. The FDIC has adopted a risk-based insurance assessment system under which depository institutions contribute funds to the FDIC insurance fund based on their risk classification. The FDIC may terminate the deposit insurance of any insured depository institution if it determines after an administrative hearing that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law. 10 Capital Adequacy Requirements. The Federal Reserve, the FDIC and the OCC (collectively, the "Agencies") have adopted risk-based capital guidelines for banks and bank holding companies that are designed to make regulatory capital requirements more sensitive to differences in risk profiles among banks and bank holding companies and account for off-balance sheet items. Failure to achieve and maintain adequate capital levels may give rise to supervisory action through the issuance of a capital directive to ensure the maintenance of required capital levels. Each of the Banks is in compliance with applicable capital level requirements. The current guidelines require all federally regulated banks to maintain a minimum risk-based total capital ratio equal to 8%, of which at least 4% must be Tier 1 capital. Tier 1 capital includes common shareholders' equity, qualifying perpetual preferred stock and minority interests in equity accounts of consolidated subsidiaries, but excludes goodwill and most other intangibles and the allowance for loan and lease losses. Tier 2 capital includes the excess of any preferred stock not included in Tier 1 capital, mandatory convertible securities, hybrid capital instruments, subordinated debt and intermediate term preferred stock, 45% of unrealized gain of equity securities and general reserve for loan and lease losses up to 1.25% of risk weighted assets. None of the Banks has received any notice indicating that it will be subject to higher capital requirements. Under these guidelines, banks' assets are given risk weights of 0%, 20%, 50% or 100%. Most loans are assigned to the 100% risk category, except for first mortgage loans fully secured by residential property and, under certain circumstances, residential construction loans (both carry a 50% rating). Most investment securities are assigned to the 20% category, except for municipal or state revenue bonds (which have a 50% rating) and direct obligations of or obligations guaranteed by the United States Treasury or United States Government Agencies (which have a 0% rating). The Agencies have also implemented a leverage ratio, which is equal to Tier 1 capital as a percentage of average total assets less intangibles, to be used as a supplement to the risk based guidelines. The principal objective of the leverage ratio is to limit the maximum degree to which a bank may leverage its equity capital base. The minimum required leverage ratio for top rated institutions is 3%, but most institutions are required to maintain an additional cushion of at least 100 to 200 basis points. Any institution operating at or near the 3% level is expected to be a strong banking organization without any supervisory, financial or operational weaknesses or deficiencies. Any institutions experiencing or anticipating significant growth would be expected to maintain capital ratios, including tangible capital positions, well above the minimum levels. Prompt Corrective Action. Regulations adopted by the Agencies impose even more stringent capital requirements. The FDIC and other Agencies must take certain "prompt corrective action" when a bank fails to meet capital requirements. The regulations establish and define five capital levels: (i) "well-capitalized," (ii) "adequately capitalized," (iii) "undercapitalized," (iv) "significantly undercapitalized" and (v) "critically undercapitalized." Increasingly severe restrictions are imposed on the payment of dividends and management fees, asset growth and other aspects of the operations of institutions that fall below the category of being "adequately capitalized". Undercapitalized institutions are required to develop and implement capital plans acceptable to the appropriate federal regulatory agency. Such plans must require that any company that controls the undercapitalized institution must provide certain guarantees that the institution will comply with the plan until it is adequately capitalized. As of February 28, 2005, neither the Company nor any of the Banks were subject to any regulatory order, agreement or directive to meet and maintain a specific capital level for any capital measure. Furthermore, as of that same date, each of the Banks was categorized as "well capitalized" under regulatory prompt corrective action provisions. Restrictions on Dividends. Dividends paid to the Company by the Banks is the major source of Company cash flow. Various federal and state statutory provisions limit the amount of dividends banking subsidiaries are permitted to pay to their holding companies without regulatory approval. Federal Reserve policy further limits the circumstances under which bank holding companies may declare dividends. For example, a bank holding company should not continue its existing rate of cash dividends on its common stock unless its net income is sufficient to fully fund each dividend and its prospective rate of earnings retention appears consistent with its capital needs, asset quality and overall financial condition. In addition, the Federal Reserve and the FDIC have issued policy statements which provide that insured banks and bank holding companies should generally pay dividends only out of current operating earnings. Federal and state banking regulators may also restrict the payment of dividends by order. 11 First National, as a national bank, generally may pay dividends from undivided profits without restriction, provided that its surplus fund is at least equal to its common stock capital fund. Boone Bank, Randall-Story Bank and State Bank are also restricted under Iowa law to paying dividends only out of their undivided profits. Additionally, the payment of dividends by the Banks is affected by the requirement to maintain adequate capital pursuant to applicable capital adequacy guidelines and regulations, and the Banks generally are prohibited from paying any dividends if, following payment thereof, the Bank would be undercapitalized. Reserves Against Deposits. The Federal Reserve requires all depository institutions to maintain reserves against their transaction accounts (primarily checking accounts) and non-personal time deposits. Generally, reserves of 3% must be maintained against total transaction accounts of $47,600,000 or less (subject to an exemption not in excess of the first $7,000,000 of transaction accounts). A reserve of $1,428,000 plus 10% of amounts in excess of $47,600,000 must be maintained in the event total transaction accounts exceed $47,600,000. The balances maintained to meet the reserve requirements imposed by the Federal Reserve may be used to satisfy applicable liquidity requirements. Because required reserves must be maintained in the form of vault cash or a noninterest bearing account at a Federal Reserve Bank, the effect of this reserve requirement is to reduce the earning assets of the Banks. Regulatory Developments In 2000, the Financial Services Modernization Act was enacted which: (i) repealed historical restrictions on preventing banks from affiliating with securities firms; (ii) broadens the activities that may be conducted by national banks and banking subsidiaries of holding companies; and (iii) provides an enhanced framework for protecting the privacy of consumers' information. In addition, bank holding companies may be owned, controlled or acquired by any company engaged in financially related activities, as long as such company meets regulatory requirements. To the extent that this legislation permits banks to affiliate with financial services companies, the banking industry may experience further consolidation. Regulatory Enforcement Authority The enforcement powers available to federal and state banking regulators are substantial and include, among other things, the ability to assess civil monetary penalties, to issue cease-and-desist or removal orders and to initiate injunctive actions against banking organizations and institution-affiliated parties. In general, enforcement actions must be initiated for violations of laws and regulations and unsafe or unsound practices. Other actions, or inactions, may provide the basis for enforcement action, including misleading or untimely reports filed with regulatory authorities. Applicable law also requires public disclosure of final enforcement actions by the federal banking agencies. National Monetary Policies In addition to being affected by general economic conditions, the earnings and growth of the Banks are affected by the regulatory authorities' policies, including the Federal Reserve. An important function of the Federal Reserve is to regulate the money supply, credit conditions and interest rates. Among the instruments used to implement these objectives are open market operations in U.S. Government securities, changes in reserve requirements against bank deposits and the Federal Reserve Discount Rate, which is the rate charged member banks to borrow from the Federal Reserve Bank. These instruments are used in varying combinations to influence overall growth and distribution of credit, bank loans, investments and deposits, and their use may also affect interest rates charged on loans or paid on deposits. The monetary policies of the Federal Reserve have had a material impact on the operating results of commercial banks in the past and are expected to have a similar impact in the future. Also important in terms of effect on banks are controls on interest rates paid by banks on deposits and types of deposits that may be offered by banks. The Depository Institutions Deregulation Committee, created by Congress in 1980, phased out ceilings on the rate of interest that may be paid on deposits by commercial banks and savings and loan associations, with the result that the differentials between the maximum rates banks and savings and loans can pay on deposit accounts have been eliminated. The effect of deregulation of deposit interest rates has been to increase banks' cost of funds and to make banks more sensitive to fluctuation in market rates. 12 Availability of Information on Company Website The Company files periodic reports with the Securities and Exchange Commission ("SEC"), including annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K. The Company makes available on or through its website free of charge all periodic reports filed by the Company with the SEC, including any amendments to such reports, as soon as reasonably practicable after such reports have been electronically filed with the SEC. The address of the Company's website on the Internet is: www.amesnational.com. The Company will provide a paper copy of these reports free of charge upon written or telephonic request directed to John P. Nelson, Vice President and Secretary, 405 Fifth Street, Ames, Iowa 50010 or (515) 232-6251 or by email request at info@amesnational.com. The information found on the Company's website is not part of this or any other report the Company files with the SEC. Executive Officers of Company and Banks The following table sets forth summary information about the executive officers of the Company and certain executive officers of the Banks. Unless otherwise indicated, each executive officer has served in his current position for the past five years. Name Age Position with the Company or Bank and Principal Occupation and Employment During the Past Five Years ------------------------ ------- ----------------------------------------------- Kevin G. Deardorff 50 Vice President & Technology Director of the Company. Leo E. Herrick 63 President of United Bank commencing June, 2002. Previously, employed as Chairman of the Board and President of F&M Bank-Iowa, Marshalltown, Iowa. Daniel L. Krieger 68 Chairman of the Company since 2003 and President of Company since 1997. Previously served as President of First National. Also serves as a Director of the Company, Chairman of the Board and Trust Officer of First National and Chairman of the Board of Boone Bank and United Bank. Stephen C. McGill 50 President of State Bank since 2003. Previously served as Senior Vice President of State Bank. John P. Nelson 38 Vice President, Secretary and Treasurer of Company. Also serves as Director of Randall-Story Bank and State Bank. Thomas H. Pohlman 54 President of First National since 1999. Previously served as Senior Vice President of First National. Jeffrey K. Putzier 43 President of Boone Bank since 1999. Harold E. Thompson 59 President of Randall Story Bank since 2003. Previously served as Executive Vice President of Randall-Story State Bank. Terrill L. Wycoff 61 Executive Vice President of First National since 2000. Previously served as served as Senior Vice President of First National. 13 ITEM 2. PROPERTIES The Company's office is housed in the main office of First National located at 405 Fifth Street, Ames, Iowa and occupies approximately 3,357 square feet. A lease agreement between the Company and First National provides the Company will make available for use by First National an equal amount of interior space at the Company's building located at 2330 Lincoln Way in lieu of rental payments. The main office is owned by First National free of any mortgage and consists of approximately 45,000 square feet and includes a drive through banking facility. In addition to its main office, First National conducts its business through two full-service offices, the University office and the North Grand office, and one super-market location, the Cub Food office. All offices are located within the city of Ames. The North Grand office is owned by First National free of any mortgage. The University office is located in a 16,000 square foot multi-tenant property owned by the Company. A 24-year lease agreement with the Company has been modified in 2002 to provide that an equal amount of interior space will be made available to the Company at First National's main office at 405 Fifth Street in lieu of rental payments. First National will continue to rent the drive-up facilities of approximately 1,850 square feet at this location for $1,200 per month. The Cub Foods office is leased by First National from Super Valu Stores under a 20 year lease with a five year initial term and three, five year renewal options. The current annual rental payment is $19,000. State Bank conducts its business from its main office located at 1025 Sixth Street, Nevada, Iowa and from two additional full-service offices located in McCallsburg and Colo, Iowa. All of these properties are owned by State Bank free of any mortgage. Boone Bank conducts its business from its main office located at 716 Eighth Street, Boone, Iowa and from one additional full-service office also located in Boone, Iowa. All properties are owned by Boone Bank free of any mortgage. Randall-Story Bank conducts its business from its main office located at 606 Broad Street, Story City, Iowa and from one additional full-service office located in Randall, Iowa. All of these properties are owned by Randall-Story Bank free of any mortgage. United Bank conducts its business from its main office located at 2101 South Center Street, Marshalltown, Iowa. The 5,200 square foot premise was constructed in 2002. The property is owned by United Bank free of any mortgage. The property the Company owns is located at 2330 Lincoln Way, Ames, Iowa consisting of a multi tenant building of approximately 16,000 square feet. First National leases 5,422 square feet of this building to serve as its University Office. 800 square feet of the remaining space is currently leased to two tenants who occupy the space for business purposes; the remaining 7,058 square feet of rentable space is currently unoccupied. The Company entered into a real estate contract on July 14, 2003 to purchase real estate adjacent to 2330 Lincoln Way at 2318 Lincoln Way for a total purchase price of $400,000. The 2318 Lincoln Way property consists of a single story commercial building with 2,400 square feet of leased space that is currently occupied by one tenant for business purposes. As of February 28, 2005, the contract has not closed; however, the agreement specifies that the closing of the contract will take place no later than July 31, 2006. ITEM 3. LEGAL PROCEEDINGS The Banks are from time to time parties to various legal actions arising in the normal course of business. The Company believes that there is no threatened or pending proceeding against the Company or the Banks, which, if determined adversely, would have a material adverse effect on the business or financial condition of the Company or the Banks. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SHAREHOLDERS There were no matters submitted to a vote of the shareholders of the Company during the fourth quarter of 2004. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS On February 28, 2005, the Company had approximately 602 shareholders of record. The Company's common stock is listed on the NASDAQ SmallCap Market under the symbol "ATLO". Trading in the Company's common stock is, however, relatively limited. 14 Based on information provided to and gathered by the Company on an informal basis, the Company believes that the high and low sales price for the common stock on a per share basis during the last two years is as follows: 2004 2003 ------------------------ ------------------------------- Market Price Market Price ------------------------- ------------------------------- Quarter High Low Quarter High Low ------------------------- ------------------------------- 1st $61.00 $58.25 1st $48.90 $46.05 2nd 63.50 60.00 2nd 55.25 51.50 3rd 71.50 62.25 3rd 57.25 53.10 4th 105.00 70.50 4th 59.75 56.75 The Company declared aggregate annual cash dividends in 2004 and 2003 of $7,590,000 and $7,142,000, respectively, or $2.42 per share in 2004 and $2.28 per share in 2003. In February 2005, the Company declared an aggregate cash dividend of $2,353,000 or $.75 per share. Quarterly dividends declared during the last two years were as follows: 2004 2003 ------------------ ------------------ Cash dividends Cash dividends Quarter declared per share declared per share ----------------------------------------------------------- 1st $0.46 $0.44 2nd 0.98 0.92 3rd 0.49 0.46 4th 0.49 0.46 The decision to declare any such cash dividends in the future and the amount thereof rests within the discretion of the Board of Directors of the Company and will be subject to, among other things, the future earnings, capital requirements and financial condition of the Company and certain regulatory restrictions imposed on the payment of dividends by the Banks. Such restrictions are discussed in greater detail in Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources. 15 ITEM 6. SELECTED FINANCIAL DATA The following financial data of the Company for the five years ended December 31, 2004 through 2000 is derived from the Company's historical audited financial statements and related footnotes. The information set forth below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operation" and the consolidated financial statements and related notes contained elsewhere in this Annual Report. Year Ended December 31 ------------------------------------------------------------ (dollars in thousands, except per share amounts) ------------------------------------------------------------ 2004 2003 2002 2001 2000 ------------------------------------------------------------- STATEMENT OF INCOME DATA Interest income $ 37,354 $ 35,314 $ 36,270 $ 41,474 $ 44,018 Interest expense 10,564 10,339 11,663 18,883 24,261 ------------------------------------------------------------- Net interest income 26,790 24,975 24,607 22,591 19,757 Provision for loan losses 479 645 688 898 460 ------------------------------------------------------------- Net interest income after provision for loan losses 26,311 24,330 23,919 21,693 19,297 Noninterest income 5,269 6,435 5,135 5,080 4,130 Noninterest expense 14,935 14,819 13,276 11,587 10,712 ------------------------------------------------------------- Income before provision for income tax 16,645 15,946 15,778 15,186 12,715 Provision for income tax 4,255 4,321 4,438 4,639 3,596 ------------------------------------------------------------- Net Income $ 12,390 $ 11,625 $ 11,340 $ 10,547 $ 9,119 ============================================================= DIVIDENDS AND EARNINGS PER SHARE DATA Cash dividends declared $ 7,590 $ 7,142 $ 6,820 $ 5,187 $ 4,932 Cash dividends declared per share 2.42 2.28 2.18 1.66 1.58 Basic and diluted earnings per share 3.95 3.71 3.63 3.38 2.92 Weighted average shares outstanding 3,135,235 3,131,224 3,127,285 3,123,885 3,120,375 BALANCE SHEET DATA Total assets $ 839,753 $ 752,786 $ 677,229 $ 622,280 $ 619,385 Net loans 411,639 355,533 329,593 323,043 344,015 Deposits 658,176 619,549 550,622 511,509 493,429 Stockholders' equity 110,924 107,325 101,523 93,622 86,177 Equity to assets ratio 13.21% 14.26% 14.99% 15.04% 13.91% FIVE YEAR FINANCIAL PERFORMANCE Net income $ 12,390 $ 11,625 $ 11,340 $ 10,547 $ 9,119 Average assets 793,076 726,945 635,816 616,971 626,560 Average stockholders' equity 108,004 104,141 98,282 91,373 80,081 Return on assets (net income divided by average assets) 1.56% 1.60% 1.78% 1.71% 1.46% Return on equity (net income divided by average equity) 11.47% 11.16% 11.54% 11.54% 11.39% Efficiency ratio (noninterest expense divided by noninterest income plus net interest income) 46.59% 47.18% 44.64% 41.87% 44.84% Dividend payout ratio (dividends per share divided by net income per share) 61.27% 61.46% 60.05% 49.11% 54.11% Dividend yield (dividends per share divided by closing year-end market price) 3.01% 3.91% 4.69% 4.15% 2.87% Equity to assets ratio (average equity divided by average assets) 13.62% 14.33% 15.46% 14.81% 12.78%
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview Ames National Corporation (Company) is a bank holding company established in 1975 that owns and operates five bank subsidiaries (Banks) in central Iowa. The following discussion is provided for the consolidated operations of the Company and its Banks, First National, State Bank, Boone Bank, Randall-Story Bank and United Bank. The purpose of this discussion is to focus on significant factors affecting the Company's financial condition and results of operations. 16 The Company does not engage in any material business activities apart from its ownership of the Banks. Products and services offered by the Banks are for commercial and consumer purposes, including loans, deposits and trust services. The Banks also offer investment services through a third-party broker dealer. The Company employs ten individuals to assist with financial reporting, human resources, audit, compliance, technology systems and the coordination of management activities, in addition to 174 full-time equivalent individuals employed by the Banks. The Company's primary competitive strategy is to utilize seasoned and competent Bank management and local decision making authority to provide customers with prompt response times and flexibility in the products and services offered. This strategy is viewed as providing an opportunity to increase revenues through creating a competitive advantage over other financial institutions. The Company also strives to remain operationally efficient to provide better profitability while enabling the Company to offer more competitive loan and deposit rates. The principal sources of Company revenues and cashflow are: (i) interest and fees earned on loans made by the Banks; (ii) service charges on deposit accounts maintained at the Banks; (iii) interest on fixed income investments held by the Banks; (iv) fees on trust services provided by those Banks exercising trust powers; and (v) securities gains and dividends on equity investments held by the Company and the Banks. The Company's principal expenses are: (i) interest expense on deposit accounts and other borrowings; (ii) salaries and employee benefits; (iii) data processing costs associated with maintaining the Banks' loan and deposit functions; and (iv) occupancy expenses for maintaining the Banks' facilities. The largest component contributing to the Company's net income is net interest income, which is the difference between interest earned on earning assets (primarily loans and investments) and interest paid on interest bearing liabilities (primarily deposit accounts and other borrowings). One of management's principal functions is to manage the spread between interest earned on earning assets and interest paid on interest bearing liabilities in an effort to maximize net interest income while maintaining an appropriate level of interest rate risk. The Company reported record net income of $12,390,000 for the year ended December 31, 2004 compared to $11,625,000 and $11,340,000 reported for the years ended December 31, 2003 and 2002, respectively. This represents an increase of 6.6% when comparing 2004 and 2003, and an increase of 2.5% when comparing 2003 and 2002. The improvement in net income for 2004 can be attributed primarily to higher net interest income resulting from a higher volume of loans and investments partially offset by lower secondary market income and security gains. The gain in net income in 2003 over 2002 related primarily to higher net interest income, secondary market income and security gains. Earnings per share for 2004 were a record $3.95 compared to $3.71 in 2003 and $3.63 in 2002. Each of the Banks had profitable operations during 2004. The Company's return on average equity for 2004 was 11.47% versus 11.16% and 11.54% in 2003 and 2002, respectively. Higher net income and lower capital levels relating to the average net unrealized gain on securities available for sale contributed to the improved return on average equity in 2004. The Company's return on average assets for 2004 was 1.56% compared to 1.60% in 2003 and 1.78% in 2002. The decline in the return on average assets in 2004 can be attributed to growth in assets at slightly lower profitability margins. The following discussion will provide a summary review of important items relating to: o Challenges o Key Performance Indicators and Industry Results o Income Statement Review o Balance Sheet Review o Asset Quality and Credit Risk Management o Liquidity and Capital Resources o Interest Rate Risk 17 Challenges Management has identified certain challenges that may negatively impact Company's revenues in the future and is attempting to position the Company to best respond to those challenges. o Rising interest rates may present a challenge to the Company in 2005. Continued increases in interest rates may negatively impact the Company's net interest margin if interest expense increases more quickly than interest income. The Company's earning assets (primarily its loan and investment portfolio) have longer maturities than its interest bearing liabilities (primarily deposits and other borrowings); therefore, in a rising interest rate environment, interest expense will increase more quickly than interest income as the interest bearing liabilities reprice more quickly than earning assets. In response to this challenge, the Banks model quarterly the changes in income that would result from various changes in interest rates. Management believes Bank earning assets have the appropriate maturity and repricing characteristics to optimize earnings and the Banks interest rate risk positions. o The Company's market in central Iowa has numerous banks, credit unions, investment and insurance companies competing for similar business opportunities. This competitive environment will continue to put downward pressure on the Banks' net interest margins and thus affect profitability. Strategic planning efforts at the Company and Banks continue to focus on capitalizing on the Banks' strengths in local markets while working to identify opportunities for improvement to gain competitive advantages. o A substandard performance in the Company's equity portfolio could lead to a reduction in the historical level of realized security gains, thereby negatively impacting the Company's earnings. The Company invests capital that may be utilized for future expansion in a portfolio of primarily financial and utility stocks with an estimated fair market value of approximately $25 million as of December 31, 2004. The Company focuses on stocks that have historically paid dividends in an effort to lessen the negative effects of a bear market. Key Performance Indicators and Industry Results Certain key performance indicators for the Company and the industry are presented in the following chart. The industry figures are compiled by the Federal Deposit Insurance Corporation (FDIC) and are derived from 8,975 commercial banks and savings institutions insured by the FDIC. Management reviews these indicators on a quarterly basis for purposes of comparing the Company's performance from quarter to quarter against the industry as a whole. Selected Indicators for the Company and the Industry Year Ended December 31, ---------------------------------------------------------- 2004 2003 2002 ---------------------------------------------------------- Company Industry Company Industry Company Industry Return on assets 1.56% 1.29% 1.60% 1.38% 1.78% 1.30% Return on equity 11.47% 13.28% 11.16% 15.04% 11.54% 14.14% Net interest margin 3.97% 3.53% 4.02% 3.73% 4.51% 3.96% Efficiency ratio 46.59% 58.03% 47.18% 56.59% 44.64% 56.00% Capital ratio 13.62% 8.12% 14.33% 7.88% 15.46% 7.87% Key performances indicators include: o Return on Assets This ratio is calculated by dividing net income by average assets. It is used to measure how effectively the assets of the Company are being utilized in generating income. Although the Company's return on assets ratio compares favorably to that of the industry, this ratio declined slightly in 2004 as compared to 2003 as assets grew more quickly in relation to net income. 18 o Return on Equity This ratio is calculated by dividing net income by average equity. It is used to measure the net income or return the Company generated for the shareholders' equity investment in the Company. The Company's return on equity ratio is below that of the industry primarily as a result of the higher level of capital the Company maintains for future growth and acquisitions. The Company's return on equity improved in 2004 as a result of net income growing more quickly in relation to average equity. o Net Interest Margin The ratio is calculated by dividing net interest income by average earning assets. Earning assets consist primarily of loans and investments that earn interest. This ratio is used to measure how well the Company is able maintain interest rates on earning assets above those of interest-bearing liabilities, which is the interest expense paid on deposit accounts and other borrowings. The Company's net interest margin compares favorably to the industry; however, management expects the competitive nature of the Company's market environment to put downward pressure on the Company's margin. o Efficiency Ratio This ratio is calculated by dividing noninterest expense by net interest income and noninterest income. The ratio is a measure of the Company's ability to manage noninterest expenses. The Company's efficiency ratio compares favorably to the industry average. o Capital Ratio The capital ratio is calculated by dividing average total equity capital by average total assets. It measures the level of average assets that are funded by shareholders' equity. Given an equal level of risk in the financial condition of two companies, the higher the capital ratio, generally the more financially sound the company. The Company's capital ratio is significantly higher than the industry average. Industry Results The FDIC Quarterly Banking Profile reported the following results for the fourth quarter of 2004: Strong loan growth and wider netinterest margins did not offset the negative effects of merger expenses at large banks and lower gains on sales of securities and other assets in the fourth quarter. Insured commercial banks and savings institutions reported $31.8 billion in net income for the quarter, a decline of $668 million (2.1%) from the record earnings registered in the third quarter. Nevertheless, the industry's earnings were the third-highest ever reported, and represented a $787-million (2.5%) improvement over the fourth quarter of 2003. Also, the industry's net operating (core) income, which does not include gains on securities sales, set a new quarterly record of $30.9 billion. The average return on assets (ROA) was 1.28% in the fourth quarter, marking the first time in two years that the industry's quarterly ROA has been below 1.30%. Fewer than half of all insured banks and thrifts (48.4%) had an ROA of 1% or higher in the fourth quarter, but this was an improvement over the fourth quarter of 2003, when only 44.8% achieved this benchmark level of profitability. Almost two out of every three institutions (62.1%) had higher net income than in the fourth quarter of 2003. Income Statement Review The following highlights a comparative discussion of the major components of net income and their impact for the last three years. Critical Accounting Policy The discussion contained in this Item 7 and other disclosures included within this report are based on the Company's audited consolidated financial statements. These statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The financial information contained in these statements is, for the most part, based on the financial effects of transactions and events that have already occurred. However, the preparation of these statements requires management to make certain estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. 19 The Company's significant accounting policies are described in the "Notes to Consolidated Financial Statements" accompanying the Company's audited financial statements. Based on its consideration of accounting policies that involve the most complex and subjective estimates and judgments, management has identified the allowance for loan losses to be the Company's most critical accounting policy. The allowance for loan losses is established through a provision for loan losses that is treated as an expense and charged against earnings. Loans are charged against the allowance for loan losses when management believes that collectibility of the principal is unlikely. The Company has policies and procedures for evaluating the overall credit quality of its loan portfolio, including timely identification of potential problem loans. On a quarterly basis, management reviews the appropriate level for the allowance for loan losses, incorporating a variety of risk considerations, both quantitative and qualitative. Quantitative factors include the Company's historical loss experience, delinquency and charge-off trends, collateral values, known information about individual loans and other factors. Qualitative factors include the general economic environment in the Company's market area and the expected trend of the economic conditions. To the extent actual results differ from forecasts and management's judgment, the allowance for loan losses may be greater or lesser than future charge-offs. Average Balances and Interest Rates The following two tables are used to calculate the Company's net interest margin. The first table includes the Company's average assets and the related income to determine the average yield on earning assets. The second table includes the average liabilities and related expense to determine the average rate paid on interest bearing liabilities. The net interest margin is equal to the interest income less the interest expense divided by average earning assets. ASSETS 2004 2003 2002 ---------------------------------------------------------------------------------------- Average Revenue/ Yield/ Average Revenue/ Yield/ Average Revenue/ Yield/ balance expense rate balance expense rate balance expense rate (dollars in thousands) ---------------------------------------------------------------------------------------- Interest-earning assets Loans Commercial $ 48,775 $ 2,548 5.22% $ 38,288 $ 2,163 5.65% $ 42,948 $ 3,042 7.08% Agricultural 28,406 1,839 6.47% 25,962 1,783 6.87% 25,274 1,895 7.50% Real estate 285,087 17,169 6.02% 264,494 16,909 6.39% 229,805 16,929 7.37% Consumer and other 23,079 1,317 5.71% 21,068 1,342 6.37% 19,494 1,341 6.88% -------------------------------------------------------------------------------------- Total loans (including fees) $385,347 $22,873 5.94% $349,812 $22,197 6.35% $317,521 $23,207 7.31% Investment securities Taxable $213,043 $ 8,911 4.18% $162,273 $ 7,925 4.88% $142,089 $ 8,414 5.92% Tax-exempt 127,048 8,125 6.40% 101,482 6,820 6.72% 78,171 5,797 7.42% -------------------------------------------------------------------------------------- Total investment securities $340,091 $17,036 5.01% $263,755 $14,745 5.59% $220,260 $14,211 6.45% Interest bearing deposits with banks $8,713 $ 130 1.49% $ 4,511 $ 62 1.37% $ 534 $ 14 2.62% Federal funds sold 11,630 159 1.37% 60,293 628 1.04% 51,206 810 1.58% -------------------------------------------------------------------------------------- Total Interest-earning assets $745,781 $40,198 5.39% $678,371 $37,632 5.55% $589,521 $38,242 6.49% Noninterest-earning assets Cash and due from banks $ 27,581 $ 27,733 $ 28,206 Premises and equipment, net 8,517 8,599 7,912 Other, less allowance for loan losses 11,197 12,242 10,177 -------------------------------------------------------------------------------------- Total noninterest-earning assets $47,295 $ 48,574 $ 46,295 -------------------------------------------------------------------------------------- TOTAL ASSETS $793,076 $726,945 $635,816 ====================================================================================== 1 Average loan balance includes nonaccrual loans, if any. Interest income collected on nonaccrual loans has been included. 2 Tax-exempt income has been adjusted to a tax-equivalent basis using an incremental tax rate of 35% in 2004 and 34% for prior years.
20 Average Balances and Interest Rates(continued) LIABILITIES AND STOCKHOLDERS' EQUITY 2004 2003 2002 ------------------------------------------------------------------------------------- Average Revenue/ Yield/ Average Revenue/ Yield/ Average Revenue/ Yield/ balance expense rate balance expense rate balance expense rate (dollars in thousands) ------- ------- ----- ------- ------- ----- ------- ------- ----- Interest-bearing liabilities Deposits Savings, NOW accounts, and money markets $329,410 $ 3,210 0.97% $298,885 $ 2,758 0.92% $260,426 $ 3,393 1.30% Time deposits < $100,000 173,581 4,974 2.87% 170,534 5,480 3.21% 152,703 6,107 4.00% Time deposits > $100,000 70,076 1,759 2.51% 65,759 1,807 2.75% 51,428 1,898 3.69% ------------------------------------------------------------------------------------- Total deposits $573,067 $ 9,943 1.74% $535,178 $10,045 1.88% $464,557 $11,398 2.45% Other borrowed funds 38,211 620 1.62% 19,588 293 1.50% 13,887 265 1.91% ------------------------------------------------------------------------------------- Total Interest-bearing liabilities $611,278 $10,563 1.73% $554,766 $10,338 1.86% $478,444 $11,663 2.44% ------------------------------------------------------------------------------------- Noninterest-bearing liabilities Demand deposits $ 65,785 $ 59,614 $ 53,318 Other liabilities 8,009 8,424 5,772 ------------------------------------------------------------------------------------- Stockholders' equity $108,004 $104,141 $ 98,282 ------------------------------------------------------------------------------------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $793,076 $726,945 $635,816 ===================================================================================== Net interest income $29,635 3.97% $27,294 4.02% $26,579 4.51% ===================================================================================== Spread Analysis Interest income/average assets $40,198 5.07% $37,632 5.18% $38,242 6.01% Interest expense/average assets 10,563 1.33% 10,334 1.42% 11,663 1.83% Net interest income/average assets 29,635 3.74% 27,294 3.76% 26,579 4.18%
Rate and Volume Analysis The rate and volume analysis is used to determine how much of the change in interest income or expense is the result of a change in volume or a change in interest rate. For example, real estate interest income increased $260,000 in 2004 compared to 2003. An increased volume of real estate loans added $1,272,000 in income in 2004; however, lower interest rates reduced interest income in 2004 by $1,012,000, a net difference of $260,000. 21 The following table sets forth, on a tax-equivalent basis, a summary of the changes in net interest income resulting from changes in volume and rates. (dollars in thousands) 2004 Compared to 2003 2003 Compared to 2002 ------------------------------------------------------------- Volume Rate Total Volume Rate Total Interest Income Loans Commercial $ 559 $ (174) $ 385 $ (307) $ (572) $ (879) Agricultural 163 (107) 56 50 (162) (112) Real estate 1,272 (1,012) 260 2,384 (2,404) (20) Consumer and other 121 (146) (25) 104 (103) 1 ------------------------------------------------------------- Total loans (including fees) $2,115 $(1,439) $ 676 $2,231 $(3,241) $(1,010) Investment securities Taxable $2,234 $(1,248) $ 986 $1,103 $(1,592) $ (489) Tax-exempt 1,644 (339) 1,305 1,608 (585) 1,023 ------------------------------------------------------------- Total investment securities $3,878 $(1,587) $2,291 $2,711 $(2,177) $ 534 62 6 68 58 (10) 48 Interest bearing deposits with banks (622) 153 $ (469) 127 (309) (182) Federal funds sold ------------------------------------------------------------- $5,433 $(2,867) $2,566 $5,127 $(5,737) $ (610) Total Interest-earning assets Interest-bearing liabilities Deposits Savings, NOW accounts, and money markets $ 285 $ 167 $ 452 $ 452 $(1,086) $ (634) Time deposits < $100,000 96 (602) (506) 663 (1,290) (627) Time deposits > $100,000 119 (167) (48) 457 (548) (91) ------------------------------------------------------------- Total deposits $ 500 $ (602) $ (102) $1,572 $(2,924) $(1,352) Other borrowed funds 281 46 327 93 (68) 25 ------------------------------------------------------------- Total Interest-bearing liabilities $ 781 $ (556) $ 225 $1,665 $(2,992) $(1,327) ------------------------------------------------------------- Net interest income/earning assets $4,652 $(2,311) $2,341 $3,462 $(2,745) $ 717 1 The change in interest due to both volume and yield/rate has been allocated to change due to volume and change due to yield/rate in proportion to the absolute value of the change in each.
Net Interest Income The Company's largest component contributing to net income is net interest income, which is the difference between interest earned on earning assets (which are primarily loans and investments) and interest paid on interest bearing liabilities (which are primarily deposits accounts and other borrowings). The volume of and yields earned on earning assets and the volume of and the rates paid on interest bearing liabilities determine net interest income. Refer to the tables preceding this paragraph for additional detail. Interest earned and interest paid is also affected by general economic conditions, particularly changes in market interest rates, and by government policies and the action of regulatory authorities. Net interest income divided by average earning assets is referred to as net interest margin. For the years December 31, 2004, 2003 and 2002, the Company's net interest margin was 3.97%, 4.02% and 4.51%, respectively. Yields on earning assets declined slightly faster than those of interest bearing liabilities and led to a slight decline in the Company's net interest margin in 2004. Assets repricing to lower market rates resulted in the decline in net interest margin in 2003 from 2002. The high level of competition in the local markets will continue to put downward pressure on the net interest margin of the Company into the foreseeable future. Currently, the Company's largest market, Ames, Iowa, has seven banks, three thrifts, four credit unions and several other financial investment companies. Multiple banks are also located in the Company's other communities creating similarly competitive environments. 22 Net interest income during 2004, 2003 and 2002 totaled $26,790,000, $24,975,000 and $24,607,000, respectively, representing a 7.27% increase in 2004 from 2003 and a 1.50% increase in 2003 compared to 2002. A higher volume of earning assets was primary reason for the increase in net interest income in 2004. The higher net interest income in 2003 resulted from lower interest expense as the Company was able to lower rates paid on deposits and other borrowings more quickly than rates declined on loans and investments. Provision for Loan Losses The provision for loan losses reflects management's judgment of the expense to be recognized in order to maintain an adequate allowance for loan losses. The Company provided a $479,000 provision for loan losses during 2004 compared to $645,000 in 2003 and $688,000 in 2002. Net charge-offs declined significantly in 2004 and was the primary reason for the lower level of provision expense in 2004. In 2003 and 2002, net charge-offs approximated 55% of the total loan provisions while loan growth was the primary contributor for the remaining provisions. Refer to the Asset Quality and Credit Risk Management discussion for additional detail with regard to loan loss provision expense. Management believes the allowance for loan losses to be adequate to absorb probable losses in the current portfolio. This statement is based upon management's continuing evaluation of inherent risks in the current loan portfolio, current levels of classified assets and general economic factors. The Company will continue to monitor the allowance and make future adjustments to the allowance as conditions dictate. Noninterest Income and Expense Total noninterest income is comprised primarily of fee-based revenues from trust and agency services, bank related service charges on deposit activities, net securities gains generated primarily by the Company's equity holdings, merchant and ATM fees related to electronic processing of merchant and cash transactions and secondary market income. Noninterest income during 2004, 2003 and 2002 totaled $5,269,000, $6,435,000 and $5,135,000, respectively, representing an 18.12% decrease in 2004 from 2003 and a 25.33% increase in 2003 compared 2002. The decrease in 2004 is the result of lower secondary market income and net securities gains that increased over 56% in 2003 from 2002. In 2003, low interest rates fueled a record year in mortgage refinancing resulting in record secondary market income. The Company also realized a higher level of securities gains in 2003 through liquidating equity holdings that no longer fit the Company's long term investment strategy. Noninterest expense for the Company consists of all operating expenses other than interest expense on deposits and other borrowed funds. Historically, the Company has not had any material expenses relating to discontinued operations, extraordinary losses or adjustments from a change in accounting principles. Salaries and employee benefits are the largest component of the Company's operating expenses and comprise 60.39% of noninterest expenses in 2004. Noninterest expense during 2004, 2003 and 2002 totaled $14,935,000, $14,820,000 and $13,276,000, respectively, representing a 0.78% increase in 2004 versus 2003 and an 11.62% increase in 2003 compared to 2002. The retirement of several higher paid senior officers allowed for stable non-interest expense for the year ended December 31, 2004 compared to the same period in 2003. An increase in salaries and employee benefits was the largest contributor to the increase in operating expenses in 2003 and related primarily to additional staffing at United Bank as a result of its significant growth. The percentage of noninterest expense to average assets was 1.88% in 2004, compared to 2.04% and 2.09% during 2003 and 2002, respectively. Provision for Income Taxes The provision for income taxes for 2004, 2003 and 2002 was $4,255,000, $4,321,000 and $4,438,000, respectively. This amount represents an effective tax rate of 25.57% during 2004, compared to 27.10% and 28.13% for 2003 and 2002, respectively. The Company's marginal federal tax rate is currently 35%. The difference between the Company's effective and marginal tax rate is primarily related to investments made in tax exempt securities. The average balance of tax exempt securities increased $25,566,000 in 2004 compared to 2003. 23 Balance Sheet Review The Company's assets are comprised primarily of loans and investment securities. Average earning asset maturity or repricing dates are less than five years for the combined portfolios as the assets are funded for the most part by short term deposits with either immediate availability or less than one year average maturities. This exposes the Company to risk with regard to changes in interest rates that are more fully explained in Item 7A of this report Quantitative and Qualitative Disclosures about Market Risk". Total assets increased to $839,753,000 in 2004 compared to $752,786,000 in 2003, an 11.55% increase. First National, State Bank and United Bank posted double digit growth in assets versus one year ago. Loan Portfolio Net loans for the year ended December 31, 2004, increased to $411,639,000 from $355,533,000 as of December 31, 2003, an increase of 15.78%. The increase in loan volume can be primarily attributed to growth in the commercial, commercial real estate and residential loan portfolios. Loans are the primary contributor to the Company's revenues and cash flows. The average yield on loans was 93 and 76 basis points higher in 2004 and 2003, respectively, than the average tax-equivalent investment portfolio yields for the same periods in the previous year. Types of Loans The following table sets forth the composition of the Company's loan portfolio for the past five years ending at December 31, 2004 . ------------------------------------------------ 2004 2003 2002 2001 2000 (dollars in thousands) ------------------------------------------------ Real Estate Construction $ 21,042 $ 13,126 $ 13,518 $ 12,677 $ 12,221 1-4 family residential 97,612 84,645 81,239 84,379 97,663 Commercial 160,176 150,723 136,351 117,211 112,415 Agricultural 27,443 24,297 21,693 21,029 21,095 Commercial 57,189 38,555 40,097 45,631 53,955 Agricultural 30,713 27,815 26,022 27,367 28,199 Consumer and other 24,584 23,242 19,921 20,920 24,576 ------------------------------------------------ Total loans 418,759 362,403 338,841 329,214 350,124 Deferred loan fees, net 644 819 777 725 736 ------------------------------------------------ Total loans net of deferred fees $418,115 $361,584 $338,064 $328,489 $349,388 The Company's loan portfolio consists of real estate loans, commercial loans, agricultural loans and consumer loans. As of December 31, 2004, gross loans totaled approximately $419 million, which equals approximately 64% of total deposits and 50% of total assets. The Company's peer group (consisting of 353 bank holding companies with total assets of $500 to $1,000 million) loan to deposit ratio as of September 30, 2004 was a much higher 86%. The primary factor relating to the lower loan to deposit ratio for the Company compared to peer group averages is a more conservative underwriting philosophy. As of December 31, 2004, the majority of the loans were originated directly by the Banks to borrowers within the Banks' principal market areas. There are no foreign loans outstanding during the years presented. Real estate loans include various types of loans for which the Banks hold real property as collateral and consist of loans primarily on commercial properties and single family residences. Real estate loans typically have fixed rates for up to five years, with the Company's loan policy permitting a maximum fixed rate maturity of up to 15 years. The majority of construction loan volume is to contractors to construct commercial buildings and these loans generally have maturities of up to 12 months. The Banks originate residential real estate loans for sale to the secondary market for a fee. Commercial loans consist primarily of loans to businesses for various purposes, including revolving lines to finance current operations, floor-plans, inventory and accounts receivable; capital expenditure loans to finance equipment and other fixed assets; and letters of credit. These loans generally have short maturities, have either adjustable or fixed rates and are unsecured or secured by inventory, accounts receivable, equipment and/or real estate. Agricultural loans play an important part in the Banks' loan portfolios. Iowa is a major agricultural state and is a national leader in both grain and livestock production. The Banks play a significant role in their communities in financing operating, livestock and real estate activities for area producers. 24 Consumer loans include loans extended to individuals for household, family and other personal expenditures not secured by real estate. The majority of the Banks' consumer lending is for vehicles, consolidation of personal debts, household appliances and improvements. The interest rates charged on loans vary with the degree of risk and the amount and maturity of the loan. Competitive pressures, market interest rates, the availability of funds and government regulation further influence the rate charged on a loan. The Banks follow a loan policy, which has been approved by both the board of directors of the Company and the Banks, and is overseen by both Company and Bank management. These policies establish lending limits, review and grading criteria and other guidelines such as loan administration and allowance for loan losses. Loans are approved by the Banks' board of directors and/or designated officers in accordance with respective guidelines and underwriting policies of the Company. Credit limits generally vary according to the type of loan and the individual loan officer's experience. Loans to any one borrower are limited by applicable state and federal banking laws. Maturities and Sensitivities of Loans to Changes in Interest Rates as of December 31, 2004 The contractual maturities of the Company's loan portfolio are as shown below. Actual maturities may differ from contractual maturities because individual borrowers may have the right to prepay loans with or without prepayment penalties. After one year but Within within After one year five years five years Total (dollars in thousands) --------------------------------------------- Real Estate Construction $10,154 $ 2,400 $ 8,488 $ 21,042 1-4 family residential 3,968 41,797 51,847 97,612 Commercial 14,670 113,706 31,800 160,176 Agricultural 1,262 7,639 18,542 27,443 Commercial 38,122 14,823 4,244 57,189 Agricultural 19,141 8,473 3,099 30,713 Consumer and other 2,563 15,328 6,693 24,584 -------------------------------------------- Total loans $89,880 $204,166 $124,713 $418,759 After one year but within After five years five years ---------------------- Loan maturities after one year with: Fixed rates $174,184 $ 42,045 Variable rates 29,982 82,668 -------------------- $204,166 $124,713 Loans Held For Sale Mortgage origination funding awaiting delivery to the secondary market totaled $234,000 and $859,000 as of December 31, 2004 and 2003, respectively. Residential mortgage loans are originated by the Banks and sold to several secondary mortgage market outlets based upon customer product preferences and pricing considerations. The mortgages are sold in the secondary market to eliminate interest rate risk and to generate secondary market fee income. It is not anticipated at the present time that loans held for sale will become a significant portion of total assets. Investment Portfolio Total investments as of December 31, 2004 were $363,460,000, an increase of $40,344,000 or 12% from the prior year end. As of December 31, 2004 and 2003, the investment portfolio comprised 43% of total assets. 25 The following table presents the market values, which represent the carrying values due to the available-for-sale classification, of the Company's investment portfolio as of December 31, 2004, 2003 and 2002, respectively. This portfolio provides the Company with a significant amount of liquidity since all of the investments are considered available for sale as of December 31, 2004, 2003 and 2002. ------------------------------------- 2004 2003 2002 (dollars in thousands) ------------------------------------- U.S. treasury securities $ 531 $ 2,229 $ 4,208 U.S. government agencies 137,634 118,637 85,780 States and political subdivisions 113,818 105,963 70,516 Corporate bonds 77,573 63,586 56,357 Equity securities 33,904 32,701 27,714 ------------------------------------- Total $363,460 $323,116 $244,575 Investments in states and political subdivisions represent purchases of municipal bonds located primarily in the state of Iowa and contiguous states. Investment in other securities includes corporate debt obligations of companies located and doing business throughout the United States. The debt obligations were all within the credit ratings acceptable under the Banks' investment policies. As of December 31, 2004, the Company did not have securities from a single issuer, except for the United States Government or its agencies, which exceeded 10% of consolidated stockholders' equity. The equity securities portfolio consists primarily of financial and utility stocks as of December 31, 2004, 2003, and 2002. Investment Maturities as of December 31, 2004 The investments in the following table are reported by contractual maturity. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without prepayment penalties. After one After five year but years but Within within within After one year five years ten years ten years Total (dollars in thousands) ------------------------------------------------------------ U.S. treasury $ - $ - $ 531 $ - $ 531 U.S. government agencies 9,691 102,607 18,546 6,790 137,634 States and political subdivisions 5,867 33,271 46,760 27,920 113,818 Corporate bonds 4,891 58,871 13,811 - 77,573 ------------------------------------------------------------ Total $20,449 $194,749 $79,648 $34,710 $329,556 Weighted average yield U.S. treasury - - 5.19% - 5.19% U.S. government agencies 4.60% 3.30% 4.49% 4.46% 3.63% States and political subdivisions* 5.27% 5.36% 6.68% 6.15% 6.09% Corporate bonds 4.55% 4.53% 5.31% - 4.67% ------------------------------------------------------------ Total 4.78% 4.03% 5.93% 5.81% 4.73% * Yields on tax-exempt obligations of states and political subdivisions have been computed on a tax-equivalent basis.
Deposits Types of Deposits Total deposits equaled $658,176,000 and $619,549,000 as of December 31, 2004 and 2003, respectively. The increase of $38,627,000 can be attributed to deposit growth at four of the five Banks, with United Bank and First National posting the largest increases of $16,656,000 and $14,861,000, respectively. Average deposits for the year ended December 31, 2004 were $37,889,000 higher than the same period in 2003. The deposit category seeing the largest balance increases were NOW accounts. 26 The Company's primary source of funds is customer deposits. The Company attempts to attract noninterest-bearing deposits, which are a low-cost funding source. In addition, the Banks offer a variety of interest-bearing accounts designed to attract both short-term and longer-term deposits from customers. Interest-bearing accounts earn interest at rates established by Bank management based on competitive market factors and the Company's need for funds. While nearly 57% of the Banks' certificates of deposit mature in the next year, it is anticipated that a majority of these certificates will be renewed. Rate sensitive certificates of deposits in excess of $100,000 are subject to somewhat higher volatility with regard to renewal volume as the Banks adjust rates based upon funding needs. In the event a substantial volume of certificates are not renewed, the Company has sufficient liquid assets and borrowing lines to fund significant runoff. A sustained reduction in deposit volume would have a significant negative impact on the Company's operation and liquidity. The Company traditionally has not relied upon brokered deposits and does not anticipate utilizing such funds at the present time. Average Deposits by Type The following table sets forth the average balances for each major category of deposit and the weighted average interest rate paid for deposits during the years ended December 31, 2004, 2003 and 2002. ---------------------------------------------------- 2004 2003 2002 ---------------------------------------------------- Amount Rate Amount Rate Amount Rate (dollars in thousands) ---------------------------------------------------- Noninterest bearing demand deposits $ 65,785 $ 59,614 - $ 53,318 - Interest bearing demand deposits 154,332 0.80% 130,138 0.70% 115,494 1.00% Money market deposits 146,479 1.25% 143,478 1.20% 120,446 1.71% Savings deposits 28,599 0.47% 25,269 0.50% 24,486 0.71% Time certificates < $100,000 173,581 2.87% 170,534 3.21% 152,703 4.00% Time certificates > $100,000 70,076 2.51% 65,759 2.75% 51,428 3.69% ---------------------------------------------------- $638,852 $594,792 $517,875
Deposit Maturity The following table shows the amounts and remaining maturities of time certificates of deposit that had balances of $100,000 and over as of December 31, 2004, 2003 and 2002. 2004 2003 2002 (dollars in thousands) -------------------------------- 3 months or less $20,613 $23,801 $15,162 Over 3 through 12 months 29,217 29,896 25,939 Over 12 through 36 months 17,131 11,374 9,281 Over 36 months 2,103 4,416 4,182 -------------------------------- Total $69,064 $69,487 $54,564 Borrowed Funds Borrowed funds that may be utilized by the Company are comprised of Federal Home Loan Bank (FHLB) advances, federal funds purchased and repurchase agreements. Borrowed funds are an alternative funding source to deposits and can be used to fund the Company's assets and unforeseen liquidity needs. FHLB advances are loans from the FHLB that can mature daily or have longer maturities for fixed or floating rates of interest. Federal funds purchased are borrowings from other banks that mature daily. Securities sold under agreement to repurchase (repurchase agreements) are similar to deposits as they are funds lent by various Bank customers; however, the bank pledges investment securities to secure such borrowings. The Company's repurchase agreements normally reprice daily. The Company does not have any FHLB advances or federal funds purchased outstanding as of December 31, 2004. 27 The following table summarizes the outstanding amount of, and the average rate on, borrowed funds as of December 31, 2004, 2003 and 2002. 2004 2003 2002 ------------------------------------------------------------------- Average Average Average Balance Rate Balance Rate Balance Rate (dollars in thousands) ------------------------------------------------------------------- FHLB advances $ - - $ - - $ - - Federal funds purchased and repurchase agreements 64,072 1.99% 18,199 1.39% 18,326 1.50% ------------------------------------------------------------------- Total $64,072 1.99% $18,199 1.39% $18,326 1.50%
Average Annual Borrowed Funds The following table sets forth the average amount of, the average rate paid and maximum outstanding balance on, borrowed funds for the years ended December 31, 2004, 2003 and 2002. 2004 2003 2002 ------------------------------------------------------------------------ Average Average Average Average Average Average Balance Rate Balance Rate Balance Rate dollars in thousands) ------------------------------------------------------------------------ FHLB advances $ - - $ - - $ 47 4.26% Federal funds purchased & repurchase agreements 38,211 1.62% 19,588 1.48% 13,840 1.91% ----------------------------------------------------------------------- Total $ 38,211 1.62% $19,588 1.48% $13,887 1.91% Maximum Amount Outstanding during the year: FHLB advances $ - $ - $ 1,000 Federal funds purchased and repurchase agreements 65,391 22,728 18,326
Off-Balance-Sheet Arrangements The Company is party to financial instruments with off-balance-sheet risk in the normal course of business. These financial instruments include commitments to extend credit and standby letters of credit. The instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the balance sheet. For additional information, see footnote 9 of the "Notes to Consolidated Statements". Asset Quality Review and Credit Risk Management The Company's credit risk is centered in the loan portfolio, which on December 31, 2004 totaled $411,639,000 as compared to $355,533,000 as of December 31, 2003, an increase of 15.78%. Loans comprise 49% of total assets as of the end of 2004. The object in managing loan portfolio risk is to reduce the risk of loss resulting from a customer's failure to perform according to the terms of a transaction and to quantify and manage credit risk on a portfolio basis. As the following chart indicates, the Company's credit risk management practices have resulted in a low level of non-performing assets that total $2,748,000 as of December 31, 2004. The Company's level of problem assets as a percentage of assets of 0.33% compares favorably to the average for FDIC insured institutions as of September 30, 2004 of 0.61%. 28 Non-performing Assets The following table sets forth information concerning the Company's non-performing assets for the past five years ending December 31, 2004. 2004 2003 2002 2001 2000 (dollars in thousands) ---------------------------------------------------------------- Non-performing assets: Nonaccrual loans $1,896 $1,756 $2,015 $2,692 $2,663 Loans 90 days or more past due and still accruing 80 431 394 797 242 ---------------------------------------------------------------- Other real estate owned 1,976 2,187 2,409 3,489 2,905 772 159 295 159 75 Total non-performing assets ---------------------------------------------------------------- $2,748 $,2,346 $2,704 $3,648 $2,980
The accrual of interest on non-accrual and other impaired loans is discontinued at 90 days or when, in the opinion of management, the borrower may be unable to meet payments as they become due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received. Interest income on restructured loans is recognized pursuant to the terms of the new loan agreement. Interest income on other impaired loans is monitored and based upon the terms of the underlying loan agreement. However, the recorded net investment in impaired loans, including accrued interest, is limited to the present value of the expected cash flows of the impaired loan or the observable fair market value of the loan's collateral. Outstanding loans of $481,000 were placed on non-accrual status in 2004 with total non-accrual loans equaling $1,896,000 as of December 31, 2004. Outstanding loans of $200,000 were placed on non-accrual status in 2003 with total non-accrual loans equaling $1,756,000 as of December 31, 2003. Outstanding loans of $383,000 were placed on non-accrual status in 2002 with total non-accrual loans equaling $2,015,000 as of December 31, 2002. A real estate loan at First National with a December 31, 2004 and 2003 balance of $1,305,000 is the largest non-performing asset. For the years ended December 31, 2004, 2003 and 2002, interest income, which would have been recorded under the original terms of such loans was approximately $239,000, $179,000 and $160,000, respectively, with $211,000, $177,000 and $17,000, respectively, recorded. Loans greater than 90 days past due and still accruing interest were $80,000 and $431,000 at December 31, 2004 and 2003, respectively. Summary of the Allowance for Loan Losses The provision for loan losses represents an expense charged against earnings to maintain an adequate allowance for loan losses. The allowance for loan losses is management's best estimate of probable losses inherent in the loan portfolio as of the balance sheet date. Factors considered in establishing an appropriate allowance include: an assessment of the financial condition of the borrower; a realistic determination of value and adequacy of underlying collateral; the condition of the local economy and the condition of the specific industry of the borrower; an analysis of the levels and trends of loan categories; and a review of delinquent and classified loans. The adequacy of the allowance for loan losses is evaluated quarterly by management and the respective Bank boards. This evaluation focuses on specific loan reviews, changes in the type and volume of the loan portfolio given the current and forecasted economic conditions and historical loss experience. Any one of the following conditions may result in the review of a specific loan: concern about whether the customer's cash flow or net worth are sufficient to repay the loan; delinquent status; criticism of the loan in a regulatory examination; the accrual of interest has been suspended; or other reasons, including when the loan has other special or unusual characteristics which warrant special monitoring. While management uses available information to recognize losses on loans, further reductions in the carrying amounts of loans may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the estimated losses on loans. Such agencies may require the Company to recognize additional losses based on their judgment about information available to them at the time of their examination. 29 Analysis of the Allowance for Loan Losses The Company's policy is to charge-off loans when, in management's opinion, the loan is deemed uncollectible, although concerted efforts are made to maximize future recoveries. The following table sets forth information regarding changes in the Company's allowance for loan losses for the most recent five years. 2004 2003 2002 2001 2000 (dollars in thousands) --------------------------------------------------------- Balance at beginning of period $ 6,051 $ 5,758 $ 5,446 $ 5,373 $ 4,986 Charge-offs: Real Estate Construction - 24 - - - 1-4 Family Residential 19 5 - - - Commercial 93 - 40 - - Agricultural - - - - - Commercial 3 392 235 768 55 Agricultural - - - - - Consumer and other 115 43 155 83 96 --------------------------------------------------------- 230 464 430 852 151 Recoveries: Real Estate Construction - - - - - 1-4 Family Residential - - 20 - - Commercial - - - - - Agricultural - - - - - Commercial 13 100 14 8 66 Agricultural - - - - - Consumer and other 163 12 20 19 12 --------------------------------------------------------- 176 112 54 27 78 Net charge-offs 54 352 376 825 73 Additions charged to operations 479 645 688 898 460 --------------------------------------------------------- Balance at end of period $ 6,476 $6,051 $5,758 $5,446 $5,373 Average Loans Outstanding $385,347 $349,812 $317,521 $341,440 $339,115 Ratio of net charge-offs during the period to average loans outstanding 0.01% 0.11% 0.12% 0.24% 0.02% Ratio of allowance for loan losses to total loans net of deferred fees 1.55% 1.67% 1.70% 1.65% 1.54%
The allowance for loan losses increased to $6,476,000 at the end of 2004 in comparison to the allowance of $6,051,000 at year end 2003. The increase can be primarily attributed to the growth of general reserves at First National. The increase in the reserve levels in 2003 relate primarily to general reserves established by United Bank. The 2002 increase relates primarily to First National as the result of higher specific reserves for two problem credits identified by management prior to 2002 and a large specific reserve for a newly downgraded problem loan in 2002. Problem commercial leases identified at First National in 2001 led to higher provision expense, net charge-offs and specific reserves as credit weaknesses were identified in 2001. General reserve allocations remained consistent in 2004 with prior years. 30 General reserves for loan categories normally range from 1.00 to 1.30% of the outstanding loan balances. As loan volume increases, the general reserve levels increase with that growth. As the previous table indicates, loan provisions have been trending downward since 2001 as the level of net charge-offs has declined. The general reserve loss factors have remained consistent over the five-year period presented. The allowance relating to commercial real estate and 1-4 family residential loans are the largest reserve components. Commercial real estate loans have higher general reserve levels than other real estate loans as management perceives more risk in this type of lending. Elements contributing to the higher risk level include susceptibility of businesses to changing environmental factors such as the economic business cycle, the larger individual loan amounts, a limited number of buyers and the specialized uses for some properties. As of December 31, 2004, commercial real estate loans have general reserves of 1.30%. The estimation methods and assumptions used in determining the allowance for the five years presented have remained consistent. Loans that the Banks have identified as having higher risk levels are reviewed individually in an effort to establish adequate loss reserves. These reserves are considered specific reserves and are directly impacted by the credit quality of the underlying loans. Normally, as the actual or expected level of non-performing loans increase, the specific reserves also increase. For December 31, 2004 specific reserves decreased $431,000 or 23.50% compared to year end 2003 levels as four of the five banks had improved loan quality. As of December 31, 2003, specific reserves increased $146,000 or 8.65% over year end 2002. In 2003, specific allocations to problem agricultural real estate loans was the largest contributor to the increase in the specific reserve level when compared to year end 2002. Specific allocations for commercial real estate loans triggered the increase in 2002 while commercial leases contributed to the increase in total reserve levels in 2001. The specific reserves are dependent upon assumptions regarding the liquidation value of collateral and the cost of recovering collateral including legal fees. Changing the amount of specific reserves on individual loans has had the largest impact on the reallocation of the reserve among different parts of the portfolio. Other factors that are considered when determining the adequacy of the reserve include loan concentrations, loan growth, the economic outlook and historical losses. The Company's concentration risks include geographic concentration in central Iowa; the local economy's dependence upon several large governmental entity employers, including Iowa State University and the Iowa Department of Transportation; and the health of Iowa's agricultural sector that in turn, is dependent on weather conditions and government programs. No significant reserves have been established for local and national economic conditions over the last five-year period as the economic outlook has generally been favorable. However, no assurances can be made that losses will remain at the favorable levels experienced over the past five years. Allocation of the Allowance for Loan Losses The following table sets forth information concerning the Company's allocation of the allowance for loan losses. 2004 2003 2002 2001 2000 (dollars in thousands) ----------------------------------------------------------------------------------------- Amount % * Amount % * Amount % * Amount % * Amount % * Balance at end of period applicable to: Real Estate Construction $ 429 5.02% $ 196 3.62% $ 210 3.99% $ 178 3.99% $ 163 3.49% 1-4 family residential 1,021 23.31% 948 23.36% 892 23.98% 980 23.98% 1,088 27.89% Commercial 2,676 38.25% 2,663 41.59% 2,453 40.24% 1,704 40.24% 1,619 32.11% Agricultural 486 6.55% 458 6.70% 302 6.40% 279 6.40% 315 6.03% Commercial 809 13.66% 775 10.64% 910 11.83% 938 11.83% 754 15.41% Agricultural 360 7.33% 488 7.68% 504 7.68% 457 7.68% 421 8.05% Consumer and other 302 5.87% 255 6.41% 235 5.88% 258 5.88% 538 7.02% Unallocated 393 268 252 652 475 ---------------------------------------------------------------------------------------- $6,476 100% $6,051 100% $5,758 100% $5,446 100% $5,373 100% * Percent of loans in each category to total loans.
31 Liquidity and Capital Resources Liquidity management is the process by which the Company, through its Banks' Asset and Liability Committees (ALCO), ensures that adequate liquid funds are available to meet its financial commitments on a timely basis, at a reasonable cost and within acceptable risk tolerances. These commitments include funding credit obligations to borrowers, funding of mortgage originations pending delivery to the secondary market, withdrawals by depositors, maintaining adequate collateral for pledging for public funds, trust deposits and borrowings, paying dividends to shareholders, payment of operating expenses, funding capital expenditures and maintaining deposit reserve requirements. Liquidity is derived primarily from core deposit growth and retention; principal and interest payments on loans; principal and interest payments, sale, maturity and prepayment of investment securities; net cash provided from operations; and access to other funding sources. Other funding sources include federal funds purchased lines, Federal Home Loan Bank (FHLB) advances and other capital market sources. As of December 31, 2004, the level of liquidity and capital resources of the Company remain at a satisfactory level and compare favorably to that of other FDIC insured institutions. Management believes that the Company's liquidity sources will be sufficient to support its existing operations for the foreseeable future. The liquidity and capital resources discussion will cover the follows topics: o Review the Company's Current Liquidity Sources o Review of the Statements of Cash Flows o Review Company Only Cash Flows o Review of Commitments for Capital Expenditures, Cash Flow Uncertainties and Known Trends in Liquidity and Cash Flows Needs o Capital Resources Review of the Company's Current Liquidity Sources Liquid assets of cash on hand, balances due from other banks, federal funds sold and interest-bearing deposits in financial institutions for December 31, 2004, 2003 and 2002 totaled $48,199,000, $58,725,000 and $85,189,000, respectively. The lower balance of liquid assets as of December 31, 2004 relates to a lower level of deposits maintained with other financial institutions. Other sources of liquidity available to the Banks include outstanding lines of credit with the Federal Home Loan Bank of Des Moines, Iowa of $28,471,000 and federal funds borrowing capacity at correspondent banks of $52,500,000. The Company did not have any outstanding FHLB advances or federal funds sold as of December 31, 2004 and securities sold under agreement to repurchase totaled $64,072,000. Approximately $40,000,000 in repurchases agreement balances at First National are expected to be withdrawn gradually from January to August 2005. Total investments as of December 31, 2004 were $363,459,000 compared to $323,116,000 as of year end 2003. At both December 31, 2004 and 2003, the investment portfolio as a percentage of average assets was 43%. This provides the Company with a significant amount of liquidity since all of the investments are classified as available for sale as of December 31, 2004 and 2003 and have net unrealized gains of $11,854,000 and $14,152,000, respectively. The investment portfolio serves an important role in the overall context of balance sheet management in terms of balancing capital utilization and liquidity. The decision to purchase or sell securities is based upon the current assessment of economic and financial conditions, including the interest rate environment, liquidity and credit considerations. The portfolio's scheduled maturities represent a significant source of liquidity. Review of the Consolidated Statements of Cash Flows Operating cash flows for December 31, 2004, 2003 and 2002 totaled $13,169,000, $14,828,000, and $13,803,000, respectively. The decrease in operating cash flows in 2004 compared to 2003 included a reduction in loans held for sale and an increase in other assets in 2004. These decreases were offset by security gains realized in 2004 as compared to 2003 and an increase net income. The primary variance in 2003 compared to 2002 was the source of cash provided from a lower level of accrued expense and other liabilities that was a use of cash in 2002. 32 Net cash used in investing activities for December 31, 2004, 2003 and 2002 was $103,647,000, $96,479,000 and 43,819,000, respectively. The largest investing activities in 2004 were the purchase of U.S. government agency and corporate bonds and the funding of commercial operating and commercial real estate loans offset by the maturities, calls, and sales of securities available for sale. U.S. government agency bonds, municipal bonds and commercial real estate loans were the most significant investing activities in 2003. Net cash provided by financing activities for December 31, 2004, 2003 and 2002 totaled $77,255,000, $61,944,000 and $39,245,000, respectively. Growth in securities sold under agreement to repurchase and deposits was the primary source of financing funds in 2004. Deposit growth was the primary source of cash flows for 2003 and 2002. As of December 31, 2004, the Company did not have any external debt financing, off balance sheet financing arrangements or derivative instruments linked to its stock. Company Only Cash Flows The Company's liquidity on an unconsolidated basis is heavily dependent upon dividends paid to the Company by the Banks. The Company requires adequate liquidity to pay its expenses and pay stockholder dividends. In 2004, dividends from the Banks amounted to $8,384,000 compared to $7,868,000 in 2003. Various federal and state statutory provisions limit the amount of dividends banking subsidiaries are permitted to pay to their holding companies without regulatory approval. Federal Reserve policy further limits the circumstances under which bank holding companies may declare dividends. For example, a bank holding company should not continue its existing rate of cash dividends on its common stock unless its net income is sufficient to fully fund each dividend and its prospective rate of earnings retention appears consistent with its capital needs, asset quality and overall financial condition. In addition, the Federal Reserve and the FDIC have issued policy statements which provide that insured banks and bank holding companies should generally pay dividends only out of current operating earnings. Federal and state banking regulators may also restrict the payment of dividends by order. First National, as a national bank, generally may pay dividends from undivided profits without restriction, provided that its surplus fund is at least equal to its common stock capital fund. Boone Bank, Randall-Story Bank and State Bank are also restricted under Iowa law to paying dividends only out of their undivided profits. United Bank is not expected to generate sufficient earnings to pay any dividends in 2005. Additionally, the payment of dividends by the Banks is affected by the requirement to maintain adequate capital pursuant to applicable capital adequacy guidelines and regulations, and the Banks generally are prohibited from paying any dividends if, following payment thereof, the Bank would be undercapitalized. The Company has unconsolidated interest bearing deposits and marketable investment securities totaling $34,902,000 that are presently available to provide additional liquidity to the Banks. Review of Commitments for Capital Expenditures, Cash Flow Uncertainties and Known Trends in Liquidity and Cash Flows Needs No material capital expenditures or material changes in the capital resource mix are anticipated at this time. Commitments to extend credit totaled $65,894,000 as of December 31, 2004 compared to a total of $71,100,000 at the end of 2003. The timing of these credit commitments varies with the underlying borrowers; however, the Company has satisfactory liquidity to fund these obligations as of December 31, 2004. The primary cash flow uncertainty would be a sudden decline in deposits causing the Banks to liquidate securities. Historically, the Banks have maintained an adequate level of short term marketable investments to fund the temporary declines in deposit balances. There are no known trends in liquidity and cash flow needs as of December 31, 2004 that are a concern to management. Capital Resources The Company's total stockholders' equity increased to $110,924,000 at December 31, 2004, from $107,325,000 at December 31, 2003. At December 31, 2004 and 2003, stockholders' equity as a percentage of total assets was 13.21% and 14.26%, respectively. Total equity increased due to retention of earnings which was partially offset by depreciation in the Banks' investment portfolios. The capital levels of the Company currently exceed applicable regulatory guidelines as of December 31, 2004. 33 Interest Rate Risk Interest rate risk refers to the impact that a change in interest rates may have on the Company's earnings and capital. Management's objectives are to control interest rate risk and to ensure predictable and consistent growth of earnings and capital. Interest rate risk management focuses on fluctuations in net interest income identified through computer simulations to evaluate volatility, varying interest rate, spread and volume assumptions. The risk is quantified and compared against tolerance levels. The Company uses a third-party computer software simulation modeling program to measure its exposure to potential interest rate changes. For various assumed hypothetical changes in market interest rates, numerous other assumptions are made such as prepayment speeds on loans, the slope of the Treasury yield curve, the rates and volumes of the Company's deposits and the rates and volumes of the Company's loans. This analysis measures the estimated change in net interest income in the event of hypothetical changes in interest rates. Another measure of interest rate sensitivity is the gap ratio. This ratio indicates the amount of interest-earning assets repricing within a given period in comparison to the amount of interest-bearing liabilities repricing within the same period of time. A gap ratio of 1.0 indicates a matched position, in which case the effect on net interest income due to interest rate movements will be minimal. A gap ratio of less than 1.0 indicates that more liabilities than assets reprice within the time period and a ratio greater than 1.0 indicates that more assets reprice than liabilities. The simulation model process provides a dynamic assessment of interest rate sensitivity, whereas a static interest rate gap table is compiled as of a point in time. The model simulations differ from a traditional gap analysis as a traditional gap analysis does not reflect the multiple effects of interest rate movement on the entire range of assets and liabilities and ignores the future impact of new business strategies. Inflation The primary impact of inflation on the Company's operations is to increase asset yields, deposit costs and operating overhead. Unlike most industries, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates generally have a more significant impact on a financial institution's performance than they would on non-financial companies. Although interest rates do not necessarily move in the same direction or to the same extent as the price of goods and services, increases in inflation generally have resulted in increased interest rates. The effects of inflation can magnify the growth of assets and, if significant, require that equity capital increase at a faster rate than would be otherwise necessary. Forward-Looking Statements and Business Risks The discussion in the foregoing Management Discussion and Analysis and elsewhere in this Report contains forward-looking statements about the Company, its business and its prospects. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. They often include use of the words "believe", "expect", "anticipate", "intend", "plan", "estimate" or words of similar meaning, or future or conditional verbs such as "will", "would", "should", "could" or "may" reward-looking statements, by their nature, are subject to risks and uncertainties. A number of factors, many of which are beyond the Company's control, could cause actual conditions, events or results to differ significantly from those described in the forward-looking statements. Such risks and uncertainties with respect to the Company include, but are not limited to, those related to the economic conditions, particularly in the areas in which the Company and the Banks operate, competitive products and pricing, fiscal and monetary policies of the U.S. government, changes in governmental regulations affecting financial institutions, (including regulatory fees and capital requirements), changes in prevailing interest rates, credit risk management and asset/liability management, the financial and securities markets and the availability of and costs associated with sources of liquidity. 34 These factors may not constitute all factors that could cause actual results to differ materially from those discussed in any forward-looking statement. The Company operates in a continually changing business environment and new facts emerge from time to time. It cannot predict such factors nor can it assess the impact, if any, of such factors on its financial position or its results of operations. Accordingly, forward-looking statements should not be relied upon as a predictor of actual results. The Company disclaims any responsibility to update any forward-looking statement provided in this document. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company's market risk is comprised primarily of interest rate risk arising from its core banking activities of making loans and taking deposits. Interest rate risk is the risk that changes in market interest rates may adversely affect the Company's net interest income. Management continually develops and applies strategies to mitigate this risk. Management does not believe that the Company's primary market risk exposure and how that exposure was managed in 2004 changed when compared to 2003. Based on a simulation modeling analysis performed as of December 31, 2004, the following table presents the estimated change in net interest income in the event of hypothetical changes in interest rates for the various rate shock levels: Net Interest Income at Risk Estimated Change in Net Interest Income for Year Ending December 31, 2004 $ Change % Change (dollars in thousands) ------------------------ +200 Basis Points $ (158) (0.6%) +100 Basis Points (91) (0.3%) -100 Basis Points (554) (2.0%) -200 Basis Points (2,595) (9.5%) As shown above, at December 31, 2004, the estimated effect of an immediate 200 basis point increase in interest rates would decrease the Company's net interest income by 0.6% or approximately $158,000 in 2005. The estimated effect of an immediate 200 basis point decrease in rates would decrease the Company's net interest income by 9.5% or approximately $2,595,000 in 2005. The Company's Asset Liability Management Policy establishes parameters for a 200 basis point change in interest rates. Under this policy, the Company and the Banks' objective is to properly structure the balance sheet to prevent a 200 basis point change in interest rates from causing a decline in net interest income by more than 15% in one year compared to the base year that hypothetically assumes no change in interest rates. Computations of the prospective effects of hypothetical interest rate changes are based on numerous assumptions. Actual values may differ from those projections set forth above. Further, the computations do not contemplate any actions the Company may undertake in response to changes in interest rates. Current interest rates on certain liabilities are at a level that does not allow for significant repricing should market interest rates decline considerably. 35 Contractual Maturity or Repricing The following table sets forth the estimated maturity or re-pricing, and the resulting interest sensitivity gap, of the Company's interest-earning assets and interest-bearing liabilities and the cumulative interest sensitivity gap at December 31, 2004. The expected maturities are presented on a contractual basis. Actual maturities may differ from contractual maturities because of prepayment assumptions, early withdrawal of deposits and competition. Less than Three One to Over three months to five five Cumulative months one year years years Total (dollars in thousands) ------------------------------------------------------------------------------- Interest - earning assets Interest-bearing deposits with banks $ 5,676 $ 1,272 $ 2,627 $ - $ 9,575 Federal funds sold 19,865 - - - 19,865 Investments * 5,158 15,291 194,749 148,261 363,459 Loans 103,940 28,146 218,301 68,372 418,759 Loans held for sale 234 234 ------------------------------------------------------------------------ Total interest - earning assets $ 134,873 $ 44,709 $415,677 $216,633 $811,892 ======================================================================== Interest - bearing liabilities Interest bearing demand deposits $ 172,313 - - - $172,313 Money market and savings deposits 174,358 - - - 174,358 Time certificates < $100,000 27,744 59,043 83,838 149 170,774 Time certificates > $100,000 20,613 29,217 19,234 - 69,064 Other borrowed funds 64,072 - - - 64,072 ------------------------------------------------------------------------ Total interest - bearing liabilities $ 459,100 $88,260 $103,072 $149 $650,581 Interest sensitivity gap $(324,227) $ (43,551) $312,605 $216,484 $161,311 ======================================================================== Cumulative interest sensitivity gap $(324,227) $(367,778) $(55,173) $161,311 $161,311 ======================================================================== Cumulative interest sensitivity gap as a percent of total assets -38.61% -43.80% -6.57% 19.21% ======================================================================== * Investments with maturities over 5 years include the market value of equity securities of $33,904.
As of December 31, 2004, the Company's cumulative gap ratios for assets and liabilities repricing within three months and within one year were 39% and 44%, respectively, meaning more liabilities than assets are scheduled to reprice within these periods. This situation suggests that a decrease in market interest rates may benefit net interest income and that an increase in interest rates may negatively impact the Company. The liability sensitive gap position is largely the result of classifying the interest bearing NOW accounts, money market accounts and savings accounts as immediately repriceable. Certain shortcomings are inherent in the method of analysis presented in the foregoing table. For example, although certain assets and liabilities may have similar maturities and periods to repricing, they may react differently to changes in market interest rates. Also, interest rates on assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other assets and liabilities may follow changes in market interest rates. Additionally, certain assets have features that restrict changes in the interest rates of such assets, both on a short-term basis and over the lives of such assets. 36 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING The management of Ames National Corporation is responsible for establishing and maintaining adequate internal control over financial reporting. Ames National Corporation's internal control system was designed to provide reasonable assurance to the company's management and board of directors regarding the preparation and fair presentation of published financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Ames National Corporation's management assessed the effectiveness of the company's internal control over financial reporting as of December 31, 2004. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on our assessment we determined that, as of December 31, 2004, the company's internal control over financial reporting is effective based on those criteria. Our management's assessment of the effectiveness of the Company's internal control over financial reporting as of December 31, 2004 has been audited by McGladrey & Pullen, LLP, an independent registered public accounting firm, as stated in their report which appears herein. By: /s/ Daniel L. Krieger ----------------------------------------- Daniel L. Krieger, Chairman and President (Principal Executive Officer) By: /s/ John P. Nelson ----------------------------------------- John P. Nelson, Vice President (Principal Financial Officer) 37 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors Ames National Corporation and Subsidiaries Ames, Iowa We have audited the accompanying consolidated balance sheets of Ames National Corporation and Subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2004. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion of these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Ames National Corporation and Subsidiaries as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Ames National Corporation and subsidiaries' internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 3, 2005 expressed an unqualified opinion. /s/ McGladrey & Pullen, LLP Des Moines, Iowa February 3, 2005 38 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors Ames National Corporation and Subsidiaries Ames, Iowa We have audited management's assessment, included in the accompanying Management's Report on Internal Control over Financial Reporting that Ames National Corporation maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Ames National Corporation's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over the financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management's assessment that Ames National Corporation maintained effective internal control over financial reporting as of December 31, 2004 is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also in our opinion, Ames National Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the balance sheets of Ames National Corporation as of December 31, 2004 and 2003, and the related statements of income, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 2004, and our report dated February 3, 2005, expressed an unqualified opinion. /s/ McGladrey & Pullen, LLP Des Moines, Iowa February 3, 2005 39 AMES NATIONAL CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 2004 and 2003 ASSETS 2004 2003 ------------------------------------------------------------------------------------------ Cash and due from banks (Note 2) $ 18,759,086 $ 31,982,144 Federal funds sold 19,865,000 20,380,000 Interest bearing deposits in financial institutions 9,575,174 6,363,538 Securities available-for-sale (Note 3) 363,459,462 323,115,914 Loans receivable, net (Note 4) 411,638,565 355,533,119 Loans held for sale 234,469 859,139 Bank premises and equipment, net (Note 5) 8,790,636 8,377,807 Accrued income receivable 6,262,424 5,842,247 Other assets 1,167,971 332,556 ---------------------------------- Total assets $ 839,752,787 $ 752,786,464 ================================== LIABILITIES AND STOCKHOLDERS' EQUITY LIABILITIES Deposits (Note 6) Demand, noninterest bearing $ 71,666,385 $ 71,372,534 NOW accounts 172,313,429 138,308,140 Savings and money market 174,358,165 166,387,319 Time, $100,000 and over 69,063,977 69,486,570 Other time 170,773,883 173,993,964 ---------------------------------- Total deposits 658,175,839 619,548,527 Federal funds purchased and securities sold under agreements to repurchase 64,072,475 18,198,403 Dividend payable 1,537,162 1,441,204 Deferred income taxes (Not8) 2,334,670 3,238,665 Accrued expenses and otheriabilities 2,708,701 3,034,670 ---------------------------------- Total liabilities 728,828,847 645,461,469 ---------------------------------- COMMITMENTS AND CONTINGENCIES (Note 9) STOCKHOLDERS' EQUITY (Note 10) Common stock, $5 par value, authorized 6,000,000 shares; issued 2004 and 2003 3,153,230 shares; outstanding 2004 3,137,066 shares, 2003 3,133,053 shares 15,766,150 15,766,150 Additional paid-in capital 25,378,746 25,351,979 Retained earnings 63,200,352 58,400,660 Treasury stock, at cost; 2004 16,164 shares, 2003 20,177 shares (889,020) (1,109,735) Accumulated other comprehensive income, net unrealized gain on securities available- for-sale 7,467,712 8,915,941 ---------------------------------- Total stockholders' equity 110,923,940 107,324,995 ---------------------------------- Total liabilities and stockholders' equity $ 839,752,787 $ 752,786,464 ==================================
See Notes to Consolidated Financial Statements. 40 CONSOLIDATED STATEMENTS OF INCOME Years Ended December 31, 2004, 2003 and 2002 2004 2003 2002 ------------------------------------------------------------------------------------------------------------------------- Interest and dividend income: Loans, including fees $ 22,872,764 $ 22,197,335 $ 23,207,184 Securities: Taxable 8,536,759 7,510,671 7,931,041 Tax-exempt 4,274,033 3,604,641 2,938,423 Federal funds sold 159,438 628,203 810,675 Dividends 1,510,665 1,372,890 1,383,350 ----------------------------------------------------- 37,353,659 35,313,740 36,270,673 ----------------------------------------------------- Interest expense: Deposits 9,942,250 10,045,178 11,397,125 Other borrowed funds 621,077 293,604 265,845 ----------------------------------------------------- 10,563,327 10,338,782 11,662,970 ----------------------------------------------------- Net interest income 26,790,332 24,974,958 24,607,703 Provision for loan losses (Note 4) 479,355 645,447 688,431 ----------------------------------------------------- Net interest income after provision for loan losses 26,310,977 24,329,511 23,919,272 ----------------------------------------------------- Noninterest income: Trust department income 1,185,681 1,225,099 1,032,500 Service fees 1,813,795 1,513,964 1,492,344 Securities gains, net (Note 3) 324,030 1,395,320 889,923 Gain on sales of loans held for sale 610,077 1,155,311 739,907 Merchant and ATM fees 534,897 513,832 405,667 Other 800,835 631,949 574,473 ----------------------------------------------------- Total noninterest income 5,269,315 6,435,475 5,134,814 ----------------------------------------------------- Noninterest expense: Salaries and employee benefits (Note 7) 9,019,139 9,044,896 8,074,181 Data processing 2,241,441 2,188,488 1,934,006 Occupancy expenses 1,048,323 1,088,438 927,287 Other operating expenses 2,626,451 2,497,692 2,340,098 ----------------------------------------------------- Total noninterest expense 14,935,354 14,819,514 13,275,572 ----------------------------------------------------- Income before income taxes 16,644,938 15,945,472 15,778,514 Provision for income taxes (Note 8) 4,255,392 4,320,787 4,438,376 ----------------------------------------------------- Net income $ 12,389,546 $ 11,624,685 $ 11,340,138 ===================================================== Basic earnings per share (Note 1) $ 3.95 $ 3.71 $ 3.63 =====================================================
See Notes to Consolidated Financial Statements. 41 AMES NATIONAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY Years Ended December 31, 2004, 2003 and 2002 Accumulated Additional Other Total Comprehensive Common Paid-in Retained Treasury Comprehensive Stockholders' Income Stock Capital Earnings Stock Income (Loss) Equity ------------------------------------------------------------------------------------------------------------------------------------ Balance, December 31, 2001 $15,766,150 $25,393,028 $49,397,011 $(1,530,805) $4,596,614 $ 93,621,998 Comprehensive income: Net income $11,340,138 - - 11,340,138 - - 11,340,138 Other comprehensive income, unrealized gains on securities, net of reclassification adjustment, net of tax (Note 3) 3,222,174 - - - - 3,222,174 3,222,174 ----------- Total comprehensive income $14,562,312 =========== Cash dividends declared, $2.18 per share - - (6,819,605) - - (6,819,605) Sale of 3,753 shares of treasury stock - (39,014) - 197,165 - 158,151 ------------------------------------------------------------------------------ Balance, December 31, 2002 $15,766,150 $25,354,014 $53,917,544 $(1,333,640) $7,818,788 $101,522,856 Comprehensive income: Net income $11,624,685 - - 11,624,685 - - 11,624,685 Other comprehensive income, unrealized gains on securities, net of reclassification adjustment, net of tax (Note 3) 1,097,153 - - - - 1,097,153 1,097,153 ----------- Total comprehensive income $12,721,838 =========== Cash dividends declared, $2.28 per share - - (7,141,569) - - (7,141,569) Sale of 4,071 shares of treasury stock - (2,035) - 223,905 - 221,870 ------------------------------------------------------------------------------ Balance, December 31, 2003 $15,766,150 $25,351,979 $58,400,660 $(1,109,735) $8,915,941 $107,324,995 Comprehensive income: Net income $12,389,546 - - 12,389,546 - - 12,389,546 Other comprehensive income, unrealized (losses) on securities,net of reclassification adjustment, net of tax benefit (Note 3) (1,448,229) - - - - (1,448,229) (1,448,229) ----------- Total comprehensive income $10,941,317 =========== Cash dividends declared, $2.42 per share - - (7,589,854) - - (7,589,854) Sale of 4,013 shares of treasury stock - 26,767 - 220,715 - 247,482 ------------------------------------------------------------------------------ Balance, December 31, 2004 $15,766,150 $25,378,746 $63,200,352 $ (889,020) $7,467,712 $110,923,940
See Notes to Consolidated Financial Statements. 42 AMES NATIONAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31, 2004, 2003 and 2002 2004 2003 2002 ------------------------------------------------------------------------------------------------------------------------------- CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 12,389,546 $ 11,624,685 $ 11,340,138 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 479,355 645,447 688,431 Amortization and accretion 683,012 563,612 51,495 Depreciation 951,477 1,030,377 996,180 Provision for deferred taxes (53,448) (284,751) (200,013) Securities gains, net (324,030) (1,395,320) (889,923) Change in assets and liabilities: Decrease in loans held for sale 624,670 1,854,307 2,582,434 (Increase) decrease in accrued income receivable (420,177) 6,770 128,336 (Increase) decrease in other assets (835,415) 250,293 (344,372) Increase (decrease) in accrued expenses and other liabilities (325,969) 532,718 (549,337) ----------------------------------------------- Net cash provided by operating activities 13,169,021 14,828,138 13,803,369 ----------------------------------------------- CASH FLOWS FROM INVESTING ACTIVITIES Purchase of securities available-for-sale (163,349,539) (194,136,066) (86,337,490) Proceeds from sale of securities available-for-sale 5,045,102 9,299,986 26,635,715 Proceeds from maturities and calls of securities available-for-sale 115,303,131 108,868,412 34,855,926 Net (increase) in interest bearing deposits in financial institutions (3,211,636) (5,363,538) (750,000) Net decrease (increase) in federal funds sold 515,000 12,120,000 (3,150,000) Net (increase) in loans (56,584,801) (26,585,515) (12,534,196) Purchase of bank premises and equipment (1,364,306) (681,787) (2,538,922) ----------------------------------------------- Net cash (used in) investing activities (103,647,049) (96,478,508) (43,818,967) ----------------------------------------------- CASH FLOWS FROM FINANCING ACTIVITIES Increase in deposits 38,627,312 68,926,148 39,113,124 Increase (decrease) in federal funds purchased and securities sold under agreements to repurchase 45,874,072 (127,171) 6,729,400 Dividends paid (7,493,896) (7,077,117) (6,755,449) Proceeds from issuance of treasury stock 247,482 221,870 158,151 ----------------------------------------------- Net cash provided by financing activities 77,254,970 61,943,730 39,245,226 ----------------------------------------------- Net increase (decrease) in cash and cash equivalents (13,223,058) (19,706,640) 9,229,628 CASH AND DUE FROM BANKS Beginning 31,982,144 51,688,784 42,459,156 ----------------------------------------------- Ending $ 18,759,086 $ 31,982,144 $ 51,688,784 =============================================== SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION Cash payments for: Interest $ 10,623,125 $ 10,504,715 $ 12,211,439 Income taxes 4,516,823 4,553,669 4,725,572
See Notes to Consolidated Financial Statements. 43 Note 1. Summary of Significant Accounting Policies Description of business: Ames National Corporation and subsidiaries (the Company) operates in the commercial banking industry through its subsidiaries in Ames, Boone, Story City, Nevada and Marshalltown, Iowa. Loan and deposit customers are located primarily in Story, Boone, Hamilton and Marshall Counties and adjacent counties in Iowa. Segment information: The Company uses the "management approach" for reporting information about segments in annual and interim financial statements. The management approach is based on the way the chief operating decision-maker organizes segments within a company for making operating decisions and assessing performance. Based on the "management approach" model, the Company has determined that its business is comprised of one operating segment: banking. The banking segment generates revenues through personal, business, agricultural and commercial lending, management of the investment securities portfolio, providing deposit account services and providing trust services. Consolidation: The consolidated financial statements include the accounts of Ames National Corporation (the Parent Company) and its wholly-owned subsidiaries, First National Bank, Ames, Iowa; State Bank & Trust Co., Nevada, Iowa; Boone Bank & Trust Co., Boone, Iowa; Randall-Story State Bank, Story City, Iowa; and United Bank & Trust NA, Marshalltown, Iowa (collectively, the Banks). All significant intercompany transactions and balances have been eliminated in consolidation. Use of estimates: The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses and fair value of financial instruments. Cash and cash equivalents: For purposes of reporting cash flows, cash and cash equivalents include cash on hand and amounts due from banks. The Company reports net cash flows for customer loan transactions, deposit transactions and short term borrowings with maturities of 90 days or less. Securities available-for-sale: Securities available-for-sale consists of equity securities and debt securities not classified as trading or held-to-maturity and are carried at fair value. Unrealized holding gains and losses, net of deferred income taxes, are reported in a separate component of accumulated other comprehensive income until realized. Realized gains and losses on the sale of such securities are determined using the specific identification method and are reflected in the consolidated statements of income. Premiums and discounts are recognized in interest income using the interest method over the period to maturity or call date of the related security. Unrealized losses judged to be other than temporary are charged to operations. Loans held for sale: Loans held for sale are the loans the Banks have the intent to sell in the foreseeable future. They are carried at the lower of aggregate cost or market value. Net unrealized losses, if any, are recognized through a valuation allowance by charges to income. Gains and losses on sales of loans are recognized at settlement dates and are determined by the difference between the sale proceeds and the carrying value of the loans. Loans: Loans are stated at the principal amount outstanding, net of deferred loan fees and the allowance for loan losses. Interest on loans is credited to income as earned based on the principal amount outstanding. The Banks' policy is to discontinue the accrual of interest income on any loan 90 days or more past due unless the loans are well collateralized and in the process of collection. Income on nonaccrual loans is subsequently recognized only to the extent that cash payments are received. Nonaccrual loans are returned to an accrual status when, in the opinion of management, the financial position of the borrower indicates there is no longer any reasonable doubt as to timely payment of principal or interest. Allowance for loan losses: The allowance for loan losses is maintained at a level deemed appropriate by management to provide for known and inherent risks in the loan portfolio. The allowance is based upon a continuing review of past loan loss experience, current economic conditions, and the underlying collateral value securing the loans. Loans which are deemed to be uncollectible are charged off and deducted from the allowance. Recoveries on loans charged-off and the provision for loan losses are added to the allowance. 44 A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Impairment is measured on a loan by loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential loans for impairment disclosures. Premises and equipment: Premises and equipment are stated at cost less accumulated depreciation. Depreciation expense is computed using straight-line and accelerated methods over the estimated useful lives of the respective assets. Depreciable lives range from 3 to 7 years for equipment and 15 to 39 years for premises. Trust department assets: Property held for customers in fiduciary or agency capacities is not included in the accompanying consolidated balance sheets, as such items are not assets of the Banks. Income taxes: Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date. The Company files a consolidated federal income tax return, with each entity computing its taxes on a separate company basis. For state tax purposes, the Banks file franchise tax returns, while the Parent Company files a corporate income tax return. Comprehensive income: Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income. Gains and losses on available-for-sale securities are reclassified to net income as the gains or losses are realized upon sale of the securities. Other-than-temporary impairment charges are reclassified to net income at the time of the charge. Fair value of financial instruments: The following methods and assumptions were used by the Company in estimating fair value disclosures: Cash and due from banks, federal funds sold and interest-bearing deposits in financial institutions: The recorded amount of these assets approximates fair value. Securities available-for-sale: Fair values of securities available-for-sale are based on bid prices published in financial newspapers, bid quotations received from securities dealers, or quoted market prices of similar instruments, adjusted for differences between the quoted instruments and the instruments being valued. Loans held for sale: The fair value of loans held for sale is based on prevailing market prices. Loans: The fair value of loans is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates, which reflect the credit and interest rate risk inherent in the loan. The estimate of maturity is based on the historical experience, with repayments for each loan classification modified, as required, by an estimate of the effect of current economic and lending conditions. The effect of nonperforming loans is considered in assessing the credit risk inherent in the fair value estimate. 45 Deposit liabilities: Fair values of deposits with no stated maturity, such as noninterest-bearing demand deposits, savings and NOW accounts, and money market accounts, are equal to the amount payable on demand as of the respective balance sheet date. Fair values of certificates of deposit are based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities. The fair value estimates do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market. Other borrowings: The carrying amounts of federal funds purchased and securities sold under agreements to repurchase approximate fair value because of the short-term nature of the instruments. Accrued income receivable and accrued interest payable: The carrying amounts of accrued income receivable and interest payable approximate fair value. Commitments to extend credit and standby letters of credit: The fair values of commitments to extend credit and stand by letters of credit are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreement and credit worthiness of the counterparties. The carry value and fair value of the commitments to extend credit and standby letters of credit are not considered significant. Limitations: Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. Because no market exists for a significant portion of the Company's financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Earnings per share: Basic earnings per share computations for the years ended December 31, 2004, 2003 and 2002, were determined by dividing net income by the weighted-average number of common shares outstanding during the years then ended. The Company had no potentially dilutive securities outstanding during the periods presented. The following information was used in the computation of basic earnings per share for the years ended December 31, 2004, 2003, and 2002. 2004 2003 2002 ------------------------------------------ Basic earning per share computation: Net income $ 12,389,546 $ 11,624,685 $ 11,340,138 Weighted average common shares outstanding 3,135,235 3,131,224 3,127,285 ------------------------------------------ Basic EPS $ 3.95 $ 3.71 $ 3.63 ========================================== New Accounting Pronouncements SEC Staff Accounting Bulletin ("SAB") No. 105, Application of Accounting Principles to Loan Commitments, was released in March 2004. This release summarizes the SEC staff position regarding the application of GAAP to loan commitments accounted for as derivative instruments. The Company accounts for interest rate lock commitments issued on mortgage loans that will be held for sale as derivative instruments. Consistent with SAB No. 105, the Company considers the fair value of these commitments to be zero at the commitment date, with the subsequent changes in fair value determined solely on changes in market interest rates. The Company's adoption of this bulletin had no impact on the consolidated financial statements. At the March 17-18, 2004 Emerging Issues Task Force ("EITF") meeting, the Task Force reached a consensus on Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments. EITF 03-1 provides guidance for determining the meaning of "other-than-temporarily impaired" and its application to certain debt and equity securities within the scope of Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities (SFAS 115") and investments accounted for under the cost method. The guidance set forth in the Statement was originally to be effective for the Company in the September 30, 2004 consolidated financial statements. However, in September 2004, the effective dates of certain parts of the Statement were delayed. Management is currently assessing the impact of Issue 03-1 on the consolidated financial statements. 46 In December 2004, the FASB issued SFAS No. 123(Revised), "Share-Based Payment" ("SFAS No. 123R"), establishing accounting standards for transactions in which an entity exchanges its equity instruments for goods or services, SFAS No. 123R also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity's equity instruments, or that may be settled by the issuance of those equity instruments. SFAS No. 123R covers a wide range of share-based compensation arrangements including stock options, restricted stock plans, performance-based stock awards, stock appreciation rights, and employee stock purchase plans. SFAS No. 123R replaces existing requirements under SFAS No. 123R, "Accounting for Stock-Based Compensation," and eliminates the ability to account for share-based compensation transactions using APB Opinion No. 25. The provisions of SFAS No. 123R are effective for the Company on July 1, 2005. The Company is currently assessing the financial statement impact of adopting SFAS No. 123R. In December 2003, the American Institute of Certified Public Accountants issued Statement of Position 03-3, "Accounting for Certain Loans or Debt Securities Acquired in a "Transfer" ("SOP 03-3"). SOP 03-3 requires loans acquired through a transfer, such as a business combination, where there are differences in expected cash flows and contractual cash flows due in part to credit quality, to be recognized at their fair value. Under the provisions of SOP 03-3, any future excess of cash flows over the original expected cash flows is to be recognized as an adjustment of future yield. Future decreases in actual cash flow compared to the original expected cash flow is recognized as a valuation allowance and expensed immediately. Under SOP 03-3, valuation allowances cannot be created or "carried over" in the initial accounting for impaired loans acquired. SOP 03-3 is effective for impaired loans acquired in fiscal years beginning after December 15, 2004. The company does not expect adoption to have material impact on the consolidated financial statement. Note 2. Restrictions on Cash and Due from Banks The Federal Reserve Bank requires member banks to maintain certain cash and due from bank reserves. The subsidiary banks' reserve requirements totaled approximately $7,562,000 and $14,375,000 at December 31, 2004 and 2003, respectively. Note 3. Debt and Equity Securities The amortized cost of securities available for sale and their approximate fair values at December 31, 2004 and 2003, are summarized below: Gross Gross Amortized Unrealized Unrealized Estimated Cost Gains (Losses) Fair Value ------------------------------------------------------------ 2004: U.S. treasury $ 495,040 $ 35,859 $ - $ 530,899 U.S. government agencies 138,024,045 627,981 (1,017,948) 137,634,078 State and political subdivisions 112,004,478 2,391,038 (577,902) 113,817,614 Corporate bonds 75,510,784 2,471,332 (408,929) 77,573,187 Equity securities 25,571,604 8,332,080 - 33,903,684 -------------------------------------------------------- $ 351,605,951 $13,858,290 $(2,004,779) $363,459,462 ======================================================== Gross Gross Amortized Unrealized Unrealized Estimated Cost Gains (Losses) Fair Value -------------------------------------------------------- 2003: U.S. treasury $ 2,158,571 $ 70,341 $ - $ 2,228,912 U.S. government agencies 117,321,783 1,728,234 (412,733) 118,637,284 State and political subdivisions 103,411,430 3,087,981 (536,295) 105,963,116 Corporate bonds 59,991,655 3,639,909 (45,868) 63,585,696 Equity securities 26,080,188 6,796,873 (176,155) 32,700,906 -------------------------------------------------------- $ 308,963,627 $15,323,338 $(1,171,051) $323,115,914 ========================================================
47 The amortized cost and estimated fair value of debt securities available-for-sale as of December 31, 2004, are shown below by contractual maturity. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. Amortized Estimated Cost Fair Value -------------------------------- Due in one year or less $ 20,357,537 $ 20,448,845 Due after one year through five years 193,586,146 194,749,053 Due after five years through ten years 77,349,858 79,647,967 Due after ten years 34,740,806 34,709,913 -------------------------------- 326,034,347 329,555,778 Equity securities 25,571,604 33,903,684 -------------------------------- $351,605,951 $363,459,462 ================================ At December 31, 2004 and 2003, securities with a carrying value of approximately $173,765,000 and $49,758,000, respectively, were pledged as collateral on public deposits, securities sold under agreements to repurchase and for other purposes as required or permitted by law. Gross realized gains and gross realized losses on sales of available-for-sale securities were $443,974 and $119,944 respectively, in 2004, $1,395,320 and none, respectively, in 2003, $1,087,290 and $197,367, respectively, in 2002. The components of other comprehensive income (loss) - net unrealized gains (losses) on securities available-for-sale for the years ended December 31, 2004, 2003, and 2002, were as follows: 2004 2003 2002 ------------------------------------------------- Unrealized holding gains (losses) arising during the period $(1,974,746) $ 3,136,832 $ 6,002,497 Reclassification adjustment for net gains realized in net income (324,030) (1,395,320) (889,923) ------------------------------------------------- Net unrealized gains (losses) before tax effect (2,298,776) 1,741,512 5,112,574 Tax effect 850,547 (644,359) (1,890,400) ------------------------------------------------- Other comprehensive income Net unrealized gains (losses) on securities $(1,448,229) $ 1,097,153 $ 3,222,174 =================================================
48 Unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, as of December 31, 2004 and 2003 are summarized as follows: Less than 12 Months 12 Months or More Total ----------------------------------------------------------------------------------- Fair Unrealized Fair Unrealized Fair Unrealized Value Losses Value Losses Value Losses ---------------------------------------------------------------------------------- 2004: Securities available for sale: U.S. government agencies $ 81,532,939 $ (775,150) $ 9,849,426 $ (242,798) $ 91,382,365 $ (1,017,948) State and political subsidivisions 24,844,595 (296,117) 10,701,463 (281,785) 35,546,058 (577,902) Corporate obligations 36,136,660 (408,929) - - 36,136,660 (408,929) Equity securities - - - - - - ------------------------------------------------------------------------------------ $142,514,194 $(1,480,196) $20,550,889 $ (524,583) $163,065,083 $ (2,004,779) ==================================================================================== Less than 12 Months 12 Months or More Total ----------------------------- --------------------------- -------------------------- Fair Unrealized Fair Unrealized Fair Unrealized Value Losses Value Losses Value Losses ------------------------------------------------------------------------------------ 2003: U.S. government agencies $ 31,608,073 $ (412,733) $ - $ - $ 31,608,073 $ (412,733) State and political subsidivisions 22,823,408 (507,233) 628,846 (29,062) 23,452,254 (536,295) Corporate obligations 15,160,687 (45,868) - - 15,160,687 (45,868) Equity securities - - 3,242,200 (176,155) 3,242,200 (176,155) ------------------------------------------------------------------------------------ $ 69,592,168 $ (965,834) $ 3,871,046 $ (205,217) $ 73,463,214 $ (1,171,051) ====================================================================================
For all of the above investment securities, the unrealized losses are generally due to changes in interest rates or general market conditions, as such, are considered to be temporary, by the Company. Note 4. Loans Receivable The composition of loans receivable at December 31, 2004 and 2003 is as follows: 2004 2003 ---------------------------------- Commercial and agricultural $ 87,901,970 $ 66,369,814 Real estate 306,272,605 272,790,845 Consumer 14,244,501 13,208,113 Other 10,339,393 10,034,281 ----------------------------------- 418,758,469 362,403,053 Less: Allowance for loan losses (6,475,530) (6,050,989) Deferred loan fees (644,374) (818,945) ----------------------------------- $ 411,638,565 $ 355,533,119 =================================== Changes in the allowance for loan losses for the year ended December 31, 2004, 2003 and 2002 are as follows: 2004 2003 2002 --------------------------------------------- Balance, beginning $ 6,050,989 $ 5,757,694 $ 5,445,671 Provision for loan losses 479,355 645,447 688,431 Recoveries of loans charged-off 174,703 111,926 53,805 Loans charged-off (229,517) (464,078) (430,213) --------------------------------------------- Balance, ending $ 6,475,530 $ 6,050,989 $ 5,757,694 ============================================= 49 Loans are made in the normal course of business to directors and executive officers of the Company and to their affiliates. The terms of these loans, including interest rates and collateral, are similar to those prevailing for comparable transactions with others and do not involve more than a normal risk of collectibility. Loan transactions with related parties were as follows for the years ended December 31, 2004 and 2003: 2004 2003 ---------------------------------- Balance, beginning of year $ 10,991,284 $ 7,791,668 New loans 17,173,833 19,425,895 Repayments (13,297,861) (16,650,452) Change in status 13,788,737 424,173 ---------------------------------- Balance, end of year $ 28,655,993 $ 10,991,284 ================================== At December 31, 2004 and 2003, the Company had impaired loans of approximately $1,977,000 and $2,187,075, respectively. The allowance for loan losses related to these impaired loans was approximately $158,000 and $134,000 at December 31, 2004 and 2003, respectively. The average balances of impaired loans for the years ended December 31, 2004 and 2003 were $2,373,465 and $2,050,154, respectively. For the years ended December 31, 2004, 2003, and 2002 interest income which would have been recorded under the original terms of such loans was approximately $239,000, $179,000, and $160,000 respectively, with $211,000, $177,000 and $17,000, respectively, recorded. Loans greater than 90 days past due and still accruing interest were approximately $80,000 and $431,000 at December 31, 2004 and 2003, respectively. The amount the Company will ultimately realize from these loans could differ materially from their carrying value because of future developments affecting the underlying collateral or the borrowers' ability to repay the loans. As of December 31, 2004, there were no material commitments to lend additional funds to customers whose loans were classified as impaired. Note 5. Bank Premises and Equipment The major classes of bank premises and equipment and the total accumulated depreciation as of December 31, 2004 and 2003, are as follows: 2004 2003 -------------------------------- Land $ 1,284,771 $ 1,284,771 Buildings and improvements 9,889,939 9,120,088 Furniture and equipment 6,041,317 5,721,259 -------------------------------- 17,216,027 16,126,118 Less accumulated depreciation 8,425,391 7,748,311 -------------------------------- $ 8,790,636 $ 8,377,807 ================================ Note 6. Deposits At December 31, 2004, the maturities of time deposits are as follows: Years ended December 31, 2005 $ 136,616,566 2006 45,485,074 2007 40,585,356 2008 10,609,685 2009 6,392,181 Thereafter 148,998 ------------- $ 239,837,860 ============= 50 Interest expense on deposits is summarized as follows: 2004 2003 2002 -------------------------------------- NOW accounts $ 1,237,381 $ 909,137 $ 1,155,459 Savings and money market 1,972,211 1,849,238 2,237,034 Time, $100,000 and over 1,758,187 1,807,047 1,897,855 Other time 4,974,471 5,479,756 6,106,777 -------------------------------------- $ 9,942,250 $ 10,045,178 $11,397,125 ====================================== Note 7. Employee Benefit Plans The Company has a stock purchase plan with the objective of encouraging equity interests by officers, employees, and directors of the Company and its subsidiaries to provide additional incentive to improve banking performance and retain qualified individuals. The purchase price of the shares is the fair market value of the stock based upon current market trading activity. The terms of the plan provide for the issuance of up to 14,000 shares of common stock per year for a ten-year period commencing in 1999 and continuing through 2008. The Company has a qualified 401(k) profit-sharing plan. The Company matches employee contributions up to a maximum of 2% of qualified compensation and also contributes an amount equal to 5% of the participating employee's compensation. In addition, contributions can be made on a discretionary basis by the combined Company on behalf of the employees. For the years ended December 31, 2004, 2003 and 2002, Company contributions to the merged plans were approximately $676,000, $659,000, and $607,000, respectively. The plan covered substantially all employees. Note 8. Income Taxes The components of income tax expense for the year ended December 31, 2004, 2003 and 2002 are as follows: 2004 2003 2002 ------------------------------------------ Federal: Current $3,493,176 $3,752,585 $3,819,350 Deferred (48,519) (266,898) (184,965) ---------------------------------------- 3,444,657 3,485,687 3,634,385 ---------------------------------------- State: Current 815,664 852,953 819,039 Deferred (4,929) (17,853) (15,048) ---------------------------------------- 810,735 835,100 803,991 ---------------------------------------- Income tax expense $4,255,392 $4,320,787 $4,438,376 ======================================== Total income tax expense differed from the amounts computed by applying the U.S. federal income tax rate of 35% to income before income taxes is a result of the following for the years ended December 31, 2004, 2003 and 2002: 2004 2003 2002 --------------------------------------- Income taxes at 35% federal tax rate $ 5,825,727 $ 5,580,915 $5,364,695 Increase (decrease) resulting from: Tax-exempt interest and dividends (1,870,264) (1,577,116) (1,356,187) State taxes, net of federal tax benefit 522,929 548,897 534,831 Other (223,000) (231,909) (104,963) --------------------------------------- Total income tax expense $ 4,255,392 $ 4,320,787 $4,438,376 ======================================= 51 The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred liabilities at December 31, 2004 and 2003, are as follows: 2004 2003 ------------------------------ Deferred tax assets: Allowance for loan losses $ 1,901,776 $ 1,741,344 ther items 333,792 297,041 ------------------------------ 2,235,568 2,038,385 ------------------------------ Deferred tax liabilities: Net unrealized gains on securities available for sale (4,385,799) (5,236,346) Other (184,439) (40,704) ------------------------------ (4,570,238) (5,277,050) ------------------------------- Net deferred tax assets (liabilities) $ (2,334,670) $ (3,238,665) =============================== At December 31, 2004 and 2003, income taxes currently payable of approximately $182,000 and $390,000, respectively, are included in accrued interest and other liabilities. Note 9. Commitments, Contingencies and Concentrations of Credit Risk The Company is party to financial instruments with off-balance-sheet risk in the normal course of business. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the balance sheet. The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as they do for on-balance-sheet instruments. A summary of the Company's commitments at December 31, 2004 and 2003 is as follows: 2004 2003 -------------------------------- Commitments to extend credit $ 65,894,000 $ 71,100,000 Standby letters of credit 2,717,000 1,741,000 -------------------------------- $ 68,611,000 $ 72,841,000 ================================ Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management's credit evaluation of the party. Standby letters of credit are conditional commitments issued by the Banks to guarantee the performance of a customer to a third-party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral held varies and is required in instances which the Banks deem necessary. In the event the customer does not perform in accordance with the terms of the agreement with the third party, the Banks would be required to fund the commitment. The maximum potential amount of future payments the Banks could be required to make is represented by the contractual amount shown in the summary above. If the commitments were funded, the Banks would be entitled to seek recovery from the customer. At December 31, 2004 and 2003, no amounts have been recorded as liabilities for the Bank's potential obligations under these guarantees. In the normal course of business, the Company is involved in various legal proceedings. In the opinion of management, any liability resulting from such proceedings would not have a material adverse effect on the Company's financial statements. 52 Concentrations of credit risk: The Banks originate real estate, consumer, and commercial loans, primarily in Story, Boone, Hamilton and Marshall Counties, Iowa, and adjacent counties. Although the Banks have diversified loan portfolios, a substantial portion of their borrowers' ability to repay loans is dependent upon economic conditions in the Banks' market areas. Note 10. Regulatory Matters The Company and its subsidiary banks are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory - and possible additional discretionary - actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company must meet specific capital guidelines that involve quantitative measures of the Company's assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company's capital amounts and classification are also subject to regulatory accounting practices. The Company's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and each subsidiary bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 2004 and 2003, that the Company and each subsidiary bank met all capital adequacy requirements to which they are subject. As of December 31, 2004, the most recent notification from the federal banking regulators categorized the subsidiary banks as well capitalized under the regulatory framework for prompt corrective action. To be categorized as adequately capitalized the banks must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table. Management believes there are no conditions or events since that notification that have changed the institution's category. The Company's and each of the subsidiary bank's actual capital amounts and ratios as of December 31, 2004 and 2003 are also presented in the table. To Be Well Capitalized Under For Capital Prompt Corrective Actual Adequacy Purposes Action Provisions -------------------------------------------------------------------------- Amount Ratio Amount Ratio Amount Ratio ---------------------------------------------------------------------------------------------------------- As of December 31, 2004: Total capital (to risk - weighted assets): Consolidated $ 109,931 18.6% $ 47,274 8.0% Boone Bank & Trust 13,047 15.0 6,966 8.0 $ 8,707 10.0% First National Bank 42,473 14.6 23,196 8.0 28,995 10.0 Randall-Story State Bank 8,262 15.7 4,220 8.0 5,275 10.0 State Bank & Trust 12,114 15.2 6,370 8.0 7,962 10.0 United Bank & Trust 7,700 12.6 4,897 8.0 6,122 10.0 Tier 1 capital ( to risk - weighted assets): Consolidated $ 103,456 17.5% $ 23,637 4.0% Boone Bank & Trust 12,092 13.9 3,483 4.0 $ 5,224 6.0% First National Bank 39,119 13.5 11,598 4.0 17,397 6.0 Randall-Story State Bank 7,602 14.4 2,110 4.0 3,165 6.0 State Bank & Trust 11,227 14.1 3,185 4.0 4,777 6.0 United Bank & Trust 7,065 11.5 2,449 4.0 3,673 6.0 Tier 1 capital( to average - weighted assets): Consolidated $ 103,456 12.3% $ 33,654 4.0% Boone Bank & Trust 12,092 10.6 4,580 4.0 $ 5,726 5.0% First National Bank 39,119 9.3 16,911 4.0 21,139 5.0 Randall-Story State Bank 7,602 10.5 2,892 4.0 3,614 5.0 State Bank & Trust 11,227 9.4 4,794 4.0 5,992 5.0 United Bank & Trust 7,065 8.2 3,458 4.0 4,322 5.0
53 To Be Well Capitalized Under For Capital Prompt Corrective Actual Adequacy Purposes Action Provisions -------------------------------------------------------------------------- Amount Ratio Amount Ratio Amount Ratio As of December 31, 2003: Total capital (to risk- weighted assets): Consolidated $ 104,460 20.3% $ 41,261 8.0% Boone Bank & Trust 12,284 14.9 6,613 8.0 $ 8,267 10.0% First National Bank 40,460 16.0 20,264 8.0 25,330 10.0 Randall-Story State Bank 7,902 15.5 4,069 8.0 5,087 10.0 State Bank & Trust 11,509 18.2 5,048 8.0 6,310 10.0 United Bank & Trust 5,491 12.0 3,653 8.0 4,566 10.0 Tier 1 capital ( to risk- weighted assets): Consolidated $ 98,409 19.1% $ 20,630 4.0% Boone Bank & Trust 11,333 13.7 3,307 4.0 $ 4,960 6.0% First National Bank 37,354 14.7 10,132 4.0 15,198 6.0 Randall-Story State Bank 7,266 14.3 2,035 4.0 3,052 6.0 State Bank & Trust 10,719 17.0 2,524 4.0 3,786 6.0 United Bank & Trust 5,011 11.0 1,826 4.0 2,740 6.0 Tier 1 capital ( to average- weighted assets): Consolidated $ 98,409 13.0% $ 30,330 4.0% Boone Bank & Trust 11,333 10.2 4,442 4.0 $ 5,553 5.0% First National Bank 37,354 9.8 15,179 4.0 18,974 5.0 Randall-Story State Bank 7,266 10.2 2,840 4.0 3,551 5.0 State Bank & Trust 10,719 9.9 4,343 4.0 5,429 5.0 United Bank & Trust 5,011 7.3 2,741 4.0 3,426 5.0
Note 11. Fair Value of Financial Instruments The estimated fair values of the Company's financial instruments (as described in Note 1) as of December 31, 2004 and 2003 were as follows: 2004 2003 ----------------------------------------------------------------------------------------------- Carrying Fair Carrying Fair Amount Value Amount Value ----------------------------------------------------------------------------------------------- Financial assets: Cash and due from banks $ 18,759,086 $ 18,759,086 $ 31,982,144 $ 31,982,144 Federal funds sold 19,865,000 19,865,000 20,380,000 20,380,000 Interest-bearing deposits 9,575,174 9,575,174 6,363,538 6,363,538 Securities available-for-sale 363,459,462 363,459,462 323,115,914 323,115,914 Loans, net 411,638,565 413,071,863 355,533,119 358,891,066 Loans held for sale 234,469 234,469 859,139 859,139 Accrued income receivable 6,262,424 6,262,424 5,842,247 5,842,247 Financial liabilities: Deposits $ 658,175,839 $ 659,865,147 $ 619,548,527 $ 623,208,058 Other borrowings 64,072,475 64,072,475 18,198,403 18,198,403 Accrued interest 1,302,021 1,302,021 1,361,819 1,361,819
54 Note 12. Ames National Corporation (Parent Company Only) Financial Statements Information relative to the Parent Company's balance sheets at December 31, 2004 and 2003, and statements of income and cash flows for each of the years in the three-year period ended December 31, 2004, is as follows: BALANCE SHEETS December 31, 2004 and 2003 2004 2003 -------------------------------------------------------------------------------- ASSETS Cash and due from banks $ 6,983 $ 1,213 Interest-bearing deposits in banks 2,718,126 1,588,995 Securities available-for-sale 32,177,363 33,654,060 Investment in bank subsidiaries 79,151,605 76,105,383 Loans receivable, net 1,077,000 - Premises and equipment, net 439,059 475,551 Accrued income receivable 160,537 151,335 Other assets 142,938 7,198 ------------------------------- Total assets $115,873,611 $111,983,735 =============================== LIABILITIES Dividends payable $ 1,537,162 $ 1,441,204 Deferred income taxes 3,074,468 2,528,955 Accrued expenses and other liabilities 338,041 688,581 ------------------------------ Total liabilities 4,949,671 4,658,740 ------------------------------- STOCKHOLDERS' EQUITY Common stock 15,766,150 15,766,150 Additional paid-in capital 25,378,746 25,351,979 Retained earnings 63,200,352 58,400,660 Treasury stock, at cost (889,020) (1,109,735) Accumulated other comprehensive income 7,467,712 8,915,941 ------------------------------- Total equity 110,923,940 107,324,995 ------------------------------- Total liabilities and stockholders' equity $115,873,611 $111,983,735 =============================== 55 STATEMENTS OF INCOME Years Ended December 31, 2004, 2003 and 2002 2004 2003 2002 -------------------------------------------------------------------------------- Operating income: Equity in net income of bank subsidiaries $11,857,298 $10,440,180 $10,108,107 Interest 473,375 542,640 745,488 Dividends 1,063,203 962,049 979,071 Rents 70,425 140,147 150,894 Securities gains, net 308,273 1,207,735 881,938 -------------------------------------- 13,772,574 13,292,751 12,865,498 Provision for loan losses 16,000 (16,000) - -------------------------------------- Operating income after provision for loan losses 13,756,574 13,308,751 12,865,498 Operating expenses: 1,517,028 1,379,066 1,320,360 -------------------------------------- Income before income taxes 12,239,546 11,929,685 11,545,138 Income tax expense (benefit) (150,000) 305,000 205,000 --------------------------------------- Net income $12,389,546 $11,624,685 $11,340,138 ======================================= 56 STATEMENTS OF CASH FLOWS Years Ended December 31, 2004, 2003 and 2002 2004 2003 2002 -------------------------------------------------------------------------------------------------------------------- CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 12,389,546 $ 11,624,685 $11,340,138 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 66,473 77,132 80,620 Provision for loan losses 16,000 (16,000) - Amortization and accretion, net (6,004) (8,014) (16,060) Provision for deferred taxes - (36,385) (56,023) Securities gains, net (308,273) (1,207,735) (881,938) Equity in net income of bank subsidiaries (11,857,299) (10,440,180) (10,108,107) Dividends received from bank subsidiaries 8,384,000 7,868,000 5,978,000 (Increase) decrease in accrued income receivable (9,202) 61,798 1,446,277 (Increase) decrease in other assets (135,740) 148,587 (130,281) Increase (decrease) in accrued expense payable and other liabilities (350,540) 336,997 246,165 ---------------------------------------------------- Net cash provided by operating activities $ 8,188,961 $ 8,408,885 $ 7,898,791 ---------------------------------------------------- CASH FLOWS FROM INVESTING ACTIVITIES Purchase of securities available-for-sale $ (1,454,604) $ (7,292,720) $(7,334,938) Proceeds from sale of securities available-for-sale 4,200,716 4,067,605 8,611,304 Proceeds from maturities and calls of securities 519,223 available-for-sale - 2,170,435 2,196,163 (Increase) decrease in interest bearing deposits in banks (1,129,131) (192,339) 769,809 (Increase) decrease in loans (1,093,000) 722,968 (448,741) Purchase of bank premises and equipment (29,981) (34,976) (95,226) Investment in bank subsidiaries (1,950,000) (1,000,000) (5,000,000) ---------------------------------------------------- Net cash (used in) investing activities $ (936,777) $ (1,559,027) $(1,301,629) ---------------------------------------------------- CASH FLOWS FROM FINANCING ACTIVITIES Dividends paid (7,493,896) (7,077,117) (6,755,449) Proceeds from issuance of treasury stock 247,482 221,870 158,151 ---------------------------------------------------- Net cash (used in) financing activities $ (7,246,414) $ (6,855,247) $(6,597,298) ---------------------------------------------------- Net increase (decrease) in cash and cash equivalents $ 5,770 $ (5,389) $ (136) CASH AND DUE FROM BANKS Beginning 1,213 6,602 6,738 ---------------------------------------------------- Ending $ 6,983 $ 1,213 $ 6,602 ====================================================
57 Note 13. Selected Quarterly Financial Data (Unaudited) 2004 ------------------------------------------------------------------- March 31 June 30 September 30 December 31 -------------------------------------------------------------------------------------------------------------------- Total interest income $ 8,914,804 $ 9,109,031 $ 9,323,847 $ 10,005,977 Total interest expense 2,391,174 2,451,952 2,662,249 3,057,952 Net interest income 6,523,630 6,657,079 6,661,598 6,948,025 Provision for loan losses 58,355 210,353 (63,820) 274,467 Net income 2,964,542 2,862,039 3,372,387 3,190,578 Basic and diluted earnings per common share 0.95 0.91 1.08 1.01 2003 ------------------------------------------------------------------- March 31 June 30 September 30 December 31 -------------------------------------------------------------------------------------------------------------------- Total interest income $ 8,714,233 $ 8,876,124 $ 8,818,046 $ 8,905,337 Total interest expense 2,690,209 2,723,323 2,467,155 2,458,095 Net interest income 6,024,024 6,152,801 6,350,891 6,447,242 Provision for loan losses 119,745 305,995 87,000 132,707 Net income 2,870,325 2,649,229 3,240,642 2,864,489 Basic and diluted earnings per common share 0.92 0.85 1.03 0.91
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There have been no changes in or disagreements with the Company's independent accountants during the two most recently ended fiscal years of the Company. ITEM 9A. CONTROLS AND PROCEDURES As of the end of the period covered by this report, an evaluation was performed under the supervision and with the participation of the Company's Chief Executive Officer and Chief Financial Officer of the effectiveness of the Company's disclosure controls and procedures (as defined in Exchange Act Rule 240.13a-15 (e)). Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer have concluded that the Company's current disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission's rules and forms. Management's annual report on internal control over financial reporting is contained in Item 8 of this Report. The attestation report of the Company's registered public accounting firm on management's assessment of the Company's internal control over financial reporting is contained in Item 8 of this Report. There were no changes in the Company's internal control over financial reporting that occurred during the quarter ended December 31, 2004 that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. ITEM 9B. OTHER INFORMATION None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Directors Refer to the information under the caption "Information Concerning Nominees for Election as Directors" and "Information Concerning Directors Other Than Nominees" contained in the Company's definitive proxy statement prepared in connection with its Annual Meeting of Shareholders to be held April 27, 2005, as filed with the SEC on March 16, 2005 (the "Proxy Statement"), which information is incorporated herein by this reference. 58 Executive Officers The information required by Item 10 regarding the executive officers appears in Item 1 of Part I of this Report under the heading "Executive Officers of the Company and Banks". Section 16(a) Beneficial Ownership Reporting Compliance Refer to the information under the caption "Section 16(a) Beneficial Ownership Reporting Compliance" in the Proxy Statement, which information is incorporated herein by this reference. Audit Committee Financial Expert The board of directors of the Company has determined that Warren R. Madden, a member of the Audit Committee, qualifies as an "audit committee financial expert" under applicable SEC rules. The board of directors has further determined that Mr. Madden qualifies as an "independent" director under applicable SEC rules and the corporate governance rules of the NASDAQ stock market. The board's affirmative determination was based, among other things, upon Mr. Madden's experience as Vice President of Finance and Business of Iowa State University, a position in which he functions as the principal financial officer of the university. Code of Ethics The Company has adopted an Ethics and Confidentiality Policy that applies to all directors, officers and employees of the Company. A copy of this policy is posted on the Company's website at www.amesnational.com. In the event that the Company makes any amendments to, or grants any waivers of, a provision of the Ethics and Confidentiality Policy that requires disclosure under applicable SEC rules, the Company intends to disclose such amendments or waiver and the reasons therefore on its website. ITEM 11. EXECUTIVE COMPENSATION Refer to the information under the caption "Executive Compensation" in the Proxy Statement, which information is incorporated herein by this reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Refer to the information under the caption "Security Ownership of Management and Certain Beneficial Owners" in the Proxy Statement, which information is incorporated herein by this reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Refer to the information under the caption "Loans to Directors and Executive Officers and Related Party Transactions" in the Proxy Statement, which information is incorporated herein by this reference. 59 ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES Refer to the information under the caption "Relationship with Independent Public Accountants" in the Proxy Statement, which information is incorporated herein by this reference. PART IV ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (a) List of Financial Statements and Schedules. 1. Financial Statements Reports of McGladrey & Pullen, LLP, Independent Registered Public Accounting Firm Consolidated Balance Sheets, December 31, 2004 and 2003 Consolidated Statements of Income for the Years ended December 31, 2004, 2003 and 2002 Consolidated Statements of Stockholders' Equity for the Years Ended December 31, 2004, 2003 and 2002 Consolidated Statements of Cash Flows for the Years ended December 31, 2004, 2003 and 2002 Notes to Consolidated Financial Statements 2. Financial Statement Schedules All schedules are omitted because they are not applicable or not required, or because the required information is included in the consolidated financial statements or notes thereto. (b) List of Exhibits. 3.1 - Restated Articles of Incorporation of the Company (incorporated by reference to Registration Statement on Form 10 filed on April 30, 2002). 3.2 - Bylaws of the Company (incorporated by reference to the Annual Report on Form 10K filed on March 12, 2004). 10 - Management Incentive Compensation Plan (incorporated by reference to) Annual Report on Form 10K filed on March 25, 2003).* 21 - Subsidiaries of the Registrant. 23.1 - Consent of Independent Registered Public Accounting Firm. 31.1 - Certification of Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2 - Certification of Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.1 - Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350 32.2 - Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350 * Indicates a management compensatory plan or arrangement. 60 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. AMES NATIONAL CORPORATION March 15, 2005 By: /s/ Daniel L. Krieger -------------------------------------------- Daniel L. Krieger, Chairman and President (Principal Executive Officer) March 15, 2005 By: /s/ John P. Nelson -------------------------------------------- John P. Nelson, Vice President (Principal Financial and Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated and on March 15, 2005. By: /s/ Betty A. Baudler Horras --------------------------------- Betty A. Baudler Horras, Director By: /s/Douglas C. Gustafson --------------------------------- Douglas C. Gustafson, Director By: /s/ Charles D. Jons -------------------------------- Charles D. Jons, Director By: /s/ Warren R. Madden ---------------------------------- Warren R. Madden, Director By: /s/ Fred C. Samuelson ---------------------------------- Fred C. Samuelson, Director By: /s/ Marvin J. Walter ---------------------------------- Marvin J. Walter, Director 61 EXHIBIT INDEX The following exhibits are filed herewith: Exhibit No. Description ---------- -------------------------------------------------------------------- 3.1 - Restated Articles of Incorporation of the Company (incorporated by reference to Registration Statement on Form 10 filed on April 30, 2002). 3.2 - Bylaws of the Company (incorporated by reference to the Annual Report on Form 10K filed on March 12, 2004). 10 - Management Incentive Compensation Plan (incorporated by reference to) Annual Report on Form 10K filed on March 25, 2003).* 21 - Subsidiaries 23.1 - Consent of Independent Registered Public Accounting Firm. 31.1 - Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2 - Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.1 - Certification of Principal Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 - Certification of Principal Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 62