-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, P1eJh5RhS63ADAsdFv+quyk/slVPTmnD3liJMQWRgsq5b0UdZhvEyLfRXvh5zHE/ kmc4VtN3BFcuEKBOySggLQ== 0000950124-04-001219.txt : 20040326 0000950124-04-001219.hdr.sgml : 20040326 20040326152453 ACCESSION NUMBER: 0000950124-04-001219 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 20031231 FILED AS OF DATE: 20040326 FILER: COMPANY DATA: COMPANY CONFORMED NAME: COMMERCIAL NATIONAL FINANCIAL CORP /MI CENTRAL INDEX KEY: 0000828535 STANDARD INDUSTRIAL CLASSIFICATION: STATE COMMERCIAL BANKS [6022] IRS NUMBER: 382799780 STATE OF INCORPORATION: MI FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 000-17000 FILM NUMBER: 04692838 BUSINESS ADDRESS: STREET 1: 101 N PINE RIVER ST CITY: ITHACA STATE: MI ZIP: 48847 BUSINESS PHONE: 5178754144 MAIL ADDRESS: STREET 1: P O BOX 280 CITY: ITHACA STATE: MI ZIP: 48847 10-K 1 k82475e10vk.txt ANNUAL REPORT FOR FISCAL YEAR ENDED 12/31/03 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, 2003 Commission File Number 0-17000 COMMERCIAL NATIONAL FINANCIAL CORPORATION (Exact name of registrant as specified in its charter) Michigan 38-2799780 (State of Incorporation) (I.R.S. Employer Identification No.) 101 North Pine River Street Ithaca, Michigan 48847 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (989) 875-4144 Securities registered pursuant to Section 12(g) of the Act: Common Stock, No 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 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 by check 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. [X] Indicate by checkmark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act) Yes [ ] No [X] State the aggregate market value of the voting stock held by non-affiliates of the registrant. The aggregate market value shall be computed by reference to the price at which the stock was sold, or the average bid and asked prices of such stock, as of a specified date within 60 days prior to the date of filing. Aggregate market value as of March 12, 2004: $33,553,534 Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date. Common Stock outstanding as of March 12, 2004: 4,072,570 shares DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrant's annual report to security holders for the year ended December 31, 2003, are incorporated by reference in Part II and Part IV. Portions of the registrant's proxy statement for its April 27, 2004, annual shareholders meeting are incorporated by reference in Part III and Part IV. INDEX PART I Item 1. Business..................................................................... 2 Item 2. Properties................................................................... 4 Item 3. Legal Proceedings............................................................ 5 Item 4. Submission of Matters to a Vote of Security Holders.......................... 5 PART II Item 5. Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities........................................ 5 Item 6. Selected Financial Data...................................................... 5 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations........................................................ 5 Item 7A. Quantitative and Qualitative Disclosure About Market Risk.................... 5 Item 8. Financial Statements and Supplementary Data.................................. 5 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure..................................................... 5 Item 9a. Control and Procedures....................................................... 5 PART III Item 10. Directors and Executive Officers of the Registrant........................... 6 Item 11. Executive Compensation....................................................... 6 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.................................................. 6 Item 13. Certain Relationships and Related Transactions............................... 6 Item 14. Principal Accountant Fees and Services....................................... 6 PART IV Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K.............. 7 SIGNATURES Signatures ............................................................................. 9 INDEX TO EXHIBITS ............................................................................. 11
1 PART I ITEM 1. BUSINESS General Commercial National Financial Corporation (the Corporation or Commercial), a financial holding company, was incorporated in Michigan on December 30, 1987. On May 31, 1988, the Corporation acquired all of the stock of Commercial National Bank, a national banking association chartered in 1962. On December 30, 1992, Commercial National Bank converted to a state-chartered bank under the name Commercial Bank (the Bank). On July 16, 1997, the Bank acquired an inactive insurance agency, Commercial National Financial Services Incorporated (the Agency). The Agency in turn purchased a minority interest in Michigan Bankers Title of Northern Michigan, LLC (the Title Agency). During 2000, Michigan Bankers Title of Northern Michigan was dissolved. The Agency made a similar investment in Michigan Bankers Title of Eastern Michigan. The investment in the Title Agency is not material. The Bank established a relationship with The Centennial Group (Centennial), a financial planning group headquartered in Lansing, Michigan in 2000. Through customer referrals to a registered representative of Centennial, the Agency receives commissions for the placement of products and fee based services. During 2001, Commercial Bank formed a mortgage company, CNFC Mortgage Corporation, 100% owned by Commercial Bank. CNFC Mortgage Corporation allows Commercial to pursue out of market mortgages and offer products and services not normally provided by community banks. The Bank concentrates its efforts primarily in two areas, commercial lending and residential real estate lending. Loan, deposit and other products are designed to support these market segments. The Bank also provides a full range of traditional banking services to individuals located in its service area. Commercial Bank offers a variety of deposit products, including checking, savings, money market, individual retirement accounts, certificates of deposit and repurchase agreements. The principal markets for financial services are the mid-Michigan communities in which the Bank is located and the areas immediately surrounding these communities. The Bank serves these markets through nine locations in or near these communities. Commercial also lends outside the principal geographic market in support of existing customers. Commercial does not have any material foreign assets or income. The principal source of revenue for Commercial is interest and fees on loans. On a consolidated basis, interest and fees on loans accounted for 79.25% of total revenue in 2003, 79.47% in 2002, and 79.71% in 2001. Interest on investment securities accounted for 6.82% of total revenue in 2003, 7.82% in 2002, and 8.04% in 2001. At December 31, 2003, the Bank had no significant concentrations of loans to any group of borrowers engaged in similar activities that would be impacted by economic or other conditions. The Bank employed 95 individuals at December 31, 2003. Competition The business of banking is highly competitive. In addition to competition from other commercial banks, banks face competition from non-bank financial institutions. Savings associations compete with commercial banks for deposits and loans. Credit unions and finance companies compete for consumer loans. Commercial banks compete for deposits with other entities such as mutual funds and corporate and government debt securities. Financial service providers compete for customers principally through price (interest rates paid on deposits, interest rates charged on borrowings and fees charged for services) and service (convenience and quality of services rendered to customers). The Bank competes directly with fifteen financial institutions in the market it serves. The Bank's competitors include other commercial banks, savings associations and local credit unions. The Bank does not believe that its ability to compete for loans and deposits is affected by the rank among its competitors. Critical Accounting Policies The "Management's Discussion and analysis of Financial Condition and Results of Operations," as well as disclosures found elsewhere in the annual report, are based upon Commercial's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires Commercial to estimate and make judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Material estimates that are particularly susceptible to significant change in the near term relate to the 2 determination of the allowance for loan losses, the valuation of mortgage servicing assets and the valuation of stock options. Actual results could differ significantly from these estimates. Allowance for Loan Losses The allowance for loan losses is maintained at a level believed adequate by management to absorb probable losses inherent in the consolidated loan portfolio. Management's evaluation of the adequacy of the allowance is an estimate based on an assessment of loss exposure on individual loans identified as substandard or substandard and impaired, and an assessment of the performance of homogenous categories of loans. A detailed discussion of Commercial's allowance for loan loss methodology is included in the Provision and Allowance for Loan Losses section of the management discussion and analysis. Mortgage Servicing Assets Servicing assets are recognized as separate assets when loans are sold with servicing retained. Capitalized servicing rights are amortized into noninterest income in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets. Servicing assets are valued based upon the estimated fair value of the rights. Value is determined by stratifying servicing rights by predominant characteristics, including term, and rate and applying a discounted cash flow model to determine an estimated market value. Some of the assumptions used in the discounted cash flow model, including the estimated life of the servicing asset, can influence the final market value. Negative adjustments to the value (referred to as impairment), are recognized through a valuation allowance by charges against mortgage servicing income. See Note 5 of the consolidated financial statements for additional information. Stock Options Incentive and non-qualified stock options are periodically issued to certain employees and directors under shareholder approved stock option plans. The options are granted at an exercise price equal to the fair value of the underlying shares at the date of grant. Employee options are generally granted for a term of 10 years with a 5 year vesting schedule. Director options are granted for a term of 10 years with a 6 month vesting schedule. Management uses the Black-Scholes option pricing model to determine the fair value of stock options. This model has certain limitations, such as not factoring in the non-transferability of employee options. The model is generally used to value options with terms shorter than the contractual ten-year life. Because of these limitations, and the use of subjective assumptions in the model, this and other option pricing models do not necessarily provide a reliable measure of the fair value of stock options. The question arises as to why management selected the Black-Scholes pricing model if it may not be reliable. In the current market place we are unable to find a reasonably priced model that will provide a more reliable measure of fair value. Management also believes that obtaining an independent appraisal of value would be cost prohibitive and also inherently unreliable. The more significant assumptions used in estimating the fair value of stock options include the risk-free interest rate, the dividend yield, the weighted average expected life of the stock options and the expected price volatility of our common stock. The risk-free interest rate is based on U.S. Treasury securities with a term equal to the expected life of the stock options. The dividend yield is based on Commercial's expected dividend payout level. The expected life is based on historical experience adjusted for changes in terms and the amount of awards granted. The expected volatility, which is the assumption where the most judgment is used, is based on historical volatility. See notes 1 and 10 of Commercial's consolidated financial statements for further discussion of stock options. Management believes the accounting estimates related to the allowance for loan losses, valuations of mortgage servicing assets and the valuation of stock options are critical accounting estimates. These estimates are susceptible to change from period to period because they require management to make assumptions concerning future events. Management regularly discusses the methodology used to determine these accounting estimates with the audit committee of the board of directors. Supervision and Regulation Banks and bank holding companies are extensively regulated. The Bank is chartered as a state bank under Michigan law and is supervised, examined and regulated by the Office of Financial and Insurance Services ("OFIS") and the Federal Deposit Insurance Corporation ("FDIC"). The business activities of the registrant are limited to banking and to other activities determined by the Board of Governors of the Federal Reserve System to be closely related to banking. Deposits of the Bank are insured by the FDIC to the extent provided by law. Commercial banks are subject to a number of federal and state laws and regulations that have a material impact on their business. These include, among others, state usury laws, state laws relating to fiduciaries, the Truth in Lending Act, the Equal Credit Opportunity Act, the Fair Credit Reporting Act, the Expedited Funds Availability Act, the Community Reinvestment Act, electronic funds transfer laws, redlining laws, antitrust laws, environmental laws and privacy laws. The policies of the 3 Federal Reserve System, and other authorities, may materially affect the growth and distribution of loans, investments and deposits and interest rates on deposits and loans. The FDIC Improvement Act of 1991 (the "FDIC Improvement Act"), revised sections of the Federal Deposit Insurance Act affecting bank regulation, deposit insurance and provisions for the funding of the bank insurance fund. The FDIC Improvement Act also revised bank regulatory structures embodied in several other federal banking statutes, links the bank regulators' authority to intervene to the deterioration of a bank's capital level, places limits on real estate lending and increases audit requirements. Among the significant revisions that could have an impact on the Corporation is the authority granted to the FDIC to impose special assessments on insured depository institutions to repay FDIC borrowings from the United States Treasury or other sources and to establish semiannual assessment rates on bank insurance fund member banks so as to maintain the bank insurance fund at the designated reserve ratio defined in the FDIC Improvement Act. The FDIC Improvement Act also required the FDIC to implement a system of risk-based premiums for deposit insurance pursuant to which the premiums paid by a depository institution are based on the perceived probability that the bank insurance fund will incur a loss in respect of such institution. Under 1994 amendments to the Federal Bank Holding Company Act, the Corporation is authorized to acquire subsidiary banks in any state in which state laws permit such acquisitions. Out-of-state bank holding companies in any state are permitted to acquire banks located in Michigan if the laws of the state in which the out-of-state bank holding company is located authorize a bank holding company located in Michigan to acquire ownership of banks in that state on a reciprocal basis. Under amendments to the Michigan Banking Code which became effective on November 29, 1995, the Bank is authorized to merge with or acquire out-of-state banks or branches in any state in which state laws permit such acquisitions. Enacted late in 1999, the Gramm-Leach-Bliley Act ("Gramm-Leach-Bliley"), broadens the scope of financial services that banks may offer to consumers, essentially removing the barriers erected during the Depression that separated banks and securities firms, closes the loophole which permitted commercial enterprises to own and operate a thrift institution, and provides some new consumer protections with respect to privacy issues and ATM usage fees. Gramm-Leach-Bliley permits affiliations between banks, securities firms and insurance companies (which affiliations were previously prohibited under the Glass-Steagall Act). Under Gramm-Leach-Bliley, a bank holding company may qualify as a financial holding company and thereby offer expanded range of financial oriented products and services which products and services may not be offered by bank holding companies. To qualify as a financial holding company, a bank holding company's subsidiary depository institutions must be well-managed, well-capitalized and have received a "satisfactory" rating on its latest examination under the Community Reinvestment Act. Gramm-Leach-Bliley provides for some regulatory oversight by the Securities and Exchange Commission for bank holding companies engaged in certain activities, and reaffirms that insurance activities are to be regulated on the state level. States, however, may not prevent depository institutions and their affiliates from engaging in insurance activities. Commercial enterprises are no longer able to establish or acquire a thrift institution and thereby become a unitary thrift holding company. Thrift institutions may only be established or acquired by financial organizations. Gramm-Leach-Bliley provides new consumer protections with respect to the transfer and use of a consumer's nonpublic personal information and generally enables financial institution customers to "opt-out" of the dissemination of their personal financial information to unaffiliated third parties. ATM operators who charge a fee to non-customers for use of its ATM must disclose the fee on a sign placed on the ATM and before the transaction is made as a part of the on-screen display or by a paper notice issued by the machine. Enacted on July 30, 2002, the Sarbanes-Oxley Act of 2002 attempts to address several issues including corporate governance, auditing and accounting oversight, executive compensation, and enhanced timely disclosure of corporate information for publicly traded companies. The rule making process used to implement the law is ongoing, however, several provisions of the Act have been implemented. Effective August 29, 2002, as directed by Section 302 (a) of Sarbanes-Oxley, Commercial's chief executive officer and chief financial officer are each required to certify that Commercial's quarterly and annual reports do not contain any untrue statement of a material fact. The rules require that these officers certify that they are responsible for establishing, maintaining and regularly evaluating the effectiveness of Commercial's internal controls; they have made certain disclosures to Commercial's auditors and the Audit Committee of the Board of Directors about internal controls; and they have included information in Commercial's quarterly and annual reports about their evaluation and whether there have been significant changes in Commercial's internal controls or in other factors that could significantly affect internal controls subsequent to the evaluation. ITEM 2. PROPERTIES The Bank currently conducts business from nine banking offices. The executive offices of the Corporation are located at 101 North Pine River Street, Ithaca, Michigan. The main office of the Bank is located at 301 North State Street, Alma, Michigan. 4 The main office property of the Bank is leased for a term expiring on December 31, 2013. The offices of the Bank are located in Alma, Greenville, Middleton, Mount Pleasant, Pompeii, and St. Louis, Michigan. The Bank owns the property for six of the office locations. Two offices are leased, one pursuant to a lease that expires August 1, 2008, subject to 2 renewals of 10 years each and one pursuant to a lease that expires January 2008 subject to 2 renewals of 5 years each. The Corporation considers all of its facilities to be well maintained and in generally good operating condition and suitable for the purposes for which they are intended. ITEM 3. LEGAL PROCEEDINGS The Corporation and the Bank are parties, as plaintiff or defendant, to several legal proceedings, none of which is considered material, and all of which arose in the ordinary course of business. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUERS PURCHASES OF EQUITY SECURITIES The information under the captions "Common Stock Information" and "Dividend Information" of the registrant's annual report to shareholders for the year ended December 31, 2003, is hereby incorporated by reference to Exhibit 13. ITEM 6. SELECTED FINANCIAL DATA The information under the caption "Selected Financial Data" of the registrant's annual report to shareholders for the year ended December 31, 2003, is hereby incorporated by reference to Exhibit 13. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information under the heading "Management's Discussion and Analysis and Results of Operations" of the registrant's annual report to shareholders for the year ended December 31, 2003, is hereby incorporated by reference to Exhibit 13. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The information under the heading "Quantitative and Qualitative Disclosures About Market Risk" of the registrant's annual report to shareholders for the year ended December 31, 2003, is hereby incorporated by reference to Exhibit 13. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements, notes and report of independent auditor included in the registrant's annual report to shareholders for the year ended December 31, 2003, are hereby incorporated by reference to Exhibit 13. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable ITEM 9a. CONTROLS AND PROCEDURES The management of Commercial National Financial Corporation is responsible for establishing and maintaining effective disclosure controls and procedures, as defined under Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934. As of December 31, 2003, an evaluation was performed under the supervision and with the participation of management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Corporation's disclosure controls and procedures. Based on that evaluation, management concluded that the Corporation's disclosure controls and procedures as of December 31, 2003 were effective, in all material respects, in ensuring that information required to be disclosed in this Annual Report on Form 10-K was recorded, processed, summarized, and reported within the time period required by the United States Securities and Exchange Commission's rules and forms. 5 Management's responsibilities related to establishing and maintaining effective disclosure controls and procedures include maintaining effective internal controls over financial reporting that are designed to produce reliable financial statements in accordance with accounting principles generally accepted in the United States. As disclosed in Management's Responsibility for Financial Statements on page 22 of the Annual Report to Shareholders for the year ending December 31, 2003, management assessed the Corporation's system of internal control over financial reporting as of December 31, 2003, in relation to criteria for effective internal control over financial reporting as described in "Internal Control - Integrated Framework," issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management believes that, as of December 31, 2003, its system of internal control over financial reporting met those criteria. The Corporation also conducted an evaluation of internal controls over financial reporting to determine whether any changes occurred during the quarter ended December 31, 2003, that have materially affected, or are reasonably likely to materially affect, the Corporation's internal control over financial reporting. Based on this evaluation, there has been no such change during the quarter that ended December 31, 2003. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT For information concerning directors and certain executive officers of the Corporation, see "Election of Directors" and "Section 16(a) Beneficial Ownership Reporting Compliance" in the Corporation's 2004 Annual Meeting Proxy Statement ("Proxy Statement") which is incorporated herein by reference. For Information concerning the Corporation's Audit Committee financial experts, see "Corporate Governance and the Board of Directors" in the Proxy Statement which is incorporated herein by reference. The Corporation has adopted a Code of Business Conduct and Ethics that applies to the Corporation's Chief Executive Officer and Principal Financial Officer. The Corporation shall provide to any person without charge upon request, a copy of its Code of Business Conduct and Ethics. Written requests should be sent to: Secretary, Commercial National Financial Corporation, 101 North Pine River, Ithaca, Michigan 48847. ITEM 11. EXECUTIVE COMPENSATION The information set forth under the captions "Compensation of Executive Officers" and "Compensation of Directors" in the registrant's definitive Proxy Statement for its April 27, 2004, annual meeting of shareholders is here incorporated by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information set forth under the caption "Voting Securities" in the registrant's definitive Proxy Statement for its April 27, 2004, annual meeting of shareholders is here incorporated by reference. The following table sets forth certain information for all equity compensation plans and individual compensation arrangements (whether with employees or non-employees, such as directors), in effect as of December 31, 2003.
Number of Shares Remaining Number of Shares to be Weighted-Average Available for Future Issuance Issued Upon the Exercise Exercise Price of (Excluding Shares Reflected Plan Category Of Outstanding Options Outstanding Options in First Column) - ------------------------------------------------------------------------------------------------------------------------ Equity Compensation Plans Approved by Security Holders 2001 Plan 138,141 $11.59 151,265 1991 Plan 155,699 9.21 - Equity Compensation Plans Not Approved by Security Holders - - - - ------------------------------------------------------------------------------------------------------------ Total 293,840 $10.32 151,265 ============================================================================================================
6 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information set forth under the caption "Certain Relationships" in the registrant's definitive Proxy Statement for its April 27, 2004, annual meeting of shareholders is hereby incorporated by reference. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES The information appearing in the definitive proxy statement, dated as of March 22, 2004, is incorporated herein by reference in response to this item. 7 PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) (1) Financial Statements. The following financial statements, notes to financial statements, and report of independent auditor of the Corporation and its subsidiary are filed as part of this report: Report of Independent Auditors* Consolidated Balance Sheets - December 31, 2003 and 2002* Consolidated Statements of Income for each of the three years ended December 31, 2003* Consolidated Statements of Changes in Shareholders' Equity for each of the three years in the period ended December 31, 2003* Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 2003* Notes to Consolidated Financial Statements* * Incorporated by reference from the 2003 Annual Report to Shareholders. (a)(2) All schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. With the exception of the portions of the registrant's annual report to shareholders for the year ended December 31, 2003 specifically incorporated herein by reference, such report shall not be deemed filed as part of this annual report on Form 10-K. (a) (3) The following exhibits are filed as part of this report: Number Exhibit 3(a) Restated Articles of Incorporation. Previously filed as an exhibit to the registrant's Form S-4 filed January 22, 1988. Here incorporated by reference. 3(b) Bylaws. Previously filed as an exhibit to the registrant's Form S-4 filed January 22, 1988. Here incorporated by reference. 10(a) 1991 Stock Option Plan. Previously filed as an exhibit to the registrant's Form 10-K for the year ended December 31, 1990. Here incorporated by reference.* 10(b) Amendment to 1991 Stock Option Plan. Previously filed as an exhibit to the registrant's Form 10-K for the year ended December 31, 1995. Here incorporated by reference.* 10(c) Lease for Main Office. Previously filed as an exhibit to registrant's Form 10-K for the year ended December 31, 1991. Here incorporated by reference. 10(d) Amendment to 1991 Stock Option Plan. Previously filed as an exhibit to the registrant's Form 10-K for the year ended December 31, 1998. Here incorporated by reference.* 10(e) Change in Control Agreement. Previously filed as an exhibit to the registrant's Form 10-K for the year ended December 31, 1998. Here incorporated by reference.* 10(f) Commercial National Financial Corporation 2001 Stock Option and Incentive Plan. Previously filed as an exhibit to the registrant's Form S-8 filed May 11, 2001 (File No. 333-60894). Here incorporated by reference.* 13 Incorporated Portions from 2003 Annual Report to Shareholders. 14 Code of Business Conduct and Ethics. Here incorporated by reference.* 21 Subsidiary of Registrant. Previously filed as an exhibit to the registrant's Form S-4 filed January 22, 1988. Here incorporated by reference. 8 23 Consent of Certified Public Accountants. 31(a) Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) 31(b) Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) 32(a) Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 32(b) Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 * Management contract or compensatory plan or arrangement. The registrant will furnish a copy of any exhibit listed above to any shareholder of the registrant without charge upon written request to Patrick Duffy, Commercial National Financial Corporation, 101 North Pine River Street, Ithaca, Michigan 48847. (b) Reports on Form 8-K. During the quarter ended December 31, 2003, the registrant filed the following report on Form 8K: Current report on Form 8-K dated November 24, 2003 filed with the Security and Exchange Commission on November 24, 2003 announcing third quarter earnings. Current report on Form 8-K dated December 1, 2003 filed with the Security and Exchange Commission on December 4, 2003 announcing fourth quarter dividend. Current report on Form 8-K dated October 31, 2003 filed with the Security and Exchange Commission on November 12, 2003 announcing a 5% stock dividend. Current report on Form 8-K dated December 17, 2003 filed with the Security and Exchange Commission on December 22, 2003 filing a copy of the amended and restated Charter of the Audit Committee. (c) Exhibits. See Item 15(a)(3) (d) Financial Statement Schedules. There are no financial statement schedules required to be filed with this report. 9 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. COMMERCIAL NATIONAL FINANCIAL CORPORATION (registrant) /s/ Jeffrey S. Barker - ----------------------------------------------- Jeffrey S. Barker President and Chief Executive Officer March 26, 2004 10 COMMERCIAL NATIONAL FINANCIAL CORPORATION Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. March 26, 2004 /s/ Jeffrey S. Barker -------------------------- Jeffrey S. Barker Director, President and Chief Executive Officer (Principal Executive Officer) March 26, 2004 /s/Richard F. Abbott -------------------------- Richard F. Abbott Director March 26, 2004 /s/ Jefferson P. Arnold -------------------------- Jefferson P. Arnold Director March 26, 2004 /s/ Don J. Dewey -------------------------- Don J. Dewey Director March 26, 2004 /s/ Patrick G. Duffy -------------------------- Patrick G. Duffy Director (Principal Financial and Accounting Officer) March 26, 2004 /s/ David A. Ferguson -------------------------- David A. Ferguson Director March 26, 2004 /s/ Paul B. Luneack -------------------------- Paul B. Luneack Director March 26, 2004 /s/Kim C. Newson -------------------------- Kim C. Newson Director March 26, 2004 /s/ Howard D. Poindexter ------------------------ Howard D. Poindexter Director March 26, 2004 /s/ Scott E. Sheldon -------------------------- Scott E. Sheldon Director 11 COMMERCIAL NATIONAL FINANCIAL CORPORATION INDEX TO EXHIBITS
Number Exhibit Page - ------ ------- ---- 3(a) Restated Articles of Incorporation. Previously filed as an exhibit to the registrant's Form S-4 filed January 22, 1988. Here incorporated * by reference. 3(b) Bylaws. Previously filed as an exhibit to the registrant's Form S-4 filed January 22, 1988. Here incorporated by reference. * 10(a) 1991 Stock Option Plan. Previously filed as an exhibit to the registrant's Form * 10-K for the year ended December 31, 1990. Here incorporated by reference. 10(b) Amendment to 1991 Stock Option Plan. Previously filed as an exhibit to the * registrant's Form 10-K for the year ended December 31, 1995. Here incorporated by reference. 10(c) Lease for Main Office. Previously filed as an exhibit to registrant's Form 10-K * for the year ended December 31, 1991. Here incorporated by reference. 10(d) Amendment to 1991 Stock Option Plan. Previously filed as an exhibit to registrant's Form 10-K for the year ended December 31, 1999. Here incorporated by reference. * 10(e) Change in Control Agreement. Previously filed as an exhibit to registrant's Form 10-K for the year ended December 31, 1999. Here incorporated by reference. * 10(f) Commercial National Financial Corporation 2001 Stock Option and Incentive Plan. Previously filed as an exhibit to the registrant's Form S-8 filed May 11, 2001 (File No. 333-60894). Here incorporated by reference. * 13 Incorporated Portions from 2003 Annual Report to Shareholders. * 14 Code of Business Conduct and Ethics * 21 Subsidiary of Registrant. Previously filed as an exhibit to the registrant's Form * S-4 filed January 22, 1988. Here incorporated by reference. 23 Consent of Independent Certified Public Accountants. 31(a) Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) 31(b) Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) 32(a) Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 32(b) Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
*This exhibit is filed by incorporation by reference to a prior filing. 12 EX-13 3 k82475exv13.txt INCORPORATED PORTIONS FROM 2003 ANNUAL REPORT COMMERCIAL NATIONAL FINANCIAL CORPORATION EXHIBIT 13 INCORPORATED PORTIONS FROM 2003 ANNUAL REPORT TO SHAREHOLDERS 13 . . . CONTENTS Report from the President................................................................................. 3 Mt. Pleasant Office....................................................................................... 4 Selected Financial Data................................................................................... 5 Management's Discussion and Analysis of Financial Condition and Results of Operations..................... 6-22 Management's Responsibility for Financial Statements...................................................... 23 Report of Independent Auditors............................................................................ 24 Consolidated Balance Sheets............................................................................... 25 Consolidated Statements of Income......................................................................... 26 Consolidated Statements of Changes in Shareholders' Equity................................................ 27 Consolidated Statements of Cash Flows..................................................................... 28 Notes to Consolidated Financial Statements................................................................ 29-44 Customer Profiles......................................................................................... 45 Directors and Officers.................................................................................... 46-47 Common Stock and Dividend Information..................................................................... 48 Locations, Transfer Agent and Market Makers............................................................... 49
1 [LOGO] 2 [LOGO] To Our Shareholders: During 2003 we opened a new office, and made tremendous gains in our mortgage loan portfolio, however, our income was below expectations. Net income for the past year totaled $2,236,000 compared to $2,901,000 for the prior year, or a decline of 22.9%. The disappointing drop in income is primarily attributable to a very large increase to the provision for loan losses and expenses associated with our expansions in both Greenville and Mt. Pleasant. The increase to the provision for loan losses was the result of losses incurred relating to two large commercial loan relationships in the manufacturing sector. We attempted to resolve the problems over many months. It became apparent during the second quarter of 2003 that it was in our best interest to work out of these two relationships, which resulted in a loss. No balances with these customers remain on our books at year end. Had the additional provision for loan losses not been necessary, net income for 2003 would have increased just over 10% compared to the prior year, despite the increased costs associated with our new offices in Greenville and Mt. Pleasant. However, both of these new banking facilities should position us to grow our business in their respective markets. Our affiliate bank, Commercial Bank Greenville, has been open for a little more than a year now and under the leadership of Jeff Loomis, our new President in Greenville, we are experiencing solid gains in both loans and deposits. Jeff brings over 20 years of community bank experience to Commercial Bank Greenville. Recently, The Centennial Group added Linda Posati, a new Registered Representative, to our bank in Greenville. Linda has been providing financial services to the Greenville market since 1987. The new Mt. Pleasant office opened in June 2003 and has been very favorably received by both new and existing customers, some of whom are featured in this annual report. Vice President, Wayne Heminger, and Branch Manager, Sandy Lucksted, head up our unique new Mt. Pleasant office designed and staffed to provide the utmost in personalized service. While net income declined for 2003, our dividend payout remained strong. Cash dividends were $.54 per share compared to $.51 for the prior year or an increase of 5.9%. The resulting dividend yield for the past year was 4.8% at year end. At the same time the total capital ratio for the company is just over 10% and substantially exceeds all regulatory capital requirements. Looking forward to 2004, we plan to continue our strong growth in real estate mortgage lending. Real estate mortgage loans totaled $77,400,000 at the end of 2003 compared to $61,600,000 for the prior year, a 25% increase. Recently, Karen Taylor was promoted to Vice President - Mortgage Lending to head up that important role in the bank. She will be adding two new Mortgage Originators beginning March 1, 2004, and we have developed several new innovative loan products. We are also updating our interactive web site to process both conventional mortgages and home equity loans. We look forward to continued growth in this important segment of our business. I encourage you to visit our mortgage loan web site at www.cbloan.info. Thank you for your continued support and investment in Commercial National Financial Corporation. Sincerely, Jeffrey S. Barker President and CEO 3 [LOGO] PICTURES OF MT. PLEASANT 4 [LOGO] SELECTED FINANCIAL DATA
2003 2002 2001 2000 1999 --------- --------- --------- --------- --------- (In thousands except financial ratios and per share data) FOR THE YEAR Net interest income $ 9,704 $ 8,922 $ 8,952 $ 9,002 $ 8,416 Provision for loan losses (1,901) (681) (375) (360) (360) Noninterest income 2,028 1,823 1,842 1,026 1,099 Noninterest expense (6,762) (6,033) (5,885) (5,572) (5,347) --------- --------- --------- --------- --------- Income before income tax expense 3,069 4,031 4,534 4,096 3,808 Income tax expense (833) (1,130) (1,331) (1,193) (1,077) --------- --------- --------- --------- --------- Net income $ 2,236 $ 2,901 $ 3,203 $ 2,903 $ 2,731 ========= ========= ========= ========= ========= AT YEAR END Total assets $ 239,788 $ 238,251 $ 218,398 $ 215,886 $ 191,022 Net loans 192,419 181,665 165,427 174,288 149,675 Total deposits 169,565 166,059 162,579 157,794 147,204 FHLB advances 32,104 32,807 26,093 26,500 16,500 Shareholders' equity 24,283 23,704 22,064 20,110 18,965 FINANCIAL RATIOS Return on average assets .94% 1.28% 1.48% 1.43% 1.47% Return on average shareholders' equity 9.21 12.60 14.93 14.67 14.67 Average shareholders' equity to average assets 10.22 10.14 9.90 9.74 10.04 Allowance for loan losses to total loans 1.01 1.51 1.54 1.44 1.83 Tier 1 leverage capital ratio 10.19 10.00 9.74 9.35 9.98 Total risk-based capital ratio 14.40 14.21 14.38 13.14 14.27 Dividend pay-out 97.33 70.35 59.48 62.23 63.37 PER SHARE DATA(1) Basic earnings $ .55 $ .73 $ .82 $ .75 $ .70 Diluted earnings .55 .72 .82 .74 .70 Dividends declared .54 .51 .49 .46 .46 Book value, end of year 5.99 5.94 5.64 5.22 4.90
(1) All per share data adjusted to reflect stock splits and stock dividends. 5 [LOGO] MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS INTRODUCTION The following discussion provides information about the financial condition and results of operations of Commercial National Financial Corporation. It should be read in conjunction with the consolidated financial statements included elsewhere in this Annual Report. BUSINESS OF COMMERCIAL NATIONAL FINANCIAL CORPORATION Commercial National Financial Corporation (the Corporation or Commercial), a financial holding company, was incorporated in Michigan on December 30, 1987. On May 31, 1988, the Corporation acquired all of the stock of Commercial National Bank, a national banking association chartered in 1962. On December 30, 1992, Commercial National Bank converted to a state-chartered bank under the name Commercial Bank (the Bank). On July 16, 1997, the Bank acquired an inactive insurance agency, Commercial National Financial Services Incorporated (the Agency). The Agency in turn purchased a minority interest in Michigan Bankers Title of Northern Michigan, LLC (the Title Agency). During 2000, Michigan Bankers Title of Northern Michigan was dissolved. The Agency made a similar investment in Michigan Bankers Title of Eastern Michigan. The investment in the Title Agency is not material. The Bank established a relationship with The Centennial Group (Centennial), a financial planning group headquartered in Lansing, Michigan in 2000. Through customer referrals to a registered representative of Centennial, the Agency receives commissions for the placement of products and fee based services. During 2001, Commercial Bank formed a mortgage company, CNFC Mortgage Corporation, 100% owned by Commercial Bank. CNFC Mortgage Corporation allows Commercial to pursue out of market mortgages and offer products and services not normally provided by community banks. The Bank concentrates its efforts primarily in two areas, commercial lending and residential real estate lending. Loan, deposit and other products are designed to support these market segments. The Bank also provides a full range of traditional banking services to individuals located in its service area. Commercial Bank offers a variety of deposit products, including checking, savings, money market, individual retirement accounts, certificates of deposit and repurchase agreements. The principal markets for financial services are the mid-Michigan communities in which the Bank is located and the areas immediately surrounding these communities. The Bank serves these markets through nine locations in or near these communities. Commercial also lends outside the principal geographic market where the Bank has locations in support of existing customers. Commercial does not have any material foreign assets or income. The principal source of revenue for Commercial is interest and fees on loans. On a consolidated basis, interest and fees on loans accounted for 79.25% of total revenue in 2003, 79.47% in 2002, and 79.71% in 2001. Interest on investment securities accounted for 6.82% of total revenue in 2003, 7.82% in 2002, and 8.04% in 2001. CRITICAL ACCOUNTING POLICIES The "Management's Discussion and analysis of Financial Condition and Results of Operations," as well as disclosures found elsewhere in the annual report, are based upon Commercial's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires Commercial to estimate and make judgments that affect the 6 [LOGO] reported amounts of assets, liabilities, revenues and expenses. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, the valuation mortgage servicing assets and the valuation of stock options. Actual results could differ significantly from these estimates. Allowance for Loan Losses The allowance for loan losses is maintained at a level believed adequate by management to absorb probable losses inherent in the consolidated loan portfolio. Management's evaluation of the adequacy of the allowance is an estimate based on an assessment of loss exposure on individual loans identified as substandard or substandard and impaired, and an assessment of the performance of homogenous categories of loans. A detailed discussion of Commercial's allowance for loan loss methodology is included in the Provision and Allowance for Loan Losses section of the management discussion and analysis. Mortgage Servicing Assets Servicing assets are recognized as separate assets when loans are sold with servicing retained. Capitalized servicing rights are amortized into noninterest income in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets. Servicing assets are valued based upon the estimated fair value of the rights. Value is determined by stratifying servicing rights by predominant characteristics, including term, and rate and applying a discounted cash flow model to determine an estimated market value. Some of the assumptions used in the discounted cash flow model, including the estimated life of the servicing asset, can influence the final market value. Negative adjustments to the value (referred to as impairment), are recognized through a valuation allowance by charges against mortgage servicing income. See Note 5 of the consolidated financial statements for additional information. Stock Options Incentive and non-qualified stock options are periodically issued to certain employees and directors under shareholder approved stock option plans. The options are granted at an exercise price equal to the fair value of the underlying shares at the date of grant. Employee options are generally granted for a term of 10 years with a 5 year vesting schedule. Director options are granted for a term of 10 years with a 6 month vesting schedule. Management uses the Black-Scholes option pricing model to determine the fair value of stock options. This model has certain limitations, such as not factoring in the non-transferability of employee options. The model is generally used to value options with terms shorter than the contractual ten-year life. Because of these limitations, and the use of subjective assumptions in the model, this and other option pricing models do not necessarily provide a reliable measure of the fair value of stock options. In the current market place we are unable to find a reasonably priced model that will provide a more reliable measure of fair value. Management also believes that obtaining an independent appraisal of value would be cost prohibitive and also inherently unreliable. The more significant assumptions used in estimating the fair value of stock options include the risk-free interest rate, the dividend yield, the weighted average expected life of the stock options and the expected price volatility of our common stock. The risk-free interest rate is based on U.S. Treasury securities with a term equal to the expected life of the stock options. The dividend yield is based on Commercial's expected dividend payout level. The expected life is based on historical experience adjusted for changes in terms and the amount of awards granted. The expected volatility, which is the assumption where the most judgment is used, is based on historical volatility. See notes 1 and 10 of Commercial's consolidated financial statements for further discussion of stock options. Management believes the accounting estimates related to the allowance for loan losses, valuations of mortgage servicing assets and the valuation of stock options are critical accounting estimates. These estimates are susceptible to change from period to period because they require management to make assumptions concerning future events. Management regularly discusses the methodology used to determine these accounting estimates with the audit committee of the board of directors. HIGHLIGHTS 2003 COMPARED TO 2002 Net income for the year ended December 31, 2003 was $2,236,000, a $665,000 or 22.9% decrease from the $2,901,000 earned in 2002. The 2003 return on average equity decreased 7 [LOGO] to 9.21% from 12.60% in 2002. The return on average assets for 2003 also decreased to .94% from 1.28% in 2002. Basic earnings per share decreased from $.73 per share for the year ending December 31, 2002 to $.55 per share for the year ending December 31, 2003. The major factors affecting 2003 results were falling interest rates, weak business loan demand, credit weakness in the business loan portfolio, and cost of expanding into Mt. Pleasant, Michigan. Interest rates, in general, continued to fall during the first 8 months of 2003. The decrease in interest rates provided incentive for residential real estate loan customers to refinance their existing residential real estate mortgages. The refinancing activity contributed to a net gain on loan sales of $818,000, a $120,000 or 17.2% increase compared to 2002. Commercial originated and sold to the secondary market $33.6 million in residential real estate loans compared to $32.7 million during 2002. This resulted in a $4.8 million or 7.8% increase in Commercial's mortgage servicing portfolio. Credit weakness in the business loan portfolio required Commercial to increase the provision for loan loss to $1,901,000 from $681,000, a $1,220,000 or 179.15% increase. Commercial also recorded gross charge-offs related to business loans of $2,996,000. In June of 2003, Commercial opened an office in Mt. Pleasant, Michigan. The office allows the Bank to support the deposit needs of existing business loan customers located in or near Mt. Pleasant. This office also provides a base of operation from which Commercial can pursue additional residential real estate and business lending opportunities. Costs of opening and staffing this location, combined with a full year of cost of operating our newest Greenville, Michigan office contributed to the $729,000 or 12.1% increase in non-interest expense. Total assets at December 31, 2003 increased $1.5 million to $239.8 million. Total gross loans increased $9.9 million primarily as a result of a $15.8 million increase in the residential real estate loan portfolio offset by an $5.4 million decrease in business related loans. Federal Funds totaling $6.2 million and $1.7 million in other interest bearing deposits were used to partially fund the increase in loans. 2002 COMPARED TO 2001 Net income for the year ended December 31, 2002 was $2,901,000, a $302,000 or 9.4% decrease from the $3,203,000 earned in 2001. The 2002 return on average equity decreased to 12.60% from 14.93% in 2001. The return on average assets for 2002 also decreased to 1.28% from 1.48% in 2001. Basic earnings per share decreased from $.82 per share for the year ending December 31, 2001 to $.73 per share for the year ending December 31, 2002. Three major events affecting 2002 results were historically low interest rates, a slowing local economy and the Bank's expansion into Greenville, Michigan. In an attempt to stimulate a slowing economy, the Federal Reserve lowered the discount rate from 1.75% at December 31, 2001 to 1.25% at December 31, 2002. This resulted in a 40 year low interest rate environment. The low interest rates continue to provide incentive to residential real estate mortgage customers to refinance their existing mortgage loans. Gain on loan sales increased $85,000 from the record $613,000 recorded in 2001. The slowing economy negatively affected the Bank's loan portfolio. Non-performing loans increased from $462,000 at December 31, 2001 to $6 million aFt December 31, 2002. The increase in non-performing loans, resulted in an increase in the provision for loan loss of $306,000. The interest income not recorded on the non-performing loans totaled $450,000. This had a negative impact on the Bank's margin which decreased from 4.46% for the year ending December 31, 2001 to 4.32% for the year ending December 31, 2002. Our expansion into Greenville, Michigan had a short-term negative impact on non-interest expense as management completed and staffed a new office. This new office increased personnel which increased salary, benefit and occupancy costs. In anticipation of the increased expenses of the new location, management has attempted to control costs in other areas of the Bank. Management was able to limit the overall increase in non-interest expense to $148,000 or 2.52% compared to the year ending December 31, 2001. Total assets at December 31, 2002 increased $19.9 million to $238.3 million from $218.4 million at December 31, 2001. Total gross loans at December 31, 2002 increased $16.2 million compared to December 31, 2001. Increases in the commercial loan, and residential real estate loan portfolios were the primary source for the increased loan totals. 8 [LOGO] NET INTEREST INCOME Treasury Yields
December 31, December 31, December 31, October 16, December 31, 2003 2002 2001 2001 2000 ------------ ------------ ----------- ---------- ------------ 3 month .93% 1.19% 1.72% 2.22% 5.09% 6 month 1.01% 1.24% 1.81% 2.20% 5.79% 1 year 1.86% 1.74% 3.18% 2.74% 5.43% 2 year 1.86% 1.74% 3.18% 2.74% 5.15% 5 year 3.24% 3.05% 4.43% 3.79% 5.01% 10 year 4.27% 4.08% 5.10% 4.59% 5.11%
The largest component of Commercial's operating income is net interest income. Net interest income is the difference between interest and fees earned on earning assets and the interest paid on deposits and other borrowings. A number of factors influence net interest income. These factors include: changes in volume and mix of interest-earning assets and interest-bearing liabilities, government monetary and fiscal policies, and national and local market interest rates. The performance of the loan portfolio can also influence net interest income. The above table illustrates how, in general, treasury rates have changed since December 31, 2000. The Treasury yield curve on October 16, 2001 reflects the initial response of the market to the events of September 11, 2001. 2003 COMPARED TO 2002 During 2003, long term interest rates continued to fall. Residential real estate and other long term borrowers continued to refinance loans at lower rates. Maturing securities were also replaced at lower yields. To help improve the yield on earning assets management invested excess Fed Funds into residential real estate loans. The yield on earning assets also improved as a result of the return to accrual status of $1.2 million in non-accrual loans and the related recapture of non-accrual interest. The net effect of these events was a 44 basis point decrease in the yield on earning assets. In response to lower yields on earning assets, management continued to lower the cost of deposit and other funding sources where possible. This included $8.7 million in FHLB maturing advances which were renewed at lower cost. Commercial was able to lower the cost of funds by 69 basis points. The net effect of the events affecting the yield on earning assets and the cost of interest bearing liabilities was a 14 basis point increase in Commercial's margin from 4.32% to 4.46%. The increase in margin combined with an increase of $9.3 million in average earning assets resulted in a $709,000 increase of tax equivalent net interest income. 2002 COMPARED TO 2001 During 2002 interest rates continued to fall in response to a slowing national economy. The Federal Reserve Open Market Committee decreased the discount rate 50 basis points during 2002. This was in addition to the 475 basis point decrease in the discount rate during 2001. Interest rates, in general, reached 40 year lows. The low interest rates continued to provide home owners with incentive to refinance their mortgage loans. In addition, business loan customers were also requesting to refinance loans at lower interest rates. In response, management continued to lower deposit rates. Despite lowering deposit rates, deposit balances increased as customers sought liquidity and safety. Loan growth continued to positively impact net interest income. Despite a slowing economy, average loan balances increased $7.1 million. The additional interest income helped offset the decrease in net interest income due to decreased yields on earning assets. Negatively impacting margin is the interest income not recorded on non-performing loans. During 2002, interest that was not recorded on loans placed on non-accrual totaled $450,000. Had this income been recorded during 2002, margin would have been 4.53% instead of 4.32%. 9 [LOGO] Average Balance Sheet and Analysis of Net Interest Income
Years ended December 31, --------------2003----------- ------------2002------------- AVERAGE YIELD/ Average Yield/ BALANCE INTEREST RATE Balance Interest Rate --------- -------- ------ --------- -------- ------ (Dollars in thousands) Interest-earning assets: Loans receivable (1)(2) $ 184,693 $ 12,644 6.85% $ 179,831 $ 12,755 7.09% Investment securities Taxable 18,850 697 3.70 14,723 773 5.25 Tax-exempt (2) 8,361 586 7.01 9,974 717 7.19 Federal funds sold and other interest-bearing deposits 9,948 97 .98 8,112 111 1.37 Federal Home Loan Bank stock 1,676 85 5.07 1,495 91 6.09 --------- -------- --------- -------- Total interest-earning assets 223,528 14,109 6.31 214,135 14,447 6.75 Non-earning assets: Cash and due from banks 5,343 5,100 Premises and equipment, net 3,851 2,953 Other assets 7,480 7,851 Allowance for loan losses (2,820) (2,888) --------- --------- Total assets $ 237,382 $ 227,151 ========= ========= Interest-bearing liabilities: Interest-bearing deposits Interest-bearing demand $ 29,427 $ 142 .48% $ 28,371 $ 152 .54% Savings 63,077 654 1.04 56,630 1,039 1.83 Time 54,220 1,652 3.05 57,610 2,197 3.81 Securities sold under agreements to repurchase 14,151 148 1.05 9,398 156 1.66 U.S. Treasury demand notes, Federal funds purchased, and other borrowings 295 3 1.02 397 6 1.51 Federal Home Loan Bank advances 29,643 1,545 5.21 29,227 1,641 5.61 --------- -------- --------- -------- Total interest-bearing liabilities 190,813 4,144 2.17 181,633 5,191 2.86 Noninterest-bearing liabilities: Noninterest-bearing demand 21,334 19,675 Other liabilities 967 2,812 Shareholders' equity 24,268 23,031 --------- --------- Total liabilities and shareholders' equity $ 237,382 $ 227,151 ========= ========= Net interest income/interest rate spread $ 9,965 4.14% $ 9,256 3.89% ======== ====== ======== ====== Net interest margin (3) 4.46% 4.32% ====== ======
Years ended December 31, -------------2001------------- Average Yield/ Balance Interest Rate ---------- -------- ------ (Dollars in thousands) Interest-earning assets: Loans receivable (1)(2) $ 172,714 $ 14,379 8.33% Investment securities Taxable 15,118 884 5.85 Tax-exempt (2) 11,212 844 7.53 Federal funds sold and other interest-bearing deposits 8,463 252 2.98 Federal Home Loan Bank stock 1,391 104 7.48 ---------- -------- Total interest-earning assets 208,898 16,463 7.88 Non-earning assets: Cash and due from banks 4,645 Premises and equipment, net 2,319 Other assets 3,570 Allowance for loan losses (2,731) ---------- Total assets $ 216,701 ========== Interest-bearing liabilities: Interest-bearing deposits Interest-bearing demand $ 26,825 $ 280 1.04% Savings 44,729 1,237 2.77 Time 69,625 3,831 5.50 Securities sold under agreements to repurchase 8,462 313 3.70 U.S. Treasury demand notes, Federal funds purchased, and other borrowings 597 23 3.85 Federal Home Loan Bank advances 23,715 1,461 6.16 ---------- -------- Total interest-bearing liabilities 173,953 7,145 4.11 Noninterest-bearing liabilities: Noninterest-bearing demand 20,148 Other liabilities 1,152 Shareholders' equity 21,448 ---------- Total liabilities and shareholders' equity $ 216,701 ========== Net interest income/interest rate spread $ 9,318 3.77% ======== ====== Net interest margin (3) 4.46% ======
(1) Average outstanding balances include non-accruing loans. Interest on loans receivable include fees. The inclusion of non-accruing loans and fees does not have material effect on either the average outstanding balance or the average yield. (2) Yields on tax-exempt loans and securities are computed on a fully taxable-equivalent basis using a federal income tax rate of 34%. (3) Net interest earnings divided by average interest-earnings assets. 10 [LOGO] The following table analyzes the effect of volume and rate changes on interest income and expense for the periods indicated.
Years ended December 31, 2003 2002 2001 -------COMPARED TO 2002------ -----Compared to 2001------ -------Compared to 2000------ NET AMOUNT AMOUNT Net Amount Amount Net Amount Amount INCREASE DUE TO DUE TO Increase Due to Due to Increase Due to Due to (DECREASE) VOLUME RATE (Decrease) Volume Rate (Decrease) Volume Rate ---------- ------- -------- ---------- ------ ------- ---------- ------ -------- (In thousands) Interest income: Loans receivable (1) (2) $ (111) $ 333 $ (444) $ (1,623) 505 $(2,128) $ (212) $ 693 $ (905) Investment securities: Taxable (76) 153 (229) (113) (20) (93) (57) (35) (22) Tax-exempt (2) (131) (113) (18) (127) (89) (38) (47) (46) (1) Federal funds sold and other interest- bearing deposits (14) 18 (32) (141) (5) (136) 115 162 (47) Federal Home Loan Bank stock (6) 9 (15) (13) 6 (19) (11) - (11) --------- ------ ------- --------- ----- ------- --------- ------ ------- Total interest income (338) 400 (738) (2,017) 397 2,414) (212) 774 (986) Interest expense: Interest-bearing deposits Interest-bearing demand (10) 5 (15) (128) 9 (137) (149) 7 (156) Savings (385) 67 (452) (198) 218 (416) 46 66 (20) Time (545) (103) (442) (1,634) (458) (1,176) (97) 71 (168) Securities sold under agreements to repurchase (8) 50 (58) (158) 15 (173) (87) 64 (151) U.S. Treasury demand notes, Federal funds purchased and other borrowings (3) (1) (2) (17) (3) (14) (32) (9) (23) Federal Home Loan Bank advances (96) 22 (118) 181 310 (129) 165 268 (103) --------- ------ ------- --------- ----- ------- --------- ------ ------- Total interest expense (1,047) 40 (1,087) (1,954) 91 (2,045) (154) 467 (621) --------- ------ ------- --------- ----- ------- --------- ------ ------- Net interest income $ 709 $ 360 $ 349 $ (63) $ 306 $ (369) $ (58) $ 307 $ (365) ========= ====== ======= ========= ===== ======= ========= ====== =======
(1) Loan fees are included in interest income and are used to calculate average rates earned. Non-accrual loans are included in the average loan balance. (2) Yields on tax-exempt loans and investment securities are computed on a fully taxable-equivalent basis using a federal income tax rate of 34%. (3) For purposes of these tables, changes in interest due to volume and rate were determined as follows: Volume Variance = Change in volume times old rate; Rate Variance = change in rate times old volume; Rate/ Volume Variance = Change in rate times change in volume allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each. NONINTEREST INCOME
Years ended December 31, 2003 2002 2001 ------ ------ ------ (In thousands) Service charge and fees $ 469 $ 494 $ 453 Net gains on mortgage loan sales 818 698 613 Dividends on bank owned life insurance 169 181 50 Receivable financing fees 166 158 227 Net gains on sale of securities - 28 211 Gain on sale of other real estate 259 - - Other 147 265 287 ------ ------ ------ Total noninterest income $2,028 $1,824 $1,841 ====== ====== ======
2003 COMPARED TO 2002 Noninterest income for the year ended December 31, 2003 was $2,028,000, a $204,000 or 11.1% increase compared to the year ended December 31, 2002. Service charge and fees decreased $25,000 as a result of checking and money market product restructuring. The restructuring process reduced the number of checking and money market products and eliminated several activity and minimum balance fees. Residential real estate mortgage rates continued to fall during the first eight months of 2003. The low interest rates provided incentive for residential real estate mortgage 11 [LOGO] customers to refinance their mortgage loans. The refinancing activity resulted in net gain on loan sales of $818,000, a $120,000 or 17.1% increase compared to 2002. Management anticipates that higher interest rates will significantly decrease the net gain on mortgage loan sales during 2004. Gain on sale of other real estate was $259,000. The gain was the result of a sale of real estate related to a business loan identified as nonperforming at December 31, 2002. Other income decreased by $119,000 or 44.9% as a result of the increased rate of amortizing mortgage servicing rights and the recording of a $132,000 valuation allowance to recognize a decline in the value of mortgage servicing rights. 2002 COMPARED TO 2001 Noninterest income for the year ended December 31, 2002 was $1,824,000 compared to $1,841,000 for the year ended December 31, 2001. At December 31, 2001 management noted an increase in residential real estate mortgage rates and a corresponding decrease in residential real estate mortgage applications. However, mortgage rates decreased during 2002 to 40 year lows. The Bank experienced significant mortgage refinancing activity again during 2002. The Bank originated and sold $32.7 million in residential mortgage loans during 2002 compared to the record $33.4 million in 2001. The Bank was able to average a slightly higher gain on the loans sold during 2002. During September of 2001, the Bank purchased $3 million in bank owned life insurance policies. The year ending December 31, 2002 reflects a full year of dividends earned on the investment. During 2001, Commercial recorded $211,000 in net gains on the sale of securities. The sale of equity securities held by the holding company accounted for $201,000 of the gain. The $201,000 gain was non-recurring. NONINTEREST EXPENSE
Years ended December 31, 2003 2002 2001 -------- -------- -------- (In thousands) Salaries $ 2,949 $ 2,689 $ 2,570 Employee benefits 750 665 660 Furniture and equipment 797 603 658 Professional fees 390 343 354 Occupancy 388 328 314 Printing and supplies 172 197 186 Director fees 199 182 156 Telephone 111 146 127 Postage 100 102 87 Advertising 95 84 71 Other insurance 66 60 55 Other taxes 25 54 47 FDIC insurance 28 31 31 Other expenses 692 549 569 -------- -------- -------- Total noninterest expense $ 6,762 $ 6,033 $ 5,885 ======== ======== ======== Efficiency ratio 56.38% 54.45% 52.74% ======== ======== ======== Noninterest expense as percentage of average assets 2.85% 2.66% 2.72% ======== ======== ======== Salaries and employee benefits as a percentage of average assets 1.56% 1.48% 1.49% ======== ======== ========
2003 COMPARED TO 2002 Noninterest expense for the year ending December 31, 2003 increased $729,000 or 12.1%. Commercial's efficiency ratio increased from 54.45% to 56.38%. During June of 2003, the Bank opened an office in Mt. Pleasant, Michigan. Costs of opening and operating this office and a full year of cost of our newest Greenville, Michigan location negatively impacted several expense categories including salaries, employee benefits, occupancy, furniture and equipment and director fees. Salary expense increased $260,000 or 9.7%. The increase reflects 12 month expense for the Greenville office staff, salary expense for new employees at the Mt. Pleasant office and normal salary increases. Full time equivalents increased from 79 at December 31, 2002 to 82 at December 31, 2003. Telephone expense decreased $35,000 or 24.0%. During 2003, the Bank was also able to renegotiate cost of lines extending from the Ithaca office to all other locations at favorable terms. 2002 COMPARED TO 2001 Noninterest expense for the year ending December 31, 2002 increased $148,000 or 2.5%. Commercial's efficiency ratio increased from 52.74% to 54.45%. [LOGO] 12 During October of 2002, the Bank opened a new office in Greenville, Michigan. Costs associated with opening this office negatively impacted several expense categories including salaries, employee benefits, occupancy, postage, printing and supplies, advertising, telephone and director fees. Management anticipates that the new office will reach break even early in 2003. Salary expense increased $119,000 or 4.6%. The increase primarily reflects normal salary adjustments and the addition of staff at the new Greenville office. The new Greenville employees were hired during the third and fourth quarters of 2002. Full time equivalents increased from 74 at December 31, 2001 to 79 at December 31, 2002. Director fees, for the year ending December 31, 2002, compared to December 31, 2001, increased $26,000 partially related to the addition of a Greenville affiliate board of directors. INCOME TAX EXPENSE Commercial's 2003 income tax expense was $833,000 compared to $1,130,000 in 2002 and $1,331,000 in 2001. The decrease from 2001 through 2003 was primarily the result of decreased income before income tax offset by a decrease in tax-exempt interest income. The decrease in income tax expense for 2003 was primarily due to lower pretax net income and a decrease in tax-exempt interest. The average balance in tax-exempt securities decreased $1,613,000 in 2003, $1,238,000 in 2002, and $614,000 in 2001. The statutory federal tax rate during 2003, 2002, and 2001, was 34%. Commercial's effective tax rate was lower than the statutory rate in all three years, primarily due to tax-exempt interest income. The effective tax rate was 27.14% in 2003, 28.03% in 2002, and 29.35% in 2001. INVESTMENT PORTFOLIO The following table shows securities by classification as of December 31, 2003, the amounts and weighted-average yields by maturity period:
MATURING Within After One But After Five But After One Within Five Within Ten Ten Year Years Years Years Total Amount Yield Amount Yield Amount Yield Amount Yield Amount Yield ----------- ----- ----------- ----- ----------- ----- ----------- ----- ----------- ----- AVAILABLE FOR SALE U.S. Treasuries and government agencies $ 5,097,188 5.10% $13,109,144 2.94% $ - $ - $18,206,332 3.54% State and municipal(1) 295,202 6.18% 1,911,573 6.43% 1,733,521 6.38% 882,479 5.65% 4,822,775 5.97% ----------- ----- ----------- ----- ----------- ----- ----------- ----- ----------- ----- Total $ 5,392,390 $15,020,717 $ 1,733,521 $ 882,479 $23,029,107 =========== ===== =========== ===== =========== ===== =========== ===== =========== ===== HELD TO MATURITY State and municipal (1) $ 1,005,318 7.00% $ 1,947,445 7.37% $ 95,000 9.16% $ - $ 3,047,763 7.30% ----------- ----- ----------- ----- ----------- ----- ----------- ----- ----------- ----- Total $ 1,005,318 $ 1,947,445 $ 95,000 $ - $ 3,047,763 =========== ===== =========== ===== =========== ===== =========== ===== =========== =====
(1) Yields on tax-exempt securities are computed on a fully taxable-equivalent basis The previous table which shows the contractual maturity of securities by classification does not account for the effect of call dates on the cash flow of the investment securities portfolio. During 2004, $8.5 million in available for sale U.S. Treasury and government agency securities maturing in years 2005 through 2008 will reach a call date. Interest rates in effect at December 31, 2003 lead management to believe that $7.1 million of the securities reaching a call date will likely be called by the issuer. [LOGO] 13 The amortized cost of investment securities, as of the dates indicated, are summarized as follows:
December 31, 2003 2002 2001 AVAILABLE HELD TO Available Held to Available Held to FOR SALE MATURITY for Sale Maturity for Sale Maturity --------- --------- --------- --------- --------- -------- (In thousands) U.S. Treasuries and government agencies $ 18,028 $ - $ 15,627 $ - $ 14,588 $ - State and municipal 4,580 3,048 4,544 4,689 4,224 7,497 Other - - 501 - 1,090 - -------- --------- -------- --------- -------- -------- Total $ 22,608 $ 3,048 $ 20,672 $ 4,689 $ 19,902 $ 7,497 ======== ========= ======== ========= ======== ========
Commercial's Asset/Liability Management Committee ("Committee") is responsible for developing investment guidelines and strategies. The Committee uses an investment advisor to help select appropriate investments for the portfolio. Decisions to purchase securities and the maturity date selected are coordinated with an overall plan to manage liquidity and interest rate exposure. For example, the U.S. Treasury and government agency securities identified as available for sale are laddered to mature over five years with the intent of achieving a three year average life. The investment time horizon and the average life are periodically adjusted to reflect the effects of loan demand, cost of funding and the interest rate environment. In the current low interest rate environment, management is electing to shorten the average maturity. The Committee has also elected to use callable government agency securities to provide protection in the event that interest rates rise. The book value of callable securities totaled $10.2 million at December 31, 2003 compared to $8.5 million at December 31, 2002. The Committee does not invest in derivative securities. Commercial holds no impaired securities at December 31, 2003. As of December 31, 2003, the aggregate book value of investment securities issued by the State of Michigan and all its political subdivisions totaled $5.0 million with an aggregate market value of $5.2 million. LOAN PORTFOLIO Lending efforts are concentrated primarily in the Michigan communities in which Commercial's branches are located. Commercial also finances projects in other communities generally as a result of supporting the business activities of our customers and their related interests. Commercial focuses its lending efforts in two categories: business lending and residential real estate lending. The Bank does not engage in indirect lending, credit cards, or sub-prime lending. Commercial has no foreign loans. 2003 COMPARED TO 2002 Total loans increased $9.9 million or 5.4% during 2003. The Bank's portfolio mix changed during 2003 as commercial, financial and agricultural loans decreased by $8.1 million while residential real estate loans increased $15.8 million. Several factors caused the $8.1 million decrease in commercial, financial and agricultural loans: the resolution of impaired and problem loans through charge-off or refinancing with other institutions, and weak business loan demand. The Bank charged-off $3.0 million in commercial, financial and agricultural loans during 2003. Several factors caused the $15.8 million increase in residential real estate loans: loan interest rates encouraging refinancing and purchase money transactions, and the Bank's need to invest excess liquidity. As interest rates continued to fall during the first eight months of 2003, residential real estate refinancing and purchase money transactions remained strong. Fifteen and 30 year fixed rate loans underwritten to Federal Home Loan Mortgage Corporation (Freddie Mac) standards were the most popular products with Commercial's customers. As loans are sold to Freddie Mac, the Bank's liquidity increases. With a lack of investment options, combined with weak loan demand, the funds received from Freddie Mac were generally invested in Federal Funds at .98% average yield during 2003. The yield on the residential real estate [LOGO] 14 loans originated during 2003 ranged from 4.25% to 7.5%. Management determined the break even point comparing holding mortgages and earning interest income vs. selling the mortgages, recording a gain on sale and investing proceeds in Federal Funds was as short as four months. Management elected to hold in portfolio a portion of 15 and 30 year fixed rate loans originated during 2003. Also, not all residential real estate loan customers qualify or request 15 and 30 year fixed rate loans. In these instances the Bank offers alternative products including adjustable rate mortgages, and first time home buyer programs. These loans are also kept in portfolio. 2002 COMPARED TO 2001 Total loans increased $16.4 million or 9.8% during 2002. The Bank's lenders are primarily focused on developing residential real estate markets and business loan customers. Both areas increased during 2002. Commercial, financial and agricultural loan category grew $11.5 million or 12.5%. Real estate-mortgages increased $5.8 million or 10.3%. The following table presents the amount of loans outstanding by loan type:
December 31, 2003 2002 2001 2000 1999 ----------- ----------- ----------- ------------ ------------ (In thousands) Commercial, financial and agricultural $ 95,947 $ 104,092 $ 92,566 $ 91,860 $ 80,116 Real estate - construction 14,698 11,952 12,556 19,318 16,145 Real estate - mortgage 77,454 61,652 55,893 57,945 47,085 Consumer and other 6,291 6,752 6,998 7,710 9,121 ----------- ----------- ----------- ----------- ----------- Total loans $ 194,390 $ 184,448 $ 168,013 $ 176,833 $ 152,467 =========== =========== =========== =========== ===========
The following table shows the maturity of loans (excluding real estate-mortgage and consumer and other loans) outstanding at December 31, 2003. Also provided are the amounts due after one year, classified according to their sensitivity to changes in interest rates.
Due Due Due After One After Five Due Within But Within But Within After One Year Five Years Ten Years Ten Years Total -------- ---------- ---------- --------- --------- Commercial, financial and agricultural $ 24,834 $ 61,993 $ 8,249 $ 871 $ 95,947 Real estate - construction 4,177 7,982 832 1,707 14,698 -------- ---------- ---------- --------- --------- Total $ 29,011 $ 69,975 $ 9,081 $ 2,578 $ 110,645 ======== ========== ========== ========= ========= Loans due after one year: Fixed rate $ 32,117 Floating or adjustable rate 49,517 -------- Total $ 81,634 ========
ASSET QUALITY Through Officer and Director Loan Committees, management reviews and monitors the quality of the various loan portfolios. Loan performance is also reviewed annually by independent, external loan review personnel. The scope of the independent loan review is established by the Audit Committee. Independent loan review results are communicated in writing to the Audit Committee and the Board of Directors. Loans are placed on non-accrual status when principal or interest is past due 90 days or more, the loan is not well-secured, and is in the process of collection or when reasonable doubt exists concerning collectibility of interest or principal. Any interest previously accrued in the current period, but not collected, is reversed and charged against current earnings. [LOGO] 15 As of December 31, 2003 there were no concentrations of loans exceeding 10% of total loans. 2003 COMPARED TO 2002 Non-performing loans decreased from $6.0 million to $825,000, a $5.2 million decrease. The $825,000 of non-performing loans is considered impaired. The $6.0 million in nonperforming loans at December 31, 2002 represented six business loan relationships. During 2003, management was able to resolve all but two of the relationships. The $825,000 in non-performing loans represents three business loan relationships, two of which management believes, will be resolved during the first quarter of 2004. The $5.2 million decrease in non-performing loans was resolved as follows: Balance at beginning of year $ 6.0 Charged-off (2.8) Cash received (1.8) Returned to accrual status (1.2) Additions .6 ---------- Balance at end of year $ .8 ==========
2002 COMPARED TO 2001 Non-performing loans increased from $463,000 to $6.0 million, a $5.6 million increase. The $6.0 million represents six business loan relationships. In addition to the $6.0 million in non-performing loans, management identified an additional $2.6 million as impaired, which are still accruing. These customers are current and paying all loans as agreed as of December 31, 2002. The following table summarizes non-accrual, past due and restructured loans:
December 31, 2003 2002 2001 2000 1999 ------- -------- -------- ------- -------- (In thousands) Non-accrual loans $ 825 $ 5,676 $ 388 $ 354 $ 963 Accruing loans past due 90 days or more - - 75 - 14 Restructured loans - 349 - - - ------- -------- -------- ------- -------- Total non-performing loans 825 6,025 463 354 977 Repossessed assets, and other real estate 598 121 1,000 42 - ------- -------- -------- ------- -------- Total non-performing assets $ 1,423 $ 6,146 $ 1,463 $ 396 $ 977 ======= ======== ======== ======= ======== Total non-performing loans as a percentage of total loans .42% 3.27% .28% .20% .65% ======= ======== ======== ======= ======== Total non-performing assets as a percentage of total assets .59% 2.58% .67% .18% .51% ======= ======== ======== ======= ========
PROVISION AND ALLOWANCE FOR LOAN LOSSES The allowance for loan losses has been allocated according to the amount deemed to be reasonably necessary to provide for the probability of losses being incurred as follows:
December 31, 2003 2002 2001 PERCENT Percent Percent OF LOANS of Loans of Loans TO TOTAL to Total to Total ALLOWANCE LOANS Allowance Loans Allowance Loans --------- -------- --------- ------- --------- -------- (In thousands) Commercial, financial and agricultural $ 1,563 49.36% $ 2,398 56.43% $ 993 55.09% Real estate - construction 298 7.56 26 6.48 15 7.47 Real estate - mortgage - 39.84 122 33.43 114 33.27 Consumer and other 64 3.24 92 3.66 342 4.17 Unallocated 45 145 - 1,122 - --------- ------ --------- ------ --------- ------ Total $ 1,970 100.00% $ 2,783 100.00% $ 2,586 100.00% ========= ====== ========= ====== ========= ======
December 31, 2000 1999 Percent Percent of Loans of Loans to Total to Total Allowance Loans Allowance Loans --------- --------- --------- --------- (In thousands) Commercial, financial and agricultural $ 1,265 51.95% $ 1,352 52.55% Real estate - construction 17 10.92 - 10.59 Real estate - mortgage 120 32.77 100 30.88 Consumer and other 427 4.36 351 5.98 Unallocated 716 - 989 - ---------- ------ --------- ------ Total $ 2,545 100.00% $ 2,792 100.00% ========== ====== ========= ======
[LOGO] 16 The following table summarizes changes in the allowance for loan losses.
Years ended December 31, 2003 2002 2001 2000 1999 ---------- ---------- ---------- ----------- ---------- (In thousands) Amount of loans outstanding at end of year $ 194,390 $ 184,448 $ 168,013 $ 176,833 $ 152,467 ========== ========== ========== =========== ========== Daily average of loans outstanding for the year $ 184,693 $ 179,831 $ 172,714 $ 164,389 $ 143,026 ========== ========== ========== =========== ========== Balance of allowance at beginning of year $ 2,783 $ 2,586 $ 2,545 $ 2,792 $ 2,344 Loans charged off: Commercial, financial and agricultural (2,996) (511) (389) (662) - Real estate - mortgage - - - - - Consumer and other (124) (27) (27) (28) (29) ---------- ---------- ---------- ----------- ---------- Total loans charged off (3,120) (538) (416) (690) (29) ---------- ---------- ---------- ----------- ---------- Recoveries of loans previously charged off: Commercial, financial, and agricultural 385 26 48 10 76 Real estate - mortgage - - 1 44 15 Consumer and other 21 28 33 29 26 ---------- ---------- ---------- ----------- ---------- Total recoveries 406 54 82 83 117 ---------- ---------- ---------- ----------- ---------- Net (charge-offs)/recoveries (2,714) (484) (334) (607) 88 Provision for loan losses (1) 1,901 681 375 360 360 ---------- ---------- ---------- ----------- ---------- Allowance at end of period $ 1,970 $ 2,783 $ 2,586 $ 2,545 $ 2,792 ========== ========== ========== =========== ========== Ratio of net (charge-offs)/recoveries during period to average loans outstanding during the period (1.47)% (.27)% (.19)% (.37)% .06% ========== ========== ========== =========== ========== Ratio of allowance for loan losses to loans outstanding at end of period 1.01% 1.51% 1.54% 1.44% 1.83% ========== ========== ========== =========== ==========
(1)The provision for loan losses charged to expense is based on loan loss experience, loan growth and other factors which, in management's judgment, deserve current recognition in maintaining an adequate allowance for loan losses. These other factors include, but are not limited to, a review of current economic conditions as they relate to loan collectibility and reviews of specific loans to evaluate their collectibility. The provision for loan losses is the amount added to the allowance for loan losses to absorb losses that are currently believed to have been incurred. During 2002, Commercial modified its methodology to more accurately reflect the performance of its portfolio over time. The effect of this change has been to reduce the unallocated portion of the allowance for loan loss compared to prior years. Management classifies loans into one of four classifications for the purpose of calculating the appropriate allowance for loan loss: non-classified, watch loans, substandard not impaired and substandard impaired. Within these four classifications management has identified four loan categories: personal, credit lines, residential real estate and business. Non-classified loans are loans that are viewed as homogeneous categories. These loans are generally current and performing as agreed. Commercial establishes a reserve on these categories of non-classified loans using historical loss experience. The loss experience is updated quarterly. Watch loans are loans that management has identified as having some change that requires additional loan officer monitoring. These loans are generally paying as agreed, however, the ability to meet debt obligations, while adequate, has deteriorated. These loans are generally not considered impaired. The reserve on these categories of loans is determined using historical loss experience. The loss experience is updated quarterly. Substandard loans are commercial loans that management reviews for impairment under FAS 114 and 118. Management reviews these loans individually for impairment using either the present value of expected cash flow or the value of collateral. Loans in this category can be impaired, non-performing, both or neither. [LOGO] 17 A specific reserve is calculated for each substandard loan determined to be impaired. Generally, loans identified as impaired are generally considered non-performing and are placed on non-accrual. A reserve based on historical loss experience is established for substandard loans not identified as impaired. This method of determining the allowance, while believed to be in compliance with generally accepted accounting principals, has limitations and is inherently subjective. For example the methodology relies on management's ability to properly identify and classify loans into appropriate categories. The Audit Committee attempts to support the assertions made by management by using the results of independent loan review services. This methodology also relies on the historical performance of the loan portfolio to establish reserves for non-classified loans. Historical losses may have the effect of overstating the required reserve in an improving economy and may understate reserves in a weakening economy. Also, management identifies loss exposure on loans considered impaired. Impaired loans are generally associated with entities dealing with a variety of problems. These problems sometimes affect the quality of financial information supplied to the Bank and may limit management's ability to assess the quality of collateral. While management uses its best estimate of loss exposure, these estimates may change as more information becomes available. 2003 COMPARED TO 2002 The allowance for loan losses at December 31, 2003 was 1.01% of loans outstanding, compared to 1.51% at December 31, 2002. Historically, Commercial's loan portfolio can be described as performing well, except for periodic problems with a few business loan customers. The majority of the credit risk at Commercial has always been in the commercial, agricultural and financial portfolio as evident by historical charge-offs. The allowance calculation allocates $1.6 million of the $2.0 million to the commercial, agricultural and financial portfolio. During 2003, the Bank experienced problems with two large loan relationships previously identified as impaired. These relationships resulted in net charge-offs of $2.7 million. The charge-offs were larger than the previously estimated loss exposure identified by management, therefore, $1.9 million was provided to the allowance during 2003. Excluding these two relationships the business portfolio recognized net recoveries of $.1 million. The dollar amount of loans identified as non-performing has decreased from $6.0 million at December 31, 2002 to $825,000 at December 31, 2003. Management believes that approximately $235,000 of the non-performing loans will be resolved during the first quarter of 2004. The mortgage loan portfolio continues to perform well. For the fifth consecutive year the Bank did not record any gross charge-off related to a residential mortgage loan. The consumer loan portfolio, while recording net charge-offs of $103,000, also continues to perform well. 2002 COMPARED TO 2001 Commercial recorded net charge-offs of $484,000 for the year. Of the $538,000 in gross charge-offs, $511,000 relates to one business loan relationship. Excluding this charge-off, Commercial recorded net recoveries of $27,000. The residential real estate loan portfolio has experienced net recoveries during the last five calendar years of $70,000. Management exited the indirect automobile market approximately 5 years ago and focused consumer lending efforts at our existing customer base. As a result, the consumer loan portfolio has experienced net recoveries in three of the last five calendar years. Despite a slowing economy, the consumer and residential real estate portfolios continue to perform at levels consistent with prior years. The business loan portfolio, however, is not performing as well compared to historical trends. In accordance with SFAS No. 114 and 118, management identifies specific loans that are experiencing financial difficulty, evaluates each loan for impairment and attempts to identify a specific allocation of the allowance for each loan. The dollar amount of loans identified as impaired increased from $3.6 million at December 31, 2001 to $8.7 million at December 31, 2002. Of the $8.7 million, management has placed $5.7 million on non-accrual. Though this trend is negative and does warrant an increase in the allowance for loan loss, there are mitigating circumstances which management believes limits the need to increase the allowance above current levels: Commercial Bank is receiving regular payments on all but one of the loans placed on non-accrual, and management believes the loss [LOGO] 18 exposure related to $3.6 million of non-accrual loans is zero based on an assessment of collateral and the current operating condition of the businesses. The loans identified as non-performing and impaired are generally well secured by real estate. Of the $8.7 million identified as impaired $5.9 million have specific allocations. The total allocated to the impaired loans is $2.1 million with approximately $1.5 million allocated to one loan relationship. Though no assurance can be provided that the financial condition of these customers will continue to improve, there are indications that the financial condition of the non-accrual loan customers is generally stable with positive short-term outlooks. For these reasons, management increased the provision for loan losses from $375,000 during 2001 to $681,000 during 2002. LIQUIDITY Liquidity is generally defined as the ability to meet cash flow needs of customers for loans and deposit withdrawals. To meet cash flow requirements, sufficient sources of liquid funds must be available. These sources include short-term investments, repayments of loans, maturing and called securities, sales of assets, growth in deposits and other liabilities and profits. It also includes access to unused Federal Funds lines of credit, borrowing capacity at the Federal Home Loan Bank and other pre-approved credit facilities. Generally, the Bank attempts to limit excess liquidity held in the form of Federal Funds sold. At December 31, 2003, Commercial had $.6 million in Federal Funds sold compared to $6.9 million at December 31, 2002. The Bank has $13.2 million of additional borrowing capacity, based on the collateral formula, at the Federal Home Loan Bank and $9.0 million of borrowing capacity with correspondent banks. The Federal Reserve also approved the Bank for a $1.5 million line of credit with the Federal Reserve Discount Window. During 2003, Commercial generated $6.3 million in cash from operating activities. All of these sources are available to meet cash flow needs of loan and deposit customers. Commercial also needs cash to pay dividends to its shareholders. The primary source of cash is the dividends paid to the parent by the Bank. Management believes that cash from operations is sufficient to supply the cash needed to continue paying a reasonable dividend. CAPITAL RESOURCES At December 31, 2003, capital totaled $24,283,000. Management monitors the capital levels of the Corporation and the Bank to provide for current and future business opportunities and to meet regulatory guidelines for "well capitalized" institutions. "Well capitalized" institutions are eligible for reduced FDIC premiums, and also enjoy other reduced regulatory restrictions. At December 31, 2003, the Corporation and the Bank exceeded all regulatory minimum capital requirements and are considered to be "well capitalized". ASSET LIABILITY MANAGEMENT QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Commercial's primary market risk exposure is interest rate risk and, to a lesser extent, liquidity risk. Commercial's transactions are denominated in U.S. dollars with no specific foreign exchange exposure. Also, Commercial has a limited exposure to commodity prices related to agricultural loans. Any impacts that changes in foreign exchange rate and commodity prices would have on interest rates are assumed to be insignificant. Interest rate risk (IRR) is the exposure of a banking organization's financial condition to movements in interest rates. Accepting this risk can be an important source of profitability and stockholder value; however, excessive levels of IRR could pose a threat to earnings and capital. Accordingly, effective risk management that maintains IRR at prudent levels is essential to Commercial's safety and soundness. Evaluating the quantitative level of IRR exposure requires the assessment of existing and potential future [LOGO] 19 effects of changes in interest rates on its consolidated financial condition, including capital adequacy, earnings, liquidity, and, where appropriate, asset quality. Commercial's Asset/Liability Committee ("Committee") is responsible for managing this process. Commercial derives the majority of income from the excess of interest collected over interest paid. The rates of interest earned on its assets and owed on its liabilities generally are established contractually for a period of time. Since market interest rates change over time, Commercial is exposed to lower profit margins (or losses) if it cannot adapt to interest rate changes. Commercial is also subject to repayment risk when interest rates fall. For example, mortgage loans and other financial assets may be prepaid by a debtor so that the debtor may refinance their obligations at lower rates. Prepayment of assets carrying higher rates reduces interest income and overall asset yields. Fluctuating interest rates and prepayment risk provide a challenge in managing the net interest income of the Bank. For example: the Bank may fund a 15 year fixed rate residential real estate loan with a long term amortizing Federal Home Loan Bank Advance. In a stable interest rate environment, the Bank can reasonably predict the net interest income earned. However, if rates fall significantly, the residential mortgage customer may refinance their mortgage at a lower rate. The Bank continues to pay the higher rate on the Federal Home Loan Bank advance, thus eroding net interest income. In an alternative scenario, the Bank funds the same 15 year fixed rate residential real estate loan with 1 year certificates of deposits. If rates rise at the end of one year, the Bank will pay more interest to continue to fund the residential mortgage loan. Net interest income will be lower in year two than it was in the first year of the mortgage loan. An additional challenge management faces in managing net interest income is the fact that what would maximize net interest income for the Bank may be in conflict with the customer's request for products and services. In the current low interest rate environment, management believes that there is greater risk that interest rates will rise over time rather than fall. Management would prefer to offer variable rate loan products that would reprice upward as interest rates rise. However, our loan customers are generally requesting long term fixed rate loans. On the funding side, management would like to extend the maturities of its liabilities to match the loan customers request for longer term fixed rate loans. However, our deposit customers are reluctant to commit to long term certificate of deposits. Commercial's primary tool in measuring interest rate risk is to perform a simulation analysis. This analysis forecasts the effect of various interest rate changes on the balance sheet, economic value of equity, net interest income and net income. One common scenario performed by the Committee is to "shock" the balance sheet by assuming that Commercial has just experienced an immediate and parallel shift in the yield curve up or down 200 basis points. The model, using data and assumptions determined by management, reprice assets and liabilities at new market rates. The objective of this analysis is to determine how the Bank's net interest income and the economic value of equity are affected by extreme changes in interest rates. These results are recorded and compared to previous results. Management performs this calculation quarterly. A limitation with this methodology is that the interest rate curve rarely experiences a 200 basis points immediate and parallel increase or decrease in interest rates. Management is in the process of implementing software that would allow for comparison of alternative interest rate scenarios, and provide management with better information to assess alternative funding and investing strategies. The following table illustrates how Commercial's net interest income might be affected by a 200 basis point immediate and parallel shift in the yield curve. The Committee applies the percentage change anticipated in net interest income to the net interest income actually earned to determine if the change is within acceptable limits. In the current low interest rate environment Commercial's net interest income might decrease $1,084,000 if interest rates increase 200 basis points in an immediate parallel shift in the yield curve. This compares to a $539,000 decrease for the year ending December 31, 2002. If interest rates were to experience a 200 basis point immediate and parallel decrease in the yield curve, Commercial might experience a slight increase in net interest income. At current interest rates, management does not have the ability to lower interest rates on the majority of deposit products 200 basis points. However, asset yields can decrease by 200 basis points. The following table illustrates how Commercial's net interest income might be affected by a 200 basis point immediate and parallel decrease in the yield curve. Commercial's net [LOGO] 20 interest income might increase $10,000 if interest rates decreased 200 basis points in an immediate parallel shift in the yield curve. This compares to a $140,000 decrease for the year ending December 31, 2002. Management has used this and other information to make the following decisions. Management elected to hold some longer term residential mortgage loans. This decision reduced excess liquidity and, in the short run, improved net interest income. To offset some of the interest rate risk, management used longer term Federal Home Loan Bank advances to reduce the negative impact to net interest income if interest rates increase. Management believes that an increase in interest rates is more likely than a decrease.
Net Interest Percentage Projected Income at Change in Net Net Interest Interest rate change December 31, 2003 Interest Income Income - -------------------- ------------------ --------------- ------------ - -200 BASIS POINTS $ 9,704,000 .10% $ 9,714,000 0 BASIS POINTS 9,704,000 0.00 9,704,000 +200 BASIS POINTS 9,704,000 (11.17) 8,620,000
Net Interest Percentage Projected Income at Change in Net Net Interest Interest rate change December 31, 2002 Interest Income Income - -------------------- ------------------ --------------- ------------ - -200 basis points $ 8,922,000 (1.56)% $ 8,782,000 0 basis points 8,922,000 0.00 8,922,000 +200 basis points 8,922,000 (6.04) 8,383,000
The following table illustrates how Commercial's economic value of equity might be impacted if interest rates increase or decrease 200 basis points. The economic value of equity reflects the impact the change in interest rates has over the long term (greater than 12 months). If rates increase 200 basis points immediately, the economic value of equity would decrease $6.8 million or 25.20%. This compares to an estimated decrease of $2.8 million or 9.34% decrease for the year ending December 31, 2002. If rates decrease 200 basis points immediately, the economic value of equity would increase $5.8 million or 21.64%. This compares to an estimated increase of $3.1 million or 10.32% increase for the year ending December 31, 2002. December 31, 2003
Percentage Projected Book Value Economic Change in Economic Economic Interest rate change of Equity Value of Equity Value of Equity Value of Equity - -------------------- -------------- --------------- ------------------ --------------- - -200 BASIS POINTS $ 24,283,000 $ 26,933,000 21.64% $ 32,761,000 0 BASIS POINTS 24,283,000 26,933,000 0.00 26,933,000 +200 BASIS POINTS 24,283,000 26,933,000 (25.20) 20,146,000
December 31, 2002
Percentage Projected Book Value Economic Change in Economic Economic Interest rate change of Equity Value of Equity Value of Equity Value of Equity - -------------------- -------------- --------------- ------------------ --------------- - -200 basis points $ 23,704,000 $ 29,748,000 10.32% $ 32,818,000 0 basis points 23,704,000 29,748,000 0.00 29,748,000 +200 basis points 23,704,000 29,748,000 (9.34) 26,970,000
[LOGO] 21 FORWARD LOOKING STATEMENT This discussion and analysis of financial condition and results of operations and other sections of this Annual Report contain forward looking statements that are based on management's beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy and about Commercial itself. Words such as "anticipates", "believes", "estimates", "expects", "forecasts", "foresee", "intends", "is likely", "plans", "projects", variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions ("Future Factors") that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. Furthermore, Commercial undertakes no obligation to update, amend or clarify forward-looking statements, whether as a result of new information, future events or otherwise. Future Factors include: - - changes in interest rates and interest rate relationships; - - demand for products and services; - - the degree of competition by traditional and non-traditional competitors; - - changes in banking regulations; - - changes in tax laws; - - changes in prices, levies and assessments; - - the impact of technology, governmental and regulatory policy changes; - - the outcome of pending and future litigation and contingencies; and - - trends in customer behavior as well as their ability to repay loans. These are representative of the Future Factors that could cause a difference between an actual outcome and a forward-looking statement. [LOGO] 22 MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL STATEMENTS Management is responsible for the preparation of the Commercial National Financial Corporation's consolidated financial statements and related information appearing in this Annual Report. Management believes that the consolidated financial statements fairly reflect the form and substance of transactions and reasonably present Commercial National Financial Corporation's financial position and results of operations and were prepared in conformity with accounting principles generally accepted in the United States of America. Management also has included in Commercial's financial statements, amounts that are based on estimates and judgments which it believes are reasonable under the circumstances. Commercial National Financial Corporation maintains internal controls designed to provide reasonable assurance that all assets are safeguarded and financial records are reliable for preparing the consolidated financial statements. Commercial complies with laws and regulations relating to safety and soundness which are designated by the FDIC and other appropriate federal banking agencies. The selection and training of qualified personnel and the establishment and communication of accounting and administrative policies and procedures are elements of this control system. The effectiveness of internal controls is monitored by a program of internal audit. Management recognizes that the cost of internal controls should not exceed the benefits derived and that there are inherent limitations to be considered. Management believes that Commercial National Financial Corporation provides the appropriate balance between costs of controls and the related benefits. The independent auditors have audited Commercial's consolidated financial statements in accordance with auditing standards generally accepted in the United States of America and provide an objective, independent review of the fairness of the reported operating results and financial position. The Board of Directors of Commercial National Financial Corporation has an Audit Committee composed of five non-management Directors. The Committee meets periodically with the internal auditors and the independent auditors. Jeffrey S. Barker Patrick G. Duffy President and Executive Vice President and Chief Executive Officer Chief Financial Officer [LOGO] 23 COMMERCIAL NATIONAL FINANCIAL CORPORATION REPORT OF INDEPENDENT AUDITORS [CROWE LOGO] Board of Directors and Shareholders Commercial National Financial Corporation Ithaca, Michigan We have audited the accompanying consolidated balance sheets of Commercial National Financial Corporation as of December 31, 2003 and 2002, and the related consolidated statements of income, changes in shareholders' equity and cash flows for each of the three years in the period ended December 31, 2003. These financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from 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 Commercial National Financial Corporation as of December 31, 2003 and 2002, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America. Crowe Chizek and Company LLC Grand Rapids, Michigan January 30, 2004 [LOGO] 24 COMMERCIAL NATIONAL FINANCIAL CORPORATION CONSOLIDATED BALANCE SHEETS
December 31, 2003 2002 ------------------------------ ASSETS Cash and due from banks $ 6,113,498 $ 8,784,826 Federal funds sold 644,807 6,850,000 Other interest bearing deposits 1,961,444 3,634,988 ------------- ------------- Total cash and cash equivalents 8,719,749 19,269,814 Securities available for sale 23,029,107 21,345,896 Securities held to maturity (fair value $ 3,171,283 - 2003, $4,911,696 - 2002) 3,047,763 4,689,025 Federal Home Loan Bank stock, at cost 1,710,700 1,647,000 Gross loans receivable 194,389,682 184,448,296 Allowance for loan losses (1,970,309) (2,783,234) ------------- ------------- Net loans receivable 192,419,373 181,665,062 Bank owned life insurance 3,400,203 3,231,374 Premises and equipment, net 3,933,347 3,687,151 Accrued interest receivable and other assets 3,528,005 2,715,261 ------------- ------------- TOTAL ASSETS $ 239,788,247 $ 238,250,583 ============= ============= LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities Deposits Noninterest-bearing $ 23,203,653 $ 21,495,410 Interest-bearing demand 29,141,354 29,872,655 Savings 62,028,217 59,432,935 Time 55,191,313 55,258,479 ------------- ------------- Total deposits 169,564,537 166,059,479 Securities sold under agreements to repurchase 11,766,630 14,266,239 Other short-term borrowings 412,389 491,840 Federal Home Loan Bank advances 32,104,222 32,807,086 Accrued expenses and other liabilities 1,657,642 921,967 ------------- ------------- Total liabilities 215,505,420 214,546,611 Shareholders' equity Common stock and paid-in-capital, no par value- 5,000,000 shares authorized; shares issued and outstanding 2003 - 4,052,480 and 2002 - 3,801,421 24,117,375 23,255,499 Retained earnings/(accumulated deficit) (112,306) 3,908 Accumulated other comprehensive income, net of tax 277,758 444,565 ------------- ------------- Total shareholders' equity 24,282,827 23,703,972 ------------- ------------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 239,788,247 $ 238,250,583 ============= =============
See accompanying notes [LOGO] 25 COMMERCIAL NATIONAL FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF INCOME
Years ended December 31, 2003 2002 2001 --------------------------------------------- Interest and dividend income Loans, including fees $ 12,582,171 $ 12,664,572 $ 14,299,287 Taxable securities 696,893 772,644 884,291 Nontaxable securities 386,531 473,237 557,143 Federal funds sold 83,229 89,126 218,151 Federal Home Loan Bank stock dividends 85,328 90,562 103,424 Interest on other deposits 14,113 21,881 34,930 ------------- ------------- ------------- Total interest and dividend income 13,848,265 14,112,022 16,097,226 ------------- ------------- ------------- Interest expense Deposits 2,447,889 3,387,852 5,348,350 Securities sold under agreements to repurchase 148,493 155,698 313,409 Federal Home Loan Bank advances 1,545,107 1,641,283 1,460,433 Other 2,677 5,644 22,844 ------------- ------------- ------------- Total interest expense 4,144,166 5,190,477 7,145,036 ------------- ------------- ------------- NET INTEREST INCOME 9,704,099 8,921,545 8,952,190 Provision for loan losses 1,901,000 681,000 375,000 ------------- ------------- ------------- NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 7,803,099 8,240,545 8,577,190 ------------- ------------- ------------- Noninterest income Service charges and fees 469,337 493,776 453,356 Net gains on loan sales 818,023 697,717 612,998 Gain on sale of other real estate 258,619 - - Receivable financing fees 166,424 157,933 226,598 Bank owned life insurance dividends 168,829 181,078 50,296 Net security gains - 27,565 210,674 Other 146,691 265,432 287,366 ------------- ------------- ------------- Total noninterest income 2,027,923 1,823,501 1,841,288 ------------- ------------- ------------- Noninterest expense Salaries and employee benefits 3,698,560 3,353,616 3,230,200 Occupancy and equipment 1,219,326 930,711 972,010 FDIC insurance 27,909 30,708 30,588 Printing, postage and supplies 272,017 299,001 273,252 Professional and outside services 390,434 342,857 353,872 Director fees 199,395 181,700 155,650 Other 954,579 894,573 869,318 ------------- ------------- ------------- Total noninterest expense 6,762,220 6,033,166 5,884,890 ------------- ------------- ------------- INCOME BEFORE INCOME TAX EXPENSE 3,068,802 4,030,880 4,533,588 Income tax expense 833,000 1,130,000 1,331,000 ------------- ------------- ------------- NET INCOME $ 2,235,802 $ 2,900,880 $ 3,202,588 ============= ============= ============= Per share information Basic earnings $ .55 $ .73 $ .82 Diluted earnings $ .55 $ .72 $ .82 Dividends declared $ .54 $ .51 $ .49
See accompanying notes [LOGO] 26 COMMERCIAL NATIONAL FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY Years ended December 31, 2003, 2002, and 2001
Accumulated Shares Retained Other Issued Common Earnings/ Comprehensive Total and Stock and Paid (Accumulated Income/(Loss), Shareholders' Outstanding In Capital Deficit) Net of Tax Equity - ------------------------------------------------------------------------------------------------------------------------------ BALANCE AT JANUARY 1, 2001 3,327,225 $ 21,617,080 $( 1,714,089) $ 207,091 $ 20,110,082 Comprehensive income: Net income 3,202,588 3,202,588 Net change in unrealized gains (losses) on securities available for sale 466,028 466,028 Reclassification adjustment for (gains) losses recognized in income (210,674) (210,674) Tax effects (86,820) (86,820) -------------- ------------ Total comprehensive income 3,371,122 ------------ Cash dividends declared, $ .49 per share (1,904,756) (1,904,756) Payment of 5% stock dividend 166,244 (1,288) (1,288) Issued under dividend reinvestment program 72,254 667,093 667,093 Issued under stock option plans 3,877 36,520 36,520 Issued under employee benefit plan 3,236 30,024 30,024 Repurchase and retirement of shares (25,136) (244,519) (244,519) --------- ------------- ------------ ------------- ------------ Balance at December 31, 2001 3,547,700 22,104,910 (416,257) 375,625 22,064,278 Comprehensive income: Net income 2,900,880 2,900,880 Net change in unrealized gains (losses) on securities available for sale 132,019 132,019 Reclassification adjustment for (gains) losses recognized in income (27,565) (27,565) Tax effects (35,514) (35,514) -------------- ------------ Total comprehensive income 2,969,820 ------------ Cash dividends declared, $ .51 per share (2,040,876) (2,040,876) Payment of 5% stock dividend 181,256 439,839 (439,839) - Issued under dividend reinvestment program 74,687 793,897 793,897 Issued under stock option plans 10,411 89,775 89,775 Issued under employee benefit plan 4,756 54,410 54,410 Repurchase and retirement of shares (17,389) (227,332) (227,332) --------- ------------- ------------ ------------- ------------ Balance at December 31, 2002 3,801,421 23,255,499 3,908 444,565 23,703,972 COMPREHENSIVE INCOME: NET INCOME 2,235,802 2,235,802 NET CHANGE IN UNREALIZED GAINS (LOSSES) ON SECURITIES AVAILABLE FOR SALE (252,738) (252,738) TAX EFFECTS 85,931 85,931 ------------- ------------ TOTAL COMPREHENSIVE INCOME 2,068,995 ------------ CASH DIVIDENDS DECLARED, $ .54 PER SHARE (2,176,213) (2,176,213) PAYMENT OF 5% STOCK DIVIDEND 192,904 175,803 (175,803) - ISSUED UNDER DIVIDEND REINVESTMENT PROGRAM 71,388 844,725 844,725 ISSUED UNDER STOCK OPTION PLANS 48 318 318 ISSUED UNDER EMPLOYEE BENEFIT PLAN 4,900 59,134 59,134 REPURCHASE AND RETIREMENT OF SHARES (18,181) (218,104) (218,104) --------- ------------- ------------ ------------- ------------ BALANCE AT DECEMBER 31, 2003 4,052,480 $ 24,117,375 $ (112,306) $ 277,758 $ 24,282,827 ========= ============= ============ ============= ============
See accompanying notes [LOGO] 27 COMMERCIAL NATIONAL FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS Years ended December 31, 2003, 2002, and 2001
2003 2002 2001 ----------------------------------------------- CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 2,235,802 $ 2,900,880 $ 3,202,588 Adjustments to reconcile net income to net cash from operating activities Provision for loan losses 1,901,000 681,000 375,000 Depreciation, amortization and accretion 722,564 507,845 510,476 Net security (gain)/losses - (27,565) (210,674) Net gains on loan sales (818,023) (697,717) (612,998) Net gains on sale of other real estate and repossessed assets (258,619) - (14,546) Originations of loans held for sale (33,642,975) (32,728,901) (33,429,150) Proceeds from sales of loans held for sale 34,460,998 33,426,618 34,042,148 Stock dividends paid on Federal Home Loan Bank stock (63,700) - - Increase in bank owned life insurance 168,829 181,078 50,296 Accrued interest receivable and other assets (1,053,829) 622,772 (1,649,284) Accrued expenses and other liabilities 700,493 (402,199) (429,959) ------------- ------------- ------------- Net cash from operating activities 4,352,540 4,463,811 1,833,897 ------------- ------------- ------------- CASH FLOWS FROM INVESTING ACTIVITIES Purchases of securities available for sale (18,286,462) (7,213,146) (12,272,389) Proceeds from maturities of securities available for sale 16,112,199 6,360,000 9,170,000 Proceeds from maturities of securities held to maturity 1,635,000 2,823,900 1,010,000 Proceeds from sales of securities available for sale - - 2,523,549 Purchases of Federal Home Loan Bank stock - (255,700) - Net change in loans (14,262,128) (17,045,958) 8,523,713 Purchase of bank owned life insurance - (3,000,000) Purchases of premises and equipment, net (719,680) (1,495,500) (641,764) Proceeds from sales of other real estate and repossessed assets 1,850,290 - 167,270 ------------- ------------- ------------- Net cash from investing activities (13,670,781) (16,826,404) 5,480,379 ------------- ------------- ------------- CASH FLOWS FROM FINANCING ACTIVITIES Net change in deposits 3,505,058 3,480,868 4,784,710 Net change in securities sold under agreements to repurchase (2,499,609) 8,028,654 (1,786,182) Net change in U.S. Treasury demand notes (79,451) 355,291 (933,646) Repayment of line of credit - - (700,000) Proceeds from Federal Home Loan Bank advances 8,000,000 14,000,000 17,000,000 Repayment of Federal Home Loan Bank advances (8,702,864) (7,285,465) (17,407,449) Dividends paid and fractional shares (2,141,031) (2,005,016) (1,874,235) Proceeds from issuance of common stock 904,177 938,082 732,349 Repurchase and retirement of shares of common stock (218,104) (227,332) (244,519) ------------- ------------- ------------- Net cash from financing activities (1,231,824) 17,285,082 (428,972) ------------- ------------- ------------- Net change in cash and cash equivalents (10,550,065) 4,922,489 6,885,304 Cash and cash equivalents at beginning of year 19,269,814 14,347,325 7,462,021 ------------- ------------- ------------- CASH AND CASH EQUIVALENTS AT END OF YEAR $ 8,719,749 $ 19,269,814 $ 14,347,325 ============= ============= ============= Cash paid during the year for Interest $ 4,195,298 $ 5,281,266 $ 7,361,383 Federal income taxes 788,000 1,430,000 1,533,000 Supplemental Disclosure of non-cash activity Transfers from loans to repossessed assets $ 475,000 $ 10,000 $ 1,000,892 Transfers from loans to other real estate owned 1,602,313 120,969 170,690
See accompanying notes [LOGO] 28 COMMERCIAL NATIONAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2003 and 2002 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accounting and reporting policies of Commercial National Financial Corporation (the Corporation) and its wholly-owned subsidiary, Commercial Bank (the Bank) (together referred to as Commercial), conform to accounting principles generally accepted in the United States of America and to general practice within the banking industry. The following describes the significant accounting and reporting policies which are employed in the preparation of the consolidated financial statements. PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Corporation, the Bank, CNFC Mortgage Corporation and CNFC Financial Services Inc., both wholly-owned subsidiaries of the Bank. Intercompany accounts and transactions are eliminated in consolidation. NATURE OF OPERATIONS, BUSINESS SEGMENTS AND CONCENTRATIONS OF CREDIT RISK The Corporation is a one-bank holding company which conducts limited business activities. The Bank performs the majority of business activities. The Bank provides a full range of banking services to individuals, agricultural businesses, commercial businesses and light industries located in its service area. It maintains a diversified loan portfolio, including loans to individuals for home mortgages, automobiles and personal expenditures, and loans to business enterprises for current operations and expansion. The Bank offers a variety of deposit products, including checking, savings, money market, individual retirement accounts and certificates of deposit. While the Corporation's chief decision makers monitor the revenue stream of various products and services, operations are managed and financial performance is evaluated as one Corporation. Accordingly, all of Commercial's banking operations are considered by management to be aggregated into one operating segment. The principal markets for the Bank's financial services are the Michigan communities in which the Bank is located and the areas immediately surrounding these communities. The Bank serves these markets through nine offices located in Gratiot, Isabella and Montcalm Counties in Michigan. USE OF ESTIMATES To prepare financial statements in conformity with accounting principles generally accepted in the United States of America, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and future results could differ. The allowance for loan losses and fair values of securities and other financial instruments are particularly subject to change. CASH FLOW REPORTING Cash and cash equivalents include cash on hand, demand deposits with other financial institutions and federal funds sold. Cash flows are reported, net, for customer loan and deposit transactions, securities sold under agreements to repurchase with original maturities of 90 days or less and U.S. Treasury demand notes. SECURITIES Securities are classified as held to maturity and carried at amortized cost when management has the positive intent and ability to hold them to maturity. Securities are classified as available for sale when they might be sold before maturity. Securities available for sale are carried at fair value, with net unrealized holding gains and losses reported in other comprehensive income. Other securities such as Federal Home Loan Bank Stock are carried at cost. Gains and losses on sales are determined using the amortized cost of the specific security sold. Interest and dividend income, includes amortization of purchase premiums and discounts. Securities are written down to fair value when a decline in fair value is not temporary. LOANS HELD FOR SALE Loans held for sale are reported at the lower of cost or market value in the aggregate. Net unrealized losses are recorded in a valuation allowance by charges to income. LOANS Loans that management has the intent and the ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of unearned interest, deferred loan fees and costs, and an allowance for loan losses. Interest income is reported on the interest method and includes amortization of net deferred loan fees and costs over the loan term. [LOGO] 29 COMMERCIAL NATIONAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2003 and 2002 Interest income is not reported when full loan repayment is in doubt, typically when payments are past due over 90 days, unless the loan is both well secured and in the process of collection. Payments received on such loans are reported as principal reductions. In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful. All interest accrued but not received for loans placed on nonaccrual is reversed against interest income. Interest received on such loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. ALLOWANCE FOR LOAN LOSSES The allowance for loan losses is a valuation allowance for probable incurred credit losses, increased by the provision for loan losses and decreased by charge-offs less recoveries. Management estimates the allowance balance using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management's judgment, should be charged-off. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. A loan is impaired when full payment under the loan terms is not expected. Impairment is evaluated in total for smaller-balance loans of similar nature such as residential mortgage and consumer loans and on an individual loan basis for other loans. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan's existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Larger groups of smaller homogenous loans, such as consumer and residential real estate loans, are collectively evaluated for impairment, and accordingly, they are not separately identified for impairment disclosure. PREMISES AND EQUIPMENT Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed using a combination of straight-line and accelerated methods with useful lives ranging from 5 to 33 years for buildings and improvements, and 3 to 7 years for furniture and equipment. These assets are reviewed for impairment when events indicate their carrying amount may not be recoverable from future undiscounted cash flows. Maintenance, repairs and minor alterations are charged to current operations as expenditures occur. Major improvements are capitalized. SERVICING RIGHTS Servicing rights represent both purchased rights and the allocated value of servicing rights retained on loans sold. Servicing rights are expensed in proportion to, and over the period of, estimated net servicing revenues. Impairment is evaluated based on the fair value of the rights, using groupings of the underlying loans as to interest rates and prepayment characteristics. Any impairment of a grouping is reported as a valuation allowance. OTHER FORECLOSED ASSETS Assets acquired in collection of a loan receivable are recorded at the lower of cost or market at acquisition. Any reduction to fair value from the carrying value of the related loan is accounted for as a loan loss. After acquisition, a valuation allowance reduces the reported amount to the lower of the initial amount or fair value less costs to sell. Expenses, gains and losses on disposition, and changes in the valuation allowance are reported in other expense. Other foreclosed assets amounted to $598,000 and $121,000 at December 31, 2003 and 2002. BANK OWNED LIFE INSURANCE The Corporation purchased life insurance policies on certain officers. Corporate owned life insurance is recorded at its cash surrender value or the amount that can be realized. SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE All of these liabilities represent amounts advanced by various customers and are secured by securities owned, as they are not covered by general deposit insurance. EMPLOYEE BENEFITS A benefit plan with 401(k) features covers substantially all employees. The plan allows participant compensation deferrals. The amount of any matching contribution is based solely on the discretion of the board of directors. Historically, Commercial has matched up to 6% of such deferrals at 100%. [LOGO] 30 COMMERCIAL NATIONAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2003 and 2002 STOCK COMPENSATION Employee compensation expense under stock options is reported using the intrinsic value method. No stock-based compensation cost is reflected in net income, as all options granted had an exercise plan equal to or greater than the market price of the underlying common stock at date of grant. The following table illustrates the effect on net income and earnings per share if expense was measured using the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation Expense.
2003 2002 2001 ------------------------------------------ Net income as reported $ 2,235,802 $ 2,900,880 $ 3,202,586 Stock based compensation expense determined under fair value method 127,334 79,064 41,755 ------------ ----------- ----------- Proforma net income $ 2,108,468 $ 2,821,816 $ 3,160,831 ============ =========== =========== Basic earnings per share as reported $ .55 $ .73 $ .82 Proforma basic earnings per share $ .52 $ .71 $ .81 Diluted earnings per share as reported $ .55 $ .72 $ .82 Proforma diluted earnings per share $ .52 $ .70 $ .81
The proforma effects are computed using option pricing models, using the following weighted-average assumptions as of grant date.
2003 2002 2001 - ------------------------------------------------- Risk-free interest rate 4.05% 4.08% 5.10% Expected life in years 10.0 9.4 9.2 Expected dividends 4.30% 4.70% 5.14% Stock price volatility 22.82% 40.82% 48.74%
INCOME TAXES Income tax expense is the sum of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax consequences of temporary differences between the carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized. EARNINGS AND DIVIDENDS PER SHARE Basic earnings per common share is based on net income divided by the weighted average number of common shares outstanding during the period. Diluted earnings per common share shows the dilutive effect of any additional potential common shares. Earnings and dividends per common share are restated for all stock splits and stock dividends, including the 5% stock dividends paid in November 2003, 2002 and 2001. STOCK DIVIDENDS Dividends issued in stock are reported by transferring the market value of the stock issued from retained earnings to common stock and additional paid-in capital to the extent of available retained earnings. Any excess of fair value over available retained earnings is considered a return of capital and thus is transferred from paid in capital. Fractional shares are paid in cash for all stock dividends. COMPREHENSIVE INCOME Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes the net change in unrealized appreciation (depreciation) on securities available for sale, net of tax, which is also recognized as a separate component of shareholders' equity. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and standby letters of credit issued to meet customer needs. The face amount for these items represents the exposure to loss before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded. FAIR VALUES OF FINANCIAL INSTRUMENTS Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed separately. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates. The fair value estimates of existing on and off-balance sheet financial instruments does not include the value of anticipated future business or values of assets and liabilities not considered financial instruments. DIVIDEND RESTRICTION Banking regulations require maintaining certain capital levels and may limit the dividends paid by the bank to the holding company or by the [LOGO] 31 COMMERCIAL NATIONAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2003 and 2002 holding company or by the holding company to shareholders. These restrictions pose no practical limit on the ability of the bank or holding company to pay dividends at historical levels. LOSS CONTINGENCIES Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there now are such matters that will have a material effect on the financial statements. RESTRICTIONS ON CASH Cash on hand or on deposit with the Federal Reserve Bank of $1,259,000 and $1,447,000 was required to meet regulatory reserve and clearing requirements at year end 2003 and 2002. These balances do not earn interest. RECLASSIFICATIONS Some items in the prior year financial statements have been reclassified to conform with the current year presentation. ADOPTION OF NEW ACCOUNTING STANDARDS During 2003, the Company adopted FASB Statement 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities, FASB Statement 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equities, FASB Statement 132 (revised 2003), Employers' Disclosures about Pensions and Other Postretirement Benefits, FASB Interpretation 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, and FASB Interpretation 46, Consolidation of Variable Interest Entities. Adoption of the new standards did not materially affect the Corporation's operating results or financial condition. Statement 149 indicates that commitments to make mortgage loans should be accounted for as derivatives if the loans are to be held for sale, because the commitment represents a written option and accordingly is recorded at the fair value of the option liability. Statement 150 requires reporting mandatorily redeemable shares as liabilities, as well as obligations not in the form of shares to repurchase shares that may require cash payment and some obligations that may be settled by issuing a variable number of equity shares. Statement 132 (revised 2003) requires additional disclosures about the assets, obligations, cash flows of defined benefit pension and postretirement plans, as well as the expense recorded for such plans. Interpretation 45 requires recognizing the fair value of guarantees made and information about the maximum potential payments that might be required, as well as the collateral or other recourse obtainable. Interpretation 45 covers guarantees such as standby letters of credit, performance guarantees, and direct or indirect guarantees of the indebtedness of others, but not guarantees of funding. Interpretation 46, as revised in December 2003, changes the accounting model for consolidation from one based on consideration of control through voting interests to a different model. Whether to consolidate an entity will now also consider whether that entity has sufficient equity at risk to enable it to operate without additional financial support, whether the equity owners in that entity lack the obligation to absorb expected losses or the right to receive residual returns of the entity, or whether voting rights in the entity are not proportional to the equity interest and substantially all the entity's activities are conducted for an investor with few voting rights. NEWLY ISSUED BUT NOT YET EFFECTIVE ACCOUNTING STANDARDS There are no newly issued, but not yet effective accounting standards that are expected to have a material impact on the Company's operating results or financial condition. [LOGO] 32 COMMERCIAL NATIONAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2003 and 2002 Note 2 - Securities The fair value of available for sale securities and the related gross unrealized gains and losses recognized in accumulated other comprehensive income (loss) were as follows:
GROSS GROSS UNREALIZED UNREALIZED FAIR AVAILABLE FOR SALE GAINS LOSSES VALUE - ----------------------------------------------------------------------------------------------------- DECEMBER 31, 2003 - ----------------------------------------------------------------------------------------------------- U.S. TREASURIES AND GOVERNMENT AGENCIES $ 208,333 $ (29,844) $ 18,206,332 STATE AND MUNICIPALS 242,540 (184) 4,822,775 ------------- ------------ ------------- TOTAL $ 450,873 $ (30,028) $ 23,029,107 ============= ============ =============
December 31, 2002 - ----------------------------------------------------------------------------------------------------- U.S. Treasuries and government agencies $ 477,156 $ (434) $ 16,103,925 State and municipals 207,171 (11,780) 4,739,745 Corporate 1,470 - 502,226 ------------- ------------ ------------- Total $ 685,797 $ (12,214) $ 21,345,896 ============= ============ =============
The carrying amount, unrecognized gains and losses, and fair value of securities held to maturity were as follows:
GROSS GROSS CARRYING UNRECOGNIZED UNRECOGNIZED FAIR HELD TO MATURITY AMOUNT GAINS LOSSES VALUE - ----------------------------------------------------------------------------------------------------------------------- DECEMBER 31, 2003 - ----------------------------------------------------------------------------------------------------------------------- STATE AND MUNICIPALS $ 3,047,763 $ 123,520 $ - $ 3,171,283 ============= ============= ============= =============
December 31, 2002 ------------- ------------- ------------- ------------- State and municipals $ 4,689,025 $ 222,671 $ - $ 4,911,696 ============= ============= ============= =============
The fair value of debt securities and carrying amounts, if different, at year-end 2003, by contractual maturity are shown below.
Available for Sale Held to Maturity - ---------------------------------------------------------------------------------------------------------- Fair Carrying Fair Value Amount Value - ---------------------------------------------------------------------------------------------------------- Due in one year or less $ 5,392,390 $ 1,005,318 $ 1,018,866 Due from one to five years 15,020,717 1,947,445 2,056,747 Due from five to ten years 1,733,521 95,000 95,670 Due from ten years plus 882,479 - - ------------- ------------- ------------- Total $ 23,029,107 $ 3,047,763 $ 3,171,283 ============= ============= =============
Sales of available for sale securities were as follows:
2003 2002 2001 ---- ---- ---- Proceeds $ - $ - $ 2,523,549 Gross gains - - 210,674 Gross losses - - -
[LOGO] 33 COMMERCIAL NATIONAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2003 and 2002 There were no securities sold during 2002, however, called securities resulted in gains of $27,565. Securities with unrealized losses at year-end 2003 not recognized into income are as follows:
Less than 12 Months 12 Months or More Total Fair Unrealized Fair Unrealized Fair Unrealized Description of Securities Value Loss Value Loss Value Loss - ------------------------------------------------------------------------------------------------------------------------------------ U.S. Treasury and government agencies $ - $ - $ 2,916,866 $ 29,844 $ 2,916,866 $ 29,844 State and municipals - - 201,730 184 201,730 184 -------- --------- -------------- ------------ ----------- ----------- Total temporarily impaired $ - $ - $ 3,118,596 $ 30,028 $ 3,118,596 $ 30,028 ======== ========= ============== ============ =========== ===========
The unrealized losses have not been realized into income because the issuers of the bonds are of high credit quality and management has the ability to hold the securities for the foreseeable future. The decline in market value is primarily due to an increase in interest rates from the purchase date of the bonds. The fair value is expected to recover as the bonds approach their maturity date. Securities having a carrying amount of approximately $18,150,000 and $16,613,000 at year-end 2003 and 2002 were pledged to secure public deposits, securities sold under agreements to repurchase and U.S. Treasury demand notes. Except as indicated, total securities of any state (including all its political subdivisions) were less than 10% of shareholders' equity. At year-end 2003 and 2002, the amortized cost of securities issued by the state of Michigan and all its political subdivisions totaled $4,971,000 and $6,407,000 with an estimated market value of $5,186,000 and $6,668,000. NOTE 3 - LOANS RECEIVABLE Year-end loans receivable are as follows:
2003 2002 - ---------------------------------------------------------------- Real estate Secured by single family residential properties $ 77,454,148 $ 61,651,977 Secured by non-farm nonresidential properties 54,625,115 62,854,082 Secured by farmland 2,059,878 2,173,633 Secured by multi-family residential properties 9,197,821 10,545,095 Construction/land development 14,698,223 11,951,805 Installment loans 6,291,176 6,751,968 Commercial 30,063,321 28,519,736 ------------- ------------- Gross loans receivable 194,389,682 184,448,296 Allowance for loan losses (1,970,309) (2,783,234) ------------- ------------- Net loans receivable $ 192,419,373 $ 181,665,062 ============= =============
Loans held for sale, included in real estate secured by single family residential properties, were $347,000 and $1,673,000 at year-end 2003 and 2002. Certain directors and executive officers, including associates of such persons, were loan customers of Commercial during 2003 and 2002. A summary of aggregate related party loan activity for loans aggregating $60,000 or more to any related party is as follows:
2003 2002 - ----------------------------------------------------------- Balance at beginning of year $ 6,297,000 $ 4,413,000 New loans 9,477,000 12,537,000 Repayments (12,593,000) (11,141,000) Other changes, net 28,000 488,000 ----------- -------------- Balance at end of year $ 3,209,000 $ 6,297,000 =========== ==============
Other changes include adjustments for persons included in one reporting period that are not reported in the other reporting period. [LOGO] 34 COMMERCIAL NATIONAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2003 and 2002 NOTE 4 - ALLOWANCE FOR LOAN LOSSES Activity in the allowance for loan losses was as follows:
2003 2002 2001 - ------------------------------------------------------------------ Beginning balance $ 2,783,234 $ 2,586,025 $ 2,545,363 Loan charge-offs (3,120,283) (538,567) (415,904) Loan recoveries 406,358 54,776 81,566 ----------- ----------- ----------- Net loan recoveries (charge-offs) (2,713,925) (483,791) (334,338) Provision for loan losses 1,901,000 681,000 375,000 ----------- ----------- ----------- Ending balance $ 1,970,309 $ 2,783,234 $ 2,586,025 =========== =========== ===========
Impaired loans were as follows:
2003 2002 2001 - ------------------------------------------------------------------ Year-end loans with allowance for loan losses allocated $ 625,129 $ 5,907,493 $ 3,621,686 Year-end loans with no allowance for loan losses allocated 200,000 2,757,205 - ----------- ----------- ----------- Total impaired loans $ 825,129 $ 8,664,698 $ 3,621,686 =========== =========== ===========
Additional information regarding impaired loans is as follows:
2003 2002 2001 - ---------------------------------------------------------------------- Amount of the allowance allocated $ 189,379 $ 2,100,175 $ 31,730 Average balance of impaired loans during the year 4,716,561 7,249,949 4,692,348 Interest income recognized during impairment 115,951 82,223 271,996 Cash-basis interest income recognized 115,951 85,392 228,905
December 31, 2003 2002 - ---------------------------------------------------------------- Non-accrual loans $ 825,129 $5,676,390 Accruing loans past due 90 days or more - - Restructured loans - 348,520 ---------- ---------- Total non-performing loans $ 825,129 $6,024,910 ========== ========== Total non-performing loans as a percentage of total loans .42% 3.27% ========== ==========
Non-performing loans includes both smaller balance homogenous loans that are collectively evaluated for impairment and individually classified impaired loans. NOTE 5 - LOAN SERVICING Mortgage loans serviced for others are not reported as assets. These loans totaled $66,897,000 and $62,072,000 at year-end 2003 and 2002. Related escrow deposit balances were approximately $28,000 and $(25,000).
2003 2002 - ----------------------------------------------------- Loans held for sale $ 346,856 $ 1,673,000 Less: Allowance to adjust to lower of cost or market - - ----------- ----------- Loans held for sale, net $ 346,856 $ 1,673,000 =========== ===========
Activity for capitalized mortgage servicing rights and the related valuation allowance follows:
Servicing rights 2003 2002 2001 - ------------------------------------------------------------- Beginning balance $ 467,822 $ 321,369 $135,931 Additions 260,707 250,241 239,044 Amortized to expense (198,848) (103,788) (53,606) Direct write-downs - - - --------- --------- -------- Ending balance $ 529,681 $ 467,822 $321,369 ========= ========= ========
[LOGO] 35 COMMERCIAL NATIONAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2003 and 2002
Valuation allowance 2003 2002 2001 - -------------------------------------------------------------- Beginning balance $ - $ - $ - Additions expensed 131,591 - - Reductions credited to expense - - - Direct write downs - - - --------- --------- -------- Ending balance $ 131,591 $ - $ - ========= ========= ========
NOTE 6 - PREMISES AND EQUIPMENT, NET Year-end premises and equipment consist of:
2003 2002 - ------------------------------------------------------------ Land $ 815,059 $ 810,059 Buildings and improvements 3,907,109 3,637,688 Equipment 2,492,693 2,115,653 ----------- ----------- Total cost 7,214,861 6,563,400 Less accumulated depreciation (3,281,514) (2,876,249) ----------- ----------- Net premises and equipment $ 3,933,347 $ 3,687,151 =========== ===========
Depreciation expense was $473,484, $408,054 and $507,232 in 2003, 2002 and 2001. NOTE 7 - DEPOSITS At year-end 2003, stated maturities of time deposits were as follows, for the years ending December 31: 2004 $ 33,482,921 2005 12,837,568 2006 3,728,775 2007 2,610,003 2008 2,170,440 Thereafter 361,606 --------------- Total time deposits $ 55,191,313 ===============
Time deposits in denominations of $100,000 or more were $12,759,000 and $12,613,000 at year-end 2003 and 2002. At year-end 2003, stated maturities of time deposits in denominations of $100,000 or more were as follows: In 3 months or less $ 4,060,000 Over 3 through 6 months 2,686,000 Over 6 through 12 months 2,011,000 Over 12 months 4,002,000 -------------- Total time deposits > $100,000 $ 12,759,000 ==============
Related party deposits were $1,971,000 and $1,173,000 at year-end 2003 and 2002. [LOGO] 36 COMMERCIAL NATIONAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2003 and 2002 NOTE 8 - SECURITIES SOLD UNDER AGREEMENT TO REPURCHASE Information concerning securities sold under agreements to repurchase is summarized as follows:
2003 2002 - ------------------------------------------------------------- Amount outstanding at year-end $ 11,766,630 $ 14,266,239 Weighted average interest rate at year-end .89% 1.43% Average daily balance during the year $ 14,148,985 $ 9,382,805 Weighted average interest rate during the year 1.05% 1.65% Maximum month end balance during the year $ 17,231,601 $ 14,266,239
NOTE 9 - FEDERAL HOME LOAN BANK ADVANCES Federal Home Loan Bank (FHLB) advances totaled $32,104,000 and $32,807,000 at year-end 2003 and 2002. At year-end, the type of advances were as follows:
2003 2002 - ----------------------------------------------------- Amortizing $ 22,104,222 $ 25,307,086 Variable 6,000,000 - Bullet - 3,500,000 Callable 4,000,000 4,000,000 ------------- ------------- Total $ 32,104,222 $ 32,807,086 ============= =============
Pursuant to collateral agreements with the Federal Home Loan Bank, in addition to Federal Home Loan Bank stock, advances are secured, under a blanket lien arrangement, by qualified 1-to-4 family mortgage loans, qualified multi-family loans and SBA government guaranteed loans with a carrying value of approximately $65,648,000 and $53,720,000 at year-end 2003 and 2002. At year-end, scheduled principal reductions on these advances were as follows for the years ending December 31:
2003 2002 - ----------------------------------------------------- 2003 $ - $ 8,702,864 2004 11,208,697 5,138,642 2005 8,306,553 8,125,567 2006 2,174,163 1,923,599 2007 2,339,531 2,080,937 Thereafter 8,075,278 6,835,477 ----------- ----------- Total FHLB advances $32,104,222 $32,807,086 =========== ===========
Scheduled principal reductions and related weighted average rate grouped by advance type for the year ending December 31, 2003 are as follows:
2004 2005 2006 2007 Thereafter Total - --------------------------------------------------------------------------------------------------------------------------------- Amount Cost Amount Cost Amount Cost Amount Cost Amount Cost Amount Cost - --------------------------------------------------------------------------------------------------------------------------------- Amortizing $ 5,208,697 5.53% $6,306,553 5.71% $2,174,163 4.44% $2,339,531 4.38% $6,075,278 4.31% $22,104,222 5.02% Variable 6,000,000 1.26 - - - - 6,000,000 1.26 Callable - 2,000,000 6.01 - - 2,000,000 4.52 4,000,000 5.26 ----------- ---- ---------- ---- ---------- ---- ---------- ---- ---------- ---- ----------- ---- Total $11,208,697 3.25% $8,306,553 5.78% $2,174,163 4.44% $2,339,531 4.38% $8,075,278 4.36% $32,104,222 4.34% =========== ==== ========== ==== ========== ==== ========== ==== ========== ==== =========== ====
[LOGO] 37 COMMERCIAL NATIONAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2003 and 2002 NOTE 10 - EMPLOYEE BENEFITS EMPLOYEE BENEFIT PLAN Commercial's employee benefit plan allows participants to defer up to 15% of their compensation. Commercial's annual contribution to the plan is based solely on the discretion of the board of directors. Historically, Commercial has matched 100% of the elective deferrals on the first 6% of the participant's compensation. Employee and employer contributions are vested immediately. The plan covers substantially all employees. Employer expense associated with funding the 401(k) plan was approximately $138,000, $132,000, and $126,000, in 2003, 2002, and 2001. STOCK OPTION PLAN Stock option plans are used to reward employees and provide them with an additional equity interest. Options issued to employees prior to 2001 were issued for a 7 year period with vesting occurring over a 5 year period. During 2001 the lives of all outstanding employee options were extended from 7 years to 10 year periods. The vesting schedule remained unchanged. Options granted to directors prior to 2001 were issued for 2 year periods with vesting occurring after 6 months. During 2001 the lives of all outstanding director options were extended from 2 to 10 year periods. On April 24, 2001, shareholders approved the 2001 Stock Option Incentive Plan. The plan allows for the issuance of 289,406 shares. The 1991 Stock Option Plan expired by its terms on April 22, 2001. Information about option grants follows.
Number Weighted Average of Options Exercise Price - ------------------------------------------------------------- Outstanding, beginning of 2001 151,994 $ 9.14 Granted 59,318 8.64 Exercised (4,247) 8.60 ------- -------- Outstanding, end of 2001 207,065 9.01 Granted 50,448 13.61 Exercised (11,033) 7.57 Forfeited (3,043) 11.34 ------- -------- OUTSTANDING, END OF 2002 243,437 10.00 GRANTED 50,454 11.90 EXERCISED (51) 6.31 FORFEITED - - ------- -------- OUTSTANDING, END OF 2003 293,840 $ 10.32 ======= ========
The weighted-average fair value of options granted in 2003, 2002, and 2001, was $2.11, $3.96, and $2.96. At year-end 2003, options outstanding had a weighted-average remaining life of 6.7 years and a range of exercise price from $5.36 to $13.61. Options exerciseable at year-end are as follows:
Number Weighted Average of Options Exercise Price - ------------------------------------------- 2001 107,381 $ 8.47 2002 134,388 $ 9.19 2003 182,585 $ 9.65
Options outstanding at year-end were as follows.
Options Outstanding Options Excercisable - ------------------------------------------------------------------------------------ ------------------------------------- Range of Outstanding Weighted-Average Excercisable Exercise as of Remaining Weighted-Average as of Weighted-Average Prices December 31, 2003 Contractual Life Exercise Price December 31, 2003 Exercise Price - --------------------------------------------------------------------------------------------------------------------------------- $ 4.08-5.44 2,318 1.7 $ 5.36 2,318 $ 5.36 5.44-6.81 31,735 3.2 6.44 31,735 6.44 6.81-8.17 - 0.0 0.00 - 0.00 8.17-9.53 78,819 6.3 8.95 55,688 9.08 9.53-10.89 35,102 5.4 9.66 28,820 9.66 10.89-12.25 97,072 7.9 11.42 45,663 11.20 12.25-13.61 48,794 8.5 13.61 18,361 13.61 - -------------- ------- --- --------- ------- --------- $ 4.08-13.61 293,840 6.7 $ 10.33 182,585 $ 9.65
[LOGO] 38 COMMERCIAL NATIONAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2003 and 2002 NOTE 11 - FEDERAL INCOME TAXES Income tax expense consists of:
2003 2002 2001 - ---------------------------------------------------------- Current $ 325,000 $1,229,000 $1,340,000 Deferred 508,000 (99,000) (9,000) ----------- ---------- ---------- $ 833,000 $1,130,000 $1,331,000 =========== ========== ==========
Income tax expense calculated at the statutory federal income tax rate of 34% differs from actual income tax expense as follows:
2003 2002 2001 - -------------------------------------------------------------------- Statutory rates $ 1,043,000 $1,370,000 $ 1,541,420 Increase (decrease) from Tax-exempt interest income (159,000) (199,000) (208,000) Life insurance (65,000) (63,000) (17,000) Other, net 14,000 22,000 14,580 ----------- ---------- ----------- $ 833,000 $1,130,000 $ 1,331,000 =========== ========== ===========
Year-end deferred tax assets and liabilities consist of:
2003 2002 - ----------------------------------------------------------------- Allowance for loan losses $ 294,000 $ 571,000 Interest on non-accrual loans 16,000 133,000 Accumulated depreciation (231,000) (130,000) Mortgage servicing rights (135,000) (159,000) Net unrealized gain on securities available for sale (143,000) (229,000) Other (38,000) (1,000) ---------- ---------- (237,000) 185,000 Valuation allowance - - ---------- ---------- Net deferred tax asset $ (237,000) $ 185,000 ========== ==========
NOTE 12 - EARNINGS PER SHARE A reconciliation of the numerators and denominators of the basic earnings per share and diluted earnings per share computations is presented below for the years ended:
2003 2002 2001 - --------------------------------------------------------------------- BASIC EARNINGS PER SHARE: Net income available to common shareholders $2,235,802 $2,900,880 $3,202,588 ========== ========== ========== Weighted-average common shares outstanding for basic earnings per share 4,030,331 3,968,609 3,890,006 ========== ========== ========== BASIC EARNINGS PER SHARE $ .55 $ .73 $ .82 ========== ========== ========== DILUTED EARNINGS PER SHARE: Net income available to common shareholders $2,235,802 $2,900,880 $3,202,588 ========== ========== ========== Weighted-average common shares outstanding for basic earnings per share 4,030,331 3,968,609 3,890,006 Add: Dilutive effect of assumed Exercise of stock options 42,211 42,705 12,300 ---------- ---------- ---------- Weighted-average common and dilutive additional potential common shares outstanding 4,072,542 4,011,314 3,902,306 ========== ========== ========== Diluted earnings per share $ .55 $ .72 $ .82 ========== ========== ==========
Stock options for 99,248, 59,208, and 111,880, shares of common stock were not considered in computing diluted earnings per common share for 2003, 2002, and 2001 because they were anti-dilutive. [LOGO] 39 COMMERCIAL NATIONAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2003 and 2002 NOTE 13 - COMMITMENTS, OFF-BALANCE-SHEET RISK AND CONTINGENCIES There are various contingent liabilities that are not reflected in the consolidated financial statements, including claims and legal actions arising in the ordinary course of business. In the opinion of management, after consultation with legal counsel, the ultimate disposition of these matters is not expected to have a material effect on Commercial's financial condition or results of operations. LOAN COMMITMENTS Commercial is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet financing needs of its customers. These financial instruments include commitments to make loans, unused lines of credit and standby letters of credit. Contractual amounts of these instruments represent the exposure to credit loss in the event of non-performance by the other party to financial instruments for commitments to make loans, unused lines of credit and standby letters of credit. Commercial follows the same credit policy to make such commitments as it uses for on-balance-sheet items. Since many commitments to make loans expire without being used, the amount of commitments shown do not necessarily represent future cash commitments. No losses are anticipated as a result of these transactions. Collateral obtained upon exercise of commitments is determined using management's credit evaluation of the borrowers and may include real estate, business assets, deposits and other items. Commitments at year-end are as follows:
2003 2002 - ----------------------------------------------------------- Commitments to extend credit $ 22,870,000 $ 22,007,000 Standby letters of credit 248,000 175,000 ------------- ------------ Total commitments $ 23,118,000 $ 22,182,000 ============= ============
At December 31, 2003, fixed and variable interest rate commitments were $2,280,000 and $20,838,000. Fixed rate commitments interest rates and terms ranged from 0.00% to 16.20% and six months to fifteen years. Leases and Other Contractual Commitments Commercial occupies two locations under long-term operating leases. In addition, Commercial is party to long-term contracts for data processing and operating systems. The future minimum annual commitments under all operating leases and other contractual commitments as of December 31, 2003 are as follows:
Lease and Other Year Contractual Commitments - --------------------------------------------------------- 2004 $ 155,607 2005 119,820 2006 121,482 2007 123,144 2008 79,920 Thereafter 28,080 ------------- Total $ 628,053 =============
NOTE 14 - FAIR VALUES OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate fair values for financial instruments: - Carrying amount is considered to estimate fair value for cash and cash equivalents, Federal Home Loan Bank (FHLB) stock, demand and savings deposits, securities sold under agreements to repurchase, other short term borrowings, accrued interest receivable, accrued interest payable, and variable rate loans or deposits that reprice frequently and fully. - Securities fair values are based on quoted market prices or, if no quotes are available, on the rate, term of the security and information about the issuer. - Fixed rate loans and time deposits, and variable rate loans with infrequent repricing, are estimated using discounted cash flow analyses or underlying collateral values, where applicable. - Fair value of Federal Home Loan Bank advances is based on currently available rates for similar financing. - Fair value of other financial instruments and off-balance-sheet items approximate cost and are not considered significant to this presentation. [LOGO] 40 COMMERCIAL NATIONAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2003 and 2002 While these estimates of fair value are based on management's judgment of the most appropriate factors, there is no assurance that if Commercial had disposed of such items at December 31, 2003 and 2002, the estimated fair values would have been achieved. Market values may differ depending on various circumstances not taken into consideration in this methodology. The estimated fair values at December 31, 2003 and 2002 should not necessarily be considered to apply at subsequent dates. Financial instruments at year-end are as follows:
2003 2002 - ----------------------------------------------------------------------------------------------------------------- CARRYING FAIR Carrying Fair VALUE VALUE Value Value - ----------------------------------------------------------------------------------------------------------------- FINANCIAL ASSETS Cash and cash equivalents $ 8,720,000 $ 8,720,000 $ 19,270,000 $ 19,270,000 Securities 26,077,000 26,200,000 26,035,000 26,258,000 FHLB stock 1,711,000 1,711,000 1,647,000 1,647,000 Loans, net of allowance 192,419,000 196,585,000 181,665,000 189,851,000 Accrued interest receivable 1,000,000 1,000,000 1,065,000 1,065,000 ------------- ------------- ------------- ------------- Total financial assets $ 229,927,000 $ 234,216,000 $ 229,682,000 $ 238,091,000 ============= ============= ============= ============= FINANCIAL LIABILITIES Demand and savings deposits $(114,373,000) $(114,373,000) $(110,801,000) $(110,801,000) Time deposits (55,191,000) (56,119,000) (55,258,000) (56,369,000) Securities sold under agreements to repurchase (11,767,000) (11,767,000) (14,266,000) (14,266,000) Other short-term borrowings (412,000) (412,000) (492,000) (492,000) Federal Home Loan Bank advances (32,104,000) (33,140,000) (32,807,000) (34,050,000) Accrued interest payable (245,000) (245,000) (297,000) (297,000) ------------- ------------- ------------- ------------- Total financial liabilities $(214,092,000) $(216,056,000) $(213,921,000) $(216,275,000) ============= ============= ============= =============
NOTE 15 - CAPITAL REQUIREMENTS AND RESTRICTIONS ON RETAINED EARNINGS The Corporation and Bank are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and prompt corrective action regulations involve quantitative and qualitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weightings, and other factors. The regulators can lower classifications in certain cases. Failure to meet various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements. The prompt corrective action regulations provide five classifications, including well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. These terms are not used to represent overall financial condition. If only adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions, asset growth and expansion are limited. Plans for capital restoration are also required. The Corporation and Bank were categorized as well capitalized at year-end 2003 and 2002. Commercial's primary source of funds to pay dividends to shareholders is the dividends received from the Bank. The Bank is subject to certain State and Federal restrictions on the amount of dividends it may declare without prior regulatory approval. The Corporation's ability to pay dividends is dependant on the Bank, which is restricted by state law and [LOGO] 41 COMMERCIAL NATIONAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2003 and 2002 regulations. These regulations pose no practical restrictions to paying dividends at historical levels. In 2004, the Bank may distribute to the Corporation, in addition to 2004 net profits, approximately $2,171,000 in dividends without prior approval from regulatory agencies. Actual capital levels (in millions) and minimum required levels were:
Minimum Required Minimum Required To Be Well Capitalized For Capital Under Prompt Corrective Actual Adequacy Purposes Action Regulations Amount Ratio Amount Ratio Amount Ratio -------- ----- -------- ------- --------- -------- 2003 TOTAL CAPITAL (TO RISK WEIGHTED ASSETS) CONSOLIDATED $ 26.0 14.4% $ 14.4 8.0% $ 18.0 10.0% BANK 21.6 12.1 14.2 8.0 17.8 10.0 TIER 1 CAPITAL (TO RISK WEIGHTED ASSETS) CONSOLIDATED 24.0 13.3 7.2 4.0 10.8 6.0 BANK 19.7 11.1 7.1 4.0 10.7 6.0 TIER 1 CAPITAL (TO AVERAGE ASSETS) CONSOLIDATED 24.0 10.2 9.4 4.0 11.8 5.0 BANK 19.7 8.5 9.3 4.0 11.7 5.0 2002 Total capital (to risk weighted assets) Consolidated $ 25.5 14.2% $ 14.3 8.0% $ 17.9 10.0% Bank 20.4 11.6 14.1 8.0 17.7 10.0 Tier 1 capital (to risk weighted assets) Consolidated 23.2 13.0 7.2 4.0 10.8 6.0 Bank 18.2 10.3 7.1 4.0 10.6 6.0 Tier 1 capital (to average assets) Consolidated 23.2 10.0 9.3 4.0 11.7 5.0 Bank 18.2 7.9 9.2 4.0 11.5 5.0
[LOGO] 42 COMMERCIAL NATIONAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2003 and 2002 NOTE 16 - PARENT CORPORATION CONDENSED Following are condensed parent only financial statements. CONDENSED BALANCE SHEETS December 31,
2003 2002 ------------ ----------- ASSETS Cash $ 2,372,702 $ 2,893,804 Investment in subsidiary 19,967,806 18,713,218 Loans, net 2,482,316 2,598,599 Other assets 29,101 31,145 ------------ ----------- Total assets $ 24,851,925 $24,236,766 ============ =========== LIABILITIES AND SHAREHOLDERS' EQUITY Dividends payable $ 567,367 $ 532,185 Other liabilities 1,731 609 Shareholders' equity 24,282,827 23,703,972 ------------ ----------- Total liabilities and shareholders' equity $ 24,851,925 $24,236,766 ============ ===========
CONDENSED STATEMENTS OF INCOME Years ended December 31,
2003 2002 2001 ----------- ---------- ---------- Dividends from subsidiary $ 750,000 $1,800,000 $1,950,000 Interest and fees on loans 159,133 183,904 257,065 Interest on securities - - 6,080 Gain on sale of security - - 201,005 Other income - - 908 ----------- ---------- ---------- Total income 909,133 1,983,904 2,415,058 Interest expense - - 3,602 Other expense 64,726 58,246 79,678 ----------- ---------- ---------- Income before income taxes and equity in undistributed net income of subsidiary 844,407 1,925,658 2,331,778 Income tax expense 30,000 47,000 129,000 Equity in undistributed net income of subsidiary 1,421,395 1,022,222 999,810 ----------- ---------- ---------- NET INCOME $ 2,235,802 $2,900,880 $3,202,588 =========== ========== ==========
CONDENSED STATEMENTS OF CASH FLOWS Years ended December 31,
2003 2002 2001 ----------- ----------- ----------- CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 2,235,802 $ 2,900,880 $ 3,202,588 Adjustment: Equity in undistributed net income (1,421,395) (1,022,222) (999,810) Gain on sale of security - - (201,005) Net change in: Other assets 2,044 (3,789) 2,071 Other liabilities 1,122 (134,619) 91,485 ----------- ----------- ----------- Net cash from operating activities 817,573 1,740,250 2,095,329 CASH FLOWS FROM INVESTING ACTIVITIES Sales/maturities of securities available for sale - - 1,514,905 Net change in loans 116,283 498,533 (59,899) ----------- ----------- ----------- Net cash from investing activities 116,283 498,533 1,455,006 CASH FLOWS FROM FINANCING ACTIVITIES Borrowings - - (700,000) Dividends paid (2,141,031) (2,005,016) (1,874,235) Issuance of common stock and fractional shares paid 904,177 938,082 732,349 Repurchase of common stock (218,104) (227,332) (244,519) ----------- ----------- ----------- Net cash from financing activities (1,454,958) (1,294,266) (2,086,405) ----------- ----------- ----------- Net change in cash and cash equivalents (521,102) 944,517 1,463,930 Cash and cash equivalents at the beginning of year 2,893,804 1,949,287 485,357 ----------- ----------- ----------- CASH AND CASH EQUIVALENTS AT END OF YEAR $ 2,372,702 $ 2,893,804 $ 1,949,287 =========== =========== ===========
NOTE 17 - DIVIDEND REINVESTMENT PLAN Commercial established a Dividend Reinvestment Plan for its shareholders in 1992. The Plan permits enrolled shareholders to automatically use dividends paid on common stock to purchase additional shares of Commercial's common stock at 95% of fair market value on the investment date. As of December 31, 2003, 104,946 shares of authorized but unissued common stock were reserved for Plan requirements. [LOGO] 43 COMMERCIAL NATIONAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2003 and 2002 NOTE 18 - STOCK REPURCHASE PLAN Commercial announced a stock repurchase plan in 1998. The Plan permits the repurchase of up to 383,340 shares of the Corporation's outstanding shares of common stock. As of December 31, 2003, Commercial had repurchased and retired 296,512 shares in accordance with the program. NOTE 19 - QUARTERLY FINANCIAL DATA (UNAUDITED)
Interest Net Interest Net Earnings Per Share Income Income Income Basic Diluted ----------- ----------- ----------- ------- ------- 2003 FIRST QUARTER $ 3,448,824 $ 2,294,364 $ 766,096 $ .19 $ .19 SECOND QUARTER 3,462,612 2,390,932 2,418 .00 .00 THIRD QUARTER 3,582,911 2,608,255 818,436 .20 .20 FOURTH QUARTER 3,353,918 2,410,548 648,852 .16 .16 ----------- ----------- ----------- ------- ------- TOTAL $13,848,265 $ 9,704,099 $ 2,235,802 $ .55 $ .55 =========== =========== =========== ======= ======= 2002 First Quarter $ 3,511,932 $ 2,181,671 $ 663,744 $ .17 $ .17 Second Quarter 3,544,469 2,264,756 677,558 .17 .17 Third Quarter 3,557,094 2,243,602 742,625 .19 .18 Fourth Quarter 3,498,527 2,231,516 816,953 .20 .20 ----------- ----------- ----------- ------- ------- Total $14,112,022 $ 8,921,545 $ 2,900,880 $ .73 $ .72 =========== =========== =========== ======= =======
[LOGO] 44 PICTURES AND PROFILES OF CUSTOMERS [LOGO] 45 PICTURES OF BOARD OF DIRECTORS AND MT. PLEASANT STAFF [LOGO] 46 COMMERCIAL NATIONAL FINANCIAL CORPORATION DIRECTORS Howard D. Poindexter Chairperson of the Board, Manager of Poindexter Farms Richard F. Abbott Vice Chairperson of the Board, Retired EVP of the Corporation and Bank Jefferson P. Arnold Attorney, Arnold Law Office Jeffrey S. Barker President and CEO of the Corporation and Bank Don J. Dewey President and Funeral Director, Dewey Funeral Homes, Inc. Patrick G. Duffy Chief Financial Officer of the Corporation and Bank David A. Ferguson Member, Chodoka LLC Paul B. Luneack Vice President, Ken Luneack Construction, Inc and Bear Truss Company Kim C. Newson President, Alma Hardware Corporation Scott E. Sheldon Owner, Kernen-Sheldon and Shepherd Insurance Agencies OFFICERS Jeffrey S. Barker President and Chief Executive Officer Patrick G. Duffy Executive Vice President - Chief Financial Officer COMMERCIAL BANK OFFICERS Scott E. Sheldon Chairperson of the Board Kim C. Newson Vice Chairperson of the Board Jeffrey S. Barker President and Chief Executive Officer Patrick G. Duffy EVP - Chief Financial Officer Andrew P. Shafley SVP - Senior Loan Officer Daniel E. Raleigh VP - Marketing, Personnel and Branch Administration Kevin D. Collison VP - Commercial Lending - Ithaca Thomas D. Cooper VP - Commercial Lending - Ithaca Wayne C. Heminger VP - Commercial Lending - Mt. Pleasant Jeffrey B. Loomis VP - Commercial Lending - Greenville Karen M. Taylor VP - Mortgage Lending - Alma Corey S. Bailey AVP - Lending - Alma Janet M. Davison AVP - Manager - Information Systems Kathryn K. Greening AVP - Mortgage Processing - Alma Wendy M. Lombard AVP - Mortgage Lending - Ithaca Vicki L. Nelson AVP - Mortgage Lending - Greenville Cathy M. Patterson AVP - Controller Dawn K. Riley AVP - Loan Officer - Greenville Carol L. Vallance AVP - Customer Relations - Alma Heather A. Lamentola Security Officer - St. Louis Jayne I. Norris Loan Officer - Alma Rebecca A. Smith Administrative Assistant - Transfer Agent Linda M. Vaughn Business Loan Administrator COMMERCIAL BANK-GREENVILLE DIRECTORS Jeffrey S. Barker Chairman, Commercial Bank-Greenville; President and CEO, Commercial Bank Carl Barberi Assistant Superintendent, Greenville Public Schools Jeffrey B. Loomis President, Commercial Bank-Greenville Edwin L. Koehn President, Ed Koehn Ford Lincoln Mercury Inc. Gerald D. Pitcher Real estate developer and property manager Andrew P. Shafley Commercial Bank, Senior Vice President-Senior Loan Officer Bradley S. Stauffer Director of Corporate Finance, Northland Corporation L. Wade Thorton Owner, Winter Inn OFFICERS Jeffrey B. Loomis President Vicki L. Nelson AVP - Mortgage Lending Dawn K. Riley AVP - Lending [LOGO] 47 COMMON STOCK INFORMATION Commercial National Financial Corporation common stock is listed on the NASD Over the Counter Bulletin Board under the symbol CEFC. Several brokers provide a market for the stock. Commercial is aware of a minimum of 707 shareholders of record and 4,052,480 common shares outstanding at December 31, 2003. All prices have been adjusted for the 5% stock dividends issued in November 2003 and November 2002. During 2003 and 2002 the price ranges of transactions reported were:
Shares Actual Price Traded Range ------ -------------------- 2003 Low High ------ ------- ------- FIRST QUARTER 29,200 $ 10.95 $ 13.14 SECOND QUARTER 19,600 11.66 12.52 THIRD QUARTER 16,500 11.29 12.38 FOURTH QUARTER 26,800 10.50 12.38 ------ ------- ------- 2002 First Quarter 24,150 $9.09 $ 10.40 Second Quarter 6,930 10.17 14.25 Third Quarter 8,715 11.50 13.58 Fourth Quarter 45,885 10.74 12.66
DIVIDEND INFORMATION The holders of Commercial National Financial Corporation common stock are entitled to dividends when, and if, declared by the Board of Directors of Commercial out of funds legally available for that purpose. The Board of Directors does not declare dividends based on any predetermined dividend policy but has paid regular quarterly cash dividends for the past fourteen years. The following table sets forth the dividends per share declared during 2003 and 2002. The dividends per share have been adjusted for the 5% stock dividends issued in November 2003 and November 2002.
2003 2002 ------- ------- First Quarter $ .13 $ .12 Second Quarter .13 .13 Third Quarter .14 .13 Fourth Quarter .14 .13 ------- ------- Total dividends declared per share $ .54 $ .51 ======= =======
[LOGO] 48 COMMERCIAL BANK LOCATIONS ALMA 301 NORTH STATE ST. Ph. (989) 463-2185 Fax (989) 463-5996 119 WEST CENTER* Ph. (989) 463-3120 1500 WRIGHT AVE.* Ph. (989) 463-3901 ITHACA 101 N. PINE RIVER* Ph. (989) 875-4144 Fax (989) 875-4534 MIDDLETON 101 NORTH NEWTON ST.* Ph. (989) 236-7236 Fax (989) 236-7732 MT. PLEASANT 1234 E. BROOMFIELD RD. STE. #8 Ph. (989) 775-0355 Fax (989) 779-1946 POMPEII 105 E. FULTON ST. Ph. (989) 838-2525 ST. LOUIS 104 N. MILL ST.* Ph. (989) 681-5738 Fax (989) 681-3509
COMMERCIAL BANK-GREENVILLE LOCATIONS GREENVILLE 10530 W. CARSON CITY RD.* Ph. (616) 754-7166 Fax (616) 754-2118 101 NORTH LAFAYETTE ST.* Ph. (616) 225-3680 Fax (616) 754-3174
*Denotes Bank locations with ATMs on site. DIVIDEND REINVESTMENT PLAN As a service to its shareholders, Commercial National Financial Corporation sponsors a Dividend Reinvestment Plan. The Plan allows a shareholder to purchase this stock without brokerage commissions using dividends. For information about this plan, contact the Corporation's Transfer Agent. TRANSFER AGENT Commercial National Financial Corporation Care of Ms. Rebecca A. Smith 101 North Pine River, P.O. Box 280 Ithaca, Michigan 48847 CORPORATE HEADQUARTERS 101 North Pine River Ithaca, Michigan 48847 www.commercial-bank.com Phone (989) 875-4144 Fax (989) 875-4534 10-K AVAILABILITY Commercial National's annual report on Form 10-K is available upon written request without charge from: Commercial National Financial Corporation, Care of Mr. Patrick G. Duffy, Executive Vice President - Chief Financial Officer, 101 North Pine River, P.O. Box 280 Ithaca, Michigan 48847 Phone (989) 875-4144 MARKET MAKERS WILLIAM KAHL R. NICHOLAS BACH MICHAEL T. SEEKELL PETER VANDERSCHAAF CHRISTOPHER TURNER MICHAEL HEBNER Wachovia Securities Howe Barnes Investment Robert W. Baird Stifel, Nicolaus McDonald & Co. Raymond James Inc. & Co. & Co. 1-800-292-1960 1-800-800-4693 1-800-888-6200 1-800-676-0477 1-800-526-7705 1-800-521-9767
[LOGO] 49 COMMERCIAL NATIONAL FINANCIAL CORPORATION 101 N. Pine River P.O. Box 280 Ithaca, Michigan 48847 www.commercial-bank.com (989) 875-4144 [LOGO] 50 EX-23 4 k82475exv23.txt CONSENT-INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS COMMERCIAL NATIONAL FINANCIAL CORPORATION EXHIBIT 23 CONSENT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS CONSENT OF INDEPENDENT AUDITORS We hereby consent to the incorporation by reference of our report dated January 30, 2004, which appears in Commercial National Financial Corporation's annual report on Form 10-K for the year ended December 31, 2003, in that corporation's previously filed registration statements as amended, for that corporation's Dividend Reinvestment Plan (Registration No. 33-30239), 2001 Stock Option Plan (Registration No. 33-60894), and 1991 Stock Option Plan (Registration No. 33-39772 and 33-92666). /s/ Crowe Chizek and Company LLC Crowe Chizek and Company LLC Grand Rapids, Michigan March 24, 2004 14 EX-31.(A) 5 k82475exv31wxay.txt CERTIFICATION OF CHIEF EXECUTIVE OFFICER COMMERCIAL NATIONAL FINANCIAL CORPORATION EXHIBIT 31 (a) I, Jeffrey S. Barker, Chief Executive Officer of the Commercial National Financial Corporation (the "registrant", certify that: 1. I have reviewed this annual report on Form 10-K of the registrant. 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in the annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officer and I, are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e) for the registrant and have: (a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under my supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; (b) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; (c) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the event of the annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): (a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial data; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. /s/ Jeffrey S. Barker - ------------------------------- Jeffrey S. Barker President and Chief Executive Officer, Principal Executive Officer March 26, 2004 15 EX-31.(B) 6 k82475exv31wxby.txt CERTIFICATION OF CHIEF FINANCIAL OFFICER COMMERCIAL NATIONAL FINANCIAL CORPORATION EXHIBIT 31(b) I, Patrick G. Duffy, Chief Financial Officer of the Commercial National Financial Corporation (the "registrant", certify that: 1. I have reviewed this annual report on Form 10-K of the registrant. 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in the annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officer and I, are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e) for the registrant and have: (a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under my supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; (b) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; (c) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the event of the annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): (a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial data; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. /s/Patrick G. Duffy - --------------------------------- Patrick G. Duffy Chief Financial Officer March 26, 2004 16 EX-32.(A) 7 k82475exv32wxay.txt CERTIFICATION OF CHIEF EXECUTIVE OFFICER COMMERCIAL NATIONAL FINANCIAL CORPORATION EXHIBIT 32(a) CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of Commercial National Financial Corporation (the "Company") on Form 10-K for the period ending December 31, 2003 as filed with the Securities and Exchange Commission on the date hereof (the "Report), I, Jeffrey S. Barker, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Annual Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Annual Report fairly presents, in all material respects, the financial condition and result of operations of the Company. /s/ Jeffrey S. Barker - ------------------------------ Jeffrey S. Barker Chief Executive Officer March 26, 2004 This certification accompanies each Report pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by the Sarbanes-Oxley Act of 2002, be deemed filed by the Corporation for purposes of Section 18 of the Securities Exchange Act of 1934, as amended. A signed original of this written statement required by Section 906 has been provided to Commercial National Financial Corporation and will be retained by Commercial National Financial Corporation and furnished to the Securities and Exchange Commission or its staff upon request. 17 EX-32.(B) 8 k82475exv32wxby.txt CERTIFICATION OF CHIEF FINANCIAL OFFICER COMMERCIAL NATIONAL FINANCIAL CORPORATION EXHIBIT 32(b) CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of Commercial National Financial Corporation (the"Company") on Form 10-K for the period ending December 31, 2003 as filed with the Securities and Exchange Commission on the date hereof (the "Report), I, Patrick G. Duffy, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Annual Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Annual Report fairly presents, in all material respects, the financial condition and result of operations of the Company. /s/Patrick G. Duffy - --------------------------- Patrick G. Duffy Chief Financial Officer March 26, 2004 This certification accompanies each Report pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by the Sarbanes-Oxley Act of 2002, be deemed filed by the Corporation for purposes of Section 18 of the Securities Exchange Act of 1934, as amended. A signed original of this written statement required by Section 906 has been provided to Commercial National Financial Corporation and will be retained by Commercial National Financial Corporation and furnished to the Securities and Exchange Commission or its staff upon request. 18 -----END PRIVACY-ENHANCED MESSAGE-----