EX-13 3 dex13.txt ANNUAL REPORT Exhibit 13 MIDDLEFIELD BANC CORP. CONSOLIDATED BALANCE SHEET
December 31, --------------------------- 2002 2001 ------------ ------------ ASSETS Cash and due from banks $ 1,775,324 $ 3,443,435 Federal funds sold 350,000 2,450,000 ------------ ------------ Cash and cash equivalents 2,125,324 5,893,435 Interest-bearing deposits in other institutions 571,969 1,240,207 Investment securities available for sale 35,917,057 21,179,786 Investment securities held to maturity (estimated market value of $6,405,918 and $10,471,978) 6,242,095 10,229,068 Loans 174,943,131 152,828,355 Less allowance for loan losses 2,300,485 2,062,252 ------------ ------------ Net loans 172,642,646 150,766,103 Premises and equipment 6,480,730 6,244,797 Accrued interest and other assets 2,265,712 2,304,568 ------------ ------------ TOTAL ASSETS $226,245,533 $197,857,964 ============ ============ LIABILITIES Deposits: Noninterest-bearing demand $ 26,610,912 $ 24,952,407 Interest-bearing demand 7,216,385 6,523,152 Money market 10,660,657 7,940,807 Savings 49,277,572 41,518,906 Time 93,618,968 86,447,456 ------------ ------------ Total deposits 187,384,494 167,382,728 Short-term borrowings 785,778 660,678 Other borrowings 15,690,053 9,301,334 Accrued interest and other liabilities 638,800 726,417 ------------ ------------ TOTAL LIABILITIES 204,499,125 178,071,157 ------------ ------------ STOCKHOLDERS' EQUITY Common stock, no par value; 5,000,000 shares authorized, 1,209,123 and 1,148,676 shares issued 7,883,155 6,287,011 Retained earnings 15,051,110 14,842,519 Accumulated other comprehensive income 475,428 133,717 Treasury stock, at cost (52,578 and 45,722 shares) (1,663,285) (1,476,440) ------------ ------------ TOTAL STOCKHOLDERS' EQUITY 21,746,408 19,786,807 ------------ ------------ TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $226,245,533 $197,857,964 ============ ============
See accompanying notes to consolidated financial statements. 1 MIDDLEFIELD BANC CORP. CONSOLIDATED STATEMENT OF INCOME
Year Ended December 31, --------------------------------------- 2002 2001 2000 ----------- ----------- ----------- INTEREST INCOME Interest and fees on loans $12,340,920 $11,807,799 $10,853,292 Interest-bearing deposits in other institutions 48,293 61,718 97,037 Federal funds sold 64,994 138,415 99,320 Investment securities: Taxable 1,241,399 1,235,922 1,195,504 Tax-exempt 424,357 462,715 525,017 ----------- ----------- ----------- Total interest income 14,119,963 13,706,569 12,770,170 ----------- ----------- ----------- INTEREST EXPENSE Deposits 5,478,030 6,198,365 5,311,657 Short-term borrowings 7,175 15,411 64,031 Other borrowings 662,881 534,146 534,196 ----------- ----------- ----------- Total interest expense 6,148,086 6,747,922 5,909,884 ----------- ----------- ----------- NET INTEREST INCOME 7,971,877 6,958,647 6,860,286 Provision for loan losses 300,000 170,000 275,000 ----------- ----------- ----------- NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 7,671,877 6,788,647 6,585,286 ----------- ----------- ----------- NONINTEREST INCOME Service charges on deposit accounts 955,121 930,431 823,888 Investment securities gains -- 97,807 -- Other income 188,096 165,955 158,775 ----------- ----------- ----------- Total noninterest income 1,143,217 1,194,193 982,663 ----------- ----------- ----------- NONINTEREST EXPENSE Salaries and employee benefits 2,523,433 2,316,342 2,240,522 Occupancy expense 357,500 291,706 320,539 Equipment expense 324,659 292,168 283,174 Data processing costs 427,164 361,839 315,011 Professional fees 246,285 247,222 212,298 Ohio state franchise tax 250,050 225,081 208,457 Other expense 1,077,248 1,007,016 828,616 ----------- ----------- ----------- Total noninterest expense 5,206,339 4,741,374 4,408,617 ----------- ----------- ----------- Income before income taxes 3,608,755 3,241,466 3,159,332 Income taxes 1,107,806 970,859 922,661 ----------- ----------- ----------- NET INCOME $ 2,500,949 $ 2,270,607 $ 2,236,671 =========== =========== =========== EARNINGS PER SHARE Basic $ 2.16 $ 1.96 $ 1.92 Diluted 2.16 1.95 1.92
See accompanying notes to consolidated financial statements 2 MIDDLEFIELD BANC CORP. CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
Accumulated Common Stock Other ----------------------- Retained Comprehensive Shares Amount Earnings Income (Loss) --------- ----------- ------------ ------------- Balance, December 31, 1999 1,148,676 $ 6,287,011 $ 11,702,564 $(90,631) Net income 2,236,671 Other comprehensive income: Unrealized gain on available for sale securities net of taxes of $92,440 179,442 Comprehensive income Cash dividends ($.54 per share) (595,255) Purchase of treasury stock Sale of treasury stock --------- ----------- ------------ -------- Balance, December 31, 2000 1,148,676 6,287,011 13,343,980 88,811 Net income 2,270,607 Other comprehensive income: Unrealized gain on available for sale securities net of taxes of $23,133 44,906 Comprehensive income Cash dividends ($.70 per share) (772,068) --------- ----------- ------------ -------- Balance, December 31, 2001 1,148,676 6,287,011 14,842,519 133,717 Net income 2,500,949 Other comprehensive income: Unrealized gain on available for sale securities net of taxes of $176,033 341,711 Comprehensive income Exercise of stock options 988 23,509 Sale of treasury stock 795 Purchase of treasury stock Five percent stock dividend (including cash paid for fractional shares) 54,997 1,429,662 (1,434,607) Dividend reinvestment plan 4,462 142,178 Cash dividends ($.75 per share) (857,751) --------- ----------- ------------ -------- Balance, December 31, 2002 1,209,123 $ 7,883,155 $ 15,051,110 $475,428 ========= =========== ============ ======== Total Treasury Stockholders' Comprehensive Stock Equity Income ----------- ------------- ------------- Balance, December 31, 1999 $ (209,889) $17,689,055 Net income 2,236,671 $2,236,671 Other comprehensive income: Unrealized gain on available for sale securities net of taxes of $92,440 179,442 179,442 ---------- Comprehensive income $2,416,113 ========== Cash dividends ($.54 per share) (595,255) Purchase of treasury stock (1,311,050) (1,311,050) Sale of treasury stock 44,499 44,499 ----------- ----------- Balance, December 31, 2000 (1,476,440) 18,243,362 Net income 2,270,607 $2,270,607 Other comprehensive income: Unrealized gain on available for sale securities net of taxes of $23,133 44,906 44,906 ---------- Comprehensive income $2,315,513 ========== Cash dividends ($.70 per share) (772,068) ----------- ----------- Balance, December 31, 2001 (1,476,440) 19,786,807 Net income 2,500,949 $2,500,949 Other comprehensive income: Unrealized gain on available for sale securities net of taxes of $176,033 341,711 341,711 ---------- Comprehensive income $2,842,660 ========== Exercise of stock options 23,509 Sale of treasury stock 17,225 18,020 Purchase of treasury stock (204,070) (204,070) Five percent stock dividend (including cash paid for fractional shares) (4,945) Dividend reinvestment plan 142,178 Cash dividends ($.75 per share) (857,751) ----------- ----------- Balance, December 31, 2002 $(1,663,285) $21,746,408 =========== ===========
2002 2001 2000 -------- ------- -------- Components of comprehensive income: Change in net unrealized gain (loss) on investments available for sale $341,711 109,459 $179,442 Realized gains included in net income, net of taxes of $33,254 -- (64,553) -- -------- ------- -------- Total $341,711 44,906 179,442 ======== ======= ======== See accompanying notes to consolidated financial statements. 3 MIDDLEFIELD BANC CORP. CONSOLIDATED STATEMENT OF CASH FLOWS
Year Ended December 31, ------------------------------------------ 2002 2001 2000 ------------ ------------ ------------ OPERATING ACTIVITIES Net income $ 2,500,949 $ 2,270,607 $ 2,236,671 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 300,000 170,000 275,000 Depreciation and amortization 354,550 300,531 352,613 Amortization of premium and discount on investment securities 159,047 69,237 75,563 Amortization of net deferred loan costs (fees) (76,684) (31,666) 35,489 Investment securities gains -- (97,807) -- Deferred income taxes (72,302) 54,403 (87,521) Decrease (increase) in accrued interest receivable 34,337 140,147 (59,663) Increase (decrease) in accrued interest payable (121,258) 38,927 84,301 Other, net 124,129 (211,763) 39,943 ------------ ------------ ------------ Net cash provided by operating activities 3,202,768 2,702,616 2,952,396 ------------ ------------ ------------ INVESTING ACTIVITIES Decrease (increase) in interest-bearing deposits in other institutions, net 668,238 (255,766) 2,361,081 Investment securities available for sale: Proceeds from repayments and maturities 10,006,949 5,144,986 766,880 Purchases (24,359,041) (16,392,621) (2,561,359) Proceeds from sales -- 2,092,980 -- Investment securities held to maturity: Proceeds from repayments and maturities 3,960,491 7,853,057 3,997,990 Purchases -- (200,000) -- Increase in loans, net (22,099,859) (17,637,544) (14,105,641) Purchase of regulatory stock (189,700) (143,100) (136,100) Purchase of premises and equipment (590,483) (1,112,856) (150,361) ------------ ------------ ------------ Net cash used for investing activities (32,603,405) (20,650,864) (9,827,510) ------------ ------------ ------------ FINANCING ACTIVITIES Net increase in deposits 20,001,766 20,216,682 12,071,587 Increase (decrease) in short-term borrowings, net 125,100 117,456 (1,964,448) Proceeds from other borrowings 7,000,000 -- 2,000,000 Repayment of other borrowings (611,281) (560,262) (1,740,900) Purchase of treasury stock (204,070) -- (1,311,050) Sale of treasury stock 18,020 -- 44,499 Exercise of stock options 23,509 -- -- Proceeds from dividend reinvestment plan 142,178 -- -- Cash dividends (862,696) (772,068) (595,255) ------------ ------------ ------------ Net cash provided by financing activities 25,632,526 19,001,808 8,504,433 ------------ ------------ ------------ Increase (decrease) in cash and cash equivalents (3,768,111) 1,053,560 1,629,319 CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 5,893,435 4,839,875 3,210,556 ------------ ------------ ------------ CASH AND CASH EQUIVALENTS AT END OF YEAR $ 2,125,324 $ 5,893,435 $ 4,839,875 ============ ============ ============ SUPPLEMENTAL INFORMATION Cash paid during the year for: Interest on deposits and borrowings $ 6,269,344 $ 6,708,995 $ 5,825,583 Income taxes 1,054,000 980,000 1,097,000
See accompanying notes to consolidated financial statements. 4 MIDDLEFIELD BANC CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES A summary of the significant accounting and reporting policies applied in the presentation of the accompanying financial statements follows: Nature of Operations and Basis of Presentation Middlefield Banc Corp. (the "Company") is an Ohio corporation organized to become the holding company of The Middlefield Banking Company (the "Bank"). The Bank is a state-chartered bank located in Ohio. The Company and its subsidiary derive substantially all of their income from banking and bank-related services which include interest earnings on residential real estate, commercial mortgage, commercial, and consumer financings as well as interest earnings on investment securities and deposit services to its customers through five locations. The Company is supervised by the Board of Governors of the Federal Reserve System, while the Bank is subject to regulation and supervision by the Federal Deposit Insurance Corporation and the Ohio Division of Financial Institutions. The consolidated financial statements of the Company include its wholly-owned subsidiary, the Bank. Significant intercompany items have been eliminated in preparing the consolidated financial statements. The financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America. In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the balance sheet date and revenues and expenses for the period. Actual results could differ significantly from those estimates. Investment Securities Investment securities are classified at the time of purchase, based on management's intention and ability, as securities held to maturity or securities available for sale. Debt securities acquired with the intent and ability to hold to maturity are stated at cost adjusted for amortization of premium and accretion of discount which are computed using a level yield method and recognized as adjustments of interest income. Certain other debt securities have been classified as available for sale to serve principally as a source of liquidity. Unrealized holding gains and losses for available for sale securities are reported as a separate component of stockholders' equity, net of tax, until realized. Realized security gains and losses are computed using the specific identification method. Interest and dividends on investment securities are recognized as income when earned. Common stock of the Federal Home Loan Bank ("FHLB") represents ownership in an institution that is wholly-owned by other financial institutions. This equity security is accounted for at cost and classified with other assets. Loans Loans are reported at their principal amount net of the allowance for loan losses. Interest income is recognized as income when earned on the accrual method. The accrual of interest is discontinued on a loan when management believes, after considering economic and business conditions, the borrower's financial condition is such that collection of interest is doubtful. Interest received on nonaccrual loans is recorded as income against principal according to management's judgment as to the collectibility of such principal. 5 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Loans (Continued) Loan origination fees and certain direct loan origination costs are being deferred and the net amount amortized as an adjustment of the related loan's yield. Management is amortizing these amounts over the contractual life of the related loans. Allowance for Loan Losses The allowance for loan losses represents the amount which management estimates is adequate to provide for probable loan losses inherent in its loan portfolio. The allowance method is used in providing for loan losses. Accordingly, all loan losses are charged to the allowance, and all recoveries are credited to it. The allowance for loan losses is established through a provision for loan losses which is charged to operations. The provision is based on management's periodic evaluation of the adequacy of the allowance for loan losses which encompasses the overall risk characteristics of the various portfolio segments, past experience with losses, the impact of economic conditions on borrowers, and other relevant factors. The estimates used in determining the adequacy of the allowance for loan losses, including the amounts and timing of future cash flows expected on impaired loans, are particularly susceptible to significant change in the near term. A loan is considered impaired when it is probable the borrower will not repay the loan according to the original contractual terms of the loan agreement. Management has determined that first mortgage loans on one-to-four family properties and all consumer loans represent large groups of smaller-balance homogeneous loans that are to be collectively evaluated. Loans that experience insignificant payment delays, which are defined as 90 days or less, generally are not classified as impaired. A loan is not impaired during a period of delay in payment if the Company expects to collect all amounts due including interest accrued at the contractual interest rate for the period of delay. All loans identified as impaired are evaluated independently by management. The Company estimates credit losses on impaired loans based on the present value of expected cash flows or the fair value of the underlying collateral if the loan repayment is expected to come from the sale or operation of such collateral. Impaired loans, or portions thereof, are charged off when it is determined a realized loss has occurred. Until such time, an allowance for loan losses is maintained for estimated losses. Cash receipts on impaired loans are applied first to accrued interest receivable unless otherwise required by the loan terms, except when an impaired loan is also a nonaccrual loan in which case the portion of the payment related to interest is recognized as income. Premises and Equipment Premises and equipment are stated at cost net of accumulated depreciation. Depreciation is computed on the straight-line method over the estimated useful lives of the assets, which range from three to twenty years for furniture, fixtures, and equipment and three to forty years for buildings and leasehold improvements. Expenditures for maintenance and repairs are charged against income as incurred. Costs of major additions and improvements are capitalized. Income Taxes The Company and the Bank file a consolidated federal income tax return. Deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. Earnings Per Share 6 The Company provides dual presentation of basic and diluted earnings per share. Basic earnings per share is calculated utilizing net income as reported in the numerator and average shares outstanding in the denominator. The computation of diluted earnings per share differs in that the dilutive effects of any stock options, warrants, and convertible securities are adjusted in the denominator. 7 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Stock Options The Company maintains a stock option plan for key officers, employees, and non-employee directors. Had compensation expense for the stock option plans been recognized in accordance with the fair vale accounting provisions of FAS No. 123, "Accounting for Stock-based Compensation," net income applicable to common stock, basic and diluted net income per common share for the year ended December 31, would have been as follows:
2002 2001 2000 ---------- ---------- ---------- Net income as reported: Less pro forma expense related to option $2,500,949 $2,270,607 $2,236,671 Pro forma net income 52,434 37,644 41,301 ---------- ---------- ---------- Basic net income per common share: 2,448,515 2,232,963 2,195,370 ========== ========== ========== As reported $ 2.16 $ 1.96 $ 1.92 Pro forma 2.12 1.92 1.88 Diluted net income per common share: As reported $ 2.16 $ 1.95 $ 1.92 Pro forma 2.11 1.92 1.88
For purposes of computing pro forma results, the Company estimated the fair values of stock options using the Black-Scholes option pricing model. The model requires the use of subjective assumptions which can materially affect fair value estimates. Therefore, the pro forma results are estimates of results of operations as if compensation expense had been recognized for the stock option plans. The fair value of each stock option granted was estimated using the following weighted-average assumptions: Expected Grant Dividend Risk-free Expected Expected Year Yield Interest Rate Volatility Life (in years) ----- -------- ------------- ---------- --------------- 2000 2.50% 5.29% 5.00% 9.95 2002 2.72% 4.19% 27.04% 9.94 Stockholders' Equity The Board of Directors approved a five percent stock dividend to stockholders of record as of June 1, 2002, payable June 14, 2002. As a result of the dividend, 54,997 additional shares of the company's common stock were issued, common stock was increased by $1,429,662 and retained earnings decreased by $1,434,607. Fractional shares paid were paid in cash. All average shares outstanding and all per share amounts included in the financial statements are based on the increased number of shares after giving retroactive effects to the stock dividend. Cash Flow Information The Company has defined cash and cash equivalents as those amounts included in the consolidated balance sheet captions Cash and due from banks and Federal funds sold. 8 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Recent Accounting Pronouncements In August 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("FAS") No. 143, Accounting for Asset Retirement Obligations, which requires that the fair value of a liability be recognized when incurred for the retirement of a long-lived asset and the value of the asset be increased by that amount. The statement also requires that the liability be maintained at its present value in subsequent periods and outlines certain disclosures for such obligations. The adoption of this statement, which is effective January 1, 2003, is not expected to have a material effect on the Company's financial statements. In October 2001, the FASB issued FAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. FAS No. 144 supercedes FAS No. 121 and applies to all long-lived assets (including discontinued operations) and consequently amends APB Opinion No. 30, Reporting Results of Operations - Reporting the Effects of Disposal of a Segment of a Business. FAS No. 144 requires that long-lived assets that are to be disposed of by sale be measured at the lower of book value or fair value less costs to sell. FAS No. 144 is effective for financial statements issued for fiscal years beginning after December 15, 2001 and, generally, its provisions are to be applied prospectively. The adoption of this statement did not have a material effect on the Company's financial statements. In April 2002, the FASB issued FAS No. 145, Recission of FASB Statement No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. FAS No. 145 rescinds FAS No. 4, which required all gains and losses from extinguishment of debt to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect. As a result, the criteria in APB Opinion No. 30 will now be used to classify those gains and losses. This statement also amends FAS No. 13 to require that certain lease modifications that have economic effects similar to sale-leaseback transactions be accounted for in the same manner as sale-leaseback transactions. This statement also makes technical corrections to existing pronouncements, which are not substantive but in some cases may change accounting practice. The provisions of this statement related to the rescission of FAS No. 4 shall be applied in fiscal years beginning after May 15, 2002. Any gain or loss on extinguishments of debt that was classified as an extraordinary item in prior periods presented that does not meet the criteria in APB Opinion No. 30 for classification as an extraordinary item shall be reclassified. Early adoption of the provisions of this statement related to FAS No. 13 shall be effective for transactions occurring after May 15, 2002. All other provisions of this statement shall be effective for financial statements issued on or after May 15, 2002. Early application of this statement is encouraged. The adoption of the effective portions of this statement did not have an impact on the Company's financial position or results of operations. The adoption of the remaining portions of this statement is not expected to have an impact on the Company's financial position or results of operations. In July 2002, the FASB issued FAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. This statement replaces EITF Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring). The new statement will be effective for exit or disposal activities initiated after December 31, 2002, the adoption of which is not expected to have a material effect on the Company's financial statements. On October 1, 2002, the FASB issued FAS No. 147, Acquisitions of Certain Financial Institutions, effective for all business combinations initiated after October 1, 2002. This statement addresses the financial accounting and reporting for the acquisition of all or part of a financial institution, except for a transaction between two or more mutual enterprises. This statement removes acquisitions of financial institutions, other than transactions between two or more mutual enterprises, from the scope of FAS No. 72, Accounting for Certain Acquisitions of Banking or Thrift Institutions, and FASB Interpretation No. 9, Applying APB Opinions No. 16 and 17 When a Savings and Loan Association or a Similar Institution Is Acquired in a Business Combination Accounted for by the Purchase Method. The acquisition of all or part of a financial institution that meets the definition of a business combination 9 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Recent Accounting Pronouncements (Continued) shall be accounted for by the purchase method in accordance with FAS No. 141, Business Combinations, and FAS No. 142, Goodwill and Other Intangible Assets. This statement also provides guidance on the accounting for the impairment or disposal of acquired long-term customer-relationship intangible assets (such as depositor and borrower-relationship intangible assets and credit cardholder intangible assets), including those acquired in transactions between two or more mutual enterprises. The adoption of this statement is not expected to have a material effect on the Company's financial statements. On December 31, 2002, the FASB issued FAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure, which amends FAS No. 123, Accounting for Stock-Based Compensation. FAS No. 148 amends the disclosure requirements of FAS No. 123 to require more prominent and more frequent disclosures in financial statements about the effects of stock-based compensation. Under the provisions of FAS No. 123, companies that adopted the preferable, fair value based method were required to apply that method prospectively for new stock option awards. This contributed to a "ramp-up" effect on stock-based compensation expense in the first few years following adoption, which caused concern for companies and investors because of the lack of consistency in reported results. To address that concern, FAS No. 148 provides two additional methods of transition that reflect an entity's full complement of stock-based compensation expense immediately upon adoption, thereby eliminating the ramp-up effect. FAS No. 148 also improves the clarity and prominence of disclosures about the pro forma effects of using the fair value based method of accounting for stock-based compensation for all companies--regardless of the accounting method used--by requiring that the data be presented more prominently and in a more user-friendly format in the footnotes to the financial statements. In addition, the statement improves the timeliness of those disclosures by requiring that this information be included in interim as well as annual financial statements. The transition guidance and annual disclosure provisions of FAS No. 148 are effective for fiscal years ending after December 15, 2002, with earlier application permitted in certain circumstances. The interim disclosure provisions are effective for financial reports containing financial statements for interim periods beginning after December 15, 2002. In November, 2002, the FASB issued Interpretation No. 45, Guarantor's Accounting and Disclosure requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. This interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. This interpretation clarifies that a guarantor is required to disclose (a) the nature of the guarantee, including the approximate term of the guarantee, how the guarantee arose, and the events or circumstances that would require the guarantor to perform under the guarantee; (b) the maximum potential amount of future payments under the guarantee; (c) the carrying amount of the liability, if any, for the guarantor's obligations under the guarantee; and (d) the nature and extent of any recourse provisions or available collateral that would enable the guarantor to recover the amounts paid under the guarantee. This interpretation also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the obligations it has undertaken in issuing the guarantee, including its ongoing obligation to stand ready to perform over the term of the guarantee in the event that the specified triggering events or conditions occur. The objective of the initial measurement of that liability is the fair value of the guarantee at its inception. The initial recognition and initial measurement provisions of this interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor's fiscal year-end. The disclosure requirements in this interpretation are effective for financial statements of interim or annual periods ending after December 15, 2002. Reclassification of Comparative Amounts Certain items previously reported have been reclassified to conform with the current year's format. Such reclassifications did not affect net income or stockholders' equity. 10 2. EARNINGS PER SHARE There are no convertible securities which would affect the numerator in calculating basic and diluted earnings per share; therefore, net income as presented on the Consolidated Statement of Income will be used as the numerator. The following table sets forth the composition of the weighted-average common shares (denominator) used in the basic and diluted earnings per share computation.
2002 2001 2000 --------- --------- --------- Weighted-average common shares outstanding 1,205,155 1,206,110 1,206,110 Average treasury stock shares (47,786) (45,722) (42,704) --------- --------- --------- Weighted-average common shares and common stock equivalents used to calculate basic earnings per share 1,157,369 1,160,388 1,163,406 Additional common stock equivalents (stock options) used to calculate diluted earnings per share 1,899 1,203 -- --------- --------- --------- Weighted-average common shares and common stock equivalents used to calculate diluted earnings per share 1,159,268 1,161,591 1,163,406 ========= ========= =========
Options to purchase 9,975 shares of common stock at prices from $29.52 to $30.24 per share were outstanding during 2002 and 2001 but were not included in the computation of diluted EPS because to do so would have been anti-dilutive. 3. INVESTMENT SECURITIES AVAILABLE FOR SALE The amortized cost and estimated market values of securities available for sale are as follows:
2002 --------------------------------------------------- Gross Gross Estimated Amortized Unrealized Unrealized Market Cost Gains Losses Value ----------- ---------- ---------- ----------- U.S. Government agency securities $ 3,737,068 $162,442 $ -- $ 3,899,510 Obligations of states and political subdivisions: Taxable 1,160,507 21,107 -- 1,181,614 Tax-exempt 10,113,698 290,242 (27,762) 10,376,178 Corporate securities 349,747 23,659 -- 373,406 Mortgage-backed securities 19,835,691 263,981 (13,323) 20,086,349 ----------- -------- -------- ----------- Total $35,196,711 $761,431 $(41,085) $35,917,057 =========== ======== ======== ===========
11 3. INVESTMENT SECURITIES AVAILABLE FOR SALE (Continued)
2001 --------------------------------------------------- Gross Gross Estimated Amortized Unrealized Unrealized Market Cost Gains Losses Value ----------- ---------- ---------- ----------- U.S. Government agency securities $ 2,152,877 $ 60,470 $ -- $ 2,213,347 Obligations of states and political subdivisions: Taxable 1,411,166 16,700 (2,957) 1,424,909 Tax-exempt 5,822,240 107,864 (15,099) 5,915,005 Corporate securities 550,472 25,809 -- 576,281 Mortgage-backed securities 11,040,429 69,408 (59,593) 11,050,244 ----------- -------- -------- ----------- Total $20,977,184 $280,251 $(77,649) $21,179,786 =========== ======== ======== ===========
The amortized cost and estimated market value of debt securities at December 31, 2002, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Estimated Amortized Market Cost Value ----------- ----------- Due in one year or less $ 2,449,962 $ 2,473,942 Due after one year through five years 8,550,471 8,910,167 Due after five years through ten years 3,004,457 3,139,208 Due after ten years 21,191,821 21,393,740 ----------- ----------- Total $35,196,711 $35,917,057 =========== =========== Investment securities with an approximate carrying value of $11,397,600 and $9,381,000 at December 31, 2002 and 2001, respectively, were pledged to secure deposits and other purposes as required by law. The gross proceeds received and the gross gains realized on the sale of investment securities available for sale for the year ended December 31, 2001 were $2,092,980 and $97,807, respectively. The Company had no sales in 2002 or 2000. 12 4. INVESTMENT SECURITIES HELD TO MATURITY The amortized cost and estimated market values of investment securities held to maturity are as follows:
2002 ------------------------------------------------- Gross Gross Estimated Amortized Unrealized Unrealized Market Cost Gains Losses Value ---------- ---------- ---------- ---------- Obligations of states and political subdivisions: Taxable $1,370,215 $ 50,360 $-- $1,420,575 Tax-exempt 3,368,276 95,092 -- 3,463,368 Corporate securities 1,503,604 18,371 -- 1,521,975 ---------- -------- --- ---------- Total $6,242,095 $163,823 $-- $6,405,918 ========== ======== === ==========
2001 --------------------------------------------------- Gross Gross Estimated Amortized Unrealized Unrealized Market Cost Gains Losses Value ----------- ---------- ---------- ----------- Obligations of states and political subdivisions: Taxable $ 2,255,342 $ 57,931 $-- $ 2,313,273 Tax-exempt 5,561,426 120,456 -- 5,681,882 Corporate securities 2,213,060 59,896 -- 2,272,956 Mortgage-backed securities 199,240 4,627 -- 203,867 ----------- -------- --- ----------- Total $10,229,068 $242,910 $-- $10,471,978 =========== ======== === ===========
The amortized cost and estimated market value of debt securities at December 31, 2002, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Estimated Amortized Market Cost Value ---------- ---------- Due in one year or less $4,370,736 $4,434,763 Due after one year through five years 1,724,637 1,802,246 Due after five years through ten years 46,722 51,811 Due after ten years 100,000 117,098 ---------- ---------- Total $6,242,095 $6,405,918 ========== ==========
13 4. INVESTMENT SECURITIES HELD TO MATURITY (Continued) Investment securities held to maturity with carrying values of approximately $1,535,726 and $3,205,000 and estimated market values of approximately $1,590,910 and $3,424,000 at December 31, 2002 and 2001, respectively, were pledged to secure public deposits and other purposes required by law. 5. LOANS Major classifications of loans are summarized as follows: 2002 2001 ------------ ------------ Commercial and industrial $ 32,915,776 $ 28,313,488 Real estate - construction 3,207,434 3,199,738 Real estate - mortgage: Residential 123,843,881 113,048,775 Commercial 9,520,812 3,387,969 Consumer installment 5,455,228 4,878,385 ------------ ------------ 174,943,131 152,828,355 Less allowance for loan losses 2,300,485 2,062,252 ------------ ------------ Net loans $172,642,646 $150,766,103 ============ ============ The Company's primary business activity is with customers located within its local trade area, eastern Geauga County, and contiguous counties to the north, east, and south. Commercial, residential, consumer, and agricultural loans are granted. Although the Company has a diversified loan portfolio at December 31, 2002 and 2001, loans outstanding to individuals and businesses are dependent upon the local economic conditions in its immediate trade area. 6. ALLOWANCE FOR LOAN LOSSES Changes in the allowance for loan losses for the years ended December 31, are as follows: 2002 2001 2000 ---------- ---------- ---------- Balance, January 1 $2,062,252 $2,037,322 $1,756,137 Add: Provisions charged to operations 300,000 170,000 275,000 Recoveries 57,388 120,814 61,002 Less loans charged off 119,155 265,884 54,817 ---------- ---------- ---------- Balance, December 31 $2,300,485 $2,062,252 $2,037,322 ========== ========== ========== 14 7. PREMISES AND EQUIPMENT Major classifications of premises and equipment are summarized as follows: 2002 2001 ----------- ----------- Land and land improvements $ 1,094,647 $ 1,094,546 Building and leasehold improvements 6,068,568 6,018,245 Furniture, fixtures, and equipment 2,452,273 2,349,709 Construction in progress 447,595 10,100 ----------- ----------- 10,063,083 9,472,600 Less accumulated depreciation and amortization 3,582,353 3,227,803 ----------- ----------- Total $ 6,480,730 $ 6,244,797 =========== =========== Depreciation and amortization charged to operations was $354,550 in 2002, $300,531 in 2001, and $337,158 in 2000. 8. OTHER ASSETS The components of other assets are as follows: 2002 2001 ---------- ---------- FHLB stock $1,245,700 $1,056,000 Accrued interest on investment securities 294,077 329,312 Accrued interest on loans 424,650 423,752 Deferred tax asset, net 87,117 190,848 Other 214,168 304,656 ---------- ---------- Total $2,265,712 $2,304,568 ========== ========== 9. DEPOSITS Time deposits at December 31, 2002 mature $49,951,941 in 2003, $33,385,345 during 2004 through 2005, and $10,281,682 beyond 2005. Time deposits include certificates of deposit in denominations of $100,000 or more. Such deposits aggregated $17,677,677 and $15,866,131 at December 31, 2002 and 2001, respectively. Maturities on time deposits of $100,000 or more at December 31, 2002, are as follows: Within three months $ 3,697,008 Beyond three but within six months 3,434,299 Beyond six but within twelve months 1,983,994 Beyond one year 8,562,366 ----------- Total $17,677,667 =========== 15 10. SHORT-TERM BORROWINGS The outstanding balances and related information of short-term borrowings which includes securities sold under agreements to repurchase are summarized as follows: 2002 2001 ---------- -------- Balance at year-end $ 785,778 $660,678 Average balance outstanding 977,343 637,106 Maximum month-end balance 1,176,829 833,008 Weighted-average rate at year-end 0.33% 0.79% Weighted-average rate during the year 0.73% 2.42% Average balances outstanding during the year represent daily average balances, and average interest rates represent interest expense divided by the related average balance. The Company maintains a $4,000,000 line of credit at an adjustable rate, currently 4.00 percent, from Lorain National Bank. At December 31, 2002 and 2001, there were no outstanding balances on this line. 11. OTHER BORROWINGS Other borrowings consist of fixed rate advances from the FHLB as follows: Interest Maturity Rate 2002 2001 ----------------------- -------- ----------- ---------- August 8, 2003 2.03% $ 1,440,000 $ -- August 9, 2004 2.70% 525,000 -- August 9, 2005 3.34% 525,000 -- August 9, 2006 3.87% 510,000 -- July 1, 2007 6.40% 880,803 1,301,334 September 4, 2008 5.36% 4,000,000 4,000,000 October 2, 2008 4.53% 2,000,000 2,000,000 July 28, 2010 6.45% 2,000,000 2,000,000 February 1, 2012 4.17% 1,863,265 -- June 4, 2012 4.04% 965,887 -- June 4, 2017 4.34% 980,098 -- ----------- ---------- Total $15,690,053 $9,301,334 =========== ========== Advances from FHLB maturing July 1, 2007, February 1, 2012, June 4, 2012, and June 4, 2017 require monthly principal and interest payments and an annual 20 percent paydown of outstanding principal. Monthly principal and interest payments are adjusted after each 20 percent paydown. Under terms of a blanket agreement, collateral for the FHLB borrowings are secured by certain qualifying assets of the Bank which consist principally of first mortgage loans. Under this credit arrangement, the Bank has a remaining borrowing capacity of approximately $91.4 million at December 31, 2002. 16 12. OTHER LIABILITIES The components of other liabilities are as follows: 2002 2001 -------- -------- Accrued interest on deposits $485,946 $607,204 Other 152,854 119,213 -------- -------- Total $638,800 $726,417 ======== ======== 13. INCOME TAXES The provision for federal income taxes consists of: 2002 2001 2000 ---------- -------- ---------- Current payable $1,180,108 $916,456 $1,010,182 Deferred (72,302) 54,403 (87,521) ---------- -------- ---------- Total provision $1,107,806 $970,859 $ 922,661 ========== ======== ========== The tax effects of deductible and taxable temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities are as follows: 2002 2001 -------- -------- Deferred tax assets: Allowance for loan losses $713,232 $632,233 Supplemental retirement plan 19,348 -- -------- -------- Gross deferred tax assets 732,580 632,233 -------- -------- Deferred tax liabilities: Deferred origination fees, net 173,186 164,450 Premises and equipment 122,908 119,082 Net unrealized gain on securities 244,918 68,885 Other 104,451 88,968 -------- -------- Gross deferred tax liabilities 645,463 441,385 -------- -------- Net deferred tax assets $ 87,117 $190,848 ======== ======== No valuation allowance was established at December 31, 2002 and 2001 in view of the Company's ability to carryback to taxes paid in previous years and certain tax strategies, coupled with the anticipated future taxable income as evidenced by the Company's earnings potential. 17 13. INCOME TAXES (Continued) The reconciliation between the federal statutory rate and the Company's effective consolidated income tax rate is as follows:
2002 2001 2000 -------------------- -------------------- -------------------- % of % of % of Pre-tax Pre-tax Pre-tax Amount Income Amount Income Amount Income ---------- ------- ---------- ------- ---------- ------- Provision at statutory rate $1,226,976 34.0% $1,102,098 34.0% $1,074,173 34.0% Tax-free income (147,425) (4.1) (157,362) (4.9) (178,520) (5.7) Nondeductible interest expense 21,590 0.6 26,068 0.8 19,966 0.6 Other 6,665 0.2 55 0.1 7,042 0.3 ---------- ---- ---------- ---- ---------- ---- Actual tax expense and effective rate $1,107,806 30.7% $ 970,859 30.0% $ 922,661 29.2% ========== ==== ========== ==== ========== ====
14. EMPLOYEE BENEFITS Retirement Plan The Bank maintains a section 401(k) employee savings and investment plan for all full-time employees and officers of the Bank with more than one year of service. The Bank's contribution to the plan is based on 50 percent matching of voluntary contributions up to 6 percent of compensation. An eligible employee can contribute up to 15 percent of salary. Employee contributions are vested at all times, and the Bank contributions are fully vested after six years beginning at the second year in 20 percent increments. Contributions for 2002, 2001, and 2000 to this plan amounted to $53,268, $49,130, and $44,411, respectively. Supplemental Retirement Plan Effective December 1, 2001, the Bank adopted a Directors Retirement Plan to provide post-retirement payments over a ten-year period to members of the Board of Directors who have completed five or more years of service. The Plan requires payment of 25 percent of the final average annual board fees paid to a director in the three years preceding the director's retirement. The expense of the plan for the years ended December 31, 2002 and 2001 amounted to $52,800 and $4,107, respectively. Stock Option Plan The Company maintains a stock option plan ("the Plan") for granting incentive stock options and non-qualified stock options for key officers and employees and non-employee directors of the Company. A total of 119,779 shares of authorized and unissued or issued common stock are reserved for issuance under the Plan, which expires ten years from the date of stockholder ratification. The per share exercise price of an option granted will not be less than the fair value of a share of common stock on the date the option is granted. No option shall become exercisable earlier than one year from the date the Plan was approved by the stockholders. 18 14. EMPLOYEE BENEFITS Stock Option Plan (Continued) The following table presents share data related to the outstanding options: Weighted- Weighted- average average Exercise Exercise 2002 Price 2001 Price ------ -------- ------ --------- Outstanding, January 1 21,985 $26.11 21,985 $26.11 Granted 9,450 28.50 -- -- Exercised (989) 22.86 -- -- Forfeited -- -- -- -- ------ ------ Outstanding, December 31 30,446 $26.97 21,985 $26.11 ====== ====== Exercisable at year-end 20,996 26.28 21,985 26.11 ====== ====== The following table summarizes the characteristics of stock options at December 31, 2002:
Outstanding Exercisable ------------------------------- ----------------- Contractual Average Average Exercise Average Exercise Exercise Grant Date Price Shares Life Price Shares Price ----------------- -------- ------ ----------- -------- ------ -------- June 14, 1999 $30.24 7,350 6.45 $30.24 7,350 $30.24 November 23, 1999 29.52 2,625 6.90 29.52 2,625 29.52 December 11, 2000 22.86 11,021 7.95 22.86 11,021 22.86 December 9, 2002 28.50 9,450 9.94 28.50 -- -- ------ ------ 30,446 26.97 20,996 26.28 ====== ======
19 15. COMMITMENTS In the normal course of business, there are various outstanding commitments and certain contingent liabilities which are not reflected in the accompanying consolidated financial statements. These commitments and contingent liabilities represent financial instruments with off-balance sheet risk. The contract or notional amounts of those instruments reflect the extent of involvement in particular types of financial instruments which were comprised of the following: 2002 2001 ----------- ----------- Commitments to extend credit $12,863,165 $17,265,756 Standby letters of credit 86,692 72,692 ----------- ----------- Total $12,949,857 $17,338,448 =========== =========== The instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. The same credit policies are used in making commitments and conditional obligations as for on-balance sheet instruments. Generally, collateral is not required to support financial instruments with credit risk. The terms are typically for a one-year period with an annual renewal option subject to prior approval by management. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the loan agreement. These commitments are comprised primarily of available commercial and personal lines of credit. Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. The exposure to loss under these commitments is limited by subjecting them to credit approval and monitoring procedures. Substantially all commitments to extend credit are contingent upon customers maintaining specific credit standards at the time of the loan funding. Management assesses the credit risk associated with certain commitments to extend credit in determining the level of the allowance for loan losses. Since many of the commitments are expected to expire without being drawn upon, the contractual amounts do not necessarily represent future funding requirements. 16. REGULATORY RESTRICTIONS Loans Federal law prevents the Company from borrowing from the Bank unless the loans are secured by specific obligations. Further, such secured loans are limited in amount of ten percent of the Bank's common stock and capital surplus. Dividends The Bank is subject to a dividend restriction which generally limits the amount of dividends that can be paid by an Ohio state-chartered bank. Under the Ohio Banking Code, cash dividends may not exceed net profits as defined for that year combined with retained net profits for the two preceding years less any required transfers to surplus. Under this formula, the amount available for payment of dividends in 2003 is $3,101,000 plus 2003 profits retained up to the date of the dividend declaration. 20 17. REGULATORY CAPITAL Federal regulations require the Company and the Bank to maintain minimum amounts of capital. Specifically, each is required to maintain certain minimum dollar amounts and ratios of Total and Tier I capital to risk-weighted assets and of Tier I capital to average total assets. In addition to the capital requirements, the Federal Deposit Insurance Corporation Improvement Act ("FDICIA") established five capital categories ranging from "well capitalized" to "critically undercapitalized." Should any institution fail to meet the requirements to be considered "adequately capitalized," it would become subject to a series of increasingly restrictive regulatory actions. As of December 31, 2002 and 2001, the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be classified as a well capitalized financial institution, Total risk-based, Tier 1 risk-based, and Tier 1 Leverage capital ratios must be at least ten percent, six percent, and five percent, respectively. The Company's actual capital ratios are presented in the following table which shows the Company met all regulatory capital requirements. The capital position of the Bank does not differ significantly from the Company's.
2002 2001 ------------------- ------------------- Amount Ratio Amount Ratio ----------- ----- ----------- ----- Total Capital (to Risk-weighted Assets) Actual $22,997,205 16.72% $21,147,628 17.82% For Capital Adequacy Purposes 11,001,899 8.00 9,493,703 8.00 To Be Well Capitalized 13,752,374 10.00 11,867,129 10.00 Tier I Capital (to Risk-weighted Assets) Actual $21,270,980 15.47% $19,657,090 16.56% For Capital Adequacy Purposes 5,500,950 4.00 4,746,851 4.00 To Be Well Capitalized 8,251,424 6.00 7,120,277 6.00 Tier I Capital (to Average Assets) Actual $21,270,980 9.42% $19,657,090 9.94% For Capital Adequacy Purposes 9,033,386 4.00 7,906,376 4.00 To Be Well Capitalized 11,291,733 5.00 9,882,970 5.00
21 18. FAIR VALUE DISCLOSURE OF FINANCIAL INSTRUMENTS The estimated fair value of the Company's financial instruments at December 31, are as follows:
2002 2001 --------------------------- --------------------------- Carrying Fair Carrying Fair Value Value Value Value ------------ ------------ ------------ ------------ Financial assets: Cash and due from banks $ 1,775,324 $ 1,775,324 $ 3,443,435 $ 3,443,435 Federal funds sold 350,000 350,000 2,450,000 2,450,000 Interest-bearing deposits in other institutions 571,969 571,969 1,240,207 1,240,207 Investment securities: Available for sale 35,917,057 35,917,057 21,179,786 21,179,786 Held to maturity 6,242,095 6,405,918 10,229,068 10,471,978 Net loans 172,642,646 182,439,113 150,766,103 157,569,103 Regulatory stock 1,245,700 1,245,700 1,056,000 1,056,000 Accrued interest receivable 718,727 718,727 753,064 753,064 ------------ ------------ ------------ ------------ Total $219,463,518 $229,423,808 $191,117,663 $198,163,573 ============ ============ ============ ============ Financial liabilities: Deposits $187,384,494 $191,025,787 $167,382,728 $170,258,728 Short-term borrowings 785,778 785,778 660,678 660,678 Other borrowings 15,690,053 16,390,391 9,301,334 9,679,000 Accrued interest payable 485,946 485,946 607,204 607,204 ------------ ------------ ------------ ------------ Total $204,346,271 $208,687,902 $177,951,944 $181,205,610 ============ ============ ============ ============
Financial instruments are defined as cash, evidence of ownership interest in an entity, or a contract which creates an obligation or right to receive or deliver cash or another financial instrument from/to a second entity on potentially favorable or unfavorable terms. Fair value is defined as the amount at which a financial instrument could be exchanged in a current transaction between willing parties other than in a forced liquidation sale. If a quoted market price is available for a financial instrument, the estimated fair value would be calculated based upon the market price per trading unit of the instrument. If no readily available market exists, the fair value estimates for financial instruments should be based upon management's judgment regarding current economic conditions, interest rate risk, expected cash flows, future estimated losses, and other factors as determined through various option pricing formulas or simulation modeling. As many of these assumptions result from judgments made by management based upon estimates which are inherently uncertain, the resulting estimated fair values may not be indicative of the amount realizable in the sale of a particular financial instrument. In addition, changes in assumptions on which the estimated fair values are based may have a significant impact on the resulting estimated fair values. As certain assets such as deferred tax assets and premises and equipment are not considered financial instruments, the estimated fair value of financial instruments would not represent the full value of the Company. The Company employed simulation modeling in determining the estimated fair value of financial instruments for which quoted market prices were not available based upon the following assumptions: 22 18. FAIR VALUE DISCLOSURE OF FINANCIAL INSTRUMENTS (Continued) Cash and Due from Banks, Interest-bearing Deposits in Other Institutions, Federal Funds Sold, Regulatory Stock, Accrued Interest Receivable, Accrued Interest Payable, and Short-term Borrowings The fair value is equal to the current carrying value. Investment Securities The fair value of investment securities available for sale and held to maturity is equal to the available quoted market price. If no quoted market price is available, fair value is estimated using the quoted market price for similar securities. Loans, Deposits, and Other Borrowings The fair value of loans, certificates of deposit, and other borrowings is estimated by discounting the future cash flows using a simulation model which estimates future cash flows and constructs discount rates that consider reinvestment opportunities, operating expenses, noninterest income, credit quality, and prepayment risk. Demand, savings, and money market deposit accounts are valued at the amount payable on demand as of year-end. Commitments to Extend Credit These financial instruments are generally not subject to sale, and estimated fair values are not readily available. The carrying value, represented by the net deferred fee arising from the unrecognized commitment or letter of credit, and the fair value, determined by discounting the remaining contractual fee over the term of the commitment using fees currently charged to enter into similar agreements with similar credit risk, are not considered material for disclosure. The contractual amounts of unfunded commitments and letters of credit are presented in Note 15. 23 19. PARENT COMPANY Following are condensed financial statements for the Company. CONDENSED BALANCE SHEET
December 31, ------------------------- 2002 2001 ----------- ----------- ASSETS Cash and due from banks $ 292,947 $ 167,074 Interest-bearing deposits in other institutions 283,969 377,207 Investment in subsidiary bank 21,169,492 19,242,526 ----------- ----------- TOTAL ASSETS $21,746,408 $19,786,807 =========== =========== STOCKHOLDERS' EQUITY $21,746,408 $19,786,807 =========== ===========
CONDENSED STATEMENT OF INCOME
Year Ended December 31, ------------------------------------ 2002 2001 2000 ---------- ---------- ---------- INCOME Dividends from subsidiary bank $1,020,895 $ 854,703 $1,335,994 Interest income 6,963 4,709 25,600 ---------- ---------- ---------- Total income 1,027,858 859,412 1,361,594 EXPENSES 166,800 152,626 120,243 ---------- ---------- ---------- Income before income tax benefit 861,058 706,786 1,241,351 Income tax benefit (54,636) (48,063) (34,178) Income before equity in undistributed net income of subsidiary 915,695 754,849 1,275,529 ---------- ---------- ---------- Equity in undistributed net income of subsidiary 1,585,254 1,515,758 961,142 ---------- ---------- ---------- NET INCOME $2,500,949 $2,270,607 $2,236,671 ========== ========== ==========
24 19. PARENT COMPANY (Continued) CONDENSED STATEMENT OF CASH FLOWS
Year Ended December 31, --------------------------------------- 2002 2001 2000 ----------- ----------- ----------- OPERATING ACTIVITIES Net income $ 2,500,949 $ 2,270,607 $ 2,236,671 Adjustments to reconcile net income to net cash provided by operating activities: Equity in undistributed net income of subsidiary (1,585,254) (1,515,758) (961,142) Other -- 32,210 (32,176) ----------- ----------- ----------- Net cash provided by operating activities 915,695 787,059 1,243,353 ----------- ----------- ----------- INVESTING ACTIVITIES Decrease (increase) in interest-bearing deposits in other institutions 93,237 (350,766) 1,002,177 ----------- ----------- ----------- Net cash provided by (used for) investing activities 93,237 (350,766) 1,002,177 ----------- ----------- ----------- FINANCING ACTIVITIES Purchase of treasury stock (204,070) -- (1,311,050) Sale of treasury stock 18,020 -- 44,499 Exercise of stock options 23,509 -- -- Proceeds from dividend reinvestment plan 142,178 -- -- Cash dividends (862,696) (772,068) (595,255) ----------- ----------- ----------- Net cash used for financing activities (883,059) (772,068) (1,861,806) ----------- ----------- ----------- Increase (decrease) in cash 125,873 (335,775) 383,724 CASH AT BEGINNING OF YEAR 167,074 502,849 119,125 ----------- ----------- ----------- CASH AT END OF YEAR $ 292,947 $ 167,074 $ 502,849 =========== =========== ===========
25 20. SELECTED QUARTERLY FINANCIAL DATA (unaudited)
Three Months Ended ------------------------------------------------------ March 31, June 30, September 30, December 31, 2002 2002 2002 2002 ---------- ---------- ------------- ------------ Total interest income $3,426,323 $3,499,140 $3,585,611 $3,557,998 Total interest expense 1,536,068 1,512,260 1,590,727 1,509,031 ---------- ---------- ---------- ---------- Net interest income 1,890,255 1,986,880 1,994,884 2,048,967 Provision for loan losses 75,000 75,000 75,000 75,000 ---------- ---------- ---------- ---------- Net interest income after provision for loan losses 1,815,255 1,911,880 1,919,884 1,973,967 Total noninterest income 261,077 283,715 285,499 363,817 Total noninterest expense 1,259,422 1,345,672 1,268,026 1,333,219 ---------- ---------- ---------- ---------- Income before income taxes 816,910 849,923 937,357 1,004,565 Income taxes 268,000 278,000 298,000 263,806 ---------- ---------- ---------- ---------- Net income $ 548,910 $ 571,923 $ 639,357 $ 740,759 ========== ========== ========== ========== Per share data: Net income Basic $ 0.47 $ 0.49 $ 0.55 $ 0.64 Diluted 0.47 0.49 0.55 0.64 Average shares outstanding Basic 1,158,377 1,158,665 1,156,181 1,156,476 Diluted 1,159,491 1,159,196 1,159,277 1,158,868
26 20. SELECTED QUARTERLY FINANCIAL DATA (unaudited) (Continued)
Three Months Ended ------------------------------------------------------ March 31, June 30, September 30, December 31, 2001 2001 2001 2001 ---------- ---------- ------------- ------------ Total interest income $3,299,426 $3,462,634 $3,508,111 $3,534,205 Total interest expense 1,655,626 1,725,151 1,730,710 1,636,435 ---------- ---------- ---------- ---------- Net interest income 1,643,800 1,737,483 1,777,401 1,897,770 Provision for loan losses 39,000 41,000 45,000 45,000 ---------- ---------- ---------- ---------- Net interest income after provision for loan losses 1,604,800 1,696,483 1,732,401 1,852,770 Total noninterest income 258,665 267,775 365,793 204,153 Total noninterest expense 1,090,308 1,237,226 1,149,978 1,263,862 ---------- ---------- ---------- ---------- Income before income taxes 773,157 727,032 948,216 793,061 Income taxes 235,900 235,600 288,326 211,033 ---------- ---------- ---------- ---------- Net income $ 537,257 $ 491,432 $ 659,890 $ 582,028 ========== ========== ========== ========== Per share data: Net income Basic $ 0.46 $ 0.42 $ 0.57 $ 0.50 Diluted 0.46 0.42 0.57 0.50 Average shares outstanding Basic 1,158,102 1,157,911 1,160,388 1,158,102 Diluted 1,159,519 1,159,738 1,160,934 1,158,565
REPORT OF INDEPENDENT AUDITORS 27 Board of Directors and Stockholders Middlefield Banc Corp. We have audited the accompanying consolidated balance sheet of Middlefield Banc Corp. and subsidiary as of December 31, 2002 and 2001, and the related consolidated statements of income, changes in stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2002. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits 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 of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Middlefield Banc Corp. and subsidiary as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ending December 31, 2002, in conformity with accounting principles generally accepted in the United States of America. /s/ S.R. Snodgrass, A.C. Wexford, PA January 17, 2003 Selected Financial Data The summary financial information to follow is not a substitute for Middlefield's historical financial 28 information and other detailed financial information we provide elsewhere in this document. You should read the summary financial information together with the historical financial information and other detailed financial information we provide elsewhere in this document. We derived the financial data from Middlefield's audited financial statements for the fiscal years ended December 31, 1998 through 2002.
As of or For the Years Ended December 31, -------------------------------------------------------------- (In thousands, except share and per share amounts and ratios) 2002 2001 2000 1999 1998 ---------- ---------- ---------- ---------- ---------- Income Statement Data: Interest income ............................................. $ 14,120 $ 13,707 $ 12,770 $ 11,449 $ 10,901 Interest expense ............................................ 6,148 6,748 5,910 5,048 5,085 ---------- ---------- ---------- ---------- ---------- Net interest income ......................................... 7,972 6,959 6,860 6,401 5,817 Provision for loan losses ................................... 300 170 275 296 270 ---------- ---------- ---------- ---------- ---------- Net interest income after provision for loan losses ......... 7,672 6,789 6,585 6,105 5,546 Noninterest income, including securities gains (losses)...... 1,143 1,194 983 804 599 Noninterest expense ......................................... 5,206 4,741 4,409 4,254 3,825 ---------- ---------- ---------- ---------- ---------- Income before income taxes .................................. 3,609 3,242 3,159 2,655 2,320 Income taxes ................................................ 1,108 971 922 735 630 ---------- ---------- ---------- ---------- ---------- Net income ............................................... $ 2,501 $ 2,271 $ 2,237 $ 1,920 $ 1,690 ========== ========== ========== ========== ========== Balance Sheet Data: Investment securities ....................................... $ 42,159 $ 31,409 $ 29,811 $ 31,818 $ 36,656 Loans, net .................................................. $ 172,643 $ 150,766 $ 133,267 $ 119,472 $ 102,728 Total deposits .............................................. $ 187,384 $ 167,383 $ 147,166 $ 135,094 $ 128,828 FHLB Cincinnati advances .................................... $ 15,690 $ 9,301 $ 9,862 $ 9,602 $ 9,576 Total stockholders' equity .................................. $ 21,746 $ 19,791 $ 18,243 $ 17,689 $ 16,657 Total assets ................................................ $ 226,246 $ 197,858 $ 176,489 $ 165,512 $ 155,558 Per Common Share Data: /(1)/ Basic net income ............................................ $ 2.16 $ 1.96 $ 1.92 $ 1.60 $ 1.40 Diluted net income .......................................... $ 2.16 $ 1.95 $ 1.92 $ 1.60 $ N/A Book value .................................................. $ 18.80 $ 17.09 $ 15.75 $ 14.75 $ 13.81 Weighted Average Number of Shares: Basic ....................................................... 1,157,369 1,160,388 1,163,406 1,200,247 1,203,673 Diluted ..................................................... 1,159,268 1,161,591 1,163,406 1,200,247 N/A Selected Ratios: Return on average total stockholders' equity ................ 12.08% 11.89% 12.83% 11.17% 10.43% Return on average total assets .............................. 1.17% 1.22% 1.31% 1.21% 1.15% Dividend payout ratio ....................................... 34.49% 33.94% 26.61% 29.82% 29.53% Efficiency ratio /(2)/ ...................................... 57.12% 58.16% 56.21% 59.05% 59.62% Asset Quality Ratios: Reserve for loan losses to ending total loans ............... 1.31% 1.35% 1.51% 1.45% 1.48% Net loan charge-offs to average loans ....................... 0.04% 0.10% --% 0.07% 0.07% Capital Ratios: Average stockholders' equity to average assets .............. 9.70% 10.24% 10.20% 10.83% 11.04% Leverage ratio /(3)/ ........................................ 9.42% 9.94% 10.32% 10.93% 11.35% Total risk-based capital ratio /(3)/ ........................ 16.72% 17.82% 17.75% 18.39% 18.37%
/(1)/ Per share amounts are adjusted for a 5% stock dividend paid in 2002, a 10% stock dividend paid in 1998, and a 2-for-1 stock split in 2000. /(2)/ Efficiency ratio is noninterest expense divided by the sum of net interest income plus noninterest income minus nonrecurring items. /(3)/ Computed in accordance with Federal Reserve Board and FDIC guidelines. 29 Management's Discussion and Analysis of Financial Condition and Results of Operation Overview The consolidated review and analysis of Middlefield Banc Corp. ("Middlefield") is intended to assist the reader in evaluating the performance of Middlefield for the years ended December 31, 2002 and 2001. This information should be read in conjunction with the consolidated financial statements and accompanying notes to the financial statements. Middlefield is an Ohio corporation organized to become the holding company of The Middlefield Banking Company ("Bank"). The Bank is a state-chartered bank located in Middlefield, Ohio. Middlefield and its subsidiary bank derive substantially all of their income from banking and bank-related services, including interest earnings on residential real estate, commercial mortgage, commercial, and consumer financings as well as interest earnings on investment securities and deposit services to its customers through five locations. Forward Looking Statement The Private Securities Litigation Reform Act of 1995 contains safe harbor provisions regarding forward-looking statements. Forward-looking statements can be identified by terminology such as "believes," "expects," "anticipates," "estimates," "intends," "should," "will," "plans," "potential" and similar words. Forward-looking statements are also statements that are not statements of historical fact. Forward-looking statements necessarily involve risks and uncertainties. They are merely predictive or statements of probabilities, involving known and unknown risks, uncertainties and other factors. If one or more of these risks of uncertainties occurs or if the underlying assumptions prove incorrect, actual results in 2003 and beyond could differ materially from those expressed in or implied by the forward-looking statements. Forward-looking statements are based upon a variety of estimates and assumptions. The estimates and assumptions involve judgments about a number of things, including future economic, competitive, and financial market conditions and future business decisions. These matters are inherently subject to significant business, economic, and competitive uncertainties, all of which are difficult to predict and many of which are beyond Middlefield's control. Although Middlefield believes its estimates and assumptions are reasonable, actual results could vary materially from those shown. Inclusion of forward-looking information does not constitute a representation by Middlefield or any other person that the indicated results will be achieved. Investors are cautioned not to place undue reliance on forward-looking information. Results of Operations Middlefield recorded net income of $2.5 million in 2002, which represents an increase of $230,000, or 10.1%, over 2001. Net income for 2001 of $2.3 million represented an increase of $34,000, or 1.5%, over 2000. Diluted earnings per share have increased each of the past three years to $2.16 per share for 2002, $1.95 per share for 2001, and $1.92 per share for 2000. 30 Net Interest Income -- 2002 Compared to 2001. Net interest income for 2002 increased to $8.0 million, compared to $7.0 million for 2001. Interest income for 2002 was $14.1 million as compared to $13.7 million for 2001. This increase of $413,000 or 3.0% was influenced primarily by an increase in interest earned on loans receivable of $533,000, while offset by decreases in interest earned on federal funds sold, investment securities, and interest-bearing deposits in other institutions of $73,000, $33,000, and $14,000 respectively. Although the rate environment forced a decrease to interest rate yields, interest income was driven by increases in average balances of interest-earning assets. The average balance of loans receivable and investment securities increased $20.3 million to $163.8 million and $5.3 million to $35.2 million, respectively, during 2002. The tax-equivalent yield on interest earning assets decreased to 6.99% for 2002 from 7.79% for 2001, and primarily resulted from a 102 basis point and 69 basis point decrease in investment securities and loans receivable, respectively. During 2002, $14.0 million in called, matured, and repayed investment securities were reinvested at substantially lower rates. The inflow of deposits coupled with the rapid repayment of mortgage-backed securities has resulted in reinvestment options at substantially lower rates than the previous year. The lower interest rate environment resulted during 2001, when interest rates were driven downward by an aggressive rate reduction policy by the Federal Reserve Board. Interest expense decreased $600,000 or 8.9% for 2002 to $6,148,000 from $6,748,000 for 2001. Interest expense incurred on deposits decreased $720,000 for 2002 as compared to 2001 and was primarily attributable to the current interest rate environment that resulted in a lowering of the cost of funds to 3.68% for 2002 as compared to 4.71% for 2001. Offsetting the declining rates was an increase in the average balance of interest-bearing liabilities of $23.9 million to $167.2 million for 2002. In particular, the average balance of savings and certificates of deposits increased $10.6 million and $6.7 million, respectively. Core deposit growth also was driven by a general shift in customer preference away from the equity markets and into insured bank deposits. Although the Bank reduced its costs on all deposit products during 2002, certificates of deposits were the primary target as such costs decreased by 113 basis points. Interest expense on borrowings increased to $670,000 for 2002 as compared to $550,000 for 2001 and resulted primarily from an additional $7.0 million in borrowings with the Federal Home Loan Bank that Middlefield did not have at December 31, 2001. 2001 Compared to 2000. Net interest income for 2001 increased slightly to $7.0 million, compared to $6.9 million for 2000. Interest income of $13.7 million in 2001 represents an increase of $0.9 million, or 7.3%, over 2000, and 2001 was influenced primarily by an increase in interest earned on loans receivable of $1.0 million. Correspondingly, interest expense of $6.7 million in 2001 increased by $0.8 million, or 14.2%, and resulted almost entirely from an increase in interest expense on deposits. The average balance of interest-earning assets increased $16.4 million for 2001 and was comprised of increases in loans receivable, specifically real estate mortgages, of $14.9 million, or 11.6%, to $143.6 million, and interest-bearing deposits with other banks of $1.8 million, or 47.3%, to $5.6 million. Due to the declining rate environment in 2001, the tax-equivalent yield on interest-earning assets declined to 7.79% from 8.02% for 2000. While the yield on loans receivable and interest-bearing deposits with other banks was reduced by 21 and 190 basis points, respectively, the investment securities yield remained unchanged as management engaged in restructuring the investment securities portfolio to include higher yielding mortgage-backed securities with longer 31 maturity periods. Partially offsetting increases in interest income in 2001 was an increase in the average balances of time deposits of $13.3 million, or 19.1%, to $83.2 million and savings deposits of $3.4 million, or 10.6%, to $35.4 million. The average cost of funds on interest-bearing liabilities increased to 4.71% in 2001 from 4.58% in 2000, primarily resulting from an increase of 14 basis points for the more competitively priced certificates of deposit products. 32 Average Balances, Interest Rates and Yields. The following table sets forth certain information relating to our average balance sheet, and it reflects the average yield on assets and average cost of liabilities for the periods indicated and the average yields earned and rates paid. Such yields are derived by dividing income or expense by the average balance of assets or liabilities, respectively, for the periods presented. Average balances are derived from daily average balances.
Year ended December 31, ------------------------------------------------------------------------------- 2002 2001 -------------------------------------- -------------------------------------- Average Average (Dollars in thousands) Average yield/cost) Average yield/cost) balance Interest/(1)/ /(4)/ balance Interest/(1)/ /(4)/ -------- ------------- ----------- -------- ------------- ----------- Interest-earning assets: Loans receivable........................ $163,828 $12,341 7.53% $143,560 $11,808 8.23% Investment securities................... 35,169 1,615 5.21% 29,887 1,625 6.24% Interest-earning deposits with other 4.85% banks................................... 6,116 164 2.68% 5,647 274 -------- ------- ------ -------- ------- ------ Total interest-earning assets.............. 205,113 14,120 6.99% 179,094 13,707 7.79% ------- ------- Non-interest-earning assets................ 8,368 7,455 -------- -------- Total assets............................... $213,481 $186,549 ======== ======== Interest-bearing liabilities: Interest-bearing demand deposits........ $ 7,905 109 1.38% $ 6,296 153 2.43% Money market deposits................... 9,090 199 2.19% 8,123 244 3.00% Savings deposits........................ 46,045 948 2.06% 35,432 954 2.69% Certificates of deposit................. 89,857 4,222 4.70% 83,177 4,847 5.83% Borrowings.............................. 14,258 670 4.70% 10,211 550 5.39% -------- ------- ------ -------- ------- ------ Total interest-bearing liabilities......... 167,155 6,148 3.68% 143,239 6,748 4.71% ------- ------- Non interest-bearing liabilities: Other liabilities....................... 25,621 24,216 Stockholders' equity....................... 20,705 19,094 -------- -------- Total liabilities and stockholders' equity. $213,481 $186,549 ======== ======== Net interest income........................ $ 7,972 $ 6,959 ======= ======= Interest rate spread/(2)/.................. 3.31% 3.08% Net yield on interest-earning assets/(3)/.. 3.99% 3.89% Ratio of average interest-earning assets to average interest-bearing liabilities ... 122.71% 125.03% Year ended December 31, -------------------------------------- 2000 -------------------------------------- (Dollars in thousands) Average yield/cost) balance Interest/(1)/ /(4)/ -------- ------------- ----------- Interest-earning assets: Loans receivable........................ $128,661 $10,852 8.43% Investment securities................... 30,162 1,658 6.39% Interest-earning deposits with other banks................................... 3,833 259 6.76% -------- ------- ------ Total interest-earning assets.............. 162,656 12,769 8.02% ------- Non-interest-earning assets................ 8,231 -------- Total assets............................... $170,887 ======== Interest-bearing liabilities: Interest-bearing demand deposits........ $ 6,268 174 2.78% Money market deposits................... 10,310 308 2.99% Savings deposits........................ 32,036 855 2.67% Certificates of deposit................. 69,866 3,975 5.69% Borrowings.............................. 10,641 598 5.62% -------- ------- ------ Total interest-bearing liabilities......... 129,121 5,910 4.58% ------- Non interest-bearing liabilities: Other liabilities....................... 24,336 Stockholders' equity....................... 17,430 -------- Total liabilities and stockholders' equity. $170,887 ======== Net interest income........................ $ 6,859 ======= Interest rate spread/(2)/.................. 3.44% Net yield on interest-earning assets/(3)/.. 4.22% Ratio of average interest-earning assets to average interest-bearing liabilities ... 125.97%
/(1)/ Interest income and expense are for the period that banking operations were in effect. /(2)/ Interest rate spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities. /(3)/ Net yield on interest-earning assets represents net interest income as a percentage of average interest-earning assets. /(4)/ Average yield/cost is presented on a taxable equivalent basis using 34%. 33 Rate/Volume Analysis. The following table sets forth certain information regarding the changes in our interest income and interest expense for the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (1) changes in volume (changes in average volume multiplied by prior year rate), and (2) changes in rates (changes in rate multiplied by prior year average volume). Increases and decreases due to both rate and volume have been allocated proportionally to the change due to volume and the change due to rate.
Changes in net interest income for the year ended December 31, ------------------------- ---------------------- 2002 vs. 2001 2001 vs. 2000 Increase (decrease) due Increase (decrease) to due to ------------------------- ---------------------- (Dollars in thousands) Volume Rate Total Volume Rate Total ------ ------- ------ ------ ----- ----- Interest income: Loans receivable ....................... $1,320 $ (787) $ 533 $1,217 $(262) $955 Investment securities .................. (138) 128 (10) (9) (24) (33) Other interest-earning assets .......... 25 (135) (110) 37 (22) 15 ------ ------- ------ ------ ----- ---- Total interest income ............... 1,207 (794) 413 1,245 (308) 937 ------ ------- ------ ------ ----- ---- Interest expense: Interest-bearing demand ................ 64 (108) (44) 1 (22) (21) Money market ........................... 35 (80) (45) (66) 2 (64) Savings ................................ (28) 22 (6) 8 99 102 Certificates of deposit ................ 443 (1,068) (625) 774 98 872 Other interest-bearing liabilities ..... 177 (57) 120 (24) (24) (48) ------ ------- ------ ------ ----- ---- Total interest expense .............. 690 (1,290) (600) 766 63 838 ------ ------- ------ ------ ----- ---- Change in net interest income ............. $ 517 $ 496 $1,013 $ 469 $(370) $ 99 ====== ======= ====== ====== ===== ====
Loan Loss Provision -- 2002 Compared to 2001. The provision for loan losses was $300,000 in 2002 as compared to $170,000 in 2001. The loan loss provision is based upon management's assessment of a variety of factors, including types and amounts of nonperforming loans, historical loss experience, collectibility of collateral values and guaranties, pending legal action for collection of loans and related guaranties, and current economic conditions. The loan loss provision reflects management's judgment of the current period cost-of-credit risk inherent in the loan portfolio. Although management believes the loan loss provision has been sufficient to maintain an adequate allowance for loan losses, actual loan losses could exceed the amounts that have been charged to operations. The change in the loan loss provision in 2002 was principally a result of an increase in nonperforming loans during the year coupled with an increase in classified assets from 2001 to 2002. 2001 Compared to 2000. The provision for loan losses was $170,000 in 2001 as compared to $275,000 in 2000. The change in the loan loss provision in 2001 was principally a result of a reduction in the amount of classified assets from 2000 to 2001. Noninterest Income -- 2002 Compared to 2001. Total noninterest income decreased slightly in 2002 to $1.1 million from $1.2 million for 2001. The decrease is accounted for principally by the recognition of investment security gains of $98,000 in 2001 that was not repeated in 2002. 34 Offsetting this decline was an increase in fee income from deposit accounts, as well as increases in ATM surcharges and debit card fees. Such fees have progressively increased as the number of accounts and volume of related transactions have increased. 2001 Compared to 2000. Total noninterest income was $1.2 million in 2001, an increase of 21.5% over 2000. The increase is accounted for principally by fee income from deposit accounts, which grew commensurate with deposit growth, coupled with the recognition of investment security gains of $98,000. Transaction deposit accounts grew at a steady pace in 2002, 2001, and 2000. In general, management prices deposits at rates competitive with rates offered by the other banks in Middlefield's market, which rates tend to be somewhat lower than rates offered by thrift institutions and credit unions. Middlefield generally has not imposed service charges and fees to the same extent as other local institutions. Although a wider range of service charges and fees and higher service charges and fees would yield more income for each dollar of deposits, imposing service charges and fees on a basis equivalent to those imposed by many other area banks might adversely affect deposit growth. To promote deposit growth and provide cross-selling opportunities, Middlefield has not adopted the most aggressive fee structure. Deposit growth is generated by developing strong customer relationships and cross-selling deposit relationships to loan customers. Management intends to continue promoting demand deposit products, particularly noninterest-bearing deposit products, in order to obtain additional interest-free lendable funds. Noninterest Expense -- 2002 Compared to 2001. Noninterest expense increased 9.8% to $5.2 million for 2002 as compared to $4.7 million for 2001. Compensation and employee benefits increased $207,000, or 8.9%, primarily as a result of normal merit raises and a 17.0% increase in health insurance expenses for 2002. Occupancy and equipment expenses increased 16.8% or $98,000 as a result of added capital expenditures in prior years, in particular the Chardon branch which became operational in 2001. As a result of increased transaction activity from operating a larger organization, data processing expenses increased $65,000 or 18.1% during 2002 as compared to 2001. In addition, all other expenses increased $94,000 or 6.4% as a result of an increase in operational expenses for such items as telephone and postage usage that resulted from expanding into a larger organization, as well as a full years worth of expenses relating to the Directors Retirement Plan. Offsetting these increases was a reduction in marketing costs that occurred in 2001 marking the 100th anniversary of the Bank. Middlefield has also purchased land for expansion of a new branch in early 2003, and anticipates incurring additional capital and operational expenditures in the next twelve months. 2001 Compared to 2000. Noninterest expense increased 7.6% to $4.7 million for 2001 as compared to $4.4 million for 2000. Compensation and employee benefits increased $76,000, or 3.4%, primarily as a result of normal merit raises. Data processing expenses increased $47,000, or 14.9%, as a result of increased transaction activity with the opening of the Chardon branch. Professional fees increased $35,000, or 16.5%, and resulted from outside assistance in complying with the increased levels of regulatory compliance of a publicly reporting company. Other expenses increased $178,000 due to the marketing of the 100th anniversary of the Bank, costs incurred with the addition 35 of internet banking, as well as increases in other expenses such as telephones, supplies, etc., that relate to increases in volume that correspond with the sustained growth of the Bank. Provision for Income Taxes. The provision for income taxes fluctuated in 2002, 2001, and 2000 in direct correlation to the changing level of pre-taxable income during these periods. Financial Condition Assets and Liabilities. Middlefield's total assets increased $28.4 million, or 14.4%, to $226.2 million at December 31, 2002 from $197.9 million at December 31, 2001. This increase primarily resulted from a $21.9 million, or 14.5%, increase in net loans receivable to $172.6 million at December 31, 2002 that was funded by a $20.0 million net increase in customer deposits and a series of borrowings with the Federal Home Loan Bank of approximately $7.0 million. The increase in net loans receivable resulted from the economic health of Middlefield's market area, the current interest rate environment, and the strategic, service-oriented marketing approach taken by management to meet the lending needs of the area. The majority of Middlefield's lending activity consists of mortgage loans secured by one-to-four family residential property. Such loans grew $10.8 million, or 9.6%, to $123.8 million at December 31, 2002, representing 70.8% of the loan portfolio. Management attributes the increases in residential real estate properties to continued customer referrals and Middlefield's overall relationship with its customers. Also affected by the local economic conditions were commercial and commercial real estate loans, which increased in total by $10.7 million to $42.4 million. Investment securities available for sale increased to $35.9 million at December 31, 2002 from $21.2 million at December 31, 2001. Meanwhile, investment securities held to maturity decreased to $6.2 million at December 31, 2002 from $10.2 million at December 31, 2001. The net increase in 2002 is primarily due to investment purchases of $24.4 million primarily in mortgage-backed securities, which was partially offset by investment calls and maturities of $14.0 million. Purchases of mortgage-backed securities, which have all been classified as available for sale, typically have maturities ranging from 15 to 30 years with yields between 4.5% and 6.0%. Approximately half of the entire investment securities portfolio is now comprised of mortgage-backed securities as compared to 36.0% at December 31, 2001. Management was able to fund this growth with an influx of deposits coupled with the utilization of excess cash and cash equivalents of $3.8 million and the reinvestment of called and matured securities during the year. Furthermore, available for sale securities now comprise 84.9% of the investment securities portfolio as compared to 67.4% at December 31, 2001. Total deposits increased $20.0 million, or 11.9%, to $187.4 million at December 31, 2002 from $167.4 million at December 31, 2001. Growth was primarily concentrated in savings and time deposits, which increased $7.8 and $7.2 million, respectively, and resulted from continual marketing efforts by management, as well as management's competitive pricing of such products. As noted previously, deposit growth also was driven by a general shift in customer preference away from the equity markets and into insured bank deposits. Time deposits at December 31, 2002 continue to account for approximately half of the total deposit portfolio and remain a dominant resource for 36 funds. Other borrowings increased $6.4 million or 68.7% to $15.7 million at December 31, 2002 from $9.3 million at December 31, 2001. As noted previously, this primarily consisted of a series of Federal Home Loan Bank borrowings with staggered maturities to be repaid over a fifteen-year period. As noted previously, the proceeds from these borrowings were used to supplement the funding of loan demand. Total stockholders' equity increased to $21.7 million at December 31, 2002 due to net income of $2.5 million that was offset partially by dividend payments of $858,000 and an increase in accumulated other comprehensive income of $342,000. Accumulated other comprehensive income increased as a result of changes in the net unrealized gain on investment securities available for sale due to fluctuations in interest rates. Because of interest rate volatility, accumulated other comprehensive income could materially fluctuate for each interim period and year-end period depending on economic and interest rate conditions. Middlefield declared a 5.0% stock dividend during the period that resulted in a transfer between retained earnings and common stock of approximately $1.4 million. In September 2002, Middlefield's dividend reinvestment plan was initiated to promote long-term ownership by investors with the proceeds from such purchases being used for general corporate purposes. Approximately $142,000 was used for reinvestment purposes in 2002. Middlefield will continue to repurchase shares of its common stock for both stock option and restricted stock purposes. In addition, future dividend policies will be determined by the Board of Directors in light of the earnings and financial condition of Middlefield, including applicable governmental regulations and policies. Allowance for Loan Losses. The allowance for loan losses represents the amount management estimates is adequate to provide for probable losses inherent in the loan portfolio as of the balance sheet date. Accordingly, all loan losses are charged to the allowance, and all recoveries are credited to it. At December 31, 2002, Middlefield's allowance for loan losses increased to $2.3 million from $2.1 million at December 31, 2001, and now represents 1.31% of the gross loan portfolio as compared to 1.35% for the previous period. The allowance for loan losses is established through a provision for loan losses, which is charged to operations. The provision is based on management's periodic evaluation of the adequacy of the allowance for loan losses, taking into account the overall risk characteristics of the various portfolio segments, the bank's loan loss experience, the impact of economic conditions on borrowers, and other relevant factors. The estimates used to determine the adequacy of the allowance for loan losses, including the amounts and timing of future cash flows expected on impaired loans, are particularly susceptible to significant change in the near term. The total allowance for loan losses is a combination of a specific allowance for identified problem loans, a formula allowance, and an unallocated allowance. The specific allowance incorporates the results of measuring impaired loans as provided in Statement of Financial Accounting Standards ("FAS") No. 114, Accounting by Creditors for Impairment of a Loan, and FAS No. 118, Accounting by Creditors for Impairment of a Loan--Income Recognition and Disclosures. These accounting standards prescribe the measurement methods, income recognition and disclosures for impaired loans. 37 The formula allowance is calculated by applying loss factors to outstanding loans by type, excluding loans for which a specific allowance has been determined. Loss factors are based on management's determination of the amounts necessary for concentrations and changes in mix and volume of the loan portfolio, and consideration of historical loss experience. The unallocated allowance is determined based upon management's evaluation of existing economic and business conditions affecting the key lending areas of the bank and other conditions, such as new loan products, credit quality trends, collateral values, specific industry conditions within portfolio segments that existed as of the balance sheet date, and the impact of those conditions on the collectibility of the loan portfolio. Management reviews these conditions quarterly. The unallocated allowance is subject to a higher degree of uncertainty because it considers risk factors that may not be reflected in the historical loss factors. Although management believes that it uses the best information available to make such determinations and that the allowance for loan losses was adequate at December 31, 2002, future adjustments could be necessary if circumstances or economic conditions differ substantially from the assumptions used in making the initial determinations. A downturn in the local economy and employment could result in increased levels of nonperforming assets and charge-offs, increased loan loss provisions, and reductions in income. Additionally, as an integral part of the examination process bank regulatory agencies periodically review a bank's loan loss allowance. The banking agencies could require the recognition of additions to the loan loss allowance based on their judgment of information available to them at the time of their examination. The following table sets forth information concerning the Middlefield's allowance for loan losses at the dates and for the periods presented.
Loan Loss Experience for the Year Ended December 31, ---------------------------------------------------- (Dollars in thousands) 2002 2001 2000 ------ ------ ------ Loan loss allowance, beginning of period................................... $2,062 $2,037 $1,756 Loans charged off: Commercial and industrial............................................... (67) (74) (3) Real estate construction................................................ 0 0 0 Mortgage: Residential..................................................... 0 (21) 0 Commercial...................................................... 0 (92) 0 Consumer installment ................................................... (52) (71) (52) ------ ------ ------ Total loans charged off ............................................. (119) (258) (55) ------ ------ ------ Recoveries of loans previously charged off: Commercial and industrial............................................... 24 4 2 Real estate construction................................................ 0 0 0 Mortgage: Residential..................................................... 0 0 0 Commercial...................................................... 0 87 0 Consumer installment.................................................... 33 22 59 ------ ------ ------ Total recoveries .................................................... 57 113 61 ------ ------ ------ Net loans recovered (charged off).......................................... (62) (145) 6 Provision charged to operations............................................ 300 170 275 ------ ------ ------
38
Loan Loss Experience for the Year Ended December 31, ---------------------------------------------------- (Dollars in thousands) 2002 2001 2000 -------- -------- -------- Loan loss allowance, end of period......................................... $ 2,300 $ 2,062 $ 2,037 ======== ======== ======== Loans outstanding: Average................................................................. $163,828 $143,560 $128,661 End of period, net...................................................... $174,943 $152,828 $135,304 Ratio of allowance for loan losses to loans outstanding at end of period... 1.31% 1.35% 1.51% Net recoveries (charge offs) to average loans.............................. (0.04)% (0.10)% 0.00%
The following table illustrates the allocation of Middlefield's allowance for probable loan losses for each category of loan for each reported period. The allocation of the allowance to each category is not necessarily indicative of future loss in a particular category and does not restrict our use of the allowance to absorb losses in other loan categories.
Allocation of the Allowance for Loan Losses at December 31, --------------------------------------------------------------------------------- 2002 2001 2000 ------------------------- ------------------------- ------------------------- Percent of loans Percent of loans Percent of loans (Dollars in thousands) in each category in each category in each category Amount to total loans Amount to total loans Amount to total loans ------ ---------------- ------ ---------------- ------ ---------------- Type of loan: Commercial and industrial..... $ 611 18.82% $ 722 18.53% $ 723 15.90% Real estate construction...... 38 1.83% 37 2.09% 26 1.90% Mortgage: Residential............ 888 70.79% 781 73.97% 684 74.95 Commercial............. 230 5.44% 161 2.22% 281 3.55% Consumer installment.......... 124 3.12% 111 3.19% 107 3.70% Unallocated................... 409 -- 250 -- 216 -- ------ ------ ------ ------ ------ ------ Total............................. $2,300 100.00% $2,062 100.00% $2,037 100.00% ====== ====== ====== ====== ====== ======
Accrual of interest is discontinued on a loan when management believes, after considering economic and business conditions, the borrower's financial condition is such that collection of interest is doubtful. Payments received on nonaccrual loans is recorded as income or applied against principal according to management's judgment as to the collectibility of principal. A loan is considered impaired when it is probable the borrower will not repay the loan according to the original contractual terms of the loan agreement. Management has determined that first mortgage loans on one-to-four family properties and all consumer loans represent large groups of smaller-balance homogeneous loans that are to be collectively evaluated. Loans that experience insignificant payment delays, which are defined as 90 days or less, generally are not classified as impaired. A loan is not impaired during a period of delay in payment if the bank expects to collect all amounts due, including interest accrued at the contractual interest rate for the period of delay. All loans identified as impaired are evaluated independently by management. The bank estimates credit losses on impaired loans based on the present value of expected cash flows, or the fair value of the underlying collateral if loan repayment is expected to come from the sale or operation of the collateral. Impaired loans, or portions thereof, are charged off when it is determined a realized loss has occurred. Until that time, an allowance for loan losses is maintained for estimated losses. 39 Unless otherwise required by the loan terms, cash receipts on impaired loans are applied first to accrued interest receivable, except when an impaired loan is also a nonaccrual loan, in which case the portion of the payment related to interest is recognized as income. Nonperforming loans as a percentage of total net loans at December 31, 2002 increased to 0.31% from 0.19% for 2001. The bank had nonaccrual loans of $357,000 and $48,000 at December 31, 2002 and 2001, respectively. There were no loans on nonacrrual status at December 31, 2000. Interest income recognized on nonaccrual loans during all of the periods was insignificant. Management does not believe the nonaccrual loans or any amounts classified as nonperforming will have a significant effect on operations or liquidity in 2003. Furthermore, management is not aware of any trends or uncertainties related to any loans classified as doubtful or substandard that might have a material effect on earnings, liquidity, or capital resources. Management is not aware of any information pertaining to material credits that would cause it to doubt the ability of borrowers to comply with repayment terms. The following table summarizes nonperforming assets by category.
Nonperforming Assets at December 31, ------------------------------------ (Dollars in thousands) 2002 2001 2000 -------- -------- ---------- Commercial and industrial: Nonaccrual .................................. $ 0 $ 48 $ 0 Past due 90 days or more .................... 30 9 0 Real estate construction: Nonaccrual .................................. 0 0 0 Past due 90 days or more .................... 0 0 0 Mortgage -- Residential: Nonaccrual .................................. 357 0 0 Past due 90 days or more .................... 144 216 0 Mortgage -- Commercial: Nonaccrual .................................. 0 0 Past due 90 days or more .................... 0 0 0 Consumer installment: Nonaccrual .................................. 0 0 0 Past due 90 days or more .................... 7 20 5 -------- -------- ---------- Total nonperforming loans ................ 538 293 5 Other real estate owned ........................ 0 0 0 -------- -------- ---------- Total nonperforming assets ............... $ 538 $ 293 $ 5 ======== ======== ========== Loans outstanding, net ......................... $172,643 $150,766 $ 133,267 Nonperforming loans to total net loans ......... 0.31% 0.19% 0.00% Nonperforming loans to total assets ............ 0.24% 0.15% 0.00% Allowance for loan losses to total loans ....... 1.31% 1.35% 1.51% Allowance for loan losses to nonperforming loans ....................................... 427.51% 703.75% 40,740.00%
(1) Represents accruing loans delinquent greater than 90 days that are considered by management to be well secured and that are in the process of collection. Liquidity. Liquidity management for Middlefield is measured and monitored on both a short- and long-term basis, allowing management to better understand and react to emerging balance sheet 40 trends. After assessing actual and projected cash flow needs, management seeks to obtain funding at the most economical cost to Middlefield. Both short- and long-term liquidity needs are addressed by maturities and sales of investments securities, loan repayments and maturities, and liquidating money market investments such as federal funds sold. The use of these resources, in conjunction with access to credit, provide the core ingredients for satisfying depositor, borrower, and creditor needs. Middlefield's liquid assets consist of cash and cash equivalents, which include investments in very short-term investments (i.e. federal funds sold), and investment securities classified as available for sale. The level of these assets is dependent on Middlefield's operating, investing, and financing activities during any given period. At December 31, 2002, cash and cash equivalents totaled $2.1 million or 0.9% of total assets while investment securities classified as available for sale totaled $35.9 million or 15.9% of total assets. Management believes that the liquidity needs of Middlefield are satisfied by the current balance of cash and cash equivalents, readily available access to traditional funding sources, FHLB advances, and the portion of the investment and loan portfolios that mature within one year. These sources of funds will enable Middlefield to meet cash obligations and off-balance sheet commitments as they come due. Operating activities provided net cash of $3.2 million, $2.7 million, and $3.0 million for 2002, 2001, and 2000, respectively, generated principally from net income of $2.5 million, $2.3 million, and $2.2 million in each of these respective periods. Investing activities consist primarily of loan originations and repayments and investment purchases and maturities. These cash usages primarily consisted of loan originations of $22.1 million, as well as investment purchases of $24.4 million. Partially offsetting the usage of investment activities is $14.0 million of proceeds from investment security maturities and repayments. For the same period ended 2001, investing activities used $20.7 million in funds, principally for the net origination of loans and the purchase of investment securities of $17.6 million and $16.6 million, respectively. Such usage of cash was offset by proceeds from repayments and maturities and sales of investment securities of $13.0 million and $2.1 million, respectively. For the same period ended 2000, investing activities used $9.8 million in funds, principally from the net origination of loans of $14.1 million and the purchases of investment securities of $2.6 million. In 2000, these cash usages were offset somewhat by an increase in investment securities repayments and maturities of $4.8 million coupled with a decline in interest-bearing deposits in other institutions from maturities of certificates of deposits of $2.4 million. Financing activities consist of the solicitation and repayment of customer deposits, borrowings and repayments, treasury stock activity, and the payment of dividends. During 2002, net cash provided by financing activities totaled $25.6 million, principally derived from an increase in deposit accounts in general, and savings and time deposits specifically. Also contributing to this influx of cash was proceeds from other borrowings of $7.0 million. During 2001, net cash provided by financing activities totaled $19.0 million, principally derived from an increase in deposit accounts in general, and time deposits specifically. During the same period ended 2000, net cash provided by financing activities was $8.5 million, and consisted of an increase in deposit accounts of $12.1 million that was offset by the net acquisition of treasury stock of $1.3 million and the repayment of other borrowings 41 of $1.7 million. Liquidity may be adversely affected by unexpected deposit outflows, excessive interest rates paid by competitors, and similar matters. Management monitors projected liquidity needs and determines the level desirable, based in part on Middlefield's commitment to make loans, as well as management's assessment of Middlefield's ability to generate funds. Middlefield anticipates that it will have sufficient liquidity to satisfy estimated short-term and long-term funding needs. Capital Resources. Middlefield's primary source of capital has been retained earnings. Historically, Middlefield has generated net retained income to support normal growth and expansion. Management has developed a capital planning policy to not only ensure compliance with regulations, but also to ensure capital adequacy for future expansion. Middlefield is subject to federal regulations imposing minimum capital requirements. Management monitors both Middlefield's and the Bank's Total risk-based, Tier I risk-based and Tier I leverage capital ratios to assess compliance with regulatory guidelines. At December 31, 2002, both Middlefield and the Bank exceeded the minimum risk-based and leverage capital ratio requirements. Middlefield's Total risk-based, Tier I risk-based and Tier I leverage ratios were 16.72%, 15.47%, and 9.42%, and the Bank's were 16.30%, 15.05%, and 9.16%, respectively, at December 31, 2002. New Accounting Pronouncements In August 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("FAS") No. 143, Accounting for Asset Retirement Obligations, which requires that the fair value of a liability be recognized when incurred for the retirement of a long-lived asset and the value of the asset be increased by that amount. The statement also requires that the liability be maintained at its present value in subsequent periods and outlines certain disclosures for such obligations. The adoption of this statement, which is effective January 1, 2003, is not expected to have a material effect on the Company's financial statements. In October 2001, the FASB issued FAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. FAS No. 144 supercedes FAS No. 121 and applies to all long-lived assets (including discontinued operations) and consequently amends APB Opinion No. 30, Reporting Results of Operations - Reporting the Effects of Disposal of a Segment of a Business. FAS No. 144 requires that long-lived assets that are to be disposed of by sale be measured at the lower of book value or fair value less costs to sell. FAS No. 144 is effective for financial statements issued for fiscal years beginning after December 15, 2001 and, generally, its provisions are to be applied prospectively. The adoption of this statement did not have a material effect on the Company's financial statements. In April 2002, the FASB issued FAS No. 145, Recission of FASB Statement No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. FAS No. 145 rescinds FAS No. 4, which required all gains and losses from extinguishment of debt to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect. As a result, the criteria in APB 42 Opinion No. 30 will now be used to classify those gains and losses. This statement also amends FAS No. 13 to require that certain lease modifications that have economic effects similar to sale-leaseback transactions be accounted for in the same manner as sale-leaseback transactions. This statement also makes technical corrections to existing pronouncements, which are not substantive but in some cases may change accounting practice. The provisions of this statement related to the rescission of FAS No. 4 shall be applied in fiscal years beginning after May 15, 2002. Any gain or loss on extinguishments of debt that was classified as an extraordinary item in prior periods presented that does not meet the criteria in APB Opinion No. 30 for classification as an extraordinary item shall be reclassified. Early adoption of the provisions of this statement related to FAS No. 13 shall be effective for transactions occurring after May 15, 2002. All other provisions of this statement shall be effective for financial statements issued on or after May 15, 2002. Early application of this statement is encouraged. The adoption of the effective portions of this statement did not have an impact on the Company's financial position or results of operations. The adoption of the remaining portions of this statement is not expected to have an impact on the Company's financial position or results of operations. In July 2002, the FASB issued FAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. This statement replaces EITF Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring). The new statement will be effective for exit or disposal activities initiated after December 31, 2002, the adoption of which is not expected to have a material effect on the Company's financial statements. On October 1, 2002, the FASB issued FAS No. 147, Acquisitions of Certain Financial Institutions, effective for all business combinations initiated after October 1, 2002. This statement addresses the financial accounting and reporting for the acquisition of all or part of a financial institution, except for a transaction between two or more mutual enterprises. This statement removes acquisitions of financial institutions, other than transactions between two or more mutual enterprises, from the scope of FAS No. 72, Accounting for Certain Acquisitions of Banking or Thrift Institutions, and FASB Interpretation No. 9, Applying APB Opinions No. 16 and 17 When a Savings and Loan Association or a Similar Institution Is Acquired in a Business Combination Accounted for by the Purchase Method. The acquisition of all or part of a financial institution that meets the definition of a business combination shall be accounted for by the purchase method in accordance with FAS No. 141, Business Combinations, and FAS No. 142, Goodwill and Other Intangible Assets. This statement also provides guidance on the accounting for the impairment or disposal of acquired long-term customer-relationship intangible assets (such as depositor and borrower-relationship intangible assets and credit cardholder intangible assets), including those acquired in transactions between two or more mutual enterprises. The adoption of this statement is not expected to have a material effect on the Company's financial statements. On December 31, 2002, the FASB issued FAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure, which amends FAS No. 123, Accounting for Stock-Based Compensation. 43 FAS No. 148 amends the disclosure requirements of FAS No. 123 to require more prominent and more frequent disclosures in financial statements about the effects of stock-based compensation. Under the provisions of FAS No. 123, companies that adopted the preferable, fair value based method were required to apply that method prospectively for new stock option awards. This contributed to a "ramp-up" effect on stock-based compensation expense in the first few years following adoption, which caused concern for companies and investors because of the lack of consistency in reported results. To address that concern, FAS No. 148 provides two additional methods of transition that reflect an entity's full complement of stock-based compensation expense immediately upon adoption, thereby eliminating the ramp-up effect. FAS No. 148 also improves the clarity and prominence of disclosures about the pro forma effects of using the fair value based method of accounting for stock-based compensation for all companies--regardless of the accounting method used--by requiring that the data be presented more prominently and in a more user-friendly format in the footnotes to the financial statements. In addition, the statement improves the timeliness of those disclosures by requiring that this information be included in interim as well as annual financial statements. The transition guidance and annual disclosure provisions of FAS No. 148 are effective for fiscal years ending after December 15, 2002, with earlier application permitted in certain circumstances. The interim disclosure provisions are effective for financial reports containing financial statements for interim periods beginning after December 15, 2002. In November, 2002, the FASB issued Interpretation No. 45, Guarantor's Accounting and Disclosure requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. This interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. This interpretation clarifies that a guarantor is required to disclose (a) the nature of the guarantee, including the approximate term of the guarantee, how the guarantee arose, and the events or circumstances that would require the guarantor to perform under the guarantee; (b) the maximum potential amount of future payments under the guarantee; (c) the carrying amount of the liability, if any, for the guarantor's obligations under the guarantee; and (d) the nature and extent of any recourse provisions or available collateral that would enable the guarantor to recover the amounts paid under the guarantee. This interpretation also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the obligations it has undertaken in issuing the guarantee, including its ongoing obligation to stand ready to perform over the term of the guarantee in the event that the specified triggering events or conditions occur. The objective of the initial measurement of that liability is the fair value of the guarantee at its inception. The initial recognition and initial measurement provisions of this interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor's fiscal year-end. The disclosure requirements in this interpretation are effective for financial statements of interim or annual periods ending after December 15, 2002. Impact of Inflation and Changing Prices Middlefield's consolidated financial statements and related data herein have been prepared in accordance with accounting principles generally accepted in the United States of America, which require measurement of financial condition and results of operations in terms of historical dollars, 44 without considering changes in the relative purchasing power of money over time due to inflation. Because the primary assets and liabilities of Middlefield and the Bank are monetary in nature, changes in the general level of prices for goods and services have a relatively minor impact on total expenses. Increases in operating expenses such as salaries and maintenance are in part attributable to inflation. However, interest rates have a far more significant effect than inflation on the performance of financial institutions, including the Bank. Quantitative and Qualitative Disclosures About Market Risk Like other financial institutions, the Bank is subject to interest rate risk. The Bank's interest-earning assets could mature or reprice more rapidly than or on a different basis from its interest-bearing liabilities (primarily borrowings and deposits with short- and medium-term maturities) in a period of declining interest rates. Although having assets that mature or reprice more frequently on average than liabilities will be beneficial in times of rising interest rates, that asset/liability structure will result in lower net interest income in periods of declining interest rates. Interest rate sensitivity, or interest rate risk, relates to the effect of changing interest rates on net interest income. Interest-earning assets with interest rates tied to the prime rate for example, or that mature in relatively short periods of time, are considered interest-rate sensitive. Interest-bearing liabilities with interest rates that can be repriced in a discretionary manner, or that mature in relatively short periods of time, are also considered interest-rate sensitive. The differences between interest-sensitive assets and interest-sensitive liabilities over various time horizons are commonly referred to as sensitivity gaps. As interest rates change, a sensitivity gap will have either a favorable effect or an adverse effect on net interest income. A negative gap -- with liabilities repricing more rapidly than assets -- generally should have a favorable effect when interest rates are falling, and an adverse effect when rates are rising. A positive gap -- with assets repricing more rapidly than liabilities -- generally should have the opposite effect: an adverse effect when rates are falling and a favorable effect when rates are rising. Middlefield and the Bank have no financial instruments entered into for trading purposes. Interest rates change daily on federal funds purchased and sold. Federal funds are therefore the most sensitive to the market and have the most stable fair values. Loans and deposits tied to indices such as the prime rate or federal discount rate are also market sensitive, with stable fair values. The least sensitive instruments include long-term, fixed-rate loans and securities and fixed-rate savings deposits, which have the least stable fair value. Management of maturity distributions of assets and liabilities between these extremes is as important as the balances maintained. Management of maturity distributions involves matching interest rate maturities as well as principal maturities, and it influences net interest income significantly. In periods of rapidly changing interest rates, a negative or positive gap can cause major fluctuations in net interest income and earnings. Managing asset and liability sensitivities to enhance growth regardless of changes in market conditions is one of the objectives of the Bank's asset/liability management strategy. Evaluating the Bank's exposure to changes in interest rates is the responsibility of the Asset/Liability 45 Committee, a committee of Bank directors and officers. The Asset/Liability Committee assesses both the adequacy of the management process used to control interest rate risk and the quantitative level of exposure, ensuring that appropriate policies, procedures, management information systems, and internal controls are in place to maintain interest rate risk at appropriate levels. Evaluating the quantitative level of interest rate risk exposure requires assessment of existing and potential effects of changes in interest rates on the bank's financial condition, including capital adequacy, earnings, liquidity, and asset quality. The Bank uses a static gap analysis to evaluate the risk associated with changes in interest rates. The table below illustrates the maturities or repricing of the Bank's assets and liabilities at December 31, 2002, based upon the contractual maturity or contractual repricing dates of loans and the contractual maturities of time deposits. Prepayment assumptions have not been applied to fixed-rate mortgage loans. Demand loans, loans having no stated schedule of repayments and no stated maturity, and overdrafts are reported as due in one year or less. Allocation of deposits other than time deposits to the various maturity and repricing periods is based upon management's best estimate, taking into account, among other things, the proposed policy statement issued by federal bank regulators on August 4, 1995. 46
Maturing or Repricing Periods ------------------------------------------------------- (Dollars in thousands) Within 3 1 - 5 Over 5 Months 4 - 12 Months Years Years Total -------- ------------- ------- ------- -------- Interest-earning assets: Interest-bearing deposits in other institutions.. $ 607 $ 27 $ 288 $ 0 $ 922 Investment securities............................ 3,696 17,795 13,907 6,041 41,439 Commercial and industrial loans /(1)/............ 9,408 9,657 10,368 3,483 32,916 Real estate construction loans /(1)/............. 507 1,598 173 929 3,207 Real estate mortgage loans /(1)/................. 26,154 28,551 67,316 11,344 133,365 Consumer installment loans /(1)/................. 829 1,464 2,334 828 5,455 ------- ------- ------- ------- -------- Total interest-earning assets................. $41,201 $59,092 $94,386 $22,625 $217,304 ------- ------- ------- ------- -------- Interest-bearing liabilities: Interest-bearing demand.......................... $ 577 $ 1,804 $ 4,835 $ 0 $ 7,216 Money market..................................... 1,835 5,343 3,483 0 10,661 Savings.......................................... 3,267 12,791 33,219 0 49,277 Time............................................. 16,987 33,456 43,176 0 93,619 Short-term borrowings............................ 786 0 0 0 786 Other borrowings................................. 137 7,853 3,757 3,943 15,690 ------- ------- ------- ------- -------- Total interest-bearing liabilities............ $23,589 $61,247 $88,470 $ 3,943 $177,249 ------- ------- ------- ------- -------- Interest sensitivity gap............................ $17,612 $(2,155) $ 5,916 $18,682 $ 40,055 ======= ======= ======= ======= ======== Cumulative interest sensitivity gap................. $17,612 $15,457 $21,373 $40,055 Cumulative interest sensitivity gap as a percent of total assets..................... 7.78% 6.83% 9.45% 17.70%
/(1)/For purposes of the gap analysis, loans are not reduced by the allowance for loan losses and nonperforming loans. The Bank's policy is that the one-year cumulative interest rate sensitivity gap should generally be within a range of negative 20% to positive 20%. As the table above shows, the one-year gap was within this range as of December 31, 2002, with a positive one-year gap of 6.83%. The cumulative gap at December 31, 2002 is due principally to fixed-rate securities and loans in the "over one year to five years" category to maximize yield on assets. One way to minimize interest rate risk is to maintain a balanced or matched interest-rate sensitivity position. However, profits are not always maximized by matched funding. To increase net interest income, the Bank selectively mismatches asset and liability repricing to take advantage of short-term interest rate movements. The magnitude of the mismatch depends on a careful assessment of the risks presented by forecasted interest rate movements. The risk inherent in such a mismatch, or gap, is that interest rates might not move as anticipated. Interest rate risk exposure is reviewed in quarterly meetings of the Asset/Liability Committee. At each meeting, guidelines are established for the following quarter and longer- 47 term exposure. Risk is mitigated by matching maturities or repricing more closely. The Bank does not use derivative financial instruments to manage interest rate risk. Limitations are inherent in any method of measuring interest rate risk. Actual results can differ significantly from simulated results if, for example, market conditions and management strategies vary from the assumptions used in the analysis. The static "gap" analysis is based on assumptions concerning such matters as when assets and liabilities will reprice in a changing interest rate environment. Because these assumptions are no more than estimates, certain assets and liabilities indicated as maturing or repricing within a stated period might actually mature or reprice at different times and at different volumes from those estimated. The actual prepayments and withdrawals experienced by the Bank after a change in interest rates could deviate significantly from those assumed in calculating the data shown in the table. Adjustable-rate loans, for example, commonly have provisions that limit changes in interest rates each time the interest rate changes and on a cumulative basis over the life of the loan. Also, the renewal or repricing of some assets and liabilities can be discretionary and subject to competitive and other pressures. The ability of many borrowers to service their debt could diminish after an interest rate increase. Therefore, the gap table above does not and cannot necessarily indicate the actual future impact of general interest movements on net interest income. Middlefield's use of a simulation model to better measure the impact of interest rate changes on net interest income is incorporated into the risk management process to effectively identify, measure, and monitor Middlefield's risk exposure. Interest rate simulations using a variety of assumptions are employed by Middlefield to evaluate its interest rate risk exposure. A shock analysis at December 31, 2002 indicated that a 200 basis point movement in interest rates in either direction would have had a minor impact on Middlefield's anticipated net interest income and the market value of assets and liabilities over the next 12 months, well within Middlefield's ability to manage effectively. Market for Middlefield's Common Equity and Related Stockholder Matters 48 Middlefield had approximately 650 stockholders of record as of March 1, 2003. There is no established market for Middlefield common stock. The stock is traded very infrequently. Bid prices are quoted from time to time on the National Quotation Bureau's "pink sheets" under the symbol "MBCN." The following table shows the high and low bid prices of and cash dividends paid on Middlefield common stock in 2002 and 2001, adjusted for stock splits and stock dividends. This information does not reflect retail mark-up, mark-down or commissions, and does not necessarily represent actual transactions. Cash dividends High bid Low bid per share -------- -------- -------------- 2002: First Quarter................ $ 24.829 $ 22.857 $ 0.171 Second Quarter............... $ 27.000 $ 23.581 $ 0.180 Third Quarter................ $ 34.000 $ 26.150 $ 0.190 Fourth Quarter............... $ 34.000 $ 26.300 $ 0.200 2001: First Quarter................ $ 28.500 $ 24.000 $ 0.133 Second Quarter............... $ 28.500 $ 27.500 $ 0.133 Third Quarter................ $ 27.500 $ 23.250 $ 0.133 Fourth Quarter............... $ 25.500 $ 24.000 $ 0.267 Because Middlefield is dependent on its bank subsidiary for earnings and funds necessary to pay dividends, the ability of Middlefield to pay dividends to its stockholders is subject to bank regulatory restrictions. 49