EX-13 2 g00399exv13.txt EX-13 ANNUAL REPORT TO STOCKHOLDERS FOR FISCAL YEAR ENDED DECEMBER 31, 2005 EXHIBIT 13 FORWARD-LOOKING STATEMENTS This annual report contains forward-looking statements that are based on assumptions and may describe future plans, strategies and expectations of Tri-County Financial Corporation (the "Company") and Community Bank of Tri-County (the "Bank"). These forward-looking statements are generally identified by use of the words "believe," "expect," "intend," "anticipate," "estimate," "project" or similar expressions. The Company and the Bank's ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors that could have a material adverse effect on the operations of the Company and its subsidiaries include, but are not limited to, changes in interest rates, national and regional economic conditions, legislative and regulatory changes, monetary and fiscal policies of the U.S. government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality and composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Company and the Bank's market area, changes in real estate market values in the Company and the Bank's market area, and changes in relevant accounting principles and guidelines. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Except as required by applicable law or regulation, the Company does not undertake, and specifically disclaims any obligation, to release publicly the result of any revisions that may be made to any forward-looking statements to reflect events or circumstances. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW Since its conversion to a commercial bank charter in 1997, the Bank has sought to increase total assets as well as certain targeted loan types. The Bank feels that its ability to offer fast, flexible and local decision-making in the commercial, commercial real estate and consumer loan areas will continue to attract significant new loans and enhance asset growth. The Bank's local focus and targeted marketing is also directed towards increasing its balances of consumer and business transaction deposit accounts. The Bank believes that increases in these account types will lessen the Bank's dependence on time deposits, such as certificates of deposit, to fund loan growth. Although management believes that the strategy outlined above will increase financial performance over time, we recognize that products, such as commercial lending and transaction accounts, will also increase the Bank's noninterest expense. We also recognize that certain lending and deposit products also increase the possibility of losses from credit and other risks. In December 2004 and December 2005, the Company declared three for two stock splits in the form of a stock dividend. All per share numbers in the following discussion reflect retroactive application of the stock splits. CRITICAL ACCOUNTING POLICIES The Company's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and the general practices of the United States banking industry. Application of these principles requires management to make estimates, assumptions and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available as of the date of the financial statements. Accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. The Company considers its determination of the allowance for loan losses and the valuation allowance on its foreclosed real estate to be critical accounting policies. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available. When these sources are not available, management makes estimates based upon what it considers to be the best available information. 1 The allowance for loan losses is an estimate of the losses that may be sustained in the loan portfolio. The allowance is based on two principles of accounting: (a) Statement on Financial Accounting Standards ("SFAS") No. 5, "Accounting for Contingencies," which requires that losses be accrued when they are probable of occurring and are estimable and (b) SFAS No. 114, "Accounting by Creditors for Impairment of a Loan," which requires that losses be accrued when it is probable that the Company will not collect all principal and interest payments according to the contractual terms of the loan. The loss, if any, is determined by the difference between the loan balance and the value of collateral, the present value of expected future cash flows, or values observable in the secondary markets. The loan loss allowance balance is an estimate based upon management's evaluation of the loan portfolio. Generally the allowance is comprised of a specific and a general component. The specific component consists of management's evaluation of certain classified loans and their underlying collateral. Loans are examined to determine a specific allowance based upon the borrower's payment history, economic conditions specific to the loan or borrower, or other factors that would impact the borrower's ability to repay the loan on its contractual basis. Management assesses the ability of the borrower to repay the loan based upon any information available. Depending on the assessment of the borrower's ability to pay the loan as well as the type, condition, and amount of collateral, management will establish an allowance amount specific to the loan. In establishing the general component of the allowance, management analyzes non-classified and non-impaired loans in the portfolio including changes in the amount and type of loans. Management also examines the Bank's history of write-offs and recoveries within each loan category. The state of the local and national economy is also considered. Based upon these factors, the Bank's loan portfolio is categorized and a loss factor is applied to each category. These loss factors may be higher or lower than the Bank's actual recent average losses in any particular loan category, particularly in loan categories where the Bank is rapidly increasing the size of its portfolio. Based upon these factors, the Bank will adjust the loan loss allowance by increasing or decreasing the provision for loan losses. Management has significant discretion in making the judgments inherent in the determination of the provision and allowance for loan losses, including in connection with the valuation of collateral, a borrower's prospects of repayment and in establishing allowance factors on the general component of the allowance. Changes in allowance factors will have a direct impact on the amount of the provision and a corresponding effect on net income. Errors in management's perception and assessment of the global factors and their impact on the portfolio could result in the allowance not being adequate to cover losses in the portfolio, and may result in additional provisions or charge-offs. For additional information regarding the allowance for loan losses, refer to Notes 1 and 4 to the Consolidated Financial Statements and the discussion under the caption "Provision for Loan Losses" below. In addition to the loan loss allowance the Company also maintains a valuation allowance on its foreclosed real estate. As with the allowance for loan losses, the valuation allowance on foreclosed real estate is based on SFAS No. 5, "Accounting for Contingencies," as well as SFAS No. 144 "Accounting for the Impairment or Disposal of Long-Lived Assets." These statements require that the Company establish a valuation allowance when it has determined that the carrying amount of a foreclosed asset exceeds its fair value. Fair value of a foreclosed asset is measured by the cash flows expected to be realized from its subsequent disposition. These cash flows should be reduced for the costs of selling or otherwise disposing of the asset. In estimating the cash flows from the sale of foreclosed real estate, management must make significant assumptions regarding the timing and amount of cash flows. In cases where the real estate acquired is undeveloped land, management must gather the best available evidence regarding the market value of the property, including appraisals, cost estimates of development, and broker opinions. Due to the highly subjective nature of this evidence, as well as the limited market, long time periods involved, and substantial risks, cash flow estimates are highly subjective and subject to change. Errors regarding any aspect of the costs or proceeds of developing, selling, or otherwise disposing of foreclosed real estate could result in the allowance being inadequate to reduce carrying costs to fair value and may require an additional provision for valuation allowances. COMPARISON OF RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003 GENERAL. For the year ended December 31, 2005, the Company reported consolidated net income of $3,979,343 ($2.30 basic and $2.16 diluted earnings per share) compared to consolidated net income of $3,719,834 ($2.16 basic and $2.07 diluted earnings per share) for the year ended December 31, 2004. The increase in net income for 2005 2 was primarily attributable to an increase in net interest income, a decline in provision for loan loss, and a small increase in noninterest income which was partially offset by increases in noninterest expenses. The Bank also substantially increased its loan portfolio and lower cost deposit balances. In 2005, the Bank used increases in loan and deposit balances to reduce securities and wholesale borrowings balances. In 2005, the Bank also used funds from the issuance of $5 million in trust preferred securities to further increase assets. These changes led to further increases in net interest income in 2005. Provision for loan losses declined in 2005 from 2004 levels as loan growth in certain areas declined and the Bank maintained an excellent record in loan quality. Noninterest income increased in 2005 because the Bank had recognized a decline in the value of certain securities in 2004 while no recognition was required in 2005. Noninterest expenses increased primarily due to increases in personnel, occupancy, data processing and professional fees. Income tax expenses increased by $610,950, or 42.40%, in 2005. For the year ended December 31, 2004, net interest income was $13,799,929 compared to $10,468,526 for the year ended December 31, 2003, an increase of $3,331,403 or 31.82%. In 2004, the Bank used funds from the issuance of $7 million of trust preferred securities and wholesale borrowing to purchase certain securities. Provision for loan losses increased by $136,035, or 42.92% due to an increase in the size of the loan portfolio. Noninterest income declined as the Bank had a large decline in gains on selling loans held for sale and a temporary decline in the market value of certain marketable securities, offset by an increase in service charges. Noninterest expenses increased by $1,340,648, or 15.91%, to $9,768,419. Increases in noninterest expenses were primarily the result of increases in salary and employee benefits expenses due to additional employees. Income tax expense increased by 39.57% to $1,440,994. NET INTEREST INCOME. The primary component of the Company's net income is its net interest income, which is the difference between income earned on assets and interest paid on the deposits and borrowings used to fund them. Net interest income is determined by the spread between the yields earned on the Company's interest-earning assets and the rates paid on interest-bearing liabilities as well as the relative amounts of such assets and liabilities. Net interest income, divided by average interest-earning assets, represents the Company's net interest margin. Net interest income for the year ended December 31, 2005 was $15,571,081 compared to $13,799,929 for the year ended December 31, 2004 and $10,468,526 for the year ended December 31, 2003. The $1,771,152 increase in the most recent year was due an increase in interest income of $7,541,373, partially offset by the increase in interest expense of $5,770,221. For the year ended December 31, 2004, the $3,331,403 increase was due to an increase of $5,448,414 in interest income offset by an increase of $2,117,011 in interest expense for the same period. Changes in the components of net interest income due to changes in average balances of assets and liabilities and to changes caused by changes in interest rates are presented in the rate volume analysis below. During 2005, the Company's interest-rate spread declined because the Bank's yield on interest-earning assets increased at a slower rate than the increase in costs for interest-bearing liabilities. The Bank's yield on loans increased as rates on certain loan types, particularly those based on the prime rate, increased as the Federal Reserve increased short-term interest rates. The Company's investment securities yields increased at a much slower rate than loans, as most of the investments are fixed rate, and the Company did not make significant purchases of investments after the first quarter of 2005. The cost of both wholesale borrowings and deposits increased from 2004 due to the Federal Reserve increasing interest rates. During 2004, the Company's interest-rate spread declined because the Bank's yield on interest earning assets fell while its cost for interest-bearing liabilities was the same. The Bank's yield on loans declined due to the continued pay off of higher interest rate loans in its portfolio. These loans were generally replaced by lower rate loans. The Bank's investment yield increased during 2004 as the Bank purchased securities with a longer maturity, which resulted in a higher yield. While the cost of both deposits and borrowings fell, the proportion of total interest-bearing liabilities that were represented by higher cost borrowings increased, leading to a stable average cost in 2004 compared to 2003. The following table presents information on the average balances of the Company's interest-earning assets and interest-bearing liabilities and interest earned or paid thereon for the past three fiscal years. 3 Net Interest Income and Margin Analysis (Dollars in Thousands) For the Year Ended December 31,
---------------------------------------------------------------------------------------- 2005 2004 2003 ---------------------------- --------------------------- --------------------------- AVERAGE AVERAGE AVERAGE AVERAGE YIELD/ AVERAGE YIELD/ AVERAGE YIELD/ BALANCE INTEREST COST BALANCE INTEREST COST BALANCE INTEREST COST ------- -------- ----- ------- -------- ------- --------- -------- ---- ASSETS Interest-earning assets Loan portfolio(1) $ 332,348 $ 22,358 6.73% $ 254,605 $ 16,033 6.30% $ 201,440 $ 13,412 6.66% Investment securities, federal funds sold and interest-bearing deposits 178,095 6,797 3.82 147,274 5,580 3.79 93,261 2,753 2.95 --------- -------- --------- -------- --------- -------- Total interest-earning assets 510,443 29,155 5.71 401,879 21,613 5.38 294,701 16,165 5.49 Cash and cash equivalents 5,437 2,937 2,648 Other assets 19,262 17,807 10,088 --------- --------- --------- Total assets $ 535,142 $ 422,623 $ 307,437 ========= ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY Interest-bearing liabilities Savings $ 36,696 $ 216 0.59% $ 37,776 $ 176 0.47 $ 32,772 $ 166 0.51% Interest-bearing demand and money market accounts 89,394 1,387 1.55 85,212 755 0.89 67,346 442 0.66 Certificates of deposit 146,512 4,869 3.32 93,267 2,298 2.46 82,248 2,260 2.75 Long-term debt 93,409 3,966 4.25 73,830 3,280 4.44 60,024 2,732 4.55 Short-term debt 82,665 2,565 3.10 64,736 1,164 1.80 7,568 96 1.26 Guaranteed preferred beneficial interest in junior subordinated debentures 9,916 581 5.86 3,255 140 4.31 - - - --------- -------- --------- -------- --------- -------- Total interest-bearing liabilities 458,592 13,584 2.96 358,076 7,813 2.18 249,958 5,696 2.28 Noninterest-bearing demand deposits 39,855 32,909 30,277 Other liabilities 4,474 3,178 1,415 Stockholders' equity 32,221 28,460 25,788 --------- --------- --------- Total liabilities and stockholders' equity $ 535,142 $ 422,623 $ 307,438 ========= ========= ========= Net interest income $ 15,571 $ 13,800 $ 10,469 ======== ======== ======== Interest rate spread 2.75% 3.20% 3.21% ====== ====== ====== Net yield on interest-earning assets 3.05% 3.43% 3.55% ====== ====== ====== Ratio of average interest-earning assets to average interest-bearing liabilities 111.31% 112.23% 117.90% ====== ====== ======
(1) Average balance includes non-accrual loans. 4 The table below sets forth certain information regarding changes in interest income and interest expense of the Bank for the periods indicated. For each category of interest-earning asset and interest-bearing liability, information is provided on changes attributable to (1) changes in volume (changes in volume multiplied by old rate); and (2) changes in rate (changes in rate multiplied by old volume). Changes in rate-volume (changes in rate multiplied by the change in volume) have been allocated to changes due to volume.
YEAR ENDED DECEMBER 31, 2005 YEAR ENDED DECEMBER 31, 2004 COMPARED TO YEAR ENDED COMPARED TO YEAR ENDED DECEMBER 31,2004 DECEMBER 31,2003 DUE TO DUE TO ---------------------------- ---------------------------- VOLUME RATE TOTAL VOLUME RATE TOTAL ------- ------- ------- -------- ------- ------- Interest income Loan portfolio $ 5,231 $ 1,094 $ 6,325 $ 3,352 $ (731) $ 2,621 Investment securities, federal funds sold and interest bearing deposits 1,176 41 1,217 2,045 782 2,827 ------- ------- ------- -------- ------- ------- Total interest-earning assets 6,407 1,135 7,542 5,397 51 5,448 ------- ------- ------- -------- ------- ------- Interest-bearing liabilities Savings (7) 47 40 23 (13) 10 Interest-bearing demand and money market accounts 65 567 632 158 155 313 Certificates of deposit 1,770 801 2,571 272 (234) 38 Noninterest-bearing demand deposits Long-term debt 831 (145) 686 613 (65) 548 Short-term debt 556 845 1,401 1,028 40 1,068 Guaranteed preferred beneficial interest in junior subordinated debentures 391 50 441 140 - 140 ------- ------- ------- -------- ------- ------- Total interest-bearing liabilities 3,606 2,165 5,771 2,234 (117) 2,117 ------- ------- ------- -------- ------- ------- Net change in net interest income $ 2,801 $(1,030) $ 1,771 $ 3,163 $ 168 $ 3,331 ======= ======= ======= ======== ======= =======
PROVISION FOR LOAN LOSSES. Provision for loan losses for the year ended December 31, 2005 was $329,467, compared to $452,998 and $316,963 for the years ended December 31, 2004 and 2003, respectively. The loan loss provision declined in 2005 as the Bank continued to have excellent results in loan quality measures such as write-offs and delinquency. For the year ended December 31, 2005, the Company recorded net charge-offs of $4,000 (.001% of average loans) compared to net recoveries of $32,000 (.01% of average loans) in 2004 and net charge off of $58,000 (0.03% of average loans) in 2003. The loan loss allowance and the provision for loan losses is determined based upon an analysis of individual loans and the application of certain loss factors to different loan categories. Individual loans are analyzed for impairment as the facts and circumstances warrant. In addition, a general component of the loan loss allowance is added based on a review of the portfolio's size and composition. At December 31, 2005, the allowance for loan loss equaled 573% of non-accrual and past due loans compared to 453% and 678% at December 31, 2004 and 2003, respectively. 5 NONINTEREST INCOME.
YEARS ENDED DECEMBER 31, % CHANGE % CHANGE ---------------------------------------- 2005 vs. 2004 vs. 2005 2004 2003 2004 2003 ----------- ----------- ----------- ---------- ---------- Loan appraisal, credit, and miscellaneous charges $ 178,424 $ 229,125 $ 261,387 (22.13)% (12.34)% Net gain on sale of loans held for sale - 21,404 505,435 (100.00) (96.00) Income from bank owned life insurance 251,220 261,411 230,607 (3.90) 13.36 Service charges 1,186,184 1,189,001 695,128 (0.24) 71.05 Gain on sale of asset 39,756 8,250 - 381.89 - Loss on the sale of investment securities (14,581) (61,875) - (76.43) - Recognition of other than temporary decline in value of marketable securities - (65,000) - (100.00) - Other - - 61,981 - (100.00) ----------- ----------- ----------- Total noninterest income $ 1,641,003 $ 1,582,316 $ 1,754,538 3.71 % (9.82)% =========== =========== ===========
Changes in noninterest income over the past three years have been the result of wide fluctuations in certain noninterest income categories including gain on sale of loans, other income, service charges, and loan fees. Loan appraisal, credit and miscellaneous charges are highly variable. Increases and decreases in this category reflect changes in lending volumes and patterns as well as competitive pressures. Gain on sale of loans held for sale has been highly variable reflecting the overall interest rate environment and the Bank's desire to keep certain loans in its portfolio. Gain on the sale of loans decreased in 2005 due to the Bank's decision to not sell its loans to third party investors in 2005. Income from bank owned life insurance (BOLI) has been stable in the last year as BOLI balances have not increased appreciably. BOLI income increased from 2003 to 2004 as the BOLI purchase was made in 2003 and 2004 reflects a full year of ownership. Service charges and fees are primarily generated by the Bank's ability to attract and retain transaction-based deposit accounts and by loan servicing fees net of amortization of and valuation allowances on mortgage servicing rights. In 2005, service charges were comparable to the prior year, reflecting the Bank's higher balances of transaction deposits, offset by lower balances of loans serviced for others and slightly lower average fees per transaction deposit reflecting the Bank's response to market pressures to limit certain transaction fees. In 2004, service charges reflected higher deposit volumes and lower total amortization of mortgage servicing rights. In 2005, the smaller loss on the sale of securities reflected a lower volume of sales of securities in 2005. NONINTEREST EXPENSES.
YEARS ENDED DECEMBER 31, % CHANGE % CHANGE ------------------------------------------ 2005 vs. 2005 vs. 2005 2004 2003 2004 2004 ------------ ----------- ----------- --------- --------- Salary and employee benefits $ 5,849,226 $ 5,432,898 $ 4,702,181 7.66% 15.54% Occupancy expense 1,156,775 858,891 750,567 34.68 14.43 Advertising 411,811 539,715 308,951 (23.70) 74.69 Data processing expense 665,981 550,781 403,967 20.92 36.34 Depreciation of furniture, fixtures, and equipment 452,037 372,237 507,236 21.44 (26.61) Telephone communications 85,436 103,421 166,553 (17.39) (37.91) Valuation allowance on foreclosed real estate - 114,606 - (100.00) - ATM expenses 277,566 345,454 274,188 (19.65) 25.99 Office supplies 138,407 151,862 131,228 (8.86) 15.72 Professional fees 629,126 261,458 185,188 140.62 41.19 Office equipment expenses 50,318 90,520 129,849 (44.41) (30.29) Other 1,134,647 946,576 867,863 19.87 9.07 ------------ ----------- ----------- Total noninterest expenses $ 10,851,330 $ 9,768,419 $ 8,427,771 11.09% 15.91% ============ =========== ===========
6 The increases reflect growth in the Bank's workforce to fully staff branches, an increasing need for highly skilled employees due to the higher complexity level of the Bank's business, and continued increases in the Bank's benefit and incentive costs. Expenses also included certain supplemental retirement benefits, which were funded by the BOLI income. In 2005, occupancy expenses reflected the opening of a new branch as well as continuing repairs and maintenance to existing locations. In 2004, occupancy expenses reflected the refurbishment of certain offices and other renovation costs. Advertising expenses have fluctuated during the three-year period. In 2005, advertising expenses declined as certain ad campaigns were curtailed. In 2004, advertising costs reflected several major advertising campaigns and marketing efforts. The increases in data processing costs are reflective of the Bank's increased size of the loan and deposit portfolios as well as increases in certain third party processing costs related to data processing. In 2005, depreciation of furniture, fixtures, and equipment increased as the Bank opened a new branch requiring major purchases of these items adding to the amount of assets being depreciated. In 2004, depreciation declined as certain assets purchased in 2001 and 2002 in anticipation of the 2002 systems conversion were fully depreciated in early 2004. Telephone communications expenses decreased reflecting changes in vendors and renegotiation of vendor contracts. In 2004, ATM expenses included costs relating to a systems conversion, which were nonrecurring. Office supplies expense decreased in 2005 due to a major overhaul of certain marketing materials was carried out which increased expenses in 2004. Professional fees including accounting, legal, consulting and other fees, has increased substantially over the last three years. These expenses reflected increased levels of outside resources relating to efforts to prepare the Company for the reporting requirements of the Sarbanes-Oxley legislation. Substantial resources were also expended in 2005 and 2004 to provide outsourced internal audit services. Office equipment expenses decreased as a result of declining needs for certain specialized equipment, which is no longer needed after our systems conversion. Other noninterest expense increased due to the growing size of the Bank. INCOME TAX EXPENSE. During the year ended December 31, 2005, the Company recorded income tax expense of $2,051,944 compared to expenses of $1,440,994 and $1,032,432 in the two prior years. The Company's effective tax rates for the years ended December 31, 2005, 2004, and 2003 were 34.02%, 27.92% and 29.68%, respectively. The 2005 effective tax rate increased as the 2004 effective rate reflected a large donation of property made in 2004. The decline in the effective tax rate from 2003 to 2004 also reflected this donation. COMPARISON OF FINANCIAL CONDITION AT DECEMBER 31, 2005 AND 2004 In 2005, the Bank used the payments received from the maturation and repayment of its investment securities portfolio to make loans. The Bank also increased retail deposits and used the funds to pay down short term wholesale borrowings as well as to increase earning assets. In 2005, the Company, through a trust subsidiary, sold trust preferred securities totaling $5,000,000 and invested the proceeds in the Bank. These proceeds were used primarily to make loans. In 2005, cash and due from banks increased to $7,262,547 from $6,018,096 in 2004, an increase of $1,244,451 or 20.68%. Interest-bearing deposits with banks increased by 34.36% or $3,751,711. Due to higher cash operating needs caused by higher loan activity, the Bank has increased its total cash. Securities available for sale fell by $5,770,077, or 44.56%, and securities held to maturity fell by $46,254,470 or 28.42% to $116,486,685. Generally the proceeds of the maturation and repayment securities in both portfolios were used to make loans. The Company purchased $25,758,903 of securities during 2005. Total securities balances decreased by $52,024,547 or 29.61%. Stock in the Federal Home Loan Bank increased due to stock purchases made necessary by increased Federal Home Loan Bank borrowing levels. Loans receivable increased by $80,267,202 or 27.74%, as the Bank continued to build assets in 2005 to increase net interest income. Loan growth was concentrated in the following loan types: commercial real estate, residential real estate, commercial business loans and construction and land development. The growth in these particular types of loans reflect strong market demand and the Bank's concentration on these areas. Other lending products such as consumer lending have not been emphasized due to declining margins brought about by competitors such as captive finance companies. Premises and equipment increased to $6,460,545 from $6,011,913 an increase of 7.46% or $448,632. This increase was due to the costs of a new branch and some renovations at our home office. BOLI increased due to the retention of income in the policies. Accrued interest receivable increased due to higher interest 7 earning asset balances. Other assets increased to $2,487,280 due to an increase in certain prepaid tax accounts. In 2005, total liabilities increased by $32,065,771 or 6.76%. Deposits increased to $363,373,740 at December 31, 2005 compared to $266,754,504 for the prior year. Both noninterest and interest-bearing deposit totals increased due to the Bank's continued marketing efforts. Short-term borrowings declined, as the Bank replaced short-term borrowings with deposits and long-term debt. The decrease in short-term borrowing was $95,229,235 or 82.59%. Long-term debt increased by $24,892,646 or 30.02%. The Company completed a trust preferred issue of $5,000,000 in 2005. The proceeds were used to increase the Bank's equity and support a larger asset base. The Company experienced a $3,454,581, or 11.10%, increase in stockholders' equity for the year ended December 31, 2005. The increase in stockholders' equity was attributable to the retention of earnings from the period of $3,979,343, less cash dividends of $930,669. Equity was also increased by the exercise of stock options totaling $259,986 as well as by the proceeds of a private placement totaling $473,040. Other increases included the tax effects of the exercise of non-incentive stock options of $44,662 and changes in ESOP shares of $60,389. These increases were partially offset by a decline in accumulated other comprehensive income of $136,778 and the repurchase of 10,012 shares of common stock (adjusted to reflect the 3-for -2 stock split) at a cost of $295,393. ASSET/LIABILITY MANAGEMENT Net interest income, the primary component of the Company's net income, arises from the difference between the yield on interest-earning assets and the cost of interest-bearing liabilities and the relative amounts of such assets and liabilities. The Company manages its assets and liabilities by coordinating the levels of and gap between interest-rate sensitive assets and liabilities to control changes in net interest income and in the economic value of its equity despite changes in market interest rates. Among the tools used to monitor interest rate risk is a "gap" report which measures the dollar difference between the amount of interest-earning assets and interest-bearing liabilities subject to repricing within a given time period. A gap is considered negative when the amount of interest rate sensitive liabilities exceeds the amount of interest rate sensitive assets. Generally, during a period of rising interest rates, an institution with a negative gap position would be in a worse position to invest in higher-yielding assets which, consequently may result in the yield on interest-earning assets increasing at a slower rate than its cost of interest-bearing liabilities than if it had a positive gap. While, conversely, during a period of falling interest rates, an institution with a negative gap would tend to have its interest-earning assets repricing downward at a slower rate than its interest-rate liabilities as compared to an institution with a positive gap which, consequently, may tend to adversely affect net interest income. The following sets forth the amounts of interest-earning assets and interest-bearing liabilities outstanding at December 31, 2005, which are anticipated by the Company, based on certain assumptions, to reprice or mature in each of the future time periods shown: 8
OVER OVER ONE OVER ZERO TO THREE TO THROUGH FIVE NON-SENSITIVE THREE MONTHS 12 MONTHS FIVE YEARS YEARS FUNDS TOTAL ------------ --------- ---------- -------- ------------- --------- (DOLLARS IN THOUSANDS) ASSETS Cash and due from banks $ - $ - $ - $ - $ 7,263 $ 7,263 Interest-bearing deposits 14,672 - - - - 14,672 Fed funds sold 641 - - - - 641 Securities 51,034 20,923 47,001 4,708 - 123,666 Loans 106,875 26,368 143,865 96,471 (3,987) 369,592 Other assets - - - - 25,453 25,453 ---------- -------- --------- ------- --------- -------- Total assets 173,222 47,291 190,866 101,179 28,729 541,287 LIABILITIES Noninterest-bearing deposits - - - - 44,325 44,325 Interest-bearing demand deposits 48,666 - - - - 48,666 Money market deposits 40,196 - - - - 40,196 Savings 34,801 - - - - 34,801 Certificates of deposit 23,494 104,382 67,479 31 - 195,386 Short-term debt 20,075 - - - 20,075 Long-term debt 5,000 7,000 40,000 55,824 107,824 Guaranteed preferred beneficial interest in junior subordinated debentures 12,000 - - - - 12,000 Other liabilities - - - - 3,437 3,437 STOCKHOLDERS' EQUITY - - - - 34,578 34,578 ---------- -------- --------- ------- --------- -------- Total liabilities and stockholders' equity 184,232 111,382 107,479 55,855 82,340 541,287 Gap (11,010) (64,091) 83,387 45,324 (53,611) - Cumulative gap (11,010) (75,101) 8,286 53,610 - - Cumulative gap as a percentage of total assets (2.03)% (13.87)% 1.53% 9.90% - -
The foregoing analysis assumes that the Bank's assets and liabilities move with rates at their earliest repricing opportunities based on final maturity. Mortgage-backed securities are assumed to mature during the period in which they are estimated to prepay and it is assumed that loans and other securities are not called nor do they prepay prior to maturity. Certificates of deposit and IRA accounts are presumed to reprice at maturity. NOW and savings accounts are assumed to reprice within three months although it is the Company's experience that such accounts may be less sensitive to changes in market rates. The Bank has an excess of liabilities over assets repricing or maturing within one year. This would indicate that the Bank's net interest income would decline if interest rates were to increase. The cumulative one year gap has become less negative both in dollars and as a percentage of total assets in the last year. This change was primarily caused by a decline in the Bank's level of funding provided by short term borrowing. The Bank has also increased the level of adjustable rate loans on its balance sheet which has also caused a decline in the negative gap. A decrease in net interest income as a result of a general increase in rates is likely, but the Bank has the ability to moderate the effect of a general increase in interest rates by controlling increases in rates on transaction accounts, using available cash to reduce the amounts in particularly rate sensitive liability accounts, and increasing total assets through increased leverage. In addition, the analysis above substantially understates the amount of loan prepayments the Bank has historically experienced even in periods of rising interest rates. 9 LIQUIDITY AND CAPITAL RESOURCES The Company currently has no business other than holding the stock of the Bank and engaging in certain passive investments and does not currently have any material funding requirements, except for payment of interest on subordinated debentures, the payment of dividends and the repurchase of stock. The Company's principal sources of liquidity are cash on hand and dividends received from the Bank. The Bank is subject to various regulatory restrictions on the payment of dividends. The Bank's principal sources of funds for investment and operations are net income, deposits from its primary market area, borrowings, principal and interest payments on loans, interest received on investment securities and proceeds from the maturity and sale of investment securities. Its principal funding commitments are for the origination or purchase of loans, the purchase of securities, and the payment of maturing deposits. Deposits are considered the primary source of funds supporting the Bank's lending and investment activities. The Bank also uses borrowings from the FHLB of Atlanta to supplement deposits. The amount of FHLB advances available to the Bank is limited to the lower of 40% of Bank assets or the amount supportable by eligible collateral including FHLB stock, current residential first mortgage loans, and certain securities. The Bank's most liquid assets are cash, cash equivalents, and federal funds sold. The levels of such assets are dependent on the Bank's operating, financing and investment activities at any given time. The variations in levels of cash and cash equivalents are influenced by deposit flows and anticipated future deposit flows. Cash, cash equivalents, and interest-bearing deposits as of December 31, 2005 totaled $22,575,240, an increase of $4,839,461, or 27.43%, from the December 31, 2004 total of $17,715,779. This increase was due to the Bank's increase in deposits and long-term borrowings. The Bank's principal sources of cash flows are its financing activities including deposits and borrowings. During 2005, all financing activities provided $30,894,663 in cash compared to $149,495,359 during 2004 and $68,939,687 during 2003. The decrease in cash flows from financing activities during the most recent period was principally due to a sharp decrease in borrowing activity in 2005. The proceeds of long-term borrowing remained constant at $30,000,000 in 2005 compared to $30,000,000 in 2004, and increased from $15,000,000 in 2003. In 2005, short-term borrowing decreased by $95,229,235. By contrast, in 2004, short-term borrowing provided a net increase in cash of $84,112,925 and in 2003, $30,438,987. During 2005, net deposit growth was $96,619,236 compared to $39,199,936 in 2004, and $24,529,456 in 2003. In 2005, the Company also issued subordinated debentures in the amount of $5,000,000 compared to $7,000,000 in 2004, the proceeds of which were invested in the Bank. The Bank also receives cash from its operating activities which provided $5,242,895 in 2005 compared to cash flows of $6,290,408 and $2,982,991 during 2004 and 2003, respectively. The Bank's principal use of cash has been in investing activities including its investments in loans for portfolio, investment securities and other assets. In 2005, the level of investing declined from the totals of 2004 and 2003. During the year ended December 31, 2005, the Bank invested a total of $31,278,097, compared to $150,239,788 in 2004 and $85,289,663 in 2003. The principal reason for the decline in cash used in investing activities was a decrease in the purchase of investments. Federal banking regulations require the Company and the Bank to maintain specified levels of capital. At December 31, 2005, the Company was in compliance with these requirements with a leverage ratio of 8.55%, a Tier 1 risk-based capital ratio of 11.04% and total risk-based capital ratio of 11.84%. At December 31, 2005, the Bank met the criteria for designation as a well-capitalized depository institution under FRB regulations. See Note 14 of the consolidated financial statements. OFF BALANCE SHEET ARRANGEMENTS In the normal course of its business, the Bank has committed to make credit available to its borrowers under various loan and other agreements provided that certain terms and conditions are met. For a discussion of these agreements including collateral and other arrangements see Note 11 to the consolidated financial statements. 10 CONTRACTUAL OBLIGATIONS In the normal course of its business, the Bank commits to make future payments to others to satisfy contractual obligations. These commitments include commitments to repay short and long-term borrowings, and commitments incurred under operating lease agreements. These commitments are summarized below:
PAYMENTS DUE BY PERIOD (IN THOUSANDS) LESS THAN ONE TO THREE TO MORE THAN TOTAL ONE YEAR THREE YEARS FIVE YEARS FIVE YEARS Long term debt obligations $107,824 $ 12,000 $ 5,000 $ 35,000 $ 55,824 Short term debt obligations 20,075 20,075 - - - Deposits 363,374 295,864 55,688 11,822 - Purchase obligations 1,729 765 964 - - Operating lease obligations 1,599 266 464 329 540 -------- -------- -------- -------- -------- $494,601 $328,970 $ 62,116 $ 47,151 $ 56,364 ======== ======== ======== ======== ========
IMPACT OF INFLATION AND CHANGING PRICES The consolidated financial statements and notes thereto presented herein have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and operating results in terms of historical dollars without considering the changes in the relative purchasing power of money over time due to inflation. Unlike most industrial companies, nearly all of the Company's assets and liabilities are monetary in nature. As a result, interest rates have a greater impact on the Company's performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services. 11 SELECTED FINANCIAL DATA
YEAR ENDED DECEMBER 31, ---------------------------------------------------------- (DOLLARS IN THOUSANDS EXCEPT PER SHARE DATA) 2005 2004 2003 2002 2001 ---------- ---------- ---------- ---------- ---------- OPERATIONS DATA Net interest income $ 15,571 $ 13,800 $ 10,469 $ 10,745 $ 9,757 Provision for loan losses 329 453 317 160 360 Noninterest income 1,641 1,582 1,755 1,847 1,402 Noninterest expense 10,851 9,768 8,428 9,398 6,995 Net income 3,979 3,720 2,446 1,968 2,486 SHARE DATA Basic net income per common share $ 2.30 $ 2.16 $ 1.44 $ 1.15 $ 1.44 Diluted net income per common share 2.16 2.07 1.36 1.09 1.38 Cash dividends paid per common share 0.53 0.31 0.24 0.22 0.18 Weighted average common shares outstanding Basic 1,731,871 1,719,509 1,696,599 1,713,188 1,725,586 Diluted 1,842,410 1,798,020 1,791,047 1,809,275 1,797,271 FINANCIAL CONDITION DATA Total assets $ 541,287 $ 505,767 $ 351,730 $ 282,128 $ 261,957 Loans receivable, net 369,592 289,325 217,740 197,449 193,450 Total deposits 363,374 266,755 227,555 203,025 183,117 Long and short term debt 127,899 198,235 94,242 48,922 50,463 Total stockholders' equity 34,578 31,124 27,912 26,873 25,586 PERFORMANCE RATIOS Return on average assets 0.74% 0.87% 0.78% 0.72% 0.97% Return on average equity 12.11 12.89 8.99 7.50 10.09 Net interest margin 3.05 3.43 3.55 4.20 4.00 Efficiency ratio 63.04 63.50 68.95 74.73 62.68 Dividend payout ratio 23.39 14.56 17.27 20.04 12.44 CAPITAL RATIOS Average equity to average assets 8.62 9.29 8.04 9.53 9.64 Leverage ratio 8.62 9.29 8.04 9.53 9.64 Total risk-based capital ratio 11.84 11.89 12.20 13.77 14.08 ASSET QUALITY RATIOS Allowance for loan losses to total loans 0.91 1.04 1.16 1.15 1.16 Nonperforming loans to total loans 0.16 0.23 0.17 0.30 0.12 Allowance for loan losses to nonperforming loans 572.96 452.97 678.30 387.60 996.07 Net charge-offs to average loans 0.00 (0.01) 0.03 0.06 0.01
All per share amounts have been adjusted for the three for two stock splits which were effected in December 2004 and 2005. 12 MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS MARKET INFORMATION. The following table sets forth high and low bid quotations reported on the OTC Bulletin for the Company's common stock for each quarter during 2005 and 2004. These quotes reflect inter-dealer prices without retail mark-up, mark-down or commission and may not necessarily reflect actual transactions. All per share amounts have been adjusted to reflect the three for two stock dividends effected in December 2004 and December 2005.
2004 High Low ------ ------ Fourth Quarter $30.00 $22.33 Third Quarter 21.78 20.91 Second Quarter 25.78 20.22 First Quarter 19.56 18.47
2005 High Low ------ ------ Fourth Quarter $33.43 $30.13 Third Quarter 33.33 28.67 Second Quarter 28.67 27.33 First Quarter 28.00 26.06
HOLDERS. The number of stockholders of record of the Company at March 17, 2006 was 529. DIVIDENDS. The Company has paid annual cash dividends since 1994. During fiscal years 2005 and 2004, the Company paid cash dividends of $0.53 and $0.47, respectively. The Company's ability to pay dividends is governed by the policies and regulations of the Federal Reserve Board (the "FRB"), which prohibits the payment of dividends under certain circumstances dependent on the Company's financial condition and capital adequacy. The Company's ability to pay dividends is also depending on the receipt of dividends from the Bank. Federal regulations impose certain limitations on the payment of dividends and other capital distributions by the Bank. The Bank's ability to pay dividends is governed by the Maryland Financial Institutions Code and the regulations of the FRB. Under the Maryland Financial Institutions Code, a Maryland bank (1) may only pay dividends from undivided profits or, with prior regulatory approval, its surplus in excess of 100% of required capital stock and (2) may not declare dividends on its common stock until its surplus funds equals the amount of required capital stock, or if the surplus fund does not equal the amount of capital stock, in an amount in excess of 90% of net earnings. Without the approval of the FRB, a state member bank may not declare or pay a dividend if the total of all dividends declared during the year exceeds its net income during the current calendar year and retained net income for the prior two years. The Bank is further prohibited from making a capital distribution if it would not be adequately capitalized thereafter. In addition, the Bank may not make a capital distribution that would reduce its net worth below the amount required to maintain the liquidation account established for the benefit of its depositors at the time of its conversion to stock form. 13 TRI-COUNTY FINANCIAL CORPORATION REPORT ON AUDITS OF CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2005, 2004, AND 2003 17 TABLE OF CONTENTS REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Page ---- CONSOLIDATED FINANCIAL STATEMENTS Balance Sheets 19 Statements of Income 20 Statements of Changes in Stockholders' Equity 22 Statements of Cash Flows 23 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 25
18 Report of Independent Registered Public Accounting Firm Board of Directors and Stockholders Tri-County Financial Corporation We have audited the accompanying consolidated balance sheets of Tri-County Financial Corporation as of December 31, 2005 and 2004, 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, 2005. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Tri-County Financial Corporation as of December 31, 2005 and 2004, and the results of its consolidated operations and cash flows for each of the three years in the period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America. /s/ Stegman & Company Baltimore, Maryland March 18, 2006 19 TRI-COUNTY FINANCIAL CORPORATION CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2005 2004 -------------- -------------- ASSETS Cash and due from banks $ 7,262,547 $ 6,018,096 Fed funds sold 640,818 777,519 Interest-bearing deposits with banks - at fair value 14,671,875 10,920,164 Securities available for sale 7,178,894 12,948,971 Securities held to maturity at amortized cost (fair value approximates $114,271,786 and $161,664,754, respectively) 116,486,685 162,741,155 Federal Home Loan Bank and Federal Reserve Bank stock - at cost 7,190,300 6,144,300 Loans receivable - net of allowance for loan losses of $3,383,334 and $3,057,558, respectively 369,592,253 289,325,051 Premises and equipment, net 6,460,545 6,011,913 Foreclosed real estate 475,561 475,561 Accrued interest receivable 2,406,542 1,870,135 Investment in bank owned life insurance 6,434,175 6,182,955 Other assets 2,487,280 2,351,303 ------------- ------------- Total assets $ 541,287,475 $ 505,767,123 ============= ============= LIABILITIES AND STOCKHOLDERS' EQUITY Deposits Noninterest-bearing $ 44,325,083 $ 35,552,503 Interest-bearing 319,048,657 231,202,001 ------------- ------------- Total deposits 363,373,740 266,754,504 Short-term borrowings 20,074,975 115,304,210 Long-term debt 107,823,759 82,931,113 Guaranteed preferred beneficial interest in junior subordinated debentures 12,000,000 7,000,000 Accrued expenses and other liabilities 3,436,845 2,653,721 ------------- ------------- Total liabilities 506,709,319 474,643,548 ------------- ------------- Commitments and contingencies (Note 11) STOCKHOLDERS' EQUITY Common stock - par value $.01; authorized - 15,000,000 shares; issued 1,760,991 and 1,146,864 shares, respectively 17,610 11,469 Additional paid in capital 9,057,805 8,252,152 Retained earnings 25,580,634 22,833,112 Accumulated other comprehensive income 49,362 186,140 Unearned ESOP shares (127,255) (159,298) ------------- ------------- Total stockholders' equity 34,578,156 31,123,575 ------------- ------------- Total liabilities and stockholders' equity $ 541,287,475 $ 505,767,123 ============= =============
See notes to consolidated financial statements 20 TRI-COUNTY FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF INCOME
YEARS ENDED DECEMBER 31, 2005 2004 2003 ------------- ------------- ------------ Interest and dividend income Loans, including fees $ 22,357,616 $ 16,033,239 $ 13,411,904 Taxable interest and dividends on investment securities 6,707,913 5,551,943 2,688,451 Interest on deposits with banks 89,183 28,157 64,570 ------------ ------------ ------------ Total interest and dividend income 29,154,712 21,613,339 16,164,925 ------------ ------------ ------------ Interest expense Deposits 6,472,032 3,229,502 2,868,709 Short-term borrowings 2,564,550 1,163,647 95,707 Long-term debt 4,547,049 3,420,261 2,731,983 ------------ ------------ ------------ Total interest expenses 13,583,631 7,813,410 5,696,399 ------------ ------------ ------------ Net interest income 15,571,081 13,799,929 10,468,526 Provision for loan losses 329,467 452,998 316,963 ------------ ------------ ------------ Net interest income after provision for loan losses 15,241,614 13,346,931 10,151,563 ------------ ------------ ------------ Noninterest income Loan appraisal, credit, and miscellaneous charges 178,424 229,125 261,387 Net gain on sale of loans held for sale - 21,404 505,435 Income from bank owned life insurance 251,220 261,411 230,607 Service charges 1,186,184 1,189,001 695,128 Gain on sale of asset 39,756 8,250 - Loss on the sale of investment securities (14,581) (61,875) - Recognition of other than temporary decline in value of marketable Securities - (65,000) Other - - 61,981 ------------ ------------ ------------ Total noninterest income 1,641,003 1,582,316 1,754,538 ------------ ------------ ------------
21 TRI-COUNTY FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF INCOME
YEARS ENDED DECEMBER 31, 2005 2004 2003 ----------- ----------- ----------- Noninterest expense Salary and employee benefits 5,849,226 5,432,898 4,702,181 Occupancy expense 1,156,775 858,891 750,567 Advertising 411,811 539,715 308,951 Data processing expense 665,981 550,781 403,967 Depreciation of furniture, fixtures, and equipment 452,037 372,237 507,236 Telephone communications 85,436 103,421 166,553 Valuation allowance on foreclosed real estate - 114,606 - ATM expenses 277,566 345,454 274,188 Office supplies 138,407 151,862 131,228 Professional fees 629,126 261,458 185,188 Office equipment expense 50,318 90,520 129,849 Other 1,134,647 946,576 867,863 ----------- ----------- ----------- Total noninterest expenses 10,851,330 9,768,419 8,427,771 ----------- ----------- ----------- Income before income taxes 6,031,287 5,160,828 3,478,330 Income tax expense 2,051,944 1,440,994 1,032,432 ----------- ----------- ----------- Net income $ 3,979,343 $ 3,719,834 $ 2,445,898 =========== =========== =========== Earnings per share Basic $ 2.30 $ 2.16 $ 1.44 Diluted $ 2.16 $ 2.07 $ 1.36
See notes to consolidated financial statements * Share and per share data have been retroactively adjusted to effect the three-for-two common stock splits effected on December 22, 2004 and December 12, 2005 as if they had occurred January 1, 2003. 22 TRI-COUNTY FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 2005, 2004, AND 2003
ACCUMULATED OTHER UNEARNED COMMON PAID-IN RETAINED COMPREHENSIVE ESOP STOCK CAPITAL EARNINGS INCOME (LOSS) SHARES TOTAL --------- ---------- ----------- ------------- --------- ----------- Balance at January 1, 2003 $ 7,598 $7,716,906 $18,817,615 $ 493,691 $(163,045) $26,872,765 Comprehensive income Net Income - - 2,445,898 - - 2,445,898 Change in unrealized gains (losses) on investment securities net of tax of $268,756 (496,821) (496,821) ----------- Total comprehensive income 1,949,077 Cash dividend $0.24 per share (422,361) (422,361) Excess of fair market value over cost of leveraged ESOP shares released 39,533 39,533 Exercise of stock options 116 200,435 200,551 Repurchase of common stock (197) (769,522) (769,719) Net change in unearned ESOP shares 16 23,886 23,902 Tax effect of the exercise of non-ISO stock options - 18,161 - - - 18,161 --------- ---------- ----------- ------------- --------- ----------- Balance at December 31, 2003 7,533 7,975,035 20,071,630 (3,130) (139,159) 27,911,909 Comprehensive income Net Income 3,719,834 3,719,834 Change in unrealized gains on investment securities net of tax of $97,503 189,270 189,270 ----------- Total comprehensive income 3,909,104 Cash dividend $0.31 per share (541,633) (541,633) Excess of fair market value over cost of leveraged ESOP shares released 28,670 28,670 Exercise of stock options 214 241,261 241,475 Repurchase of common stock (93) (412,880) (412,973) Net change in unearned ESOP shares (24) (20,139) (20,163) Three for two stock split in the form of a dividend 3,839 (3,839) - Tax effect of the exercise of non-ISO stock options - 7,186 - - - 7,186 --------- ---------- ----------- ------------- --------- ----------- Balance at December 31, 2004 11,469 8,252,152 22,833,112 186,140 (159,298) 31,123,575 Comprehensive income Net Income 3,979,343 3,979,343 Change in unrealized gains on investment securities net of tax of $70,460 (136,778) (136,778) ----------- Total comprehensive income 3,842,565 Cash dividend $0.53 per share (930,669) (930,669) Excess of fair market value over cost of leveraged ESOP shares released 28,354 28,354 Exercise of stock options 231 259,755 259,986 Proceeds of private placement 158 472,882 473,040 Net change in unearned ESOP shares (7) 32,043 32,036 Repurchase of common stock (60) (295,333) (295,393) Three for two stock split in the form of a dividend 5,819 (5,819) - Tax effect of the exercise of non-ISO stock options - 44,662 - - - 44,662 --------- ---------- ----------- ------------- --------- ----------- Balance at December 31, 2005 $ 17,610 $9,057,805 $25,580,634 $ 49,362 $(127,255) $34,578,156 ========= ========== =========== ============= ========= ===========
All per share amounts have been adjusted for stock split. See notes to consolidated financial statements. 23 TRI-COUNTY FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31 2005 2004 2003 ------------- ------------- ------------- CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 3,979,343 $ 3,719,834 $ 2,445,898 Adjustments to reconcile net income to net cash provided by operating activities: Valuation allowance on foreclosed real estate - 114,606 - Provision for loan losses 329,467 452,998 316,963 Loss on sale of investment security 14,581 126,875 - Depreciation and amortization 811,866 636,711 663,134 Net amortization of premium/discount on mortgage-backed securities and investments 341,858 116,256 447,503 Increase in cash surrender of bank owned life insurance (251,220) (261,411) (221,544) Deferred income tax expense (benefit) (452,351) 65,850 (22,219) Increase in accrued interest receivable (536,407) (551,817) (275,865) Increase (decrease) in deferred loan fees (160,660) 114,618 (17,849) Increase (decrease) in accrued expenses and other liabilities 783,124 349,818 (1,332,467) Decrease in other assets 386,834 906,843 179,439 Loss (gain) on disposal of premises and equipment 36,216 (8,250) 12,241 Origination of loans held for sale - - (16,792,123) Proceeds from sale of loans held for sale - 496,284 18,085,314 Loss (gain) on sale of other real estate owned (39,756) 32,597 - Gain on sales of loans held for sale - (21,404) (505,434) ------------- ------------- ------------- Net cash provided by operating activities 5,242,895 6,290,408 2,982,991 ------------- ------------- ------------- CASH FLOWS FROM INVESTING ACTIVITIES Purchase of investment securities available for sale (9,655) (27,944,571) (65,726,882) Proceeds from sale, redemption or principal payments of investment securities available for sale 5,540,515 53,031,692 67,772,952 Purchase of investment securities held to maturity (25,749,248) (143,349,900) (64,384,597) Proceeds from maturities or principal payments of investment securities held to maturity 71,679,258 42,511,543 5,898,120 Net purchase of FHLB and Federal Reserve stock (1,046,000) (1,367,450) (2,040,100) Loans originated or acquired (202,475,708) (192,785,961) (172,289,356) Principal collected on loans 122,039,699 120,633,447 151,699,369 Purchase of premises and equipment (1,296,714) (1,068,435) (528,169) Proceeds from disposal of premises and equipment - 8,250 9,000 Purchase of bank owned life insurance policies - - (5,700,000) Sale of foreclosed real estate 39,756 91,597 - ------------- ------------- ------------- Net cash used in investing activities (31,278,097) (150,239,788) (85,289,663) ------------- ------------- -------------
See notes to consolidated financial statements. 24 TRI-COUNTY FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31 2005 2004 2003 ------------- ------------- ------------- CASH FLOWS FROM FINANCING ACTIVITIES Net increase in deposits 96,619,236 39,199,936 24,529,456 Net (decrease) increase in short-term borrowings (95,229,235) 84,112,925 30,438,987 Dividends paid (930,669) (541,633) (422,361) Exercise of stock options 304,648 248,661 218,712 Proceeds from private placement of common stock 473,040 - - Net change in unearned ESOP shares 60,390 8,508 63,436 Repurchase of common stock (295,393) (412,973) (769,719) Proceeds from long-term borrowings 30,000,000 30,000,000 15,000,000 Payments of long-term borrowings (5,107,354) (10,120,063) (118,824) Proceeds from issuance of trust preferred debentures 5,000,000 7,000,000 - ------------- ------------- ------------- Net cash provided by financing activities 30,894,663 149,495,361 68,939,687 ------------- ------------- ------------- Increase (decrease) in Cash and Cash Equivalents 4,859,461 5,545,981 (13,366,985) Cash and Cash Equivalents at Beginning of Year 17,715,779 12,169,798 25,536,783 ------------- ------------- ------------- Cash and Cash Equivalents at End of Year $ 22,575,240 $ 17,715,779 $ 12,169,798 ============= ============= ============= Supplementary Cash Flow Information Cash paid during the year for Interest $ 13,503,581 $ 7,784,244 $ 5,647,280 Income taxes 2,032,500 1,232,500 1,715,369
See notes to consolidated financial statements. 25 TRI-COUNTY FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2005, 2004, AND 2003 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of Tri-County Financial Corporation and its wholly owned subsidiaries, Community Bank of Tri-County (the "Bank"), Tri-County Capital Trust I and Tri-County Capital Trust II, and the Bank's wholly owned subsidiaries, Tri-County Investment Corporation and Community Mortgage Corporation of Tri-County (collectively, the "Company"). All significant intercompany balances and transactions have been eliminated in consolidation. The accounting and reporting policies of the Company conform with accounting principles generally accepted in the United States of America and to general practices within the banking industry. Certain reclassifications have been made to amounts previously reported to conform with classifications made in 2005. NATURE OF OPERATIONS The Company provides a variety of financial services to individuals and small businesses through its offices in southern Maryland. Its primary deposit products are demand, savings, and time deposits and its primary lending products are consumer and commercial mortgage loans and commercial loans. USE OF ESTIMATES In preparing consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, the valuation of foreclosed real estate, and deferred tax assets. SIGNIFICANT GROUP CONCENTRATIONS OF CREDIT RISK Most of the company's activities are with customers located in the Southern Maryland area comprising St. Mary's, Charles and Calvert counties. Note 3 discusses the types of securities held by the Company. Note 4 discusses the type of lending in which the Company is engaged. The Company does not have any significant concentration to any one customer or industry. CASH AND CASH EQUIVALENTS For purposes of the consolidated statements of cash flows, the Company considers all highly liquid debt instruments with original maturities of three months or less when purchased to be cash equivalents. SECURITIES Debt securities that management has the positive intent and ability to hold to maturity are classified as "held to maturity" and recorded at amortized cost. Securities not classified as held to maturity or trading, including equity securities with readily determinable fair values are classified as "available for sale" and recorded at estimated fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income. Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Declines in the estimated fair value of held to maturity and available for sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other than temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method. Investment in Federal Reserve Bank and Federal Home Loan Bank of Atlanta stock are recorded at cost and are considered restricted as to marketability. The Bank is required to maintain investments in the Federal Reserve Bank and Federal Home Loan Bank based upon levels of financial activity. LOANS HELD FOR SALE Loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated fair value, in the aggregate. Net unrealized losses, if any, are recognized through a valuation allowance by charges to income. Mortgage loans held for sale are generally sold with the mortgage servicing rights retained by the Company. The carrying value of mortgage loans sold is reduced by the cost allocated to the associated servicing rights. Gains or losses on sales of mortgage loans are recognized based on the difference between the selling price and the carrying value of the related mortgage loans sold, using the specific identification method. 26 LOANS The Company originates mortgage, commercial, and consumer loans to customers. A substantial portion of the loan portfolio is represented by loans throughout southern Maryland. The ability of the Company's debtors to honor their contracts is dependent upon the real estate and general economic conditions in this area. Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at their outstanding unpaid principal balances adjusted for the allowance for loan losses and any deferred fees or costs on originated loans. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method. The accrual of interest on mortgage and commercial loans is discontinued at the time the loan is 90 days delinquent unless the credit is well secured and in the process of collection. Consumer loans are charged-off no later than 180 days past due. In all cases, loans are placed on non-accrual or charged-off at an earlier date if collection of principal or interest is considered doubtful. All interest accrued but not collected from loans that are placed on non-accrual or charged-off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured. ALLOWANCE FOR LOAN LOSSES The allowance for loan losses is established as probable losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes that the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. The allowance for loan losses is evaluated on a regular basis by management and is based upon management's periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower's ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. The allowance for loan losses consists of a specific component and a general component. The specific component relates to loans that are classified as either doubtful, substandard, or special mention. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than carrying value of that loan. The general component covers the non-classified loans and is based on historical loss experience, peer group comparisons, industry data and loss percentages used for similarly graded loans adjusted for qualitative factors. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower's prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's observable market price, or the fair value of the collateral if the loan is collateral dependent. Large groups of smaller homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential loans for impairment disclosures, unless such loans are the subject of a restructuring agreement. SERVICING Servicing assets are recognized as separate assets when rights are acquired through purchase or through the sale of financial assets. Generally, purchased servicing rights are capitalized at the cost to acquire the rights. For sales of mortgage loans, a portion of the cost of originating the loan is allocated to the servicing based on relative estimated fair value. Estimated fair value is based on market prices for comparable mortgage servicing contracts, when available, or alternatively, is based on a valuation model that calculates the present value of estimated future net servicing. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as the cost to service, the discount rate, an inflation rate, ancillary income, prepayment speeds and default rates and losses. Capitalized servicing rights are reported in other assets and are amortized into noninterest income in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets. Servicing assets are evaluated for impairment based upon the estimated fair value of the rights as compared to amortized cost. Impairment is determined by stratifying rights into tranches based on predominant risk characteristics, such as interest rate, loan type and investor type. Impairment is recognized through a valuation allowance for an individual tranche, to the extent that fair value is less than the capitalized amount for the tranche. If the Company later determines that all or a portion of the impairment no longer exists for a particular tranche, a reduction of the allowance may be recorded as an increase to income. 27 Servicing fee income is recorded for fees earned for servicing loans. The fees are based on a contractual percentage of the outstanding principal; or a fixed amount per loan and recorded as income when earned. The amortization of mortgage servicing rights is netted against loan servicing fee income. PREMISES AND EQUIPMENT Land is carried at cost. Premises and improvements and equipment are carried at cost, less accumulated depreciation and amortization computed by the straight-line method over the estimated useful lives of the assets, which are as follows Buildings and improvements 10 - 50 years Furniture and equipment 3 - 15 years Automobiles 5 years
Maintenance and repairs are charged to expense as incurred while improvements that extend the useful life of premises and equipment are capitalized. FORECLOSED REAL ESTATE Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at the lower of cost or estimated fair value at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or estimated fair value less cost to sell. Revenue and expenses from operations and changes in the valuation allowance are included in noninterest expense. TRANSFERS OF FINANCIAL ASSETS Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity. ADVERTISING COSTS The Company expenses advertising costs as incurred. INCOME TAXES The Company files a consolidated federal income tax return with its subsidiaries. Deferred tax assets and liabilities are determined using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary differences between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws. OFF BALANCE SHEET CREDIT RELATED FINANCIAL INSTRUMENTS In the ordinary course of business, the Company has entered into commitments to extend credit, including commitments under commercial lines of credit, letters of credit, and standby letters of credit. Such financial instruments are recorded when they are funded. STOCK-BASED COMPENSATION Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock Based Compensation, encourages all entities to adopt a fair value based method of accounting for employee stock compensation plans, whereby compensation cost is measured at the grant date based on the value of the award and is recognized over the service period, which is usually the vesting period. However, it also allows an entity to continue to measure compensation cost for these plans using the intrinsic value based method of accounting prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, whereby compensation cost is the excess, if any, of the quoted market price of the stock at the grant date (or other measurement date) over the amount an employee must pay to acquire the stock. The Company has elected to continue with the accounting methodology in Opinion No. 25. Stock options issued under the Company's stock option plans have no intrinsic value at the grant date, and under Opinion No. 25 no compensation cost is recognized for them. However, SFAS No. 123 was revised as SFAS No. 123R in December 2004. This revision is discussed further in the "Recent Accounting Pronouncements" section of this Note. At December 31, 2005, the Company maintains stock-based compensation plans, which are more fully described in Note 12. Had compensation cost for the Company's stock option plans been determined based on the fair value based method of accounting at the grant dates for awards under the plan consistent with the method prescribed by SFAS No. 123, the Company's net income and earnings per share would have been adjusted to the pro forma amounts indicated below: 28
YEARS ENDED DECEMBER 31, 2005 2004 2003 ------------- ------------- ------------- Net income, as reported $ 3,979,343 $ 3,719,834 $ 2,445,898 Additional expense had the Company adopted SFAS 123R (942,297) (735,180) (141,000) ------------- ------------- ------------- Pro forma net income $ 3,037,046 $ 2,984,654 $ 2,304,898 ============= ============= ============= Earnings per share as reported Basic $ 2.30 $ 2.16 $ 1.44 Diluted $ 2.16 $ 2.07 $ 1.36 Pro forma earnings per share Basic $ 1.75 $ 1.73 $ 1.35 Diluted $ 1.65 $ 1.66 $ 1.29
Per share amounts have been adjusted retroactively to reflect the three for two stock splits in December 2004 and December 2005. For the purpose of computing the pro forma amounts indicated above, the fair value of each option on the date of grant is estimated using the Black-Scholes option pricing model with the following weighted-average assumptions used for the grants:
2005 2004 2003 ------ ------ ------ Dividend yield 1.02% 1.80% 2.17% Expected volatility 34.89 25.51 17.24 Risk-free interest rate 4.66 4.31 4.29 Expected lives (in years) 10 10 10 Weighted average fair value $15.83 $ 8.45 $ 6.81
EARNINGS PER COMMON SHARE Basic earnings per common share represents income available to common stockholders divided by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Company relate solely to outstanding stock options and are determined using the treasury stock method. In 2005 and 2004 there were 59,526 and 69,407 options with an exercise price that exceeded the current market price, which were excluded from the calculation as their effect would be anti-dilutive. Earnings per common share have been computed based on the following:
YEARS ENDED DECEMBER 31, 2005 2004 2003 ---------- ---------- ---------- Net Income $3,979,343 $3,719,834 $2,445,898 ========== ========== ========== Average number of common shares outstanding 1,731,871 1,719,509 1,696,599 Effect of dilutive options 110,539 78,512 94,449 ---------- ---------- ---------- Average number of shares used to calculate earnings per share outstanding 1,842,410 1,798,020 1,791,048 ========= ========= =========
The numbers of common shares outstanding have been adjusted to give retroactive effect to the three for two stock splits in December 2004 and 2005. COMPREHENSIVE INCOME Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available for sale securities, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income. 29 The components of other comprehensive income and related tax effects are as follows:
YEARS ENDED DECEMBER 31, 2005 2004 2003 ----------- ----------- ----------- Net Income $ 3,979,343 $ 3,719,834 $ 2,445,898 Other comprehensive income items Unrealized holding (losses) gains on available for sale securities net of tax expense (benefit) of $(75,419), $74,465, and $(268,756), respectively (146,110) 148,473 (496,821) Plus: reclassification adjustment for losses net of tax benefit of $5,249 and $21,038 respectively. 9,332 40,797 - ----------- ----------- ----------- Total other comprehensive income $ (136,778) $ 189,270 $ (496,821) ----------- ----------- ----------- Total comprehensive income $ 3,842,565 $ 3,909,104 $ 1,949,077 ----------- ----------- -----------
The components of accumulated other comprehensive income, included in stockholders' equity are as follows: DECEMBER 31, 2005 2004 2003 --------- --------- --------- Net unrealized gains (losses) on securities available for sale $ 74,793 $ 282,031 $ 4,741 Tax effect (25,431) (95,891) (1,612) --------- --------- --------- Net of tax amount $ 49,362 $ 186,140 $ 3,129 ========= ========= =========
RECENT ACCOUNTING PRONOUNCEMENTS In January 2005, the Financial Accounting Standards Board ("FASB") issued SFAS No. 123R, Share-Based Payment (Revised 2004), which establishes standards for accounting for transactions in which an entity (i) exchanges its equity instruments for goods and services, or (ii) incurs liabilities in exchange for goods and services that are based on an entity's equity instruments or that may be settled by the issuance of equity instruments. SFAS 123R eliminates the ability to account for stock-based compensation using Accounting Principles Board ("APB") No. 25 and requires that such transactions be recognized as compensation cost in the income statement based on their fair values on the date of the grant. SFAS 123R is effective for fiscal periods beginning after December 15, 2005. The Company will transition to fair value-based compensation using a modified version of the prospective application, which means the fair value-based method prescribed under SFAS 123R will apply to new awards, modification of previous awards, repurchases and cancellations after January 1, 2006. Additionally, compensation cost for awards for which requisite service has not been rendered, (non-vested options of stock grants) that are outstanding as of December 31, 2005 must be recognized as the remaining requisite service is rendered during the period of and/or the periods after the adoption of SFAS 123R. The Company has no such awards outstanding as of December 31, 2005. Future levels of compensation expense related to stock-based compensation may be impacted by new awards, modifications, repurchases or cancellations of existing awards both before and after the adoption of this standard. In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets, an amendment of APB No. 29, Accounting for Nonmonetary Transactions. This statement amends the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged and more broadly provides for exceptions regarding exchanges occurring in fiscal periods beginning after June 15, 2005. The adoption of this standard did not have a material impact on the Company's financial condition, results of operations, or liquidity. In March 2004, the FASB Emerging Issues Task Force (EITF) released Issue 03-01, Meaning of Other Than Temporary Impairment, which addressed other-than-temporary impairment for certain debt and equity investments. The recognition and measurement requirements of Issue 03-01, and other disclosure requirements not already implemented, were effective for periods after June 15, 2004. In September 2004, the FASB staff issued FASB Staff Position ("FSP") EITF 03-01-1, which delayed the effective date for certain measurement and recognition guidance during the period of delay until a final consensus is reached. We do not anticipate the issuance of the final rules will have a material impact on the Company's financial condition, results of operations or liquidity. In June of 2005, the Financial Accounting Standards Board (FASB) issued Statement No. 154 (SFAS 154), "Accounting Changes and Error Corrections", a replacement of APB No. 20, "Accounting Changes" and FASB Statement No. 3, "Reporting Accounting Changes in Interim Financial Statements". SFAS 154 applies to all voluntary changes in accounting principle and changes the requirements for accounting for, and reporting of, a change in accounting principle. Previously, most voluntary changes in accounting principles were required to be recognized by way of a cumulative effect adjustment within net income during the period of the change. SFAS 154 requires retrospective application to prior periods' financial statements, unless it is impracticable to determine either the period specific effects or the cumulative effect of the change. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The 30 implementation of FAS 154 is not expected to have a material impact on the Company's consolidated financial statements. NOTE 2 - RESTRICTIONS ON CASH AND AMOUNTS DUE FROM BANK The Bank is required to maintain average balances on hand or with the Federal Reserve Bank. At December 31, 2005 and 2004, these reserve balances amounted to $4,359,000 and $4,045,000, respectively. NOTE 3 - INVESTMENT SECURITIES The amortized cost and estimated fair values of securities with gross unrealized losses and gains are as follows
DECEMBER 31, 2005 ----------------- GROSS AMORTIZED UNREALIZED GROSS UNREALIZED ESTIMATED COST GAINS LOSSES FAIR VALUE ------------ ------------ ---------------- ------------ Securities available for sale Asset-backed securities issued by GSEs $ 6,494,335 $ 42,077 $ 203,717 $ 6,332,695 Corporate equity securities 481,010 239,338 1,000 719,348 Bond mutual funds 128,756 - 1,905 126,851 ------------ ------------ ------------ ------------ Total securities available for sale $ 7,104,101 $ 281,415 $ 206,622 $ 7,178,894 ============ ============ ============ ============ Securities held-to-maturity Asset-backed securities issued by GSEs $ 78,001,293 $ 182,831 $ 1,777,533 $ 76,406,591 Other 37,382,662 53,007 673,204 36,762,465 ------------ ------------ ------------ ------------ Total debt securities held-to-maturity 115,383,955 235,838 2,450,737 113,169,056 U.S. Government obligations 499,091 - - 499,091 Other investments 603,639 - - 603,639 ------------ ------------ ------------ ------------ Total securities held-to-maturity $116,486,685 $ 235,838 $ 2,450,737 $114,271,786 ============ ============ ============ ============
December 31, 2004 ----------------- Amortized Gross Unrealized Gross Unrealized Estimated Cost Gains Losses Fair Value ------------ ---------------- ---------------- ------------ Securities available for sale Asset-backed securities issued by GSEs $ 11,543,520 $ 113,741 $ 104,584 $ 11,552,677 Corporate equity securities 481,010 290,467 5,000 766,477 Bond mutual funds 642,408 - 12,591 629,817 ------------ ------------ ------------ ------------ Total securities available for sale $ 12,666,938 $ 404,208 $ 122,175 $ 12,948,971 ============ ============ ============ ============ Securities held-to-maturity Asset-backed securities issued by GSEs $108,862,740 $ 127,154 $ 1,275,511 $107,714,383 Other 51,796,259 350,848 234,149 51,912,958 ------------ ------------ ------------ ------------ Total debt securities held-to-maturity 160,658,999 478,002 1,509,660 159,627,341 U.S. Government obligations 301,181 - 726 300,455 Other investments 1,780,975 - 44,017 1,736,958 ------------ ------------ ------------ ------------ Total securities held-to-maturity $162,741,155 $ 478,002 $ 1,554,403 $161,664,754 ============ ============ ============ ============
Other investments consist of certain certificate of deposit strip instruments whose fair value is based on market returns on similar risk and maturity instruments because no active market exists for these instruments. At December 31, 2005, U.S. government obligations with a carrying value of $499,091 were pledged to secure municipal deposits. In addition, at December 31, 2005, certain other securities with a carrying value of $4,731,000 were pledged to secure certain deposits. At December 31, 2005, securities with a carrying value of $53,987,000 were pledged as collateral for advances from the Federal Home Loan Bank of Atlanta. 31 Gross unrealized losses and estimated fair value by length of time that the individual available-for-sale securities have been in a continuous unrealized loss position at December 31, 2005 are as follows
CONTINUOUS UNREALIZED LOSSES EXISTING FOR ------------------------------------------------------ LESS THAN 12 MORE THAN 12 TOTAL UNREALIZED FAIR VALUE MONTHS MONTHS LOSSES ---------- ------------ ------------ ---------------- Asset-backed securities issued by GSE's $5,562,030 $ 66,646 $ 137,071 $ 203,717 Corporate equity securities 434,000 - 1,000 1,000 Bond mutual funds 91,013 - 1,905 1,905 ---------- ---------- ---------- ---------- $6,087,043 $ 66,646 $ 139,976 $ 206,622 ========== ========== ========== ==========
The available-for-sale investment portfolio has a fair value of $7,178,894 of which $6,087,043 of the securities have some unrealized losses from their amortized cost. Of these securities, $5,562,030, or 92%, are mortgage-backed securities issued by GSEs, $91,013 or 1% are short duration mutual fund shares, and $434,000 or 7% are equity securities. The unrealized losses that exist in the mortgage-backed securities and mutual fund shares are the result of market changes in interest rates since the original purchase. The mutual fund shares have a modest duration and are backed by one year adjustable-rate mortgage-backed securities. The asset-backed securities have an average duration of 3.3 years and are guaranteed by their issuer as to credit risk. Total unrealized losses on these investments are small (approximately 3%). We believe that the losses in the equity securities are temporary. Persistent losses may require a reevaluation of these losses. These factors coupled with the fact the Company has both the intent and ability to hold these investments for a period of time sufficient to allow for any anticipated recovery in fair value substantiates that the unrealized losses in the available-for-sale portfolio are temporary. Gross unrealized losses and estimated fair value by length of time that the individual held-to-maturity securities have been in a continuous unrealized loss position at December 31, 2005 are as follows
CONTINUOUS UNREALIZED LOSSES EXISTING FOR -------------------------------------------------------- LESS THAN 12 MORE THAN 12 TOTAL UNREALIZED FAIR VALUE MONTHS MONTHS LOSSES ----------- ------------ ------------ ---------------- Asset-backed securities issued by GSE's $57,693,786 $ 271,336 $ 1,506,197 $ 1,777,533 Asset-backed securities issued by other 34,302,722 307,172 366,032 673,204 ----------- ----------- ----------- ----------- $91,996,508 $ 578,508 $ 1,872,229 $ 2,450,737 =========== =========== =========== ===========
The held-to-maturity investment portfolio has an estimated fair value of $114,271,786 of which $91,996,508 of the securities have some unrealized losses from their purchase price. Of these securities, $57,693,786 or 63%, are mortgage-backed securities issued by GSE's and the remainder, or $34,302,722, are mortgage-backed securities issued by others. The asset-backed securities have a duration of approximately four years, are guaranteed as to payment by the issuer, and have minimal losses compared to carrying value (approximately 2.6%). The unrealized losses that exist are the result of market changes in interest rates since the original purchase. These factors coupled with the Company's intent and ability to hold these investments for a period of time sufficient to allow for any anticipated recovery in fair value substantiates that the unrealized losses in the held-to-maturity portfolio are temporary. The amortized cost and estimated fair value of debt securities at December 31, 2005, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because the issuers of the securities may have the right to prepay obligations without prepayment penalties.
AVAILABLE FOR SALE HELD TO MATURITY --------------------------------------------------------- ESTIMATED ESTIMATED AMORTIZED FAIR AMORTIZED FAIR COST VALUE COST VALUE ------------ ------------ ------------ ------------ Within one year $ 128,756 $ 126,851 $ 958,292 $ 958,292 Over one year through five years - - 144,438 144,438 Over five years through ten years - - - - ------------ ------------ ------------ ------------ 128,756 126,851 1,102,730 1,102,730 Mortgage-backed securities 6,494,335 6,332,695 115,383,955 113,169,056 ------------ ------------ ------------ ------------ $ 6,623,091 $ 6,459,546 $116,486,685 $114,271,786 ============ ============ ============ ============
32 Total sales of investments available for sale during 2005 and 2004 were $1,350,000 and $36,900,000, these sales produced a net loss of $14,582 and $61,875. There were no sales of investment securities available for sale during 2003. Asset-backed securities are comprised of mortgage-backed securities as well as mortgage-derivative securities such as collateralized mortgage obligations and real estate mortgage investment conduits. NOTE 4 - LOANS RECEIVABLE AND ALLOWANCE FOR LOAN LOSSES A summary of the balances of loans are as follows
2005 2004 ------------ ------------ Commercial real estate $166,850,838 $136,341,597 Residential first mortgages 73,627,717 59,087,000 Construction and land development 32,608,002 17,597,911 Home equity and second mortgage 25,884,406 23,925,108 Commercial loans 54,737,693 39,136,778 Consumer loans 3,128,425 3,462,613 Commercial equipment 16,742,220 13,595,978 ------------ ------------ 373,579,301 293,146,983 ------------ ------------ Less Deferred loan fees, net 603,714 764,374 Allowance for loan loss 3,383,334 3,057,558 ------------ ------------ 3,987,048 3,821,932 ------------ ------------ $369,592,253 $289,325,051 ============ ============
An analysis of the allowance for loan losses follows
2005 2004 2003 ---------- ---------- ---------- Balance January 1, $3,057,558 $2,572,799 $2,314,074 Add Provision charged to operations 329,466 452,998 316,963 Recoveries 5,185 49,083 2,445 Less Charge-offs 8,875 17,322 60,684 ---------- ---------- ---------- Balance as of December 31 $3,383,334 $3,057,558 $2,572,799 ========== ========== ==========
No loans included within the scope of SFAS No. 114 were identified as being impaired at December 31, 2005, 2004 or 2003 and for the years then ended. Loans on which the recognition of interest has been discontinued, which were not included within the scope of SFAS No. 114, amounted to approximately $591,000, $675,000, and $379,000 at December 31, 2005, 2004, and 2003, respectively. If interest income had been recognized on nonaccrual loans at their stated rates during 2005, 2004, and 2003, interest income would have been increased by $67,558, $44,391, and $11,626, respectively. Income in the amount of $7,763, $21,955 and $29,066 was recognized on these loans in 2005, 2004, and 2003, respectively. Included in loans receivable at December 31, 2005 and 2004 is $1,682,994 and $1,268,353 due from officers and directors of the Bank. These loans are made in the ordinary course of business at substantially the same terms and conditions as those prevailing at the time for comparable transactions with outsiders and are not considered to involve more than the normal risk of collectibility. For the years ending December 31, 2005 and 2004 all loans to directors and officers of the Bank were performing according to the original loan terms. Activity in loans outstanding to officers and directors is summarized as follows: 33
2005 2004 ----------- ----------- Balance, beginning of year $ 1,268,353 $ 593,452 New loans made during year 524,708 1,211,526 Repayments made during year (110,067) (285,765) Reductions due to change in directors and officers - (250,860) ----------- ----------- Balance at end of year $ 1,682,994 $ 1,268,353 =========== ===========
NOTE 5 - LOAN SERVICING Loans serviced for others are not reflected in the accompanying balance sheets. The unpaid principal balances of mortgages serviced for others were $34,530,296 and $39,327,875 at December 31, 2005 and 2004, respectively. Servicing loans for others generally consists of collecting mortgage payments, maintaining escrow accounts, disbursing payments to investors and foreclosure processing. Loan servicing income is recorded on the accrual basis and includes servicing fees from investors and certain charges collected from borrowers, such as late payment fees. The following table presents the activity of the mortgage servicing rights ("MSR").
YEAR ENDED DECEMBER 31, 2005 2004 2003 --------- --------- ---------- Balance at beginning of the year $ 477,202 $ 676,940 $ 780,408 Additions - 7,861 284,327 Amortization (151,141) (207,599) (177,795) Application of valuation allowance to permanently impaired MSR's - - (210,000) --------- --------- --------- $ 326,061 $ 477,202 $ 676,940 ========= ========= =========
NOTE 6 - FORECLOSED REAL ESTATE Foreclosed assets are presented net of an allowance for losses. An analysis of the allowance for losses on foreclosed assets is as follows
YEARS ENDED DECEMBER 31, 2005 2004 2003 --------- -------- --------- Balance at beginning of year $ 671,740 $ 972,899 $ 972,899 Provision for losses - 114,606 - Charge-offs (30,000) (415,765) - --------- --------- --------- Balance at end of year $ 671,740 $ 671,740 $ 972,899 ========= ========= =========
Expenses applicable to foreclosed assets include the following
YEARS ENDED DECEMBER 31, 2005 2004 2003 -------- -------- -------- Net gain on sale of foreclosed real estate $ - $ - $ - Donation of property - 25,000 Provision for losses - 114,606 - Operating expenses 3,083 6,278 10,153 -------- -------- -------- $ 3,083 $145,884 $ 10,153 ======== ======== ========
NOTE 7 - PREMISES AND EQUIPMENT A summary of the cost and accumulated depreciation of premises and equipment follows 34
2005 2004 ---------- ---------- Land $1,368,077 $1,368,077 Building and improvements 5,579,868 5,048,190 Furniture and equipment 2,662,799 3,137,954 Automobiles 168,426 168,426 ---------- ---------- Total cost 9,779,170 9,722,647 Less accumulated depreciation 3,318,625 3,710,734 ---------- ---------- Premises and equipment, net $6,460,545 $6,011,913 ========== ==========
Certain bank facilities are leased under various operating leases. Rent expense was $238,573, $190,306, and $197,157 in 2005, 2004 and 2003, respectively. Future minimum rental commitments under noncancellable operating leases are as follows 2006 $ 265,910 2007 265,460 2008 199,010 2009 198,560 2010 130,160 Thereafter 540,320 ---------- Total $1,599,420 ==========
NOTE 8 - DEPOSITS Deposits at December 31 consist of the following:
2005 2004 ------------ ------------ Noninterest-bearing demand $ 44,325,083 $ 35,552,503 Interest-bearing Demand 48,666,460 57,855,850 Money market deposits 40,195,630 34,692,434 Savings 34,800,535 36,851,743 Certificates of deposit 195,386,032 101,801,974 ------------ ------------ Total interest-bearing 319,048,657 231,202,001 ------------ ------------ Total deposits $363,373,740 $266,754,504 ============ ============
The aggregate amount of time deposits in denominations of $100,000 or more at December 31, 2005 and 2004 was $64,722,620 and $32,268,000, respectively. At December 31, 2005, the scheduled maturities of time deposits are as follows (in thousands) 2006 $127,876 2007 49,567 2008 6,121 2009 4,832 2010 6,959 2011 31 -------- $195,386 ========
35 NOTE 9 - SHORT-TERM BORROWINGS AND LONG-TERM DEBT The Bank's long-term debt consists of advances from the Federal Home Loan Bank of Atlanta. The Bank classifies debt based upon original maturity and does not reclassify debt to short term status during its life. These include fixed-rate, adjustable-rate, fixed convertible, and variable convertible advances. Rates and maturities on these advances are as follows
FIXED ADJUSTABLE FIXED RATE VARIABLE 2005 RATE RATE CONVERTIBLE CONVERTIBLE ---- ---- ----------- ----------- Highest rate 5.43% N/A 6.25% 3.88% Lowest rate 1.13% N/A 3.27% 3.88% Weighted average rate 3.99% N/A 4.54% 3.88% Matures through 2022 N/A 2014 2020 2004 Highest rate 5.43% 1.96% 6.25% N/A Lowest rate 1.13% 1.96% 3.27% N/A Weighted average rate 3.98% 1.96% 4.68% N/A Matures through 2022 2005 2014 N/A
Average rates of long and short-term debt were as follows
AT OR FOR THE YEAR ENDED DECEMBER 31, (DOLLARS IN THOUSANDS) ------------------------------------- 2005 2004 2003 -------- -------- -------- Long-term debt Maximum outstanding long-term debt of any month end $107,826 $ 82,931 $ 74,062 Average outstanding long-term debt 93,409 73,830 60,024 Approximate average rate paid on long-term debt 4.25% 4.39% 4.56% Short-term debt Maximum outstanding short-term debt at any month end $123,968 $122,693 $ 40,000 Average outstanding short-term debt 82,665 64,736 7,568 Approximate average rate paid on short-term debt 3.10% 1.80% 1.26%
The Bank's fixed-rate debt generally consists of advances with monthly interest payments and principal due at maturity. The Bank's adjustable-rate long-term debt adjusts quarterly based upon a margin over the three month London Interbank Offered Rate ("LIBOR"). The margin was set at 80 basis points. The debt had a minimum interest of 0.80% and a maximum rate of 5.30%. The Bank's fixed-rate, convertible, long-term debt is callable by the issuer, after an initial period ranging from six months to five years. Advances become callable on dates ranging from 2006 to 2009. Depending on the specific instrument, the instrument is callable either continuously after the initial period (Bermuda option) or only at the date ending the initial period (European). All advances have a prepayment penalty, determined based upon prevailing interest rates. Variable convertible advances have an initial variable rate based on a discount to LIBOR. The debt has a discount of 43 basis points to LIBOR. After an initial period of five years, the advance will convert at the issuer's option to a fixed-rate advance at a rate of 4.0% and a term of ten years. The contractual maturities of long-term debt are as follows
DECEMBER 31, 2005 DECEMBER 31, 2004 ---------------------------------------------- ----------------------------- FIXED FIXED RATE VARIABLE RATE CONVERTIBLE CONVERTIBLE TOTAL TOTAL ------------ ----------- ----------- ----------- ------------ Due in 2006 $ 12,000,000 $ - $ - $ 12,000,000 $ 12,000,000 Due in 2007 5,000,000 - - 5,000,000 5,000,000 Due in 2008 - - - - - Due in 2009 15,000,000 - - 15,000,000 15,000,000 Due in 2010 5,000,000 15,000,000 - 20,000,000 20,000,000 Thereafter 10,823,759 35,000,000 10,000,000 55,823,759 25,857,113 ------------ ------------ ------------ ------------ ------------ $ 47,823,759 $ 50,000,000 $ 10,000,000 $107,823,759 $ 77,857,113 ============ ============ ============ ============ ============
From time to time, the Bank also has daily advances outstanding, which are classified as short-term debt. These advances are repayable at the Bank's option at any time and reprice daily. These advances totaled $19,500,000 and $36,000,000 at December 31, 2005 and 2004, 36 respectively. The rates on the short-term debt at December 31, 2005 and 2004 were 4.58% and 2.44% respectively. Under the terms of an Agreement for Advances and Security Agreement with Blanket Floating Lien (the "Agreement"), the Company maintained eligible collateral consisting of one to four unit residential first mortgage loans, discounted at 80% of the unpaid principal balance, equal to 100% of its total outstanding long and short-term Federal Home Loan Bank advances. During 2003 and 2004, the Bank entered into addendums to the Agreement that expanded the types of eligible collateral under the Agreement to include certain commercial real estate and second mortgage loans. These loans are subject to eligibility rules, and collateral values are discounted at 50% of the unpaid loan principal balance. In addition, only 50% of total collateral for Federal Home Loan Bank advances may consist of commercial real estate loans. In addition the Bank has pledged its Federal Home Loan Bank stock of $6,740,000 and securities with a carrying value of $53,987,000 as additional collateral for its advances. The Bank is limited to total advances of up to 40% of assets or $216,000,000. At December 31, 2005, the Bank had filed collateral statements identifying collateral sufficient to borrow $158,226,000, and had identified additional collateral enabling it to borrow an additional $58,417,000, which had not been filed with the Federal Home Loan Bank of Atlanta. In addition, the Bank had outstanding notes payable to the U.S. Treasury, which are federal treasury tax and loan deposits accepted by the Bank and remitted on demand to the Federal Reserve Bank. At December 31, 2005 and 2004, such borrowings were $574,975 and $454,210, respectively. The Bank pays interest on these balances at a slight discount to the federal funds rate. The notes are secured by investment securities with an amortized cost of approximately $624,000 and $5,949,000 at December 31, 2005 and 2004, respectively. In addition to the other short-term borrowings noted above, the Bank has had outstanding agreements to repurchase certain securities that had been sold. These agreements were classified as short-term debt and were reflected as the cash received in connection with the transaction. Generally these agreements matured within three months. The Bank was sometimes required to provide additional collateral based on the fair value of these underlying securities. There were no amounts outstanding under these agreements at December 31, 2005 and $78,850,000 at December 31, 2004. NOTE 10 - INCOME TAXES Allocation of federal and state income taxes between current and deferred portions is as follows
2005 2004 2003 ----------- ----------- ----------- Current Federal $ 2,219,558 $ 1,284,026 $ 961,686 State 284,737 91,118 92,965 ----------- ----------- ----------- 2,504,295 1,375,144 1,054,651 ----------- ----------- ----------- Deferred Federal (398,238) 57,973 (19,561) State (54,113) 7,877 (2,658) ----------- ----------- ----------- (452,351) 65,850 (22,219) ----------- ----------- ----------- Total Income Tax Expense $ 2,051,944 $ 1,440,994 $ 1,032,432 =========== =========== ===========
The reasons for the differences between the statutory federal income tax rate and the effective tax rates are summarized as follows
2005 2004 2003 PERCENT PERCENT OF OF PRE- PERCENT OF PRE-TAX TAX PRE-TAX AMOUNT INCOME AMOUNT INCOME AMOUNT INCOME ------------ ---------- ----------- ------ ------------ ---------- Expected income tax expense at federal tax rate $ 2,050,638 34.00% $ 1,754,682 34.00% $ 1,182,632 34.00% State taxes net of federal benefit 152,212 2.52 65,337 1.27 59,603 1.70 Nondeductible expenses 3,124 0.05 2,527 0.05 14,130 0.40 Nontaxable income (154,337) (2.55) (179,442) (3.48) (213,613) (6.10) Donation of property - 0.00 (202,109) (3.92) - - Other 307 0.00 - 0.00 (10,320) (0.30) ----------- ----------- ----------- ----- $ 2,051,944 34.02% $ 1,440,994 27.92% $ 1,032,432 29.70 =========== ===== =========== ===== =========== =====
37 The net deferred tax assets in the accompanying balance sheets include the following components:
2005 2004 ---------- ---------- DEFERRED TAX ASSETS Deferred fees $ 4,583 $ 7,609 Allowance for loan losses 1,277,020 1,151,205 Deferred compensation 471,786 159,396 Valuation allowance on foreclosed real estate 259,991 259,991 ---------- ---------- 2,013,380 1,578,201 ---------- ---------- DEFERRED TAX LIABILITIES FHLB stock dividends 152,896 152,896 Depreciation 389,626 406,797 Unrealized gain on investment securities available for sale 25,431 95,891 ---------- ---------- 567,953 655,584 ---------- ---------- $1,445,427 $ 922,617 ========== ==========
Retained earnings at December 31, 2005, included approximately $1.2 million of bad debt deductions allowed for federal income tax purposes (the "base year tax reserve") for which no deferred income tax has been recognized. If, in the future, this portion of retained earnings is used for any purpose other than to absorb bad debt losses, it would create income for tax purposes only and income taxes would be imposed at the then prevailing rates. The unrecorded income tax liability on the above amount was approximately $463,000 at December 31, 2005. Prior to January 1, 1996, the Bank computed its tax bad debt deduction based upon the percentage of taxable income method as defined by the Internal Revenue Code. The bad debt deduction allowable under this method equaled 8% of taxable income determined without regard to the bad debt deduction and with certain adjustments. The tax bad debt deduction differed from the bad debt expense used for financial accounting purposes. In August 1996, the Small Business Job Protection Act (the "Act") repealed the percentage of taxable income method of accounting for bad debts effective for years beginning after December 31, 1995. The Act required the Bank to change its method of computing reserves for bad debts to the experience method. This method is available to banks with assets less than $500 million and allows the Bank to maintain a tax reserve for bad debts and to take bad debt deductions for reasonable additions to the reserve. As a result of this change, the Bank has to recapture into income a portion of its existing tax bad debt reserve. This recapture occurs ratably over a six-taxable year period, beginning with the 1998 tax year. For financial reporting purposes, this recapture does not result in additional tax expense as the Bank adequately provided deferred taxes in prior years. Furthermore, this change does not require the Bank to recapture its base-year tax reserve. NOTE 11 - COMMITMENTS AND CONTINGENCIES The Bank is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments are commitments to extend credit. These instruments may, but do not necessarily, involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheets. The Bank's exposure to credit loss in the event of nonperformance by the other party to the financial instrument is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments as it does for on-balance-sheet loans receivable. As of December 31, 2005 and 2004, in addition to the undisbursed portion of loans receivable of approximately $23,051,485 and $25,796,553, respectively, the Bank had outstanding loan commitments approximating $5,537,000 and $578,000, respectively. Standby letters of credit written are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. These guarantees are issued primarily to support construction borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank holds cash or a secured interest in real estate as collateral to support those commitments for which collateral is deemed necessary. Standby letters of credit outstanding amounted to $8,183,000 and $8,998,000 at December 31, 2005 and 2004, respectively. In addition to the commitments noted above, customers had approximately $48,001,000 and $39,200,000 available under lines of credit at December 31, 2005 and 2004, respectively. NOTE 12 - STOCK OPTION AND INCENTIVE PLAN The Company has stock option and incentive plans to attract and retain personnel and provide incentive to employees to promote the success of the business. On January 31, 2005, the Company's 1995 Stock Option and incentive Plan and 1995 Stock Option Plan for Non-Employee 38 Directors each expired. All shares authorized and available under this plan were awarded as of December 31, 2004. In May 2005, the 2005 Equity Compensation Plan was approved by the shareholders. The exercise price for options granted under this plan is set at the discretion of the committee administering this plan, but is not less than the market value of the shares as of the date of grant. An option's maximum term is ten years and the options vest at the discretion of the committee administering this plan. All outstanding options were fully vested at December 31, 2005. The following tables summarize activity in the plans:
2005 2004 2003 --------------------------- ---------------------------- --------------------------- WEIGHTED AVERAGE WEIGHTED AVERAGE WEIGHTED AVERAGE SHARES EXERCISE PRICE SHARES EXERCISE PRICE SHARES EXERCISE PRICE ------- ---------------- ------- ---------------- ------ ---------------- Outstanding at beginning of year 268,921 $ 16.08 231,291 $ 11.21 219,603 $ 9.54 Granted 59,526 33.43 86,956 23.01 37,835 18.43 Exercised (31,320) 8.30 (46,207) 4.97 (26,145) 7.66 Forfeitures (625) 17.99 (3,119) 12.85 - - ------- ------- ------- Outstanding at end of year 296,502 20.38 268,921 16.08 231,293 11.21 ======= ======= =======
Option amounts and exercise prices have been adjusted retroactively to give effect to the three for two stock splits. Options outstanding are all currently exercisable and are summarized as follows
NUMBER OUTSTANDING WEIGHTED AVERAGE WEIGHTED AVERAGE DECEMBER 31, 2005 REMAINING CONTRACTUAL LIFE EXERCISE PRICE ----------------- -------------------------- -------------- 30,893 3 years 10.75 15,656 4 years 11.82 28,649 5 years 11.84 28,283 6 years 11.86 15,721 7 years 17.33 48,593 8 years 19.35 69,182 9 years 23.83 59,525 10 years 33.43 ------- 296,502 20.38 =======
NOTE 13--EMPLOYEE BENEFIT PLANS The Bank has an Employee Stock Ownership Plan (ESOP) which covers substantially all its employees. The ESOP acquires stock of Tri-County Financial Corporation. The Company accounts for its ESOP in accordance with AICPA Statement of Position 93-6. Accordingly, unencumbered shares held by the ESOP are treated as outstanding in computing earnings per share. Shares issued to the ESOP but pledged as collateral for loans obtained to provide funds to acquire the shares are not treated as outstanding in computing earnings per share. Dividends on ESOP shares are recorded as a reduction of retained earnings. Contributions are made at the discretion of the Board of Directors. Expense recognized for the years ending 2005, 2004, and 2003 totaled $64,837, $78,421, and $100,079 respectively. As of December 31, 2005, the ESOP plan held 116,061 allocated and 7,528 unallocated shares with an approximate market value of $3,879,919 and $251,661, respectively. The Company also has a 401(k) plan. The Company matches a portion of the employee contributions. This ratio is determined annually by the Board of Directors. In 2005, 2004, and 2003, the Company matched one-half of the employee's first 8% deferral. All employees who have completed one year of service and have reached the age of 21 are covered under this defined contribution plan. Contributions are determined at the discretion of management and the Board of Directors. For the years ended December 31, 2005, 2004, and 2003, the Company charged $92,000, $89,000, and $81,000, respectively, against earnings to fund the plan. The Bank has a separate nonqualified retirement plan for non-employee directors. Directors are eligible for a maximum benefit of $3,500 a year for ten years following retirement from the Board of Community Bank of Tri-County. The maximum benefit is earned at 15 years of service as a non-employee director. Full vesting occurs after two years of service. Expense recorded for this plan was $5,173, $18,000, and $24,000 for the years ending December 31, 2005, 2004, and 2003, respectively. In addition, the Bank has established a separate supplemental retirement plan for certain of the Bank's key executives. This plan provides a 39 retirement income payment for 15 years from the date of the employee's expected retirement date. The payments are set at the discretion of the Board of Directors and vesting occurs ratably from the date of employment to the expected retirement date. Expense recorded for this plan totaled $286,000, $316,000, and $286,000 for 2005, 2004, and 2003 respectively. NOTE 14--REGULATORY MATTERS The Company and the Bank are subject to various regulatory capital requirements administered by the federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the table below) of tangible and core capital (as defined in the regulations) to total adjusted assets (as defined), and of risk-based capital (as defined) to risk-weighted assets (as defined). Management believes, as of December 31, 2004, that the Company and the Bank meet all capital adequacy requirements to which they are subject. As of December 31, 2005, the most recent notification from the Federal Reserve categorized the Bank as well-capitalized under the regulatory framework for prompt corrective action. To be categorized as well-capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the Company's or the Bank's category. The Company's and the Bank's actual capital amounts and ratios for 2005 and 2004 are presented in the tables below.
TO BE CONSIDERED WELL REQUIRED FOR CAPITAL CAPITALIZED UNDER PROMPT ACTUAL ADEQUACY PURPOSES CORRECTIVE ACTION --------------------- ---------------------- ------------------------ AT DECEMBER 31, 2005 Total capital (to risk weighted assets) The Company $49,544 11.84% $33,463 8.00% The Bank $48,753 11.67% $33,391 8.00% $ 41,739 10.00% Tier 1 capital (to risk weighted assets) The Company $46,161 11.04% $16,731 4.00% The Bank $45,370 10.87% $16,696 4.00% $ 25,044 6.00% Tier 1 capital (to average assets) The Company $46,161 8.55% $21,590 4.00% The Bank $45,370 8.42% $21,550 4.00% $ 26,937 5.00% AT DECEMBER 31, 2004 Total capital (to risk weighted assets) The Company $41,368 11.89% $27,842 8.00% The Bank $40,605 11.67% $27,826 8.00% $ 34,782 10.00% Tier 1 capital (to risk weighted assets) The Company $38,310 11.01% $13,921 4.00% The Bank $37,548 10.80% $13,913 4.00% $ 20,869 6.00% Tier 1 capital (to average assets) The Company $38,310 9.29% $16,494 4.00% The Bank $37,548 9.13% $16,454 4.00% $ 20,568 5.00%
NOTE 15--FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is necessarily required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market 40 exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. Therefore, any aggregate unrealized gains or losses should not be interpreted as a forecast of future earnings or cash flows. Furthermore, the fair values disclosed should not be interpreted as the aggregate current value of the Company.
DECEMBER 31, 2005 DECEMBER 31, 2004 ----------------------------- ----------------------------- CARRYING ESTIMATED CARRYING ESTIMATED AMOUNT FAIR VALUE AMOUNT FAIR VALUE ------------ ------------ ------------ ------------ ASSETS Cash and cash equivalents $ 22,575,240 $ 22,575,240 $ 17,715,779 $ 17,715,779 Investment securities and stock in FHLB and FRB 130,855,879 128,640,980 181,834,426 180,758,025 Loans receivable, net 369,592,253 370,164,000 289,325,051 292,988,000 LIABILITIES Savings, NOW, and money market accounts 167,987,707 167,987,707 164,952,530 164,952,530 Time certificates 195,386,032 189,574,936 101,801,974 101,448,140 Long-term debt and other borrowed funds 127,898,734 $126,788,777 198,235,323 199,752,029 Guaranteed preferred beneficial interest in junior subordinated securities $ 12,000,000 $ 12,000,000 $ 7,000,000 $ 7,000,000
At December 31, 2005 and 2004, the Company had outstanding loan commitments and standby letters of credit of $14 million and $9 million, respectively. Based on the short-term lives of these instruments, the Company does not believe that the fair value of these instruments differs significantly from their carrying values. Valuation Methodology Cash and Cash Equivalents - For cash and cash equivalents, the carrying amount is a reasonable estimate of fair value. Investment Securities - Fair values are based on quoted market prices or dealer quotes. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. Loans Receivable - For conforming residential first-mortgage loans, the market price for loans with similar coupons and maturities was used. For nonconforming loans with maturities similar to conforming loans, the coupon was adjusted for credit risk. Loans which did not have quoted market prices were priced using the discounted cash flow method. The discount rate used was the rate currently offered on similar products. Loans priced using the discounted cash flow method included residential construction loans, commercial real estate loans, and consumer loans. The estimated fair value of loans held for sale is based on the terms of the related sale commitments. Deposits - The fair value of checking accounts, saving accounts, and money market accounts was the amount payable on demand at the reporting date. Time Certificates - The fair value was determined using the discounted cash flow method. The discount rate was equal to the rate currently offered on similar products. Long-Term Debt and Other Borrowed Funds - These were valued using the discounted cash flow method. The discount rate was equal to the rate currently offered on similar borrowings. Guaranteed Preferred Beneficial Interest in Junior Subordinated Securities-These were valued using discounted cash flows. The discount rate was equal to the rate currently offered on similar borrowings. Off-Balance Sheet Instruments - The Company charges fees for commitments to extend credit. Interest rates on loans for which these commitments are extended are normally committed for periods of less than one month. Fees charged on standby letters of credit and other financial guarantees are deemed to be immaterial and these guarantees are expected to be settled at face amount or expire unused. It is impractical to assign any fair value to these commitments. The fair value estimates presented herein are based on pertinent information available to management as of December 31, 2005 and 2004. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since that date and, therefore, current estimates of fair value may differ significantly from the amount presented herein. 41 NOTE 16 - GUARANTEED PREFERRED BENEFICIAL INTEREST IN JUNIOR SUBORDINATED DEBENTURES On June 15, 2005, Tri-County Capital Trust II ("Capital Trust II"), a Delaware business trust formed, funded and wholly owned by the Company, issued $5,000,000 of variable-rate capital securities with an interest rate of 5.07% in a private pooled transaction. The variable rate is based on the 90-day LIBOR rate plus 1.70%. The Trust used the proceeds from this issuance to purchase $5,155,000 of the Company's junior subordinated debentures. The interest rate on the debentures and the trust preferred securities is variable and adjusts quarterly. The Company has, through various contractual arrangements, fully and unconditionally guaranteed all of Capital Trust II's obligations with respect to the capital securities. These capital securities qualify as Tier I capital and are presented in the Consolidated Balance Sheets as "Guaranteed Preferred Beneficial Interests in Junior Subordinated Debentures." Both the capital securities of Capital Trust II and the junior subordinated debentures are scheduled to mature on June 15, 2035, unless called by the Company not earlier than June 15, 2010. On July 22, 2004, Tri-County Capital Trust I ("Capital Trust I"), a Delaware business trust formed, funded and wholly owned by the Company, issued $7,000,000 of variable-rate capital securities with an interest rate of 4.22% in a private pooled transaction. The variable rate is based on the 90-day LIBOR rate plus 2.60%. The Trust used the proceeds from this issuance, along with the Company's $217,000 capital contribution for Capital Trust 1's common securities, to purchase $7,217,000 of the Company's junior subordinated debentures. The interest rate on the debentures and the trust preferred securities is variable and adjusts quarterly. The Company has, through various contractual arrangements, fully and unconditionally guaranteed all of Capital Trust I's obligations with respect to the capital securities. These debentures qualify as Tier I capital and are presented in the Consolidated Balance Sheets as "Guaranteed Preferred Beneficial Interests in Junior Subordinated Debentures." Both the capital securities of Capital Trust I and the junior subordinated debentures are scheduled to mature on July 22, 2034, unless called by the Company not earlier than July 22, 2009. Costs associated with the issuance of the trust-preferred securities were less than $10,000 and were expensed as period costs. NOTE 17 - PRIVATE PLACEMENT On December 30, 2005, the Company completed a private placement of securities in an offering exempt from registration under the Securities Act. The seven investors were officers, directors, and counsel for the Company. The offering was for 15,768 shares at $30.00 per share and raised $473,040. The costs of the offering were less than $5,000 and were expensed. NOTE 18 - CONDENSED FINANCIAL STATEMENTS - PARENT COMPANY ONLY Financial information pertaining only to Tri-County Financial Corporation is as follows BALANCE SHEETS
DECEMBER 31, 2005 2004 ------------ ------------ ASSETS Cash - noninterest bearing $ 881,185 $ 269,072 Cash - interest bearing 167,830 181,516 Investment securities available for sale 35,838 34,666 Investment in wholly owned subsidiaries 45,791,231 37,951,438 Other assets 853,740 194,074 ------------ ------------ Total assets $ 47,729,824 $ 38,630,766 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities $ 779,668 $ 290,191 Guaranteed preferred beneficial interest in junior subordinated debentures 12,372,000 7,217,000 ------------ ------------ Total liabilities 13,151,668 7,507,191 ------------ ------------ STOCKHOLDERS' EQUITY Common stock 17,610 11,469 Surplus 9,057,805 8,252,152 Retained earnings 25,580,634 22,833,112 Total accumulated other comprehensive income 49,363 186,140 Unearned ESOP shares (127,256) (159,298) ------------ ------------ Total stockholders' equity 34,578,156 31,123,575 ------------ ------------ Total liabilities and stockholders' equity $ 47,729,824 $ 38,630,766 ============ ============
42 CONDENSED STATEMENTS OF INCOME
YEAR ENDED DECEMBER 31, 2005 2004 2003 ----------- ----------- ----------- Dividends from subsidiary $ 1,700,000 $ - $ 500,000 Interest income 16,059 6,349 10,356 Interest expense 580,584 140,341 - ----------- ----------- ----------- Net interest income 1,135,475 (133,992) 510,356 Miscellaneous expenses (257,031) (166,364) (174,595) ----------- ----------- ----------- Income before income taxes and equity in 878,444 (300,356) 335,761 undistributed net income of subsidiary Federal and state income tax benefit 279,328 102,120 55,841 Equity in undistributed net income of subsidiary 2,821,571 3,918,070 2,054,296 ----------- ----------- ----------- NET INCOME $ 3,979,343 $ 3,719,834 $ 2,445,898 =========== =========== ===========
CONDENSED STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31, 2005 2004 2003 ----------- ----------- ----------- CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 3,979,343 $ 3,719,834 $ 2,445,898 Adjustments to reconcile net income to net cash provided by operating activities Equity in undistributed earnings of subsidiary (2,821,571) (3,918,070) (2,054,296) (Decrease) increase in other assets (659,666) 763,470 (72,560) Increase in current liabilities 489,477 30,835 5,008 ----------- ----------- ----------- Net cash provided by operating activities 987,583 596,069 324,050 ----------- ----------- ----------- CASH FLOWS FROM INVESTING ACTIVITIES Purchase of investment securities available for sale (1,172) (1,514) (714) Net cash used by investing activities (1,172) (1,514) (714) ----------- ----------- ----------- CASH FLOWS FROM FINANCING ACTIVITIES Sale of guaranteed preferred beneficial interests in junior subordinated securities 5,155,000 7,217,000 - Downstream of capital to subsidiary (5,000,000) (7,000,000) Investment in trust subsidiary (155,000) (217,000) Dividends paid (930,669) (541,633) (422,361) Proceeds from private placement 473,040 - - Exercise of stock options 304,648 248,661 218,713 Net change in ESOP loan 60,390 8,506 63,435 Redemption of common stock (295,393) (412,973) (769,720) ----------- ----------- ----------- Net cash used in financing activities (387,984) (697,439) (909,933) ----------- ----------- ----------- INCREASE (DECREASE) IN CASH 598,427 (102,884) (586,597) CASH AT BEGINNING OF YEAR 450,588 553,472 1,140,069 ----------- ----------- ----------- CASH AT END OF YEAR $ 1,049,015 $ 450,588 $ 553,472 =========== =========== ===========
43 NOTE 19 - QUARTERLY FINANCIAL RESULTS (UNAUDITED) A summary of selected consolidated quarterly financial data for the two years ended December 31, 2005 is reported as follows
2005 FOURTH 2005 THIRD 2005 SECOND 2005 FIRST 2004 FOURTH 2004 THIRD 2004 SECOND 2004 FIRST QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER ----------- ---------- ----------- ---------- ----------- ---------- ----------- ---------- Interest and dividend income $7,872,103 $7,433,702 $7,284,039 $6,564,868 $6,455,056 $5,915,854 $4,648,618 $4,593,811 Interest expense 3,838,465 3,566,630 3,369,456 2,809,080 2,560,878 2,086,208 1,602,035 1,564,289 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Net interest income 4,033,638 3,867,072 3,914,583 3,755,788 3,894,178 3,829,646 3,046,583 3,029,522 Provision for loan loss 129,160 11,183 126,097 63,027 136,028 232,996 13,772 70,202 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Net interest income after provision 3,904,478 3,855,889 3,788,486 3,692,761 3,758,150 3,596,650 3,032,811 2,959,320 Noninterest income 339,218 466,650 433,806 401,329 422,187 329,876 434,025 396,228 Noninterest expense 2,943,137 2,769,564 2,589,915 2,548,714 2,747,623 2,307,562 2,317,511 2,395,723 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Income before income taxes 1,300,559 1,552,975 1,632,377 1,545,376 1,432,714 1,618,964 1,149,325 959,825 Provision for income taxes 414,733 562,908 553,288 521,015 486,960 537,658 345,749 70,627 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Net income $ 885,826 $ 990,067 $1,079,089 $1,024,361 $ 945,754 $1,081,306 $ 803,576 $ 889,198 ========== ========== ========== ========== ========== ========== ========== ========== Earnings per common share(1,2) Basic $ 0.51 $ 0.57 $ 0.62 $ 0.59 $ 0.54 $ 0.63 $ 0.47 $ 0.53 Diluted 0.48 0.53 0.59 0.56 0.52 0.60 0.45 0.50
(1) All per share amounts have been adjusted for the three for two stock splits effected in December 2005 and December 2004. (2) Earnings per share are based upon quarterly results and may not be additive to the annual earnings per share amounts. 44