-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, JmA/dWnyvZYO9dM7jds6k+TTkc6lYJ/2MG4qFQKmnK4yQuhYL4TJ73KaKt+rmsmr /NjZVfCf/3fTgQDIzX8f6w== 0000744126-06-000010.txt : 20060316 0000744126-06-000010.hdr.sgml : 20060316 20060316145912 ACCESSION NUMBER: 0000744126-06-000010 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 9 CONFORMED PERIOD OF REPORT: 20051231 FILED AS OF DATE: 20060316 DATE AS OF CHANGE: 20060316 FILER: COMPANY DATA: COMPANY CONFORMED NAME: FIRST CHESTER COUNTY CORP CENTRAL INDEX KEY: 0000744126 STANDARD INDUSTRIAL CLASSIFICATION: NATIONAL COMMERCIAL BANKS [6021] IRS NUMBER: 232288763 STATE OF INCORPORATION: PA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 000-12870 FILM NUMBER: 06691512 BUSINESS ADDRESS: STREET 1: 9 N HIGH ST STREET 2: PO BOX 523 CITY: WEST CHESTER STATE: PA ZIP: 19381 BUSINESS PHONE: 6106923000 MAIL ADDRESS: STREET 1: 9 NORTH HIGH ST STREET 2: PO BOX 523 CITY: WEST CHESTER STATE: PA ZIP: 19381 FORMER COMPANY: FORMER CONFORMED NAME: FIRST WEST CHESTER CORP DATE OF NAME CHANGE: 19920703 10-K 1 k10annualwrap2005.txt FORM 10-K FOR YEAR ENDED 12/31/05 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K (Mark One) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2005, OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _____________ to _____________ Commission File No. 0-12870 FIRST CHESTER COUNTY CORPORATION (Exact name of Registrant as specified in its charter) Pennsylvania 23-2288763 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 9 North High Street, West Chester, Pennsylvania 19380 (Address of principal executive offices) Registrant's telephone number, including area code (484) 881-4000 Securities registered pursuant to Section 12(b) of the Act: Name of Each Exchange Title of Each Class on Which Registered ------------------- ------------------- None None Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $1.00 per share --------------------------------------- (Title of Class) Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ___ No X Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ___ No X Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No __ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ( __ ) The aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the Registrant's most recently completed second fiscal quarter: $ 99,791,107. Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See the definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer ___ Accelerated filer X Non-accelerated filer ___ Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ___ No X 1 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES The number of shares outstanding of Common Stock of the Registrant as of February 17, 2006, was 5,132,224. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Registrant's definitive Proxy Statement for its 2006 Annual Meeting of Shareholders, which definitive Proxy Statement will be filed with the Securities and Exchange Commission not later than 120 days after the Registrant's year end at December 31, 2005, are incorporated by reference into Part III. 2
FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES TABLE OF CONTENTS PAGE PART I: Item 1 - Business 4 Item 1A - Risk Factors 10 Item 1B - Unresolved Staff Comments 12 Item 2 - Properties 12 - 14 Item 3 - Legal Proceedings 14 Item 4 - Submission of Matters to a Vote of Security Holders 14 PART II: Item 5 - Market for the Corporation's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 14 - 15 Item 6 - Selected Financial Data 16 Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operation 17 - 36 Item 7A - Quantitative and Qualitative Disclosures about Market Risk 36 - 38 Item 8 - Financial Statements and Supplementary Data 39 - 68 Item 9 - Changes In and Disagreements with Accountants on Accounting and Financial Disclosure 69 Item 9A - Controls and Procedures 69 Item 9B - Other Information 69 PART III: Item 10 - Directors and Executive Officers of the Corporation 70 Item 11 - Executive Compensation 70 Item 12 - Security Ownership of Certain Beneficial Owners 70 and Management and Related Stockholder Matters Item 13 - Certain Relationships and Related Transactions 71 Item 14 - Principal Accountant Fees and Services 71 PART IV: Item 15 - Exhibits, Financial Statement Schedules 71 - 76 SIGNATURES 71 - 76
3 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES PART I Item 1. Business. - ------ -------- First Chester County Corporation (the "Corporation") may from time to time make written or oral "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, including statements contained in the Corporation's filings with the Securities and Exchange Commission (including this Report on Form 10-K), its reports to shareholders and in other communications by the Corporation. These statements can often be identified by the use of forward-looking terminology such as "believes", "expects", "intends", "may", "will", "should" or "anticipates" or similar terminology. These statements involve risks and uncertainties and are based on various assumptions. Although the Corporation believes that its expectations are based on reasonable assumptions, investors and prospective investors are cautioned that such statements are only projections. Also, future results may differ materially from the Corporation's historic results. The risks and uncertainties noted below, among others, could cause the Corporation's actual future results to differ materially from those described in forward-looking statements made in this Report, or presented elsewhere by Management from time to time, or from the Corporation's historic results. Many of these risks and uncertainties are discussed in Item 1A, "Risk Factors", in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," and elsewhere in this Report. These risks, among others, could cause our actual future results to differ materially from those described in our forward-looking statements or from our prior results. We are not obligated to update our forward-looking statements, even though our situation may change in the future. GENERAL The Corporation is a Pennsylvania corporation and a bank holding company registered under the Federal Bank Holding Company Act of 1956, as amended (the "BHC Act"). As a bank holding company, the Corporation's operations are confined to the ownership and operation of banks and activities deemed by the Board of Governors of the Federal Reserve System (the "Federal Reserve Board") to be so closely related to banking to be a proper incident thereto. The Corporation was incorporated on March 9, 1984, for the purpose of becoming a registered bank holding company pursuant to the BHC Act and acquiring First National Bank of Chester County, formerly known as The First National Bank of West Chester (the "Bank"), thereby enabling the Bank to operate within a bank holding company structure. On September 13, 1984, the Corporation acquired all of the issued and outstanding shares of common stock of the Bank. The principal activities of the Corporation are the owning and supervising of the Bank, which engages in a general banking business based in Chester County, Pennsylvania. The Corporation directs the policies and coordinates the financial resources of the Bank. In addition, the Corporation is the sole shareholder of Turks Head Properties, Inc., a Pennsylvania corporation, which was formed in 1994, and Turks Head II LLC, which was formed in 2003, each of which serves the purpose of holding the Bank's interests in and operating foreclosed real property until liquidation of such properties. First Chester County Capital Trust I, which was formed on July 11, 2002, and First Chester County Capital Trust II, which was formed on November 13, 2003, are special purpose statutory trusts created expressly for the issuance of preferred capital securities and investing proceeds in junior subordinated debentures of the Corporation. The Bank has two other wholly-owned subsidiaries, FNB Insurance Services, LLC, trading as First National Wealth Advisory Services, and FNB Properties, LLC. First National Wealth Advisory Services offers insurance, full-service brokerage, financial planning and mutual fund services. FNB Properties, LLC acts as property manager for the properties where the Bank's Lionville and New Garden branches are located. On August 5, 2001, the Corporation became a financial holding company pursuant to the Gramm-Leach-Bliley Act of 1999. The Corporation's filings with the SEC including its annual report on Form 10-K, quarterly reports on Form 10-Q, periodic reports on Form 8-K, and amendments to these reports, are accessible free of charge at our website at http://www.fnbchestercounty.com as soon as reasonably practicable after filing with the SEC. By making this reference to our website, we do not intend to incorporate into this report any information contained in the website. The website should not be considered part of this Report. The SEC maintains a website at http:///www.sec.gov that contains reports, proxy and information statements, and other information free of charge regarding issuers, including the Corporation, that file electronically with the SEC. 4 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES BUSINESS OF THE BANK The Bank is engaged in the business of commercial and retail banking and was organized under the banking laws of the United States in December 1863. The Bank currently conducts its business through twenty banking offices located in Chester and Delaware Counties, Pennsylvania, including its main office. In addition, the Bank operates 25 ATM facilities. The Bank is a member of the Federal Reserve System. At December 31, 2005, the Bank had total assets of approximately $845 million, total loans of approximately $664 million, total deposits of approximately $696 million and employed 232 persons, of which 218 were full-time and 14 were part-time. The Bank is a full service commercial bank offering a broad range of retail banking, commercial banking, Internet banking, trust and investment management and insurance services to individuals, businesses, governmental entities, nonprofit organizations, and community service groups. Retail services include checking accounts, savings programs, money-market accounts, certificates of deposit, safe deposit facilities, consumer loan programs, residential mortgages, overdraft checking, automated tellers and extended banking hours. Commercial services include revolving lines of credit, commercial mortgages, equipment leasing and letter of credit services. These retail and commercial banking activities are provided primarily to consumers and small to mid-sized companies within the Bank's market area. Lending services are focused on commercial, consumer, and real estate lending to local borrowers. The Bank attempts to establish a total borrowing relationship with its customers that may typically include commercial loans, a mortgage loan for the borrower's residence, a consumer loan or a revolving personal credit line. The Bank's Trust and Investment Services Division (the "TIS Division") provides a broad range of trust and investment management services. It administers and provides services for estates, trusts, agency accounts, and individual and employer sponsored retirement plans. At December 31, 2005, the Bank's Trust and Investment Services Division administered or provided investment management services to accounts that held assets with an aggregate market value of approximately $561 million. For the year ended December 31, 2005, gross income from the Bank's Trust and Investment Services Department and related activities amounted to approximately $3.4 million. In addition to retail and commercial banking and trust services, the Bank offers an array of investment opportunities including mutual funds, annuities, retirement planning, education planning and insurance through the Wealth Advisory Services Division. COMPETITION The Bank's service area consists primarily of greater Chester County, as well as the fringe of Delaware County, Pennsylvania. The core of the Bank's service area is located within a fifteen-mile radius of the Bank's main office in West Chester, Pennsylvania. The Bank encounters vigorous competition for market share in the communities it serves from bank holding companies, other community banks, thrift institutions, credit unions, Internet banks and other non-bank financial organizations such as mutual fund companies, brokerage firms, and the financing arms of corporate conglomerates. The Bank also competes with banking and financial institutions, some from out-of-state that have opened branches in the Bank's market, which are substantially larger and have greater financial resources than the Bank. The Bank's TIS Division competes with a variety of companies including private trust companies, banks with trust departments, private money managers, brokerage firms, mutual fund companies, attorneys, accountants and insurance companies. Management believes that the Bank is able to effectively compete with its competitors because of its ability to provide responsive personalized services and competitive rates. This ability is a direct result of Management's knowledge of the Bank's market area and customer base. Management believes the needs of the small to mid-sized commercial business and retail customers are not adequately met by larger financial institutions, therefore creating a marketing opportunity for the Bank. 5 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES SUPERVISION AND REGULATION General The Corporation is a bank holding company subject to supervision and regulation by the Federal Reserve Board. In addition, the Bank is subject to supervision, regulation and examination by the Office of the Comptroller of the Currency (the "OCC") and secondary regulation by the Federal Deposit Insurance Corporation (the "FDIC"). The OCC must approve bank mergers, if the surviving bank would be a national bank, as well as the establishment of new branches. Federal and state laws impose a number of requirements and restrictions on the operations of the Bank, including requirements to maintain reserves against deposits, restrictions on the types and amounts of loans that may be made and the types of services which may be offered, and restrictions on the ability to acquire deposits under certain circumstances. The Bank must also comply with various consumer laws and regulations. Certain aspects of the Bank's operation are also subject to state laws. The following sections discuss more fully some of the principal elements of the regulatory framework applicable to the Corporation and the Bank. This discussion is not intended to be an exhaustive description of the statutes and regulations applicable to the Corporation and the Bank and is subject to and qualified by reference to the statutory and regulatory provisions. A change in these statutes, regulations or regulatory policies, or the adoption of new statutes, regulations or regulatory policies, may have a material effect on the Corporation's business. Bank Holding Company Act The Corporation is required to file with the Federal Reserve Board an annual report, other periodic reports, and such additional information as the Federal Reserve Board may require pursuant to the BHC Act. The Federal Reserve Board also makes examinations of bank holding companies and their subsidiaries. The BHC Act requires each bank holding company to obtain the prior approval of the Federal Reserve Board before it may acquire substantially all of the assets of any bank, or if it would acquire or control more than 5% of the voting shares of such a bank. The Federal Reserve Board considers numerous factors, including its capital adequacy guidelines, before approving such acquisitions. For a description of certain applicable guidelines, see this Item "Capital," Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Capital Adequacy," and Part II, Item 8, "Note I -- Regulatory Matters" in the consolidated financial statements. The Community Reinvestment Act The Community Reinvestment Act of 1977, as amended (the "CRA"), and the regulations promulgated to implement the CRA are designed to create a system for bank regulatory agencies to evaluate a depository institution's record in meeting the credit needs of its community. The CRA regulations were completely revised in 1995 to establish performance-based standards for use in examining a depository institution's compliance with the CRA (the "revised CRA regulations"). The revised CRA regulations establish new tests for evaluating both small and large depository institutions' investment in the community. For the purposes of the revised CRA regulations, the Bank is deemed to be a large retail institution, based upon financial information as of December 31, 2005. In connection with its assessment of CRA performance, the FDIC assigns a rating of "outstanding," "satisfactory," "needs to improve," or "substantial compliance." The Bank has opted to be examined under a three-part test evaluating the Bank's lending service and investment performance. The Bank received an outstanding rating at its last regulatory examination in May 2005. Dividend Restrictions The Corporation is a legal entity separate and distinct from the Bank. Virtually all of the revenue of the Corporation available for payment of dividends on its Common Stock will result from amounts paid to the Corporation from dividends received from the Bank. All such dividends are subject to limitations imposed by federal and state laws and by regulations and policies adopted by federal and state regulatory agencies. The Bank, as a national bank, is required by federal law to obtain the approval of the OCC for the payment of dividends if the total of all dividends declared by the Board of Directors of the Bank in any calendar year will exceed the total of the Bank's net income for that year and the retained net income for the preceding two years, less any required transfers to surplus or a fund for the retirement of any preferred stock. Under this formula, in 2005, the Bank, without affirmative governmental approvals, could declare aggregate dividends of approximately $10.0 million, plus an amount approximately equal to the net income, if any, earned by the Bank for the period from January 1, 2006, through the date of declaration of such dividend less dividends previously paid, subject to the further limitations that a national bank can pay dividends only to the 6 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES extent that retained net profits (including the portion transferred to surplus) exceed bad debts and provided that the Bank would not become "undercapitalized" (as these terms are defined under federal law). Dividends declared and paid in 2005 were $2.7 million. If, in the opinion of the applicable regulatory authority, a bank or bank holding company under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice (which, depending on the financial condition of the bank or bank holding company, could include the payment of dividends), such regulatory authority may require such bank or bank holding company to cease and desist from such practice, or to limit dividends in the future. Finally, the several regulatory authorities described herein, may from time to time, establish guidelines, issue policy statements and adopt regulations with respect to the maintenance of appropriate levels of capital by a bank or bank holding company under their jurisdiction. Compliance with the standards set forth in such policy statements, guidelines and regulations could limit the amount of dividends which the Corporation and the Bank may pay. Capital The Corporation and the Bank are both subject to minimum capital requirements and guidelines. The Federal Reserve Board measures capital adequacy for bank holding companies on the basis of a risk-based capital framework and a leverage ratio. The Federal Reserve Board has established minimum leverage ratio guidelines for bank holding companies. These guidelines currently provide for a minimum leverage ratio of Tier I Capital to average total assets of 3% for bank holding companies that meet certain criteria, including that they maintain the highest regulatory rating. All other bank holding companies are required to maintain a leverage ratio of 3% plus an additional cushion of at least 100 to 200 basis points. The Federal Reserve Board has not advised the Corporation of any specific minimum leverage ratio under these guidelines which would be applicable to the Corporation. Failure to satisfy regulators that a bank holding company will comply fully with capital adequacy guidelines upon consummation of an acquisition may impede the ability of a bank holding company to consummate such acquisition, particularly if the acquisition involves payment of consideration other than common stock. In many cases, the regulatory agencies will not approve acquisitions by bank holding companies and banks unless their capital ratios are well above regulatory minimums. The Bank is subject to capital requirements which generally are similar to those affecting the Corporation. The minimum ratio of total Risk-Based Capital to Risk-Weighted assets (including certain off-balance sheet items, such as standby letters of credit) is 8%. Capital may consist of equity and qualifying perpetual preferred stock, less goodwill ("Tier I Capital"), and certain convertible debt securities, qualifying subordinated debt, other preferred stock and a portion of the reserve for possible credit losses ("Tier II Capital"). A depository institution's capital classification depends upon its capital levels in relation to various relevant capital measures, which include a Risk-Based Capital measure and a leverage ratio capital measure. A depository institution is considered well capitalized if it significantly exceeds the minimum level required by regulation for each relevant capital measure, adequately capitalized if it meets each such measure, undercapitalized if it fails to meet any such measure, significantly undercapitalized if it is significantly below any such measure and critically undercapitalized if it fails to meet any critical capital level set forth in the regulations. An institution may be placed in a lower capitalization category if it receives an unsatisfactory examination rating, is deemed to be in an unsafe or unsound condition, or engages in unsafe or unsound practices. Under applicable regulations, for an institution to be well capitalized it must have a Total Risk-Based Capital ratio of at least 10%, a Tier I Capital ratio of at least 6% and a Leverage ratio of at least 5% and not be subject to any specific capital order or directive. As of December 31, 2005 and 2004, the Corporation and the Bank had capital in excess of all regulatory minimums and the Bank was "well capitalized." Deposit Insurance Assessments The Bank is subject to deposit insurance assessments by the FDIC's Bank Insurance Fund ("BIF"). The FDIC has developed a risk-based assessment system, under which the assessment rate for an insured depository institution varies according to its level of risk. An institution's risk category is based upon whether the institution is well capitalized, adequately capitalized or undercapitalized and the institution's "supervisory subgroups": Subgroup A, B or C. Subgroup A institutions are financially sound institutions with a few minor weaknesses; Subgroup B institutions are institutions that demonstrate weaknesses which, if not corrected, could result in significant deterioration; and Subgroup C institutions are institutions for which there is a substantial probability that the FDIC will suffer a loss in connection with the institution unless effective action is taken to correct the areas of weakness. Based on its capital and supervisory subgroups, each BIF member institution is assigned an annual 7 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES FDIC assessment rate per $100 of insured deposits varying between 0.00% per annum (for well capitalized Subgroup A institutions) and 0.27% per annum (for undercapitalized Subgroup C institutions). As of January 1, 2001, well capitalized Subgroup A institutions paid 0.00%. The Bank's Subgroup for 2005 was A. In accordance with the Deposit Insurance Act of 1997 an additional assessment by the Financing Corporation ("FICO") became applicable to all insured institutions as of January 1, 1998. This assessment is not tied to the FDIC risk classification. The FICO assessment rates effective for both the fourth quarter 2005 and the first quarter of 2006 were $0 per $100 of BIF assessable deposits. FDIC deposit insurance expense was $91,000, $86,000 and $88,000 for the years 2005, 2004, and 2003. Financial Services Modernization Act of 1999 On November 12, 1999, the President signed into law the Gramm-Leach-Bliley Act (the "Act") which became effective in 2000. Among the Act's various provisions are some changes governing the operations of companies doing business in the financial services industry. The Act eliminates many of the restrictions previously placed on the activities of banks and bank holding companies, and through the creation of two new designations, financial holding companies and financial subsidiaries, bank holding companies and national banks may participate in a wider array of financial services and products (referred to as "financial activities" in the Act), including services and products that had been reserved only for insurance companies and securities firms. In addition, a bank holding company can now affiliate with an insurance company and a securities firm. A "financial activity" is an activity that does not pose a safety and soundness risk and is financial in nature, incidental to an activity that is financial in nature, or complementary to a financial activity. Some examples of "financial activities" which are permitted under the Act are: o Lending, investing or safeguarding money or securities; o Underwriting insurance or annuities, or acting as an insurance or annuity principal, agent or broker; o Providing financial or investment advice; o Underwriting, dealing in or making markets in securities; and o Insurance company portfolio investments. The Corporation currently meets the qualifications set forth under the Act to be a financial holding company, and the Bank, as a national bank, is authorized by the Act to use "financial subsidiaries" to engage in financial activities, subject to the limitations imposed by the Act. During 2000, First National Wealth Advisory Services was formed as a wholly-owned subsidiary of the Bank for the purpose of offering insurance, full service brokerage, financial planning and mutual fund services. First National Wealth Advisory Services has elected to become a financial subsidiary under the Act. Control Acquisitions The Change in Bank Control Act prohibits a person or group of persons from acquiring "control" of a bank holding company, unless the Federal Reserve Board has been notified and has not objected to the transaction. Under a rebuttable presumption established by the Federal Reserve Board, the acquisition of ten percent or more of a class of voting stock of a bank holding company with a class of securities registered under Section 12 of the Exchange Act, such as the Corporation, would, under the circumstances set forth in the presumption, constitute acquisition of control of the bank holding company. In addition, as described above, under the BHC Act, the Federal Reserve Board must give its prior approval of any transaction pursuant to which any person or persons may acquire 25 percent (five percent in the case of an acquirer that is a bank holding company) or more of any class of outstanding common stock of a bank holding company, such as the Corporation, or otherwise obtaining control or a "controlling influence" over that bank holding company. See this Item, "Bank Holding Company Act". The USA Patriot Act The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism of 2002 (the "USA Patriot Act") gives the federal government new powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing, and broadened anti-money laundering requirements. Through amendments to the Bank Secrecy Act, the USA Patriot Act takes measures intended to encourage information sharing among bank regulatory agencies and law enforcement agencies. Among other requirements, the USA Patriot Act requires 8 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES banks to establish anti-money laundering policies, to adopt procedures and controls to detect and report money laundering, and to comply with certain enhanced recordkeeping obligations and due diligence standards with respect to correspondent accounts of foreign banks. Congress is currently considering some changes to the USA Patriot Act, however, these changes will generally not affect the provisions pertaining to commercial banking activities. Compliance with these new requirements has not had a material effect on the Corporation's operations. Other Matters Federal and state law also contains a variety of other provisions that affect the operations of the Corporation and the Bank including certain reporting requirements, regulatory standards and guidelines for real estate lending, "truth in savings" provisions, the requirement that a depository institution give 90 days prior notice to customers and regulatory authorities before closing any branch, certain restrictions on investments and activities of nationally-chartered insured banks and their subsidiaries, limitations on credit exposure between banks, restrictions on loans to a bank's insiders, guidelines governing regulatory examinations, and a prohibition on the acceptance or renewal of brokered deposits by depository institutions that are not well capitalized or are adequately capitalized and have not received a waiver from the FDIC. EFFECT OF GOVERNMENTAL POLICIES The earnings of the Bank and, therefore, of the Corporation are affected not only by domestic and foreign economic conditions, but also by the monetary and fiscal policies of the United States and its agencies (particularly the Federal Reserve Board), foreign governments and other official agencies. The Federal Reserve Board can and does implement national monetary policy, such as the curbing of inflation and combating of recession, by its open market operations in United States government securities, control of the discount rate applicable to borrowings from the Federal Reserve and the establishment of reserve requirements against deposits and certain liabilities of depository institutions. The actions of the Federal Reserve Board influence the level of loans, investments and deposits and also affect interest rates charged on loans or paid on deposits. The nature and impact of future changes in monetary and fiscal policies are not predictable. From time to time, various proposals are made in the United States Congress and the Pennsylvania legislature and before various regulatory authorities, who would alter the powers of different types of banking organizations, remove restrictions on such organizations and change the existing regulatory framework for banks, bank holding companies and other financial institutions. It is impossible to predict whether any of such proposals will be adopted and the impact, if any, of such adoption on the business of the Corporation. 9 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES Item 1A. RISK FACTORS The following are some of the factors that could materially and adversely affect our future performance or could cause actual results to differ materially from those expressed or implied in our forward-looking statements. The risks and uncertainties described below are not the only ones facing us and we cannot predict every event and circumstance that may adversely affect our business. However, these risks and uncertainties are the most significant factors that we have identified at this time. If one or more of these risks actually occurs, our business, results of operations, and financial condition could likely suffer, and the price of our stock would be negatively affected. Unless the context requires otherwise, references to "we," "us," or "our" in this "Risk Factors" section are intended to mean First Chester County Corporation, First National Bank of Chester County and its other wholly-owned subsidiaries, collectively. Adverse changes in the economic conditions in our market area could materially and negatively affect our business. Substantially all of our business is with consumers and small to mid-sized companies located within Chester and Delaware Counties, Pennsylvania. Our business is directly impacted by factors such as economic, political and market conditions, broad trends in industry and finance, legislative and regulatory changes, changes in government monetary and fiscal policies and inflation, all of which are beyond our control. A deterioration in economic conditions, whether caused by national, regional or local concerns, including an economic slowdown in southeastern Pennsylvania, could result in the following consequences, any of which could materially harm our business and operating results: o customer's credit quality may deteriorate; o loan delinquencies and losses may increase; o problem assets and foreclosures may increase; o need to increase our allowance for losses, thus reducing net income; o more non-accrual loans may reduce net income; o demand for our products and services may decrease; o competition for low cost or non-interest bearing deposits may increase; and o collateral securing loans may decline in value. Competitive pressures from banks, financial services companies and other companies offering banking services could negatively impact our business. We conduct banking operations primarily in southeastern Pennsylvania. Increased competition in our market area may result in reduced loans and deposits, a decline in loan growth and/or loan margins, high customer turnover, and lower interest rate margins. We may not be able to compete successfully against current and future competitors. Many competitors in our market area, including national banks, regional banks and other community banks, offer the same banking services as we offer. We also face competition from many other types of financial institutions, including without limitation, savings and loan institutions, finance companies, brokerage firms, insurance companies, credit unions, mortgage banks and other financial intermediaries. These competitors often have greater resources than we do, affording them competitive advantages, including the ability to maintain numerous banking locations and ATMs and conduct extensive promotional and advertising campaigns. Changes in interest rates could reduce our net interest margin and net interest income. Our income and cash flows and the value of our assets and liabilities depend to a great extent on the difference between the interest rates earned on interest-earning assets such as loans and investment securities, and the interest rates paid on interest-bearing liabilities such as deposits and borrowings. These interest rates are highly sensitive to many factors which are beyond our control, including general economic conditions and policies of various governmental and regulatory agencies, in particular, the Federal Reserve and the Office of Comptroller of Currency. Changes in monetary policy, including changes in interest rates, will influence the origination and market value of loans and investment securities and the amounts paid on deposits. If we are unable to timely adjust our interest rates on our loans and deposits in response to any such changes in monetary policy, our earnings could be adversely affected. If the rate of interest we pay on our deposits, borrowings, and other interest-bearing liabilities increases faster than the rate of interest we earn on our loans, investments and other interest-earning assets, our net interest income, and therefore our earnings will decrease. Conversely, our earnings could also be adversely affected if the interest rates on our loans or other investments decline more quickly than those on our deposits and other borrowings. 10 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES Significant increases in interest rates may affect customer loan demand and payment habits. Significant increases in market interest rates, or the perception that an increase may occur, could adversely impact our ability to generate new variable interest rate loans. An increase in market interest rates may also adversely affect the ability of adjustable rate borrowers to meet repayment obligations, thereby causing non-performing loans and loan charge-offs to increase. We may experience lower net interest income if our loan growth exceeds that of deposit growth requiring us to obtain other sources of funds at higher costs. Our growth strategy depends upon generating an increasing level of loans while maintaining a low level of loan losses. As our loans grow, it is necessary for the deposits to grow at a comparable pace in order to avoid the need for us to obtain other sources of loan funds at higher costs. If our loan growth exceeds the deposit growth, we may have to obtain other sources of funds at higher costs, thus reducing our net interest income. If our allowance for loan losses is not adequate to cover actual loan losses, our earnings may decline. We maintain an allowance for loan losses to provide for loan defaults and non- performance by borrowers of their obligations. Our allowance for loan losses may not be adequate to cover actual loan losses and future provisions for loan losses could materially and adversely affect our operating results. Our allowance for loan losses is based on prior experience, as well as an evaluation of risks in the current portfolio. However, these losses may exceed our current estimates. The amount of future losses is susceptible to changes in economic, operating and other conditions that may be beyond our control, including changes in interest rates, changes in borrowers' creditworthiness and the value of collateral securing loans and leases. Federal regulatory agencies review our loans and allowance for loan losses and may require us to increase our allowance. While we believe that our allowance for loan losses is adequate to cover our anticipated losses, we cannot assure that we will not further increase the allowance for loan losses or that regulators will not require us to increase the allowance. Either of these occurrences could materially affect our earnings. Adverse changes in the market value of securities and investments that we manage for others may negatively impact the growth level of our non-interest income. We provide a broad range of trust and investment management services for estates, trusts, agency accounts, and individual and employer sponsored retirement plans. Fees for such services are typically based upon a percentage of the market value of such funds under management. The market value of such securities and investments may decline for a variety of factors, many of which are outside our control. Any such adverse changes in the market value of the securities and investments could negatively impact our non-interest income generated from providing these services. Our branch locations may be negatively affected by changes in regional and local demographics. We have strategically selected locations for our branches based upon regional and local demographics. Any unanticipated changes in such demographics may impact our ability to reach or maintain profitability at our branch locations. Changes in regional and local demographics may also affect the relative benefits of certain branch locations and Management may be required to reduce the number and/or locations of our branches, which may result in unanticipated expenses. Changes in the regulatory environment may adversely affect our business. The banking industry is highly regulated and we are subject to extensive state and federal regulation, supervision, and legislation. We are subject to regulation and supervision by the Board of Governors of the Federal Reserve System, the Offices of the Comptroller of the Currency, and the Securities and Exchange Commission and the FDIC. Laws restricting our activities include, but are not limited to, the Gramm-Leach-Blilely Act, the Bank Secrecy Act, the Truth-in-Lending Act, the Equal Credit Opportunity Act, the Fair Housing Act, the Bank Holding Company Act, the Community Reinvestment Act, the USA Patriot Act and the Real Estate Settlement Procedures Act. These laws may change from time to time, and new laws may be enacted, any of which may limit our ability to offer new products and services, obtain financing, attract deposits, and originate loans. Any changes to these laws may adversely affect loan demand, credit quality, consumer spending and saving habits, interest rate margins, FDIC assessments, and operating expenses, thus negatively affecting our results of operations and financial condition. 11 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES Technology costs, new product development, and marketing costs may exceed our expectations and negatively impact our profitability. The financial services industry is constantly undergoing technological changes in the types of products and services provided to customers to enhance customer convenience. Our future success will depend upon our ability to address the changing technological needs of our customers. We have invested a substantial amount of resources to update our technology. Our investment in such technology seeks to increase overall efficiency and improve accessibility to customers. We are also investing in the expansion of bank branches, improvement of operating systems, and the development of new marketing initiatives. The benefits of such investments may not be achieved as quickly as anticipated, or at all. The costs of implementing technological changes, new product development, and marketing costs may exceed our expectations and negatively impact our results of operations and profitability. Changes to financial accounting standards may affect our reported results of operations. We prepare our financial statements in accordance with Generally Accepted Accounting Principles ("GAAP"). GAAP is subject to the rules and interpretations of the Securities and Exchange Commission and various bodies formed to interpret and create appropriate accounting policies. A change in those policies can have a significant effect on our reported results and may even affect our reporting of transactions completed before a change is announced. Accounting rules affecting many aspects of our business, including rules relating to accounting for business combinations, asset impairment, revenue recognition, restructuring or disposal of long-lived assets and stock option grants have recently been revised or are currently under review. Changes to those rules or current interpretation of those rules may have a material adverse effect on our reported financial results or on the way we conduct our business. For example, SFAS No. 123(R) requires that employee stock option plan shares be treated as a compensation expense which would reduce reported net income and earnings per share. We have not yet determined the impact of applying the various provisions of SFAS No. 123(R). If we fail to maintain an effective system of internal controls, we may not be able to accurately report our financial results or prevent fraud. If we fail to maintain an effective system of internal controls, fail to correct any issues in the design or operating effectiveness of internal controls over financial reporting, or fail to prevent fraud, our shareholders could lose confidence in our financial reporting, which could harm our business and the trading price of our Common Stock. Item 1B. Unresolved Staff Comments. - -------- -------------------------- None. Item 2. Properties. - ------- ----------- The Bank owns eleven properties which are not subject to any mortgages. In addition, the Corporation leases the Westtown-Thornbury, Exton, Frazer, Kendal at Longwood, Crosslands, Lima Estates, Granite Farms Estates, Hershey's Mill, Coatesville, Bradford Plaza, Freedom Village, and Oxford offices. Management of the Corporation believes the Corporation's and the Bank's facilities are suitable and adequate for their respective present needs. Set forth below is a listing of each banking office presently operated by the Bank, and other properties owned or leased by the Bank and the Corporation which may serve as future sites for branch offices. Management is currently evaluating all of its properties for future use.
Current Date Banking Acquired Offices / Use Address or Opened - ------------- ------- --------- Main Office / Branch 9 North High Street December 1863 and Corporate West Chester, Pennsylvania Headquarters Market Street / Branch 17 East Market Street February 1978 West Chester, Pennsylvania 12 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES Current Date Banking Acquired Offices / Use Address or Opened - ------------- ------- --------- Westtown-Thornbury / Route 202 and Route 926 May 1994 Branch Westtown, Pennsylvania Goshen / Branch 311 North Five Points Road September 1956 West Goshen, Pennsylvania Kennett Square / Branch 126 West Cypress Street February 1987 Kennett Square, Pennsylvania Exton / Branch Route 100 and Boot Road August 1995 West Chester, Pennsylvania Frazer / Branch 309 Lancaster Avenue August 1999 Frazer, Pennsylvania Swope Building / Office Space High & Market Streets July 1995 West Chester, Pennsylvania Kendal at Longwood / Branch 1109 E. Baltimore Pike December 1999 Kennett Square, Pennsylvania Crosslands / Branch 1660 E. Street Road December 1999 Kennett Square, Pennsylvania Lima Estates / Branch 411 North Middletown Road December 1999 Media, Pennsylvania Granite Farms Estates / Branch 1343 West Baltimore Pike December 1999 Wawa, Pennsylvania Lionville / Branch Route 113 & Sheree Boulevard December 2000 Uwchlan Township, Pennsylvania New Garden / Branch 741 West Cypress Street August 2001 Kennett Square, Pennsylvania Hershey's Mill / Branch 1371 Boot Road December 2001 West Chester, Pennsylvania Coatesville / Branch 258A East Lincoln Highway June 2003 Coatesville, PA 19320 Bradford Plaza / Branch 700 Downingtown Pike September 2003 West Chester, PA 19380 Freedom Village / Branch 15 Freedom Village Blvd. July 2004 West Brandywine, PA 19320 Oxford / Branch 275 Limestone Road December 2004 Oxford, PA 19363 Wellington / Branch 1361 Boot Road November 2005 West Chester, PA 19380 13 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES Other Date Acquired Properties / Use Address or Opened - ---------------- ------- --------- Operations 202 Carter Drive July 1988 Center / Operations West Chester, Pennsylvania Matlack Street / 887 South Matlack Street September 1999 Operations West Chester, Pennsylvania Paoli Pike / Parking 1104 Paoli Pike July 1963 West Chester, Pennsylvania
Item 3. Legal Proceedings. - ------- ------------------ There are no material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the Corporation, or any of its subsidiaries, is a party or of which any of their respective property is the subject. The Corporation and the Bank are not parties to any legal proceedings under federal and state environmental laws. Item 4. Submission of Matters to a Vote of Security Holders. - ------- ---------------------------------------------------- None. PART II Item 5. Market for the Corporation's Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities. The Corporation's Common Stock is publicly traded over the counter under the symbol "FCEC". Information regarding high and low bid quotations is set forth in Part II, Item 7 on page 35 of this Report. As of January 31, 2006, there were approximately 986 shareholders of record of the Corporation's Common Stock. The closing stock price as of January 31, 2006 was $19.75. The Corporation declared cash dividends per share on its Common Stock during each quarter of the fiscal years ended December 31, 2005 and 2004, as set forth in the following table: Dividends Amount Per Share 2005 2004 ---- ---- First Quarter.............................................$ 0.1295 $ 0.1250 Second Quarter............................................ 0.1300 0.1250 Third Quarter............................................. 0.1300 0.1250 Fourth Quarter............................................ 0.1350 0.1295 -------- -------- Total...................................................$ 0.5245 $ 0.5045 ======== ======== All per share data has been adjusted for a 10% stock dividend declared April 19, 2005. The holders of the Corporation's Common Stock are entitled to receive such dividends as may be legally declared by the Corporation's Board of Directors. The amount, time, and payment of future dividends, however, will depend on the earnings and financial condition of the Corporation, government policies and other factors. The following chart shows the purchases of the Corporation's Common Stock during the fourth quarter of 2005: 14 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES
(a) (b) (c) (d) Total Number Average Total Number of Shares Maximum Number (or Approximate Period of Shares (or Price Paid (or Units) Purchased as Dollar Value) of Shares (or Units) per Share Part of Publicly Announced Units) that May Yet Be Purchased Purchased (or Unit) Plans or Programs Under the Plans or Programs October 1 to October 31, 2005 -- -- -- $6,298,873 November 1 to November 30, -- -- -- $10,000,000 2005 December 1 to December 31, -- -- -- $10,000,000 2005 Total -- -- -- $10,000,000 Note: The Corporation announced on November 15, 2005 a program to repurchase up to $10.0 million of the Corporation's Common Stock. This program replaced a previous program that expired in October 2005.
15 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES Item 6. Selected Financial Data - ------- -----------------------
(Dollars in thousands, except per share data) STATEMENTS OF CONDITION - ----------------------- December 31 ---------------------------------------------------------------- 2005 2004 2003 2002 2001 -------- --------- -------- -------- ------- Assets $ 845,108 $ 805,475 $ 689,210 $ 640,010 $ 584,332 Loans 664,276 618,005 511,249 447,682 448,110 Investment securities 97,088 140,029 130,729 128,375 80,741 Deposits 696,097 663,018 577,314 558,738 498,825 Stockholders' equity 58,677 55,402 51,750 48,612 43,839 Trust and Investment Services assets under management and custody (1) 561,029 555,644 550,217 531,756 497,120
STATEMENTS OF INCOME - -------------------- Year Ended December 31 ---------------------------------------------------------------- 2005 2004 2003 2002 2001 -------- --------- -------- -------- ------- Interest income $ 44,604 $ 37,518 $ 33,533 $ 37,101 $ 38,985 Interest expense 13,579 7,863 7,154 10,673 15,586 ---------- --------- --------- --------- --------- Net interest income 31,025 29,655 26,379 26,428 23,399 Provision for possible loan losses 1,382 1,164 2,519 2,231 2,929 ---------- --------- --------- --------- --------- Net interest income after provision for possible loan losses 29,643 28,491 23,860 24,197 20,470 Non-interest income 9,325 9,313 11,506 9,154 6,638 Non-interest expense 30,557 29,213 27,400 25,205 22,415 ---------- -------- --------- --------- --------- Income before income taxes 8,411 8,591 7,966 8,146 4,693 Income taxes 1,900 2,430 2,161 2,444 1,361 ---------- --------- --------- --------- --------- Net income $ 6,511 $ 6,161 $ 5,805 $ 5,702 $ 3,332 ========== ========= ========= ========= ========= PER SHARE DATA (2) - -------------- Net income per share (Basic) $ 1.28 $ 1.24 $ 1.18 $ 1.17 $ 0.68 Net income per share (Diluted) $ 1.23 $ 1.19 $ 1.14 $ 1.16 $ 0.67 Cash dividends declared $ 0.5245 $ 0.5045 $ 0.4932 $ 0.4773 $ 0.4727 Book value $ 11.41 $ 11.04 $ 10.42 $ 9.98 $ 9.01 Basic weighted average shares outstanding 5,104,745 4,980,584 4,924,819 4,865,424 4,896,486 ========== ========= ========= ========= ========= Diluted weighted average shares outstanding 5,240,497 5,174,926 5,082,166 4,901,767 4,944,893 ========== ========= ========= ========= ========= Notes: (1) These assets are managed by the TIS Division of the Bank and are not assets of the Bank or the Corporation. (2) All per share data has been retroactively adjusted for stock dividends.
16 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES Item 7. Management's Discussion and Analysis of Financial Condition and Results - ------- of Operations. DISCLOSURE ABOUT FORWARD LOOKING STATEMENTS The Corporation may from time to time make written or oral "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, including statements contained in the Corporation's filings with the Securities and Exchange Commission (including this Report on Form 10-K), its reports to shareholders and in other communications by the Corporation. These statements can often be identified by the use of forward-looking terminology such as "believes", "expects", "intends", "may", "will", "should" or "anticipates" or similar terminology. These statements involve risks and uncertainties and are based on various assumptions. Although the Corporation believes that its expectations are based on reasonable assumptions, investors and prospective investors are cautioned that such statements are only projections. Also, future results may differ materially from the Corporation's historic results. The risks and uncertainties noted below, among others, could cause the Corporation's actual future results to differ materially from those described in forward-looking statements made in this report, or presented elsewhere by Management from time to time, or from the Corporation's historic results. These risks and uncertainties are discussed in Item 1A, "Risk Factors", in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," and elsewhere in this Report. These risks, among others, could cause our actual future results to differ materially from those described in our forward-looking statements or from our prior results. We are not obligated to update our forward-looking statements, even though our situation may change in the future. OVERVIEW Net income for the year ended December 31, 2005 was $6.5 million, an increase of $350,000 or 5.7% from $6.2 million in 2004. Basic earnings per share in 2005 were $1.28, an increase of 3.2% from 2004 earnings. Return on average equity in 2005 decreased to 11.48%, compared with 11.59% in 2004. Return on average assets decreased to 0.79% in 2005 from 0.81% in 2004. During 2005, total assets increased 4.9% to $845.1 million; loans and leases grew 7.5% to $664.3 million; and deposits grew 5.0% to $696.0 million. Deposit growth during 2005 is attributed to an expanded branch network and an aggressive marketing campaign designed to generate additional deposit relationships. Loan growth in 2005 reflects the Corporation's focus on growing quality loan relationships. Earnings in 2005 were driven primarily by increases in net interest income which increased $1.4 million or 4.6% from 2004 to 2005, and a decrease in income tax expenses of $530,00 or 21.8% which resulted primarily from an increase in permanent differences as a percentage of pretax income. These improvements were partially offset by an increase in non-interest expense of $1.3 million or 4.6%. The increases in the provision for possible loan and lease losses in 2005 to $1.4 million from $1.2 million in 2004 was primarily related to loan growth and increased non-accrual loans. The increase in net interest income was primarily the result of the 7.5% increase in loans and leases outstanding during 2005. Non-interest income increased by $12,000, or 0.1% from 2004 to 2005 due to decreases in TIS income, and service charges on deposit accounts for the year ended December 31, 2005, which offset increases in operating lease rental income and gains on the sales of residential mortgages. The decreases in service charges can be attributed to the aggressive effort to generate additional deposit relationships noted above. Non interest expense increased by $1.3 million or 4.6% from 2004 to 2005. Management acted to address the increasing non interest expenses by instituting a reduction in the work force of 5% during the second quarter of 2005. Severance packages and career transitioning services, which the Corporation provided, reduced earnings for the second quarter by approximately $188,000. Management expects to recognize an annual savings of approximately $646,000 as a result of this restructuring. Professional services increased by $853,000 from 2004 to 2005 primarily as a result of the following: Sarbanes Oxley compliance, real estate management costs, branch site analysis, benefit plan review, and management planning. Net income increased $350,000 or 5.7% to $6.5 million from $6.2 million in 2004. Net income for the year ended December 31, 2004 was $6.2 million, an increase of $356,000 or 6.1% from $5.8 million in 2003. Additional performance measurements are included in the following table. 17 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES
PERFORMANCE RATIOS 2005 2004 2003 ------------------ -------- -------- ------- Return on Average Assets 0.79% 0.81% 0.88% Return on Average Equity 11.48% 11.59% 11.48% Earnings Retained 59.07% 58.95% 58.07% Dividend Payout Ratio 40.93% 41.05% 41.93% Basic Earnings per Share 1.28 1.24 1.18
NET INTEREST INCOME Net interest income is the difference between interest income on interest-earning assets and interest expense on interest-bearing liabilities. Net interest income, on a tax equivalent basis, increased 4.6% or $1.4 million from $30.2 million in 2004 to $31.6 million in 2005, compared to a 12.9% increase or $3.5 million from 2003 to 2004. The increase in tax equivalent net interest income for 2005 was largely the result of an increase in interest-earning assets which was higher than the increase in interest-bearing liabilities. Average interest-earning asset growth was approximately $64.8 million while average interest-bearing liabilities increased by $59.0 million. Partially offsetting the increase in interest income generated as a result of this growth in 2005 was a larger increase in the average rate on interest-bearing liabilities which increased 76 basis points as compared to the average cost of interest-earning assets, which increased by 47 basis points. Basis points, with regards to interest rate, are defined as one-hundredth of one percentage point. Net yields on interest-earning assets, on a tax equivalent basis, were 4.03% and 4.21% for 2005 and 2004, respectively. Average interest-earning assets for 2005 were $783.4 million, an increase of $64.8 million or 9.0% when compared to 2004. In 2004, average interest-earning assets were $718.6 million, an increase of $100.3 million or 16.2% compared to 2003. The increase in average interest-earning assets for 2005 was a result of increases in average loans outstanding and federal funds sold and other overnight investments, which were partially offset by a decrease in investments and investment securities. The increase in net interest income in 2004 compared to 2003 was primarily driven by a 20.7% or $97.3 million increase in average loans outstanding, partially offset by a 46 basis point decline in the effective portfolio rate to 5.68% from 6.14%. Additionally, the rising interest rate environment in the second half of 2005 has resulted in an increase in yields as adjustable-rate loans reprice to current market rates on both contractual and negotiated-basis loans. However, yields on interest-bearing liabilities increased more than the yield on interest-earning assets primarily due to the rising rates paid on deposit accounts as the Corporation reacted to external rate changes. Continued rising interest rates and pricing competition has put pressure on the Corporation's net-interest margin as shown in the chart on page 29. These factors may continue to adversely impact net interest income in future periods. In 2005, average interest-bearing liabilities increased $59.0 million or 10.2% to $639.0 million when compared to $580.1 million in 2004. In 2004, average interest-bearing liabilities increased 16.7% from the average of $497.2 million in 2003. The increase in 2005 was the result of an increase of 10.1% or $50.9 million increase in average interest-bearing deposits and a 13.0% or $8.0 million increase in Federal Home Loan Bank ("FHLB") advances and other borrowings. The increase in 2004 was the result of a 9.4% or $42.6 million increase in average interest-bearing deposits. 18 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES CONSOLIDATED AVERAGE BALANCE SHEET AND TAX EQUIVALENT INCOME/EXPENSES AND RATES FOR THE YEAR ENDED DECEMBER 31,
2005 2004 2003 ---------------------- ---------------------- ------------------------- (Dollars in thousands) Daily Daily Daily Average Average Average Balance Interest Rate% Balance Interest Rate% Balance Interest Rate% ------- -------- ----- ------- -------- ----- ------- -------- ----- ASSETS Federal funds sold and other $ 21,060 $ 752 3.57 $ 15,868 $ 243 1.53 $ 17,368 $ 211 1.21 overnight investments Interest bearing deposits in banks 585 9 1.54 693 6 0.87 543 3 0.55 Investment securities Taxable 92,772 3,923 4.23 110,056 4,504 4.09 115,689 4,158 3.59 Tax-exempt (1) 18,079 781 4.32 24,209 1,086 4.49 14,280 660 4.62 ------- ------ ------- ------ ------- ------ Total investment securities 110,851 4,704 4.24 134,265 5,590 4.16 129,969 4,818 3.71 ------- ------ ------- ------ ------- ------ Loans and leases (2) Taxable 636,592 38,807 6.10 557,808 31,656 5.68 462,806 28,414 6.14 Tax-exempt (1) 14,346 898 6.26 9,947 590 5.93 7,607 468 6.16 ------- ------ ------- ------ ------- ------ Total loans 650,938 39,705 6.10 567,755 32,246 5.68 470,413 28,882 6.14 ------- ------ ------- ------ ------- ------ Total interest-earning assets 783,434 45,170 5.77 718,581 38,085 5.30 618,293 33,914 5.49 Non-interest-earning assets Allowance for possible loan and lease losses (7,930) (6,526) (6,253) Cash and due from banks 27,187 24,029 25,209 Other assets 23,262 23,284 22,981 ------- ------- ------- Total assets $825,953 $759,368 $660,230 ======= ======= ======= LIABILITIES AND STOCKHOLDERS' EQUITY Savings, NOW, and money market deposits $386,668 $ 4,712 1.22 $391,057 $ 2,604 0.67 $338,343 $ 2,501 0.74 Certificates of deposit and other time 167,195 5,297 3.17 111,838 2,700 2.41 119,162 3,386 2.84 ------- ------ ------- ------ ------- ------ Total interest-bearing deposits 553,863 10,009 1.81 502,895 5,304 1.05 457,505 5,887 1.29 Securities sold under repurchase agreements - - - - - - 133 3 2.26 Subordinated debt 15,465 1,015 6.56 15,465 728 4.71 - - - Guaranteed preferred beneficial interest in Corporation's subordinated debentures - - - - 6,342 312 4.92 Federal Home Loan Bank advances and other borrowings 69,736 2,555 3.66 61,707 1,832 2.97 33,176 952 2.87 ------- ------ ------- ----- ------- ------ Total interest-bearing liabilities 639,064 13,579 2.12 580,067 7,864 1.36 497,156 7,154 1.44 Non-interest-bearing liabilities Non-interest-bearing demand deposits 124,684 121,664 107,310 Other liabilities 5,514 4,468 5,203 ------- ------- ------- Total liabilities 769,262 706,199 609,669 Stockholders' equity 56,691 53,169 50,561 ------- ------- ------- Total liabilities and stockholders' Equity $825,953 $759,368 $660,230 ======= ======= ======= Net interest income $31,591 $30,221 $26,760 ====== ====== ====== Net yield on interest-earning assets 4.03 4.21 4.33 ==== ==== ==== (1) The indicated income and annual rate are presented on a tax equivalent basis using the federal marginal rate of 34%, adjusted for the TEFRA 20% penalty for 2005, 2004, and 2003. (2) Non accruing loans are included in the average balance.
19 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES RATE VOLUME ANALYSIS
Increase (decrease) in net interest income due to: ------------------------------------------------------------------------ Volume (1) Rate (1) Total Volume (1) Rate (1) Total ------ ---- ----- ------ ---- ----- (Dollars in thousands) 2005 Compared to 2004 2004 Compared to 2003 ---------------------------------- ---------------------------- INTEREST INCOME Federal funds sold $ 79 $ 430 $ 509 $ (18) $ 50 $ 32 Interest bearing deposits in banks (1) 4 3 1 2 3 ------ ------ ------- ------ ------ ----- Total Interest Income 78 434 512 17 52 35 Investment securities Taxable (707) 126 (581) (202) 548 346 Tax-exempt(2) (275) (30) (305) 459 (32) 426 ------ ------ ------- ------ ------ ----- Total investment securities (982) 96 (886) 256 516 772 Loans Taxable 4,475 2,676 7,151 5,833 (2,591) 3,242 Tax-exempt(2) 261 47 308 144 (22) 122 ------ ------ ------- ------ ------ ----- Total loans(3) 4,736 2,723 7,459 5,577 (2,613) 3,364 ------ ------ ------- ------ ------ ----- Total interest income 3,832 3,253 7,085 6,216 (2,045) 4,171 ------ ------ ------- ------ ------ ----- INTEREST EXPENSE - ---------------- Savings, NOW and money market deposits (29) 2,137 2,108 390 (287) 103 Certificates of deposits and other time 1,334 1,263 2,597 (208) (478) (686) ------ ------ ------- ------ ------ ----- Total interest bearing deposits 1,305 3,400 4,705 181 (765) (583) Securities sold under repurchase Agreements 0 0 0 (3) 0 (3) Subordinated debt and guaranteed preferred beneficial interest in Corp.'s subordinated debentures 0 287 287 449 (32) 416 Other borrowings 238 485 723 819 62 881 ------ ------ ------- ------ ------ ----- Total Interest expense 1,543 4,172 5,715 1,446 (735) $ 710 ------ ------ ------- ------ ------ ----- Net Interest income $ 2,289 $ (919) $ 1,370 $ 4,771 $(1,310) $3,461 ====== ======= ======= ====== ====== ===== NOTES: (1) The changes in interest due to both rate and volume have been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each. (2) The indicated changes are presented on a tax equivalent basis. (3) Non-accruing loans have been used in the daily average balances to determine changes in interest due to volume. Loan fees included in the interest income computation are not material.
20 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES INTEREST INCOME ON FEDERAL FUNDS SOLD AND OTHER OVERNIGHT INVESTMENTS Interest income on federal funds sold, other overnight investments, and interest-bearing deposits at other banks increased 205.6% to $761,000 from $249,000 in 2004. This follows an increase of $35,000 or 16.4% from 2003 to 2004. The increase in interest income on these investments in 2005 is the direct result of increases in the average federal fund balances, overnight investments, and interest-bearing deposits at other banks from $16.6 million to $21.6 million, an increase of $5 million or 30.5%. The strategy to increase federal funds sold was a combination of wanting to improve liquidity and to remain in short-term funds in a rising rate environment. Also, the yield on overnight funds, given the flat yield curve, was very competitive with alternative short term investment securities. Between 2003 and 2004, the average balance of these types of interest-earning assets decreased from $17.9 million to $16.6 million, a decrease of $1.3 million or 7.3%. The increase in interest income earned on federal funds sold and other overnight investments was also affected by an increase in the rates earned on these investments from 2004 to 2005. The yield increased from 1.50% during 2004 to 3.52% during 2005. The comparative rate during 2003 was 1.19%. INTEREST INCOME ON INVESTMENT SECURITIES On a tax equivalent basis, interest income on investment securities decreased $886,000 or 15.8% from $5.6 million in 2004 to $4.7 million in 2005, compared to a $772,000 or 16.0% increase from 2003 to 2004. The decrease in investment interest income in 2005 was the direct result of a decrease in average investment securities of 17.4% or $23.4 million which was partially offset by an increase in the yield on these assets of 8 basis points from 4.16% in 2004 to 4.24% in 2005. From 2003 to 2004, the yield on investment securities increased by 45 basis points. Each of these yields is expressed on a tax-equivalent basis. The decrease in average investment securities from 2004 to 2005 resulted from an increase in the amount of funds needed to provide for loan growth. The increase from 2003 to 2004 was the result of the Corporation's increased cash position due to increased deposits generated by its new and existing branch locations and Management's decision to invest excess funds in higher yielding securities. 21 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES INVESTMENT SECURITIES AT DECEMBER 31,
2005 2004 2003 ---------------------- --------------------- -------------------- (Dollars in thousands) Book Fair Book Fair Book Fair Value Value Value Value Value Value ----- ----- ----- ----- ----- ----- Held-to-Maturity Mortgage-backed securities$ $ -- $ -- $ -- $ -- $ 4 $ 4 State and municipal 10 10 10 11 15 16 ------- ------ ------- ------- ------- ------- 10 10 10 11 19 20 ------- ------ ------- ------- ------- ------- Available-for-Sale U.S. Treasury $ 2,504 $ 2,476 $ 27,503 $ 27,514 $ 2,498 $ 2,561 U.S. Government agency 1,040 1,018 1,058 1,049 10,821 10,715 Mortgage-backed securities 57,456 56,020 65,830 65,685 69,821 70,035 State and municipal 15,672 15,160 24,797 24,713 25,815 25,840 Corporate securities 13,655 13,086 13,756 13,863 13,012 13,299 Asset-backed securities 117 116 377 376 2,692 2,666 Mutual Funds 796 788 863 797 863 801 Other equity securities 8,758 8,414 5,951 6,022 4,724 4,793 ------- ------ ------- ------- ------- ------- 9,998 97,078 140,135 140,019 130,246 130,710 ------- ------ ------- ------- ------- ------- $100,008 $97,078 $140,135 $140,019 $130,246 $130,710 ======= ====== ======= ======= ======= =======
INVESTMENT SECURITIES YIELD BY MATURITY AT DECEMBER 31, 2005
Due over Due over Due 1 year 5 years Due Within Through Through Over (Dollars in thousands) 1 year 5 years 10 years 10 years Total ------ ------- -------- -------- ----- Held-to-Maturity State and municipal (2) $ -- $ 10 $ -- $ -- $ 10 -------- -------- -------- -------- -------- -- 10 -- -- 10 -------- -------- -------- -------- -------- Available-for-Sale U.S. Treasury 2,504 0 -- -- 2,504 U.S. Government agency -- -- -- 1,040 1,040 Mortgage-backed s ecurities (1) -- 11,684 -- 45,772 57,456 State and municipal (2) -- 6,547 9,125 -- 15,672 Corporate securities -- 4,558 6,768 2,329 13,655 Asset-backed securities(1) -- -- 81 36 117 Mutual Funds -- -- -- 796 796 Other equity securities (3) -- -- -- 8,758 8,758 -------- -------- -------- -------- -------- 2,504 22,789 15,974 58,731 99,998 -------- -------- -------- -------- -------- Total Investment securities $ 2,504 $ 22,799 $ 15,974 $ 58,731 $ 100,008 ======== ======== ======== ======== ======== Percent of portfolio 2.5% 22.8% 16.0% 58.7% 100.00% ======= ======= ======= ======== ======= Weighted average yield 6.66% 3.50% 4.04% 4.89% 4.48% ======= ======= ======== ======== ======= NOTES: (1) Mortgage-backed and Asset-backed securities are included in the above table based on their contractual maturity. (2) The yield on tax-exempt obligations has been computed on a tax equivalent basis using the Federal marginal rate of 34% adjusted for the 20% interest expense disallowance. (3) Other equity securities having no stated maturity have been included in "Due over 10 years".
22 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES INTEREST INCOME ON LOANS AND LEASES During 2005, interest income on loans and leases, on a tax equivalent basis, increased by $7.4 million or 23.1% from 2004. This increase resulted from an increase in average loan balances of $83.2 million or 14.7% from $567.7 million in 2004 to $650.9 million in 2005. During 2004, interest income on loans and leases increased by $3.3 million or 11.6% from $28.9 million to $32.2 million. The yields on interest-earning assets increased to 6.10% in 2005, up from 5.68% in 2004, and from 6.14% as compared to 2003. During 2003 yields were impacted by the declining rate environment in the economy at the beginning of the year contrasted by the Federal Reserve's 13 consecutive rate increases over the 18 months beginning in June 2003 through December 2005. LOAN PORTFOLIO BY TYPE AT DECEMBER
(Dollars in thousands) 2005 2004 2003 2002 2001 --------------- --------------- ---------------- ---------------- -------------- Amount % Amount % Amount % Amount % Amount % ------ - ------ - ------ - ------ - ------ - Commercial loans $218,365 33% $187,903 30% $142,144 28% $122,005 27% $118,420 26% Real estate - construction 49,095 7% 59,093 10% 56,340 11% 47,601 11% 40,065 9% Real estate - other 266,067 40% 243,490 40% 202,898 40% 175,846 39% 199,398 45% Consumer loans (1) 112,993 17% 101,157 16% 77,113 15% 62,646 14% 48,323 11% Lease financing receivables 17,756 3% 26,362 4% 32,754 6% 39,584 9% 41,904 9% ------- ------- ------- ------- ------- Total gross loans and lease $664,276 100% $618,005 100% $511,249 100% $447,682 100% $448,110 100% Allowance for possible loan and lease losses $ (8,549) $ (7,213) $ (5,864) $ (6,230) $(6,344) ------- ------- ------- ------- ------ Total net loans (2) $655,727 $610,792 $505,385 $441,452 $441,766 ======= ======= ======= ======= ======= NOTES: (1) Consumer loans include open-end home equity lines of credit and credit card receivables. (As of February 21, 2003, the $2.7 million credit card portfolio was sold). (2) At December 31, 2005 there were no concentrations of loans exceeding 10% of total loans which is not otherwise disclosed as a category of loans in the above table.
23 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES MATURITIES AND RATE SENSITIVITY OF LOANS DUE TO CHANGES IN INTEREST RATES AT DECEMBER 31, 2005 (1) (2)
Maturing Maturing After 1 Year Maturing Within And Within After (Dollars in thousands) 1 Year (3) 5 Years 5 Years Total ----------- --------------- ------------ ---------- Commercial loans $ 23,835 $ 54,372 $ 140,158 $ 218,365 Real Estate - construction 36,239 9,823 3,033 49,095 --------- ------- -------- -------- Total $ 60,074 $ 64,195 $ 143,191 $ 267,460 ========= ======= ======== ========= Loans maturing after 1 year with: Fixed interest rates Commercial Loans $ 43,183 $ 6,734 Commercial real estate - construction 558 1,870 Variable interest rates Commercial Loans 11,189 133,424 Commercial Real Estate - construction 9,265 1,163 ------- ------- Total $ 64,195 $143,191 ======= ======= NOTES: (1) Determination of maturities included in the loan maturity table are based upon contract terms. In situations where a "rollover" is appropriate, the Corporation's policy in this regard is to evaluate the credit for collectability consistent with the normal loan evaluation process. This policy is used primarily in evaluating ongoing customer's use of their lines of credit with the Bank that are at floating interest rates. (2) This data excludes real estate-other loans, consumer loans and lease financing receivables. (3) Demand loans and overdrafts are reported maturing "Within 1 Year". Most construction real estate loans are reported maturing "Within 1 Year" because of their short term maturity or index to the Bank's prime rate. An immaterial amount of loans has no stated schedule of repayments.
24 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES INTEREST EXPENSE ON DEPOSIT ACCOUNTS Interest expense on deposit accounts increased 88.7% from $5.3 million in 2004 to $10.0 million in 2005. The increase in interest-bearing balances and an increase in the cost of these deposits contributed to this change. Average interest-bearing balances increased from $502.9 million in 2004 to $553.8 million in 2005, an increase of $51.0 million or 10.1%. The cost of these deposits increased from 1.05% in 2004 to 1.81% in 2005. Interest expense on deposit accounts decreased 9.9% or $583,000 from $5.9 million in 2003 to $5.3 million in 2004. This decrease in interest expense on deposit accounts during 2004 was the direct result of an 18.6% or 24 basis point decrease on rates paid on interest bearing deposits, partially offset by a 9.9% or $45.4 million increase in the average interest-bearing deposit balance. During the latter part of 2004 and throughout 2005 the Bank increased rates paid on its interest bearing deposits in response to the increases in Federal Reserve rates and the increase in competitive pressures in the Corporation's marketplace. These pressures are expected to continue in the first half of 2006 and the Bank will continue to respond with necessary rate increases to maintain and/or increase the Corporation's market share of deposits. DEPOSIT ANALYSIS
(Dollars in thousands) 2005 2004 2003 ---------------------- ----------------------- ---------------------- Average Effective Average Effective Average Effective DEPOSIT TYPE Balance Yield Balance Yield Balance Yield ------------ ------- --------- ------- --------- ------- --------- NOW $125,755 1.20% $129,569 0.51% $ 88,518 0.19% Money Market 53,946 1.17% 26,255 0.51% 26,051 0.70% Statement Savings 56,653 0.80% 65,682 0.56% 63,032 0.77% Other Savings 932 0.75% 1,370 0.51% 1,522 0.79% CD's Less than $100,000 129,058 2.63% 85,873 2.46% 96,773 2.93% ------- ------- ------- Total Core Deposits 366,344 1.64% 308,749 1.06% 275,896 1.33% Non-Interest-Bearing Demand Deposits 128,404 -- 125,074 -- 107,334 -- ------- ------- ------- Subtotal 494,748 1.21% 433,823 0.75% 383,230 0.96% Tiered Savings 133,158 1.58% 168,180 0.86% 159,220 1.04% CD's Greater than $100,000 78,684 2.41% 25,966 2.28% 22,365 2.48% ------- ------- ------- Total Deposits $706,590 $627,696 $564,815 ======= ======= =======
MATURITIES OF CERTIFICATES OF DEPOSIT AND OTHER TIME DEPOSITS, $100,000 OR MORE, AT DECEMBER 31, 2005
Due Within Over 3 Months Over 6 Months Due Over (Dollars in thousands) 3 Months Through 6 Months Through 12 Months 12 Months Total ----------- ---------------- ----------------- --------- ----- Certificates of Deposit $100,000 or more $ 25,772 $ 23,519 $ 5,268 $ 6,720 $ 61,279
25 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES PROVISION FOR LOAN AND LEASE LOSSES During 2005, the Corporation recorded a provision for loan and lease losses of $1.4 million, compared to $1.2 million in 2004 and $2.5 million in 2003. Net charge-offs in 2005 were $46,000, compared to $185,000 net of recoveries in 2005 and $2.9 million net charge-offs in 2004. Net charge-offs as a percentage of average loans outstanding were 0.01%, -0.03%, and 0.61% for 2005, 2004, and 2003, respectively. The provision expense in 2005 was increased to provide for potential increased loan write-downs and charge-offs. Management believes that the allowance for loan and leases losses is adequate based on its current assessment of probable and estimated losses. The provision expense in 2004 decreased when compared to the previous period, primarily due to the overall improved credit quality of the portfolio and the high level of recoveries during 2004. The allowance for loan and lease losses as a percentage of loans outstanding was 1.29%, 1.17%, and 1.15% for 2005, 2004, and 2003 respectively. The percentage and dollar amount of non-performing loans declined slightly in 2005 versus 2004 to $8.4 million or 1.26% of total loans and leases from $8.6 million or 1.27% in 2004. The amount of non-performing loans in 2003 was $4.7 million or 0.91% of total loans and leases and reflects the impact of $3.1 million in gross charge-offs during the year. For more information on the gains on the sale of Other Real Estate Owned ("OREO"), see the following "Non-Interest Income" section. NON-INTEREST INCOME Total non-interest income increased $12,000 or 0.1%, and amounted to $9.3 million in 2005, compared to a decrease of $2.2 million or 19.1% from 2003 to 2004. The various components of non-interest income are discussed below. The largest component of non-interest income is TIS revenue which decreased $93,000 or 2.7% from $3.5 million in 2004 to $3.4 million in 2005. This compares to an increase of $209,000 or 6.4% from $3.3 million in 2003. The decline in 2005 is primarily due to lower estate fee income earned in 2005 compared to 2004. The market value of TIS assets under management and custody increased 1.0% from $555.6 million at December 31, 2004 to $561.0 million at December 31, 2005. TIS assets under management and custody grew 1.0% or $5.4 million in 2004. In the third quarter of 2004, the Corporation announced that its TIS Division had retained Haverford Financial Services (HFS) as a sub-advisor. HFS provides investment management services on a sub-advisory basis to current and future TIS clients. The Corporation anticipates new opportunities to increase assets under management from this relationship. Service charges on deposit accounts decreased $161,000 or 7.6% from $2.1 million in 2004 to $1.9 million in 2005 compared to an increase of $94,000 or 4.7% in 2004 from 2003. To remain competitive and increase the core deposit base, the Corporation introduced a "Free Checking" product during the first quarter of 2005 which contributed to this decrease in service charges and will impact this component of non-interest income in the future as certain existing accounts, on which service charges are currently collected, may move to this new product. Gains on the sale of investment securities decreased to $58,000 in 2005 from $70,000 in 2004, a decline of $12,000 or 17.2%. From 2003 to 2004, gains on the sale of investment securities decreased from $410,000 to $70,000, a decrease of $340,000 or 82.9%. The gains realized on the sales of investment securities throughout the periods are the results of normal portfolio management. The Corporation has operating lease agreements with several customers. The income on these agreements is classified as "Rental Income". Rental Income on operating lease agreements increased $170,000 or 20.5% from $828,000 in 2004 to $998,000 in 2005. This compares with a $39,000 decrease in 2004. See the discussion of related depreciation expense in the "Non-Interest Expense" section. Gains on the sale of fixed assets and OREO in 2005 decreased by $152,000 from $145,000 in 2004 and resulted in a net loss on these sales of $7,000. This compares with a large gain of $1.0 million in 2003 related to foreclosed property that was sold at a higher value than the Corporation had anticipated. Gains and fee income generated in the sale of residential mortgage loans during 2005 increased by $97,000 or 25.9% from $377,000 in 2004 to $474,000 in 2005. This compares with a decrease of $642,000 from $1.0 million in 2003. During 2004, refinancing and originations of salable loans had substantially decreased, resulting in a lower amount of gains and fees being collected when compared to prior periods. During 2003 this activity was strong and resulted in a substantial amount of gains and fee income. In a rising interest rate environment, management expects continued pressure to generate new origination volume as well as margins on the gains from the sales of residential mortgages. When a mortgage is sold, all unamortized fees collected are 26 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES recognized as income for that period and any gain or loss based on the current market value is recorded at the time of the sale. The Corporation retains the servicing on a portion of the loans sold and earns a servicing fee. Gains from the sale of the Corporation's credit card portfolio in 2004 amounted to $34,000. This income was a residual piece of a 2003 sale of the portfolio that had been held back to provide for any losses that may have occurred for a period of 12 months after the sale. There were no credit card portfolio sales in 2005. In 2003, the Corporation received proceeds of $422,000 from life insurance upon the death of its former President and CEO. There was no income from life insurance proceeds in 2004 or 2005. Other non-interest income increased $196,000 or 8.7% from $2.2 million in 2004 to $2.4 million in 2005. This compares with an increase of $86,000 or 4.0% in 2003. The primary components of other non-interest income over the past three years are as follows: OTHER NON-INTEREST INCOME 2005 2004 2003 ---- ---- ---- Electronic Banking $ 873 $ 823 $ 760 Wealth Advisory Services 367 268 124 Miscellaneous Loan Fees 229 341 377 Other* 985 826 911 ----- ------ ----- $2,454 $2,258 $2,172 ====== ===== ===== * Other includes rental income, safe deposit box fees, merchant services income, and other commission and fee income. NON-INTEREST EXPENSE Total non-interest expense increased $1.3 million or 4.6% from $29.2 million in 2004 to $30.5 million in 2005, compared to an increase of $1.8 million or 6.6% from 2003 to 2004. The growth in non-interest expense reflects the increased costs incurred to service the Corporation's expanding customer base. The various components of non-interest expense changes are discussed below. Employee salaries and benefits increased $66,000 or 0.4% from $15.8 million in 2004 to $15.9 million in 2005, compared to an increase of $844,000 or 5.6% from $15.0 million in 2003. This slight increase results from Management's initiative to optimize the Corporation's work force. During the second quarter of 2005, approximately 5% of the work force was reduced in an effort to control salary and benefit costs. Increased staff, annual employee raises, promotions and a proportional increase in employee benefits are primarily responsible for the increase in 2004. Net occupancy, equipment and data processing expense increased $244,000 or 4.6% from $5.4 million in 2004 to $5.6 million in 2005, compared to a decrease of $115,000 or 2.1% from 2003 to 2004. The increases are the direct result of the opening of two full service branches during 2005 as well as increased computer and related equipment costs associated with servicing the Corporation's customer base. Depreciation on operating leases increased $129,000 or 17.4% from $740,000 in 2004 to $869,000 in 2005. This compares to an increase of $49,000 or 7.1% from $691,000 in 2003 to $740,000 in 2004. This depreciation expense is the result of operating lease agreements the Corporation has with several of its customers. The income associated with this operating lease is classified as Rental Income. See related discussion of Rental Income in the Non-Interest Income section, above. Professional services increased $853,000 or 48.8% from $1.7 million in 2004 to $2.6 million in 2005 compared to an increase of $586,000 or 50.4% from $1.2 million in 2003. Professional services were directly impacted by the costs associated with the Corporation's efforts to comply with the Sarbanes Oxley legislation that became effective for the Corporation in 2004. Direct Sarbanes Oxley costs of $272,000 are included in 2004 operating results. The Company also hired a real estate consultant in 2004 to help identify real estate opportunities and efficiencies. Additional costs associated with consulting fees for demographic and branch site analysis, benefit plans, and management planning are also reflected in the increase. 27 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES FDIC deposit insurance expense was $91,000, $86,000, and $88,000 for the years 2005, 2004 and 2003, respectively. Bank shares tax was $549,000, $517,000, and $493,000 in 2005, 2004, and 2003, respectively. Bank Shares Tax represented 0.84%, 0.83%, and 0.93% of average stockholders' equity for 2005, 2004, and 2003, respectively. The Pennsylvania Bank Shares Tax is based primarily on Bank stockholders' equity, and is paid on an annual basis. Federal law currently requires that the FDIC increase assessment rates if the reserve ratio of the FDIC's BIF were to fall below 1.25%. Such increased assessments would be required to be designed to restore the BIF reserve ratio to at least 1.25% within 12 months. At present, Management cannot be sure whether the BIF reserve ratio will be above or below the minimum required level or whether Congress will enact legislation that would change the requirement that the FDIC increase assessment rates. Management also cannot predict at this time what the Bank's assessment for FDIC insurance premiums would be if the FDIC is required to increase assessment rates in 2006, because that would be a function of the FDIC's analysis of what level of fees would be necessary to bring the BIF into compliance. Total other non-interest expense increased $15,000 or 0.3% from $4.9 million to $5.0 million in 2005 compared with an increase of $427,000 or 9.4% from $4.5 million in 2003. The increase in 2004 in other non-interest expense can be primarily attributed to increased costs associated with the adoption of a new corporate image and marketing campaign. It is expected that this marketing expense will continue to increase as more parts of the campaign are rolled out and expanded. In the fourth quarter of 2004, the Corporation opened a temporary modular facility in the Oxford area. This facility was equipped to meet all of our customers' needs and was replaced by a newly designed full-service branch in the fourth quarter of 2005. The Corporation also opened a mini-branch in the Wellington Retirement Community in late November 2005. The Corporation anticipates an increase in the deposit base as additional new branches are opened. These branches have a direct impact on all the components of non-interest expense. It is anticipated that the increases in costs will be offset over time by increases in net interest and fee income generated by business in the new marketing areas. The primary components of other non-interest expense over the past three years are as follows: OTHER NON-INTEREST EXPENSE 2005 2004 2003 ---- ---- ---- Telephone, Postage, and Supplies $1,004 $1,084 $1,083 Marketing and Corporate Communications 1,094 1,168 881 Loan and Deposit Supplies 569 629 634 Other* 2,294 2,065 1,921 ----- ----- ----- $4,961 $4,946 $4,519 ===== ===== ===== * Other includes director costs, travel and mileage, trust processing, dues and subscriptions, and other general expenses. INCOME TAXES Income tax expense was $1.9 million in 2005 compared with $2.4 million in 2004 and $2.2 million in 2003, representing an effective tax rate of 22.6%, 28.3%, and 27.1%, respectively. The decrease in the effective tax rate in 2005 is primarily a result of an increase in permanent differences as a relative percentage of pretax income. 28 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES ASSET QUALITY AND ALLOWANCE FOR LOAN AND LEASE LOSSES The allowance for loan and lease losses is an amount that Management believes will be adequate to absorb loan and lease losses on existing loans and leases that may become uncollectible based on Management's evaluations of the collectibility of loans and leases. These evaluations take into consideration such factors as changes in the nature and volume of the loan and lease portfolio, overall portfolio quality, adequacy of collateral, review of specific problem loans and leases, and current economic conditions that may affect the borrower's ability to pay. Management evaluates the adequacy of the allowance on a quarterly basis to ensure the provision for loan and lease losses has been charged against earnings in an amount necessary to maintain the allowance at a level that is appropriate based on management's assessment of probable estimated losses. The Corporation's methodology for assessing the appropriateness of the allowance for loan and lease losses consists of several key elements. These elements include a specific allowance for loan and lease classified list loans and an allowance based on historical trends. The Corporation consistently applies the following comprehensive methodology. The allowance for loan and lease losses addresses those loans and leases maintained on the Corporation's loan and lease classified list, which are assigned a rating of substandard, doubtful, or loss. Substandard loans and leases are those with a well-defined weakness, which jeopardizes the repayment of the debt. A loan or lease may be classified as substandard as a result of impairment of the borrower's financial condition and repayment capacity. Loans and leases for which repayment plans have not been met or collateral equity margins do not protect the Corporation may also be classified as substandard. Doubtful loans and leases have the characteristics of substandard loans and leases with the added characteristic that collection or liquidation in full, on the basis of presently existing facts and conditions, is highly improbable. Although the possibility of loss is extremely high for doubtful loans and leases, the classification of loss is deferred until pending factors, which might improve the loan or lease, have been determined. Loans and leases rated as doubtful in whole or in part are placed on non-accrual status. Loans and leases, which are classified as loss, are considered uncollectible and are charged to the allowance for loan and lease losses. Loans and leases on the loan and lease classified list may also be impaired loans, which are defined as non-accrual loans and leases or troubled debt restructurings, which are not in compliance with the restructured terms. Each of the classified loans and leases on the watch list is individually analyzed to determine the level of the potential loss under the current circumstances. The specific reserve established for these criticized by management and impaired loans and leases is based on careful analysis of the loan's and lease's performance, the related collateral value, cash flow considerations and the financial capability of any guarantor. The allowance for classified list loans and leases is equal to the total amount of potential unconfirmed losses for the individual classified loans and leases on the classified list. Classified loans and leases are managed and monitored by management. The allowance is based on historical trends and uses charge-off experience of the Corporation to estimate potential unconfirmed losses in the balances of the loan and lease portfolios. The historical loss experience percentage is based on the charge-off history. Historical loss experience percentages are applied to all non-classified loans and leases to obtain the portion of the allowance for loan and lease losses which is based on historical trends. Before applying the historical loss experience percentages, loan and lease balances are reduced by amounts of government agency guarantees. Installment loan balances are also adjusted for unearned discounts. The Corporation also maintains an unallocated allowance. The unallocated allowance is used to cover any factors or conditions, which may cause a potential loan and lease loss but are not specifically identifiable. It is prudent to maintain an unallocated portion of the allowance because no matter how detailed an analysis of potential loan and lease losses may be, the analysis produces only estimates, which, by definition lack precision. Since all identified losses are immediately charged off, no portion of the allowance for loan and lease losses is restricted to any individual loan or groups of loans, or lease or groups of leases, and the entire allowance is available to absorb any and all loan and lease losses. The following table's present information regarding the Corporation's total allowance for loan and lease losses as well as the allocation of such amounts to the various categories of loans at the dates indicated: 29 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES
December 31, 2005 --------------------------------- Allowance for Loan Percent of (Dollars in thousands) Losses Total Loans ---------- ---------- Commercial loans and leases $ 6,285 0.94% Residential real estate 470 0.07% Consumer loans 1,782 0.27% Unallocated 12 0.01% ------ Total allowance for loan and lease losses $ 8,549 1.29% ====== ====
December 31, 2004 --------------------------------- Allowance for Loan Percent of (Dollars in thousands) Losses Total Loans ---------- ---------- Commercial loans and leases $ 4,717 0.76% Residential real estate 276 0.05% Consumer loans 1,502 0.24% Unallocated 718 0.12% ------ Total allowance for loan and lease losses $ 7,213 1.17% ====== ====
December 31, 2003 --------------------------------- Allowance for Loan Percent of (Dollars in thousands) Losses Total Loans ---------- ---------- Commercial loans and leases $ 3,875 0.76% Residential real estate 199 0.04% Consumer loans 1,187 0.23% Unallocated 603 0.12% ------ Total allowance for loan and lease losses $ 5,864 1.15% ====== ====
December 31, 2002 --------------------------------- Allowance for Loan Percent of (Dollars in thousands) Losses Total Loans ---------- ---------- Commercial loans and leases $ 4,639 1.04% Residential real estate 105 0.02% Consumer loans 1,403 0.31% Unallocated 83 0.02% ------ Total allowance for loan and lease losses $ 6,230 1.39% ====== ====
December 31, 2001 --------------------------------- Allowance for Loan Percent of (Dollars in thousands) Losses Total Loans ---------- ---------- Commercial loans and leases $ 4,989 1.11% Residential real estate 150 0.03% Consumer loans 1,009 0.23% Unallocated 196 0.05% ------ Total allowance for loan and lease losses $ 6,344 1.42% ====== ====
30 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES ANALYSIS OF CHANGES IN THE ALLOWANCE FOR POSSIBLE LOAN LOSSES AND COMPARISON OF LOANS OUTSTANDING
December 31 ------------------------------------------------------ (Dollars in thousands) 2005 2004 2003 2002 2001 ------- -------- -------- -------- -------- Balance at beginning of year $ 7,213 $ 5,864 $ 6,230 $ 6,344$ $ 6,609 ------- ------- ------- ------- ------- Provision charged to operating expense 1,382 1,164 2,519 2,231 2,929 ------- ------- ------- ------- ------- Recoveries of loans previously charged off Commercial loans 178 955 175 274 76 Real estate - mortgages 196 31 9 - Consumer loans 12 28 28 51 114 Lease financing receivables 51 81 2 - 8 ------- ------- ------- ------- ------- Total recoveries 437 1,095 214 325 198 ------- ------- ------- ------- ------- Loan charge-offs Commercial loans (59) (261) (1,044) (841) (2,173) Real estate - mortgages (245) (294) (545) (1,265) (955) Consumer loans (82) (121) (261) (216) (256) Lease financing receivables (97) (234) (1,248) (348) (8) ------- ------- ------- ------- ------- Total charge-offs (483) (910) (3,099) (2,670) (3,392) ------- ------- ------- ------- ------- Net loan charge-offs (46) 185 (2,885) (2,345) (3,194) ------- ------- ------- ------- ------- Balance at end of year $ 8,549 $ 7,213 $ 5,864 $ 6,230 $ 6,344 ======= ======= ======= ======= ======= Year-end loans outstanding $664,276 $618,005 $511,249 $447,682 $448,110 Average loans outstanding $650,938 $567,755 $470,413 $442,613 $419,984 Allowance for possible loan losses as a percentage of year-end loans outstanding 1.29% 1.17% 1.15% 1.39% 1.42% Ratio of net charge-offs to average loans outstanding 0.01% (0.03)% 0.61% 0.53% 0.76%
Non-performing loans and leases include those on non-accrual status and loans past due 90 days or more and still accruing. The Corporation's policy is to write down all non-performing loans to net realizable value based on updated appraisals. Non-performing loans are generally collateralized and are in the process of collection. Non-performing loans reduce the Corporation's earnings because interest income is not earned on such assets. Non-accrual loans at December 31, 2005 include two commercial loans of $5.9 million and $1.9 million, respectively. Management is actively working to collect these loans and does not anticipate a loss of principal. Management continues to take steps to reduce levels and correct and control current and future credit quality issues. The Credit Administration Department assists Management in improving the components of the allowance of loans and lease losses including the provision for loan and lease losses, recoveries, and charged-off loans. Please see the "Non-Interest Income" section for information regarding gains on the sale of OREO. The following chart represents detailed information regarding non-performing loans: 31 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NON-PERFORMING LOANS AND ASSETS
December 31 ------------------------------------------------------------------ (Dollars in thousands) 2005 2004 2003 2002 2001 -------- --------- -------- -------- -------- Past due over 90 days and still accruing $ -- $ -- $ 597 $ 321 $ 174 Non-accrual loans and leases 8,358 7,877 3,093 5,216 7,630 ---------- -------- -------- -------- -------- Total non-performing loans and leases 8,358 7,877 3,690 5,537 7,804 Other real estate owned ("OREO") -- 757 965 368 831 ---------- -------- -------- -------- -------- Total non-performing assets $ 8,358 $ 8,634 $ 4,655 $ 5,905 $ 8,635 ========== ======== ======== ======== ======== Interest income which would have been recorded $ 638 $ 209 $ 348 $ 448 $ 308 Interest income that was received from customer -- (27) $ (46) (234) -- ---------- -------- -------- -------- -------- Total contractual interest for nonaccruing loans and leases not collected $ 638 $ 182 $ 302 $ 214 $ 308 ========== ======== ======== ======== ======== Non-performing loans as a percentage of total loans and leases 1.26% 1.27% 0.72% 1.24% 1.74% Allowance for loan losses as a percentage of non-performing loans and leases 102.29% 91.57% 158.92% 112.52% 81.29% Non-performing assets as a percentage of total loans and leases and other real estate owned 1.26% 1.40% 0.91% 1.32% 1.92% Allowance for loan and lease losses as a percentage of non-performing assets 102.29% 83.54% 125.97% 105.50% 73.47% (1) Generally the Bank places a loan in non-accrual status when principal or interest has been in default for a period of 90 days or more unless the loan is both well secured and in the process of collection.
Management believes that the allowance for loan and lease losses is adequate based on its current assessment of probable estimated losses. OREO represents residential and commercial real estate owned by the Corporation following default by borrowers that has been written down to estimated realizable value (net of estimated disposal costs) based on professional appraisals. Management is not aware of any loans or leases other than those included in these tables and mentioned in this section as well as the "Asset Quality and Allowance for Loan and Lease Losses" section that would be considered potential problem loans and cause Management to have doubts as to the borrower's ability to comply with loan repayment terms. At December 31, 2005, there were no properties held by the Corporation as OREO. 32 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES CAPITAL ADEQUACY The Corporation is subject to Risk-Based Capital Guidelines adopted by the Federal Reserve Board for bank holding companies. The Bank is also subject to similar capital requirements adopted by the OCC. Under these requirements, the regulatory agencies have set minimum thresholds for Tier I Capital, Total Capital, and Leverage ratios. At December 31, 2005, both the Corporation's and the Bank's capital exceeded all minimum regulatory requirements and were considered "well capitalized", as defined in the regulations issued pursuant to the FDIC Improvement Act of 1994. The Corporation's and Bank's Risk-Based Capital Ratios, shown below, have been computed in accordance with regulatory accounting policies.
December 31 RISK-BASED -------------------------------------- "Well Capitalized" CAPITAL RATIOS 2005 2004 2003 Requirements - -------------- ------------ ------------ ----------- ------------------- Corporation Leverage Ratio 8.80% 8.62% 9.71% N/A Tier I Capital Ratio 10.94% 10.80% 12.01% N/A Total Risk-Based Capital Ratio 12.19% 11.91% 13.07% N/A Bank Leverage Ratio 8.14% 8.11% 8.68% 5.00% Tier I Capital Ratio 10.08% 10.16% 10.72% 6.00% Total Risk-Based Capital Ratio 11.32% 11.26% 11.79% 10.00%
The Bank is not under any agreement with the regulatory authorities nor is it aware of any current recommendations by the regulatory authorities that, if they were to be implemented, would have a material effect on liquidity, capital resources or operations of the Corporation. CONTRACTUAL OBLIGATIONS AND OTHER COMMITMENTS The following table sets forth contractual obligations and other commitments representing required and potential cash outflows as of December 31, 2005:
(Dollars in thousands) 2010 2009 2008 2007 2006 -------- --------- -------- -------- --------- Minimum annual rentals on non-cancelable $ 1,475 $ 942 $ 922 $ 686 $ 467 operating leases Remaining contractual maturities of time deposits 2,164 4,219 8,141 24,190 134,937 Loan commitments - - - - 250,152 Long-term borrowed funds 5,070 14,070 23,816 5,946 4,566 Subordinated debt(1) - - - - - Standby letter of credit - - - - 12,273 ------- ------- ------- ------- ------- Total $ 8,709 $ 19,231 $ 32,879 $ 30,822 $402,395 ======= ======= ======= ======= ======= Notes: (1) The Corporation had $10.0 million in subordinated debt to be redeemed in the year 2033 or callable at the Corporation's option in 2008 outstanding at December 31, 2005. The Corporation also had $5.0 million in subordinated debt to be redeemed in the year 2032 or callable at the Corporation's option in 2007 outstanding at December 31, 2005. The Corporation had no capital leases outstanding at December 31, 2005 or 2004.
BRANCHING AND TECHNOLOGY PROJECTS The Corporation intends to open a series of new branch locations throughout Chester County, Pennsylvania over the next five years. A new, customer-focused branch design was introduced with the construction of the branch office in Oxford, Pennsylvania. This new "signature look" will be rolled out to new and 33 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES certain current locations over the next five years. Technological improvements expected over the next 18 months include secure electronic delivery of customer checking and savings statements, and an improvement of customer service issues as the Bank utilizes the power of its new customer relationship management system ("CRM"). Management hopes to utilize the CRM along with the Answer Center to identify service issues and customer trends on a proactive basis resulting in a higher degree of customer satisfaction. DESCRIPTION OF CAPITAL STOCK AND MARKET INFORMATION The authorized capital stock of the Corporation consists of 10,000,000 shares of Common Stock, par value $1.00 per share, of which 5,143,723 and 4,562,225 shares were outstanding (net of shares held in Treasury) at the end of 2005 and 2004, respectively. The Corporation's Common Stock is publicly traded over the counter under the symbol "FCEC". Trading is sporadic. The following table shows the range of high and low bid prices for the Common Stock based upon transactions reported for each quarter respectively. Bid Prices ---------- 2005 2004 ---- ---- Quarter Ended High Low High Low ------------- ---- --- ---- --- First $29.50 $26.45 $27.45 $24.26 Second $28.00 $21.00 $25.25 $21.50 Third $21.46 $18.25 $26.90 $23.50 Fourth $19.75 $17.55 $28.00 $24.88 CRITICAL ACCOUNTING POLICIES, JUDGEMENTS AND ESTIMATES The accounting and reporting policies of the Corporation conform with accounting principles generally accepted in the United States of America and general practices within the financial services industry. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires Management to make estimates and assumptions that affect the amounts reported in the financial statements and the accompanying notes. Actual results could differ from those estimates. The Corporation considers that the determination of the allowance for loan and lease losses involves a higher degree of judgment and complexity than its other significant accounting policies. The balance in the allowance for loan losses is determined based on Management's review and evaluation of the loan portfolio in relation to past loss experience, the size and composition of the portfolio, current economic events and conditions, and other pertinent factors, including Management's assumptions as to future delinquencies, recoveries and losses. All of these factors may be susceptible to significant change. To the extent actual outcomes differ from Management's estimates, additional provisions for loan and lease losses may be required that would adversely impact earnings in future periods. Under the liability method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities. Deferred tax assets are subject to Management's judgment based upon available evidence that future realization is more likely than not. If Management determines that the Corporation may be unable to realize all or part of the net deferred tax assets in the future, a direct charge to income tax expense may be required to reduce the recorded value of the net deferred tax asset to the expected realizable amount. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS On December 16, 2004, the Financial Accounting Standards Board ("FASB") issued FASB Statement No. 123 (revised 2004), "Share-Based Payment" (Statement 123(R)). Statement 123(R) addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise's equity instruments or that may be settled by the issuance of such equity instruments. Statement 123(R) requires an entity to recognize the grant-date fair-value of stock options and other equity-based 34 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES compensation issued to employees in the income statement. Statement 123(R) generally requires that an entity account for those transactions using the fair-value-based method; and eliminates an entity's ability to account for share-based compensation transactions using the intrinsic value method of accounting in APB Opinion No. 25, "Account for Stock Issued to Employees," which was permitted under Statement 123, as originally issued. Statement 123 (R) requires entities to disclose information about the nature of the share-based payment transactions and the effects of those transactions on the financial statements. Statement 123(R) is effective for the Corporation beginning January 1, 2006. The Corporation must use either the modified prospective or the modified retrospective transition method. Early adoption of Statement 123(R) for interim or annual periods for which financial statements or interim reports have not been issued is permitted. The adoption of Statement 123(R) is expected to reduce reported net income and earnings per share. Management is evaluating Statement 123(R) and has not yet determined its full impact on the consolidated financial statements of the Corporation. In March 2005, the SEC issued Staff Accounting Bulletin No. 107 ("SAB 107"), which provides guidance on the interaction between Statement 123(R) and certain SEC rules and regulations. SAB 107 was issued to assist issuers in their initial implementation of Statement 123(R) and to enhance the information received by investors and other users of the financial statements. In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error Corrections," which replaces APB Opinion No. 20, "Accounting Changes," and SFAS No. 3, "Reporting Accounting Changes in Interim Financial Statements," and changes the requirements for the accounting for and reporting of a change in accounting principle. SFAS No. 154 applies to all voluntary changes in accounting principle and to changes required by an accounting pronouncement when the pronouncement does not include specific transition provisions. SFAS No. 154 requires retrospective application of changes in accounting principle to prior periods' financial statements unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. APB Opinion No. 20 previously required that most voluntary changes in accounting principle be recognized by including the cumulative effect of the change in net income for the period of the change in accounting principle. SFAS No. 154 carries forward without change the guidance contained in PB Opinion No. 20 for reporting the correction of an error in previously issued financial statements and a change in accounting estimate. SFAS No. 154 also carries forward the guidance in PB Opinion No. 20 requiring justification of a change in accounting principle on the basis of preferability. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005, with early adoption permitted. The Corporation's adoption of SFAS No. 154 will not have an impact on our financial condition or results of operations. Emerging Issues Task Force ("EITF") Issue 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments." EITF 03-1 provides guidance for determining when an investment is considered impaired, whether impairment is other-than-temporary, and measurement of an impairment loss. An investment is considered impaired if the fair value of the investment is less than its cost. Generally, an impairment is considered other-than-temporary unless: (i) the investor has the ability and intent to hold an investment for a reasonable period of time sufficient for an anticipated recovery of fair value up to (or beyond) the cost of the investment; and (ii) evidence indicating that the cost of the investment is recoverable within a reasonable period of time outweighs evidence to the contrary. If impairment is determined to be other-than-temporary, then an impairment loss should be recognized equal to the difference between the investment's cost and its fair value. Certain disclosure requirements of EITF 03-1 were adopted in 2003 and the Corporation began presenting the new disclosure requirements in its consolidated financial statements for the year ended December 31, 2003. The recognition and measurement provisions were initially effective for other-than-temporary impairment evaluations in reporting periods beginning after June 15, 2004. However, in September 2004, the effective date of these provisions was delayed until the finalization of a FASB Staff Position to provide additional implementation guidance. In June, the FASB decided not to provide additional guidance on the meaning of other-than-temporary impairment, but directed its staff to issue proposed FSP EITF 03-1-a, "Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1," as final. The final FSP will supersede EITF Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments," and EITF Topic No. D-44, "Recognition of Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value." The final FSP (retitled FSP FAS 115-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments") will replace the guidance set forth in paragraphs 10-18 of Issue No. 03-1 with references to existing other-than-temporary impairment guidance, such as FASB Statement No. 115, "Accounting for Certain Investments in Debt and Equity 35 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES Securities", SEC Staff Accounting Bulletin No. 59, "Accounting for Noncurrent Marketable Equity Securities", and APB Opinion No. 18, "The Equity Method of Accounting for Investments in Common Stock." FASB Staff Position No. FAS 115-1 and FAS 124-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" (the "FSP"), was issued on November 3, 2005 and addresses the determination of when an investment is considered impaired; whether the impairment is other than temporary; and how to measure an impairment loss. The FSP also addresses accounting considerations subsequent to the recognition of an other-than-temporary impairment on a debt security, and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The FSP replaces the impairment guidance in EITF Issue No. 03-1 with references to existing authoritative literature concerning other-than-temporary determinations (principally Statement of Financial Accounting Standards No. 115 and SEC Staff Accounting Bulleting 59). Under the FSP, impairment losses must be recognized in earnings equal to the entire difference between the security's cost and its fair value at the financial statement date, without considering partial recoveries subsequent to that date. The FSP also requires that an investor recognize an other-than-temporary impairment loss when a decision to sell a security has been made and the investor does not expect the fair value of the security to fully recover prior to the expected time of sale. The FSP is effective for reporting periods beginning after December 5, 2005. The Corporation does not expect that the application of the FSP will have a material impact on its financial condition, results of operations or financial statement disclosures. Item 7A. Quantitative and Qualitative Disclosures About Market Risk LIQUIDITY MANAGEMENT AND INTEREST RATE SENSITIVITY The objective of liquidity management is to ensure the availability of sufficient cash flows to meet all financial commitments and to capitalize on opportunities for business expansion. Liquidity management addresses the Corporation's ability to meet deposit withdrawals either on demand or at contractual maturity, to repay borrowings as they mature and to make new loans and investments as opportunities arise. Liquidity is managed on a daily basis enabling Senior Management to monitor changes in liquidity and to react accordingly to fluctuations in market conditions. The primary sources of liquidity for the Corporation are funding available from growth of our existing deposit base, new deposits, FHLB, and cash flow from the investment and loan portfolios. The Corporation considers funds from such sources to comprise its "core" deposit base because of the historical stability of such sources of funds. Additional liquidity comes from the Corporation's non-interest bearing demand deposit accounts and credit facilities. Other deposit sources include a tiered savings product and certificates of deposit in excess of $100,000. Details of core deposits, non-interest-bearing demand deposit accounts and other deposit sources are highlighted in the following table: 36 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES The Corporation utilizes borrowings from the FHLB and collateralized repurchase agreements in managing its interest rate risk and as a tool to augment deposits and in funding asset growth. The Corporation may utilize these funding sources to better match its assets that are subject to longer term repricing (i.e., between one and five years). The Bank, as a member of the FHLB, maintains several credit facilities (overnight lines of credit, amortizing and non-amortizing fixed rate term and variable rate term advances with FHLB). As of December 31, 2005, the amount outstanding under the Bank's line of credit with the FHLB was $0. FHLB borrowings totaled $68.9 million compared to $66.5 million at December 31, 2004. These advances consist of short and long term borrowings representing a combination of maturities. The average interest rate for 2005 and 2004 on these advances was approximately 3.7% and 3.0%, respectively. The Bank currently has a maximum borrowing capacity with the FHLB of approximately $189.2 million. The goal of interest rate sensitivity management is to avoid fluctuating net interest margins, and to enhance consistent growth of net interest income through periods of changing interest rates. Such sensitivity is measured as the difference in the volume of assets and liabilities in the existing portfolio that are subject to repricing in a future time period. The Corporation's net interest rate sensitivity of its "gap position" within one year is a negative $122.6 million or 14.5% of total assets at December 31, 2005, compared with a negative $213.4 million or 26.5% of total assets at the end of 2004. The Corporation's gap position is just one tool used to evaluate interest rate risk and the stability of net interest margins. The data in the following chart represents the gap position at a specific point in time and may not be indicative of future gap positions. Another tool that Management uses to evaluate interest rate risk is a computer simulation model that assesses the impact of changes in interest rates on net interest income, net-income under various interest rate forecasts and scenarios. Management has set acceptable limits of risk within its Asset Liability Committee policy and monitors the results of the simulations against these limits quarterly. Management monitors interest rate risk as a regular part of corporate operations with the intention of maintaining a stable net interest margin. INTEREST RATE SENSITIVITY GAP AS OF DECEMBER 31, 2005
(Dollars in thousands) Within Through Five Non-Rate One Year Five Years Years Sensitive Total ------------ ---------- ---------- ---------- ----------- ASSETS Federal funds sold $ 31,000 $ - $ - $ - $ 31,000 Investment securities 25,114 48,125 23,849 - 97,088 Interest bearing deposits in banks 542 - - - 542 Loans and leases 269,906 287,427 106,943 (8,549) 655,727 Cash and due from banks - - - 37,401 37,401 Premises & equipment - - - 13,786 13,786 Other assets - - - 9,564 9,564 -------- ------- -------- -------- -------- Total assets $ 326,562 $335,552 $ 130,792 $ 52,202 $ 845,108 ======== ======= ======== ======== ======== LIABILITIES AND CAPITAL Non-interest-bearing deposits$ - $ - $ - $ 136,082 $ 136,082 Interest bearing deposits 428,890 38,716 92,409 - 560,015 FHLB advances and other Borrowings 4,566 48,902 15,432 - 68,900 Guaranteed Preferred Securities 15,465 - - - 15,465 Other liabilities 220 - 5,749 - 5,969 Capital - - - 58,677 58,677 -------- -------- -------- -------- -------- Total liabilities and capital $ 449,141 $ 87,618 $ 113,590 $ 194,759 $ 845,108 ======== ======== ======== ======== ======== Net interest rate sensitivity gap $(122,579) $247,934 $ 17,202 $(142,557) $ - ======== ======= ======== ======== ======== Cumulative interest rate sensitivity gap $(122,579) $125,355 $ 142,557 $ - $ - ======== ======= ======== ======== ======== Cumulative interest rate sensitivity gap divided by total assets (14.5%) (14.8%) 16.9% ======= ======= ======
37 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES The Corporation's gap position is one factor used to evaluate interest rate risk and the stability of net interest margins. Other factors include computer simulations of what might happen to net interest income under various interest rate forecasts and scenarios. The Corporation's Asset Liability Management Policy requires quarterly calculation of the effects of changes in interest rates on net interest income. The table below summarizes estimated changes in net interest income over the twelve-month period ending December 31, 2005 under alternative interest rate scenarios. The change in interest rates was modeled to simulate the effect of a proportional shift in asset and liability ratios (rate ramp). The prime rate as reported in the Wall Street Journal as of December 31, 2005 of 7.25% is used as the "driver rate" in these simulations. (Dollars in thousands) Change in Net Dollar Percent Interest Rates Interest Income Change Change -------------- --------------- ------ ------ +200 Basis Points $ 40,973 $ 1,400 3.54% +100 Basis Points 40,270 698 1.76 Flat Rate 39,573 - - -100 Basis Points 38,878 (695) (1.76) -200 Basis Points 38,193 (1,380) (3.49) Management believes that the assumptions utilized in evaluating the vulnerability of the Corporation's net interest income to changes in interest rates approximate actual experience; however, the interest rate sensitivity of the Corporation's assets and liabilities, as well as the estimated effect of changes in interest rates on net interest income, could vary substantially if different assumptions are used or actual experience differs from the experience on which the assumptions were based. In the event the Corporation should experience a mismatch in its desired gap position or an excessive decline in its net interest income subsequent to an immediate and sustained change in interest rates, it has a number of options which it could utilize to remedy such a mismatch. The Corporation could restructure its investment portfolio through sale or purchase of securities with more favorable repricing attributes. It could also promote loan products with appropriate maturities or repricing attributes. The Corporation could also solicit deposits or search for borrowings with more desirable maturities. However, market circumstances might make execution of these strategies cost prohibitive or unattainable. The nature of the Corporation's current operation is such that it is not subject to foreign currency exchange or commodity price risk. Additionally, neither the Corporation nor the Bank owns trading assets. At December 31, 2005, the Corporation did not have any hedging transactions in place such as interest rate swaps, caps or floors. 38 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES Item 8. Financial Statements and Supplementary Data. - ------- -------------------------------------------- Report of Independent Registered Public Accounting Firm ------------------------------------------------------- Board of Directors First Chester County Corporation We have audited the accompanying consolidated balance sheets of First Chester County Corporation as of December 31, 2005 and 2004, and the related consolidated statements of earnings, changes in stockholders' equity and cash flows for each of the three years in the period ended December 31, 2005. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of First Chester County Corporation as of December 31, 2005 and 2004, and the consolidated results of their operations and their consolidated cash flows for each of the three years ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of First Chester County Corporation's internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 10, 2006 expressed an unqualified opinion on management's assessment of the effectiveness of internal controls over financial reporting and an unqualified opinion on the effectiveness of internal controls over financial reporting. Grant Thornton LLP Philadelphia, Pennsylvania March 10, 2006 39 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
(Dollars in thousands) December 31 ---------------------------- 2005 2004 -------------- ---------- ASSETS Cash and due from banks $ 37,401 $ 24,656 Federal funds sold and other overnight investments 31,000 6,500 Interest bearing deposits 542 454 -------- -------- Total cash and cash equivalents 68,943 31,610 -------- -------- Investment securities held-to-maturity (fair value of $10 and $11 in 2005 and 2004, respectively) 10 10 Investment securities available-for-sale, at fair value 97,078 140,019 Loans and leases 664,276 618,005 Less allowance for possible loan and lease losses (8,549) (7,213) -------- -------- Net loans 655,727 610,792 Premises and equipment, net 13,786 14,137 Other assets 9,564 8,907 -------- -------- Total assets $ 845,108 $ 805,475 ======== ======== LIABILITIES Deposits Non-interest-bearing $ 136,082 $ 125,452 Interest-bearing (including certificates of deposit over $100 of $61,281 and $33,048 - 2005 and 2004, respectively) 560,015 537,566 -------- -------- Total deposits 696,097 663,018 Federal Home Loan Bank advances and other borrowings 68,900 66,464 Subordinated debt 15,465 15,465 Other liabilities 5,969 5,126 -------- -------- Total liabilities 786,431 750,073 -------- -------- STOCKHOLDERS' EQUITY Common stock, par value $1.00; authorized, 10,000,000 shares; Outstanding 5,279,815 at December 31, 2005 and 4,799,666 at December 31, 2004 5,280 4,800 Additional paid-in capital 12,441 2,052 Retained earnings 46,503 53,749 Accumulated other comprehensive loss (1,929) (78) Treasury stock, at cost: 2005 - 136,092 and 2004 - 237,441 (3,618) (5,121) -------- -------- Total stockholders' equity 58,677 55,402 -------- -------- Total liabilities and stockholders' equity $ 845,108 $ 805,475 ======== ========
The accompanying notes are an integral part of these statements. 40 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME
(Dollars in thousands, except per share) Years ended December 31 ------------------------------------- 2005 2004 2003 ----------- ---------- ---------- INTEREST INCOME Loans and leases, including fees $ 39,402 $ 32,046 $ 28,724 Investment securities 4,441 5,223 4,595 Federal funds sold and other overnight investments 752 243 211 Deposits in banks 9 6 3 --------- --------- --------- Total interest income 44,604 37,518 33,533 --------- --------- --------- INTEREST EXPENSE Deposits 10,009 5,304 5,887 Securities sold under repurchase agreements 0 0 3 Subordinated debt 1,015 728 312 Federal Home Loan Bank advances and other borrowings 2,555 1,831 952 --------- --------- --------- Total interest expense 13,579 7,863 7,154 --------- --------- --------- Net interest income 31,025 29,655 26,379 PROVISION FOR POSSIBLE LOAN AND LEASE LOSSES 1,382 1,164 2,519 --------- --------- --------- Net interest income after provision for possible loan and lease losses 29,643 28,491 23,860 --------- --------- --------- NON-INTEREST INCOME Trust and Investment Services 3,393 3,486 3,277 Service charges on deposit accounts 1,954 2,115 2,021 Investment securities gains, net 58 70 410 Operating lease rental income 998 828 867 Gains (losses) on the sale of fixed assets and OREO (6) 145 1,012 Gains and fees on the sale of residential mortgages 474 377 1,019 Gains on the sale of credit card portfolio -- 34 306 Proceeds from life insurance -- -- 422 Other 2,454 2,258 2,172 --------- --------- --------- Total non-interest income 9,325 9,313 11,506 --------- --------- --------- NON-INTEREST EXPENSE Salaries and employee benefits 15,881 15,815 14,971 Occupancy, equipment, and data processing 5,605 5,361 5,476 Depreciation expense on operating leases 869 740 691 FDIC deposit insurance 91 86 88 Bank shares tax 549 517 493 Professional services 2,601 1,748 1,162 Other 4,961 4,946 4,519 --------- --------- --------- Total non-interest expense 30,557 29,213 27,400 --------- --------- --------- Income before income taxes 8,411 8,591 7,966 INCOME TAXES 1,900 2,430 2,161 --------- --------- --------- NET INCOME $ 6,511 $ 6,161 $ 5,805 ========= ========= ========= PER SHARE Basic earnings per common share $ 1.28 $ 1.24 $ 1.18 ======== ========= ========= Diluted earnings per common share $ 1.24 $ 1.19 $ 1.14 ======== ========= ========= Dividends declared $ 0.525 $ 0.505 $ 0.493 ======== ========= =========
The accompanying notes are an integral part of these statements. 41 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
Accumulated Additional Other Total Common Stock Paid-in Retained Comprehensive Treasury Comprehensive Stockholders' (Dollars in thousands) Shares Par Value Capital Earnings Income(Loss) Stock Income Equity ------ --------- ---------- -------- ------------- -------- ------------- ------------ Balance at January 1, 2003 4,799,666 $ 4,800 $ 860 $ 46,746 $ 1,378 $ (5,172) $ - $ 48,612 Net income - - - 5,805 - - 5,805 5,805 Cash dividends declared - - - (2,434) - - - (2,434) Other Comprehensive Income Net unrealized gains on investment securities available-for-sale - - - - (1,072) - (1,072) (1,072) Treasury stock transactions - - 1,017 - - (178) - 839 Comprehensive Income $ 4,733 ====== Balance at December 31, 2003 4,799,666 $ 4,800 $ 1,877 $ 50,117 $ 306 $ (5,350) $ - $ 51,750 Net income - - - 6,161 - - 6,161 6,161 Cash dividends declared - - - (2,529) - - - (2,529) Other Comprehensive Income Net unrealized gains on investment securities available-for-sale - - - - (384) - (384) (384) Treasury stock transactions - - (328) - - 229 - (99) Tax benefit from stock option exercises - - 503 - - - - 503 Comprehensive Income $ 5,777 ======= Balance at December 31, 2004 4,799,666 $ 4,800 $ 2,052 $ 53,749 $ (78) $ (5,121)$ - $ 55,402 Net income - - - 6,511 - - 6,511 6,511 Cash dividends declared - - - (2,665) - - - (2,665) Stock dividends declared 480,149 480 10,612 (11,092) - - - - Other Comprehensive Income Net unrealized (losses) gains on investment securities available- for-sale - - - - (1,851) - (1,851) (1,851) Treasury stock transactions - - (223) - - 1,503 - 1,280 Comprehensive Income $ 4,660 ====== Balance at December 31, 2005 5,279,815 $ 5,280 $ 12,441 $ 46,503 $ (1,929) $ (3,618) $ - $ 58,677 ========= ======= ======= ======= ======= ======= ====== =======
The accompanying notes are an integral part of these statements 42 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands) Years ended December 31 -------------------------------------- 2005 2004 2003 ------------ ---------- --------- OPERATING ACTIVITIES Net income $ 6,511 $ 6,161 $ 5,805 Adjustments to reconcile net income to net cash provided by operating activities Depreciation 2,615 1,558 2,744 Provision for loan losses 1,382 1,164 2,519 Amortization of investment security premiums and accretion of discounts, net 194 563 1,812 Amortization of deferred loan fees (111) (54) (234) Investment securities (gains) losses, net (58) (70) (410) (Increase) decrease in other assets (2,508) (361) (620) Increase (decrease) in other liabilities 843 524 (379) -------- --------- -------- Net cash provided by operating activities 8,868 9,485 11,237 -------- --------- -------- INVESTING ACTIVITIES Net increase in loans (46,206) (106,517) (64,668) Proceeds from sales of investment securities available-for-sale 85,784 32,066 17,736 Proceeds from maturities of investment securities 56,985 101,351 71,243 Purchase of investment securities available-for-sale (99,964) (143,131) (95,909) Purchase of premises and equipment, net (2,264) (2,527) (1,968) -------- --------- -------- Net cash used in investing activities ( 5,665) (118,758) (73,566) -------- --------- -------- FINANCING ACTIVITIES Increase (decrease) in Federal Home Loan Bank Advances S-T 750 (850) 849 Increase (decrease) in Federal Home Loan Bank Advances L-T 1,686 26,771 17,015 Increase (decrease) in deposits 33,079 85,704 18,576 Cash dividends paid (2,665) (2,529) (2,434) Proceeds from issuance of subordinated debt - - 10,000 Net increase in Treasury Stock 1,280 404 839 -------- --------- -------- Net cash provided by financing activities 34,130 109,500 44,845 -------- --------- -------- NET INCREASE IN CASH AND CASH EQUIVALENTS 37,333 227 (17,484) Cash and cash equivalents at beginning of year 31,610 31,383 48,867 -------- --------- -------- Cash and cash equivalents at end of year $ 68,943 $ 31,610 $ 31,383 ======== ========= ========
The accompanying notes are an integral part of these statements. 43 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES First Chester County Corporation (the "Corporation"), through its wholly-owned subsidiary, First National Bank of Chester County (the "Bank"), has been serving the residents and businesses of Chester County, Pennsylvania, since 1863. The Bank is a locally managed community bank providing loan, deposit, cash management and trust and investment services from its twenty branch locations. The Bank encounters vigorous competition for market share in the communities it serves from bank holding companies, other community banks, Internet banks, thrift institutions, credit unions and other non-bank financial organizations such as mutual fund insurance and brokerage companies. The Corporation and the Bank, and their wholly-owned subsidiaries FNB Property Management, LLC, First National Insurance Services, LLC, and Turks Head Properties, Inc., First Chester County Capital Trust I ("Trust I"), and First Chester County Capital Trust II ("Trust II") are subject to regulations of certain state and federal agencies. These regulatory agencies periodically examine the Corporation and the Bank for adherence to laws and regulations. 1. Basis of Financial Statement Presentation The accounting policies followed by the Corporation and its wholly-owned subsidiaries conform to generally accepted accounting principles ("GAAP") and predominant practices within the banking industry. The accompanying consolidated financial statements include the accounts of the Corporation, the Bank, Turks Head Properties, Turks Head II, First National Bank Investment Services, and FNB Properties. All significant intercompany transactions have been eliminated. In preparing the financial statements, Management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the balance sheets, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The principal estimate that is susceptible to significant change in the near term relates to the allowance for loan and lease losses. The evaluation of the adequacy of the allowance for loan and lease losses includes an analysis of the individual loans and leases and overall risk characteristics and size of the different loan and lease portfolios, and takes into consideration current economic and market conditions, the capability of specific borrowers to pay specific loan and lease obligations, as well as current loan collateral values. However, actual losses on specific loans and leases, which also are encompassed in the analysis, may vary from estimated losses. Statement of Financial Accounting Standards ("SFAS") No. 131 establishes standards for public business enterprises reporting information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in subsequent interim financial reports issued to shareholders. It also establishes standards for related disclosure about products and services, geographic areas, and major customers. Operating segments are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and assess resources and performance. The Corporation has applied the aggregation criteria set forth in SFAS No. 131 for its operating segments to create one reporting segment, "community banking." The Corporation's Community Banking segment consists of construction, commercial, retail, and mortgage banking. The community banking segment is managed as a single strategic unit, which generates revenue from a variety of products and services provided by the Corporation. For example, construction and commercial lending is dependent upon the ability of the Corporation to fund itself with retail deposits and other borrowings and to manage interest rate and credit risk. This situation is also similar for consumer and residential mortgage lending. Accordingly, all significant operating decisions are based upon analysis of the Corporation as one operating segment or unit. 44 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - continued Management has determined that Trust I and Trust II (Trust I and Trust II, collectively, the "Trusts") each qualify as variable interest entities under FASB Interpretation 46 (FIN 46). Each of the Trusts issued mandatory redeemable preferred stock to investors and loaned the proceeds to the Corporation. Trust I and Trust II holds, as its sole asset, subordinated debentures issued by the Corporation. Trust I and Trust II are included in the Corporation's consolidated statements of income for 2003. The Corporation has evaluated the impact of FIN 46 and concluded it should continue to consolidate the Trusts' financial statements with the Corporation's financial statements as of December 31, 2003, in part, due to its ability to call the preferred stock prior to the mandatory redemption date and thereby benefit from a decline in required dividend yields. Subsequent to the issuance of FIN 46, the FASB issued a revised interpretation, FIN 46(R), the provisions of which must be applied to certain variable interest entities. The Corporation adopted the provisions under the revised interpretation in the first quarter of 2004. FIN 46(R) required the Corporation to deconsolidate the Trusts. Accordingly, the Corporation deconsolidated the Trusts at the end of the first quarter of 2004, which resulted in an increase in outstanding debt of $15.10 million. In March 2005, the Federal Reserve Board adopted a final rule that would continue to allow the inclusion of trust preferred securities in Tier I Capital, but with stricter quantitative limits. Under the final rule, after a five-year transition period, the aggregate amount of trust preferred securities and certain other capital elements would be limited to 25% of Tier I Capital elements, net of goodwill. The amount of trust preferred securities and certain other elements in excess of the limit could be included in Tier II Capital, subject to restriction. Based on the final rule, the Corporation expects to include all of its $5.2 million in trust preferred securities in Tier I Capital. 2. Financial Instruments The Corporation follows SFAS No. 107, "Disclosures about Fair Value of Financial Instruments," which requires all entities to disclose the estimated fair value of their assets and liabilities considered to be financial instruments. Financial instruments requiring disclosure consist primarily of investment securities, loans, and deposits and borrowings. 3. Investment Securities The Corporation follows SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which requires investments in securities to be classified in one of three categories: held-to-maturity, trading, or available-for-sale. Debt securities that the Corporation has the positive intent and ability to hold to maturity are classified as held-to-maturity and are reported at amortized cost. As the Corporation does not engage in security trading, the balance of its debt securities and any equity securities are classified as available-for-sale. Net unrealized gains and losses for such securities, net of tax effect, are required to be recognized as a separate component of stockholders' equity and excluded from the determination of net income. The Corporation adopted EITF 03-1, "The Meaning of Other than Temporary Impairment and Its Application to Certain Investments as December 31, 2003. EITF 03-1 includes certain disclosures regarding quantitative and qualitative disclosures for investment securities accounted for under SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities" that is impaired at the balance sheet date, but an other-than-temporary impairment has not been recognized. The disclosure under EITF 03-1 is required for financial statements for years ending after December 15, 2003 and are included in these financial statements. The Corporation adopted the provisions of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activity," as amended by SFAS No. 138 on January 1, 2001. SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments imbedded in other contracts, and for hedging activities. It requires that an entity recognize all derivatives either as assets or liabilities in the statement of financial position and measure those instruments at fair value. The Corporation did not have any derivative instruments at December 31, 2005, 2004, and 2003. 45 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - continued 4. Loans and Leases and Allowance for Loan and Lease Losses Loans and leases that Management has the intent and ability to hold for the foreseeable future or until maturity or payoff are stated at the amount of unpaid principal, reduced by unearned discount and an allowance for loan and lease losses. The allowance for loan and lease losses is established through a provision for loan and lease losses charged to expense. Loan and lease principal considered to be uncollectible by Management is charged against the allowance for loan and lease losses. The allowance is an amount that Management believes will be adequate to absorb possible losses on existing loans and leases that may become uncollectible based upon an evaluation of known and inherent risks in the loan and lease portfolio. The evaluation takes into consideration such factors as changes in the nature and size of the loan and lease portfolio, overall portfolio quality, specific problem loans, loss experience, and current and future economic conditions which may affect the borrowers' ability to pay. The evaluation also details historical losses by loan category, the resulting loss rates for which are projected at current loan and lease total amounts. Loss estimates for specified problem loans and leases are also detailed. Interest on loans and leases is accrued and credited to operations based upon the principal amount outstanding. Certain origination and commitment fees and related direct loan or lease origination costs are deferred and amortized over the contractual life of the related loans and leases, resulting in an adjustment of the related loan's yield. Accrual of interest is discontinued on a loan when Management believes that the borrower's financial condition is such that collection of interest and principal is doubtful. Upon such discontinuance, all unpaid accrued interest is reversed. The Corporation accounts for impairment in accordance with SFAS No. 114, "Accounting by Creditors for Impairment of a Loan," as amended by SFAS No. 118, "Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures." SFAS No. 114 requires loan impairment to be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate, its observable market price or the fair value of the collateral if the loan is collateral dependent. If it is probable that a creditor will foreclose on a property, the creditor must measure impairment based on the fair value of the collateral. SFAS No. 118 allows creditors to use existing methods for recognizing interest income on impaired loans. Residential mortgage loans originated and intended for sale in the secondary market are carried at the lower of aggregate cost or estimated fair value. Gains and losses and unamortized fees on sales of residential mortgage loans are included in non-interest income. The Corporation accounts for its transfers and servicing of financial assets in accordance with SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities". SFAS No. 140 revises the standards for accounting for securitizations and other transfers of financial assets and collateral. The Corporation adopted FASB Interpretation 45 (FIN 45) "Guarantor's Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others," on January 1, 2003. FIN 45 requires a guarantor entity, at the inception of a guarantee covered by the measurement provisions of FIN 45, to record a liability for the fair value of the obligation undertaken in issuing the guarantee. The Corporation has issued financial and performance letters of credit. Financial letters of credit require the Corporation to make payment if the customer's financial condition deteriorates, as defined in underlying agreements. Performance letters of credit require the Corporation to make payments if the customer fails to perform certain non-financial contractual obligations. The Corporation previously did not record an initial liability, other than the fees received for these letters of credit, unless it became probable that the Corporation would have to perform under the letter of credit. Under FIN 45, the Corporation will record a liability equal to the initial fair value of the liability for the letters of credit. The Corporation defines the initial fair value of these letters of credit as the fee received from the customer. FIN 45 applies prospectively to letters of credit the Corporation issues or modifies subsequent to December 31, 2002. The maximum potential undiscounted amounts of future payments of letters of credit outstanding as of December 31, 2005 were $19.0 million, and they expire through March 31, 2019. Amounts due under these letters of credit would be reduced by any proceeds that the 46 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - continued Corporation would be able to obtain in liquidating the collateral for the letter of credit, which varies depending on the customer. The adoption of the provisions of FIN 45 is not expected to have a material impact on the financial condition or results of operation of the Corporation. The Corporation follows the Staff Accounting Bulletin (SAB) No. 102 issued by the SEC which provides guidance on the development, documentation, and application of a systematic methodology for determining the allowance for loans and leases in accordance with United States GAAP. The adoption of SAB No. 102 did not to have a material impact on the Company's financial position or results of operations. 1. Premises and Equipment Premises and equipment are stated at cost less accumulated depreciation. Assets are depreciated over their estimated useful lives, principally by the straight-line method. The Corporation accounts for impairment of long-term assets in accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." The standard requires recognition and measurement of long-lived assets to be held and used or to be disposed of by sale. The Corporation had no impaired long-lived assets at December 31, 2005, 2004, or 2003. 2. Contributions The Corporation accounts for contributions in accordance with SFAS No. 116, "Accounting for Contributions Received and Contributions Made." SFAS No. 116 specifies that contributions made by the Corporation be recognized as expenses in the period made and as decreases of assets or increases of liabilities depending on the form of the benefits given. In accordance with SFAS No. 116, the Corporation incurred contribution expenses relating to long-term commitments to local not-for-profit organizations of $192,000, $52,000 and $94,000 during 2005, 2004 and 2003, respectively. 3. Income Taxes The Corporation accounts for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes." Under the liability method specified by SFAS No. 109, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities as measured by the enacted tax rates which will be in effect when these differences reverse. Deferred tax expense and benefits are the result of changes in deferred tax assets and liabilities. 4. Employee Benefit Plans The Corporation has certain employee benefit plans covering eligible employees. The Bank accrues such costs as earned by the employee. 5. Stock Based Compensation Plan At December 31, 2005, the Corporation had one stock-based compensation plan. The Corporation accounts for that plan under the recognition and measurement principles of APB 25, "Accounting for Stock Issued to Employees", and related interpretations. No stock-based compensation cost is reflected in net income, as all options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of grant. 47 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - continued The following table provides the disclosures required by SFAS No. 148 and illustrates the effect on net income and earnings per share if the Corporation had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation.
2005 2004 2003 --------- --------- --------- Net income (in thousands) As reported $ 6,511 $ 6,161 $ 5,805 Stock-based compensation costs determined under fair value method for all awards 114 39 87 ------- -------- ------- Pro forma $ 6,397 $ 6,122 $ 5,718 ======= ======== ======= Earnings per share (Basic) As reported $ 1.28 $ 1.24 $ 1.18 Pro forma $ 1.23 $ 1.23 $ 1.16 Earnings per share (Diluted) As reported $ 1.24 $ 1.19 $ 1.14 Pro forma $ 1.22 $ 1.18 $ 1.12
The fair value of an option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 2005: dividend yield of 2.74%; expected volatility of 0.66; risk-free interest rate of 4.34%; and an expected life of 2.14 years. FASB Statement No. 123 (revised 2004), Share-based payment. Statement No. 123(R) addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise's equity instruments or that may be settled by the issuance of such equity instruments. Statement No. 123(R) requires an entity to recognize the grant-date fair-value of stock options and other equity-based transactions using the fair-value-0based method: and eliminates an entity's ability to account for share-based compensation transactions using the intrinsic value method of accounting in APB Opinion No. 25, "Accounting for Stock Issued to Employees," which was permitted under Statement No. 123, as originally issued. The revised Statement requires entities to disclose information about the nature of the share-based payment transactions and the effects of those transactions on the financial statements. Statement No. 123(R) is effective for the Corporation beginning July 1 2005. The Corporation anticipates using the modified prospective transition method with the adoption of this standard. Management has not yet determined the effect on the Corporation's net income of adopting Statement No. 123(R). 10. Trust and Investment Services Division Assets and Income Assets held by the Corporation in fiduciary or agency capacities for its customers are not included in the accompanying consolidated balance sheets since such items are not assets of the Bank or Corporation. Operating income and expenses of the TIS Division are included under their respective captions in the accompanying consolidated statements of income and are recorded on the accrual basis. 11. Earnings per Share and Stockholders' Equity The Corporation follows the provisions of SFAS No. 128, "Earnings Per Share," which eliminates primary and fully diluted earnings per share ("EPS") and requires presentations of basic and diluted EPS in conjunction with the disclosure of the methodology used in computing such EPS. Basic EPS excludes dilution and is computed by dividing income available to common shareholders by the weighted average common shares outstanding during the period. All per share data has been retroactively adjusted for stock dividends. 48 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - continued 12. Cash Flow Information For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, and federal funds sold and overnight investments. Generally, federal funds are purchased and sold for one-day periods. Cash paid during the years ended December 31, 2005, 2004, and 2003 for interest was $12.9 million, $7.9 million, and $7.6 million, respectively. Cash paid during the years ended December 31, 2005, 2004, and 2003 for income taxes was $2.3 million, $1.7 million, and $2.1 million, respectively. 13. Reporting Comprehensive Income The Corporation follows the provisions of SFAS No. 130, "Reporting of Comprehensive Income", which establishes standards for reporting and display of comprehensive income and its components (revenues, expenses, gains and losses) in a full set of financial statements. This statement also requires that all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement. Total comprehensive income is the sum of other comprehensive income (loss) and net income.
December 31, 2005 -------------------------------------------------- (Dollars in thousands) Before Tax Net of Tax (Expense) Tax Amount Benefit Amount ------ --------- ---------- Unrealized holding gains (losses) arising during the period $ (2,983) $ 1,095 $ (1,888) Reclassification adjustment for gains realized in net income 58 (21) 37 ------- ------- ------- Other comprehensive loss $ (2,925) $ 1,074 $ (1,851) ======= ======= =======
December 31, 2004 -------------------------------------------------- (Dollars in thousands) Before Tax Net of Tax (Expense) Tax Amount Benefit Amount ------ --------- ---------- Unrealized holding losses arising during the period $ (651) $ 221 $ (430) Reclassification adjustment for gains realized in net income 70 (24) 46 ------- ------- ------- Other comprehensive income $ (581) $ 197 $ (384) ======= ======= =======
December 31, 2003 -------------------------------------------------- (Dollars in thousands) Before Tax Net of Tax (Expense) Tax Amount Benefit Amount ------ --------- ---------- Unrealized holding gains (losses) arising during the period $ (2,034) $ 691 $ (1,343) Reclassification adjustment for gains realized in net income 410 (139) 271 ------- ------- ------- Other comprehensive loss $ (1,624) $ 552 $ (1,072) ======= ======= ========
Advertising Costs The Bank expenses advertising costs as incurred. 49 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - continued 14. Reclassifications Certain prior year amounts have been reclassified to conform to the current year presentation. NOTE B - INVESTMENT SECURITIES The amortized cost, gross unrealized gains and losses, and fair market value of the Corporation's available-for-sale and held-to-maturity securities at December 31, 2005 and 2004 are summarized as follows:
Held-to-Maturity Available-for-Sale ------------------------------------------ ------------------------------------------ (Dollars in thousands) Gross Gross Gross Gross 2005 Amortized Unrealized Unrealized Fair Amortized Unrealized Unrealized Fair ---- Cost Gains Losses Value Cost Gains Losses Value --------- ---------- ---------- -------- --------- ---------- ---------- ------ U.S. Treasury $ - $ - $ - $ - $ 2,504 $ - $ (28) $ 2,476 U.S. Government agency - - - - 1,040 1 (23) 1,018 Mortgage-backed securities - - - - 57,456 3 (1,439) 56,020 State and municipal 10 - - 10 15,672 3 (515) 15,160 Corporate securities - - - - 12,326 36 (571) 11,791 Corporate CMO's - - - - 1,329 - (34) 1,295 Asset-backed securities - - - - 117 - (1) 116 Mutual funds - - - - 796 - (8) 788 Other equity securities - - - - 8,758 53 (397) 8,414 -------- -------- -------- ------- -------- -------- ------- ------- $ 10 $ - $ - $ 10 $ 99,998 $ 96 $(3,016) $ 97,078 ======== ======== ======== ======= ======== ======== ====== =======
Held-to-Maturity Available-for-Sale ------------------------------------------ ------------------------------------------ (Dollars in thousands) Gross Gross Gross Gross 2004 Amortized Unrealized Unrealized Fair Amortized Unrealized Unrealized Fair ---- Cost Gains Losses Value Cost Gains Losses Value --------- ---------- ---------- -------- --------- ---------- ---------- ------ U.S. Treasury $ - $ - $ - $ - $ 27,503 $ 11 $ - $ 27,514 U.S. Government agency - - - - 1,058 2 (11) 1,049 Mortgage-backed securities - - - - 65,830 226 (371) 65,685 State and municipal 10 1 - 11 24,797 109 (193) 24,713 Corporate securities - - - - 12,069 209 (102) 12,176 Corporate CMO's - - - - 1,687 1 (1) 1,687 Asset-backed securities - - - - 377 - (1) 376 Mutual funds - - - - 863 - (66) 797 Other equity securities - - - - 5,951 71 - 6,022 -------- -------- -------- ------- ------- ------- ------- ------- $ 10 $ 1 $ - $ 11 $140,135 $ 629 $ (745) $140,019 ======== ======== ======== ======= ======= ======= ======= =======
The amortized cost and estimated fair value of debt securities classified as available-for-sale and held-to-maturity at December 31, 2005, by contractual maturity, are shown in the following table. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. 50 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE B - INVESTMENT SECURITIES - continued
Held-to-Maturity Available-for-Sale ------------------------ --------------------------- (Dollars in thousands) Amortized Fair Amortized Fair Cost Value Cost Value --------- -------- --------- -------- Due in one year or less $ - $ - $ 3,870 $ 3,816 Due after one year through five years 10 10 14,434 13,956 Due after five years through ten years - - 12,227 11,683 Due after ten years - - 2,340 2,285 --------- --------- -------- ------- 10 10 32,871 31,740 Mortgage-backed securities - - 57,456 56,020 Asset-backed securities - - 117 115 Mutual Funds - - 797 788 Other equity securities - - 8,757 8,415 --------- -------- -------- ------- $ 10 $ 10 $ 99,998 $ 97,078 ========= ========= ======== =======
Proceeds from the sale of investment securities available for sale during 2005 were $85.8 million. Gains of $112,000, $371,000, and $550,000, and losses of $54,000, $301,000, and $140,000 were realized on sales of securities in 2005, 2004, and 2003, respectively. The Corporation uses the specific identification method to determine the cost of the securities sold. The principal amount of investment securities pledged to secure public deposits and for other purposes required or permitted by law was $73.3 million and $68.7 million at December 31, 2005 and 2004, respectively. There were no securities held from a single issuer that represented more than 10% of stockholders' equity. The table below indicates the length of time individual securities have been in a continuous unrealized loss position at December 31, 2005 (Dollars in thousands).
Description of Number of Securities Securities Less than 12 months 12 months or longer Total ----------------- ------------ ------------------------- ------------------------- ---------------------- Fair Unrealized Fair Unrealized Fair Unrealized Value Losses Value Losses Value Losses ----- ------------ ----- ---------- ------ ---------- U.S. Government treasury 1 $ 2,476 $ (28) $ - $ - $ 2,476 $ (28) U.S. Government agency 1 - - 990 (23) 990 (23) Mortgage backed 28 14,472 (192) 40,164 (1,247) 54,636 (1,439) Municipal securities 34 4,734 (163) 10,423 (353) 15,157 (516) Corporate bonds 10 6,240 (252) 3,521 (319) 9,761 (571) Corporate CMO's 3 1,267 (33) 28 (1) 1,295 (34) Asset-backed 2 - - 115 (1) 115 (1) ------ ------ ------ ------ ------ ------ ------- Subtotal 79 29,189 (668) 55,241 (1,944) 84,430 (2,612) Marketable equity securities 1 - - 4,250 (404) 4,250 (404) ------ ------ ------ ------ ------ ------ ------- Total temporarily impaired investment securities 80 $29,189 $ (668) $59,491 $(2,348) $88,680 $(3,016) ====== ====== ====== ====== ====== ====== =======
Management has considered factors regarding other than temporarily impaired securities and believes that there are no securities that are impaired as of December 31, 2005. 51 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE B - INVESTMENT SECURITIES - continued The table below indicates the length of time individual securities have been in a continuous unrealized loss position at December 31, 2004 (Dollars in thousands).
Description of Number of Securities Securities Less than 12 months 12 months or longer Total ----------------- ------------ ------------------------- ------------------------- ---------------------- Fair Unrealized Fair Unrealized Fair Unrealized Value Losses Value Losses Value Losses ----- ------------ ----- ---------- ------ ---------- U.S. Government treasury - $ - $ - $ - $ - $ - $ - U.S. Government agency 1 - - 1,002 (11) 1,002 (11) Mortgage backed 14 29,919 (169) 21,435 (202) 51,354 (371) Municipal securities 30 2,946 (17) 8,962 (176) 11,908 (193) Corporate bonds 4 1,079 (7) 2,697 (96) 3,776 (102) Corporate CMO's 1 49 (1) - - 49 (1) Asset-backed 2 - - 376 (1) 376 (1) ------ ------ ------ ------ ------- ------ ------- Subtotal 52 23,993 (193) 34,472 (486) 68,465 (679) Marketable equity securities 1 - - 863 (66) 863 (66) ------ ------ ------ ------ ------- ------ ------- Total temporarily impaired investment securities 53 $33,993 $( 193) $35,335 $( 552) $69,328 $( 745) ====== ====== ====== ====== ======= ====== =======
Management has considered factors regarding other than temporarily impaired securities and believes that there are no securities that are impaired as of December 31, 2004. NOTE C - LOANS AND LEASES Major classifications of loans are as follows:
(Dollars in thousands) 2005 2004 ------------ ------------ Commercial loans $ 218,365 $ 187,903 Real estate - construction 49,095 59,093 Real estate - other 266,067 243,490 Consumer loans 112,993 101,157 Lease financing receivables 17,756 26,362 --------- -------- 664,276 618,005 Less: Allowance for loan and lease losses (8,549) (7,213) --------- -------- $ 655,727 $ 610,792 ========= ========
Loan and lease balances on which the accrual of interest has been discontinued amounted to approximately $8.4 million and $7.9 million at December 31, 2005 and 2004, respectively. Interest on these non-accrual loans and leases would have been approximately $638,000 and $211,000 in 2005 and 2004, respectively. Loan and lease balances past due 90 days or more, which are not on a non-accrual status, but which Management expects will eventually be paid in full, 52 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE C - LOANS AND LEASES - Continued amounted to $0 at both December 31, 2005 and 2004. Changes in the allowance for loan and lease losses are summarized as follows:
(Dollars in thousands) 2005 2004 2003 ----------- ---------- --------- Balance at beginning of year $ 7,213 $ 5,864 $ 6,230 Provision charged to operating expenses 1,382 1,164 2,519 Recoveries of charged-off loans 437 1,095 214 Loans charged-off (483) (910) (3,099) ------- ------- ------- Balance at end of year $ 8,549 $ 7,213 $ 5,864 ======= ======= =======
The Bank identifies a loan as impaired when it is probable that interest and principal will not be collected according to the contractual terms of the loan agreement. The accrual of interest is discontinued on impaired loans and no income is recognized until all recorded amounts of interest and principal are recovered in full. The balance of impaired loans was $8.4 million, $7.9 million, and $3.1 million at December 31, 2005, 2004, and 2003, respectively. The associated allowance for loan and lease losses for impaired loans was $897,000, $882,000, and $309,000 at December 31, 2005, 2004, and 2003, respectively. During 2005, activity in the allowance for impaired loan and lease losses included a provision of $365,000, write offs of $122,000, recoveries of $0, and loans paid off or returned to performing status of $0. Interest income of $0 was recorded in 2005, while contractual interest in the same period amounted to $638,000. Cash collected on impaired loans in 2005 was $1.9 million, of which $1.9 million was applied to principal and $0 was applied to past due interest. During 2004, activity in the allowance for impaired loan and lease losses included a provision of $808,000, write offs of $61,000, recoveries of $1,000 and loans paid off or returned to performing status of $1,000. Interest income of $0 was recorded in 2004, while contractual interest in the same period amounted to $211,000. Cash collected on impaired loans in 2004 was $1.2 million, of which $1.2 million was applied to principal and $27,000 was applied to past due interest. During 2003, activity in the allowance for impaired loan and lease losses included a provision of $836,000, write offs of $267,000, recoveries of $32,000, and loans paid off or returned to performing of $784,000. Interest income of $46,000 was recorded in 2003, while contractual interest in the same period amounted to $348,000. Cash collected on impaired loans in 2003 was $3.7 million; $3.4 million was applied to principal and $46,000 was applied to past due interest. In the normal course of business, the Bank makes loans to certain officers, directors, and their related interests. All loan transactions entered into between the Bank and such related parties were made on the same terms and conditions as transactions with all other parties. In Management's opinion, such loans are consistent with sound banking practices and are within applicable regulatory lending limitations. The balance of these loans at December 31, 2005 and 2004, was approximately $21.7 million and $11.6 million, respectively. In 2005 and 2004, new loans to these individuals and principal payments on these loans amounted to approximately $13.4 million and $2.2 million, respectively. NOTE D - PREMISES AND EQUIPMENT Premises and equipment are summarized as follows:
(Dollars in thousands) Useful Lives 2005 2004 2003 ------------ ---------- ---------- ---------- Premises 5 - 40 Years $ 16,356 $ 15,532 $ 15,233 Equipment 1 - 5 Years 20,282 18,842 16,614 36,638 34,374 31,847 --------- --------- --------- Less Accumulated depreciation (22,852) (20,237) (18,679) --------- --------- --------- $ 13,786 $ 14,137 $ 13,168 ========= ========= =========
53 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE D - PREMISES AND EQUIPMENT - Continued For 2005, included in the above equipment and accumulated depreciation are $5.0 million and $1.6 million of operating leased assets, respectively. For 2004, included in the above equipment and accumulated depreciation are $3.9 million and $1.0 million of operating leased assets, respectively. For 2003, included in the above equipment and accumulated depreciation are $3.3 million and $691,000 of operating leased assets, respectively. NOTE E - DEPOSITS At December 31, 2005, the scheduled maturities of certificates of deposit are as follows: (Dollars in thousands) 2006 $ 134,937 2007 24,190 2008 8,141 2009 4,219 2010 2,164 Thereafter 13,483 -------- $ 187,134 NOTE F - BORROWINGS The Bank, as a member of the FHLB, maintains several credit facilities secured by the Bank's mortgage-related assets. FHLB borrowings provide additional funds to meet the Bank's liquidity needs. The Bank currently has a maximum borrowing capacity with the FHLB of approximately $189.2 million of which 65.2% or $123.3 million is currently available. FHLB advances are collateralized by a pledge on the Bank's entire portfolio of unencumbered investment securities, certain mortgage loans and a lien on the Bank's FHLB stock. 1. Short Term Borrowings Short term FHLB advances generally have maturities of less than one year. The details of these short term advances are as follows:
(Dollars in thousands) 2005 2004 2003 --------- --------- -------- Average balance outstanding $ 5,000 $ 3,407 $ 3,994 Maximum amount outstanding at any month-end during the period $ 5,000 $ 4,778 $ 15,351 Balance outstanding at period end $ 5,000 $ 4,250 $ 850 Weighted-average interest rate during the period 3.19% 2.14% 2.65% Weighted-average interest rate at period end 3.74% 1.55% 3.58%
* Short term advances above do not include a Federal Funds purchased amount of $3,003 and $1,020 for the periods ending 2005 and 2004 respectively. 2. Long Term Borrowings At December 31, 2005 and 2004, long term advances from the FHLB totaled $60,897 and $61,194. Long term advances consist of fixed-rate amortizing and non-amortizing advances that will mature within one to ten years. The amortizing advances had a weighted average interest rate of 5.53%, 5.56%, and 5.62% and the non-amortizing advances had a weighted average interest rate of 3.39%, 2.73%, and 2.92% for 2005, 2004, and 2003, respectively. 54 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE F - BORROWINGS - Continued As of December 31, 2005, Long term FHLB advances mature as follows: (Dollars in thousands) 2006 $ 4,566 2007 5,946 2008 23,816 2009 14,070 2010 5,070 Thereafter 7,429 -------- $ 60,897 NOTE G - OTHER NON-INTEREST EXPENSE The components of other non-interest expense are detailed as follows:
(Dollars in thousands) 2005 2004 2003 -------- -------- -------- Telephone, postage, and supplies $ 1,004 $ 1,084 $ 1,083 Marketing and corporate communications 1,094 1,168 881 Loan and deposit supplies 569 629 634 Director costs 285 259 201 Travel and mileage 289 367 274 Dues and subscription 110 106 101 Trust processing 300 271 278 General expenses 834 589 527 Other 475 473 540 ------- ------- ------- $ 4,960 $ 4,946 $ 4,519 ======= ======= =======
NOTE H - INCOME TAXES The components of income tax expense are detailed as follows:
(Dollars in thousands) 2005 2004 2003 --------- -------- --------- Current expense $ 2,401 $ 2,161 $ 2,282 Deferred expense (ben efit) (501) 269 (121) ------- ------- ------- Total tax expense $ 1,900 $ 2,430 $ 2,161 ======= ======= =======
The income tax provision reconciled to the statutory federal rate follows:
2005 2004 2003 ------ ------ ------ Statutory rate 34.0% 34.0% 34.0% Increase (decrease) in tax rate from Tax-exempt loan and investment income (4.9) (4.6) (3.3) Tax credits (3.2) (2.9) (2.7) Other, net (3.3) 1.8 (0.9) ---- ---- ------ Applicable income tax rate 22.6% 28.3% 27.1% ==== ==== ====
55 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE H - INCOME TAXES - Continued The net deferred tax asset consists of the following:
(Dollars in thousands) 2005 2004 --------- ------- Allowance for possible loan losses $ 2,889 $ 2,449 Unrealized losses on investment securities available-for-sale 992 39 Prepaid expenses (178) (190) Accrued pension and deferred compensation 231 445 Depreciation 669 375 Bond accretion 3 70 Other 22 (14) ------- ------- Total net deferred tax asset $ 4,628 $ 3,174 ======= =======
NOTE I - REGULATORY MATTERS The Bank is required to maintain average reserve balances with the Federal Reserve Bank based upon deposit levels and other factors. The average amount of those reserve balances for the years ended December 31, 2005 and 2004, was $1.5 million and $2.1 million, respectively. Dividends are paid by the Corporation from its assets which are mainly provided by dividends from the Bank. However, certain restrictions exist regarding the ability of the Bank to transfer funds to the Corporation in the form of cash dividends, loans or advances. The Bank, without the prior approval of regulators, can declare dividends to the Corporation totaling approximately $10.0 million plus additional amounts equal to the net earnings of the Bank for the period from January 1, 2006, through the date of declaration of such a dividend, less dividends previously paid subject to the further limitations that dividends may be paid only to the extent the retained net profits (including the portion transferred to surplus) exceed bad debts and provided that the Bank would not become "undercapitalized" (as defined by Federal law). The Corporation and the Bank are subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Corporation's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Corporation must meet specific capital guidelines that involve quantitative measures of the Corporation's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Corporation'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 Corporation to maintain minimum amounts and ratios of Total and Tier I Capital to risk-weighted assets, and Tier I Capital to average quarterly assets (Total Risk Based Capital ratio, Tier I Capital ratio, and Leverage ratio, respectively). Management believes that the Corporation and the Bank meet all capital adequacy requirements to which it is subject, as of December 31, 2005. Federal banking agencies categorized the Corporation and the Bank as well capitalized under the regulatory framework for corrective action. To be categorized as adequately capitalized the Corporation and the Bank must maintain minimum Total Risk-Based, Tier I Risk-Based, and Tier I leverage ratios as set forth in the table. There are no conditions or events since the notification that Management believes have changed the institution's category. 56 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE I - REGULATORY MATTERS - continued The Corporation's and Bank's actual capital amounts and ratios are presented below:
To Be Well Capitalized Under For Capital Prompt Corrective (Dollars in thousands) Actual Adequacy Purposes Action Provisions ------ -------------------- ------------------- Amount Ratio Amount Ratio Amount Ratio ------ ----- ------ ----- ------ ----- As of December 31, 2005: Leverage Ratio Corporation $ 75,373 8.80% $ 34,248 >4.00% $ 42,810 N/A - Bank $ 69,325 8.14% $ 34,086 >4.00% $ 42,607 >5.00% - - Tier I Capital Ratio Corporation $ 75,373 10.94% $ 27,546 >4.00% $ 41,319 N/A - Bank $ 69,325 10.08% $ 27,512 >4.00% $ 41,269 >6.00% - - Total Risk Based Capital Ratio Corporation $ 83,922 12.19% $ 55,092 >8.00% $ 68,865 N/A - Bank $ 77,891 11.32% $ 55,025 >8.00% $ 68,781 >10.00% - -
To Be Well Capitalized Under For Capital Prompt Corrective (Dollars in thousands) Actual Adequacy Purposes Action Provisions ------ ------------------- ----------------- Amount Ratio Amount Ratio Amount Ratio ------ ----- ------ ----- ------ ----- As of December 31, 2004: Leverage Ratio Corporation $ 70,479 8.62% $ 32,714 >4.00% $ 40,892 N/A - Bank $ 66,112 8.11% $ 32,604 >4.00% $ 40,755 >5.00% - - Tier I Capital Ratio Corporation $ 70,479 10.80% $ 26,103 >4.00% $ 39,154 N/A - Bank $ 66,112 10.16% $ 26,037 >4.00% $ 39,056 >6.00% - - Total Risk Based Capital Ratio Corporation $ 77,692 11.91% $ 52,206 >8.00% $ 65,257 N/A - Bank $ 73,325 11.26% $ 52,075 >8.00% $ 65,093 >10.00% - -
57 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE J - FAIR VALUE OF FINANCIAL INSTRUMENTS SFAS No. 107, "Disclosures about Fair Value of Financial Instruments," requires disclosure of the estimated fair value of an entity's assets and liabilities considered to be financial instruments. For the Corporation, as for most financial institutions, the majority of its assets and liabilities are considered financial instruments as defined in SFAS No. 107. However, many such instruments lack an available trading market, as characterized by a willing buyer and seller engaging in an exchange transaction. Also, it is the Corporation's general practice and intent to hold its financial instruments to maturity and not to engage in trading or sales activities. Therefore, the Corporation had to use significant estimations and present value calculations to prepare this disclosure. Changes in the assumptions or methodologies used to estimate fair values may materially affect the estimated amounts. Also, Management is concerned that there may not be reasonable comparability between institutions due to the wide range of permitted assumptions and methodologies in the absence of active markets. This lack of uniformity gives rise to a high degree of subjectivity in estimating financial instrument fair values. Fair values have been estimated using data which Management considered the best available and estimation methodologies deemed suitable for the pertinent category of financial instrument. The estimated fair value of cash and cash equivalents, deposits with no stated maturities, repurchase agreements and FHLB advances and commitments to extend credit, and outstanding letters of credit has been estimated to equal the carrying amount. Quoted market prices were used to determine the estimated fair value of investment securities held-to-maturity and available-for-sale. Fair values of net loans and deposits with stated maturities were calculated using estimated discounted cash flows based on the year-end offering rate for instruments with similar characteristics and maturities. The estimated fair values and carrying amounts are summarized as follows:
2005 2004 ----------------------- ------------------------ (Dollars in thousands) Fair Carrying Fair Carrying Value Amount Value Amount ------------- ---------- ------------ ---------- Financial Assets Cash and cash equivalents $ 68,943 $ 68,943 $ 31,610 $ 31,610 Investment securities held-to-maturity 10 10 11 10 Investment securities available-for-sale 97,078 97,078 140,019 140,019 Net loans 630,292 664,276 585,828 618,005 Financial Liabilities Deposits with no stated maturities 508,963 508,963 547,172 547,172 Deposits with stated maturities 174,791 187,134 106,058 115,846 FHLB advances 53,528 68,900 51,319 66,464 Subordinated debt 15,465 15,465 15,465 15,465 Off-Balance-Sheet Investments Commitments for extended credit and outstanding letters of credit $ 262,425 $ 262,425 $ 225,392 $ 225,392
58 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE K - SUBORDINATED DEBT AND GUARANTEED PREFERRED BENEFICIAL INTEREST IN THE CORPORATION'S SUBORDINATED DEBENTURES In 2003, the Corporation issued $10.0 million (net proceeds of $9.79 million) of preferred capital securities for the purpose of raising additional capital for general corporate purposes. These securities were issued through Trust II, a special purpose statutory trust created expressly for the issuance of these securities and investing the proceeds in junior subordinated debentures of the Corporation. These subordinated debentures will be redeemed in the year 2033. The debentures and securities will each be callable by the Corporation or Trust II, as applicable, at its option after five years of the date of issuance. At December 31, 2005, the rate paid on these subordinated debentures, based on three-month London Inter-bank offering rate ("LIBOR") plus 295 basis points, was 7.20%. In 2002, the Corporation issued $5.0 million (net proceeds of $4.82 million) of preferred capital securities for the purpose of raising additional capital for general corporate purposes. These securities were issued through Trust I, a special purpose statutory trust created expressly for the issuance of these securities and investing the proceeds in junior subordinated debentures of the Corporation. These subordinated debentures will be redeemed in the year 2032. The debentures and securities will each be callable by the Corporation or Trust I, as applicable, at its option after five years of the date of issuance. At December 31, 2005, the rate paid on these subordinated debentures is based on three-month LIBOR plus 365 basis points, was 7.80%. For 2005, 2004, and 2003, interest expense for this debt was $1.0 million, $728,000, and $312,000, respectively, with an average interest rate of 6.56%, 4.71%, and 4.92%, respectively. Management has determined that the Trusts each qualify as variable interest entities under FIN 46. Each of the Trusts issued mandatory redeemable preferred stock to investors and loaned the proceeds to the Corporation. Trust I holds, as its sole asset, subordinated debentures issued by the Corporation. Trust I and Trust II are included in the Corporation's consolidated statements of income for 2003. The Corporation has evaluated the impact of FIN 46 and concluded it should continue to consolidate the Trusts' financial statements with the Corporation's financial statements as of December 31, 2003, in part, due to its ability to call the preferred stock prior to the mandatory redemption date and thereby benefit from a decline in required dividend yields. Subsequent to the issuance of FIN 46, the FASB issued a revised interpretation, FIN 46(R), the provisions of which must be applied to certain variable interest entities. The Corporation adopted the provisions under the revised interpretation in the first quarter of 2004. FIN 46(R) required the Corporation to deconsolidate the Trusts. Accordingly, the Corporation deconsolidated the Trusts at the end of the first quarter of 2004, which resulted in an increase in outstanding debt of $15.10 million. In March 2005, the Federal Reserve Board adopted a final rule that would continue to allow the inclusion of trust preferred securities in Tier I Capital, but with stricter quantitative limits. Under the final rule, after a five-year transition period, the aggregate amount of trust preferred securities and certain other capital elements would be limited to 25% of Tier I Capital elements, net of goodwill. The amount of trust preferred securities and certain other elements in excess of the limit could be included in Tier II Capital, subject to restriction. Based on the final rule, the Corporation expects to include all of its $5.2 million in trust preferred securities in Tier I Capital. 59 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE L - FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK AND CONCENTRATIONS OF CREDIT RISK The Corporation is a party to financial instruments with off-balance-sheet risk to meet the financing needs of its customers and reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and standby letters of credit. Such financial instruments are recorded in the financial statements when they become payable. Those instruments involve, to varying degrees, elements of credit and interest rate risks in excess of the amount recognized in the consolidated balance sheets. The contract or notional amounts of those instruments reflect the extent of involvement the Corporation has in particular classes of financial instruments. The Corporation's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual or notional amount of those instruments. The Corporation uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. Unless noted otherwise, the Corporation does not require collateral or other security to support financial instruments with credit risk. The contract amounts are as follows:
(Dollars in thousands) 2005 2004 --------- --------- Financial instruments whose contract amounts represent credit risk Commitments to extend credit $ 250,152 $ 225,392 Standby letters of credit and financial guarantees written 12,273 11,430
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Corporation evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Corporation upon extension of credit, is based on Management's credit evaluation. Standby letters of credit are conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Corporation holds residential or commercial real estate, accounts receivable, inventory and equipment as collateral supporting those commitments for which collateral is deemed necessary. The extent of collateral held for those commitments at December 31, 2005, varies up to 100%. Standby letters of credit are collaterized within Management policies. Substantially all of the Corporation's loans, commitments, and commercial and standby letters of credit have been granted to customers in the Corporation's primary market area, Chester County, Pennsylvania. Investments in state and municipal securities also involve governmental entities within the Corporation's market area. The concentrations of credit by type of loan are set forth in Note C - Loans. Although the Corporation has a diversified loan portfolio, a substantial portion of its debtors' ability to honor their contracts is dependent upon Chester County's economy. The distribution of commitments to extend credit approximates the distribution of loans outstanding. Commercial and standby letters of credit were granted primarily to commercial borrowers. 60 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE M - ACCOUNTING FOR STOCK-BASED COMPENSATION PLANS The Corporation's stock option plan allows the Corporation to grant up to 807,500 fixed stock options to key employees and directors. The options have a term of ten years and become exercisable six months after grant. The exercise price of each option equals the average between the bid and ask price of the Corporation's stock on the date of grant. The Corporation has elected to account for its stock option plan under APB Opinion No. 25, "Accounting for Stock Issued to Employees." Accordingly, no compensation cost has been recognized for its stock option plan. Information about stock options outstanding at December 31, 2005, is summarized as follows:
Weighted-Average Outstanding Exercise Price ----------- ---------------- Balance January 1, 2003 776,641 $ 13.78 Granted -- -- Exercised (146,110) 13.60 Cancelled (3,022) 13.73 -------- Balance December 31, 2003 627,509 13.83 -------- Granted -- -- Exercised (137,114) 13.39 Cancelled (3,740) 13.31 -------- Balance December 31, 2004 486,655 13.95 -------- Granted 17,886 24.80 Exercised (118,207) 13.63 Cancelled (2,035) 13.53 -------- Balance December 31, 2005 384,299 14.56 ========
The fair value of the options granted in 2005 was $9.63 per share. There were no options granted in 2004 or 2003.
Options Outstanding Options Exercisable ----------------------------------- ------------------------------------------------------- Weighted-Average Range of Number Remaining Weighted-Average Number Weighted-Average Exercise-Price Outstanding Contractual Life Exercisable Price Exercisable Exercisable Price ---------------- ----------- ----------------- ------------------ ----------- ----------------- $10.10 - $12.56 56,963 3.20 years $11.61 56,963 $11.61 $12.73 13,200 6.75 years $12.73 13,200 12.73 $13.41 73,425 3.75 years $13.41 73,425 13.41 $13.64 39,662 6.88 years $13.64 39,662 13.64 $13.86 27,643 5.93 years $13.86 27,643 13.86 $14.09 39,800 1.75 years $14.09 39,800 14.09 $14.10 - $14.38 27,720 4.29 years $14.24 27,720 14.24 $16.08 57,200 2.75 years $16.08 57,200 16.08 $16.19 - $19.21 30,800 2.72 years $17.51 30,800 17.51 $24.80 17,886 9.01 years $24.80 17,886 24.80 -------- ------- 384,299 384,299 14.56 ======== ======= =====
61 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE N - EARNINGS PER SHARE The following table illustrates the reconciliation of the numerators and denominators of the basic and diluted EPS computations:
For the Year Ended December 31, 2005 ------------------------------------------------ Income Shares Per-Share (Numerator) (Denominator) Amount ---------- ------------- --------- Basic EPS: Net income available to common stockholders $6,510,718 5,104,745 $ 1.28 Effect of Dilutive Securities Add options to purchase common stock - 135,752 (0.04) --------- --------- ----- Diluted EPS: $6,510,718 5,240,497 $ 1.24 ========= ========= ====
No anti-dilutive shares have been excluded in the computation of 2005 diluted EPS because the options' exercise price was greater than the average market price of the common shares. The average market price on December 31, 2005 was $19.15
For the Year Ended December 31, 2004 -------------------------------------------------- Income Shares Per-Share (Numerator) (Denominator) Amount ------------ ------------- ---------- Basic EPS: $ 6,160,648 4,980,584 $ 1.24 Net income available to common stockholders Effect of Dilutive Securities Add options to purchase common stock - 194,342 (0.05) ---------- --------- -------- Diluted EPS: $ 6,160,648 5,174,926 $ 1.19 ========== ========= ========
No anti-dilutive shares have been excluded in the computation of 2004 diluted EPS because the options' exercise price was greater than the average market price of the common shares. The average market price on December 31, 2004 was $24.75
For the Year Ended December 31, 2003 ------------------------------------------------ Income Shares Per-Share (Numerator) (Denominator) Amount ----------- ------------- ---------- Basic EPS: Net income available to common stockholders $ 5,805,066 4,924,819 $ 1.18 Effect of Dilutive Securities Add options to purchase common stock - 157,347 (.04) ---------- --------- ------- Diluted EPS: $ 5,805,066 5,082,166 $ 1.14 ========== ========== =======
17,000 anti-dilutive shares were excluded in the computation of 2003 diluted EPS because the options' exercise price was greater than the average market price of the common shares. The average price on December 31, 2003 was $24.90 62 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE O - EMPLOYEE BENEFIT PLANS 1. Qualified The Corporation has a qualified deferred salary savings 401(k) plan (the "401(k) Plan") under which the Corporation contributes $0.75 for each $1.00 that an employee contributes, up to the first 5% of the employee's salary. The Corporation's expenses were $324,000, $390,000, and $348,000 in 2005, 2004, and 2003, respectively. The Corporation also has a qualified defined contribution pension plan (the "QDCP Plan"). Under the QDCP Plan, the Corporation makes annual contributions into the 401(k) Plan on behalf of each eligible participant in an amount equal to 3% of salary up to $30,000 in salary plus 6% in excess of $30,000 up to $200,000. Contribution expense in 2005, 2004 and 2003 under the QDCP Plan was $406,000, $391,000 and $386,000, respectively. The Corporation may make additional discretionary employer contributions subject to approval of the Board of Directors. 2. Non-Qualified The Corporation makes annual contributions to a non-qualified defined contribution Plan (the "NQDCP Plan ") equal to 3% of the participant's salary. Contribution expense for 2005, 2004 and 2003 under the NQDCP Plan was $70,000, $58,000, and $67,000, respectively. The Corporation may make additional discretionary employer contributions subject to approval of the Board of Directors. NOTE P - COMMITMENTS AND CONTINGENCIES The Corporation has employment agreements with several of the Corporation's Officers. These agreements provide for severance payments upon termination of employment under certain circumstances or a change of control as defined. The Corporation is involved in certain litigation arising in the ordinary course of business. In the opinion of Management, the outcome of this litigation will not have a significant effect on the accompanying financial statements. 63 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE Q - CONDENSED FINANCIAL INFORMATION - PARENT CORPORATION ONLY Condensed financial information for First Chester County Corporation (Parent Corporation only) follows: CONDENSED BALANCE SHEETS
(Dollars in thousands) December 31 -------------------------- 2005 2004 --------- --------- ASSETS Cash and cash equivalents $ 487 $ 1,409 Investment securities available for sale, at market value 3,313 495 Investment in subsidiaries, at equity 68,851 68,354 Intercompany loan 1,322 989 Other assets 681 68 -------- -------- Total assets $ 74,654 $ 71,315 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Subordinated debt $ 15,465 $ 15,465 Other liabilities 512 448 Stockholders' equity 58,677 55,402 -------- -------- Total liabilities and stockholders' equity $ 74,654 $ 71,315 ======== ========
CONDENSED STATEMENTS OF INCOME
(Dollars in thousands) Year ended December 31 ---------------------------------------- 2005 2004 2003 ------------ ------------ ---------- INCOME Dividends from subsidiaries $ - $ - $ 3,978 Dividends from investment securities 158 42 20 Other income 276 270 93 -------- --------- -------- Total income 434 312 4,091 -------- --------- -------- EXPENSES Other expenses 1,385 1,026 454 -------- -------- -------- Total expenses 1,385 1,026 454 -------- -------- -------- Income before equity in undistributed income of subsidiaries (951) (714) 3,637 EQUITY IN UNDISTRIBUTED INCOME OF SUBSIDIARIES 7,462 6,875 2,168 -------- -------- -------- NET INCOME $ 6,511 $ 6,161 $ 5,805 ======== ======== ========
64 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE Q - CONDENSED FINANCIAL INFORMATION - PARENT CORPORATION ONLY - continued CONDENSED STATEMENTS OF CASH FLOWS
Year ended December 31 ------------------------------------- (Dollars in thousands) 2005 2004 2003 -------- -------- -------- OPERATING ACTIVITIES Net income $ 6,511 $ 6,161 $ 5,805 Adjustments to reconcile net income to net cash provided by operating activities Equity in undistributed income of subsidiary (3,063) (6,858) (739) (Increase) decrease in other assets (14) 639 (259) Increase in other liabilities 258 (592) 27 -------- -------- -------- Net cash provided by (used in) operating activities 3,692 (650) 4,834 -------- -------- -------- INVESTING ACTIVITIES Proceeds from sales and maturities of investment securities - (100) - Purchases of investment securities available for sale (3,230) - - Additional investment in subsidiaries - - (8,087) -------- ------- -------- Net cash used in investing activities (3,230) (100) (8,087) -------- ------- -------- FINANCING ACTIVITIES Repayments of Inter-company loans - - (1,237) Dividends paid (2,665) (2,529) (2,434) Proceeds from issuance of subordinated debt - - 10,000 Purchase of treasury stock and tax benefit from stock option exercise 1,281 405 839 -------- ------- -------- Net cash used in financing activities (1,384) (2,124) 7,168 -------- -------- -------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (922) (2,874) 3,915 Cash and cash equivalents at beginning of year 1,409 4,283 368 -------- ------- -------- Cash and cash equivalents at end of year $ 487 $ 1,409 $ 4,283 ======== ======= ========
65 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE R - QUARTERLY FINANCIAL DATA (UNAUDITED) A summary of the unaudited quarterly results of operations is as follows:
2005 ---- (Dollars in thousands, except per share) December 31 September 30 June 30 March 31 ----------- ------------ ------------- ---------- Interest income $ 12,102 $ 11,592 $ 10,726 $ 10,184 Interest expense 4,157 3,756 3,099 2,567 ------- ------- ------- ------- Net interest income 7,945 7,836 7,627 7,617 Provision for loan losses 60 311 504 507 Investment securities gains (loss), net -- (2) (8) 67 Income before income taxes 3,085 2,397 1,501 1,428 Net income 2,578 1,843 1,072 1,018 Per share Net income (Basic) 0.50 0.36 0.21 0.20 Net Income (Diluted) 0.49 0.35 0.21 0.19 Dividends declared $ 0.1350 $ 0.1300 $ 0.1300 $ 0.1283
2004 ---- (Dollars in thousands, except per share) Interest income $ 9,989 $ 9,835 $ 9,055 $ 8,639 Interest expense 2,271 2,057 1,866 1,669 Net interest income 7,718 7,778 7,189 6,970 ------- ------- ------- ------- Provision for loan losses 354 454 56 300 Investment securities gains (loss), net -- 17 -- 53 Income before income taxes 2,337 1,955 2,156 2,143 Net income 1,721 1,430 1,509 1,501 Per share Net income (Basic) $ 0.35 $ 0.29 $ 0.30 $ 0.30 Net Income (Diluted) 0.30 0.28 0.29 0.29 Dividends declared 0.1283 0.1250 0.1250 0.1250
66 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors and Shareholders First Chester County Corporation We have audited management's assessment, included in the accompanying Management's Report on Internal Control Over Financial Reporting, that First Chester County Corporation maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). First Chester County Corporation's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the company's internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management's assessment that First Chester County Corporation maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also in our opinion, First Chester County Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005 based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of First Chester County Corporation and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2005 and our report dated March 10, 2006 expressed an unqualified opinion on those financial statements. /s/ Grant Thornton LLP Philadelphia, Pennsylvania March 10, 2006 67 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Management of the Corporation is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended, as a process designed by, or under the supervision of, the Corporation's principal executive and principal financial officers and effected by the Corporation's board of directors, management and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that: o Pertain to the maintenance of records, that in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Corporation; o Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Corporation are being made only in accordance with authorizations of management and directors of the Corporation; and o Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Corporation's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Management's Assessment Management assessed the effectiveness of the Corporation's internal control over financial reporting as of December 31, 2005. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control-Integrated Framework. Based upon this assessment, management believes that, as of December 31, 2005, the Corporation's internal control over financial reporting is effective at a reasonable assurance level based on these criteria. The Corporation's independent auditors have issued an attestation report on our assessment of the Corporation's internal control over financial reporting. This report appears on page 67 of this annual report. March 10, 2006 68 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES Item 9. Changes in and Disagreements with Accountants on Accounting and - ------- Financial Disclosure. None. Item 9A. Controls and Procedures - -------- ----------------------- Appearing as Exhibits 31.1, 31.2, and 31.3 (the "302 Certifications") to this Annual Report are three certifications, one by each of the Corporation's Chief Executive Officer (CEO), President, Chief Financial Officer ("CFO"), and Treasurer (the Corporation's principal accounting and financial officer), (the "Principal Officers"). This Item 9A contains information concerning the evaluation of the Corporation's disclosure controls and procedures and matters regarding its internal control over financial reporting that are referred to in the Section 302 Certifications. This information should be read in conjunction with the Section 302 Certifications for a more complete understanding of the topics presented in the 302 Certifications. Discussion of Disclosure Controls and Procedures The SEC requires that as of the end of the period covered by this Annual Report on Form 10-K, the Corporation's CEO, President, and CFO/Treasurer evaluate the effectiveness of the design and operation of the Corporation's "disclosure controls and procedures" and report their conclusions on the effectiveness of the design and operation of the Corporation's disclosure controls and procedures in this Annual Report. "Disclosure controls and procedures" mean the controls and other procedures that are designed with the objective of ensuring that information required to be disclosed in the Corporation's reports filed under the Securities Exchange Act of 1934 (the "Exchange Act"), such as this Annual Report, is recorded, processed, summarized and reported within the time periods specified in the rules and forms promulgated by the SEC. The Corporation's disclosure controls and procedures are also designed with the objective of ensuring that such information is accumulated and communicated to Management, including the CEO, President, and CFO/Treasurer, as appropriate to allow timely decisions regarding required disclosure. Based upon their evaluation of the disclosure controls and procedures, the Principal Officers have concluded that, subject to the limitations noted above, the Corporation's disclosure controls and procedures are effective as of December 31, 2005 to provide reasonable assurance that material information relating to the Corporation and its consolidated subsidiaries is made known to Management, including the CEO, President, and CFO/Treasurer, on a timely basis. Discussion of Internal Control Over Financial Reporting As of December 31, 2005 there were no significant changes to the Corporation's internal control over financial reporting or in other factors that could significantly affect the internal control over financial reporting, subsequent to the date of our last evaluation including any corrective actions with regard to significant deficiencies and material weaknesses. Management's report on internal control over financial reporting set forth on page 69 of this Report is incorporated in this Item by reference. 69 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES PART III Item 10. Directors and Executive Officers of the Corporation. - -------- ---------------------------------------------------- The information called for by this Item is incorporated herein by reference to the Corporation's Proxy Statement for its 2006 Annual Meeting of Shareholders. Item 11. Executive Compensation. - -------- ----------------------- The information called for by this Item is incorporated herein by reference to the Corporation's Proxy Statement for its 2006 Annual Meeting of Shareholders. Item 12. Security Ownership of Certain Beneficial Owners and Management and - -------- Related Stockholder Matters. The information called for in Item 201(d) of Regulation S-K is set forth below. The other information called for by this item is incorporated herein by reference to the Corporation's Proxy Statement for its 2006 Annual Meeting of Shareholders. Equity Compensation Plan Information Form
Number of securities remaining Number of securities Weighted-average available for to be issued upon exercise price future exercise of of outstanding issuance under outstanding options, options, equity warrants and warrants and compensation rights* rights* plans* ------------------- --------------- --------------- Equity compensation plans approved by security holders 384,299** $14.56 0 Equity compensation plans not approved by security holders -- -- -- Total 384,299** $14.56 0 * The securities referred to in this table are shares of the Corporation's Common Stock issuable upon exercise of options issued pursuant to the 1995 Stock Option Plan. ** Number of options issued and outstanding that were exercisable as December 31, 2005.
70 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES Item 13. Certain Relationships and Related Transactions. - -------- ----------------------------------------------- The information called for by this item is incorporated herein by reference to the Corporation's Proxy Statement for its 2006 Annual Meeting of Shareholders. Item 14. Principal Accountant Fees and Services - -------- -------------------------------------- The information called for by this Item is incorporated herein by reference to the Corporation's Proxy Statement for its 2006 Annual Meeting of Shareholders. PART IV Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. - -------- ----------------------------------------------------------------- 1. Financial Statements -------------------- The Consolidated Financial Statements, for the years ending December 31, 2005 and 2004, together with the report thereon of Grant Thornton LLP dated March 15, 2006, are filed as part of this Report under Item 8. 2. Financial Statement Schedules ----------------------------- Financial Statement Schedules are not required under the related instructions of the Securities and Exchange Commission, are inapplicable or are included in the Consolidated Financial Statements or notes thereto. 3. Exhibits -------- The following is a list of the exhibits filed with, or incorporated by reference into, this Report (those exhibits marked with an asterisk are filed herewith and those exhibits marked "(CP)" are management contracts or compensatory plans, contracts or arrangements in which a director or executive officer participates): 3(i). Articles of Incorporation. Copy of the Articles of Incorporation of the Corporation, as amended, filed as Exhibit 3 (i) to the Corporation's Annual Report on Form 10-Q for the quarter ended March 31, 2004 is incorporated by reference. 3(ii). By-Laws of the Corporation. By-Laws of the Corporation, filed as Exhibit 3 (ii) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1997 is incorporated by reference. 10. Material contracts. (a) Copy of Employment Agreement among the Corporation, the Bank and John A. Featherman, III, dated as of November 13, 2003 is incorporated herein by reference to Exhibit 10(a) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 2004. (SEC File No. 00012870)(CP) (b) Copy of Employment Agreement among the Corporation, the Bank and Kevin C. Quinn, dated as of November 13, 2003 is incorporated herein by reference to Exhibit 10(b) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 2004. (SEC File No. 00012870)(CP) * (c) Compensatory Arrangements of Executive Officers and Directors for 2006. (d) Copy of the Corporation's Dividend Reinvestment and Stock Purchase Plan, filed as an exhibit to the Corporation's registration statement on Form S-3 filed August 7, 2003 (SEC File No. 333-107739) is incorporated herein by reference. (e) Copy of the Corporation's Amended and Restated Stock Bonus Plan, filed as an exhibit to the Corporation's registration statement on Form S-8 filed August 12, 1997 (SEC File No. 333-33411) is incorporated herein by reference. (CP) 71 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES (f) Copy of the Bank's Amended and Restated Supplemental Benefit Retirement Plan, effective date January 1, 1995, is incorporated herein by reference to Exhibit 10(g) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1994. (SEC File No. 00012870. (CP) (g) Summary of changes to the Amended and Restated Supplemental Benefit Retirement Plan approved through December 31, 2004, is incorporated herein by reference to Exhibit 10(g) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 2004. (SEC File No. 00012870)(CP) (h) Copy of the Corporation's and the Bank's Directors' Deferred Compensation Plan is incorporated herein by reference to Exhibit 10(h) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 2004. (SEC File No. 00012870)(CP) (i) Copy of the Corporation's Amended and Restated 1995 Stock Option Plan, filed as an appendix to the Corporation's Proxy statement for the 2003 Annual Meeting of Shareholders as filed with the SEC via EDGAR is incorporated herein by reference. (CP) (j) Copy of form of Stock Option Agreement (Directors) is incorporated herein by reference to Exhibit 10(j) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 2004. (SEC File No. 00012870)(CP) (k) Copy of form of Stock Option Agreement (Executive Officers) is incorporated herein by reference to Exhibit 10(k) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 2004. (SEC File No. 00012870)(CP) 14. Code of Conduct (Ethics). Copy of Code of Conduct (Ethics) filed as Exhibit 14 to the Corporation's Annual Report on Form 10-K for the year ended December 31, 2003 is incorporated herein by reference. * 21. Subsidiaries of the Corporation. First National Bank of Chester County, formerly known as The First National Bank of West Chester, is a banking institution organized under the banking laws of the United States in December 1863. Turks Head Properties, Inc., formerly known as 323 East Gay Street Corporation, was incorporated in 1996 in the State of Pennsylvania. Turks Head II, was incorporated in 2003 in the State of Pennsylvania. FNB Insurance Services, LLC, t/a First National Wealth Advisory Services, a wholly-owned subsidiary of the Bank, is a limited liability company formed in 2000 under the laws of Pennsylvania. FNB Properties, LLC, a wholly-owned subsidiary of the Bank, is a limited liability company formed in 2000 under the laws of Pennsylvania. First Chester County Capital Trust I was formed on July 11, 2002. First Chester County Capital Trust II was formed on November 13, 2003. * 23. Consents. Consent of Grant Thornton LLP, dated March 10, 2006 * 31.1 Certification of Chief Executive Officer * 31.2 Certifications of President * 31.3 Certification of Treasurer and Chief Financial Officer * 32.1 Certification of Chief Executive Officer * 32.2 Certification of President * 32.3 Certification of Treasurer and Chief Financial Officer 72 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES SIGNATURES ---------- Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Corporation has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. FIRST CHESTER COUNTY CORPORATION By: /s/ John A. Featherman, III --------------------------- John A. Featherman, III, Chief Executive Officer and Chairman of the Board Date: March 16, 2006 Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed below by the following persons on behalf of the Corporation and in the capacities indicated as of March 16, 2006. Signature Title --------- ----- /s/ John A. Featherman, III Chief Executive Officer and __________________________________ Chairman of the Board John A. Featherman, III /s/ John Balzarini Treasurer __________________________________ (Principal Accounting and Financial Officer) John Balzarini (Signatures continued on following page) 73 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES (Signatures continued from previous page) Signature Title --------- ----- /s/ John A. Featherman, III Director - ---------------------------------- John A. Featherman, III /s/ John J. Ciccarone Director - ---------------------------------- John J. Ciccarone /s/ M. Robert Clarke Director - ---------------------------------- M. Robert Clarke /s/ Clifford E. DeBaptiste Director - ---------------------------------- Clifford E. DeBaptiste /s/ John S. Halsted Director - ---------------------------------- John S. Halsted /s/ J. Carol Hanson Director - ---------------------------------- J. Carol Hanson /s/ Lynn Johnson-Porter Director - ---------------------------------- Lynn Johnson-Porter /s/ Edward A. Leo Director - ---------------------------------- Edward A. Leo /s/ David L. Peirce Director - ---------------------------------- David L. Peirce /s/ John B. Waldron Director - ---------------------------------- John B. Waldron /s/ Kevin C. Quinn Director - ---------------------------------- Kevin C. Quinn 74 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES INDEX TO EXHIBITS ----------------- The following is a list of the exhibits filed with, or incorporated by reference into, this Report (those exhibits marked with an asterisk are filed herewith and those exhibits marked "(CP)" are management contracts or compensatory plans, contracts or arrangements in which a director or executive officer participates): 3(i). Articles of Incorporation. Copy of the Articles of Incorporation of the Corporation, as amended, filed as Exhibit 3 (i) to the Corporation's Annual Report on Form 10-Q for the quarter ended March 31, 2004 is incorporated by reference. 3(ii). By-Laws of the Corporation. By-Laws of the Corporation, filed as Exhibit 3 (ii) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1997 is incorporated by reference. 10. Material contracts. (a) Copy of Employment Agreement among the Corporation, the Bank and John A. Featherman, III, dated as of November 13, 2003 is incorporated herein by reference to Exhibit 10(a) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 2004. (SEC File No. 00012870)(CP) (b) Copy of Employment Agreement among the Corporation, the Bank and Kevin C. Quinn, dated as of November 13, 2003 is incorporated herein by reference to Exhibit 10(b) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 2004. (SEC File No. 00012870)(CP) * (c) Compensatory Arrangements of Executive Officers and Directors for 2005. (d) Copy of the Corporation's Dividend Reinvestment and Stock Purchase Plan, filed as an exhibit to the Corporation's registration statement on Form S-3 filed August 7, 2003 (SEC File No. 333-107739) is incorporated herein by reference. (e) Copy of the Corporation's Amended and Restated Stock Bonus Plan, filed as an exhibit to the Corporation's registration statement on Form S-8 filed August 12, 1997 (SEC File No. 333-33411) is incorporated herein by reference. (CP) (f) Copy of the Bank's Amended and Restated Supplemental Benefit Retirement Plan, effective date January 1, 1995, is incorporated herein by reference to Exhibit 10(g) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1994.(SEC File No. 00012870)(CP) (g) Summary of changes to the Amended and Restated Supplemental Benefit Retirement Plan approved through December 31, 2004, is incorporated herein by reference to Exhibit 10(g) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 2004. (SEC File No. 00012870)(CP) (h) Copy of the Corporation's and the Bank's Directors' Deferred Compensation Plan is incorporated herein by reference to Exhibit 10(h) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 2004. (SEC File No. 00012870)(CP) (i) Copy of the Corporation's Amended and Restated 1995 Stock Option Plan, filed as an appendix to the Corporation's Proxy statement for the 2003 Annual Meeting of Shareholders as filed with the SEC via EDGAR is incorporated herein by reference. (CP) (j) Copy of form of Stock Option Agreement (Directors) is incorporated herein by reference to Exhibit 10(j) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 2004. (SEC File No. 00012870)(CP) (k) Copy of form of Stock Option Agreement (Executive Officers) is incorporated herein by reference to Exhibit 10(k) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 2004. (SEC File No. 00012870)(CP) 77 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES INDEX TO EXHIBITS (Continued) 14. Code of Conduct (Ethics). Copy of Code of Conduct (Ethics) filed as Exhibit 14 to the Corporation's Annual Report on Form 10-K for the year ended December 31, 2003 is incorporated herein by reference. * 21. Subsidiaries of the Corporation. First National Bank of Chester County, formerly known as The First National Bank of West Chester, is a banking institution organized under the banking laws of the United States in December 1863. Turks Head Properties, Inc., formerly known as 323 East Gay Street Corporation, was incorporated in 1996 in the State of Pennsylvania. Turks Head II, was incorporated in 2003 in the State of Pennsylvania. FNB Insurance Services, LLC, t/a First National Wealth Advisory Services, a wholly-owned subsidiary of the Bank, is a limited liability company formed in 2000 under the laws of Pennsylvania. FNB Properties, LLC, a wholly-owned subsidiary of the Bank, is a limited liability company formed in 2000 under the laws of Pennsylvania. First Chester County Capital Trust I was formed on July 11, 2002. First Chester County Capital Trust II was formed on November 13, 2003. * 23. Consents. Consent of Grant Thornton LLP, dated March 10, 2006 * 31.1 Certification of Chief Executive Officer * 31.2 Certification of President * 31.3 Certification of Treasurer and Chief Financial Officer * 32.1 Certification of Chief Executive Officer * 32.2 Certification of President * 32.3 Certification of Treasurer and Chief Financial Officer 78 EX-10 2 exhibit10c.txt EXHIBIT 10C FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES EXHIBIT 10C Compensatory Arrangements of Executive Officers and Directors for 2006 Messrs. Featherman and Quinn are employed by the Corporation and the Bank pursuant to employment agreements included as exhibits to this Annual Report on Form 10-K. Each of our other executive officers is employed on an at will basis. The compensation to be paid in 2006 to the Corporation's CEO, President and Executive Vice Presidents will be based upon the annual salaries as set forth in the chart below. Executive Officer New Salary ----------------- ---------- John A. Featherman, III $341,550 Kevin C. Quinn $256,163 John Balzarini $181,125 Deborah R. Pierce $150,075 Michelle Venema $140,000 Karen D. Walter $133,515 Susan Bergen-Painter $130,000 Linda M. Hicks $130,000 Anthony J. Poluch $130,000 Messrs. Featherman and Quinn receive benefits as described in their respective Employment Agreements. Each of the other listed officers receives the Bank's standard benefits package and is paid a car allowance. In addition, in February 2006 the Corporation adopted an incentive compensation plan, as reported in the Corporation's Current Report on Form 8-K filed on February 23, 2006, the description of which is hereby incorporated by reference herein. In 2006, Directors who are not also officers of the Corporation or Bank (each a "non-employee director") will receive a fee of $500 for each Corporation or Bank board meeting attended and $300 for each committee meeting attended. Each non-employee director will also receive a $1,000 monthly retainer. Additionally, a quarterly fee of $250 will be paid to Mr. Waldron for serving as the Secretary of the Board, a quarterly fee of $750 will be paid to Mr. Clarke for serving as the Chairman of the Audit Committee, and a quarterly fee of $500 will be paid to Mr. Peirce for serving as the Chairman of the Bank's Asset Management Committee. Other Committee Chairmen will be paid a quarterly fee of $250 for such service. In addition to the foregoing fees, in 2005, the non-employee directors also received a bonus of $1,500. EX-23 3 exhibit23.txt EXHIBIT 23 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES Exhibit 23. Consent of Independent Registered Public Accounting Firm We have issued our report dated March 10, 2006, accompanying the consolidated financial statements included in the 2005 Annual Report of First Chester County Corporation and subsidiaries on Form 10-K, and management's assessment of the effectiveness of internal control over financial reporting as of December 31, 2005 and the effectiveness of internal control over financial reporting as of December 31, 2005. We hereby consent to the incorporation by reference of said reports in the Registration Statements of First Chester County Corporation on Forms S-8 (File No. 333-128500, effective September 22, 2005, File No. 333-09241, effective July 31, 1996, File No. 333-15733, effective November 7, 1996, File No. 333-33411, effective August 12, 1997, File No. 333-69315, effective December 21, 1998, and File No. 333-107763 effective date August 8, 2003) and Forms S-3 (File No. 333-33175, effective August 8, 1997 and File No. 333-107739 effective date August 7, 2003). /s/Grant Thornton LLP Philadelphia, Pennsylvania March 10, 2006 EX-31 4 exhibit311.txt EXHIBIT 31.1 CEO CERTIFICATION FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES Exhibit 31.1 CERTIFICATION ------------- I, John A. Featherman, III, Chief Executive Officer of the Corporation, certify that: 1. I have reviewed this annual report on Form 10-K for the period ending December 31, 2005 of First Chester County Corporation; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; (c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. March 16, 2006 /s/ John A. Featherman, III - --------------------------- John A. Featherman, III Chief Executive Officer EX-31 5 exhibit312.txt EXHIBIT 31.2 PRESIDENT CERTIFICATION FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES Exhibit 31.2 CERTIFICATION ------------- I, Kevin C. Quinn, President of the Corporation, certify that: 1. I have reviewed this annual report on Form 10-K for the period ending December 31, 2005 of First Chester County Corporation; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; (c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. March 16, 2006 /s/ Kevin C. Quinn - ------------------ Kevin C. Quinn President EX-31 6 exhibit313.txt EXHIBIT 31.3 CFO CERTIFICATION FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES Exhibit 31.3 CERTIFICATION ------------- I, John Balzarini, Treasurer and Chief Financial Officer of the Corporation, certify that: 1. I have reviewed this annual report on Form 10-K for the period ending December 31, 2005 of First Chester County Corporation; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; (c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. March 16, 2006 /s/ John Balzarini - ------------------ John Balzarini Treasurer and Chief Financial Officer EX-32 7 exhibit321.txt EXHIBIT 32.1 CEO CERTIFICATION FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES EXHIBIT 32.1 CERTIFICATION PURSUANT TO 18 U.S.C. ss. 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of First Chester County Corporation (the "Company") on Form 10-K for the period ending December 31, 2005 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, John A. Featherman, III, Chief Executive Officer and Chairman of the Board of the Company, certify, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. Date: March 16, 2006 /s/ John A. Featherman, III --------------------------- John A. Featherman, III Chief Executive Officer and Chairman of the Board EX-32 8 exhibit322.txt EXHIBIT 32.2 PRESIDENT CERTIFICATION FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES EXHIBIT 32.2 CERTIFICATION PURSUANT TO 18 U.S.C. ss. 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of First Chester County Corporation (the "Company") on Form 10-K for the period ending December 31, 2005 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Kevin C. Quinn, President of the Company, certify, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. Date: March 16, 2006 /s/Kevin C. Quinn --------------------------- Kevin C. Quinn President EX-32 9 exhibit323.txt EXHIBIT 32.3 CFO CERTIFICATION FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES EXHIBIT 32.3 CERTIFICATION PURSUANT TO 18 U.S.C. ss. 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of First Chester County Corporation (the "Company") on Form 10-K for the period ending December 31, 2005 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, John Balzarini, Treasurer and Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. Date: March 16, 2006 /s/ John Balzarini ------------------ John Balzarini Treasurer and Chief Financial Officer (Principal Accounting and Financial Officer) -----END PRIVACY-ENHANCED MESSAGE-----