10-K 1 k04.txt HORIZON FINANCIAL CORP. FORM 10-K SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ------------------------- FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ended March 31, 2004 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number: 0-27062 Horizon Financial Corp. ----------------------------------------------------------------------------- - (Exact name of registrant as specified in its charter) Washington 91-1695422 ------------------------------------------------ ------------------- - (State or other jurisdiction of incorporation (I.R.S. Employer or organization) I.D. Number) 1500 Cornwall Avenue, Bellingham, Washington 98225 ------------------------------------------------ ------------------- - (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (360) 733-3050 ------------------- - Securities registered pursuant to Section 12(b) of the Act: 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 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 whether 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 other information statements incorporated by reference in Part III of this Form 10-K or any amendments to this Form 10-K. YES NO X --- --- Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). YES X NO --- --- The aggregate market value of the voting stock held by nonaffiliates of the registrant, based on the closing sales price of the registrant's Common Stock as quoted on the Nasdaq Stock Market under the symbol "HRZB" on September 30, 2003, was $169,067,630 (10,475,070 shares at $16.14 per share). DOCUMENTS INCORPORATED BY REFERENCE 1. Portions of the Registrant's Proxy Statement for the 2004 Annual Meeting of Stockholders. (Parts II. and III). HORIZON FINANCIAL CORP. 2004 ANNUAL REPORT ON FORM 10-K TABLE OF CONTENTS Page PART I. ---- Item 1. Business General. . . . . . . . . . . . . . . . . . . . . . . . . . 1 Lending Activities . . . . . . . . . . . . . . . . . . . . 1 Investment Activities. . . . . . . . . . . . . . . . . . . 10 Savings Activities and Other Sources of Funds. . . . . . . 13 Competition. . . . . . . . . . . . . . . . . . . . . . . . 15 Personnel. . . . . . . . . . . . . . . . . . . . . . . . . 15 Regulation and Supervision . . . . . . . . . . . . . . . . 15 Taxation . . . . . . . . . . . . . . . . . . . . . . . . . 22 Available Information. . . . . . . . . . . . . . . . . . . 23 Item 2. Properties. . . . . . . . . . . . . . . . . . . . . . . . . . 24 Item 3. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . 25 Item 4. Submission of Matters to a Vote of Security Holders . . . . . 25 PART II. Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities . . . . . . 26 Item 6. Selected Financial Data . . . . . . . . . . . . . . . . . . . 27 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations . . . . . . . . . . . . . 29 Forward Looking Statements. . . . . . . . . . . . . . . . . 29 General . . . . . . . . . . . . . . . . . . . . . . . . . . 29 Operating Strategy. . . . . . . . . . . . . . . . . . . . . 29 Critical Accounting Estimate. . . . . . . . . . . . . . . . 30 Critical Accounting Policies. . . . . . . . . . . . . . . . 31 Financial Condition . . . . . . . . . . . . . . . . . . . . 32 Results of Operations . . . . . . . . . . . . . . . . . . . 33 Yields Earned and Rates Paid . . . . . . . . . . . . . . . 36 Rate/Volume Analysis. . . . . . . . . . . . . . . . . . . . 38 Liquidity and Capital Resources . . . . . . . . . . . . . . 38 Quantitative and Qualitative Disclosures About Market Risk . . . . . . . . . . . . . . . . . . . . 39 Effects of Interest Rate Floors . . . . . . . . . . . . . . 40 Contractual Obligations . . . . . . . . . . . . . . . . . . 41 Off-Balance Sheet Arrangements. . . . . . . . . . . . . . . 41 Impact of Inflation . . . . . . . . . . . . . . . . . . . . 42 Recent Accounting Pronouncements. . . . . . . . . . . . . . 42 Item 7A. Quantitative and Qualitative Disclosures About Market Risk . 42 Item 8. Financial Statements and Supplementary Data . . . . . . . . . 42 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. . . . . . . . . . . . 70 Item 9A. Controls and Procedures. . . . . . . . . . . . . . . . . . . 70 PART III. Item 10. Directors and Executive Officers of the Registrant . . . . . 70 Item 11. Executive Compensation . . . . . . . . . . . . . . . . . . . 72 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters . . . . . . . 72 Item 13. Certain Relationships and Related Transactions . . . . . . . 73 Item 14. Principal Accountant Fees and Services . . . . . . . . . . . 73 PART IV. Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. . . . . . . . . . . . . . . . . . . . . . . . . 73 (i) PART I Item 1. Business ----------------- (a) General ------- Horizon Financial Corp. ("Horizon Financial" or the "Corporation") was formed under Washington law on May 22, 1995, and became the holding company for Horizon Bank ("Horizon Bank" or the "Bank"), effective October 13, 1995. Effective June 19, 1999 the Corporation completed the acquisition of Bellingham Bancorporation, a $64.3 million, bank holding company for the Bank of Bellingham, which was merged with and into Horizon Bank. At March 31, 2004, the Corporation had total assets of $858.9 million, total deposits of $670.3 million and total equity of $109.3 million. The Corporation's business activities generally are limited to passive investment activities and oversight of its investment in the Bank. Accordingly, the information set forth in this report, including consolidated financial statements and related data, relates primarily to the Bank and its subsidiary. The Bank was organized in 1922 as a Washington State chartered mutual savings and loan association and converted to a federal mutual savings and loan association in 1934. In 1979, the Bank converted to a Washington State chartered mutual savings bank, the deposits of which are insured by the Federal Deposit Insurance Corporation ("FDIC"). On August 12, 1986, the Bank converted to a state chartered stock savings bank under the name "Horizon Bank, a savings bank." The Bank became a member of the Federal Home Loan Bank ("FHLB") of Seattle in December 1998. Effective March 1, 2000, the Bank changed its name to its current title, "Horizon Bank." The Bank's operations are conducted through 16 full-service office facilities, three commercial loan centers, and three real estate loan centers, located in Whatcom, Skagit and Snohomish counties in Northwest Washington. The acquisition of Bellingham Bancorporation increased Horizon Financial's and Horizon Bank's presence in Whatcom County. During fiscal 2000, the Bank purchased a bank site in Marysville. In fiscal 2002, the Bank acquired a bank site in Lynnwood, Washington, which was remodeled and opened for business in March 2003. The Bank opened commercial banking/loan centers in Bellingham, Snohomish, and Everett and expanded its operations in Burlington during the first quarter of fiscal 2004. Future plans for the Bank include the opening of a full service office in Marysville during fiscal 2005 and a full service office in Everett during fiscal 2006, which will replace the Bank's existing Everett office. The Corporation has been in various buy-back programs of its outstanding common stock ("Common Stock") since August 1996. In March 2004, the Board of Directors approved a new stock repurchase plan that runs concurrent with the 2005 fiscal year, allowing the Corporation to repurchase up to 10% of total shares outstanding, or approximately 1.04 million shares. This marked the Corporation's sixth stock repurchase plan. In fiscal 2004, under the previous plans, the Corporation repurchased 314,240 shares at an average price of $17.353. For additional information concerning the Corporation's repurchase activities during the fourth quarter of fiscal 2004, see Item 5 hereof. Lending Activities ------------------ General. The Bank's loan portfolio, net totaled $658.2 million at March 31, 2004, representing approximately 76.6% of its total assets. On that date, 33.0% of total outstanding loans consisted of loans secured by mortgages on one-to-four family residential properties, 8.0% of total outstanding loans consisted of loans secured by mortgages on over four unit residential properties, and 55.0% of total outstanding loans consisted of commercial loans and commercial real estate loans. The balance of the Bank's outstanding loans at that date consisted of secured and unsecured consumer loans and loans secured by savings deposits. The Bank originates both fixed rate and adjustable rate mortgages ("ARMs") secured by residential, business, and commercial real estate, the majority of which include building improvements. The Bank has no significant concentration of credit risk other than that a substantial portion of its loan portfolio is secured by real estate located in the Bank's primary market area, which the Bank considers to be Whatcom, Skagit and Snohomish Counties in Washington. This concentration of credit risk could have a material adverse effect on the Bank's 1 financial condition and results of operations to the extent there is a material deterioration in the counties' economic and real estate values. In order to have the ability to make the yields on its loan portfolio and investments more interest rate sensitive, the Bank has implemented a number of measures. Those measures include: (i) adoption of a policy under which the Bank generally originates long-term, fixed-rate mortgage loans when such loans are written to specifications promulgated by the Federal Home Loan Mortgage Corporation ("FHLMC") and qualify for sale in the secondary market, (ii) origination of ARM loans on residential and commercial properties subject to market conditions, (iii) origination of variable rate commercial and consumer loans, and (iv) increased emphasis on originating shorter term loans for its portfolio, and selling much of its long-term mortgage loan production into the secondary market. The following table provides selected data relating to the composition of the Bank's loan portfolio by type of loan on the dates indicated. At March 31, ------------------------------------------------------------------------------------- - 2004 2003 2002 2001 2000 ---------------- --------------- --------------- --------------- ------------- - Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent ------ ------- ------ ------- ------ ------- ------ ------- ------ ------ - (Dollars in thousands) Type of Loan: First mortgage loans: One-to-four family..$286,127 43.5% $350,488 60.2% $493,098 86.8% $619,395 103.7% $606,703 102.9% One-to-four family construction....... 14,165 2.1 28,036 4.8 29,958 5.3 26,716 4.5 25,912 4.4 Participations sold. (74,279) (11.3) (137,174) (23.5) (228,874) (40.3) (246,583) (41.3) (176,538)(29.9) -------- ----- -------- ----- -------- ----- -------- ----- -------- ----- Subtotal.......... 226,013 34.3 241,350 41.5 294,182 51.8 399,528 66.9 456,077 77.4 Construction and land development........ 36,304 5.5 66,112 11.3 55,747 9.8 30,364 5.1 18,717 3.2 Residential commer- cial real estate... 53,344 8.1 56,930 9.8 28,604 5.0 24,187 4.0 21,999 3.7 Nonresidential commercial real estate............. 257,322 39.1 182,158 31.3 169,697 29.9 139,232 23.3 88,323 15.0 Commercial loans.... 78,752 11.9 54,132 9.3 37,844 6.7 20,221 3.4 14,473 2.4 Home equity secured. 26,291 4.0 22,729 3.9 18,873 3.3 19,835 3.3 16,953 2.9 Other consumer loans.............. 6,330 1.0 6,887 1.2 5,263 0.9 2,531 0.4 4,829 0.8 -------- ----- -------- ----- -------- ----- -------- ----- -------- ----- Subtotal.......... 684,356 103.9 630,298 108.3 610,210 107.4 635,898 106.4 621,371 105.4 Less: Deferred loan fees.. (4,046) (0.6) (4,845) (0.8) (5,613) (1.0) (6,746) (1.1) (7,398) (1.3) Allowance for loan losses............. (10,121) (1.5) (8,506) (1.5) (5,887) (1.0) (4,977) (0.8) (4,757) (0.8) Undisbursed loan proceeds........... (11,963) (1.8) (34,678) (6.0) (30,407) (5.4) (26,793) (4.5) (19,632) (3.3) -------- ----- -------- ----- -------- ----- -------- ----- -------- ----- $658,226 100.0% $582,269 100.0% $568,303 100.0% $597,382 100.0% $589,584 100.0% ======== ===== ======== ===== ======== ===== ======== ===== ======== =====
Loan Maturity. The following table sets forth certain information at March 31, 2004 regarding the dollar amount of loans maturing in the Bank's portfolio based on their contractual terms to maturity. Demand loans, loans having no stated schedule of repayments and no stated maturity, and overdrafts are reported as due in one year or less. Loan balances are net of undisbursed loan proceeds, unearned discounts, unearned income and allowance for loan losses. Due After Due Within 1 Through Due Over One Year After 5 Years After 5 Years After March 31, 2004 March 31, 2004 March 31, 2004 Total -------------- -------------- -------------- -------- - (In thousands) Commercial real estate, financial, and agricultural..... $188,940 $146,983 $120,420 $456,343 One-to-four real estate construction.. -- -- 14,165 14,165 Real estate-mortgage, installment and other................ 35,588 39,665 112,465 187,718 -------- -------- -------- ------- - Total............ $224,528 $186,648 $247,050 $658,226 ======== ======== ======== ======== 2 The following table sets forth the dollar amount of all loans due after one year after March 31, 2004 which have fixed interest rates and have floating or adjustable interest rates. Loan balances do not include undisbursed loan proceeds, unearned discounts, unearned income, and allowance for loan losses. Adjustable Fixed Rates Rates Total ----------- ----- ----- (In thousands) Commercial, financial and agricultural................ $ 96,982 $170,421 $267,403 One-to-four family real estate construction......... 13,965 200 14,165 Real estate-mortgage, installment and other....... 134,639 17,491 152,130 -------- -------- -------- Total.................... $245,586 $188,112 $433,698 ======== ======== ======== Residential Loans. The primary lending activity of the Bank has historically been the granting of conventional loans to enable borrowers to purchase existing homes or construct new homes. The Bank's real estate loan portfolio also includes loans on two-to-four family dwellings, multi-family housing (over four units), and loans made to purchase or refinance improved buildings to be used for residential housing. At March 31, 2004, approximately 33.0% of the Bank's total loan portfolio consisted of loans secured by one-to-four residential real estate. The Bank's lending practices generally limit the maximum loan-to-value ratio on one-to-four family residential mortgage loans to 97% of the appraised value as determined by an independent appraiser, with the condition that private mortgage insurance generally be required on any home loans with loan-to-value ratios in excess of 80% of the appraised value. The Bank places this insurance with carriers approved by the FHLMC. The coverage generally limits the Bank's exposure to 72.0% of the loan amount. If private mortgage insurance is required, the borrower pays the premium at loan closing and any recurring premiums through an escrow reserve account established with the Bank for such period of time as the Bank requires the insurance coverage to be in force. Multi-family residential and commercial real estate loans and unimproved real estate loans generally do not exceed 80.0% of appraised value. The Bank presently originates both fixed-rate and ARMs secured by one-to-four family properties with a loan term not exceeding 30 years. Under certain conditions, ARM borrowers are allowed to convert beginning on the first interest rate change date and ending on the fifth interest rate change date from the date of the loan note. In addition, certain consumer safeguards are built into the ARM instruments used by the Bank. These safeguards include limits on annual and lifetime interest rate adjustments. The Bank generally originates these loans in accordance with guidelines established by the FHLMC. For the fiscal year ended March 31, 2004, adjustable mortgage loans totalled $6.4 million or 2.7% of total originations as compared to $45.6 million, or 14.4%, of total originations for the year ended March 31, 2003. Construction Loans. The Bank also provides construction financing for single-family dwellings and to a lesser extent makes land acquisition and development loans on properties intended for residential use. The interest rate charged by the Bank on these loans varies depending upon the type of security property and the creditworthiness of the borrower. At March 31, 2004, the Bank had $50.5 million, or 7.4%, of total loans outstanding in residential construction loans, as compared to $94.1 million, or 14.9%, of total loans at March 31, 2003. At March 31, 2004, $36.3 million, or 71.9%, of the construction loan portfolio consisted of "speculative" construction loans (i.e., loans on dwellings for which there is not an underlying contract for sales). Construction lending is generally considered to involve a higher level of risk as compared to one-to-four family residential permanent lending because of the inherent difficulty in estimating both a property's value at completion of the project and the estimated cost of the project. The nature of these loans is such that they are generally more difficult to evaluate and monitor. If the estimate of value proves to be inaccurate, the Bank may be confronted at, or prior to, the maturity of the loan, with a project whose value is insufficient to assure full repayment. Loans for the construction of speculative homes carry more risk because the payoff for the loan is dependent on the builder's ability to sell the property prior to the time that the construction loan is due. 3 Multi-Family, Business and Commercial Real Estate Lending. Commercial real estate loans totaled $334.4 million, or 50.8% of total loans receivable at March 31, 2004. The Bank originates commercial real estate loans primarily secured by owner-occupied business facilities, apartment buildings, warehouses, mini-storage facilities, industrial use buildings, office and medical office buildings, hospitality facilities, commercial land development and retail shopping centers located in its market area. Commercial real estate loans typically range in principal amount from $500,000 to $10.0 million. At March 31, 2004, the largest commercial real estate loan on one property had an outstanding balance of $17.0 million and is secured by a destination resort and surrounding real estate located in the Bank's market area. This loan was performing according to its terms at March 31, 2004. Commercial adjustable rate mortgage loans are originated with variable rates which generally adjust annually after an initial period ranging from one to five years. These adjustable rate mortgage loans have generally utilized Prime or Federal Home Loan Bank Advance Rates as indices, with principal and interest payments fully amortizing over terms of 15 to 25 years, and are generally due in ten years. The Bank has also originated fixed rate commercial loans due in five to 15 years, with amortization terms of 15 to 25 years. Commercial loans originated with interest rates fixed for the initial three, five or ten year terms generally contain prepayment penalties during their fixed rate period ranging from 1.0% to 5.0%. The Bank requires appraisals or evaluations on all properties securing commercial real estate loans. The Bank considers the quality and location of the real estate, the credit of the borrower, the cash flow of the project and the quality of management involved with the property. The Bank generally imposes a minimum debt coverage ratio of approximately 1.20 times for originated loans secured by income producing commercial properties. The Bank generally obtains loan guarantees from financially capable parties based on a review of personal financial statements, or if the borrower is a corporation, the Bank also generally obtains personal guarantees from corporate principals based on a review of personal financial statements. Commercial real estate lending affords the Bank an opportunity to receive interest at rates higher than those generally available from one- to- four family residential lending. However, loans secured by such properties usually are greater in amount, more difficult to evaluate and monitor and, therefore, involve a greater degree of risk than one- to- four family residential mortgage loans. Because payments on loans secured by commercial properties often depend upon the successful operation and management of the properties, repayment of such loans may be affected by adverse conditions in the real estate market or the economy. The Bank seeks to minimize these risks by limiting the maximum loan-to-value ratio to 80% and carefully reviewing the financial condition of the borrower, the quality of the collateral and the management of the property securing the loan. The continued year-over-year increase in the commercial real estate portfolio is attributable to the Company's desire to meet the growing demand in this sector of the lending market. Commercial Loans. The Bank's loan portfolio also includes a wide range of commercial loans to small and medium sized businesses. This portfolio presently includes lines of credit with floating rates and maturities of one year or less and term loans for the purchase of equipment, real estate and other operating purposes with maturities generally not exceeding ten years. These loans are secured by a variety of business assets including equipment, real estate, accounts receivable and inventory. These types of loans constituted $77.1 million, or approximately 11.7% of the Bank's net loan portfolio at March 31, 2004. Under certain conditions, the Bank also offers unsecured credit to qualified borrowers. Commercial lending carries increased risks compared to residential mortgage lending due to the heavy reliance upon the future income of the customer and the uncertain liquidation value of the collateral. In the event of default, the liquidation of collateral is often insufficient to cover the outstanding debt. To mitigate these inherent risks, the Bank combines a conservative lending policy with experienced lending personnel responsible for the ongoing management of their assigned accounts. Consumer Loans. The Bank makes a variety of loans for consumer purposes. Included among these are home equity loans, home equity lines of credit, loans secured by personal property, such as automobiles, boats, and other vehicles, loans secured by deposit accounts, unsecured loans, and loans for mobile homes located in parks. 4 Horizon Bank actively markets consumer loans in order to provide a wider range of financial services to its customers and to achieve shorter terms and higher interest rates normally typical of such loans. At March 31, 2004, the Bank held $32.0 million of consumer loans. Consumer loans entail greater risk than do residential mortgage loans, particularly in the case of consumer loans which are unsecured or secured by rapidly depreciating assets such as automobiles, boats and other vehicles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. The remaining deficiency often does not warrant further substantial collection efforts against the borrower beyond obtaining a deficiency judgment. In addition, consumer loan collections are dependent on the borrower's continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount that can be recovered on such loans. Consumer loans are made based on an evaluation of the borrower's creditworthiness, including income, other indebtedness, and satisfactory credit history, and the value of the collateral. Designated managers or Loan Committee members approve consumer loan requests. Secured loan amounts typically do not exceed 90.0% of the value of the collateral, or 90.0% of the appraised value of the residence in the case of home equity loans. Loan Solicitation and Processing. The primary sources for loan originations are attributable to deposit customers, current borrowers, walk-in customers, and referrals from existing customers, real estate agents, and builders. The Bank does not actively utilize mortgage brokers in the origination of loans. The Bank accepts completed loan applications from all of its offices. Processing is substantially centralized in the main office of the Bank. Detailed information is obtained to determine the creditworthiness of the borrower and the borrower's ability to repay. The more significant items appearing on the applications and accompanying material are verified through the use of written credit reports, financial statements, and confirmations. After analysis of the loan application, supporting documents and the property to be pledged as loan security, including an appraisal of the property by either a staff appraiser or an independent fee appraiser, the application is forwarded to the Bank's Loan Committee. Loan approval requires the signatures of two or three members of the Loan Committee depending on the size of the loan. The Loan Committee consists of officers of the Bank who are appointed by the Bank's Board of Directors. The Bank generally requires its mortgage notes to be co-signed individually by the principals on loans made to entities other than natural persons. Certain lending personnel have been given limited loan approval authority by the Board of Directors covering secondary market quality loans. Loan assumption requests of adjustable rate loans are handled by the Bank in a manner similar to new loan requests. FHLMC standards are generally applied to each request and full credit underwriting is required. For fixed rate loans, a sale or transfer of the secured property generally results in the Bank enforcing its due on transfer rights contained in the mortgage instrument. Residential Loan Originations, Purchases and Sales. Currently, the Bank emphasizes the origination of 15 to 30 year fixed rate loans on terms and conditions which will permit them to be sold in the secondary market, while originating ARM loans and shorter term fixed-rate loans for its own portfolio. In addition to originating loans, Horizon Bank may purchase real estate loans in the secondary market. The Bank's purchases in the secondary market depend upon the demand for mortgage credit in the local market area and the inflow of funds from traditional sources. Loan purchases enable the Bank to utilize funds more quickly, particularly where sufficient loan demand is not obtainable locally. The Bank is a qualified servicer for both FHLMC and Fannie Mae. The Bank's general practice is to close its fixed-rate, one-to-four family residential loans on FHLMC loan documents in order to facilitate future sales to the 5 mortgage corporation as well as to other institutional investors. From time to time, depending upon interest rates and economic conditions, the Bank has sold participation interests in loans in order to provide additional funds for lending, to generate servicing fee income and to decrease the dollar amount of its intermediate and long-term fixed-rate loans. The sale of loans in the secondary mortgage market reduces the Bank's interest rate risk and allows the Bank to continue to make loans during periods when savings flows decline or funds are otherwise unavailable for lending purposes. As of March 31, 2004, the Bank was servicing loans for others aggregating approximately $88.2 million for which it generally receives a fee payable monthly of 0.25% to 0.375% per annum of the unpaid balance of each loan. In February 2001, the Bank began selling much of its current loan production on a servicing released basis, and plans to continue doing so for many of the long-term fixed rate loan originations. All sales of loan interests by the Bank are made without right of recourse to the Bank by the buyer of the loan interests in the event of default by the borrower. Loan Commitments. The Bank is a party to financial instruments with off-balance-sheet risk (loan commitments) made in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. Loan commitments involve, to varying degrees, elements of credit and interest-rate risk in excess of the amount recognized in the balance sheet. The contract amounts of those commitments reflect the extent of the Bank's exposure to credit loss from these commitments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. 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 amount of collateral obtained, if it is deemed necessary by the Bank upon extension of credit, is based on management's credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property, plant, and equipment; and income-producing commercial properties. Standby letters of credit are conditional commitments issued by the Bank 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. Except for certain long-term guarantees, the majority of guarantees expire in one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral supporting those commitments, for which collateral is deemed necessary, generally amounts to one hundred percent of the commitment amount at March 31, 2004. The following is a summary of the off-balance-sheet financial instruments or contracts outstanding as of the dates indicated. As of March 31, ------------------- 2004 2003 ------- ------- (In thousands) Commitments to extend credit.... $80,275 $58,878 Credit card arrangements........ 7,991 7,385 Standby letters of credit....... 2,059 1,263 Loan Origination and Other Fees. In addition to interest earned on loans, the Bank receives loan origination fees for originating loans. Loan origination fees are a percentage of the principal amount of the mortgage loan which are charged to the borrower at the closing of the loan. The Bank's loan origination fees are generally 0% to 2.5% on conventional residential mortgages and 1.0% to 2.0% for commercial real estate loans. The total amount of deferred loan origination fees and unearned discounts at March 31, 2004 was $4.0 million. Any unamortized loan fees are recognized as income at the time the loan is sold or paid off. 6 Income from loan origination and commitment fees varies with the volume and type of loans and commitments made and purchased and with competitive conditions in mortgage markets, which in turn responds to the demand for and availability of money. The Bank experiences an increase in loan fee income and other fee income, such as appraisal and loan closing fees, during periods of low interest rates due to the resulting demand for mortgage loans. The Bank also receives other fees and income from charges relating to existing loans, which include late charges, and fees collected in connection with a change in terms or other loan modifications. These fees and charges have not constituted a material source of income. Loan Modifications. The Bank offers a loan modification program to assist existing customers who are considering refinancing their home loans. For a fee the Bank will modify customers' loans under the program. No new principal is required and only the interest rate and payment amounts are changed. All other terms and conditions remain the same. In fiscal 2004, the Bank modified $46.0 million of real estate loans, compared to $66.3 million in fiscal 2003. Delinquent Loans, Loans in Foreclosure and Foreclosed Property. Loans are defined as delinquent when any payment of principal and/or interest is past due. While the Bank generally is able to work out a satisfactory repayment schedule with a delinquent borrower, the Bank will undertake foreclosure proceedings if the delinquency is not otherwise resolved within 90 days. Property acquired by the Bank as a result of foreclosure or by deed in lieu of foreclosure is classified as "real estate owned" until such time as it is sold or otherwise disposed of. At March 31, 2004, the Bank had eight loans over 90 days delinquent and no loans on nonaccrual status. At March 31, 2004 total non-performing loans were $339,000. Real estate owned at March 31, 2004 totaled $63,000. Total non-performing assets represented $402,000, or 0.05%, of total assets at March 31, 2004. Management does not anticipate incurring material losses from these loans. The following table sets forth information with respect to the Bank's non-performing assets at the dates indicated. At March 31, ----------------------------------------------- - 2004 2003 2002 2001 2000 ---- ---- ---- ---- ---- (Dollars in thousands) Non-accrual loans............ $ -- $ 242 $ -- $ -- $ 455 Loans 90 days or more delinquent and accruing interest.......... 339 350 618 832 457 Restructured loans........... -- -- -- -- -- Real estate acquired through foreclosure........ 63 1,072 340 -- 323 ------ ------- ------- ------- ------- Total.................... $ 402 $ 1,664 $ 958 $ 832 $ 1,235 ====== ======= ======= ======= ======= As a percentage of net loans. 0.06% 0.29% 0.17% 0.14% 0.21% As a percentage of total assets..................... 0.05% 0.20% 0.12% 0.11% 0.17% Additional interest income which would have been recorded had nonaccruing loans been current in accordance with their original terms was considered immaterial as of March 31, 2004. No interest income was recorded on nonaccrual loans for the year ended March 31, 2004. Reserves for Losses. The Bank operates under a general loan loss reserve system. The provision for loan losses is maintained at a level sufficient to provide for estimated loan losses based on evaluating known and inherent risks in the loan portfolio. These factors include changes in the size and composition of the loan portfolio, actual loan loss experience, current and anticipated economic conditions, detailed analysis of individual loans for which full collectibility may not be assured, and determination of the existence and realizable value of the collateral and guarantees securing the loans. The reserve is based upon factors and trends identified by management at the time financial statements are prepared, but the ultimate recovery of loans is susceptible to future market factors beyond the Bank's control, which may result in losses or recoveries differing significantly from those provided for in the financial statements. 7 The Bank maintains an allowance for credit losses sufficient to absorb losses inherent in the loan portfolio. The Bank has established a systematic methodology to ensure that the allowance is adequate. The Bank reviews the following information, on a quarterly basis, to estimate the necessary additions to its loan loss reserve: * All loans classified during the previous analysis. Current informa- tion as to payment history, or actions taken to correct the deficiency are reviewed, and changes are made, as appropriate. If conditions have not improved, the loan classification is reviewed to ensure that the appropriate action is being taken to mitigate loss. * All loans past due on scheduled payments. The Bank reviews all loans that are past due 30 days or more, taking into consideration the borrower, nature of the collateral and its value, the circumstances that have caused the delinquency, and the likelihood of the borrower correcting the conditions that have resulted in the delinquent status. * Composition of the Bank's portfolio. The Bank also analyzes its mix of loans when establishing appropriate allowances for loan losses. For example, reserves for losses on the Bank's one-to-four family mortgage portfolio (on a percentage basis) are lower than the percentage reserve estimates for commercial or credit card loans. Therefore, the Bank's allowance for loan losses is likely to change, as the composition of the Bank's loan portfolio changes. * Current economic conditions. The Bank takes into consideration economic conditions in its market area, the state's economy, and national economic factors that could influence the quality of the loan portfolio in general. * Trends in the Bank's delinquencies. Prior period statistics are reviewed and evaluated to determine if the current conditions warrant changes to the Bank's loan loss allowance. The amount that is to be added to allowance for loan losses is based upon a variety of factors. Many financial institutions establish required reserves based, to a great extent, upon their own experience. The Bank's loan portfolio has traditionally consisted primarily of loans secured by single family homes, and as a result, the loss experience has been minimal. Each individual loan, previously classified by management, or newly classified during the quarterly review, is evaluated for loss potential, and a specific amount or percentage deemed to be at risk is added to the overall required reserve amount. For the remaining portion of the portfolio, a reserve factor is applied that is consistent with the Bank's experience in that portfolio or with industry guidelines if management believes such guidelines are more appropriate. The applied percentage is also influenced by other economic factors as noted in the beginning of this section. The calculated amount is compared to the actual amount recorded in the allowance at the end of each quarter and a determination is made as to whether the allowance is adequate. Management increases the amount of the allowance for loan losses by charges to income and decreases the amount by loans charged off (net of recoveries). The following comments represent management's view of the risks inherent in each portfolio category. * One- to Four-Family Residential - Market conditions in the Bank's primary market area have, over the long term, supported a stable or increasing market value of real estate. Absent an overall economic downturn in the economy, experience in this portfolio indicates that losses are minimal provided the property is reasonably maintained, and marketing time to resell the property is relatively short. * Multi-Family Residential - While there have been minimal losses taken in this segment of the portfolio, the rental market is susceptible to the effects of an economic downturn. While the Bank monitors loan-to-value ratios, the conditions that would create a default would carry through to a new owner which may require that the Bank discount the property or hold it until conditions improve. 8 * Commercial Real Estate - As with multi-family loans, the classifi- cation of commercial real estate loans closely corresponds to economic conditions which will limit the marketability of the property, resulting in higher risk than a loan secured by a single-family residence. Commercial real estate loans have historically been assigned higher reserve levels than one-to-four family residential loans, but lower than commercial business loans. * Commercial Business Loans - These types of loans carry a higher degree of risk, relying on the ongoing success of the business to repay the loan. Collateral for commercial credits is often difficult to secure, and even more difficult to liquidate in the event of a default. If a commercial business loan demonstrates any credit weakness, the reserve is increased to recognize the additional risk. * Consumer Loans - The consumer loan portfolio has a wide range of factors, determined primarily by the nature of the collateral and the credit history and capacity of the borrower. The loans tend to be smaller in principal amount and secured by second deeds of trust, automobiles, boats, and other vehicles. Loans for automobiles, boats, and other vehicles, generally experience higher than average wear in the environment and hold a higher degree of risk of loss in the event of repossession. * Unsecured Credit Cards - Due to the unsecured nature of these accounts, these types of loans represent the highest degree of risk. The Bank, therefore, uses a higher percentage factor than any other loan classification, when estimating future potential loan losses. Management believes that the allowance for loan losses at March 31, 2004 was adequate at that date. Although management believes that it uses the best information available to make these determinations, future adjustments to the allowance for loan losses may be necessary and results of operations could be significantly and adversely affected if circumstances differ substantially from the assumptions used in making the determinations. While the Bank believes it has established its existing allowance for loan losses in accordance with generally accepted accounting principles, there can be no assurance that regulators, in reviewing the Bank's loan portfolio, will not request the Bank to increase significantly its allowance for loan losses. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is adequate or that substantial increases will not be necessary should the quality of any loans deteriorate as a result of the factors discussed above. Any material increase in the allowance for loan losses may adversely affect the Bank's financial condition and results of operations. The Bank established an allowance for losses for the year ended March 31, 2004 in the amount of $10.1 million and $8.5 million for the year ended March 31, 2003. The Bank's loan loss reserve as of March 31, 2004, was approximately 1.5% of net loans receivable. The following table sets forth an analysis of the Bank's allowance for loan losses for the periods indicated. Year Ended March 31, ----------------------------------------------- - 2004 2003 2002 2001 2000 ---- ---- ---- ---- ---- (Dollars in thousands) Allowance at beginning of period...................... $ 8,506 $5,887 $4,977 $4,757 $4,463 Provision for loan losses.... 1,915 2,740 1,089 320 437 Recoveries: First mortgage loans........ -- -- -- -- -- Commercial loans............ 79 -- -- -- -- Credit card loans........... 6 8 4 1 1 Other consumer loans........ 1 -- 4 -- - ------- ------ ------ ------ ------ Total recoveries.......... 86 8 8 1 1 (table continues on following page) 9 Year Ended March 31, ----------------------------------------------- - 2004 2003 2002 2001 2000 ---- ---- ---- ---- ---- (Dollars in thousands) Charge-offs: First mortgage loans........ -- -- (28) (60) (90) Commercial loans............ (254) (54) (148) (21) (10) Credit card loans........... (124) (72) (5) (20) (43) Other consumer loans........ (8) (4) (6) -- (1) ------- ------ ------ ------ ------ Total charge-offs......... (386) (129) (187) (101) (144) Net charge-offs........... (300) (121) (179) (100) (143) ------- ------ ------ ------ ------ Allowance at end of period... $10,121 $8,506 $5,887 $4,977 $4,757 ======= ====== ====== ====== ====== Allowance for loan losses as a percentage of total loans outstanding at the end of the period................ 1.48% 1.35% 0.96% 0.78% 0.77% Net charge-offs as a percent- of average loans outstanding during the period............ 0.05% 0.02% 0.03% 0.02% 0.02% Allowance for loan losses as a percentage of nonperform- ing assets at end of period..2,518.51% 511.09% 614.70% 597.94% 385.13% The following table sets forth the breakdown of the allowance for loan losses by loan category for the periods indicated. At March 31, --------------------------------------------------------------------------------------- 2004 2003 2002 2001 2000 ---------------- ---------------- ---------------- ---------------- ---------------- Percent Percent Percent Percent Percent of Loans of Loans of Loans of Loans of Loans in Each in Each in Each in Each in Each Category Category Category Category Category to Total to Total to Total to Total to Total Amount Loans Amount Loans Amount Loans Amount Loans Amount Loans ------ ----- ------ ----- ------ ----- ------ ----- ------ ----- (Dollars in thousands) Commercial, financial and agricultural.... $ 8,007 79.1% $6,365 74.8% $3,353 51.6% $1,923 37.4% $1,187 27.0% Residential real estate-mortgage. 2,114 20.9 2,141 25.2 2,534 48.4 3,054 62.6 3,570 73.0 ------- ----- ------ ----- ------ ----- ------ ----- ------ ----- Total allowance for loan losses........ $10,121 100.0% $8,506 100.0% $5,887 100.0% $4,977 100.0% $4,757 100.0% ======= ===== ====== ===== ====== ===== ====== ===== ====== =====
The Bank had an allowance of $0, $0, $50,000, $0 and $0 for real estate acquired through foreclosure at March 31, 2004, 2003, 2002, 2001 and 2000. Investment Activities --------------------- Under Washington law, savings banks are permitted to own U.S. government and government agency obligations, commercial paper, corporate bonds, mutual fund shares, debt and equity obligations issued by creditworthy entities, whether traded on public securities exchanges or placed privately for investment purposes. The Bank holds a diverse portfolio of money market instruments, United States Treasury obligations, federal agency securities, municipal securities, common stock, preferred stock and corporate notes. 10 The FDIC has adopted the Federal Financial Institutions Examination Council statement of policy on securities activities and accounting procedures. This policy requires that institutions establish prudent policies and strategies for securities activities, identify certain securities trading practices that are unsuitable for an investment portfolio, recommends procedures for selection of a securities dealer, and limits investment in high risk mortgage securities and disproportionately large holdings of long-term zero coupon bonds. The policy addresses concerns about speculative or other non-investment activities in the securities investment portfolios of depository institutions. Speculative securities activities can impair earnings or capital and, in some cases, may cause the failure of the institution. The policy establishes a framework for structuring securities activities and clarifies various accounting issues concerning investment accounts versus trading accounts. The amortized cost of the above investments at March 31, 2004 was $78.0 million compared to a market value of $85.6 million. For further information concerning the Bank's investment securities portfolio, see Notes 3 and 4 of the Notes to the Consolidated Financial Statements contained in Item 8 of this Form 10-K. The Bank also invests in mortgage-backed securities. At March 31, 2004, such securities had an amortized cost of $28.9 million and a market value of $29.4 million. The following table presents the amortized cost of the Bank's investment securities portfolio and short-term investments. The market value of the Bank's investment securities portfolio at March 31, 2004 was approximately $115.0 million. This does not include interest-bearing deposits and cash equivalents. At March 31, ---------------------------------- 2004 2003 2002 -------- -------- -------- (In thousands) Investment securities: U.S. Government: Available for sale................ $ 57,397 $ 38,821 $ 23,587 Held to maturity.................. 369 369 369 -------- -------- -------- 57,766 39,190 23,956 Mortgage-backed securities(1): Available for sale................ 27,363 37,141 29,453 Held to maturity.................. 1,544 2,793 4,410 -------- -------- -------- 28,907 39,934 33,863 Other securities(2): Available for sale................ 20,266 27,386 17,031 Held to maturity.................. -- -- -- -------- -------- -------- 20,266 27,386 17,031 -------- -------- -------- Total investments................. 106,939 106,510 74,850 Interest bearing deposits and cash equivalents......................... 39,199 75,013 83,962 -------- -------- -------- $146,138 $181,523 $158,812 ======== ======== ======== -------------- (1) Consists of mortgage-backed securities and CMO's. (2) Consists of corporate debt securities, marketable equity securities and mutual funds. At March 31, 2004, the Bank did not have any investment securities (exclusive of obligations of the U.S. Government and federal agencies) issued by any one entity with a total book value in excess of 10% of stockholders' equity. 11 The following table sets forth the scheduled maturities, amortized cost, market values and average yields for the Bank's investment securities at March 31, 2004. At March 31, 2004* ---------------------------------------------------------------------------------------- One Year One to Five Five to Ten More than Total or Less Years Years Ten Years Investment Securities ------------- ------------- ------------- ------------- ---------------------- Amor- Aver- Amor- Aver- Amor- Aver- Amor- Aver- Amor- Aver- tized age tized age tized age tized age tized Market age Cost Yield Cost Yield Cost Yield Cost Yield Cost Value Yield ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- (Dollars in thousands) U.S. Government, agency securities, state and politi- cal subdivisions: Available for sale..........$ 8,025 4.14% $43,703 3.98% $2,868 4.37% $ 2,801 4.72% $ 57,397 $ 59,001 4.06% Held to maturity...... -- -- 369 4.30 -- -- -- -- 369 400 4.30 ------ ---- ------- ---- ------ ---- ------- ---- ------- -------- ---- 8,025 4.14 44,072 3.98 2,868 4.37 2,801 4.72 57,766 59,401 4.06 Mortgage-backed securities: Available for sale......... 87 5.96 882 4.76 5,089 4.87 21,305 3.54 27,363 27,760 3.84 Held to maturity..... 1 16.24 863 6.43 439 6.43 241 9.21 1,544 1,653 6.87 ------ ---- ------- ---- ------ ---- ------- ---- ------- -------- ---- 88 5.96 1,745 5.59 5,528 4.99 21,546 3.61 28,907 29,413 4.00 Other: Available for sale......... 13,245 5.25 7,021 4.57 -- -- -- -- 20,266 26,183 5.01 Held to maturity..... -- -- -- -- -- -- -- -- -- -- -- ------ ---- ------- ---- ------ ---- ------- ---- ------- -------- ---- 13,245 5.25 7,021 4.57 -- -- -- -- 20,266 26,183 5.01 ------ ---- ------- ---- ------ ---- ------- ---- ------- -------- ---- Total........ $21,358 4.83% $52,838 4.11% $8,396 4.78% $24,347 3.74% $106,939 $114,997 4.21% ======= ==== ======= ==== ====== ==== ======= ==== ======== ======== ==== ---------------- * At March 31, 2004, yields on the Bank's tax-exempt obligations had not been computed on a tax equivalent basis.
12 Savings Activities and Other Sources of Funds General. Savings accounts and other types of deposits have traditionally been an important source of the Bank's funds for use in lending and for other general business purposes. In addition to deposit accounts, the Bank derives funds from loan repayments, loan sales, and other borrowings and operations. The availability of funds from loan sales is influenced by general interest rates and other market conditions. Loan repayments are a relatively stable source of funds while deposit inflows and outflows vary widely and are influenced by prevailing interest rates and money market conditions. Borrowings may be used on a short-term basis to compensate for reductions in deposits or deposit inflows at less than projected levels and may be used on a longer term basis to support expanded lending activities. Deposits. Horizon Bank offers several deposit accounts, including Regular Passbook and Statement Savings Accounts, Personal and Business Checking Accounts, Money Market with and without Check Access and Certificates of Deposit Accounts with maturities ranging from 30 days up to 10 years. Certificates of Deposit account requirements vary according to minimum principal balances, the time period the funds must remain on deposit and the interest rate determined for each term and minimum balance. The following table sets forth certain information concerning the deposits at the Bank. Year Ended March 31, ----------------------------------------------------- 2004 2003 2002 ----------------- ----------------- ----------------- Weighted Weighted Weighted Average Average Average Average Average Average Type Balance Rate Balance Rate Balance Rate ------------------ ------- ---- ------- ---- ------- ---- (Dollars in thousands) Savings............. $ 39,611 0.73% $ 36,652 1.19% $ 33,676 2.06% Checking............ 107,933 0.46 82,516 0.60 69,457 0.82 Money Market........ 122,314 1.08 126,080 1.75 95,280 2.80 Time Deposits....... 373,725 2.99 391,576 3.73 406,920 5.20 -------- ---- -------- ---- -------- ---- Total............. $643,583 2.06% $636,824 2.79% $605,333 4.14% ======== ==== ======== ==== ======== ==== The following table indicates the amount of the Bank's deposits by time remaining until maturity as of March 31, 2004 of $100,000 or more. Certificates Maturity Period of Deposit -------------------------- -------------- (In thousands) Three months or less........... $ 22,159 Three through six months....... 16,855 Six through twelve months...... 28,360 Over twelve months............. 61,969 -------- Total....................... $129,343 ======== The Bank has a number of different programs designed to attract both short-term and long-term savings of the general public by providing a wide assortment of accounts and rates. The program includes traditional savings accounts; nonnegotiable time deposits with minimum deposits of $100,000 and terms of 30 days to five years called Jumbo Certificates of Deposit; nonnegotiable, nontransferable time deposits with minimum deposits of $500 and terms from 30 days to five years at fixed rates; 12-month to 10-year variable rate fixed term certificates; Individual Retirement Accounts (IRAs); Qualified Retirement Plans; transaction accounts such as regular checking; MMDAs with and without limited check access. 13 The Bank's practice on early withdrawal penalties is applicable only to time deposits. Management believes that in periods of rising interest rates this practice will discourage depositors from making premature withdrawals for the purpose of reinvesting in higher rate time deposits. The minimum amount required to open a time deposit varies from $500 to $100,000, depending on the type of time deposit. Pricing of rates on time deposits with maturities from 30 days to 10 years are determined periodically by the Bank, based upon competitive rates and local market rates, national money market rates, and yields on assets of the same maturity. The Bank's personal MMDA currently has a $1,000 minimum deposit and has a tiered pricing program, with interest rates that vary by account dollar balance -- $1,000, $10,000, $25,000, $50,000 and higher. The Bank's Business MMDA has tiers of $1,000, $10,000, $50,000, $100,000 and higher, with a $1,000 minimum deposit. These accounts have no maturity requirements, no regulatory interest rate ceilings, and limited check writing privileges. The interest rates on these accounts are adjusted by the Bank periodically, based on money market conditions. The Bank currently has a $10,000 minimum deposit (ULT) money market and has a tiered pricing program, with interest rates that vary by account dollar balance -- $10,000, $25,000, $50,000 and higher. The Bank also offers a $25,000 minimum deposit (ULT PLUS) money market and has a tiered pricing program, with interest rates that vary by account dollar balance -- $25,000, $50,000, $100,000 and higher. These accounts have no maturity requirements, no regulatory interest rate ceiling, and no check writing privileges. The interest rates on the account are adjusted by the Bank periodically or as dictated by money market conditions. The large variety of deposit accounts offered by the Bank has increased the Bank's ability to retain deposits and has allowed it to be competitive in obtaining new funds, although the threat of disintermediation (the flow of funds away from the Bank into direct investment vehicles, such as common stocks and mutual funds) still exists. The ability of the Bank to attract and retain deposits and the Bank's cost of funds have been, and will continue to be, significantly affected by capital and money market conditions. Horizon Bank attempts to control the flow of deposits by pricing its accounts to remain competitive with other financial institutions in its market area but does not necessarily seek to match the highest rates paid by competing institutions. The senior officers of the Bank meet periodically to determine the interest rates which the Bank will offer to the general public. Such officers consider the amount of funds needed by the Bank on both a short-term and long-term basis, the rates being offered by the Bank's competitors, alternative sources of funds and the projected level of interest rates in the future. The Bank's deposits are obtained primarily from residents of Northwest Washington. Horizon Bank attracts deposits by offering a wide variety of services and convenient branch locations and service hours. Historically, the Bank has not solicited brokered deposits. For further information concerning the Bank's savings deposits, reference is made to Note 9 of the Notes to the Consolidated Financial Statements contained in Item 8 hereof. Borrowings. In December 1998, the Bank joined the Federal Home Loan Bank of Seattle providing access to a variety of wholesale funding options. In addition, the Bank's security portfolio provides additional borrowing capacity in the reverse repurchase markets. The Bank also has other borrowed funds in the form of retail repurchase agreements. The agreements are collateralized by securities held by a safekeeping agent not under control of the Bank. These advances are considered overnight borrowings bearing interest rates that fluctuate daily based on current market rates. At March 31, 2004, the Bank had $67.5 million in borrowings, compared to $53.8 million at March 31, 2003 and $29.1 million in borrowings during the year ended March 31, 2002. Access to these wholesale borrowings allows management to meet cyclical funding needs, and assists in interest rate risk management efforts. See Note 11 of the Notes to the Consolidated Financial Statements contained in Item 8 of the Form 10-K. 14 Competition ----------- The Bank faces strong competition in its market area in originating loans and attracting deposits. Competition in originating loans is primarily from other commercial banks, thrift institutions, mortgage companies, credit unions and consumer finance companies. The Bank competes for loan originations primarily through interest rates and loan fees it charges and through the efficiency and quality of services it provides borrowers. Competition is affected by, among other things, the general availability of lendable funds, general and local economic conditions and current interest rate levels. In attracting deposits, the Bank competes primarily with other commercial banks, thrift institutions, credit unions and brokerage firms. The Bank competes for customer deposits principally on the basis of convenience and quality of its banking services and the investment opportunities that satisfy the requirements of investors with respect to rate of return, liquidity, risk and other factors. The primary factors in competing for deposits are interest rates and the convenience of office locations. In light of the deregulation of interest rate controls on deposits, the Bank has faced increasing competition for deposits from commercial banks, other thrift institutions and non-regulated financial intermediaries. Personnel --------- At March 31, 2004, Horizon Bank employed 225 full-time and 18 part-time employees. Horizon Bank employees are not represented by any collective bargaining agreement. Management of Horizon Bank considers its relations with its employees to be good. Regulation and Supervision -------------------------- The Bank. General. As a state-chartered, federally insured bank, Horizon Bank is subject to extensive federal and state regulation. Lending activities and other investments must comply with various statutory and regulatory requirements, including prescribed minimum capital standards. Horizon Bank is regularly examined by the FDIC and the Washington Department of Financial Institutions, Division of Banks, and files periodic reports concerning the Bank's activities and financial condition with its regulators. The Bank's relationship with depositors and borrowers also is regulated to a great extent by both federal and state law, especially in such matters as the ownership of deposit accounts and the form and content of loan documents. The law and regulations of the State of Washington pertaining to banks and other corporations apply to the Bank. Among other things, those laws and regulations govern the Bank's investments and borrowings, loans, payment of interest and dividends, and establishment and relocation of branch offices. Federal and state banking laws and regulations govern all areas of the operation of the Bank, including reserves, loans, mortgages, capital, issuance of securities, payment of dividends and establishment of branches. Federal and state bank regulatory agencies also have the general authority to limit the dividends paid by insured banks and bank holding companies if such payments should be deemed to constitute an unsafe and unsound practice. The respective primary federal regulators of the Corporation and the Bank have authority to impose penalties, initiate civil and administrative actions and take other steps intended to prevent banks from engaging in unsafe or unsound practices. State Regulation and Supervision. As a state-chartered savings bank, the Bank is subject to applicable provisions of Washington law and regulations of the Washington Department of Financial Institutions. State law and regulations govern the Bank's ability to take deposits and pay interest, to make loans on or invest in residential and other real estate, to make consumer loans, to invest in securities, to offer various banking services to its customers, and to establish branch offices. Under state law, savings banks in Washington also generally have all of the powers that federal savings banks have under federal laws and regulations. The Bank is subject to periodic examination and reporting requirements by and of the Washington Department of Financial Institutions, Division of Banks. 15 Deposit Insurance. The FDIC is an independent federal agency that insures the deposits, up to applicable limits, of depository institutions. The FDIC currently maintains two separate deposit insurance funds: the BIF and the SAIF. The BIF is a deposit insurance fund for commercial banks and some state-chartered savings banks. The SAIF is a deposit insurance fund for most savings associations. The Bank is insured under the BIF fund. As an insurer of the Bank's deposits, the FDIC has examination, supervisory and enforcement authority over the Bank. The FDIC has established a risk-based system for setting deposit insurance assessments. Under the risk-based assessment system, an institution's insurance assessment varies according to the level of capital the institution holds, the balance of insured deposits during the preceding two quarters, and the degree to which it is the subject of supervisory concern. In addition, regardless of the potential risk to the insurance fund, federal law requires the ratio of reserves to insured deposits at $1.25 per $100. Both funds currently meet this reserve ratio. Since 1997, the assessment rate for both SAIF and BIF deposits has ranged from zero to 0.27% of covered deposits. As a well capitalized bank, Horizon Bank qualified for the lowest rate on its deposits for 2004. In addition to deposit insurance assessments, the FDIC is authorized to collect assessments against insured deposits to be paid to the Financing Corporation ("FICO") to service FICO debt incurred in the 1980's to help fund the thrift industry cleanup. The FICO assessment rate is adjusted quarterly. The FDIC may terminate the deposit insurance of any insured depository institution if it determines after a hearing that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, order or any condition imposed by an agreement with the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital. If insurance of accounts is terminated, the accounts at the institution at the time of termination, less subsequent withdrawals, shall continue to be insured for a period of six months to two years, as determined by the FDIC. Management is not aware of any existing circumstances that could result in termination of the deposit insurance of Horizon Bank. Capital Requirements. Federally insured savings institutions, such as Horizon Bank, are required to maintain a minimum level of regulatory capital. FDIC regulations recognize two types, or tiers, of capital: core ("Tier 1") capital and supplementary ("Tier 2") capital. Tier 1 capital generally includes common stockholders' equity and noncumulative perpetual preferred stock, less most intangible assets. Tier 2 capital, which is limited to 100 percent of Tier 1 capital, includes such items as qualifying general loan loss reserves, cumulative perpetual preferred stock, mandatory convertible debt, term subordinated debt and limited life preferred stock; however, the amount of term subordinated debt and intermediate term preferred stock (original maturity of at least five years but less than 20 years) that may be included in Tier 2 capital is limited to 50 percent of Tier 1 capital. The FDIC currently measures an institution's capital using a leverage limit together with certain risk-based ratios. The FDIC's minimum leverage capital requirement specifies a minimum ratio of Tier 1 capital to average total assets. Most banks are required to maintain a minimum leverage ratio of at least 4% to 5% of total assets. The FDIC retains the right to require a particular institution to maintain a higher capital level based on an institution's particular risk profile. The Bank's leverage ratio was 12.58% as of March 31, 2004. Horizon Bank has not been notified by the FDIC of any higher capital requirements specifically applicable to it. FDIC regulations also establish a measure of capital adequacy based on ratios of qualifying capital to risk- weighted assets. Assets are placed in one of four categories and given a percentage weight -- 0%, 20%, 50% or 100% -- based on the relative risk of that category. In addition, certain off-balance-sheet items are converted to balance-sheet credit equivalent amounts, and each amount is then assigned to one of the four categories. Under the guidelines, the ratio of total capital (Tier 1 capital plus Tier 2 capital) to risk-weighted assets must be at least 8%, and the ratio of Tier 1 capital to risk-weighted assets must be at least 4%. In evaluating the adequacy of a bank's capital, the FDIC may also consider other factors that may affect a bank's financial condition. Such factors may include interest rate risk exposure, liquidity, funding and market risks, the quality and level of earnings, concentration of credit risk, risks arising from nontraditional activities, loan and investment quality, the effectiveness of loan and investment policies, and management's 16 ability to monitor and control financial operating risks. At March 31, 2004, the Bank's determined that its total risk-based ratio was 16.6% and its Tier 1 risk-based capital ratio was 15.0%. The Washington Department of Financial Institutions requires that net worth equal at least 5% of total assets. Intangible assets must be deducted from net worth and assets when computing compliance with this requirement. At March 31, 2004, Horizon Bank had a net worth of 12.7% of total assets. Horizon Bank's management believes that, under the current regulations, the Bank will continue to meet its minimum capital requirements in the foreseeable future. However, events beyond the control of the Bank, such as a downturn in the economy in areas where the Bank has most of its loans, could adversely affect future earnings and, consequently, the ability of the Bank to meet its capital requirements. Federal Deposit Insurance Improvement Act ("FDICIA"). Horizon Bank has surpassed the $500 million asset threshold, and as such, is required to be compliant with the FDICIA originally enacted in 1991 and with enhanced provisions adopted in 1993. In general, FDICIA requires the Bank to conduct an annual independent audit of its financial statements, appoint an independent audit committee of outside directors, report on and assess management's responsibilities for preparing financial statements, and establish an internal control structure. An independent accountant must attest to and report on the assertions in management's reports concerning these internal controls with the desired outcome of efficient and effective operations; the safeguarding of assets; reliable financial reporting and compliance with applicable laws and regulations. The FDIC as the primary regulator of the Bank has outlined, in general, the requirements for compliance with FDICIA, but does not provide specific guidance on the internal control structure, documentation, or procedures to test the Bank's effectiveness. It is up to each bank to establish, document and design procedures to evaluate and test the internal control structure over financial reporting and compliance with designated laws and regulations that minimally include loans to insiders and dividend restrictions. In brief, to ensure compliance, the Bank has established and coordinated a management team that identifies and documents existing controls with consideration given to the Bank's control environment, risk assessment, control activities, information and communication systems, and monitoring activities. In addition, management establishes internal control procedures, develops and selects criteria for evaluation, tests the effectiveness of controls, and ensures that proper written documentation is in place. Under FDICIA, the Audit Committee has several responsibilities that include but are not limited to overseeing the internal audit function; conducting periodic meetings with management, the independent public accountant, and the internal auditors; review of significant accounting policies, and audit conclusions regarding significant accounting estimates; review of the assessments prepared by management and independent auditor on the adequacy of internal controls and the resolution of identified material weaknesses and reportable conditions in internal controls; and the review of compliance with laws and regulations. Federal Home Loan Bank System. The FHLB of Seattle serves as a reserve or central bank for the member institutions within its assigned region. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLBs. It makes loans (i.e., advances) to members in accordance with policies and procedures established by the Federal Housing Finance Board and the Board of Directors of the FHLB of Seattle. As a member, the Bank is required to purchase and hold stock in the FHLB of Seattle in an amount equal to the greater of 1% of their aggregate unpaid home loan balances at the beginning of the year or an amount equal to 5% of FHLB advances outstanding. As of March 31, 2004, Horizon Bank held stock in the FHLB of Seattle in the amount of $7.0 million. See "Business -- Savings Activities and Other Sources of Funds -- Borrowings." Federal Reserve System. The Federal Reserve Board requires (under "Regulation D") that all depository institutions, including savings banks, maintain reserves on transaction accounts and non-personal time deposits. These reserves may be in the form of cash or non-interest bearing deposits with the regional Federal Reserve Bank. NOW 17 accounts and other types of accounts that permit payments or transfers to third parties fall within the definition of transaction accounts and are subject to Regulation D reserve requirements, as are any non-personal time deposits at savings bank. Under Regulation D, a bank must maintain reserves against net transaction accounts, in the amount of 3% on amounts of $37.3 million or less, plus10% on amounts in excess of $37.3 million. In addition, a bank may designate and exempt $5.0 million of certain reservable liabilities from these reserve requirements. The amounts and percentages are subject to adjustment by the Federal Reserve. The reserve requirement on non-personal time deposits with original maturities of less than 1.5 years is 0%. As of March 31, 2004, the Bank was in compliance with the Federal Reserve Bank's reserve requirements. Prompt Corrective Action. Federal statutes establish a supervisory framework based on five capital categories: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. An institution's category depends upon where its capital levels are in relation to relevant capital measure, which include a risk-based capital measure, a leverage ratio capital measure, and certain other factors. The federal banking agencies have adopted regulations that implement this statutory framework. Under these regulations, an institution is treated as well capitalized if its ratio of total capital to risk-weighted assets is 10% or more, its ratio of core capital to risk-weighted assets is 6% or more, its ratio of core capital to adjusted total assets is 5% or more, and it is not subject to any federal supervisory order or directive to meet a specific capital level. In order to be adequately capitalized, an institution must have a total risk-based capital ratio of not less than 8%, a Tier 1 risk-based capital ratio of not less than 4%, and a leverage ratio of not less than 4%. Any institution which is neither well capitalized nor adequately capitalized will be considered undercapitalized. Undercapitalized institutions are subject to certain prompt corrective action requirements, regulatory controls and restrictions which become more extensive as an institution becomes more severely undercapitalized. Failure by the Bank to comply with applicable capital requirements would, if unremedied, result in restrictions on its activities and lead to enforcement actions, including, but not limited to, the issuance of a capital directive to ensure the maintenance of required capital levels. Banking regulators will take prompt corrective action with respect to depository institutions that do not meet minimum capital requirements. Additionally, approval of any regulatory application filed for their review may be dependent on compliance with capital requirements. The Corporation. General. The Corporation, as the sole shareholder of the Bank, is a bank holding company and is registered as such with the Federal Reserve. Bank holding companies are subject to comprehensive regulation by the Federal Reserve under the Bank Holding Company Act of 1956, as amended (the "BHCA"), and the regulations of the Federal Reserve. As a bank holding company, the Corporation is required to file with the Federal Reserve annual reports and such additional information as the Federal Reserve may require and will be subject to regular examinations by the Federal Reserve. The Federal Reserve also has extensive enforcement authority over bank holding companies, including, among other things, the ability to assess civil money penalties to issue cease and desist or removal orders and to require that a holding company divest subsidiaries (including its bank subsidiaries). In general, enforcement actions may be initiated for violations of law and regulations and unsafe or unsound practices. The Bank Holding Company Act. Under the BHCA, the Corporation is supervised by the Federal Reserve. The Federal Reserve has a policy that a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe or unsound manner. In addition, the Federal Reserve provides that bank holding companies should serve as a source of strength to its subsidiary banks by being prepared to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity, and should maintain the financial flexibility and capital raising capacity to obtain additional resources for assisting its subsidiary banks. A bank holding company's failure to meet its obligation to serve as a source of strength to its subsidiary banks will generally be considered by the Federal Reserve to be an unsafe and unsound banking practice or a violation of the Federal Reserve's regulations or both. 18 The Corporation is required to file quarterly and periodic reports with the Federal Reserve and provide additional information as the Federal Reserve may require. The Federal Reserve may examine the Corporation and any of its subsidiaries, and charge the Corporation for the cost of the examination. The Corporation and any subsidiaries that it may control are considered "affiliates" within the meaning of the Federal Reserve Act, and transactions between the Corporation's bank subsidiary and affiliates are subject to numerous restrictions. With some exceptions, the Corporation and its subsidiaries, are prohibited from tying the provision of various services, such as extensions of credit, to other services offered by the Corporation, or our affiliates. Gramm-Leach-Bliley Financial Services Modernization Act of 1999 (the "Act"). The Act modernized the financial services industry by establishing a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms and other financial service providers. Generally, the Act: (a) repealed the historical restrictions and eliminated many federal and state law barriers to affiliations among banks, securities firms, insurance companies and other financial service providers; (b) provided a uniform framework for the functional regulation of the activities of banks, savings institutions and their holding companies; (c) broadened the activities that may be conducted by national banks, banking subsidiaries of bank holding companies and their financial subsidiaries; (d) provided an enhanced framework for protecting the privacy of consumer information; and (e) addressed a variety of other legal and regulatory issues affecting day-to-day operations and long-term activities of financial institutions. The USA Patriot Act. In response to the terrorist events of September 11, 2001, the President of the United States signed into law the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, or the USA Patriot Act, on October 26, 2001. 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. By way of amendments to the Bank Secrecy Act, Title III of the USA Patriot Act takes measures intended to encourage information sharing among bank regulatory agencies and law enforcement bodies. Further, certain provisions of Title III impose affirmative obligations on a broad range of financial institutions. Among other requirements, Title III of the USA Patriot Act imposes the following requirements with respect to financial institutions: * Financial institutions must establish anti-money laundering programs that include: (i) internal policies, procedures, and controls; (ii) specific designation of an anti-money laundering compliance officer; (iii) ongoing employee training programs; and (iv) an independent audit function to test the anti-money laundering program. * Financial institutions that establish, maintain, administer, or manage private banking accounts or correspondent accounts in the United States for non-United States persons or their representatives must establish appropriate, specific, and, where necessary, enhance due diligence policies, procedures, and controls designed to detect and report money laundering. * Financial institutions are prohibited from establishing, maintaining, administering or managing correspondent accounts for foreign banks that do not have a physical presence in any country and will be subject to certain recordkeeping obligations with respect to correspondent accounts of foreign banks. 19 * Bank regulators must consider a holding company's effectiveness in combating money laundering when ruling on Federal Reserve Act and Bank Merger Act applications. The Corporation's policies and procedures have been updated to reflect the requirements of the USA Patriot Act. No significant changes in the Corporation's business or customer practices were required as a result of the implementation of these requirements. Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley Act") was signed into law by the President of the United States on July 30, 2002 in response to public concerns regarding corporate accountability in connection with the recent accounting scandals. The stated goals of the Sarbanes-Oxley Act are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws. The Sarbanes-Oxley Act generally applies to all companies, both U.S. and non-U.S., that file or are required to file periodic reports with the Securities and Exchange Commission ("SEC"), under the Securities Exchange Act of 1934 ("Exchange Act"). The Sarbanes-Oxley Act includes very specific additional disclosure requirements and new corporate governance rules, requires the SEC and securities exchanges to adopt extensive additional disclosure, corporate governance and other related rules and mandates further studies of certain issues by the SEC and the Comptroller General. The Sarbanes-Oxley Act represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of directors and management and between a board of directors and its committees. The Sarbanes-Oxley Act addresses, among other matters: * audit committees; * certification of financial statements by the chief executive officer and the chief financial officer; * the forfeiture of bonuses or other incentive-based compensation and profits from the sale of an issuer's securities by directors and senior officers in the twelve month period following initial publication of any financial statements that later require restatement; * a prohibition on insider trading during pension plan black out periods; * disclosure of off-balance sheet transactions; * a prohibition on personal loans to directors and officers; * expedited filing requirements for Form 4s; * disclosure of a code of ethics and filing a Form 8-K for a change or waiver of such code; * "real time" filing of periodic reports; * the formation of a public accounting oversight board; * auditor independence; and * various increased criminal penalties for violations of securities laws. Acquisitions. Under the BHCA, a bank holding company must obtain Federal Reserve approval before: (1) acquiring, directly or indirectly, ownership or control of any voting shares of another bank or bank holding company if, 20 after such acquisition, it would own or control more than 5% of such shares (unless it already owns or controls the majority of such shares); (2) acquiring all or substantially all of the assets of another bank or bank holding company; or (3) merging or consolidating with another bank holding company. The BHCA also prohibits a bank holding company, with certain exceptions, from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank or bank holding company, or from engaging directly or indirectly in activities other than those of banking, managing or controlling banks, or providing services for its subsidiaries. The principal exceptions to these prohibitions involve certain non-bank activities which, by statute or by Federal Reserve regulation or order, have been identified as activities closely related to the business of banking or managing or controlling banks. The list of activities permitted by the Federal Reserve includes, among other things, operating a savings institution, mortgage company, finance company, credit card company or factoring company, performing certain data processing operations; providing certain investment and financial advice; underwriting and acting as an insurance agent for certain types of credit-related insurance; leasing property on a full-payout, non-operating basis; selling money orders, travelers' checks and United States Savings Bonds; real estate and personal property appraising; providing tax planning and preparation services; and, subject to certain limitations, providing securities brokerage services for customers. Dividends. The Federal Reserve's policy statement on the payment of cash dividends by bank holding companies expresses the Federal Reserve's view that a bank holding company should pay cash dividends only to the extent that the company's net income for the past year is sufficient to cover both the cash dividends and a rate of earning retention that is consistent with the company's capital needs, asset quality and overall financial condition. The Federal Reserve also indicated that it would be inappropriate for a company experiencing serious financial problems to borrow funds to pay dividends. Capital Requirements. The Federal Reserve has established capital requirements for bank holding companies that generally parallel the capital requirements for national banks under the Office of the Comptroller of the Currency's regulations. Under the Federal Reserve Board's capital guidelines, at March 31, 2004, the Corporation's levels of consolidated regulatory capital exceed the Federal Reserve's minimum requirements, as follows: Amount Percent ------ ------- (Dollars in thousands) Tier 1 Capital $103,505 14.99% Minimum Tier 1 (leverage) requirement 32,954 4.00 -------- ----- Excess $ 70,551 10.99% ======== ===== Risk-based capital $114,607 16.60% Minimum risk-based capital requirement 55,247 8.00 -------- ----- Excess $ 59,360 8.60% ======== ===== Stock Repurchases. Bank holding companies, except for certain "well-capitalized" and highly rated bank holding companies, are required to give the Federal Reserve prior written notice of any purchase or redemption of its outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months, is equal to 10% or more of their consolidated net worth. The Federal Reserve may disapprove such a purchase or redemption if it determines that the proposal would constitute an unsafe or unsound practice or would violate any law, regulation, Federal Reserve order, or any condition imposed by, or written agreement with, the Federal Reserve. The Corporation has been in various buy-back programs of its outstanding Common Stock since August 1996. In March 2004, the Board of Directors approved a new stock repurchase plan that runs concurrent with the 2005 fiscal year, allowing the Corporation to repurchase up to 10% of total shares outstanding, or approximately 1.04 million shares. This marked the Corporation's sixth stock repurchase plan. In fiscal 2004, under the previous plans, the Corporation 21 repurchased 314,240 shares at an average price of $17.353. For additional information concerning the Corporation's repurchase activities during the fourth quarter of fiscal 2004, see Item 5 hereof. Taxation -------- Federal Taxation. General. The Corporation and the Bank report their consolidated income on a fiscal year basis using the accrual method of accounting and are subject to federal income taxation in the same manner as other corporations with some exceptions, including particularly the Bank's reserve for bad debts discussed below. The following discussion of tax matters is intended only as a summary and does not purport to be a comprehensive description of the tax rules applicable to the Bank or the Corporation. Reference is made to Note 12 of the Notes to the Consolidated Financial Statements contained in Item 8 of this Form 10-K for additional information concerning the income taxes payable by the Bank. Tax Bad Debt Reserves. Historically, savings institutions such as the Bank, which met certain definitional tests primarily related to their assets and the nature of their businesses, were permitted to establish a reserve for bad debts and to make annual additions to the reserve. These additions may, within specified formula limits, have been deducted in arriving at the Bank's taxable income. For purposes of computing the deductible addition to its bad debt reserve, the Bank's loans are separated into "qualifying real property loans" (i.e., generally those loans secured by interests in residential real property) and all other loans ("non-qualifying loans"). The following formulas were used to compute the bad debt deduction with respect to qualifying real property loans: (i) actual loss experience or (ii) a percentage equal to 8% of taxable income. The deduction with respect to non-qualifying loans was computed under the experience method. Reasonable additions to the reserve for losses on non-qualifying loans were based upon actual loss experience and would reduce the current year's addition to the reserve for losses on qualifying real property loans, unless that addition was also determined under the experience method. The sum of the additions to each reserve for each year was the Bank's annual bad debt deduction. The provisions repealing the current thrift bad debt rules were passed by Congress as part of "The Small Business Job Protection Act of 1996." The new rules eliminate the 8% of taxable income method for deducting additions to the tax bad debt reserves for all financial institutions for tax years beginning after December 31, 1995. These rules also require that all institutions recapture all or a portion of their bad debt reserves added since the base year (last taxable year beginning before January 1, 1988). The Bank has previously recorded a deferred tax liability equal to the bad debt recapture and as such the new rules will have no effect on the net income or federal income tax expense. For taxable years beginning after December 31, 1995, the Bank's bad debt deduction will be determined under the experience method using a formula based on actual bad debt experience over a period of years or, if the Bank is a "large" association (assets in excess of $500 million) on the basis of net charge-offs during the taxable year. The new rules allow an institution to suspend bad debt reserve recapture for the 1996 and 1997 tax years if the institution's lending activity for those years is equal to or greater than the institution's average mortgage lending activity for the six taxable years preceding 1996 adjusted for inflation. For this purpose, only home purchase or home improvement loans are included and the institution can elect to have the tax years with the highest and lowest lending activity removed from the average calculation. If an institution is permitted to postpone the reserve recapture, it must begin its six year recapture no later than the 1998 tax year. The unrecaptured base year reserves will not be subject to recapture as long as the institution continues to carry on the business of banking. In addition, the balance of the pre-1988 bad debt reserves continue to be subject to provisions of present law referred to below that require recapture in the case of certain excess distributions to shareholders. Distributions. If a stock institution distributes amounts to stockholders and the distribution is treated as being from its accumulated bad debt reserves, the distribution will cause the institution to have additional taxable income. A distribution to stockholder is deemed to have been made from accumulated bad debt reserves to the extent that (i) the reserves exceed the amount that would have been accumulated on the basis of actual loss experience, and (ii) the distribution is a "non-dividend distribution." A distribution in respect of stock is a non-dividend distribution to the extent that, for federal income tax purposes, (i) it is redemption of shares, (ii) it is pursuant to a liquidation or partial liquidation of the institution, or (iii) in the case of current distribution, together with all other such distributions during the taxable 22 year, it exceeds the institution's current and post-1951 accumulated earnings and profits. The amount of additional taxable income created by a non-dividend distribution is an amount that, when reduced by tax attributable to it, is equal to the amount of the distribution. Minimum Tax. In addition to regular corporate income tax, corporations are subject to an alternative minimum tax which generally is equal to 20% of alternative minimum taxable income (taxable income, increased by tax preference items and adjusted for certain regular tax items). The preference items which are generally applicable include an amount equal to 75% of the amount by which a financial institution's adjusted current earnings (generally alternative minimum taxable income computed without regard to this preference and prior to reduction for net operating losses) exceeds its alternative minimum taxable income without regard to this preference and the excess of the institution's bad debt deduction over the amount deductible under the experience method, as discussed below. Alternative minimum tax paid can be credited against regular tax due in later years. Audits. The Bank has not been audited by the IRS during the past five years. Washington Taxation. The Bank is subject to a business and occupation tax which is imposed under Washington law at the rate of 1.50% of gross receipts; however, interest received on loans secured by mortgages or deeds of trust on residential properties is not subject to such tax. The Bank's business and occupation tax returns were audited in November 1995. Available Information --------------------- The Corporation's Internet address is www.horizonbank.com. You may access, free of charge, copies of the following documents from the Corporation's website by using the "About Us/Investor Relations" hyperlink: * Annual Reports on Form 10-K; * Quarterly Reports on Form 10-Q; and * Current Reports on Form 8-K. The Corporation makes these reports and certain other information that it files available on its website as soon as reasonably practicable after filing or furnishing them electronically with the SEC. These and other SEC filings the Corporation are also available, free of charge, from the SEC on its website at www.sec.gov. The information contained on the Corporation's website is not incorporated by reference into this document and should not be considered a part of this Annual Report on Form 10-K. The Corporation's website address is included in this document as an inactive textual reference only. 23 Item 2. Properties ------------------- The following table sets forth the location of the Bank's offices, as well as certain information relating to these offices. Net Book Year Value as of Square Leased/ Opened March 31, 2004 Feet Owned ------ -------------- ---- ----- (In thousands) Bellingham Main Office............ 1971 $1,414 19,179 Owned 1500 Cornwall Avenue Bellingham, WA 98225 Bellingham/Meridian............... 1987 696 4,650 Owned 4110 Meridian Bellingham, WA 98226 Ferndale Office................... 1976 282 3,692 Owned Third and Main Ferndale, WA 98248 Lynden Office..................... 1981 493 3,702 Owned Third and Grover Lynden, WA 98264 Blaine Office..................... 1976 506 3,610 Owned Fourth & "H" Streets Blaine, WA 98230 Mount Vernon Office............... 1976 $ 266 3,275 Owned 1503 Riverside Dr. Mount Vernon, WA 98273 Anacortes Office.................. 1987 737 3,650 Owned 1218 Commercial Avenue Anacortes, WA 98221 Snohomish Office.................. 1987 162 1,388 Owned 620 2nd Street Snohomish, WA 98290 Everett Office.................... 1991 29 1,972 Leased 909 S.E. Everett Mall Way, #E-500 Everett, WA 98208 Burlington Office................. 1994 1,210 3,980 Owned 1020 S. Burlington Blvd Burlington, WA 98232 (table continues on following page) 24 Net Book Year Value as of Square Leased/ Opened March 31, 2004 Feet Owned ------ -------------- ---- ----- (In thousands) Edmonds Office.................... 1994 2,088 15,265 Owned 130 Fifth Avenue South Edmonds, WA 98020 Murphy's Corner Office............ 2000 1,701 3,720 Owned 12830 Bothell Everett Hwy. Everett, WA 98208 Barkley Office.................... 1999 3,105 14,691 Owned 2122 Barkley Blvd. Bellingham, WA 98228 Holly Street Office............... 1999 439 4,000 Owned 211 E. Holly Street Bellingham, WA 98227 Alabama Office.................... 1999 691 4,500 Owned 802 Alabama Street Bellingham, WA 98228 Marysville Office (1)............. -- 676 -- Owned 3609 88th St NE Marysville, WA 98270 Lynnwood Office................... 2003 $2,448 4,230 Owned 19405 44th Avenue W. Lynnwood, WA 98036 Whatcom Commercial Center......... 2003 190 5,200 Leased 2211 Rimland Drive, Suite 230 Bellingham, WA 98226 Snohomish Commercial Center....... 2003 60 1,700 Leased 906 S. Everett Mall Way, Suite 140 Everett, WA 98208 ------------ (1) To open late fiscal 2005. At March 31, 2004, the aggregate book value of the Corporation's premises and equipment was $17.2 million. Item 3. Legal Proceedings -------------------------- Neither the Corporation nor the Bank is engaged in any legal proceedings of a material nature at the present time. From time to time it is a party to legal proceedings wherein it enforces its security interest in loans made by it. Item 4. Submission of Matters to a Vote of Security Holders ------------------------------------------------------------ Not applicable. 25 PART II Item 5. Market for Registrant's Common Equity, Related Stockholder Matters --------------------------------------------------------------------------- and Issuer Purchases of Equity Securities ----------------------------------------- Horizon Financial Corp.'s Common Stock is traded on The Nasdaq Stock Market under the symbol HRZB. The Common Stock began trading on the Nasdaq Stock Market at the time of Horizon's conversion to stock form in August 1986. The following table presents the high and low prices as reported by the Nasdaq Stock Market and dividends paid for the last two fiscal years. These prices represent quotations by the dealers and do not necessarily represent actual transactions, and do not include retail markups, markdowns or commissions. The Corporation has approximately 4,500 shareholders. 2004 Fiscal Year Quarter High Low Dividend ---------------- ---- --- -------- Fourth $19.39 $16.82 $0.125 Third 19.00 16.25 0.125 Second 17.73 14.98 0.120 First 18.00 14.17 0.120 2003 Fiscal Year Quarter High Low Dividend ---------------- ---- --- -------- Fourth $15.70 $12.11 $0.115 Third 12.48 10.21 0.115 Second 12.80 10.00 0.110 First 13.28 9.88 0.110 Dividend Policy --------------- Horizon Financial Corp. historically has paid cash dividends on its Common Stock. The Corporation must adhere to certain regulatory requirements governing the distribution of dividends, and there can be no assurance that the Corporation will continue to declare cash dividends in the future. Stock Repurchases ----------------- The Corporation has had various buy-back programs since August 1996. Repurchases of the Corporation's outstanding Common Stock were authorized by the Board of Directors in (i) October 2000 for the repurchase of up to 10% (approximately 1,121,250 shares, as restated) over a 24 month period that resulted in the repurchase of 769,058 shares at an average price of $9.88 per share, (ii) October 2002 for the repurchase of up to 10% (approximately 1,065,000 shares) over a 12 month period that resulted in the repurchase of 358,100 shares at an average price of $15.277 per share, and (iii) September 2003 for the repurchase of up to 10% (approximately 1,050,000 shares) for a 12 month period that, as of the year ended March 31, 2004, had resulted in the repurchase of 151,840 shares at an average price of $18.39 per share. Repurchases in fiscal 2004 totaled 314,240 shares, at an average price of $17.353 per share. 26 The following table sets forth the Corporation's repurchases of its outstanding Common Stock during the fourth quarter of the year ended March 31, 2004. Issuer Purchases of Equity Securities ------------------------------------------------- (d) Maximum (c) Number (or Total Number Approximate of Shares Dollar Value) (or Units) of Shares (or (a) Purchased as Units that May Total (b) Part of Yet to Be Number of Average Publicly Purchased Shares (or Price Paid Announced Under the Units) per Share Plans or Plans or Period Purchased (or Unit) Programs Programs ------------------------ --------- --------- -------- -------- January 1, 2004 - January 31, 2004........ 5,600 $18.926 89,440(1) 960,560 February 1, 2004 - February 29, 2004....... 37,100 18.929 126,540(1) 923,460 March 1, 2004 - March 31, 2004.......... 25,300 19.00 151,840(1) 898,160 Total..................... 68,000 18.954 151,840(1) 1,040,000(2) --------------- (1) Reflects purchases made under the repurchase plan authorized by the Board of Directors in September 2003. (2) Reflects new repurchase plan authorized by the Board of Directors in March 2004. Item 6. Selected Financial Data -------------------------------- The following table sets forth certain information concerning the financial position of the Corporation at and for the dates indicated. March 31, ---------------------------------------------- 2004 2003 2002 2001 2000 ---- ---- ---- ---- ---- (In thousands) Financial Condition Data: ------------------------ Total Assets............ $858,876 $819,872 $772,063 $729,736 $713,914 Loans Receivable, net... 658,226 582,269 568,303 597,382 589,584 Cash and Investment Securities............ 161,071 197,296 171,346 106,117 99,375 Deposits................ 670,259 646,722 628,782 595,914 564,327 Borrowings.............. 67,469 53,763 29,121 22,938 39,853 Stockholders' Equity.... 109,307 106,244 100,600 97,909 95,935 (table continues on following page) 27 Year Ended March 31, ---------------------------------------------- 2004 2003 2002 2001 2000 ---- ---- ---- ---- ---- (In thousands) Operating Data: -------------- Interest Income........ $48,979 $50,698 $ 53,312 $ 56,017 $50,046 Interest Expense....... (15,509) (19,461) (26,541) (32,239) (26,257) ------- ------- -------- -------- ------- Net Interest Income.... 33,470 31,237 26,771 23,778 23,789 Other Income........... 7,881 6,939 4,393 2,771 2,752 Non-interest Expense... (20,238) (17,346) (14,891) (13,756) (13,243) Provision for Loan Losses........... (1,915) (2,740) (1,089) (320) (437) ------- ------- -------- -------- ------- Income Before Taxes.... 19,198 18,090 15,184 12,473 12,861 Provision for Income Tax............ (6,332) (5,950) (5,130) (4,202) (4,180) ------- ------- -------- -------- ------- Net Income............. $12,866 $12,140 $ 10,054 $ 8,271 $ 8,681 ======= ======= ======== ======== ======= Per Common Share:(1) Fully-diluted earnings............. $1.20 $1.12 $0.91 $0.72 $0.70 Dividends............. 0.49 0.45 0.38 0.34 0.33 Equity................ 10.50 10.07 9.35 8.84 8.06 Weighted average shares outstanding..10,480,785 10,674,506 10,921,233 11,441,342 12,228,884 ---------- (1) Restated for 15% stock dividend effective May 11, 2001 and 25% stock split effective July 23, 2002. Key Operating Ratios: -------------------- The table below sets forth certain performance ratios of the Corporation for the periods indicated. These ratios are calculated based on month end balances. At and for the Year Ended March 31, ----------------------- 2004 2003 2002 ---- ---- ---- Return on average assets (net income divided by average total assets).............. 1.55% 1.52% 1.35% Return on average equity (net income divided by average equity).................... 11.94 11.69 10.14 Dividend payout ratio (dividends declared per share divided by fully-diluted earnings per share).................................... 40.83 40.18 42.11 Equity to assets ratio (average equity divided by average total assets).............. 13.02 13.02 13.29 Interest rate spread (difference between average yield on interest-earning assets and average cost of interest bearing liabilities). 4.24 4.01 3.39 Net yield on earning assets (net interest income as a percentage of average interest earning assets)............................... 4.42 4.26 3.81 Efficiency ratio............................... 48.94 45.44 47.78 28 Item 7. Management's Discussion and Analysis of Financial Condition and ------------------------------------------------------------------------ Results of Operations --------------------- The following discussion is intended to assist in understanding the financial condition and results of operations of the Corporation and its subsidiary. The information contained in this section should be read in conjunction with the Consolidated Financial Statements and the accompanying Notes contained in Item 8 herein. Forward Looking Statements -------------------------- This Form 10-K contains forward-looking statements which are based on assumptions and describe future plans, strategies and expectations of the Corporation. These forward-looking statements are generally identified by use of the word "believe," "expect," "intend," "anticipate," "estimate," "project," or similar words. The Corporation's ability to predict results of the actual effect of future plans or strategies is uncertain. Factors which could have a material adverse effect on the Corporation's operations include, but are not limited to, changes in interest rates, general economic conditions, legislative/regulatory changes, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality or composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Corporation's market areas and accounting principles and guidelines. These risks and uncertainties should be considered in evaluating forward-looking statements and you should not rely too much on these statements. General ------- The Corporation's results of operations depend primarily on revenue generated as a result of its net interest income and non-interest income. Net interest income is the difference between the interest income the Corporation earns on its interest-earning assets (consisting primarily of loans and investment securities) and the interest the Corporation pays on its interest-bearing liabilities (consisting primarily of customer savings and money market accounts, time deposits and borrowings). Non-interest income consists primarily of service charges on deposit and loan accounts, gains on the sale of loans and investments, and loan servicing fees. The Corporation's results of operations are also affected by our provisions for loan losses and other expenses. Other expenses consist primarily of non-interest expense, including compensation and benefits, occupancy, equipment, data processing, marketing, automated teller machine costs and, when applicable, deposit insurance premiums. The Corporation's results of operations may also be affected significantly by general and local economic and competitive conditions, changes in market interest rates, governmental policies and actions of regulatory authorities. Operating Strategy ------------------ The Corporation does not presently engage in any activities outside of serving as a shell parent company for the Bank. The operating strategy of the Corporation has been to expand and diversify the consolidated operations of the Corporation across a variety of companies and/or operating units that are engaged in complementary, but different, businesses and/or operating strategies. This diversification strategy is expected to continue as opportunities arise, although there are no specific acquisitions or new business formations planned at this time. The primary business of the Bank is to acquire funds in the form of deposits and wholesale funds, and to use the funds to make commercial, consumer, and real estate loans in its primary market area. In addition, the Bank invests in a variety of investment grade securities including, but not necessarily limited to U.S. Government and federal agency obligations, mortgage-backed securities, corporate debt, equity securities, and municipal securities. The Bank intends to continue to fund its assets primarily with retail and commercial deposits, although FHLB advances, and other wholesale borrowings, may be used as a supplemental source of funds. The Corporation's profitability depends primarily on its net interest income, which is the difference between the income it receives on the Bank's loan and investment portfolio and the Bank's cost of funds, which consists of interest paid on deposits and borrowings. 29 Net interest income is also affected by the relative amounts of interest-earning assets and interest-bearing liabilities. When interest-earning assets equal or exceed interest-bearing liabilities, any positive interest rate spread will generate net interest income. The Corporation's profitability is also affected by the level of the Bank's other income and expenses. Other noninterest income includes income associated with the origination and sale of mortgage loans, loan servicing fees and net gains and losses on sales of interest-earning assets. Other noninterest expenses include compensation and benefits, occupancy and equipment expenses, deposit insurance premiums, data servicing expenses and other operating costs. The Corporation's results of operations are also significantly affected by general economic and competitive conditions, particularly changes in market interest rates, government legislation, regulation, and monetary and fiscal policies. The Bank's business strategy is to operate as a well-capitalized, profitable and independent community bank, dedicated to commercial lending, home mortgage lending, consumer lending, small business lending and providing quality financial services to local personal and business customers. The Bank has sought to implement this strategy by: (i) focusing on commercial banking opportunities; (ii) continued efforts towards the origination of residential mortgage loans, including one- to- four family residential construction loans; (iii) providing high quality, personalized financial services to individuals and business customers and communities served by its branch network; (iv) selling many of its fixed rate mortgages to the secondary market; (v) focusing on asset quality; (vi) containing operating expenses; and (vii) maintaining capital in excess of regulatory requirements combined with prudent growth. Critical Accounting Estimate ---------------------------- Management recognizes that loan losses occur over the life of a loan, and that the allowance for loan losses must be maintained at a level sufficient to absorb probable losses inherent in the loan portfolio. Management's determination of the allowance is based on a number of factors, including the level of non-performing loans, loan loss experience, credit concentrations, a review of the quality of the loan portfolio, collateral values and uncertainties in economic conditions. The allowance is increased by the provision for loan losses, which is charged against current period operating results and decreased by the amount of actual loan charge-offs, net of recoveries. Management believes that the accounting estimate related to the allowance for loan losses is a "critical accounting estimate" because: (1) it is highly susceptible to change from period to period because it requires management to make assumptions about future losses on loans; and (2) the impact of a sudden large loss could deplete the allowance and potentially require increased provisions to replenish the allowance, which would negatively affect earnings. The Corporation operates under a general loan loss reserve system. The allowance for loan losses is maintained at a level sufficient to provide for estimated loan losses based on evaluating known and inherent risks in the loan portfolio. These factors include changes in the size and composition of the loan portfolio, actual loan loss experience, current and anticipated economic conditions, detailed analysis of individual loans for which full collectibility may not be assured, and determination of the existence and realizable value of the collateral and guarantees securing the loans. The reserve is based upon factors and trends identified by management at the time financial statements are prepared, but the ultimate recovery of loans is susceptible to future market factors beyond the Bank's control, which may result in losses or recoveries differing significantly from those provided for in the financial statements. The Bank maintains an allowance for credit losses sufficient to absorb losses inherent in the loan portfolio. The Bank has established a systematic methodology to ensure that the allowance is adequate. The allowance is calculated by applying a loss percentage factor to the various loan pool types based on past due ratios, historical loss experience, the regulatory and internal credit grading and classification systems, and general economic conditions that could affect the collectibility of the portfolio. These factors may be adjusted for events that are significant in management's judgment as of the evaluation date. The conditions evaluated in connection with the general allowance include loan volumes and concentrations, seasoning of the loan portfolio, specific industry conditions within portfolio segments, governmental regulatory actions, recent loss experience in a particular segments of the portfolio and the duration of the current business cycle. The general 30 allowance addresses risks in the portfolio that are not specifically associated with a pool or individual loan but exist due to changes in economic conditions, rapid loan portfolio growth, changes in credit underwriting, weakness in specific loan markets, unseasoned nature of loan portfolio, and new loan products. The Corporation's senior management reviews and analyzes the loan portfolio, charge-offs, and allowance on a quarterly basis. Management then discusses the development and calculation of this critical accounting estimate with the executive committee of the Board of Directors. The audit committee also reviews the Corporation's disclosures including this critical accounting estimate. Management reviewed and evaluated the loan portfolio and the adequacy of the allowance at March 31, 2004 and believes that the allowance is adequate for the risk inherent in the loan portfolio considering the growth, unseasoned loans, and relatively weak economic environment. In the review, management determined that the allowance was adequate at 1.5% of gross loans, or $10.1 million. The allowance was 1.4% of gross loans or $8.5 million at March 31, 2003. In fiscal 2004, the loan portfolio grew 13.0% to $658.2 million at March 31, 2004 from $582.3 million at March 31, 2003. The strong portfolio growth in the last few years has resulted in a relatively unseasoned loan portfolio which has the potential for increased loan losses. The loan portfolio has experienced substantial growth especially in multi-family and commercial real estate loans. At March 31, 2004, the multi-family and commercial real estate portfolios totaled $310.7 million up from the $239.1 million and $198.3 million for the years ended March 31, 2003 and 2002, respectively. The increase in the allowance is primarily attributable to the substantial growth in the loan portfolio and the unseasoned nature of the portfolio, all of which has occurred in a relatively weak economic environment. The Bank recorded net charge-offs of $300,000, $121,000, $179,000, $100,000, and $143,000 during the years ended March 31, 2004, 2003, 2002, 2001, and 2000, respectively. Consumer loans (including home equity) totaled $32.6 million or 4.8% of the loan portfolio at March 31, 2004. Visa card loans and one commercial loan accounted for all of the Bank's charge-offs. Based on historical trends, the Bank is expected to continue to charge-off consumer loans in excess of $100,000 a year. The provision for loan losses has fluctuated depending on the growth of the loan portfolio and the level of charge-offs especially during weak economic times. The provision for loan losses was $1.9 million, $2.7 million, $1.1 million, $320,000, and $437,000 for the fiscal years ended 2004, 2003, 2002, 2001, and 2000, respectively. If management's estimate of the allowance deviated by plus or minus 10% then the $10.1 million allowance would either decrease to $9.1 million or increase to $11.1 million. The provision for loan losses would then subsequently decrease or increase by $1.0 million. Accordingly, net income would increase or decrease by $668,000 after federal income taxes. Critical Accounting Policies ---------------------------- The Corporation's significant accounting principles are described in Note 1 of the Notes to Consolidated Financial Statements included in Item 8 of this report and are essential to understanding Management's Discussion and Analysis of Financial Condition and Results of Operations. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions which affect the reported amounts and disclosures. Actual results may differ from these estimates under different assumptions or conditions. The following policies involve a higher degree of judgment than do our other significant accounting policies detailed in Note 1 of the Notes to Consolidated Financial Statements included in Item 8 of this report. Allowance for Loan Losses. The Corporation reviews historical origination and charge-off relationships, charge-off experience factors, collection data, delinquency reports, estimates of the value of the underlying collateral, economic conditions and trends and other information in order to make the necessary judgments as to the appropriateness of the provision for loan losses and the allowance for loan losses. Loans are charged-off to the allowance for loan losses when the Corporation repossesses and disposes of the collateral or the account is otherwise deemed uncollectible. The Corporation believes that the allowance for loan losses is adequate to cover probable losses inherent in its loan portfolio; however, because the allowance for loan losses is based on estimates, there can be no assurance that the ultimate charge-off amount will not exceed such estimates. 31 Investments. The Corporation classifies its investments as either available-for-sale or held-to-maturity. Available-for-sale securities are reported at their fair value, which is determined by obtaining quoted market prices. Unrealized gains and losses on available-for-sale securities are included in other comprehensive income and excluded from earnings. Realized gains and losses and declines in fair value judged to be other than temporary are included in earnings. The fair value of investments is discussed in more detail in Notes 3 and 4 of the Notes to Consolidated Financial Statements included in Item 8 of this report. Long-Lived Assets and Intangibles. The Corporation periodically assesses the impairment of its long-lived assets and intangibles using judgment as to the effects of external factors, including market conditions. Judgment is also required in projecting future operating results. If actual external conditions and future operating results differ from the Corporation's judgments, impairment charges may be necessary to reduce the carrying value of these assets to the appropriate market value. Accrued Taxes. The Corporation estimates tax expense based on the amount it expects to owe various tax authorities. Taxes are discussed in more detail in Note 12 of the Notes to Consolidated Financial Statements included in Item 8 of this report. Accrued taxes represent the net estimated amount due or to be received from taxing authorities. In estimating accrued taxes, management assesses the relative merits and risks of the appropriate tax treatment of transactions taking into account statutory, judicial and regulatory guidance in the context of our tax position. Financial Condition ------------------- Total consolidated assets for the Corporation as of March 31, 2004, were $858.9 million, a 4.8% increase from the March 31, 2003, level of $819.9 million. This increase in assets was due primarily to the growth in loans receivable to $658.2 million at March 31, 2004 versus $582.3 million at March 31, 2003. This growth was primarily attributable to the growth in commercial loans during this period, as the Bank continued its practice of selling most of its single-family fixed rate loan production into the secondary market. The Bank sold $216.8 million of real estate loans in fiscal 2004, compared to $216.2 million in fiscal 2003. The Bank sells real estate loans during periods of increased loan volume to improve cash flow and to manage its interest rate risk profile. Also contributing to the increase in assets was the change in investment securities, available for sale, which increased 14.3% to $85.2 million at March 31, 2004 from $74.6 million at March 31, 2003. The tables below display the characteristics of the available for sale ("AFS") and held to maturity ("HTM") portfolios as of March 31, 2004: As of March 31, 2004 ---------------------------------- Amortized Net Estimated Cost Gain/Loss Fair Value --------- --------- ---------- (In thousands) Available-For-Sale Securities ("AFS") State and political subdivisions and U.S. government agency securities.... $ 57,397 $1,604 $ 59,001 Marketable equity securities........... 1,831 5,465 7,296 Mutual funds........................... 5,000 (20) 4,980 Corporate debt securities.............. 13,434 473 13,907 Mortgage-backed securities and CMO's... 27,363 397 27,760 -------- ------ -------- Total available-for-sale securities.. $105,025 $7,919 $112,944 -------- ------ -------- Held-To-Maturity Securities ("HTM") State and political subdivisions and U.S. government agency securities.... $ 369 $ 31 $ 400 Mortgage-backed securities and CMO's... 1,544 109 1,653 -------- ------ -------- Total held-to-maturity securities.... 1,913 140 2,053 -------- ------ -------- Total securities..................... $106,939 $8,059 $114,997 ======== ====== ======== 32 Maturity Schedule of Securities as of March 31, 2004 --------------------------------------------- - Available-For-Sale Held-To-Maturity ---------------------- -------------------- - Amortized Estimated Amortized Estimated Cost Fair Value Cost Fair Value -------- ---------- -------- --------- - (In thousands) Maturities: One year.................... $ 14,525 $ 14,764 $ 1 $ 1 Two to five years........... 51,605 53,429 1,232 1,317 Five to ten years........... 7,958 8,186 439 469 Over ten years.............. 24,106 24,288 241 266 -------- -------- -------- -------- 98,194 100,667 1,913 2,053 -------- -------- -------- -------- Mutual funds and marketable equity securities (liquid)... 6,831 12,277 -- -- -------- -------- -------- -------- Total investment securities................. $105,025 $112,944 $ 1,913 $ 2,053 ======== ======== ======== ======== Total liabilities also increased 5.0% to $749.6 million at March 31, 2004, from $713.6 million at March 31, 2003. This increase in liabilities was due in large part to the growth in deposits, which increased 3.6% to $670.3 million at March 31, 2004 from $646.7 million at March 31, 2003. The following is an analysis of the deposit portfolio by major type of deposit at March 31, 2004 and March 31, 2003: 2004 2003 -------- -------- (In thousands) Demand Deposits Savings ............................ $ 40,527 $ 38,455 Checking............................ 78,697 66,169 Checking (noninterest-bearing)...... 44,774 28,052 Money Market........................ 131,310 125,805 -------- -------- 295,308 258,481 -------- -------- Time certificates of deposit Less than $100,000.................. 245,608 258,623 Greater than or equal to $100,000... 129,343 129,617 -------- -------- 374,951 388,241 -------- -------- Total deposits ..................... $670,259 $646,722 ======== ======== Also contributing to the growth was an increase in other borrowed funds to $67.5 million at March 31, 2004, from $53.8 million at March 31, 2003. During the year, an additional $19.0 million was borrowed from the Federal Home Loan Bank to help control interest rate risk and support the growth in assets. Shareholders' equity at March 31, 2004 increased 2.9% to $109.3 million from $106.2 million at March 31, 2003. This increase was due primarily to the increase in net income of $12.9 million less dividends paid and shares repurchased. The Corporation remains strong in terms of its capital position, with a shareholder equity-to-assets ratio of 12.7% at March 31, 2004, compared to 13.0% at March 31, 2003. Results of Operations --------------------- Net Interest Income. Net interest income in fiscal 2004 was $33.5 million, a 7.2% increase from fiscal 2003 of $31.2 million, compared to $26.8 million in fiscal 2002. Total interest income decreased 3.4% in fiscal 2004 to $49.0 million from $50.7 million in fiscal 2003, compared to $53.3 million in fiscal 2002. 33 Interest income on loans in fiscal 2004 was $43.8 million, a 1.8% decrease from $44.6 million in fiscal 2003, compared to $47.6 million in fiscal 2002. The decreases in fiscal 2004 and 2003 were due primarily to the overall decline in interest rates. The decrease in fiscal 2002 was due primarily to the decrease in loans receivable resulting from the sale of mortgage loans in the secondary market. Included in these amounts for 2004, 2003 and 2002 are approximately $1.9 million, $1.9 million and $2.0 million, respectively, of deferred fee income as a result of loan paydowns, payoffs, and loans sold from the available for sale mortgage portfolio. Interest and dividends on investments and mortgage-backed securities was $5.1 million in fiscal 2004, a 15.4% decrease from $6.1 million in fiscal 2003, compared to $5.7 million in fiscal 2002. The decrease in fiscal 2004 was due to principal paydowns in the CMO and mortgage backed securities portion of the Bank's investment portfolio and an overall decline in interest rates. The increase in fiscal 2003 was due to the overall growth in the investment portfolio compared to the prior year. The decrease in fiscal 2002 was due in part to the sale of selected long-term fixed rate mortgage-backed securities during the year, which shifted a portion of the investment portfolio into liquid, short-term assets with less interest rate risk. Total interest expense in fiscal 2004 decreased 20.3% to $15.5 million from $19.5 million in fiscal 2003, compared to $26.5 million in fiscal 2002. Interest on deposits decreased 25.2% in fiscal 2004 to $13.2 million, compared to $17.7 million in fiscal 2003, and $25.0 million in fiscal 2002. The decreases in fiscal 2004, 2003 and 2002 were due to the overall decline in interest rates. Interest on borrowings increased to $2.3 million in fiscal 2004, compared to $1.8 million in fiscal 2003, and $1.5 million in fiscal 2002. The increase in fiscal 2004 was due to a higher level of borrowings outstanding of $67.5 million at March 31, 2004 versus $53.8 million at March 31, 2003, and $29.1 million at March 31, 2002. The Bank continues to carry wholesale borrowings in order to further leverage its balance sheet and better manage its interest rate risk profile. Provision for loan losses. Provisions for loan losses are charges to earnings to bring the total allowance for loan losses to a level considered by management as adequate to provide for known and inherent risks in the loan portfolio, based on management's continuing analysis of factors underlying the quality of the loan portfolio. These factors include changes in portfolio size and composition, actual loss experience, current economic conditions, detailed analysis of individual loans for which full collectibility may not be assured, and determination of the existence and realizable value of the collateral and guarantees securing the loans. The provision for loan losses was $1.9 million for the year ended March 31, 2004 compared to $2.7 million and $1.1 million for the years ended March 31, 2003 and 2002, respectively. This change resulted from management's ongoing analysis of changes in loan portfolio composition by collateral categories, overall credit quality of the portfolio, peer group analysis, and current economic conditions. The reserve for loan losses was $10.1 million, or 1.5% of loans receivable at March 31, 2004, compared to $8.5 million, or 1.5% of loans receivable at March 31, 2003. The increased allowance level resulted from continued loan portfolio growth in the higher-risk lending categories of commercial and multi-family construction/permanent loans and business loans during the period, which comprised $443.6 million, or 67.4% of the portfolio at March 31, 2004, versus $360.5 million, or 61.9% at March 31, 2003. In addition, commercial and multi-family loans have larger individual loan amounts, which have a greater single impact on the total portfolio quality in the event of delinquency or default. The Corporation considers these increased provisions to be appropriate, due to the changing portfolio mix and the uncertain regional economic environment. Northwest Washington's economy has been adversely affected by a number of factors, including but not limited to slowdowns in the aerospace, technology and telecommunications industries. As of March 31, 2004, there were eight loans in the loan portfolio over 90 days delinquent and no loans on non-accrual status. At March 31, 2004 total non-performing loans were $338,000. Real estate owned at March 31, 2004 totaled $63,000. Total non-performing assets represented $402,000, or 0.1% of total assets at March 31, 2004 compared to $1.7 million, or 0.2% of total assets at March 31, 2003. 34 As of March 31, ------------------ 2004 2003 -------- -------- (Dollars in thousands) Non-Performing Assets Accruing loans 90 days past due........... $339 $350 Non-accrual loans......................... -- 242 ----- ----- Total non-performing loans................ 339 592 Total non-performing loans/net loans...... 0.05% 0.10% Real estate owned......................... 63 1,072 ----- ----- Total non-performing assets............... 402 1,664 ----- ----- Total non-performing assets/total assets.. 0.05% 0.20% Noninterest Income. Noninterest income in fiscal 2004 was $7.9 million, an increase of 13.6% from fiscal 2003 of $7.0 million, compared to $4.4 million in fiscal 2002. Contributing to the increase in fiscal 2004 was the increase in services fees of 26.4% to $2.9 million in fiscal 2004 from $2.3 million in fiscal 2003 and fiscal 2002. The primary reasons for this increase was the growth in deposits and revisions to the Bank's fee schedules during the year. The net gain or loss on sales of investment securities increased to $689,000 in fiscal 2004 from $62,000 in fiscal 2003 and from $249,000 in fiscal 2002. The gains in these periods were due primarily to the sale of selected common stocks and mortgage backed securities from the AFS investment portfolio. Other non-interest income increased 6.0% to $1.9 million in fiscal 2004 from $1.8 million in fiscal 2003 and $533,000 in fiscal 2002. The primary reason for the increase in fiscal 2004 was the recognition of approximately $422,000 in profits through March 31, 2004 compared to approximately $206,000 in profits in the prior period from a real estate development joint venture of the Bank's wholly owned subsidiary, Westward Financial Services Corporation. The increase in fiscal 2003 was due to the recognition of income related to approximately $10.0 million in bank-owned life insurance which was acquired in late March and early April 2002. Noninterest Expense. Noninterest expense in fiscal 2004 increased to $20.2 million, a 16.7% increase from fiscal 2003 of $17.3 million, compared to fiscal 2002 of $14.9 million. Compensation and employee benefits increased 23.1% in fiscal 2004 to $11.5 million from $9.4 million in fiscal 2003, compared to $7.8 million in fiscal 2002. The increases in compensation and employee benefits during fiscal 2004 and 2003 were primarily due to the overall growth in employment at the Corporation, including key additions to staff as the Corporation continues its efforts to enhance its commercial banking expertise, along with additional staff for the Lynnwood office and new commercial banking loan centers. Building occupancy expense was $2.6 million in fiscal 2004, a 13.1% increase from $2.3 million in fiscal 2003 and fiscal 2002. The increase in fiscal 2004 was due to the opening of our Lynnwood office, three new commercial banking/loan centers in Bellingham, Snohomish, and Everett, and the expansion of the Burlington office/commercial center. Other noninterest expenses increased 16.7% to $4.7 million in fiscal 2004 from $4.0 million in fiscal 2003, compared to $3.0 million in fiscal 2002. The increases in fiscal 2004 and 2003 were primarily due to the overall growth of the Corporation and a decreasing mortgage servicing portfolio as a result of the increased refinance activity due to the low rate environment which results in increased amortization of the associated mortgage servicing asset. Also contributing to the increase in fiscal 2004 was an increase in Business and Occupation (B&O) tax expense due to the shift in the loan portfolio from one-to-four family mortgages, which are exempt from B&O tax, to B&O taxable commercial loans. Data processing expenses decreased in fiscal 2004 to $558,000 from $838,000 in fiscal 2003, compared to $970,000 in fiscal 2002. The primary reason for this decline relates to a renegotiation of the Bank's contract with its core data processor which included substantial concessions in the first quarter of fiscal 2004, and a reduced monthly expense thereafter. Subsequent to year end, the Corporation entered into a five year service agreement with a third party 35 processor for account processing services, development services and software products. Included in this agreement are system conversion services, for which the third party processor will bill the Corporation on a monthly basis, as services are used and products installed. Advertising and marketing expenses increased 3.5% to $784,000 in fiscal 2004 from $758,000 in fiscal 2003 compared to $728,000 in fiscal 2002. The increases in fiscal 2004 and 2003 were due primarily to additional marketing. In connection with the Bank's expanded commercial product lines and services, the transition to a new advertising and marketing agency, and the development of a new brand strategy for the Bank. Provisions for Income Tax. Income tax expense increased to $6.3 million in fiscal 2004, from $5.9 million in fiscal 2003, compared to $5.1 million in fiscal 2002. The Corporation's effective tax rate was approximately 33.0% in each of the past three fiscal years. Net Income. Net income of $12.9 million for fiscal 2004 represents a 6.0% increase from net income of $12.1 million for fiscal 2003, compared to net income of $10.0 million in fiscal 2002. Basic earnings per share for 2004 was $1.23 on weighted average shares of 10,480,785 compared to basic earnings per share of $1.14 on weighted average shares of 10,674,506 in fiscal 2003, and basic earnings per share of $0.92 on weighted average shares of 10,921,233 in fiscal 2002. Yields Earned and Rates Paid ---------------------------- The Corporation's pre-tax earnings depend primarily on its net interest income, the difference between the income it receives on the loan portfolio and other investments and its cost of money, consisting primarily of interest paid on savings deposits, and other borrowings. Net interest income is affected by (i) the difference between rates of interest earned on its interest-earning assets and rates paid on its interest-bearing liabilities ("interest rate spread") and (ii) the relative amounts of its interest-earning assets and interest-bearing liabilities. When interest-earning assets approximate or exceed interest-bearing liabilities, any positive interest rate spread will generate net interest income. Financial institutions have traditionally used interest rate spreads as a measure of net interest income. Another indicator of an institution's net interest income is its "Net Interest Margin" which is net interest income divided by average interest earning assets. 36 The following table presents at the date and for the periods indicated, the total dollar amount of interest income and interest expense, as well as the resulting yields earned and rates paid. At March 31, Year Ended March 31, -------------- --------------------------------------------------------------------------- - 2004 2004 2003 2002 -------------- ------------------------ ------------------------ ----------------------- - Average Average Average Average Yield/ Average Yield/ Average Yield/ Average Yield/ Balance Cost Balance Interest Cost Balance Interest Cost Balance Interest Cost ------- ---- ------- -------- ---- ------- -------- ---- ------- -------- ---- (Dollars in thousands) Interest- earning assets: Loans re- ceivable(1)..$658,226 7.15% $613,474 $43,842 7.15% $573,814 $44,157 7.69% $576,406 $47,352 8.21% Investment securities(2) 106,321 3.51 107,832 3,787 3.51 122,313 4,139 3.39 87,634 3,412 3.89 Mortgage- backed securities... 29,304 3.67 36,780 1,350 3.67 36,115 1,933 5.35 37,970 2,327 6.13 -------- ----- -------- ------- ----- -------- ------- ----- -------- ------- ----- Total interest- earning assets....... 793,851 6.46 758,086 48,979 6.46 732,242 50,229 6.86 702,010 53,091 7.56 Interest- bearing liabilities: Deposits...... 670,259 2.06 641,691 13,225 2.06 633,796 17,673 2.79 604,607 24,996 4.13 Borrowings.... 67,469 4.06 56,318 2,285 4.06 38,276 1,788 4.67 27,131 1,544 5.69 -------- ----- -------- ------- ----- -------- ------- ----- -------- ------- ----- Total interest- bearing liabilities.. 737,728 2.22 698,009 15,510 2.22 672,072 19,461 2.90 631,738 26,540 4.20 ------- ------- ------- Net interest income........ $33,470 $30,768 $26,551 ======= ======= ======= Interest rate spread........ 4.24% 3.96% 3.36% ===== ===== ===== Net interest margin........ 4.42% 4.20% 3.78% ===== ===== ===== Ratio of aver- age interest- earning assets to average interest- bearing lia- bilities...... 108.61% 108.95% 111.12% ====== ====== ====== ---------- (1) Average balances include nonaccrual loans, if any. Interest income on nonaccural loans has been included. (2) The yield on investment securities is calculated using historical cost basis. 37
Rate/Volume Analysis -------------------- The table below sets forth certain information regarding changes in interest income and interest expense for the Corporation for the periods indicated. For each category of interest-earning asset and interest-bearing liability, information is provided on changes attributable to (1) changes in volume (change in volume multiplied by old rate); (2) changes in rates (change in rate multiplied by old volume); (3) changes to rate-volume (changes in rate multiplied by the change in volume); and (4) the total changes (the sum of the prior columns). Year Ended March 31, --------------------------------------------------------------------- 2004 vs. 2003 2003 vs. 2002 --------------------------------- -------------------------------- Increase (Decrease) Increase (Decrease) Due to Due to --------------------------------- -------------------------------- Rate/ Rate/ Volume Rate Volume Total Volume Rate Volume Total ------ ---- ------ ----- ------ ---- ------ ----- (In thousands) Interest income: Interest and fees on loans..... $3,019 $(3,566) $(237) $ (784) $(212) $(2,995) $ 13 $(3,194) Investment securities and other interest-bearing securities.................... (529) (444) 39 (934) 1,521 (943) (246) 332 ------ ------- ----- ------- ------ ------- ----- ------- Total interest-earning assets.. $2,490 $(4,010) $(198) $(1,718) $1,309 $(3,938) $(233) $(2,862) ====== ======= ====== ======= ====== ======= ===== ======= Interest expense: Deposit accounts............... $ 219 $(4,610) $ (57) $(4,448) $1,211 $(8,141) $(393) $(7,323) Borrowings..................... 839 (232) (110) 497 634 (277) (113) 244 ------ ------- ----- ------- ------ ------- ----- ------- Total interest-bearing liabilities................... $1,058 $(4,842) $(167) $(3,951) $1,845 $(8,418) $(506) $(7,079) ====== ======= ====== ======= ====== ======= ===== =======
Liquidity and Capital Resources ------------------------------- The Bank maintains liquid assets in the form of cash and short-term investments to provide a source to fund loans, savings withdrawals, and other short-term cash requirements. At March 31, 2004, the Bank had liquid assets (cash and marketable securities with maturities of one year or less) with a book value of $74.0 million. As of March 31, 2004, the total book value of investments and mortgage-backed securities was $106.9 million compared to a market value of $115.0 million with an unrealized gain of $8.0 million. As of March 31, 2003, the total book value of investments and mortgage-backed securities was $106.5 million compared to a market value of $115.9 million with an unrealized gain of $9.4 million. The Corporation foresees no factors that would impair its ability to hold debt securities to maturity. As indicated on the Corporation's Consolidated Statement of Cash Flows contained in Item 8 hereof, the Corporation's primary sources of funds are cash flow from operations, which consist primarily of mortgage loan repayments, deposit increases, loan sales, borrowings, and cash received from the maturity or sale of investment securities. The Corporation's liquidity fluctuates with the supply of funds and management believes that the current level of liquidity is adequate at this time. If additional liquidity is needed, the Corporation's options include, but are not necessarily limited to: (1) selling additional loans in the secondary market; (2) entering into reverse repurchase agreements; (3) borrowing from the FHLB of Seattle; (4) accepting additional jumbo and/or public funds deposits; or (5) accessing the discount window of the Federal Reserve Bank of San Francisco. Shareholders' equity as of March 31, 2004 was $109.3 million, or 12.7% of assets, compared to $106.2 million, or 13.0% of assets at March 31, 2003. The Bank continues to exceed the 5.0% minimum tier one capital required by the FDIC in order to be considered well capitalized. The Bank's total risk-adjusted capital ratio as of March 31, 2004 38 was 16.6%, compared to 18.7% as of March 31, 2003. These figures are well above the well-capitalized minimum of 10% set by the FDIC. The Corporation has been in various buy-back programs since August 1996. In March 2004, the Board of Directors approved a new stock repurchase plan that runs concurrent with the 2005 fiscal year, allowing the Corporation to repurchase up to 10% of total shares outstanding, or approximately 1.04 million shares. This marked the Corporation's sixth stock repurchase plan. In fiscal 2004, under the previous plans, the Corporation repurchased 314,240 shares at an average price of $17.353. For additional information concerning the Corporation's repurchase activities during the fourth quarter of fiscal 2004, see Item 5 hereof. Management intends to continue its stock buy-back programs from time to time as long as repurchasing the stock is perceived to contribute to the overall growth of shareholder value. The number of shares of stock that will be repurchased and the price that will be paid is the result of many factors, several of which are outside of the control of the Corporation. The primary factors, however, are market and economic factors such as the price at which the stock is trading in the market, the number of shares available in the market; the attractiveness of other investment alternatives in terms of the rate of return and risk involved in the investment; the ability to increase the value and/or earnings per share of the remaining outstanding shares, and the Corporation's liquidity and capital needs and regulatory requirements. Presently, it is management's belief that purchases made under the current Board approved plan will not materially affect the Corporation's capital or liquidity position. Quantitative and Qualitative Disclosures About Market Risk ---------------------------------------------------------- The Corporation continues to be exposed to interest rate risk, although at reduced levels compared to prior years. Currently, the Corporation's assets and liabilities are not materially exposed to foreign currency or commodity price risk. At March 31, 2004, the Corporation had no off-balance sheet derivative financial instruments, nor did it have a trading portfolio of investments. In fiscal 2004 and fiscal 2003, the Corporation continued to improve its interest rate risk analysis efforts by outsourcing its interest rate risk modeling to a third party provider that utilizes an IPS Sendero model@ . This model analyzes the Corporation's major balance sheet components, and attempts to estimate the changes to the Corporation's income statement and economic value of equity, under a variety of interest rate change scenarios. The figures contained in the table presented below, in the Quantitative Disclosures About Market Risk section, were derived from this model. While numerous assumptions go into this modeling, and undue reliance should not be placed on the specific results, management believes that this improved modeling will enhance its interest rate risk management efforts. In years prior to fiscal 2002, the Corporation analyzed its interest rate sensitivity using GAP analysis. The interest rate GAP is defined as the difference between the amount of interest-earning assets maturing or repricing within a specific time period, and the interest-bearing liabilities maturing or repricing within that same time period. A GAP is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate liabilities during the same period. Banks with a positive GAP are considered "Asset Sensitive". A GAP is considered negative when the amount of interest sensitive liabilities exceeds the amount of interest sensitive assets. Banks with a negative GAP are considered "Liability Sensitive." Regardless of the method used (the more sophisticated model being used currently, or the GAP analysis performed in prior years) the Corporation's balance sheet has historically been considered liability sensitive, due to the assumption that its liabilities (primarily comprised of liquid deposit accounts and certificates of deposit) would reprice more rapidly than its assets (which are primarily longer term loans). However, recent interest rate risk modeling shows that the Corporation is currently moderately asset sensitive. This is due in large part to the growth in variable rate and shorter term commercial loans on the Corporation's Balance Sheet. Also contributing to this change is the growth in wholesale borrowings in recent years, most of which with maturities greater than three years at the time of the borrowing. Other factors, such as prepayments on mortgages and investments, the interest rate sensitivity of deposits, the overall level of interest rates, and general economic conditions can also have significant effects on the Corporation's performance in a changing interest rate environment. For example, at the end of fiscal 2004, interest rates were near historically low 39 levels. As a result, the Corporation's liability rates already reflect the impact of a lower rate environment. Therefore, further declines in rates would not likely result in improved profitability for the Corporation. In the past three fiscal years, the balance sheet was further diversified by adding variable rate loans, shorter term fixed rate loans, and a decreased reliance on certificates of deposits for its funding needs. As a result of the Bank's shift in focus to a community commercial bank, the balance sheet has become slightly asset sensitive. For example, with the level of interest rates at March 31, 2004, and the associated prepayment assumptions in the low-rate environment, interest rate risk modeling predicts moderate improvement in the Bank's performance in a moderately higher rate environment. However, as interest rates increase, prepayment assumptions can change significantly, therefore it would be inappropriate to assume that significantly higher rates would have a sustained positive effect on the Bank's and the Corporation's performance. Further, an increase in rates, without a corresponding increase in certain indices (such as Prime), would adversely affect the Corporation's performance. For example, if it becomes necessary for the Corporation to increase the rates it pays to attract funds in a rising rate environment, an absence of a corresponding increase in Prime would, of course, negatively affect performance. In addition, depending on timing differences, the magnitude of various rates change in future quarters, and the composition of the Corporation's balance sheet, future modeling efforts may show the Corporation's returning to a liability sensitive position. Management continues to monitor these areas, in its ongoing effort to manage the Corporation's interest rate risk. Effects of Interest Rate Floors ------------------------------- Periodically, the Corporation is able to establish interest rate floors on certain loans, in order to enhance the Corporation's profitability. At March 31, 2004, the Corporation had $212.6 in commercial loans tied to Prime. Of these Prime based loans, approximately 63% will increase immediately when Prime increases due to the lack of difference between the loan's current rate and any floors in place. Approximately 12% of the Corporation's Prime Based loans are at their floor, and require an increase of 0.50% before floating; 12% will float only after an increase of 1.0%; 11% require an increase of 1.50%; and the balance of the Prime based portfolio will float only after Prime increases 2.0% to 3.0%. While these floors provide an overall better return for the Corporation, the information provided in this section is intended to provide additional information regarding the degree to which the Corporation's earnings may be enhanced due to future increases in Prime. Quantitative Disclosures About Market Risk. The table below represents the balances of the Bank's financial instruments at March 31, 2004. The expected maturity categories take into consideration projected prepayment rates as well as actual amortization of principal. In preparation of the table, numerous assumptions were made regarding prepayment rates and deposit account interest sensitivity. Amor- tized Fair Average Within 1 Year to 2 Years 3 Years Beyond Cost Value Yield 1 Year 2 Years to 3 Years to 5 Years 5 Years Total Total ----- ------ ------- ---------- ---------- ------- ----- ----- (Dollars in thousands) Interest-Sensitive Assets: Loans receivable......... 7.15% $335,489 $131,681 $73,299 $96,347 $21,410 $658,226 $665,897 Mortgage-backed securities............. 3.71 9,277 3,297 2,874 6,234 7,225 28,907 29,413 Investments and other interest-earning assets. 3.51 50,734 22,688 10,411 18,726 3,255 98,799 106,352 (table continued on following page)
40 Amor- tized Fair Average Within 1 Year to 2 Years 3 Years Beyond Cost Value Yield 1 Year 2 Years to 3 Years to 5 Years 5 Years Total Total ----- ------ ------- ---------- ---------- ------- ----- ----- (Dollars in thousands) Interest-Sensitive Liabilities: Checking accounts........ 0.46 7,870 17,367 17,367 23,105 57,762 123,471 123,471 Money market/ ultimate accounts....... 1.08 91,918 9,848 9,848 5,628 14,069 131,311 131,311 Savings accounts......... 0.73 8,105 4,053 4,053 6,947 17,369 40,527 40,527 Certificates of deposit.. 2.99 220,406 79,520 30,505 44,520 -- 374,951 380,778 Other borrowings......... 4.06 11,969 12,000 13,500 30,000 -- 67,469 69,275 Off-Balance Sheet Items: Commitments to extend credit........... 5.00 33,233 -- -- -- -- 33,233 33,233 Unused lines of credit... 5.75 47,042 -- -- -- -- 47,042 47,042 Credit card arrange- ments................... 11.88 7,991 -- -- -- -- 7,991 7,991
As with any method of measuring interest rate risk, certain shortcomings are inherent in the method of analysis presented in the foregoing table. For example, although certain assets and liabilities may have similar maturities, they may react in different degrees to changes in market interest rates. In addition, in the event of changes in interest rates, expected rates of prepayments on loans and withdrawals from savings accounts might deviate significantly from those assumed in presenting the table. Therefore, the data presented in the table should not be relied upon as necessarily indicative of actual future results. Contractual Obligations ----------------------- In the normal course of business, the Corporation enters into contractual obligations that meet various business needs. These contractual obligations include time deposits to customers, borrowings from the FHLB of Seattle and lease obligations for facilities. See Note 9, 11 and 16 of the Notes to Consolidated Financial Statements included in Item 8 of this report for additional information. The following table summarizes the Corporation's long-term contractual obligations at March 31, 2004: Less than One to Three to One Three Five Year Years Years Thereafter Total -------- -------- ------- ---------- -------- (In thousands) Time deposits............. $212,282 $112,933 $46,849 $2,887 $374,951 Long-term borrowings...... 11,969 25,500 30,000 -- 67,469 Operating lease obligations.............. 205 327 171 130 833 -------- -------- ------- ------ -------- Total................. $224,456 $138,760 $77,020 $3,017 $443,253 ======== ======== ======= ====== ======== Off-Balance Sheet Arrangements ------------------------------ In the normal course of business, the Corporation makes off-balance sheet arrangements, including credit commitments to its customers to meet their financial needs. These arrangements involve, to varying degrees, elements of credit and interest rate risk not recognized in the consolidated statement of financial condition. The Bank makes personal, commercial, and real estate lines of credit available to customers as well as stand by letters of credit or financial guarantees. 41 Commitments to extend credit to customers are subject to the Bank's normal credit policies and are essentially the same as those involved in extending loans to customers. See Note 19 of the Notes to Consolidated Financial Statements included in Item 8 of this report for additional information. Impact of Inflation ------------------- The Consolidated Financial Statements and related financial data presented herein have been prepared in accordance with accounting principles generally accepted in the United States of America. These principles generally require the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative purchasing power of money over time due to inflation. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. The primary impact of inflation is reflected in the increased cost of our operations. As a result, interest rates generally have a more significant impact on a financial institution's performance than do general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services. In a period of rapidly rising interest rates, the liquidity and maturities structures of our assets and liabilities are critical to the maintenance of acceptable performance levels. The principal effect of inflation on earnings, as distinct from levels of interest rates, is in the area of non-interest expense. Expense items such as employee compensation, employee benefits and occupancy and equipment costs may be subject to increases as a result of inflation. An additional effect of inflation is the possible increase in dollar value of the collateral securing loans that we have made. Our management is unable to determine the extent, if any, to which properties securing loans have appreciated in dollar value due to inflation. Recent Accounting Pronouncements -------------------------------- For a discussion of new accounting pronouncements and their impact on the Corporation, see Note 1 of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K. Item 7A. Quantitative and Qualitative Disclosures About Market Risk ------------------------------------------------------------------- Information required by this item is incorporated herein by reference to the section captioned "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Quantitative and Qualitative Disclosures About Market Risk" contained in Item 7 hereof. Item 8. Financial Statements and Supplementary Data ---------------------------------------------------- (a) (1) Financial Statements. Page -------------------- ---- Independent Auditor's Report 43 Consolidated Statement of Financial Position, March 31, 2004 and 2003 44 Consolidated Statement of Income for the years ended March 31, 2004, 2003 and 2002 45 Consolidated Statement of Stockholders' Equity for the years ended March 31, 2004, 2003 and 2002 46 Consolidated Statement of Cash Flows for the years ended March 31, 2004, 2003 and 2002 47 Notes to Consolidated Financial Statements 48 42 Independent Auditor's Report To the Stockholders and Directors Horizon Financial Corp. We have audited the accompanying consolidated statement of financial position of Horizon Financial Corp. and Subsidiary as of March 31, 2004 and 2003, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the three years in the period ended March 31, 2004. 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 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Horizon Financial Corp. and Subsidiary as of March 31, 2004 and 2003, and the results of their operations and cash flows for each of the three years in the period ended March 31, 2004, in conformity with accounting principles generally accepted in the United States of America. /s/ Moss Adams LLP Bellingham, Washington April 16, 2004 43 HORIZON FINANCIAL CORP. CONSOLIDATED STATEMENT OF FINANCIAL POSITION MARCH 31, 2004 AND 2003 ----------------------------------------------------------------------------- - Assets 2004 2003 ------------ ------------ Cash and cash equivalents $ 18,431,964 $ 15,083,505 Interest-bearing deposits 20,767,398 59,929,418 Investment securities Available-for-sale (amortized cost 2004: $77,662,276; 2003: $66,206,662) 85,183,872 74,560,801 Held-to-maturity (estimated fair value 2004: $400,299; 2003: $402,020) 369,444 369,292 Mortgage-backed securities Available-for-sale (amortized cost 2004: $27,362,914; 2003: $37,140,593) 27,759,813 37,921,192 Held-to-maturity (estimated fair value 2004: $1,653,590; 2003: $2,983,743) 1,544,034 2,793,089 Federal Home Loan Bank Stock 7,014,900 6,638,500 Loans receivable, net of allowance for loan losses of $10,121,532 in 2004 and $8,506,133 in 2003 658,226,144 582,269,145 Loans held for sale 1,333,500 2,838,300 Accrued interest and dividends receivable 4,032,007 4,620,466 Premises and equipment, net 17,193,671 15,934,254 Real estate owned 63,432 1,072,341 Net deferred income tax assets 831,123 - Other assets 16,124,579 15,841,571 ------------ ------------ TOTAL ASSETS $858,875,881 $819,871,874 ============ ============ Liabilities and Stockholders' Equity Deposits $670,259,218 $646,722,160 Accounts payable and other liabilities 8,301,761 8,048,477 Other borrowed funds 67,468,842 53,762,740 Advances by borrowers for taxes and insurance 416,899 986,702 Income tax currently payable 1,375,274 906,003 Net deferred income tax liabilities - 1,531,504 Deferred compensation 1,746,894 1,670,770 ------------ ------------ Total liabilities 749,568,888 713,628,356 ------------ ------------ COMMITMENTS AND CONTINGENCIES STOCKHOLDERS' EQUITY Serial preferred stock, $1 par value, 10,000,000 shares authorized; none issued or outstanding - - Common stock, $1 par value, 30,000,000 shares authorized; 10,405,331 and 10,550,113 issued and outstanding, respectively 10,405,331 10,550,113 Additional paid-in capital 56,893,824 57,352,824 Retained earnings 36,925,836 32,527,963 Unearned ESOP shares (144,205) (216,309) Accumulated other comprehensive income 5,226,207 6,028,927 ------------ ------------ Total stockholders' equity 109,306,993 106,243,518 ------------ ------------ TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $858,875,881 $819,871,874 ============ ============ See accompanying notes to these financial statements 44 HORIZON FINANCIAL CORP. CONSOLIDATED STATEMENT OF INCOME YEARS ENDED MARCH 31, 2004, 2003, AND 2002 ----------------------------------------------------------------------------- - 2004 2003 2002 ----------- ----------- ----------- INTEREST INCOME Interest on loans $43,842,447 $44,626,384 $47,572,857 Investment and mortgage-backed securities Taxable interest 4,474,212 5,336,638 4,991,974 Nontaxable interest income 111,519 37,855 46,168 Dividends 551,436 696,866 700,875 ----------- ----------- ----------- Total interest income 48,979,614 50,697,743 53,311,874 ----------- ----------- ----------- INTEREST EXPENSE Interest on deposits 13,224,629 17,672,959 24,996,112 Interest on other borrowings 2,284,728 1,788,142 1,544,457 ----------- ----------- ----------- Total interest expense 15,509,357 19,461,101 26,540,569 ----------- ----------- ----------- Net interest income 33,470,257 31,236,642 26,771,305 PROVISION FOR LOAN LOSSES 1,915,000 2,740,000 1,089,642 ----------- ----------- ----------- Net interest income after provision for loan losses 31,555,257 28,496,642 25,681,663 ----------- ----------- ----------- NONINTEREST INCOME Service fees 2,860,089 2,262,860 2,308,411 Other 1,938,208 1,828,618 533,476 Net gain (loss) on sales of loans - servicing retained 195,354 100,413 (252,984) Net gain on sales of loans - servicing released 2,198,500 2,685,251 1,554,853 Net gain on sale of investment securities 689,350 62,258 249,393 ----------- ----------- ----------- Total noninterest income 7,881,501 6,939,400 4,393,149 ----------- ----------- ----------- NONINTEREST EXPENSE Compensation and employee benefits 11,520,922 9,359,463 7,852,528 Building occupancy 2,641,378 2,335,481 2,324,248 Other expenses 4,733,971 4,055,430 3,016,851 Data processing 557,803 837,983 969,739 Advertising 784,149 757,602 727,542 ----------- ----------- ----------- Total noninterest expense 20,238,223 17,345,959 14,890,908 ----------- ----------- ----------- INCOME BEFORE PROVISION FOR INCOME TAX 19,198,535 18,090,083 15,183,904 PROVISION FOR INCOME TAX Current 8,281,271 7,457,372 5,866,947 Deferred (1,949,104) (1,507,160) (737,000) ----------- ----------- ----------- Total provision for income tax 6,332,167 5,950,212 5,129,947 ----------- ----------- ----------- NET INCOME $12,866,368 $12,139,871 $10,053,957 =========== =========== =========== BASIC EARNINGS PER SHARE $ 1.23 $ 1.14 $ .92 =========== =========== =========== DILUTED EARNINGS PER SHARE $ 1.20 $ 1.12 $ .91 =========== =========== =========== See accompanying notes to these financial statements 45 HORIZON FINANCIAL CORP. CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY YEARS ENDED MARCH 31, 2004, 2003, AND 2002 ----------------------------------------------------------------------------------------------------------- - Common Stock Accumulated ------------------------ Additional Unearned Other Number of At Par Paid-In Retained ESOP Comprehensive Shares Value Capital Earnings Shares Income (Loss) ---------- ----------- ------------ ------------ --------- ----------- BALANCE, March 31, 2001 8,861,238 $ 8,861,238 $ 62,380,016 $ 23,046,017 $ (360,517) $3,982,603 Comprehensive income Net income - - - 10,053,957 - - Other comprehensive income Change in unrealized gains on available-for-sale securities, net taxes of $87,116 - - - - - 169,107 Total other comprehensive income - - - - - - Comprehensive income - - - - - - Recognition of ESOP shares released - - - - 72,104 - Cash dividends on common stock at $.48 per share - - - (4,172,135) - - Dividend reinvestment plan 16,879 16,879 190,371 - - - Stock options exercised 57,288 57,288 291,998 - - - Stock dividend - fractional shares adjustment (336) (336) (3,368) 3,704 - - Treasury stock purchased - - - - - - Retirement of treasury stock (327,952) (327,952) (2,430,779) (1,230,604) - - ---------- ------------ ------------ ------------ ---------- ---------- BALANCE, March 31, 2002 8,607,117 8,607,117 60,428,238 27,700,939 (288,413) 4,151,710 Comprehensive income Net income - - - 12,139,871 - - Other comprehensive income Change in unrealized gains on available-for- sale securities, net taxes of $967,051 - - - - - 1,877,217 Total other comprehensive income - - - - - - Comprehensive income - - - - - - Recognition of ESOP shares released - - - - 72,104 - Cash dividends on common stock at $.45 per share - - - (4,789,101) - - Dividend reinvestment plan 43,536 43,536 522,227 - - - Stock options exercised 141,670 141,670 914,187 - - - 25% stock split 2,138,190 2,138,190 (2,138,190) - - - Cash paid for fractional shares - - - (7,425) - - Treasury stock purchased - - - - - - Retirement of treasury stock (380,400) (380,400) (2,373,638) (2,516,321) - - ---------- ------------ ------------ ------------ ---------- ---------- BALANCE, March 31, 2003 10,550,113 10,550,113 57,352,824 32,527,963 (216,309) 6,028,927 Comprehensive income Net income - - - 12,866,368 - - Other comprehensive income Change in unrealized gains (losses) on available-for-sale securities, net tax (benefit) of $(413,523) - - - - - (802,720) Total other comprehensive income - - - - - - Comprehensive income - - - - - - Recognition of ESOP shares released - - - - 72,104 - Cash dividends on common stock at $.49 per share - - - (5,121,345) - - Dividend reinvestment plan 39,601 39,601 646,876 - - - Stock options exercised 129,857 129,857 685,606 - - - Treasury stock purchased - - - - - - Retirement of treasury stock (314,240) (314,240) (1,791,482) (3,347,150) - - ---------- ------------ ------------ ------------ ---------- ---------- BALANCE, March 31, 2004 10,405,331 $ 10,405,331 $ 56,893,824 $ 36,925,836 $ (144,205) $5,226,207 ========== ============ ============ ============ ========== ==========
Treasury Total Stock Stockholders' Comprehensive at Cost Equity Income ----------- ------------- ------------ BALANCE, March 31, 2001 $ - $ 97,909,357 Comprehensive income Net income - 10,053,957 $ 10,053,957 Other comprehensive income Change in unrealized gains on available-for-sale securities, net taxes of $87,116 - 169,107 169,107 ------------ Total other comprehensive income - - 169,107 ------------ Comprehensive income - - $ 10,223,064 ============ Recognition of ESOP shares released - 72,104 Cash dividends on common stock at $.48 per share - (4,172,135) Dividend reinvestment plan - 207,250 Stock options exercised - 349,286 Stock dividend - fractional shares adjustment - - Treasury stock purchased (3,989,335) (3,989,335) Retirement of treasury stock 3,989,335 - ----------- ------------- BALANCE, March 31, 2002 - 100,599,591 Comprehensive income Net income - 12,139,871 $ 12,139,871 Other comprehensive income Change in unrealized gains on available-for- sale securities, net taxes of $967,051 - 1,877,217 1,877,217 ------------ Total other comprehensive income - - 1,877,217 ------------ Comprehensive income - - $ 14,017,088 ============ Recognition of ESOP shares released - 72,104 Cash dividends on common stock at $.45 per share - (4,789,101) Dividend reinvestment plan - 565,763 Stock options exercised - 1,055,857 25% stock split - - Cash paid for fractional shares - (7,425) Treasury stock purchased (5,270,359) (5,270,359) Retirement of treasury stock 5,270,359 - ----------- ------------- BALANCE, March 31, 2003 - 106,243,518 Comprehensive income Net income - 12,866,368 $ 12,866,368 Other comprehensive income Change in unrealized gains (losses) on available-for-sale securities, net tax (benefit) of $(413,523) - (802,720) (802,720) ------------ Total other comprehensive income - - (802,720) ------------ Comprehensive income - - $ 12,063,648 ============ Recognition of ESOP shares released - 72,104 Cash dividends on common stock at $.49 per share - (5,121,345) Dividend reinvestment plan - 686,477 Stock options exercised - 815,463 Treasury stock purchased (5,452,872) (5,452,872) Retirement of treasury stock 5,452,872 - ----------- ------------- BALANCE, March 31, 2004 $ - $ 109,306,993 =========== ============= See accompanying notes to these financial statements 46
HORIZON FINANCIAL CORP. CONSOLIDATED STATEMENT OF CASH FLOWS YEARS ENDED MARCH 31, 2004, 2003, AND 2002 ----------------------------------------------------------------------------- - Increase (Decrease) in Cash and Cash Equivalents 2004 2003 2002 ------------ ------------ ------------ CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 12,866,368 $ 12,139,871 $ 10,053,957 Adjustments to reconcile net income to net cash provided by operating activities Depreciation 1,085,060 1,000,314 1,112,467 Amortization and deferrals, net 799,212 771,900 1,128,744 Stock dividends - Federal Home Loan Bank stock (376,400) (395,200) (411,300) Provision for loan losses 1,915,000 2,740,000 1,089,642 Provision for deferred income tax (1,949,104) (1,507,160) (737,000) Changes in assets and liabilities Interest and dividends receivable 588,459 (125,106) 128,554 Interest payable 3,692 (27,533) 6,343 Federal income tax payable 469,271 392,494 331,947 Net change in loans held for sale 1,504,800 457,600 (913,675) Other assets (283,008) (6,703,825) (5,121,933) Other liabilities (331,490) (422,065) 787,060 ------------ ------------ ------------ Net cash flows from operating activities 16,291,860 8,321,290 7,454,806 ------------ ------------ ------------ CASH FLOWS FROM INVESTING ACTIVITIES Investment in interest-bearing deposits, net 39,162,020 9,845,582 (57,214,988) Purchases of investment securities - available- for-sale (28,598,597) (30,941,880) (27,723,932) Proceeds from sales and maturities of investment securities - available- for-sale 17,142,983 5,352,629 2,972,914 Purchases of mortgage-backed securities - available- for-sale (12,811,737) (18,285,779) (9,812,336) Proceeds from sales and maturities of mortgage-backed securities - available- for-sale 22,589,915 10,598,409 27,336,684 Proceeds from maturities of mortgage-backed securities - held-to-maturity 1,248,403 1,617,115 2,120,006 Net change in loans (78,599,106) (18,857,731) 26,398,362 Purchases of bank premises and equipment (2,344,477) (1,739,519) (1,092,997) Net change in other real estate owned 1,008,909 669,359 244,799 ------------ ------------ ------------ Net cash flows from investing activities (41,201,687) (41,741,815) (36,771,488) ------------ ------------ ------------ CASH FLOWS FROM FINANCING ACTIVITIES Net change in deposits 23,537,058 17,939,690 32,868,803 Repayments of securities sold under agreements to repurchase - - (5,938,000) Advances from other borrowed funds 20,706,102 24,642,011 22,120,729 Repayments of other borrowed funds (7,000,000) - (10,000,000) Common stock issued, net 925,792 1,132,286 363,918 Cash dividends paid (4,457,794) (4,126,638) (3,869,999) Treasury stock purchased (5,452,872) (5,270,359) (3,989,335) ------------ ------------ ------------ Net cash flows from financing activities 28,258,286 34,316,990 31,556,116 ------------ ------------ ------------ NET CHANGE IN CASH AND CASH EQUIVALENTS 3,348,459 896,465 2,239,434 CASH AND CASH EQUIVALENTS, beginning of year 15,083,505 14,187,040 11,947,606 ------------ ------------ ------------ CASH AND CASH EQUIVALENTS, end of year $ 18,431,964 $ 15,083,505 $ 14,187,040 ============ ============ ============ SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION Cash paid during the year for interest $ 15,505,666 $ 19,488,634 $ 26,527,133 ============ ============ ============ Cash paid during the year for income tax $ 7,812,000 $ 7,315,000 $ 5,535,000 ============ ============ ============ NONCASH INVESTING AND FINANCING TRANSACTIONS Property taken in settlement of loans $ 382,086 $ 1,452,271 $ 641,158 ============ ============ ============ Property sold through seller financing $ - $ - $ (106,930) ============ ============ ============ See accompanying notes to these financial statements 47 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2004, 2003, AND 2002 ----------------------------------------------------------------------------- - Note 1 - Nature of Operations and Summary of Significant Accounting Policies Nature of Operations - Horizon Financial Corp. (the "Company"), through its wholly-owned subsidiary, Horizon Bank (the "Bank"), provides a full range of commercial and mortgage lending services to borrowers and a full range of customer services to depositors through 16 full-service offices, three commercial loan centers, and three real estate loan centers located in Whatcom, Skagit and Snohomish Counties of Washington State. The Bank is an FDIC insured, state-chartered stock savings bank. Financial Statement Presentation and Use of Estimates - The financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and reporting practices applicable to the banking industry. In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of revenues and expenses for the period and assets and liabilities as of the balance sheet date. Actual results could differ from estimated amounts. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for losses on loans and the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the estimated losses on loans and foreclosed assets held for sale, management obtains independent appraisals for significant properties. All per share date included in the financial statements have been restated to reflect the stock dividend effective May 11, 2001 and the 25% stock split effective July 23, 2002 as well as the Company's ongoing share repurchase activities. Principles of Consolidation - As of March 31, 2004, 2003, and 2002, and for the years then ended, the consolidated financial statements include the accounts of Horizon Financial Corp. and its wholly-owned subsidiary, Horizon Bank. Westward Financial Services, Inc. a land development company, is a wholly-owned subsidiary of Horizon Bank, whose accounts are also included in the consolidation. All material intercompany balances and transactions have been eliminated. Cash and Cash Equivalents - For purposes of reporting cash flows, cash and cash equivalents include cash on hand and noninterest-bearing amounts due from banks. Included in cash and cash equivalents are legally reserved amounts which are required to be maintained on an average basis in the form of cash and balances due from the Federal Reserve Bank and other banks. Reserve requirements approximate $2,616,000 and $2,787,000 for the years ended March 31, 2004 and 2003, respectively. The Company maintains cash balances at several banks. Accounts at each institution are insured by the Federal Deposit Insurance Corporation up to $100,000. Investments in Interest-Bearing Deposits - Investments in interest-bearing deposits consist principally of funds on deposit with the Federal Home Loan Bank and short-term certificates of deposit with Western Washington financial institutions. Investments and Mortgage-Backed Securities - The Company classifies its securities into one of three categories: (1) held-to-maturity, (2) available-for-sale, or (3) trading. Investment securities are categorized as held-to-maturity when the Bank has the positive intent and ability to hold those securities to maturity. Securities which are held-to-maturity are stated at cost, adjusted for amortization of premiums, and accretion of discounts which are recognized as adjustments to interest income. Investment securities categorized as available-for-sale are generally held for investment purposes (to maturity), although unanticipated future events may result in the sale of some securities. Available-for-sale securities are recorded at fair value, with the net unrealized gain or loss included as other comprehensive income within the statement of stockholders' equity, net of the related tax effect. Realized gains or losses on dispositions are based on the net proceeds and the adjusted carrying amount of securities sold, using the specific identification method. Declines in the fair value of individual held-to-maturity and available-for-sale securities below their cost that are other than temporary are recognized by write-downs of the individual securities to their fair value. Such write-downs would be included in earnings as realized losses. 48 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2004, 2003, AND 2002 ----------------------------------------------------------------------------- - Note 1 - Nature of Operations and Summary of Significant Accounting Policies (Continued) Premiums and discounts are recognized in interest income using the interest method over the period to maturity. The Company had no trading securities at March 31, 2004 and 2003. Noncash Investing and Financing Transactions - Noncash investing and financing transactions consist principally of securitizing mortgage loans and exchanging them for FHLMC participation certificates. At the time of the securitization, the pool of loans are reclassified from the loan portfolio and are aggregated in a participation certificate in the available-for-sale investment portfolio. A separate mortgage servicing right is established using an estimate of fair market value and reorganized upon securitization. The transaction does not result in the recognition of income or expense in the income statement. Federal Home Loan Bank Stock - The Bank's investment in Federal Home Loan Bank (the "FHLB") stock is a restricted investment carried at par value ($100 per share), which reasonably approximates its fair value. As a member of the FHLB system, the Bank is required to maintain a minimum level of investment in FHLB stock based on specific percentages of its outstanding FHLB advances. The Bank may request redemption at par value of any stock in excess of the amount the Bank is required to hold. Stock redemptions are at the discretion of the FHLB. Loans Held for Sale - Mortgage loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated market value in the aggregate. Net unrealized losses are recognized through a valuation allowance by charges to income. Loans Receivable - Loans receivable that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their outstanding principal adjusted for any charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans and unamortized premiums or discounts on purchased loans. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct loan origination costs, are deferred and recognized as an adjustment of the yield on the related loans, using the interest method. Impaired Loans and Related Income - A loan is considered impaired when management determines that it is probable that all contractual amounts of principal and interest will not be paid as scheduled in the loan agreement. These loans include nonaccruing loans past due 90 days or more, loans restructured in the current year, and other loans that management considers to be impaired. When a loan is placed on nonaccrual status, all interest previously accrued, but not collected, is reversed and charged against interest income. Income on nonaccrual loans is then recognized only when the loan is brought current, or when, in the opinion of management, the borrower has demonstrated the ability to resume payments of principal and interest. Interest income on restructured loans is recognized pursuant to the terms of new loan agreements. Interest income on other impaired loans is monitored and based upon the terms of the underlying loan agreement. However, the recorded net investment in impaired loans, including accrued interest, is limited to the present value of the expected cash flows of the impaired loan, or the observable fair market value of the loan, or the fair value of the loan's collateral. Provision for Loan Losses - Management estimates the provision for loan losses by evaluating known and inherent risks in the loan portfolio. These factors include changes in the size and composition of the loan portfolio, actual loan loss experience, current and anticipated economic conditions, detailed analysis of individual loans for which full collectibility may not be assured, and determination of the existence and realizable value of the collateral and guarantees securing the loans. The allowance is based upon factors and trends identified by future market factors beyond the Company's control, which may result in losses or recoveries differing significantly from those provided for in the financial statements. The majority of the Company's loan portfolio consists of commercial loans and single-family residential loans secured by real estate in the Whatcom, Skagit and Snohomish County areas. Real estate prices in this market are stable at this time. However, the ultimate collectibility of a substantial portion of the Company's loan portfolio may be susceptible to changes in local market conditions in the future. 49 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2004, 2003, AND 2002 ----------------------------------------------------------------------------- - Note 1 - Nature of Operations and Summary of Significant Accounting Policies (Continued) While management uses available information to recognize losses on loans, further reductions in the carrying amounts of loans may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as an integral part of their examination process periodically review the estimated losses on loans. Such agencies may require the Company to recognize additional losses based on their judgment about information available to them at the time of their examination. Mortgage Servicing Rights - The Company allocates its total cost in mortgage loans between mortgage servicing rights and loans, based upon their relative fair values, when loans are subsequently sold or securitized, with the servicing rights retained. Fair values are generally obtained through quoted market prices. The Company has established a valuation allowance to measure impairment of its mortgage servicing rights. Impairment is measured based upon the characteristics of the individual loans, including note rate, term, underlying collateral, current market conditions and estimates of net servicing income. The Company accounts for its recorded value, and possible impairment of mortgage servicing rights, on a loan-by-loan basis. The cost allocated to mortgage servicing rights is amortized in proportion to, and over the period of, estimated net servicing income. Premises and Equipment - Premises and equipment are stated at cost less accumulated depreciation. Major renewals or betterments are capitalized and depreciated over their estimated useful lives. Depreciation is computed on the straight-line method over the estimated useful lives of 35 years for buildings and three to ten years for equipment. Bank Owned Life Insurance - The carrying amount of Bank Owned Life Insurance approximates its fair value. Fair value of Bank Owned Life Insurance is estimated using the cash surrender value. The Bank owns approximately $11 million and $10 million in Bank Owned Life Insurance as of March 31, 2004 and 2003, respectively, and is included in Other Assets. Goodwill - Goodwill was recognized in connection with the purchase of branch assets and related liabilities. The Company performs periodic evaluations for impairment. During the current year impairment testing was performed and Goodwill was found not to be impaired. At March 31, 2004 and 2003, Goodwill in the amount of $545,336 was included in Other Assets Other Real Estate Owned - Other real estate owned includes properties acquired through foreclosure. These properties are recorded at the lower of cost or estimated fair value. Losses arising from the acquisition of property, in full or partial satisfaction of loans, are charged to the allowance for loan losses. Subsequent to the transfer to other real estate owned, these assets continue to be recorded at the lower of cost or fair value (less estimated cost to sell), based on periodic evaluations. Generally, legal and professional fees associated with foreclosures are expensed as incurred. Costs incurred to improve property prior to sale are capitalized, however, in no event are recorded costs allowed to exceed fair value. Subsequent gains, losses, or expenses recognized on the sale of these properties are included in noninterest income or expense. Income Taxes - The Company reports income and expenses using the accrual method of accounting and files a consolidated tax return which includes its subsidiary. Deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled using the liability method. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. Deferred taxes result from temporary differences in the recognition of certain income and expense amounts between the Bank's financial statements and its tax returns. Earnings Per Share - Basic earnings per share amounts are computed based on the weighted average number of shares outstanding during the period after giving retroactive effect to stock dividends and stock splits. Diluted earnings per share amounts are computed by determining the number of additional shares that are deemed outstanding due to stock options under the treasury stock method. 50 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2004, 2003, AND 2002 ----------------------------------------------------------------------------- - Note 1 - Nature of Operations and Summary of Significant Accounting Policies (Continued) Financial Instruments - All financial instruments held or issued by the Bank are held or issued for purposes other than trading. In the ordinary course of business, the Bank enters into off-balance-sheet financial instruments consisting of commitments to extend credit. These commitments are recorded in the financial statements when they are funded. Advertising Costs - The Company expenses advertising costs as they are incurred. Stock Options - The Company recognizes the financial effects of stock options under the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25 Accounting for Stock Issued to Employees (APB 25). Generally, stock options are issued at a price equal to the fair value of the Company's stock as of the grant date. Under APB 25, options issued in this manner do not result in the recognition of employee compensation in the Company's financial statements. Disclosures required by Statement of Financial Accounting Standard No. 123 Accounting for Stock-Based Compensation, as amended are as follows. The pro forma information recognizes, as compensation, the value of stock options granted using an option valuation model known as the Black Scholes model. Pro forma earnings per share amounts also reflect an adjustment for an assumed purchase of treasury stock from proceeds deemed obtained from the issuance of stock options. The estimated fair value for options issued for the years ended 2004, 2003 and 2002 is estimated at $2,317, $64,192, and $1,093, respectively. The following assumptions were used to estimate the fair value of the options for the year ended March 31: 2004 2003 2002 -------- -------- -------- Risk-free interest rate 1.93% 2.35% 4.438% Dividend yield rate 3.02% 3.65% 4.130% Price volatility 3.884% 2.457% 2.606% Weighted average expected life of options 3.72 yr. 3.70 yr. 3.50 yr. Management believes that the assumptions used in the option pricing model are highly subjective and represent only one estimate of possible value, as there is no active market for the options granted. The fair value of the options granted will be allocated to pro forma earnings over the vesting period of the options. Pro forma disclosures for the years ended March 31: 2004 2003 2002 ----------- ----------- ----------- Net income as reported $12,866,368 $12,139,871 $10,053,957 Additional compensation for fair value of stock options (78,469) (88,462) (237,564) ----------- ----------- ----------- Pro forma net income $12,787,899 $12,051,409 $ 9,816,393 =========== =========== =========== Earnings per share Basic As reported $ 1.23 $ 1.14 $ .92 =========== =========== =========== Pro forma $ 1.22 $ 1.13 $ .90 =========== =========== =========== Diluted As reported $ 1.20 $ 1.12 $ .91 =========== =========== =========== Pro forma $ 1.20 $ 1.11 $ .89 =========== =========== =========== The remaining unrecognized compensation for fair value of stock options was $1,738, $32,096 and $273 as of March 31, 2004, 2003, and 2002, respectively. 51 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2004, 2003, AND 2002 ----------------------------------------------------------------------------- - Note 1 - Nature of Operations and Summary of Significant Accounting Policies (Continued) Recent Accounting Pronouncements - In November 2003, the Emerging Issues Task Force (EITF) researched a consensus that certain quantitative and qualitative disclosures should be required for debt and marketable equity securities classified as available-for-sale or held-to-maturity under FASB Statements No. 115 and 124, that are impaired at the balance sheet date but for which an other-than-temporary impairment has not been recognized. This EITF consensus is effective for fiscal years ending after December 15, 2003. Accordingly, the Company has adopted this statement as of March 31, 2004 and the result did not have an impact on the Company's statement of financial position or results of operations. Reclassifications - Certain reclassifications have been made to prior years' amounts to conform to the current year presentation. These reclassifications have no significant effect on the Bank's previously reported financial position or results of operations. Note 2 - Interest-Bearing Deposits Interest bearing deposits consisted of the following at March 31, 2004 and 2003: 2004 2003 ----------- ---------- FHLB Demand $20,467,373 59,629,418 Certificates of deposit 300,025 300,000 ----------- ---------- $20,767,398 59,929,418 =========== ========== The Company has funds on deposit with the Federal Home Loan Bank in a Demand account. This account acts like a savings account and earns interest based on the daily federal funds rate. These funds are uninsured deposits held at the Federal Home Loan Bank of Seattle. The FHLB of Seattle, a federally chartered corporation, is one of 12 district FHLBanks, which operate under the supervision of the Federal Housing Finance Board. The Finance Board is an independent agency of the executive branch within the US Government which ensures that the FHLBanks operate in a safe and sound manner, remain adequately capitalized, and can raise funds in the capital markets. Note 3 - Investment Securities The Company's investment policy requires that the Company purchase only high- grade investment securities. Purchases of debt instruments are generally restricted to those rated A or better by a nationally recognized statistical rating organization. 52 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2004, 2003, AND 2002 ----------------------------------------------------------------------------- - Note 3 - Investment Securities (Continued) The amortized cost and estimated market values of investments, together with unrealized gains and losses, are as follows as of March 31, 2004 and 2003, respectively: 2004 ----------------------------------------------------------- Gross Gross Unrealized Unrealized Gross Losses Losses Estimated Amortized Unrealized Less Than Greater Than Fair Costs Gains 12 Months 12 Months Value --------- ---------- --------- ------------ ---------- Available-For-Sale Securities State and political subdivisions and U.S. government agency securities $57,396,588 $1,666,140 $ - $(62,268) $59,000,460 Marketable equity securities 1,831,368 5,906,524 (441,000) - 7,296,892 Mutual funds 5,000,000 - (20,141) - 4,979,859 Corporate debt securities 13,434,320 472,341 - - 13,906,661 ----------- ---------- --------- -------- ---------- - Total available- for-sale securities 77,662,276 8,045,005 (461,141) (62,268) 85,183,872 ----------- ---------- --------- -------- ---------- - Held-To-Maturity Securities State and political subdivisions and U.S. government agency securities 369,444 30,855 - - 400,299 ----------- ---------- --------- -------- ---------- - Total held-to- maturity securities 369,444 30,855 - - 400,299 ----------- ---------- --------- -------- ---------- - Total investment securities $78,031,720 $8,075,860 $(461,141) $(62,268) $85,584,171 =========== ========== ========= ======== =========== Certain investment securities shown above currently have fair values less than amortized cost and therefore contain unrealized losses. At March 31, 2004, the Company has evaluated these securities and has determined that the decline in value is temporary and is related to the change in market interest rates since purchase. The decline in value is not related to any company or industry specific event. At March 31, 2004, there are approximately 10 investment securities with unrealized losses. The Company anticipates full recovery of amortized cost with respect to these securities at maturity or sooner in the event of a more favorable market interest rate. 2003 ----------------------------------------------------- Gross Gross Estimated Amortized Unrealized Unrealized Fair Costs Gains Losses Value ----------- ---------- ---------- ----------- Available-For-Sale Securities State and political subdivisions and U.S. government agency securities $38,820,895 $1,888,238 $ - $40,709,133 Marketable equity securities 3,805,723 5,553,778 (130,000) 9,229,501 Mutual funds 5,000,000 10,070 - 5,010,070 Corporate debt securities 18,580,044 1,032,053 - 19,612,097 ----------- ---------- ---------- ----------- Total available- for-sale securities 66,206,662 8,484,139 (130,000) 74,560,801 ----------- ---------- ---------- ----------- Held-To-Maturity Securities State and political subdivisions and U.S. government agency securities 369,292 32,728 - 402,020 ----------- ---------- ---------- ----------- Total held-to-maturity securities 369,292 32,728 - 402,020 ----------- ---------- ---------- ----------- Total investment securities $66,575,954 $8,516,867 $ (130,000) $74,962,821 =========== ========== ========== =========== 53 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2004, 2003, AND 2002 ----------------------------------------------------------------------------- - Note 3 - Investment Securities (Continued) The amortized cost and estimated fair value of investment securities at March 31, 2004, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. 2004 ----------------------------------------------------- Available-For-Sale Held-To-Maturity ------------------------- -------------------------- Amortized Estimated Amortized Estimated Cost Fair Value Cost Fair Value ---------- ---------- ---------- ---------- State and political subdivisions and U.S. government agencies One year $ 8,025,037 $ 8,131,630 $ - $ - Two to five years 43,702,611 45,207,580 369,444 400,299 Five to ten years 2,868,213 2,869,326 - - Over ten years 2,800,727 2,791,924 - - ----------- ----------- ---------- ---------- 57,396,588 59,000,460 369,444 400,299 ----------- ----------- ---------- ---------- Corporate debt securities One year 6,413,622 6,545,261 - - Two to five years 7,020,698 7,361,400 - - Over ten years - - - - ----------- ----------- ---------- ---------- 13,434,320 13,906,661 - - ----------- ----------- ---------- ---------- Mutual funds and marketable equity securities (liquid) 6,831,368 12,276,751 - - ----------- ----------- ---------- ---------- Total investment securities $77,662,276 $85,183,872 $ 369,444 $ 400,299 =========== =========== ========== ========== Proceeds from sales of investments and gross realized gains and losses on investment sales were as follows for the year ended March 31: 2004 2003 2002 ---------- -------- -------- Proceeds from sales of investments $6,839,100 $ - $64,725 ========== ====== ======= Gross gains realized on sales of investments $ 688,001 $ - $64,397 ========== ====== ======= Gross losses realized on sales of investments $ (3,000) $ - $ - ========== ====== ======= Please refer to Note 4 for information on gross gains and losses on mortgage- backed security sales. Information about concentrations of investments in particular industries for marketable equity securities and corporate debt securities at March 31 consist of the following: 2003 2002 ------------------------ ----------------------- - Market Market Cost Value Cost Value ----------- ----------- ----------- ---------- - Marketable equity securities Banking $ 315,171 $ 1,822,492 $ 318,380 $ 1,636,271 Government agency stocks 1,516,197 5,474,400 3,487,343 7,593,230 ----------- ----------- ----------- ---------- - $ 1,831,368 $ 7,296,892 $ 3,805,723 $ 9,229,501 =========== =========== =========== =========== Corporate debt securities Finance companies $ 6,940,420 $ 7,177,139 $11,045,036 $11,650,459 Private utilities 2,710,725 2,792,817 2,705,224 2,853,869 Manufacturing companies 3,783,175 3,936,705 4,829,784 5,107,769 ----------- ----------- ----------- ---------- - Total $13,434,320 $13,906,661 $18,580,044 $19,612,097 =========== =========== =========== =========== 54 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2004, 2003, AND 2002 ----------------------------------------------------------------------------- - Note 3 - Investment Securities (Continued) At March 31, 2004 and 2003, U.S. government agency and corporate debt securities of $9,170,000 and $3,370,000 were pledged as collateral for deposits of state and local government agencies and deposits for trust accounts in excess of $100,000, as required by Washington State Law. Note 4 - Mortgage-Backed Securities Mortgage-backed securities at March 31 consist of the following: 2004 ----------------------------------------------------------- Gross Gross Unrealized Unrealized Gross Losses Losses Estimated Amortized Unrealized Less Than Greater Than Fair Costs Gains 12 Months 12 Months Value --------- ---------- --------- ------------ ---------- Available-for-sale securities $27,362,914 $ 506,130 $ - $ (109,231) $27,759,813 Held-to-maturity securities 1,544,034 109,556 - - 1,653,590 ----------- --------- ------ ---------- ---------- - Total mortgage- backed securities $28,906,948 $ 615,686 $ - $ (109,231) $29,413,403 =========== ========= ====== ========== =========== Certain investment securities shown above currently have fair values less than amortized cost and therefore contain unrealized losses. At March 31, 2004, the Company has evaluated these securities and has determined that the decline in value is temporary and is related to the change in market interest rates since purchase. The decline in value is not related to any company or industry specific event. At March 31, 2004, there are approximately 17 investment securities with unrealized losses. The Company anticipates full recovery of amortized cost with respect to these securities at maturity or sooner in the event of a more favorable market interest rate environment. 2003 -------------------------------------------------- - Gross Gross Estimated Amortized Unrealized Unrealized Fair Cost Gains Losses Value ----------- ---------- --------- ---------- - Available-for-sale securities $37,140,593 $ 894,448 $(113,849) $37,921,192 Held-to-maturity securities 2,793,089 190,654 - 2,983,743 ----------- ---------- --------- ---------- - Total mortgage-backed securities $39,933,682 $1,085,102 $(113,849) $40,904,935 =========== ========== ========= =========== The amortized cost and estimated fair value of mortgage-backed securities at March 31, 2004, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to prepay obligations with or without prepayment penalties. 2003 --------------------------------------------------- - Available-For-Sale Held-To-Maturity ------------------------ ------------------------ - Amortized Estimated Amortized Estimated Cost Fair Value Cost Fair Value ----------- ----------- ---------- ---------- - Mortgage-backed securities One year $ 86,753 $ 87,025 $ 988 $ 1,088 Two to five years 881,648 860,482 862,792 917,418 Six to ten years 5,089,356 5,316,098 438,955 468,743 After ten years 21,305,157 21,496,208 241,299 266,341 ----------- ----------- ---------- ---------- Total $27,362,914 $27,759,813 $1,544,034 $1,653,590 =========== =========== ========== ========== All of the above mortgage-backed securities are rated AAA by a nationally recognized statistical rating organization. 55 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2004, 2003, AND 2002 ----------------------------------------------------------------------------- - Note 4 - Mortgage-Backed Securities (Continued) Proceeds from sales of mortgage-backed securities and gross realized gains and losses on mortgage-backed security sales were as follows for the year ended March 31: 2004 2003 2002 --------- --------- -------- Proceeds from sales of mortgage-backed securities $ - $2,403,548 $22,429,008 ======== ========== =========== Gross gains realized on sales of mortgage-backed securities $ - $ 62,187 $ 225,104 ======== ========== =========== Gross losses realized on sales of mortgage-backed securities $ - $ - $ (70,108) ======== ========== =========== Note 5 - Loans Receivable Loans receivable (collateralized principally by properties in the Whatcom, Skagit and Snohomish Counties of Washington State) at March 31 consist of the following: 2004 2003 ------------ ------------ First mortgage loans 1-4 Family $286,126,631 $350,487,597 1-4 Family construction 14,165,219 28,035,560 Less participations (74,278,637) (137,172,801) ------------ ------------ Net first mortgage loans 226,013,213 241,350,356 Construction and land development 36,303,953 66,111,738 Residential commercial real estate 53,343,779 56,929,901 Non-residential commercial real estate 257,321,796 182,157,758 Commercial loans 78,751,858 54,132,254 Home equity secured 26,291,270 22,729,371 Other consumer loans 6,330,294 6,886,950 ------------ ------------ 684,356,163 630,298,328 Less: Undisbursed loan proceeds (11,962,770) (34,678,121) Deferred loan fees (4,045,717) (4,844,929) Allowance for loan losses (10,121,532) (8,506,133) ------------ ------------ $658,226,144 $582,269,145 ============ ============ The Company originates both adjustable and fixed interest rate loans. At March 31, 2004, the Company had adjustable and fixed rate loans as follows: Fixed Rate Adjustable Rate ----------------------------------- ------------------------------------ Term to Maturity Book Value Term to Maturity Book Value ------------------ ------------ ------------------ ------------ Less than one year $ 71,943,306 Less than one year $152,584,370 One to two years 15,186,248 One to two years 38,913,311 Two to five years 56,798,921 Two to five years 75,649,679 Five to ten years 91,232,992 Five to ten years 36,373,484 Over ten years 108,698,311 Over ten years 36,975,541 Loans serviced for others are $88,190,792 and $140,535,316, respectively, as of March 31, 2004 and 2003. The Bank generally receives a monthly fee of 0.25% to 0.375% per annum of the unpaid balance of each loan. The sold loans are sold without right of recourse to the Bank by the buyer of the loan interests in the event of default by the borrower. Impaired loans on a nonaccrual basis and the related interest are not material as of March 31, 2004 and 2003. 56 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2004, 2003, AND 2002 ----------------------------------------------------------------------------- - Note 5 - Loans Receivable (Continued) The allowance for loan losses at March 31, and changes during the year are as follows: 2004 2003 2002 ----------- ----------- ---------- Balance, beginning of year $ 8,506,133 $ 5,887,482 $4,976,670 Provision for loan losses 1,915,000 2,740,000 1,089,642 Loan chargeoffs (385,335) (129,406) (187,095) Loan recoveries 85,734 8,057 8,265 ----------- ----------- ---------- Balance, end of year $10,121,532 $ 8,506,133 $5,887,482 =========== =========== ========== Note 6 - Mortgage Servicing Rights Loan costs allocated to mortgage servicing rights as of March 31, were as follows: 2004 2003 ---------- ----------- Beginning balance $1,284,143 $ 2,129,964 Additions for new loans 107,798 63,850 Amortization (745,823) (909,671) ---------- ----------- Ending balance 646,118 1,284,143 Valuation allowance for impairment of mortgage servicing rights (333,678) (668,183) ---------- ----------- Balance, end of year $ 312,440 $ 615,960 ========== =========== Changes in the valuation allowance for impairment of mortgage servicing was as follows: Beginning balance $ (668,183) $(1,111,016) Additions (42,819) (29,090) Credited to income 377,324 471,923 ---------- ----------- Balance, end of year $ (333,678) $ (668,183) ========== =========== Note 7 - Accrued Interest and Dividends Receivable Accrued interest and dividends receivable at March 31 is summarized as follows: 2004 2003 ---------- ----------- Investment securities $1,015,346 $1,020,845 Mortgage-backed securities 147,503 191,989 Loans receivable 2,763,333 3,237,921 Dividends on marketable equity securities 105,825 169,711 ---------- ---------- $4,032,007 $4,620,466 ========== ========== Note 8 - Premises and Equipment Premises and equipment at March 31 consisted of: 2004 2003 ---------- ----------- Buildings $12,728,536 $11,952,760 Equipment 8,816,230 8,072,921 ----------- ----------- 21,544,766 20,025,681 Accumulated depreciation (9,593,624) (9,308,956) ----------- ----------- 11,951,142 10,716,725 Land 5,242,529 5,217,529 ----------- ----------- Balance, end of year $17,193,671 $15,934,254 =========== =========== 57 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2004, 2003, AND 2002 ----------------------------------------------------------------------------- - Note 9 - Deposits A comparative summary of deposits at March 31 follows: 2004 2003 ------------ ------------ Demand deposits Savings $ 40,526,619 $ 38,455,124 Checking 78,697,106 66,169,430 Checking (noninterest-bearing) 44,773,672 28,052,250 Money market 25,264,073 26,426,247 Ultimate Money Market 106,046,597 99,378,323 ------------ ------------ 295,308,067 258,481,374 ------------ ------------ Time certificates of deposit Less than $100,000 245,608,118 258,623,337 Greater than or equal to $100,000 129,343,033 129,617,449 ------------ ------------ 374,951,151 388,240,786 ------------ ------------ Total deposits $670,259,218 $646,722,160 ============ ============ Time certificate of deposit maturities at March 31 are as follows: 2004 --------------------------------------- Variable Fixed Rate Rate Total 2002 ----------- ------------ ------------ ------------ Within one year $12,460,768 $199,821,284 $212,282,052 $237,979,138 One to two years 1,989,834 79,519,385 81,509,219 65,822,342 Two to three years 918,740 30,504,899 31,423,639 26,007,151 Three to four years 924,429 30,360,116 31,284,545 26,354,415 Four to five years 1,360,620 14,203,839 15,564,459 30,922,698 Over five years 2,887,237 - 2,887,237 1,155,042 ----------- ------------ ------------ ------------ $20,541,628 $354,409,523 $374,951,151 $388,240,786 =========== ============ ============ ============ The terms of variable rate certificates of deposit allow customers to make additional deposits to existing certificates of deposit at any time. The weighted average nominal interest rate on all deposits at March 31, 2004 and 2003 was 2.06 percent and 2.79 percent, respectively. Interest expense on deposits for the years ended March 31 is summarized as follows: 2004 2003 2002 ----------- ----------- ----------- Money market $ 1,323,697 $ 2,212,086 $ 2,664,570 Checking 500,240 491,383 572,826 Savings 288,768 437,912 694,646 Certificates of deposit 11,111,924 14,531,578 21,064,070 ----------- ----------- ----------- Balance, end of year $13,224,629 $17,672,959 $24,996,112 =========== =========== =========== 58 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2004, 2003, AND 2002 ----------------------------------------------------------------------------- - Note 10 - Securities Sold Under Agreements to Repurchase The Bank has from time to time sold certain securities of the U.S. Government and its agencies and other approved investments under agreements to repurchase. A safekeeping agent not under control of the Bank held the securities underlying the agreements. The Bank did not have any securities sold under agreements to repurchase as of March 31, 2004 and 2003. Note 11 - Other Borrowed Funds The Bank is a member of the Federal Home Loan Bank ("FHLB") of Seattle. As a member, the Bank has a committed line of credit up to 20% of total assets, subject to the Bank pledging sufficient collateral and maintaining the required stock investment. Committed lines of credit agreements totaling approximately $164.1 million and $162.3 million were available to the Bank, of which, $64.5 million and $52.5 million were outstanding at March 31, 2004 and 2003, respectively. These advances bear interest ranging from 2.67% to 5.35% and 2.67% to 5.96% per annum, respectively. Maturities for the advances are $9,000,000 in fiscal 2005, $12,000,000 in fiscal 2006, $13,500,000 in fiscal 2007, $29,000,000 in fiscal 2008, and $1,000,000 in fiscal 2009. The maximum outstanding and average outstanding balances and average interest rates on advances from the FHLB were as follows for the year ended March 31: In Thousands ------------------------------- 2004 2003 2002 ---------- -------- -------- Maximum outstanding at any month-end $ 64,500 $ 52,500 $ 28,000 Average outstanding 56,318 38,276 27,131 Weighted average interest rates: Annual 4.06% 4.67% 5.69% ==== ==== ==== End of year 3.84% 4.33% 5.07% ==== ==== ==== The Bank also has other borrowed funds in the form of retail repurchase agreements. These agreements are collateralized by securities held by a safekeeping agent not under control of the Bank. These advances are considered overnight borrowings bearing interest rates that fluctuate daily based on current market rates. The Bank had $2,968,842 and $1,262,740 outstanding as of March 31, 2004 and 2003, respectively. Note 12 - Income Tax Deferred income tax results from temporary differences in the recognition of income and expense for tax and financial statement purposes. The source of these differences and the related tax effects for the years ended March 31 are as follows: 2004 2003 2002 ---------- ---------- --------- Deferred loan fees $ (274,000) $ (264,000) $ 219,000 Loan loss and general reserves 560,000 873,000 700,000 Deferred compensation 26,000 71,000 (3,000) Other, net 1,637,104 827,160 (179,000) ---------- ---------- --------- $1,949,104 $1,507,160 $ 737,000 ========== ========== ========= 59 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2004, 2003, AND 2002 ----------------------------------------------------------------------------- - Note 12 - Income Tax (Continued) The nature and components of the Company's net deferred tax assets (liabilities), established at an estimated tax rate of 34.25%, are as follows at March 31: 2004 2003 ----------- ----------- Deferred Tax Assets Deferred compensation agreements $ 598,000 $ 572,000 Deferred loan fees for tax purposes in excess of amounts deferred for financial reporting purposes 671,000 - Financial reporting loan loss reserve not recognized for tax purposes 3,467,000 2,541,000 Financial reporting accrued expenses not recognized for tax purposes 183,000 222,000 Other deferred tax assets 166,000 188,000 ----------- ----------- Total deferred assets 5,085,000 3,523,000 ----------- ----------- Deferred Tax Liabilities Deferred loan fees for tax purposes in excess of amounts deferred for financial reporting purposes - (466,000) Tax effect of unrealized gains on available-for-sale securities (2,692,000) (3,106,000) FLHB stock dividends (720,000) (605,000) Other deferred tax liabilities (841,877) (877,504) ----------- ----------- Total deferred liabilities (4,253,877) (5,054,504) ----------- ----------- Net deferred tax assets (liabilities) $ 831,123 $(1,531,504) =========== =========== The Company believes, based upon the available evidence, that all deferred assets will be realized in the normal course of operations. Accordingly, these assets have not been reduced by a valuation allowance. A reconciliation of the Company's income tax provision to the statutory federal income tax rate for the years ended March 31 is as follows: 2004 2003 2002 ---------- ---------- ---------- Provision for income tax at the statutory rate of 35 percent $6,721,000 $6,332,000 $5,314,366 Increase (decrease) in tax resulting from: Income taxed at lower brackets - (100,000) (95,000) Dividends received deduction (53,000) (70,000) (71,166) Other, net (335,833) (211,788) (18,253) ---------- ---------- ---------- Income tax provision $6,332,167 $5,950,212 $5,129,947 ========== ========== ========== Prior to 1997, the Company was allowed a bad debt deduction of 8 percent of taxable income, subject to certain limitations. During 1997, a tax law change eliminated this tax deduction and, in addition, requires the Company to recapture and pay taxes on these deductions taken after fiscal year ended March 31, 1988. The Company previously recorded deferred tax liabilities to account for this obligation, thus retroactive effects of this law change have not been significant. The cumulative tax-basis bad debt deduction as of March 31, 2004 and 2003 was approximately $-0- and $1,067,000, respectively. If any portion of this amount is subsequently used for purposes other than to absorb loan losses, that portion will be subject to federal income tax at the then prevailing tax rate. 60 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2004, 2003, AND 2002 ----------------------------------------------------------------------------- - Note 13 - Benefit Plans Deferred Compensation Plan - The Company has entered into deferred compensation agreements with certain of its officers. The agreements provide for additional retirement benefits payable over a 12 to 20 year period following retirement. In connection with these agreements, the Company has acquired life insurance policies on the individual officers covered by the deferred compensation agreements. At March 31, 2004 and 2003, the cash surrender values of these policies included in Other Assets aggregated $2,617,276 and $2,411,219, respectively. The Company performs a present value calculation using an appropriate discount rate on an annual basis to ensure that those obligations are adequately estimated in the accompanying financial statements. The discount rate was 3.50%, 4.00%, and 4.75% in 2004, 2003 and 2002, respectively. Deferred compensation expense amounted to $150,000, $155,000 and $191,298 in 2004, 2003 and 2002, respectively. Employee Incentive Plan - The Company has an incentive plan with employees meeting certain service requirements. Payments made to employees pursuant to the plan are based upon earnings, growth in deposits and loans and attainment of certain corporate objectives. Costs of the plan were $1,657,000, $1,403,000 and $751,488 for the years ended March 31 2004, 2003 and 2002, respectively. Employee Stock Ownership Plan - The Company has a noncontributory employee stock ownership plan (ESOP) for those employees who have completed a minimum of two years of service. The Company's contribution is determined annually by the Board of Directors. Participants receive distributions from the ESOP only in the event of retirement, disability or termination of employment. The primary purpose of the ESOP is to acquire shares of the Company's common stock on behalf of ESOP participants. In April 1996, the Company issued a new loan to the ESOP in the amount of $500,000, to purchase 40,000 shares of common stock in the open market. The loan is to be repaid over a period of ten years, with annual payments including interest due on March 31. The ESOP shares initially were pledged as collateral for its debt. As the obligation is reduced, shares are released from collateral and allocation to the participants' accounts at a rate of 10% a year. In May 1997, the Company issued a 15% stock dividend which added an additional 5,400 shares to the unallocated ESOP shares. In May 1999, the Company made an additional loan to the ESOP in the amount of $154,725, to purchase 12,500 shares of common stock in the open market. The loan is to be repaid over seven years with annual payments including interest due March 31. In April 2001, the Company issued a 15% stock dividend which added an additional 4,789 shares to the unallocated ESOP shares. In July 2002, the Company issued a 25% stock split which added an additional 7,342 shares to the unallocated ESOP shares. Shares released for allocation were 9,180 for the years ended March 31, 2004, 2003, and 2002. The ESOP shares relating to the loans outstanding as of March 31 were as follows: 2004 2003 2002 --------- --------- --------- Number of shares Allocated shares 65,738 56,558 47,378 Unallocated shares 18,355 27,535 36,715 --------- --------- --------- Total ESOP shares 84,093 84,093 84,093 ========= ========= ========= Fair value Unallocated shares $ 340,118 $ 409,996 $ 371,568 ========= ========= ========= Dividends paid on unallocated shares of stock are reinvested and the new shares purchased are allocated to the participants. Compensation expense for the ESOP plan is based upon the fair value of shares committed to be released each year. 401(k) Plan - Effective January 1, 1993, the Company adopted a defined contribution 401(k) retirement and savings plan (the "Plan") covering substantially all employees. The Company contributes three percent of participating employee's eligible salary to the Plan and a discretionary amount determined annually by the Board of Directors. Total contributions to the Plan amounted to $430,000, $360,000 and $323,850 for the years ended March 31, 2004, 2003, and 2002, respectively. 61 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2004, 2003, AND 2002 ----------------------------------------------------------------------------- - Note 14 - Stockholders' Equity Capital Requirements - The Company and Bank are subject to various regulatory capital requirements administered by the 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 Company's financial statements. Under capital adequacy guidelines within the regulatory framework for prompt corrective action, the Company must meet specific capital adequacy guidelines that involve quantitative measures of each entity's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. Capital classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures are established by regulation to ensure capital adequacy, require maintenance of minimum amounts and ratios (set forth in the table below in thousands) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets, and of Tier 1 capital to average assets. Management believes, as of March 31, 2004, that each entity meets all capital adequacy requirements to which they are subject. As of February 17, 2004, the most recent notification from the Bank's regulator categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the institution's category. To Be Well Capitalized For Capital Under Prompt Corrective Actual Adequacy Purposes Action Provisions --------------------- -------------------- --------------------- Amount Ratio Amount Ratio Amount Ratio -------- ------- -------- ------ -------- ------ As of March 31, 2004 Total Capital (to Risk Weighted Assets) Consolidated $ 114,607 16.60% $ 55,247 >8.00% $ 69,059 >10.00% Horizon Bank $ 114,765 16.60% $ 55,299 >8.00% $ 69,124 >10.00% Tier I Capital (to Risk Weighted Assets) Consolidated $ 103,505 14.99% $ 27,624 >4.00% $ 41,436 > 6.00% Horizon Bank $ 103,655 15.00% $ 27,650 >4.00% $ 41,475 > 6.00% Tier I Capital (to Average Assets) Consolidated $ 103,505 12.56% $ 32,954 >4.00% $ 41,192 > 5.00% Horizon Bank $ 103,655 12.58% $ 32,954 >4.00% $ 41,192 > 5.00%
To Be Well Capitalized For Capital Under Prompt Corrective Actual Adequacy Purposes Action Provisions --------------------- -------------------- --------------------- Amount Ratio Amount Ratio Amount Ratio -------- ------- -------- ------ -------- ------ As of March 31, 2003 Total Capital (to Risk Weighted Assets) Consolidated $109,357 18.75% $ 46,652 >8.00% $ 58,315 >10.00% Horizon Bank $109,147 18.70% $ 46,684 >8.00% $ 58,355 >10.00% Tier I Capital (to Risk Weighted Assets) Consolidated $ 99,608 17.08% $ 23,326 >4.00% $ 34,989 > 6.00% Horizon Bank $ 99,393 17.03% $ 23,342 >4.00% $ 35,013 > 6.00% Tier I Capital (to Average Assets) Consolidated $ 99,608 12.46% $ 31,979 >4.00% $ 39,973 > 5.00% Horizon Bank $ 99,393 12.44% $ 31,954 >4.00% $ 39,943 > 5.00%
62 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2004, 2003, AND 2002 ----------------------------------------------------------------------------- - Note 14 - Stockholders' Equity (Continued) Holding Company Loans - Under federal regulations, the Bank is limited, unless previously approved, as to the amount it may loan to the holding company and any one affiliate, to 10 percent of its capital stock and surplus, and the total of loans to the holding company and affiliates must not exceed 20 percent of capital and surplus. Further, all such loans must be fully collateralized. Dividend Reinvestment Plan - As a service to its stockholders of record, the Bank offers a Dividend Reinvestment and Stock Purchase Plan ("Reinvestment Plan"). Under the terms of the Reinvestment Plan, dividends and optional cash payments may be reinvested toward the purchase of additional shares of stock. No brokerage commission or fees are charged to acquire shares through the Reinvestment Plan. Stock Repurchase Plans - In January 2000, the Company announced a plan to repurchase up to 1,240,562 shares, as restated, or approximately 10% of the Company's outstanding common stock. During fiscal 2001, 710,269 shares were repurchased under this plan at a cost of $4,898,256. In October 2000, the Company announced a plan to repurchase up to 1,121,250 shares, as restated, or approximately 10% of the Company's outstanding common stock. During fiscal 2001, 144,468 shares were repurchased under this plan at a cost of $1,109,850. Effective March 31, 2001, all 1,380,862 shares of treasury stock were retired. During fiscal 2002, 409,940 shares were repurchased and subsequently retired under this plan at a cost of $3,989,335. During fiscal 2003, 214,650 shares were repurchased and subsequently retired under this plan at a cost of $2,498,191. In October 2002, the Company announced a plan to repurchase up to 1,065,000 shares, or approximately 10% of the Company's outstanding common stock. During Fiscal 2003, 195,700 shares were repurchased and subsequently retired under this plan at a cost of $2,772,168. During Fiscal 2004, 162,400 shares were repurchased and subsequently retired under this plan at a cost of $2,698,586. In September 2003, the Company announced a plan to repurchase up to 1,050,000 shares, or approximately 10% of the Company's outstanding common stock. During Fiscal 2004, 151,840 shares were repurchased and subsequently retired under this plan at a cost of $2,754,286. In total, the Company repurchased 314,240 shares and subsequently retired at a cost of $5,452,872. All share information has been restated to reflect stock splits and dividends. Stock Split - The Company's Board of Directors at its June 25, 2002 Board meeting, announced a 25% stock split to be issued July 23, 2002 for shareholders of record July 11, 2002. Stock Dividend - The Company's Board of Directors at its April 24, 2001 Board meeting, announced a 15% stock dividend to be issued June 4, 2001 for shareholders of record May 11, 2001. Stock Warrants - In 1992, certain key organizers of the Bank of Bellingham received warrants for 24,000 shares of stock at an exercise price of $12.50 per share. In conjunction with the merger of Bellingham Bancorporation, the outstanding warrants as of June 19, 1999 were converted at 2.74 shares of Horizon for each share of Bellingham Bancorporation - amounting to 37,812 shares at an exercise price of $4.56 per share. The number of shares were then adjusted to 47,365 at an exercise price of $3.17 per share due to stock splits and stock dividends. Warrants for 7,877 and 39,387 shares of stock were still outstanding as of March 31, 2002 and 2001, respectively. During the fiscal year ended March 31, 2003, all remaining warrants were exercised. Stock Option and Incentive Plans - The Company may award options for a maximum of 595,125 as restated, of authorized common stock to certain officers and key employees under the 1995 Stock Option and Incentive Plan. Options are granted at no less than fair market value and may or may not vest immediately upon issuance based on the terms established by the Board of Directors. Options are generally exercisable within one to five years from date of grant and expire after ten years. 63 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2004, 2003, AND 2002 ----------------------------------------------------------------------------- - Note 14 - Stockholders' Equity (Continued) Shares of Common Stock ------------------------ Weighted Average of Available for Under Exercise Price of Option/Award Plan Shares Under Plan ------------ ------- ------------------ Balance, March 31, 2002 25,638 586,982 Authorized - - Granted (33,000) 33,000 $ 10.66 - 14.625 Exercised - (148,652) $ 4.19 - 14.625 Lapsed 15,922 (15,922) $ 4.19 - 14.625 Expired (12) - ------- -------- Balance, March 31, 2003 8,548 455,408 Authorized - - Granted (1,000) 1,000 $ 14.485 Exercised - (146,888) $ 4.19 - 14.625 Lapsed 2,055 (2,055) $ 4.19 - 14.625 Expired (8) - ------- -------- Balance, March 31, 2004 9,595 307,465 ======= ======== Options Outstanding Options Exercisable ------------------------------------ ----------------------- Weighted Average Weighted Range of Remaining Average Average Exercise Number Contractual Exercise Number Exercise Prices Outstanding Life Price Exercisable Price ---------- ----------- ----------- -------- ----------- --------- $ 5 to $ 10 273,465 4.842 years $ 7.75 240,945 $ 7.91 $10 to $ 15 34,000 8.068 years 11.75 8,251 $11.66 At March 31, 2004, 317,060 shares of common stock were reserved for issuance pursuant to stock plans and options. Note 15 - Earnings Per Share The numerators and denominators of basic and diluted earnings per share are as follows: 2004 2003 2002 ----------- ----------- ----------- Net income (numerator) $12,866,368 $12,139,871 10,053,957 Shares used in the calculation (denominators) Basic earnings per weighted average share outstanding 10,480,785 10,674,506 10,921,233 Effect of dilutive stock options 205,260 190,463 145,822 ----------- ----------- ----------- Diluted shares 10,686,045 10,864,969 11,067,055 =========== =========== =========== Basic earnings per share $ 1.23 $ 1.14 $ .92 =========== =========== =========== Diluted earnings per share $ 1.20 $ 1.12 $ .91 =========== =========== =========== At March 31, 2004, 2003, and 2002, there were options to purchase 307,465, 455,408, and 586,982 shares of common stock outstanding. At March 31, 2004, 2003, and 2002, all options to purchase shares of common stock were included in the diluted net income per share calculation. 64 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2004, 2003, AND 2002 ----------------------------------------------------------------------------- - Note 16 - Commitments And Contingencies Employment Agreement - The Company has entered into a four-year employment agreement with the Company's president at an amount approximating his current level of compensation. In the event of specified termination of the president's employment following a change in control of the Company (as defined), the agreement provides the president with severance payments of up to 2.99 times his annual compensation plus continuation of certain benefits. Purchase Commitments - As of March 31, 2004, the Bank had a purchase commitment outstanding of approximately $1,200,000 to purchase a full service office and regional facility in Everett, Washington, which will replace the Company's existing Everett office. Long-Term Lease Commitments - The Company has entered into lease agreements for certain parcels of land and branch offices. Future noncancelable lease payments under these agreements are as follows for the years ending March 31: 2005 $ 204,402 2006 162,090 2007 164,988 2008 136,744 2009 34,654 Thereafter 130,171 ---------- $ 833,049 ========== Rent expense charged to operations was $248,661, $162,440, and $151,169 for the years ending March 31, 2004, 2003, and 2002. CBS Conversion Agreement - Subsequent to year end, the Company entered into a 5 year service agreement with a third party processor for account processing services, development services, and software products. Included in this agreement are system conversion services, for which the third party processor will bill the Company on a monthly basis, as services are used and products installed. Note 17 - Related Party Transactions Certain directors, executive officers, and principal stockholders are Bank customers and have had banking transactions with the Bank. All loans and commitments to loan included in such transactions were made in compliance with applicable laws on substantially the same terms (including interest rates and collateral) as those prevailing at the time for comparable transactions with other persons and do not involve more than the normal risk of collectibility or present any other unfavorable features. The aggregate balances and activity during 2004, 2003 and 2002 are as follows and were within regulatory limitations: 2004 2003 2002 ------------ ------------ ------------ Balance, beginning of year $ 19,851,634 $ 19,846,801 $ 11,935,707 New loans or advances 7,572,429 16,750,744 13,753,750 Repayments (11,733,810) (16,745,911) (5,842,656) ------------ ------------ ------------ Balance, end of year $ 15,690,253 $ 19,851,634 $ 19,846,801 ============ ============ ============ Interest earned on loans $ 1,080,891 $ 1,372,680 $ 1,095,527 ============ ============ ============ Deposits from related parties totaled approximately $1,663,000 and $1,625,000 at March 31, 2004 and 2003, respectively. 65 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2004, 2003, AND 2002 ----------------------------------------------------------------------------- - Note 18 - Significant Group Concentrations of Credit Risk Most of the Bank's business activity is with customers located within Whatcom, Skagit and Snohomish Counties. Investments in state and municipal securities involve governmental entities within the state of Washington. The Bank originates commercial, real estate and consumer loans. Generally, loans are secured by deposit accounts, personal property or real estate. Rights to collateral vary and are legally documented to the extent practicable. Although the Bank has a diversified loan portfolio, local economic conditions may affect borrowers' ability to meet the stated repayment terms. Note 19 - Financial Instruments The Bank is a party to financial instruments with off-balance-sheet risk (loan commitments) in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. Loan commitments involve, to varying degrees, elements of credit and interest-rate risk in excess of the amount recognized in the balance sheet. The contract amounts of those commitments reflect the extent of the Bank's exposure to credit loss from these commitments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. 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 amount of collateral obtained, if it is deemed necessary by the Bank upon extension of credit, is based on management's credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property, plant, and equipment; and income-producing commercial properties. Standby letters of credit are conditional commitments issued by the Bank 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. Except for certain long-term guarantees, the majority of guarantees expire in one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral supporting those commitments, for which collateral is deemed necessary, generally amounts to one hundred percent of the commitment amount at March 31, 2004. The Bank has not been required to perform on any financial guarantees and has not incurred any losses on its commitments for the years ended March 31 2004, 2003 and 2002. The following is a summary of the off-balance-sheet financial instruments or contracts outstanding at March 31: 2004 2003 ----------- ----------- Commitments to extend credit $80,275,294 $58,878,487 Credit card arrangements 7,991,317 7,385,414 Standby letters of credit 2,058,818 1,263,217 Note 20 - Disclosures About Fair Value of Financial Instruments The following methods and assumptions were used to estimate the fair value of the following classes of financial instruments: Cash Equivalents, Interest-bearing Deposits, and Loans Held-for-Sale - Due to the relatively short period of time between the origination of these instruments and their expected realization, the carrying amount is estimated to approximate market value. 66 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2004, 2003, AND 2002 ----------------------------------------------------------------------------- - Note 20 - Disclosures About Fair Value of Financial Instruments (Continued) Investment and Mortgage-Backed Securities Fair values are based on quoted market prices or dealer quotes, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. Federal Home Loan Bank ("FHLB") Stock - FHLB Stock is carried at $100 par value. This investment is considered restricted, as a minimum investment must be maintained in order to obtain borrowing commitments from FHLB. The Company may redeem its investment only at par value, which is used as the estimated market value. Loans Receivables - For certain homogeneous categories of loans, such as those written to Federal Home Loan Mortgage Corporation ("FHLMC") standards, fair value is estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. Accrued Income and Expense Accounts - Due to the short-term nature of these amounts, recorded book value is believed to approximate fair value. Deposit Liabilities, Repurchase Agreements and Other Borrowed Funds - The fair value of demand deposits, savings accounts, certain money market deposits, and federal funds purchased, is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit, repurchase agreements and other borrowed funds are estimated by discounting the estimated future cash flows using the rates currently offered for these instruments with similar remaining maturities. Off-Balance-Sheet Instruments - The Company's off-balance-sheet instruments include unfunded commitments to extend credit and borrowing facilities available to the Company. The fair value of these instruments is not considered practicable to estimate because of the lack of quoted market price and the inability to estimate fair value without incurring excessive costs. The carrying amounts and estimated fair values of the Bank's financial instruments at March 31, 2004 and 2003 are as follows: 2004 2003 -------------------------- -------------------------- Carrying Carrying Amount Fair Value Amount Fair Value ------------ ------------ ------------ ------------ Financial Assets Cash and cash equivalents $ 18,431,964 $ 18,431,964 $ 15,083,505 $ 15,083,505 Investment securities 85,553,316 85,584,171 74,930,093 74,962,821 Mortgage-backed securities 29,303,847 29,413,403 40,714,281 40,904,935 Interest-bearing deposits 20,767,398 20,767,398 59,929,418 59,929,418 Federal Home Loan Bank stock 7,014,900 7,014,900 6,638,500 6,638,500 Loans receivable 658,226,144 665,897,087 582,269,145 590,991,597 Loans held-for-sale 1,333,500 1,333,500 2,838,300 2,838,300 Accrued interest and dividends receivable 4,032,007 4,032,007 4,620,466 4,620,466 Financial Liabilities Demand and savings deposits 295,308,067 295,308,067 258,481,374 258,481,374 Time deposits 374,951,151 380,778,241 388,240,786 396,849,780 Accounts payable and other liabilities 8,011,206 8,011,206 7,761,614 7,761,614 Accrued interest payable 290,555 290,555 286,863 286,863 Other borrowed funds 67,468,842 69,275,192 53,762,740 55,720,840 67 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2004, 2003, AND 2002 ----------------------------------------------------------------------------- - Note 21 - Parent Company (Only) Financial information In Thousands ----------------------------- 2004 2003 --------- --------- Condensed balance sheet at March 31: Cash $ 28 458 Investment in Bank 109,457 106,029 Other assets 1,148 1,000 --------- --------- $ 110,633 $ 107,487 ========= ========= Other liabilities $ 1,326 $ 1,243 Stockholders' equity 109,307 106,244 --------- --------- $ 110,633 $ 107,487 ========= ========= Condensed statement of income for the years ended March 31, 2004 and 2003 and 2002: In Thousands ------------------------------------ 2004 2003 2002 -------- -------- -------- Income Cash dividends from Bank subsidiary $ 9,028 $ 9,005 $ 7,787 Interest 5 6 8 -------- -------- -------- Total income 9,033 9,011 7,795 -------- -------- -------- Expenses Compensation 108 105 124 Other 321 330 170 -------- -------- -------- Total expenses 429 435 294 -------- -------- -------- Income before equity in undistributed income of subsidiary and benefit equivalent to income taxes 8,604 8,576 7,501 Benefit equivalent to income taxes 81 84 43 -------- -------- -------- Income before equity in undistributed income of subsidiary 8,685 8,660 7,544 Equity in undistributed income of subsidiary 4,181 3,480 2,510 -------- -------- -------- Net income $ 12,866 $ 12,140 $ 10,054 ======== ======== ======== 2004 2003 2002 -------- -------- -------- Cash flows from operating activities Net income $ 12,866 $ 12,140 $ 10,054 Adjustments to reconcile net income to net cash flows from operating activities Equity in undistributed income of subsidiary (4,181) (3,480) (2,510) Other operating activities (152) 23 (65) -------- --------- -------- Net cash flows from operating activities (8,533) (8,683) 7,479 -------- --------- -------- Cash flows from investing activities Other investing activities 22 22 22 -------- --------- -------- Net cash flows from investing activities 22 22 22 -------- --------- -------- Cash flows from financing activities Sale of common stock 926 1,132 363 Dividends paid (4,458) (4,126) (3,870) Treasury stock purchased (5,453) (5,270) (3,989) -------- --------- -------- Net cash flows from financing activities (8,985) (8,264) (7,496) -------- --------- -------- Net change in cash (430) 441 5 Cash, beginning of year 458 17 12 -------- --------- -------- Cash, end of year $ 28 $ 458 $ 17 ======== ========= ======== 68 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2004, 2003, AND 2002 ----------------------------------------------------------------------------- - Note 22 - Selected Quarterly Financial Data (Unaudited) Year Ended March 31, 2004 ----------------------------------------------------- 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter ----------- ----------- ----------- ----------- Interest income $12,494,587 $12,210,493 $11,978,834 $12,295,700 Interest expense 4,136,452 3,932,265 3,762,912 3,677,728 ----------- ----------- ----------- ----------- Net interest income 8,358,135 8,278,228 8,215,922 8,617,972 Provision for loan losses 525,000 500,000 220,000 670,000 Noninterest income 2,031,321 2,458,097 1,440,968 1,951,115 Noninterest expense 4,915,759 5,262,744 5,125,364 4,934,356 ----------- ----------- ----------- ----------- Income before provision for income tax 4,948,697 4,973,581 4,311,526 4,964,731 Provision for income tax 1,627,357 1,632,861 1,409,485 1,662,464 ----------- ----------- ----------- ----------- Net income $ 3,321,340 $ 3,340,720 $ 2,902,041 $ 3,302,267 =========== =========== =========== =========== Basic earnings per share (adjusted for stock splits and dividends) $ .31 $ .32 $ .28 $ .32 =========== =========== =========== =========== Diluted earnings per share (adjusted for stock splits and dividends) $ .31 $ .31 $ .27 $ .31 =========== =========== =========== =========== Year Ended March 31, 2003 ----------------------------------------------------- 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter ----------- ----------- ----------- ----------- Interest income $12,558,048 $12,625,067 $12,979,617 $12,535,010 Interest expense 5,318,384 5,011,148 4,772,948 4,358,621 ----------- ----------- ----------- ----------- Net interest income 7,239,664 7,613,919 8,206,669 8,176,389 Provision for loan losses 300,000 350,000 1,050,000 1,040,000 Noninterest income 1,479,411 1,432,947 2,059,342 1,967,701 Noninterest expense 4,163,790 4,363,950 4,281,989 4,536,230 ----------- ----------- ----------- ----------- Income before provision for income tax 4,255,285 4,332,916 4,934,022 4,567,860 Provision for income tax 1,401,031 1,421,061 1,624,108 1,504,012 ----------- ----------- ----------- ----------- Net income $ 2,854,254 $ 2,911,855 $ 3,309,914 $ 3,063,848 ========== =========== =========== =========== Basic earnings per share (adjusted for stock splits and dividends) $ .27 $ .27 $ .31 $ .29 ========== =========== =========== =========== Diluted earnings per share (adjusted for stock splits and dividends) $ .26 $ .27 $ .31 $ .28 ========== =========== =========== =========== 69 Item 9. Changes in and Disagreements with Accountants on Accounting and ------------------------------------------------------------------------ Financial Disclosure -------------------- Not applicable. Item 9A. Controls and Procedures --------------------------------- (a) Evaluation of Disclosure Controls and Procedures: (a) Evaluation of Disclosure Controls and Procedures: An evaluation of the Corporation's disclosure controls and procedures (as defined in Section 13(a)-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 was carried out under the supervision and with the participation of the Corporation's Chief Executive Officer, Chief Financial Officer and several other members of the Corporation's senior management as of the end of the period covered by this report. The Corporation's Chief Executive Officer and Chief Financial Officer concluded that the Corporation's disclosure controls and procedures as currently in effect are effective in ensuring that the information required to be disclosed by the Corporation in the reports it files or submits under the Securities and Exchange Act of 1934 is (i) accumulated and communicated to the Corporation's management (including the Chief Executive Officer and Chief Financial Officer) in a timely manner, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. (b) Changes in Internal Controls: In the year ended March 31, 2004, the Corporation did not make any significant changes in, nor take any corrective actions regarding, its internal controls or other factors that could significantly affect these controls. PART III Item 10. Directors and Executive Officers of the Registrant ------------------------------------------------------------ The information contained under the section captioned "Proposal I -- Election of Directors" and "Compliance with Section 16(a) of the Exchange Act" in the Registrant's Proxy Statement is incorporated herein by reference. The executive officers of the Corporation and the Bank are as follows: Name Age Position ------------------- --- -------------------------------------------------- V. Lawrence Evans 57 Chairman of the Board, Chief Executive Officer and President of the Corporation; and Chairman of the Board and Chief Executive Officer of the Bank (1) Dennis C. Joines 54 President, Chief Operating Officer and Director of the Bank; Executive Vice President and Director of the Corporation Richard P. Jacobson 41 Vice President and Secretary of the Corporation and Executive Vice President and Secretary of the Bank Steve L. Hoekstra 53 Executive Vice President of the Bank Karla C. Lewis 57 Senior Vice President of the Bank Kelli J. Holz 35 Vice President of the Corporation and the Bank A.R. (Gus) Ayala 54 Senior Vice President of the Bank Tammy D. Barnett 44 Senior Vice President of the Bank Jane L. VanVoorst 52 Senior Vice President of the Bank (footnote on following page) 70 ------------ (1) Effective April 23, 2002, Dennis C. Joines, was named President and Chief Operating Officer of Horizon Bank. V. Lawrence Evans, who has served as President of Horizon Bank since 1990 continues to serve as Chairman of the Board and Chief Executive Officer of Horizon Bank and Chairman of the Board, President and Chief Executive Officer of Horizon Financial Corp. The following is a description of the principal occupation and employment of the executive officers of the Corporation and the Bank during at least the past five years: V. LAWRENCE EVANS joined the Bank in 1972 and served as the Bank's Executive Vice President from 1983 to 1990. Mr. Evans served as President of the Bank from May 14, 1990 to April 23, 2002. He has served as Chief Executive Officer of the Bank since March 26, 1991 and as Chairman of the Bank's Board of Directors since July 1997. Mr. Evans also serves as Chairman of the Board, President and Chief Executive Officer of the Corporation. DENNIS C. JOINES became President and Chief Operating Officer of the Bank on April 23, 2002 and a Director of the Corporation and the Bank on April 23, 2002. He joined the Bank following an extensive career in the Pacific Northwest banking industry for over 30 years. Most recently, Mr. Joines was Senior Vice President/National Small Business and SBA Manager for Washington Mutual Bank from 2001 to 2002. Prior to that time, he served in a variety of key roles at KeyBank from 1993 to 2001. RICHARD P. JACOBSON has worked for the Bank for 17 years and was appointed Vice President/Finance and Corporate Secretary in December 1994. In March 1998, Mr. Jacobson was appointed Senior Vice President of the Bank. In March 2000, he was appointed Executive Vice President of the Bank. STEVE L. HOEKSTRA joined the Bank in June, 2002 as Executive Vice President, Commercial Banking. Mr. Hoekstra has 25 years of experience in the local commercial banking industry. Most recently, he led the Bellingham commercial and retail team for Frontier Bank. Prior to that, Mr. Hoekstra was employed for 22 years by SeaFirst/Bank of America, where his titles included Commercial Credit Administrator, Sales Team Leader, Equipment Financing and Leasing Specialist and Dealer Banking. KARLA C. LEWIS joined Horizon Bank in 1973. From 1983 to December 1994, she was the Manager of the Loan Servicing Department. She was appointed Vice President in June 1987 and is currently the Bank's Chief Lending Officer. In March 1998, she was appointed Senior Vice President of the Bank. KELLI J. HOLZ, CPA, joined the Bank in 1988. From 1991 to 1998 she was the Manager of the Internal Audit Department. In March 1998, she was appointed Vice President and is currently the Controller of the Bank. A.R. (GUS) AYALA joined the Bank pursuant to the merger of Bellingham Bancorporation effective June 19, 1999. He served as Chief Financial Officer for the Bank of Bellingham from September 1997 until completion of the merger. Previously, he was Senior Vice President with a commercial bank in Lompoc, California. He is currently Senior Vice President, and Operations Manager for the Bank. TAMMY D. BARNETT joined the Bank in 1994. From 1994 to March 2003, she was the Branch Manager of the Burlington office. She was appointed Vice President in March 2002. In March 2003, she was appointed Senior Vice President, and is currently the Bank's Mortgage Loan Operations Manager. JANE L. VANVOORST joined Horizon Bank in May, 2002 as Vice President, Consumer Lending Manager. In March 2004, she was appointed Senior Vice President, Retail Sales Manager. Previously, Mrs. VanVoorst was Senior Vice President, District Retail Leader for Key Bank from 1998 to 2002. 71 Audit Committee Financial Expert The Audit Committee of the Corporation is composed of Directors Fred R. Miller (Chairperson), James A. Strengholt and Robert C. Tauscher. Each member of the Audit Committee is "independent," in accordance with the requirements for companies quoted on The Nasdaq Stock Market. The Corporation's Board of Directors has determined that there is no "audit committee financial expert," as defined in the SEC regulations. The Board believes that the current members of the Audit Committee are qualified to serve based on their experience and background. Code of Ethics The Board of Directors adopted Codes of Ethics for the Corporation's officers (including its senior financial officers), directors, and employees. The Codes of Ethics require the Corporation's officers, directors, and employees to maintain the highest standards of professional conduct. A copy of the Code of Ethics applicable to the Principal Executive Officer and Senior Financial Officer is attached hereto as Exhibit 14. Item 11. Executive Compensation -------------------------------- Information regarding management compensation and transactions with management and others is incorporated by reference to the section captioned "Proposal I -- Election of Directors" in the Proxy Statement. Item 12. Security Ownership of Certain Beneficial Owners and Management and ---------------------------------------------------------------------------- Related Stockholder Matters --------------------------- (a) Security Ownership of Certain Beneficial Owners Information required by this item is incorporated herein by reference to the section captioned "Voting Securities and Principal Holders Thereof" in the Proxy Statement. (b) Security Ownership of Management Information required by this item is incorporated herein by reference to the section captioned "Voting Securities and Principal Holders Thereof" in the Proxy Statement. Equity Compensation Plan Information. The following table summarizes share and exercise price information about the Corporation's equity compensation plans as of March 31, 2004. (c) Number of securities remaining available for (a) (b) future issuance Number of securities Weighted-average under equity to be issued upon exercise price compensation exercise of of outstanding plans (exclud- outstanding options, options ing securities Warrants warrants reflected in Plan category and rights and rights column (a)) ---------------------- ---------- ---------- ----------- Equity compensation plans approved by security holders: Option plan............. 307,465 $ 8.19 9,595 Equity compensation plans not approved by security holders................... -- -- -- 72 (c) Changes in Control The Corporation is not aware of any arrangements, including any pledge by any person of securities of the Corporation, the operation of which may at a subsequent date result in a change in control of the Corporation. Item 13. Certain Relationships and Related Transactions -------------------------------------------------------- The information contained under the section captioned "Voting Securities and Principal Holders Thereof" in the Proxy Statement is incorporated herein by reference. Item 14. Principal Accountant Fees and Services ------------------------------------------------ The information contained under the section captioned "Independent Auditors" is included in the Corporation's Proxy Statement and is incorporated herein by reference. PART IV Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K -------------------------------------------------------------------------- (a) Exhibits 3.1 Articles of Incorporation of Horizon Financial, Corp. (incorporated by reference to Exhibit 3.1 to the Registrant's Current Report on Form 8-K dated October 13, 1995) 3.2 Bylaws of Horizon Financial Corp. (incorporated by reference to Exhibit 3.2 to the Registrant's Current Report on Form 8-K dated October 13, 1995) 10.1 Amended and Restated Employment Agreement with V. Lawrence Evans (incorporated by reference to the Registrant's Annual Report on Form 10-K for the year ended March 31, 1996) 10.2 Deferred Compensation Plan (incorporated by reference to the Registrant's Annual Report on Form 10-K for the year ended March 31, 1996) 10.3 1986 Stock Option and Incentive Plan (incorporated by reference to Exhibit 99.1 to the Registrant's Registration Statement on Form S-8 (File No. 33-99780)) 10.4 1995 Stock Option Plan (incorporated by reference to Exhibit 99.2 to the Registrant's Registration Statement on Form S-8 (File No. 33-99780)) 10.5 Bank of Bellingham 1993 Employee Stock Option Plan (incorporated by reference to Exhibit 99 to the Registrant's Registration Statement on Form S-8 (File No. 33-88571)) 10.6 Severance Agreement with Dennis C. Joines (incorporated by reference to the Registrant's Annual Report on Form 10-K for the year ended March 31, 2002) 10.7 Severance Agreement with Richard P. Jacobson (incorporated by reference to the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 2002) 10.8 Severance Agreement with Steve Hoekstra (incorporated by reference to the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 2002) 14 Code of Ethics 21 Subsidiaries of the Registrant 23 Consent of Independent Auditors 31.1 Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act 31.2 Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act 32 Certification of Chief Executive Officer and Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act (b) Reports on Form 8-K A Current Report on Form 8-K was filed on January 26, 2004 to report the Corporation's earnings for the quarter ended December 31, 2003. 73 SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. HORIZON FINANCIAL CORP. Date: June 11, 2004 By: /s/ V. Lawrence Evans --------------------------------------- V. Lawrence Evans Chairman of the Board, Chief Executive Officer, and President (Duly Authorized Representative) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. By: /s/V. Lawrence Evans By: /s/Robert C. Diehl ---------------------------- ---------------------------- V. Lawrence Evans Robert C. Diehl Chairman of the Board, Chief Executive Director Officer, and President Date: June 11, 2004 Date: June 11, 2004 By: /s/ Richard P. Jacobson By: /s/Fred R. Miller ---------------------------- ---------------------------- Richard P. Jacobson Fred R. Miller Principal Financial Officer Director Date: June 11, 2004 Date: June 11, 2004 By: /s/ Dennis C. Joines By: /s/ James A. Strengholt ---------------------------- ---------------------------- Dennis C. Joines James A. Strengholt President, Chief Operating Officer Director and Director of Horizon Bank, and Executive Vice President and Director of Horizon Financial Corp. Date: June 11, 2004 Date: June 11, 2004 By: /s/Kelli J. Holz By: /s/Robert C. Tauscher ---------------------------- ---------------------------- Kelli J. Holz Robert C. Tauscher Principal Accounting Officer Director Date: June 11, 2004 Date: June 11, 2004 74 By: /s/ Richard R. Haggen By: /s/Gary E. Goodman ---------------------------- ---------------------------- Richard R. Haggen Gary E. Goodman Director Director Date: June 11, 2004 Date: June 11, 2004 75 Exhibit 14 Code of Ethics Horizon Financial Corp. Code of Ethics for Principal Executive Officer And Senior Financial Officers Introduction The business of Horizon Financial Corp. ("Horizon") is built on trust. Our stockholders, customers and employees depend upon our honesty and integrity. Accordingly, the Board of Directors of Horizon has adopted this Code of Ethics ("Code") to express a code of conduct applicable to our Chairman of the Board, Chief Executive Officer, President, Chief Operating Officer, Chief Financial Officer, Controller, and Investor Relations Manager (collectively, the "Senior Financial Officers"). This Code does not constitute a new set of requirements to which the Senior Financial Officers must adhere, but simply reduces to writing the behavior that has always been required of the Senior Financial Officers. The Code sets forth certain standards for the guidance of the Senior Financial Officers. The Code should be considered as illustrative, but not regarded as all-inclusive. The Senior Financial Officers are also subject to Horizon's Code of Ethics applicable to all officers and employees. Honest and Ethical Conduct Each Senior Financial Officer must act honestly and ethically. Senior Financial Officers should also promote honest and ethical behavior within Horizon. Acting honestly and ethically includes the duty to avoid actual or apparent conflicts of interest. A conflict of interest may arise when personal or financial interest is adverse to, or appears adverse to, the interests of Horizon. In those cases where personal interests do exist, or may appear to exist, the officer or employee in question should disqualify himself or herself and permit other members of our staff to handle the transaction. Each Senior Financial Officer should report to the Audit Committee of the Board of Directors any material transaction or relationship that reasonably could be expected to result in a conflict of interest. In addition to the duty to avoid conflicts of interest, Senior Financial Officers must treat confidential information properly. All information obtained by virtue of employment with Horizon should be held in strictest confidence. Confidential information must not be disclosed to anyone except as required for business transactions or as required by law. When confidential information is disclosed, it must be done in a manner that does not risk violating confidentiality. 1 Preparation of Public Documents Each Senior Financial Officer must ensure that all public documents and documents filed with the Securities and Exchange Commission, NASDAQ, or other regulatory bodies, which he or she is involved in preparing or reviewing contain full, fair, accurate, timely and understandable disclosure. In order to ensure this, the Senior Financial Officers must maintain the skills relevant to Horizon's needs. The Senior Financial Officers are also responsible for establishing and maintaining appropriate disclosure controls and procedures and internal controls. Compliance with Laws, Rules and Regulations Each Senior Financial Officer must comply with all local, state and federal laws, rules and regulations. Any Senior Financial Officer engaged in activities found to be in conflict with and against these laws, rules and regulations will be subject to disciplinary action, up to and including termination of employment. Administration of the Code Any violation or suspected violation of this Code of Ethics must be promptly reported to the Audit Committee of the Board of Directors. Violators of the Code may be subject to disciplinary action, up to and including termination of employment. Questions regarding the Code and requests for a waiver from the Code should be brought to the Audit Committee. The Audit Committee will administer the Code and will make periodic reports to the Board of Directors, as necessary. This Code of Ethics shall be publicly available. Changes to, and waivers from, the Code shall also be disclosed to the public. 2 Exhibit 21 Subsidiaries of the Registrant Parent ------ Horizon Financial Corp. Jurisdiction Percentage or State of Subsidiaries (a) of Ownership Incorporation ------------------ ------------ ------------- Horizon Bank 100% Washington Westward Financial Services, Inc. (b) 100% Washington -------- (a) The operation of the Corporation's wholly owned subsidiaries are included in the Consolidated Financial Statements contained in the Item 8 of this Form 10-K. (b) Wholly-owned subsidiary of Horizon Bank. Exhibit 23 Consent of Independent Auditors CONSENT OF INDEPENDENT AUDITOR'S We consent to the incorporation by reference in the Registration Statement on Form S-8 (No. 33-99780) of Horizon Financial Corp. pertaining to the 1986 Stock Option and Incentive Plan, and the 1995 Stock Option Plan; and the Registration Statement on Form S-8 (No. 333-88571) pertaining to the Bank of Bellingham 1993 Employee Stock Option Plan; of our report dated April 16, 2004, appearing in the Annual Report on Form 10-K of Horizon Financial Corp., which is incorporated by reference in Horizon Financial Corp.'s Annual Report on Form 10-K for the year ended March 31, 2004. /s/Moss-Adams LLP Bellingham, Washington June 9, 2004 Exhibit 31.1 Certification Required by Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934 I, V. Lawrence Evans, certify that: 1. I have reviewed this annual report on Form 10-K of Horizon Financial Corp.; 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 state- ments 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 officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under 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) 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 officer(s) 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. Date: June 11, 2004 /s/V. Lawrence Evans -------------------------------------- V. Lawrence Evans Chief Executive Officer and President Exhibit 31.2 Certification Required by Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934 I, Richard P. Jacobson, certify that: 1. I have reviewed this annual report on Form 10-K of Horizon Financial Corp.; 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 state- ments 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 officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under 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) 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 officer(s) 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. Date: June 11, 2004 /s/Richard P. Jacobson ------------------------------------- Richard P. Jacobson Chief Financial Officer Exhibit 32 CERTIFICATION OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER OF HORIZON FINANCIAL CORP. PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 The undersigned hereby certify, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and in connection with this Annual Report on Form 10-K, that: 1. the report fully complies with the requirements of Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended, and 2. the information contained in the report fairly presents, in all material respects, the company's financial condition and results of operations. /s/V. Lawrence Evans /s/Richard P. Jacobson ----------------------------------- ------------------------------ V. Lawrence Evans Richard P. Jacobson Chief Executive Officer Chief Financial Officer Dated: June 11, 2004