EX-13 2 exhibit13.htm EXHIBIT 13







EXHIBIT 13



LCNB Corp. 2004 Annual Report



President's Letter to Shareholders (pages 2 - 3 of Annual Report):


Dear Shareholders,


The theme of this year’s Annual Report is “Preparing for our Future – Everyday.” While our corporate culture has always been based on integrity, conservative business models, service and confidentiality, within this foundation has also been the willingness to evolve and change. The ability to change without compromising principles has always been essential to both longevity and prosperity.


Preparing for our future encompasses facilities, systems, products, delivery channels and, most important of all, people. We work every day to improve in every aspect of our business because we believe that is the best way to serve the interest of our shareholders and our customers.


The success we experienced in 2004 is the direct result of the hard work and dedication of our 256 LCNB and Dakin employees. Their willingness to embrace change and to “prepare for our future – every day” is what sets us apart and ensures our tomorrow.


Financially, 2004 was a challenging year as low interest rates and a declining interest rate margin resulted in a decrease in tax-equivalent interest income of $1,873,000. Fortunately, we were able to reduce our interest expense, increase our non-interest income faster than our non-interest expense, take gains on investments, and as a result, post exactly the same earnings per share in 2004 that we enjoyed in 2003.


Net income for 2004 was $6.6 million, representing a 1.29% return on average assets and a 12.56% return on average shareholders equity. Earnings per share were $1.97 matching the earnings per share in 2003 of $1.97. Total assets at year-end totaled $522.3 million, which was flat when compared to the $523.6 million in total assets at the end of 2003. Total capital, or shareholders equity, at December 31, 2004 was $52.3 million as compared to $52.4 million at December 31, 2003. Our capital position remains strong and it is management’s intention to maintain the FDIC “Well Capitalized” designation.


For the 19th consecutive year your Board of Directors increased the dividend paid to shareholders. The total dividend paid in 2004 was $1.115 per share compared with $1.0625 in 2003 for a 4.94% increase. The 2004 dividend added to the appreciation in the value of a share of LCNB Corp. stock resulted in a total annual return of 14.61%.


Loan growth proved to be an important component of our success in 2004. Our loan portfolio grew by $18.8 million or 5.90%. This growth was achieved in spite of the fact that during 2004 LCNB exited the credit card market because of the high administrative cost of servicing a small portfolio. LCNB will continue to offer credit card products under a marketing agreement with MBNA. Our overall asset quality remained high with a low delinquency rate of .23%.


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Total deposits grew $867,000 during 2004, with non-interest bearing deposits growing $7.3 million and interest bearing deposits declining $6.4 million. Due to our extremely liquid position and declining interest rate margin we chose not to be aggressive in seeking interest bearing deposits. We look forward to changes in the future that will allow us to be more aggressive in this area.


Another key factor in our success was the growth we experienced in non-interest income. The push to grow our line of products and our delivery channels paid off in 2004. Along with our commercial bank, the Trust Department, brokerage unit and insurance subsidiary all contributed to non-interest income. With the decline in interest income, noted earlier, the non-interest income became essential to our continued success.


The following financial highlight shows total assets under management as of December 31, 2004 and 2003 and the percent change for each category.


Assets Under Management ($000’s)


2004

 


2003

 

% Change

LCNB Corp. total assets

$522,251

 

523,608

 

-0.26%

Trust and investments*

180,122

 

165,499

 

8.84%

Mortgage loans serviced

46,345

 

54,802

 

-15.43%

Business cash management

26,554

 

20,985

 

26.54%

Brokerage accounts*

24,826

 

13,612

 

82.38%

Total assets managed

$800,098

 

778,506

 

2.77%

      

*at fair market value

     


In addition to this illustration of assets under management, our Dakin Insurance subsidiary has also experienced continued growth. The measurement for growth in the insurance industry is not assets under management, but premiums written. In less than the five years that Dakin has been part of LCNB Corp. (they became a wholly-owned subsidiary on April 11, 2000), premiums written have grown from $4.5 million to $8.8 million.


Non-interest income from all sources within the LCNB Corp. family of products, including gains from sales of the credit card portfolio and securities, grew 12.68% in 2004.


Additional statistical data and information on our financial performance for 2004 are available in the Management Discussion and Analysis (MD&A) document. The MD&A document is enclosed with the initial mailing of this Annual Report to shareholders and is also available in the LCNB Corp. Annual Report on Form 10-K. This report is filed annually with the Securities and Exchange Commission and is available upon request or from the Shareholder information section of our website, www.LCNB.com.


Preparing for our future involved extraordinary efforts by all of our employees throughout the 366 days of 2004. The renovation of our main office was the most significant of our tasks. Through this project we positioned our bank, from a facilities standpoint, to grow to a billion dollars in total assets. We now have corporate, financial reporting, training and data processing on the third floor. All loan functions and item processing occupy the second floor. The first floor houses all of our deposit services, our call center, human resources, accounting, trust, insurance, and our main office branch operation. The main office is now configured to provide the very best in support to our branch offices and most importantly, to our customers. These new facilities join our state-of-the-art computer, phone and network systems to provide the backbone of our financial service delivery.

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During 2004 we received permission from the Office of the Comptroller of the Currency to open our 19th and 20th offices. Fairfield opened in November and the new Lebanon High School branch office will open during the first quarter of 2005. Fairfield is our fifth office in Butler County. We see Butler County as a major contributor to our future growth. The Lebanon High School office will not only provide full-service banking to our future customers, but is designed to train future bankers and help provide much needed financial literacy training to the entire school. On the systems front, we made a move to migrate all of our internal access points to Microsoft Windows XP. We completed our conversion to a new platform automation system, continued to prepare for Check 21 and installed several upgrades to our existing computer programs.


Our strategic initiatives revolved around our strong capital position and our need to employ that capital for the benefit of our shareholders. We moved forward with five programs in this area. The first was the continuation of our stock buyback programs to increase shareholder value. The second was to continue an aggressive dividend payout program. The third was to spend capital to position our bank for continued organic or internal growth. The fourth is to be more aggressive in acquiring facilities, deposits and loans, or entire bank partners. The fifth and final method is our willingness to invest more capital in our insurance operation for growth through acquisition.


To properly position us for future acquisition opportunities, you will see proposals presented at our Annual Meeting to authorize additional shares of common stock and to authorize a new preferred class of stock. Both of these proposals will place in reserve shares of stock that could be used in the future for acquisition opportunities.


2004 also saw a continuation of LCNB Corp.’s commitment to the communities we serve. In addition to over $100,000 in various corporate donations and other corporate support, our directors, officers and employees provide personal support to over 96 organizations that work to improve the quality of life in our region.


The Annual Meeting for LCNB Corp. will be April 12, 2005 at 10:00am EST at our Main Office located at 2 North Broadway in Lebanon, Ohio. Proxy material is included with this mailing. You will notice a significant event in the history of Lebanon Citizens National Bank and LCNB Corp. when you review the Proxy material. Howard E. Wilson and James B. Miller are not standing for re-election to the Board of Directors. These two individuals represent a combined 62 years of service to our bank and our community. Jim Miller joined the bank Board in 1980 and has always demonstrated the highest standards as he represented the shareholders and worked to provide the very best in services for our customers. Howard Wilson joined the bank in 1968 and led our bank from a small 16 million dollar hometown bank to the full-service financial corporation we know today. Always embracing community bank standards, Howard Wilson provided leadership that included vision, integrity, compassion and a drive for excellence. The lessons we learned as young officers through his leadership will guide your bank and us for many years to come.


Please review, sign and return the Proxy in the envelope provided. We would be pleased to have you attend our Annual Meeting in person. Thank you for your continued support.



Stephen P. Wilson

President/Chief Executive Officer


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Financial Statements and Supplementary Data (pages 14 - 24 of Annual Report):



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





To the Board of Directors and Shareholders

LCNB Corp. and subsidiaries

Lebanon, Ohio



We have audited the accompanying consolidated balance sheets of LCNB Corp. and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the three years in the period ended December 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of LCNB Corp. and subsidiaries as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles.


We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of LCNB Corp. and subsidiaries’ internal control over financial reporting as of December 31, 2004, based on criteria established in “Internal Control – Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 14, 2005 expressed an unqualified opinion on management’s assessment of internal control over financial reporting and an unqualified opinion on the effectiveness of internal control over financial reporting.




 

/s/ J.D. Cloud & Co. L.L.P.

 

Certified Public Accountants

  

Cincinnati, Ohio

 

February 14, 2005

 



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LCNB CORP. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

At December 31,

(Dollars in thousands)

 
 
   

2004

   

2003

 

ASSETS:

        

   Cash and due from banks

 

$

10,715 

   

11,784 

 

   Federal funds sold

  

32,400 

   

22,625 

 

        Total cash and cash equivalents

  

43,115 

   

34,409 

 
         

   Securities available for sale, at market value

  

113,437 

   

150,939 

 

   Federal Reserve Bank and Federal Home Loan

     Bank stock, at cost

  


3,058 

   


2,962 

 

   Loans, net

  

334,440 

   

315,683 

 

   Premises and equipment, net

  

12,233 

   

12,009 

 

   Intangibles, net

  

2,173 

   

2,832 

 

   Other assets

  

13,795 

   

4,774 

 

            TOTAL ASSETS

 

$

522,251 

   

523,608 

 
         

LIABILITIES:

        

   Deposits -

        

    Noninterest-bearing

 

$

73,417 

   

66,159 

 

    Interest-bearing

  

390,483 

   

396,874 

 

        Total deposits

  

463,900 

   

463,033 

 

   Long-term debt

  

2,137 

   

4,197 

 

   Accrued interest and other liabilities

  

3,918 

   

3,930 

 

            TOTAL LIABILITIES

  

469,955 

   

471,160 

 
         

SHAREHOLDERS' EQUITY:

        

   Common stock-no par value, authorized 4,000,000

     shares; 3,551,884 shares issued

  


10,560 

   


10,560 

 

   Surplus

  

10,553 

   

10,553 

 

   Retained earnings

  

36,735 

   

33,872 

 

   Treasury shares at cost, 223,585 and 177,508 shares

     at December 31, 2004 and 2003, respectively

  


(6,078)

   


(4,356)

 

   Accumulated other comprehensive income,

     net of taxes

  


526 

   


1,819 

 

            TOTAL SHAREHOLDERS' EQUITY

  

52,296 

   

52,448 

 
         

            TOTAL LIABILITES AND

               SHAREHOLDERS' EQUITY

 


$


522,251 

   


523,608 

 
         
         
         

The accompanying notes to consolidated financial statements are an integral part of these statements.

         

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LCNB CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

For the years ended December 31,

(Dollars in thousands, except per share data)

 
 
  

2004

 

2003

 

2002

INTEREST INCOME:

      

   Interest and fees on loans

$

20,517

 

21,991

 

24,792

   Dividends on Federal Reserve Bank

     and Federal Home Loan Bank stock

 


136

 


129

 


139

   Interest on investment securities-

      

       Taxable

 

2,792

 

3,040

 

3,068

       Non-taxable

 

1,954

 

2,100

 

1,825

   Other short-term investments

 

249

 

177

 

339

        TOTAL INTEREST INCOME

 

25,648

 

27,437

 

30,163

       

INTEREST EXPENSE:

      

   Interest on deposits

 

7,157

 

8,395

 

10,102

   Interest on short-term borrowings

 

6

 

6

 

13

   Interest on long-term debt

 

205

 

279

 

555

        TOTAL INTEREST EXPENSE

 

7,368

 

8,680

 

10,670

        NET INTEREST INCOME

 

18,280

 

18,757

 

19,493

PROVISION FOR LOAN LOSSES

 

489

 

658

 

348

       

        NET INTEREST INCOME AFTER

          PROVISION FOR LOAN LOSSES

 


17,791

 


18,099

 


19,145

       

NON-INTEREST INCOME:

      

   Trust income

 

1,544

 

1,308

 

1,145

   Service charges and fees

 

3,836

 

3,126

 

2,521

   Net gain on sales of securities

 

306

 

9

 

429

   Insurance agency income

 

1,359

 

1,464

 

1,164

   Gains from sales of mortgage loans

 

52

 

758

 

235

   Gain from sale of credit card portfolio

 

403

 

-

 

-

   Other operating income

 

159

 

132

 

129

        TOTAL NON-INTEREST INCOME

 

7,659

 

6,797

 

5,623

       

NON-INTEREST EXPENSE:

      

   Salaries and wages

 

6,955

 

6,808

 

6,531

   Pension and other employee benefits

 

1,875

 

1,737

 

1,702

   Equipment expenses

 

1,030

 

1,021

 

877

   Occupancy expense – net

 

1,178

 

1,115

 

1,029

   State franchise tax

 

581

 

552

 

529

   Marketing

 

436

 

385

 

394

   Intangible amortization

 

598

 

609

 

608

   ATM expense

 

310

 

292

 

412

   Computer maintenance and supplies

 

402

 

364

 

240

   Other non-interest expense

 

3,039

 

2,842

 

3,383

        TOTAL NON-INTEREST EXPENSE

 

16,404

 

15,725

 

15,705

       

        INCOME BEFORE INCOME TAXES

 

9,046

 

9,171

 

9,063

       
      
       

PROVISION FOR INCOME TAXES

 

2,450

 

2,434

 

2,523

        NET INCOME

$

6,596

 

6,737

 

6,540

       

Earnings per common share:

      

   Basic

$

1.97

 

1.97

 

1.90

   Diluted

 

1.97

 

1.97

 

1.90

       

Weighted average shares outstanding:

      

   Basic

 

3,351,146

 

3,417,254

 

3,447,548

   Diluted

 

3,352,297

 

3,417,652

 

3,447,548

       
       
       

The accompanying notes to consolidated financial statements are an integral part of these statements.

       

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LCNB CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY

For the years ended December 31,

(Dollars in thousands, except per share amounts)

 
 
          

Accumulated

       
          

Other

  

Total

    
  

Common

   

Retained

 

Treasury

 

Comprehensive

 

Shareholders'

Comprehensive

  

Shares

 

Surplus

 

Earnings

 

Shares

 

Income

  

Equity

  

Income

 
                     

Balance January 1, 2002

$

10,560

 

10,553

 

27,714 

 

(516)

  

1,196 

    

49,507 

    
                     

Net income

     

6,540 

         

6,540 

  

6,540 

 
                     

Net unrealized gain on available-

  for-sale securities (net of taxes

  of $685)

          



1,329 

    



1,329 

  



1,329 

 
                     

Reclassification adjustment for net

  realized gain on sale of available-

  for-sale securities included in net

  income (net of taxes of $146)

          




(283)

    




(283)

  




(283)

 
                     

Total comprehensive income

                  

7,586 

 
                     

Treasury shares purchased

       

(1,677)

       

(1,677)

    
                     

Cash dividends declared,

  $1.0125 per share

     


(3,486)

         


(3,486)

    
                     

Balance, December 31, 2002

 

10,560

 

10,553

 

30,768 

 

(2,193)

  

2,242 

    

51,930 

    
                     

Net income

     

6,737 

         

6,737 

  

6,737 

 
                     

Net unrealized loss on available-

  for-sale securities (net of tax

  benefit of $215)

          



(417)

    



(417)

  



(417)

 
                     

Reclassification adjustment for net

  realized gain on sale of available-

  for-sale securities included in net

  income (net of taxes of $3)

          




(6)

    




(6)

  




(6)

 
                     

Total comprehensive income

                  

6,314 

 
                     

Treasury shares purchased

       

(2,163)

       

(2,163)

    
                     

Cash dividends declared,

  $1.0625 per share

     


(3,633)

         


(3,633)

    
                    

Balance, December 31, 2003

 

10,560

 

10,553

 

33,872 

 

(4,356)

  

1,819 

    

52,448 

    
                     

Net income

     

6,596 

         

6,596 

  

6,596 

 
                     

Net unrealized loss on available-

  for-sale securities (net of tax

  benefit of $562)

          



(1,091)

    



(1,091)

  



(1,091)

 
                     

Reclassification adjustment for net

  realized gain on sale of available-

  for-sale securities included in net

  income (net of taxes of $104)

          




(202)

    




(202)

  




(202)

 
                     

Total comprehensive income

                  

5,303 

 
                     

Treasury shares purchased

       

(1,722)

       

(1,722)

    
                     

Cash dividends declared,

  $1.115 per share

     


(3,733)

         


(3,733)

    
                     

Balance, December 31, 2004

$

10,560

 

10,553

 

36,735 

 

(6,078)

  

526 

    

52,296 

    
                     
                     

The accompanying notes to consolidated financial statements are an integral part of these statements.

                     

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LCNB CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the years ended December 31,

(Dollars in thousands)

       
  

2004

 

2003

 

2002

CASH FLOWS FROM OPERATING ACTIVITIES:

      

   Net income

$

6,596 

 

6,737 

 

6,540 

   Adjustments to reconcile net income to net cash

    provided by operating activities-

      

      Depreciation, amortization and accretion

 

2,974 

 

3,209 

 

2,548 

      Provision for loan losses

 

489 

 

658 

 

348 

      Deferred income tax provision (benefit)

 

(14)

 

83 

 

(63)

      Federal Home Loan Bank stock dividends

 

(96)

 

(91)

 

(99)

      Realized gains on sales of securities available for sale

 

(306)

 

(9)

 

(429)

      Realized gain on sale of credit card portfolio

 

(403)

 

- 

 

- 

      Origination of mortgage loans for sale

 

(2,237)

 

(35,060)

 

(20,852)

      Realized gains from sales of mortgage loans

 

(52)

 

(758)

 

(235)

      Proceeds from sales of mortgage loans

 

2,264 

 

35,448 

 

21,087 

      (Increase) decrease in income receivable

 

642 

 

(72)

 

98 

      (Increase) decrease in other assets

 

337 

 

(238)

 

(261)

      Increase (decrease) in other liabilities

 

32 

 

106 

 

(308)

         TOTAL ADJUSTMENTS

 

3,630 

 

3,276 

 

1,834 

       

           NET CASH FLOWS FROM OPERATING

             ACTIVITIES

 


10,226

 


10,013 

 


8,374 

       

CASH FLOWS FROM INVESTING ACTIVITIES:

      

   Proceeds from sales of securities available for sale

 

36,315 

 

1,775 

 

25,739 

   Proceeds from maturities of securities available for sale

 

36,620 

 

46,959 

 

29,093 

   Purchases of securities available for sale

 

(38,007)

 

(65,429)

 

(91,171)

   Purchases of bank-owned life insurance

 

(10,000)

 

- 

 

- 

   Proceeds from sale of credit card portfolio

 

2,927 

 

- 

 

- 

   Net decrease (increase) in loans

 

(22,059)

 

6,283 

 

1,829 

   Purchases of premises and equipment

 

(1,306)

 

(1,394)

 

(1,061)

   Proceeds from sales of premises and equipment

 

2 

 

26 

 

3 

            NET CASH FLOWS FROM INVESTING

              ACTIVITIES

 


4,492 

 


(11,780)

 


(35,568)

       

CASH FLOWS FROM FINANCING ACTIVITIES:

      

   Net change in deposits

 

867 

 

20,813 

 

27,449 

   Net change in short-term borrowings

 

636 

 

(2,389)

 

2,329 

   Principal payments on long-term debt

 

(2,060)

 

(2,056)

 

(6,053)

   Cash dividends paid

 

(3,733)

 

(3,633)

 

(3,486)

   Purchases of treasury shares

 

(1,722)

 

(2,163)

 

(1,677)

            NET CASH FLOWS FROM FINANCING

              ACTIVITIES

 


(6,012)

 


10,572 

 


18,562 















       

            NET CHANGE IN CASH AND CASH

               EQUIVALENTS

 


8,706 

 


8,805 

 


(8,632)

       
       

CASH AND CASH EQUIVALENTS AT BEGINNING

   OF YEAR

 


34,409 

 


25,604 

 


34,236 

       

CASH AND CASH EQUIVALENTS AT END OF

   YEAR


$


43,115 

 


34,409 

 


25,604 

       

SUPPLEMENTAL CASH FLOW INFORMATION:

      
       

CASH PAID DURING THE YEAR FOR:

      

   Interest

$

7,388 

 

8,778 

 

10,968 

   Income taxes

 

2,416 

 

2,245 

 

2,540 

       
       

The accompanying notes to consolidated financial statements are an integral part of these statements.

       

- 8 -















LCNB CORP. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS

December 31, 2004



NOTE 1 -

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES


LCNB Corp. (the "Company"), an Ohio corporation formed in December 1998, is a financial holding company whose principal assets are the ownership of Lebanon Citizens National Bank (the "Bank") and Dakin Insurance Agency, Inc. ("Dakin").  The Bank was founded in 1877 and provides full banking services, including trust and brokerage services, to customers primarily in the southwestern Ohio area of Warren, Hamilton, Clermont, Clinton and Butler counties. Dakin is an independent insurance agency founded in 1876 and offers a wide range of insurance products for businesses and individuals in the Bank's primary market area.


BASIS OF PRESENTATION-

The consolidated financial statements include the accounts of the Company and its subsidiaries. Significant intercompany accounts and transactions are eliminated in consolidation.  The accounting and reporting policies of the Company conform with U.S. generally accepted accounting principles (“GAAP”) and with general practices in the banking industry.  


USE OF ESTIMATES-

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.


STOCK DIVIDEND-

The Board of Directors of the Company at the regular meeting of April 13, 2004 declared a stock dividend of one share for each share owned by shareholders of record on April 20, 2004.  The stock dividend was paid on April 30, 2004 and was accounted for as a stock split.  All share and per share information for all periods presented have been retroactively restated to reflect the stock dividend.





- 9 -















NOTE 1 -

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES  (Continued)


INVESTMENT SECURITIES-

All of the Company's debt securities are classified as available for sale and are reported at fair value with unrealized holding gains and losses reported net of income taxes as Accumulated Other Comprehensive Income, a separate component of shareholders' equity. Amortization of premiums and accretion of discounts are recognized as adjustments to interest income using the level-yield method.  Realized gains or losses from the sale of securities are computed using the specific identification method.  Declines in the fair value of available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses.  In estimating other than temporary impairment losses, management considers the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability of the Company to retain its investment in the issuer for period of time sufficient to allow for any anticipated recovery in fair value.  Currently, the Company and its subsidiaries do not hold any derivatives or conduct hedging activities.


Federal Home Loan Bank ("FHLB") stock is an equity interest in the Federal Home Loan Bank of Cincinnati.  It can be sold only at its par value of $100 per share and only to the FHLB or to another member institution.  In addition, the equity ownership rights are more limited than would be the case for a public company because of the oversight role exercised by the Federal Housing Finance Board in the process of budgeting and approving dividends.  Federal Reserve Bank stock is similarly restricted in marketability and value.  Both investments are carried at cost, which is their par value.


LOANS AND ALLOWANCE FOR LOAN LOSSES-

Loans are stated at the principal amount outstanding, net of unearned income, deferred origination fees and costs, and the allowance for loan losses.  Interest income is accrued on the unpaid principal balance.  Generally, a loan is placed on non-accrual status when there is an indication that the borrower’s cash flow may not be sufficient to meet payments as they come due, unless the loan is well secured and in the process of collection.  Subsequent cash receipts on non-accrual loans are recorded as a reduction of principal, and interest income is recorded once principal recovery is reasonably assured.  The current year's accrued interest on loans placed on non-accrual status is charged against earnings.  Previous years' accrued interest is charged against the allowance for loan losses.


Loan origination fees and certain direct loan origination costs are deferred and the net amount amortized as an adjustment of loan yields.  These amounts are being amortized over the lives of the related loans.




- 10 -















NOTE 1 -

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES  (Continued)


The allowance for loan losses is established through a provision for loan losses charged to expense.  Loans are charged against the allowance for loan losses when management believes that the collectibility of the principal is unlikely.  The allowance is an amount that management believes will be adequate to absorb possible losses on loans that may become uncollectible, based on evaluations of the collectibility of loans and prior loan loss experience.  The evaluations take into consideration such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, and current economic conditions that may affect the borrowers' ability to pay.  


The allowance consists of specific, general, and unallocated components.  The specific component relates to loans that are classified as either doubtful, substandard, or special mention.  For such loans that are also classified as impaired, an allowance is established when the discounted cash flows or collateral value or observable market price of the impaired loan is lower than the carrying value of that loan.  The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors.  An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses.  The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.


Loans are considered impaired when management believes, based on current information and events, it is probable that the Bank will be unable to collect all amounts due according to the contractual terms of the loan agreement.  Impaired loans are measured by the present value of expected future cash flows using the loan's effective interest rate.  Impaired collateral-dependent loans may be measured based on collateral value.  Smaller-balance homogenous loans, including residential mortgage and consumer installment loans, are collectively evaluated for impairment.


PREMISES AND EQUIPMENT-

Premises and equipment are stated at cost less accumulated depreciation.  Depreciation is computed on both the straight-line and accelerated methods over the estimated useful lives of the assets, generally 15 to 40 years for premises and 3 to 10 years for equipment.  Costs incurred for maintenance and repairs are expensed currently.


REAL ESTATE ACQUIRED THROUGH FORECLOSURE-

Real estate acquired through foreclosure is recorded at the lower of cost or fair value, less estimated selling costs.  The allowance for loan losses is charged for any write down of the loan’s carrying value to fair value at the date of acquisition.  Any subsequent reductions in fair value are recorded to other non-interest expense.  Expenses incurred from holding foreclosed real estate are charged to other non-interest expense as incurred.  




- 11 -















NOTE 1 -

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES  (Continued)


INTANGIBLE ASSETS-

The Company's intangible assets at December 31, 2004 primarily represent the unamortized intangible related to the Company's 1997 acquisition of three branch offices from another bank.  Management determined its 1997 branch office acquisition did not meet the definition of a business combination and continues to amortize the intangible over ten years, subject to periodic review for impairment in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144.  At December 31, 2004, the carrying amount of this intangible was $1.9 million, net of accumulated amortization of $4.2 million.


Mortgage servicing rights on originated mortgage loans that have been sold are capitalized by allocating the total cost of the loans between mortgage servicing rights and the loans based on their relative estimated fair values.  Capitalized mortgage servicing rights are amortized to loan servicing income in proportion to and over the period of estimated servicing income.  Such assets are periodically evaluated as to the recoverability of their carrying value.


Annual estimates of intangible amortization expense, including amortization of the mortgage servicing rights asset, for the years 2005 through 2009 are $650,000, $650,000, $580,000, $252,000, and $24,000, respectively.


BANK OWNED LIFE INSURANCE-

The Company has purchased life insurance policies on certain officers of the Company.  Bank owned life insurance is recorded at its estimated cash surrender value and is included in other assets in the consolidated balance sheet.  Income on the policies, based on the increase in cash surrender value, is included in other non-interest income in the consolidated statements of income.


MARKETING EXPENSE-

Marketing costs are expensed as incurred.


EMPLOYEE BENEFITS-

The Company has a noncontributory pension plan covering full-time employees. The retirement plan cost is made up of several components that reflect different aspects of the Company's financial arrangements as well as the cost of benefits earned by employees. These components are determined using the projected unit credit actuarial cost method and are based on certain actuarial assumptions.






- 12 -















NOTE 1 -

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES  (Continued)


STOCK OPTIONS-

The Company established an Ownership Incentive Plan (the "Plan") during 2002 that is more fully described in Note 7.  The Company accounts for the Plan under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations.  No stock-based employee compensation cost is reflected in net income, as all options granted under the Plan have an exercise price equal to the market value of the underlying common stock on the date of grant.  The following table illustrates the effect on net income and earnings per share for the years ended December 31, 2004 and 2003 if the Company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation (000's):


  

2004

 

2003

Net income, as reported

$

6,596

 

6,737

Deduct total stock-based employee compensation

   expense estimated using Black-Scholes model,

   net of tax

 



6

 



3

     

Pro-forma net income

$

6,590

 

6,734


The pro-forma affect of the above adjustment on basic and diluted earnings per share was not material.


INCOME TAXES-

Deferred income taxes are determined using the liability method of accounting.  Under this method, the net deferred tax asset or liability is determined based on the tax effects of temporary differences between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws.


STATEMENTS OF CASH FLOWS-

For purposes of reporting cash flows, cash and cash equivalents include cash, balances due from banks, and federal funds sold, all highly liquid investments with original maturities of three months or less.





- 13 -















NOTE 1 -

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES  (Continued)


EARNINGS PER SHARE-

Basic earnings per share is calculated by dividing net income by the weighted average number of common shares outstanding during the period.  Diluted earnings per share is adjusted for the dilutive effects of stock options.  The diluted average number of common shares outstanding has been increased for the assumed exercise of stock options with proceeds used to purchase treasury shares at the average market price for the period.


Earnings per share for the years ended December 31, 2004, 2003, and 2002 were calculated as follows ($000’s except per share data):


  

2004

 

2003

 

2002

       

Net income (loss)

$

6,596

 

6,737

 

6,540

       

Weighted average number of shares

  outstanding used in the calculation of

  basic earnings per common share

 



3,351,146

 



3,417,254

 



3,447,548

       

Add - Dilutive effect of stock options (a)

 

1,151

 

398

 

-

       

Adjusted weighted average number of

  shares outstanding used in the

  calculation of diluted earnings per

  common share

 




3,352,297

 




3,417,652

 




3,447,548

       

Basic earnings per common share

$

1.97

 

1.97

 

1.90

       

Diluted earnings per common share

 

1.97

 

1.97

 

1.90


(a)  Stock options were not outstanding during the year ended December 31, 2002.


RECLASSIFICATIONS-

Certain prior period data presented in the financial statements has been reclassified to conform with the current year presentation.






- 14 -
















NOTE 1 -

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES  (Continued)


RECENT ACCOUNTING PRONOUNCEMENTS-

SFAS No. 153, Exchanges of Nonmonetary Assets – an amendment of APB Opinion No. 29, was issued in December, 2004.  It amends the guidance in Accounting Principles Board Opinion No. 29, Accounting for Nonmonetary Transactions, to eliminate an exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance.  Under SFAS No. 153, a nonmonetary exchange will have commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange.  This statement is not expected to have a material impact on the Company’s financial statements.


SFAS No. 123 (revised 2004), Share-Based Payment, was issued in December, 2004 and replaces SFAS No. 123, Accounting for Stock-Based Compensation, and supersedes APB No. 25, Accounting for Stock Issued to Employees.  SFAS No. 123 (revised) focuses primarily on accounting for transactions where employees receive share-based compensation, but also covers transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of equity instruments.  SFAS No. 123 (revised) generally requires an entity to recognize expense for the grant-date fair value of share-based compensation, where the original SFAS No. 123 encouraged but did not require an entity to recognize expense for such transactions.  The estimated cost of share-based compensation is to be recognized over the period during which an employee is required to provide service in exchange for the award, usually the vesting period.  SFAS No. 123 (revised) is effective for the first interim or annual reporting period that begins after June 15, 2005.  The Company will be required to adopt SFAS No. 123 (revised) no later than July 1, 2005.  The Company intends to adopt the provisions of SFAS No. 123 (revised) in the first quarter of 2005 using the modified prospective approach as allowed by SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure—an amendment of FASB Statement No. 123.  Adoption of SFAS No. 123 (revised) is not expected to have a material short-term impact on the Company’s financial statements because of its relatively limited use of options.



- 15 -
















NOTE 2 -

INVESTMENT SECURITIES


The amortized cost and estimated market value of available-for-sale investment securities at December 31 are summarized as follows (000’s):


 

2004

 

Amortized

Unrealized

Unrealized

 

Market

  

Cost

  

Gains

 

Losses

 

Value

            

U.S. Treasury notes

$

1,193

  

1

  

-

  

1,194

U.S. Agency notes

 

23,940

  

45

  

196

  

23,789

U.S. Agency mortgage-

   backed securities

 


28,659

  


98

  


254

  


28,503

Municipal securities:

           

     Non-taxable

 

51,149

  

1,197

  

74

  

52,272

     Taxable

 

7,699

  

55

  

75

  

7,679

 

$

112,640

  

1,396

  

599

  

113,437



 

2003

 

Amortized

Unrealized

Unrealized

 

Market

  

Cost

  

Gains

 

Losses

 

Value

            

U.S. Treasury notes

$

2,137

  

12

  

-

  

2,149

U.S. Agency notes

 

61,397

  

608

  

183

  

61,822

U.S. Agency mortgage-

   backed securities

 


20,951

  


158

  


121

  


20,988

Municipal securities:

           

     Non-taxable

 

52,441

  

2,002

  

34

  

54,409

     Taxable

 

11,258

  

357

  

44

  

11,571

 

$

148,184

  

3,137

  

382

  

150,939


Contractual maturities of debt securities at December 31, 2004 were as follows (000’s).  Actual maturities may differ from contractual maturities when issuers have the right to call or prepay obligations.


 

Amortized

 

Market

 
  

Cost

  

Value

 
       

Due within one year

$

15,754

  

15,829

 

Due from one to five years

 

47,118

  

47,445

 

Due from five to ten years

 

12,152

  

12,427

 

Due after ten years

 

8,957

  

9,233

 
  

83,981

  

84,934

 
       

U.S. Agency mortgage-backed securities

 

28,659

  

28,503

 
 

$

112,640

  

113,437

 


- 16 -















NOTE 2 -

INVESTMENT SECURITIES (Continued)


Information concerning securities with gross unrealized losses at December 31, 2004, aggregated by length of time that individual securities have been in a continuous loss position, is as follows (000’s):



  

Less than Twelve

Months

More than Twelve

Months

  

Fair

Unrealized

Fair

 

Unrealized

  

Value

Losses

Value

 

Losses

           

U.S. Treasury notes

$

-

 

-

 

-

  

-

 

U.S. Agency notes

 

11,085

 

87

 

5,095

  

109

 

U.S. Agency mortgage

  backed securities

 


18,492

 


229

 


1,351

  


25

 
           

Municipal securities:

          

    Non-taxable

 

5,937

 

64

 

384

  

10

 

    Taxable

 

4,196

 

58

 

308

  

17

 
 

$

39,710

 

438

 

7,138

  

161

 



The decline in the fair values is primarily due to increases in market interest rates.  Because the Company has the ability and intent to hold these securities for a period of time sufficient to allow for any anticipated recovery in fair values, no individual declines are deemed to be other than temporary.


For the years ended December 31, 2004, 2003, and 2002, proceeds from sales of securities available for sale amounted to $36,315,000, $1,775,000, and $25,739,000, respectively.  Gross gains realized on sales were $306,000, $18,000, and $446,000 for 2004, 2003 and 2002, respectively.  Gross realized losses during 2004, 2003 and 2002 amounted to $0, $9,000 and $17,000, respectively.  The tax provision applicable to these net realized gains amounted to $104,000, $3,000, and $146,000, respectively.  


Investment securities with a market value of $56,733,000 and $74,130,000 at December 31, 2004 and 2003, respectively, were pledged to secure public deposits and for other purposes required or permitted by law.








- 17 -















NOTE 3 -

LOANS


Major classifications of loans at December 31 are as follows (000's):


  

2004

 

2003

 
      

Commercial and industrial

$

32,931 

 

30,519 

 

Commercial, secured by real estate

 

107,138 

 

99,461 

 

Residential real estate

 

159,286 

 

139,305 

 

Consumer, excluding credit card

 

34,672 

 

43,283 

 

Agricultural

 

1,653 

 

1,192 

 

Credit card

 

- 

 

2,707 

 

Other loans

 

167 

 

212 

 

Lease financing

 

253 

 

588 

 
  

336,100 

 

317,267 

 

Deferred net origination costs

 

490 

 

566 

 
  

336,590 

 

317,833 

 

Allowance for loan losses

 

(2,150)

 

(2,150)

 

     Loans-net

$

334,440 

 

315,683 

 


Changes in the allowance for loan losses were as follows (000's):


  

2004

 

2003

 

2002

       

BALANCE - BEGINNING OF YEAR

$

2,150 

 

2,000 

 

2,000 

Provision for loan losses

 

489 

 

658 

 

348 

Charge-offs

 

(614)

 

(560)

 

(390)

Recoveries

 

125 

 

52 

 

42 

BALANCE - END OF YEAR

$

2,150 

 

2,150 

 

2,000 


Non-accrual, past-due, and restructured loans at December 31, 2004 and 2003 were as follows (000’s)


  

2004

 

2003

     

Non-accrual loans

$

-

 

794

Past-due 90 days or more and still accruing

 

165

 

2,442

Restructured loans

 

1,817

 

-

     Total

$

1,982

 

3,236



Non-accrual loans at December 31, 2003 included a commercial loan in the amount of $564,000, which was paid in full during the second quarter, 2004; a consumer loan in the amount of $146,000; and residential real estate mortgage loans in the amount of $84,000.  Interest income that would have been recorded during 2003 if loans on a non-accrual status at December 31, 2003 had been current and in accordance with their original terms was approximately $72,000.


- 18 -















NOTE 3 -

LOANS (Continued)


The restructured loan at December 31, 2004 consists of a commercial loan whose predecessor loans were classified as loans past due 90 days or more and still accruing at December 31, 2003, at which time they had a total balance of $2,030,000.  Information received during the first quarter, 2004, raised uncertainties concerning the collectibility of certain collateral and management transferred the loans to the non-accrual classification, where they remained until they were re-written in October, 2004.  The $213,000 difference in the loan balances at December 31, 2004 and 2003 is due to principal payments received.  All related interest due on the predecessor loans was paid during October, 2004, and the loans were re-written at that time.  Such interest has been recorded on a cash basis as received.  The restructured loan is secured by a combination of mortgages and other collateral.


The following is a summary of information pertaining to loans considered to be impaired in accordance with SFAS No. 114 at December 31 (000’s):


  

2004

 

2003

     

Impaired loans without a valuation allowance

$

71

 

84

Impaired loans with a valuation allowance

 

2,049

 

2,740

Total impaired loans

 

2,120

 

2,824

     

Valuation allowance related to impaired loans

$

540

 

674


The average balance of impaired loans during 2004 and 2003 was $2,629,000 and $2,857,000, respectively.  During 2004 the Company received and recognized $164,000 of interest income on impaired loans.  During 2003 the Company accrued interest income totaling $183,000 on impaired loans classified as past due 90 days or more and still accruing because they were considered well secured and in the process of collection.  This accrued interest was received during the first quarter, 2004.  


The Company is not committed to lend additional funds to debtors whose loans have been modified to provide a reduction or deferral of principal or interest because of deterioration in the financial position of the borrower.


Mortgage loans sold to and serviced for the Federal Home Loan Mortgage Corporation are not included in the accompanying balance sheets.  The unpaid principal balances of those loans at December 31, 2004, 2003 and 2002 were $46,345,000, $54,802,000, and $36,592,000 respectively.  


Approximately $25,000 and $370,000 in mortgage servicing rights were capitalized and $86,000 and $49,000 was amortized to loan servicing income during the years ended  December 31, 2004 and 2003, respectively.



- 19 -















NOTE 4 -

PREMISES AND EQUIPMENT


Premises and equipment at December 31 are summarized as follows (000's):


  

2004

 

2003

 
      

Land

$

2,244

 

2,244

 

Buildings

 

10,592

 

9,843

 

Equipment

 

8,888

 

8,442

 

Construction in progress

 

81

 

408

 

     Total

 

21,805

 

20,937

 

Less - Accumulated depreciation

 

9,572

 

8,928

 

     Premises and equipment – net

$

12,233

 

12,009

 


Depreciation charged to income was $1,080,000 in 2004, $1,040,000 in 2003 and $999,000 in 2002.


Some of the Bank's branches, telephone equipment, and other equipment are leased under agreements expiring at various dates through 2050.  These leases are accounted for as operating leases.  At December 31, 2004, required minimum annual rentals due in the future on non-cancelable leases having terms in excess of one year aggregated $2,189,000.  Minimum annual rentals for each of the years 2005 through 2009 are as follows (000's):


2005

$

296

2006

 

275

2007

 

155

2008

 

30

2009

 

30


Rental expense for all leased branches and equipment amounted to $321,000 in 2004, $309,000 in 2003 and $305,000 in 2002.



NOTE 5 -

DEPOSIT LIABILITIES


Contractual maturities of time deposits at December 31, 2004 were as follows (000’s):


 

Certificates

All other

 
 

over $100,000

Certificates

Total

        

2005

$

26,082

  

53,507

 

79,589

2006

 

8,182

  

27,483

 

35,665

2007

 

6,067

  

23,422

 

29,489

2008

 

621

  

8,464

 

9,085

2009

 

309

  

2,916

 

3,225

Thereafter

 

13,843

  

13,465

 

27,308

 

$

55,104

  

129,257

 

184,361


- 20 -















NOTE 6 -

EMPLOYEE BENEFITS


The Company's noncontributory defined benefit retirement plan covers all regular full-time employees.  The benefits are based on years of service and the employee's highest average compensation during five consecutive years.  Pension costs are funded based on the Plan's actuarial cost method.  All plan assets are invested in time and other deposits with the Bank.


The Company used a December 31 measurement date for its retirement plan starting in 2004 and a September 30 measurement date for previous years.


The components of net periodic pension cost are summarized as follows (000's):


  

2004

 

2003

 

2002

       

Service cost

$

624 

 

624 

 

629 

Interest cost

 

296 

 

298 

 

262 

Expected return on plan assets

 

(325)

 

(233)

 

(248)

Amortization of unrecognized transition

   obligation

 


- 

 


- 

 


10 

Recognized net actuarial loss (gain)

 

2 

 

(46)

 

5 

        Net periodic pension cost

$

597 

 

643 

 

658 


A summary of the Plan's prepaid benefit cost, included in other assets on the consolidated balance sheets, and the Plan's funded status at December 31 follows (000's):


  

2004

 

2003

 

Change in projected benefit obligations

     

Projected benefit obligation at beginning of year

$

5,732 

 

5,733 

 

Service cost

 

624 

 

624 

 

Interest cost

 

296 

 

298 

 

Actuarial gain

 

(181)

 

(336)

 

Benefits paid

 

(394)

 

(587)

 

Projected benefit obligation at end of year

 

6,077 

 

5,732 

 
      

Change in plan assets

     

Fair value of plan assets at beginning of year

 

5,942 

 

5,678 

 

Actual return on plan assets

 

114 

 

233 

 

Employer contribution

 

626 

 

618 

 

Benefits paid

 

(394)

 

(587)

 

Fair value of plan assets at end of year

 

6,288 

 

5,942 

 
      

Funded status

 

211 

 

210 

 

Unrecognized net actuarial loss

 

654 

 

626 

 

Prepaid benefit cost

$

865 

 

836 

 



- 21 -















NOTE 6 -

EMPLOYEE BENEFITS  (Continued)


Significant actuarial assumptions used for 2004 and 2003 included a discount rate, an expected long-term rate of return on Plan assets, and a future compensation rate increase of 5.50%, 5.50%, and 4.00%, respectively.  The expected long-term rate of return on Plan assets was estimated using historic returns on investments, adjusted for expected long-term interest rates.


The accumulated benefit obligation at December 31, 2004 and 2003 was $5,478,000 and $4,901,000, respectively.


The Company expects to contribute approximately $650,000 to its retirement plan in 2005.


The following estimated future benefit payments, which reflect expected future service, as appropriate, are expected to be paid (000's):


2005

$

7

2006

 

7

2007

 

35

2008

 

76

2009

 

153

2010 through 2014

 

1,796


The Bank has a benefit plan which permits eligible officers to defer a portion of their compensation.  The deferred compensation balance, which accrues interest at 8% annually, is distributable in cash after retirement or termination of employment.  The amount of such deferred compensation liability at December 31, 2004 and 2003 was $797,000 and $663,000, respectively.


The Bank also has a supplemental income plan which provides a covered employee an amount based on a percentage of average compensation, payable annually for ten years upon retirement. The projected benefit obligation included in other liabilities for this supplemental income plan at December 31, 2004 and 2003 is $192,000 and $159,000, respectively. The discount rate used to determine the present value of the obligation was 5.5% in 2004 and 6.5% in 2003. The service cost associated with this plan was $24,000 for 2004 and approximately $16,000 for each year in 2003 and 2002.  Interest costs were approximately $10,000, $9,000, and $8,000 for 2004, 2003, and 2002, respectively.  Both of these plans are nonqualified and unfunded.  Participation in each plan is limited to a select group of management.






- 22 -















NOTE 7 -

STOCK OPTIONS AND AWARDS


The Company established an Ownership Incentive Plan (the "Plan") during 2002 that allows for stock-based awards to eligible employees, as determined by the Board of Directors.  The awards may be in the form of stock options, share awards, and/or appreciation rights.  The Plan provides for the issuance of up to 100,000 shares.  No awards were granted during 2002.  Stock options for 4,054 and 5,528 shares with an exercise price of $35.32 and $26.19 per share were granted to key executive officers of the Company during the first quarter, 2004 and 2003, respectively.  Such options vest ratably over a five year period and expire in 2013.  No options have been exercised through December 31, 2004.


The estimated weighted-average fair value of the options granted in 2004 and 2003 were $5.57 and $3.77 per option, respectively.  The fair value was estimated at the date of grant using the Black-Scholes option-pricing model and the following assumptions:


  

    2004

    2003

Risk-free interest rate

 

2.76%

2.72%

Average dividend yield

 

3.50%

4.65%

Volatility factor of the expected market

   

  price of the Company's common stock

 

24.54%

25.79%

Average life

 

4 years

4 years



NOTE 8 -     LONG-TERM DEBT AND OTHER BORROWINGS


Long-term debt consists of the following at December 31 (000’s):


  

2004

 

2003

 
      

Federal  Home Loan Bank note

$

2,000

 

4,000

 

Note payable to former shareholder of Dakin

 

137

 

197

 

     Total

$

2,137

 

4,197

 


Maturities of long-term debt in the years ending December 31 are as follows (000's):


  2005

$

64

  2006

 

2,067

  2007

 

6


In August 2002, the Company retired $4.0 million in Federal Home Loan Bank notes bearing a weighted average interest rate of 7.72%.  These notes were scheduled to mature in 2004 and 2005.  In connection with this transaction, the Company recorded an expense of $425,000 in other non-interest expense in the 2002 consolidated statement of income, which was the required prepayment penalty.



- 23 -















NOTE 8 -     LONG-TERM DEBT AND OTHER BORROWINGS (continued)


A $2.0 million Federal Home Loan Bank note bearing an interest rate of 4.40% matured and was paid by the Company during December, 2004.  At December 31, 2004, the Federal Home Loan Bank borrowing consists of a note with a  five-year maturity and an interest rate of 5.54%.  Interest on the note is fixed and payable monthly.  The note is secured by $2.5 million of 1-4 family residential mortgage loans.  Additionally, the Company is required to hold minimum levels of FHLB stock, based on the outstanding borrowings.  The Company’s addition borrowing capacity at December 31, 2004 is approximately $79 million.


The note payable to a former shareholder of Dakin matures in 2007.  Payments are due monthly at a nominal interest rate of 6%.


At December 31, 2004 and 2003, accrued interest and other liabilities include U.S. Treasury demand note borrowings of approximately $1,269,000 and $633,000, respectively.  The interest rate on these borrowings was 1.87% and 0.73% at December 31, 2004 and 2003, respectively.



NOTE 9 -

INCOME TAXES


The provision for federal income taxes consists of (000's):


  

2004

 

2003

 

2002

       

Income taxes currently payable

$

2,464 

 

2,351

 

2,586 

Deferred income tax provision (benefit)

 

(14)

 

83

 

(63)

     Provision for income taxes

$

2,450 

 

2,434

 

2,523 


A reconciliation between the statutory income tax and the Company's effective tax rate follows:


  

2004

 

2003

 

2002

       

Statutory tax rate

 

34.0%

 

34.0%

 

34.0%

Increase (decrease) resulting from -

      

   Tax exempt interest

 

(6.9) 

 

(7.2) 

 

(6.1) 

   Other – net

 

-  

 

(0.2) 

 

(0.1) 

      Effective tax rate

 

27.1%

 

26.6%

 

27.8%




- 24 -















NOTE 9 -

INCOME TAXES (continued)


Deferred tax assets and liabilities at December 31 consist of the following (000's):


  

2004

 

2003

 

Deferred tax assets:

     

   Allowance for loan losses

$

627 

 

591 

 

   Amortization of intangibles

 

340 

 

263 

 

   Pension and deferred compensation

 

47 

 

- 

 
  

1,014 

 

854 

 
      

Deferred tax liabilities:

     

   Depreciation of premises and equipment

 

(590)

 

(439)

 

   Unrealized gains on securities available for sale

 

(271)

 

(937)

 

   Deferred loan fees

 

(27)

 

(37)

 

   Pension and deferred compensation

 

- 

 

(28)

 

   FHLB stock dividends

 

(153)

 

(120)

 
  

(1,041)

 

(1,561)

 

       Net deferred tax asset (liability)

$

(27)

 

(707)

 




NOTE 10 -

COMMITMENTS AND CONTINGENT LIABILITIES


The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers.  These financial instruments include commitments to extend credit.  They involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheets.  The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contract amount of those instruments.


The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.  Financial instruments whose contract amounts represent off-balance-sheet credit risk at December 31 were as follows (000's):


  

2004

 

2003

 
      

Commitments to extend credit

$

68,235

 

74,828

 

Standby letters of credit

 

6,186

 

6,770

 





- 25 -















NOTE 10 -

COMMITMENTS AND CONTINGENT LIABILITIES (continued)


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.  Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. At December 31, 2004 and 2003, outstanding guarantees of $1,983,000 and  $1,880,000, respectively, were issued to developers and contractors. These guarantees generally are fully secured and have varying maturities.  In addition, the Company has a participation in a letter of credit securing payment of principal and interest on a bond issue.  The participation amount at December 31, 2004 and 2003 was approximately $4.2 million and $4.9 million, respectively.  The letter of credit will expire on July 15, 2009.  It is secured by an assignment of rents and the underlying real property.


The Company evaluates each customer's credit worthiness on a case-by-case basis.  The amount of collateral obtained if deemed necessary by the Company is based on management's credit evaluation of the borrower.  Collateral held varies, but may include deposit accounts, accounts receivable, inventory, property, plant and equipment, residential realty, and income-producing commercial properties.


At December 31, 2004, the Company is committed under various contracts to expend approximately $835,000 to complete certain building acquisition and renovation projects.


The Company and its subsidiaries are parties to various claims and proceedings arising in the normal course of business.  Management, after consultation with legal counsel, believes that the liabilities, if any, arising from such proceedings and claims will not be material to the consolidated financial position or results of operations.








- 26 -















NOTE 11 -

RELATED PARTY TRANSACTIONS


The Company has entered into related party transactions with various directors and executive officers.  Such transactions originate in the normal course of the Bank's operations as a depository and lending institution and were made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated customers.  Management believes these transactions do not involve more than a normal risk of collectibility or present other unfavorable features.   At December 31, 2004 and 2003, executive officers, directors and related interests of such persons were indebted to the Bank directly or as guarantors in the aggregate amount of $2,792,000 and $3,340,000, respectively.  Loan activity for these officers and directors was as follows (000's):


  

2004

 

2003

 
      

Beginning balances

$

3,340

 

3,961

 

Additions

 

812

 

3,658

 

Reductions

 

1,360

 

4,279

 

Ending Balance

$

2,792

 

3,340

 


Deposits from executive officers, directors and related interests of such persons held by the Company at December 31, 2004 and 2003 amounted to $7,023,000 and $9,624,000, respectively.



NOTE 12 -

FAIR VALUE OF FINANCIAL INSTRUMENTS


Carrying amounts and estimated fair values of financial instruments as of December 31, were as follows (000’s):


  

2004

  

2003

 

Carrying

Fair

Carrying

 

Fair

  

Amount

  

Value

 

Amount

 

Value

            

FINANCIAL ASSETS:

           

  Cash and cash equivalents

$

43,115

  

43,115

  

34,409

  

34,409

  Securities available for sale

 

113,437

  

113,437

  

150,939

  

150,939

  Federal Reserve Bank and

    Federal Home Loan Bank

    stock

 



3,058

  



3,058

  



2,962

  



2,962

  Loans, net

 

334,440

  

334,761

  

315,683

  

323,754

            

FINANCIAL LIABILITIES:

           

  Deposits

 

463,900

  

463,831

  

463,033

  

466,522

  Short-term borrowings

 

1,269

  

1,269

  

633

  

633

  Long-term debt

 

2,137

  

2,189

  

4,197

  

4,481



-. 27 -















NOTE 12 -

FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)


The fair value of off-balance-sheet financial instruments at December 31, 2004 and 2003 was not material.


Fair values of financial instruments are based on various assumptions, including the discount rate and estimates of future cash flows.  Therefore, the fair values presented may not represent amounts that could be realized in actual transactions.  In addition, because the required disclosures exclude certain financial instruments and all nonfinancial instruments, any aggregation of the fair value amounts presented would not represent the underlying value of the Bank.  The following methods and assumptions were used to estimate the fair value of certain financial instruments:


Cash and cash equivalents

The carrying amounts presented are deemed to approximate fair value.


Investment Securities

Fair values are based on quoted market prices, if available.  If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.


Loans

Fair value is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.


Deposits

The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date.  The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities.


Borrowings

The carrying amounts of federal funds purchased and U.S. Treasury notes are deemed to approximate fair value of short-term borrowings.  For long-term debt, fair values are estimated based on the discounted value of expected net cash flows using current interest rates.





- 28 -















NOTE 13 -

REGULATORY MATTERS


The Federal Reserve Act requires depository institutions to maintain cash reserves with the Federal Reserve Bank.  In 2004 and 2003, the Bank was required to maintain average reserve balances of $1,924,000 and $1,911,000, respectively.


The Company (consolidated) and the Bank must meet certain minimum capital requirements set by federal banking agencies.  Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a material effect on the Company's and Bank's financial statements.  The minimum regulatory capital ratios are 8% for total risk-based, 4% for Tier 1 risk-based, and 4% for leverage.  The Company’s and Bank’s capital amounts and classification are also subject to qualitative judgments by regulators about components, risk weightings, and other factors.


For various regulatory purposes, institutions are classified into categories based upon capital adequacy.  The highest "well-capitalized" category requires capital ratios of at least 10% for total risk-based, 6% for Tier 1 risk-based, and 5% for leverage.  As of the most recent notification from their regulators, the Company and Bank were categorized as "well-capitalized" under the regulatory framework for prompt corrective action.  Management believes that no conditions or events have occurred since the last notification that would change the Bank's category.  A summary of the regulatory capital of the Consolidated Company and Bank at December 31 follows ($000's):


  

2004

  

2003

 

Consolidated

 

Consolidated

  
 

Company

 

Bank

 

Company

 

Bank

            

Regulatory Capital:

           

  Shareholders' equity

$

52,296 

  

46,511 

  

52,448 

  

46,320 

  Intangible assets

 

(1,939)

  

(1,888)

  

(2,550)

  

(2,475)

  Net unrealized securities

    losses (gains)

 


(526)

  


(526)

  


(1,819)

  


(1,752)

       Tier 1 risk-based capital

 

49,831 

  

44,097 

  

48,079 

  

42,093 

Eligible allowance for loan

  losses

 


2,150 

  


2,150 

  


2,150 

  


2,150 

       Total risk-based capital

$

51,981 

  

46,247 

  

50,229 

  

44,243 

            

Capital Ratios:

           

  Total risk-based

 

15.49%

  

13.85%

  

15.58%

  

13.79%

  Tier 1 risk-based

 

14.85%

  

13.20%

  

14.91%

  

13.12%

  Leverage

 

9.58%

  

8.57%

  

9.34%

  

8.29%



- 29 -















NOTE 13 -

REGULATORY MATTERS (continued)


The principal source of income and funds for LCNB Corp. is dividends paid by the Bank.  The payment of dividends is subject to restriction by regulatory authorities.  For 2005, the restrictions generally limit dividends to the aggregate of net income for the year 2005 plus the net earnings retained for 2004 and 2003.  In addition, dividend payments may not reduce capital levels below minimum regulatory guidelines. Accordingly, future dividends may require the prior approval of the Comptroller of the Currency.



NOTE 14 -

PARENT COMPANY FINANCIAL INFORMATION


Condensed financial information for the LCNB Corp., parent company only, follows (000’s):


Condensed Balance Sheets:

     

December 31,

     
  

2004

 

2003

 

Assets:

     

  Cash on deposit with subsidiary

$

139

 

74

 

  Corporate and municipal debt securities

 

5,159

 

5,757

 

  Investment in subsidiaries

 

46,955

 

46,628

 

  Other assets

 

43

 

40

 

Total assets

$

52,296

 

52,499

 
      

Liabilities

$

-

 

51

 
      

Shareholders' equity

 

52,296

 

52,448

 

Total liabilities and shareholders' equity

$

52,296

 

52,499

 


Condensed Statements of Income

      

Year ended December 31,

 

2004

 

2003

 

2002

       

Income:

      

  Dividends from subsidiary

$

4,895

 

3,746 

 

5,485 

  Interest

 

168

 

216 

 

243 

  Gain on sale of investment securities

 

-

 

3 

 

9 

Total income

 

5,063

 

3,965 

 

5,737 

       

Total expenses

 

31

 

40 

 

40 

       

Income before income tax benefit and

  equity in undistributed income of

  subsidiaries

 



5,032

 



3,925 

 



5,697 

Income tax (expense) benefit

 

10

 

(17)

 

(80)

Equity in undistributed income of

  subsidiaries

 


1,554

 


2,829 

 


923 

Net income

$

6,596

 

6,737 

 

6,540 


- 30 -















Condensed Statements of Cash Flows

      

Year ended December 31,

 

2004

 

2003

 

2002

       

Cash flows from operating activities:

      

  Net income

$

6,596 

 

6,737 

 

6,540 

  Adjustments for non-cash items -

      

    Equity in (undistributed income)/

      

       excess dividends of subsidiaries

 

(1,554)

 

(2,829)

 

(923)

    Other, net

 

57 

 

114 

 

105 

Net cash flows from operating activities

 

5,099 

 

4,022 

 

5,722 

       

Cash flows from investing activities:

      

  Purchases of securities available for sale

 

(879)

 

(2,985)

 

(4,224)

  Proceeds from sales of securities

      

    available for sale

 

- 

 

1,775 

 

3,992 

  Proceeds from maturities of securities

      

    available for sale

 

1,300 

 

1,565 

 

1,075 

Net cash flows from investing activities

 

421 

 

355 

 

843 

       

Cash flows from financing activities:

      

  Treasury shares purchased

 

(1,722)

 

(2,163)

 

(1,677)

  Cash dividends paid

 

(3,733)

 

(3,633)

 

(3,486)

Net cash flows from financing activities

 

(5,455)

 

(5,796)

 

(5,163)

Net change in cash

 

65 

 

(1,419)

 

1,402 

Cash at beginning of year

 

74 

 

1,493 

 

91 

Cash at end of year

$

139 

 

74 

 

1,493 





- 31 -