-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, NdbZgHGEAwDLy+a8oarAAOtvkFCt8Yyy7OfbB6iDP+YAQLch8phaNwN6ZRf+z9Y7 C4lHh5bMYsVYWjX0Y+wNTA== 0000950109-98-002361.txt : 19980401 0000950109-98-002361.hdr.sgml : 19980401 ACCESSION NUMBER: 0000950109-98-002361 CONFORMED SUBMISSION TYPE: 10KSB40 PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980331 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: AUBURN NATIONAL BANCORPORATION INC CENTRAL INDEX KEY: 0000750574 STANDARD INDUSTRIAL CLASSIFICATION: STATE COMMERCIAL BANKS [6022] IRS NUMBER: 630885779 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10KSB40 SEC ACT: SEC FILE NUMBER: 000-26486 FILM NUMBER: 98582185 BUSINESS ADDRESS: STREET 1: 165 E MAGNOLIA AVE STREET 2: STE 203 CITY: AUBURN STATE: AL ZIP: 36830 BUSINESS PHONE: 2058219200 MAIL ADDRESS: STREET 1: 165 EAST MAGNOLIA AVE STREET 2: SUITE 203 CITY: AUBURN STATE: AL ZIP: 36830 10KSB40 1 FORM 10-K SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-KSB ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ended December 31, 1997 Commission File No. 0-26486 Auburn National Bancorporation, Inc. (Name of small business issuer in its charter) Delaware 63-0885779 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 165 East Magnolia Avenue, Suite 203 Auburn, Alabama 36830 (334) 821-9200 (Address and telephone number of principal executive offices) Securities registered pursuant to Section 12(b) of the Exchange Act: Name of each exchange Title of each class on which registered ------------------- ------------------ None Securities registered pursuant to Section 12(g) of the Exchange Act: Common Stock of $.01 par value (Title of class) Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or 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 [_] Check if disclosure of delinquent filers in response to Item 405 of Regulation S-B is not contained in this form, and no disclosure will be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB. [X] Issuer's revenues for its most recent fiscal year were $21,920,381. The aggregate market value of the common stock held by non-affiliates of registrant as of February 27, 1998, computed by reference to the price at which the stock was sold as of such date, was $46,894,405. As of February 27, 1998, there were issued and outstanding 1,308,191 shares of the registrant's $.01 par value common stock. Transitional Small Business Disclosure Format: Yes [_] No [ x ] PART I SPECIAL CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS Certain of the matters discussed under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" and elsewhere in this Annual Report may constitute forward-looking statements for purposes of the Securities Act of 1933, as amended and the Securities Exchange Act of 1934, as amended, and as such may involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements to differ from those expressed or implied by such forward-looking statements. The Company's actual results may differ materially from the results anticipated in these forward-looking statements including those described under interest rate management, due to a variety of factors, including, without limitation: the effects of future economic conditions; governmental monetary and fiscal policies, as well as interest rate risks; the effects of competition from other commercial banks, thrifts, mortgage banking firms, consumer finance companies, credit unions, securities brokerage firms, insurance companies, money market and other mutual funds and other financial institutions operating in the Company's market area and elsewhere, including institutions operating locally, regionally, nationally and internationally, together with such competitors offering banking products and services by mail, telephone, and computer and the Internet; and the failure of assumptions underlying the establishment of reserves for loan losses and estimations of values of collateral and various financial assets and liabilities. All forward-looking statements attributable to the Company are expressly qualified in their entirety by these Cautionary Statements. ITEM 1. BUSINESS Auburn National Bancorporation, Inc. ("the Company") is a bank holding company registered with the Board of Governors of the Federal Reserve System (the "Federal Reserve") under the Bank Holding Company Act of 1956, as amended (the "BHC Act"). The Company was incorporated in Delaware in 1990, and in 1994 it succeeded its Alabama predecessor as the bank holding company controlling AuburnBank, an Alabama state bank with its principal office in Auburn, Alabama (the "Bank"). The Company and its predecessor have controlled the Bank since 1984. As a bank holding company, the Company facilitates the Bank's ability to serve its customers' requirements for financial services. The holding company structure permits diversification by the Company into a broader range of financial services and other business activities than currently are permitted to the Bank under applicable law. The holding company structure also provides greater financial and operating flexibility than is presently permitted to the Bank. During 1997, the Company also owned 100% of the stock of ANB Systems, Inc., an inactive subsidiary ("ANB Systems," and collectively with the Bank, the "Subsidiaries") which was dissolved on November 11, 1997. The Bank has operated continuously since 1907 and conducts its business in East Alabama, including Lee County and surrounding areas. In April 1995, in order to gain flexibility and reduce certain regulatory burdens, the Bank converted from a national bank to an Alabama state bank that is a member of the Federal Reserve System (the "Charter Conversion"). Upon consummation of the Charter Conversion, the Bank's primary regulator changed from the Office of the Comptroller of the Currency (the "OCC") to the Federal Reserve and the Alabama Superintendent of Banks (the "Alabama Superintendent"). The Bank has been a member of the Federal Home Loan Bank of Atlanta (the "FHLB-Atlanta") since 1991. General The Company's business is conducted primarily through the Bank. The Bank's business consists of (i) accepting demand, savings, and time deposits; (ii) making loans to consumers, businesses, and other institutions; -2- (iii) investments of money market instruments, U.S. government and agency obligations, and state, county, and municipal bonds; and (iv) other financial services. Although it has no immediate plans to conduct any other business, the Company may engage directly or indirectly in a number of activities which the Federal Reserve has determined to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. Services The Bank offers checking, savings, negotiable order of withdrawal ("NOW") accounts, money market deposit accounts ("MMDAs") and certificates of deposit, and is an active residential mortgage lender in its primary service area ("PSA"). The Bank also offers commercial, financial, agricultural, real estate construction and consumer loan products. During 1995, the Bank sold its credit card portfolio and began providing credit cards, including MasterCard(R), MasterCard Gold, Visa(R), and Visa Gold through an agent bank arrangement with Columbus Bank & Trust Company in Columbus, Georgia. The Bank is one of the largest providers of automated teller services in East Alabama with 13 locations and was one of the nine original founders of Alabama Network, Inc. (Alert(R)), an Alabama ATM network that processes more than 18 million transactions annually. As of December 31, 1996, the Bank owned 12.5% of the stock of Alert(R). The Company was a one eighth owner of Alert(R). On January 1, 1997, Alert(R), Internet, Inc., and Southeast Switch, Inc. merged to become Honor Technologies, Inc. (Honor). At December 31, 1996, the Company was paid a one time special dividend of $150,000 from Alert(R), in connection with the merger of these ATM networks. Pursuant to such merger, the Company received an equity position in Honor equal to 0.3125% of combined total equity and a 30 month waiver of certain fees in Honor. The Bank's Tiger Teller ATM cards can be used internationally through the Cirrus(R) network. Starting in 1998, the Bank is offering VISA Checkcards, which are ATM cards with the VISA logo that work like checks but can be used anywhere VISA is accepted. Competition The banking business in Alabama, including Lee County, is highly competitive with respect to loans, deposits, and other services, and the area is dominated by a number of major banks and bank holding companies which have numerous offices and affiliates operating over wide geographic areas. The Bank competes for deposits, loans, and other business with these banks, as well as with credit unions, mortgage companies, insurance companies, and other local and nonlocal financial institutions, including services offered through the mail, by telephone and over the Internet. Among the advantages that certain of these institutions have vis-a-vis the Bank are their ability to finance extensive advertising campaigns and to allocate and diversify their assets among loans and securities of the highest yield and in locations with the greatest demand. Many of the major commercial banks operating in the Bank's service area, or their affiliates, offer services, such as international banking and investment services, which are not presently offered directly by the Bank. Such competitors, because of their greater capitalization, also have substantially higher lending limits than the Bank. The Bank faces further competition for loans and deposits from a wide variety of local and nonlocal financial institutions. As more and different kinds of businesses enter the market for financial services, competition from nonbank financial intermediaries such as thrifts, credit unions, mortgage companies, insurance companies, and other financial institution intermediaries may be expected to intensify further. Community banks also have experienced significant competition for deposits from mutual funds, insurance companies, and other investment companies, and money center banks' offerings of high-yield investments and deposits. Certain of these competitors are not subject to the same regulatory restrictions as the Bank. In addition, the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the "Riegle-Neal Act"), which became effective on September 29, 1995, repealed the prior statutory restrictions on interstate acquisition of banks by bank holding companies, such that any bank holding company located outside Alabama may presently acquire any bank based in Alabama or any other state, regardless of state law to the contrary, subject to certain deposit-percentage, aging requirements, and other restrictions. Alabama has also opted in to the provisions of the Riegle-Neal Act which permit national and state-chartered banks -3- to branch interstate through acquisitions of banks in other states after May 31, 1997. See "Supervision and Regulation." Selected Economic Data The Bank's primary service area ("PSA") includes the cities of Auburn and Opelika, Alabama and nearby surrounding areas in East Alabama, primarily in Lee County. Lee County's population is approximately 96,000, which ranks it 11th in the state. The 1994 per capita income in Lee County was $15,438, which ranked it 32nd in the state. Unemployment has been relatively low in Lee County, and during 1997, the County had average unemployment of 3.6%. Approximately 71% of the land in Lee County is devoted to agriculture, with 91% comprised of forests. An estimated 10% is urban or developed. Timber and timber products, greenhouses and horticulture, beef cattle, and cotton are the major agricultural products. Principal manufactured products in the Company's PSA include magnetic recording tapes, tires, textiles, small gasoline engines, and hardware. The largest employers in the area are Auburn University, East Alabama Medical Center, Quantegy Corporation, Uniroyal-Goodrich, West Point Stevens, and Briggs & Straton. Loans and Loan Concentrations The Bank makes loans for commercial, financial, and agricultural purposes, as well as for real estate mortgage, real estate construction, and consumer purposes. While there are certain risks unique to each type of lending, management believes that there is more risk associated with commercial, real estate construction, agricultural, and consumer lending than with real estate mortgage loans. To help manage these risks, the Bank has established underwriting standards, which are substantially similar for each type of loan, used in evaluating each extension of credit on an individual basis. These standards include a review of the economic conditions affecting the borrower, the borrower's financial strength and capacity to repay the debt, the underlying collateral, and the borrower's past credit performance. These standards are used to determine the creditworthiness of the borrower at the time a loan is made and are monitored periodically throughout the life of the loan. The Bank has loans outstanding to borrowers in all industries within its PSA. Any adverse economic or other conditions affecting these industries would also likely have an adverse effect on the local workforce, other local businesses, and individuals in the community that have entered into loans with the Bank. However, management believes that due to the diversified mix of industries located within the Bank's PSA, adverse changes in one industry may not necessarily affect other area industries to the same degree or within the same time frame. Management realizes that the Bank's PSA is also subject to both local and national economic fluctuations. Employees At December 31, 1997, the Company had 2 full-time equivalent employees, both of which are officers, and the Bank had 102 full-time equivalent employees, including 13 officers. SUPERVISION AND REGULATION Bank holding companies and banks are extensively regulated under federal and state law. This discussion is qualified in its entirety by reference to the particular statutory and regulatory provisions referred to below and is not intended to be an exhaustive description of the statutes or regulations applicable to the Company's and the Bank's business. Supervision, regulation, and examination of the Company and the Bank by the bank regulatory agencies are intended primarily for the protection of depositors rather than holders of Company capital stock. Any change in applicable law or regulation may have a material effect on the Company's business. -4- Bank Holding Company Regulation The Company, as a bank holding company, is subject to supervision and regulation by the Federal Reserve under the BHC Act. The Company is required to file with the Federal Reserve periodic reports and such other information as the Federal Reserve may request. The Federal Reserve examines the Company, and may examine the Bank. The State of Alabama does not regulate bank holding companies. The BHC Act requires prior Federal Reserve approval for, among other things, the acquisition by a bank holding company of direct or indirect ownership or control of more than 5% of the voting shares or substantially all the assets of any bank, or for a merger or consolidation of a bank holding company with another bank holding company. With certain exceptions, the BHC Act prohibits a bank holding company from acquiring direct or indirect ownership or control of voting shares of any company which is not a bank or bank holding company and from engaging directly or indirectly in any activity other than banking or managing or controlling banks or performing services for its authorized subsidiaries. A bank holding company may, however, engage in or acquire an interest in a company that engages in activities which the Federal Reserve has determined by regulation or order to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. The Company is a legal entity separate and distinct from the Bank. Various legal limitations restrict the Bank from lending or otherwise supplying funds to the Company or any non-bank subsidiaries. The Company and the Bank are also subject to Section 23A of the Federal Reserve Act, which defines "covered transactions," which include extensions of credit, and limits a bank's covered transactions with any affiliate to 10% of such bank's capital and surplus. All covered and exempt transactions between a bank and its affiliates must be on terms and conditions consistent with safe and sound banking practices, and banks and their subsidiaries are prohibited from purchasing low-quality assets from the bank's affiliates. Finally, Section 23A requires that all of a bank's extensions of credit to an affiliate be appropriately secured by acceptable collateral, generally United States government or agency securities. The Company and the Bank also are subject to Section 23B of the Federal Reserve Act, which generally limits covered and other transactions among affiliates to terms and under circumstances, including credit standards, that are substantially the same or at least as favorable to the bank as prevailing at the time for transactions with unaffiliated companies. The BHC Act, as amended by the interstate banking provisions of the Riegle- Neal Act, which became effective on September 29, 1995, repealed the prior statutory restrictions on interstate acquisition of banks by bank holding companies, such that the Company and any other bank holding company located in Alabama may now acquire a bank located in any other state, and any bank holding company located outside Alabama may lawfully acquire any bank based in Alabama or any other state, regardless of state law to the contrary, in either case subject to certain deposit-percentages, aging requirements, and other restrictions. The Riegle-Neal Act also generally provides that after May 31, 1997, national and state-chartered banks may branch interstate through acquisitions of banks in other states. By adopting legislation prior to that date, a state has the ability to "opt in" and accelerate the date after which interstate branching is permissible or "opt out" and prohibit interstate branching altogether. Alabama has adopted legislation opting into interstate branching, effective May 31, 1997. Alabama has also adopted legislation, which became effective on September 29, 1995, that allows Alabama banks to establish a branch in any other state, territory, or country in accordance with federal law or the law of such other state, territory, or country and upon prior approval of the Alabama Superintendent. Federal Reserve policy requires a bank holding company to act as a source of financial strength and to take measures to preserve and protect bank subsidiaries in situations where additional investments in a troubled bank may not otherwise be warranted. In addition, under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA"), where a bank holding company has more than one bank or thrift subsidiary, each of the bank holding company's subsidiary depository institutions are responsible for any losses to the Federal Deposit Insurance Corporation (the "FDIC") as a result of an affiliated depository institution's failure. As a result, a bank holding company may be required to loan money to its subsidiaries in the form of capital notes or other instruments -5- which qualify as capital under regulatory rules. However, any loans from the holding company to such subsidiary banks likely will be unsecured and subordinated to such bank's depositors and perhaps to other creditors of the bank. On February 20, 1997, the Federal Reserve adopted, effective April 21, 1997, amendments to its Regulation Y implementing certain provisions of The Economic Growth and Regulatory Paperwork Reduction Act of 1996 ("EGRPRA"), which was signed into law on September 30, 1996. Among other things, these amendments to Federal Reserve Regulation Y reduce the notice and application requirements applicable to bank and nonbank acquisitions and de novo expansion by well- capitalized and well-managed bank holding companies; expand the list of nonbanking activities permitted under Regulation Y; reduce certain limitations on previously permitted activities; and amend Federal Reserve anti-tying restrictions to allow banks greater flexibility to package products and services with their affiliates. Bank Regulation Generally The Bank is subject to supervision, regulation, and examination by the Federal Reserve and the Alabama Superintendent, which monitor all areas of the operations of the Bank, including reserves, loans, mortgages, issuances of securities, payment of dividends, establishment of branches, and capital. In addition, the Federal Reserve is responsible for conducting special, periodic examinations for compliance with federal regulations. The Bank is a member of the FDIC Bank Insurance Fund ("BIF") and, as such, its deposits are insured by the FDIC to the maximum extent provided by law. See "FDIC Insurance Assessments." The powers of Alabama chartered banks include certain provisions designed to provide such banks with competitive equality to the powers of national banks regulated by the Office of the Comptroller of the Currency ("OCC"). In December 1996, the Federal Reserve adopted the Federal Financial Institutions Examination Council's ("FFIEC") updated statement of policy entitled "Uniform Financial Institutions Rating System" ("UFIRS") effective January 1, 1997. UFIRS is an internal rating system used by the federal and state regulators for assessing the soundness of financial institutions on a uniform basis and for identifying those institutions requiring special supervisory attention. Under the previous UFIRS, each financial institution was assigned a confidential composite rating based on an evaluation and rating of five essential components of an institution's financial condition and operations including capital adequacy, asset quality, management, earnings, and liquidity. The major changes include an increased emphasis on the quality of risk management practices and the addition of a sixth component for sensitivity to market risk. For most institutions, the FFIEC has indicated that market risk primarily reflects exposures to changes in interest rates. When regulators evaluate this component, consideration is generally given to: management's ability to identify, measure, monitor, and control market risk; the institution's size; the nature and complexity of its activities and its risk profile; and the adequacy of its capital and earnings in relation to its level of market risk exposure. Market risk is rated based upon, but not limited to, an assessment of the sensitivity of the financial institution's earnings or the economic value of its capital to adverse changes in interest rates, foreign exchange rates, commodity prices, or equity prices; management's ability to identify, measure, monitor, and control exposure to market risk and the nature and complexity of interest rate risk exposure arising from nontrading positions. Under the Community Reinvestment Act of 1977 (the "CRA"), the appropriate federal bank regulatory agency, in connection with its regular examination of a bank, is required to assess the bank's record in meeting the credit needs of the community serviced by the bank, including low- and moderate-income neighborhoods. The regulatory agency's assessment of the bank's record is made available to the public. Further, such assessment is required of any bank which has applied to, among other things, establish a new branch office that will accept deposits, relocate an existing office, or merge or consolidate with or acquire the assets or assume the liabilities of a -6- federally regulated financial institution. An unsatisfactory CRA record may constitute grounds for denial of such application. Under new CRA regulations, effective January 1, 1996, the process-based CRA assessment factors were replaced with a new evaluation system that rates institutions based on their actual performance in meeting community credit needs. The evaluation system used to judge an institution's CRA performance consists of three tests: a lending test; an investment test; and a service test. Each of these tests are applied by the institutions's primary federal regulator taking into account such factors as: (i) demographic data about the community; (ii) the institution's capacity and constraints; (iii) the institution's product offerings and business strategy; and (iv) data on the prior performance of the institution and similarly-situated lenders. The lending test - the most important of the three tests for all institutions other than wholesale and limited purpose (e.g. credit card) banks - evaluates an institution's lending activities as measured by its home mortgage loans, small business and farm loans, community development loans, and, at the option of the institution, its consumer loans. Each of these lending categories are weighed to reflect its relative importance to the institution's overall business and, in the case of community development loans, the characteristics and needs of the institution's service area and the opportunities available for this type of lending. Assessment criteria for the lending test includes: (i) geographic distribution of the institution's lending; (ii) distribution of the institution's home mortgage and consumer loans among different economic segments of the community; (iii) the number and amount of small business and small farm loans made by the institution; (iv) the number and amount of community development loans outstanding; and (v) the institution's use of innovative or flexible lending practices to meet the needs of low-to-moderate income individuals and neighborhoods. At the election of an institution, or if particular circumstances so warrant, the banking agencies take into account in making their assessments, lending by the institution's affiliates as well as community development loans made by the lending consortia and other lenders in which the institution has invested. As part of the new regulation, all financial institutions are required to report data on their small business and small farm loans as well as their mortgage loans. The investment test focuses on the institution's qualified investments within it service area that (i) benefit low-to-moderate income individuals and small business or farms, (ii) address affordable housing needs, or (iii) involve donations of branch offices to minority or women's depository institutions. Assessment of an institution's performance under the investment test is based upon the dollar amount of the institution's qualified investments, its use of innovative or complex techniques to support community development initiatives, and its responsiveness to credit and community development needs. The service test evaluates an institution's systems for delivering retail banking services, taking into account such factors as: (i) the geographic distribution of the institution's branch offices and ATMs; (ii) the institution's record of opening and closing branch offices and ATMs; and (iii) the availability of alternative product delivery systems such as home banking and loan production offices in low-to-moderate income areas. The federal regulators also consider an institution's community development service as part of the service test. In addition, a financial institution has the option of having its CRA performance evaluated based on a strategic plan of up to five years in length that it has developed in cooperation with local community groups. In order to be rated under a strategic plan, an institution is required to obtain the prior approval of its federal regulator. The interagency CRA regulations provide that an institution evaluated under a given test will receive one of five ratings for that test: outstanding, high satisfactory, low satisfactory, needs to improve, or substantial noncompliance. An institution will receive a certain number of points for its rating on each test, and the points are combined to produce an overall composite rating of either outstanding, satisfactory, needs to improve, or substantial noncompliance. Under the agencies' rating guidelines, an institution that receives an "outstanding" rating on the lending test will receive an overall rating of at least "satisfactory", and no institution can receive an overall rating of "satisfactory" unless it receives a rating of at least "low satisfactory" on its lending test. In addition, evidence of -7- discriminatory or other illegal credit practices would adversely affect an institution's overall rating. As a result of the Bank's most recent CRA examination in August 1996, the Bank received an "outstanding" CRA rating. Payment of Dividends The Company is a legal entity separate and distinct from its subsidiary. The prior approval of the Federal Reserve and/or the Alabama Superintendent is required if the total of all dividends declared by a state member bank (such as the Bank) in any calendar year will exceed the sum of such bank's net profits for the year and its retained net profits for the preceding two calendar years, less any required transfers to surplus. Federal law also prohibits any state member from paying dividends that would be greater than such bank's undivided profits after deducting statutory bad debt in excess of such bank's allowance for loan losses. During 1997, the Bank paid cash dividends of $697,000 to the Company. In addition, the Company and the Bank are subject to various general regulatory policies and requirements relating to the payment of dividends, including requirements to maintain adequate capital above regulatory minimums. The appropriate federal regulatory and state authorities are authorized to determine, under certain circumstances relating to the financial condition of a state member bank or a bank holding company, that the payment of dividends would be an unsafe or unsound practice and to prohibit payment thereof. The Federal Reserve and the Alabama Superintendent have indicated that paying dividends that deplete a state member bank's capital base to an inadequate level would be an unsound and unsafe banking practice. The Federal Reserve and the Alabama Superintendent have indicated that financial depository institutions should generally pay dividends only out of current operating earnings. Capital The Federal Reserve has adopted final risk-based capital guidelines for bank holding companies and state member banks. As fully phased-in at the end of 1992, the guideline for a minimum ratio of capital to risk-weighted assets (including certain off-balance-sheet activities, such as standby letters of credit) is 8%. At least half of the total capital must consist of common equity, retained earnings and a limited amount of qualifying preferred stock, less goodwill ("Tier 1 risk-based capital"). The remainder may consist of subordinated debt, non-qualifying preferred stock and a limited amount of any loan loss allowance ("Tier 2 risk-based capital" and, together with Tier 1 risk-based capital, "Total risk-based capital"). In addition, the federal agencies have established minimum leverage ratio guidelines for bank holding companies and state member banks which provide for a minimum leverage ratio of Tier 1 risk-based capital to adjusted average quarterly assets ("Tier 1 leverage ratio") equal to 3%, plus an additional cushion of 100 to 200 basis points (i.e., 1%-2%) if the institution has less than the highest regulatory rating. The guidelines also provide that institutions experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels without significant reliance on intangible assets. Furthermore, the Federal Reserve's guidelines indicate that the Federal Reserve will continue to consider a "tangible Tier 1 leverage ratio" (deducting all intangibles) in evaluating proposals for expansion or new activity. The Federal Reserve has not advised the Company or the Bank of any specific minimum leverage ratio or tangible Tier 1 leverage ratio applicable to them. The Federal Deposit Insurance Corporation Improvement Act of 1992 ("FDICIA"), among other things, requires the federal banking agencies to take "prompt corrective action" in respect of depository institutions that do not meet minimum capital requirements. FDICIA establishes five capital tiers: "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized." A depository institution's capital tier will depend upon how its capital levels compare to various relevant capital measures and certain other factors, as established by regulation. -8- All of the federal banking agencies have adopted regulations establishing relevant capital measures and relevant capital levels. The relevant capital measures are the Total risk-based capital ratio, Tier 1 risk-based capital ratio, and the Tier 1 leverage ratio. Under the regulations, a state member bank will be (i) well capitalized if it has a Total risk-based capital ratio of 10% or greater, a Tier 1 risk-based capital ratio of 6% or greater, and a Tier 1 leverage ratio of 5% or greater and is not subject to any order or written directive by a federal regulatory agency to meet and maintain a specific capital level for any capital measure, (ii) adequately capitalized if it has a Total risk-based capital ratio of 8% or greater, a Tier 1 risk-based capital ratio of 4% or greater, and a Tier 1 leverage ratio of 4% or greater (3% in certain circumstances), (iii) undercapitalized if it has a Total risk-based capital ratio of less than 8%, a Tier 1 risk-based capital ratio and a Tier 1 leverage ratio of less than 4% (3% in certain circumstances), (iv) significantly undercapitalized if it has a Total risk-based capital ratio of less than 6%, a Tier 1 risk-based capital ratio and a Tier 1 leverage ratio of less than 3%, or (v) critically undercapitalized if its tangible equity is equal to or less than 2% of average quarterly tangible assets. Under the current guidelines, the Company and the Bank are considered well capitalized. As of December 31, 1997, the consolidated capital ratios of the Company and the Bank were as follows:
Regulatory Minimum Company Bank ---------- ------- ------ Tier 1 risk-based capital ratio 4.0% 14.06% 12.72% Total risk-based capital ratio 8.0% 15.22% 13.89% Tier 1 leverage ratio 3.0-5.0% 9.80% 8.84%
FDICIA generally prohibits a depository institution from making any capital distribution (including payment of a dividend) or paying any management fee to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to growth limitations and are required to submit a capital restoration plan for approval. For a capital restoration plan to be acceptable, the depository institution's parent holding company must guarantee that the institution comply with such capital restoration plan. The aggregate liability of the parent holding company is limited to the lesser of 5% of the depository institution's total assets at the time it became undercapitalized and the amount necessary to bring the institution into compliance with applicable capital standards. If a depository institution fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized. If the controlling holding company fails to fulfill its obligations under FDICIA and files (or has filed against it) a petition under the federal Bankruptcy Code, the claim would be entitled to a priority in such bankruptcy proceeding over third party creditors of the bank holding company. Because the Company and the Bank exceed applicable capital requirements, the respective managements of the Company and the Bank do not believe that the provisions of FDICIA had any material impact on the Company and the Bank or their respective operations. Significantly undercapitalized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. Critically undercapitalized institutions are subject to the appointment of a receiver or conservator. FDIC Insurance Assessments The Bank is subject to FDIC deposit insurance assessments (FICO). The Bank's deposits are insured by the FDIC's Bank Insurance Fund ("BIF"), and it has no deposit insured by the Savings Association Insurance Fund ("SAIF"). Prior to January 1, 1996, the annual premiums ranged from $.04 to $.31 for every $100 of BIF deposits. In 1996, the FDIC adopted a new risk-based premium schedule which decreased the assessment rates for BIF depository institutions. Under this schedule, which took effect for assessment periods beginning January 1, 1996, the annual premiums range from zero to $.27 for every $100 of deposits. In addition, the FDIC Board eliminated -9- the $2,000 minimum annual assessment and authorized the refund of the fourth- quarter minimum assessment of $500 paid by certain BIF-insured institutions on September 30, 1996, by crediting such amount against each BIF member's first semiannual assessment in 1997. EGRPRA recapitalized the FDIC's SAIF Fund to bring it into parity with BIF. As part of this recapitalization, The Deposit Insurance Funds Act of 1996 (the "Funds Act") authorized FICO to levy assessments on BIF-assessable deposits at a rate equal to one-fifth of the FICO assessment rate that is applied to deposits assessable by SAIF. The actual annual assessment rates for FICO for 1997 have been set at 1.296 basis points for BIF-assessable deposits and 6.480 basis points for SAIF deposits. Each financial institution is assigned to one of three capital groups -well capitalized, adequately capitalized or undercapitalized - and further assigned to one of three subgroups within a capital group, on the basis of supervisory evaluations by the institution's primary federal and, if applicable, state regulators and other information relevant to the institution's financial condition and the risk posed to the applicable insurance fund. For the years 1996 and before the actual assessment rate applicable to a particular institution will, therefore, depend in part upon the risk assessment classification so assigned to the institution by the FDIC. During the years ended December 31, 1997, 1996 and 1995 the Bank paid $26,000, $2,000 and $192,000, respectively, in BIF deposit insurance premiums. Legislative and Regulatory Changes Various legislative and regulatory proposals regarding changes in banking, and the regulation of banks and other financial institutions and bank and bank holding company powers are being considered by the executive branch of the Federal government, Congress and various state governments, including Alabama. Among other items under consideration are changes in or repeal of the Glass- Steagall Act which separates commercial banking from investment banking, and changes in the BHC Act to broaden the powers of "financial services" companies to own and control depository institutions and engage in activities not closely related to banking. Certain of these proposals, if adopted, could significantly change the regulation of banks and the financial services industry. It cannot be predicted whether any of these proposals will be adopted, and, if adopted, how these proposals will affect the Company and the Bank. Enforcement Policies and Actions FIRREA and subsequent federal legislation significantly increased the enforcement authorities of the FDIC and other federal depository institution regulators, and authorizes the imposition of civil money penalties of up to $1 million per day. Persons who are affiliated with depository institutions can be removed from any office held in such institution and banned for life from participating in the affairs of any such institution. The banking regulators have not hesitated to use the new enforcement authorities provided under FIRREA. Fiscal and Monetary Policy Banking is a business which depends on interest rate differentials. In general, the difference between the interest paid by a bank on its deposits and its other borrowings, and the interest received by a bank on its loans and securities holdings, constitutes the major portion of a bank's earnings. Thus, the earnings and growth of the Company will be subject to the influence of economic conditions generally, both domestic and foreign, and also to the monetary and fiscal policies of the United States and its agencies, particularly the Federal Reserve. The Federal Reserve regulates the supply of money through various means, including open market dealings in United States government securities, the discount rate at which banks may borrow from the Federal Reserve, and the reserve requirements on deposits. The nature and timing of any changes in such policies and their impact on the Company cannot be predicted. While the Federal Reserve increased the discount rate once in 1995 to curb inflation, it lowered the discount rate in January 1996 to avoid a possible stalling of a period of moderate economic growth. There have been no changes to the discount rate since January 1996. See "Management's Discussion and Analysis of Financial Condition and Results of Operations-Effects of Inflation and Changing Prices" and "-Interest Rate Sensitivity Management." -10- ITEM 2. DESCRIPTION OF PROPERTY The Bank conducts its business from its main office and three branches. The main office is located in the center of Auburn, Alabama, in a 16,150 square foot building that is owned by the Bank. The original building was constructed in 1964, and an addition was completed in 1981. Portions of the building have been renovated within the last five years in order to accommodate growth and changes in the Bank's operational structure and to adapt to technological changes. The main office building is surrounded on two sides by paved areas that provide parking for 84 vehicles, including four handicapped spaces. The Bank's Kroger branch is located in the Kroger supermarket in the Corner Village Shopping Center in Auburn, Alabama. On September 15, 1987, the Bank entered into a 15-year lease agreement for approximately 300 square feet of space in the supermarket. This branch offers the full line of the Bank's services, with the exception of loans and safe deposit boxes. The Opelika branch is located in Opelika, Alabama, in a 4,000 square foot building. This branch is owned by the Bank and was built in 1991. This branch offers the full line of the Bank's services and has drive-through windows and an ATM. This branch offers parking for approximately 36 vehicles, including two handicapped spaces. The Bank's Winn Dixie branch which opened on April 3, 1997 is located in the Winn Dixie supermarket in the Tiger Crossing Shopping Center on the south side of Auburn, Alabama. The Bank entered into a five year lease agreement for approximately 350 square feet of space in the supermarket. This branch offers the full line of the Bank's services, with the exception of loans and safe deposit boxes. The Bank has entered into a contract with Wal-mart to open a full service branch subject to approval from the State Banking Department and the Federal Reserve Bank inside the Wal-mart in Phenix City, Alabama, which is 10 miles south of Auburn, Alabama. The branch is tentatively scheduled to open August 1998. The Bank's initial investment in fixed assets are expected to be approximately $320,000. In the first year of operation, the Bank estimates that income will be reduced by approximately $150,000, due to various factors such as depreciation expense, start-up costs, and operating costs related to this branch. The Bank owns a drive-in facility located directly across the street from its main office. This drive-in facility was constructed in 1979 and has five drive-through lanes and a walk-up window. In addition, the Bank leases from the Company approximately 8,300 square feet of space in the AuburnBank Center (the "Center"), which is located next to the main office. This building, which has approximately 18,000 square feet of space, is also leased to outside third parties. Leases between the Bank and the Company are based on the same terms and conditions as leases to outside third parties leasing space in the same building. The Bank's data processing activities, as well as other operations, are located in this leased space. The parking lot provides parking for approximately 120 vehicles, including handicapped parking. The Bank also owns a two-story building located directly behind the main office. The first floor of this building is leased to outside third parties. The Company owns a commercial office building (the "Hudson Building") located across the street from the main office in downtown Auburn. The Hudson Building has two floors and a basement which contain approximately 14,395 square feet of leasable space. Approximately 73.2% of this building is for rent by third party tenants. However, the Bank occupies approximately 3,900 square feet, which includes a portion of the basement level used for storage and office space used to house certain bank functions. The Bank pays rent to the Company based on current market rates for such space. -11- In 1994, the Bank acquired a piece of commercial real estate located in Auburn on U.S. Highway 29. This property, which was acquired in satisfaction of debt previously contracted, was formerly used by a floor covering business and contained approximately 6,045 square feet of office, showroom, and warehouse space. The Bank subsequently removed an underground storage tank ("UST") containing petroleum products from the site. In March 1995, the Alabama Department of Environmental Management ("ADEM") requested that the Bank submit a Secondary Investigation Plan ("Secondary Investigation") as a result of underground soil and water contamination of petroleum-based hydrocarbon products. The Secondary Investigation was completed and submitted to ADEM by Roy R. Weston, Inc. ("Weston"), an independent consultant hired by the Bank. The Secondary Investigation indicated low concentrations of soil contamination on site and elevated concentrations of gasoline constituents both on-site and off- site. The Secondary Investigation indicated a low risk to human receptors, and Weston recommended to ADEM initiation of a quarterly ground water monitoring program for one year, at which time the program would be reassessed. In response to ADEM's Letter of Requirement dated January 18, 1996, Weston prepared and submitted, on behalf of the Bank, a Monitoring Only Corrective Action Plan on February 20, 1996. Quarterly groundwater monitoring will continue in 1998 as required by ADEM. Samples from the eight (8) existing monitoring wells will be collected and analyzed by Roy F. Weston, Inc. The monitoring data will be submitted by Weston to ADEM as required. It is estimated that the cost for monitoring and providing reporting data to ADEM for 1998 will be approximately $9,000 (unless the site is released by ADEM during the year). The extent and cost of any further testing and remediation, if any, cannot be predicted at this time. Directly behind the Center is an older home that is also owned by the Company. This building is rented as housing to university students. The rear portion of this property is used as a parking area for approximately 20 vehicles of Bank employees. ITEM 3. LEGAL PROCEEDINGS In the normal course of its business, the Company and the Bank from time to time are involved in legal proceedings. The Company and Bank management believe there are no pending or threatened legal proceedings which upon resolution are expected to have a material adverse effect upon the Company's or the Bank's financial condition. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended December 31, 1997. -12- PART II ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Effective February 7, 1995, the Company engaged in a public offering (the "Public Offering"). The Company's Common Stock is listed on the Nasdaq SmallCap Market, under the symbol AUBN. The following table sets forth, for the indicated periods, the high and low closing sale prices for Company's Common Stock as reported on the Nasdaq SmallCap Market.
Estimated Cash Price Range Dividends Per Share(1) Declared --------------------- ---------- High Low ---- --- 1997 First Quarter $ 27.50 $ 23.50 $ 0.12 Second Quarter 26.00 23.00 0.12 Third Quarter 29.50 23.50 0.12 Fourth Quarter 41.50 34.00 0.12 1996 First Quarter 20.25 19.00 0.10 Second Quarter 20.25 19.25 0.11 Third Quarter 20.50 19.25 0.11 Fourth Quarter 23.50 21.50 0.11 - --------------
(1) The price information represents actual transactions. The Company has paid cash dividends on its capital stock since 1985. Prior to this time, the Bank paid cash dividends since its organization in 1907, except during the Depression years of 1932 and 1933. Holders of Common Stock are entitled to receive such dividends as may be declared by the Company's Board of Directors. The amount and frequency of cash dividends will be determined through the judgment of the Company's Board of Directors based upon a number of factors, including the Company's earnings, financial condition, capital requirements, and other relevant factors. Company management presently intends to continue its present dividend policies. The amount of dividends payable by the Bank is limited by law and regulation. The need to maintain adequate capital in the Bank also limits dividends that may be paid to the Company. Although Federal Reserve policy could restrict future dividends on Common Stock, such policy places no current restrictions on such dividends. See "SUPERVISION AND REGULATION -- DIVIDENDS" and "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -- CAPITAL RESOURCES." ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS The following discussion and analysis is designed to provide a better understanding of various factors related to the Company's results of operations and financial condition. Such discussion and analysis should be read in conjunction with "Business" and "Financial Statements and Related Notes." The purpose of this discussion is to focus on significant changes in the financial condition and results of the operations of the Company during the three years ended December 31, 1997, 1996 and 1995. This discussion and analysis is intended to supplement and highlight information contained in the accompanying consolidated financial statements and the selected financial data presented elsewhere herein. -13- Summary Net earnings increased $327,000 (11.9%) to $3,080,000 during 1997 from $2,753,000 for the year ended December 31, 1996. Basic income per share was $2.36 and $2.11 for 1997 and 1996, respectively, an increase of 11.8%. Comparatively, net earnings during 1996 increased $662,000 (31.7%) from the 1995 total of $2,091,000, while basic income per share showed a similar increase of $0.50 per share for 1996 from a 1995 per share total of $1.61. The increase in net earnings for 1997 is attributable to higher net interest income for the year. The increase in 1996 was due to higher levels of net interest income and noninterest income and lower noninterest expense as compared to 1995. See "FINANCIAL CONDITION -- CAPITAL RESOURCES" and the "CONSOLIDATED AVERAGE BALANCES, INTEREST INCOME/EXPENSE AND YIELDS/RATES" tables. Total assets at December 31, 1997 and 1996 were $264,734,000 and $258,055,000, an increase of $6,679,000 (2.6%). The Company's growth during 1997 resulted primarily from the growth in loans. See "FINANCIAL CONDITION-INVESTMENT SECURITIES AND LIQUIDITY." Financial Condition Investment Securities Investment securities held to maturity were $14,364,000 and $17,903,000 at December 31, 1997 and 1996, respectively. This decline of $3,539,000 (19.8%) in 1997 resulted entirely from scheduled paydowns, calls and maturities. The securities available for sale portfolio was $40,446,000 and $44,027,000 at December 31, 1997 and 1996, respectively. This decrease of $3,581,000 (8.1%) reflects the reinvestment of investment funds to fund loan growth. See "-- LOANS AND LIQUIDITY." The composition of the Company's total investment securities portfolio reflects the Company's investment strategy to provide acceptable levels of interest income from portfolio yields while maintaining an appropriate level of liquidity to assist with controlling the Company's interest rate position. In recent years, the Company has invested primarily in taxable securities due to its inability to fully realize the benefits of the preferential treatment afforded tax-exempt securities under the tax laws. Because of their liquidity, credit quality and yield characteristics, the majority of the purchases of taxable securities have been in investment grade mortgage-backed securities ("MBS") and collateralized mortgage obligations ("CMOs"). The yields, values, and durations of such MBS and CMOs generally vary with interest rates, prepayment levels, and general economic conditions, and as a result, the values of such instruments may be more volatile than other instruments with similar maturities. Such MBS and CMOs also may have longer stated maturities than other securities, which may result in further price volatility. The following table indicates the amortized cost of the portfolio of investment securities held to maturity at the end of the last three years:
Amortized Cost December 31, -------------------------------- 1997 1996 1995 ------ ----- ---- (In thousands) Investment Securities Held to Maturity: U.S. government agency $ 3,216 2,028 2,054 State and political subdivisions 1,479 1,470 1,790 Mortgage-backed securities 9,470 13,663 18,887 Collateralized mortgage obligations 199 535 998 Other -- 207 899 ------- ------ ----- Total investment securities held to maturity $14,364 17,903 24,628 ======== ====== ======
-14- The following table indicates the fair value of the portfolio of investment securities available for sale at the end of the last three years:
Total Fair Value ---------------------------------- 1997 1996 1995 ---- ---- ---- (In thousands) Investment Securities Available for Sale: Treasury $ -- -- 1,016 U.S. Government agency 12,097 17,873 15,084 State and political subdivisions 498 490 -- Mortgage-backed securities 7,990 363 2,155 Collateralized mortgage obligations 19,861 24,854 12,062 Mutual funds -- 447 457 -------- ------ ------ Total investment securities available for sale $ 40,446 44,027 30,774 -------- ------ ------
All investment securities are subjected to the "Stress Test" on a semi- annual basis. Securities are tested as to their average life, average life sensitivity and price volatility. At December 31, 1997 and 1996, all CMOs passed their most recent Federal Financial Institutions Examination Council's ("FFIEC") stress test. As a result, none were considered high risk. There are no interest only ("I/Os") or principal only ("P/Os") securities. At December 31, 1997, the Bank owned CMOs with a total amortized cost of $19,859,000. All of the CMOs are rated AAA. The CMOs are all backed by federal agency guaranteed mortgages except for 3 issues in the amount of $7,298,000 which are privately issued mortgage pass-through certificates. Fair values for the private placement CMOs were estimated based on fair values for similar instruments. The MBS portfolio's total amortized cost of $17,428,000 at December 31, 1997, is a mixture of fixed rate mortgages, adjustable rate mortgages ("ARMs"), and loans with balloon payments. At the time of purchase, the Bank looks at various prepayment speeds and makes the purchase based on the ability to accept the yield and average life based on both increasing and decreasing prepayment speeds. The following table presents the maturities and weighted average yields of investment securities held to maturity at December 31, 1997: Maturities of Held-to-Maturity Investment Securities Amortized Cost
After one After five Within through through After one year five years 10 years 10 years -------- ---------- ---------- -------- (In thousands) U.S. government agencies, excluding mortgage-backed securities $ -- -- -- 3,216 State and political subdivision securities -- 796 410 273 Mortgage-backed securities 208 273 3,555 5,434 Collateralized mortgage obligations -- -- -- 199 ---- ----- ----- ----- Total investment securities held to maturity $ 208 1,069 3,965 9,122 ==== ===== ===== =====
-15-
Weighted average yields After one After five Within through through After one year five years 10 years 10 years -------- ---------- --------- -------- U.S. government agencies, excluding mortgage-backed securities -- -- -- 8.01% State and political subdivision securities -- 6.49% 5.30% 7.58% Mortgage-backed securities 6.98% 6.82% 6.16% 6.93% Collateralized mortgage obligations -- -- -- 6.09% ----- ----- ----- ----- Total weighted average yield 6.98% 6.53% 6.09% 7.30% Maturities of Available for Sale Investment Securities Amortized Cost After one After five Within through through After one year five years 10 years 10 years -------- ---------- ---------- -------- (In thousands) U.S. government agencies, excluding mortgage-backed securities $ -- 9,986 2,070 -- State and political subdivision securities -- -- 480 -- Mortgage-backed securities -- 237 7,720 -- Collateralized mortgage obligations 5,921 4,897 7,894 948 ------ ----- ----- --- Total investment securities held to maturity $5,921 15,120 18,164 948 ====== ====== ====== === Weighted average yields After one After five Within through through After one year five years 10 years 10 years ------- ---------- ---------- -------- U.S. government agencies, excluding mortgage-backed securities -- 6.31% 6.14% -- State and political subdivision securities -- -- 4.96% -- Mortgage-backed securities -- 6.81% 6.50% -- Collateralized mortgage obligations 5.98% 6.79% 7.06% 7.83% ----- ----- ----- ----- Total weighted average yield 5.98% 6.45% 6.73% 7.83%
Loans Total loans, net of unearned income, of $183,368,000 at December 31, 1997, reflected an increase of $23,743,000 (14.9%), over total loans, net of unearned income, of $159,625,000 at December 31, 1996. The primary growth during 1997 occurred in the real estate mortgage and commercial, financial and agricultural loan -16- area. The real estate mortgage loan component of the loan portfolio increased $12,469,000 (12.3%) to $113,826,000 at December 31, 1997 over the 1996 balance of $101,357,000 and represented 61.3% of the total loan portfolio at December 31, 1997, as compared to 62.7% at December 31, 1996. This growth was attributable to the increase in commercial real estate mortgages of $8,887,000 (20.8%) combined with an increase in residential real estate mortgage loans of $3,582,000 (6.1%). The commercial, financial and agricultural portfolio increased $7,116,000 (18.1%) to $46,329,000 at December 31, 1997 compared to $39,213,000 at December 31, 1996. The increase was due primarily to increased demand for commercial credits. Commercial, financial and agricultural loans represented 25.0% and 24.2% of the total loans at December 31, 1997 and 1996, respectively. The increase in residential real estate mortgage loans continues to reflect the strong demand for these loans in the Bank's primary market area. The increase in commercial real estate mortgage loans and commercial, financial and agricultural loans reflects strong demand as well as management's focus on balancing the composition of its loan portfolio by increasing the volume of loans in these categories. In addition to originating mortgage loans for its own portfolio, the Company also actively originates residential mortgage loans which are sold in the secondary market. In addition to selling real estate mortgage loans to the Federal National Mortgage Association ("FNMA") with the Company maintaining the servicing, the Bank has arranged with one mortgage servicing company to originate and sell, without recourse, residential first mortgage real estate loans, with servicing released. During 1997, the Bank sold mortgage loans totaling approximately $9,899,000, to FNMA, with the Bank maintaining the servicing, and sold mortgage loans, totaling approximately $4,393,000, to mortgage servicing companies, with servicing released. At December 31, 1997, the Bank was servicing loans totaling approximately $54,744,000. The Bank collects monthly servicing fees of 0.25% to 0.375% annually of the outstanding balances of loans serviced for FNMA. See "- Effects of Inflation and Changing Prices." The following table presents the composition of the loan portfolio by major categories at the end of the last five years:
Loan Portfolio Composition December 31, ------------------------------------------------------ 1997 1996 1995 1994 1993 ---- ---- ---- ---- ---- (In thousands) Commercial, financial and agricultural $ 46,329 39,213 35,800 32,443 27,728 Real estate - construction: Commercial 3,172 3,572 945 1,076 1,959 Residential 3,583 3,068 2,323 1,657 2,342 Real estate - mortgage: Commercial 51,714 42,827 33,593 33,517 30,179 Residential 62,112 58,530 54,384 50,677 42,614 Consumer installment 18,620 14,600 13,583 21,168 19,800 -------- ------- ------- ------- ------- Total loans $185,530 161,810 140,628 140,538 124,622 Less: Unearned income (37) (91) (157) (210) (138) Allowance for loan losses (2,125) (2,094) (2,012) (2,100) (2,264) -------- ------- ------- ------- ------- Loans, net $183,368 159,625 138,459 138,228 122,220 ======== ======= ======= ======= =======
-17- The following table presents maturities by major loan classifications and the sensitivity of loans to changes in interest rates within each maturity category at December 31, 1997:
Loan Portfolio Maturing After one Within through After one year five years five years Total -------- ---------- ---------- ----- In thousands) Commercial, financial and agricultural $27,767 14,610 3,952 46,329 Real estate - construction 6,445 310 -- 6,755 Real estate - mortgage 17,752 18,729 77,345 113,826 Consumer installment 8,817 9,102 701 18,620 ------- ------ ------ ------- Total loans 60,781 42,751 81,998 185,530 ======= ====== ====== ======= Variable-rate loans 30,630 6,575 73,666 110,871 Fixed-rate loans 30,151 36,176 8,332 74,659 ------ ------ ------ ------- Total loans $60,781 42,751 81,998 185,530 ======= ====== ====== =======
Allowance for Loan Losses and Risk Elements Interest on loans is normally accrued from the date an advance is made. The performance of loans is evaluated primarily on the basis of a review of each customer relationship over a period of time and the judgment of lending officers as to the ability of borrowers to meet the repayment terms of loans. If there is reasonable doubt as to the repayment of a loan in accordance with the agreed terms, the loan may be placed on a nonaccrual basis pending the sale of any collateral or a determination as to whether sources of repayment exist. This action may be taken even though the financial condition of the borrower or the collateral may be sufficient ultimately to reduce or satisfy the obligation. Generally, when a loan is placed on a nonaccrual basis, all payments are applied to reduce principal to the extent necessary to eliminate doubt as to the repayment of the loan. Any interest income on a nonaccrual loan is recognized only on a cash basis. The Company's policy generally is to place a loan on nonaccrual status when it is contractually past due 90 days or more as to payment of principal or interest. A loan may be placed on nonaccrual status at an earlier date when concerns exist as to the ultimate collections of principal or interest. At the time a loan is placed on nonaccrual status, interest previously accrued but not collected is reversed and charged against current earnings. Loans that are contractually past due 90 days or more which are well secured or guaranteed by financially responsible third parties and are in the process of collection generally are not placed on nonaccrual status. Lending officers are responsible for the ongoing review and administration of each particular loan. As such, they make the initial identification of loans which present some difficulty in collection or where circumstances indicate that the probability of loss exists. The responsibilities of the lending officers include the collection effort on a delinquent loan. To strengthen internal controls in the collection of delinquencies, senior management and the Loan Committee are informed of the status of delinquent and "watch" or problem loans on a monthly basis. Senior management reviews the allowance for loan losses and makes recommendations to the Loan Committee as to loan charge-offs on a monthly basis. The allowance for loan losses represents management's assessment of the risk associated with extending credit and its evaluation of the quality of the loan portfolio. Management analyzes the loan portfolio to determine the adequacy of the allowance for loan losses and the appropriate provision required to maintain a level considered adequate to absorb anticipated loan losses. In assessing the adequacy of the allowance, management reviews the -18- size, quality and risk of loans in the portfolio. Management also considers such factors as the Bank's loan loss experience, the amount of past due and nonperforming loans, specific known risk, the status and amount of nonperforming assets, underlying collateral values securing loans, current and anticipated economic conditions and other factors which affect the allowance for potential credit losses. An analysis of the credit quality of the loan portfolio and the adequacy of the allowance for loan losses is prepared by the Bank's Credit Administration area and presented to the Loan Committee on a quarterly basis. In addition, the Bank has engaged an outside loan review consultant, on a semi- annual basis, to perform an independent review of the quality of the loan portfolio and adequacy of the allowance. The Bank's allowance for loan losses is also subject to regulatory examinations and determinations as to adequacy, which may take into account such factors as the methodology used to calculate the allowance for loan losses and the size of the allowance for loan losses in comparison to a group of peer banks identified by the regulators. During their routine examinations of banks, the Federal Reserve and the Alabama Superintendent may require a bank to make additional provisions to its allowance for loan losses when, in the opinion of the regulators, credit evaluations and allowance for loan loss methodology differ materially from those of management. See "SUPERVISION AND REGULATION." While it is the Bank's policy to charge off in the current period the loans in which a loss is considered probable, there are additional risks of future losses which cannot be quantified precisely or attributed to particular loans or classes of loans. Because these risks include the state of the economy, management's judgment as to the adequacy of the allowance is necessarily approximate and imprecise. -19- The following table summarizes the levels of the allowance for loan losses at the end of the last five years and activity in the allowance during such years:
Allowance for Loan Loss Activity for year ended December 31, ------------ 1997 1996 1995 1994 1993 ---- ---- ---- ---- ---- (In thousands) Balance at beginning of period $ 2,094 2,012 2,100 2,264 1,510 Provision for loan losses 285 80 -- 172 222 Charge-offs: Commercial, financial, and agricultural 146 64 43 90 7 Real estate 1 1 1 164 11 Consumer 173 108 113 183 46 --- --- --- --- --- Total charge-offs 320 173 157 437 64 Recoveries: Commercial, financial and agricultural 15 100 4 7 375 Real estate 3 5 28 34 180 Consumer 48 70 88 60 41 -- -- -- -- -- Total recoveries 66 175 120 101 596 -- --- --- --- --- Net charge-offs (recoveries) 254 (2) 37 336 (532) Other adjustments (1) -- -- (51) -- -- --- --- ---- --- ----- Balance at end of period $ 2,125 2,094 2,012 2,100 2,264 ===== ===== ====== ===== ===== Ratio of allowance for loan losses to loans outstanding, net of unearned discount 1.15% 1.29% 1.43% 1.50% 1.82% Ratio of allowance for loan losses to nonaccrual loans, renegotiated loans, and other nonperforming assets -- 1,957.01% 1,468.61% 156.72% 249.61% Ratio of net charge-offs (recoveries) to average loans outstanding, net of unearned income 0.15% (0.001)% 0.03% 0.26% (0.43)%
- ------------------------ (1) In conjunction with the sale of its credit card portfolio in 1995, the Bank reversed the portion of the allowance for loan losses that had been maintained to absorb losses on credit card lines. During 1997, the Company had loan charge-offs totaling $320,000 and recoveries of $66,000, as compared to $173,000 in charge-offs and recoveries of $175,000 in the prior year. Management believes that the $2,125,000 in allowance for loan losses at December 31, 1997 (1.15% of total outstanding loans, net of unearned income) at such date is adequate to absorb known risks in the portfolio. However, no assurance can be given that adverse economic circumstances will not result in increased losses in the Bank's loan portfolio. The Bank does not currently allocate its allowance for loan losses among its various classifications of loans. While management recognizes that there is more risk traditionally associated with commercial and consumer lending as compared to real estate mortgage lending, the Bank currently has in place a tiered approach to determine the adequacy of its allowance for loan losses. This methodology focuses on the specific and potential loss of certain loans classified as problem credits and uses a three-year historical loss factor on the general loan portfolio as opposed to allocations based on major loan categories. Level I includes specific allowances that have been reserved for particular problem loans where management has identified specific losses. Level II allowances are set aside to cover potential losses associated with problem loans which possess more than a normal degree of credit risk but where no specific losses have been identified. These loans have been criticized or classified by the Bank's regulators, external loan reviewers engaged by the Bank, or internally by management. The three-year historical loss -20- factor for Level II problem loans is applied to the total Level II loans in determining the allocation. Level III is the unallocated general allowance for the balance of the loan portfolio. The loans in this tier consist of all loans that are not classified as Level I or Level II problem credits, and less risk- free loans. Risk-free loans are defined as loans fully secured by cash or cash equivalents, readily marketable collateral, and portions of the portfolio that are partially covered by a U.S. Government or government agency guaranty. Adjustments are then made for local economic conditions and anticipated loan growth. The allocation for Level III is determined by applying the historical loss factor, derived from the prior three years actual experience, to the adjusted outstanding balance for this classification. The Company is currently expanding its methodology to determine the adequacy of the allowance for loan losses by major loan types. This change is not expected to have a material adverse effect on the financial condition or the results of operation of the Company or the Bank. Based on historical trends and management's assessment of the quality of the loan portfolio, the Company presently estimates that gross loan charge-offs for the 12-month period ending December 31, 1998 will be approximately $90,000, $31,000 and $116,000 for the commercial, financial and agricultural; real estate mortgage; and consumer installment loan categories, respectively. During this same period, the Company does not anticipate any chargeoffs in its real estate construction loan category. There is no assurance that the actual experience during this period will not be materially different from these estimates. On January 1, 1995, the Company adopted Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan" ("SFAS No. 114") and Statement of Financial Accounting Standards No. 118, "Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures" ("SFAS No. 118"), which amends SFAS No. 114, with no material effect on its financial condition or results of operations. At December 31, 1997, the Company had approximately $578,000 of impaired loans, which included 1 loan, totaling approximately $72,000 with a valuation allowance of approximately $49,000. No valuation allowance was deemed necessary for the remaining $506,000 of impaired loans. In comparison, at December 31, 1996, the Company had approximately $620,000 of impaired loans, which included 1 loan, totaling approximately $84,000 with a valuation allowance of approximately $64,000. No valuation allowance was deemed necessary for the remaining $536,000 of impaired loans. Nonperforming Assets Nonperforming assets consist of loans on nonaccrual status, loans that have been renegotiated at terms more favorable to the borrower than those for similar credits, real estate and other assets acquired in partial or full satisfaction of loan obligations and loans that are past due 90 days or more. Nonperforming assets were $276,000, $219,000, and $270,000 at December 31, 1997, 1996, and 1995, respectively. These levels represent an increase of $57,000 (26.0%) for the year ended 1997, and a decrease of $51,000 (18.9%) for the year ended 1996. The increase is mainly due to a overdrawn checking account. The decrease during 1996 is attributable to the disposal of other nonperforming assets offset by a slight increase in nonaccrual loans. -21- An analysis of the components of nonperforming assets at the end of the last five years is presented in the following table:
Nonperforming Assets December 31, ------------ 1997 1996 1995 1994 1993 ---- ---- ---- ---- ---- (In thousands) Nonaccrual loans $ -- 107 73 27 30 Renegotiated loans -- -- -- -- -- Other nonperforming assets (primarily other real estate) -- -- 64 1,313 877 Accruing loans 90 days or more past due 276 112 133 120 32 --- --- --- --- -- Total nonperforming assets $ 276 219 270 1,460 939 === === === ===== === Nonaccrual loans and renegotiated loans as a % of total loans -- 0.07% 0.05% 0.02% 0.02% Nonaccrual loans, renegotiated loans and other nonperforming assets as a percentage of total loans, net of unearned income -- 0.07% 0.10% 0.95% 0.72% Nonperforming assets as a percentage of total loans, net of unearned income 0.15% 0.14% 0.19% 1.03% 0.75%
If nonaccrual loans had performed in accordance with their original contractual terms, interest income would have increased approximately $0, $6,300, and $3,800 for the years ended December 31, 1997, 1996 and 1995 respectively. The amount of interest income earned and collected on nonaccrual loans which is included in net income was $0 for 1997, $2,200 for 1996 and $3,800 for 1995. Other Potential Problem Loans Potential problem loans consist of those loans where management has serious doubts as to the borrower's ability to comply with the present loan repayment terms. At December 31, 1997, 73 loans totaling approximately $2,681,000 or 1.5% of total net loans were considered potential problem loans. Deposits Total deposits increased $7,251,000 (3.4%) to $223,978,000 at December 31, 1997, as compared to $216,727,000 at December 31, 1996. Noninterest-bearing deposits were $32,638,000 and $28,407,000 while total interest-bearing deposits were $191,340,000 and $188,320,000 at December 31, 1997 and 1996, respectively. This positive trend is the result of management's decision to maintain a competitive position in its deposit rate structure coupled with the Bank's marketing efforts to attract local deposits. At December 31, 1997, as a percentage of total deposits, noninterest-bearing accounts comprised approximately 14.6%, while MMDAs, NOWs and regular savings made up approximately 37.2%, certificates of deposit under $100,000 comprised approximately 31.7%, and certificates of deposit and other time deposits of $100,000 or more comprised 16.5%. At December 31, 1996, as a percentage of total deposits, noninterest- bearing accounts comprised approximately 13.1%, while MMDAs, NOWs and regular savings made up approximately 33.7%, certificates of deposit under $100,000 comprised approximately 34.3%, and certificates of deposit and other time deposits of $100,000 or more comprised 18.9%. -22- The composition of total deposits for the last three years is presented in the following table:
December 31, ----------------------------------------------------------------------------------------------- 1997 1996 1995 ---- ---- ---- % Change % Change % Change from prior from prior from prior Amount year end Amount year end Amount year end ------ -------- ------- -------- ------ --------- (Dollars in thousands) Demand deposits $ 32,638 14.89 % 28,407 11.44 % 25,491 (4.42)% Interest bearing deposits: NOWs 22,423 11.62 % 20,089 (13.48)% 23,220 (2.19)% MMDAs 50,678 18.81 % 42,656 66.35 % 25,643 (0.84)% Savings 10,217 (0.39)% 10,257 (0.37)% 10,295 (6.15)% Certificates of deposit under $100,000 71,136 (4.49)% 74,477 (3.78)% 77,402 29.87 % Certificates of deposit and other time deposits of $100,000 and over 36,886 (9.68)% 40,841 71.95 % 23,752 30.46 % ------ ------- ------ ------ ------ ------ Total interest bearing deposits 191,340 16.04 % 188,320 17.47 % 160,312 15.85 % ------- ------ ------- ------ ------- ------ Total deposits $ 223,978 3.35 % 216,727 16.64 % 185,803 12.57 % ======= ====== ======= ====== ======= ======
The average balances outstanding and the average rates paid for certain categories of deposits at the end of the last three years are disclosed in the "Consolidated Average Balances, Interest Income/Expense and Yields/Rates" table immediately following: -23- AUBURN NATIONAL BANCORPORATION, INC. & SUBSIDIARIES Consolidated Average Balances, Interest Income/Expense and Yields/Rates Taxable Equivalent Basis
Years Ended December 31, ------------------------------------------------------------------------- 1997 1996 ------------------------------------- ----------------------------------- Average Yield/ Average Yield/ ASSETS Balance Interest Rate Balance Interest Rate - ------------------------------------------------ ------- -------- ---- ------- -------- ---- Interest Earning Assets: Loans, net of unearned income (1) $ 172,742 15,220 8.81% 150,356 13,067 8.69% Investment securities held to maturity: Taxable 15,274 1,047 6.85% 20,794 1,456 7.00% Tax-exempt (2) 1,540 152 9.87% 1,549 158 10.20% ---------------------------- ------------------------- Total investment securities held to maturity 16,814 1,199 7.13% 22,343 1,614 7.22% Investment securities available for sale: Taxable 44,555 2,886 6.48% 41,020 2,619 6.38% Tax-exempt (2) 491 36 7.33% 312 23 7.28% ---------------------------- ------------------------- Total investment securities available for sale 45,046 2,922 6.49% 41,332 2,642 6.39% Federal funds sold 6,778 388 5.72% 6,249 337 5.39% Interest bearing deposits with other banks 1,446 81 5.60% 25 2 8.00% ---------------------------- ------------------------- Total interest earning assets 242,826 19,810 8.16% 220,305 17,661 8.02% Allowance for loan losses (2,151) (2,055) Cash and due from banks 7,652 7,207 Premises and equipment 3,597 3,530 Rental property, net 1,859 1,954 Other assets 3,879 2,905 --------------- ------------ Total Assets $ 257,662 233,846 =============== ============ LIABILITIES & SHAREHOLDERS' EQUITY - ------------------------------------------------ Interest bearing liabilites: Deposits: Demand $ 20,143 426 2.11% 20,042 414 2.07% Savings and Money Market 59,098 2,660 4.50% 42,219 1,680 3.98% Certificates of deposits less than $100,000 71,933 4,495 6.25% 75,139 4,998 6.65% Certificates of deposit and other time deposits of $100,000 or more 37,808 1,972 5.22% 28,972 1,592 5.49% ---------------------------- ------------------------- Total interest bearing deposits 188,982 9,553 5.05% 166,372 8,684 5.22% Federal funds purchased and securities sold under agreements to repurchase 2,868 128 4.46% 7,784 425 5.46% Other short term borrowings 94 9 9.57% 602 30 4.98% Other borrowed funds 11,160 645 5.78% 9,003 513 5.70% Employee stock ownership plan debt 113 8 7.08% 171 12 7.02% ---------------------------- ------------------------- Total interest bearing liabilities 203,217 10,343 5.09% 183,932 9,664 5.25% Noninterest bearing demand deposits 27,941 26,131 Accrued expenses and other liabilities 2,070 1,896 Shareholders' equity 24,434 21,887 --------------- ------------ Total Liabilities and shareholders' equity $ 257,662 233,846 =============== ============ Net Interest Income $9,467 $7,997 ============= ============= Net Yield on Total Interest Earning Assets 3.90% 3.63% ========== ========= Years Ended December 31, ----------------------------------------------- 1995 ----------------------------------------------- Average Yield/ ASSETS Balance Interest Rate - ------------------------------------------------ ------- -------- ---- Interest Earning Assets: Loans, net of unearned income (1) 140,829 12,118 8.60% Investment securities held to maturity: Taxable 31,427 2,173 6.91% Tax-exempt (2) 1,708 205 12.00% ------------------------------ Total investment securities held to maturity 33,135 2,378 7.18% Investment securities available for sale: Taxable 21,678 1,388 6.40% Tax-exempt (2) -- -- -- ------------------------------ Total investment securities available for sale 21,678 1,388 6.40% Federal funds sold 5,784 345 5.96% Interest bearing deposits with other banks 48 3 6.25% ------------------------------ Total interest earning assets 201,474 16,232 8.06% Allowance for loan losses (2,224) Cash and due from banks 6,346 Premises and equipment 2,876 Rental property, net 1,943 Other assets 3,533 --------------- Total Assets 213,948 =============== LIABILITIES & SHAREHOLDERS' EQUITY - ------------------------------------------------ Interest bearing liabilites: Deposits: Demand 19,435 468 2.41% Savings and Money Market 34,555 1,317 3.81% Certificates of deposits less than $100,000 76,489 4,757 6.22% Certificates of deposit and other time deposits of $100,000 or more 24,111 1,516 6.29% ------------------------------ Total interest bearing deposits 154,590 8,058 5.21% Federal funds purchased and securities sold under agreements to repurchase 2,599 150 5.77% Other short term borrowings 712 38 5.34% Other borrowed funds 9,708 595 6.13% Employee stock ownership plan debt 227 17 7.49% ------------------------------ Total interest bearing liabilities 167,836 8,858 5.28% Noninterest bearing demand deposits 24,350 Accrued expenses and other liabilities 1,869 Shareholders' equity 19,893 --------------- Total Liabilities and shareholders' equity 213,948 =============== Net Interest Income 7,374 =============== Net Yield on Total Interest Earning Assets 3.66% =========
- ------------------ (1) Loans on nonaccrual status have been included in the computation of average balances. (2) Yields on tax-exempt securities have been computed on a tax-equivalent basis using an income tax rate of 34%. The following table presents the maturities of certificates of deposit and other time deposits of $100,000 or more at December 31, 1997: Maturities of Time Deposits over $100,000 December 31, 1997 ----------------- (In thousands)
Three months or less.......................... $15,202 After three within six months................. 5,398 After six within twelve months................ 3,646 After twelve months........................... 12,640 ------- Total..................................... $36,886 ======= Weighted Average rate on time deposits of $100,000 or more at period-end......... 6.10%
Schedule of Short-term Borrowings (1) The following table shows the maximum amount of short-term borrowings and the average and year-end amount of borrowings, as well as interest rates.
Maximum Weighted Year ended Outstanding at Average Interest Rate Ending Average Interest December 31 any Month-end Balance During Year Balance Rate at Year-end - ----------- ------------- ------- ------------- ------- ----------------- (Dollars in thousands) 1997 $8,516 $2,963 5.30% $1,274 5.29% 1996 12,774 $8,386 5.42% $5,856 5.13%
(1) Consists of federal funds purchased, treasury tax and loan, securities sold under agreements to repurchase, and borrowings from the FHLB-Atlanta that mature either overnight or on a fixed maturity not to exceed three months. Capital Resources The Company's consolidated stockholders' equity was $26,047,000 and $23,083,000 at December 31, 1997 and 1996, respectively, an increase of $2,964,000 (12.8%) since year end 1996. This represents a continuation of positive trends from prior periods. The Company has been able to fund its capital growth primarily through retained earnings. During 1997, cash dividends of $627,000 or $0.48 per share, were declared on the Common Stock as compared to $560,000, or $0.43 per share, in 1996, representing an increase of $67,000 (12.0%). The Company plans to continue a dividend payout policy that provides cash returns to its investors and allows the Company to maintain adequate capital to support future growth and capital adequacy. Management believes that a strong capital position is vital to the continued profitability of the Company and provides a foundation for future growth as well as promoting depositor and investor confidence in the institution. See "Supervision and Regulation." In the third quarter of 1994, the Company filed a registration statement with the Securities and Exchange Commission (the "SEC") to offer up to 172,500 shares of its Common Stock for sale in the Public Offering. While the Company has maintained a capital position well above minimum levels required by its regulators, management decided to pursue the Public Offering in order to further strengthen the Company's capital position for future growth. The registration statement was declared effective on February 7, 1995. The Company issued 69,045 shares of Common Stock pursuant to the Public Offering which resulted in a total increase in Common Stock and Surplus, net of the cost of the Public Offering, of approximately $1,234,000 during 1995. The Public Offering ended May 31, 1995. 25 Certain financial ratios for the Company for the last three years are presented in the following table:
Equity and Asset Ratios December 31, ----------------------------------------------- 1997 1996 1995 ----- ----- ------ Return on average assets 1.20% 1.18% 0.98% Return on average equity 12.61% 12.58% 10.51% Common dividend payout ratio 20.34% 20.38% 22.36% Average equity to average asset ratio 9.48% 9.36% 9.30%
The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory actions, 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 and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification of the Bank are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Management believes, as of December 31, 1997, that the Bank meets all capital adequacy requirements to which it is subject. See "Supervision and Regulation." The following table sets forth the Bank's actual capital levels and the related required capital levels at December 31, 1997:
Actual Required Capital Actual Capital Amount Ratio Amount Required Ratio ------- ------ -------- -------------------------- Tier 1 Risk-Based Capital $23,104 12.72% $ 7,264 greater than or equal to 4% Leverage Capital 23,104 8.84% 10,453 greater than or equal to 4% Total Qualifying Capital 25,229 13.89% 14,529 greater than or equal to 8%
Effective January 1, 1996, the Company adopted Statement of Financial Accounting Standards No. 122, "Accounting for Mortgage Servicing Rights" an amendment of FASB Statement No. 65 (SFAS 122). SFAS 122 requires that a mortgage banking enterprise recognize as separate assets, rights to service mortgage loans for others, however those servicing rights are acquired. SFAS 122 also requires that a mortgage banking enterprise assess its capitalized mortgage servicing rights for impairment based on the fair value of those rights. The recognition criteria under SFAS 122 has not had a material impact on the Company's consolidated financial statements. On January 1, 1996, the Company adopted the Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS No. 123"). SFAS No. 123 establishes financial accounting and reporting standards for stock-based employee compensation plans. Those plans include all arrangements by which employees receive shares of stock or other equity instruments of the employer or the employer incurs liabilities to employees in amounts based on the price of the employer's stock. Such instruments include stock purchase plans, stock options, restricted stock and stock appreciation rights. SFAS No. 123 also applies to transactions in which an entity issues its equity instruments to acquire goods or services from nonemployees. Those transactions are accounted for based on the fair value of the consideration received or the fair value of the equity instrument issued, whichever is more reliably measurable. SFAS No. 123 provides a choice for accounting for employee stock compensation plans. A company can elect to use the new fair-value-based method of accounting for employee stock compensation plans, under which compensation cost is measured and recognized in results of operations, or it can continue to account for these plans under the current accounting standards. Entities electing to remain with the present accounting standards must make disclosure of what net income and earnings per share -26- would have been if the fair-value-based method of accounting had been applied. No options were granted in 1997, though upon the granting of any stock options in future periods, the Company plans to account for employee stock options using the present accounting standards and to include the required disclosures in the financial statements. During 1997, the Company adopted Statement of Financial Accounting Standards No. 128, "Earnings Per Share" (SFAS No. 128). SFAS No. 128 establishes standards for computing and presenting earnings per share. Under SFAS No. 128 entities with complex capital structures are required to present basic and diluted earnings per share. Diluted earnings per share reflects the effect of dilutive potential outstanding shares. The Company has no potential outstanding shares that would result in diluted earnings per share, thus only basic earnings per share are presented. Liquidity Liquidity is the Company's ability to convert assets into cash equivalents in order to meet daily cash flow requirements, primarily for deposit withdrawals, loan demand, and maturing liabilities. Without proper management, the Company could experience higher costs of obtaining funds due to insufficient liquidity, while excessive liquidity can lead to a decline in earnings due to the cost of foregoing alternative higher-yielding investment opportunities. At the Bank, asset liquidity is provided primarily through cash, the repayment and maturity of investment securities, and the sale and repayment of loans. Sources of liability liquidity include customer deposits, federal funds purchased and investment securities sold under agreements to repurchase. Although deposit growth historically has been a primary source of liquidity, such balances may be influenced by changes in the banking industry, interest rates available on other investments, general economic conditions, competition and other factors. In addition to deposits and repurchase agreements, the Bank has participated in the FHLB-Atlanta's advance program. Advances include both fixed and variable terms and are taken out with varying maturities. The Bank has a current line of credit of $25,000,000. This line is collateralized by a blanket lien against its one to four family residential properties. At December 31, 1997, the Bank had credit available from FHLB-Atlanta of $14,124,000, and had $10,876,000 in advances drawn down. Overall, net cash provided from financing activities decreased $31,015,000 (92.8%) to $2,404,000 during 1997 from the previous year's total of $33,419,000. Net cash provided by operating activities increased $1,704,000 (77.7%) to $3,896,000 from $2,192,000 for the year ended December 31, 1997. $18,590,000 of the cash was used in investing activities during 1997. The Company depends mainly on management fees and lease payments for building and equipment, from the Bank, for its liquidity. In addition, the Bank makes transfers to the Company, under its Tax Sharing Agreement, for payment of consolidated tax obligations. The Tax Sharing Agreement calls for the allocation of the consolidated tax liability or benefit between the Company and each Subsidiary based on their individual tax positions as if each entity filed a separate tax return. Other sources of liquidity may include the sale of stock. The Company provides services to the Bank for which they are paid a management fee comparable to a third party vendor. The Bank paid the Company $295,000 and $277,000 in management fees and $187,000 and $180,000 in lease payments for the years ended December 31, 1997 and 1996, respectively. These funds were used to pay operating expenses and fund dividends to the Company's shareholders. Management has made the decision to allow the Bank's capital position to grow in order to increase its legal lending limit. As a result of this decision, the Company only receives cash dividends from the Bank if the cash flow from other sources is not sufficient to maintain a positive cash flow. Accordingly, the Bank paid the Company $697,000, $265,000, and $0 in cash dividends for 1997, 1996, and 1995 respectively. Year 2000 The Company is aware of the issues associated with the programming code in existing computer systems as the millennium ("Year 2000") approaches. The Company has conducted a comprehensive review of its computer -27- systems to identify the systems that could be affected by the Year 2000 issue and has developed a plan to resolve any modifications necessary in order be prepared for the new millennium. Any modifications are expected to be completed by December 31, 1998. The Company has received certification of Year 2000 compliance from their critical vendors used in the major operations of the Company. The Company has followed the Federal Reserve guidelines for preparing for Year 2000. The Company also reports quarterly to the Board the progress of the Year 2000 project. Accordingly, the Company does not expect the Year 2000 issue to pose any significant operational problems and has not discovered any Year 2000 problems with significant counter-parties that it believes will have material effect on the financial position or results of operations of the Company. However, the Company has not fully evaluated the effect of any Year 2000 problems on its loan and deposit customers, and no assurance can be given that potential Year 2000 problems of those with whom the Company does business will not occur, and if they occur, that the consequences to the Company will not be material. The total cost of the project is estimated not to exceed $20,000 and is estimated to be funded through operating cash flows. Interest Rate Sensitivity Management An integral part of the funds management of the Company and the Bank is to maintain a reasonably balanced position between interest rate sensitive assets and liabilities. The Bank's Asset/Liability Management Committee ("ALCO") is charged with the responsibility of managing, to the degree prudently possible, its exposure to "interest rate risk," while attempting to provide earnings enhancement opportunities. The dollar difference between rate sensitive assets and liabilities for a given period of time is referred to as the rate sensitive gap ("GAP"). A GAP ratio is calculated by dividing rate sensitive assets by rate sensitive liabilities. Due to the nature of the Bank's balance sheet structure and the market approach to pricing of liabilities, management and the Board of Directors recognize that achieving a perfectly matched GAP position in any given time frame would be extremely rare. ALCO has determined that an acceptable level of interest rate risk would be for net interest income to fluctuate no more than 5.0% given a change in selected interest rates of up or down 200 basis points over any 12-month period. Using an increase of 200 basis points and a decrease of 200 basis points, the Bank's net interest income at December 31, 1997, would increase approximately 0.83% in a rising rate environment and decrease approximately 0.75% in a falling rate environment. Interest rate scenario models are prepared on the Bank's Balance Sheet Information System created by Darling Consulting Group. For purposes of measuring interest rate sensitivity, Company management assumes that the asset and liability balances remain constant over the 12-month period. Deposit withdrawals are only considered in measuring liquidity. Although demand and savings accounts are subject to immediate withdrawal, all passbook savings and regular NOW accounts are reflected to reprice in over 5 years due to their historically stable volume and limited repricing. High balance MMDAs and NOW accounts are considered volatile and, as such, are shown as repricing in 1-3 months. Assets and liabilities that are subject to interest rate changes are shown as repricing immediately. -28-
Interest Sensitivity Analysis Over Five One to Four to One to Years and Three Twelve Five Non-rate December 31, 1997 Immediate Months Months Years Sensitive Total --------- ------ ------ ----- --------- --------- (In thousands) Earning Assets: Loans, net of unearned $ 31,094 24,168 38,237 84,380 7,614 185,493 Taxable investment securities -- 2,494 5,955 4,436 -- 12,885 Tax-exempt investment securities -- 273 201 1,005 -- 1,479 Investment securities available for sale -- 14,728 5,852 19,616 250 40,446 Federal funds sold and securities purchased under agreements to resell 2,615 -- -- -- -- 2,615 Interest bearing deposits with other banks 1,723 -- -- -- -- 1,723 --------- ------- ------- ------- ------- ------- Total earning assets 35,432 41,663 50,245 109,437 7,864 244,641 --------- ------- ------- ------- ------- ------- Interest bearing liabilities: Demand deposits -- 3,207 -- -- 19,216 22,423 Savings and Money Market 50,678 -- -- -- 10,217 60,895 Certificates of deposit less than $100,000 -- 12,470 25,972 32,694 -- 71,136 Certificates of deposit and other time deposits of $100,000 or more -- 15,202 9,044 12,640 -- 36,886 Federal funds purchased and securities sold under agreements to repurchase 1,274 -- -- -- -- 1,274 Other short-term borrowings -- -- -- -- -- -- FHLB and other borrowings -- 5,030 90 5,665 410 11,195 --------- ------- ------- ------- ------- ------- Total interest bearing liabilities 51,952 35,909 35,106 50,999 29,843 203,809 Noninterest bearing sources of funds, net -- -- -- -- 32,639 32,639 Off-balance sheet items-asset/(liability) -- (5,000) 5,000 10,000 -- 10,000 --------- ------- ------- ------- ------- ------- Interest sensitivity gap (16,520) 754 20,139 68,438 (54,618) 18,193 --------- ------- ------- ------- ------- ------- Cumulative interest sensitivity gap $ (16,520) (15,766) 4,373 72,811 18,193 ========= ======= ======= ======= =======
The interest sensitive assets at December 31, 1997, that reprice or mature within 12 months were $127,340,000 while the interest sensitive liabilities that reprice or mature within the same time frame were $122,967,000. At December 31, 1997, the 12 month cumulative GAP position, including the effect of off-balance sheet items, was a positive $4,373, resulting in a GAP ratio of 104.0%. A positive GAP indicates that the Company has more interest-bearing assets than interest-earning liabilities that reprice within the GAP period. The Bank enters into interest rate protection contracts to help manage its interest rate exposure. These contracts include interest rate swaps, caps and floors. Interest rate swap transactions involve the exchange of fixed and floating rate interest payment obligations based on the underlying notional principal amounts. Interest rate caps and floors are purchased by the Bank for a non-refundable fixed amount. The Bank receives interest based on the underlying notional principal amount if the specified index rises above the cap rate or falls below the floor strike rate. Notional principal amounts are used to express the volume of these transactions, but because they are never exchanged, the amounts subject to credit risk are much smaller. Risks associated with interest rate contracts include interest rate risk and creditworthiness of the counterparty. These risks are considered in the Bank's overall asset liability management program. The Bank utilizes periodic financial statements issued by the counterparty to analyze the creditworthiness of the counterparty prior to entering into a contract and to monitor changes in the financial condition of the counterparty throughout the term of the contract. Current contracts are issued by a securities broker-dealer and were entered into with the purpose of managing the Bank's interest rate exposure. Although none of the interest rate protection agreements are traded on any organized exchange, an active secondary market is available to the Company for such contracts. -29- The Bank's Asset Liability Management Policy states that establishing limits on interest rate swaps, caps, and floors can be somewhat confusing or misleading since the notional amount by which these instruments are expressed is never exchanged between counterparties and therefore is not "at risk." Furthermore, since they represent off-balance sheet tools used by ALCO to manage imbalances in the Bank's balance sheet in a prudent and cost effective manner, the appropriate volume of swaps for the Bank is not a static variable; it changes with elements such as the economic environment, the capital position, and the ability to efficiently replicate hedging actions in the cash markets. The Bank endeavors to limit outstanding notional value of off-balance sheet contracts executed for purposes of managing net interest income to 25% of total assets as reported in the most recent quarterly call report. Notional value of off-balance sheet contracts executed with one counterparty are limited to 10% of total assets as reported in the Bank's most recent quarterly call report. The following table presents the Company's interest rate swaps and floors position as of December 31, 1997:
Weighted Average Weighted Remaining Notional Carrying Estimated Average Rate(1) Life Amount Value Fair Value Received Paid (Years) ------ ----- ---------- -------- ----- --------- (Dollars in thousands) Swaps: Receive fixed: One year or less $ 5,000 -- 8 6.37% 5.91% 0.50 Over one year through two years 10,000 -- 68 6.42% 5.88% 1.25 Floors Purchased Over two years through five years 10,000 11 11 2.25 Over two years through five years 10,000 32 73 6.00% 5.81% 2.25 ------ $35,000 =======
________________ (1) The weighted average rates received/paid are shown only for swaps and floors for which net interest amounts were receivable or payable at the end of each period. For floors when the index rate has not been reached, no rate is shown. Interest rates on variable rate derivative products held by the Bank are derived from the 3 Month-LIBOR-BBA ("British Bankers Association") rate. In January 1997, the Securities and Exchange Commission approved rule amendments (the Release) regarding disclosures about derivative financial instruments, other financial instruments and derivative commodity instruments. The release requires inclusion in the footnotes to the financial statements of extensive detail about the accounting policies followed by a registrant in connection with its accounting for derivative financial instruments and derivative commodity instruments. The accounting policy requirements become effective for all registrants for filings that include financial statements for periods ending after June 15, 1997. As part of its overall interest rate risk management activities, the Company utilizes off-balance sheet derivatives to modify the repricing characteristics of on-balance sheet assets and liabilities. The primary instruments utilized by the Company are interest rate swaps and interest rate floor and cap agreements. The fair values of these off-balance sheet derivative financial instruments are based on dealer quotes and third party financial models. Interest rate swaps, floor and caps are accounted for on an accrual basis, and the net interest differential, including premiums paid, if any, is recognized as an adjustment to interest income or expense of the related designated asset or liability. Changes in the fair values of the swaps, floors and caps are not recorded in the consolidated statements of income because these agreements are being treated as a synthetic alteration of the designated assets or liabilities. The Company considers its interest rate swaps to be a synthetic alteration of an asset or liability as long as (i) the swap is designated with a specific asset or liability or finite pool of assets or liabilities; (ii) there is a high correlation, at inception and throughout the period of the synthetic alteration, between changes in the interest income or expense generated by the swap and changes in the interest income or expense generated by -30- the designated asset or liability; (iii) the notional amount of the swap is less than or equal to the principal amount of the designated asset or liability; and (iv) the swap term is less than or equal to the remaining term of the designated asset or liability. The criteria for consideration for a floor or cap as a synthetic alteration of an asset or liability are generally the same as those for a swap arrangement. If the swap, floor or cap arrangements are terminated before their maturity, the net proceeds received or paid are deferred and amortized over the shorter of the remaining contract life or the maturity of the designated asset or liability as an adjustment to interest income or expense. If the designated asset or liability is sold or matures, the swap agreement is marked to market and the gain or loss is included with the gain or loss on the sale/maturity of the designated asset or liability. Changes in the fair value of any undesignated swaps, floors and caps are included in other income in the consolidated statement of income. The impact of such derivatives has been determined by Management to be immaterial to its financial statements. Effects of Inflation and Changing Prices Inflation generally increases the costs of funds and operating overhead, and to the extent loans and other assets bear variable rates, the yields on such assets. Unlike most industrial companies, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates generally have a more significant impact on the performance of a financial institution than the effects of general levels of inflation. In addition, inflation affects financial institutions' cost of goods and services purchased, the cost of salaries and benefits, occupancy expense, and similar items. Inflation and related increases in interest rates generally decrease the market value of investments and loans held and may adversely affect liquidity, earnings, and stockholders' equity. Mortgage originations and refinancings tend to slow as interest rates increase, and likely will reduce the Company's earnings from such activities and the income from the sale of residential mortgage loans in the secondary market. Results of Operations Net Income Net income increased $327,000 (11.9%) to $3,080,000 during 1997 from $2,753,000 for the year ended December 31, 1996. Basic income per share was $2.36 and $2.11 for 1997 and 1996, respectively, an increase of 11.8%. Comparatively, net income during 1996 increased $662,000 (31.7%) from the 1995 year end total of $2,091,000, while basic income per share showed a similar increase of $0.50 per share for 1996 from a 1995 per share total of $1.61. The increase in net income for 1997 is attributable to higher net interest income offset by a decrease in noninterest income. The increase in 1996 compared to 1995 was due to higher net interest income and noninterest income and lower noninterest expense for the year. Net Interest Income Net interest income is the difference between the interest the Company earns on its loans, investment securities and other earning assets and the interest cost of its deposits, borrowed funds and other interest-bearing liabilities. This is the primary component of the Company's earnings. Net interest income was $9,403,000 for the year ended December 31, 1997. This increase of $1,466,000 (18.5%) over 1996 is due to the increase in average interest earning assets during 1997 and an increase in the net yield on earning assets of 27 basis points. Net interest income for 1996 was $7,937,000, $633,000 (8.7%) higher than 1995 net interest income of $7,304,000. This increase over 1995 is due to the increase in average interest earning assets during 1997 which offset a decrease in the net yield on earning assets of 3 basis points. -31- The Company uses interest rate protection contracts, primarily interest rate swaps, caps and floors, to protect the yields on earning assets and the rates paid on interest-bearing liabilities. Such contracts act as hedges against unfavorable rate changes. The income and expense associated with interest rate swaps, caps and floors are ultimately reflected as adjustments to the net interest income or expense of the underlying assets or liabilities. The effect of such interest rate protection contracts resulted in a net increase in net interest income of $43,525 during 1997 compared to a net increase in 1996 of $6,000 and a decrease in net interest income of $56,000 during 1995. It is the intention of the Company to continue to utilize interest rate protection contracts to manage exposure to certain future changes in interest rate environments. However, there can be no assurance that such transactions will positively affect earnings. See "-- Interest Rate Sensitivity Management", the "Consolidated Average Balances, Interest Income/Expense and Yields/Rates" table appearing elsewhere herein and the "Rate/Volume Variance Analysis" tables immediately following.
Rate/Volume Variance Analysis Taxable-Equivalent Basis (1)(2) Change Due to Years Ended December 31, Net Rate/ 1997 Compared to 1996 change Rate Volume volume ------ ---- ------ ------ (In thousands) Interest income: Loans, net of unearned income $2,153 207 1,973 (27) Investment securities held to maturity: Taxable (409) (22) (379) (8) Tax-exempt (6) (5) (1) -- Total investment securities-HTM (415) (27) (380) (8) Investment securities available for sale: Taxable 267 41 229 (3) Tax-exempt 13 -- 13 -- -- -- -- -- Total investment securities-AFS 280 41 242 (3) Federal funds sold 51 22 31 (2) Interest bearing deposits with other banks 79 (35) 80 34 ------ ----- ----- ----- Total earning assets $2,148 208 1,946 (6) ====== ===== ===== ===== Interest expense: Deposits: Demand $ 12 10 2 -- Savings 980 308 760 (88) Certificates of deposit less than $100,000 (503) (290) (200) (13) Certificates of deposit and other time deposits of $100,000 or more 380 (106) 461 25 ------ ----- ----- ----- Total interest bearing deposits 869 (78) 1,023 (76) Federal funds purchased and securities sold under agreements to repurchase (297) (29) (219) (49) Other short term borrowings (21) 4 (48) 23 Other borrowed funds 128 8 121 (1) ------ - ----- ----- Total interest bearing liabilities $ 679 (95) 877 (103) ====== ===== ===== ===== - -------------
(1) For analytical purposes, income for tax-exempt assets, primarily securities issued by state and local governments or authorities, is adjusted by an increment which equates tax-exempt income to interest from taxable assets (assuming a 34% effective federal income tax rate). (2) The change in interest due to rate is calculated by multiplying the previous volume by the rate change and the change in interest due to volume is calculated by multiplying the change in volume by the previous rate. Changes attributable to both changes in rate and volume have been allocated to the rate and volume components in proportion to the relationship of the dollar amounts of the change in each. -32-
Rate/Volume Variance Analysis Taxable-Equivalent Basis (1)(2) Change Due to Years Ended December 31, Net Rate/ 1996 Compared to 1995 change Rate Volume volume ------ ---- ------ ------- (In thousands) Interest income: Loans, net of unearned income $ 949 129 827 (7) Investment securities held to maturity: Taxable (717) 18 (743) 8 Tax-exempt (47) (28) (16) (3) -- -- -- - Total investment securities-HTM (764) (10) (759) 5 Investment securities available for sale: Taxable 1,231 (7) 1,232 6 Tax-exempt 23 -- -- 23 -- -- -- -- Total investment securities-AFS 1,254 (7) 1,232 29 Federal funds sold (8) (35) 25 2 Interest bearing deposits with other banks (1) -- (1) -- ------ ---- ----- ---- Total earning assets $1,430 77 1,324 29 ====== ==== ===== ==== Interest expense: Deposits: Demand $ (54) (70) 13 3 Savings 363 71 305 (13) Certificates of deposit less than $100,000 241 325 (90) 6 Certificates of deposit and other time deposits of $100,000 or more 76 (230) 267 39 ------ ---- ---- ---- Total interest bearing deposits 626 96 495 35 Federal funds purchased and securities sold under agreements to repurchase 346 88 325 (67) Other short term borrowings (130) (4) (109) (17) Other borrowed funds 135 134 3 (2) ------ ---- - ---- Total interest bearing liabilities $ 977 314 714 (51) ====== ==== ==== ==== - -------------
(1) For analytical purposes, income for tax-exempt assets, primarily securities issued by state and local governments or authorities, is adjusted by an increment which equates tax-exempt income to interest from taxable assets (assuming a 34% effective federal income tax rate). (2) The change in interest due to rate is calculated by multiplying the previous volume by the rate change and the change in interest due to volume is calculated by multiplying the change in volume by the previous rate. Changes attributable to both changes in rate and volume have been allocated to the rate and volume components in proportion to the relationship of the dollar amounts of the change in each. Interest Income Interest income is a function of the volume of interest earning assets and their related yields. Interest income was $19,746,000, $17,601,000, and $16,162,000 for the years ended December 31, 1997, 1996, and 1995, respectively. Average interest earning assets increased $22,521,000 (10.2%) during 1997, $18,831,000 (9.4%) during 1996, and $21,979,000 (12.2%) during 1995, while the fully taxable equivalent yields on average earning assets increased 14 basis points in 1997 after decreasing 4 basis points in 1996 and increasing 34 basis points in 1995. The combination of these factors resulted in increases in interest income of $2,145,000 (12.1%), $1,439,000 (8.9%) and $2,504,000 (18.3%) during 1997, 1996 and 1995, respectively. See "--Consolidated Average Balances, Interest Income/Expense and Yields/Rates" and the "Rate/Volume Variance Analysis" tables. -33- Loans are the main component of the Bank's earning assets. Interest and fees on loans were $15,220,000, $13,067,000, and $12,118,000 for the years ended December 31, 1997, 1996, and 1995, respectively. These levels reflected increases of $2,153,000 (16.5%) during 1997, $949,000 (7.8%) during 1996, and $1,611,000 (15.3%) during 1995 due to a combination of steady increases in the average volume outstanding and fully taxable equivalent yields on loans over the past three years. While the level of average balances has grown to $172,742,000 in 1997 from $150,356,000 and $140,829,000 for 1996 and 1995, respectively, the fully taxable equivalent yield on loans has also shown increases of 12 basis points to 8.81% in 1997, and 9 basis points to 8.69% in 1996 from the 1995 average yield of 8.60%. Interest income on investment securities held to maturity decreased $413,000 (26.4%) to $1,147,000 in 1997, following decreases of $748,000 (32.4%) to $1,560,000 in 1996 and $63,000 (2.7%) to $2,308,000 in 1995. The 1997 decrease was due to the combination of a $5,529,000 decrease in average volume outstanding and a 9 basis point decrease in the fully taxable equivalent yield over 1996 levels. The 1996 decrease was due to a combination of a $10,792,000 decrease in average volume outstanding offset by a 4 basis point increase in the fully taxable equivalent yield over 1995 levels. The decrease in average outstandings for 1997 and 1996 was due to scheduled paydowns and calls of principal. The fully taxable equivalent yields on investment securities held to maturity were 7.13% in 1997, 7.22% in 1996, and 7.18% in 1995. The Company established an available for sale portfolio in 1994 with the adoption of SFAS No. 115. Interest income on such investments was $2,910,000, $2,634,000 and $1,388,000 for the years ended December 31, 1997, 1996 and 1995, respectively. These increases in income from such portfolio of $276,000 (10.5%) and $1,246,000 (89.8%) for 1997 and 1996, respectively were due almost entirely to increases in the average volume outstanding. The average balance outstanding of investment securities available for sale increased $3,714,000 (9.0%) to $45,046,000 in 1997 over the 1996 average balance of $41,332,000, which in turn represented an increase of $19,654,000 (90.7%) over the 1995 balance of $21,678,000. Theses increases reflect management's intention to reinvest runoff from the investment securities held to maturity portfolio and to invest new funds into investment securities available for sale to maintain flexibility in its liquidity planning. The fully taxable equivalent yield on investment securities available for sale was 6.49% in 1997, 6.39% in 1996 and 6.40% in 1995. See "Financial Condition--Investment Securities." Interest Expense Total interest expense was $10,343,000, $9,664,000 and $8,858,000 for the years ended December 31, 1997, 1996 and 1995 respectively, representing increases of $679,000 (7.0%), of $806,000 (9.1%) and $2,714,000 (44.2%) during 1997, 1996, and 1995, respectively. Total average balances outstanding of interest-bearing liabilities have continued an upward trend over the last three years to $203,217,000 in 1997 from $183,932,000 in 1996 and $167,836,000 in 1995. The rates paid on these liabilities decreased 16 basis points in 1997 to 5.09% after decreasing 3 basis points to 5.25% during 1996, and decreasing 116 basis points to 5.28% during 1995. Interest on deposits, the primary component of total interest expense, increased $869,000 to $9,553,000 (10.0%) during 1997 from $8,684,000 in 1996, which in turn represented a $626,000 (7.8%) increase from the 1995 level of $8,058,000. The average balance outstanding of interest-bearing deposits has increased steadily to the 1997 level of $188,982,000 as compared to $166,372,000 in 1996 and $154,590,000 in 1995. The 1997 increase is attributable to growth in money market deposit accounts in the normal course of business, while the 1996 increase was due to new deposit growth in money market deposit account and growth in certificate of deposit balances also in the normal course of business. The average rates paid on interest-bearing deposits were 5.05%, 5.22%, and 5.21% for 1997, 1996, and 1995, respectively. Interest expense on borrowed funds, including both short term borrowings and other borrowed funds, was $662,000 in 1997, $555,000 in 1996, and $650,000 in 1995. These levels represent an increase of $107,000 (19.3%) during 1997, a decrease of $95,000 (14.6%) during 1996, and a decrease of $41,000 (5.9%) during 1995. The increase in 1997 is due to a full year of interest expense relating to a $5,000,000 FHLB advance drawn in May 1996 compared to 7 months of interest expense in 1996. -34- Provision for Loan Losses During 1997, the Company made a total provision for loan losses of $285,000 based on management's assessment of the risk in the loan portfolio, the growth of the loan portfolio and historical loan loss trends. During 1996, the Company made a total provision for loan losses of $80,000. For 1995, the Company made no provision for loan losses due to the credit quality of the loan portfolio, coupled with the relatively low loan growth and low level of net charge-offs during the year. See "Financial Condition -- Allowance for Loan Losses and Risk Elements." Noninterest Income Noninterest income decreased $233,000 (9.7%) to $2,175,000 for the year ended December 31, 1997 from the 1996 total of $2,408,000, which in turn represented an increase of $114,000 (5.0%) over the total of $2,294,000 for 1995. Service charges on deposit accounts increased $64,000 (8.0%) during 1997 and $66,000 (9.0%) in 1996 both primarily due to increases in nonsufficient funds and overdraft charges. During 1997, the Company experienced net losses of $60,000 on the sale, in the ordinary course of business, of investment securities available for sale, as compared to net gains of $26,000 in 1996 and $37,000 in 1995. See "FINANCIAL CONDITION - INVESTMENT SECURITIES." Other noninterest income decreased $212,000 (13.4%) to $1,369,000 in 1997 from $1,581,000 in 1996. Comparatively, the 1996 total represents an increase of $58,000 (3.8%) from $1,523,000 in 1995. The decrease in 1997 was due to a $30,000 decrease in rental income, a $18,000 increase in ATM transaction fees and a $151,000 decrease in stock dividends from other companies primarily due to the one time dividend paid in 1996 in connection with the sale of Alert. The increase in 1996 was due to a $99,000 increase in other fee income, especially ATM transaction fees, a $162,000 increase in dividends received from stock held in other companies primarily due to a one time dividend paid in connection with the sale of Alert, offset by a $33,000 decrease in non-interest loan income and fees due to the sale of the Bank's credit card portfolio in 1995 and a decrease in rental income of $95,000. Noninterest Expense Total noninterest expense was $6,385,000 for 1997, $6,007,000 for 1996, and $6,419,000 for 1995 reflecting an increase of $378,000 (6.3%) for 1997, a decrease of $412,000 (6.4%) for 1996 and an increase of $440,000 (7.4%) for 1995. Salaries and benefits increased $202,000 (6.9%) to $3,143,000 for the year ended December 31, 1997 and decreased $46,000 (1.5%) to $2,941,000 for the year ended December 31, 1996 from the 1995 total of $2,987,000. At December 31, 1997, the Company had 104 full-time equivalent employees, an increase of 2 over the level at December 31, 1996. The salary and benefit increase over 1996 was primarily due to merit and cost-of-living raises and the cost of benefits associated with such increases. Net occupancy expense was $972,000, $817,000, and $724,000 for 1997, 1996 and 1995, respectively, representing increases of $155,000 (19.0%) in 1997 and $93,000 (12.8%) in 1996 over the previous year's levels. The 1997 increase resulted primarily from a $30,000 increase in property taxes, a $24,000 increase in furniture and equipment depreciation, a $18,000 increase in service contract expense, a $43,000 increase in leases payments due to the new Winn Dixie branch and a $40,000 increase in equipment lease payments. The 1996 increase is attributable to increases in furniture and equipment depreciation and lease payments on equipment. Other noninterest expense was $2,270,000 for 1997, $2,250,000 for 1996, and $2,708,000 for 1995. These levels represent an increase of $20,000 (0.9%) in 1997 and a decrease of $458,000 (16.9%) in 1996 over the respective previous years. The 1997 increase resulted from a $40,000 increase in electronic services due to -35- Mastercard/Visa processing expenses and ATM expenses, $25,000 increase in FDIC assessment due to an increase in premiums, $70,000 decrease in professional fees mainly due to expenses in 1996 to set up the Dividend reinvestment plan, and a $28,000 increase in marketing expenses due to the Winn Dixie branch opening and the promotion of the Checkcard. The 1996 decrease resulted from a $189,000 decrease in FDIC insurance from the reassessment of insurance rates in the second quarter of 1995, a decrease of $180,000 in losses on sale of premises and equipment due to one-time losses incurred in 1995, a decrease of $26,000 in loan related expenses, and a decrease of $38,000 in sales and use taxes, offset by increases in software expense of $60,000, in-house data processing of $26,000 and special project expense of $18,000. See "Supervision and Regulation-FDIC Insurance Assessments." Income Taxes The Company's income tax expense was $1,828,000, $1,505,000, and $1,089,000 in 1997, 1996 and 1995, respectively. These levels represent an effective tax rate on pre-tax earnings of 37.2% for 1997, 35.3% for 1996, and 34.2% for 1995. Details of the tax provision for income taxes are included in Note 8, "Income Tax Expense" to the Notes to the Consolidated Financial Statements included elsewhere herein. ITEM 7. FINANCIAL STATEMENTS See pages 44 to 74. ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT Board of Directors and Executive Officers The following table sets forth certain information regarding the Company's and the Bank's directors, executive officers and principal shareholders as of December 31, 1997:
Shares of Common Stock Beneficially Owned and Name (Age) and Year First Percentage of Common Elected as Director Information About Director or Executive Officer(1) Stock Outstanding (2) C. Wayne Alderman (47) Director of the Bank; Dean of Auburn University 1,113* (3) Bank Board: 1993 College of Business since 1993; member of Auburn University staff since 1988. Otis D. Alsobrook, III (46) City President, Opelika Office and Senior Vice 1,586* (4) President of the Bank since 1990; previously Vice President of AmSouth Bank in Opelika, Alabama from 1977 to 1990.
-36- Terry W. Andrus (45) Director of the Bank; President and Chief Executive 300* (5) Bank Board: 1991 Officer of the East Alabama Medical Center since 1984. Terrell E. Bishop (61) Senior Vice President - Mortgage Lending of the 4,993* (6) Bank since 1991; formerly Executive Vice President, Treasurer and Director of Charter Federal Savings and Loan Assn., West Point, Georgia, from 1964 to 1990. Winifred H. Boyd (75) Director of the Company and the Bank; community 15,294 (7) Bank Board: 1981 civic leader. 1.16% Company Board: 1993 Curt B. Cope (44) Director of the Bank; President of Cope International 7,138* Bank Board: 1993 since 1994; Previous owner and President of PowerGuard, Inc. Robert W. Dumas (44) Senior Vice President - Commercial & Consumer 8,215* (8) Lending of the Bank since 1988; Employee of the Bank since 1984. J. E. Evans (56) Director of the Bank; Owner of Evans Realty since 6,000* Bank Board: 1986 1970. Linda D. Fucci (50) Chief Financial Officer, Secretary and Treasurer of 72,174 (9) the Company since 1984; Chief Financial Office 5.52% and Senior Vice President of the Bank since 1988; Employee of the Bank since 1972 Jo Ann Hall (48) Senior Vice President - Operations of the Bank since 4,219* (10) 1994; Employee of the Bank since 1974. William F. Ham, Jr. (44) Director of the Bank; Owner of Varsity Enterprises, a 352* (11) Bank Board: 1993 coin-operated laundry equipment operating company, since 1977. David E. Housel (51) Director of the Bank; Director of Auburn University 60* Bank Board: 1997 Athletics since 1994; Member of the Auburn University staff since 1970. Anne M. May (46) Director of the Company and the Bank; Partner, 73,084 (12) Bank Board: 1982 Machen, McChesney & Chastain, Certified Public 5.59% Company Board: 1990 Accountants, since 1973. E. L. Spencer, Jr. (67) Director of the Company and the Bank; Chairman of 252,370 (13)(14) Bank Board: 1975 the Board of Directors of the Bank since 1980; 19.29% Company Board: 1984 President and Chief Executive Officer of the Bank and the Company since 1990; President of Spencer Lumber Company since 1970. (14)
-37- Edward L. Spencer, III (42) Director of the Bank; Vice President of Spencer 1,900* (15) Bank Board: 1991 Lumber Company since 1990. (14) Emil F. Wright, Jr. (61) Director of the Company and the Bank; Vice 142,260 (16) Bank Board: 1973 Chairman of the Company and the Bank since 10.87% Company Board: 1984 1991; practicing law clerk 1998; former Ophthalmologist practicing with the Medical Arts Eye Clinic 1971 - 1997. Directors and executive 451,430 officers as a group 34.51% (16 persons)
__________________ * Denotes less than 1% beneficial ownership. (1) The business address of each officer and director is 100 N. Gay Street, Auburn, Alabama 36830. (2) Information relating to beneficial ownership of Common Stock by directors is based upon information furnished by each person using "beneficial ownership" concepts set forth in rules of the Commission under the Exchange Act. Under such rules, a person is deemed to be a "beneficial owner" of a security if that person has or shares "voting power," which includes the power to vote or direct the voting of such security, or "investment power," which includes the power to dispose of or to direct the disposition of such security. The person is also deemed to be a beneficial owner of any security of which that person has a right to acquire beneficial ownership within 60 days. Under such rules, more than one person may be deemed to be a beneficial owner of the same securities, and a person may be deemed to be a beneficial owner of securities as to which he or she may disclaim any beneficial ownership. Accordingly, directors and officers are named as beneficial owners of shares as to which they may disclaim any beneficial interest. Except as indicated in other notes to this table describing special relationships with other persons and specifying shared voting or investment power, directors and officers possess sole voting and investment power with respect to all shares of Common Stock set forth opposite their names. (3) Includes 413 shares held jointly with Mr. Alderman's wife, as to which Mr. Alderman may be deemed to have shared voting and investment power, and 700 shares held in Mr. Alderman's Simplified Employee Pension Plan. (4) Includes 250 shares held jointly with Mr. Alsobrook's wife, as to which Mr. Alsobrook may be deemed to have shared voting and investment power, and 1,336 shares held by the trustees for the ESOP for the benefit of Mr. Alsobrook. (5) Includes 100 shares held jointly with Mr. Andrus' wife, as to which Mr. Andrus may be deemed to have shared voting and investment power. (6) Includes 3,664 shares held jointly with Mr. Bishop's wife, as to which Mr. Bishop may be deemed to have shared voting and investment power, and 1,329 shares held by the trustees for the ESOP for the benefit of Mr. Bishop. (7) Includes 6,000 shares held by Ms. Boyd's husband, as to which Ms. Boyd may be deemed to have shared voting and investment power, and as to which Ms. Boyd disclaims beneficial ownership. (8) Includes 2,750 shares held jointly with Mr. Dumas' wife, and 828 shares held jointly with Mr. Dumas' parents, as to which Mr. Dumas may be deemed to have shared voting and investment power, and 4,639 shares held by the ESOP trustees for the benefit of Mr. Dumas. -38- (9) Includes 64,726 shares held by the ESOP, of which Ms. Fucci is a co- trustee, as to which Ms. Fucci may be deemed to have shared voting and investment power with E. L. Spencer, Jr. and Anne M. May, as co-trustees of the ESOP, and as to which Ms. Fucci disclaims beneficial ownership of 60,213 shares. The remaining 4,513 shares are held by the ESOP trustees for the benefit of Ms. Fucci. Also includes 7,448 shares held jointly with Ms. Fucci's husband, as to which Ms. Fucci may be deemed to have shared voting and investment power. (10) Includes 2,884 shares held by the ESOP trustee for the benefit of Ms. Hall. (11) Includes 100 shares held in Mr. Ham's self-directed Individual Retirement Account ("IRA"). (12) Includes 64,726 shares held by the ESOP, of which Ms. May is a co-trustee, as to which Ms. May may be deemed to have shared voting and investment power with E. L. Spencer, Jr. and Linda D. Fucci, as co-trustees of the ESOP, and as to which Ms. May disclaims beneficial ownership. Also includes 149 shares held by Ms. May's daughter, as to which Ms. May may be deemed to have shared voting and investment power. (13) Includes 64,726 shares held by the ESOP, of which Mr. Spencer is a co- trustee, as to which Mr. Spencer may be deemed to have shared voting and investment power with Linda D. Fucci and Anne M. May, as co-trustees of the ESOP, and as to which Mr. Spencer disclaims beneficial ownership of 61,254 shares. The remaining 3,472 shares are held by the ESOP trustees for the benefit of Mr. Spencer. Also includes 24,900 shares held in the Trust of E. L. Spencer, Sr., of which Mr. Spencer serves as trustee, and 5,000 shares held by Mr. Spencer's wife, as to which Mr. Spencer may be deemed to have shared voting and investment power. (14) E. L. Spencer, Jr. is the father of Edward L. Spencer, III. (15) Includes 10 shares held by a minor of which Mr. Spencer serves as custodian. (16) Includes 9,800 shares held by DTS, a company in which Mr. Wright is a partner, as to which Mr. Wright may be deemed to have shared voting and investment power, and as to which Mr. Wright disclaims beneficial ownership of 9,702 shares. Also includes 1,500 shares held for the benefit of Mr. Wright by the Medical Arts Eye Clinic, PC Money Purchase Plan. Committees and Meetings of the Board of Directors All Company Directors hold office until the next annual meeting of Company stockholders, unless they sooner resign, become disqualified, or are removed. All executive officers of the Company are elected annually. All Company Directors are members of the Bank's Board of Directors. Various Bank Directors are not directors of the Company. The Company's Board of Directors held 6 meetings during 1997 and has five standing committees: the Executive Committee, the Proxy Committee, the Personnel and Salary Committee, the Audit and Compliance Committee, and the Strategic Planning Committee. The Bank's Board of Directors held 12 meetings during 1997 and has the following standing committees separate from the Company: the Audit and Compliance Committee, the Property Committee, the Executive Committee, the Loan Committee, the Asset Liability Committee, the Personnel and Salary Committee, and the Strategic Planning Committee. Such committees perform those duties customarily performed by similar committees at other financial institutions. All directors attended at least 75% of all meetings of the Company's and the Bank's Board and each committee on which they served. The Company's and the Bank's Executive Committees are authorized to act in the absence of the respective Boards of Directors on most matters that require Board approval. The members of this committee for the Company are E. L. Spencer, Jr., Anne M. May, and Emil F. Wright, Jr. The members of this committee for the Bank are E. L. Spencer, Jr., Anne M. May, Emil F. Wright, Jr., and Winifred H. Boyd. Both the Company's and the Bank's committees held 4 meetings in 1997. -39- The Company's Proxy Committee is authorized to act on behalf of Company stockholders when authorized by Proxy. E. L. Spencer,Jr., Winifred H. Boyd and Emil F. Wright, Jr. are the members of this committee, which held 1 meeting in 1997. The Company's and the Bank's Personnel and Salary Committees make recommendations to the respective Boards of Directors with respect to the compensation of executive officers and employees of the Company and the Bank. Anne M. May, Winifred H. Boyd. Emil F. Wright, Jr. and Terry Andrus are the members of these committees for both the Company and the Bank, each of which held 3 meetings in 1997. The Company's and the Bank's Audit and Compliance Committees are composed of at least three Directors that are not serving as officers of the Company or the Bank. These committees are authorized to make an examination of the affairs of the Company and Bank, respectively, and report the results of such examinations to the respective Boards of Directors. These committees are also responsible for reviewing the reports of any independent certified public accountants' examinations and to report to the Boards on such examinations. Anne M. May, Emil F. Wright, Winifred H. Boyd, Terry W. Andrus, C. Wayne Alderman and Edward L. Spencer, III are the members of these committees for both the Company and the Bank, each of which held 12 meetings in 1997. The Company's and the Bank's Strategic Planning Committees evaluate potential acquisitions and the Company's and the Bank's long range goals and oversees the planning process for officer and director strategic planning sessions. The members of this committee for the Company are E. L. Spencer, Jr., Anne M. May, and Linda D. Fucci. The members of this committee for the Bank are E. L. Spencer, Jr., Anne M. May, Linda D. Fucci and Terry Andrus. Both the Company's and Bank's committees held 1 meeting in 1997. The Bank's Property Committee evaluates and oversees building projects and property acquisitions. J. E. Evans, William F. Ham,Jr., Anne M. May and E. L. Spencer, Jr. are members of this committee, which held 2 meetings in 1997. The Bank's Loan Committee is comprised of three or more non-employee Directors and the Bank's CEO. This committee has the authority to examine and approve loans and discounts, to exercise authority regarding loans and discounts, to ensure adherence to the Bank's loan policy. E. L. Spencer, Jr., C. Wayne Alderman, Winifred H. Boyd, J. E. Evans, William F. Ham, Jr. and Edward Lee Spencer, III are members of this committee, which held 12 regular and at least 7 phone meetings in 1997. The Bank's Asset Liability Committee is responsible for managing the Bank's exposure to interest rate risk and its liquidity position and for developing and monitoring strategies to protect performance and safety. Terry Andrus, Curt B. Cope, David E. Housel and Emil F. Wright are members of this committee. Members of the Boards of Directors that are not Company or Bank executives are paid $300 for each Board meeting attended. For his services as such, the Chairman of the Company's and the Bank's Board of Directors is paid $600 for each Board meeting attended. In addition to Board meeting fees, members of the Loan and the Audit and Compliance Committees receive $900 per year for serving on each of these committees, and members of the Personnel and Salary Committee receive $75 per meeting held. Members of the Asset Liability Committee receive $75 per meeting attended. The chairman of the Audit and Compliance Committee receives $1,800 per year, and the Chairman of the Personnel and Salary Committee received $450 during 1997. Total directors' fees and bonuses of $103,875 were paid during 1997. Principal Stockholders EL. Spencer, Jr. and Emil F. Wright, Jr. (whose ownership is described above) are the only stockholders that are known to the Company to be the beneficial owner of more than 5% of the outstanding shares of Common Stock. -40- Compliance with Section 16(a) of the Exchange Act The Company's officers, directors, and 10% stockholders are required to file reports under Section 16(a) of the Exchange Act and no such persons failed to file any such reports, on a timely basis, as disclosed to the Company by such persons. ITEM 10. EXECUTIVE COMPENSATION Summary Compensation of Executive Officers The following table sets forth certain information regarding compensation paid or to be paid by the Company or the Bank during 1997, 1996 and 1995 to E. L. Spencer, Jr., as the Company's Chief Executive Officer and during 1997 to Robert W. Dumas, a Bank Senior Vice President. No other executive officers' aggregate salaries and bonuses in 1997 exceeded $100,000. The Company has not granted any stock options or stock appreciation rights and has not made any payouts under any long-term incentive plan. Summary Compensation Table
Long-Term Compensation Annual Compensation (1) Awards ----------------------- ------------ Securities Underlying Name and Other Annual Options/ All Other Principal Position Year Salary Bonus Compensation SARs Compensation ------------------ ---- ------ ------- ------------ ------------ ------------ E. L. Spencer, Jr., 1997 $176,000 $35,000 $ - $ - $26,389 (2) Chairman, CEO 1996 168,000 30,000 - - 44,319 (2) and Director of the 1995 159,148 21,000 - - 40,630 (2) Company and the Bank Robert W. Dumas 1997 $ 83,738 $18,500 - - 5,319 (4) Senior Vice 1996 (3) President of the Bank 1995 (3)
- ------------------ (1) Excludes certain personal benefits, the total value of which did not exceed the lesser of $50,000 or 10% of the total annual salary and bonus for Mr.Spencer and Mr. Dumas. (2) Includes Company contributions or other allocations to the 401(k) Plan of $8,289, 7,319, and $9,530; and Board of Directors and Board committee fees of $18,100, $17,000, and $11,100, respectively, for the years 1997, 1996, and 1995. Includes premiums paid on split-dollar whole life insurance policy of $20,000 for the years 1996 and 1995. The Company purchased the split-dollar whole life policy in 1990. Through 1996, premiums paid totaled $120,000. In 1997, the Company elected to reduce the base face amount to $208,530 and to use a portion of the cash value to purchase the paid up value of $42,357. Beginning in 1997, dividends earned by the policy will be used to pay annual premiums of $8,777 or to purchase additional insurance. Should the dividends be insufficient to pay the annual premium, the Company will either make a payment of the difference or reduce the face amount of insurance accordingly. Upon the Chairman's death, the Company will receive a return of all premiums paid, and the Chairman's spouse will receive the remaining benefits in trust. If the policy surrendered, the Company will receive the cash surrender value. The policy is reevaluated on an annual basis by the Personnel and Salary Committee. (3) Reporting not required for 1996 and 1995 since the aggregate salary and bonuses did not exceed $100,000. -41- (4) Includes Company contributions or other allocations to the 401(k) Plan of $5,319. ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT See Item 9 "Directors, Executive Officers, Promoters and Control Persons; Compliance with Section 16(a) of the Exchange Act." ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Various Company directors, officers, and their affiliates, including corporations and firms of which they are officers or in which they and/or their families have an ownership interest, are customers of, or had transactions with, the Company and/or the Bank. All such transactions were in the ordinary course of business with the Company and/or the Bank, including borrowings, all of which the Company believes were on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unaffiliated persons and did not involve more than the normal risk of collectibility or present other unfavorable features. The Company and the Bank expect to continue to have such transactions on similar terms with their directors, officers, and their affiliates and associates. The aggregate amount of loans outstanding by the Bank to directors, executive officers, and related parties of the Company or the Bank as of December 31, 1997 was approximately $7,073,000, which represented approximately 27.1% of the Company's consolidated stockholders' equity on that date. None of the directors of the Company serves as an executive officer of, or owns, or during 1997 or 1996 owned, of record or beneficially, in excess of 10% equity interest in any business or professional entity that made during 1997, 1995, or 1995, payments to the Company or the Bank for property or services in excess of $60,000. -42- ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits 3 A. Certificate of Incorporation of Auburn National Bancorporation, Inc. (incorporated by reference from Registrant's Registration Statement on Form SB-2 (File No. 33-86180)). B. Bylaws of Auburn National Bancorporation, Inc. (incorporated by reference from Registrant's Registration Statement on Form SB-2 (File No. 33-86180)). 10. Material Contracts A. Auburn National Bancorporation, Inc. 1994 Long-Term Incentive Plan (incorporated by reference from Registrant's Registration Statement on Form SB-2 (File No. 33-86180)). B. Lease and Equipment Purchase Agreement, dated September 15, 1987 (incorporated by reference from Registrant's Registration Statement on Form SB-2 (File No. 33-86180)). 21. Subsidiaries of Registrant 23. Consent of Accountants 27. Financial Data Schedule (b) Reports on Form 8-K No reports on Form 8-K were filed during the last quarter of the fiscal year ended December 31, 1997 -43- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Consolidated Financial Statements December 31, 1997, 1996, and 1995 With Independent Auditors' Report Thereon -44- Independent Auditors' Report The Board of Directors Auburn National Bancorporation, Inc. and Subsidiary: We have audited the accompanying consolidated balance sheets of Auburn National Bancorporation, Inc. and subsidiary (the Company) as of December 31, 1997 and 1996, and the related consolidated statements of earnings, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1997. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. 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 Auburn National Bancorporation, Inc. and subsidiary as of December 31, 1997 and 1996, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1997, in conformity with generally accepted accounting principles. KPMG Peat Marwick LLP Atlanta, Georgia February 17, 1998 -45- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Consolidated Balance Sheets December 31, 1997 and 1996
Assets 1997 1996 ------ ---- ---- Cash and due from banks (note 2) $ 12,268,412 15,427,715 Federal funds sold 2,615,000 11,745,000 ------------ ----------- Cash and cash equivalents 14,883,412 27,172,715 Interest-earning deposits with other banks 1,722,982 6,354 Investment securities held to maturity (fair value of $14,401,723 and $17,916,468 for December 31, 1997 and 1996, respectively) (note 3) 14,364,262 17,903,079 Investment securities available for sale (note 3) 40,445,856 44,026,979 Loans: Loans, less unearned income of $36,706 and $91,167 at December 31, 1997 and 1996, respectively 185,493,178 161,718,475 Less allowance for loan losses (2,125,104) (2,093,682) ------------ ----------- Loans, net (notes 4 and 7) 183,368,074 159,624,793 Premises and equipment, net (note 5) 3,520,542 3,447,099 Rental property, net 1,807,359 1,899,354 Other assets (note 8) 4,621,187 3,974,984 ------------ ----------- Total assets $264,733,674 258,055,357 ============ ===========
See accompanying notes to consolidated financial statements. -46-
Liabilities and Stockholders' Equity 1997 1996 ------------------------------------ ---- ---- Deposits: Noninterest-bearing $ 32,638,352 28,406,946 Interest-bearing (note 6) 191,339,635 188,320,228 ------------ ----------- Total deposits 223,977,987 216,727,174 Securities sold under agreements to repurchase 1,273,507 4,652,834 Other short-term borrowings (note 7) - 1,203,130 Other borrowed funds (note 7) 11,138,850 10,908,338 Accrued expenses and other liabilities 2,238,989 1,367,149 Employee Stock Ownership Plan debt (note 9) 56,934 113,940 ------------ ----------- Total liabilities 238,686,267 234,972,565 ------------ ----------- Stockholders' equity (notes 12 and 13): Preferred stock of $.01 par value; authorized 200,000 shares; issued shares - none - - Common stock of $.01 par value; authorized 2,500,000 shares; issued 1,319,045 shares at December 31, 1997 and 1996 13,190 13,190 Surplus 3,733,853 3,691,099 Retained earnings 22,396,461 19,942,980 Unrealized gain (loss) on mutual funds and investment securities available for sale, net of taxes 175,436 (146,528) Less: Treasury stock, 10,854 shares and 15,974 shares at December 31, 1997 and 1996, respectively, at cost (214,599) (304,009) Employee Stock Ownership Plan debt (56,934) (113,940) ------------ ----------- Total stockholders' equity 26,047,407 23,082,792 Commitments and contingencies (note 10) ------------ ----------- Total liabilities and stockholders' equity $264,733,674 258,055,357 ============ ===========
-47- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Consolidated Statements of Earnings Years Ended December 31, 1997, 1996, and 1995
1997 1996 1995 ---- ---- ---- Interest income: Interest and fees on loans $15,219,545 13,067,275 12,118,238 ----------- ---------- ---------- Interest and dividends on investment securities held to maturity: Taxable 1,047,042 1,455,910 2,172,396 Tax-exempt 99,505 104,492 135,223 ----------- ---------- ---------- Total interest and dividends on investment securities held to maturity 1,146,547 1,560,402 2,307,619 ----------- ---------- ---------- Interest and dividends on investment securities available for sale: Taxable 2,886,436 2,618,820 1,387,669 Tax-exempt 23,785 15,464 - ----------- ---------- ---------- Total interest and dividends on investment securities available for sale 2,910,221 2,634,284 1,387,669 ----------- ---------- ---------- Interest on federal funds sold 387,773 337,452 345,069 Interest on interest-earning deposits with other banks 81,421 1,550 3,215 ----------- ---------- ---------- Total interest income 19,745,507 17,600,963 16,161,810 ----------- ---------- ---------- Interest expense: Interest on deposits 9,553,095 8,684,432 8,058,254 Interest on federal funds purchased 86 11,040 15,635 Interest on securities sold under agreements to repurchase 127,727 413,650 133,979 Interest on other borrowings 661,592 554,606 649,726 ----------- ----------- ----------- Total interest expense 10,342,500 9,663,728 8,857,594 ----------- ----------- ----------- Net interest income 9,403,007 7,937,235 7,304,216 Provision for loan losses (note 4) 285,245 80,102 - ----------- ----------- ---------- Net interest income after provision for loan losses 9,117,762 7,857,133 7,304,216 ----------- ----------- ---------- Noninterest income: Service charges on deposit accounts 865,473 801,124 734,522 Investment securities gains (losses), net (note 3) (59,876) 26,478 37,237 Other (note 14) 1,369,277 1,580,735 1,522,726 ----------- ----------- ---------- Total noninterest income 2,174,874 2,408,337 2,294,485 ----------- ----------- ---------- Noninterest expense: Salaries and benefits (note 9) 3,142,740 2,940,791 2,986,511 Net occupancy expense 972,108 816,653 723,916 Other (note 14) 2,269,782 2,249,867 2,708,243 ----------- ----------- ----------- Total noninterest expense 6,384,630 6,007,311 6,418,670 ----------- ----------- ----------- Earnings before income taxes 4,908,006 4,258,159 3,180,031 Income tax expense (note 8) 1,827,963 1,504,805 1,088,797 ----------- ----------- ----------- Net earnings $ 3,080,043 2,753,354 2,091,234 =========== =========== =========== Basic income per share $ 2.36 2.11 1.61 =========== =========== =========== Weighted-average shares outstanding 1,305,482 1,304,742 1,301,372 =========== =========== ===========
See accompanying notes to consolidated financial statements. -48- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Consolidated Statements of Stockholders' Equity Years ended December 31, 1997, 1996, and 1995
Common Retrained Shares stock Surplus earnings ------ ------ ------- ---------- Balance at December 31, 1994 1,250,000 $12,500 2,452,449 16,128,345 Issuance of common stock (69,045 shares) 69,045 690 1,233,039 - Net earnings - - - 2,091,234 Cash dividends paid ($0.36 per share) - - - (469,669) Change in net unrealized gain (loss) on mutual funds and investment securities available for sale - - - - Payment of Employee Stock Ownership Plan debt - - - - Purchase of Treasury stock (1,202 shares) - - - - --------- ------- --------- ---------- Balance at December 31, 1995 1,319,045 13,190 3,685,488 17,749,910 Net earnings - - - 2,753,354 Cash dividends paid ($0.43 per share) - - - (560,284) Change in net unrealized gain (loss) on mutual funds and investment securities available for sale - - - - Payment of Employee Stock Ownership Plan debt - - - - Sale of Treasury stock (1,111 shares) - - 5,611 - Purchase of Treasury stock (11,265 shares) - - - - --------- ------- --------- ---------- Balance at December 31, 1996 1,319,045 13,190 3,691,099 19,942,980 Net earnings - - - 3,080,043 Cash dividends paid ($0.48 per share) - - - (626,562) Change in net unrealized gain (loss) on mutual funds and investment securities available for sale - - - - Payment of Employee Stock Ownership Plan debt - - - - Sale of Treasury stock (5,488 shares) - - 42,754 - Purchase of Treasury stock (368 shares) - - - - --------- ------- --------- ---------- Balance at December 31, 1997 1,319,045 $13,190 3,733,853 22,396,461 ========= ======= ========= ==========
Net unrealized gain (loss) on mutual funds Employee and investment stock securities ownership Treasury available for sale plan debt stock Total ------------------ ---------- -------- ----- Balance at December 31, 1994 (348,663) (227,953) (74,994) 17,941,684 Issuance of common stock (69,045 shares) - - - 1,233,729 Net earnings - - - 2,091,234 Cash dividends paid ($0.36 per share) - - - (469,669) Change in net unrealized gain (loss) on mutual funds and investment securities available for sale 439,438 - - 439,438 Payment of Employee Stock Ownership Plan debt - 57,007 - 57,007 Purchase of Treasury stock (1,202 shares) - - (24,761) (24,761) -------- -------- -------- ---------- Balance at December 31, 1995 90,775 (170,946) (99,755) 21,268,662 Net earnings - - - 2,753,354 Cash dividends paid ($0.43 per share) - - - (560,284) Change in net unrealized gain (loss) on mutual funds and investment securities available for sale (237,303) - - (237,303) Payment of Employee Stock Ownership Plan debt - 57,006 - 57,006 Sale of Treasury stock (1,111 shares) - - 16,887 22,498 Purchase of Treasury stock (11,265 shares) - - (221,141) (221,141) -------- -------- -------- ---------- Balance at December 31, 1996 (146,528) (113,940) (304,009) 23,082,792 Net earnings - - - 3,080,043 Cash dividends paid ($0.48 per share) - - - (626,562) Change in net unrealized gain (loss) on mutual funds and investment securities available for sale 321,964 - - 321,964 Payment of Employee Stock Ownership Plan debt - 57,006 - 57,006 Sale of Treasury stock (5,488 shares) - - 98,058 140,812 Purchase of Treasury stock (368 shares) - - (8,648) (8,648) -------- -------- -------- ---------- Balance at December 31, 1997 175,436 (56,934) (214,599) 26,047,407 ======== ======== ======== ==========
See accompanying notes to consolidated financial statements. -49- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Consolidated Statements of Cash Flows Years Ended December 31, 1997, 1996, and 1995
1997 1996 1995 ---- ---- ---- Cash flows from operating activities: Net earnings $ 3,080,043 2,753,354 2,091,234 Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation and amortization 524,338 519,063 435,302 Net amortization (accretion) of investment premiums (discounts) (95,906) 46,623 104,234 Provision for loan losses 285,245 80,102 - Deferred tax (benefit) expense (76,861) 55,231 (27,713) Loans originated for resale (14,185,691) (13,730,694) (10,391,523) Proceeds from sale of loans originated for resale 14,184,327 12,480,598 9,938,200 Gain on sale of credit card loan portfolio - - (125,269) Loss on sale of premises and equipment - - 178,216 Loss on disposal of rental property - - 6,045 Loss (gain) on sale of investment securities 59,876 (26,478) (37,237) Loss (gain) on sale of other real estate 3,687 - (39,993) Increase in interest receivable (261,171) (241,612) (72,926) Writedown on lease with bargain purchase option - - 10,000 (Increase) decrease in other assets (493,632) 332,842 (422,785) Increase (decrease) in interest payable 129,857 (94,652) 239,913 Increase (decrease) in accrued expenses and other liabilities 741,983 17,896 (50,775) ------------ ----------- ----------- Net cash provided by operating activities 3,896,095 2,192,273 1,834,923 ------------ ----------- ----------- Cash flows from investing activities: Proceeds from sales of investment securities available for sale 11,288,950 3,871,059 498,750 Proceeds from maturities/calls/paydowns of investment securities held to maturity 6,908,351 6,668,991 10,923,422 Purchases of investment securities held to maturity (3,325,876) (17,800) (500,000) Proceeds from maturities/calls/paydowns of investment securities available for sale 14,699,633 16,102,270 6,143,749 Purchases of investment securities available for sale (21,907,663) (33,557,621) (24,848,140) Proceeds from sale of credit card loan portfolio - - 1,008,468 Proceeds from sale of student loan portfolio - - 6,863,214 Other net increase in loans (24,092,861) (20,078,467) (7,012,292) Purchases of premises and equipment (504,116) (224,636) (1,896,232) Proceeds from sale of other real estate 62,012 82,500 680,595 Proceeds from sales of premises and equipment - - 375 Additions to rental property (1,670) (35,745) (68,388) Proceeds from lease of other real estate - - 4,584 Net (increase) decrease in interest-bearing deposits with other banks (1,716,628) 756 (408) ------------ ----------- ----------- Net cash used in investing activities $(18,589,868) (27,188,693) (8,202,303) ------------ ----------- -----------
(Continued) -50- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Consolidated Statements of Cash Flows Years Ended December 31, 1997, 1996, and 1995
1997 1996 1995 ---- ---- ---- Cash flows from financing activities: Net increase (decrease) in noninterest-bearing deposits $ 4,231,406 2,915,890 (1,180,109) Net increase in interest-bearing deposits 3,019,407 28,008,756 21,933,364 Net (decrease) increase in securities sold under agreements to repurchase (3,379,327) (2,357,264) 2,389,538 Borrowings from FHLB 251,261 5,000,000 - Repayments to FHLB - (100,000) (11,600,000) Repayments of other borrowed funds (20,749) (20,800) (18,493) Net (decrease) increase in other short-term borrowings (1,203,130) 730,935 (261,076) Proceeds from issuance of common stock - - 1,233,729 Proceeds from sale of treasury stock 140,812 22,498 - Purchase of treasury stock (8,648) (221,141) (24,761) Dividends paid (626,562) (560,284) (469,669) ------------ ---------- ----------- Net cash provided by financing activities 2,404,470 33,418,590 12,002,523 ------------ ---------- ----------- Net (decrease) increase in cash and cash equivalents (12,289,303) 8,422,170 5,635,143 Cash and cash equivalents at beginning of year 27,172,715 18,750,545 13,115,402 ------------ ---------- ----------- Cash and cash equivalents at end of year $ 14,883,412 27,172,715 18,750,545 ============ ========== =========== Supplemental information on cash payments: Interest paid $ 10,212,643 9,758,380 8,617,681 ============ ========== =========== Income taxes paid $ 1,596,005 1,239,739 1,147,122 ============ ========== =========== Supplemental information on noncash transactions: Loans transferred to other real estate $ 129,699 82,500 23,000 ============ ========== =========== Loans to facilitate the sale of other real estate $ 64,000 - 534,186 ============ ========== =========== Change in unrealized gain (loss) on investment securities available for sale, net of change in deferred tax $ 321,964 (237,303) 439,438 ============ ========== ===========
See accompanying notes to consolidated financial statements. -51- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements December 31, 1997, 1996, and 1995 (1) Summary of Significant Accounting Policies ------------------------------------------ Auburn National Bancorporation, Inc. (the Company) provides a full range of banking services to individual and corporate customers in Lee County, Alabama and surrounding counties through its subsidiary, AuburnBank (the Bank). The Company is subject to competition from other financial institutions. The Company is also subject to the regulations of certain federal and state agencies and undergoes periodic examinations by those regulatory authorities. The bank holding company was reincorporated in July 1994 from Alabama to Delaware to take advantage of certain provisions of Delaware law, but made no material change in the business, management, or financial condition of the Company. The accounting policies followed by the Company and its subsidiaries and the methods of applying these principles conform with generally accepted accounting principles and with general practice within the banking industry. Certain principles which significantly affect the determination of financial position, results of operations and cash flows are summarized below. Basis of Financial Statement Presentation ----------------------------------------- The consolidated financial statements have been prepared in conformity with generally accepted accounting principles. In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the allowance for loan losses and the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the allowances for loan losses and foreclosed real estate owned, management obtains independent appraisals for significant properties. The Company's real estate loans are secured by real estate located principally in Lee County, Alabama and surrounding areas. In addition, the foreclosed real estate owned by the Company is located in this same area. Accordingly, the ultimate collectibility of a substantial portion of the Company's loan portfolio and the recovery of real estate owned are susceptible to changes in market conditions in this area. Management believes that the allowances for losses on loans and real estate owned are adequate. While management uses available information to recognize losses on loans and real estate owned, future additions to the allowances may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowances for losses on loans and real estate owned. Such agencies may require the Company to recognize additions to the allowances based on their judgments about information available to them at the time of their examination. (Continued) -52- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Principles of Consolidation --------------------------- The consolidated financial statements include the accounts of the Company and its subsidiary, AuburnBank. During the year ended December 31, 1997, the Company merged its existing subsidiary, ANB Systems, Inc. into the Company. All significant intercompany accounts and transactions have been eliminated. Cash Equivalents ---------------- Cash equivalents include amounts due from banks and federal funds sold. Federal funds are generally sold for one-day periods. Investment Securities --------------------- The Company accounts for investment securities under the provisions of Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities whereby investment securities are classified in one of three portfolios: (i) trading account securities, (ii) held-to-maturity securities, and (iii) securities available for sale. Trading account securities are to be stated at fair value. The Company does not have trading account securities. Investment securities held to maturity are those for which the Company has both the intent and ability to hold until maturity and are stated at cost adjusted for amortization of premiums and accretion of discounts. Investment securities available for sale are stated at fair value with any unrealized gains and losses reported in a separate component of stockholders' equity, net of tax effects, until realized. Accretion of discounts and amortization of premiums are calculated on the effective interest method over the anticipated life of the security, taking into consideration prepayment assumptions. Gains and losses from the sale of investment securities are computed under the specific identification method. A decline in the market value of any available for sale or held to maturity security below cost that is deemed other than temporary results in a charge to earnings and the establishment of a new cost basis for the security. The Company uses interest rate swaps, caps, and floors as part of its overall interest rate risk management. Any gains and losses arising from the use of interest rate contracts are deferred and amortized over the lives of the underlying assets or liabilities as an adjustment to interest income or expense. Interest income or expense related to interest rate swaps, caps, and floors is recorded over the life of the agreement as an adjustment to interest income or expense. Interest rates on variable rate derivative products held by the Bank are derived from the Telerate USD-LIBOR rate. Loans ----- Loans are stated at principal amounts outstanding, net of unearned income. Interest on fixed rate precomputed installment loans is credited to income based on a method which approximates the level-yield method. Interest on all other loans is credited to income on the simple interest method. (Continued) -53- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements It is the general policy of the Bank to discontinue the accrual of interest when principal or interest payments become more than ninety days' delinquent. When a loan is placed on a nonaccrual basis, any interest previously accrued but not collected is reversed against current income unless the collateral for the loan is sufficient to cover the accrued interest. Income on such loans is then recognized only to the extent that cash is received and where the future collection of principal is probable. Interest accruals are recorded on such loans only when they are brought fully current with respect to interest and principal and when, in the judgment of management, the loans are estimated to be fully collectible as to both principal and interest. The Company adopted the provisions of SFAS 114, Accounting by Creditors for Impairment of a Loan, as amended by SFAS 118, Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures, on January 1, 1995. Under the provisions of SFAS 114 and 118, management considers a loan to be impaired when it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. When a loan is considered impaired, the amount of impairment is measured based on the present value of expected future cash flows discounted at the note's effective interest rate. If the loan is collateral-dependent, the fair value of the collateral is used to determine the amount of impairment. Impairment losses are included in the allowance for loan losses through the provision for loan losses. Impaired loans are charged to the allowance when such loans are deemed to be uncollectible. Subsequent recoveries are added to the allowance. When a loan is considered impaired, cash receipts are applied under the contractual terms of the loan agreement, first to principal and then to interest income. Once the recorded principal balance has been reduced to zero, future cash receipts are applied to interest income, to the extent that any interest has not been recognized. Any further cash receipts are recorded as recoveries of any amount previously charged off. A loan is also considered impaired if its terms are modified in a troubled debt restructuring after January 1, 1995. For those accruing impaired loans, cash receipts are typically applied to principal and interest receivable in accordance with the terms of the restructured loan agreement. Interest income is recognized on these loans using the accrual method of accounting. Allowance for Loan Losses ------------------------- The amount of provision for loan losses charged to earnings is based on actual loss experience and management's evaluation of the loan portfolio under current economic conditions. In addition, loans are examined for credit quality, documentation, and financial information annually by a qualified non-employee loan review examiner. Such provisions, adjusted for loan charge-offs and recoveries, comprise the allowance for loan losses. Loans are charged against the allowance when management determines such loans to be uncollectible. Subsequent recoveries are credited to the allowance. (Continued) -54- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Premises and Equipment ---------------------- Premises and equipment are stated at cost, less accumulated depreciation. Depreciation is computed on both the double-declining balance and straight-line methods for buildings and principally on a straight-line method for furniture, fixtures, and equipment over the estimated useful lives of the assets, which range from three to 39 years. Rental Property --------------- Rental property consists of land; buildings; and furniture, fixtures, and equipment which are rented to the Bank and the general public. Rental property is stated at cost less accumulated depreciation. Depreciation is computed on both the double-declining balance and straight-line methods for buildings and principally on a straight-line method for furniture, fixtures, and equipment over the estimated useful lives of the assets. Other Real Estate ----------------- Real estate acquired through foreclosure or in lieu of foreclosure is carried at the lower of cost or fair value, adjusted for estimated selling costs. Any write-down at the time of foreclosure is charged to the allowance for loan losses. Subsequent declines in fair value below acquisition cost and gains or losses on the sale of these properties are credited or charged to earnings. Income Taxes ------------ Income taxes are accounted for under the asset and liability method, whereby deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company files its federal income tax returns on a consolidated basis. Earnings per Share ------------------ Basic income per share is computed on the weighted-average number of shares outstanding in accordance with SFAS No. 128, Earnings Per Share. The Company reserved 75,000 shares of common stock in May 1994 for issuance under stock option plans; however, no options have been granted as of December 31, 1997, thus there are no potential common shares that would result in diluted earnings per share. (Continued) -55- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Accounting Pronouncements ------------------------- In June 1997, the Financial Accounting Standards Board (FASB) issued SFAS No. 130, Reporting Comprehensive Income. This statement establishes standards for reporting and displaying comprehensive income and its components in a full set of general purpose financial statements. SFAS No. 130 requires all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed in equal prominence with the other financial statements. The term "comprehensive income" is used in the statement to describe the total of all components of comprehensive income including net income. "Other comprehensive income" refers to revenues, expenses, gains, and losses that are included in comprehensive income but excluded from earnings under current accounting standards. Currently, "other comprehensive income" for the Company consists of items recorded directly in equity under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. SFAS No. 130 is effective for financial statements for both interim and annual periods beginning after December 15, 1997. In June 1997, the FASB issued SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information. SFAS No. 131 establishes new standards for the disclosures made by public business enterprises to report information about operating segments in annual financial statements and requires those enterprises to report selected information about operating segments in interim financial reports issued to shareholders. It also establishes standards for related disclosures about products and services, geographic areas, and major customers. SFAS No. 131 is effective for financial statements for years beginning after December 15, 1997. The Company does not have any segments other than banking that are considered material. Reclassifications ----------------- Certain of the 1996 and 1995 amounts have been reclassified to conform to the 1997 presentation. (2) Cash and Due from Banks ----------------------- The Bank is required to maintain certain average cash reserve balances in accordance with Federal Reserve Board requirements. The amounts of those required balances as of December 31, 1997 and 1996 were approximately $1,243,000 and $1,117,000, respectively. (Continued) -56- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements (3) Investment Securities --------------------- The amortized cost and approximate fair value of investment securities at December 31, 1997, were as follows:
Gross Gross Approximate Amortized unrealized unrealized fair cost gains losses value ----------- ---------- ---------- ----------- Investment securities held to maturity: U.S. government agencies excluding mortgage-backed securities $ 3,216,614 - 71,264 3,145,350 State and political subdivisions 1,478,866 41,216 1,520,082 Mortgage-backed securities 9,469,748 67,907 - 9,537,655 Collateralized mortgage obligations 199,034 - 398 198,636 ----------- ------- ------ ---------- $14,364,262 109,123 71,662 14,401,723 =========== ======= ====== ==========
Gross Gross Approximate Amortized unrealized unrealized fair cost gains losses value ----------- ---------- ---------- ----------- Investment securities available for sale: U.S. government agencies excluding mortgage-backed securities $12,056,107 41,107 - 12,097,214 Mortgage-backed securities 7,957,596 32,576 - 7,990,172 Collateralized mortgage obligations 19,659,759 234,443 33,519 19,860,683 State and political subdivisions 480,000 17,787 - 497,787 ----------- ------- ------ ---------- $40,153,462 325,913 33,519 40,445,856 =========== ======= ====== ==========
(Continued) -57- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements The amortized cost and approximate fair value of investment securities at December 31, 1997, by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without prepayment penalties.
Approximate Amortized fair cost value ------------ ----------- Investment securities held to maturity: Due in one year or less $ - - Due after one year through five years 795,578 552,925 Due after five years through ten years 410,000 684,940 Due after ten years 3,489,902 3,427,567 ----------- ---------- Subtotal 4,695,480 4,665,432 Mortgage-backed securities 9,469,748 9,537,655 Collateralized mortgage obligations 199,034 198,636 ----------- ---------- Total $14,364,262 14,401,723 =========== ==========
Approximate Amortized fair cost value ----------- ----------- Investment securities available for sale: Due in one year or less $ - - Due after one year through five years 9,986,600 10,033,814 Due after five years through ten years 2,549,507 2,561,187 Due after ten years - - ----------- ---------- Subtotal 12,536,107 12,595,001 Mortgage-backed securities 7,957,596 7,990,172 Collateralized mortgage obligations 19,659,759 19,860,683 ----------- ---------- Total $40,153,462 40,445,856 =========== ==========
(Continued) -58- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements The amortized cost and approximate fair value of investment securities at December 31, 1996, were as follows:
Gross Gross Approximate Amortized unrealized unrealized fair cost gains losses value ----------- ---------- ---------- ----------- Investment securities held to maturity: U.S. government agencies excluding mortgage-backed securities $ 2,027,883 16,177 - 2,044,060 State and political subdivisions 1,469,847 50,776 - 1,520,623 Mortgage-backed securities 13,662,962 86,246 141,014 13,608,194 Collateralized mortgage obligations 535,093 219 - 535,312 Corporate bonds 207,294 985 - 208,279 ----------- ------- ------- ---------- $17,903,079 154,403 141,014 17,916,468 =========== ======= ======= ==========
Gross Gross Approximate Amortized unrealized unrealized fair cost gains losses value ----------- ---------- ---------- ----------- Investment securities available for sale: U.S. government agencies excluding mortgage-backed securities $18,013,005 20,805 160,980 17,872,830 Mortgage-backed securities 364,647 - 1,556 363,091 Collateralized mortgage obligations 24,906,147 104,037 155,224 24,854,960 Mutual funds 478,211 - 31,708 446,503 State and political subdivisions 480,000 9,595 - 489,595 ----------- ------- ------- ---------- $44,242,010 134,437 349,468 44,026,979 =========== ======= ======= ==========
There were no sales of investment securities held to maturity during any of the years in the three-year period ended December 31, 1997. Proceeds from sales of investment securities available for sale were $11,288,950, $3,871,059, and $498,750 for the years ended December 31, 1997, 1996, and 1995, respectively. Gross losses of $59,876 were realized on sales of investment securities for the year ended December 31, 1997. Gross gains of $26,478 and $37,237 were realized on sales for the years ended December 31, 1996 and 1995, respectively. Investment securities with an aggregate carrying value of $50,086,378 and $52,721,095 at December 31, 1997 and 1996, respectively, were pledged to secure public and trust deposits as required by law and for other purposes. The Company maintains a diversified investment portfolio, including held-to-maturity and available-for-sale securities, with limited concentration in any given region, industry, or economic characteristic. Investments in municipal governments are made throughout the U.S. with no concentration in any given state. Included in other assets is stock in the Federal Home Loan Bank (FHLB) of Atlanta. FHLB stock is carried at cost, has no contractual maturity, has no quoted fair value, and no ready market exists; therefore, the fair value of such stock is assumed to approximate cost. The investment in the stock is required of every member of the FHLB system. The investment in the stock was $899,600 and $859,200 at December 31, 1997 and 1996, respectively. (Continued) -59- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements (4) Loans ----- At December 31, 1997 and 1996, the composition of the loan portfolio was as follows:
1997 1996 ---- ---- Commercial, financial, and agricultural $ 46,328,523 39,212,438 Real estate - construction: Commercial 3,172,382 3,572,030 Residential 3,582,534 3,068,125 Real estate - mortgage: Commercial 51,713,918 42,827,126 Residential 62,112,576 58,529,443 Consumer installment 18,619,951 14,600,480 ------------ ----------- Total loans 185,529,884 161,809,642 Less: Unearned income (36,706) (91,167) Allowance for loan losses (2,125,104) (2,093,682) ------------ ----------- Loans, net $183,368,074 159,624,793 ============ ===========
During 1997 and 1996, certain executive officers and directors of the Company and the Bank, including companies with which they are associated, were loan customers of the Bank. Total loans outstanding to these persons at December 31, 1997 and 1996 amounted to $7,072,874 and $8,260,845, respectively. The change from 1996 to 1997 reflects payments of $7,613,296 and advances of $6,425,325. In management's opinion, these loans were made in the ordinary course of business at normal credit terms, including interest rate and collateral requirements, and do not represent more than normal credit risk. A summary of the transactions in the allowance for loan losses for the years ended December 31, 1997, 1996, and 1995 is as follows:
1997 1996 1995 ---- ---- ---- Balance at beginning of year $2,093,682 2,012,133 2,099,599 Provision charged to earnings 285,245 80,102 - Loan recoveries 66,224 174,050 119,521 Loans charged off (320,047) (172,603) (156,419) Reversal of credit card allowance - - (50,568) ---------- --------- --------- Balance at end of year $2,125,104 2,093,682 2,012,133 ========== ========= =========
At December 31, 1997 and 1996, the Company had $578,130 and $620,438, respectively, of impaired loans. Impaired loans at December 31, 1997 include loans of $71,983 that had a related valuation allowance of $49,450. Impaired loans at December 31, 1996 include loans of $84,248 that had a related valuation allowance of $64,205. (Continued) -60- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements For the years ended December 31, 1997, 1996, and 1995, the average recorded investment in the impaired loans was $593,750, $655,907, and $1,521,355, respectively. The related amount of interest income recognized during 1997, 1996, and 1995 amounted to $54,459, $54,258, and $87,525, respectively. Nonperforming loans, consisting of loans on nonaccrual status and accruing loans past due greater than 90 days, amounted to $276,000 and $219,000 at December 31, 1997 and 1996, respectively. There were no nonaccrual loans at December 31, 1997. Nonaccrual loans were $73,000 at December 31, 1996. The impact of nonaccrual loans on interest income for the years ended December 31, 1997, 1996, and 1995 was not significant. The Company's loan servicing portfolio consisted of 832 loans with an outstanding balance of $63,565,693, 730 loans with an outstanding balance of $53,774,538, and 691 loans with an outstanding balance of $50,630,296, as of December 31, 1997, 1996, and 1995, respectively. (5) Premises and Equipment ---------------------- Premises and equipment at December 31, 1997 and 1996 are summarized as follows:
1997 1996 ---- ---- Land $ 407,747 407,747 Buildings 2,713,251 2,713,251 Furniture, fixtures, and equipment 3,961,765 3,549,955 ----------- ---------- Total premises and equipment 7,082,763 6,670,953 Less accumulated depreciation (3,562,221) (3,223,854) ----------- ---------- $ 3,520,542 3,447,099 =========== ==========
(6) Interest-Bearing Deposits ------------------------- At December 31, 1997 and 1996, the composition of interest-bearing deposits was as follows:
1997 1996 ---- ---- NOW, Super NOW, and Automatic Transfer Service $ 22,422,519 20,089,382 Money market 50,677,710 42,656,180 Savings 10,217,311 10,257,485 Certificates of deposit under $100,000 71,136,109 74,476,181 Certificates of deposit and other time deposits of $100,000 and over 36,885,986 40,841,000 ------------ ----------- $191,339,635 188,320,228 ============ ===========
(Continued) -61- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Interest expense on certificates of deposit and other time deposits of $100,000 and over amounted to approximately $1,972,000, $1,592,000, and $1,516,000 in 1997, 1996, and 1995, respectively. (7) Other Short-term Borrowings and Other Borrowed Funds ---------------------------------------------------- Other short-term borrowings and other borrowed funds at December 31, 1997 and 1996 consisted of the following:
Maturity date Interest rate 1997 1996 ------------- ------------- ---- ---- Short-term borrowings: Treasury tax and loan (note option) Demand 5.20% $ - 1,203,130 =========== ========== Other borrowed funds: Federal Home Loan Bank borrowings February 2017 6.64 351,261 - March 2003 5.79 525,000 625,000 January 2001 5.87 5,000,000 5,000,000 May 1998 5.63 5,000,000 5,000,000 Small business administration debt June 2004 3.00 27,355 32,180 June 2004 5.08 235,234 251,158 ----------- ---------- $11,138,850 10,908,338 =========== ==========
The Bank has a $25,000,000 available line of credit from the FHLB which is reviewed annually by the FHLB. The above advances are against this line of credit. Interest expense on FHLB advances was $630,494, $498,705, and $577,847 in 1997, 1996, and 1995, respectively. The interest rate on the Federal Home Loan Bank borrowing that matures in May 1998 is a variable rate. Other borrowings have fixed interest rates. The advances and line of credit are collateralized by the Bank's investment in the stock of the FHLB and all first mortgage residential loans, which are sufficient to draw the full line of credit. (8) Income Tax Expense ------------------ Total income tax expense (benefit) for the years ended December 31, 1997, 1996, and 1995 was allocated as follows:
1997 1996 1995 ---- ---- ---- Income from continuing operations $1,827,963 1,504,805 1,088,797 ========== ========= ========= Stockholders' equity, for unrealized gains (losses) on investment securities available-for-sale $ 185,461 (131,858) 235,421 ========== ========= =========
(Continued) -62- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements For the years ended December 31, 1997, 1996, and 1995 the components of income tax expense were as follows:
1997 1996 1995 ---- ---- ---- Current income tax expense: Federal $1,733,135 1,314,952 1,045,510 State 171,689 134,622 71,000 ---------- --------- --------- Total 1,904,824 1,449,574 1,116,510 ---------- --------- --------- Deferred income tax expense (benefit): Federal (68,833) 45,912 (19,004) State (8,028) 9,319 (8,709) ---------- --------- --------- Total (76,861) 55,231 (27,713) ---------- --------- --------- $1,827,963 1,504,805 1,088,797 ========== ========= =========
Total income tax expense differed from the amount computed by applying the statutory federal income tax rate of 34 percent to pretax earnings as follows:
1997 1996 1995 ---- ---- ---- Income tax expense at statutory rate $1,668,722 1,447,774 1,081,211 Increase (decrease) resulting from: Tax-exempt interest (49,177) (59,513) (69,680) State income tax expense net of federal income tax benefit 108,016 95,001 41,112 Increase (decrease) in valuation allowance for deferred tax assets 7,956 - (12,640) Other 92,446 21,543 48,794 ---------- --------- --------- $1,827,963 1,504,805 1,088,797 ========== ========= =========
(Continued) -63- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1997 and 1996 are presented below:
1997 1996 ---- ---- Deferred tax assets: Loans, principally due to allowance for loan losses $658,913 619,899 Principal amortization for leases being depreciated for tax 77,487 67,236 Capital loss carryforward 7,956 - Unrealized loss on investment securities available for sale - 68,503 Other 17,313 17,840 -------- ------- Total gross deferred tax assets before valuation allowance 761,669 773,478 Valuation allowance (7,956) - -------- ------- Total deferred tax assets 753,713 773,478 -------- ------- Deferred tax liabilities: Accrued dividend income - 27,500 Premises and equipment, principally due to differences in depreciation 280,058 294,085 Investments, principally due to discount accretion 109,337 96,403 FHLB stock dividend 21,068 21,068 Prepaid expenses 69,952 61,112 Loans, principally due to differences in deferred loan fees 42,681 30,257 Unrealized gain on investment securities available for sale 116,958 - Other 4,127 24,921 -------- ------- Total deferred tax liabilities 644,181 555,346 -------- ------- Net deferred tax asset $109,532 218,132 ======== =======
In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based upon the level of historical taxable income and projection for future taxable income over the periods which the temporary differences resulting in the deferred tax assets are deductible, management believes it is more likely than not that the Company will realize the benefits of these deductible differences, giving consideration to the valuation allowance recorded. (Continued) -64- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements (9) Retirement Plans ---------------- The Bank sponsored two retirement plans, the Auburn National Bancorporation, Inc. Employee Incentive Plan and the Auburn National Bancorporation, Inc. Employee Stock Ownership Plan (ESOP). In January 1994, the two plans were merged into one plan, Auburn National Bancorporation, Inc. 401(k) and Employee Stock Ownership Plan. The plan covers substantially all employees. Participants become 20 percent vested in their accounts after two years of service and 100 percent vested after six years of service. Contributions to the plan are determined by the board of directors. Company contributions to the plan amounted to $125,870, $121,076, and $122,862 in 1997, 1996, and 1995, respectively. During 1989, the ESOP borrowed $570,062 from an unrelated financial institution to purchase 6,306 shares of common stock of the Company. The remaining unallocated common stock acquired by the ESOP collateralizes the loan. The note is payable in annual principal installments of $57,006 and quarterly interest payments until December 31, 1998. The note bears interest at 82 percent of the lender's prime rate and is guaranteed by the Company. (10) Off-Balance-Sheet Risk 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, and standby letters of credit and financial guarantees. Such instruments involve elements of credit risk in excess of the amounts recognized in the consolidated financial statements. The Company's exposure to credit loss in the event of nonperformance by the other party to these financial instruments is represented by the contractual amount of these instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. The financial instruments whose contract amounts represent credit risk as of December 31, 1997 are as follows: Commitments to extend credit $3,750,000 Standby letters of credit 2,205,000
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. Standby letters of credit are commitments issued by the Company to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. All guarantees expire within one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company holds various assets as collateral supporting those commitments for which collateral is deemed necessary. (Continued) -65- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements The Bank enters into interest rate protection contracts to help manage the Bank's interest rate exposure. These contracts include interest rate swaps, caps, and floors. Interest rate swap transactions generally involve the exchange of fixed and floating rate interest payment obligations without the exchange of the underlying principal amounts. Entering into interest rate swap agreements involves not only the risk of dealing with counterparties and their ability to meet the terms of the contracts but also the risk associated with the movements in interest rates. Notional principal amounts often are used to express the volume of these transactions; however, the amounts potentially subject to credit risk are much smaller. The notional principal amount related to these contracts was $35,000,000 at December 31, 1997. The Company estimates its current credit exposure on the purchased swaps, caps, and floors to be approximately $117,000 at December 31, 1997. The current credit exposure of derivatives is represented by the excess of the fair value of contracts over the respective carrying value for those contracts with a net positive fair value at the reporting date. Risks associated with interest rate contracts include interest rate risk and creditworthiness of the counterparty. These risks are considered in the Bank's overall asset liability management program. The Bank utilizes periodic financial statements issued by the counterparty to analyze the creditworthiness of the counterparty prior to entering into a contract and to monitor changes in the financial condition of the counterparty throughout the term of the contract. Although none of the interest rate protection agreements are traded on any organized exchange, the Company believes that an active secondary market exists for such contracts. In February 1995, the Bank entered into two interest rate floors with respect to $20,000,000 in variable rate loans. These agreements allow the Bank to receive interest payments based on three-month LIBOR should the floor rate fall below 5.00% and 6.00%, respectively. The agreements required the Bank to pay a fixed amount of $26,000 and $76,500, respectively, upon consummation of the agreements. The purpose of these contracts was to reduce interest rate exposure to variable assets in a low interest rate environment. In June 1996, the Bank entered into an interest rate swap with respect to $5,000,000 in two-year six percent certificates of deposit. This agreement allows the Bank to receive fixed interest payments at 6.37% per annum and to pay a variable rate equal to three months LIBOR. The purpose of this contract was to reduce the Bank's effective cost of funds to better match the costs of funding variable rate loans. The Bank has secured this interest rate swap with approximately $500,000 in principal amount of mortgage-backed securities. In May 1997, the Bank entered into an interest rate swap with respect to $10,000,000 in two-year 6.25% certificates of deposit. This agreement allows the Bank to receive fixed interest payments at 6.42% per annum and to pay a variable rate equal to three-month LIBOR. The purpose of this contract was to reduce the Bank's effective cost of funds to better match the costs of funding variable rate loans. (Continued) -66- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements The following table summarizes information on interest rate swaps and floors at December 31, 1997: INTEREST RATE PROTECTION CONTRACTS
Weighted- Thousands Weighted- average ----------------------------------- average rate remaining Notional Carrying Estimated ----------------- life amount value fair value Received Paid (years) -------- -------- ---------- -------- ---- --------- December 31, 1997 Swaps: Receive fixed: One year or less $ 5,000 - 8 6.37% 5.91 0.50 Over one year through two years 10,000 - 68 6.42% 5.88 1.25 Floors: Purchased: Over two years through five years 10,000 11 11 - - 2.25 Over two years through five years 10,000 32 73 6.00% 5.81 2.25 ------- -- --- $35,000 43 160 ======= == ===
All interest rate protection contracts reprice quarterly. The weighted-average rates received/paid are shown only for swaps and floors for which net interest amounts were receivable or payable at the end of each period. For floors when the index rate has not been reached, no rate is shown. Interest rates on variable rate derivative products held by the Bank are derived from the USD-LIBOR rate. The Company and the Bank are involved in various legal proceedings, arising in connection with their business. In the opinion of management, based upon consultation with legal counsel, the ultimate resolution of these proceedings will not have a material adverse effect upon the financial position or results of operations of the Company. (Continued) -67- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements (11) Fair Value of Financial Instruments ----------------------------------- Statement of Financial Accounting Standards No. 107 (SFAS 107), Disclosures about Fair Value of Financial Instruments, requires disclosure of fair value information about financial instruments, whether or not recognized on the face of the balance sheet, for which it is practicable to estimate that value. The assumptions used in the estimation of the fair value of the Company's financial instruments are explained below. Where quoted market prices are not available, fair values are based on estimates using discounted cash flow and other valuation techniques. Discounted cash flows can be significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. The following fair value estimates cannot be substantiated by comparison to independent markets and should not be considered representative of the liquidation value of the Company's financial instruments, but rather a good-faith estimate of the fair value of financial instruments held by the Company. SFAS 107 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. The following methods and assumptions were used by the Company in estimating the fair value of its financial instruments: (a) Cash, Cash Equivalents, and Interest-Bearing Deposits with ---------------------------------------------------------- Other Banks ----------- Fair value equals the carrying value of such assets. (b) Investment Securities --------------------- The fair value of investment securities is based on quote market prices. (c) Loans ----- The fair value of loans is calculated using discounted cash flows and excludes lease financing arrangements. The discount rates used to determine the present value of the loan portfolio are estimated market discount rates that reflect the credit and interest rate risk inherent in the loan portfolio. The estimated maturities are based on the Company's historical experience with repayments adjusted to estimate the effect of current market conditions. The carrying amount of accrued interest approximates its fair value. (d) Off-Balance-Sheet Instruments ----------------------------- Fair value of interest rate swaps, financial futures, and interest rate caps and floors is based on quoted market prices. These values represent the estimated amount the Company would receive or pay to terminate the contracts or agreements, taking into account current interest rates and, when appropriate, the creditworthiness of the counterparties. (Continued) -68- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements (e) Deposits -------- As required by SFAS 107, the fair value of deposits with no stated maturity, such as noninterest-bearing demand deposits, NOW accounts, savings, and money market deposit accounts, is equal to the carrying value. Certificates of deposit have been valued using discounted cash flows. The discount rates used are based on estimated market rates for deposits of similar remaining maturities. (f) Short-term Borrowings --------------------- The fair value of federal funds purchased, securities sold under agreements to repurchase, and other short-term borrowings approximates their carrying value. (g) Long-term Borrowings -------------------- The fair value of the Company's fixed rate long-term debt is estimated using discounted cash flows based on estimated current market rates for similar types of borrowing arrangements. The carrying amount of the Company's variable rate long-term debt approximates its fair value. The carrying value and estimated fair value of the Company's financial instruments at December 31, 1997 and 1996 are as follows (in thousands):
1997 1996 ---------------------- ---------------------- Estimated Estimated Carrying fair Carrying fair amount value amount value -------- --------- -------- --------- Financial assets: Cash and short-term investments $ 16,606 16,606 27,179 27,179 ======== ======= ======= ======= Investment securities $ 54,810 54,848 61,930 61,970 ======== ======= ======= ======= Loans, net of allowance for loan losses $183,368 186,582 159,625 163,560 ======== ======= ======= ======= Financial liabilities: Deposits $223,978 223,387 216,727 217,673 ======== ======= ======= ======= Short-term borrowings $ 1,274 1,274 5,856 5,856 ======== ======= ======= ======= Long-term borrowings $ 11,196 10,999 11,022 11,964 ======== ======= ======= ======= Off-balance sheet financial instruments: Interest rate contracts: Swaps $ - 76 - 27 Caps and floors 43 84 92 178 -------- ------- ------- ------ $ 43 160 92 205 -------- ------- ------- ------
(Continued) -69- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements (12) Common Stock and 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 consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and Bank must meet specific capital guidelines that involve quantitative measures of the Company's and Bank's assets, liabilities, and certain off-balance- sheet items as calculated under regulatory accounting practices. The Company's and Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 1997, that the Company and Bank meet all capital adequacy requirements to which they are subject. As of December 31, 1997, based on its most recent notification the Bank is categorized 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 I risk-based, and Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the Bank's capital category. (Continued) -70- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements The actual capital amounts and ratios and the aforementioned minimums as of December 31, 1997 and 1996 are as follows (dollars in thousands):
Minimum Minimum to be well for capital capitalized under adequacy prompt corrective Actual purposes action provisions ---------------- --------------- ----------------- Amount Ratio Amount Ratio Amount Ratio -------- ----- -------- ----- -------- ----- Auburn National Bancorporation, Inc. As of December 31, 1997 Total capital (to risk-weighted assets) $27,997 15.22% $14,717 8% N/A N/A Tier I risk-based capital (to risk-weighted assets) 25,872 14.06 7,359 4 N/A N/A Tier I leverage capital (to average assets) 25,872 9.80 10,561 4 N/A N/A As of December 31, 1996 Total capital (to risk-weighted assets) $25,248 15.39% $13,124 8% N/A N/A Tier I risk-based capital (to risk-weighted assets) 23,198 14.14 6,562 4 N/A N/A Tier I leverage capital (to average assets) 23,198 8.99 10,322 4 N/A N/A AuburnBank As of December 31, 1997 Total capital (to risk-weighted assets) $25,229 13.89% $14,529 8% $ 18,161 10% Tier I risk-based capital (to risk-weighted assets) 23,104 12.72 7,264 4 10,897 6 Tier I leverage capital (to average assets) 23,104 8.84 10,453 4 13,066 5 As of December 31, 1996 Total capital (to risk-weighted assets) $22,662 14.03% $12,921 8% $ 16,151 10% Tier I risk-based capital (to risk-weighted assets) 20,643 12.78 6,460 4 9,691 6 Tier I leverage capital (to average assets) 20,643 8.09 10,203 4 12,753 5
(13) Dividends from Subsidiary ------------------------- Dividends paid by the Bank are a principal source of funds available to the Company for payment of dividends to its stockholders and for other needs. Applicable federal and state statutes and regulations impose restrictions on the amounts of dividends that may be declared by the subsidiary bank. In addition to the formal statutes and regulations, regulatory authorities also consider the adequacy of the Bank's total capital in relation to its assets, deposits, and other such items. Capital adequacy considerations could further limit the availability of dividends from the Bank. At December 31, 1997, the Bank could have declared dividends of approximately $1,214,394 without prior approval of regulatory authorities. As a result of this limitation, approximately $22,065,755 of the Company's investment in the Bank was restricted from transfer in the form of dividends. (14) Supplemental Information ------------------------ Components of other noninterest income exceeding one percent of revenues for any of the years in the three-year period ended December 31, 1997, included merchant discounts and fees on MasterCard and Visa sales of $310,416, $293,004, and $241,254 in 1997, 1996, and 1995, respectively; and, gain on sale of mortgage loans of $76,747, $68,433, and $76,559 in 1997, 1996, and 1995, respectively. Also included were servicing fees of $166,538, $163,820, and $169,376 in 1997, 1996, and 1995, respectively; and, rental income of $138,618, $161,510, and $175,056 in 1997, 1996, and 1995, respectively. (Continued) -71- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Components of other noninterest expense exceeding one percent of revenues for any of the years in the three-year period ended December 31, 1997, included FDIC insurance expense of $26,315, $2,000, and $191,942 in 1997, 1996, and 1995, respectively; and, professional fees of $155,635, $225,036, and $214,248 in 1997, 1996, and 1995, respectively. Also included were marketing expenses of $221,504, $191,553, and $188,040 in 1997, 1996, and 1995, respectively; rental property expenses of $239,192, $236,206, and $211,123 in 1997, 1996, and 1995, respectively; and, MasterCard and Visa processing fees of $254,863, $231,432, and $216,891 in 1997, 1996, and 1995, respectively. (15) Parent Company Financial Information The condensed financial information for Auburn National Bancorporation, Inc. (Parent Company Only) is presented as follows: Parent Company Only Condensed Balance Sheets December 31, 1997 and 1996
Assets 1997 1996 ------ ---- ---- Cash and due from banks $ 474,460 43,300 Investment securities 693,221 747,775 Investment in subsidiaries: Bank 23,280,149 20,528,398 Nonbank - 1,423 ----------- ---------- Total investment in subsidiaries 23,280,149 20,529,821 Premises and equipment, net 68,194 55,096 Rental property 1,807,359 1,899,354 Other assets 154,238 296,675 ----------- ---------- Total assets $26,477,621 23,572,021 =========== ========== Liabilities and Stockholders' Equity ------------------------------------ Other borrowed funds $ 262,589 283,338 Accrued expenses and other liabilities 110,691 91,951 Employee Stock Ownership Plan debt 56,934 113,940 ----------- ---------- Total liabilities 430,214 489,229 ----------- ---------- Stockholders' equity: Preferred stock of $.01 par value; authorized 200,000 shares; issued shares - none - - Common stock of $.01 par value; authorized 2,500,000 shares; issued 1,319,045 shares at December 31, 1997 and 1996 13,190 13,190 Surplus 3,733,853 3,691,099 Retained earnings 22,396,461 19,942,980 Unrealized gain (loss) on mutual funds and investment securities available for sale, net of taxes 175,436 (146,528) Less: Employee Stock Ownership Plan debt (56,934) (113,940) Treasury stock, 10,854 shares and 15,974 shares in 1997 and 1996, respectively, at cost (214,599) (304,009) ----------- ---------- Total stockholders' equity 26,047,407 23,082,792 ----------- ---------- Total liabilities and stockholders' equity $26,477,621 23,572,021 =========== ----------
(Continued) -72- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Parent Company Only Condensed Statements of Earnings Years Ended December 31, 1997, 1996, and 1995
1997 1996 1995 ---- ---- ---- Income: Cash dividends from bank subsidiary $ 697,000 265,000 - Property dividend from bank subsidiary - - 234,692 Interest on interest-earning deposits - 7,306 26,854 Interest on investment securities held to maturity: Taxable 3,822 3,453 4,442 Tax-exempt 37,765 43,258 22,021 ---------- --------- --------- Total interest on investment securities held to maturity 41,587 46,711 26,463 ---------- --------- --------- Other income 612,970 819,286 685,429 ---------- --------- --------- Total income 1,351,557 1,138,303 973,438 ---------- --------- --------- Expense: Interest on borrowed funds 22,450 26,197 28,863 Net occupancy expense 24,218 25,368 49,814 Salaries and benefits 357,186 322,750 321,051 Other 331,948 369,930 367,015 ---------- --------- --------- Total expense 735,802 744,245 766,743 ---------- --------- --------- Earnings before income tax expense (benefit) and equity in undistributed earnings (loss) of subsidiaries 615,755 394,058 206,695 Applicable income tax expense (benefit) (35,924) 10,917 (30,344) ---------- --------- --------- Earnings before equity in undistributed earnings (loss) of subsidiaries 651,679 383,141 237,039 Equity in undistributed earnings (loss) of subsidiaries: Bank 2,429,787 2,370,686 1,854,789 Other (1,423) (473) (594) ---------- --------- --------- Net earnings $3,080,043 2,753,354 2,091,234 ========== ========= =========
(Continued) -73- AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Parent Company Only Condensed Statements of Cash Flows Years Ended December 31, 1997, 1996, and 1995
1997 1996 1995 ---- ---- ---- Cash flows from operating activities: Net earnings $ 3,080,043 2,753,354 2,091,234 Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation and amortization 116,919 124,980 136,977 Amortization of premium on investment securities held to maturity - 391 1,287 Property dividend from bank subsidiary - - (234,692) Net undistributed earnings of subsidiaries (2,428,364) (2,370,213) (1,854,195) Decrease (increase) in other assets 142,437 (191,004) 101,323 Increase (decrease) in other liabilities 18,740 17,929 (58,651) ----------- --------- --------- Net cash provided by operating activities 929,775 335,437 183,283 ----------- --------- --------- Cash flows from investing activities: Proceeds from paydowns of investment securities held to maturity 9,554 11,155 13,245 Proceeds from calls of investment securities held to maturity 45,000 95,000 50,000 Purchase of investment securities held to maturity - - (500,000) Purchase of premises and equipment (83,488) - (13,133) Proceeds from sale of premises and equipment 47,444 11,554 - Purchase of rental property (1,978) (35,746) (68,388) ----------- --------- --------- Net cash provided by (used in) investing activities 16,532 81,963 (518,276) ----------- --------- --------- Cash flows from financing activities: Decrease in other borrowed funds (20,749) (20,800) (14,270) Proceeds from issuance of common stock - - 1,233,729 Purchase of Class B common stock of bank subsidiary - - (2,400) Proceeds from sale of treasury stock 140,812 22,498 - Purchase of treasury stock (8,648) (221,141) (24,761) Dividends paid (626,562) (560,284) (469,669) ----------- --------- --------- Net cash (used in) provided by financing activities (515,147) (779,727) 722,629 ----------- --------- --------- Net increase (decrease) in cash and cash equivalents 431,160 (362,327) 387,636 Cash and cash equivalents at beginning of year 43,300 405,627 17,991 ----------- --------- --------- Cash and cash equivalents at end of year $ 474,460 43,300 405,627 =========== ========= =========
(Continued) -74- SIGNATURES In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Auburn, State of Alabama, on the 26th day of March, 1998. AUBURN NATIONAL BANCORPORATION, INC. (Registrant) By: /s/ E.L. SPENCER, JR. --------------------- E.L. Spencer, Jr. President In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature Title Date --------- ----- ---- /s/ E.L. SPENCER, JR. President, CEO and March 26, 1998 ---------------------------------- Director E.L. Spencer, Jr. /s/ LINDA D. FUCCI Chief Financial Officer March 26, 1998 ---------------------------------- and Chief Accounting Linda D. Fucci Officer /s/ WINIFRED H. BOYD Director March 26, 1998 ---------------------------------- Winifred H. Boyd /s/ ANNE M. MAY Director March 26, 1998 ---------------------------------- Anne M. May /s/ EMIL F. WRIGHT, JR. Director March 26, 1998 ---------------------------------- Emil F. Wright, Jr.
-75- AUBURN NATIONAL BANCORPORATION, INC. EXHIBIT INDEX
Exhibit Sequentially Number Description Numbered Page - -------- ----------- ------------- 3.A. Certificate of Incorporation of Auburn National Bancorporation, Inc. * - 3.B. Bylaws of Auburn National Bancorporation, Inc. * - 4. Instruments Defining the Rights of Security Holders (See Certificate of Incorporation and Bylaws). * - 10.A. Auburn National Bancorporation, Inc. 1994 Long-Term Incentive Plan. * - 10.B. Lease and Equipment Purchase Agreement, dated September 15, 1987. * - 21. Subsidiaries of Registrant 77 23. Consent of Accountants 78 27. Financial Data Schedule 79
- ---------------------- * Incorporated by reference from Registrant's Registration Statement on Form SB-2 (File No. 33-86180). -76- EX-21 2 SUBSIDIARIES OF REGISTRANT AUBURN NATIONAL BANCORPORATION INC. AND SUBSIDIARIES EXHIBIT 21 - SUBSIDIARIES AuburnBank -77- EX-23 3 CONSENT OF ACCOUNTANTS AUBURN NATIONAL BANCORPORATION INC AND SUBSIDIARIES EXHIBIT 23 - CONSENT OF ACCOUNTANTS The Board of Directors Auburn National Bancorporation, Inc. We consent to the incorporation by reference in the registration statement (No. 333-03516) on Form S-3 of Auburn National Bancorporation, Inc. of our report dated February 17, 1998, relating to the consolidated balance sheets of Auburn National Bancorporation, Inc. and subsidiary as of December 31, 1997 and 1996, and the related statements of earnings, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1997, which report appears in the December 31, 1997 annual report on Form 10-KSB of the Auburn National Bancorporation, Inc. KPMG PEAT MARWICK LLP Atlanta, Georgia March 30, 1998 -78- EX-27 4 FINANCIAL DATA SCHEDULE
9 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE 10-KSB FOR DECEMBER 31, 1997 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 12-MOS DEC-31-1997 DEC-31-1997 12,268 1,723 2,615 0 40,446 14,364 14,402 185,493 2,125 264,734 223,978 1,274 2,239 11,196 0 0 13 26,034 264,734 15,220 4,057 469 19,746 9,553 10,343 9,403 285 (60) 6,385 4,908 4,908 0 0 3,080 2.36 2.36 3.90 0 276 0 2,681 2,094 320 66 2,125 2,125 0 0
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