EX-13 13 ex132005.htm EXHIBIT 13 Exhibit 13                                                                                 Exhibit 13
FINANCIAL INFORMATION 2005

 
CONTENTS

2
   
3
   
3
3
3
4
4
5
11
13
16
17
17
17
   
19
   
 
20
   
 
21
   
 
22
   
23
   
23
24
25
26-27
28-51




     
   
(unless otherwise noted)
 
 
2005
 
2004
 
2003
 
2002
 
2001
 
                       
Summary of Operations
                     
Interest income
 
$
57,311
  
$
45,737
  
$
41,224
  
$
40,689
  
$
37,919
  
Interest expense
   
26,506
   
17,960
   
17,530
   
18,842
   
20,438
 
Net interest income
   
30,805
   
27,777
   
23,694
   
21,847
   
17,481
 
Provision for loan losses
   
1,479
   
1,050
   
915
   
1,215
   
830
 
Net interest income after provision
                               
for loan losses
   
29,326
   
26,727
   
22,779
   
20,632
   
16,651
 
Noninterest income
   
28,874
   
27,252
   
5,824
   
1,945
   
1,810
 
Noninterest expense
   
42,246
   
38,789
   
16,884
   
12,607
   
10,737
 
Income before income taxes
   
15,954
   
15,190
   
11,719
   
9,970
   
7,724
 
Income taxes
   
4,712
   
4,582
   
3,511
   
2,732
   
2,458
 
Net income
 
$
11,242
  
$
10,608
  
$
8,208
  
$
7,238
  
$
5,266
  
                                 
Balance Sheet Data (at year end)
                               
Assets
 
$
1,109,532
  
$
889,489
  
$
791,465
  
$
671,894
  
$
591,757
  
Securities
   
223,772
   
211,362
   
235,409
   
212,598
   
207,117
 
Loans
   
816,504
   
622,075
   
509,374
   
419,205
   
347,526
 
Deposits
   
673,901
   
524,614
   
511,801
   
458,648
   
396,205
 
Short-term borrowings
   
182,028
   
120,629
   
49,714
   
20,191
   
24,033
 
Long-term borrowings and subordinated debentures
   
170,501
   
172,201
   
168,255
   
137,396
   
123,445
 
Shareholders' equity
   
73,803
   
65,708
   
57,188
   
52,080
   
44,287
 
                                 
Per Share Data
                               
Basic earnings
 
$
1.58
  
$
1.51
  
$
1.17
  
$
1.03
  
$
0.75
  
Diluted earnings
   
1.56
   
1.49
   
1.16
   
1.03
   
0.75
 
Shareholders' equity (at year end)
   
10.36
   
9.33
   
8.15
   
7.43
   
6.31
 
Cash dividends
   
0.30
   
0.26
   
0.215
   
0.1875
   
0.175
 
                                 
Performance Ratios
                               
Return on average equity
   
15.87
%
  
17.21
%
  
15.03
%
  
15.15
%
  
12.38
%
Return on average assets
   
1.16
%
  
1.26
%
  
1.14
%
  
1.15
%
  
1.00
%
Dividend payout
   
19.0
%
  
17.2
%
  
18.4
%
  
18.2
%
  
23.3
%
Equity to assets
   
6.7
%
  
7.4
%
  
7.2
%
  
7.8
%
  
7.5
%


This annual report contains comments or information that constitute forward-looking statements (within the meaning of the Private Securities Litigation Act of 1995) that are based on current expectations that involve a number of risks and uncertainties. Words such as “expects”, “anticipates”, “believes”, “estimates” and other similar expressions or future or conditional verbs such as “will”, “should”, “would” and “could” are intended to identify such forward-looking statements.

Although we believe the expectations reflected in such forward-looking statements are reasonable, actual results may differ materially. Factors that might cause such a difference include changes in interest rates and interest rate relationships; demand for products and services; the degree of competition by traditional and non-traditional competitors; changes in banking laws and regulations; changes in tax laws; the impact of technological advances; the outcomes of contingencies; trends in customer behavior as well as their ability to repay loans; and changes in the national and local economy.


We are a $1 billion community-based financial services company providing a full range of banking and other financial services to individuals and businesses through two major business segments: community banking and mortgage banking. Our two community banks, Summit Community Bank and Shenandoah Valley National Bank, have a combined total of 14 banking offices located in West Virginia and Virginia. In addition, Summit Mortgage, which comprises our entire mortgage banking segment, originates mortgage loans to consumers located throughout the United States. We continue to seek other business opportunities which earn non-interest income. Thus, in 2004, we acquired an insurance agency in Moorefield, West Virginia, Summit Insurance Services, LLC, which offers both commercial and personal lines of insurance. Summit Financial Group, Inc. employs approximately 255 full time equivalent employees.
 

Our primary source of income is net interest income from loans and deposits. Business volumes tend to be influenced by the overall economic factors including market interest rates, business spending, and consumer confidence, as well as competitive conditions within the marketplace.

Key Items in 2005

·  
We achieved record earnings in 2005 despite an after tax other-than-temporary charge of $940,000 on certain preferred stocks that we own. Net income totaled $11,242,000, or $1.56 per diluted share, an increase of 4.7%.

·  
Our earnings allowed us to return $2.1 million, or $0.30 per share, to our shareholders in 2005 in the form of cash dividends.
 
·  
Total assets surpassed $1 billion, growing 25% during 2005, as commercial loans grew 50%, primarily in commercial real estate loans, which grew 56%.

·  
Our net interest margin came under pressure, dropping to 3.51% for 2005, compared to 3.66% for 2004, due to continued robust loan growth in excess of our ability to grow low cost retail deposits.

·  
Our mortgage banking segment contributed $2,375,000 to net income in 2005, compared to $1,794,000 in 2004.

·  
Our mortgage banking segment originated 5,900 loans totaling $315 million in mortgage loans for resale.

·  
We funded our 2005 balance sheet growth through both retail deposits, which grew 16% and wholesale deposits and other non-deposit funding sources, which increased 39%.

·  
Our credit quality remains strong, evidenced by a decrease of $256,000 in net charge offs compared to 2004, and our total nonperforming loans as a percentage of total loans remains low at 0.19% at December 31, 2005, compared to 0.11% at December 31, 2004.

3

MANAGEMENT’S DISCUSSION AND ANALYSIS




Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and follow general practices within the financial services industry. Application of these principles requires us to make estimates, assumptions, and judgments that affect the amounts reported in our financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported.

Our most significant accounting policies are presented in Note 1 to the accompanying consolidated financial statements. These policies, along with the disclosures presented in the other financial statement notes and in this financial review, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined.

Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, we have identified the determination of the allowance for loan losses and the valuation of goodwill to be the accounting areas that require the most subjective or complex judgments, and as such could be most subject to revision as new information becomes available.

The allowance for loan losses represents our estimate of probable credit losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on our consolidated balance sheet. To the extent actual outcomes differ from our estimates, additional provisions for loan losses may be required that would negatively impact earnings in future periods. Note 1 to the accompanying consolidated financial statements describes the methodology used to determine the allowance for loan losses and a discussion of the factors driving changes in the amount of the allowance for loan losses is included in the Asset Quality section of this financial review.

Goodwill is subject to impairment testing at least annually to determine whether write-downs of the recorded balances are necessary. A fair value is determined based on at least one of three various market valuation methodologies. If the fair value equals or exceeds the book value, no write-down of recorded goodwill is necessary. If the fair value is less than the book value, an expense may be required on our books to write down the goodwill to the proper carrying value. During the third quarter of 2005, we completed the required annual impairment test and determined that no impairment write-offs were necessary. We can not assure you that future goodwill impairment tests will not result in a charge to earnings.

See Notes 1 and 8 of the accompanying consolidated financial statements for further discussion of our intangible assets, which include goodwill.



We are organized and managed along two major business segments, as described in Note 16 of the accompanying consolidated financial statements. The results of each business segment are intended to reflect each segment as if it were a stand alone business. Net income by segment follows:


(dollars in thousands)
  
2005
  
2004
  
2003
  
Community banking
  
$
9,790
  
$
9,671
  
$
8,540
  
Mortgage banking
    
2,375
   
1,794
   
96
 
Parent and other
    
(923
)
  
(857
)
  
(428
)
Consolidated net income
  
$
11,242
  
$
10,608
  
$
8,208
  


4

MANAGEMENT’S DISCUSSION AND ANALYSIS




Earnings Summary

Net income for the three years ended December 31, 2005, 2004 and 2003, was $11,242,000, $10,608,000, and $8,208,000, respectively. On a per share basis, diluted net income was $1.56 in 2005, compared to $1.49 in 2004 and $1.16 in 2003. Return on average equity was 15.87% in 2005 compared to 17.21% in 2004, and 15.03% in 2003. Return on average assets for the year ended December 31, 2005 was 1.16% compared to 1.26---% in 2004 and 1.14% in 2003. During 2005, we took an other-than-temporary non-cash impairment charge of $1.5 million pre-tax, equivalent to $940,000 after-tax, related to $5.7 million of certain preferred stock issuances of the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. A summary of the significant factors influencing our results of operations and related ratios is included in the following discussion.

Net Interest Income

The major component of our net earnings is net interest income, which is the excess of interest earned on earning assets over the interest expense incurred on interest bearing sources of funds. Net interest income is affected by changes in volume, resulting from growth and alterations of the balance sheet's composition, fluctuations in interest rates and maturities of sources and uses of funds. We seek to maximize net interest income through management of our balance sheet components. This is accomplished by determining the optimal product mix with respect to yields on assets and costs of funds in light of projected economic conditions, while maintaining portfolio risk at an acceptable level.

Net interest income on a fully tax equivalent basis, average balance sheet amounts, and corresponding average yields on interest earning assets and costs of interest bearing liabilities for the years 2005, 2004 and 2003 are presented in Table I. Table II presents, for the periods indicated, the changes in interest income and expense attributable to (a) changes in volume (changes in volume multiplied by prior period rate) and (b) changes in rate (change in rate multiplied by prior period volume). Changes in interest income and expense attributable to both rate and volume have been allocated between the factors in proportion to the relationship of the absolute dollar amounts of the change in each.

Net interest income on a fully tax equivalent basis, totaled $32,076,000, $29,096,000, and $24,812,000 for the years ended December 31, 2005, 2004 and 2003, respectively. This increase in net interest income is the result of substantial loan growth in the commercial real estate and residential mortgage portfolios in all three years, which more than offset the impact of a lower interest rate environment. Total average earning assets increased 15.1% to $914,682,000 from $794,611,000 at December 31, 2004. Total average interest bearing liabilities increased 15.2% to $829,347,000 at December 31, 2005, compared to $719,620,000 at December 31, 2004. As identified in Table II, tax equivalent net interest income grew $2,980,000 and $4,284,000 during 2005 and 2004, respectively.

Our net interest margin was 3.51% for 2005 compared to 3.66% and 3.63% for 2004 and 2003, respectively. Our net interest margin decreased 15 basis points in 2005, despite an increase of 48 basis points on the yields on interest earning assets, which was more than offset by the 70 basis point increase in the cost of interest bearing liabilities. Our margin continues to be affected by our rapid loan growth, as that growth is at a faster pace than we have been able to grow lower cost retail funds, causing us to rely more on higher cost, non-retail deposit funding vehicles. If loan growth continues at levels similar to 2005, this could cause continued margin contraction. Although our net interest margin increased 3 basis points in 2004, the yields on taxable securities and loans declined 21 and 46 basis points, respectively. At the same time, we had a decrease in our cost of funds, declining to 2.50% for 2004, compared to 2.84% for 2003. Despite 5 increases in rates by the Fed during the second half of 2004, assets that repriced during the year typically repriced downward. See Tables I and II for further details regarding changes in volumes and rates of average assets and liabilities and how those changes affect our net interest income.

We anticipate modest growth in our net interest income to continue over the near term as the growth in the volume of interest earning assets will more than offset the expected continued modest decline in our net interest margin. However, if market interest rates were to rise significantly in 2006, the spread between interest earning assets and interest bearing liabilities could narrow, thus negatively impacting our net interest income. We continue to monitor the net interest margin through net interest income simulation to minimize the potential for any significant negative impact. See the Market Risk Management section for further discussion of the impact changes in market interest rates could have on us.

 

5

MANAGEMENT’S DISCUSSION AND ANALYSIS





TABLE I - AVERAGE DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY,
                  
INTEREST EARNINGS & EXPENSES, AND AVERAGE YIELDS/RATES
                          
Dollars in thousands
                                      
   
2005
  
2004
  
2003
  
   
Average
  
Earnings/
  
Yield/
  
Average
  
Earnings/
  
Yield/
  
Average
  
Earnings/
  
Yield/
  
 
  
Balances
  
Expense
  
Rate
  
Balances
  
Expense
  
Rate
  
Balances
  
Expense
  
Rate
  
ASSETS
                                      
Interest earning assets
                                      
Loans, net of unearned interest (1)
                                      
Taxable
  
$
691,041
  
$
47,582
    
6.89
%
$
567,066
  
$
35,769
    
6.31
%
$
455,526
  
$
30,842
    
6.77
%
Tax-exempt (2)
    
8,688
   
635
   
7.31
%
  
8,818
   
662
   
7.51
%
  
5,933
   
489
   
8.24
%
Securities
                                                        
Taxable
    
164,611
   
7,076
   
4.30
%
  
166,882
   
7,195
   
4.31
%
  
175,821
   
7,952
   
4.52
%
Tax-exempt (2)
    
47,563
   
3,180
   
6.69
%
  
48,356
   
3,303
   
6.83
%
  
41,537
   
2,889
   
6.96
%
Federal Funds sold and interest
                                                        
bearing deposits with other banks
    
2,779
   
109
   
3.92
%
  
3,489
   
127
   
3.64
%
  
5,368
   
170
   
3.17
%
   
$
914,682
  
$
58,582
    
6.40
%
$
794,611
  
$
47,056
    
5.92
%
$
684,185
  
$
42,342
    
6.19
%
Noninterest earning assets
                                                        
Cash and due from banks
    
17,583
               
14,367
               
8,970
             
Banks premises and equipment
    
21,234
               
19,998
               
14,168
             
Other assets
    
21,121
               
16,879
               
19,746
             
Allowance for loan losses
    
(5,652
)
              
(4,972
)
              
(4,325
)
            
Total assets
  
$
968,968
              
$
840,883
              
$
722,744
              
                                                         
LIABILITIES AND SHAREHOLDERS' EQUITY
                                                
Liabilities
                                                       
Interest bearing liabilities
                                                        
Interest bearing demand deposits
  
$
151,271
  
$
3,120
    
2.06
%
$
120,066
  
$
1,183
    
0.99
%
$
100,084
  
$
793
    
0.79
%
Savings deposits
    
47,745
   
312
   
0.65
%
  
49,806
   
242
   
0.49
%
  
46,985
   
256
   
0.54
%
Time deposits
    
319,377
   
9,970
   
3.12
%
  
306,850
   
8,285
   
2.70
%
  
280,064
   
8,950
   
3.20
%
Short-term borrowings
    
138,694
   
4,824
   
3.48
%
  
70,318
   
1,204
   
1.71
%
  
31,907
   
441
   
1.38
%
Long-term borrowings and
                                                        
subordinated debentures
    
172,260
   
8,280
   
4.81
%
  
172,580
   
7,046
   
4.08
%
  
158,040
   
7,090
   
4.49
%
   
$
829,347
  
$
26,506
    
3.20
%
$
719,620
  
$
17,960
    
2.50
%
$
617,080
  
$
17,530
    
2.84
%
Noninterest bearing liabilities
                                                        
Demand deposits
    
61,543
               
54,212
               
46,166
             
Other liabilities
    
7,258
               
5,416
               
4,870
             
Total liabilities
    
898,148
               
779,248
               
668,116
             
Shareholders' equity
    
70,820
               
61,635
               
54,628
             
Total liabilities and
                                                        
shareholders' equity
  
$
968,968
              
$
840,883
              
$
722,744
              
NET INTEREST EARNINGS
        
$
32,076
              
$
29,096
              
$
24,812
        
NET INTEREST YIELD ON EARNING ASSETS
        
3.51
%
              
3.66
%
              
3.63
%

 
 

(1) For purposes of this table, non-accrual loans are included in average loan balances. Included in interest and fees on loans are loan fees of $469,000,
      $421,000 and $416,000 for the years ended December 31, 2005, 2004 and 2003 respectively.
        
                 
(2) For purposes of this table, interest income on tax-exempt securities and loans has been adjusted assuming an effective combined Federal and state tax
      rate of 34% for all years presented. The tax equivalent adjustment results in an increase in interest income of $1,271,000, $1,319,000 and $1,118,000
      for the years ended December 31, 2005, 2004 and 2003, respectively.
            

 
6

MANAGEMENT’S DISCUSSION AND ANALYSIS


 
 
 

Table II - Changes in Interest Margin Attributable to Rate and Volume
              
Dollars in thousands
                          
                           
   
2005 Versus 2004
  
2004 Versus 2003
  
   
Increase (Decrease)
  
Increase (Decrease)
  
   
Due to Change in:
  
Due to Change in:
  
   
Volume
  
Rate
  
Net
  
Volume
  
Rate
  
Net
  
Interest earned on:
  
 
  
 
  
 
  
 
  
 
  
 
  
Loans
                                      
Taxable
  
$
8,325
  
$
3,488
  
$
11,813
  
$
7,148
  
$
(2,221
)
$
4,927
  
Tax-exempt
    
(10
)
  
(17
)
  
(27
)
  
220
   
(47
)
  
173
 
Securities
                                      
Taxable
    
(98
)
  
(21
)
  
(119
)
  
(394
)
  
(363
)
  
(757
)
Tax-exempt
    
(53
)
  
(70
)
  
(123
)
  
466
   
(52
)
  
414
 
Federal funds sold and interest
                                      
bearing deposits with other banks
    
(27
)
  
9
   
(18
)
  
(66
)
  
23
   
(43
)
Total interest earned on
                         
interest earning assets
    
8,137
   
3,389
   
11,526
   
7,374
   
(2,660
)
  
4,714
 
                           
Interest paid on:
                                      
Interest bearing demand
                                     
deposits
    
372
   
1,565
   
1,937
   
175
   
215
   
390
 
Savings deposits
    
(10
)
  
80
   
70
   
14
   
(28
)
  
(14
)
Time deposits
    
349
   
1,336
   
1,685
   
805
   
(1,470
)
  
(665
)
Short-term borrowings
    
1,757
   
1,863
   
3,620
   
637
   
126
   
763
 
Long-term borrowings and
                                      
subordinated debentures
    
(13
)
  
1,247
   
1,234
   
622
   
(666
)
  
(44
)
Total interest paid on
                         
interest bearing liabilities
    
2,455
   
6,091
   
8,546
   
2,253
   
(1,823
)
  
430
 
                           
Net interest income
  
$
5,682
  
$
(2,702
)
$
2,980
  
$
5,121
  
$
(837
)
$
4,284
  

Noninterest Income

Noninterest income totaled 3.0%, 3.2%, and 0.8% of average assets in 2005, 2004, and 2003, respectively. Noninterest income totaled $28,874,000 in 2005, compared to $27,252,000 in 2004, and $5,824,000 in 2003, as mortgage origination revenue continues to be the primary component. Further detail regarding noninterest income is reflected in the following table. Also, refer to Note 16 of the accompanying consolidated financial statements for our segment information.
 
 

Noninterest Income
              
Dollars in thousands
              
 
  
2005
  
2004
  
2003
  
Insurance commissions
  
$
853
  
$
527
  
$
239
  
Service fees
    
2,589
   
2,238
   
1,586
 
Mortgage origination revenue
    
26,371
   
24,089
   
3,138
 
Securities gains (losses)
    
(1,390
)
  
33
   
212
 
Gain (loss) on sale of assets
    
(198
)
  
(29
)
  
336
 
Other
    
649
   
394
   
313
 
                     
Total
  
$
28,874
  
$
27,252
  
$
5,824
  


7

MANAGEMENT’S DISCUSSION AND ANALYSIS



Insurance commissions: These commissions increased 61.9% in 2005 and 120.5% in 2004 over 2003 due to our acquisition in 2004 of a full lines insurance agency offering both commercial and personal lines of insurance.

Service fees: Total service fees increased 15.7% in 2005 and 41.1% in 2004 as a result of increases in overdraft and nonsufficient funds (NSF) fees due to an increased number of overdrafts by customers. These increases reflect policy changes made during 2004 permitting additional customer flexibility regarding overdraft privileges.

Mortgage origination revenue: The following table shows our mortgage origination segment’s loan activity:
 

Dollars in thousands
  
2005
  
2004
  
2003
  
               
Loans originated
                    
Principal amount
  
$
314,702
  
$
261,355
  
$
62,936
  
Number
    
5,896
   
5,116
   
948
 
                     
Loans sold
                    
Principal amount
  
$
309,157
  
$
251,052
  
$
57,225
  
Number
    
5,786
   
4,983
   
826
 

 
 
The growth in mortgage origination revenue during 2004 reflected the first full year of operation for Summit Mortgage.

Summit Mortgage originates loans solely for the purpose of selling them. We do not service these loans, therefore there is no servicing intangible associated with this segment. Our mortgage banking revenue consists entirely of two components: 1) fees collected at the time of origination and 2) the gains we receive when selling the loans. The breakout of these fees and gains follows:
 

Mortgage origination revenue
          
               
Dollars in thousands
  
2005
  
2004
  
2003
  
               
Origination fees, net
  
$
15,514
  
$
15,005
  
$
2,178
  
Gains
    
10,857
   
9,084
   
960
 
                     
Total
 
$
26,371
  
$
24,089
  
$
3,138
  

 
Although mortgage origination revenue increased in 2005, profitability was impacted by the continued change in mix of loans originated. During 2005, 19.2% of the total dollar amount of loan originations were first mortgage loans as compared to 14.5% for 2004. Sales of first mortgage loans typically result in smaller margins than sales of second mortgage loans. Although mortgage origination revenue increased for 2004, we experienced a decline in this revenue for the 4th quarter of 2004, compared to the 3rd quarter of 2004. This decline was caused by increased competitive conditions, causing reduced margins on loan sales. These margins rebounded in early 2005, and remained relatively stable during the year.

Securities losses: During 2005, we took an other-than-temporary non-cash impairment charge of $1.5 million pre-tax, equivalent to $940,000 after-tax, related to $5.7 million of certain preferred stock issuances of the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation.

Gains/losses on sales of assets: Included in noninterest income are losses on sales of assets of $198,000 in 2005 and $29,000 in 2004, and gains on sales of assets of $336,000 in 2003. The $198,000 loss in 2005 includes the loss on the sale of one of our foreclosed properties. The gain in 2003 included a gain on the sale of one of our facilities.


8

MANAGEMENT’S DISCUSSION AND ANALYSIS



Other: Other income increased 64.7% during 2005 to $649,000, compared to $394,000 in 2004. The three major components of this increase are: 1) an increase in financial services revenue, 2) increases in debit card and ATM income due to increased card usage by customers, and 3) fee income earned on interest rate swaps between us and loan customers to hedge the interest rate risk of their loans.

Noninterest Expense

Noninterest expense totaled $42,246,000, $38,789,000, and $16,884,000 or 4.4%, 4.6%, and 2.3% of average assets for each of the years ended December 31, 2005, 2004 and 2003, respectively. Total noninterest expense increased $3,457,000 in 2005 compared to 2004 and $21,905,000 in 2004 compared to 2003. Table III below shows the breakdown of these increases by segment. Also, refer to Note 16 of the accompanying consolidated financial statements for our segment information.

Community Banking, Parent and Other Segments

Total noninterest expense for our community banking segment, parent, and other increased 13.7% over 2004, and 21.1% from 2003 to 2004. The major factors contributing to these increases follow.

Salaries and employee benefits: Salaries and employee benefits expense increased 15.4% in 2005 due to an increase in performance based incentive compensation, general merit raises, and also additional staffing requirements needed as a result of our growth, including opening a new community banking office in Warrenton, Virginia. The increase of 24.1% in 2004 over 2003 was attributed to an increase in performance based incentive compensation, increased staffing needs as a result of our growth, including opening an office in Harrisonburg, Virginia, and general merit raises.

Net occupancy and Equipment expense: The 32.8% increase in net occupancy and equipment expense in 2004 is attributed to increased depreciation expense recognized for our new corporate headquarters in Moorefield, West Virginia and our new community banking facility in Petersburg, West Virginia.

Advertising: Advertising expense increased $321,000 during 2005 as we have more aggressively advertised our recently opened offices in the Virginia markets.

Mortgage Banking Segment

Total noninterest expense for our mortgage banking segment in 2005 increased 5.3% over 2003 and 620.2% from 2003 to 2004. The 2004 increase is attributed to the formation of Summit Mortgage in 3rd quarter 2003. 2003 expenses were comprised of 3 full months of operation of Summit Mortgage while 2004 is for the entire year.

Salaries and employee benefits: The 9.0% increase in salaries and employee benefits during 2005 is due to an increase in profitability based incentive compensation paid to Summit Mortgage management, and increases in both employee health insurance and employee pension expense due to employees reaching eligibility status. 2004 reflects the first full year of operation for Summit Mortgage.

Net occupancy and Equipment expense: In 2004, we entered into a lease for a larger location to support our additional staffing needs, which increased net occupancy expense $273,000. The $194,000 net occupancy expense increase in 2005 was impacted by this new 2004 lease, and also, in late 2005, we entered into a lease for a second location.

Supplies and Professional fees: The 2004 increase in these categories is a result of 2004 being the first full year of operation for Summit Mortgage.

Postage and Advertising expense: Postage expense and advertising expense, combined, increased 670.6% from 2003 to 2004. This increase reflects the costs incurred with the direct mail method of obtaining customers.  

9

MANAGEMENT’S DISCUSSION AND ANALYSIS




Table III - Noninterest Expense
                              
Dollars in thousands
                              
                               
       
Change
      
Change
      
Community Banking and Other
  
2005
  
 $
  
%
  
2004
  
$
  
%
  
2003
  
Salaries and employee benefits
  
$
10,810
  
$
1,446
    
15.4
%
$
9,364
  
$
1,818
    
24.1
%
$
7,546
  
Net occupancy expense
    
1,371
   
184
   
15.5
%
  
1,187
   
362
   
43.9
%
  
825
 
Equipment expense
    
1,713
   
136
   
8.6
%
  
1,577
   
321
   
25.6
%
  
1,256
 
Supplies
    
549
   
10
   
1.9
%
  
539
   
91
   
20.3
%
  
448
 
Professional fees
    
749
   
155
   
26.1
%
  
594
   
81
   
15.8
%
  
513
 
Postage
    
231
   
(3
)
  
-1.3
%
  
234
   
47
   
25.1
%
  
187
 
Advertising
    
615
   
321
   
109.2
%
  
294
   
27
   
10.1
%
  
267
 
Amortization of intangibles
    
151
   
-
   
0.0
%
  
151
   
-
   
0.0
%
  
151
 
Other
    
2,849
   
45
   
1.6
%
  
2,804
   
174
   
6.6
%
  
2,630
 
Total
  
$
19,038
  
$
2,294
    
13.7
%
$
16,744
  
$
2,921
    
21.1
%
$
13,823
  

 

       
Change
      
Change
      
Mortgage Banking
  
2005
  
 $
  
%
  
2004
  
 $
  
%
  
2003
  
Salaries and employee benefits
  
$
9,505
  
$
782
    
9.0
%
$
8,723
  
$
7,265
    
498.3
%
$
1,458
  
Net occupancy expense
    
510
   
194
   
61.4
%
  
316
   
273
   
634.9
%
  
43
 
Equipment expense
    
198
   
(1
)
  
-0.5
%
  
199
   
135
   
210.9
%
  
64
 
Supplies
    
109
   
(18
)
  
-14.2
%
  
127
   
94
   
284.8
%
  
33
 
Professional fees
    
221
   
(6
)
  
-2.6
%
  
227
   
175
   
336.5
%
  
52
 
Postage
    
5,632
   
15
   
0.3
%
  
5,617
   
4,819
   
603.9
%
  
798
 
Advertising
    
4,263
   
(168
)
  
-3.8
%
  
4,431
   
3,925
   
775.7
%
  
506
 
Other
    
2,770
   
365
   
15.2
%
  
2,405
   
2,298
   
2147.7
%
  
107
 
Total
  
$
23,208
  
$
1,163
    
5.3
%
$
22,045
  
$
18,984
    
620.2
%
$
3,061
  


       
Change
      
Change
      
Consolidated
  
2005
  
$
  
%
  
2004
  
 $
  
%
  
2003
  
Salaries and employee benefits
  
$
20,315
  
$
2,228
    
12.3
%
$
18,087
  
$
9,083
    
100.9
%
$
9,004
  
Net occupancy expense
    
1,881
   
378
   
25.1
%
  
1,503
   
635
   
73.2
%
  
868
 
Equipment expense
    
1,911
   
135
   
7.6
%
  
1,776
   
456
   
34.5
%
  
1,320
 
Supplies
    
658
   
(8
)
  
-1.2
%
  
666
   
185
   
38.5
%
  
481
 
Professional fees
    
970
   
149
   
18.1
%
  
821
   
256
   
45.3
%
  
565
 
Postage
    
5,863
   
12
   
0.2
%
  
5,851
   
4,866
   
494.0
%
  
985
 
Advertising
    
4,878
   
153
   
3.2
%
  
4,725
   
3,952
   
511.3
%
  
773
 
Amortization of intangibles
    
151
   
-
   
0.0
%
  
151
   
-
   
0.0
%
  
151
 
Other
    
5,619
   
410
   
7.9
%
  
5,209
   
2,472
   
90.3
%
  
2,737
 
Total
  
$
42,246
  
$
3,457
    
8.9
%
$
38,789
  
$
21,905
    
129.7
%
$
16,884
  
Income Tax Expense

Income tax expense for the three years ended December 31, 2005, 2004 and 2003 totaled $4,712,000, $4,582,000, and $3,511,000, respectively. Refer to Note 11 of the accompanying consolidated financial statements for further information and additional discussion of the significant components influencing our effective income tax rates.

10

MANAGEMENT’S DISCUSSION AND ANALYSIS




Total average assets in 2005 were $968,968,000, an increase of 15.2% over 2004's average of $840,883,000. Similarly, average assets grew 16.3% in 2004, from $722,744,000 in 2003. The primary growth in both 2005 and 2004 was in loans throughout our company. Significant changes in the components of our balance sheet in 2005 and 2004 are discussed below.

Loan Portfolio

Table IV depicts loan balances by type and the respective percentage of each to total loans at December 31, as follows: 

Table IV - Loans by Type
                                     
Dollars in thousands
                                          
                                           
   
2005
  
2004
  
2003
  
2002
  
2001
  
       
Percent
      
Percent
      
Percent
      
Percent
      
Percent
  
   
Amount
  
of Total
  
Amount
  
of Total
  
Amount
  
of Total
  
Amount
  
of Total
  
Amount
  
of Total
  
                                           
Commercial
  
$
63,206
    
7.9
%
$
53,226
    
8.7
%
$
46,860
    
9.3
%
$
34,745
    
8.3
%
$
26,464
    
7.6
%
Commercial real estate
    
436,803
   
54.5
%
  
279,631
   
46.0
%
  
209,391
   
41.5
%
  
171,822
   
41.0
%
  
121,576
   
34.9
%
Real estate - construction
    
4,343
   
0.5
%
  
3,916
   
0.6
%
  
2,369
   
0.5
%
  
4,494
   
1.1
%
  
2,394
   
0.7
%
Real estate - mortgage
    
251,886
   
31.4
%
  
223,690
   
36.7
%
  
196,135
   
38.9
%
  
161,006
   
38.4
%
  
149,050
   
42.9
%
Consumer
    
36,863
   
4.6
%
  
38,948
   
6.4
%
  
41,112
   
8.2
%
  
40,655
   
9.7
%
  
41,509
   
11.9
%
Other
    
8,598
   
1.1
%
  
9,605
   
1.6
%
  
8,223
   
1.6
%
  
6,390
   
1.5
%
  
7,264
   
2.0
%
                                           
Total loans
  
$
801,699
    
100.0
%
$
609,016
    
100.0
%
$
504,090
    
100.0
%
$
419,112
    
100.0
%
$
348,257
    
100.0
%

Total net loans averaged $699,729,000 in 2005 and comprised 72.2% of total average assets compared to $575,884,000 or 68.5% of total average assets during 2004. The increase in the dollar volume of loans is primarily attributable to our current growth mode. We are aggressively seeking loans in the Virginia markets, primarily in the Shenandoah Valley of northern Virginia, as this area is currently a vibrant market for commercial loans, especially commercial real estate loans. Also, at December 31, 2005, Summit Mortgage had $17,037,000 of loans that had been originated and in the process of being sold. These loans are included on our balance sheet.

Refer to Note 4 of the accompanying consolidated financial statements for our loan maturities and a discussion of our adjustable rate loans as of December 31, 2005.

In the normal course of business, we make various commitments and incur certain contingent liabilities, which are disclosed in Note 13 of the accompanying consolidated financial statements but not reflected in the accompanying consolidated financial statements. There have been no significant changes in these types of commitments and contingent liabilities and we do not anticipate any material losses as a result of these commitments.

Securities
 
Securities comprised approximately 20.2% of total assets at December 31, 2005 compared to 23.8% at December 31, 2004. This decrease was the result of our high loan demand, reducing our need to invest funds in securities. Average securities approximated $212,174,000 for 2005 or 1.4% less than 2004's average of $215,238,000. Refer to Note 3 of the accompanying consolidated financial statements for details of amortized cost, the estimated fair values, unrealized gains and losses as well as the security classifications by type.

11

MANAGEMENT’S DISCUSSION AND ANALYSIS



All of our securities are classified as available for sale to provide us with flexibility to better manage our balance sheet structure and react to asset/liability management issues as they arise. Pursuant to SFAS No. 115, anytime that we carry a security with an unrealized loss that has been determined to be “other than temporary”, we must recognize that loss in income. During 2005, we took an other-than-temporary non-cash impairment charge of $1.5 million pre-tax, equivalent to $940,000 after-tax, related to $5.7 million of certain preferred stock issuances of the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. We continue to own these securities, and this charge was taken primarily due to difficulty in accurately projecting the future recovery period of these securities. At December 31, 2005, we did not own securities of any one issuer that were not issued by the U.S. Treasury or a U.S. Government agency that exceeded ten percent of shareholders’ equity. The maturity distribution of the securities portfolio at December 31, 2005, together with the weighted average yields for each range of maturity, is summarized in Table V. The stated average yields are actual yields and are not stated on a tax equivalent basis.



Table V - Securities Maturity Analysis
 
(At amortized cost, dollars in thousands)
 
 
  
 
  
 
  
After one
 
After five
 
 
  
 
  
 
  
Within
 
but within
 
but within
 
After
 
 
  
one year
 
five years
 
ten years
 
ten years
 
 
  
Amount
 
Yield
 
Amount
 
Yield
 
Amount
 
Yield
 
Amount
 
Yield
 
 
  
 
  
 
  
 
  
 
  
 
  
 
  
 
  
 
  
U. S. Government agencies
                                 
and corporations
 
$
1,993
    
4.6
%
$
29,691
    
4.4
%
$
8,543
    
5.4
%
$
-
    
-
  
Mortgage backed securities
   
35,016
   
4.4
%
  
74,046
   
4.5
%
  
7,938
   
4.8
%
  
530
   
5.4
%
State and political
                                 
subdivisions
   
1,369
   
6.3
%
  
3,828
   
5.4
%
  
14,632
   
7.2
%
  
22,441
   
7.4
%
Corporate debt securities
   
1,602
   
6.1
%
  
1,692
   
5.0
%
  
-
   
-
    
-
   
-
  
Other
   
-
   
-
    
-
   
-
    
-
   
-
    
22,462
   
2.5
%
 
                                  
Total
 
$
39,980
    
4.6
%
$
109,257
    
4.5
%
$
31,113
    
6.1
%
$
45,433
    
4.9
%

 
Deposits

Total deposits at December 31, 2005 increased $149,287,000 or 28.5% compared to December 31, 2004. Average interest bearing deposits increased $41,671,000, or 8.7% during 2005. This increase resulted primarily from growth of Shenandoah’s deposits. Also, presented as other deposits below, are brokered deposits, which increased 141.8% to $128,797,000 at December 31, 2005. These deposits totaled $53,268,000 at December 31, 2004, an increase of 60.5% over 2003. Brokered deposits represent certificates of deposit acquired through a third party.
 

Deposits
                      
In thousands
                      
   
2005
  
2004
  
2003
  
2002
  
2001
  
Noninterest bearing demand
  
$
62,631
  
$
55,402
  
$
51,004
  
$
46,313
  
$
38,686
  
Interest bearing demand
    
200,638
   
122,355
   
112,671
   
99,752
   
81,510
 
Savings
    
44,681
   
50,428
   
47,397
   
46,732
   
43,766
 
Consumer time
    
210,923
   
217,863
   
241,351
   
234,060
   
211,116
 
Individual Retirement Accounts
    
26,231
   
25,298
   
26,185
   
24,411
   
21,127
 
Core deposits
    
545,104
   
471,346
   
478,608
   
451,268
   
396,205
 
Other deposits
    
128,797
   
53,268
   
33,193
   
7,380
   
-
 
Total deposits
  
$
673,901
  
$
524,614
  
$
511,801
  
$
458,648
  
$
396,205
  

See Table I for average deposit balance and rate information by deposit type for 2005, 2004 and 2003 and Note 9 of the accompanying consolidated financial statements for a maturity distribution of time deposits as of December 31, 2005.

12

MANAGEMENT’S DISCUSSION AND ANALYSIS



Borrowings

Lines of Credit: We have available lines of credit from various correspondent banks totaling $19,700,000 at December 31, 2005. These lines are utilized when temporary day to day funding needs arise. They are reflected on the consolidated balance sheet as short-term borrowings. We also have remaining available lines of credit from the Federal Home Loan Bank totaling $68,657,000 at December 31, 2005. We use these lines primarily to fund loans to customers. Funds acquired through this program are reflected on the consolidated balance sheet in short-term borrowings or long-term borrowings, depending on the repayment terms of the debt agreement. In addition, Summit Financial Group, Inc. has a long-term line of credit available through an unaffiliated banking institution which is secured by the common stock of one of our subsidiary banks. At December 31, 2005, we had $5,500,000 available to draw on this line.

Short-term Borrowings: Total short-term borrowings increased $61,399,000 from $120,629,000 at December 31, 2004 to $182,028,000 at December 31, 2005. See Note 10 of the accompanying consolidated financial statements for additional disclosures regarding our short-term borrowings. These borrowings were made principally to fund our loan growth.

Long-term Borrowings: Total long-term borrowings of $150,912,000 at December 31, 2005, consisting primarily of funds borrowed on available lines of credit from the Federal Home Loan Bank, decreased $9,948,000 compared to the $160,860,000 outstanding at December 31, 2004. Refer to Note 10 of the accompanying consolidated financial statements for additional information regarding our long-term borrowings.


Table VI presents a summary of non-performing assets at December 31, as follows:


Table VI - Nonperforming Assets
                 
Dollars in thousands
                      
   
2005
  
2004
  
2003
  
2002
  
2001
  
Nonaccrual loans
  
$
750
  
$
532
  
$
1,014
  
$
917
  
$
788
  
Accruing loans past due
                                
90 days or more
    
799
   
140
   
342
   
574
   
328
 
Total nonperforming loans
    
1,549
   
672
   
1,356
   
1,491
   
1,116
 
                                 
Foreclosed properties and
                                
repossessed assets
    
395
   
646
   
497
   
95
   
81
 
Nonaccrual securities
    
-
   
349
   
396
   
421
   
-
 
Total nonperforming assets
  
$
1,944
  
$
1,667
  
$
2,249
  
$
2,007
  
$
1,197
  
                                 
Total nonperforming loans
                                
as a percentage of total loans
    
0.19
%
  
0.11
%
  
0.27
%
  
0.36
%
  
0.32
%
                                 
Total nonperforming assets
                                
as a percentage of total assets
    
0.18
%
  
0.19
%
  
0.28
%
  
0.30
%
  
0.20
%

As illustrated in Table VI, the quality of our loan portfolio remains sound. Although total nonaccrual loans and accruing loans past due 90 days or more increased from $672,000 at December 31, 2004 to $1,549,000 at December 31, 2005, they remain at historically moderate levels in relation to the loan portfolio’s size and substantially below recent industry averages. Refer to Note 5 of the accompanying consolidated financial statements for a discussion of impaired loans which are included in the above balances. 

Included in the net balance of loans are nonaccrual loans amounting to $750,000 and $532,000 at December 31, 2005 and 2004, respectively. If these loans had been on accrual status throughout 2005, the amount of interest income that we would have recognized would have been $64,000. The actual amount of interest income recognized in 2005 on these loans was $21,000.

13

MANAGEMENT’S DISCUSSION AND ANALYSIS


 
We maintain the allowance for loan losses at a level considered adequate to provide for losses that can be reasonably anticipated. We conduct quarterly evaluations of our loan portfolio to determine its adequacy. In assessing the adequacy of our allowance for loan losses, we conduct a two part evaluation. First, we specifically identify loans that have weaknesses that have been identified, using the fair value of collateral method. Second, we stratify the loan portfolio into 11 homogeneous loan pools, including commercial real estate, other commercial, residential real estate, autos, and others. Historical loss rates, as adjusted, are applied against the then outstanding balance of loans in each classification to estimate probable losses inherent in each segment of the portfolio. Historical loss rates are adjusted using potential risk factors that could result in actual losses deviating from prior loss experience. Such risk factors considered are (1) levels of and trends in delinquencies and impaired loans, (2) levels of and trends in charge-offs and recoveries, (3) trends in volume and term of loans, (4) effects of any changes in risk selection and underwriting standards, and other changes in lending policies, procedures, and practice, (5) experience, ability, and depth of lending management and other relevant staff, (6) national and local economic trends and conditions, (7) industry conditions, and (8) effects of changes in credit concentrations. In addition, we conduct comprehensive, ongoing reviews of our loan portfolio, which encompasses the identification of all potential problem credits to be included on an internally generated watch list.

The identification of loans for inclusion on the watch list of loans that have been specifically identified is facilitated through the use of various sources, including past due loan reports, previous internal and external loan evaluations, classified loans identified as part of regulatory agency loan reviews and reviews of new loans representative of current lending practices. Once this list is reviewed to ensure it is complete, we review the specific loans for collectibility, performance and collateral protection. In addition, a grade is assigned to the individual loans utilizing internal grading criteria, which is somewhat similar to the criteria utilized by each subsidiary bank's primary regulatory agency. Based on the results of these reviews, specific reserves for potential losses are identified and the allowance for loan losses is adjusted appropriately through a provision for loan losses.

While there may be some loans or portions of loans identified as potential problem credits which are not specifically identified as either nonaccrual or accruing loans past due 90 or more days, we consider them to be insignificant to the overall disclosure and are, therefore, not specifically quantified within this discussion. In addition, we feel these additional loans do not represent or result from trends or uncertainties which we reasonably expect will materially impact future operating results, liquidity or capital resources. Also, these loans do not represent material credits about which we are aware of any information which would cause the borrowers to not comply with the loan repayment terms.

The allocated portion of the allowance for loan losses is established on a loan-by-loan and pool-by-pool basis. The unallocated portion is for inherent losses that probably exist as of the evaluation date, but which have not been specifically identified by the processes used to establish the allocated portion due to inherent imprecision in the objective processes we utilize to identify probable and estimable losses. This unallocated portion is subjective and requires judgment based on various qualitative factors in the loan portfolio and the market in which we operate. At December 31, 2005 and 2004, respectively, the unallocated portion of the allowance approximated $4,000 and $32,000, or 0.1% and 0.6% of the total allowance. This unallocated portion of the allowance is considered necessary based on consideration of the known risk elements in certain pools of loans in the loan portfolio and our assessment of the economic environment in which we operate. More specifically, while loan quality remains good, the subsidiary banks have typically experienced greater losses within certain homogeneous loan pools when our market area has experienced economic downturns or other significant negative factors or trends, such as increases in bankruptcies, unemployment rates or past due loans.

14

MANAGEMENT’S DISCUSSION AND ANALYSIS



At December 31, 2005 and 2004, our allowance for loan losses totaled $6,152,000, or 0.77% of total loans and $5,073,000 or 0.83% of total loans, respectively, and is considered adequate to cover inherent losses in our loan portfolio. Table VII presents an allocation of the allowance for loan losses by loan type at each respective year end date, as follows:
Table VII - Allocation of the Allowance for Loan Losses
                         
Dollars in thousands
                                     
                                           
   
2005
 
2004
 
2003
 
2002
 
2001
 
   
Amount
 
% of loans in each category to total loans
 
Amount
 
% of loans in each category to total loans
 
Amount
 
% of loans in each category to total loans
 
Amount
 
% of loans in each category to total loans
 
Amount
 
% of loans in each category to total loans
 
Commercial
 
$
4,502
    
62.3
%
$
2,649
    
54.6
%
$
2,353
    
50.8
%
$
2,054
    
49.4
%
$
1,036
    
42.8
%
Real estate
   
1,019
   
32.0
%
  
1,376
   
37.4
%
  
1,127
   
39.4
%
  
939
   
39.6
%
  
985
   
43.8
%
Consumer
   
580
   
4.6
%
  
1,016
   
6.4
%
  
1,174
   
8.2
%
  
998
   
9.5
%
  
937
   
11.8
%
Other
   
47
   
1.1
%
  
-
   
1.6
%
  
13
   
1.6
%
  
-
   
1.5
%
  
-
   
1.6
%
Unallocated
   
4
   
-
   
32
   
-
   
14
   
-
   
62
   
-
   
152
   
-
 
   
$
6,152
    
100.0
%
$
5,073
    
100.0
%
$
4,681
    
100.0
%
$
4,053
    
100.0
%
$
3,110
    
100.0
%

 
At December 31, 2005, we had approximately $378,000 in other real estate owned which was obtained as the result of foreclosure proceedings. Foreclosures have been insignificant throughout 2005 and we do not anticipate any material losses on the property currently held in other real estate owned.

A reconciliation of the activity in the allowance for loan losses follows:

TABLE VIII - ALLOWANCE FOR LOAN LOSSES
                  
Dollars in thousands
                      
                       
 
  
2005
  
2004
  
2003
  
2002
  
2001
  
Balance, beginning of year
  
$
5,073
  
$
4,681
  
$
4,053
  
$
3,110
  
$
2,571
  
Losses:
                                
Commercial, financial & agricultural
    
36
   
478
   
98
   
138
   
108
 
Residential - mortgage
    
204
   
5
   
60
   
30
   
47
 
Consumer
    
173
   
208
   
178
   
173
   
191
 
Other
    
364
   
286
   
73
   
75
   
76
 
Total
    
777
   
977
   
409
   
416
   
422
 
Recoveries:
                                
Commercial, financial & agricultural
    
47
   
46
   
5
   
39
   
10
 
Residential - mortgage
    
-
   
9
   
-
   
17
   
1
 
Consumer
    
56
   
109
   
79
   
71
   
99
 
Other
    
274
   
155
   
38
   
17
   
21
 
Total
    
377
   
319
   
122
   
144
   
131
 
                                 
Net Losses
    
400
   
658
   
287
   
272
   
291
 
Provision for loan losses
    
1,479
   
1,050
   
915
   
1,215
   
830
 
                                 
Balance, end of year
  
$
6,152
  
$
5,073
  
$
4,681
  
$
4,053
  
$
3,110
  

 


15

MANAGEMENT’S DISCUSSION AND ANALYSIS




Bank Liquidity: Liquidity reflects our ability to ensure the availability of adequate funds to meet loan commitments and deposit withdrawals, as well as provide for other transactional requirements. Liquidity is provided primarily by funds invested in cash and due from banks (net of float and reserves), Federal funds sold, non-pledged securities, and available lines of credit with the Federal Home Loan Bank, which totaled approximately $125.2 million or 11.3% of total consolidated assets at December 31, 2005.

Our liquidity strategy is to fund loan growth with deposits and other borrowed funds while maintaining an adequate level of short- and medium-term investments to meet normal daily loan and deposit activity. Core deposits increased $74 million in 2005, while loans increased approximately $192 million. This caused us to rely on other wholesale funding vehicles, which included brokered deposits, which increased $76 million, and FHLB advances, which increased approximately $56 million. As a member of the Federal Home Loan Banks of Pittsburgh and Atlanta, we have access to approximately $396 million. As of December 31, 2005 and 2004, these advances totaled approximately $327 million and $272 million, respectively. At December 31, 2005, we had additional borrowing capacity of $69 million through FHLB programs. We also have the ability to borrow money on a daily basis through correspondent banks using established federal funds purchased lines. These available lines totaled $20 million at December 31, 2005. Also, we classify all of our securities as available for sale to enable us to liquidate them if the need arises.
 
We continuously monitor our liquidity position to ensure that day-to-day as well as anticipated funding needs are met. We are not aware of any trends, commitments, events or uncertainties that have resulted in or are reasonably likely to result in a material change to our liquidity.

 Growth and Expansion: During 2005, we continued our community bank branching strategy in Virginia, by opening our first full service branch in Warrenton, Virginia. We now have 14 total banking offices, and plan to continue to branch in Northwestern Virginia and the Eastern panhandle of West Virginia, with our next branch opening planned in Martinsburg, West Virginia. Our branching strategy is subject to availability of suitable sites, hiring qualified personnel, obtaining regulatory approval, and other conditions and contingencies.

We also continue to seek and enter into business opportunities which earn noninterest income. Accordingly, in first quarter 2004, we acquired a full lines insurance agency in Moorefield, West Virginia.

During 2005, we spent approximately $3.9 million on capital expenditures for premises and equipment. We expect our capital expenditures to approximate $2 million in 2006, primarily for building construction, furniture and equipment related to office openings. Actual expenditures may vary significantly from those expected, primarily depending on the number and cost of additional branch openings.

Capital Compliance: Our capital position remains strong, despite our continued growth. Stated as a percentage of total assets, our equity ratio was 6.7% and 7.4% at December 31, 2005 and 2004, respectively. Our risk weighted Tier 1 capital, total capital and leverage capital ratios approximated 11.4%, 10.7% and 8.6%, respectively, at December 31, 2005, all of which are in excess of the minimum guidelines to be “well capitalized” under the regulatory prompt corrective action provisions. Our subsidiary banks are also subject to minimum capital ratios as further discussed in Note 15 of the accompanying consolidated financial statements.

Issuance of Trust Preferred Securities: In December 2005, we issued an additional $8 million of adjustable rate trust preferred securities (see Note 10 of the accompanying consolidated financial statements). The proceeds from this issuance were used to pay company debt that had been obtained to fund additional capital needs at our subsidiary banks, and to provide us additional regulatory capital to support our growth. Under Federal Reserve Board guidelines, we had the ability to issue an additional $4 million of trust preferred securities as of December 31, 2005 that would qualify as Tier 1 regulatory capital to support our future growth. Trust preferred securities issuances in excess of this limit generally may be included in Tier 2 capital.

Dividends: Cash dividends per share rose 15.4% to $0.30 in 2005 compared to $0.26 in 2004, representing dividend payout ratios of 19.0% and 17.2% for 2005 and 2004, respectively. It is our intention to continue to pay dividends on a similar schedule during 2006. Future cash dividends will depend on the earnings and financial condition of our subsidiary banks as well as general economic conditions.

16

MANAGEMENT’S DISCUSSION AND ANALYSIS



The primary source of funds for the dividends paid to our shareholders is dividends received from our subsidiary banks. Dividends paid by our subsidiary banks are subject to restrictions by banking regulations. The most restrictive provision requires approval by the respective bank’s regulatory agency if dividends declared in any year exceed the bank’s current year's net income, as defined, plus its retained net profits of the two preceding years. During 2006, the net retained profits available for distribution to Summit as dividends without regulatory approval are approximately $18,962,000, plus net income for the interim periods through the date of declaration.

On October 29, 2004, our Board of Directors authorized a 2-for-1 split of our common stock to be effected in the form of a 100% stock dividend which was distributed on December 15, 2004 to shareholders of record as of December 1, 2004.

Contractual Cash Obligations: During our normal course of business, we incur contractual cash obligations. The following table summarizes our contractual cash obligations at December 31, 2005.
 

   
Long Term
     
   
Debt and
      
   
Subordinated
  
Operating
  
 
  
Debentures
  
Leases
  
2006
  
$
21,944,946
  
$
1,068,283
  
2007
    
18,318,204
   
1,019,498
 
2008
    
16,085,851
   
984,275
 
2009
    
2,110,094
   
431,349
 
2010
    
62,734,338
   
116,263
 
Thereafter
    
49,307,402
   
257,140
 
Total
  
$
170,500,835
  
$
3,876,808
  



Off-Balance Sheet Arrangements: We are involved with some off-balance sheet arrangements that have or are reasonably likely to have an effect on our financial condition, liquidity, or capital. These arrangements at December 31, 2005 are presented in the following table. Refer to Note 13 of the accompanying consolidated financial statements for further discussion of our off-balance sheet arrangements. 


Commitments to extend credit:
  
Revolving home equity and
       
credit card lines
  
$
28,721
  
Construction loans
    
100,524
 
Other loans
    
37,926
 
Standby letters of credit
    
11,254
 
Total
  
$
178,425
  


Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to changes in interest rates, exchange rates and equity prices. Interest rate risk is our primary market risk and results from timing differences in the repricing of assets, liabilities and off-balance sheet instruments, changes in relationships between rate indices and the potential exercise of embedded options. The principal objective of asset/liability management is to minimize interest rate risk and our actions in this regard are taken under the guidance of our Asset/Liability Management Committee (“ALCO”). The ALCO is comprised of members of senior management and members of the Board of Directors. The ALCO actively formulates the economic assumptions that we use in our financial planning and budgeting process and establishes policies which control and monitor our sources, uses and prices of funds.


17

MANAGEMENT’S DISCUSSION AND ANALYSIS



Some amount of interest rate risk is inherent and appropriate to the banking business. Our net income is affected by changes in the absolute level of interest rates. Our interest rate risk position is moderately liability sensitive in the short term, and asset sensitive beyond two years. That is, in the short term, liabilities are likely to reprice faster than assets, resulting in a decrease in net income in a rising rate environment. Our net income would increase modestly in a falling interest rate environment. Over the long term, assets are likely to reprice faster than liabilities, resulting in an increase in net income in a rising rate environment while a falling interest rate environment would produce a decrease in net income. Net income is also subject to changes in the shape of the yield curve. In general, a flattening yield curve would result in a decline in our earnings due to the compression of earning asset yields and funding rates, while a steepening would result in increased earnings as margins widen.

Several techniques are available to monitor and control the level of interest rate risk. We primarily use earnings simulations modeling to monitor interest rate risk. The earnings simulation model forecasts the effects on net interest income under a variety of interest rate scenarios that incorporate changes in the absolute level of interest rates and changes in the shape of the yield curve. Each increase or decrease in rates is assumed to take place over a 12 month period, and then remain stable. Assumptions used to project yields and rates for new loans and deposits are derived from historical analysis. Securities portfolio maturities and prepayments are reinvested in like instruments. Mortgage loan prepayment assumptions are developed from industry estimates of prepayment speeds. Noncontractual deposit repricings are modeled on historical patterns.

The following table presents the estimated sensitivity of our net interest income to changes in interest rates, as measured by our earnings simulation model as of December 31, 2005. The sensitivity is measured as a percentage change in net interest income given the stated changes in interest rates (gradual change over 12 months, stable thereafter) compared to net interest income with rates unchanged. The estimated changes set forth below are dependent on the assumptions discussed above and are well within our ALCO policy limit of +/- 10%.
 

Change in
 
Estimated % Change in Net
  
Interest Rates
  
Interest Income Over:
  
(basis points)
  
12 Months
  
24 Months
  
Down 200 (1)
    
0.51
%
  
-0.71
%
Down 200, steepening yield curve (2)
    
1.39
%
  
5.10
%
Up 100 (1)
    
-0.95
%
  
0.03
%
Up 200 (1)
    
-2.71
%
  
-5.22
%
 
(1) assumes a parallel shift in the yield curve
  
(2) assumes steepening curve whereby short term rates decline by
  200 basis points while long term rates decline by 50 basis points
 



 

 
  
 
  
 
  
 
  
 
  
 
  
   
First
  
Second
  
Third
  
Fourth
  
Full
  
(Dollars in thousands, except per share amounts)
 
Quarter
  
Quarter
  
Quarter
  
Quarter
  
Year
  
                       
2005
                                
Interest income
  
$
12,293
  
$
13,524
  
$
14,837
  
$
16,657
  
$
57,311
  
Interest expense
    
5,138
   
5,920
   
7,027
   
8,421
   
26,506
 
Net interest income
    
7,155
   
7,604
   
7,810
   
8,236
   
30,805
 
Provision for loan losses
    
330
   
425
   
424
   
300
   
1,479
 
Securities gains (losses)
    
-
   
5
   
39
   
(1,434
)
  
(1,390
)
Other noninterest income
    
6,667
   
8,210
   
8,426
   
6,961
   
30,264
 
Noninterest expense
    
10,055
   
10,875
   
10,878
   
10,438
   
42,246
 
Income before income taxes
    
3,437
   
4,519
   
4,973
   
3,025
   
15,954
 
Income taxes
    
1,026
   
1,403
   
1,700
   
583
   
4,712
 
Net income
    
2,411
   
3,116
   
3,273
   
2,442
   
11,242
 
Basic earnings per share
    
0.34
   
0.44
   
0.46
   
0.34
   
1.58
 
Diluted earnings per share
    
0.34
   
0.43
   
0.45
   
0.34
   
1.56
 
Dividends paid per share
    
-
   
0.14
   
-
   
0.16
   
0.30
 
                                 
2004
                                
Interest income
  
$
10,873
  
$
11,092
  
$
11,634
  
$
12,138
  
$
45,737
  
Interest expense
    
4,271
   
4,294
   
4,573
   
4,822
   
17,960
 
Net interest income
    
6,602
   
6,798
   
7,061
   
7,316
   
27,777
 
Provision for loan losses
    
233
   
233
   
293
   
291
   
1,050
 
Securities gains (losses)
    
20
   
17
   
(35
)
  
31
   
33
 
Other noninterest income
    
4,922
   
7,415
   
8,580
   
6,302
   
27,219
 
Noninterest expense
    
7,839
   
10,168
   
10,767
   
10,015
   
38,789
 
Income before income taxes
    
3,472
   
3,829
   
4,546
   
3,343
   
15,190
 
Income taxes
    
1,021
   
1,155
   
1,420
   
986
   
4,582
 
Net income
    
2,451
   
2,674
   
3,126
   
2,357
   
10,608
 
Basic earnings per share
    
0.35
   
0.38
   
0.44
   
0.34
   
1.51
 
Diluted earnings per share
    
0.35
   
0.38
   
0.43
   
0.33
   
1.49
 
Dividends paid per share
    
-
   
0.12
   
-
   
0.14
   
0.26
 



19
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
ON EFFECTIVENESS OF INTERNAL CONTROL OVER FINANCIAL REPORTING


                                        
 
 
 
To the Board of Directors
Summit Financial Group, Inc.
Moorefield, West Virginia

We have audited management's assessment, included in the accompanying Report on Management’s Assessment of Internal Control Over Financial Reporting, that Summit Financial Group, Inc. and subsidiaries maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Summit Financial Group, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the company's internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management's assessment that Summit Financial Group, Inc. and subsidiaries maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also in our opinion, Summit Financial Group, Inc. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of Summit Financial Group, Inc. and subsidiaries and our report dated March 3, 2006, expressed an unqualified opinion.


/s/ Arnett & Foster, P.L.L.C.
Charleston, West Virginia
March 3, 2006


20
REPORT OF MANAGEMENT’S ASSESSMENT OF INTERNAL CONTROL
OVER FINANCIAL REPORTING

 

 
Summit Financial Group, Inc. is responsible for the preparation, integrity, and fair presentation of the consolidated financial statements included in this annual report. The consolidated financial statements and notes included in this annual report have been prepared in conformity with United States generally accepted accounting principles and necessarily include some amounts that are based on management’s best estimates and judgments.

We, as management of Summit Financial Group, Inc., are responsible for establishing and maintaining effective internal control over financial reporting that is designed to produce reliable financial statements in conformity with United States generally accepted accounting principles. The system of internal control over financial reporting as it relates to the financial statements is evaluated for effectiveness by management and tested for reliability through a program of internal audits. Actions are taken to correct potential deficiencies as they are identified. Any system of internal control, no matter how well designed, has inherent limitations, including the possibility that a control can be circumvented or overridden and misstatements due to error or fraud may occur and not be detected. Also, because of changes in conditions, internal control effectiveness may vary over time. Accordingly, even an effective system of internal control will provide only reasonable assurance with respect to financial statement preparation.

The Audit Committee, consisting entirely of independent directors, meets regularly with management, internal auditors and the independent registered public accounting firm, and reviews audit plans and results, as well as management’s actions taken in discharging responsibilities for accounting, financial reporting, and internal control. Arnett & Foster, P.L.L.C., independent registered public accounting firm, and the internal auditors have direct and confidential access to the Audit Committee at all times to discuss the results of their examinations.

Management assessed the Corporation’s system of internal control over financial reporting as of December 31, 2005. In making this assessment, we used the criteria for effective internal control over financial reporting set forth in Internal Control-Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this assessment, management concludes that, as of December 31, 2005, its system of internal control over financial reporting is effective and meets the criteria of the Internal Control-Integrated Framework. Arnett & Foster, P.L.L.C., independent registered public accounting firm, has issued an attestation report on management’s assessment of the Corporation’s internal control over financial reporting.



/s/ H. Charles Maddy, III
/s/ Robert S. Tissue                        
/s/  Julie R. Cook
President and
Senior Vice President
Vice President
Chief Executive Officer
and Chief Financial Officer
and Chief Accounting Officer



Moorefield, West Virginia
March 13, 2006


21
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
ON CONSOLIDATED FINANCIAL STATEMENTS




                                       
To the Board of Directors
Summit Financial Group, Inc.
Moorefield, West Virginia

We have audited the accompanying consolidated balance sheets of Summit Financial Group, Inc. and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of income, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2005. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provided 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 Summit Financial Group, Inc. and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Summit Financial Group, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 3, 2006, expressed an unqualified opinion on management’s assessment of the effectiveness of Summit Financial Group, Inc. and subsidiaries’ internal control over financial reporting and an unqualified opinion on the effectiveness of Summit Financial Group, Inc. and subsidiaries’ internal control over financial reporting.


/s/ Arnett & Foster, P.L.L.C.


Charleston, West Virginia
March 3, 2006



 

 
   
December 31,
  
 
  
2005
 
2004
 
ASSETS
             
Cash and due from banks
 
$
22,535,761
  
$
19,416,219
  
Interest bearing deposits with other banks
   
1,536,506
   
2,338,698
 
Federal funds sold
   
3,650,000
   
48,000
 
Securities available for sale
   
223,772,298
   
211,361,504
 
Loans held for sale, net
   
16,584,990
   
14,273,916
 
Loans, net
   
793,766,837
   
602,727,975
 
Property held for sale, net
   
378,287
   
593,137
 
Premises and equipment, net
   
23,089,412
   
20,776,007
 
Accrued interest receivable
   
4,835,763
   
3,651,907
 
Intangible assets
   
3,347,672
   
3,498,824
 
Other assets
   
16,034,499
   
10,802,330
 
Total assets
 
$
1,109,532,025
  
$
889,488,517
  
               
LIABILITIES AND SHAREHOLDERS' EQUITY
             
Liabilities
             
  Deposits
             
   Non-interest bearing
 
$
62,631,410
  
$
55,401,552
  
    Interest bearing
   
611,269,308
   
469,212,146
 
Total deposits
   
673,900,718
   
524,613,698
 
Short-term borrowings
   
182,028,113
   
120,629,214
 
Long-term borrowings
   
150,911,835
   
160,860,182
 
Subordinated debentures owed to unconsolidated subsidiary trusts
   
19,589,000
   
11,341,000
 
Other liabilities
   
9,299,134
   
6,336,402
 
Total liabilities
   
1,035,728,800
   
823,780,496
 
Commitments and Contingencies
             
               
Shareholders' Equity
             
Preferred stock and related surplus, $1.00 par value; authorized
             
     250,000 shares, 2004 - 33,400 shares issued
   
-
   
1,158,471
 
Common stock and related surplus, $2.50 par value; authorized 20,000,000;
             
     issued 2005 - 7,126,220 shares; 2004 - 7,155,420 shares
   
18,856,774
   
18,123,492
 
Retained earnings
   
56,214,807
   
47,108,898
 
Less cost of shares acquired for the treasury, 2004 - 115,880 shares
   
-
   
(627,659
)
Accumulated other comprehensive income
   
(1,268,356
)
  
(55,181
)
Total shareholders' equity
   
73,803,225
   
65,708,021
 
               
Total liabilities and shareholders' equity
 
$
1,109,532,025
  
$
889,488,517
  

See notes to consolidated financial statements
 

23

CONSOLIDATED FINANCIAL STATEMENTS 

   
For the Year Ended December 31,
  
 
  
2005
  
2004
  
2003
  
Interest income
             
Interest and fees on loans
                   
Taxable
 
$
47,582,262
  
$
35,768,855
  
$
30,842,054
  
Tax-exempt
   
419,541
   
437,658
   
323,148
 
Interest and dividends on securities
                   
Taxable
   
7,076,226
   
7,194,736
   
7,952,074
 
Tax-exempt
   
2,124,699
   
2,208,424
   
1,936,831
 
Interest on interest bearing deposits with other banks
   
90,563
   
123,036
   
151,068
 
Interest on Federal Funds sold
   
18,194
   
4,117
   
18,391
 
Total interest income
   
57,311,485
   
45,736,826
   
41,223,566
 
Interest expense
                   
Interest on deposits
   
13,401,988
   
9,710,108
   
9,998,904
 
Interest on short-term borrowings
   
4,824,365
   
1,203,395
   
441,447
 
Interest on long-term borrowings and subordinated debentures
   
8,279,489
   
7,046,299
   
7,089,635
 
Total interest expense
   
26,505,842
   
17,959,802
   
17,529,986
 
Net interest income
   
30,805,643
   
27,777,024
   
23,693,580
 
Provision for loan losses
   
1,479,400
   
1,050,000
   
915,000
 
Net interest income after provision for loan losses
   
29,326,243
   
26,727,024
   
22,778,580
 
Noninterest income
                   
Insurance commissions
   
852,664
   
527,492
   
239,356
 
Service fees
   
2,589,234
   
2,237,887
   
1,585,778
 
Mortgage origination revenue
   
26,370,978
   
24,088,909
   
3,137,702
 
Realized securities gains (losses)
   
110,012
   
33,471
   
211,897
 
Unrealized securities gains (losses)
   
(1,500,000
)
  
-
   
-
 
Gain (loss) on sale of assets
   
(198,460
)
  
(29,183
)
  
335,969
 
Other
   
649,776
   
393,561
   
313,687
 
Total noninterest income
   
28,874,204
   
27,252,137
   
5,824,389
 
Noninterest expenses
                   
Salaries and employee benefits
   
20,315,017
   
18,087,278
   
9,004,422
 
Net occupancy expense
   
1,881,063
   
1,502,583
   
868,261
 
Equipment expense
   
1,911,076
   
1,776,004
   
1,320,353
 
Supplies
   
658,260
   
666,061
   
481,157
 
Professional fees
   
969,794
   
821,225
   
564,477
 
Postage
   
5,862,812
   
5,851,393
   
984,929
 
Advertising
   
4,878,312
   
4,724,647
   
772,358
 
Amortization of intangibles
   
151,152
   
151,152
   
151,152
 
Other
   
5,618,975
   
5,208,730
   
2,736,579
 
Total noninterest expenses
   
42,246,461
   
38,789,073
   
16,883,688
 
Income before income tax expense
   
15,953,986
   
15,190,088
   
11,719,281
 
Income tax expense
   
4,711,582
   
4,581,715
   
3,510,925
 
Net income
 
$
11,242,404
  
$
10,608,373
  
$
8,208,356
  
                     
Basic earnings per common share
 
$
1.58
  
$
1.51
  
$
1.17
  
                     
Diluted earnings per common share
 
$
1.56
  
$
1.49
  
$
1.16
  
                     
Average common shares outstanding
                   
Basic
   
7,093,402
   
7,025,118
   
7,010,007
 
Diluted
   
7,206,838
   
7,121,761
   
7,073,287
 
 
 

See notes to consolidated financial statements
 

24

CONSOLIDATED FINANCIAL STATEMENTS 

For the Years Ended December 31, 2005, 2004 and 2003
 

       
 
                  
 
  
Preferred
 
Common
 
 
  
 
  
Accumulated
 
 
  
   
Stock and
 
Stock and
         
Other
 
Total
 
   
Related
 
Related
 
Retained
 
Treasury
 
Comprehensive
 
Shareholders'
 
 
  
Surplus
 
Surplus
 
Earnings
 
Stock
 
Income
 
Equity
 
Balance, December 31, 2002
   
-
   
17,808,990
   
31,627,634
   
(619,711
)
  
3,262,883
   
52,079,796
 
Comprehensive income:
                                     
Net income
   
-
   
-
   
8,208,356
   
-
   
-
   
8,208,356
 
Other comprehensive income,
                                     
net of deferred tax (benefit) of ($1,003,928):
                                     
Net unrealized (loss) on
                                     
securities of ($1,506,611), net
                                     
of reclassification adjustment
                                     
for gains included in net
                                     
income of $131,376
   
-
   
-
   
-
   
-
   
(1,637,987
)
  
(1,637,987
)
Total comprehensive income
                                 
6,570,369
 
Exercise of stock options
   
-
   
53,265
   
-
   
-
   
-
   
53,265
 
Purchase of 800 shares for treasury
   
-
   
-
   
-
   
(7,948
)
  
-
   
(7,948
)
Cash dividends declared ($0.215 per share)
   
-
   
-
   
(1,507,939
)
  
-
   
-
   
(1,507,939
)
Balance, December 31, 2003
   
-
   
17,862,255
   
38,328,051
   
(627,659
)
  
1,624,896
   
57,187,543
 
Comprehensive income:
                                     
Net income
   
-
   
-
   
10,608,373
   
-
   
-
   
10,608,373
 
Other comprehensive income,
                                     
net of deferred tax (benefit) of ($1,029,725):
                                     
Net unrealized (loss) on
                                     
securities of ($1,659,325), net
                                     
of reclassification adjustment
                                     
for gains included in net
                                     
income of $20,752
   
-
   
-
   
-
   
-
   
(1,680,077
)
  
(1,680,077
)
Total comprehensive income
                                 
8,928,296
 
Exercise of stock options
   
-
   
261,237
   
-
   
-
   
-
   
261,237
 
Issuance of preferred stock
   
1,158,471
   
-
   
-
   
-
   
-
   
1,158,471
 
Cash dividends declared ($0.26 per share)
   
-
   
-
   
(1,827,526
)
  
-
   
-
   
(1,827,526
)
Balance, December 31, 2004
   
1,158,471
   
18,123,492
   
47,108,898
   
(627,659
)
  
(55,181
)
  
65,708,021
 
Comprehensive income:
                                     
Net income
   
-
   
-
   
11,242,404
   
-
   
-
   
11,242,404
 
Other comprehensive income,
                                     
net of deferred tax (benefit) of ($743,559):
                                     
Net unrealized (loss) on
                                     
securities of ($2,074,968), net
                                     
of reclassification adjustment
                                     
for losses included in net
                                     
income of ($861,793)
   
-
   
-
   
-
   
-
   
(1,213,175
)
  
(1,213,175
)
Total comprehensive income
                                 
10,029,229
 
Exercise of stock options
   
-
   
202,470
   
-
   
-
   
-
   
202,470
 
Conversion of preferred shares
   
(1,158,471
)
  
1,158,471
   
-
   
-
   
-
   
-
 
Retirement of treasury shares
         
(627,659
)
  
-
   
627,659
         
-
 
Cash dividends declared ($0.30 per share)
   
-
   
-
   
(2,136,495
)
  
-
   
-
   
(2,136,495
)
Balance, December 31, 2005
 
$
-
  
$
18,856,774
  
$
56,214,807
  
$
-
  
$
(1,268,356
)
$
73,803,225
  


See notes to consolidated financial statements
 

25

CONSOLIDATED FINANCIAL STATEMENTS 

 
 

   
For the Year Ended December 31,
 
   
2005
  
2004
  
2003
  
CASH FLOWS FROM OPERATING ACTIVITIES
                   
Net income
 
$
11,242,404
  
$
10,608,373
  
$
8,208,356
  
Adjustments to reconcile net earnings to
                   
net cash provided by operating activities:
                   
Depreciation
   
1,680,779
   
1,506,698
   
1,058,354
 
Provision for loan losses
   
1,479,400
   
1,050,000
   
915,000
 
Deferred income tax (benefit)
   
(1,014,918
)
  
(449,935
)
  
(368,650
)
Loans originated for sale
   
(314,600,774
)
  
(259,316,402
)
  
(62,670,581
)
Proceeds from loans sold
   
323,146,988
   
260,478,758
   
58,184,770
 
(Gains) on loans sold
   
(10,857,288
)
  
(9,083,436
)
  
(960,125
)
Security (gains) losses
   
(110,012
)
  
(33,471
)
  
(211,897
)
Writedown of preferred stock
   
1,500,000
         
-
 
(Gain) loss on disposal of premises, equipment and other assets
   
198,460
   
29,183
   
(171,590
)
Amortization of securities premiums (accretion
                   
of discounts), net
   
653,483
   
848,775
   
1,341,955
 
Amortization of goodwill and purchase
                   
accounting adjustments, net
   
162,684
   
176,340
   
171,010
 
Tax benefit of exercise of stock options
   
77,000
   
141,000
   
-
 
(Increase) decrease in accrued interest receivable
   
(1,183,856
)
  
126,233
   
248,049
 
(Increase) in other assets
   
(920,936
)
  
(684,038
)
  
(910,575
)
Increase (decrease) in other liabilities
   
1,995,379
   
1,106,824
   
1,174,571
 
Net cash provided by operating activities
   
13,448,793
   
6,504,902
   
6,008,647
 
CASH FLOWS FROM INVESTING ACTIVITIES
                   
Proceeds from maturities and calls of
                   
securities available for sale
   
9,216,910
   
22,532,825
   
33,368,900
 
Proceeds from sales of securities available for sale
   
18,386,829
   
49,689,639
   
12,206,105
 
Principal payments received on securities available for sale
   
32,085,084
   
35,379,512
   
89,184,506
 
Purchases of securities available for sale
   
(76,054,905
)
  
(87,029,752
)
  
(161,303,052
)
Net (increase) decrease in federal funds sold
   
(3,602,000
)
  
196,000
   
3,146,135
 
Net loans made to customers
   
(192,861,006
)
  
(105,705,168
)
  
(85,792,687
)
Purchases of premises and equipment
   
(3,994,963
)
  
(4,463,284
)
  
(8,273,263
)
Proceeds from sales of premises, equipment and other assets
   
419,351
   
351,425
   
2,890,424
 
(Purchases of) proceeds from interest bearing deposits with other banks
   
802,192
   
802,394
   
(955,723
)
Purchases of life insurance contracts
   
(2,500,000
)
  
-
   
-
 
Net cash paid in acquisition of Sager Insurance Agency
   
-
   
(850,000
)
  
-
 
Net cash (used in) investing activities
   
(218,102,508
)
  
(89,096,409
)
  
(115,528,655
)
CASH FLOWS FROM FINANCING ACTIVITIES
                 
Net increase in demand deposit,
                   
NOW and savings accounts
   
79,765,031
   
17,112,187
   
18,275,248
 
Net increase (decrease) in time deposits
   
69,630,895
   
(4,299,909
)
  
34,940,815
 
Net increase (decrease) in short-term borrowings
   
61,398,899
   
70,914,968
   
29,523,143
 
Proceeds from long-term borrowings
   
32,764,000
   
23,326,000
   
37,320,000
 
Repayments of long-term borrowings
   
(41,774,543
)
  
(26,315,072
)
  
(6,134,767
)
Net proceeds from issuance of trust preferred securities
   
8,000,000
   
7,406,250
   
-
 
Purchases of treasury stock
   
-
   
-
   
(7,948
)
Net proceeds from issuance of preferred stock
   
-
   
1,158,471
   
-
 
Exercise of stock options
   
125,470
   
120,237
   
53,265
 
Dividends paid
   
(2,136,495
)
  
(1,827,526
)
  
(1,507,939
)
Net cash provided by financing activities
   
207,773,257
   
87,595,606
   
112,461,817
 
Increase (decrease) in cash and due from banks
   
3,119,542
   
5,004,099
   
2,941,809
 
Cash and due from banks:
                   
Beginning
   
19,416,219
   
14,412,120
   
11,470,311
 
Ending
 
$
22,535,761
  
$
19,416,219
  
$
14,412,120
  


See notes to consolidated financial statements
 

 
26

CONSOLIDATED FINANCIAL STATEMENTS

 
Consolidated Statements of Cash Flows-continued


   
For the Year Ended December 31,
 
 
  
2005
 
2004
 
2003
 
SUPPLEMENTAL DISCLOSURES OF CASH
             
FLOW INFORMATION
             
Cash payments for:
                   
Interest
 
$
25,528,195
  
$
18,045,519
  
$
17,346,163
  
Income taxes
 
$
5,245,000
  
$
5,030,534
  
$
3,420,000
  
                     
SUPPLEMENTAL SCHEDULE OF NONCASH
                   
INVESTING AND FINANCING ACTIVITIES
                   
Other assets acquired in settlement of loans
 
$
342,744
  
$
515,593
  
$
779,896
  
Acquisition of Sager Insurance Agency:
                   
Net cash and cash equivalents paid in acquisition of Sager Insurance
                   
Agency
 
$
-
  
$
850,000
  
$
-
  
Fair value of assets acquired (principally building and land)
 
$
-
  
$
250,000
  
$
-
  
Goodwill
   
-
   
600,000
   
-
 
 
  
$
-
  
$
850,000
  
$
-
  
                     
Noncash investment in unconsolidated subsidiary trust
 
$
248,000
  
$
232,000
  
$
-
  

 

 
See notes to consolidated financial statements
 

27

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


 

NOTE 1. SIGNIFICANT ACCOUNTING POLICIES

Nature of business: Summit Financial Group, Inc. (“We”, “Company” or “Summit”) is a financial holding company headquartered in Moorefield, West Virginia. We operate two primary business segments, community banking and mortgage banking. Our community banking segment provides commercial and retail banking services primarily in the Eastern Panhandle and South Central regions of West Virginia and the Northern region of Virginia. We provide these services through our two community bank subsidiaries: Summit Community Bank (“Summit Community”) and Shenandoah Valley National Bank (“Shenandoah”) (collectively, the “Bank Subsidiaries”). Summit Mortgage, our mortgage banking segment, originates loans to customers throughout the United States from its headquarters in Chesapeake, Virginia. We also operate Summit Insurance Services, LLC.

Basis of financial statement presentation: Our accounting and reporting policies conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry.

Use of estimates: We must make estimates and assumptions that affect the reported amounts and disclosures in preparing our financial statements in conformity with accounting principles generally accepted in the United States of America. Actual results could differ from those estimates.

Principles of consolidation: The accompanying consolidated financial statements include the accounts of Summit and its subsidiaries. All significant accounts and transactions among these entities have been eliminated.

Presentation of cash flows: For purposes of reporting cash flows, cash and due from banks includes cash on hand and amounts due from banks (including cash items in process of clearing). Cash flows from federal funds sold, demand deposits, NOW accounts, savings accounts and short-term borrowings are reported on a net basis, since their original maturities are less than three months. Cash flows from loans and certificates of deposit and other time deposits are reported net.

Securities: We classify debt and equity securities as “held to maturity”, “available for sale” or “trading” according to management’s intent. The appropriate classification is determined at the time of purchase of each security and re-evaluated at each reporting date.

Securities held to maturity - Certain debt securities for which we have the positive intent and ability to hold to maturity are reported at cost, adjusted for amortization of premiums and
accretion of discounts. There are no securities classified as held to maturity in the accompanying financial statements.  
 
Securities available for sale - Securities not classified as "held to maturity" or as "trading" are classified as "available for sale." Securities classified as "available for sale" are those
securities that we intend to hold for an indefinite period of time, but not necessarily to maturity. "Available for sale" securities
are reported at estimated fair value net of unrealized gains or losses, which are adjusted for applicable income taxes, and reported as a separate component of shareholders' equity.

Trading securities - There are no securities classified as "trading" in the accompanying financial statements.

We review our securities portfolio quarterly for possible other-than-temporary impairment. This determination requires significant judgment. In making this judgment, Management evaluates the facts and circumstances of each individual investment such as the severity of loss, the length of time the fair value has been below cost, the expectation for that security’s performance, the creditworthiness of the issuer and our intent and ability to hold the security. A decline in value that is considered to be other-than-temporary is recorded as a loss within noninterest income in the Consolidated Financial Statements.

Realized gains and losses on sales of securities are recognized on the specific identification method. Amortization of premiums and accretion of discounts are computed using the interest method.

Loans held for sale: Loans held for sale are valued at the lower of aggregate carrying cost or fair value. Gains or losses realized on the sales of loans are recognized at the time of sale. These gains and losses are included in mortgage origination revenue.

  Loans and allowance for loan losses: Loans are generally stated at the amount of unpaid principal, reduced by unearned discount and allowance for loan losses

The allowance for loan losses is maintained at a level considered adequate to provide for losses that can be reasonably anticipated. The allowance is increased by provisions charged to operating expense and reduced by net charge-offs. We make continuous credit reviews of the loan portfolio and consider current economic conditions, historical loan loss experience, review of specific problem loans and other potential risk factors in determining the adequacy of the allowance for loan losses. Loans are charged against the allowance for loan losses when we believe that collectibility is unlikely. While we use the best information available to make our evaluation, future adjustments may be necessary if there are significant changes in conditions.

A loan is impaired when, based on current information and events, it is probable that we will be unable to collect all amounts due in accordance with the contractual terms of the
 
 
28

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


specific loan agreement. Impaired loans, other than certain large groups of smaller-balance homogeneous loans that are collectively evaluated for impairment, are required to be reported at the present value of expected future cash flows discounted using the loan's original effective interest rate or, alternatively, at the loan's observable market price, or at the fair value of the loan's collateral if the loan is collateral dependent. The method selected to measure impairment is made on a loan-by-loan basis, unless foreclosure is deemed to be probable, in which case the fair value of the collateral method is used.

Generally, after our evaluation, loans are placed on nonaccrual status when principal or interest is greater than 90 days past due based upon the loan's contractual terms. Interest is accrued daily on impaired loans unless the loan is placed on nonaccrual status. Impaired loans are placed on nonaccrual status when the payments of principal and interest are in default for a period of 90 days, unless the loan is both well-secured and in the process of collection. Interest on nonaccrual loans is recognized primarily using the cost-recovery method.

Interest on loans is accrued daily on the outstanding balances.
 
Loan origination fees and certain direct loan origination costs are deferred and amortized as adjustments of the related loan yield over its contractual life.

Property held for sale: Property held for sale consists of premises qualifying as held for sale under Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-lived Assets, and of real estate acquired through foreclosure on loans secured by such real estate. Qualifying premises are transferred to property held for sale at the lower of carrying value or estimated fair value less anticipated selling costs. Foreclosed property is recorded at the estimated fair value less anticipated selling costs based upon the property’s appraised value at the date of foreclosure, with any difference between the fair value of foreclosed property and the carrying value of the related loan charged to the allowance for loan losses. We perform periodic valuations of property held for sale subsequent to transfer. Gains or losses not previously recognized resulting from the sale of property held for sale is recognized on the date of sale. Changes in value subsequent to transfer are recorded in noninterest income. Depreciation is not recorded on property held for sale. Expenses incurred in connection with operating foreclosed properties are charged to noninterest expense.

Premises and equipment: Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed primarily by the straight-line method for premises and equipment over the estimated useful lives of the assets. The estimated useful lives employed are on average 30 years for premises and 3 to 10 years for furniture and equipment. Repairs and maintenance expenditures are charged to operating expenses as incurred. Major improvements and additions to premises and equipment, including construction period interest costs, are capitalized. Total interest capitalized
during 2003 was approximately $40,000. No interest was capitalized during 2005 or 2004.

Intangible assets: Goodwill and certain other intangible assets with indefinite useful lives are not amortized into net income over an estimated life, but rather are tested at least annually for impairment. Intangible assets determined to have definite useful lives are amortized over their estimated useful lives and also are subject to impairment testing.

Securities sold under agreements to repurchase: We generally account for securities sold under agreements to repurchase as collateralized financing transactions and record them at the amounts at which the securities were sold, plus accrued interest. Securities, generally U.S. government and Federal agency securities, pledged as collateral under these financing arrangements cannot be sold or repledged by the secured party. The fair value of collateral provided is continually monitored and additional collateral is provided as needed.

Advertising: Direct response advertising is recorded as a prepaid asset and amortized to expense generally over a one month period. Our prepaid direct response advertising included in other assets approximated $563,000 and $431,000 December 31, 2005 and 2004, respectively. All other advertising costs are expensed as incurred.
 
Guarantees: In November 2002, the FASB issued FASB Interpretation No. 45 (FIN 45), Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. This interpretation expands the disclosures to be made by a guarantor in its financial statements about its obligations under certain guarantees and requires the guarantor to recognize a liability for the fair value of an obligation assumed under a guarantee. FIN 45 clarifies the requirements of SFAS 5, Accounting for Contingencies, relating to guarantees. In general, FIN 45 applies to contracts or indemnification agreements that contingently require the guarantor to make payments to the guaranteed party based on changes in an underlying that is related to an asset, liability, or equity security of the guaranteed party. Certain guarantee contracts are excluded from both the disclosure and recognition requirements of this interpretation, including, among others, guarantees relating to employee compensation, residual value guarantees under capital lease arrangements, commercial letters of credit, loan commitments, subordinated interests in an SPE, and guarantees of a company’s own future performance. Other guarantees are subject to the disclosure requirements of FIN 45 but not to the recognition provisions and include, among others, a guarantee accounted for as a derivative instrument
 
29

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


under SFAS 133, a parent’s guarantee of debt owed to a third party by its subsidiary or vice versa, and a guarantee which is based on performance, not price.

Income taxes: The consolidated provision for income taxes includes Federal and state income taxes and is based on pretax net income reported in the consolidated financial statements, adjusted for transactions that may never enter
into the computation of income taxes payable. Deferred tax assets and liabilities are determined based on the differences between the financial statement and tax basis of assets and liabilities that will result in taxable or deductible amounts in the future based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. Valuation allowances are established when deemed necessary to reduce deferred tax assets to the amount expected to be realized.

Stock-based compensation: In accordance with Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, we have elected to follow Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees, and related interpretations in accounting for our employee stock options.

Basic and diluted earnings per share: Basic earnings per share is computed by dividing net income by the weighted-average number of shares of common stock outstanding. Diluted earnings per share is computed by dividing net income by the weighted-average number of shares outstanding increased by the number of shares of common stock which would be issued assuming the exercise of employee stock options and the conversion of preferred stock.

Trust services: Assets held in an agency or fiduciary capacity are not our assets and are not included in the accompanying consolidated balance sheets. Trust services income is recognized on the cash basis in accordance with customary banking practice. Reporting such income on a cash basis rather than the accrual basis does not have a material effect on net income.

Derivative instruments and hedging activities: In accordance with SFAS 133, Accounting for Derivative Instruments and Hedging Activities, as amended, all derivative instruments are recorded on the balance sheet at fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and, if it is, depending on the type of hedge transaction.

   Fair-value hedges - For transactions in which we are hedging changes in fair value of an asset, liability, or a firm commitment, changes in the fair value of the derivative instrument are generally offset in the income statement by changes in the hedged item’s fair value.

Cash-flow hedges - For transactions in which we are hedging the variability of cash flows related to a variable-rate asset, liability, or a forecasted transaction, changes in the fair value of the derivative instrument are reported in other comprehensive income. The gains and losses on the derivative instrument, which are reported in comprehensive income, are reclassified to earnings in the periods in which earnings are impacted by the variability of cash flows of the hedged item.

The ineffective portion of all hedges is recognized in current period earnings.

Other derivative instruments used for risk management purposes do not meet the hedge accounting criteria and, therefore, do not qualify for hedge accounting. These derivative instruments are accounted for at fair value with changes in fair value recorded in the income statement.

During 2005, 2004, and 2003 we were party to instruments that qualified for fair-value hedge accounting and other instruments that were held for risk management purposes that did not qualify for hedge accounting.

Variable interest entities: In accordance with FIN 46-R, Consolidation of Variable Interest Entities, business enterprises that represent the primary beneficiary of another entity by retaining a controlling interest in that entity's assets, liabilities and results of operations must consolidate that entity in its financial statements. Prior to the issuance of FIN 46-R, consolidation generally occurred when an enterprise controlled another entity through voting interests. If applicable, transition rules allow the restatement of financial statements or prospective application with a cumulative effect adjustment. We have determined that the provisions of FIN 46-R do not require consolidation of subsidiary trusts which issue guaranteed preferred beneficial interests in subordinated debentures (Trust Preferred Securities). The Trust Preferred Securities continue to qualify as Tier 1 capital for regulatory purposes. The banking regulatory agencies have not issued any guidance which would change the regulatory capital treatment for the Trust Preferred Securities based on the adoption of FIN 46-R. The adoption of the provisions of FIN 46-R has had no material impact on our results of operations, financial condition, or liquidity. See Note 10 of our Notes to Consolidated Financial Statements for a discussion of our subordinated debentures.

Loan commitments: Statement of Financial Accounting Standards No. 149 (“SFAS 149”), Amendment of Statement 133 on Derivative Instruments and Hedging Activities requires that
 
30

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


commitments to make mortgage loans should be accounted for as derivatives if the loans are to be held for sale, because the commitment represents a written option and accordingly is recorded at the fair value of the option liability. The adoption of SFAS 149 did not have a material impact on our results of operations, financial position, or liquidity.
 
Reclassifications: Certain accounts in the consolidated financial statements for 2004 and 2003, as previously presented, have been reclassified to conform to current year classifications.

NOTE 2.  SIGNIFICANT NEW ACCOUNTING PRONOUNCEMENTS

Stock-based compensation: In December 2004, the Financial Accounting Standards Board (FASB) issued revised statement 123, Share-Based Payment (Revised 2004). SFAS
123R establishes accounting requirements for share-based compensation to employees. SFAS 123R eliminates our ability to account for stock-based compensation using APB 25 effective January 1, 2006 for all equity awards granted after the effective date. SFAS 123R requires us to recognize compensation expense based on the estimated number of stock awards expected to actually vest, exclusive of the awards expected to be forfeited. The adoption of this standard is not expected to have a material impact on our financial condition, results of operations, or liquidity.

 
NOTE 3. SECURITIES

The amortized cost, unrealized gains and losses, and estimated fair values of securities at December 31, 2005 and 2004, are summarized as follows:
 
 
  
2005
 
   
Amortized
 
Unrealized
 
Estimated
 
 
  
Cost
 
Gains
 
Losses
 
Fair Value
 
Available for sale
                 
Taxable:
                 
U. S. Government agencies
                 
and corporations
 
$
40,227,124
  
$
33,754
  
$
426,554
  
$
39,834,324
  
Mortgage-backed securities
   
117,530,036
   
150,766
   
2,884,861
   
114,795,941
 
State and political subdivisions
   
3,741,271
   
219
   
-
   
3,741,490
 
Corporate debt securities
   
3,294,123
   
37,063
   
2,206
   
3,328,980
 
Federal Reserve Bank stock
   
571,500
   
-
   
-
   
571,500
 
Federal Home Loan Bank stock
   
15,761,400
   
-
   
-
   
15,761,400
 
Other equity securities
   
150,410
   
-
   
-
   
150,410
 
Total taxable
   
181,275,864
   
221,802
   
3,313,621
   
178,184,045
 
Tax-exempt:
                         
State and political subdivisions
   
38,529,013
   
1,191,186
   
74,709
   
39,645,490
 
Other equity securities
   
5,978,611
   
-
   
35,848
   
5,942,763
 
Total tax-exempt
   
44,507,624
   
1,191,186
   
110,557
   
45,588,253
 
Total
 
$
225,783,488
  
$
1,412,988
  
$
3,424,178
  
$
223,772,298
  


31

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


 
 
  
2004
 
   
Amortized
 
Unrealized
 
Estimated
 
 
  
Cost
 
Gains
 
Losses
 
Fair Value
 
Available for sale
                 
Taxable:
                 
U. S. Government agencies
                         
and corporations
 
$
21,429,728
  
$
154,012
  
$
37,242
  
$
21,546,498
  
Mortgage-backed securities
   
118,872,576
   
513,765
   
1,029,288
   
118,357,053
 
State and political subdivisions
   
3,745,196
   
8,954
   
-
   
3,754,150
 
Corporate debt securities
   
5,000,328
   
180,939
   
-
   
5,181,267
 
Federal Reserve Bank stock
   
436,500
   
-
   
-
   
436,500
 
Federal Home Loan Bank stock
   
13,843,100
   
-
   
-
   
13,843,100
 
Other equity securities
   
175,535
   
-
   
-
   
175,535
 
Total taxable
   
163,502,963
   
857,670
   
1,066,530
   
163,294,103
 
Tax-exempt:
                         
State and political subdivisions
   
40,475,405
   
1,508,540
   
24,043
   
41,959,902
 
Other equity securities
   
7,482,503
   
-
   
1,375,004
   
6,107,499
 
Total tax-exempt
   
47,957,908
   
1,508,540
   
1,399,047
   
48,067,401
 
Total
 
$
211,460,871
  
$
2,366,210
  
$
2,465,577
  
$
211,361,504
  



We held 155 available for sale securities having an unrealized loss at December 31, 2005. Provided below is a summary of securities available for sale which were in an unrealized loss position at December 31, 2005 and 2004. We have the ability and intent to hold these securities until such time as the value recovers or the securities mature. Further, we believe that the decline in value is attributable to changes in market interest rates and not credit quality of the issuer, as all are rated AA or better, and no additional impairment is warranted at this time.
During 2005, we recognized a $1.5 million pre-tax fourth quarter other-than-temporary non-cash impairment charge, which equals $940,000 on an after-tax basis. This impairment charge relates to $5.7 million of certain preferred stock issuances of the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation which Summit continues to own, and was made primarily due to difficulty in accurately projecting the future recovery period of these securities. Although the securities are still rated as investment grade, we recognized the impairment charge at this time, in accordance with generally accepted accounting principles (“GAAP”).
 

 
  
2005
  
   
Less than 12 months
  
12 months or more
  
Total
  
   
Estimated
 
Unrealized
  
Estimated
 
Unrealized
 
Estimated
 
Unrealized
 
 
  
Fair Value
  
Loss
  
Fair Value
  
Loss
  
Fair Value
  
Loss
  
Taxable:
                         
U. S. Government agencies
                                     
and corporations
 
$
25,474,029
  
$
(255,281
)
$
9,387,858
  
$
(171,276
)
$
34,861,887
  
$
(426,557
)
Mortgage-backed securities
   
41,326,014
   
(711,403
)
  
60,441,083
   
(2,175,663
)
  
101,767,097
   
(2,887,066
)
Tax-exempt:
                                     
State and political subdivisions
   
3,658,564
   
(41,183
)
  
1,553,065
   
(33,524
)
  
5,211,629
   
(74,707
)
Other equity securties
   
-
   
-
   
1,702,763
   
(35,848
)
  
1,702,763
   
(35,848
)
Total temporarily impaired securities
 
$
70,458,607
  
$
(1,007,867
)
$
73,084,769
  
$
(2,416,311
)
$
143,543,376
  
$
(3,424,178
)


32

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS




 
  
2004
  
   
Less than 12 months
  
12 months or more
  
Total
  
   
Estimated
 
Unrealized
  
Estimated
 
Unrealized
 
Estimated
 
Unrealized
 
 
  
Fair Value
  
Loss
  
Fair Value
  
Loss
  
Fair Value
  
Loss
  
Taxable:
                         
U. S. Government agencies
                                     
and corporations
 
$
8,280,339
  
$
(37,242
)
$
-
  
$
-
  
$
8,280,339
  
$
(37,242
)
Mortgage-backed securities
   
79,186,543
   
(936,776
)
  
5,717,127
   
(92,512
)
  
84,903,670
   
(1,029,288
)
Tax-exempt:
                                     
State and political subdivisions
   
2,293,686
   
(24,043
)
  
-
   
-
   
2,293,686
   
(24,043
)
Other equity securties
   
1,495,376
   
(4,625
)
  
4,612,123
   
(1,370,379
)
  
6,107,499
   
(1,375,004
)
Total temporarily impaired securities
 
$
91,255,944
  
$
(1,002,686
)
$
10,329,250
  
$
(1,462,891
)
$
101,585,194
  
$
(2,465,577
)


 
Federal Reserve Bank stock and Federal Home Loan Bank stock are equity securities, which are included in securities available for sale in the accompanying consolidated financial statements. Such securities are carried at cost, since they may only be sold back to the respective Federal Reserve Bank or Federal Home Loan Bank at par value.

Mortgage-backed obligations having contractual maturities ranging from 1 to 30 years, are reflected in the following maturity distribution schedules based on their anticipated average life to maturity, which ranges from 1 to 10 years. Accordingly, discounts are accreted and premiums are amortized over the anticipated average life to maturity of the specific obligation.

The proceeds from sales, calls and maturities of securities, including principal payments received on mortgage-backed obligations and the related gross gains and losses realized are as follows:

   
Proceeds from
  
Gross realized
  
       
Calls and
  
Principal
          
Years ended December 31,
  
Sales
  
Maturities
  
Payments
  
Gains
  
Losses
  
2005
                                
Securities available for sale
  
$
18,386,828
  
$
9,216,910
  
$
32,085,084
  
$
166,868
  
$
56,856
  
   
$
18,386,828
  
$
9,216,910
  
$
32,085,084
  
$
166,868
  
$
56,856
  
2004
                                
Securities available for sale
  
$
49,689,639
  
$
22,532,825
  
$
35,379,512
  
$
409,644
  
$
376,173
  
   
$
49,689,639
  
$
22,532,825
  
$
35,379,512
  
$
409,644
  
$
376,173
  
2003
                                
Securities available for sale
  
$
12,206,105
  
$
33,368,900
  
$
89,184,506
  
$
334,597
  
$
122,700
  
   
$
12,206,105
  
$
33,368,900
  
$
89,184,506
  
$
334,597
  
$
122,700
  

The maturities, amortized cost and estimated fair values of securities at December 31, 2005, are summarized as follows:


 

   
Amortized
 
Estimated
 
 
  
Cost
 
Fair Value
 
           
Due in one year or less
 
$
39,979,270
  
$
39,437,073
  
Due from one to five years
   
109,257,627
   
107,025,823
 
Due from five to ten years
   
31,113,195
   
31,127,631
 
Due after ten years
   
22,971,475
   
23,755,698
 
Equity securities
   
22,461,921
   
22,426,073
 
Total
 
$
225,783,488
  
$
223,772,298
  

 
At December 31, 2005 and 2004, securities with estimated fair values of $92,532,692 and $84,647,104, respectively, were pledged to secure public deposits, and for other purposes required or permitted by law.


33

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


 
NOTE 4. LOANS

Loans are summarized as follows:
 

 
  
2005
 
2004
 
Commercial
 
$
63,205,991
  
$
53,225,840
  
Commercial real estate
   
436,802,799
   
279,631,237
 
Residential - construction
   
4,342,926
   
3,916,361
 
Residential - mortgage
   
251,886,228
   
223,689,617
 
Consumer
   
36,863,170
   
38,947,775
 
Other
   
8,597,768
   
9,604,693
 
           Total loans
   
801,698,882
   
609,015,523
 
Less unearned income
   
1,780,315
   
1,214,262
 
Total loans net of unearned income
   
799,918,567
   
607,801,261
 
Less allowance for loan losses
   
6,151,730
   
5,073,286
 
Loans, net
 
$
793,766,837
  
$
602,727,975
  

 
The following presents loan maturities at December 31, 2005.
 

       
After 1
      
   
Within
  
but within
  
After
  
 
  
1Year
  
5 Years
  
5 Years
  
Commercial
  
$
23,946,414
  
$
25,093,783
  
$
14,165,794
  
Commercial real estate
    
105,238,584
   
101,775,730
   
229,788,485
 
Residential-construction
    
2,595,586
   
-
   
1,747,340
 
Residential-mortgage
    
19,077,998
   
13,098,842
   
219,709,388
 
Consumer
    
3,721,289
   
28,022,194
   
5,119,687
 
Other
    
977,489
   
1,849,029
   
5,771,250
 
 
  
$
155,557,360
  
$
169,839,578
  
$
476,301,944
  

 
Loans due after one year with:
      
Variable rates
  
$
289,691,943
  
Fixed rates
    
356,449,579
 
   
$
646,141,522
  
 
Concentrations of credit risk: We grant commercial, residential and consumer loans to customers primarily located in the Eastern Panhandle and South Central regions of West Virginia, and the Northern region of Virginia. Although we strive to maintain a diverse loan portfolio, exposure to credit losses can be adversely impacted by downturns in local economic and employment conditions. Major employment within our market area is diverse, but primarily includes government, health care, education, poultry and various professional, financial and related service industries. As of December 31, 2005, we had no concentrations of loans to any single industry in excess of 10% of loans.
 
We evaluate the credit worthiness of each of our customers on a case-by-case basis and the amount of collateral we obtain is based upon this credit evaluation.

Loans to related parties: We have had, and may be expected to have in the future, banking transactions in the ordinary course of business with our directors, principal officers, their immediate families and affiliated companies in which they are principal stockholders (commonly referred to as related parties). These transactions have been, in our opinion, on the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with others.

The following presents the activity with respect to related party loans aggregating $60,000 or more to any one related party (other changes represent additions to and changes in director and executive officer status):
 

 
  
2005
  
2004
 
Balance, beginning
 
$
10,803,084
  
$
15,817,042
  
Additions
   
10,821,133
   
1,833,783
 
Amounts collected
   
(5,998,721
)
  
(6,695,213
)
Other changes, net
   
104,938
   
(152,528
)
Balance, ending
 
$
15,730,434
  
$
10,803,084
  

 
NOTE 5. ALLOWANCE FOR LOAN
LOSSES

An analysis of the allowance for loan losses for the years ended December 31, 2005, 2004 and 2003 is as follows:

 
  
2005
 
2004
 
2003
 
               
Balance, beginning of year
 
$
5,073,286
  
$
4,680,625
  
$
4,053,131
  
Losses:
                   
Commercial
   
35,809
   
141,815
   
1,308
 
Commercial real estate
   
-
   
335,777
   
96,640
 
Residential - mortgage
   
204,926
   
5,199
   
59,952
 
Consumer
   
173,020
   
208,391
   
178,305
 
Other
   
364,311
   
285,671
   
72,539
 
Total
   
778,066
   
976,853
   
408,744
 
Recoveries:
                   
Commercial
   
6,495
   
18,702
   
1,805
 
Commercial real estate
   
41,228
   
27,302
   
2,602
 
Residential - mortgage
   
42
   
9,413
   
413
 
Consumer
   
55,700
   
109,211
   
78,515
 
Other
   
273,645
   
154,886
   
37,903
 
Total
   
377,110
   
319,514
   
121,238
 
Net losses
   
400,956
   
657,339
   
287,506
 
Provision for loan losses
   
1,479,400
   
1,050,000
   
915,000
 
Balance, end of year
 
$
6,151,730
  
$
5,073,286
  
$
4,680,625
  


34

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



Our total recorded investment in impaired loans at December 31, 2005 and 2004 approximated $3,797,000 and $2,833,000, respectively. The related allowance associated with impaired loans for 2005 and 2004 was approximately $452,000 and $252,000, respectively. At December 31, 2005 and 2004, impaired loans with an associated allowance approximated $1,298,000 and $592,000, respectively. Approximately $2,499,000 at December 31, 2005 and $2,241,000 at December 31, 2004 of impaired loans had no related allowance. Our average investment in such loans approximated $3,458,000, $2,670,000, and $1,373,000 for the years ended December 31, 2005, 2004, and 2003 respectively. Impaired loans at December 31, 2005 and 2004 included loans that were collateral dependent, for which the fair values of the loans’ collateral were used to measure impairment.
 
For purposes of evaluating impairment, we consider groups of smaller-balance, homogeneous loans to include: mortgage loans secured by residential property, other than those which significantly exceed our typical residential mortgage loan amount (currently those in excess of $100,000); small balance commercial loans (currently those less than $50,000); and consumer loans, exclusive of those loans in excess of $50,000.

For the years ended December 31, 2005, 2004, and 2003, we recognized approximately $181,000, $123,000, and $65,000 in interest income on impaired loans after the date that the loans were deemed to be impaired. Using a cash-basis method of accounting, we would have recognized approximately the same amount of interest income on such loans.

NOTE 6.  PROPERTY HELD FOR SALE

Property held for sale, consisting of foreclosed properties, was $378,000 and $593,000 at December 31, 2005 and December 31, 2004, respectively.  

In 2005, we sold a foreclosed property that resulted in a $214,000 pre-tax loss, which is reflected in other income. In 2003 we sold our primary branch facility in Petersburg, West Virginia, which produced a pre-tax gain of $338,000, which is reflected in other income. A new Petersburg facility was constructed during 2004. We also sold our corporate headquarters located in Moorefield, West Virginia and have constructed new corporate headquarters in Moorefield.

NOTE 7. PREMISES AND EQUIPMENT

The major categories of premises and equipment and accumulated depreciation at December 31, 2005 and 2004, are summarized as follows:


 
  
2005
 
2004
 
           
Land
 
$
5,845,211
  
$
3,817,266
  
Buildings and improvements
   
16,100,504
   
15,216,987
 
Furniture and equipment
   
10,197,308
   
9,188,026
 
     
32,143,023
   
28,222,279
 
Less accumulated depreciation
   
9,053,611
   
7,446,272
 
               
Total premises and equipment
 
$
23,089,412
  
$
20,776,007
  
 
Depreciation expense for the years ended December 31, 2005, 2004 and 2003 approximated $1,681,000, $1,507,000, and $1,058,000, respectively. 

NOTE 8. INTANGIBLE ASSETS

In accordance with SFAS 142, goodwill is subject to impairment testing at least annually to determine whether write-downs of the recorded balances are necessary. A fair value is determined based on at least one of three various market valuation methodologies. If the fair value equals or exceeds the book value, no write-down of recorded goodwill is necessary. If the fair value is less than the book value, an expense may be required on our books to write down the goodwill to the proper carrying value. During the third quarter, we completed the required annual impairment test for 2005 and determined that no impairment write-offs were necessary.
  
In addition, at December 31, 2005 and December 31, 2004, we had $1,259,642 and $1,410,794 respectively, in unamortized acquired intangible assets consisting entirely of
unidentifiable intangible assets recorded in accordance with SFAS 72.
 

   
Goodwill Activity by Operating Segment
  
   
Community
 
Mortgage
  
Parent and
      
   
Banking
  
Banking
  
Other
  
Total
  
Balance, January 1, 2005
  
$
1,488,030
  
$
-
  
$
600,000
  
$
2,088,030
  
Acquired goodwill, net
    
-
   
-
   
-
   
-
 
                           
Balance, December 31, 2005
  
$
1,488,030
  
$
-
  
$
600,000
  
$
2,088,030
  


   
Unidentifiable Intangible Assets
 
   
December 31,
 
December 31,
 
   
2005
 
2004
 
Unidentifiable intangible assets
             
Gross carrying amount
 
$
2,267,323
  
$
2,267,323
  
Less: accumulated amortization
   
1,007,681
   
856,529
 
Net carrying amount
 
$
1,259,642
  
$
1,410,794
  
 
35

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


We recorded amortization expense of $151,000 for the year ended December 31, 2005 relative to our unidentifiable intangible assets. Annual amortization is expected to be approximately $151,000 for each of the years ending 2006 through 2009.

NOTE 9. DEPOSITS

The following is a summary of interest bearing deposits by type as of December 31, 2005 and 2004:
 


 
  
2005
 
2004
 
Demand deposits, interest bearing
 
$
200,637,520
  
$
122,355,331
  
Savings deposits
   
44,680,540
   
50,427,556
 
Certificates of deposit
   
339,720,153
   
271,130,829
 
Individual Retirement Accounts
   
26,231,095
   
25,298,430
 
Total
 
$
611,269,308
  
$
469,212,146
  
 
Time certificates of deposit and Individual Retirement Account's (IRA’s) in denominations of $100,000 or more totaled $200,976,319 and $117,179,440 at December 31, 2005 and 2004, respectively. Interest paid on time certificates of deposit and IRA’s in denominations of $100,000 or more was $4,255,899, $3,051,189, and $2,535,703 for the years ended December 31, 2005, 2004 and 2003, respectively.

Included in certificates of deposits are brokered certificates of deposit, which totaled $ 129,176,000 and $53,268,000 at December 31, 2005 and 2004, respectively. Brokered deposits represent certificates of deposit acquired through a third party. The following is a summary of the maturity distribution of certificates of deposit and IRA's in denominations of $100,000 or more as of December 31, 2005:
 

 
  
Amount
 
Percent
 
Three months or less
 
$
23,812,718
    
11.9
%
Three through six months
   
25,762,339
   
12.8
%
Six through twelve months
   
52,132,857
   
25.9
%
Over twelve months
   
99,268,405
   
49.4
%
Total
 
$
200,976,319
    
100.0
%


A summary of the scheduled maturities for all time deposits as of December 31, 2005, follows:
 

2006
 
$
197,121,696
  
2007
   
113,590,224
 
2008
   
32,467,450
 
2009
   
14,426,322
 
2010
   
6,973,245
 
Thereafter
   
1,372,311
 
Total
 
$
365,951,248
  
 
At December 31, 2005 and 2004, our deposits of related parties including directors, executive officers, and their related interests approximated $16,605,000 and $17,225,000, respectively.

NOTE 10. BORROWED FUNDS

Our subsidiary banks are members of the Federal Home Loan Bank (“FHLB”). Membership in the FHLB makes available short-term and long-term advances under collateralized borrowing arrangements with each subsidiary bank. All FHLB advances are collateralized primarily by similar amounts of residential mortgage loans, certain commercial loans, mortgage backed securities and securities of U. S. Government agencies and corporations.

At December 31, 2005, our subsidiary banks had combined additional borrowings availability of $68,657,000 from the FHLB. Short-term FHLB advances are granted for terms of 1 to 365 days and bear interest at a fixed or variable rate set at the time of the funding request.

In addition, Summit Financial Group, Inc. has a long-term line of credit available through an unaffiliated banking institution which is secured by the common stock of one of our subsidiary banks. At December 31, 2005 we had $5,500,000 available to draw on this line.

Short-term borrowings: At December 31,2005, we had $19,700,000 borrowing availability through credit lines and Federal funds purchased agreements. A summary of short-term borrowings is presented below.
 
36

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


 
  
2005
 
           
Federal Funds
 
   
Short-term
     
Purchased
 
   
FHLB
 
Repurchase
 
and Lines
 
 
  
Advances
 
Agreements
 
of Credit
 
Balance at December 31
 
$
175,510,100
  
$
6,518,013
  
$
-
  
Average balance outstanding
                   
  for the year
   
130,023,493
   
8,060,676
   
888,214
 
Maximum balance outstanding
           
  at any month end
   
175,510,100
   
10,881,188
   
3,395,500
 
Weighted average interest
                   
  rate for the year
   
3.54
%
  
2.27
%
  
4.77
%
Weighted average interest
                   
  rate for balances
                   
  outstanding at December 31
   
4.27
%
  
3.65
%
  
-
 
 
 
 
  
2004
 
           
Federal Funds
 
   
Short-term
     
Purchased
 
   
FHLB
 
Repurchase
 
and Lines
 
 
  
Advances
 
Agreements
 
of Credit
 
Balance at December 31
 
$
109,798,900
  
$
10,830,314
  
$
-
  
Average balance outstanding
                   
  for the year
   
59,498,008
   
9,739,367
   
1,076,402
 
Maximum balance outstanding
           
  at any month end
   
109,798,900
   
11,098,557
   
1,173,000
 
Weighted average interest
                   
  rate for the year
   
1.72
%
  
1.59
%
  
2.11
%
Weighted average interest
                   
  rate for balances
                   
  outstanding at December 31
   
2.31
%
  
1.85
%
  
-
 
 
 
Federal funds purchased and repurchase agreements mature the next business day. The securities underlying the repurchase agreements are under our control and secure the total outstanding daily balances.

Long-term borrowings: Our long-term borrowings of $150,911,835 and $160,860,182 as of December 31, 2005 and 2004, respectively, consisted primarily of advances from the FHLB. These borrowings bear both fixed and variable interest rates and mature in varying amounts through the year 2016. The average interest rate paid on long-term borrowings during 2005 and 2004 approximated 4.67% and 4.05%, respectively.

Subordinated Debentures: We have three statutory business trusts that were formed for the purpose of issuing mandatorily redeemable securities (the “capital securities”) for which we are obligated to third party investors and investing the proceeds from the sale of the capital securities in our junior subordinated debentures (the “debentures”). The debentures held by the trusts are their sole assets. Our subordinated debentures totaled $19,589,000 at December 31, 2005, and $11,341,000 at December 31, 2004.

In October 2002, we sponsored SFG Capital Trust I, in March 2004, we sponsored SFG Capital Trust II, and in December 2005, we sponsored SFG Capital Trust III, of which 100% of the common equity of each trust is owned by us. SFG Capital Trust I issued $3,500,000 in capital securities and $109,000 in common securities and invested the proceeds in $3,609,000 of debentures. SFG Capital Trust II issued $7,500,000 in capital securities and $232,000 in common securities and invested the proceeds in $7,732,000 of debentures. SFG Capital Trust III issued $8,000,000 in capital securities and $248,000 in common securities and invested the proceeds in $8,248,000 of debentures. Distributions on the capital securities issued by the trusts are payable quarterly at a variable interest rate equal to 3 month LIBOR plus 345 basis points for SFG Capital Trust I, 3 month LIBOR plus 280 basis points for SFG Capital Trust II, and 3 month LIBOR plus 145 basis points for SFG Capital Trust III, and equals the interest rate earned on the debentures held by the trusts, and is recorded as interest expense by us. The capital securities are subject to mandatory redemption in whole or in part, upon repayment of the debentures. We have entered into agreements which, taken collectively, fully and unconditionally guarantee the capital securities subject to the terms of the guarantee. The debentures of SFG Capital Trust I, SFG Capital Trust II, and SFG Capital Trust III are first redeemable by us in November 2007, March 2009, and March 2011, respectively.
 
  The capital securities held by SFG Capital Trust I, SFG Capital Trust II, and SFG Capital Trust III qualify as Tier 1 capital under Federal Reserve Board guidelines. In accordance with these Guidelines, trust preferred securities generally are limited to 25% of Tier 1 capital elements, net of goodwill. The amount of trust preferred securities and certain other elements in excess of the limit can be included in Tier 2 capital.
 
A summary of the maturities of all long-term borrowings and subordinated debentures for the next five years and thereafter is as follows:

Year Ending
      
December 31,
  
Amount
  
2006
  
$
21,944,946
  
2007
    
18,318,204
 
2008
    
16,085,851
 
2009
    
2,110,094
 
2010
    
62,734,338
 
Thereafter
    
49,307,402
 
Total
  
$
170,500,835
  



37

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



NOTE 11. INCOME TAXES
 
The components of applicable income tax expense (benefit) for the years ended December 31, 2005, 2004 and 2003, are as follows:
 

 
  
2005
 
2004
 
2003
 
Current
             
Federal
 
$
5,319,400
  
$
4,650,000
  
$
3,678,325
  
State
   
407,100
   
381,650
   
201,250
 
 
    
5,726,500
   
5,031,650
   
3,879,575
 
Deferred
                   
Federal
   
(945,358
)
  
(424,385
)
  
(572,400
)
State
   
(69,560
)
  
(25,550
)
  
203,750
 
 
    
(1,014,918
)
  
(449,935
)
  
(368,650
)
Total
 
$
4,711,582
  
$
4,581,715
  
$
3,510,925
  



Reconciliation between the amount of reported income tax expense and the amount computed by multiplying the statutory income tax rates by book pretax income for the years ended December 31, 2005, 2004 and 2003 is as follows:



 
  
2005
 
2004
 
2003
 
 
  
Amount
 
Percent
 
Amount
 
Percent
 
Amount
 
Percent
 
Computed
                                     
tax at applicable
                                     
statutory rate
 
$
5,424,355
    
34
 
$
5,164,630
    
34
 
$
3,984,556
    
34
 
                                       
Increase (decrease)
                                     
in taxes
                                     
resulting from:
                                     
Tax-exempt interest
                                     
and dividends, net
   
(865,042
)
  
(5
)
  
(899,668
)
  
(6
)
  
(768,393
)
  
(6
)
                                       
State income
                                     
taxes, net of
                                     
Federal income
                                     
tax benefit
   
268,686
   
2
   
251,889
   
2
   
132,825
   
1
 
Other, net
   
(116,417
)
  
(1
)
  
64,864
   
-
   
161,937
   
1
 
Applicable income taxes
 
$
4,711,582
    
30
 
$
4,581,715
    
30
 
$
3,510,925
    
30
 








38

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Deferred income taxes reflect the impact of "temporary differences" between amounts of assets and liabilities for financial reporting purposes and such amounts as measured for tax purposes. Deferred tax assets and liabilities represent the future tax return consequences of temporary differences, which will either be taxable or deductible when the related assets and liabilities are recovered or settled. Valuation allowances are established when deemed necessary to reduce deferred tax assets to the amount expected to be realized.

The tax effects of temporary differences, which give rise to our deferred tax assets and liabilities as of December 31, 2005 and 2004, are as follows:
 
 
  
2005
 
2004
 
Deferred tax assets
             
Allowance for loan losses
 
$
2,253,848
  
$
1,861,126
  
Deferred compensation
   
685,007
   
581,593
 
Other deferred costs and accrued expenses
   
787,039
   
552,683
 
Net unrealized loss on securities and
             
other financial instruments
   
1,258,649
   
125,335
 
 
    
4,984,543
   
3,120,737
 
Deferred tax liabilities
             
Depreciation
   
385,137
   
272,527
 
Accretion on tax-exempt securities
   
53,747
   
40,518
 
Purchase accounting adjustments
             
and goodwill
   
159,054
   
135,443
 
Net unrealized gain on securities and
             
other financial instruments
   
-
   
-
 
 
    
597,938
   
448,488
 
Net deferred tax assets (liabilities)
 
$
4,386,605
  
$
2,672,249
  

 
NOTE 12. EMPLOYEE BENEFITS

 
Retirement Plans: We have defined contribution profit-sharing plans with 401(k) provisions covering substantially all employees. Contributions to the plans are at the discretion of the Board of Directors. Contributions made to the plans and charged to expense were $386,893, $277,187, and $276,380 the years ended December 31, 2005, 2004 and 2003, respectively.

Employee Stock Ownership Plan: We have an Employee Stock Ownership Plan (“ESOP”), which enables eligible employees to acquire shares of our common stock. The cost of the ESOP is borne by us through annual contributions to an Employee Stock Ownership Trust in amounts determined by the Board of Directors.

The expense recognized by us is based on cash contributed or committed to be contributed by us to the ESOP during the year. Contributions to the ESOP for the years ended December 31, 2005, 2004 and 2003 were $354,757, $233,813 and $217,120, respectively. Dividends paid by us to the ESOP are reported as a reduction to retained earnings. The ESOP owned 202,489 and 194,408 shares of our common stock at December 31, 2005 and December 31, 2004, respectively, all of which were purchased at the prevailing market price and are considered outstanding for earnings per share computations.

The trustees of the Retirement Plans and ESOP are also members of our Board of Directors.

Supplemental Executive Retirement Plan: In May 1999, Summit Community Bank entered into a non-qualified Supplemental Executive Retirement Plan (“SERP”) with certain senior officers, which provides participating officers with an income benefit payable at retirement age or death. During 2000, Shenandoah Valley National Bank adopted a similar plan and during 2002, Summit Financial Group, Inc. adopted a similar plan. The liabilities accrued for the SERP’s at December 31, 2005 and 2004 were $930,977 and $730,785 respectively, which are included in other liabilities. In addition, we purchased certain life insurance contracts to fund the liabilities arising under these plans. At December 31, 2005 and 2004, the cash surrender value of these insurance contracts was $8,057,631 and $5,326,246, respectively, and is included in other assets in the accompanying consolidated balance sheets.

Stock Option Plan: The Officer Stock Option Plan, which provides for the granting of stock options for up to 960,000 shares of common stock to our key officers, was adopted in 1998 and expires in 2008. Each option granted under the plan vests according to a schedule designated at the grant date and shall have a term of no more than 10 years following the vesting date. Also, the option price per share shall not be less than the fair market value of our common stock on the date of grant. Accordingly, no compensation expense is recognized for options granted under the Plan.


The following pro forma disclosures present for 2005, 2004 and 2003, our reported net income and basic and diluted earnings per share had we recognized compensation expense for our Officer Stock Option Plan based on the grant date fair values of the options (the fair value method described in Statement of Financial Accounting Standards No. 123).
 
39

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 
 

(in thousands, except per share data)
  
Years Ended December 31,
  
 
  
2005
  
2004
  
2003
  
               
Net income:
                    
As reported
  
$
11,242
  
$
10,608
  
$
8,208
  
                     
Deduct total stock-based
                    
employee compensation
                    
expense determined under
                    
fair value based method
                    
for all awards, net of
                    
related tax effects
    
(717
)
  
(260
)
  
(42
)
Pro forma
  
$
10,525
  
$
10,348
  
$
8,166
  
                     
Basic earnings per share:
                    
As reported
  
$
1.58
  
$
1.51
  
$
1.17
  
Pro forma
  
$
1.48
  
$
1.48
  
$
1.17
  
                     
Diluted earnings per share:
                    
As reported
  
$
1.56
  
$
1.49
  
$
1.16
  
Pro forma
  
$
1.46
  
$
1.46
  
$
1.16
  

 
   For purposes of computing the above pro forma amounts, we estimated the fair value of the options at the date of grant using a Black-Scholes option pricing model using the following weighted-average assumptions for grants in each respective year: risk free interest rates of 4.44% for 2005, 3.60% for 2004, and 3.75% for 2003; dividend yields of 1.25% or 2005, 1.04% for 2004, and 1.21% for 2003; volatility factors of the expected market price of our common stock of 25 for 2005, 20 for 2004, and 22 for 2003; and an expected option life of 8 years for 2005, 2004 and 2003. The weighted-average grant date fair value of options granted during 2005, 2004, and 2003 was $8.07, $7.85, and $5.30, respectively. For purposes of the pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting period.

A summary of activity in our Officer Stock Option Plan during 2003, 2004 and 2005 is as follows:
 
 

       
       
Weighted-
 
       
Average
 
       
Exercise
 
 
  
Options
 
Price
 
Outstanding, December 31, 2002
   
165,800
 
$
6.16
  
Granted
   
52,000
   
17.79
 
Exercised
   
(10,600
)
  
5.03
 
Forfeited
   
-
   
-
 
Outstanding, December 31, 2003
   
207,200
 
$
9.14
  
Granted
   
98,400
   
25.55
 
Exercised
   
(21,500
)
  
5.59
 
Forfeited
   
-
   
-
 
Outstanding, December 31, 2004
   
284,100
 
$
15.09
  
Granted
   
87,500
   
24.41
 
Exercised
   
(9,860
)
  
12.73
 
Forfeited
   
-
   
-
 
Outstanding, December 31, 2005
   
361,740
 
$
17.41
  
               
Exercisable Options:
             
December 31, 2005
    
309,340
 
$
17.99
  
December 31, 2004
    
153,300
 
$
12.14
  
December 31, 2002
    
98,800
 
$
5.47
  

Other information regarding options outstanding and exercisable at December 31, 2005 is as follows:

   
Options Outstanding
 
Options Exercisable
 
           
Wted. Avg.
         
           
Remaining
         
Range of
 
# of
     
Contractual
 
# of
     
exercise price
  
shares
 
WAEP
 
Life (yrs)
 
shares
 
WAEP
 
$4.63 - $6.00
    
94,200
 
$
5.30
    
6.87
    
87,400
 
$
5.25
  
6.01 - 10.00
    
33,640
   
9.49
    
10.03
    
19,240
   
9.49
  
10.01 - 17.50
    
3,600
   
17.43
    
8.17
    
3,600
   
17.43
  
17.51 - 20.00
    
51,800
   
17.79
    
10.96
    
20,600
   
17.79
  
20.01 - 25.93
    
178,500
   
25.19
    
9.57
    
178,500
   
25.19
  
                                 
     
361,740
   
17.41
          
309,340
   
17.99
  

 
NOTE 13. COMMITMENTS AND CONTINGENCIES

Financial instruments with off-balance sheet risk: We are a party to certain financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the statement of financial position. The contract amounts of these instruments reflect the extent of involvement that we have in this class of financial instruments.
40

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Many of our lending relationships contain both funded and unfunded elements. The funded portion is reflected on our balance sheet. The unfunded portion of these commitments is not recorded on our balance sheet until a draw is made under the loan facility. Since many of the commitments to extend credit may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash flow requirements.

A summary of the total unfunded, or off-balance sheet, credit extension commitments follows:
 
 

 
  
December 31,
  
 
  
2005
  
2004
  
Commitments to extend credit:
      
Revolving home equity and
             
credit card lines
  
$
28,721,276
  
$
24,530,616
  
Construction loans
    
100,523,486
   
57,482,302
 
Other loans
    
37,926,160
   
30,836,445
 
Standby letters of credit
    
11,253,896
   
6,148,776
 
Total
  
$
178,424,818
  
$
118,998,139
  

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. We evaluate each customer's credit worthiness on a case-by-case basis. The amount of collateral obtained, if we deem necessary upon extension of credit, is based on our credit evaluation. Collateral held varies but may include accounts receivable, inventory, equipment or real estate.

Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. Standby letters of credit generally are contingent upon the failure of the customer to perform according to the terms of the underlying contract with the third party.

Our exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contractual amount of those instruments. We use the same credit policies in making commitments and conditional obligations as we do for on-balance sheet instruments.

Operating leases: We occupy certain facilities under long-term operating leases. The aggregate minimum annual rental commitments under those leases total approximately $1,068,000 in 2006, $1,019,000 in 2007, $984,000 in 2008, $431,000 in 2009, and $116,000 in 2010. Total net rent expense included in the accompanying consolidated financial statements was $673,000 in 2005, $439,000 in 2004 and $130,000 in 2003.

Litigation: We are involved in various legal actions arising in the ordinary course of business. In the opinion of counsel, the outcome of these matters will not have a significant adverse effect on the consolidated financial statements.
 

On December 26, 2003, two of our subsidiaries, Summit Financial, LLC and Shenandoah Valley National Bank, and various employees of Summit Financial, LLC were served with a Petition for Temporary Injunction and a Bill of Complaint filed in the Circuit Court of Fairfax County, Virginia by Corinthian Mortgage Corporation.  The filings allege various claims against Summit Financial, LLC and Shenandoah Valley National Bank arising out of the hiring of former employees of Corinthian Mortgage Corporation and the alleged use of trade secrets. The individual defendants have also been sued based on allegations arising out of their former employment relationship with Corinthian Mortgage and their employment with Summit Financial, LLC. Summit Financial, LLC now operates as Summit Mortgage, a division of Shenandoah Valley National Bank.
 
The plaintiff seeks damages in the amount proven at trial on each claim and punitive damages in the amount of $350,000 on each claim.  Plaintiff also seeks permanent and temporary injunctive relief prohibiting the alleged use of trade secrets by Summit Financial and the alleged solicitation of Corinthian’s employees. 

On January 22, 2004, we successfully defeated the Petition for Temporary Injunction brought against us by Corinthian Mortgage Corporation. The Circuit Court of Fairfax County, Virginia denied Corinthian’s petition. 
 
We, after consultation with legal counsel, believe that Corinthian’s claims made in its lawsuit arising out of the hiring of former employees of Corinthian Mortgage Corporation and the alleged use of trade secrets are without foundation and that meritorious defenses exist as to all the claims. We will continue to evaluate the claims in the Corinthian lawsuit and intend to vigorously defend against them. We believe that the lawsuit is without merit and will have no material adverse effect on us. Management, at the present time, is unable to estimate the impact, if any, an adverse decision may have on our results of operations or financial condition.
 
On January 4, 2006, Mary Forrest, an individual, filed suit in the United States District Court for the Eastern District of Wisconsin, Milwaukee Division, against our subsidiary, Shenandoah Valley National Bank. The plaintiff claims that Shenandoah violated the Federal Fair Credit Reporting Act (“FCRA”) alleging that Shenandoah used information contained in her consumer report, without extending a “firm offer of credit” within the meaning of the FCRA. Plaintiff requests statutory damages. This case is a purported class action. Presently, we do not have final information as to the size of the alleged class. Responsive pleadings have only recently been filed, and discovery will be initiated shortly.  We will continue to evaluate the claim in this lawsuit and intend to vigorously defend against it.  Management, at the present time, is unable to estimate the impact, if any, an adverse decision may have on our results of our operations or financial condition.
 
Employment Agreements:  We have various employment agreements with our chief executive officer and certain other executive officers. These agreements contain change in control provisions that would entitle the officers to receive compensation in the event there is a change in control in the Company (as defined) and a termination of their employment without cause (as defined).

NOTE 14. ISSUANCE OF PREFERRED STOCK

On April 23, 2004, the Board of Directors approved an amendment to our Articles of Incorporation establishing the
 
41

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

 
Rockingham National Bank Series Convertible Preferred Stock (“Preferred Stock”) and authorizing up to 40,000 shares of its issuance. On May 17, 2004, we completed the sale of 33,400 shares of Preferred Stock in a private placement. The Preferred Stock was sold to potential investors that we believed would be beneficial to the development and support of the Rockingham National Bank, a division of Summit’s subsidiary, Shenandoah Valley National Bank, and to the outside directors of Shenandoah Valley National Bank. The offering price for each share of the Preferred Stock was the mean of the closing prices of Summit’s common stock reported on the last five (5) business days on which the stock traded prior to and inclusive of May 10, 2004, which was $35.28 per share, and aggregate offering proceeds were $1,158,471, net of related issuance costs. The holders of this Preferred Stock did not receive dividends. The shares of Preferred Stock converted automatically into 76,820 shares of our common stock on May 15, 2005. The conversion was effected for the December 2004 two-for-one stock split, and was based on the total loans and deposits of the Rockingham National Bank division of Shenandoah Valley National Bank on May 15, 2005.

NOTE 15. REGULATORY MATTERS

The primary source of funds for our dividends paid to our shareholders is dividends received from our subsidiary banks. Dividends paid by the subsidiary banks are subject to restrictions by banking regulations. The most restrictive provision requires approval by their regulatory agencies if dividends declared in any year exceed the year’s net income, as defined, plus the net retained profits of the two preceding years. During 2006, our subsidiaries have $18,962,000 plus net income for the interim periods through the date of declaration, available for dividends for distribution to us.

We and our subsidiaries are subject to various regulatory capital requirements administered by the banking regulatory agencies. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we and each of our subsidiaries must meet specific capital guidelines that involve quantitative measures of our and our subsidiaries’ assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. Our and each of our subsidiaries’ capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Failure to meet these minimum capital requirements can result in certain mandatory and possible additional discretionary actions by regulators that could have a material impact on our financial position and results of operations.

Quantitative measures established by regulation to ensure capital adequacy require us and each of our subsidiaries to maintain minimum amounts and ratios 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). We believe, as of December 31, 2005, that we and each of our subsidiaries met all capital adequacy requirements to which we were subject.

The most recent notifications from the banking regulatory agencies categorized us and each of our subsidiary banks as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, we and each of our subsidiaries must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table below.

Our subsidiary banks are required to maintain noninterest bearing reserve balances with the Federal Reserve Bank. The required reserve balance was $13,635,000 at December 31, 2005.

Summit’s and its subsidiary banks’, Summit Community Bank (“SCB”) and Shenandoah Valley National Bank’s (“SVNB”) actual capital amounts and ratios are also presented in the following table (dollar amounts in thousands).

42

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS




                           
(Dollars in thousands)
                 
To be Well Capitalized
  
           
Minimum Required
  
under Prompt Corrective
  
   
Actual
  
Regulatory Capital
  
Action Provisions
  
   
Amount
 
Ratio
  
Amount
 
Ratio
  
Amount
 
Ratio
  
As of December 31, 2005
                         
Total Capital (to risk weighted assets)
                                     
Summit
 
$
96,837
    
11.4
%
$
68,010
    
8.0
%
$
85,013
    
10.0
%
Summit Community
   
54,550
   
10.4
%
  
41,792
   
8.0
%
  
52,240
   
10.0
%
Shenandoah
   
35,834
   
11.2
%
  
25,589
   
8.0
%
  
31,986
   
10.0
%
Tier 1 Capital (to risk weighted assets)
                                     
Summit
   
90,686
   
10.7
%
  
34,005
   
4.0
%
  
51,008
   
6.0
%
Summit Community
   
50,490
   
9.7
%
  
20,896
   
4.0
%
  
31,344
   
6.0
%
Shenandoah
   
33,743
   
10.5
%
  
12,794
   
4.0
%
  
19,191
   
6.0
%
Tier 1 Capital (to average assets)
                                     
Summit
   
90,686
   
8.6
%
  
31,764
   
3.0
%
  
52,940
   
5.0
%
Summit Community
   
50,490
   
7.5
%
  
20,251
   
3.0
%
  
33,752
   
5.0
%
Shenandoah
   
33,743
   
9.0
%
  
11,199
   
3.0
%
  
18,664
   
5.0
%
                                       
As of December 31, 2004
                                     
Total Capital (to risk weighted assets)
                                     
Summit
 
$
77,301
    
11.9
%
  
51,863
   
8.0
%
  
64,829
   
10.0
%
Summit Community
   
45,672
   
10.8
%
  
33,817
   
8.0
%
  
42,271
   
10.0
%
Shenandoah
   
23,253
   
10.7
%
  
17,440
   
8.0
%
  
21,800
   
10.0
%
Tier 1 Capital (to risk weighted assets)
                                     
Summit
   
72,228
   
11.1
%
  
25,932
   
4.0
%
  
38,897
   
6.0
%
Summit Community
   
42,165
   
10.0
%
  
16,908
   
4.0
%
  
25,363
   
6.0
%
Shenandoah
   
21,687
   
9.9
%
  
8,720
   
4.0
%
  
13,080
   
6.0
%
Tier 1 Capital (to average assets)
                                     
Summit
   
72,228
   
8.3
%
  
26,256
   
3.0
%
  
43,761
   
5.0
%
Summit Community
   
42,165
   
7.1
%
  
17,739
   
3.0
%
  
29,565
   
5.0
%
Shenandoah
   
21,687
   
8.0
%
  
8,128
   
3.0
%
  
13,546
   
5.0
%



43

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



NOTE 16. SEGMENT INFORMATION

We operate two business segments: community banking and mortgage banking. These segments are primarily identified by the products or services offered and the channels through which they are offered. The community banking segment consists of our full service banks which offer customers traditional banking products and services through various delivery channels. The mortgage banking segment consists of mortgage origination facilities that originate and sell mortgage products. The accounting policies for each of our business segments are the same as those described in Note 1.

Intersegment revenue and expense consists of management fees allocated to the banks, Summit Mortgage and Summit Insurance Services, LLC for all centralized functions that are performed at the parent location including data processing, bookkeeping, accounting, treasury management, loan administration, loan review, compliance, risk management and internal auditing. We also provide overall direction in the areas of credit policy and administration, strategic planning, marketing, investment portfolio management and other financial and administrative services. Also included is intercompany interest expense on the Summit Mortgage warehouse line of credit with SVNB. Information for each of our segments is included below:
 

   
December 31, 2005
  
   
Community
  
Mortgage
  
Insurance
             
   
Banking
  
Banking
  
Services
  
Parent
  
Eliminations
  
Total
  
                           
Net interest income
  
$
31,000,104
  
$
658,442
  
$
-
  
$
(852,903
)
$
-
  
$
30,805,643
  
Provision for loan losses
    
1,295,000
   
184,400
   
-
   
-
   
-
   
1,479,400
 
Net interest income after provision for loan losses
    
29,705,104
   
474,042
   
-
   
(852,903
)
  
-
   
29,326,243
 
Other income
    
1,861,713
   
26,370,978
   
620,755
   
4,885,636
   
(4,864,878
)
  
28,874,204
 
Other expenses
    
17,643,904
   
23,207,664
   
591,561
   
5,668,210
   
(4,864,878
)
  
42,246,461
 
Income (loss) before income taxes
    
13,922,913
   
3,637,356
   
29,194
   
(1,635,477
)
  
-
   
15,953,986
 
Income tax expense (benefit)
    
4,132,750
   
1,262,237
   
10,845
   
(694,250
)
  
-
   
4,711,582
 
Net income
  
$
9,790,163
  
$
2,375,119
  
$
18,349
  
$
(941,227
)
$
-
  
$
11,242,404
  
Intersegment revenue (expense)
  
$
(3,490,719
)
$
(1,342,659
)
$
(31,500
)
$
4,864,878
  
$
-
  
$
-
  
Average assets (in thousands)
  
$
958,210
  
$
22,613
  
$
967
  
$
83,466
  
$
(96,288
)
$
968,968
  


   
December 31, 2004
  
   
Community
  
Mortgage
  
Insurance
 
Parent
          
   
Banking
  
Banking
  
Services
  
and Other
  
Eliminations
  
Total
  
                           
Net interest income
  
$
27,570,920
  
$
696,135
  
$
-
  
$
(490,031
)
$
-
  
$
27,777,024
  
Provision for loan losses
    
1,050,000
   
-
   
-
   
-
   
-
   
1,050,000
 
Net interest income after provision for loan losses
    
26,520,920
   
696,135
   
-
   
(490,031
)
  
-
   
26,727,024
 
Other income
    
2,862,390
   
24,087,294
   
312,219
   
3,903,104
   
(3,912,870
)
  
27,252,137
 
Other expenses
    
15,522,907
   
22,045,525
   
321,362
   
4,812,149
   
(3,912,870
)
  
38,789,073
 
Income (loss) before income taxes
    
13,860,403
   
2,737,904
   
(9,143
)
  
(1,399,076
)
  
-
   
15,190,088
 
Income tax expense (benefit)
    
4,188,450
   
944,000
   
(2,935
)
  
(547,800
)
  
-
   
4,581,715
 
Net income
  
$
9,671,953
  
$
1,793,904
  
$
(6,208
)
$
(851,276
)
$
-
  
$
10,608,373
  
Intersegment revenue (expense)
  
$
(3,063,304
)
$
(827,066
)
$
(22,500
)
$
3,912,870
  
$
-
  
$
-
  
Average assets (in thousands)
  
$
817,414
  
$
16,701
  
$
821
  
$
73,280
  
$
(67,333
)
$
840,883
  

44

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


 
December 31, 2003
  
   
Community
  
Mortgage
              
   
Banking
  
Banking
  
Parent
  
Eliminations
  
Total
  
                       
Net interest income
 
$
23,848,159
  
$
69,097
  
$
(223,676
)
$
-
  
$
23,693,580
  
Provision for loan losses
    
915,000
   
-
   
-
   
-
   
915,000
 
Net interest income after provision for loan losses
    
22,933,159
   
69,097
   
(223,676
)
  
-
   
22,778,580
 
Other income
    
2,706,245
   
3,137,702
   
3,291,622
   
(3,311,180
)
  
5,824,389
 
Other expenses
    
13,443,687
   
3,060,882
   
3,690,299
   
(3,311,180
)
  
16,883,688
 
Income (loss) before income taxes
    
12,195,717
   
145,917
   
(622,353
)
  
-
   
11,719,281
 
Income tax expense (benefit)
    
3,655,277
   
49,798
   
(194,150
)
  
-
   
3,510,925
 
Net income
  
$
8,540,440
  
$
96,119
  
$
(428,203
)
$
-
  
$
8,208,356
  
Intersegment revenue (expense)
  
$
(3,225,159
)
$
(86,021
)
$
3,311,180
  
$
-
  
$
-
  
Average assets (in thousands)
  
$
717,565
  
$
4,081
  
$
60,164
  
$
(59,066
)
$
722,744
  


 
NOTE 17. EARNINGS PER SHARE

The computations of basic and diluted earnings per share follow:

   
For the Year Ended December 31,
  
 
  
2005
  
2004
  
2003
  
Numerator:
                    
Net Income
  
$
11,242,404
  
$
10,608,373
  
$
8,208,356
  
                     
Denominator
                    
Denominator for basic earnings
                    
per share-weighted average
                    
common shares outstanding
    
7,093,402
   
7,025,118
   
7,010,007
 
                     
Effect of dilutive securities:
                    
Convertible preferred stock
    
28,202
   
23,607
   
-
 
Stock options
    
85,234
   
73,036
   
63,280
 
     
113,436
   
96,643
   
63,280
 
Denominator for diluted earnings
                    
per share-weighted average
                    
common shares outstanding and
                    
assumed conversions
    
7,206,838
   
7,121,761
   
7,073,287
 
                     
Basic earnings per share
  
$
1.58
  
$
1.51
  
$
1.17
  
                     
Diluted earnings per share
  
$
1.56
  
$
1.49
  
$
1.16
  
 
        Stock option grants are disregarded in this calculation if they are determined to be anti-dilutive. At December 31, 2005, all stock options were dilutive. At December 31, 2004 and 2003, our anti-dilutive stock options totaled 94,000 shares, and 52,000 shares, respectively

 
NOTE 18. DERIVATIVE FINANCIAL INSTRUMENTS

We use derivative instruments primarily to protect against the risk of adverse interest rate movements on the value of certain liabilities. Derivative instruments represent contracts between parties that usually require little or no initial net investment and result in one party delivering cash or another type of asset to the other party based upon a notional amount and an underlying as specified in the contract. A notional amount represents the number of units of a specific item, such as currency units. An underlying represents a variable, such as an interest rate or price index. The amount of cash or other asset delivered from one party to the other is determined based upon the interaction of the notional amount of the contract with the underlying. Derivatives can also be implicit in certain contracts and commitments.

Market risk is the risk of loss arising from an adverse change in interest rates or equity prices. Our primary market risk is interest rate risk. We use interest rate swaps to protect against the risk of interest rate movements on the value of certain funding instruments.

As with any financial instrument, derivative instruments have inherent risks, primarily market and credit risk. Market risk associated with changes in interest rates is managed by establishing and monitoring limits as to the degree of risk that may be undertaken as part of our overall market risk monitoring process. Credit risk occurs when a counterparty to a derivative contract with an unrealized gain fails to perform according to the terms of the agreement. Credit risk is managed by monitoring the size and maturity structure of the derivative portfolio, and applying uniform credit standards to all activities with credit risk.

Fair value hedges: We primarily use receive-fixed interest rate swaps to hedge the fair values of certain fixed rate long term FHLB advances and certificates of deposit against changes in interest rates. These hedges are 100% effective,
 
 
45

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

therefore there is no ineffectiveness reflected in earnings. The net of the amounts earned on the fixed rate leg of the swaps and amounts due on the variable rate leg of the swaps are reflected in interest expense. 
 
Other derivative activities: We also have other derivative financial instruments which do not qualify as SFAS 133 hedge relationships.

We have issued certain certificates of deposit which pay a return based upon changes in the S&P 500 equity index. Under SFAS 133, the equity index feature of these deposits is deemed to be an embedded derivative accounted for separately from the deposit. To hedge the returns paid to the depositors, we have entered into an equity swap indexed to the S&P 500. Both the embedded derivative and the equity swap are accounted for as other derivative instruments. Gains and losses on both the embedded derivative and the swap are included in other noninterest income on the consolidated statement of income.

We have also entered into receive-fixed interest rate swaps with certain customers (“Customer Swaps”) who have a variable rate commercial real estate loan, but desire a long-term fixed interest rate. The notional amount of each Customer Swap equals the principal balance of the customer’s related commercial real estate loan. Further, under the terms of each Customer Swap, the variable rate payment we pay the customer equals the interest payment the customer pays us under the terms of their commercial real estate loan. Accordingly, the customer’s fixed rate payment under the Customer Swap represents the customer’s effective borrowing cost. In addition, to hedge the long-term interest rate risk associated with these transactions, we have entered into receive-variable interest rate swaps with an unrelated counterparty (“Counterparty Swap”) in notional amounts equaling the notional amounts of each related Customer Swap. The amounts we pay to the unrelated counterparty under the fixed rate leg of each Counterparty Swap equals the amount we receive from each customer under the fixed rate leg of their Customer Swap. Gains and losses associated with both the Customer Swaps and Counterparty Swaps are included in other noninterest income on the consolidated statement of income.

A summary of our derivative financial instruments by type of activity follows:

   
December 31, 2005
  
               
Net
  
       
Derivative
  
Ineffective
  
   
Notional
 
Fair Value
  
Hedge Gains
  
   
Amount
  
Asset
  
Liability
  
(Losses)
  
FAIR VALUE HEDGES
                  
Receive-fixed interest
                          
rate swaps
                          
FHLB advances
  
$
40,000,000
  
$
-
  
$
1,941,645
  
$
-
  
Brokered deposits
    
15,000,000
   
-
   
104,635
   
-
 
     
55,000,000
   
-
   
2,046,280
   
-
 
 
 

   
December 31, 2004
  
               
Net
  
       
Derivative
  
Ineffective
  
   
Notional
 
Fair Value
  
Hedge Gains
  
   
Amount
  
Asset
  
Liability
  
(Losses)
  
FAIR VALUE HEDGES
                  
Receive-fixed interest
                          
rate swaps
                          
FHLB advances
  
$
46,000,000
  
$
-
  
$
809,120
  
$
-
  
 
 

   
December 31, 2005
  
       
Derivative
  
Net
  
   
Notional
         
Gains
  
   
Amount
  
Asset
  
Liability
  
(Losses)
  
                   
OTHER DERIVATIVE INSTRUMENTS
          
Equity index
                          
   linked certificates
                          
   of deposit
  
$
1,354,630
  
$
87,426
  
$
-
  
$
(11,264
)
Equity index swap
    
1,354,630
   
-
   
150,131
   
4,909
 
Receive-fixed interest
                  
   rate swaps
    
7,792,100
   
-
   
17,728
   
(17,728
)
Receive-variable
                          
   interest rate swaps
    
7,792,100
   
144,572
   
-
   
144,572
 
                           
   
$
18,293,460
  
$
231,998
  
$
167,859
  
$
120,489
  
 
 
 

   
December 31, 2004
  
       
Derivative
  
Net
  
   
Notional
         
Gains
  
   
Amount
  
Asset
  
Liability
  
(Losses)
 
                   
OTHER DERIVATIVE INSTRUMENTS
          
Equity index
                          
   linked certificates
                          
   of deposit
  
$
1,354,630
  
$
23,653
  
$
-
  
$
(33,290
)
Equity index swap
    
1,354,630
   
-
   
138,867
   
28,100
 
   
$
2,709,260
  
$
23,653
  
$
138,867
  
$
(5,190
)
 
 
46

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


 
 
NOTE 19. FAIR VALUE OF FINANCIAL INSTRUMENTS

The following summarizes the methods and significant assumptions we used in estimating our fair value disclosures for financial instruments.

Cash and due from banks: The carrying values of cash and due from banks approximate their estimated fair value.
 
Interest bearing deposits with other banks: The fair values of interest bearing deposits with other banks are estimated by discounting scheduled future receipts of principal and interest at the current rates offered on similar instruments with similar remaining maturities.

Federal funds sold: The carrying values of Federal funds sold approximate their estimated fair values.

Securities: Estimated fair values of securities are based on quoted market prices, where available. If quoted market prices are not available, estimated fair values are based on quoted market prices of comparable securities.

Loans held for sale: The carrying values of loans held for sale approximate their estimated fair values.
 
Loans: The estimated fair values for loans are computed based on scheduled future cash flows of principal and interest, discounted at interest rates currently offered for loans with similar terms to borrowers of similar credit quality. No prepayments of principal are assumed.

Accrued interest receivable and payable: The carrying values of accrued interest receivable and payable approximate their estimated fair values.
 
Deposits: The estimated fair values of demand deposits (i.e. non-interest bearing checking, NOW, money market and savings accounts) and other variable rate deposits approximate their carrying values. Fair values of fixed maturity deposits are estimated using a discounted cash flow methodology at rates currently offered for deposits with similar remaining maturities. Any intangible value of long-term relationships with depositors is not considered in estimating the fair values disclosed.

Short-term borrowings: The carrying values of short-term borrowings approximate their estimated fair values.

Long-term borrowings: The fair values of long-term borrowings are estimated by discounting scheduled future payments of principal and interest at current rates available on borrowings with similar terms.

Derivative financial instruments: The fair values of the interest rate swaps are valued using cash flow projection models.

Off-balance sheet instruments: The fair values of commitments to extend credit and standby letters of credit are estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present credit standing of the counter parties. The amounts of fees currently charged on commitments and standby letters of credit are deemed
insignificant, and therefore, the estimated fair values and carrying values are not shown below.

The carrying values and estimated fair values of our financial instruments are summarized below:



47

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



   
2005
 
2004
 
       
Estimated
     
Estimated
 
   
Carrying
 
Fair
 
Carrying
 
Fair
 
   
Value
 
Value
 
Value
 
Value
 
Financial assets:
                         
Cash and due from banks
 
$
22,535,761
  
$
22,535,761
  
$
19,416,219
  
$
19,416,219
  
Interest bearing deposits,
                         
other banks
   
1,536,506
   
1,536,506
   
2,338,698
   
2,338,698
 
Federal funds sold
   
3,650,000
   
3,650,000
   
48,000
   
48,000
 
Securities available for sale
   
223,772,298
   
223,772,298
   
211,361,504
   
211,361,504
 
Loans held for sale, net
   
16,584,990
   
16,584,990
   
14,273,916
   
14,273,916
 
Loans, net
   
793,766,837
   
785,575,694
   
602,727,975
   
600,648,677
 
Accrued interest receivable
   
4,835,763
   
4,835,763
   
3,651,907
   
3,651,907
 
Derivative financial assets
   
231,998
   
231,998
   
23,653
   
23,653
 
   
$
1,066,914,153
  
$
1,058,723,010
  
$
853,841,872
  
$
851,762,574
  
Financial liabilities:
                         
Deposits
 
$
673,900,718
  
$
675,526,380
  
$
524,613,698
  
$
525,367,208
  
Short-term borrowings
   
182,028,113
   
182,028,113
   
120,629,214
   
120,629,214
 
Long-term borrowings and
                         
subordinated debentures
   
170,500,835
   
172,769,867
   
172,201,182
   
179,418,281
 
Accrued interest payable
   
2,904,801
   
2,904,801
   
1,927,158
   
1,927,158
 
Derivative financial liabilities
   
2,214,139
   
2,214,139
   
947,987
   
947,987
 
   
$
1,031,548,606
  
$
1,035,443,300
  
$
820,319,239
  
$
828,289,848
  

 
NOTE 20. CONDENSED FINANCIAL STATEMENTS OF PARENT COMPANY
Our investment in our wholly-owned subsidiaries is presented on the equity method of accounting. Information relative to our balance sheets at December 31, 2005 and 2004, and the related statements of income and cash flows for the years ended December 31, 2005, 2004 and 2003, are presented as follows:

 
 

48

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



 

 
Balance Sheets
 
December 31,
 
 
  
2005
 
2004
 
Assets
         
Cash and due from banks
 
$
373,693
  
$
410,282
  
Investment in subsidiaries, eliminated in consolidation
   
86,662,381
   
68,966,924
 
Securities available for sale
   
150,409
   
175,534
 
Premises and equipment
   
6,581,084
   
6,804,384
 
Accrued interest receivable
   
4,682
   
2,388
 
Other assets
   
1,711,542
   
1,387,502
 
Total assets
 
$
95,483,791
  
$
77,747,014
  
               
Liabilities and Shareholders' Equity
             
Long-term borrowings
 
$
1,000,000
  
$
-
  
Subordinated debentures owed to
             
    unconsolidated subsidiary trusts
   
19,589,000
   
11,341,000
 
Other liabilities
   
1,091,566
   
697,993
 
Total liabilities
   
21,680,566
   
12,038,993
 
               
Preferred stock and related surplus, $1.00 par value, authorized
     
    250,000 shares; 2004 - 33,400 shares issued
   
-
   
1,158,471
 
Common stock and related surplus, $2.50 par value, authorized
     
    20,000,000 shares; issued 2005 - 7,126,220 shares;
     
    2004 - 7,155,420 shares
   
18,856,774
   
18,123,492
 
Retained earnings
   
56,214,807
   
47,108,898
 
Less cost of shares acquired for the treasury -
             
    2004 - 115,880 shares
   
-
   
(627,659
)
Accumulated other comprehensive income
   
(1,268,356
)
  
(55,181
)
Total shareholders' equity
   
73,803,225
   
65,708,021
 
               
Total liabilities and shareholders' equity
 
$
95,483,791
  
$
77,747,014
  

 


49

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS




Statements of Income
 
For the Year Ended December 31,
 
 
  
2005
 
2004
 
2003
 
Income
             
Dividends from bank subsidiaries
 
$
2,800,000
  
$
2,500,000
  
$
2,800,000
  
Other dividends and interest income
   
26,966
   
16,489
   
8,060
 
Gain (loss) on sale of assets
   
20,758
   
(9,766
)
  
-
 
Management and service fees from bank subsidiaries
   
4,864,878
   
3,912,870
   
3,311,180
 
Total income
   
7,712,602
   
6,419,593
   
6,119,240
 
Expense
                   
Interest expense
   
879,870
   
506,519
   
231,736
 
Operating expenses
   
5,668,209
   
4,812,149
   
3,709,857
 
Total expenses
   
6,548,079
   
5,318,668
   
3,941,593
 
Income before income taxes and equity in
                   
undistributed income of bank subsidiaries
   
1,164,523
   
1,100,925
   
2,177,647
 
Income tax (benefit)
   
(694,250
)
  
(547,800
)
  
(194,150
)
Income before equity in undistributed income
                   
    of bank subsidiaries
   
1,858,773
   
1,648,725
   
2,371,797
 
Equity in (distributed) undistributed
                   
    income of bank subsidiaries
   
9,383,631
   
8,959,648
   
5,836,559
 
Net income
 
$
11,242,404
  
$
10,608,373
  
$
8,208,356
  





50

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



Statements of Cash Flows
 
For the Year Ended December 31,
 
 
  
2005
 
2004
 
2003
 
CASH FLOWS FROM OPERATING ACTIVITIES
                   
Net income
 
$
11,242,404
  
$
10,608,373
  
$
8,208,356
  
Adjustments to reconcile net earnings to
                   
net cash provided by operating activities:
                   
Equity in (undistributed) distributed net income of
                   
bank subsidiaries
   
(9,383,631
)
  
(8,959,648
)
  
(5,836,559
)
Deferred tax expense (benefit)
   
(43,750
)
  
10,200
   
219,850
 
Depreciation
   
593,597
   
565,672
   
344,546
 
Securities (gains)losses
   
(20,625
)
  
-
   
-
 
Loss on disposal of premises and equipment
   
-
   
9,766
   
-
 
Tax benefit of exercise of stock options
   
77,000
   
141,000
   
-
 
(Increase) decrease in other assets
   
(78,333
)
  
(199,724
)
  
138,841
 
Increase (decrease) in other liabilities
   
437,322
   
376,607
   
120,210
 
Net cash provided by operating activities
   
2,823,984
   
2,552,246
   
3,195,244
 
                     
CASH FLOWS FROM INVESTING ACTIVITIES
                   
Investment in subsidiaries
   
(9,525,000
)
  
(3,150,000
)
  
(2,100,000
)
Proceeds sales of available for sale securities
   
45,750
   
-
   
-
 
Purchase of available for sale securities
   
-
   
-
   
(87,186
)
Proceeds from sales of premises and equipment
   
-
   
-
   
1,000,000
 
Purchases of premises and equipment
   
(370,297
)
  
(1,219,361
)
  
(5,325,450
)
Net cash (used in) investing activities
   
(9,849,547
)
  
(4,369,361
)
  
(6,512,636
)
                     
CASH FLOWS FROM FINANCING ACTIVITIES
                   
Dividends paid to shareholders
   
(2,136,495
)
  
(1,827,526
)
  
(1,507,939
)
Exercise of stock options
   
125,469
   
120,237
   
53,265
 
Purchase of treasury stock
   
-
   
-
   
(7,948
)
Proceeds from long-term borrowings
   
4,000,000
   
125,000
   
4,720,000
 
Repayment of long-term borrowings
   
(3,000,000
)
  
(4,845,000
)
  
-
 
Net proceeds from issuance of trust preferred securities
   
8,000,000
   
7,406,250
   
-
 
Net proceeds from issuance of preferred stock
   
-
   
1,158,471
   
-
 
Net cash provided by (used in)
                   
financing activities
   
6,988,974
   
2,137,432
   
3,257,378
 
Increase (decrease) in cash
   
(36,589
)
  
320,317
   
(60,014
)
Cash:
                   
Beginning
   
410,282
   
89,965
   
149,979
 
Ending
 
$
373,693
  
$
410,282
  
$
89,965
  
                     
SUPPLEMENTAL DISCLOSURES OF CASH
                   
FLOW INFORMATION
                   
Cash payments for:
                   
Interest
 
$
824,201
  
$
476,449
  
$
223,228
  
                     
SUPPLEMENTAL SCHEDULE OF NONCASH
                   
INVESTING AND FINANCING ACTIVITIES
                   
Noncash investment in unconsolidated subsidiary trust
 
$
248,000
  
$
232,000
  
$
-
  


51