ITEM 1. DESCRIPTION OF BUSINESS
ORGANIZATIONAL HISTORY AND SUBSIDIARIES
CNB Financial Services, Inc. (the "Company") was organized under the laws of West Virginia in March 2000 at the direction of the Board of Directors of Citizens National Bank (the "Bank") for the purpose of becoming a financial services holding company. The Company and its subsidiary are collectively referred to herein as "CNB".
A special meeting of the Bank's shareholders was held on August 4, 2000, and the shareholders approved the Agreement and Plan of Merger between the Bank and the Company, whereby the Bank became a wholly-owned subsidiary of the Company and the shareholders of the Bank became shareholders of the Company. The merger became effective on August 31, 2000. Each Bank shareholder received two shares of the Company stock for each share of the Bank's common stock. On August 31, 2000, the Company consummated its merger with the Bank and subsidiary, in a tax-free exchange of stock. Shareholders of the Bank received two shares of CNB Financial Services, Inc. common stock for each of the 229,024 shares of the Bank's common stock. The merger was accounted for as a pooling of interests.
CNB became a 50% member of a limited liability corporation, Morgan County Title Insurance Agency, LLC in February 2001, for the purpose of selling title insurance.
Citizens National Bank of Berkeley Springs, (the Bank or Citizens National Bank), was organized on June 20, 1934 and has operated in Berkeley Springs, Morgan County, West Virginia, as a national banking association continuously since that time. The Bank formed CNB Insurance Services, Inc., a wholly owned subsidiary, which is a property and casualty insurance agency selling primarily personal lines of insurance.
EMPLOYEES
As of December 31, 2002 and 2001, CNB employed 81 and 80 full-time equivalent employees, respectively.
BUSINESS OF CNB FINANCIAL SERVICES, INC. AND CITIZENS NATIONAL BANK
The Company's primary function is to direct, plan and coordinate the business activities of the Bank and its subsidiary.
Citizens National Bank is a full-service commercial bank conducting general banking and trust activities through four full-service offices and five automated teller machines located in Morgan and Berkeley Counties, West Virginia. The Bank opened a full-service branch in Martinsburg, Berkeley County, West Virginia on March 18, 2002. The Bank accepts time, demand and savings deposits including NOW accounts, regular savings accounts, money market accounts, fixed-rate certificates of deposit and club accounts. In addition, the Bank provides safe deposit box rentals, wire transfer services and 24-hour ATM services through a regional network known as STAR. STAR is a participant in the nationwide Cirrus network.
The Bank offers a full spectrum of lending services to its customers, including commercial loans and lines of credit, residential real estate loans, consumer installment loans and other personal loans. Commercial loans are generally secured by various collateral, including commercial real estate, accounts receivable and business machinery and equipment. Residential real estate loans consist primarily of mortgages on the borrower's personal residence, and are typically secured by a first lien on the subject property. Consumer and personal loans are generally secured, often by first liens on automobiles, consumer goods or depository accounts. A special effort is made to keep loan products as flexible as possible within the guidelines of prudent banking practices in terms of interest rate risk and credit risk. Bank lending personnel adhere to established lending limits and authorities based on each individual's lending expertise and experience.
The Bank's trust department acts as trustee under trusts and wills, as executor of wills and administrator of estates, as guardian for estates of minors and incompetents and serves in various corporate trust capacities.
COMPETITION
Citizens National Bank faces a high degree of competition for all its services from local banks. Within its market area of Morgan and Berkeley Counties in West Virginia and Washington County in Maryland, there exist numerous competing commercial banks.
Nonbank competition has also increased in recent years locally by the establishment of finance companies and the expansion of insurance operations and credit unions, as well as from mutual funds located throughout the country.
West Virginia banks are allowed unlimited branch banking throughout the State. The Interstate Banking and Branch Efficiency Act of 1994 also authorizes interstate branching by acquisition and consolidation nationwide. These and similar provisions impacting both the banking and thrift industries may serve to intensify future competition within the Bank's market.
SUPERVISION AND REGULATION
As a registered bank holding company, CNB is subject to the supervision of the Federal Reserve Board and is required to file with the Federal Reserve Board reports and other information regarding its business operations and the business operations of its subsidiaries. CNB is also subject to examination by the Federal Reserve Board and is required to obtain Federal Reserve Board approval prior to acquiring, directly or indirectly, ownership or control of voting shares of any bank, if, after such acquisition, it would own or control more than 5% of the voting stock of such bank. In addition, pursuant to federal law and regulations promulgated by the Federal Reserve Board, CNB may only engage in, or own or control companies that engage in, activities deemed by the Federal Reserve Board to be so closely related to banking as to be a proper incident thereto. Prior to engaging in most new business activities, CNB must obtain approval from the Federal Reserve Board.
CNB's banking subsidiary has deposits insured by the Bank Insurance Fund of the FDIC, and is subject to supervision, examination and regulation by the Office of the Comptroller of the Currency.
The Gramm-Leach-Bliley Act of 1999 was enacted into law on November 12, 1999. The Act removes the Glass-Steagall Act restrictions on affiliation between banks and securities firms and it authorizes financial holding companies that own a bank to engage in a full range of insurance activities. The result is that qualifying bank holding companies may opt to become financial holding companies and thus to hold subsidiaries that engage in banking, securities underwriting and dealing, and insurance agency and underwriting. They may also engage in financial activities listed in the Act, including merchant banking or venture capital activities, the distribution of mutual funds and securities lending.
Bank holding companies now have the option under the Act to continue to operate as bank holding companies or, if they qualify, to act as financial holding companies. CNB has qualified and elected to be a financial holding company. It is important to note in this regard that both bank holding companies and financial holding companies and their non-bank operating subsidiaries are subject to the full panoply of affiliate transaction rules under Sections 23A and B of the Federal Reserve Act. As a consequence, all transactions between affiliated depository institutions and these entities will be restricted under the provisions of those laws.
Under the Act, certain activities are listed as being "financial in nature" including "underwriting, dealing in, or making a market in securities," and "merchant banking". In addition, national banks and state banks (if the state bank chartering authority permits) may engage in certain "financial in nature" activities through financial services subsidiaries. Activities prohibited to financial services subsidiaries include merchant banking but not securities underwriting and dealing.
To engage in these new activities, all depository institutions and financial subsidiaries of a financial holding company must be well capitalized, well managed and have no less than a satisfactory rating under the federal Community Reinvestment Act. CNB and its subsidiaries meet these requirements.
Dividend Restrictions
There are statutory limits on the amount of dividends the bank can pay to CNB without regulatory approval. Under applicable federal regulations, appropriate bank regulatory agency approval is required if the total of all dividends declared by a bank in any calendar year exceeds the available retained earnings and exceeds the aggregate of the bank's net profits (as defined by regulatory agencies) for that year and its
retained net profits for the preceding two years, less any required transfers to surplus or a fund for the retirement of any preferred stock.
FDIC Insurance
The FDIC has the authority to raise the insurance premiums for institutions in the Bank Insurance Fund to a level necessary to achieve a target reserve level of 1.25% of insured deposits within not more than 15 years. In addition, the FDIC has the authority to impose special assessments in certain circumstances. The level of deposit premiums affects the profitability of the bank and thus the potential flow of dividends to parent companies.
Under the risk-based insurance assessment system that became effective January 1, 1994, the FDIC places each insured depository institution in one of nine risk categories based on its level of capital and other relevant information (such as supervisory evaluations).
Federal Deposit Insurance Corporation Improvement Act of 1991
In December 1991, Congress enacted the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), which substantially revised the bank regulatory and funding provisions of the Federal Deposit Insurance Act and makes revisions to several other federal banking statutes.
Among other things, FDICIA requires federal bank regulatory authorities to take "prompt corrective action", with respect to depository institutions that do not meet minimum capital requirements. For these purposes, FDICIA establishes five capital tiers: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized.
Rules adopted by the Federal banking agencies under FDICIA provide that an institution is deemed to be: "well capitalized" if the institution has a total (Tier I plus Tier II) risk-based capital ratio of 10.0% or greater, a Tier I risk-based ratio of 6.0% or greater, and a leverage ratio of 5.0% or greater, and the institution is not subject to an order, written agreement, capital directive, or prompt corrective action directive to meet and maintain a specific level for any capital measure; "adequately capitalized" if the institution has a Total risk-based capital ratio of 8.0% or greater, a Tier I risk-based capital ratio of 4.0% or greater, and a leverage ratio of 4.0% or greater (or a leverage ratio of 3.0% or greater if the institution is rated composite 1 in its most recent report of examination, subject to appropriate Federal banking agency guidelines), and the institution does not meet the definition of a well-capitalized institution; "undercapitalized" if the institution has a Total risk-based capital ratio that is less than 8.0%, a Tier I risk-based capital ratio that is less than 4.0% or a leverage ratio that is less than 4.0% (or a leverage ratio that is less than 3.0% if the institution is rated composite 1 in its most recent report of examination, subject to appropriate Federal banking agency guidelines) and the institution does not meet the definition of a significantly undercapitalized or critically undercapitalized institution; "significantly undercapitalized" if the institution has a Total risk-based capital ratio that is less than 6.0%, a Tier I risk-based capital ratio that is less than 3.0%, or a leverage ratio that is less than 3.0% and the institution does not meet the definition of a critically undercapitalized institution; and "critically undercapitalized" if the institution has a ratio of tangible equity to total assets that is equal to or less than 2%.
At December 31, 2002, CNB qualified as a well-capitalized institution based on the ratios and guidelines noted above. A bank's capital category, however, is determined solely for the purpose of applying the prompt corrective action rules and may not constitute an accurate representation of that bank's overall financial condition or prospects.
The appropriate Federal banking agency may, under certain circumstances, reclassify a well-capitalized insured depository institution as adequately capitalized. The appropriate agency is also permitted to require an adequately capitalized or undercapitalized institution to comply with the supervisory provisions as if the institutions were in the next lower category (but not treat a significantly undercapitalized institution as critically undercapitalized) based on supervisory information other than the capital levels of the institution.
The statute provides that an institution may be reclassified if the appropriate Federal banking agency determines (after notice and opportunity for hearing) that the institution is in an unsafe and unsound condition or deems the institution to be engaging in an unsafe or unsound practice.
FDICIA generally prohibits a depository institution from making any capital distributions (including payment of a dividend) or paying any management fee to its holding company if the depository institution
would thereafter be undercapitalized. Undercapitalized depository institutions are subject to growth limitations and are required to submit a capital restoration plan. The Federal banking agencies may not accept a capital restoration plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution's capital. In addition, for a capital restoration plan to be acceptable, the depository institution's parent holding company must guarantee that the institution will comply with such capital restoration plan. The aggregate liability of the parent holding company is limited to the lesser of (i) an amount equal to 5% of the depository institution's total assets at the time it became undercapitalized, and (ii) the amount which is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized.
Significantly undercapitalized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets and cessation of receipt of deposits from correspondent banks. Critically undercapitalized institutions are subject to the appointment of receiver or conservator.
FDICIA also contains a variety of other provisions that may affect the operation of CNB, including reporting requirements, regulatory standards for real estate lending, "truth in savings" provisions, and the requirement that a depository institution give 90 days' prior notice to customers and regulatory authorities before closing any branch.
Capital Requirements
The risk-based capital guidelines for bank holding companies and banks adopted by the Federal banking agencies were phased in at the end of 1992. The minimum ratio of qualifying total capital to risk-weighted assets (including certain off-balance sheet items, such as standby letters of credit) under the fully phased-in guidelines is 8%. At least half of the total capital is to be comprised of common stock, retained earnings, noncumulative perpetual preferred stocks, minority interests and, for bank holding companies, a limited amount of qualifying cumulative perpetual preferred stock, less goodwill and certain other intangibles ("Tier I capital"). The remainder ("Tier II capital") may consist of other preferred stock, certain other instruments, and limited amounts of subordinated debt and the reserve for credit losses.
In addition, the Federal Reserve Board has established minimum leverage ratio (Tier I capital to total average assets less goodwill and certain other intangibles) guidelines for bank holding companies and banks. These guidelines provide for a minimum leverage ratio of 3.0% for bank holding companies and banks that meet certain specified criteria, including that they have the highest regulatory rating. All other banking organizations are required to maintain a leverage ratio of 3.0% plus an additional cushion of at least 100 to 200 basis points. The guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets. Furthermore, the guidelines indicate that the Federal Reserve Board will continue to consider a "tangible Tier I leverage ratio" in evaluating proposals for expansion or new activities. The tangible Tier I leverage ratio is the ratio of Tier I capital, less intangibles not deducted from Tier I capital, to total assets, less all intangibles.
As of December 31, 2002, the bank had capital in excess of all applicable requirements. Additional information relating to risk-based capital calculations is set forth under the heading "Note 22 Regulatory Matters" of the Annual Report to Shareholders and is incorporated herein by reference.
ITEM 2.
ITEM 2. PROPERTIES
CNB Financial Services, Inc.
CNB's headquarters are located at the main office of Citizens National Bank located at 101 South Washington Street, Berkeley Springs, West Virginia.
Citizens National Bank
The principal executive office and main banking office is located at 101 South Washington Street, Berkeley Springs, West Virginia. In addition, the bank has owned and operated a full service branch bank located at 2450 Valley Road, Berkeley Springs, West Virginia since 1991. In October 1998, the bank opened a full service branch located at 2646 Hedgesville Road, Martinsburg, West Virginia. In March 2002, the
bank opened an additional full service branch located at 14994 Apple Harvest Drive, Martinsburg, West Virginia. The main banking office and each location in Berkeley County provides ATM services, in addition to traditional lobby and drive-in services. During 1998, the bank purchased two cash machines and placed them at Cacapon State Park Lodge and the Woods Resort. In November of 1998, the bank acquired CNB Insurance Services, Inc. which is operated out of the main office in Berkeley Springs. The main office and branches are owned free and clear of any indebtedness. The net book value of the bank's premises and equipment as of December 31, 2002 is $4.8 million.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
In the ordinary course of business, the company and its subsidiary are involved in various legal proceedings.
In the opinion of the management of CNB, there are no proceedings pending to which CNB is a party or to which its property is subject, which, if determined adversely to CNB, would be material in relation to CNB's financial condition. There are no proceedings pending other than ordinary routine litigation incident to the business of CNB. In addition, no material proceedings are pending or are known to be threatened or contemplated against CNB by government authorities.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of 2002.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The price of CNB's common stock ranged from $63.50 to $90.00 in 2002 and from $66.75 to $135.00 in 2001. The prices listed below represent the high and low market prices for stock trades reported during each quarter.
CNB's stock is not traded on an established exchange and there are no known market makers, therefore there is no established public trading market for CNB's stock. The prices listed above are based upon information available to management through discussions with shareholders, and to the best of management's knowledge, accurately represent the amount at which its stock was traded during the periods indicated. Prices reflect amounts paid by purchasers of the stock and, therefore, may include commissions or fees. The amounts of such commissions or fees, if any, are not known to management. No attempt was made by management to ascertain the prices for every sale made during these periods.
The ability of CNB to pay dividends is subject to certain limitations imposed by national banking laws. As of March 5, 2003, the number of record holders was 606.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
TABLE 1. FIVE YEAR SELECTED CONSOLIDATED FINANCIAL DATA
(1) Adjusted to reflect 100% stock dividend on March 1, 1998
(2) Restated to reflect the formation of CNB Financial Services, Inc. and the acquisition of Citizens National Bank and subsidiary on August 31, 2000 and accounted for as a pooling of interests.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis presents the significant changes in financial condition and results of operations of CNB, for the years ended December 31, 2002 and 2001. This discussion and analysis should be read in conjunction with the audited, consolidated financial statements and the accompanying notes thereto. This discussion may include forward looking statements based upon management's expectations; actual results may differ. Amounts and percentages used in this discussion have been rounded. All average balances are based on monthly averages.
EARNINGS SUMMARY
CNB had net income totaling $1.3 million or $2.86 per share, $1.2 million or $2.70 per share and $1.3 million or $2.85 per share for fiscal years 2002, 2001 and 2000, respectively. Annualized return on average assets and average equity were .7% and 8.4%, respectively for 2002 compared to .8% and 8.5% for 2001 and .9% and 10.2% for 2000.
NET INTEREST INCOME
Net interest income represents the primary component of the Bank's earnings. It is the difference between interest and fee income related to earning assets and interest expense incurred to carry interest-bearing liabilities. Net interest income is impacted by changes in the volume and mix of interest-earning assets and interest-bearing liabilities, as well as by changing interest rates. In order to manage these changes, their impact on net interest income and the risk associated with them, the Bank utilizes an ongoing asset/liability management program. This program includes analysis of the difference between rate sensitive assets and rate sensitive liabilities, earnings sensitivity to rate changes, and source and use of funds. A discussion of net interest income and the factors impacting it is presented below.
Net interest income in 2002 increased by $217,000 or 3.7% over 2001. Interest income in 2002 decreased by $379,000 or 3.2% compared to 2001, while interest expense decreased by $596,000 or 10.0% during 2002 as compared to 2001. Interest income decreased during 2002 compared to 2001 as a result of a decrease in the average rates earned on loans, securities and federal funds sold offset by an increase in the average balances of the earning assets. Interest expense decreased during 2002 compared to 2001 as a result of a decrease in the average rates paid on NOW, money market, savings and time deposits offset by an increase in the average balances of the interest bearing liabilities.
Net interest income in 2001 increased by $260,000 or 4.6% over 2000. Interest income in 2001 increased by $833,000 or 7.6% compared to 2000, while interest expense increased by $573,000 or 10.7% during 2001 as compared to 2000. Interest income increased during 2001 compared to 2000 as a result of an increase in the average balance of loans, securities and federal funds sold offset by a decrease in the average rates earned thereon. Interest expense increased during 2001 compared to 2000 as a result of an increase in the average balance of time deposits and the rates paid thereon and the average balance of NOW accounts offset by lower rates paid on deposit products other than time deposits.
During both 2002 and 2001, the Bank used funds generated from deposit account growth to fund loan commitments and to increase the average balance of investment securities, especially high quality U.S. government agency securities.
The net interest margin is impacted by the change in the spread between yields on earning assets and rates paid on interest bearing liabilities. Net interest margin declined slightly from 2001 to 2002. See Table 2 -- Distribution of Assets, Liabilities and Shareholders' Equity; Interest Rates and Interest Differential.
TABLE 2. DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY; INTEREST RATES AND INTEREST DIFFERENTIAL
(1) Yields are expressed on a tax equivalent basis using a 34% tax rate.
(2) For the purpose of these computations, nonaccruing loans are included in the amounts of average loans outstanding.
(3) Net interest spread is the difference between the weighted average yield on interest-earning assets and the weighted average cost of interest-bearing liabilities.
(4) Interest income on loans excludes fees of $365,000 in 2002, $285,000 in 2001and $233,000 in 2000.
(5) Interest income on loans includes fees of $158,085 in 2002, $200,039 in 2001and $141,729 in 2000 from the Business Manager Program, student loans and lease receivables.
Table 3 sets forth a summary of the changes in interest earned and interest expense detailing the amounts attributable to (i) changes in volume (change in average volume times the prior year's average rate), (ii) changes in rate (change in the average rate times the prior year's average volume). The changes in rate/volume (change in the average volume times the change in the average rate), had been allocated to the changes in volume and changes in rate in proportion to the relationship of the absolute dollar amounts of the change in each. During 2002, net interest income increased $648,000 due to changes in volume and decreased $509,000 due to changes in interest rates. Also, net interest income was affected by a $80,000 increase in loan fees. In 2001, net interest income increased $380,000 due to changes in volume and increased $172,000 due to changes in interest rates. Also, net interest income was affected by a $52,000 decrease in loan fees.
TABLE 3. VOLUME AND RATE ANALYSIS OF CHANGES IN INTEREST INCOME
Another method of analyzing the change in net interest income is to examine the changes between interest rate spread and the net interest margin on earning assets. The interest rate spread as shown in Table 4 is the difference between the average rate earned on earning assets and the average rate on interest bearing liabilities. The net interest margin takes into account the benefit derived from assets funded by interest free sources such as non-interest bearing demand deposits and capital.
TABLE 4. INTEREST RATE SPREAD AND NET INTEREST MARGIN ON EARNING ASSETS
(1) Non-interest bearing liabilities and shareholders' equity less non-interest earning assets.
The following discussion analyzes changes in the Bank's spreads and margins in terms of basis points. A basis point is a unit of measure for interest rates equal to .01%. One hundred basis points equals 1%.
Interest rate spread decreased 18 basis points in 2002 while the net interest margin declined 37 basis points. Both the interest rate spread and margin were negatively impacted by a 117 basis point decrease in earning asset yields offset by a 99 basis point decrease in interest bearing liability costs. Although the prime rate only decreased 50 basis points in 2002, loan yields decreased 103 basis points because a significant portion of the loan portfolio repriced at lower rates through refinancing or variable rate loans. The decrease in liability costs is primarily the result of the lower cost of funds on savings, NOW, money market and time deposit accounts during the year.
Interest rate spread decreased 32 basis points in 2001 while the net interest margin decreased 30 basis points. Both the interest rate spread and margin were negatively impacted by a 36 basis point decrease in earning asset yields and offset by a 4 basis point decrease in interest bearing liability costs. Although the prime rate decreased 475 basis points in 2001, loan yields only decreased 9 basis points due to a significant portion of the loan portfolio are variable rate loans that only reprice on a one, three or five year basis. The decrease in liability costs is primarily the result of lower cost of funds on savings, NOW, money market and time deposit accounts during the year.
PROVISION FOR LOAN LOSSES
The amount charged to provision for loan losses is based on Management's evaluation of the loan portfolio. Management determines the adequacy of the allowance for loan losses based on past loan loss experience, current economic conditions, composition of the loan portfolio. The allowance for loan losses is the best estimate by Management of the probable losses which have been incurred as of the balance sheet date. See Nonperforming Loans and Allowance for Loan Losses for a comprehensive analysis.
NONINTEREST INCOME
Noninterest income increased $377,000 or 36.8% during 2002 over the prior comparable period. The increase in 2002 was attributable to fees generated from the Bounce Protection program, which is a new service the Bank began to offer to checking deposit account holders in April 2001, overdraft fees, debit cards, gain on sale of securities and trust fees. Income from CNB's insurance operations decreased. Bounce Protection is a form of overdraft protection which enables the customer to have insufficient funds checks paid
instead of returned. The customer is charged a fee for each check paid. Bounce Protection, overdraft fees and debit card fees increased due to the Bank's increased number of checking accounts and volume of activity on these accounts.
There was also an increase in other fees, which included trust fees. Fees generated from trust assets under management increased even though the level of assets being managed decreased from $24.1 million at December 31, 2001 to $22.7 million at December 31, 2002. The trust fees increased due to a large estate being settled in 2002. Another factor contributing to the increase in noninterest income was in March 2002, one of the Bank's Board of Directors passed away and the Bank was the beneficiary of a life insurance policy on the director. The Bank received $43,379 in a death benefit, $21,645 of which was recorded in assets as cash surrender value. The difference of $21,734 is reflected in other operating income.
Noninterest income increased $183,000 or 21.7% during 2001 over the prior comparable period. The increase in 2001 was attributable to insurance operations, a new service the Bank began to offer to checking deposit account holders in April 2001, debit cards and trust fees. Income from CNB's insurance operations increased, including the investment in the title company.
Fees generated from the Bounce Protection program and debit card income offset by the decrease in gain on stock received from the demutualization of an insurance company in the first quarter of 2000 accounted for the increase in noninterest income. There were also an increase in other fees, which included trust fees. Fees generated from trust assets under management increased as the level of assets being managed reached $24.1 million at December 31, 2001, a 12.1% increase from $21.5 million at December 31, 2000.
NONINTEREST EXPENSES
Noninterest expenses increased $507,000 or 10.6% during 2002 over the prior comparable period. The increase was primarily due to an increase in occupancy expense, furniture and equipment expense, salaries and employee benefits and other operating expenses. Higher health insurance costs, normal recurring merit increases and additional staffing at the south Martinsburg branch facility accounted for the additional costs of salaries and benefits in 2002. Additional depreciation related to the Bank's new technology systems and south Martinsburg branch facility caused occupancy expense and furniture and equipment expense to increase.
Components of other operating expense, which significantly increased during 2002, included telephone, advertising, conventions and meetings, and NSF check and other losses. These increases were offset by decreases to stationary, supplies and printing, Bounce Protection expenses, Business Manager expenses, other outside service fees and miscellaneous other operating expenses. Expenses related to the first full year of operation of the new branch facility in south Martinsburg, Berkeley County West Virginia attributed to the increase in other operating expenses. Expenses related to the Bounce Protection Program decreased due to a contract revision reducing the percentage of income shared with the vendor. Advertising expense increased due to the bank contracting a third party vendor for additional advertising services. A decrease in the volume of the Business Manager program caused the expenses related to this program to decrease.
Noninterest expenses increased $515,000 or 12.0% during 2001 over the prior comparable period. The increase was primarily due to an increase in occupancy expense, salaries and employee benefits and other operating expenses. Higher health insurance costs, normal recurring merit increases and additional hiring for the south Martinsburg branch facility accounted for the additional costs of salaries and benefits in 2001.
Components of other operating expense, which significantly increased during 2001, included stationary, supplies and printing, data processing fees, postage, professional fees and business manager program expenses. Expenses related to the opening and operation of the temporary banking facility in south Martinsburg, Berkeley County West Virginia beginning in August 2001 attributed to the increase in occupancy expense and stationery, supplies and printing expense. Also, contributing to the slight increase in occupancy expense was the main Bank renovations, offset by the 2000 write-off of the fixed asset abandonment related to the Bank not pursing main office expansion plans. Maintenance expense related to technology systems caused data processing expense to increase. Professional fees increased due to holding company regulatory financial reporting expenses. An increase in the volume of the Business Manager program caused the expenses related to this program to increase.
INCOME TAXES
Provision for income tax totaled $681,000 in 2002, $700,000 in 2001 and $758,000 in 2000. The effective tax rate was 34.2% in 2002 compared to 36.1% and 36.7% in 2001 and 2000, respectively. The Bank's income tax expense differs from the amount computed at statutory rates primarily due to the tax-exempt earnings from certain investment securities. See Note 18 of the Notes to Consolidated Financial Statements for a comprehensive analysis of income tax expense.
FINANCIAL CONDITION
Table 5 examines Citizens National Bank's financial condition in terms of its sources and uses of funds. Average funding sources and uses increased $20.4 million or 13.5% in 2002 compared with an increase of $16.5 million or 12.2% in 2001.
TABLE 5. SOURCES AND USES OF FUNDS
(1) Noninterest bearing liabilities and shareholders' equity less noninterest earning assets.
Total assets increased $20.1 million or 11.7% to $191.6 million from December 31, 2001 to December 31, 2002, due primarily to a $17.8 million increase in loans, a $4.1 million increase in federal funds sold, a $3.6 million increase in cash and cash equivalents and a $517,000 increase in premises and equipment, net, which were partially offset by a $5.5 million decrease in securities available for sale.
Total liabilities increased $18.7 million or 11.9% to $175.3 million from December 31, 2001 to December 31, 2002 substantially due to the increase in deposits. Shareholders' equity increased $1.4 million to $16.3 million at December 31, 2002 primarily due to net income of $1.3 million and a $503,000 increase in accumulated other comprehensive income, offset by cash dividends of $467,000.
The increase in accumulated other comprehensive income was due to the unrealized market value appreciation of the available for sale investment security portfolio. The only component of accumulated other comprehensive income at December 31, 2002 was unrealized gains and losses on available for sale
securities net of deferred income taxes. The unrealized gains and losses are primarily a function of available market interest rates relative to the yield being generated on the available for sale portfolio. No earnings impact results, however, unless the securities are actually sold.
LOAN PORTFOLIO
At December 31, 2002, total loans increased $17.8 million or 16.1% to $128.3 million from $110.5 million at December 31, 2001. The loan mix changed slightly compared with December 31, 2001. The Bank's real estate loans grew as a direct result of the increased debt consolidation and refinancing of existing loans at lower rates. The Bank's new programs targeting purchases and home construction loans generated additional growth. The Bank's commercial real estate and business loans grew as a direct result of the Bank's continued efforts to develop new commercial lending relationships especially in the Berkeley County, West Virginia market. The Bank's management believes additional growth in all lending areas is possible into year 2003. Management's intent is to control the loan volume in a manner which would produce a loan to deposit ratio between 75% and 80% and maintain credit quality. The loan to deposit ratio was 74.2% at December 31, 2002 and 71.6% at December 31, 2001. The ratio of net charge-offs to average loans outstanding was .08% in 2002 and .10% in 2001.
Growth recorded in the commercial loan area resulted in increases of 38.8% to $9.7 million outstanding at December 31, 2002 and 15.6% to $7.0 million outstanding at December 31, 2001. The Bank's market area was expanded to Berkeley County, West Virginia in 1999 which provides a much larger area for commercial lending. Additional growth in both commercial business and commercial real estate is possible in 2003.
Real estate mortgage loans comprised mainly of one to four family residences continued to be the Bank's dominant loan category. Mortgage lending comprises approximately 64% or $83.2 million of the total loan portfolio at December 31, 2002 compared to 61% or $67.9 million at December 31, 2001.
Demand for the Bank's primary mortgage products, variable rate loans carrying annual interest rate adjustments based on one, three and five year Treasury rates, continues to increase and have become more attractive to the Bank's customers because these loans usually have lower rates, lower closing costs and quicker settlement. The Bank continues to see demand for fixed rate mortgage products, and for all loan products, as the Bank penetrates the Berkeley County, West Virginia real estate market. As of December 31, 2002, 60.1% of the Bank's mortgage loans were adjustable rate loans and 39.9% were fixed rate loans. Currently, the Bank has approximately $3.8 million in fixed rate loans in the portfolio which were originated under terms that would allow them to be sold on the secondary market, although there is no present intent to sell these loans.
The consumer loan portfolio showed a decrease. The primary factor causing the decrease was new automobile loans were considerably affected by the dealer incentive programs offered by the competition. In the third quarter of 2002, the Bank adopted a managed risk pricing structure for its consumer loans which significantly reduced loan rates for borrowers with excellent credit. Indirect loan contracts from automobile dealers did show a marked increase when the new pricing structure took effect, however, the new managed risk pricing structure rates have not been advertised to the Bank's market area. Due to this new pricing structure, the Bank opted not to have a formal loan sale.
Additional information on the composition of the loan portfolio may be found in Note 5 of the Notes to the Consolidated Financial Statements.
Bank policy requires those loans which are past due 90 days or more be placed on nonaccrual status unless they are both well secured and in the process of collection. As of December 31, 2002 and 2001, nonaccrual loans approximated ..01% and .02% of total loans (net), respectively.
TABLE 6. LOANS AND LEASE RECEIVABLE
TABLE 7. LOAN MATURITIES AND INTEREST SENSITIVITY (1)
(1) Excludes residential mortgages and consumer loans.
NONPERFORMING LOANS AND ALLOWANCE FOR LOAN LOSSES
Nonperforming loans consist of loans in nonaccrual status, loans which are past due 90 days or more and still accruing interest and restructured loans. The Bank has no loans which are considered to be impaired as of December 31, 2002 and 2001. As of December 31, 2002, management is aware of three borrowers who have exhibited weaknesses. Their loans have aggregate uninsured balances of $862,190 and are primarily secured by real estate. A specific allowance of $100,000 related to these loans has been established as part of the allowance for loan losses. Management believes that any additional potential loss would be minimal.
TABLE 8. NON-PERFORMING ASSETS
The allowance for loan losses is the best estimate by management of the probable losses which have been incurred as of the respective balance sheet date. Management makes a determination quarterly by analyzing overall loan quality, changes in the mix and size of the loan portfolio, previous loss experience, general economic conditions, information about specific borrowers and other factors. The Bank's methodology for determining the allowance for loan losses establishes both an allocated and an unallocated component. The allocated portion of the allowance represents the results of analyses of individual loans that are being monitored for potential credit problems and pools of loans within the portfolio. The allocated portion of the allowance for loans is based principally on current loan risk ratings, historical loan loss rates adjusted to reflect current conditions, as well as analyses of other factors that may have affected the collectibility of loans in the portfolio. The Bank analyzes all commercial loans that are being monitored as potential credit problems to determine whether such loans are impaired, with impairment measured by reference to the borrowers' collateral values and cash flows. The unallocated portion of the allowance for loan losses represents the results of analyses that measure probable losses inherent in the portfolio that are not adequately captured in the allocated allowance analyses. These analyses include consideration of unidentified losses inherent in the portfolio resulting from changing underwriting criteria, changes in the types and mix of loans originated, industry concentrations and evaluations, allowance levels relative to selected overall credit criteria and other economic indicators used to estimate probable incurred losses. At December 31, 2002 and 2001, the allowance for loan losses totaled $1.5 million and $1.3 million, respectively. The allowance for loan losses as a percentage of loans was 1.2% and 1.2% as of December 31, 2002 and 2001. The provision for loan losses exceeded net charge-offs by $147,000 and $121,000 in 2002 and 2001. An analysis of the allowance for loan losses for the years ended December 31, 2002 and 2001 may be found in Note 5 of the Notes to the Consolidated Financial Statements.
The provision for loan losses is a charge to earnings which is made to maintain the allowance for loan losses at a sufficient level. In 2002, 2001 and 2000, the provision totaled $261,000, $226,000 and $170,000, respectively. While loan quality remains good and past due and nonaccrual loans are minimal, management increased the provision for loan losses in 2002 based on the declining general economic conditions as evidenced by the slowdown in the economy as cited in various financial publications. Having increased the provision for loan losses, management believes the allowance for loan losses to be adequate and is not aware of any information relating to the loan portfolio which it expects will materially impact future operating results, liquidity or capital resources. In addition, federal regulators may require additional reserves as a result of their examination of the Bank. The allowance for loan losses reflects what management currently believes is an adequate level of allowance, although there can be no assurance that future losses will not exceed the estimated amounts, thereby adversely affecting future results of operations.
TABLE 9. ALLOWANCE FOR LOAN LOSSES
TABLE 10. ALLOCATION OF ALLOWANCE FOR LOAN LOSSES
SECURITIES PORTFOLIO AND FEDERAL FUNDS SOLD
The Bank's securities portfolio consists of only available for sale securities. Classifying the securities portfolio as available for sale provides management with increased ability to manage the balance sheet structure and address asset/liability management issues when needed. The fair value of the investment portfolio has decreased $5.5 million to $43.4 million at December 31, 2002 from 2001.
The composition of the portfolio continues to reflect the Bank's conservative philosophy which places greater importance on safety and liquidity than on yield. At December 31, 2002, approximately 64.8% of the portfolio is comprised of US Treasury and Agency securities, 32.5% in Mortgage Backed securities and 2.7% in State and Political Subdivision securities. The term to maturity is limited to seven years for Treasury and Agency bonds and 10 years for Municipal bonds. Typically, investments in Agency bonds contain a call feature. These bonds generally have a somewhat higher yield. The average term to maturity of the portfolio as of December 31, 2002 was 4.0 years.
The Bank generally participates in the overnight federal funds sold market. Depending upon specific investing or funding strategies and/or normal fluctuations in loan and deposit balances, the Bank may need, on occasion, to purchase funds on an overnight basis. In 2002 and 2001, the average balance in federal funds sold was $4.7 million and $4.3 million, respectively.
DEPOSITS AND OTHER FUNDING SOURCES
Total deposits were $173.1 million at December 31, 2002, an increase of $18.7 million or 12.1% over deposits at December 31, 2001. Average deposits, however, showed a $23.1 million, or 16.2% growth, to $166.3 million in 2002. Deposits at the Hedgesville branch totaled $21.2 million at December 31, 2002, an increase of $600,000 over December 31, 2001. Deposits at the Martinsburg branch totaled $5.6 million at December 31, 2002, an increase of $4.3 million over December 31, 2001. The Bank has experienced a change in the deposit account mix during 2002. A shift from time deposits to jumbo certificates of deposit is a direct result of customers making deposits to the 36-month Ultimate Certificate of Deposit throughout the year. The increase in jumbo certificates of deposit and other certificates of deposit are primarily due to the continued growth in the 36-month Ultimate Certificate of Deposit. The Bank's 36-month Ultimate Certificate of Deposit allows the customer to withdraw all or a portion of the CD on the first or second year anniversary date without penalty. Deposits may also be made to this CD at any time.
Noninterest-bearing deposits also grew by $7.5 million or 39.1%, during 2002, from $19.2 million at December 31, 2001, to $26.7 million at December 31, 2002. At December 31, 2002, noninterest-bearing deposits represented 15.4% of total deposits, compared to 12.4% for 2001. Average noninterest-bearing deposits increased 33.1% from $17.5 million in 2001 to $23.3 million in 2002. The Bank's noninterest-bearing deposit account with no minimum balance and check truncation continues to grow since its introduction in 1999.
Interest-bearing deposits increased by $11.2 million or 8.3% to $146.4 million at December 31, 2002. Interest-bearing checking increased by $5.2 million in 2002. Included in this category are NOW accounts and Money Market accounts. Savings accounts increased $3.6 million in 2002 from the previous year to $21.5 million, while the average savings deposits increased only $3.0 million or 18.2% to $19.6 million at December 31, 2002. The Bank's largest source of interest-bearing funds is certificates of deposit. These accounts totaled $94.8 million at December 31, 2002, an increase of $2.3 million or 2.5%. The increase is primarily due to the continue growth in the 36-month Ultimate Certificate of Deposit which was first offered as a promotional certificate of deposit with the grand opening of the Hedgesville branch location in 1998.
The Bank's institutional advertising campaign which began in 2000 has generated an influx of new noninterest-bearing and interest-bearing deposit accounts especially at the Hedgesville and south Martinsburg branches.
Table 11 is a summary of the maturity distribution of certificates of deposit in amounts of $100,000 or more as of December 31, 2002:
TABLE 11. MATURITY OF TIME DEPOSITS OF $100,000 OR MORE
CAPITAL RESOURCES
The Bank remains well capitalized. Total shareholders' equity at December 31, 2002 of $16.3 million represents 8.5% of total assets. This compares to $14.9 million or 8.7%, at December 31, 2001. Included in capital at December 31, 2002 are $681,000 of unrealized gains on available for sale securities, net of deferred income taxes. At December 31, 2001, the Bank had unrealized gains on available for sale securities, net of deferred income taxes of $178,000. Such unrealized gains and losses are recorded net of related deferred taxes and are primarily a function of available market interest rates relative to the yield being
generated on the available for sale portfolio. No earnings impact will result, however, unless the securities are actually sold.
The stock of CNB Financial Services, Inc., and prior to the formation of CNB, the Bank, are not listed on an exchange and are not heavily traded. The trades that have occurred are those that, to management's knowledge, have been individually arranged. Based on information that management is aware of, the majority of shares sold during 2002 were at a price that ranged from $64 to $90 per share. During 2001, information available to management indicates that stock trades ranged from $67 to $135 per share. Book value per share increased from $32.59 at December 31, 2001 to $35.52 at December 31, 2002.
Dividends which have been declared by the Board of Directors semiannually, remained the same in 2002 and 2001 at $1.02 per share. All stock prices and per share amounts have been restated to reflect the formation of CNB Financial Services, Inc. and the acquisition of Citizens National Bank and subsidiary on August 31, 2000 and accounted for as a pooling of interests.
The Federal Reserve's risk-based capital guidelines provide for the relative weighting of both on-balance-sheet and off-balance-sheet items based on their degree of risk. The Bank continues to exceed all regulatory capital requirements, and is unaware of any trends or uncertainties, nor do any plans exist, which may materially impair or alter its capital position.
RETURN ON EQUITY AND ASSETS
Table 12 shows consolidated operating and capital ratios for the periods indicated.
TABLE 12. OPERATING AND CAPITAL RATIOS
LIQUIDITY AND INTEREST RATE SENSITIVITY
The objective of the Bank's liquidity management program is to ensure the continuous availability of funds to meet the withdrawal demands of depositors and the credit needs of borrowers. The basis of the Bank's liquidity comes from the stability of its core deposits. Liquidity is also available through the available for sale securities portfolio and short-term funds such as federal funds sold. At December 31, 2002, these sources totaled $47.6 million, or 24.8% of total assets. In addition, liquidity may be generated through loan repayments and over $7.0 million of available borrowing arrangements with correspondent banks. At December 31, 2002, management considered the Bank's ability to satisfy its anticipated liquidity needs over the next twelve months. Management believes that the Bank is well positioned and has ample liquidity to satisfy these needs. The Bank generated $2.2 million of cash from operations in 2002, which compares to $1.5 million in 2001 and $1.8 million in 2000. Additional cash of $18.2 million, $19.9 million and $9.0 million was generated through net financing activities in 2002, 2001 and 2000, respectively. These proceeds along with proceeds from the sales and maturities of investment securities were used to fund loans and purchase securities during each year. Net cash used in investing activities totaled $16.8 million in 2002 compared to $20.9 million in 2001 and $11.1 million in 2000. Details on both the sources and uses of cash are presented in the Consolidated Statements of Cash Flows contained in the financial statements.
The objective of the Bank's interest rate sensitivity management program, also known as asset/liability management, is to maximize net interest income while minimizing the risk of adverse effects from changing interest rates. This is done by controlling the mix and maturities of interest-sensitive assets and liabilities. The Bank has established an asset/liability committee for this purpose. Daily management of the Bank's sensitivity of earnings to changes in interest rates within the Bank's policy guidelines are monitored by using a combination of off-balance sheet and on-balance sheet financial instruments. The Bank's Chief Executive Officer, Senior Lending Officer, Chief Financial Officer and the Chief Operations Officer monitor day to day deposit flows, lending requirements and the competitive environment. Rate changes occur within policy guidelines if necessary to minimize adverse effects. Also, the Bank's policy is intended to ensure that the Bank measures a range of rate scenarios and patterns of rate movements that are reasonably possible.
In analyzing interest rate sensitivity for policy measurement, the Bank compares its forecasted earnings in both a "high rate" and "low rate" scenario to a base-line scenario. The Bank's base-line scenario is that short-term interest rates over the next 12 months remain at the current rate. The "high rate" and "low rate" scenarios assume a 200 basis point increase or decrease in the prime rate from beginning point of the base-line scenario over the most current 12-month period. The Bank's policy limit for the maximum negative impact on earnings resulting from "high rate" or "low rate" scenarios is 10 percent. The policy measurement period is 12 months in length, beginning with the first month of the forecast.
The Bank's base-line scenario holds the prime rate constant at 4.25 percent through December 2003. Based on the January 2003 outlook, the model indicates that earnings during the policy measurement period would be affected by less than 10 percent, in both an increasing or decreasing interest rate scenario.
One common interest rate risk measure is the gap, or the difference between rate sensitive assets and rate sensitive liabilities. A positive gap occurs when rate-sensitive assets exceed rate-sensitive liabilities. This tends to be beneficial in rising interest rate environments. A negative gap refers to the opposite situation and tends to be beneficial in declining interest rate environments. However, the gap does not consider future changes in the volume of rate sensitive assets or liabilities or the possibility that interest rates of various products may not change by the same amount or at the same time. In addition, certain assumptions must be made in constructing the gap. For example, the Bank considers administered rate deposits, such as savings accounts, to be immediately rate sensitive although their actual rate sensitivity could differ from this assumption. The Bank monitors its gap on a quarterly basis.
TABLE 13. INTEREST SENSITIVITY ANALYSIS
RECENTLY ISSUED ACCOUNTING STANDARDS
In April 2002, FASB Statement 145 was issued. This Statement rescinds FASB Statement 4, Reporting Gains and Losses from Extinguishment of Debt, and it's subsequent amendment in FASB Statement 64, Extinguishment of Debt Made to Satisfy Sinking-Fund Requirements. This Statement also rescinds FASB Statement 44, Accounting for Intangible Assets of Motor Carriers. Finally, this statement amends FASB statement number 13, Accounting for Leases. The amendment to FASB 13 modifies the required accounting treatment for leases that have similar economic effects of the sale-leaseback transactions to follow the same requirements as a true sale-leaseback transaction.
FASB Statement 146, Accounting for Cost Associated with Exit of Disposal Activities, was issued in June of 2002. Statement 146 nullifies Emerging Issues Task Force Issue number 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructure)." Under EITF Issue 94-3, companies were required to recognize the liability of costs associated with disposal activities at a plan date. This statement now requires that the costs associated with a disposal activity be measured at fair value and recognized only when the liability is incurred. FASB Statement 146 is effective for exit or disposal activities that occur after December 31, 2002.
In October 2002, FASB Statement 147, Acquisitions of Certain Financial Institutions was issued. This Statement was an amendment of FASB Statements 72 and 144 and Interpretation 9. The provisions of this Statement relate to the application of the purchase method of accounting which applies to all acquisitions of financial institutions, except for transactions between mutual enterprises. Following the issuance of FASB Statements 141, Business Combinations, and 142, Goodwill and Other Intangible Assets, in 2001, the Financial Account Standards Board concluded that certain guidance provided in Statement 72 and Interpretation 9 was no longer necessary. Statement 147 is effective for acquisitions on or after October 1, 2002.
In November 2002, FASB Interpretation 45 was issued. The interpretation was titled Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. This Statement rescinds FASB Interpretation 34 and provides an interpretation of FASB Statements 5, 57, and 107. This Interpretation elaborates on the disclosures to be made by guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. These new disclosure requirements are effective for financial statement periods ending after December 15, 2002.
In December 2002, FASB Statement 148, Accounting for Stock-Based Compensation - Transition and Disclosure, was issued. This statement was an amendment for FASB Statement 123, and provided alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of Statement 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported financial results.
Adoption of Statements 145, 146, 147 and 148 and Interpretation 45 are not expected to have a material impact on CNB Financial Services, Inc.'s financial condition or results of operations.
IMPACT OF INFLATION
The results of operations and financial position of the Bank have been presented based on historical cost, unadjusted for the effects of inflation, except for the recording of unrealized gains and losses on securities available for sale. Inflation could significantly impact the value of the Bank's interest rate-sensitive assets and liabilities and the cost of noninterest expenses, such as salaries, benefits and other operating expenses. Management of the money supply by the Federal Reserve to control the rate of inflation may have an impact on the earnings of the Bank. Further, changes in interest rates to control inflation may have a corresponding impact on the ability of certain borrowers to repay loans granted by the Bank.
As a financial intermediary, the Bank holds a high percentage of interest rate-sensitive assets and liabilities. Consequently, the estimated fair value of a significant portion of the Bank's assets and liabilities change more frequently than those of non-banking entities. The Bank's policies attempt to structure its mix of financial instruments and manage its interest rate sensitivity in order to minimize the potential adverse effects of market forces on its net interest income, earnings and capital.
A comparison of the carrying value of the Bank's financial instruments to their estimated fair value as of December 31, 2002 and December 31, 2001 is disclosed in Note 24 of the Notes to the Consolidated Financial Statements.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Interest Rate Sensitivity" in Item 7 hereof.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The following audited consolidated financial statements are set forth in this Annual Report of Form 10-K on the following pages:
INDEPENDENT AUDITOR'S REPORT
Shareholders and Board of Directors CNB Financial Services, Inc. Berkeley Springs, West Virginia
We have audited the accompanying consolidated statements of financial condition of CNB Financial Services, Inc. and subsidiary as of December 31, 2002 and 2001, and the related consolidated statements of income, changes in shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2002. These financial statements are the responsibility of CNB Financial Services, Inc.'s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of CNB Financial Services, Inc. and subsidiary as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America.
/s/ SMITH ELLIOTT KEARNS & COMPANY, LLC
Hagerstown, Maryland February 12, 2003
CNB FINANCIAL SERVICES, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION DECEMBER 31, 2002 AND 2001
The Notes to Consolidated Financial Statements are an integral part of these statements.
CONSOLIDATED STATEMENTS OF INCOME YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
The Notes to Consolidated Financial Statements are an integral part of these statements.
CNB FINANCIAL SERVICES, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
(1) Restated to reflect the formation of CNB Financial Services, Inc. and the acquisition of Citizens National Bank and subsidiary on August 31, 2000 and accounted for as a pooling of interests.
The Notes to Consolidated Financial Statements are an integral part of these statements.
CNB FINANCIAL SERVICES, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
The Notes to Consolidated Financial Statements are an integral part of these statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The following is a description of the more significant accounting policies of CNB Financial Services, Inc. and its subsidiary.
NATURE OF OPERATIONS: CNB Financial Services, Inc. ("CNB" or the "Company") is a financial services holding company incorporated under the laws of West Virginia in March 2000. It became a bank holding company when it acquired all of the common stock of Citizens National Bank of Berkeley Springs on August 31, 2000.
Citizens National Bank of Berkeley Springs (the "Bank"), a wholly owned subsidiary of CNB, provides a variety of banking services to individuals and businesses through its two locations in Morgan County, West Virginia and its two locations in Berkeley County, West Virginia. Its primary deposit products are demand deposits and certificates of deposit, and its primary lending products are commercial business, real estate mortgage and installment loans.
In February 2001, CNB became a 50% member in a limited liability corporation, Morgan County Title Insurance Agency, LLC which sells title insurance.
CNB Insurance Services, Inc., a wholly owned subsidiary of Citizens National Bank, is a property and casualty insurance agency selling primarily personal lines of insurance in Morgan and Berkeley Counties.
The accounting policies of the Company and its subsidiary conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry.
PRINCIPLES OF CONSOLIDATION: The consolidated financial statements of CNB Financial Services, Inc., include the accounts of the Company and its wholly owned subsidiary, Citizens National Bank and CNB Insurance Services, Inc., a wholly owned subsidiary of the Bank. The financial statements of Morgan County Title Insurance Agency, LLC are not included in these consolidated financial statements. All significant intercompany transactions and balances have been eliminated.
USE OF ESTIMATES: The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
SECURITIES AND MORTGAGE-BACKED SECURITIES: Investments in equity securities that have readily determinable fair values and for all investments in debt securities are classified and accounted for as follows:
a. Debt securities that management has the positive intent and ability to hold to maturity are classified as held-to-maturity securities and reported at amortized cost.
b. Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings.
c. Debt and equity securities not classified as either held-to-maturity securities or trading securities are classified as available-for-sale securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders' equity as accumulated other comprehensive income.
CNB classifies all investments as available for sale, except for stock in the Federal Reserve Bank and Federal Home Loan Bank, which are restricted investments.
Interest and dividends on securities, including amortization of premiums and accretion of discounts, are included in interest income. Realized gains and losses from the sales of securities are determined using the specific identification method.
IMPAIRED LOANS: Impaired loans are defined as those loans for which it is probable that contractual amounts due will not be received. Statement of Financial Accounting Standards (SFAS) No. 114, "Accounting by Creditors for Impairment of a Loan," as amended by SFAS No. 118, requires that the measurement of impaired loans is based on the present value of expected future cash flows discounted at the historical effective interest rate, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral. Larger groups of small-balance loans such as residential mortgage and installment loans that are considered to be part of homogeneous loan pools are aggregated for the purpose of measuring impairment, and therefore, are not subject to these statements. Management has established a dollar-value threshold for commercial loans. The larger commercial loans are evaluated in accordance with the statements. No loans are considered to be impaired at December 31, 2002 and 2001.
ALLOWANCE FOR LOAN LOSSES: The allowance for loan losses is maintained at a level which, in management's judgment, is adequate to absorb credit losses inherent in the loan portfolio. The amount of the allowance is based on management's evaluation of the collectibility of the loan portfolio, including the nature of the portfolio, credit concentrations, trends in historical loss experience, specific impaired loans and economic conditions.
Allowances for impaired loans are generally determined based on collateral values or the present value of estimated cash flows. The allowance is increased by a provision for loan losses, which is charged to expense and reduced by charge-offs, net of recoveries. Changes in the allowance relating to impaired loans are charged or credited to the provision for loan losses. Because of uncertainties inherent in the estimation process, management's estimate of credit losses inherent in the loan portfolio and the related allowance may change in the near term.
LOANS HELD FOR SALE: Mortgage loans held for sale are recorded at the lower of cost or market value. Gains and losses realized from the sale of loans and adjustments to market value are included in non-interest income. Mortgage loans are sometimes sold to the Federal Home Loan Mortgage Corporation (Freddie Mac) and other commercial banks.
INTANGIBLE ASSETS: Intangible assets represent the acquisition of customer lists, contracts and records in the amount of $130,270 in November 1998 and January 2000 by CNB Insurance Services, Inc. The intangible assets are being amortized over fifteen years on a straight line basis. On January 1, 2002, CNB adopted SFAS No. 142, Goodwill and Other Intangible Assets. The implementation of SFAS No. 142 did not have a significant impact on the financial statements.
LOAN SERVICING: The cost of mortgage servicing rights is amortized in proportion to, and over the period of, estimated net servicing revenues. Impairment of mortgage servicing rights is assessed based on the fair value of those rights. Fair values are estimated using discounted cash flows based on a current market interest rate. For purposes of measuring impairment, the rights are stratified based on the predominant risk characteristics of the underlying loans: product type, investor type, interest rate, term and geographic location. An analysis of the risk characteristics of CNB's loan servicing portfolio allows for all loans to be defined by one risk category.
INTEREST INCOME ON LOANS: Interest on loans is accrued and credited to income based on the principal amount outstanding. The accrual of interest on loans is discontinued when, in the opinion of management, there is an indication that the borrower may be unable to meet payments as they become due.
NONPERFORMING/NONACCRUAL ASSETS: Nonperforming/nonaccrual assets consist of loans on which interest is no longer accrued, loans which have been restructured in order to allow the borrower the ability to maintain control of the collateral, real estate acquired by foreclosure and real estate upon which deeds in lieu of foreclosure have been
accepted. Interest previously accrued but not collected on nonaccrual loans is reversed against current income when a loan is placed on a nonaccrual basis.
LOANS AND LEASE RECEIVABLE: Loans and lease receivable that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at their outstanding unpaid principal balances reduced by any charge-offs or specific valuation accounts and net of any deferred fees or costs on originated loans, or unamortized premiums or discounts on purchased loans.
LOAN ORIGINATION FEES AND COSTS: Loan origination fees, net of certain direct costs of originating loans are being deferred and recognized over the contractual life of the loan as an adjustment of the yield on the related loan.
PREMISES AND EQUIPMENT: Premises and equipment are carried at cost less accumulated depreciation. Depreciation is calculated on both straight-line and accelerated methods over the estimated useful lives of 15 to 50 years for buildings and 3 to 20 years for equipment. Computer software is being amortized over 3 to 5 years. Maintenance and repairs are charged to operating expenses as incurred.
INCOME TAXES: Deferred tax assets or liabilities are computed based on the difference between the financial statement and income tax bases of assets and liabilities using the enacted marginal tax rate. Deferred income tax expenses or credits are based on the changes in the asset or liability from period to period.
PENSION PLAN: Pension plan costs are funded by annual contributions as required by applicable regulations.
CASH AND CASH EQUIVALENTS: For purposes of the Consolidated Statements of Cash Flows, cash and cash equivalents include all highly liquid debt instruments purchased with a maturity of three months or less except for federal funds sold. Those amounts are included in the balance sheet captions "Cash and Due From Banks."
EARNINGS AND DIVIDENDS PER SHARE: Basic earnings and dividends per share are computed on the basis of the weighted average number of 458,048 shares of common stock outstanding during each year.
OFF-BALANCE SHEET FINANCIAL INSTRUMENTS: In the ordinary course of business, CNB has entered into off-balance-sheet financial instruments consisting of commitments to extend credit, commercial lines of credit and letters of credit. Such financial instruments are recorded in the financial statements when they become due or payable.
POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS OTHER THAN PENSIONS: Postretirement insurance benefits are provided to selected officers and employees. During the years that the employee renders the necessary service, the Bank accrues the cost of providing postretirement health and life insurance benefits to the employee.
FORECLOSED REAL ESTATE: Real estate properties acquired through, or in lieu of, loan foreclosure are to be sold and are initially recorded at fair value at the date of foreclosure, establishing a new cost basis. After foreclosure, valuations are periodically performed by management and the real estate is carried at the lower of carrying amount or fair value less estimated cost to sell. Revenue and expenses from operations and changes in the valuation allowance are included in loss on foreclosed real estate. The historical average holding period for such properties is twelve to eighteen months.
TRUST ASSETS: Assets held by CNB in a fiduciary or agency capacity are not included in the consolidated financial statements since such assets are not assets of CNB. In accordance with banking industry practice, income from fiduciary activities is generally recognized on a cash basis which is not significantly different from amounts that would have been recognized accrual basis.
ADVERTISING COSTS: The Company expenses advertising costs in the period in which they are incurred. Advertising cost amounted to $118,017, $110,979 and $112,642 for the years ended December 31, 2002, 2001 and 2000, respectively.
COMPREHENSIVE INCOME: Comprehensive income is defined as the change in equity from transactions and other events from nonowner sources. It includes all changes in equity except those resulting from investments by shareholders and distributions to shareholders. Comprehensive income includes net income and certain elements of "other comprehensive income" such as foreign currency translations; accounting for futures contracts; employers accounting for pensions; and accounting for certain investments in debt and equity securities.
CNB has elected to report its comprehensive income in the Consolidated Statements of Changes in Shareholders' Equity. The only element of "other comprehensive income" that CNB has is the unrealized gains or losses on available for sale securities.
The components of the change in net unrealized gains (losses) on securities were as follows:
NOTE 2. FORMATION OF HOLDING COMPANY
In March 2000, the Bank's Board of Directors approved the formation of CNB, a financial services holding company. A special meeting of the Bank's shareholders was held on August 4, 2000 and the shareholders approved the Agreement and Plan of Merger between the Bank and CNB, whereby the Bank became a wholly-owned subsidiary of CNB and the shareholders of the Bank became shareholders of CNB. The merger became effective on August 31, 2000. Each Bank shareholder received two shares of CNB stock for each share of the Bank's common stock. The Bank received approval for the reorganization from the Comptroller of the Currency and the Federal Reserve Bank of Richmond. Also, the Securities and Exchange Commission (SEC) declared the registration statement on Form S-4 related to the Agreement and Plan of Merger between the Bank and CNB effective on July 12, 2000. The Bank incurred and expensed all costs of start-up activities including activities related to organizing the new entity and filings with the SEC and Bank regulators. On August 31, 2000, CNB consummated its merger with the Bank and subsidiary, in a tax-free exchange of stock. Shareholders of the Bank received two shares of CNB Financial Services, Inc. common stock for each of the 229,024 shares of the Bank's common stock. The merger was accounted for as a pooling of interests.
NOTE 3. INVESTMENT IN LIMITED LIABILITY CORPORATION
In February 2001, CNB paid $5,000 to become a 50% member in a limited liability corporation, Morgan County Title Insurance Agency, LLC for the purpose of selling title insurance. CNB accounts for their investment in Morgan County Title Insurance Agency, LLC as part of "Other Assets" using the equity method of accounting.
The following represents the limited liability corporation's financial information:
MORGAN COUNTY TITLE INSURANCE AGENCY, LLC STATEMENTS OF FINANCIAL CONDITION (Unaudited) DECEMBER 31, 2002 AND 2001
MORGAN COUNTY TITLE INSURANCE AGENCY, LLC STATEMENTS OF INCOME (Unaudited) YEARS ENDED DECEMBER 31, 2002 AND 2001
MORGAN COUNTY TITLE INSURANCE AGENCY, LLC STATEMENTS OF CASH FLOWS (Unaudited) YEARS ENDED DECEMBER 31, 2002 AND 2001
NOTE 4. SECURITIES AVAILABLE FOR SALE
The amortized cost and estimated market value of debt securities at December 31, 2002 and 2001 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Securities are summarized as follows:
The carrying value of securities pledged to secure public deposits and for other purposes as required or permitted by law totaled $12,864,841 at December 31, 2002 and $12,099,922 at December 31, 2001.
Proceeds from sales of securities available for sale (excluding maturities) for the years ended December 31, 2002, 2001 and 2000 were $7,075,471, $901,406 and $2,659,593, respectively. Gross gains and (losses) of $78,028 and $(0) in 2002, $7,071 and $(6,238) in 2001, and $7,115 and $(21,106) in 2000 were realized on the respective sales.
NOTE 5. LOANS AND LEASE RECEIVABLE
Major classifications of loans at December 31, 2002 and 2001 were as follows:
At December 31, 2002, approximately $38,467,000 or 39.6% of the real estate loans had fixed rates of interest and $58,708,000 or 60.4% had adjustable rates of interest.
The net investment in the direct financing lease was $135,341 at December 31, 2002.
An analysis of the allowance for loan losses were as follows:
Loans are placed on nonaccrual status when, in the judgement of management, the probability of collection of interest is deemed to be insufficient to warrant further accrual. A summary of nonperforming loans is as follows:
The contractual amount of interest that would have been recorded on nonaccrual loans during 2002 and 2001 was $6,599 and $9,976, respectively. The amount of interest income that was recorded on nonaccrual loans during 2002 and 2001 was $5,248 and $6,719, respectively.
The Bank is not committed to lend additional funds to debtors whose loans are nonperforming or on nonaccrual status.
The Bank has no loans which are considered to be impaired at December 31, 2002 and 2001.
NOTE 6. LOAN SERVICING
Mortgage loans serviced for others are not included in the accompanying financial statements. The unpaid principal balances of mortgage loans serviced for others were $5,207,621 and $6,089,473 at December 31, 2002 and 2001, respectively.
Custodial balances maintained in connection with the foregoing loan servicing, and included in demand deposits, were $100,206 and $10,988 at December 31, 2002 and 2001, respectively.
The Bank did not capitalize any mortgage servicing rights in 2002, 2001 or 2000. An analysis of the predominant risk characteristics indicates that there is not more than a normal amount of prepayment risk and thus no write down is necessary. Amortization of mortgage servicing rights was $2,248, $1,792 and $2,264 in 2002, 2001 and 2000, respectively. Mortgage servicing rights at December 31, 2002 and 2001 were $29,921 and $32,169, respectively.
NOTE 7. PREMISES AND EQUIPMENT
Major classifications of premises and equipment at December 31 were as follows:
Depreciation expense amounted to $293,787, $220,698 and $200,995 in 2002, 2001 and 2000, respectively.
Computer software included in the statement of financial condition caption "Other Assets" amounted to $400,742 and $128,534 at December 31, 2002 and 2001, respectively. Amortization expense on computer software amounted to $38,205, $22,080 and $28,482 in 2002, 2001 and 2000, respectively.
In December 2001, the Bank entered into a contract to upgrade its technology systems. The technology is expected to create operational efficiencies and enhance customer service and product delivery.
The Bank's remaining commitments totaled $273,000 at December 31, 2002 to upgrade the Bank's technology systems.
NOTE 8. INTANGIBLE ASSETS
Amortized intangible assets representing customer lists, contracts and records acquired by CNB Insurance Services, Inc. have a carrying amount of $130,270 and accumulated amortization of $33,787 and $25,107 at December 31, 2002 and 2001, respectively. These intangibles are amortized over fifteen years on a straight line basis.
Amortization expense on intangible assets amounted to $8,685 in 2002, 2001 and 2000, respectively.
The estimated amortization expense for 2003 through 2007 is $8,685 per year.
NOTE 9. TIME DEPOSITS
At December 31, 2002, the scheduled maturities of time deposits are as follows:
NOTE 10. MEMBERSHIP IN FEDERAL HOME LOAN BANK
Effective October 4, 2000, Citizens National Bank became a member of the Federal Home Loan Bank (FHLB) of Pittsburgh. By virtue of its membership, the Bank has the ability to obtain borrowings from the FHLB. Access to borrowing is dependent upon submission of advance applications and adequate collateral. The Bank has no outstanding advances from the FHLB at December 31, 2002 and 2001, respectively.
NOTE 11. UNUSED LINES OF CREDIT
The Bank entered into an open-ended unsecured line of credit with Bank of America for $5,000,000 for federal fund purchases. Funds issued under this agreement are at the Bank of America federal funds rate effective at the time of borrowing. The line matures September 30, 2003. The Bank had not drawn on these funds at December 31, 2002 and 2001.
The Bank also entered into an open-ended unsecured line of credit with Wachovia Bank of N.C. for $1,000,000 for federal fund purchases and $200,000 for a standby letter of credit. Funds issued under this agreement are at the Wachovia Bank of N.C. federal funds rate effective at the time of borrowing. This line matures July 31, 2003. The Bank had not drawn any of these funds at December 31, 2002 and 2001.
NOTE 12. OPERATING LEASES
The Bank entered into two lease agreements in 2001, which were terminated in March 2002. A lease for a parcel of land to locate a temporary banking unit required a monthly payment of $1,500. The additional lease was for the temporary banking unit which required a monthly payment of $3,575. Both leases were classified as operating leases.
Lease expense under operating leases for the periods ending December 31, 2002, 2001 and 2000 amounted to $15,019, $30,738 and $1,205, respectively.
NOTE 13. PENSION PLAN
The Bank is a member of The West Virginia Bankers Association Retirement Plan, a multi-employer, defined benefit pension plan. All employees participate in the plan after completing one year of service and attaining the age of 21. The benefits are based on years of service and the highest average earnings during any five consecutive calendar years. Plan assets are invested primarily in corporate bonds, common stocks and U.S. Government and Agency Securities.
The following table sets forth information about the Bank's plan as of October 31:
NOTE 14. 401(k) PROFIT SHARING PLAN
All employees are eligible to participate in the Bank's 401(k) Profit Sharing Plan after completing one year of service. Employees may defer up to 15% of their salary in 2002, 2001 and 2000. The Bank may, at the discretion of the Board of Directors, match all or part of the employee deferrals. For 2002, 2001 and 2000, the Bank matched 50% of employee deferrals up to 5% of salary. The percentage of match varies based on the Bank's profit level.
The Bank's contribution charged to income during 2002, 2001 and 2000 was $25,600, $24,000 and $25,200, respectively.
NOTE 15. DEFERRED COMPENSATION PLAN
The Bank has a plan pursuant to which a director may elect to waive receipt of all or a portion of his fees for Board of Directors' meetings or committee meetings in exchange for a retirement benefit to be received during a ten-year period after attaining a certain age. The Bank has acquired life insurance on the lives of participating directors to fund its obligation under the plan. The cash surrender value of these life insurance policies has been recorded as an asset. The present value of payments to be paid to directors or their beneficiaries for services rendered to date has been recorded as a liability. The net expense for these benefits was $(2,967), $11,032 and $(18,941) for 2002, 2001 and 2000, respectively.
NOTE 16. SHAREHOLDERS' EQUITY
On August 31, 2000, CNB consummated its merger with the Bank, and shareholders received two shares of CNB stock with a $1 par value for each share of Bank stock with a $10 par value. Common stock, capital surplus and retained earnings have been restated to reflect the change in par value and the shares issued due to the formation of CNB.
CNB initially issued 12,000 shares of common stock, which were redeemed and canceled on August 31, 2000, concurrent with the closing of the merger with the Bank.
All references in the accompanying consolidated financial statements and notes to per share amounts have been restated to reflect the above stock split and shares issued in the acquisition of the Bank by CNB. Basic earnings and dividends per share have been computed based on 458,048 weighted average number of shares outstanding in 2002, 2001 and 2000.
NOTE 17. GAIN ON DEMUTUALIZATION OF INSURANCE COMPANY
The Bank owns several life insurance policies which were issued by a mutual insurance company. In January 2000, the insurance company demutualized and converted to a stock company. The Bank received stock from the insurance company as part of the demutualization. There was no direct effect on the Bank's interest as a policyholder. The receipt of the stock was accounted for at fair value with a gain recognized in income from continuing operations. The stock was sold during 2000 at an additional gain of $4,401, included in gain (loss) on sale of securities.
NOTE 18. INCOME TAXES
Income taxes reflected in the statements of income are as follows:
Deferred income taxes reflect the impact of "temporary differences" between the amount of assets and liabilities for financial reporting purposes and such amounts as measured by tax laws and regulations.
The following is a reconciliation of the statutory federal income tax rate applied to pre-tax accounting income, with the income tax provisions in the statements of income.
Federal and state income taxes receivable included in the balance sheet as other assets were $155,625 and $80,538 at December 31, 2002 and 2001, respectively.
The components of deferred taxes included in the balance sheet as of December 31 are as follows:
Generally accepted accounting principles require a valuation allowance against deferred tax assets if, based on the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. The Bank believes that the deferred tax assets will be realized and therefore no valuation allowance was established.
NOTE 19. OTHER OPERATING EXPENSES
NOTE 20. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK
CNB is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk which are not reflected in the statements of financial condition. The contractual amounts of those instruments reflect the extent of involvement CNB has in particular classes of financial instruments.
CNB's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit written is represented by the contractual amount of those instruments. CNB uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.
Commitments to extend credit are agreements to lend funds as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses. Commercial line of credit arrangements usually require payment of a fee.
CNB evaluates each customer's creditworthiness and related collateral on a case-by-case basis. The amount of collateral obtained if deemed necessary by CNB upon extension of credit is based on management's credit evaluation of the customer. Collateral held varies but may include accounts receivable, inventory, real estate, equipment and income-producing commercial properties.
Standby letters of credit written are conditional commitments issued by CNB to guarantee the performance of a customer to a third party. Those guarantees are issued to support public and private borrowing arrangements, bond financing and similar transactions. The credit risk involved in issuing a letter of credit is essentially the same as that involved in extending loan facilities to customers.
A summary of off-balance sheet instruments as of December 31 is as follows:
NOTE 21. SIGNIFICANT GROUP CONCENTRATIONS OF CREDIT RISK
CNB's primary business is mortgage loans, which consists of originating residential, construction, multi-family and commercial real estate loans and consumer and commercial loans. CNB's primary lending area is Morgan and Berkeley Counties, West Virginia. Loans are occasionally made in surrounding counties in West Virginia, Maryland, Virginia and Pennsylvania.
CNB evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained if deemed necessary by CNB upon the extension of credit is based on management's credit evaluation of the customer. Collateral held varies but generally includes vehicles, equipment and real estate.
NOTE 22. REGULATORY MATTERS
The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios of total and Tier I capital to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 2002, that the Bank meets all capital adequacy requirements to which it is subject.
As of December 31, 2002 and 2001, the most recent notification from the Office of the Comptroller of the Currency categorized the Bank as well-capitalized under the regulatory framework for prompt corrective action. To be categorized as well-capitalized the Bank must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios. There are no conditions or events since that notification that management believes have changed the institution's category.
The Bank's actual capital amounts and ratios are presented in the table. There were no deductions from capital for interest-rate risk in 2002 and 2001.
NOTE 23. REGULATORY RESTRICTIONS
Included in Cash and Due From Banks are average daily reserve balances the Bank is required to maintain with the Federal Reserve Bank. The amount of these required reserves, calculated based on percentages of certain deposit balances was $1,751,000 at December 31, 2002.
Certain restrictions exist regarding the ability of the Bank subsidiary to transfer funds to CNB in the form of cash dividends, which in turn impact the ability of CNB to declare dividends to its shareholders. The approval of the Comptroller of the Currency is required if the total dividends declared by a national bank in any calendar year exceed the bank's net profits (as defined) for that year combined with its retained net profits for the preceding two calendar years.
Certain regulations prohibit affiliates from transferring funds to CNB in the form of loans or advances exceeding 10% of its capital stock and surplus, as defined in the Act. In addition, all loans or advances to nonbank affiliates must be secured by specific collateral. Based on this limitation, there was approximately $1,558,000 available for loans or advances to CNB as of December 31, 2002, at which time there were no material loans or advances outstanding.
NOTE 24. FAIR VALUE OF FINANCIAL INSTRUMENTS
The fair value of financial instruments is the amount at which the asset or obligation could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the entire holdings of a particular financial instrument. Because no market value exists for a significant portion of the financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature, involve uncertainties and matters of judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates.
Fair value estimates are based on financial instruments both on and off the balance sheet without attempting to estimate the value of anticipated future business, and the value of assets and liabilities that are not considered financial instruments. Additionally, tax consequences related to the realization of the unrealized gains and losses can have a potential effect on fair value estimates and have not been considered in many of the estimates.
The following methods and assumptions were used to estimate the fair value of significant financial instruments:
Financial Assets: The carrying amounts of cash, due from Banks and federal funds sold are considered to approximate fair value. The fair value of investment securities, including available for sale, are generally based on quoted market prices. The fair value of loans is estimated using a combination of techniques, including discounting estimated future cash flows and quoted market prices of similar instruments where available.
Financial Liabilities: The carrying amounts of deposit liabilities payable on demand are considered to approximate fair value. For fixed maturity (time) deposits, fair value is estimated by discounting estimated future cash flows using currently offered rates for deposits of similar remaining maturities.
Off-Balance-Sheet-Financial Instruments: The fair value of commitments to extend credit and standby letters of credit is estimated using the fees currently charged to enter into similar agreements.
The estimated fair value of financial instruments at December 31, is summarized as follows:
NOTE 25. RELATED PARTY TRANSACTIONS
In the ordinary course of business, the Bank has granted loans to officers, directors, and their affiliates amounting to $1,433,386 and $1,308,100 at December 31, 2002 and 2001, respectively. During 2002, $1,166,544 of new loans were made, or became reportable, and repayments and other decreases totaled $1,041,258. Deposits from related parties held by the Bank at December 31, 2002 and 2001 amounted to $4,347,387 and $2,248,568, respectively.
NOTE 26. PARENT COMPANY ONLY FINANCIAL INFORMATION
The following represents parent company only financial information:
STATEMENTS OF FINANCIAL (PARENT ONLY) DECEMBER 31, 2002, AND 2001
STATEMENTS OF INCOME (PARENT ONLY) YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
STATEMENTS OF CASH FLOWS (PARENT ONLY) YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
(1) Represents dividends paid by CNB Financial Services, Inc. subsequent to its acquisition of the Bank.
NOTE 27. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
ITEM 9.
ITEM 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
There were no changes in or disagreements with accountants in accounting and financial disclosure.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The following table contains certain information, as of March 20, 2003, with respect to current directors, nominees for directors and certain officers of CNB.
All nominees are incumbent directors of CNB Financial Services, Inc.
The names, ages and position of each executive officer of the company are listed below along with the positions with Citizens National Bank held by each of them during the last five years. Officers are appointed annually by the Board of Directors at the meeting of directors immediately following the annual meeting.
(1) Mr. Kesecker is not an employee of CNB.
Section 16 (a) of the Securities Exchange Act of 1934 requires CNB's directors and executive officers, and persons who own more than 10% of the registered class of CNB's equity securities, to make stock ownership and transaction filings with the Securities and Exchange Commission and to provide copies to CNB. Based solely on a review of the reports furnished to CNB and written statements that no other reports were required, all Section 16(a) filing requirements applicable to its officers and directors were met except for Arnold K. Stotler, who filed one report late. CNB is required to report late filings.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The table below reflects information concerning the annual compensation for services in all capacities to the corporation for the fiscal years ended December 31, 2002, 2001 and 2000, of those persons who were, as of December 31, 2002, (a) the chief executive officer, and (b) the four other most highly compensated executive officers to the extent that such persons, total annual salary and bonus exceeded $100,000.
SUMMARY COMPENSATION TABLE
(1) CNB's group life and health insurance program, which is paid for by CNB, is made available to all full-time employees. In accordance with IRS Code Section 79, the cost of group life insurance coverage for an individual in excess of $50,000 is added to the individual's earnings and is included in salary. Also included in this figure are board fees earned and the corporation's contributions to the individual's 401(k) retirement savings program to which the individual has a vested interest.
(2) CNB's contributions to the pension plan, a defined benefit plan, are not and cannot be calculated separately for specific participants. Contributions for the plan year of $168,151, $99,502 and $178,376 were made by CNB in 2002, 2001 and 2000, respectively.
CNB does not maintain any form of stock option, stock appreciation rights, or other long-term compensation plans.
Directors receive $125 for each board meeting of the bank they attend, $150 for each discount committee meeting and $75 for other committee meetings they attend. There is no compensation for attendance at CNB board meetings. In addition, each director receives a fee of $4,150 per year. The chairman of the board receives an additional $3,500 per year and the vice chairman receives an additional $1,000 per year. Other than the deferred compensation/supplemental insurance plan described below, there are no other special arrangements with any directors. In 2002, the board of directors of CNB received $144,262, in the aggregate, for all board of directors' meetings attended and all fees paid.
CNB maintains a deferred compensation/supplemental insurance plan for directors pursuant to which a director may elect to defer receipt of a portion of fees for board meetings for at least four years or until he reaches age 65, whichever is later. An amount equal to fees waived in addition to interest at an annual rate of 10% per year will be paid to each participating director or his designated beneficiary during a period of 10 years after the director reaches age 65. The payments after retirement will be paid from the general funds of CNB. CNB purchases and is the beneficiary of insurance on the lives of participants, the proceeds of which are used to help recover the net after-tax cost of the benefits and insurance premiums paid. Funds from the deferred fees of a participating director will be used to reimburse CNB for the costs of the premium for the insurance policies. The cost of the insurance premiums in 2002 was $49,078. At December 31, 2002, these policies had a net accumulated cash value of $964,179.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICAL OWNERS AND MANAGEMENT
The following table sets forth information as of February 21, 2003, relating to the beneficial ownership of the common stock by (a) each person or group known by CNB to own beneficially more than 5% of the outstanding common stock; (b) each of CNB's directors; and (c) all directors and executive officers of CNB as a group. Unless otherwise noted below, the persons named in the table have sole investment power with respect to each of the shares reported as beneficially owned by such person.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
CNB has had and intends to continue to have banking and financial transactions in the ordinary course of business with directors and executive officers of CNB and their associates. Total loans outstanding from CNB at December 31, 2002, to CNB's officers and directors as a group and members of their immediate families and companies in which they had an ownership interest of 10% or more was $1,101,859, or approximately 6.8% of total equity capital. These loans do not involve more than the normal risk of collectibility or present other unfavorable features.
Trump and Trump, in which director Charles S. Trump, IV is a partner, performed legal services for CNB and the bank. Fees paid by CNB and the bank to that law firm were $39,670 during 2002.
CNB, Charles S. Trump, IV and George I. McVey are members in a Limited Liability Corporation, Morgan County Title Insurance Agency, LLC, which was formed in February 2001. Morgan County Title Insurance Agency, LLC, paid Trump and Trump management fees of $125,789. Charles S. Trump, IV and George I. McVey are partners in Trump and Trump.
ITEM 14.
ITEM 14. CONTROLS AND PROCEDURES
The Company's chief executive officer and chief financial officer, based on their evaluation within 90 days prior to the date of this report of the Company's disclosure controls and procedures (as defined in Rule 13(a)-14(c) of the Securities Exchange Act of 1934), have concluded that the Company's disclosure controls and procedures are adequate and effective for purposes of Rule 13(a)-14(c) and timely, alerting them to material information relating to the Company required to be included in the Company's filings with the Securities and Exchange Commission under the Securities Exchange Act of 1934.
There were no significant changes in the Company's internal controls or in other factors that could significantly affect internal controls subsequent to the date of their evaluation with the exception of the Company converting to the use of new software for its core processing system on February 14, 2003. The conversion significantly affected the Company's accounting systems as well as the loan and deposit processing. The conversion resulted in changes to procedures and controls, both manual and through electronic data processing. Throughout the preparation for the conversion, the new procedures and controls were reviewed and planned for and are in the implementation stage. Although, the Company's procedures and controls have changed with the conversion, management's conclusion that the controls are adequate and effective has not changed.
Appearing immediately following the signatures of this annual report on Form 10-K, certificates of the chief executive office and chief financial officer appear. This form of certification is required in accordance with Section 302 of the Sarbanes-Oxley Act of 2002. This section of the annual report on Form 10-K is the information concerning the controls evaluation referred to in the Section 302 certifications. This information should be read in conjunction with those certifications for a more complete understanding of the topics presented.
Disclosure controls are procedures that a company designs with the objective of ensuring that information required to be disclosed in their reports filed under the Securities Exchange Act of 1934 (such as this Form 10-K), is recorded, processed, summarized and reported within the time period specified under the SEC's rules and forms. Disclosure controls are also designed with the objective of ensuring that such information is accumulated and communicated to management, including the CEO and CFO, as appropriate, to allow timely decisions regarding required disclosure. Internal controls are procedures that a company designs with the objective of providing reasonable assurance that transactions are properly authorized, assets are safeguarded against unauthorized or improper use and transactions are properly recorded and reported all to permit the preparation of a company's financial statements in conformity with generally accepted accounting principles.
The Company's management, including the CEO and CFO, does not expect that our disclosure controls or internal controls will prevent all error and fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgements and decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of control also is based in part upon certain assumptions about the likelihood of future events and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.
Based upon the controls evaluation conducted by our CEO and CFO, they have concluded that, subject to the limitations noted above, the Company's disclosure controls are effective to ensure
that material information relating to CNB Financial Services, Inc. and its subsidiaries is made known to management, including the CEO and CFO, particularly during the period when our periodic reports are being prepared, and that our internal controls are effective to provide reasonable assurance that our financial statements are fairly presented in conformity with generally accepted accounting principles.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) 1. Financial Statements
The consolidated financial statements listed on the index to Item 8 of this Annual Report on Form 10-K are filed as a part of this Annual Report.
2. Financial Statement Schedules
All schedules applicable to the Registrant are shown in the respective financial statements or in the notes thereto included in this Annual Report.
3. Exhibits
2.2 Articles of Incorporation of CNB Financial Services, Inc. filed as exhibit 3.1 to the Registration Statement on Form S-4.
2.3 Bylaws of CNB Financial Services, Inc. filed as exhibit 3.2 to the Registration Statement on Form S-4.
21 Subsidiaries of CNB Financial Services, Inc. filed as an exhibit hereto and incorporated herein by reference.
99.1 Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
(b) Reports on Form 8-K
There were no reports on Form 8-K filed in the fourth quarter of 2002.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
CNB Financial Services, Inc. - ------------------------------------------------------ (Registrant)
Date March 28, 2003 /s/ Thomas F. Rokisky - ----------------------- ------------------------------------------------ Thomas F. Rokisky, President/CEO
Date March 28, 2003 /s/ Rebecca S. Stotler - ----------------------- ------------------------------------------------ Rebecca S. Stotler, Vice President/CFO (Principal Financial and Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities indicated on the 28th March 2003.
Signatures Title - ----------------------------- ---------------------------
/s/ J. Philip Kesecker Chairman and Director - ----------------------------- J. PHILIP KESECKER
/s/ Thomas F. Rokisky President/CEO and Director - ----------------------------- THOMAS F. ROKISKY
/s/ J. Robert Ayers Director - ----------------------------- J. ROBERT AYERS
/s/ John E. Barker Director - ----------------------------- JOHN E. BARKER
/s/ Margaret S. Bartles Director - ----------------------------- MARGARET S. BARTLES
/s/ Jay E. Dick Director - ----------------------------- JAY E. DICK
/s/ Herbert L. Eppinger Director - ----------------------------- HERBERT L. EPPINGER
/s/ Robert L. Hawvermale Director - ----------------------------- ROBERT L. HAWVERMALE
/s/ Jerald McGraw Director - ----------------------------- JERALD MCGRAW
/s/ Martha H. Quarantillo Director - ----------------------------- MARTHA H. QUARANTILLO
/s/ Charles S. Trump IV Director - ----------------------------- CHARLES S. TRUMP IV
/s/ Arlie R. Yost Director - ----------------------------- ARLIE R. YOST
CERTIFICATION
I, Thomas F. Rokisky, certify that:
1. I have reviewed this annual report on Form 10-K of CNB Financial Services, Inc.;
2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial conditions, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report.
4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 12a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions):
a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officer and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Date: March 28, 2003
/s/ Thomas F. Rokisky --------------------- Thomas F. Rokisky Chief Executive Officer
CERTIFICATION
I, Rebecca S. Stotler, certify that:
7. I have reviewed this annual report on Form 10-K of CNB Financial Services, Inc.;
8. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
9. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial conditions, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report.
10. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 12a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
11. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions):
a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and
12. The registrant's other certifying officer and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Date: March 28, 2003
/s/ Rebecca S. Stotler ---------------------- Rebecca S. Stotler Chief Financial Officer