Item 10 - See information that appears under the headings “Election of Directors”, “Executive Officers” and “Report of the Audit Committee”.
Item 11
Item 11 - See information that appears under the heading “Executive Compensation”.
Item 12
Item 12 - See information that appears under the headings “Voting Securities Outstanding and Principal Shareholders” and “Security Ownership of Management”.
Item 13
Item 13 - See information that appears under the heading “Indebtedness of Officers and Directors”.
Item 14
Item 14 - See information that appears under the heading “Independent Auditors”.
BUSINESS
General
FNB Corp. is a bank holding company incorporated under the laws of the State of North Carolina in 1984. On July 2, 1985, through an exchange of stock, FNB Corp. acquired a wholly owned bank subsidiary, First National Bank and Trust Company (“First National Bank”), a national banking association founded in 1907. First National Bank has a financial subsidiary, First National Investor Services, Inc. On August 1, 2002, FNB Corp. acquired another wholly owned bank subsidiary, Rowan Savings Bank SSB, Inc. (“Rowan Bank”), a North Carolina-chartered savings bank founded in 1905. First National Bank and Rowan Bank are collectively referred to as the “subsidiary banks”. On April 1, 2003, FNB Corp. acquired, as discussed below, a mortgage banking subsidiary, Dover Mortgage Company (“Dover”). FNB Corp. and its subsidiaries are collectively referred to as the “Corporation”.
The subsidiary banks, which are full-service banks, currently conduct all of their operations in Chatham, Guilford, Montgomery, Moore, Randolph, Richmond, Rowan and Scotland counties in central North Carolina. First National Bank has three offices, including the main office, in Asheboro and additional community offices in Archdale (two offices), Biscoe, Ellerbe, Laurinburg, Pinehurst, Ramseur, Randleman, Rockingham (two offices), Seagrove, Siler City, Southern Pines and Trinity. A loan production office is located in Greensboro. Rowan Bank has its main office in China Grove and additional community offices in Kannapolis and Salisbury. Some of the major banking services offered include regular checking accounts, interest checking accounts (including package account versions that offer a variety of products and services), money market accounts, savings accounts, certificates of deposit, individual retirement accounts, debit cards, credit cards and loans, both secured and unsecured, for business, agricultural and personal use. Other services offered include internet banking, cash management, investment management and trust services. The subsidiary banks also have automated teller machines and are members of Plus, a national teller machine network, and Star, a regional network.
Dover Mortgage Company, which currently conducts all of its operations in North Carolina, originates, underwrites and closes mortgage loans for sale into the secondary market. Dover has its main office in Charlotte and additional loan production offices in Goldsboro, Greenville, Lake Norman, Raleigh and Wilmington.
On August 1, 2002, the Corporation completed a merger for the acquisition of Rowan Bancorp, Inc. (“Rowan Bancorp”), holding company for Rowan Savings Bank SSB, Inc. (“Rowan Bank”), headquartered in China Grove, North Carolina. Per the terms of the merger agreement, Rowan Bank will be operated as a separate subsidiary of FNB Corp. for a period of not less than 24 months; provided, however, that the Board of Directors of Rowan Bank may elect to cause Rowan Bank to merge with First National Bank or another subsidiary of FNB Corp. prior to the termination of the 24-month period. The merger transaction has been accounted for using the purchase method of accounting for business combinations, and accordingly, the assets and liabilities of Rowan Bank were recorded based on a preliminary estimate of fair values as of August 1, 2002, subject to possible adjustment during the one-year period from that date. The only adjustments recorded during that one-year period related to accrued acquisition costs and resulted in an $18,000 reduction of the amount initially recorded for goodwill. The consolidated financial statements include the results of operations of Rowan Bank since August 1, 2002.
On April 1, 2003, the Corporation completed a merger for the acquisition of Dover Mortgage Company, headquartered in Charlotte, North Carolina. Operating as a separate subsidiary of FNB Corp., Dover originates, underwrites and closes mortgage loans for sale into the secondary market. Mortgage production is sold on a service-released basis to a number of national lenders who in turn service the loans. At the date of the merger, Dover operated six offices and, based on estimated fair values, had $47,001,000 in total assets and $5,823,000 in shareholders’ equity. Pursuant to the terms of the merger, 50% of the outstanding shares of Dover common stock were converted into FNB Corp. common stock and the remaining 50% were converted into cash. The aggregate purchase price was $5,567,000, consisting of $2,908,000 of cash payments and 126,140 shares of FNB Corp. common stock valued at $2,659,000. Subject to a maximum total payment, Dover shareholders will be entitled to
additional cash consideration over the four-year period following closing, based on a percentage of Dover’s pretax net income during that four-year period. Any additional cash consideration paid to Dover shareholders will be recorded as an adjustment to goodwill. The merger transaction has been accounted for using the purchase method of accounting for business combinations, and accordingly, the assets and liabilities of Dover were recorded based on a preliminary estimate of fair values as of April 1, 2003, subject to possible adjustment during the one-year period from that date. The consolidated financial statements include the results of operations of Dover since April 1, 2003.
In August 2003, First National Bank received regulatory approval for relocation of its existing branch offices in Laurinburg and Randleman, North Carolina. Construction of the new offices is expected to be complete by the end of 2004. The Laurinburg office will replace a leased facility, while the Randleman office represents a move from an owned facility that is expected to be disposed of.
In January 2004, First National Bank received regulatory approval for establishment of a new branch office in Greensboro, North Carolina. A loan production office was initially opened in February 2004 with a full-service banking office to follow.
FNB Corp. makes its annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K and amendments to those reports available on its website at www.fnbnc.com without charge as soon as reasonably practicable after filing or furnishing them to the Securities and Exchange Commission. In addition, FNB Corp. will provide without charge a copy of its annual report on Form 10-K to any shareholder by mail. Requests should be sent to FNB Corp., Attention: Secretary, 101 Sunset Avenue, Asheboro, North Carolina 27203.
Competition
The banking industry within the marketing area of the subsidiary banks is extremely competitive. The subsidiary banks face direct competition in Chatham, Guilford, Montgomery, Moore, Randolph, Richmond, Rowan and Scotland counties from approximately 70 different financial institutions, including commercial banks, savings institutions and credit unions. Although no one of these entities is dominant, the subsidiary banks consider themselves on a combined basis to be one of the significant financial institutions in the area in terms of total assets and deposits. Further competition is provided by banks located in adjoining counties, as well as other types of financial institutions such as insurance companies, finance companies, pension funds and brokerage houses and other money funds. The principal methods of competing in the commercial banking industry are improving customer service through the quality and range of services provided, improving cost efficiencies and pricing services competitively.
Dover faces competition within its market area from other mortgage banking companies and from all types of financial institutions engaged in the mortgage loan business. Dover considers itself to be a significant producer in its market locations of mortgage loans intended for sale into the secondary market. The principal methods of competing in the mortgage banking business are offering competitively priced mortgage loan products and providing prompt and efficient customer service.
Regulation and Supervision
The following discussion sets forth material elements of the regulatory framework applicable to bank holding companies and their subsidiaries. It also provides certain specific information relevant to FNB Corp. This regulatory framework is intended primarily for the protection of depositors and the deposit insurance funds that insure deposits of banks and savings institutions, and not for the protection of security holders. To the extent that the following information describes statutory and regulatory provisions, it is qualified in its entirety by reference to those provisions. A change in the statutes, regulations or regulatory policies applicable to FNB Corp. or the subsidiary banks may have a material effect on the business of the Corporation. Additional information
related to regulatory matters is contained in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” below.
General
As a bank holding company, FNB Corp. is subject to regulation under the Bank Holding Company Act of 1956, as amended, and to inspection, examination and supervision by the Federal Reserve Board. Under the Bank Holding Company Act, bank holding companies, such as FNB Corp., that have not elected to become financial holding companies under the Gramm-Leach-Bliley Financial Modernization Act of 1999 generally may not acquire ownership or control of more than 5% of the voting shares or substantially all the assets of any company, including a bank, without the Federal Reserve Board’s prior approval.
As a national banking association, First National Bank is subject to regulation and examination primarily by the Office of the Comptroller of the Currency (OCC). It is also regulated by the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve Board. First National Bank’s deposits are insured by the FDIC through the Bank Insurance Fund and the Savings Association Insurance Fund. The OCC and the FDIC impose various requirements and restrictions on First National Bank, including requirements to maintain reserves against deposits, restrictions on the types and amounts of loans that may be granted and the interest that may be charged on loans, limitations on the types of investments that may be made and the types of services that may be offered, and requirements governing capital adequacy, liquidity, earnings, dividends, management practices and branching. As a member of the Federal Reserve System, First National Bank is subject to the applicable provisions of the Federal Reserve Act, which imposes restrictions on loans by subsidiary banks to a holding company and its other subsidiaries and on the use of stock or securities as collateral security for loans.
As a North Carolina-chartered savings bank, Rowan Bank is subject to regulation and examination by the FDIC and the North Carolina Commissioner of Banks and to regulations governing such matters as capital standards, mergers, establishment of branch offices, subsidiary investments and activities, and general investment authority. Rowan Bank is a member of the Federal Home Loan Bank System and its deposits are insured by the FDIC through the Savings Association Insurance Fund. Generally, North Carolina-chartered savings banks whose deposits are insured by the Savings Association Insurance Fund are subject to restrictions with respect to activities and investments, transactions with affiliates and loans to one borrower. Being regulated by the FDIC, Rowan Bank is subject to the provisions of Regulation W under the Federal Reserve Act, which impose restrictions on loans by subsidiary banks to their holding company and its other nonbank subsidiaries and on the use of stock or securities as collateral for loans.
Various consumer laws and regulations also affect the operations of the Corporation. In addition to the impact of regulation, financial institutions may be significantly affected by legislation, which can change the statutes affecting them in substantial and unpredictable ways, and by the actions of the Federal Reserve Board as it attempts to control the money supply and credit availability to influence the economy. The instruments of monetary policy used by the Federal Reserve Board include its open market operations in U.S. Government securities, changes in the discount rate on member bank borrowings, and changes in reserve requirements on member bank deposits. The actions of the Federal Reserve Board influence the growth of bank loans, investments and deposits and also affect interest rates charged on loans or paid on deposits.
In view of changing conditions in the national economy and money markets, as well as the effect of actions by monetary and fiscal authorities, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand or the business and earnings of the Corporation.
Liability for Bank Subsidiaries
Under current Federal Reserve Board policy, a bank holding company is expected to act as a source of financial and managerial strength to its subsidiary banks and to maintain resources adequate to support each
subsidiary bank. This support may be required at times when the bank holding company may not have the resources to provide it. Similarly, the cross-guaranty provisions of the Federal Deposit Insurance Act provide that if the FDIC suffers or anticipates a loss as a result of a default by a banking subsidiary or by providing assistance to a subsidiary in danger of default, then any other bank subsidiaries may be assessed for the FDIC’s loss. Federal law authorizes the OCC to order an assessment of FNB Corp. if the capital of First National Bank were to become impaired. If the assessment were not paid within three months, the OCC could order the sale of FNB Corp.’s stock in First National Bank to cover the deficiency.
Capital Requirements
FNB Corp. and the subsidiary banks are required to comply with federal regulations on capital adequacy. There are two measures of capital adequacy: a risk-based measure and a leverage measure. All capital standards must be satisfied for an institution to be considered in compliance. For additional information, see “Capital Adequacy” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” below.
Dividend Restrictions
FNB Corp. is a legal entity separate and distinct from its bank subsidiaries. Because the principal source of FNB Corp. revenues is dividends from the subsidiary banks, the ability of FNB Corp. to pay dividends to its shareholders depends largely upon the amount of dividends the subsidiary banks may pay to FNB Corp. There are statutory and regulatory limitations on the payment of dividends by the subsidiary banks to FNB Corp., as well as by FNB Corp. to its shareholders.
First National Bank must obtain the prior approval of the OCC to pay dividends if the total of all dividends declared by the bank in any calendar year will exceed the sum of its net profits for that year and its retained net profits for the preceding two calendar years, less any required transfers to surplus. Federal law also prohibits First National Bank from paying dividends that in the aggregate would be greater than its undivided profits after deducting statutory bad debts in excess of its loan loss allowance.
Rowan Bank is not permitted to declare or pay a cash dividend if the effect of the dividend would be to cause the net worth of Rowan bank to be reduced below the minimum regulatory capital required by the North Carolina Commissioner of Banks or the FDIC or the liquidation account established in connection with its conversion from mutual to stock form.
FNB Corp. and subsidiary banks are also subject to various general regulatory policies and requirements relating to the payment of dividends, including requirements to maintain adequate capital above regulatory minimums.
Community Reinvestment Act
The subsidiary banks are subject to the provisions of the Community Reinvestment Act of 1977, as amended (CRA). Under the CRA, all financial institutions have a continuing and affirmative obligation consistent with their safe and sound operation to help meet the credit needs for their entire communities, including low- and moderate-income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions, nor does it limit an institution’s discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA.
The CRA requires the appropriate federal bank regulatory agency, in connection with its examination of the bank, to assess the bank’s record in meeting the credit needs of the community served by the bank, including low- and moderate-income neighborhoods. The regulatory agency’s assessment of the bank’s record is made available to the public.
Interstate Banking and Branching
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (“Interstate Banking Act”) permits interstate acquisitions of banks by bank holding companies. FNB Corp. and any other bank holding company located in North Carolina may acquire a bank located in any other state, and any bank holding company located outside North Carolina may lawfully acquire any North Carolina-based bank, regardless of state law to the contrary, in either case subject to certain deposit-percentage limitations, aging requirements and other restrictions. The Interstate Banking Act also generally provides that national and state-chartered banks may branch interstate through acquisitions of banks in other states. It allowed, however, any state to elect prior to June 1, 1997 either to “opt in” and accelerate the date after which interstate branching was permissible or to “opt out” and prohibit interstate branching altogether. North Carolina enacted “opt in” legislation permitting interstate branching. The Interstate Banking Act may have the effect of increasing competition within the markets in which FNB Corp. operates. The extent and timing of any such increase cannot be predicted.
Gramm-Leach-Bliley Act
The Gramm-Leach-Bliley Financial Modernization Act of 1999 allows bank holding companies to engage in a wider range of nonbanking activities, including greater authority to engage in the securities and insurance businesses. Under the Gramm-Leach-Bliley Act, a bank holding company that elects to become a financial holding company may engage in any activity that is financial in nature, is incidental to financial activity or complements financial activity and does not pose a substantial risk to the safety or soundness of depository institutions or the financial system generally. Activities cited by the law as being “financial in nature” include securities underwriting, dealing in securities and market making, insurance underwriting and agency, providing financial, investment or economic advisory services, and activities that the Federal Reserve Board has determined to be closely related to banking. FNB Corp. has not elected to become a financial holding company.
Subject to certain limitations on investment, a national bank or its financial subsidiary may also engage in activities that are financial in nature, other than insurance underwriting, insurance company portfolio investment, real estate development and real estate investment, so long as the bank is well-capitalized, well-managed and has at least a satisfactory Community Reinvestment Act rating. Subsidiary banks of a financial holding company or national banks with financial subsidiaries must continue to be well-capitalized and well-managed to continue to engage in activities that are financial in nature. In addition, a financial holding company or a bank may not acquire a company that is engaged in activities that are financial in nature unless each of the subsidiary banks of the financial holding company or the bank has at least a satisfactory Community Reinvestment Act rating.
The Gramm-Leach-Bliley Act also modified other financial laws, including laws related to financial privacy. Under the act, federal banking regulators adopted rules limiting the ability of banks and other financial institutions to disclose nonpublic information about consumers to nonaffiliated third parties. The rules require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to nonaffiliated third parties.
International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001
The President signed the USA Patriot Act of 2001 into law in October 2001. This act contains the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001 (the “IMLAFA”). The IMLAFA substantially broadens existing anti-money laundering legislation and the extraterritorial jurisdiction of the United States, imposes new compliance and due diligence obligations, creates new crimes and penalties, compels the production of documents located both inside and outside the United States, including those of foreign institutions that have a correspondent relationship in the United States, and clarifies the safe harbor from civil liability to customers. The U.S. Treasury Department has issued a number of regulations implementing the USA Patriot Act that apply certain of its requirements to financial institutions such as our bank subsidiaries. The regulations impose new obligations on financial institutions to maintain appropriate policies, procedures and
controls to detect, prevent and report money laundering and terrorist financing. The Treasury Department is expected to issue a number of additional regulations, which will further clarify the USA Patriot Act’s requirements.
Pursuant to the IMLAFA, the Corporation established anti-money laundering compliance and due diligence programs.
Sarbanes-Oxley Act of 2002
The President signed into law the Sarbanes-Oxley Act of 2002, that addresses, among other issues, corporate governance, auditing and accounting, executive compensation and enhanced and timely disclosure of corporate information. The act is intended to allow shareholders to monitor more easily and efficiently the performance of public companies and their directors.
Future Legislation
Changes to the laws and regulations in the United States and North Carolina can affect the Corporation’s operating environment in substantial and unpredictable ways. FNB Corp. cannot predict whether those changes in laws and regulations will occur, and, if those changes occur, the ultimate effect they would have upon the financial condition or results of operations of the Corporation.
Employees
As of December 31, 2003, FNB Corp. had four officers, all of whom were also officers of First National Bank. On that same date, First National Bank had 204 full-time employees and 26 part-time employees, Rowan Bank had 34 full-time employees and 7 part-time employees and Dover had 42 full-time employees and 2 part-time employees. Each subsidiary considers its relationship with its employees to be excellent. The Corporation provides employee benefit programs, including a noncontributory defined benefit pension plan, matching retirement/savings (401(k)) plan, group life, health and dental insurance, paid vacations, sick leave, and health care and life insurance benefits for retired employees.
Properties
The main offices of First National Bank and the principal executive offices of FNB Corp. are located in an office building at 101 Sunset Avenue, Asheboro, North Carolina. The premises contain approximately 36,500 square feet of office space. First National Bank also has other community offices in Asheboro (two offices), Archdale (two offices), Biscoe, Ellerbe, Laurinburg, Pinehurst, Ramseur, Randleman, Rockingham (two offices), Seagrove, Siler City, Southern Pines and Trinity, North Carolina. A loan production office is located in Greensboro, North Carolina. The Bush Hill office in Archdale and the Greensboro, Laurinburg and Pinehurst offices are leased facilities. The land on which the Seagrove office is situated is also under a lease.
The main offices of Rowan Bank are located in China Grove, North Carolina. Rowan Bank also has other community offices in Kannapolis and Salisbury, North Carolina.
The main offices of Dover are located in Charlotte, North Carolina. Dover also has loan production offices in Goldsboro, Greenville, Lake Norman, Raleigh and Wilmington, North Carolina. All of the Dover facilities are leased.
FNB CORP. AND SUBSIDIARIES
FIVE YEAR FINANCIAL HISTORY (1)
(1)
Financial data for all prior periods has been restated to reflect the merger with Carolina Fincorp, Inc., which became effective on April 10, 2000 and was accounted for as a pooling of interests.
(2)
Cash dividends declared represent FNB Corp. historical cash dividends declared.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The purpose of this discussion and analysis is to assist in the understanding and evaluation of the financial condition, changes in financial condition and results of operations of FNB Corp. (the “Parent Company”) and its wholly owned subsidiaries, First National Bank and Trust Company (“First National Bank”), Rowan Savings Bank SSB, Inc. (“Rowan Bank”) and Dover Mortgage Company (“Dover”), collectively referred to as the “Corporation”. First National Bank and Rowan Bank are collectively referred to as the “subsidiary banks”. This discussion should be read in conjunction with the consolidated financial statements and supplemental financial information appearing elsewhere in this report.
Overview
Description of Operations
FNB Corp. is a multi-bank holding company with two full-service subsidiary banks, First National Bank and Rowan Bank, that offer a complete line of consumer, mortgage and business banking services, including loan, deposit, cash management, investment management and trust services, to individual and business customers. The subsidiary banks have offices in Chatham, Guilford, Montgomery, Moore, Randolph, Richmond, Rowan and Scotland counties in North Carolina.
Additionally, FNB Corp. has a mortgage banking subsidiary, Dover Mortgage Company, that originates, underwrites and closes loans for sale into the secondary market. Dover operates six mortgage production offices in North Carolina at Charlotte, Goldsboro, Greenville, Lake Norman, Raleigh and Wilmington.
For business segment information related to the financial performance of the full-service subsidiary banks and Dover Mortgage Company, see Note 20 to the Consolidated Financial Statements.
Merger Acquisition of Rowan Bank in 2002
On August 1, 2002, the Corporation completed a merger for the acquisition of Rowan Bancorp, Inc. (“Rowan Bancorp”), holding company for Rowan Savings Bank SSB, Inc. (“Rowan Bank”), headquartered in China Grove, North Carolina. Per the terms of the merger agreement, Rowan Bank will be operated as a separate subsidiary of FNB Corp. for a period of not less than 24 months; provided, however, that the Board of Directors of Rowan Bank may elect to cause Rowan Bank to merge with First National Bank or another subsidiary of FNB Corp. prior to the termination of the 24-month period. At the date of merger, Rowan Bank operated three offices and, based on estimated fair values, had $134,208,000 in total assets, $95,738,000 in loans and $101,205,000 in deposits. Pursuant to the terms of the merger, each share of Rowan Bancorp common stock was converted into either 2.3715 shares of FNB Corp. common stock or $36.00 in cash or a combination of stock and cash, the overall conversion to stock being limited to 45% of Rowan Bancorp shares. The aggregate purchase price was $21,830,000, consisting of $11,205,000 of cash payments, 603,859 shares of FNB Corp. common stock valued at $9,094,000 and outstanding Rowan Bancorp stock options valued at $1,531,000. The merger transaction has been accounted for using the purchase method of accounting for business combinations, and accordingly, the assets and liabilities of Rowan Bank were recorded based on a preliminary estimate of fair values as of August 1, 2002, subject to possible adjustment during the one-year period from that date. The only adjustments recorded during that one-year period related to accrued acquisition costs and resulted in an $18,000 reduction of the amount initially recorded for goodwill. The consolidated financial statements include the results of operations of Rowan Bank since August 1, 2002.
Merger Acquisition of Dover Mortgage Company in 2003
On April 1, 2003, the Corporation completed a merger for the acquisition of Dover Mortgage Company (“Dover”), headquartered in Charlotte, North Carolina. Operating as a separate subsidiary of FNB Corp., Dover
originates, underwrites and closes mortgage loans for sale into the secondary market. Mortgage production is sold on a service-released basis to a number of national lenders who in turn service the loans. At the date of the merger, Dover operated six offices and, based on estimated fair values, had $47,001,000 in total assets and $5,823,000 in shareholders’ equity. Pursuant to the terms of the merger, 50% of the outstanding shares of Dover common stock were converted into FNB Corp. common stock and the remaining 50% were converted into cash. The aggregate purchase price was $5,567,000, consisting of $2,908,000 of cash payments and 126,140 shares of FNB Corp. common stock valued at $2,659,000. Subject to a maximum total payment, Dover shareholders will be entitled to additional cash consideration over the four-year period following closing, based on a percentage of Dover’s pretax net income during that four-year period. Any additional cash consideration paid to Dover shareholders will be recorded as a purchase adjustment which will increase goodwill. The merger transaction has been accounted for using the purchase method of accounting for business combinations, and accordingly, the assets and liabilities of Dover were recorded based on a preliminary estimate of fair values as of April 1, 2003, subject to possible adjustment during the one-year period from that date. The consolidated financial statements include the results of operations of Dover since April 1, 2003.
Primary Financial Data for 2003
The Corporation earned $8,400,000 in 2003, a 2.4% increase in net income from 2002. Basic earnings per share decreased from $1.63 in 2002 to $1.50 in 2003 and diluted earnings per share decreased from $1.58 to $1.43, for percentage decreases of 8.0% and 9.5%, respectively. As noted above, Rowan Bank and Dover Mortgage Company were acquired as subsidiaries through mergers effective August 1, 2002 and April 1, 2003, respectively, impacting both net income and the calculation of earnings per share since the acquisition dates. Largely reflecting the Dover acquisition, total assets were $773,245,000 at December 31, 2003, up 2.5% from year-end 2002. Loans amounted to $551,913,000 at December 31, 2003, increasing 9.9% from the prior year. Total deposits grew 0.9% to $597,925,000 in 2003.
Significant Factors Affecting Earnings in 2003
The financial performance of Dover Mortgage Company was negatively impacted in 2003 by reductions of approximately $1,250,000 in the third quarter and $80,000 in the fourth quarter in income from mortgage loan sales as a result of the failure to properly obtain forward sales commitments when certain interest rate locks or commitments to lend were entered into with potential borrowers. Failure to adhere to policies in connection with forward sales commitments, along with steep increases in conforming mortgage interest rates, created the reduction in income enumerated above. The Corporation is continuing to review and enhance the controls and procedures in place at this subsidiary which had not been subject to public reporting company requirements prior to the time of its acquisition on April 1, 2003.
Net interest income did not increase in proportion to the increase in earning assets in 2003, reflecting the continuing decline in interest rates. The net interest margin, as a percentage of earning assets, decreased 56 basis points to 3.84% in 2003 from 4.40% in 2002.
The provision for loan losses continued to negatively affect earnings in 2003 as in 2002, remaining above the historical trend. The 2003 provision was $1,860,000 compared to $1,780,000 in 2002, $1,200,000 in 2001 and $1,352,000 in 2000, the latter amount being net of a $450,000 charge that was merger related. The provision in recent years has been affected by asset quality considerations, increases in charge-offs and general economic conditions.
Income tax expense was reduced $173,000 in 2003 for the change in the valuation allowance for state deferred income tax assets as a result of management’s judgment that these will now be realized in future periods.
Critical Accounting Policies
The Corporation’s significant accounting policies are set forth in Note 1 to the Consolidated Financial Statements. Of these significant accounting policies, the Corporation considers its policy regarding the allowance for loan losses to be its most critical accounting policy, because it requires management’s most subjective and complex judgments. In addition, changes in economic conditions can have a significant impact on the allowance for loan losses and therefore the provision for loan losses and results of operations. The Corporation has developed appropriate policies and procedures for assessing the adequacy of the allowance for loan losses, recognizing that this process requires a number of assumptions and estimates with respect to its loan portfolio. The Corporation’s assessments may be impacted in future periods by changes in economic conditions, the impact of regulatory examinations, and the discovery of information with respect to borrowers which is not known to management at the time of the issuance of the consolidated financial statements. For additional discussion concerning the Corporation’s allowance for loan losses and related matters, see “Asset Quality”.
Earnings Review
The Corporation’s net income increased $200,000 in 2003, up 2.4% over 2002, reflecting in part the acquisitions of Rowan Bank and Dover Mortgage Company on August 1, 2002 and April 1, 2003, respectively, as discussed above. Earnings were positively impacted in 2003 by increases of $940,000 or 3.7% in net interest income and $6,068,000 or 73.4% in noninterest income. The net $7,008,000 gain in revenue from operations was significantly offset, however, by increases of $7,019,000 or 34.9% in noninterest expense and $80,000 in the provision for loan losses. Noninterest income has been significantly augmented by the increase in income from mortgage loan sales following the Dover acquisition, except for the reductions in Dover income from mortgage loan sales as noted in the “Overview-Significant Factors Affecting Earnings in 2003”. Additionally, noninterest income has been further augmented by the first full-year increase in service charges on deposit accounts resulting from the implementation of an overdraft protection program in July 2002 and by the increased level of income from mortgage loan sales by the subsidiary banks as long-term conforming mortgage rates remained at historical lows through most of 2003. Noninterest expense has been impacted significantly by the Dover acquisition and also by the Rowan Bank acquisition.
The Corporation’s net income increased $1,472,000 in 2002, up 21.9% over 2001, reflecting in part the acquisition of Rowan Bank on August 1, 2002 as discussed above. Earnings were positively impacted in 2002 by increases of $4,570,000 or 22.0% in net interest income and $2,368,000 in noninterest income. These gains were significantly offset, however, by increases of $4,063,000 in noninterest expense and $580,000 in the provision for loan losses. Noninterest income was favorably impacted by the increase in service charges on deposit accounts resulting from the implementation of an overdraft protection program in July 2002 and by the increase in income from mortgage loan sales as long-term conforming mortgage rates remained at historical lows.
Return on average assets improved from 1.15% in 2001 to 1.25% in 2002 and decreased to 1.07% in 2003. Return on average shareholders’ equity improved from 11.63% in 2001 to 12.82% in 2002 and decreased to 10.66% in 2003. In 2003, return on tangible assets and equity (calculated by deducting average goodwill from average assets and from average equity) amounted to 1.09% and 13.25%, respectively.
Net Interest Income
Net interest income is the difference between interest income, principally from loans and investments, and interest expense, principally on customer deposits. Changes in net interest income result from changes in interest rates and in the volume, or average dollar level, and mix of earning assets and interest-bearing liabilities.
Net interest income was $26,278,000 in 2003 compared to $25,338,000 in 2002. The increase of $940,000 or 3.7% resulted largely from the acquisitions of Rowan Bank and Dover Mortgage Company on August 1, 2002 and April 1, 2003, respectively, as discussed above, which was the primary factor resulting in an 18.7% increase in the level of average earning assets, the effect of which was partially offset by a decline in the net yield on
earning assets, or net interest margin, from 4.40% to 3.84%. In 2002, there was a $4,570,000 or 22.0% increase in net interest income that resulted partially from the acquisition of Rowan Bank on August 1, 2002, but was primarily due to an improvement in the net yield on earning assets, or net interest margin, from 4.03% to 4.40% coupled with an 11.6% increase in the level of average earning assets. On a taxable equivalent basis, the increases in net interest income in 2003 and 2002 were $929,000 and $4,798,000, respectively, reflecting changes in the relative mix of taxable and non-taxable earning assets in each year.
Table 1 sets forth for the periods indicated information with respect to the Corporation’s average balances of assets and liabilities, as well as the total dollar amounts of interest income (taxable equivalent basis) from earning assets and interest expense on interest-bearing liabilities, resultant rates earned or paid, net interest income, net interest spread and net yield on earning assets. Net interest spread refers to the difference between the average yield on earning assets and the average rate paid on interest-bearing liabilities. Net yield on earning assets, or net interest margin, refers to net interest income divided by average earning assets and is influenced by the level and relative mix of earning assets and interest-bearing liabilities.
Table 1
Average Balances and Net Interest Income Analysis
(1)
Interest income and yields related to certain investment securities and loans exempt from both federal and state income tax or from state income tax alone are stated on a fully taxable equivalent basis, assuming a 34% federal tax rate and applicable state tax rate, reduced by the nondeductible portion of interest expense.
(2)
Nonaccrual loans are included in the average loan balance. Loan fees and the incremental direct costs associated with making loans are deferred and subsequently recognized over the life of the loan as an adjustment of interest income.
Changes in the net interest margin and net interest spread tend to correlate with movements in the prime rate of interest. There are variations, however, in the degree and timing of rate changes, compared to prime, for the different types of earning assets and interest-bearing liabilities.
Until the significant interest rate declines in 2001, there had been a much greater degree of stability for several years in the interest rates both earned and paid by the Corporation. After rate cuts totaling 4.75% in 2001 and an additional rate cut of .50% in 2002, the prime rate averaged 6.99% in 2001 and 4.67% in 2002 compared to the average prime rates of 9.21%, 7.99% and 8.37% in 2000, 1999 and 1998, respectively. Due to a general slowdown in the economy that began to be perceived in the 2000 fourth quarter, the Federal Reserve acted to provide a stimulus through a series of interest rate reductions commencing in the 2001 first quarter, resulting in eight 50 basis point reductions and three 25 basis point reductions in the prime rate that lowered it to the 4.75% level at December 31, 2001. The reductions in the prime rate tended to negatively impact the net interest margin and net interest spread until the 2001 third quarter when these measures began to improve. An additional rate cut of 50 basis points in November 2002 further lowered the prime rate to the 4.25% level at December 31, 2002. In 2003, a rate cut of 25 basis points in June lowered the prime rate to 4.00%. The prime rate averaged 4.12% in 2003 compared to 4.67% in 2002.
The Corporation’s net interest margin and net interest spread were negatively impacted in 2003 due in part to the prime rate reductions in November 2002 and June 2003 but also because of the cumulative effect of the reductions in yields on fixed rate earning assets over an extended period.
In 2003, the net interest spread declined by 46 basis points from 4.06% in 2002 to 3.60% in 2003, reflecting the effect of a decrease in the average total yield on earning assets that more than offset the decrease in the average rate paid on interest-bearing liabilities, or cost of funds. The yield on earning assets decreased by 106 basis points from 6.72% in 2002 to 5.66% in 2003, while the cost of funds decreased by 60 basis points from 2.66% to 2.06%. In 2002, the 62 basis points increase in net interest spread resulted from a 107 basis points decrease in the yield on earning assets that was more than offset by a 169 basis points decrease in the cost of funds.
The 2003 and 2002 changes in net interest income on a taxable equivalent basis, as measured by volume and rate variances, are analyzed in Table 2. Volume refers to the average dollar level of earning assets and interest-bearing liabilities.
Table 2
Volume and Rate Variance Analysis
(1)
The mix variance, not separately stated, has been proportionally allocated to the volume and rate variances based on their absolute dollar amount.
(2)
Interest income related to certain investment securities and loans exempt from both federal and state income tax or from state income tax alone is stated on a fully taxable equivalent basis, assuming a 34% federal tax rate and applicable state tax rate, reduced by the nondeductible portion of interest expense.
Provision for Loan Losses
This provision is the charge against earnings to provide an allowance or reserve for probable losses inherent in the loan portfolio. The amount of each year’s charge is affected by several considerations including management’s evaluation of various risk factors in determining the adequacy of the allowance (see “Asset Quality”), actual loan loss experience and loan portfolio growth. The provision for loan losses continued to negatively affect earnings in 2003 as in 2002, remaining above the historical trend. The 2003 provision was $1,860,000 compared to $1,780,000 in 2002, $1,200,000 in 2001 and $1,352,000 in 2000, the latter amount being net of a $450,000 charge that was merger related. The provision in recent years has been affected by asset quality considerations, increases in charge-offs and general economic conditions.
The allowance for loan losses, as a percentage of loans held for investment, amounted to 1.14% at December 31, 2003, 1.22% at December 31, 2002 and 1.17% at December 31, 2001. The increase in the allowance percentage from December 31, 2001 to December 31, 2002 related primarily to asset quality considerations, increases in historical charge-off trends and general economic conditions, while the decrease from December 31, 2002 to December 31, 2003 was due to charge-offs of impaired loans which were specifically reserved.
Noninterest Income
Noninterest income increased $6,068,000 or 73.4% in 2003, reflecting in large part the acquisition of Dover Mortgage Company on April 1, 2003 as discussed above, to a lesser extent the acquisition of Rowan Bank on August 1, 2002 as discussed above, and further to the general increase in the volume of business. The increase was primarily due to a $3,995,000 increase in income from mortgage loan sales and a $1,209,000 increase in service charges on deposit accounts. The increase in income from mortgage loan sales was largely due to the Dover acquisition but there was also an increase in the level of income from mortgage loan sales by the subsidiary banks as long-term conforming mortgage rates remained at historical lows through most of 2003. The increase in service charges on deposit accounts was primarily due to the first full-year results of an overdraft protection program implemented in July 2002. The increase in annuity and brokerage commissions was largely related to the general increase in the volume of sales of annuity products.
As additionally discussed in the “Overview-Significant Factors Affecting Earnings in 2003”, the Corporation sustained a reduction in 2003 of approximately $1,330,000 in income from mortgage loan sales of Dover Mortgage Company as a result of the failure to properly obtain forward sales commitments when certain interest rate locks or commitments to lend were entered into with potential borrowers.
Noninterest income increased $2,368,000 or 40.1% in 2002, reflecting in part the acquisition of Rowan Bank on August 1, 2002 as discussed above and also the general increase in the volume of business. The increase was primarily due to a $1,203,000 increase in service charges on deposit accounts and an $800,000 increase in income from mortgage loan sales. The increase in service charges on deposit accounts primarily related to the implementation of an overdraft protection program in July 2002. Other factors favorably affecting the level of service charges on deposit accounts in 2002 were the selected increases in service charge rates that became effective in the 2002 first and third quarters and the increase in the level of deposit accounts subject to service charges. Income from mortgage loan sales benefited in 2002 from long-term conforming mortgage rates that remained at historical lows.
Noninterest Expense
Noninterest expense was $7,019,000 or 34.9% higher in 2003, due primarily to the acquisitions of Rowan Bank and Dover Mortgage Company on August 1, 2002 and April 1, 2003, respectively, as discussed above, with the Dover acquisition being the most significant factor with regard to the higher level of noninterest expense after the 2003 first quarter. The largest factor resulting in higher noninterest expense was the generally increased level of personnel expense, which was impacted by increased staffing requirements in addition to what was attributable to the acquisitions of Rowan Bank and Dover, by normal salary adjustments and by higher costs of fringe benefits. The cost of data processing services was higher in the 2003 first quarter because of the outside data processing services employed by Rowan Bank until the conversion to an in-house system in March 2003, with the conversion project separately resulting in $140,000 in expenses. Other expense has been affected commencing in the third quarter of 2002 by expenses related to the new overdraft protection program (see “Noninterest Income”), such expenses amounting to $312,000 in 2003 and $174,000 in 2002.
Noninterest expense was $4,063,000 or 25.3% higher in 2002 due in part to the acquisition of Rowan Bank on August 1, 2002 as discussed above. The largest factor resulting in higher noninterest expense was the generally increased level of personnel expense, which was impacted by increased staffing requirements in addition to the acquisition of Rowan Bank, by normal salary adjustments, by increased incentive compensation and by higher costs of fringe benefits. Other expense was affected in 2002 by increases in consulting fees and advertising and marketing expense, by losses recorded on disposal of fixed assets and by expenses related to the new overdraft protection program (see “Noninterest Income”).
Income Taxes
As noted in the “Overview-Significant Factors Affecting Earnings in 2003”, the 2003 results were positively affected by a $173,000 reduction in income tax expense for the change in the valuation allowance for
state deferred income tax assets as a result of management’s judgment that these will now be realized in future periods. Exclusive of the change in the valuation allowance for state deferred income tax assets, the effective income tax rate decreased from 29.8% in 2002 to 29.0% in 2003 due principally to a decrease in the ratio of taxable to tax-exempt income. The effective income tax rate increased from 28.4% in 2001 to 29.8% in 2002 due principally to an increase in the ratio of taxable to tax-exempt income.
Liquidity
Liquidity for the subsidiary banks refers to their continuing ability to meet deposit withdrawals, fund loan and capital expenditure commitments, maintain reserve requirements, pay operating expenses and provide funds to the Parent Company for payment of dividends, debt service and other operational requirements. Liquidity is immediately available from five major sources: (a) cash on hand and on deposit at other banks, (b) the outstanding balance of federal funds sold, (c) lines for the purchase of federal funds from other banks, (d) the lines of credit established at the Federal Home Loan Bank totaling $151,700,000, less existing advances against those lines, and (e) the investment securities portfolio. All debt securities are of investment grade quality and, if the need arises, can be promptly liquidated on the open market or pledged as collateral for short-term borrowing.
Consistent with the general approach to liquidity, loans and other assets of the subsidiary banks are based primarily on a core of local deposits and the subsidiary bank’s capital position. To date, the steady increase in deposits, retail repurchase agreements and capital, supplemented by Federal Home Loan Bank advances, has been adequate to fund loan demand in each subsidiary bank’s market area, while maintaining the desired level of immediate liquidity and a substantial investment securities portfolio available for both immediate and secondary liquidity purposes.
Liquidity for Dover Mortgage Company refers to its continuing ability to fund mortgage loan commitments, pay operating expenses and provide funds to the Parent Company for payment of dividends, debt service and other operational requirements. Liquidity is principally available from a line of credit with another financial institution.
Contractual Obligations
Under existing contractual obligations, the Corporation will be required to make payments in future periods. Table 3 presents aggregated information about the payments due under such contractual obligations at December 31, 2003. Transaction deposit accounts with indeterminate maturities have been classified as having payments due in one year or less.
Table 3
Contractual Obligations
Commitments, Contingencies and Off-Balance Sheet Risk
In the normal course of business, various commitments are outstanding that are not reflected in the consolidated financial statements. Significant commitments at December 31, 2003 are discussed below.
Commitments by the subsidiary banks to extend credit and undisbursed advances on customer lines of credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. At December 31, 2003, total commitments to extend credit and undisbursed advances on customer lines of credit amounted to $169,217,000. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many commitments expire without being drawn, the total commitment amounts do not necessarily represent future cash requirements. The Corporation evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary, upon extension of credit is based on the credit evaluation of the borrower.
The subsidiary banks issue standby letters of credit whereby the Corporation guarantees the performance of a customer to a third party if a specified triggering event or condition occurs. The guarantees generally expire within one year and may be automatically renewed depending on the terms of the guarantee. All standby letters of credit provide for recourse against the customer on whose behalf the letter of credit was issued, and this recourse may be further secured by a pledge of assets. The maximum potential amount of undiscounted future payments related to standby letters of credit was $6,221,000 at December 31, 2003 and $497,000 at December 31, 2002. Due to insignificance, the Corporation has recorded no liability at December 31, 2003 for the current carrying amount of the obligation to perform as a guarantor.
Dover Mortgage Company originates certain residential mortgage loans with the intention of selling these loans. Between the time that Dover enters into an interest rate lock or a commitment to originate a residential mortgage loan with a potential borrower and the time the closed loan is sold, the Corporation is subject to variability in market prices related to these commitments. The Corporation believes that it is prudent to limit the variability of expected proceeds from the future sales of these loans by entering into forward sales commitments and commitments to deliver loans into a mortgage-backed security. The commitments to originate residential mortgage loans and the forward sales commitments are freestanding derivative instruments. They do not qualify for hedge accounting treatment so their fair value adjustments are recorded through the income statement in income from mortgage loan sales. The commitments to originate residential mortgage loans totaled $15,890,000 at December 31, 2003. The related forward sales commitments totaled $15,890,000 at December 31, 2003. The fair value of these commitments was recorded as a net asset of $176,000 at December 31, 2003. Loans held for sale by Dover Mortgage Company totaled $8,201,000 at December 31, 2003. The related forward sales commitments totaled $8,153,000 at December 31, 2003. The fair value of these commitments was recorded as a net asset of $6,000 at December 31, 2003. The Corporation is exposed to interest rate risk and market risk on the $48,000 in loans held for sale for which it does not have forward sales commitments at December 31, 2003.
The subsidiary banks had loans held for sale of $367,000 at December 31, 2003. Binding commitments of the subsidiary banks for the origination of mortgage loans intended to be held for sale at December 31, 2003 were not material.
The Corporation does not have any special purpose entities or other similar forms of off-balance sheet financing.
Asset/Liability Management and Interest Rate Sensitivity
One of the primary objectives of asset/liability management is to maximize the net interest margin while minimizing the earnings risk associated with changes in interest rates. One method used to manage interest rate sensitivity is to measure, over various time periods, the interest rate sensitivity positions, or gaps; however, this method addresses only the magnitude of timing differences and does not address earnings or market value. Therefore, management uses an earnings simulation model to prepare, on a regular basis, earnings projections based on a range of interest rate scenarios in order to more accurately measure interest rate risk.
The Corporation’s balance sheet was asset-sensitive at December 31, 2003. An asset-sensitive position means that, for cumulative gap measurement periods of one year or less, there are more assets than liabilities subject to immediate repricing as market rates change. Because immediately rate sensitive assets exceed rate sensitive interest-bearing liabilities, the earnings position could improve in a rising rate environment and could deteriorate in a declining rate environment, depending on the correlation of rate changes in these two categories. Included in interest-bearing liabilities subject to rate changes within 90 days is a portion of the interest-bearing demand, savings and money market deposits. These types of deposits historically have not repriced coincidentally with or in the same proportion as general market indicators.
Table 4 presents information about the periods in which the interest-sensitive assets and liabilities at December 31, 2003 will either mature or be subject to repricing in accordance with market rates, and the resulting interest-sensitivity gaps. This table shows the sensitivity of the balance sheet at one point in time and is not necessarily indicative of what the sensitivity will be on other dates. As a simplifying assumption concerning repricing behavior, 50% of the interest-bearing demand, savings and money market deposits are assumed to reprice immediately and 50% are assumed to reprice beyond one year.
Table 4
Interest Rate Sensitivity Analysis
Market Risk
Market risk reflects the risk of economic loss resulting from adverse changes in market price and interest rates. This risk of loss can be reflected in diminished current market values and/or reduced potential net interest income in future periods.
The Corporation’s market risk arises primarily from interest rate risk inherent in its lending and deposit-taking activities. The structure of the Corporation’s loan and deposit portfolios is such that a significant decline in interest rates may adversely impact net market values and net interest income. The Corporation does not maintain a trading account nor is the Corporation subject to currency exchange risk or commodity price risk. Interest rate risk is monitored as part of the Corporation’s asset/liability management function, which is discussed in “Asset/Liability Management and Interest Rate Sensitivity” above.
Table 5 presents information about the contractual maturities, average interest rates and estimated fair values of financial instruments considered market risk sensitive at December 31, 2003.
Table 5
Market Risk Analysis of Financial Instruments
(1)
The average interest rate related to debt securities is stated on a fully taxable equivalent basis, assuming a 34% federal income tax rate and applicable state income tax rate, reduced by the nondeductible portion of interest expense.
(2)
Debt securities are reported on the basis of amortized cost. Mortgage-backed securities which have monthly curtailments of principal are categorized by final maturity.
(3)
Nonaccrual loans are included in the balance of loans. The allowance for loan losses is excluded.
Capital Adequacy
Under guidelines established by the Board of Governors of the Federal Reserve System, capital adequacy is currently measured for regulatory purposes by certain risk-based capital ratios, supplemented by a leverage capital ratio. The risk-based capital ratios are determined by expressing allowable capital amounts, defined in terms of Tier 1, Tier 2 and Tier 3, as a percentage of risk-weighted assets, which are computed by measuring the relative credit risk of both the asset categories on the balance sheet and various off-balance sheet exposures. Tier 1 capital consists primarily of common shareholders’ equity and qualifying perpetual preferred stock, net of goodwill and other disallowed intangible assets. Tier 2 capital, which is limited to the total of Tier 1 capital, includes allowable amounts of subordinated debt, mandatory convertible debt, preferred stock and the allowance for loan losses. Tier 3 capital, applicable only to financial institutions subject to certain market risk capital guidelines, is capital allocated to support the market risk related to a financial institution’s ongoing trading activities. At December 31, 2003, FNB Corp. and each of the subsidiary banks were not subject to the market risk capital guidelines and, accordingly, had no Tier 3 capital allocation. Total capital, for risk-based purposes, consists of the sum of Tier 1, Tier 2 and Tier 3 capital. Under current requirements, the minimum total capital ratio is 8.00% and the minimum Tier 1 capital ratio is 4.00%. At December 31, 2003, FNB Corp. had a total capital ratio of 11.69% and a Tier 1 capital ratio of 10.66%. First National Bank and Rowan Bank had total capital ratios of 12.68% and 13.29%, respectively, and Tier 1 capital ratios of 11.65% and 12.13%.
The leverage capital ratio, which serves as a minimum capital standard, considers Tier 1 capital only and is expressed as a percentage of average total assets for the most recent quarter, after reduction of those assets for goodwill and other disallowed intangible assets at the measurement date. As currently required, the minimum leverage capital ratio is 4.00%. At December 31, 2003, FNB Corp. had a leverage capital ratio of 8.31%. First National Bank and Rowan Bank had leverage capital ratios of 9.40% and 8.68%, respectively.
First National Bank and Rowan Bank are also required to comply with prompt corrective action provisions established by the Federal Deposit Insurance Corporation Improvement Act. To be categorized as well-capitalized, a bank must have a minimum ratio for total capital of 10.00%, for Tier 1 capital of 6.00% and for leverage capital of 5.00%. As noted above, both First National Bank and Rowan Bank met all of those ratio requirements at December 31, 2003 and, accordingly, are well-capitalized under the regulatory framework for prompt corrective action.
Balance Sheet Review
The growth in total assets in both 2003 and 2002 largely reflected an acquisition through merger in each year. As discussed in the “Overview”, Dover Mortgage Company was acquired on April 1, 2003 and Rowan Bank on August 1, 2002. Total assets increased $18,875,000 or 2.5% in 2003 and $160,628,000 or 27.1% in 2002. Deposits grew $5,571,000 or 0.9% and $112,124,000 or 23.3%, respectively, in the same periods. The level of total assets was affected in 2002 by a $15,000,000 advance from the Federal Home Loan Bank to First National Bank that was obtained primarily to help fund future loan growth. Additionally, the level of Federal Home Loan Bank advances at December 31, 2002 was further increased by advances totaling $8,388,000 which resulted from the Rowan Bank acquisition. The average asset growth rates were 20.2% in 2003 and 12.6% in 2002. The corresponding average deposit growth rates were 12.9% and 10.1%.
Investment Securities
Investments are carried on the consolidated balance sheet at estimated fair value for available-for-sale securities and at amortized cost for held-to-maturity securities. Table 6 presents information, on the basis of selected maturities, about the composition of the investment securities portfolio for each of the last three years. As discussed in Note 1 to the Consolidated Financial Statements, on January 1, 2001, the Corporation transferred all of its securities from the held-to-maturity portfolio to the available-for-sale portfolio in connection with the adoption of Statement of Financial Accounting Standards No. 133. In 2003 and 2002, certain new purchases of debt securities were classified as held-to-maturity securities.
Table 6
Investment Securities Portfolio Analysis
(1)
Yields are stated on a fully taxable equivalent basis, assuming a 34% federal income tax rate and applicable state income tax rate, reduced by the nondeductible portion of interest expense.
Additions to the investment securities portfolio depend to a large extent on the availability of investable funds that are not otherwise needed to satisfy loan demand. In 2003, when the growth in loans significantly exceeded that for total assets, there was a net decrease of $9,598,000 or 6.2% in the level of investment securities. Also, the level of funds temporarily invested as federal funds sold or as interest-bearing balances at other banks, which was higher than normal at December 31, 2002 due to proceeds from investment maturities and calls being held in a liquid status, was significantly reduced in 2003 to supply part of the funding for loan growth. In 2002, because of economic and interest rate uncertainties that resulted in the holding of the higher than normal level of proceeds from investment maturities and calls in a liquid status, there was a $9,293,000 or 5.7% reduction in the level of investment securities. Investable funds not otherwise utilized are temporarily invested on an overnight basis as federal funds sold or as interest-bearing balances at other banks, the level of which is affected by such considerations as near-term loan demand and liquidity needs. As noted above, the level of funds temporarily invested as federal funds sold or as interest-bearing balances at other banks was higher than normal at December 31, 2002.
Loans
The Corporation’s primary source of revenue and largest component of earning assets is the loan portfolio. In 2003, loans increased $49,571,000 or 9.9% due largely to internal loan generation, although augmented by the acquisition of Dover Mortgage Company on April 1, 2003 as discussed in the “Overview”. In 2002, loans increased $110,710,000 or 28.3% due primarily to the acquisition of Rowan Bank on August 1, 2002 as discussed in the “Overview”. Average loans increased $117,181,000 or 27.1% in 2003 and $40,926,000 or 10.5% in 2002. The ratio of average loans to average deposits increased from 82.0% in 2002 to 92.4% in 2003. The ratio of loans to deposits at December 31, 2003 was 92.3%.
Table 7 sets forth the major categories of loans for each of the last five years. The maturity distribution and interest rate sensitivity of selected loan categories at December 31, 2003 are presented in Table 8.
Table 7
Loan Portfolio Composition
Table 8
Selected Loan Maturities
While the level of the entire loan portfolio has been adversely impacted for an extended period by the general slowdown of the economy, the portfolios related to commercial and agricultural loans, construction loans and commercial and other real estate loans experienced significant gains in 2003. The balance of the 1-4 family residential mortgage loan portfolio has been negatively affected by the high level of refinancing activity, especially since certain loans previously included in the “held for investment” category were refinanced and subsequently sold.
Asset Quality
Management considers the asset quality of the subsidiary banks to be of primary importance. A formal loan review function, independent of loan origination, is used to identify and monitor problem loans. As part of the loan review function, a third party assessment group is employed to review the underwriting documentation and risk grading analysis.
In determining the allowance for loan losses and any resulting provision to be charged against earnings, particular emphasis is placed on the results of the loan review process. Consideration is also given to a review of individual loans, historical loan loss experience, the value and adequacy of collateral, and economic conditions in the market areas of the subsidiary banks. For loans determined to be impaired, the allowance is based on discounted cash flows using the loan’s initial effective interest rate or the fair value of the collateral for certain collateral dependent loans. This evaluation is inherently subjective as it requires material estimates, including the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan losses of each of the subsidiary banks. Such agencies may require the subsidiary banks to recognize changes to the allowance based on their judgments about information available to them at the time of their examinations. Loans are charged off when in the opinion of management, they are deemed to be uncollectible. Recognized losses are charged against the allowance, and subsequent recoveries are added to the allowance.
At December 31, 2003, the Corporation had impaired loans which totaled $1,963,000 and were also on nonaccrual status. The related allowance for loan losses on these loans amounted to $1,133,000. At December 31, 2002, the Corporation had impaired loans which totaled $3,211,000 and were also on nonaccrual status. The related allowance for loan losses on these loans amounted to $1,401,000.
A model that considers both allocated and unallocated components of the allowance for loan losses is used on a quarterly basis to analyze the adequacy of the allowance to absorb probable losses inherent in the loan portfolio. Homogeneous pools of loans are segregated, and classifications of individual loans within certain of
these pools are identified using risk grades derived from regulatory guidelines. Allocations of estimated reserves are assigned to the most adversely classified loans based upon an individual analysis of present-value repayment and/or liquidation projections of each loan. The reserve is allocated to each pool, and remaining classifications within pools, based upon a two-year historical loss ratio of First National Bank, concentrations within industries, economic and industry-specific trends, portfolio trends, and other subjective factors. An additional portion of the reserve is unallocated to any specific portion of the loan portfolio, and is based upon the mix and weight of the several homogeneous pools. The determination within the allowance model of allocated and unallocated components is not necessarily indicative of future losses or allocations. The entire balance of the allowance for loan losses is available to absorb losses in the loan portfolio.
The allowance for loan losses, as a percentage of loans held for investment, amounted to 1.14% at December 31, 2003, 1.22% at December 31, 2002 and 1.17% at December 31, 2001. The increase in the allowance percentage from December 31, 2001 to December 31, 2002 related primarily to asset quality considerations, increases in historical charge-off trends and general economic conditions, while the decrease from December 31, 2002 to December 31, 2003 was due to charge-offs of impaired loans which were specifically reserved.
Management believes the allowance for loan losses of $6,172,000 at December 31, 2003 is adequate to cover probable losses in the loan portfolio; however, assessing the adequacy of the allowance is a process that requires considerable judgment. Management’s judgments are based on numerous assumptions about current events which it believes to be reasonable, but which may or may not be valid. Thus there can be no assurance that loan losses in future periods will not exceed the current allowance or that future increases in the allowance will not be required. No assurance can be given that management’s ongoing evaluation of the loan portfolio in light of changing economic conditions and other relevant circumstances will not require significant future additions to the allowance, thus adversely affecting the operating results of the Corporation.
Table 9 presents an analysis of the changes in the allowance for loan losses and of the level of nonperforming assets for each of the last five years. Information about management’s allocation of the allowance for loan losses by loan category is presented in Table 10.
Table 9
Allowance for Loan Losses and Nonperforming Assets
(1)
Approximately $450,000 of the total provision for loan losses in 2000 was merger related.
Table 10
Allocation of Allowance For Loan Losses
Deposits
The level and mix of deposits is affected by various factors, including general economic conditions, the particular circumstances of local markets and the specific deposit strategies employed. In general, broad interest rate declines tend to encourage customers to consider alternative investments such as mutual funds and tax-deferred annuity products, while interest rate increases tend to have the opposite effect.
In addition to the significant increase in deposits in 2002 from the acquisition of Rowan Bank on August 1, 2002 as discussed in the “Overview”, the level and mix of deposits has been specifically affected by the following factors. Reflecting new deposit products and extensive promotion efforts, noninterest-bearing demand deposits grew the most of any component of deposits in 2003, increasing $12,365,000. Time deposits decreased $15,369,000 due to the continuing effect of interest rate declines. In 2002, money market deposits and interest-bearing demand deposits, excluding the amount of Rowan Bank deposits initially added on August 1, 2002, had the most significant growth of the deposit components, increasing $23,266,000 and $15,779,000, respectively. By similar comparison, time deposits, reflecting the effect of deposit maturities related to prior promotions for premium-rate certificates of deposit, decreased $34,998,000 in 2002. Further, the level of time deposits obtained from governmental units fluctuates, amounting to $49,605,000, $42,323,000, and $53,573,000 at December 31, 2003, 2002 and 2001, respectively.
Table 12 shows the year-end and average deposit balances for the years 2003, 2002 and 2001 and the changes in 2003 and 2002.
Table 11
Analysis of Deposits
Business Development Matters
As discussed in the “Overview” and in Note 2 to the Consolidated Financial Statements, the Corporation completed a merger on August 1, 2002 for the acquisition of Rowan Bancorp, Inc., holding company for Rowan Savings Bank SSB, Inc., headquartered in China Grove, North Carolina, in a transaction accounted for using the purchase method of accounting for business combinations.
As also discussed in the “Overview” and in Note 2 to the Consolidated Financial Statements, the Corporation completed a merger on April 1, 2003 for the acquisition of Dover Mortgage Company, headquartered in Charlotte, North Carolina, in a transaction accounted for using the purchase method of accounting for business combinations.
In April 2002, First National Bank received regulatory approval for establishment of a new branch office in Pinehurst, North Carolina. The office, located in a leased facility which had previously been used as a banking office by another financial institution, was renovated and then opened for business in October 2002.
In August 2003, First National Bank received regulatory approval for relocation of its existing branch offices in Laurinburg and Randleman, North Carolina. Construction of the new offices is expected to be complete by the end of 2004. The Laurinburg office will replace a leased facility, while the Randleman office represents a move from an owned facility that is expected to be disposed of.
In January 2004, First National Bank received regulatory approval for establishment of a new branch office in Greensboro, North Carolina. A loan production office was initially opened in February 2004 with a full-service banking office to follow.
Accounting Pronouncement Matters
In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS No. 146”), which addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)”. SFAS No. 146 applies to costs associated with an exit activity that does not involve an entity newly acquired in a business combination or with a disposal activity covered by SFAS No. 144. Examples of these costs include, but are not limited to, lease termination costs and certain employee severance costs. SFAS No. 146 does not apply to costs associated with the retirement of a long-lived asset covered by SFAS No. 143, “Accounting for Asset Retirement Obligations”. A liability for a cost associated with an exit or disposal activity shall be recognized and measured initially at its fair value in the period in which the liability is incurred. A liability for a cost associated with an exit or disposal activity is incurred when the definition of a liability is met. The provisions of this Statement are effective for exit or disposal activities that are initiated after December 31, 2002, with early application encouraged. The Corporation adopted the provisions of SFAS No. 146 on January 1, 2003 with no effect on its consolidated financial statements.
In November 2002, the FASB issued Financial Accounting Standards Board Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FASB Interpretation No. 45”), which addresses the disclosure to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees. FASB Interpretation No. 45 requires the guarantor to recognize a liability for the non-contingent component of the guarantee, such as the obligation to stand ready to perform in the event that specified triggering events or conditions occur. The initial measurement of this liability is the fair value of the guarantee at inception. The recognition of the liability is required even if it is not probable that payments will be required under the guarantee or if the guarantee was issued with a premium payment or as part of a transaction with multiple
elements. The disclosure requirements are effective for interim and annual financial statements ending after December 15, 2002. The initial recognition and measurement provisions are effective for all guarantees within the scope of FASB Interpretation No. 45 issued or modified after December 31, 2002. The Corporation issues standby letters of credit whereby the Corporation guarantees performance if a specified triggering event or condition occurs. The guarantees generally expire within one year and may be automatically renewed depending on the terms of the guarantee. Information concerning standby letters of credit is presented in Note 18 to the Consolidated Financial Statements.
In January 2003, the FASB issued Financial Accounting Standards Board Interpretation No. 46, “Consolidation of Variable Interest Entities” (FASB Interpretation No. 46”), which addresses consolidation by business enterprises of variable interest entities. Under FASB Interpretation No. 46, an enterprise that holds a significant variable interest in a variable interest entity but is not the primary beneficiary is required to disclose the nature, purpose, size and activities of the variable interest entity, its exposure to loss as a result of the variable interest holder’s involvement with the entity, and the nature of its involvement with the entity, and date when the involvement began. The primary beneficiary of a variable interest entity is required to disclose the nature, purpose, size and activities of the variable interest entity, the carrying amount and classification of consolidated assets that are collateral for the variable interest entity’s obligations, and any lack of recourse by creditors (or beneficial interest holders) of a consolidated variable interest entity to the general creditors (or beneficial interest holders) of a consolidated variable interest entity to the general credit of the primary beneficiary. FASB Interpretation No. 46 is effective for the first fiscal year or interim period beginning after June 15, 2003. The Corporation adopted the provisions of FASB Interpretation No. 46 with no effect on its consolidated financial statements.
In December 2003, the FASB issued revised FASB Interpretation No. 46, which clarifies certain provisions of original FASB Interpretation No. 46 and adds new scope exceptions. The provisions of revised FASB No. 46 are effective no later than March 31, 2004. However, companies must apply either original FASB Interpretation No. 46 or revised FASB Interpretation No. 46 to those entities considered special-purpose entities no later than December 31, 2003. The Corporation adopted the provisions of revised FASB Interpretation No. 46 as of December 31, 2003 with no effect on its consolidated financial statements.
In April 2003, the FASB issued Statement of Financial Accounting Standards No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“SFAS No. 149”), which amends and clarifies financial accounting and reporting for derivative instruments and for hedging activities under Statement of Financial Accounting Standards No. 133 (“SFAS No. 133”). SFAS No. 149 clarifies when a contract with an initial net investment meets the characteristic of a derivative, clarifies when a derivative instrument contains a financing component, amends the definition of an underlying to conform it to language used in FASB Interpretation No. 45. SFAS No. 149 requires that contracts with comparable characteristics be accounted for similarly. SFAS No. 149 is effective for most contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. For contracts with forward purchases or sales of TBA-type securities or other securities that do not yet exist, SFAS No. 149 is effective for both existing contracts and new contracts entered into after June 30, 2003. The Corporation adopted the provisions of SFAS No. 149 with no material effect on its consolidated financial statements.
In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“SFAS No. 150”), which establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. It is to be implemented by reporting the cumulative effect of a change in accounting principle for financial instruments created before the issuance date of the Statement and still existing at the beginning of the interim period of adoption. The Corporation adopted the provisions of SFAS No. 150 with no effect on its consolidated financial statements.
In December 2003, the FASB issued revised Statement of Financial Accounting Standards No. 132, “Employers’ Disclosures about Pensions and Other Postretirement Benefits” (“SFAS No. 132”), which, similar to original SFAS No. 132, revises employers’ disclosures about pension plans and other postretirement benefit plans. It does not change the measurement or recognition of those plans required by SFAS No. 87, “Employers’ Accounting for Pensions”, SFAS No. 88, “Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits”, and SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions”. Revised SFAS No. 132 retains the disclosure requirements contained in original SFAS No. 132, “Employers’ Disclosures about Pensions and Other Postretirement Benefits”, which it replaces. Revised SFAS No. 132 requires additional disclosures to those in original SFAS No. 132 about the assets, obligations, cash flows, and net periodic benefit cost of defined benefit pension plans and other defined benefit postretirement plans. The provisions of original SFAS No. 132 remain in place until the provisions of revised SFAS No. 132 are adopted. Certain provisions of revised SFAS No. 132 are effective for fiscal years ending after December 15, 2003 while others are effective for fiscal years ending after June 15, 2004. Additionally, certain provisions are effective for interim periods beginning after December 15, 2003. The Corporation has adopted the disclosure provisions specifically effective for fiscal years ending after December 15, 2003 and will adopt the remaining disclosure provisions as they become effective.
Effects of Inflation
The operations of the subsidiary banks and Dover Mortgage Company and, therefore, of the Corporation are subject to the effects of inflation through interest rate fluctuations and changes in the general price level of noninterest operating expenses. Such costs as salaries, fringe benefits and utilities have tended to increase at a rate comparable to or even greater than the general rate of inflation. Broadly speaking, all operating expenses have risen to higher levels as inflationary pressures have increased. Management has responded to this situation by evaluating and adjusting fees charged for specific services and by emphasizing operating efficiencies.
The level of interest rates is also considered to be influenced by inflation, rising whenever inflationary expectations and the actual level of inflation increase and declining whenever the inflationary outlook appears to be improving. Management constantly monitors this situation, attempting to adjust both rates received on earning assets and rates paid on interest-bearing liabilities in order to maintain the desired net yield on earning assets.
Additionally, the level of activity in the origination of 1-4 family residential mortgage loans which directly affects the amount of income from mortgage loan sales, the principal source of revenue for Dover and an important source for the subsidiary banks, is significantly affected by the level of interest rates, increasing as rates decline and decreasing as rates rise. In periods of rising rates, which do not generally benefit from the activity that results from the refinancing of residential mortgage loans, management attempts to increase the volume of originations resulting from traditional purchase mortgage transactions.
Non-GAAP Measures
This Annual Report on Form 10-K contains financial information determined by methods other than in accordance with generally accepted accounting principles (“GAAP”). The Corporation’s management uses these non-GAAP measures in their analysis of the Corporation’s performance. These non-GAAP measures exclude average goodwill from the calculations of return on average assets and return on average equity. Management believes presentations of financial measures excluding the impact of goodwill provide useful supplemental information that is essential to a proper understanding of the operating results of the Corporation’s core businesses. These disclosures should not be viewed as a substitute for results determined in accordance with GAAP, nor are they necessarily comparable to non-GAAP performance measures that may be presented by other companies.
Cautionary Statement for Purpose of the “Safe Harbor” Provisions of the Private Securities Litigation Reform Act of 1995
The statements contained in this Annual Report on Form 10-K that are not historical facts are forward-looking statements (as such term is defined in the Private Securities Litigation Reform Act of 1995), which can be identified by the use of forward-looking terminology such as “believes”, “expects”, “plans”, “projects”, “goals”, “estimates”, “may”, “could”, “should”, or “anticipates” or the negative thereof or other variations thereon of comparable terminology, or by discussions of strategy that involve risks and uncertainties. In addition, from time to time, the Corporation or its representatives have made or may make forward-looking statements, orally or in writing. Such forward-looking statements may be included in, but are not limited to, various filings made by the Corporation with the Securities and Exchange Commission, or press releases or oral statements made by or with the approval of an authorized executive officer of the Corporation. Forward-looking statements are based on management’s current views and assumptions and involve risks and uncertainties that could significantly affect expected results. The Corporation wishes to caution the reader that factors, such as those listed below, in some cases have affected and could affect the Corporation’s actual results, causing actual results to differ materially from those in any forward-looking statement. These factors include: (i) expected cost savings from the Corporation’s acquisitions described in the Overview may not materialize within the expected time frame, (ii) revenues following the acquisitions may not meet expectations, (iii) costs or difficulties related to the integration of the businesses of the companies acquired may be greater than anticipated, (iv) competitive pressure in the banking industry or in the Corporation’s markets may increase significantly, (v) changes in the interest rate environment may reduce margins, (vi) general economic conditions, either nationally or regionally, may be less favorable than expected, resulting in, among other things, credit quality deterioration, (vii) changes may occur in banking legislation and regulation, (viii) changes may occur in general business conditions and (ix) changes may occur in the securities markets.
Table 12
Quarterly Financial Data (Unaudited)
(1)
FNB Corp. common stock is traded on the Nasdaq National Market under the symbol FNBN. At December 31, 2003, there were 1,858 shareholders of record.
INDEPENDENT AUDITORS’ REPORT
THE BOARD OF DIRECTORS
FNB Corp.
We have audited the accompanying consolidated balance sheets of FNB Corp. and subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of income, shareholders’ equity and comprehensive income and cash flows for each of the years in the three-year period ended December 31, 2003. These consolidated financial statements are the responsibility of the Corporation’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with 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 FNB Corp. and subsidiaries as of December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America.
Greenville, South Carolina
March 12, 2004
FNB CORP. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
Commitments (Note 18)
See accompanying notes to consolidated financial statements.
FNB CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
See accompanying notes to consolidated financial statements.
FNB CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY AND COMPREHENSIVE INCOME
See accompanying notes to consolidated financial statements.
FNB CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to consolidated financial statements.
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations/Consolidation
FNB Corp. is a multi-bank holding company whose wholly owned subsidiaries are the First National Bank and Trust Company (“First National Bank”), Rowan Savings Bank SSB, Inc. (“Rowan Bank”) and Dover Mortgage Company (“Dover”). First National Bank and Rowan Bank are collectively referred to as the “subsidiary banks”. First National Bank has one wholly owned subsidiary, First National Investor Services, Inc. Through its subsidiaries, FNB Corp. offers a complete line of consumer, mortgage and business banking services, including loan, deposit, cash management, investment management and trust services, to individual and business customers. The subsidiary banks have offices in Chatham, Guilford, Montgomery, Moore, Randolph, Richmond, Rowan and Scotland counties in North Carolina. Dover Mortgage Company operates six mortgage production offices in North Carolina at Charlotte, Goldsboro, Greenville, Lake Norman, Raleigh and Wilmington.
The consolidated financial statements include the accounts of FNB Corp. and its subsidiaries (collectively the “Corporation”). All significant intercompany balances and transactions have been eliminated.
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 liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.
Business Segments
The Corporation reports business segments in accordance with Statement of Financial Accounting Standards No. 131, “Disclosures about Segments of an Enterprise and Related Information” (“SFAS No. 131”). Business segments are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and assess performance. SFAS No. 131 requires that a public enterprise report a measure of segment profit or loss, certain specific revenue and expense items, segment assets, information about the way that the business segments were determined and other items. The Corporation has two reportable business segments, the full-service subsidiary banks, First National Bank and Rowan Bank, and the mortgage banking subsidiary, Dover Mortgage Company. Business segment information is disclosed in Note 20.
Recently Adopted Accounting Pronouncements
In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS No. 146”), which addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)”. SFAS No. 146 applies to costs associated with an exit activity that does not involve an entity newly acquired in a business combination or with a disposal activity covered by SFAS No. 144. Examples of these costs include, but are not limited to, lease termination costs and certain employee severance costs. SFAS No. 146 does not apply to costs associated with the retirement of a long-lived asset covered by SFAS No. 143, “Accounting for Asset Retirement Obligations”. A liability for a cost associated with an exit or disposal activity shall be recognized and measured initially at its fair value in the period in which the liability is incurred. A liability for a cost associated with an exit or disposal activity is incurred when the definition of a liability is met. The provisions of this Statement are effective for exit or
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 1-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES-(Continued)
disposal activities that are initiated after December 31, 2002, with early application encouraged. The Corporation adopted the provisions of SFAS No. 146 on January 1, 2003 with no effect on its consolidated financial statements.
In November 2002, the FASB issued Financial Accounting Standards Board Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FASB Interpretation No. 45”), which addresses the disclosure to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees. FASB Interpretation No. 45 requires the guarantor to recognize a liability for the non-contingent component of the guarantee, such as the obligation to stand ready to perform in the event that specified triggering events or conditions occur. The initial measurement of this liability is the fair value of the guarantee at inception. The recognition of the liability is required even if it is not probable that payments will be required under the guarantee or if the guarantee was issued with a premium payment or as part of a transaction with multiple elements. The disclosure requirements are effective for interim and annual financial statements ending after December 15, 2002. The initial recognition and measurement provisions are effective for all guarantees within the scope of FASB Interpretation No. 45 issued or modified after December 31, 2002. The Corporation issues standby letters of credit whereby the Corporation guarantees performance if a specified triggering event or condition occurs. The guarantees generally expire within one year and may be automatically renewed depending on the terms of the guarantee. Information concerning standby letters of credit is presented in Note 18.
In January 2003, the FASB issued Financial Accounting Standards Board Interpretation No. 46, “Consolidation of Variable Interest Entities” (FASB Interpretation No. 46”), which addresses consolidation by business enterprises of variable interest entities. Under FASB Interpretation No. 46, an enterprise that holds a significant variable interest in a variable interest entity but is not the primary beneficiary is required to disclose the nature, purpose, size and activities of the variable interest entity, its exposure to loss as a result of the variable interest holder’s involvement with the entity, and the nature of its involvement with the entity, and date when the involvement began. The primary beneficiary of a variable interest entity is required to disclose the nature, purpose, size and activities of the variable interest entity, the carrying amount and classification of consolidated assets that are collateral for the variable interest entity’s obligations, and any lack of recourse by creditors (or beneficial interest holders) of a consolidated variable interest entity to the general creditors (or beneficial interest holders) of a consolidated variable interest entity to the general credit of the primary beneficiary. FASB Interpretation No. 46 is effective for the first fiscal year or interim period beginning after June 15, 2003. The Corporation adopted the provisions of FASB Interpretation No. 46 with no effect on its consolidated financial statements.
In December 2003, the FASB issued revised FASB Interpretation No. 46, which clarifies certain provisions of original FASB Interpretation No. 46 and adds new scope exceptions. The provisions of revised FASB No. 46 are effective no later than March 31, 2004. However, companies must apply either original FASB Interpretation No. 46 or revised FASB Interpretation No. 46 to those entities considered special-purpose entities no later than December 31, 2003. The Corporation adopted the provisions of revised FASB Interpretation No. 46 as of December 31, 2003 with no effect on its consolidated financial statements.
In April 2003, the FASB issued Statement of Financial Accounting Standards No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“SFAS No. 149”), which amends and clarifies financial accounting and reporting for derivative instruments and for hedging activities under Statement of Financial Accounting Standards No. 133 (“SFAS No. 133”). SFAS No. 149 clarifies when a contract with an initial net investment meets the characteristic of a derivative, clarifies when a derivative instrument contains a
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 1-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES-(Continued)
financing component, amends the definition of an underlying to conform it to language used in FASB Interpretation No. 45. SFAS No. 149 requires that contracts with comparable characteristics be accounted for similarly. SFAS No. 149 is effective for most contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. For contracts with forward purchases or sales of TBA-type securities or other securities that do not yet exist, SFAS No. 149 is effective for both existing contracts and new contracts entered into after June 30, 2003. The Corporation adopted the provisions of SFAS No. 149 with no material effect on its consolidated financial statements.
In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“SFAS No. 150”), which establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. It is to be implemented by reporting the cumulative effect of a change in accounting principle for financial instruments created before the issuance date of the Statement and still existing at the beginning of the interim period of adoption. The Corporation adopted the provisions of SFAS No. 150 with no effect on its consolidated financial statements.
In December 2003, the FASB issued revised Statement of Financial Accounting Standards No. 132, “Employers’ Disclosures about Pensions and Other Postretirement Benefits” (“SFAS No. 132”), which, similar to original SFAS No. 132, revises employers’ disclosures about pension plans and other postretirement benefit plans. It does not change the measurement or recognition of those plans required by SFAS No. 87, “Employers’ Accounting for Pensions”, SFAS No. 88, “Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits”, and SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions”. Revised SFAS No. 132 retains the disclosure requirements contained in original SFAS No. 132, “Employers’ Disclosures about Pensions and Other Postretirement Benefits”, which it replaces. Revised SFAS No. 132 requires additional disclosures to those in original SFAS No. 132 about the assets, obligations, cash flows, and net periodic benefit cost of defined benefit pension plans and other defined benefit postretirement plans. The provisions of original SFAS No. 132 remain in place until the provisions of revised SFAS No. 132 are adopted. Certain provisions of revised SFAS No. 132 are effective for fiscal years ending after December 15, 2003 while others are effective for fiscal years ending after June 15, 2004. Additionally, certain provisions are effective for interim periods beginning after December 15, 2003. The Corporation has adopted the disclosure provisions specifically effective for fiscal years ending after December 15, 2003 and will adopt the remaining disclosure provisions as they become effective.
Business Combinations
For all business combination transactions initiated after June 30, 2001, the purchase method of accounting has been used, and accordingly, the assets and liabilities of the acquired company have been recorded at their estimated fair values as of the merger date. The fair values are subject to adjustment as information relative to the fair values as of the acquisition date becomes available. The Corporation uses an allocation period, not to exceed one year, to identify and quantify the fair value of the assets acquired and liabilities assumed in business combinations accounted for as purchases. The consolidated financial statements include the results of operations of any acquired company since the acquisition date.
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 1-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES-(Continued)
Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, and federal funds sold. Generally, federal funds are purchased and sold for one-day periods.
Investment Securities
Investment securities are categorized and accounted for as follows:
•
Held-to-maturity securities-Debt securities that the Corporation has the positive intent and ability to hold to maturity are reported at amortized cost.
•
Trading securities-Debt and equity securities bought and held principally for the purpose of being sold in the near future are reported at fair value, with unrealized gains and losses included in earnings.
•
Available-for-sale securities-Debt and equity securities not classified as either held-to-maturity securities or trading securities are reported at fair value, with unrealized gains and losses, net of related tax effect, included as an item of other comprehensive income and reported as a separate component of shareholders’ equity.
The Corporation intends to hold its securities classified as available-for-sale securities for an indefinite period of time but may sell them prior to maturity. All other securities, which the Corporation has the positive intent and ability to hold to maturity, are classified as held-to-maturity securities.
A decline, which is deemed to be other than temporary, in the market value of any available-for-sale or held-to-maturity security to a level below cost results in a reduction in carrying amount to fair value. The impairment is charged to earnings and a new cost basis for the security is established.
As permitted in connection with the adoption of SFAS No. 133 on January 1, 2001, as discussed under “Derivatives” below, the Corporation transferred all of its securities from the held-to-maturity portfolio to the available-for-sale portfolio. As of January 1, 2001, the transfer of the securities had a net of tax effect of $242,000 on other comprehensive income.
Interest income on debt securities is adjusted using the level yield method for the amortization of premiums and accretion of discounts. The adjusted cost of the specific security is used to compute gains or losses on the disposition of securities.
Loans
Interest income on loans is generally calculated by using the constant yield method based on the daily outstanding balance. The recognition of interest income is discontinued when, in management’s opinion, the collection of all or a portion of interest becomes doubtful. Loans are returned to accrual status when the factors indicating doubtful collectibility cease to exist and the loan has performed in accordance with its terms for a demonstrated period of time. The past due status of loans is based on the contractual payment terms.
A loan is considered impaired when, based on current information or events, it is probable that a borrower will be unable to pay all amounts due according to the contractual terms of the loan agreement. For loans determined to be impaired, the allowance is based on discounted cash flows using the loan’s initial effective interest rate or the fair value of the collateral for certain collateral dependent loans. When the ultimate collectibility of the impaired loan’s principal is doubtful, all cash receipts are applied to principal. Once the
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 1-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES-(Continued)
recorded principal balance has been reduced to zero, future cash receipts are first recorded as recoveries of any amounts previously charged-off and are then applied to interest income, to the extent that any interest has been foregone.
Loan fees and the incremental direct costs associated with making loans are deferred and subsequently recognized over the life of the loan as an adjustment of interest income. The premium or discount on purchased loans is amortized over the expected life of the loans and is included in interest and fees on loans.
Residential mortgage loans held for sale are valued at the lower of cost or market as determined by outstanding commitments from investors or current investor yield requirements, calculated on the aggregate loan basis.
Allowance for Loan Losses
The allowance for loan losses represents an amount considered adequate to absorb loan losses inherent in the portfolio. Management’s evaluation of the adequacy of the allowance is based on a review of individual loans, historical loan loss experience, the value and adequacy of collateral, and economic conditions in the market areas of the subsidiary banks. For loans determined to be impaired, the allowance is based on discounted cash flows using the loan’s initial effective interest rate or the fair value of the collateral for certain collateral dependent loans. Losses are charged and recoveries are credited to the allowance for loan losses. This evaluation is inherently subjective as it requires material estimates, including the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change.
In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan losses of each of the subsidiary banks. Such agencies may require the subsidiary banks to recognize changes to the allowance based on their judgments about information available to them at the time of their examinations.
Other Real Estate
Other real estate, which is included in other assets on the consolidated balance sheet, represents properties acquired through foreclosure or deed in lieu thereof. In accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, the property is classified as held for sale when the sale is probable and expected to occur within one year. The property is initially carried at the lower of cost or fair value based on recent appraisals, less estimated costs to sell. Declines in the fair value of properties included in other real estate below carrying value are recognized by a charge to income.
Premises and Equipment
Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is computed on a straight-line basis over the estimated useful lives of the assets as follows: buildings and improvements, 10 to 50 years and furniture and equipment, 3 to 10 years. Leasehold improvements are amortized on a straight-line basis over the shorter of the estimated life of the improvement or the term of the lease.
Intangible Assets
Intangible assets include goodwill and other identifiable assets, such as core deposit premiums, resulting from acquisitions. Core deposit premiums are amortized over a six-year life using the sum-of-the-years-digits
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 1-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES-(Continued)
method based upon historical studies of core deposits. Goodwill is not amortized but is tested annually for impairment or at any time an event occurs or circumstances change that may trigger a decline in the value of the reporting unit. Examples of such events or circumstances include adverse changes in legal factors, business climate, unanticipated competition, change in regulatory environment or loss of key personnel.
The Corporation tests for impairment in accordance with SFAS No. 142. Potential impairment of goodwill exists when the carrying amount of a reporting unit exceeds its implied fair value. The fair value of a reporting unit is computed using one or a combination of the following three methods: income, market value or cost method. The income method uses a discounted cash flow analysis to determine fair value by considering a reporting unit’s capital structure and applying a risk-adjusted discount rate to forecast earnings based on a capital asset pricing model. The market value method uses recent transaction analysis or publicly traded comparable analysis for similar assets and liabilities to determine fair value. The cost method assumes the net assets of a recent business combination accounted for under the purchase method of accounting will be recorded at fair value if no event or circumstance has occurred triggering a decline in the value. To the extent a reporting unit’s carrying amount exceeds its fair value, an indication exists that the reporting unit’s goodwill may be impaired, and a second step of impairment test will be performed. In the second step, the implied fair value of the reporting unit’s goodwill, determined by allocating the reporting unit’s fair value to all of its assets (recognized and unrecognized) and liabilities as if the reporting unit had been acquired in a business combination at the date of the impairment test. If the implied fair value of reporting unit goodwill is lower than its carrying amount, goodwill is impaired and is written down to its implied fair value. The loss recognized is limited to the carrying amount of goodwill. Once an impairment loss is recognized, future increases in fair value will not result in the reversal of previously recognized losses.
Mortgage Servicing Rights (MSRs)
The rights to service mortgage loans for others are included in other assets on the consolidated balance sheet. MSRs are capitalized based on the allocated cost which is determined when the underlying loans are sold. MSRs are amortized over the life of the underlying loan as an adjustment of servicing income. Impairment reviews of MSRs are performed on a quarterly basis.
Income Taxes
Income tax expense includes both a current provision based on the amounts computed for income tax return purposes and a deferred provision that results from application of the asset and liability method of accounting for deferred taxes. Under the asset and liability method, deferred tax assets and liabilities are established for the temporary differences between the financial reporting basis and the tax basis of the Corporation’s assets and liabilities at enacted tax rates expected to be in effect when such amounts are realized or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
Earnings Per Share (EPS)
As required for entities with complex capital structures, a dual presentation of basic and diluted EPS is included on the face of the income statement, and a reconciliation is provided in a footnote of the numerator and denominator of the basic EPS computation to the numerator and denominator of the diluted EPS computation.
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 1-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES-(Continued)
Comprehensive Income
Comprehensive income is defined as the change in equity of an enterprise during a period from transactions and other events and circumstances from nonowner sources and, accordingly, includes both net income and amounts referred to as other comprehensive income. The items of other comprehensive income are included in the consolidated statement of shareholders’ equity and comprehensive income. The accumulated balance of other comprehensive income is included in the shareholders’ equity section of the consolidated balance sheet.
Employee Benefit Plans
The Corporation has a defined benefit pension plan covering substantially all full-time employees. Pension costs, which are actuarially determined using the projected unit credit method, are charged to current operations. Annual funding contributions are made up to the maximum amounts allowable for Federal income tax purposes.
The Corporation has a noncontributory, nonqualified supplemental executive retirement plan (the “SERP”) covering certain executive employees. Annual benefits payable under the SERP are based on factors similar to those for the pension plan, with offsets related to amounts payable under the pension plan and social security benefits. SERP costs, which are actuarially determined using the projected unit credit method and recorded on an unfunded basis, are charged to current operations and credited to a liability account on the consolidated balance sheet.
Medical and life insurance benefits are provided by the Corporation on a postretirement basis under defined benefit plans covering substantially all full-time employees. Postretirement benefit costs, which are actuarially determined using the attribution method and recorded on an unfunded basis, are charged to current operations and credited to a liability account on the consolidated balance sheet.
Stock Options
The Corporation accounts for awards under employee stock-based compensation plans using the intrinsic value method in accordance with APB Opinion No. 25, “Accounting for Stock Issued to Employees” and, accordingly, no compensation cost has been recognized for such awards in the consolidated financial statements. The pro forma effect on net income and earnings per share as if the compensation cost that would have been determined under the fair value method had been recorded in the consolidated financial statements, pursuant to the provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” and Statement No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure, an amendment of FASB Statement No. 123”, is disclosed as follows and in Note 17, for stock option grants in 1995 and subsequent years.
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 1-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES-(Continued)
Derivatives and Financial Instruments
Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No. 133”), as amended by SFAS Nos. 137, 138 and 149, establishes accounting and reporting standards for derivative and hedging activities. It requires an entity to recognize all derivatives as either assets or liabilities in the balance sheet, and measure those instruments at fair value. Changes in the fair value of those derivatives are reported in current earnings or other comprehensive income depending on the purpose for which the derivative is held and whether the derivative qualifies for hedge accounting.
The Corporation has identified the following derivative instruments which were recorded on the consolidated balance sheet at December 31, 2003: commitments to originate residential mortgage loans and forward sales commitments.
Dover Mortgage Company originates certain residential mortgage loans with the intention of selling these loans. Between the time that Dover enters into an interest rate lock or a commitment to originate a residential mortgage loan with a potential borrower and the time the closed loan is sold, the Corporation is subject to variability in market prices related to these commitments. The Corporation believes that it is prudent to limit the variability of expected proceeds from the future sales of these loans by entering into forward sales commitments and commitments to deliver loans into a mortgage-backed security. The commitments to originate residential mortgage loans and the forward sales commitments are freestanding derivative instruments. They do not qualify for hedge accounting treatment so their fair value adjustments are recorded through the income statement in income from mortgage loan sales.
See Note 18 for additional information related to derivatives and financial instruments.
As permitted when SFAS No. 133 was adopted on January 1, 2001, the Corporation transferred all of its securities from the held-to-maturity portfolio to the available-for-sale portfolio as follows:
As of January 1, 2001, the transfer of the securities had a net of tax effect of $242,000 on other comprehensive income.
NOTE 2-MERGER INFORMATION
Rowan Bancorp, Inc.
On August 1, 2002, the Corporation completed a merger for the acquisition of Rowan Bancorp, Inc. (“Rowan Bancorp”), holding company for Rowan Savings Bank SSB, Inc. (“Rowan Bank”), headquartered in China Grove, North Carolina. Per the terms of the merger agreement, Rowan Bank will be operated as a separate
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 2-MERGER INFORMATION-(Continued)
subsidiary of FNB Corp. for a period of not less than 24 months; provided, however, that the Board of Directors of Rowan Bank may elect to cause Rowan Bank to merge with First National Bank or another subsidiary of FNB Corp. prior to the termination of the 24-month period. At the date of merger, Rowan Bank operated three offices and, based on estimated fair values, had $134,208,000 in total assets, $95,738,000 in loans and $101,205,000 in deposits.
Pursuant to the terms of the merger, each share of Rowan Bancorp common stock was converted into either 2.3715 shares of FNB Corp. common stock or $36.00 in cash or a combination of stock and cash, the overall conversion to stock being limited to 45% of Rowan Bancorp shares. The aggregate purchase price was $21,830,000, consisting of $11,205,000 of cash payments, 603,859 shares of FNB Corp. common stock valued at $9,094,000 and outstanding Rowan Bancorp stock options valued at $1,531,000.
The merger transaction has been accounted for using the purchase method of accounting for business combinations, and accordingly, the assets and liabilities of Rowan Bank were recorded based on a preliminary estimate of fair values as of August 1, 2002, subject to possible adjustment during the one-year period from that date. The only adjustments recorded during that one-year period related to accrued acquisition costs and resulted in an $18,000 reduction of the amount initially recorded for goodwill. The consolidated financial statements include the results of operations of Rowan Bank since August 1, 2002.
The portion of the purchase price allocated to goodwill and other intangible assets at the date of merger on August 1, 2002, and the subsequent adjustments during the one-year period from that date, are presented below:
The core deposit intangible will be amortized on the sum-of-the-years-digits basis over a six-year life. The amortization method and valuation of the core deposit intangible are based upon a historical study of the deposits acquired. Goodwill will not be amortized but will be tested at least annually for impairment in accordance with SFAS No. 142. None of the goodwill is expected to be deductible for income tax purposes. Premiums and discounts that resulted from recording the Rowan Bancorp assets and liabilities at their respective fair values are being amortized using methods that approximate an effective yield over the life of the assets and liabilities. The net amortization increased net income before income taxes by $202,000 in 2003 and $127,000 in 2002.
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 2-MERGER INFORMATION-(Continued)
Direct acquisition costs associated with the merger and included in goodwill at the date of the merger on August 1, 2002, and subsequent adjustments during the one-year period from that date, are summarized as follows:
Dover Mortgage Company
On April 1, 2003, the Corporation completed a merger for the acquisition of Dover Mortgage Company (“Dover”), headquartered in Charlotte, North Carolina. Operating as a separate subsidiary of FNB Corp., Dover originates, underwrites and closes mortgage loans for sale into the secondary market. Mortgage production is sold on a service-released basis to a number of national lenders who in turn service the loans. At the date of the merger, Dover operated six offices and, based on estimated fair values, had $47,001,000 in total assets and $5,823,000 in shareholders’ equity.
Pursuant to the terms of the merger, 50% of the outstanding shares of Dover common stock were converted into FNB Corp. common stock and the remaining 50% were converted into cash. The aggregate purchase price was $5,567,000, consisting of $2,908,000 of cash payments and 126,140 shares of FNB Corp. common stock valued at $2,659,000. Subject to a maximum total payment, Dover shareholders will be entitled to additional cash consideration over the four-year period following closing, based on a percentage of Dover’s pretax net income during that four-year period. Any additional cash consideration paid to Dover shareholders will be recorded as a purchase price adjustment which will increase goodwill.
The merger transaction has been accounted for using the purchase method of accounting for business combinations, and accordingly, the assets and liabilities of Dover were recorded based on a preliminary estimate of fair values as of April 1, 2003, subject to possible adjustment during the one-year period from that date. The consolidated financial statements include the results of operations of Dover since April 1, 2003.
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 2-MERGER INFORMATION-(Continued)
The estimated fair values of the assets acquired and liabilities assumed at the date of merger based on the information currently available is as follows (in thousands):
The portion of the purchase price allocated to goodwill is presented below (in thousands):
The following unaudited pro forma financial information presents the combined results of operations of FNB Corp. and Dover as if the merger had occurred as of the beginning of the period for each period presented. Pro forma financial information for 2002 is further adjusted to include the results of Rowan Bancorp as if the merger of FNB Corp. and Rowan Bancorp had occurred at the beginning of that year. Net income for Dover prior to the merger does not include a provision for income taxes since Dover had been operating as a Subchapter S corporation and hence was not subject to Federal and state income taxes. The pro forma financial information does not necessarily reflect the results of operations that would have occurred had FNB Corp., Dover and Rowan Bancorp constituted a single entity during such periods.
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 2-MERGER INFORMATION-(Continued)
Direct acquisition costs of $568,000 associated with the merger are included in goodwill and are summarized as follows:
NOTE 3-INTANGIBLE ASSETS
Business Combinations
For intangible assets related to business combinations, the following is a summary of the gross carrying amount and accumulated amortization of amortized intangible assets and the carrying amount of unamortized intangible assets:
Amortization of intangibles totaled $69,000 for core deposit premiums in 2003 and $30,000 in 2002. The estimated amortization expense for core deposit premiums for the years ending December 31 is as follows: $55,000 in 2004, $44,000 in 2005, $32,000 in 2006, $19,000 in 2007 and $7,000 in 2008.
The changes in the carrying amount of goodwill in 2003 were as follows:
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 3-INTANGIBLE ASSETS-(Continued)
Mortgage Servicing Rights
The following is an analysis of mortgage servicing rights included in other assets on the consolidated balance sheet:
The estimated amortization expense for mortgage servicing rights for the years ending December 31 is as follows: $324,000 in 2004, $324,000 in 2005, $324,000 in 2006, $324,000 in 2007, $324,000 in 2008 and $8,000 in 2009. The estimated amortization expense is based on current information regarding loan payments and prepayments. Amortization expense could change in future periods based on changes in the volume of prepayments and economic factors.
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 4-INVESTMENT SECURITIES
Summaries of the amortized cost and estimated fair value of investment securities and the related gross unrealized gains and losses are presented below:
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 4-INVESTMENT SECURITIES-(Continued)
The amortized cost and estimated fair value of investment securities at December 31, 2003, by contractual maturity, are shown below. Actual maturities may differ from contractual maturities because issuers may have the right to prepay obligations with or without prepayment penalties.
Debt securities with an estimated fair value of $91,110,000 at December 31, 2003 and $66,861,000 at December 31, 2002 were pledged to secure public funds and trust funds on deposit. Debt securities with an estimated fair value of $24,878,000 at December 31, 2003 and $24,631,000 at December 31, 2002 were pledged to secure retail repurchase agreements.
Proceeds from the sales of investment securities classified as available-for-sale amounted to $2,060,000 in 2002. Gross gains realized on the sales were $16,000 in 2002. There were no securities sales in 2003 and 2001.
The subsidiary banks, as members of the Federal Home Loan Bank (the “FHLB”) of Atlanta, are required to own capital stock in the FHLB of Atlanta based generally upon the balances of residential mortgage loans and FHLB advances. FHLB capital stock is pledged to secure FHLB advances. No ready market exists for this stock, and it has no quoted market value. However, redemption of this stock has historically been at par value. At December 31, 2003 and 2002, the subsidiary banks owned a total of $2,864,000 and $3,233,000, respectively, of FHLB stock.
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 4-INVESTMENT SECURITIES-(Continued)
Gross unrealized losses on investment securities and the estimated fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2003, are as follows:
Information concerning the status of investment securities with unrealized losses is as follows:
Debt securities other than mortgage-backed securities. The unrealized losses were caused by interest rate increases. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the par value of the investment, adjusted for call premiums if appropriate. Because the decline in fair value is attributable to changes in interest rates and not credit quality, and because the Corporation has the ability and intent to hold these investments until maturity or a market price recovery, these investments are not considered other-than-temporarily impaired.
Mortgage-backed securities. The unrealized losses were caused by interest rate increases. The contractual cash flows of these securities are guaranteed by U.S Government agencies and corporations. It is expected that the securities would not be settled at a price less than the amortized cost of the investment. Because the decline in fair value is attributable to changes in interest rates and not credit quality, and because the Corporation has the ability and intent to hold these investments until maturity or a market price recovery, these investments are not considered other-than-temporarily impaired.
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 5-LOANS
Major classifications of loans are as follows:
Loans as presented are reduced by net deferred loan fees of $761,000 and $781,000 at December 31, 2003 and 2002, respectively. Accruing loans past due 90 days or more amounted to $758,000 at December 31, 2003 and $1,268,000 at December 31, 2002. Nonaccrual loans amounted to $5,235,000 at December 31, 2003 and $4,944,000 at December 31, 2002. Interest income that would have been recorded on nonaccrual loans for the years ended December 31, 2003, 2002 and 2001, had they performed in accordance with their original terms, amounted to approximately $317,000, $471,000 and $373,000, respectively. Interest income on all such loans included in the results of operations amounted to approximately $67,000 in 2003, $231,000 in 2002 and $213,000 in 2001.
At December 31, 2003, the Corporation had impaired loans which totaled $1,963,000 and were also on nonaccrual status. The related allowance for loan losses on these loans amounted to $1,133,000. At December 31, 2002, the Corporation had impaired loans which totaled $3,211,000 and were also on nonaccrual status. The related allowance for loan losses on these loans amounted to $1,401,000. The average carrying value of impaired loans was $2,074,000 in 2003, $3,260,000 in 2002 and $536,000 in 2001. Interest income recognized on impaired loans amounted to approximately $5,000 in 2003, $91,000 in 2002 and $51,000 in 2001.
Loans with outstanding balances of $1,354,000 in 2003 and $539,000 in 2002 were transferred from loans to other real estate acquired through foreclosure. Other real estate acquired through loan foreclosures amounted to $1,008,000 at December 31, 2003 and $414,000 at December 31, 2002 and is included in other assets on the consolidated balance sheet.
Loans held for investment are primarily made in the region of North Carolina that includes Chatham, Guilford, Montgomery, Moore, Randolph, Richmond, Rowan and Scotland counties. The real estate loan portfolio can be affected by the condition of the local real estate markets.
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 5-LOANS-(Continued)
Loans have been made by the subsidiary banks to directors and executive officers of the Corporation and to the associates of such persons, as defined by the Securities and Exchange Commission. Such loans were made in the ordinary course of business on substantially the same terms, including rate and collateral, as those prevailing at the time in comparable transactions with other borrowers and do not involve more than normal risk of collectibility. A summary of the activity with respect to related party loans, based upon the related parties as determined in each year, is as follows:
NOTE 6-ALLOWANCE FOR LOAN LOSSES
Changes in the allowance for loan losses were as follows:
NOTE 7-PREMISES AND EQUIPMENT
Premises and equipment are summarized as follows:
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 8-INCOME TAXES
Income taxes as reported in the consolidated income statement included the following expense (benefit) components:
A reconciliation of income tax expense computed at the statutory Federal income tax rate to actual income tax expense is presented below:
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 8-INCOME TAXES-(Continued)
The components of deferred tax assets and liabilities and the tax effect of each are as follows:
Changes in net deferred tax asset (liability) were as follows:
The balance at December 31, 2002 of the valuation allowance for deferred tax assets, which has primarily served as an offset to certain deferred tax benefits recognized for state income tax purposes, was reversed in 2003 as a result of management’s assessment that these deferred tax assets will now be realized in future periods. Based upon taxable income available in the carryback period, the reversal of taxable temporary differences and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not the Corporation will realize the benefits of the deductible differences existing as of December 31, 2003.
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 8-INCOME TAXES-(Continued)
Under accounting principles generally accepted in the United States of America, the Corporation is not required to provide a deferred tax liability for the tax effect of additions to the tax bad debt reserve through 1987, the base year. Retained earnings at December 31, 2003 includes approximately $2,686,000 for which no provision for federal income tax has been made. These amounts represent allocations of income to bad debt deductions for tax purposes only. Reductions of such amounts for purposes other than bad debt losses could create income for tax purposes in certain remote instances, which would then be subject to the then current corporate income tax rate.
NOTE 9-TIME DEPOSITS
The scheduled maturities of time deposits at December 31, 2003 are as follows (in thousands):
NOTE 10-SHORT-TERM BORROWED FUNDS
Funds are borrowed on an overnight basis through retail repurchase agreements with bank customers and federal funds purchased from other financial institutions. Retail repurchase agreement borrowings are collateralized by securities of the U.S. Treasury and U.S. Government agencies and corporations.
Information concerning retail repurchase agreements and federal funds purchased is as follows:
NOTE 11-LONG-TERM BORROWED FUNDS
Federal Home Loan Bank (FHLB) Advances
The subsidiary banks have lines of credit totaling $151,700,000 with the FHLB, secured by blanket collateral agreements on qualifying 1-4 family residential mortgage loans and, as required, by other qualifying collateral. At December 31, 2003, FHLB advances under these lines amounted to $53,303,000 and were at interest rates ranging from 2.58% to 6.77%. At December 31, 2002, FHLB advances amounted to $53,388,000 and were at interest rates ranging from 3.26% to 6.77%.
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 11-LONG-TERM BORROWED FUNDS-(Continued)
At December 31, 2003, the scheduled maturities of FHLB advances, certain of which are callable at the option of the FHLB before scheduled maturity, are as follows (in thousands):
Other Borrowed Funds
Under an agreement with an external financial institution, funds in the amount of $11,000,000 were borrowed on a long-term basis in 2002. The borrowing is to be repaid in equal annual installments of $1,100,000 until the final maturity in 2012 unless the lending institution exercises its right to call the remaining note balance in full in 2007. Interest is payable on a variable rate basis, subject to a minimum rate of 3.56% and a maximum rate of 8.31%. At December 31, 2003, the note balance outstanding was $9,900,000 at a current interest rate of 3.56%. At December 31, 2002, the note balance outstanding was $11,000,000 at a current interest rate of 3.56%.
Dover mortgage Company has a line of credit totaling $25,000,000 with an external financial institution, secured by a blanket collateral agreement on the mortgage loans and certain other assets of Dover and separately guaranteed by FNB Corp. Interest is payable on a variable rate basis and the line of credit is subject to annual renewal. At December 31, 2003, the balance outstanding on the line of credit was $8,077,000 at a current interest rate of 2.79%.
NOTE 12-EMPLOYEE BENEFIT PLANS
Pension Plan
The Corporation has a noncontributory defined benefit pension plan covering substantially all full-time employees who qualify as to age and length of service. Benefits are based on the employee’s compensation, years of service and age at retirement. The Corporation’s funding policy is to contribute annually to the plan an amount which is not less than the minimum amount required by the Employee Retirement Income Security Act of 1974 and not more than the maximum amount deductible for income tax purposes.
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 12-EMPLOYEE BENEFIT PLANS-(Continued)
Information concerning the status of the plan is as follows:
The expected long-term rate of return on plan assets considers the portfolio as a whole and not on the sum of the returns on individual asset categories. The return is based exclusively on historical returns, without adjustments.
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 12-EMPLOYEE BENEFIT PLANS-(Continued)
Net periodic pension cost included the following components:
The Corporation’s investment policies and strategies for the pension plan use a target allocation of 50% to 70% for equity securities and 30% to 50% for debt securities. The investment goals attempt to maximize returns while remaining within specific risk management policies. While the risk management policies permit investment in specific debt and equity securities, a significant percentage of total plan assets is maintained in mutual funds, approximately 60% at December 31, 2003, to assist in investment diversification. Generally the investments are readily marketable and can be sold to fund benefit payment obligations as they become payable.
The Corporation expects to contribute $600,000 to its pension plan in 2004.
Supplemental Executive Retirement Plan
The Corporation has a noncontributory, nonqualified supplemental executive retirement plan (the “SERP”) covering certain executive employees. Annual benefits payable under the SERP are based on factors similar to those for the pension plan, with offsets related to amounts payable under the pension plan and social security benefits.
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 12-EMPLOYEE BENEFIT PLANS-(Continued)
Information concerning the status of the plan is as follows:
Net periodic SERP cost included the following components:
The SERP is an unfunded plan. Consequently, there are no plan assets or cash contribution requirements other than for the direct payment of benefits.
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 12-EMPLOYEE BENEFIT PLANS-(Continued)
Other Postretirement Defined Benefit Plans
The Corporation has postretirement medical and life insurance plans covering substantially all full-time employees who qualify as to age and length of service. The medical plan is contributory, with retiree contributions adjusted whenever medical insurance rates change. The life insurance plan is noncontributory.
Information concerning the plans, which are unfunded, is as follows:
Increasing or decreasing the assumed medical cost trend rate by one percentage point would not have a significant effect on either the postretirement benefit obligation at December 31, 2003 or the aggregate of the service and interest cost components of net periodic postretirement benefit cost for the year ended December 31, 2003.
Net periodic postretirement benefit cost included the following components:
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 12-EMPLOYEE BENEFIT PLANS-(Continued)
The postretirement medical and life insurance plans are unfunded plans. Consequently, there are no plan assets or cash contribution requirements other than for the direct payment of benefits.
Matching Retirement/Savings Plan
The Corporation has a matching retirement/savings plan which permits eligible employees to make contributions to the plan up to a specified percentage of compensation as defined by the plan. A portion of the employee contributions are matched by the Corporation based on the plan formula. The matching contributions amounted to $320,000 in 2003, $238,000 in 2002 and $154,000 in 2001.
NOTE 13-LEASES
Future obligations at December 31, 2003 for minimum rentals under noncancellable operating lease commitments, primarily relating to premises, are as follows (in thousands):
Net rental expense for all operating leases amounted to $271,000 in 2003, $85,000 in 2002 and $86,000 in 2001.
NOTE 14-SUPPLEMENTARY INCOME STATEMENT INFORMATION
Significant components of other expense were as follows:
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 15-FNB CORP. (PARENT COMPANY) FINANCIAL DATA
The Parent Company’s principal asset is its investment in the subsidiary companies, and its principal source of income is dividends from those subsidiaries.
The Parent Company’s condensed balance sheets as of December 31, 2003 and 2002, and the related condensed statements of income and cash flows for each of the years in the three-year period ended December 31, 2003 are as follows:
Condensed Balance Sheets
Condensed Statements of Income
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 15-FNB CORP. (PARENT COMPANY) FINANCIAL DATA-(Continued)
Condensed Statements of Cash Flows
NOTE 16-CAPITAL ADEQUACY REQUIREMENTS
Certain regulatory requirements restrict the lending of funds by the subsidiary banks to FNB Corp. and the amount of dividends which can be paid to FNB Corp. In 2004, the maximum amount of dividends First National Bank can pay to FNB Corp., without the approval of the Comptroller of the Currency, is $6,642,000 plus an additional amount equal to the retained net income in 2004 up to the date of any dividend declaration.
Rowan Bank’s ability to pay dividends to FNB Corp. depends upon the following factors. Pursuant to Chapter 54C of the North Carolina General Statutes and the regulations of the North Carolina Commissioner of Banks (the “Commissioner”), a stock savings bank may not declare or pay a cash dividend if the effect thereof would be to reduce the net worth of the savings bank to an amount which is less than the minimum required by the FDIC and the Commissioner. A stock savings bank must obtain prior written approval of the Commissioner before it can declare and pay a cash dividend on its capital stock in an amount in excess of one-half of the greater of (i) the savings bank’s net income for the most recent fiscal year or (ii) the average of the savings bank’s net income after dividends for the most recent fiscal year and not more than two of the immediately prior fiscal years, if applicable. As a result of these limiting factors, as of December 31, 2003, Rowan Bank cannot declare a dividend to FNB Corp. in excess of approximately $612,000 without the approval of the Commissioner.
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 16-CAPITAL ADEQUACY REQUIREMENTS-(Continued)
First National Bank is required to maintain average reserve balances with the Federal Reserve Bank based on a percentage of deposits. For the reserve maintenance period in effect at December 31, 2003, the average daily reserve requirement was $3,949,000.
FNB Corp. and the subsidiary banks are required to comply with capital adequacy standards established by the Board of Governors of the Federal Reserve System. In addition, the subsidiary banks are required to comply with prompt corrective action provisions established by the Federal Deposit Insurance Corporation Improvement Act. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, there are minimum ratios of capital to risk-weighted assets. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Failure to meet minimum capital requirements can initiate certain mandatory and possibly discretionary actions by regulators that, if undertaken, could have a material effect on the consolidated financial statements.
Regulatory capital amounts and ratios are set forth in the table below. The risk-based capital ratios are determined by expressing allowable capital amounts, defined in terms of Tier 1, Tier 2 and Tier 3, as a percentage of risk-weighted assets, which are computed by measuring the relative credit risk of both the asset categories on the balance sheet and various off-balance sheet exposures. Tier 1 capital consists primarily of common shareholders’ equity and qualifying perpetual preferred stock, net of goodwill and other disallowed intangible assets. Tier 2 capital, which is limited to the total of Tier 1 capital, includes allowable amounts of subordinated debt, mandatory convertible debt, preferred stock and the allowance for loan losses. Tier 3 capital, applicable only to financial institutions subject to certain market risk capital guidelines, is capital allocated to support the market risk related to a financial institution’s ongoing trading activities. At December 31, 2003, FNB Corp. and the subsidiary banks were not subject to the market risk capital guidelines and, accordingly, had no Tier 3 capital allocation. Total capital, for risk-based purposes, consists of the sum of Tier 1, Tier 2 and Tier 3 capital.
First National Bank and Rowan Bank are well-capitalized under the regulatory framework for prompt corrective action. To be categorized as well-capitalized, each bank must meet minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the table below. There are no events or conditions since the notification that management believes have changed the category for either bank.
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 17-SHAREHOLDERS’ EQUITY
Stock Buyback Program
Under stock buyback programs authorized by the Board of Directors for the repurchase of shares of common stock, the Corporation repurchased 63 shares in 2003, 59,143 shares in 2002 and 320,841 shares in 2001. Under the stock buyback program in effect at December 31, 2003, a maximum of 300,000 shares could be repurchased, of which 63 shares were repurchased in 2003, resulting in a remaining authorization of 299,937 shares available for future repurchases.
Earnings Per Share (EPS)
Basic net income per share, or basic EPS, is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if the Corporation’s dilutive stock options were exercised. The numerator of the basic EPS computation is the same as the numerator of the diluted EPS computation for all periods presented. A reconciliation of the denominators of the basic and diluted EPS computations is as follows:
For the years 2003, 2002 and 2001, there were 2,697, 5,911 and 134,667 stock options, respectively, that were antidilutive since the exercise price exceeded the average market price. These common stock equivalents were omitted from the calculations of diluted EPS for their respective years.
Stock Options
The Corporation adopted stock compensation plans in 1993 and 2003 that allow for the granting of incentive and nonqualified stock options to key employees and directors. Under terms of both the 1993 and 2003 plans, options are granted at prices equal to the fair market value of the common stock on the date of grant. Options become exercisable after one year in equal, cumulative installments over a five-year period. No option shall expire later than ten years from the date of grant. No further grants can be made under the 1993 stock compensation plan after March 10, 2003. Based on the stock options outstanding at December 31, 2003, a maximum of 533,847 shares of common stock has been reserved for issuance under the 1993 stock compensation plan. A maximum of 420,000 shares of common stock has been reserved for issuance under the 2003 stock compensation plan. At December 31, 2003, there were 250,000 shares available under the 2003 plan for the granting of additional options.
The Corporation assumed a stock compensation plan in its merger acquisition of Carolina Fincorp in 2000. One grant of qualified and nonqualified stock options was made under the plan in 1999 to key employees and directors at a price equal to fair market value on the date of grant. No additional grants will be made under the plan. Based on the stock options outstanding at December 31, 2003, a maximum of 61,498 shares of common stock has been reserved for issuance under the stock compensation plan.
The Corporation assumed another stock compensation plan in its merger acquisition of Rowan Bancorp in 2002. Remaining under the plan was one grant of incentive and nonqualified stock options made in 1993 to key
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 17-SHAREHOLDERS’ EQUITY-(Continued)
employees and directors at a price equal to fair market value on the date of grant. No additional grants will be made under the plan. The total stock options assumed on August 1, 2002, the date of completion of the merger, amounted to 141,223 shares after adjustment for the exchange ratio in converting from Rowan Bancorp shares to FNB Corp. shares. All options of Rowan Bancorp that were outstanding on August 1, 2002 were fully vested under normal plan provisions prior to the assumption by FNB Corp. There were no options that remained outstanding under the stock compensation plan at December 31, 2003 and, consequently, no shares of common stock are reserved for issuance.
The Corporation accounts for awards under employee stock-based compensation plans using the intrinsic value method in accordance with APB Opinion No. 25, “Accounting for Stock Issued to Employees” and, accordingly, no compensation cost has been recognized for such awards in the consolidated financial statements. The pro forma effect on net income and earnings per share as if the compensation cost that would have been determined under the fair value method had been recorded in the consolidated financial statements, pursuant to the provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” and Statement No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure, an amendment of FASB Statement No. 123”, is disclosed in Note 1.
The weighted-average fair value per share of options granted in 2003 and 2002 amounted to $6.58 and $2.82, respectively. There were no options granted in 2001. Fair values were estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions:
The following is a summary of stock option activity. Under the purchase method used to account for the acquisition of Rowan Bancorp, the options assumed by the Corporation on August 1, 2002 are separately identified as an addition to option shares outstanding.
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 17-SHAREHOLDERS’ EQUITY-(Continued)
At December 31, 2003, information concerning stock options outstanding and exercisable is as follows:
NOTE 18-COMMITMENTS
In the normal course of business, various commitments are outstanding that are not reflected in the consolidated financial statements. Significant commitments at December 31, 2003 are discussed below.
Commitments by the subsidiary banks to extend credit and undisbursed advances on customer lines of credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. At December 31, 2003, total commitments to extend credit and undisbursed advances on customer lines of credit amounted to $169,217,000. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many commitments expire without being drawn, the total commitment amounts do not necessarily represent future cash requirements. The Corporation evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary, upon extension of credit is based on the credit evaluation of the borrower.
The subsidiary banks issue standby letters of credit whereby the Corporation guarantees the performance of a customer to a third party if a specified triggering event or condition occurs. The guarantees generally expire within one year and may be automatically renewed depending on the terms of the guarantee. All standby letters of credit provide for recourse against the customer on whose behalf the letter of credit was issued, and this recourse may be further secured by a pledge of assets. The maximum potential amount of undiscounted future payments related to standby letters of credit was $6,221,000 at December 31, 2003 and $497,000 at December 31, 2002. Due to insignificance, the Corporation has recorded no liability at December 31, 2003 for the current carrying amount of the obligation to perform as a guarantor.
Dover Mortgage Company originates certain residential mortgage loans with the intention of selling these loans. Between the time that Dover enters into an interest rate lock or a commitment to originate a residential mortgage loan with a potential borrower and the time the closed loan is sold, the Corporation is subject to variability in market prices related to these commitments. The Corporation believes that it is prudent to limit the variability of expected proceeds from the future sales of these loans by entering into forward sales commitments and commitments to deliver loans into a mortgage-backed security. The commitments to originate residential mortgage loans and the forward sales commitments are freestanding derivative instruments. They do not qualify for hedge accounting treatment so their fair value adjustments are recorded through the income statement in income from mortgage loan sales. The commitments to originate residential mortgage loans totaled $15,890,000 at December 31, 2003. The related forward sales commitments totaled $15,890,000 at December 31, 2003. The fair value of these commitments was recorded as a net asset of $174,000 at December 31, 2003. Loans held for
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 18-COMMITMENTS-(Continued)
sale by Dover Mortgage Company totaled $8,201,000 at December 31, 2003. The related forward sales commitments totaled $8,153,000 at December 31, 2003. The fair value of these commitments was recorded as a net asset of $8,000 at December 31, 2003. The Corporation is exposed to interest rate risk and market risk on the $48,000 in loans held for sale for which it does not have forward sales commitments at December 31, 2003.
The subsidiary banks had loans held for sale of $366,000 at December 31, 2003. Binding commitments of the subsidiary banks for the origination of mortgage loans intended to be held for sale at December 31, 2003 were not material.
The Corporation does not have any special purpose entities or other similar forms of off-balance sheet financing.
NOTE 19-FAIR VALUE OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used to estimate the fair value for each class of financial instruments.
Cash and Cash Equivalents. For cash on hand, amounts due from banks, and federal funds sold, the carrying value is considered to be a reasonable estimate of fair value.
Investment Securities. The fair value of investment securities is based on quoted market price, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.
Loans. The fair value of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.
Deposits. The fair value of demand, savings and money market deposits is the amount payable on demand at the reporting date. The fair value of time deposits is estimated using the rates currently offered for deposits of similar remaining maturities.
Borrowed Funds. The carrying value of retail repurchase agreements and federal funds purchased is considered to be a reasonable estimate of fair value. The fair value of Federal Home Loan Bank advances and other borrowed funds is estimated using the rates currently offered for advances of similar remaining maturities.
Commitments. The fair value of commitments to extend credit is considered to approximate carrying value, since the large majority of these commitments would result in loans that have variable rates and/or relatively short terms to maturity or sale. For other commitments, generally of a short-term nature, the carrying value is considered to be a reasonable estimate of fair value. The various commitment items are disclosed in Note 18.
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 19-FAIR VALUE OF FINANCIAL INSTRUMENTS-(Continued)
The estimated fair values of financial instruments are as follows:
The fair value estimates are made at a specific point in time based on relevant market and other information about the financial instruments. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Corporation’s entire holdings of a particular financial instrument nor are potential taxes and other expenses that would be considered in an actual sale considered. Because no market exists for a significant portion of the Corporation’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and such other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.
FNB CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 20-BUSINESS SEGMENT INFORMATION
Prior to the acquisition of Dover Mortgage Company on April 1, 2003, the chief operating decision maker had reviewed the results of operations of the Corporation and its subsidiaries as a single enterprise. There are now considered to be two principal business segments: the full-service subsidiary banks, First National Bank and Rowan Bank, and the mortgage banking subsidiary, Dover Mortgage Company. Dover originates, underwrites and closes loans for sale into the secondary market. Financial performance for each segment for the year ended December 31, 2003 is detailed in the following table, which includes information for twelve months for the subsidiary banks and nine months for Dover Mortgage Company which was acquired using the purchase method of accounting for business combinations. Included in the “Other” column are amounts for other corporate activities and eliminations of intersegment transactions.
In 2003, the financial performance of Dover Mortgage Company was negatively impacted by reductions of approximately $1,250,000 in the third quarter and $80,000 in the fourth quarter in income from mortgage loan sales as a result of the failure to properly obtain forward sales commitments when certain interest rate locks or commitments to lend were entered into with potential borrowers. Failure to adhere to policies in connection with forward sales commitments, along with steep increases in conforming mortgage interest rates, created the reduction in income enumerated above. The Corporation is continuing to review and enhance the controls and procedures in place at this subsidiary which had not been subject to public reporting company requirements prior to the time of its acquisition on April 1, 2003. Information concerning the acquisition of Dover is provided in Note 2.
CONTROLS AND PROCEDURES
As of December 31, 2003, the end of the period covered by this report, FNB Corp. carried out an evaluation under the supervision and with the participation of the company’s management, including FNB Corp.’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of FNB Corp.’s disclosure controls and procedures. In designing and evaluating the company’s disclosure controls and procedures, FNB Corp. and its management recognize that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and FNB Corp.’s management necessarily was required to apply its judgment in evaluating and implementing possible controls and procedures. Based upon the evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the company’s disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed by FNB Corp. in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. No significant changes in the company’s internal control over financial reporting occurred during the period ended December 31, 2003 that has materially affected, or is reasonably likely to materially affect, FNB Corp.’s internal control over financial reporting. FNB Corp. reviews its disclosure controls and procedures, which may include its internal controls over financial reporting, on an ongoing basis and may from time to time make changes aimed at enhancing their effectiveness. FNB Corp. is continuing to review and enhance the controls and procedures in place at Dover, which had not been subject to public reporting company requirements prior to the time of its acquisition on April 1, 2003.
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, as of March 12, 2004.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated, as of March 12, 2004.
INDEX TO EXHIBITS
Exhibit No.
Description of Exhibit
2.10
Agreement and Plan of Merger dated as of February 11, 2002 by and between the Registrant and Rowan Bancorp, Inc., incorporated herein by reference to Exhibit 2.10 to the Registrant’s Form 10-K Annual Report for the fiscal year ended December 31, 2001.
2.11
Merger Agreement dated as of February 20, 2003 by and among the Registrant, Dover Mortgage Company and the shareholders of Dover Mortgage Company, incorporated herein by reference to Exhibit 2.11 to the Registrant’s Form 10-K Annual Report for the fiscal year ended December 31, 2002.
3.10
Articles of Incorporation of the Registrant, incorporated herein by reference to Exhibit 3.1 to the Registrant’s Form S-14 Registration Statement (No. 2-96498) filed March 16, 1985.
3.11
Articles of Amendment to Articles of Incorporation of the Registrant, adopted May 10, 1988, incorporated herein by reference to Exhibit 19.10 to the Registrant’s Form 10-Q Quarterly Report for the quarter ended June 30, 1988.
3.12
Articles of Amendment to Articles of Incorporation of the Registrant, adopted May 12, 1998, incorporated herein by reference to Exhibit 3.12 to the Registrant’s Form 10-Q Quarterly Report for the quarter ended June 30, 1998.
3.13
Articles of Amendment to Articles of Incorporation of the Registrant, adopted May 23, 2003, incorporated herein by reference to Exhibit 3.13 to the Registrant’s Form 10-Q Quarterly Report for the quarter ended June 30, 2003.
3.20
Amended and Restated Bylaws of the Registrant, adopted May 21, 1998, incorporated herein by reference to Exhibit 3.20 to the Registrant’s Form 10-Q Quarterly Report for the quarter ended June 30, 1998.
Specimen of Registrant’s Common Stock Certificate, incorporated herein by reference to Exhibit 4 to Amendment No. 1 to the Registrant’s Form S-14 Registration Statement (No. 2-96498) filed April 19, 1985.
10.10*
Form of Split Dollar Insurance Agreement dated as of November 1, 1987 between First National Bank and Trust Company and certain of its key employees and directors, incorporated herein by reference to Exhibit 19.20 to the Registrant’s Form 10-Q Quarterly Report for the quarter ended June 30, 1988.
10.11*
Form of Amendment to Split Dollar Insurance Agreement dated as of November 1, 1994 between First National Bank and Trust Company and certain of its key employees and directors, incorporated herein by reference to Exhibit 10.11 to the Registrant’s Form 10-KSB Annual Report for the fiscal year ended December 31, 1994.
10.20*
Stock Compensation Plan as amended effective May 12, 1998, incorporated herein by reference to Exhibit 10.30 to the Registrant’s Form 10-Q Quarterly Report for the quarter ended June 30, 1998.
10.21*
Form of Incentive Stock Option Agreement between FNB Corp. and certain of its key employees, pursuant to the Registrant’s Stock Compensation Plan, incorporated herein by reference to Exhibit 10.31 to the Registrant’s Form 10-KSB Annual Report for the fiscal year ended December 31, 1994.
10.22*
Form of Nonqualified Stock Option Agreement between FNB Corp. and certain of its directors, pursuant to the Registrant’s Stock Compensation Plan, incorporated herein by reference to Exhibit 10.32 to the Registrant’s Form 10-KSB Annual Report for the fiscal year ended December 31, 1994.
10.23*
FNB Corp. 2003 Stock Incentive Plan, incorporated herein by reference to Exhibit 99.1 to the Registrant’s Registration Statement on Form S-8 (File No. 333-105442).
10.24*
Form of Incentive Stock Option Agreement between FNB Corp. and certain of its key employees, pursuant to the Registrant’s 2003 Stock Incentive Plan, incorporated herein by reference to Exhibit 10.24 to the Registrant’s Form 10-Q Quarterly Report for the quarter ended September 30, 2003.
10.25*
Form of Nonqualified Stock Option Agreement between FNB Corp. and certain of its directors, pursuant to the Registrant’s 2003 Stock Incentive Plan.
Exhibit No.
Description of Exhibit
10.30*
Employment Agreement dated as of December 27, 1995 between First National Bank and Trust Company and Michael C. Miller, incorporated herein by reference to Exhibit 10.50 to the Registrant’s Form 10-KSB Annual Report for the fiscal year ended December 31, 1995.
10.31*
Carolina Fincorp, Inc. Stock Option Plan (assumed by the Registrant on April 10, 2000), incorporated herein by reference to Exhibit 99.1 to the Registrant’s Registration Statement on Form S-8 (File No. 333-54702).
10.32*
Employment Agreement dated as of April 10, 2000 between First National Bank and Trust Company and R. Larry Campbell, incorporated herein by reference to Exhibit 10.32 to the Registrant’s Form 10-K Annual Report for the fiscal year ended December 31, 2000.
10.33*
Nonqualified Supplemental Retirement Plan with R. Larry Campbell, incorporated herein by reference to Exhibit 10(c) to the Annual Report on Form 10-KSB of Carolina Fincorp, Inc. for the fiscal year ended June 30, 1997.
10.34*
Employment Agreement dated as of August 1, 2002 between Rowan Savings Bank SSB, Inc. and Bruce D. Jones, incorporated herein by reference to Exhibit 10.34 to the Registrant’s Form 10-Q Quarterly Report for the quarter ended September 30, 2002.
10.35*
Form of Change of Control Agreement between FNB Corp. and certain of its key employees and officers.
Code of Ethics for Senior Financial Officers.
Subsidiaries of the Registrant.
Independent Auditors’ Consent.
31.10
Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.11
Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
*
Management contract, or compensatory plan or arrangement.