Item 1: Business Codorus Valley Bancorp, Inc. (Codorus Valley or Corporation) is a Pennsylvania business corporation, incorporated on October 7, 1986. On March 2, 1987, Codorus Valley became a bank holding company, under the Bank Holding Company Act of 1956. PeoplesBank, A Codorus Valley Company (PeoplesBank) is its wholly owned bank subsidiary. SYC Realty Co., Inc. is its wholly owned nonbank subsidiary. Codorus Valley’s business consists primarily of managing PeoplesBank, and its principal source of income is dividends received from PeoplesBank. On December 31, 2006, Codorus Valley had total consolidated assets of $548 million, total deposits and other liabilities of $505 million, and total shareholders’ equity of $43 million.
Bank subsidiary PeoplesBank, organized in 1934, is a Pennsylvania chartered bank. It is not a member of the Federal Reserve System. PeoplesBank offers a full range of business and consumer banking services through fourteen financial centers located throughout York County, Pennsylvania. It also offers investment, insurance, trust and real estate settlement services. PeoplesBank also operates a loan production office in Towson, Maryland. The Federal Deposit Insurance Corporation insures the deposits of PeoplesBank to the maximum extent provided by law. On December 31, 2006, PeoplesBank had total loans of $407 million and total deposits of $457 million. PeoplesBank’s market share of deposits for York County, PA was approximately 7.3 percent as of June 30, 2006, the latest available date.
PeoplesBank is not dependent on deposits or exposed to a loan concentration to a single customer, or a small group of customers. Therefore, losses of a single customer, or small customer group, would not have a material adverse effect on the financial condition of PeoplesBank. At year-end 2006, the largest indebtedness of a single PeoplesBank client was $5,849,000 or 1.4 percent of the total loan portfolio, which was within the regulatory lending limit.
Most of the Corporation’s business is with customers in York County, Pennsylvania and northern Maryland. Although this may pose a concentration risk geographically, we believe that the diverse local economy and detailed knowledge of the customer base minimizes this risk. At year-end 2006, the Corporation had one industry concentration that exceeded 10 percent of the total loan portfolio, real estate construction and land development, which was 22.5 percent of the portfolio. Comparatively, at year-end 2005 real estate construction and land development was 20.2 percent of the portfolio, and commercial real estate leasing was 11.0 percent of the portfolio. Commercial leasing pertains to borrowers who lease real estate for business purposes. Loans to borrowers within these industries are usually collateralized by real estate.
Codorus Valley Financial Advisors, Inc. is a wholly owned subsidiary of PeoplesBank that sells non-deposit investment products. Prior to its name change in December 2005, this subsidiary was titled SYC Insurance Services, Inc., which began operations in January 2000. Products sold by Codorus Valley Financial Advisors, Inc. are not FDIC insured, are not obligations of or guaranteed by PeoplesBank and are subject to investment risk including the possible loss of principal.
SYC Settlement Services, Inc. is a wholly owned subsidiary of PeoplesBank that provides real estate settlement services. SYC Settlement began operations in January 1999.
Historically, Codorus Valley Financial Advisors, Inc. and SYC Settlement Services, Inc. have not had a material impact on consolidated operating results.
Nonbank subsidiaries In June 2006, Codorus Valley formed CVB Statutory Trust No. 2, a wholly-owned special purpose subsidiary whose sole purpose was to facilitate a pooled trust preferred debt issuance of $7,217,000. In November 2004, Codorus Valley formed CVB Statutory Trust No. 1 to facilitate a pooled trust preferred debt issuance of $3,093,000.
On June 20, 1991, SYC Realty was incorporated as a wholly owned subsidiary of Codorus Valley. Codorus Valley created this nonbank subsidiary primarily for the purpose of disposing of selected properties obtained by PeoplesBank in satisfaction of debts previously contracted. SYC Realty commenced business operations in October 1995. To date, the financial impact of this subsidiary’s operations on Codorus Valley and PeoplesBank has not been material.
Employees At year-end 2006, PeoplesBank employed 146 full-time employees and 43 part-time employees, which equated to 168 full-time equivalents. Employees are not covered by a collective bargaining agreement and management considers its relations with employees to be satisfactory.
Segment Reporting Management has determined that it operates in only one segment, community banking. The Corporation’s non-banking activities are insignificant to the consolidated financial statements.
Competition The banking industry in PeoplesBank’s service area, principally York County, Pennsylvania, and northern Maryland, specifically, Baltimore, Harford and Carroll counties, is extremely competitive. PeoplesBank competes through service, price and by leveraging its hometown image. It competes with commercial banks and other financial service providers such as thrifts, credit unions, consumer finance companies, investment firms and mortgage companies. Some financial service providers operating in PeoplesBank’s service area operate on a national and regional scale and possess resources that are greater than PeoplesBank’s.
Supervision and regulation Codorus Valley is registered as a bank holding company and is subject to regulation by the Board of Governors of the Federal Reserve System (Federal Reserve) under the Bank Holding Company Act of 1956, as amended. The Bank Holding Company Act requires bank holding companies to file periodic reports with, and is subject to examination by, the Federal Reserve. The Federal Reserve has issued regulations under the Bank Holding Company Act that require a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks. As a result, the Federal Reserve may require Codorus Valley to use its resources to provide adequate capital funds to PeoplesBank during periods of financial stress or adversity.
The Bank Holding Company Act prohibits Codorus Valley from acquiring direct or indirect control of more than 5 percent of the outstanding voting stock of any bank, or substantially all of the assets of any bank, or merging with another bank holding company, without the prior approval of the Federal Reserve. The Pennsylvania Department of Banking must also approve any similar transactions. Pennsylvania law permits Pennsylvania bank holding companies to control an unlimited number of banks.
The Bank Holding Company Act restricts Codorus Valley to activities that the Federal Reserve has found to be closely related to banking, and which are expected to produce benefits for the public that will outweigh any potentially adverse effects. Therefore, the Bank Holding Company Act prohibits Codorus Valley from engaging in most nonbanking businesses, or acquiring ownership or control of more than 5 percent of the outstanding voting stock of any company engaged in a nonbanking business, unless the Federal Reserve has determined that the nonbanking business is closely related to banking. Under the Bank Holding Company Act, the Federal Reserve may require a bank holding company to end a nonbanking business if it constitutes a serious risk to the financial soundness and stability of any bank subsidiary of the bank holding company.
The operations of PeoplesBank are subject to federal and state statutes applicable to banks chartered under the banking laws of the Commonwealth of Pennsylvania and whose deposits the Federal Deposit Insurance Corporation (FDIC) insures.
The FDIC is the primary federal regulator of PeoplesBank. It regularly examines banks in such areas as loss allowances, loans, investments, management practices and other aspects of operations. These examinations are designed for the protection of PeoplesBank’s depositors rather than Codorus Valley’s shareholders. PeoplesBank must furnish annual and quarterly reports to the FDIC.
Federal and state banking laws and regulations govern such things as: the scope of a bank’s business, permissible investments, the reserves against deposits a bank must maintain, the types and terms of loans a bank may make and the collateral it may take, the activities of a bank with respect to mergers and consolidations, the establishment of branches, and the sale of nondeposit investment products by the bank and its insurance subsidiary. The Pennsylvania Insurance Department, the Securities and Exchange Commission (SEC) and the National Association of Securities Dealers (NASD) control and supervise the licensing and activities of employees engaged in the sale of nondeposit investment products.
Pennsylvania business and banking laws restrict dividend payments if such payment would render the Corporation insolvent or result in negative net worth, and the Corporation and PeoplesBank are subject to regulatory capital requirements. More information about dividend restrictions and capital requirements can be found in Note 10-Regulatory Matters, to the 2006 financial statements.
The Federal Reserve Act imposes restrictions on a subsidiary bank of a bank holding company, such as PeoplesBank. The restrictions affect extensions of credit to the bank holding company and its subsidiaries, investments in the stock or other securities of the bank holding company and its subsidiaries, and taking such stock or securities as collateral for loans. The Federal Reserve Act and the Federal Reserve regulations also place limitations and reporting requirements on extensions of credit by a bank to the principal shareholders of its parent holding company, among others, and to related interests of such principal shareholders. In addition, such legislation and regulation may affect the terms upon which any person becoming a principal shareholder of a holding company may obtain credit from banks with which the subsidiary bank maintains a correspondent relationship.
PeoplesBank and the banking industry, in general, are affected by the monetary and fiscal policies of government agencies, including the Federal Reserve. Through open market securities transactions and changes in its federal funds and discount rates and reserve requirements, the Federal Reserve exerts considerable influence over the cost and availability of funds for lending and investment.
A brief discussion of selected federal agency pronouncements that affect Codorus Valley and/or PeoplesBank follows.
Sarbanes-Oxley Act of 2002 The Sarbanes-Oxley Act (SOA) was signed into law in July 2002 and applies to all companies, both U.S. and non-U.S, that file periodic reports under the Securities Exchange Act of 1934. The stated goals of the SOA are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws. The SOA is the most far-reaching U.S. securities legislation enacted in some time. The SEC is responsible for establishing rules to implement various provisions of the SOA. The SOA includes very specific disclosure requirements and new corporate governance rules, requires the SEC and securities exchanges to adopt extensive additional disclosure, corporate governance and other related rules and mandates further studies of certain issues by the SEC. The SOA represents significant regulation of the accounting profession, and has greatly impacted state corporate law, such as the relationship between a board of directors and management and between a board of directors and its committees.
Section 404 of the SOA became effective for the year ended December 31, 2004, for companies whose public float (the product of outstanding shares times the share price on a specified date) was above $75 million. For smaller companies, including Codorus Valley, the effective date, after several postponements, is the fiscal year ending on or after December 15, 2007. Section 404 requires publicly held companies to document, test and certify that their internal control systems over financial reporting are effective. Additionally, it presently requires the Corporation’s independent auditors to audit and issue an attestation report on management’s internal control assessment covering the first fiscal year ending on or after December 15, 2008. Compliance costs associated with Section 404 will increase in the period ahead, but management does not expect these costs to be material.
USA Patriot Act of 2001 In October of 2001, the USA Patriot Act of 2001 was enacted to strengthen U.S. law enforcement’s and the intelligence communities’ abilities to work cohesively to combat terrorism on a variety of fronts. The Patriot Act contains sweeping anti-money laundering and financial transparency laws and imposes various regulations on financial institutions, including standards for verifying client identification at account opening, and rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering.
Periodically, various types of federal and state legislation are proposed that could result in additional regulation of, and restrictions on, the business of Codorus Valley and PeoplesBank. It cannot be predicted whether such legislation will be adopted or, if adopted, how such legislation would affect the business of Codorus Valley and its subsidiaries. As a consequence of the extensive regulation of commercial banking activities in the United States of America, Codorus Valley and PeoplesBank’s business is particularly susceptible to being affected by federal legislation and regulations that may increase the cost of doing business. Except as specifically described above, management believes that the effect of the provisions of the aforementioned legislation on the liquidity, capital resources, and results of operations of Codorus Valley will not be material. Management is not aware of any other current specific recommendations by regulatory authorities or proposed legislation, which, if they were implemented, would have a material adverse effect upon the liquidity, capital resources or results of operations. However, the general cost of compliance with numerous and multiple federal and state laws and regulations does have, and in the future may have, a negative impact on Codorus Valley’s results of operations.
Other information This Annual Report on Form 10-K is filed with the Securities and Exchange Commission (SEC). Copies of this document and other SEC filings by Codorus Valley Bancorp, Inc. may be obtained electronically at PeoplesBank’s website at www.peoplesbanknet.com (select Investor Relations, then select SEC filings), or the SEC’s website at www.sec.gov/edgarhp.htm. Copies can also be obtained
without charge by writing to: Treasurer, Codorus Valley Bancorp, Inc., P.O. Box 2887, York, PA 17405-2887.
Item 1A:
Item 1A: Risk Factors An investment in the Corporation’s common stock is subject to risks inherent to the Corporation’s business. The material risks and uncertainties that management believes affect the Corporation are described below. Before making investment decisions, carefully consider these risks and uncertainties together with all of the other information included or incorporated by reference in the report. These risks and uncertainties are not the only ones facing the Corporation. Additional risks and uncertainties that management is not aware of or focused on, or currently deems immaterial, or are not controllable by management may also impair the Corporation’s business operations. This report is qualified in its entirety by these risk factors.
If any of the following risks occur, the Corporation’s financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of the Corporation’s common stock could decline significantly, and you could lose all or part of your investment.
Changes in market interest rates may adversely affect our earnings and financial condition.
The Corporation’s earnings and cash flows are largely dependent upon its net interest income, which is subject to interest rate risk due to fluctuations in market interest rates. We are unable to predict changes in market interest rates, which are affected by many factors beyond our control, including inflation, unemployment, money supply, and domestic and international events, among others. We attempt to manage interest rate risk, in part, by controlling the mix of interest rate sensitive assets and interest rate sensitive liabilities. However, interest rate risk management is not an exact science. A rapid increase or decrease in market interest rates could adversely affect our financial performance. During 2006, the flat (and sometimes inverted) US treasury yield curve environment that prevailed resulted in a significant increase in funding costs without a commensurate increase in asset yields, which lowered net interest margin. A flat yield curve, a growing reliance on interest rate sensitive funding sources, and competitive pricing pressures can all adversely affect net interest income and margin. In the period ahead, management expects that some or all of these factors could continue to constrain net interest income and margin. Interest rate risk is discussed under Item 7A - Quantitative and qualitative disclosures about market risk, and is incorporated herein by reference.
The Corporation is subject to credit risk.
The Corporation is subject to credit risk if loan customers do not repay their loans according to the terms of their loans, and the collateral securing the payment of loans is insufficient to assure repayment. The Corporation may experience significant credit losses, which could have a material adverse effect on its operating results. In an economic downturn or recession, our credit risk could increase. Management makes various assumptions and judgments about the collectability of its loan portfolio, including the creditworthiness of its borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of its loans. Credit risk is discussed under the Credit Risk Management and Nonperforming Assets sections of this report, which are incorporated herein by reference.
The Corporation’s allowance for possible loan losses may be insufficient.
Management makes significant estimates in determining the allowance for loan losses. Management considers a variety of factors in establishing this estimate such as current economic conditions, diversification of the loan portfolio, delinquency statistics, results of internal loan reviews, financial and managerial strength of borrowers, adequacy of collateral, if collateral dependent, or present value of future cash flows and other relevant factors. Estimates related to the value of collateral also have a significant impact on whether or not management continues to accrue income on delinquent loans and on the amounts at which foreclosed real estate is recorded on the statement of financial condition. In
addition, bank regulatory agencies periodically review the Corporation’s allowance for loan losses and may require an increase in the provision for loan losses or the recognition of further loan charge-offs, based on judgments different from management. Any increases in the allowance for loan losses will result in a decrease in net income, and possibly capital, and may have a material adverse effect on the Corporation’s financial condition and results of operations. The adequacy of the allowance is discussed under the Allowance for Loan Losses section of this report and is incorporated herein by reference.
The trading volume in the Corporation’s common stock is less than that of other larger financial services companies.
Codorus Valley’s common stock is listed on the NASDAQ Global Market under the symbol CVLY. The trading volume in its common stock is less than that of other larger financial companies. A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of willing buyers and sellers of the Corporation’s common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which the Corporation has no control. Given the lower trading volume of the Corporation’s common stock, significant sales of the Corporation’s common stock, or the expectation of these sales, could cause the Corporation’s stock price to languish or fall.
The Corporation is subject to extensive governmental regulation and supervision.
Periodically, federal and state legislation is proposed that could result in additional regulation of, or restrictions on, the business of Codorus Valley and its subsidiaries. At present, banking regulators are considering modifications to the risk-based capital framework to enhance its risk sensitivity. The proposal is expected to provide a banking organization the ability to elect to adopt the proposed revisions or remain subject to existing risk-based capital rules. In December 2006, banking regulators provided guidance that describes sound risk management practices that are important for an institution, like Codorus Valley, that has strategically decided to concentrate in real estate lending. Other than proposed modifications to the risk-based capital framework, and the recent final ruling on concentrations in commercial real estate lending, management is not aware of any current specific recommendations by regulatory authorities or proposed legislation, which, if they were implemented, would have a material adverse effect upon the liquidity, capital resources, or results of operations. However, the general cost of compliance with numerous and multiple federal and state laws and regulations does have, and in the future may have, a negative impact on Codorus Valley’s results of operations. Governmental regulation is discussed in Item I, under the Supervision and Regulation section within this report and is incorporated herein by reference.
Item 1B:
Item 1B: Unresolved Staff Comments Not applicable.
Item 2:
Item 2: Properties Codorus Valley owns the following property, subject to two liens. A regional financial institution holds a first lien for approximately $1.6 million and Codorus Valley’s wholly owned subsidiary PeoplesBank holds a second lien for approximately $1.8 million.
Codorus Valley Corporate Center-The Corporate Center is located at 105 Leader Heights Road, York Township, York, PA. This facility serves as the corporate headquarters and is approximately 40,000 square feet. Approximately sixty-seven percent of the leasable space is leased to PeoplesBank and the remaining thirty-three percent is leased to nonaffiliated parties. The Corporate Center is adjacent to PeoplesBank’s Data Operations Center and the Leader Heights banking office.
PeoplesBank owns the following properties without liens:
Glen Rock Office-Located at 1 Manchester Street in the borough of Glen Rock, PA. Two bank-owned parking lots are located nearby on Hanover Street and at 7 Manchester Street in the borough of Glen Rock.
Jacobus Office-Located at 1 North Main Street in the borough of Jacobus, PA.
Jefferson Office-Located at 6 Baltimore Street in Jefferson Borough, PA. A bank-owned parking lot is located nearby at 10 Baltimore Street in Jefferson Borough.
York New Salem Office-Located at 320 North Main Street in the borough of York New Salem, PA.
Leader Heights Office-This facility serves as both a banking office and data operations center. It is located at 109 Leader Heights Road in York Township, PA.
Cape Horn Office-Located at 2587 Cape Horn Road, Red Lion in Windsor Township, PA.
East York Office-Located at 2701 Eastern Boulevard, York in Springettsbury Township, PA.
PeoplesBank leases the following properties:
Stewartstown Office-Located at 2 Ballast Lane in the borough of Stewartstown, PA. This office is a 1,278 square foot unit of a business complex known as Village Square at Stewartstown. The lease, signed November 29, 1993, is for a twenty-year term with four five-year term renewal options.
South Hanover Office-Located at 1400 Baltimore Street, Hanover in Penn Township, PA. This office is a 1,850 square foot unit adjacent to a Rutter’s Farm Store and gas station. The capital lease, effective February 1, 2001, is for a fifteen-year term with three five-year term renewal options.
East Market Street Office-Located at 48 East Market Street, York City, PA. The office is approximately 685 square feet and located in the lobby entrance of the historic Yorktowne Hotel. The lease, effective February 1, 2006, is for a five-year term with one five-year renewal option.
West Philadelphia Street Office-Located within the Susquehanna Commerce Center at 221 W. Philadelphia Street, York City, PA. This office is a 2,814 square foot unit located in the City of York. The lease, effective December 10, 2002, is for an eight-year term with two five-year term renewal options.
Brogue Office-Located at 2510 Delta Road in Chanceford Township, PA. This office is a 1,600 square foot portion of a business complex known as Brogue Center. The lease, effective November 5, 2004, is for a five-year term with five five-year term renewal options.
West York Office-Located at 1477 Carlisle Road in West Manchester Township, PA. This office is a 2,800 square foot unit. The lease, effective December 1, 2004, is for a ten-year term with three five-year term renewal options.
New Freedom Office-Located at 26 East Main Street, New Freedom Borough, PA. This office is a 1,600 square foot building. The lease, effective September 20, 2004, is for a ten-year term with five-year renewal options.
Towson Loan Production Office-Located at 40 West Chesapeake Avenue, Towson, MD. This 266 square foot office space is located on the 6th floor of the 40 West Chesapeake Building and is used as a loan production office (LPO). The lease, effective December 1, 2005, is renewable annually.
All of the above properties are located in York County, Pennsylvania, with the exception of the Towson LPO which is located in Towson, Maryland and, in the opinion of management, are adequate for the business purposes of Codorus Valley and its subsidiaries.
Item 3:
Item 3: Legal proceedings There are no legal proceedings pending against Codorus Valley Bancorp, Inc. or any of its subsidiaries which are expected to have a material impact upon the financial position and/or operating results of the Corporation. Management is not aware of any proceedings known or contemplated by governmental authorities.
Item 4:
Item 4: Submission of matters to a vote of security holders
No matters were submitted to a vote of security holders during the fourth quarter of 2006.
PART II Item 5:
Item 5: Market for Codorus Valley Bancorp, Inc.’s common equity, related shareholder matters and
issuer purchase of equity securities
Market Information The shares of Codorus Valley Bancorp, Inc. are traded on the NASDAQ Global Market under the symbol CVLY. Codorus Valley had approximately 939 registered shareholders of record as of December 31, 2006. The following table sets forth high and low sales prices and dividends paid per share for Codorus Valley as reported by NASDAQ during the periods indicated. The sales prices and cash dividends per share listed are adjusted for stock dividends.
Codorus Valley has a long history of paying quarterly cash dividends on its common stock. Codorus Valley presently expects to pay future cash dividends at levels comparable with those of prior years. However, the payment of such dividends will depend primarily upon the earnings of its subsidiary, PeoplesBank. Management anticipates that substantially all of the funds available for the payment of dividends by Codorus Valley will be derived from dividends paid to it by PeoplesBank. The payment of cash dividends is also subject to restrictions on dividends and capital requirements as reported in Note 10-Regulatory Matters.
The Corporation maintains various employee, director and shareholder benefit plans that could result in the issuance of its common stock. The information appearing in Note 11-Benefit Plans, and Note 12-Stock-Based Compensation within this report pertains to these plans. Information pertaining to new plans, approved by the Board of Directors and subject to shareholder approval, are included in the 2007 Proxy Statement, which is incorporated herein by reference.
On October 14, 2004, the Corporation issued a press release, which was also filed on Form 8-K, announcing that its Board of Directors authorized the purchase, in open market and privately negotiated transactions, of up to 4.9 percent or approximately 146,000 shares of its then outstanding common stock. As of December 31, 2006, no shares of common stock were acquired under this authorization.
Shareholder Total Return Performance Graph The following graph compares the yearly dollar change in the cumulative total shareholder return on Codorus Valley Bancorp, Inc.’s common stock against the cumulative total return of the SNL Mid-Atlantic Bank Index and the NASDAQ Composite Index for the period of five fiscal years commencing January 1, 2002, and ending December 31, 2006. The graph shows the cumulative investment return to shareholders based on the assumption that a $100 investment was made on December 31, 2001 in each of Codorus Valley’s common stock, the SNL Mid-Atlantic Bank Index and the NASDAQ Composite Index. We computed returns assuming the reinvestment of all dividends. The shareholder return shown on the following graph is not indicative of future performance.
Item 6:
Item 6: Selected financial data
Item 7:
Item 7: Management’s discussion and analysis of financial condition and results of operations Management’s discussion and analysis of the significant changes in the results of operations, capital resources and liquidity presented in the accompanying consolidated financial statements for Codorus Valley Bancorp, Inc., (Codorus Valley or Corporation) a bank holding company, and its wholly owned subsidiary, PeoplesBank, A Codorus Valley Company, (PeoplesBank) are provided below. Codorus Valley’s consolidated financial condition and results of operations consist almost entirely of PeoplesBank’s financial condition and results of operations. Current performance does not guarantee and may not be indicative of similar performance in the future.
Forward-looking statements Management of the Corporation has made forward-looking statements in this Annual Report. These forward-looking statements may be subject to risks and uncertainties. Forward-looking statements include information concerning possible or assumed future results of operations of the Corporation and its subsidiaries. When words such as “believes,” “expects,” “anticipates” or similar expressions occur in this Annual Report, management is making forward-looking statements.
Shareholders should note that many factors, some of which are discussed elsewhere in this report and in the documents that management incorporates by reference, could affect the future financial results of the Corporation and its subsidiaries, both individually and collectively, and could cause those results to differ materially from those expressed in the forward-looking statements contained or incorporated by reference in this Annual Report. These factors include the following:
•
operating, legal and regulatory risks;
•
economic, political and competitive forces affecting banking, securities, asset management and credit services businesses; and
•
the risk that management’s analyses of these risks and forces could be incorrect and/or that the strategies developed to address them could be unsuccessful.
The Corporation undertakes no obligation to publicly revise or update these forward-looking statements to reflect events or circumstances that arise after the date of this report. Readers should carefully review the risk factors described in other documents that Codorus Valley files periodically with the Securities and Exchange Commission.
Critical accounting estimates Disclosure of Codorus Valley’s significant accounting policies is included in Note 1 to the consolidated financial statements of this Annual Report. Some of these policies are particularly sensitive, requiring that significant judgments, estimates and assumptions be made by management. Additional information is contained in Management’s Discussion and Analysis for the most sensitive of these issues, including the provision and allowance for loan losses, located on pages 20 and 31 of this report.
Management makes significant estimates in determining the allowance for loan losses. Management considers a variety of factors in establishing this estimate such as current economic conditions, diversification of the loan portfolio, delinquency statistics, results of internal loan reviews, financial and managerial strength of borrowers, adequacy of collateral, if collateral dependent, or present value of future cash flows and other relevant factors. Estimates related to the value of collateral also have a significant impact on whether or not management continues to accrue income on delinquent loans and on the amounts at which foreclosed real estate is recorded on the statement of financial condition.
Declines in the fair value of available-for-sale and held-to-maturity securities below their cost that are deemed to be other-than-temporary are reflected in earnings as realized losses. In estimating other-than-temporary impairment losses, management considers: 1) the length of time and the extent to which the fair value has been less than cost, 2) the financial condition and near-term prospects of the issuer, and 3) the intent and ability of the Corporation to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.
The Corporation changed its method of accounting for stock-based compensation in 2006, in accordance with Financial Accounting Statement No. 123(R), which is described in Note 1 under the subheading Recent Accounting Pronouncements. Based on stock options outstanding on December 31, 2006, approximately $76,000 will be expensed over the weighted average period of 1.6 years.
Management discussed the development and selection of critical accounting estimates and related Management Discussion and Analysis disclosure with the Audit Committee. There were no material changes made to the critical accounting estimates during the periods presented within this report.
OVERVIEW Executive summary Throughout 2006, management and the Board of Directors (Board) continued to implement a series of initiatives, as guided by the Corporation’s long-range strategic plan. Our financial performance was strong in 2006, as described in the Financial Highlights section below, even though our net interest margin was under constant pressure as a result of a flat (and sometimes inverted) US treasury yield curve environment. Asset quality remained sound and capital was increased through profitable operations and the issuance of trust preferred debt to support planned balance sheet growth. Selected accomplishments for 2006 included: opening a loan production office in Towson, MD; opening a limited service banking facility at the Shrewsbury Lutheran Retirement Village in Shrewsbury, PA; enhancing brand awareness through advertising, community sponsorships and special events; offering new financial products, including the popular ultimate money market deposit account; improving sales incentive systems as an important component of our focus on service excellence; implementing multi-factor authentication, which provides greater security to our growing client base that uses our internet banking system; and increased operating efficiency by exchanging check images (as opposed to physical checks) for settlement with other participating banks. Also during the year, management laid the foundation for two important initiatives. The first is to restructure the wealth management business to increase sales effectiveness and improve operating efficiency, and the second is to implement remote deposit capture, which will enable our business clients to process check payments at their place of business. Both of these initiatives are scheduled for implementation in the first half of 2007.
In the period ahead, management will remain focused on profitable balance sheet growth, acquiring and nurturing client relationships, branch office expansion, risk management, and increasing noninterest income. Challenges include a continuation of the flat (and sometimes inverted) US treasury yield curve environment, competitive pricing pressures and a slowing housing market.
Financial Highlights The Corporation earned $5,322,000 or $1.53 per share ($1.49 diluted) for 2006, compared to $4,617,000 or $1.33 per share ($1.30 diluted) for 2005, and $4,008,000 or $1.16 per share ($1.14 diluted) for 2004. For 2006, the $705,000 or 15 percent increase in net income above 2005 was the result of increases in net interest income and noninterest income, which more than offset an increase in noninterest expense.
The $1,819,000 or 11 percent increase in net interest income was primarily the result of an increase in earning assets, principally business loans. Earning assets averaged $471 million and yielded 7.17 percent (tax equivalent basis) for 2006, compared to $401 million and 6.45 percent, respectively, for 2005. While net interest income increased, net interest margin decreased due to increased funding costs, which resulted from a flat (and sometimes inverted) US treasury yield curve environment and competitive pricing pressures. The net interest margin was 3.97 percent for 2006, compared to 4.16 percent for 2005. The $462,000 or 9 percent increase in noninterest income was attributable to increases in income from wealth management and deposit services, which resulted from increased sales and business growth. The $1,408,000 or 10 percent increase in noninterest expense was attributable in part to corporate expansion, principally in 2005, planned staff additions and normal business growth. In June 2006, the Corporation achieved a historic financial milestone when total assets exceeded $500 million. By year-end 2006, total assets were $548 million, an increase of approximately $72 million or 15 percent above year-end 2005. Asset growth occurred primarily in business and consumer loans, which were funded by strong deposit growth, principally money market deposits and floating rate CDs. Quarterly earnings for 2006 and 2005 are shown in Note 18-Quarterly Results of Operations.
Comparatively, net income for 2005 increased $609,000 or 15 percent above 2004, the result of increases in net interest income and noninterest income, which more than offset increases in noninterest expense and loan loss provision. The $2,499,000 or 18 percent increase in net interest income was attributable to an increase in the volume and yield on loans, principally business and consumer loans, and loan fees. The net interest margin was 4.16 percent for 2005, compared to 4.01 percent for 2004. The $377,000 or 8 percent increase in noninterest income was attributable to a larger volume of fees and commissions resulting from increased sales and business growth. The $1,713,000 or 13 percent increase in noninterest expense was largely attributable to corporate expansion, which increased personnel, occupancy and marketing expenses. PeoplesBank opened three full service financial centers and renovated three existing financial centers since July 2004. Personnel expense was also impacted by an increase in performance-based compensation and higher health insurance premiums. Marketing expense was impacted by the cost to develop and partially implement a branding initiative for PeoplesBank. The $355,000 or 85 percent increase in the loan loss provision for 2005 was based in part on the significant increase in commercial and commercial real estate loans, which are inherently more risky than other types of loans. Total assets were $476 million on December 31, 2005, an increase of approximately $68 million or 17 percent above December 31, 2004. Asset growth occurred primarily in business and consumer loans, which were funded by growth in deposits and long-term borrowings.
Annual cash dividends per share, as adjusted, were $.49 for 2006, compared to $.45 for 2005. Two 5 percent stock dividends, which included a special 5 percent stock dividend, were distributed in 2006. Comparatively, one 5 percent stock dividend was distributed in 2005. Book value per share, as adjusted, was $12.21 for year-end 2006, compared to $11.11 for year-end 2005.
Net income as a percentage of average shareholders’ equity (return on equity or ROE), was 13.0 percent for 2006, compared to 12.25 percent for 2005. Net income as a percentage of average total assets (return on assets or ROA), was 1.05 percent for 2006, compared to 1.06 percent for 2005.
At December 31, 2006, nonperforming assets as a percentage of total loans and net foreclosed real estate was 1.09 percent, compared to .28 percent at year-end 2005. Information regarding nonperforming assets is provided in the Risk Management section of this report, including Table 10-Nonperforming Assets. The allowance for loan losses as a percentage of total loans was .77 percent for year-end 2006, compared to .69 percent for year-end 2005. Information regarding the allowance is provided in the Risk Management section of this report, including Tables 11 - Analysis of Allowance for Loan Losses and 12 - Allocation of Allowance for Loan Losses. Based on a recent evaluation of probable loan losses and the current loan portfolio, management believes that the allowance is adequate to support losses inherent in the portfolio at December 31, 2006.
Throughout 2006, the Corporation maintained a capital level well above minimum regulatory quantitative requirements. Currently, there are three federal regulatory definitions of capital that take the form of minimum ratios. Table 9-Capital Ratios, shows that the Corporation and PeoplesBank were well capitalized on December 31, 2006.
A more detailed analysis of the factors and trends affecting corporate earnings follows.
INCOME STATEMENT ANALYSIS Net Interest Income The Corporation’s principal source of revenue is net interest income, which is the difference between interest income earned on loans and investment securities, and interest expense incurred on deposits and borrowed funds. Fluctuations in net interest income are caused by changes in interest rates, volumes and the composition or mix of interest rate sensitive assets and liabilities.
For analytical purposes, Tables 1, 2, and 3 are presented on a tax equivalent basis to make it easier to compare taxable and tax-exempt assets. Income from tax-exempt assets, primarily loans to or securities issued by state and local governments, is increased by the amount of federal income taxes which would have been incurred if the income was taxable at the statutory rate of 34 percent. Unless otherwise noted, the discussion that follows is based on interest income and interest expense as reported in the consolidated statements of income, not on a tax equivalent basis.
Net interest income for 2006 was $18,242,000, an increase of $1,819,000 or 11 percent above 2005. The increase was primarily the result of an increase in the volume of earning assets. Earning assets averaged $471 million and yielded 7.17 percent (tax equivalent basis) for 2006, compared to $401 million and 6.45 percent, respectively, for 2005. The $71 million or 18 percent increase in earning assets occurred primarily in business loans and secondarily in consumer loans. Rising market interest rates resulted in increases in yields on variable rate business loans, investment securities and overnight investments, which also contributed to the increase in net interest income. Interest bearing liabilities averaged $418 million at an average rate of 3.60 percent for 2006, compared to $352 million and 2.60 percent, respectively, for 2005. The $66 million or 19 percent increase in the average volume of interest bearing liabilities occurred primarily in money market deposits and floating rate CDs. Current period deposit growth was attributable to several factors including the successful introduction of new money market products, the addition of two financial centers in March 2005, and higher market interest rates, which improved returns for bank depositors. Funding costs also increased as a result of issuing $7.2 million in floating rate trust preferred debt in June 2006, as a capital strategy to support planned balance sheet growth.
A flat yield curve, a growing reliance on interest rate sensitive funding sources, and competitive pricing pressures all contributed to the decrease in net interest margin, which was 3.97 percent (tax equivalent basis) for 2006, compared to 4.16 percent for 2005. Net interest margin is net interest income (tax equivalent basis) as a percentage of average earning assets. In the period ahead, management expects that growth in net interest income will remain constrained by the flat or inverted US treasury yield curve environment and competitive pricing pressures.
Comparatively, net interest income for 2005 was $16,423,000, an increase of $2,499,000 or 18 percent above 2004. The increase was primarily the result of an increase in loan volume, although an increase in loan yields and fees also contributed. Earning assets averaged $401 million and yielded 6.45 percent (tax equivalent basis) for 2005, compared to $353 million and 5.86 percent, respectively, for 2004. The
$47 million or 13 percent increase in earning assets occurred primarily in business loans and secondarily in consumer loans. Interest bearing liabilities averaged $352 million at an average rate of 2.60 percent for 2005, compared to $314 million and 2.08 percent, respectively, for 2004. The $38 million or 12 percent increase in the average volume of interest bearing liabilities occurred somewhat evenly between long-term debt, interest bearing demand deposits and time deposits. The net interest margin, on a tax equivalent basis, was 4.16 percent for 2005, compared to 4.01 percent for 2004.
Table 1-Net Interest Income (tax equivalent basis)
* Compound annual growth rate (CAGR) is the average annual rate of growth over the five-year period beginning in 2001.
Table 2-Rate/Volume Analysis of Changes in Net Interest Income (tax equivalent basis)
Changes which are due to both volume and rate are allocated in proportion to their relationship to the amount of change attributed directly to volume or rate. Taxable loans include net loan fees of $1,253,000 in 2006, $1,178,000 in 2005, and $917,000 in 2004.
Table 3-Average Balances and Interest Rates (tax equivalent basis)
(1)
Interest includes net loan fees of $1,253,000 in 2006, $1,178,000 in 2005 and $917,000 in 2004.
(2)
Average balance includes average nonaccrual loans of $3,721,000 in 2006, $686,000 in 2005, and $1,022,000 in 2004.
Provision for Loan Losses The provision for loan losses is an expense charged to earnings to address estimated losses attributable to uncollectible loans. The provision reflects management’s judgment of an appropriate level for the allowance for loan losses. The Risk Management section, including Tables 10 - Nonperforming Assets, 11 - Analysis of Allowance for Loan Losses, and 12 - Allocation of Allowance for Loan Losses, of this report, provides detailed information about the allowance, provision and credit risk. For 2006, the provision expense for loan losses was $650,000, compared to $775,000 for 2005 and $420,000 for 2004. The current period provision was based on management’s assessment of overall credit quality, loan growth, particularly commercial and commercial real estate loans, which are inherently more risky than other types of loans, and macro-economic factors. Macro-economic factors included heightened energy costs and market interest rates, and a downturn in the real estate market, which could portend debt service problems for some of our borrowers.
As reported on Form 8-K, filed by Codorus Valley on February 13, 2007, PeoplesBank received a check for approximately $839,000. The check represented PeoplesBank’s portion of a $12 million restitution
fund created in settlement of a claim by the United States Department of Justice against the Bank of New York. The check partially reimbursed PeoplesBank for loan losses that were incurred in 2002 and 2003 that pertained to a group of related equipment leasing contracts that PeoplesBank acquired from a third-party broker who designated Bank of New York as escrow agent for payments under these contracts. Management plans to recognize this recovery as a credit to the loan loss provision in the first quarter of 2007.
Noninterest Income The following table presents the components of total noninterest income for each of the past three years. A key operating strategy is to increase noninterest or fee based income by offering new services, enhancing traditional services and expanding sales into new geographic markets.
Table 4-Noninterest Income
The discussion that follows addresses changes in noninterest income.
Trust and investment services fees-For 2006, trust fees increased $108,000 or 9 percent above 2005. Comparatively, 2005 trust fees increased $71,000 or 7 percent above 2004. The increase for both periods was attributable to business growth.
Service charges on deposit accounts-For 2006, service charges on deposits increased $232,000 or 14 percent above 2005. Comparatively, 2005 service charges increased $137,000 or 9 percent above 2004. The increase for both periods was due to an increase in the volume of transactions and number of accounts. Check card (debit card) interchange income and overdraft fees continued to trend up in response to increased customer usage.
Mutual fund, annuity and insurance sales-For 2006, commissions from the sale of mutual funds, annuities and insurance products increased $193,000 or 17 percent above 2005. Comparatively, 2005 commissions increased $226,000 or 24 percent above 2004. The increase for both periods was due to increased sales volume.
Other income-Other income is comprised of many fees including, but not limited to: real estate settlement fees, ATM fees (from non-customers using PeoplesBank’s ATMs), safe deposit box rental fees, credit card merchant fees, checking supplies fees, wire transfer fees and internet banking fees. For 2006, other income decreased $22,000 or 4 percent below 2005 due primarily to a $34,000 decrease in real estate settlement services, which resulted in part from a downturn in the real estate market and competition. The current period also contained a nonrecurring gain of $45,000 from the sale of two
small parcels of land, totaling .3 acre, to the local township for a road throughway. One parcel was held by Codorus Valley Bancorp, Inc. and the other was held by its subsidiary, PeoplesBank. Other income for 2005 was approximately the same as 2004.
Gain on sales of mortgages-For 2006, gains on sales of mortgages decreased $49,000 or 13 percent below 2005 due to a decline in originations and sales. Mortgage banking operations in the current period was adversely affected by a downturn in the residential real estate market. Comparatively, 2005 gains increased $56,000 or 18 percent above 2004 due to an increase in the volume of mortgage loan originations and sales.
(Loss) gain on sales of securities-For 2006 and 2005 the Corporation recognized losses of ($80,000) and ($86,000), respectively, from the sale of securities in connection with an “investment swap.” A swap entails selling low yielding investments at a loss (investments purchased in a low interest rate environment) and replacing them with higher yielding investments, which increases portfolio yield and interest income in future periods.
Noninterest Expense The following table presents the components of total noninterest expense for each of the past three years.
Table 5-Noninterest Expense
The discussion that follows addresses changes in noninterest expense. Generally, corporate expansion in the form of financial center additions and normal business growth were principal expense drivers for all three years. PeoplesBank opened two financial centers in 2005 and one in 2004. Additionally, several existing financial centers were renovated over the past three years to better serve our cliental.
Personnel-For 2006, personnel expense, comprised of wages, payroll taxes and employee benefits, increased $917,000 or 11 percent above 2005 due primarily to planned staff additions to support business growth. Comparatively, 2005 increased $1,086,000 or 15 percent above 2004 due to planned staff additions associated with financial center expansion and increases in performance based compensation and health care insurance premiums.
Occupancy of premises, net-For 2006, occupancy of premises expense increased $57,000 or 4 percent above 2005 due in part to a full year’s impact of financial center expansion in the prior year. Comparatively, 2005 increased $237,000 or 22 percent above 2004 due to financial center expansion and renovation, and increases in energy expense and real estate taxes.
Furniture and equipment-For 2006, furniture and equipment expense increased $109,000 or 9 percent above 2005 due in part to financial center expansion and renovation in the prior period. Current period expense was also impacted by the timing of ATM maintenance contracts and a bulk replacement of personal computers. Comparatively, 2005 increased $59,000 or 5 percent above 2004 due primarily to financial center expansion and renovation.
Postage, stationery and supplies-For 2006, postage, stationery and supplies expense category decreased $58,000 or 12 percent below 2005. Stationery and supplies expense for 2005 was higher than normal due to franchise expansion and implementation of a branding initiative (new logo) for PeoplesBank. Comparatively, 2005 increased $56,000 or 14 percent above 2004.
Professional and legal-For 2006, professional and legal expense decreased $49,000 or 15 percent below 2005 due to the settlement of two unrelated lawsuits that arose from routine bank business. Both lawsuits were settled by early January 2006, which curtailed further legal expense. One of the lawsuits also resulted in a $35,000 reimbursement to PeoplesBank in 2006 for legal expenses that it incurred in a prior period. While legal expense decreased in the current period the consulting expense component increased $66,000 or 77 percent above 2005 due in part to third party assistance to comply with Section 404 of the Sarbanes-Oxley Act of 2002. Comparatively, 2005 professional and legal expense increased $32,000 or 11 percent above 2004 due primarily to an increase in legal expense from the aforementioned lawsuits.
Marketing and advertising-For 2006, marketing and advertising expense decreased $109,000 or 16 percent below 2005. Expense for 2005 was relatively high due to the cost of developing and implementing a strategic branding initiative for PeoplesBank, coupled with costs to promote the addition of two financial centers. Comparatively, 2005 increased $220,000 or 46 percent above 2004 for the reasons previously described.
Other- For 2006, other expense, which is comprised of many underlying expenses, increased $541,000 or 24 percent above 2005. The increase was primarily the result of increases in problem loan and foreclosed real estate carrying costs, miscellaneous expense, ATM/point-of-sale processing costs, employee training, Pennsylvania shares tax, and normal business growth. Current period problem loan and foreclosed real estate carrying costs increased $192,000 above 2005, due primarily to the recognition of an unusually large $151,000 gain from the sale of loan collateral in 2005. The level of current period expense also reflected a larger portfolio of nonaccrual loans. Current period miscellaneous expense reflected the recognition of two non-recurring expenses. The first was a $62,000 loss (charge-off) on architectural drawings for a branch office prototype that did not materialize. The second was a $35,000 expense for services to create a manuscript of the history of PeoplesBank, which management plans to use for client appreciation and promotional purposes. Current period ATM/point of sale processing costs increased $53,000 due to an increase in transaction volume, deposit account growth and branch office and ATM expansion. Current period employee training expense increased $46,000 above 2005 due to management’s commitment to service quality. Current period Pennsylvania shares tax (before state tax credits from charitable donations) increased $31,000 above 2005 due to normal business growth. The other expense category remained relatively stable for 2005 and 2004.
In the period ahead, it is probable that noninterest expense will increase as a result of planned franchise expansion, financial center renovations and regulatory compliance. Effective January 1, 2007, the Federal Deposit Insurance Corporation (FDIC) created a new risk framework of four risk categories and established assessment rates to coincide with each category. Assessment rates for Risk Category I institutions, which is likely to include PeoplesBank, will range from 5 to 7 basis points. The FDIC also approved a one-time assessment credit for banks in existence on December 31, 1996, that paid a deposit
insurance assessment prior to that date. Management believes that the one-time credit will more than offset the new FDIC assessment cost for 2007.
Income Taxes The provision for income taxes was $1,845,000 for 2006, an increase of $293,000 or 19 percent above 2005 due to a 16 percent increase in pretax income. Comparatively, 2005 increased $199,000 or 15 percent above 2004 due to a 15 percent increase in pretax income. For 2006, the Corporation recognized $317,000 in tax benefits, principally tax credits, compared to $330,000 for 2005 and $260,000 for 2004 from investments in low-income housing partnerships. The increase in tax credits for 2005 compared to 2004 reflected a full year’s impact of investment in a low-income housing development known as Village Court. In June 2004, the Corporation began to recognize pro-rated credits as rental units in this development were constructed and leased to qualified tenants. For all three years, the Corporation’s marginal federal income tax rate was 34 percent, compared to an effective tax rate of 26 percent for 2006 and 25 percent for years 2005 and 2004.
BALANCE SHEET REVIEW Federal funds sold On December 31, 2006, federal funds sold, i.e., overnight investments, were $24 million, compared to $0 for year-end 2005. The increase in federal funds sold was caused primarily by an increase in liquidity from strong deposit growth throughout the current period as described within the Deposits section of this report.
Investment Securities The investment securities portfolio is an interest earning asset, second in size to the loan portfolio. Investment securities serve as an important source of revenue and liquidity, and as collateral for public and trust deposits. The investment securities portfolio is managed to comply with the Corporation’s Investment Securities Policy, and accounted for in accordance with Financial Accounting Standards Board Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities.”
On December 31, 2006, the securities available-for-sale portfolio totaled $71.5 million, which reflected a $13 million or 23 percent increase from year-end 2005. The increase occurred primarily from the purchase of high quality, tax-exempt municipal bonds with maturities that range from 8 to 20 years. Decisions to purchase or sell securities are based on an assessment of current economic and financial conditions, including the interest rate environment, liquidity and income requirements. Securities available-for-sale are limited to high quality debt instruments as shown in Note 3-Securities Available-for-Sale and Held-to-Maturity. Note 3 shows that unrealized losses for this portfolio exceeded unrealized gains for year-end 2006 due to rising market interest rates. Table 6-Analysis of Investment Securities shows that the available-for-sale portfolio had a yield of 4.92 percent with an average maturity of 4.8 years on December 31, 2006, compared to 4.28 percent and 3.1 years, respectively, on December 31, 2005. The increase in yield reflected higher market interest rates and an investment focus on municipal bonds with relatively longer maturities and higher yields.
Securities classified as held-to-maturity, recorded at amortized cost, reflect management’s intent and the Corporation’s ability to hold these instruments to maturity. On December 31, 2006, securities held-to-maturity totaled $7.5 million, compared to $9.1 million for year-end 2005. The decrease in the portfolio balance was the result of two bonds being called by issuers exercising their call options. The held-to-
maturity portfolio for both years consisted of fixed rate, long-term preferred stock (trust preferreds) issued by commercial bank holding companies. These trust preferreds are junior subordinated debt, that pays interest semi-annually, are callable in 2007 and thereafter, and mature in years 2026-2028. Table 6 shows that the portfolio has a weighted average yield of 8.59 percent and a weighted average remaining maturity of 19 years as of December 31, 2006. Approximately $4.6 million, held by PeoplesBank, are rated investment grade by a national rating service. The remaining $2.9 million, held by the bank holding company, are either not rated or rated below investment grade, and limited to $500,000 per issuer. In the period ahead, it is probable that more high yielding trust preferred investments will be called by issuers based on the current level of market interest rates. If this occurs, the call will be at a premium; however, reinvestment yields are expected to be much lower.
Table 6-Analysis of Investment Securities (amortized cost basis)
(1)
Yields were based on amortized cost basis. Additionally, yields on tax-exempt obligations were computed on a tax equivalent basis using a 34% tax rate.
(2)
U.S. agency mortgage-backed securities are included in the maturity categories based on average expected life.
Loans On December 31, 2006, total loans were $406 million, an increase of approximately $37 million or 10 percent above year-end 2005. Table 7 presents the composition of total loans on a comparative basis for five year-end periods. The table shows a clear trend of growth and corporate emphasis on commercial lending. At year-end 2006, commercial loans increased $28 million or 10 percent above year-end 2005, while consumer loans increased $9 million or 11 percent. During 2006, PeoplesBank’s mortgage banking staff focused on originating and selling residential mortgages without retaining servicing rights. These loans are classified on the balance sheet as loans held for sale and reported at the lower of cost or fair value. On December 31, 2006, loans held for sale were $1.7 million, representing a slight increase above year-end 2005.
Table 7-Loan Portfolio Composition
Table 8-Selected Loan Maturities and Interest Rate Sensitivity shows that, at December 31, 2006, the commercial loan portfolio was comprised of $179 million or 58 percent in fixed rate loans and $131 million or 42 percent in floating or adjustable rate loans. Comparatively, the mix was 56/44 on December 31, 2005. The slight increase in the proportion of fixed rate commercial loans for 2006 was the result of rising market interest rates, as borrowers locked in their financing costs before further rate increases. Floating rate loans reprice periodically with changes in the Wall Street Journal (WSJ) prime rate and LIBOR. Adjustable rate loans reprice at annual intervals based on the US treasury yield curve. Additional loan information can be found in Note 4-Loans, and within the Risk Management section of this report.
Table 8-Selected Loan Maturities and Interest Rate Sensitivity
Other Assets Included in other assets are PeoplesBank’s investments in real estate partnerships and life insurance. On December 31, 2006, the carrying value of investments in two unrelated real estate partnerships totaled $3.6 million, compared to $4.1 million at year-end 2005. The purpose of these partnerships is to provide low cost housing to qualified families. PeoplesBank’s role in these real estate partnerships is solely as an investor, whose return is in the form of federal tax credits, which will be realized over a specified number of years. Also included in other assets is an investment in life insurance policies on a select group of employees and directors. This investment is carried at the cash surrender value of the underlying policies. The cash surrender value was approximately $7.9 million on December 31, 2006, compared to approximately $7.7 million on December 31, 2005. Additional information about
investment in real estate partnerships and bank owned life insurance can be found in Note 1 under the appropriate subheadings.
Funding Deposits Deposits are the principal source of funding for earning assets. On December 31, 2006, total deposits were $457 million, an increase of $71 million or 19 percent above year-end 2005. The increase in deposits, which reflected the continuation of a long trend of successful sales efforts, occurred primarily within the money market and CD categories. The increase in money market deposits was primarily the result of a new money market product, which was priced competitively and heavily promoted. CD growth occurred primarily in variable rate CDs, which re-price weekly based on the one year US treasury bond rate. The trend of rising short-term market interest rates, since July 2004, was a factor in overall deposit growth and product selection by bank customers. The increase was also attributable in part to the addition of two financial centers in March of 2005. The average rate paid on interest bearing deposits was 3.42 percent for 2006, compared to 2.33 percent for 2005. A comparative breakdown of deposits is located in Note 8-Deposits. On December 31, 2006, the balance of certificates of deposit $100,000 and above was $56 million. Of this total, $10 million mature in three months, $9 million mature after three months but within six months, $24 million mature after six months but with twelve months, and the remaining $13 million mature beyond twelve months.
Short-term Borrowings and Long-term Debt In order to meet short-term funding needs, PeoplesBank may borrow from larger correspondent banks in the form of federal funds purchased. It also can use credit available at the Federal Home Loan Bank of Pittsburgh (FHLBP). Interest rates are established daily based on prevailing market conditions for overnight funds. On December 31, 2006, PeoplesBank had no outstanding short-term borrowings, compared to $9.8 million on December 31, 2005. Overnight borrowings for year-end 2005 temporarily funded an increase in commercial loan volume.
Long-term debt is a primary funding source for asset growth. On December 31, 2006, long-term debt was $45.3 million, compared to $39.7 million for year-end 2005. During June 2006, Codorus Valley issued $7.2 million in trust preferred debt securities to provide capital to support planned corporate growth. This obligation has a 30-year maturity, but is callable at quarterly intervals after the fifth year. The interest rate is variable tied to the 3-month LIBOR rate plus 154 basis points. A listing of outstanding long-term debt obligations is provided in Note 9-Short-term Borrowings and Long-term Debt. Generally, funds for the payment of long-term debt come from operations and refinancings.
PeoplesBank’s maximum borrowing capacity, as established quarterly by the FHLBP, was approximately $117 million as of September 30, 2006, the most recent available date. On December 31, 2006, PeoplesBank had approximately $33 million outstanding on its account with the FHLBP at an average rate of 4.49 percent.
Shareholders’ Equity and Capital Adequacy Shareholders’ equity, or capital, is a source of funds enabling the Corporation to maintain asset growth and absorb losses. Capital adequacy can be negatively affected by a multitude of factors, including: corporate expansion, balance sheet growth, losses, dividend policy, and regulatory mandates, among others. Total shareholders’ equity was $42.8 million on December 31, 2006, compared to $38.7 million for year-end 2005. The increase in equity was primarily attributable to profitable operations.
The Corporation typically pays cash dividends on a quarterly basis. The Board of Directors determines the dividend rate after considering the Corporation’s capital requirements, current and projected net income, and other factors. Annual cash dividends per common share totaled $.49 for 2006 and $.45 for 2005. All per share amounts were adjusted for stock dividends.
Periodically, the Corporation distributes stock dividends as an additional means of enhancing long-term shareholder value. For 2006, the Corporation distributed a 5 percent stock dividend in June, followed by a special 5 percent stock dividend in December. Comparatively, the Corporation distributed a 5 percent stock dividend in June of 2005 and 2004. Distribution of these stock dividends resulted in the issuance of 324,038 additional common shares in 2006, 149,593 in 2005 and 141,672 in 2004. The weighted average number of shares of common stock outstanding, adjusted for stock dividends, was 3,489,229 for 2006, 3,475,192 for 2005, and 3,453,571 for 2004.
As disclosed in this report, the Corporation maintains various employee, director and shareholder benefit plans that could result in the issuance of its common stock. Information regarding these plans can be found in Note 11-Benefit Plans and Note 12-Stock-Based Compensation to the consolidated financial statements. On February 20, 2007, the Corporation filed a Form 8-K to disclose the adoption of the 2007 Long-Term Incentive Compensation Plan (LTIP). The LTIP is designed to provide stock-based awards to officers, directors and other key employees. Also in February 2007, the Corporation established the 2007 Employee Stock Purchase Plan to provide eligible employees with a convenient method of purchasing company stock at a discount. Both of these plans, which will be disclosed in the 2007 Proxy Statement, are subject to shareholder approval at the annual meeting of shareholders to be held May 15, 2007.
On October 14, 2004, the Corporation issued a press release, which was also filed on a Form 8-K, announcing that its Board of Directors authorized the purchase, in open market and privately negotiated transactions, of up to 4.9 percent or approximately 146,000 shares of its then outstanding common stock. As of December 31, 2006, the Corporation had not acquired any of its common stock under the authorization reported in October 2004.
The Corporation and PeoplesBank are subject to various regulatory capital requirements administered by banking regulators that involve quantitative guidelines and qualitative judgments. Quantitative measures established by regulators pertain to minimum capital ratios, as set forth in Table 9. Table 9 provides a comparison of the Corporation’s and PeoplesBank’s risk-based capital ratios and leverage ratios to the minimum regulatory requirement for the periods indicated. The Corporation issued $7.2 million in trust preferred debt securities in June 2006 and $3.1 million in November 2004, which are included in Tier 1 capital for regulatory capital purposes, to support business growth.
Table 9-Capital Ratios
* Net unrealized gains and losses on securities available-for-sale, net of taxes, are disregarded for capital ratio computation purposes in accordance with federal regulatory banking guidelines.
Risk Management The Corporation’s Risk Management Committee (Committee) meets at least quarterly and includes members of senior management and an independent director. The objective of the Committee is to identify and manage risk inherent in the operations of the Corporation and its affiliates. The Committee’s risk review is broad in scope and includes the following risks: credit, interest rate, liquidity, price, transaction, compliance, strategic and reputation. A primary responsibility of the Committee is to develop, implement and monitor compliance with formal risk management policies and procedures.
Credit Risk Management The Corporation emphasizes the management of credit risk. To support this objective a sound lending policy framework has been established. This framework includes six basic policies that guide the lending process and minimize risk. First, the Corporation follows detailed written lending policies and procedures. Second, lending authority is granted commensurate with dollar amount, loan type, level of risk, and loan officer experience. Third, loan review committees function at both the senior lending officer level and the board level to review and approve loans that exceed preestablished dollar thresholds and/or meet other criteria. Fourth, the Corporation directly lends mainly within its primary geographical market area, York County, Pennsylvania and northern Maryland. Although this focus may pose a geographical concentration risk, the diverse local economy and employee knowledge of customers minimizes this risk. Fifth, the loan portfolio is diversified to prevent dependency upon a single customer or small group of related customers. And sixth, the Corporation does not lend to foreign countries or persons residing therein.
In addition to a comprehensive lending policy, numerous internal reviews of loan and foreclosed real estate portfolios occur throughout the year. In addition to internal controls, loan portfolios are reviewed by independent auditors in connection with their annual financial statement audit and are examined periodically by bank regulators.
One component of the internal credit risk review is the identification and management of industry concentrations, defined as greater than 10 percent of the total loan portfolio. At year-end 2006, the Corporation had one industry concentration that exceeded 10 percent of the total loan portfolio, real estate construction and land development, which was 22.5 percent of the portfolio. Comparatively, at year-end 2005, real estate construction and land development was 20.2 percent of the portfolio, and commercial real estate leasing was 11.0 percent of the portfolio. Commercial leasing pertains to borrowers who lease real estate for business purposes. Loans to borrowers within these industries are usually collateralized by real estate.
Nonperforming Assets Table 10-Nonperforming Assets, presents asset categories posing the greatest risk of loss. Management generally places a loan on nonaccrual status and ceases accruing interest income when loan payment performance is unsatisfactory and the loan is past due 90 days or more. Loans past due 90 days or more and still accruing interest, are contractually past due, but well collateralized and in the process of collection. The final category, foreclosed real estate, is real estate acquired to satisfy debts owed to PeoplesBank. Table 10 also provides a summary of nonperforming assets and related ratios. The paragraphs below explain significant changes in the aforementioned categories for December 31, 2006, compared to December 31, 2005.
Table 10-Nonperforming Assets
On December 31, 2006, nonaccrual loans consisted of collateralized business and mortgage loans, and consumer loans. The Corporation recognizes interest income on a cash basis for nonaccrual loans. On December 31, 2006, the nonaccrual loan portfolio was $4,368,000, compared to $1,034,000 on December 31, 2005. The $3,334,000 increase was attributable to the addition of two unrelated business loans with outstanding principal balances at year-end 2006 of $2,624,000 and $530,000, respectively. In management’s judgment, the $2,624,000 loan, which has matured, is adequately secured both by collateral (based on a recent independent appraisal), and personal guarantees, which should ensure the
ultimate recovery of interest and principal in full. The net realizable value of the collateral for the $530,000 loan was deemed insufficient. Accordingly, management has established a $90,000 loss allowance for this account. On December 31, 2006, nonaccrual loans were comprised of 19 unrelated accounts ranging in size from $1,000 to $2,624,000. Management and the Board of Directors evaluate the adequacy of the allowance for loan losses at least quarterly. Collection efforts, including modification of contractual terms for individual accounts based on prevailing market conditions and liquidation of collateral assets, are being employed to maximize recovery.
Foreclosed real estate, net of allowance, was $38,000 on December 31, 2006, compared to $7,000 on December 31, 2005. The increase was attributable to the acquisition of a property in satisfaction of a delinquent mortgage loan. In January 2007, this property was sold resulting in a principal loss of approximately $1,800. The provision expense for foreclosed real estate, due to declines in the fair value of individual assets, was $0 for 2006, compared to $17,000 for 2005 and $19,000 for 2004.
On December 31, 2006, there were approximately $1.9 million in potential problem loans closely monitored by management. Potential problem loans consist of loans for which management has doubts as to the ability of the borrower to comply with present repayment terms, and which were not disclosed in Table 10. A loss allowance is established for those potential problem loans that in management’s judgment were inadequately collateralized. Comparatively, management was monitoring approximately $10 million in potential problem loans on December 31, 2005.
Allowance for Loan Losses Although the Corporation maintains sound credit policies, certain loans deteriorate and must be charged off as losses. The allowance for loan losses is maintained to absorb losses inherent in the portfolio at December 31, 2006. The allowance is increased by provisions charged to expense and is reduced by loan charge-offs, net of recoveries. The allowance is based upon management’s continuous evaluation of the loan portfolio coupled with a formal review of adequacy on a quarterly basis, which is subject to review and approval by the Board. In analyzing the adequacy of the allowance, management considers the results of internal and external credit reviews, past loss experience, changes in the size and composition of the loan portfolio, adequacy of collateral, general economic conditions and the local business outlook. All of these factors are susceptible to significant change. Determining the level of the allowance for probable loan losses at any given period is difficult, particularly during deteriorating or uncertain economic periods. Management must make estimates using assumptions and information which are often subjective and fluid. Table 11 presents an analysis of the activity in the allowance for loan losses over a five-year period. Table 12 presents an allocation of the allowance for loan losses by major loan category. The unallocated component of the allowance for loan losses represents probable losses inherent in the portfolio that are not fully captured in the allocated allowance analyses, such as: industry concentrations, imprecision in the loan risk evaluation process and current economic factors.
The allowance was $3,126,000 or .77 percent of total loans on December 31, 2006, compared to $2,538,000 and .69 percent, respectively, on December 31, 2005. The $588,000 or 23 percent increase in the allowance was based on management’s estimate to bring the allowance to a level reflective of risk in the portfolio, loan growth, and macro-economic factors such as the heightened level of energy costs and interest rates, and a downturn in the real estate market. These factors contributed to an increase in the unallocated component in 2006 as noted in Table 12. Based on a recent evaluation of probable loan losses in the current portfolio, management believes that the allowance is adequate to support losses inherent in the loan portfolio on December 31, 2006.
Table 11-Analysis of Allowance for Loan Losses
Table 12-Allocation of Allowance for Loan Losses
Note: The specific allocation for any particular loan category may be reallocated in the future as risk perceptions change. Furthermore, the portion allocated to each loan category is not the total amount available for future losses that might occur within such categories since the total allowance is a general allowance applicable to the entire loan portfolio.
Liquidity Maintaining adequate liquidity provides the Corporation with the ability to meet financial obligations to depositors, loan customers, employees, and shareholders on a timely and cost effective basis in the normal course of business. Additionally, it provides funds for growth and business opportunities as they arise. Liquidity is generated from transactions relating to both the Corporation’s assets and liabilities. The primary sources of asset liquidity are scheduled investment security maturities and cash inflows, funds received from customer loan payments, and asset sales. The primary sources of liability liquidity are deposit growth, short-term borrowings and long-term debt. Retained earnings from profitable operations are another source of liquidity. The Consolidated Statements of Cash Flows present the changes in cash from operating, investing and financing activities. For 2006, management believes that liquidity was more than adequate based on the level of overnight investment, the potential liquidation of a $71 million portfolio of available-for-sale securities, valued at December 31, 2006, and available credit from the Federal Home Loan Bank of Pittsburgh. On September 30, 2006, the latest available date, available funding from the FHLBP was approximately $84 million. The Corporation’s loan-to-deposit ratio was 89 percent for year-end 2006, compared to 96 percent for year-end 2005. The decrease in this ratio was the result of strong deposit growth. Management believes that the addition of two financial centers in March of 2005 will continue to provide liquidity in the form of new deposits.
Off-Balance Sheet Arrangements
The Corporation’s financial statements do not reflect various commitments that are made in the normal course of business, which may involve some liquidity risk. These commitments consist mainly of unfunded loans and letters of credit made under the same standards as on-balance sheet instruments. Financial instruments with off-balance sheet risk are disclosed in Note 14-Commitments to Extend Credit of this report and totaled $122 million at December 31, 2006, compared to $120 million at December 31, 2005. Normally these commitments have fixed expiration dates or termination clauses and are for specific purposes. Accordingly, many of the commitments are expected to expire without being drawn and therefore, generally do not present significant liquidity risk to the Corporation or PeoplesBank.
Contractual Obligations
Table 13-Contractual Obligations, presents the amount and timing of payments due under long-term contractual obligations.
Table 13-Contractual Obligations
Impact of Inflation and Changing Prices The majority of assets and liabilities of a financial institution are monetary in nature and therefore differ greatly from most commercial and industrial companies that have significant investments in fixed assets or inventories. However, inflation may impact the growth of total assets in the banking industry and the resulting need to increase equity capital at higher than normal rates in order to maintain an appropriate equity-to-assets ratio. Inflation may also significantly affect noninterest expenses, which tend to rise during periods of general inflation. The level of inflation can be measured by the change in the Consumer Price Index (CPI) for all urban consumers (December vs. December). The change in the CPI for 2006 was 2.5 percent, compared to 3.4 percent for 2005 and 3.3 percent for 2004.
Management believes that the most significant impact on financial results is the Corporation’s ability to react to changes in market interest rates. As discussed below in the Market Risk Management section, management strives to structure the balance sheet to increase net interest income by managing interest rate sensitive assets and liabilities to reprice in response to changes in market interest rates. Additionally, management is focused on increasing fee income, an income component that is less sensitive to changes in market interest rates.
Item 7A:
Item 7A: Quantitative and qualitative disclosures about market risk Market Risk Management In the normal course of conducting business, the Corporation is exposed to market risk, principally interest rate risk, through the operations of its banking subsidiary, PeoplesBank. Interest rate risk arises from market driven fluctuations in interest rates that may affect cash flows, income, expense and the values of financial instruments. PeoplesBank is particularly vulnerable to changes in short-term interest rates such as the prime rate and LIBOR. An Asset-Liability Committee (Committee) comprised of members of senior management manages interest rate risk. The Committee’s objective is to maximize net interest income within acceptable levels of liquidity and interest rate risk and within capital adequacy constraints. PeoplesBank is not subject to foreign currency or commodity price risk and it does not own any trading assets.
The Committee manages interest rate risk primarily through sensitivity analysis. Asset-liability management simulation software (ALM model) is used to model and measure the potential loss in future net income based on hypothetical changes in interest rates. Interest rate forecasts are supplied by a national forecasting service and integrated with the ALM model. The Corporation’s policy limit for the maximum negative impact on net income is 10 percent over a twelve-month period. This policy limit is tested on a quarterly basis by measuring the change in net income from a baseline scenario where interest rates are held constant, to a high rate scenario (gradual 200 basis point increase in prime and fed funds rates), a low rate scenario (gradual 200 basis point decrease in prime and fed funds rates) and a most likely scenario (defined by a forecasting service) over the future twelve-month period. Important ALM modeling assumptions include: the use of a static balance sheet and contractual cash flows; varying levels of prepayments for loans and mortgage-backed securities; stability of noninterest income and expense; reinvestment of repriceable cash flows in the same type of asset or liability; and constant product rate spreads, determined at the balance sheet date, over the twelve-month measurement period. The ALM model also includes significant balance sheet characteristics such as rate caps and floors. For year-end 2006, management presumed that in all scenarios trust preferred investment securities, which are callable at a premium, would be called by the issuers due to the relatively high coupon rate and would result in a one time increase in interest income.
The Corporation performed a financial simulation on the balance sheet for December 31, 2006 and 2005. The results of these point-in-time analyses are shown in Table 14. For year-end 2006, the ALM model portrayed a balance sheet that was liability sensitive. Liability sensitivity means that deposits and debt are likely to re-price to a greater and faster degree than the loans and investments that they fund. This suggests that net income may increase if market interest rates, particularly short-term rates, decrease. Conversely, net income would be expected to decrease if market interest rates increase. From June 2004 through June 2006, short-term market interest rates have systematically increased in response to economic tightening by the Federal Reserve, while long-term interest rates remained relatively stable, or in some cases declined slightly. During the flat (slightly inverted) US treasury yield curve environment that prevailed in 2006 many loan clients showed a preference for fixed rate loans to lock in rates, while deposit clients preferred variable or floating rate deposit products with short maturities. The result was a gradual shift in the balance sheet to a liability sensitive position for year-end 2006, compared to a more neutral interest rate risk position for year-end 2005.
Table 14-Interest Rate Sensitivity
Measurement of interest rate risk requires many assumptions. These assumptions are inherently uncertain and, as a result, the model cannot precisely estimate net interest income or precisely predict the impact of higher or lower rates on net income. Actual results may differ from simulated results due to many factors including: timing of cash flows, magnitude and frequency of interest rate changes, customer behavior, changes in market conditions, and management strategies.
Item 8:
Item 8: Financial statements and supplementary data
Codorus Valley Bancorp, Inc.
Consolidated Balance Sheets
See accompanying notes.
Codorus Valley Bancorp, Inc.
Consolidated Statements of Income
See accompanying notes.
Codorus Valley Bancorp, Inc.
Consolidated Statements of Cash Flows
See accompanying notes.
Codorus Valley Bancorp, Inc.
Consolidated Statements of Changes in Shareholders’ Equity
See accompanying notes.
Codorus Valley Bancorp, Inc.
Notes to Consolidated Financial Statements
NOTE 1-Summary of Significant Accounting Policies Nature of Operations and Basis of Presentation
Codorus Valley Bancorp, Inc. (Corporation or Codorus Valley) is a one-bank holding company headquartered in York, Pennsylvania that provides a full range of banking services through its subsidiary, PeoplesBank, A Codorus Valley Company (PeoplesBank). PeoplesBank operates two wholly owned subsidiaries, Codorus Valley Financial Advisors, Inc. (formerly SYC Insurance Services, Inc.) that sells nondeposit investment products, and SYC Settlement Services, Inc., which provides real estate settlement services. PeoplesBank operates under a state charter subject to regulation by the Pennsylvania Department of Banking and the Federal Deposit Insurance Corporation.
The consolidated financial statements include the accounts of Codorus Valley and its wholly owned bank subsidiary, PeoplesBank, and its wholly owned nonbank subsidiary, SYC Realty Company, Inc. All significant intercompany account balances and transactions have been eliminated in consolidation. The accounting and reporting policies of Codorus Valley and subsidiaries conform to accounting principles generally accepted in the United States of America and have been followed on a consistent basis.
Investment Securities
The classification of securities is determined at the time of acquisition and is reevaluated at each reporting date. Securities classified as available-for-sale are debt securities that the Corporation intends to hold for an indefinite period of time, but not necessarily to maturity. Any decision to sell a security classified as available-for-sale would be based on various factors, including significant movements in interest rates, changes in maturity mix of assets and liabilities, liquidity needs, regulatory considerations and other factors. Securities available-for-sale are carried at fair value, with unrealized gains and losses, net of taxes, reported as a component of accumulated other comprehensive income or loss in shareholders’ equity. Premiums and discounts are recognized in interest income using the interest method over the estimated life of the securities. Realized gains and losses from the sale of available-for-sale securities are computed on the basis of specific identification of the adjusted cost of each security and are shown net as a separate line item in the statement of income.
Securities classified as held-to-maturity are those debt securities that the Corporation has both the intent and ability to hold to maturity regardless of changes in market conditions, liquidity needs or general economic conditions. These securities are carried at cost adjusted for amortization of premium and accretion of discount, computed by the interest method over the estimated life of the securities.
Declines in the fair value of available-for-sale and held-to-maturity securities below their cost that are deemed to be other-than-temporary are reflected in earnings as realized losses. In estimating other-than-temporary impairment losses, management considers: 1) the length of time and the extent to which the fair value has been less than cost, 2) the financial condition and near-term prospects of the issuer, and 3) the intent and ability of the Corporation to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.
Restricted Stock
Federal law requires a member institution of the Federal Home Loan Bank (FHLB) to hold stock of its district FHLB according to a predetermined formula. The stock is carried at cost.
Loans Held for Sale
Loans held for sale are reported at the lower of cost or fair value, as determined in the aggregate. The amount, by which cost exceeds fair value, if any, is accounted for as a valuation allowance and is charged to expense in the period of the change.
Loans
Loans receivable that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are stated at their outstanding unpaid principal balances, net of any deferred fees and costs. Interest income is accrued on the unpaid principal balance. Loan origination fees and costs are generally deferred and recognized as adjustments of interest rate yields, by being amortized to interest income over the terms of the related loans. Determination of a loans past due status is based on contractual terms. When circumstances indicate that collection of a loan is doubtful, the accrual of interest income is discontinued and unpaid interest previously credited to income is reversed and charged against current income. Loans are returned to accrual status when management determines that circumstances have improved to the extent that both principal and interest are deemed collectible.
Allowance for Loan Losses
The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.
The allowance for loan losses is maintained at a level considered adequate to provide for losses that can be reasonably anticipated. Management’s periodic evaluation of the adequacy of the allowance is based on current economic conditions, prior loss experience, adequacy of collateral, risk characteristics of the loan portfolio and other relevant factors. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as additional information becomes available.
The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as doubtful, substandard or special mention. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses and reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
A loan is considered impaired when, based on current information and events, it is probable that PeoplesBank will be unable to collect all amounts when due according to contractual terms of the loan agreement. Factors considered by management in determining impairment, include: payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. An insignificant delay or shortfall in the amount of payments received would not cause a loan to be rendered impaired. Impairment is measured on an individual loan basis for business loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent. Large groups of smaller balance homogeneous consumer loans are collectively evaluated for impairment using loss factors derived in part from historical charge-offs. Accordingly, the Corporation does not separately identify individual consumer and residential loans for impairment disclosure, unless such loans are the subject of a restructuring agreement. Income on impaired loans is recognized under the same policy as disclosed under Loans in this Note.
Transfers of Financial Assets
Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Corporation, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Corporation does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
Premises and Equipment
Land is carried at cost. Premises and equipment are carried at cost less accumulated depreciation. Depreciation expense is calculated principally on the straight-line method over the assets’ estimated useful lives. Estimated useful lives are ten to forty years for buildings and improvements, five to ten years for furniture and equipment and three to five years for computer equipment and software. Maintenance and repairs are charged to expense as incurred. The cost of significant improvements to existing assets is capitalized. When facilities are retired or otherwise disposed of, the depreciated cost is removed from the asset accounts and any gain or loss is reflected in the statement of income.
Foreclosed Real Estate
Foreclosed real estate, included in other assets, is comprised of property acquired through a foreclosure proceeding, acceptance of a deed-in-lieu of foreclosure, or insubstance foreclosures. Foreclosed real estate is initially recorded at fair value at the date of foreclosure, establishing a new cost basis. Appraisals are generally used to determine fair value. After foreclosure, management reviews valuations at least quarterly and adjusts the asset to the lower of cost or fair value minus estimated costs to sell. Costs related to the improvement of foreclosed real estate are generally capitalized until the real estate reaches a saleable condition. Revenue and expense from operations and changes in the valuation allowance are included in expense. When a foreclosed real estate asset is ultimately sold, any gain or loss on the sale is included in the income statement as a component of other expense. At year-end 2006, foreclosed real estate, net of allowance, was $38,000, compared to $7,000 for year-end 2005.
Investments in Real Estate Partnerships
In March 2003, PeoplesBank acquired a 73.47 percent limited partner interest in a real estate joint venture known as Village Court, which was formed to develop, construct, own and operate a 60-unit affordable housing complex located in Dover Township, York County, Pennsylvania. Construction of the housing complex was completed in the fourth quarter of 2004 and the complex was fully leased by December 31, 2004. The investment balance included in other assets was $2,251,000 at December 31, 2006, compared to $2,502,000 at December 31, 2005. Additionally, PeoplesBank is a 99.99 percent limited partner in a real estate joint venture known as SMB Properties that rehabilitated and now operates seven buildings in the City of York, Pennsylvania as part of a revitalization initiative. The buildings provide low-income housing to qualified families and to a lesser degree, space for commercial purposes. The investment balance included in other assets was $1,328,000 at December 31, 2006, compared to $1,561,000 at December 31, 2005.
Investment and related tax credits are accounted for under the effective yield method of accounting whereby tax credits are recognized as they are allocated and the cost of the investment is amortized to provide a constant yield over the period that tax credits are allocated, generally ten years.
Bank Owned Life Insurance
PeoplesBank invests in bank owned life insurance (BOLI) as a source of funding for employee benefit expenses. BOLI involves the purchasing of life insurance by PeoplesBank on a select group of employees and directors. PeoplesBank is the owner and beneficiary of the policies. This life insurance investment is carried at the cash surrender value of the underlying policies and is included in other assets
in the amount of $7,922,000 at December 31, 2006, compared to $7,652,000 at December 31, 2005. Income from the increase in cash surrender value of the policies is a separate line item within the noninterest income section of the income statement.
Trust and Investment Services Assets
Assets held by PeoplesBank in a fiduciary or agency capacity for its customers are not included in the consolidated statements of financial condition since these items are not assets of PeoplesBank.
Advertising
Advertising costs are charged to expense when incurred.
Income Taxes
Deferred income taxes are provided on the liability method whereby deferred tax assets are recognized for deductible temporary differences and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases. Deferred tax assets are reduced by a valuation allowance, when in the opinion of management, it is more likely than not that some portion or all the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted through the provision for income taxes for the effects of changes in tax laws and rates on the effective date.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles in the U.S. of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses and the evaluation of other than temporary impairment losses of securities.
Per Share Data
Basic net income per share is calculated as net income divided by the weighted average number of common shares outstanding. Diluted net income per share is calculated as net income divided by the weighted average number of common shares outstanding plus common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Corporation relate solely to outstanding stock options, and are determined using the treasury stock method. All share and per share amounts are adjusted for stock dividends that are declared prior to the issuance of the financial statements.
The computation of net income per share for the years ended December 31, 2006, 2005 and 2004 is provided in the table below. Anti-dilutive options excluded from the computation of earnings per share were 0 for 2006, 53,607 for 2005, and 18,923 for 2004.
Stock dividends issued by the Board of Directors of Codorus Valley for the years 2004 through 2006 were as follows:
Stock Based Compensation
The Corporation adopted Statement of Financial Accounting Standards No. 123R, “Share-Based Payments” (Statement 123R) in the first quarter of 2006, using the “modified prospective method.” Prior to the implementation of FAS 123R, stock options issued under shareholder approved employee and director stock option plans were accounted for under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25). Under APB 25, no compensation expense was recognized related to these plans. Stock options are granted at exercise prices not less than the fair value of the common stock on the date of grant. See Note 12 - Stock-Based Compensation.
Cash Flow Information
For purposes of the statements of cash flows, the Corporation considers interest bearing deposits with banks, cash and due from banks, and federal funds sold to be cash and cash equivalents. Noncash items for the years ended December 31, 2006, 2005 and 2004 consisted of the transfer of loans to foreclosed real estate for $38,000, $22,000 and $17,000, respectively.
Off-Balance Sheet Financial Instruments
In the ordinary course of business, the Corporation enters into off-balance sheet financial instruments consisting of commitments to extend credit and standby letters of credit. These financial instruments are recorded on the balance sheet when they become a receivable to the Corporation.
Comprehensive Income
Accounting principles generally accepted in the U.S. of America require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income or loss. The components of other comprehensive income and related tax effects are presented in the following table:
Segment Reporting
Management has determined that it operates in only one segment, community banking. The Corporation’s non-banking activities are insignificant to the consolidated financial statements.
Recent Accounting Pronouncements
In February 2007, the Financial Accounting Standards Board issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities-Including an amendment of FASB Statement No. 115.” SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value. Unrealized gains and losses on items for which the fair value option has been elected will be recognized in earnings at each subsequent reporting date. SFAS No. 159 is effective for Codorus Valley on January 1, 2008. The Corporation is evaluating the impact that the adoption of SFAS No. 159 will have on its consolidated financial statements.
In September 2006, the Financial Accounting Standards Board issued FASB Statement No. 157, “Fair Value Measurements,” which defines fair value, establishes a framework for measuring fair value under Generally Accepted Accounting Principles, and expands disclosures about fair value measurements. FASB Statement No. 157 applies to other accounting pronouncements that require or permit fair value measurements. The new guidance is effective for financial statements issued for fiscal years beginning after November 15, 2007, and for interim periods within those fiscal years. The Corporation is currently evaluating the potential impact, if any, of the adoption of FASB Statement No. 157 on our consolidated financial position, results of operations and cash flows.
In September 2006, the FASB’s Emerging Issues Task Force (EITF) issued EITF Issue No. 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split Dollar Life Insurance Arrangements” (“EITF 06-4”). EITF 06-4 requires the recognition of a liability related to the postretirement benefits covered by an endorsement split-dollar life insurance arrangement. The consensus highlights that the employer (who is also the policyholder) has a liability for the benefit it is providing to its employee. As such, if the policyholder has agreed to maintain the insurance policy in force for the employee’s benefit during his or her retirement, then the liability recognized during the employee’s active service period should be based on the future cost of insurance to be incurred during the employee’s retirement. Alternatively, if the policy holder has agreed to provide the employee with a death benefit, then the liability for the future death benefit should be recognized by following the guidance in SFAS No. 106 or Accounting Principals Board (APB) Opinion No. 12, as appropriate. For transition, an entity can choose to apply the guidance using either of the following approaches: (a) a change in accounting principle through retrospective application to all periods presented or (b) a change in accounting principle through a cumulative-effect adjustment to the balance in retained earnings at the beginning of the year of adoption. The disclosures are required in fiscal years beginning after December 15, 2007, with early adoption permitted. The Corporation is evaluating the impact that the adoption of EITF Issue No. 06-4 will have on its consolidated financial statements.
In June 2006, the Financial Accounting Standards Board issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes.” The interpretation clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with Statement of Financial Accountings Standards No.109, “Accounting for Income Taxes.” Specifically, the pronouncement prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The interpretation also provides guidance on the related derecognition, classification, interest and penalties, accounting for interim periods, disclosure and transition of uncertain tax positions. The interpretation is effective for fiscal years beginning after December 15, 2006. The Corporation is evaluating the impact of this new pronouncement on its consolidated financial statements.
NOTE 2-Restrictions on Cash and Due from Banks Cash balances reserved to meet regulatory requirements of the Federal Reserve Bank and balances maintained at other banks for compensating balance requirements averaged approximately $802,000 for 2006 and $899,000 for 2005.
NOTE 3-Securities Available-for-Sale and Held-to-Maturity A summary of available-for-sale and held-to-maturity securities at December 31, follows:
The amortized cost and estimated fair value of debt securities at December 31, 2006, by contractual maturity, are shown below. Actual maturities may differ from contractual maturities if call options on selected debt issues are exercised in the future. Mortgage-backed securities are included in the maturity categories based on average expected life.
Gross (losses) gains realized from the sale of available-for-sale securities were ($80,000), ($86,000), and $38,000 for 2006, 2005 and 2004, respectively. Securities, issued by agencies of the federal government, with a carrying value of $40,875,000 and $37,789,000 on December 31, 2006 and 2005, respectively, were pledged to secure public and trust deposits.
The table below shows investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2006 and 2005.
Management believes that unrealized losses at December 31, 2006, were primarily the result of changes in market interest rates and that it has the ability to hold these investments for a time necessary to recover the amortized cost. The $61,000 unrealized loss within the less than 12 months category was attributable to sixteen different securities issued primarily by municipalities. The $680,000 unrealized loss in the 12 months or more category relates to thirty eight securities issued primarily by the following agencies of the federal government: Federal Home Loan Bank (FHLB), Federal Home Loan Mortgage Corporation (FHLMC) and the Federal National Mortgage Association (FNMA). Management believes that collection of the contractual principal and interest is probable and therefore all impairment is considered to be temporary.
NOTE 4-Loans The composition of the loan portfolio at December 31, is as follows:
Concentrations of credit risk arise when a number of customers are engaged in similar business activities in the same geographic region or have similar economic features that could cause their ability to meet contractual obligations to be similarly affected by changes in economic conditions. Most of the Corporation’s business is with customers in York County, Pennsylvania and northern Maryland, specifically Baltimore, Harford and Carroll counties. Although this focus may pose a concentration risk geographically, we believe that the diverse local economy and detailed knowledge of the customer base minimizes this risk. At year-end 2006, the Corporation had one industry concentration that exceeded 10 percent of the total loan portfolio, real estate construction and land development which was 22.5 percent of the portfolio. Comparatively, at year-end 2005, real estate construction and land development was 20.2 percent of the portfolio, and commercial real estate leasing was 11.0 percent of the portfolio. Loans to borrowers within these industries are usually collateralized by real estate.
The principal balance of loans outstanding to directors, executive officers, principal shareholders, and any associates of such persons were $4,662,000 at December 31, 2006, and $3,035,000 at December 31, 2005. During 2006, total loan additions were $2,283,000 and total payments collected were $2,419,000. Changes in executive officers and directors resulted in an additional net increase of $1,763,000. Related party loans are made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons and do not involve more than normal risk of collection. As of year-end 2006, all loans to this group were current and performing in accordance with contractual terms.
NOTE 5-Impaired, Nonaccrual and Past Due Loans Information regarding impaired commercial loans at December 31, was as follows:
Impairment related to the above loans was measured based on fair values of collateral. As of December 31, 2006 and 2005, the loan portfolio included total nonaccrual loans of $4,368,000 and $1,034,000, respectively. Interest that would have been included in income had those loans been accruing at their contractual rates in 2006 was $336,000, compared to $162,000 that was recognized in income. Loans contractually past due 90 days or more as to principal or interest, but still accruing interest totaled $4,000 at December 31, 2006 compared to no loans at December 31, 2005.
NOTE 6-Analysis of Allowance for Loan Losses Changes in the allowance for loan losses for each of the three years ended December 31, were as follows:
As reported on Form 8-K filed by Codorus Valley on February 13, 2007, PeoplesBank received a check for approximately $839,000. The check represented PeoplesBank’s portion of a $12 million restitution fund created in settlement of a claim by the U.S. Department of Justice against the Bank of New York. The check partially reimbursed PeoplesBank for loan losses that it incurred in 2002 and 2003 that pertained to a group of related equipment leasing contracts that PeoplesBank acquired from a third-party broker who used Bank of New York as its agent. Management plans to recognize this recovery as a credit to the loan loss provision in the first quarter of 2007.
NOTE 7-Premises and Equipment A summary of premises and equipment at December 31, is as follows:
PeoplesBank leases certain banking branches under capital and noncancellable operating leases. The terms include various renewal options and provide for rental increases based upon predetermined factors. Total lease expenses under operating leases amounted to $163,000 in 2006, $137,000 in 2005 and $73,000 in 2004. At December 31, 2006, future minimum lease payments for these leases and a capital lease are payable as follows:
NOTE 8-Deposits The composition of deposits at December 31, was as follows:
Scheduled maturities of time deposits as of December 31, were as follows:
NOTE 9-Short-term Borrowings and Long-term Debt The schedule below provides a summary of short-term borrowings that consist of federal funds purchased and other borrowings. Federal funds purchased from correspondent banks usually mature in one business day. Other short-term borrowings consist of credit available through the Federal Home Loan Bank of Pittsburgh (FHLBP) and the Atlantic Central Bankers Bank (ACBB). Based on the most recent analysis, total credit available from the FHLBP, for both short and long-term credit needs, is approximately $117 million. As of December 31, 2006, total unused credit with the FHLBP was approximately $84 million. Obligations to the FHLBP are secured by FHLB stock and qualifying collateral, principally the unpledged portion of PeoplesBank’s investment securities portfolio and qualifying mortgage loan receivables. The interest rate for short-term borrowings reprices daily based on the federal funds rate or the open repo market depending on the borrowing program. As of December, 31, 2006, the Corporation maintained an unsecured line of credit of $3 million with ACBB which is renewable annually. No funds were drawn on the ACBB line during 2006.
A summary of aggregate short-term borrowings on December 31, is as follows:
A summary of long-term debt at December 31, is as follows:
PeoplesBank’s obligations to FHLBP are fixed rate and fixed/floating (convertible) rate instruments. The FHLBP has the option on the convertible borrowings to convert the rate to a floating rate after the expiration of a specified period. The floating rate is based on the LIBOR index plus a spread. If the FHLBP elects to exercise the conversion option, PeoplesBank may repay the converted loan, without a prepayment penalty.
The obligation of Codorus Valley due in 2011 is secured by a mortgage on the Codorus Valley Corporate Center office building at 105 Leader Heights Road, York, Pennsylvania. In February 2004, this obligation refinanced, without interest penalty, an obligation due in 2009. To support planned growth, Codorus Valley issued trust preferred debt securities in the amount of $3,093,000 in November 2004 and $7,217,000 in June 2006, which are included in Tier 1 capital for regulatory capital purposes. These obligations have a 30-year maturity, but are callable at quarterly intervals after the fifth year. Maturities of total long-term debt over the next five years are as follows: $8,198,000 in 2007, $1,253,000 in 2008, $6,309,000 in 2009, $7,340,000 in 2010, $5,611,000 in 2011 and $16,628,000 thereafter.
NOTE 10-Regulatory Matters The Corporation is subject to restrictions on the payment of dividends to its shareholders pursuant to the Pennsylvania Business Corporation Law of 1988, as amended (BCL). The BCL prohibits dividend payments if such payment would render the Corporation insolvent or result in negative net worth. Federal and state banking regulations place certain restrictions on dividends paid and loans or advances made by PeoplesBank to the Corporation. The amount of total dividends, which may be paid at any date, is generally limited to the retained earnings of PeoplesBank. Furthermore, dividend payments would be prohibited if the effect thereof would cause PeoplesBank’s capital to be reduced below applicable minimum capital requirements as discussed below. Loans and advances by PeoplesBank to affiliates, including the Corporation, are limited to 10 percent of PeoplesBank’s capital stock and contributed capital on a secured basis.
The Corporation and PeoplesBank are subject to various regulatory capital requirements. Failure to meet minimum capital requirements can result in certain mandatory and possible additional discretionary actions by regulators that, if imposed, could have a material effect on the Corporation’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Corporation and PeoplesBank must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators.
Quantitative measures established by regulators to ensure capital adequacy require the Corporation and PeoplesBank to maintain minimum ratios to total and tier 1 capital as a percentage of risk-weighted assets, and of tier 1 capital to average assets (leverage ratio) as set forth below. In September 2006, PeoplesBank received the most recent notification from the Federal Deposit Insurance Corporation, which categorized PeoplesBank as well capitalized, as of June 30, 2006, under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes would change PeoplesBank’s well capitalized category.
*Under prompt corrective action provisions
NOTE 11-Benefit Plans Defined Contribution Plan
The Corporation maintains a 401(k) savings and investment plan covering substantially all employees. Under the plan, employees can contribute a percentage of their gross salary. In 2006, 2005, and 2004, the Corporation matched 50 percent of the first 6 percent of an employee’s contribution. The Corporation’s expense for the 401(k) savings and investment plan was $140,000 for 2006, $109,000 for 2005, and $92,000 for 2004.
Supplemental Benefit Plans
PeoplesBank maintains supplemental retirement plans for selected executives and supplemental life insurance for executive officers and directors. The supplemental life insurance plans replaced other insurance coverage. The expense associated with these plans was approximately $204,000 for 2006, $167,000 for 2005, and $155,000 for 2004. The accrued liability was $1,154,000 at December 31, 2006, $951,000 at December 31, 2005, and $784,000 at December 31, 2004. Investment in bank owned life insurance policies was used to finance the supplemental benefit plans, and provide a tax-exempt return to PeoplesBank.
Dividend Reinvestment and Stock Purchase Plan
The Corporation maintains a Dividend Reinvestment and Stock Purchase Plan (Plan). Shareholders of common stock may participate in the Plan, which allows additional shares of common stock to be purchased with reinvested dividends at prevailing market prices. For 2006, 2005 and 2004 all shares were purchased from the open market. To the extent that shares are not available in the open market, 194,412 shares of common stock are reserved and available for issuance at December 31, 2006. Open market purchases were made by an independent purchasing agent retained to act as agent for Plan participants, and the purchase price to participants was the actual price paid, excluding brokerage commissions and other expenses which were paid by the Corporation. The Plan also permits participants to make additional voluntary cash payments to purchase shares of the Corporation’s common stock.
NOTE 12-Stock-Based Compensation The Corporation adopted Statement of Financial Accounting Standards No. 123(R), “Share-Based Payments” (Statement 123R) in the first quarter of 2006, using the “modified prospective method.” Statement 123R requires that the fair value of equity awards to employees be recognized as compensation expense over the period during which an employee is required to provide service in exchange for such award. Compensation expense of $54,000 net of $0 tax effect during 2006 was included in net income and earnings per share. Comparatively, the impact on net income and earnings per share during 2005 and 2004 that would have occurred if compensation expense would have been recognized based on the estimated fair value of the options on the date of grant is as follows:
The Corporation’s equity awards consist of stock options granted under three stock option plans as follows: a 2000 Stock Incentive Plan (2000 Plan), a 1998 Independent Directors Stock Option Plan (1998 Plan) and a 1996 Stock Incentive Plan (1996 Plan), (collectively the Option Plans). All options
available for grant under the 1998 and 1996 Plans have been granted. The 2000 Plan also allows for the granting of stock appreciation rights and restricted stock, none of which have been granted to date at December 31, 2006.
Shares reserved and available for issuance as of December 31, 2006, adjusted for stock dividends declared, were 134,374 for the 2000 Plan, 135,823 for the 1998 Plan, and 83,268 for the 1996 Plan. Shares reserved for future issuance under each plan are subject to adjustment in the event of specified changes in the Corporation’s capital structure. Options awarded under these plans to date have been granted with an exercise price equal to the fair value of the stock on the grant date, a minimum vesting period of six months and an expiration period of ten years. Upon exercise, the Corporation has historically issued from its authorized, but unissued, common stock to satisfy the options.
The grant-date fair value, adjusted for stock dividends declared, of options granted in 2006 was $6.95, compared to $6.53 for 2005 and $6.98 for 2004. The fair value of the options awarded under the Option Plans is estimated on the date of grant using the Black-Scholes valuation model, which is dependent upon certain assumptions as presented below.
The expected life of the options was estimated using one half of the exercise period plus the vesting period and represents the period of time that options granted are expected to be outstanding. The risk-free interest rate is the U.S. Treasury rate commensurate with the expected life of the options on the grant date. Volatility of the Corporation’s stock price was based on historical volatility. Dividend yield was based on dividends for the most current year divided by the average market price for the most current year.
A summary of stock options activity from all Plans, adjusted for stock dividends declared, is shown below.
Intrinsic value represents the amount by which the market price of the stock on the measurement date exceeded the exercise price of the option. The intrinsic value of options exercised during 2006 was $188,000, 2005 was $119,000 and 2004 was $46,000. Cash received from such exercises during 2006 was $164,000 and the tax benefit recognized was $64,000, 2005 was $235,000 and the tax benefit recognized was $41,000, and 2004 was $104,000 and the tax benefit recognized was $16,000.
As of December 31, 2006, total unrecognized compensation cost related to nonvested options was $76,000. The cost is expected to be recognized over a weighted average period of 1.6 years.
The Corporation also maintains an Employee Stock Bonus Plan, administered by nonemployee members of the Corporation’s Board of Directors, under which the Corporation may issue shares of its common stock to employees as performance based compensation. As of December 31, 2006, 13,037 shares of common stock were reserved for possible issuance under this plan, subject to future adjustment in the event of specified changes in the Corporation’s capital structure. Under the Employee Stock Bonus Plan, 53 shares were issued during 2006, no shares of stock were issued during 2005, and 26 shares were issued during 2004.
NOTE 13-Income Taxes The provision for income taxes for the years ended December 31, consists of the following:
The differences between the effective income tax rate and the Federal statutory income tax rate are as follows:
The provision for income taxes includes ($27,000), ($29,000) and $13,000 of applicable income tax (benefit) expense related to net investment security (losses) gains in 2006, 2005 and 2004, respectively.
Significant components of the Corporation’s deferred tax asset, included in other assets as of December 31, were as follows:
NOTE 14-Commitments to Extend Credit In the normal course of business, the Corporation is a party to various financial transactions that are not funded as of the balance sheet date. Off-balance sheet financial instruments, which enable bank customers to meet their financing needs, are comprised mainly of commitments to extend credit and standby letters of credit. Standby letters of credit written are conditional commitments issued by PeoplesBank to guarantee the performance of a customer to a third party. The credit and market risk involved in issuing letters of credit is essentially the same as that involved in extending other loan commitments. To manage these risks the Corporation uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments and requires collateral to support these letters of credit as deemed necessary. Management believes that the proceeds obtained through a liquidation of such collateral would be sufficient to cover the maximum potential amount of future payments required under the corresponding guarantees. The current amount of the liability as of December 31, 2006 and 2005, for guarantees under standby letters of credit issued is not material. Normally, commitments to extend credit and letters of credit have fixed expiration dates or termination clauses, have specific rates and are for specific purposes. Many of the commitments are expected to expire without being extended; therefore, total commitment amounts do not necessarily represent future cash requirements.
The following is a summary of outstanding commitments:
NOTE 15-Contingent Liabilities Periodically, the Corporation and its subsidiary bank may be defendants in legal proceedings relating to the conduct of their banking business. Most of such legal proceedings are a normal part of the banking business and, in management’s opinion, do not materially affect the financial position or results of operations of the Corporation.
NOTE 16-Fair Values of Financial Instruments FASB Statement No. 107, “Disclosures About Fair Value of Financial Instruments,” requires disclosure of fair value information about financial instruments, whether or not recognized on the balance sheet, for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based on estimates using present value of expected future cash flows or other valuation techniques. These techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument. Statement No. 107 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Corporation.
The following methodologies and assumptions were used by Codorus Valley to estimate its fair value disclosures.
Cash and cash equivalents-The fair value for total cash and cash equivalents is deemed to be the same as the carrying amount.
Investment securities-Fair values for investment securities are based on quoted market prices. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments.
Restricted investment in bank stocks-Fair values for Federal Home Loan Bank and Atlantic Central Bankers Bank stock approximate the carrying values based on the redemption provisions of the respective issuer.
Loans held for sale-Fair values for loans held for sale are based on quoted market prices.
Loans, net of allowance-For variable rate and adjustable rate loans that reprice frequently with no significant change in credit risk, fair value is deemed to be the same as the carrying amount. Fair values for all other loans in the portfolio are estimated by discounting estimated future cash flows using comparable current interest rates at which similar loans would be made to borrowers with similar credit risk.
Mortgage servicing rights-The fair value for mortgage servicing rights is based on observable market prices available or the present value of expected future cash flows when not available.
Interest receivable and payable-The fair values for interest receivable and interest payable approximate their carrying amounts.
Noninterest bearing deposits, NOW, money market and savings deposits-Fair values for noninterest bearing demand, NOW, money market and savings deposits approximate their carrying amounts.
Time deposits- The fair value for variable rate time deposits is deemed to approximate the carrying amount. The fair value for fixed rate time deposits is estimated by discounting expected future cash flows using rates offered for deposits of similar remaining maturities at the reporting date.
Short-term borrowings-The fair value for short-term borrowings approximates the carrying value.
Long-term debt-The fair value of fixed rate long-term debt is estimated by discounting estimated future cash flows using rates available to Codorus Valley, at the reporting date, for similar types of borrowings. The fair value of variable rate long-term debt approximates carrying amount.
Off-balance sheet instruments-Fair values for off-balance sheet instruments, such as commitments to extend credit and standby letters of credit, are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. These amounts were not considered to be material at December 31, 2006 and 2005.
The following table summarizes the carrying amounts and fair values of financial instruments at December 31, 2006 and 2005.
Note 17-Condensed Financial Information-Parent Company Only
Condensed Balance Sheets
Condensed Statements of Income
Note 17-Condensed Financial Information-Parent Company Only (continued)
Condensed Statements of Cash Flows
Note 18-Quarterly Results of Operations (Unaudited) The following is a summary of the quarterly results of operations for the years ended December 31, 2006 and 2005.
REPORT OF INDEPENDENT REGISTERED
PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders
Codorus Valley Bancorp, Inc.
York, Pennsylvania
We have audited the accompanying consolidated balance sheets of Codorus Valley Bancorp, Inc. and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of income, changes in shareholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2006. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, 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 Codorus Valley Bancorp, Inc. and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 1 to the consolidated financial statements, Codorus Valley Bancorp, Inc. changed its method of accounting for share-based payments in 2006.
Beard Miller Company LLP
Harrisburg, Pennsylvania
March 5, 2007
Item 9:
Item 9: Changes in and disagreements with accountants on accounting and financial disclosure None.
Item 9A:
Item 9A: Controls and procedures Codorus Valley maintains controls and procedures designed to ensure that information required to be disclosed in the reports that the company files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC. Based upon their evaluation of those controls and procedures performed as of December 31, 2006, the chief executive and chief financial officers of Codorus Valley concluded that Codorus Valley’s disclosure controls and procedures were adequate.
Codorus Valley made no changes in its internal controls over financial reporting or in other factors that has materially affected these controls subsequent to the date of the evaluation of the controls by the chief executive and chief financial officers.
Item 9B:
Item 9B: Other Information On January 23, 2007, the Compensation Committee of the Board of Directors of the Corporation, after a review of performance and competitive market data, finalized the annual base salaries of the Corporation’s executive officers for fiscal year 2007, which began on January 1, 2007. The compensation adjustments were effective as of January 1, 2007.
The following table sets forth the annual base salary levels of the Corporation’s named executive officers for fiscal years 2006 and 2007:
PART III Item 10:
Item 10: Directors, executive officers and corporate governance of Codorus Valley Bancorp, Inc. Information appearing in the Proxy Statement relating to the 2007 Annual Meeting of Shareholders to be held May 15, 2007 (Proxy Statement), under the captions “Information about Nominees and Continuing Directors,” “Executive Officers,” and “Governance of the Corporation” is incorporated by reference in response to this item.
The Corporation has adopted a Code of Business Conduct and Ethics (Code of Ethics) as defined in Item 406 of Regulation S-K. The Code of Ethics was filed as Exhibit 14 to a Form 8-K, filed with the SEC on September 16, 2004, and is incorporated by reference in response to this item. The Code of Ethics is also published on PeoplesBank’s website at www.peoplesbanknet.com, under the Investor Relations tab.
Information regarding Section 16(a) Beneficial Ownership Reporting Compliance follows. Section 16(a) of the Securities Exchange Act of 1934, requires that the Corporation’s officers and directors, and persons who own more than 10% of the registered class of the Corporation’s equity securities, file reports of ownership and changes in ownership with the SEC. Officers, directors and greater than 10% shareholders are required by SEC regulation to furnish the Corporation with copies of all Section 16(a) forms they file.
Based solely on its review of the copies of Forms 3, 4 and 5 and amendments thereto received by it, or written representations from certain reporting persons that no Form 5 was required for that reporting person, the Corporation believes that during the period from January 1, 2006 through December 31, 2006, its officers and directors were in compliance with all filing requirements applicable to them.
Item 11:
Item 11: Executive compensation Information appearing in the Proxy Statement, under the captions “Executive Compensation,” “Director Compensation” and “Compensation Committee Report” is incorporated by reference in response to this item.
Item 12:
Item 12: Security ownership of certain beneficial owners and management and related shareholder matters
Information appearing in the Proxy Statement, under the caption “Share Ownership,” “Outstanding Equity Awards at Fiscal Year End” and “Potential Payments Upon Termination of Change in Control” is incorporated by reference in response to this item.
Item 13:
Item 13: Certain relationships and related transactions, and director independence Information appearing in the Proxy Statement, under the caption “Related Person Transactions,” is incorporated by reference in response to this item.
Item 14:
Item 14: Principal accountant fees and services Information appearing in the Proxy Statement, under the caption “Independent Certified Public Accountants,” is incorporated by reference in response to this item.
PART IV Item 15:
Item 15: Exhibits and financial statement schedules
(a)
Documents filed as part of this Form 10-K report.
1.
Financial Statements
The following consolidated statements of Codorus Valley Bancorp, Inc. are incorporated by reference to Part II, Item 8 hereof:
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Income
Consolidated Statements of Changes in Shareholders’ Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
2.
Financial Statement Schedules
Required financial statement schedules are omitted. This information is either not applicable, not required or is shown in the respective financial statements or in the notes thereto.
3.
Exhibits filed as part of 10-K pursuant to Item 601 of Regulation S-K.
Exhibit
Number
Description of Exhibit
3(i)
Amended Articles of Incorporation (Incorporated by reference to Exhibit 3(i) to the Registrant’s Current Report on Form 8-K, filed with the Commission on October 14, 2005.)
3(ii)
Amended By-laws (Incorporated by reference to Exhibit 3(ii) to the Registrant’s Current Report on Form 8-K, filed with the Commission on October 14, 2005.)
Rights Agreement dated as of November 4, 2005 (Incorporated by reference to Exhibit 4 to the Registrant’s Current Report on Form 8-K, filed with the Commission on November 8, 2005.)
10.1
1996 Stock Incentive Plan (Incorporated by reference to Exhibit 99 of Registration Statement No. 333-09277 on Form S-8, filed with the Commission on July 31, 1996.)
10.2
Employment Agreement between Codorus Valley Bancorp, Inc., PeoplesBank, A Codorus Valley Company and Larry J. Miller dated December 27, 2005. (Incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K, filed with the Commission on January 3, 2006.)
10.3
Change of Control Agreement by and among Codorus Valley Bancorp, Inc., PeoplesBank, A Codorus Valley Company and Jann A. Weaver, dated December 27, 2005. (Incorporated by reference to Exhibit 10.7 to the Registrant’s Current Report on Form 8-K, filed with the Commission on January 3, 2006.)
10.4
Change of Control Agreement by and among Codorus Valley Bancorp, Inc., PeoplesBank, A Codorus Valley Company and Harry R. Swift, dated December 27, 2005. (Incorporated by reference to Exhibit 10.6 to the Registrant’s Current Report on Form 8-K, filed with the Commission on January 3, 2006.)
10.5
1998 Independent Directors Stock Option Plan (Incorporated by reference to Exhibit 4.3 of Registrant Statement No. 333-61851 on Form S-8, filed with the Commission on August 19, 1998.)
10.6
2000 Stock Incentive Plan (Incorporated by reference to Exhibit 4.3 of Registration Statement No. 333-40532 on Form S-8, filed with the Commission on June 30, 2000.)
10.7
2001 Employee Stock Bonus Plan (Incorporated by reference to Exhibit 99.1 of Registration Statement No. 333-68410 on Form S-8, filed with the Commission on August 27, 2001.)
10.8
Dividend Reinvestment and Stock Purchase Plan (Incorporated by reference to Exhibit 4(a) Registration Statement no. 33-46171 on Amendment No. 4 to Form S-3, filed with the Commission on July 23, 2004.)
10.9
Amendment to Salary Continuation Agreement by and among PeoplesBank, A Codorus Valley Company, a wholly owned subsidiary of Codorus Valley Bancorp, Inc. and Larry J. Miller dated December 27, 2005. (Incorporated by reference to Exhibit 10.3 to the Registrant’s Current Report on Form 8-K, filed with the Commission on January 3, 2006.)
10.10
Amendment to Salary Continuation Agreement by and among PeoplesBank, A Codorus Valley Company, a wholly owned subsidiary of Codorus Valley Bancorp, Inc. and Harry R. Swift dated December 27, 2005. (Incorporated by reference to Exhibit 10.4 to the Registrant’s Current Report on Form 8-K, filed with the Commission on January 3, 2006.)
10.11
Amendment to Salary Continuation Agreement by and among PeoplesBank, A Codorus Valley Company, a wholly owned subsidiary of Codorus Valley Bancorp, Inc. and Jann A. Weaver dated December 27, 2005. (Incorporated by reference to Exhibit 10.5 to the Registrant’s Current Report on Form 8-K, filed with the Commission on January 3, 2006.)
10.12
Form of Group Term Replacement Plan, dated December 1, 1998, as amended, including Split Dollar Policy Endorsements pertaining to senior officers of the Corporation’s subsidiary, PeoplesBank, A Codorus Valley Company. (Incorporated by reference to Exhibit 10.12 to the Registrant’s Annual Report on Form 10-K, filed on March 29, 2005.)
10.13
Sample form of Director Group Term Replacement Plan, dated December 1, 1998, including Split Dollar Policy Endorsements pertaining to non-employee directors of the Corporation’s subsidiary, PeoplesBank, A Codorus Valley Company. (Incorporated by reference to Exhibit 10.13 to the Registrant’s Annual Report on Form 10-K, filed on March 29, 2005.)
10.14
Long Term Nursing Care Agreement between Codorus Valley Bancorp, Inc., PeoplesBank, A Codorus Valley Company and Larry J. Miller, dated December 27, 2005. (Incorporated by reference to Exhibit 10.2 to the Registrant’s Current Report on Form 8-K, filed with the Commission on January 3, 2006.)
10.15
Codorus Valley Bancorp, Inc. Change in Control and Supplemental Benefit Trust Agreement between Codorus Valley Bancorp, Inc., PeoplesBank, A Codorus Valley Company and Hershey Trust Company, dated January 25, 2006. (Incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K, filed with the Commission on January 27, 2006.)
10.16
Amended and Restated Declaration of Trust of CVB Statutory Trust No. 2, dated as of June 28, 2006, among Codorus Valley Bancorp, Inc., as sponsor, the Delaware and institutional trustee named therein, and the administrators named therein. (Incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed with the Commission on June 30, 2006.)
10.17
Indenture, dated as of June 28, 2006, between Codorus Valley Bancorp, Inc., as issuer, and the trustee named therein, relating to the Junior Subordinated Debt Securities due 2036. (Incorporated by reference to Exhibit 10.2 to the Registrant’s Current Report on Form 8-K filed with the Commission on June 30, 2006.)
10.18
Guarantee Agreement, dated as of June 28, 2006, between Codorus Valley Bancorp, Inc. and guarantee trustee named therein. (Incorporated by reference to Exhibit 10.3 to the Registrant’s Current Report on Form 8-K filed with the Commission on June 30, 2006.)
10.19
2007 Long-Term Incentive Plan of Codorus Valley Bancorp, Inc. (Incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K, filed with the Commission on February 20, 2007.)
10.20
Leadership Cash Incentive Plan (Incorporated by reference to Exhibit 10.2 to the Registrant’s Current Report on Form 8-K, filed with the Commission on February 20, 2007.)
Code of Ethics (Incorporated by reference to Exhibit 14 to the Registrant’s Current Report on Form 8-K, filed with the Commission on September 16, 2004.)
List of subsidiaries of Codorus Valley Bancorp, Inc.
Consent of Independent Registered Public Accounting Firm
Power of Attorney
31.1
Certification of Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2
Certification of Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
Certification of Principal Executive Officer and Principal Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
Signatures Under the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed on its behalf by the authorized undersigned.
Codorus Valley Bancorp, Inc. (Registrant)
/s/ Larry J. Miller
Larry J. Miller, President
Date: March 13, 2007
and Chief Executive Officer
Under 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 and on the dated indicated.
Signature and Capacity
Exhibit Index