content_image/19045.jpg
## NOTESTO CONSOLIDATED FINANCIAL STATEMENTS 

(Dollar Amounts in Thousands, except per share data) 

NOTE 1— Statement of Accounting Policies (continued) 

## Employee Stock Option Plan (continued) 

No. 123, the Corporation has elected to use the intrinsic value method to measure stock based compensation under APB 25 and to disclose in a footnote to the financial statements, net income and earnings per share determined as if the fair value methodology of FAS No. 123 had been implemented. No stock-based employee compensation expense is reflected in the Corporation’s net income as reported in the Consolidated Statements of Income because all stock options granted under the Corporation’s plan had an exercise price equal to the market value of the underlying common stock on the date of the grant. 

Management has considered various factors in its decision to account for stock-based compensation, including stock options granted, using the intrinsic value method of APB 25. Generally, expenses are easily measured as of the date they are incurred. At some point the Corporation must pay cash to cover these expenses. This is not the case with the methodology for expensing stock options. The amount expensed for the purposes of this disclosure is equivalent to a theoretic value calculated on the date the option was granted. Calculating a value of the option at the grant date requires a variety of assumptions that may have little to do with the actual realization of value by the option holder. In fact, many of the options are forfeited or expire for a variety of reasons without ever being exercised. 

Additionally, valuation models operate under the assumption that the options are similar to those that are actively traded. In reality they are not marketable. Also there exists times where executives are unable to exercise their options due to trading restrictions. This limits the ability of certain option holders to benefit from some periods of volatility. Changes in the assumptions used could affect the estimated impact of the stock options and this disclosure. 

The variety of methodologies and assumptions permitted to be used by each reporting company gives rise to a high degree of subjectivity in estimating the impact of the options. Management is concerned that due to the lack of uniformity and variations in assumptions, there may not be reasonable comparability between institutions. See NOTE 24 for additional information. 

The following table illustrates the effect on net income and earnings per share if the Corporation had applied the fair value recognition provisions of FAS No. 123 to stock-based employee compensation: 

<img src='content_image/19045.jpg'>

## Derivative Instruments and Hedging Activities 

The Corporation accounts for derivative instruments and hedging activities utilizing guidelines established in FASB Statement No. 133 “Accounting for Derivative Instruments and Hedging Activities” (“FASB No. 133”), as amended. The Corporation recognizes all derivatives as either assets or liabilities on the balance sheet and measures those instruments at fair value. Changes in fair value of derivatives designated and accounted for as cash flow hedges, to the extent they are effective as hedges, are recorded in “Other Comprehensive Income,” net of deferred taxes. Any hedge ineffectiveness would be recognized in the income statement line item pertaining to the hedged item. 

Management periodically reviews contracts from various functional areas of the Corporation to identify potential derivatives embedded within selected contracts. Management has identified potential embedded derivatives in certain loan commitments for residential mortgages where the Corporation has intent to sell to an outside investor. Due to the short-term nature of these loan commitments and the minimal historical dollar amount of commitments outstanding, the corresponding impact on the Corporation’s financial condition and results of operation has not been material. The Corporation had no freestanding derivative or hedging instruments prior to the third quarter of 2003 when it entered into an interest rate swap that is described in NOTE 7. 

## Earnings Per Common Share 

Basic earnings per share excludes dilution and is computed by dividing income available to common shareholders by the weighted-average number of common shares outstanding for the period less unallocated ESOP shares. 

Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared 

