UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
/X/ Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act
of 1934
For the fiscal year ended December 31, 2002 or
/ / Transition report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934
Commission file number 000-29829
PACIFIC FINANCIAL CORPORATION
(Exact Name of Registrant as specified in its Charter)
Washington 91-1815009
(State or Other Jurisdiction of (IRS Employer Identification No.)
Incorporation or Organization)
300 East Market Street
Aberdeen, Washington 98520-5244
(Address of Principal Executive Offices) (Zip Code)
Registrant's telephone number, including area code: (360) 533-8870
Securities Registered Pursuant to Section 12(b) of the Act:
None
Securities Registered Pursuant to Section 12(g) of the Act:
Common Stock, par value $1.00 per share
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter periods that the Registrant was
required to file such reports), and (2) has been subject to such requirements
for the past 90 days.
Yes__X___ No______
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
Indicate by check mark whether the Registrant is an accelerated filer (as
defined by Exchange Act Rule 12b-2). Yes [ ] No [X ]
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The aggregate market value of the common stock held by non-affiliates of the
registrant at June 28, 2002 (the last business day of the most recent second
quarter), was $59,176,189. (based on the closing price on that date)
The number of shares outstanding of each of the registrant's classes of common
stock as of February 28, 2003, was:
Title of Class Number of Shares Outstanding
-------------- ----------------------------
Common Stock, $1.00 Par Value 2,512,659 shares
DOCUMENTS INCORPORATED BY REFERENCE
PART III of Form 10-K - The definitive Proxy Statement filed with the Securities
and Exchange Commission in connection with Registrant's annual meeting to be
held April 16, 2003 (only portions of which are incorporated by reference).
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PACIFIC FINANCIAL CORPORATION
ANNUAL REPORT ON FORM 10-K FOR THE FISCAL YEAR
ENDED DECEMBER 31, 2002
TABLE OF CONTENTS
PART I
Page
Item 1. Business 4
Item 2. Properties 14
Item 3. Legal Proceedings 14
Item 4. Submission of Matters to a Vote of Security Holders 14
PART II
Item 5. Market for Registrant's Common Equity
and Related Stockholder Matters 14
Item 6. Selected Financial Data 15
Item 7. Management's Discussion and Analysis of Financial 16
Condition and Results of
Operations
Item 7A. Quantitative and Qualitative Disclosures About
Market Risk 30
Item 8. Financial Statements and Supplementary Data 31
Item 9. Changes in and Disagreements with Accountants
on Accounting and Financial Disclosure 31
PART III
Item 10. Directors and Executive Officers of the Registrant 31
Item 11. Executive Compensation 31
Item 12. Security Ownership of Certain Beneficial Owners
and Management And Related Stockholder Matters 32
Item 13. Certain Relationships and Related Transactions 32
Item 14. Controls and Procedures 32
PART IV
Item 15. Exhibits, Financial Statement Schedules,
and Reports on Form 8-K 33
SIGNATURES AND CERTIFICATIONS 65
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PART I
ITEM 1. Business
Pacific Financial Corporation (the Company) is a financial holding company
headquartered in Aberdeen, Washington. The Company owns one bank, Bank of the
Pacific (Pacific or the Bank), which is located in Washington. The Company
conducts its banking business through 10 branches located in communities
throughout Grays Harbor County, Pacific County, and Wahkiakum County in
Southwest Washington. At December 31, 2002, the Company had total consolidated
assets of $268.5 million, loans of $185.5 million, and deposits of $225.2
million. The Company was incorporated in the State of Washington on February 12,
1997, pursuant to a holding company reorganization of the Bank. Although an SEC
reporting company, the Company's stock is not listed on any exchange.
FORWARD LOOKING INFORMATION
This document contains forward-looking statements that are subject to risks and
uncertainties. These statements are based on the beliefs and assumptions of our
management, and on information currently available to them. Forward-looking
statements include the information concerning our possible future results of
operations set forth under "Management's Discussion and Analysis of Financial
Condition and Results of Operations" and statements preceded by, followed by or
that include the words "believes," "expects," "anticipates," "intends," "plans,"
"estimates" or similar expressions.
Any forward-looking statements in this document are subject to risks relating
to, among other things, the following:
1. competitive pressures among depository and other financial
institutions which may impede our ability to attract and retain
borrowers, depositors and other customers;
2. changes in the interest rate environment resulting in reduced
margins;
3. general economic or business conditions, either nationally or
in the state or regions in which we do business, may be less favorable
than expected, resulting in, among other things, a deterioration in
credit quality, including as a result of lower prices in the real
estate market, or a reduced demand for credit;
4. legislative or regulatory changes may adversely affect the
businesses in which we are engaged; and
5. continued downturns in the securities markets.
Our management believes the forward-looking statements are reasonable; however,
you should not place undue reliance on them. Forward-looking statements are not
guarantees of performance. They involve risks, uncertainties and assumptions.
Many of the factors that will determine our future results and share value are
beyond our ability to control or predict. We undertake no obligation to update
forward-looking statements.
THE BANK
Bank of the Pacific was organized in 1978 and opened for business in 1979 to
meet the need for a regional community bank with local interests to serve the
small to medium-sized local businesses and
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professionals in the region. Services offered by the Bank include commercial
loans, installment loans, real estate loans, residential mortgage loans and
personal and business deposit products.
The Bank originates loans primarily in its local markets. Its underwriting
policies focus on assessment of each borrower's ability to service and repay the
debt, and the availability of collateral that can be used to secure the loan.
Depending on the nature of the borrower and the purpose and amount of the loan,
the Bank's loans may be secured by a variety of collateral, including business
assets, real estate, and personal assets.
The Bank's commercial and agricultural loans consist primarily of secured
revolving operating lines of credit and business term loans, some of which may
be partially guaranteed by the Small Business Administration or the U.S.
Department of Agriculture.
Consumer installment loans and other loans represent a small percentage of total
outstanding loans and include home equity loans, auto loans, boat loans, and
personal lines of credit.
The Bank's primary sources of deposits are from individuals and businesses in
its local markets. A concerted effort has been made to attract deposits in the
local market areas through competitive pricing and delivery of quality products.
These products include demand accounts, negotiable order of withdrawal ("NOW")
accounts, money market investment accounts, savings accounts, and time deposits.
The Bank traditionally has not sought brokered deposits and does not intend to
do so in the future.
The Bank provides 24 hour online banking to its customers with access to account
balances and transaction histories, plus an electronic check register to make
account management and reconciliation simple. The online banking system is
compatible with budgeting software like Intuit's Quicken or Microsoft's Money.
In addition, the online banking system includes the ability to transfer funds,
make loan payments, reorder checks, request statement reprints, provides loan
calculators and allows for e-mail exchanges with The Bank. Also for a nominal
fee, customers can request stop payments and pay an unlimited number of bills
online. These services along with rate information and stock information can be
accessed through the Bank's website at www.thebankofpacific.com.
The Bank operates under the banking laws of the State of Washington and the
rules and regulations of the Federal Deposit Insurance Corporation ("FDIC").
COMPETITION
Competition in the banking industry is significant and has intensified as the
regulatory environment has grown more permissive. Banks face a growing number of
competitors and greater degree of competition with respect to the provision of
banking services and the attracting of deposits. The Company competes in Grays
Harbor County with well-established thrifts which are headquartered in the area
along with branches of large banks and small community banks with headquarters
outside the area. The Company competes with well-established branches of large
banks, thrifts and credit unions in Pacific and Wahkiakum Counties. Other
non-bank and non-depository institutions can be expected to increase competition
further as they offer bank type products.
The adoption of the Gramm-Leach-Bliley Act of 1999 (the Financial Services
Modernization Act) in November of that year eliminated many of the barriers to
affiliation among providers of financial services and further opened the door to
business combinations involving banks, insurance companies, securities or
brokerage firms, and others. This regulatory change has led to further
consolidation in the financial services industry and the creation of financial
conglomerates which frequently offer multiple financial services, including
deposit services, brokerage and others. When combined with technological
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developments such as the Internet that have reduced barriers to entry faced by
companies physically located outside the Company's market area, changes in the
market have resulted in increased competition and can be expected to result in
further increases in competition in the future.
Although it cannot guarantee that it will continue to do so, the Company has
been able to maintain a competitive advantage as a result of its status as a
local institution, offering products and services tailored to the needs of the
community. Further, because of the extensive experience of management in its
market area and the business contacts of management and the directors,
management believes the Company can continue to compete effectively.
According to the Market Share Report compiled by the FDIC, as of June 30, 2002,
the Company held a deposit market share of 30% in Pacific County, 43.9% in
Wahkiakum County and a 15.7% share in Grays Harbor County.
EMPLOYEES
As of December 31, 2002, the Bank employed 92 full time equivalent employees.
Management believes relations with its employees are good.
SUPERVISION AND REGULATION
The following generally refers to certain significant statutes and
regulations affecting the banking industry. This regulation is intended
primarily for the protection of depositors and not for the benefit of the
Company's shareholders. The following discussion is intended to provide a brief
summary and, therefore, is not complete and is qualified by the statutes and
regulations referenced. Changes in applicable laws or regulations may have a
material effect on the business and prospects of the Company.
The operations of the Company may also be affected by changes in the policies of
banking and other government regulators. The Company cannot accurately predict
the nature or extent of the effects on its business and earnings that fiscal or
monetary policies, or new federal or state laws, may have in the future.
THE COMPANY
GENERAL
As a financial holding company, the Company is subject to the Bank Holding
Company Act of 1956, as amended, ("BHCA") which places the Company under the
supervision of the Board of Governors of the Federal Reserve System (the
"Federal Reserve"). The Company must file annual reports with the Federal
Reserve and must provide it with such additional information as it may require.
In addition, the Federal Reserve periodically examines the Company and its
subsidiaries, including the Bank.
BANK HOLDING COMPANY REGULATION
In general, the BHCA limits a bank holding company to owning or controlling
banks and engaging in other banking-related activities. Bank holding companies
must obtain the Federal Resserve approval before they: (1) acquire direct or
indirect ownership or control of any voting shares of any bank that results in
total ownership or control, directly or indirectly, of more than 5% of the
voting shares of such bank; (2) merge or consolidate with another bank holding
company; or (3) acquire substantially all of the assets of another bank or bank
holding company.
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Control of Nonbanks. With certain exceptions, the BHCA prohibits bank
holding companies from acquiring direct or indirect ownership or control of more
than 5% of the voting shares in any company that is not a bank or a bank holding
company unless the Federal Reserve determines that the activities of such
company are incidental or closely related to the business of banking. If a bank
holding company is well-capitalized and meets certain criteria specified by the
FRB, it may engage de novo in certain permissible nonbanking activities without
prior Federal Reserve approval.
Control Transactions. The Change in Bank Control Act of 1978, as amended,
requires a person (or group of persons acting in concert) acquiring "control" of
a bank holding company to provide the Federal Reserve with 60 days' prior
written notice of the proposed acquisition. Following receipt of this notice,
the Federal Reserve has 60 days within which to issue a notice disapproving the
proposed acquisition, but the Federal Reserve may extend this time period for up
to another 30 days. An acquisition may be completed before expiration of the
disapproval period if the Federal Reserve issues written notice of its intent
not to disapprove the transaction. In addition, any "company" must obtain the
Federal Reserve approval before acquiring 25% (5% if the "company" is a bank
holding company) or more of the outstanding shares or otherwise obtaining
control over the Company.
FINANCIAL SERVICES MODERNIZATION ACT
On November 12, 1999, the Financial Services Modernization Act was signed into
law. The Financial Services Modernization Act repeals the two affiliation
provisions of the Glass-Steagall Act: Section 20, which restricted the
affiliation of Federal Reserve member banks with firms "engaged principally" in
specified securities activities; and Section 32, which restricts officer,
director, or employee interlocks between a member bank and any company or person
"primarily engaged" in specified securities activities. In addition, the
Financial Services Modernization Act contains provisions that expressly preempt
any state law restricting the establishment of financial affiliations, primarily
related to insurance. The general effect of the law is to establish a
comprehensive framework to permit affiliations among commercial banks, insurance
companies, securities firms, and other financial service providers by revising
and expanding the bank holding company framework to permit a holding company
system to engage in a full range of financial activities through a new entity
known as a financial holding company.
The Company received approval to become a financial holding company during 2000.
Bank holding companies that elect to become a financial holding company may
affiliate with securities firms and insurance companies and engage in other
activities that are financial in nature or are incidental or complementary to
activities that are financial in nature. "Financial in nature" activities
include securities underwriting, dealing, and market marking, sponsoring mutual
funds and investment companies, insurance underwriting and agency, merchant
banking, and activities that the Federal Reserve, in consultation with the
Secretary of Treasury, determines from time to time to be so closely related to
banking or managing or controlling banks as to be a proper incident thereto.
In December 2000, the Federal Reserve approved an interim rule defining the
three categories of activities financial in nature or incidental to a financial
activity:
o lending, exchanging, transferring, investing for others, or safeguarding
financial assets other than money or securities;
o providing any device or other instrumentality for transferring money or
other financial assets; or
o arranging, effecting or facilitating financial transactions for the
account of third parties.
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The law also:
o broadens the activities that may be conducted by national banks, banking
subsidiaries of bank holding companies, and their financial subsidiaries;
o provides an enhanced framework for protecting the privacy of consumer
information;
o adopts a number of provisions related to the capitalization, membership,
corporate governance, and other measures designed to modernize the
Federal Home Loan Bank system;
o modifies the laws governing the implementation of the Community
Reinvestment Act; and
o addresses a variety of other legal and regulatory issues affecting both
day-to-day operations and long-term activities of financial institutions.
The Company does not believe that the Financial Services Modernization Act will
have a material adverse effect on its operations in the near-term. However, to
the extent that the legislation permits banks, securities firms, and insurance
companies to affiliate, the financial services industry may experience further
consolidation. The Financial Services Modernization Act is intended to grant to
community banks certain powers as a matter of right that larger institutions
have accumulated on an ad hoc basis. Nevertheless, this legislation may have the
result of increasing the amount of competition that the Company faces from
larger institutions and other types of companies with substantially greater
resources than the Company and offering a wider variety of financial products
than the Bank currently offers.
PRIVACY RULES. The Financial Services Modernization Act required federal banking
regulators to adopt rules that limit the ability of banks and other financial
institutions to disclose non-public information about consumers to nonaffiliated
third parties. Regulations were adopted in 2000 and became effective November
13, 2000, although compliance was optional until July 1, 2001. Adopted
regulations require disclosure of privacy policies to consumers and, in some
circumstances, allow consumers to prevent disclosure of personal information. We
have implemented procedures to comply with these rules and believe that
compliance has not had an adverse effect on operations.
INSURANCE PRODUCTS. In December 2000 pursuant to the requirements of the
Financial Services Modernization Act, the federal bank and thrift regulatory
agencies adopted consumer protection rules for the sale of insurance products by
depository institutions. The rule was effective on April 1, 2001. The final rule
applies to any depository institution or any person selling, soliciting,
advertising, or offering insurance products or annuities to a consumer at an
office of the institution or on behalf of the institution. The regulation
requires oral and written disclosure before the completion of the sale of an
insurance product that such product:
o is not a deposit or other obligation of, or guaranteed by, the depository
institution or its affiliate;
o is not insured by the FDIC or any other agency of the United States, the
depository institution or its affiliated; and
o has certain risks of investment, including the possible loss of value.
The depository institution may not condition as extension of credit on the
consumer's purchase of an insurance product or annuity from the depository
institution or from any of its affiliates, or on the consumer's agreement not to
obtain, or a prohibition on the consumer from obtaining, an insurance product or
annuity from an unaffiliated entity. Furthermore, to the extent practicable, a
depository institution must keep
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insurance and annuity sales activities physically segregated from the areas
where retail deposits are routinely accepted from the general public. Finally,
the rule addresses cross marketing and referral fees.
INFORMATION SECURITY. In January 2000, the banking agencies adopted guidelines
requiring financial institutions to establish an information security program
to:
o identify and assess the risks that may threaten customer information;
o develop a written plan containing policies and procedures to manage and
control these risks;
o implement and test the plan; and
o adjust the plan on a continuing basis to account for changes in
technology, the sensitivity of customer information and internal
or external threats to information security.
Each institution may implement a security program appropriate to its size and
complexity and the nature and scope of its operations. The guidelines were
effective July 1, 2001. The Company believes that it is in compliance with the
guidelines and that they will not adversely affect its operations.
USA PATRIOT ACT OF 2001
On October 26, 2001, President Bush signed the Uniting and Strengthening America
by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism
("USA Patriot Act") of 2001. Among other things, the USA Patriot Act (1)
prohibits banks from providing correspondent accounts directly to foreign shell
banks; (2) imposes due diligence requirements on banks opening or holding
accounts for foreign financial institutions or wealthy foreign individuals; (3)
requires financial institutions to establish an anti-money-laundering compliance
program, and (4) eliminates civil liability for persons who file suspicious
activity reports. The Act also increases governmental powers to investigate
terrorism, including expanded government access to account records. The
Department of the Treasury is empowered to administer and make rules to
implement the Act. We do not believe that compliance with the USA Patriot Act
has had a material effect on our business and operations.
SARBANES-OXLEY ACT OF 2002
The Sarbanes-Oxley Act of 2002 was signed into law by President Bush on
July 30, 2002 in response to public concerns regarding corporate accountability
in connection with the recent accounting scandals at various large publicly
traded companies. The stated goals of the act 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 Sarbanes-Oxley Act generally applies to all companies, both U.S. and
non-U.S., that file or are required to file periodic reports with the Securities
and Exchange Commission ("SEC"), under the Securities Exchange Act of 1934
("Exchange Act").
The Sarbanes-Oxley Act includes very specific additional 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
and the Comptroller General. The Sarbanes-Oxley Act represents significant
federal involvement in matters traditionally left to state regulatory systems,
such as the regulation of the accounting profession, and to state corporate law,
such as the relationship between a board of directors and management and between
a board of directors and its committees.
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The Sarbanes-Oxley Act addresses, among other matters, (1) board audit
committees; (2) certification of Exchange Act reports by the chief executive
officer and the chief financial officer; (3) the forfeiture of bonuses or other
incentive-based compensation and securities trading profits by directors and
executive officers in the twelve-month period following initial publication of
any financial statements that later require restatement; (4) disclosure of
off-balance sheet transactions; (5) expedited reporting of stock transactions by
insiders; (6) disclosure of a code of ethics, if any, and changes or waivers of
such code; (7) the formation of a Public Company Accounting Oversight Board; (8)
auditor independence; and (9) increased criminal penalties for violations of
securities laws.
Provisions of the Sarbanes-Oxley Act become effective at various times
during the 18 months beginning July 30, 2002. The SEC has been delegated the
task of adopting rules to implement various provisions, including disclosure in
periodic filings pursuant to the Exchange Act. While we believe the
Sarbanes-Oxley Act may, to some degree, affect our reporting expenses, we do not
believe that the Act will have a material adverse effect on our business and
operations.
TRANSACTIONS WITH AFFILIATES
The Company and the Bank are deemed affiliates within the meaning of the
Federal Reserve Act, and transactions between affiliates are subject to certain
restrictions. Accordingly, the Company and the Bank must comply with Sections
23A and 23B of the Federal Reserve Act. Generally, Sections 23A and 23B (1)
limit the extent to which a financial institution or its subsidiaries may engage
in "covered transactions" with an affiliate, as defined, to an amount equal to
10% of such institution's capital and surplus and an aggregate limit on all such
transactions with all affiliates to an amount equal to 20% of such capital and
surplus, and (2) require all transactions with an affiliate, whether or not
"covered transactions," to be on terms substantially the same, or at least as
favorable to the institution or subsidiary, as those provided to a
non-affiliate. The term "covered transaction" includes the making of loans,
purchase of assets, issuance of a guarantee and other similar types of
transactions.
REGULATION OF MANAGEMENT
Federal law (1) sets forth the circumstances under which officers or
directors of a financial institution may be removed by the institution's federal
supervisory agency; (2) places restraints on lending by an institution to its
executive officers, directors, principal stockholders, and their related
interests; and (3) prohibits management personnel from serving as a director or
in other management positions with another financial institution which has
assets exceeding a specified amount or which has an office within a specified
geographic area.
TIE-IN ARRANGEMENTS
The Company and the Bank cannot engage in certain tie-in arrangements in
connection with any extension of credit, sale or lease of property or furnishing
of services. For example, with certain exceptions, neither the Company nor the
Bank may condition an extension of credit to a customer on either (1) a
requirement that the customer obtain additional services provided by it or (2)
an agreement by the customer to refrain from obtaining other services from a
competitor.
The Federal Reserve has adopted amendments to its anti-tying rules that:
(1) removed Federal Reserve-imposed anti-tying restrictions on bank holding
companies and their non-bank subsidiaries; (2) allow banks greater flexibility
to package products with their affiliates; and (3) establish a safe harbor from
the tying restrictions for certain foreign transactions. These amendments were
designed to enhance competition
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in banking and nonbanking products and to allow banks and their affiliates to
provide more efficient, lower cost services to their customers.
SOURCE OF STRENGTH REQUIREMENTS
Under Federal Reserve policy, the Company is expected to act as a source of
financial and managerial strength to the Bank. This means that the Company is
required to commit, as necessary, resources to support the Bank. Any capital
loans made by the Company to the Bank would be subordinate in priority to
deposits and to certain other indebtedness of the Bank.
STATE LAW RESTRICTIONS
As a Washington business corporation, the Company may be subject to certain
limitations and restrictions as provided under applicable Washington corporate
law. In addition, Washington banking law restricts and governs certain
activities of the Bank.
THE BANK
GENERAL
The Bank, as an FDIC insured institution, is subject to regulation and
examination by the FDIC and the State of Washington. The federal laws that apply
to the Bank regulate, among other things, the scope of its business, its
investments, its reserves against deposits, the timing of the availability of
deposited funds and the nature and amount of and collateral for loans.
CRA. The Community Reinvestment Act (the "CRA") requires that, in
connection with examinations of financial institutions within their
jurisdiction, the FDIC evaluate the record of the financial institutions in
meeting the credit needs of their local communities, including low and moderate
income neighborhoods, consistent with the safe and sound operation of those
banks. These factors are also considered in evaluating mergers, acquisitions,
and applications to open a branch or facility. In connection with the FDIC's
assessment of the record of financial institutions under the CRA, it assigns a
rating of either, "outstanding," "satisfactory," "needs to improve," or
"substantial noncompliance" following an examination. The Bank received a CRA
rating of "outstanding" during its most recent examination.
INSIDER CREDIT TRANSACTIONS. Banks are also subject to certain restrictions
imposed by the Federal Reserve Act on extensions of credit to executive
officers, directors, principal shareholders, or any related interests of such
persons. Extensions of credit (i) must be made on substantially the same terms,
including interest rates and collateral, and follow credit underwriting
procedures that are not less stringent than those prevailing at the time for
comparable transactions with persons not covered above and who are not employees
and (ii) must not involve more than the normal risk of repayment or present
other unfavorable features. Banks are also subject to certain lending limits and
restrictions on overdrafts to such persons. A violation of these restrictions
may result in the assessment of substantial civil monetary penalties on the
affected bank or any officer, director, employee, agent, or other person
participating in the conduct of the affairs of that bank, the imposition of a
cease and desist order, and other regulatory sanctions.
FDICIA. Under the Federal Deposit Insurance Corporation Improvement Act of
1991 ("FDICIA"), each federal banking agency has prescribed, by regulation,
noncapital safety and soundness standards for institutions under its authority.
These standards cover internal controls, information systems, and internal audit
systems, loan documentation, credit underwriting, interest rate exposure, asset
growth, compensation, fees and benefits, such other operational and managerial
standards as the agency
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determines to be appropriate, and standards for asset quality, earnings and
stock valuation. An institution which fails to meet these standards must develop
a plan acceptable to the agency, specifying the steps that the institution will
take to meet the standards. Failure to submit or implement such a plan may
subject the institution to regulatory sanctions. Management believes that the
Bank meets all such standards, and therefore, does not believe that these
regulatory standards will materially affect the Company's business operations.
INTERSTATE BANKING AND BRANCHING
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994
(the "Interstate Act") permits nationwide interstate banking and branching under
certain circumstances. This legislation generally authorizes interstate
branching and relaxes federal law restrictions on interstate banking. Currently,
bank holding companies may purchase banks in any state, and states may not
prohibit such purchases. Additionally, banks are permitted to merge with banks
in other states as long as the home state of neither merging bank has "opted
out." The Interstate Act requires regulators to consult with community
organizations before permitting an interstate institution to close a branch in a
low-income area.
With regard to interstate bank mergers, Washington has "opted in" to the
Interstate Act and allows in-state banks to merge with out-of-state banks
subject to certain aging requirements. Washington law generally authorizes the
acquisition of an in-state bank by an out-of-state bank through merger with a
Washington financial institution that has been in existence for at least 5 years
prior to the acquisition. With regard to interstate bank branching, out-of-state
banks that do not already operate a branch in Washington may not establish de
novo branches in Washington or establish and operate a branch by acquiring a
branch in Washington. Under FDIC regulations, banks are prohibited from using
their interstate branches primarily for deposit production. The FDIC has
accordingly implemented a loan-to-deposit ratio screen to ensure compliance with
this prohibition.
DEPOSIT INSURANCE
The deposits of the Bank are currently insured to a maximum of $100,000 per
depositor through the Bank Insurance Fund ("BIF") administered by the FDIC. All
insured banks are required to pay semi-annual deposit insurance premium
assessments to the FDIC.
FDICIA included provisions to reform the Federal deposit insurance system,
including the implementation of risk-based deposit insurance premiums. FDICIA
also permits the FDIC to make special assessments on insured depository
institutions in amounts determined by the FDIC to be necessary to give it
adequate assessment income to repay amounts borrowed from the U.S. Treasury and
other sources, or for any other purpose the FDIC deems necessary. The FDIC has
implemented a risk-based insurance premium system under which banks are assessed
insurance premiums based on how much risk they present to the BIF. Banks with
higher levels of capital and a low degree of supervisory concern are assessed
lower premiums than banks with lower levels of capital or a higher degree of
supervisory concern. The FDIC has indicated that deposit premiums will likely
increase in 2003.
DIVIDENDS
The principal source of the Company's cash revenues is dividends received
from the Bank. The payment of dividends is subject to government regulation, in
that regulatory authorities may prohibit banks and bank holding companies from
paying dividends in a manner that would constitute an unsafe or unsound banking
practice. In addition, a bank may not pay cash dividends if that payment could
reduce the amount of its capital below that necessary to meet minimum applicable
regulatory capital
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requirements. Other than the laws and regulations noted above, which apply to
all banks and bank holding companies, neither the Company nor the Bank are
currently subject to any regulatory restrictions on their dividends. Under
applicable restrictions, as of December 31, 2002, the Bank could declare
dividends totaling $3,955,000 without obtaining prior regulatory approval.
CAPITAL ADEQUACY
Federal bank regulatory agencies use capital adequacy guidelines in the
examination and regulation of bank holding companies and banks. If capital falls
below minimum guideline levels, the holding company or bank may be denied
approval to acquire or establish additional banks or non-bank businesses or to
open new facilities.
The FDIC and Federal Reserve use risk-based capital guidelines for banks
and bank holding companies. These are designed to make such capital requirements
more sensitive to differences in risk profiles among banks and bank holding
companies, to account for off-balance sheet exposure and to minimize
disincentives for holding liquid assets. Assets and off-balance sheet items are
assigned to broad risk categories, each with appropriate weights. The resulting
capital ratios represent capital as a percentage of total risk-weighted assets
and off-balance sheet items. The guidelines are minimums, and the Federal
Reserve has noted that bank holding companies contemplating significant
expansion programs should not allow expansion to diminish their capital ratios
and should maintain ratios well in excess of the minimum. The current guidelines
require all bank holding companies and federally-regulated banks to maintain a
minimum risk-based total capital ratio equal to 8%, of which at least 4% must be
Tier I capital. Tier I capital for bank holding companies includes common
shareholders' equity, certain qualifying perpetual preferred stock and minority
interests in equity accounts of consolidated subsidiaries, less intangibles
except as described above and accumulated other comprehensive income (loss).
The Federal Reserve also employs a leverage ratio, which is Tier I capital
as a percentage of total assets less intangibles, to be used as a supplement to
risk-based guidelines. The principal objective of the leverage ratio is to
constrain the maximum degree to which a bank holding company may leverage its
equity capital base. The Federal Reserve requires a minimum leverage ratio of
3%. However, for all but the most highly rated bank holding companies and for
bank holding companies seeking to expand, the Federal Reserve expects an
additional cushion of at least 1% to 2%.
FDICIA created a statutory framework of supervisory actions indexed to the
capital level of the individual institution. Under regulations adopted by the
FDIC, an institution is assigned to one of five capital categories depending on
its total risk-based capital ratio, Tier I risk-based capital ratio, and
leverage ratio, together with certain subjective factors. Institutions which are
deemed to be "undercapitalized" depending on the category to which they are
assigned are subject to certain mandatory supervisory corrective actions. The
Company does not believe that these regulations have any material effect on its
operations.
EFFECTS OF GOVERNMENT MONETARY POLICY
The earnings and growth of the Company are affected not only by general
economic conditions, but also by the fiscal and monetary policies of the federal
government, particularly the Federal Reserve. The Federal Reserve can and does
implement national monetary policy for such purposes as curbing inflation and
combating recession, but its open market operations in U.S. government
securities, control of the discount rate applicable to borrowings from the
Federal Reserve, and establishment of reserve requirements against certain
deposits, influence the growth of bank loans, investments and deposits, and also
affect interest rates charged on loans or paid on deposits. The nature and
impact of future changes in monetary policies and their impact on the Company
and the Bank cannot be predicted with certainty.
-13-
ITEM 2. PROPERTIES
The Company's administrative offices are located in Aberdeen, Washington. The
building located at 300 East Market Street is owned by the Bank and houses the
main branch and the administrative and operations offices of the Bank and the
Company. The Bank completed construction and occupied the building in December
of 1979. There are nine branches in addition to the main office owned by
Pacific.
Pacific owns the building and land occupied by its Hoquiam, Ocean Shores,
Pacific Beach, and Montesano branches. Pacific also owns the land and building
located at 1007 South Pacific Highway, Long Beach, Washington, which houses the
Long Beach branch and the data processing operations of Pacific. Pacific owns
the land and buildings occupied by the Ocean Park, Ilwaco, Naselle, and
Cathlamet offices.
In addition to the land and buildings owned by Pacific, it also owns all of its
furniture, fixtures and equipment including data processing equipment. At
December 31, 2002, the net book value of the Company's premises and equipment
was $3.8 million.
ITEM 3. LEGAL PROCEEDINGS
The Company and the Bank from time to time are party to various legal
proceedings arising in the ordinary course of their business. Management
believes that there are no threatened or pending proceedings against the Company
or the Bank which, if determined adversely, would have a material effect on its
business or financial position.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders in the fourth quarter of
2002.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
No broker makes a market in the Company's common stock, and trading has not
otherwise been extensive. The trades that have occurred cannot be characterized
as amounting to an established public trading market. The Company's common stock
is traded by individuals on a personal basis and is not listed on any exchange
or traded on the over-the-counter market, and the prices reported reflect only
the transactions known to Company management. Because only limited information
is available, the following data may not accurately reflect the actual market
value of the Company's common stock. The following data includes trades between
individual investors, as reported to the Company as its own transfer agent.
2002 2001
Shares Traded High Low Shares Traded High Low
First Quarter 7,399 $ 25 $ 23 5,012 $ 25 $ 23
Second Quarter 9,265 $ 24 $ 22 12,341 $ 25 $ 21
Third Quarter 36,554 $ 24 $ 21 27,166 $ 24 $ 23
Fourth Quarter 10,106 $ 25 $ 24 7,691 $ 25 $ 23
-14-
As of December 31, 2002, there were approximately 1,024 stockholders of record
of the Company's common stock.
The Company's Board of Directors declared dividends on its common stock in
December 2002 and 2001 in the amounts per share of $1.35 and $1.32,
respectively. The Board of Directors has adopted a dividend policy which is
reviewed annually.
Payment of dividends is subject to regulatory limitations. Under federal banking
law, the payment of dividends by the Company and the Bank is subject to capital
adequacy requirements established by the Federal Reserve and the FDIC. Under
Washington general corporate law as it applies to the Company, no cash dividend
may be declared or paid if, after giving effect to the dividend, the Company is
insolvent or its liabilities exceed its assets. Payment of dividends on the
Common Stock is also affected by statutory limitations, which restrict the
ability of the Bank to pay upstream dividends to the Company. Under Washington
banking law as it applies to the Bank, no dividend may be declared or paid in an
amount greater than net profits then available, and after a portion of such net
profits have been added to the surplus funds of the Bank.
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth certain selected consolidated financial data of
the Company at and for the years ended December 31:
2002 2001 2000 1999 1998
-------------------------------------------------------------------
($ in thousands, except per share data)
OPERATIONS DATA
Net interest income $ 11,788 $ 11,572 $ 11,675 $ 11,430 $ 11,100
Provision for credit losses 954 580 635 60 110
Noninterest income 2,059 1,529 1,217 1,255 1,281
Noninterest expense 7,414 7,193 7,530 7,011 6,687
Provision for income taxes 1,563 1,521 1,424 1,692 1,590
Net income 3,916 3,807 3,303 3,922 3,994
Net income per share:
Basic 1.57 1.53 1.33 1.60(1) 1.64(1)
Diluted 1.56 1.52 1.31 1.59(1) 1.61(1)
Dividends declared 3,392 3,289 3,204 3,105 2,379
Dividends declared per share 1.35 1.32 1.28 1.25(1) .97(1)
Dividends paid ratio 87% 86% 97% 79% 60%
(1) Restated to reflect the 5 for 1 stock split effected in July 2000.
PERFORMANCE RATIOS
Net interest margin 5.05% 5.16% 5.14% 5.10% 5.37%
Efficiency ratio 53.54% 54.90% 58.41% 55.27% 54.01%
Return on average assets 1.54% 1.55% 1.34% 1.64% 1.80%
Return on average equity 15.81% 15.57% 14.95% 17.26% 18.57%
BALANCE SHEET DATA
Total assets $ 268,534 243,617 253,313 242,189 236,364
Loans, net 183,031 174,495 175,142 150,734 145,416
Total deposits 225,254 214,644 213,511 206,139 210,650
Other borrowings 12,800 -0- 11,358 9,675 86
-15-
Shareholders' equity 24,683 23,514 22,743 21,438 21,485
Book value per share 9.82 9.44 9.09 8.63(1) 8.79(1)
Equity to assets ratio 9.19% 9.65% 8.98% 8.85% 9.09%
(1) Restated to reflect the 5 for 1 stock split effected in July 2000.
ASSET QUALITY RATIOS
Nonperforming loans to total loans 1.00% .71% 1.93% 0.21% 0.01%
Allowance for loan losses
to total loans 1.33% 1.19% 1.14% 1.26% 1.27%
Allowance for loan losses
to nonperforming loans 132.67% 168.18% 59.24% 612.69% 12426.67%
Nonperforming assets to
total assets .69% .51% 1.35% 0.13% 0.06%
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RESULTS OF OPERATIONS
Years ended December 31, 2002, 2001, and 2000
General. The Company's net income for 2002 was $3,916,000, a 2.9% increase
compared to $3,807,000 in 2001, and an increase of 18.6% from $3,303,000 in
2000. Basic earnings per share were $1.57, $1.53, and $1.33 for 2002, 2001, and
2000, respectively. Return on average assets was 1.54%, 1.55%, and 1.34% in
2002, 2001, and 2000 respectively. Return on average equity was 15.81%, 15.57%,
and 14.95%, respectively, in 2002, 2001, and 2000.
The following table presents condensed consolidated statements of income for the
Company for each of the years in the three-year period ended December 31, 2002.
Increase Increase
(Decrease) (Decrease)
(Dollars in thousands) 2002 Amount % 2001 Amount % 2000
---------------------------------------------------------------------------------------------------------------------------
Interest income $ 15,779 $(2,323) (12.8) $18,102 $(2,170) (10.7) $20,272
Interest expense 3,991 (2,539) (38.9) 6,530 (2,067) (24.0) 8,597
Net interest income 11,788 216 1.9 11,572 (103) (.9) 11,675
Provision for credit losses 954 374 64.5 580 (55) (8.7) 635
Net interest income after
provision for credit losses 10,834 (158) (1.4) 10,992 (48) (.4) 11,040
Other operating income 2,059 530 34.7 1,529 312 25.6 1,217
Other operating expense 7,414 221 3.1 7,193 (337) (4.5) 7,530
Income before income taxes 5,479 151 2.8 5,328 601 12.7 4,727
Income taxes 1,563 42 2.8 1,521 97 6.8 1,424
Net income 3,916 109 2.9 3,807 504 15.3 3,303
NET INTEREST INCOME. The Company derives the majority of its earnings from net
interest income, which is the difference between interest income earned on
interest earning assets and interest expense incurred on interest bearing
liabilities. The following table sets forth information with regard to average
balances of the interest earning assets and interest bearing liabilities and the
resultant yields or cost, net interest income, and the net interest margin.
-16-
Year Ended December 31,
2002 2001 2000
---- ---- ----
Interest Interest Interest
Average Income Avg Average Income Avg Average Income Avg
Balance (Expense) Rate Balance (Expense) Rate Balance (Expense) Rate
------- -------------- ------- --------- ---- ------- --------- ----
Assets (dollars in thousands)
Earning assets:
Loans $ 178,765 $ 13,212* 6.95% $170,628 $ 15,032* 8.81% $165,834 $ 16,500* 9.95%
Investment Securities:
Taxable 32,991 1,541 4.67% 27,360 1,638 5.99% 45,857 2,812 6.13%
Tax-Exempt 14,510 1,165* 8.03% 15,042 1,225* 8.14% 13,187 1,007* 7.64%
Total investment
securities 47,501 2,706 5.70% 42,402 2,863 6.75% 59,044 3,819 6.47%
Federal Home Loan Bank Stock 3,102 186 6.01% 3,657 251 6.86% 3,450 223 6.43%
Federal funds sold and
deposits in banks 5,644 107 1.90% 11,339 410 3.61% 2,258 148 6.55%
Total earning assets/interest
income $ 235,013 $ 16,211 6.90% $228,026 $ 18,556 8.14% $230,586 $ 20,690 8.97%
Cash and due from banks 8,331 8,448 8,599
Bank premises and equipment
(net) 3,930 4,104 3,728
Other assets 9,552 6,822 5,447
Allowance for credit losses (2,515) (1,912) (1,997)
Total assets $254,310 $245,488 $246,548
Liabilities and Shareholders' Equity
Interest bearing liabilities:
Deposits:
Savings and interest-
bearing demand $104,111 $ (1,080) 1.04% $105,846 $ (2,395) 2.26% $109,266 $ (4,483) 4.10%
Time 79,664 (2,667) 3.35% 75,819 (3,945) 5.20% 68,516 (3,537) 5.16%
Total deposits 183,775 (3,747) 2.04% 181,665 (6,340) 3.49% 177,782 (8,020) 4.51%
Short-term borrowings 174 (4) 2.48% 3,065 (190) 6.20% 8,876 (577) 6.50%
Long-term borrowings 6,548 (240) 3.67% ---- ---- ---- ---- ---- ----
Total interest-bearing liabilities/
Interest expense $190,497 $ (3,991) 2.10% $184,730 $ (6,530) 3.53% $186,658 $ (8,597) 4.61%
Demand deposits 36,180 33,419 34,343
Other liabilities 2,867 2,888 3,457
Shareholders' equity 24,766 24,451 22,090
Total liabilities and shareholders'
equity $254,310 $245,488 $239,513
Net interest income $ 12,220* $ 12,026* $ 12,093*
Net interest income as a percentage of
average earning assets
Interest income 6.90% 8.14% 8.97%
Interest expense 1.72% 2.86% 3.73%
Net interest income 5.18% 5.28% 5.24%
* Tax equivalent basis - 34% tax rate used
Nonaccrual loans are included in "loans."
Interest income on loans include loan fees of $778,605, $708,270, and $822,516
in 2002, 2001, and 2000, respectively.
For purposes of computing the average yield, the Company used historical cost
balances which do not give effect to changes in fair value that are reflected as
a component of shareholders' equity.
Net interest income increased 1.9% to $11,788,000 in 2002 compared to 2001. The
increase is primarily the result of a decreased interest rate environment. The
Company's interest income decreased 12.8% to $15,779,000 in 2002 from
$18,102,000 in 2001. This decrease, also due to declining interest rates, was
-17-
substantially offset by a 38.9% decrease in interest expense from $6,530,000 in
2001 to $3,991,000 in 2002. Net interest income decreased .9% to $11,572,000 in
2001 compared to 2000. The decrease is also primarily the result of a decreased
interest rate environment. The Company's interest income decreased 10.7% to
$18,102,000 in 2001 from $20,272,000 in 2000. This decrease, also due to
decreasing interest rates, was substantially offset by a 24% decrease in
interest expense from $8,597,000 in 2000 to $6,530,000 in 2001.
The Company's average loan portfolio increased $8,137,000, or 4.8%, from 2001,
and increased $4,794,000 or 2.9% in 2001 from 2000. A large portion of the
Company's loan portfolio rates are tied to variable rate indexes. Given the
unprecedented drop in rates experienced in 2001 and the 50 basis point drop in
prime rate in 2002, the decrease in rates overshadowed the growth in the
portfolio, causing a decline in interest income earned.
The Company's average investment portfolio increased $5,099,000 or 12% from
2001. These investments, along with the proceeds from long-term borrowings
during the third quarter of 2002, were invested in various long-term investment
products. This resulted in an increase in earnings on the investment portfolio
due to the change in yield earned on long-term products versus short-term
products. The Company's average investment portfolio decreased $16,642,000, or
28.2% during 2001 from 2000. The changes in 2001 were primarily in U.S.
Government agency securities due to call options being exercised by the issuers.
Proceeds from the portfolio decrease were used to decrease short term borrowings
during 2001.
The Company's average deposits increased $2,110,000 or 1.2% from 2001, and
increased $3,883,000 or 2.2% in 2001 from 2000. Along with the increase in
average deposits, the Company was able to reprice its deposit offerings to
current market rates more quickly than loans repriced, yielding a decrease in
interest expense.
The Company increased its average borrowings during 2002 by $3,657,000 or
119.3%. These borrowings consist of advances from the Federal Home Loan Bank of
Seattle. The proceeds were used to fund loan growth and for investment purposes.
The Company decreased its average borrowings during 2001 by $5,811,000 or 65.5%.
Net interest margins were 5.05%, 5.16%, and 5.14% for the years ended December
31, 2002, 2001, and 2000, respectively.
The following table presents changes in net interest income attributable to
changes in volume or rate. Changes not solely due to volume or rate are
allocated to volume and rate based on the absolute values of each.
2002 compared to 2001 2001 compared to 2000
Increase (decrease) due to Increase (decrease) due to
(dollars in thousands) Volume Rate Net Volume Rate Net
------ ---- --- ------ ---- ---
Interest earned on:
Loans $690 $(2,510) $(1,820) $466 $(1,934) $(1,468)
Securities:
Taxable 301 (398) (97) (1,109) (65) (1,174)
Tax-exempt (43) (17) (60) 148 70 218
Total securities 258 (415) (157) (961) 5 (956)
Federal Home Loan Bank Stock (35) (30) (65) 14 15 29
-18-
Fed funds sold and
interest bearing deposits
in other banks (156) (147) (303) 354 (93) 261
Total interest earning assets 757 (3,102) (2,345) (127) (2,007) (2,134)
Interest paid on:
Savings and interest bearing
demand deposits 39 1,276 1,315 (136) (1,952) (2,088)
Time deposits (191) 1,469 1,278 380 28 408
Other borrowings (157) 103 (54) (362) (25) (387)
Total interest bearing liabilities (309) 2,848 2,539 (118) (1,949) (2,067)
Change in net interest income 448 (254) (194) (9) (58) (67)
Non-Interest Income. Non-interest income was $2,059,000 for 2002, an increase of
$530,000 or 34.7% from 2001 when it totaled $1,529,000. The 2001 amount was an
increase of $312,000 or 25.6% compared to the 2000 total of $1,217,000.
In 2002, service charges on deposit accounts increased $241,000 or 29.1% to a
total of $1,069,000 compared to $828,000 in 2001. The 2001 total was up $151,000
or 22.3% compared to the 2000 total of $677,000. During the second half of 2001,
a new customer overdraft protection program was implemented which contributed to
the increase in service charges on deposit accounts during both 2001 and 2002.
Income from sources other than service charges on deposit accounts totaled
$987,000 in 2002, an increase of $318,000 from 2001, or 47.4%. The primary
reason for the increase was income from foreclosed real estate, which totaled
$132,000. In addition, during 2002, the Bank sold two parcels of foreclosed real
estate and realized a profit on sale of $160,000. The properties consisted of a
motel and a medical care facility. Other major components of non-interest income
were credit card income and bank owned life insurance income. Additional bank
owned life insurance was purchased during fourth quarter 2001 which resulted in
higher earnings during 2002. Income from other sources for 2001 was $669,000, an
increase of $138,000 or 26% compared to 2000, primarily due to collecting
operating revenues from a motel that was brought into foreclosed real estate.
The following table represents the principal categories of non-interest income
for each of the years in the three-year period ended December 31, 2002.
Increase Increase
(Decrease) (Decrease)
(Dollars in thousands) 2002 Amount % 2001 Amount % 2000
---------------------------------------------------------------------------------------------------------------------------
Service charges on
deposit accounts $1,069 $241 29.1% $828 $151 22.3% $677
Mortgage broker fees 3 (29) (90.6)% 32 23 255.0% 9
Net gain on sale of securities --- --- --- --- --- --- ---
Other operating income 987 318 47.5% 669 138 26.0% 531
Total non-interest income 2,059 530 34.7% 1,529 312 25.6% 1,217
Non-Interest Expense. Total non-interest expense was $7,414,000, an increase of
$221,000 or 3.1% compared to $7,193,000 in 2001. In 2001 non-interest expense
decreased $337,000 or 4.5% compared to $7,530,000 in 2000.
Salary and employee benefits increased by $138,000, or 3.4%, in 2002 to
$4,196,000 and decreased by $77,000, or 1.9%, in 2001. The increase in 2002 was
primarily due to addition of staff and normal merit
-19-
increases. The primary reason for the decrease in 2001 was the retirement of the
Company's Chief Executive Officer, Robert Worrell.
Occupancy and equipment expense increased $21,000 or 2.2% in 2002 and decreased
$176,000 or 15.5% in 2001. The increase in 2002 was due to costs associated with
maintenance of buildings, equipment, utilities and property taxes. The 2001
decrease was the result of a decline in equipment maintenance expense and
reduced equipment depreciation expense.
Other expense increased $62,000 or 2.9% in 2002 compared to a decrease of
$84,000 or 3.7% in 2001 over 2000. The increase in 2002 is due to an increase in
advertising expense of $30,000, professional fees of $35,000 and data processing
cost of $47,000, which offset decreases in legal expense of $33,000, travel
expenses $10,000 and loan collection expense of $22,000. The decrease in 2001 is
related primarily to lower advertising expense of $20,000, non-recurring
deferred director fees of $160,000 paid in 2000, decreased insurance expense of
$26,000 and an increase in foreclosed real estate expenses of $127,000 primarily
due to the operations of a motel.
The following table represents the principal categories of non-interest expense
for each of the years in the three-year period ended December 31, 2002.
Increase Increase
(Decrease) (Decrease)
(Dollars in thousands) 2002 Amount % 2001 Amount % 2000
---------------------------------------------------------------------------------------------------------------------------
Salaries and employee benefits $ 4,196 $ 138 3.4% $4,058 $ (77) (1.9%) $4,135
Occupancy and equipment 984 21 2.2% 963 (176) (15.5%) 1,139
Other expense 2,234 62 2.9% 2,172 (84) (3.7%) 2,256
Total non-interest expense $ 7,414 $ 221 3.1% $7,193 $ (337) (4.5%) $7,530
CRITICAL ACCOUNTING POLICY:
The Company's consolidated financial statements are prepared in accordance with
accounting principles generally accepted in the United States of America. The
financial information contained within these statements is, to a significant
extent, financial information that is based on approximate measures of the
financial effects of transactions and events that have already occurred. Based
on its evaluation of accounting policies that involve the most complex and
subjective decisions and assessments, management has identified its most
critical accounting policy as related to the allowance for loan losses. The
Company's allowance for credit loss methodology incorporates a variety of risk
considerations, both quantitative and qualitative, in establishing an allowance
for loan losses that management believes is appropriate at each reporting date.
Quantitative factors include the Company's historical loss experience,
delinquency and charge-off trends, collateral values, changes in nonperforming
loans, and other factors. Quantitative factors also incorporate known
information about individual loans, including borrowers' sensitivity to interest
rate movements. Qualitative factors include the general economic environment in
the Company's markets, including economic conditions and, in particular, the
state of certain industries. Size and complexity of individual credits in
relation to loan structure, existing loan policies and pace of portfolio growth
are other qualitative factors that are considered in the methodology. As the
Company adds new products and increases the complexity of its loan portfolio, it
intends to enhance its methodology accordingly. A materially different amount
could be reported for the provision for loan losses in the statement of
operations to change the allowance for loan losses if management's assessment of
the above factors were different. This discussion and analysis should be read in
conjunction with the Company's financial statements and the accompanying notes
presented elsewhere herein, as well as the portion of this Management's
Discussion and Analysis section entitled "Lending - Allowance and
-20-
Provision for Credit Losses". Although management believes the levels of the
allowance as of both December 31, 2002 and 2001 were adequate to absorb losses
inherent in the loan portfolio, a decline in local economic conditions, or other
factors, could result in increasing losses that cannot reasonably be predicted
at this time.
ASSET AND LIABILITY MANAGEMENT
The largest component of the Company's earnings is net interest income. Interest
income and interest expense are affected by general economic conditions,
competition in the market place, market interest rates and repricing and
maturity characteristics of the Company's assets and liabilities. Exposure to
interest rate risk is primarily a function of differences between the maturity
and repricing schedules of assets (principally loans and investment securities)
and liabilities (principally deposits). Assets and liabilities are described as
interest sensitive for a given period of time when they mature or can reprice
within that period. The difference between the amount of interest sensitive
assets and interest sensitive liabilities is referred to as the interest
sensitive "GAP" for any given period. The "GAP" may be either positive or
negative. If positive, more assets reprice than liabilities. If negative, the
reverse is true.
Certain shortcomings are inherent in the interest sensitivity "GAP" method of
analysis. Complexities such as prepayment risk and customer responses to
interest rate changes are not taken into account in the "GAP" analysis.
Accordingly, management also utilizes a net interest income simulation model to
measure interest rate sensitivity. Simulation modeling gives a broader view of
net interest income variability, by providing various rate shock exposure
estimates. Management regularly reviews the interest rate risk position and
provides measurement reports to the Board of Directors.
The following table shows the dollar amount of interest sensitive assets and
interest sensitive liabilities at December 31, 2002 and differences between them
for the maturity or repricing periods indicated.
Due after
Due in one one through Due after
(dollars in thousands) year or less five years five years Total
------------------------------------------------------------------------------------------------------------------------
Interest earning assets
Loans $ 70,081 $ 45,383 $ 70,326 $ 185,790
Investment securities 23,856 18,445 20,291 62,592
Fed Funds and interest
bearing balances with banks 373 -0- -0- 373
Federal Home Loan Bank Stock -0- -0- 866 866
Total interest earning assets $ 94,310 $ 63,828 $ 91,483 $ 249,621
Interest bearing liabilities
Interest bearing demand deposits $ 31,030 $ -0- $ -0- $ 31,030
Savings deposits 72,163 -0- -0- 72,163
Time deposits 71,441 10,536 -0- 81,977
Short term borrowings 1,800 -0- -0- 1,800
Long term borrowings ---- 5,000 6,000 11,000
Total interest bearing liabilities $ 176,434 $ 15,536 $ 6,000 $ 197,970
Net interest rate sensitivity GAP $ (82,124) $ 48,292 $ 85,483 $ 51,651
Cumulative interest rate sensitivity GAP $ (33,832) $ 51,651 51,651
Cumulative interest rate sensitivity GAP
as a % of earning assets (13.6%) 20.7% 20.7%
-21-
The following table shows the dollar amount of interest sensitive assets and
interest sensitive liabilities at December 31, 2001 and difference between them
for the maturity or repricing periods indicated.
Due after
Due in one one through Due after
(dollars in thousands) year or less five years five years Total
------------------------------------------------------------------------------------------------------------------------
Interest earning assets
Loans $ 88,042 $ 34,490 $ 54,072 $ 176,604
Investment securities 12,820 14,358 9,440 36,618
Fed Funds and interest
bearing balances with banks 4,973 -0- -0- 4,973
Federal Home Loan Bank Stock -0- -0- 3,813 3,813
Total interest earning assets $ 105,835 $ 48,848 $ 67,325 $ 222,008
Interest bearing liabilities
Interest bearing demand deposits $ 27,120 $ -0- $ -0- $ 27,120
Savings deposits 77,608 -0- -0- 77,608
Time deposits 59,037 12,442 -0- 71,479
Short term borrowings -0- -0- -0- -0-
Total interest bearing liabilities $ 163,765 $ 12,442 $ -0- $ 176,207
Net interest rate sensitivity GAP $ (57,930) $ 36,406 $ 67,325 $ 45,801
Cumulative interest rate sensitivity GAP $ (21,524) $ 45,801 $ 45,801
Cumulative interest rate sensitivity GAP
as a % of earning assets (9.7%) 20.6% 20.6%
Effects of Changing Prices. The results of operations and financial conditions
presented in this report are based on historical cost information, and are
unadjusted for the effects of inflation. Since the assets and liabilities of
financial institutions are primarily monetary in nature, the performance of the
Company is affected more by changes in interest rates than by inflation.
Interest rates generally increase as the rate of inflation increases, but the
magnitude of the change in rates may not be the same.
The effects of inflation on financial institutions is normally not as
significant as its influence on businesses which have investments in plants and
inventories. During periods of high inflation there are normally corresponding
increases in the money supply, and financial institutions will normally
experience above-average growth in assets, loans and deposits. Inflation does
increase the price of goods and services, and therefore operating expenses
increase during inflationary periods.
INVESTMENT PORTFOLIO
The Company's investment securities portfolio increased $25,974,000, or 70.9%
during 2002 to $62,592,000 at year end from $36,618,000 in 2001, which was a
$18,454,000 decrease over 2000. The changes in 2002 were primarily in U.S.
Government agency mortgaged backed securities and in other securities which grew
primarily in short term mutual fund securities. Based on the low interest rate
environment during 2002, the Bank borrowed long term funds from the Federal Home
Loan Bank of Seattle totaling $7,000,000 and purchased U.S. Government agency
mortgage backed securities. The transaction resulted in a yield spread of 195
basis points.
The carrying values of investment securities at December 31 in each of the last
-22-
three years are as follows:
(dollars in thousands) 2002 2001 2000
-----------------------------------------------------------------------------------------------------------------------
Treasury securities $ -0- $ -0- $ 500
U.S. Agencies securities 25,775 6,872 27,613
Obligations of states and political subdivisions 15,849 16,658 13,554
Other securities 20,968 13,088 13,405
Total $ 62,592 $ 36,618 $55,072
The following table presents the maturities of investment securities at December
31, 2002. Taxable equivalent values are used in calculating yields assuming a
tax rate of 34%.
Due after Due after
Due in one one through five through Due after
(dollars in thousands) year or less five years ten years ten years Total
------------------------------------------------------------------------------------------------------------------------------
U.S. Agency securities $ 4,527 $ 1,684 $ 5,871 $ 13,693 $ 25,775
Weighted average yield 4.64% 6.29% 3.74% 4.75%
Obligations of states and political
subdivisions 896 7,818 4,395 2,740 15,849
Weighted average yield 6.30% 6.15% 6.58% 6.60%
Other securities 18,371 2,597 -0- -0- 20,968
Weighted average yield 3.40% 6.22% -0- -0-
Total $ 23,794 $ 12,099 $ 10,266 $ 16,433 $ 62,592
LENDING
General. The Company's policy is to originate loans primarily in its local
markets. Depending on the purpose of the loan, the loans may be secured by a
variety of collateral, including business assets, real estate, and personal
assets.
The following table sets forth the composition of the Company's loan portfolio
at December 31 in each of the past five years.
(dollars in thousands) 2002 2001 2000 1999 1998
---------------------------------------------------------------------------------------------------------------------------
Commercial $ 69,794 $ 72,427 $ 68,827 $ 56,198 $ 48,455
Real Estate Construction 9,697 6,554 6,118 3,325 4,929
Real Estate Mortgage 101,151 91,714 96,334 88,905 90,027
Installment 4,114 4,941 4,612 3,379 3,104
Credit cards and overdrafts 1,034 968 1,277 857 764
Total $185,790 $ 176,604 $ 177,168 $ 152,664 $147,280
Loan Maturities and Sensitivity in Interest Rates. The following table presents
information related to maturity distribution and interest rate sensitivity of
commercial and real estate construction loans outstanding, based on scheduled
repayments at December 31, 2002.
-23-
Due after
Due in one one through Due after
(dollars in thousands) year or less five years five years Total
------------------------------------------------------------------------------------------------------------------------
Commercial $ 39,141 $ 18,648 $ 12,005 $ 69,794
Real estate construction 5,596 915 3,186 9,697
Total $ 44,737 $ 19,563 $ 15,191 $ 79,491
Total loans maturing after one year with
Predetermined interest rates (fixed) $ 37,290 $ 76,008 $ 113,298
Floating or adjustable rates (variable) 9,897 511 10,408
Total $ 47,187 $ 76,519 $ 123,706
At December 31, 2002, 37.7% of the loan portfolio presented above was due in one
year or less.
Risk Elements. Risk elements include accruing loans past due ninety days or
more, non-accrual loans, and loans which have been restructured to provide
reduction or deferral of interest or principal for reasons related to the
debtor's financial difficulties. The Company's policy for placing loans on
non-accrual status is based upon management's evaluation of the ability of the
borrower to meet both principal and interest payments as they become due.
Generally, loans with interest or principal payments which are ninety or more
days past due are placed on non-accrual, unless they are well-secured and in the
process of collection, and the interest accrual is reversed against income.
The following table presents information related to the Company's non-accrual
loans and other non-performing assets at December 31 in each of the last five
years.
(dollars in thousands) 2002 2001 2000 1999 1998
-------------------------------------------------------------------------------------------------------------------------
Non-accrual loans $ 1,864 $ 1,254 $ 3,128 $ 175 $ 15
Accruing loans past due
90 days or more 2 79 292 140 4
Restructured loans 0 0 0 0 0
Foreclosed real estate owned 686 1,040 ---- 177 ----
Non-accrual loans increased approximately $610,000 to $1,864,000 in 2002 from
2001. The total is net of charge-offs based on management's estimate of fair
market value or the result of appraisals. The properties consist of real estate
and commercial real estate properties. During 2002, sales of foreclosed real
estate owned totaled $1,421,000. At December 31, 2002, the balance remaining in
foreclosed real estate owned totaled $686,000. Non-accrual loans decreased
$1,874,000 to $1,254,000 at year-end 2001 after increasing to $3,128,000 in
2000, and increasing to $175,000 in 1999 from $15,000 in 1998. The increase in
non-accrual loans experienced in 2000 was attributable to the decline in the
regional and national economies and the local agriculture economy. Interest
income on non-accrual loans that would have been recorded had those loans
performed in accordance with their initial terms, as of December 31, was
$118,000 for 2002, $75,000 for 2001, $168,000 for 2000, $10,000 for 1999 and
$20,000 for 1998. Interest income recognized on impaired loans for 2002 was
$13,000, for 2001 was $2,000, for 2000 was $31,000, for 1999 was $11,000, and
was none for 1998.
There are $2,000 of loans which are ninety days or more past due and still
accruing at year-end 2002. The loans in management's opinion are adequately
collateralized and, if foreclosure and sale of collateral is necessary, no loss
will be incurred.
-24-
Loan Concentrations. The Company has credit risk exposure related to real estate
loans. The Company makes real estate loans for construction and loans for other
purposes which are secured by real estate. At December 31, 2002 loans secured by
real estate totaled $110,848,000, which represents 59.6% of the total loan
portfolio. Real estate construction loans comprised $9,697,000 of that amount,
while real estate loans secured by residential properties totaled $29,945,000.
As a result of these concentrations of loans, the loan portfolio is susceptible
to changes in economic and market conditions in the Company's market areas. The
Company generally requires collateral on all real estate exposures and typically
maintains loan-to-value ratios of no greater than 80%.
Allowance and Provision for Credit Losses. The allowance for credit losses
reflects management's current estimate of the amount required to absorb losses
on existing loans and commitments to extend credit. Loans deemed uncollectible
are charged against and reduce the allowance. Periodically, a provision for
credit losses is charged to current expense. This provision acts to replenish
the allowance for credit losses and to maintain the allowance at a level that
management deems adequate. There is no precise method of predicting specific
loan losses or amounts that ultimately may be charged off on segments of the
loan portfolio. The determination that a loan may become uncollectible, in whole
or in part, is a matter of judgment. Similarly, the adequacy of the allowance
for credit losses can be determined only on a judgmental basis, after full
review, including (a) consideration of economic conditions and the effect on
particular industries and specific borrowers; (b) a review of borrowers'
financial data, together with industry data, the competitive situation, the
borrowers' management capabilities and other factors; (c) a continuing
evaluation of the loan portfolio, including monitoring by lending officers and
staff credit personnel of all loans which are identified as being of less than
acceptable quality; (d) an in-depth appraisal, on a monthly basis, of all loans
judged to present a possibility of loss (if, as a result of such monthly
appraisals, the loan is judged to be not fully collectible, the carrying value
of the loan is reduced to that portion considered collectible); and (e) an
evaluation of the underlying collateral for secured lending, including the use
of independent appraisals of real estate properties securing loans. A formal
analysis of the adequacy of the allowance is conducted monthly and is reviewed
by the Board of Directors. Based on this analysis, management considers the
allowance for credit losses to be adequate.
Periodic provisions for loan losses are made to maintain the allowance for
credit losses at an appropriate level. The provisions are based on an analysis
of various factors including historical loss experience based on volumes and
types of loans, volumes and trends in delinquencies and non-accrual loans,
trends in portfolio volume, results of internal and independent external credit
reviews, and anticipated economic conditions. Transactions in the allowance for
credit losses for the five years ended December 31, 2002 are as follows:
(dollars in thousands) 2002 2001 2000 1999 1998
---------------------------------------------------------------------------------------------------------------------------
Balance at beginning of year $ 2,109 $ 2,026 $ 1,930 $ 1,864 $ 1,937
Charge-offs:
Commercial 131 170 554 114 9
Real estate loans 461 366 0 0 194
-25-
Credit card 16 13 6 13 18
Installment 24 15 8 7 0
Total charge-offs $ 632 $ 564 $ 568 $ 134 $ 221
Recoveries:
Commercial $ 11 $ 54 $ 15 $ 23 $ 34
Real estate loans 28 0 12 110 0
Credit card 2 0 0 6 3
Installment 1 13 2 1 1
Total recoveries $ 42 $ 67 $ 29 $ 140 $ 38
Net charge-offs (recoveries) 590 497 539 (6) 183
Provision for credit losses 954 580 635 60 110
Balance at end of year $ 2,473 $ 2,109 $ 2,026 $ 1,930 $ 1,864
Ratio of net charge-offs (recoveries)
To average loans outstanding .33% .29% .33% --- .13%
The allowance for credit losses was $2,473,000 at year-end 2002, compared with
$2,109,000 at year-end 2001, an increase of $364,000 or 17.3%. The aggregate
increase resulted from the provision of $954,000 and net charge-offs totaling
$590,000 in 2002. The increased level of allowance for credit losses was
primarily due to changes in the composition of the loan portfolio and increased
loss factors utilized in the allowance for loan loss analysis. Changes in the
composition of the loan portfolio included a 3.6% decrease in commercial loans,
while real estate construction and real estate mortgage loans increased 12.8%.
Estimated loss factors used in the allowance for credit loss analysis are
established based in part on historic charge-off data by loan category and
economic conditions. Based on the trends in historical charge-offs analysis, the
loss factors used in the allowance for credit loss analysis for commercial loans
and real estate loans were increased during the year ended December 31, 2002.
Based on the methodology used for credit loss analysis, management deemed the
allowance for credit losses of $2.47 million at December 31, 2002 (1.33% of
loans receivable and 132.67% of non-performing loans) adequate to provide for
estimated losses based on an evaluation of known and inherent risks in the loan
portfolio at that date.
The allowance for credit losses during 2001 increased $83,000 compared to
year-end 2000. The total allowance for credit losses was $2,109,000 at year-end
2001 and $2,026,000 in 2000. The aggregate increase during 2001 was the result
of the provision of $580,000 and net charge-offs. The allowance increased in
2000 from the provision of $635,000 and net charge-offs. The allowance for
credit losses as a percentage of total loans outstanding was 1.19% at year-end
2001, 1.14% at year-end 2000 and 1.26% in 1999. The allowance for credit losses
at year-end 1999 was $1,930,000 and $1,864,000 in 1998. The net recoveries were
$6,000 in 1999 and provisions for credit losses were $60,000. The net
charge-offs for 1998 were $183,00 and provisions for credit losses were
$110,000. The allowance for credit losses as a percentage of total loans
outstanding at year-end 1998 was 1.27%.
In May 1993, the Financial Accounting Standards Board (FASB) issued SFAS No.
114, "Accounting by Creditors for Impairment of a Loan" and in October 1996,
issued SFAS No. 118, "Accounting by Creditors for Impairment of a Loan--Income
Recognition Disclosures, an amendment to SFAS No. 114". The Company measures
impaired loans based on the present value of expected future cash flows
discounted at the loan's effective interest rate or, as a practical expedient,
at the loan's observable market price or the fair market value of the collateral
if the loan is collateral dependent. The Company excludes loans that are
currently measured at fair value or at the lower of cost or fair value, and
certain large groups of smaller balance homogeneous loans that are collectively
measured for impairment. The following table summarizes the Bank's impaired
loans at December 31:
(dollars in thousands) 2002 2001 2000 1999 1998
-----------------------------------------------------------------------------------------------------------------------------
Total Impaired Loans $2,314 $ 1,662 $ 3,128 $ 175 $ 15
Total Impaired Loans with Valuation Allowance 18 1,180 1,114 --- ---
Valuation Allowance related to Impaired Loans 2 143 412 --- ---
-26-
No allocation of the allowance for credit losses was considered necessary for
the remaining impaired loans. The balance of the allowance for credit losses in
excess of these specific reserves is available to absorb losses from all loans.
It is the Company's policy to charge-off any loan or portion of a loan that is
deemed uncollectible in the ordinary course of business. The entire allowance
for credit losses is available to absorb such charge-offs. The Company allocates
its allowance for credit losses primarily on the basis of historical data. Based
on certain characteristics of the portfolio, losses can be anticipated for major
loan categories.
The following table presents the allocation of the allowance for credit losses
among the major loan categories based primarily on their historical net
charge-off experience and other business considerations at December 31 in each
of the last five years.
% of % of % of % of % of
2002 Total 2001 Total 2000 Total 1999 Total 1998 Total
(Dollars in thousands) Reserve Loans Reserve Loans Reserve Loans Reserve Loans Reserve Loans
------------------------------------------------------------------------------------------------------------------------------
Commercial loans $ 967 37% 548 41% $689 39% $720 37% $710 33%
Real estate loans 1,406 60% 1,413 56% 1,256 58% 1,153 60% 1,091 64%
Consumer loans 100 3% 148 3% 81 3% 58 3% 63 3%
Total allowance $ 2,473 100% $ 2,109 100% $2,026 100% $1,930 100% $1,864 100%
Ratio of allowance for credit
losses to loans outstanding
at end of year 1.33% 1.19% 1.14% 1.26% 1.27%
The table indicates an increase of $419,000 from December 31, 2001 to December
31, 2002 in the allowance related to commercial loans, which was offset by
decreases of $7,000 in real estate loans and $48,000 in consumer loans during
the same period ended December 31, 2002.
DEPOSITS
The Company's primary source of funds has historically been customer deposits. A
variety of deposit products are offered to attract customer deposits. The
products include non-interest bearing demand accounts, negotiable order of
withdrawal (NOW) accounts, savings accounts, and time deposits. Interest-bearing
accounts earn interest at rates established by management, based on competitive
market factors and the need to increase or decrease certain types of maturities
of deposits. The Company has succeeded in growing its deposit base over the last
three years despite increasing competition for deposits in our markets. The
Company believes that it has benefited from its local identity and superior
customer service. Attracting deposits remains integral to the Company's business
as it is the primary source of funds for loans and a major decline in deposits
or failure to attract deposits in the future could have an adverse effect on
operations.
The following table sets forth the average balances for each major category of
deposits and the weighted average interest rate paid for deposits for the
periods indicated.
(dollars in thousands) 2002 RATE 2001 RATE 2000 RATE
-----------------------------------------------------------------------------------------------------------------------
Demand deposits $ 36,180 0.00% $ 33,419 0.00% $ 34,343 0.00%
Interest bearing demand deposits 29,137 .76% 26,949 2.09% 26,416 2.51%
-27-
Savings deposits 74,974 1.15% 78,897 2.32% 82,850 3.65%
Time deposits 79,664 3.35% 75,819 5.20% 68,516 5.16%
Total $ 219,955 1.70% $215,084 3.49% $212,125 3.78%
Maturities of time certificates of deposit as of December 31, 2002 are
summarized as follows:
Under Over
(dollars in thousands) $100,000 $100,000 Total
-------- -------- -----
3 months or less $ 20,784 $ 15,820 $ 36,604
Over 3 through 6 months 6,662 7,961 14,623
Over 6 through 12 months 13,237 6,977 20,214
Over 12 months 5,786 4,750 10,536
Total 46,469 35,508 81,977
SHORT-TERM BORROWINGS
The following is information regarding the Company's short-term borrowings for
the years ended December 31, 2002, 2001 and 2000.
(dollars in thousands) 2002 2001 2000
-----------------------------------------------------------------------------------------------------------------------
Amount outstanding at end of period $1,800 $ 0 $11,358
Weighted average interest rate thereon 1.35% 0% 6.39%
Maximum amount outstanding at any month end during period $2,790 $7,580 $11,358
Average amounts outstanding during the period 174 963 9,036
Weighted average interest rate during period 2.48% 5.68% 6.39%
KEY FINANCIAL RATIOS
Year ended December 31, 2002 2001 2000 1999 1998
---------------------------------------------------------------------------------------------------------------------------
Return on average assets 1.54% 1.55% 1.34% 1.64% 1.80%
Return on average equity 15.81% 15.57% 14.95% 17.26% 18.57%
Average equity to average assets ratio 9.74% 9.96% 8.96% 9.49% 9.69%
Dividend payout ratio 87% 86% 97% 79% 60%
LIQUIDITY AND CAPITAL RESOURCES
Liquidity. The primary concern of depositors, creditors and regulators is the
Company's ability to have sufficient funds readily available to repay
liabilities as they mature. In order to ensure adequate funds are available at
all times, the Company monitors and projects the amount of funds required on a
daily basis. Through the Bank, the Company obtains funds from its customer base,
which provides a stable source of "core" demand and consumer deposits.
Other sources are available with borrowings from the Federal Home Loan Bank of
Seattle and correspondent banks. Liquidity requirements can also be met through
disposition of short-term assets. In management's opinion, the Company maintains
an adequate level of liquid assets, consisting of cash and due from banks,
interest bearing deposits with banks, and federal funds sold to support the
daily cash flow requirements.
-28-
Management expects to continue to rely on customer deposits as the primary
source of liquidity, but may also obtain liquidity from maturity of its
investment securities, sale of securities currently available for sale, net
income, and other borrowings. Although deposit balances have shown historical
growth, deposit habits of customers may be influenced by changes in the
financial services industry, interest rates available on other investments,
general economic conditions, consumer confidence, and competition. Borrowings
may be used on a short-term basis to compensate for reductions in deposits, but
are generally not considered a long term solution to liquidity issues.
Therefore, reductions in deposits could adversely affect the Company's results
of operations.
Capital. The Company endeavors to maintain equity capital at an adequate level
to support and promote investor confidence. The Company conducts its business
through the Bank. Thus, the Company needs to be able to provide capital and
financing to the Bank should the need arise. The primary sources for obtaining
capital are additional stock sales and retained earnings. Total shareholders'
equity averaged $24,766,000 in 2002, compared to $24,451,000 in 2001, an
increase of 1.3%, and $22,090,000 in 2000, a decrease of 2.8% compared to 1999.
The Company's Board of Directors considers financial results, growth plans, and
anticipated capital needs in formulating its dividend policy. The payment of
dividends is subject to adequate financial results of the Bank, and limitations
imposed by law and governmental regulations.
The Federal Reserve has established guidelines that mandate risk-based capital
requirements for bank holding companies. Under the guidelines, one of four risk
weights is applied to balance sheet assets, each with different capital
requirements based on the credit risk of the asset. The Company's capital ratios
include the assets of the Bank on a consolidated basis in accordance with the
requirements of the Federal Reserve. The Company's capital ratios have exceeded
the minimum required to be classified "well capitalized" for each of the past
three years.
The following table sets forth the minimum required capital ratios and actual
ratios for December 31, 2002 and 2001.
Capital
Adequacy
Actual Purposes
(dollars in thousands) Amount Ratio Amount Ratio
---------------------- ------ ----- ------ -----
December 31, 2002
Tier 1 capital (to average assets) $23,966 9.42% $10,172 4.00%
Tier 1 capital (to risk-weighted 23,966 11.73% 8,172 4.00%
assets)
Total capital (to risk-weighted 26,457 12.95% 16,344 8.00%
assets)
December 31, 2001
Tier 1 capital (to average assets) $23,106 9.49% $ 9,738 4.00%
Tier 1 capital (to risk-weighted 23,106 12.27% 7,459 4.00%
assets)
Total capital (to risk-weighted 25,215 13.39% 14,918 8.00%
assets)
-29-
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company's results of operations are largely dependent upon its ability to
manage interest rate risk. Management considers interest rate risk to be a
significant market risk that could have a material effect on the Company's
financial condition and results of operations. The Company does not currently
use derivatives to manage market and interest rate risks. All of the Company's
transactions are denominated in U.S. dollars. Approximately 38% of the Company's
loans have interest rates that float with the Company's reference rate. Fixed
rate loans generally are made with a term of five years or less.
In the Asset and Liability section of the Management's Discussion and Analysis
in Item 7 is a table presenting estimated maturity or pricing information
indicating the Company's exposure to interest changes. The assumptions and
description of the process used to manage interest rate risk is further
discussed in the Asset and Liability Management section. The following table
discloses the balances of the financial instruments including the fair value as
of December 31, 2002.
The expected maturities are disclosed based on contractual schedules. Principal
repayments are not considered. The expected maturities for financial liabilities
with no stated maturity reflect estimated future roll-off rates. The roll-off
rates for non-interest bearing deposits, interest bearing demand deposits, money
market accounts, and savings deposits are 15%, 25%, 25% and 20%, respectively.
The interest rates disclosed are based on rates in effect at December 31, 2002.
Fair values are used in accordance with generally accepted accounting principles
as disclosed in the financial statements.
Expected Maturity
Year ended December 31, 2002 there Fair
(dollars in thousands) 2003 2004 2005 2006 2007 after Total Value
------------------------------------------------------------------------------------------------------------------------------
Financial Assets
Cash and cash equivalents
Non-interest bearing $8,473 ---- ---- ---- ---- ---- 8,473 8,473
Interest bearing deposits in banks 373 ---- ---- ---- ---- ---- 373 373
Weighted average interest rate 1.30%
Federal funds sold
Fixed rate ---- ---- ---- ---- ---- ---- ---- ----
Weighted average interest rate
Securities available for sale
Fixed rate 3,913 3,796 3,186 2,601 703 18,157 32,356 32,356
Weighted average interest rate 5.17% 5.81% 6.00% 4.93% 4.63% 4.65%
Adjustable rate 15,863 35 ---- ---- ---- 3,976 19,874 19,874
Weighted average interest rate 2.95% 2.76% 2.93%
Securities held to maturity
Fixed rate 5 468 ---- 84 295 9,510 10,362 10,362
Weighted average interest rate 6.50% 3.01% 6.03% 6.75% 4.92%
Loans receivable
Fixed rate 30,941 6,504 7,126 10,768 11,071 69,345 135,755 138,212
Weighted average interest rate 6.75% 8.35% 7.96% 6.92% 7.17% 7.55%
Adjustable rate 39,627 6,387 525 1,524 1,972 ---- 50,035 50,035
Weighted average interest rate 5.55% 8.29% 7.62% 6.88% 6.75%
Federal Home Loan Bank stock 866 ---- ---- ---- ---- ---- 866 866
Weighted average interest rate 6.50%
-30-
Expected Maturity
Year ended December 31, 2002 there Fair
(dollars in thousands) 2003 2004 2005 2006 2007 after Total Value
------------------------------------------------------------------------------------------------------------------------------
Financial Liabilities
Non-interest bearing deposits $6,013 5,111 4,344 3,692 3,138 17,786 40,084 40,084
Interest bearing checking accounts 7,757 5,818 4,363 3,273 2,455 7,364 31,030 31,030
Weighted average interest rate .58% .58% .58% .58% .58% .58%
Money Market accounts 5,405 4,054 3,041 2,280 1,710 5,131 21,621 21,621
Weighted average interest rate 1.13% 1.13% 1.13% 1.13% 1.13% 1.13%
Savings accounts 10,108 8,087 6,469 5,176 4,140 16,562 50,542 50,542
Weighted average interest rate .96% .96% .96% .96% .96% .96%
Certificates of deposit
Fixed rate 61,061 5,710 1,163 537 3,098 ---- 71,569 72,461
Weighted average interest rate 2.32% 3.24% 3.56% 4.42% 4.80%
Variable rate 10,408 ---- ---- ---- ---- ---- 10,408 10,408
Weighted average interest rate 3.39%
Borrowings
Fixed rate 1,800 2,000 2,000 1,000 ---- 6,000 12,800 12,905
Weighted average interest rate 1.35% 3.20% 4.41% 3.48% 3.48%
As illustrated in the tables above, our balance sheet is currently sensitive to
increasing interest rates, meaning that more interest earning liabilities mature
or re-price than interest bearing assets. Therefore, if our asset and liability
mix were to remain unchanged, and there was an increase in market rates of
interest, the Company would expect that its net income would be adversely
affected. In contrast, a decreasing interest rate environment would positively
affect such income. While the table presented above provides information about
the Company's interest sensitivity, it does not predict the trends of future
earnings. For this reason, financial modeling is used to forecast earnings under
varying interest rate projections. While this process assists in managing
interest rate risk, it does require significant assumptions for the projection
of loan prepayments, loan origination volumes and liability funding sources that
may prove to be inaccurate.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Information required for this item is included in Item 15 of this report.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Not Applicable.
Part III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information concerning directors and executive officers requested by this item
is contained in the registrant's 2003 Proxy Statement in the sections entitled
"MANAGEMENT-Certain Executive Officers," "Proposal No. 1 - Election of
Directors," and "Compliance with Section 16(a) of the Exchange Act" and is
incorporated by reference herein.
ITEM 11. EXECUTIVE COMPENSATION
Information concerning executive compensation requested by this item is
contained in the registrant's 2003 Proxy Statement in the sections entitled
"DIRECTOR COMPENSATION" and "EXECUTIVE
-31-
COMPENSATION" (not including "Audit Committee Report," "Report of the
Compensation Committee" and "Stock Performance Graph"), and is incorporated by
reference herein.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
Information concerning security ownership of certain beneficial owners and
management requested by this item is contained in the registrant's 2003 Proxy
Statement in the section entitled "MANAGEMENT - Security Ownership of Certain
Beneficial Owners and Management," and is incorporated by reference herein.
Equity Compensation Plan Information. The following table summarizes share and
exercise price information about the Company's equity compensation plans as of
December 31, 2002.
(a) (b) (c)
Number of securities Weighted-average Number remaining
to be issued upon exercise price available for future
exercise of of outstanding issuance under equity
outstanding options, options, warrants compensation plans
warrants and rights and rights (excluding securities
reflected in column (a)
Plan Category --------------- ------------- ----------------------
-------------
Equity compensation plans approved
by security holders: 141,496 $22.41 358,504
Equity compensation plans not approved
by security holders: ------- ------- -------
--------------- ------------ -------------
Total 141,496 $22.41 358,504
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information concerning certain relationships and related transactions requested
by this item is contained in the registrant's 2003 Proxy Statement in the
section entitled "Compensation Committee Interlocks and Insider Participation"
and is incorporated by reference herein.
ITEM 14. CONTROLS AND PROCEDURES
Our disclosure controls and procedures are designed to ensure that information
the Company must disclose in its reports filed or submitted under the Securities
Exchange Act of 1934, as amended (the "Exchange Act"), is recorded, processed,
summarized, and reported on a timely basis. Within 90 days prior to the filing
of this report, we carried out an evaluation, under the supervision and with the
participation of our chief executive officer ("CEO") and chief financial officer
("CFO"), of the effectiveness of our disclosure controls and procedures. Based
on that evaluation, the CEO and CFO have concluded that the Company's disclosure
controls and procedures are effective in bringing to their attention on a timely
basis information required to be disclosed by the Company in reports that it
files or submits under the Exchange Act. Also, since the date of their prior
evaluation, there have not been any significant changes in the Company's
internal controls or in other factors that could significantly affect those
controls, including any corrective actions with regard to significant
deficiencies and material weaknesses.
-32-
Part IV
ITEM 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
(a) (1) The following financial statements are filed below:
Independent Auditors Reports
Consolidated Balance Sheets
Consolidated Statements of Income
Consolidated Statements of Shareholders' Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
(a) (2) Schedules: None
(a) (3) Exhibits: See Exhibit Index immediately following the
Certifications.
(b) Reports on Form 8-K: None
-33-
Independent Auditor's Report
Board of Directors
Pacific Financial Corporation
Aberdeen, Washington
We have audited the accompanying consolidated balance sheets of Pacific
Financial Corporation and Subsidiary as of December 31, 2002 and 2001, and the
related consolidated statements of income, shareholders' equity and cash flows
for the years then ended. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audit in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides 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 Pacific Financial
Corporation and Subsidiary as of December 31, 2002 and 2001, and the results of
their operations and their cash flows for the years then ended, in conformity
with accounting principles generally accepted in the United States of America.
/s/McGladrey & Pullen, LLP
Tacoma, Washington
January 24, 2003
-34-
Independent Auditor's Report
Board of Directors
Pacific Financial Corporation
Aberdeen, Washington
We have audited the accompanying consolidated statements of income,
shareholders' equity and cash flows for Pacific Financial Corporation and
Subsidiary for the year ended December 31, 2000. These financial statements are
the responsibility of the Company's management. Our responsibility is to express
an opinion on these financial statements based on our audit.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the results of Pacific Financial Corporation
and Subsidiary operations and cash flows for the year ended December 31, 2000,
in conformity with accounting principles generally accepted in the United States
of America.
/s/ Knight, Vale & Gregory PLLC
Tacoma, Washington
January 26, 2001
-35-
Consolidated Balance Sheets
--------------------------------------------------------------------------------
(Dollars in Thousands)
Pacific Financial Corporation and Subsidiary
December 31, 2002 and 2001
2002 2001
Assets
Cash and due from banks $ 8,473 $ 10,231
Interest bearing deposits in banks 373 1,468
Federal funds sold - - 3,505
Securities available for sale 52,230 31,673
Securities held to maturity (market value $10,414 and $4,942) 10,362 4,945
Federal Home Loan Bank stock, at cost 866 3,813
Loans held for sale 286 - -
Loans 185,504 176,604
Allowance for credit losses 2,473 2,109
------- -------
Loans - net 183,031 174,495
Premises and equipment 3,850 4,014
Foreclosed real estate 686 1,040
Accrued interest receivable 1,493 1,405
Cash surrender value of life insurance 5,898 5,579
Other assets 986 1,449
------- -------
Total assets $268,534 $243,617
======== ========
Liabilities and Shareholders' Equity
Liabilities
Deposits:
Demand deposits, non-interest bearing $ 40,084 $ 38,437
Savings and interest-bearing demand 103,193 104,728
Time, interest-bearing 81,977 71,479
------- -------
Total deposits 225,254 214,644
Accrued interest payable 318 441
Short-term borrowings 1,800 - -
Long-term borrowings 11,000 - -
Other liabilities 5,479 5,018
------- -------
Total liabilities 243,851 220,103
------- -------
Commitments and Contingencies - - - -
Shareholders' Equity
Common stock (par value $1); authorized: 25,000,000 shares;
issued and outstanding: 2002 - 2,512,659 shares; 2001 - 2,491,629 shares 2,513 2,492
Additional paid-in capital 9,839 9,524
Retained earnings 11,614 11,090
Accumulated other comprehensive income 717 408
------- -------
Total shareholders' equity 24,683 23,514
------- -------
Total liabilities and shareholders' equity $268,534 $243,617
======== ========
See notes to consolidated financial statements.
-36-
Consolidated Statements of Income
--------------------------------------------------------------------------------
(Dollars in Thousands, Except Per Share Amounts)
Pacific Financial Corporation and Subsidiary
Years Ended December 31, 2002, 2001 and 2000
2002 2001 2000
Interest Income
Loans $13,175 $14,994 $16,425
Federal funds sold and deposits in banks 107 410 148
Securities available for sale:
Taxable 1,401 1,638 2,812
Tax-exempt 501 545 567
Securities held to maturity:
Taxable 139 - - - -
Tax-exempt 270 264 98
Federal Home Loan Bank stock dividends 186 251 222
------ ------ ------
Total interest income 15,779 18,102 20,272
------ ------ ------
Interest Expense
Deposits 3,747 6,340 8,020
Short-term borrowings 4 190 577
Long-term borrowings 240 - - - -
------ ------ ------
Total interest expense 3,991 6,530 8,597
------ ------ ------
Net interest income 11,788 11,572 11,675
Provision for Credit Losses 954 580 635
------ ------ ------
Net interest income after provision for credit losses 10,834 10,992 11,040
Non-Interest Income
Service charges on deposit accounts 1,069 828 677
Mortgage broker fees 3 32 9
Income from and gains on sale of foreclosed real estate 292 139 32
Earnings on bank owned life insurance 350 167 129
Other operating income 345 363 370
Total non-interest income 2,059 1,529 1,217
Non-Interest Expense
Salaries and employee benefits 4,196 4,058 4,135
Occupancy 419 409 388
Equipment 565 554 751
State taxes 206 227 228
Data processing 268 214 229
Other 1,760 1,731 1,799
------ ------ ------
Total non-interest expense 7,414 7,193 7,530
------ ------ ------
Income before income taxes 5,479 5,328 4,727
Income Taxes 1,563 1,521 1,424
------ ------ ------
Net income $ 3,916 $ 3,807 $ 3,303
======== ======== ========
Earnings Per Share
Basic $ 1.57 $1.53 $1.33
Diluted 1.56 1.52 1.31
See notes to consolidated financial statements.
-37-
Consolidated Statements of Shareholders' Equity
--------------------------------------------------------------------------------
(Dollars in Thousands)
Pacific Financial Corporation and Subsidiary
Years Ended December 31, 2002, 2001 and 2000
Accumulated
Shares of Additional Other
Common Common Paid-in Retained Comprehensive
Stock Stock Capital Earnings Income (Loss) Total
Balance at December 31, 1999 496,770 $ 497 $11,420 $10,473 ($952) $21,438
Comprehensive income:
Net income - - - - - - 3,303 - - 3,303
Other comprehensive income,
net of tax:
Change in fair value of
securities available for sale - - - - - - - - 761 761
Comprehensive income 4,064
5-for-1 stock split 1,987,110 1,987 (1,987) - - - - - -
Stock options exercised 2,750 3 30 - - - - 33
Stock purchase of branch site 16,500 16 396 - - - - 412
Cash dividends declared
($1.28 per share) - - - - - - (3,204) - - (3,204)
--------- ----- ----- ------ ---- ------
Balance at December 31, 2000 2,503,130 2,503 9,859 10,572 (191) 22,743
Comprehensive income:
Net income - - - - - - 3,807 - - 3,807
Other comprehensive income,
net of tax:
Change in fair value of
securities available for sale - - - - - - - - 599 599
Comprehensive income 4,406
Stock options exercised 12,750 13 150 - - - - 163
Repurchase of common stock (24,281) (24) (486) - - - - (510)
Issuance of common stock 30 - - 1 - - - - 1
Cash dividends declared
($1.32 per share) - - - - - - (3,289) - - (3,289)
--------- ----- ----- ------ ---- ------
Balance at December 31, 2001 2,491,629 2,492 9,524 11,090 408 23,514
Comprehensive income:
Net income - - - - - - 3,916 - - 3,916
Other comprehensive income,
net of tax:
Change in fair value of
securities available for sale - - - - - - - - 309 309
Comprehensive income 4,225
Stock options exercised 21,000 21 275 - - - - 296
Issuance of common stock 30 - - 1 - - - - 1
Cash dividends declared
($1.35 per share) - - - - - - (3,392) - - (3,392)
Tax benefit from exercise of
stock options - - - - 39 - - - - 39
--------- ------ -------- ------- ---- -------
Balance at December 31, 2002 2,512,659 $2,513 $ 9,839 $11,614 $717 $24,683
========= ====== ======== ======= ==== =======
See notes to consolidated financial statements.
-38-
Consolidated Statements of Cash Flows
--------------------------------------------------------------------------------
(Dollars in Thousands)
Pacific Financial Corporation and Subsidiary
Years Ended December 31, 2002, 2001 and 2000
2002 2001 2000
Cash Flows from Operating Activities
Net income $ 3,916 $ 3,807 $ 3,303
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 433 423 568
Provision for credit losses 954 580 635
Deferred income tax (benefit) (82) 225 (81)
Originations of loans held for sale (548) - - - -
Proceeds from loans held for sale 262 - - - -
Stock dividends received (186) (251) (222)
Gain on sales of foreclosed real estate (178) - - (32)
Earnings on bank owned life insurance (350) (167) (129)
(Increase) decrease in interest receivable (88) 897 (298)
Increase (decrease) in interest payable (123) (338) 230
Write-down of foreclosed real estate 420 18 - -
Other - net 929 (748) 614
----- ----- -----
Net cash provided by operating activities 5,359 4,446 4,588
----- ----- -----
Cash Flows from Investing Activities
Net (increase) decrease in interest bearing deposits in banks 1,095 (988) 1,264
Net (increase) decrease in federal funds sold 3,505 (2,935) (570)
Activity in securities available for sale:
Sales - - 10,694 - -
Maturities, prepayments and calls 14,109 36,987 12,062
Purchases (34,338) (24,828) (2,423)
Activity in securities held to maturity:
Maturities 3,481 190 239
Purchases (8,920) (1,123) - -
Federal Home Loan Bank stock redemption 3,133 - - - -
Proceeds from sales of loans - - 1,407 1,293
Increase in loans made to customers, net of principal collections (10,046) (5,165) (26,133)
Purchases of premises and equipment (261) (509) (764)
Proceeds from sales of premises and equipment - - 50 - -
Proceeds from sales of foreclosed real estate 707 161 - -
Purchase of bank owned life insurance - - (3,000) - -
------- ------ ------
Net cash provided by (used in) investing activities (27,535) 10,941 (15,032)
------- ------ -------
(continued)
See notes to consolidated financial statements.
-39-
Consolidated Statements of Cash Flows
--------------------------------------------------------------------------------
(concluded) (Dollars in Thousands)
Pacific Financial Corporation and Subsidiary
Years Ended December 31, 2002, 2001 and 2000
2002 2001 2000
Cash Flows from Financing Activities
Net increase in deposits $10,610 $ 1,133 $ 7,372
Net increase (decrease) in short-term borrowings 1,800 (11,358) 1,683
Proceeds from issuance of long-term debt 11,000 3,000 - -
Repayments of long-term debt - - (3,000) - -
Common stock issued 297 164 33
Cash dividends paid (3,289) (3,204) (3,105)
Repurchase of common stock and fractional shares - - (510) - -
------ ------ -----
Net cash provided by (used in) financing activities 20,418 (13,775) 5,983
------ ------- -----
Net change in cash and due from banks (1,758) 1,612 (4,461)
Cash and Due from Banks
Beginning of year 10,231 8,619 13,080
------ ----- ------
End of year $ 8,473 $10,231 $ 8,619
======== ======= ========
Supplemental Disclosures of Cash Flow Information
Interest paid $4,114 $6,868 $8,367
Income taxes paid 1,260 1,375 1,247
Supplemental Disclosures of Non-Cash Investing Activities
Fair value adjustment of securities available for sale, net of tax $ 309 $ 599 $761
Transfer of loans to foreclosed real estate 1,198 1,733 26
Stock purchase of branch site - - - - 412
Financed sales of foreclosed real estate 629 514 235
Reclassification of loan receivable to securities available for sale - - 2,636 - -
See notes to consolidated financial statements.
-40-
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2002 and 2001
Note 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of Pacific Financial
Corporation (the Company) and its wholly owned subsidiary, The Bank of the
Pacific (the Bank). All significant intercompany transactions and balances have
been eliminated.
NATURE OF OPERATIONS
The Company is a holding company which operates primarily through its subsidiary
bank. The Bank operates ten branches located in Grays Harbor, Pacific and
Wahkiakum Counties in western Washington. The Bank provides loan and deposit
services to customers, who are predominately small- and middle-market businesses
and middle-income individuals in western Washington.
CONSOLIDATED FINANCIAL STATEMENT PRESENTATION
The consolidated financial statements have been prepared in accordance with
accounting principles generally accepted in the United States of America and
practices within the banking industry. The preparation of financial statements
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities, and the disclosure of contingent assets and
liabilities, as of the date of the balance sheet, and the reported amounts of
revenues and expenses during the reporting period. 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 credit losses and the valuation of loans held for sale, foreclosed real
estate and deferred tax assets.
Certain prior year amounts have been reclassified, with no change to net income
or shareholders' equity, to conform to the 2002 presentation. All dollar
amounts, except per share information, are stated in thousands.
SECURITIES AVAILABLE FOR SALE
Securities available for sale consist of debt securities, marketable equity
securities and mutual funds that the Bank intends to hold for an indefinite
period, but not necessarily to maturity. Such securities may be sold to
implement the Bank's asset/liability management strategies and in response to
changes in interest rates and similar factors. Securities available for sale are
reported at fair value. Unrealized gains and losses, net of the related deferred
tax effect, are reported as a net amount in a separate component of
shareholders' equity entitled "accumulated other comprehensive income (loss)."
Realized gains and losses on securities available for sale, determined using the
specific identification method, are included in earnings. Amortization of
premiums and accretion of discounts are recognized in interest income over the
period to maturity.
(continued)
-41-
--------------------------------------------------------------------------------
Notes to Consolidated Financial Statements
Pacific Financial Corporation and Subsidiary
December 31, 2002 and 2001
Note 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
SECURITIES HELD TO MATURITY
Debt securities for which the Company has the positive intent and ability to
hold to maturity are reported at cost, adjusted for amortization of premiums and
accretion of discounts, which are recognized in interest income over the period
to maturity.
Declines in the fair value of individual securities held to maturity and
available for sale below their cost that are other than temporary result in
write-downs of the individual securities to their fair value. Such write-downs
are included in earnings as realized losses.
FEDERAL HOME LOAN BANK STOCK
The Company, as a member of the Federal Home Loan Bank (FHLB) system, is
required to maintain an investment in capital stock of the FHLB in an amount
equal to the greater of 1% of its outstanding home loans or 5% of advances from
the FHLB. No ready market exists for the FHLB stock, and it has no quoted market
value.
LOANS HELD FOR SALE
Mortgage loans originated for sale in the foreseeable future in the secondary
market are carried at the lower of aggregate cost or estimated market value.
Gains and losses on sales of loans are recognized at settlement date and are
determined by the difference between the sales proceeds and the carrying value
of the loans. All sales are made without recourse. Net unrealized losses are
recognized through a valuation allowance established by charges to income.
LOANS
Loans are stated at the amount of unpaid principal, reduced by an allowance for
credit losses. Interest on loans is accrued daily based on the principal amount
outstanding.
Generally, the accrual of interest on loans is discontinued when, in
management's opinion, the borrower may be unable to meet payments as they become
due or when they are past due 90 days as to either principal or interest, unless
they are well secured and in the process of collection. When interest accrual is
discontinued, all unpaid accrued interest is reversed against current income. If
management determines that the ultimate collectibility of principal is in doubt,
cash receipts on nonaccrual loans are applied to reduce the principal balance on
a cash-basis method, until the loans qualify for return to accrual status. Loans
are returned to accrual status when all principal and interest amounts
contractually due are brought current and future payments are reasonably
assured. The interest on these loans is accounted for on the cash-basis method,
until qualifying for return to accrual.
(continued)
-42-
--------------------------------------------------------------------------------
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2002 and 2001
Note 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
ALLOWANCE FOR CREDIT LOSSES
The allowance for credit losses is maintained at a level considered adequate to
provide for probable losses on existing loans based on evaluating known and
inherent risks in the loan portfolio. The allowance is reduced by loans charged
off, and increased by provisions charged to earnings and recoveries on loans
previously charged off. The allowance is based on management's periodic,
systematic evaluation of factors underlying the quality of the loan portfolio,
including changes in the size and composition of the loan portfolio, the
estimated value of any underlying collateral, actual loan loss experience,
current economic conditions, and detailed analysis of individual loans for which
full collectibility may not be assured. This evaluation is inherently subjective
as it requires estimates that are susceptible to significant revision as more
information becomes available. While management uses the best information
available to make its estimates, future adjustments to the allowance may be
necessary if there is a significant change in economic conditions.
The allowance consists of specific, general and unallocated components. The
specific component relates to loans that are classified as either 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. The unallocated component
of the allowance reflects the margin of imprecision inherent in the underlying
assumptions used in the methodologies for estimating specific and general losses
in the portfolio.
When available information confirms that specific loans or portions thereof are
uncollectible, these amounts are charged off against the allowance for credit
losses. The existence of some or all of the following criteria will generally
confirm that a loss has been incurred: the loan is significantly delinquent and
the borrower has not evidenced the ability or intent to bring the loan current;
the Bank has no recourse to the borrower, or if it does, the borrower has
insufficient assets to pay the debt; the estimated fair value of the loan
collateral is significantly below the current loan balance, and there is little
or no near-term prospect for improvement.
When management determines that it is probable that a borrower will be unable to
repay all amounts due according to the terms of the loan agreement, including
scheduled interest payments, the loan is considered impaired. Factors considered
by management in determining impairment include payment status, collateral
value, and the probability of collecting scheduled principal and interest
payments when due. Loans that experience insignificant payment delays and
payment shortfalls are generally not classified as impaired. Management
determines the significance of payment delays and payment shortfalls on a
case-by-case basis, taking into consideration all of the circumstances
surrounding the loan and the borrower, including the length of the delay, the
reasons for the delay, the borrower's prior payment record, and the amount of
shortfall in relation to the principal and interest owed. The amount of
impairment is measured based on the present value of expected future cash flows
discounted at the loan's effective interest rate or, when the primary source of
repayment is provided by real estate collateral, at the fair value of the
collateral less estimated selling costs. Large groups of smaller balance
homogenous loans are collectively evaluated for impairment. Accordingly, the
Bank does not separately identify individual consumer and residential loans for
impairment disclosures. In addition, regulatory agencies, as an integral part of
their examination process, periodically review the Bank's allowance for credit
losses, and may require the Bank to make additions to the allowance based on
their judgment about information available to them at the time of their
examinations.
The ultimate recovery of all loans is susceptible to future market factors
beyond the Bank's control. These factors may result in losses differing
significantly from those provided for in the consolidated financial statements.
(continued)
-43-
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2002 and 2001
Note 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
PREMISES AND EQUIPMENT
Premises and equipment are stated at cost less accumulated depreciation, which
is computed on the straight-line method over the estimated useful lives of the
assets. Leasehold improvements are amortized over the terms of the respective
leases or the estimated useful lives of the improvements, whichever is less.
Gains or losses on dispositions are reflected in earnings.
FORECLOSED REAL ESTATE
Real estate properties acquired through, or in lieu of, foreclosure are to be
sold and are initially recorded at the lower of cost or fair value of the
properties less estimated costs of disposal. Any write-down to fair value at the
time of transfer to other real estate owned is charged to the allowance for
credit losses. Properties are evaluated regularly to ensure that the recorded
amounts are supported by their current fair values, and that valuation
allowances to reduce the carrying amounts to fair value less estimated costs to
dispose are recorded as necessary. Any subsequent reductions in carrying values,
and revenue and expense from the operations of properties, are charged to
operations.
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 Bank, (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 Bank does not maintain effective control over the transferred assets through
an agreement to repurchase them before their maturity.
INCOME TAXES
Deferred tax assets and liabilities result from differences between the
financial statement carrying amounts and the tax bases of assets and
liabilities, and are reflected at currently enacted income tax rates applicable
to the period in which the deferred tax assets or liabilities are expected to be
realized or settled. The deferred tax provision represents the difference
between the net deferred tax asset/liability at the beginning and end of the
year. As changes in tax laws or rates are enacted, deferred tax assets and
liabilities are adjusted through the provision for income taxes.
The Bank provides for income taxes separately and remits to the Company amounts
currently due.
(continued)
-44-
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2002 and 2001
Note 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
STOCK-BASED COMPENSATION
At December 31, 2002, the Company has three stock-based employee compensation
plans, which are described more fully in Note 13. The Company accounts for those
plans under the recognition and measurement principles of APB No. 25, Accounting
for Stock Issued to Employees, and related interpretations. Accordingly, no
stock-based compensation cost is reflected in net income, as all options granted
under those plans had an exercise price equal to the market value of the
underlying common stock on the date of grant. The following illustrates the
effect on net income and earnings per share if the Company had applied the fair
value recognition provisions of SFAS No. 123, Accounting for Stock-Based
Compensation, to stock-based compensation awards for the effects of all options
granted on or after January 1, 1995 for the years ended December 31:
2002 2001 2000
Net income, as reported $3,916 $3,807 $3,303
Less total stock-based compensation expense determined
under fair value method for all qualifying awards 95 13 23
Pro forma net income $3,821 $3,794 $3,280
Earnings Per Share
Basic:
As reported $1.57 $1.53 $1.33
Pro forma 1.53 1.52 1.32
Diluted:
As reported 1.56 1.52 1.31
Pro forma 1.53 1.50 1.30
Fair Values of Financial Instruments
The following methods and assumptions were used by the Company in estimating the
fair values of financial instruments disclosed in these consolidated financial
statements:
Cash, Interest Bearing Deposits at Other Financial Institutions, and
Federal Funds Sold
The carrying amounts of cash, interest bearing deposits at other
financial institutions, and federal funds sold approximate their fair
value.
Securities Available for Sale and Held to Maturity
Fair values for securities are based on quoted market prices.
Federal Home Loan Bank Stock
The carrying value of Federal Home Loan Bank stock approximates its
fair value.
(continued)
-45-
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2002 and 2001
Note 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Fair Values of Financial Instruments (concluded)
LOANS
For variable rate loans that reprice frequently and have no significant
change in credit risk, fair values are based on carrying values. Fair
values for fixed rate loans are estimated using discounted cash flow
analysis, using interest rates currently being offered for loans with
similar terms to borrowers of similar credit quality. Fair values of
loans held for sale are based on their estimated market prices. Fair
values for impaired loans are estimated using discounted cash flow
analyses or underlying collateral values, where applicable.
DEPOSITS
The fair value of deposits with no stated maturity date is included at
the amount payable on demand. The fair value of fixed rate maturity
certificates of deposit is estimated by discounting future cash flows
using rates currently offered by the Bank for deposits of similar
remaining maturities. Fair values for fixed rate certificates of
deposit are estimated using a discounted cash flow calculation based on
interest rates currently being offered on similar certificates.
SHORT-TERM BORROWINGS
The carrying amounts of federal funds purchased and other short-term
borrowings maturing within 90 days approximate their fair values. Fair
values of other short-term borrowings are estimated using discounted
cash flow analyses based on the Bank's current incremental borrowing
rates for similar types of borrowing arrangements.
LONG-TERM BORROWINGS
The fair values of the Bank's long-term borrowings are estimated using
discounted cash flow analyses based on the Bank's incremental borrowing
rates for similar types of borrowing arrangements.
ACCRUED INTEREST
The carrying amounts of accrued interest approximate their fair values.
OFF-BALANCE-SHEET INSTRUMENTS
The fair value of commitments to extend credit and standby letters of
credit was estimated using the fees currently charged to enter into
similar agreements, taking into account the remaining terms of the
agreements and the present creditworthiness of the customers. Since the
majority of the Bank's off-balance-sheet instruments consist of non-fee
producing, variable-rate commitments, the Bank has determined they do
not have a distinguishable fair value.
CASH EQUIVALENTS AND CASH FLOWS
The Company considers all amounts included in the balance sheet caption "Cash
and due from banks" to be cash equivalents. Cash flows from loans, interest
bearing deposits in banks, federal funds purchased and sold, short-term
borrowings, and deposits are reported net.
The Company maintains balances in depository institution accounts which, at
times, may exceed federally insured limits. The Company has not experienced any
losses in such accounts.
(continued)
-46-
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2002 and 2001
Note 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
EARNINGS PER SHARE
Basic earnings per share exclude dilution and are computed by dividing net
income by the weighted average number of common shares outstanding. Diluted
earnings per share reflect the potential dilution that could occur if common
shares were issued pursuant to the exercise of options under the Company's stock
option plans.
COMPREHENSIVE INCOME
Accounting principles generally 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 securities available for
sale, are reported as a separate component of the equity section of the
consolidated balance sheets, such items, along with net income, are components
of comprehensive income. Gains and losses on securities available for sale are
reclassified to net income as the gains or losses are realized upon sale of the
securities. Other-than-temporary impairment charges are reclassified to net
income at the time of the charge.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS No.
143, Accounting for Asset Retirement Obligations. This Statement addresses
financial accounting and reporting for obligations associated with the
retirement of tangible long-lived assets and the associated asset retirement
costs. This Statement is effective for all fiscal years beginning after June 15,
2002. The Company does not anticipate that the adoption of SFAS No. 143 will
have a material effect on its financial position or results of operations.
In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statement Nos.
4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections.
This Statement rescinds FASB Statement No. 4, Reporting Gains and Losses from
Extinguishment of Debt, and an amendment of that Statement, FASB Statement No.
64, Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements. This
Statement also rescinds FASB Statement No. 44, Accounting for Intangible Assets
of Motor Carriers. This Statement amends FASB Statement No. 13, Accounting for
Leases, to eliminate inconsistency between the required accounting for
sale-leaseback transactions and the required accounting for certain lease
modifications that have economic effects that are similar to sale-leaseback
transactions. This Statement also amends other existing authoritative
pronouncements to make various technical corrections, clarify meanings, or
describe the applicability under changed conditions. The Company does not
anticipate the adoption of SFAS No. 145 to have a material effect on its
financial position or results of operations.
In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with
Exit or Disposal Activities. This Statement addresses financial accounting and
reporting for costs associated with exit or disposal activities, and nullifies
Emerging Issues Task Force (EITF) Issue No. 94-3, Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring). This Statement is
effective for exit or disposal activities that are initiated after December 31,
2002. The Company does not expect the Statement to have a material effect on its
financial position and results of operations.
(continued)
-47-
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2002 and 2001
Note 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (concluded)
RECENT ACCOUNTING PRONOUNCEMENTS (concluded)
In October 2002, the FASB issued SFAS No. 147, Acquisitions of Certain Financial
Institutions, an amendment of FASB Statement Nos. 72 and 144, and FASB
Interpretation No. 9. The provisions of this Statement, that relate to the
application of the purchase method of accounting, apply to all acquisitions of
financial institutions, except transactions between two or more mutual
enterprises. This Statement removes acquisitions of financial institutions from
the scope of both Statement No. 72 and Interpretation No. 9, and requires that
those transactions be accounted for in accordance with FASB Statements No. 141,
Business Combinations, and No. 142, Goodwill and Other Intangible Assets. In
addition, this Statement amends FASB Statement No. 144, Accounting for
Impairment or Disposal of Long-Lived Assets, to include in its scope long-term
customer-relationship intangible assets of financial institutions such as
depositor- and borrower-relationship intangible assets and credit cardholder
intangible assets. This Statement is effective for acquisitions for which the
date of the transaction is on or after October 1, 2002. The Company does not
expect the Statement to have a material effect on its financial position and
results of operations.
In December 2002, the Financial Accounting Standards Board issued FASB Statement
No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure.
This Statement amends FASB Statement No. 123, Accounting for Stock-Based
Compensation, and APB Opinion No. 28, Interim Financial Reporting, to provide
alternative methods of transition for a voluntary change to the fair value based
method of accounting for stock-based employee compensation. This Statement does
not require any change from the method currently used by the Company to account
for stock-based compensation, but does require more prominent disclosure in the
annual and interim financial statements about the method of accounting for such
compensation and the effect of the method used on reported results. This
Statement was effective for years ending after December 15, 2002. The Company
has adopted the disclosure provisions of SFAS No. 148 in the accompanying
consolidated financial statements; the disclosure requirements are set forth in
the Stock-Based Compensation section.
The Financial Accounting Standards Board has issued Interpretation No. 45,
Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others, an interpretation of FASB
Statement Nos. 5, 57 and 107 and rescission of FASB Interpretation No. 34. This
Interpretation elaborates on the disclosures to be made by a guarantor in its
interim and annual financial statements about its obligations under certain
guarantees that it has issued. It also clarifies that a guarantor is required to
recognize, at the inception of a guarantee, a liability for the fair value of
the obligation undertaken in issuing the guarantee. The initial recognition and
measurement provisions of this Interpretation are applicable on a prospective
basis to guarantees issued or modified after December 31, 2002. Implementation
of these provisions of the Interpretation is not expected to have a material
impact on the Bank's consolidated financial statements. The disclosure
requirements of the Interpretation are effective for financial statements of
interim or annual periods ending after December 15, 2002, and have been adopted
in the consolidated financial statements for December 31, 2002, with no
additional disclosure required.
Note 2 - RESTRICTED ASSETS
Federal Reserve Board regulations require that the Bank maintains certain
minimum reserve balances in cash and on deposit with the Federal Reserve Bank.
The average amounts of such balances for the years ended December 31, 2002 and
2001 were approximately $650 and $2,878, respectively.
-48-
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2002 and 2001
Note 3 - SECURITIES
Investment securities have been classified according to management's intent. The
carrying amounts of securities and their approximate fair values are as follows:
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
SECURITIES AVAILABLE FOR SALE
DECEMBER 31, 2002
U.S. Treasury and Government agency securities $ 2,165 $ 142 $ - - $ 2,307
Obligations of states and political subdivisions 11,502 609 13 12,098
Mortgage-backed securities 16,669 215 27 16,857
Corporate bonds 5,979 127 7 6,099
Mutual funds 14,828 47 6 14,869
------ ----- --- ------
$51,143 $1,140 $53 $52,230
======= ====== === =======
DECEMBER 31, 2001
U.S. Treasury and Government agency securities $ 3,517 $134 $ - - $ 3,651
Obligations of states and political subdivisions 11,359 355 1 11,713
Mortgage-backed securities 3,255 22 56 3,221
Corporate bonds 8,859 170 14 9,015
Mutual funds 4,065 8 - - 4,073
------- ---- --- -------
$31,055 $689 $71 $31,673
======= ==== === =======
SECURITIES HELD TO MATURITY
DECEMBER 31, 2002
State and municipal securities $ 3,751 $39 $28 $ 3,762
Mortgage-backed securities 6,611 41 - - 6,652
------- ---- ---- -------
$10,362 $80 $28 $10,414
======= ==== ==== =======
DECEMBER 31, 2001
State and municipal securities $ 4,945 $- - $ 3 $ 4,942
======= ==== ==== =======
(continued)
-49-
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2002 and 2001
Note 3 - Securities (concluded)
The contractual maturities of investment securities held to maturity and
available for sale at December 31, 2002 are as follows:
Held to Maturity Available for Sale
Amortized Fair Amortized Fair
Cost Value Cost Value
Due in one year or less $ 5 $ 5 $ 4,829 $ 4,908
Due from one year to five years 848 857 8,699 9,166
Due from five to ten years 967 996 3,741 3,930
Due after ten years 1,931 1,904 2,377 2,500
Mortgage-backed securities 6,611 6,652 16,669 16,857
Mutual funds - - - - 14,828 14,869
------ ------ ------ ------
Total $10,362 $10,414 $51,143 $52,230
======= ======= ======= =======
There were no sales of securities in 2002, 2001 and 2000.
Securities carried at approximately $25,622 at December 31, 2002 and $11,618 at
December 31, 2001 were pledged to secure public deposits, borrowings at the
Federal Home Loan Bank, and for other purposes required or permitted by law.
Note 4 - Loans
Loans at December 31 consist of the following:
2002 2001
Commercial and agricultural $ 69,794 $ 72,427
Real estate:
Construction 9,697 6,554
Residential 1-4 family 28,085 31,089
Multi-family 1,574 2,040
Commercial 65,336 54,894
Farmland 5,870 3,691
Consumer 5,148 5,909
------- -------
$185,504 $176,604
======== ========
(continued)
-50-
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2002 and 2001
Note 4 - Loans (concluded)
Changes in the allowance for credit losses for the years ended December 31 are
as follows:
2002 2001 2000
Balance at beginning of year $2,109 $2,026 $1,930
Provision for credit losses 954 580 635
Charge-offs (632) (564) (568)
Recoveries 42 67 29
----- ----- -----
Net charge-offs (590) (497) (539)
----- ----- -----
Balance at end of year $2,473 $2,109 $2,026
====== ====== ======
Following is a summary of information pertaining to impaired loans:
2002 2001 2000
December 31
Impaired loans without a valuation allowance $2,296 $ 482 $2,014
Impaired loans with a valuation allowance 18 1,180 1,114
------ ------ ------
Total impaired loans $2,314 $1,662 $3,128
====== ====== ======
Valuation allowance related to impaired loans $ 2 $ 143 $ 412
====== ====== ======
Years Ended December 31
Average investment in impaired loans $2,390 $1,262 $3,425
Interest income recognized on a cash basis on impaired loans 13 2 31
At December 31, 2002, there were no commitments to lend additional funds to
borrowers whose loans have been modified. Loans 90 days and over past due and
still accruing interest totaled $79 at December 31, 2001. There were no loans 90
days and over past due and still accruing interest at December 31, 2002.
Certain related parties of the Company, principally directors and their
associates, were loan customers of the Bank in the ordinary course of business
during 2002 and 2001. Total loans outstanding at December 31, 2002 and 2001 to
key officers and directors were $3,233 and $3,748, respectively. During 2002,
new loans of $1,490 were made, and repayments totaled $2,005. In management's
opinion, these loans and transactions were on the same terms as those for
comparable loans and transactions with non-related parties. No loans to related
parties were on non-accrual, past due or restructured at December 31, 2002.
-51-
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2002 and 2001
Note 5 - PREMISES AND EQUIPMENT
The components of premises and equipment at December 31 are as follows:
2002 2001
Land $1,125 $1,125
Premises 3,992 3,884
Equipment, furniture and fixtures 4,074 4,026
----- -----
9,191 9,035
Less accumulated depreciation and amortization 5,341 5,021
----- -----
Total premises and equipment $3,850 $4,014
====== ======
Note 6 - DEPOSITS
The composition of deposits at December 31 is as follows:
2002 2001
Demand deposits, non-interest bearing $ 40,084 $ 38,437
NOW and money market accounts 52,651 50,799
Savings deposits 50,542 53,929
Time certificates, $100,000 or more 35,086 26,453
Other time certificates 46,891 45,026
------ ------
Total $225,254 $214,644
======== ========
Scheduled maturities of time certificates of deposit are as follows for future
years ending December 31:
2003 $63,749
2004 6,525
2005 8,014
2006 537
2007 3,152
---- ------
$81,977
=======
-52-
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2002 and 2001
Note 7 - SHORT-TERM BORROWINGS
Short-term borrowings consist of federal funds purchased which generally mature
within one to four days from the transaction date. Information concerning
short-term borrowings is summarized as follows for the years ended December 31:
2002 2001
Average balance during the year $174 $963
Average interest rate during the year 2.48% 5.68%
Maximum month-end balance during the year $2,790 $7,580
Balance outstanding at year-end $1,800 $- -
Average interest rate at year-end 1.35% - -%
Note 8 - LONG-TERM BORROWINGS
Long-term borrowings at December 31, 2002 represent advances from the Federal
Home Loan Bank bearing interest at 3.20% to 4.41% and maturing at 2004 - $2,000;
2005 - $2,000; 2006 - $1,000; and 2009 - $6,000. The Bank has pledged $41,127 of
securities and loans as collateral for these borrowings and short-term
borrowings at December 31, 2002.
Note 9 - INCOME TAXES
Income taxes are comprised of the following for the years ended December 31:
2002 2001 2000
Current $1,645 $1,296 $1,505
Deferred (benefit) (82) 225 (81)
----- ----- -----
Total income taxes $1,563 $1,521 $1,424
====== ====== ======
The tax effects of temporary differences that give rise to significant portions
of deferred tax assets and liabilities at December 31 are:
2002 2001
Deferred Tax Assets
Allowance for credit losses $ 730 $ 626
Deferred compensation 161 230
Other 8 70
--- ---
Total deferred tax assets 899 926
(continued)
-53-
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2002 and 2001
Note 9 - INCOME TAXES (concluded)
2002 2001
Deferred Tax liabilities
Unrealized gain on securities available for sale $ 369 $ 210
Depreciation 119 68
Deferred revenue 884 1,045
----- -----
Total deferred tax liabilities 1,372 1,323
----- -----
Net deferred tax liabilities ($ 473) ($ 397)
======= =======
Net deferred tax liabilities are included in other liabilities on the
consolidated balance sheets.
The following is a reconciliation between the statutory and effective federal
income tax rate for the years ended December 31:
2002 2001 2000
Percent Percent Percent
of Pre-tax of Pre-tax of Pre-tax
Amount Income Amount Income Amount Income
Income tax at statutory rate $1,918 35.0% $1,865 35.0% $1,654 35.0%
Adjustments resulting from:
Tax-exempt income (276) (5.0) (272) (5.1) (236) (5.0)
Net earnings on life insurance
policies (111) (2.0) (26) (.5) (36) (.7)
Other 32 .5 (46) (.8) 42 .9
----- ----- -----
Total income tax expense $1,563 28.5% $1,521 28.6% $1,424 30.2%
====== ====== ======
Note 10 - EMPLOYEE BENEFITS
Incentive Compensation Plan
The Bank has a plan that provides incentive compensation to key employees if the
Bank meets certain performance criteria established by the Board of Directors.
The cost of this plan was $435, $355 and $490 in 2002, 2001 and 2000,
respectively.
(continued)
-54-
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2002 and 2001
Note 10 - EMPLOYEE BENEFITS (concluded)
401(k) Plans
The Bank has established a 401(k) profit sharing plan for those employees who
meet the eligibility requirements set forth in the plan. Eligible employees may
contribute up to 15% of their compensation. Matching contributions by the Bank
are at the discretion of the Board of Directors. Contributions totaled $126,
$115 and $94 for 2002, 2001 and 2000, respectively.
DIRECTOR AND EMPLOYEE DEFERRED COMPENSATION PLANS
The Company has director and employee deferred compensation plans. Under the
terms of the plans, a director or employee may participate upon approval by the
Board. The participant may then elect to defer a portion of his or her earnings
(directors' fees or salary) as designated at the beginning of each plan year.
Payments begin upon retirement, termination, death or permanent disability, sale
of the Company, the ten-year anniversary of the participant's participation
date, or at the discretion of the Company. There are currently two participants
in the plans. Total deferrals plus earnings were $110, $304 and $297 at December
31, 2002, 2001 and 2000, respectively. There is no expense to the Company for
this plan.
The directors of a bank acquired by the Company in 1999 adopted two deferred
compensation plans for directors - one plan providing retirement income benefits
for all directors and the other, a deferred compensation plan, covering only
those directors who have chosen to participate in the plan. At the time of
adopting these plans, the Bank purchased life insurance policies on directors
participating in both plans which may be used to fund payments to them under
these plans. Cash surrender values on these policies were $2,700 and $2,555 at
December 31, 2002 and 2001, respectively. In 2002, 2001 and 2000, the net
(benefit)/cost recorded from these plans, including the cost of the related life
insurance, was ($315), ($104) and $30, respectively. Both of these plans were
fully funded and frozen as of September 30, 2000. Plan participants were given
the option to either remain in the plan until reaching the age of 70 or to
receive a lump sum distribution. Participants electing to remain in the plan
will receive annual payments over a ten-year period upon reaching 70 years of
age.
QUALIFIED NON-CONTRIBUTORY DEFINED BENEFIT PLAN
The Company maintained a non-contributory defined benefit plan covering
substantially all employees of the former Bank of the Pacific, which was frozen
and terminated on December 31, 2000. The Bank made annual contributions to the
plan equal to the amount accrued for pension expenses, which were invested in
shares of registered investment companies. Final funding of the plan did not
occur until 2001 upon receipt of plan administrator distribution totals.
Contributions of $149 and $312 were made in 2001 and 2000, respectively.
NON-QUALIFIED DEFERRED COMPENSATION PLAN
The Company has a non-qualified deferred compensation plan to cover selected
employees. Its annual contributions to the plan totaled $6, $8 and $22 in 2002,
2001 and 2000, respectively. Covered employees may also contribute to the plan.
-55-
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2002 and 2001
Note 11 - COMMITMENTS AND CONTINGENCIES
The Bank is party to financial instruments with off-balance-sheet risk in the
normal course of business to meet the financing needs of their customers. These
financial instruments include commitments to extend credit and standby letters
of credit, and involve, to varying degrees, elements of credit risk in excess of
the amount recognized on the balance sheets.
The Bank's exposure to credit loss in the event of nonperformance by the other
party to the financial instrument for commitments to extend credit and standby
letters of credit is represented by the contractual amount of those instruments.
The Bank uses the same credit policies in making commitments and conditional
obligations as they do for on-balance-sheet instruments. A summary of the Bank's
commitments at December 31 is as follows:
2002 2001
Commitments to extend credit $23,638 $23,262
Standby letters of credit 2,326 1,688
Commitments to extend credit are agreements to lend to a customer as long as
there is no violation of any condition established in the contract. Since many
of the commitments are expected to expire without being drawn upon, the total
commitment amounts do not necessarily represent future cash requirements. The
Bank's experience has been that approximately 67% of loan commitments is drawn
upon by customers. The Bank evaluates each customer's creditworthiness on a
case-by-case basis. The amount of collateral obtained, if deemed necessary by
the Bank upon extension of credit, is based on management's credit evaluation of
the party. Collateral held varies, but may include accounts receivable,
inventory, property and equipment, residential real estate, and income-producing
commercial properties.
Standby letters of credit are conditional commitments issued by the Bank to
guarantee the performance of a customer to a third party. Those guarantees are
primarily issued to support public and private borrowing arrangements. The
credit risk involved in issuing letters of credit is essentially the same as
that involved in extending loan facilities to customers. Collateral held varies
as specified above, and is required in instances where the Bank deems necessary.
Certain executive officers have entered into employment contracts with the Bank
which provide for contingent payments subject to future events.
The Bank has agreements with commercial banks for lines of credit totaling
$14,700, none of which was used at December 31, 2002. In addition, the Bank has
a credit line with the Federal Home Loan Bank of Seattle totaling 20% of assets,
$12,800 of which was used at December 31, 2002. These borrowings are
collateralized under blanket pledge and custody agreements.
Because of the nature of its activities, the Company is subject to various
pending and threatened legal actions which arise in the ordinary course of
business. In the opinion of management, liabilities arising from these claims,
if any, will not have a material effect on the financial position of the
Company.
-56-
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2002 and 2001
Note 12 - SIGNIFICANT CONCENTRATIONS OF CREDIT RISK
Most of the Bank's business activity is with customers and governmental entities
located in the state of Washington, including investments in state and municipal
securities. Loans are generally limited by state banking regulations to 20% of
the Bank's shareholder's equity, excluding accumulated other comprehensive
income (loss). As of December 31, 2002 the Bank's loans to companies in the
hotel\motel industry totaled $26,082 or 14% of total loans. Standby letters of
credit were granted primarily to commercial borrowers. The Bank, as a matter of
practice, generally does not extend credit to any single borrower or group of
borrowers in excess of $4 million.
Note 13 - STOCK OPTIONS
The Company's three stock incentive plans provide for granting incentive stock
options, as defined under current tax laws, to key personnel and under the plan
adopted in 2000, options not qualified for favorable tax treatment and other
types of stock based awards. Under the first plan, options are exercisable 90
days from the date of grant. These options terminate if not exercised within ten
years from the date of grant. If after six years from the date of grant fewer
than 20% of the options have been exercised, they will expire at a rate of 20%
annually. Under the second plan, the options are exercisable one year from the
date of grant, at a rate of 10% annually. Options terminate if not exercised
when they become available, and no additional grants will be made under these
two plans. The plan adopted in 2000, authorizes the issuance of up to a total of
500,000 shares, (358,504 shares are available for grant at December 31, 2002).
Under the 2000 plan, options become exercisable ratably over five years. Under
the 2000 plan, the Company may grant up to 75,000 shares of its common stock to
a single individual in a calendar year.
The fair value of each option granted in 2001 and 2000 was estimated on the date
of grant, based on the Black-Scholes option pricing model and using the
following weighted-average assumptions. There were no options granted in 2000.
2002 2001
Dividend yield 5.67% 5.51% - 5.76%
Volatility 18.99% 19.13%
Expected life 10 years 10 years
Risk-free interest rate 4.64% - 5.59% 4.92% - 5.19%
The weighted average fair value of options granted during 2002 and 2001 was
$3.03 and $2.59, respectively. The Black-Scholes model used by the Company to
calculate option values, as well as other currently accepted option valuation
models, were developed to estimate the fair value of freely tradable, fully
transferable options without vesting restrictions, which significantly differ
from the Company's stock option awards. These models also require highly
subjective assumptions, including future stock price volatility and expected
time until exercise, which greatly affect the calculated values. Accordingly,
management believes that this model does not necessarily provide a reliable
single measure of the fair value of the Company's option awards.
(continued)
-57-
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2002 and 2001
Note 13 - STOCK OPTIONS (concluded)
A summary of the status of the Company's stock option plans as of December 31,
2002, 2001 and 2000, and changes during the years ending on those dates, is
presented below:
2002 2001 2000
Weighted Weighted Weighted
Average Average Average
Exercise Exercise Exercise
Shares Price Shares Price Shares Price
Outstanding at beginning of year 184,300 $21.19 74,550 $18.21 78,550 $18.13
Granted 23,996 23.34 126,000 22.22 - - - -
Exercised (21,000) 14.09 (12,750) 12.82 (2,750) 12.00
Forfeited (7,500) 22.22 (3,500) 25.63 (1,250) 27.00
------ ------ ------
Outstanding at end of year 179,796 $22.26 184,300 $21.19 74,550 $18.21
======= ======= ======
Exercisable at end of year 53,300 $21.08 32,165 $14.40 34,030 $13.65
The following information summarizes information about stock options outstanding
and exercisable at December 31, 2002:
Weighted
Average Weighted Weighted
Remaining Average Average
Exercise Number Contractual Exercise Number Exercise
Price Outstanding Life (Years) Price Exercisable Price
$15.29 17,550 4 $15.29 17,550 $15.29
22.22 - 24.00 140,996 8 22.41 23,000 22.22
27.00 21,250 7 27.00 12,750 27.00
------- ------
179,796 53,300
======= ======
Note 14 - STOCK TRANSACTIONS
In June 2000, the Board of Directors effected a 5-for-1 stock split. In
addition, the Board of Directors approved an increase in the number of
authorized common shares from 5,000,000 to 25,000,000.
-58-
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2002 and 2001
Note 15 - REGULATORY MATTERS
The Company and the Bank are subject to various regulatory capital requirements
administered by the federal banking agencies. Failure to meet minimum capital
requirements can initiate certain mandatory and possibly additional
discretionary actions by regulators that, if undertaken, could have a direct
material effect on the Company's consolidated financial statements. Under
capital adequacy guidelines on the regulatory framework for prompt corrective
action, the Bank must meet specific capital adequacy guidelines that involve
quantitative measures of the Bank's assets, liabilities and certain
off-balance-sheet items as calculated under regulatory accounting practices. The
Bank's capital classification is also subject to qualitative judgments by the
regulators about components, risk weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy
require the Company and the Bank to maintain minimum amounts and ratios (set
forth in the table below) of Tier 1 capital (as defined in the regulations) to
total average assets (as defined), and minimum ratios of Tier 1 and total
capital (as defined) to risk-weighted assets (as defined).
As of December 31, 2002, the most recent notification from the Bank's regulator
categorized the Bank as well capitalized under the regulatory framework for
prompt corrective action. To be categorized as well capitalized, the Bank must
maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios
as set forth in the table. There are no conditions or events since that
notification that management believes have changed the institution's category.
The Company and the Bank's actual capital amounts and ratios are also presented
in the table. Management believes, as of December 31, 2002, the Company and the
Bank meet all capital requirements to which they are subject.
To be Well Capitalized
Under Prompt
Capital Adequacy Corrective Action
Actual Purposes Provisions
Amount Ratio Amount Ratio Amount Ratio
December 31, 2002
Tier 1 capital (to average assets):
Consolidated $23,966 8.92% $10,753 4.00% N/A N/A
Bank 23,832 8.87 10,753 4.00 $13,441 5.00%
Tier 1 capital (to risk-weighted assets):
Consolidated 23,966 11.73 8,172 4.00 N/A N/A
Bank 23,832 11.67 8,171 4.00 12,257 6.00
Total capital (to risk-weighted assets):
Consolidated 26,457 12.95 16,344 8.00 N/A N/A
Bank 26,323 12.89 16,342 8.00 20,428 10.00
(continued)
-59-
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2002 and 2001
Note 15 - REGULATORY MATTERS (concluded)
To be Well Capitalized
Under Prompt
Capital Adequacy Corrective Action
Actual Purposes Provisions
Amount Ratio Amount Ratio Amount Ratio
December 31, 2001
Tier 1 capital (to average assets):
Consolidated $23,106 9.49% $ 9,738 4.00% N/A N/A
Bank 23,077 9.48 9,738 4.00 $12,173 5.00%
Tier 1 capital (to risk-weighted assets):
Consolidated 23,106 12.27 7,459 4.00 N/A N/A
Bank 23,077 12.02 7,681 4.00 11,521 6.00
Total capital (to risk-weighted assets):
Consolidated 25,215 13.39 14,918 8.00 N/A N/A
Bank 25,186 13.12 15,362 8.00 19,202 10.00
Note 16 - FAIR VALUES OF FINANCIAL INSTRUMENTS
The estimated fair values of the Company's financial instruments at December 31
are as follows:
2002 2001
Carrying Fair Carrying Fair
Amount Value Amount Value
Financial Assets
Cash and due from banks,
interest-bearing deposits with
banks, and federal funds sold $ 8,846 $ 8,846 $ 15,204 $ 15,204
Securities available for sale 52,230 52,230 31,673 31,673
Securities held to maturity 10,362 10,414 4,945 4,942
Federal Home Loan Bank stock 866 866 3,813 3,813
Loans receivable, net 183,031 188,247 174,495 177,569
Loans held for sale 286 286 - - - -
Accrued interest receivable 1,493 1,493 1,405 1,405
Financial Liabilities
Deposits $225,254 $226,146 $214,644 $214,914
Short-term borrowings 1,800 1,800 - - - -
Long-term borrowings 11,000 11,105 - - - -
Accrued interest payable 318 318 441 441
(continued)
-60-
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2002 and 2001
Note 16 - FAIR VALUES OF FINANCIAL INSTRUMENTS (concluded)
The Bank assumes interest rate risk (the risk that general interest rate levels
will change) as a result of its normal operations. As a result, the fair values
of the Bank's financial instruments will change when interest rate levels change
and that change may either be favorable or unfavorable to the Bank. Management
attempts to match maturities of assets and liabilities to the extent believed
necessary to minimize interest rate risk. However, borrowers with fixed rate
obligations are less likely to prepay in a rising rate environment and more
likely to prepay in a falling rate environment. Conversely, depositors who are
receiving fixed rates are more likely to withdraw funds before maturity in a
rising rate environment and less likely to do so in a falling rate environment.
Management monitors rates and maturities of assets and liabilities, and attempts
to minimize interest rate risk by adjusting terms of new loans, and deposits and
by investing in securities with terms that mitigate the Bank's overall interest
rate risk.
Note 17 - EARNINGS PER SHARE DISCLOSURES
Following is information regarding the calculation of basic and diluted earnings
per share for the years indicated.
Net Income Shares Per Share
(Numerator) (Denominator) Amount
Year Ended December 31, 2002
Basic earnings per share:
Net income $3,916 2,492,526 $1.57
Effect of dilutive securities:
Options - - 17,869 (.01)
Diluted earnings per share: ------ --------- -----
Net income $3,916 2,510,395 $1.56
====== ========= =====
Year Ended December 31, 2001
Basic earnings per share:
Net income $3,807 2,491,426 $1.53
Effect of dilutive securities:
Options - - 19,736 (.01)
Diluted earnings per share: ------ --------- -----
Net income $3,807 2,511,162 $1.52
====== ========= =====
Year Ended December 31, 2000
Basic earnings per share:
Net income $3,303 2,492,326 $1.33
Effect of dilutive securities:
Options - - 20,493 (.02)
Diluted earnings per share: ------ --------- -----
Net income $3,303 2,512,819 $1.31
====== ========= =====
The number of shares shown for "options" is the number of incrementional shares
that would result from the exercise of options and use of the proceeds to
repurchase shares at the average market price during the year.
-61-
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2002 and 2001
Note 18 - CONDENSED FINANCIAL INFORMATION - PARENT COMPANY ONLY
CONDENSED BALANCE SHEETS - DECEMBER 31
2002 2001
Assets
Cash $ 3,467 $ 3,317
Investment in the Bank 24,549 23,485
Due from the Bank 59 - -
------- -------
Total assets $28,075 $26,802
======= =======
Liabilities and Shareholders' Equity
Dividends payable $ 3,392 $ 3,288
Shareholders' equity 24,683 23,514
------- -------
Total liabilities and shareholders' equity $28,075 $26,802
======= =======
Condensed Statements of Income - Years Ended December 31
2002 2001 2000
Dividend Income from the Bank $3,200 $3,670 $3,275
Expenses (59) (69) (169)
------ ------ -------
Income before income taxes 3,141 3,601 3,106
Income Tax Benefit 20 23 18
------ ------ -------
Income before equity in undistributed income of the Bank 3,161 3,624 3,124
Equity in Undistributed Income of the Bank 755 183 179
------ ------ -------
Net income $3,916 $3,807 $3,303
====== ====== ======
(continued)
-62-
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2002 and 2001
Note 18 - CONDENSED FINANCIAL INFORMATION - PARENT COMPANY ONLY (concluded)
Condensed Statements of Cash Flows - Years Ended December 31
2002 2001 2000
Operating Activities
Net income $3,916 $3,807 $3,303
Adjustments to reconcile net income to
net cash provided by operating activities:
Equity in undistributed income of subsidiary (755) (183) (179)
Other - net (19) (1) 57
Net cash provided by operating activities 3,142 3,623 3,181
----- ----- -----
Investing Activities
(Increase) decrease in due from the Bank - - 3,178 (1,794)
----- ----- -----
Financing Activities
Common stock issued 297 164 33
Dividends paid (3,289) (3,204) (3,105)
Repurchase of common stock and fractional shares - - (510) - -
----- ----- -----
Net cash used in financing activities (2,992) (3,550) (3,072)
----- ----- -----
Net increase (decrease) in cash 150 3,251 (1,685)
Cash
Beginning of year 3,317 66 1,751
----- ----- -----
End of year $3,467 $3,317 $ 66
====== ====== =======
-63-
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2002 and 2001
Note 19 - QUARTERLY DATA (Unaudited)
First Second Third Fourth
Quarter Quarter Quarter Quarter
Year Ended December 31, 2002
Interest income $3,880 $3,930 $3,942 $4,027
Interest expense 971 981 1,046 993
----- ----- ----- -----
Net interest income 2,909 2,949 2,896 3,034
Provision for credit losses 954 - - - - - -
Non-interest income 454 704 477 424
Non-interest expenses 1,819 1,873 1,848 1,874
----- ----- ----- -----
Income before income taxes 590 1,780 1,525 1,584
Income taxes 182 534 452 395
--- --- --- ---
Net income $ 408 $1,246 $1,073 $1,189
====== ====== ====== ======
Earnings per common share:
Basic $ .16 $ .50 $ .43 $.48
Diluted .16 .50 .43 .47
Year Ended December 31, 2001
Interest income $4,985 $4,671 $4,401 $4,045
Interest expense 2,151 1,766 1,539 1,074
----- ----- ----- -----
Net interest income 2,834 2,905 2,862 2,971
Provision for credit losses 102 98 98 282
Non-interest income 314 346 442 427
Non-interest expenses 1,808 1,759 1,761 1,865
----- ----- ----- -----
Income before income taxes 1,238 1,394 1,445 1,251
Income taxes 361 429 399 332
----- ----- ----- -----
Net income $ 877 $ 965 $1,046 $ 919
====== ====== ====== ======
Earnings per common share:
Basic $ .35 $ .39 $ .42 $.37
Diluted .35 .38 .42 .36
-64-
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized, on the 19th day of March,
2003.
PACIFIC FINANCIAL CORPORATION
(Registrant)
/s/ Dennis A. Long /s/ John Van Dijk
-------------------------------- -------------------------------
Dennis A. Long, President and CEO John Van Dijk, Secretary
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities indicated, on the 19th day of March, 2003.
Principal Executive Officer and Director Principal Financial and
Accounting Officer
/s/ Dennis A. Long /s/ John Van Dijk
-------------------------------- -------------------------------
Dennis A. Long, President and CEO John Van Dijk, Treasurer (CFO)
and Director Principal Financial and
Principal Executive Officer Accounting Officer
Remaining Directors
/s/ Joseph A. Malik
-------------------------------- -------------------------------
Joseph A. Malik (Chairman of the Board) Sidney R. Snyder
/s/ Duane E. Hagstrom
-------------------------------- -------------------------------
Gary C. Forcum Duane E. Hagstrom
/s/ Walter L. Westling /s/ Robert A. Hall
-------------------------------- -------------------------------
Walter L. Westling Robert A. Hall
/s/ David L. Woodland /s/ Robert J. Worrell
-------------------------------- -------------------------------
David L. Woodland Robert J. Worrell
/s/ Susan C. Freese /s/ Randy W. Rognlin
-------------------------------- -------------------------------
Susan C. Freese Randy W. Rognlin
/s/ Edward Ketel
-------------------------------- -------------------------------
Edward Ketel Douglas M. Schermer
-65-
CERTIFICATIONS UNDER 18 U.S.C. ss. 1350
The undersigned certify, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to
ss. 906 of the Sarbanes-Oxley Act of 2002, that the preceding Annual Report on
Form 10-K fully complies with the requirements of Section 13(a) or 15(d) of the
Securities Exchange Act of 1934, and the information contained therein fairly
presents, in all material respects, the financial condition and results of
operations of Pacific Financial Corporation.
/s/ Dennis A. Long /s/ John Van Dijk
------------------------ ---------------------------
Dennis A. Long John Van Dijk
President Secretary/Treasurer
Chief Executive Officer Chief Financial Officer
March 19, 2003 March 19, 2003
CERTIFICATION OF CHIEF EXECUTIVE OFFICER
UNDER SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002
I, Dennis A. Long, certify that:
1. I have reviewed this annual report on Form 10-K of Pacific Financial
Corporation;
2. Based on my knowledge, this annual report does not contain any
untrue statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by this
annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
(a) Designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this annual report is being prepared;
(b) Evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
annual report (the "Evaluation Date"); and
-66-
(c) Presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed,
based on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):
(a) All significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
(b) Any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officer and I have indicated in
this annual report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: March 19, 2003 /s/ Dennis A. Long
--------------------------------
Dennis A. Long
President and Chief Executive Officer
-67-
CERTIFICATION OF CHIEF FINANCIAL OFFICER
UNDER SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002
I, John Van Dijk, certify that:
1. I have reviewed this annual report on Form 10-K of Pacific Financial
Corporation;
2. Based on my knowledge, this annual report does not contain any
untrue statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by this
annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
(a) Designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this annual report is being prepared;
(b) Evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
annual report (the "Evaluation Date"); and
(c) Presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed,
based on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):
(a) All significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
(b) Any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and
-68-
6. The registrant's other certifying officer and I have indicated in
this annual report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: March 19, 2003 /s/ John Van Dijk
--------------------------------
John Van Dijk
Treasurer
-69-
Exhibit Index
EXHIBIT NO. EXHIBIT
----------------- ------------
3.1 Restated Articles of Incorporation (1)
3.2 Bylaws (2)
10 Executive Compensation Plans and Arrangements and Other Management
Contracts
10.1 Employment Agreement with Dennis A. Long dated January 2, 2003
10.2 Employment Agreement with John Van Dijk dated January 2, 2003
10.3 Bank of the Pacific Incentive Stock Option Plan (3)
10.4 The Bank of Grays Harbor Incentive Stock Option Plan (3)
10.5 2000 Stock Incentive Compensation Plan (4)
10.6 Bonus Program for Officers (5)
10.7 The Bank of Grays Harbor Employee Deferred Compensation Plan (5)
10.8 Employment Agreement with Bruce D. MacNaughton dated January 2, 2003
21 Subsidiaries of Registrant - Bank of the Pacific, organized
under Washington Law
23 Consents of McGladrey & Pullen, LLP, and Knight, Vale & Gregory PLLC,
Independent Auditors
99 Description of common stock of the Company (6)
(1) Incorporated by reference to Exhibit 3.2 to the Company's Quarterly Report
on Form 10-Q for the quarter ended June 30, 2000.
(2) Incorporated by reference to Exhibit 2b to Form 8-A filed by the Company and
declared effective on March 7, 2000 (Registration No. 000-29329)
(3) Incorporated by reference to Exhibits 10.7 and 10.8 to the Company's Annual
Report on Form 10-K for the year ended December 31, 1999.
(4) Incorporated by reference to Exhibits 10.1 and 10.2 to the Company's
Quarterly Report on Form 10-Q for the quarter ended March 31, 2000.
(5) Incorporated by reference to Exhibit 10.10 to the Company's Annual Report on
Form 10-K for the year ended December 31, 2000.
(6) Incorporated by reference to Exhibit 99 to the Company's Quarterly Report on
Form 10-Q for the quarter ended September 30, 2000.
-70-