U.S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
FORM 10-KSB/A
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended September 30, 2003
Commission File No.: 01-13465
FALMOUTH BANCORP, INC.
(Name of small business issuer in its charter)
Delaware 04-3337685
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
20 Davis Straits, Falmouth, Massachusetts 02540
(Address of principal executive offices)
(508) 548-3500
(Issuer's Telephone Number)
Securities registered pursuant to section 12(g) of the Exchange Act:
Title of each class Name of Each Exchange on Which Registered:
------------------- -----------------------------------------
Common Stock, American Stock Exchange
par value $0.01 per share
Check whether the issuer (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 12 months (or for
such shorter period that the registrant was required to file such reports),
and (2) has been subject to such filing requirements for the past 90 days.
Yes X No [ ]
Check if there is no disclosure of delinquent filers in response to Item 405
of Regulation S-B is not contained in this form, and no disclosure will be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form
10-KSB/A or any amendment to this Form 10-KSB/A. [ ]
The revenues for the issuer's fiscal year ended September 30, 2003 were
$7,862,818.
State the aggregate market value of the voting and non-voting common
equity held by non-affiliates computed by reference to the price at which
the common equity was sold, as of a specified date within the last 60 days.
On December 1, 2003: $21,767,972.
State the number of shares outstanding of each of the issuer's classes
of common equity, as of the latest practicable date. The Company had
914,827 shares outstanding as of December 1, 2003.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the definitive proxy statement pursuant to Regulation 14A,
which was delivered to the Commission for filing on December 17, 2003, is
incorporated by reference into Part II of this report.
Transitional Small Business Disclosure Format (check one): Yes [ ] No X
EXPLANATORY NOTE
We hereby amend Items 1, 6, 7 and 13 of our Form 10-KSB/A for the fiscal
year ended September 30, 2003 in response to comment letters received from
the Securities and Exchange Commission to (1) revise Exhibits 31.1 and 31.2
in accordance with Item 601 of Regulation S-B, (2) explain the procedure
behind our determination of the allowance for loan losses and the reduction
in the loan loss ratio, (3) describe how we determined it was more likely
than not that some portion of the deferred tax assets would not be realized
and (4) restate our financial statements to (i) present loans held for sale
separately from total loans, (ii) reflect the results of a change in
Massachusetts tax law in income from continuing operations instead of as an
extraordinary item and (iii) revise the statement of cash flows to include
loans originated for resale and proceeds from those loans sold in operating
activities.
TABLE OF CONTENTS
Page
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FORWARD LOOKING STATEMENTS i
PART I 1
ITEM 1. DESCRIPTION OF BUSINESS 1
PART II 37
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS 37
ITEM 7. CONSOLIDATED FINANCIAL STATEMENTS 55
ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K 56
SIGNATURES 58
EXHIBITS 59
FINANCIAL STATEMENTS F-1
FORWARD LOOKING STATEMENTS
This Form 10-KSB/A contains certain forward-looking statements
consisting of estimates with respect to the financial condition, results of
operations and business of the Company and the Bank that are subject to
various factors which could cause actual results to differ materially from
these estimates. These factors include, but are not limited to: general and
local economic conditions; changes in interest rates, deposit flows, demand
for mortgages and other loans, real estate values, and competition; changes
in accounting principles, policies, or guidelines; changes in legislation or
regulation; and other economic, competitive, governmental, regulatory, and
technological factors affecting our operations, pricing, products and
services.
Any or all of our forward-looking statements in this Form 10-KSB/A and
in any other public statements we make may turn out to be wrong. They can
be affected by inaccurate assumptions we might make or by known or unknown
risks and uncertainties. Consequently, no forward-looking statement can be
guaranteed.
We undertake no obligation to publicly update forward-looking
statements, whether as a result of new information, future events or
otherwise, except as required by law.
i
PART I
ITEM 1. DESCRIPTION OF BUSINESS
General
Falmouth Bancorp, Inc. (the "Company" or "Bancorp"), a Delaware
corporation, is the holding company for Falmouth Co-operative Bank (the
"Bank"), a Massachusetts-chartered stock co-operative bank. At September
30, 2003, there were 913,727 shares outstanding. The Company's sole
business activity is ownership of the Bank. The Company also makes
investments in long and short-term marketable securities and other liquid
investments. The Company's common stock trades on the American Stock
Exchange under the symbol "FCB." Unless otherwise disclosed, the
information presented in this Report on Form 10-KSB/A represents the
consolidated activity of Falmouth Bancorp, Inc. and subsidiaries. The
Company had total assets of $166.1 million as of September 30, 2003.
The Bank conducts its business through an office located in Falmouth,
Massachusetts, where it was originally founded in 1925 as a Massachusetts
chartered mutual co-operative Bank, and branches located in East Falmouth
and North Falmouth, Massachusetts. The Bank opened a new branch office in
Bourne, Massachusetts in November 2003. The Bank's deposits are currently
insured up to applicable limits by the Bank Insurance Fund of the Federal
Deposit Insurance Corporation ("FDIC") and the Share Insurance Fund of the
Co-operative Central Bank of Massachusetts.
The Bank's principal business consists of attracting deposits from the
general public and uses these funds to originate mortgage loans secured by
one- to four-family residences located primarily in Falmouth, Massachusetts
and surrounding areas and to invest in United States Government and Agency
securities.
Business Strategy
The Bank's business strategy is to operate as a profitable and
independent community bank dedicated primarily to financing home ownership
and consumer needs in its market area and to provide quality service to its
customers. The Bank has implemented this strategy by: (i) closely
monitoring the needs of customers and providing quality service; (ii)
emphasizing consumer-oriented banking by originating residential mortgage
loans and consumer loans, and by offering checking accounts and other
financial services and products; (iii) focusing on expanding lending
activities to produce moderate increases in loan originations; (iv)
maintaining asset quality; (v) maintaining capital in excess of regulatory
requirements; and (vi) producing stable earnings.
The Bank serves its primary market area, the Massachusetts communities
of Falmouth and Mashpee located in the Cape Cod region of Massachusetts,
through its offices in Falmouth, North Falmouth and East Falmouth. The Bank
expanded its market area in November 2003 by opening a branch office in the
Massachusetts community of Bourne. The Bank continues to offer traditional
retail and commercial banking services as well as electronic services such
as its toll free Voice Response System "ON CALL," which enables its
customers to access current
1
balance information and transfer funds between accounts by telephone, its
new Internet Banking and Bill Paying product on its web site at
www.FalmouthBank.com, and three on-site, as well as three off-site ATMs.
The Bank competes with fifteen branches of financial institutions (including
national banks, savings banks, savings and loans and credit unions), which
are headquartered outside its market area. The Bank is the only independent
financial institution headquartered in Falmouth.
To a lesser extent, the Bank also makes commercial real estate loans,
commercial and industrial, and consumer loans, including passbook loans,
automobile, home equity and other consumer loans. The Bank originates both
fixed-rate and adjustable-rate loans and emphasizes the origination of
residential real estate mortgage loans with adjustable interest rates, and
makes other investments which allow the Bank to more closely match the
interest rate and maturities of its assets and liabilities.
Market Area
The Bank considers its primary market area to be the communities of
Falmouth and Mashpee in Barnstable County, which is located in the Cape Cod
region of Massachusetts, approximately 72 miles south of Boston. The year-
round population of Barnstable County is over 200,000. The majority of the
Bank's lending has been in Falmouth and Mashpee. The Cape Cod region is a
major recreational resort/retirement community, with seasonal tourism being
the most significant economic activity. Falmouth's year-round population of
32,660 (2000 census) increases to a summer population of approximately
75,000. Falmouth is the second most populous and second largest town on the
Cape. Visitors find accommodations in the many motels, hotels and inns in
the area. Falmouth has approximately 44 miles of ocean and lake shoreline.
There are nine harbors and inlets, some with docking and most with mooring
facilities. Two major harbors offer access, via ferry, to the island of
Martha's Vineyard with service to the island of Nantucket during the summer
months from Woods Hole. In addition to swimming, boating, fishing and other
forms of water recreation, Falmouth also has four public and two private
golf courses.
The major employers in the Falmouth area are the Woods Hole
Oceanographic Institute, with approximately 800 employees, Falmouth
Hospital, with 750 employees and Woods Hole, Martha's Vineyard and Nantucket
Steamship Authority, with 500 employees. Other major employers include
Marine Biological Laboratories.
Employees
At September 30, 2003, the Bank employed 33 full-time and 6 part-time
employees. The Bank's employees are not represented by a collective
bargaining agreement, and the Bank considers its relationship with its
employees to be good.
2
Lending Activities
General. The principal lending activity of the Bank is the
origination of conventional mortgage loans for the purpose of purchasing or
refinancing owner-occupied, one- to four-family residential properties in
its designated community reinvestment area of the Massachusetts towns of
Falmouth and Mashpee. To a lesser extent, the Bank also originates consumer
loans including home equity and passbook loans and commercial loans. The
Bank also originates and retains in its loan portfolio adjustable-rate loans
and fixed-rate loans with maturities of up to 30 years. Traditionally,
fixed-rate loans with terms of up to 30 years are originated and sold in the
secondary market. Loan originations for the year ended September 30, 2003,
achieved the level of $111.2 million and were primarily single-family
residential loans. During this period, the Bank was ranked by Banker and
Tradesman as one of the largest producers of residential mortgage loans in
the Falmouth market. The mortgage market in the Falmouth area was vigorous
in both the purchase money and refinance categories during fiscal 2003. The
Bank is a qualified seller/servicer for the Federal National Mortgage
Association ("FNMA") and was servicing $68.1 million in loans for FNMA and
$1.9 million for other investors at September 30, 2003. For all tables
presented, total loans and loans, net include loans held-for-sale.
3
Loan Portfolio. The following table presents selected data relating to the
composition of the Bank's loan portfolio by type of loan on the dates
indicated.
At September 30,
------------------------------------------------------------------------------------------------
2003 2002 2001 2000 1999
---------------- ---------------- ---------------- ---------------- ----------------
Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent
------ ------- ------ ------- ------ ------- ------ ------- ------ -------
(Dollars in thousands)
Residential mortgage loans $50,525 58.06% $ 69,694 69.40% $ 94,084 79.63% $ 88,647 79.50% $67,709 81.02%
Commercial real estate loans 15,702 18.04 11,845 11.80 10,406 8.81 11,865 10.64 8,488 10.16
Consumer loans 403 .46 439 .44 546 .46 527 .47 577 .69
Home equity loans 15,451 17.75 13,251 13.20 8,486 7.18 7,143 6.41 4,621 5.53
Commercial loans 4,943 5.69 5,179 5.16 4,634 3.92 3,331 2.98 2,175 2.60
------- ------ -------- ------ -------- ------ -------- ------ ------- ------
Gross loans 87,024 100.00% 100,408 100.00% 118,156 100.00% 111,513 100.00% 83,570 100.00%
------- ====== -------- ====== -------- ====== -------- ====== ------- ======
Less:
Deferred loan (cost), net
of origination fees (257) (297) (362) (190) (19)
Unadvanced principal 3,201 4,756 5,019 5,216 2,533
Allowance for loan losses 761 939 945 755 569
------- -------- -------- -------- -------
Loans, net $83,319 $ 95,010 $112,554 $105,732 $80,487
======= ======== ======== ======== =======
4
One- to Four-Family Residential Real Estate Lending. The primary
emphasis of the Bank's lending activity is the origination of conventional
mortgage loans secured by one- to four-family residential dwellings located
in the Bank's primary market area. As of September 30, 2003, loans on one-
to four-family residential properties accounted for 58.1% of the Bank's loan
portfolio and totaled $50.5 million.
The Bank's mortgage loan originations are for terms of up to 30 years,
amortized on a monthly basis with interest and principal due each month.
Residential real estate loans often remain outstanding for significantly
shorter periods than their contractual terms allow as borrowers may
refinance or prepay loans at their option, without penalty. Conventional
residential mortgage loans granted by the Bank customarily contain "due-on-
sale" clauses that permit the Bank to accelerate the indebtedness of the
loan upon transfer of ownership of the mortgaged property.
The Bank makes conventional mortgage loans and it uses standard FNMA
documents to allow for the sale of loans in the secondary mortgage market.
The Bank's lending policies generally limit the maximum loan-to-value ratio
on mortgage loans secured by owner-occupied properties to 95% of the lesser
of the appraised value or purchase price of the property, with the condition
that private mortgage insurance is required on loans with a loan-to-value
ratio in excess of 80%.
The Bank also offers adjustable-rate mortgage loans with terms of up
to 30 years. Adjustable-rate loans offered by the Bank include loans which
reprice every one, three, five and seven years and provide for an interest
rate which is based on the interest rate paid on United States Treasury
securities of a corresponding term, plus a margin of 2.75%. The Bank
currently offers adjustable-rate loans with initial rates below those that
would prevail under the foregoing computations, based upon the Bank's
determination of market factors and competitive rates for adjustable-rate
loans in its market area. For adjustable-rate loans, borrowers are qualified
at the initial rate plus an anticipated upward adjustment of 200 basis
points.
The Bank retains substantially all of the adjustable-rate mortgages it
originates. The Bank's adjustable-rate mortgages include caps on increases
or decreases of 2% per year, and 6% over the life of the loan (2% per yearly
adjustment, and 5% over the life of the loan for five-year adjustable-rate
loans). The retention of adjustable-rate mortgage loans in the Bank's loan
portfolio helps reduce the Bank's exposure to increases in interest rates.
However, there are unquantifiable credit risks resulting from potential
increased costs to the borrower as a result of repricing of adjustable-rate
mortgage loans. It is possible that during periods of rising interest rates,
the risk of default on adjustable-rate mortgage loans may increase due to
the upward adjustment of interest cost to the borrower.
During the year ended September 30, 2003, the Bank originated $8.6
million in adjustable-rate mortgage loans and $78.1 million in fixed-rate
mortgage loans. Approximately 57.1% of all loan originations during fiscal
2003 were the refinancing of loans already in the Bank's loan portfolio. At
September 30, 2003, the Bank's loan portfolio included $29.0 million in
adjustable-rate one- to four-family residential mortgage loans, or 34.5% of
the Bank's total
5
loan portfolio, and $33.3 million in fixed-rate one- to four-family
residential mortgage loans, or 39.6% of the Bank's total loan portfolio.
The Bank engages in a limited amount of construction lending generally
for the construction of single-family residences. Most are
construction/permanent loans structured to become permanent loans upon the
completion of construction. All construction loans are secured by first
liens on the property. Loan proceeds are disbursed as construction
progresses and inspections warrant. Loans involving construction financing
present a greater risk than loans for the purchase of existing homes, since
collateral values and construction costs can only be estimated at the time
the loan is approved. Due to the small amount of construction loans in the
Bank's portfolio, the risk in this area is limited.
Commercial Real Estate Loans. At September 30, 2003, the Bank's
commercial real estate loan portfolio totaled $15.7 million, or 18.7% of
total loans. The Bank's largest loan is a commercial loan with an
outstanding commitment of $1.5 million at September 30, 2003 secured by a
lumber company located in Falmouth, Massachusetts.
Commercial real estate lending entails additional risks compared with
one- to four-family residential lending. For example, commercial real estate
loans typically involve large loan balances to single borrowers or groups of
related borrowers and the payment experience on such loans is typically
dependent on the successful operation of a real estate project and/or the
collateral value of the commercial real estate securing the loan. At
September 30, 2003, all of the Bank's commercial real estate loans were
performing.
Home Equity Loans. The Bank also originates home equity loans, which
are loans, secured by available equity based on the appraised value of one-
to four-family residential property. Home equity loans will be made for up
to 80% of the tax assessed or appraised value of the property (less the
amount of the first mortgage). Home equity loans have an adjustable
interest rate which ranges from 0% to 1% above the prime rate as reported in
The Wall Street Journal and have terms of twenty years or less. At September
30, 2003, the Bank had $33.7 million in home equity loans with unused credit
available to existing borrowers of $18.2 million.
Consumer Loans. The Bank's consumer loans consist of passbook loans,
and other consumer loans, including automobile loans. At September 30,
2003, the consumer loan portfolio totaled $403,000 or .48% of total loans.
Consumer loans generally are offered for terms of up to five years at fixed
interest rates. Consumer loans do not exceed $15,000 individually.
Management expects to continue to promote consumer loans as part of its
strategy to provide a wide range of personal financial services to its
customers and as a means to increase the yield on the Bank's diversified
loan portfolio.
The Bank makes loans up to 90% of the amount of the depositor's
savings account balance. The interest rate on the loan is 4.0% higher than
the rate being paid on regular savings accounts and 3% higher than the rate
being paid on certificates of deposit. The Bank also makes other consumer
loans, which may or may not be secured. The terms of such loans usually
depend on the collateral. At September 30, 2003, the total amount of
passbook and other consumer loans, including overdraft lines of credit, was
$201,000.
6
The Bank makes loans for automobiles, both new and used, directly to
the borrowers. The loans are generally limited to 80% of the purchase price
or the retail value listed by the National Automobile Dealers Book. The
terms of the loans are determined by the age and condition of the
collateral. Collision insurance policies are required on all these loans. At
September 30, 2003, the total amount of automobile loans was $202,000.
Consumer loans generally are originated at higher interest rates than
residential mortgage loans but also tend to have a higher credit risk than
residential loans due to the loan being unsecured or secured by rapidly
depreciable assets. Despite this risk, the Bank's level of consumer loan
delinquencies generally has been low. No assurance can be given, however,
that the Bank's delinquency rate on consumer loans will continue to remain
low in the future, or that the Bank will not incur future losses on these
activities.
Commercial Loans. The Bank employs a commercial loan officer with
over 20 years of experience in commercial lending in the Falmouth market.
The Bank is pursuing, on a selective basis, the origination of commercial
loans to meet the working capital and short-term financing needs of
established local businesses. Unless otherwise structured as a mortgage on
commercial real estate, such loans are generally being limited to terms of
five years or less. Substantially all such commercial loans have variable
interest rates tied to the prime rate as reported in The Wall Street
Journal. Whenever possible, the Bank collateralizes these loans with a lien
on commercial real estate, or alternatively, with a lien on business assets
and equipment and the personal guarantees from principals of the borrower.
Commercial loans do not presently comprise a significant portion of the
Bank's loan portfolio. At September 30, 2003 the Bank's non-real estate
commercial loan portfolio totaled $4.9 million or 5.9% of the Bank's loan
portfolio.
Commercial business loans generally are considered to involve a higher
degree of risk than residential mortgage loans because the collateral may be
in the form of intangible assets and/or inventory subject to market
obsolescence. Commercial loans also may involve relatively large loan
balances to single borrowers or groups of related borrowers, with the
repayment of such loans typically dependent on the successful operation and
income stream of the borrower. Such risks can be affected significantly by
economic conditions. In addition, commercial business lending generally
requires substantially greater oversight efforts compared to residential
real estate lending.
Loan Commitments. The Bank makes a 60-day loan commitment to
borrowers. At September 30, 2003, the Bank had $3.2 million in loan
commitments outstanding for the origination of one- to four-family
residential real estate loans.
Loan Solicitation Origination and Loan Fees. The Bank originates
loans through its main office located in Falmouth, Massachusetts and branch
offices located in East Falmouth, North Falmouth and Bourne. Loan
originations are derived from a number of sources, including the Bank's
existing customers, referrals, realtors, advertising and "walk-in" customers
at the Bank's offices.
The Bank has one full-time residential loan originator who is
compensated with commission. The originator meets with applicants at their
convenience and location and is in regular contact with real estate brokers,
attorneys, accountants, building contractors, developers
7
and others in the Bank's local market area. The Bank increased its
advertising in locally distributed newspapers and has utilized local radio
advertising to increase its market share of residential loan originations.
Upon receipt of a loan application from a prospective borrower, a
credit report and verifications are ordered to verify specific information
relating to the loan applicant's employment, income and credit standing.
For all mortgage loans, an appraisal of real estate intended to secure the
proposed loan is obtained from an independent fee appraiser who has been
approved by the Bank's Board of Directors. Fire, casualty and sometimes
flood insurance are required on all loans secured by improved real estate.
Insurance on other collateral is required, unless waived by the loan
committee. The Board of Directors of the Bank has the responsibility and
authority for the general supervision over the loan policies of the Bank.
The Board has established written lending policies for the Bank. All
applications for residential and commercial real estate mortgages and
commercial business loans must be ratified by the Bank's Board of Directors.
In addition, certain designated officers of the Bank have limited authority
to approve consumer loans.
Interest rates charged by the Bank on all loans are primarily
determined by competitive loan rates offered in its market area and the Bank
generally charges an origination fee on new mortgage loans. The origination
fees, net of direct origination costs, are deferred and amortized into
income over the life of the loan.
Loan Maturities. The following table sets forth certain information
at September 30, 2003 regarding the dollar amount of loans maturing in the
Bank's portfolio based on their contractual terms to maturity, including
scheduled repayments of principal. Demand loans, loans having no stated
schedule of repayments and any stated maturity, and overdrafts are reported
as due in one year or less.
At September 30, 2003(1)
--------------------------------
Real Consumer Total
Estate and Other Loans
------- --------- -----
(In thousands)
Total loans scheduled to mature:
In one year or less $ 6,410 $1,924 $ 8,334
After one year through five years 12,756 945 13,701
Beyond five years 59,245 2,800 62,045
------- ------ -------
Total $78,411 $5,669 $84,080
======= ====== =======
Loan balance by type scheduled to
mature after one year:
Fixed $41,819 $1,238 $43,057
Adjustable $30,182 $2,507 $32,689
-----------------
Net of unearned income and unadvanced principal.
8
Originations and Sales of Loans. The following table sets forth
information with respect to originations and sales of loans during the
periods indicated.
Years Ended September 30,
------------------------------------------------------------
2003 2002 2001 2000 1999
---- ---- ---- ---- ----
(In thousands)
Beginning balance(1) $ 95,949 $113,499 $106,487 $ 81,056 $ 78,182
-------- -------- -------- -------- --------
Mortgage loan originations(2) 96,411 65,782 44,141 39,853 28,279
Consumer loan originations 12,130 12,573 8,999 5,318 4,323
Commercial loan originations 2,644 3,914 1,519 1,619 2,249
Less:
Amortization and payoffs(3) (58,324) (62,992) (38,734) (21,299) (24,193)
Transfers to other real estate
owned (OREO) - - - - -
-------- -------- -------- -------- --------
Net loans originated 52,861 19,277 15,925 25,491 10,658
-------- -------- -------- -------- --------
Total loans sold (64,730) (36,827) (8,913) (60) (7,784)
-------- -------- -------- -------- --------
Ending balance(1) $ 84,080 $ 95,949 $113,499 $106,487 $ 81,056
======== ======== ======== ======== ========
-----------------
Net of unearned income and unadvanced principal.
Includes residential and commercial real estate loans.
Includes unadvanced principal.
Non-Performing Assets, Asset Classification and Allowances for Losses.
Loans are reviewed on a regular basis and are placed on a non-accrual status
when, in the opinion of management, the collection of principal and interest
is doubtful. The level established for the provision for loan losses is
determined by management in its effort to maintain an allowance for loan
losses that is adequate for the size and composition of its loan portfolio
and reflects the Bank's historical record of loan losses. Each element of
the allowance is reviewed by type of loan which consists of 1-4 family
residential mortgages, representing 52.4% of the total loans used for the
allowance for loan losses general reserve calculation; home equity lines of
credit, representing 18.5%; 1-4 family construction loans to the extent the
funds have been advanced, representing 3.5%; commercial real estate loans,
representing 19.1%; non-real estate commercial loans, representing 6.0%; and
other consumer loan types, representing 0.5%. All commercial loans are
reviewed individually on a monthly basis, as are all other loans that are 60
or more days delinquent, have high loan-to-value ratios, or are involved in
litigation that could jeopardize the value of the property or ability to
repay the loan.
As of September 30, 2003 the Bank had one delinquent residential real
estate loan, two delinquent consumer loans and no non-performing loans.
Loans with deviations in their quality are monitored on the Bank's
"watch list" and are assigned specific reserve allocations, such as
commercial loans and construction loans, which are weighted heavier than
owner occupied 1-4 family residential loans and warrant increased provisions
on an on-going basis. The Bank's non-real estate commercial loans totaled
$4.9 million at September 30, 2003, as compared to $5.2 million at September
30, 2002.
Real estate acquired by the Bank as a result of foreclosure is
classified as real estate owned until such time as it is sold. When such
property is acquired, it is recorded at the lower of
9
the unpaid principal balance or its fair value. Any required write-down of
the loan to its fair value is charged to the allowance for loan losses.
At September 30,
--------------------------------------------
2003 2002 2001 2000 1999
---- ---- ---- ---- ----
(Dollars in thousands)
Loans 30-89 days past due
(not included in non-performing loans) $ 81 $100 $ - $ - $ 57
Loans 30-89 days past due as a
percent of total loans .10% .10% -% -% .07%
Non-performing loans:
(90 days past due) $ - $ - $ - $ - $ -
OREO $ - $ - $ - $ - $ -
Total non-performing assets $ - $ - $ - $ - $ -
Non-performing loans as a percent of
total loans -% -% -% -% -%
Non-performing assets as a
percent of total assets -% -% -% -% -%
During the year ended September 30, 2003, no gross interest income
would have been recorded on loans accounted for on a non-accrual basis if
the loans had been current throughout the period.
No interest on such loans was included in income during the respective
periods. At September 30, 2003, management was not aware of any loans not
currently classified as non-accrual, 90 days past due or restructured but
which may be so classified in the near future because of concerns over the
borrower's ability to comply with repayment terms.
Federal and state regulations require each banking institution to
classify its asset quality on a regular basis. In addition, in connection
with examinations of such banking institutions, federal and state examiners
have authority to identify problem assets and, if appropriate, classify
them. An asset is classified substandard if it is determined to be
inadequately protected by the current net worth and paying capacity of the
obligor or of the collateral pledged, if any. As a general rule, the Bank
will classify a loan as substandard if the Bank can no longer rely on the
borrower's income as the primary source for repayment of the indebtedness
and must look to secondary sources such as guarantors or collateral. An
asset is classified as doubtful if full collection is highly questionable or
improbable. An asset is classified as loss if it is considered
uncollectible, even if a partial recovery could be expected in the future.
The regulations also provide for a special mention designation, described as
assets which do not currently expose a banking institution to a sufficient
degree of risk to warrant classification but do possess credit deficiencies
or potential weaknesses deserving management's close attention. Assets
classified as substandard or doubtful require a banking institution to
establish general allowances for loan losses. If an asset or portion thereof
is classified loss, a banking institution must either establish specific
allowances for loan losses in the amount of the portion of the asset-
classified loss, or charge off such amount. Examiners may disagree with a
banking institution's classifications and amounts reserved. If a banking
institution does not agree with an examiner's classification of an asset, it
may appeal this determination to the FDIC Regional Director. At September
30, 2003, the Bank had no assets classified as special mention or doubtful,
no assets designated as substandard, and none classified as loss.
10
In originating loans, the Bank recognizes that credit losses will
occur and that the risk of loss will vary with, among other things, the type
of loan being made, the creditworthiness of the borrower over the term of
the loan, general economic conditions and, in the case of a secured loan,
the quality of the security for the loan. It is management's policy to
maintain an adequate general allowance for loan losses based on, among other
things, the Bank's and the industry's historical loan loss experience,
evaluation of economic conditions and regular reviews of delinquencies and
loan portfolio quality. Further, after properties are acquired following
loan defaults, additional losses may occur with respect to such properties
while the Bank is holding them for sale. The Bank increases its allowances
for loan losses and losses on real estate owned by charging provisions for
losses against the Bank's income. Specific reserves also are recognized
against specific assets when warranted.
Results of recent examinations by bank regulators indicate that these
regulators may be applying more conservative criteria in evaluating real
estate market values, requiring significantly increased provisions for
potential loan losses. While Falmouth believes it has established its
existing allowances for loan losses in accordance with generally accepted
accounting principles, there can be no assurance that regulators, in
reviewing the Bank's loan portfolio, will not request the Bank to increase
its allowance for loan losses, thereby negatively affecting the Bank's
financial condition and earnings.
The bank regulatory agencies, including the FDIC, have a policy
statement regarding maintenance of an adequate allowance for loan and lease
losses and an effective loan review system. This policy includes an
arithmetic formula for checking the reasonableness of an institution's
allowance for loan loss estimate compared to the average loss experience of
the industry as a whole. Examiners will review an institution's allowance
for loan losses and compare it against the sum of (i) 50% of the portfolio
that is classified doubtful; (ii) 15% of the portfolio that is classified as
substandard; and (iii) for the portions of the portfolio that have not been
classified (including those loans designated as special mention), estimated
credit losses over the upcoming twelve months given the facts and
circumstances as of the evaluation date. This amount is considered neither a
"floor" nor a "safe harbor" of the level of allowance for loan losses an
institution should maintain, but examiners will view a shortfall relative to
the amount as an indication that they should review management's policy on
allocating these allowances to determine whether it is reasonable based on
all relevant factors.
11
The following table analyzes activity of the Bank's allowance for loan
losses for the periods indicated.
Year Ended September 30,
-----------------------------------------------------------
2003 2002 2001 2000 1999
---- ---- ---- ---- ----
(Dollars in thousands)
Average loans, net $85,333 $106,785 $111,573 $ 94,315 $77,657
------- -------- -------- -------- -------
Period-end total loans(1) $84,080 $ 95,949 $113,499 $106,487 $81,056
------- -------- -------- -------- -------
Allowance for loan losses at
beginning of period $ 939 $ 945 $ 755 $ 569 $ 527
Loans charged-off - 6 - 4 -
Recoveries 2 - - 1 -
Provision charged to operations (180) - 190 189 42
------- -------- -------- -------- -------
Allowance for loan losses at
end of period $ 761 $ 939 $ 945 $ 755 $ 569
======= ======== ======== ======== =======
Ratios:
Allowance for loan losses as a
percentage of period end total
loans .91% .98% .83% .71% .70%
Allowance for loan losses as a
percentage of non-performing
loans - - - - -
Net charge-offs to average loans,
net - .01% - - -
Net charge-offs to allowance for
loan losses - .64% - .40% -
-----------------
Net of unearned income and unadvanced principal.
12
The following table sets forth a breakdown of the allowance for loan
losses by loan category at the dates indicated. Management believes that the
allowance can be allocated by category only on an approximate basis. These
allocations are not necessarily indicative of future losses and do not
restrict the use of the allowance to absorb losses in any loan category.
At September 30,
-----------------------------------------------------------------------------------------
2003 2002 2001 2000 1999
Percent of Percent of Percent of Percent of Percent of
Loans in Loans in Loans in Loans in Loans in
Each Each Each Each Each
Category Category Category Category Category
to Total to Total to Total to Total to Total
Amount Loans Amount Loans Amount Loans Amount Loans Amount Loans
------ ----- ------ ----- ------ ----- ------ ----- ------ -----
(Dollars in Thousands)
Real estate mortgage:
Residential $211 55.57% $330 65.56% $532 78.79% $436 78.53% $282 80.42%
Commercial 330 19.64 310 14.78 201 9.17 181 11.14 171 10.47
Commercial loans, other 99 5.90 162 5.39 119 4.08 76 3.13 62 2.70
Consumer, including
home equity loans 121 18.89 137 14.27 93 7.96 62 7.20 54 6.41
---- ------ ---- ------ ---- ------ ---- ------ ---- ------
Total allowance
for loan losses $761 100.00% $939 100.00% $945 100.00% $755 100.00% $569 100.00%
==== ====== ==== ====== ==== ====== ==== ====== ==== ======
13
Investment Activities
General. The Bank is required to maintain an amount of liquid assets
appropriate for its level of net withdrawals from savings accounts and
current borrowings. Generally, it has been the Bank's policy to maintain a
liquidity portfolio in excess of regulatory requirements. At September 30,
2003, the Bank's liquidity ratio was 53.1%. Liquidity levels may be
increased or decreased depending upon the yields on investment alternatives,
management's judgment as to the attractiveness of the yields then available
in relation to other opportunities, management's expectations of the level
of yield that will be available in the future and management's projections
as to the short-term demand for funds to be used in Falmouth's loan
origination and other activities.
Interest income from investments in various types of liquid assets
provides a significant source of revenue for the Bank. In the late 1980s,
the Bank maintained its conservative underwriting standards in an effort to
avoid asset quality problems and chose instead to invest excess liquidity in
its investment portfolio. The Bank's short-term investments include United
States Treasury securities and United States Agency securities, commercial
paper, equity securities, short-term corporate debt securities and overnight
federal funds. The balance of the securities investments maintained by the
Bank in excess of regulatory requirements reflects management's historical
objective of maintaining liquidity at a level that assures the availability
of adequate funds, taking into account anticipated cash flows and available
sources of credit, for meeting withdrawal requests and loan commitments and
making other investments.
The Bank purchases securities through a primary dealer of United
States Government obligations or such other securities dealers authorized by
the Board of Directors and requires that the securities be delivered to the
safekeeping agent (Investors Bank & Trust Company) before the funds are
transferred to the broker or dealer. The Bank purchases investment
securities pursuant to an investment policy established by the Board of
Directors.
All securities and investments are recorded on the books of the Bank
in accordance with accounting principles generally accepted in the United
States of America (GAAP). The Bank does not purchase securities and
investments for trading. Available-for-sale securities are reported at fair
value with unrealized gains or losses reported as a separate component of
net worth. All purchases of securities and investments conform to the Bank's
interest rate risk policy.
14
The following table sets forth the scheduled maturities, average
yields, amortized cost and market value for the Bank's investment securities
at September 30, 2003.
September 30, 2003
------------------------------------------------------------------------------------------------
One Year One to Five to More than Total Investment
or Less Five Years Ten Years Ten Years Portfolio
--------------- --------------- --------------- --------------- ------------------------
Amor- Amor- Amor- Amor- Amor-
tized Average tized Average tized Average tized Average tized Average Market
Cost Yield Cost Yield Cost Yield Cost Yield Cost Yield Value
----- ------- ----- ------- ----- ------- ----- ------- ----- ------- ------
(Dollars in thousands)
U.S. Government Obligations $ 5,536 0.94% $ - -% $ - -% $ - -% $ 5,536 0.94% $ 5,534
Mortgage-backed Securities - - 32 7.74 352 7.49 118 7.27 502 7.45 531
Corporate Notes and Bonds 53,094 1.99 8,993 1.99 - - - - 62,088 1.99 62,045
------- ------ ---- ---- ------- -------
Total $58,630 3.22% $9,025 3.77% $352 7.49% $118 7.27% 68,126 1.94 68,110
======= ====== ==== ====
Marketable Equity Securities 1,703 1.47 1,626
FHLB Stock 878 3.81 878
------- -------
Total Investment Portfolio $70,707 1.96% $70,614
======= =======
15
The following tables set forth information regarding the investment
portfolio at the dates indicated.
September 30, 2003
---------------------------------------------------------------------------
Available-for-Sale Held-to-Maturity
----------------------------------- -------------------------------------
Amortized Market Amortized Market
Cost Value Percent(1) Cost Value Percent(2)
--------- ------ --------- --------- ------ ----------
(Dollars in thousands)
Investment securities(3):
U.S. government
obligations $ 5,536 $ 5,534 14.9% $ - $ - -%
Other bonds and
obligations 29,688 29,643 79.7 32,400 32,401 99.5
Marketable equity
securities 1,703 1,626 4.4 - - -
Mortgage-backed
securities(4) 352 376 1.0 150 155 .5
------- ------- ----- ------- ------- -----
Total Investment
Portfolio $37,279 $37,179 100.0% $32,550 $32,556 100.0%
======= ======= ===== ======= ======= =====
September 30,
------------------------------------------------------------------------
2003 2002 2001
--------------------- ---------------------- ---------------------
Carrying Carrying Carrying
Amount Percent Amount Percent Amount Percent
-------- ------- -------- ------- -------- -------
(Dollars in thousands)
Investment securities
at carrying amount(3):
U.S. government
obligations $ 5,534 7.9% $14,506 31.0% $ 4,581 23.7%
Other bonds and
obligations 62,043 89.0 29,447 63.0 10,722 55.5
Marketable equity
securities 1,626 2.3 1,984 4.2 2,630 13.6
Mortgage-backed
securities(4) 526 0.8 836 1.8 1,398 7.2
------- ----- ------- ----- ------- -----
Total Investment
Portfolio $69,729 100.0% $46,773 100.0% $19,331 100.0%
======= ===== ======= ===== ======= =====
-----------------
As a percentage of total market value.
As a percentage of total amortized cost.
Does not include federal funds sold of $4 million or Federal Home Loan
Bank Stock of $878,000.
Consists of GNMA, FHLMC and FNMA certificates.
16
Deposit Activity and Other Sources of Funds
General. Deposits are the primary source of the Bank's funds for
lending and other investment purposes. In addition to deposits, the Bank
derives funds from principal repayments and interest payments on loans and
investments as well as other sources arising from operations in the
production of net earnings. Loan repayments and interest payments are a
relatively stable source of funds, while deposit inflows and outflows are
significantly influenced by general interest rates and money market
conditions. Borrowings may be used on a short-term basis to compensate for
reductions in the availability of funds from other sources, or on a longer-
term basis for general business purposes.
Deposits. Deposits are attracted principally from within the Bank's
primary market area through the offering of a broad selection of deposit
instruments, including passbook savings, NOW accounts, demand deposits,
money market accounts and certificates of deposit. Deposit account terms
vary, with the principal differences being the minimum balance required, the
time periods the funds must remain on deposit and the interest rate.
The Bank's policies are designed primarily to attract deposits from
local residents and businesses rather than to solicit deposits from areas
outside its primary market. The Bank does not accept deposits from brokers
due to the volatility and rate sensitivity of such deposits. Interest rates
paid, maturity terms, service fees and withdrawal penalties are established
by the Bank on a periodic basis. Determination of rates and terms are
predicated upon funds acquisition and liquidity requirements, rates paid by
competitors, growth goals and federal regulations.
17
The following table sets forth the various types of deposit accounts
at the Bank and the balances in these accounts at the dates indicated.
At September 30,
-----------------------------------------------------------------------------------------------------
2003 2002 2001 2000 1999
----------------- ----------------- ----------------- ----------------- -----------------
Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent
------ ------- ------ ------- ------ ------- ------ ------- ------ -------
(Dollars in thousands)
Savings deposits $ 25,406 17.5% $ 21,463 16.3% $ 18,683 15.3% $ 19,380 17.2% $17,782 19.1%
NOW accounts 14,863 10.2 9,540 7.2 9,637 7.9 10,095 9.0 9,389 10.1
Money market deposits 31,386 21.6 26,049 19.8 19,413 15.9 16,462 14.7 14,188 15.3
-------- ----- -------- ----- -------- ----- -------- ----- ------- -----
Total 71,655 49.3 57,052 43.3 47,733 39.1 45,937 40.9 41,359 44.5
Demand deposits 20,426 14.0 17,552 13.3 16,147 13.2 14,243 12.6 8,091 8.7
Certificates of deposit 53,454 36.7 57,113 43.4 58,296 47.7 52,194 46.5 43,436 46.8
-------- ----- -------- ----- -------- ----- -------- ----- ------- -----
Total deposits $145,535 100.0% $131,717 100.0% $122,176 100.0% $112,374 100.0% $92,886 100.0%
======== ===== ======== ===== ======== ===== ======== ===== ======= =====
For more information on the Bank's deposit accounts, see Note 6 of the Notes
to Consolidated Financial Statements.
18
The following table indicates the amount of the Bank's certificates of
deposit of $100,000 or more by time remaining until maturity at September
30, 2003.
Certificates of
Maturity Period Deposit
--------------- ---------------
(In thousands)
Within three months $ 2,638
After three but within six months 3,272
After six but within twelve months 3,712
After twelve months 3,461
-------
Total $13,083
=======
The following table sets forth the deposit activity of the Bank for
the periods indicated.
Years Ended September 30,
------------------------------------------------------------
2003 2002 2001 2000 1999
---- ---- ---- ---- ----
(In thousands)
Deposits $809,151 $675,994 $551,960 $448,303 $344,310
Withdrawals 797,522 669,546 546,278 432,244 335,933
-------- -------- -------- -------- --------
Net increase (decrease)
before interest credited 11,629 6,448 5,682 16,059 8,377
Interest credited 2,189 3,093 4,120 3,429 2,990
-------- -------- -------- -------- --------
Net increase
in deposits $ 13,818 $ 9,541 $ 9,802 $ 19,488 $ 11,367
======== ======== ======== ======== ========
Borrowings. Savings deposits historically have been the primary source
of funds for the Bank's lending and investment activities and for its
general business activities. The Bank is authorized, however, to use
advances from the FHLB of Boston to supplement its supply of lend able funds
and to meet deposit withdrawal requirements. Advances from the FHLB are
secured by the Bank's stock in the FHLB and a portion of the Bank's mortgage
loans. The Bank had $2.6 million of FHLB advances outstanding at September
30, 2003.
The FHLB of Boston functions as a central reserve bank providing
credit for savings institutions and certain other financial institutions. As
a member, the Bank is required to own capital stock in the FHLB and is
authorized to apply for advances on the security of such stock and certain
of its home mortgages and other assets (principally, securities which are
obligations of, or guaranteed by the United States) provided certain
standards related to creditworthiness have been met.
Competition
The Bank experiences substantial competition both in attracting and
retaining savings deposits and in the making of mortgage and other loans.
Direct competition for savings deposits primarily comes from larger
commercial banks and other savings institutions located in or near the
Bank's primary market area that generally have significantly greater
financial and technological resources than the Bank. Additional significant
competition for savings deposits comes from credit unions, money market
funds and brokerage firms. The primary factors in
19
competing for loans are interest rates and loan origination fees and the
range of services offered by the various financial institutions. Competition
for origination of real estate loans normally comes from commercial banks,
other thrift institutions, mortgage bankers, mortgage brokers and insurance
companies. Management considers the Bank's competitors in its market area to
consist of 15 branches of financial institutions headquartered outside of
its market area. The Bank is the only independent financial institution
headquartered in Falmouth.
FEDERAL AND STATE TAXATION
Federal Taxation
General. The following is intended only as a discussion of material
federal income tax matters and does not purport to be a comprehensive
description of the federal income tax rules applicable to the Bank or the
Company. The Bank's federal income tax return was last audited for the tax
year ended September 30, 1975. For federal income tax purposes, the Company
and the Bank, as members of the same affiliated group, file consolidated
income tax returns on a September 30 fiscal year basis using the accrual
method of accounting and are subject to federal income taxation in the same
manner as other corporations with some exceptions, including particularly
the Bank's tax reserve for bad debts, discussed below.
Bad Debt Reserves. The Bank, as a "small bank" (one with assets
having an adjusted tax basis of $500 million or less) is permitted to
maintain a reserve for bad debts with respect to "qualifying loans," which,
in general, are loans secured by certain interests in real property, and
to make, within specified formula limits, annual additions to the reserve
which are deductible for purposes of computing the Bank's taxable income.
Pursuant to the Small Business Job Protection Act of 1996, the Bank is now
recapturing (taking into income) over a multi-year period a portion of the
balance of its bad debt reserve as of September 30, 1996. See Note 9 to the
consolidated financial statements.
Distributions. To the extent that the Bank makes "non-dividend
distributions" to the Company, such distributions will be considered to have
been made from the Bank's "base year reserve," i.e., its reserve as of
September 30, 1988, and then from the Bank's supplemental reserve for losses
on loans, to the extent thereof, and an amount based on the amount
distributed (but not in excess of the amount of such reserves) will be
included in the Bank's income. Non-dividend distributions include
distributions in excess of the Bank's current and accumulated earnings and
profits, as calculated for federal income tax purposes, distributions in
redemption of stock, and distributions in partial or complete liquidation.
Dividends paid out of the Bank's current or accumulated earnings and profits
will not be so included in the Bank's income.
The amount of additional taxable income created from a non-dividend
distribution is an amount that, when reduced by the tax attributable to the
income, is equal to the amount of the distribution. Thus, if the Bank makes
a non-dividend distribution to the Company, approximately one and one-half
times the amount of such distribution (but not in excess of the amount of
such reserves) would be includible in income, assuming a 34% federal
corporate income tax rate. The Bank does not intend to pay dividends that
would result in a recapture of any portion of its bad debt reserves.
20
Corporate Alternative Minimum Tax. The Code imposes a tax ("AMT") on
alternative minimum taxable income ("AMTI") at a rate of 20%. Only 90% of
AMTI can be offset by net operating loss carryovers of which the Bank
currently has none. AMTI is also adjusted by determining the tax treatment
of certain items in a manner that negates the deferral of income resulting
from the regular tax treatment of those items. The Bank does not expect to
be subject to the AMT.
Elimination of Dividends; Dividends Received Deduction. The Company
may exclude from its income 100% of dividends received from the Bank as a
member of the same affiliated group of corporations. The corporate
dividends-received deduction is generally 70% in the case of dividends
received from unaffiliated corporations with which the Company and the Bank
will not file a consolidated tax return, except that if the Company or the
Bank owns more than 20% of the stock of a corporation distributing a
dividend, then 80% of any dividends received may be deducted.
State Taxation
Massachusetts Taxation. The Bank currently files a separate
Massachusetts excise tax return, based on net income. Under state laws,
Massachusetts-based financial institutions may apportion income earned in
other states. However, the Massachusetts bank excise (income) tax applies
to non-bank entities and out-of-state financial institutions as well as
Massachusetts-based financial institutions. The Massachusetts excise tax
rate for co-operative banks is currently 10.50% of federal taxable income,
adjusted for certain items. Taxable income includes gross income as defined
under the Code, plus interest from bonds, notes and evidences of
indebtedness of any state, including Massachusetts, less deductions, but not
the credits, allowable under the provisions of the Code. Carry forwards and
carry backs of net operating losses are not allowed. In March of 2003, tax
legislation enacted by the Commonwealth of Massachusetts, effective
retroactively to 1999, eliminated the 95% income tax dividend exclusion on
dividends the Bank received from its real estate investment trust
subsidiary.
For additional information regarding taxation, see Note 9 of the Notes
to Financial Statements.
Delaware Taxation. As a Delaware holding company not earning income
in Delaware, the Company is exempt from Delaware corporate income tax but is
required to file an annual report with and pay an annual franchise tax to
the State of Delaware.
21
REGULATION AND SUPERVISION
General
As a co-operative bank chartered by the Commonwealth of Massachusetts,
whose deposits are insured by the Bank Insurance Fund of the FDIC, the Bank
is subject to extensive regulation under state law with respect to many
aspects of its banking activities; this state regulation is administered by
the Commissioner of the Massachusetts Division of Banks (the "Division").
In addition, the FDIC levies assessments or deposit insurance premiums on
the Bank and is vested with authority to supervise the Bank and to exercise
a broad range of enforcement powers. Finally, the Bank is required to
maintain reserves against deposits according to a schedule established by
the Federal Reserve System. These laws and regulations have been
established primarily for the protection of depositors and the deposit
insurance fund, not the Company's stockholders.
The Company, as the bank holding company controlling Falmouth Co-
operative Bank, is subject to the Bank Holding Company Act of 1956, as
amended, and its rules and regulations promulgated by the Federal Reserve
Board. The Company is also subject to certain Massachusetts banking laws
applicable to bank holding companies.
The following references to the laws and regulations under which the
Company and the Bank are regulated are brief summaries thereof, do not
purport to be complete and are qualified in their entirety by reference to
such laws and regulations.
Financial Services Modernization Legislation
On November 12, 1999, President Clinton signed into law the Gramm-
Leach-Bliley Financial Services Modernization Act of 1999 ("GLB Act"). This
federal legislation was intended to modernize the financial services
industry by establishing a comprehensive framework to permit affiliations
among commercial banks, insurance companies, securities firms and other
financial service providers.
Bank holding companies are now permitted to engage in a wider variety
of financial activities than permitted under prior law, particularly with
respect to insurance and securities activities if such companies elect to be
regulated as a financial holding company. In addition, in a change from
prior law, bank holding companies will be in a position to be owned,
controlled or acquired by any company engaged in financially related
activities.
Federal Banking Regulations
Capital Requirements. FDIC regulations require BIF-insured banks,
such as the Bank, to maintain minimum levels of capital. The FDIC
regulations define two tiers, or classes, of capital- Tier 1 Capital and
Tier 2 Capital.
Overall, the amount of Tier 2 Capital that may be included in total capital
cannot exceed 100% of Tier 1 Capital.
22
The FDIC regulations establish a minimum leverage capital requirement
for banks in the strongest financial and managerial condition, with a rating
of 1 (the highest examination rating of the FDIC for banks) under the
Uniform Financial Institutions Rating System, of not less than a ratio of
3.0% of Tier 1 capital to total assets. For all other banks, the minimum
leverage capital requirement is 4.0%, unless a higher leverage capital ratio
is warranted by the particular circumstances or risk profile of the
depository institution.
The FDIC regulations also require that co-operative banks meet a risk-
based capital standard. The risk-based capital standard requires the
maintenance of a ratio of total capital (which is defined as the sum of Tier
1 capital and Tier 2 capital) to risk-weighted assets of at least 8% and a
ratio of Tier 1 capital to risk-weighted assets of at least 4%. In
determining the amount of risk-weighted assets, all assets, plus certain off
balance sheet items, are multiplied by a risk-weight of 0% to 100%, based on
the risks the FDIC believes are inherent in the type of asset or item.
The federal banking agencies, including the FDIC, have also adopted
regulations to require an assessment of an institution's exposure to
declines in the economic value of a bank's capital due to changes in
interest rates when assessing the bank's capital adequacy. Under such a
risk assessment, examiners will evaluate a bank's capital for interest rate
risk on a case-by-case basis, with consideration of both quantitative and
qualitative factors. According to the agencies, applicable considerations
include:
* the quality of the bank's interest rate risk management process;
* the overall financial condition of the bank; and
* the level of other risks at the bank for which capital is
needed.
Institutions with significant interest rate risk may be required to
hold additional capital. The agencies also issued a joint policy statement
providing guidance on interest rate risk management, including a discussion
of the critical factors affecting the agencies' evaluation of interest rate
risk in connection with capital adequacy.
23
The following table shows the Company's and the Bank's leverage
capital ratio, their Tier 1 risk-based capital ratio, and their total risk-
based capital ratio, at September 30, 2003:
At September 30, 2003
-----------------------------------------------------
Capital Percent of Capital Percent of
Amount Assets(1) Requirement Assets(1)
------- ---------- ----------- ----------
Falmouth Bancorp, Inc (Dollars in thousands)
Tier 1 leverage capital $17,696 10.74% $ 6,590 > or =4.0%
Tier 1 risk-based capital $17,696 13.36% $ 5,297 > or =4.0%
Total risk-based capital $18,457 13.94% $10,594 > or =8.0%
Falmouth Cooperative Bank
Tier 1 leverage capital $16,443 9.96% $ 6,602 > or =4.0%
Tier 1 risk-based capital $16,443 12.48% $ 5,269 > or =4.0%
Total risk-based capital $17,204 13.06% $10,538 > or =8.0%
--------------------
For purposes of calculating the Tier 1 leverage capital ratio, assets
include adjusted total average assets. In calculating Tier 1 risk-
based capital and total risk-based capital ratio, assets include total
risk-weighted assets.
As the table shows, the Bank and the Company exceeded the minimum
capital adequacy requirements at September 30, 2003.
Enforcement
The FDIC has extensive enforcement authority over insured co-operative
banks, including the Bank. This enforcement authority includes, among other
things, the ability to assess civil money penalties, to issue cease and
desist orders and to remove directors and officers. In general, these
enforcement actions may be initiated in response to violations of laws and
regulations and to unsafe or unsound practices.
The FDIC has authority under federal law to appoint a conservator or
receiver for an insured bank under certain circumstances. The FDIC is
required, with certain exceptions, to appoint a receiver or conservator for
an insured state bank if that bank is "critically undercapitalized." For
this purpose, "critically undercapitalized" means having a ratio of tangible
capital to total assets of less than 2%. The FDIC may also appoint a
conservator or receiver for a state bank on the basis of the institution's
financial condition or upon the occurrence of certain events, including: (i)
insolvency (whereby the assets of the bank are less than its liabilities to
depositors and others); (ii) substantial dissipation of assets or earnings
through violations of law or unsafe and unsound practices; (iii) existence
of an unsafe or unsound condition to transact business; (iv) likelihood that
the bank will be unable to meet the demands of its depositors or to pay its
obligations in the normal course of business; and (v) insufficient capital,
or the incurring or likely incurring of losses that will deplete
substantially all of the institution's capital with no reasonable prospect
of replenishment of capital without federal assistance.
Deposit Insurance
The FDIC has adopted a risk-based deposit insurance assessment system.
The FDIC assigns an institution to one of three capital categories based on
the institution's financial
24
information, as of the reporting period ending seven months before the
assessment period, consisting of (1) well capitalized, (2) adequately
capitalized or (3) undercapitalized, and one of three supervisory
subcategories within each capital group. The supervisory subgroup to which
an institution is assigned is based on a supervisory evaluation provided to
the FDIC by the institution's primary federal regulator and information that
the FDIC determines to be relevant to the institution's financial condition
and the risk posed to the deposit insurance funds. An institution's
assessment rate depends on the capital category and supervisory category to
which it is assigned. Assessment rates for BIF deposits currently range
from 0 basis points to 27 basis points. The Bank's assessment rate is
currently 0 basis points. The FDIC is authorized to raise the assessment
rates in certain circumstances, including maintaining or achieving the
designated reserve ratio of 1.25%, which requirement the BIF currently
meets. The FDIC has exercised its authority to raise rates in the past and
may raise insurance premiums in the future. If the FDIC takes such action,
it could have an adverse effect on the earnings of the Bank. In addition,
legislation requires BIF-insured institutions like the Bank to assist in the
payment of FICO bonds.
Under the Federal Deposit Insurance Act (the "FDI Act"), insurance of
deposits may be terminated by the FDIC upon a finding that the institution
has engaged in unsafe or unsound practices, is in an unsafe or unsound
condition to continue operations or has violated any applicable law,
regulation, rule, order or condition imposed by the FDIC or the Division.
The management of the Bank does not know of any practice, condition or
violation that might lead to termination of deposit insurance.
Transactions with Affiliates and Insiders
Transactions between state non-member banks and any affiliate are
governed by Sections 23A and 23B of the Federal Reserve Act. An affiliate
of a bank is any company or entity that controls, is controlled by or is
under common control with the bank. Currently, a subsidiary of a bank that
is not also a depository institution is not treated as an affiliate of the
bank for purposes of Sections 23A and 23B. Generally, Section 23A:
* limits the extent to which the bank or its subsidiaries may
engage in "covered transactions" with any one affiliate to an
amount equal to 10% of such bank's capital and surplus, and
contains an aggregate limit on all such transactions with all
affiliates to an amount equal to 20% of such capital and
surplus; and
* requires that all such transactions be on terms that are
consistent with safe and sound banking practices.
The term "covered transaction" includes the making of loans, purchase of
assets, issuance of guarantees and similar other types of transactions. In
addition, most extensions of credit by a bank to any of its affiliates must
be secured by collateral in amounts ranging from 100% to 130% of the loan
amounts, depending on the type of collateral. Section 23B requires that any
covered transaction, and certain other transactions, including the bank's
sale of assets and purchase of services from an affiliate must be on terms
that are substantially the same, or at least as favorable, to the
institution as those that would prevail in a comparable transaction with a
non-affiliate.
25
Effective April 1, 2003, the Federal Reserve Board, or FRB, rescinded
its interpretations of Sections 23A and 23B of the Federal Reserve Act and
replaced these interpretations with Regulation W. In addition, Regulation W
made various changes to existing law regarding Sections 23A and 23B,
including expanding the definition of what constitutes an affiliate subject
to Sections 23A and 23B and exempting certain subsidiaries of state-
chartered banks from the restrictions of Sections 23A and 23B.
Under Regulation W, all transactions entered into on or before
December 12, 2002, which either became subject to Section 23A and 23B solely
because of Regulation W, and all transactions covered by Sections 23A and
23B, the treatment of which changed solely because of Regulation W on July
1, 2003. All other covered affiliate transactions became subject to
Regulation W on April 1, 2003. The Federal Reserve Board expects each
depository institution that is subject to Sections 23A and 23B to implement
policies and procedures to ensure compliance with Regulation W. We do not
expect that the changes made by Regulation W will have a material adverse
effect on our business.
Banks are also subject to the restrictions contained in Section 22(h)
of the Federal Reserve Act and the FRB's Regulation O, there under on loans
to executive officers, directors and principal stockholders. Under Section
22(h), loans to a director, an executive officer or a holder of more than
10% of the shares of a bank, as well as certain affiliated interests of such
persons, may not exceed, together with all other outstanding loans to such
person and affiliated interests, the loans-to-one-borrower limit applicable
to national banks (generally 15% of an institution's unimpaired capital and
surplus) and all loans to all such persons in the aggregate may not exceed
an institution's unimpaired capital and unimpaired surplus. Regulation O
also prohibits the making of loans in an amount greater than the lesser of
$25,000 or 5% of capital and surplus but in any event over $500,000, to a
director, executive officer and greater than 10% stockholder of a bank, and
the respective affiliates of such a person, unless such loans are approved
in advance by a majority of the board of directors of the bank, with any
"interested" director not participating in the voting. Further, the FRB
pursuant to Regulation O requires that loans to directors, executive
officers and principal stockholders (a) be made on terms substantially the
same as those that are offered in comparable transactions to persons not
affiliated with the bank and (b) follow credit underwriting procedures not
less stringent than those prevailing for comparable transactions with
persons not affiliated with the bank. Regulation O also prohibits a
depository institution from paying, with certain exceptions, an overdraft of
any of the executive officers or directors of the institution or any of its
affiliates unless the overdraft is paid pursuant to written pre-authorized
extension of interest-bearing extension of credit or transfer of funds from
another account at the bank.
Section 402 of the Sarbanes-Oxley Act of 2002, of Sarbanes-Oxley,
prohibits the extension of personal loans to directors and executive
officers of issuers (as defined in Sarbanes-Oxley). The prohibition,
however, does not apply to mortgages advanced by an insured depository
institution, such as the Bank, that are subject to the insider lending
restrictions of Section 22(h) of the FRA.
26
State chartered non-member banks are further subject to the
requirements and restrictions of 12 U.S.C. section 1972 against certain
tying arrangements and on extensions of credit involving correspondent
banks. Specifically, a depository institution is prohibited from extending
credit to or offering any other service, or fixing or varying the
consideration for such extension of credit or service, on the condition that
the customer obtain some additional service from the institution or certain
of its affiliates or not obtain services of a competitor of the institution,
subject to certain exceptions. In addition, a depository institution with a
correspondent banking relationship with another depository institution is
prohibited from extending credit to the executive officers, directors, and
holders of more than 10% of the stock of the other depository institution,
unless such extension of credit is on substantially the same terms as those
prevailing at the time for comparable transactions with other persons and
does not involve more than the normal risk of repayment or present other
unfavorable features.
Real Estate Lending Policies
Under FDIC regulations, state-chartered non-member banks must adopt
and maintain written policies that establish appropriate limits and
standards for extensions of credit that are secured by liens or interest in
real estate or are made for the purpose of financing permanent improvements
to real estate. These policies must establish loan portfolio
diversification standards, prudent underwriting standards, including loan-
to-value limits that are clear and measurable, loan administration
procedures and documentation, approval and reporting requirements. The real
estate lending policies must reflect consideration of the Interagency
Guidelines for Real Estate Lending Policies (the "Interagency Guidelines")
that have been adopted by the federal bank regulators.
Community Reinvestment Act
Under the Community Reinvestment Act (the "CRA"), any insured
depository institution, including the Bank, has a continuing and affirmative
obligation consistent with its safe and sound operation to help meet the
credit needs of its entire community, including low and moderate income
neighborhoods. The CRA does not establish specific lending requirements or
programs for financial institutions nor does it limit an institution's
discretion to develop the types of products and services that it believes
are best suited to its particular community. The CRA requires the FDIC, in
connection with its examination of a bank to assess the depository
institution's record of meeting the credit needs of its community and to
take such record into account in its evaluation of certain applications by
such institution, including applications for additional branches and
acquisitions.
CRA regulations rate an institution based on its actual performance in
meeting community needs. In particular, the evaluation system focuses on
three tests:
* a lending test, to evaluate the institution's record of making
loans in its service areas;
* an investment test, to evaluate the institution's record of
investing in community development projects, affordable housing,
and programs benefiting low or moderate income individuals and
businesses; and
27
* a service test, to evaluate the institution's delivery of
services through its branches, ATMs and other offices.
The CRA requires the FDIC to provide a written evaluation of an
institution's CRA performance utilizing a four-tiered descriptive rating
system and requires public disclosure of an institution's CRA rating. The
Bank received a "satisfactory" rating in its CRA examination conducted by
the FDIC on January 17, 1999.
Standards for Safety and Soundness
Pursuant to the requirements of the Federal Deposit Insurance
Corporation Improvement Act ("FDICIA"), as amended by the Riegle Community
Development and Regulatory Improvement Act of 1994, each federal banking
agency, including the FDIC, has adopted guidelines establishing general
standards relating to internal controls, information and internal audit
systems, loan documentation, credit underwriting, interest rate exposure,
asset growth, asset quality, earnings and compensation, fees and benefits.
In general, the guidelines require, among other things, appropriate systems
and practices to identify and manage the risks and exposures specified in
the guidelines. The guidelines prohibit excessive compensation as an unsafe
and unsound practice and describe compensation as excessive when the amounts
paid are unreasonable or disproportionate to the services performed by an
executive officer, employee, director, or principal shareholder. In
addition, the FDIC adopted regulations to require a bank that is given
notice by the FDIC that it is not satisfying any of such safety and
soundness standards to submit compliance plan to the FDIC. If, after being
so notified, a bank fails to submit an acceptable compliance plan or fails
in any material respect to implement an accepted compliance plan, the FDIC
may issue an order directing corrective and other actions of the types to
which a significantly undercapitalized institution is subject under the
"prompt corrective action" provisions of FDICIA. If a bank fails to comply
with such an order, the FDIC may seek to enforce such an order in judicial
proceedings and to impose civil monetary penalties.
Prompt Corrective Action
FDICIA also established a system of prompt corrective action to
resolve the problems of undercapitalized institutions. The FDIC, as well as
the other federal banking regulators, adopted regulations governing the
supervisory actions that may be taken against undercapitalized institutions.
The regulations establish five categories, consisting of "well capitalized,"
"adequately capitalized," "undercapitalized," "significantly
undercapitalized," and "critically undercapitalized." At September 30, 2003,
the Bank was categorized as "well capitalized."
The severity of the action authorized or required to be taken under
the prompt corrective action regulations increases as bank's capital
deteriorates within the three undercapitalized categories. All banks are
prohibited from paying dividends or other capital distributions or paying
management fees to any controlling person if, following such distribution,
the bank would be undercapitalized.
28
Federal Home Loan Bank System
The Bank is member of the FHLB System, which consists of 12 regional
Federal Home Loan Banks subject to supervision and regulation by the Federal
Housing finance Board ("FHFB"). The Federal Home Loan Banks provide a
central credit facility primarily for member institutions. As a member of
the FHLB, the Bank is required to acquire and hold shares of capital stock
in the FHLB in an amount equal to 1% of the aggregate unpaid principal of
its home mortgage loans, home purchase contracts, and similar obligations,
but not less than $500. The Bank was in compliance with this requirement
with an investment in FHLB stock at September 30, 2003, of $878,000.
The FHLB serves as a reserve of central bank for its member
institutions within its assigned region. It is funded primarily from the
proceeds derived from the sale of consolidated obligations of the FHFB
System. It offers advances to members in accordance with policies and
procedures established by the FHLB and the Board of Directors of the FHLB.
Title 6 of the GLB Act, entitled the Federal Home Loan Bank System
Modernization Act of 1999 ("FHLB Modernization Act"), has amended the FHLB
Act by allowing for voluntary membership in, and the modernizing of the
capital structure and governance of, the FHLB system. The new capital
structure established under the FHLB Modernization Act sets forth new
leverage and risk-based capital requirements based on permanence of capital.
It also requires some minimum investment in FHLB stock of all member
entities. Capital will include retained earnings and two forms of stock:
Class A stock redeemable within six months, written notice and Class B stock
redeemable within five years, written notice. The FHLB Modernization Act
provides a transition period top the new capital regime, which will not be
effective until the FHLB enacts implementing regulations. The FHLB
Modernization Act also reduces the period of time in which a member exiting
the FHLB system must stay out of the system.
Pursuant to regulations promulgated by the FHFB, as required by the
GLB Act, the FHLB of Boston has adopted, and the FHFB has approved, a
capital plan that changes the foregoing minimum stock ownership requirements
for FHLB of Boston stock. Under the new capital plan, each member of the
FHLB of Boston must maintain a minimum investment in FHLB of Boston capital
stock in an amount equal to the sum of (i) .35% of member eligible
collateral (subject to a minimum of $10,000 and a maximum of $25,000,000,
per member), and (ii) 4.50% of the member's activity-based assets.
Federal Reserve System
Under FRB regulations, the Bank is required to maintain no interest-
earning reserves against its transaction accounts (primarily NOW and regular
checking accounts). The FRB regulations generally require that reserves of
3% must be maintained against aggregate transaction accounts of $42.1
million or less (subject to adjustment by the FRB) and an initial reserve of
$1.2 million plus 10% (subject to adjustment by the FRB between 8% and 14%)
against that portion of total transaction accounts in excess of $42.1
million. The first $6 million of otherwise reservable balances (subject to
adjustments by the FRB) are exempted from the reserve requirements. As of
September 30, 2003, the Bank met its reserve requirements.
29
Massachusetts Banking Laws and Supervision
Massachusetts's co-operative banks such as the Bank are also regulated
and supervised by the Division of Banks. The Division of Banks is required
to regularly examine each state-chartered bank. The approval of the
Division of Banks is required to establish or close branches, to merge with
another bank, to form a bank holding company, to issue stock or to undertake
many other activities. Any Massachusetts bank that does not operate in
accordance with the regulations, policies and directives of the Division of
Banks is subject to sanctions. The Division of Banks may under certain
circumstances suspend or remove directors or officers of a bank who have
violated the law, conducted a bank's business in a manner which is unsafe,
unsound or contrary to the depositors' interests, or been negligent in the
performance of their duties.
All Massachusetts-chartered co-operative banks are required to be
members of the Co-operative Central Bank and are subject to its assessments.
The Co-operative Central Bank maintains the Share Insurance Fund, a private
deposit insurer, which insures all deposits in member banks in excess of
FDIC deposit insurance limits. In addition, the Co-operative Central Bank
acts as a source of liquidity to its members in supplying them with low-cost
funds, and purchasing certain qualifying obligations from them.
Lending Activities. A Massachusetts-chartered co-operative bank may
make a wide variety of mortgage loans. Fixed-rate loans, adjustable-rate
loans, variable-rate loans, participation loans, graduated payment loans,
construction loans, condominium and co-operative loans, second mortgage
loans and other types of loans may be made in accordance with applicable
regulations. Mortgage loans may be made on real estate in Massachusetts or
in another New England state if the bank making the loan has an office there
or under certain other circumstances. In addition, certain mortgage loans
may be made on improved real estate located anywhere in the United States.
Commercial loans may be made to corporations and other commercial
enterprises with or without security. With certain exceptions, such loans
may be made without geographic limitations. Consumer and personal loans may
be made with or without security and without geographic limitations. Loans
to individual borrowers generally will be limited to 20% of the total of the
Bank's capital accounts and stockholders' equity.
Investments Authorized. Massachusetts-chartered co-operative banks
have broad investment powers under Massachusetts's law, including so-called
"leeway" authority for investments that are not otherwise specifically
authorized. Federal law to permit only investments of the kinds that would
be permitted for national banks restricts the investment powers authorized
under Massachusetts's law. The Bank has authority to invest in all of the
classes of loans and investments that are permitted by its existing loan and
investment policies.
Payment of Dividends. A Massachusetts-chartered co-operative bank may
only pay dividends on its capital stock from net profits and no dividends
may be declared, credited or paid so long as there is any impairment of the
capital stock. Prior approval by the Division is required if the Bank
intends to declare dividends on its common stock for any period other than
for which dividends are declared upon the preferred stock. The approval of
the Division is also required for a co-operative bank to declare a dividend
if the total of all dividends declared by the Bank in any calendar year
exceeds the total of its net profits for that year combined with its
retained net
30
profits of the preceding two years, less any required transfer to surplus or
a fund for the retirement of any preferred stock.
Branches. With the approval of the Division of Banks, bank branches
may be established in any city or town in Massachusetts. In addition, co-
operative banks may operate automated teller machines at any of their
offices or, with the approval of the Division of Banks, anywhere in
Massachusetts. Sharing of ATMs or "networking" is also permitted with the
approval of the Division of Banks. Massachusetts-chartered co-operative
banks may also operate ATMs outside of Massachusetts if permitted to do so
by the law of the jurisdiction in which the ATM is located.
Interstate Banking. An out-of-state bank may (subject to various
regulatory approvals and to reciprocity in its home state) establish and
maintain bank branches in Massachusetts by:
* merging with a Massachusetts bank that has been in existence for
at least three years;
* acquiring a branch or branches of a Massachusetts bank without
acquiring the entire bank; or
* opening such branches de novo.
Massachusetts banks' ability to exercise similar interstate banking powers
in other states depends upon the laws of the other states. For example,
according to the law of the bordering state of New Hampshire, out-of-state
banks may acquire New Hampshire banks by merger, but may not establish de
novo branches in New Hampshire.
Community Reinvestment Act. The Bank is also subject to provisions
of the Massachusetts banking laws that, like the provisions of the federal
Community Reinvestment Act, impose continuing and affirmative obligations
upon a banking institution organized in Massachusetts to serve the credit
needs of its local communities. The obligations of the Massachusetts
Community Reinvestment Act are similar to those imposed by the federal
Community Reinvestment Act with the exception of the assigned exam ratings.
Massachusetts banking law provides for an additional exam rating of "high
satisfactory" in addition to the federal Community Reinvestment Act ratings
of "outstanding," "satisfactory," "needs to improve" and "substantial
noncompliance." The Division has adopted regulations to implement the
Massachusetts Community Reinvestment Act that are based on the federal
Community Reinvestment Act. The Division is required to consider a bank's
Massachusetts Community Reinvestment Act rating when reviewing the bank's
application to engage in certain transactions, including mergers, asset
purchases and the establishment of branch offices or automated teller
machines, and provides that such assessment may serve as a basis for the
denial of any such application. The Massachusetts Community Reinvestment
Act requires the Division to assess a bank's compliance with the
Massachusetts Community Reinvestment Act and to make such assessment
available to the public. The Bank received a "high satisfactory" rating in
its Community Reinvestment Act examination conducted by the Commonwealth of
Massachusetts on June 18, 2003.
31
Other Powers. Massachusetts-chartered co-operative banks may also
lease machinery and equipment, act as trustee or custodian for tax qualified
retirement plans, establish trust departments and act as professional
trustee or fiduciary, provide payroll services for their customers, issue or
participate with others in the issuance of mortgage-backed securities and
establish mortgage banking companies and discount securities brokerage
operations. Some of these activities require the prior approval of the
Division of Banks.
Loans to Bank's Insiders. The Massachusetts banking laws prohibit any
officer, director or trustee from borrowing, otherwise becoming indebted, or
becoming liable for a loan or other extension of credit by such bank to any
other person, except for any of the following loans or extensions of credit:
* loan or extension of credit, secured or unsecured, to an officer
of the bank in an amount not exceeding $20,000;
* loan or extension of credit intended or secured for educational
purposes to an officer of the bank in an amount not exceeding
$75,000;
* loan or extension of credit secured by a mortgage on residential
real estate to be occupied in whole or in part by the officer to
whom the loan or extension of credit is made, in an amount not
exceeding $275,000; or
* loan or extension of credit to a director or trustee of the bank
who is not also an officer of the bank in an amount permissible
under the bank's loan-to-one borrower limit.
The loans listed above require approval of the majority of the members of
the Bank's executive committee, excluding any member involved in the loan or
extension of credit. No such loan or extension of credit may be granted
with an interest rate or other terms that are preferential in comparison to
loans granted to persons not affiliated with the Bank.
Regulation of Holding Company
Federal Regulation. The Company is subject to examination, regulation
and periodic reporting under the BHCA, as administered by the FRB. The FRB
has adopted capital adequacy guidelines for bank holding companies on a
consolidated basis substantially similar to those of the FDIC for the Bank.
The Company is required to obtain the prior approval of the FRB and
the Massachusetts Board of Bank Incorporation ("BBI") to acquire all, or
substantially all, of the assets or any bank of bank holding company. Prior
FRB and BBI approval would be required for the Company to acquire direct or
indirect ownership or control of any voting securities of any bank or bank
holding company if, after giving effect to such acquisition, it would,
directly or indirectly, own or control more than 5% of any class of voting
shares of such bank or bank holding company.
32
The Company is required to give the FRB prior written notice of any
purchase or redemption of its outstanding equity securities if the gross
consideration for the purchase or redemption, when combined with the net
consideration paid for all such purchases or redemptions during the
preceding 12 months, is equal to 10% or more of the Company's consolidated
net worth. The FRB may disapprove such a purchase or redemption if it
determines that the proposal would constitute an unsafe and unsound
practice, or would violate any law, regulation, FRB order or directive, or
any condition imposed by, or written agreement with, the FRB. Such notice
and approval is not required for a bank holding company that would be
treated as "well capitalized" under applicable regulations of the FRB, both
before and after the redemption that is well managed, and that is not the
subject of any unresolved supervisory issues.
The status of the Company as a registered bank holding company under
the BHCA does not exempt it from certain federal and state laws and
regulations applicable to corporations generally, including, without
limitation, certain provisions of the federal securities laws.
In addition, a bank holding company which does not qualify as a
financial holding company under the GLB Act, is generally prohibited from
engaging in, or acquiring 5% or more of any class of voting securities of
any company engaged in, non-banking activities. One of the principal
exceptions to this prohibition is for activities found by the FRB to be so
closely related to banking or managing or controlling banks as to be a
proper incident thereto. Bank holding companies that qualify as a financial
holding company may engage in activities that are financial in nature or
incident to activities that are financial in nature. To date, the Company
has not elected to become regulated as a financial holding company.
Under the Federal Deposit Insurance Act, depository institutions are
liable to the FDIC for losses suffered or anticipated by the FDIC in
connection with the default of a commonly controlled depository institution
or any assistance provided by the FDIC to such an institution in danger of
default. This law would have potential applicability if the Company ever
acquired as a separate subsidiary a depository institution in addition to
the Bank.
USA PATRIOT Act
In response to the events of September 11th, President George W. Bush
signed into law the Uniting and Strengthening America by Providing
Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001,
or the USA PATRIOT Act, on October 26, 2001. The USA PATRIOT Act gives the
federal government new powers to address terrorist threats through enhanced
domestic security measures, expanded surveillance powers, increased
information sharing, and broadened anti-money laundering requirements. By
way of amendments to the Bank Secrecy Act, Title III of the USA PATRIOT Act
takes measures intended to encourage information sharing among bank
regulatory agencies and law enforcement bodies. Further, certain provisions
of Title III impose affirmative obligations on a broad range of financial
institutions, including banks, thrifts, brokers, dealers, credit unions,
money transfer agents and parties registered under the Commodity Exchange
Act.
33
Among other requirements, Title III of the USA PATRIOT Act imposes the
following requirements with respect to financial institutions:
* Pursuant to Section 352, all financial institutions must
establish anti-money laundering programs that include, at
minimum: (i) internal policies, procedures, and controls, (ii)
specific designation of an anti-money laundering compliance
officer, (iii) ongoing employee training programs, and (iv) an
independent audit function to test the anti-money laundering
program.
* Pursuant to Section 326, on May 9, 2003 the Secretary of the
Department of Treasury, in conjunction with other bank
regulators, issued a Joint Final Rule that provides for minimum
standards with respect to customer identification and
verification. The Bank was required to comply with this rule by
October 1, 2003.
* Section 312 requires financial institutions that establish,
maintain, administer, or manage private banking accounts or
correspondent accounts in the United States for non-United
States persons or their representatives (including foreign
individuals visiting the United States) to establish
appropriate, specific, and, where necessary, enhanced due
diligence policies, procedures, and controls designed to detect
and report money laundering.
* Effective December 26, 2001, financial institutions are
prohibited from establishing, maintaining, administering or
managing correspondent accounts for foreign shell banks (foreign
banks that do not have a physical presence in any country), and
are subject to certain record-keeping obligations with respect
to correspondent accounts of foreign banks.
* Bank regulators are directed to consider a holding company's
effectiveness in combating money laundering when ruling on
Federal Reserve Act and Bank Merger Act applications.
Although we anticipate that we will incur additional expense in complying
with the provisions of the USA PATRIOT ACT and the resulting regulations,
management does not expect that such compliance will have a material impact
on our results of operations or financial condition.
The Sarbanes-Oxley Act
On July 30, 2002, President George W. Bush signed into law the
Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act implements a broad range
of corporate governance and accounting measures for public companies
designed to promote honesty and transparency in corporate America and better
protect investors from the type of corporate wrongdoing that occurred in
Enron, WorldCom and similar companies. The Sarbanes-Oxley Act's principal
legislation includes:
* the creation of an independent accounting oversight board;
* Auditor independence provisions which restrict non-audit
services that accountants may provide to their audit clients;
34
* additional corporate governance and responsibility measures,
including the requirement that the chief executive officer and
chief financial officer certify financial statements;
* the forfeiture of bonuses or other incentive-based compensation
and profits from the sale of an issuer's securities by directors
and senior officers in the twelve month period following initial
publication of any financial statements that later require
restatement;
* an increase in the oversight of, and enhancement of certain
requirements relating to audit committees of public companies
and how they interact with the company's independent auditors;
* requirement that audit committee members must be independent and
are absolutely barred from accepting consulting, advisory or
other compensatory fees from the issuer;
* requirement that companies disclose whether at least one member
of the committee is a "financial expert" (as such term will be
defined by the Securities and Exchange Commission) and if not,
why not;
* expanded disclosure requirements for corporate insiders,
including accelerated reporting of stock transactions by
insiders and a prohibition on insider trading during pension
blackout periods;
* a prohibition on personal loans to directors and officers,
except certain loans made by insured financial institutions;
* disclosure of a code of ethics and filing a Form 8-K for a
change or waiver of such code;
* mandatory disclosure by analysts of potential conflicts of
interest; and
* a range of enhanced penalties for fraud and other violations.
The SEC has been delegated the task of enacting rules to implement
various provisions with respect to, among other matters, disclosure in
periodic filings pursuant to the Securities Exchange Act. To date, the SEC
has implemented some of the provisions of the Sarbanes-Oxley Act. However,
the SEC continues to issue final rules, reports, and press releases. As the
SEC provides new requirements, we review those rules and comply as required.
Although we anticipate that we will incur additional expense in
complying with the provisions of the Sarbanes-Oxley Act and the resulting
regulations, management does not expect that such compliance will have a
material impact on our results of operations or financial condition.
35
Federal Securities Laws
The Company's common stock is registered with the SEC under Section
12(b) of the Securities Exchange Act of 1934 (the "Exchange Act"). The
Company is subject to the information, proxy solicitation, insider trading
restrictions and other requirements under the Exchange Act.
36
PART II
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
The selected consolidated financial and other data of the Company and
the Bank set forth below is derived in part from and should be read in
conjunction with the Consolidated Financial Statements of the Company and
Notes thereto.
At September 30,
------------------------------------------------------------
2003 2002 2001 2000 1999
---- ---- ---- ---- ----
(Dollars in thousands)
Selected Financial Condition Data:
Assets $166,118 $154,521 $147,439 $135,464 $118,652
Loans, net 83,319 95,010 112,554 105,732 80,487
Investment securities 70,607 47,651 20,209 19,304 27,507
Deposits 145,534 131,717 122,176 112,374 92,886
Stockholders' equity 17,743 16,339 16,911 17,992 19,259
Year Ended September 30,
----------------------------------------------------------------
2003 2002 2001 2000 1999
---- ---- ---- ---- ----
(Dollars in thousands, except per share data)
Selected Operating Data:
Interest and dividend income $ 6,730 $ 8,692 $ 9,645 $ 8,306 $ 7,488
Interest expense on deposits and
borrowings 2,419 3,390 4,518 3,742 3,358
-------- -------- -------- ---------- ----------
Net interest income 4,311 5,302 5,127 4,564 4,130
(Benefit) provision for loan losses (180) - 190 189 42
-------- -------- -------- ---------- ----------
Net interest income after (benefit)
provision for loan losses 4,491 5,302 4,937 4,375 4,088
-------- -------- -------- ---------- ----------
Other income:
Gain (loss) on available-for-sale
securities, net (451) (581) 168 398 263
Other 1,584 1,050 528 359 386
-------- -------- -------- ---------- ----------
Total other income 1,133 469 696 757 649
-------- -------- -------- ---------- ----------
Operating expenses 3,958 3,368 3,424 3,296 2,924
-------- -------- -------- ---------- ----------
Income before income taxes 1,666 2,403 2,209 1,836 1,813
Income taxes 1,072 887 779 659 844
-------- -------- -------- ---------- ----------
Net Income $ 594 $ 1,516 $ 1,430 $ 1,177 $ 969
======== ======== ======== ========== ==========
Per Share Data:
Earnings per common share $ 0.68 $ 1.73 $ 1.48 $ 1.17 $ .78
Earnings per common share,
assuming dilution $ 0.64 $ 1.64 $ 1.45 $ 1.16 $ .77
Cash dividends per share $ 0.52 $ 0.50 $ 0.42 $ .31 $ .28
Dividend payout ratio 76.47% 28.90% 28.38% 26.50% 35.90%
Weighted average number of
common shares outstanding 874,422 875,569 967,882 1,009,475 1,243,925
37
At or for the Year Ended September 30,
--------------------------------------------------
2003 2002 2001 2000 1999
---- ---- ---- ---- ----
Interest rate spread information: (1)
Average during period 2.46% 3.15% 3.02% 3.07% 2.98%
End of period 2.47 2.87 3.17 2.81 2.93
Net interest margin (2) 2.84 3.68 3.84 3.81 3.80
Return on average assets 0.37 1.00 1.02 0.93 0.85
Return on average equity 3.47 8.99 7.93 6.63 4.61
Asset Quality Ratios:
Non-performing loans as a percent of
total loans - - - - -
Non-performing assets as a percent of
total assets - - - - -
Allowance for loan losses as a percent
of non-performing loans - - - - -
Capital Ratios:
Average equity to average assets 10.68 11.15 12.91 14.05 18.35
Regulatory Tier 1 leverage capital ratio (3) 10.00 9.40 10.12 12.82 13.46
--------------------
Interest rate spread represents the difference between weighted average
yield on interest-earning assets and the weighted average cost of
interest-bearing liabilities.
Net interest margin represents net interest income divided by average
interest-earning assets.
Represents capital ratios of the Bank.
38
Summarized quarterly financial data for the fiscal years ended September 30,
2003 and 2002 are as follows:
Fiscal year 2003 Quarters Ended
-----------------------------------------------------------
12/31/02 03/31/03 06/30/03 09/30/03
-------- -------- -------- --------
Interest and dividend income $ 1,883,848 $ 1,687,702 $ 1,624,607 $ 1,533,781
Interest expense 717,787 625,983 558,405 516,316
----------- ----------- ----------- -----------
Net interest and dividend income 1,166,061 1,061,719 1,066,202 1,017,465
Provision (benefit) for loan losses - - - (179,868)
Other income 393,489 18,254 461,854 259,283
Other expense 961,582 1,036,112 1,134,115 825,893
----------- ----------- ----------- -----------
Income before income taxes 597,968 43,861 393,941 630,723
Income tax expense (benefit) 222,850 615,387 (174,577) 408,601
----------- ----------- ----------- -----------
Net income $ 375,118 $ (571,526) $ 568,518 $ 222,122
=========== =========== =========== ===========
Basic (loss) earnings per common share $ 0.43 $ (0.66) $ 0.65 $ 0.26
(Loss) earnings per common share assuming dilution $ 0.41 $ (0.62) $ 0.62 $ 0.23
Fiscal year 2002 Quarters Ended
-----------------------------------------------------------
12/31/01 03/31/02 06/30/02 09/30/02
-------- -------- -------- --------
Interest and dividend income $ 2,277,825 $ 2,151,050 $ 2,227,749 $ 2,035,443
Interest expense 985,614 846,261 778,272 779,531
----------- ----------- ----------- -----------
Net interest and dividend income 1,292,211 1,304,789 1,449,477 1,255,912
Provision (benefit) for loan losses 50,000 30,000 30,000 (110,000)
Other income (loss) 340,913 184,584 134,836 (191,233)
Other expense 850,256 840,701 873,089 804,413
----------- ----------- ----------- -----------
Income before income taxes 732,868 618,672 681,224 370,266
Income tax expense 266,200 226,425 253,667 140,553
----------- ----------- ----------- -----------
Net income $ 466,668 $ 392,247 $ 427,557 $ 229,713
=========== =========== =========== ===========
Basic earnings per common share $ 0.52 $ 0.45 $ 0.49 $ 0.27
Earnings per common share assuming dilution $ 0.50 $ 0.43 $ 0.46 $ 0.25
The quarterly results of operations above for the period ended March 31,
2003 and June 30, 2003 have been revised from that previously reported to
remove the extraordinary item. The extraordinary item treatment previously
presented has been revised and its individual components are now presented
as part of income from continuing operations within income tax expense and
other expense. Prior to the revision, other expense for the three months
ended March 31, 2003 and June 30, 2003 was $1,014,038 and $1,099,833,
respectively; income before income taxes and extraordinary item for the
three months ended March 31, 2003 and June 30, 2003 was $93,142 and
$378,424, respectively; and income tax expense (benefit) for the three
months ended March 31, 2003 and June 30, 2003 was $92,320 and $105,295,
respectively.
39
General
Falmouth Bancorp, Inc. (the "Company"), a Delaware corporation, is the
holding company for Falmouth Bank (the "Bank"), a Massachusetts-chartered
stock co-operative bank. At September 30, 2003 there were 913,727 shares
outstanding. The Company's sole business activity is ownership of the Bank.
The Company also makes investments in long and short-term marketable
securities and other liquid investments.
The business of the Bank consists of attracting deposits from the
general public and using these funds to originate mortgage loans secured by
one- to four-family residences located primarily in Falmouth, Massachusetts
and surrounding areas and to invest in investment securities. To a lesser
extent, the Bank engages in various forms of consumer and home equity
lending. The Bank's profitability depends primarily on its net interest
income, which is the difference between the interest income it earns on its
loans and investment portfolios and its cost of funds, which consists mainly
of interest paid on deposits. Net interest income is affected by the
relative amounts of interest-earning assets and interest-bearing liabilities
and the interest rates earned or paid on these balances. When interest-
earning assets approximate or exceed interest-bearing liabilities, any
positive interest rate spread will generate net interest income.
The Bank's level of non-interest income and expense also affects the
Bank's profitability. Non-interest income, or other income, consists
primarily of service fees, net gains on sale of loans and gains on
investment securities. Non-interest expense, or operating expenses, consists
of salaries and benefits, deposit insurance premiums paid to the Federal
Deposit Insurance Corporation ("FDIC"), occupancy related expenses and other
operating expenses.
The operations of the Bank, and banking institutions in general, are
influenced significantly by general economic conditions and related monetary
and fiscal policies of financial institutions' regulatory agencies. Deposit
flows and the cost of funds are influenced by interest rates on competing
investments and general market rates of interest. Lending activities are
affected by the demand for financing real estate and other types of loans,
which in turn are affected by the interest rates at which such financing may
be offered and other factors affecting loan demand and the availability of
funds.
Business Strategy
The Bank's business strategy is to operate as a well-capitalized,
profitable and independent community bank dedicated to financing home
ownership and consumer needs in its market area and to providing quality
service to its customers. The Bank has implemented this strategy by: (i)
closely monitoring the needs of customers and providing quality service;
(ii) emphasizing consumer-oriented banking by originating residential
mortgage loans and consumer loans and by offering checking accounts and
other financial services and products; (iii) focusing on expanding lending
activities to produce moderate increases in loan originations; (iv)
maintaining asset quality; (v) maintaining capital in excess of regulatory
requirements; and (vi) producing stable earnings.
40
Critical Accounting Policies
The Notes to our Audited Consolidated Financial Statements for the
year ended September 30, 2003 contain a summary of our significant
accounting policies. We believe our policies with respect to the
methodology for our determination of the allowance for loan losses, the
valuation of mortgage servicing rights and asset impairment judgments, and
other than temporary declines in the value of our securities, involve a
higher degree of complexity and require management to make difficult and
subjective judgments which often require assumptions or estimates about
highly uncertain matters. Changes in these judgments, assumptions or
estimates could cause reported results to differ materially. The Audit
Committee and our Board of Directors periodically review these critical
policies and their application.
Comparison of Financial Condition at September 30, 2003 and 2002
The Company's total assets were $166.1 million at September 30, 2003,
as compared to $154.5 million at September 30, 2002, an increase of $11.6
million or 7.51%. Total deposits were $145.5 million at September 30, 2003,
as compared to $131.7 million at September 30, 2002, an increase of $13.8
million, or 10.49%. This increase was due, in part, to consumers seeking
safer havens with insured deposits as a result of the downturn in the stock
markets. Total net loans were $83.3 million or 57.3% of total deposits at
September 30, 2003, as compared to $95.0 million or 72.1% of total deposits
at September 30, 2002, representing a decrease of $11.7 million for the
period. This decrease is due, in part, to low mortgage rates and to the
active local real estate market driving single-family re-financing at lower
yields. This results in the Bank selling more of its lower rate loans in
the secondary market. During the year, the Bank sold $63.6 million in
residential mortgages and $1.1 million in commercial mortgages, all with
servicing retained. Investment securities were $70.6 million or 42.5% of
total assets at September 30, 2003, as compared to $47.7 million or 30.9% of
total assets at September 30, 2002. As investment securities matured, funds
were reinvested in short-term investment grade securities and utilized to
repay $2.6 million in maturing FHLB advances. Stockholders' equity was
$17.7 million at September 30, 2003 as compared to $16.3 million at
September 30, 2002, an increase of $1.4 million. The net increase in
stockholders' equity was primarily caused by a decrease in the accumulated
other comprehensive loss of $716,000, combined with increased retained
earnings of $123,000 after dividend payments and the routine reduction in
stock based employee compensation liabilities of $565,000. Stockholders'
equity reported at September 30, 2003 included an unrealized loss, net of
tax effects, in available-for-sale securities of $91,000 and retained
earnings of $594,000. The Bank realized an expense of $277,000 (net of tax
benefits) due to tax legislation enacted by the Commonwealth of
Massachusetts in March of 2003, effective retroactively to 1999, eliminating
the 95% income tax dividend exclusion on dividends the Bank received from
its real estate investment trust subsidiary. The ratio of stockholders'
equity to total assets was 10.7% at September 30, 2003, as compared to 10.6%
at September 30, 2002. The book value of common stock was $19.43 at
September 30, 2003, as compared to $18.14 at September 30, 2002.
41
Comparison of Financial Condition at September 30, 2002 and 2001
The Company's total assets were $154.5 million at September 30, 2002,
as compared to $147.4 million at September 30, 2001, an increase of $7.1
million or 4.8%. Total deposits were $131.7 million at September 30, 2002,
as compared to $122.2 million at September 30, 2001, an increase of $9.5
million, or 7.8%. This increase was due, in part, to consumers seeking
safer havens with insured deposits as a result of the downturn in the stock
markets. Total net loans were $95.0 million or 72.1% of total deposits at
September 30, 2002, as compared to $112.6 million or 92.1% of total deposits
at September 30, 2001, representing a decrease of $17.5 million for the
period. This decrease is due, in part, to low mortgage rates and to the
active local real estate market driving single-family re-financing at lower
yields. This results in the Bank selling more of its lower rate loans in
the secondary market. During the year, the Bank sold $36.0 million in
residential mortgages and $1.4 million in commercial mortgages, all with
servicing retained. Investment securities were $47.7 million or 30.9% of
total assets at September 30, 2002, as compared to $20.2 million or 13.7% of
total assets at September 30, 2001. As investment securities matured, funds
were reinvested in short-term investment grade securities and utilized to
repay $2.1 million in maturing FHLB advances. Stockholders' equity was
$16.3 million at September 30, 2002 as compared to $16.9 million at
September 30, 2001, a decrease of $572,000. The net decrease in
stockholders' equity was primarily caused by the repurchase of 52,960 shares
of the Company's common stock at a cost of $1.3 million, a decrease in the
accumulated other comprehensive loss of $401,000, combined with increased
retained earnings of $1.1 million after dividend payments. Stockholders'
equity reported at September 30, 2002 included an unrealized loss, net of
tax effects, in available-for-sale securities of $806,000 and retained
earnings of $13.7 million. The ratio of stockholders' equity to total
assets was 10.6% at September 30, 2002, as compared to 11.5% at September
30, 2001. The book value of common stock was $18.14 at September 30, 2002,
as compared to $18.01 at September 30, 2001.
Comparison of Operating Results at September 30, 2003 and 2002
Net Income. The Company's net income for the twelve months ended
September 30, 2003, was $594,000 as compared to $1.5 million for the twelve
months ended September 30, 2002. The decrease in net income of $922,000 was
primarily due to tax legislation enacted by the Commonwealth of
Massachusetts in March of 2003, effective retroactively to 1999, eliminating
the 95% income tax dividend exclusion on dividends the Bank received from
its real estate investment trust subsidiary. Additionally, the Company
realized losses of $451,000 in its investment securities portfolio.
Management chose to divest itself of certain equity investment securities in
accordance with its strategic business plan to structure the Company's
balance sheet to minimize credit risk and sensitivity to market conditions
and movements in interest rates. For additional information about the
impact of our strategic business plan on income taxes, see "Taxes", below.
A decrease in interest expense of $971,000, an increase in other expenses of
$555,000, offset by a decrease in interest and dividend income of $2.0
million, an increase in other income of $664,000 and a decrease in income
taxes of $58,000 also contributed to the decrease. The annualized return on
average assets (ROA) for the 12 months ended September
42
30, 2003 was 0.37%, a decrease of 63 basis points, as compared to 1.00% for
the prior year. Interest and dividend income decreased, primarily, as the
result of an increase in residential loans re-written at lower rates during
the year, accompanied with lower yields on investment securities. The
decrease in interest expense was primarily due to the general reduction in
interest on deposits.
Net Interest and Dividend Income. Net interest and dividend income
for the twelve-months ended September 30, 2003 was $4.3 million, as compared
to $5.3 million for the 12 months ended September 30, 2002. The decrease of
$1.0 million was the result of a $2.0 million decrease in interest and
dividend income, offset by a $1.0 million decrease in interest expense. The
net interest margin for the twelve months ended September 30, 2003 was
2.84%, a decrease of 84 basis points, as compared to 3.68% for the twelve
months ended September 30, 2002. The decrease in net interest margin was
primarily the result of the decrease in interest income due to the lower
general level of interest rates.
Interest and Dividend Income. Total interest and dividend income for
the twelve months ended September 30, 2003 was $6.7 million, a decrease of
$2 million as compared to $8.7 million for the twelve months ended September
30, 2002. The decrease in interest and dividend income was due to a $2
million decrease in interest income on loans, and a $17,000 decrease in
other interest, offset by a $221,000 increase in interest and dividends on
securities and short-term investments. The decrease in interest income on
loans was primarily the result of increased refinancing volume at lower
rates. The increase in interest and dividends on securities was the result
of utilizing cash flow from the refinancing of loans to increase the volume
in short-term securities.
Interest Expense. Interest expense for the twelve months ended
September 30, 2003 was $2.4 million, a decrease of $1 million, as compared
to $3.4 million for the twelve months ended September 30, 2002. The
decrease in interest expense was due to the general decrease in interest
rates as well as a decrease in Federal Home Loan Bank borrowings during the
period.
Provision for Loan Losses. We recorded a benefit for loan losses for
the fiscal year ended September 30, 2003 of $180,000, as compared to no
provision for loan losses in fiscal year 2002. The benefit for loan losses
in fiscal year 2003 reflected the decrease in our classified and impaired
loans and reduction in total loans outstanding due to increased sales of
residential mortgage loans and pre-payments of existing loans. These
factors, that resulted in a benefit for loan losses during fiscal year 2003,
were partially offset by changes in the Company's loan mix, with increases
in commercial real estate loans and equity lines of credit and reduction in
residential mortgage loans. An additional factor that contributed to the
benefit for loan losses during fiscal year 2003 was our decision to reduce
estimated reserves for commercial business loans, commercial real estate
loans, residential real estate loans and consumer loans. This decision was
based on our ongoing analysis of historical losses and other relevant
qualitative factors, and resulted in a benefit for loan losses of $84,000.
Net recoveries were $1,200 during fiscal year 2003 compared to net charge-
offs of $6,000 during fiscal year 2002.
The allowance for loan losses at September 30, 2003 was $761,000, as
compared to $939,000 at September 30, 2002, a decrease of 19%. The Bank's
allowance for loan losses as a percentage of total loans ratio was 0.91% at
September 30, 2003 as compared to 0.98% at
43
September 30, 2002. The decrease was due to the benefit for loan losses as
discussed above. There were no nonperforming loans at September 30, 2003 as
compared to $42,000, or 0.05% of total loans, at September 30, 2002. The
$42,000 decrease in nonperforming loans from September 30, 2002 to September
30, 2003 was attributable to the removal of one nonperforming commercial
business loan from the nonperforming category because the loan was paid in
full.
The allowance for loan losses is maintained at a level determined to
be adequate by management to absorb future charge-offs of loans deemed
uncollectible. This allowance is increased by provisions charged to income
and by recoveries on loans previously charged off, and reduced by benefits
for loan losses credited to income and charge-offs. Arriving at an
appropriate level of allowance for loan losses necessarily involves a high
degree of judgment and is determined based on management's ongoing
evaluation.
We maintain an allowance for loan losses at a level which we believe
is sufficient to cover potential charge-offs of loans deemed to be
uncollectible based on a continuous review of a variety of factors. These
factors consist of the character and size of the loan portfolio, business
and economic conditions, loan growth, charge-off experience, delinquency
trends, non-performing loan trends and other asset quality factors. The
primary means of adjusting the level of this allowance is through provisions
(benefits) for loan losses, which are established and charged (credited) to
income on a quarterly basis. Although we use available information to
establish the appropriate level of the allowance for loan losses, future
additions to the allowance may be necessary because our estimates of the
potential losses in our loan portfolio are susceptible to change as a result
of changes in the factors noted above. Any such increase would adversely
affect our results of operations. At September 30, 2003, our allowance for
loan losses amounted to $761,000, and during fiscal years 2003, 2002 and
2001 our (benefits) provisions for loan losses amounted to ($180,000), $0
and $190,000, respectively.
For the commercial business loan and commercial real estate loan
portfolios, we evaluate each loan rated "substandard" or worse. On an
ongoing basis, we review classified loans to ensure the accuracy of the loan
classifications. Estimated reserves for each of these credits are
determined by reviewing current collateral value, financial information,
cash flow, payment history and trends and other relevant facts surrounding
the particular credit. Provisions for losses on the remaining commercial
loans are based on pools of similar loans using historical loss experience
and other qualitative factors.
For the residential real estate and consumer loan portfolios, the
range of reserves is calculated by applying historical charge-offs and
recovery experience to the current outstanding balance in each loan
category, with consideration given to loan growth over the preceding twelve
months.
Non-interest Income. Non-interest income or other income for the
twelve months ended September 30, 2003 was $1.1 million as compared to
$469,000 for the twelve months ended September 30, 2002. The $664,000
increase was due to a decrease in net security losses of $131,000, an
increase of $18,000 in service charge income, a $10,000 increase in loan
servicing fees a $12,000 increase in other income, and an increase of
$493,000 in gains on mortgages sold. Lower market values made it necessary
to write down several of the Bank's equity securities
44
holdings during the year. For additional information about the impact of
these write-downs on income tax expense, see "Taxes", below. The Bank
continued a moderate-term strategic objective of selling off packages of the
lowest rate residential loans, service retained, for market gains.
Non-Interest Expense. Non-interest expense, or other expense, for the
twelve months ended September 30, 2003 was $3.9 million as compared to $3.4
million in 2002. A $555,000 increase was primarily due to the combination
of an increase in salaries and employee benefits of $251,000, an increase in
write-downs on mortgage servicing assets of $243,000, an increase in
occupancy expense of $10,000, an increase in data processing fees of
$32,000, an increase in Directors' fees of $16,000, an increase in deposit
insurance expense of 1,000 and an increase in other operating expenses of
$44,000, off-set in part by a decrease in equipment expense of $9,000, and a
decrease in legal and professional fees of $33,000. The increase in the
write-down of mortgage servicing assets was due to serviced loans being paid
off sooner than had been anticipated because of the historically low
interest rates that were available. The increase in data processing expense
was partially due to the modernization of our teller operating equipment and
software as well as the implementation of a bank wide area network
interconnecting the main office and branches.
Taxes. Our effective tax rate was 64.3% in fiscal year 2003 and 36.9%
in fiscal year 2002. The increase in the effective tax rate was due
primarily to the additional state taxes, net of federal tax benefit,
attributable to the real estate investment trust dividend deduction
settlement with the Commonwealth of Massachusetts. An additional reason for
the increase in the effective tax rate was the increase in the valuation
allowance against accumulated realized capital losses and impairment write-
downs related to equity securities. We consider a full valuation allowance
against the deferred tax assets created by the realized capital losses,
impairment write-downs and the unrealized losses recorded in accordance with
SFAS No. 115, in the aggregate amount of $212,348, to be appropriate. The
reason for this position is that we do not anticipate generating any
significant capital gains in future periods that would be necessary to
utilize the tax benefits created by prior accumulated realized and
unrealized equity losses in the investment portfolio. Our strategic
business plan is to structure the balance sheet to minimize credit risk and
sensitivity to market conditions and movements in interest rates. Our
strategic business plan is driving management's decisions as opposed to tax
strategies emphasizing utilization of accumulated deferred tax benefits. We
feel that it is more likely than not that we will be unable to generate any
significant future capital gains under existing tax strategies to utilize
existing deferred tax benefits.
For additional information regarding taxation, see Note 9 of the Notes
to Financial Statements.
Comparison of Operating Results at September 30, 2002 and 2001
Net Income. The Company's net income for the twelve months ended
September 30, 2002, was $1.5 million as compared to $1.4 million for the
twelve months ended September 30, 2001. The increase in net income of
$86,000 was primarily due to a decrease in interest expense of $1.1 million,
a decrease in the provision for loan losses of $190,000 and a decrease in
other
45
expense of $24,000, offset by a decrease in interest and dividend income of
$953,000, a decrease in other income of $195,000 and an increase in income
taxes of $108,000. The annualized return on average assets (ROA) for the 12
months ended September 30, 2002 was 1.00%, a decrease of 2 basis points, as
compared to 1.02% for the prior year. Interest and dividend income
decreased, primarily as the result of an increase in residential loans re-
written at lower rates during the year, accompanied by lower yields on
investment securities. The decrease in interest expense was primarily due to
the general reduction in interest on deposits.
Net Interest and Dividend Income. Net interest and dividend income
for the twelve-months ended September 30, 2002 was $5.3 million, as compared
to $5.1 million for the 12 months ended September 30, 2001. The increase of
$175,000 was the result of a $953,000 decrease in interest and dividend
income, offset by a $1.1 million decrease in interest expense. The net
interest margin for the twelve months ended September 30, 2002 was 3.68%, a
decrease of 16 basis points, as compared to 3.84% for the twelve months
ended September 30, 2001. The decrease in net interest margin was primarily
the result of an increase in the sale of loans and a decrease in interest
income due to the lower general level of interest rates.
Interest and Dividend Income. Total interest and dividend income for
the twelve months ended September 30, 2002 was $8.7 million, a decrease of
$953,000, as compared to $9.6 million for the twelve months ended September
30, 2001. The decrease in interest and dividend income was due to a
$990,000 decrease in interest income on loans, and a $58,000 decrease in
other interest, offset by a $95,000 increase in interest and dividends on
securities and short-term investments. The decrease in interest income on
loans was primarily the result of increased refinancing volume at lower
rates. The increase in interest and dividends on securities was the result
of utilizing cash flow from the refinancing of loans to increase the volume
in short-term securities.
Interest Expense. Interest expense for the twelve months ended
September 30, 2002 was $3.4 million, a decrease of $1.1 million, as compared
to $4.5 million for the twelve months ended September 30, 2001. The
decrease in interest expense was due to the general decrease in interest
rates, as well as a decrease in Federal Home Loan Bank borrowings during the
period.
Provision for Loan Losses. There was no provision for loan loss
expense for the twelve months ended September 30, 2002, which compared to
$190,000 for the twelve months ended September 30, 2001. The decrease in
the amount of the provision for loan losses was the result of the Bank's
decline in total loans due to the selling of residential mortgages, which is
commensurate with loan loss risk. The allowance for loan losses at September
30, 2002 was $939,000, as compared to $945,000 at September 30, 2001, for a
decrease of 0.6%. On September 30, 2002 the Bank had no residential
mortgage loans 90 days or more delinquent, one residential real estate loan
60 days delinquent and one small commercial loan 90 days overdue. The Bank's
allowance for loan losses to total loans ratio was 0.98% at September 30,
2002 as compared to 0.83% at September 30, 2001.
Non-interest Income. Non-interest income, or other income, for the
twelve months ended September 30, 2002 was $502,000, as compared to $696,000
for the twelve months ended September 30, 2001. The $195,000 decrease was
due to a decrease in net securities gains of $749,000, off-set in part by an
increase of $29,000 in service charge income, a $45,000 increase
46
in loan servicing fees, a $23,000 increase in other income, and an increase
of $458,000 in gains on mortgages sold. A decline in market values made it
necessary to write down several of the Bank's equity securities holdings
during the year. The Bank continued a moderate-term strategic objective of
selling off packages of the lowest rate residential loans, service retained,
for market gains.
Non-Interest Expense. Non-interest expense, or other expense, was
$3.4 million for the twelve months ended September 30, 2002 and 2001. A
$24,000 decrease was primarily due to the combination of a decrease in
salaries and employee benefits of $40,000, a decrease in occupancy expense
of $33,000, a decrease in legal and professional fees of $29,000, and a
decrease in other operating expenses of $23,000, off-set in part by an
increase in data processing fees of $71,000, an increase in equipment
expense of $14,000, and an increase in Directors' fees of $16,000. The
increase in data processing expense was partially due to the introduction of
a new Cash Management Program for our business customers within the Bank's
web site, www.falmouthbank.com.
Liquidity and Capital Resources
The Bank's primary sources of funds consist of deposits, repayment and
prepayment of loans and mortgage-backed securities, maturities of
investments and interest-bearing deposits, other borrowed funds and funds
provided from operations. While scheduled repayments of loans and mortgage-
backed securities and maturities of investment securities are predictable
sources of funds, deposit flows and loan prepayments are greatly influenced
by the general level of interest rates, economic conditions and competition.
The Bank uses its liquidity resources principally to fund existing and
future loan commitments, to fund net deposit outflows, to invest in other
interest-earning assets, to maintain liquidity and to meet operating
expenses. Management believes that loan repayments and other sources of
funds will be adequate to meet the Bank's liquidity needs for fiscal year
2004.
The Bank is required to maintain adequate levels of liquid assets.
This guideline, which may be varied depending upon economic conditions and
deposit flows, is based upon a percentage of deposits and short-term
borrowings. The Bank has historically maintained a level of liquid assets
in excess of regulatory requirements. The Bank's liquidity ratio at
September 30, 2003 was 53.1%.
A major portion of the Bank's liquidity consists of short-term U.S.
Government and high-grade corporate obligations. The level of these assets
is dependent on the Bank's operating, investing, lending and financing
activities during any given period. At September 30, 2003, net cash and
short-term assets totaled $7.4 million.
The primary investing activities of the Bank include the origination
of loans and the purchase of investment securities. During the year ended
September 30, 2003, purchases of investment securities and mortgage-backed
securities totaled $92.1 million, while loan originations totaled $111.2
million. These investments were funded primarily from loan repayments of
$58.5 million, loans sold of $64.7 million, investment security maturities
of $65.4 million, an increase in deposits of $13.8 million, and a reduction
in the amount of advances from the Federal Home Loan Bank of Boston (FHLB)
of $2.6 million.
47
Liquidity management is both a daily and long-term function of
management. If the Bank requires more funds than it can generate
internally, the Bank will borrow additional funds from the FHLB of Boston.
At September 30, 2003, the Bank had $2.5 million in outstanding advances
from the FHLB of Boston.
At September 30, 2003, the Bank had $8.0 million in outstanding
commitments to originate loans. The Bank anticipates that it will have
sufficient funds available to meet its current loan origination commitments.
Certificates of deposit which are scheduled to mature in one year or less
totaled $40.5 million at September 30, 2003. Based on historical
experience, management believes that a significant portion of such deposits
will remain with the Bank.
At September 30, 2003, the Company and the Bank exceeded all of their
respective regulatory capital requirements.
Impact of Inflation and Changing Prices
The financial statements and related data presented herein have been
prepared in accordance with accounting principles generally accepted in the
United States of America, which require the measurement of financial
position and results of operations in terms of historical dollars without
considering changes in the relative purchasing power of money over time
because of inflation. Unlike, for instance, industrial companies, virtually
all of the assets and liabilities of the Bank are monetary in nature. As a
result, interest rates have a more significant impact on the Bank's
performance than the effects of general levels of inflation. Interest rates
do not necessarily move in the same direction or in the same magnitude as
the prices of goods and services.
Asset/Liability Management
A principal operating objective of the Bank is to produce stable
earnings by achieving a favorable interest rate spread that can be sustained
during fluctuations in prevailing interest rates. Since the Bank's
principal interest-earning assets have longer terms to maturity than its
primary source of funds (deposit liabilities), increases in general interest
rates will generally result in an increase in the Bank's cost of funds
before the yield on its asset portfolio adjusts upwards. Banking
institutions generally have sought to reduce their exposure to adverse
changes in interest rates by attempting to achieve a closer match between
the periods in which their interest-bearing liabilities and interest-earning
assets can be expected to reprice through the origination of adjustable-rate
mortgages and loans with shorter terms and the purchase of other shorter
term interest-earning assets.
The term "interest rate sensitivity" refers to those assets and
liabilities, which mature and reprice periodically in response to
fluctuations in market rates and yields. Thrift institutions historically
have operated in a mismatched position with interest-sensitive liabilities
exceeding interest-sensitive assets over short-term time periods. As noted
above, one of the principal goals of the Bank's asset/liability program is
to more closely match the interest rate sensitivity characteristics of the
asset and liability portfolios.
48
In order to properly manage interest rate risk, the Bank's Board of
Directors has an Executive Committee to monitor the difference between the
Bank's maturing and repricing assets and liabilities and to develop and
implement strategies to decrease the "negative gap" between the two. The
primary responsibilities of the committee are to assess the Bank's
asset/liability mix, recommend strategies to the Board of Directors that
will enhance income while managing the Bank's sensitivity to changes in
interest rates and report to the Board of Directors the results of the
strategies used.
Since the mid-1980s, the Bank has stressed the origination of
adjustable-rate residential mortgage loans and adjustable-rate home equity
loans. Historically, the Bank did not retain fixed-rate loans with terms in
excess of 15 years in its portfolio. Beginning in March 1995, however, the
Bank retained a portion of its fixed-rate loans with terms in excess of 15
years in the portfolio. At September 30, 2003, the Bank's loan portfolio
included $14.0 million of adjustable-rate mortgages and $15.4 million of
adjustable-rate home equity loans that together represent 34.8% of the
Bank's total loans.
In order to increase the interest rate sensitivity of its assets, the
Bank has also maintained a consistent level of investment securities and
other assets of maturities of three years or less. At September 30, 2003,
the Bank had $59.6 million of investment securities maturing within one year
or less and $8.0 million of investment securities maturing over one through
five years.
In the future, in managing its interest rate sensitivity, the Bank
intends to continue to stress the origination of adjustable-rate mortgages
and loans with shorter maturities and the maintenance of a consistent level
of short-term securities.
Interest Rate Sensitivity Analysis
The matching of assets and liabilities may be analyzed by examining
the extent to which such assets and liabilities are "interest rate
sensitive" and by monitoring an institution's amount of interest rate
sensitive assets. Generally, during a period of rising interest rates, a
negative gap would adversely affect net interest income while a positive gap
would result in an increase in net interest income. Conversely, during a
period of falling interest rates, a negative gap would result in an increase
in net interest income, and a positive gap would adversely affect net
interest income. An asset or liability is said to be interest rate
sensitive within a specific period if it will mature or reprice within that
period. The interest rate sensitivity gap is defined as the difference
between the amount of interest-earning assets maturing or repricing within a
specific time period and the amount of interest-bearing liabilities maturing
or repricing within that time period. A gap is considered positive when the
amount of interest rate sensitive assets exceeds the amount of interest rate
sensitive liabilities, and is considered negative when the amount of
interest rate sensitive liabilities exceeds the amount of interest-rate-
sensitive assets.
49
The following table sets forth the amounts of interest-earning assets
and interest-bearing liabilities outstanding at September 30, 2003, which is
expected to mature or reprice in each of the time periods shown. The
investment securities and mortgage-backed securities in the following table
are presented at carrying amount.
At September 30, 2003
---------------------------------------------------------------
Over One Over Five
One Year Through Through Over Ten
or Less Five Years Ten Years Years Total
-------- ---------- --------- -------- -----
(Dollars in thousands)
Interest-earning assets:
Investment securities (1) $ 59,660 $ 7,917 $ - $ - $ 67,577
Mortgage-backed securities - 32 352 118 502
Other interest-earning assets 7,014 - - - 7,014
Adjustable rate 1-4 family loans 10,471 7,248 1,456 10,286 29,461
Fixed rate 1-4 family loans 706 3,529 9,197 20,095 33,527
Commercial real estate loans 2,104 12,241 929 453 15,727
Consumer and commercial loans 1,857 3,508 - - 5,365
-------- ------- ------- ------- --------
Total (2) $ 81,812 $34,475 $11,934 $30,952 $159,173
======== ======= ======= ======= ========
Interest-bearing liabilities:
Certificates of deposit $ 40,566 $12,887 $ - $ - $ 53,453
Money market accounts 31,386 - - - 31,386
NOW accounts 14,863 - - - 14,863
Passbook accounts 25,407 - - - 25,407
Repurchase agreements - - - - -
FHLB advances 101 482 2,000 - 2,583
-------- ------- ------- ------- --------
Total $112,332 $13,369 $ 2,000 $ - $127,692
======== ======= ======= ======= ========
Interest sensitivity gap $(30,511) $21,106 $ 9,934 $30,952 $ 31,481
======== ======= ======= ======= ========
Cumulative interest sensitivity
gap $(30,511) $(9,405) $ 529 $31,481
======== ======= ======= =======
Ratio of cumulative gap to total
assets (18.37)% (5.66)% 0.32% 18.95%
--------------------
Excludes marketable equity securities.
Loans are presented net of unearned income and unadvanced principal.
Management believes the current one-year gap of negative 18.4%
presents a risk to net interest income should a sustained increase occur in
the current level of interest rates. If interest rates increase, the Bank's
negative one-year gap should cause the net interest margin to decrease. A
conservative rate-gap policy provides a stable net interest income margin.
Accordingly, management emphasizes a structured schedule of investments
spread by term to maturity with greater emphasis on maturities of one year
or less. The preceding table utilized no assumptions or adjustments
regarding the retention of core deposits, prepayment of loans and decay
rates based upon Falmouth's actual experience. Accordingly, it is possible
that the actual interest rate sensitivity of the Bank's assets and
liabilities could vary significantly from the information set forth in the
table due to market and other factors.
Certain shortcomings are inherent in the method of analysis presented
in the preceding table. Although certain assets and liabilities may have
similar maturity or periods of repricing,
50
they may react in different degrees to changes in market interest rates. The
interest rates on certain types of assets and liabilities may fluctuate in
advance of changes in market interest rates, while rates on other types of
assets and liabilities may lag behind changes in market interest rates.
Certain assets, such as adjustable-rate mortgages, generally have features
which restrict changes in interest rates on a short-term basis and over the
life of the asset. In the event of a change in interest rates, prepayments
and early withdrawal levels would likely deviate significantly from those
assumed in calculating the table. Additionally, an increased credit risk may
result as the ability of many borrowers to service their debt may decrease
in the event of an interest rate increase. Virtually all of the adjustable-
rate loans in the Bank's portfolio contain conditions which restrict the
periodic change in interest rate.
51
Impact of New Accounting Standards
In June 2001, the FASB issued SFAS No. 142, "Goodwill and Other
Intangible Assets". This Statement addresses financial accounting and
reporting for acquired goodwill and other intangible assets and supercedes
APB Opinion No. 17, "Intangible Assets". The initial recognition and
measurement provisions of SFAS No. 142 apply to intangible assets which are
defined as assets (not including financial assets) that lack physical
substance. The term "intangible assets" is used in SFAS No. 142 to refer to
intangible assets other than goodwill. The accounting for a recognized
intangible asset is based on its useful life. An intangible asset with a
finite useful life is amortized; an intangible asset with an indefinite
useful life is not amortized. An intangible asset that is subject to
amortization shall be reviewed for impairment in accordance with SFAS No.
144, "Accounting for the Impairment or Disposal of Long-Lived Assets."
SFAS No. 142 provides that goodwill shall not be amortized. Goodwill
is defined as the excess of the cost of an acquired entity over the net of
the amounts assigned to assets acquired and liabilities assumed. SFAS No.
142 further provides that goodwill shall be tested for impairment at a level
of reporting referred to as a reporting unit. Impairment is the condition
that exists when the carrying amount of goodwill exceeds its implied fair
value.
All of the provisions of SFAS No. 142 were effective for the Company
beginning with its fiscal year ending September 30, 2003. The adoption of
SFAS No. 142 did not have an impact on the Company's consolidated financial
statements.
In August 2001, the FASB issued SFAS No. 144 "Accounting for the
Impairment or Disposal of Long-Lived Assets". SFAS No. 144 addresses
financial accounting and reporting for the impairment or disposal of long-
lived assets. SFAS No. 144 supercedes SFAS No. 121 "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed
Of", but retains the basic recognition and measurement model for assets held
for use and held for sale. The provisions of SFAS No. 144 are required to
be adopted starting with fiscal years beginning after December 15, 2001.
The adoption of this Statement did not have a material impact on the
Company's consolidated financial statements.
In June 2002, the FASB issued SFAS No. 146 "Accounting for Costs
Associated with Exit or Disposal Activities". This Statement requires that
a liability for a cost associated with an exit or disposal activity be
recognized and measured initially at fair value only when the liability is
incurred. SFAS No. 146 is effective for exit or disposal activities that
are initiated after December 31, 2002. This Statement did not have any
material impact on the Company's consolidated financial statements.
In October 2002, the FASB issued SFAS No. 147 "Acquisitions of Certain
Financial Institutions", an Amendment of SFAS Nos. 72 and 144 and FASB
Interpretation No. 9. SFAS No. 72 "Accounting for Certain Acquisitions of
Banking or Thrift Institutions" and FASB Interpretation No. 9 "Applying APB
Opinions No. 16 and 17 When a Savings and Loan Association or a Similar
Institution Is Acquired in a Business Combination Accounted for by the
Purchase Method" provided interpretive guidance on the application of the
purchase method to acquisitions of financial institutions. Except for
transactions between two or more mutual
52
enterprises, SFAS No. 147 removes acquisitions of financial institutions
from the scope of both Statement 72 and Interpretation 9 and requires that
those transactions be accounted for in accordance with SFAS No. 141
"Business Combinations" and SFAS No. 142 "Goodwill and Other Intangible
Assets". Thus, the requirement in paragraph 5 of Statement 72 to recognize
(and subsequently amortize) any excess of the fair value of liabilities
assumed over the fair value of tangible and identifiable intangible assets
acquired as an unidentifiable intangible asset no longer applies to
acquisitions within the scope of SFAS No. 147. In addition, SFAS No. 147
amends SFAS No. 144 "Accounting for the 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.
Consequently, those intangible assets are subject to the same undiscounted
cash flow recoverability test and impairment loss recognition and
measurement provisions that SFAS No. 144 requires for other long-lived
assets that are held and used.
Paragraph 5 of SFAS No. 147, which relates to the application of the
purchase method of accounting, is effective for acquisitions for which the
date of acquisition is on or after October 1, 2002. The provisions in
paragraph 6 related to accounting for the impairment or disposal of certain
long-term customer-relationship intangible assets were effective on October
1, 2002. Transition provisions for previously recognized unidentifiable
intangible assets in paragraphs 8-14 was effective on October 1, 2002, with
earlier application permitted. There was no impact on the Company's
consolidated financial statements on adoption of this Statement.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-
Based Compensation-Transition and Disclosure." This Statement amends SFAS
No. 123, "Accounting for Stock-Based Compensation," and provides three
alternative methods of transition for a voluntary change to the fair value
based method of accounting for stock-based compensation. In addition, this
Statement amends the disclosure requirements of SFAS No. 123. The
transition guidance and annual disclosure provisions of this Statement are
effective for fiscal years ending after December 15, 2002 and the interim
period disclosure provisions are effective for interim periods beginning
after December 31, 2002. This Statement did not have any effect on the
Company's consolidated financial statements.
In May, 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity."
This Statement provides new rules on the accounting for certain financial
instruments that, under previous guidance, issuers could account for as
equity. Most of the guidance in SFAS No. 150 is effective for financial
instruments entered into or modified after May 31, 2003, and otherwise is
effective at the beginning of the first interim period beginning after June
30, 2003. This Statement did not have any material effect on the Company's
consolidated financial statements.
53
Average Balances, Interest and Average Yields
The following table sets forth certain information relating to the
Bank's average balance sheet and reflects the average yield on assets,
average cost of liabilities, interest earned and interest paid for the
periods indicated. Such yields and costs are derived by dividing income or
expense by the average monthly balance of assets or liabilities,
respectively, for the periods presented. Average balances are derived from
monthly balances. Management does not believe that the use of monthly
balances instead of daily balances has caused any material difference in the
information presented. Interest earned on loan portfolios is net of reserves
for uncollected interest.
Year Ended September 30,
---------------------------------------------------------------------------------------------
2003 2002 2001
----------------------------- ----------------------------- -----------------------------
Average Average Average
Average Yield/ Average Yield/ Average Yield/
Balance Interest Cost Balance Interest Cost Balance Interest Cost
------- -------- ------- ------- -------- ------- ------- -------- -------
(Dollars in thousands)
Assets:
Interest-earning assets:
Loans, net:
Mortgages $ 79,745 $4,928 6.18% $100,663 $6,999 6.95% $106,658 $8,034 7.53%
Consumer and other 5,588 371 6.64 6,122 466 7.61 4,915 421 8.57
-------- ------ -------- ------ -------- ------
Total loans, net 85,333 5,299 6.21 106,785 7,465 6.99 111,573 8,455 7.58
Investments 57,993 1,316 2.27 31,426 1,095 3.48 18,465 1,000 5.42
Other earning assets 8,557 115 1.34 5,900 132 2.24 3,340 190 5.69
-------- ------ -------- ------ -------- ------
Total interest-earning assets 151,883 6,730 4.43 144,111 8,692 6.03 133,378 9,645 7.23
------ ------ ------
Cash and due from banks 3,555 3,480 3,313
Other assets 4,143 3,582 2,995
-------- -------- --------
Total assets $159,581 $151,173 $139,686
======== ======== ========
Liabilities:
Interest-bearing liabilities:
Deposits:
Savings deposits $ 23,545 $ 157 0.67% $ 20,175 $ 236 1.17% $ 18,209 $ 305 1.67%
NOW 12,070 18 0.15 10,387 31 0.30 8,810 62 0.70
Money market deposits 27,520 372 1.35 23,539 495 2.10 16,793 547 3.26
Certificates of deposit 54,836 1,641 2.99 57,133 2,332 4.08 55,720 3,207 5.76
Borrowed money 4,953 230 4.64 6,336 296 4.67 7,880 397 5.04
-------- ------ -------- ------ -------- ------
Total interest-bearing
liabilities 122,924 2,418 1.97 117,570 3,390 2.88 107,412 4,518 4.21
------ ------ ------
Non-interest bearing
liabilities 19,559 16,688 14,183
-------- -------- --------
Total liabilities 142,483 134,258 121,595
Stockholders' equity 17,051 16,861 18,037
Minority interest in
consolidated subsidiary 47 54 54
-------- -------- --------
Total liabilities and
stockholders' equity $159,581 $151,173 $139,686
======== ======== ========
Net interest and dividend income $4,312 $5,302 $5,127
====== ====== ======
Interest rate spread 2.46% 3.15% 3.02%
Net interest margin 2.84% 3.68% 3.84%
Ratio of average interest-
earning assets to average
interest-bearing liabilities 123.56% 122.57% 124.17%
54
Rate/Volume Analysis
The following table sets forth certain information regarding changes
in interest income and interest expense of the Bank for the periods
indicated. For each category of interest-earning assets and interest-
bearing liabilities, information is provided on changes attributable to: (i)
changes in volume (change in volume multiplied by old rate); and (ii)
changes in rates (change in rate multiplied by old volume). Changes in
rate-volume (change in rate multiplied by change in volume) are allocated
between changes in rates and changes in volume.
Year Ended September 30,
----------------------------------------------------------------------
2003 vs. 2002 2002 vs. 2001
Increase (Decrease) Increase (Decrease)
Due To Due To
--------------------------------- -------------------------------
Volume Rate Total Volume Rate Total
------ ---- ----- ------ ---- -----
(Dollars in thousands)
Interest-earning assets:
Loans $(1,328) $ (838) $(2,166) $(325) $ (665) $ (990)
Investments in other earning assets 639 (435) 204 509 (472) 37
------- ------- ------- ----- ------- -------
Total interest-earning assets (689) (1,273) (1,962) 184 (1,137) (953)
------- ------- ------- ----- ------- -------
Interest-bearing liabilities:
Savings deposits 22 (101) (79) 23 (92) (69)
NOW 3 (16) (13) 5 (36) (31)
Money market deposits 54 (177) (123) 142 (194) (52)
Certificates of deposit (69) (622) (691) 58 (933) (875)
Borrowed money (64) (2) (66) (72) (29) (101)
------- ------- ------- ----- ------- -------
Total interest-bearing liabilities (54) (918) (972) 156 (1,284) (1,128)
------- ------- ------- ----- ------- -------
Net change in net interest income $ (635) $ (355) $ (990) $ 28 $ 147 $ 175
======= ======= ======= ===== ======= =======
Off-Balance Sheet Arrangements
The Company does not have any off-balance sheet arrangements that have
or are reasonably likely to have a current or future effect on the Company's
financial condition, revenues or expenses, results of operations, liquidity,
capital expenditures or capital resources that is material to investors.
ITEM 7. CONSOLIDATED FINANCIAL STATEMENTS
See "Consolidated Financial Statements and Notes to Consolidated
Financial Statements" beginning on page F-1 of this Form 10-KSB/A.
55
ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K
Exhibits. The following exhibits are either filed as part of this
report or are incorporated herein by reference:
3.1 Certificate of Incorporation of Falmouth Bancorp, Inc. (1)
3.2 By-laws of Falmouth Bancorp, Inc.(1)
4.1 Specimen Stock Certificate of Falmouth Bancorp, Inc. (1)
10.1 1997 Stock Option Plan for Outside Directors, Officers and
Employees of Falmouth Bancorp, Inc. (1)
10.2 Amendments to 1997 Stock Option Plan for Outside Directors,
Officers and Employees of Falmouth Bancorp, Inc. (2)
10.3 1997 Recognition and Retention Plan for Outside Directors,
Officers and Employees of Falmouth Bancorp, Inc. (1)
10.4 Agreement and Plan of Reorganization by and between Falmouth
Co-operative Bank and Falmouth Bancorp, Inc., dated November
25, 1997 (1)
10.5 Employment Agreement by and between Falmouth Co-operative
Bank and Santo Pasqualucci. (2)
10.6 Change of Control Agreement by and among Falmouth Co-
operative Bank, Falmouth Bancorp, Inc., and George E. Young
III (3)
10.7 Falmouth Co-operative Bank Employee Stock Ownership Plan. (1)
10.7(a) Amendment No. 5 to Falmouth Co-operative Bank Employee Stock
Ownership Plan. (3)
10.8 Falmouth Bancorp, Inc. Employee Stock Ownership Trust. (1)
13.1 Annual Report to Stockholders for the Year Ended September
30, 2003. (3)
14.1 Code of Ethics (3)
21.1 Subsidiaries of the Registrant. (3)
23.1 Consent of Shatswell, MacLeod & Company, P.C.
31.1 Certification of Chief Executive Officer Pursuant to Section
302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of Chief Financial Officer Pursuant to Section
302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Chief Executive Officer Pursuant to Section
906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification of Chief Financial Officer Pursuant to Section
906 of the Sarbanes-Oxley Act of 2002.
56
99.1 Proxy Statement for the 2004 Annual Meeting of Stockholders
of Falmouth Bancorp, Inc., filed with the Securities and
Exchange Commission on December 18, 2003.
--------------------
Incorporated herein by reference to the Registration Statement on
Form S-4 (Registration No. 333-16931), as filed with the
Securities and Exchange Commission on November 27, 1996.
Incorporated herein by reference to the Annual Report on Form 10-KSB
for the year ended September 30, 2001, as filed with the Securities
and Exchange Commission on December 22, 2001.
Incorporated herein by reference to the Annual Report on Form 10-KSB
for the year ended September 30, 2003, as filed with the Securities
and Exchange Commission on December, 29, 2003.
(c) The Company filed a report on form 8-K with the SEC on July 25,
2003 reporting its earnings for the period ended June 30, 2003.
57
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the
registrant caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.
FALMOUTH BANCORP, INC.
By: /s/ Santo P. Pasqualucci
--------------------------------
Santo P. Pasqualucci
President and Chief Executive
Officer
In accordance with the Exchange Act, this report has been signed below
by the following persons on behalf of the registrant and in the capacities
and on the dates indicated.
Name Title Date
---- ----- ----
/s/ Santo P. Pasqualucci Director, President and April 5, 2004
-------------------------- Chief Executive Officer
Santo P. Pasqualucci (Principal executive officer)
/s/ George E. Young, III Senior Vice President and April 5, 2004
-------------------------- Chief Financial Officer
George E. Young, III (Principal financial officer)
/s/ Peter A. Frizzell, DMD Director April 5, 2004
--------------------------
Peter A. Frizzell, DMD
/s/ Gardner L. Lewis Director April 5, 2004
--------------------------
Gardner L. Lewis
/s/ John J. Lynch, Jr. Chairman of the Board April 5, 2004
--------------------------
John J. Lynch, Jr.
/s/ Eileen C. Miskell Director April 5, 2004
--------------------------
Eileen C. Miskell
/s/ Robert H. Moore Director April 5, 2004
--------------------------
Robert H. Moore
/s/ Henry D. Newman, III Director April 5, 2004
--------------------------
Henry D. Newman, III
58
The Board of Directors
Falmouth Bancorp, Inc.
Falmouth, Massachusetts
INDEPENDENT AUDITORS' REPORT
----------------------------
We have audited the accompanying consolidated balance sheets of Falmouth
Bancorp, Inc. and Subsidiaries as of September 30, 2003 and 2002 and the
related consolidated statements of income, changes in stockholders' equity
and cash flows for each of the years in the three-year period ended
September 30, 2003. These consolidated financial statements are the
responsibility of the Company's management. Our responsibility is to
express an opinion on these consolidated financial statements based on our
audits.
We conducted our audits in accordance with 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
consolidated financial statements are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts
and disclosures in the consolidated financial statements. An audit also
includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall consolidated
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 consolidated financial
position of Falmouth Bancorp, Inc. and Subsidiaries as of September 30,
2003 and 2002, and the consolidated results of their operations and their
cash flows for each of the years in the three-year period ended September
30, 2003, in conformity with accounting principles generally accepted in
the United States of America.
SHATSWELL, MacLEOD & COMPANY, P.C.
West Peabody, Massachusetts
October 28, 2003 (except for Note 19 which
is dated March 12, 2004)
F-1
FALMOUTH BANCORP, INC. AND SUBSIDIARIES
---------------------------------------
CONSOLIDATED BALANCE SHEETS
---------------------------
September 30, 2003 and 2002
---------------------------
ASSETS 2003 2002
------ ---- ----
Cash, due from banks and interest bearing deposits $ 3,335,059 $ 2,916,804
Federal funds sold 4,037,306 4,505,780
------------ ------------
Total cash and cash equivalents 7,372,365 7,422,584
Investments in available-for-sale securities (at fair value) 37,179,799 18,712,954
Investments in held-to-maturity securities (fair values of
$32,556,554 as of September 30, 2003 and $28,034,474 as of
September 30, 2002) 32,549,241 28,060,267
Federal Home Loan Bank stock, at cost 878,000 878,000
Loans held-for-sale, fair value $840,474 as of
September 30, 2003 and $1,596,894 as of September 30, 2002 825,677 1,575,000
Loans, net of allowance for loan losses of $760,552 as of
September 30, 2003 and $939,173 as of September 30, 2002 82,493,801 93,434,955
Premises and equipment 1,911,894 1,792,016
Accrued interest receivable 1,333,910 1,114,924
Co-operative Central Bank Reserve Fund Deposit 395,395 395,395
Other assets 1,178,108 1,134,907
------------ ------------
Total assets $166,118,190 $154,521,002
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Deposits:
Noninterest-bearing $ 20,425,557 $ 17,552,180
Interest-bearing 125,109,413 114,164,879
------------ ------------
Total deposits 145,534,970 131,717,059
Securities sold under agreements to repurchase 471,872
Federal Home Loan Bank advances 2,582,885 5,178,175
Other liabilities 256,956 761,663
------------ ------------
Total liabilities 148,374,811 138,128,769
------------ ------------
Minority preferred stockholders' equity in a subsidiary
company of Falmouth Co-Operative Bank 53,500
------------ ------------
Stockholders' equity:
Preferred stock, par value $.01 per share; authorized
500,000 shares; none issued
Common stock, par value $.01 per share; authorized
2,500,000 shares; issued 1,454,750 shares; outstanding
913,727 shares at September 30, 2003 and 900,779 shares
at September 30, 2002 14,547 14,547
Paid-in capital 14,093,713 13,981,543
Retained earnings 13,858,343 13,735,221
Unallocated Employee Stock Ownership Plan shares (213,114) (301,299)
Treasury stock (541,023 shares as of September 30, 2003
and 553,971 shares as of September 30, 2002) (9,578,649) (9,807,890)
Unearned compensation (340,994) (477,088)
Accumulated other comprehensive loss (90,467) (806,301)
------------ ------------
Total stockholders' equity 17,743,379 16,338,733
------------ ------------
Total liabilities and stockholders' equity $166,118,190 $154,521,002
============ ============
The accompanying notes are an integral part of these consolidated financial
statements.
F-2
FALMOUTH BANCORP, INC. AND SUBSIDIARIES
---------------------------------------
CONSOLIDATED STATEMENTS OF INCOME
---------------------------------
Years Ended September 30, 2003, 2002 and 2001
---------------------------------------------
2003 2002 2001
---- ---- ----
Interest and dividend income:
Interest and fees on loans $5,299,009 $7,465,526 $8,455,351
Interest on debt securities:
Taxable 1,240,007 1,012,470 864,333
Dividends on marketable equity securities 75,980 81,525 105,146
Dividends on Co-operative Bank Investment
and Liquidity Funds 551 30,063
Other interest 114,942 131,995 190,265
---------- ---------- ----------
Total interest and dividend income 6,729,938 8,692,067 9,645,158
---------- ---------- ----------
Interest expense:
Interest on deposits 2,188,626 3,093,465 4,120,397
Interest on securities sold under agreements
to repurchase 11,179 5,269 36,313
Interest on Federal Home Loan Bank advances 218,686 290,944 361,049
---------- ---------- ----------
Total interest expense 2,418,491 3,389,678 4,517,759
---------- ---------- ----------
Net interest and dividend income 4,311,447 5,302,389 5,127,399
(Benefit) provision for loan losses (179,868) 190,000
---------- ---------- ----------
Net interest and dividend income after (benefit)
provision for loan losses 4,491,315 5,302,389 4,937,399
---------- ---------- ----------
Other income:
Service charges on deposit accounts 198,772 181,205 151,963
(Losses) gains on available-for-sale securities, net (450,700) (581,151) 167,957
Net gains on sales of loans 1,043,733 550,488 92,427
Loan servicing fees, net 40,164 29,948 17,952
Other income 300,911 288,610 266,031
---------- ---------- ----------
Total other income 1,132,880 469,100 696,330
---------- ---------- ----------
Other expense:
Salaries and employee benefits 1,957,968 1,706,956 1,746,736
Occupancy expense 170,115 159,970 192,589
Equipment expense 186,663 195,214 181,129
Data processing expense 427,442 395,818 325,127
Directors' fees 87,165 71,350 54,850
Legal and professional fees 163,971 197,018 226,479
Deposit insurance expense 22,500 21,175 20,821
Writedowns of mortgage servicing rights 242,727
Other expense 699,151 620,958 676,964
---------- ---------- ----------
Total other expense 3,957,702 3,368,459 3,424,695
---------- ---------- ----------
Income before income taxes 1,666,493 2,403,030 2,209,034
Income taxes 1,072,261 886,845 779,273
---------- ---------- ----------
Net income $ 594,232 $1,516,185 $1,429,761
========== ========== ==========
F-3
FALMOUTH BANCORP, INC. AND SUBSIDIARIES
---------------------------------------
CONSOLIDATED STATEMENTS OF INCOME
---------------------------------
Years Ended September 30, 2003, 2002 and 2001
---------------------------------------------
(Continued)
2003 2002 2001
---- ---- ----
Basic earnings per share $ 0.68 $ 1.73 $ 1.48
========== ========== ==========
Diluted earnings per share $ 0.64 $ 1.64 $ 1.45
========== ========== ==========
The accompanying notes are an integral part of these consolidated financial
statements.
F-4
FALMOUTH BANCORP, INC. AND SUBSIDIARIES
---------------------------------------
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
----------------------------------------------------------
Years Ended September 30, 2003, 2002 and 2001
---------------------------------------------
Unallocated Accumulated
Employee Other
Stock Compre-
Ownership hensive
Common Paid-in Retained Plan Treasury Unearned Income
Stock Capital Earnings Shares Stock Compensation (Loss) Total
------ ------- -------- ----------- -------- ------------ ---------- ------
Balance, September 30, 2000 $14,547 $13,901,452 $11,669,877 $(477,668) $(6,850,722) $(291,097) $ 25,674 $17,992,063
Employee Stock Ownership Plan 52,332 52,332
ESOP shares released 88,185 88,185
Recognition and retention plan 109,819 109,819
Distribution of RRP shares (153,668) 153,668
Tax benefit from RRP 1,166 1,166
Purchases of treasury stock (1,980,119) (1,980,119)
Exercise of stock options and
related tax benefit (9,822) 81,104 71,282
Dividends declared ($.42
per share) (423,440) (423,440)
Comprehensive income:
Net income 1,429,761
Change in net unrealized
holding gain on available-
for-sale securities, net of
tax effect (430,361)
Comprehensive income 999,400
------- ----------- ----------- --------- ----------- --------- --------- -----------
Balance, September 30, 2001 14,547 13,901,279 12,676,198 (389,483) (8,749,737) (137,429) (404,687) 16,910,688
Employee Stock Ownership Plan 113,614 113,614
ESOP shares released 88,184 88,184
Recognition and retention plan 80,443 80,443
Distribution of RRP shares (137,429) 137,429
Purchase of shares for RRP (477,088) (477,088)
Tax benefit from RRP 28,718 28,718
Purchases of treasury stock (1,328,902) (1,328,902)
Exercise of stock options and
related tax benefit (5,082) 270,749 265,667
Dividends declared ($.50
per share) (457,162) (457,162)
Comprehensive income:
Net income 1,516,185
Change in net unrealized
holding loss on available-
for-sale securities, net of
tax effect (401,614)
Comprehensive income 1,114,571
------- ----------- ----------- --------- ----------- --------- --------- -----------
Balance, September 30, 2002 14,547 13,981,543 13,735,221 (301,299) (9,807,890) (477,088) (806,301) 16,338,733
Employee Stock Ownership Plan 135,148 135,148
ESOP shares released 88,185 88,185
Recognition and retention plan 118,783 118,783
Distribution of RRP shares (136,094) 136,094
Tax benefit from RRP 8,112 8,112
Exercise of stock options and
related tax benefit (13,779) 229,241 215,462
Dividends declared ($.52
per share) (471,110) (471,110)
Comprehensive income:
Net income 594,232
Change in net unrealized
holding loss on available-
for-sale securities, net of
tax effect 715,834
Comprehensive income 1,310,066
------- ----------- ----------- --------- ----------- --------- --------- -----------
Balance, September 30, 2003 $14,547 $14,093,713 $13,858,343 $(213,114) $(9,578,649) $(340,994) $ (90,467) $17,743,379
======= =========== =========== ========= =========== ========= ========= ===========
F-5
FALMOUTH BANCORP, INC. AND SUBSIDIARIES
---------------------------------------
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
----------------------------------------------------------
Years Ended September 30, 2003, 2002 and 2001
---------------------------------------------
(continued)
Reclassification disclosure for the years ended September 30:
2003 2002 2001
---- ---- ----
Net unrealized gains (losses) on available-for-sale securities $238,293 $(695,284) $(549,312)
Reclassification adjustment for realized losses (gains) in net income 450,700 581,151 (167,957)
-------- --------- ---------
Other comprehensive income (loss) before income tax effect 688,993 (114,133) (717,269)
Income tax benefit (expense) 26,841 (287,481) 286,908
-------- --------- ---------
Other comprehensive income (loss), net of tax $715,834 $(401,614) $(430,361)
======== ========= =========
Accumulated other comprehensive loss as of September 30, 2003, 2002 and 2001
consists of net unrealized holding losses on available-for-sale securities,
net of taxes.
The accompanying notes are an integral part of these consolidated financial
statements.
F-6
FALMOUTH BANCORP, INC. AND SUBSIDIARIES
---------------------------------------
CONSOLIDATED STATEMENTS OF CASH FLOWS
-------------------------------------
Years Ended September 30, 2003, 2002 and 2001
---------------------------------------------
2003 2002 2001
---- ---- ----
Cash flows from operating activities:
Net income $ 594,232 $ 1,516,185 $ 1,429,761
Adjustments to reconcile net income to net cash
provided by operating activities:
Losses (gains) on available-for-sale securities, net 450,700 581,151 (167,957)
Amortization of investment securities, net 1,752,610 518,396 55,910
(Benefit) provision for loan losses (179,868) 190,000
Change in deferred loan costs, net of origination fees 40,437 64,419 (171,939)
Net gains on sales of loans not originated for sale (78,631)
Decrease (increase) in loans held-for-sale 749,323 (1,395,000) (180,000)
Depreciation and amortization 165,353 188,339 187,777
Loss on disposal of equipment 1,071
Increase in accrued interest receivable (218,986) (284,503) (79,731)
Decrease in prepaid expenses 24,100 21,880 12,732
Increase in taxes receivable (143,346) (131,081) (84,507)
(Increase) decrease in other assets (2,932) (1,030) 6,605
(Increase) decrease in mortgage servicing rights (192,375) (404,970)
Recognition and retention plan (RRP) 118,783 80,443 109,819
Deferred tax expense (benefit) 342,944 (107,420) 73,281
Increase (decrease) in accrued expenses 5,362 (77,473) 1,898
(Decrease) increase in accrued interest payable (49) (356) 419
(Decrease) increase in other liabilities (510,020) 484,958 52,476
------------ ------------ ------------
Net cash provided by operating activities 2,996,268 1,055,009 1,357,913
------------ ------------ ------------
Cash flows from investing activities:
Purchases of available-for-sale securities (49,943,612) (13,984,026) (7,366,058)
Proceeds from sales of available-for-sale securities 2,197,181 96,317 1,410,851
Proceeds from maturities of available-for-sale securities 28,854,295 3,614,057 3,780,839
Purchases of held-to-maturity securities (42,133,350) (34,668,159) (11,235,627)
Proceeds from maturities of held-to-maturity securities 36,555,350 16,285,640 12,057,785
Purchases of Federal Home Loan Bank stock (157,300)
Loan originations and principal collections, net 11,078,815 18,874,719 (14,027,374)
Recoveries of previously charged off loans 1,770
Proceeds from sales of loans 7,445,360
Capital expenditures (285,231) (83,729) (94,397)
------------- ------------ ------------
Net cash used in investing activities (13,674,782) (9,865,181) (8,185,921)
------------- ------------ ------------
F-7
FALMOUTH BANCORP, INC. AND SUBSIDIARIES
---------------------------------------
CONSOLIDATED STATEMENTS OF CASH FLOWS
-------------------------------------
Years Ended September 30, 2003, 2002 and 2001
---------------------------------------------
(continued)
2003 2002 2001
---- ---- ----
Cash flows from financing activities:
Net increase in demand deposits, NOW and savings accounts 17,477,554 10,724,566 3,698,627
Net (decrease) increase in time deposits (3,659,643) (1,183,343) 6,102,969
Net decrease in securities sold under agreements to repurchase (471,872) (203,884) (188,187)
Proceeds from Federal Home Loan Bank long-term advances 7,500,000
Repayment of Federal Home Loan Bank long-term advances (2,595,290) (2,089,773) (6,084,013)
Net change in Federal Home Loan Bank short-term advances 2,000,000
Redemption of preferred share relative to minority interest (53,500) (500)
Proceeds from exercise of stock options 178,823 211,765 66,460
Dividends paid (471,110) (457,162) (423,440)
Employee Stock Ownership Plan 135,148 113,614 52,332
Unallocated ESOP shares released 88,185 88,184 88,185
Purchase of shares for RRP (477,088)
Purchases of treasury stock (1,328,902) (1,980,119)
------------ ------------ ------------
Net cash provided by financing activities 10,628,295 5,397,477 10,832,814
------------ ------------ ------------
(Decrease) increase in cash and cash equivalents (50,219) (3,412,695) 4,004,806
Cash and cash equivalents at beginning of period 7,422,584 10,835,279 6,830,473
------------ ------------ ------------
Cash and cash equivalents at end of period $ 7,372,365 $ 7,422,584 $ 10,835,279
============ ============ ============
Supplemental disclosures:
Interest paid $ 2,418,540 $ 3,390,034 $ 4,517,340
Income taxes paid 872,663 1,125,346 790,499
The accompanying notes are an integral part of these consolidated financial
statements.
F-8
FALMOUTH BANCORP, INC. AND SUBSIDIARIES
---------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
------------------------------------------
Years Ended September 30, 2003, 2002 and 2001
---------------------------------------------
NOTE 1 - NATURE OF OPERATIONS
-----------------------------
Falmouth Bancorp, Inc. (the "Company"), a Delaware corporation was
organized by the Falmouth Co-Operative Bank (the "Bank") on November 25,
1996 to be a bank holding company with the Bank as its wholly-owned
subsidiary.
The Bank was organized in 1925 and is headquartered in Falmouth,
Massachusetts. The Bank is engaged principally in the business of
attracting deposits from the general public and investing those deposits in
residential real estate, consumer and small business loans.
NOTE 2 - ACCOUNTING POLICIES
----------------------------
The accounting and reporting policies of the Company and its subsidiaries
conform to accounting principles generally accepted in the United States of
America and predominant practices within the savings institution industry.
The consolidated financial statements were prepared using the accrual
method of accounting. The significant accounting policies are summarized
below to assist the reader in better understanding the consolidated
financial statements and other data contained herein.
USE OF ESTIMATES:
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and the reported
amounts of revenues and expenses during the reporting period. Actual
results could differ from those estimates.
BASIS OF PRESENTATION:
The consolidated financial statements include the accounts of the Company,
the Company's wholly-owned subsidiaries, the Bank and the RRP Trust, and
the Bank's wholly-owned subsidiaries, Falmouth Securities Corporation and
Falmouth Capital Corporation. All significant intercompany accounts and
transactions have been eliminated in the consolidation.
The RRP Trust was formed on October 21, 1997 in connection with the Bank's
1997 Recognition and Retention Plan for Outside Directors, officers and
employees of Falmouth Bancorp, Inc. (the "RRP"). The Company contributes
to the RRP Trust from time to time. The RRP Trust invests the assets of
the Trust in shares of the Company.
The Trustees of the RRP Trust are also directors or retired directors of
the Company. The RRP is administered by the compensation committee of the
Board of Directors of the Company which consists of certain non-employee
members of the Board of Directors of the Company.
Falmouth Securities Corporation was established solely for the purpose of
acquiring and holding investments which are permissible for banks to hold
under Massachusetts law. This corporation was dissolved on August 13, 2001
and is no longer in existence. The assets and liabilities were transferred
to Falmouth Co-Operative Bank.
F-9
Falmouth Capital Corporation, a real estate investment trust, was
established as part of the Company's tax management planning. This
corporation was dissolved effective October 21, 2003 and is no longer in
existence. The assets and liabilities were transferred to Falmouth Co-
Operative Bank.
CASH AND CASH EQUIVALENTS:
For purposes of reporting cash flows, cash and cash equivalents include
cash on hand, cash items, due from banks, interest bearing deposits and
federal funds sold.
Cash and due from banks as of September 30, 2003 and 2002 includes $770,160
and $574,000, respectively which is subject to withdrawals and usage
restrictions to satisfy the reserve requirements of the Federal Reserve
Bank.
SECURITIES:
Investments in debt securities are adjusted for amortization of premiums
and accretion of discounts computed so as to approximate the interest
method. Gains or losses on sales of investment securities are computed on
a specific identification basis.
The Company classifies debt and equity securities into one of three
categories: held-to-maturity, available-for-sale, or trading. This
security classification may be modified after acquisition only under
certain specified conditions. In general, securities may be classified as
held-to-maturity only if the Company has the positive intent and ability to
hold them to maturity. Trading securities are defined as those bought and
held principally for the purpose of selling them in the near term. All
other securities must be classified as available-for-sale.
-- Held-to-maturity securities are measured at amortized cost on
the consolidated balance sheets. Unrealized holding gains and
losses are not included in earnings or in a separate component
of stockholders' equity. They are merely disclosed in the
notes to the consolidated financial statements.
-- Available-for-sale securities are carried at fair value on the
consolidated balance sheets. Unrealized holding gains and
losses are not included in earnings, but are reported as a net
amount (less expected tax) in a separate component of
stockholders' equity until realized.
-- Trading securities are carried at fair value on the
consolidated balance sheets. Unrealized holding gains and
losses for trading securities are included in earnings.
If a decline in the fair value below the adjusted cost basis of an
investment is judged to be other than temporary, the cost basis of the
investment is written down to fair value as the new cost basis and the
amount of the write down is included as a charge against securities gains,
net.
LOANS:
Loans receivable that management has the intent and ability to hold until
maturity or payoff, are reported at their outstanding principal balances
adjusted for amounts due to borrowers on unadvanced loans, any charge-offs,
the allowance for loan losses and any deferred fees, costs on originated
loans or unamortized premiums or discounts on purchased loans.
Interest on loans is recognized on a simple interest basis.
Loan origination, commitment fees and certain direct origination costs are
deferred and the net amount amortized as an adjustment of the related
loan's yield. The Company is amortizing these amounts over the contractual
life of the related loans.
F-10
Residential real estate loans are generally placed on nonaccrual when
reaching 90 days past due or in process of foreclosure. All closed-end
consumer loans 90 days or more past due and any equity line in the process
of foreclosure are placed on nonaccrual status. Secured consumer loans are
written down to realizable value and unsecured consumer loans are charged-
off upon reaching 120 or 180 days past due depending on the type of loan.
Commercial real estate loans and commercial business loans and leases which
are 90 days or more past due are generally placed on nonaccrual status,
unless secured by sufficient cash or other assets immediately convertible
to cash. When a loan has been placed on nonaccrual status, previously
accrued and uncollected interest is reversed against interest on loans. A
loan can be returned to accrual status when collectibility of principal is
reasonably assured and the loan has performed for a period of time,
generally six months.
Cash receipts of interest income on impaired loans is credited to principal
to the extent necessary to eliminate doubt as to the collectibility of the
net carrying amount of the loan. Some or all of the cash receipts of
interest income on impaired loans is recognized as interest income if the
remaining net carrying amount of the loan is deemed to be fully
collectible. When recognition of interest income on an impaired loan on a
cash basis is appropriate, the amount of income that is recognized is
limited to that which would have been accrued on the net carrying amount of
the loan at the contractual interest rate. Any cash interest payments
received in excess of the limit and not applied to reduce the net carrying
amount of the loan are recorded as recoveries of charge-offs until the
charge-offs are fully recovered.
LOANS HELD-FOR-SALE:
Loans held-for-sale in the secondary market are carried at the lower of
cost or estimated fair value in the aggregate. Net unrealized losses are
provided for in a valuation allowance by charges to operations.
Interest income on loans held-for-sale is accrued currently and classified
as interest on loans.
ALLOWANCE FOR LOAN LOSSES:
The allowance for loan losses is established as losses are estimated to
have occurred through a provision for loan losses charged to earnings.
Loan losses are charged against the allowance when management believes the
uncollectibility of a loan balance is confirmed. Subsequent recoveries, if
any, are credited to the allowance.
The allowance for loan losses is evaluated on a regular basis by management
and is based upon management's periodic review of the collectibility of the
loans in light of historical experience, the nature and volume of the loan
portfolio, adverse situations that may affect the borrower's ability to
repay, estimated value of any underlying collateral and prevailing economic
conditions. This evaluation is inherently subjective as it requires
estimates that are susceptible to significant revision as more information
becomes available.
A loan is considered impaired when, based on current information and
events, it is probable that the Company will be unable to collect the
scheduled payments of principal or interest when due according to the
contractual terms of the loan agreement. Factors considered by management
in determining impairment include payment status, collateral value, and the
probability of collecting scheduled principal and interest payments when
due. Loans that experience insignificant payment delays and payment
shortfalls generally are 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 the
shortfall in relation to the principal and interest owed. Impairment is
measured on a loan by loan basis for commercial and construction loans by
either the present value of expected future cash flows discounted at the
loan's effective interest rate, the loan's obtainable market price, or the
fair value of the collateral if the loan is collateral dependent.
Large groups of smaller balance homogeneous loans are collectively
evaluated for impairment. Accordingly, the Company does not separately
identify individual consumer and residential loans for impairment
disclosures.
F-11
PREMISES AND EQUIPMENT:
Premises and equipment are stated at cost, less accumulated depreciation
and amortization. Cost and related allowances for depreciation and
amortization of premises and equipment retired or otherwise disposed of are
removed from the respective accounts with any gain or loss included in
income or expense. Depreciation and amortization are calculated
principally on the straight-line method over the estimated useful lives of
the assets.
OTHER REAL ESTATE OWNED AND IN-SUBSTANCE FORECLOSURES:
Other real estate owned includes properties acquired through foreclosure
and properties classified as in-substance foreclosures in accordance with
SFAS No. 15, "Accounting by Debtors and Creditors for Troubled Debt
Restructuring." These properties are carried at the lower of cost or
estimated fair value less estimated costs to sell. Any write-down from
cost to estimated fair value, required at the time of foreclosure or
classification as in-substance foreclosure, is charged to the allowance for
loan losses. Expenses incurred in connection with maintaining these
assets, subsequent write-downs and gains or losses recognized upon sale are
included in other expense.
In accordance with SFAS No. 114, "Accounting by Creditors for Impairment of
a Loan," the Company classifies loans as in-substance repossessed or
foreclosed if the Company receives physical possession of the debtor's
assets regardless of whether formal foreclosure proceedings take place.
COOPERATIVE CENTRAL BANK RESERVE FUND DEPOSIT:
The Reserve Fund was established for liquidity purposes and consists of
deposits required of all insured cooperative banks in Massachusetts. The
Fund is used by the Central Bank to advance funds to member banks, but such
advances generally are not made until Federal Home Loan Bank and commercial
bank sources of borrowings have been exhausted. The Company has not
borrowed funds from the Central Bank since rejoining the Federal Home Loan
Bank on January 2, 1975.
ADVERTISING:
The Company directly expenses costs associated with advertising as they are
incurred.
INCOME TAXES:
The Company recognizes income taxes under the asset and liability method.
Under this method, deferred tax assets and liabilities are established for
the temporary differences between the accounting basis and the tax basis of
the Company 's assets and liabilities at enacted tax rates expected to be
in effect when the amounts related to such temporary differences are
realized or settled.
RETIREMENT PLAN:
The compensation cost of an employee's pension benefit is recognized on the
net periodic pension cost method over the employee's approximate service
period. The aggregate cost method is used for funding purposes.
FAIR VALUES OF FINANCIAL INSTRUMENTS:
Statement of Financial Accounting Standards No. 107, "Disclosures About
Fair Value of Financial Instruments," requires that the Company disclose
estimated fair value for its financial instruments. Fair value methods and
assumptions used by the Company in estimating its fair value disclosures
are as follows:
F-12
Cash and cash equivalents: The carrying amounts reported in the
consolidated balance sheet for cash and cash equivalents approximate those
assets' fair values.
Securities (including mortgage-backed securities): Fair values for
securities are based on quoted market prices, where available. If quoted
market prices are not available, fair values are based on quoted market
prices of comparable instruments.
Loans held-for-sale: Fair values of loans held-for-sale are based on
commitments on hand from investors or prevailing market prices.
Loans receivable: For variable-rate loans that reprice frequently and with
no significant change in credit risk, fair values are based on carrying
values. The fair values for other loans are estimated using discounted
cash flow analyses, using interest rates currently being offered for loans
with similar terms to borrowers of similar credit quality.
Accrued interest receivable and Co-operative Central Bank Reserve Fund
Deposit: The carrying amounts of accrued interest receivable and Co-
operative Central Bank Reserve Fund Deposit approximate their fair values.
Deposit liabilities: The fair values disclosed for demand deposits (e.g.,
interest and non-interest checking, passbook savings and money market
accounts) are, by definition, equal to the amount payable on demand at the
reporting date (i.e., their carrying amounts). Fair values for fixed-rate
certificates of deposit are estimated using a discounted cash flow
calculation that applies interest rates currently being offered on
certificates to a schedule of aggregated expected monthly maturities on
time deposits.
Securities sold under agreements to repurchase: The carrying amount
reported on the consolidated balance sheet for securities sold under
agreements to repurchase approximates those liabilities' fair values.
Federal Home Loan Bank Advances: Fair values for Federal Home Loan Bank
advances are estimated using a discounted cash flow technique that applies
interest rates currently being offered on advances to a schedule of
aggregated expected monthly maturities on Federal Home Loan Bank advances.
Off-balance sheet instruments: The fair value of commitments to originate
loans is estimated using the fees currently charged to enter similar
agreements, taking into account the remaining terms of the agreements and
the present creditworthiness of the counterparties. For fixed-rate loan
commitments and the unadvanced portion of loans, fair value also considers
the difference between current levels of interest rates and the committed
rates. The fair value of letters of credit is based on fees currently
charged for similar agreements or on the estimated cost to terminate them
or otherwise settle the obligation with the counterparties at the reporting
date.
STOCK-BASED COMPENSATION:
At September 30, 2003, the Company has a stock-based employee compensation
plan which is described more fully in Note 10. The Company accounts for
this plan under the recognition and measurement principles of APB Opinion
No. 25, "Accounting for Stock Issued to Employees," and related
Interpretations. No stock-based employee compensation is reflected in net
income, as all options granted under this plan had an exercise price equal
to the market value of the underlying common stock on the date of grant.
The following table 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
employee compensation.
F-13
For the Years Ended September 30,
----------------------------------------
2003 2002 2001
---- ---- ----
Net income, as reported $594,232 $1,516,185 $1,429,761
Deduct: Total stock-based employee compensation
expense determined under fair value based method
for all awards, net of related tax effects 31,333 33,053 60,273
-------- ---------- ----------
Pro forma net income $562,899 $1,483,132 $1,369,488
======== ========== ==========
Earnings per share:
Basic - as reported $ 0.68 $ 1.73 $ 1.48
Basic - pro forma $ 0.64 $ 1.69 $ 1.42
Diluted - as reported $ 0.64 $ 1.64 $ 1.45
Diluted - pro forma $ 0.61 $ 1.61 $ 1.39
EARNINGS PER SHARE:
Basic earnings per share represents income available to common stockholders
divided by the weighted-average number of common shares outstanding during
the period. Diluted earnings per share reflects additional common shares
that would have been outstanding if dilutive potential common shares had
been issued, as well as any adjustment to income that would result from the
assumed issuance. Potential common shares that may be issued by the
Company relate solely to outstanding stock options, and are determined
using the treasury stock method.
RECENT ACCOUNTING PRONOUNCEMENTS:
In June 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible
Assets." This Statement addresses financial accounting and reporting for
acquired goodwill and other intangible assets and supercedes APB Opinion
No. 17, "Intangible Assets." The initial recognition and measurement
provisions of SFAS No. 142 apply to intangible assets which are defined as
assets (not including financial assets) that lack physical substance. The
term "intangible assets" is used in SFAS No. 142 to refer to intangible
assets other than goodwill. The accounting for a recognized intangible
asset is based on its useful life. An intangible asset with a finite
useful life is amortized; an intangible asset with an indefinite useful
life is not amortized. An intangible asset that is subject to amortization
shall be reviewed for impairment in accordance with SFAS No. 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets."
SFAS No. 142 provides that goodwill shall not be amortized. Goodwill is
defined as the excess of the cost of an acquired entity over the net of the
amounts assigned to assets acquired and liabilities assumed. SFAS No. 142
further provides that goodwill shall be tested for impairment at a level of
reporting referred to as a reporting unit. Impairment is the condition
that exists when the carrying amount of goodwill exceeds its implied fair
value.
All of the provisions of SFAS No. 142 were applied for the Company
beginning with its fiscal year ending September 30, 2003. SFAS No. 142 has
been applied to all goodwill and intangible assets recognized in the
Company's statement of financial position at the beginning of that fiscal
year, regardless of when those previously recognized assets were initially
recognized.
The adoption of this Statement did not have a material impact on the
consolidated financial statements.
In August 2001, the FASB issued SFAS No. 144 "Accounting for the Impairment
or Disposal of Long-Lived Assets." SFAS No. 144 addresses financial
accounting and reporting for the impairment or disposal of long-lived
assets. SFAS No. 144 supercedes SFAS No. 121 "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed
Of," but retains the basic recognition and measurement model for assets
held for use and held for sale. The provisions of SFAS No. 144 are
required to be adopted starting with fiscal years beginning after December
15, 2001. The adoption of this Statement did not have a material impact on
the Company's consolidated financial statements.
F-14
In June 2002, the FASB issued SFAS No. 146 "Accounting for Costs Associated
with Exit or Disposal Activities." This Statement requires that a
liability for a cost associated with an exit or disposal activity be
recognized and measured initially at fair value only when the liability is
incurred. SFAS No. 146 is effective for exit or disposal activities that
are initiated after December 31, 2002. The adoption of this Statement did
not have any material impact on the Company's consolidated financial
statements.
In October 2002, the FASB issued SFAS No. 147 "Acquisitions of Certain
Financial Institutions," an Amendment of SFAS Nos. 72 and 144 and FASB
Interpretation No. 9. SFAS No. 72 "Accounting for Certain Acquisitions of
Banking or Thrift Institutions" and FASB Interpretation No. 9 "Applying APB
Opinions No. 16 and 17 When a Savings and Loan Association or a Similar
Institution Is Acquired in a Business Combination Accounted for by the
Purchase Method" provided interpretive guidance on the application of the
purchase method to acquisitions of financial institutions. Except for
transactions between two or more mutual enterprises, SFAS No. 147 removes
acquisitions of financial institutions from the scope of both Statement 72
and Interpretation 9 and requires that those transactions be accounted for
in accordance with SFAS No. 141 "Business Combinations" and SFAS No. 142
"Goodwill and Other Intangible Assets." Thus, the requirement in paragraph
5 of Statement 72 to recognize (and subsequently amortize) any excess of
the fair value of liabilities assumed over the fair value of tangible and
identifiable intangible assets acquired as an unidentifiable intangible
asset no longer applies to acquisitions within the scope of SFAS No. 147.
In addition, SFAS No. 147 amends SFAS No. 144 "Accounting for the
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. Consequently, those intangible assets are
subject to the same undiscounted cash flow recoverability test and
impairment loss recognition and measurement provisions that SFAS No. 144
requires for other long-lived assets that are held and used.
Paragraph 5 of SFAS No. 147, which relates to the application of the
purchase method of accounting, is effective for acquisitions for which the
date of acquisition is on or after October 1, 2002. The provisions in
paragraph 6 related to accounting for the impairment or disposal of certain
long-term customer - relationship intangible assets are effective on
October 1, 2002. Transition provisions for previously recognized
unidentifiable intangible assets in paragraphs 8-14 are effective on
October 1, 2002, with earlier application permitted. There was no
substantial impact on the Company's consolidated financial statements on
adoption of this Statement.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation-Transition and Disclosure an amendment of SFAS No. 123." This
Statement amends SFAS No. 123, "Accounting for Stock-Based Compensation,"
and permits two additional transition methods for a voluntary change to the
fair value based method of accounting for stock-based compensation. In
addition, this Statement amends the disclosure requirements of SFAS No.
123. The transition guidance and annual disclosure provisions of this
Statement are effective for fiscal years ending after December 15, 2002 and
the interim period disclosure provisions are effective for interim periods
beginning after December 31, 2002. This Statement did not have any effect
on the Company's consolidated financial statements.
On May 15, 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity."
This Statement establishes standards for the classification and measurement
of certain financial instruments with characteristics of both liabilities
and equity. SFAS No. 150 requires that certain financial instruments that
were previously classified as equity must be classified as a liability.
Most of the guidance in SFAS No. 150 is effective for financial instruments
entered into or modified after May 31, 2003, and otherwise is effective at
the beginning of the first interim period beginning after June 15, 2003.
This Statement did not have any material effect on the Company's
consolidated financial statements.
F-15
NOTE 3 - INVESTMENTS IN SECURITIES
----------------------------------
Debt and equity securities have been classified in the consolidated balance
sheets according to management's intent. The carrying amount of securities
and their approximate fair values are as follows as of September 30:
Gains in Losses in
Accumulated Accumulated
Amortized Other Other
Cost Comprehensive Comprehensive Fair
Basis Income Income Value
--------- ------------- ------------- -----
Available-for-sale:
September 30, 2003:
Debt securities issued by the U.S. Treasury
and other U.S. government corporations
and agencies $ 5,535,863 $ 164 $ 2,317 $ 5,533,710
Corporate debt securities 29,687,903 29,225 73,185 29,643,943
Mortgage-backed securities 352,404 23,756 376,160
Marketable equity securities 1,703,247 115,000 192,261 1,625,986
----------- -------- -------- -----------
$37,279,417 $168,145 $267,763 $37,179,799
=========== ======== ======== ===========
September 30, 2002:
Debt securities issued by the U.S. Treasury
and other U.S. government corporations
and agencies $ 6,481,735 $ 9,235 $ $ 6,490,970
Corporate debt securities 9,608,236 26,013 20,175 9,614,074
Mortgage-backed securities 586,688 36,958 623,646
Marketable equity securities 2,824,906 50,885 891,527 1,984,264
----------- -------- -------- -----------
$19,501,565 $123,091 $911,702 $18,712,954
=========== ======== ======== ===========
F-16
Gross Gross
Net Unrecognized Unrecognized
Carrying Holding Holding Fair
Amount Gains Loss Value
-------- ------------ ------------ -----
Held-to-maturity:
September 30, 2003:
Corporate debt securities $32,399,711 $ 55,121 $ 53,523 $32,401,309
Mortgage-backed securities 149,530 5,715 155,245
----------- -------- -------- -----------
$32,549,241 $ 60,836 $ 53,523 $32,556,554
=========== ======== ======== ===========
September 30, 2002:
Debt securities issued by the U.S. Treasury
and other U.S. government corporations
and agencies $ 8,014,458 $ 33,552 $ $ 8,048,010
Corporate debt securities 19,833,400 11,082 78,832 19,765,650
Mortgage-backed securities 212,409 8,405 220,814
----------- -------- -------- -----------
$28,060,267 $ 53,039 $ 78,832 $28,034,474
=========== ======== ======== ===========
The scheduled maturities of debt securities were as follows as of September
30, 2003:
Available-For-Sale Held-To-Maturity
------------------ ----------------------------
Fair Net Carrying Fair
Value Amount Value
----- ------------ -----
Due within one year $31,505,028 $28,155,830 $28,128,719
Due after one year through five years 3,672,625 4,243,881 4,272,590
Mortgage-backed securities 376,160 149,530 155,245
----------- ----------- -----------
$35,553,813 $32,549,241 $32,556,554
=========== =========== ===========
For the year ended September 30, 2003, proceeds from sales of securities
available-for-sale amounted to $2,197,181. Gross realized gains and gross
realized losses on those sales amounted to $75,403 and $477,087,
respectively. For the year ended September 30, 2002, proceeds from sales
of securities available-for-sale amounted to $96,317. Gross realized gains
and gross realized losses on those sales amounted to $25,550 and $9,786,
respectively. For the year ended September 30, 2001, proceeds from sales
of securities available-for-sale amounted to $1,410,851. Gross realized
gains and gross realized losses on those sales amounted to $204,597 and
$36,640, respectively. The tax (benefit) provision applicable to these net
realized gains or losses amounted to ($164,409), $6,449 and $68,745 for the
years ended September 30, 2003, 2002 and 2001, respectively.
Total carrying amounts of $0 and $1,013,874 of debt securities were pledged
to secure repurchase agreements and borrowings from the Federal Reserve
Bank discount window as of September 30, 2003 and 2002, respectively.
F-17
The following are securities of issuers which exceeded 10% of stockholders'
equity as of September 30, 2003:
Amortized Fair
Cost Basis Value
---------- -----
Comcast Cable Communications, Inc. $ 2,077,851 $ 2,072,400
Time Warner Inc. 2,985,699 2,963,595
International Lease Finance Corp. 3,092,612 3,105,330
Deere & Co. 3,478,914 3,480,963
Sempra Energy 2,083,688 2,077,500
Walt Disney Co. 1,966,727 1,966,978
First Union Corp. 2,114,996 2,123,640
Conoco Inc. 3,078,156 3,073,740
Whitman Corp. 3,241,290 3,232,877
CVS Corp. 2,438,447 2,435,616
Rohm & Haas Co. 2,088,390 2,077,600
McDonalds Corp. 2,110,366 2,102,193
American Telephone & Telegraph Corp. 3,048,634 3,066,680
Textron Financial Corp. 1,931,038 1,934,423
General Motors Acceptance Corp. 2,649,630 2,650,280
NOTE 4 - LOANS
--------------
Loans consisted of the following as of September 30:
2003 2002
---- ----
Commercial, financial and agricultural $ 4,943,352 $ 5,178,877
Real estate - construction and land
development 5,075,051 8,488,005
Real estate - residential 56,874,004 68,125,808
Real estate - commercial 15,701,970 11,844,559
Consumer 402,948 439,414
----------- -----------
82,997,325 94,076,663
Deferred loan costs, net of origination
fees 257,028 297,465
Allowance for loan losses (760,552) (939,173)
----------- -----------
Loans, net $82,493,801 $93,434,955
=========== ===========
Certain directors and executive officers of the Company were customers of
the Bank during the year ended September 30, 2003. Total loans to such
persons and their companies amounted to $2,036,837 as of September 30,
2003. During the year ended September 30, 2003, total principal payments
amounted to $95,031 and principal advances were $1,731,868.
F-18
Changes in the allowance for loan losses were as follows for the years
ended September 30:
2003 2002 2001
---- ---- ----
Balance at beginning of period $939,173 $945,247 $755,247
Loans charged off (523) (6,074)
Recoveries 1,770
(Benefit) provision for loan losses (179,868) 190,000
-------- -------- --------
Balance at end of period $760,552 $939,173 $945,247
======== ======== ========
The following table sets forth information regarding nonaccrual loans and
accruing loans 90 days or more overdue as of September 30:
2003 2002
---- ----
Nonaccrual loans $0 $ 0
Accruing loans which are 90 days or more overdue $0 $42,000
Information about loans that meet the definition of an impaired loan in
Statement of Financial Accounting Standards No. 114 is as follows as of
September 30:
2003 2002
-------------------------- --------------------------
Recorded Related Recorded Related
Investment Allowance Investment Allowance
In Impaired For Credit In Impaired For Credit
Loans Losses Loans Losses
----------- ---------- ----------- ----------
Loans for which there is a related allowance
for credit losses $ 0 $0 $42,000 $42,000
Loans for which there is no related allowance
for credit losses 0 0
------- -- ------- -------
Totals $ 0 $0 $42,000 $42,000
======= == ======= =======
Average recorded investment in impaired loans
during the year ended September 30 $16,800 $16,800
======= =======
Related amount of interest income recognized
during the time, in the year ended
September 30, that the loans were impaired
Total recognized $ 2,793 $ 0
======= =======
Amount recognized using a cash-basis
method of accounting $ 2,793 $ 0
======= =======
Loans serviced for others are not included in the accompanying consolidated
balance sheets. The unpaid principal balances of mortgage loans serviced
for others were $70,015,072 and $42,860,464 as of September 30, 2003 and
2002, respectively.
F-19
In years prior to the year ended September 30, 2002, the Company considered
the value of its mortgage servicing asset to be immaterial. The "loans
serviced for others" portfolio has increased significantly and the Company
now recognizes its mortgage servicing rights as an asset on the
consolidated balance sheet. The Company adheres to the accounting and
reporting standards as set forth in SFAS No. 140, "Accounting for Transfers
and Servicing of Financial Assets and Extinguishments of Liabilities" and
SFAS No. 65, "Accounting for Certain Mortgage Banking Activities" as
amended by Statement 140. When the Company sells a mortgage loan and
retains the servicing rights, the Company allocates the cost of the loan
and servicing based on their relative fair values. The asset created
thereby is amortized in proportion to, and over the period of, estimated
net servicing income. The servicing asset is reviewed for impairment on a
quarterly basis. The amount by which the book value exceeds the fair value
is recorded in a valuation allowance and charged to current period income.
No valuation allowance for the carrying amount of mortgage servicing rights
at September 30, 2003 and 2002 was recorded because management estimates
that there is no impairment in the carrying amount of those rights. The
Bank estimated the fair values of these rights to be $783,823 as of
September 30, 2003. Changes in the mortgage servicing asset, which are
included in other assets, were as follows for the years ended September 30:
2003 2002
---- ----
Balance at beginning of period $ 404,970 $ 0
Capitalized mortgage servicing rights 542,321 437,564
Amortization (107,219) (32,594)
Writedowns (242,727)
--------- ---------
Balance at end of period $ 597,345 $ 404,970
========= =========
NOTE 5 - PREMISES AND EQUIPMENT
-------------------------------
The following is a summary of premises and equipment as of September 30:
2003 2002
---- ----
Land $ 73,793 $ 73,793
Bank building 2,171,399 2,085,845
Furniture and equipment 991,881 914,972
Vehicle 56,688 56,688
----------- -----------
3,293,761 3,131,298
Accumulated depreciation and amortization (1,381,867) (1,339,282)
----------- -----------
$ 1,911,894 $ 1,792,016
=========== ===========
NOTE 6 - DEPOSITS
-----------------
The aggregate amount of time deposit accounts in denominations of $100,000
or more as of September 30, 2003 and 2002 was $13,083,234 and $13,975,494,
respectively.
For time deposits as of September 30, 2003, the scheduled maturities for
each of the following years ended September 30 are as follows:
(in thousands)
2004 $40,566
2005 8,699
2006 4,002
2007 186
-------
$53,453
=======
F-20
Deposits from related parties held by the Company as of September 30, 2003
and 2002 amounted to $1,807,851 and $1,546,374, respectively.
NOTE 7 - SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE
-------------------------------------------------------
The securities sold under agreements to repurchase are securities sold on a
short term basis by the Company that have been accounted for not as sales
but as borrowings. The securities were held in the Company 's safekeeping
account at Investors Bank & Trust Company under the control of the Company
and pledged to the purchasers of the securities. The purchasers have
agreed to sell to the Company substantially identical securities at the
maturity of the agreements. As of September 30, 2003, the Company no
longer enters into repurchase agreements with customers.
NOTE 8 - FEDERAL HOME LOAN BANK ADVANCES
----------------------------------------
Advances consist of funds borrowed from the Federal Home Loan Bank (FHLB).
Maturities of advances from the FHLB for the five fiscal years ending after
September 30, 2003 and thereafter are summarized as follows:
AMOUNT
------
2004 $ 101,061
2005 107,316
2006 113,951
2007 120,940
2008 139,617
Thereafter 2,000,000
----------
$2,582,885
==========
As of September 30, 2003, a $2,000,000 advance from the FHLB maturing on
December 27, 2010 was redeemable at par at the option of the FHLB on
December 26, 2003 and quarterly thereafter.
Amortizing advances are being repaid in equal monthly payments and are
being amortized from the date of the advance to the maturity date on a
direct reduction basis.
Borrowings from the FHLB are secured by a blanket lien on qualified
collateral, consisting primarily of loans with first mortgages secured by
one to four family properties and other qualified assets.
At September 30, 2003, the interest rates on FHLB advances ranged from
4.80% to 5.94%. At September 30, 2003, the weighted average interest rate
on FHLB advances was 5.06%.
NOTE 9 - INCOME TAXES
---------------------
The components of income tax expense are as follows for the years ended
September 30:
2003 2002 2001
---- ---- ----
Current:
Federal $ 207,729 $ 952,731 $693,502
State 521,588 41,534 12,490
---------- --------- --------
729,317 994,265 705,992
---------- --------- --------
Deferred:
Federal 185,096 (115,465) 11,313
State 83,073 (39,840) 3,903
---------- --------- --------
268,169 (155,305) 15,216
Change in valuation allowance 74,775 47,885 58,065
---------- --------- --------
342,944 (107,420) 73,281
---------- --------- --------
Total income tax expense $1,072,261 $ 886,845 $779,273
========== ========= ========
F-21
The components of the deferred tax assets, included in other assets, are as
follows as of September 30:
2003 2002
---- ----
Deferred tax assets:
Allowance for loan losses $ 315,889 $ 373,226
Deferred income 33,824 54,887
Reserve for contingencies 6,619 5,723
Employee benefit plan 19,095 18,128
Impairment loss on equity securities 111,790 244,317
Impairment loss on leasehold improvements and equipment 120,271 124,387
Capital loss carryforward 68,935
Net unrealized holding loss on available-for-sale
securities 40,774 268,128
--------- ----------
Gross deferred tax assets 717,197 1,088,796
Valuation allowance (212,348) (391,768)
--------- ----------
504,849 697,028
--------- ----------
Deferred tax liabilities:
Excess depreciation (84,217) (77,259)
Mortgage servicing rights (244,493) (165,754)
Deferred loan costs (115,326) (77,099)
--------- ----------
Gross deferred tax liabilities (444,036) (320,112)
--------- ----------
Net deferred tax assets $ 60,813 $ 376,916
========= ==========
At September 30, 2003, the Company had realized capital loss carryforwards
of approximately $203,000 which will expire in the fiscal year ended
September 30, 2008 if not utilized against future realized capital gains.
The reasons for the difference between the tax at the statutory federal
income tax rate and the effective tax rate are summarized as follows for
the years ended September 30:
2003 2002 2001
---- ---- ----
Tax at statutory rate of 34% 34.0% 34.0% 34.0%
Increase (decrease) resulting from:
State taxes, net of federal tax benefit 8.5 .1 .5
Dividend received deduction (.7) (.5) (.5)
Additional state taxes, net of federal tax benefit
due to REIT dividend deduction settlement 15.4
Other, net 2.9 1.3 (1.4)
Change in valuation allowance 4.2 2.0 2.7
---- ---- ----
Effective tax rates 64.3% 36.9% 35.3%
==== ==== ====
In prior years, the Company was allowed a special tax-basis bad debt
deduction under certain provisions of the Internal Revenue Code. As a
result, retained earnings of the Company as of September 30, 2003 includes
$1,639,418 for which federal and state income taxes have not been provided.
Under the provisions of recent federal income tax legislation, if the
Company no longer qualifies as a bank as defined in certain provisions of
the Internal Revenue Code, this amount will be subject to recapture in
taxable income ratably over six (6) years, subject to a combined federal
and state tax rate of approximately 41% based on the effective tax rates of
the Company in prior years.
REIT Dividend Deduction Settlement
----------------------------------
Falmouth Capital Corporation ("FCC"), a subsidiary of the Bank, was
established in December 1999 as a Massachusetts-chartered real estate
investment trust ("REIT"). The Bank received dividends from FCC.
On March 5, 2003, the Commonwealth of Massachusetts enacted tax legislation
which denied the dividends received deduction for dividends received from
real estate investment trusts retroactively to 1999. The additional
F-22
state tax liability created by the new law for the Bank would have been
$778,833 plus previously assessed interest of $67,527 for the calendar
years 1999 through 2002.
On June 20, 2003, the Bank and its subsidiary real estate investment trust,
FCC, entered into an agreement with the Massachusetts Department of Revenue
(the "DOR") settling the dispute concerning the dividends received
deduction through calendar year 2002 claimed or to be claimed by the Bank.
Under the agreement, the Bank agreed to pay and the DOR agreed to abate 50%
of all tax and interest assessed or unassessed relating to the REIT
dividend deduction. Therefore, the previously unrecorded tax liability of
$389,416 plus interest of $33,764 and federal and state tax benefits of
$146,221 were recognized during the year ended September 30, 2003.
NOTE 10 - EMPLOYEE RETIREMENT, PENSION PLANS AND BENEFITS
---------------------------------------------------------
Retirement Plan
---------------
The Company is a participant in the Co-operative Banks Employee Retirement
Association Defined Contribution Plan. This plan provides benefits to
substantially all of the Company's employees. Benefits under the defined
contribution plan are based on a percentage of employee contributions.
Prior to September 30, 2001 the Company was also a participant in the Co-
operative Banks Employee Retirement Association Defined Benefit Plan (a
multi-employer plan) which provided benefits to substantially all of the
Company's employees. Benefits under the defined benefit plan were based
primarily on years of service and employees' compensation. The Company's
funding policy for the defined benefit plan was to fund amounts required by
applicable regulations and which were tax deductible. Effective September
30, 2001 the Company discontinued making annual contributions to and
withdrew from the defined benefit plan.
Contributions by the Company in the year ended September 30, 2003 were
$33,273 for the defined contribution plan. The defined benefit plan was
terminated by the Company effective September 30, 2001 and the last
contribution was made as of September 30, 2002. Contributions by the
Company in the year ended September 30, 2002 were $29,507 for the defined
contribution plan and $83,816 for the defined benefit plan. Contributions
by the Company to the plans in the year ended September 30, 2001 were
$113,570.
Employee Stock Ownership Plan
-----------------------------
Effective March 1996 the Bank adopted the Falmouth Co-Operative Bank
Employee Stock Ownership Plan (ESOP).
Falmouth Bancorp, Inc. made a loan to the ESOP. As of September 30, 2003
the balance of the loan was $213,114. In the consolidated financial
statements of the Company the loan is classified as a component of
stockholders' equity with the caption "Unallocated Employee Stock Ownership
Plan shares." The loan is secured by a pledge of the Company's common
stock. The Company makes annual contributions to the ESOP in amounts
determined by the Board of Directors. Dividends received by the ESOP may
be credited to participants' accounts or may be used to repay the ESOP's
debt.
Any shares of the Company purchased by the ESOP are subject to the
accounting specified by the American Institute of CPA's Statement of
Position 93-6. Under the statement, as any shares are released from
collateral, the Company will report compensation expense equal to the
current market price of the shares and the shares will be outstanding for
earnings-per-share computations. Also, as the shares are released, the
related dividends will be recorded as a reduction of retained earnings and
dividends on the allocated shares will be recorded as a reduction of debt
and accrued interest.
F-23
The shares purchased by the ESOP are pledged as collateral for its debt.
As the debt is repaid, shares are released from collateral and allocated to
active employees, based on the proportion of debt service paid in the year.
The ESOP shares were as follows as of September 30:
2003 2002
---- ----
Allocated shares 51,569 42,912
Committed to be released shares 8,728 8,728
Unreleased shares 21,823 30,551
-------- --------
82,120 82,191
======== ========
Fair value of unreleased shares $629,594 $710,311
Annual contributions to the plan are discretionary. Contributions to the
ESOP by the Bank or Company were $88,185, $88,184 and $88,185 for the years
ended September 30, 2003, 2002 and 2001, respectively and ESOP compensation
expense was $223,333, $201,798 and $140,517, respectively.
Stock Option Plan
-----------------
On November 19, 1996, the Bank adopted the 1997 Stock Option Plan for
Outside Directors, Officers, and Employees of the Company. The plan was
approved by shareholders effective as of January 21, 1997. The Board of
Directors formed an Option Committee to administer the plan. A total of
145,475 shares were made available for issuance under the plan.
Stock Options Granted to Eligible Directors
-------------------------------------------
The price, at which an option granted to an eligible director may be
exercised, is the fair market value of a share on the date on which the
option is granted. Such options expire ten years after the grant date.
The options are not exercisable in the first year after grant. In the
second through fifth year after the grant, the options are exercisable on a
pro rata basis up to 80% of the grant by the fifth year. After the fifth
year, 100% of the grant not previously exercised may be exercised. Options
granted in the year ending September 30, 2002 vest over a four year period.
Stock Options Granted to Eligible Employees
-------------------------------------------
An option granted to an eligible employee must be designated as either an
Incentive Stock Option or a Non-Qualifying Stock Option. The price at
which an option may be exercised is determined by the Committee, at its
discretion; provided, however, that the exercise price shall not be less
than the fair market value of a share on the grant date. These options may
be exercised in periods specified by the Committee in the option agreement.
The fair value of each option grant is estimated on the date of grant using
the Black-Scholes option-pricing model with the following weighted-average
assumptions used for grants in the year ended September 30, 2002: dividend
yield of 1.8 percent; expected volatility of 17 percent; risk-free interest
rate of 4.74 percent; and expected lives of 8 years.
F-24
A summary of the status of the Company's stock option plan as of September
30, 2003, 2002 and 2001 and changes during the years ending on those dates
is presented below:
2003 2002 2001
------------------------ ------------------------ ------------------------
Weighted- Weighted- Weighted-
Average Average Average
Options Shares Exercise Price Shares Exercise Price Shares Exercise Price
------- ------ -------------- ------ -------------- ------ --------------
Outstanding at beginning of year 122,986 $14.708 124,649 $13.727 131,468 $13.732
Granted 14,069 22.00
Exercised (12,948) 13.81 (15,732) 13.46 (4,969) 13.375
Forfeited (1,850) 15.02
------- ------- -------
Outstanding at end of year 110,038 14.813 122,986 14.708 124,649 13.727
======= ======= =======
Options exercisable at year-end 102,517 108,917 105,112
Weighted-average fair value of
options granted during the year N/A $5.56 N/A
The following table summarizes information about stock options outstanding
as of September 30, 2003:
Options Outstanding Options Exercisable
-------------------------------------------------------------- -------------------------------
Range of Weighted-Average
Exercise Number Remaining Weighted-Average Number Weighted-Average
Prices Outstanding Contractual Life Exercise Price Exercisable Exercise Price
-------- ----------- ---------------- ---------------- ----------- ----------------
$12.25 200 6.6 years $12.25 200 $12.25
13.375 72,338 3.6 13.375 72,338 13.375
15.00 22,381 6.1 15.00 22,381 15.00
15.625 1,300 5.2 15.625 1,300 15.625
22.00 13,819 8.5 22.00 6,298 22.00
------- -------
110,038 4.8 14.813 102,517 14.286
======= =======
Recognition and Retention Plan
------------------------------
On November 19, 1996, the Bank adopted the 1997 Recognition and Retention
Plan for Outside Directors, Officers and Employees of Falmouth Co-Operative
Bank (the RRP). The Company subsequently adopted and assumed sponsorship
of the RRP and appointed a compensation committee to administer it. The
Company established the RRP Trust and contributes, or causes to be
contributed, to the RRP Trust, from time to time, such amounts of money or
property as determined by the Compensation Committee. In no event shall
the assets of the RRP Trust be used to purchase more than 58,190 shares of
Company common stock. In its discretion, the Compensation Committee may
grant awards of restricted stock to officers and employees. Each award
will become vested and distributable at a rate of 20% on each anniversary
date of the grant or at a rate established by the Compensation Committee
and become fully vested on the date of the award holder's death or
disability. Stock subject to awards is held in the RRP Trust until the
award is vested. An individual to whom an award is granted is entitled to
exercise voting rights and receive cash dividends with respect to stock
subject to awards granted to him/her whether or not vested. The
Compensation Committee exercises voting rights with respect to the shares
in the RRP Trust that have not been allocated as directed by the
individuals eligible to participate. Compensation expense amounted to
$118,783, $80,443 and $109,819 for the years ending September 30, 2003,
2002 and 2001, respectively. Compensation expense is based on the fair
value of the common stock on the grant date. As of September 30, 2003, the
RRP Trust had purchased and awarded a total of 58,190 shares, and 44,930
vested shares had been distributed to eligible participants.
F-25
NOTE 11 - 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 financial statements. Under
capital adequacy guidelines and the regulatory framework for prompt
corrective action, the Company and the Bank must meet specific capital
guidelines that involve quantitative measures of their assets, liabilities
and certain off-balance-sheet items as calculated under regulatory
accounting practices. Their capital amounts and classification are also
subject to qualitative judgments by the regulators about components, risk
weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy
require the Company and the Bank to maintain minimum amounts and ratios
(set forth in the table below) of total and Tier 1 capital (as defined in
the regulations) to risk-weighted assets (as defined), and of Tier 1
capital (as defined) to average assets (as defined). Management believes,
as of September 30, 2003, that the Company and the Bank meet all capital
adequacy requirements to which they are subject.
As of September 30, 2003 the most recent notification from the Federal
Deposit Insurance Corporation 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 institutions' category.
F-26
The Company's and the Bank's actual capital amounts and ratios are also
presented in the table.
To Be Well
Capitalized Under
For Capital Prompt Corrective
Actual Adequacy Purposes Action Provisions
------------------- ----------------------- ------------------------
Amount Ratio Amount Ratio Amount Ratio
------ ----- ------ ----- ------ -----
(Dollar amounts in thousands)
As of September 30, 2003:
Total Capital (to Risk Weighted Assets):
Consolidated $18,457 13.94% $10,594 > or =8.0% N/A
Falmouth Co-Operative Bank 17,204 13.06 10,538 > or =8.0 $13,173 > or =10.0%
Tier 1 Capital (to Risk Weighted Assets):
Consolidated 17,696 13.36 5,297 > or =4.0 N/A
Falmouth Co-Operative Bank 16,443 12.48 5,269 > or =4.0 7,904 > or =6.0
Tier 1 Capital (to Average Assets):
Consolidated 17,696 10.74 6,590 > or =4.0 N/A
Falmouth Co-Operative Bank 16,443 9.96 6,602 > or =4.0 8,252 > or =5.0
As of September 30, 2002:
Total Capital (to Risk Weighted Assets):
Consolidated 17,203 16.03 8,584 > or =8.0 N/A
Falmouth Co-Operative Bank 15,617 14.59 8,561 > or =8.0 10,702 > or =10.0
Tier 1 Capital (to Risk Weighted Assets):
Consolidated 16,264 15.16 4,292 > or =4.0 N/A
Falmouth Co-Operative Bank 14,678 13.72 4,281 > or =4.0 6,421 > or =6.0
Tier 1 Capital (to Average Assets):
Consolidated 16,264 10.25 6,344 > or =4.0 N/A
Falmouth Co-Operative Bank 14,678 9.40 6,245 > or =4.0 7,806 > or =5.0
The ability of the Company to pay dividends on its common stock is
restricted by Massachusetts banking law. No dividends may be paid if such
dividends would reduce stockholders' equity of the Company below the amount
of the liquidation account required by Massachusetts conversion regulations
and described in Note 17.
NOTE 12 - COMMITMENTS AND CONTINGENT LIABILITIES
------------------------------------------------
The Company is obligated under certain agreements issued during the normal
course of business which are not reflected in the accompanying consolidated
financial statements.
The Company is obligated under a lease agreement signed May 8, 2003 for a
branch in Bourne, Massachusetts. Lease payments begin in November of 2003.
The original term of the lease is ten years with two additional periods of
five years each excercisable at the option of the Bank. The Company is
also obligated under lease agreements for several ATM locations and various
equipment. The total minimum rental payments due in future periods under
these agreements is as follows as of September 30, 2003:
2004 $103,670
2005 90,820
2006 83,220
2007 76,043
2008 75,000
Thereafter 143,750
--------
Total minimum lease payments $572,503
========
F-27
The total rental expense amounted to $35,170, $45,832 and $48,648 for the
years ended September 30, 2003, 2002 and 2001, respectively.
NOTE 13 - FINANCIAL INSTRUMENTS
-------------------------------
The Company is party to financial instruments with off-balance sheet risk
in the normal course of business to meet the financing needs of its
customers. These financial instruments include commitments to originate
loans, standby letters of credit and unadvanced funds on loans. The
instruments involve, to varying degrees, elements of credit risk in excess
of the amount recognized in the balance sheets. The contract amounts of
those instruments reflect the extent of involvement the Company has in
particular classes of financial instruments.
The Company's exposure to credit loss in the event of nonperformance by the
other party to the financial instrument for loan commitments and standby
letters of credit is represented by the contractual amounts of those
instruments. The Company uses the same credit policies in making
commitments and conditional obligations as it does for on-balance sheet
instruments.
Commitments to originate loans are agreements to lend to a customer
provided there is no violation of any condition established in the
contract. Commitments generally have fixed expiration dates or other
termination clauses and may require payment of a fee. 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 Company evaluates each customer's creditworthiness on a case-by-case
basis. The amount of collateral obtained, if deemed necessary by the
Company upon extension of credit, is based on management's credit
evaluation of the borrower. Collateral held varies, but may include
secured interests in mortgages, accounts receivable, inventory, property,
plant and equipment and income-producing properties.
Standby letters of credit are conditional commitments issued by the Company
to guarantee the performance by a customer to a third party. The credit
risk involved in issuing letters of credit is essentially the same as that
involved in extending loan facilities to customers.
The estimated fair values of the Company 's financial instruments, all of
which are held or issued for purposes other than trading, are as follows as
of September 30:
2003 2002
------------------------------ ------------------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
-------- ----- -------- -----
Financial assets:
Cash and cash equivalents $ 7,372,365 $ 7,372,365 $ 7,422,584 $ 7,422,584
Available-for-sale securities 37,179,799 37,179,799 18,712,954 18,712,954
Held-to-maturity securities 32,549,241 32,556,554 28,060,267 28,034,474
Federal Home Loan Bank stock 878,000 878,000 878,000 878,000
Loans held-for-sale 825,677 840,474 1,575,000 1,596,894
Loans, net 82,493,801 83,850,526 93,434,955 95,953,106
Accrued interest receivable 1,333,910 1,333,910 1,114,924 1,114,924
Co-operative Central Bank Reserve Fund
Deposit 395,395 395,395 395,395 395,395
Financial liabilities:
Deposits 145,534,970 145,972,000 131,717,059 132,291,000
Securities sold under agreements to
repurchase 471,872 471,872
Federal Home Loan Bank advances 2,582,885 2,716,001 5,178,175 5,292,000
The carrying amounts of financial instruments shown in the above table are
included in the balance sheet under the indicated captions. Accounting
policies related to financial instruments are described in Note 2.
F-28
Notional amounts of financial instrument liabilities with off-balance sheet
credit risk are as follows as of September 30:
2003 2002
---- ----
Commitments to originate loans $ 4,166,192 $ 6,596,000
Unadvanced funds on construction loans 1,819,762 2,870,360
Unadvanced funds on home equity lines
of credit 18,242,420 14,622,114
Unadvanced funds on commercial loans and
lines of credit 4,045,115 4,769,175
Unadvanced funds on overdraft lines
of credit 484,425 454,173
Standby letters of credit 12,000 12,000
----------- -----------
$28,769,914 $29,323,822
=========== ===========
There is no material difference between the notional amount and the
estimated fair value of the off-balance sheet liabilities.
NOTE 14 - EMPLOYMENT AND CHANGE IN CONTROL AGREEMENTS
-----------------------------------------------------
The Company has an employment agreement with its President and Chief
Executive Officer and a change in control agreement with its Vice President
and CFO. The employment agreement generally provides for the continued
payment of specified compensation and benefits for specified periods after
termination, unless the termination is for "cause" as defined in the
employment agreement. The employment agreement also provides for lump-sum
payments in the event of the officer's voluntary termination of employment
on the occurrence of certain specified events. The agreements provide for
the payment, under certain circumstances, of lump-sum amounts upon
termination following a "change in control" as defined in the agreements.
NOTE 15 - SIGNIFICANT GROUP CONCENTRATIONS OF CREDIT RISK
---------------------------------------------------------
Most of the Company's business activity is with customers located within
the state. There are no concentrations of credit to borrowers that have
similar economic characteristics. The majority of the Company's loan
portfolio is comprised of loans collateralized by real estate located in
the state of Massachusetts.
F-29
NOTE 16 - EARNINGS PER SHARE (EPS)
----------------------------------
Reconciliation of the numerators and the denominators of the basic and
diluted per share computations for net income are as follows:
Income Shares Per-Share
(Numerator) (Denominator) Amount
----------- ------------- ---------
Year ended September 30, 2003
Basic EPS
Net income and income available to
common stockholders $ 594,232 874,422 $0.68
Effect of dilutive securities, options 49,429
---------- -------
Diluted EPS
Income available to common stockholders
and assumed conversions $ 594,232 923,851 $0.64
========== =======
Year ended September 30, 2002
Basic EPS
Net income and income available to
common stockholders $1,516,185 875,569 $1.73
Effect of dilutive securities, options 46,162
---------- -------
Diluted EPS
Income available to common stockholders
and assumed conversions $1,516,185 921,731 $1.64
========== =======
Year ended September 30, 2001
Basic EPS
Net income and income available to
common stockholders $1,429,761 967,882 $1.48
Effect of dilutive securities, options 20,726
---------- -------
Diluted EPS
Income available to common stockholders
and assumed conversions $1,429,761 988,608 $1.45
========== =======
NOTE 17 - LIQUIDATION ACCOUNT
-----------------------------
At the time of conversion to stock form, the Bank established a liquidation
account in an amount equal to the Bank's net worth as of the date of the
latest financial statements included in the final Offering Circular used in
connection with the Conversion. In accordance with Massachusetts statutes,
the liquidation account is maintained for the benefit of Eligible Account
Holders who continue to maintain their accounts in the Bank after the
conversion. The liquidation account is reduced annually to the extent that
Eligible Account Holders have reduced their qualifying deposits.
Subsequent increases will not restore an Eligible Account Holder's interest
in the liquidation account. In the event of a complete liquidation, each
Eligible Account Holder is entitled to receive a distribution from the
liquidation account in a proportionate amount to the current adjusted
qualifying balances for the account then held. The balance in the
liquidation account was $807,710 as of September 30, 2003.
NOTE 18 - MINORITY INTEREST IN SUBSIDIARY
-----------------------------------------
In the fiscal year ended September 30, 2000, the Bank formed a subsidiary,
Falmouth Capital Corporation (FCC) which issued to the Bank 1,000 shares of
FCC common stock. No other shares of FCC common stock have been issued.
FCC also issued to the Bank 3,000 shares of FCC 8% Cumulative Non-
Convertible Preferred Stock (the "preferred stock"). No other shares of
FCC preferred stock have been issued. In the fiscal year ended September
30, 2000, the Bank distributed the 108 shares to directors and employees of
the Bank, leaving the Bank with an ownership of 2,892 shares of the
preferred stock at September 30, 2002 and 2001. As of September 30, 2002,
the minority interest in subsidiary on the balance sheet consisted of 107
shares of the preferred stock, at a stated value of $500 per share. During
the year ended September 30, 2002, one share of the preferred stock was
redeemed. These shares were part of the original 3,000 shares of the
preferred stock issued to the Bank.
F-30
Effective September 30, 2003 Falmouth Capital Corporation was dissolved,
all assets and liabilities were transferred to the Bank and all remaining
minority interest preferred stockholders were paid $500 for each share
held.
NOTE 19 - RECLASSIFICATION
--------------------------
As of September 30, 2003 and 2002, loans held-for-sale with carrying values
of $825,677 and $1,575,000, respectively, are reported separately on the
Company's consolidated balance sheets. Previously, loans held-for-sale
were included with loans, net of allowance for loan losses. In addition,
the Company's consolidated statements of cash flows for each of the years
in the three year period ended September 30, 2003 were revised to properly
reflect the change in loans held-for-sale and proceeds from the sales of
loans.
For the year ended September 30, 2003, $276,959 related to a REIT Dividend
Deduction Settlement, see Note 9, was previously reported as an
extraordinary item. This extraordinary item treatment was revised and its
individual components, income tax expense of $243,195 and interest expense
of $33,764, are currently reported as part of income from continuing
operations. As a result, the extraordinary item previously reported of
$276,959 was eliminated and income taxes expense was increased by $243,195
and other expense was increased by $33,764.
Certain amounts in the prior years have been reclassified to be consistent
with the current year's statement presentation.
F-31
NOTE 20 - PARENT COMPANY ONLY FINANCIAL STATEMENTS
--------------------------------------------------
The following financial statements are presented for Falmouth Bancorp, Inc.
(Parent Company) and should be read in conjunction with the consolidated
financial statements.
FALMOUTH BANCORP, INC.
----------------------
(Parent Company Only)
BALANCE SHEETS
--------------
September 30, 2003 and 2002
---------------------------
ASSETS 2003 2002
------ ---- ----
Cash and due from banks $ 25,000 $ 24,752
Federal funds sold 737,645 1,224,147
----------- -----------
Cash and cash equivalents 762,645 1,248,899
Investment in Falmouth Co-Operative Bank 16,489,729 14,752,769
Loan to ESOP 213,114 301,299
Due from subsidiary, Falmouth Co-operative Bank 39,338
Prepaid expenses 3,750 5,000
Other assets 274,537 199,907
----------- -----------
Total assets $17,783,113 $16,507,874
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Accrued expenses $ 39,734 $ 52,564
Due to subsidiary, Falmouth Co-Operative Bank 116,577
----------- -----------
Total liabilities 39,734 169,141
----------- -----------
Stockholders' equity:
Preferred stock, par value $.01 per share;
authorized 500,000 shares; none issued
Common stock, par value $.01 per share;
authorized 2,500,000 shares; issued
1,454,750 shares; outstanding 913,727 shares
at September 30, 2003 and 900,779 shares at
September 30, 2002 14,547 14,547
Paid-in capital 23,427,784 23,315,614
Retained earnings 4,524,272 4,401,150
Unallocated Employee Stock Ownership Plan shares (213,114) (301,299)
Treasury stock (541,023 shares as of
September 30, 2003 and 553,971 shares
as of September 30, 2002) (9,578,649) (9,807,890)
Unearned compensation (340,994) (477,088)
Accumulated other comprehensive loss (90,467) (806,301)
----------- -----------
Total stockholders' equity 17,743,379 16,338,733
----------- -----------
Total liabilities and stockholders' equity $17,783,113 $16,507,874
=========== ===========
F-32
FALMOUTH BANCORP, INC.
----------------------
(Parent Company Only)
STATEMENTS OF INCOME
--------------------
Years Ended September 30, 2003, 2002 and 2001
---------------------------------------------
2003 2002 2001
---- ---- ----
Interest and dividend income:
Interest on loan to ESOP $ 18,914 $ 25,307 $ 31,701
Dividends on Co-operative Bank Investment Fund 551 30,063
Dividends from Falmouth Co-Operative Bank 1,600,000 3,250,000
Other interest 6,645 15,771 16,133
--------- ---------- -----------
Total interest and dividend income 25,559 1,641,629 3,327,897
--------- ---------- -----------
Other income 66
--------- ---------- -----------
Expenses:
Legal and professional fees 116,730 130,950 109,185
Securities losses, net 25,059
Other expense 36,825 41,007 40,347
--------- ---------- -----------
Total expenses 153,555 171,957 174,591
--------- ---------- -----------
(Loss) income before income tax benefit and equity in
undistributed net income (loss) of subsidiary (127,996) 1,469,672 3,153,372
Income tax benefit (43,218) (44,010) (17,729)
--------- ---------- -----------
(Loss) income before equity in undistributed net income
(loss) of subsidiary (84,778) 1,513,682 3,171,101
Equity in undistributed net income (loss) of subsidiary,
Falmouth Co-Operative Bank 679,010 2,503 (1,741,340)
--------- ---------- -----------
Net income $ 594,232 $1,516,185 $ 1,429,761
========= ========== ===========
F-33
FALMOUTH BANCORP, INC.
----------------------
(Parent Company Only)
STATEMENTS OF CASH FLOWS
------------------------
Years Ended September 30, 2003, 2002 and 2001
---------------------------------------------
2003 2002 2001
---- ---- ----
Cash flows from operating activities:
Net income $ 594,232 $ 1,516,185 $ 1,429,761
Adjustments to reconcile net income to net cash (used in)
provided by operating activities:
Losses on sales of available-for-sale securities 25,059
Undistributed net (income) loss of subsidiary (679,010) (2,503) 1,741,340
Decrease (increase) in prepaid expenses 1,250 (2,667) 258
(Increase) decrease in other assets (29,879) (89,344) 11,277
(Decrease) increase in accrued expenses (12,830) 1,530 11,553
---------- ----------- -----------
Net cash (used in) provided by operating activities (126,237) 1,423,201 3,219,248
---------- ----------- -----------
Cash flows from investing activities:
Proceeds from sales of available-for-sale securities 572,982
Increase in due from subsidiary, Falmouth Co-Operative Bank (39,338)
Payments received on ESOP loan 88,185 88,184 88,185
---------- ----------- -----------
Net cash provided by investing activities 48,847 88,184 661,167
---------- ----------- -----------
Cash flows from financing activities:
(Decrease) increase in due to subsidiary,
Falmouth Co-Operative Bank (116,577) 116,577
Proceeds from exercise of stock options 178,823 211,765 66,460
Dividends paid (471,110) (457,162) (423,440)
Purchase of shares for RRP (477,088)
Purchases of treasury stock (1,328,902) (1,980,119)
---------- ----------- -----------
Net cash used in financing activities (408,864) (1,934,810) (2,337,099)
---------- ----------- -----------
Net (decrease) increase in cash and cash equivalents (486,254) (423,425) 1,543,316
Cash and cash equivalents at beginning of year 1,248,899 1,672,324 129,008
---------- ----------- -----------
Cash and cash equivalents at end of year $ 762,645 $ 1,248,899 $ 1,672,324
========== =========== ===========
F-34