ChoiceOne Financial Services, Inc.
Annual Report 2010

Plain-text annual report

CHOICEONE FINANCIAL SERVICES, INC. 2010 ANNUAL REPORT TO SHAREHOLDERS CHOICEONE FINANCIAL SERVICES, INC. 2010 Annual Report to Shareholders Contents To Our Shareholders................................................................................................................................ 1 About ChoiceOne Financial Services, Inc............................................................................................... 1 Stock Information .................................................................................................................................... 1 Selected Financial Data ........................................................................................................................... 3 Management’s Discussion and Analysis of Financial Condition and Results of Operations.................. 4 Management’s Report on Internal Control Over Financial Reporting .................................................... 18 Report of Independent Registered Public Accounting Firm.................................................................... 19 Consolidated Financial Statements.......................................................................................................... 20 Notes to Consolidated Financial Statements ........................................................................................... 24 Corporate and Shareholder Information .................................................................................................. 48 Directors and Officers.............................................................................................................................. 49 TO OUR SHAREHOLDERS This 2010 Annual Report to Shareholders contains our audited financial statements, detailed financial review and all of the information that regulations of the Securities and Exchange Commission (the “SEC”) require to be presented in annual reports to shareholders. For legal purposes, this is the ChoiceOne Financial Services, Inc. 2010 Annual Report to Shareholders. Although attached to our proxy statement, this report is not part of our proxy statement, is not considered to be soliciting material and is not considered to be filed with the SEC except to the extent that it is expressly incorporated by reference in a document filed with the SEC. Shareholders who would like to receive even more detailed information than that contained in this 2010 Annual Report to Shareholders are invited to request our Annual Report on Form 10-K. Our Annual Report on Form 10-K for the year ended December 31, 2010, including the financial statements and financial statement schedules, will be provided to any shareholder, without charge, upon written request to Mr. Thomas Lampen, Treasurer, ChoiceOne Financial Services, Inc., 109 East Division Street, Sparta, Michigan 49345. ABOUT CHOICEONE FINANCIAL SERVICES, INC. ChoiceOne Financial Services, Inc. is a single-bank holding company. Its principal banking subsidiary, ChoiceOne Bank (Sparta, Michigan), primarily serves communities in portions of Kent, Muskegon, Newaygo, and Ottawa counties in Michigan where the Bank’s offices are located and the areas immediately surrounding those communities. Currently the Bank serves those markets through thirteen full-service offices. ChoiceOne Insurance Agencies, Inc. is a wholly-owned subsidiary of ChoiceOne Bank and sells insurance and investment products. ChoiceOne Mortgage Company of Michigan, formerly a wholly-owned subsidiary of ChoiceOne Bank, was formed on January 1, 2002 and was engaged in mortgage lending. As of December 31, 2008, ChoiceOne consolidated the operations of ChoiceOne Mortgage Company of Michigan into ChoiceOne Bank and eliminated the separate mortgage company subsidiary. ChoiceOne’s business is primarily concentrated in a single industry segment – banking. ChoiceOne Bank is a full-service banking institution that offers a variety of deposit, payment, credit and other financial services to all types of customers. These services include time, savings, and demand deposits, safe deposit services, and automated transaction machine services. Loans, both commercial and consumer, are extended primarily on a secured basis to corporations, partnerships and individuals. Commercial lending covers such categories as business, industry, agricultural, construction, inventory and real estate. ChoiceOne Bank’s consumer loan department (and ChoiceOne Mortgage Company of Michigan through December 31, 2008) makes direct loans to consumers and purchasers of residential property. The principal source of revenue for ChoiceOne is interest and fees on loans. On a consolidated basis, interest and fees on loans accounted for 69%, 70%, and 74% of total revenues in 2010, 2009, and 2008, respectively. Interest from securities accounted for 10%, 11%, and 12% of total revenues in 2010, 2009, and 2008, respectively. STOCK INFORMATION Several brokers trade ChoiceOne’s common shares in the over-the-counter bulletin board market. There is no well-established public trading market for the shares and trading activity is infrequent. ChoiceOne’s trading volume and recent share price information can be viewed under the symbol ‘COFS.OB’ on certain financial websites. The range of high and low bid prices for shares of common stock for each quarterly period during the past two years is as follows: First Quarter Second Quarter Third Quarter Fourth Quarter 2010 2009 Low High Low $ 7.75 8.30 9.50 10.25 $ 9.00 10.10 11.00 12.25 $ 4.25 5.65 7.75 7.50 High $ 10.01 8.00 9.50 9.00 The prices listed above are over-the-counter market quotations reported to ChoiceOne by its market makers listed in this annual report. The over-the-counter market quotations reflect inter-dealer prices without retail markup, markdown or commission and may not necessarily represent actual transactions. As of February 28, 2011, there were 3,281,944 shares of ChoiceOne Financial Services, Inc. common stock issued and outstanding. As of February 28, 2011, there were 824 shareholders of record of ChoiceOne Financial Services, Inc. common stock. 1 The following table summarizes cash dividends declared per share of common stock during 2010 and 2009: First Quarter Second Quarter Third Quarter Fourth Quarter Total 2010 $ 0.12 0.12 0.12 0.12 $ 0.48 2009 $ 0.12 0.12 0.12 0.12 $ 0.48 ChoiceOne’s principal source of funds to pay cash dividends is the earnings and dividends paid by ChoiceOne Bank. ChoiceOne Bank is restricted in its ability to pay cash dividends under current banking regulations. See Note 21 to the consolidated financial statements for a description of these restrictions. Based on information presently available, management expects ChoiceOne to declare and pay regular quarterly cash dividends in 2011, although the amount of the quarterly dividends will be dependent on market conditions and ChoiceOne’s requirements for cash and capital, among other things. 2 ChoiceOne Financial Services, Inc. SELECTED FINANCIAL DATA (Dollars in thousands) 2010 2009 2008 2007 2006 For the year Net interest income ............................................ $ Provision for loan losses.................................... Noninterest income............................................ Noninterest expense........................................... Income before income taxes .............................. Income tax expense/(benefit)............................. Net income......................................................... Cash dividends declared .................................... 16,995 3,950 5,569 15,249 3,365 654 2,711 1,572 $ 15,996 4,875 5,421 15,259 1,283 (195) 1,478 1,563 Per share * Basic earnings.................................................... $ Diluted earnings................................................. Cash dividends declared .................................... Shareholders’ equity (at year end) ..................... 0.83 0.83 0.48 16.56 $ 0.45 0.45 0.48 16.21 Average for the year Securities ........................................................... $ Gross loans ........................................................ Deposits ............................................................. Federal Home Loan Bank advances .................. Shareholders’ equity .......................................... Assets................................................................. At year end Securities ........................................................... $ Gross loans ........................................................ Deposits ............................................................. Federal Home Loan Bank advances .................. Shareholders’ equity .......................................... Assets................................................................. 86,437 315,031 374,274 16,477 54,012 469,484 94,979 316,940 389,884 8,473 54,313 480,524 $ 76,934 320,328 347,007 28,857 53,115 453,876 $ 78,987 322,716 365,010 21,980 52,926 465,915 $ $ $ $ $ $ $ $ 15,331 3,475 4,083 14,711 1,228 (207) 1,435 2,202 0.44 0.44 0.68 16.08 85,086 326,420 347,190 38,803 53,411 465,741 81,941 325,977 346,998 39,957 52,185 463,551 $ $ 15,143 2,035 6,481 15,070 4,519 939 3,580 2,200 1.11 1.10 0.68 16.45 8,748 200 2,877 8,698 2,727 639 2,088 1,397 1.09 1.09 0.68 15.85 84,059 328,335 358,244 27,061 52,205 465,143 $ 57,407 205,851 222,287 26,073 27,349 288,407 87,725 328,358 351,844 35,933 53,142 470,155 $ 81,417 331,631 366,380 23,908 51,519 466,650 Selected financial ratios Return on average assets.................................... Return on average shareholders’ equity............. Cash dividend payout as a percentage of net income .................................................. Shareholders’ equity to assets (at year end)....... 0.58% 5.02 0.33% 2.78 0.31% 2.69 0.77% 6.86 0.72% 7.63 57.99 11.30 105.75 11.36 153.45 11.26 61.45 11.30 66.91 11.04 * Per share amounts are retroactively adjusted for the effect of stock dividends and stock splits. In November 2006, ChoiceOne merged with Valley Ridge Financial Corp. Accordingly, two months of combined operations are included in the 2006 results of operations and all assets acquired and liabilities assumed from Valley Ridge Financial Corp. are included in the 2006 year-end balance sheet. 3 ChoiceOne Financial Services, Inc. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion is designed to provide a review of the consolidated financial condition and results of operations of ChoiceOne Financial Services, Inc. ("ChoiceOne" or the “Company”), and its wholly-owned subsidiaries, ChoiceOne Bank (the "Bank"), ChoiceOne Insurance Agencies, Inc. (the "Insurance Agency"), and ChoiceOne Mortgage Company of Michigan (the “Mortgage Company”). As of December 31, 2008, ChoiceOne consolidated the operations of the Mortgage Company into the Bank and eliminated the mortgage company subsidiary. This discussion should be read in conjunction with the consolidated financial statements and related footnotes. FORWARD-LOOKING STATEMENTS This discussion and other sections of this annual report contain forward-looking statements that are based on management’s beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy, and ChoiceOne itself. Words such as "anticipates," "believes," "estimates," "expects," "forecasts," "intends," "is likely," "plans," "predicts," "projects," "may," "could," variations of such words and similar expressions are intended to identify such forward-looking statements. Management’s determination of the provision and allowance for loan losses, the carrying value of goodwill and loan servicing rights, and the fair value of investment securities (including whether any impairment on any investment security is temporary or other than temporary) and management’s assumptions concerning pension and other postretirement benefit plans involve judgments that are inherently forward-looking. All of the information concerning interest rate sensitivity is forward-looking. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions ("risk factors") that are difficult to predict with regard to timing, extent, likelihood, and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed, implied or forecasted in such forward-looking statements. Furthermore, ChoiceOne undertakes no obligation to update, amend, or clarify forward-looking statements, whether as a result of new information, future events, or otherwise. Risk factors include, but are not limited to, the risk factors discussed in Item 1A of the Company’s Annual Report on Form 10-K; changes in interest rates and interest rate relationships; demand for products and services; the degree of competition by traditional and non-traditional competitors; changes in banking laws and regulations; changes in tax laws; changes in prices, levies, and assessments; the impact of technological advances; governmental and regulatory policy changes; the outcomes of pending and future litigation and contingencies; trends in customer behavior as well as their abilities to repay loans; changes in the local and national economies; changes in market conditions; the possibility that anticipated cost savings and revenue enhancements from the merger with Valley Ridge Financial Corp. may not be realized in full or at all or within the expected time frames; the level and timing of asset growth; various other local and global uncertainties such as acts of terrorism and military actions; and current uncertainties and fluctuations in the financial markets and stocks of financial services providers due to concerns about capital and credit availability and concerns about the Michigan economy in particular. These are representative of the risk factors that could cause a difference between an ultimate actual outcome and a preceding forward-looking statement. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The purpose of this section of the annual report is to provide a narrative discussion about the Company’s financial condition and results of operations during 2010. Management’s discussion and analysis of financial condition and results of operations as well as disclosures found elsewhere in the annual report are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the allowance for loan losses and loan servicing rights. Actual results could differ from those estimates. Securities Securities available for sale may be sold prior to maturity due to changes in interest rate, prepayment risks, yield, availability of alternative investments, liquidity needs, credit rating changes, or other factors. Securities classified as available for sale are reported at their fair value. Declines in the fair value of securities below their cost that are considered to be “other than temporary” are recorded as losses in the income statement. In estimating whether a fair value decline is considered to be “other than temporary,” management considers the length of time and extent that the security’s fair value has been less than its carrying value, the financial condition and near term prospects of the issuer, and the Bank’s ability and intent to hold the security for a period of time sufficient to allow for any anticipated recovery in fair value. Market values for securities available for sale are obtained from outside sources and applied to individual securities within the portfolio. The difference between the amortized cost and the fair value of securities is recorded as a valuation adjustment and reported net of tax effect in other comprehensive income. 4 Allowance for Loan Losses The allowance for loan losses is maintained at a level believed adequate by management to absorb probable incurred losses inherent in the consolidated loan portfolio. Management’s evaluation of the adequacy of the allowance is an estimate based on reviews of individual loans, assessments of the impact of current economic conditions on the portfolio and historical loss experience of seasoned loan portfolios. Management believes the accounting estimate related to the allowance for loan losses is a “critical accounting estimate” because (1) the estimate is highly susceptible to change from period to period because of assumptions concerning the changes in the types and volumes of the portfolios and current economic conditions and (2) the impact of recognizing an impairment or loan loss could have a material effect on the Company’s assets reported on the balance sheet as well as its net income. Loan Servicing Rights Loan servicing rights represent the estimated value of servicing loans that are sold with servicing retained by ChoiceOne. Servicing rights are expensed in proportion to, and over the period of, estimated net servicing revenues. Management’s accounting treatment of loan servicing rights is estimated based on current prepayment speeds that are typically market driven. Management believes the accounting estimate related to loan servicing rights is a “critical accounting estimate” because (1) the estimate is highly susceptible to change from period to period because of significant changes within long-term interest rates affecting the prepayment speeds for current loans being serviced and (2) the impact of recognizing an impairment loss could have a material effect on ChoiceOne’s net income. Management has obtained a third-party valuation of its loan servicing rights to corroborate its current carrying value at the end of each reporting period. Goodwill Generally accepted accounting principles require that the fair value of the assets and liabilities of an acquired entity be recorded at their fair value on the date of acquisition. The fair values are determined using both internal computations and information obtained from outside parties when deemed necessary. The net difference between the price paid for the acquired company and the net value of its balance sheet is recorded as goodwill. Generally accepted accounting principles also require that goodwill be evaluated for impairment on an annual basis or more frequently whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Management performed its annual review of goodwill as of June 30, 2010. ChoiceOne engaged an outside consulting firm to perform a goodwill impairment analysis. The following steps were used in the valuation: determination of the reporting unit, determination of the appropriate standard of value, determination of the appropriate level of value, calculation of fair value, and comparison of the fair value computed to the equity carrying value. The standard of value used in the valuation was fair value as determined by generally accepting accounting principles. The appropriate level of value was determined to be the controlling interest level. The appraisal methodology used to calculate the fair value included the following valuation approaches: Income Approach: A discounted cash flow value was calculated based on earnings capacity. The discount rate used for the calculation was 12.70%. The discount rate was based on a risk free rate adjusted for both external and internal risk factors. The growth assumption for assets was 0% for the first year and 2% in subsequent years. In addition, it was assumed that cost savings of 20% of noninterest expense would occur as a result of synergies and cost reductions from a change in control. The cost savings assumption percentage was based on estimated cost savings for bank and thrift merger and acquisition transactions that were announced from January 1, 2007 through June 30, 2010. Market Approach: The analysis was based on price-to-earnings multiples, price-to-tangible-book-value ratios, and core deposit premiums for selected bank sale transactions. The Asset Approach was also an approach reviewed, but it was not used in determining the fair value since it did not render a control level indication of value. The results from the valuation approaches were used to calculate an estimate of the fair value of ChoiceOne’s equity. The fair value was compared to the carrying value of equity to determine whether the Step 1 test under generally accepted accounting principles that govern the valuation of goodwill was passed. The goodwill analysis determined that the fair value of ChoiceOne’s equity exceeded the carrying value by 4.6%. Based on this assessment, management believed that there was no indication of goodwill impairment. Taxes Income taxes include both a current and deferred portion. Deferred tax assets and liabilities are recorded to account for differences in the timing of the recognition of revenues and expenses for financial reporting and tax purposes. Generally accepted accounting principles require that deferred tax assets be reviewed to determine whether a valuation allowance should be established using a “more 5 likely than not” standard. Based on its review of ChoiceOne’s deferred tax assets as of December 31, 2010, management determined that a valuation allowance of $87,000 was necessary. MERGER WITH VALLEY RIDGE FINANCIAL CORP. On November 1, 2006, ChoiceOne merged with Valley Ridge Financial Corp. (“VRFC”). At the time of the merger, VRFC was roughly equal in size in terms of assets with ChoiceOne. The 2006 results of operations include two months of combined financial results after the close of the merger and the 2006 year-end balance sheet includes all of the assets acquired and all of the liabilities assumed from VRFC in the merger. Therefore, a comparison of 2006 financial condition and results of operations to the financial condition and results of operations for any subsequent year is materially affected as a result of the merger. The increase in the total allowance for loan losses in 2006 was related to the allowance of $1,751,000 acquired from the merger with VRFC in November 2006. Summary (Dollars in thousands) RESULTS OF OPERATIONS Year ended December 31 2010 16,995 Net interest income ................................................................ Provision for loan losses................................................................ (3,950 ) Noninterest income................................................................ 5,569 Noninterest expense................................................................(15,249 ) Income tax (expense)/benefit........................................................... (654 ) 2,711 Net income................................................................$ $ $ $ 2009 15,996 (4,875) 5,421 (15,259) 195 1,478 $ $ 2008 15,331 (3,475) 4,083 (14,711) 207 1,435 Return on average assets................................................................0.58 % Return on average equity ................................................................5.02 % 2010 2009 0.33% 2.78% 2008 0.31% 2.69% Net income for 2010 was $2,711,000, which represented a $1,233,000 or 84% increase from 2009. The growth in net income resulted from increases in net interest income and noninterest income while decreases occurred in the provision for loan losses and noninterest expense in 2010 compared to 2009. The increase in net interest income was due to growth in average earning assets and an increase in ChoiceOne’s net interest spread in 2010 compared to the prior year. The expansion in noninterest income was due to higher levels of gains on sales of loans and gains on sales of securities in 2010 than in 2009. The decrease in the provision for loan losses resulted from lower net charge-offs in 2010 than in 2009 and a $5.6 million reduction in nonperforming loans from December 31, 2009 to December 31, 2010. The small decline in noninterest expense was due to lower occupancy and equipment expense, loan and collection expense, and FDIC insurance expense, offset by increases in salaries and benefits and various other expenses in 2010 compared to the prior year. Net income for 2009 was $1,478,000, which represented a $43,000 or 3% increase from 2008. The increase in net income resulted from increased net interest income and noninterest income in 2009, which was offset by a higher provision for loan losses and higher noninterest expense in 2009 than in 2008. The growth in net interest income was due to an increase in ChoiceOne’s net interest spread, which was partially offset by lower average earning assets in 2009 than in 2008. The expansion in noninterest income was due to an increase in gains on sales of loans and gains on sales of securities in 2009 compared to the prior year. Noninterest income was affected in 2008 by $867,000 of securities losses related to money market preferred securities. The increase in the provision for loan losses was caused by a higher level of charge-offs in 2009 than in 2008. The growth in noninterest expense was due to increased FDIC insurance expense and costs related to carrying other real estate properties and loan collection expenses. Dividends Cash dividends of $1,572,000 or $0.48 per common share were declared in 2010, compared to $1,563,000 or $0.48 per common share in 2009 and $2,202,000 or $0.68 per common share in 2008. Dividends declared were $0.12 per share in each quarter in 2010 and 2009, compared to $0.17 per share in each quarter in 2008. The dividend reduction in 2009 was believed prudent based on the Board of Directors’ desire to retain more capital due to the uncertainty of Michigan’s economy. The dividend yield on ChoiceOne’s common stock was 4.79% in 2010, compared to 6.66% in 2009 and 6.50% in 2008. The cash dividend payout as a percentage of net income was 58% in 2010, compared to 106% in 2009 and 153% in 2008. ChoiceOne’s principal source of funds to pay cash dividends is the earnings of the Bank. The availability of these earnings is dependent upon the capital needs, regulatory constraints and other factors involving the Bank. Regulatory constraints include the maintenance of minimum capital ratios and limits based on net income and retained earnings of the Bank for the past three years. ChoiceOne expects to pay quarterly cash dividends in 2011 to shareholders based on the actual earnings of the Bank, although the amount of the quarterly dividends will be dependent on market conditions and ChoiceOne’s requirements for cash and capital, among other things. 6 Table 1 – Average Balances and Tax-Equivalent Interest Rates (Dollars in thousands) 2010 Year ended December 31 2009 2008 Average Balance Interest Average Rate Average Balance Average Rate Average Balance Interest Interest Average Rate Assets Loans (1) (2) ................................ $ 315,031 $ 19,103 Taxable securities (3)................... 50,997 1,460 Tax-exempt securities (1)............. 35,440 2,110 Other ............................................ 6,498 22 Interest-earning assets ............... 407,966 22,695 Noninterest-earning assets (4)...... 61,518 Total assets................................ $ 469,484 6.06% $ 320,328$ 19,944 1,390 34,115 2.86 2,669 42,819 5.95 7 2,695 0.34 399,957 24,010 5.56 53,919 $ 453,876 6.23% $ 326,420 $ 22,677 2,105 39,160 4.07 2,609 45,926 6.23 66 2,527 0.26 414,033 27,457 6.00 51,708 $ 465,741 6.95% 5.38 5.68 2.61 6.63 Liabilities and Shareholders’ Equity Interest-bearing demand deposits........................ $ 108,522 Savings deposits........................... 40,534 Certificates of deposit .................. 160,390 Advances from FHLB .................. 16,477 Other ............................................ 19,273 Interest-bearing liabilities....... 345,196 Demand deposits.......................... 64,828 Other noninterest-bearing liabilities.................................... Total liabilities .......................... Shareholders’ equity .................... Total liabilities and shareholders’ equity ............... $ 469,484 5,448 415,472 54,012 Net interest income (tax-equivalent basis) – interest spread .............................. Tax-equivalent adjustment (1) ........ Net interest income ......................... Net interest income as a percentage of earning assets (tax-equivalent basis) ................... 553 80 3,281 748 304 4,966 0.51% $ 85,154 36,371 0.20 167,065 2.05 28,857 4.54 19,435 1.58 336,882 1.44 58,417 520 113 4,920 1,186 351 7,090 0.61% $ 89,035 30,554 0.31 173,963 2.94 38,803 4.11 19,928 1.81 352,283 2.10 53,638 1,295 140 7,497 1,704 567 11,203 1.45% 0.46 4.31 4.39 2.85 3.18 5,462 400,761 53,115 $ 453,876 6,409 412,330 53,411 $ 465,741 17,729 4.12 % 16,920 3.90 % 16,254 3.45 % (734) $ 16,995 (924) $ 15,996 (923) $ 15,331 4.35 % 4.23 % 3.93 % (1) (2) Interest on nontaxable securities and loans has been adjusted to a fully tax-equivalent basis to facilitate comparison to the taxable interest-earning assets. The adjustment uses an incremental tax rate of 34% for the years presented. Interest on loans included net origination fees charged on loans of approximately $751,000, $783,000, and $758,000 in 2010, 2009, and 2008, respectively. Interest on taxable securities includes dividends on Federal Home Loan Bank and Federal Reserve Bank stock. (3) (4) Noninterest-earning assets include loans on a nonaccrual status, which averaged approximately $10,286,000, $8,961,000, and $7,075,000 in 2010, 2009, and 2008, respectively. Net Interest Income As shown in Tables 1 and 2, tax-equivalent net interest income increased $809,000 in 2010 compared to 2009. The growth was due to growth of $8.0 million in average interest-earning assets in 2010 compared to 2009 and a 22 basis point increase in ChoiceOne’s net interest income spread compared to 2009. The higher level of average interest-earning assets contributed an additional $406,000 in net interest income in 2010 compared to 2009, while the growth in the net interest income spread caused an increase of $403,000 in net interest income in 2010 compared to the prior year. 7 The average balance of loans declined $5.3 million in 2010 compared to 2009. This decline, combined with a 17 basis point decrease in the average rate earned on loans, caused interest income on loans to fall $841,000 in 2010 compared to the prior year. The average balance of total securities increased by $9.5 million in 2010 compared to 2009. This growth in the average balance was offset by a lower average rate earned on securities, causing interest income from securities to decrease $489,000 in 2010 compared to the prior year. An increase in both the average balance and average rate earned on other interest-earning assets resulted in an increase in interest income of $15,000 in 2010 compared to 2009. The reduction in loans resulted from sluggish loan demand, which was caused by continued concerns about the Michigan economy. Growth in securities was due to ChoiceOne’s desire to maintain earning assets. The average balance of interest-bearing demand deposits increased $23.4 million in 2010 compared to 2009. The effect of this increase, partially offset by a 10 basis point decline in the average rate paid, caused interest expense to be $33,000 higher in 2010 than in the prior year. The effect of an 11 basis point decrease in the average rate paid on savings deposits in 2010 compared to 2009 was partially offset by the effect of growth of $4.2 million in the average balance as interest expense dropped $33,000. The average balance of certificates of deposit was $6.7 million lower in 2010 than in the prior year. Approximately $4.9 million of the certificates of deposit decline was related to certificates from ChoiceOne’s local markets, while the remaining $1.8 million was a lower level of brokered certificates. The average balance decrease plus the effect of an 89 basis point decline in the average rate paid caused interest expense on certificates of deposit to fall $1.6 million in 2010 compared to 2009. A $12.4 million decrease in the average balance of Federal Home Loan Bank advances offset by a 43 basis point increase in the average rate paid caused interest expense to decline $438,000 in 2010 compared to the prior year. Interest expense on other interest-bearing liabilities fell $47,000 in 2010 compared to 2009 due to a small decline in the average balance and a 23 basis point decrease in the average rate paid. The growth experienced in interest-bearing demand deposits and savings deposits was primarily due to depositors choosing the liquidity and safety afforded by this type of deposit as compared to certificates of deposit or nonbank investments. ChoiceOne’s net interest income spread was 4.12% (shown in Table 1) for 2010, compared to 3.90% in 2009. The average yield received on interest-earning assets in 2010 decreased 44 basis points to 5.56% while the average rate paid on interest-bearing liabilities in 2010 fell 66 basis points to 1.44%. The decline in general market interest rates in both 2009 and 2010 caused the reduction in rates for both assets and liabilities in the two time periods. Table 2 – Changes in Tax-Equivalent Net Interest Income (Dollars in thousands) Year ended December 31 2010 Over 2009 Volume Rate Total 2009 Over 2008 Volume Rate Total Increase (decrease) in interest income (1) Loans (2) ...................................................... $ Taxable securities......................................... Tax-exempt securities (2)............................. Other ............................................................ Net change in tax-equivalent income ........ (841) $ 70 (559) 15 (1,315) (326) $ (515) (490) 560 (115) (444) 12 3 (1,117) (198) $ (2,733) $ (715) 60 (59) (3,447) (417) $ (2,316) (467) (248) 244 (184) (63) 4 (2,602) (845) Increase (decrease) in interest expense (1) Interest-bearing demand deposits................. Savings deposits........................................... Certificates of deposit .................................. Advances from Federal Home Loan Bank ... Other ............................................................ Net change in interest expense .................. Net change in tax-equivalent net interest income 33 (33) (1,639) (438) (47) (2,124) 128 12 (189) (552) (3) (604) (95) (45) (1,450) 114 (44) (1,520) (775) (27) (2,577) (518) (216) (4,113) (54) 23 (287) (414) (14) (746) (721) (50) (2,290) (104) (202) (3,367) $ 809 $ 406 $ 403 $ 666 $ (99) $ 765 (1) The volume variance is computed as the change in volume (average balance) multiplied by the previous year’s interest rate. The rate variance is computed as the change in interest rate multiplied by the previous year’s volume (average balance). The change in interest due to both volume and rate has been allocated to the volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each. Interest on tax-exempt securities and loans has been adjusted to a fully tax-equivalent basis using an incremental tax rate of 34% for the years presented. (2) 8 Tax-equivalent net interest income increased $666,000 in 2009 compared to 2008. The increase was caused by a 45 basis point increase in the net interest spread, offset by a decline in average interest-earning assets. The growth in ChoiceOne’s net interest spread was caused by a 108 basis point decrease in the average rate paid on interest-bearing liabilities compared to a 63 basis point decline in the average rate earned on interest-earning assets. The decline in general market interest rates in 2009 caused almost all of the rates earned on assets and paid on liabilities to be lower than in the prior year. Average interest-earning assets decreased $14.1 million while average interest-bearing liabilities fell $15.4 million in 2009 compared to 2008. Management anticipates that the level of net interest income in 2011 will depend upon the Bank’s ability to grow or maintain interest- earning assets in the form of loans and securities as well as its ability to do the same with its base of core deposits. Growth in earning assets will continue to be dependent on the Michigan economy. If growth in loans is difficult to obtain, the Bank can opt to invest in securities as it did in 2010. The Bank’s ability to maintain or grow its net interest spread will be contingent on movement in general market interest rates and their effect on new and maturing assets and liabilities. Allowance and Provision For Loan Losses Information regarding the allowance and provision for loan losses can be found in Table 3 below: Table 3 – Provision and Allowance For Loan Losses (Dollars in thousands) $ Allowance for loan losses at beginning of year ................................ $ 2010 4,322 2009 3,600 $ 2008 3,600 2007 3,569 $ 2006 1,963 $ Charge-offs: Agricultural................................................................ Commercial and industrial................................................................ Real estate - commercial................................................................ Real estate - construction................................................................ Real estate - residential................................................................ Consumer................................................................ Total ................................................................................................ — 765 1,523 — 1,152 444 3,884 — 1,558 1,218 14 1,369 535 4,694 Recoveries: Agricultural................................................................ Commercial and industrial................................................................ Real estate - commercial................................................................ Real estate - construction................................................................ Real estate - residential................................................................ Consumer................................................................ Total ................................................................................................ — 68 16 — 27 230 341 — 102 58 29 106 246 541 — 1,193 816 — 1,252 567 3,828 — 60 35 — 6 252 353 33 599 841 — 191 635 2,299 3 27 1 — 10 254 295 Net charge-offs ................................................................3,543 4,153 3,475 2,004 — 221 — — 92 200 513 — 51 — — — 117 168 345 Provision for loan losses................................................................ Allowance for loan losses acquired from VRFC ................................ 3,950 — 4,875 — 3,475 — 2,035 — 200 1,751 Allowance for loan losses at end of year ................................ 4,729 $ $ 4,322 $ 3,600 $ 3,600 $ 3,569 Allowance for loan losses as a percentage of: Total loans as of year end ................................................................ Nonaccrual loans, accrual loans past due 90 days or more and troubled debt restructurings ................................................................ Ratio of net charge-offs to average total loans outstanding during the year................................................................ Loan recoveries as a percentage of prior year’s charge-offs ................................................................ 1.49 % 1.12 % 9 % 56 % 1.34% 1.10% 1.10% 1.08% 31 % 39 % 62 % 53 % 1.30% 1.06% 0.61% 0.17% 16% 15% 58% 42% 9 As shown in Table 3, the provision for loan losses was $925,000 lower in 2010 than in 2009. The reduction in the provision level resulted in part from a decrease of $610,000 in net charge-offs experienced in 2010 compared to 2009. Net charge-offs of commercial and industrial loans declined $759,000 in 2010 from the level experienced in 2009. Approximately $737,000 of the commercial and industrial charge-offs in 2009 was related to an unsecured relationship with one borrower that was charged off in December 2009 due to the borrower’s bankruptcy. Commercial real estate loan net charge-offs increased $347,000 in 2010 compared to the prior year. Residential real estate loan net charge-offs declined $138,000 in 2010 compared to 2009. Consumer loan net charge-offs were down slightly in 2010 compared to the prior year. The allowance for loan losses as a percentage of total loans increased from 1.34% as of the end of 2009 to 1.49% as of the end of 2010. The coverage ratio of the allowance for loan losses to nonperforming loans increased from 31% as of December 31, 2009 to 56% as of December 31, 2010. This was primarily due to a reduction of nonperforming loans from $14.0 million as of the end of 2009 to $8.4 million as of the end of 2010. ChoiceOne had $582,000 of specific allowance allocations for problem loans as of the end of 2010, compared to $1,112,000 as of the prior year end. Special allowance amounts have been allocated where the fair value of loans was considered to be less than their carrying value. ChoiceOne obtains valuations on collateral dependent loans when the loan is considered by management to be impaired and uses the valuation amounts in the determination of fair value. Management believes the specific reserves allocated to certain problem loans at the end of 2010 and 2009 were reasonable based on the circumstances surrounding each particular borrower. The following schedule presents an allocation of the allowance for loan losses to the various loan categories as of the years ended December 31: (Dollars in thousands) Agricultural................................................................$ $ Commercial and industrial................................................................ Real estate - commercial................................................................ Real estate - construction................................................................ Real estate - residential................................................................ Consumer................................................................ Unallocated................................................................ 2010 181 641 1,729 2 1,554 243 379 2009 124 735 1,546 3 1,590 306 18 $ 2008 242 616 996 5 1,124 351 266 $ 2007 397 873 886 10 881 489 64 $ 2006 314 1,160 1,029 12 575 289 190 Total allowance for loan losses................................ $ 4,729 $ 4,322 $ 3,600 $ 3,600 $ 3,569 The increase in the allowance allocation to agricultural loans from 2009 to 2010 was based on the slightly higher perceived level of risk in this portfolio. The increase in the allocation to commercial real estate loans in 2010 was due to the higher level of charge-offs experienced in 2010 than in the prior year. The small decline in the allowance allocated to the other loan categories was due to lower charge-off levels in 2010 than the prior year. The growth in the unallocated allowance from 2009 to 2010 was believed prudent based on management’s continued concerns regarding the economy and its impact on the ability of borrowers to make loan payments. Management maintains the allowance at a level which it believes adequately provides for losses inherent in the loan portfolio. Such losses are estimated by a variety of factors, including specific examination of certain borrowing relationships and consideration of historical losses incurred on certain types of credits. Current economic conditions and declining collateral values affect loss estimates. Management focuses on early identification of problem credits through ongoing reviews by management and the independent loan review function. Based on the current state of the economy and a recent review of the loan portfolio, management believes that the allowance for loan losses as of December 31, 2010 is adequate. As charge-offs, changes in the level of nonperforming loans, and changes within the composition of the loan portfolio occur, the provision and allowance for loan losses will be reviewed by the Bank's management and adjusted as necessary. Noninterest Income Total noninterest income increased $148,000 in 2010 compared to 2009. Customer service charges were virtually unchanged as decreases in overdraft charges were offset by increases in fees from debit card usage. Gains on sales of loans grew $81,000 in 2010 compared to the prior year as mortgage refinancing activity continued to be stimulated by low interest rates for long-term fixed rate mortgages. ChoiceOne sold $28.1 million and $28.0 million of mortgage loans in 2010 and 2009, respectively. If rates for long-term fixed rate mortgage loans rise in 2011, management believes that mortgage refinancing activity may slow and resulting gains on sales of loans may be lower than in 2010. ChoiceOne’s net gains on sales of securities grew $135,000 in 2010 compared to 2009. Gains on sales of preferred stock were $386,000 in 2010 compared to $245,000 in the prior year. These gains represented a recovery of losses recognized on money market preferred securities in 2008. The loss on other than temporary impairment of securities in 2010 and 2009 was related to a municipal security that defaulted upon its maturity in September 2009. Total noninterest income increased $1,338,000 in 2009 compared to 2008. Customer service charges were $103,000 less in 2009 compared to 2008 due to a $99,000 decrease in overdraft charges. Lower levels of life insurance commission income and mutual fund 10 commission income in 2009 caused the decline in insurance and investment commission income from 2008. Gains on sales of loans increased $386,000 in 2009 compared to 2008 due to a higher level of mortgage refinancing activity stimulated by low interest rates for long-term fixed rate mortgage loans. ChoiceOne sold $28.0 million of mortgage loans in 2009 compared to $12.2 million in 2008. ChoiceOne had $355,000 of net gains on sales of securities in 2009, compared to $833,000 of net losses in 2008. The net gains in 2009 included $245,000 of gains on sales of preferred stock that represented a recovery of losses recognized on money market preferred securities in 2008. Net losses from sales of securities in 2008 included a $435,000 loss recognized when a money market preferred security was converted to preferred stock. A $432,000 loss on other than temporary impairment of securities in 2008 resulted when a decline in the market value of another money market preferred security was considered to be other than temporary. The net loss on sales of other assets was $230,000 larger in 2009 than in 2008 due to the sale of more real estate properties. An increase of $184,000 in other noninterest income in 2009 compared to 2008 was caused in part by higher levels of check printing fees, rental income from foreclosed properties, and income from an investment in Michigan Bankers Title Company. Management anticipates that regulatory changes in 2010 and proposed changes for 2011 will continue to have a negative impact on deposit-related fees in 2011. A change that became effective July 1, 2010 restricted ChoiceOne’s ability to charge overdraft fees for certain types of transactions, which include automatic teller machine or one-time debit card usage, unless the depositors opted in for overdraft coverage for these types of transactions. This caused some decrease in overdraft fees in the second half of 2010 and will affect the full year of 2011. In addition, the Dodd-Frank Act passed in 2010 gave the Federal Reserve the authority to establish rules regarding interchange fees that are charged for electronic debit transactions. In December 2010, the Federal Reserve proposed a new regulation that would establish standards for determining whether an interchange fee related to an electronic debit transaction is reasonable. The new standards, which are scheduled to become effective on July 21, 2011, propose to set limits at one-third to one- half of the fees currently charged by banks. Although the standards are restricted to banks with assets of $10 billion or more, ChoiceOne believes that the potential restrictions for big banks may also affect community banks like ChoiceOne. Noninterest Expense Total noninterest expense decreased $10,000 in 2010 compared to 2009. Salaries and benefits increased $138,000 in 2010 compared to the prior year, partly due to an increase of $113,000 in 401(k) plan expense as ChoiceOne reinstated its company contribution in 2010. Occupancy and equipment expense was $70,000 lower in 2010 than in 2009 as depreciation expense and various other expenses declined from the prior year. The $52,000 increase in data processing expense in 2010 compared to the prior year resulted from higher costs related to electronic banking usage. Professional fees were $46,000 higher in 2010 than in 2009 due to increases in legal, accounting, and consulting costs. Advertising and promotional expense grew $44,000 in 2010 compared to the prior year as a result of more promotion of ChoiceOne’s new and existing products. Loan and collection expense declined $99,000 in 2010 compared to 2009 due to lower collection costs for problem loans. FDIC insurance expense was $144,000 lower in 2010 than in the prior year due to a special assessment of $204,000 that was levied in the second quarter of 2009, the effect of which was partially offset by higher deposit balances in 2010 than in 2009. Other noninterest expense grew by $51,000 in 2010 compared to 2009 as a result of changes in a number of expense accounts. Total noninterest expense increased $548,000 in 2009 compared to 2008. The $238,000 decrease in salaries and benefits expense in 2009 compared to the prior year was partly due to a $141,000 reduction in 401(k) plan expense as no company contribution was made in 2009. Data processing expense grew $213,000 in 2009 compared to 2008 as a result of increased numbers of accounts and increased volumes, especially in the form of electronic banking. Loan and collection expense increased $355,000 in 2009 compared to 2008 as a result of more costs related to other real estate owned and problem loans. FDIC insurance expense was $518,000 higher in 2009 as a result of a special assessment of $204,000 levied in the second quarter of 2009 and a doubling of assessment rates in 2009 compared to 2008. A decrease of $262,000 in other noninterest expense in 2009 compared to 2008 was caused by reductions in training and seminars, Michigan business tax, directors’ fees, and various other expenses. Management believes that loan and collection expense will continue to be affected by Michigan’s economy in 2011. The FDIC passed a regulation in November 2010 that changed the deposit insurance assessment base from total domestic deposits to average total assets less average tangible equity. The change is effective with the quarter beginning April 1, 2011. Management anticipates that ChoiceOne’s insurance expense may be lower under the adjusted total assets assessment base than it would have been under the total domestic deposits assessment base. Income Taxes Income taxes were $654,000 in 2010, compared to benefits of $195,000 in 2009 and $207,000 in 2008. The change in the income tax effect from 2009 to 2010 was caused by a $2.1 million increase in income before income tax in 2010 compared to the prior year. The tax benefit realized in both 2009 and 2008 was due to the level of ChoiceOne’s tax-exempt interest income, which was larger than income before income tax in both years. 11 FINANCIAL CONDITION Summary Total assets were $480.5 million as of December 31, 2010, which represented an increase of $14.6 million or 3% from the end of 2009. Cash and cash equivalents grew $4.3 million in 2010 as excess funds from deposit growth were held at correspondent banks or sold as overnight federal funds. Securities available for sale increased $16.4 million during 2010 as management purchased securities to use funds that were provided by deposit growth. Loans declined $5.8 million in 2010 due to sluggish loan demand. Total deposits grew $24.9 million in 2010 due to increases in checking and savings deposits, which were partially offset by a decrease in certificates of deposit. Advances from the Federal Home Loan Bank of Indianapolis were reduced $13.5 million in 2010 as the deposit growth was used to pay off maturing advances. Securities The Bank’s securities available for sale balances as of December 31 were as follows: (Dollars in thousands) U.S. Government and federal agency ................................................................................... $ State and municipal............................................................................................................... Mortgage-backed .................................................................................................................. Corporate .............................................................................................................................. FDIC-guaranteed financial institution debt........................................................................... Equity securities.................................................................................................................... Total ................................................................................................................................ $ 2010 29,066 47,881 7,599 2,883 2,053 1,338 90,820 $ $ 2009 18,571 44,599 8,929 — — 2,314 74,413 The securities available for sale portfolio increased $16.4 million from December 31, 2009 to December 31, 2010. ChoiceOne purchased a mix of government agency, municipal, mortgage-backed, corporate securities, and FDIC-guaranteed financial institution debt totaling $44.1 million during 2010 to replace securities that matured or were called and to provide growth in earning assets. Approximately $19.6 million in various securities were called or matured in 2010. Principal payments for municipal and mortgage- backed securities totaling $2.7 million were received during 2010. Various securities totaling approximately $6.1 million were sold during 2010 for net gains totaling $537,000. Approximately $3.7 million of the sales that occurred in 2010 were sales of municipal securities as ChoiceOne lessened its exposure to certain issuers. The Bank’s Investment Committee continues to monitor the portfolio and purchases securities as it considers prudent. Also, certain securities are sold under agreements to repurchase and management plans to continue this practice as a low-cost source of funding. State and municipal securities as of the end of 2010 included a security that matured on September 1, 2009 and was not redeemed by the issuer. A principal payment of $29,000 was received in October 2009 on the par value of $500,000. No further payments have been received. Legal counsel was engaged in September 2009 by the bondholders to work with the issuer on their behalf. ChoiceOne’s third party investment advisor is a member of the bondholder executive committee and is working closely with the legal counsel. Due to the uncertainty as to when and how much value will be received for the remaining principal balance of the bond, other than temporary impairments were recorded in 2009 and 2010 to reduce the carrying value to 70% of the remaining par value as of December 31, 2010. Equity securities included a money market preferred security (MMP) of $838,000 and a trust preferred security of $500,000 as of December 31, 2010 and preferred stock of $954,000, an MMP of $860,000, and a trust preferred security of $500,000 as of December 31, 2009. The preferred stock held as of the end of 2009 was sold in the first quarter of 2010 and a gain of $386,000 was recognized. The MMP had a $162,000 unrealized loss as of December 31, 2010 that was recorded to other comprehensive income. Auctions remain active for this security and interest continues to be received. Management will continue to monitor its municipal and equity securities closely in 2011. Securities may be sold if believed prudent from a risk standpoint. 12 Loans The Bank’s loan portfolio as of December 31 was as follows: (Dollars in thousands) Agricultural........................................................................................................................... $ Commercial and industrial.................................................................................................... Consumer.............................................................................................................................. Real estate - commercial....................................................................................................... Real estate - construction...................................................................................................... Real estate - residential......................................................................................................... Total loans ....................................................................................................................... $ 2010 29,681 55,947 16,709 116,351 853 97,399 316,940 $ $ 2009 31,322 53,964 16,285 121,100 1,158 98,887 322,716 The loan portfolio (excluding loans held for sale) decreased $5.8 million from December 31, 2009 to December 31, 2010. Loan demand continued to be sluggish in 2010 as the uncertain economy in Michigan affected the willingness of borrowers to assume debt. Growth was achieved in commercial and industrial loans and consumer loans in 2010 through officer calling activities and marketing of consumer loan products. Loans secured by real estate continued to be affected by reduced collateral values, which impacted the ability to originate these loans. Residential real estate loans were also affected by portfolio loans that were refinanced into long-term fixed rate loans and sold in the secondary market. Information regarding impaired loans can be found in Note 3 to the consolidated financial statements included in this report. In addition to its review of the loan portfolio for impaired loans, management also monitors various nonperforming loans. Nonperforming loans are comprised of (1) loans accounted for on a nonaccrual basis; (2) loans, not included in nonaccrual loans, which are contractually past due 90 days or more as to interest or principal payments; and (3) loans, not included in nonaccrual or past due 90 days or more, which are considered troubled debt restructurings. The balances of these nonperforming loans as of December 31 were as follows: (Dollars in thousands) Loans accounted for on a nonaccrual basis Loans contractually past due 90 days or more as to principal or interest payments Loans considered troubled debt restructurings which are not included above Total $ $ 2010 6,273 23 2,141 8,437 $ $ 2009 11,882 206 1,919 14,007 Nonaccrual loans included $3,621,000 in commercial and industrial and commercial real estate loans, $2,646,000 in residential real estate loans, and $6,000 in consumer loans as of December 31, 2010, compared to $7,805,000, $4,060,000, and $17,000, respectively, as of December 31, 2009. The decreases in nonaccrual loans in 2010 were caused by charge-offs, transfers to other real estate owned, and payments received on loans. Loans considered troubled debt restructurings which were not on a nonaccrual basis and were not 90 days or more past due as to principal or interest payments consisted of $2,141,000 in residential real estate loans as of December 31, 2010, compared to $134,000 in commercial and industrial loans and $1,785,000 in residential real estate loans as of December 31, 2009. Troubled debt restructurings consist of loans where the terms have been modified to assist the borrowers in making their payments. The modifications can include capitalization of interest onto the principal balance, reduction in interest rate, and extension of the loan term. ChoiceOne began making the modifications for residential real estate loans in September 2009 and plans to continue this process in 2011. Management also maintains a list of loans that are not classified as nonperforming loans but where some concern exists as to the borrowers’ abilities to comply with the original loan terms. These loans totaled $21.2 million as of December 31, 2010, compared to $17.1 million as of December 31, 2009. 13 Deposits and Other Funding Sources The Bank’s deposit balances as of December 31 were as follows: (Dollars in thousands) Noninterest-bearing demand deposits................................................................................... $ Interest-bearing demand deposits ......................................................................................... Money market deposits......................................................................................................... Savings deposits ................................................................................................................... Local certificates of deposit.................................................................................................. Brokered certificates of deposit ............................................................................................ Total deposits .................................................................................................................. $ 2010 66,932 59,853 59,021 43,572 152,602 7,904 389,884 $ $ 2009 60,802 43,731 58,094 36,791 159,217 6,375 365,010 Total deposits increased $24.9 million from December 31, 2009 to December 31, 2010. Local deposits grew $23.4 million while brokered certificates of deposit grew $1.5 million since the end of 2009. Management believes that the local deposit growth was due in part to the attractiveness of FDIC-guaranteed deposits in contrast to the uncertainty of investments in the stock market. Deposit growth also resulted from new product offerings and calling efforts on business and municipal clients. The balance in all checking and savings account categories increased during the year while the balance of local certificates of deposit declined. Management believes that some of the local certificate of deposit decrease consisted of transfers into the other interest-bearing deposit accounts since the liquidity obtained offset the relatively small difference in the interest rate paid. Securities sold under agreements to repurchase increased $1.6 million during 2010. The change was due to a higher balance in sweep repurchase accounts used by the Bank’s local customers. Advances from the Federal Home Loan Bank of Indianapolis (“FHLB”) decreased $13.5 million in 2010 as growth in deposits caused it to be unnecessary to replace maturing advances. A blanket collateral agreement covering residential real estate loans was pledged against all outstanding advances at the end of 2010. Approximately $35 million of additional advances were available as of December 31, 2010 based on the collateral pledged. In 2011, management will continue to focus its marketing efforts toward growth in local deposits. If local deposit growth is insufficient to support asset growth, management believes that advances from the FHLB, repurchase agreements and brokered certificates of deposit can address corresponding funding needs. Shareholders’ Equity Total shareholders' equity increased $1.4 million from December 31, 2009 to December 31, 2010. The growth in equity resulted primarily from the retention of earnings in 2010 as net income exceeded dividends paid by $1.1 million. Issuances of common stock and an increase in accumulated other comprehensive income also contributed to the growth in 2010. Note 21 to the consolidated financial statements presents regulatory capital information for the Bank at the end of 2010 and 2009. The Bank’s capital ratios for total risk-based capital and Tier 1 capital increased slightly in 2010 while the Tier 1 leverage capital ratio declined slightly. Management will monitor these capital ratios closely during 2011 as they relate to asset growth and earnings retention. ChoiceOne’s Board of Directors and management do not plan to allow capital to decrease below those levels necessary to be considered “well capitalized” by regulatory guidelines. The Board of Directors and management believe that ChoiceOne’s capital level as of December 31, 2010 is adequate for the foreseeable future. Table 4 – Contractual Obligations The following table discloses information regarding the maturity of ChoiceOne’s contractual obligations at December 31, 2010: (Dollars in thousands) Contractual Obligations Time deposits.......................................................................$ 160,506 Repurchase agreements........................................................ 22,249 Advances from Federal Home Loan Bank........................... 8,473 Operating leases................................................................ 141 Other obligations ................................................................ 1,161 Total .................................................................................$ 192,530 Total 14 Payment Due By Period Less than 1 year $ 101,768 17,249 26 61 151 $ 119,255 1-3 Years 50,858 5,000 8,055 80 124 64,117 $ $ $ $ 3-5 Years More than 5 Years 116 – 332 – 735 1,183 7,764 $ – 60 – 151 7,975 $ Liquidity and Interest Rate Risk Net cash from operating activities was $9.2 million for both 2010 and 2009. The effect of higher net income and the positive change in other assets was offset by the effect of a lower provision for loan losses and lower proceeds from sales of other real estate owned in 2010 compared to 2009. Cash used in investing activities was $16.4 million in 2010 compared to $1.1 million in 2009. The increase was caused by higher net purchases of securities, which was partially offset by lower net loan originations. Cash flows from financing activities were $11.5 million in 2010 compared to $0.5 million in the prior year. The increase resulted from more growth in deposits in 2010 than in 2009 and lower net payments of FHLB advances. ChoiceOne's primary market risk exposure occurs in the form of interest rate risk. Liquidity risk also can have an impact but to a lesser extent. ChoiceOne's business is transacted in U.S. dollars with no foreign exchange risk exposure. Agricultural loans comprise a small portion of ChoiceOne's total assets. Management believes that ChoiceOne's exposure to changes in commodity prices is insignificant. Management believes that the current level of liquidity is sufficient to meet the Bank's normal operating needs. This belief is based upon the availability of deposits from both the local and national markets, maturities of securities, normal loan repayments, income retention, federal funds purchased lines from correspondent banks, and advances available from the FHLB. Liquidity risk deals with ChoiceOne's ability to meet its cash flow requirements. These requirements include depositors desiring to withdraw funds and borrowers seeking credit. Relatively short-term liquid funds exist in the form of lines of credit to purchase federal funds at three of the Bank’s correspondent banks. As of December 31, 2010, the amount of federal funds available for purchase from the Bank's correspondent banks totaled approximately $23.5 million. ChoiceOne had no federal funds purchased at the end of 2010 or 2009. The Bank also has a line of credit secured by ChoiceOne’s commercial loans with the Federal Reserve Bank of Chicago for $41 million, which is designated for nonrecurring short-term liquidity needs. Longer-term liquidity needs may be met through local deposit growth, maturities of securities, normal loan repayments, advances from the FHLB, brokered certificates of deposit, and income retention. Approximately $35 million of borrowing capacity was available from the FHLB based on residential real estate loans pledged as collateral at year-end 2010. The acceptance of brokered certificates of deposit is not limited as long as the Bank’s capital to assets ratio is considered to be “well capitalized” under regulatory guidelines. Interest rate risk is related to liquidity because each is affected by maturing assets and sources of funds. ChoiceOne’s Asset/Liability Management Committee (the "ALCO") attempts to stabilize the interest rate spread and avoid possible adverse effects when unusual or rapid changes in interest rates occur. The ALCO uses a simulation model to measure the Bank’s interest rate risk. The model incorporates changes in interest rates on rate-sensitive assets and liabilities. The degree of rate sensitivity is affected by prepayment assumptions that exist in the assets and liabilities. One method the ALCO uses of measuring interest rate sensitivity is the ratio of rate- sensitive assets to rate-sensitive liabilities. An asset or liability is considered to be rate-sensitive if it matures or otherwise reprices within a given time frame. 15 Table 5 documents the maturity or repricing schedule for ChoiceOne’s rate-sensitive assets and liabilities for selected time periods. Table 5 – Maturities and Repricing Schedule (Dollars in thousands) 0-3 Months As of December 31, 2010 1-5 Years 3-12 Months Over 5 Years Assets Federal funds sold...........................................................$ 5,000 Securities available for sale ............................................ 14,280 – Federal Home Loan Bank stock…………………… Federal Reserve Bank stock............................................ – Loans held for sale.......................................................... 1,610 Loans .............................................................................. 72,792 – Cash surrender value of life insurance policies............... Rate-sensitive assets .................................................... 93,682 $ – 12,049 2,889 – – 79,576 – 94,514 $ – 37,215 – 1,270 – 134,245 9,520 182,250 Liabilities Interest-bearing demand deposits ................................ 59,853 Savings deposits ............................................................. 43,572 Money market deposits……………………………. 59,021 Certificates of deposit ..................................................... 47,038 Repurchase agreements................................................... 17,249 Advances from FHLB..................................................... – Rate-sensitive liabilities............................................... 226,733 Rate-sensitive assets less rate-sensitive liabilities: Asset (liability) gap for the period ...............................$ (133,051) $ Cumulative asset (liability) gap ................................$ (133,051) $ (94,101) $ – – – 55,564 – – 55,564 38,950 – – – 57,904 5,000 8,000 70,904 $ 111,346 17,245 $ – $ 27,276 – – – 30,327 – 57,603 – – – – – 473 473 $ 57,130 $ $ 74,375 Total 5,000 90,820 2,889 1,270 1,610 316,940 9,520 428,049 59,853 43,572 59,021 160,506 22,249 8,473 353,674 74,375 Under this method, the ALCO measures interest rate sensitivity by focusing on the one-year repricing gap. ChoiceOne’s ratio of rate- sensitive assets to rate-sensitive liabilities that matured or repriced within a one-year time frame was 67% at December 31, 2010, compared to 69% at December 31, 2009. Table 5 above shows the entire balance of interest-bearing demand deposits, savings deposits, money market deposits, and overnight repurchase agreements in the shortest repricing term. Although these categories have the ability to reprice immediately, management has some control over the actual timing or extent of the changes in interest rates on these liabilities. The ALCO plans to continue to monitor the ratio of rate-sensitive assets to rate-sensitive liabilities on a quarterly basis in 2011. As interest rates change during 2011, the ALCO will attempt to match its maturing assets with corresponding liabilities to maximize ChoiceOne’s net interest income. Another method the ALCO uses to monitor its interest rate sensitivity is to subject rate-sensitive assets and liabilities to interest rate shocks. At December 31, 2010, management used a simulation model to subject its assets and liabilities up to an immediate 400 basis point increase. Management limited the immediate interest rate decrease to a maximum of 15 basis points due to the very low general market rates that existed as of the end of 2010. The maturities of loans and mortgage-backed securities were affected by certain prepayment assumptions. Maturities for interest-bearing core deposits were based on an estimate of the period over which they would be outstanding. The maturities of advances from the FHLB were based on their contractual maturity dates. In the case of variable rate assets and liabilities, repricing dates were used to determine their values. The simulation model measures the effect of immediate interest rate changes on both net interest income and shareholders' equity. ChoiceOne’s Interest Rate Risk Policy states that the changes in interest rates cannot cause net interest income to decrease more than 10% if rates are instantaneously shocked 200 basis points upward or downward. ChoiceOne’s Interest Rate Risk Policy states that the changes in interest rates cannot cause the market value of shareholders’ equity to decrease more than 20% if rates are instantaneously shocked 200 basis points upward or downward. Table 6 provides an illustration of hypothetical interest rate changes as of December 31, 2010 and 2009, respectively: 16 Table 6 – Sensitivity to Changes in Interest Rates (Dollars in thousands) 2010 Net Interest Income Percent Change Market Value of Equity Percent Change Change in Interest Rates 400 basis point rise ......................................................... 17,936 300 basis point rise ......................................................... 17,896 200 basis point rise ......................................................... 17,853 100 basis point rise ......................................................... 17,541 Base rate scenario ........................................................... 17,606 15 basis point decline ..................................................... 17,587 $ + 2% + 2% + 1% –% –% - 1% (Dollars in thousands) 2009 Net Interest Income Percent Change Change in Interest Rates 16,620 300 basis point rise ......................................................... 200 basis point rise ......................................................... 16,467 100 basis point rise ......................................................... 16,313 Base rate scenario ........................................................... 16,147 16,056 15 basis point decline ..................................................... 20 basis point decline ..................................................... 16,023 15,986 25 basis point decline ..................................................... $ + 3% + 2% + 1% –% - 1% - 1% - 1% $ $ 68,278 71,110 74,274 77,547 80,508 80,698 - 15% - 12% - 8% - 4% –% –% Market Value of Equity Percent Change 66,959 70,620 74,682 79,513 79,871 80,086 80,250 - 16% - 11% - 6% –% + 1% + 1% + 1% As of both December 31, 2010 and December 31, 2009, the Bank was within its guidelines for immediate rate shocks up and down for both net interest income and the market value of shareholders’ equity. The ALCO plans to continue to monitor the effect of changes in interest rates on both net interest income and shareholders’ equity and will make changes in the duration of its rate-sensitive assets and rate-sensitive liabilities where necessary. 17 ChoiceOne Financial Services, Inc. MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Management of ChoiceOne Financial Services, Inc. is responsible for establishing and maintaining adequate internal control over financial reporting that is designed to produce reliable financial statements in conformity with United States generally accepted accounting principles. The system of internal control over financial reporting as it relates to the financial statements is evaluated for effectiveness by management and tested for reliability through a program of internal audits. Actions are taken to correct potential deficiencies as they are identified. Any system of internal control, no matter how well designed, has inherent limitations, including the possibility that a control can be circumvented or overridden and misstatements due to error or fraud may occur and not be detected. Also, because of changes in conditions, internal control effectiveness may vary over time. Accordingly, even an effective system of internal control will provide only reasonable assurance with respect to financial statement preparation. Management assessed the effectiveness of the Company’s system of internal control over financial reporting as of December 31, 2010, as required by Section 404 of the Sarbanes-Oxley Act of 2002. Management’s assessment is based on the criteria for effective internal control over financial reporting as described in “Internal Control – Integrated Framework,” issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on this assessment, management has concluded that, as of December 31, 2010, its system of internal control over financial reporting was effective and meets the criteria of the “Internal Control – Integrated Framework.” This annual report is not required to include an attestation report of the Company’s independent registered public accounting firm regarding internal control over financial reporting. James A. Bosserd President and Chief Executive Officer March 25, 2011 Thomas L. Lampen Treasurer March 25, 2011 18 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Shareholders and Board of Directors of ChoiceOne Financial Services, Inc. We have audited the accompanying consolidated balance sheet of ChoiceOne Financial Services, Inc. as of December 31, 2010 and 2009, and the related consolidated statements of income, shareholders’ equity, and cash flows for each year in the three-year period ended December 31, 2010. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit 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 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 ChoiceOne Financial Services, Inc. as of December 31, 2010 and 2009, and the consolidated results of its operations and its cash flows for each year in the three-year period ended December 31, 2010, in conformity with accounting principles generally accepted in the United States of America. Grand Rapids, Michigan March 25, 2011 Plante & Moran, PLLC 19 ChoiceOne Financial Services, Inc. CONSOLIDATED BALANCE SHEETS (Dollars in thousands) Assets Cash and due from banks............................................................................................... Federal funds sold.......................................................................................................... Cash and cash equivalents ........................................................................................ $ Securities available for sale (Note 2) ............................................................................. Federal Home Loan Bank stock..................................................................................... Federal Reserve Bank stock........................................................................................... Loans held for sale......................................................................................................... Loans (Note 3) ............................................................................................................... Allowance for loan losses (Note 3)................................................................................ Loans, net ................................................................................................................. Premises and equipment, net (Note 5) ........................................................................... Other real estate owned, net (Note 7) ............................................................................ Loan servicing rights, net (Note 4) ................................................................................ Cash value of life insurance policies.............................................................................. Intangible assets, net (Note 6)........................................................................................ Goodwill (Note 6).......................................................................................................... Other assets.................................................................................................................... Total assets ............................................................................................................... Liabilities Deposits – noninterest-bearing (Note 8) ........................................................................ Deposits – interest-bearing (Note 8) .............................................................................. Total deposits ........................................................................................................... Repurchase agreements (Note 9) ................................................................................... Advances from Federal Home Loan Bank (Note 10) .................................................... Other liabilities (Notes 11 and 13)................................................................................. Total liabilities.......................................................................................................... $ $ December 31 2010 $ $ $ 19,074 5,000 24,074 90,820 2,889 1,270 1,610 316,940 (4,729) 312,211 12,525 1,953 347 9,520 2,620 13,728 6,957 480,524 66,932 322,952 389,884 22,249 8,473 5,605 426,211 2009 9,957 9,793 19,750 74,413 3,304 1,270 322 322,716 (4,322) 318,394 11,918 2,201 491 9,201 3,068 13,728 7,855 465,915 60,802 304,208 365,010 20,684 21,980 5,315 412,989 Shareholders’ Equity (Note 21) Preferred stock; shares authorized: 100,000; shares outstanding: none........................... Common stock and paid-in capital, no par value; shares authorized: 7,000,000; shares outstanding: 3,280,515 in 2010 and 3,265,714 in 2009 (Note 14) .................... Retained earnings............................................................................................................. Accumulated other comprehensive income, net (Note 16) .............................................. Total shareholders’ equity .......................................................................................... Total liabilities and shareholders’ equity.................................................................... $ – – 46,461 6,952 900 54,313 480,524 $ 46,326 5,813 787 52,926 465,915 See accompanying notes to consolidated financial statements. 20 ChoiceOne Financial Services, Inc. CONSOLIDATED STATEMENTS OF INCOME (Dollars in thousands, except per share data) Interest income Loans, including fees ....................................................................$ Securities Taxable ...................................................................................... Tax exempt ................................................................................ Other ............................................................................................. Total interest income ............................................................ Interest expense Deposits ........................................................................................ Advances from Federal Home Loan Bank.................................... Other borrowings .......................................................................... Total interest expense ........................................................... Net interest income ........................................................................ Provision for loan losses (Note 3).................................................. Net interest income after provision for loan losses ..................... Noninterest income Customer service charges ............................................................. Insurance and investment commissions ........................................ Gains on sales of loans (Note 4) ................................................... Gains (losses) on sales of securities (Note 2) ............................... Loss on other than temporary impairment of securities (Note 2).. Losses on sales of other assets (Note 7)........................................ Earnings on life insurance policies ............................................... Other income ................................................................................ Total noninterest income...................................................... Noninterest expense Salaries and benefits (Notes 13 and 14)........................................ Occupancy and equipment (Note 5) ............................................. Data processing............................................................................. Professional fees ........................................................................... Supplies and postage .................................................................... Advertising and promotional ........................................................ Intangible asset amortization (Note 6) .......................................... Loan and collection expense......................................................... FDIC insurance............................................................................. Other expense ............................................................................... Total noninterest expense..................................................... Income before income tax ............................................................. Income tax expense/(benefit) (Note 11) ........................................ Net income ......................................................................................$ 2,711 Basic earnings per common share (Note 15)................................$ Diluted earnings per common share (Note 15) ............................$ Dividends declared per common share ........................................$ 0.83 0.83 0.48 See accompanying notes to consolidated financial statements. 21 Years ended December 31 2010 2009 2008 19,081 $ 19,915 $ 22,641 1,460 1,398 22 21,961 3,914 748 304 4,966 16,995 3,950 13,045 3,160 690 682 537 (94) (432) 360 666 5,569 7,040 2,157 1,651 675 497 168 448 678 641 1,294 15,249 3,365 654 1,390 1,774 7 23,086 5,553 1,186 351 7,090 15,996 4,875 11,121 3,177 690 601 402 (47) (434) 365 667 5,421 6,902 2,227 1,599 629 504 124 469 777 785 1,243 15,259 1,283 (195) 1,478 0.45 0.45 0.48 $ $ $ $ $ $ $ $ 2,105 1,722 66 26,534 8,932 1,704 567 11,203 15,331 3,475 11,856 3,280 769 215 (401) (432) (204) 373 483 4,083 7,140 2,163 1,386 645 537 152 494 422 267 1,505 14,711 1,228 (207) 1,435 0.44 0.44 0.68 ChoiceOne Financial Services, Inc. CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (Dollars in thousands, except per share data) Common Stock and Paid in Capital Accumulated Other Comprehensive Income (Loss), Net Retained Earnings Number of Shares Total Balance, January 1, 2008 3,229,814 $ 45,956 $ 6,665 $ 521 $ 53,142 Comprehensive income: Net income Net change in unrealized gain (loss) on securities available for sale, net of tax of ($228) Net change in funded status of post- retirement benefit plan Total comprehensive income Shares issued Change in ESOP repurchase obligation Effect of stock options granted Effect of employee stock purchases Cash dividends declared ($0.68 per share) 1,435 1,435 16,295 147 23 33 12 (2,202) (442) (442) 37 37 1,030 147 23 33 12 (2,202) Balance, December 31, 2008 3,246,109 $ 46,171 $ 5,898 $ 116 $ 52,185 Comprehensive income: Net income Net change in unrealized gain (loss) on securities available for sale, net of tax of $343 Net change in funded status of post- retirement benefit plan Total comprehensive income Shares issued Change in ESOP repurchase obligation Effect of stock options granted Effect of employee stock purchases Cash dividends declared ($0.48 per share) 1,478 665 6 19,605 126 (4 ) 22 11 (1,563) 1,478 665 6 2,149 126 (4) 22 11 (1,563) Balance, December 31, 2009 3,265,714 $ 46,326 $ 5,813 $ 787 $ 52,926 Comprehensive income: Net income Net change in unrealized gain (loss) on securities available for sale, net of tax of $65 Net change in funded status of post- retirement benefit plan Total comprehensive income Shares issued Shares cancelled Change in ESOP repurchase obligation Effect of stock options granted Effect of employee stock purchases Cash dividends declared ($0.48 per share) 2,711 (1,572) 127 (14) 2,711 127 (14) 2,824 125 – (16) 15 11 (1,572) 14,805 (4) 125 – (16 ) 15 11 Balance, December 31, 2010 See accompanying notes to consolidated financial statements. 3,280,515 $ 46,461 $ 6,952 $ 900 $ 54,313 22 ChoiceOne Financial Services, Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) Cash flows from operating activities: Net income................................................................................................. $ Adjustments to reconcile net income to net cash from operating activities: Provision for loan losses......................................................................... Depreciation ........................................................................................... Amortization........................................................................................... Compensation expense on stock options and employee purchases......... Losses (gains) on sales of securities ....................................................... Loss on other than temporary impairment of securities .......................... Gains on sales of loans ........................................................................... Loans originated for sale ........................................................................ Proceeds from loan sales ........................................................................ Earnings on bank-owned life insurance .................................................. (Gains)/losses on sales of other real estate owned .................................. Write-downs of other real estate owned ................................................. Proceeds from sales of other real estate owned ...................................... Deferred federal income tax benefit ....................................................... Net change in: Other assets.......................................................................................... Other liabilities .................................................................................... Net cash from operating activities ..................................................... Cash flows from investing activities: Sales of securities available for sale ......................................................... Maturities, prepayments and calls of securities available for sale ............ Purchases of securities available for sale.................................................. Purchase of Federal Reserve Bank stock .................................................. Loan originations and payments, net ........................................................ Additions to premises and equipment....................................................... Net cash from investing activities ...................................................... Cash flows from financing activities: Net change in deposits .............................................................................. Net change in repurchase agreements ....................................................... Proceeds from Federal Home Loan Bank advances ................................. Payments on Federal Home Loan Bank advances .................................... Issuance of common stock ........................................................................ Cash dividends and fractional shares from stock dividends...................... Net cash from financing activities...................................................... Net change in cash and cash equivalents ..................................................... Beginning cash and cash equivalents........................................................... Ending cash and cash equivalents...................................................... $ Supplemental disclosures: Cash paid for interest ................................................................................... $ Cash paid for income taxes.......................................................................... Loans transferred to other real estate owned ............................................... Other real estate owned transferred to premises and equipment.................. See accompanying notes to consolidated financial statements. 23 Years ended December 31 2010 2009 2008 2,711 $ 1,478 $ 1,435 3,950 903 1,173 26 (537) 94 (682 ) (28,816) 28,088 (360) (96) 528 1,174 (163) 875 357 9,225 6,059 22,271 (44,063) — 875 (1,510) (16,368) 24,874 1,565 — (13,525) 125 (1,572) 11,467 4,324 19,750 24,074 5,112 285 1,358 — $ $ 4,875 974 1,102 33 (402) 47 (601) (27,598) 27,983 (365) 7 442 4,200 (410) (2,289) (241) 9,235 8,171 27,180 (31,269) (1) (4,381) (816) (1,116) 18,012 1,898 37,000 (55,002) 126 (1,563) 471 8,590 11,160 19,750 7,288 31 3,489 331 $ $ 3,475 844 996 45 401 432 (215) (12,249) 12,198 (373) 9 204 1,270 (644) 372 (970) 7,230 2,540 22,206 (20,603) (4) (4,760) (764) (1,385) (4,846) (2,924) 50,000 (46,000) 147 (2,202) (5,825) 20 11,140 11,160 11,519 575 3,666 — ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 – Summary of Significant Accounting Policies Principles of Consolidation The consolidated financial statements include ChoiceOne Financial Services, Inc., its wholly-owned subsidiary, ChoiceOne Bank, and ChoiceOne Bank’s wholly-owned subsidiary, ChoiceOne Insurance Agencies, Inc., and its former wholly-owned subsidiary, ChoiceOne Mortgage Company of Michigan (together referred to as "ChoiceOne"). Intercompany transactions and balances have been eliminated in consolidation. Nature of Operations ChoiceOne Bank (the "Bank") is a full-service community bank that offers commercial, consumer, and real estate loans as well as traditional demand, savings and time deposits to both commercial and consumer clients in portions of Kent, Muskegon, Newaygo, and Ottawa counties in Michigan. Substantially all loans are secured by specific items of collateral including business assets, consumer assets, and real estate. Commercial loans are expected to be repaid from the cash flows from operations of businesses. Real estate loans are collateralized by either residential or commercial real estate. ChoiceOne Insurance Agencies, Inc. (the "Insurance Agency") is a wholly-owned subsidiary of the Bank. The Insurance Agency sells insurance policies such as life and health for both commercial and consumer clients. The Insurance Agency also offers alternative investment products such as annuities and mutual funds through a registered broker. ChoiceOne Mortgage Company of Michigan (the “Mortgage Company”) originated and sold a full line of conventional type mortgage loans for 1-4 family and multi-family residential real estate properties. It also originated second mortgages on residential real estate with home equity term loans and lines of credit. Effective December 31, 2008, ChoiceOne consolidated the operations of the Mortgage Company into the Bank and eliminated the mortgage company subsidiary. Together, the Bank, the Insurance Agency, and the former Mortgage Company account for substantially all of ChoiceOne’s assets, revenues and operating income. Use of Estimates To prepare financial statements in conformity with accounting principles generally accepted in the United States of America, ChoiceOne’s management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided. Actual results may differ from these estimates. Estimates associated with securities available for sale, the allowance for loan losses, other real estate owned, core deposit intangible assets, loan servicing rights, goodwill, and fair values of certain financial instruments are particularly susceptible to change. Cash and Cash Equivalents Cash and cash equivalents are defined to include cash on hand, demand deposits with other banks, and federal funds sold. Cash flows are reported on a net basis for customer loan and deposit transactions, deposits with other financial institutions, and short-term borrowings with original terms of 90 days or less. Securities Securities are classified as available for sale because they might be sold before maturity. Securities classified as available for sale are carried at fair value, with unrealized holding gains and losses reported separately in the accumulated other comprehensive income or loss section of shareholders’ equity, net of tax effect. Restricted investments in Federal Reserve Bank stock and Federal Home Loan Bank stock are carried at cost. Equity securities consist of investments in preferred stock, trust-preferred securities, and investments in common stock of other financial institutions. Interest income includes amortization of purchase premium or discount. Premiums and discounts on securities are amortized using the level-yield method without anticipating prepayments. Gains or losses on sales are recorded on the trade date based on the amortized cost of the security sold. Declines in the fair value of securities below their cost that are other than temporary are reflected as recognized losses. In estimating other than temporary losses, management considers: the length of time and extent that fair value has been less than cost, the financial condition and near-term prospects of the issuer, and ChoiceOne’s ability and intent to hold the security for a period sufficient to allow for any anticipated recovery in fair value. 24 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Loans Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of unearned interest, deferred loan fees and costs, and an allowance for loan losses. Loans held for sale are reported at the lower of cost or market, on an aggregate basis. Interest income on loans is reported on the interest method and includes amortization of net deferred loan fees and costs over the estimated loan term. Interest on loans is accrued based upon the principal balance outstanding. The accrual of interest is discontinued at the time at which commercial loans are 90 days past due unless the loan is secured by sufficient collateral and in the process of collection. Interest on consumer or real estate secured loans is discontinued at the time at which the loan is 120 days past due unless the credit is secured by sufficient collateral and in the process of collection. Past due status is based on the contractual terms of the loan. In all cases, loans are placed into nonaccrual status or charged off at an earlier date if collection of principal or interest is considered doubtful. Interest accrued but not received is reversed against interest income when the loans are placed into nonaccrual status. Interest received on such loans is applied to principal until qualifying for return to accrual. Loans are returned to accrual basis when all the principal and interest amounts contractually due are brought current and future payment is reasonably assured. Allowance for Loan Losses The allowance for loan losses is a valuation allowance for probable incurred credit losses. The allowance is increased by the provision for loan losses and decreased by loans charged off less any recoveries of charged off loans. Management estimates the allowance balance required based on past loan loss experience, the nature and volume of the loan portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. Loan losses are charged against the allowance when management believes the collectibility of a loan balance is not possible. The allowance consists of general and specific components. The general component covers non-classified loans and is based on historical loss experience adjusted for current factors. The specific component relates to loans that are individually classified as impaired or loans otherwise classified as substandard or doubtful. A loan is impaired when full payment under the loan terms is not expected. Commercial loans are evaluated for impairment on an individual loan basis. If a loan is considered impaired, a portion of the allowance for loan losses is allocated to the loan so that it is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Large groups of smaller balance homogeneous loans such as consumer and real estate mortgage loans are collectively evaluated for impairment, and accordingly, they are not separately identified for impairment disclosures. Premises and Equipment Premises and equipment are stated at cost less accumulated depreciation. Land is carried at cost. Land improvements are depreciated using the straight-line method with useful lives ranging from 7 to 15 years. Building and related components are depreciated using the straight-line method with useful lives ranging from 5 to 39 years. Leasehold improvements are depreciated over the shorter of the estimated life or the lease term. Furniture and equipment are depreciated using the straight-line method with useful lives ranging from 3 to 7 years. Fixed assets are periodically reviewed for impairment when events indicate their carrying amounts may not be recoverable from future undiscounted cash flows. If impaired, the assets are recorded at fair value. Other Real Estate Owned Real estate properties acquired in the collection of a loan are initially recorded at fair value at acquisition establishing a new cost basis. Any reduction to fair value from the carrying value of the related loan is accounted for as a loan loss. After acquisition, a valuation allowance reduces the reported amount to the lower of the initial amount or fair value less costs to sell. Expenses to repair or maintain properties are included within other noninterest expenses. Gains and losses upon disposition and changes in the valuation allowance are reported net within other noninterest income. Loan Servicing Rights Servicing rights represent the allocated value of servicing rights on loans sold with servicing retained. Servicing rights are expensed in proportion to, and over the period of, estimated net servicing revenues. Impairment is evaluated based on the fair value of the rights, using groupings of the underlying loans as to interest rates and then, secondarily, as to geographic and prepayment characteristics. Fair value is determined using prices for similar assets with similar characteristics when available or based upon discounted cashflows using market-based assumptions. Any impairment of a grouping is reported as a valuation allowance. 25 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Goodwill Goodwill results from business acquisitions and represents the excess of the purchase price over the fair value of the acquired tangible assets and liabilities and identifiable intangible assets. Goodwill is assessed at least annually for impairment and any such impairment will be recognized in the period identified. Loan Commitments and Related Financial Instruments Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and commercial letters of credit issued to meet financing needs of customers. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded. Employee Benefit Plans ChoiceOne’s 401(k) plan allows participants to contribute up to the IRS maximum. Contributions from ChoiceOne to its 401(k) plan are discretionary. ChoiceOne also allows retired employees to participate in its health insurance plan. Employees who have attained age 55 and completed at least ten years of service to ChoiceOne are eligible to participate as a retiree until they are eligible for Medicare. These postretirement benefits are accrued during the years in which the employee provides service. Employee Stock Ownership Plan The cost of shares issued to the Employee Stock Ownership Plan (the "ESOP") but not yet allocated to participants is presented as a reduction of shareholders’ equity. Compensation expense is recorded based on the market price of the shares as they are committed to be released for allocation to participant accounts. The difference between the market price and the cost of shares committed to be released is recorded as an adjustment to additional paid-in capital. Dividends on allocated ESOP shares are recorded as a reduction of retained earnings while dividends on unallocated ESOP shares are reflected as a reduction of debt and accrued interest. Upon distribution of shares to a participant, the participant has the right to require the Company to purchase his or her shares at fair value in accordance with the terms and conditions of the ESOP. As such, these shares are not classified in shareholders’ equity as permanent equity. Income Taxes Income tax expense is the sum of the current year income tax due and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax consequences of temporary differences between the carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized. Earnings Per Share Basic earnings per common share ("EPS") is based on weighted-average common shares outstanding. The weighted-average number of shares used in the computation of basic and diluted EPS includes shares allocated to the ESOP. Diluted EPS further assumes issue of any dilutive potential common shares issuable under stock options. Earnings and dividends per share are restated for stock dividends and splits through the issue date of the financial statements. Comprehensive Income Comprehensive income consists of net income and other comprehensive income or loss. Other comprehensive income or loss includes unrealized gains and losses on securities available for sale, net of tax, and changes in the funded status of postretirement plans which are also recognized as a separate component of shareholders’ equity. Loss Contingencies Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe that there are any such matters that may have a material effect on the financial statements. Cash Restrictions Cash on hand or on deposit with the Federal Reserve Bank of $83,000 and $221,000 was required to meet regulatory reserve and clearing requirements at December 31, 2010 and 2009, respectively. The balance in excess of the amount required was interest- bearing as of December 31, 2010 and December 31, 2009. Stock-Based Compensation ChoiceOne records stock-based compensation cost using the fair value method. Compensation costs related to stock options granted is disclosed in Note 14. 26 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Dividend Restrictions Banking regulations require the maintenance of certain capital levels and may limit the amount of dividends that may be paid by the Bank to ChoiceOne (see Note 21). Fair Value of Financial Instruments Fair values of financial instruments are estimated using relevant market information and other assumptions, which are more fully documented in Note 18 to the consolidated financial statements. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates. Operating Segments While ChoiceOne’s management monitors the revenue streams of various products and services for the Bank and Insurance Agency, operations and financial performance are evaluated on a company-wide basis. Accordingly, all of the financial service operations are considered by management to be aggregated into one reportable operating segment. Recent Accounting Pronouncements In January 2010, the Financial Accounting Standards Board ("FASB") issued ASU No. 2010-06 "Fair Value Measurements and Disclosures (Topic 820) - Improving Disclosures about Fair Value Measurements." ASU 2010-06 amends the fair value disclosure guidance. The amendments include new disclosures and changes to clarify existing disclosure requirements. ASU 2010-06 was effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements of Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. The impact of ASU 2010-06 on ChoiceOne’s disclosures is reflected in Note 19 of the consolidated financial statements. In July 2010, the FASB issued ASU No. 2010-20 "Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses." ASU 2010-20 requires expansion of the disclosure about the credit quality of ChoiceOne’s loans and the related reserves against them. The additional disclosures will include details on past due loans and credit quality indicators. For public entities, ASU 2010-20 disclosures of period-end balances are effective for interim and annual reporting periods ending on or after December 15, 2010 and are included in Note 3 of the consolidated financial statements. Disclosures related to activity that occurs during the reporting period are required for interim and annual reporting periods beginning on or after December 15, 2010. Reclassifications Certain amounts presented in prior year consolidated financial statements have been reclassified to conform to the current year’s presentation. Note 2 – Securities The fair value of securities available for sale and the related gross unrealized gains and losses recognized in accumulated other comprehensive income (loss) at December 31 were as follows: (Dollars in thousands) 2010 Gross Unrealized Gains Gross Unrealized Losses Amortized Cost U.S. Government and federal agency ..................................... $ State and municipal................................................................. Mortgage-backed .................................................................... Corporate ................................................................................ FDIC-guaranteed financial institution debt............................. Equity securities...................................................................... Total .................................................................................. $ 28,737 47,319 7,307 2,854 2,020 1,500 89,737 $ $ 382 935 298 36 33 — 1,684 $ $ (53) $ (373) (6) (7) — (162) (601) $ Fair Value 29,066 47,881 7,599 2,883 2,053 1,338 90,820 27 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands) 2009 Gross Unrealized Gains Gross Unrealized Losses Amortized Cost U.S. Government and federal agency ..................................... $ State and municipal................................................................. Mortgage-backed .................................................................... Equity securities...................................................................... Total .................................................................................. $ 18,550 44,230 8,672 2,069 73,521 $ $ 108 699 285 385 1,477 $ $ (87) $ (330) (28) (140) (585) $ Fair Value 18,571 44,599 8,929 2,314 74,413 Information regarding sales of securities available for sale follows: (Dollars in thousands) Proceeds from sales of securities ................................ Gross realized gains................................................................ Gross realized losses................................................................3 Loss on other than temporary impairment ................................ 94 $ $ 2010 6,059 540 $ 2009 8,171 414 12 47 2008 2,540 39 440 432 Contractual maturities of securities available for sale at December 31, 2010 were as follows: (Dollars in thousands) Fair Value Due within one year ................................................................................................$ 15,389 46,697 Due after one year through five years ............................................................................................ Due after five years through ten years ........................................................................................... 18,337 1,460 Due after ten years ................................................................................................ 81,883 Total debt securities................................................................................................ 7,599 Mortgage-backed securities, not due at a specific date................................................................ Equity securities............................................................................................................................. 1,338 90,820 Total ................................................................................................................................ $ Various securities were pledged as collateral for securities sold under agreements to repurchase and for Treasury, Tax, and Loan accounts. The carrying amount of securities pledged as collateral at December 31 was as follows: (Dollars in thousands) Securities pledged for securities sold under agreements to repurchase ......................................... Securities pledged for Treasury, Tax, and Loan accounts ............................................................. Total securities pledged as collateral ........................................................................................ $ $ 2010 27,509 – 27,509 $ $ 2009 24,800 521 25,321 Securities with unrealized losses at year-end 2010 and 2009, aggregated by investment category and length of time the individual securities have been in a continuous unrealized loss position, were as follows: (Dollars in thousands) Less than 12 months Fair Value Unrealized Losses 2010 More than 12 months Fair Value Unrealized Losses Total Fair Value Unrealized Losses $ U.S. Government and federal 4,663 agency................................................................ State and municipal................................11,341 Mortgage-backed ................................ 938 Corporate ................................................................ 540 Equity securities................................ – Total temporarily impaired ................................ $ 17,482 $ $ ) $ (53 (297) (6) (7) – (363) $ 28 – 1,460 – – 838 2,298 $ $ – (76) – – (162) (238) $ $ 4,663 12,801 938 540 838 19,780 $ $ ) (53 (373) (6) (7) (162) (601) ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands) Less than 12 months Fair Value Unrealized Losses 2009 More than 12 months Fair Value Unrealized Losses Total Fair Value Unrealized Losses U.S. Government and federal agency................................................................ 8,033 State and municipal................................ 9,211 1,465 Mortgage-backed ................................ Equity securities................................ – $ Total temporarily impaired ................................ 18,709 $ $ $ ) $ (87 (244) (28) – (359) $ – 1,771 – 860 2,631 $ $ – (86) – (140) (226) $ $ 8,033 10,982 1,465 860 21,340 $ $ (87 ) (330) (28) (140) (585) One municipal security with a fair value of $306,000 was considered to be other than temporarily impaired as of December 31, 2010. The issuer of the security defaulted upon its maturity of September 1, 2009. Impairment losses of $141,000 have been recorded through December 2010 due to uncertainty as to when principal repayment will be received. In the case of the remaining state and municipal securities, ChoiceOne does not intend to sell the securities prior to a recovery in their value nor is it likely that ChoiceOne would be forced to sell them. Equity securities included a Money Market Preferred auction rate security (MMP) with a fair value of $838,000 as of December 31, 2010. Auctions remain active for the MMP and interest payments have remained current. An impairment loss of $432,000 was recorded in December 2008 when a decline in the market value of an MMP was considered to be other than temporary. The MMP was converted to 40,000 shares of preferred stock in January 2009 when auction activity ceased and the collateral supporting the MMP was unwound. A gain of $32,000 was recognized upon the conversion. Subsequent to the conversion, ChoiceOne sold 15,000 shares in 2009 for a gain of $92,000 and 25,000 shares in 2010 for a gain of $204,000. ChoiceOne evaluates all securities on a quarterly basis for other than temporary impairment. Consideration is given to the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability of ChoiceOne to retain its investment in the issue for a period of time sufficient to allow for any anticipated recovery in fair value. Except for the impairments described in the previous paragraphs, no other than temporary impairments were recorded in 2010 or 2009. Note 3 – Loans and Allowance for Loan Losses The Bank’s loan portfolio as of December 31 was as follows: (Dollars in thousands) Agricultural........................................................................................................................... $ Commercial and industrial.................................................................................................... Consumer.............................................................................................................................. Real estate – commercial ...................................................................................................... Real estate - construction...................................................................................................... Real estate - residential......................................................................................................... Loans, gross .................................................................................................................... Allowance for loan losses ..................................................................................................... Loans, net ........................................................................................................................ $ 2010 29,681 55,947 16,709 116,351 853 97,399 316,940 (4,729) 312,211 Activity in the allowance for loan losses was as follows: (Dollars in thousands) Balance, beginning of year .......................................................................... $ Provision charged to expense ...................................................................... Recoveries credited to the allowance........................................................... Loans charged off ........................................................................................ Balance, end of year .................................................................................... $ 2010 4,322 3,950 341 (3,884) 4,729 $ $ 2009 3,600 4,875 541 (4,694) 4,322 2009 31,322 53,964 16,285 121,100 1,158 98,887 322,716 (4,322) 318,394 2008 3,600 3,475 353 (3,828) 3,600 $ $ $ $ 29 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ChoiceOne manages its credit risk through the use of its loan policy and its loan approval process and by monitoring of loan credit performance. The loan approval process for commercial loans involves individual and group approval authorities. Individual authority levels are based on the experience of the lender. Group authority approval levels can consist of an internal loan committee that includes the Bank’s President or Senior Lender and other loan officers for loans that exceed individual approval levels, or a loan committee of the Board of Directors for larger commercial loans. Most consumer loans are approved by individual loan officers based on standardized underwriting criteria, with larger consumer loans subject to approval by the internal loan committee. Ongoing credit review of commercial loans is the responsibility of the loan officers. ChoiceOne’s internal credit committee meets at least monthly and reviews loans with payment issues and loans with a risk rating of 5, 6, or 7. Risk ratings of commercial loans are reviewed periodically and adjusted if needed. ChoiceOne’s consumer loan portfolio is primarily monitored on an exception basis. Loans where payments are past due are turned over to the Bank’s collection department, who works with the borrower to bring payments current or takes other actions when necessary. In addition to internal reviews of credit performance, ChoiceOne contracts with a third party for independent loan review that monitors the loan approval process and the credit quality of the loan portfolio. Activity in the allowance for loan losses and balances in the loan portfolio were as follows: (Dollars in thousands) Commercial Agricultural and Industrial Consumer Commercial Real Estate Construction Real Estate Residential Real Estate Unallocated Total 2010 Allowance for Loan Losses Beginning balance ............... $ Charge-offs .......................... Recoveries ........................... Provision ............................. Ending balance .................... $ Individually evaluated for impairment......................... $ Collectively evaluated for impairment......................... $ 124 – – 57 181 – 181 Loans Individually evaluated for impairment......................... $ Collectively evaluated for impairment......................... Ending balance .................... $ 39 29,642 29,681 2009 Allowance for Loan Losses Beginning balance ............... $ Charge-offs .......................... Recoveries ........................... Provision ............................. Ending balance .................... $ Individually evaluated for impairment......................... $ Collectively evaluated for impairment......................... $ – – – 124 124 29 95 $ $ $ $ $ $ $ $ $ $ 735 (765) 68 603 641 – 641 $ $ $ $ 306 (444) 230 151 243 – 243 272 $ – 55,675 55,947 16,709 $ 16,709 754 (1,558) 102 1,437 735 52 683 $ $ $ $ 351 (535) 246 244 306 – 306 1,546 (1,523) 16 1,690 1,729 582 1,147 3,529 112,822 116,351 1,100 (1,218) 58 1,606 1,546 1,031 515 $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 30 3 – – (1) 2 – 2 – 853 853 5 (14) 29 (17) 3 – 3 $ $ $ $ $ $ $ $ $ $ 1,590 (1,152) 27 1,089 1,554 – 1,554 2,733 94,666 97,399 1,124 (1,369) 106 1,729 1,590 – 1,590 $ $ $ $ $ $ $ $ 18 – – 361 379 – 379 $ $ $ $ 4,322 (3,884) 341 3,950 4,729 582 4,147 $ 6,573 310,367 $ 316,940 266 – – (248) 18 – 18 $ $ $ $ 3,600 (4,694) 541 4,875 4,322 1,112 3,210 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Commercial Agricultural and Industrial Consumer Commercial Real Estate Construction Real Estate Residential Real Estate Unallocated Total Loans Individually evaluated for impairment......................... $ Collectively evaluated for impairment......................... Ending balance .................... $ 378 30,944 31,322 2008 Allowance for Loan Losses Beginning balance ............... $ Charge-offs .......................... Recoveries ........................... Provision ............................. Ending balance .................... $ Individually evaluated for impairment......................... $ Collectively evaluated for impairment......................... $ Loans Individually evaluated for impairment......................... $ Collectively evaluated for impairment......................... Ending balance .................... $ – – – – – – – – 23,408 23,408 $ $ $ $ $ $ $ $ 698 $ – 53,266 53,964 16,285 $ 16,285 1,211 (1,193) 60 676 754 75 679 $ $ $ $ 489 (568) 252 178 351 – 351 273 $ – 57,314 57,587 16,047 $ 16,047 $ $ $ $ $ $ $ $ 6,886 114,214 121,100 945 (815) 35 935 1,100 470 630 1,845 122,107 123,952 $ $ $ $ $ $ $ $ – 1,158 1,158 – – – 5 5 – 5 $ $ $ $ $ $ 1,785 97,102 98,887 891 (1,252) $ 6 1,479 1,124 – 1,124 $ $ $ $ 9,747 312,969 $ 322,716 64 – – 202 266 – 266 $ $ $ $ 3,600 (3,828) 353 3,475 3,600 545 3,055 – $ – 2,026 2,026 102,957 $ 102,957 $ 2,118 323,859 $ 325,977 The process to monitor the credit quality of ChoiceOne’s loan portfolio includes tracking (1) the risk ratings of business loans, (2) the level of classified business loans, and (3) delinquent and nonperforming consumer loans. Business loans are risk rated on a scale of 1 to 8. A description of the characteristics of the ratings follows: Risk rating 1 through 3: These loans are considered pass credits. They exhibit acceptable to exceptional credit risk and demonstrate the ability to repay the loan from normal business operations. Risk rating 4: These loans are considered watch credits. They have potential developing weaknesses that, if not corrected, may cause deterioration in the ability of the borrower to repay the loan. While a loss is possible for a loan with this rating, it is not anticipated. Risk rating 5: These loans are considered special mention credits. Loans in this risk rating are considered to be inadequately protected by the net worth and debt service coverage of the borrower or of any pledged collateral. These loans have well defined weaknesses that may jeopardize the borrower’s ability to repay the loan. If the weaknesses are not corrected, loss of principal and interest could be probable. Risk rating 6: These loans are considered substandard credits. These loans have well defined weaknesses, the severity of which makes collection of principal and interest in full questionable. Loans in this category may be placed on nonaccrual status. Risk rating 7: These loans are considered doubtful credits. Some loss of principal and interest has been determined to be probable. The estimate of the amount of loss could be affected by factors such as the borrower’s ability to provide additional capital or collateral. Loans in this category are on nonaccrual status. Risk rating 8: These loans are considered loss credits. They are considered uncollectible and will be charged off against the allowance for loan losses. 31 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Information regarding the Bank’s credit exposure as of December was as follows: (Dollars in thousands) Corporate Credit Exposure - Credit Risk Profile By Creditworthiness Category Risk rating 2.................................... $ Risk rating 3.................................... Risk rating 4.................................... Risk rating 5.................................... Risk rating 6.................................... Risk rating 7.................................... $ $ Agricultural 2010 1,901 17,592 8,919 1,017 213 39 29,681 2009 2,248 21,112 7,417 – 488 57 $ 31,322 $ $ Commercial and Industrial 2009 3,438 28,342 17,650 3,780 328 426 53,964 2010 2,818 29,806 20,198 2,703 251 171 55,947 $ $ Consumer Credit Exposure - Credit Risk Profile Based On Payment Activity Performing ...................................... $ Nonperforming................................ $ Consumer 2010 16,519 190 16,709 2009 $ 16,267 18 $ 16,285 Construction Real Estate 2009 1,158 – 1,158 2010 853 – 853 $ $ $ $ Commercial Real Estate $ 2010 6,755 57,265 31,921 14,069 5,412 929 $ 116,351 2009 6,066 56,402 38,597 9,600 5,451 4,984 121,100 $ $ Residential Real Estate 2010 92,885 4,514 97,399 $ $ $ $ 2009 93,177 5,710 98,887 Loans are classified as performing when they are current as to principal and interest payments or are past due on payments less than 90 days. Loans are classified as nonperforming when they are past due 90 days or more as to principal and interest payments or are considered a troubled debt restructuring. 32 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Impaired loans by loan category as of December 31 follow: (Dollars in thousands) Recorded Investment Unpaid Principal Balance Related Allowance Average Recorded Investment Interest Income Recognized 2010 With no related allowance recorded Agricultural .............................................. $ Commercial and industrial ........................ Commercial real estate.............................. Residential real estate................................ With an allowance recorded......................... Agricultural ............................................... Commercial and industrial ........................ Commercial real estate.............................. Residential real estate................................ Total............................................................. Agricultural ............................................... Commercial and industrial ........................ Commercial real estate.............................. Residential real estate................................ 2009 With no related allowance recorded Agricultural ............................................... $ Commercial and industrial ........................ Commercial real estate.............................. Residential real estate................................ With an allowance recorded......................... Agricultural ............................................... Commercial and industrial ........................ Commercial real estate.............................. Residential real estate................................ Total............................................................. Agricultural ............................................... Commercial and industrial ........................ Commercial real estate.............................. Residential real estate................................ 39 222 1,914 2,733 – 50 1,615 – 39 272 3,529 2,733 321 535 2,287 1,785 57 163 4,599 – 378 698 6,886 1,785 $ $ $ $ $ $ 44 229 2,385 2,736 – 50 1,672 – 44 279 4,057 2,736 321 1,304 2,549 1,785 58 163 4,637 – 379 1,467 7,186 1,785 – – – – – 50 531 – – 50 531 – – – – – 28 82 986 – 28 82 986 – $ $ 165 211 1,951 2,640 65 464 3,591 – 230 675 5,542 2,640 174 550 3,728 357 48 191 3,200 – 222 741 6,928 357 – (5) (2) 170 – 12 (3) – – 7 (5) 170 1 21 67 20 – 6 (17) – 1 27 50 20 An aging analysis of loans by loan category as of December 31 follows: (Dollars in thousands) 30 to 59 Days 60 to 89 Days 2010 Agricultural ..................................... Commercial and industrial .............. Consumer ........................................ Commercial real estate.................... Construction real estate................... Residential real estate...................... $ 71 133 84 266 – 1,223 $ 1,777 $ 7 175 41 646 – 833 $ 1,702 (1) Includes nonaccrual loans. Greater Than 90 Days (1) $ $ 39 142 29 2,129 – 2,249 4,588 33 Total $ 117 450 154 3,041 – 4,305 $ 8,067 Loans Not Past Due $ 29,564 55,497 16,555 113,310 853 93,094 $ 308,873 Total Loans $ $ 29,681 55,947 16,709 116,351 853 97,399 316,940 90 Days Past Due and Accruing $ $ – – 23 – – – 23 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Nonaccrual loans by loan category as of December 31 follow: (Dollars in thousands) Agricultural ................................................................... $ Commercial and industrial ............................................ Consumer ...................................................................... Commercial real estate.................................................. Construction real estate................................................. Residential real estate.................................................... $ 2010 64 256 5 3,302 – 2,646 6,273 $ 2009 387 441 17 6,977 – 4,060 $ 11,882 Note 4 – Mortgage Banking Activity during the year was as follows: (Dollars in thousands) 2010 Loans originated for resale, net of principal payments ................................ 28,816 $ Proceeds from loan sales ................................................................ 28,088 Net gains on sales of loans held for sale ................................................................682 Loan servicing fees, net of amortization ................................................................41 $ $ 2009 27,598 27,983 601 4 2008 12,249 12,198 215 67 Loans serviced for others are not reported as assets in the accompanying consolidated balance sheets. The unpaid principal balances of these loans were $107 million and $117 million at December 31, 2010 and 2009, respectively. The Bank maintains custodial escrow balances in connection with these serviced loans; however, such escrows were immaterial at December 31, 2010 and 2009. Activity for loan servicing rights was as follows: (Dollars in thousands) 2010 Balance, beginning of year ................................................................................................ 491 $ 122 Capitalized................................................................................................ (266) Amortization................................................................................................ 347 $ Balance, end of year ................................................................................................ $ $ 2009 580 210 (299) 491 $ $ 2008 792 51 (263) 580 The fair value of loan servicing rights was $852,000 and $1,048,000 as of December 31, 2010 and 2009, respectively. Consequently, a valuation allowance was not necessary at year-end 2010 or 2009. The fair value of servicing rights at December 31, 2010 was determined using a discount rate of 7.7% and prepayment speeds ranging from 0% to 35%. The fair value of servicing rights at December 31, 2009 was determined using a discount rate of 7.6% and prepayment speeds ranging from 0% to 17%. Note 5 – Premises and Equipment As of December 31, premises and equipment consisted of the following: (Dollars in thousands) Land and land improvements................................................................................................ $ Leasehold improvements ...................................................................................................... Buildings............................................................................................................................... Furniture and equipment....................................................................................................... Total cost ......................................................................................................................... Accumulated depreciation .................................................................................................... Premises and equipment, net............................................................................................ $ 2010 4,025 36 10,950 4,178 19,189 (6,664) 12,525 $ $ 2009 3,918 37 10,595 3,312 17,862 (5,944) 11,918 Depreciation expense was $903,000, $974,000, and $844,000 for 2010, 2009 and 2008, respectively. 34 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The Bank leases certain branch properties and automated-teller machine locations in its normal course of business. Rent expense totaled $78,000, $71,000, and $70,000 for 2010, 2009 and 2008, respectively. Rent commitments under non-cancelable operating leases were as follows, before considering renewal options that generally are present (dollars in thousands): 2011 ................................................................................................ 2012 ................................................................................................ 2013 ................................................................................................ Total................................................................................................ 60 46 34 140 $ $ Note 6 - Goodwill and Intangible Assets Goodwill There were no changes in the goodwill balance in 2010 or 2009. ChoiceOne engaged an outside consulting firm to assist management in performing its annual evaluation of goodwill for impairment as of June 30, 2010. The appraisal methodology used to calculate the fair value included the income approach, which was a discounted cash flow value based on projected earnings capacity, and the market approach, which was based on price-to-earnings multiples, price-to-tangible book value ratios, and core deposit premiums for selected bank sale transactions. The results from the valuation approaches were used to calculate an estimate of the fair value of ChoiceOne’s equity, which was compared to the carrying value of equity to determine whether the Step 1 test under generally accepted accounting principles that govern the valuation of goodwill was passed. The goodwill analysis determined that the fair value of ChoiceOne’s equity exceeded the carrying value by 4.6%. Based on this assessment, management believed that there was no indication of goodwill impairment at June 30, 2010. Based on the testing performed and a review of factors that might impact ChoiceOne’s stock value subsequent to the annual evaluation, no impairment of goodwill was deemed to exist as of December 31, 2010. Acquired Intangible Assets Information for acquired intangible assets at December 31 follows: (Dollars in thousands) Gross Carrying Amount Core deposit intangible ................................................................ Other intangible assets ................................................................ Totals ................................................................................................ 4,134 348 4,482 $ $ 2010 2009 Accumulated Amortization 1,723 139 1,862 $ $ Gross Carrying Amount $ $ 4,134 473 4,607 Accumulated Amortization 1,309 230 1,539 $ $ The core deposit intangible is being amortized on a straight-line basis over ten years and other intangible assets are being amortized over periods ranging from two to ten years. Aggregate amortization expense was $448,000, $469,000 and $494,000 for 2010, 2009 and 2008, respectively. The estimated amortization expense for the next five years ending December 31 is as follows: (Dollars in thousands) Core Deposit Intangible 413 2011 ................................................................................................ 2012 ................................................................................................ 413 2013 ................................................................................................ 413 2014 ................................................................................................ 413 2015 ................................................................................................ 413 Thereafter................................................................................................345 2,410 Total................................................................................................ $ $ Other Intangible Assets 35 35 35 35 35 35 210 $ $ Total 448 448 448 448 448 380 2,620 $ $ 35 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 7 – Other Real Estate Owned Other real estate owned represents residential and commercial properties owned and is reported net of a valuation allowance. Activity within other real estate owned was as follows: (Dollars in thousands) 2010 Balance, beginning of year ................................................................ $ 2,201 Transfers from loans ................................................................................................1,358 Reclassification to buildings ................................................................ — Proceeds from sales ................................................................................................ (1,174) (Gains)/losses on sales................................................................................................96 Write-downs ................................................................................................ (528) 1,953 Balance, end of year ................................................................................................ $ $ $ 2009 3,692 3,489 (331) (4,200) (7) (442) 2,201 Activity in the valuation allowance on other real estate owned was as follows: (Dollars in thousands) Balance, beginning of year .......................................................................... $ Write-downs charged to expense ................................................................. Deletions from sales of other real estate owned........................................... Balance, end of year .................................................................................... $ 2010 438 528 (57) 909 $ $ 2009 206 442 (210) 438 Note 8 – Deposits Deposit balances as of December 31 consisted of the following: (Dollars in thousands) Noninterest-bearing demand deposits................................................................................... $ Interest-bearing demand deposits ......................................................................................... Money market deposits......................................................................................................... Savings deposits ................................................................................................................... Local certificates of deposit.................................................................................................. Brokered certificates of deposit ............................................................................................ Total deposits .................................................................................................................. $ Scheduled maturities of certificates of deposit at December 31 were as follows: (Dollars in thousands) 2010 66,932 59,853 59,021 43,572 152,602 7,904 389,884 2011 ................................................................................................................................. $ 2012 ................................................................................................................................. 2013 ................................................................................................................................. 2014 ................................................................................................................................. 2015 ................................................................................................................................. 2016 ................................................................................................................................. Total ........................................................................................................................... $ 101,768 41,245 9,613 2,710 5,054 116 160,506 2008 30 205 (29) 206 2009 60,802 43,731 58,094 36,791 159,217 6,375 365,010 $ $ $ $ The Bank had certificates of deposit issued in denominations of $100,000 or greater totaling $72.6 million and $68.4 million at December 31, 2010 and 2009, respectively. The Bank had brokered certificates of deposit totaling $7.9 million at December 31, 2010 compared to $6.4 million at December 31, 2009. As of December 31, 2010, the weighted average interest rate on these brokered certificates of deposit was 1.26% with maturities ranging from May 2011 to May 2013. In addition, the Bank had $18.5 million of certificates of deposit as of December 31, 2010 and $20.0 million as of December 31, 2009 that had been issued through the 36 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Certificate of Deposit Account Registry Service (CDARS). Although certificates of deposit issued through CDARS are issued to local customers, this type of deposit is classified as brokered deposits for regulatory purposes. Note 9 – Repurchase Agreements Securities sold under agreements to repurchase are advances to the Bank by customers or another bank. These agreements are direct obligations of the Bank and are secured by securities held in safekeeping at a correspondent bank. Most repurchase agreements with Bank customers mature daily. As of December 31, 2010, the Bank had a $5 million structured repurchase agreement with a correspondent bank maturing on July 31, 2012 with a fixed interest rate of 4.55%. The repurchase agreement became putable by the correspondent quarterly starting July 1, 2009. Information regarding repurchase agreements follows: (Dollars in thousands) Outstanding balance at December 31 ................................$ Average interest rate at December 31 ................................ 1.33% Average balance during the year................................................................ $ Average interest rate during the year ................................ 1.58% Maximum month end balance during the year ................................ $ 19,269 22,249 2010 22,249 2009 20,684 1.64% 18,419 1.88% 20,684 $ $ $ Note 10 – Federal Home Loan Bank Advances At December 31, advances from the Federal Home Loan Bank (the “FHLB”) were as follows: (Dollars in thousands) 2010 2009 Maturities ranging from January 2011 to November 2024, fixed interest rates ranging from 2.54% to 4.16%, with an average rate of 3.58% ................................$ 8,473 Maturities ranging from January 2010 to November 2024, fixed interest rates ranging from 3.98% to 5.95%, with an average rate of 4.55% ................................ Total advances outstanding at year-end ................................$ 8,473 $ $ 21,980 21,980 Penalties are charged on fixed rate advances that are paid prior to maturity. No fixed rate advances were paid prior to maturity in 2010, 2009 or 2008. An advance maturing in 2012 may be converted to a variable rate by the FHLB. If the FHLB exercises its option, the Bank may prepay the advance without penalty. Advances were secured by residential real estate loans with a carrying value of approximately $66 million at December 31, 2010 and by residential real estate loans with a carrying value of approximately $83 million at December 31, 2009. Based on this collateral, the Bank was eligible to borrow an additional $35 million at year-end 2010. The scheduled maturities of advances from the FHLB at December 31, 2010 were as follows (dollars in thousands): 2011 ................................................................................................ 26 2012 ................................................................................................5,027 2013 ................................................................................................3,028 2014 ................................................................................................ 29 2015 ................................................................................................ 31 Thereafter................................................................................................332 8,473 Total................................................................................................ $ $ 37 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 11 – Income Taxes Information as of December 31 and for the year follows: (Dollars in thousands) 2010 2009 Provision for Income Taxes Current federal income tax expense................................................................$ 817 Deferred federal income tax benefit ................................................................ (163) Income tax expense/(benefit)........................................................................................... 654 $ Reconciliation of Income Tax Provision to Statutory Rate 1,144 Income tax computed at statutory federal rate of 34%................................ $ Tax exempt interest income ................................................................................................ (483 ) (122 ) Tax exempt earnings on bank-owned life insurance ............................................................. 25 Nondeductible interest expense ............................................................................................ Other items ........................................................................................................................... 90 654 Income tax expense/(benefit)........................................................................................... $ 2010 $ $ $ $ $ 215 (410) (195) $ 2009 436 (608) (124) 44 57 (195) $ $ 2008 437 (644) (207) 2008 418 (644) (126) 72 73 (207) 19 % Effective income tax rate ................................................................................................ (15)% (17)% Components of Deferred Tax Assets and Liabilities Deferred tax assets: Allowance for loan losses ................................................................................................... $ Deferred compensation....................................................................................................... Write-downs on other real estate owned............................................................................. Alternative minimum tax credit carryforward..................................................................... Nonaccrual loan interest ..................................................................................................... Purchase accounting adjustments from merger with VRFC................................................ Other ................................................................................................................................... Total deferred tax assets ................................................................................................ Deferred tax liabilities: Depreciation ....................................................................................................................... Purchase accounting adjustments from merger with VRFC................................................ Unrealized gains on securities available for sale ................................................................ Loan servicing rights .......................................................................................................... Postretirement benefits obligation ....................................................................................... Other ................................................................................................................................... Total deferred tax liabilities........................................................................................... Net deferred tax liabilities ............................................................................................. $ $ 2010 773 377 309 154 124 83 259 2,079 1,142 883 369 118 95 116 2,723 (644) $ 2009 1,214 426 113 399 154 184 300 2,790 1,132 1,057 303 140 64 201 2,897 (107) ChoiceOne had a deferred tax asset of $69,000 as of December 31, 2010 that resulted from capital losses incurred on the sales of equity securities in 2009 and 2010. A capital loss of $72,000 can be carried back to 2007, which will utilize $24,000 of the deferred tax asset. A valuation allowance of $45,000 has been recorded for the remaining balance due to the uncertainty as to ChoiceOne’s ability to generate capital gains in the future that can offset the capital loss carryforward. ChoiceOne also had a $42,000 deferred tax asset as of December 31, 2010 that was related to unexercised stock options. A valuation allowance for the entire balance has been recorded due to the fact that the exercise price of all of the options was higher than the market price of ChoiceOne’s stock as of the end of 2010. The valuation allowance totaling $87,000 has been netted in the total deferred tax assets listed above. There was no valuation allowance related to deferred taxes as of December 31, 2009. 38 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 12 – Related Party Transactions Loans to executive officers, directors and their affiliates were as follows at December 31: (Dollars in thousands) Balance, beginning of year ................................................................................................... $ New loans ............................................................................................................................. Repayments........................................................................................................................... Balance, end of year ............................................................................................................. $ 2010 5,786 2,152 (1,370) 6,568 $ $ 2009 6,266 574 (1,054) 5,786 Deposits from executive officers, directors and their affiliates were $13.5 million and $11.1 million at December 31, 2010 and 2009, respectively. Note 13 – Employee Benefit Plans 401(k) Plan: The 401(k) plan allows employees to contribute up to the IRS maximum. Matching company contributions to the plan are discretionary. Expense of this plan was $112,000, $0, and $141,000 in 2010, 2009, and 2008, respectively. Employee Stock Ownership Plan: Employees participate in an Employee Stock Ownership Plan (the "ESOP"). ChoiceOne makes discretionary contributions to the ESOP. Shares of ChoiceOne common stock are allocated to participants based on relative compensation earned and compensation expense is recorded when allocated. Dividends on allocated shares increase the participant accounts. Participants become fully vested upon completing six years of qualifying service. Participants receive the shares at the end of employment. A participant may require stock received to be repurchased by ChoiceOne at any time. ChoiceOne did not contribute to the ESOP nor was any expense recorded in 2010, 2009, or 2008. Shares held by the ESOP as of December 31 were as follows: (Dollars in thousands) Shares allocated to participants ........................................................................ Shares unallocated ........................................................................................... Total shares of ChoiceOne stock held by ESOP............................................... 2010 5,355 – 5,355 2009 5,355 – 5,355 2008 5,355 – 5,355 Fair value of allocated shares, subject to repurchase obligation, recorded in other liabilities ............................................................................ $ 64 $ 48 $ 44 Postretirement Benefits Plan: ChoiceOne maintains an unfunded postretirement health care plan, which permits employees (and their dependents) the ability to participate upon retirement from ChoiceOne. ChoiceOne does not pay any portion of the health care premiums charged to its retired participants. A liability has been accrued for the obligation under this plan. ChoiceOne incurred negative postretirement benefit expense of $15,000 in 2010, $17,000 in 2009, and $6,000 in 2008. The postretirement obligation liability was $119,000 as of December 31, 2010 and $113,000 as of December 31, 2009. Deferred Compensation Plans: A deferred director compensation plan covers former directors of Valley Ridge Bank. Under the plan, ChoiceOne pays each former director the amount of director fees deferred plus interest at rates ranging from 0.90% to 5.84% over various periods as elected by each director. The payout periods range from 1 month to 10 years beginning with the individual’s termination of service. A liability has been accrued for the obligation under this plan. ChoiceOne incurred deferred compensation plan expense of $20,000, $28,000, and $49,000 in 2010, 2009, and 2008, respectively. The deferred compensation liability was $357,000 as of December 31, 2010 and $476,000 as of December 31, 2009. 39 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A supplemental retirement plan covers four former executive officers of Valley Ridge Bank. Under the plan, ChoiceOne pays these individuals a specific amount of compensation plus interest at 7.50% over a 15-year period commencing upon early retirement age (as defined in the plan) or normal retirement age (as defined in the plan). A liability has been accrued for the obligation under this plan. ChoiceOne incurred deferred compensation plan expense of $41,000 in 2010, $76,000 in 2009, and $104,000 in 2008. Deferred compensation liabilities of $751,000 and $778,000 were outstanding as of December 31, 2010 and December 31, 2009, respectively. Note 14 - Stock Options Options to buy stock are granted to key employees under an incentive stock option plan to provide them with an additional equity interest in ChoiceOne. The plan provides for the issuance of up to 147,767 shares of common stock. ChoiceOne recognized compensation expense of $15,000 in 2010, $22,000 in 2009, and $33,000 in 2008 in connection with stock options that vested for current participants during these years. The maximum option term is 10 years and options vest over 3 years. At December 31, 2010, there were 98,535 options available for future grants. A summary of the activity in the plan follows: Options outstanding, beginning of year ................................ 49,232 Options granted................................................................– Options exercised ................................................................ Options forfeited or expired................................ Options outstanding, end of year ................................ – – 49,232 $16.46 – – – $16.46 49,232 – – – 49,232 2010 Weighted average exercise price Shares Shares 2009 2008 Weighted average exercise price $16.46 – – – $16.46 Weighted average exercise price $17.36 13.50 – – $16.46 Shares 37,732 11,500 – – 49,232 Options exercisable at December 31 ................................ 46,357 $16.64 41,107 $16.78 34,357 $16.89 The range of prices for options outstanding and exercisable at the end of 2010 ranged from $13.04 to $21.43 per share. The weighted average remaining contractual life of options outstanding and exercisable at the end of 2010 was approximately 4.5 years. The exercise price of all options outstanding was higher than ChoiceOne’s closing stock price as of the end of 2010. As a result, the aggregate intrinsic value of both options outstanding and options exercisable was $0 as of December 31, 2010. The number of options, weighted average exercise prices, and fair value of options granted has been adjusted for all stock dividends and splits. Information pertaining to options outstanding at December 31, 2010 is as follows: Number of options outstanding at year-end Exercise price of stock options: $ 13.04 ................................................................ 3,857 $ 13.50 ................................................................11,500 $ 13.70 ................................................................ 5,250 $ 16.31 ................................................................ 6,299 $ 17.95 ................................................................ 9,500 $ 18.85 ................................................................ 6,000 $ 21.43 ................................................................ 6,826 Number of options exercisable at year-end Average remaining contractual life (in years) 3,857 8,625 5,250 6,299 9,500 6,000 6,826 1.14 7.07 2.04 3.06 6.05 5.05 4.05 The fair value of each option award is estimated on the date of grant using a Black-Scholes option valuation model that uses the weighted average assumptions noted in the following table. ChoiceOne uses historical data to estimate the volatility of the option exercise price and employee terminations within the valuation model. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. No options were granted in 2010 or 2009. Information regarding options granted in 2008 is as follows: 40 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2008 21.96% Expected stock price volatility................................................................ Dividend yield................................................................ 4.41% Expected option life (in years) ................................................................7 Risk-free interest rate................................................................ Fair value of options granted during year ................................ 3.02% 1.91 $ During 2010, shares totaling 5,250 were vested at an average exercise price of $15.51. As of December 31, 2010, there was approximately $5,000 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the plan. That cost is expected to be recognized by ChoiceOne in 2011. Note 15 - Earnings Per Share (Dollars in thousands, except per share data) Basic Net income..................................................................................................... $ 2010 2009 2008 2,711 $ 1,478 $ 1,435 Weighted average common shares outstanding ............................................. 3,273,151 3,255,984 3,236,984 Basic earnings per common share.................................................................. $ 0.83 Diluted Net income..................................................................................................... $ 2,711 $ $ 0.45 1,478 $ $ 0.44 1,435 Weighted average common shares outstanding ............................................. Plus: dilutive effect of assumed exercises of stock options ........................... Average shares and dilutive potential common shares................................... 3,273,151 – 3,273,151 3,255,984 – 3,255,984 3,236,984 – 3,236,984 Diluted earnings per common share............................................................... $ 0.83 $ 0.45 $ 0.44 There were 49,232 stock options as of December 31, 2010 and December 31, 2009 considered to be anti-dilutive to earnings per share and thus have been excluded from the calculations above. Note 16 - Other Comprehensive Income (Loss) Other comprehensive income (loss) components and related taxes follow: (Dollars in thousands) Unrealized holding gains (losses) on available for sale securities ................. $ Less reclassification adjustments for gains (losses) included in net income .. Net unrealized gains (losses) ......................................................................... Less tax effect ................................................................................................ Net-of-tax amount....................................................................................... Change in funded status of postretirement benefit plan ................................. Tax effect....................................................................................................... Net-of-tax amount....................................................................................... Total $ 2010 635 443 192 65 127 (21) (7) (14) 113 $ $ 2009 1,364 355 1,009 344 665 9 3 6 671 $ $ 2008 (1,502) (833) (669) (227) (442) 56 19 37 (405) 41 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Accumulated other comprehensive income, a component of equity, was comprised of the following at December 31: (Dollars in thousands) Unrealized holding gains (losses) on available for sale securities ........................................ $ Unrecognized actuarial gains on postretirement benefit plan ............................................... Tax effect.............................................................................................................................. Net accumulated other comprehensive income..................................................................... $ Note 17 – Condensed Financial Statements of Parent Company (Dollars in thousands) Condensed Balance Sheets 2010 1,084 280 (464) 900 $ $ 2009 892 301 (406) 787 December 31 2010 Assets Cash ................................................................................................................................. $ Securities available for sale ............................................................................................. Other assets...................................................................................................................... Investment in ChoiceOne Bank ....................................................................................... Total assets ................................................................................................................. $ Liabilities Mandatory redeemable shares under ESOP, at fair value................................................ $ Other liabilities ................................................................................................................ Total liabilities............................................................................................................ 201 207 76 53,899 54,383 64 6 70 Shareholders’ equity ............................................................................................................. Total liabilities and shareholders’ equity.................................................................... $ 54,313 54,383 $ $ $ $ (Dollars in thousands) Years Ended December 31 Condensed Statements of Income Interest and dividends from ChoiceOne Bank ......................................... $ Interest and dividends from other securities ............................................ Gains on sales of securities...................................................................... Total income............................................................................................ Other expenses......................................................................................... Income before income tax and equity in undistributed net income of subsidiary............................................................................. Income tax benefit ................................................................................... Income before equity in undistributed net income of subsidiary ............. Equity in undistributed net income (distributions in excess of net income) of subsidiary ................................................................. Net income............................................................................................... $ 2010 1,641 7 — 1,648 67 1,581 23 1,604 1,107 2,711 $ $ 42 2009 81 202 59 52,655 52,997 48 23 71 52,926 52,997 2008 2,017 27 18 2,062 61 2,001 26 2,027 $ 2009 938 17 17 972 67 905 17 922 556 1,478 $ ) (592 1,435 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Condensed Statements of Cash Flows (Dollars in thousands) Cash flows from operating activities: Net income............................................................................................ $ Adjustments to reconcile net income to net cash from operating activities: Equity in (undistributed net income) distributions in excess of net income of subsidiary.............................................................. Amortization....................................................................................... Gains on sales of securities................................................................. Changes in other assets ....................................................................... Changes in other liabilities ................................................................. Net cash from operating activities ................................................. Cash flows from investing activities: Sales of securities ................................................................................. Maturities of securities ......................................................................... Purchases of securities.......................................................................... Net cash from (used in) investing activities ................................... Cash flows from financing activities: Issuance of common stock .................................................................... Cash dividends paid.............................................................................. Net cash used in financing activities.............................................. Years Ended December 31 2010 2009 2008 2,711 $ 1,478 $ 1,435 (1,107) — — (17) (18) 1,569 — 200 (202) (2) 125 (1,572) (1,447) (556) 2 (17) 3 30 940 524 — — 524 126 (1,563) (1,437) 592 2 (18) 3 (13) 2,001 40 — — 40 147 (2,202) (2,055) (14) 68 54 Net change in cash and cash equivalents ................................................. Beginning cash and cash equivalents....................................................... Ending cash and cash equivalents............................................................ $ 120 81 201 $ 27 54 81 $ Note 18 – Financial Instruments Financial instruments as of December 31 were as follows: (Dollars in thousands) Assets: Cash and due from banks........................................$ Federal funds sold................................................... Securities available for sale .................................... Federal Home Loan Bank and Federal Reserve Bank stock ......................................................... Loans held for sale.................................................. Loans, net ............................................................... Accrued interest receivable..................................... Liabilities: Demand, savings and money market deposits......... Time deposits.......................................................... Repurchase agreements........................................... Advances from Federal Home Loan Bank.............. Accrued interest payable......................................... 2010 2009 Carrying Amount Estimated Fair Value Carrying Amount Estimated Fair Value $ 19,074 5,000 90,820 $ 19,074 5,000 90,820 $ 9,957 9,793 74,413 4,159 1,610 314,781 2,000 229,378 159,616 22,251 8,947 231 4,574 322 318,394 2,091 199,418 165,592 20,684 21,980 377 4,159 1,610 312,211 2,000 229,378 160,506 22,249 8,473 231 43 9,957 9,793 74,413 4,574 322 314,491 2,091 199,418 165,597 20,686 21,986 377 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The estimated fair values approximate the carrying amounts for all assets and liabilities except those described later in this paragraph. The methodology for determining the estimated fair value for securities available for sale is described in Note 19. The estimated fair value for loans is based on the rates charged at December 31 for new loans with similar maturities, applied until the loan is assumed to reprice or be paid. The allowance for loan losses is considered to be a reasonable estimate of discount for credit quality concerns. The estimated fair values for time deposits and FHLB advances are based on the rates paid at December 31 for new deposits or FHLB advances, applied until maturity. The estimated fair values for other financial instruments and off-balance sheet loan commitments are considered nominal. Note 19 – Fair Value Measurements The following tables present information about the Bank’s assets and liabilities measured at fair value on a recurring basis at December 31, 2010 and December 31, 2009, and the valuation techniques used by the Bank to determine those fair values. In general, fair values determined by Level 1 inputs use quoted prices in active markets for identical assets or liabilities that the Bank has the ability to access. Fair values determined by Level 2 inputs use other inputs that are observable, either directly or indirectly. These Level 2 inputs include quoted prices for similar assets and liabilities in active markets, and other inputs such as interest rates and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs, including inputs that are available in situations where there is little, if any, market activity for the related asset or liability. In instances where inputs used to measure fair value fall into different levels in the above fair value hierarchy, fair value measurements in their entirety are categorized based on the lowest level input that is significant to the valuation. The Bank’s assessment of the significance of particular inputs to these fair value measurements requires judgment and considers factors specific to each asset or liability. There were no liabilities measured at fair value as of December 31, 2010 or December 31, 2009. Disclosures concerning assets measured at fair value are as follows: Assets Measured at Fair Value on a Recurring Basis (Dollars in Thousands) Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) Balance at Date Indicated Investment Securities, Available for Sale – December 31, 2010 U.S. Government and federal agency State and municipal Mortgage-backed Corporate FDIC-guaranteed financial institution debt Equity securities Total Investment Securities, Available for Sale - December 31, 2009 U.S. Government and federal agency State and municipal Mortgage-backed Equity securities Total $ 29,066 — — 2,883 2,053 — $ 34,002 $ 18,571 1,904 8,929 954 $ 30,358 $ — 45,542 7,599 — — 838 $ 53,979 $ — 40,388 — 860 $ 41,248 $ — 2,339 — — — 500 $ 2,839 $ — 2,307 — 500 $ 2,807 $ 29,066 47,881 7,599 2,883 2,053 1,338 $ 90,820 $ 18,571 44,599 8,929 2,314 $ 74,413 44 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Changes in Level 3 Assets Measured at Fair Value on a Recurring Basis (Dollars in Thousands) Investment Securities, Available for Sale Balance at December 31, 2009 Total realized and unrealized gains included in income Total unrealized gains included in other comprehensive income Net purchases, sales, calls, and maturities Net transfers into Level 3 Balance at December 31, 2010 $ 2,807 — 10 (284) 306 $ 2,839 Of the Level 3 assets that were still held by the Bank at December 31, 2010, the net unrealized gain for the twelve months ended December 31, 2010 was $10,000, which is recognized in other comprehensive income in the consolidated balance sheet. There were no sales or purchases of Level 3 securities in 2010. One security was reclassified from a Level 2 measurement of fair value to a Level 3 measurement in 2010 as a result of a change in the marketability of the security. Both observable and unobservable inputs may be used to determine the fair value of positions classified as Level 3 assets and liabilities. As a result, the unrealized gains and losses for these assets and liabilities presented in the tables above may include changes in fair value that were attributable to both observable and unobservable inputs. Available for sale investment securities categorized as Level 3 assets consist of bonds issued by local municipalities and a trust preferred security. The Bank estimates the fair value of these assets based on the present value of expected future cash flows using management’s best estimate of key assumptions, including forecasted interest yield and payment rates, credit quality and a discount rate commensurate with the current market and other risks involved. The Bank also has assets that under certain conditions are subject to measurement at fair value on a non-recurring basis. These assets are not normally measured at fair value, but can be subject to fair value adjustments in certain circumstances, such as impairment. Disclosures concerning assets measured at fair value on a non-recurring basis are as follows: Assets Measured at Fair Value on a Non-recurring Basis (Dollars in Thousands) Significant Balance at Dates Indicated Quoted Prices in Active Markets for Identical Assets (Level 1) Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) Total Losses for the Period Ended Impaired Loans December 31, 2010 December 31, 2009 Other Real Estate December 31, 2010 December 31, 2009 $ 6,573 $ 9,747 $ 1,953 $ 2,201 $ – $ – $ – $ – $ – $ – $ – $ – $ 6,573 $ 9,747 $ 164 $ 1,855 $ 1,953 $ 2,201 $ 528 $ 319 Impaired loans categorized as Level 3 assets consist of non-homogeneous loans that are considered impaired. The Bank estimates the fair value of the loans based on the present value of expected future cash flows using management’s best estimate of key assumptions. These assumptions include future payment ability, timing of payment streams, and estimated realizable values of available collateral (typically based on outside appraisals). The changes in fair value consisted of charge-downs of impaired loans that were posted to the allowance for loan losses and write-downs of other real estate that were posted to a valuation account. The fair value of other real estate owned was based on appraisals or other reviews of property values, adjusted for estimated costs to sell. Note 20 – Off-Balance Sheet Activities Some financial instruments, such as loan commitments, credit lines, letters of credit, and overdraft protection, are issued to meet customers’ financing needs. These are agreements to provide credit or to support the credit of others, as long as conditions established in the contract are met, and usually have expiration dates. Commitments may expire without being used. Off-balance sheet risk to 45 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS credit loss exists up to the face amount of these instruments, although material losses are not anticipated. The same credit policies are used to make such commitments as are used for loans, including obtaining collateral at exercise of the commitment. The contractual amount of financial instruments with off-balance sheet risk was as follows at December 31: (Dollars in thousands) 2010 2009 Fixed Rate Variable Rate Fixed Rate Variable Rate Unused lines of credit and letters of credit ..................$ Commitments to fund loans (at market rates) .............. 5,370 5,088 $ 42,985 3,000 $ 4,246 4,683 $ 41,575 1,190 Commitments to fund loans are generally made for periods of 180 days or less. The fixed rate loan commitments have interest rates ranging from 4.00% to 7.00% and maturities ranging from 2 years to 30 years. Note 21 – Regulatory Capital ChoiceOne Bank is subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance sheet items calculated under regulatory accounting practices. The prompt corrective action regulations provide five classifications, including well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If only adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as are asset growth and expansion, and plans for capital restoration are required. At year-end 2010 and 2009, the most recent regulatory notifications categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Bank’s categories. Actual capital levels and minimum required levels for ChoiceOne Bank were as follows: (Dollars in thousands) Actual Minimum Required for Capital Adequacy Purposes Amount Ratio Amount Ratio Minimum Required to be Well Capitalized Under Prompt Corrective Action Regulations Amount Ratio December 31, 2010 Total capital (to risk weighted assets) .................$ Tier 1 capital (to risk weighted assets)................ Tier 1 capital (to average assets)......................... 40,588 36,654 36,654 12.1% 10.9 7.9 December 31, 2009 Total capital (to risk weighted assets) .................$ Tier 1 capital (to risk weighted assets)................ Tier 1 capital (to average assets)......................... 39,130 35,073 35,073 11.9% 10.7 8.0 $ $ 26,787 13,393 18,502 26,278 13,139 17,450 $ $ 8.0% 4.0 4.0 8.0% 4.0 4.0 33,483 20,090 23,128 10.0% 6.0 5.0 32,847 19,708 21,812 10.0% 6.0 5.0 Banking regulations limit capital distributions by state-chartered banks. Generally, capital distributions are limited to undistributed net income for the current and prior two years. At December 31, 2010, approximately $1,071,000 was available for ChoiceOne Bank to pay dividends to ChoiceOne Financial Services, Inc. ChoiceOne’s ability to pay dividends to shareholders is dependent on the Bank, which is restricted by state law and regulations. 46 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 22 – Quarterly Financial Data (Unaudited) (Dollars in thousands) Interest Income Net Interest Income Net Income Earnings Per Share Fully Diluted Basic 2010 First Quarter Second Quarter Third Quarter Fourth Quarter 2009 First Quarter Second Quarter Third Quarter Fourth Quarter $ $ $ $ 5,438 5,494 5,507 5,522 5,913 5,816 5,794 5,563 4,060 $ 4,210 4,289 4,436 3,898 $ 4,018 4,084 3,996 644 669 739 659 741 305 409 23 $ 0.20 0.20 0.23 0.20 $ 0.23 0.09 0.13 0.00 $ 0.20 0.20 0.23 0.20 $ 0.23 0.09 0.13 0.00 There were no significant fluctuations in the quarterly financial data in 2010. The low net income in the fourth quarter of 2009 resulted from a higher provision for loan losses. The provision for loan losses in the fourth quarter of 2009 was $1,700,000, compared to a provision of $3,175,000 for the first three quarters of 2009. 47 ChoiceOne Financial Services, Inc. CORPORATE AND SHAREHOLDER INFORMATION Corporate Headquarters ChoiceOne Financial Services, Inc. 109 East Division Street Sparta, Michigan 49345 Phone: (616) 887-7366 Fax: (616) 887-7990 Website: www.choiceone.com Market Makers in ChoiceOne Financial Services, Inc. Stock Howe Barnes Hoefer & Arnett Chicago, Illinois (800) 800-4693 Kent King Securities, Division of Royal Securities, Inc. Grand Rapids, Michigan (616) 459-3317 (800) 321-9171 Stifel Nicolaus & Company, Inc. Grand Rapids, Michigan (616) 942-1717 (800) 676-0477 Stock Registrar and Transfer Agent Registrar and Transfer Company 10 Commerce Drive Cranford, New Jersey 07016 (800) 368-5948 Annual Shareholder Meeting The 2011 Annual Shareholder Meeting of ChoiceOne Financial Services, Inc., will be held at 11:00 a.m. local time on Thursday, April 28, 2011, at Moss Ridge Golf Club in Ravenna, Michigan. ChoiceOne Bank Alpine Office 5050 Alpine Avenue NW Comstock Park, Michigan 49321 ChoiceOne Insurance Agencies, Inc. Sparta Office 109 East Division Street Sparta, Michigan 49345 Cedar Springs Office 4170 – 17 Mile Road Cedar Springs, Michigan 49319 Coopersville Office 661 West Randall Street Coopersville, Michigan 49404 Egelston Office 5475 East Apple Avenue Muskegon, Michigan 49442 Fremont Office 1423 West Main Street Fremont, Michigan 49412 Grant Office 10 West Main Street Grant, Michigan 49327 Kent City Office 450 West Muskegon Street Kent City, Michigan 49330 Newaygo Office 246 West River Drive Newaygo, Michigan 49337 Ravenna Office 3069 Slocum Road Ravenna, Michigan 49451 Rockford Office 6795 Courtland Drive Rockford, Michigan 49341 Sparta - Main Office 109 East Division Street Sparta, Michigan 49345 Sparta - Appletree Office 416 West Division Street Sparta, Michigan 49345 White Cloud Office 47 South Charles Street White Cloud, Michigan 49349 48 Officers ChoiceOne Financial Services, Inc. James A. Bosserd President and Chief Executive Officer Louis D. Knooihuizen Senior Vice President Michael E. McHugh Senior Vice President Linda R. Pitsch Secretary Thomas L. Lampen Treasurer ChoiceOne Financial Services, Inc. DIRECTORS AND OFFICERS Directors ChoiceOne Financial Services, Inc. (continued) Nels W. Nyblad President, Nyblad Orchards (Fruit Producer) Roxanne M. Page CPA and Partner, Beene Garter LLP (Certified Public Accountants) Jon E. Pike CPA and Chairman, Beene Garter LLP (Certified Public Accountants) Donald VanSingel Former Consultant, Governmental Consultant Services. Former Legislator, Michigan House of Representatives Director Emeritus Richard L. Edgar Former Director and Chairman of the Board, ChoiceOne Financial Services, Inc. and ChoiceOne Bank. Former President and Chief Executive Officer, Valley Ridge Financial Corp. and Valley Ridge Bank Directors ChoiceOne Financial Services, Inc. Jerome B. Arends Former President and Chief Executive Officer of Ravenna Farm Equipment (Agricultural Equipment Supplier) Frank G. Berris President and Chief Executive Officer, American Gas & Oil Co., Inc. (Distributor of Petroleum Products) James A. Bosserd President and Chief Executive Officer, ChoiceOne Financial Services, Inc. and ChoiceOne Bank K. Timothy Bull President, Moon Lake Orchards, Inc. (Fruit Producer) William F. Cutler, Jr. Former Vice President, H. H. Cutler Co. (Apparel Manufacturer) Lewis G. Emmons President, Emmons Development; President, Brat Development (Real Estate Development) Stuart Goodfellow Owner, Goodfellow Blueberry Farms and Former Owner, Goodfellow Vending Services (Vending Company) Gary Gust Former President, Gust Construction Company (General Contractor) Paul L. Johnson Former President, Falcon Resources, Inc. (Automotive and Furniture Design) Dennis C. Nelson, DDS General Dentistry 49 Officers ChoiceOne Bank James A. Bosserd President Chief Executive Officer Sheila R. Clark Senior Vice President Human Resources Director Mary J. Johnson Senior Vice President Cashier Louis D. Knooihuizen Senior Vice President Chief Lending Officer Michael E. McHugh Senior Vice President Accounting, Sales and Marketing Linda R. Pitsch Senior Vice President Operations Kelly J. Potes Senior Vice President Retail Services Linda K. Anderson Vice President Office Manager – Rockford Customer Service Center Manager Lee A. Braford Vice President Commercial Loans and Credit Risk Amy S. Homich Vice President Business Development Officer Thomas L. Lampen, CPA Vice President Chief Financial Officer Valerie F. VanKlompenberg Vice President Information Systems Officer Daniel C. Wheat Vice President Consumer Loan Sales Office Manager – Grant Brian R. Bacon Assistant Vice President Commercial Loans Marilyn B. Childress Assistant Vice President Mortgage Loans Officers ChoiceOne Bank (continued) Officers ChoiceOne Bank (continued) Judy A. Schulz Assistant Vice President Collections Manager Cynthia J. Watson Assistant Vice President Operations Marva J. Zeldenrust Assistant Vice President Office Manager – Fremont Sally K. Anderson Credit Analyst Officer Jennifer M. Bellamy Office Manager – Kent City Candace J. Bouwkamp Administrative Services Manager Erin M. Burdick-Bloom Office Manager – Alpine Lee J. Decker Office Manager – Egelston Officers ChoiceOne Insurance Agencies, Inc. James A. Bosserd President Kelly J. Potes, CFP Senior Vice President Randy A. Schmidt, CFP Vice President Linda R. Pitsch Secretary Thomas L. Lampen, CPA Treasurer Rita A. Flintoff Assistant Vice President Office Manager – Newaygo and White Cloud Denise L. Gates Assistant Vice President Office Manager – Cedar Springs Gregory M. Goss Assistant Vice President Security Officer Stephen P. Grey Assistant Vice President Commercial Loans, Credit Department Manager Jason J. Herbig Assistant Vice President Information Technology Rebecca J. Johnson Assistant Vice President Retail Banking Kevin T. Kelling Assistant Vice President Mortgage Loans Sales & Operations Bonnie K. Koehn Assistant Vice President Office Manager – Sparta Linda S. Nichols Assistant Vice President Office Manager – Ravenna Lori J. O’Brien Assistant Vice President Commercial Loans Peggy A. O’Dea Assistant Vice President Office Manager – Coopersville Ryan F. Peacock Assistant Vice President Commercial Loan Officer Maria J. Roossinck Assistant Vice President Risk Management Paul E. Tucker Assistant Vice President Information Technology 50

Continue reading text version or see original annual report in PDF format above